Six Questions on Internal Carbon Pricing

This article by Gianfranco Gianfrate, Research Director at EDHEC-Risk Climate, has been originally published in the October newsletter of the Institute. To subscribe to this complimentary newsletter, please contact: [email protected].

EDHEC Business School Professor Gianfrate has pioneered academic research

into the application of internal carbon pricing

Companies are increasingly called upon to collaborate in the fight against climate change in the context of emerging global climate governance and rising public awareness for the need to accelerate decarbonisation. Corporate involvement in climate mitigation is crucial as over two thirds of global emissions since the start of the industrial revolution are attributed to large companies. For the same reason, corporates are particularly exposed to the risk that government at different levels will impose policies and regulations aimed at reducing emissions. New tools are emerging to assist with the delivery of corporate greenhouse gas (GHG) emissions reduction objectives, with internal carbon pricing (ICP) becoming a widespread practice globally (Aldy and Gianfrate, 2019). ICP is a voluntary method for companies to internalise the social cost of their GHG emissions, even when all or part of their operations are out of the scope of external carbon regulations.

Companies adopt ICP in various settings and for multiple reasons. ICP can be used for risk management purposes, strategic planning activities, decisions about capital investments. Such voluntary practices are particularly important as mandatory emissions trading and carbon taxing schemes cover less than a fourth of global emissions and less than 5% of emissions are covered by a direct carbon price that is consistent with the goals of the Paris Agreement (World Bank, 2023). Disclosure of ICP usage may also help persuade investors to reduce the premium required to compensate for poor current performance in terms of GHG emissions. As for measuring the impact of such disclosure on climate performance, further investigation is required.

Understanding ICP becomes all the more relevant for corporates and investors alike with the recent inclusion of ICP in the cross-industry metrics whose disclosure is required for compliance with the updated guidance of the Task Force on Climate-related Financial Disclosures (TCFD, 2021).[1]

How does internal carbon pricing work?

An increasing number of global companies are adopting internal carbon pricing—also referred to as “shadow carbon pricing”— to integrate climate change mitigation concerns into their long-term business models and make decisions about current operations ICP is a voluntary method that allows companies to assess the opportunity cost of GHG emissions and to internalise the impacts of those emissions, including in the absence of carbon regulations.

Carbon policy is a source of both risks and opportunities for companies; carbon pricing policies put a price on carbon emissions to create economic incentives for reducing emissions (with the most common approaches being carbon taxes and cap-and-trade systems). Scenario-planning techniques and rigorous analysis of climate policy risks can provide executives an overall view of how their business might evolve under different carbon pricing regimes. Developing this sophisticated information can enable managers to more effectively engage with regulators and policymakers, investors, customers, and suppliers. They can identify investments and strategies robust to alternative future climate policy scenarios and those that can establish a stronger competitive position in the company’s markets.

Which businesses are doing it?

Amongst the 8,402 companies reporting under CDP (formally the Carbon Disclosure Project) in 2022, 15% (1,203) had implemented an ICP and 18% planned to do so in the next two years (World Bank, 2023).

Many companies do not price carbon as a part of their business operations yet. This may reflect a number of factors. Some companies may be fairly energy and carbon-lean and thus changes in energy prices due to carbon pricing policies will have a limited expected impact on the company’s cash flows. Other companies do not have the capabilities to understand potential future climate-related regulations and policies, and they do not fully realise how exposed they are to climate change risks. The growth in the use of internal carbon pricing following the 2015 Paris Agreement suggests that more and more firms recognise internal carbon pricing as an important tool in their operations. This trend also provides more opportunities for learning about the practice from those that have implemented internal carbon pricing. Only companies able to understand and to proactively manage carbon risks will sustain their competitive advantage in the long-term.

What are the key benefits from a business perspective?

Internal carbon prices are used in various settings. First, they are factored into the decisions about capital investments (especially when projects involve emissions reductions, energy efficiency improvements or changes in the portfolio of energy sources). Second, the internal pricing of carbon is an instrument of risk management. As companies are increasingly exposed to regulatory and financial risks attached to the (potential) implementation of governmental carbon pricing regimes, they seek to measure, model, and manage such risks. Third, internally defined prices of carbon integrate strategic planning activities in companies. Carbon prices are an important input for defining the long-term business model of a company, particularly for the identification of new strategic risks and opportunities.

How should firms calculate their internal carbon prices?

At the outset, the company must get a clear picture of its emissions and the exposure to carbon taxes or cap-and-trade regimes they represent. Since different countries (and different administrative authorities within the same country) are adopting different environmental regulations and are pricing carbon differently, it is important to understand not only how much GHG operations are emitting but also where they are doing so.  Thus, companies need to determine the location and quantity of both direct and indirect carbon emissions.

Direct emissions (often referred to as Scope 1 emissions) occur from sources owned or controlled by the company, for example, emissions from combustion in a company’s boilers or from its vehicle fleet. Indirect emissions (Scope 2) result from a company’s consumption of purchased electricity, heat, steam and cooling. Other indirect emissions (Scope 3) occur up and down a company’s supply chain, for example in production and transport of purchased materials and waste disposal.  The distinction between direct and indirect emissions shows that even companies not operating in carbon intensive industries may actually be accountable for significant emissions.

After mapping their emissions, companies should examine their exposure to current and estimated future carbon prices. To do so, a company should assess the climate policies in place in the countries where it operates or plans to expand. In jurisdictions with markets for carbon emission allowances, the natural indication of the price for ton of CO2 is obtained by the current market transactions (e.g., the EU Emissions Trading System). In other jurisdictions, carbon tax rates can be easily retrieved by national tax laws. While the current carbon prices are useful data points, they are just a starting step for companies willing to build a climate-resilient long-term strategy.  In order to be climate-ready, managers should understand the future patterns of carbon prices even for the long term. This is a daunting exercise because not only there is a lack of agreement about the likely price of carbon in the long run, but it is also clear that significant policy, technological and economic developments may result in significant deviations from the most likely carbon price pattern.

How should companies use the internal carbon prices?

With an understanding about the likely trajectory of carbon prices under public policy, companies can set their internal carbon price. This is a complex task that requires a deep understanding of carbon economics and, at the same time, of the operations and strategy of the company. It also requires organisational skills and leadership, because along the technical fix there is a pervasive cultural change that needs to be ignited throughout the organization.

First, a company should define for what kind of business decisions the internal carbon prices are going to be used. Given the overarching objective of making companies competitive in a low-carbon world, the decisions that affect the climate resilience regard the new investments, the management of carbon-risks of the existing operations and supply chain, and the long-term business model. An internal carbon price in line with the current level of regulated external carbon price is adequate for short- to medium-term decisions. When assessing the threats and opportunities for the firm’s business model, working on long term carbon prices scenarios make more sense. Second, companies should set internal carbon prices consistent with the design of the mechanisms that can foster change throughout the organization. In most cases, internal carbon prices are used as “shadow prices” when making climate-related decisions. Shadow pricing mechanisms feature, for example, a carbon price in the calculations of the convenience of alternative investments, but they do not determine actual monetary transfers. New investments that result in significant greenhouse gas emissions look less attractive financially, which can shift decisions towards low-carbon alternatives. On the other hand, actual monetary transfers can be created at companies implementing an “internal carbon fee”. For example, by charging to each business unit a fee proportional to carbon footprint of the energy used, it is possible to steer operational decisions towards low-carbon choices. The fees generated by this system are then collected in a fund whose proceeds can be used to reward the best performers in terms of carbon footprint reduction or to make further investments to greenify the company.

Finally, setting the internal carbon prices also depends on the organisational incentives executives have to deliver on carbon reduction initiatives. If the company has ambitious targets in terms of climate resilience and compensates its employees accordingly against those targets, higher internal carbon prices can be instrumental to help the organisation fulfill its objectives.

Why (and how) financial managers should care about internal carbon pricing?

Because climate policies are changing fast, and regulated prices of carbon can move abruptly, companies should measure and manage their exposure to carbon risks. Internal carbon prices are useful tools to gauge the impact of changing regulations and a way assess the exposure to carbon risks throughout the supply chain, beyond the operations directly controlled by the company. The management of carbon risks is similar to what most companies already do for other financial risks (e.g. currency and interest) and compliance risks.

Regardless of the purpose of the ICP application, a key point is that the uncertainty about the price is as important as the level of price.  In the practical application of ICP for investments decisions, risk management, strategy definition is essential to consider not only the most likely configuration of the price but also the consequences of possible “extreme” prices. When dealing with relevant carbon pricing risks, managers and investors should consider enhancing their valuation approaches by using valuation models based on scenarios and simulations. When valuing a new investment generating carbon footprint, the base case valuation would be based on the future expected cash flows reflecting year after year the cost impact of the most likely future price of carbon.

On the contrary, scenarios allow more effective valuations of the impact of different carbon prices. Scenario-based valuation requires at least two, but often three scenarios: a best case, a most likely case, and a worse case. The future cash flows under all the scenarios are then estimated and the different valuation outcomes can be considered measures of the “value at risk” showing how the investment value would change in case certain extreme carbon prices are hit.

Expanding on this approach, simulation-based valuations focus on the full probability distributions of key variables affecting future cash flows, in lieu of a small set of possible scenarios. Representing the uncertainty over future carbon prices with a probability distribution, company analysts can deliver project valuation that reflect all possible states of the world.

All in all, internal carbon prices enhance decision making for internal projects with cash flows impacted by carbon risks and allow better interactions between companies and their stakeholders, especially investors, concerned with carbon risks. Carbon risks are impacting the cash flows of companies, especially of the large emitters. Carbon-abatement efforts will put dramatically different levels of stress on the cash flows of different industries. The immediate impact on cash flows might be limited for now, but it will eventually be relevant in many industries. As carbon pricing influences current and future cash flows, firm valuations are affected as well. Therefore, effectively accounting for carbon pricing risk when measuring corporate value becomes of paramount importance for both executives and investors.

Footnotes

[1] The TCFD explains that: “Internal carbon prices provide users with an understanding of the reasonableness of an organisation’s risk and opportunity assessment and strategy resilience. The disclosure of internal carbon prices can help users identify which organizations have business models that are vulnerable to future policy responses to climate change and which are adapting their business models to ensure resilience to transition risks.” For futher information on the updated TCFD guidance, the reader is referred to Ducoulombier (2021).

References

Aldy, J.E., Bento, N. and G. Gianfrate (2021). National climate policies and corporate internal carbon pricing, The Energy Journal, Volume 42 Issue 5, pp.87–98

Aldy, J.E. and G. Gianfrate (2019). Future-proof your climate strategy. Harvard Business Review, May-June: 91–101

Bento, N. and G. Gianfrate (2020). Determinants of internal carbon pricing, Energy Policy, Volume 143

Ducoulombier (2021). TCFD Recommendations and 2021 Guidance. Scientific Beta. November 2021. https://www.scientificbeta.com/factor/download/file/tcfd-recommendations...

TCFD (2021). Guidance on Metrics, Targets, and Transition Plans, Taskforce on Climate-Related Financial Disclosure. https://assets.bbhub.io/company/sites/60/2021/07/2021-Metrics_Targets_Gu...

World Bank (2023). State and Trends of Carbon Pricing 2023. Washington, DC: World Bank. https://openknowledge.worldbank.org/handle/10986/39796