On January 27, 2010 the SEC voted to issue interpretive guidance on disclosure requirements of climate risks in SEC filings. The SEC stressed that the interpretive releases do not create new legal requirements but are intended to provide clarity and enhance consistency on existing requirements. Nonetheless, the issuance of guidance indicates the growing focus of the SEC on climate change disclosure and the need for companies to expand and improve their environmental disclosure.

Till now the SEC had not called for any specific disclosures regarding climate change nor provided interpretative guidance regarding the application of existing disclosure requirements for “material risks” to climate change-related matters. The SEC sent a signal that it was preparing for future action when in a briefing released July of 2009 it included “Environmental, Climate Change and Sustainability Disclosure” on the list of possible refinements of the disclosure regime for the Investor Advisory Committee.

As the SEC explains in its release, existing regulations require a company to disclose information related to risk factors and call for management discussion and analysis. The new guidance on those rules emphasizes that when assessing potential risks, companies should consider the impact of existing climate change legislation and regulation, international accords or treaties on climate change, indirect consequences of regulation or business trends, for example new risks for the company created by legal, technical, political and scientific developments, and the physical impacts of climate change. This appears to be an impressively comprehensive assessment of investor risk associated with climate change.

Ceres proclaimed this action to be the “the first economy-wide climate risk disclosure requirement in the world”. The guidance follows a petition sent to the SEC in 2007 by a group of investors, state agencies and environmental advocates, led by Ceres, urging the SEC to issue guidance on climate-related impacts. Ceres has long pursued a strategy of exerting leverage on companies by institutionalizing information disclosure of value to investors. Ceres initiated the Global Reporting Initiative and, more recently, the Investor Network on Climate Risk. The Carbon Disclosure Project (CDP) mechanism has become the most prominent mechanism for corporate carbon disclosure, though the value of the information to investors is unclear.    

Moreover, CDP-style data has not been integrated into formal SEC reports. According to two major studies released last year by Ceres, Environmental Defense Fund (EDF) and the Center for Energy and Environmental Security (CEES) climate-related disclosure “continues to be weak or altogether nonexistent in SEC filings of global companies with the most at stake in preparing for a low-carbon global economy.” The SEC initiative responds to repeated investor requests for formal guidance on the climate-related disclosure companies should be providing in securities filings.

SEC Commissioner Elisse Walter commented that the decision “is designed to improve the quality of disclosures filed by U.S. public companies for the benefit of investors.”. She mentioned that she does not consider “that public companies today are doing the best job they possible can do with respect to their current mandated disclosures.” The SEC guidance thus represents an endorsement for more stringent and meaningful carbon disclosure, and moves it beyond a voluntary “social responsibility” type of activity into the regulatory realm.

Some critics have argued that the guidance will not lead to meaningful change in corporate reporting. Zac Bissonnette from DailyFinance writes that “the absolute best thing that will come of this policy is that some public companies will add a few lines of boilerplate that no one reads to the risk factors section of the 10-Ks they file with the SEC.” Others argue that some of the terms used are unclear. As an example, the guidance states that “when assessing potential disclosure obligations, a company should consider whether the impact of certain existing laws and regulations regarding climate change is material.” Jane Wells of CNBC questions “what constitutes material”. Julie Gorte, a senior VP for sustainable investing at mutual fund company Pax World Management LLC, suggested that corporate officers would still have considerable discretion in deciding what constitutes a “material risk” that must be shared with investors.

The guidance is likely, however, to prompt companies to increase climate disclosure or face the threat of legal action for failure to disclose required information in light of the 1933 Act. In his blog, John Shideler makes the case that “the SEC’s action should prompt more companies to collect, analyze and report on climate change information. Companies that do not do so face added risks of litigation or regulatory action if future developments show that management failed to disclose material financial impacts linked to climate change.”

Even though this SEC initiative provides “guidance” rather than create new legal requirements, its impact could be very far reaching. SEC enforcement and legal challenges will gradually clarify the detail and form in which companies have to assess and disclose climate-related risks in their filings and improve their climate related disclosure.

In the emerging carbon economy‚ projects that reduce‚ eliminate‚ or sequester carbon emissions will have enormous value. An examination of climate change legislation recently passed by the U.S. House of Representatives¹ indicates how important such projects will be and the many questions that remain about them. Those who participate in the legislative and regulatory processes that will define the amounts and types of eligible projects can gain a competitive advantage by ensuring they capture the full value of such projects.

To date‚ most technology entrepreneurs‚ project developers and investors‚ anticipating a “cap and trade” regulatory system‚ have focused on the number of allowances that the government would issue. This makes sense: the availability of allowances will have an important influence on the severity of the reductions required by “capped entities” and‚ correspondingly‚ on the competitive advantages of non-carbon fuel sources.

But allowances are not the whole story. In fact‚ from the perspective of driving investment decisions and market valuations‚ they may be less influential than carbon offset credits. The price for emitting carbon and the prospects for non-emitting competitors will be heavily influenced by the amount of offsets that can be used for compliance‚ the types of projects eligible to create offsets‚ and whether or not they are located in the U.S.

Carbon offset projects avoid‚ reduce‚ or sequester carbon emissions‚ and generally include activities such as:

• Capture and destruction of methane emissions from landfills
• Sequestration of carbon through forest preservation and expansion
• Reduction in CO2 emissions through energy efficiency in buildings
• Avoidance of methane emissions through management of agricultural manure.²

The influence of offsets on the economic impacts of a federal cap and trade carbon control policy is vividly demonstrated in a recent study by the Congressional Research Service (CRS). It examines the potential costs of the climate legislation passed in June by the U.S. House‚ officially known as the American Clean Energy and Security Act. In its review of seven reports that used computer models to predict the economic impacts of the cap and trade portion of Waxman-Markey‚ the CRS found that the ability to use carbon offsets to achieve compliance is “potentially the key factor in determining the cost” of the bill’s proposed cap and trade program.³

Waxman-Markey sets two important constraints on the use of offsets for compliance with its cap and trade program. One is a limit on the total amount of offsets that can be used for compliance. The other sets a limit on how many of these offsets can be obtained from outside the U.S. These two constraints will be crucial in determining the long-run marginal price of carbon offsets‚ indirectly the long-run price of carbon allowances‚ and the future competitive positions of low-carbon energy sources like wind‚ solar‚ and biomass.

The Total Amount of Offsets Allowed for Compliance

Waxman-Markey allows the federal government to issue five billion tons of allowances beginning in 2012‚ increasing that amount slightly each year until it reaches its high point of 5.05 billion tons by 2015. The limit then drops steadily each year‚ so that for example‚ by 2030‚ total annual allowances would be reduced to 2.9 billion tons.

The number of allowances alone is very likely insufficient to enable “business as usual” emissions‚ even at the outset‚ and these insufficiencies grow larger over time. Obviously‚ marginal industries may choose to comply with these new requirements by simply ceasing operation‚ making compliance relatively easier and less expensive for those that continue to operate. But the vast majority of emitters will seek to find a way to comply. If the supply of allowances is insufficient‚ bidding to purchase an allowance could produce prices that get very high indeed. The most important antidote to this is to expand the supply of compliance options by allowing the use of carbon offsets (certified reductions from sources outside the cap-and-trade system). The environmental effect of purchasing credit for an emissions reduction from an offset project is the same as purchasing an allowance.

Because offset credits and allowances are interchangeable for compliance purposes‚ long-run prices for them will tend to converge. Whenever the long-run marginal cost of an offset project appears likely to yield an offset price that is less (by a significant margin) than the anticipated long-run price of allowances‚ it will make more sense for developers to build‚ and investors to invest in‚ carbon offset projects.⁴

Waxman-Markey would allow for the use of up to two billion tons of offset credits for compliance each year starting in 2012. This means that offsets‚ if they were fully used‚ would expand the compliance options available to capped entities by about 30% in 2012 and by about 67% in 2030. If offset projects are supported by investors and built by developers‚ they will constitute a dramatic expansion of the supply side of the carbon market and will moderate the price of allowances significantly.

One of the studies examined by the CRS suggests the large impact of allowing offsets to be used interchangeably with allowances for compliance. It estimates that if the two billion tons of allowances in Waxman-Markey were disallowed‚ allowance prices in 2030 would be expected to increase from $40 per ton to $138 per ton and that‚ between 2012 and 2050‚ the average annual savings from offsets could be about 70%.⁵

On the other hand‚ offset projects take time to be approved‚ financed‚ and built. The CRS report notes that the seven studies generally agree that it will take time for the supply of international and domestic offsets to start producing credits‚ and that offset limits in the bill are generally not reached until 2025‚ if at all.⁶ This suggests that the price moderating effect of offsets will be quite modest at the outset‚ but increase over time as the price–escalating effects of diminishing allowances take effect.

Types of Offsets Projects Allowed for Compliance

Waxman-Markey sets up a process to determine which types of projects are eligible and which projects actually receive credit. An offset credit would be awarded to project developers for each ton of CO2 equivalent reduced‚ avoided‚ or sequestered after January 1‚ 2009.⁷ Each project would receive credits from the Administrator of the Environmental Protection Agency (EPA) based on an assessment prepared by an independent third party who verifies the quantity of greenhouse gases that would be reduced‚ avoided‚ or sequestered.

Eligible types of offset projects are not defined nor are the criteria on which their performance will be evaluated. Instead‚ Waxman-Markey directs the EPA Administrator to determine the types of projects that are eligible to earn offset credits and the criteria for obtaining certification of project performance. It seems likely that the version of climate legislation signed into law will leave substantial discretion to the EPA Administrator to conduct rule-makings and make determinations to clarify eligible project types and performance evaluation criteria.

International Versus Domestic Offsets

The cost of offset projects varies widely from one type of project to another. Moreover‚ the cost of similar types of projects can vary widely‚ depending on whether they are located in the U.S. or abroad. Experience with the use of offsets under the Kyoto Protocol has shown that offsets available in less-developed countries can be considerably less expensive than those produced domestically. Thus‚ it is widely assumed that allowing compliance using offsets from projects in other countries will tend to lower the price of allowances and the overall cost of compliance.

Waxman-Markey allows covered entities to achieve compliance each year by using up to one billion tons of domestic offsets and one billion tons of international offsets. Further‚ if the supply of domestic offsets is below 0.9 billion tons‚ the remainder can be made up with international offsets‚ up to an additional 0.5 billion tons.⁸ The EPA Administrator is allowed to issue offset credits for projects in other countries and to exchange U.S. credits for credits issued by an international body established pursuant to the U.N. Framework on Climate Change or the Kyoto Protocol.⁹

The CRS report notes that‚ of the seven reports it examined‚ three modeled scenarios in which international offsets could not be used for compliance. Those three studies predict that if international offsets cannot be used for compliance‚ by 2030 the price of carbon allowances would increase dramatically‚ ranging from a low of 65% in one study to a high of 180% in another.¹⁰

Conclusion

The volume of carbon offset projects deemed eligible for compliance with emission requirements under federal cap and trade legislation will substantially influence the cost compliance for capped entities. A large supply of approved offset projects will bring down the price of carbon allowances‚ and make the overall cost of compliance lower than it would be otherwise. A large supply of international offsets available to be used for compliance will further reduce the cost of allowances and the overall cost of compliance.

At the same time‚ wind‚ solar‚ biomass‚ and other low carbon-emitting sources of energy are likely to see their competitive advantages over carbon-emitting sources of energy vary according to the supply and price of qualifying carbon offsets‚ and the supply of eligible international offsets allowed by the legislation will determine the degree to which investors choose to invest in domestic carbon-reducing technologies and projects.

Technology entrepreneurs‚ project developers‚ and investors may find their competitive positions in the new carbon economy heavily influenced by federal policies on carbon offsets. The degree to which this will be the case will be determined‚ not only as a result of the legislative debates now underway‚ but also even after legislation is enacted. Federal agencies will have to write the rules on eligible projects‚ performance evaluation‚ and verification requirements. Clean energy companies and offset project developers would do well to create a chorus of vibrant and influential voices throughout this process.

[Note from David Levy, Climate Inc. editor: I will soon post an update that describes the proposed changes to offset rules in the US Senate Kerry-Boxer version of cap-and-trade]

¹ The American Clean Energy and Security Act‚ H. 2454‚ June 26‚ 2009

² For an example of offset project categories approved in one cap and trade program in the U.S.‚ see the categories eligible for compliance with the Regional Greenhouse Gas Initiative at http://www.rggi.org/offsets/categories.

³ Larry Parker and Brent D. Yacobucci‚ “Climate Change: Costs and Benefits of the Cap-and-Trade Provisions of H.R. 2454‚” Congressional Research Office (Washington‚ DC: September 14‚ 2009): ii.

⁴ This is not to say that prevailing (i.e. short-run) prices for allowances and offsets will be identical. The certainty of compliance obtained by purchasing an allowance will always tend to give it a short-term advantage over the uncertainty of future production and compliance inherent in an offset project. Buyers will want to obtain a discount on the purchase price of offset credits that reflects this risk difference. This short-run price advantage of allowances may be countered by the ability to buy project offset credits under a long-term contract and obtain a hedge against future volatility in allowance prices.

⁵ Congressional Budget Office‚ “The Use of Offsets to Reduce Greenhouse Gases” (August 3‚ 2009); Economic and Policy Brief prepared by Natalie Tawil.

⁶ CRS‚ ibid. p. 46

⁷ At the EPA Administrator’s discretion‚ offset credits may be awarded to projects started after January 1‚ 2001 and to offset projects for which credits were issued by another regulatory or voluntary program‚ provided that the program’s evaluation standards are at least as rigorous as those used by the proposed federal program [See ACESA‚ Section 740 (a)].

⁸ Under Waxman–Markey‚ after 2017 international offsets are discounted by 20%; that is‚ five international offsets are required to offset four tons of emissions.

⁹ While the bill doesn’t stipulate the type of international projects that would be eligible for offset credits‚ it does establish guidelines regarding international offsets from reduced deforestation.

¹⁰ The three reports are (1) EPA/IGEM: “Data Annex” available on the EPA Web site‚ here. (2) EIA/NEMS: EIA‚ Energy Market and Economic Impacts of H.R. 2454‚ the American Clean Energy and Security Act of 2009‚ (August 2009); and (3) NBCC/CRA: CRA International‚ Impact on the Economy of the American Clean Energy and Security Act of 2009 (H.R. 2454) (May 2009).

Carbon comes in many forms: depending on how the atoms are arranged, carbon can be a tough brilliant diamond, a rigid bucky-ball, a super-strong nanotube, soft graphite, or a lump of coal. These forms have very different properties and uses – diamonds are not the best fuel for generating electric power. Similarly, carbon measurement and disclosure comes in various shapes and sizes, from the Carbon Disclosure Project to product-level carbon footprints to Enterprise Carbon Management Systems. Yet the various modes of carbon measurement have very different goals and intended audiences, causing considerable confusion amongst firms and potential users of carbon information. This is going to impede the adoption of carbon information systems that are most crucial, those designed to manage and reduce emissions.

The Carbon Disclosure Project (CDP), a non-profit UK-based organization, launched its 2009 report in late September with great fanfare. The report is impressive in many ways. It’s based on a detailed questionnaire sent to companies that includes topics such as greenhouse gas (GHG) emissions, risks and opportunities to the reporting company, programs to address corporate emissions, and the assignment of managerial responsibility. With seven years of data, CDP claims to hold the largest database of primary corporate climate change information in the world.

CDP’s strategy has been to leverage the influence of institutional investors to pressure companies to voluntarily disclose their carbon-related activities, on the premise that this information is important in assessing asset values and predicting financial performance. The CDP has now signed up 475 investors with a total $55 trillion under management. CDP states that over 2,000 organizations in 66 countries around the world now measure and disclose their greenhouse gas emissions and climate change strategies through CDP. The headline 2009 report focuses on the “Global 500”, the 500 largest corporations in the FTSE Global Equity Index Series, which in June 2009 had a combined market capitalization of US$15.5 trillion. CDP achieved an 82% response rate for this group. These are impressive numbers indeed.

The CDP has certainly helped to spread familiarity and acceptance for carbon reporting and disclosure in the corporate world. Yet it is questionable how much CDP has actually contributed to emissions reductions. First, the investors who sign up do not undertake any commitment themselves (unlike the similar but smaller CERES INCR project). As Charles Morand writes in his Alt Energy Stocks blog post “Climate Change & Corporate Disclosure: Should Investors Care?”:

in 2008, worldwide investments in “sustainable energy” totaled $155 billion. That’s about 0.28% of the $55 trillion in assets under management represented by CDP signatories. A mere 1% commitment annually, or $550 billion for 2008, would substantially accelerate the de-carbonization of our energy supply.

Second, and more important, CDP does not generate data that is useful for reporting companies to measure and manage their GHG emissions at the facility, process, or product level. Neither is it adequate for compliance with EPA’s new rules for mandatory carbon reporting, or for carbon trading under ETS, RGGI, or a future national US system. These require carbon information systems, analogous to cost and management accounting systems, designed specifically for these purposes. But the goal of CDP is primarily to pressure corporations to wake up to climate change and pay attention to carbon. It’s simply not designed as a carbon management tool. True, CDP has been evolving under the guidance of the accounting firm PricewaterhouseCoopers, but the problems are structural. Charles Morand points out that “The problem with the CDP is that it’s really an activist organization parading as an investor group.

As with the Global Reporting Initiative (GRI), CDP is designed for a dual purpose: to assess and rank corporate social performance, and simultaneously to institutionalize the disclosure of social and environmental information useful for investors. I’ve recently been involved in academic studies of GRI and CDP (click links to download papers) and after interviewing many of the stakeholders involved, the message is clear. The information is simply not very useful, at least in its current form, for the reporting companies, for investors, and even for environmental NGOs. The reporting systems are put together by awkward coalitions of companies, NGOs, and professional accountants and consultants. As a result of the compromises made along the way, they tend to be too broad and vague. For example, the CDP section on risks and opportunities simply asks companies to write some text in response. There is no format for strategic appraisal in any systematic sense.

There is a rapidly growing market for corporate carbon management systems that attempt to cover multiple purposes. The London-based consulting company Verdantix recently released a proprietary report on carbon management software from vendors such as CarbonView, Carbon Hub, ESS, Greenstone Carbon Management, Hara, IHS, PE International, SAP and SAS. The report notes that “Many Board members would be horrified at the low quality and poor verification of carbon emissions data that is released into the public domain through channels like the Carbon Disclosure Project.” A recent spate of acquisitions demonstrates the spike of interest in this area: SAP bought Clear Standards in May 2009, while EnerNOC bought eQuilibrium Solutions in June. (Update 1.20.10: see NYT article on Groom Energy report).

These software packages aggregate emissions data from multiple sources across a company and integrate carbon price projections for planning purposes. But these systems are very immature compared with financial and management accounting systems, or Enterprise Resource Management systems for logistics and inventory control. While carbon management software systems might be useful for generating data needed for compliance purposes and for CDP-style public reports, they will not realize their potential for management control of carbon till they are better integrated with traditional corporate software systems. Verdantix provides examples of very high rates of return from implementing carbon management, but many companies will likely find the short-term gains to be as elusive as those from Total Quality Management; there are considerable hurdles to system-wide implementation, from confusion and data problems to inertia and even resistance.

One important driver for carbon management and reporting systems is the trend toward product labeling. While already well underway among major European retailers such as Tesco, Walmart jolted its 100,000 strong supplier base with an initiative announced in June to provide a label for every product on its shelves with environmental impact information (see the New York Times and the Wall Street Journal). Walmart will soon be sending an initial survey to all its suppliers with questions regarding their sustainability practices. This project requires that Walmart’s suppliers develop accurate estimates at the SKU level not just of the greenhouse gas emissions, but also of water consumption, air pollution, and other measures for all the inputs required to source, manufacture and ship their goods. As Stephen Stokes of AMR Research wrote in an earlier Climate Inc. post, Sticker Shock, this could prove hugely expensive, divert funds from investments in cutting carbon, and still not provide the information necessary for managing carbon effectively. Moreover, consumers seem either indifferent or confused by the various labels out there.

If CDP is geared toward aggregating carbon information at the corporate level, product labeling aims to allocate these emissions to individual products. Most carbon data has been generated with external audiences in mind, consumers, NGOs, and regulatory agencies. There has not been nearly enough attention to the needs of management for intermediate level information that is designed to help manage carbon and reduce costs at the facilities and process level. Whether enterprise carbon management systems can really serve these multiple needs remains to be seen.

The world faces twin energy-related threats: not having adequate and secure supplies of energy at affordable prices, and the environmental harm caused by consuming too much of it. Companies are central to paving the way towards a low-carbon society because a large portion of carbon inputs and GHG emissions stems from industrial production. As a consequence, stakeholders increasingly require companies to disclose their strategies for addressing climate change. In particular, actors in financial markets are investigating the implications of climate change on the competitive position of companies and on risks to shareholder value. However, business responses to climate and carbon issues have been characterized as ambiguous, and external assessments of corporate efforts have been contradictory, even when analyzing the same firms. Furthermore, for many companies, emissions from their own operations are dwarfed by emissions that occur upstream or downstream in the value chain, e.g. those connected to energy provision or product usage, which are often not covered in voluntary GHG emission reports.

The literature on Industrial Ecology has termed this perspective ‘life cycle thinking’ of material and energy flows. In order to increase the reliability of life cycle-wide carbon assessments and to determine performance differences between companies, indicators are required that concisely measure a company’s performance with respect to carbon. These indicators can be used for analysis and reporting purposes, which aim to increase the transparency of corporate carbon performance assessments.

However, the key question: How to construct comprehensive and systematic carbon performance indicators? In a paper published in the Journal of Industrial Ecology we suggest an answer to this question. We distinguish between two dimensions: on one axis, whether an indicator measures a firm’s physical carbon flow performance or the monetary value of these flows; on the other axis, whether an indicator assesses the carbon performance in a static of dynamic manner. This two-by-two matrix gives four distinct indicators.

The first indicator, carbon intensity, relates to a company’s physical carbon performance in a static manner. It describes the extent to which a company’s business activities are based on carbon usage for a defined scope and year. A firm’s carbon intensity is measured by the ratio between a company’s carbon usage in absolute terms (e.g., the total greenhouse gas emissions of the fiscal year 2005) and a related business metric (e.g., the sales of the same year).

The second indicator, carbon dependency, describes the change in a company’s physical carbon intensity over time – as such this indicator displays a dynamic component. For this purpose, certain steps need to be undertaken: first, a time period has to be determined. Second, the future carbon intensity has to be estimated, for example, based on specific scenarios and models (e.g., the total greenhouse gas emissions and the sales in 2015). Third, a specific carbon intensity (e.g., 2005) is put into relation to a future one (e.g., 2015). Based on this information, the carbon dependency describes the degree to which a company is able to reduce its carbon intensity over time (e.g., between 2005 and 2015). As result, a highly carbon dependent company has difficulty reducing its carbon intensity over a given time period.

The third indicator, carbon exposure, brings the monetary dimension into the picture. For this purpose, the prices for a firm’s carbon inputs (i.e., fossil fuels) as well carbon outputs (i.e., for greenhouse gas emissions, if emission trading schemes or taxation exist) are taken into account. Like the carbon intensity indicator, the carbon exposure assesses the static performance; it, therefore, determines the monetary implications of the business activities due to carbon usage for a defined scope and fiscal year (e.g., 2005). Through the use of prices (for the same year), the carbon inputs and outputs can be combined in one monetary figure. The result describes how much carbon matters for a firm from a cost point of view.

The fourth indicator, carbon risk, describes the change in a company’s monetary carbon performance within a given time period. Similar to the carbon dependency indicator, a firm’s carbon risk measures the relative performance change from the status quo to a future carbon exposure. In order to obtain this future carbon exposure, the results of the estimated carbon dependency can be utilized, complemented by forecasts regarding future price conditions for fossil fuels and carbon emissions (as, e.g., provided by EIA reports).  With these estimates, the risk feature of the indicator becomes vivid: especially when taking into account a future price for greenhouse gas emissions (e.g., $30 per ton of CO2) that are likely under a future international climate regime or national climate policies and the potential increase of fossil fuel prices (due to increasing resource scarcity), the real monetary risks lurking behind carbon become transparent. The indicator does not address potential risks (or opportunities) associated with new technologies or loss of market share for carbon intense products; it reflects increasing costs incurred by a company in paying for fuels and credits.

These indicators shed light on the physical and monetary dimensions of a company’s current and future activities with respect to carbon inputs and outputs. Based on this kind of information stakeholders are enabled to assess a company’s stake in climate change and its efforts towards better managing carbon usage: policy makers can use such information to formulate and evaluate policies, while financial markets obtain insights regarding the performance of companies with respect to carbon and corresponding financial effects. Furthermore, companies themselves can use the indicators for benchmarking purposes with competitions as well as with respect to own performance improvements over time.

The full paper is available here and the citation is: Hoffmann, V.H., Busch, T. (2008): Corporate Carbon Performance Indicators: Carbon Intensity, Dependency, Exposure, and Risk. Journal of Industrial Ecology 12 (4), 505-520.

Addressing climate change and other environmental issues requires real action at the facility and process level –  just creating product labels may not be effective

Walmart’s product environmental labeling aspirations went public in the New York Times and the Wall Street Journal last month and sent ripples of fear and excitement considerably more widely.  Excitement for software and service vendors who anticipate a lucrative business supporting Walmart’s  product labeling program.  Fear for its 100,000 suppliers who will be required to generate the detailed data needed for Walmart’s environmental labels. Walmart will soon be sending an initial survey to all its suppliers with questions regarding their sustainability practices.

Walmart plans to develop labels based on a standardized index  of the environmental impact of every product on its shelves. This ambitious project demands that Walmart’s suppliers develop accurate and defendable estimates at the SKU level of the  greenhouse gas emissions,  water consumption, air pollution, and other measures for all the inputs required to source, manufacture and ship their goods. Walmart’s Chief Merchandising Officer John Fleming made clear that it would require participation from suppliers across the board.

In designing environmental initiatives, there is a need to pragmatically consider what’s achievable, what’s desirable, and what is likely to actually make a difference to the environment.  Rushing to force a product labeling agenda too quickly will result in a lack of standards and expectations, and potentially lead to disappointing  outcomes and a great deal of consumer confusion.

Transformation from the Grinch to the Gentle Green Giant

Walmart’s sustainability program has been transformational for the organization and delivered huge cost savings and performance improvements. It has created a virtual love affair with previously adversarial environmental lobby groups and a new relationship with the customer.  Their programs have been holistically implemented across the global organization.  Best practices in logistics, refrigeration, lighting, energy efficiency and packaging have prompted many to consider the Arkansas Grocer’s transformation to be the model of successful corporate sustainable transformation. Walmart’s vast supplier network and huge scale, approaching 8% of US retail sales, means that it has the power to change industry norms and practices not just in retail but also upstream in the value chain, in consumer goods industries.

But even the largest retailer in the world can stick their neck out too far  in the confusing and complex world of product labeling. It’s great that Walmart is thinking ambitiously and comprehensively about environmental information, but I forecast that it will ultimately be unpopular and unsuccessful if pursued at a store-wide SKU level as currently planned.

Sacked (and Stacked) in the In(store) Zone

Here are some key issues that deserve evaluation prior to the implementation of product labeling.

Who has their eye on compliance costs?

Pepsico UK told us last year that the cost of carbon footprinting their highly publicized Walkers potato crisps (chips for Americans!) was well in excess of $40,000 and took more than four years to complete – for one SKU.  Moving forward they are anticipating costs on the order of $10,000 to $12,000 per SKU.  At 20,000 to 25,000 SKUs per typical supermarket that’s a $250M task just for carbon – and Wal-Mart Supercenters carry over 100,000 SKU’s.

What about the full product life cycle beyond the manufacturers control?

The full environmental impact of goods is frequently strongly influenced by consumer actions.  More than half of the embodied carbon within an Apple MacBook Air for example is associated with downstream energy usage and disposal.  The carbon footprint of Proctor and Gamble’s cold water tide can be reduced by a third if used at 30°C instead of 40°C, and reduced by a further third if used in France where low carbon nuclear electricity dominates grid supply.  Should the labeling be based on cradle-to-gate versus cradle-to-cradle lifecycles? How will they change as consumers adapt their behavior with new environmental awareness?

Who will be able to judge environmental claims and performance?

An environmental label is not directly comparable to a nutritional label.  A challenge to the accuracy of a nutritional claim can be readily verified via laboratory analysis of the contents concerned.  There is no scope for direct back-calculation and tracking of carbon or environmental information once labeled and on the shelf.  And the labels are trying to hit a moving target, because environmental impacts change as companies adjust their sourcing and processes. Manufacturing supply chains are dynamic and evolving systems whose impact or footprint cannot be quantified in a singular value.

Lets not forget the consumer.

Most of the more recent European research in this area indicates that significant (c. 44%) and increasing numbers of consumers would switch to greener products even if they carry a higher price tag.  At the same time, 78% of consumers indicated an awareness of carbon labeling but only 20% saw it as a positive development – it is hard to make the case that this issue is being driven by pull from end customers.  Most report confusion in their attempts to interpret carbon labels at the granulated product level; green branding seem to be more of a market force at the company level – like  the Body Shop, Wholefoods, Apple and Dell.

What should be the functional unit for analyzing corporate environmental performance?

With limited budgets should firms spend much or all of it cataloguing and labeling performance on a product by product basis or actually invest in doing something about it?  Manufacturers pursuing ongoing process and production improvement can rightly expect that the benefit over time will reach throughout the supply chain and through multiple SKUs.  So should we not be tracking, evaluating and benchmarking corporations at the corporate, or at least, facility level? We think so.

At AMR Research we have been analyzing the increasing environmental agenda in manufacturing for some time.   Picking a small subset of SKUs to deep dive into full life cycle impact assessment has merit and will deliver knowledge for process improvement. Labeling of all SKU’s is overkill, however.  The compliance costs associated with the exercise have been mentioned above.  Pepsico were able to reduce energy use (and potential emissions) by more than 11% based on the knowledge they gained in the footprinting exercise. The actions taken by Pepsico depended on this detailed and rigorous  knowledge, not a simplified aggregate environmental rating. Moreover, this knowledge can be rolled out where applicable throughout their snack food lines without subjecting each SKU to the same detailed and rigorous analysis.

Forcing portfolio-wide cataloguing at the SKU level may well siphon funding away from reinvestment in efficient technologies and processes. As energy price volatility continues to increase and continuous improvement forces year-on-year searches for waste and resource reduction, we can reasonably assume that all SKUs under some company or process or production line will over time benefit from the process improvement and investment. In any case, labels at the SKU level require estimating and allocating company and facility level environmental impacts, generating data that are not always useful for management trying to reduce these impacts.

Falling Off the Shoulders of Giants – the Future of Environmental Information Should be Where it can be Accurately and Effectively Traced at the Corporate Level

Environmentally responsible products are produced by environmentally responsible organizations.  Green brands reside at the corporate level, and only rarely with specific products.   Walmart’s decision to drive its supply chains to environmental labels at the SKU level is beyond the level of production utility, of achievable accuracy given limited resources, and of utility to consumers – green or otherwise.  What is key for the future is the collection of accurate and transparent environmental information that is not just meaningful for consumers but helps management to take the necessary action.

The smallprint of the Walmart program, which has been less widely circulated, plots a 5+ year course for a green index which migrates from a supplier-based evaluation to a product-based one.  There is much merit in pursuing environmental performance at the supplier level.  Walmart, like all successful corporations in the newly emerging economy, will wish to do business wherever possible with like-minded, sustainable and environmentally cognizant organizations.  They and their supply chain partners should converge on an appropriate and rationally-based level of environmental information – fixed at the corporate and plant level to ensure transparency and ongoing environmental and sustainable performance.  SKU-based commitments  promise to deliver high compliance costs, out of scope and inaccurate data, and market confusion.