Internal carbon price: What it is, why it matters, and what to consider

An introduction to internal carbon pricing

An internal carbon price is a theoretical monetary value an organisation assigns to each tonne of carbon or other greenhouse gas (GHG) emissions it emits or avoids.

This value is determined based on the organisation and the environment within which it operates. It can be based on external factors such as the current or expected price of a particular carbon or emissions unit, or internal factors such as the organisation’s decarbonisation goals.

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There are two main ways to use a carbon price, with some companies using a mix of both methods:

1. Internal fee:  Where companies charge a fee for each tonne of carbon emissions generated by a business unit, and allocate those funds towards emissions reduction activities with the business.
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   The high-emitting business units capture the fee as a cost in their financial statements. This allows them to understand the financial implications of emissions associated with operations and processes, and encourages them to bring their emissions down.  
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   It also helps to prioritise investments based on the merit order of the emissions cost. In some cases, this implied price may make this investment financially unviable
   
   For example, a European energy company decided to close several power plants when the internal fee on growing emissions negatively affected plant profits, and therefore commercial viability of those plants.
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2. Shadow price: A shadow price is used as a guide when making investment decisions, evaluating projects or prioritising emissions reduction initiatives.
   
   One way of implementing a shadow price is as a compulsory input to business cases produced by an organisation. For example, as an expense item in projected Profit & Loss statements. In this scenario, investments with a large carbon footprint would likely show a lower ROI than low-carbon investments, helping to guide investment decisions.

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Whatever the method of implementation, an internal carbon price links climate and commercial decision making in a powerful way and serves as a business planning and change management tool.

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As such, it helps businesses to:

• Identify the most cost-effective and impactful emissions reduction opportunities
• Support investment decisions
• Evaluate carbon-related risks and opportunities
• Drive behaviour that supports decarbonisation
• Clearly communicate a company’s climate ambition
• Prepare for future regulatory changes in the low-carbon economy

Around one third of global companies have or plan to implement an internal carbon price with this number expected to grow.  Recent studies indicate that sectors with the highest rate of adoption are energy (50% of companies), materials (39%), tech media and telecom (38%) and industrials (38%).  

Risks and opportunities driving the uptake of an internal carbon price

There are several organisational drivers supporting the uptake of an internal carbon price as a decarbonisation tool.

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These may be seen as risks or opportunities and include:

• Accelerate internal decarbonisation
  Setting an internal carbon price lets businesses see the impact of their current emissions position in financial statements such as the Profit & Loss. This helps to quantify the emission reduction target, align stakeholders across the organisation and improve transparency of goals and progress. Tying climate related KPIs with financial KPIs helps to guide investments, operational priorities and incentivise the right behaviours.
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• Help meet government-set emissions baselines
  Organisations captured under national emission reduction schemes, such as Australia’s Safeguard Mechanism legislation, already have a strong commercial link between the external cost of carbon and cost of compliance. Even if they don’t have a formal internal carbon price in place. Formalising the process, however, through direct links to financial performance, may further streamline decision making across the organisation.
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• Demonstrate climate leadership
  By disclosing its internal carbon price an organisation can demonstrate its climate ambition. Sharing the price level shows a commitment to transparency for all stakeholders, including investors, customers, employees and regulators. It may also inspire other organisations to take similar action.
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• Assist in climate and financial risk reporting
  Reporting of climate-related financial risk is becoming a mandatory requirement for businesses globally.  The Task Force on Climate-related Financial Disclosures (TCFD) reporting framework is most-widely used, with many businesses in the UK and Canada, for example, required to use it by law.
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  Australia too is considering making TCFD-aligned disclosure mandatory for companies of a certain size. One of TCFD’s recommendations is for organisations to apply an internal carbon price as part of their strategy to manage climate-related risks and opportunities.

• Prepare for evolving domestic and international policy
  Climate policy is continually evolving. A recent development affecting many global manufacturers is the European Union’s (EU's) introduction of the Carbon Border Adjustment Mechanism (CBAM).
  
  The CBAM is designed to level the playing field between European importers and manufacturers. It operates by placing a carbon charge on imports to the levels imposed on local producers, with adjustments made based on mandatory carbon prices in exporting countries.
  
  Building the price of carbon into the product will help the organisation be competitive when exporting to the EU, or when part of a supply chain for EU-bound products.

• Possible improvement in finance terms
  Your emissions are your financier’s Scope 3 footprint. As a result, many financiers are looking at the impact of their customers' emissions on their broader portfolio of assets.

Key considerations when setting a value for your internal carbon price

Setting your internal carbon price is a complex process and unique to your organisation. Before you determine the value, you need to be clear on your:

1. Current emissions footprint
2. Climate objectives and decarbonisation strategy
3. Pricing model that works best for your business (e.g. shadow price or internal fee)

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And while there is no one-size-fits all approach when setting the value of your internal carbon price, here are some key points to consider:

• Understand current carbon market price dynamics
  There is not one single carbon market price. Prices vary greatly across compliance and voluntary carbon markets, and even across carbon credit types and methodologies. It’s important to take the time to understand the mechanics of the various frameworks to inform your own analysis and decision making.

• Consider future price projections
  It is difficult to predict further carbon market prices with any certainty, though many well-considered models exist. Organisations like the International Monetary Fund (IMF) and other economists model carbon price levels needed to reach global Paris Agreement goals. Their recommendations range between US$50 – 250 per tonne. Understanding this global context is an important part of the puzzle when setting your own internal carbon price now and into the future.

• Review the cost of your emissions reduction initiatives
  The cost of current and future emissions reduction initiatives – such as renewable energy investments or equipment upgrades - is sometimes referred to as an ‘implicit carbon price’.  Understanding this cost helps in setting your internal carbon price, and in running commercial scenarios when prioritising internal initiatives and investments in external carbon projects.

• Tailor your carbon price to your business needs
  Aligning your business objectives with an in-depth understanding of external and internal costs (as outlined above) can help you set an internal carbon price that’s tailored to your business.  A price that helps you meet your climate goals, stakeholder expectations and demands of evolving regulatory frameworks.
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• Embed your carbon price in business-as-usual decision making
  Whether it’s the business case for a new product line or an initiative to reduce emissions, bringing business decisions back to the internal cost of carbon will ensure alignment across the organisation.  
  
  There are tools available today – such as the Emissions Manager feature on the CORE Markets platform – that enable you to model ‘what-if’ scenarios using different carbon price inputs, and to collaborate on emission reduction initiatives.

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Align your commercial and climate goals with an internal carbon price

As the world increasingly puts a price on carbon, so do many forward-looking organisations. An internal carbon price can help organisations better align their commercial and climate goals and guide their decarbonisation decisions.

But there is no one-size-fits all approach.  The right internal carbon price model will support your decarbonisation strategy and be aligned with your industry norms and relevant regulatory frameworks.

The CORE Markets can help inform you internal carbon price setting process, validate your approach and help you stay up to date with evolving carbon market dynamics. Contact us today.

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