Environmental, Social, and (Corporate) Governance (ESG) is an evaluation of goals and initiatives beyond the profit and loss of a corporation that extend into the support and active social responsibility to do well by the environment, employees, and executive oversight of each company.
As of March 21st, 2022, the Securities Exchange Commission (SEC) proposed a rule that would require U.S. based SEC registered companies to include climate-related disclosures in registration statements, periodic reports, and audited financial statements.
Before addressing the SEC proposal and its potential impact, let’s take a closer look at the three levels of scope in which emissions can be classified. Scope 1 contains direct emissions, Scope 2 contains indirect emissions still owned by a corporation, and Scope 3 contains indirect emissions not owned by a corporation. Each level of scope is important in addressing the overall impact of emissions per corporation.
Emissions Scope Classifications
Direct emissions, result from company-owned and controlled resources necessary for day-to-day business. Within itself, Scope 1 can be broken down into four distinct categories as defined by the United States Environmental Protection Agency (EPA): stationary combustion, mobile combustion, fugitive emissions, and process emissions. Stationary combustion includes fuels and heating sources such as boilers, heaters, furnaces, ovens, dryers, or other equipment or combustion machinery. Mobile combustion is all fleet vehicles owned or operated by a corporation which burns fuel. With the uptick in electric vehicle adoption, some fleets may increasingly shift to Scope 2 emissions. Next, fugitive emissions are unintended emissions related to facilities or activities such as aerosols, quarries, and leaks from compressors or valves. Lastly, process emissions which are released during the direct industrial manufacturing process such as factory fumes and chemicals.
Indirect emissions, come from the purchase and generation of emissions not produced by a corporation. Examples of these emissions include electricity utilized in steam, heating and cooling purchased via external utility companies. When looking at global emissions, nearly 40% of emissions can be traced to energy generation, half of which is used by industrial businesses. Scope 2 emissions often create a significant impact on the carbon footprint due to the nature of current methods of production and the need to meet consumer demand.
The most wide-ranging and difficult level of emissions to measure relates to all other indirect emissions from a corporation that are not covered within scope levels 1 or 2. Indirect emissions contained in Scope 3 include both upstream and downstream emissions throughout the value chain of company operations. Examples of these emissions include business travel, employee commuting, generated waste, disposed raw materials, leased assets, use of sold products, and end of product life treatment. Additionally, shipping and handling of both product and raw materials occurring in between stages of the supply chain create a difficult level of emissions to measure due to a lack of clear ownership. Scope 3 emissions can contribute up to 95% of a corporation’s carbon footprint, differing between industries. Failure to address Scope 3 creates a limited situation on reducing emissions if corporate initiatives are strictly aimed at Scope levels 1 and 2, which has led to the SEC’s latest proposed disclosures.
With all three scopes of emissions covered, Scope level 3 arguably creates the most challenges for a corporation in terms of calculating the impact for adequate disclosures. Many businesses are focused on Scope levels 1 & 2 as they fall under direct management and remain easier to control within the organizational structure. Ownership of level 3 emissions often creates differing opinions among management and related parties as they fall in various places within the supply chain. In order to make an impactful difference, all members of the supply chain must track, improve upon, and actively implement ways of reducing emissions. Lack of transparency, knowledge, or effort among those within the supply chain creates both upstream and downstream issues in reducing the carbon footprint. As we look ahead, increased pressure from entities throughout the supply chain will be applied to manage and adequately disclose emissions.
As of March 21st, 2022, the SEC proposed rule changes that would require registrants to report on climate-related disclosures and risks that are reasonably likely to have a material impact on their business and financial statements. The disclosure of greenhouse gas emissions would be the primary source of information in assessing the risk per each registrant. While the proposal creates a new set of hurdles in implementing rules across different industries, both the public and investors are calling for enhanced transparency. Globally, the United Kingdom is already requiring companies to disclose emissions under the Streamlined Energy & Carbon Reporting Requirements. Companies operating both domestically and internationally will need to be cognizant of required disclosures and potential financial statement impacts among the countries in which they conduct operations. If U.S. companies resist, they will face increased pressure from investors to produce disclosures or risk falling behind global competition. Consistent, comparable, and reliable information on emissions remains nearly non-existent for investors across the market, which raises the question, how exposed are corporations to the latest SEC proposal?
The costs associated with tracking, measuring, and aggregating the emissions data will vary depending on the size of the corporation. Corporations such as Anheuser-Busch, Coca-Cola, and Kraft-Heinz currently report full emissions (Scope 1+2+3) on a voluntary basis, which will likely keep them ahead of the curve if the SEC proposal is adopted. Smaller to mid-size corporations will likely be impacted at a higher clip due to financial budgeting constraints that large corporations do not typically face. While these costs may create difficulty in the short term, in the long term all corporations will produce comparable statements on emissions, leaving investors with clear answers with respect to emissions. Despite the cost associated with producing emissions data, corporations who actively work towards reducing emissions while disclosing their progress may retain and attract new investors due to improved social perceptions.
The proposal for disclosures among SEC registrants is a positive step towards transparency and ownership over emissions caused through day-to-day business activities related to the production of goods and services. Corporations that organize early to track, aggregate, and report on their emissions will likely be in the best position going forward amongst investors concerned with these disclosures.
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Material discussed is meant for informational purposes only, and it is not to be construed as investment, tax, or legal advice. Please note that individual situations can vary. Therefore, this information should be relied upon when coordinated with individual professional advice.