Investors beware – Scope 3 emissions hide as much as they reveal

From

Pablo Berrutti

Companies and investors have a crucial role to play in addressing climate change. As one of today’s most urgent challenges, the requirement for companies and investors to adopt ‘net-zero’ targets has exponentially increased.

If humanity is to achieve the goals of the Paris Agreement set in 2015, companies must align with global emission reduction goals by significantly reducing greenhouse gas (GHG) emissions by 2030 and achieving net zero emissions across their value chains by 2050. However, accounting for corporate emissions is complex and reporting standards remain inconsistent.

What are the three emission types?

Accounting for corporate emissions is not straightforward, and includes three emission types: Scope 1, 2 and 3. The idea is to provide a global framework for measuring and managing greenhouse gas emissions for all types of companies across various industries.

Scope 1 emissions include all greenhouse gas emissions created by a company directly, through burning fossil fuels, chemical reactions like in cement production, and refrigerant leaks. Scope 2 emissions relate to electricity and heat purchased by the company from third parties. To tell Scopes 1 and 2 apart, imagine buying gas for heating that is burnt on site being Scope 1, but if the company’s utility provider burns the gas and provides steam for heating instead, that would be Scope 2. All other emissions fall into Scope 3. These include the deforestation in a company’s supply chain, emissions generated in the use and disposal of the company’s products, and also covers employee commuting and business travel.

For Scope 1 and Scope 2, it can be challenging to identify companies best positioned to contribute to and benefit from the transition to net-zero. However, in many cases the solutions are similar for different companies across sectors; for example, switching to renewable energy to reduce Scope 2 emissions.

The same cannot be said for Scope 3 emissions which are more nuanced and company-specific. For Scope 3 emissions, social and other environmental impacts need to be considered. For example, understanding how the electrification of transport is driving demand for conflict minerals in the supply chain.

While Scope 3 emissions are the most challenging to dissect, they offer investors a richer understanding of a company’s value chain and carry the potential for deeper investment insights. In the United States, the Securities Exchange Commission has proposed including Scope 3 in new disclosure requirements. Yet, the feedback from asset managers has been anything but positive. 

Does Scope 3 improve emission reporting?

Companies’ carbon and climate change reporting remains inconsistent even with these defined emission types and well-established reporting standards like the Greenhouse Gas Protocol. The results of voluntary reporting standards has often been greenwashing or well-intended but ultimately ineffectual emission reduction efforts.

Many companies and investors are taking bold actions to achieve genuine greenhouse gas emission reduction across their value chains, but they cannot rely on Scope 3 as a single quantitative measure for understanding the implications of these actions. A focus on quantitative measures hides more than it reveals and almost guarantees unintended consequences.

What is the alternative?

For us, Scope 3 is a crucial consideration in the investment process, but we rarely use the term as it is not just one activity or impact but hundreds of activities deeply interconnected with other sustainable development considerations. Understanding the true positioning of a company in this context cannot be achieved top-down with broad sector analysis or Scope 3 numbers which are mostly estimated. The only way to more accurately reflect this is by analysing companies from the bottom up.

The complex and systemic nature of decarbonisation means the solutions are outside a company’s direct control. However, by focusing on practical outcomes that can improve supply chain resilience or help customers achieve their emission goals, companies can take Scope 3 emissions out of the theoretical and into the real world. Companies must also consider human and environmental challenges, especially in low and middle-income countries, which require deep engagement by investors and the right values to resolve often thorny issues.

A good example is plastic waste in emerging markets. For many consumer goods companies, plastic is essential in getting the final products to the consumer in a reliable manner. However, plastic results in upstream and downstream Scope 3 emission. As it is made from fossil fuels, upstream plastic production is emissions intensive and also impacts biodiversity and human health, while downstream the management of plastic waste disposal leads to pollution or if incinerated additional greenhouse gas emissions.

We have long engaged with companies on plastic waste and, in 2016, brought together 11 of the largest consumer goods companies in India to discuss the issue. In turn, we part-funded the establishment of and then encouraged these companies to join the Indian Plastics Pact, convened by the NGO WRAP so they can set ambitious targets and work together on systems that can resolve the many challenges plastic pollution entails. Three of the Indian consumer companies we invest in now collect more post-consumer plastic waste than they produce and are increasing the recycled content in their packaging.

While alternatives and avoidance measures are still needed, these actions are helping to close the loop on this source of Scope 3 emissions without calling it that. A single number will never be able to capture the quality of activities such as this, so a more holistic picture must be formed.

Where do we go from here?

Rather than Scope 3, it is Scope Everything. These emissions are being produced across the whole value chain of companies in ways that interact with many other issues, from biodiversity to human rights. They are key to the resilience of many businesses but poorly understood. Measures like Scope 1, 2 and 3 can be useful, but analysing business quality and stewardship bottom-up remains an investor’s best tool for understanding the sources and best solutions for these challenges and opportunities. Disclosure requirements should reflect that reality.

By Pablo Berrutti, investment specialist

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