An increasing number of investors are incorporating climate-related risks and considerations into investment decisions as they gain access to a wider and more accurate set of data representing greenhouse gas emissions of companies.

The Greenhouse Gas (GHG) Protocol, the standard framework used to measure and manage emissions in the corporate world, is made up of three different tiers, or scopes. Understanding their purpose, utility and limitations is critical for climate-aware investors. 

Those seeking to manage climate-related risks should consider using, in addition to scope 1, scopes 2 and 3 emissions data to gain a comprehensive understanding of a company’s carbon risk. Investors who wish to both manage climate risks and make a positive contribution to the energy transition may need to go beyond this protocol. This involves deploying more complex techniques that attempt to measure avoided emissions – or what is sometimes referred to as scope 4.

Scopes defined

The GHG Protocol is the most widely-used international accounting tool. Scope 1 covers a company's direct GHG emissions, those that stem from its operations and the resources it owns or controls. Examples of scope 1 emissions include the carbon dioxide produced by a coal-burning power plant. 

Scope 2 represents a company’s indirect GHG emissions, or those that result from its purchased energy. Scope 2 emissions are essentially the scope 1 emissions of other companies. For example, when a car manufacturer purchases electricity from a power utility, its scope 2 emissions are effectively the utility’s scope 1 emissions. 

Scope 3 is the indirect GHG emissions generated by every activity in a company’s value chain. Scope 3 emissions can be upstream, those generated by a firm’s suppliers, or downstream, those which arise during product usage and disposal (see Fig. 1). For a car manufacturer, for instance, the emissions generated during the production of auto parts it receives from suppliers would be classified as upstream scope 3 emissions. The emissions released by car owners during the lifetime of the vehicle, meanwhile, represent the automaker’s downstream scope 3 emissions.

Fig.1 - Classification of greenhouse gas emissions

Source: Pictet Asset Management

A relatively new concept that is not part of the official GHG protocol, avoided emissions, aim to quantify the carbon-reducing effects of a company’s products or services.

These are sometimes referred to as scope 4 emissions, and typically apply to companies operating in the clean energy and environmental technology industries. A renewable energy company, for example, could be expected to have high avoided emissions because its products will generate far lower emissions relative to the fossil fuel-based power supplier it replaced.

Scopes: rationale and use cases

Investors should understand each category of emissions data and its limitations before using them in security selection and portfolio construction.

Scope 1 emissions are best viewed as the first and essential building block in a hierarchy of emissions types. They are easy to calculate and are widely available. However, a key reason for investors to consider GHG emissions is to gauge companies’ exposure to the risk of rising carbon prices (i.e. carbon risk). Scope 1 emissions do not always provide an accurate assessment of a company’s carbon risk; relying on them exclusively, therefore, can deliver misleading results. 

This is because companies, especially those with strong pricing power, can offload the financial risks associated with their Scope 1 emissions to their customers or other businesses in their supply chain by way of charging higher prices.

Because of these shortcomings, scope 2 emissions are a major component of corporate GHG footprint which, when combined with scope 1, give investors a more comprehensive view of carbon risks.

Scope 2 emissions represent a company’s risk of having to pay the cost of an increasing carbon price out of its own profits. A prime example would be a capital goods manufacturer with high electricity consumption. Such a company may have very low scope 1 but high scope 2 emissions. 

Scope 3 captures emissions that occur across a company’s value chain. They are emissions that are linked to a company’s activities but that it does not directly control.

Having a clear sense of both upstream and downstream scope 3 emissions is useful as they represent the upper bound of a firm's carbon-related risk. In other words, they indicate the carbon risk of a company that possesses no pricing power and is forced to bear the entire cost of rising carbon prices across its value chain. 

In reality, however, the picture is more complex. A company’s exposure to carbon price increases is invariably linked to the bargaining power it has relative to its suppliers and customers.[1]

Firms that enjoy dominant positions across their value chain – those large enough to set their terms of business – are generally less exposed to carbon risk for a given level of scope 3 emission as they’re able to pass these risks on. Firms that are price takers, by contrast, will typically be more exposed to the scope 3 carbon risk. These considerations are often crucial to investment decisions.

Fig. 2 – Volkswagen greenhouse gas emissions, by scope*

Source: Volkswagen Sustainability Report 2021, annual data; *figures given are CO2 equivalent, a metric used to compare different greenhouse gas emissions based on the global warming potential in a common unit.

Consider the environmental credentials of Volkswagen (VW). Clearly, the dominant source of the company’s GHG emissions is car usage. This is defined as downstream scope 3 emissions. For investors considering an investment in VW, this is the relevant dimension when assessing any potential risk to the firm’s profitability. This would help quantify the threat of an unexpected increase in carbon prices.

Another sector for which scope 3 emissions are an essential part of climate risk analysis is food manufacturing. Yet here it is the up-stream component that matters most. 

Take Kraft Heinz. For this global food producer, purchased goods and services – all upstream scope 3 emissions – account for the bulk of the company’s total emissions. This is likely a result of its reliance on carbon-intensive ingredients such as red meat and indicates that any spike in carbon prices could very easily feed through to its input costs. 

Fig. 3 – Kraft Heinz greenhouse gas emissions, by scope

Source: Kraft Heinz ESG Report, 2021, annual data; figures given are CO2 equivalent

While using scopes 1, 2 and 3 emissions as analytical tools can help investors better manage carbon risk, the approach can also open up investment opportunities by helping investors 

identify which issuers are leaders and laggards on the path toward decarbonisation and assess whether their valuations reflect this appropriately. 

Avoided emissions

For those who wish to pursue impact investing, or seeking to make a positive contribution in addition to securing a financial return, scope 1, 2 and 3 emissions are insufficient metrics because they do not capture the positive contribution a company’s products and services may have in facilitating the climate transition. 

For example, a wind turbine manufacturer would have a sizeable scope 2 and 3 emission footprint, reflecting the emissions from the extraction and processing of raw materials as well as those from manufacturing processes. 

Yet its positive contribution - the role it plays in the substitution away from fossil fuel-powered electricity generation (i.e. the avoided emissions) is not captured. Yet, that is exactly the dimension that impact investors would consider crucial.

While the relevance of avoided emissions is clear, estimating them is complex and inevitably relies on a number of assumptions. 

As a concept, the substitution effect represents a departure from a counterfactual baseline scenario. In other words, it is difficult for investors to ascertain what the climate outcome would have been in the absence of the product or service in question.

Yet because it not possible to accurately calculate the net emissions avoided due to the adoption of a product or service, it is necessary to use proxies. One way of doing so involves comparing a new product’s full life-cycle emissions to that of the product it is looking to replace. While methodologies are still evolving, the technical problems are not insurmountable.

Driving climate change mitigation

For investors who wish to use scope 3 or avoided emissions in portfolio construction, data quality is an important consideration. Disclosure of scope 3 emissions is still incomplete for many companies. 

While estimates and proxies should always be treated with caution, they play an important role, giving investors a basis upon which to engage with the companies they invest in.

In any case, having accurate emission readings won't ensure investors achieve their climate goals. To do that, such data needs to be used as part of a broader engagement and capital re-allocation programme. 

We believe investors’ key contribution to halting climate change comes via two channels: 1) through actively engaging with companies to encourage them to transition and 2) through financing climate solutions, which require a concept such as avoided emissions to assess.

Within listed equities markets, improvements in the measurement of corporate carbon footprints have given rise to a growing number of environmentally-themed investment strategies, many of which aim to invest in businesses that provide solutions to environmental challenges through the products and services that companies offer.

Calls for climate investment solutions, in particular by impact investors, are likely to only grow louder, as will demands for standardisation and the adoption of avoided emissions measurement approaches.

[1] In precise economic terms, this reflects the relative elasticities of supply and demand in all relevant intermediate markets.