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The outperformance over the past 18 months of some “green” equities, or those with direct or obvious climate solutions (such as renewable energy), has left investors wondering whether climate transition risks are already priced in. A new study by MSCI finds that transition-risk pricing differs by region and by a company’s greenness, as measured by its greenhouse gas (GHG) emissions and proportion of “green” revenues.1Even after normalizing for industry effects, equities with low GHG emissions and a higher share of revenues from “green,” low-carbon activities commanded higher valuations than equities with more “brown,” high-carbon-intensity revenues.
While we recognize the strong performance of certain green equities, we believe the lack of reliable emissions data makes it difficult for markets to properly price transition risks, and an active approach can help investors navigate these data gaps through bottom-up research.
Transition risk can be difficult to price because of incomplete carbon emissions disclosure. While 80% of MSCI All Country World Index (ACWI) constituents disclose Scope 1 and Scope 2 emissions,2 only 63% disclose emissions in ways that are comparable with peers. Fewer than 20% of companies included in MSCI’s climate coverage have reported at least one category of Scope 3 emissions.3 Making things even more difficult, when Scope 3 emissions data is disclosed, the extent and detail of reporting also varies widely. In an attempt to complete the emissions picture, data vendors populate datasets for constituents using rough estimates based on business activities and output levels. Many investors are using this data in portfolio decision making despite these data gaps and widespread use of estimation.
Mispricing example #1: Not accounting for Scope 3 emissions
Scope 3 emissions dwarf Scope 1 and Scope 2 in many industries, including outside of fossil-fuel-heavy sectors. With more than 80% of companies not yet reporting Scope 3, it’s no wonder the market cannot assess — or price — risks associated with the low-carbon transition. Take, for example, an asset-light industry like food or personal products. One might assume that because these consumer industries have relatively low Scope 1 and Scope 2 emissions intensity, they also have low transition risk. However, the industries’ Scope 3 emissions are estimated to represent nearly 90% of their overall carbon intensity.4 A consumer company’s failure to manage and account for its indirect emissions from its supply chain and product end use could increase its transition risk, especially as buying preferences shift to favor more energy-efficient products.
Mispricing example #2: Overreliance on emission estimates
For high-emitting industries or regions with predominantly estimated emissions data, many investors use proxied data, leading to a misperception that all companies within that industry or region are subject to high transition risk. Without standardized disclosure, however, it is very challenging for investors to identify which companies are actively reducing their emission footprints and establishing a competitive position relative to peers.
We also believe differences in the quality and credibility of a transition plan can create material dispersion within “green” or “brown” market segments. During our engagements with companies that have announced transition plans, we find that some management teams view them more as a marketing tool than a form of strategic risk management. Some transition plans exclude Scope 3 outright, with companies saying that indirect emissions are beyond their control.
Because these differences introduce the potential for further performance divergence — for example, as a function of companies’ ability (or lack thereof) to limit eroding profit margins from higher input costs by identifying inefficiencies within their upstream supply chain — we believe it is critical for investors to evaluate the quality and extent of each company’s decarbonization plan over time.
Unavailable or inconsistent information on carbon emissions and companies’ approach to managing transition risk present critical challenges — as well as opportunities — for investors. Until carbon emissions data and reporting improve, we believe investors can capitalize on potential mispricings through active management. With bottom-up research and engagement, active managers may be better able to evaluate company-specific nuances around emissions and transition planning, and identify climate-related risks and opportunities.
1“Foundations of Climate Investing: How Equity Markets Have Priced Climate Transition Risks,” MSCI, February 2021. | 2Scope 1 emissions are those generated directly from a company’s operations and production. Scope 2 emissions are those generated indirectly from the company’s electricity consumption. Scope 3 emissions are those generated indirectly from all other activities as a consequence of a company’s operations, including the activities of vendors, suppliers, and end users. | 3Includes more than 10,000 issuers. | 4Calculation based on MSCI datasets, including most recently available Scope 1 and 2 emissions intensity and estimated Scope 3 emissions intensity, as of 30 June 2021.