Private Enforcement of Corporate Climate Pledges

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Scholars propose a new means of holding corporations accountable for emissions reduction pledges.

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With Nestle committing to halve its greenhouse gas emissions, American Airlines pledging to reach net zero emissions, and Microsoft promising to remove its historical emissions by 2050, a seismic shift in the way businesses operate appears to be underway.

But these pledges may do little good without more robust and effective regulation, warn professors Michael P. Vandenbergh and Oren Perez in a recent article.

Rather than ushering in a new era of corporate responsibility, existing regulations governing corporate climate pledges have fallen short of holding corporations accountable for their commitments, Vandenbergh and Perez argue. With this concern in mind, Vandenbergh and Perez urge policymakers to look beyond existing public governance schemes and endorse an alternative means of private enforcement—namely, a financial instrument that Vandenbergh and Perez refer to as a carbon letter of credit—or CarbonLC, for short.

Vandenbergh and Perez explain that a CarbonLC would represent an irrevocable, long-term contractual arrangement that would allow a third party to hold a corporation accountable for its emissions reduction goals. Vandenbergh and Perez’s proposal draws upon the traditional letter of credit payment mechanism, which brings together a credit applicant, a third party beneficiary, and an issuing bank authorized to make specified payments to the beneficiary on behalf of the credit applicant. The letter of credit serves as an irrevocable promise from a bank that a buyer’s payment to a seller will be timely and complete provided that the seller has met its contractual obligations.

A CarbonLC arrangement would modify the traditional letter of credit mechanism by situating the bank as an intermediary between a company that has pledged to reduce its greenhouse gas emissions and a carbon capture broker. Carbon capture refers to the process of capturing and storing carbon emissions from sources such as power plants or industrial facilities. A carbon capture broker facilitates the buying and selling of carbon credits, which are carbon offsets generated by carbon capture projects. By purchasing carbon credits, a corporation finances carbon capture projects that help counteract its emissions.

Vandenbergh and Perez outline the progression of a CarbonLC arrangement. To start, a corporation planning on announcing an emissions reduction pledge would sign a CarbonLC with an issuing bank,  which would then commit to purchasing at the end of a specified period carbon credits equivalent to the difference between the corporation’s carbon reduction target and what the firm actually achieved. Next, the bank would contract with a carbon credit broker to facilitate the purchase of carbon credits.

The parties to the CarbonLC would also nominate a beneficiary that is contractually authorized to force the bank to abide by its commitment to purchase carbon credits if the corporation does not reach its emissions reduction goal. Vandenbergh and Perez clarify that the presence of the beneficiary would help prevent collusion between the bank and the corporation. The propose that any established and reputable climate organization could serve as a CarbonLC beneficiary.

Once the agreed-upon timeframe for the corporation to meet its emissions reduction goal has elapsed, the beneficiary would inform the bank of any gap between the corporation’s announced goal and its actual emissions. If there is a gap between the corporation’s pledge and actual emissions, the bank would purchase carbon credits to compensate for the gap. Vandenbergh and Perez recommend that parties to a CarbonLC agree to a five-to-ten-year timeframe.

Vandenbergh and Perez acknowledge that their proposal carries potential risks and challenges. In particular, CarbonLCs may create what Vandenbergh and Perez call a “moral hazard”—a situation in which insurance perversely encourages actors to engage in risky behavior. Vandenbergh and Perez recognize that CarbonLCs may let wealthy corporations that fail to meet emission reduction goals off the hook by allowing them to purchase compensatory carbon credits. Although climate scientists agree that carbon offsets have a role to play in mitigating climate change, “on balance it is better for a company to reduce its emissions than to pay others to do so,” Vandenbergh and Perez explain.

Nevertheless, Vandenbergh and Perez remain confident that CarbonLCs could provide “a mixture of financial carrots and sticks” and encourage corporations to reduce their gross emissions. For example, Vandenbergh and Perez propose that parties to a CarbonLC agree to adjust annually the size of the collateral—the asset that guarantees the CarbonLC—based on whether the corporation met its emissions target in the preceding year.

In addition, Vandenbergh and Perez recommend that CarbonLCs constitute part of a larger financial relationship and that an issuing bank also finance the corporation’s change mitigation measures. Such arrangement would allow the parties to a CarbonLC to tie a corporation’s gross emissions to the interest rate that the company pays on its climate mitigation financing.

Vandenbergh and Perez envision corporate climate pledges as playing a key role in addressing climate change. Nevertheless, they emphasize that unenforceable climate pledges will do little good. CarbonLCs offer a viable means of increasing accountability and aligning corporate interests with climate policy, Vandenbergh and Perez argue.