Puzzle times three: Scope 3 for finance

Scope 3 disclosures are complex and Category 15 (investments) is an opaque segment that covers emissions resulting from one company’s involvement with one other (i.e. financial transactions).¹For most firms, it is a proverbial footnote of their overall emissions profile. Given the unique conceptual and data challenges of Category 15, it isn’t any coincidence that it’s at the underside of the Scope 3 catalogue.

However, for financial institutions, financial transactions are their core business, which is why Category 15 emissions are a critical a part of their overall emissions disclosures.

Compared to other industries, financial institutions typically generate low emissions in categories 1 and a couple of, that are mainly generated in offices and Electricity consumption. Financial institutions produce limited emissions from most Scope 3 categories, and these emissions are mainly related to the products and services they purchase and to business travel.

In contrast, their Category 15 emissions are exceptionally high. On average, over 99% of a financial institution’s total emissions footprint comes from Category 15 emissions.²

Financed and facilitated emissions

Category 15 issues from financial institutions include and. Funded issues are on-balance sheet issues from direct lending and investment activities. These include issues from an organization to which a bank lends or during which an asset manager holds shares. Facilitated issues are off-balance sheet issues from the facilitation of capital market services and transactions. An example is issues from an organization that an investment bank helps to issue debt or equity. Securities or for whom it arranges a loan through syndication.

Financed and facilitated emissions are key to understanding the climate risk exposure of monetary institutions. This could possibly be of great importance for a bank with a big loan portfolio focused on airlines, for instance, or an insurance company specialising in oil and gas activities. It is subsequently not surprising that various stakeholders have advocated for more disclosuresThese include the Partnership for Carbon Accounting Financials (PCAF), the Principles for Responsible Investing (PRI), the Glasgow Financial Alliance for Net Zero (GFANZ), the Science Based Targets Initiative (SBTi), CDP and the Transition Pathway Initiative (TPI).

As Scope 3 disclosures grow to be mandatory in several jurisdictions, this becomes much more pressing for the financial industry. For example, the European Union’s Corporate Sustainability Reporting Directive requires all large firms listed on its regulated markets to reveal their Scope 3 emissions, and similar requirements are emerging in other jurisdictions world wide. While disclosure rules don’t typically dictate which Scope 3 emission categories must be included in disclosures, they typically require that material categories be covered, making it difficult for financial institutions to argue against disclosing their financed and enabled emissions.

This poses a big challenge. Figure 1 shows that financial institutions’ Scope 3 reporting rates are amongst the very best of all sectors. Only one-third of monetary institutions disclose their financed emissions and infrequently only cover parts of their portfolios.³ So far, few have attempted to reveal the emissions they cause. A recent report by TPI examining the climate disclosures of 26 global banks shows that none of them has fully disclosed the emissions they financed or enabled.⁴

Three key challenges

To improve their reporting rate, financial institutions must address three key challenges in disclosing their financed and supported emissions.

First, unlike other Scope 3 categories, the framework for reporting financed and facilitated emissions is in some ways evolving and incomplete. The accounting rules for financed emissions were only finalised by the PCAF in 2020 and adopted by the Greenhouse Gas (GHG) Protocol – the worldwide standard setter for greenhouse gas accounting.⁵ These codify the accounting rules for banks, asset managers, asset owners and insurance firms. Rules for facilitated emissions will follow from 2023⁶covering major investment banks and brokerage services. Those for reinsurance portfolios are currently awaiting approval of the GHG Protocol⁷while for a lot of other varieties of financial institutions (not least exchanges and data providers like us) no rules currently exist.

Exhibition 1.

Source: LSEG, CDP. Companies reporting material and other Scope 3 in comparison with non-reporting firms within the FTSE All-World Index 2022, by sector

Second, collecting customer emissions data presents significant challenges. In principle, the calculations of funded and assisted emissions are quite easy. They require two foremost inputs: the Scope 1, 2 and three emissions generated by a customer’s business and an allocation factor that determines the share of a customer’s emissions to which a reporting financial institution is exposed or responsible.

In practice, financial institutions often shouldn’t have robust issuance data for big parts of their diverse customer base. Such data is commonly available for big, listed firms, but rarely for personal firms or SMEs, which usually make up a big part of monetary institutions’ customer base. This can result in enormous data gaps in financial institutions’ emissions databases.

Annex 2. Characteristics of the emission standards funded and supported by PCAF^5.6

Third, there are complexities across the attribution aspects. For funded emissions, these are the ratio of investments and/or outstanding loan balance to the client’s enterprise value. However, market fluctuations in equity prices complicate this picture and might result in fluctuations in funded emissions that should not linked to the actual emissions profile of client firms.^eighth

With facilitated emissions, the identical problem still exists, but in a fair worse form. Determining appropriate allocation aspects is commonly conceptually difficult because financial institutions conduct financial transactions in countless other ways, from issuing securities to Assumption of syndicated loansAs HSBC’s Chief Sustainability Officer recently stated:⁹ “These things sit on our books sometimes for hours, days or weeks. Just like the corporate lawyer involved in that transaction or one of the big four accounting firms … they facilitate the transaction. That’s not really our financing.”

Next Steps?

Given this complexity and the numerous reporting burden, funded and facilitated issuances are more likely to proceed to cause headaches for reporting firms, investors and regulators for a while to return.

In the meantime, proxy data and estimates are more likely to play a vital role in closing disclosure gaps. One concrete way forward could possibly be to encourage financial institutions to higher disclose the breakdown of their customer books by sector and region. This data is quickly available but rarely published. This could enable investors and regulators to realize a greater, albeit incomplete, understanding of monetary institutions’ transition risk profile as reporting systems for funded and supported issuance proceed to mature.

resources

FTSE Russell’s potential for improvement report addresses 10 key questions on Scope 3 emissions and proposes solutions to enhance data quality.

Footnotes