LEGO, the world’s largest toy manufacturer, has built a reputation not only for the durability of its bricks, designed to last for decades, but also for its substantial investment in sustainability. The company has pledged $1.4 billion to reduce carbon emissions in its supply chain by 2025, despite netting annual profits of just over $2 billion in 2022. This commitment is not just for show: LEGO sees its core customers as children and their parents, and sustainability is fundamentally about ensuring that future generations inherit a planet as hospitable as the one we enjoy today. Against this background, it was surprising when the Financial Times reported last month that LEGO had pulled out of its widely publicized “Bottles to Bricks” initiative.

This ambitious project aimed to replace traditional LEGO plastic with a new material made from recycled plastic bottles. However, when LEGO assessed the project’s environmental impact throughout its supply chain, it found that producing bricks with the recycled plastic would require extra materials and energy to make them durable enough. Because this conversion process would result in higher carbon emissions, the company decided to stick with its current fossil fuel-based materials while continuing to search for more sustainable alternatives.

LEGO’s pivot is the beginning of a larger trend toward developing sustainable solutions for entire supply chains in a circular economy. New regulations in the European Union – and expected in California – are about to speed things up.

Examining all the emissions

Business leaders are increasingly integrating environmental, social and governance factors, commonly known as ESG, into their operational and strategic frameworks. But the pursuit of sustainability requires attention to the entire life cycle of a product, from its materials and manufacturing processes to its use and ultimate disposal. The results can lead to counterintuitive outcomes, as LEGO discovered.

Understanding a company’s entire carbon footprint requires looking at three types of emissions: Scope 1 emissions are generated directly by a company’s internal operations. Scope 2 emissions are caused by generating the electricity, steam, heat or cooling a company consumes. And scope 3 emissions are generated by a company’s supply chain, from upstream suppliers to downstream distributors and end customers.

Currently, fewer than 30 percent of companies report meaningful scope 3 emissions, in part because these emissions are difficult to track. Yet, companies’ scope 3 emissions are on average 11.4 times greater than their scope 1 emissions, data from corporate disclosures reported to the nonprofit CDP show. LEGO is a case study of this lopsided distribution and the importance of tracking scope 3 emissions. A staggering 98 percent of LEGO’s carbon emissions are categorized as scope 3. From 2020 to 2021, the company’s total emissions increased by 30 percent, amid surging demand for LEGO sets during the COVID-19 lockdowns – even though the company’s scope 2 emissions related to purchased energy such as electricity decreased by 40 percent. The increase was almost entirely in its scope 3 emissions.

As more companies follow in LEGO’s footsteps and begin reporting scope 3 emissions, they will likely find themselves in the same position, realizing that efforts to reduce carbon emissions often boil down to supply chain and consumer-use emissions. And the results may force them to make some tough choices.

Policy & Disclosure: The next frontier

New regulations in the European Union and pending in California are designed to increase corporate emissions transparency by including supply chain emissions. In June 2023, the EU adopted the first set of European Sustainability Reporting Standards, which will require publicly traded companies in the EU to disclose their scope 3 emissions, starting in their reports for fiscal year 2024. California’s legislature passed similar legislation requiring companies with revenues of more than $1 billion to disclose their scope 3 emissions. California’s governor has until October 14, 2023, to consider the bill and is expected to sign it.

At the federal level, the U.S. Securities and Exchange Commission released a proposal in March 2022 that, if finalized, would require all public companies to report climate-related risk and emissions data, including scope 3 emissions. After receiving significant pushback, the SEC began reconsidering the scope 3 reporting rule. But SEC Chairman Gary Gensler suggested during a congressional hearing in late September 2023 that California’s move could influence federal regulators’ decision.

This increased focus on disclosure of scope 3 emissions will undoubtedly increase pressure on companies. Because scope 3 emissions are significant, yet often not measured or reported, consumers are rightly concerned that companies that claim to have low emissions may be greenwashing without taking action to reduce emissions in their supply chains to combat climate change. At the same time, as more investors support sustainable investing, they may prefer to invest in companies that are transparent in disclosing all areas of emissions. Ultimately, we believe consumers, investors and governments will demand more than lip service from companies. Instead, they’ll expect companies to take actionable steps to reduce the most significant part of a company’s carbon footprint – scope 3 emissions. 

A journey, not a destination

The LEGO example serves as a cautionary tale in the complex ESG landscape for which most companies are not well prepared. As more companies come under scrutiny for their entire carbon footprint, we may see more instances where well-intentioned sustainability efforts run into uncomfortable truths. This calls for a nuanced understanding of sustainability, not as a checklist of good deeds, but as a complex, ongoing process that requires vigilance, transparency and, above all, a commitment to the benefit of future generations.

Tinglong Dai is a Professor of Operations Management & Business Analytics at Carey Business School at Johns Hopkins University.   

Christopher S. Tang is a Professor of Supply Chain Management at the University of California, Los Angeles.

Hau L. Lee is a Professor of Operations, Information & Technology at Stanford University. (This article was initially published by The Conversations.)

If you own stocks, chances are good you have heard the term ESG. It stands for environmental, social and governance, and it is a way to laud corporate leaders who take sustainability – including climate change – and social responsibility seriously and punish those who do not. In less than two decades since a United Nations report drew attention to the concept, ESG investing has evolved into a $35 trillion industry. Money managers overseeing one-third of total U.S. assets under management said they used ESG criteria in 2020, and by 2025 global assets managed in portfolios labeled “ESG” are expected to reach $53 trillion.

These investments have gained momentum in part because they cater to investors’ growing desire to have a positive impact on society. By quantifying a company’s actions and outcomes on environmental, social and governance issues, ESG measures offer investors a way to make informed trading decisions. However, investors’ trust in ESG funds may be misplaced. As scholars in the field of supply chain management and sustainable operations, we see a major flaw in how rating agencies, such as Bloomberg, MSCI and Sustainalytics, are measuring companies’ ESG risk: the performance (and sustainability) of their supply chains.

The problem with ignoring supply chains

Nearly every company’s operations are backed by a global supply chain that consists of workers, information and resources. To accurately measure a company’s ESG risks, its end-to-end supply chain operations must be considered. Our recent examination of ESG measures shows that most ESG rating agencies do not measure companies’ ESG performance from the lens of the global supply chains supporting their operations. For example, Bloomberg’s ESG measure lists “supply chain” as an item under the “S” (social) pillar. By this measure, supply chains are treated separately from other items, such as carbon emissions, climate change effects, pollutants, and human rights. This means all those items, if not captured in the ambiguous “supply chain” metric, reflect each company’s own actions but not their supply chain partners’ actions. 

Even when companies collect their suppliers’ performance, “selective reporting” can arise because there is no unified reporting standard. One recent study found that companies tend to report environmentally responsible suppliers and conceal “bad” suppliers, effectively “greenwashing” their supply chain.

Carbon emissions are another example. Many companies, such as Timberland, have claimed great successes in reducing emissions from their own operations. Yet the emissions from their supply chain partners and customers, known as “Scope 3 emissions,” may remain high. ESG rating agencies have not been able to adequately include Scope 3 emissions because of a lack of data: Only 19 percent of companies in the manufacturing industry and 22 percent in the service industry disclose this data.

More broadly, without accounting for a company’s entire supply chain, ESG measures fail to reflect global supply chain networks that today’s big and small companies alike depend on for their day-to-day operations.

Amazon & the third party-supplier problem

Amazon, for example, is among ESG funds’ largest and favorite holdings. As a company bigger than Walmart in terms of annual sales, Amazon has reported emissions from shipping that are only one-seventh of Walmart’s. But when researchers for two advocacy groups reviewed public data on imports, they found only about 15 percent of Amazon’s ocean shipments could be tracked. In addition, Amazon’s figure does not reflect emissions generated by its many third-party sellers and their suppliers who operate outside the U.S. This difference matters: Whereas Walmart’s supply chain relies on a centralized procurement strategy, Amazon’s supply chain is highly decentralized – a large percentage of its revenue comes from third-party suppliers, about 40 percent of which sell directly from China, which further complicates emissions tracking and reporting.

Another important ESG metric concerns consumer protection. Amazon prides itself as “Earth’s most customer-centric company.” However, when its customers have been injured by products sold by third-party sellers on its platform, Amazon has argued that it should not be held liable for the damage, because it functions as an “online marketplace” matching buyers and sellers. Amazon’s foreign third-party sellers are often not subject to U.S. jurisdiction so can’t be held accountable.

Yet. major ESG rating agencies do not appear to reflect the supply chain implication on customer protection when measuring Amazon supply chain performance. For example, in 2020, MSCI, the largest ESG ratings agency, upgraded Amazon’s ESG rating from BB to BBB, reflecting its strength in areas such as corporate governance and data security, despite its consumer liability risk. These gaps are also concerns for ratings of companies, such as 3MExxonMobil, and Tesla.

Other countries are adding pressure

Currently there is no unified reporting standard, so different companies may cherry-pick certain ESG performance measures to report to boost their sustainability and social ratings. To improve consistency, the next step would be for ESG rating agencies to redesign their methodology to take into account what may be environmentally harmful and unethical operations across the entire global supply chain. ESG rating agencies could, for example, create incentives for companies to collect and disclose their supply chain partners’ activities, such as Scope 3 emissions. 

In June 2021, the German Parliament passed the Supply Chain Due Diligence Act, which will become effective in 2023. Under this new law, large companies based in Germany will be responsible for social and environmental issues arising from their global supply chain networks. This includes prohibitions on child labor and forced labor, and attention to occupational health and safety throughout the entire supply chain. Those who violate the law face a fine of up to 2 percent of their annual revenues.

The European Union’s new Sustainable Finance Disclosure Regulation, which went into effect in March 2021, adds pressure in a different way. It requires funds to report details on how they integrate ESG characteristics into their investment decisions. That has led some money managers to drop the phrase “ESG integrated” from some of their assets, Bloomberg reported. Without similar laws in the U.S., ESG rating agencies could fill an important gap. To be sure, surveying a company’s entire supply chain’s ESG performance is far more complex. Yet, by tying all the ESG dimensions to a company’s supply chain end-to-end operations, rating agencies can nudge corporate leaders to be responsible for actions across their supply chains that would otherwise be kept in the dark.

Tinglong Dai is a Professor of Operations Management & Business Analytics at the Carey Business School at Johns Hopkins University.

Christopher S. Tang is a Professor of Supply Chain Management at the University of California, Los Angeles. (This article was initially published by The Conversation.)