Integrating estimated Scope 3 (S3) data into portfolio construction could inadvertently lead to portfolios being tilted towards low revenue companies, according to a recent whitepaper by Osmosis Investment Management.
The research highlights some of the more commonly known problems investors encounter when looking at S3 emissions – such as poor coverage and comparability – which can question whether S3 data sets are truly fit for portfolio construction purposes.
The paper – The Obstructive Role of Scope 3 Emissions Data in Portfolio Construction – showed that integrating S3 data (responsible for approximately 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.
S3 emissions are those associated with the upstream and downstream activities of a company’s own operations, and are not covered by Scope 1 and 2 emissions (S1+2). Due to S3 encompassing the entire value chain, S3 can outweigh S1+2 by several orders of magnitude and will more accurately describe a company’s total impact on the climate than combined S1+2.
Unsurprisingly then, Osmosis claimed, S3 is of increasing interest to companies, investors, and regulators: the EU, for example, plans to introduce obligatory S3 integration in its Paris-Aligned Benchmark policies over the next few years.
Currently, there are two significant issues with Scope 3 data, the firm stated. Firstly, the poor rates of S3 disclosure, and secondly, the inferior quality of the data that is reported.
To overcome these issues and fulfil market demands, major data providers, such as MSCI and Bloomberg, produce datasets based on inhouse estimation models, often using a revenue-based model. This type of model uses life-cycle analysis tools to create industry-averaged intensity factors which are then multiplied by a company’s revenue (as an estimator of corporate activity), to model emissions across the categories of S3.
The whitepaper 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.
“Using revenue-based estimated Scope 3 data in portfolio construction is therefore misguided. Any claimed environmental benefits are unfounded, and, from a financial perspective, we would argue it is irresponsible,” according to the report.
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.
Osmosis believes 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.
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