November 7

More harm than good: scope 3 emissions disclosures risk being too broad

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The other evening, I was a panellist at an event bringing together energy companies, investors, bankers and other interested parties, to discuss the ways in which companies and investors communicate on issues relating to the energy transition. We discussed various questions around what investors want from companies, how engagement should work, and the approach to scope 3 emissions.

While I have noticed a distinct and welcome trend in the past year or so among investors to move away from previous simplistic approaches to “ESG” (environmental, social and governance-based) investing, this discussion of scope 3 emissions was a timely reminder that not everything is moving in the right direction.

There are a number of reasons that ESG has somewhat fallen out of favour recently. Firstly, and most importantly, high energy prices over the past year have seen oil and gas stocks outperform other parts of the economy, while ESG portfolios have underperformed. Secondly, there has been something of a cultural backlash, particularly in the US, where concerns over green-washing and “woke capitalism” have seen an increasing politicisation of the subject. Thirdly, there has been a realisation that environmental and social concerns are not black and white, and that a more nuanced approach to projects might be more aligned with their overall objectives.

One of the other panellists highlighted that the key objective for investors is to generate returns, and that they view questions around transition risks from an economic rather than ideological standpoint. This is not always the case – I have seen worthwhile projects denied funds on the basis they involved fossil fuels, and just recently wrote about the exodus of banks from financing projects in the UK North Sea, which is counter-productive since in the absence of demand reductions a lack of domestic production will simply result in more imports, and there is no expectation that demand for oil and gas will go away in the coming decades.

In my discussions with investors over the past year, the main topic of interest has been around power grids, and in particular issues around connection queues, reliability and the backlogs of infrastructure investments. Investors are realising that many projects are being held up due to a lack of grid capacity, and that delivering those upgrades could take a long time and cost a lot of money. This obviously presents both risks and opportunities, and makes investments in mining particularly interesting from a fundamentals perspective.

To a slightly lesser extent, concerns about grid reliability are also on investors’ minds, not least in the US where there have been well-publicised threats of rolling blackouts during the peak summer months.

These, in my opinion, are sensible considerations for investors to occupy themselves with. But at the same time, there is pressure for companies to take responsibility for the impact they have on the environment and on people. Some of this is entirely reasonable, but the disclosures are some-what one-sided and as a result could drive unintended adverse consequences.

This was seen in Sri Lanka – in April 2021 the country was hailed as leading the world when it implemented a ban on synthetic fertilisers, but within months, agricultural yields had collapsed and the country went from a net exporter to net importer of rice. Economic collapse and an IMF bailout followed. The ban was quietly dropped in November 2021. This was a prime example of a well-intentioned but badly thought-through policy – a heavy-handed approach to environmental reporting could well create similar problems if companies are dis-incentivised from producing important products on the basis of their environmental impact.

New EU listed company ESG reporting rules

Back in January 2023, new ESG reporting rules came into force in the EU – the Corporate Sustainability Reporting Directive (“CSRD”) covering both EU  and non-EU companies meeting certain thresholds for net turnover in the EU, and companies with securities listed on a regulated EU market. The rules will be phased in starting from 1 January 2024 some larger companies, and will apply to all in-scope companies by 1 January 2028.

Companies will be required to disclose information both about how sustainability-related factors, such as climate change, affect their operations and information about how their business model impacts sustainability factors, covering environmental, social and human rights, and governance factors. Environmental factors include not only climate (including Scopes 1, 2 and 3 greenhouse gas emissions – see below) but also water/marine resources, circular economy, pollution and biodiversity.

Companies will have reporting obligations under the CSRD if they:

are “large” EU entities or groups (they are part of a consolidated group which meets at least two of: (i) a balance sheet total exceeding €20 million, (ii) net turnover exceeding €40 million, and (iii) average number of employees during the financial year exceeding 250;
have securities (including debt securities with denominations lower than €100,000 or equivalent or depositary receipts) listed on an EU regulated market (except micro-enterprises); or
are non-EU entities with significant EU revenues and an EU branch or subsidiary.

Non-EU entities will fall into the third category if they have annual net turnover in the EU exceeding €150 million for each of the last two consecutive financial years and have at least one large subsidiary, one subsidiary listed on an EU regulated market, or one branch in the EU that generated over €40 million in annual net turnover the preceding financial year. Disclosures by non-EU entities will be required to cover their consolidated global group, not just their EU subsidiary or branch, but their reporting requirements are likely to be less onerous than for EU groups.

Large EU and EU-listed entities (other than large listed entities) will be exempted from reporting if their parent prepares a consolidated group report that is either prepared in accordance with the CSRD or prepared in accordance with reporting standards that the European Commission deems equivalent to the CSRD and includes certain key performance indicators.

Under CSRD, companies will have to disclose how sustainability considerations are integrated into their businesses and how material ESG impacts, risks and opportunities are identified and managed. Disclosures will be required to follow what the EU calls a “double-materiality” perspective, covering both the impacts of their activities on people and the environment, and how various sustainability matters affect the company. The disclosures will take into account short-, medium- and long-term time horizons and contain information about a company’s value chain, own operations, products and services, business relationships and supply chain, where applicable.

Disclosures will cover a range of ESG-related topics, including:

Environmental disclosures for each of the EU Taxonomy environmental objectives, which are climate change mitigation (including scope 1, scope 2 and sj`cope 3 greenhouse gas emissions), climate change adaptation, water and marine resources, resource use and circular economy, pollution, and biodiversity and ecosystems;

Social and human rights disclosures covering information on gender equality, working conditions and respect for human rights as defined by core United Nations and EU human rights conventions; and
Governance disclosures covering information on how the company’s administrative, management and supervisory bodies manage sustainability matters, risk management and internal controls over the sustainability reporting process, business ethics and lobbying activities.

Companies will have to report on plans to ensure their business models are compatible with the goal of limiting global warming to 1.5 °C in line with the Paris Agreement and the European Climate Law, which aims to achieve climate neutrality by 2050. They will also have to outline the due diligence processes implemented with regard to sustainability matters, including any actions taken to prevent or mitigate adverse impacts in their own operations or value chain.

Companies will be required to obtain third-party assurance over their CSRD disclosures, initially this will be “limited” assurance, such as confirmation no matter has been identified which suggests the information is materially incorrect, but by 2028, the European Commission plans to adopt standards for reasonable assurance analogous to the standard currently required for financial statements.

Members of a company’s administrative, management and supervisory bodies will have “collective responsibility” for ensuring that sustainability information is prepared and published in accordance with CSRD requirements.

The European Sustainability Reporting Standards (“ESRS”) were adopted in August 2023 and apply to all companies within the scope of CSRD. Some reporting entities within the scope of CSRD will have to apply ESRS for reporting periods commencing on or after 1 January 2024. Twelve Standards have been issued:

Two cross cutting Standards which apply to all sustainability matters:

ESRS 1 – General Requirements
ESRS 2 – General Disclosures

Environmental Standards

ESRS E1 – Climate change
ESRS E2 – Pollution
ESRS E3 – Water and marine resources
ESRS E4 – Biodiversity and ecosystems
ESRS E5 – Resource use and circular economy

Social Standards

ESRS S1 – Own Workforce
ESRS S2 – Works in the value chain
ESRS S3 – Affected communities
ESRS S4 – Consumers and end-users

Governance Standards

ESRS G1 – Business Conduct

There is some phasing in which has been proposed:

Reporting entities with fewer than 750 employees may omit:

For the first year of applying the standards, scope 3 GHG emissions data and the disclosure requirements specified in the standard on ‘Own Workforce’.
For the first two years of applying the standards, the disclosure requirements specified in the standards on biodiversity and on value-chain workers, affected communities, and consumers and end-users.

All reporting entities in the first year of applying the standards may omit:

The anticipated financial effects related to non-climate environmental issues (pollution, water, biodiversity, and resource use). They can then provide qualitative disclosures only on the financial impacts of these disclosures for a further two years.
Certain datapoints related to their own workforce (social protection, persons with disabilities, work-related ill-health, and work-life balance). All these datapoints are included in ESRS S1 (Own Workforce).

The EC has decided that many of the disclosures and datapoints that were mandatory in the first draft of the ESRS will now become voluntary, including biodiversity transition plans, certain indicators about ‘non-employees’ in the undertaking’s own workforce, and an explanation of why the undertaking considers that a particular sustainability topic is not material.  The EC has also introduced some flexibility around the disclosure of mandatory datapoints. For example, in disclosing the financial effects arising from sustainability risks and on engagement with stakeholders, and in selecting which methodology should be used for the materiality assessments.

There have been efforts to ensure interoperability with standards set by the International Sustainability Standards Board (“ISSB”) however, companies applying ESRS will not automatically meet the requirements of the ISSB so companies need check the differences between the two Standards if both sets are being applied.

In the US the Securities and Exchange Commission has proposed its own expansive climate related disclosure rules which are expected to be confirmed next year, while in the UK, climate disclosure requirements apply to certain large private UK incorporated companies and all companies with UK-listed equity, but unlike the CSRD do not extend to non-UK companies without a UK listing. The UK climate rules also do not currently require scope 3 greenhouse gas emissions disclosure and has issued a call for evidence on the costs, benefits and practicalities of scope 3 greenhouse gas emissions reporting in the UK.

Scope 1, 2 and 3 emissions reporting

For those who are not familiar with these terms, they first appeared in the Green House Gas Protocol of 2001 and are now the basis for mandatory greenhouse gas reporting in the UK and elsewhere.

Scope 1 emissions are the greenhouse gas emissions that a company produces directly through its operations;
Scope 2 emissions are emissions a company produces indirectly for example through the electricity it uses in its operations – it does not generate the electricity itself but someone else must do so on its behalf;
Scope 3 emissions are all the emissions for which a company is indirectly responsible, both up and down its value chain. This includes the emissions from both its suppliers and its customers.

The first two are entirely reasonable, but the third is, in my opinion, quite problematic, and so the growing attention it is getting from policy-makers is concerning.

My first big problem with scope 3 emissions is that it conflates two separate things: the upstream supply chain and downstream customers. Companies can reasonably exert influence over their suppliers – they can and should ensure that suppliers operate ethically (eg avoiding forced and child labour, adhering to environmental standards and so on) and that they have reasonable plans to improve their environmental sustainability. Not all companies will have the capability to improve their environmental sustainability in a meaningful way, either because they are already sustainable, or because there is minimal scope for improvement.

For example, a hydroelectric company that operates a fleet of legacy assets will have minimal emissions. It still needs to manage water resources responsibly, treat staff and suppliers fairly and so on, but there probably isn’t a lot it could do to be more sustainable because it already is. A mining company will find it materially more difficult to become environmentally sustainable because the very nature of extraction industries is to take something out of the ground for consumption elsewhere. It may be able to reduce production emissions, and should take all reasonable steps to clean up sites when they are closed, but the fundamental nature of the business means it will never be sustainable, and trying to make it look as if it is, is likely to be an expensive exercise in futility.

All companies can try to ensure their suppliers are as clean and ethical as possible, but there are natural limits to this as well. China dominates the market for rare earth metals used in wind turbines, electric cars and a host of other industrial applications. They are an essential raw material that is difficult to source elsewhere at scale. It is extremely hard to impose operational obligations onto Chinese companies, and since competition for these scare resources is intense, attempts to do so may result in a loss of supply. Windfarm developers face the choice between not building their windfarms, or accepting key raw materials on the basis on which the supplier is willing to sell them, which puts them in something of a lose-lose situation: trying to comply with the expectations inherent in scope 3 reporting will be next to impossible.

Even more difficult is holding companies accountable for what happens after they sell their product. If it is hard for companies to influence their suppliers, particularly where those suppliers have market power, it is harder still for them to influence their customers. Inherent in the scope 3 approach is an assumption that companies should assist their customers in reducing emissions, for example by reducing the emissions from their products or encouraging limitations to their use. This might make sense for car companies – they can develop more efficient engines or make cars lighter, which would reduce fuel consumption, or develop electric or hybrid alternatives, or new types of combustible fuels.

It’s significantly harder for companies which produce raw materials. If you dig copper out of the ground, that copper can be used in a huge range of different ways, some of which will involve significant greenhouse gas emissions. A mining company might sell its copper to a cable company which in turn sells to an electricity grid operator which will use it to connect renewable generation to its network. How should the mining company measure these emissions? Does it get some credit for the renewable generation displacing a coal power station for example? But what if it is used to connect a new coal power station instead of a windfarm – can the mining company be responsible for what its customer does with the product it makes with those raw materials, particularly when the range of possible applications is so wide?

Another consideration is around toxicity. It is desirable, in general, for companies to ensure their products or products made from the raw materials they produce, do not pollute the environment. But this can be difficult to avoid. For example, there is evidence that certain medications, particularly hormones and antibiotics are finding their way into water courses as a result of human and animal use of these medications. There is a danger that focusing on the downsides without also considering the benefits might ultimately lead to the withdrawal of some important products. Lots of medications have the potential to be toxic to the environment, and yes, efforts should be made to reduce their impact, but the emphasis of climate and sustainability reporting is on the negative rather than positive impacts and could lead to unintended consequences.

“It is sometimes argued that public reporting requirements are beneficial for companies. They can help to persuade reluctant boards to take ESG issues seriously or provide those companies that are already doing so an opportunity to demonstrate their leadership on these issues. In some cases, they can provide a framework for business planning and risk management. That is all undoubtedly true, but conversations with companies in recent months suggest that there are also potential adverse impacts on companies that may be underappreciated. It should be emphasized that none of these companies argued against the importance of addressing and reporting on material ESG issues, but they had concerns about the volume and content of the data being demanded and how it is used,”– Chris Hodge, Special Advisor, Morrow Sodali

This quickly turns into a huge headache for everyone except for the myriad of consulting companies that have sprung up to “help” companies tackle this whole question – the market for ESG reporting and data management software is forecast to exceed US$4.3 billion by 2027, according to research and advisory firm Verdantix. And often the advice is quite naïve. For example, suggesting companies reduce the distance between the supplier and the customer to reduce distribution emissions. How does that work in practice? Should the company refuse to sell to consumers who are far away? Do those consumers have alternative suppliers from whom they can buy? Should the company build a new factory closer to its customers? Wouldn’t that involve even more emissions?

Companies are not unreasonably concerned about the costs of complying with these significant new disclosure obligations with some worrying they are excessive. Sportswear company Puma has said meeting EU requirements would be a challenge.

“We are nowhere near being able to fulfil the requirements of CSRD… So I think it’s maybe a bit over the top,”– Stefan Seidel, Head of Sustainability at Puma

A recent report by Sustainable Fitch found that increasing regulatory requirements are leading to “rising levels of regulatory and compliance fatigue among corporates and investors”, as well as highlighting “persistent concerns about the interoperability of an ever-greater number of taxonomies introduced”. The Open University recently found that just 8% of UK companies surveyed have a fully realised ESG strategy, with lack of financial resources (28%), missing essential skills (24%) and complexity (23%) being cited as key barriers.

Compliance with these new reporting obligations is going to be challenging for companies. Vast amounts of data must be collected, and efforts made to validate their veracity, which will take time and resources. But with the recent under-performance of ESG funds, and the litigation risks described below, it may be that some of this effort turns out to be pointless.

The threat of climate litigation

Of course, there are benefits to be gained from thinking about managing waste and end-of-life questions for products, but a lot of the scope 3 analysis seems to go way beyond this, and intrude on the choices made by downstream users of a company’s products irrespective of any further transformation which may have taken place. And while most people might be inclined to dismiss such concerns, they quickly become serious if they are used as a basis for litigation.

According to the Grantham Research Institute on Climate Change and the Environment, 28 cases aimed at preventing the flow of finance to high emitting or harmful projects or activities have been filed globally, 14 against public bodies or state-owned financial institutions (such as export credit agencies), and 12 against private parties including banks and pension funds. 14 cases challenge a government or corporation for failure to adapt to the requirements of the climate crisis, either by failing to adapt property or operations to physical risks or by failing to consider transition risks. cases seeking monetary damages or awards from defendants based on an alleged contribution to climate change harms have been filed. These include cases seeking compensation for past and present loss and damage associated with climate change; contributions to the costs of adapting to anticipated future climate impacts; compensation to ‘offset’ emissions, where defendants’ activities have caused damage to carbon climate sinks.

“Efforts to establish corporate responsibility for harm from climate change caused by products have gained traction in recent years. Around 60 cases have been filed globally against the so-called ‘Carbon Majors’, with 20 of the 29 US cases filed by cities and states,”– Joana Setzer and Catherine Higham, Grantham Research Institute on Climate Change and the Environment

Corporate liability cases have been characterised by significant differences in the type of relief sought, with some claimants seeking financial damages based on historic responsibility, while others are more forward-looking, seeking to force companies to align their activities with the Paris Agreement and human rights obligations. Recently some cases have merged both eg Asmania et al v Holcim and Greenpeace Italy et al v ENI SpA.

Loss and damage arguments are increasingly prevalent in polluter-pays cases. In Municipalities of Puerto Rico v. Exxon Mobil Corp, fossil fuel companies are accused of continuous deception, amounting to racketeering and damages are being sought for the losses suffered by communities during the 2017 hurricane season. The case uses claims under the Racketeer Influenced and Corrupt Organizations Act (“RICO”), which was previously used against the tobacco industry.

But while it is difficult to identify any non-harmful uses for tobacco, there are very many benign uses of hydrocarbons. For example, hydrocarbons are widely used in medical settings. Plastic machine casings, mattress covers, IV packaging, adhesives and some bandages and dressings all contain hydrocarbons. A lot of the personal protective equipment, disinfectants and hand sanitisers are made from hydrocarbons. As are many medical devices including artificial heart valves and prosthetics. Diagnostic equipment, including MRI machines, also have major parts that are made from petroleum-based materials. Aspirins and other pharmaceuticals also contain petroleum as do other analgesics, antihistamines, antibiotics, antibacterials, rectal suppositories, cough syrups, lubricants, creams, ointments, salves, and many gels. Petrochemicals are used in radiological dyes and films, intravenous tubing, syringes, and oxygen masks. Of course, ambulances and helicopter air ambulances depend on petroleum. Most medical supplies and equipment are shipped — often from overseas — in petroleum-powered carriers.

Legislation seeking to make corporations responsible for the direct and indirect harms their products may cause are very one-sided. But what about the benefits? How do you evaluate what is fair if a person who survived cancer later dies as a result of climate change, when many cancer treatments are derived from hydrocarbons? If the hydrocarbons had not been produced then the climate harm might have been avoided, but the person might have died years previously from their untreated cancer. Would the people of Puerto Rico prefer a world with no hydrocarbons if that also means a world without modern medicine?

Several cases against car manufacturers in Germany seeking to prohibit the production and sale of internal combustion engine vehicles have been dismissed. However, new cases continue to be filed invoking “due diligence” obligations, including cases involving financial institutions.

Some climate litigation focuses on mis-information eg companies claiming to be “net zero” or having net zero policies when they are not or do not in practice. I have no objections to this – businesses should not seek to mislead their investors, customers, regulators or anyone else. But I have a big problem with litigation with only focuses on the downsides of certain products without considering their benefits.

In a world of greys we need to stop thinking in black and white

Most investors and business, when asked, say they care about ESG and that managing transition risks is important to them. But this is not necessarily reflected by their behaviours. The same can be said of the public – people often say they care about the environment but seem reluctant to accept any associated increase in cost, as evidenced by recent softening of climate rules in response to public concerns over the costs of the transition. The fact that is that people tend to lie to make themselves look good, and will often choose the cheapest rather than most socially responsible approach, threaten to undermine to benefits of ESG reporting.

ESG reporting may, in many cases, be a waste of time if it does not lead to any change in behaviour either by companies or investors. And there are significant litigation risks associated with these additional disclosures, particularly in the US.

To a certain extent, oil and gas companies are losing the PR war. They are more widely associated with negative rather than positive outcomes, and most people probably don’t think twice about where medical equipment etc comes from. It is interesting to see climate protesters wearing clothes made from hydrocarbons or sticking themselves to roads using adhesives made from hydrocarbons. (Yes, there are non-hydrocarbon based adhesives, but they tend to be water soluble which isn’t ideal if you’re gluing yourself to something as a protest since you can be easily un-stuck. Literally.)

I was asked recently what I would do if I was a senior oil executive, and my answer was “take myself private” since a lot of the problems these companies are facing derive from being public companies. Climate litigation would be much more difficult for claimants to progress if it weren’t for stock exchange disclosure rules covering listed companies. And there would be fewer distractions from activist shareholders since there probably wouldn’t be any.

Investors have come to realise in the past year that defence stocks are not all bad given the need to supply Ukraine. When a country is invaded it can either surrender and live under occupation or it can fight back, but that takes guns, and bullets, and bombs and tanks, all of which have to be made, normally by for-profit companies. And that is not inherently wrong because a country defending itself against foreign aggression cares that the bombs etc are well-made and effective, and not how much profit the company made or what level of bonuses its executives earned. Or even whether producing or using those munitions was environmentally harmful.

Similarly, oil and gas are not uniformly good or bad. Without hydrocarbons, modern life would not be possible, and very few people believe that we should simply forgo all of their benefits in order to limit climate change. Oil and gas companies should keep producing oil and gas, and work to make their processes as clean as possible. But they should not be forced to worry about whether their product is used for “bad” uses (combustion) or “good” uses (medicines).

The event I attended focused a lot on “companies managing their transition risks”. Many of these risks are the invention of policy-makers and activists – only a subset are genuinely real eg if climate change increases the incidence of hurricanes then oil and gas platforms in the Gulf of Mexico might face larger risks.

One of the core functions of the financial services sector is to identify, measure and manage risk. Climate risk should not be treated any differently from any other sort of risk, and that means distinguishing between real, fundamental risks, political and regulatory risks, litigation risks and meaningless noise. Unfortunately, a lot of what is currently discussed in relation to scope 3 emissions falls into that latter category, but is given an importance it doesn’t merit by the mis-guided actions of policy-makers.

Care needs to be taken that climate frameworks such as the greenhouse gas scopes are realistic and reasonable. Yes, companies should build clean and ethical supply chains, where possible, and yes, they should try to ensure that their products do not result in toxic waste, can be re-cycled or have suitable end of life or disposal pathways. But we saw during covid that the large amounts of waste PPE such as discarded facemasks were considered a small price to pay for their safety benefits (which were actually quite tenuous but that is beside the point) – people cared less about the waste than the utility of the products. This will always be true for some products, and some of those will be made from hydrocarbons.

True risk management isn’t a tick-box exercise, and nor should this be, but climate reporting frameworks risk reducing them to this, and that does not help anyone.

Source: Watt-logic.com

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