Scope 3 emissions and increased disclosures; a source of heightened transition risk

Overview of GHG protocol scopes

Source ghgprotocol.org

Summary: forthcoming climate-related disclosures will heighten transition risks. Entities are generally well prepared for scope 1 and scope 2 but also need to prepare for measurement and mitigation of scope 3 emissions. Increased disclosure and focus on scope 3 emissions is expected to increase policy, legal, reputational and market risks for reporting entities and their supply chain.

Why? Scope 3 emissions are hard to measure, and they are generated beyond the boundaries of traditional responsibility of a company. When viewed holistically, as in across the full lifecycle of a product, scope 3 emissions potentially comprise the majority of total emissions. With disclosure, this will become more apparent to policy makers, investors and customers. Companies that currently focus on decarbonization of scope 1 and scope 2 emissions will face pressure to broaden their scope of responsibility to include scope 3.

Background

Scope 3 emissions are defined as the indirect emissions that are a consequence of the activities of a company. Scope 3 are often referred to with respect to the value chain - both upstream and downstream. 

The current focus for many Australian entities is on reducing emissions for scope 1 (direct emissions) and scope 2 (indirect purchased energy emissions), noting that scope 3 is not currently reported to the National Greenhouse and Energy Reporting Scheme (NGER). Generally speaking, supporting data for scope 3 is less readily available, and there is a valid concern that scope 3 duplicates scope 1 and scope 2 of other upstream and downstream entities.

However, with forthcoming climate related financial disclosures (the AASB roadmap commences 1 July 2024), greater scrutiny is expected across entire value chains, requiring accurate measurement, and potentially a degree of pressure to address scope 3 emissions.

Table 1. AASB’s Proposed Mandatory Climate-related Financial Disclosure Roadmap

Transition risks

Policy and legal risks

At present, Treasury offers a modified liability framework, whereby entities will be provided relief for a fixed three-year period for disclosures relating to Scope 3 emissions and certain climate-related forward-looking statements. But this provides only temporary relief for Directors from their disclosure-related duties.

With increased disclosure, comes increased scrutiny. Pressure to do more may increase as governments realise the limits of current strategies. Or policy risks may arise from international peer pressure (particularly from Europe) and transmit via a change to international reporting standards (IFRS S1 and S2).

It’s plausible that these policy risks and regulatory pressures will lead to further requirements for entities to take greater responsibility across their value chain, particularly for downstream indirect emissions.

Disclosure may also lead to allegations of greenwashing. A recent study of 1200 companies at UNSW, found companies were under reporting their scope 3 emissions by up to 44 percent by focusing on measuring low emissions categories like business travel, rather than product use. The implications for greenwashing risks here are self-evident and could still be captured by regulatory action under the temporary modified liability framework.

Shifts in consumer and investor sentiment

Activist investors and consumers may target companies that do not include scope 3 emissions within their decarbonization strategies, accusing them of a ‘credibility gap’ between their decarbonisation strategy and their actual carbon footprint. The potential for reputational damage will increase with disclosure. Evidence of this ‘credibility gap’ is illustrated in a report published in July 2023, where CDP and Capgemini found:

• “The overwhelming majority of emissions (92%) disclosed by European companies in 2022 were scope 3.

• But only 37% of these are being addressed with current decarbonisation measures”.

Some companies are well advanced on their journey, whilst others have some catching up: compare BHP’s 2023 annual report page 49 where it outlines the baseline, targets, and collaborations with downstream customers, with Mineral Resources’ 2023 Sustainability Report page 167 where it “acknowledges the significance of understanding its scope 3 emissions” and has “initiated a materiality assessment and accounting process to measure scope 3 emissions and explore potential opportunities for influencing positive changes within its supply chain.” Admirably, MinRes recognizes the work that it has yet to do. Many Australian companies do not.

Market changes

Increased disclosure may introduce pressures on an entity’s supply chain:

• To reduce scope 3 emissions, procurement decisions may need to consider the emissions intensity of suppliers.

• With short lead times, both upstream suppliers and downstream customers may not be able to invest the capital required and may find themselves as a non-preferred supplier or customer.

These risks can be mitigated by early engagement with suppliers and customers, such as through the CDP Supply Chain initiative.

Where to from here?

Increased disclosures of scope 3 emissions could lead to increased transition risks for Australian reporting entities.

Entities should plan accordingly, ensure their climate risk strategies encompass scope 3 emissions, invest in measurement, and engage with their supply chain and customers.

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