Why Scope 3 emissions hide as much as they reveal, and what investors can do about it.
Climate change is one of the most urgent challenges of our time, and businesses have a crucial role in addressing it. To align with global goals, companies must significantly reduce greenhouse gas (GHG) emissions by 2030 and achieve net zero emissions across their value chains by 2050.
While in recent years there has been a trend for companies and investors to adopt ‘net-zero’ targets, generally, by 2050, it is important to recognize that each additional ton of greenhouse gas adds to global warming, so our sights need to be set on achieving net zero as soon as possible. As tricky as the decarbonization challenge is, we also know that delivering on other sustainable development challenges, particularly human development in low and middle-income countries, will be essential for achieving a zero-carbon economy, as missing one significantly increases the chances of missing the other.
Accounting for corporate emissions can be complex and includes three emission types: Scope 1, 2 and 3. Scope 1 emissions include all greenhouse gas emissions created by a company directly, primarily through burning fossil fuels, but also activities like chemical reactions (e.g. cement production) and refrigerant leaks (e.g. from a retailer’s display fridges). 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 burns the gas and provides steam for heating instead, that would be Scope 2.
All other emissions related to products and services produced by a company are Scope 3. These include everything from deforestation in a company’s supply chain to the emissions created in the use and disposal of the company’s products. It also includes employee commuting and business travel. In the U.S., the SEC has proposed including Scope 3 in new disclosure requirements, but the feedback from many asset managers has opposed this move. We believe it is a vital discussion, but more nuance and real-world implications are needed.
Identifying companies best positioned to contribute to and benefit from a rapid transition to net zero can be challenging for Scope 1 and Scope 2 but are generally similar for different companies, such as by using renewable energy to reduce Scope 2 emissions. However, Scope 3 emissions are much more nuanced and company-specific. All the more so when considering social and other environmental impacts. For example, how the electrification of transport is driving demand for conflict minerals. While more challenging, the most investment insight can be gained by understanding Scope 3 emissions (for most industries).
However, companies' carbon and climate change reporting remains inconsistent, while approaches to achieving genuine abatement remain contested. The potential for greenwashing, or well-intended but ultimately ineffectual efforts, is high. While leading companies are taking bold actions toward achieving genuine GHG emission reductions across their value chains, this complex work requires more than a single quantitative measure than Scope 3. A narrow quantitative approach risks hiding more than it reveals and almost guarantees unintended consequences. We have already seen this occur in scandals, from worthless forest-based carbon offsets to the Volkswagen emissions scam.
While Scope 3 emissions are crucial considerations in our investment process, we rarely use the term “Scope 3” because it is not just one activity or impact but hundreds of activities deeply interconnected with other sustainable development considerations. We believe that understanding the true positioning of a company in this context cannot be achieved top-down with broad sector analysis or single Scope 3 numbers which are mostly estimated. Only by understanding companies from the bottom up, with relevant disclosure can Scope 3 emissions be understood with the nuance they require.
For example, one of the most attractive features of the industrial companies we invest in is that they help their customers reduce energy and material use. These companies are leaders or emerging leaders in their respective fields. Their products produce Scope 3 emissions during use and disposal but also create savings versus alternatives. We carefully consider the quality of products that these companies produce, including capital expenditure, and investments in research & development, because we believe these investments will benefit the company as customers increasingly turn to them for help in reducing their carbon footprints.
For consumer goods companies, supply chains are complex, but are essential business issues that we consider when investing. While Scope 3 emissions, particularly from deforestation, are a concern so are the effects on smallholder farmers, biodiversity, food security, water availability, and so on. Because these issues are interconnected, we look for companies with leaders who take their stewardship responsibilities seriously and are working to resolve these complex issues. We regularly commission research to help us to understand these issues better, including on smallholder farmers, palm oil and soy.
Plastic waste is also a significant risk for many of the consumer goods companies we invest in, resulting in Scope 3 emissions upstream, biodiversity and human health effects downstream, and further Scope 3 emissions depending on how the firms dispose their waste. We have long engaged with companies on plastic waste and, in 2016, brought together 11 of the biggest consumer goods companies in India to discuss the issue. In turn, we encouraged these companies to join the Indian Plastics Pact, convened by the NGO WRAP.
In their most recent reporting, three of the four Indian consumer companies we engaged with are collecting more post-consumer plastic waste than they produce and 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.
Lastly, banks must actively finance sustainable development and a zero-carbon economy if net zero goals are to be met. We have commissioned research on the responsible lending approaches of the banks we invest in and have engaged with some banks on these issues. Scope 3 emissions for banks primarily relate to their lending books or “financed emissions.” In the same practical terms that we consider the issue for industrial and consumer goods companies, banks can improve the quality of their loan books by reducing exposure to polluting activities and lending more to actions that reduce emissions. This is particularly true for banks that help their customers’ future-proof assets by providing capital for retrofitting, which, in many cases, improves the loan's asset value and credit quality and reduces emissions.
The complex and systemic nature of decarbonization means the solutions are outside an individual company’s direct control. However, by focusing on practical outcomes that 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. In doing so, companies must consider human and other environmental challenges, which require deep engagement and the right values to resolve often thorny issues. A single number will never capture the quality of these activities, so a more holistic picture must be formed.
Rather than Scope 3, it is Scope Everything and these emissions are being produced everywhere, all at once. While measures can be useful, analyzing business quality and stewardship remains investors’ best tools for understanding the sources and best solutions for these emissions. Any disclosure requirements should reflect that.
Pablo Berrutti is a Sydney-based senior investment specialist at Stewart Investors, a long-only active equity specialist and global leader in sustainable investing.
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