GHG Emissions & Regulation

The following section outlines several important developments concerning emissions disclosure regulation and contextualises the growing importance of emissions reporting.

The push for guidelines around sustainable investing has witnessed the EU and the UK develop legislation mandating companies and financial market participants (FMPs) (e.g., asset managers, institutional investors, and insurance companies) to justify their social and environmental claims through reporting. For FMPs, in the EU, or with EU clients, the most relevant regulations are the EU’s Sustainable Finance Disclosures Regulation (SFDR) and the UK’s Sustainable Disclosure Requirements (SDR). Emissions disclosure and analysis will be critical under these regulations as they will govern what financial products can be classified as “sustainable.”

The SFDR employs a principle adverse impacts (PAI) regime whereby asset managers must report a variety of social and environmental indicators associated with negative social and environmental externalities. Under this regime, FMPs will need to demonstrate that they have considered their own negative impact (i.e. entity-level disclosure) on environmental and social issues in addition to the impact of their products’ underlying assets (i.e. financial product disclosure). If managers are claiming to make sustainable investments, they will need to disclose how their decision is aligned with the Do No Significant Harm (DNSH) principle which requires an investment to not significantly harm any of the SFDR’s environmental or social objectives. Demonstrating compliance with PAI disclosure and the DNSH principles requires emissions analysis, as currently 25% of the mandatory environmental indicators used to validate these concepts are related to GHG emissions.

Under the SFDR, FMPs will need to explore tolerances around GHG emissions, navigate reporting in the instance of short-term holdings, and offer benchmarking analysis for end investors. In June 2022, the joint committee of the European Supervisory Authorities (ESA) issued clarifications on the SFDR’s Regulatory Technical Standards (RTS), mentioning that an analysis of a PAI indicator over time (e.g., GHG emissions) could be used to illustrate the sustainable impact of an investment. Given that the UK’s SDR follows a similar approach, any investment manager currently or considering venturing into sustainable investing in the UK and EU will need to robustly analyse and disclose their portfolio companies’ GHG emissions.

These regulations will be supported by company-focused non-financial reporting legislation such as the EU’s Corporate Sustainability Reporting Directing (CSRD) and the UK’s Task Force on Climate-Related Financial Disclosures (TCFD) aligned requirements. The CSRD will require all public and private companies with over 250 employees and/or €40 million in turnover to disclose sustainability-related metrics accompanied by mandatory external assurance. The TCFD-aligned requirements will compel public and private companies in the UK with over 500 employees and £500 million in turnover to disclose in line with the TCFD framework. Similar mandatory non-financial reporting proposals have been made in the US regarding public companies with public Securities and Exchange Commission (SEC) registered securities, as covered by 9fin here.

GHG Emissions in Practice

A recap on greenhouse gas emissions (GHG)

Over the past three decades, carbon dioxide (CO2) has become synonymous with the term emissions. However, CO2 is only one of several greenhouse gases (GHGs) that causes atmospheric warming, meaning companies must also assess and report GHG emissions linked to methane, nitrous oxide, and fluorinated gases. Even though GHGs possess different warming effects, non-CO2 GHG emissions will often be bundled with CO2 emissions in a company’s environmental disclosures and reported as CO2 equivalents (CO2e) through the use of a global warming potential factor.

Organisational Boundaries

GHG emissions reporting begins with a company defining what parts of the organisation it will report on (i.e, its organisational boundary). There are two primary methods to establish an organisational boundary: the equity share approach (e.g., a 20% equity stake in an entity would entail reporting 20% of that entity’s emissions) and the control approach, which may be based on financial or operational control.

Awareness of these boundary differences is important as a company’s GHG emissions may differ depending on which method is used (for better or worse!). For example, oil and gas companies will often have non-controlling equity stakes in multiple firms, meaning using an equity boundary will result in higher reported emissions than an operational control approach. While not in 9fin’s coverage universe, the below examples of Shell and Totale Energies are illustrative of the material difference in their emissions reporting only depending on how they calculate their organisational boundaries.

The Scopes

The level of control a company has over emission-generating activities in its value chain is referred to as an emissions “scope”. These scopes can be categorised as direct (i.e. Scope 1) and indirect emissions (i.e. Scope 2 and 3). Concerning indirect emissions, Scope 2 refers to emissions related to the purchase of electricity, steam and heating and cooling, while Scope 3 describes emissions that are produced across a company’s value chain but are not owned or controlled by the company (see here for a full list).

GHG emissions are conventionally measured by calculations based on energy usage and emission factors rather than direct measuring using devices like sensors. Therefore, while access to data is generally not an issue in developed economies, in emerging markets, the lack of precedent and infrastructure around emissions reporting means that even when data is reported it is often incomplete.

The division of scope 1 and 2 emissions is important in avoiding “double counting.”  Without distinguishing between Scope 1 and 2 emissions, the same Scope 1 emissions could be allocated to both an electricity seller and an electricity purchaser, eroding the accuracy of emissions-related initiatives like carbon-trading schemes (used exclusively for Scope 1 emissions). However, more pertinent is the increasing tendency for companies to report Scope 2 emissions using the "market-based method." The market-based method takes into consideration “contractual instruments,” most commonly, energy attribute certifications (e.g., Renewable Energy Contracts (RECs) and Guarantees of Origin (GOs)). This is in contrast with the “location-based” method which is calculated using the average emissions intensity of the local electricity grid. The benefit to reporting companies in using the market-based methodology is that by including RECs, companies may subtract purchased renewable electricity from their total Scope 2 emissions.

Scope 2: Market-based vs Location-based

The argument for the market-based method is its potential to incentivise green energy production and its recognition of energy purchased from renewable energy providers. However, because some types of energy credits sell at a considerable discount and only represent the purchase of renewable energy and not actually the use of renewable energy, there is concern that these credits are simply being used as a way to reduce the Scope 2 emissions. While the Science Based Target Initiatives (SBTi) permits companies to reduce Scope 2 emissions through RECs, research shows that using exclusively a market-based approach has inflated corporate emissions reduction progress. When investigating Scope 2 emissions, good practice always involves assessing both sets of Scope 2 emissions.

Scope 3: Other Indirect Emissions

Unlike Scope 1 and 2 emissions, where calculation is relatively standardised, reporting Scope 3 emissions is where the greatest methodology discrepancies between companies exist. This is problematic because estimates indicate that Scope 3 emissions represent anywhere between 40-90% of a company's total carbon footprint. For investors, looking at Scope 3 emissions will no longer be optional, as the SFDR will require FMPs to assess Scope 3 emissions as part of the PAI regime beginning in January 2023.

Over the past decade, guidance for Scope 3 reporting has improved in response to corporate reporting initiatives and regulatory pressure. Nevertheless, in 2022, more than 40% of publicly listed companies reporting Scope 1 and 2 emissions do not report Scope 3 emissions.

This is the result of several factors. Under the GHG’s Corporate Standard companies can choose to report Scope 3 emissions partly or not at all. Calculating emissions across the corporate value chain depends on a combination of data sourced from supply chain actors and product-level emissions estimations, creating challenges around data availability and accuracy.

Scope 3 emissions reporting is associated with high levels of inaccuracy, with a report finding a 44% difference between the medians of Scope 3 emissions for verified and unverified reports.

Use and misuse of Net-Zero & Carbon Neutrality

Net-Zero and carbon neutrality are concepts that refer to the reduction of GHG emissions.

Understanding their differences is important because these terms are commonly and incorrectly used interchangeably in companies’ sustainability reports. Both concepts reflect the goal of reducing CO2, but the difference lies in the scope and how carbon will be reduced.

Carbon neutrality is primarily focused on not increasing CO2 emissions (Scope 1 and 2) and using offsets to reduce remaining GHG emissions. Net-Zero focuses on reducing all GHG emissions (Scope 1-3, and not just CO2) and using offsets exclusively for unavoidable residual emissions.

A Net-Zero target is therefore much more closely aligned with the Paris Agreement’s goal of limiting global temperature increase to 1.5°C than a climate-neutral target and thus requires more onerous operational and supply chain adjustments. Because of the lack of understanding and regulation around Net-Zero, coupled with the term’s popularity and the difficulty in actually achieving it, Net-Zero claims are prime targets for greenwashing.

At 9fin, part of our analysis of Net-Zero claims involves determining whether a company has committed to the SBTi’s Net-Zero target which offers verification that a company’s Net-Zero roadmap has been substantiated by a third party and is aligned with climate science. The SBTi has been criticised from some quarters, with accusations of insufficient and opaque methodologies and conflicts of interest arising from its fee-based model. Thus, when analysing Net-Zero targets, SBTi validation should be one consideration of many.

Limitations of GHG Emissions Data

Scope 1-3 emissions are static and backward-looking; unlike financial performance, the vast majority of companies in 9fin’s company universe only disclose their GHG emissions annually, often with a 1-2 year lag. Further, emissions figures do not address how a company’s facilities or supply chains are exposed to climate-related disasters (e.g., floods or hurricanes) and provide little information regarding a company’s response to forthcoming environmental-related risks (regulatory or physical).

A 2021 Task Force on Climate-Related Financial Disclosures (TCFD) consultation reflects these concerns, finding widespread demand for climate linked forward-looking financial metrics. However, forward-looking metrics are not conventionally reported by companies and there are challenges to modelling metrics like climate value-at-risk (i.e. a risk measure for estimating the amount of financial loss due to climate change) and unpriced carbon cost (the difference between what a company pays for carbon today and what it may pay at a given future date) given the non-linear impacts of climate change and its complex drivers.

Establishing an accurate assessment of how climate risk relates to a business's future financial performance and identifying pathways for mitigation depends much more on evaluating a management team's materiality assessment and its risk-management processes than on just analysing Scope 1-3 emissions metrics.

Companies provide information on their GHG emissions performance which can be misleading, incomplete, or difficult to parse. specific examples/insights from our ESG team9fin's ESG Team has witnessed this manifest in several ways. This article was originally published to clients with a list of what to look out for when analysing GHG emissions based upon specific insights from our team. To request this list please complete your details here.