Decarbonizing Investments: New Science-Based Target Framework for Financial Institutions
October 2020 marked a significant milestone for the corporate climate action movement: nearly five years after the Paris Agreement the 1,000th company joined the Science Based Targets initiative (SBTi). While science-based target setting becomes imperative, the SBTi’s new framework for financial institutions – including banks, investors, insurance companies, pension funds and others – allows new segments to join the program and set science-based targets to align their lending and investment activities with the Paris Agreement. Financial institutions are the key to unlocking the system-wide change needed to reach net-zero emissions. In this blog, Schneider Electric sustainability expert, Dorottya Oláh summarizes the new framework and looks into further impacts across the business landscape.
Dorottya Oláh, Sustainability Consultant, Schneider Electric Energy & Sustainability Services
Dorottya works in the EMEA region focusing on the development of climate strategies, establishing carbon footprint and emission reduction targets to help companies achieve their climate goals and spearhead the green transition.
The Science Based Targets Initiative is a non-profit organization developing methodology and providing target validation for companies to enable them to align their GHG reduction targets with the latest climate science in order to be able to meet the climate goals set in the Paris Agreement. To date, over 1,000 companies have committed to taking science-based climate action and more than 500 companies have approved science-based targets. Among these SBTi signatories, many sectors from manufacturing to telecommunication are utilizing the available methodology of SBTi. However, the current methodology and general framework are not suitable to capture the emissions and the impact of investment portfolios.
Financial institutions have a different-looking GHG footprint than a manufacturing company, for example, as they provide services and their impact is largely realized through their investment portfolios. Due to the vastly different nature of some sectors, financial services included, there was a clear need to develop specific methodologies that would enable financial institutions (FIs) to capture, report and take action on their most significant climate impact: their investment portfolios.
Over the past two years, SBTi worked on developing such recommendations and methodology in collaboration with WRI, WWF and CDP, involving a wide range of stakeholders for consultation. In October 2020, they published the first version of the target setting and validation framework developed for FIs aligned with the latest climate science. This was accompanied by a pilot project inviting the first 20 FIs to go through the target validation process free of charge while providing useful information on the methodology and process. It is expected that the revised methodology following this pilot project will be available in 2021.
Why are FIs so different from most other industries that it was necessary to develop a standalone framework for them?
The emission footprint and subsequent GHG targets of a production company are fairly straightforward to establish following the standard best practices of the GHG Protocol and SBTi criteria. For these companies, the emissions in Scope 1 and 2 are a significant part of the total footprint and usually are addressed via efficiency measures and renewable electricity purchase/generation instruments, while Scope 3 emissions are routinely addressed via supplier engagement, procurement and R&D strategies. Scope 3 targets are also not as stringent at the moment as Scope 1 and 2 targets.
A typical FI, on the other hand, provides services instead of products. Scope 1 and 2 emissions can be identified from their own operations, offices or customer serving locations for example, but the various investment portfolios, loan, mortgage and project financing solutions place this particular Scope 3 category in the most impactful range, which easily outstrips the FIs own Scope 1 and 2 emissions as well as the other 14 Scope 3 categories. Due to this discrepancy, the regular requirements for Scope 3 targets are not robust enough to reflect the impact of these investments, therefore specific assessment and target setting criteria were required. In addition to the technicalities of target setting, it’s becoming increasingly clear that FIs have a significant role to play in driving the decarbonization of the economy by favoring green solutions with their investments.
What does the new framework include and how does it help FIs to take control of their investments’ climate impact?
As part of the new framework, SBTi has published a guidance document which, among other important considerations, contains the specific criteria set out to enable FIs to set SBTs on their investment portfolios as well as on their own Scope 1 and 2 footprints.
There are a few notable differences in Scope 1 and 2 GHG footprint calculations and subsequent target setting for FIs. FIs can set these targets using two main approaches:
- the Sectoral Decarbonization Approach for Services/Commercial Buildings aligned with the beyond 2 degrees scenario
- set physical intensity targets utilizing the Temperature Rating option ensuring that the underlying absolute reduction is in line with the Absolute Contraction approach for a well-below 2 degrees (2.5% annual linear reduction) or the 1.5 degrees (4.2% annual linear reduction) scenarios.
A similar approach can be taken using an economic intensity target, but this would not be applicable to all types of FIs based on different activities and therefore should be taken with caution.
The main attraction of this document is the detailed Scope 3 target setting approach describing which methods can be used to set targets on different asset-classes within an FI’s portfolio. The document introduces an asset-class-specific approach with three methodology options, one or more being applicable to each of the asset-classes, taking into account industry best practices, underlying data availability and nature of assets. When using these methods, specific criteria are set out for the FIs to observe. The categorization and extent of Scope 3 emissions associated with various types of investments follow guidelines from Partnership for Carbon Accounting Financials (PCAF), which provides more clarity on asset-classes and subsequent data quality criteria. The PCAF methods are also currently under review which might affect the updated content of the SBTi framework.
The Scope 3 methodology options described divide as follows:
- Sectoral Decarbonization Approach (SDA): Physical intensity targets based on real emissions are set, aligned with the IEAs CO2 sector scenarios. This method is available for multiple asset-classes but is the only option for real estate loans and electricity generation activities. Targets set using this methodology have to be aligned as a minimum with the well below 2 degrees scenario pathway and have to cover 5-15 years with a recommended additional target to 2050.
- SBTi Portfolio Coverage Approach: In this method, FIs commit to having a portion of their portfolio companies set their own SBTs to ensure the FI is on a linear path to 100% portfolio coverage by 2040. The portfolio coverage target has to be met within 5 years, while borrowers/investee targets have to be approved within 5 years of FI’s target being set.
- Temperature Rating Approach: This approach can be used to convert existing goals into a comparable temperature rating, establish the current rating of the FI and portfolio companies and encourage their portfolios to set ambitious targets in order to reach an identified target temperature score. As a minimum, the portfolio’s Scope 1 and 2 temperature scores shall be aligned with well below 2 degrees scenario, and Scope 1, 2 and 3 shall be aligned with 2 degrees scenario by 2040. These alignment targets must be fulfilled within 5 years of target submission.
It is important to note, that a three-tier system has been introduced to organize asset-classes, with different levels of ambition associated with each tier.
Required activities are asset-classes where, if present among the activities of the FI, a target has to be set using one of the three methodologies. Required activities include electricity generation project finance, corporate loans to commercial real estate, electricity generation or other long-term debt, common and preferred stock, corporate bonds, investments in real estate investment trusts, real estate mutual funds and listed real estate companies. In the case of electricity generation project financing, 100% of activities shall be covered. In the case of long-term lending in fossil fuel companies, 95% of activities shall be covered. For lending activities in all other sectors, the mandatory coverage of required activities is 67%.
FIs are encouraged to set targets on optional activities as well. While these are not mandatory at the moment, it is predicted that ambitious targets addressing activities currently in this category will become necessary (and recommended) to keep the momentum of engagement with private equities as well as not to endanger the progress towards achieving the goals of the Paris Agreement.
Communicating targets is an additional requirement
FIs are required to communicate their SBTs, describe the specific actions they intend to take to achieve these targets and report on progress against the targets annually. There are currently no specific requirements set out by SBTi as to where the annual progress should be reported, as long as it is publicly available, such as the company’s annual or sustainability reports, CDP response or the company’s website.
During the submission of the target, FIs must develop a target language (utilizing the Target Language Template) and employ that in their future communications around the target. In this document, FIs shall describe their:
- Scope 1 and 2 target
- Scope 3 target addressing any of the 1-14 categories besides “Investments”
- Scope 3 headline target for portfolios, listing the asset-classes which will be covered by target(s) as well as the percentage of portfolio coverage
- Scope 3 asset-level targets describing the individual targets for each asset-class
In addition to the target details, FIs also need to submit a strategy and list of actions they intend to implement in order to meet their targets accompanied by a brief description of why the specified strategy and actions were selected. This strategy description will be published on the SBTi website upon target approval, alongside the target itself. Having to disclose this strategy will not only increase transparency and robustness but also will help shed more light on which are the most effective actions to reduce the impact of investment portfolios, to inform further development of methodologies.
Next steps and recommendations
While the framework is in its pilot phase and welcomes the first 20 FIs to submit their targets for validation free of charge, the methodology is expected to develop and change drawing on the lessons learned during this pilot phase. It is expected to be a widely used tool with clear guidelines on target setting in this very specific sector.
To underline the relevance of this new framework, already more than 55 FIs have expressed interest and committed publicly to setting targets aligned with the latest climate science, and this framework is the first step enabling all FIs to take meaningful and transparent action to mitigate the impacts of climate change.
Taking into account the global trend toward sustainable finance, early adoption of this framework will most likely benefit the participating FIs. In the EU, for example, the Sustainable Finance Action Plan — a complex mix of legislative measures including Taxonomy Regulation, Sustainability Disclosure Regulation, Climate Benchmarks Regulation and a proposed Green Bond Standard — will push FIs based in or doing business in the EU to assess and report on the sustainability impact of their portfolios. A science-based GHG reduction target will set them apart in future ratings.