This whitepaper written by the Research Team at Osmosis Investment Management warns that integrating estimated Scope 3 data emissions into portfolio construction inadvertently leads to portfolios that are tilted towards low-revenue companies.
|Scope 3 emissions (S3) result from activities upstream and downstream of a company’s own operations, which are covered by Scope 1 and 2 emissions (S1+2). S3 encompasses the entire value chain and is of increasing interest to firms and regulators as, when done well, it will more accurately describe a company’s impact on the climate than S1+2 alone. The EU, for example, plans to introduce S3 integration as a necessary condition in its Paris-Aligned Benchmark policies over the next few years.
The team’s research highlights some of the more commonly known problems investors encounter when looking at scope 3 emissions, not least the poor coverage and comparability, but it goes much further, bringing into question whether scope 3 data sets are truly fit for portfolio purpose. Indeed, Osmosis conclude that integrating scope 3 data (responsible for approx. 90% of a company’s overall emissions) not only leads to portfolios with unattractive investment characteristics (such as low revenue) but directly undermines any claimed environmental benefits.
Unfortunately, data disclosure levels pose a significant issue in Scope 3 emissions integration. To overcome the issue of disclosure availability, and to fulfil market demands, major data providers produce datasets based on in-house estimation models. At least 2/3rds of the S3 emissions in the MSCI World data set are estimated using a revenue-based model. This type of model derives a S3 figure by taking the company’s revenue and multiplying this with a conversion factor, created using life-cycle analysis tools and academic research.
Given that S3 encompasses the majority of a company’s total emissions and it is predominately estimated using a revenue-based method, the Osmosis team hypothesised that any portfolio seeking to minimise carbon emissions (S1+2+3) is simply minimising revenue. The paper confirms the association between S3 and revenue, and demonstrates that portfolios minimising S1+2+3 (on a sector basis) look very similar to portfolios that minimise revenue. In order to replicate their analysis on a live-fund basis, Osmosis analysed BlackRock’s iShares MSCI World Paris-Aligned Climate Fund. The data showed that, using an estimation based methodology, and after adjusting for size, portfolios minimising S1+2+3 were indeed simultaneously minimising revenue.
The whitepaper includes a discussion on the link between economic value creation and supposed environmental impact and argues that, when resource use is estimated using revenue, the two are very much interwoven. The only way to minimise the environmental impact of this sort of portfolio is by minimising the economic value. This is an issue for both the environment and for investors. Not only does estimated data bear little relation to the environmental impact of a company, it pushes investors towards overweighting companies that have a higher share price than would be expected for the revenue that they produce. Using these estimation models results in fewer environmental benefits and investments with undesirable financial characteristics. Given the complexity of calculating, reporting, and integrating S3 emissions into portfolios, Osmosis advocate for a more granular approach and argue that targeted, in-depth research is required to make full use of its potential. The team argue that for the purposes of portfolio construction, asset managers should not consider evaluating company performance on S3 data if it is considered immaterial or outside of management control. They give the example of emissions stemming from ‘Employee Commuting’, which they argue has little or nothing to do with a company’s valuation, even if high-quality data were available. On the other hand, ‘Business Travel’ emission data is well reported, and very comparable between one company and the next. Moreover, how, and how much employees travel for business is something company management has direct control over. In its framework, Osmosis bring ‘Business Travel’ S3 emissions directly back onto the environmental balance sheet. The firm also incorporates ‘Waste Generated in Operations’ onto the environmental balance sheet in a way that it believes provides a more useful insight into company operations. The asset manager’s three-factor approach includes primary waste generation data, which it attests gives a purer indication of environmental impact than conversion to a carbon equivalent.
This document was prepared and issued by Osmosis Investment Research Solutions Limited (“OIRS”). OIRS is an affiliate of Osmosis Investment Management US LLC (regulated in the US by the SEC) and Osmosis Investment Management UK Limited (regulated in the UK by the FCA). OIRS and these affiliated companies are wholly owned by Osmosis (Holdings) Limited (“Osmosis”), a UK based financial services group. Osmosis has been operating its Model of Resource Efficiency since 2011