Financed Emissions - Unlisted Equity

Sumday Team
February 15, 2024
9 Minutes
Photo by Sean Pollock

Financed Emissions Recap

Before we dive into the nitty gritty, let's recap.

Financed emissions are emissions resulting from the investing or lending activities associated with an organisation. The logic is that if an organisation has provided funding to a business or project, they are then responsible for a portion of those emissions based on their overall contribution to funding.

Depending on the standard, financed emissions may be referred to by slightly different names. Under the GHG Protocol, financed emissions are referred to as "Investments", while under Partnership for Carbon Accounting Financials (PCAF) they are referred to as "Financed Emissions", even though both terms refer to the same subcategory of emissions.

PCAF provides more detailed guidance in relation to accounting for financed emissions and as a result, many leading financial institutions and standard setting organisations have aligned with their approach. Under the PCAF Financed Emissions standards financing activities are divided into the following 7 categories.

Source: PCAF Financed Emissions Standard pg.7

From the Private Equity perspective, the main category that is relevant under the standard is ‘Business loans and unlisted equity’.

Still want more of a recap? Check out our beginner's guide here.

Accounting for Unlisted Equity

Now that we have a high-level understanding of the types of financed emissions PCAF includes, let's dive into the unlisted equity side of things.

PCAF defines ‘Unlisted Equity’ as:

“Unlisted equity includes all on-balance sheet equity investments to businesses, nonprofits, and any other structure of Organisation that are not traded on a market and are for general corporate”- PCAF Financed Emissions Standard page 67

So in simple terms - pretty much all equity investments that aren’t in listed organisations.

In order to quantify financed emissions from unlisted equity, we essentially need two things:

  1. The emissions associated with the organisation in which the investor holds a stake.
  2. The portion of those emissions that relate to the investor's stake - this is referred to under the standards as Attribution Factor.

Financed emissions are then calculated by multiplying the organisation's emissions by the attribution factor.

So how do we determine the emissions of the organisation?

Under Financed Emissions, there are three broad ways to determine the emissions of the organisation in which the investor holds a stake. These are reported emissions, physical activity-based emissions, and economic activity-based emissions.

Reported emissions: Where verified or unverified emissions are collected from the borrower or investee company directly or indirectly via verified third-party data providers and then allocated to the reporting financial institutions using the attribution factor.

Physical activity-based emissions: Where emissions are estimated by the reporting financial institution based on primary physical activity data collected from the borrower or investee company and then allocated to the reporting financial institution using the attribution factor. The emissions data should be estimated using an appropriate calculation methodology or tool with verified emission factors expressed per physical activity issued or approved by a credible independent body.

Economic activity-based emissions: Where emissions are estimated by the reporting financial institution based on economic activity data from the borrower or investee company and then allocated to the reporting financial institution using the attribution factor. The emissions data should be estimated using the official statistical data or acknowledged environmentally extended input-output tables providing region or sector-specific emission factors.

Reported emissions and physical activity-based emissions are the preferred methods, as they are much more accurate than economic activity-based emissions.

Each of the methods has different levels of data quality. Ideally, all of the companies within the investor’s portfolio would be carbon accounting properly and as a result, the investor could use the reported emissions from each of the portcos. However, this is currently not always the case so lower-quality data may need to be used in the absence of reported emissions. The Physical and Economic activity-based emissions are calculated with industry averages which generally come from trusted academic or government sources.

Want to learn more about Emission Factors? Check out our blog post where we explore them in more detail.

How do we determine the Attribution Factor?

As we have touched on, the Attribution Factor is an important component in calculating financed emissions. Basically, the attribution factor allows us to determine what portion of the emissions of each portfolio company is allocated to the investor. Essentially it provides a logical way for owners of the company to slice up the emissions pie.

As a basic principle, the financial institution accounts for a portion of the annual emissions of the financed company determined by the ratio between the institution’s outstanding amount and the value of the financed company. This ratio is called the attribution factor.

Outstanding Amount: This is the actual outstanding amount in listed equity or corporate bonds. The value of outstanding listed equity is defined based on its market value (i.e., market price multiplied by the number of shares), and the value of corporate bonds is defined based on the book value of the debt that the borrower owes to the lender. Financial institutions most commonly use the financial year-end outstanding amount in order to align with their annual financial reports, however, if a different approach has been determined this should be clearly disclosed within the GHG inventory.

Company value: For all listed entities, this is the enterprise value including cash (EVIC) of the respective company. Like other financial metrics or indicators EVIC can be used somewhat subjectively in different contexts, however for the purposes of  PCAF the interpretation converges around the definition outlined by the European Commission, with the following being the definition included in the Financed Emissions Standard.

It is important to understand that the attribution factor for listed investments can be sensitive to movements in the share price. The attribution factor is generally calculated based on the share price at the end of the financial year. This means that sudden movements in the share price will affect the relative attribution of emissions to debt and equity investments. For example, a lower share price will result in a higher portion of emissions being allocated to debt investors and vice versa.

For private companies, capital markets are less liquid and, as such, the market capitalisation of shares might not be a reliable or available data point to quantify the equity value of the organisation. Instead, the book value of equity is used, which includes any issued capital and retained earnings.

This means that investors will need data collection practices in place to ensure that each of their portfolio companies provides key details of their financial position to support the calculation of financed emissions. In some instances, the portfolio company may also provide the Attribution Factor rather than the inputs into the calculation. For assurance purposes, it is still a good idea to ensure that this information is traceable back to source documents.

How do I report on Data Quality?

The calculation of reported emissions is one thing, however, stakeholders also have an interest in the quality of the information that has been used to prepare the GHG inventory. PCAF provides financial institutions with a framework for estimating data quality across the portfolio. Largely this is linked to how the portfolio company has estimated their emissions and whether actual data, physical activity or economic activity data has been used in the calculation.

The data quality scoring system is out of 5 with 1 being the highest level of data quality (i.e. what we are aiming for) and 5 being the lowest level of data quality. PCAF and other standard setting organisations recognised that in a lot of instances, portfolio data quality is relatively low and that overtime it needs to improve.

Having a consistent approach to report on data quality will mean that organisations can hopefully demonstrate an improvement in their reported data quality as well as a reduction of their portfolio emissions over time.

Details of the available calculation methods under PCAF for Unlisted Equity are summarised in the following table taken from the standards. Each of the calculation methods includes a corresponding data quality score making it relatively easy to estimate data quality based on the approach adopted.

Source: PCAF financed emissions standard p143

Considerations for reporting unlisted equity investments

So far we have covered a lot of ground and explored the key concepts associated with quantifying financed emissions relating to unlisted equity. In this section, we are going to outline a few of the specific considerations that might affect organisations new to reporting portfolio emissions.

Scope of reported portfolio emissions

Under PCAF, financial institutions are required to report on the Scope 1 and 2 emissions associated with their portfolio companies. Over time, the requirement to report on Scope 3 of the portfolio will become mandatory. This will start with the oil and gas sector, before moving on to building materials and industrial activities, and finally requiring other organisations to report on their Scope 3 portfolio emissions by 2025.

This phase-in approach means a couple of things; firstly because the scope of reported emissions is expanding and therefore your reported Scope 3 emissions will likely increase. The potential impact of this will likely be significant especially when you reflect on the fact that for most organisations Scope 3 accounts for upwards of 90% of their overall emissions. Organisations who have an existing Net Zero target will need to be mindful of this and ensure changes don’t have a significant impact on their ability to meet the stated Net Zero commitment.

Secondly, financial institutions with significant exposure to the oil & gas and construction sectors will be required to report on elements of Scope 3 emissions earlier. This means that these financial institutions will not only need to have more robust data collection processes in place earlier, but also that these sectors will represent a larger share of your overall disclosed portfolio emissions if you are only reporting the minimum of S1&2 for other sectors.

Accounting for your early stage companies

For early stage companies, some of the emissions calculation options available may not be representative of the emissions associated with their activities. This is especially true if the company is pre-product or pre-revenue. Options 2b, 3a and 3c all rely on sales and production data which as this data doesn’t exist at this stage of the company an alternate calculation needs to be used.

In this case, the investor has only two options available: either they engage with their portfolio companies to understand the portcos' actual emissions and key energy inputs, or the investor needs to rely on the asset-based calculation under Option 3b, which has low accuracy and the lowest PCAF data quality score.

For early stage companies, the complexity of their activities are relatively low so in general their carbon accounting is pretty straightforward, as such it is a good opportunity to engage the portfolio, collect primary data and get systems in place to ensure that they are carbon accounting in a way that can scale as their business grows.

Attribution of emissions between debt and equity

As we discussed earlier, the attribution for private companies is based on the total debt and equity balance at the end of the reporting year. In the current economic climate, we are seeing many private companies, especially startups, look to alternate debt funding options such as convertible notes or bridging finance.

If you are an investor who provides this type of funding, it is important to understand the impact that this has on the portfolio company emissions that are attributed to you.

Say, for example, you were the lead investor in a seed round and total equity in the company is $5mil and your outstanding amount is $3mil, assuming no liabilities the attribution factor would be 60%.

If in the lead up to Series A, the lead investor then provided additional debt funding of $2mil, this would increase their outstanding amount to $5mil and their attribution factor would increase to ~71%, even if the debt funding was only in place for a relatively short period of time.

Where to from here?

As carbon accounting is becoming a compliance requirement in countries around the world, financial institutions are generally among the first organisations required to disclose their emissions.

For financial institutions such as private equity and venture capital funds, where private companies make up a significant portion of their portfolio, understanding carbon accounting and climate risks is becoming increasingly important. Embedding carbon accounting into the business as usual across the finance, investment, and sustainability teams doesn't have to be hard.

Sumday has developed a Financed Emissions course to upskill internal teams on how to measure and report on financed emissions in line with the global standards. The course includes interactive materials and practical worked examples to help you apply the learnings in your organisation. Reach out for a chat with us or sign up for a free trial to get access to the learning resources today.

For funds looking to have a broader impact across their portfolio, get in touch to understand how Sumday can support portfolio companies to understand their own emissions and build capacity for the coming world of carbon compliance.