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Home » A New Way to Measure Supply Chain Climate Risks

A New Way to Measure Supply Chain Climate Risks

climate strike
An activist carries a sign that reads, "The climate is changing, so should we!" during the September 2019 climate strikes. Photo: Markus Spiske/ Pexels.
May 11, 2022
Bloomberg

AQR Capital Management, the investment firm co-founded by Cliff Asness, has come up with a new way to measure supply chain climate risks.

Today, most investors focus on Scope 3 emissions — the emissions generated as a function of a company’s supply chain or through the use of its products by customers. AQR says the data available on Scope 3 vary from company to company and is often imprecise.

AQR says the better and more accurate metric is focusing on the overall climate exposure of a company’s customers and suppliers. In other words, AQR measures the extent to which a company does business with partner firms that may suffer, or even go out of business, because of climate-related risks.

As an example, AQR examined a U.S. payments services company that seems on its face as green as any business around. An initial AQR review found its Scope 1, Scope 2 and Scope 3 emissions were lower than industry competitors. But regulatory filings showed that the company’s customers included three large oil companies, which accounted for about 21% of its consolidated revenue as recently as 2011, according to AQR.

This example — while dated — highlights the key difference between AQR's methodology and a simple reading of Scope 3 emissions, said Lukasz Pomorski, AQR’s head of research. Scope 3 isolates the emissions from suppliers and customers that are attributable to a given company’s products — a daunting challenge even when their overall emissions are known.

By contrast, AQR’s approach is to focus on “economic linkages.” This means assessing how much indirect climate-risk exposure a company has by identifying what portion of its revenue comes from customers with large climate exposures themselves, and how much it spends on supplies from climate-risky firms. This is regardless of whether such exposures are attributable to the client or producer’s product, Pomorski said. It measures an underappreciated risk, because a very green firm may be indirectly exposed to climate risks across its supply and customer chains.

“It’s true that Scope 3 is important and relevant, but the data around Scope 3 are questionable at best,” he said. 

AQR, which oversees about $110 billion, says it trades on this supply chain data because it’s verifiable and climate-related risks are only increasing globally. Some AQR clients also have shown interest in the metric and strategies that use it, the firm said.

From an investors’ perspective, the essential question is how exposed are their portfolios to environmental-related risks across the supply chain, Pomorski said. At the extreme, how at risk is a company if one of its customers goes bankrupt for climate-related reasons? Will the company lose meaningful revenue because of a client's bankruptcy?

AQR’s research goes beyond the climate-risk application outlined above.

“Our measure can also capture potential emissions offshoring, which occurs when a company switches from making the most carbon-intensive components in-house to buying them from suppliers,” Pomorski said.

As investors pressure companies to become greener, corporate executives may respond by shutting down their most carbon-intense assets and instead buying the same ingredients from third-party suppliers. This just shifts carbon across the supply chain, with no net effect for global emissions. AQR’s metric could help investors monitor such behavior while Scope 3 data remains sparse.

In the end, AQR's research provides a way for investors to analyze companies that are heavily exposed to climate change via their customers and suppliers. For example, if a company’s customer emits a lot of CO2 or has lots of fossil-fuel reserves, then that company indirectly inherits that exposure even if by itself it may seem “green.”

“While there are similarities between our measure and Scope 3 emissions, our metric captures somewhat different information and has a meaningful advantage of being much easier to assess, using data many investors already have access to,” Pomorski said.

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