Owning up to carbon
Why mandatory climate disclosure requirements could drive demand for emission allowances
The US like many jurisdictions across the globe are in the process of tightening up the rules around what climate related information companies should make public.
Many companies are releasing data on a voluntary basis, but it can be difficult to compare one firms data to another. Standardised data on climate related risks should help accelerate the expansion of sustainable investing by making it clearer to investors and firms alike where the risks, and opportunities lie.
In January 2022 the UK became the first G20 country to enshrine in law mandatory climate related disclosure requirements for its largest companies and financial institutions. The Companies (Strategic Report) (Climate-related Financial Disclosure) Regulations 2021 will apply to over 1,300 of the largest UK-registered companies and financial institutions for financial years commencing on or after 6 April 2022.1
Last year, the US Securities and Exchange Commission (SEC) began work on a new rule (a draft of which is expected later in 2022) also requiring listed companies provide investors with detailed climate related disclosures. The SEC has signalled that it will likely require companies to disclose both qualitative data (i.e., governance situation and strategies to address the physical and transition risks), and quantitative data (i.e., emissions, etc.).
While Scope 1 emissions are relatively straightforward to measure and report on, it is much more challenging to measure and report on indirect emissions under Scope 2 and 3. Indirect emissions involve third parties after all which complicates the process of data gathering and calculation, while publication of the data potentially risks legal challenge. Many companies, particularly carbon intensive companies such as ExxonMobil have begun reporting Scope 3 emissions following pressure from investors and campaigners.2
Mandating the publication of emissions data will increase pressure on companies to provide firm plans on how they will meet net-zero targets. It is also likely to mean increased demand for alternative means by which companies can show that they have offset their emissions in some way.
That could mean that demand for carbon offsets is about to increase significantly. However, greater calls for transparency will naturally mean even greater scope for critique of the use of offsets, whether by investors, environmental groups or obligated firms competitors.
In a joint letter to the SEC published by Sierra Club, Public Citizen and Americans for Financial Reform Education Fund, the groups call for much greater clarity on obligated companies use of carbon offsets, casting doubt on the poor record of many which use the voluntary carbon market (VCM):
“[n]one of the assessed companies demonstrate good practice with regards to the transparency set out in their [beyond-value-chain] climate contributions or offsetting claims. In many cases, information could not be found in the public domain to understand or assess the approaches. In other cases, disclosure is limited to marketing soundbites and superficial descriptions. Only in a small minority of cases is more detailed information identifiable, through the compilation of information from public project registries or third-party news outlets.”
The letter also highlights the risk that the continued lack of transparency in the VCM pose to the orderly, fair and efficient functioning of markets. This echoes a point raised by the Climate Risk Disclosure Lab of Duke Law’s Global Financial Markets Center, in a September 2021 note to the Commodity Futures Trading Commission (CFTC) where they are sceptical of non-compliance carbon markets:
“…we believe that carbon markets, when properly designed, implemented and overseen by the Commission, can perform a useful function for companies with hard-to-abate emissions to satisfy statutorily-imposed emissions caps. However, we have major concerns about the global proliferation of offsets, particularly under any ‘voluntary’ (industry self-regulated) framework not subject to oversight by CFTC oversight or foreign regulators.”
The authors go on to highlight the opacity of the sector, and in particular the lack of widely accepted standards:
“Carbon offsets in the voluntary markets suffer from a lack of scientific rigor and consistent methodology that would permit market participants to make informed decisions about the environmental benefits of various offset programs across multiple registries. This in turn makes it difficult for investors to assess the integrity of offset futures contracts and their susceptibility to manipulation.”
The note also highlights the risk of delaying action should the use of carbon offsets go unchallenged in climate disclosures and how this could result in a build-up of climate and financial risk:
“Given the growing volume of corporate net-zero commitments that can only be achieved with a heavy reliance on offsets, it is only a matter of time before companies purchase large volumes of offset futures and declare that they have fulfilled their net-zero commitments. A powerful lobby will then emerge to resist any regulatory intervention that might expose the fundamental weaknesses of these commitments. As regulatory intervention is delayed, systemic financial risk builds.
There is clearly a need to ensure that the SEC and CFTC are aligned on the issue of mandatory climate disclosure reporting and use of carbon offsets. Indeed, hopefully that is part of the reason why the SEC climate disclosure draft has been delayed.
In the absence of regulatory clarity over the use of carbon offsets under climate reporting disclosure obligations, there is one carbon hedging option companies have at their disposal which can reduce regulatory uncertainty, and lower the risk of future scrutiny. Instead of purchasing carbon credits, buy carbon allowances in the regional market that is most relevant to their business operations.
One non-profit organisation in the US is already helping companies and individuals do just that. Climate Vault purchases emission allowances from regulated compliance markets including California and RGGI and stores them, preventing them from being used by obligated entities within those compliance markets. At some point in the future Climate Vault will then resell the allowances back into the compliance market to fund an equivalent carbon removal from the atmosphere using permanent carbon removal technology.
At present corporate commitments to net-zero and individual firms carbon compliance obligations are two separate markets - unregulated voluntary vs regulated compliance. That may be about to change as increased scrutiny by investors watchful of greenwashing result in corporates turning to the regulated compliance markets to hedge their carbon risk.
The EU Commission has proposed a Corporate Sustainability Reporting Directive (CSRD) to extend the scope of the EU Non-Financial Reporting Directive (NFRD) already in force. The proposal extends the scope of the reporting requirements and the categories of companies subject to them. The CSRD is likely (pending review and agreement by the EU Parliament and Council) to apply from 2024 with companies reporting on the 2023 financial year.
There are three layers of emissions - 1, 2 and 3. According to the UK’s Carbon Trust, “Scope 1 covers direct emissions from owned or controlled sources. Scope 2 covers indirect emissions from the generation of purchased electricity, steam, heating and cooling consumed by the reporting company. Scope 3 includes all other indirect emissions that occur in a company's value chain.”