Indirect Emissions Disclosures Are Important but Tricky

For this second article in our series about the proposed climate disclosure rule from the US Securities and Exchange Commission, experts answer: What are the main concerns with Scope 3 emissions disclosures? What does it mean for investors and companies?

Virginia Harper Ho, City University of Hong Kong

Under the proposed rules, a public company also will have to disclose Scope 3 emissions if the company has determined that Scope 3 emissions are material to investors or if it has set a Scope 3 emissions target. Scope 3 emissions are the indirect GHG emissions that are not Scope 1 or Scope 2 emissions but instead come from the “upstream and downstream” activities in the company’s “value chain”—for instance, emissions related to the goods and services it purchases from others, the products it transports or sells to others, or the investments it makes. Scope 3 emissions may be the most significant emissions source for some industries, but Scope 3 emissions data are generally not publicly available and can be difficult to find and use in a consistent and comparable way.

The SEC’s proposed rules also require companies to report on their “Scope 3 GHG intensity,” which means emissions per unit of economic value (such as total revenue) or per unit of commodity produced. For any goals the company has set, the proposed rules also require companies to report additional information about the activities and emissions the company includes in setting the target, the relevant time periods for achieving those goals, and annual data about the company’s progress toward the targets it has set.

However, reporting Scope 3 GHG emissions may pose particular challenges for some companies, some of which are addressed in the SEC’s proposal. First, Scope 3 emissions data may not be directly available to the reporting company itself, but will need to be obtained from its suppliers, customers, and other third parties. And verifying this information from other entities may be more difficult or costly than verifying the information about GHG emissions produced by the company itself or its energy suppliers (i.e., Scope 1 and Scope 2 emissions). Companies also will vary in their ability to influence their suppliers and other third parties to reduce Scope 3 emissions to meet emissions targets or goals.

Second, for companies that are not already reporting GHG emissions data in some form, the cost of new staff and new reporting processes may be significant. In an attempt to reduce the cost burden for companies, the SEC has based the proposed rules on the leading voluntary disclosure standards that many companies are already familiar with; nonetheless, the costs may be significant. Smaller public companies in particular may be less able to afford the added cost of collecting and reporting Scope 3 emissions data. For this reason, the SEC plans to exempt smaller reporting companies from the requirement altogether and to delay the requirement of Scope 3 emissions reporting for even the largest companies until filings are submitted in 2025 for the 2024 fiscal year.

Third, companies may need to rely more heavily on estimates for Scope 3 emissions. Estimates may become more important because the proposed rules specify that companies can choose their own GHG emissions calculation approach and may use reasonable estimates as long as they disclose their assumptions. Companies also will need to determine how far across the value chain to report. These uncertainties could affect the quality of the reported information and the ability of investors to compare the information meaningfully across companies and over time.

Finally, reporting on Scope 3 GHG emissions may give rise to higher liability risk for companies compared to other climate disclosures, since the reporting company cannot ensure the quality and accuracy of the information that it gets from third parties. For this reason, the SEC has proposed a new “safe harbor” that would protect companies that disclose Scope 3 information from liability for making false or misleading statements or omissions as long as the company disclosed the information in good faith and on a reasonable basis.

Christian Blanco, The Ohio State University

In 2010, 62 public companies measured and reported their supply-chain carbon emissions using the new Greenhouse Gas Protocol Product Life Cycle Accounting and Reporting Standard and the Corporate Value Chain (Scope 3) Accounting and Reporting Standard developed by the World Resources Institute and the World Business Council for Sustainable Development. These standards guide firms in measuring the life-cycle emissions of individual products and the emissions by corporations across their supply chains. By 2020, more than 1,000 public companies had estimated and publicly disclosed their Scope 3 emissions.

Early adopters of Scope 3 reporting will benefit greatly from their proactive decisions; they will be ready for the new carbon reporting requirements from the SEC.

Measuring Scope 3 emissions has benefits beyond conferring a corporate readiness to respond to mandatory reporting. The fact that many firms do it every year suggests that measuring Scope 3 emissions has intrinsic benefits. For instance, many corporations are made aware of their climate change–related risks and opportunities after they measure their Scope 3 emissions. This recognition happens because most of these climate change–related risks and opportunities are in the supply chain, rather than within the company’s direct control.

Although Scope 3 emissions standards have been around for more than a decade, much work still lies ahead in terms of verification, setting up reporting systems for suppliers to submit their carbon footprints, and monitoring products and services at the end of their life cycles. Some critiques of voluntary reporting relate to the wide variation in quality of the disclosures. I imagine that the quality of reporting expected by the SEC will be more rigorous compared to the expectations for voluntary disclosures.

But mandatory reporting poses new challenges and implications that firms haven’t needed to address with voluntary reporting. For example, what incentives are created by the SEC’s approach to assigning partially owned emissions sources? What are the implications of mandatory reporting on the allocation of and visibility into Scope 3 emissions? How will the SEC determine whether firms are reporting their Scope 3 emissions comprehensively enough? Some of these challenges have come up in voluntary reporting, but we don’t yet know what actions the SEC will take to address the issues.

Climate change reporting and carbon footprinting are not new, but these kinds of efforts have been voluntary to date. I’ve been excited to read reports from firms that had never before disclosed climate change–related data, but I also anticipate that the companies merely responding to the mandate may be less inclined to take advantage of the intrinsic benefits that are captured by those companies which are motivated to report their emissions voluntarily.

Meredith Fowlie; University of California, Berkeley

Before diving into why the Scope 3 accounting is going to be complicated and controversial, it’s worth remembering why it’s important to account for Scope 3 emissions in the first place. The SEC climate disclosure requirements apply to only a subset of the firms that emit GHGs and contribute to global climate change (e.g., publicly traded firms in the United States). If firms were required by the SEC to disclose only their Scope 1 and Scope 2 GHG emissions, they would have an ability—and an incentive—to transfer the most carbon-intensive parts of their operations to firms with less onerous reporting requirements. This behavior would reduce a firm’s Scope 1 and Scope 2 emissions—but it would not reduce global emissions. And global emissions are what climate-concerned investors should care about.

A mandate that requires Scope 3 emissions reporting is designed to broaden the accounting frame and include all GHG emissions that are emitted up and down the firm’s value chain. The mandate limits the extent to which firms can shift their GHG emissions out of accounting view. But this Scope 3 solution is not without problems.

First, requiring Scope 3 emissions reporting for publicly traded US firms could induce a “reshuffling” of supply-chain relationships. Regulated firms that are looking to shrink their Scope 3 emissions will want to source their inputs from less carbon-intensive suppliers. Less carbon-intensive inputs will, therefore, be preferentially allocated to firms with Scope 3 disclosure requirements. Highly carbon-intensive inputs may then be reallocated or “shuffled” to firms that are not subject to Scope 3 reporting obligations. In other words, counting reductions in disclosed Scope 3 emissions could significantly overstate the actual GHG reductions achieved.

Another concern is that Scope 3 accounting is going to be expensive to implement and hard to standardize or verify. Herein lies a tension: designing metrics that provide investors with a comprehensive measure of a company’s true climate impact comes into conflict with defining metrics that are relatively straightforward to calibrate, compare, and verify.

Limiting the reporting requirements to just the Scope 1 and Scope 2 emissions would keep the GHG accounting relatively simple and transparent. But if investors are concerned about a firm’s contribution to global GHG emissions, a limited accounting is akin to measuring a firm’s GHG weight with one foot off the scale. The SEC proposal includes a “materiality qualifier” that aims to balance the onerousness of Scope 3 reporting costs and the likelihood that a reasonable investor would consider these metrics as “important when making an investment or voting decision.” This will be a difficult balance to strike. But it’s a balance worth negotiating if we want to help investors understand the true climate impacts of their portfolio choices.

For more information, contact Marc Hafstead, the director of RFF’s Climate Finance and Financial Risk Initiative.

Browse the articles in this blog series about the SEC’s proposed climate disclosure rule.