Carbon Markets Volume 1: Carbon Accounting
Carbon Markets Volume 1: Carbon Accounting
Carbon accounting is increasingly gaining momentum to tackle climate change. Here's what it would take to strengthen carbon accounting practices to support climate action on a large scale.
Global stakeholders are becoming more climate-conscious than ever, as extreme weather events have reverberated across the world in the past year. Heatwaves and excessive rainfall leading to forest fires and floods have brought climate change to the forefront, not only as a concept but as a real threat. Individuals, governments, public and private companies are increasingly exploring ways to reduce their greenhouse gas (GHG) emissions, as well as their dependency on environmentally polluting resources, realizing that a delay in reducing these negative impacts can lead to irreversible damage to the world. Regulators are placing increased scrutiny on companies' environmental impact as consumers demand that brands be held responsible for their emissions.
“We are at a crossroads. The decisions we make now can secure a livable future. We have the tools and know-how required to limit warming, and if these are scaled up and applied more widely and equitably, they can support deep emissions reductions and stimulate innovation,” said IPCC chair, Hoesung Lee, after the release of the most recent IPCC report on climate action.
At Theia, we are excited to see the progress made in this regard and the increasing number of companies setting ambitious climate goals in the past few years. In parallel, we are seeing a growing demand for carbon accounting service-led models that have led to the growth of a horizontal category of carbon accounting and ESG compliance software solutions.
A New Era for Carbon Accounting
Sustainability has become a business imperative rather than a marketing and compliance exercise. Recent announcements by large technology companies have demonstrated how significant reduction of carbon emissions have become for businesses. For example, Apple and Meta have pledged to reach net zero emissions across their value chain by 2030. Cross-sector initiatives such as the Transform to Net Zero initiative founded by huge companies (Unilever, Nike, Danone, Microsoft, Starbucks, Wipro etc.) enable business transformations to accelerate the transition to a net zero economy.
This change has been driven by increasing regulatory pressure and consumer demands. New regulations and legal battles are compelling companies to set and achieve climate targets. The recently proposed rule by the SEC for new requirements for detailed disclosures of the risks and costs of GHG emissions is the latest in a string of regulatory changes in the past few years. Last year, the EU ratified the region's GHG emission targets to be legally binding.
Similarly, in India, SEBI introduced the BRSR (Business Responsibility and Sustainability Reporting) framework in May 2021 to ensure that investors have access to standardized ESG disclosures. BRSR will apply to the top 1,000 listed businesses, with the reporting being optional for FY21-22 to allow enterprises the time to adjust to the changes, but it is required for FY22-23.
Corporations are not only bound to commit to reducing their carbon footprint because of environmental regulations but also because of the court of public opinion that sets expectations from brands and holds them responsible.
When it comes to green consumerism, consumers want their brands to be more sustainable and more than half are willing to pay a premium.
Much like the case of data privacy, organizations are working hard to anticipate shifts in consumer sentiment, enforcing stricter customer demands towards GHG emissions. This has led to the emergence of Chief Sustainability Officers responsible for measuring, tracking and managing their employer's carbon footprint.
What is Carbon Accounting?
Carbon accounting or GHG accounting refers to collecting and aggregating information surrounding how much carbon dioxide equivalent emissions an entity emits by engaging in its business activities.
Carbon emissions form up to 81% of overall GHG emissions, the rest comprising methane, NOx and fluorinated gases. For this reason, the GHG emissions data collected across the value chain is translated into - CO2e, a carbon dioxide equivalent. According to the GHG protocol, the current dominant system for carbon accounting, a company's emissions are classified into three scopes. Scope 1 covers direct emissions from company-owned or controlled sources. Scope 2 covers indirect emissions from the generation of purchased energy from a utility provider consumed by the reporting company. Scope 3 includes all other (not included in scope 2) indirect emissions that occur across the value chain of the reporting company. These include emissions from upstream and downstream activities like business travel, sourcing of raw materials, disposal of waste, using the company's sold products and distribution activities.
Emissions along the value chain (Scope 3) represent the most significant carbon impact; it has been a missed opportunity for improvement for the past decade. For example, Kraft Foods reported that indirect sources in its value chain emitted 90% of its total emissions. Thus, all companies need to conduct a complete GHG emissions inventory – scopes 1,2 and 3 - to focus on specific sources to reduce their emissions to eventually reach the goal of becoming carbon neutral.
Limitations in Current Carbon Accounting Standards
The GHG Protocol has become the de-facto accounting standard; major accounting frameworks like TCFD, SASB, and SBTi are based on the standards set by the GHG protocol. The protocol's Scope 1 standard provides the basis for proper accounting of an organization's direct emissions, as these are the only 'corporate emissions'.
But the protocol falls short in its Scope 3 standard, which is considered the holy grail of emissions as it makes up the majority of the emissions in the value chain. The Scope 3 standard requires a company to estimate the Scope 1 emissions of all its direct and indirect suppliers and customers. Today, across industries, supply chains have become multi-tiered, and contractors are increasingly outsourcing to sub-contractors.
It is a complex task to collect meaningful emissions data from multi-tiered supply chains other than tier-1 suppliers and customers that are known well enough to collect meaningful data.
The opacity caused by interconnected, global and multi-tiered supply chains has forced the protocol standard-setters to allow companies the option to use regional and industry averages (referred to as secondary data) as a proxy rather than actually measuring the emissions data provided by their supplier, distributors and customers related to specific activities along their value chain (referred to as primary data).
Allowing companies to use averages rather than actual, precise, and traceable data undermines the integrity of Scope 3 emissions data.
Even though Scope 3 reporting is voluntary, according to CDP, the world's leading aggregator of data for environmental disclosures, less than half of the companies that disclose such data actually track and report on Scope 3 emissions.
Some regulators also seem to have reservations about the credibility of Scope 3 reporting. Earlier this year, the SEC proposed that certain companies must provide audited Scope 1 and 2 disclosures by 2024. However, it gives a litigation-safe passage for any company that voluntarily provides Scope 3 disclosures, implicitly acknowledging that such data would be unreliable.
Moreover, the GHG Protocol provides guidelines for companies to follow to calculate their Scope 3 emissions, while CDP reports the data in a standard format to the market. But the interpretation and calculation of the emissions needed to adhere to the standards are left up to the reporting entities. There is significant variability in the input data, equations and emission factors chosen by reporting entities to calculate their emissions. This leads to structural problems in measuring and reporting the data as the data is voluntarily shared, largely unaudited, and incomplete. As part of their study, the Aggregate Confusion Project by the MIT Sloan Sustainability Initiative concluded that the ratings from different providers diverge substantially. This divergence leads to a lack of comparability between companies and even a lack of comparability between sustainability disclosures of the same company over different years due to a change in the aggregation methodology.
Opportunities for Innovation
The Scope 3 standard's tolerance for secondary data allows companies lagging behind in their sustainability initiatives to take credit for their competitors' emissions, reducing innovation without making any changes to their products or processes.
Thus, the current Scope 3 standard allows sustainability laggards to engage in 'greenwashing'. Companies with a majority of environmentally conscious consumers or active equity owners or that have built an environmental competitive advantage by innovations in product design, revamping processes or new technology, are motivated to adopt stricter reporting standards. They are willing to pay a premium to credibly report their low per unit GHG emissions to highlight the positive impact created and to differentiate from less climate-conscious competitors. This has helped the growth of carbon accounting platforms that offer better ways to measure and manage a company's environmental impact. Companies like Watershed, Persefoni, Plan A and Normative have stepped up to provide comprehensive emissions calculation and carbon footprint tracking software.
Moving towards the use of primary data provides an accurate picture of the company's emissions. In its current form, analysts must collect data manually, begging various departments in the company, such as procurement and facility managers, to share data over email or pursue vendors to share information that would help estimate emissions along the value chain. Owing to the multi-tiered nature of the supply chain today, the data needed to estimate emissions come from disparate sources, and the scope of the data is also extensive- from the time raw materials are extracted all the way to how the end product is used and disposed of.
These factors are creating a growing opportunity for software companies like Interos, Sourcemap, Altruistiq and Ecovadis to help facilitate the collection of data across the value chain through integrations, and extract information in an automated manner from vendor reports, bills and other documents. These solutions would benefit from supply chain network effects and virality as their data collection standard would proliferate as adopters would encourage upstream and downstream players to maintain similar data standards, increasing the virality of such software as carbon tracking becomes increasingly commonplace. Such software offerings would help set industry-specific data collection standards, having knock-off effects such as increased adoption of sustainable procurement and waste management practices. This would create new opportunities to connect various stakeholders along the supply chain to provide solutions like Carbonchain and Sourceful, for sustainable sourcing.
Looking Ahead
We at Theia believe that unlocking valuable carbon data across the value chain would make way for full-stack solutions or new applications in collecting and analyzing data.
It could include use cases in quantifying and forecasting climate risk affecting companies and for carbon offsetting. These developments in carbon accounting would help set a baseline for the emissions linked to an enterprise and allow for emission benchmarking. It would enable a company to prioritize areas whose emission reduction would have maximum impact on the value chain.
As for hard-to-abate sectors like steel, cement, chemicals and oil and gas, the next natural step would be to turn to carbon offset projects and carbon credit markets.
These developments would help build the demand in carbon markets, incentivizing carbon offset project developers to build a pipeline of projects to match the demand. In turn, it would help to mobilize funds to scale and fund carbon removal, as well as nature-based solutions, helping hard-to-abate sectors reduce their carbon footprints and meet critical year-end targets.
In summary, even though carbon accounting is just one part of our transition to a net-zero economy, we are optimistic about the future of carbon reporting and the resulting carbon markets it would create. We are excited to work with founders aiding enterprises in this transition to a net-zero emissions economy.
This article is Part 1 of a two-part series to analyse the role carbon markets can play in supporting large-scale climate action and the factors that would increase the credibility of emissions reporting and offset projects to enable the growth of large-scale carbon markets. Stay tuned for Part 2, wherein we will look at carbon credits, voluntary carbon markets, and factors that can help them scale in the coming years.