To the casual observer, it might seem that banks’ commitment to reducing greenhouse gas (GHG) emissions has taken a back seat to shorter term priorities. After all, this year has seen several major institutions either withdrawing from the Net Zero Banking Alliance, pushing back their net zero target dates, or deprioritising climate-related targets in c-suite remuneration packages.
But the truth is that banks realise the need to monitor their financed GHG emissions – those enabled by their lending and underwriting activities – for reasons of business strategy and risk management, as much as increasing regulatory pressures.
With central banks and securities commissions now analysing the potential impacts of climate policies and climate change on financial stability and economic resilience over the next five years, it’s increasingly important that banks understand their biggest exposures.
Many use industry-level guidance – including the tools developed by the Partnership for Carbon Accounting Financials (PCAF) – to track and segment their financed emissions across sectors and geographies to better understand material financial risks and opportunities. If they can accurately model the current and future emissions profile of their clients, they are better placed to provide financing solutions to support their net zero transition plans – while reducing their own risks and meeting their own commitments to decarbonising the wider economy.
The biggest hole in many banks’ climate-risk assessments is the financed emissions of small- and medium-sized enterprises (SMEs), the reporting of which has been overlooked to date. On the regulatory front, SMEs are largely exempt from climate disclosure rules by policymakers who do not wish to overburden a competitive and dynamic sector of the economy. On the voluntary front, SMEs rarely track GHG emissions themselves, due to a mix of perceptions over levels of difficulty, cost, impact and business relevance.
Lack of accuracy
HSBC is one of many leading banks to acknowledge the challenges of accurately assessing financed emissions. Its 2024 annual report acknowledged the limitations arising from proxies – including industry averages “where company specific-data was unavailable” – pointing out a two-year lag in the emissions data in some third-party datasets.
Research into SMEs’ net zero transition by the British Business Bank (BBB) highlighted both the opportunity and the problem when it estimated smaller businesses accounted for 43-53% of UK business emissions – an imprecise, but nevertheless substantial proportion. The BBB found the sector at an early stage in its net zero journey, with a wide spread of approaches to reducing emissions. Costs, feasibility and access to finance were all cited as critical factors.
As SMEs and their banks grapple with the scale of financed emissions, regulators are increasingly clear that climate-related data from clients must play a central role in banks’ risk management and reporting.
A recent report from the Network for Greening the Financial System into data gaps in financed emissions highlighted the problem in the SME sector as “considerable”, saying the information was “crucial when analysing risk profiles” in order to make lending decisions. Last year, the European Central Bank underlined expectations for strong data management processes to support banks’ risk reporting, including assessments of climate impacts on business model and strategy.
In April, the UK’s Prudential Regulation Authority updated its climate-risk guidance, underlining the need for banks to implement strategies to “manage and close” any data gaps, as part of efforts to ensure adequate climate-related risk management capabilities. These should include processes “to ensure aggregated data are accurate and reliable”.
Such pressures make the current uncertainties around financed emissions from SMEs unsustainable. Banks are admitting their own misgivings about the metrics they are providing to regulators, and are rarely using these aggregations and proxies as more than necessary placeholders. This leaves banks with significant blind spots around an important client group, rendering them uninformed about the risks, opportunities and business realities they face.
A new lens
But what might lead from more accurate intelligence for banks on financed emissions from SME clients?
In the first instance, accurate emissions data provides a valuable lens through which to segment a bank’s SME client base, helping it to identify where climate-related risks and opportunities align most closely with material financial exposures. Higher-than-average emissions from a firm in the manufacturing sector might suggest a need for capital investment in new processes, while a low-emissions profile could imply rapid net-zero transition, which could be further fuelled by lower lending rates.
Banks that have confidence in the information they are gathering on the climate performance or governance profile of SME clients are already factoring this into loan decisions. As well as favourable credit terms, lower service fees or interest rates, banks may also be in a position to offer (access to) services that support lower emissions, including credible offset schemes, carbon removal programmes, and technologies such as heat pumps, insulation and green transport options. Banks may seek to further leverage their network capabilities, bringing together service providers, sectoral peers, and subject matter experts to share knowledge and enable collaboration to support SMEs’ transition to lower emissions.
In any field of commerce, reliable data that brings additional insight into the client’s needs and priorities allows the service provider to deliver a more tailored solution to a targeted subset, potentially driving up margins and / or revenues, while minimising costs. More accurate information on SME emissions will enable banks to develop custom financing solutions and advice that links emissions reductions to financial savings. But the same data will also help to provide bank regulators with solid evidence of a comprehensive and cohesive climate risk management strategy.
Filling the gap
The Disruption House (TDH) has mapped a route to filling this critical data gap. Drawing on the proven correlation between firms’ ESG performance, the strength of their governance and business practices and GHG emissions levels, we have developed a methodology that can leverage these linkages to provide accurate new insights for banks.
The solution is underpinned by two robust information pillars: the third iteration of TDH’s proprietary sustainability scoring methodology – a set of 100+ core metrics – and publicly available data sources that reflect firms’ ‘sustainability exhaust’.
In the first instance, TDH develops a sector-based assessment of GHG emissions, which is then segmented into high, medium and low performance brackets, with average emissions for each serving as a peer benchmark. We then use a firm’s TDH M3 sustainability score to adjust its GHG emissions level in proportion to its deviation from the sector average.
This ‘bracket-and-skew’ model relies on a variety of data sources to build up a more accurate assessment, including firms’ own sustainability reporting if available, annual reports, public disclosures and policy documents, as well as best-in-class industry average GHG emissions data from Sage.
This approach has the power to elevate banks’ data on financed emissions from SMEs from category 4 on PCAF’s data quality hierarchy to category 2, which gives the information greater credibility and usability among both internal and external stakeholders.
The first step
It could also prove a key step toward deepening collaboration between borrowers and lenders on a climate-resilient business strategy fit for a low-to-no carbon economy. Even so, it should be viewed merely as a first step. TDH’s ’bracket-and-skew’ methodology provides a more precise emissions estimate for firms that do not currently conduct a rigorous audit. But it is only a starting point for further action or engagement, leading to more accurate reporting, but also greater support for the client’s net zero journey.
Where further might more accurate data on SME emissions lead? A 2022 paper prepared for Bankers for Net Zero reported that UK lenders were keen to play a role in “in creating the mechanisms for supporting SMEs in changing behaviours and reducing GHG emissions”. It also identified a lack of consensus on the most effective channels, with possible options including a greater role in location- or sector-specific collaborative initiatives. A more precise view of clients’ climate risks might also equip banks to be stronger and better-informed advocates for the SME-specific policies that could pave the way to a smooth and profitable transition.
