The ESG Advocate 018 - Disclosures and the emissions paradox
There's been a string of first-time CSR reports popping up in my LinkedIn feed lately and, I'll be honest, they've been pretty decent reads with a mix of material projects, philanthropy, and disclosures.
When it comes to these reports, I choose to believe that they are well intentioned, although I read a lot of them and can tell when it's marketing and greenwashing instead of impact. Many follow a similar pattern, but most end with metrics and disclosures, aligned to various frameworks.
Investors crave those metrics, but activists lament the lack of progress. Against the other trends globally, these disclosures and a narrow view could miss the point entirely, if not carefully considered across E, S, and G.
Let's get to it!
Scope Creep: Value Chain Emissions
Upcoming sustainability and disclosure regulations are already driving corporate behavior. If you could see my work calendar, you'd know carbon measurement is especially of enormous interest.
Three significant draft proposals are partially driving this activity and focus. Earlier this year, we saw proposals from the SEC, the EU Commission (with Corporate Sustainability Reporting Directive, or CSRD), and the IFRS, which sets accounting standards in 140 jurisdictions globally. The IFRS created a new organization called the International Sustainability Standards Board, or ISSB, to work on its draft.
These regulatory drafts and standards are built to give investors a view into environmental data that they deem critical. Investors sometimes want to understand how a company is 'saving the planet' by considering its impact on the world. In the case of ESG, emissions and climate change could be material and present risks to the company. These drafts build reporting structures for that data to help inform an investment decision.
Yet, all three proposals are striking fear into the hearts of Chief Sustainability Officers, CFOs, and procurement teams for one reason, the disclosure of Scope 3 emissions. But why?
If you aren't familiar with the universally adopted GHG Protocol:
Scope 1 emissions are direct emissions from owned or controlled sources.
Scope 2 emissions are indirect emissions from the generation of purchased energy consumed by the reporting company.
Scope 3 emissions are all other indirect emissions that occur in a company’s value chain.
Scope 3 emissions are all the activities outside of a company's control. The data is likely not visible to the company or well understood, even for the products it makes.
In a May 2022 article titled SEC’s Climate Risk Disclosure Proposal Likely to Face Legal Challenges, the authors call out why corporates may challenge these rules, specifically around Scope 3 disclosures. It comes down to some pretty big pain points:
Cost for corporates to implement
Resources needed to collect, quantify, and ensure accuracy
Liability risk for inaccuracies outside of the reporting company's control
While the SEC hasn't indicated a direction for Scope 3 yet, corporates in 140 reporting jurisdictions outside the US won't find a reprieve. Last week, the ISSB voted unanimously:
...to require company disclosures on Scope 1, Scope 2 and Scope 3 greenhouse gas (GHG) emissions...As part of these requirements, the ISSB will develop relief provisions to help companies apply the Scope 3 requirements.
Again, these draft regulations are meant to give investors decision-useful information, but corporates are the ones who will need to do the heavy lifting. Value chain visibility is complex, and many companies struggle to uncover accurate (or any) information. Compounding this obfuscation is just how significant Scope 3 emissions are.
According to a CDP report, "across all sectors Scope 3 emissions account for 75% of total Scope 1+2+3 emissions in the sample."
A June 2022 report from the World Resources Institute gives us a little more insight into the challenge of Scope 3, specifically with these two stats:
Two-thirds of companies reported Scope 3 emissions in most industries in 2021. NOTE: It doesn't state the accuracy here.
The industries with lower scope 3 reporting rates include those with supply chains that account for half of the world’s GHG emissions, including food, fashion, freight, electronics, and automotive.
Anecdotally, I talk to many reporting companies, and many use proxy data or estimates for reporting Scope 3. Some don't have clear boundaries set for their carbon accounting and use intermediaries or processors in their supply chain who have poor traceability.
Corporates not paying attention to these regulations will find themselves woefully behind. This regulation could increase visibility into the supply chain and drive environmental improvements, but the "S" is getting lost and other factors are compounding the issue.
Energy and reshoring
The scrutiny of Scope 3 emissions is coming at a turbulent time for the global supply chain, especially for those in the global south. Many of the economies where raw materials are sourced or farmed are still emerging. As they look to energy to support economic growth, the options for green may not surface fast enough.
The intersection of emissions with emerging markets
First, remember that we're coming out of a COP26 where the strong language around coal was moved from 'phase-out' to 'phase-down,' to the dismay of many. Yet, the global south can hardly be blamed for this effort. The cheap cost of coal and fossil fuels built northern economies, and they are in line next.
Writing about Africa in the Financial Times, David Pilling put it this way:
The most important step is to acknowledge the right of African countries to expand, rather than cut, their energy consumption. Some 600mn Africans live without electricity.
Unless investment is made in emerging markets, they will go down the same dirty energy path of least resistance. As Pilling concludes, 'who can blame them?'
Developed economies have the infrastructure to 'electrify everything' and support a green transition. Bloomberg reported that 87 countries have gone past the tipping point (5%) into widespread adoption of green energy. This number sounds impressive, but there are 195 countries, and all the countries Bloomberg lists are developed (I couldn't find the underlying data).
In early October, the IMF announced that:
Estimates vary, but these economies must collectively invest at least $1 trillion in energy infrastructure by 2030 and $3 trillion to $6 trillion across all sectors per year by 2050 to mitigate climate change by substantially reducing greenhouse gas emissions.
The IMF goes further to state that
Private sustainable finance in emerging market and developing economies rose to a record $250 billion last year. But private finance must at least double by 2030.
The increased requirements for funding are being felt in South Africa, where the transition estimates are over five times what western countries have pledged.
In addition to private capital mobilizing and hopefully growing, there is perhaps more good news. Climate reparations will be discussed at COP27 with the backing of the US. The bad news is that it is not the proactive investment needed to drive a green transition during economic emergence, which means these economies might have higher emissions for some time.
Talks of reshoring kick up
...and there's even more bad news for the global south as reshoring supply chains have become the next hot topic for business. MarketWatch put it this way:
An increasingly chaotic world has U.S. companies bringing back their supply chains. The pandemic, U.S.-China tensions, disputes about Taiwan and war have all seriously damaged supply chains. “Just in time” has become “just in doubt” delivery.
Despite being an inflationary and costly exercise, reshoring for supply chain resilience seems to be the long-term goal.
Side note: How executives can reshore in service to long-term resilience, but not other long-term ESG goals is beyond me.
Could high emissions in emerging economies, combined with emissions reduction targets accelerate reshoring?
Blind spot warning: The emissions paradox
For all the regulations and good intentions of companies, there is a massive blind spot at the intersection of stakeholder pressure, emerging economic growth, and efforts to reshore supply chains.
Let's say a company made an emissions reduction goal to be net zero by 2030. There are many ways to achieve that within the company's control, like operational reductions and efficiencies (Scope 1) and sourcing from green energy (Scope 2). But that pesky Scope 3 could be over 75% of total emissions and well outside the company's control unless...
When a board looks at its commitments through the singular lens of the "E" and sees that Scope 3 is SO HUGE and that regulators are looking for evidence of their efforts, it can lead to myopia. A short-term solution would be to reshore supply chains. Not only would the company lower emissions due to greener energy options in the global north, but they would potentially add resilience to the supply chain and perhaps even decrease cash conversion rates due to faster consumer delivery.
It seems like a win-win, but it isn't.
This leads to a must-read story from last week in the Financial Times: Making funding flows fair: Must ESG be bad news for emerging markets? Colin Mayer, who I know best as the author of Prosperity, did not mince words:
In essence, [ESG] is a mechanism for encouraging investment to flow out of relatively high-risk emerging markets into what are perceived to be less exposed developed markets.
And he's right, to a degree. If you are driven by sustainability goals and reducing ESG risk from emerging markets, you might decide to divest rather than invest or engage. Alison Taylor, Executive Director at Ethical Systems, carries the logic forward:
This is arguably worse than divestment out of oil and gas, because if you divest from a country, you leave it to organised crime, terrorist financing and violence.
And she's right! If you make a short-term decision to divest from an emerging economy, you create many risks. Would you be accountable? Yes. Would anyone notice or figure it out? Well, they might. Companies are held to account for less, but the connection could just be lost.
It's these types of decisions that make ESG so difficult. If you lean in on the sustainability piece to lower Scope 3 and even do it in a way that lowers a material risk, you could exacerbate risk for others.
This is why I'm a huge fan of two things:
Keeping E, S, and G together. By doing this (hopefully), leaders are forced to consider issues through the lens of multiple perspectives. If done well, the nuance and the complexity surface, and more informed, considerate decisions will be made.
SDG17, or partnership for the goals. Rather than divestment, open up dialogues, seek opinions in your value chain with empathy (ambitious, I know), and engage rather than divest. Remember, though, cooperate, and don't collude.
Today, the threats from climate change are material to every company. Emissions reductions are important, but not for the metrics alone.
In April, I heard Dr. Ndidi Nnoli-Edozien, Chair and Founder, AfriKairos GmbH, speak at an event on sustainability standards. I took notes and will (poorly) paraphrase what I heard:
This is not about perfect information, it's about changing behavior and changing the world. It isn't about data, it's about people. Saving the planet is about saving humanity.
This is the emissions paradox. We have to lower emissions, but we can't lose sight of what's important.
In my notes from her panel, I conclude this:
"What gets measured, gets managed" MUST include the other components (S and G) because there are side effects across all kinds of stakeholders, not just the ones with capital.
While important for decision-making, lower emissions and data aren't the goal. We must save ourselves and our planet. If we lose sight of that one critical piece, we've collectively lost everything.
Tweets of the Week
Two tweets about Scope 3 from this month:
Investors want it, and corporates think it's hard (it is). We still have to do it, but with intention.
