Robert Kaplan and Karthik Ramanna propose a new approach for verifiable accounting on indirect corporate emissions that would apply to all corporations, increase incentives to reduce carbon in their supply and distribution chains, and reduce their ability to game carbon reporting.
The first week of November saw world leaders gather for the UN’s Climate Change Conference in Glasgow. The grand plans announced at the summit, however, risk failure as major proposed policies, such as those requiring corporations and investment funds to meet so-called “Net Zero” pledges over greenhouse-gas emissions, rely on unverifiable and conceptually flawed corporate-reporting practices.
The trouble boils down to the dominant accounting standard for corporate greenhouse-gas emissions, the GHG Protocol, used today by over 90 percent of the Fortune 500. The specific issue is the Protocol’s method for capturing indirect corporate emissions. For the vast majority of companies, direct emissions (known as Scope 1 emissions) are a small part of their GHG footprint—the exceptions are hydrocarbon-based energy and transport companies, chemical refineries, and agribusinesses. Most other companies—including those in the finance, service, and tech sectors—rely on these direct emitters at some point in their own value-chains, so such indirect emitters ought to be accountable for making more climate-friendly product-development, purchasing, and selling decisions.
But the GHG Protocol, introduced in 2001 by a not-for-profit with little prior accounting expertise, leaves it to companies to estimate indirect GHG emissions up and down their value-chains. The Protocol encourages companies to aggregate the entire (estimated) GHG from their value-chains and report it as their own, as so-called “Scope-3 emissions.” This is akin to a company reporting, within its own income, the associated profits of all its suppliers and customers—a basic accounting error that results in multiple-counting.
Apart from the multiple-counting problems, a large company that purchases raw materials and services from thousands of suppliers over multiple tiers and distributes its finished product to thousands of customers—again, over many tiers—would have to acquire Scope 1 information from all these entities to estimate its total Scope 3 emissions, an impossible and unverifiable task. While companies obviously know their direct (tier-1) suppliers and some of their tier-2 suppliers, few would know the names, much less the Scope 1 emissions, of suppliers farther down their multi-tier supply chains. No automotive company would likely know which manufacturers produced the steel, pig iron, and bauxite used in its thermostats and alternators.
Estimating Scope 3 emissions for multi-product, multi-echelon supply-chains is a problem of geometric complexity. Such complexity also precludes independent validation and assurance of a company’s Scope 3 report, making any company’s commitment to “Net Zero” emissions to be unverifiable rhetoric. Unsurprisingly, twenty years on, most companies either ignore the Protocol on indirect GHG emissions or fabricate numbers that are redundant and inaccurate. (After all, most corporate GHG reporting remains voluntary and not subject to securities laws.)
Yet, plans at Glasgow to combat climate change continue to rely on the Protocol’s flawed methods. For instance, the international banking system’s strategy to drive “Whole Economy Transition” away from carbon critically hinges on corporate Scope-3 disclosures “notwithstanding the challenges” described above, essentially setting up a house of cards.
In an article just published in Harvard Business Review, we introduce a new approach for verifiable accounting on indirect GHG emissions. Just as traditional accounting systems collect and transmit costing data across multi-tier supplier-customer relationships, our environmental accounting system channels GHG information across companies’ purchase and sale contracts for products and services.
When an output is sold from one company to another in a supply chain, we propose that the transaction involve both an asset transfer on the seller and buyer’s financial-accounting books and an E-liability transfer on new, parallel set of books we call E-accounting books. The latter operates on the same principles as financial-accounting books; the key difference is that it accounts in units of GHG rather than cash. E-liabilities acquired from suppliers, together with any internally generated ones, are then allocated to a company’s products using activity-based costing principles. End-of-period E-liabilities can be audited by reconciling beginning-of-period values to acquisitions, transfers, and direct emissions, similar to accounts-payable audits. Moreover, blockchains can capture direct corporate emissions so that their totals must always reconcile to E-liability transfers across supply chains.
The E-liability method leverages a simple insight: shift the unit of analysis for GHG calculations from the corporation to its outputs of products and services. This is the basis for cost accounting, allowing existing accounting software to assign GHG emissions, measured in units such as tons of CO2, to the company’s outputs. The GHG content is then transmitted with the outputs, as they move downstream to customers, exactly how cost/price information moves today from suppliers to customers along even the most complex, multi-tier supply chains.
The E-liability system can be applied to all corporations—publicly listed, privately owned, not-for-profit, or state-controlled—and to governmental agencies too. It reduces a corporation’s ability to game its carbon reporting because E-liability transfers are negotiated at arm’s length, like prices. The numbers are thus contractible and mirror a basic advantage of the financial-reporting system: that corporations on opposite sides of the planet can use accounting data to drive product specifications.
Currently, high Scope 1 emitters bear all the opprobrium for their emissions while their customers, with unmeasured and unaudited Scope 3 emissions, escape accountability. The E-liability method motivates all companies to be transparent about the total GHG content of their products and services. Downstream companies now have an incentive to lower the carbon content of their purchases. They could, for instance, require suppliers to use recycled—rather than “virgin”—raw-materials, or to purchase reliable carbon offsets. Universities, currently coping with demands from environmentally conscious faculty and students to divest from fossil-fuel energy companies, could take more direct and effective action by choosing contractors for construction projects that use lower GHG-content steel and cement. Companies with high Scope 1 emissions, of course, remain accountable for the GHG content they add to the supply chain. The E-liability method provides multiple accountability for GHG emissions without the Scope 3 error of multiple accounting.
Further, the E-liability method decouples carbon reporting from financial profits, closing the loophole for big polluters to evade climate accountability on actions not “material” to income. The system then provides investors and end-use consumers with relevant GHG data on all goods and services, akin to nutrition labels on foodstuffs, unleashing the power of demand and supply to address climate change. And if such GHG data does not drive more carbon-conscious market choices, E-liabilities provide a verifiable basis for a variety of carbon taxes, including VATs, sales taxes, and capital taxes.
The prior lack of an objective accounting method for indirect GHG emissions has impeded corporate environmental accountability and enabled much chicanery in the field of climate finance. Some “green” investment funds extract handsome premiums from pensioners by peddling portfolios devoid of so-called “sin stocks,” such as fossil fuels and mining. This approach is absurd: such sin companies would not exist at their scale were it not for purchases made from them by “clean” downstream businesses such as Apple and Google. Our system recognizes the interconnectedness of the GHG economy and requires all companies (and governments and consumers) to be accountable for their proportionate burden in emissions, an “inconvenient truth” for many.
Disclosure: Robert Kaplan is a compensated consultant for Palladium and Geigsen Group, and a compensated speaker with Stern Strategy Group.
Learn more about our disclosure policy here.