How should banks report environmental risk?

One of the most commonly used measures for environmental risk is carbon emissions, sometimes referred to as a carbon footprint.

Carbon footprinting refers to the process of calculating and analyzing the total amount of GHGs (not just carbon dioxide) emitted directly or indirectly by an individual or entity. For banks and other businesses, it can help to inform sustainability strategies and enhance their reputation.

A carbon footprint is expressed as tonnes (metric tons) of carbon dioxide equivalent (CO2e) and can be measured at various levels, from an individual factory to company/group level, and aggregated across loan and/or investment portfolios.

***

Get weekly finance insights from The Intuition Finance Digest. Elevate your understanding of the finance world with expertly-crafted articles and podcasts sent straight to your inbox every week. Click here: https://www.intuition.com/finance-insights-the-intuition-finance-digest/

***

One widely discussed issue is the scope of emissions included in any calculations. To address this, many banks use the concept of “scopes” as set out by the Greenhouse Gas Protocol’s Corporate Accounting and Reporting Standard. This sets out three categories for measuring and reporting GHG emissions, based on where they originate along the value chain of a business.

• Scope 1: Direct GHG emissions – emissions from sources owned or controlled by a company.
• Scope 2: Electricity indirect GHG emissions – emissions arising from electricity purchased by a company.
• Scope 3: Other indirect GHG emissions – emissions from all other indirect emissions, such as from third parties that form part of supply chains.

Producing and tracking such measures over time can provide an indication of progress toward reaching targets for both direct and indirect emissions. However, caution is needed when interpreting reported values. This is particularly true when making peer comparisons as the calculation methods used may not be comparable or may change over time. It can also be unclear as to what is included in the measure, for example, emissions for all subsidiaries or only some.

Decarbonization: What role do banks play?

What other measures capture environmental risk?

On their own, carbon emissions measures provide a limited amount of information. One way to enhance this is to classify activities as either “green” or “brown.”

Green activities are those expected to have a positive impact on climate change. Clean energy production is an obvious example.

Brown activities are those that have a negative impact on climate change. Coal mining is an example.

Using such a classification enables banks to, for example, report data on the proportions of a loan portfolio that are green and brown, and track this over time. Obviously, this relies heavily on being able to allocate activities to the correct category. This is something that, for EU-based entities at least, the EU Taxonomy has been established to do. This provides a classification system (taxonomy) for assessing whether economic activities can be deemed to be environmentally sustainable and the conditions that must be met for this to be applicable.

Other metrics that are produced include:

• Financed emissions – this measures the level of indirect GHG emissions associated with a bank’s portfolio of loans and investments.
• Facilitated emissions – this is used where a bank provides capital markets and advisory services to its customers for a fee rather than providing direct financing.
• Avoided emissions – sometimes referred to as “Scope 4” emissions, this measures emissions reductions that result from the use of a product rather than its production (for example, an electric car).

Clean vs. renewable energy: What’s the difference?

What other tools and techniques measure environmental risk?

There are a number of other tools and techniques that banks use to assess environmental risks, some of which may involve emissions data.

• Scoring: new scorecards have been developed, or existing ones amended, to score the riskiness of a transaction or customer based on their climate risk characteristics.
• Impact assessments: by undertaking a detailed analysis of the potential impacts of climate change, particularly physical risks, a better understanding of potential climate risk impacts can be obtained.
• Modeled values: various methodologies can be used to produce absolute or relative measures of risk or the potential impacts of climate change. Examples include climate value-at-risk (climate VaR), input-output (IO) models, and integrated assessment models (IAMs).
• Scenario analysis/stress testing: this assesses the possible impacts, at customer and/or portfolio level, of different climate change scenarios of varying severity. Outputs from such exercises can be included in risk scores, as part of capital adequacy and liquidity assessments, and for provisioning.

Such tools often use external data (such as risk scores) or methodologies (such as the scenarios produced by Network for Greening the Financial System).

Increasingly, environmental risk measures that once focused largely on climate-related risks are being expanded to include other potential environmental impacts such as nature-related risks.

The content for this article is taken directly from Intuition Know-How‘s tutorial ‘ESG Risk – Measurement’ which is part of Intuition Know-How’s comprehensive Sustainability and ESG channel.

Fill in the form below to learn more about the full Intuition Know-How offering and how you can use it to improve organizational performance.