The hidden emissions of ESG portfolios
One main goal of many ESG portfolios is to reduce greenhouse gas emissions in their portfolio holdings. However, because in the past, greenhouse gas emissions have been measured incompletely, these portfolios may inadvertently have shifted these emissions beyond the horizon of reported data.
Before I go into details, let me state that what I am talking about here is greenhouse gas emissions intensity per million dollar revenues. Obviously, a larger company has larger emissions and one sneaky way of removing greenhouse gas emissions would be to invest more in growth stocks that have higher valuations and thus lower greenhouse gas emissions per dollar invested. Similarly, one could simply invest in smaller companies that have lower absolute greenhouse gas emissions. No, what I am interested in are greenhouse gas emissions per revenue, which provide a level playing field to assess the true impact different funds have on the environment.
A new study looked at the entire emissions of companies, not just scope 1 and 2 emissions (i.e. the emissions a company is directly responsible for), but also scope 3 emissions (i.e. the emissions along the supply chain and the distribution channels including the use by end customers).
In the past, we would mostly measure scope 1 and 2 emissions but not scope 3 emissions, but these scope 3 emission measurements become increasingly sophisticated and future regulation will demand a full accounting of all emissions. And this might bring with it some nasty surprises for ESG investors.
The chart below shows the emissions intensity of conventional and socially responsible funds in Europe. As you can see, the emission intensity of socially responsible funds is somewhat lower than that of conventional funds, but when it comes to scope 3 emissions, the intensity of socially responsible funds is higher than for conventional funds. The result is that once all emissions are taken into account, there is hardly any difference between conventional and socially responsible funds.
Emissions intensity of conventional and socially responsible funds in Europe
Source: Popescu et al. (2022)
In fact, the chart below shows the scope 3 emissions intensity of different indices and the average of European socially responsible funds. European market indices have higher scope 3 emissions intensity because they are less geared towards technology, telecom, and more geared towards industrials, energy, and banking, all of which tend to have high scope 3 emissions. And while on average socially responsible investment funds in Europe have lower scope 3 emissions than the European market indices, about one in four of these funds have higher scope 3 emissions than the Stoxx Europe index. As scope 3 emissions become more widely available, these funds will have to deal with some bad news.
Scope 3 emissions intensity of different indices
Source: Popescu et al. (2022)