Chicago Booth Review Podcast Could Reporting Carbon Emissions Help Cut Them?

Christian Leuz: We basically computed what the dollar damages to society are from the carbon emissions. And what that allows you to do is to then express them relative to other figures or measures that people can understand, so for instance, firms revenues or their operating profits. And by putting it into perspective, you can basically do two things. A, you make it much easier for people to understand why this is potentially a problem, but then you also allow for these peer comparisons and relative comparisons that you were alluding to.

Hal Weitzman: Imagine that you want to lose weight. First, you need to know how much you weigh, how many calories you're eating a day, and how many minutes of exercise you're getting. Want to save money? Start by calculating your take-home pay, how much you're spending and how little you're putting away for a rainy day. Now, imagine you post all that information on your social media page and ask your contacts to hold you accountable. Could that same idea help us tackle global warming?

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 thinks the same transparency that helps regulators and investors understand what businesses are doing financially could help combat the damage they do to the environment. This is the first of two podcasts with Leuz about emissions reporting and climate change. Carbon taxes and emissions caps are politically tricky, but Leuz says that forcing companies to disclose their carbon emissions in the same way they disclose their financial situation could bring pressure on them to reduce their production of greenhouse gases. Christian Leuz, welcome to the Chicago Booth Review Podcast.

Christian Leuz: Hi, Hal. Thanks for having me.

Hal Weitzman: Would it be too much to say that accounting could help us tackle global warming?

Christian Leuz: Well, I think that is even more than a little bit of an exaggeration. I think I've come out in support of mandatory disclosure, in particular for firms carbon emissions, but the reason I've come out in support of mandatory reporting is not because I think it can by itself solve the climate crisis, the primary reason in my mind is that carbon emissions are an externality. They impose costs on society, but they're free to firms or cost them far less. And because of these negative side effects that they have, they distort consumption. They distort production. And so addressing externalities is in the interest of society and would make us better off.

Hal Weitzman: So we have this externality, which is we all suffer the cost of carbon emissions, both from pollution, global warming, everything else. And then you're saying, "Okay, accounting might not save the planet, but it's part of the solution," isn't it?

Christian Leuz: Yes. I think in order to address the carbon externalities, we basically need to measure the externalities from corporate activities. We need to know where they occur, how large they are, we need to measure them, and it's hard to envision a successful policy or way to address the carbon emissions without good data and widespread mandatory disclosure.

Hal Weitzman: Okay. Just before we move on, let's be completely clear, Christian, I know there's a lot of conversation about this. What exactly are you proposing that we measure?

Christian Leuz: So I would focus on company's direct emissions, which people sometimes call scope one emissions. So those are the direct emissions that come from the firm's activities and exclude both the emissions that would happen downstream from, say, the usage of the product as well, as the upstream emissions that would occur at the suppliers or when people source products from somewhere else.

Hal Weitzman: And just to be clear, the reason you would do that is because the people who use the product or the people who supply the components for the product, they should be reporting their own emissions. Is that the idea?

Christian Leuz: I think so, yes. And if everybody reports essentially their direct emissions, then everything would add up to the global emissions. So by just reporting the direct emissions, we are basically avoiding some double counting. And I'm not opposed to some more intricate schemes that would try to measure what went into a product and then have product labels that give you information on every carbon emission that went into the product. But I think for starters, I would start with firms direct emissions and make those a mandate.

Hal Weitzman: When you say a mandate, you are suggesting that we actually require companies to disclose that information, right?

Christian Leuz: Yes. And I would make it a broad mandate where both the publicly traded firms, as well as private firms would provide this information.

Hal Weitzman: Okay. So let's imagine we live in a world now, where companies publicly report their carbon emissions. What would be different? What would the mechanism be that would actually lower those emissions?

Christian Leuz: So first of all, we can design policies that would restrict carbon emissions once we have a better sense where they occur. And that's been a traditional tool of environmental policy. We could also devise market-based mechanisms. And the primary one that everybody discusses in that space would be some form of carbon taxes or cap and trade type systems. And then the last mechanism that I think more recently has gained traction and people have talked a lot about is this idea that by reporting, you expose the carbon emissions that occur at the corporate level, and then that would create some public pressure, that in turn would then create incentives for firms to reduce their emissions.

Hal Weitzman: So public pressure is part of it. What about the shame factor? Just if I have to tell the world that I'm emitting a lot of carbon, then obviously I don't want to do that. So I'm more likely just to try to reduce it?

Christian Leuz: I think, to me, they're quite related or similar. And I think the underlying idea is what Supreme Court Justice Brandeis expressed a long time ago is this idea that he famously said that, "Publicity is justly commended as a remedy for social and industrial diseases. Sunlight is set to be the best of disinfectants." So he's exactly talking about when he talks about social and industrial diseases, about these externalities. And then the idea is that instead of prohibiting or restricting the activities, we're spotlighting them, we're targeting them with transparency. And then the underlying idea is that by exposing it to sunlight, there will be stakeholders, there will be the public that sees this information that then imposes costs back onto the firm, and then that makes the firm change its behavior.

Hal Weitzman: But I guess with all due respect to Justice Brandeis, that doesn't always work. You do have situations where transparency doesn't necessarily produce the result you want. I'm thinking of in some states in the United States, they were forced to publish the calorie counts of different foods, and the research suggests that doesn't actually promote healthy eating in the longer term. So why would this necessarily be different?

Christian Leuz: So it's a fair question and an important one, and my answer will be somewhat nuanced, but let me first say that we have a fair bit of evidence that transparency regimes can change firm behavior, especially when it exposes or spotlights clearly bad firm behavior or bad conduct. So the idea or the evidence is for tax avoidance, work safety violations and mining accidents. Carbon emissions are more subtle in that they're a form of pollution that doesn't have an immediate, clearly negative effect that you can see. It's not like there's a black smokestack, and so the emissions are local, but the damages from carbon emissions are global, and that makes the climate issue much more thorny and difficult, which is why I think you're raising a good question.

Hal Weitzman: Yeah, and that seems to be resonating a lot in the United States this year, in particular, in an election year, there's a trade-off there. On the one hand, the companies are polluting. On the other hand, they could say, "Yeah, but we're creating jobs as a net positive. That's what it takes in order to get America working." And you can instantly see, when you phrase it like that, there's a proportion of the electorate that would say, "Drill, baby drill, let's get on with it. Let's pollute. Let's create jobs because actually what we need right now."

Christian Leuz: I think this is in essence built into the mechanism because as I explained, the reason transparency could have this sort of effect of a changing corporate behavior is because whoever receives the information has to interpret the information. If it's a negative externality, it would have to be that the receiver would view this information as negative, respond to it in a negative way, and impose costs onto the firm. If the receiver, on the other hand, says, "Oh, this is not so bad," doesn't even see it as a negative thing, then this mechanism is not going to work. So you're absolutely right.

And we have some evidence, and I've done some work in the space of hydraulic fracturing since you mentioned the drill, baby drill, where we did see that the transparency mechanism worked in the way it was intended. I think it was because at least at that time, hydraulic fracturing was much more controversial. It was viewed negatively. And so what we saw is transparency basically spurred negative newspaper coverage. It led to more protests locally. It also led to more people signing up for local NGOs, watershed groups, that then would advocate for the communities. So it can work, but it critically relies on, as you identified, on the receiver seeing this information and then responding to it in the way that the policy was intended.

Hal Weitzman: Okay. So let's assume that that doesn't happen and that the narrative comes out as you expect that it would, or you hope that it would, which is that carbon emissions generally are not a positive thing, even if they may have some positive trade-offs. You talked about various mechanisms, so let's dig into those a bit more. One is peer benchmarking. So how would that actually work? Because if we're in an industry which is very polluting and I'm emitting a lot of carbon, but slightly less than my peers, I might be under the false impression that I'm actually doing a great job, which could lead to inertia.

Christian Leuz: Yeah. Let me actually back up a little bit and say one important thing first. So I think for what we established in the conversation is that for targeted transparency, the work people will have to understand the disclosures and they need to be motivated to take actions. And so in my mind, for carbon emissions, as we were saying earlier, they're not as clearly negative as, say, work safety violations or mining accidents or black smoke coming out of a smoke stack. And so one of the key things in my mind is to make it clearer for people why carbon emissions are actually bad.

And so one thing that we've done in a recent paper that we published in science is we monetize the carbon emissions so that we basically computed what the dollar damages to society are from the carbon emissions. And what that allows you to do is to then express them relative to other figures and measures that people can understand, so for instance, firms revenues or their operating profits. And by putting it into perspective, you can basically do two things. A, you make it much easier for people to understand why this is potentially a problem, but then you also allow for these peer comparisons and relative comparisons that you were alluding to.

Hal Weitzman: Okay. So let's think a little bit more about how this might actually work. What does it mean to peer benchmark companies against each other?

Christian Leuz: I think the underlying idea is fairly simple. It's this idea that nobody wants to be the dirtiest kid on the block. And as the name of peer benchmarking implies in the statement that I just made is that we're making relative comparisons. So firms that have similar activities, and then we're comparing across these firms with similar activities. And one of the things that we found in this recent study in science is that there's actually tremendous variation in firms carbon damages, even when you focus on a set of firms that do very similar things.

So for instance, take the set of motorcycle manufacturers or semiconductor manufacturers or airlines, the ratio of damages of the firms that you would put in the top quartile in terms of carbon damages and carbon emissions and those that are in the bottom quartile is four to one. And so that means that you have firms that do very similar things with a lot more carbon emissions. And so these differences in what you could essentially call carbon inefficiencies, could give you potential for the top emitters to learn and change their behavior so that they're only emitting as much as the bottom quartile of producers. And if that were to happen, then there would be potentially substantial savings.

Hal Weitzman: So just to be clear, you're talking there about companies doing basically the same thing in the same place?

Christian Leuz: Yes. We've tried to do the comparison as much as possible within an industry that engages in very similar activities. But as you point out, I think the core to this argument or the key will be that we're making apples to apples comparisons. They don't necessarily have to be in the same place because some geographies are probably more efficient than other geographies. And so that is potentially one reason why there is this variation. But again, the idea would be to expose this differences in carbon emissions, and then that opens up the possibility for a conversation or for stakeholders to look at this and ask the question, "Why is it that the same manufacturer seems to have four times as many emissions as some other manufacturer?"

Hal Weitzman: Oh, so you're even talking about the same company could be behaving very differently in one part of the world, making the same product as it is in another part of the world?

Christian Leuz: No, that actually wasn't what I had in mind. I was just thinking take a set of motorcycle manufacturers or a set of semiconductor manufacturers, and then within that set, assuming that they're doing very similar things, some seem to be doing it relative to their output, either revenues or their operating profits, seem to be doing it with far fewer carbon damages and carbon emissions.

Hal Weitzman: Okay, so we would establish these benchmarks, and it sounds like they would be international, so we'd have a sense of where some of the cleaner jurisdictions are, right?

Christian Leuz: Yes. You would also be able to do even jurisdiction benchmarking as well. I think where I see a lot of the potential is within industrial activities that are similar, not so much across jurisdictions, but you could make these comparisons.

Hal Weitzman: Okay. So then let's imagine that we have our peer benchmark. What happens now?

Christian Leuz: I think now we come back to the public pressure and who uses this information issue. And so the question is, who would be the people that would put pressure on the companies or make these comparisons? And here, I think we have a whole host of potential stakeholders. One could be investors because investors might look at this and saying, "Isn't this potentially also a production inefficiency?" Others that could look at this could be the consumers. Employees increasingly care about working for firms that have less environmental footprint. But it could also be the NGOs and it could also be information intermediaries that first pick up this information. So the rating agencies, as well as various data providers that then provide this to the NGOs or the investors who might use this information and then put pressure on companies.

Hal Weitzman: So we're not depending on the public, because I guess there might be a concern that even when policymakers try to send very clear messages to the public, for example, about interest rates, the public doesn't always respond. So investors, yes, I can see that, but you're not depending on the public to be demonstrating outside the headquarters of some polluting company.

Christian Leuz: Again, in the case of a study that we did on hydraulic fracturing, we did see that the local communities and the people were protesting or going to these local NGOs, but you're right that in essence, that is less clear maybe for carbon emissions and that there is a collective action problem here. So that's why it is useful that the set of stakeholders here is potentially larger, and it's not just relying on the general public at large.

Hal Weitzman: Christian Leuz, thank you so much for coming in and explaining to us how accounting maybe won't save the world, but could be part of the solution.

Christian Leuz: Thanks for having me. It was fun.

Hal Weitzman: For more on how economics can help us tackle climate change, visit Chicago Booth Review's 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.