What is E-liability? What are E-assets?
Managers manage what is accurately measured. The E-ledgers system puts specific, timely, and verifiable information on the net emissions of inputs, processes, and outputs in the hands of decision-makers allowing them to buy and build products in ways that give them a competitive edge on energy efficiency.
What is E-liability?
E-liability is an accounting algorithm that allows organizations to calculate the greenhouse gas emissions embedded in any product or service in as close to real-time as practical, in a manner that is auditable to the highest standards used in financial accounting. It is a simple, open-source, free-to-use set of principles that should be the basis of any sound emissions-accounting standard.
The E-liability approach produces, for every product and service in the economy, an accurate and auditable measure of its total “cradle-to-gate” emissions. This allows any purchaser – whether a company acquiring a batch of cement, a consumer buying a movie on their tablet, or an investor looking for their next project – to see the total GHG pollution impact of creating that specific product or delivering that specific service.
The approach was developed by Professors Karthik Ramanna (Oxford) and Robert Kaplan (Harvard), co-founders of the E-liability Institute. Professors Ramanna and Kaplan first published the idea in the November/December 2021 issue of the Harvard Business Review and it won the journal’s 2022 McKinsey Prize for “groundbreaking management thinking.”
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How does it work?
In a nutshell, the E-liability algorithm works as follows: (i) a company measures the direct emissions from its own operations, (ii) the company obtains from its immediate (or tier-one) suppliers the emissions embedded in products it has purchased, (iii) the company then allocates the sum of (i) and (ii) to its outputs, and (iv) the company transfers those emissions to its customers when those outputs are sold, akin to inventory accounting.
A key advantage of this approach is that all direct emissions are recorded and audited once, and only once, at source (i.e., step (i) above). Thereafter, these direct emissions are apportioned to products transacting through value chains using principles similar to how cost accounting functions (i.e., step (iii) above). This approach keeps compliance costs low and, crucially, enables the production of emissions accounts that are auditable to the high (“reasonableness”) standard used in financial accounting.
The E-liability algorithm improves upon current commonly deployed methods for reporting product-level emissions (such as from the Greenhouse Gas Protocol) where, in the absence of using inventory-accounting precepts to transfer embedded emissions of inputs and outputs through value chains (i.e., steps (ii) and (iv) above), every entity in a value chain must separately estimate the emissions of its suppliers, its suppliers’ suppliers, and so on. This latter process is inefficient and also hampers auditability, as an entity’s estimates become progressively less reliable the further up its supply chain it has to contrive the embedded emissions of its (indirect) inputs.
To see the E-liability algorithm in action, consider a car door manufacturer. The company has many suppliers for the sheet steel, glass, plastics, fabric, and electronic components that are assembled into the door. Under the E-liability method, as each of these components arrives at the car-door factory, their accumulated emissions are transferred from the suppliers’ E-ledgers to the company’s E-ledger. The company next adds to its E-ledger its own direct emissions from its production and assembly stages, such as emissions from on-site energy conversion that it uses to process the materials. All of the relevant E-ledger emissions, both transferred in from suppliers and generated on-site, are then assigned to its various outputs (i.e., the door products), similar to a standard accounting practice that assigns the cost of materials and overheads to finished products.
The total emissions incurred to make and transport a finished car door are finally transferred from the door company’s E-ledger to that of the next company in the value chain – the car assembly factory – when the door is sold to that factory. Thus, in a method similar to how value-added taxes work, the E-liability approach also resolves the multiple-counting problem in current emissions-counting approaches like the GHG Protocol’s Scope 3 standard.
Information technologies such as blockchain, combined with existing inventory and cost-accounting systems, can record, transmit, and provide an audit trail for E-liability transactions. And the emissions data for each product will automatically aggregate into company-level accounts – just like in financial reporting. The data can be presented in a similar format as a financial balance sheet, making it easy for independent analysts to assess and verify.
How is it different to LCAs and the GHG Protocol’s Scopes 2 and 3 approaches?
Unlike a standard life-cycle analysis (LCA) or environmental product declaration (EPD) report, which some companies currently produce about every three years, the E-liability approach produces dynamic, real-time accounts on all of a company’s products, based on its current processes, sourcing, and designs. The E-liability approach is thus far more decision-relevant than LCAs and EPDs, and it provides strong incentives for continuous innovation toward greater energy efficiency.
On the GHG Protocol as it currently stands: Despite years of application, current emissions-counting approaches in the GHG Protocol’s Corporate Value Chain (Scope 3) and Product Life Cycle standards have faced criticism for their inaccuracy. We contend that this situation is due to inherent shortcomings in these standards. In particular:
– The construction of Scope 3 measures, which starts from the perspective of the reporting entity and looks up and down its value chain to imagine the identities of all its tier-n suppliers and customers and their associated emissions, is flawed. In practice, such information is unknowable in modern value chains, and entities are reduced to making guestimates and using often outdated industry- and regional-average emissions, if at all, in fabricating Scope 3 numbers. A similar process is advocated in the GHG Protocol’s Product Life Cycle standard. Supporters of the GHG Protocol note that these approaches have long exhorted for improved data quality; but the sheer impossibility of accurately calculating (and auditing) emissions numbers under these approaches creates little incentive for companies to actually improve their reporting accuracy over time.
– The Scope 3 and Product Life Cycle standards also muddle upstream incurred emissions with downstream prospective emissions, effectively adding the known past to the unknown future. The result distorts an entity’s accountability over controllable actions from its past actions and diffuses systemwide accountability over actions that can be controlled by downstream entities in the future. (In essence, there is no way to reasonably audit an action that has not yet occurred.)
– Even if it were faithfully followed, the Scope 3 and Product Life Cycle processes are redundant across entities and economically wasteful, as each entity in a value chain must indulge in the same guesstimates up and down that chain. Any public policy that mandates such calculations risks violating basic cost-benefit considerations.
– Perhaps most worrisomely, Scope 3 enshrines multiple counting of the same emissions by different entities. Because entities do not debit emissions liabilities as they sell associated inventories down a value chain, there is an overcounting of emissions in that chain. The result enables freeriding across entities as no one entity need take its Scope 3 numbers seriously, and the system as a whole institutionalizes a deliberate overstatement of emissions that is incompatible with basic scientific methods.
These attributes limit the usefulness of corporate emissions reporting under current GHGP standards. Indeed, notwithstanding the GHGP appropriating the word “accounting” to describe what its standards do, the approaches do not meet basic accounting criteria widely described in introductory financial accounting textbooks. For example, the approaches yield data that are not fungible, mutually exclusive, and collectively exhaustive across and within entities, which is necessary for accounting numbers.
The E-liability approach overcomes all these shortcomings, as described earlier. We have developed a draft proto-standard for product-level emissions accounting and auditing using the E-liability method, which can serve as a basis for improving current emissions-counting standards. We welcome groups like the GHG Protocol, the ISO, and the ISSB, to use the proto-standard as an input into their own standard-setting work.
What are E-assets?
Just as E-liabilities refer to units of GHG emissions (into the atmosphere) that can be attributed to a given entity or product, E-assets refer to units of GHG removals (from the atmosphere) that can be attributed to a given entity or product. Our E-asset framework establishes the conditions under which an act of removing GHG from the atmosphere can be recognized as a tradeable asset on an E-ledger and when such an asset can be used to “net” against E-liabilities (to help establish, for instance, an entity or product’s claim to be “net zero”). The E-asset framework is a set of principles, drawing from established financial accounting practice, for the robust accounting of carbon removal activities. These principles that define E-assets ensure that transactions in E-assets are accurate, comparable, reliable, and fungible, all indispensable properties of accounts.
The E-asset system brings a baseline rigor to current (largely voluntary) markets in carbon offsets. These markets have been plagued by criticisms of chicanery and fraud, owing largely to the absence of any robust and consistent system of offset measurement. Like with current carbon-counting standards for emissions, current offset-reporting approaches do not always forestall multiple counting of offsets, and they yield numbers that are not always fungible or auditable. The E-asset system can bring transformative clarity to offset markets, ensuring that only true and valid removals actually trade and are usable as offsets.
The E-ledger system
Together, E-liabilities and E-assets provide the two sides of the E-ledgers framework, a comprehensive system for managing emissions and instruments that counteract those emissions. The duality of E-ledgers ensures that organizations are incentivized and accountable for both emissions and removal actions.
This comprehensive approach can bring order to the current haphazard efforts across myriad different markets and technologies to enhance energy efficiency. Just as the introduction of generally accepted (financial) accounting principles (or GAAP) in the 1930s brought consistency and reliability to capital markets, unleashing trillions in economic activity, the systemwide adoption of the E-ledgers approach can usher in a whole new scale to energy efficiency efforts, creating the potential for energy abundance worldwide.
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For a summary White Paper on E-ledgers, how it works, and its applications in markets and public policy, please email us with details on the nature of your interest.
