Scope creep
Mandatory climate disclosures target under-reported carbon risk
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This year many of the worlds largest economies are introducing tough climate disclosure laws that require companies report on their entire supply chain. Crucially many of these laws go beyond direct emissions (Scope 1 and 2), and also mandate firms report on their indirect emissions too (Scope 3).1
Mandatory reporting increases the pressure to provide a credible plan on how to meet emission reduction targets. It puts the onus on businesses operating both upstream and downstream to be clear on their own environmental impact. It enables investors to compare one firms emissions with another, and helps direct capital to the best carbon mitigation opportunities.
Scope 3 is critical to understanding how firms are financially exposed to carbon pricing and climate risks. Indeed, there is evidence that firms that are already publishing comprehensive emissions data, including their Scope 3 emissions are benefitting from lower borrowing costs. An emissions transparency premium (see Owning up to Scope 3).
A global trend in climate disclosure
Lets first look at Europe. New laws introduced in January 2024 require companies operating in the European Union to start collecting and then disclosing a wide range of data regarding their impact on the planet. In addition to information on water, biodiversity, and social impacts, the EU’s Corporate Sustainability Reporting Directive (CSRD) requires firms to report on their Scope 1, 2 and 3 emissions. Although the CSRD will be introduced in stages starting with the largest companies that are already subject to the Non-Financial Reporting Directive (NFRD), the directive is expected to ensnare some 50,000 companies, including many non-European companies that have operations in the EU.
On the other side of the world, the Australian government has issued a proposal that requires large companies and financial institutions to disclose their climate impacts (including their Scope 3 emissions). The law, which is expected to be introduced in July 2024, will require obligated companies to provide climate related disclosures covering the 2024-25 financial year. Companies that fail to disclose their data or provide inaccurate data could face civil penalties.
Across the Pacific, companies based in California will need to comply with supply chain emissions reporting requirements from 2026. The Climate Corporate Data Accountability Act, signed into law in 2023, will require companies with an annual revenue of more than $1 billion to report their annual direct and indirect supply chain emissions. Businesses will need to begin capturing data from 2025 in order to be ready.
The Securities and Exchange Commission (SEC) has yet to announce their final climate disclosure rules. The decision to include or exclude Scope 3 emissions appears to be the most contentious part of the ruling, with critics arguing that it would be unduly burdensome. A compromise deal might involve companies being required to report on Scope 3 emissions if deemed “material”, or if they are included in an emissions reduction target. The latest regulatory agenda indicates that the SEC is likely to publish their final iteration of the rules in April 2024.
Under-reported impact
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.
Measuring Scope 3 emissions accurately is fraught with difficulty. It 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
Research conducted by Emmi, the carbon risk management firm, in collaboration with Griffith University and The University of Otago, discovered that Scope 3 emission disclosures were found to be under-reported by up to 44%. The analysts used a sample of over 9,500 observations from 1,972 firms that disclosed Scope 3 emissions between 2010 and 2019.2
Not every source of Scope 3 emissions was reported on by companies, and those that did get reported tended to be those that mattered the least to overall indirect emissions. For example, categories such as travel emissions (low materiality) were reported much more frequently than the use of products and processing of sold products (high materiality).
Predicting Scope 3 emissions for individual companies via simple scaling techniques or more elaborate machine learning is limited by the low number of estimates. Scope 3 disclosures have improved over time with companies typically reporting a broader range of categories. The study suggests that extensive reporting on a consistent basis is likely to improve the accuracy of Scope 3 estimates considerably. As jurisdictions such as the EU, Australia, and the US embed Scope 3 reporting, the accuracy of that data and its value to investors is likely to grow.
Internalising a Scope 3 carbon price
Irrespective of whether they are subject to a regulatory carbon price or not, a growing number of firms are putting their own internal price on carbon. The three main reasons companies cite for doing so are driving low carbon investment, encouraging energy efficiency, and changing internal behaviour (see In the shadows: Everything you need to know about internal carbon pricing).
Analysis by the CDP for Reuters found that 20% of 5,345 global companies making climate-related disclosures in 2022 used an internal carbon price, up from 17% in 2021. Internal carbon prices range from close to zero to more than €1,000 per tonne CO2. The median is closer to €25 per tonne, roughly one-third of the prevailing price in the EU ETS.
Carbon taxes and compliance carbon markets typically put a carbon price on Scope 1 emissions, while only covering Scope 2 emissions indirectly via utilities obligation on electricity generation. Scope 3 emissions go unpriced. Up until recently individual companies have taken the same approach to applying an internal price on carbon.
However, as companies become more familiar with their Scope 3 emissions, and more concerned about the underlying climate and financial risk, an increasing number of companies are likely to expand internal carbon pricing to also cover Scope 3 emissions. CPD data from 2021 shows that of those companies that applied a separate internal carbon price for each scope of emissions, the median Scope 3 price was roughly double the Scope 1 or Scope 2 price.
As Scope 3 emission data becomes more accurate, other companies are likely to engage by applying their own internal carbon price - helping to drive capital to the best internal mitigation opportunities. However, the evidence suggests that the impact could be much broader than that. Scope 3 disclosure requirements and internal carbon pricing is also likely to mean that more capital is directed towards carbon credit projects.
Analysis by MSCI Carbon Markets (née Trove Research prior to its acquisition by MSCI) found that firms which purchased a ‘material’ number of carbon credits cut their emissions twice as fast as those firms that did not purchase carbon credits. The result also tallies with previous analysis conducted by Sylvera, the carbon credit rating firm. Both pieces of research revealed that those companies most engaged with decarbonising their own operations are also likely to be active in the carbon credit market, and vice versa (see Carbon credits - a permission to pollute, or a signal to decarbonise?).
Whether it’s those companies subject to climate disclosure laws, or those firms further up or down the supply chain, every business will now be under pressure to assess their carbon risk.
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.”
https://www.emmi.io/post/new-emmi-research-suggests-7billion-tonne-gap-in-scope-3-reporting