INSIGHT by Dr. Ralf Seiz, CEO and founder, Finreon, Lecturer University of St.Gallen, Dr. Christian Vial, Head of Innovation & Research, Finreon, Arnaud Gougler, Head of Strategic Projects & ESG, Finreon
Paper published by Finreon on the concept of carbon footprint and the consideration of derivatives in carbon reporting | St. Gallen – Schweiz – April 2023
As the world faces the threat of climate change, investors and financial institutions are increasingly looking at investment portfolios’ carbon characteristics. Like other metrics and communication around investment, transparency and clear reporting on carbon characteristics of investment portfolios are paramount. To achieve this, we have identified three key elements that should be considered.
1. Investors and other stakeholders should differentiate between financed emissions and real emissions. Financed emissions represent financial instruments’ exposures to greenhouse gas emissions, while real emissions are generated by companies through their business activities and directly released into the atmosphere. The differentiation makes it clear that reducing an investment portfolio’s financed emissions does not remove CO2 from the atmosphere immediately. The removal of emissions only materialises indirectly and gradually through exerting pressure and signalling to the companies that are (de-)financed. Not differentiating between these two emission types could lead to greenwashing.
2. In order to obtain representative portfolio carbon metrics, carbon accounting should rely on the economic exposure of financial instruments to determine the overall financed emissions of portfolios. Alongside the investment in equities and fixed income securities, derivative instruments play a pivotal role in portfolio management. With derivatives, investors can achieve the same economic exposure to a company as through direct investments. Accordingly, when accounting for financed emissions, all types of financial instruments should be considered in accordance with their economic exposure. Otherwise, savvy investors could avoid accounting for emissions in carbon accounting by gaining economic exposure through the use of derivatives, while bypassing the accountability of financed emissions. Not taking derivatives into account in the carbon accounting would consequently open the floodgates to greenwashing.
3. The overall amount of financed emissions should always be equal to the amount of real emissions of a company. Because derivative contracts always have two contracting parties, financed emissions should be reported both positively and negatively in accordance with their economic exposure, so that derivatives neither increase nor decrease the overall amount of financed emissions. In particular, if derivatives were to artificially increase the total amount of financed emissions, this would lead to a misleading scenario in which the overall financed emissions would be larger than and disentangled from the real emissions. On the other hand, if derivatives were to artificially decrease the total amount of financed emissions, this would open the doors to greenwashing.
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