Source: Harvard Business Review
In the latest Harvard Business Review article from Palladium thought leader and creator of The Balanced Scorecard, Dr. Robert S. Kaplan, and Karthik Ramanna, the two make recommendations for improvements to the way companies report on environmental, social, and governance (ESG) matters.
As corporations around the world face mounting pressure to address and reduce greenhouse gas (GHG) emissions within their operations and ecosystems, many are finding that current measures fail to capture the true scope of these emissions.
The problem, according to Kaplan and Ramanna, is that the GHG Protocol, the standard used today by over 90 percent of Fortune 500 companies to account for GHG emissions, doesn’t quite capture the full picture. While it does give companies the ability to account for their direct (or “Scope 1”) emissions, it falls short when it comes to indirect (“Scope 3”) emissions.
For most organisations, Scope 1 emissions account for a very small percentage of overall GHG. The Scope 3 emissions are where much of the liability lies and where things get complicated. For a big company that purchases materials and services from hundreds or even thousands of suppliers and distributes products to customers globally, even estimating Scope 3 emissions can be an impossible task.
“Because there is no way to properly account for the carbon in the upstream or downstream parts of the supply chain, beyond the immediate company, there is no credibility to the numbers,” explains Eduardo Tugendhat, Palladium Director of Thought Leadership.
The GHG Protocol, which was introduced in 2001 and has been updated several times since, established a common language for GHG measurement, but with what Kaplan and Ramanna consider to be serious conceptual errors.
“The poor accountability of ESG reports stems partly from the flaws in the GHG Protocol,” they note. “The 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.”
At a time when honestly and reliably reporting on all GHG emissions is critical to achieving a net zero economy, what’s the right answer?
According to Kaplan and Ramanna, the answer is E-liabilities accounting. Just like a traditional accounting system tracks costs across transactions between suppliers and customers, their proposed E-accounting system operates on the same principles – but rather than tracking cash, it tracks GHG emissions.
E-Liabilities and Accounting
According to the pair, the “E-liability accounting system eliminates the duplicative counting of emissions. It also reduces incentives for gaming and manipulation.”
In the proposed new system, E-liabilities acquired from suppliers, along with internally generated ones can be allocated to the company’s final products utilising activity-based costing principles.
“The idea is that as a product flows through a supply chain, say metals used in electric car batteries, as different companies in the supply chain buy raw materials, they are acquiring the E-liability (while from a traditional accounting standpoint the material is considered an asset),” explains Tugendhat.
By integrating recent advances in measuring emissions by environmental engineers, leveraging blockchain technologies to support the accounting and auditing, the authors believe that the new system will enable GHG reports to approach the relevance and reliability expected of today’s corporate financial reports.
“Accurately measuring the GHG liabilities through an entire supply chain will encourage greater collaboration among the different actors,” adds Tugendhat. “For example, an electric car or food brand will have a greater incentive to collaborate with its upstream suppliers on ‘insetting’ solutions where together they will be able to differentiate themselves in the market.”
The authors contend that the E-liabilities method motivates any and all companies to be more transparent about the GHG emissions associated with their products and services. “Companies can 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,” they note.
Simply put, in this system, any GHG emission produced by an outsourced supplier within an organisation’s ecosystem will be transferred to the organisation upon purchase.
Decoupling carbon reporting from profits will also force some of the big polluters to face accountability on actions not considered ‘material’ to income. Eventually, the system will provide both investors and end users with the GHG data associated with all products and services, creating what the authors suggest could be like a nutrition label on food.
By tackling GHG as a starting point, Kaplan and Ramanna put forth a plan to support immediate action in a critical area and believe that with time, lessons learned from applying this approach can serve as a model for measuring and tracking other environmental and social outcomes from business operations, eventually moving the needle on improving ESG reporting.
“Environment is the most amenable to rigorous corporate reporting, because it involves objective, physical measurements of the amounts of gases, solids, and liquids that companies use and produce,” which is good news because this is the component that presents the greatest threat in our fight against climate change.
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