Chicago Booth Review Podcast Does Tackling Global Warming Require Global Reporting Rules?

Christian Leuz: Uneven disclosure will lead to what people call carbon leakage. This idea that if there is substantial pressure on companies and their carbon emissions, then the more carbon intensive activities will move potentially elsewhere, into the shadows, so to speak.

Hal Weitzman: Climate change is a global problem, so it can't be solved by a limited number of countries acting alone. But can we develop and enforce global rules? Welcome to the Chicago Booth Review Podcast, where we bring you ground-breaking academic research in a clear and straightforward way. I'm Hal Weitzman and in this episode I'm talking with Chicago Booth's Christian Leuz, an accounting and finance professor who advocates for companies to report their carbon emissions. This is our second podcast with Leuz about emissions reporting and climate change. We released the first in March under the title Could Reporting Carbon Emissions Help Cut Them?

Leuz has thought a lot about two potential problems associated with emissions reporting and how to prevent them. One is the possibility of carbon leakage. If it's expensive or burdensome to follow environmental rules in one jurisdiction, companies might shift production to other countries that have less strict rules. A second unintended consequence of more regulation might be greenwashing. Companies using inventive techniques to make themselves look more environmentally friendly than they are. As rules are increasingly being introduced to improve emissions reporting, how concerned should we be about carbon leakage and greenwashing? And what can be done to prevent them from undermining our efforts to tackle climate change?

Christian Leuz, welcome back to the Chicago Booth Review Podcast.

Christian Leuz: Hi, Hal. Great to be back.

Hal Weitzman: Last time we talked about bringing more transparency to emissions reporting. And this is certainly something there's a lot of conversation about right now. There are proposals being considered in the United States, it's happening elsewhere. Why do you think there's so much more conversation now about more reporting rather than, say, carbon taxes, a proposal that many economists agree with, or just capping emissions completely?

Christian Leuz: Yeah, I think it's a great question and something that I've thought a great deal about. And I think the push for transparency and more broadly sustainability reporting or ESG reporting right now is because many are frustrated with the progress that we've made with other climate policies, and in particular with carbon taxes. It seems like a lot of people have come to the conclusion that carbon taxes are politically infeasible, and so we're turning to transparency instead.

Hal Weitzman: Okay. Is the idea then that this is a first step and then when we can measure the emissions, then we might be able to at some point talk about taxing them and then possibly capping them?

Christian Leuz: In my mind, transparency regimes and mandatory reporting of some sort, as we've talked about in the previous podcast, are a stepping stone and an important cornerstone of other climate policies. So in that sense, I do think that it is important that we have some form of mandatory disclosure that we get good data on corporate carbon emissions. But we should remember why we're turning to transparency. I think it is in part because it's politically expedient, it's easier to push through transparency. It's very hard for, say, the corporate lobby to oppose transparency because it's viewed as sort of inherently a good thing. It's hard to say you're for opacity. But it's probably also the case because it's less intrusive and it imposes fewer costs. But then I think the other side of that coin is going to be, it's also probably less effective.

Hal Weitzman: Okay. Is the idea then that this is a first step? So when we can measure the emissions, then we might be able to at some point talk about taxing them and possibly capping them.

Christian Leuz: Yes, I think. And to be clear, I don't think we can solve the climate challenge with transparency alone. We will need other mechanisms, either incentives to innovate in the climate and energy space, as well as some form of carbon pricing or carbon regulation that caps the emissions. So again, I think in my mind greater transparency would be a critical input for other policies and should become the foundation in the same way mandatory disclosure has become the foundation for our capital markets. But it's by itself the accountants can't save the world.

Hal Weitzman: On the podcast, you said that this puts in place some of the incentives for things like innovation and just reducing emissions in general. Because if I know that other companies in my industry are producing the same product or service and are emitting a lot less, presumably it puts some pressure on me to benchmark myself against them. Which brings up something that I wanted to ask you about last time, which is uneven regulation. Because in the United States you have this vast disparity between the amounts of information that private firms have to report, which is pretty scant compared to how much public companies have to report, every quarter vast amounts of information. So is that same system going to apply where private companies can get away with not reporting anything?

Christian Leuz: So you, I think, rightly point to this issue and have identified what the Achilles heel of a transparency regime is. It's definitely a concern. Uneven disclosure will lead to what people call carbon leakage. This idea that if there is substantial pressure on companies and their carbon emissions, then the more carbon intensive activities will move potentially elsewhere, into the shadow, so to speak. And we have evidence from other studies on other transparency regimes that you have to worry about these avoidance actions and this type of carbon leakage if we have uneven mandatory reporting. Now it's for this reason that I think the right answer would be here to say we should impose a carbon reporting regime, not just on the publicly traded firms. Private companies have carbon emissions too, therefore they impose costs on society, they have carbon damages, so they should be equally asked to report. And that is in essence what the EU has been doing.

Hal Weitzman: Right. But I'm just wondering, you talked about transparency being politically more feasible. That immediately sounds like a hurdle to that. What do you think?

Christian Leuz: I'm not so sure. Again, I think the EU is a good place where you see that they have essentially said once you're above a certain size limit, it doesn't matter whether you're publicly traded or privately held, you have to provide this information. And there's other efforts underway that would lead to global carbon reporting, like the International Sustainability Standards Board has put out standards that could be used globally. And again, countries could use these standards and say we're going to impose them evenly on our public and private firms once they're above a certain size. I think to ask every mom-and-pop store to provide information doesn't make sense, but once they're above a certain size limit, to then make no distinction between public or private, from my perspective, makes a lot of sense. Because it has nothing to do with your ownership base here. It has to do with what your activities mean for society.

Hal Weitzman: I understand that it would be effective and I understand that they do that in Europe, but am I right in thinking that there's also more financial transparency in the European Union? So there's something of a track record there that private companies are more used to reporting. Whereas in the United States, that's a lot of the reason that companies go private or stay private because they don't want that transparency.

Christian Leuz: And that's actually an interesting question for which I don't know the answer or a study that would directly answer it, but at least anecdotally and from private conversations I've had with various private firms, my sense is even in the US, a lot of private companies would be more open to some form of sustainability reporting or some type of environmental and social reporting. Because there they see benefits with some of their stakeholders, be it the employees, be it their consumers, then they see it for financial reporting where they're very worried about revealing information to their competitors and so on.

Hal Weitzman: I want to ask you about that as well. And you talked about the global picture there. Would there be a concern that, and you mentioned this when we talked in the last podcast, you talked about tax and the global tax system. And it's pretty obvious that those who wish to avoid paying tax will go where they can do that and they'll set up companies and jurisdictions where they can do that. Would the same concern apply here that even if you had big industrial countries or industrialized countries signed up to some kind of global regime, if it wasn't completely global, you'd still be able to move to less transparent jurisdictions?

Christian Leuz: Yeah, I think that is again, this carbon leakage concern that we briefly touched on. I think there's ways to mitigate that somewhat and those come in different flavors. So one thing you could do is you could create an accounting and reporting system that takes the carbon emissions from the cradle of the product and then passes them on as that product becomes an input into another product. So you're passing it on from company to company through the supply chain, from the cradle to the gate essentially, and so that at any point in time you know how much carbon emissions went into the product. In a similar way, we do this with VAT systems, so value added taxes. And there are companies, bigger ones that have already implemented that. They can essentially tell you all the carbon emissions that went into their individual products and they've had their suppliers essentially provide this information to you.

So that's one possibility. The other one is we could impose what the EU actually also recently just did is a Carbon Border Adjustment Tax. Where the idea is that if the product was produced elsewhere and there's no carbon pricing or no carbon taxes there, then you pay the taxes at the border. And one interesting feature of the system is that it creates incentives for other countries to then say, "Oh, we should have a carbon tax system too." Because then they capture the taxes rather than the EU getting the taxes at the border when they tax these products.

Hal Weitzman: I see. So you make it financially attractive for countries to try to capture emissions in their territory?

Christian Leuz: And be part of the carbon tax club, so to speak.

Hal Weitzman: You referred earlier to this idea of innovation. Because anytime you talk about greater transparency, some companies will say, "Well, we might be able to have greater transparency, but that's going to hurt our ability to innovate." Because to some extent, innovation and new products and services depend on keeping stuff secret from our competitors. So there'll be less incentive to innovate. What evidence do we have on that?

Christian Leuz: I think it's a very significant concern if we were to expand sustainability reporting into many areas. So sustainability reporting in my mind is different from financial reporting in that it requires firms to provide disclosures about their processes, about maybe things related to the human capital, essentially how they do things. And how you do things can reveal proprietary information, can reveal some of the innovative things you have come up with. And so if the competitors use this information and copy these innovations, then that can kill the incentives to innovate in the first place.

Hal Weitzman: What does the research tell us about innovation and transparency?

Christian Leuz: So we don't have evidence as far as I know on sustainability reporting, but I've done a project with two co-authors, Matthias Breuer and Steven Vanhaverbeke, where we look at this in the space of financial reporting. And so we exploit differences in mandatory reporting for private and public companies in Europe. And we can basically show that where the mandatory reporting regimes go deeper, asking smaller and smaller companies to report their profits and their revenues and their financial information, that then that reduces in those, we do this in part by geographies as well as within industries, in those industries and geographies, we're basically seeing less innovation. So there's a negative effect on innovation.

Hal Weitzman: Do you think that having less innovation is just the cost of having lower carbon emissions?

Christian Leuz: So I don't think the concern for carbon emissions is too large. This is why I started by saying that I think it's a bigger concern if we expand sustainability reporting into many areas. Because if we reveal the aggregate carbon emissions of the firm, the aggregate carbon emissions in my mind are not particularly proprietary. But generally speaking, I think the concern or this trade-off is if we impose more and more transparency regulation that that can have negative effects for innovation is a significant concern. And the reason it's an important concern in the space of sustainability and environmental discussion is that this is an area where we need lots of innovation to address the environmental challenges that we face.

Hal Weitzman: I wanted to ask you about greenwashing because one of the things that's happened in the absence of a standardized reporting regime is that all sorts of companies are saying, "We're green, we're environmental." You think of the big oil companies suddenly saying, "We're renewable energy companies now." And greenwashing is a big concern even before you start having a mandatory regime, which is what you're suggesting. How worried would you be about companies using all sorts of clever techniques to deploy greenwashing to make themselves look better in these peer benchmarking type reports than they actually are?

Christian Leuz: I think I'm very worried about it in many areas of sustainability reporting when it comes to say, supply chain disclosures, worker conditions in your supply chain, child labor and various areas or just their overall environmental performance, how good it really is. How selected is it what they're providing to us? I think it is less of a concern when it comes to carbon emissions in the particular direct emissions as our ability to measure and verify these carbon emissions as well as to have estimates of what they roughly should be for the type of production processes that we're talking about are getting better by the day. I mean, there's companies that use satellite image technology to also measure these emissions. So we're improving our ability to rein in greenwashing in the carbon space, I think, by the day and substantially.

Hal Weitzman: Last time we spoke, we talked about public pressure and how that could work to rein in carbon emissions. How effective do you think and how significant would just publishing the data be just in itself?

Christian Leuz: I think this is a great question and there's going to be some uncertainty around my prediction of how big this could be. Prior studies on the effects of transparency for different or various transparency regimes have actually come in with relatively comparable or similar magnitude. So prior studies tell us that the effects from a transparency regime would be on the order of 8% to 15% in terms of reducing that activity. So we've done some studies on fracking, there's actually a few studies on carbon emissions and some other activities. And usually the effects were on the order of about 8% to 15% of that baseline activity. So that's clearly meaningful, but not large enough to solve the climate problem.

I think what could potentially make the effects bigger in the carbon space is if we were to get the peer benchmarking going in the way we talked about in the previous podcast. Where you not only get a one-time effect where this information gets revealed for the first time and we see some firms are having higher emissions relative to others, but that we can also make year-over-year comparison. So I can make a comparison to how did this firm do this year relative to last year? Did this firm improve as much as some of the competitors were able to improve? And so to the extent we make this a more continuous, year-over-year peer benchmarking, then I think that that can create continued incentives for firms to improve and that can make the effects bigger.

Hal Weitzman: Can we quantify how significant it would be then for emissions to have this reporting mechanism?

Christian Leuz: I mentioned in the earlier podcast that there is a lot of variation within an industry or within firms or across firms doing similar activities. And so in our science paper, we did a hypothetical exercise where we essentially computed by how much emissions would fall if all the firms within the narrow industry that would define essentially who are the peers. If all the firms with above median carbon damages would reduce their damages down to the median firm, just to gauge how big would this be. And the reduction would be a staggering 49% of emissions. That is probably an aggressive estimate in the sense that it's not going to be that easy for everyone to adjust their carbon emissions. But it gives you a sense for how much potential there is to do these peer benchmarkings and year-over-year comparisons as well as across firm within industry comparisons that we've talked about.

Hal Weitzman: Christian, we've now recorded two podcasts, both of which have been about getting companies to report their emissions. And I can imagine somebody from a company listening to all this and saying, "Why are we the only source of the problem? What about the rest of society?" What do you think? How should the rest of us, who are not necessarily responsible, we're not high enough to make the decisions that will have these big effects, how should we think about this issue?

Christian Leuz: It's very important to note that the responsibility for what we called, for instance, the science paper, Corporate Carbon Damages, the sole responsibility does not fall just on the firms because these carbon damages arise because of firms activities. But those firms activities take place because the consumers demand the products and the services that the firms produce. And therefore the consumers share in the responsibilities, and to some extent the workers too, because they're getting jobs, they're working at these firms and they're earning wages. So in the end, what we're trying to provide information on is what do these activities that we as society engage in for which we're getting products and services, what are they costing society because we're not pricing the carbon externality?

That is what we're trying to provide information for, but we're not saying that therefore this is entirely the responsibility of the firms. And just to say that, imagine that we were to get a carbon tax. It is also clear that the carbon tax would not just fall on shareholders and on the firm. The firms would change how much they produce, but they would also change how much they charge for the product, which again, would mean that some of this incidence is going to fall on the consumers. And they might also change how many people they employ, which also then means some of the incidence is going to fall on the workers.

Hal Weitzman: Christian Leuz, thank you very much for coming back to the Chicago Booth Review Podcast. This has been a fascinating conversation.

Christian Leuz: Thanks so much again for having me. It's been a pleasure.

Hal Weitzman: That's it for this episode. To learn more, visit our website at chicagobooth.edu/review. When you're there, sign up for our weekly newsletter so you never miss the latest in business-focused academic research. This episode was produced by Josh Stunkel. If you enjoyed it, please subscribe, and please do leave us a five-star review. Until next time, I'm Hal Weitzman. Thanks for listening to the Chicago Booth Review Podcast.