How to quantify transition risk

In case you missed the first blog in this two-part series, read it here.

There are two questions that need to be answered in order to quantify financed emissions: One, what is the share of an investor (or lender) company in total emissions of a counterparty? And two, how much is the carbon footprint of that counterparty? The share of the investor can be calculated by dividing the outstanding balance of a counterparty either by its enterprise value (for public companies) or by the sum of total equity and debt (for private companies) as recommended by Partnership for Carbon Accounting Financials (PCAF) methodology and shown in Equations 1 and 2 in the table below, where c is the borrower or investee company.

To answer the second question, i.e., calculating company emissions in the equations below, the investor would ideally have access to self-reported counterparty-level data. Besides the emissions factors used to estimate Scope 1, 2, and all 15 categories of Scope 3 emissions for each counterparty, such data should include detailed material and energy flow to provide the highest-quality data for financed emissions quantification. It is important to note that Scope 3 emissions are more challenging to quantify as they include all of a company’s upstream and downstream emissions. As such, setting up the right system boundary and transparency when reporting data is crucial.

In cases where counterparty-specific data is not available (which might be the case for smaller companies), banks can use industry averages based on the industry segment of the counterparty. Multiple third-party data vendors provide historic and target emissions for most public companies as well as a benchmark against their industry segment. Financial institutions could leverage publicly available data and make appropriate adjustments to better represent their counterparties. For example, the geographic location of counterparties could be considered as there might be more region-specific restrictions and carbon tax policies moving forward.

While such data should be collected across all loan portfolio segments, due to the more important role that specific industry segments play in transition risk, more focus should be placed on collecting data for commercial and industrial as well as auto loans and leases, as these sectors will be more significantly impacted by a transition into a low-carbon economy. In order to estimate emissions from carbon-intensive industry segments, such as oil and gas and power sectors, banks can reference academic literature that quantify emissions for these sectors. For example, Tavakkoli et al1 surveyed over 200 datasets to estimate the lifecycle of greenhouse gas (GHG) emissions from U.S. natural gas-fired electricity to derive accurate estimates for every stage of the natural gas lifecycle and natural gas combustion. This study quantified natural gas supply chain emissions (CO2 eq./mcf) as well as emissions from combustion of natural gas at power plants (CO2 eq./kWh) and reported lifecycle emissions for power generation (supply chain + combustion). Financial institutions can use these studies when estimating emissions from certain sectors knowing their material or energy flow (e.g., how much natural-gas-fired electricity was used). Other physical activity-based emission intensity data sources such as PCAF European building emission factor database could be leveraged to estimate emissions from other segments of the investment portfolio such as commercial real estate and mortgages. Collectively, the PCAF methodology explained above and these data sources could help guide financial institutions to make an informed decision about their transition risk.

Double-counting consideration in financed emissions calculations

Industry segments are interrelated, and if a financial institution has investments in multiple sectors, double-counting could occur in estimating financed emissions. For example, if a bank has investments or loans in both oil and gas and the power sector, some categories of Scope 3 emissions from the power sector could already be captured in financed emissions from the energy sector. This emphasizes the importance of defining the system boundary when calculating Scope 3 emissions as well as transparency when reporting financed emissions.

Summary

Financial institutions play a vital role in reaching the goals of achieving a net-zero economy. Quantifying and disclosing GHG emissions associated with loans and investments (also referred to as Scope 3, Category 15 financed emissions) is an essential step in evaluating transition risk. With recent improvements in both methodology and data availability, financial institutions should take the first step toward measuring and mitigating the risk of ever-increasing GHG emissions.

Footnotes

1. Tavakkoli, Sakineh, et al. “Implications of Generation Efficiencies and Supply Chain Leaks for the Life Cycle Greenhouse Gas Emissions of Natural Gas-Fired Electricity in the United States.” Environmental Science & Technology, 56.4 (2022): 2540–2550.