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Unseen Financial Risks of Scope 3 Upstream Emissions: Insights from the BCG and CDP Report
The recent BCG and CDP report, "Scope 3 Upstream: Big Challenges, Simple Remedies," unveils significant financial risks posed by unmeasured Scope 3 upstream emissions. These emissions, primarily from supply chains, dwarf the more commonly tracked Scope 1 and 2 emissions by 26 times.
Despite this, they remain largely unaddressed by corporates and investors.
The Scope 3 Upstream Imperative
Scope 3 upstream emissions, which include all indirect emissions that occur in a company’s value chain, present a colossal challenge. These emissions cover a wide range of activities, from the extraction of raw materials to manufacturing processes, transportation, and distribution. Essentially, they encompass all emissions not directly produced by the company itself but are a result of its business operations.
Despite their significant impact, only a small fraction of companies have taken proactive steps to address these emissions. According to the report, a mere 15% of companies have established targets for their Scope 3 upstream emissions. This statistic is alarming, especially considering the vast scale of these emissions.
The enormity of the challenge is further underscored by comparing upstream emissions to more commonly tracked emissions. Upstream emissions from just the manufacturing, retail, and materials sectors are 1.4 times the total CO2 emissions of the European Union in 2022. This comparison illustrates the massive footprint of Scope 3 emissions and the critical need for comprehensive management and reduction strategies.
The difficulty in addressing Scope 3 upstream emissions lies in their complexity and the need for extensive coordination across the supply chain. Companies must engage with numerous suppliers, often across different regions and industries, to gather accurate data and implement effective reduction measures. This complexity is a significant barrier to progress, but it also represents a crucial area for innovation and leadership in sustainability.
The imperative to address Scope 3 upstream emissions is clear. The scale of these emissions, combined with the current lack of targeted efforts by most companies, highlights a significant gap in the global approach to reducing carbon footprints. By setting ambitious targets and engaging deeply with their supply chains, companies can make substantial progress in mitigating their overall environmental impact.
Disproportionate Scale
Supply chain emissions are vastly greater than operational emissions. Suppliers reported that their upstream Scope 3 emissions were, on average, 26 times higher than their direct operations emissions (Scopes 1 and 2).
The number of companies reporting through CDP has doubled since 2020, shedding light on the true scale of supply chain emissions. Upstream emissions just from the manufacturing, retail, and materials sectors have a footprint that is 1.4 times the total CO2e emitted in the EU in 2022.
Lack of Measurement and Targets
Corporates are twice as likely to measure their Scope 1 and 2 emissions and 2.4 times more likely to set targets for these emissions compared to their Scope 3 emissions. This gap indicates a significant oversight in corporate sustainability strategies.
Only 15% of corporates reporting through CDP have set a Scope 3 target, highlighting the significant gaps in transparency and supplier engagement.
Financial Implications
The report estimates that the carbon liability from disclosed upstream emissions in manufacturing, materials, and retail sectors alone exceeds $335 billion. This emphasizes the financial risks of ignoring these emissions.
Without robust Scope 3 emission management, companies expose themselves to substantial financial liabilities and regulatory pressures.
Factors Driving Scope 3 Upstream Action
Climate-Responsible Boards: Corporates with boards that oversee climate actions are 4.8 times more likely to set Scope 3 upstream targets.
However, only one-third of companies have such boards. Effective governance is crucial for ensuring checks and balances. An engaged board mandates climate-aligned KPIs for management incentivizes the procurement team, and supports a CO2-aligned operating model.
Supplier Engagement: Engaging suppliers is essential for managing Scope 3 upstream emissions, as it aligns climate ambitions across the entire supply chain. Companies that actively engage with their suppliers are 6.6 times more likely to set Scope 3 targets aligned with a 1.5°C transition plan.
Yet, only 4 in 10 companies engage with their suppliers on climate issues, and just 1 in 10 collaborate closely. Supplier engagement is crucial for setting realistic targets. Among the 2,191 companies with upstream Scope 3 targets in 2022 and 2023, 1 in 4 revised their targets and scaled back on their upstream Scope 3 reduction ambitions.
Internal Carbon Pricing: Companies that adopt internal carbon pricing are 4.1 times more likely to have a 1.5°C-aligned transition plan. However, only 14% of companies use this tool, underscoring the need for broader adoption.
Setting an internal carbon price drives climate-aligned decisions through financial metrics, ensuring climate cost transparency across an organization. Corporates with an internal carbon price integrated into business decisions are 3.7 times more likely to have a Scope 3 target and a 1.5°C-aligned transition plan.
Regulatory and Investor Roles
Regulatory Developments: The impending mandatory disclosure regulations will drive greater transparency and accountability. However, the pace of implementation, particularly outside Europe, may delay significant actions on upstream emissions.
Forthcoming mandatory disclosures for emissions will continue to drive transparency, but the slow rollout of mandatory disclosures outside Europe likely further delay action for upstream emissions.
Investor Engagement: Investors play a crucial role by demanding transparency and pricing in climate risks. Fewer than 10% of investors require companies to disclose their Scope 3 upstream emissions. By incorporating climate risks into their capital asset pricing models, investors can drive more responsible corporate behaviors. Investors are not adequately pricing in upstream risks.
As part of investment policies, fewer than 1 in 10 require investees or clients to disclose Scope 3 upstream emissions. Investors must demand disclosure on upstream risks and price in climate risk as a surrogate force to drive transparency and action.
Measuring Climate Risk
There is a dichotomy in how risk is priced by corporates and investors, leading to significant supply chain risks that can adversely impact business performance. Only 1 in 2 corporates evaluate the financial risks from upstream emissions, and a third of corporates that evaluate upstream Scope 3 financial risks acknowledge the risk to profit.
Disclosed upstream emissions from just the manufacturing, retail, and materials sectors in 2023 alone imply a carbon liability of over $335bn. Investors must embed climate risk in the Capital Asset Pricing Model (CAPM) to ensure fair market valuations and drive emissions transparency and Scope 3 action.
Immediate Priorities for Action
For Corporates:
Appoint climate-competent board members.
Launch comprehensive supplier engagement programs.
Implement internal carbon pricing to guide business decisions.
For Investors:
Integrate climate risk into investment policies.
Demand detailed disclosures of Scope 3 emissions.
Use climate-adjusted capital asset pricing models to reflect true risk.
Steps for Corporates
Board-Level Actions:
Nominate at least one climate-competent board member.
Set up a board climate committee with independent members or advisors.
Mandate financial quantification of upstream Scope 3 risks and report to the Audit and Risk Committee.
Management-Level Actions:
Launch holistic supplier engagement programs and measure and set upstream targets.
Pilot and embed internal carbon pricing in decision-making processes.
Steps for Investors
Embed Climate Risk in CAPM:
Integrate climate risks into capital asset pricing models to ensure accurate valuation and drive emissions transparency.
Use a climate-adjusted Capital Asset Pricing Model (CAPM) to embed risk into valuations and ensure fair market valuations.
Demand Transparency and Action:
Require investees and clients to disclose Scope 3 upstream emissions.
Use the disclosed data to benchmark performance within sectors and across regions.
The Financial and Environmental Imperative of Addressing Scope 3 Upstream Emissions
Addressing Scope 3 upstream emissions is not just an environmental imperative but a financial one. The staggering scale of these emissions, combined with the substantial financial risks, makes it essential for both corporates and investors to take decisive action.
By focusing on board accountability, supplier engagement, and internal carbon pricing, and by adhering to forthcoming regulatory requirements, companies can make significant strides in reducing their overall carbon footprint.
To access the BCG and CDP Report click here.
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