Tackling 'financed emissions' as the gateway to a greener economy

The urgency of addressing climate change and transitioning to a greener economy has become increasingly evident in recent years. As countries and industries strive to cut their carbon footprints, the concept of "financed emissions" has gained widespread attention.

The term refers to the emissions resulting from investments and financial activities, including loans, investments and portfolios. Understanding and mitigating financed emissions presents an opportunity to reshape our financial systems and drive the transition towards a greener economy.

According to StepChange’s estimates, more than 15% of India’s greenhouse gas emissions can be attributed to the production and consumption of goods and services financed by scheduled commercial banks, with a significant multiplier effect on the rest of the economy. This staggering figure highlights how financial institutions are uniquely positioned to influence other actors through their investment and lending activities.

The business case for financial institutions to set net-zero targets for their investment and lending portfolios is based on a four-part rationale:

Policy: Financial institutions with targets are better positioned to respond to new regulatory adjustments as governments ramp up climate action efforts.

Resilience: Futureproof business models by mitigating climate-related risks to portfolios.

Demand: Clients are increasingly demanding climate actions by financial institutions.

Innovation: Science-based targets (SBTs) help direct financial institution innovation toward potentially higher-margin products that support emissions reductions.

For effective climate change mitigation, financial institutions must holistically address commitments, measurement of emissions/disclosure, scenario analysis, target setting, implantation actions and reporting.

Encouragingly, financial institution SBTs quadrupled globally in 2022, led by US, European, Taiwanese and South Korean institutions. However, many commitments only cover scope 1 and 2 emissions, which relate to those owned or controlled by the company itself.

Understanding the importance of the indirect emissions covered by scope 3, Category 15 investments – also referred to as “financed emissions” – means reassessing how to quantify and qualify these downstream emissions attributable to lending and investment activities. For some financial institutions, these emissions are approximately 700 times larger than their direct emissions and, therefore, should be a major focus.

Measuring and attributing the emissions associated with products and services across various geographies, sectors, product types, and line of business originations presents unique challenges to any financial institution.

Determining scoping boundaries, calculation approaches and relevant touchpoints with the financial product, customer, geography, sector and underlying operating assets is essential.

Estimating and attributing financed emissions is a complex exercise, with many potential risks around double counting. There are several products and services in the market which are trying to simplify the net zero journey for financial institutions.

Given the size of the Indian economy, a top-five bank can expect to have a financed emissions footprint in excess of 50 million tonnes of CO2e – more than the total emissions attributed to countries like Norway and Switzerland, estimates from StepChange suggest.

Also, a large majority of funding for Indian corporations and smaller businesses alike comes from banks through loans as opposed to equity or bonds, meaning that banks can plan an outsized role in helping decarbonize the Indian economy.

The Reserve Bank of India (RBI) released its Discussion Paper on Climate Risk and Sustainable Finance in July 2022, along with the results of a survey on climate risk and sustainable finance undertaken in January 2022.

In RBI’s assessment, the survey responses indicate that although Indian banks have begun taking steps in climate risk and sustainable finance, there are huge gaps and a need for immediate and robust actions.

Here are some things the banks must do in order to step up their efforts:

Board Agenda: Banks need to make climate part of the board agenda, with a committee empowered to drive climate risk and sustainability initiatives.

Net zero ambition: Banks should set up and publicly announce clear ambition in terms of timelines to get to net zero emissions in line with international guidelines (like the Science Based Targets initiative, or SBTi) and India’s updated nationally determined contributions.

Climate risk: Banks need to start putting a framework around types of the physical and transition risks associated with climate change and actively start managing them at a loan and portfolio level.

Opportunities: Most importantly, banks should deeply understand the new opportunities created because of the green transition and support them.

Measure and reduce: Banks need to start measuring their own financed emissions in line with Partnership for Carbon Accounting Financials and SBTi guidelines and drive emissions reduction.

Report: Banks need to align climate-related financial disclosures with an internationally accepted framework to improve the comparability and consistency of the disclosures with their global counterparts.

According to the World Meteorological Organization, there is a 66% likelihood of the annual average near-surface global temperature exceeding 1.5°C above pre-industrial levels for at least one year between 2023 and 2027 and a 98% likelihood that this five-year period will be the warmest on record. This will have far-reaching repercussions for health, food security, water management and the environment.

These developments necessitate an immediate, large-scale reduction in greenhouse gas emissions. Recognizing the significant influence of banks and financial institutions on economic activity, it is crucial for them to take a leading role in combating climate change.

By integrating ESG factors in financial decision-making, incorporating carbon pricing mechanisms, managing climate risk in portfolios and investing in sustainable projects, the financial sector can effectively address financed emissions and become the gateway to a greener economy.