Navigating Emissions Reduction and Climate-Related Risk

As the Center for Science Education and others report, reducing greenhouse gases (GHGs) is required to limit the effects that climate change likely will have on the planet. GHGs absorb infrared radiation and trap its heat in the atmosphere, creating a “greenhouse effect” that results in global heating.¹

Actuaries can play an important role in companies working toward activities that reduce society’s reliance on fossil fuels, further the green economy and mitigate climate-related risk. They can, among other things, help insurers understand the economic risks associated with such a climate transition.

Categorizing GHG Emissions

The Greenhouse Gas Protocol (GHGp) is an accounting system that aims to represent a true and fair perspective of the emissions associated with business activities. It aims to understand and mitigate global carbon emissions and has evolved into one of the leading frameworks for emissions accounting and disclosure.

The GHGp divides emissions into three “scopes,” depending on where GHG-emitting activities occur within a company’s value chain:

1. Scope 1 emissions refer to direct or indirect emissions from owned or controlled sources. For an insurer, an example of Scope 1 emissions would be emissions associated with driving company-owned vehicles.
2. Scope 2 emissions refer to emissions associated with purchased energy. An example of Scope 2 emissions would be those a utility company generates to produce electricity to heat company offices.
3. Scope 3 emissions encompass all other indirect emissions that occur in a company’s value chain, including emissions that are associated with financing activities. Scope 3 emissions would cover aviation emissions associated with business travel, for example.

Financed and Insurance-associated Emissions

The GHGp corporate standard defines 15 distinct categories of Scope 3 emissions. For insurers, a significant category of these emissions is Category 15 – Investments. The Partnership for Carbon Accounting Financials (PCAF), the leading accounting guideline for Scope 3, Category 15 emissions, further delineates investment emissions into three categories:

1. Emissions associated with investments (financed emissions)
2. Emissions associated with insurance underwriting (insurance-associated emissions)
3. Emissions associated with capital market facilitation

Financed and insurance-associated emissions are significant sources of an insurer’s emissions. One market study has estimated that an insurer’s financed and insurance-associated emissions can be more than 90% of the insurer’s total emissions.²

Financed and insurance-associated emissions are calculated based on the premise that providers of capital, either through direct financing or financial facilitation of ongoing operations, should take responsibility for the emissions of the real-economy companies being financed. The PCAF defines separate calculation methodologies for different investment asset classes and underwriting lines of business. Still, the general premise is that the insurer records a proportionate share of the investee or insured’s emissions based on the level of financing provided to the company.

Currently, the PCAF provides emissions calculation guidance for investment asset classes, commercial insurance products and personal auto insurance. Other insurance products, including life and health lines of business, are currently out of scope for emissions calculations.

The Importance of Emissions Management

For insurance companies aiming to align business activities with the goals of the 2015 Paris Agreement or other climate change scenarios, reducing GHGs and understanding and disclosing their carbon footprint, including financed and insurance-associated emissions, is important, in our opinion. Building an inventory of corporate emissions can be a foundational step for an insurer in developing a climate transition plan, which lays out an insurer’s objectives, strategy and goals for navigating the global transition to a lower carbon economy.

Through the creation of an emissions inventory and transition plan, insurers can help gain insight into the environmental impact of their operations, investment and underwriting portfolios. We believe this could lead to societal benefits, such as reducing the impact of climate change for future generations. We also believe it could offer strategic and compliance-oriented benefits, especially in an era of increasing climate-related regulatory disclosure requirements.

Sustainability Regulatory Landscape

Mandatory Disclosure Requirements

The regulatory landscape for climate-related disclosures is evolving rapidly, but a common theme across the regulatory landscape is a movement to quantify and disclose emissions. The Corporate Sustainability Reporting Directive in Europe mandates holistic sustainability reporting, including detailed GHG emissions data across all three scopes of emissions.

In the United States, the Securities and Exchange Commission has passed a rule (though currently on hold) requiring public companies to disclose climate-related risks and emissions, although this disclosure is limited to Scope 1 and 2 emissions. Additionally, California introduced regulations that emphasize climate-related risk disclosure and emissions reporting across all three emissions scopes.

Voluntary Disclosures and Market Trends

Voluntary initiatives like the Task Force on Climate-related Financial Disclosures (TCFD) and the Forum for Insurance Transition to Net Zero (FIT) encourage insurers to adopt industry-leading practices in emissions reporting and set ambitious decarbonization targets. These frameworks support insurers in understanding and managing their emissions and associated climate-related risks while helping to build brand strength by distinguishing themselves as leaders on climate.

Financed and Insurance-associated Emissions

Methodologies for Calculating Financed and Insurance-associated Emissions

As mentioned, the PCAF and GHGp have developed standardized methodologies for calculating financed and insurance-associated emissions. This standardized approach fosters emissions disclosure comparability and transparency across the industry. The methodology emphasizes the importance of high-quality data and encourages insurers to continuously improve their data collection practices.

Systems and Data Requirements

Accurate emissions calculations depend on effective systems and reliable data. The PCAF has defined a data quality standard that ranks the data used in financed and insurance-associated emissions calculations from 1 to 5, where a score of 1 represents the highest-quality data that is most likely to represent the real-world emissions generated from the financed or underwritten activity, and a score of 5 represents a very high-level estimate using many assumptions. This hierarchy allows the comparison of portfolios in terms of the quality and level of estimation within the results. In general, higher data quality scores imply greater use of estimation techniques, which can be less accurate and more volatile over time than higher-quality data.

For financed emissions, insurers should strive to obtain detailed information about the financial and emissions profiles of the companies they invest in. To perform the calculations according to the PCAF’s prescribed methodology, insurers could collect market data, including book value, enterprise value and amounts invested across their entire universe of holdings.

Insurers will likely also need information about the emissions profile of the investee companies. In some instances, these companies might report this information and make it available through investment data providers. However, this typically varies by asset class, and for some asset classes or individual securities, reported emissions information might not be available. In those instances, we suggest insurers develop an emissions estimation methodology that could consider additional data points such as the sector, geography and revenue of the investee company.

For insurance-associated emissions, the data requirements are generally the same as those for financed emissions when it comes to commercial insurance policies. One significant difference may be driven by the level of small and medium enterprises in the underwriting portfolio, which may not be present in the asset portfolio. These companies generally have less information (collected or available) of the sort needed for emissions estimation, which can complicate the process.

In addition, insurers writing personal vehicle coverages might be able to capture additional data—like the make, model and mileage of insured vehicles—to report on such emissions. Insurers could also source emissions factors used to translate driving activity into emissions. Organizations that provide such data include the U.S. Environmental Protection Agency (EPA) and the Intergovernmental Panel on Climate Change (IPCC).

To begin performing these calculations, insurers may start with pilot lines of business or asset classes, using ad hoc systems and technologies. However, as the programs mature and the calculated figures become subject to disclosure and audit, we believe insurers should develop strong processes and systems such as those present in existing financial reporting. Such processes should be able to take data from disparate investment and underwriting systems, perform centralized emissions calculations, develop a PCAF score and aggregate results into understandable and auditable reports. The information also should be stored and tracked, as one of the core tenets of GHG accounting is the reporting and explanation of changes in emissions levels over time.

Key Challenges in the Calculation

Data quality and availability are primary challenges in measuring financed and insurance-associated emissions. Through initial pilot exercises, gaps in available data can be identified and remediation plans developed. Gap identification could include identifying systems that have or do not have key data elements, implementing common data standards and definitions across systems, and prioritizing a plan to capture key missing data through future system developments.

Another challenge insurers may face when making these calculations is consistency across systems. At the outset of developing an emissions inventory, financed and insurance-associated emissions may be performed in silos, with the investment management system providing data for financed emissions and the underwriting system providing data for insurance-associated emissions. In many cases, insurers may underwrite policies for the same companies that they invest in. This necessitates consistency in the emissions calculation for those entities, which can be a technological challenge.

A third challenge relates to developing people and processes to take ownership of the emissions calculations. Today, as we have observed, ownership of such calculations is mixed among finance, sustainability, underwriting and actuarial professionals. We believe insurers interested in measuring financed and insurance-associated emissions would benefit from developing a clear process and governance structure to assign responsibility for emissions inventory calculation and track those calculations over time.

Decarbonization Targets and Transition Strategy

Once an insurer has developed its emissions inventory, it can begin developing a climate transition strategy and organizing its implementation. A key component of a climate transition strategy is setting a decarbonization goal that outlines the scope, boundary and target of the decarbonization effort; the approach and methodology for measuring and reporting emissions; progress against decarbonization targets; and likely impacts to the bottom line.

Insurers likely would benefit from aligning efforts with a credible third-party decarbonization framework when determining their level of climate ambition and strategy. Common frameworks used in the industry include the Science Based Targets initiative (SBTi), the Net-Zero Asset Owner Alliance (NZAOA) and the FIT. These frameworks can provide science-based guidelines on the level and timeline of emissions reductions necessary in various parts of the economy to achieve the goals of the 2015 Paris Agreement.

Determining a goal level for decarbonization can set the tone for the insurer’s overall carbon-reduction transition strategy, and context for the business impacts associated with a given ambition level is critical.

The Role of Scenario Analysis in Managing Climate-related Risks

Scenario analysis is a critical tool for understanding decarbonization pathways for investment and underwriting portfolios and the potential impacts of climate-related risks on business operations. Market-leading practices include evaluating multiple scenarios that envision various emissions pathways and resultant levels of global warming. This analysis helps companies understand the likelihood of success, the costs associated with a decarbonization target and forward-looking climate-related risks. Conducting scenario analysis could help insurers prepare for a range of future scenarios, enabling them to respond to various climate-related challenges.

Possible Benefits of Setting Targets

Setting decarbonization targets can offer several benefits, including:

• Improved risk management
• Enhanced investor confidence
• Alignment with regulatory expectations

It also can help demonstrate a company’s commitment to sustainability, which can enhance its reputation and give it a competitive advantage in the market.

Actuarial Involvement in Financed and Insurance-associated Emissions

We believe actuaries can play a key role in calculating financed and insurance-associated emissions, helping their organizations set and track decarbonization targets. Given their centralized role within companies across underwriting, risk management and finance, actuaries also can help organizations incorporate emissions considerations into company operations and strategy. The following are some of the ways actuaries can be involved in the emissions quantification process.

Contributing to Emissions Calculations

Actuaries can leverage their technical skills to create emissions databases across the underwriting and investment portfolios. Quantifying emissions generally requires navigating disparate systems across hundreds of thousands of rows of data and processing the data into a centralized repository. Therefore, the leading candidate for developing a Scope 3, Category 15 emissions inventory should be proficient in database management software such as SQL, have coding experience in a language such as Python, and should have familiarity with both investment management and underwriting systems at their employer—all of which can play to the strengths of many actuaries.

Assisting in Target Setting

Actuaries can contribute to setting realistic and achievable emissions reduction targets. Their analytical skills help them understand the potential financial and strategic impacts of various scenarios, so they can then develop strategies to achieve the targets.

Conducting Scenario Analysis and Setting Targets

To ensure success and mitigate negative reputational impacts, companies will want to perform thorough scenario analyses on future emissions trajectories for their investment and underwriting portfolios before announcing a public decarbonization goal.

A credible scenario analysis requires the evaluation of models across a host of parameters, including:

• Macro parameters, such as gross domestic product (GDP) and population growth
• Micro parameters, such as localized energy costs
• Company-specific parameters, such as those included in an insurer’s business plan

The results of the scenario analysis can be used to identify key areas of risk and opportunity resulting from climate change, such as impacts on the risk and return profile of the investment portfolio and the profitability of insurance products.

In our experience, actuaries as risk management professionals generally have the requisite skill set to navigate multiple models and integrate the results to develop a point of view under each scenario. Armed with this type of analysis regarding the feasibility of achieving a given decarbonization goal under various global futures, actuaries could work with strategy and sustainability personnel to identify the level of decarbonization that effectively aligns with company strategy.

Incorporating Emissions Into Ongoing Operations

Once a decarbonization goal is set, insurers can operationalize a strategic plan to help achieve the targets. A central role in this process likely would be to incorporate emissions considerations into both asset and liability matching and product pricing. Actuaries could leverage their experience in building asset-liability management (ALM) and pricing models to assist companies in embedding emissions into the process. Through this type of analysis, actuaries could help their company develop an internal cost of carbon for both investments and underwriting, providing a guiding risk and return criteria for emissions across the underwriting and investment portfolios.

Conclusion

As the insurance industry navigates the complexities of climate change, we believe actuaries have a significant role to play. Our specialty in risk modeling, data analysis and strategic planning, coupled with our centralized role across multiple functions within an organization, could be important for measuring emissions, setting targets and embedding emissions considerations into day-to-day operations. We’re confident actuaries can help companies navigate meaningful progress toward a sustainable future for the insurance industry and beyond.

Statements of fact and opinions expressed herein are those of the individual authors and are not necessarily those of the Society of Actuaries or the respective authors’ employers.

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