1. Response to climate change risks is an important management issue

Response to climate change risks has become an important management issue for companies. According to the Task Force on Climate-related Financial Disclosures (TCFD), climate change risks can be broadly divided into physical risks and transition risks. Examples of physical risks include factory shutdowns and supply chain disruptions due to natural disasters, decreased productivity due to extreme heat, shifts in agricultural production regions, and the loss of business sites due to sea level rise. On the other hand, examples of transition risks include the introduction of carbon taxes and emissions trading, restrictions on the sale of gasoline-powered vehicles, changes in competitive advantage due to new technologies aimed at decarbonization, and growing consumer preference for products with low greenhouse gas emissions. These risks are thought to have a significant impact on corporate management in the medium to long term.

2. Disclosure of greenhouse gas emissions

Under these circumstances, it is becoming increasingly important for companies to disclose information on climate change risks. The GHG Protocol, which is an international standard for greenhouse gas emissions related to corporate climate change risks, requires that emissions from corporate activities be measured and disclosed. These emissions must be categorized into direct emissions within the company (Scope1), indirect emissions from purchased energy consumption, such as electricity. (Scope2), and all other indirect emissions that occur in the value chain of the reporting company (Scope3). Scope3 covers emissions throughout the entire value chain, from the production and distribution of raw materials and parts, to the expansion of production facilities, employee commuting, and product use and disposal.

3. Importance of supply chain emissions

For many companies, emissions in the supply chain far exceed emissions resulting from their own in-house activities. For example, automobile manufacturers emit far more when their vehicles are driven by users than they do directly during manufacturing or from their own consumption of electricity. In the case of food manufacturers, more emissions are emitted during the production of ingredients. In the apparel industry, where outsourcing is common, there are high emissions during manufacturing upstream in the supply chain, as well as high emissions at the time of product disposal.

4. Stock prices reflect future expectations

How does information on climate change risks impact stock prices? In equity valuation, a discount rate is used to convert future cash flows to present value. The discount rate is composed of the risk free rate and the risk premium. Here, risk premium refers to the return that investors demand in exchange for bearing risk. At present, it is thought that climate change risks impact stock prices mainly through the discount rate, as they increase the uncertainty of companies' future cash flows. Assuming that other conditions are constant, a higher risk premium will result in lower stock prices.

5. Climate change risks are being reflected in stock prices

In fact, recent previous research suggests that direct emissions on business premises and indirect emissions from purchased energy consumption, such as electricity (in other words, emissions categorized in Scope1 and Scope2) are already reflected in corporate valuations.^[1] However, due to limitations in data, the impact of disclosing Scope3 emissions generated in the supply chain on stock prices is largely unknown.

6. Issues in disclosing supply chain emissions

As one can easily imagine, measuring and disclosing Scope3 emissions is a difficult task. Measuring emissions in each category requires estimating the amount of activity corresponding to each category and emissions for each activity. Sharing of information with business partners is also required. Furthermore, even among companies that disclose emissions, there are cases where an insufficient number of categories is disclosed, and there are also problems with the accuracy and consistency of data. Due to these issues, some previous studies have questioned whether the benefits to disclosing companies are worth the costs associated with Scope3 disclosure.

7. Benefits of disclosing supply chain emissions

Are the benefits of disclosing Scope3 emissions worth the costs? To answer this question, we analyzed the impact of disclosing Scope3 emissions on the cost of equity capital.^[2]

There are two ways in which Scope3 disclosure can affect the cost of equity capital. First, firms that can measure and disclose Scope3 emissions may be able to appropriately deal with future climate change risks, and thus Scope3 disclosure can be a signal for the ability to respond to climate change risks. Second, disclosing Scope3 emissions makes it more difficult to transfer emissions to the supply chain, etc. (carbon leakage). For example, a company could reduce direct emissions by outsourcing production to another company. However, such a reduction in direct emissions is merely a transfer to supply chain emissions, and is not an essential reduction in emissions. If supply chain emissions are disclosed, such carbon leakage will be made visible. We hypothesized that disclosing Scope3 emissions would mitigate the risk premium associated with climate change risks through these two channels.

8. What is the impact of disclosing supply chain emissions?

We verified our hypothesis using the implied cost of capital, which is calculated based on stock prices and earnings forecast data. The advantage of using the implied cost of capital rather than ex-post returns is that the former directly reflects the ex-ante returns required by investors.

Empirical analysis showed that Scope1 and Scope2 emissions increase the cost of equity capital. These findings are consistent with previous research and suggest that investors are demanding a risk premium for climate change risks arising from a company's activities. On the other hand, it was shown that such an increase in capital costs is mitigated to some extent for companies that disclose Scope3 emissions. These results are consistent with our hypothesis, and suggest that disclosure of Scope3 emissions may mitigate the increase in risk premium associated with climate change risks.

9. Disclosing supply chain emissions can increase access to financing

In order to reduce greenhouse gas emissions, it is essential to reduce not only emissions within a company but also emissions in the supply chain. Measuring and disclosing Scope3 emissions is the first step in efforts to reduce supply chain emissions. If, as shown by our analysis, Scope3 disclosure suppresses increases in the cost of equity capital, companies engaged in disclosure will find it easier to raise funds and be able to further advance climate change measures. There are pros and cons to mandatory Scope3 disclosure, but it is hoped that an increasing number of companies will recognize the benefits and engage in voluntary Scope3 disclosure.

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[1] For recent research trends on the relationship between climate change and stock prices, see the following literature: Sasaki, T. (2023), "Climate Change Risks and Risk Premium," Securities Analysts Journal, 61 (10), pp. 48-53.
[2] Collaborative research conducted with Yamane, S. (International Christian University)

Takafumi Sasaki／Professor, Faculty of Policy Studies, Chuo University
Areas of Specialization: Corporate Social Responsibility, Corporate Governance, and Corporate Finance

Takafumi Sasaki graduated from the Faculty of Science, Tokyo University of Science. He completed the Master’s Program in the Graduate School of Management Science and Public Policy Studies, the University of Tsukuba, and completed the Doctoral Program in the Graduate School of Commerce and Management, Hitotsubashi University. He holds a Ph.D. in commerce. He worked at a think tank (Nikko Research Center) affiliated with Nikko Securities (now SMBC Nikko Securities) and in the Graduate School of Economics, Nagoya City University and the School of Management, Tokyo University of Science before assuming his current position. He serves as a council member of the Japan Finance Association (since 2019), editor-in-chief of the Japan Journal of Finance (2021-2022), and member of the editorial committee for the Securities Analysts Journal (since 2001).

He has published papers in academic journals such as Financial Management, Pacific-Basin Finance Journal, Accounting and Finance, and Asia Pacific Journal of Management.

His areas of specialization are corporate social responsibility, corporate governance, and corporate finance.

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