Why Companies Should Be Required To Disclose Their Scope 3 Emissions
Why Companies Should Be Required To Disclose Their Scope 3 Emissions
Investors and other market participants need information about companies’ Scope 3 climate emissions in order to make investment and voting decisions.
Capital markets today face growing risks due to the physical impacts of climate change and the legal and regulatory measures aimed at transitioning the economy away from fossil fuels. Investors and other market participants concerned about climate-related risks have placed a major focus on greenhouse gas emissions—the emissions that cause climate change. Indeed, whether and how a company is responsible for greenhouse gas emissions can have significant effects on its profitability, risk profile, and long-term resilience. As such, the U.S. Securities and Exchange Commission (SEC) should require public companies to disclose the emissions information that investors need, including Scope 3 emissions.
The leading global organization that researches and develops accounting and reporting standards for greenhouse gas emissions—known as the Greenhouse Gas Protocol—divides the emissions of companies into three categories based on the scope of the analysis. Scopes 1 and 2 generally include emissions that a company causes through its operations and energy use. A company usually has direct control over these emissions, which it can reduce, for example, by ensuring that gases do not leak from its facilities (Scope 1) or by reducing the amount of energy it uses to run its operations (Scope 2).
Scope 3 emissions, on the other hand, require a wider lens. These emissions are associated with activities up and down the value chain from the company in question and, as such, often require engagement with employees, outside companies, or consumers to address. For instance, a paper company that purchases raw materials, such as lumber, harvested from a rainforest in Africa bears some responsibility for and is exposed to some of the financial risks associated with the emissions—not to mention the biodiversity loss—from the deforestation necessary to supply the lumber. These emissions are up the value chain from that firm. For a downstream example, consider a company that makes gas-powered equipment and thus bears some responsibility for and financial risk from the emissions resulting from use of its products by customers.
The scope of this category of emissions is diverse and wide, varying by company and industry; furthermore, it is not always obvious. Yet in many industry sectors, Scope 3 emissions have grown much faster than Scope 1 and 2 emissions over recent decades. In addition to exposing companies to climate transition risks, Scope 3 emissions can potentially raise costs within a firm’s value chain, undermining profitability and, ultimately, market performance.
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Without disclosure, Scope 3 emissions are a hidden risk for investors
Public information on companies’ Scope 3 emissions is difficult to find. Without consistent, reliable, and comparable disclosures from companies, investors cannot determine if companies are living up to their stated climate commitments or how exposed they are to changing policies aimed at curbing emissions.
Notably, because Scope 3 includes emissions up and down the value chain, it is often the largest category of emissions. This is especially true for certain industries. An obvious example is oil and gas companies, whose products are responsible for a wide range of emissions down the value chain—including combustion of fuel in aircraft, trucks, heavy equipment, and cars. In fact, Scope 3 emissions account for about 88 percent of total emissions from the oil and gas sector. A low-carbon economy cannot be achieved without addressing these emissions, which is why shareholders have been pressuring companies to disclose their Scope 3 emissions and demonstrate how they are managing them.
Financial institutions are a unique example of an industry where Scope 3 emissions dominate and why it is imperative that they be disclosed. These firms have comparatively few emissions within Scopes 1 and 2. Instead, the emissions embedded in their lending, equity, and insurance portfolios are Scope 3 emissions—often referred to as “financed emissions.” In other words, the Scope 1, 2, and 3 emissions of the companies they make loans to, invest in, or insure constitute the financial firm’s Scope 3 emissions. The financial firm bears a share of responsibility and risk for those emissions based on its investment in a company. A bank that owns 30 percent of Company A, for example, should include 30 percent of Company A’s total emissions in the bank’s Scope 3 emissions.
Financial institutions are uniquely positioned to pressure a wide range of companies to disclose and manage their emissions, as presumably they, too, are interested in the potential risk to their portfolios and have the leverage to encourage customers to assess their Scope 3 emissions. Indeed, this is why federal regulators are beginning to focus on the systemic risks posed to the financial system by climate change. Transparency around Scope 3 emissions is also critical to ensuring that capital formation is aligned with the goals of investors, other market participants, and the public.
Reporting of Scope 3 emissions protects investors
Unless climate disclosure regulations require Scope 3 emissions reporting, investors and other market participants may have no way of knowing the extent of a company’s Scope 3 emissions or what steps the company is taking to reduce them.
Many of these firms, including oil and gas companies, have made commitments to reduce their climate emissions to zero by a certain date; or they may be located in a jurisdiction that has made such a commitment. For instance, federal, state, and local restrictions or fees on fossil fuel combustion could affect a firm’s inputs from up the supply chain or their ability to sell products for use down the supply chain. In July 2020, a Ceres study found that 92 percent of companies in the S&P 100 plan to set emission reduction goals—a fact that was noted by SEC Chair Gary Gensler. Yet investors concerned about climate risk cannot assess these commitments without information on companies’ Scope 3 emissions.
While reporting of Scope 3 emissions is currently voluntary under the Greenhouse Gas Protocol, there are signs that this may be changing, which could expose companies that ignore their Scope 3 emissions, along with their investors. In the United Kingdom, reporting of one type of Scope 3 emissions is already compulsory for certain companies, and the U.K. government has made it clear that more categories of Scope 3 emissions reporting will be required going forward. If the United States fails to require Scope 3 emissions reporting while the United Kingdom and other countries move ahead, investors in U.S. companies will be at a disadvantage.
Scope 3 emissions disclosure must be standardized
The data and methodologies necessary to calculate Scope 3 emissions are important to ensuring that Scope 3 emissions disclosures are reliable, consistent, and comparable for investors. But to date, they have not been fully developed for all industries. At the same time, Scope 3 emissions are a substantial part of many companies’ greenhouse gas emissions. Experience with countless disclosures in the past suggests that getting started is the fair and most efficient way to approach Scope 3 emissions disclosure, whether by starting with the largest firms or those with the greatest emissions impact or by starting with certain industries.
However, without a specific regulatory requirement to disclose Scope 3 emissions, most companies are unlikely to incorporate Scope 3 calculations into their climate risk analysis in a serious and reasonably accurate way. Worse yet, companies may make statements about Scope 3 emissions that cannot be verified because they are not part of the annual reporting that is assured by outside auditors, but rather exist in unverified narratives that could be misleading to investors.
Progress on data and methodologies for calculating Scope 3 emissions is moving fast, so it may be getting easier for both financial and nonfinancial companies to calculate their Scope 3 emissions. Clearly, in the case of fossil fuel sales, there are very accurate estimates available to gauge the emissions expected when fuels are ultimately combusted. It would be very straightforward, therefore, to require fossil fuel companies to disclose to their investors these obviously foreseeable emissions. For banks and other financial companies, meanwhile, the Partnership for Carbon Accounting Financials has been developing a U.S. platform with data and methodologies to make it easier for financial institutions to calculate their Scope 3 emissions. And for nonfinancial companies, the U.S. Environmental Protection Agency’s Greenhouse Gas Reporting Program includes a GHG Emission Factors Hub, which provides standardized data and methodologies that companies can use to calculate some of the most common emission-intensive sources under Scope 3—including transportation, business travel, product transport and employee commuting, and waste, as well as purchased electricity (Scope 2). While these initiatives do not cover all Scope 3 emissions, in time, they will cover much more.
Only with SEC direction can investors obtain the reliable, consistent, and comparable information they need on Scope 3 emissions to make informed investment and voting decisions.
These efforts alone could provide a sound basis for the SEC to take the lead by requiring and standardizing Scope 3 emissions disclosure. They demonstrate that the SEC as an agency need not have deep expertise on the science of greenhouse gas emissions, but rather can provide the leadership it was granted by Congress in the 1930s to ensure that companies are making reliable and consistent disclosures that investors can use to compare companies. Moreover, the accompanying processes of public comments, staff letters and guidance, and input from industry and investor advisory groups would expedite progress on standardizing and improving this important area of risk disclosure.
Inevitably, some companies will claim that Scope 3 emissions reporting will result in double counting, but this is not a serious problem. The goal of disclosure of Scope 3 emissions—as with Scopes 1 and 2—is not to create a national inventory, but rather to help investors understand which companies are connected to emissions and therefore exposed to increased risk. With complete information on emissions, investors can make informed investment and voting decisions. As mentioned above, this information currently is not easy for investors to find through public sources. Lack of Scope 3 emissions reporting also leaves gaps in reporting that companies may be able to exploit to avoid risk disclosure.
The SEC’s Proposed Scope 3 Emissions Disclosure Will Not Affect Farms and Ranches
The pressure is on. Investors are increasingly aware of the risks associated with a company’s greenhouse gas emissions. They want comprehensive emissions disclosures. The SEC should therefore require both financial and nonfinancial companies to begin tracking and reporting Scope 3 emissions. An SEC Scope 3 emissions disclosure requirement could facilitate standardized formats for reporting Scope 3 emissions in 10-K filings, along with standardized data and methodologies as well as a plan to phase in widespread compliance. Only with SEC direction can investors obtain the reliable, consistent, and comparable information they need on Scope 3 emissions to make informed investment and voting decisions.
The author would like to thank Alex Martin, Trevor Higgins, and Todd Phillips for their contributions to this column, and Chester Hawkins for helping create the graphic.
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Senior Director, Financial Regulation