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Don’t Fall Foul of the ‘Streetlight Effect’

Alex Collins, Corporate Analyst in Emerging Markets at BlueBay Asset Management, says it pays to measure emissions across the supply chain.

According to one report, 40% of European and Asian pension providers intend to reach net zero emissions by 2050. This commitment toward a greener world has led some commentators to question how viable it is for pensions to continue to invest in emerging markets.

Emerging market extraction companies are an easy target for ESG scrutiny. But analysis bias to one end of the supply chain risks reducing investors’ ability to engage for positive influence.

Cause for concern?

For ESG-conscious investors, extractive industries – such as oil, gas and mining – are typical causes for concern. Especially when these companies operate out of emerging markets, where business practices can be more opaque and ESG disclosure levels are typically weaker than in developed markets.

While the gap in financial reporting practices is slowly closing, it’s still wise to take extra care when it comes to ESG analysis. It’s all too easy to focus on ESG data that’s easy to measure and readily available, when what’s really most informative might be missing from the equation.

Take carbon emissions, for example. These have been followed for far longer than many other environmental factors. As such, measurements are more standardised and it’s easier to model companies that don’t report their emission levels.

One of the most common reasons for a company to be screened out of an investment portfolio is carbon emissions. But even as a broadly standardised metric, measurement challenges remain.

The three scopes of carbon emissions

Emissions are usually classed into three groups, or ‘scopes’:

  • Scope 1 are created in the direct course of a company’s business, such as by burning fuel.
  • Scope 2 are created by generating a company’s energy, such as through the power plants that power its factories.
  • Scope 3 covers everything else – all the indirect emissions created in the extraction, production and transport of raw materials a company uses.

To reduce emissions globally, we need to consider all three. Scope 1 and Scope 2, which are broadly direct emissions, can be measured easily. But as estimating Scope 3 requires mapping all companies in the supply chain, most measures of carbon intensity focus only on the first two. This risks the so-called ‘streetlight effect’ – searching for something only where it’s easiest to find.

But Scope 3 emissions matter, even if we can’t yet measure them reliably. Without good data, screening is typically biased against the extractive end of the supply chain, flattering the companies that are end-users of the commodities that extractive companies produce, such as power. For more holistic ESG analysis, we must account for Scope 3, even if only qualitatively.

Solving the measurement problem

Solving the Scope 3 measurement problem will require a substantial collective effort, and any solutions will need to be refined continuously over time. However, it is a problem that should ultimately be solved. The new Task Force on Climate-related Financial Disclosures  guidelines are a positive step in this ongoing process.

Investor pressure will remain absolutely key – not only because of the difficulty of the task, but also because there will be limited motivation from companies to push this forward themselves. Scope 3 typically represents the majority of a company’s emissions, so companies will have to work very hard to measure something that actually makes them look worse. In some cases, it could also invalidate the carbon neutrality plans companies have already announced based on Scope 1 and 2 emissions only.

In the meantime, we need to be pragmatic with the Scope 3 information available, and take care drawing broad conclusions based on data and processes that remain at a relatively nascent stage.

Progress over the whole supply chain

At present, commodity extraction is where the greatest potential environmental risk lies. The problem for investors is that you can’t easily separate the ESG record of a mining company in the Congo from an electric vehicle producer in California. Unless we find alternatives for the metals in electric batteries, you can’t have one company without the other.

Even extraction companies that are proactive about ESG factors often believe they will never improve investors’ perceptions, because of their place in the supply chain. Yet many of these companies could continue without international investment. This creates a risk that they give up trying to improve, cutting off investors’ ability to influence them and isolating companies with the greatest potential for ESG gains.

A key role for emerging markets

Over the last few years’ we have seen the level of commitment to ESG development strengthen meaningfully across issuers and investors within emerging markets. While there is still work to do, we believe strongly that emerging markets will play a key role in the evolution of the global ESG landscape. This should create a multitude of opportunities to build momentum behind the process and also invest in the resulting positive stories.

In an environment of negative yielding rates, emerging markets continue to present an opportunity for yield-hungry pension funds. To bluntly discount this segment of the market is perhaps counterintuitive to pushing the green agenda and shrinking deficits.

The practical information hub for asset owners looking to invest successfully and sustainably for the long term. As best practice evolves, we will share the news, insights and data to guide asset owners on their individual journey to ESG integration.

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