Best-in-class external standards have emerged in recent years — notably, standards for setting carbon-emission reduction targets that are based on climate science.
With the 2015 Paris Agreement, governments the world over made a commitment to limiting global temperature increases. Then in 2018, the Intergovernmental Panel on Climate Change (IPCC) warned that global warming must not exceed 1.5°C above pre-industrial temperatures to avoid the catastrophic impacts of climate change. To achieve this, greenhouse gas (GHG) emissions must halve by 2030 and drop to net zero by 2050.
Business has a vital role to play in building a zero-emission economy. To empower peer companies, suppliers and customers to follow suit, we need a race to the top, led by pioneering companies. And science-based targets (SBTs) are a critical part of the solution.
In the realm of business, it is widely accepted that targets should be both challenging and attainable. However, the role of internal performance standards (e.g., prior year performance, internal budgets) versus external performance standards (e.g., thresholds prescribed by experts and regulators) in setting optimal targets is less understood. As with most things in life, there are trade-offs to be made. Although internal standards allow managers to retain some influence over the targets their company sets, embracing external standards can bolster a company’s credibility and reputation.
Best-in-class external standards have emerged in recent years — notably, standards for setting carbon-emission reduction targets that are based on climate science. Targets adopted by companies to reduce emissions are only considered science-based if they are in line with the level of decarbonization required to keep global temperature increases below 2°C compared to pre-industrial temperatures, as described in the Fifth Assessment Report of the IPCC.
In recent research, David Freiberg, George Serafeim and I used the emergence of the Science-Based Targets initiative (SBTi) as our backdrop to study the outcomes of science-based target setting.
Understanding how targets are set is important because they play a key role in many aspects of management, ranging from selecting action plans and investments to evaluating performance. Research indicates that performance standards used to set targets generate important incentives when employees can influence the standards. Outside of incentive compensation, managers routinely face decisions about whether to set targets using internal standards (over which they retain a higher degree of influence and control) versus external standards (over which they retain a lower degree of influence). For example, setting a target for revenue based on the prior year’s results is more controllable than an external revenue threshold set by a regulator or stock exchange.
Although firms may be unwilling to relinquish control over their targets, there are other considerations. For instance, some may choose to use external target standards in order to bolster their credibility and reputation. This is particularly relevant in the context of environmental performance, where firms often face pressure from activists, investors and customers to improve environmental outcomes. Accordingly, adopting external standards for carbon reduction targets can send a credible signal of commitment, enhance reputation and placate concerned stakeholders.
Moreover, if adopting external standards leads to more ambitious targets and engenders greater accountability to achieve them, firms may subsequently increase their efforts in the environmental arena.
Several researchers have shown a significant link between financial and environmental performance due to the cost savings from improved process efficiency and the reduction of future liabilities from regulations: They have documented a US$34 million increase in market value for a 10 per cent reduction in toxic chemical emissions and a penalty to firm value of US$212,000 for every additional thousand metric tonnes of carbon emissions.
A related stream of literature studies firms’ decisions to disclose or not disclose information on environmental performance and the consequences of doing so. This research shows that markets penalize firms that do not disclose emissions information and that mandatory disclosure regulations improve subsequent environmental performance.
A new standard setter
In the context created by these collective findings, the effects of external standard adoption were an open-ended question. In 2015, the Science Based Targets initiative set out to change that. SBTi is a collaboration between the Carbon Disclosure Project, the United Nations Global Compact, World Resources Institute, World Wide Fund for Nature and the We Mean Business Coalition. The initiative’s aim is for science-based target setting to become a standard business practice. To this end, it defines and promotes best practices in setting science-based targets with the support of a Technical Advisory Group and Scientific Advisory Group. The SBTi has four key roles:
• To define and promote best practices in emissions reductions and net-zero targets in line with climate science;
• To provide technical assistance and expert resources to companies that set science-based targets in line with the latest climate science;
• To bring together a team of experts to provide companies with independent assessment and validation of targets; and
• To serve as the lead partner of the Business Ambition for 1.5°C campaign — an urgent call to action from a global coalition of UN agencies and industry leaders mobilizing companies to set net-zero science-based targets in line with a 1.5°C future.
At press time, 3,249 multinational firms — including Walmart, McDonald’s, BMW, Bloomberg, Volvo, MasterCard, EY and Nike — had released or committed to release science-based targets based on the work of the SBTi.
As indicated earlier, targets adopted to reduce carbon emissions are considered science-based if they are in line with what climate science says is necessary to meet the goals of the Paris Agreement. To set a science-based target that addresses its particular activities, a firm must first sign a commitment letter indicating that it will work to set such a target. If the firm already has an internal emissions-reduction target, the letter confirms its interest in having the existing target independently verified against a set of criteria developed by the SBTi. Once a firm signs, it has up to two years to develop and submit its results for official validation. Upon confirmation that the target meets the SBTi criteria, the firm can then use the SBTi logo on its website and promotional materials. The SBTi offers companies three approaches to set science-based targets:
• A sector-based approach, where the global carbon budget is divided by sector and emission reductions are allocated to individual companies based on the sector’s "budget";
• An absolute-based approach, where whereby the targeted percentage reduction in emissions required is applied to all companies within the industry equally; and
• An economic-based approach, where targets are linked to global GDP and a company’s share of emissions is determined by its gross profit.
The SBTi recommends that companies adopt either the sector-based or absolute-based approach. Per our discussions with a senior member of the SBTi, by far, the most frequently adopted approach is the sector-based approach.
SBTi recommends that companies analyze the three approaches and choose the one that will best drive emissions reductions and demonstrate sector leadership. It also urges companies not to default to a target that is easy to meet, but instead, to use ambitious decarbonization scenarios and methods that lead to the earliest reductions and the least cumulative emissions.
Using an international sample of firms that set carbon reduction targets from 2011 to 2019, we first analyzed why firms adopted external science-based standards, as opposed to keeping their targets aligned with internal standards. Next, we analyzed how target difficulty changed following the adoption of science-based standards. Lastly, we examined whether firms that set SBTs actually changed their behaviour to reduce emissions. We developed three hypotheses:
Hypothesis 1A: Firms with more difficult internal targets and achievement of these past targets are more likely to adopt external standards for target setting.
Hypothesis 1B: Firms with greater economic incentives to address climate change are more likely to adopt external standards for target setting.
Hypothesis 2: Adopting external standards is related to increased target difficulty.
Hypothesis 3: Adopting external standards is related to increased efforts on the ground to reduce carbon emissions.
Using a novel data set compiled by the CDP that included more than 1,752 firms from around the world, we found that firms with a track record of ambitious and successful target completion are indeed more likely to adopt external standards for setting targets as opposed to continuing with internal standards. We also found that economic incentives help predict the adoption of external standards. Given that firms with economic incentives to reduce emissions are more likely to have already set ambitious targets, our results imply that firms face uncertainty about optimal target setting for emissions and, in the presence of economic incentives to reduce them, will adopt external standards upon learning what constitutes tough but achievable targets according to scientific standards.
Next, we examined whether the adoption of external standards is positively related to target difficulty. Because firms set multiple carbon-emissions targets, we conducted our analysis at the target level and followed specific targets through the adoption (or non-adoption) of external standards. Our results suggest that targets that become aligned with the science-based standard increase in magnitude between 21 and 25 per cent, on average.
We also found that SBT-adopting firms do change their investments and behaviours in ways that are likely to reduce emissions. Specifically, the required investment in, and expected monetary and carbon emissions savings from emissions reduction initiatives increases after adapting SBTs. This is consistent with real effects from the adoption of external standards for target setting, as opposed to firms adopting external standards as a marketing ploy, a symbolic act, or "cheap talk."
Given that science-based targets are likely to be more ambitious than internal targets, we assessed whether the adoption of scientific standards has an incremental effect on firm behaviour. To do this, we examined a sample of firms that set targets that were as (or more) difficult than the science-based targets in the firm’s sector but did not identify their targets as science-based in their CDP response. Our finding: the scientific standard has incremental real effects over and above the target’s difficulty. This could be due to additional external pressure on firms to achieve targets once they become more visible after certification, or greater motivation to achieve targets that are part of a collaborative effort to limit global warming.
The vast research on target setting in management prescribes that targets should be set at levels that are both difficult and attainable. But there has been a dearth of evidence around how firms choose between internal and external standards, and the performance implications arising from these choices. We have addressed this gap by examining the factors influencing firms’ decisions in hopes of having a positive effect on target attainment and corporate behaviour going forward.