Investors might be measuring climate risk at some companies all wrong
New study shows indirect emissions from customers can be just as big a risk to companies who otherwise look clean
(Mark Hulbert, an author and longtime investment columnist, is the founder of the Hulbert Financial Digest; his Hulbert Ratings audits investment newsletter returns.)
CHAPEL HILL, N.C. (Callaway Climate Insights) — Ready for today’s climate finance riddle? How can a company with a zero net carbon footprint nevertheless have huge climate-related investment risk?
The answer: If the company’s largest customers are oil companies.
This riddle captures a fundamental challenge that investors face when trying to reduce their exposure to climate-related risks.
Traditional approaches to measuring climate risks have found it difficult to incorporate the indirect exposure a company faces when its suppliers or customers are themselves major producers of GHG emissions.
In fact, many of those traditional approaches end up simply ignoring those indirect risks. But indirect exposure is still exposure, even if it is difficult to measure.
GMO, the Boston-based investment firm and one of the earliest proponents of investors taking climate risks into account, has addressed this challenge by devising what it calls its “Indirect Emissions Model.” The firm describes the model as follows:
“[It] can efficiently estimate all direct and indirect effects of company production on both upstream and downstream companies across the value chain. For a given company, we can estimate all upstream production [of GHG emissions] from direct suppliers and indirect suppliers-of-suppliers used as inputs in the company’s operations. We can also estimate all downstream production of direct customers and indirect customers-of-customers that use the company’s outputs in their processes”—including households.
Scopes 1, 2 and 3
To fully appreciate GMO’s model, a short detour is helpful to review how GHG emissions currently are reported. Almost all companies rely on the Greenhouse Gas Protocol (GHGP) to calculate their emissions in three categories.
Scope 1 reflects a company’s direct emissions from sources it owns or controls, such as electricity usage or air conditioners
Scope 2 reflects the emissions from the utilities from which the company purchases electricity
Scope 3 reflects indirect emissions, both upstream and downstream, that occur in the company’s value chain. This is the one that has been so controversial.
On first pass it might seem as though the GMO Indirect Emissions Model is measuring the same thing as Scope 3. But that category does not include all indirect GHG emissions.
For example, for the hypothetical company mentioned in my riddle above, Scope 3 would not include the emissions of the oil companies that are the company’s customers — even though this company’s business model is vulnerable to policy changes that prevent those oil companies from continuing to drill for, extract and refine the oil.
Furthermore, even when a particular type of indirect emissions is included in Scope 3, it is inconsistently measured. The GHGP gives companies significant flexibility in deciding how to estimate their emissions in each of fifteen Scope 3 categories.
As a result, as the GHGP concedes, their protocol is “not designed to support comparisons between companies based on their scope 3 emissions.”
How can you be sure of a company’s carbon risk?
This GHGP concession is significant. It means that investors who choose companies based on those having the lowest GHG emissions in Scopes 1, 2 and 3 have no assurance that they are really investing in companies with the lowest carbon-related risks.
Readers interested in a more in-depth discussion of the limitations of what Scope 3 emissions include and exclude should read an article that appeared a couple of years ago in the Financial Analysts Journal.
The study is titled “Supply Chain Climate Exposure” and was written by four directors at AQR Capital Management. Like GMO, AQR developed a proprietary model for estimating a company’s indirect GHG emissions exposure, both upstream and downstream.
Differences are more than theoretical
These contrasts between Scope 3 and the GMO model have more than just theoretical significance. They can lead to significant differences in which companies an investor would favor when wanting to avoid climate-related risks.
An illustration, provided by Deborah Ng, Head of ESG and Sustainability at GMO, is Arch Capital ACGL 0.00%↑, an insurance and reinsurance company. When ranked by total Scopes 1, 2 and 3 emissions, Ng said in an email, Arch Capital is the 29th lowest among S&P 500 companies. Its rank falls to 150th when including both direct and indirect emissions as calculated by the GMO Indirect Emissions Model.
The bottom line? If you’re truly interested in having your investment dollars support the shift towards a lower carbon future, you must focus on companies’ total emissions, both direct and indirect.
Read more from Mark Hulbert:
The electricity and water consumed by asking ChatGPT just one question
‘The canary is dying’ - climate change comes for property insurance
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