Scope 3 emissions: The only way to see the full climate picture?

Scope 3 emissions enable ETF issuers and index providers to tell the full story of a company’s carbon footprint. While it is an epic task to collect hard data on the entire value chain, it is perhaps unavoidable for ETFs seeking to call themselves ‘Paris-Aligned’

Jamie Gordon


There is a rift between ETFs labelled as sustainable and alignment with the climate goals set out in the 2015 Paris Agreement, despite ongoing work by the European Commission (EC) to green investor portfolios.

Unsurprisingly, this issue is hardly helped by the fact companies are not obliged to disclose on the full range of polluting activities across their value chains. Though it has been 20 years since the 2001 Green House Gas Protocol began the categorisation of emissions into Scope 1, 2 and 3, most companies still choose to only disclose on Scope 1 and 2, meaning these are the metrics available to asset managers.

Unhelpfully, these first two tiers only account for companies’ direct and indirect operational emissions, with little consideration of the upstream and downstream emissions created before and after a company has fulfilled its role in delivering a product or service.

A paper from Fidelity Climate Solutions, titled We need to measure emissions holistically, estimated as much as 90% of overall emissions could be going unaccounted for by ignoring Scope 3, however, the discussion over this issue is only set to heat up following the EC’s decision to make incorporating Scope 3 mandatory in Paris-Aligned Benchmark (PAB) and Climate Transition Benchmark (CTB) indices from 2022.

Creating a holistic view

Making the case for Scope 3 inclusion, the Fidelity Climate Solutions paper said Scope 1 and 2 do not represent the impact of products throughout their entire lifetimes, including raw materials extraction, their use by consumers and eventually their impact either as waste or as recycled items.

Jaakko Kooroshy, head of SI Research at FTSE Russell, said: “It is critical because in some of these industries, a discussion without Scope 3 does not make any sense. For example, if an auto manufacturer tells you they are going net zero on Scope 1 and 2 by 2030, it deserves a pat on the back but it does not move the needle on global emissions.”

Speaking on the impact of Scope 3, Camilla Ritchie, senior investment manager at 7IM, continued: “For an oil exploration company this is likely to be significantly higher than the combined Scope 1 and 2 emissions by a factor of around 10 times. Therefore, if you are hoping to get to Net Zero by 2030, just looking at Scope 1 and 2 emissions is not really enough, even though it is difficult to calculate Scope 3 emissions.”

Interestingly, incorporating Scope 3 analysis might also uncover some harsh truths about the usual suspects of climate ETFs. For instance, outsourced or forgotten parts of electric vehicle and mobile phone companies’ supply chains – including mining for battery metals, lifespan electricity usage and disposal of battery components – would all be accounted for in an all-encompassing account of Scope 3.

A Scope 3 patchwork

While progress on integrating Scope 3 might appear slow, the reality is its impact is already being felt, and will gain a more explicit presence in the near future. From next year, the EC will require index providers to start incorporating Scope 3 emissions on PABs and CTBs, initially on energy and mining sectors, then a few other carbon-intensive industries, before eventually incorporating all sectors.

“It effectively becomes a sector-by-sector discussion and a sector-by-sector data exercise,” FTSE Russell’s Kooroshy said. “We will have to live with a patchwork of data and a sectoral patchwork of emissions that focuses on those most material emissions in those most material sectors and there will be a huge amount of pressure in these industries to make progress on Scope 3, while in others it is probably less of a concern.”

However, Kooroshy noted the impact of these changes may not be as significant as many are expecting given PABs and CTBs already require reporting on Scope 1 and 2 emissions, companies’ commitments to the Transition Pathway Initiative (TPI), their degrees of green revenues and their fossil fuel reserves.

The latter entered the climate investment discussion six years ago and looks at how much oil, coal or gas reserves a company has on its balance sheets. Kooroshy argued it acts as a good proxy for potential forward-looking scope three emissions for oil and gas companies as when these reserves are used, the at-present sequestered emissions will be released.

Between these carbon reserves being factored into PAB and CTB indices already, and companies such as Tesla already receiving weighting uplifts due to their green revenues, Kooroshy expected the implementation of Scope 3 over time to have an incremental rather than rapid impact on many companies, with the greatest effect being on those with large Scope 3 footprints that have until now been able to “fly under the radar”.

Data utopia versus reality

Overall, though, he says the reason for mandatory Scope 3 being introduced in some sectors and not others is those chosen are more straightforward to calculate. For instance, it is easy to figure out the downstream emissions of an oil production company per million barrels of oil produced – save for the use of technologies such as carbon capture.

Looking at sectors with more diffuse and complex value chains and corresponding emissions then requires what Kooroshy describes as “heroic estimations”, given how hard it is to agree on conceptual boundaries for Scope 3, let alone collecting any hard data.

“For a broader set of sectors, you have to go through a more systemic estimation approach. We use environmentally-extended input-output tables to look at how materials flow through value chains and then associate this with carbon footprints and what a company’s consumption pattern looks like,” Kooroshy continued. “For this, you are dealing with very large and very noisy data sets, so you need to come with more of an estimation and data science approach to this. Because of that, Scope 3 is something where, as an industry, data sets will have to attach some health warnings to.”

One example of these diffuse and at-times intangible data include tracking the downstream emissions of computer device usage. It is hard to attribute power usage from a grid to each device and the wireless networks and data centres used to perform day-to-day tasks such as virtual calls and internet searches.

On the other end of the spectrum, Kooroshy describes the task of fully portraying the upstream emissions of an EV manufacturer as an “extremely granular process”. Not only do cars often consist of around 3,000 parts but car companies themselves usually only know their suppliers and rarely have full visibility more than two or more steps up their value chain.

This is important in the context of EVs, given individual components relying heavily on industrial metals such as copper and battery metals such as lithium, cobalt, nickel and others. The emissions profiles of these metals vary significantly, Kooroshy says, with some mines using hydro power while others use coal-fire power stations – both of which result in very different emissions profiles.

Another issue Fidelity Climate Solutions highlights with universal Scope 3 incorporation is double counting, which occurs when the Scope 1 emissions of one party make up a portion of the Scope 3 emissions of one or more downstream entities.

Not concerned by this, Kooroshy says both parties have a responsibility to resolve their shared emissions, given they fulfil respective supply and demand roles within that part of the value chain.

He explained: “Look at the companies that provide Amazon’s delivery vans. Is it Amazon’s fault or the providers’ fault that the delivery fleet is producing emissions? In reality, both the problem and the solution are a shared one.”

However, double counting also poses an issue at a portfolio construction level. Fidelity Climate Solutions said if a portfolio manager invests in companies within the same value chain – for instance a wind turbine manufacturer and its parts supplier – the carbon footprint for their Scope 3 and 1 emissions for the same component would be double-counted. This can reach amount to as much as 30-40% of a portfolio’s emissions, according to the Institutional Investors Group on Climate Change (IIGNCC).

Offering one solution, Fidelity said double counting in portfolios could be avoided by breaking value chains into discreet parts and assessing the emissions footprints of each segment separately.

Investor view

Echoing some of the concerns raised against emissions at more granular levels, Matt Brennan, head of investment management at AJ Bell, posed the question about how emissions data might be gathered for energy consumption during the work-from-home and hybrid economies.

“The other challenge I have with carbon data is how the intensity is reported. It is usually done as carbon per $1m of sales,” he added. “I am really not a massive fan of this. Because for example many technology companies are on high valuations and have high profit margins, compared to energy companies, so the per sales comparison for me is not a true comparison of say £1m invested in Apple compared to £1m invested in Shell.”

While these challenges exist, 7IM’s Ritchie said the Paris Agreement cannot be achieved by only resorting to Scope 1 and 2 emissions.

“To stabilise global temperatures, we all need to reduce the total amount of our carbon emissions and that is Scope 1, 2 and 3,” Ritchie argued.

“Some oil companies – including BP – have stated that they will disclose how each of their future material investments will be compliant with the Paris Agreement. Although none of these companies have actually laid out how this will happen, the vast majority of them have continued to set their targets using only Scope 1 and 2 emissions so it is really difficult to see how they think they are going to be aligned to the Paris Agreement.”

BHP has started to disclose on Scope 3 emissions and companies such as Volvo are beginning to set net-zero targets featuring Scope 3, however, there is a long way yet to go. By the beginning of 2020, only 18% of the constituents of the MSCI AC World index reported on Scope 3.

Karooshy concluded: “Where we can calculate it and it is material, it makes sense that this now becomes a focal point for the industry. It would be a fool’s errand to try, for every company in a large investment universe, to figure out in great detail their Scope 3 emissions. But it is a very important piece of the puzzle that has been missing so far.”

This article first appeared in ETF Insider, ETF Stream's new monthly ETF magazine for professional investors in Europe. To access the full issue, click here.

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