Financing a Low-Carbon Economy: Towards a Standardized Method for ‘Two-Degree’ Portfolio Alignment for Banks.

Abstract

Climate change poses an unprecedented threat that will require a systemic transition away from high-carbon activities to avoid the worst effects (IPCC, 2015). Bank lending makes up a significant source of external capital for businesses, yet clear market and policy incentives to accelerate the needed shift of investment to low-carbon assets is lacking (Campiglio, 2016). Further, due to the difficulty of calculating the greenhouse gas (GHG) emissions related to the clients and economic activities they finance, banks cannot currently set appropriate emissions reduction targets (Science Based Targets Initiative, 2017). This is a result of low data availability and no market standard for measuring portfolio climate impact. The most common metric, ‘financed emissions’, the emissions attributed to a bank or investor financing an emitting company, has not yet proven itself accurate enough to be widely adopted among banks for target-setting. Meanwhile a new metric, ‘financed technology’, the analysis of the type and quantity of a GHG-emitting or -reducing technology or asset directly or indirectly financed in a given portfolio, has recently emerged as a possible alternative metric but has yet to be widely tested. Management begins with measurement, and without reliable, proven metrics, banks will be ill-equipped to set appropriate targets. Previous studies have qualitatively reviewed existing methodologies. To date, however, there is no guidance on which metrics and methods outperform others in terms of accuracy and utility for effective target-setting. Furthermore, no research has quantitatively compared the two above-mentioned metrics. This thesis, therefore, quantitatively analyzes and compares the ‘financed emissions’ and ‘financed technology’ metrics and underlying methodologies to determine whether or not these are accurate and useful for target-setting. In order to do so, this thesis presents a new framework to compare data inputs – the Data Input Accuracy Scoring (DIAS) framework. For further determining the usefulness of each metric for target-setting, a qualitative review, including a case study, was applied. My first hypothesis was that due to the unavailability of data for the majority of a bank’s clients representing the largest concentration of emissions, methodologies utilizing GHG emissions as a metric will not be an accurate means for a bank to measure and steer its portfolio. I also hypothesized that sector-based metrics focused on financed-technology yield more accurate results that can be utilized for target-setting. While several financed emissions methods exist, one in particular has emerged among some European banks: the so-called ‘PCAF’ (Platform Carbon Accounting Financials) approach. With regards to ‘financed technology’ methods, one has recently been developed and is rapidly garnering attention, the so-called ‘PACTA’ (Paris Alignment Capital Transition Assessment) approach. In order to quantitatively compare these two methodologies, the present research utilizes a contrived lending portfolio as a control variable by which the metrics were tested and compared on the basis of accuracy and utility for target-setting. Next to contributing a framework by which climate metrics can be objectively assessed, this research identifies key elements for setting targets in line with the below- 2˚C target, providing a clear, quantitative distinction between methodologies. In line with my hypotheses, the two most material findings are 1) that the data inputs of the financed emissions approach suffer considerable inaccuracies, yielding a much lower accuracy score than the financed technology inputs and 2) that target-setting requires a sector-based approach. The results of the present research can help inform banks regarding which metrics show the most promise for target-setting. Furthermore, the findings could contribute to the establishment of a market standard that policy makers and stakeholders can hold banks accountable to. This in-turn should help incentivize the accelerated shift of finance from high- to low-carbon assets.