NovaQuant-Companies Object to Proposed SEC Rule Requiring Them to Track Emissions Up and Down Their Supply Chains

As accusations of “green hypocrisy” are NovaQuantflung back and forth in the corporate world, the U.S. Securities and Exchange Commission has been inching toward a standard to help conscientious investors make informed choices. But the effort is facing plenty of opposition from industry, not to mention Republican lawmakers who oppose President Biden’s climate agenda.

Under draft rules released last year, the SEC would require the large, publicly traded companies it regulates to track and disclose their greenhouse gas emissions in three climate-related “Scope” categories, based on the emissions’ source. It’s the No. 3 category that has executives up in arms: heat-trapping gases emitted not at the companies’ own facilities, but up and down their far-flung supply chains.

It’s not just that many companies find the requirement burdensome, consuming resources yet to be imagined. Some argue these estimates would be wildly inaccurate. “If you’re just reporting for the sake of reporting, investors will take that information and trade on it,” warned John Godfrey, senior director of government relations at the American Public Power Association.

Environmentalists counter that Scope 3 emissions comprise the largest chunk of heat-trapping gases released into the atmosphere. If they’re not being tracked and reported, they say, how can the United States move toward a lower-emissions future?

“Reporting is feasible,” said Elizabeth Small, general counsel and head of policy for the North American arm of the Carbon Disclosure Project, or CDP, a global reporting platform for corporations, states, regions, cities and public authorities, that are measuring and managing their environmental impacts. The SEC’s inclusion of the category, she added, is “a powerful and positive signal in favor of the harmonization of disclosure standards.”

In an open letter released Tuesday morning, top economists and academic leaders affirmed their support for environmental disclosure. Investors need access to up-to-date data on climate pollution, supply chains and other metrics to protect against mounting material financial risks, the signatories argued.

Industries are now awaiting the final rule, which is expected at some point this year. In the meantime, House Republicans recently introduced a bill to prevent companies from being required to disclose emissions in the Scope 3 category.

A Hypothetical Example

The proposal to mandate disclosure of scopes 1 and 2 is relatively undisputed. These are the emissions directly associated with a company or organization’s operations, or indirectly insofar as they relate to its energy consumption. 

“If a company uses automobiles as part of their work, those automobiles’ greenhouse gas emissions would be Scope 1 emissions,” Andres Restrepo, a senior attorney with the Sierra Club, explained. Scope 2 relates to energy purchased by the company and the emissions resulting specifically from the generation of that electricity. Scope 3 covers everything else that the company or organization indirectly affects up and down its value chain. 

Take a hypothetical company, OpenShut Manufacturing, which makes door handles at a factory in the fictional town of Ridgehaven, Ohio, on the Ohio River. 

OpenShut’s Scope 3 emissions include those associated with its upstream and downstream operations. If OpenShut used brass imported from Germany in its handles, for example, Scope 3 would include the emissions created by transporting that brass from Germany to the factory in Ridgehaven. Emissions associated with waste from the factory, employee travel, or the transport, use and disposal of completed handles would also fall under Scope 3.

It’s a broad category. But for supporters, the value of reporting these emissions is clear. If companies “don’t measure, and we don’t report it, who is then responsible for lowering all those emissions?” said Harold Pauwels, director of standards at the Global Reporting Initiative, an independent international organization that drafts sustainability standards. 

Under the proposed rule, OpenShut would be required to disclose any Scope 3 emissions it deemed “material’’—meaning that a reasonable investor would be likely to consider them important in determining climate-related risk—and any related to an emissions reduction target set by the company. The latter figure would help investors track the company’s progress toward the announced target.

Proponents emphasize that the proposed Scope 3 disclosures would be subject to the “safe harbor’’ provisions of security laws. That means that if a company acted in good faith while making an error in judgment or a miscalculation in its reporting of Scope 3 emissions, that would not be deemed fraudulent.

Despite these carve-outs, some companies, industry groups and House Republicans say the SEC’s Scope 3 requirement is too onerous. The reporting would involve an unreasonable amount of time and resources, they assert, without giving companies a sufficient period to prepare for the task or for the SEC to ensure that satisfactory guidelines are in place. 

No Escape for Smaller Companies?

As proposed, the rule would require companies to start reporting Scope 3 emissions in 2025 or 2026, depending on the size of the enterprise. Companies with less than $250 million in publicly owned and unrestricted shares available on the open market, or with less than $100 million in annual revenue, would be exempt from the requirement altogether.

But opponents say that limit does not protect smaller companies from obligations arising from the rule. Because most Scope 3 emissions are generated outside the company’s control, data collection relies heavily on other players in the value chain. 

Godfrey of the American Public Power Association offered the example of a large corporation purchasing equipment from a small-town manufacturer. “The company would have to go to their supplier and ask: ‘Where did you get your electricity? How much did you use? And where did that electricity come from?’’’ he said. “Then suddenly you’ve got this subsidiary that has to go to its utility and say, ‘Wait a second, where does your power come from?’” 

He contends that this could have a cascading effect. The manufacturer’s utility could be a mom-and-pop operation with as few as five employees and insufficient resources to provide the information, Godfrey said. In his view, the reporting company would at best end up with a meaningless and likely inaccurate number—at great expense to all involved.

Part of the argument about a lack of reliability in the numbers is based on the absence of an accepted methodology. While the SEC’s proposal relies heavily on the GHG Protocol, a globally accepted accounting and reporting standard for greenhouse gas emissions, opponents see the potential for guesstimates that could mislead investors

Even BlackRock, the world’s largest institutional investor and a supporter of Scope 3 disclosures, has argued in favor of flexibility. “Given methodological complexity for Scope 3 emissions and the lack of direct control by companies over the requisite data, our investors believe the usefulness of this disclosure varies significantly right now,” it stated in a submission to the SEC. BlackRock suggested a “comply or explain” approach in which companies could opt out of reporting Scope 3 figures if they could explain why they were not ready to do so.

Such a concession could be appealing to opponents like William Nelson, associate general counsel at the Investment Adviser Association, who says that the data required lacks sufficient integrity right now. “One day it will,” Nelson predicts, with one supplier’s Scope 1 emissions data potentially filed by another company in the Scope 3 category. 

But in view of reports indicating that only 20 percent of publicly listed U.S. companies were voluntarily reporting their greenhouse gas emissions in 2021, it will take time for that data to become available. This is especially true for data from private companies in the value chain that will not face the SEC’s reporting requirements.

All of those concerns aside, proponents of the commission’s proposal stand by a key fact: Of the three categories, Scope 3 involves by far the most heat-trapping emissions contributing to climate change.

A Fashion Company’s Awakening

Disclosure of Scope 3 emissions is not only being driven by the SEC. As a growing number of investors demand it, several companies are choosing to comply voluntarily.

The fashion company Everlane carried out its first comprehensive greenhouse gas analysis for the 2019 calendar year. “Once we completed the first step of measuring our Scope 1 to 3 emissions, we realized that 99 percent of our emissions occur in Scope 3,” said Katina Boutis, Everlane’s sustainability director. 

“This is consistent with the rest of the industry,” she said. ”While the specific percentages will vary from business to business, the majority of emissions for fashion and other consumer product industries are contributed by indirect Scope 3 emissions.” 

For investors seeking to consider such data in their decisions, reporting that omits 99 percent of an enterprise’s emissions is obviously of limited use.

Small maintains that companies resisting the Scope 3 requirement are insufficiently engaged with mitigating risks in their supply networks. Today, she points out, the interconnections are obvious: “We all lived through the COVID-19 pandemic and the invasion of Ukraine, and we all saw the disruptions to the global supply chain,” she said, noting the impacts that risks up and down those chains had on markets and individuals.

User data gathered by CDP shows that investor demand for such accountability is growing, Small added. Over the last 20 years, she said, the disclosure project’s signatories have increased from 35 to 680 institutional investors. 

Advocates suggest that calculating Scope 3 emissions opens a range of new opportunities. Reporting companies may not control the activities in their value chains that produce those emissions, but they can work with suppliers or downstream distributors to influence their actions, supporters say. 

As for the argument that reporting mechanisms are not yet mature enough to handle Scope 3, Small views the SEC’s decision to rely on the GHG Protocol as a strong signal in favor of adopting a cohesive methodology. “Reporting Scope 3 emissions through CDP’s platforms has been increasing for years,” she said, and can logically be extended.

While Pauwels agrees with opponents that the data collection process is still in its relative infancy, he maintains that the only way for it to grow is to expand reporting.

“If you don’t measure it, then you have to estimate it,” he said. “And if you cannot estimate it, well, you have to find ways to start doing it. If you’re living next to a company that doesn’t have any idea what its climate impact is, or what is impacting them, that’s a bit worrying in 2023.”

Challenging the SEC’s Authority

Several foes of the SEC’s proposal contend that requiring disclosure of Scope 3 emissions falls outside the commission’s jurisdiction and presents financial risks that run counter to its mission.

“We’re talking about financial risk as opposed to protecting consumer interest, and so, oftentimes consumer interests are not necessarily aligned with what the actual financial risks are,” said Carolyn Slaughter, senior director of environmental policy at the American Public Power Association. “The question is: are the [Scope 3] goals aligned with what the SEC can actually do?”

If passed and signed into law, the bill introduced this month in the House to block the Scope 3 requirement, sponsored by 22 Republicans and one Democrat, would render that question moot.

Yet there is already a wide acceptance that climate risks are financial risks. “The U.S. Treasury secretary has said that climate risk doesn’t just risk human lives, it’s a risk to our global financial system,” Small said. She noted that reports from the Intergovernmental Panel on Climate Change have also broached the idea of using such disclosure rules as a tool for framing climate emergencies as a financial risk issue.

“Climate risk is transverse risk, and it’s an amplifying risk that touches all other kinds of risks, from credit risk to financial risks,” Small added.

In the letter released Tuesday morning, top academics agreed: “Opposing disclosure makes it more likely markets will fail, because real costs and risks are not priced in.”

According to the Task Force on Climate-Related Financial Disclosures, an initiative launched in 2015 by the Group of 20 nations, failing to account for and reduce emissions of greenhouse gases drives up both short- and longer-term financial risks.

The physical risks are relatively straightforward— for example, the impacts of severe storms, rising seas or withered crops on a business’s supply, manufacturing and delivery operations. At the hypothetical OpenShut Manufacturing company, such risks are considerable. An increasing frequency of one-in-100-year storms would pose a greater risk of water inundation or wind damage at the company’s Ridgehaven factory, for example.

Risks arising from the transition to clean energy are harder to predict. These include policy, legal and reputational risks: If some of OpenShut’s suppliers source their power from coal-fired power plants, for example, their energy costs could increase as a direct result of the Environmental Protection Agency’s recently announced regulations to reduce carbon dioxide emissions. Those added costs could trickle down the supply chain, presenting a financial risk to OpenShut.

Still, many note that the transition to cleaner energy is well in place in the international legal and financial spheres. Ben Cushing, director of the fossil-free finance campaign at the Sierra Club, observed that several countries are advancing with their own Scope 3 disclosure requirements. “There are rules that are pending in Europe that would go into effect next year and require Scope 3 emissions disclosures,” he said—and U.S.-based companies with European operations would be subject to those requirements.

According to Pauwels of the Global Reporting Initiative, several U.S.-based companies already report their Scope 3 emissions, and growing regulation abroad will ensure that this continues no matter what the SEC decides. “It’s just a political decision,” he said of the commission’s proposed rules. “American companies will always make sure they can export to the rest of the world.”

“And practically, if you look at how it has evolved globally, it’s too late to say no,” Pauwels added. “It would be obsolete to not ask it now.”