Key findings

Total carbon footprints reflect a company’s climate impact, but they do not always provide a clear signal for transition risk. This research highlights that business context and the specific source of emissions are critical factors. A materiality-weighted footprint better captures financially relevant emissions by focusing on those under the most significant business pressure. This approach demonstrated stronger links to corporate earnings, equity outperformance, and credit risk than total emissions metrics, potentially explaining why previous academic studies using total emissions have found mixed results regarding financial performance.

Abstract

The total carbon footprint of a portfolio is frequently used to assess both climate impact and financial transition risk. However, these two objectives require different analytical approaches. While every metric ton of greenhouse gas affects the climate equally, not all emissions carry the same financial risk. Transition risk is highly dependent on where emissions originate within the value chain and the surrounding business environment. A materiality-weighted carbon footprint focusing on emissions most exposed to sub-industry business pressure provides a clearer risk signal. For example, in the MSCI ACWI Index, this weighted approach retains 78% of Scope 1 + 2 emissions, 62% of Scope 3 downstream, and only 6% of Scope 3 upstream emissions. Over the past decade, these materiality-weighted emissions have shown stronger correlations with financial indicators than total emissions, even after controlling for industry and style factors.

The concept of materiality-weighted carbon footprint

Investors often begin their analysis by looking at the total carbon footprint, which aggregates Scope 1, 2, and 3 emissions. While this is appropriate for measuring environmental impact, it may fall short for assessing financial risk. The risk signal from emissions under strong business pressure is often diluted by emissions that face little to no near-term business pressure. To address this, a materiality-weighted approach identifies which parts of the value chain are financially relevant based on location and industry-specific factors.

Rules-based approach to determine the materiality-weighted footprint

MSCI ESG Research developed a rules-based framework to identify relevant emissions. This framework is built on two primary insights: emissions alone do not create risk; rather, risk is created by policy and business pressures. Policy pressure includes government-imposed costs like carbon taxes, while business pressure arises when more efficient or cheaper technology alternatives become available. The model calculates business pressure as the product of emissions intensity and technology pressure. Rule 1 sets a constant threshold of five (on a scale of 0 to 10) for business pressure. Rule 2 applies to Scope 3 upstream and downstream emissions, requiring them to make up at least 70% of the overall footprint to be considered materially relevant. This prevents the signal from becoming too diffuse due to pass-through rates and supply chain layers.

Material emissions scopes by GICS sub-industry

The application of these thresholds results in a significant reduction in the emissions considered materially relevant, particularly for Scope 3. For instance, Scope 1 + 2 are identified as relevant for construction materials and electric utilities, whereas Scope 3 upstream is material for packaged foods and meat. Scope 3 downstream is critical for sectors like automobile manufacturers and oil and gas.

Empirical analysis in equities

Using the MSCI ACWI universe, the study compared the equity market outcomes of total emissions intensity versus materiality-weighted intensity. The analysis showed significant performance differences, with carbon-efficient companies outperforming carbon-intensive peers in developed markets. This differentiation was clearer when using materiality-weighted carbon intensity. In emerging markets, the underperformance of carbon-efficient companies was reduced when applying the materiality-weighting approach. Furthermore, in all regions, the most carbon-efficient companies demonstrated higher earnings-per-share (EPS) growth than their carbon-intensive peers.

Empirical analysis in corporate bonds

A similar analysis was conducted in the corporate bond market using residual risk metrics. The results suggest that emissions intensity is a relevant indicator for issuer-specific risk not explained by traditional fixed-income drivers. The materiality-weighted approach enlarged the risk gap between the highest and lowest carbon-intensity issuers, particularly when neutral-risk emissions were excluded from the sample. This confirms that focusing narrowly on material emissions is necessary to identify relevant risk reduction in credit markets.

Conclusion

The report concludes that investors should differentiate between two distinct use cases for carbon data. Total carbon emissions remain a valid measure for assessing climate impact or alignment with environmental objectives. However, for portfolio risk assessment and construction, a risk-focused approach using materiality weighting provides superior explanatory power for stock performance and credit spread risks. Financial markets appear capable of differentiating between emissions subject to business pressure and those that are not.