When developing a climate-oriented investment strategy, there are three components to grapple with:
- Climate risk exposure;
- Portfolio carbon emissions; and
- Real-world climate impact.
Current emissions data tells us there’s often a trade-off between emissions and impact. But is this a real trade-off, or is it a perception driven by incomplete data?
Today, investors hold more information on carbon emissions than ever before. This data can be used to manage portfolio-level emissions and to gain insight into climate risk and climate impact.
Climate risk is multi-faceted, but one dimension can be understood through emissions data. Assessing the carbon intensity of the issuers in their portfolio can help investors identify those holdings that are subject to a high climate transition risk (specifically, carbon-intensive companies are most likely to be impacted by higher carbon prices).
Climate impact, on the other hand, is about the real-world change that will support our transition to a low-carbon world. An impactful company should offer products and services that help solve for environmental challenges. From a carbon emissions perspective, impactful companies should offer solutions that help reduce emissions versus the status quo. This impact will allow companies, and investors in those companies, to contribute to real economy decarbonisation.
But is there a trade-off between emissions and impact?
Earlier this year, we researched impact opportunities within public equity strategies. Our aim was to find managers who are experts in identifying companies that are delivering meaningful solutions to our environmental crisis (such as solar glass manufacturers, waste treatment facilities and battery producers). However, it became apparent that these high-impact companies are often high emitters, since sectors where change is most urgently needed, and where more compelling impact opportunities present themselves, are often carbon-intensive (such as industrials, utilities, and materials). This meant that when running a simple carbon emissions footprinting comparison (scope 1 and 2) versus the MSCI World, the portfolios didn’t look as expected. So, the question is, is there really a trade-off between emissions and impact, or can this be explained by shortfalls in the data?
To answer this, let us take a closer look at the emissions data. Most carbon footprinting today only includes scope 1 and 2 emissions. This covers all emissions occurring on company-owned facilities (buildings, factories, land etc.) and any emissions linked to that company’s energy usage (electricity, heating and cooling). What this data is missing is scope 3 emissions: emissions induced across the company’s value chain, upstream and downstream.
Overlooking scope 3 emissions can lead to very misleading conclusions. Take, for example, a comparison between Glencore, a mining business, and Veolia, a utility company. On a scope 1 and 2 basis, Veolia is c.7 times more carbon-intensive than Glencore. It’s only when you consider scope 3 emissions that you capture the nature of Glencore’s business model. For Glencore, 93% of its emissions are scope 3 (i.e. induced across its value chain through the extraction of raw materials and the burning of fossil fuels).
This example might look ‘cherry-picked’, but it’s not. MSCI estimates that the average carbon intensity of scope 3 is almost three times greater than the average carbon intensity of scope 1 and 2 combined across the entire MSCI ACWI index.
In that case, why are we even looking at emissions data?
Clearly our current emissions data is incomplete, but let’s not dismiss the value of what is already available. Using current emissions data (scope 1 and 2), investors can develop portfolio decarbonisation strategies that will send a powerful signal across markets and push companies to adopt more meaningful decarbonisation objectives globally.
However, the absence of scope 3 data does pose issues when trying to understand climate risk and impact. Ultimately, investors can only assess whether a company relies on carbon-intensive activities across its value chain (both upstream and downstream) using scope 3 emissions. This is crucial information for both climate risk and impact analysis. So, why is it so often left out of emissions data?
When it comes to obtaining scope 3 emissions data, there are a few roadblocks we need to overcome. The biggest challenge is disclosure. Only 18% of MSCI ACWI companies report their scope 3 emissions, and very few of these report complete scope 3 emissions (across all 15 categories). Due to this lack of disclosure, carbon footprinting tools must rely on industry-based scope 3 estimation models which fail to capture idiosyncratic carbon patterns. Investors have also raised issues around the risk of double-counting emissions within scope 3 and the lack of control companies have over emissions induced within their supply chain. While double-counting and lack of ownership should be addressed, are these enough to stop us from seeking out the full picture?
How can we capture carbon emissions in their entirety?
To see the full picture, impact investors generally perform a complete life cycle analysis of companies in their universe. This analysis considers everything from raw material extraction to product use and disposal, providing detailed visibility of scope 3 emissions data and, ultimately, a complete picture of a business’s carbon risk and impact. Unfortunately, this complete life cycle is not captured in most emissions data. Therefore, as mentioned previously, impact funds can sometimes appear more carbon-intensive than their market benchmark. It’s only when accounting for scope 3 that this perceived trade-off dwindles out.
As more investors seek to align their portfolio with the Paris Agreement, they should be mindful of all three factors – emissions, risk, and impact – acknowledging that a decarbonised portfolio is not always consistent with investing for real-world impact. Until we can complete the missing piece of the emissions puzzle, aligning these two components together, it’s important they’re managed as separate portfolio objectives.
In light of this, we encourage all investors to actively engage with their portfolio companies, seeking greater disclosures around scope 3 emissions which will help us better understand how to transition towards a low carbon economy.
Sources:
MSCI, Scope 3 Carbon Emissions: Seeing the Full Picture
Greenhouse Gas Protocol, Do We Need a Standard to Calculate “Avoided Emissions”?
