Investors wrestle with the ‘Scope 3 Conundrum’

When asset managers first made commitments to align their portfolios with net-zero emissions, they mostly skirted the thorny issue of Scope 3.

Three years on and that’s no longer possible. A wave of regulation and public scrutiny is pushing investors to face what a unit of London Stock Exchange Group calls “one of the most vexing problems in climate finance.”

Scope 3 emissions are those produced by a company’s customers and supply chain. They typically account for more than 80% of a company’s carbon footprint. In some of the most polluting industries such as oil and gas, the number can be even higher.

The concept isn’t new, but there’s a renewed urgency among investors to work out the implications for the companies they invest in—as well as their own climate commitments. The urgency comes as regulators from the European Union, Japan, the UK and elsewhere signal mandatory Scope 3 disclosures are on the horizon for corporates. The US Securities and Exchange Commission also has discussed whether big emitters should be required to disclose their Scope 3 emissions.

The Institutional Investors Group on Climate Change succinctly explained why it’s important: “Without recognizing the Scope 3 emissions of a company, it isn’t possible to fully understand and assess its contribution to climate change.” The IIGCC added, however, that there are numerous “practical challenges” to properly report and calculate Scope 3 numbers, and these are the obstacles that need to be overcome.

This is what FTSE Russell, the indexes and benchmark unit of LSEG, calls the “Scope 3 Conundrum.” Incorporating value-chain emissions is “indispensable to a clear-eyed assessment of climate risks for companies,” but integrating Scope 3 data with portfolio analysis and investment decisions is “often hobbled” by the complexity of Scope 3 accounting. That complexity is caused by low disclosure rates, variable data quality and poor comparability, according to the report.

“On the one hand, it’s really critical; we need this data and we need to understand it and bring this into the investment process, not least because there’s real business and regulatory risks attached to these Scope 3 emissions,” said Jaakko Kooroshy, global head of sustainable investment research at FTSE Russell. “But on the other hand, we don’t really have the mature data sets to do this.”

FTSE Russell found that just 45% of the 4,000 medium to large-sized publicly traded companies in the FTSE All-World Index disclose Scope 3 data, and less than half of those do so for the most material-emissions categories in their sector.

And even when the data does exist, making it useful for investment purposes is another matter entirely, according to Lucian Peppelenbos, a climate strategist at Dutch asset manager Robeco, who’s also co-chair of IIGCC’s working group on Scope 3.

One problem is that the most widely used voluntary emissions reporting standard, the GHG Protocol, was not originally designed with investors in mind. (The protocol was devised in the early 2000s and divides Scope 3 into 15 categories, ranging from the emissions resulting from purchased goods and services, to business travel and the processing of sold products).

Unlike Scope 1 and 2 emissions, which are derived from a company’s own activity and from purchased energy, accurately assessing Scope 3 is much more difficult.

It may be no surprise then that when investors in the Net Zero Asset Managers initiative set targets to align their portfolios with net-zero emissions by 2050, they are only required to take into account Scope 3 emissions to “the extent possible.” Many of the asset managers in the $57 trillion initiative say they intend to add Scope 3 as the availability and quality of emissions data improves.

Ella Sexton, senior manager for climate strategy implementation at IIGCC, said she hopes the working group co-chaired by Robeco and HSBC Asset Management will soon “provide some clarity as to how and where Scope 3 emissions should be used in reporting and targets in a way that incentivizes real action on climate, not just on paper.”

Peppelenbos said the group is working to “reconceptualize” Scope 3 by “defining materiality and the level of complicity per sector.” Specifically, that means defining which of the 15 categories of Scope 3 are most material for companies and which should therefore receive the most attention from investors.

Recent research from FTSE Russell found that investors should focus on the two most material Scope 3 categories for an industry because those two categories will account for an average of 81% of the sector’s total Scope 3 emissions. In the energy industry, for example, purchased goods and the use of sold products account for 88% of Scope 3 emissions intensity, according to FTSE Russell.

By simplifying the problem and narrowing the lens in this way, “you get your arms around the lion’s share of the problem,” Kooroshy said.

Sustainable finance in brief

The best defence against Republican attacks on ESG is to persuade naysayers that the investing strategy can actually help financial performance, according to the chief investment officer for responsible investment at Man Group. The world’s largest publicly traded hedge fund doesn’t screen for environmental, social and governance risks “just to try to make the world a better place,” Rob Furdak, Man Group’s CIO overseeing its ESG assets, said. “We do it because we think it improves our investment process.” Furdak said it’s also important to remember where the financial wealth lies in the US. “There’s this perception outside the US that the US is incredibly anti-ESG, but it’s a very vocal minority that seems to be getting the headlines,” he said. “There are actually more assets in pro-ESG states than there are in anti-ESG states.”

• After assembling more than 100 bankers in a new transition finance team, Barclays is now setting parameters for how to expand the business without being accused of greenwashing.
• A senior manager at the fund unit of Goldman Sachs says last year’s deep selloff of green stocks may have blinded some equity investors to the growth potential in key corners of the market.
• Tensions within Germany’s ruling coalition are holding up a deal on the European Union’s toughest ESG rule to date.

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