Deciphering ESRS, CSRD & PCAF

About 4,000 large companies started reporting on their environmental performance under the EU Taxonomy from 1 January 2023. This presented a significant implementation challenge for banks and insurers, particularly in adhering to the EU Taxonomy’s mandates, such as calculating the ‘Green Asset Ratio (GAR)’ and ‘Banking Book Taxonomy Ratio (BTAR).’ These inaugural figures are due for release from January 1, 2024, for the 2023 fiscal year. ?

The ‘Corporate Sustainability Reporting Directive’ (CSRD) is crucial in the realm of ESG Reporting within the EU. Established by the ‘European Financial Reporting Advisory Group’ (EFRAG), the CSRD, integral to the EU Taxonomy, mandates the disclosure of sustainability information in the appendices of annual reports. It supersedes the ‘Non-Financial Reporting Directive’ (NFDR), significantly broadening its applicability. The CSRD is expected to increase the number of EU companies obligated to report from around 11,600 to 49,000. This directive will become effective in January 2023, with large companies (those with more than 500 employees) implementing it from January 1, 2024. From January 2029 onwards, even non-EU companies will have to publish their sustainability information for the 2028 financial year in accordance with the CSRD.

The EU Member States have a deadline of 18 months to incorporate the CSRD into their national laws following its review. The CSRD aligns with the EU Taxonomy, particularly referencing Article 8 for reporting requirements. It also includes references to the ‘Greenhouse Gas Protocol (GHG)’ concerning Scope 3 emissions. Article 47 of the CSRD emphasizes the inclusion of information related to Scope 3 emissions in sustainability reports. The CSRD outlines disclosure requirements but does not specify the nature of the information to be disclosed.

On November 22, 2022, EFRAG, serving as the technical advisor to the Commission, released the first draft of the ‘European Sustainability Reporting Standards’ (ESRS). These standards aim to reflect international regulations and are closely linked with the EU Taxonomy, SFDR, and other frameworks, as detailed in their ‘Explanatory Note’. The ESRS are scheduled for implementation by January 1, 2024, with the first CSRD reports expected post-2025.

The European Sustainability Reporting Standards (ESRS) are universally applicable across different sectors and comprise 12 'Exposure Drafts (ED)', split into two general EDs (ESRS1 and ESRS2) and ten theme-specific EDs. Altogether, the ESRS encapsulates 82 Disclosure Requirements (DR), distributed across these 12 EDs.

All companies within the ESRS's scope are obliged to comply with the requirements of the two sector-agnostic EDs, ESRS 1 and ESRS 2. To determine the applicability of specific EDs within the series ESRS E1-5, S1-4, and G1, firms must conduct a ‘Materiality Assessment.’ ?

In alignment with the Corporate Sustainability Reporting Directive (CSRD), the ESRS adheres to the principle of ‘double materiality.’ This means companies must report sustainability from two viewpoints:

1. Impact Materiality: This involves assessing how a company's operations impact humans and the environment. It includes both direct and indirect impacts through business activities, products, services, and value chain relationships.

2. Financial Materiality: This perspective evaluates how environmental and social factors influence the company's financial aspects like cash flow, cost of capital, and access to financial resources, focusing on associated risks and opportunities.

The application of the Corporate Sustainability Reporting Directive (CSRD) and the European Sustainability Reporting Standards (ESRS) presents unique challenges for financial institutions like banks and insurers, given their distinct business models. Unlike other industries, a significant portion of emissions related to financial institutions arise indirectly through financed or insured activities, categorized as Scope 3 emissions under the Greenhouse Gas Protocol (GHG). These emissions are not directly produced by the institutions themselves but result from their financial activities in the broader economic chain.

For financial institutions, integrating emissions from their value chain into their sustainability reporting is complex, particularly due to the indirect nature of these emissions and the sometimes private nature of information about borrowers and insured parties. The EFRAG’s draft 'Implementation Guidance for Value Chain' (VCIG) doesn’t provide definitive guidelines on how financial assets like loans and investments, considered as 'Business Relationships,' should be accounted for in terms of their environmental impact.

To address this gap, the Draft ESRS suggests that financial institutions refer to the ‘Greenhouse Gas Accounting and Reporting Standard for Financial Industry’ developed by the Partnership for Carbon Accounting Financials (PCAF).

PCAF offers a framework for measuring and reporting emissions associated with various financial services, encouraging financial institutions to account for their financed emissions.

PCAF’s standard is divided into three parts:

1. Part A ‘Financed Emissions’: This section provides methods for calculating emissions linked to different investment categories.

2. Part B ‘Facilitated Emissions’: It outlines methods for determining emissions associated with capital market transactions.

3. Part C ‘Insurance Associated Emissions’: This includes methods for calculating emissions tied to insurance and reinsurance activities.

However, the ESRS, as it currently stands, mainly focuses on ‘Financial Institutions’ without a clear differentiation between banks and insurance companies. Furthermore, while the ESRS requires financial institutions to screen for Scope 3 emissions based on the 15 categories of the GHG Protocol, these categories do not explicitly cover insurance business. As a result, it appears that the ESRS primarily addresses Part A of the PCAF standards ('Financed Emissions') and does not fully encompass emissions associated with insurance activities ('Insurance Associated Emissions' or IAE).

The primary purpose of the PCAF (Partnership for Carbon Accounting Financials) standards is to measure and report greenhouse gas (GHG) emissions resulting from investments and loans. This measurement is crucial for identifying the risks and opportunities associated with GHG emissions, thereby facilitating strategies towards decarbonization. Moreover, the insights gained from these calculations are instrumental in developing strategies and products aimed at advancing climate action.

The PCAF Standard for 'Financed Emissions' (Part A) lays out specific methods for calculating emissions across seven distinct investment categories, each with its unique requirements. These categories are:

1. Exchange-listed shares and corporate debt

2. Corporate credit and unquoted equity capital

3. Project financing

4. Commercial real estate

5. Mortgages

6. Loans for automobiles

7. State debts

To determine the appropriate investment category for each financial product, PCAF provides a methodology based on the 'Follow-the-money Principle'. This approach involves three key steps:

1. Defining the Type and Source of Financing: This step involves identifying the nature of the financing, whether it is corporate finance (financing of companies), project finance (financing of projects), or consumer finance (finance for private customers).

2. Determining the 'Use of Proceeds' and the Industry or Financing Activity: This involves understanding the purpose for which the funds are being used and the specific industry or financing activity involved.

3. Assigning the Financial Resources to the Appropriate Investment Categories: Based on the type and use of financing, the financial resources are then categorized into one of the seven investment categories outlined above.

This structured approach allows financial institutions to systematically categorize their investments and loans, ensuring that the emissions associated with each category are accurately measured and reported. This process is essential for financial institutions to understand their environmental impact and contribute effectively to climate change mitigation efforts.

After identifying the appropriate investment category, the PCAF Standard applies the 'Attribution Principle' to calculate 'Financed Emissions'. According to the GHG Protocol Value Chain Accounting and Reporting Standard, the GHG emissions from loans and investments are attributed to the financial institution based on its proportional share in the borrower or investor. Essentially, the financial institution is accountable for a portion of the emissions generated by the entities it finances.?

The calculation process involves several key steps:

1. Determine the Attribution Factor: This factor is calculated based on the proportion of the residual value of a loan or investment to the total firm value (equity plus debt) of the financed companies or projects. The Attribution Factor is then used to allocate a portion of the total emissions from these entities to the financial institution.

2. Gather Emissions Data from Capital or Loan Recipients: Accurate emissions data from borrowers or investors is critical. This information can be directly provided by them or sourced from their sustainability reports. However, the quality of this data may vary in terms of timeliness and accuracy.

3. Implement a Scoring Model for Data Quality: To address the variability in data quality, PCAF provides a scoring model with five levels. 'Score 1' indicates the highest data quality, while 'Score 5' suggests the lowest. This scoring system varies for each investment class and guides institutions on the type of data to use at each score level. The scoring model aims to standardize and improve the reliability of the emissions data used in calculations.

?4. Apply Data Quality Scores to Different Investment Classes: The application and implications of these scores are detailed in the Appendix of the 'Financed Emissions' Standards for each investment category. For instance, in project financing, the scoring model clarifies the differences in data quality and precision for each score.

By following these steps, financial institutions can systematically calculate their 'Financed Emissions', thereby gaining a clearer understanding of their contribution to GHG emissions. This process not only helps in meeting reporting standards but also aids in identifying areas for strategic interventions to reduce emissions and support decarbonization efforts.

In summary, the PCAF (Partnership for Carbon Accounting Financials) standard is a significant step forward in calculating financed and projected emissions, particularly for the financial sector. However, it's important to note that it doesn't completely or accurately encompass all Scope 3 emissions for financial institutions. A key limitation is its lack of specific guidance for insurance companies, leaving them to determine their own methods for calculating Scope 3 emissions. This lack of uniformity could lead to challenges in comparing Scope 3 emissions across different institutions.

Another issue with the PCAF standard is its allowance for varying data qualities. While PCAF provides a scoring model to help standardize data quality, it also means that financial institutions might rely on incomplete or unverified customer information for calculating emissions related to financing and investment activities. This variability in data quality can hinder consistent comparisons, both within an institution's portfolio and across different companies and projects.

Looking ahead, financial institutions are tasked with implementing the requirements of the Corporate Sustainability Reporting Directive (CSRD) and, by extension, the European Sustainability Reporting Standards (ESRS) starting January 2024. While there are no explicit guidelines yet for insurance companies regarding the calculation and disclosure of Scope 3 emissions, financial institutions are encouraged to adopt the PCAF standard for this purpose.

However, this adoption presents considerable challenges. One of the biggest is ensuring the availability and validation of sustainability information from customers. Additionally, financial institutions must develop technical solutions for storing, managing, and utilizing collected data from business partners and customers. This is essential not only for calculating and reporting key figures but also for compliance with regulatory requirements.

In conclusion, while the PCAF standard offers a framework for assessing financed emissions, its limitations and the challenges in data management and standardization highlight the complexity financial institutions face in aligning with evolving sustainability reporting requirements.

It is not surprising that last week, the global Core Team of PCAF announced the following priority areas were identified for methodology development in 2024:

• Transition finance and green finance
• Fluctuations in absolute GHG inventory (resulting from changes over time to the financial attribution metrics, such as EVIC)
• Additional insurance products
• Securitized and structured products

?Reference reading:

EU Taxonomie Regulation (EU) 2020/852

CSR – Corporate Sustainability Reporting Directive (CSRD)

EFRAG –?First Set of Draft ESRS

ESRS, Appendix I Disclosure Requirement Index?

S&P Global –?Podcast ‘How financial institutions are tackling Scope 3 financed emissions’

EFRAG –?Implementation Guidance for Value Chain (VCIG),?23. August 2023

PCAF –?‘Financed Emissions’ Standard