Follow the money of financed emissions: An alternative emissions attribution framework for sovereign debt

Co-author: Stavros Kourtis (Intern)

The most important GHG emission category of a financial institution is the “investment” scope 3 category of the Greenhouse Gas Protocol. This includes the emissions associated with all types of financial products, also referred to as financed emissions. The role of the PCAF is to standardize the methodology for financed emission reporting in the industry. The financial institutions worldwide that adhere to PCAF’s guidance account for a total financial assets of more than USD 90 trillion.

A central component in the calculation of financed emissions is the attribution factor, which determines the percentage of the borrower’s emissions that are attributed to the financial institution. The principle of PCAF’s shared ownership framework is that the attribution factor will be the size of the exposure over the borrower’s total value. The borrower’s total value includes both the asset value of the borrower and their debt. For most asset classes, it is fairly straightforward to define the borrower’s total value. For example, the value of a listed company is simply the sum of equity value and the company’s debt. For a company that lists at EUR 80 million for equity and has EUR 20 million in debt, 20% of the company’s emissions are attributed to the debt holder(s).

There is one asset class for which it is intrinsically ambiguous to determine the value of the borrower: sovereign debt. What is the value of a country? Countries are not for sale, and it is impossible to determine the value of a sovereign government that “rules” over an economy that it does not own (with the exception of government organizations and some state owned companies).

In the first PCAF guidance document published in 2019, the value of a sovereign government was simply defined as the total outstanding sovereign debt. As a result, 100% of the sovereign emissions – being the emissions of the entire economy – were attributed to the shareholders of government bonds. PCAF acknowledged that the total debt is not a suitable proxy for the value of a country, and changed their guidance in 2022. This new guidance proposed to use the Purchase Power Parity (PPP)-adjusted GDP as a proxy for the “value of a country”.

While we recognize the improvements of the sovereign debt attribution factor in the 2022 PCAF update, we remain critical of applying the shared ownership framework to the sovereign debt asset class. To address the shortcomings, we have developed a fundamentally different attribution framework, based on PCAF’s second key principle: “follow the money”. This principle[1] suggests that the money should be followed as far as possible to identify the impact of financial institutions in the real economy. Our follow-the-money framework attributes emissions based on direct and indirect debt-financed government spending. The indirect component is based on the economic growth that is realized through direct debt-financed government spending. This approach does not require an estimation of the “value of a country”, which is an important distinction from the shared ownership framework. Instead, our follow-the-money framework requires an estimation of the economic multiplier. The concept of the multiplier is used in Keynesian economics to quantify the stimulated economic growth per amount of the government expenditures. Conveniently, there is a rich literature on empirical studies that estimate so-called Keynesian economic multipliers, providing us with useful estimates to be used for our follow-the-money attribution factor.

In this report, we explain the PCAF shared ownership attribution for sovereign debt, and propose our methodology based on the follow-the-money framework as an alternative. To illustrate the advantages and disadvantages of follow-the-money framework, we then compare the attribution factors of the two frameworks for the 27 EU countries.

[1] See page 39 in PCAF 2022 Reporting Standard