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To track Net Zero outcomes in investment portfolios, there are many metrics available, as well as a plethora of data providers to choose from. Some of the most common metrics to assess Net Zero outcomes include the level of carbon emissions (Scope 1, Scope 2 and Scope 3 emissions), carbon intensity, carbon risk ratings and emerging net zero alignment metrics. While these metrics are critical in tracking progress towards Net Zero, there are some limitations that need to be considered.
The reduction of carbon emissions is the most important KPI in terms of meeting net zero commitments. Carbon emissions are typically expressed in tonnes of carbon dioxide equivalent (tCO2e). Carbon emissions can be split into Scope 1, Scope 2 and Scope 3 emissions. Scope 1 emissions refer to the direct emissions associated with the energy that a company produces for its own use. Scope 2 emissions cover the indirect emissions from the generation of purchased energy/electricity consumed by the company. Scope 3 emissions refer to indirect emissions included in a company’s value chain that are not covered by Scope 2 emissions.
Let’s take a company that manufactures cement as an example:
Data providers can provide the total level of carbon emissions for your portfolio, which are typically the combination of Scope 1 and Scope 2 emissions.
While disclosure of Scope 3 emissions has increased among companies in recent times, the overall disclosure rate is low and hence is not well incorporated by most data providers. This is a challenge because Scope 3 emissions account for more than 70% of a typical company’s carbon footprint*. It can be challenging and onerous for a company to collect Scope 3 emissions, given it encompasses the broader supply chain, meaning that it would require substantially more data collection work compared to sourcing combined Scope 1 and 2 emissions. Furthermore, reporting on Scope 3 emissions is a “voluntary” requirement from regulatory bodies such as GHG Protocol and TCFD, disincentivising companies to disclose this. While there are data providers that track emissions in the supply chain of companies, we note that this is still in its nascent stages. We expect that as technology around the digitisation of supply chains advances further, and regulatory bodies start implementing stricter requirements, we will start to see increase in Scope 3 emissions data coverage and quality.
Given the lack of Scope 3 emissions reporting across companies, estimation models are being used by data providers to fill this gap. As Scope 3 emissions reporting is not yet reliable and can vary materially depending on the data provider, we believe that it is important to engage with fund managers and underlying companies to both report and reduce Scope 3 carbon emissions, which will have a more pronounced impact on Net Zero outcomes compared to only focussing on Scope 1 and 2 emissions.
Another limitation associated with looking at carbon emissions is that it is not “forward-looking” as it does not tell us much about what management is doing to transition to net-zero, or whether there is increased spending towards renewables in the pipeline. This is where EU Taxonomy aligned CAPEX and revenue data may prove useful as an indication of whether capital expenditure is flowing towards green projects.
Carbon intensity is an adjusted version of carbon emissions to account for company revenue. A commonly used measure for carbon intensity is tCO2e per $million of company revenue. The benefit with using carbon intensity is that you can compare between portfolios and sectors to ascertain the most carbon-intensive portfolios or sectors. Another advantage of using carbon intensity is that it can be applied across asset classes beyond equities and fixed income, such as real assets and private equity. This is because unlike metrics like carbon emissions, it does not require market capitalisation or enterprise value data. While carbon intensity measures mostly use Scope 1 and Scope 2 emissions, this is understandable, given the challenges of obtaining sufficient Scope 3 emissions data.
A limitation associated with carbon intensity data is that it is more useful from an ESG standpoint than from a Net Zero standpoint. Net Zero commitments are centred on the absolute reduction in carbon emissions, while the carbon intensity measure is influenced by the level of company revenue.
Data providers also provide carbon risk ratings, to measure the level of carbon risk for your portfolio. Carbon risk ratings, while more holistic and forward-looking, are more subjective than carbon emissions and intensity data. In addition to considering the level of carbon emissions and carbon intensity of a portfolio, it encompasses considerations such as management initiatives, risk management protocols, commitments towards net-zero/science-based targets as well as others. Similar to the carbon intensity measure, risk ratings can usefully be compared across different portfolios and sectors, so long as a single data provider is used and the subjective judgment of the data provider is trusted.
However, a key limitation to note on carbon risk ratings is that data providers have different rating methodologies and may have different assessments for the same companies. As is always the case when using third party data, it’s imperative that investors understand the methodology when interpreting results.
There are several emerging metrics that may be used to track net zero alignment, which we believe can be used as complements to the other metrics to provide a fuller picture of the portfolio progress towards net zero. One such metric is alignment to EU Taxonomy, which is a first of its kind classification system of environmentally sustainable economic activities introduced by the European Commission this year. Another metric is alignment to UN SDGs (Sustainable Development Goals), a list of 17 Sustainable Development Goals, out of which net zero related goal is Goal 13 “Climate Action”. Increasing alignment in these metrics over time in your portfolio can indicate better management of transition and carbon risk if the limitations set out below are accounted for.
However, investors should be aware that better alignment to UN SDGs does not necessarily translate to a lower carbon footprint, at least over the short to medium term. For example, a diversified energy company investing significantly in green hydrogen would align with these metrics, however it might still be a heavy carbon emitter and could fare poorly with the aforementioned net zero metrics.
Carbon emissions, carbon intensity and carbon risk ratings are very useful when monitored across a portfolio every year to track the progress of the reduction in emissions, reduction in carbon intensity and the mitigation of carbon risk over time. In addition, it can be helpful to understand the companies or sectors that are the greatest contributors towards carbon emissions, carbon intensity and carbon risk in your portfolio. Many investors use this information to support constructive engagement with investment managers and companies.
Using a combination of carbon emissions, carbon intensity, carbon risk ratings and emerging net zero alignment metrics form an integral part of analysing portfolios progression towards Net Zero outcomes. While there are limitations with these measures, we believe that an increase in data quality, combined with greater levels of carbon disclosure by companies will increase the usefulness of these measures over time.
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