We Need Better Carbon Accounting. Here’s How to Get There.

We Need Better Carbon Accounting. Here’s How to Get There.

by Bloomberg Stocks
0 comments 85 views
A+A-
Reset

Any effective system of greenhouse gas (GHG) accounting needs to measure each company’s supply-chain carbon impacts accurately, providing visibility and incentives for it to make more climate-friendly product-specification and purchasing decisions. The authors’ recent HBR article, “Accounting for Climate Change” (Nov-Dec 2021), noted how the current dominant system for carbon accounting, the GHG Protocol, misses this critical point by allowing companies to guestimate upstream and downstream emissions. To address this shortcoming, they introduced an E-liability accounting system, based on well-established practices from inventory and cost accounting, for accurately measuring GHG emissions across corporate supply-chains. In this follow-up piece, they describe the basic flaw inherent in the GHG Protocol, explain why it has persisted, and offer a way forward for robust carbon accounting that does not involve rescinding the Protocol, which has been widely embedded in many global climate agreements. They conclude by identifying which companies stand to gain most from accurate GHG accounting and could be early adopters of the E-liability system.

The Rocky Mountain Institute reports that the average company’s supply-chain greenhouse gas (GHG) emissions are 5.5 times higher than the direct emissions from its own assets and operations. Any effective system of GHG accounting, therefore, needs to measure accurately each company’s supply-chain carbon impacts, providing visibility and incentives for it to make more climate-friendly product-specification and purchasing decisions.

Our recent HBR article, “Accounting for Climate Change” (Nov-Dec 2021), noted how the current dominant system for carbon accounting, the GHG Protocol, misses this critical point by allowing companies to guestimate upstream and downstream emissions. To address this shortcoming, we introduced an E-liability accounting system, based on well-established practices from inventory and cost accounting, for accurately measuring GHG emissions across corporate supply chains.

Since the article’s publication, we have had dozens of conversations with corporate executives, consultants, regulators, and standard-setters about the E-liability system. Many have expressed frustration that something like it has not been introduced sooner. In this follow-up piece, we describe the basic flaw inherent in the GHG Protocol, explain why it has persisted, and offer a way forward for robust carbon accounting that does not involve rescinding the Protocol, which has been widely embedded in many global climate agreements. We’ll conclude by identifying which companies stand to gain most from accurate GHG accounting and could be early adopters of the E-liability system.

The current GHG-accounting standard discourages supply-chain decarbonization

Introduced in 2001, the GHG Protocol has become the de-facto global accounting standard for measuring an entity’s direct, upstream, and downstream GHG emissions. The Protocol’s Scope 1 standard provides the basis for valid accounting of an entity’s direct GHG emissions, an important feature since these are the only corporate emissions that actually go into the atmosphere.

But the Protocol falls short in its Scope 3 standard, which requires a company to estimate the Scope 1 emissions of all its direct and indirect suppliers and customers. Even apart from the multiple counting of the same emissions inherent to this approach, our previous article expressed skepticism about the standard’s feasibility. Most companies know only a few of their non-tier-1 suppliers and customers well enough to get meaningful data from them. Yet the Protocol expects companies with diverse product lines to gather emissions data from all their multiple-tier customers and suppliers for each line — a fiendishly complex task. (We have not commented here on Scope 2 emissions, defined by the Protocol as emissions from an entity’s purchased electricity, because they are in reality a type of Scope 3 emission, given their own category solely because they can be accurately measured, unlike other Scope 3 emissions.)

The near-impossibility of measuring Scope 3 emissions forced the Protocol standard-setters to allow companies the option to use industry and regional averages, rather than measure the specific emissions produced by their actual suppliers, distributors, and customers. Although the Protocol expresses a preference for “primary data,” defined as “provided by suppliers or other value chain partners related to specific activities in the reporting company’s value chain,” it allows the use of secondary data “in some [emphasis added] cases, [when] primary data may not be available or may not be of sufficient quality.” Secondary data is defined as “industry-average data (e.g., from published databases, government statistics, literature studies, and industry associations), financial data, proxy data, and other generic data.”

Unsurprisingly, “some cases” has, in practice, become “for all cases.” But allowing companies to use average rather than specific and traceable data fundamentally undermines the integrity of Scope 3 measurements. Imagine a financial accounting standard that allows a company to use industry-average raw-material costs rather than actual invoiced raw-material costs. Would such a financial report, based on average rather than actual profit margins, be acceptable to shareholders, financial analysts, and tax authorities? Yet this is the standard set by the Protocol for reporting Scope 3 emissions.

Fortunately, Scope 3 reporting is currently voluntary, and most companies (sensibly in our opinion) skip reporting on their supplier and customer emissions. Even amongst those that do, there is skepticism: IBM, for example, notes “the assumptions that must be made to estimate Scope 3 emissions in most categories do not enable credible, factual numbers.” A few companies, such as Mars, voluntarily use industry-average data to comply largely with the Scope 3 standard. Most companies reporting on their Scope 3 emissions, however, are quite selective, cynics would say opportunistic, about what they report. Google and Microsoft, although in the same industry and generally considered leaders in climate accounting, report different categories of indirect GHG sources.

U.S. regulators also seem to have reservations about the validity of Scope 3 reporting. Last month, the SEC proposed that certain registrant companies must provide audited Scope 1 and 2 climate disclosures by 2024. But it also provided a litigation safe-harbor to any companies that voluntarily provide Scope 3 disclosures, an implicit acknowledgement that such disclosures would be unreliable and unauditable.

Why Scope 3 persists

Part of the answer is that the current standard enables corporate greenwashing. Scope 3’s tolerance for secondary data is a gift for companies that want to take credit for their competitors’ GHG-reducing innovations without having to change their own product design and procurement processes.

For instance, when a given entity invests in a GHG-saving technology, it and all its downstream customers should be the only ones to report lower GHG emissions. But the Scope 3 standard, through the use of secondary data, allows all competitor companies, and all their downstream customers, to claim the emissions-reduction benefit from the innovation as well. This means that unscrupulous companies can achieve NetZero targets without even trying to lower their own direct emissions or energy consumption.

The availability of a weak standard for Scope 3 reporting inhibits the adoption of a more accurate approach through a GHG analogy to Gresham’s Law. The inclusion of average data by the Scope 3 standard prevents any superior accounting method based on actual supply-chain emissions, such as the E-liability method, from entering and remaining in circulation. An entity that incurs costs to voluntarily supply accurate GHG accounts is immediately disadvantaged by competitors using those numbers as their own. And, with the greenwashing advantages of industry-average data, why would any company benefiting from the current Scope 3 approach voluntarily move to a tougher, more accurate system?

Ideological objectives also work against tightening up the standard. Currently, companies must estimate and report both their upstream and downstream GHG emissions, even though they have far more influence, control, and traceability over their upstream operations than over their downstream emissions. Consider a company mining iron ore. It cannot influence decisions made by deep-downstream entities, such as companies that build automobiles and appliances made from steel derived off its ores much less the consumers that purchase and use these products. Even direct-to-consumer companies, such as Apple and Wal-Mart, cannot control how their end-consumers use the products they sell. Apple, for instance, cannot demand that its consumers limit iPhone and iPad usage to less than one hour per day to keep the company’s Scope 3 emissions low.

When we have noted to some standard-setters the benefits of restricting a company’s GHG accountability to Scope 1 and supply-chain emissions (thereby excluding downstream emissions), we have experienced the push-back that such a practice would allow fossil-fuel producers to avoid being seen as the prime culprits for anthropogenic climate change. We certainly have no interest in absolving coal or oil companies — or anyone else — for their appropriate responsibility for GHG emissions. But a petroleum company, just like an automotive supplier, cannot require downstream customers to drive less. Effectively, oil companies would not exist at their scale and scope if their customers did not prefer their products versus alternative energy sources.

Under the E-liability system, oil companies will be just as transparent and accountable for their controllable GHG emissions as any other company such as Apple, Mars, Toyota, and Wal-Mart. But this accuracy upsets some in the GHG-regulation business who have already determined which industries should be blamed for climate change.

The way forward

The 20-year-old GHG Protocol has now been embedded into many international climate-monitoring agreements. The Financial Stability Board’s Task Force on Climate-Related Financial Disclosures (TCFD) — the standard setter for monitoring GHG emissions from global asset-managers’ investments — recommends that constituents follow the Protocol, “notwithstanding the challenges” in the Scope 3 standard, perhaps additional evidence of the political forces at play.

Renegotiating such agreements to follow a more accurate accounting system could be politically challenging and further delay corporate actions to reduce emissions from their supply chains. We recommend, therefore, that the use of industry average data to comply with the Scope 3 standard be phased out rather than eliminated immediately, allowing time for companies and regulators to test and adopt the more accurate E-liability approach to GHG accounting.

We propose to start the journey by having standard setters and regulators establish a three-year transition period, after which only primary data will be acceptable for Scope 3 reporting (except for immaterial GHG quantities). A company, during this transition period, should have the option to remain compliant with the existing GHG Protocol standard while, as we recommend, reporting on activities only under their control and influence, that is their Scope 1 and supply-chain emissions, which would, of course, include the “Scope 2” emissions from its suppliers of electricity.

Auditors can also play a role in the transition to more accurate GHG accounting. Many companies don’t currently seek assurance for their environmental reports. Those that do purchase assurance services only for a “limited-scope audit” designed to produce a double-negative opinion that a company’s reported GHG measurements are “not obviously false.” Such limited-scope assurance is well below the standard of the opinion provided for a company’s financial report: that a reporting company’s assertions (say, of the value of its inventory) “are fairly stated, in all material respects.”

We propose that, after the three-year transition period, the only acceptable assurance for a GHG report be a “fairly stated opinion,” which would deny assurance to Scope 3 reports based substantively on industry-average data. Such true-and-fair audit opinions would enable companies’ GHG reports to have the same reliability as their financial statements, and, like these, provide a sound basis for investment decisions and accountability for corporate performance.

Who would benefit the most from rigorous carbon accounting?

Three types of companies will benefit most from voluntary early adoption of the more accurate and transparent E-liability system. First are companies with environmentally sensitive consumers that want to demonstrate reductions in their total supply-chain emissions. Second are companies with environmentally sensitive equity-ownership, especially actively managed high-commitment green-fund investors, who want auditable evidence of their progress towards achieving ambitious NetZero targets. These two groups of companies, under high scrutiny from consumers and shareholders, should be willing to source and potentially pay more to suppliers that credibly deliver lower-GHG products.

A third group of potential early adopters are those with already high Scope 1 (direct) emissions in their own production processes and supply chains. These companies can be viewed as the environmental equivalents of “Willie Sutton” targets, named after the 1950s criminal who explained that he robbed banks because “that’s where the money was.”

These environmental Willie Sutton companies have hydrocarbon-intensive production processes and/or produce vast GHG from other chemical reactions: examples include companies producing or using large quantities of steel, cement, concrete, glass, and beef products. Several of these high Scope-1 companies have already created an environmental competitive-advantage, by innovations in new technologies, product design, and procurement policies. Consider, for examples, a steel company that recycles scrap steel in energy-efficient furnaces or that uses the HIsarna method of ironmaking. Its outputs have far lower GHG content per ton than a competitor that processes pig iron and metallurgical coal through high-polluting blast furnaces. A consumer-goods company producing paper products from recycled fiber has a lower GHG footprint than one using fiber processed from virgin forests. Concrete companies that replace fly ash, produced from burning coal, with recycled glass will have lower emissions per ton than their competitors. And cattle farms that use low-methane feed and fertilizers, or that capture and recycle methane produced from animal waste and agricultural runoff, can produce lower-carbon beef products.

These companies have the highest motivation to adopt an accurate system, such as E-liability accounting, to measure and report on the actual Scope 1 emissions from their production processes and supply chains. Such adoption would enable them to credibly report their lower per unit GHG outputs to environmentally conscious customers, investors, and the public at large.

. . .

The E-liability system we’ve proposed will stimulate aggressive decarbonization actions along the supply chain by providing a contractual and enforceable basis for customers and investors to specify maximum amount of tolerable GHG emissions in the products and services they purchase and finance. Such a grounded, market-driven and enforceable approach will be far more effective than the GHG Protocol’s current permissive and imprecise standard for Scope 3 emissions. It’s time to make sure that decarbonization by corporations can be a source of competitive advantage.

Read More

You may also like

Leave a Comment