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Seven misconceptions about scope 3 emissions: companies can no longer ignore them in their carbon calculations
What are scope 3 emissions? And how are they calculated? Nowadays, there’s much talk about the need to reduce global carbon emissions in order to reach the goals of the Paris Agreement. And we know that many companies are aspiring to achieve net zero by 2030. To do this, businesses need to understand and report on their carbon emissions. So how can this be done effectively? Is there a gold standard? And what does it all really mean?
Here, we explore seven misconceptions about scope 3 emissions that we think can lead investors to make financially material miscalculations.
Defining scope 3 emissions
The Greenhouse Gas Protocol is the leading global standard for GHG emissions reporting. It divides emissions into three ‘scopes’ that define the different stages of a product or service’s lifecycle during which emissions are generated.
Scope 1 emissions comprise all those directly under the control of a company.
Scope 2 emissions come from the generation of power, heat, steam and cooling a company buys.
Scope 3 emissions include emissions linked to a company’s wider value chain. These emissions can be roughly divided into those linked to the company’s upstream supply chain and those linked to the downstream lifecycle of its products and services.
Because of the relative complexity of scope 3 emissions, they remain the subject of much confusion. But with scope 3 emissions accounting for the lion’s share of most companies’ carbon footprints, they are crucial to understanding climate-related investment risks and opportunities.
Read also: How can a company reduce its carbon footprint?
Misconception n°1: scope 3 emissions are less important to analyse than scope 1 and 2
Looking only at a company’s scope 1 and 2 footprint often gives only a partial, if not entirely misleading, insight into its climate positioning. In the automotive industry, for instance, not accounting for scope 3 emissions would make it impossible to distinguish an electric vehicle manufacturer from a traditional car manufacturer or to understand the full scale of transition risks.
While some specific sectors are still dominated by scope 1 and 2 emissions, they represent a relatively small portion of the economy. As such, for the majority of an investor’s portfolio, scope 3 emissions will usually be the most significant source of emissions and are, therefore, crucial to assessing its climate value impact.
Misconception n°2: companies can’t do as much to control their scope 3 emissions
In general, we believe that most companies can exert significant control over their scope 3 emissions. First, companies can directly engage with their supply chain to encourage the adoption of more efficient technologies and processes. And second, companies can directly reduce their scope 3 emissions by re-aligning their business models to less carbon-intensive alternatives and substitutes – rethinking what products are fit for the future.
Of course, there may be some limited cases where a company is unable to significantly influence its upstream emissions. However, understanding a company’s full exposure to carbon emissions is vital to the assessment of its future economic and financial performance. Even in the rare case where a company has limited influence over its scope 3 emissions, its exposure can still create significant transitional risks. Only a company with a credible transitional strategy in place will be well-positioned for the shift to a net-zero economy.
Misconception n°3: data coverage is too poor to support a meaningful assessment of scope 3 emissions
While it’s true that systematic and robust emissions disclosure remains elusive, too much emphasis is perhaps put on self-reported emissions, at least where scope 3 emissions are concerned. Scope 3 supply chain emissions are often estimated by companies using industry models that show, for instance, the amount of steel or copper that might have gone into the vehicle that they sourced, or the amount of business travel a supplier in a given industry might have undertaken. These same calculations can often be done by third parties, and often more consistently so – ensuring consistency in the assumptions used.
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The same is true for downstream scope 3 emissions, linked to product use. For a car manufacturer, such an analysis might include the number of vehicles sold and their average lifespan, distance driven and emissions per kilometre. Once again, a third party with a good understanding of different manufacturers’ tailpipe emissions can often replicate this analysis in a manner that leads to more comparable results than relying on individual companies’ varied approaches to assessing such emissions.
Although these approaches admittedly only yield approximations, we believe it’s better to be approximately right than entirely wrong – which would result from failing to integrate scope 3 emissions at all.
Misconception n°4: including scope 3 emissions induces a lot of double-counting within portfolios
Double counting can occur if, within a single portfolio, multiple companies fall within the same supply chain. When an oil and gas company sells petrol to a trucking company, both companies will be reporting emissions linked to the burning of that petrol.
Double-, triple- and even quintuple-counting are common across the entire economy under the present GHG Protocol. However, the scale of this issue is much smaller in most portfolios, as it would be rare for a portfolio to include a company’s entire supply chain. When the trucking company mentioned above sources fuel from not one but multiple suppliers, then unless each of those suppliers is also included in the portfolio, double-counting would be much reduced. Theoretically, a portfolio invested in a representative 10% portion of the economy would only source 10% of its inputs from and sell 10% of its outputs to companies within that same portfolio, which would limit the extent of internal double-counting. For smaller, more concentrated portfolios, double-counting is even rarer.
Misconception n°5: double-counting scope 3 is undesirable and should be adjusted for
While double-counting is generally of a more limited scale within portfolios, it certainly occurs across the economy as a whole. But we do not believe that double-counting is necessarily undesirable from an investor’s perspective.
Carbon exposure reverberates through the supply chain and affects each company equally, even when the responsibility for these emissions may be shared. In the example above, if a tax is imposed on petrol, that would affect both the trucking company and the oil and gas company.
Only when we recognise the full scale of a company’s exposure to carbon can we assess its transitional risks. Discounting the emissions for each company because the responsibility is shared would lead to an underestimation of the true financial significance of the climate transition.
Misconception n°6: we should delay our analysis of scope 3 emissions until the data is better
We believe delaying the analysis of scope 3 emissions would be a mistake. Often, the reluctance to integrate scope 3 emissions is based on a misunderstanding of how scope 3 emissions are calculated and a failure to recognise that it’s still possible to meaningfully estimate such emissions.
Many companies will soon have no choice about reporting their scope 3 emissions. From 2025, it will become a requirement for firms in Europe, including those based outside the continent but with European operations. The US has also talked about making publicly listed companies report scope 3 emissions, but no regulatory changes have yet been made.
Read also: Being a sustainable company means being a responsible company
Delaying the integration of scope 3 emissions blinds investors to a significant portion of their portfolio’s exposure to carbon risks. Simply assessing which companies have high scope 1 and 2 emissions may lead to a skewed understanding, and fail to identify companies with hidden, scope 3 exposures. With scope 3 emissions entering into reporting requirements in some jurisdictions, this could result in significant portfolio turnover as many companies that previously appeared attractive lose their appeal. They may need to be underweighted or divested – although by that time, it may have simply become a case of damage limitation.
Misconception n°7: high scope 3 emissions disqualify companies from a climate-aligned portfolio
We do not believe that simply divesting out of companies that are high emitting today is the right approach. Key industries, such as the automotive industry, the chemical industry, and many manufacturing industries may be high emitting today, but will remain economically essential even in a low-carbon or net-zero future. In short, it makes more environmental and financial sense to invest in a company in a high-emitting sector that is rapidly decarbonizing, than to invest in a low-carbon company that’s moving in the wrong direction and exacerbating the problem, even if from a lower base.
The challenge is not to identify which companies or industries are low carbon today, but which companies within each industry – including higher-emitting, climate relevant sectors – are taking adequate action to decarbonise.
The challenge, therefore, is not to identify which companies or industries are low carbon today, but which companies within each industry – including higher-emitting, climate relevant sectors – are taking adequate action to decarbonise. Identifying such companies requires a more forward-looking perspective, taking account of the rate of decarbonisation individual companies are achieving, and the credibility and ambition of the targets and commitments they have set. This analysis requires specialized capabilities and expertise, which we believe will be essential to support investors’ preparedness for the transition ahead.
Many of these industries are central to a functioning economy and will remain so in a lower-carbon future. As such, the challenge is not to avoid investing in these industries, but to ensure that such investments contribute to their rapid decarbonisation. In addition, such an approach creates investment upsides as alignment to the low-carbon economy unlocks new commercial opportunities and gains in market share.
Important information
This document is issued by Bank Lombard Odier & Co Ltd or an entity of the Group (hereinafter “Lombard Odier”). It is not intended for distribution, publication, or use in any jurisdiction where such distribution, publication, or use would be unlawful, nor is it aimed at any person or entity to whom it would be unlawful to address such a document. This document was not prepared by the Financial Research Department of Lombard Odier.
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