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Chain Reaction: The Ever-Increasing Scope of Carbon Risk

Jan. 08, 2016

Jan. 08, 2016

Changes affecting the global climate see increasing numbers of asset owners and managers of pension funds acknowledging their responsibility to take action and decarbonize their investments. This is facilitated by measuring, disclosing and managing the carbon footprint of investment portfolios.

To give a concrete example, the Montréal Carbon Pledge drives investors’ commitment to measure and publicly disclose the carbon footprint of their investment portfolios on an annual basis. Support for the Montréal Carbon Pledge comes from investors across the globe, more than 120 investors with over USD 10 trillion in assets under management participate, as of the United Nations Climate Change Conference (COP21) in December 2015 in Paris.

Although this is a crucial development as it is, the challenge remains, how to measure the carbon footprint of investment portfolios and then, how to meaningfully report it. So far, big steps have been taken including the Greenhouse Gas (or GHG) Protocol, the leading international accounting standard for measuring carbon emissions. Companies and organizations around the world are using these standards to manage and disclose their emissions and thereby enable the transition to a carbon-efficient economy. By doing so, they respond to the increasing institutional investors’ demands for corporate information.

The GHG Protocol lists three specific grades, or “scopes”, of emissions:

- Scope 1: Perhaps the most immediately apparent measure, Scope 1 refers to those emissions that occur from sources that are owned or controlled by companies. This can be for instance fumes generated by the burning of fossil fuels at factories or processing plants.

- Scope 2: These emissions are indirect, as they occur from the consumption of purchased energy and resources. Scope 2 covers electricity, steam, heat, or cooling. Some examples are lighting in warehouses, displays in shops, computers on office desks, and similar electricity consuming processes.

- Scope 3: This scope has the ambitious goal of measuring the carbon footprint of a company’s entire value chain. The sources of these emissions aren’t owned or controlled by the company. The Scope 3 emissions are divided into upstream and downstream emissions, which are based on the financial transactions of a company. Upstream emissions are related to purchased goods and services, downstream emissions to sold outputs. Other Source 3 emissions are considering employee activities such as commuting or business-related traveling.

Currently most data is available for Scope 1 and Scope 2 emissions. Scope 3 is proving to be the most difficult area to generate reliable data, but it is the scope with the most potential for improvement. According to the GHG protocol, Scope 3 is an optional reporting category and therefore often not publicly disclosed. For institutional investors, these emissions are the most crucial as they will be closely associated with their investments. So measuring all these scopes is vital for asset owners if they want to fully understand and identify the carbon risk exposure of their portfolio. In response, CDP (formerly Carbon Disclosure Project)—which also works with corporations and government to provide investors with emission metrics—has created a supply chain program to help better measure Scope 3 emissions and reduce the associated risks. This initiative puts pressure on suppliers and encourages them to improve their sustainability performance. With carbon emissions becoming an increasingly crucial consideration for investors and asset managers across the world, initiatives such as the Montréal Pledge and organizations like the CDP are only going to grow in importance.

No less challenging is the issue of how the carbon emissions of portfolio holdings should be reported. In Sweden, the government is pushing hard threatening legislation—for a standardization of reporting that will allow comparing emissions between different portfolios. Acting in accordance with their fiduciary responsibility, the Swedish National Pension (AP) Funds manage their investments in a sustainable manner and encourage standardized reporting. They agreed to coordinate the way they calculate and report their investment’s carbon footprint in November 2015. In order to do so, they use the following and most common three indicators: 

1. Absolute carbon footprint: This looks at an equity portfolio’s percentage stake in a company and then measures an equivalent proportion of total greenhouse gas emissions. The measured emissions can comprise only Scope 1 emissions, Scope 1 and Scope 2 emissions or all three types.

2. Carbon intensity (market value): In this measure, the absolute carbon footprint is related to the fund’s holding in a company in terms of that company’s market value.

3. Carbon intensity (company revenue): The absolute carbon footprint is gauged in terms of the fund’s equity interest as a proportion of that company’s revenue.

Identifying reporting indicators, such as the three outlined above, provides a solution to increase transparency. The next pivotal step would be standardize overall measurement and reporting of carbon emissions. This would equip institutional investors with the data they need to address climate change related risks and opportunities within their portfolio.

 

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