Scope 1, 2, and 3 Emissions

Scope 1, 2, and 3 Emissions are categories used to classify a company's greenhouse gas (GHG) output, forming the backbone of modern corporate carbon accounting. This framework, developed by the Greenhouse Gas Protocol, provides a comprehensive way to measure a company's total climate impact. Think of it as a financial statement, but for carbon. Scope 1 covers direct emissions from sources the company owns or controls. Scope 2 includes indirect emissions from purchased energy—essentially, the emissions produced on the company's behalf to keep the lights on. Scope 3 is the big one: it encompasses all other indirect emissions that occur in a company’s value chain, both from its suppliers and its customers. For investors, particularly those focused on ESG (Environmental, Social, and Governance) principles, understanding these scopes is no longer optional; it's fundamental to assessing a company's long-term risks, operational efficiency, and overall resilience.

Imagine you own a pizza shop. The way you measure your carbon footprint can be broken down into these three simple categories.

These are the direct emissions. It's the smoke coming straight out of your own chimney. For our pizza shop, this would include:

• The natural gas burned by your pizza ovens.
• The gasoline used by your company-owned delivery scooters.
• Any refrigerant leaks from your freezers.

In short, Scope 1 emissions are generated by assets you directly own and control. For an airline, it's the jet fuel they burn; for a cement factory, it's the CO2 released during the production process. This is the most straightforward category to measure and often the first that companies report.

These are indirect emissions from purchased energy. You're not burning the coal yourself, but you're buying the electricity from a power plant that does. For your pizza shop, this is purely the emissions associated with the electricity you buy to power your lights, refrigerators, and cash register. Scope 2 emissions represent a company's energy consumption choices. A company that powers its headquarters with solar panels will have a much lower Scope 2 footprint than one relying on a coal-fired grid. It's an important indicator of a company's commitment to clean energy.

This is the most complex but arguably the most important category for investors. Scope 3 includes all other indirect emissions throughout a company's entire value chain. It’s the carbon footprint of everything it takes to make your product and everything that happens to your product after it's sold. For most businesses, Scope 3 emissions are the largest portion of their total carbon footprint, often accounting for over 75% of the total. Scope 3 is typically split into two parts:

• Upstream Activities: This covers emissions from your suppliers. For the pizza shop, it's the emissions from the farmer who grew the tomatoes, the dairy that made the cheese, and the factory that produced your cardboard pizza boxes. It also includes employee business travel and commuting.
• Downstream Activities: This covers emissions generated after your product leaves the shop. This includes the emissions from the third-party delivery service that transports your pizzas and, most importantly, the disposal of your pizza boxes by the customer.

For a car manufacturer, its Scope 1 (factory emissions) is small compared to its Scope 3, which includes emissions from its steel suppliers (upstream) and, crucially, the gasoline burned by all the cars it ever sold (downstream).

A savvy investor looks beyond the surface, and Scopes 1, 2, and 3 provide a lens to uncover deep-seated risks and opportunities that aren't always visible on the balance sheet.

Scope 3 emissions often represent a company's biggest hidden liability. A business might look clean and efficient based on its low Scope 1 and 2 emissions, but a deep dive into its Scope 3 can reveal a massive dependency on carbon-intensive suppliers or products that face obsolescence in a low-carbon world. An oil company's primary risk isn't from running its refineries (Scope 1); it's from the world deciding to stop burning its product (Scope 3). Ignoring Scope 3 is like buying a house without checking for foundation cracks.

A company that actively measures, manages, and reduces its Scope 3 emissions is often a sign of superior management and a durable economic moat. This company isn't just optimizing its own four walls; it's building a more resilient and efficient supply chain, innovating less carbon-intensive products, and anticipating future market shifts. This proactive stance can lead to lower costs, stronger brand loyalty, and a business model built to last. It demonstrates a forward-thinking culture that protects long-term value.

Governments are increasingly looking to regulate entire value chains, not just what happens at the factory gate. Carbon taxes, border adjustments, and disclosure requirements are expanding to cover Scope 3. A company with a high, unmanaged Scope 3 footprint is exposed to significant future regulatory costs and reputational damage. By analyzing all three scopes, an investor can better assess a company's true regulatory risk and adjust their margin of safety accordingly.

Let's compare a traditional carmaker (ICE Co.) with a new electric vehicle maker (EV Co.).

• ICE Co.: Its Scope 1 and 2 emissions from its factories might be relatively low and well-managed. However, its Scope 3 emissions are astronomical. They include the lifetime tailpipe emissions of every single gasoline-powered car it sells. This is a massive, long-term liability in a world moving away from fossil fuels.
• EV Co.: Its Scope 1 and 2 emissions are similar to ICE Co.'s factory footprint. Its Scope 3 emissions are not zero; they include the carbon-intensive production of batteries (upstream) and the emissions from the electricity grid used to charge its cars (downstream).

However, the nature of the risk is different. EV Co.'s downstream emissions profile improves as the global electricity grid gets greener, a trend that is already well underway. ICE Co.'s downstream emissions are locked in by the physics of internal combustion. A value investor who only looked at factory emissions (Scope 1 & 2) would completely miss the fundamental difference in the long-term viability of these two business models.