As you know, the SEC has proposed a sweeping set of regulations for disclosure on climate (see this PubCo post, this PubCo post and this PubCo post), and we anxiously wait to see what the final rules have in store (obviously not happening in October as the SEC had previously targeted). One controversial part of that proposal draws on the Greenhouse Gas Protocol, requiring disclosure of a company’s Scopes 1 and 2 greenhouse gas emissions, and, for larger companies, Scope 3 GHG emissions if material (or included in the company’s emissions reduction target), with a phased-in attestation requirement for Scopes 1 and 2 data for large accelerated filers and accelerated filers. There haven’t been many complaints about the Scope 1 and Scope 2 requirements, but Scope 3 is another matter. According to the SEC, some commenters indicated that, for many companies, Scope 3 emissions represent a large proportion of overall GHG emissions, and therefore, could be material. However, those emissions result from the activities of third parties in the company’s “value chain,” making collection of the data much more difficult and much less reliable. In two articles published in the Harvard Business Review—“Accounting for Climate Change” and “We Need Better Carbon Accounting. Here’s How to Get There”—Robert Kaplan and Karthik Ramanna from Harvard Business School and the University of Oxford, respectively, propose another idea—the E-liability accounting system. The GHG protocol is, at this point, deeply embedded. Would the E-liability system work? Should the SEC or other regulators make room for a different concept?
What’s wrong with the Scope 3? The authors of the two articles contend that Scope 3 was created to “encourage companies to exert influence over emissions that they don’t control directly.” But how likely is it that Scope 3 disclosure will be effective in accomplishing that purpose? According to the authors, companies typically have much greater “influence, control, and traceability over their upstream operations [supply chain] than over their downstream emissions [customers and consumers]. 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…cannot control how their end-consumers use the products they sell.”
But the most significant problem, according to the authors, is that the GHG “protocol has serious conceptual errors: The same emissions are reported multiple times by different companies, while some entities entirely ignore emissions from their supply and distribution chains.” And, while Scopes 1 and 2 are relatively easy to measure—relative to Scope 3 anyway—Scope 3 is the “fatal flaw….[T]he difficulty of tracking emissions from multiple suppliers and customers across multitier value chains makes it virtually impossible for a company to reliably estimate its Scope 3 numbers.” To estimate “all those upstream and downstream emissions—especially for companies with long, complex, and multi-jurisdictional value chains—introduces high measurement error, opening the door to bias and manipulation,” the authors assert.
In most cases, the authors observe, companies are not familiar with their customers or their suppliers beyond the first tier and, as a result, are not always able to elicit the necessary data. Consequently, the GHG Protocol allows companies to “use industry and regional averages, rather than measure the specific emissions produced by their actual suppliers, distributors, and customers.” Even though the Protocol indicates a preference for “primary data,” it permits the use of secondary data, such as “industry-average data (e.g., from published databases, government statistics, literature studies, and industry associations), financial data, proxy data, and other generic data,” when primary data is not available. “Unsurprisingly,” the authors suggest, “‘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.” In addition, they observe, the use of industry-average estimates might actually run counter to the objectives of GHG emissions reporting: the authors argue that “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.”
How does the E-liability accounting system work? With the E-liability accounting system, the authors propose a different concept. To illustrate the proposed system, the authors posit the example of a car-door manufacturer. Under the existing GHG Protocols, reporting Scope 3 requires the manufacturer “to track all GHG emissions from the processes of its upstream suppliers, including the extraction of metallurgical coal and iron ore, the transport of those minerals to a steel producer, the production of sheet steel from the coal, iron ore, and other inputs, and the transport of that steel to its own production facility. The car-door company must also estimate the GHG impact of downstream activities, including transport of the car door to its customer (the automotive-assembly factory), manufacture of the finished car, transport of the car to a showroom, and operation of the vehicle, for perhaps 15 years, by the end-use consumer.”
The E-liability accounting system is similar to the system employed by cost and financial accountants in estimating “a company’s value added—a fundamental corporate measurement task. When our car-door manufacturer calculates its value added, it does not estimate all the prices paid by all the organizations across all the stages of its value chain. Rather, each organization records only what it pays for goods and services from its immediate suppliers and what it receives when it sells products to immediate customers.” The authors want to apply the same concept to GHG emissions.
As the authors describe it, the “new accounting system requires two basic steps: (1) Calculate the net E-liabilities the company creates and eliminates each period, adding them to the E-liabilities it acquires and has accumulated, and (2) allocate some or all of the total E-liabilities to the units of output produced by the company during the reporting period.” Downstream emissions are apparently not counted.
Using the same example of a car-door manufacturer, the authors start with a mining company that extracts the coal and iron ore, measures its total Scope 1 emissions during a reporting period and assigns its total emissions to the tons of coal and iron ore extracted during the period, ultimately developing an estimate of GHG emissions per ton of each type of material produced. The authors analogize this process to the process used to estimate “the unit production costs of its outputs in a standard activity-based costing system….Whereas financial accounting would record the monetary cost of producing a ton of material as inventory—an asset on its balance sheet—we label the GHG units emitted per ton of extracted material an E-liability, reflecting their environmental cost to society.”
Then, according to the model, when “the mining company transfers the coal and iron ore to a shipping company, the shipping company assumes the E-liability from the mining company on its E-accounting books (much the way it assumes production inputs as inventory on its financial-accounting books). If the mining company transfers all the materials it mines in the reporting period to downstream entities like the shipping company, its E-liability account at the end of the period will match what it was at the beginning.” GHG emissions used to power the ships are also added to the shipping company’s E-liability account. Upon transfer of some percentage of the coal and iron ore to a steel producer, the shipper will transfer that same percentage of its E-liabilities on its E-accounting ledger to the steel company, which now “owns” those liabilities. That process continues until the steel—and related E-liabilities—are transferred to the car-door manufacturer. The authors provide graphics to help explain their proposed e-accounting system. [SideNote: Won’t there still be difficulties collecting upstream emissions data, especially from companies that are not subject to regulatory requirements to provide it?]
As described by a related nonprofit (the authors are on the board), “[w]hen we pick up a box of cereal off a store shelf, we can see its price and its nutrition information. Thus, we are able to make food-consumption decisions on the basis of two dimensions that are most salient. We currently cannot do this with purchasing decisions where the GHG impact is salient (in addition to price)—e.g., buying a wind turbine, buying a car—because we have no way of reliably measuring the total GHG impact of making products or services.” With E-liability accounting, as described in the two articles, “the consumer who buys the finished car receives a report card on the quantity of GHG emissions produced throughout its manufacture and transportation.”
What do companies report? The authors propose that, in an E-liability statement, companies “report on the stocks and flows of their E-liabilities just as they report on their opening inventory, annual purchases of raw materials, finished goods produced, cost of goods sold, and closing inventory. The equivalent items would be net E-liabilities at the beginning of a period, E-liabilities acquired, net E-liabilities produced during the period, E-liabilities disposed of (sold), and net E-liabilities at the end of the period.”
What are the advantages of E-liability accounting? Among the most important advantages, according to the authors, is the elimination of the “duplicative counting of emissions that is embedded in current Scope 3 measurements” and the reduction of “incentives for gaming and manipulation.” For example, the authors suggest, “a company cannot reduce its reported Scope 1 emissions simply by outsourcing production and then, as is currently possible, ignoring its Scope 3 emissions on the grounds of high measurement error and lack of access to distant suppliers and customers. In the E-liability system, any GHG emissions produced by an outsourced supplier will be transferred to the company upon purchase.” “What’s more,” the authors contend, “a company can’t benefit from understating the E-liability transferred to its customers, because its own end-of-period net E-liability would steadily escalate, suggesting that the company’s products are more heavily polluting than customers will accept. Conversely, a company attempting to overstate E-liability transfers to downstream customers would meet with resistance from buyers that preferred to engage with less-polluting suppliers.”
Another major advantage, they contend, is that “a company’s end-of-period E-liability balance can be audited in much the same way that its financial asset and liability accounts are. The external auditors (preferably a team including environmental engineers and cost accountants) can verify the company’s internal GHG measurement and allocation models and its purchases and transfers, particularly of GHG-intensive products and services, and reconcile E-liability balances at the beginning and the end of the period. Auditors can cross-check a client’s E-liability transactions with corresponding activity in the financial accounts: A red flag would be raised if E-liabilities booked seemed unusually small, relative to industry peers, for the scale of the client’s inventory movements in a period.” The authors suggest that blockchain technology “can be used to accumulate and transfer E-liabilities from stage to stage, reducing accounting and auditing costs across the entire system.” And, if deemed necessary, the system might enable the imposition of a carbon tax.
The authors believe that their proposed E-liability system “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.” In the end, the authors contend that reporting on carbon emissions really is “amenable to rigorous corporate reporting, because it involves objective, physical measurements of the amounts of gases, solids, and liquids that companies use and produce. This is good news, because the easiest component [of ESG] to measure presents the most urgent threat to humanity.”