5 hidden emission sources in many low-carbon strategies

Second issue: Carbon intensity of what?

A similar example may be found in the automotive industry. Much like the food industry, this industry too is dominated by scope 3 emissions linked largely to emissions generated during the use cycle of the vehicles.

Once again, an investor looking only at scope 1 and 2 emissions may fail to appreciate the difference between a manufacturer of electric vehicles and that of petrol-fuelled cars. But, even when considering scope 3 emissions, an investor may still be misled, if the wrong metrics are used.

Consider an investor looking at the amount of emissions generated for a given amount of revenue – a common metric in use today. Using such a metric, a manufacturer of petrol-guzzling performance cars may score better given that higher tailpipe emissions of these vehicles maybe diluted by the higher value of each car. After all, only a handful of top-end, performance cars would be sufficient to generate a million dollars of revenue, compared to a few dozen for lower end and midrange vehicles that may cumulatively generate more emissions.

Does that make the manufacturer of performance cars lower carbon, or insulated from carbon risks?

Hardly so. Regulators care less about the emissions per dollar of revenue than about the emissions per kilometre driven. Through regulation on tailpipe emissions the manufacturer of performance cars, despite its lower carbon-revenue intensity, would be far more severely exposed to such regulation and the technological and market risks it creates. Once again, an investor using the wrong metrics would be led far astray.

Third issue: Land use change emissions 

Moreover, even when using the right metrics and looking at all scope 1, 2 and 3 emissions, do these really capture all the emissions in a company’s supply chain?

At this point, you may be able to guess the answer – no. To see why, let us return to the example of the food processing industry we looked at earlier.

Today, most greenhouse gas emissions are generated through the burning of fossil fuels and other process emissions. However, around 11% of global emissions are generated through land use change, largely linked to deforestation. When forested lands are burned down or converted to agricultural use, carbon embodied in these forests is released, acting as a major contributor to climate change and biodiversity loss.

Beef, palm oil, soy, cocoa and coffee are some of the commodities linked most directly to deforestation. While an investor that has progressed to the inclusion of scope 3 emissions would, at least, identify the high agricultural emissions linked to cattle herds, these would still omit the analysis of indirect emissions that might result from weak supply chain controls and inadvertent exposure to deforestation.

For the same reason, an investor involved in chocolate manufacturing might believe to be invested in a lower carbon activity. Yet, taking exposure to land use change into account, chocolate may be far higher than pig or poultry production, and roughly on par with the production of dairy, lamb and mutton.

That is not to say that all production of chocolate leads to deforestation. Good supply chain management may mitigate these risks. But, as before, the seemingly low carbon footprint of these activities may keep an investor from asking these critical questions.

Fourth issue: Financed emissions

Remember those low carbon strategies we discussed earlier? Ask an investor in these strategies what sectors they are underweight in, and they will likely tell you energy, industrials, materials, and other high-emitting industries. Ask them about the overweights, and they may tell you healthcare, education, IT, communications – and financials.

Financials are often seen by investors as a low carbon sector. Yet, when taking the financed emission associated with financials’ balance sheets into account, this perception may be demonstrably false. With some investment banks being highly exposed to sectors that are not only high carbon, but failing to decarbonise, climate-related risks inherent in such loanbooks may be significant.

Would such financed emissions not be captured through scope 3 emissions? In an ideal world, yes. Indeed, the GHG accounting protocol includes investments on companies balance sheets within its definition of scope 3 emissions. Yet, even where financial firms disclose their scope 3 emissions to the Carbon Disclosure Project or otherwise, such financed emissions are rarely included, and neither are they included by most third-party data providers.

Assessing exposure of financials thus requires additional work, involving an analysis of the composition of loanbooks. At Lombard Odier, we incorporate loanbooks as part of our analysis of financials’ carbon footprint where possible – and as a result, we do not consider the sector to be low carbon.

Fifth issue: Enabled emissions

Have you heard of avoided emissions? When a manufacturer produces wind turbines, those wind turbines may generate a limited number of emissions during their lifecycle – captured through scope 1, 2 and 3 emissions. In addition, however, the use of these wind turbines may displace coal or gas plants, reducing emissions in the economy overall. This concept is known as avoided emissions and has generated increased interest, given its relevance to climate solution providers.

Yet, much in the same way that some companies may help avoid emissions, others may enable it. Consider a company drilling oil and gas wells, as a supporting service to the energy sector. Once the well has been drilled, the company’s involvement may cease, and analysis of the lifecycle emissions of the company’s service often ends at this point. The fact that the well may subsequently support the production of vast amounts of fossil fuels and emissions might, at best, be considered an “indirect” form of emission by the company. Under the GHG accounting protocol, the reporting of such emissions is deemed optional.

Astonishingly, therefore, a company drilling oil and gas wells, and reporting only emissions generated during this brief exploration and initial development phase, may once again appear low carbon. Hiding in plain sight is the obvious realisation that such a company would be anything but, and that the viability of its business model would be highly exposed to the accelerating energy transition.

And let us look at another example. A travel operator would typically rank among other low carbon service providers. Rarely would the emissions that its customers generate via air travel, hotel stays, or rental cars be included. Such a company may argue that they offer only a facilitating service and that it is the airlines – and not them – that ultimately are responsible for promoting decarbonisation. Even if we accept that argument, that does not change the exposure of such companies to transitional risks, as in the case of regulators moving to ban short-haul flights. Low carbon or not, carbon risks for a travel operator are still very real.

Conclusion: Not so low carbon after all

From the examples above, it is apparent that “low carbon” strategies may often not be so low carbon after all. Low carbon strategies may include everything from meat processors to manufacturers of performance cars, companies drilling oil and gas wells, and travel operator dependent on selling tickets for high-carbon flights.

All of the above points to one obvious fact: Looking at basic carbon footprints alone is insufficient. At Lombard Odier, we consider all scope 1, 2 and 3 emissions, consider tailpipe emissions alongside other metrics, and seek to assess the financed emissions of financials’ loanbooks. Similarly, we seek to assess exposure to land use change emissions by understanding which industries are most at risk – and the supply chain practices that may mitigate it.

Moreover, we consider not only the scale of emissions today, but what companies are doing to mitigate these. To enable this, forward looking expertise is urgently needed. This means involving metrics such as Implied Temperature Rise (ITR) as well as an analysis of exposure to transitional, physical and liability risks.

Such an approach, executed through qualitative and quantitative analyses, is best able to mitigate climate risks and seize growth opportunities across the economy as the net zero transition progresses, in our view. It can only be achieved by rethinking net-zero.

Discover more about our TargetNetZero Equity, IG Fixed Income and Convertible strategies.