Scope 3: Omission impossible

For investors with diversified long-term portfolios, climate risk poses a substantial investment risk. As fiduciaries of our clients’ assets, we have a responsibility to advocate on their behalf and mitigate financial risks. Measuring the risk is a crucial first step to allow investors to price climate risks.

In our view carbon emissions largely remain an under-priced risk for investors. Yet measuring corporate emissions is challenging. They are defined in three scopes:

• Scope 1 covers direct emissions from operations
• Scope 2 includes the indirect emissions from the generation of purchased energy to run those operations
• Scope 3 covers all the other indirect emissions across a company’s value chain

Estimates suggest that Scope 3 accounts for over 80% of total emissions in the median MSCI World company[1].

The challenge is in the details

We therefore believe that Scope 3 is a vital tool for measuring decarbonisation progress at a systems level and inadequate disclosure may blind stakeholders to efficient decarbonisation options and transition risk. Yet today’s data quality makes the use of Scope 3 challenging for investors.

In particular, there are a number of complex challenges around Scope 3 emissions that require careful handling. For instance:

• There is no fully developed and agreed methodology
• Not all Scope 3 emissions are within a company’s control
• Existing calculation approaches do not deliver consistent results
• Many categories of emissions are not directly comparable
• Reporting oil & gas industry emissions is fraught with complexity

The path forward

 We are advocating for improved and standardised Scope 3 disclosure to facilitate comparisons between similar companies, and the same company across time, allowing for meaningful insights to be drawn.

 In summary, we believe that:

1. Despite the complexity, companies should report on, and regulators support the disclosure of, accurate and standardised Scope 3 emissions data
2. Investors should only incorporate currently available Scope 3 data into investment decisions with careful consideration of inaccuracy, estimation bias, and methodology constraints
3. Investors should treat Scope 3 emissions separately from Scopes 1 and 2 – and ideally should separate upstream from downstream emissions within Scope 3, which are very clearly distinct

Inadequate disclosure of Scope 3 emissions presents material risks

Scope 3 emissions are far too important to ignore. Including them in corporate disclosures is fundamentally a question of investment risk and return; we can see no good reason for regulators to stand in the way of disclosure by listed companies. In fact, we think not disclosing Scope 3 emissions will lead to market inefficiencies and the potential undercalculation of the financial risks created by the energy transition.

The energy transition is and will continue to be complicated – but its complexity is not a reason to ignore it. Scope 3 emissions need more, not less, attention if climate risks are to be properly priced and both companies and investors are to be ready to take the actions required to protect themselves.

For more information, please read our full research paper on Scope 3 emissions.

 

[1] Source: ISS, Carbon Disclosure Project (CDP), LGIM analysis. Carbon data as at 31/12/2021