How should we measure and manage carbon emissions? Scopes 1, 2 and 3 explained

Key points

• Financial institutions and investors rely on the GHG Protocol which provides a framework to accurately assess climate-related risk associated with emissions and track companies’ transition to a net-zero economy.
• The existing protocol – composed of scopes 1, 2 and 3 – is facing criticism for accounting challenges, particularly in scope 2. Accurate measurement of scope 3 emissions is also challenging due to inconsistent data quality, and lack of direct access to supplier and customer emissions information.
• Global emissions reporting is rapidly evolving under regulatory pressure in places like California and the EU. And new scope – scope 4 – is being considered to account for avoided emissions.

As identifying climate-related risk increasingly becomes the norm, financial institutions and investors need information on corporate greenhouse gas (GHG) emissions in order to accurately assess those risks. The transition to a net-zero economy means companies that have high levels of emissions in their value chains may be viewed as higher risk, particularly if they don’t have a clear plan to reduce or mitigate those emissions.

The most widely used accounting standard is the framework that defines scopes 1, 2 and 3. Developed by the GHG Protocol – a partnership between the World Resources Institute and the World Business Council for Sustainable Development – it has become the principal method of collating and assessing emission data. In 2023, 97% of disclosing S&P 500 companies used GHG Protocol standards to report their emissions to CDP, a global non-profit that runs the world’s only independent environmental disclosure system.

The protocol defines three different categories, or scopes, of emissions:

• Scope 1 includes emissions that a company or organisation has direct control over, most commonly generated by burning oil, coal or gas, such as in their own fleet of vehicles
• Scope 2 covers indirect emissions that come from the use of electricity, steam, heat and cooling bought from third parties to power offices and factories
• Scope 3 is indirect emissions from the whole value chain, including those generated in producing products or services bought from a supplier, as well as emissions created when customers use their products or services. For example, car manufacturers would include the emissions created when their cars are used.

The first protocol standard was published in 2001, covering seven greenhouse gases including carbon dioxide, methane and nitrous oxide. The GHG Protocol Initiative says this standard has enjoyed broad adoption and acceptance by businesses, NGOs and governments because many stakeholders were included in its development.

Scope 2 emissions were added in 2015, a big step forward as generating electricity and heat account for at least a third of global emissions. The inclusion of scope 2 also created new incentives for investment in renewable energy, as the protocol uses market-based accounting to permit companies to report lower scope 2 emissions if they purchase renewable energy certificates (RECs) to offset their consumption of electricity generated from fossil fuels. Law firm Morrison Foerster says this has been a key driver in adding more than 100 gigawatts of clean electricity to the US grid since 2014.

Criticism over scope 2 double accounting

However, the protocol has also drawn criticism for encouraging misleading emission accounting. Academics at the Centre for Business, Climate Change and Sustainability at Edinburgh University say it suffers from several kinds of accounting challenges.

For example, they note that the protocol has led to European companies buying RECs from Norwegian hydropower plants thousands of kilometres away, even though they cannot be physically supplied by them. At the same time, Norwegian companies also report the climate benefit of using this power, a kind of double accounting. In a similar vein, the accounting standard allows companies to claim they are solely powered by solar energy, even at night. This topic has become all the more pressing due to the expansion of power-hungry data centres needed for AI.

The GHG Protocol recently held public consultations on revising scope 2 guidance to respond to these criticisms.

“If adopted, the updates are poised to profoundly reshape corporate renewable energy procurement strategies … the changes would likely increase the complexity and cost of achieving ‘zero-emissions’ Scope 2 targets,” according to Morrison Foerster partner Susan Mac Cormac.

“Greater rigor in Scope 2 accounting is desirable for accuracy. However, imposing strict mandatory requirements without sufficient market readiness or technological solutions could inadvertently slow corporate renewable energy adoption, especially among smaller companies with fewer resources.”

Updated guidance on scope 2 guidance is expected towards the end of 2027, with a phased-in implementation period.

Scope 3 make up bulk of emissions

Companies are also struggling to measure scope 3 emissions.

“Most companies lack direct access to emissions data from their suppliers or customers, making it hard to build a complete picture of their scope 3 footprint. Even when such data is available, its quality often poses a problem. It may be incomplete, outdated or based heavily on assumptions rather than primary measurements,” says carbon accountancy firm Asuene.

McKinsey estimates that scope 3 emissions often represent around 90% of a company’s total emissions, though the figure can vary by industry and company. To achieve their emissions reductions targets, many organisations have made scope 3 emissions a higher priority.

Consultants Deloitte says the Partnership for Carbon Accounting Financials (PCAF) is the leading standard for the financial sector, adopted by many leading European and Norwegian financial institutions. It aims to address the complexity of accounting for scope 3 emissions across asset classes such as listed equities, corporate bonds, mortgages and project finance. PCAF complements global disclosure initiatives such as the Task Force on Climate-related Financial Disclosures or the Science Based Targets initiative.

“The emissions reporting landscape for financial institutions is evolving rapidly under the dual pressures of regulatory requirements and stakeholder expectations,” said Deloitte senior manager Jonathan Krakow. “Achieving comparability and reliability across the industry remains a work in progress.”

Last year, together with the International Organization for Standardization, the GHG Protocol announced a partnership to harmonise their portfolios of emissions standards and to jointly develop new standards for emissions accounting and reporting.

The EU’s corporate sustainable reporting directive (CSRD) requires disclosing scopes 1,2, and 3, although the regulation will only apply to bigger companies after it was watered down last year.

Franziska Mager, formerly a senior researcher at the Tax Justice Network, notes that the CSRD is not designed to take on the role of internal capital markets and subsidiary activities. As a result, it can easily be flouted.

“Lacking transparency standards and differences in emerging regulatory frameworks between regions create a fertile ground for greenlaundering to thrive. Regulation meant to enhance transparency is insufficient and unstandardised,” Mager said.

Public and private US companies doing business in California with annual revenue over US$1bn will have to start disclosing their scope 1 and 2 emissions this year, with scope 3 reporting required in 2027.

However, the Securities and Exchange Commission voted last year to end its defense of the rules requiring disclosure of climate-related risks and greenhouse gas emissions, although the California requirements mean many US companies will still have to report their emissions.

The Sierra Club estimates that 75% of the Fortune 1000 could be required to disclose their carbon emissions – including scope 3 – under the Californian rule.

Banks were encouraged to include their clients’ scope 1, 2 and 3 emissions “where significant and where data allow” by the now disbanded Net-Zero Banking Alliance.

“It may not be possible to calculate the precise proportion of a bank’s financed emissions that have been measured. Nevertheless, banks should take reasonable steps to ensure that the assessment covers a significant majority of their emissions,” the NZBA wrote in guidance for banks.

Looking to the future

Zaneta Sedilekova, director of climate and nature risk consultancy Planet Law Lab, highlighted that existing climate reporting rules still leave a gap for many professional services firms, whose most significant climate impact comes not from their own operations but from their clients’ activities, such as oil and gas projects they advise on. She says there is growing pressure to account for these serviced or advised emissions, including through emerging standards and guidance for banks, insurers and law firms.

Sedilekova said the motivation to consider these indirect climate impacts is shifting.

“It is no longer just about being a ‘good corporate citizen’, but about meeting professional responsibilities on risk management, disclosure and client advice, in a context where climate litigation is increasingly recognised as a material financial risk,” she said.

“A lawyer, accountant or other adviser who ignores foreseeable, material climate risks in their advice could face allegations of negligence in the coming years, particularly as supervisory expectations, professional guidance and case law continue to evolve.”

Some have proposed introducing a new category, or scope 4, to refer to emissions that are avoided due to the activities of an organisation or company, such as through the sale of a more efficient or environmentally friendly product.

There are no official standards or guidelines for this category but the GHG Protocol notes that companies have a considerable interest in claiming their products can help avoid emissions. The World Resources Institute has proposed a framework for estimating and disclosing both positive and negative impacts of products, and provides recommendations for companies to improve the credibility and consistency of their claims

“While it’s true that the use of some products can help to avoid GHG emissions, accurately measuring a product’s impact – whether positive or negative – can be challenging,” the proposal states.

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