Q&A: why credit investors need to think about carbon emissions

The world needs to reduce the amount of carbon it emits if the effects and potential harm of climate change is to be mitigated and reduced. The business sector and investors have a big role to play.

Investment and financing is needed to help implement the large scale infrastructure and technological changes required, while companies can adapt their supply chains and operations to become carbon neutral.

Investors can direct capital to the companies which are making the strongest efforts and progressing towards ambitious targets. They can also spur on and support companies through engagement and sharing knowledge.

The greenhouse gas emissions Scope 1, 2 and 3 framework is helpful in fostering target-setting and monitoring so that progress, or indeed lack of, can be effectively measured.

This is helpful to investors, looking to make the best informed decisions by taking account of environmental factors, and societies, working to limit rising global temperatures.

What are the different categories of carbon emissions and is this framework helpful?

Companies make financial choices every day for their own activities as well as the value chain they operate within, but every step also leads to emitting carbon – with or without targets.

Scope 1 includes all direct emissions from a firm's own operations or sources that are controlled or owned by the organisation. Included are emissions from gas boilers or transportation used by the business. For mining, steel companies or manufacturers, Scope 1 is an integral part of operating given emissions from furnaces or industrial processes.

Scope 2 emissions result indirectly from electricity purchased and used by the organisation. In countries where energy is generated mostly by coal, companies will have higher scope 2 emissions. Switching to alternative energy sources will be key in bringing down scope 2 emissions.

Scope 3 emissions are all other indirect emissions that the organisation does not own or control, but which occur across the  value chain of the organisation, from procurement to final product sold.

For a company producing trucks or cars that consume fossil fuel, for a bank with majority of loans to fossil fuel and, last but not least, for all oil and gas explorers and producers, Scope 3 is by far the biggest emissions category. For the corporate universe as a whole, emissions due to business travel in vehicles not owned or operated by the company, and waste disposal and treatment of product sold  are classified as scope 3. Given these emissions are shared or sometimes also part of other scopes elsewhere, some double counting of scope 3 happens and reported data here is limited.

Why do you focus on scope 1 and 2 emissions in particular?

As credit investors, we want to be aligned with and contributing, as far as we can, to global carbon neutrality targets. We want to see results in the near term, which in the world of climate change is five years at most. This starts with holding organisations accountable for emissions that are directly controlled – where it is within their power to increase efficiency immediately or through new technology, or carbon recycling in the case of hard to abate sectors like steel or basic materials – so Scope 1.

It is also important to focus on indirect emissions, which most companies are already measuring like electricity, heat, cooling, and are reporting on. The companies leading on carbon reduction are setting clear targets for reduction with a roadmap of milestones. Scope 2 can be meaningful depending on the sector or country the organisation is based in.

We like to push companies to bring down scope 2 in a major way and this helps to make low emission energy scalable, affordable, storable and available over the globe. Renewables including solar, wind, hydro, bio fuels and others are still less than 50% of the energy used globally.

Without the world switching to less carbon intense energy sources we will be nowhere near the target to cap global warming at 1.5 degrees by 2050, and will not meet 2030 intermediate targets.

Exclusion of production or energy generated from fossil fuels – like coal, oil and gas – is an expedient way of reducing the emissions intensity of investments, since these are the highest scope 3 emitters and a major source of global emissions. The consumption of these fuels needs to decrease. At the same time, new technologies must be used to reduce methane emissions and leakage in the sector if we are to see visible intensity reduction here by 2030. We engage with companies in the sector.

Scope 3 emissions are not consistently measured let alone reported by companies. We are increasingly encouraging close work with suppliers as well as product design teams to increase reporting and target setting in scope 3 – across sectors including financials. We also support environmental regulations that are requiring scope 3 intensity reductions for car manufacturers or requiring utilities to purchase and sell lower intensity electricity.   

Why is this important?

Companies focusing on carbon emissions reduction and neutrality are going to be better placed for the transition to a more sustainable economy. The investment needed to effect the change will create revenue opportunities.

Carbon neutral and low carbon intensity businesses will be betterr insured to risks such as stranded assets (fossil fuel reserves which will not be extracted and have to be written off) and might also have plans to deal with physical risks arising form extreme weather.

Other reasons for carbon emission reduction and avoidance are higher costs due to carbon taxes, higher financing costs (interest on bonds or bank loans), reduced consumer demand for products which are environmentally harmful, reputational and legal risks.

What holds companies back from committing to carbon reduction?

Lack of resources or infrastructure, but also, more problematically, wrong or short term prioritisations and incentives, or lack of knowledge or awareness, particularly of technology. All of this can hold back companies.

As investors we are responsible for trying to find out what is holding them back. Sometimes we see large profile companies making 2050 net zero targets, but not near and medium term intensity reduction targets. This approach underestimates the risk of not acting in the near term and pushing the targets further in the future.

Some smaller companies might actually be low emitters, but without having targets or reporting, due to lack of ESG resources in house, they might then fall under the radar of potential investors.

Carbon neutrality by 2025 or an 80% reduction in carbon emissions over a decade looks ambitious, how can companies achieve this? Will this be principally achieved by switching energy sources?

An 80% reduction in Scope 1 and 2 intensity level by 2030 is indeed praise worthy, and it is the most ambitious companies with the right culture and also commitment to all stakeholders that lead here.  Interestingly many of these companies also have some sort of Scope 3 reduction ambition. 

Certainly, we are keen to invest in such companies. French auto parts manufacturer Faurecia is a best-in-class example. It is committed to 80% reductions in absolute scope 1 and 2 greenhouse gas (GHG) emissions by 2025, from a 2019 base year, and to reducing absolute scope 3 GHG emissions 46% by 2030. Beyond this, Faurecia aims to reach 100% reduction by 2050.

We do see some carbon neutral  companies also manufacturing carbon efficient products and using certified carbon credit from that to be carbon neutral on top of using renewables. Turkish household appliances maker Arcelik successfully implemented this strategy. This approach is in line with the Science Based Targets Initiative. Companies like Arcelik focus on selling lower carbon products and thus push their suppliers as well. 

How do you engage with companies on emissions reduction and what have been some of the focus points of engagements so far?

We are trying to engage across sectors. In 2020, our financials analysts together with our Sustainability investment team asked banks globally to calculate, publish and set targets on financed emissions. We have these results and are readying to follow up.

With utilities we engage on phasing out coal, increasing generation capex in to renewables and bringing down absolute intensity while also using water more efficiently.

Sometimes the credit team tries to motivate low emitters to set targets, so they become eligible for investment. Or we might ask companies to quantify how much carbon they help others to avoid by reporting revenues generated from say solar or wind.

How well positioned are European and UK companies for meeting national carbon reduction goals?

I want to be optimistic, so as we see more companies especially with greener government policies and more carbon conscious consumers, committing to carbon reduction, we are moving in the right direction. Reducing carbon emissions - their own or in the value chain - requires financial and managerial prioritisations, as well as consistent reporting, technology and science.

Governments will need to support and lead. We have a G20 agreement to limit global warming to 1.5 degrees Celsius, and to end international public financing of new coal power by the end of 2021. European and UK leaders are working to get commitments to phase out coal completely.  

Importantly the European Commission’s ‘Fit for 55’ package of proposals would greatly extend the share of GHG emissions subject to carbon pricing from 22% today, to over two thirds by 2030. This will increase the revenues from carbon pricing severalfold, which can be used for transitioning of workers from the coal sector, and other things, increasing public acceptance.

The EU as a whole is issuing up to €250 billion of green next generation bills and bonds between now and the end of 2026, to finance the infrastructure that enables climate resiliency, supporting the EU’s sustainability vision for transition to energy efficiency and climate change adaptation. The companies working to enable this change are also hoping for regulation to drive a faster transition, for example on more waste recycling to control pollution. As sustainability reporting is rolled out near to medium term, companies will have to face more investors with disclosure, carbon reduction plans and milestones.

Some smaller companies are less prepared and need industry technical assistance and help securing sources of renewable energy, while bigger polluters need near term targets and not only 2050 ambition. Schroders and other investors are engaging with UK companies to enhance decarbonisation and resource use efficiency goals. UK leadership in COP26 will enhance the urgency for action.

It seems we could expect to see a correlation between a country’s targets for emissions reduction and those of companies, is this the case?

The targets, the means, the people and resources, all require cooperation between companies and governments, but also communities. For companies it is also crucial to drive their diverse suppliers - both locally and globally - by setting targets and helping technically and when needed financially. Introduction of carbon pricing at national levels could also send a strong signal for companies to prioritise their R&D capital spending and carbon efficiency. Best-in-class companies can lead country efforts towards reducing environmental footprints, but also benefit from policy support. 

What are some examples of credit investments that contribute to future carbon neutral economic growth?

Finnish real estate company Citycon is a good example. Its plan for carbon neutrality has been verified by the Science Based Targets initiative, a partnership that works with the corporate sector on enabling emissions reductions. Citycon will reduce its own energy consumption and increase renewable energy use through innovative technology. One of its major new developments opening in 2022 will be powered by a geothermal heating and cooling energy plant and as such carbon neutral.

Dutch telecom operator KPN has just publicised goals to reduce Scope 3 emissions by 30% by 2030 with baseline 2014, having been climate neutral in its own operations since 2015, using 100% green electricity and reducing energy consumption despite high growth in data communication.

Within financials, American Express has been carbon neutral since 2008 and now also committed to Net Zero Emissions by 2035. This will involve working with its suppliers primarily.

Body Shop and Avon owner Natura is planning scientific Scope 1, 2 and 3 target setting in Q4 2021. This company has a holistic climate and nature strategy expanding from their nature based products to engagements with communities.