The Investor's Guide to Scope 1, 2, and 3 Emissions

The era of 'greenwashing' is over. Investors, regulators, and consumers are no longer satisfied with vague sustainability pledges—they demand transparent, data-driven action. This push for transparency stems from growing pressure and a sense of urgency to understand and address the ways investment decisions impact global warming. A key part of that is actively measuring, managing, and disclosing greenhouse gas (GHG) emissions. 

Earlier this year, the U.S. Securities and Exchange Commission (SEC) released new rules requiring publicly traded companies to disclose their scope 1 and 2 emissions, signaling a significant shift towards environmental accountability. While the rules are currently on pause amid legal challenges, the message is clear: businesses can no longer afford to ignore their carbon footprint. 

It’s only a matter of time before private companies are subject to similar regulation. For their investors, this means assessing the carbon footprint of their portfolio companies. That means tracking scope 1, 2, and 3 emissions.

Understanding Scope 1, 2, and 3 Emissions

The foundation of any carbon reduction strategy is understanding where your portfolio companies’ emissions originate, which is the main differentiator in the categories of GHG emissions—scope 1, 2, and 3.

Scope 1 emissions are direct emissions from company-owned or controlled sources, such as the fuel burned in company vehicles or on-site manufacturing processes. These emissions are relatively straightforward to measure and control but represent a key area for operational cost savings and regulatory risk mitigation.

Scope 2 emissions cover indirect emissions from purchased energy, such as electricity, steam, or heating and cooling. A company’s ability to source renewable or more efficient energy can directly influence their financial and operational performance. Scope 2 emissions can be minimized by shifting to renewable energy, offering both environmental and cost savings benefits.

Scope 3 emissions include all other indirect emissions within a company’s value chain. These include emissions from suppliers, transportation of goods, or customer use of products. These emissions typically account for the majority of a company’s carbon footprint and are often the most complex to measure and address. 

For private market investors, the ability to assess companies' scope 1, 2, and 3 emissions is critical to identifying risks and opportunities in your portfolio. Investors can use this information to engage with management teams, assess the company’s environmental and financial sustainability, and guide them in implementing emissions reduction strategies that can enhance long-term value.

How to Assess Private Equity Portfolio Emissions

One of the key challenges in assessing portfolio emissions is defining the organizational and operational boundaries of each company.

Organizational boundaries refer to which parts of a company’s emissions should be counted, based on ownership or control. Investors will need to decide if they will report emissions proportional to their ownership stake or based on the activities they control.

Operational boundaries, on the other hand, define what types of emissions your portfolio companies should track. This involves identifying which emissions are under the company’s direct control (scope 1), and which come from energy use (scope 2) or other indirect sources, like suppliers and product use (scope 3). 

Organizational and operational boundaries are often interconnected when determining the scope of emissions to be included. The specific approach will depend on the unique ownership and operational structure of each portfolio company. 

Ultimately, the goal of emissions tracking is not simply to perform calculations, but to drive meaningful impact and reduce carbon footprints. To achieve this, investors should work closely with portfolio companies to gain clarity on these boundaries and accurately account for emissions. By understanding where emissions come from and who is responsible for them, investors can better guide their portfolio companies on reducing their carbon footprint. Asking how companies plan to tackle these emissions and what steps they are taking to reduce them will be key in aligning emissions tracking with broader sustainability goals.

Long Term Considerations for Investors

At this point, investors may be asking themselves, Why? Why me? Why now? And they are right to ask. Ignoring these requirements would be shortsighted for several reasons:

• Supplier and Customer Expectations: As integral parts of supply chains, private companies need to demonstrate climate responsibility to meet transparency and sustainability demands from public company partners.
• Regulatory Precedent: SEC regulations often set industry standards, and private companies may anticipate similar climate reporting requirements emerging at state or federal levels. 
• Future IPO Aspirations: Many private companies, especially those backed by private equity, aim to go public. Preparing for SEC-like disclosures can facilitate a smoother transition to public markets.
• Risk Mitigation: Engaging in climate reporting helps private companies proactively identify and mitigate climate-related risks, including regulatory changes and reputational damage.
• Competitive Positioning: By voluntarily adopting climate reporting practices akin to those of public companies, private firms can enhance their reputation and gain a competitive edge in environmental responsibility.
• LP Expectations: As sustainability concerns grow, GPs face pressure to disclose their environmental impact, which can improve their attractiveness to investors. 
• Access to Capital: Even without going public, private firms may need to secure financing from investors who prioritize climate risk. Transparent reporting can provide the assurance these stakeholders seek. This is particularly important as private firms increasingly seek capital from a wider range of sources, including blended finance options like debt and grants, which can complement equity investments and reduce investor risk.

Turning Emissions Insights into Action

Investors should actively engage with portfolio companies to understand their emissions reduction strategies, with a focus on early implementation. Prioritizing capital expenditures for climate initiatives early in the investment lifecycle allows investors to capitalize on returns earlier in the hold period. Calculating the return on investment for emissions reduction efforts is also crucial for guiding decision-making and demonstrating the value of these initiatives. While some climate-related initiatives may take longer to show a return, early investments can enhance operational efficiency, reduce regulatory risks, and ultimately lead to a higher valuation at the time of exit. 

Investors should encourage portfolio companies to act decisively and implement emissions reduction strategies to maximize long-term value. By taking swift action and prioritizing sustainable practices, companies can position themselves for success in a low-carbon economy and achieve both environmental and financial benefits.

For more in-depth guidance on determining which emissions are material to your investment decisions, read our follow-up article on materiality and emissions.

Work with Tablecloth

At Tablecloth, we understand the complexities of emissions reporting and are here to assist businesses and investors in navigating this evolving landscape. Whether you're at the beginning of your sustainability journey or looking to refine your strategy, we offer the tools and insights needed to transform climate-related risks into opportunities for growth and impact. Book a demo to learn more.