The role of portfolio emissions in transformation financing

When banks, investment funds and insurance companies reduce greenhouse gases, they do so by cutting their ‘portfolio emissions’. This means that they finance fewer companies with high CO2 emissions and focus more on companies with a small CO2 footprint. In a transitional phase of the transformation, this can indeed lead to financing shortfalls for some high-emission companies, even if they are investing in reducing their CO2 footprint.

Companies in NRW will need to make immense investments as part of the digital and climate-neutral transformation. This need for investment was gauged in the study ‘Transformation in NRW: What is the best way to finance the digital and climate-neutral transformation in NRW?’. In addition to state investments in infrastructure, companies will have to make huge investments in order to attain climate neutrality. The study authors expect a total of between €45.4 and €55.1 billion euros to be invested in NRW every year until 2030. In addition, an estimated €17.2 billion will be invested in digitalisation. For banks, investment funds and insurance companies, there is great potential for financing the transformation in NRW.

The financial sector is aiming for climate neutrality too

Banks, investment funds and insurance companies are also working to become climate-neutral. Even though these are not the most high-emission sectors, they finance companies that emit greenhouse gases. When banks and insurance companies reduce greenhouse gases, they do so by cutting their ‘portfolio emissions’. These are the emissions of the companies that they finance. As well as credit risk, sustainability indicators have become an important basis for making financing decisions. The standards set by sector initiative PCAF (Partnership for Carbon Accounting Financials) help to determine the level of greenhouse gas emissions that were financed. A total of 260 banks, investment funds and insurance companies worldwide are now members of the initiative, including 14 institutes from Germany. For the most part, the members are banks with a particular emphasis on sustainability who apply this voluntary standard.

Portfolio emissions: a new control variable

Portfolio emissions are determined in the following asset classes: shares and bonds, loans, real estate and real estate financing, project financing and automotive financing. PCAF proposes dividing up emissions into three classes. Scope 1 refers to emissions that are generated by the financed company itself. Scope 2 refers to indirect emissions caused by electricity, heating or cooling purchased as a service by the financed company. Scope 3 goes beyond this. It contains additional emissions that are not included in Scope 1 or 2 and which are generated via the value chain. Upstream emissions are generated through the emissions of purchased materials. Downstream emissions arise from products and services being used by end customers or by employees driving to their place of work.

This division takes into account the different levers that companies can use to become climate-neutral. However, it also demonstrates the complexity of measuring greenhouse gas emissions at company level. By offering its employees incentives to cycle to work, a company can reduce Scope 3 but not Scope 2 or Scope 1 emissions. An electric car manufacturer may well produce less Scope 3 emissions than a manufacturer of conventional cars with combustion engines. However, the electric car manufacturer could have higher Scope 2 emissions than the conventional car manufacturer if the latter sources green electricity. These examples show that the method used for measuring emissions is of central importance for financing. If a finance provider focuses its attention on low Scope 1 emissions, it can still finance companies with high Scope 2 and Scope 3 emissions. A company that has reduced its Scope 3 but not its Scope 1 emissions would then not contribute to reducing the portfolio emissions of a bank that is aiming to lower the Scope 1 emissions in its portfolio.

After the portfolio emissions have been measured they need to be managed. This means that banks and insurance companies aiming for a net-zero performance must try to reduce their portfolio emissions. On the whole, however, reducing portfolio emissions means that the financial companies finance fewer and fewer companies with high CO2 emissions and focus more on companies with a small CO2 footprint. In a transitional phase of the transformation, this can indeed lead to financing shortfalls for some high-emission companies, even if they are investing in reducing their CO2 footprint. For instance, a bank that already has high portfolio emissions can refuse a loan application if the customer still emits too much COor cannot reduce this sufficiently. This is even the case for customers with a high credit rating. In this case, the customer would have to try to find a bank that has lower portfolio emissions and that still has room in its self-set CO2 budget to finance this customer. 

EU taxonomy defines sustainability

However, the CO2-intensive sectors are already also in the midst of a transformation process towards more climate neutrality. If banks or insurance companies actively avoid these companies, this can also hamper efforts to achieve climate neutrality, given that the aim of the transformation is clearly also to digitalise traditional sectors and to make products like steel and cement climate-neutral. For this reason, it is also important for the companies to invest early on in reducing CO2. If they do not, banks and insurance companies may be unwilling to provide follow-up financing.

The EU taxonomy for sustainable financing takes this aspect into account in that a company’s route to climate neutrality is held to be a sustainable activity. The EU taxonomy divides up activities in a way that allows investors and finance providers to determine whether a company and its activities can be categorised as sustainable. The taxonomy goes beyond measuring emissions. This is because it defines sustainability based on the following criteria: climate protection, adapting to climate change, using water and marine resources sustainably and protecting them, transition to closed-circle economy, avoiding and reducing environmental pollution, and protecting and restoring the biodiversity of the ecosystems. For an economic activity to be sustainable, it must contribute to at least one of these objectives. The term ‘sustainable’ therefore applies to the manufacture of industrial products with low levels of CO2 or the generation of solar or wind electricity, but also to low-CO2 transport and buildings or plants for creating renewable energies.

While the banks assist the transformation above all by providing loans, the insurance companies’ funds are channelled into the transformation primarily through bonds. The Green Bond Standard is an important investment instrument for them as this bond allows them to measure and manage their portfolio emissions easily. What sets Green Bonds apart from conventional ones is that companies can only use the issue proceeds from Green Bonds for activities that conform with the EU taxonomy. This means that companies that emit high levels of CO2 can issue Green Bonds too. However, they cannot use these funds for general company financing but only for sustainable projects in their companies. For example, German energy giant RWE has issued Green Bonds for financing wind and solar projects.

Digitalisation plays a central role in measuring the portfolio emissions of banks and insurance companies. This is because banks and insurance companies are required to set up databases to document the CO2 emissions of their individual assets. This makes it clear that digitalisation and sustainability are not separate trends because digitalisation can help companies to become more sustainable.

Expert advice on sustainable finance important for companies

In addition to credit risk, climate neutrality is now an important parameter for the portfolio decisions of banks and insurance companies. Sustainable finance has led to a re-regulation of the financial markets that appears to be as disruptive as the introduction of the credit risk approach from Basel II.

This is leading to concerns among companies that it will be more difficult for them to access financing in future and that this will involve even more red tape. While large companies in the field of Investor Relations have also set up a Sustainable Finance department, there is indeed a risk that the administrative burden associated with applying for loans will be too great for smaller companies and that, as a consequence, these will not have the full advantages of sustainable financing.

At this point, it is important to ensure that SMEs are provided with sufficient expert advice. The Transformation in NRW study proposed setting up a Sustainable Finance for NRW competence centre. The main function of this centre would be to provide companies with materials to help them better determine how to apply the taxonomy for their respective business fields. The Fin.Connect.NRW networking platform can help the transformation process of NRW-based companies by making them more visible for banks, investment funds and insurance companies.