Employing a perfectly good tool in a way that it was never intended to be used can be frustrating. It's a familiar feeling for investors in climate transition solutions, particularly those who are applying the new ISSB sustainability disclosure standards, IFRS S1 and IFRS S2.
Recently, the International Sustainability Standards Board (ISSB) launched its first-ever sustainability disclosure standards, IFRS S1 and IFRS S2, aiming to "improve trust and confidence in company disclosures about sustainability to inform investment decisions." [1] This move by the ISSB is a step forward in creating standardised corporate climate disclosures targeted at providing financially material, decision-useful information for investors. Although adoption across global jurisdictions remains a work-in-progress, and the ISSB focuses solely on single materiality in contrast to the double materiality approach being taken in European standards, the IFRS S2 standards serve as a useful global baseline for company reporting.
However, climate datasets currently require keen scrutiny by investors. Climate risk is an evolving concept and the regulatory environment for companies and investors is changing rapidly. The data and regulations regarding corporate climate risk disclosures must also evolve and improve on this baseline, in order to avoid unintended consequences and remain useful and relevant.
Hidden traps in climate data
Storebrand Asset Management's research on systematic incorporation of corporate climate data into portfolio construction has highlighted risks from uncritical use of corporate climate data. Our latest research shows that Scope 1-3 emissions data does not necessarily provide a good indication of company or portfolio climate transition risk, or 'Paris alignment'.
Take the example of heat pumps: they are described by the IEA[2] as the solution to household heating issues in the context of climate mitigation, replacing gas boilers. Even though heat pumps offer a sustainable solution to heating problems, and the IEA predicts huge global growth in the market, heat pump companies report high Scope 3 emissions. The same goes for companies making other products that will be required in an electrified economy, such as LED lights and parts for electric vehicles (EVs). The reason is that the electricity powering these products is currently being reported based on the emissions of a fossil-fuel-powered grid. If an investor focuses on carbon emissions data in its portfolio construction, without accounting for the grid dependence of heat pumps and other products for economy electrification, they may decide not to invest in solution companies that are vital to the low carbon transition, based on these companies' high Scope 3 emissions. [3] This shows how integrating Scope 3 emissions, without accounting for the avoided emissions (Scope 4) from using new technologies rather than old combustion dependent technologies, might result in climate solutions companies being underweighted or even screened out.
The new IFRS S2 standard requires companies to disclose absolute gross greenhouse gas emissions, measured in line with the GHG Protocol, including Scope 3 emissions. Storebrand Asset Management welcomes the reporting of Scope 3 emissions and encourages companies to track and manage those emissions as part of their science-based target setting and delivery. This is critical for real world emissions reductions and meeting the goals of the Paris agreement.
New regulations in Europe (SFDR) require investors to disclose and, in the case of EU benchmark regulations, to reduce/decarbonise portfolio emissions at 7 per cent annually, using the same GHG Protocol Scope 3 standard. This can create unintended consequences in portfolio construction – specifically directing assets away from climate friendly solutions, in direct contradiction to the aims of the investor regulations and the Paris agreement goals.
The GHG Protocol Technical Guidance for Calculating Scope 3 Emissions[4] was designed for companies to understand and manage their value chain emissions. However, this company reported data is now being used by investors an indication of the financially material transition risk associated with investing in a company. The current reporting standard, when applied indiscriminately across all sectors and products, is not fit for this purpose of transition risk indication.
The existing accounting framework assumes combustion related emissions from fossil fuels are equal to indirect emissions from, for example, climate solutions technology and associated products…
Distinguishing between data to improve portfolio construction
Our recently published white paper on this topic provides further context and examples of how the problem presents itself in portfolio construction. In short, whereas the GHG Protocol's suggested calculation formula 11.1 (CO2 emissions from use of sold products) is appropriate and necessary when applied to fuel combustion and GHG leakage, it creates an unwarranted risk signal when applied to products involved in the electrification of the economy, which is necessary for the low carbon transition. New guidance from the SBTi [6] on supplier engagement helps companies with upstream decarbonisation but does not address the investor-related issue associated with downstream emissions reporting.
The distinction between categories of Scope 3 emissions is important for understanding climate risk exposure. When it comes to Category 11 (use of sold products), which is a dominant source of Scope 3 emissions in global equity portfolios, a distinction should be made between those emissions which will be reduced over time via the actions of others (e.g., transition of the electricity grid to low carbon), and those which cannot be reduced due to the nature of the product (e.g., oil consumption for transportation). The existing accounting framework assumes combustion related emissions from fossil fuels are equal to indirect emissions from, for example, climate solutions technology and associated products – but the current grid mix should not be a reason to pull back on developing, or allocating capital to, transition-necessary technology.
The climate risk associated with suppliers to the grid does not propagate through the grid to downstream consumers of the grid, as the grid is being decarbonized over time with limited consumer action. For oil, there is no energy-grid intermediary, and the product intrinsically leads to emissions – whereas electrons in the grid are not coupled in the same way to fossil fuel emissions.
A useful short-term workaround
We are far from having standardized, accurate or widely reported Scope 4 emissions data. Further, as illustrated in recent research from King's College London, emissions factors used in company reporting are varied and often inaccurate. However, we believe there may be a short-term solution to help investors better understand climate risk exposures.
The GHG Protocol has indicated that it is updating the Scope 3 standard and will engage with stakeholders in this process. [7] We have written to the GHG Protocol with the following proposal:
Category 11 in the Scope 3 technical guidance, use of product, could be separated into two parts: Category 11a would deal with combustion-related and GHG leakage emissions, while Category 11b would address grid-related indirect emissions that would be diminishing following the shift to electrification. Investors could then choose to treat Category 11b as separate to Category 11a in portfolio construction. For example, investors could discount Category 11b, to achieve a proxy for the climate risk of the sold product in a fully decarbonised future electricity grid, or to compare relative climate risk of alternative solutions and products.
We believe this simple near-term solution will address a capital allocation problem for investors while datasets, reporting standards and regulations continue to evolve. This is currently an underappreciated yet highly valuable stance for achieving transition, and we try to spread our perspective through public and targeted engagement activities. In August, Storebrand Asset Management is meeting with the GHG protocol to emphasize our proposed solution, acknowledging the importance of taking a nuanced perspective on Scope 3 emissions en route to transition.
References
[1] https://www.ifrs.org/news-and-events/news/2023/06/issb-issues-ifrs-s1-ifrs-s2/
[2] IEA, The Future of Heat Pumps, November 2022
[3] The Paris Alignment Paradox: Scoping Out Solutions - www.storebrand.com
[4] https://ghgprotocol.org/sites/default/files/2023-03/Scope3_Calculation_Guidance_0%5B1%5D.pdf
[5] Storebrand: The Paris Alignment Paradox
[6] SBTi: Engaging supply chains on the decarbonization journey
