By Alex White, Head of ALM Research at Redington
Since this is an evolving area, different reports may not be comparable, and therefore, the key focus should be on how emissions decrease over time, rather than how low they are to begin with. Here’s why:
The first reason is scope 3. Broadly speaking, scope 3 (or indirect) emissions aren’t mandatory to report, so some investors may decline to reveal them. There are sensible reasons for this: scope 3 emissions are extremely difficult to estimate, and differing methodologies mean the figures (at least reported figures) may not be comparable between firms.
But the problem with this is that scope 3 emissions can be large. Take a car manufacturer, for example – scope 3 emissions can be well above 90% of their total emissions. This is because all the emissions produced by mining the raw materials and by driving petrol cars fall under scope 3. In general, firm A’s scope 3 emissions account for some of firm B’s scope 1 emissions, so if you adjust for double-counting, scope 3 emissions must still be half the problem. Ignoring these emissions entirely can easily make a higher-emitting portfolio look like a lower-emitting portfolio.
As an aside, there’s arguably more controversy to come. For example, the standard scope 3 approach can penalise cars that last longer over those that fall apart quickly. This is potentially less sustainable, and perhaps a reason to stick to scopes 1 and 2.
The second problem is coincidentally another definition of scope: the assets covered. At the most basic level, more complicated assets, such as derivatives, can be excluded. And although this makes sense, it has the same consequence mentioned above that two asset owners’ reported emissions may not be comparable.
As an example, consider commodities. An investor may have a low-emitting equity portfolio, and perhaps even a policy to avoid investing in fossil fuel companies. But this investor may also hold a hedge fund with commodity futures as an inflation hedge. Now, there are plenty of approaches that could be used to estimate commodity emissions. Regardless of the approach used, we’d expect the emissions from oil, for example, to be high (there’s an argument that scope 1 and 2 emissions could be nil, or just the emission costs of storage, but scope 3 emissions would include both drilling for and burning it).
A simpler example is an equity future. While some option structures are too complex to resolve sensibly, if an index has emissions of X tonnes per million pounds invested, there’s a case that a future on that index should be treated as having the same emissions.
An investor who choses to adjust their report to include this would end up reporting higher emissions.
There are perfectly good reasons for the rules as they are, and they’re rapidly evolving. However, this isn’t a simple problem. If two investors appear to have very different emission profiles, the investor with the higher-emitting portfolio may be the one to emulate.
There’s no shortcut to looking through these emission reports thoroughly and objectively – without doing so, there’s a very real possibility investors could be penalised for genuinely attempting to disclose emissions beyond the regulatory minimum.
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