Managing financed emissions: How banks can support the net-zero transition – EQ Mag

Banks finance carbon-emitting businesses, and they finance decarbonization of the economy, as well. How effectively they address financed emissions can make all the difference.

Over the past few years, many banks have made public commitments to reduce their “financed emissions,”1 meaning the emissions they finance in the real economy, in line with the objectives of the Paris Agreement. This commitment is seen in the number of banks joining the Net-Zero Banking Alliance (NZBA), which grew from 43 to 122 banks, representing 40 percent of global banking assets, in just over a year. Membership requires that banks commit to transitioning the emissions from their lending and investment portfolios to align with a net-zero pathway. Even more banks have conducted internal assessments of their financed emissions and are considering whether they want to set a public target. Yet more are considering the journey to measure and set targets for their financed emissions. Stakeholders increasingly expect such efforts, and in many geographies, emerging regulatory requirements will change the disclosure of financed emissions from a voluntary task to one required by financial or securities regulation.

The process of assessing and setting targets for financed emissions is far from simple. It involves multiple complexities arising from differences between sectors, geographic variation, shifting counterparty plans, changing industry standards, and a nascent and rapidly evolving data environment, to name a few forces. Furthermore, the actions that banks take to achieve targets often create pressure on other objectives, such as revenue growth in critical business areas, and require changes to key processes and policies—a situation that calls for careful reconciliation. Finally, banks must balance their goal of reducing financed emissions with the simultaneous goal of financing reduced emissions—which often involves increasing financing to responsibly heavy emitters who need capital to decarbonize their businesses.

Against this backdrop, best practices are emerging. These can enable banks to create durable, reliable emissions measurement capabilities; set and monitor progress toward well-defined targets; and identify opportunities to support clients in their decarbonization transition. In this article, we outline some of the most critical insights for conducting effective financed emissions baselining and target setting, following a six-step process (Exhibit 1).

Step 1: Measuring the financed emissions baseline

Before they can set objectives, decision makers need to establish their starting point. The emission baseline is a “footprint”—a measure of emissions in a specific time period, such as a year—that is taken as the starting point against which to measure change. A robust and accurate baseline is critical to understanding the current state of a bank’s business, the distance to be traveled, and the practical client and operational considerations that must be addressed.

Building a robust emissions baseline requires clear definitions of what the bank will measure in terms of the following criteria:

• Breadth of sector coverage. Most banks that have measured their financed emissions baseline have started with a short list of prioritized heavy-emitting sectors, such as oil and gas, power generation, automotive, and mining. The NZBA requires its members to eventually set sector-level targets for priority sectors: agriculture, aluminum, cement, coal, commercial real estate, residential real estate, iron and steel, oil and gas, power generation, and transport. It is important to note that the Science Based Targets initiative has set standards for some, but not all, of these sectors. We recommend undertaking this exercise in waves, starting initially with a few priority sectors and then moving to cover the remaining sectors required by NZBA and regulation, as well as any other sectors that constitute the majority of a bank’s portfolio. This creates a comprehensive view of the portfolio and prepares the organization for measurement and action on climate commitment.
• Asset class coverage. Currently, the Partnership for Carbon Accounting Financials (PCAF)—the financial industry’s primary greenhouse-gas accounting standards body—has provided guidance for six asset classes: listed equities and corporate bonds, business loans and unlisted equities, project finance, commercial real estate, mortgages, and motor vehicle loans. Draft methods have also been published for green bonds, sovereign bonds, and emissions removals. However, the coverage may extend further, as many banks have significant portfolios in other asset classes.2
• Parts of value chain included. Typically, banks include only specified value chain components in the baseline. This follows the approach pioneered by the Katowice banks as part of the Paris Agreement Capital Transition Assessment (PACTA) developed by the 2° Investing Initiative (2DII).3 The value chain segments in focus are those that control the source of the majority of emissions in a given sector. For example, for automotive manufacturing, the focus is ordinarily on automotive manufacturers (not upstream suppliers of parts or downstream users), as they control the choice of vehicle engine, which ultimately determines emissions.
• Greenhouse gases included. Some banks have included only CO2 in their emissions measurement, but other gases, especially methane, are critical drivers of emissions in certain sectors, including oil and gas and especially agriculture. We recommend as broad a definition as feasible, including all greenhouse gases, especially where they constitute the majority of emissions, as in agriculture. Doing so allows the bank to obtain a more holistic picture of its emissions baseline. The resulting data can be captured in a CO2-equivalent metric.
• Scope of emissions. For covered counterparties in the bank’s portfolio, the baseline typically should include Scope 1 emissions (direct emissions, as from fossil-fuel combustion) and Scope 2 emissions (indirect emissions, as from purchasing electricity, heat, or steam). It should include Scope 3 emissions (emissions from use of products) where they are material, as in oil, gas, and mining. We recommend including Scope 3 in part because international standards and regulatory requirements tend to include Scope 3—but also because insight into Scope 3 at a counterparty level is critical to enabling business development activities.
• Time period for baseline. Most guidance recommends using the latest available year, which often means at least a one-year lag, based on when emissions reports are available. We recommend using the latest available data and noting any trends that affect potential target setting, with some exceptions where explicitly guided by industry standards (for example, in aviation, where the COVID-19 pandemic resulted in very different emissions profiles in 2020 and 2021 than the norm).
• Legal entities and attribution. The measurement and attribution of emissions requires understanding in which sector the legal entities are active. For example, a diversified company might span multiple sectors. Sometimes financing might be identified for a specific purpose or sector, such as a renewable-energy investment that requires bank finance; often, however, sector classification is not straightforward. We recommend taking as granular an approach as feasible, given the existing data, and considering a future tagging system to understand what will be financed.
• Data and attribution. In assessing portfolio emissions, banks should work to identify the best possible data source and decide how emissions are attributed. The climate data landscape is currently disparate and requires a carefully crafted data strategy that incorporates a clear climate data ownership model and an operating model for processes and procedures related to climate data acquisition and use, all built around a set of use cases. Often this requires combining multiple inputs—counterparties’ own data, third-party data sources, and where available, emissions estimates using public data sets for proxy development—and ensuring they are consistent. Estimates often rely on using emissions factors, which can be drawn from various sources (and are of varying quality). Corporate reporting of carbon emissions remains unstandardized in most geographies and is often not required for non-listed companies. However, efforts are under way to address this,4 which may increase data quality and coverage.
• Score the data. Working with the preceding criteria, the bank should assess the quality of the baseline data. Scoring methods exist for rating data coverage and quality; an example is PCAF’s data quality score. Scoring enables a better understanding of how reliable the data are and where improvements are needed for future iterations of the emissions baseline.

Step 2: Projecting the portfolio’s momentum case

Banks should build a momentum case—a view about what will happen to a given sector or given counterparty—for each sector. The momentum case is essentially the unmanaged outcome: If the bank continued to finance its current counterparties at the current rate, what would its financed emissions be next year, in 2025, and in 2030? The momentum case is based on counterparties’ announced targets and aspirations, industry and asset-level forecasts, and announced government policies and targets. Banks can also create bespoke scenarios and simulate sensitivities within the portfolio (for example, counterparties drawing on their lending facility, or counterparties missing their announced targets).

The projections in this step will be most accurate and relevant if the process includes the following efforts:

• Detailed counterparty-level analysis of announced targets. Banks should deeply understand announced targets, particularly for the high-exposure and high-emission counterparties. In some cases, this requires translating different counterparties’ announced targets to a comparable metric and aligning targets set by parent companies with those of their subsidiaries, which typically have different emissions profiles and hence trajectories. This work may get simpler, because sources that provide emissions data (for example, CDP, Planetrics by McKinsey, Transition Pathway Initiative, and Trucost) are starting to make data on targets available.
• Involvement of sector bankers and sector expertise. Because momentum cases are fundamentally views about a given sector or given counterparty, it is critical that a bank’s momentum cases take into account the knowledge of its individual bankers who serve clients in those sectors. This is particularly true in the sectors that are the largest exposures for a bank and where it likely has the most internal expertise.
• Accounting for realistic changes to the trajectory. Banks cannot simply base their momentum cases on the “house” view of each sector. A good momentum case needs to be derisked and account for realistic assessments of how quickly a sector or large counterparties will decarbonize. Even the best-laid plans for decarbonization may be derailed by exogenous disruptions, such as macroeconomic impacts, supply chain challenges, and regulatory changes. A bank must ensure that the momentum case is reliable, as it will constitute the basis for understanding the gap to target and the actions necessary to accelerate decarbonization. To account for uncertainty, some institutions have used a range of scenarios and outcomes, as opposed to single scenarios, in developing their momentum case.
• Embedding an understanding of technology assumptions. In some instances, the momentum case is predicated on the scaling of near-term technologies. Banks should start to build insight and expertise in these technologies, given the impact they could have on the reliability of their momentum case.
• Analysis of government policies to understand their impact. It is important to understand how government targets and existing and announced policies affect counterparties’ emissions, and therefore banks’ financed emissions. This is especially true in cross-cutting sectors such as power—which often represent the majority of counterparties’ Scope 2 emissions. For example, a target of 100 percent clean electricity, such as the US 2035 target, has an impact on the emissions intensity of electricity-intensive sectors such as aluminum. Lastly, there are ways for banks to accelerate the achievement of policy targets that provide opportunities for “green growth.” For example, a government target for a significant proportion of heat pumps in residential real estate creates a market for products that finance their deployment.

A good momentum case needs to be derisked and account for realistic assessments of how quickly a sector or large counterparties will decarbonize.

Step 3: Selecting a reference scenario to align the portfolio

Once a bank understands the momentum case, it can model what it would take to align the portfolio with the Paris Agreement. In practice, there is not just one “Paris aligned” view of the world; rather, various organizations have published a range of reference scenarios. These represent pathways to Paris alignment and set out the associated temperature rises, probabilities, and emissions trajectories for particular sectors.

A thoughtful choice of a reference scenario for a given sector requires consideration of three issues:

• Temperature ambition. The Paris Agreement expresses an objective to keep global temperatures well below 2 degrees Celsius higher than preindustrial levels—ideally just 1.5 degrees higher. A pathway well below 2 degrees is very different from a 1.5-degree pathway: the latter requires much deeper and faster decarbonization, especially between now and 2030. Therefore, the bank’s choice of its temperature ambition has huge implications for the speed of transition required across the bank’s portfolio. The NZBA requires a 1.5-degree pathway, which means that the more than one hundred banks in the alliance globally are required to align their lending with this pathway.
• Core scenario. The existing reference scenarios are published by organizations including the Intergovernmental Panel on Climate Change,5 International Energy Agency,6 Network for Greening the Financial System, One Earth Climate Model,7 and UN Inevitable Policy Response.8 Banks should choose a scenario for each sector for which they intend to set targets.
• Scenario expansion. Off-the-shelf scenarios often lack the detail necessary to set targets for the bank’s priority sectors or geographies, or include assumptions that differ from a bank’s in-house views (for example, on new oil and gas exploration). Some banks therefore “augment” climate models to create custom versions of these scenarios, interpolating more specific geographic or industry-level data as required for their portfolios.

Step 4: Determining whether and how to achieve the pathway and capture opportunities

Once the bank has established its financed emissions baseline, developed a momentum case, and selected reference scenario, it has the information it needs for decision making, beginning with whether and how to achieve the reference scenario selected for each sector. It is critical for banks to assess if and how they can feasibly align with that pathway, taking into account the full set of business constraints they face.

In some exercises, this step receives too little attention. We believe that for banks to create a durable target approach, they must get this step right. A thorough process of feasibility assessment includes a few common components:

• Understand the business implications of potential targets. Banks need to assess what it would take, in terms of emissions reductions, new green and decarbonization finance, and P&L impact, to achieve the chosen reference scenario, while also considering capital allocation constraints, sectoral and counterparty concentration limits, and credit risk performance. Emissions feasibility assessments that are made in a vacuum—ignoring these realities—are difficult to operationalize. Determining the potential range of impacts on the business requires scenario analysis (Exhibit 2).
• Extensive involvement of the business and risk. This exercise must include the business and risk leadership for the relevant sectors. Because the business and risk partners will be implementing the required changes to meet a pathway, it is critical that they fully understand the trade-offs required and the speed of the migration of the portfolio—and believe they can execute the plan while delivering against all the constraints above.
• Identify execution levers required to achieve the target for each sector. Banks need to build a detailed approach to ensure that they achieve their emissions reductions target. A range of levers can be used to reduce financed emissions, including accelerating green finance and helping existing counterparties in their decarbonization transition.
• Purposefully identify growth opportunities. McKinsey Global Institute estimates that achievement of net zero will require about $9 trillion per year of capital expenditure until 2050 in transport, buildings, infrastructure, power, agriculture, industry, and more.9 Banks that move quickly to embed net zero into their business execution will be best placed to capture share. Areas for growth need to go beyond classic green-finance activities such as renewables lending and green bonds. There will not be enough of that business, at a high enough return, to support a successful alignment of the portfolio. A feasible pathway will need to use decarbonization finance, for example, as a tool to grow while also aligning the portfolio with emissions reduction targets. This is true for lending, and as targets begin to include facilitated emissions, it will include higher return advisory businesses as well.
• Building capabilities to understand decarbonization technologies. Hard-to-abate sectors rely heavily on new technologies to achieve net-zero targets. Banks should start building the capabilities to understand these technologies; such capabilities will open up business opportunities and support reliable credit assessments.
• Explicitly address the use of carbon credits. Counterparties can use carbon credits to pursue two objectives: to become carbon neutral, they can compensate by purchasing avoidance and reduction credits, and to become net zero, they can neutralize by purchasing removal credits. Banks need a perspective on counterparty use of carbon credits, as well as an approach to prioritize real emission reductions.

Step 5: Setting a financed emissions target (if desired), based on the reference scenario

Based on the momentum case, the reference scenario, and the feasibility assessment, banks should then decide what the target should be. In practice, the process of setting targets overlaps with the earlier work of selecting a reference scenario. Determining whether scenarios are feasible would involve estimating the business impact of achieving the target associated with each scenario and evaluating whether meeting the target would be feasible.

Setting the target requires decisions in a few key areas:

• Financed emissions target metrics. Banks generally choose metrics from among the four commonly used metrics for financed emissions. These are: absolute emissions (reduction in total sector-level financed emissions); physical intensity (reduction in emissions per unit of activity, such as kilometers traveled); economic intensity (reduction in emissions per unit of revenue); and absolute financing (reduction in exposure to a sector over time). In making a choice, considerations should include the metric’s potential impact on ability to finance clients and grow the portfolio, robustness in terms of outcomes for the environment, ease of tracking and measurement, levers available to meet the target, and relevance to the sector’s decarbonization pathway. Sometimes a bank adopts multiple metrics (see sidebar, “Other approaches to portfolio alignment”).
• Granularity. Most banks have publicly announced their targets at a sector level. However, many banks internally have cascaded those targets down to a more granular level, to ensure they are fully actionable.
• How to handle decarbonization financing. A target focused purely on reducing financed emissions may not effectively address how to finance reduced emissions. In setting targets, banks should create credible ways to measure and report their transition financing while still meeting their financed emissions targets. This approach, addressing the demand for carbon, not just the supply of carbon, will be increasingly critical to the successful transition of a lending portfolio or an advisory book of business. This includes aligning with approaches being developed by bodies such as the International Capital Markets Association that have been exploring the structuring of financial instruments for decarbonization financing.

Step 6: Embedding execution and opportunity creation into the businesses

For banks to reach targets, they must embed their net-zero commitments into their operations, including their commercial execution, credit operations, and management reporting. This effort needs to take into account the bank’s other constraints, including capital, liquidity, profitability, and reporting requirements. A complete effort involves several practices:

• Embed targets into credit policies, data, and incentives. To ensure alignment with their emissions targets, leading banks are building dedicated frameworks for activities including product development, credit assessment, and pricing. In addition, leading banks are beginning to embed emissions data into data collection processes and looking to digitize and automate the process of measuring financed emissions. Further, banks are starting to consider how to incentivize bankers to achieve net-zero targets, which can be challenging if the targets conflict with short-term returns.
• Measure, report, disclose, and adjust. Regulatory requirements and evolving investor expectations are leading banks to publish information on their emissions exposures and remediation activities. Many stakeholders are increasingly focused on the quality of that reporting and the credibility of commitments, including gaining more detailed insight into how banks will achieve and implement commitments. Finally, banks often caveat that there is some risk of restating the emissions baseline, as data and methodologies improve.
  Optimize the balance sheet for emissions. Ultimately, emissions are one more factor around which to optimize the balance sheet. Emission optimization helps make explicit the trade-off between emissions, financial objectives, and risk constraints.
• Exercise sectoral leadership in must-win sectors. In hard-to-abate sectors, some banks are working in collaboration with industry to develop solutions and standards. Banks and asset owners in the maritime industry, for example, have drafted the Poseidon Principles, which support climate standards and assessments specific to maritime shipping finance.
• Involve the board and management. In most banks, net-zero commitments have been approved by the board or CEO. During this process, it is important to go beyond traditional board governance committees (for example, risk and reputation) to tap into the expertise of all board members, including those who may have experience and insight into real-economy counterparties of the bank. In addition, it is important to bring the whole organization along on the journey. Robust and ongoing syndication is required with those on the ground, such as sector teams and those responsible for risk, finance, model risk management, and data.
• Acquire and retain talent and expertise. The industry is experiencing a shortage of deep and practical expertise on climate topics. It is critical that banks start now to improve their capabilities through both upskilling and hiring. Many new capabilities are required: capturing and appraising climate data, assessing clients’ emissions reduction targets and transition plans, and forming a perspective on specific projects and strategies a client might adopt and developing new products and offerings.
• Get and manage climate data. Sourcing client-level emissions data and other external climate data is very challenging; it often involves multiple data vendors and extracting client-level data from multiple sources, including often unstructured data sets. Several actions can support improved availability and usability of climate data, including assigning accountable data leads and clearly defining roles and responsibilities for data ownership and use, mapping the data landscape by priority use cases, building high-quality targeted data assets, and expanding the bank’s existing data architecture to incorporate climate data effectively.
• Build client engagement. Typically, banks have specialist groups handle emissions calculations and assessments in an initial set of priority sectors, which simplifies the initial task of involving the bankers and building their capabilities. However, as an institution starts to move to other sectors, involving the bankers and credit teams becomes critical. This requires a concerted effort on two fronts: building the capabilities of frontline teams and cascading emission reductions targets to priority clients, including development of client-level account plans for client engagement.

Banks can play a critical role in facilitating an effective transition to a lower-carbon global economy. Banks can facilitate the growth of green alternatives and help companies that need to decarbonize. Through allocating capital and supporting their clients, they have the potential to be—as they must be—leaders in the transition.

Source: mckinsey