As the ESG reporting landscape continues to evolve, there are five ways companies can continue to enhance the credibility of their sustainability claims:
- Standardization
- Due diligence over procurement decisions
- Goal setting
- Progress reporting
- Assurance
Standardization to drive comparability
The various existing and proposed ESG regulations have been designed to help delineate specific qualitative and quantitative disclosures. For example, GHG emissions in the SEC proposed rule on climate-related disclosures are to be disclosed on a gross basis, with separate disclosure for the use of carbon offsets.
This disaggregation will make it much more apparent to users of the disclosures what a company’s primary emissions reduction strategy is — and whether its strategy involves real emissions reductions. Does it plan on decarbonization through changes in core business/operations, or is the plan business as usual with purchases of voluntary carbon offsets? The standardization from regulations will aid in comparability for investors and other stakeholders, allowing for better identification of a company’s true GHG emissions strategy.
Companies may consider reconciling the various regulatory requirements against their current disclosures around their relevant claims to evaluate how those claims may be perceived when full information is provided in the regulated disclosures.
Due diligence over procurement decisions
The strongest decarbonization strategies involve true structural changes in the business. Those are often long-term strategic decisions that take significant time to implement and may involve disruption to the strategic differentiators that drive the business today.
In these instances, in the near term (as those longer-term strategies begin to be implemented) companies may turn to renewable energy purchases, either directly on-site with operations (such as on-site solar panels) or contractual instruments such as PPAs (power purchase agreements). These procurement decisions will aid in the reduction of Scope 2 market-based emissions and are often a key driver in claims and goals related to overall emissions. It is important for companies to do proper due diligence on the credibility of all renewable energy purchases, with adherence to the Scope 2 quality criteria² driving those procurement decisions in the market, even if the claim or target isn’t directly tied to the Greenhouse Gas Protocol (GHGP) (e.g., if they have a renewable energy goal).
Many companies still rely on carbon offsets. Such offsets are typically associated with carbon-neutral goals/claims, and they have come under significant scrutiny in recent years. The quality of carbon offsets available for purchase in the market can vary greatly, and there has been increased concern regarding the validity of offsets purchased as well as the legitimacy of the offset providers. This sits alongside the structural concern that offsets do not in fact “reduce” emissions.
For example, many renewable energy projects (carbon avoidance) that take place in the US and other developed countries are no longer considered by the market to be additional, which is a requirement of many of the established third-party offset verifiers. Other alternatives in the market, such as carbon-removal offsets, focus on removal and storage of carbon from the atmosphere. These projects come at a cost premium compared to carbon avoidance offsets but are expected to result in higher quality and credibility when net zero goals are disclosed.
The regulations are clear that offsets should be distinguished from emissions and that emissions should be disclosed on a gross basis, providing a more complete overview of a company’s GHG footprint.
Establish a framework for goal setting
Leveraging a consistent, objective and recognized framework to set a sustainability-related goal or commitment will be important and help companies define the right ambition. This will also assist organizations if these goals and targets are included in management’s compensation.
Chapter 1 of the GHGP lays out five principles for GHG accounting and reporting: relevance, completeness, consistency, transparency and accuracy. It may be helpful to consider these same principles when establishing a given goal or claim and measuring related progress.
For example, if a company has a goal to reduce Scope 1 and 2 emissions 30% by 20XX, it should explicitly state which Scope 2 emissions calculation method (location-based or market-based) is used to establish the baseline and measure progress (principle of transparency).
A key piece of the goal setting and measurement relates to the establishment of a base year to measure against. The base year should be representative of a “typical” year of emissions in order to identify meaningful and long-term trends in emissions reductions. For companies looking to establish or refresh goals it will be important to consider the impacts of COVID-19 on a business when deciding on a base year – for example, if a business experienced a significant downturn or growth as a result of COVID-19 and those impacts have since normalized, using those impacted years (such as 2020) may not be the best basis to measure progress against. There are also established frameworks available, such as the Science Based Targets initiative (SBTi), for companies to formally follow.
Of course, setting the goal is just the first step. Companies then must develop and disclose credible plans to enable them to meet those goals, including the interim goals along the way to the ultimate goal (such as net zero). Institutional investors have begun to closely question the credibility of corporate goal setting,³ and many initiatives provide frameworks for describing transition plans.⁴ Some companies have also begun to use EU Taxonomy disclosures to describe the speed of their transition plans. These disclosures highlight the critical role that capital expenditure plans will play in enabling companies to demonstrate that their goals are supported by the capital investments to make them a reality.
Progress reporting and re-baselining
The time horizons designated for goals/claims vary widely, with many companies setting short-, medium- and long-term ambitions. The operational makeup of a company will likely undergo changes during the periods of measuring progress to a stated goal, prompting companies to address possible progression in the wrong direction or re-evaluate goals entirely.
For GHG emissions, the GHGP addresses how to think about structural changes to an organization for purposes of measuring emissions-reduction progress. A company cannot meet its stated goal by selling off pieces of its business, as those emissions still exist in the atmosphere and are only transferred to the acquiring organization. Similarly, acquisitions will increase a company’s overall emissions but should not negatively impact progress to a company’s goals.
This is where the concept of re-baselining comes into play: per the GHGP⁵, structural changes in the reporting organization — such as mergers, acquisitions, divestments, outsourcing and insourcing —warrant a recalculation of the baseline year (the year used to measure goal progress) for a “like for like” comparison from baseline year to current year. This means emissions related to the structural change should be adjusted in the baseline year as if the structural change was in place at that time. For example, if a company acquires a business in 2022 and its baseline year is 2019, the 2019 baseline will be recalculated to add in the 2019 emissions of the acquired company.
There is no established threshold (e.g., materiality of the structural change) for when to recalculate the baseline, and it should be evaluated on a case by case basis as structural changes occur. Many companies have established formal “significance thresholds,” based on qualitative and quantitative considerations, to have a consistent application of recalculations. It is important to evaluate structural changes individually and in the aggregate. For example, a company may have several “insignificant” divestitures when evaluated individually, but when taken together they exceed its established quantitative significance threshold, indicating a recalculation may now be warranted.
It is important to note that base-year emissions and any historic data are not recalculated for organic growth or decline. The rationale is that organic growth or decline results in a change of emissions to the atmosphere and therefore needs to be counted as an increase or decrease in the company’s emissions profile over time.
Obtain independent third-party assurance
ESG assurance can help provide confidence in the credibility of ESG data and disclosures to both management and external stakeholders. Several of the global ESG regulations contain an assurance requirement for GHG emissions, which are the key input for calculating GHG emissions-reduction goal progress, renewable energy goals, etc. However, when it comes to assurance over something like GHG emissions-reduction goal progress, it is important to remember that both the baseline year and most recent year of measurement need to undergo assurance.
Conclusion
Though companies have been talking about ESG and making sustainability claims for some time, regulation is causing a necessary rethink. How credible are the goals we have set? Do we have a credible plan to meet them? How decision-useful are our disclosures? What was the process to develop our disclosures? Do we have governance and monitoring in place? Are our assurance providers sufficiently engaged?
By standardizing disclosures, regulation is taking away much of the discretion and optionality companies had around what and how they disclose sustainability information and forcing more disclosure on themes that have often been avoided in the voluntary context. Now is the time for companies to assess their existing claims and those they will make in the future in the context of ESG disclosure moving into a regulated setting on an expanded footprint.
