Transcript by Kensho. 

Lindsey Hall: I'm Lindsey Hall, Head of thought leadership at S&P Global Sustainable1.  

Esther Whieldon: And I'm Esther Whieldon, a senior writer on the Sustainable1 Thought Leadership Team  

Lindsey Hall: Welcome to ESG Insider, a podcast hosted by S&P Global, where we explore environmental, social and governance issues that are shaping investor activity and company strategy.

In the past few years, hundreds of financial institutions have made big announcements about becoming net zero or carbon neutral by 2050. They've been setting targets to cut their greenhouse gas emissions as close to zero as possible and offset the remainder usually by midcentury. 

Esther Whieldon: Setting net zero and carbon-neutral targets is an important step because financial institutions are exposed to the wider economy through lending, investing and underwriting, and that means that they could be more exposed to the economic impacts of climate change. They can also play a key role in financing the transition and facilitating the flow of trillions of dollars in capital that is needed to mitigate and adapt to climate change. 

Lindsey Hall: Announcements on net zero targets have definitely grabbed headlines, but the reality is complicated. Data collected in the 2022 S&P Global Corporate Sustainability Assessment, or CSA, indicates that while financial institutions are committing to net zero or reducing emissions, less than 1/4 of them are currently aiming to reduce emissions across their entire value chain. 

Esther Whieldon: For a bit of background here, financial institutions have relatively low Scope 1 and Scope 2 emissions. In simple terms, Scope 1 emissions come from direct operations, while Scope 2 emissions are indirect emissions that typically come from purchased energy. 

But financial institutions have much higher Scope 3 indirect emissions. This includes the greenhouse gas emissions that are emitted by the businesses or projects they finance, invest in or underwrite. And it represents their most significant climate footprint. 

Lindsey Hall: To drive that point home, in our research, we reference data from the environmental disclosure nonprofit CDP that estimates financial institutions Scope 3 emissions are 700 time greater than their direct emissions. We'll include a link to that piece in our show notes, by the way. Our colleague Jennifer Laidlaw is a senior writer on the thought leadership team here at S&P Global Sustainable1 and a regular contributor to this podcast. She was also one of the authors on this research, and she's been speaking to banks about the struggle of Scope 3. 

In today’s episode, we’ll hear her interview with the global head of sustainable finance at big Danish lender Danske Bank. We’ll also hear from the global head of responsible business at Spanish bank BBVA.  First up, though, here’s Jennifer setting the scene in an interview with Laurent Babikian, global director of data products at CDP. She asked him about the importance of reporting on Scope 3 emissions and how financial institutions are doing so far.   

Laurent Babikian: We see clearly that financial institutions, they report to CDP, the number is increasing, but it's not because the number of financial institutions is increasing that they are increasing and making more transparent, their Scope 3 emissions. And it's not when they report something on the Scope 3. It's part of the Scope 3. It's not 100% of the Scope. And that's basically a problem because it means that we don't have any clue of the carbon footprint of the financial sector at large in the world, while we have a good estimation of what's the carbon footprint of the oil and gas industry. When they calculate the Scope 3 or part of the Scope 3, so what we call the finance emissions, they usually take into account only the Scope 1 and the Scope 2 of the company they have in portfolio or they lend money to. And they miss doing this, they miss 80% of the carbon footprint of their portfolio companies because we show that CDP that in average, across all sectors, the Scope 3 of the company is something like between 80% to 90% of the total emissions of the company. 

And when we get to the financial sector, it's even worse because the top 3 of the financial sector is 700x greater than the Scope 1 and 2. Or in other words, it's 99% of the emissions of the financial sector. When the financial institutions calculate the Scope 3, they only take Scope 1 and Scope 2. And when they do that, they don't report even 100% of their emissions, but only a fraction of it. So that's a problem. It should be not solved, but it should be changed with the increasing number of financial institutions joining NetZero alliances. So we have 4 of them. We have the Net Zero Banking Alliance. We have the Net Zero Asset Manager Alliance, Net Zero Asset Owner Alliance and the Net Zero Insurance Alliance, and they are all regrouped under an overarching alliance, which is called GFNZ. Those alliances are supposed to help those organizations on their transition pathway to net zero. And they have all of them a commitment letter. I think the strongest commitment letter is the one from the Net Zero Banking Alliance. -- where in the 18 months after joining the banking alliance, the bank should select some of the high meeting sectors. And in the 18 months, they should provide 100% of the Scope 3 of those sectors publicly, they should disclose publicly using Scope 1, Scope 2 and Scope 3. And like what I said at the beginning, they are supposed to be calculating the full value of the Scope 3, which is a very good sign.

Esther Whieldon: Okay, Jen, thanks for setting the scene. So what did the banks you spoke with have to say about how they're tackling the challenge of finance emissions?

Jennifer Laidlaw: Banks are coming at it in all different ways. One bank, Danske Bank, has just published a new climate plan that maps all of its direct and indirect emissions. I spoke to Samu Slotte, global head of sustainable finance at Danske Bank and asked him how exactly that works.

Samu Slotte:First of all, it lays out and describes the emissions for the whole group, including then the finance emissions, and it also then sets targets for the most high emitting sectors, both sort of increases the ambition level on the targets that we have had already earlier, but also introduces new sectors. The largest part of the emissions for the bank are so-called finance emissions. So they constitute more than 99% of -- or actually 99.9% of the bank's overall emissions. 

So really, that's where the bulk of the emissions are. The way we've gone about it in estimating the finance emissions, is by using a methodology drawn up by PCAF or Partnership for Carbon Accounting Financials, which is originally a Dutch initiative where financial institutions and institutional investors come together and really create sort of an accounting standard for how to estimate financed emissions. And the analysis we've done shows that the bulk of the emissions on the lending side are really concentrated to 4 sectors, namely shipping, oil and gas oil production and agriculture. And furthermore, what the analysis showed is that within these sectors, there is a huge concentration into a relatively small number of individual clients. agriculture being a bit different there. We have a sort of broader spectrum of clients. But in these 3 other sectors, it's really concentrated on a few names. 

And I think the good part about that is that it really then allows us to focus our efforts in improving the data quality with a focus on these few sectors and they're within really the largest names. And that then means that we're actually quite satisfied with the data quality for the most high-emitting sectors and are then able to set targets and work on those. So I think the finance emission mapping really helps us to identify the hotspots in the loan book, where we have the emissions. However, it's not necessarily a very good tool for target setting. But for that hotspot analysis, it's a good methodology.

Jennifer Laidlaw: Okay, right. So you said it's not really a good tool for target setting. So why is that?

Samu Slotte:Yes, I'd like to point out 3 reasons. So first of all, finance emissions are really a point-in-time indicator. So it doesn't really take into account the trajectory that each of the sectors should take in order for it to be aligned with the Paris Agreement. So we would need different indicators that purely financed emissions for that purpose. Then secondly, the methodology for actually calculating financial emissions, a key parameter is to divide a company's emissions between the shareholders, bond investors and bank lenders. 

And in order to do that, the first step is really to calculate the enterprise value or EV for each individual company and then allocate the company's emissions based on that enterprise value to these different creditors and investors. That means the finance emissions allocated to Danske Bank, in this case, could change quite a lot for an individual company simply because the company's share price changes. And that, of course, has nothing to do with real-world emissions. It's an accounting rule. And clearly, we need these accounting rules, which are then set much in this PCAF framework. But it also means that it's not necessarily a really good indicator or the movements in that, those finance emissions could be a result of something else than actually the company taking action or the power exposure to it would have changed. So that's the second reason. 

Thirdly, I think if we were to set a cap on reducing finance emissions for a certain sector, it would also mean that we might be in a situation where we cannot provide more financing to that sector because the sector as a whole has higher absolute emissions than another sector. So reallocation between sectors might not be possible. And if we think what needs to happen in these high emitting sectors, it's really a transition. And that transition is mostly a very capital-intensive one, which means that actually in order to achieve that transition, finance is needed. Therefore, an absolute cap on finance emissions isn't really useful. But instead, what we've used is scale physical intensity indicators. So, for example, for power production, we've said a 50% reduction target in CO2 or kilos of CO2 per megawatt hour. And that then allows us to allocate more financing to companies in these sectors, these high emitting sectors provided that they are transitioning fast enough and that the carbon intensity of their production goes down.

Jennifer Laidlaw: You set targets for Scope 3 emissions for different sectors. And in some of them, you include your client;s Scope 1 and 2 and in some of them, the 1, 2 and 3. So is it basically you adjust that in terms of what the client does or the information that you're getting from the client?

Samu Slotte:Yes. So all of the financed emissions that we, as a bank, that Danske Bank reports, those would be our Scope 3 emissions. And within those financed emissions, Scope 3 emissions, we then have our clients cope 1, Scope 2 and Scope 3 emissions and then where the Scope 1 and 2 here refer to our clients' own emissions and then the clients Scope 3 emissions to emissions in their value chain. And what we strive towards is to include our clients' Scope 3 emissions when they are a material part of the client's overall emissions. And we follow here the greenhouse gas protocol recommendations that when more than 40% of the clients' total emissions are in the Scope 3, then that should be reported. 

And this we do, for example, for oil and gas companies where the bulk of the clients and the company's emissions take place when the oil or gas or fuel is combusted. And for oil and gas, we would then have these Scope 3 emissions also included. But in some sectors, this has not been possible really based on data quality. An example of that would be real estate, where we have only included Scope 1 and Scope 2, but where we know that there are significant upstream Scope 3 emissions related to the actual construction of the buildings. So even if I say that the data quality is very, very good for those sectors that really matter. There are a few exceptions where adding Scope 3 emissions would give a more complete picture. And we clearly seek to do that also once the data quality improves. So that would be an example where we would not have Scope 3 emissions included. But for the most of the sectors where they are material, we would seek to include them.

 Jennifer Laidlaw: One of the things we looked at in our research was the importance of short-term targets to help financial institutions set a road back for achieving net zero goals. I also spoke to Toni Ballabriga, global head of responsible business at Spanish lender BBVA, about the importance of interim targets to help banks achieve their net zero goals. You'll hear him mention the TCFD. That's the Task Force on Climate-related Financial Disclosures, a voluntary disclosure framework.

Toni Ballabriga: This is a very important challenge that we have in this major journey, okay? Once we have set the ambition and as members of the Net Zero Banking Alliance, we are using the guidelines that were released on April 2021, which are very robust and defines that we have to set intermediate targets by 2030 in those sectors with high intention emissions. And that's what we are already doing. In fact, we have already set targets by 2030 in 6 sectors in oil and gas, in power, auto, cement, steel and coal. 

In our case, we use the IEA net-zero scenario. So this is the scenario that we are using. And a very strategic decision is the type of metrics you want to use for this target. For the experience that we have, we have decided to use in some cases, intensity metrics in line with the sectoral recognition approach -- in some cases, we have used absolute metrics. So in sectors like power, or cement and steel or even auto, we are using intensity metrics in terms of CO2 emissions by unit produced. But in oil and gas, we decided to use absolute emissions. And we have set a target to reduce 30% of absolute emissions in oil and gas. While for instance, in power, we have set a target to reduce 52% of intensity per cubic produced by 2030. And then cold in coal, we also have a phase out by 2030 in developed countries, 2040 or for the rest of the world. So we have also a method here to follow.

Jennifer Laidlaw: Okay. Interesting. And in what sense are you embedding these targets into your risk management and into your lending policies?

Toni Ballabriga: First, we have decided to have a governance, a strong governance focus on alignment on net zero alignment. So we have a specific stream group with the key business lines and risk and ensuring that we make the right oversight of all the process and the targets and the performance. Then second decision very relevant is that business lines, our bankers are the ones that has to be at the end of the day, accountable because they are the ones that are going to engage with our clients. We understand that the target is our target, but it depends on our client positions we rely on the policies in each country. So we can help our clients. But at the end of the day, its their decisions to align, and we have to provide them the advice and the solutions to help them to reduce emissions. So client engagement is a key pillar in order to embed. So that's very important. 

And the final point is to embed is, well, we have to integrate these new metrics into our decision-making, into our frame work, into our risk appetite. We are developing tools in order to help this happen. And one example of these tools beyond the typical red lines that some banks have in terms of certain activities that you want to exit or reviews and so on. The most important tool that we have is what we call the transition risk indicator. The transition risk indicator it scores our clients in those sectors beyond the metric of emissions because it's important to understand the resilience that our clients have in terms of transition risk. And the score today is being used in our decision-making. This is score that obviously, we assess the reporting, especially on TCFD reporting from our clients in terms of governance, strategy, risk management and metrics and targets. This accounts for around 20% of this transition risk indicator. But then the other 80% is what we call the carbon position condition assessment. So we take into account the exposure of our clients in the different regions because that conditions a lot because the expectations in terms of condition risks are different worldwide. We take into account the plans and the investment plans that our clients have in order to reduce the emissions. And also, we take into account the challenges, the technological challenges that those sectors have.

Jennifer Laidlaw: BVA is a Spanish bank by its largest market is in Mexico, and it has operations in several Latin American countries. It also has a presence in Turkey. So I asked Tony how the bank is measuring finance emissions in other regions, especially in gathering information about small- and medium-sized enterprises that don't report any climate-related data.

Toni Ballabriga: Is it true that, obviously, each country has its own policies and priorities, and we see that, obviously, in countries like Mexico and other countries in Latin America or Turkey obviously, there is a lot to do. There are a lot of priorities on the table. In the region of South America, we see Colombia has very well advanced on that on sustainable finance. So positively, we see that market as with high potential. But coming back to SMEs, we have to have also SMEs to participate in this process. 

The point is that SMEs, they used to have a very short-term time frame when -- on the decision-making. It's quite challenging for banks to help them on that. And we need to focus on what is really, really material for them. So we have to focus on solutions on energy efficiency, solutions on renewable energy, or solutions on mobility. 

So you have to focus on specific areas where you can have a, let's say, clear business case where they can get the payback in 3, 4 years. And then we have to make it very easy. We have to provide them some data. For instance, we have a carbon footprint calculator in our website and apps or SMEs you're seeing artificial intelligence to help them to calculate the carbon emissions. And that creates awareness to promote certain decisions on this. So we have to combine awareness, and then very easy solutions to help them to act because it's not so easy. But yes, this is absolutely critical, and this is a challenge for all banks.

Jennifer Laidlaw: We've heard about some of the work that banks are doing with their clients. Laurent from CDP, Top financial institutions need to ensure that the companies they invest in or lend to are aligned with the Paris Agreement, which aims to limit global warming to 1.5 degrees Celsius by the end of the century. Here's Laurent again.

Laurent Babikian: Now the targets, they need to build a 1.5 degree aligned or net  zero or even better net zero aligned portfolio, it means that they need to choose companies that are themselves 1.5 degree aligned or even better net zero aligned. And you don't have on the global stock of corporation in the world, you don't have so many of them that are aligned. If I take the 1.5-degree aligned company validated by the Science Based Target Initiative, I think we have now 1,600 companies in the world, out of, I don't know, 100,000 or 200,000 or 300,000 companies. So it's a very, very small number. And we need to increase dramatically this number because if we do that, then you increase the investable universe to which financial institute can lend money to or invest in what is a bank? 

Jennifer Laidlaw: What is the financial institution do if most of its clients are not aligned and have no intention of doing so? 

Laurent Babikian: Yes. So that's the good thing. I mean, because the bank joined those Net Zero Alliances, so they need to achieve those targets unless it is greenwashing, if I join an alliance knowing exactly that you will not achieve the target, then this is called greenwashing. But if they are serious about the commitment that they are signing, then they need to be aligned. And on the top of that, you have a lot of regulation coming here and there, especially in Europe. Europe is quite at the forefront of regulation and requesting investors to disclose public information on their Scope 3 and on their portfolio. Investors, they have a very -- so they need to build those 2 degrees or 1.5-degree-aligned portfolio -- to do so, as we said, they need to have a much higher number of company. So the first thing that I can do really strongly is to engage with them and directly or through campaigns, as I explained before. 

And the engagement is part of their transition to net zero because they all need to transition. And one part of this transition is to engage in the company they have stake our shares in or they lend money to. And ultimately, in the last result, they could sell the stock. But that's not -- if you sell the stock, you don't solve the problem because somebody else will buy the stock. So if you are talking about the loan book, what it means is that when the loan is reaching the maturity when we arrive at the maturity time, then you negotiate with your client and you say, "Hey, you need to be 1.5 because if you're not 1.5, I cannot lend you money because I myself must be 1.5". So it's a strong incentive that the company will listen to because, make no mistake, the -- most probably, the cost of capital of the company that are not aligned will be higher than the cost of capital of the companies which are aligning themselves to net zero or 1.5. So it means that the company needs to be ahead of the transition because if they are not ahead of the transition, then they will probably lose some market share and some profitability. And that's a problem for an investor. So it's also in the interest of the company to change and if they don't change, then investors will look less at those companies and more the company at the 1.5 aligned company or even better, the net zero line company, they find all the money of the world they want today right now. It's not a problem of liquidity. They have everything they want, which is not the case of the average crowd on the market, which has not transitioned yet and which is still waiting on the platform to say, should that get on the train or not?

Esther Whieldon: That brings up the question we've been looking at a lot in this podcast of divestment or engagement. So Jen, what did the bankers you spoke with make of that?

Jennifer Laidlaw: Samu who told me there was not an easy answer to that and the experience of asset managers and banks was very different. Here he is again.

Samu Slotte:So for a shareholder, be it an asset manager or pension fund, engagement clearly makes sense and active ownership makes sense because that's the way that they can influence the companies and by voting at AGMs. And typically, an equity investor would acquire their shares from the secondary market which means that none of the funds at the point of investments or divestment actually go to the company or are leaving the company. And this is, of course, very different to a bank lender in terms of how we operate with companies. 

So for a bank lender, first of all, the dialogue is much more of a partnership type than an "now we engage with you" type of a dialogue, where we, as a financier have basically daily dialogue with our clients on a variety of topics. Her we will also communicate well in advance to the company or in sort of well in advance of a refinancing, what our expectations on the financial metrics or their climate policies and ESG targets should be in order for us to refinance at the next juncture. And let's say that there's a refinancing of a core facility, which typically takes place every 5 years for a large company, then the sort of the real divestment point, if there would be one comes at those refinancings and provided them that we have sufficiently clearly laid out what the requirements from our side and expectations from our side as a bank are to the client, we can then determine at that point in time whether the client actually is living up to these expectations and whether we can then continue with the refinancing. 

If a shareholder divests, then there's not really any action needed by the company. I mean it's not financing leaving the company. It's something that happens in the secondary market. But whereas a bank then divest or discontinues the relationship by not refinancing, then it actually requires some action by the company. They need to find a new lender, a new financier to take the seat of the one who has not decided to refinance. So that's also a difference in the dynamics.

Jennifer Laidlaw: I then asked Tony if BBVA would stop working with clients who decided that they just didn't want to transition.

Toni Ballabriga: Well, there are only a few red lines that, as I said before, that probably we have to have in place, and that's what we have and also other banks but -- and activities that we have to phase out. But in general, what we have to do is we have to not only finance the core pure green activities, we have also to finance the whole economy to transition. Otherwise, we are not going to succeed. So it's not only how we reduce our finance emissions is how will it help to reduce our clients' emissions in terms of financing the emissions reduction. And that's important. And that means that all clients have to have the opportunity to make that process. Obviously, that is very relevant because in the short term, you may have 3 types of clients: the client that maybe, well, they are very well positioned with a very nice TRI with a very nice low emissions intensity or business profile and with a very nice tradition plan in front of them. So that's fantastic. But also, we are going to have clients and we have clients today that the starting point is not so good. But they have a very credible transition plan to reduce significantly the emissions and to transform the business model. We have to provide them solutions and the financial solutions to make it happen. I mean it's important, although maybe the starting point is not so good. So I insist on that, transitional financing is key, we need to engage with our clients to understand which are their transition plans. And if they have transition plans credible, robust, with a strong CapEx to transform the business model, even for those sectors difficult to abate, banks have to be there to help them to conform. So that's the approach. So it's not divesting. It's about engaging on obviously, after 2, 3, 4 years, that client doesn't want to change, do was to confirm. Obviously, this will have implications in terms of asset allocation or in terms of pricing, that's true. But the priority is to help banks and finance emissions reduction for our clients.

 Jennifer Laidlaw: Tony also explained net zero was a massive opportunity for banks.

Toni Ballabriga: We see climate change as a huge business opportunity. We need to mobilize practically $275 trillion the next 30 years, 8% of GDP year after year. We need to have a massive asset reallocation worldwide, we need to scale up technologies that are already there available and with no green premium, we need to invest also help investment or promote investment on those technologies for sectors difficult to abate. So it is a massive, massive opportunity for bank as refinancial institutions.

Jennifer Laidlaw: Opportunities abound in the green financing space, Laurent told me, and financial institutions need to be more innovative if they want to meet those net zero goals. Here he is one last time.

Laurent Babikian: There is a huge lack of innovation on the financial markets. We have green bonds now. The new thing is the sustainability-linked bonds or sustainability in loans, which are, by the way, excellent. -- and they should become the norm. We shouldn't have any more vanilla alone without condition. We should, from now on, if we are serious about the objective of the transition to net zero and nature positive or regenerative world, we should have only sustainability-linked loans which work this way. If the loan -- the interest rate is attached to a KPI or multiple KPI, very often linked to the environment or to climate. So if the company is achieving the KPI, then the company will pay less interest rate to the bank. And if the company is not achieving the KPI, then the company will pay more interest rate to the bank. And it means that if the company is achieving the KPI, they're doing good and they're doing well. At the same time, they lower the cost of capital. So everybody is happy. The Chief Sustainability Officer in the company is happy and the Chief Financial Officer in the company is happy. Maybe the banker is less happy because he's going to receive less, but he's playing on the fact that in average, some of the company will not make the targets and will pay more interest rates, and they're also playing probably on the reputational risk to give a good image of the bank saying that it's the bank financing the goods and the transition. 

But a part of this, there is a very low level of innovation. We should have options, swaps, swaptions, futures, options linked to temperature, we should have call inputs to one degree for Unilever or put 2.5 degree sensors for Unilever, the same with L'Oreal or with Apple. We should create all these tools that we have in the vanilla market apply to ESG because it will create the conditions for the liquidity and the market players need to have those tools, so I'm thinking about the hedgers, the speculators, the market makers need to have those tools to do that job. And their job is to also create liquidity.

Lindsey Hall: So it sounds like financial institutions are making strides on reducing financed emissions, but also it looks like it's going to be challenging times ahead. 

Jennifter Laidlaw: Yes, and the urgency is growing. As Laurent told us, financial institutions need to ensure that their clients are getting on the train for the journey to net zero.

Esther Whieldon: Well, thanks, Jen, for joining us today. We'll be sure to keep our listeners informed on finance emissions and the challenges of Scope 3 emissions going forward.

Lindsey Hall: Thanks so much for listening to this episode of ESG Insider and a special thanks to our producer, Kyle Cangialosi. Please be sure to subscribe to our podcast and sign up for our weekly newsletter, ESG Insider. See you next time.  

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