To understand a company’s emissions profile, one must account for all sources of corporate emissions.
To understand a company’s emissions profile, one must account for all sources of corporate emissions. Most such analysis focuses on emissions produced directly by company-owned facilities (Scope 1) and emissions from purchased energy in those controlled facilities (Scope 2). However, we feel there should be a greater focus on Scope 3 – the emissions attributed to a company’s value chain. Scope 3 often dwarfs the more commonly used Scope 1 and 2 emissions, and we believe it will become increasingly important and necessary for accurate GHG accounting.
Measuring Scope 3
Scope 3 emissions must be estimated either by the company itself or a third party. While the GHG Protocol supplies accounting guidance, the methodologies across companies may not be standardised. The GHG Protocol breaks Scope 3 down into upstream and downstream emissions.1 Upstream emissions include those from the production of product inputs, such as purchased goods and services. In contrast, downstream emissions refer to emissions that occur from sources such as the use of a company’s products.
While one might initially think that Scope 3 is out of a company’s control, companies can make efforts to mitigate these emissions. For instance, they can use less emissions-intensive materials to build their products or they can create a product that uses less carbon throughout its product life cycle. None of these examples would be captured in Scope 1 and 2, but nevertheless are decisions that companies can make. In addition, a company can outsource all or part of its manufacturing process, effectively reducing its Scope 1 emissions, without truly lowering their emissions footprint. Thus, it is important to account for Scope 3 to ensure that Scope 1 and 2 are not being reduced at the expense of increasing Scope 3 emissions, or vice versa.
Scope 3 can be a significant part of a company’s overall emissions. As Trucost data suggest, Ford and Tesla both have very low Scope 1 and 2 emissions intensity, for example, but Scope 3 accounts for the majority of their emissions (Figure 1). Incorporating only Scope 1 and 2 when evaluating such companies can miss a significant portion of their carbon emissions.
Figure 1. Ford and Tesla Carbon Intensity (FY 2018)
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Source: Trucost; data for FY 2018.
Current Reporting of Scope 3
Focusing on the MSCI World benchmark, in FY 2019 we see a reported Scope 3 percentage in the range of 20% to 40% which is dramatically lower than that of Scope 1 and 2, which range from 50% to 80% of index constituents (Figures 2 and 3).
Figure 2. Reported Scope Disclosures by Region (MSCI World, FY 2019)
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Source: Man Group, Sustainalytics; data for FY 2019.
Figure 3. Reported Scope Disclosures by Sector (MSCI World, FY 2019)
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Source: Man Group, Sustainalytics; data for FY 2019.
Across the MSCI Emerging Markets, Europe, and World indices, Scope 3 has low reported coverage (Figure 4). For most of the unreported Scope 3 names in the benchmarks, the values are estimated by the data vendor. Estimated Scope 3 names can account for up to 80% of the benchmark, such as in MSCI Emerging Markets.
Figure 4. Sustainalytics Scope 3 Coverage by Benchmark (FY 2019) Percentage of Companies
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Source: Man Group and Sustainalytics; data for FY 2019.
As Scope 3 can be difficult to measure, there are some limitations in using largely estimated data. Trucost also notes as another potential issue that the estimated values may be lower than the true Scope 3, as the companies that report might be those that have lower emissions intensity.2
Relative Importance of Scope 3
To get an idea of the level of upstream Scope 3 by sector, we look at a recent cross-section of the data which highlights that energy and consumer staples have the highest emissions, although largely due to outliers (Figure 5). Real estate and communication services have the lowest emissions.
Figure 5. Upstream Scope 3 Emissions (Million Metric Tons of CO2 Equivalent)
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Source: Man Group and Trucost; as of 1 January 2021.
We find that trying to use Scope 1 and 2 to estimate the values of Scope 3 even with sectors may not provide very accurate estimates on what the actual Scope 3 would be, except for utilities.
The relative importance of Scope 3 can depend on a company’s industry and business model. To examine this, we show the average percentage breakdown of Scope 1, 2, upstream and downstream carbon intensity by sector (Figure 6). At the sector level, Scope 3 accounts for around 80% of total emissions intensity in consumer staples, but less than 50% for utilities, where Scope 1 is on average the most significant contributor to carbon intensity. These variations can suggest that the incorporation of Scope 3 may even paint a different picture of what sectors or industries are actually more or less energy intensive than Scope 1 and 2 alone would show.
Figure 6. Average Percentage Breakdown of Carbon Intensity by Sector (MSCI World, FY 2018)
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Source: Man Group and Trucost; data for FY 2018.
Using estimated values from Trucost, we can see quite a difference in the emissions profile of the Scope categorisation by sector for upstream emissions. Plotting Scope 1 and 2 versus upstream Scope 3 emissions intensity, we see the relationship is fairly sector dependent (Figure 7).
Figure 7. Scope 1, 2 and Upstream 3 Carbon Intensity (Metric tons of CO2 equivalent / Million USD revenues) by Sector
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Source: Man Group and Trucost; data as of 1 January 2021.
Potential Problems with Scope 3
One potential solution to understand the degree of double counting would be to use detailed supply-chain data.
Scope 3 captures indirect emissions from the supply chain and product use. For business-to-business firms, one company’s Scope 3 can make up another firm’s Scope 1 and 2. One potential solution to understand the degree of double counting would be to use detailed supply-chain data.
There are also clear cases where emissions overlap would not be an issue. A simple example would be a car company producing vehicles for personal use. Since the end user is not a business, these cars would not be counted in another company’s emissions. However, it is not always that clear. In an estimation by MSCI, approximately 80% of Scope 3 emissions are counted towards another firm’s Scope 1 and 2.3
One final consideration of double counting is the group of stocks that are being aggregated which might have a significant impact on the amount of double counting that would be present. If an industry-level analysis on carbon emissions was the goal, there may be significantly more overlap than in a diverse portfolio of 100 stocks.
Portfolio Implementation
The most practical way to implement portfolio level information on Scope 3 emissions, in our view, is either through trend analysis or relative company comparisons. These approaches compare the same emissions methodology and thus would not suffer from double counting or a requirement to know the total emissions of a group of firms, either at portfolio level or sector/industry level.
Below, we look at the 1,500 most liquid names in our global equity universe and constrain a hypothetical core long/short portfolio in two ways:
- Varying levels less than the benchmark for the long exposure
- Long side varying levels less than short side exposure
We show first the portfolio exposure with just Scope 1 and 2, followed by three levels of Scope 1, 2 and upstream Scope 3 constraints at just less than the benchmark or long side less than the short side and finally 60% less (Figure 8). We can see that the sectors with high emissions are hit the hardest, namely energy, utilities and materials.
Figure 8. Portfolio Exposure with Increasing Carbon-to-Market-Cap Constraints
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Source: Man Group and Trucost; data from 1 Jan 2013 to 31 Dec 2021. Please see the important information linked at the end of this document for additional information on hypothetical results.
Scope 3 is essential to capturing a full view of a company’s carbon emissions.
While there are currently issues with Scope 3 emissions data – mainly that the current reporting standards are quite loose and the data are not reported broadly enough – we do expect these to improve through increased regulation and market demand. There are nonetheless ways we can gain insight through relative comparisons across companies and sectors, as well as trend analysis. While more cumbersome to gather and interpret, Scope 3 is essential to capturing a full view of a company’s carbon emissions. Yet given the challenges when implementing portfolio analytics and constraints, we believe managers who take the time to understand the scope of the issue will have an advantage.
This is just a summary of our full research paper on Scope 3. To read the entire analysis, please click here.
1. Source: GHG Protocol, Corporate Value Chain (Scope 3) Accounting and Reporting Standard.
2. Source: Trucost, “Methodology - Trucost Scope 3 Carbon Emissions Data”.
3. Source: MSCI, Scope 3 Carbon Emissions: Seeing the Full Picture.
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