Asset owners grapple with the limits of Scope 3

Part 1 of RI's Scope 3 Series: Investors highlight ‘mind-boggling assumptions’, the risk of triple counting and the limits of Scope 3 as a tool.

This article is the first in a five-part series on Scope 3 by Responsible Investor. Look out for upcoming deep dives on how companies, data providers, regulators and assurance providers are tackling the push to address indirect emissions across value chains.

The difficulties with Scope 3 are well known. But beyond the mind-boggling assumptions involved with some estimations, are there limits to where the metric can be applied?

While the use case for companies seems fixed in the minds of investors, there is less consensus on its application at the portfolio level, particularly when it comes to targets.

A point of difference exists between the two main asset owner net-zero initiatives when it comes to the issue of Scope 3 portfolio targets.

Paris Aligned Asset Owners (PAAO) members are expected to set interim ones “for 2030 or sooner”. Net Zero Asset Owner Alliance signatories are expected to just track them for now “until interpretation of these emissions in a portfolio context becomes clearer and data becomes more reliable”.

Three of New York City’s public pension funds – New York City Board of Education Retirement System, New York City Employees’ Retirement System and Teachers’ Retirement System of the City of New York – are PAAO signatories.

John Adler, New York City

John Adler, chief ESG officer at the Office of the New York City Comptroller, which oversees the city’s five public funds, tells RI that it hopes to have Scope 3 portfolio goals covering listed equities and corporate fixed income in place by 2025.

By then, the funds will be in the third cycle of Scope 3 reporting. But Adler admits that data quality is still an issue.

“We don’t have the same confidence in the Scope 3 data we’re getting that we have with Scopes 1 and 2,” he says.

Adler tells RI that he recently sat down with a large ESG data provider who modelled their process for estimating corporate Scope 3 emissions. He describes the number of assumptions underpinning it as “mind-boggling”. 

“We don’t have the same confidence in the Scope 3 data we’re getting that we have with Scopes 1 and 2.”

John Adler, Office of the New York City Comptroller

“We’re anticipating that by 2025, the data will be good enough and that we will feel confident enough that we can set a 2030 interim emissions reduction target, maybe 2035, too,” he says.

“I don’t know that for a fact, but that’s our expectation.”

But not everyone sees merit in focusing on Scope 3 emissions when it comes to portfolios.

“If you have a global portfolio, operating across all sectors in the economy, setting Scope 3 targets will result in a lot of double and triple-accounting, and that will make it difficult to assign responsibility for those emissions in the portfolio and confuses engagement,” PensionDanmark’s head of ESG and sustainability, Jan Kæraa Rasmussen, tells RI.

He cites the example of a portfolio that holds the producer of fuel, a haulage firm that uses the fuel, and the manufacturer of the trucks that runs on the fuel as a situation where triple-counting might occur.

That’s why when you have a multi-sector portfolio, it’s not meaningful to set reduction targets because you can risk setting ones that are not impacting real-world emissions.”

Jan Kæraa Rasmussen, PensionDanmark

A fund with a Scope 3 portfolio emissions reduction target could take steps to meet it by excluding the fossil fuel producer. But, as Kæraa Rasmussen notes, this would not reduce the portfolio’s exposure to the real-world emissions.

“If you want to exclude real-world emissions, you should exclude the transport company and truck manufacturer too,” he says. “That’s why when you have a multi-sector portfolio, it’s not meaningful to set reduction targets because you can risk setting ones that are not impacting real-world emissions.”

New York City’s Adler believes there needs to be a “clearer disclosure regime to make Scope 3 more useful and tangible”.

He notes that US retailer Target includes the Scope 3 emissions of the televisions it sells but online retailer Amazon does not. “Why should a brick-and-mortar seller incorporate it into their Scope 3 and the online does not? I don’t understand that.”

Adler says some asset owners are “engaging in portfolio decarbonisation strategies that I really think have no value”.

The three New York City funds that committed to divest fossil fuels completed the process in 2022

But Adler says there has been a misunderstanding about that decision, which he describes as “unique” and based on financial risk, not portfolio decarbonisation.

“The focus is addressing systemic risk. You do nothing for systemic risk by tilting your portfolio away from high emitters.”

Keeping tabs

Kæraa Rasmussen says PensionDanmark would be “very hesitant to set targets for Scope 3 emissions on multi-sector portfolios”. However, he adds that it will probably track them, in part because of growing regulatory requirements.

Tim Smith, Norges Bank Investment Management

Echoing this position is Norges Bank Investment Management’s (NBIM) lead investment stewardship manager, Tim Smith. The manager of Norway’s trillion-dollar sovereign wealth fund has committed to disclose its Scope 3 financed emissions but does not have “a separate quantitative portfolio level emissions target, including for Scope 3”, he says.

In July, NBIM became a signatory to global carbon accounting initiative PCAF to support this work. 

“When the fund started looking at setting a definite climate strategy, we considered what is fundamentally compatible with our fund’s strategy and our status as a universal owner,” Smith says.

“Ultimately, we concluded that investing in accordance with a low-carbon index or a portfolio carbon target was not the optimal strategy for managing long-term climate risk in our portfolio.”

NBIM’s theory of change for managing climate risk in its portfolio is “primarily to undertake company-facing activities and help strengthen climate disclosure frameworks”, Smith says.

Limitations of Scope 3

When it comes to applying Scope 3 to a portfolio setting, the original purpose of the Scope 3 GHG protocols should be considered, Smith tells RI. It was intended for companies to estimate their own upstream and downstream emissions as part of their own accounting, “not for portfolio aggregation”.

“I think we need to be careful in how we apply this framework to a context it was not originally designed for,” he says.

A recent paper from Dutch investment manager Robeco highlights that the GHG Protocol Standard acknowledges the difficulty in aggregating and comparing Scope 3 emissions.

“Use of this standard is intended to enable comparisons of a company’s GHG emissions over time. It is not designed to support comparisons between companies based on their Scope 3 emissions,” the protocol states.

The limitations around Scope 3 have not been appreciated as widely as they should have been, Kæraa Rasmussen says, in part because the data issue has dominated much of the conversation. But, he adds, “we need to face the strain and talk about what we can use Scope 3 to answer”.

“For me, we can certainly use them, and it is very important for assessing individual companies and high-emitting sectors. But we should not use it on a portfolio level to set targets because we risk making targets that are not optimal.”

Engaging corporates

One of NBIM’s core climate expectations is that companies disclose their Scope 1, 2 and 3 emissions and ask for reasonable assurance of Scopes 1 and 2 and limited assurance for Scope 3, Smith tells RI.

While Scope 3 disclosure is ultimately a universal expectation, it is one that is applied with discretion, he says. He cites the example of a company operating in a context in which there has been a mandatory reporting requirement for a decade compared with one where such disclosure has just been set.

“The end point for all companies has to be the same, but we try and be sympathetic to relevant factors” such as regional considerations, size of the company and sector, Smith adds.

When it comes to setting Scope 3 targets, Kæraa Rasmussen thinks there are some sectors where this is particularly important, at both company and sectoral level.

The Danish fund is in the process of monitoring and setting Scope 3 targets for four sectors: oil and gas, utilities, shipping and cement.

Adler says New York City expects science-based targets to be set by companies where Scope 3 comprises 40 percent or more of their emissions.

He adds that, by 2030, the three funds want 90 percent of financed emissions covered by science-based targets for Scope 1, 2 and 3.

Their current goal is for 70 percent of emissions to be covered by such targets for Scope 1 and 2 by 2025.

Jan Kæraa Rasmussen, PensionDanmark

While Scope 3 data is a real challenge for companies, Kæraa Rasmussen believes there has been a “change of tune” in the last couple of years. “Before, we heard from companies that it is almost impossible [to provide Scope 3 data]… I think there’s a growing view that it is a challenge but one that can be handled and validated to an extent.”

He adds that the improvement in data and validation over the last five years has enabled investors to estimate Scope 3 without the input of companies.

“The approach from many investors has been that if we don’t get the answer from you, we will try to estimate them,” he says. “As a company, you will probably prefer that you are the one providing the data rather than somebody outside trying to estimate it.”

Regulation is also likely to play a role.

Despite the uncertainty around what will come out from the US Securities and Exchange Commission (SEC) on Scope 3 as part of its climate disclosure rule, Smith says it is fair to say that “globally there will be more rather than less” in terms of regulatory requirements for Scope 3 disclosures over time.

New York City’s Adler points to the importance of the recent disclosure bill passed in California as evidence of the growing regulatory landscape on Scope 3. “I do think it will help our engagement [on Scope 3],” he says.

At the same time, he pushes back on the suggestion that the SEC’s rule no longer matters.

“The SEC regulations are still very important, not just because there are companies that won’t fit into the California rules, but also because it needs to set a tone that companies have to take climate disclosure seriously, that it’s part and parcel of their financial disclosure.”

Part of the challenge with Scope 3 is the lack of mandatory requirements to disclose it, he adds. “That’s why the numbers we get are so assumption-based. If we get a regulatory regime that requires Scope 3 disclosure that will force companies to take it more seriously.”

Procurement and escalation

One of the most interesting discussions when it comes to Scope 3, according to NBIM’s Smith, is around upstream procurement, an area where he says companies can do more. 

He gives the recent example of Italian cabling company Prysmian, which signed a five-year agreement with Rio Tinto to buy low-carbon aluminium to support its 2050 net-zero goal. 

In its recently revised climate expectations, NBIM flagged advance market commitments, which create confidence on the demand side. It is an area Smith says the team will spend more time on.

Meanwhile, NBIM last year filed its first ever shareholder proposals, calling on four US firms to set emissions reduction targets, including material Scope 3 ones. Two were withdrawn and the others attracted 12 and 32 percent respectively at Westlake Chemical Corp and NewMarket Corp.

Smith says that NBIM’s core expectations, like those on Scope 1, 2 and 3 disclosures, are what it also considers when it looks at board votes. “That’s a pretty important consideration when it comes to some escalations,” he adds.

New York City’s Alder reveals that his office is currently engaging with utilities. While it is not filing any climate proposals at them for 2024, he says, “if we run into brick walls, absolutely, shareholder resolutions or director votes are certainly tools at our disposal”.

He adds that the New York City funds will not rule out divestment down the road, “if there’s a utility that’s completely intransigent and is continuing, for example, to build a coal-fired power plant”.