Why Financed Emissions Move Up and Down

For financial organisations it is important to fully understand the formula used to calculate financed emissions. This helps them understand what this measure means and what influences it.

Figure 1 – General approach to calculation of financed emissions, according to the PCAF 2nd edition (pg. 40).

Examining this formula in detail, there are five influences that will impact an organisation’s financed emissions:

1. Emissions of the underlying company – if the underlying company itself increases or decreases its emissions, but the attribution factor remains the same, more or less financed emissions will be attributed to the investor. This makes sense – if an investee makes process changes or capital improvements to reduce emissions, the financed emissions of a portfolio holding that company will change.
2. The size of the position in an individual holding – if the value of the position (the numerator of the attribution factor, or the outstanding amount above) changes, but the denominator (valuation) does not, then more or less financed emissions will be attributed to the investor. Again, this makes sense – the more money invested in a company, more of its emissions are attributed to the investor.
3. The relative size of holdings compared to one another – for different holdings, both the attribution factor and the company emissions will be different. All else being equal, if an investor changes the relative outstanding amount of high emission holdings vs low emission holdings the total financed emissions will increase. This makes sense as well – if an investor sells Exxon and buys Brookfield Renewable Energy, the total portfolio emissions will decline.
4. The total fund inflows and outflows – if there are fund inflows that are invested, either the total number of holdings or the outstanding amount of current holdings will change, and the total financed emissions of the investor will change as a result. All else being equal, a larger portfolio will have larger total financed emissions than a smaller portfolio.
5. Company valuation – if the company valuation metric for an individual holding (the denominator of the attribution factor, or equity plus debt above) changes, but the outstanding amount (the numerator of the attribution factor) does not, the attribution factor will change and more or less of the underlying emissions will be attributed to you. This is less intuitive, but it means that a change in, for example, the stock price of a listed equity will directly impact financed emissions of the portfolio.

Understanding these factors is important, as this helps financial organizations understand what influences financed emissions. If the five points above are the major influences on a portfolio’s financed emissions, the list of four points below represents the different stakeholders that can impact a portfolio’s financed emissions.

1. The underlying company. Financed emissions are fundamentally a portion of underlying corporate emissions. If these change, either up or down, portfolio emissions change. Corporate emissions may change due to capital investment, M/A activity, or changes in emissions calculation methods, and are not directly within the control of the investor, although they may be influenced by engagement with boards or management.
2. The investor or fund manager. These influences are within the control of the fund manger, in the sense that the manager can decide to allocate more or less to different sectors and/or positions in a portfolio.
3. The market. Most investors cannot predict future company valuation, but this influences total financed emissions. This influence on financed emissions is market-driven and outside the control of the investor or fund manager.
4. Subscribers. Total portfolio size has a major impact on the financed emissions of a portfolio. Total fund size is a result of the decisions of the fund’s subscribers, although obviously impacted by the fund management.

The many factors influencing financed emissions makes changes over time unintuitive. This can lead to disillusionment of the manger making decisions (“I changed my whole investment strategy to sell oil majors and buy renewables, but my financed emissions barley changed!”), isolation of the sustainability team (“I manage other people’s money and am evaluated on returns, I can’t just invest in green companies!”), and financial organizations having difficulty describing the impact of their climate strategy or their progress towards financed emissions targets to stakeholders.

Sustainability analysts can avoid this by providing the appropriate information to investors and portfolio managers. Clearly, just calculating financed emissions, or telling portfolio managers to buy renewable energy stocks won’t cut it. Investment teams need to understand:

• How and why investment decisions can change future financed emissions, based on the influences under the investor’s control, and an estimate of how much these decisions change financed emissions. This is forward-looking information, largely to help investors make decisions on sector and company allocation. Given the right information, an investor may be able to, for example, change a few holdings to impact financed emissions without changing the overall sector allocation and risk profile of the portfolio.
• Information to help investors understand the result of past decisions and the impact on financed emissions. This needs to disaggregate the impacts of the investment manager, the market, the company, and fund size, and attribute numeric changes to each so that investors understand the impact of decisions separate from other influences.

Investors looking to meet climate targets have two objectives that may be in conflict – first to reduce financed emissions, and second, to earn an above-market return on their investments. The sustainability analysts job is to provide the investor with the information required to understand the trade-offs between these objectives, helping the investment team to achieve a reduction in portfolio emissions while minimizing changes to investment strategy. If sustainability analysts can do that, then more investors will be able to both make market returns while reducing their financed emissions.