Biodiversity, Natural Capital and the Scope 3 Debate
Biodiversity and Natural Capital
Biodiversity and natural capital are emerging areas that present risks and opportunities that we will continue to research and manage our exposure to. To date we have conducted research and have had internal investment team discussions on palm oil–related deforestation and peatland burning, tailings management and water pollution. We also engage with portfolio companies on these topics if we feel the company is not managing this risk adequately.
Natural capital is worth considering in its own right, but its link to climate change makes it all the more important. In our view, we cannot realize the goals of the Paris Agreement without halting and indeed reversing nature loss. Land use and forestry changes (mainly agriculture and deforestation) amount to just under a quarter of human-caused greenhouse gas emissions. Forests and oceans currently absorb vast amounts of carbon dioxide. Oceans alone can now absorb around 25% to 30% of anthropogenic atmospheric carbon, but this is diminishing due to acidification, biodiversity loss and plastic pollution.
Our increasing understanding of the value derived from nature and our impact on it is another major driver. As we approach various tipping points, such as those relating to greenhouse gas emissions, biodiversity loss, novel entities and pollution, the impact of the impairment of natural capital becomes more important.
Source: Integrated Ocean Carbon Research available at https://unesdoc.org/ark:/48223/pf0000376708.
In response, we published a white paper, which examines natural capital and how it, along with the ecosystem services it provides, poses a material systematic risk and at the same time presents opportunities in several key sectors. One of our key findings is that the impacts of natural capital risk are extremely complex, and there are serious analytical challenges in being able to determine winners or losers and even identify those most at risk. We believe that in order to do this well, we have to conduct granular bottom-up analysis. To build out a framework for our global platform of investment specialists to use, we began in the food sector by seeking the answer to questions such as those below in our own meetings and in meetings with relevant companies:
- How dependent are the companies on commodities that have a high natural capital impact, and where in the supply chain does the impact occur?
- What types of natural capital are most impacted, and how disruptive could the impact be?
- What can companies do to reverse or remediate the impact?
As we continue to work through the details, we are learning a lot about how to think about these risks and opportunities and value them. We also participate in some industry collaborations on natural capital risks, including the Ceres Land Use and Climate Working Group.
Case study: American food and beverage company
During the year, we engaged in discussions with a food and beverage company about deforestation management. The Cerrado biome of Brazil is a critically important region for the climate, in which grain traders like this company have the potential to exert a strong influence over their suppliers such as soy farmers who are driving deforestation in the region. After several discussions with the company, we developed the view that while it has many targets in place and extensive coverage of this topic in its sustainability report, we do not believe that they are best-in-class in this area. During our discussions, they said they disagreed with certain findings and the underlying data of forward-thinking NGOs like Forest500 and TRACE. For example, the company claimed that despite soy continuing to expand in the Cerrado region every year, it is not the main driver of deforestation, even through indirect land use. Beef, not soy, is the problem, the company said.
We recognize that this company is thinking deeply about its deforestation efforts. However, as a shareholder, and given the importance of the topic, we were hoping to see company management become more willing to take on a forward-thinking, leadership role on these issues. Instead, we came away with the impression that they were reluctant to engage in conversation in a manner that is open and reflective. We will continue to make deforestation a key topic in future engagements.
The Scope 3 Debate
Scope 3 emissions have long been a hot topic within the sustainability space. As investors, emissions reporting plays a vital role in the transition away from carbon, and reporting on Scope 1 and 2 emissions is crucial, particularly in the context of the Paris Agreement and the world mobilizing around 2050 and interim targets. While there is a consensus around measuring and reporting these emissions, the shortcomings of Scope 3 emissions are obvious. For example, the data require many estimates, and there is substantial double-counting in Scope 3. Nevertheless, interest in the concept remains high. As a result, our investment professionals have been focused on the topic and have been facilitating a deep dialogue with the broader team.
In our view, the primary goal of Scope 3 analysis is to avoid surprises resulting from suppliers passing higher energy- or emissions-related costs on to the companies we own. We also want to avoid supply chain business interruptions resulting from new regional laws or regulations, as well as decreased demand for products or services that lead to higher greenhouse gas emissions. Scope 3 disclosure may help companies and their investors in the following ways:
- Revealing GHG problem areas in the value chain, which will enable prioritization of risk mitigation efforts and enhance business resiliency
- Helping suppliers reduce costs through the improved efficiency of materials, resources and energy
- Identifying potential new business, product design or sourcing opportunities
- Enhancing corporate reputations and investor valuation
While there is often value in companies reporting and targeting reductions in Scope 3 emissions, we need to recognize that this information may not always be material or benefit shareholders and our clients. In those instances, we might choose to focus our questions elsewhere. For example, oil and gas producers have very large Scope 3 emissions (consumers and businesses heating their homes, driving cars, flying in planes, etc.), but we are currently uncomfortable asking these companies to report Scope 3 emissions for a number of reasons, including these two:
- Scope 3 data are unlikely to be useful in relative calls between oil and gas producers but likely to instead become fodder for negative media or political headlines.
- Company culture could be impacted by the publication of data documenting large Scope 3 emissions (which will dwarf Scope 1 and 2 emissions) by discouraging innovation, distracting teams endeavoring to reduce Scope 1 and 2 emissions and encouraging employees to leave the company or field.
In summary, Scope 3 disclosure from these companies may not provide investors any benefit and could increase risk. As a result, we have chosen to focus on talking to the companies about 1) their plans to move toward producing the lowest-cost, lowest- GHG barrels available and 2) how they are thinking about long-term demand for oil and gas, i.e., leading up to 2050 and beyond. Engagement on these two topics is likely to be more interesting and fruitful for us, the companies we own and our clients.
Case study: American oil and gas company
Members of our investment team engaged in discussions with the CEO of a multinational oil company around the topic of Scope 3 emissions. The company’s position was to not include Scope 3 emissions in their targets. We came to understand that it is Paris- aligned on Scope 1 and 2 and has an energy transition plan. The company expressed concern that focusing too heavily on Scope 3 emissions reductions could potentially be used in ways that are not in shareholders’ best interests.
We expect companies to have a sound plan for dealing with the energy transition while reducing emissions over time. And we expect them to offer an attractive risk-adjusted return over our holding period, part of which includes returning cashflows to shareholders to mitigate the long-term terminal value risk of these businesses.
Overall, this company’s net zero plans are sensible in our view, and their concerns around Scope 3 are valid. We had a constructive dialogue and will continue to maintain open lines of communication on this topic going forward.
Case study: Canadian mining company
Our investment team recently reevaluated the outlook of a Canadian extractives company owned in several of our equity and fixed income strategies. Previous significant governance issues negatively impacted our view of the company across strategies, and we minimized our exposure to the risks posed by these events. By 2021, with investigations by regulators reaching resolution, there was significant change in management and the board including the departure of long tenured executives.
There were also environmental and social concerns with the company operations. For example, the company had little in place regarding targets and strategies for addressing direct or product use carbon footprints. Rather than excluding the company based on its poor ESG profile, we engaged with a long-term focus to seek positive change in the company. We have been pleased to see the company’s new management address multiple areas of concern. MFS’ investment team saw an opportunity for the company to improve its ESG profile whilst increasingly playing an important role in supplying the metals and minerals needed for the energy transition, as well as interim energy needs.
Throughout 2022, we engaged with the company’s new management team and board on governance and its low carbon transition strategy. Following document review, engagement and internal discussion we voted in support of the company’s transition progress report. We wrote to the company setting out where the reporting fell short of providing the information needed to assess progress and plans and setting out our specific requests for future reports. The extent the company addresses these points will determine our vote decision on future reports.
The governance concerns that affected our valuation of the company have steadily improved over the past few years, and although legacy issues are still being concluded the new management has given a promising outlook for the future. Ethics and culture appear to be a greater part of governance and decision making and the company is committing significant resources to ensure new practices and goals are achieved. We will maintain caution and close monitoring until the company can demonstrate a multi-year track record on a new standard of governance and culture and adherence to their climate-related and social commitments.
MFS may incorporate environmental, social, or governance (ESG) factors into its fundamental investment analysis and engagement activities when communicating with issuers. The examples provided above illustrate certain ways that MFS has historically incorporated ESG factors when analyzing or engaging with certain issuers but they are not intended to imply that favorable investment or engagement outcomes are guaranteed in all situations or in any individual situation. Engagements typically consist of a series of communications that are ongoing and often protracted, and may not necessarily result in changes to any issuer’s ESG-related practices. Issuer outcomes are based on many factors and favorable investment or engagement outcomes, including those described above, may be unrelated to MFS analysis or activities. The degree to which MFS incorporates ESG factors into investment analysis and engagement activities will vary by strategy, product, and asset class, and may also vary over time. Consequently, the examples above may not be representative of ESG factors used in the management of any investor’s portfolio. The information included above, as well as individual companies and/or securities mentioned, should not be construed as investment advice, a recommendation to buy or sell or an indication of trading intent on behalf of any MFS product.
Index data source: MSCI. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed or produced by MSCI.
Statistics included in this report are calculated based on accounts for which MFS clients have fully delegated proxy voting authority pursuant to the MFS Proxy Voting Policies and Procedures. With the exception of the meetings voted statistics listed on page 47 of this report, all voting statistics exclude instances where MFS did not cast a vote. Statistics also do not include instances where an MFS client may have loaned shares and therefore was not eligible to vote. Statistics are calculated on a meetings-level basis. All engagement statistics listed above include only those managed by the MFS proxy team.
As an active manager, please be advised that the companies named in this report may no longer be held by an MFS client at the time that this report is published.
The views expressed are those of the author(s) and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as a solicitation or investment advice from the Advisor.