Are you incentivising climate destruction?

Imagine the following scenario, based on my research: A supermarket publishes its net-zero strategy and incentives designed to reward store managers for reducing the business’s carbon emissions. Carbon KPIs that measure the emissions of each store are introduced into department scorecards and performance rankings published monthly. Each month the top three emission-reducing stores, as measured by their monthly store carbon emissions measure (SCEM), are spotlighted in staff magazines and webpages and awarded net-zero medals.

In the first six months all stores report downward trends in their SCEM. But after nine months, the net-zero leader board was dominated by a small number of stores. Managers of the other stores expressed frustration that their SCEM performance remained stubbornly static despite initiatives such as encouraging staff to walk or cycle to work, stocking products with lower carbon footprints, and encouraging customers to reduce food waste and increase home composting.

The performance management team started to analyse the SCEM data to identify elements of good practice to share throughout the business. The team noticed that the top-performing managers dramatically reduced the amount of produce purchased from farms owned and managed by the grocery company itself and switched to sourcing from overseas suppliers. In contrast, the worst-performing stores had increased their procurement from company farms and almost eliminated the amount purchased from overseas suppliers.

This seems counterintuitive. Surely transporting produce from the other side of the world should increase carbon emissions, purchasing locally should reduce them, and this should be represented in the SCEMs.

The problem lies in how the supermarket calculated the SCEM and how that was connected to incentives. Because the SCEM was not capturing all the carbon emissions of the managers’ actions, the business was inadvertently incentivising behaviour that increased, rather than reduced, the business’s carbon footprint. The supermarket had based its SCEM on carbon reporting standards that limit the required disclosures to indirect carbon emissions from purchased electricity or energy used in heating or cooling (Scope 2 emissions) and carbon emitted from its buildings, vehicles, operation of equipment, or any land use (Scope 1 emissions) rather than on its carbon footprint.

Scope 1 and Scope 2 emissions are only part of a business’s carbon footprint. When calculating a business’s carbon footprint, you also need to consider the carbon emitted in the business supply chain or that related to other assets owned by a business (often referred to as Scope 3 upstream emissions) and carbon emitted after the sale of a product or service, as a result of its consumption and any eventual disposal (often referred to as Scope 3 downstream emissions).

A carbon footprint aims to measure total global emissions across the life cycle of a product or service (see the table “Typical Carbon Footprint Components,” below, arranged by the main stages of a product life cycle).

The shaded columns in the table represent the components that most businesses include in their carbon KPIs or corporate accounts. Most carbon disclosure regulations also focus on these two columns, which only represent a very small percentage of the carbon emissions associated with a product, service, or overall business activities.

Research suggests that, on average, the most common carbon KPIs capture only around 20% of total emissions, but this can vary considerably by sector. In some sectors, such as IT, only 1% of total climate-related emissions are captured in publicly disclosed carbon KPIs. A recent survey of UK businesses suggests that only a minority included carbon emissions beyond those required for corporate disclosure (see the table “Carbon Emissions Beyond Corporate Disclosures,” below).

In the supermarket scenario, the SCEM is consistent with carbon disclosure requirements. But rewarding managers for reducing their monthly SCEM could actually increase the supermarket’s total carbon emissions. This is because the SCEM allows store managers to leave out carbon emissions related to procurement and logistics.

The SCEM includes emissions related to in-house production and use of company vehicles but excludes carbon emissions related to purchased goods and services. This has the unintended consequence of internally sourced products’ adding to the SCEM, whereas buying similar goods from external suppliers overseas could increase carbon emissions but not the SCEM. Because the SCEM does not adequately capture all the carbon emissions, it incentivises increasing carbon emissions.

Actions can affect the life-cycle carbon footprint in ways that are not adequately captured by conventional carbon KPIs, such as the SCEM (see the tables under the heading “Impact on Carbon Footprint of Different Actions,” below). The most commonly used carbon KPIs provide misleading accounts of the climate change consequences of different decisions. They do this by excluding increases in carbon emissions and not recognising reductions in carbon emissions from actions such as reducing consumer waste or encouraging lower carbon commuting.

Impact on carbon footprint of different actions

The following tables explore the likely consequences of three activities adopted by the store managers in the scenario: (1) “Switching From Buying Internally to Overseas Suppliers”; (2) “Encouraging Staff to Commute/Travel for Business Purposes Using Public Transport, Cycling, or Walking”; and (3) “Providing In-Store Education to Reduce Food Waste by Customers”. Each table identifies the impact of the actions on the different sources of carbon emissions. The shaded cells represent the emissions included in the SCEM.

1. Switching from buying internally to overseas suppliers

2. Encouraging staff to commute/travel for business purposes using public transport, cycling, or walking

The SCEM used by the supermarket is not without merit, but it does not apply to all business decisions. For example, it does capture the carbon consequences of decisions such as purchasing renewable energy (eg, generated from solar, hydro, or wind), introducing energy-saving measures, or implementing more carbon-efficient logistics. Even a carbon KPI that only measures Scope 1 and 2 emissions is considerably better than not including carbon consequences in business strategy or KPIs.

Excluding measures of carbon emissions means that any decision will ignore its impact on the climate and, by its omission, further incentivise global warming. Only 6% of UK businesses reward employees for reducing carbon emissions, which suggests that 94% may be inadvertently rewarding global warming. Two of the most common metrics used for incentives — making profits (used by 30% of UK businesses) and increased sales (used by 24%) — do not explicitly consider their climate impact and are unlikely to be aligned with net-zero strategies.

It is possible to align KPIs, employee rewards, and net-zero strategies through the use of a carbon footprint KPI that includes all the columns in the “Typical Carbon Footprint Components” table. Generally speaking, the narrower the scope of a carbon KPI, the more likely employees will game the system. The wider the scope of a carbon KPI, the stronger the alignment of the incentive with net-zero outcomes. (See the table “Using a Comprehensive Carbon Footprint KPI,” below.)

Using a comprehensive carbon footprint KPI

How the finance team can align KPIs with net-zero strategies

Businesses are under increasing pressure to reduce their impact on climate change by reducing their carbon emissions. Imagine the reputational damage if a business is found to be, even inadvertently, incentivising increases in emissions.

KPIs, scorecards, and incentives are not set in stone. They represent past choices as to what and how to measure and reward — past choices that may not be valid now or are steering us in the wrong direction. Finance professionals need to work with others in the business to ensure that all aspects of its accounting systems are aligned with net-zero strategies.

To achieve this, finance teams should:

• Audit existing KPIs and employee remuneration schemes to ensure they are not inadvertently incentivising climate change.
• Use “ethical hacking” methods to expose loopholes that reward problematic behaviour.
• Reflect on behavioural assumptions of existing KPIs, and assume that employees will always look for winning strategies within the rules.
• Given the urgent need for action to reduce the costs of climate change, businesses should actively consider introducing carbon KPIs into their scorecards and incentivise carbon footprint-reducing activities, using a combination of financial and nonfinancial rewards.
• Ensure the scope of any carbon KPI captures all material carbon emissions.
• When interpreting any carbon KPIs or designing any incentive scheme, bear in mind the top nine tips for interpreting carbon KPIs (see the sidebar, “Top 9 Tips When Interpreting Carbon KPIs,” below).

Top 9 tips when interpreting carbon KPIs

Don’t take carbon emissions disclosed in corporate reports or scorecards at face value. Finance professionals can mitigate many of the mistakes and misinterpretations of carbon emissions observed in practice if they follow these steps:

1. Always confirm how the carbon emissions have been calculated, looking for a breakdown by categories in the table “Typical Carbon Footprint Components” and whether the numbers have been assured or independently verified.

2. If you cannot identify which categories are included in carbon KPIs, do not use them because you cannot guarantee they will provide reliable evidence for decision-making or performance measurement.

3. Look for other carbon KPIs produced by the company in relation to departments or products, including annual reports, regulatory returns, integrated reports, or external sources such as the Carbon Disclosure Project. Always use the carbon KPI that includes the most categories.

4. Look for discrepancies between corporate climate change strategies, aspirations, and targets, and how carbon KPIs are calculated.

5. Check the timescale of the carbon KPIs. Are they quarterly, annual, rolling averages, or two-year targets? Remember this is a fast-evolving topic, and there is considerable variation in practice.

6. Take care when interpreting carbon KPIs based on ratios, eg, carbon/sales. Check that there is a meaningful relationship between the two numbers. For example, ask if sales really drive the carbon emissions and whether all the carbon emissions associated with sales are included in the carbon KPI.

7. Make sure you use the most relevant carbon data. If you are looking at pricing, use the carbon emissions associated with the product life cycle. If you are measuring the performance of a manager, use the carbon emissions they are responsible for.

8. If there is any doubt, contact those responsible for producing the carbon KPIs to get as much additional detail as possible on carbon emissions before starting your analysis.

9. Always qualify any analysis of carbon KPIs with an assessment of the quality of data available and clearly disclose what information is missing.

Ian Thomson, ACMA, CGMA, is professor of accounting and sustainability and director of the Centre for Responsible Business at the University of Birmingham in the UK. To comment on this article or to suggest an idea for another article, contact Oliver Rowe at Oliver.Rowe@aicpa-cima.com.

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