Since the 2008 credit crisis, financial services organizations have worked diligently to integrate their finance and risk management systems into a single information management infrastructure. This has proven to be a worthwhile investment and a standard practice – at least among large organizations – as this framework enables better, more predictive business decision-making.
Today, however, we have a newer category of data – carbon emissions – that in most organizations sits in its own information silo, outside of the integrated framework. This an important issue that needs to be addressed. Companies need to integrate and elevate the management of this data because we now know that carbon emissions have a significant financial and risk impact on a financial services business.
Emissions impacts financial performance in several ways, including cost of operations. It has numerous implications for risk as well, including the simple fact that it puts earnings at risk.
That’s why the idea of a carbon tax persists. The idea is we need a system of penalties and incentives to consume less CO2. We’re already seeing this concept in financial services, where lenders levy a “carbon premium” on loans to “carbon-intensive” borrowers.
Certainly, companies are feeling outside pressure to refine and improve the way they account for the impact of carbon emissions. Industry leaders like Laurence. D. Fink of BlackRock have been advocating for it for years. Regulators are studying the reporting issues, and inevitably the Securities and Exchange Commission will provide guidance for U.S. financial institutions, as their counterparts in Europe have. And non-government organizations are strongly making their voices heard.
Senior leaders take ownership of emissions data
In response, companies are beginning to change the way they report and use emissions metrics. While companies continue to report energy usage and emissions through sustainability reports, the finance organization itself is utilizing these metrics in earnings calls and other external reports. In other words, senior leadership is now presenting the company’s strategy for emissions reduction alongside key performance metrics.
As emissions reporting becomes a strategic priority, new practices in carbon accounting are emerging. In this article, the first of a three-part series, we describe a data product-based approach to reporting emissions’ impact on financial performance.
Part two will look at how to incorporate carbon accounting into risk reporting. Part three will describe a solution architecture to enable this level and range of reporting.
Measuring financial impact using carbon data products
As we said, carbon emissions have a direct impact on financial performance. In fact, it affects both the asset and liability sides of the balance sheet. That’s why companies are beginning to utilize data products to determine the impact of carbon emissions on financial performance. These products map data to specific components of a business process, enabling a controller to accurately allocate costs for accounting purposes.
The central benefit of using carbon data products in financial services is it allows a company to align emissions costs with specific products and processes. Not only does your company know that its carbon emissions are having an impact on financial performance; it can pinpoint and quantify exactly where this impact is. It might be associated with a particular commercial loan or portfolio. Or, the impact could be attributed to a specific process, such as the workflow that takes place during loan servicing.
The point is, carbon emissions do not need to be viewed simply as a problem with financial implications. Emissions can be analyzed at a granular level, and this analysis can and should be quantified for accounting and financial reporting purposes.
In fact, The Partnership for Carbon Accounting Financials (PCAF) provides guidance to financial institutions for emissions accounting for six asset classes. Guidance includes asset class definition, emission scopes covered, attribution of emissions, equations to calculate financed emissions, data requirements, and other considerations or limitations. The PCAF guidance was developed as an extension of its GHG protocol.
Leading practices are emerging
As companies begin to elevate the carbon emissions issue, leading practices for assessing the impact on financials are emerging. They include:
- A defined methodology beyond the simple “judgment based” principle.
- Be selective. Use the highest quality data available for each asset class and improve data quality over time.
- Develop the ability to analyze the share of emissions with respect to the institution’s exposure to the borrower or investee’s total value.
- Be transparent and report out to all stakeholders, internal and external.
Download the graphic below to see how carbon emission data needs to be analyzed to calculate financed emission for a loan portfolio.
The precision of calculating the attribution factor will be based on the level of details captured and enriched in the subledgers. The table below shows a subset of commercial lending business events that would impact outstanding amount and debt calculations. Based on an initial analysis, at least 44% of existing business events that occur within a commercial lending lifecycle is likely to contribute to the carbon emission calculation.
|Business Event||Event Frequency||Potential Carbon Impact|
|Loan initiation2||At origination||Yes – carbon surcharge/benefit based on deal valuation|
|Record purchase discount||At origination||No|
|Record purchase premium||At origination||Yes|
|Prepaid record fee||At origination||No|
|Record origination cost2||At origination||Yes – FPNA allocation|
|Interest accrual||Daily||Yes – separate carbon interest|
|Amortization of purchase premium||Daily||TBD|
|Fee accrual2||Daily||Yes – separate carbon fee|
|Fee amortization of origination cost||Periodic||TBD|
|Periodic interest payment||Periodic||Yes - separate carbon interest|
|Loan write-down2||Periodic||Yes – “carbon adjusted” valuation|
As this table illustrates, carbon data products can be used to develop a project-specific method to calculate the incremental impact of emissions on financials. This will enable a more accurate emission calculation and enable better reserve/allowance and attribution analysis of emission-related financial impact.
In addition, existing finance data products can be enriched with inputs from carbon data products, and institutions can track, analyze, and report the impact of carbon emissions on financial performance.
Ultimately, this will provide greater transparency helping to make financial markets more efficient and economies more stable and resilient.
- Harvard Law School Forum on Corporate Governance Web site, “A Sense of Purpose,” January 2018.
- Business events that potentially have higher impacts from carbon emission related charges.