The International Sustainability Standards Board (ISSB) was created at COP26 in 2021 with the aim of establishing global standards for sustainability and climate reporting, building on existing frameworks such as the Taskforce for Climate Related Financial Disclosures (TCFD).
Given the important role that financial institutions (FI) play in supporting change through their ability to direct critically needed capital to – or away from – particular companies or sectors, the ISSB has proposed that FIs should be required to publish estimates of the GHG emissions (categorised as scope 1, 2, and 3) linked to their loans and investments. The ISSB confirmed this policy in October 2022 and new rules are due to be published in early 2023. In addition, FIs are also being required to publish their transition plans for achieving their net zero ambitions. This disclosure momentum is building the pressure on FIs to work with their lending base to support them in reducing emissions and moving to a low-carbon economy.
Why are lenders’ scope 3 emissions so important?
GHG emissions are categorised as scope 1, 2, and 3.
Scope 1 emissions are created directly by a company. Scope 2 emissions are those emissions produced indirectly, for example, from purchased energy.
Scope 3 emissions occur in the value chain of the reporting company – crucially, for lenders, this includes ‘financed emissions’, ie, emissions produced by their borrowers
Lenders’ scope 1 and 2 emissions tend to be very low. But their scope 3 exposure is measured by financed emissions, and is directly related to emissions generated by the borrowers in their portfolio.
A survey by CDP has shown that on average, banks ‘financed emissions’ - scope 3 - are over 700 times higher than their ‘operational emissions’ - scope 1 and 2.
Lenders under pressure to reduce scope 3 emissions directly affects borrowers
The pressure on lenders globally to report their ESG credentials, including reducing GHG emissions, has steadily increased – both from regulation (such as the TCFD aligned reporting framework requirements and the forthcoming ISSB and transition plan proposals, as well as from their own investors and stakeholders.
All major lenders now have targets for reducing the client emissions they finance via their lending activities. For example Lloyds Banking Group has targeted reducing the carbon emissions they finance by more than 50% by 2030. Barclays has set emissions targets for four of the highest emitting sectors in its portfolio – energy, power, cement and steel – to be met by 2030. The bank set a 15% reduction target in absolute financed emissions for its energy portfolio by 2025, and by year end 2021 had achieved a 22% reduction. Targets for additional sectors are due to be introduced in 2023 and 2024.
This has been achieved by using an in-house methodology to track the bank’s financed emissions. This is evidence of what adequate financial reporting around emissions can achieve and is illustrative of the trend to come.
What does this mean for the mid-market?
Mid-market firms need to be aware that an emphasis on reporting a lenders’ scope 3 emissions could directly affect their ability to continue to borrow cost-effectively. A firm’s carbon emissions - which speak directly to a lender's scope 3 emissions - is increasingly becoming part of due diligence.
Some lenders may choose to avoid high emitting firms altogether, choosing to reallocate resources to less carbon intensive firms. It may no longer be a question of ‘pricing in’ the carbon risk.
While firms aren't expected to reduce their carbon footprint overnight, will higher emitting firms still enjoy the same access to capital in three years’ time?
We already know that banks undertake a ‘transition to net zero’ risk assessment as part of their annual credit review process for their mid-market and large corporate clients. Our own research has shows that...
A borrowers emission profile will become as relevant as its credit risk in determining who to lend to, and on what terms.
Scope 3 emissions also affects a firm’s business model
According to the rating agency Scope's ESG Analysis, many companies refer only to their scope 1 and 2 emissions when attempting to demonstrate their ESG credentials. Apparent reductions can therefore be achieved by outsourcing high emission activities. By mandating disclosure of scope 3 emissions, and introducing a universal accounting standard, it's hoped that this type of ‘corporate greenwashing’ will be reduced.
Publishing their transition plans (including GHG reduction targets) from 2023 will incentivise UK-listed companies to show that they're focused on ESG throughout their supply chain. Mid-market firms who feed these supply chains will consequently be at risk of losing business if they're unable to meet ESG expectations. We've already seen clients who have lost major contracts due to their carbon emission profile being viewed as unacceptably high.
Lenders looking to increase ESG-linked lending
Lenders’ attention to reducing scope 3 emissions is complemented by a focus on ESG related lending – for example, sustainability-linked loans where the terms of the loan track specified sustainability-based key performance indicators (KPIs). This places increasing importance on developing a robust transition plan to achieve net zero targets with clear and defined KPIs. Our recent survey shows that...
Mid-market firms need to prioritise their ESG agenda to maintain competitive advantage and preserve their access to capital.
Our debt advisory team, together with our dedicated ESG advisory team work with mid-market companies to develop a GHG emissions baseline as part of their net zero transition framework, and help develop and communicate their bespoke ESG strategy. For more insight and guidance, get in touch with our team.