Show me the incentive and I will show you the outcome - Charlie Munger
As companies waver on their climate commitments, I look at some of the mechanisms that are being proposed to enhance incentives for climate action. Helpful innovations or yet more can kicking?
What caught my eye last month
Market-based accounting
The news over the last few months has been awash with companies rowing back on their climate commitments. A recent article by the Financial Times summarises the mood, observing that "talk of purpose has given way to pragmatism".
As activist investor Chris Hohn notes, "we can all talk and say we're all green. But then when [companies] have to make the investments, they can't justify them without regulation and taxation". And, indeed, prominent greenwashing cases are starting to sift out those that have only been paying lip service to climate goals.
Even among companies that are genuinely committed to climate action, aligning incentives to unlock investment is proving challenging, especially against a backdrop of (increasingly) mixed political signals and still high technology costs in some sectors.
For some this has justified a renewed interest in the role of voluntary carbon markets. Last month the White House threw its weight behind the SBTi's controversial proposal to allow companies to use carbon credits to meet their scope 3 targets.
Yet cheap offsets could risk further skewing incentives away from more costly internal decarbonisation. It is not a coincidence that companies that have fallen foul of greenwashing allegations have often done so due to an over reliance on low integrity offsets and carbon neutrality claims - see LSE's recent analysis on climate-washing cases.
An area that is gaining increased attention as a way to create incentives for decarbonisation are market-based approaches to carbon accounting.
Proponents argue that these approaches can help companies to: demonstrate a wider range of climate impacts outside their existing inventory; take credit and responsibility for emission-reducing interventions where the physical connection to the emissions source is hard-to-trace or purely financial; facilitate the uptake of new technologies where physical infrastructure does not yet exist at scale to enable direct supply; and provide more options for investors looking to invest in decarbonisation.
The GHG Protocol recently completed a consultation on the topic as part of its process to update the corporate standards. By the GHG Protocol's own admission, this is an area where consensus on definitions and common vocabulary has yet to fully settle. But, in general terms, it encompasses two broad approaches.
(i) Project-based accounting and crediting: showing impact
Current GHG Protocol standards are based on a separation between inventory (the Corporate Standards) and intervention accounting (the Project Accounting Standard).
Most companies are familiar with inventory accounting, reporting their absolute company-wide operational and value chain emissions for comparison over time. By contrast, intervention (also known as project or impact) accounting is used to measure and report GHG emissions reductions, removals or increases associated with specific activities relative to a counterfactual baseline scenario.
Project-based accounting is used for carbon credits, which (in theory) buy emission-reductions or removals outside a firm's value chain. And are sometimes claimed by companies to offset their own inventory emissions.
Some companies have also started to report on their avoided emissions as a way to capture broader climate impact. Avoided emissions reflect the difference between the GHG emissions that occur due to a company's intervention (e.g. its solutions and products) and the GHG emissions that would have occurred without the solution.
At present, the GHG Protocol allows for companies to present project-based GHG reductions from specific actions alongside their inventory (scope 1, 2 and 3 emissions), as part of a GHG Emissions Report. These two elements are reported separately to avoid mixing apples and pears.
But, in reality, most disclosure requirements and target setting programmes do not take intervention accounting into consideration. Proponents argue that a more explicit exposure of interventions would provide more context and incentivise companies to invest in more action by capturing impacts outside of their immediate inventory.
For example, a company that invests in creating a new range of products that produce lower emissions than an incumbent, might be disincentivised from doing so because only the emissions associated with making the product would be captured in their inventory.
The GHG Protocol is currently reviewing a slew of proposals which could give greater prominence to such approaches, including ideas such as creating a separate impact category in GHG reporting.
(ii) Traceability mechanisms: counting influence
According to the GHG Protocol, "market-based approaches have typically arisen in cases where companies purchase products or commodities from common pools or distribution systems, and direct contracting with suppliers or traceability to individual points of origin is not feasible."
In other words, when companies engage in actions to reduce their emissions but lack the ability to trace the physical relationship to the original emissions source and therefore to claim a reduction in their inventory emissions. This is distinct from intervention based accounting which looks at impact relative to a counterfactual (though in some proposals the two can become jumbled - itself a topic of debate).
Such situations can occur when:
A direct physical relationship exists but can't be traced to a single provider. For example, when firms source from a defined group of suppliers within a market (an activity pool). Think of a company sourcing grain from a distributor which in turn draws from multiple farms in a geographic area. An intervention impacting an individual farm might be hard to trace though its grain is part of the overall mix.
Only a financial relationship exists but there is a claim of causality, such as when a company contracts off-site green energy by buying renewable energy credits (RECs) or entering into a vPPA.
In such cases, market-based solutions may provide a way for companies to claim that they have caused a reduction in their inventory emissions. Typically this involves using a different (i.e. lower) emissions factor than the average that would otherwise apply.
There is precedent for this in Scope 2 dual reporting requirements. Companies that buy contractual instruments (e.g. RECs or vPPAs) apply a specific emissions factor for the cleaner energy, which is reported alongside grid emissions intensity.
(Though the jury is still out as to whether these instruments have actually had much additional impact on renewable energy production. And critics would argue that a purely contractual arrangement without physical connectivity stretches the bounds of causality.)
Some proponents advocate extending dual reporting to Scope 1 and Scope 3. They argue that this would create incentives for investment in things like biomethane or recycled-carbon fuels to reduce (market-based) scope 1 emissions. Or would encourage companies to invest in green energy on behalf of their supply chain. Or engage in collaborative value chain interventions.
Various versions of chain-of-custody schemes have been proposed to facilitate tracing claims. These include mass balance approaches, when a physical relationship exists but traceability is limited, and book-and-claim schemes, where causality is purely financial. These approaches are viewed by proponents as potential solutions to support nascent markets for greener solutions where direct physical supply is not yet available to all, such as sustainable available fuels.
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My take: Even though many companies are aware of the severity of the climate crisis, incentives driving corporate action are often not sufficient to bring necessary investments to fruition.
In this regard, market-based approaches might help to shift the business case in favour of more climate investment and collaborative approaches, especially where regulatory pressure is lacking.
But the further such innovations move away from underlying physical relationships and stretch the bounds of causality (e.g. through purely financial relationships), the more like greenwashing they can feel. Carbon offsets are a case in point. Solving one market failure with another amounts to little more than sophisticated can kicking.
The GHG Protocol's draft summary report makes clear that there are strong opinions on both sides but gives little a way in terms of direction of travel. As experts Brander and Bjørn set out in a recent paper, one option would be to clearly separate market-based accounting from inventory reporting via the separate intervention accounting framework. An alternative would be to allow market-based accounting but with physical connectivity and causality constraints to avoid greenwashing.
RECOMMENDED READING
It's hard to summarise all the details of this complex topic in a few paragraphs. For those wishing to dive further down the rabbit hole, we recommend taking a look at the GHG Protocol's draft summary report on the responses to the Market-Based Accounting survey.