For financial institutions, financed emissions—the emissions associated with investments and lending activities—pose one of the greatest challenges in their climate journey. Not only does it constitute the largest part of their footprint, but it’s also something that they have the least control over.
To address their clients’ impact, they must rely on data deep within their customers’ value chains, which might not always be reliable.
The role of financial institutions also means that they’re in a unique position to push their customers and loan books toward better climate action. They have an exciting part to play in the changing world, but they have to start taking action now to allocate capital in the right places in spite of data management challenges.
David Carlin has made an entire career out of helping governments, corporations, and financial institutions make the sustainability transition. He empowers organizations to manage the risks of the changing world while claiming the opportunities it offers. He believes that finance can and should be mobilized to take action on sustainability-related topics.
We recently chatted with him, and he provided a roadmap for the financial institution’s green transition.
Identifying gaps in the climate journey
Carlin identifies three key challenges for financial institutions: gaining insight into the full value chain, data availability and quality, and a disconnect between information and action.
Gaining insight into the full value chain
The bulk of a financial institution’s carbon footprint comes from financed emissions. Carlin aptly refers to these types of emissions as “the Scope 3 of Scope 3.” What this means is that a significant portion of the emissions they include in their climate impact comes from the customers of the companies they support.
Let’s say that a bank lends money to a company in the energy sector to construct a coal-fired power plant. The emissions generated by the plant during its operation would count as the bank’s financed emissions since its funding made the project possible. Therefore, to calculate financed emissions, financial institutions must delve into their companies’ value chains to gather data.
He also highlights that the relationship financial institutions have with financed emissions is not always under their control. For example, if they extend an unrestricted loan to an industrial company, they’ll be given a share of its emissions. If the company makes a decision that results in increased emissions, it will, therefore, increase the investor’s emissions. Even though nothing changed from the investor’s side, and the loan remained the same, their emissions responsibility increased through no direct fault of their own.
The challenge of gathering data along the value chain isn’t limited to just emissions-related information. The same problem applies to all data used to determine climate risk exposure at a financial institution level. Although financed emissions constitute the most significant portion of a financial institutions’ impact, they must gather all types of climate risk data to paint a full picture of how they can allocate funds to alleviate climate risks.
Data availability and quality
Because financial institutions must gather data far along the value chain, collecting appropriate data can be logistically challenging. The more distance between the investor and the data, the more convoluted and confusing it becomes. Many find it difficult to trust the information they receive. “The further we go from the source, the less comfort many have with that data,” Carlin confirms.
He also notes the difficulty of gathering a large quantity of data, whether financial institutions support SMEs or large multinationals. In the case of SMEs, the data they gather individually is often thin and difficult to take action on. Even so, when you support thousands of SMEs, collectively, they constitute a large portion of financed emissions. On the other hand, multinationals' supply chains often come from countries with poor reporting standards, leading to opaque data.
Disconnect between data and actionable information
Although frameworks such as TCFD and ISSB seek to provide transparency and address the challenge of data availability, Carlin says they don’t necessarily inspire action.
He observes that these market-faithful frameworks assume better information will yield better outcomes but asserts that it’s not necessarily the case. Often, the data gathered within these frameworks have limited actionable use.
Carlin uses what he calls the analyst test to determine whether the data he receives is something with real utility or if it’s just something that’s required from a reporting standpoint. He puts himself in the shoes of a bank analyst trying to determine whether or not to award a loan. From this perspective, he asks whether the information would affect their decision. If it wouldn’t, he proposes that the data isn’t actually all that useful.
Building climate resilience with imperfect data
Even with the challenges of data management, Carlin again stresses the need for action.
To make his point, he puts us in a car with a map on our phone. But there’s a problem: the map hasn’t fully loaded. The course to the highway is defined, but the rest of the map is blurry. Should we sit in the car and wait for the resolution to clear, or should we get on the road with the information we have and trust that the map will load along the way? Carlin proposes we go with the latter. He says that it’s a process of fixing things as you go and not one of waiting until you know the exact numbers before you take any meaningful action.
The same goes for the financial institution’s climate journey. Climate change will be no closer to being solved just because we’ve perfectly calculated these financed emissions,” Carlin states.
As we head down the highway with our blurry map, we can also anticipate risks we know may happen along the way. “We don’t know where the accident will happen, but know a seatbelt will make us safer at any point that an accident happens,” he says. Perfect prediction won’t be in our grasp, but stronger resilience is.
Carlin stresses that organizations can’t mistake words and reports for actions. Simply measuring and collecting data, even as part of compliance, is not the same as allocating capital or applying pressure on clients to address climate risks. Financial institutions need to take the imperfect information that they have to take steps toward climate action.
We must put ourselves in the perspective of the future, understanding that even the near future is a lot more diverse and volatile than we may be expecting. Companies should develop robust strategies for better capital allocation to build resilience down the line. They have to make sure that their seatbelts are secure and their airbags are working by utilizing technology for better data collection, changing the reporting norms, and embracing the purpose of Scope 3 emissions.
How financial institutions can take action
So, what can financial institutions do to utilize available and imperfect data toward action? Carlin outlines three steps.
1. Change the norms around reporting
“[We need to change] the expectations of what good looks like,” he says.
Carlin emphasizes that we need data that can lead to tangible change. So, how do we find actionable data? By providing context. Carlin points out that knowing a company’s impact isn’t useful on its own. You also need to compare the company’s climate impact with its peers, ascertain costs associated with addressing climate risks, determine the policy environment, and many other considerations.
He says that financial institutions need to assess climate risks the same way they analyze other metrics. “If I can’t make heads or tails of your financial statement, it’s going to be very hard for me to want to include a financial relationship with you.” He says we should hold the same climate risk expectations, too.
He provides a wishlist of the context he’d like to see: “Tell me what the emissions are for a company that I have a financial relationship with. Tell me how those compare to others in its industry. Tell me what the potential costs might be for abatement for that activity that they're doing. Tell me if they're near alternatives for that activity.”
Climate reporting needs to go beyond the numbers to paint a full picture of a company’s climate impact. “Numbers without context aren’t so useful,” Carlin explains. “Numbers with it really begin to allow us to order our thoughts and develop our strategy.”
2. Embrace the purpose of Scope 3 emissions
The idea behind financed emissions is to encourage financial institutions to apply pressure on their clients so that they reduce their impact. However, this is not always the reality, as financial institutions tend to change how they report rather than make any changes with their clients. “If we haven’t actually taken any steps… to improve and drive down the operational emissions of our clients, then I think we’re falling well short of the goal,” Carlin warns.
Financial institutions need to work closely with their clients to develop strategies that improve their impact. If all of these institutions made an effort to address their clients’ climate risks, then we’d be much closer to achieving global climate goals.
3. Utilize technology for better data collection
Tech has a huge and important role in financial institutions’ climate journeys, as speed is essential. Continuing his car analogy, Carlin compares AI to a souped-up engine. “It’s gonna allow you to drive faster. It’s not going to drive for you.” Automating data collection allows companies to access large amounts of data, providing better information and enhanced insights.
While AI allows us to get more information, we still need people to make sense of it and put it into context. “It’s the rocket fuel; it’s not the steering,” Carlin clarifies. “I think it’s hard to have a human-centered organization and society that doesn’t have humans in the loop.”
Financial institutions have an exciting role in the sustainability transition, but only if they take action. We have access to more data than ever before, and although it’s not perfect, it points us in the right direction so that we can get on the road and start driving. Information means nothing without action, and Carlin encourages institutions to act now and build resilience for the future.
The road to better capital allocation is unpaved and winding, but it’s navigable. If financial institutions work toward collecting actionable data, improving the operational emissions of their clients and portfolio companies, and utilizing technology for continuously better data collection, they will get to their destination—robust climate risk management and a brighter sustainability future for all.
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