Scope 3 emissions reporting: What's in store for fund managers

Scope 3 emissions, often seen as the ‘hidden emissions’ within an organisation’s carbon footprint, encompass indirect emissions from a company's value chain. But while they have typically received less focus than both Scope 1 and 2 emissions, the fact that they often account for more than 70% of a business’s total carbon emission, according to the UN Global Compact, means that they are ultimately the most impactful area that alternative investment funds can influence.

“Scope 3 emissions are where investment funds have the greatest impact on climate change,” says Leifur Tomasson, ESG analyst at RBS International. “Understanding the emissions of the companies in your portfolio, and the levers you can pull to reduce those emissions, will have the greatest return in terms of resources spent generating a positive climate impact.”

“If you could sort that out, then it would dwarf anything else, so you should focus your return on investment, time and resources on Scope 3 emissions.”

The shift towards a greener economy hinges on understanding and mitigating Scope 3 emissions, compelling alternative investment funds to not just follow the trend but lead the charge toward a more sustainable future.

One of the primary reasons why Scope 3 emissions reporting is crucial for alternative investment funds is its role in providing a more accurate and holistic ESG assessment. ESG has moved beyond a mere checkbox for investors, and they are increasingly scrutinising the full environmental impact of their investments.

Hidden impact: understanding Scope 3 emissions

By addressing Scope 3 emissions, alternative investment funds can better understand the true sustainability of their portfolio companies. This knowledge enables funds to make more informed investment decisions, ultimately reducing the risks associated with environmentally unsustainable assets. Such transparency can attract capital from individuals and institutions who prioritise sustainability, thereby enhancing the fund's attractiveness and competitiveness in the market.

Mandatory ESG reporting requirements are also being implemented or considered in many jurisdictions. Regulatory compliance is becoming increasingly important for alternative investment funds. Compliance with these regulations is crucial to avoid potential legal and reputational issues.

For instance, the United Kingdom has implemented the Task Force on Climate-related Financial Disclosures (TCFD) regulation, which includes reporting on Scope 3 emissions. Non-compliance with such regulations can result in financial penalties, damage to the fund's reputation, and potential exclusion from certain investment opportunities.

However, while the importance of Scope 3 emissions reporting is clear, funds will face several challenges in gathering accurate and reliable data.

Obtaining detailed emissions data from portfolio companies and investee entities can be a formidable task. Many private companies, which may form a significant portion of a fund's investments, lack comprehensive reporting systems for emissions. In such cases, data availability is limited, and funds may struggle to compile a comprehensive Scope 3 emissions report.

To overcome this challenge, funds can engage with portfolio companies and encourage them to adopt more robust environmental reporting practices. Collaboration and dialogue with investee entities are essential for improving the availability of data.

Another challenge is the lack of uniformity in emissions reporting methodologies. Different organisations use different standards and metrics to report emissions, making it difficult to ensure consistency and comparability across investments. This lack of standardisation can hinder the creation of meaningful benchmarks and the ability to accurately assess the impact of investments.

Efforts to standardise emissions reporting methodologies are underway, with organisations like the Sustainability Accounting Standards Board (SASB) and the Global Reporting Initiative (GRI) working to establish common reporting standards. Alternative investment funds should support and encourage these initiatives to facilitate more uniform data collection.

Some companies, especially those with high Scope 3 emissions, may be hesitant to disclose sensitive data. Others may simply lack the awareness or motivation to measure and report Scope 3 emissions accurately. This limited disclosure poses a challenge for funds aiming to create a comprehensive Scope 3 emissions report.

To address this challenge, alternative investment funds can incentivise investee companies to adopt more transparent and sustainable practices. Offering guidance, sharing best practices, and providing financial incentives can encourage companies to measure and report Scope 3 emissions more accurately.

Opportunities for sustainable investing

Despite these challenges, Scope 3 emissions reporting creates opportunities for alternative investment funds.

By identifying emissions hotspots within their portfolios, funds can assess and mitigate potential climate-related risks. This not only safeguards the fund's investments but also enhances the long-term sustainability of their portfolios. Risk management, which has always been a critical aspect of investment strategies, now incorporates climate and ESG risks.

Scope 3 reporting can reveal opportunities for investing in companies with low-carbon supply chains. Such investments can foster a more sustainable and resilient portfolio. By optimising their portfolios for reduced Scope 3 emissions, alternative investment funds can not only improve their ESG ratings but also ensure the long-term success of their investments.

Transparent Scope 3 emissions reporting facilitates better communication with stakeholders, including investors, regulators, and the wider public. Investors increasingly expect funds to demonstrate their commitment to sustainability, and comprehensive Scope 3 reporting helps build trust and reputation. It allows funds to engage with stakeholders in a meaningful way, demonstrating their dedication to responsible investing.

Embracing sustainability and Scope 3 emissions reporting can also drive innovation and create value for alternative investment funds. By encouraging investments in cutting-edge technologies, eco-friendly practices, and green initiatives, funds can contribute to the development of a more sustainable future. This not only benefits society and the environment but can also result in attractive returns for investors.

Gaining a competitive edge: seizing the ESG momentumain

Scope 3 emissions reporting provides a crucial tool for funds to monitor their progress against science-based targets (SBTs) and develop effective transition plans. SBTs help ensure that emissions reductions are in line with the broader climate goals set by international agreements. By assessing Scope 3 emissions and working towards their reduction, alternative investment funds can make meaningful contributions to these targets and strengthen their commitment to sustainability.

According to David Marriage, disruption and innovation lead on sustainability at PwC, funds are still mainly motivated by external pressures, rather than the additional value that is offered. “At the moment many funds and boards still see sustainability as either a philanthropic action, ‘I am doing the right thing because I'm nice’, or a regulatory burden, ‘I just have to do it’.”

However, with the value of global assets that include some form of ESG mandate estimated to reach a value of more than $50 trillion by the end of 2025, according to Bloomberg, then the true motive should be less altruistic and more driven by performance.

“If you take the $50+ trillion of assets that will have some sort of ESG mandate, let alone the inter-generational transfer of $30 trillion of assets that we are seeing become more purposeful as it moves from baby boomers to millennials in the coming years, then the value case becomes immediately apparent,” says David.

“There’s a huge value pool that will respond to organisations or funds that are demonstrably doing the right thing from a climate action perspective, so if you can access that market then your share price or your asset base will go up in value.”

In this context, Scope 3 emissions reporting isn't merely an option for alternative investment funds: it's an imperative. As ESG continues to wield ever greater influence in both regulatory and capital terms, those who seize the opportunities presented by transparent and comprehensive reporting will not only demonstrate their commitment to a greener future but also stand out as more attractive investment choices in an increasingly conscious and competitive financial market.

“If you can get an edge like this, by being able to say I understand my Scope 3 emissions and I understand how I can reduce my impact,” says Leif.  “You can turn that into an advantage when fundraising and engaging with institutional investors and lenders.”

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