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Financial players are destined to become major drivers of the low-carbon transition, and while European and French regulations are gradually shaping this transition, funds that commit to a decarbonization strategy today are gaining a head start in a rapidly evolving sector.
Several reasons explain this underlying trend, starting with the desire to limit exposure to various risks stemming from climate change and the societal shift toward a low-carbon economy; as well as the choice to differentiate from competitors and meet the demands of stakeholders (employees, regulators, civil society, etc.).
What does a financial fund's commitment to the low-carbon transition entail?
1. Regulatory constraints: climate reporting
Regulations regarding ESG criteria in finance have been rapidly increasing in complexity since the start of the decade: the French TECV, the European SFDR, the Green Taxonomy... What are the current obligations for financial firms?
The SFDR regulation (since March 2021):
The SFDR requires financial market participants to disclose how they account for risks and "principal adverse impacts," which are the primary negative effects of their investments on sustainability.
Under this new regulation, financial products are classified into three categories that define their sustainability objective:
- Without a sustainability objective (Article 6)
- With environmental or social characteristics (Article 8)
- With the goal of sustainable investment, meaning investment in economic activities that contribute to an environmental or social objective (Article 9)
This concerns not only financial market participants, but also all institutional investors, including credit institutions (banks, financial companies, etc.) and investment firms, which are covered by Article 29 of the Energy-Climate Law, which reinforces the provisions of the SFDR.
The French Energy-Climate Law also specifies that financial actors with more than 500 million euros in assets under management or balance sheet total must publish comprehensive information on:
- internal resources deployed
- climate alignment strategy
- ESG governance
For financial actors below this 500 million euro threshold, only general information regarding the consideration of ESG criteria and the overall approach is expected in their 2022 reporting for the 2021 fiscal year.
This information must be consolidated into an annual report submitted to ADEME and published on the company's website.
No sanctions are currently in place for companies that provide incomplete information, but the prevailing rule iscomply or explain, meaning that for any element not explained, the reason must be provided. Additionally, the entity must then publish a continuous improvement plan outlining its areas for improvement and the associated implementation timeline.
2. Measuring the portfolio's impact on climate change
When we think about measuring climate impact, we think of a carbon footprint—the measurement of greenhouse gas emissions resulting from an entity's activities. For funds, there are obviously emissions directly linked to operational activities: energy consumption for offices, fuel for employee travel, and so on. However, the bulk of these emissions, and the most significant part of climate impact measurement, concerns financial flows. It is therefore necessary to measure the emissions associated with the portfolio to assess the current situation and make informed decisions. How do you measure the emissions of held securities?
- Measure the carbon footprint of held companies across scopes 1, 2, and 3.
By knowing the emissions across the entire value chain of the companies held, the investor can determine the emissions that can be attributed to them. The goal is to measure the financed emissions based on the share of capital held.
If you hold 20% of a company that emits 100,000 tCO2e per year (scopes 1, 2, and 3), the emissions associated with this investment will be 20,000 tCO2e.
Depending on the types of financial products involved, the PCAF, Partnership for Carbon Accounting Financials, has identified different types of calculation elements. For example, for real estate, we calculate the building's emissions, multiplied by the ratio between the outstanding amount and the original value of the property:
Building emissions x Outstanding amountOriginal value of the property
Below are the 6 PCAF calculation methods:
The Global GHG Accounting & Reporting for the Financial Industry Standard - Partnership for Carbon Accounting Financials (2020)
https://carbonaccountingfinancials.com/files/downloads/PCAF-Global-GHG-Standard.pdf
- What if not all the companies invested in have carried out a carbon footprint assessment yet?
Some companies have not yet calculated their carbon footprint across all three scopes, making it difficult to estimate the emissions attributable to the investor. As an investor, you can ask the company to conduct a carbon assessment, or even make new investments conditional upon the completion of a carbon footprint covering all three scopes.
However, as a first approximation, if you do not yet have precise carbon footprint data, the company's main physical data can help estimate the order of magnitude of its emissions. A questionnaire can be sent to the organization to obtain details on the nature of physical flows. This data can be supplemented by an estimate based on accounting records, but this approach is in no way a substitute for a full carbon footprint.
- Can avoided emissions, or "positive carbon impact," be accounted for?
Are you investing in green energy or financing projects with an environmental impact, and would you like to include them in your carbon footprint?
These "avoided" emissions refer to the emission reductions enabled by an organization's activities, products, or services. These emissions are compared to a baseline scenario if they allow for reductions outside the organization's own scope of activity. Typically, if you finance an electric bike startup that enables users to ditch their cars and thus avoid emitting CO2 during their daily commutes, your funding will have effectively helped reduce emissions outside the organization's direct scope.
While you can certainly measure these emissions, the carbon footprint methodology specifies that they cannot be included in the carbon footprint itself—meaning you cannot subtract avoided emissions from actual emissions.
3. Develop a low-carbon strategy
- Set a target aligned with the commitments of the Paris Agreement
The SBTi, the leading authority on low-carbon targets, published a guide for the financial sectorin February 2022, which you can find on their website.
To develop a credible target and meet your commitments, you can read our article on how to reach your SBTi target.
- Deploy your strategy across your portfolio
- Redirecting capital flows. One way to decarbonize investments is to redirect financial flows toward low-carbon or carbon-reducing activities that help lower society's overall emissions. This is paralleled by divestment, or withdrawing capital from highly polluting activities, such as fossil fuels.
This approach aims to restrict capital access for the most polluting sectors. By applying it, investors contribute to the global transformation of society toward less carbon-intensive activities.
- Making funding conditional. Many financial institutions already require specific ESG due diligence. Financial players can go further by including climate clauses in term sheets and making funding conditional upon the organization publishing a carbon footprint and a climate strategy.
Developing your own climate analysis framework allows you to differentiate between potential investments and select only those that align with your climate ambitions: Does the organization have a business model compatible with a 1.5°C world? Is its physical and economic carbon intensity lower than that of its competitors?
- Engaging with funded organizations. Investor engagement is a powerful lever for decarbonization, and investors can be key drivers of a company's low-carbon transition. By proactively proposing carbon strategies and demanding monitoring and results regarding climate performance, investors can make climate action a central priority for organizations.
Conclusion
Green finance is at the heart of current debates, with the emergence of new tools such as green bonds, green funds, and labeled funds. Amid this structural trend toward decarbonization, investors can anticipate regulatory changes by adopting investment strategies that fully integrate climate issues, much like BlackRock, which uses its shareholder rights to promote its climate ambitionswithin the organizations it funds.
Please feel free to contact us if you have any questions about low-carbon finance!