Financing reduced emissions vs reducing financed emissions - which works better?

Glance through a financial institution’s net zero strategy and you are likely to encounter the phrase ‘financed emissions’. Often described as the ‘emissions of investments’, the metric captures the emissions attributable to a portfolio and consequently the investor-in-charge. Some of the world’s largest financiers have set interim targets to reduce financed emissions by 2030 and in some cases, by 2025.

The Border to Coast Pensions Partnership, for example, considers financed emissions as the “primary metric” against which progress is assessed. In its latest climate change report, the pensions pool says it has reduced financed emissions by 58% and is aiming to achieve a 66% reduction by 2030, relative to a 2019 baseline.

As the date to deliver on interim targets draws near, investors are questioning the value of financed emissions reduction targets. That’s according to the Institutional Investors Group on Climate Change (IIGCC), which arrived at this conclusion whilst developing its latest Net Zero Investment Framework.

The NZIF 2.0 brings in a new proposition for investors to consider – net zero strategies should be focused on financing reduced emissions instead of reducing financed emissions.

The limits of financed emissions reduction

“It is increasingly clear that strict financed emissions targets may not be as effective in achieving net zero goals as the industry had once hoped”, says Mahesh Roy, the IIGCC’s investor strategies programme director.

Roy’s concerns have a lot to do with the fact that despite large asset owners reporting a reduction in financed emissions, real-world emissions are still on the rise. The parallel existence of both trends suggests, to Roy and those who agree with him, that the current strategy is in need of revision.

One of the key limitations of a financed emissions as a metric is that it is not forward-looking. A forward looking approach would allow for higher financed emissions, provided that capital is flowing into companies able and willing to drive down real-world emissions in the long-term.

For now, investors could reduce financed emissions by simply titling their portfolios away from hard-to-abate sectors. Yet, companies within these sectors need finance to transition. In the absence of that capital, the link between lower financed emissions and real-world decarbonisation weakens.

Financing emissions reduction

The IIGCC’s answer to the problem is a proposed shift in direction that focuses more on financing emissions reduction. “NZIF 2.0 encourages investors to transition portfolios to align with the Paris Agreement’s goals, focusing on real economy decarbonisation and increasing investment in climate solutions.”, says Roy.

A capital allocation strategy inspired by the NZIF 2.0 would focus on two key domains– transition assets and climate solutions.

For the former, NZIF 2.0 recommends an asset-level alignment assessment which, for asset owners, is familiar territory. At AP7, a Swedish pension fund, the Climate Action Plan places a spotlight on “the degree of maturity of the companies’ climate work”. The fund’s targets and stewardship priorities reflect this view.

“By 2025 at the latest, our goal is that 100 percent of the prioritised companies with the highest emissions in our portfolio should be subject to deepened active ownership work. By 2025, at least 50 percent of the companies should conduct credible transition work and the goal by 2030 is 100 percent”, the fund says in its plan.

In addition, alongside the 2030 financed emission reduction targets, portfolio tilting in favour of climate solutions is well underway.

CalPERS’s commitment to invest $100bn in climate solutions by 2030 epitomises the wave of climate solutions targets set in recent years. Another Californian asset owner, CalSTRS has tilted a fifth of its public equity portfolio towards a low-carbon index since 2022. On last count, $21 bn was being managed against the index. Elsewhere on America’s east coast, the New York State Common Retirement Fund committed an additional $2bn to MSCI World ex-USA Climate Change Index in 2024, following a $1bn investment into the strategy a year prior.

It seems unlikely that investors might abandon financed emissions targets altogether, indeed the IIGCC warns against this. Asset owners across the world seem to have set both strategies into action - in most cases a strategy that finances reduced emissions coexists with one that reduces financed emissions.

The question that remains is one that Roy’s concerns reflect – how closely linked are portfolio emissions with real world decarbonisation? Perhaps time will tell.