Inconsistent and incomplete Scope 3 data and reporting is making it difficult for asset managers to calculate their exposure to emissions and carbon transition risk and create new low-carbon products and strategies, according to Boston-based investor GMO.
GMO has spent two years creating an in-house methodology called the GMO Indirect Emissions model to consider all indirect emissions exposure across companies' full value chains that it is currently using internally.
"The data and the way that Scope 3 is currently reported isn't really fit for use by investors," said Deborah Ng, head of ESG and sustainability at GMO.
Scope 1 covers direct emissions from companies' own operations and Scope 2 covers indirect emissions from purchased energy. Scope 3 covers all indirect emissions from companies' full value chains, including upstream and downstream emissions and their supply chains.
Companies commonly report Scope 1 and 2 emissions, but the data to accurately estimate Scope 3 emissions are not easily accessible or reliable, despite an increasing focus from regulators such as the SEC in the US, which is expected to unveil new rules in April.
The Greenhouse Gas Protocol gives guidance on multiple estimation methodologies for 15 categories of Scope 3 emissions that cover companies' upstream and downstream operations, but it was designed to help companies track their own emissions over time rather than allow comparison between companies.
GMO said this gives companies a lot of flexibility on what they are reporting, which makes it difficult to compare and benchmark companies and sectors.
"Most companies are supposed to report on the most material Scope 3 categories, but a lot of times, what I see is business travel," Ng said.
The Indirect Emissions model allows GMO to calculate "indirect emissions" by allocating them across the supply chain, which it said gives a more consistent way to measure emissions.
Its methodology uses a "top down" approach using OECD global emissions data, which GMO allocates across countries and sectors that it then supplements with "bottom up" information from companies' supply chain emissions, allowing it to estimate individual company value chains.
"We get a very consistent way to compare companies. We think our approach to using supply chain data provides more accurate information," Ng said.
Ng said consumer discretionary retail and information technology companies typically have a higher carbon footprint using the analysis when end-to-end value chain emissions are considered.
"What we're trying to do when we look at Scope 3 emissions is understand what the company's exposure is to potential carbon transition risks. This could come from a carbon tax that gets introduced that would increase supply chain costs, or it might have downstream impact where customers shift away from their products because they have high emissions," she said.
GMO can also apply its indirect emissions estimates to look at the carbon efficiency of sectors in terms of embodied emissions per dollar of revenue. Using this analysis it finds the energy, utilities and material sectors are the least efficient, while real estate, financials and communication services are the most carbon efficient.
The firm is using the Indirect Emissions model to create new products and strategies, which include building better low carbon indices. The firm's GMO Horizons strategy is targeting 50% lower Scope 1, 2 and 3 emissions than the benchmark by targeting companies that sell green products and services and offer better ESG risk mitigation.
Varied strategies
GMO runs a variety of other ESG-related funds, including climate change and resources strategies, and has assigned the same manager – Boston-based Lucas White – to both.
The former holds stocks of companies the firm expects to benefit from mitigation and adaptation efforts (including macro initiatives such as the US Inflation Reduction Act and the European Union’s Green Deal), while the latter invests across the natural resources sector.
Despite clean energy stocks’ wretched recent performance, with the benchmark Wilderhill Clean Energy Index down 45% in the past 12 months and 16% since January, GMO is positive on the sector. It sees notable opportunities in beaten-down areas such as solar and biofuels that have suffered from “overly punitive” market sentiment despite companies’ growth and profitability, according to White.
The strategy has also benefited from strong performance from water-exposed stocks like Ebara, its Q4 review shows.
Meanwhile, the resources strategy holds both fossil fuel and clean energy stocks and gained from its off-benchmark renewables weighting in Q4’s rebound, as well as its notable 30%-plus allocation to industrial metals.
GMO had US$58bn of assets under management at the end of September.
Additional reporting by Julian Lewis