Climate Finance | November 17, 2022

From carbon counting to carbon accounting: The case for Emissions Liability Management 

Alicia Seiger and Marc Roston

Get a weekly pulse on news and trends in impact investing with our free newsletter.

*I agree to receive marketing emails from ImpactAlpha, its affiliates, and accept our terms of use and privacy policy.
By signing up you agree to receive marketing emails from ImpactAlpha Inc. and accept our Terms of Service and Privacy Policy.
Guest Author

Alicia Seiger

Guest Author

Marc Roston

“There does not yet exist the capacity,” Microsoft’s president, Brad Smith warned at last month’s Breakthrough Energy Summit in Seattle, for almost any of the thousands of companies that have signed climate pledges, “to with confidence turn that pledge into the progress that has been promised.”

Such a stark statement from an industry-leading climate actor brings a sobering dose of reality to climate action. It calls the question: How might the flashing warning sign of ineffective progress drive a course-correction in climate action?

The tools and tactics that have driven voluntary climate action are unlikely to withstand the pressures of traversing from voluntary to mandatory emissions disclosure, let alone lead practitioners to the desired destination of shifting capital allocation at the necessary speed and scale. 

Shifting from carbon counting to carbon accounting will enable drivers of climate action to steer more productively toward scaling climate investment from billions to trillions. In our new paper, “The Road to Climate Stability Runs Through Emissions Liability Management,” we acknowledge that the road will be bumpy, but a more fit-for-purpose system of measuring GHG emissions and a requirement to balance liabilities with corresponding assets can pave the way toward robust carbon markets, cost of capital adjustments for high-emitting firms, and alignment of corporate, national, and global carbon ledgers.   

Resetting current practice

Course corrections will be hard – especially now, when it feels as though climate-action proponents have taken the lead.

It’s been just four years since the IPCC catalyzed the net zero lexicon with the release of its special report on limiting warming to 1.5°C

This amount of public and private sector progress is nothing short of remarkable based on the relentless effort of climate leaders in the face of subscale policy support and with the backdrop of heartbreaking human suffering. 

Fueled by science-based targets and moral imperatives, advocates have mobilized businesses and investors to steer toward 2050 net-zero greenhouse gas (GHG) emissions. 

Among Fortune 500 companies, 38% have made a net zero pledge, up 50% since 2021. The Glasgow Financial Alliance for Net Zero (GFANZ) signatories represent over $150 trillion in assets. 

To support this massive mobilization of voluntary action, non-governmental organizations (NGOs) and industry coalitions have partnered to design rules and frameworks for measuring and managing progress. 

The Task Force on Climate-related Financial Disclosures (TCFD), a stakeholder-led effort born out of the G20 Financial Stability Board, has produced the most widely recognized framework for disclosing climate information. TCFD incorporates a suite of existing voluntary standards, including the GHG Protocol, the preferred method of measuring and reporting carbon emissions. 

Policymakers in Europe and Asia have taken-up the carbon disclosure mantle following voluntary frameworks. Here in the US, the Securities and Exchange Commission has proposed a climate-related financial disclosure rule consistent with TCFD. The White House recently announced an Executive Order to require major Federal contractors to disclose climate-related information. 

In an effort to reconcile what could become a heterogeneous global reporting landscape, the International Financial Reporting Standards Foundation (IFRS) created the International Sustainability Standards Board (ISSB.) The ISSB’s mandate is to deliver “a comprehensive global baseline” to provide investors with decision-useful information about sustainability-related risks and opportunities.

But to arrive at a stable climate, leaders must keep open the possibility of having to “reset” some long-held practices. 

Even if disclosure regulation in the US remains on the horizon, global firms are having to navigate mandatory disclosure requirements abroad while confronting confounding politicization of sustainability metrics in the US.   

Smith’s concerns echo other signs of trouble ahead. GFANZ has distanced itself from the UN’s Race to Zero campaign as tensions rise over continued financing of fossil fuels. In the EU, anticipation of mandatory Scope 3 reporting for financial institutions has put a spotlight on automakers. Toyota, for example, is using the flexibility of carbon reporting frameworks to reduce estimates on the lifetime mileage of their vehicles to lessen their reported downstream emissions. 

Climate-action leaders ought to consider these growing cracks on the path to success. Some cracks can be fortified with reforms to current practice, like higher frequency Scope 2 and corporate clean energy procurement reporting

Emissions liability management

E-liabilities accounting, proposed by Robert Kaplan and Karthik Ramanna in the Harvard Business Review, provides a method to recursively track carbon emissions embodied in products or services by identifying emissions at each stage of production, and allocating those emissions to firm outputs, similar to cost accounting. 

This approach is quite similar to the GHG Protocol, a framework for measuring greenhouse gas emissions from operations, value chains and mitigation programs, but without downstream emissions and without industry averages. Moreover, rather than estimating emissions flows, E-liabilities track a firm’s stock of carbon emissions on an ongoing basis. 

Shifting focus from GHG Protocol to E-liability accounting would provide technically sound, audited carbon balance sheets reflecting atmospheric emissions liabilities. Firms would have the choice to retain these liabilities, or pass them to customers. Retained emissions result in very long duration liabilities until permanent and additional carbon removal projects extinguish the liability. 

In the meantime, firms would manage a portfolio of capital, offsets and other carbon risk management transactions to balance their carbon liabilities. This suite of activities describes what we call emissions liability management, or ELM.

The benefits of ELM are many and powerful. First, ELM closes the gap between the GHG Protocol counting, financial accounting, and firm cost of capital. High emissions firms would consume more capital to purchase assets or insurance to balance their E-liabilities. 

Using this method, Partnership for Carbon Accounting Financials (PCAF) signatories could directly penalize firms based on straightforward financial risk measures for the emissions on their balance sheets, rather than making complex and confusing judgements about the sustainability merits of various borrowers. 

Second, ELM provides a stable foundation on which the voluntary carbon market would scale and thrive. The proliferation of initiatives aiming to improve the voluntary-market focus on questions of quality and appropriateness. Though most have “integrity” in their names, they fail to address market integrity concerns. Emissions remain in the atmosphere essentially forever. 

Therefore, E-liabilities ought to remain a liability until a firm irreversibly removes carbon. The vast majority of offset purchases fall short on additionality and permanence. That’s okay. Markets can develop scientifically, financially, and legally sound methods to trade offsets of varied quality and duration – that’s how bond markets work today. 

Rather than debating bright-line quality distinctions, markets can price assets reflecting risk-adjusted permanence and additionality, with the understanding that their long-term carbon removal obligation remains.

Beyond Scope 3

To better understand the potential of E-liabilities and ELM, consider what they would mean for a company like Apple. Apple expends significant effort to manage supply chain emissions in pursuit of its net zero pledge. Under current practice, Apple’s GHG Protocol team must navigate complex Scope 2 procurement and measurement while also tracking the 15 categories of Scope 3 across multiple companies and thousands of miles of logistics all while maintaining decision-useful levels of certainty – a near impossible task (for more on the difficulties of navigating data quality, Scope 3 boundaries, offset timing, and management obligations, see our book, “Settling Climate Accounts, Navigating the Road to Net Zero”).  

Now, imagine FASB requires that companies account for E-liabilities, produce a carbon balance sheet, and manage their emissions liabilities. Every Apple supplier, including suppliers of electricity, would transfer the inventory or service (on financial accounting books) and the E-liability (on a carbon balance sheet.) Rather than explaining a net zero corporate pledge, Apple could sell audited zero E-liability products achieved through modifying upstream suppliers and retaining permanent responsibility for final product E-liabilities. 

ELM has clear advantages over the GHG Protocol but it does not solve every problem. The first problem, data quality, exists regardless of which system firms employ. The emissions footprint of upstream activities derived from natural capital are difficult to measure and verify. Though ELM doesn’t solve this problem, it provides the tools and incentives to drive improvement in data quality.

 Furthermore, ELM enables better use of improved data The GHG Protocol allows industry averages. This confounds accuracy and hamstrings innovation (why invest in lower carbon solutions when laggards can borrow the benefits of leaders by way of averages?) E-liability accounting removes the free pass embedded in industry averages, and requires only one level of audited supply chain data. 

The perceived second problem is that E-liability accounting and ELM drop downstream emissions. Essential to voluntary climate action up to this point, abandoning downstream Scope 3 feels jarring to many climate activists. Scope 3 helps to highlight fossil fuel companies, and more recently, financial firms, for their role facilitating emissions. That many fossil fuel companies have actively obscured climate science and campaigned against climate action infuriates reasonable people.

Yet in reality, emissions enter the atmosphere only once, through Scope 1. Scopes 2 and 3 count Scope 1 emissions repeatedly, and reassign responsibility to multiple other parties. 

For fossil fuel companies, the vast majority of “their” emissions occur when households combust the gasoline in their cars, take-off on airplanes, turn on the AC, or flip the light switch. And, even the most optimistic activists have trouble linking reporting downstream Scope 3 to direct responsibility for managing emissions outside the control of the reporting firm. 

In fact, little additional information is gained from most downstream Scope 3 estimates. Policy tools such as efficiency standards, design regulations and, ultimately, carbon pricing provide better alternatives. Leading firms may still choose to use downstream Scope 3 estimates as a tool to reduce product lifecycle emissions but such activities will best (and likely only) flourish in a voluntary arena. 

In parallel, attribution science and multiple lawsuits moving through courts around the world hold promise that fossil fuel companies will eventually be held liable for climate damages. Demanding downstream Scope 3 estimates has no obvious mechanism for action.

Companies such as Alphabet, Apple and Microsoft broke ground with effective but costly power procurement as early adopters of 100% renewable energy targets. They accomplished this with the tailwinds of fast growth, insatiable demand for electricity, and huge profits. 

Net zero ambitions today must reconcile with a different environment. Few firms have the legal or financial cover to spend materially on voluntary climate action. For most firms today, their climate spend literally counts as advertising. Under ELM, spending on carbon offsets and carbon removals moves from “good corporate citizenship” to essential financially responsible decisions.

Carbon balance sheets

Can E-liability accounting and ELM work in a voluntary system, or must we have a regulatory pathway? Firms most certainly could adopt E-liability accounting voluntarily. In fact, if the GHG Protocol phased-out industry estimates and dropped downstream Scope 3, firms would be close. In the same way global frameworks and alliances have adopted the GHG protocol and Science Based Targets (SBTi), groups like the GFANZ, Climate Action 100+, and PCAF could pressure companies to furnish carbon balance sheets. 

However, bridging the gap from E-liabilities to ELM would have material impact on firm capital allocation and investments. The best-intentioned CEOs cannot take on these obligations voluntarily. That’s not because CEOs are ultimately heartless capitalists, but because shareholders can sue management for “wasting” real money on non-essential investments. 

Which returns us to the fatal flaw of net zero pledges: absent legal cover or regulatory demands for material action, firms have limited capacity for costly emissions responsibility and accountability.

Passionate adherents to the tactics that gave rise to voluntary climate action may see these ideas as threatening. We see them as a way to evolve the practice of emissions disclosures into something that will drive real reductions at speed and scale. 

Alicia Seiger is a lecturer at Stanford Law School and leads sustainable finance initiatives at Stanford law and business schools and the Precourt Energy Institute. She co-chaired California’s Climate Risk Disclosure Advisory Group.

Marc Roston is a research fellow at the Steyer-Taylor Center for Energy Policy and Finance, a joint initiative of Stanford law and business schools. He is a contributing author to “Settling Climate Accounts,” and has spent more than 25 years in the asset management industry.