Decarbonization: How to handle Scope 3 emissions

The vast majority of actively managed Swisscanto funds with traditional asset classes focus on a continuous reduction in the intensity of greenhouse gas emissions (CO₂e emissions) of at least 4% per year, plus economic growth. We use the GHG Protocol (Greenhouse Gas Protocol), which is the international standard for accounting for greenhouse gas emissions.

The decisive factor for the inclusion of CO₂e data in asset management is a data basis that is both clearly quantifiable and meaningful. However, if Scope 3 or even Scope 4 emissions are to be included in addition to Scope 1 and 2, this still proves to be challenging at present. Scope 1 and Scope 2 data is currently used for our Swissscanto funds with a reduction pathway.

In an ideal world, this categorisation would help to comprehensively determine the intensity of greenhouse gas emissions of companies and, as a result, of investment portfolios. In practice, it is challenging. Scope 1 and 2 are well understood; scopes 3 and 4 less so.

• Scope 3 emissions are those that occur along the company's value chain. These include emissions from the procurement of raw materials, the use and disposal of products, business travel and commuting by employees and third-party transportation services. Scope 3 emissions are often the most extensive and complex to measure, as they encompass many activities and actors, and thus many assumptions.
• Although Scope 4 is not officially defined in the GHG Protocol, this term is used to describe the impact of emission-reducing measures through the use of products and services. This could include, for example, the reduction of emissions through the use of energy efficiency technologies.

Scope 3 and 4 categories are not yet fully developed

In practice, Scope 4 data is only available to a very limited extent, while the quality of Scope 3 data is only improving slowly. Regulatory requirements are also limited. The following challenges arise:

• The proxy risk we assume by using estimated data is high.

• Multiple-counting may disconnect footprints from reality and shifts the emphasis from reducing Scope 1 & 2 to Scope 3. If several companies within the same supply chain report their Scope 3 emissions, the same emission can be recorded multiple times. For example, a logistics manufacturer reports emissions from the transportation of smartphones as Scope 1 and Scope 2 emissions. The smartphone manufacturer reports the same quantity of emissions as a Scope 3 emission. Due to this and other multiple counting, Scope 3 data is around nine times greater than the sum of all Scope 1 and Scope 2 data (as per Institutional Shareholder Services, Inc. (ISS ESG), emissions data for the financial year 2022).

• For Scope 3 in particular, it is difficult to obtain accurate and complete data, as a lot of information depends on external suppliers and service providers. 
• Climate solution providers tend to have large Scope 3 and 4 footprints. Adding Scope 3 without Scope 4 would discourage or prevent sustainable funds from owning them, even though they are important drivers and beneficiaries of the climate transition. For example, the Scope 3 emissions of Signify, a leader in LED lighting, include all the electricity used during the lifetime of the product. Signify has a lower Scope 3 intensity than a provider of conventional lighting, but its intensity of 536 tons CO₂e per million USD is very high relative to other sectors. For reference, Halliburton has an intensity of around 650 tons CO₂e per million USD (similar to most oil & gas equipment & services companies)

A possible solution

In order to obtain as meaningful a basis as possible when taking Scope 3 data into account (in addition to Scope 1 and Scope 2 data), we are developing "influence-based adjustment factors" that adress the problems outlined above. The influence-based adjustment factor shall reflect the control or responsibility that a company has over its Scope 3 emissions, and to a significant extent, the climate-transition risks facing its business.

For example, an oil & gas producer has an extremely high degree of control of its Scope 3 emissions, and a tire company has a very low degree of control. If the economy shifts to renewables and electric vehicles faster than expected, the oil & gas producer may see its growth slow, the value of its assets decline or become "stranded" and, its share price follow. On the other hand, the tire company is prepared to produce tires for automobiles with both internal combustion engines and electric vehicles (although it does face the risk of substitution from public transportation).

To incorporate these degrees of influence into our use of Scope 3 data, we assigned adjustment factors to companies based on their sector or revenues. We then add the adjusted Scope 3 emissions to Scopes 1 & 2. The result is a total intensity that we believe better reflects climate risks and opportunities.

For illustration, we show how this works for companies in the automotive value chain:

Source: Swisscanto

Applying this approach to our equity universe, we show that the average intensity of sectors better aligns with our fundamental view of their relative climate risk (see table above). For example, the Energy sector now has an average Scope 1-3 intensity that is 40% higher than the Utility sector and twice that of the Materials sector. In the table below we show each sectors' contribution to total emissions for the universe (including Scopes 1, 2 and 3).

Average CO₂e Intensity (tons per million USD revenues)
 

Thresholds for the sustainable investment universe

We will use the first generation of our data on the influence-based adjustment factors for Scope 3 as part of the "Do No Significant Harm" assessment. We will do this by setting a maximum threshold for the total emissions footprint. Companies that exceed this threshold are considered to be causing significant harm. They are not eligible for inclusion in our sustainable investment universe in the Sustainable Funds. Furthermore, for our Responsible Funds under Luxembourg law, the turnover of the sustainable economic activities of such companies is not included in the proportion of sustainable investments.

Looking to the future, we hope to be able to include Scope 4 data. This would also reward companies that offer solutions for decarbonisation as an investment perspective.