Why AP4 has decided to integrate Scope 3 emissions across equities

AP4, the SEK533.3 billion ($51 billion) Swedish buffer fund, is integrating Scope 3 emissions into its systematic equity allocation in the latest bid to improve risk and return at the pension fund, globally recognised as a role model in sustainability.

The systematic equity portfolio sits alongside a fundamental allocation which already integrates Scope 3 and supply chain risk in its deep fundamental processes. It means the latest innovation will complete Scope 3 integration across the entire SEK165 billion ($16 billion) equity portfolio apart from a (SEK 29 billion ) $2 billion allocation to emerging markets.

“We aim to be exposed to as little systematic risk as possible and want to find the green leaders of the future,” says Julia Ripa a senior analyst in the listed equities portfolio tasked with building sustainable equity strategies. “Because Scope 3 can be a large part of a company’s emissions, it is very important to integrate this risk into the portfolio and we can’t wait for ever to integrate Scope 3 – the danger of being exposed to the systematic risk of climate change is growing all the time.”

AP4 aims to achieve net zero emissions in its portfolio by 2040 and has cut emissions by 65 per cent since 2012 when it was one of the first pension funds out of the gate with the strategy. In 2023, the portfolio’s carbon dioxide emissions decreased by a further 11 per cent.

Although Scope 3 emission data is still frequently based on inaccurate estimates (in contrast to reported Scope 1 and 2 data) Ripa says the tide is turning, and the decision to integrate Scope 3 is a response to the steady improvement in emissions data from companies’ complex up- and downstream processes.

It is also born from AP4’s belief that new European reporting standards will yield better data going forward, despite fears amongst some investors that the regulatory focus on reporting could end up hindering genuine corporate change.

“EU regulation is really helping because we need reported data to improve data quality and availability. Once companies report their Scope 3 data it makes it much easier for us to select the best companies from the worst companies,” she says.

In the systematic portfolio the team continuously optimises the parameters that govern the algorithms used to select the sustainable winners of the future. If the data is poor quality, it yields noise and is often volatile; it holds too many inaccurate estimations that don’t correlate enough to reveal significant trends. “The team can end up just targeting companies on the basis of luck,” she warns.

Feeding Scope 3 data into the systematic portfolio won’t necessarily lead multiple companies falling out of the index.

“We won’t exclude all companies with high Scope 3 emissions,” she says.

Instead, the team aims to use the data to increase AP4’s weighting to the winners in each sector in the sector neutral strategy. They believe this will reflect the transition risk that the team is trying to capture more accurately compared to simply excluding the worst sectors. It is this, she says, that will ultimately lead to higher risk-adjusted returns.

“We are convinced sustainable investment will yield excess returns going forward, both by minimising sustainability risks but also by identifying winners,” she says. “In the long run, companies that are producing sustainable products and have sustainable business relationships, will be the future winners and yield excess returns.”

Ripa acknowledges that in some ways integrating Scope 3 data might not reveal significant corporate change. High emitting companies under Scope 1 and 2 like energy and utilities will still be high emitting under Scope 3.

However, she does say integrating Scope 3 will give a more holistic view of the carbon footprint of a company, something that will potentially change the way a corporate is viewed through a sustainability lens. It is possible that corporates that were clean under Scope 1 and 2 emissions will become brown when their Scope 3 data is revealed. “We will be able to fully understand company risk,” she says.

Car manufacturers which don’t have high emissions in their own manufacturing processes and have fallen out of Scope 1 and 2, but which produce a product that does have high emissions will be picked up in Scope 3, are a case in point.

Although the data from financials still has gaps, she says that Scope 3 data will also cast banks and insurance groups in a new light. For example, it can expose banks’ corporate lending book, particularly those financing fossil fuels.

“Banks have the opportunity of playing a large role within the climate transition, and we will finally be able to track their activity,” she says.

When it comes to high emitting sectors, AP4 combines Ripa’s team’s quantitative skills with the experience of the fundamental portfolio managers so that fundamental analysis is integrated into the systematic strategies.

The lack of quality, forward-looking data makes it challenging to pinpoint future leaders in these sectors, she says. A fundamental, qualitative approach is better suited to look deeply into individual companies and create a sustainability profile based on a corporate’s ability to transition and become a green leader of the future.

AP4 has continued to invest in the energy sector and in select fossil fuel companies in accordance with a belief that fossil fuels are essential for a successful transition. However, the investor has divested from thermal coal and oil groups it doesn’t believe are on a transition path.

Both the fundamental and systematic allocation seek out transitioning companies. Both portfolios also incorporate forward looking metrics, analysing how aligned companies are to the Paris Agreement and how exposed they are to rising carbon prices.

AP4’s allocation to emerging markets doesn’t sit within either the fundamental or systematic allocation, and is managed by external managers. Here the investor also aims to reduce emissions in the index, but hasn’t begun to integrate Scope 3 – although Ripa says it’s in the pipeline.

“Our approach when investing in emerging market equities is just the same. It’s about finding companies willing to transition and trying to improve, but doing so is more challenging in emerging markets. Data quality, reporting and to some extent awareness haven’t come as far as in developed market. In the end, it’s the same approach, just a few steps behind.”