Owning up to Scope 3
How investors should think about the SEC's proposed disclosure requirements
The Securities and Exchange Commission (SEC), the US government agency responsible for ensuring the integrity of securities markets, is expected to publish new rules in April requiring listed companies to provide detailed climate related disclosures.
The disclosure rules will make it harder for companies to get away with “greenwashing”. That includes businesses making bogus environmental claims about their products or services, and investment institutions touting financial products that fail to deliver on promised ESG metrics (see ESG investment backlash hits nature-based carbon credit prices).
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 the latest SEC proposal, published in March 2022, the agency has signalled that it will require companies to disclose how they plan to meet greenhouse gas (GHG) emission reduction and other climate related targets, whether they have introduced an internal carbon price, what strategies they plan using to address physical and transition risks, and vital quantitative data such as greenhouse gas emissions (see In the shadows: Everything you need to know about internal carbon pricing).
It is the requirement to disclose detailed emissions data that this article will focus on.
There are three layers of greenhouse gas emissions - Scope 1, Scope 2 and Scope 3. According to the definition provided by 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.”
Scope 3 emissions typically account for three-quarters of a company’s emissions, according to estimates from the CDP. However, this varies considerably by sector and can vary from as low as 16% of a company’s emissions for the cement industry, and approach 100% for firms involved with transport, capital goods and financial services.
While Scope 1 and 2 emissions are relatively straightforward to measure and report on, it is much more challenging to measure and report Scope 3 emissions. Recall that this includes all of the other emissions the firm is indirectly responsible for - both up and down its value chain.
To measure Scope 3 emissions accurately requires obtaining information on all of the inputs and products sourced by the business (potentially thousands of products from hundreds of suppliers located across the globe), in addition to making reasonable assumptions about how the outputs from the firm (i.e. the products and services sold) are being used by their own customers.
According to the SEC proposal, large companies would be required to disclose and have independently verified their Scope 1 and Scope 2 emissions. Based on the initial proposal, it is thought that Scope 3 emissions disclosures would be limited only to situations where they were deemed “material or if the registrant has set a GHG emissions target or goal that includes Scope 3 emissions”. Unlike Scope 1 and 2 emissions, Scope 3 emission disclosures would not need third-party verification and would be protected from legal liabilities.
That will be a relief to CFO’s and their lawyers across the US. By it’s nature double counting is a feature of Scope 3 emissions accounting. The Scope 1 and 2 emissions from an individual firm may also be counted under the Scope 3 emissions from some other firm elsewhere in the supply chain. Its impossible to demarcate the sphere of influence that an individual business has on GHG emissions entirely, a task that only gets more challenging as the complexity of the business increases.
Of those companies that report Scope 3 emissions already (54% of North American companies that disclosed their emissions to CDP also reported their Scope 3 emissions), its not uncommon to find similar companies in the same industry reporting vastly different Scope 3 emissions.
There are a number of sound reasons for this. First, one firm may only measure a certain portion of Scope 3 emissions, while another measures all of it. Second, their interpretation of what is and what isn’t included under Scope 3 may also be different. Without a uniform methodology it is going to be impossible to get consistent results. The charts below demonstrates this well, illustrating how the contribution to upstream and downstream Scope 3 emissions have changed since 2015.
Banks and other financial institutions face a particularly challenge in accounting for their own Scope 3 emissions For example, according to the Partnership for Carbon Accounting Financials (PCAF) underwriting “exerts material impact on the direction of capital towards economic activities that will allow the transition to net zero no later than 2050”. In 2020, almost two-thirds of bank financing for fossil fuels was through underwriting. Should banks account for a proportion of the emissions they have facilitated though their activities, and if so, how much (see Whack-A-Mole: How patchy global carbon markets channel fossil fuel finance)?
Despite the significant challenges involved in estimating Scope 3 emissions, being required to do so by the SEC may still have its benefits, even if estimates come with a wide margin of error. Without some sense of an individual firms exposure to carbon, other greenhouse gases, and other environmental risks, it is impossible for management to begin engaging their supply chain, either pushing for change or making the decision to move their business elsewhere (see Repricing deforestation risk in the wake of Brazil's presidential election).
It may even result in some surprising conclusions. For example, Canadian heavy oil is often maligned as being the "dirtiest barrels in the world", with environmental campaigners coining the term “tar sands” to describe the region where the oil is extracted. Taking a full lifecycle approach (which is what considering Scope 1, 2 and 3 sets out to do) and you find that there is much less difference in emissions intensity between crudes, even more so once Canada’s oil industry cuts it’s Scope 1 and 2 emissions (see Decarbonising the oil sands).
Of course, the carbon risk represented by Scope 3 emissions must also be weighed up against all the other risks faced by a business. These includes other environmental risks (water scarcity and pollution, non-GHG air pollution, biodiversity, etc.), security of supply risks (geopolitical, geographical, etc.) and commercial risks (e.g. exposure to taxes including carbon, change in relative competitiveness).
Financial markets are already reacting to emissions data disclosures. A recent paper led by Ahyan Panjwani, an economist in the Division of Financial Stability at the Federal Reserve Board of Governors, examined how credit markets reacted to those firms reporting Scope 3 emissions data as part of the CDP carbon disclosure system. The researchers found that firms disclosing Scope 3 emissions face a lower cost of borrowing in credit markets, particularly in Europe and Asia Pacific while the trend is also starting to emerge in North America. They estimate an average disclosure premium of −20 basis points.
Firms that publish Scope 3 emissions are benefitting from a disclosure or transparency premium in their borrowing costs right now. However, once reporting is more common across industries, and as the SEC rules are introduced and enforced, credit markets are likely to be more picky, perhaps penalising those companies with high Scope 3 emissions. That might result in firms attempting to game their Scope 3 emission disclosures to appear better than their competitors.
What about the opportunities for investors? Well, there is going to be increased demand for services that can monitor emissions in real time, for example companies that use drones, satellites, AI, etc to accurately report and benchmark different GHG emissions. All of this data will require software that can source and collate disparate data sources together. Demand for trusted carbon accountants will also increase. The Big 4 accountancy firms no doubt have an eye on this market, but they will need the data and the ability to interpret complex, industry specific analysis and that’s where newer entrants into the market may have a competitive advantage.
Mandating the disclosure of businesses emissions data increases the pressure on companies to provide a credible plan on how they will meet GHG reduction targets. Carbon credits are likely to feature on many company strategies. In the past, management may have pointed to their lofty net-zero ambitions, knowing that low quality carbon credits underpinned those claims and been able to get away with it. Going forward the disclosure will invite much deeper scrutiny by investors, environmental groups, and by the SEC. Only the highest quality offset projects are likely to survive in this market.
Despite the immense challenges involved, Scope 3 emissions are simply too important to ignore. The next few years could result in opportunities as investors and companies initial confusion results in markets erroneously pricing Scope 3 carbon risk. In the meantime, the infrastructure to support credible emission disclosures and sound climate mitigation plans to respond to carbon risks will need to be built out.