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Purchased Energy Emissions In Second Party Opinions And ESG Evaluations


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Purchased Energy Emissions In Second Party Opinions And ESG Evaluations

This commentary was authored by the Sustainable Finance Group of S&P Global Ratings. It relates only to our second party opinions and ESG evaluations. It does not relate to credit ratings, comment on current credit ratings, or constitute a methodology used for credit ratings.

We updated this report, originally titled "Purchased Energy Emissions In ESG Evaluations And Sustainable Financing Opinions," and published June 9, 2022, to include carbon capture technologies and a more granular analysis of various contractual instruments used to mitigate carbon emissions. An appendix has also been added to provide examples of scope 2 emissions accounting under different scenarios.

S&P Global Ratings believes that current greenhouse gas (GHG) accounting practices can obscure how effectively corporates are contributing to national and international net-zero goals. This makes differentiating climate leaders from the pack difficult. In this report, we pinpoint the challenges of interpreting and comparing corporate disclosures on scope 2 emissions, an important source of emissions associated with procured energy. We also lay out how different corporate strategies to improve emissions performance influence emission reductions, and how we factor these considerations into our SPOs and ESG evaluations. This report discusses scope 2 emissions in the context of stakeholder materiality and not in the context of our credit ratings.

The Scope 2 Accounting Dilemma

To support broader climate and net-zero goals, many companies include scope 2 emissions in their near-term sustainability strategies, in addition to those generated by their own operations (scope 1). To compare emissions performance across corporates and determine if companies are on track to meet their sustainability targets, it is essential to understand how entities calculate and report their emissions.

Differences in how companies report scope 2 emissions make interpreting and comparing emissions performance a challenge.  Currently, most emissions are accounted for using the GHG Protocol Corporate Accounting and Reporting Standard. In accordance with the standard, scope 2 emissions should be reported using either the location-based method or both the location- and market-based method (defined below). However, in practice, companies do not always disclose location-based data in addition to market-based data, or clearly identify which method they have used when reporting emissions. Reported emissions can widely diverge under the two methods (see Appendix for examples of accounting outcomes when using different energy sources and contractual instruments). To complicate matters further, data bases storing this information do not always specify the method used, may mix reporting methods, or only collect data based on a single method. This variance makes it difficult to compare performance across companies and determine whether a company's actions meet broader net-zero goals set at the country level or globally through the Paris Agreement.

The location-based method of calculating emissions closely tracks reductions of the company and at the global level, making it the more useful of the two methods, in our view.  According to this method, companies measure scope 2 emissions associated with the energy they receive from the local grid by each of their assets. As such, emission reductions under location-based reporting stem largely from factors outside the company's control, such as decarbonization of the grid funded by other entities (including from utilities or through government subsidies). The company's impact on emissions reduction is then limited to its own efforts to use less energy through efficiency projects, or the deployment of on-site low-carbon energy generation--in which case, a small amount of emissions may migrate to its scope 1 reporting.

There are limitations to relying solely on location-based accounting though.  Companies that purchase power with higher emissions than the grid they operate in can hide emissions by sticking with location-based reporting, since it effectively provides a cap to a company's reported scope 2 emissions.

With market-based accounting, a reduction in a company's scope 2 emissions may not necessarily indicate improvements in national or global emissions, however.  This is because the market-based approach allows companies to report emissions based on contracted agreements with energy suppliers for any procured renewable energy. This method of accounting allows companies that have secured green energy contracts, often at a premium, to distinguish themselves. Companies then report the emissions of the residual energy mix that is not secured by renewable energy contracts; this likely has a higher concentration of fossil fuels, reflecting the local grid mix. So, at the regional or global level, there may not be any actual reductions in emissions, despite a reduction in a company's reported market-based scope 2 emissions. This disconnect means that a company's reduced scope 2 emissions might not advance national or global net-zero goals if the procured renewable energy comes from existing and older renewable energy assets, or assets located in another country from the reporting company.

If standardized GHG reporting evolved to include both market- and location-based accounting methods, this would improve benchmarking.  At the aggregate level, total emissions from location- and market-based purchased energy should be the same. However, the disclosure optionality creates an incentive for companies that spend on renewables--and disincentives to those that don't--to publish market-based figures. Reporting using only one approach leads to data inconsistencies and weaker comparisons on company performance. As such, we view best-practice disclosure to include both market- and location-based methods.

Not All Emission-Mitigation Strategies Are Created Equal

While companies have a variety of options to cut their scope 2 emissions, some are more effective than others and contributions toward national and global net-zero goals vary.  Most companies' disclosures do not provide further insight into the strategies they are using. This breakdown, however, is a point of interest in analysis. Below we clarify our views on the relative strengths of various strategies broken down into two broader baskets: those that focus on how energy is supplied or procured, and those that focus on the demand side. Both types of strategies are required on a large scale to achieve emission reductions compatible with the goals of the Paris Agreement. From a procurement standpoint, we see as strongest the strategies that result in the addition of renewable energy generation capacity. From a demand standpoint, the strongest strategies, in our view, are the ones that result in the consumption of less energy, or consuming energy at the right time and place to best match renewable energy generation.

A closer look at supply-side strategies

Chart 1


On the supply side, companies can look toward renewable energy generation facilities, various contractual instruments like power purchase agreements (PPAs) and energy attribute certificates (EACs), as well as other approaches like carbon credits and carbon capture and storage (CCS) to bring down their scope 2 emissions. In assessing the strength of these strategies, we focus on two main aspects:

  • Whether related projects appear more likely to support additional renewable energy production, since these have a greater potential to reduce global emissions (see sidebar on additionality); and
  • The full lifecycle of emissions associated with the power generated in contractual instruments or other energy technologies used, among other aspects, since low-carbon power production and technologies like CCS generate varying amounts of emissions over their lifetime.

Renewable energy generation facilities are among the most effective tools to cut emissions but are not viable for all companies.  When a company installs renewable generation assets like solar panels on its premises, it ensures that electricity is from a renewable energy source. It is owned by the company and would not have taken place without the company's investment and hence meets the additionality criteria. A company needs to have the space to install generation capacity (e.g., rooftops for solar) and sufficient energy potential in its assets' locations.

Companies can also switch their assets' heating and cooling systems to low-carbon solutions, such as ground source heating and cooling. This significantly reduces emissions compared with conventional systems.

With PPAs, it is important to consider the specific agreement and corresponding local electricity market conditions when assessing their emissions-abatement potential.  For a PPA, a company secures a purchasing contract with the renewable energy supplier; and these usually come with EACs (covered in greater detail below). Since PPAs are often measured in megawatts of electricity capacity, they may not be viable for companies with smaller needs, for example, corporate offices. PPAs can be considered additional if the company's agreement with the supplier makes the generation capacity built financially viable. There are two main types of agreements:

  • Physical PPAs, where there is either a direct connection between a generator and off-taker or it is "sleeved" through the grid. A physical PPA is more likely to be additional, if it involves a new power generator specifically connecting to an off-taker's assets. In these cases, we view PPAs as a relatively strong supply-side emissions-reduction tool.
  • Virtual PPAs, which act as a financial hedge on energy prices and may or may not directly support additional renewable energy generation. Virtual PPAs can correspond poorly to reductions in local grid emissions, when generated in a market that differs from the purchaser's location or from old renewable assets. This is often the case when projects arrive at the end of the original offtake contract that supported the financing of their construction. As such, we view them as weaker than other supply-side emission-reduction tools. That said, we recognize they may still be the best or only option in some instances and that most climate initiatives still accept virtual PPAs as a valid method of meeting corporate climate-related goals. This includes the Science Based Targets initiative (SBTi), which relies on RE100 guidelines to achieve 100% renewable energy purchased when validating companies' GHG emissions reduction targets (RE100 is a global corporate renewable energy initiative, with over 300 members, that provides guidelines on how to reach 100% renewable electricity by "making credible claims").

The tariffs paid for EACs have so far been insufficient to meet additionality criteria and improve the financial viability of new renewable generation capacity, but this may change.  Companies purchase EACs to claim their electricity is from a utility's renewable energy sources. Each utility can issue EACs in proportion of its renewable energy production. While a company pays for this claim, it still receives the same electricity supply as before and it may come from fossil sources. These certificates exist in bundled and unbundled forms:

  • With bundled EACs, generally included in "green tariffs" or "green pricing," a company pays extra to claim its electricity is from its utility's renewable energy sources. If prices are high enough to incentivize renewable capacity additions, then with bundled certificates this would take place within the same grid as the company's assets. As such, we view bundled EACs as having more potential to support decarbonization claims than unbundled EACs, depending on the specific circumstances of the tariff and market we assess.
  • With unbundled certificates, a company also purchases the rights to claim its electricity comes renewable energy sources, but from another utility, often located in another country and grid. As such, they can correspond poorly to reductions in local grid emissions. If the price of unbundled certificates makes more renewable energy projects financially viable, the new projects would need to be local to the company's assets for those assets to use less fossil fuel-based electricity. Given this, we view them as weaker than other supply-side emission-reduction tools. That said, like virtual PPAs, we recognize that most climate initiatives, including the SBTi, still accept unbundled certificates as a valid method of meeting corporate climate-related goals. Furthermore, we recognize that in some instances there are significant barriers to alternatives, owing to local regulations. While the use of unbundled certificates is slowly declining, it still accounted for a high 39% of renewable energy sourcing methods among RE100's members in 2021 (down from 46% in 2017), according to the initiative's latest annual report.

Renewable energy certificates (RECs), guarantees of origin (GoOs), or renewable energy guarantees of Origin (REGOs) are all specific types of EACs.

We view carbon credits primarily as a tool to compensate for any residual emissions that other more tangible and urgent efforts on the volume and source of energy consumed cannot, making them a less robust approach to managing scope 2 emissions.  A carbon credit is a tradable certificate a company can purchase on voluntary markets that represents emission reductions made elsewhere. These differ from the contractual instruments mentioned above in that they do not necessarily describe the nature of or the quantity of energy consumed. Instead, they represent the emissions avoided or reduced by a potentially vast array of other activities. Some entities use voluntary carbon credits to claim that their net emissions impact is effectively zero by purchasing a number of credits equal to their emissions. However, the underlying emissions of the entity still occur. Carbon credits in voluntary markets have often had challenges demonstrating projects' additionality and the amount of emissions reduced. What's more, some carbon credits may not reflect permanently reduced emissions.

There are potential benefits to CCS, but we currently view them with caution.   Entities can theoretically lower their emissions by sourcing power from facilities that use CCS technologies to reduce the amount of emissions reaching the atmosphere. However, this power may still be generated from fossil fuels--indeed the vast majority of CCS projects currently in operation capture emissions directly from gas-fired power plants. Companies can also outsource carbon capture to support claims on a net emissions basis, a more recent development. In those instances, a CCS project removes carbon from the atmosphere without consideration for its provenance using technologies such as direct air capture (DAC). These approaches can either involve a contract between the CCS operator and customer or the generation of carbon credits, which companies can purchase or trade. Another benefit of CCS, at this point, may be the high price it puts on carbon; for example, recent DAC cost estimates are as high as $600 per ton, which appears more in sync with long-term decarbonization goals than the few dollars per megawatt-hour fetched by RECs. While we see such high prices as reflecting technological developments yet to achieve scale, we also believe that they are likely to incentivize developers to continue building capacity and buyers to keep gross emissions in check.

We see potential drawbacks to CCS at the moment though, including possibly perpetuating the use of fossil-fuel intensive systems and the lack of green power additionality. There is also uncertainty about the emissions generated by the operation of the capture and storage process, which is highly heat and water intensive, and the need for verification of the removal of carbon from the atmosphere. That said, there are efforts to develop certification standards, which is positive.

The flip side of the coin: Strategies to reduce (brown) energy demand

Companies may reduce their demand for electricity or create changes in their demand that have a positive effect on emission reductions.  The graphic below describes our view of projects that change the quantity and characteristics of demand for electricity and their link to emission reductions. The stronger practices are more likely to have an immediate impact on emissions, provided these practices are beyond business as usual.

Chart 2


Significant improvements in energy-efficiency projects are critical to achieve net-zero trajectories.  Every climate scenario makes assumptions on energy efficiency gains. This includes those that are aligned with net zero or the Paris Agreement as well as the less ambitious business as usual-type scenarios that fail to keep global warming below 2 degrees Celsius by the end of the century. As such, energy-efficiency projects for companies to reduce scope 2 emissions need to go beyond historical patterns and existing national plans to support net-zero trajectories.

Energy-efficiency projects may not always be economically viable though. For example, a company with a large vehicle fleet might look to electrify the fleet to mitigate its emissions; although scope 1 emissions might reduce, this will ultimately drive up its overall electricity demand, shifting the financial burden from its gas or diesel bill to its electricity bill.

Load-shifting can have a strong impact on emissions but faces practical limitations.   This is when a company shifts electricity demand to times where renewable energy generation is maximized. Depending on the location and grid, this could be at night when wind energy potential is highest, or during peak solar potential. Load-shifting may not always be possible for a company to implement, and it will also depend on the demand of other users of electricity in the grid.

Similarly, while relocating assets to cleaner grids offers potential, it may not always be feasible.   Furthermore, the act of relocation might come with an emission cost if the company has to build a new facility, or if the supply chain becomes longer causing higher emissions from its logistics due to the increased demand for fossil fuel-based transportation. Since the net impact on emissions could increase over the lifespan of the asset, we view this practice as only having limited emission-reduction potential.

The sale or outsourcing of assets, particularly those that consume energy from conventional fossil fuels, reduce scope 2 emissions, but actual environmental benefits can vary widely.   If the company takes the asset out of its full consolidation scope for accounting purposes and emissions reporting "boundaries," but still uses the asset (for example via an affiliate or supplier) then the scope 2 emission reduction is likely to be superficial and may result in an equivalent bump in the less scrutinized scope 3 emissions. There is also a risk that large public companies sell units with the most problematic environmental records to smaller private firms with less clearly stated environmental ambitions, resulting in no change to overall emissions volumes. In this case, a visible scope 2 figure moves to a less visible place. Non-standardized methods of calculating and adjusting key performance indicators in sustainability-linked instruments may incentivize such arbitrage.

Companies can also advocate for policy changes that encourage grid transformation or enable energy reductions, but this is only likely to yield benefits in the longer term.   We note that there are many industry groups that work with government stakeholders to co-create policies that could accelerate climate mitigation. The Glasgow Finance Alliance for Net Zero is one. We also note recent efforts by competition regulators to adjust rules for firms that collaborate on climate ambitions, alleviating concerns about competitors setting common de-carbonization objectives.

Better Disclosure Could Help Identify Climate Leaders

Detailed disclosure of emission-mitigation strategies, including breakdowns of renewable energy sourcing methods, could help analysts identify climate leaders.  To date, however, limited disclosure on how companies achieve scope 2 emission reductions makes it difficult to determine the overall reliance on certificates, PPAs, or other mitigating strategies. We expect disclosure rules, guidance, and industry initiatives to improve transparency on how scope 2 emissions data should be reported and information on energy use. In 2023, the International Organization of Securities Commissions, which sets standards for securities supervision, plans to share its recommendations on compliance carbon markets and voluntary carbon markets. This would mark a step forward in promoting sound and efficient markets and helping financial regulators support the integrity of those markets.

Going Beyond Scope 2 Disclosures In Our SPOs and ESG Evaluations

Within our SPOs and ESG evaluations, we consider the connection between companies' emissions, their strategy and active efforts to reduce these emissions, their reporting, and the ultimate impact on the global goal to mitigate climate change.  Our interactions with entities we evaluate give us greater insights on these topics. We consider projects of higher quality when they meet the International Panel on Climate Change's condition of additionality, since this is likely to have greater impact on global emission reductions. Additionally, our views on the different emission-mitigation approaches on the supply and demand side (see graphics above) are reflected in the scores we assign, when relevant. This is the case, for example, in our assessment of sustainability-linked target ambitions.

In our SPOs, we look to include the relative strength of mitigation strategies to understand how committed a company is to actually meet its target.  Notably, scope 2 emissions are an area where we believe this nuance warrants particular focus to understand how ambitious the company's sustainability performance targets are. There is a tradeoff between strong practices from an emission-abatement potential and the feasibility of the practices. As such, the choice of mitigation strategy speaks also to the ambition to achieve the target set, in our view.

We also look beyond scope 2.  While this article focuses on scope 2 emissions, we acknowledge that some activities involving significant energy use may occur in a company's value chain and sources of revenue, including investments, leased assets, or use of sold products, which constitute scope 3 emissions. For example, to meet science-based targets companies may encourage their suppliers, franchises, or investments to reduce emissions by achieving renewable energy targets. We carry our views on the relative strength of mitigation strategies over to other relevant scopes. For example, while an individual target on scope 1 and 2 emissions may be ambitious on its own, especially when emissions are large in absolute terms, its relevance may only become apparent in full in conjunction with an analysis of other targets, notably for scope 3 emissions. When companies in sectors with large scope 3 emissions set scope 1, 2, and 3 reduction targets, we view this more favorably than if they only set targets for one of those, all else equal. We also pay attention to the targets companies select for their individual debt issuance among the potentially broad array of targets they have defined in their sustainability frameworks. Indeed, while a company's sustainability-linked debt framework usually lists all possible indicators and targets it is considering using, the company will only commit to targets it selects for its subsequent debt issuances.

Appendix: Scope 2 Emissions Accounting Examples

Below we provide three examples of how location- and market-based reporting methods yield widely different results when using various procurement and contractual instrument mixes. This gives consumers different incentives to report market-based emissions.




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