ESG Disclosure Regulations Aren't a Bluff to be Called
It appears we were wrong about the possibility of global ESG reporting standards as evidenced by the highly anticipated proposal issued mid-March by the Securities and Exchange Commission (SEC) and its adherence to the Task Force on Climate-Related Financial Disclosures (TCFD) and the Greenhouse Gas Protocol.
Setting forth landmark climate-change disclosure regulations, out of the gate responses are variegated, including the ‘palming off’ Congress’ social and economic policy responsibility to financial regulators; new rationale to villainize oil and gas; general explorations into the great lack of global business processes required to accurately track, nonetheless, disclose greenhouse gas emissions (GHG) for scope 3 across already strained supply chains; as well as a lengthy dissent from Commissioner Peirce critiquing the proposed rules for overlap and incongruent materiality use, while also citing the SEC’s general lack of authority.
Contention aside however, climate risk will continue to be of the most “momentous risks to face capital markets,” and while the accelerating trend for more accurate and transparent corporate sustainability disclosures have been largely — to date – driven by the investor community and stakeholders, there are several baseline truths emergent alongside the SEC’s proposal that will impact the road ahead regardless of which side of the climate spectrum you lean toward.
Two major take-aways: one, changes to current reporting methods are a given. Two, the earth and its carbon is essentially a closed-loop system which means that – politics shelved – creating a carbon accounting structure to track, measure and account for carbon dioxide equivalents (CO2e) is entirely feasible along any value chain. By examining financial accounting frameworks that oversee transactions between entities, a similar discipline can be replicated to tackle the carbon accounting reporting challenge. And it need not take hundreds of years to develop carbon accounting into the global, professional system that financial accounting has become. We can leverage emerging technologies to build on fundamental principles and accelerate their adoption just like we have seen with B2C transactions over the last two decades. Sitting back and claiming that it is too hard or that the sky is falling is the wrong way to go about.
Before we delve into the parallel between financial accounting and creating a system for carbon based accounting, first a brief dive into the basics of what the SEC has put forth.
Deeply prescriptive and granular, the SEC’s 500+ page proposal is a sea to wade through. Parseable summarization includes requirements that registrants provide detailed information about their handling of climate change issues including TCFD’s four pillars: climate-related governance, strategy, risk management, metrics and goals. Registrants must measure and disclose GHG emissions in accordance with the well-known and international calculating standard of GHG Protocol methodology, as well as larger registrants reporting data for Scope 1, 2 and 3 emissions (if material, or if the company has set emission reduction targets or goals that include the Scope 3 category of emissions).
Lastly, larger registrants must provide disaggregated metrics and related disclosures concerning climate-related impacts that include line items of the financial statements required under current financial statement requirements.
Follow the Financial Model
Financial accounting is standardized and pervasive; two facets helpful for understanding how it’s conceivable to carry its concepts across to burgeoning carbon accounting practices.
Consider how currency works; money is an imaginary construct created to reflect a transfer of a real, physical thing or a service rendered (even if it’s soon to be entirely digital, it’s still not ‘real’); money is a medium of exchange, yet financial accounting trades and tracks money easily between entities and maintains visibility into financial health. On the other hand, carbon is a real physical thing that follows the laws of physics. It can be measured, tracked, quantified and accounted for if rules for how to measure and account for it exist. CO2e’s value is derived from the accumulating benefit of maintaining (or reducing) its free presence in our atmosphere (a finite closed system) within a range that mitigates/minimizes climate change and its harmful impact to the planet and all that entails.
The challenge, then, is how do you measure CO2e and account for it through all of its permutations across a massive global network where debits and credits are continuously occurring from billions of disconnected sources? In financial accounting, measurement systems occur inside of entities with balance sheets and P&Ls for example. For carbon accounting, the measurements must be verifiable, fungible and able to move between entities, which means that the answer comes down to a distributed network of measurements.
Track it on the Chain
When blockchain, otherwise known as a distributed ledger system, is deployed to automate transactions with smart contracts between enterprises and vendors, counterparties or customers, the technology captures and aggregates operating data by tapping connected devices and other Industrial Internet of Things (IIoT) information sources. The smart contract reaches across commercial supply chains to generate a third-party record of truth that corroborates physical events and services in real-time and stores relevant, unalterable data used to automate transactions on an immutable blockchain.
Because it can be an immutable source of truth, government agencies have shown a strong appetite for the technology’s efficacy in also providing transparency into a product’s custody timeline. This same capability can be used to automate sustainability impact measurements and certifications while providing accountability, accessibility, and the sorely needed distributed network that enables industries to accurately report ESG related disclosures (especially GHG emissions) across their full value chains. It is through this network of connected nodes that the facilitation of carbon debits and credits between entities can occur.
The technology to do this exists today with the combination of IIoT, smart contracts and blockchain and it is proven and in use. Setting up and using a smart contract to automate B2B commercial transactions or to automate the reporting of scope 3 GHG emissions is actually quite simple. Specifically relating to GHG emissions and the developing practices for carbon accounting, it is the breadth and scale that is daunting, not the how. But, it can be done with a technology that is inherently iterative and agile where you build the network one node and one smart contract at a time. It is no different to how we built the national rail system, the power grid or the transportation and fueling networks; additionally the internet and the resulting B2C networks in use today.
With a healthy dose of skepticism for the timetable at hand, companies can hem and haw or get after what’s laid out on the table. It will certainly be a different iteration of the proposed new rules but whether it is the SEC calling the shots, or the funds and banks withholding capital until you prove net-zero, best to bet that ESG isn’t a bluff to be called. With technology that combines data standardization, automation, and a verifiable source of truth, we are now able to accurately account for CO2e through its full life cycle, and with consistent carbon accounting rules and methodologies we can derive a credible valuation.