Financial institutions targets must be based on real-world decarbonization

Developments over the past several months have highlighted the inherent complexities in measuring the financial sector’s contribution to climate change — and the ways in which this complexity enables the sector to manipulate metrics and methodologies in its favor. Major gaps in data on corporate-level emissions, flaws in the methodology used to measure “financed emissions,” poorly structured and opaque target designs, and the potential use of offsets all weaken the impact of financial institution decarbonization targets. Ensuring that pressure from the finance sector is sufficient to push their corporate clients and investees to align with 1.5°C will require better designed, more ambitious, and more diverse types of targets, as well as exclusion and engagement policies, in particular on ending support for fossil fuel expansion. 

Since the 2021 launch of the Glasgow Financial Alliance on Net Zero (GFANZ), hundreds of the alliance’s members have set decarbonization targets (1). There are as yet few signs of financial institutions making meaningful changes to their engagement and financing practices as a result of these targets, and the design of many targets is deeply flawed. Among the most common and serious design problems are targets that use an emissions intensity rather than an absolute metric; targets that cover only part of a financial institution’s activities; and targets that cover only part of the value chain of the sector.  Even where targets are comprehensive in their coverage, they suffer from further weaknesses including the lack of high quality, consistent data on corporate emissions (2) and problems with the standard methodology used to attribute corporate emissions to banks and investors. 

The now 139 members (3) of the Net-Zero Banking Alliance (NZBA) are required to set 2030 targets for their most carbon-intensive sectors. A key problem with these bank targets lies in how corporate emissions are attributed to their multiple lenders. Most banks base their lending targets on the “financed emissions” methodology developed by the Partnership for Carbon Accounting Financials (PCAF) (4). Using PCAF, a bank calculates the financed emissions from its loans to a public company by multiplying the company’s emissions by an attribution factor. This attribution factor is the value of the bank’s exposure to that company, divided by that company’s enterprise value including cash (EVIC).

EVIC is the bug in the ointment for this calculation. It equals the sum of a company’s market capitalization (the combined value of all its shares) and its debt. But EVIC is extremely volatile: share prices and debt levels vary widely from year to year (even hour to hour in the case of shares). The impact of relying on a formula with EVIC as a denominator is that a bank’s sectoral financed emissions can plunge if that sector has a banner year on the stock market, even though actual emissions from the bank’s clients in that sector, and the bank’s exposure to that sector, may stay relatively constant (5). Conversely if the shares of the companies across a sector have a miserable year, its bankers’ financed emissions will likely rise. But because the long-term trend is for share prices to rise— and because of the impact of compound interest — sectoral financed emissions will tend to decline over the medium- and long-term, at a pace that far outstrips any real-world drop in the emissions of the companies in that sector (and even if sectoral emissions rise moderately).

Oil and gas companies stock prices soared in 2022 due to the disruption to energy markets caused by Russian’s invasion of Ukraine. The S&P 500 Energy index, for example, comprised of the 23 large oil and gas companies in the S&P 500, rose by 59% that year (6). One result is that banks’ financed emissions for 2022 plummeted even though global CO2 emissions from oil and gas rose slightly (7). This has enabled many banks to meet their oil and gas financed emissions targets for 2030 eight years ahead of schedule. Deutsche Bank, for example, reported a 29% reduction in oil and gas financed emissions for 2022, compared to its 2021-2030 target — set only in October 2022 — of a 23% cut (8). Crédit Agricole set a target in June 2022 of reducing its oil and gas absolute financed emissions 30% between 2020-2030. As of the end of 2022 it had already cut these “emissions” by 40% (9).

However there are signs that even with all these flaws, if the ambition of a target is sufficiently high, financial institutions can fear that the targets may require them to cut off their support for some of their most polluting clients. Exhibit A for this argument is provided by JPMorgan Chase (JPMC), who recently redefined their oil and gas end-use intensity target into an “energy mix” target which mixes the US banking giant’s “clean” energy finance into their oil and gas financing, and so creates a new sector with a drastically lower carbon intensity than the old one.  

The recent proposal by GFANZ of the “Expected Emission Reduction” (EER) concept appears to be a similar attempt to reduce the pressure that decarbonization targets pose to financial institutions’ relationships with their clients and investees. The EER concept would allow financial institutions to quantify their contribution to corporate decarbonization based not on the falling emissions of the companies they support, but on the assumed gap between a counterfactual pathway of what these companies’ emissions would have been without a transition plan, and what they are projected to be with a transition plan in place. This is a similar approach to the concept behind the generation of carbon offsets from avoided emissions which has repeatedly been shown to encourage hugely inflated estimates of climate benefits (10). 

This EER concept was introduced in a consultative document and drew considerable criticism from NGOs and others, especially for its complexity and the ease by which the methodology could be gamed (11). GFANZ released the final version of this paper during COP28 as a “technical review note” and without any fanfare. The “note” recognizes that the concept requires substantial further work and “may be highly complex to implement (12).” Overall it appears that GFANZ has listened to its critics in this case, and hopefully it will allow this bad idea to die the death that it deserves.  

Going forward, financial institution plans to align with 1.5° will need to include a dashboard of different types of targets. Financed emissions targets covering loans and investments must be supplemented by “facilitated emissions” targets for bank capital markets activities, and “insurance-facilitated emissions” targets for insurers (13). PCAF has developed methodologies for these emission types, but in addition to other weaknesses (14), all depend on EVIC-based attribution. Developing a better method of attributing real-world emissions to financial institutions should be a priority for PCAF in 2024.  

All these emissions target types must be expressed in absolute as well as intensity terms, and be comprehensive in terms of their coverage of corporate value chains and the activities of financial institutions. Emission targets should be differentiated to cover individual sectors, asset classes, and gases, as well as aggregated across portfolios, and gases (by using the metric of CO2-equivalent). Financial institutions should also set targets for the total emissions of the companies that they finance, both at a sectoral and portfolio-wide level, without using an attribution factor (if emissions of the companies that an institution finances are not dropping, it would be an important sign that the efforts of financial institutions to help their clients and investees transition are not working).  

GFANZ believes that financed emissions targets may have the impact of dissuading banks and investor from financing the retirement of coal plants or other high-emission infrastructure like coal plants (15). If this is the case, financial institutions can ringfence emissions from these transactions as “phaseout emissions” — provided there are strong social, environmental and climate safeguards to ensure that the retirements enable a just transition. 

Emission targets must be complemented with a suite of non-emission-based sectoral and portfolio alignment targets. Examples are sectoral exposure targets for lending, targets based on overall fossil fuel financing (16), and targets based on reducing fossil fuel production (17). Reductions in capital expenditure of clients and investees that are devoted to new fossil fuel infrastructure must also be tracked, as well as increases in capex for clean and sustainable energy. Financial institutions should aim to meet the ratio specified in the IEA’s net zero emission scenario of six dollars of investment in “clean energy supply” for every dollar put into fossil fuels (18). 

Finally, financial sector transition plans should include sectoral and portfolio-wide policies. Engagement policies are needed that mandate robust, time-bound processes with financial consequences for companies that fail to meet benchmarks. Sectoral policies should include criteria to exclude financing for particularly environmentally destructive activities and to ensure that companies halt the development of new fossil fuel infrastructure.  

Through their individual commitments and their membership of various net-zero alliances and initiatives financial institutions have accepted the existential threat of climate change, and their responsibility to play a key role in addressing the threat. Evidence suggests that the private finance sector’s efforts to align with 1.5°C are yet to have a meaningful impact on corporate emissions. A major upgrade to these efforts is needed that relies on a greater diversity of target types complemented with policies that are clear on the financial consequences for companies that fail to transition.