Why Did the SEC Leave Out Scope 3?

The Securities and Exchange Commission (SEC) has released on March 6, 2024, its final recommendation on the reporting of greenhouse gas emissions for large public U.S. companies. We look closer at this event and use it to tell you a bit more about carbon footprints, scopes of emissions, and other important notions relating to sustainability.

Regulations and reporting of companies are often complex topics which can be expanded at will. We propose here to provide a simple overview of some important terms that are often used by regulators and practitioners in the field of sustainable finance. Armed with these definitions, we will then discuss some of the elements of the decisions taken by the SEC, with the hope that you will then have a better ability to read about this topic by yourself.

Transition risks, carbon footprints, and scopes

Sustainable finance uses a lot of different terms (and acronyms!), and it can sometimes feel overwhelming to follow a discussion with all these technical terms. So let us define a few essential ones, which you probably have heard on many occasions by now.

Transition risk: the financial risks associated with the transition to a low-carbon economy. These risks arise from the significant structural changes to energy systems, technologies, market preferences, and regulations aimed at addressing climate change. They affect asset values, profitability, and the viability of certain business models, and include several components:

1. Policy and Legal Risks: changes in policies, regulations, and laws aiming to reduce GHG* emissions can increase costs for certain sectors, affect market demand, or impose fines and liabilities on non-compliant companies. This includes carbon pricing, emissions reporting requirements, and restrictions on activities or products.

2. Technology Risks: the development and adoption of new technologies that reduce emissions can disrupt existing markets and render current technologies or products obsolete. Companies that fail to innovate or adapt may face reduced demand, loss of market share, or stranded assets.

3. Market Risks: changes in supply and demand for goods and services due to the transition can affect profitability. For example, shifts in demand in the energy sector.

4. Reputational Risks: stakeholder (e.g. consumers, employees) perceptions of how a company is responding to climate change can affect its reputation and profitability.

5. Regulatory Risks: Beyond direct policy changes, regulatory risks can include increased disclosure requirements related to climate risks and GHG emissions. This can impact companies' reporting obligations, transparency requirements, and potentially expose them to legal and financial repercussions for non-compliance.

*GHG: Greenhouse Gases

Carbon footprint: it refers to the total amount of greenhouse gases, especially carbon dioxide, emitted directly or indirectly by an individual, organization, event, product, or activity, measured in units of carbon dioxide equivalents.

The GHG Protocol is a widely used international standard for accounting and reporting greenhouse gas emissions. It categorizes GHG emissions into three scopes:

• Scope 1 (Direct Emissions): these are emissions from sources that are directly owned or controlled by the entity. This includes emissions from combustion in owned or controlled boilers, furnaces, vehicles, etc., as well as emissions from chemical production in owned or controlled process equipment.
  

• Scope 2 (Indirect Emissions from Electricity, Heat, or Steam): these emissions result from the generation of electricity, heat, or steam that the entity consumes but does not produce. They are indirect emissions because they occur at the place where the electricity, heat, or steam is generated, not at the entity's site. Scope 2 accounts for the emissions inherent in the energy purchased and used by an organization.
  

• Scope 3 (Other Indirect Emissions): these are the emissions that are a consequence of the activities of the entity but occur from sources not owned or controlled by it. This can include emissions associated with the production of purchased materials, the waste generated in operations, employee travel and commuting, transportation and distribution (both upstream and downstream), the use and end-of-life treatment of sold products, etc.

Scope 3 emissions often represent the largest source of greenhouse gas emissions for organizations (people often cite a number of ~70%) and is often the most challenging source of emission to quantify and manage. For these reasons, scope 3 is not always included in the carbon footprint, as it can significantly impact the assessment of a company and reduce the reliability of the quantitative estimates.

Nevertheless, understanding and managing Scope 1, 2, and 3 emissions are crucial for comprehensive greenhouse gas accounting, helping entities to identify opportunities for reducing their environmental impact and contributing to global efforts against climate change.

Last, one can sometimes read or hear about Scope 4 emissions, often referred to as "avoided emissions". This term is not officially recognized by the GHG Protocol or other standard emissions accounting frameworks. Instead, this concept emerged to describe the positive impacts an organization's products or services have on reducing emissions outside of its direct control. These are emissions that avoided due to the use of a company's products or services compared to a higher-emitting alternative, highlighting the positive impact the products or services have on reducing GHG emissions in the broader economy.

The SEC final ruling

The SEC's proposed rules have been released on the SEC's website, and the rule is about 900 pages long! What we can learn from its press release and fact sheet is that the rule's main purpose is to enhance and standardize climate-related disclosures for the benefit of investors. Given the growing base of investors demanding information from companies regarding their climate-related impact and risks, the SEC is protecting their rights to make better informed decisions, and help improve the transparency of the financial markets. Companies will thus be enforced to disclose climate risk metrics which are deemed financially material, in both their registration and periodic reports, and this includes GHG emissions.

The most noticeable requirements are those directly listed on the SEC's website, that we present and simplify below:

• "Climate-related risks that have had or are reasonably likely to have a material impact on the registrant’s business strategy, results of operations, or financial condition;" ↪ disclosing what are the risks exposures.
  

• "The actual and potential material impacts of any identified climate-related risks on the registrant’s strategy, business model, and outlook;" ↪ describing the potential financial impact of those risks.
  

• "If, as part of its strategy, a registrant has undertaken activities to mitigate or adapt to a material climate-related risk, a quantitative and qualitative description of material expenditures incurred and material impacts on financial estimates and assumptions that directly result from such mitigation or adaptation activities;" ↪ the realized cost of mitigation or adaptation measures (such as protecting a building against possible future floods).
  

• "Specified disclosures regarding a registrant’s activities, if any, to mitigate or adapt to a material climate-related risk including the use, if any, of transition plans, scenario analysis, or internal carbon prices;" ↪ the strategy to reduce emissions (i.e. mitigation) and adapt to physical risks.
  

• "Any oversight by the board of directors of climate-related risks and any role by management in assessing and managing the registrant’s material climate-related risks;" ↪ who is supervising the strategy in the company.
  

• "Any processes the registrant has for identifying, assessing, and managing material climate-related risks and, if the registrant is managing those risks, whether and how any such processes are integrated into the registrant’s overall risk management system or processes;" ↪ how integrated in management is the strategy.
  

• "Information about a registrant’s climate-related targets or goals, if any, that have materially affected or are reasonably likely to materially affect the registrant’s business, results of operations, or financial condition. Disclosures would include material expenditures and material impacts on financial estimates and assumptions as a direct result of the target or goal or actions taken to make progress toward meeting such target or goal;" ↪ what is done to reach the goals of the strategy.
  

• "For large accelerated filers (LAFs) and accelerated filers (AFs) that are not otherwise exempted, information about material Scope 1 emissions and/or Scope 2 emissions;" ↪ the direct and indirect emissions from electricity, heat, and cooling consumption.
  

• "For those required to disclose Scope 1 and/or Scope 2 emissions, an assurance report at the limited assurance level, which, for an LAF, following an additional transition period, will be at the reasonable assurance level;" ↪ showing the quality of accounted or estimated emissions.
  

• "The capitalized costs, expenditures expensed, charges, and losses incurred as a result of severe weather events and other natural conditions, such as hurricanes, tornadoes, flooding, drought, wildfires, extreme temperatures, and sea level rise, subject to applicable one percent and de minimis disclosure thresholds, disclosed in a note to the financial statements;" ↪ the realized losses from physical risk events.
  

• "The capitalized costs, expenditures expensed, and losses related to carbon offsets and renewable energy credits or certificates (RECs) if used as a material component of a registrant’s plans to achieve its disclosed climate-related targets or goals, disclosed in a note to the financial statements; and" ↪ the cost of emission reduction through indirect offsetting.
  

• "If the estimates and assumptions a registrant uses to produce the financial statements were materially impacted by risks and uncertainties associated with severe weather events and other natural conditions or any disclosed climate-related targets or transition plans, a qualitative description of how the development of such estimates and assumptions was impacted, disclosed in a note to the financial statements." ↪ how estimates integrate occurred physical risk events.

So why no Scope 3?

As we can see, the SEC has covered the most important aspects of climate-related impacts and risks. It included the main transition risk factor represented by the carbon footprint of companies, including scopes 1 and 2 emissions, as well as the physical risk exposures and losses of the companies. It also includes the mitigation and adaptation targets of the company. However, and contrary to what was initially proposed 2 years ago (c.f. the previous SEC press release), the SEC decided not include Scope 3.

Many experts in the field have expressed their support of the new ruling, but deplored the non-inclusion of Scope 3 emissions. As we have mentioned, Scope 3 emissions can represent the majority of emissions related to a company's activities as they account for the whole upstream and downstream supply chains. The main reasons for excluding Scope 3 are to be found in some of the recent push-backs against ESG and the inherent difficulties to account for Scope 3 emissions. Many companies have complex supply chains and the evaluation of their Scope 3 emissions could impose a large cost on them, which could significantly impact the popularity of the new rule. Another complication of Scope 3 emissions is the issue of multiple counting of emissions, which will be covered in another post. As regulations progress more in the ESG sector, the development of methods to estimate supply chain emissions will also improve. The simple fact that Scope 1 and 2 emissions are now part of the enforced disclosures is a very positive signal for the development of sustainable finance. This decision will bring a large amount of normalized data which will serve the development of better estimates and the integration of carbon-related metrics into the investment process, as many investors have been demanding to be able to do.