Transcript by Kensho.

Lindsey Hall: Hi. 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.

Esther Whieldon: On this podcast, we routinely hear about the critical role financial institutions will play in the low carbon transition. That's everything from financing the transition to engaging with companies in their portfolios to take action on climate change. And we've seen some big examples in recent years of financial institutions setting net-zero emissions targets and joining initiatives aimed at moving towards that goal.

Lindsey Hall: Well, today, we're talking with the Science Based Targets initiative, or SBTi, and this is a widely recognized organization for companies that want to ensure their decarbonization targets align with the latest scientific understanding about climate change. SBTi is a partnership between the Climate Disclosure Platform, CDP, the United Nations Global Compact, the World Resources Institute, or WRI, and the World Wide Fund for Nature or WWF.

In 2021, SBTi updated its science-based target certification to include a net zero standard for corporations, and it also began work on updating its standards for financial institutions, which is what we'll be exploring today. If you'd like to learn more about SBTi's net-zero standard for corporations, we'll include a link to a past podcast episode we did on that topic in our show notes.

Esther Whieldon: In this episode, we'll dig into what the science-based net-zero standard for financial institutions might look like. We'll explore why financial institutions are getting a separate standard from other kinds of companies as well as the ways in which the disclosure landscape and the broader dialogue on climate change for financial institutions have evolved.

For this, we'll talk with SBTi Cofounder and Chief Technical Officer, Alberto Carrillo Pineda. And we'll also hear from a financial institution that was among the first to have its climate targets validated by SBTi. For that, we'll turn to Marina Severinovsky. Marina is Head of Sustainability North America at Schroders, and that's an asset management firm with more than $923 billion in private and public assets under management.

Now today's episode is quite timely, Lindsey, because SBTi is closing the window for its public consultation process on the draft guidance documents it issued for financial institutions, and that's closing this coming Monday, August 14. Alberto told me that SBTi aims to finalize the standards by the end of 2023 with, of course, the caveat that the timing will ultimately depend on what SBTi learns from the stakeholder feedback.

Lindsey Hall: Before we turn to those guests, let's just do a quick run through of some of the acronyms, groups and terms we'll be hearing about. One is PCAF, and that's the Partnership for Carbon Accounting Financials. Another is GFANZ. That's the Glasgow Financial Alliance for Net Zero. We'll also hear the ISSB mentioned. That's the International Sustainability Standards Board, which in June just issued Sustainability Disclosure Standards. 

You'll also hear the GHG Protocol mentioned. That's an international standard for corporate accounting and reporting emissions, which leads me to Scope 1, 2 and 3 emissions. Now Scope 1 emissions are direct emissions from a company's operations. Scope 2 is those indirect emissions, and those are primarily derived from purchased energy. And lastly, Scope 3 emissions, those occur up and down the company's supply chain as well as when a customer uses the products. And for financial institutions, Scope 3 emissions include financed emissions, which come from investments they make or the loans that they finance.

Esther Whieldon: And you'll also hear a lot of discussion of 1.5- and 2-degree targets. This refers generally to targets countries set under the Paris Agreement on climate change in 2015 that aims to limit global warming to well below 2 degrees Celsius relative to pre-industrial levels. And that accord also included the goal to ideally stop global warming at 1.5 degrees.

Since then, scientists have said the world needs to reach net-zero emissions by 2050 to have any hope of staying near 1.5 degrees, which was the basis for many companies setting net-zero goals. Where SBTi fits in this is its standards for what companies would need to do to align their targets with that 1.5-degree or net-zero pathway.

And SBTi also reviews and validates companies' targets based on those standards. Okay, now with all that in mind, let's turn to my interview with Alberto, where he explains SBTi's role, why the group sees a need to update the 1.5-degree standard for financial institutions, and what the new net-zero standard will entail.

Alberto Carrillo Pineda: The development of resources for the financial sector and the SBTi has been an iterative process. We started working formally on this in 2017, 2018. And we published the first framework, which is basically guidance for science-based target setting in the financial sector in 2020. And I would say, since then, there has been a very rapid development in the wider ecosystem.

As an example, for instance, the world shifted towards a focus on 1.5 degrees and net zero. There was emergence of important actors in the ecosystem, for instance, GFANZ, which is the coalition that mobilizes financial institutions that want to align to the goal of reaching net zero emissions at the global level. And then this has also enabled the development of different resources for different sectors or different subsectors in the financial sector.

Again, if you think about where climate more broadly and target setting was 5 or 8 years ago, where I would say it was a nascent practice, something that was good to do. And yes, something that was still a practice was implemented by a few stakeholders than the level of expectations in the weather ecosystem were different.

Now that you have a wide range of stakeholders are pushing for entities to mitigate their impact on the climate, that you have a number of decisions being made on how companies set and implement their targets, including, for instance, for financial institutions, decisions on whether to continue to invest or not in a specific entity. Now that you have also litigation happening around the type of claims that entities make, I would say that requires a much more rigorous approach to how climate is managed more broadly. And I would say, eventually, this is part of a transformation that needs to go from voluntary initiatives to voluntary standards to international standards and to regulation. That's the process that needs to happen. And then again, that's why for me, SBTi is basically part of a broader accountability ecosystem that is needed to really enable this transformation at the global level.

The reason why we have decided to develop a framework for financial institutions is because of the central role that financial institutions play in enabling the current economy, but also in enabling the transition that our economy needs to undergo to stabilize global warming. And so financial institutions is a different sector. They are not directly involved in controlling the activities that create emissions to the atmosphere, but they enable these activities and entities through the financial services that they provide. And so they play a key central and overarching role over the entire economy and the development of guidance and standards for the financial sector is something that I would say is -- yes, it has followed a different time line, mainly due to the fact that climate and emissions management in the financial sector is a bit less matured than where we are with the corporate sector.

Just to give you an example, for instance, we have had accounting standards, well-established greenhouse gas accounting standards for the corporate sector for at least 2 decades, whereas for the financial sector, greenhouse gas accounting is a much newer practice and some of the greenhouse gas accounting standards just basically started to get consolidated over the past few years. So, it's a topic that is less developed in the financial sector. And I would say it also involves more complexity than in the corporate sector.

The data collection aspect can be quite complex for financial institutions because normally, they, of course, engage in transactions with hundreds, thousands of entities and activities in the real world. And so the data collection process is complicated. It takes time. And so just to get, for instance, an understanding of the impact of an entity on the climate can be a lengthy process, and that's the first challenge.

The second challenge is there's different ways in which financial institutions can directly or indirectly enable emissions, depending on the nature of the financial services that they provide. There's different asset classes, for instance, whether an entity is providing finance for the construction of a new airport or new port, for instance, that's normally something that happens through project finance. Whether they are enabling or supporting an entity through holding assets in that entity by having shares in that entity, or by providing loans to that entity, whether they're enabling an activity by, for instance, providing insurance against an entity or an activity. So there's different activities in which financial sectors engage in the real economy and each of them have different ways which their impact can be attributed to the financial sector or the financial sector entity.

Esther Whieldon: We just heard from Alberto how measuring, setting and implementing science-based targets is a more complex undertaking for financial institutions than for other kinds of companies. I wanted to know how that complexity then is translated into a verifiable science-based target. Here he is.

Alberto Carrillo Pineda: The financial sector net-zero standard, basically, what is doing is to kind of reverse engineer what the economy needs to look like when we reach net zero emissions, which is, of course, the end goal that we have and then what it would look like in terms of a financial sector portfolio. And based on that, then we have identified that there are 2 key metrics that need to be used.

One of these metrics is basically what is usually known as financed emissions, which is the estimation of impact and emissions attributable to a financial entity, and that metric is important because it helps us understand the emissions that are attributed to a financial institution from the financial services that they provide. But we also realize that, that metric is insufficient to inform the transition that needs to happen.

And so where you're seeing a second metric that basically we call net-zero alignment, and that helps us understand the degree in which the different activities are enabled through the financial institution are already transitioning or have already transitioned into the state that is compatible with a net-zero economy. And both of these metrics are critical, both of these metrics are basically complementary, and both of these metrics need to be assessed to have a robust understanding of the degree of transition in a portfolio.

So if you take, for instance, an asset manager, normally they would have a portfolio of assets in their portfolio that they are managing. And then they can estimate the impact of that portfolio from using financed emissions metrics. So that's the purpose of greenhouse gas accounting. And they could influence that metric by, for instance, changing the composition of the portfolio, which is important, its a market signal.

But then that doesn't take away that the fact that each of the underlying activities included in a portfolio also need to decarbonize and also needs to align the transformation needed to reach net-zero emissions. And that's where we see the value of the second metric, which basically helps us understand, okay, for each of the activities that are covered in a portfolio, have they already transitioned? For instance, if we are thinking about power sector again, have they already reached a performance level, which is compatible with a net-zero economy? In this case, the power generation, we're talking about basically 0 tons of CO2 per megawatt hour. So that means basically carbon-free or renewable electricity generation. And then if there is, for instance, a low level of emissions, but there is some degree of assets that still need to be decarbonized, then those metrics combined help us basically identify that and help financial institutions know where to put their efforts next, right? So normally, they would start with a high emitting sources. But then as they start transitioning and aligning activities in their portfolio, then of course, they need to focus on the next batch of action.

Esther Whieldon: SBTi has issued several draft documents in developing the net-zero standard for financial institutions. One of those, the Fossil Fuel Finance Position Paper proposes 4 broad requirements related to the disclosure, arrest, transition and phaseout of fossil fuel-related assets and activities. Here's Alberto explaining why SBTi decided to break out this topic and specifically what the organization is proposing.

Alberto Carrillo Pineda: Well, I would say the first thing that we have to keep in mind is what we need from a physical point of view is for those activities, in this case, fossil fuel production, for instance, to be aligned to what is needed in a net-zero world. And what is needed in the net-zero world is basically that we don't have any more volume of greenhouse gas emissions coming from the conversion of fossil fuels. And so that's the ultimate outcome that we want to incentivize that basically there's different ways to get to that outcome. 

And the first thing that we proposed in our framework, we have 4 steps that we consider here. The first step that we consider in our framework is basically first a transparency exercise, which is important because it helps stakeholders understand first the degree of exposure that they have to this activity.

And so by encouraging disclosure, we basically incentivize financial institutions to assess the degree of exposure to fossil fuel activities and to disclose it transparently. Then the second step is basically to make sure that this problem doesn't become a worse problem, so to avoid making things worse. And so basically, this means that we need to cease new financing or financing for new fossil fuel production activities.

And I would say that's pretty well established already in climate science. We don't have room anymore for new fossil fuel production. So that's the second thing that we are incentivizing through our framework. Then the third step is for those activities that are already exist in portfolios, we need to basically incentivize that those activities are transformed in a way that basically enables that activity to be aligned to a net-zero economy. And so in some cases, we're talking about the phaseout of those activities.

In other cases, we're talking about the transformation of those activities so that the impact of that activity is updated or mitigated. And then finally, in case there are some persistent activities that, for some reason, are not being abated, then that's where we consider a divestment option. And I would say we see that as a last step, right? We don't think that, that should be the first step because financial institution can divest from an activity and that has zero impact on the climate. We want this further activity to be transformed to align to a net-zero world, and that requires the active investment, and so the active engagement and involvement from financial institutions and from the other actors that enable that activity, as I mentioned earlier, including the entities that operate that activity, the jurisdictions where that activity is happening and then the other enablers like the buyers or in this case, the investors that enable that activity.

Esther Whieldon: So what kind of level of participation have you had from financial institutions so far, both through getting validation and also expressing interest or commitments to use the process once it's finalized?

Alberto Carrillo Pineda: So far, since we released the first guidance, we've 67 entities that have had their targets validated. We have around 230 entities that are in the process that committed to have targets and that basically have -- are in the process of modeling their targets. And out of this, we have nearly 120 entities that have committed to set net-zero targets. And so because of this, I would say there's quite a lot of interest in this consultation process that we are running right now and a lot of engagement happening.

Esther Whieldon: Among that first set of financial institutions that Alberto mentioned had their 1.5 degree targets validated by SBTi was Schroders. So let's turn to my interview with Marina, where she describes the asset manager's climate targets and why it chose to get those targets validated by SBTi.

Marina Severinovsky: So we calculated Schroders Group baseline emissions for 2019 based on a PCAF methodology, and we set the Schroders Group target to cover Scope 1, 2 and 3 emissions over the medium and long term. And then we outlined the activities that we actually plan to undertake in order to achieve the emissions reductions targets.

What we're aligned to is from a portfolio temperature score, and I'll talk about why we use a temperature alignment methodology, we're trying to achieve 2.92 Celsius. From that in 2019, we're trying to get to 2.19. So from 2.9 to about 2.2 by 2030, and that's across our finance Scope 1 and 2 emissions. And then from 3.13 Celsius in 2019, we're trying to get to 2.29, it's about 2.3 Celsius by 2030 across finance Scope 1, 2 and 3 emissions, which would put us in line with a 1.5 Celsius pathway by 2040.

And we're trying to aim for portfolio coverage to be 100%, so kind of all of our assets by 2050, and that is also our target for net zero. Now we set this science-based target with a 2019 baseline, as I said, covering kind of direct emissions under Scopes 1 and 2 and then our Scope 3 emissions, and that includes our investment. We published our climate transition action plan back in December 2021.

We set out those targets, how we plan to achieve them, and this was very much in line with our commitment that we had made through the Net Zero Asset managers initiative. What I would say is as a financial institution, our biggest climate impact is from our investments. So our financed emissions are about 6,000 times greater than our direct emissions. And just to put that into perspective, our baseline group financed emissions are about the same as those of Singapore while our operating emissions are about the same as a small town. 

So we really have to focus in on that sort of Scope 3 of the financed emissions. And so that's kind of what we really, as I said, in our target we focus on. Today, this covers about 62% of our AUM, that's substantially public equities and listed credit. And we are planning to increase that coverage over time to different asset classes until we get to 100%. And our target was validated by the Science Based Targets initiative in February of 2022. 

What people like us to answer is, of course, why we set a target. So setting a science-based target, I think, reflected our commitment to taking climate action and making the decision to set a target was pretty straightforward because we were already very focused on climate change. We had already been running a number of different climate risk analysis and looking at investment opportunities from that low carbon transition.

So looking at it both from a risk and an opportunity perspective. I would say the difference today compared to a few years ago is that the transition has gone from being a possible risk to portfolios to being really a probable one, very likely. And so setting a target to decarbonize kind of aligns with our approach to managing those risks for our clients and to seeking investment opportunities.

The other thing people ask is sort of why we chose the Science Based Targets initiative. And it made a lot of sense to us to set our target using SBTi methodology because it does reflect the leading industry standard. It's a very strong coalition of highly recognized organizations. You have CDP, WRI, WWF. And then it uses industry standards like PCAF and also the GHG Protocol.

Having the target assessed by an independent third party, I would say, gives us a lot of confidence and credibility in our approach. And also the methodology was flexible enough to allow us to consider what we felt would be the most sensible option for setting our target given our size and the types of asset classes that we hold and the decarbonization strategy that we wanted to pursue. So we appreciated that flexibility.

Esther Whieldon: Marina went on to explain why Schroders picked a temperature-based climate target.

Marina Severinovsky: We ultimately chose to adopt the temperature alignment approach, which provides a very consistent and intuitive scale over time. It focuses our attention on the emissions and the targets of the companies that we invest in. Now our group level temperature score is impacted by whether the companies we invest in have set targets, and it's weighted by the companies to which we have the highest exposure, obviously, and also the companies that have the highest emissions.

And this gives us a very detailed view of the progress of our portfolio. So we can look at it from an individual issuer perspective, but also at a fund level. We can look at it from an investment desk level all the way to the group level through the aggregation of the temperature scores. And one of the most important elements of the temperature alignment methodology for us is the fact that we're looking not just at net-zero targets 30 years from now, but across different time frames.

We know that the next decade is critical for climate action, which is why we've set these interim- and long-term targets, and this makes it vital that we understand which companies have set an interim target and a long-term target, and that we encourage the ones who haven't done it yet to do so. And finally, the temperature alignment score gives us a breakdown of targets across different scopes. And this is really important because we need companies to set targets across their value chain.

Esther Whieldon: How do you treat how you engage with the carbon-intensive industries?

Marina Severinovsky: Absolutely. I mean we try not to, I would say, single out like kind of individual industries because, obviously, you have these issues across. And in fact, sometimes the companies in those industries are the most -- well, among the most knowledgeable, right, about the risk that this presents to their business. And sometimes it depends company by company, but they're sometimes the ones who are most sort of becoming most prepared, right, and making the commitments and really kind of working on this.

So you always try to say people can be part of the solution and not just sort of part of the problem that these very intensive industries are, again, have also happened to be places where people have the engineering know-how, the kind of deep pockets, the wherewithal, right? They understand that their businesses are evolving rapidly and that they have to be working that way in that direction. So I think it's a very fair question. 

It is, it is -- I won't minimize it, it's definitely a challenge. That's sort of last piece, as you say, I mean, ultimately, yes, you have an engagement strategy over many years. It ultimately does have to end in certain things not being able to be in the portfolio if they're not able to evolve apace. So today, it's pretty minimal for us. It's around -- on the kind of coal side, thermal coal. The vast majority of sort of the fossil fuel industry, we're still in the kind of mindset of engagement with. But obviously, over the longer-term time horizon, just the realities, the pragmatic realities for those companies who are carbon-intensive who are not able to adjust or not willing to adjust their business models will change such that, frankly, just our investors themselves, as they look at risk and stranded asset risk and those sorts of things will not want to take client risk in those places.

So what I would say is this new, obviously, draft standard is out. We're working on a kind of response to a consultation for it. We are going to decide whether we are going to seek validation for the sort of net-zero standard. There is this fossil fuel policy requirements for financial institutions. And because we don't have anything yet beyond coal, that is something that we need to look at.

I would say we're very encouraged by the way that the standard has a greater emphasis on alignment with a key objective of aligning all financial flows with pathways that limit warming to 1.5 Celsius with no or low overshoot, alongside net zero, that kind of 90% plus neutralizing impact of residual portfolio emissions. This is essentially the net-zero plan that we do have. And in fact, the SBTi folks told us that we basically, what we're doing would be in line with the new standard.

Now there's sort of 3 key components here for the 1.5-degree Celsius alignment, one of which is decarbonizing existing activities. So that's engagement, certainly, and kind of a managed phasedown or phaseout. And this, of course, touches on -- or rather is very focused on our engagement program, which I can talk about more. And then there is the support of the net-zero aligned economy, so kind of financed solutions. And so here, we can talk a lot about kind of climate-oriented products that we're building for clients and trying to deploy money in that direction.

The kind of piece that obviously needs more discussion is the kind of stop financing further development of high-emitting assets. And so that, again, from the perspective of where we currently are in our business, we -- this is the part that we really have to evolve towards. 

I think like I said, realistically, where we talk about like no more financing and further development of high-emitting assets, we just have to think as investors about how we go about that in portfolios where we obviously have to remain diversified. And in some cases, there just aren't yet alternatives, right? So it's -- we saw even during proxy season, some of the proposed resolutions to banks, for example, that sort of said don't finance any more, right, kind of development for fossil fuel capacity. It's just a hard moment here like right now to be able to say that this is like pragmatic going forward because there's still a need for cost efficient and available, right, fuel for consumers and businesses. And so it's just a question of how we, again, sort of take that forward as investors with the companies that we're invested with in a pragmatic way. And again, part of it is, we think, obviously, very hard as investors about the kind of integrity of portfolios.

So where clients are invested with us in a climate-oriented product, right, they want to be low fossil fuel. That's completely fine. But in our diversified portfolio, which is the bulk of our business, if somebody is in international equities, emerging market equities, we really have to think long and hard about, again, how those portfolios look from a diversification standpoint, how they're performing, it's kind of a risk and return perspective.

And obviously, we can't -- like I said, the integrity of the portfolio has to come first. And so at the same time, as we are very diligently engaging with companies, at the same time that we're trying to move capital towards the sort of more climate-positive products, I think it just takes some time practically to find alternatives and solutions that allow you to then not finance further development of high-emitting assets. I mean, again, I think we're not a bank, and so it's a bit of a different situation, we're obviously just investing in both public and private assets. We have a big business called Greencoat, which is sustainable infrastructure. And so we definitely are trying to pivot right into those directions. But again, it's like as always said, you have to be practical about what can be done on Day 1 versus sort of the direction of travel.

And so we've had this conversation, I think, very openly with the folks at SBTi and they certainly understand our perspective on this as very sort of diversified investment portfolios and how we can, again, sort of approach that. So like I said, we have 3 components on 2 of the components, it's kind of all systems go. And then the third, we obviously want to be aligned, it's just a matter of kind of what is the time horizon over which we can do that in a practical way.

Esther Whieldon: So as Marina mentioned, we still have to see what SBTi decides to do based on all the feedback it's going to get.

Lindsey Hall: And we'll continue to cover on this podcast this topic of net-zero targets: How do you set them? How do you reach them? How do you ensure they're credible? This is sure to be a big theme as we head into the UN's COP 28 climate change conference later in the fall. 

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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