Financial companies play a crucial role in financing the world's economic activities and are also expected to play a major role in financing the global economy's transition to a more sustainable future.
Perhaps the most crucial role that banks in particular can play in driving positive change is by shifting their lending portfolio away from less sustainable companies towards more sustainable companies within the same industry. However, as we will learn in this post, it is vital that banks are making such decisions based on the correct information.
Today we compare the emissions disclosures of two very similar companies from the Aerospace & Defense industry (BAE Systems and Safran, the British and French giants). We then think through how these disclosures might impact a bank's decision to lend to one of these companies in preference over the other. There is a pretty big twist in this tale so please make sure you read the details of what follows and don't just glance at the tables!
You can watch Barrie's video summary here:
Introducing Financed Emissions
Banks account for the emissions in their lending portfolios through a concept known as Financed Emissions. The main reference document for this framework comes from PCAF and I have to say that I'm a big fan of what they have developed. The framework is still being evolved but already covers many of the major aspects of a bank's lending and investment activities.
The 7 asset classes covered by the PCAF Standard:
The framework allocates the emissions of real-economy companies to the banks based on the amount that a bank has lent to the company expressed as a percentage of the company's overall liabilities.
PCAF General Formula (the details vary for the above asset classes):
So as you might hope, the framework encourages banks to invest more in companies that have low emissions relative to their peers and to divest companies that have high emissions relative to their peers.
Which of these two Aerospace/Defense giants should a bank prefer to lend to?
ktonnes CO2e | Scope 1 | Scope 2 | Scope 3 |
BAE Systems | 113 | 56 | 63 |
Safran | 261 | 143 | 61,012 |
source: 2022 GHG emissions disclosures for these companies
The first thing I would like to point out is that there are no typos in the above table! Safran and BAE Systems are similar-sized companies involved in very similar activities, but Safran disclosed their Scope 3 emissions to be roughly 1,000 times higher than those of BAE Systems!
Now an unsuspecting banker that takes those disclosures at face value will immediately jump to the conclusion that BAE Systems is a better company to lend to (from a sustainability perspective) than their French rival Safran. But are they correct to jump to such a conclusion?
Let's dig deeper into the Scope 3 sub-categories of their disclosures
ktonnes CO2e | BAE Systems | Safran |
3.01 Purchase Goods | not disclosed | 4,400 |
3.03 Fuel and Energy | not disclosed | 98 |
3.05 Waste in operations | not disclosed | 15 |
3.06 Business Travel | 63 | 28 |
3.07 Employee Commute | not disclosed | 104 |
3.09 Downstream Transp. | not disclosed | 267 |
3.11 Product Use | not disclosed | 56,100 |
The above table sheds a great deal more light on what is going on here. BAE Systems only disclosed the GHG emissions related to the "Business Travel" of their employees. If you read the footnotes of their disclosures they mention that they are in the process of calculating "the more complex categories of Scope 3".
The two main sources of Scope 3 emissions in the Aerospace industry relate to 3.01 Purchased Goods & Services and 3.11 Downstream Product Use. These companies both manufacture military aircraft and so its not surprising to see large numbers in category 3.11 resulting from the large quantities of jet fuel that their aircraft consume during their lifetime.
Does assurance fix this problem?
The BAE Systems disclosures were accompanied by the following statement:
In short, assurance does not solve this problem. The auditor in this case is basically saying that they Business Travel numbers look reasonable (which I would tend to agree with).
But it is VERY IMPORTANT to understand that this assurance statement is not saying that these Business Travel emissions are a good representation of the entirety of BAE System's Scope 3 emissions. As we will learn below, BAE System's Scope 3 emissions are likely something like 1,000 times larger than their Business Travel disclosures.
The vulnerability in PCAF
The PCAF framework encourages banks to use the "verified emissions" of reporting companies where they are available, so you can see there is a risk of a misunderstanding in the above situation.
I'm pretty sure that it was not the intention of the PCAF framework to assume that the total Scope 3 emissions of the BAE Systems can be equated to their Business Travel emissions even if those Business Travel emissions have been verified.
How do we fill the gaps?
The PCAF framework also permits the use of revenue-based, industry-specific benchmarks. This is where our datasets clearly come in handy since they are designed for this very purpose.
PCAF rightly encourages the use of verified actual disclosures over the revenue-based benchmarks, but the crucial point is that these decisions in the case of Scope 3 need to be made at the level of Scope 3 sub-categories, not for Scope 3 in its entirety.
If we apply this logic properly, then we should use the actual sub-category emissions where they are available, and then populate the missing items with revenue-based benchmarks. The below table shows what we get for BAE Systems and Safran when we follow this approach:
ktonnes CO2e | BAE Systems | Safran |
Scope 1 | 113 | 261 |
Scope 2 | 56 | 143 |
3.01 | 3,540 | 4,400 |
3.02 | 209 | 164 |
3.03 | 85 | 98 |
3.04 | 84 | 65 |
3.05 | 15 | 15 |
3.06 | 63 | 28 |
3.07 | 63 | 104 |
3.09 | 341 | 267 |
3.11 | 104,043 | 56,100 |
The numbers shown in black are the actual 2022 disclosures. The numbers shown in purple are then the revenue-based estimates based on our Aerospace & Defense industry dataset. As can be seen, Safran also had a couple of categories missing which we have populated with our benchmarks.
Our benchmarks (in ktonnes CO2e) are higher for BAE Systems because it has higher revenue than Safran.
This approach is a bit similar to way regulators allow banks to employ "internal models" where they are available but then to fall back on "standardized" benchmarks where an internal estimate isn't available.
But doesn't it pay for banks to bury their head in the sand and just assume that these missing categories are zero?
In the short-term, yes, you could argue that a bank would be better off lending to BAE Systems and pretending that their Scope 3 emissions are lower than they are in reality by ignoring all the missing categories. But there is a major risk to this approach.
Banks have promised their stakeholders that their Finance Emissions will come down through time. If a bank lends to BAE Systems without accounting for the missing categories, and then this company starts to disclose more categories through time, the bank's numbers will start moving violently upwards.
This could lead to some serious problems were banks are forced into a hasty exit of certain lending position to avoid their numbers going up. I can't tell how painful that type of thing is for a bank. It basically destroys their relationship with the client for years to come.
In our system we prefer to reward companies for transparency. As a result, we have awarded Safran a Platinum rating for disclosing all categories of GHG emissions. BAE Systems is currently unrated in our system since they have disclosed less than 25% of their total emissions (according to our calculations):
We are here to help
We have already been through the process of filling in all the blanks for 10,000+ publicly-listed companies based on our benchmark datasets. In other words we have a fully-functioning Financed Emissions model for the larger corporations and we are now extending it into the SME market. Even if a banks are not keen to throw away their existing Financed Emissions model, they would certainly benefit from gaining access to our data so they can gain some visibility for how their portfolio might evolve through time as companies start to disclosure more categories.
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