Scope 3 emissions and the cost of debt

For the majority of companies, reporting scope 1+2 greenhouse gas emissions is standard and, in the UK, it is becoming mandatory for all companies listed on the main market of the London Stock Exchange. But scope 1+2 emissions are typically only some 20% of total emissions, which is why there is a strong push to mandate companies to calculate and disclose their scope 3 emissions (i.e. emissions created by the services and products the company buys in as well as the emissions created by the use and further manipulation of the products and services the company produces) as well.

This expansion of emissions measurements to scope 3 is very important ignoring them can make companies look greener than they really are. Indeed, when scope 3 emissions are taken into account, many ESG indices don’t have a lower greenhouse gas footprint than conventional indices. Furthermore, we know that companies with lower greenhouse gas emissions have a lower cost of debt. But does the cost of debt of a company depend only on its scope 1+2 emissions or also on its scope 3 emissions? Ahyan Panjwani and his colleagues took a closer look at American, as well as European and Asian companies.

First, they find that companies that report scope 3 emissions on top of scope 1+2 emissions have lower credit costs. This may sound counterintuitive, but it confirms the results I discussed here. There is a transparency premium in markets and by just disclosing ESG data, no matter how good or bad it is, companies can reduce their cost of debt. The benefit of disclosing scope 3 emissions data is not small. On average, the researchers found that the cost of debt drops by about 20bps once a company discloses its scope 3 emissions.

Second, they find that credit markets, at least for now, do not penalise companies with higher scope 3 emissions. That is surprising but it may be due to the fact that many lenders simply don’t yet have systems in place that reflect the risks to a business from scope 3 emissions. Think about it this way. Until 2017 the benefit of disclosing scope 3 emissions on lowering the cost of debt was non-existent. Only in the last five years has this reduction in the cost of debt emerged in the market. As scope 3 emissions become more widespread, I expect that companies with higher scope 3 emissions will start to be penalised through higher costs of debt again.

This, of course, means that there is an incentive for businesses to game the system and artificially lower their scope 3 emissions. Scope 3 emissions are incredibly complicated to measure because it requires a firm to get information on thousands or even millions of products from suppliers and make reasonable assumptions about how much and in what way their products are used by customers. When I read greenhouse gas emissions reports from different companies, I regularly come across companies in the same industry with vastly different scope 3 emissions. The reason typically is that one company only measures part of its scope 3 emissions while another company measures all or nearly all of it. Therefore I will keep a copy of the chart below in my records. It shows which elements of scope 3 emissions make up what percentage of total scope 3 emissions on average. It allows me to adjust reported scope 3 emissions at least qualitatively to a common denominator.

Average split of scope 3 emissions of companies

Source: Panjwani et al. (2022)