7.1 From Naming ESG to Understanding It
Company emissions are counted in three scopes under the GHG Protocol. Scope 1 comes from sources the company owns or controls. Scope 2 comes from the energy it buys. Scope 3 covers everything else in its value chain, from suppliers to customers’ use of the product. Scope 3 is usually the largest share and the least precise, so a carbon footprint is only as good as its Scope 3 method.
Why it matters: A footprint that leaves out the biggest part is only a partial picture.
Summary: Company emissions are counted in three scopes under the GHG Protocol: Scope 1 from sources the company owns or controls, Scope 2 from the energy it buys, and Scope 3 from the rest of its value chain. Scope 3 is usually the largest share and the least precise, so a footprint is only as good as its Scope 3 method.
- Scope 2 has two methods: location-based (grid average) and market-based (contracts and certificates); report and read both.
- In the worked example, Scope 3 is 88.7% of a 186,010-ton footprint, and certificates cut market-based Scope 2 by 62% without changing a machine.
- Financed emissions attribute a borrower’s emissions to lenders by outstanding amount ÷ enterprise value including cash (PCAF).
- Outsourcing, asset sales, estimates and price-driven revenue growth all change reported numbers without changing physical emissions.
Volume I, Part 8: Operational Risk Governance & Reconciliation named ESG (Environmental, Social, Governance) as a set of factors investors weigh alongside financial metrics. This Part shows how that idea is put into practice: how emissions are counted (this section), how ratings are built from disclosures and why they disagree (Sections 7.2 and 7.3), how green and sustainability-linked debt is structured (Sections 7.4 and 7.5), how regulators police the claims (Section 7.6: Greenwashing and Regulatory Response), and why the whole field is now contested from two sides at once (Section 7.7: The Real Debates Surrounding ESG). Start with carbon, because almost every climate number you will meet in a rating, a fund report or a loan agreement is built from the same accounting.
The accounting rules come from the Greenhouse Gas Protocol, which almost every disclosure standard and regulator builds on. It sorts a company’s emissions into three “scopes” so that each ton has one owner within the company’s own report. Scope 1 emissions are direct emissions from sources the company owns or controls: the gas burned in its boilers, the diesel in its trucks, the chemical reactions in its plants. Scope 2 emissions are the indirect emissions from generating the electricity, steam, heat or cooling the company buys. Scope 3 emissions are everything else in the value chain, upstream and downstream, across 15 categories, from purchased goods (category 1) to the use of sold products (category 11) to investments (category 15). For most companies Scope 3 is by far the largest share, and it is also the least precise, because it depends on other companies’ data and on estimates.
Scope 2 has two methods, and the gap between them is where many claims are made. The location-based method multiplies the electricity a company used by the average emission rate of the grid it draws from. The market-based method uses the contracts the company has signed instead: renewable energy certificates, power purchase agreements and supplier-specific rates. Where such contracts are available, the GHG Protocol’s Scope 2 Guidance requires both figures to be reported, each labeled by method. Because certificates can be bought separately from the electrons, the market-based number can fall sharply while the physical grid is unchanged. The GHG Protocol opened a consultation on October 20, 2025, proposing hourly matching and deliverability tests for market-based claims, with a final revised standard expected in 2027 (GHG Protocol, Scope 2 consultation).
A hypothetical US manufacturer has revenue of $500 million. Fuel and power figures come from its invoices; emission factors for fuel and the grid are the EPA’s (GHG Emission Factors Hub, 2025); the Scope 3 figures and the residual-mix factor are illustrative assumptions. Only CO₂ is counted, to keep the arithmetic visible.
| Line | Formula | Metric tons CO₂ |
|---|---|---|
| Scope 1: natural gas | 150,000 MMBtu × 53.06 kg ÷ 1,000 | 7,959 |
| Scope 1: diesel fleet | 250,000 gallons × 10.21 kg ÷ 1,000 | 2,553 |
| Scope 1 total | 7,959 + 2,553 | 10,512 |
| Scope 2, location-based | 30,000 MWh × 771.5 lb ÷ 2,204.6 lb per ton | 10,498 |
| Scope 2, market-based | 20,000 MWh covered by certificates at 0 + 10,000 MWh × 0.40 t (assumed residual mix) | 4,000 |
| Scope 3, category 1 | $200 million of purchases × 0.45 kg per dollar (assumed spend-based factor) | 90,000 |
| Scope 3, category 11 and others | 60,000 (use of sold products) + 15,000 (other categories), assumed | 75,000 |
| Total, location-based | 10,512 + 10,498 + 165,000 | 186,010 |
What the numbers say. Scope 3 is 165,000 ÷ 186,010 = 88.7% of the total. Scope 1 and 2 intensity is (10,512 + 10,498) ÷ $500 million = 42.0 tons per $1 million of revenue on the location basis and (10,512 + 4,000) ÷ 500 = 29.0 on the market basis. Buying certificates cut reported Scope 2 by 1 − 4,000 ÷ 10,498 = 62% without changing a single machine. A bank that holds $40 million of the company’s debt, against an enterprise value including cash (EVIC) of $800 million, attributes 40 ÷ 800 = 5% of the company’s emissions to itself: 0.05 × 21,010 = 1,050 tons of Scope 1 and 2 financed emissions, the attribution rule of the PCAF Standard that banks and asset managers use for Scope 3 category 15.
Emissions totals look like hard numbers. These situations change them without any change in what the company physically emits.
| Situation | What changes | Why |
|---|---|---|
| The company outsources its trucking | Diesel moves from Scope 1 to Scope 3 | Scope follows ownership and control, not physics; the total footprint is unchanged |
| It buys certificates instead of building solar | Market-based Scope 2 falls; location-based does not | Certificates transfer a claim, not electrons; always read both numbers |
| It sells its dirtiest plant | Reported emissions fall; the plant keeps emitting under the buyer | The protocol tells companies to recalculate the base year after structural changes, so a fair trend excludes the sale |
| Its emissions are vendor-estimated | Ratings and portfolio metrics rely on a model, not a disclosure | Estimates track company size and industry; research finds they behave differently from disclosed figures (Section 7.7: The Real Debates Surrounding ESG) |
| Revenue jumps on price, not volume | Intensity per dollar falls while tons rise | A ratio can improve because the denominator grew; check absolute tons alongside intensity |
| A fund adds up its holdings’ Scope 3 | The same ton is counted many times | One firm’s Scope 3 is another’s Scope 1; Scope 3 cannot be summed across a portfolio without double counting |
Before you rely on any company’s carbon number, ask four questions. If the claim is about Scope 2, demand both the location-based and market-based figures; if they differ by more than about a third, the reduction is mostly contractual. If Scope 3 is more than about 70% of the total (the GHG Protocol notes that Scope 3 is the majority of most companies’ emissions), treat any Scope 1 and 2 target as covering the minority of the footprint. If the figure is estimated rather than disclosed, treat it as a model output with a wide error band. If the trend crosses an acquisition or a sale, use the recalculated base year. The thresholds are heuristics; ignore them for a company whose own operations are its footprint (a cement or power producer, where Scope 1 dominates).
Judging a company on Scope 1 and 2 alone. In the worked example, the company’s own operations produce 21,010 tons, 11.3% of its footprint; a “50% cut in operational emissions” would remove 10,505 tons, about 5.6% of the 186,010-ton total. An investor who buys a low-carbon story on that basis owns a value chain whose emissions, and the policy and demand risks attached to them, are almost untouched. Read Scope 3 first, then judge the operational target as the share it is.
What is the difference between Scope 1, 2 and 3 emissions?
Scope 1 is what a company emits directly from sources it owns or controls. Scope 2 is the emissions from producing the electricity, heat or steam it buys. Scope 3 is everything else in its value chain, from suppliers’ emissions to the fuel customers burn using its products, grouped into 15 categories by the GHG Protocol.
Why is Scope 3 so hard to measure?
Because it depends on data the company does not control. Most firms start with spend-based estimates (dollars spent times an average emission factor per dollar), which move with prices as much as with emissions, then replace them with supplier-specific data over time. That is why Scope 3 figures can shift sharply when the method changes.
Do renewable energy certificates reduce a company’s emissions?
They reduce its market-based Scope 2 figure, not necessarily the emissions of the grid it uses. The location-based figure, which reflects the grid average, does not change. The GHG Protocol’s 2025–26 revision proposes hourly matching and deliverability tests so that certificates better reflect when and where clean power is produced.
Emissions are reported in three scopes under the GHG Protocol: direct (Scope 1), purchased energy (Scope 2, on a location-based and a market-based method) and the value chain (Scope 3, usually the largest). Read both Scope 2 figures, judge targets against the full footprint, and watch for changes in reported numbers that come from outsourcing, asset sales or estimates rather than from physical cuts.
Six questions on this chapter. Decide on your answer first, then click “Reveal Answer.”
1. A plant burns 100,000 MMBtu of natural gas. Using the EPA factor of 53.06 kg CO₂ per MMBtu, what are its Scope 1 emissions from gas?
- About 5,306 metric tons of CO₂
- About 530.6 metric tons of CO₂
- About 10,612 metric tons of CO₂
- About 53,060 metric tons of CO₂
Reveal Answer
Answer: A. 100,000 × 53.06 kg = 5,306,000 kg; ÷ 1,000 = 5,306 metric tons.
2. A manufacturer sells its truck fleet and hires a logistics firm to move the same goods the same distances. What happens to its reported emissions?
- The diesel disappears from its inventory entirely
- The diesel moves from its Scope 1 to its Scope 3
- The diesel moves from its Scope 1 to its Scope 2
- Its total footprint falls by the fleet’s emissions
Reveal Answer
Answer: B. Scope follows ownership and control; the trucking is now a purchased service in the value chain, so the same tons are reported as Scope 3.
3. A company buys renewable energy certificates covering all the electricity it uses from a coal-heavy grid. Which figure falls?
- Both Scope 2 figures equally
- Its Scope 1 figure
- Its location-based Scope 2 figure
- Its market-based Scope 2 figure
Reveal Answer
Answer: D. Certificates change the contractual (market-based) figure; the location-based figure still reflects the grid’s average emission rate.
4. A bank lends $20 million to a company with an enterprise value including cash of $400 million and Scope 1 and 2 emissions of 50,000 tons. Under the PCAF attribution, what are the bank’s financed emissions?
- 1,000 tons
- 5,000 tons
- 2,500 tons
- 20,000 tons
Reveal Answer
Answer: C. Attribution = 20 ÷ 400 = 5%; 0.05 × 50,000 = 2,500 tons, reported as Scope 3 category 15.
5. Worked problem: A footprint is 186,010 tons and Scope 3 is 88.7% of it. How many tons is Scope 3?
Reveal Answer
Answer: 0.887 × 186,010 = 164,991 tons.
6. Worked problem: Market-based Scope 2 is 12,000 tons and certificates cut it 62%. What remains, and does the physical grid use change?
Reveal Answer
Answer: 12,000 × 0.38 = 4,560 tons. The grid use is unchanged: only the accounting changed.
7.2 How ESG Ratings Are Constructed
An ESG rating adds up many small scores into one grade, but providers answer different questions. MSCI grades a company against its industry peers, from AAA to CCC. Sustainalytics measures the absolute amount of risk the company has not managed. The ratings also rest on company disclosures, and the standards for those disclosures split between financial materiality, used by the ISSB, and double materiality, used by the EU’s CSRD.
Why it matters: Two ratings can both be sound and still disagree, because they ask different questions.
Summary: An ESG rating aggregates issue-level scores into one grade, but providers answer different questions: MSCI grades companies against industry peers from AAA to CCC, while Sustainalytics measures absolute unmanaged risk. Ratings rest on disclosures whose standards split between financial materiality (ISSB) and double materiality (EU CSRD).
- An industry-relative AA on an oil producer says it manages oil-industry risks well, not that it is low carbon.
- Unmanaged risk = exposure − managed risk; a weak manager in a low-risk industry can score better than a strong manager in a high-risk one.
- TCFD disbanded in 2023; its recommendations live on in ISSB’s IFRS S2, used or being introduced in more than 40 jurisdictions.
- The EU’s CSRD now covers only groups with over 1,000 employees and €450 million turnover after the 2026 Omnibus.
- As of October 2026 the US has no federal climate disclosure rule in force; California’s SB 253 first reports are due November 10, 2026.
ESG rating agencies (MSCI, Sustainalytics and others) build a company score by aggregating dozens of data points across the three pillars: carbon emissions and resource use (Environmental), labor practices and product safety (Social), and board independence and executive pay (Governance, which overlaps with Capital Markets Part 7’s governance material). Each provider chooses which issues count for which industry, how to measure them and how to weight them, then turns the result into a single score or letter grade. The two largest providers do this in visibly different ways, and the difference explains much of what follows in this Part.
A crucial, often-misunderstood nuance: most major ESG ratings measure a company’s exposure to financially material ESG risks to itself (sometimes called “single materiality” or a “financial materiality” lens) — not necessarily the company’s own broader environmental or social impact on the world (called “impact materiality”; reporting both views together is “double materiality”). A company can, in principle, score well on a major ESG rating specifically because it has few climate-related risks to its own bottom line, even while having a large carbon footprint in absolute terms — a distinction that explains a great deal of the public confusion and criticism ESG ratings regularly attract.
Industry-relative grades. MSCI’s ESG Ratings run from AAA to CCC and are assigned relative to industry peers. MSCI picks the financially material “key issues” for each GICS sub-industry, scores the company on its exposure to and management of each, weights them and ranks it against its industry. An oil producer that manages spills, safety and governance better than other oil producers can earn AA while emitting more than any software company in the index; the grade answers “how good is this oil company at handling the risks oil companies face?”
Absolute risk scores. Sustainalytics’ ESG Risk Rating measures unmanaged risk on one absolute scale across industries, grouped into five bands from negligible to severe. The logic is subtraction: unmanaged risk = exposure − managed risk, where managed risk = exposure × the share that is manageable × how well the company manages it. Illustrative inputs: an oil producer with exposure 55, 90% manageable, managed at 60%, has managed risk 55 × 0.90 × 0.60 = 29.7 and unmanaged risk 55 − 29.7 = 25.3. A software firm with exposure 25, 95% manageable, managed at only 50%, has managed risk 25 × 0.95 × 0.50 = 11.875 and unmanaged risk 13.1. The weaker manager gets the better (lower) score because its industry carries less risk to begin with.
Neither method is wrong. They answer different questions, and an investor who mixes them, or who reads an industry-relative AA as “low carbon”, draws a conclusion the rating never offered.
Ratings are only as good as the disclosures underneath, and those disclosures now come from a handful of standards that split along the materiality line above. The Task Force on Climate-related Financial Disclosures (TCFD), set up by the Financial Stability Board, organized climate reporting into four pillars: governance, strategy, risk management, and metrics and targets. Its work now lives inside the ISSB (International Sustainability Standards Board) standards, which take the investor’s view: report what could affect the company’s prospects. The EU’s CSRD (Corporate Sustainability Reporting Directive) and its European Sustainability Reporting Standards (ESRS) take the double view: ESRS 1 states that “double materiality has two dimensions, namely: impact materiality and financial materiality” (Delegated Regulation (EU) 2023/2772, ESRS 1 paragraph 37). The United States has no federal requirement in force.
| Framework | Lens | Status as of October 2026 |
|---|---|---|
| TCFD | Financial (climate only) | Disbanded October 12, 2023, after its final status report; the FSB asked the IFRS Foundation to take over monitoring |
| ISSB: IFRS S1 and S2 | Financial (investor-focused) | Issued June 26, 2023, fully incorporating TCFD; effective for periods from January 1, 2024, where a jurisdiction adopts them; more than 40 jurisdictions using or taking steps to introduce them (April 2026); December 2025 amendments ease greenhouse gas requirements, effective January 1, 2027 |
| EU CSRD and ESRS | Double materiality | Narrowed by the Omnibus I Directive (EU) 2026/470 (published February 26, 2026; in force March 18, 2026): only groups with more than 1,000 employees and over €450 million turnover; limited assurance only; most large companies first report for fiscal 2027 after the April 2025 “stop-the-clock” delay; national transposition due March 19, 2027; simplified ESRS still to be adopted |
| SEC climate rule (US) | Financial | Adopted March 6, 2024, stayed April 4, 2024, and never in effect; the SEC stopped defending it in March 2025 and proposed rescission on May 29, 2026 (comments closed August 3, 2026); no final rescission yet |
| California SB 253 | Emissions inventory | Companies with over $1 billion revenue doing business in California; first Scope 1 and 2 reports due November 10, 2026 (moved from August 10), no assurance required for that first round; Scope 3 later by rulemaking; the companion climate-risk law, SB 261, is on hold pending litigation |
Match the rating to the question. If your question is “which company in this industry manages its ESG risks best?”, an industry-relative grade such as MSCI’s is the right tool. If it is “how much ESG risk am I carrying across industries?”, use an absolute risk score. If it is “what is this company doing to the climate?”, no rating answers it: go to the emissions data (Section 7.1: From Naming ESG to Understanding It) and, for EU reporters, the impact side of the CSRD double-materiality disclosures. Before using any rating, read the provider’s methodology page for three things: relative or absolute, which issues are counted for the industry, and whether emissions are disclosed or estimated.
Using an industry-relative ESG grade as a carbon screen. Illustrative numbers: an oil producer and a software firm each have an enterprise value of $50 billion; the oil producer emits 20 million tons of Scope 1 and 2 a year, the software firm 0.2 million. A $100 million holding attributes 100 ÷ 50,000 × 20,000,000 = 40,000 tons to the investor in the oil producer and 100 ÷ 50,000 × 200,000 = 400 tons in the software firm, 100 times more, even if both carry the same AA grade. A fund marketed as “low carbon” on the strength of AA grades is making a claim the ratings do not support, the kind of gap that regulators now treat as misleading (Section 7.6: Greenwashing and Regulatory Response).
How is an ESG score calculated?
A provider selects the ESG issues it considers material for the company’s industry, scores the company’s exposure to and management of each from disclosures, news and its own estimates, weights the issue scores and aggregates them. MSCI then grades the result from AAA to CCC against industry peers; Sustainalytics reports an absolute unmanaged-risk score.
What is double materiality?
It is the principle that a company should report both how sustainability matters affect its finances (financial materiality) and how the company affects people and the environment (impact materiality). The EU’s CSRD standards require it. The ISSB standards and most ratings use only the financial side.
Is ISSB reporting mandatory in the United States?
No. As of October 2026 no US federal rule requires ISSB or any climate reporting: the SEC‘s 2024 rule was stayed and the SEC has proposed rescinding it. California’s SB 253 requires large companies doing business in the state to report Scope 1 and 2 emissions, first due November 10, 2026.
ESG ratings combine issue-level scores using each provider’s own choices: MSCI grades against industry peers, Sustainalytics measures absolute unmanaged risk, and most ratings use a financial-materiality lens. The disclosures beneath them follow ISSB standards (financial materiality) or the EU’s narrowed CSRD (double materiality), while the US has no federal rule in force as of October 2026.
Six questions on this chapter. Decide on your answer first, then click “Reveal Answer.”
1. Using the unmanaged-risk logic, a company has exposure 40, 80% of it manageable, and manages that manageable risk at 50%. What is its unmanaged risk?
- 24
- 20
- 16
- 32
Reveal Answer
Answer: A. Managed risk = 40 × 0.80 × 0.50 = 16; unmanaged = 40 − 16 = 24.
2. What does an MSCI ESG rating of AA on an oil producer tell you?
- Its products have low impact on the climate
- Its absolute emissions are below the market average
- It manages oil-industry ESG risks better than most peers
- It has passed an EU taxonomy alignment test
Reveal Answer
Answer: C. MSCI grades AAA to CCC relative to industry peers on financially material issues; it is not an absolute carbon measure.
3. Which reporting framework requires companies to assess both impact materiality and financial materiality?
- The SEC’s 2024 climate rule
- California’s SB 253
- The ISSB’s IFRS S1 and IFRS S2 standards
- The EU’s CSRD and its ESRS
Reveal Answer
Answer: D. ESRS 1 defines double materiality as having two dimensions, impact and financial; ISSB and the SEC rule take the investor’s financial view.
4. What was the status of the SEC’s climate disclosure rule in October 2026?
- In force for large accelerated filers since fiscal 2025
- Stayed, never in effect, rescission proposed
- Struck down by the US Supreme Court in mid-2025
- Replaced by mandatory ISSB reporting
Reveal Answer
Answer: B. Adopted March 6, 2024, and stayed April 4, 2024; the SEC proposed rescission on May 29, 2026, and no final rescission had been adopted.
5. Worked problem: An ESG rating weights Environmental 40%, Social 30% and Governance 30%. Scores are E 60, S 70 and G 80. What is the weighted score?
Reveal Answer
Answer: 0.4 × 60 + 0.3 × 70 + 0.3 × 80 = 69.
6. Worked problem: A different provider weights them 25/25/50 using the same scores. What does it get?
Reveal Answer
Answer: 0.25 × 60 + 0.25 × 70 + 0.50 × 80 = 72.5: the weights alone change the answer.
- US EPA, GHG Emission Factors Hub (2025) — Natural gas 53.06 kg CO2/MMBtu, diesel 10.21 kg/gallon, US grid 771.5 lb/MWh (7.1 worked example)
- Delegated Regulation (EU) 2023/2772, ESRS — ESRS 1 paragraph 37 on double materiality
- IFRS Foundation, ISSB issues IFRS S1 and IFRS S2 (June 26, 2023) — ISSB standards incorporate TCFD
- IFRS Foundation, ISSB update (April 2026) — More than 40 jurisdictions; December 2025 GHG amendments effective 2027