Written by the Stewardship Team at Evenlode Investment
The message from COP26 and the 6th Intergovernmental Panel on Climate Change report is clear: the world is on a trajectory to surpass the agreed global warming threshold of 1.5°. This failure to meet the Paris climate accord will have dire consequences for human society and entire ecosystems.
To accelerate the race to net zero, asset managers must assess the true size of their carbon footprint. Comprehensive emissions analysis can have myriad mutual benefits for investors and the planet, permitting fund managers to mitigate climate transition risk and better target engagements with the heaviest polluting investee companies. This will be crucial to safeguard returns and ensure portfolio resilience over the coming years, as the risks businesses face from mounting consumer pressure and climate regulation grow.
However, to get a true picture of their carbon count, investors must delve below the surface to gain an accurate understanding of their financed emissions.
Scoping out the problem
As per the Greenhouse Gas Protocol – the world’s most widely used greenhouse gas accounting standard – emissions are categorised under three different ‘scopes’, depending on where they are actually emitted from. Scope 1 and 2 refer to emissions occurring in companies’ operations, while scope 3 are indirect emissions occurring in the value chain, both upstream and downstream.
While scope 3 emissions are harder to control and measure for companies, they make up the vast majority of most investors’ portfolio emissions. Scope 1 and 2 emissions only represent a small proportion of total emissions for low capital intensive companies, such as software specialists and platform pioneers, for example. If investors looked at scope 1 and 2 alone, they would subsequently only see a small part of the full picture. After all, companies often outsource parts of their operations, pushing them outside of the boundaries of their scope 1 and 2 footprints, even though their suppliers might operate in a much less environmentally friendly way.
The other side of the coin is companies can effect change by choosing more climate-friendly suppliers, opting for lower-carbon ways to transport supplies to their sites, optimising operations to minimise waste, and redesigning their products so they use less energy during their lifetime – all of which would impact scope 3 emissions.
The Partnership for Carbon Accounting Financials (PCAF) released a standard for calculating portfolio emissions in November 2020, requiring signatories to report financed scope 1 and 2 emissions as a minimum – that is the scope 1 and 2 emissions of investee companies. However, in order to truly understand companies’ climate impacts and risks, we believe it is critical to also include scope 3 emissions in investors’ financed emissions reporting. Fortunately for asset managers, the large and growing level of data around emissions is making this task increasingly easy to achieve.
Filling in the gaps
Having become the first UK asset manager to disclose our financed emissions in alignment with the PCAF standard for financial emission accounting in 2021, we believe the most comprehensive and practical source of emissions data currently available to investors is the full greenhouse gas dataset provided by the Carbon Disclosure Project (CDP). As part of its climate change survey, the CDP annually requests emission data from companies in the MSCI All Country World Index, as well as the highest emitting companies not included in the index. Other companies can also voluntarily report through the CDP.
The CDP dataset has several key advantages. Firstly, it fills in all the categories companies have failed to report on. Secondly, it provides crucial detail by requiring companies to report emissions segregated into scope 1, 2 and 3 categories, rather than in aggregated form. Thirdly, it has the advantage of providing additional quality assurance, as its data teams check reported emissions, flagging those that deviate from its own estimates of a company’s likely emissions and checking a subset against emissions disclosed in company reports for external consistency.
While the CDP dataset seems the most suitable data source available to investors, it is nonetheless incomplete and relies on the occasional estimation. This is particularly true of scope 3 emissions, which require a high degree of judgement from reporting firms. The CDP subsequently uses models to fill in the gaps where companies do not report.
With tools such as the CDP dataset now easily accessible, there is no longer any excuse for asset managers to remain in the dark around their financed emissions – and certainly no good reason. With every passing day, the climate emergency escalates, and investors grow increasingly curious around the environmental impacts of their investments. The asset managers without adequate answers will be found wanting as the climate-conscious generation of investors takes the reins.