Fundamentals of carbon emissions scaling: Implications for sector peer comparisons and carbon efficient indexing

We show that carbon intensity metrics, used to assess emissions efficiency across firms, vary significantly depending on the financial metric used to scale emissions. This variation-driven by within-sector differences in profit margins, asset and labor utilization, and valuation multiples-results in substantial reshuffling of firms' carbon intensity rankings relative to their peers. At the market level, the choice of scaling variable shapes the composition of carbon-efficient indices, which overweight (underweight) firms with lower (higher) carbon intensity within each sector. While carbon-efficient indices deliver returns comparable to the standard market index, they differ in carbon footprints and transaction costs. Indices scaled by market cap or enterprise value achieve lower carbon footprints by overweighting lower-emitting firms with higher valuation multiples but exhibit higher turnover. These findings underscore the critical role of scaling variable selection in carbon efficiency comparisons and highlight a tradeoff between carbon savings and transaction costs for emissions-focused investors.