The Impact of Financed Emissions on Capital Allocation and Lending Strategies in the Indian BFSI Sector

In the evolving world of finance, the urgency of addressing climate change has become a defining challenge for institutions worldwide. Among the many facets of sustainable finance, financed emissions have emerged as a critical metric that financial institutions must understand and manage. These emissions, which represent the greenhouse gases linked to the activities financed through loans and investments, have far-reaching implications on how capital is allocated and how lending strategies are formulated. For banks, asset managers, and other financial players, integrating financed emissions into decision-making processes is no longer optional but essential for regulatory compliance, risk management, and long-term value creation.

Financed emissions refer to the indirect greenhouse gas emissions associated with the companies and projects that financial institutions fund, unlike direct emissions from a company’s own operations or emissions from purchased energy, financed emissions fall under a broader scope known as Scope 3 emissions, specifically category 15 of the Greenhouse Gas Protocol. Essentially, when a bank provides a loan to a coal-fired power plant or an investment firm backs an oil exploration project, the emissions produced by those entities are counted as the financier’s financed emissions. This indirect footprint is significant; studies show that financed emissions can be hundreds or even thousands of times larger than the institution’s direct operational emissions, underscoring the magnitude of climate impact embedded in financial portfolios.

The importance of understanding financed emissions has grown rapidly due to multiple converging factors. Regulatory bodies worldwide are increasingly mandating financial institutions to disclose their climate-related risks and emissions, with frameworks such as the Task Force on Climate-related Financial Disclosures (TCFD), the Global Reporting Initiative (GRI), and the International Sustainability Standards Board (ISSB) gaining prominence. Beyond compliance, managing financed emissions is crucial for identifying climate-related financial risks. For example, investments in fossil fuel-intensive sectors face the risk of asset stranding as the world transitions to a low-carbon economy. Investors and customers are also demanding greater transparency and accountability, making financed emissions a key factor in reputational management and capital access. Furthermore, institutions that proactively manage these emissions can unlock new opportunities in sustainable finance, positioning themselves as leaders in the green transition.

Measuring financed emissions, however, is a complex task. The Partnership for Carbon Accounting Financials (PCAF) has developed a widely accepted methodology that helps financial institutions quantify emissions associated with their lending and investment portfolios. This involves collecting emissions data from borrowers and investees, or estimating emissions using sector-specific benchmarks when direct data is unavailable. Despite these advances, challenges remain. Data quality and availability often vary significantly across sectors and geographies, making accurate measurement difficult. Additionally, evolving regulatory requirements necessitate ongoing updates to measurement methodologies. Many institutions still rely on manual processes and spreadsheets, which can increase the risk of errors and complicate audits.

In India, the Reserve Bank of India (RBI) and the Securities and Exchange Board of India (SEBI) have responded decisively to this challenge. The RBI has introduced draft disclosure frameworks for climate-related financial risks, mandating scheduled commercial banks, large cooperative banks, and top-tier NBFCs to report on governance, strategy, and risk management related to climate risks starting FY 2025-26, with more granular metrics and target reporting from FY 2027-28. These requirements complement SEBI’s Business Responsibility and Sustainability Reporting (BRSR) framework, which already compels listed entities to disclose their environmental impact, including financed emissions. This regulatory push is compelling BFSI institutions to invest in robust carbon accounting systems, build in-house expertise, and adopt global best practices for climate risk management. 

For Indian banks and financial institutions, understanding and managing financed emissions is not just about regulatory compliance—it is central to risk management and business strategy. As India pursues its net-zero target by 2070, banks are reassessing their portfolios, reducing exposure to fossil fuels, and increasing investments in renewable energy and low-carbon sectors. This shift is evident in the growing issuance of green bonds, the introduction of green deposits, and the expansion of ESG-themed mutual funds and lending products. Sustainable finance is no longer a niche; it is rapidly becoming mainstream, driven by investor demand, regulatory mandates, and the need to future-proof portfolios against climate transition risks. 

Financial institutions globally, are aligning with climate goals, and this alignment often involves divesting from high-emission sectors like coal and oil and increasing investments in low-carbon alternatives such as renewable energy, energy efficiency projects, and sustainable infrastructure. Many institutions are also setting science-based targets to guide their emissions reduction pathways, ensuring that their capital allocation decisions support the broader transition to a sustainable economy. These strategic shifts not only reduce climate risks but also respond to growing investor demand for climate-aligned portfolios. In India, the scale of these emissions is enormous; estimates suggest that more than 15% of the country’s total greenhouse gas emissions can be traced back to activities financed by scheduled commercial banks, amplifying the sector’s influence well beyond its operational boundaries. 

The implications extend to India’s vast SME ecosystem, which accounts for a significant share of industrial energy consumption and emissions. Fintechs, in collaboration with traditional banks, are developing innovative solutions such as low-carbon lending products, green bonds, and carbon credit trading platforms tailored for SMEs. The government’s supportive policy environment—including the RBI’s Innovation Hub and the inclusion of renewables in priority sector lending—fosters this innovation and collaboration, accelerating the green transition across the broader economy.

Overall, the integration of financed emissions into capital allocation decisions is going to transform lending strategies. Banks will embed ESG criteria and climate risk assessments into their credit appraisal processes, especially for sectors with high carbon footprints. This means enhanced due diligence, stricter lending terms for carbon-intensive businesses, and preferential rates or terms for borrowers with credible decarbonization plans or those operating in green sectors. The RBI’s guidance on climate scenario analysis and stress testing further supports this approach, enabling institutions to quantify the potential impact of climate risks on their balance sheets and adjust their strategies accordingly. 

Its not only going to transform allocation strategies, but also lending strategies. Enhanced due diligence processes now require borrowers to provide detailed environmental disclosures, including verified greenhouse gas emissions data and credible transition plans. This increased scrutiny helps lenders identify climate risks early and support clients in their decarbonization journeys. There is a noticeable shift in sectoral focus, with reduced lending to high-emission industries and preferential financing terms for green sectors such as renewables and clean technologies. Moreover, many financial institutions are adopting active engagement and stewardship approaches, working collaboratively with clients to improve their climate performance rather than simply divesting from carbon-intensive businesses.

Incorporating financed emissions data into risk assessment and pricing is another significant development to look out for. Climate-related risks -  both physical risks from climate impacts and transition risks from policy and market change - will become integral to credit risk evaluations. Lenders are likely to adjust interest rates or collateral requirements based on a borrower’s emissions profile and climate strategy, among the regular details. Stress testing portfolios against various climate scenarios will help institutions anticipate potential losses and make informed capital allocation decisions. This integration of climate data into traditional financial models presents a fundamental shift in how risk is understood and priced in the financial sector.

Despite the clear benefits, managing financed emissions presents challenges. Data gaps and inconsistencies remain a significant hurdle, as many borrowers lack standardized emissions reporting. The complexity of integrating climate considerations into traditional financial analysis requires new skills and tools. Additionally, the transition to low-carbon portfolios may involve short-term financial trade-offs, such as reduced returns or increased costs. However, these challenges are outweighed by the opportunities. Institutions that act early can gain a first-mover advantage, attracting sustainability-focused clients and investors. Innovation in green financial products, such as green bonds and sustainability-linked loans, offers new revenue streams. Ultimately, aligning capital allocation and lending strategies with climate goals supports long-term resilience and value creation.

For financial institutions seeking to lead in this space, adopting a robust financed emissions framework is essential. StepChange offers tailored solutions to help organizations measure, disclose, and manage their financed emissions, understand climate risks, model for different scenarios and build decarbonization strategies.

In conclusion, financed emissions have become a critical factor shaping capital allocation and lending strategies across the financial sector. As climate risks and regulatory demands intensify, institutions must integrate financed emissions into their decision-making processes to remain competitive and responsible. By doing so, they can mitigate risks, capitalize on emerging opportunities, and contribute meaningfully to the global transition to a sustainable, low-carbon economy. StepChange is committed to supporting this journey, helping financial institutions transform their portfolios and lending practices for a greener future.