Smaller Nuts can be the Hardest to Crack

Risks to investors may lurk if SMEs don’t get guidance on climate-related disclosures.

Regulations aimed at measuring and managing greenhouse gas (GHG) emissions have almost exclusively targeted the largest firms with the biggest carbon footprints.

But the focus is beginning to broaden, partly thanks to updated recommendations from the Task Force on Climate-related Financial Disclosures (TCFD), which underline the importance of reporting Scope 3 emissions that are largely generated up and down the supply chain.

Small and medium-sized enterprises (SMEs) will likely come under pressure to calculate and report their own emissions, with large customers and suppliers demanding data to complete their own Scope 3 disclosures. Similarly, investors and lenders are expected to collect granular data on financed emissions.

And before long, SMEs might also face climate reporting mandates directly. With few SMEs equipped to handle climate-related information requests and requirements, their directors and investors will soon need to ensure they have the necessary guidance and resources.

These have been thin on the ground, but are now beginning to emerge. In November, environmental disclosure non-profit CDP launched an SME-specific climate disclosure framework, in collaboration with the SME Climate Hub.

“Nobody has taken responsibility for talking to SMEs until recently,” says Sonya Bhonsle, Global Head of Value Chains at CDP to ESG Investor. She says that the knowledge around regulatory frameworks was something many SMEs wanted, needed, and had clamoured for.

However, the issue lies not just with bigger companies wanting to make sure their supply chain is reflecting their own values around sustainability, but with those SMEs that are not on a journey to climate transition. These companies – which may operate in spaces where conversations around sustainability are yet to be significant or are not aware regulation could soon touch them – are where Bhonsle says more work needs to be done.

Shifting the culture

The under-utilising of SMEs in climate change mitigation efforts has wide economic and societal impacts, which could be an incentive for investors to encourage further reporting. SMEs represent about 90% of businesses and more than 50% of employment worldwide, according to CDP’s report. SMEs are also major engines of value creation, accounting for between 50% and 70% of value added in OECD economies and contributing to, on average, 33% of GDP in emerging economies.

Jannis Bille, ESG and climate associate at law firm Herbert Smith Freehills, agrees with claims that SMEs have been overlooked. “Climate change strategy for UK SMEs has not been given the level of attention it needs because particularly small SMEs have more limited resources.”

He says large companies have been playing catch up, in terms of implementing new processes and strategies in response to the climate crisis, but can move quicker. “They can hire the right people, and therefore push topics, but that same level of awareness might not have been trickling down at the same pace.”

However, SMEs can be teachers too, says Caroline Le Meaux, Global Head of ESG Research at Amundi. The feedback loop between larger and smaller companies on climate reporting should go both ways. “As an investor, we need to increase engagement efforts with all the issues around SMEs and decarbonisation and we need to make sure that every large company is engaged with their supply chain,” she says. “You can assess your own scenario to create a loop rather than just a top-down approach.”

According to Le Meaux, the key challenge for smaller companies and their investors is a lack of reporting expertise. “It is not that they don’t want to do things, but rather that they need guidelines and a better sense of what it is they should do. Even assessing their carbon footprint is something they need tools to do.”

Aligning with best practice

The CDP’s new framework provides climate-related reporting indicators and metrics that SMEs should be reporting on, says Bhonsle, both to manage their emissions and to provide information on them to stakeholders. Further, it reiterates that some SMEs are an innovation force for climate solutions, which will enable their customers to avoid or reduce emissions if harnessed correctly.

Bhonsle says most companies need to know how to align with global best practice climate reporting, which was designed with the big players in mind. “If large corporations are talking to SMEs, they need to know they are aligned with TCFD and Scope 3, and that they can understand each other. We all have to pull in the same direction,” she says.

The framework includes guidance on how SMEs should report on their current emissions, reduction targets and actions, and proposes that they expand their disclosures over time, with reference to four modules. But it is careful not to be prescriptive and burdensome. “We wanted to give the SMEs a high bar that is aligned to what their models are, what the next structures are, and what the capacity is,” says Bhonsle.

CDP’s framework, co-created with Normative and the Exponential Roadmap Initiative, was designed to work alongside and build upon existing initiatives, rather than add to the noise.

“This framework feeds into a wider industry move,” Bhonsle says. “Since the Greenhouse Gas (GHG) Protocol, we have seen more companies taking ownership of their emissions. More companies reported on it, and more companies started setting targets based on it.”

The GHG Protocol, which traces its roots to the late 1990s, established accounting and reporting frameworks to measure GHG emissions from companies and helps with mitigation actions.

“Larger companies said to us that their suppliers’ influence these emissions, and it is these larger companies’ job to make better buying decisions and talk to these suppliers to implement Scope 3,” Bhonsle adds.

Future proofing

Noting the dynamic role of SMEs, Bhonsle explains that the CDP framework is designed not just for firms at their current size but also for when they scale up. “If we have SMEs embedding climate change knowledge into what they do, and they are being innovative and impactful then when they grow bigger it will already be in their DNA.”

The framework is also intended to be helpful for larger companies with Scope 3 emissions reporting.

Scope 3 covers indirect emissions that occur in the supply chain of the reporting company. For financial institutions, this includes emissions facilitated by financing or investment activities.

But the complexity of tracking indirect emissions means they were until recently only regarded as ‘nice to have’. Asset owners in future will be in a better position to assess the credibility of corporates’ net-zero pathways following the recent update to the recommendations of the TCFD which emphasised the importance of providing Scope 3 GHG emissions disclosures.

Previously, the TCFD had only called for Scope 3 emissions to be reported as an aspiration, effectively allowing firms to under-report climate risks in jurisdictions setting climate reporting mandates in line with the task force’s guidelines. Earlier this year, Scope ESG, the sustainability analytics arm of Scope Ratings, analysed the disclosures of the 2,000 largest companies and noted that more than three-quarters had not reported any information on Scope 3 emissions.

SMEs do need to report on climate even if they don’t yet need to report to regulators. And not just for the sake of relationships with stakeholders. The CDP framework helps SMEs make climate commitments and to track and report progress against those commitments, and demonstrate climate leadership.

Bhonsle sees the reporting requirements as future-proofing businesses. “By talking to SMEs about climate change – enabling them to measure and reduce their emissions, set climate pledges, and talk about their resiliency – it is enabling SMEs to gear up to reduce.”

The CDP framework states that SMEs need to take climate action to build business resilience, gain competitive advantage, keep up with supply chain demands and policy regulation, and meet consumer expectations. “While many businesses are demonstrating transformational ambition on climate action, much of the progress made has been driven by large, high emitting, global corporations,” it says.

SMEs will likely need additional resources to support and guide their journeys to net zero. “Small companies have a huge learning curve on what climate means to them, and they don’t necessarily have the wealth to invest in long-term projections of risk assessment to tailor their strategy to that,” says Bille.

Learning curve

The introduction of voluntary frameworks dedicated to the needs of SMEs should ease their path up the inevitable learning curve as mandatory requirements are introduced. In major jurisdictions such as the UK and Europe, climate reporting is limited to firms above a revenue or headcount thresholds which will reduce over time.

Amundi’s Le Meaux says adherence to voluntary schemes will present challenges to SMEs. “The level of pressure might be a little bit lower for SMEs that are engaged by their clients,” she says, saying stakeholders should look to provide support where possible.

Bhonsle says that, ultimately, SMEs must be equipped with the tools and resources needed to set commitments aligned with a 1.5°C future and disclose environmental performance. She adds that larger companies will pressure SMEs, preferring to do business with enterprises that have the same values as them. Alignment of mutual interests, she suggests, is essential.

“By enabling them to measure and reduce their emissions, SMEs are supporting some of the larger companies, their buyers, and their customers to make climate pledges. They are also enabling lenders to issue loans to them because they know that they’ve discussed climate resiliency.”

The practical information hub for asset owners looking to invest successfully and sustainably for the long term. As best practice evolves, we will share the news, insights and data to guide asset owners on their individual journey to ESG integration.

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