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May 18, 2024

Understanding direct and indirect emissions

Measures encouraging companies to reduce greenhouse gas emissions constitute a major weapon in policymakers’ armoury in seeking to curb climate change. Up to now, this has focused on requiring businesses to monitor and report on direct emissions – those resulting from their own activities and processes. Increasingly, however, the focus is turning to indirect, also known as ‘induced’ emissions, generated by a company’s suppliers. This shift could have profound repercussions for businesses across Europe.

The framework for monitoring and reporting on emissions is the Greenhouse Gas Protocol, established in 1998 by the World Business Council for Sustainable Development and World Resources Institute, which is widely accepted by governments and business leaders as a tool to quantify emissions.

The protocol covers the six main greenhouse gases: carbon dioxide, methane, nitrous oxide, hydrofluorocarbons, perfluorocarbons, and sulphur hexafluoride. Starting in 2025, as many as 50,000 companies across Europe, including groups based elsewhere that have European operations, will be required to report on emissions arising from all the areas that the protocol defines as scope 1, 2 and 3.

Emission sources that companies own or control

Scope 1 emissions reporting requires businesses to measure all the emissions derived from sources they own or control, including fumes emitted by the factories of manufacturing groups or the heating of buildings used by services businesses. It’s relatively easy for most companies to understand where and how these emissions arise and how to measure them.

Scope 2 emissions are those generated by the energy a company purchases, which may be in the form of electricity, steam, heating or cooling, occurring at the plant where the energy is generated or converted. As a consumer of energy, the company must accept responsibility for the emissions used to create the energy it uses on a daily basis.

Scope 3 emissions are by far the most complex to calculate: these arise from the company’s activities but are not directly generated by the business.

Scope 3 emissions are by far the most complex to calculate: these arise from the company’s activities but are not directly generated by the business. They include, for example, emissions generated by the company’s suppliers in creating the products, services and raw materials it consumes, and employees’ business travel or their commuting to work. They also include use of the companies’ products or services. For carbon fuel companies, this means emissions arising from their use directly or to generate power.

The sources of scope 3 emissions may include waste disposal, transportation and upstream and downstream distribution, as well as investments made by the company and its leased assets and franchises. For many businesses, scope 3 emissions may constitute by some margin the largest volume of emissions arising from their activities – as a rule of thumb, supply chains generate 11 times more emissions than a company’s own operations.

From reporting to mitigation

While it is more straightforward to calculate scope 1 and 2 emissions, scope 3 requires obtaining information from suppliers and apportioning their emissions data appropriately. The GHG Protocol’s Scope 3 Standard has become the benchmark for companies in identifying and managing scope 3 emissions.

Mitigation is the final part of the puzzle. The over-arching reason to collect emissions data is to enable a business to understand how it can reduce its carbon footprint. Policymakers hope that businesses will be incentivised not only to manage their own supply chain, but to limit their dealings with high-emission suppliers, which should create a virtuous circle.

Policymakers hope that businesses will be incentivised not only to manage their own supply chain, but to limit their dealings with high-emission suppliers, which should create a virtuous circle.

Once a business has collected the required data, it can target the most climate-damaging areas across its supply chain and from the products and services it provides. The Scope 3 Standard identifies 15 categories across upstream and downstream activities, some of which may be easier to mitigate than others depending on the business activity. For example, for some, business travel or waste may be relatively easy to reduce while sourcing new suppliers or re-engineering business processes imply longer-term projects.

However, understanding the sources of emissions gives businesses key pointers on areas to prioritise and can help identify problematic suppliers or business lines. It can help suppliers to improve their energy efficiency and to make better-informed decisions on procurement, product development and logistics. It can also help driving human resources initiatives such as engaging with employees to reduce emissions from travel.

Enter the Corporate Sustainable Reporting Directive

While policymakers have focused mainly on larger businesses, the impact of new reporting standards in the EU’s Corporate Sustainable Reporting Directive (CSRD) will be felt throughout supply chains. Where they have a choice, large companies are likely to select suppliers with a smaller carbon footprint in order to minimise their own scope 3 emissions – thus driving smaller businesses that may not themselves be covered by the European legislation to address their own emissions in order to keep existing customers or attract new ones.

Banks and other financial institutions will also need to factor emissions data into their lending and investment decisions, since financing of high-emission customers will raise their own scope 3 emission levels. This may result in companies that will not or cannot address their carbon emissions facing an increased cost of capital, unless they can obtain financing from institutions not covered by reporting rules in the EU or elsewhere. They could also their carbon emissions by applying to green loans or by issuing green bonds, which are conditioned by their use of proceeds being directed towards the financing of mitigation solutions/adaptations.

Companies that do take steps to reduce their overall carbon footprint may benefit from improved business performance if their capital costs are lower than those of competitors and their products and services are perceived as more attractive by climate-conscious customers.

Businesses in Europe are still finding their way, and for unlisted and smaller companies the deadline for CSRD reporting compliance will come later in the decade as the legislation progressively takes effect. Many are choosing to outsource monitoring and analysis of scope 3 emissions to specialists, but it is not an issue that companies large or small can ignore, because the attractiveness of business partners in terms of their readiness to address emissions could be an important factor shaking up supply chains in Europe and beyond.

Business travel or waste may be relatively easy to reduce, but sourcing new suppliers or re-engineering business processes imply longer-term projects.