AQR Capital: Measuring supply chain climate risk exposure

Provide a short overview of the research innovation being proposed for the award, including how it is innovative.

Investors want good quality information on their investments’ climate risk exposure and are often stymied by a lack of accuracy and breadth of data. To address this issue, we combine Scope 1 and 2 emissions data, among the highest quality metrics available, with corporate supply chain information to create a novel and intuitive supply chain climate risk measure. This metric can generate powerful insights because some companies may seem green on traditional climate data, but may have material climate risk exposure if they do more business with firms that themselves face climate risks.

The strength of the metric is that it utilises raw data that are broadly accessible and that are of higher quality than alternatives such as data on Scope 3 emissions. This has allowed us to look at applications across broad universes of securities and empirically validate our work, showing, for example, that our measure helps explain stock price movements around climate news. We also discuss applications of our framework for measuring risk, enhancing investment views, influencing corporate reporting, and identifying targets for engagement. We conclude that our metric’s intuitive definition and transparency should be appealing for both investors and corporate decision makers.

Provide a description of why you decided to undertake this approach.

We began this research because we needed a clean way to measure supply chain climate risks, and there was little existing data that could be used to gauge such risks with any precision. For example, the often-discussed Scope 3 emissions data could potentially help but does not capture all risk exposures (e.g., a firm with low Scope 3 emissions may still derive a meaningful fraction of its revenue from oil majors, leading to material climate risk exposure). Moreover, reported Scope 3 data is not widely available, making practical applications difficult, particularly for allocators with diversified portfolios potentially holding hundreds of stocks. Our challenge was to build a measure that addresses these weaknesses.

We also anticipated other applications of our idea, for example in stewardship. Our measure can identify potential engagement targets or help measure the progress that portfolio companies make in engaging with their own supply chain partners. This may be particularly relevant for emissions offshoring, which occurs when a company switches from making the most carbon-intensive components in-house to buying them from suppliers. Our measure may also help improve an investor’s investment view, for example by enhancing the understanding of a company’s quality profile. We anticipate that such applications will be of interest to both discretionary and systematic investors.

Because the need for reliable measures of supply chain exposure goes well beyond AQR’s clients, we decided to publish a whitepaper describing this research, hoping to educate and help the broader investor community.

Provide an outline as to:

1. The value this approach has provided or a summary of the key conclusions.

2. What you have learned from this approach or report that can be applied more broadly.

Our goal was to develop a framework for measuring supply chain climate risks, ideally focusing on risks that may be more material for an issuer and utilising data that can be broadly accessed and estimated with relatively higher precision. The measure we came up with looks at each company’s customers (or suppliers) and what percentage of the firm’s revenue they account for. We then look through those customers (or suppliers) to see their Scope 1 and 2 emissions exposures. This gives a more holistic view of the full value chain of a company’s exposures. It also captures the intuition that a company may seem green on a standalone basis but may still have meaningful, and potentially material, climate risk exposure if it has customers or suppliers whose activities could be impaired by climate risks. Our own applications leverage customers’ carbon intensity, but our approach is easily applied to other measures that investors may prefer; for example, implied temperature rise or green revenues. As we explain above, this intuitive framework has a number of practical applications, some of which we already pursue at AQR, that will be relevant for investors more broadly.

An important part of our project was building a blueprint for testing climate-related data. Unfortunately, such empirical validation is rarely attempted, with some analysts or data providers arguing that the most severe climate risks have not yet materialised and thus are not testable using historical data. We disagree with this stance. Markets are forward-looking and do react to future, unrealised risks. We believe market reactions to climate-type news can, and should, be used to test climate-related ESG data.

When we apply such tests to our supply chain measure, we find that it helps explain price movements around climate news better than traditional climate data. In fact, we show that it subsumes climate-related information that is contained in measures such as Scope 1, 2, or 3 emissions. Moreover, we found that greener stocks (identified using our measure) have substantially outperformed browner stocks, consistent with the idea that markets react to climate risk exposures and reflect them in stock prices. We also find evidence that the measure can help predict fundamentals, suggesting that it may enrich one’s investment view of a portfolio company, perhaps by capturing a facet of its quality (the measure correlates with, but is not fully explained by, other quality factors). Collectively, these findings support using our measure for risk management and possibly also as an alpha factor.

Finally, our research innovation could influence corporate reporting. Firms will find our measure much easier to compute than Scope 3 emissions. For example, in its 2020 Environment Report, IBM stated that “the assumptions that must be made to estimate Scope 3 emissions in most categories do not enable credible, factual numbers.” By contrast, our measure only requires data that is already obvious to a reporting firm (the revenue share of each of its customers, or the cost share of its suppliers) and relatively standard, broadly accessible climate data (e.g., customers’ Scope 1 and 2 emissions). In addition, the focus on business linkages makes our measure more likely than Scope 3 emissions to capture financially material climate risks. For these reasons, corporate issuers may consider adding our supply chain metric to their ESG reporting packages, particularly if they want to strengthen measurement and reporting of their own supply chain exposures.