Financed Emissions: A New Standard for Calling Balls and Strikes
May 10, 2022
For a long time, we have had a uniform system of accounting rules to make sure banks, and businesses in general, are honest and transparent in reporting their financial performance. What about the performance of the financial sector when it comes to climate change though? Now, a new standard exists to give us the same honest and transparent reporting when it comes to financed emissions.
It takes a special kind of person to be a professional referee. I have loved sports my entire life, but not once have I thought, “I could see myself being a referee.” It is such a thankless job. At the highest level of sports, the calls that referees make can swing championships and millions of dollars. At the lowest level of sports - think 5-year-old coach-pitch baseball here - referees are often subjected to the rantings of overzealous parents. Who wants the pressure and the profanity that referees are so often subjected to? Well…referees do, I guess! And thank goodness for it, because without them, we couldn’t have the sports so many of us love so dearly.
But I’m not here to write about sports refs. Instead, as I so often do, I’m leaning on the crutch of a sports analogy to talk about something else entirely. I’m here to write about the referees of the finance world, also known as the Financial Accounting Standards Board (FASB). So grab your whistle and your favorite zebra shirt and let’s call some balls and strikes.
Why We Need a Good Accounting Standard
Remember the Enron scandal? Here’s your Cliffs Notes version: Enron was a Houston-based energy company that in the 1990s grew to become one of the largest sellers of natural gas in the world. Its executives were crooks who, in pursuit of ever-growing profitability, began fiddling with their financial statements to artificially inflate their revenues and hide their debts. To keep their nefarious deeds hidden as long as possible, they also pressured their accountants at Arthur Andersen to not rat them out to investors and the Securities and Exchange Commission. Eventually, enough smart people realized that Enron’s financial statements were rosier than they should be, and the house of cards they had built came tumbling down in the capital markets and the courts.
Accounting is a funny thing, though. How is it that we know that one way of accounting is right while another is wrong? There is real ambiguity in our commercial systems, and that presents challenges. Let’s say I slap a $20 bill on a lemonade stand at the end of my street and say “keep the change” as I walk off with my probably-too-sweet glass of local entrepreneurism. How should the seven-year-old vendor book that transaction? Is that $20 of revenue, or $1 of revenue with a $19 gift from the guy who occasionally yells “get off my lawn!” at them? [Note this is hypothetical - I do not yell “get off my lawn” at anyone, at least not yet.]
The laws of accounting aren’t objective like the laws of physics. They are conventions that are agreed upon by those who need a set of rules to make the system work. In this case, the rules are called the generally accepted accounting principles (GAAP), and the standards are set by FASB. If you need a Cliffs Notes version of my Enron Cliffs Notes from above, it would be to simply say that Enron didn’t play within FASB’s rules, and as a result, some people went to jail and billions of dollars were lost.
Accounting for Carbon: A New Rulebook for Financed Emissions
Accounting is, therefore, a set of rules about how to properly count dollars and cents. In recent years though, there has been a growing awareness that financial institutions, and really businesses in general, need to be counting something else in addition - carbon. What does that set of rules look like? And who is the FASB that can help the world of finance count carbon in an honest and transparent way?
Behold, the Partnership for Carbon Accounting Financials (PCAF). In their own words, they are “enabling financial institutions to assess and disclose greenhouse gas emissions of loans and investments.” There is some real weight behind their work, as evident by the 134 pages that their carbon accounting standard fills (to strain my analogy a bit, these standards are the equivalent to GAAP). They recognize, for instance, that how you account for carbon in the commercial real estate asset class is different from how you account for it in your motor vehicle loans. There’s a whole lot of math at stake here, and it’s about time we had a uniform way to crunch those numbers. Without a good standard to use, much like a clear rulebook for the sports we all know and love, it is really hard to know which financial institutions are winning and losing in the race to finance the clean economy.
Why Counting Financed Emissions Can Accelerate the Shift to the Clean Economy
Though it’s exceptionally important to have a how-to guide for counting financed emissions, PCAF and its standard also do something else that is critical - signal to the market that counting financed emissions is important. If you think about it, the operations of a bank are not terribly carbon-intensive. They have to build some buildings, keep the lights on in their offices, put some people on airplanes for various trips, and use electricity to keep their online banking systems running, but that’s about it. Viewed that way, banks might be able to install some LED lighting, buy a bunch of offsets, and claim carbon neutrality. But when you ask a bank to take responsibility for the emissions of its financing activities? My oh my, is that a different ballgame.
Just imagine if financial institutions started proactively reducing the carbon intensity of their lending portfolios. That would make the cost of capital for fossil-fuel industries, and fossil-fuel adjacent industries, noticeably higher. All of a sudden, it would cost more to extract coal and burn it for electricity. The price of cars with an internal combustion engine would go up. Carbon-intensive buildings will cost more to build and operate.
In a moment of high inflation, that might sound scary. “We can’t afford to have more price increases for the things we need,” some might say. But what really matters here is relative prices. If coal becomes costlier, then renewable energy becomes even more price competitive than it already is. If gasoline powered cars have a higher price tag, then more people will make the switch to electric vehicles. If the market begins penalizing poorly built buildings, it will simultaneously reward better constructed ones.
I believe that we cannot make the pivot to a clean economy without the financial sector. That sector cannot be a part of the pivot without a uniform standard for measuring financed emissions. Now we have it, and it's a matter of getting more and more institutions to use it. This game is too important to not have good referees calling our balls and strikes.