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Internal Carbon Pricing — Why do businesses need to start implementing it right now

The material risk that climate change represents to investors in the form of stranded assets is increasingly being recognised. To address this issue, hundreds of companies are now setting an internal price on carbon in order to mitigate risks from current or future climate change regulation, thereby protecting investors interests, and also as a way to drive investments to clean energy and low carbon alternatives.

- Fiona Reynolds, Managing Director Principles for Responsible Investment

The conversation around carbon pricing has been growing in the past few years, it is an indispensable component of our way to net zero. The core idea of carbon pricing is to internalise the externalities of greenhouse gas emissions of activities ( mainly business activities ) that used to be paid by the public. Carbon pricing markets around the globe have expanded rapidly, back in 2016, it was estimated by the Institute for Climate Economics that only 13% of global emissions were covered by explicit pricing mechanisms, whereas according to the World Bank, in 2021, a total of 65 carbon pricing initiatives around the world covers 21.5%, equivalent to 11.65Gt CO2 equivalent of global greenhouse gases emissions.

Source: Unsplash

On national and regional levels, the two main types of carbon pricing mechanisms are emission trading systems — ETS, in which emitters trade emission allowances to meet emission targets and regulations, and the less flexible approach — carbon tax, where a tax rate is defined on per unit of greenhouse gas emission. However, these high-level schemes are not available for every national and subnational jurisdiction, there are regulatory uncertainties as new considerations continue to emerge, such as cross-border adjustment issues. Details of the schemes still need to be refined for them to become more efficient.

In such a huge, ever-changing market, what should you do as an individual business? Is the carbon market only for billion-dollar companies? How should you be prepared for the risks and opportunities presented by the carbon market? How could your business contribute to low-carbon economic growth?

Internal Carbon Pricing might give you an answer to all these questions.

1. What is internal carbon pricing (ICP) and where we’re at right now?

Internal carbon pricing is a price set by businesses themselves on each unit of carbon emission resulting from their business activities. It is used as a tool to help companies factor in climate risks and opportunities into business decisions, investment choices and incentivise businesses to invest in low-carbon innovations.

Just like how the global carbon market has expanded, the number of companies reporting the usage of ICP processes has also surged. According to the CDP, in 2020, 853 companies have disclosed their use of ICP, and an additional 1159 companies have the intention to adopt it over the next two years — a 20% increase from 2019. Leading businesses are becoming increasingly mindful of climate risks, nearly half of the 500 largest companies by market capitalization now has adopted ICP. A geographic breakdown of the results from 2019 indicated that most of the early adopters are from Europe, Japan, the UK and the US.

Well… Voluntarily adding extra costs to your own business operations doesn’t seem to make financial sense…

2. Why put a price on yourself?

Reason 1: Understanding and mitigating carbon and climate risks

When talking about climate risks, there are in fact a few aspects — physical risks, transition risks, and the financial risks associated with them.

Physical risks are straightforward, but they could have the most devastating impact. Rising sea levels, more frequent climate disasters, hurricanes are putting human lives and billion dollars of physical assets at risk. However, from the aspect of ICP, the more relevant risks are transition risks. As governments around the world put harsher limits on carbon emission, the prices of carbon will inevitably climb up, driven by higher demand for emission permits. If your business is not able to reduce carbon emission by transforming your business operations, redesigning your products and processes, you would have to buy high-priced carbon emission permits, which puts you in a disadvantageous position in your market. Paying a higher price for emissions might even force you out of the market under intense competition.

Source: Unsplash

Apart from the rising cost of purchasing emission permits, another aspect of the financial risk is related to the ability to obtain funding. With more investors taking ESG factors into consideration and more banks issuing loans based on companies’ ESG performances, the ability of firms to obtain financial support from financial institutions and the public now depends heavily on how well are they responding to environmental, social and governance concerns. Inability to transit to a low-carbon business model might expose you to the risk of cash flow shortages and a lack of financial capital. This is not only a risk for individual businesses, but the whole financial system — the European Central Bank ( ECB ) has estimated that the probability of default for the average eurozone bank’s corporate loan book could be 7.1% higher by 2050 if climate actions are not accelerated.

Therefore, establishing an ICP that gets incorporated into businesses’ investment decisions allows low-carbon investments and low-carbon projects to be prioritised, more investments could be driven into innovative low-carbon technologies, gradually helping your business to transit and mitigate future climate and carbon risks, before it gets too late.

Reason 2: get prepared for the unpredictable future carbon price

As I have mentioned, currently there are huge uncertainties in the global carbon market. In the EU, in 2017, the carbon permit price was only about €3 per tonne of CO2 equivalent whereas, in 2022, the price has blown up to a staggering €82 per tonne. It is extremely difficult for businesses to anticipate how fast the carbon price will rise in the future. Setting an ICP upfront could help businesses reduce cash flow shocks due to sudden surges in national carbon price and therefore stay competitive in their market under stressful situations.

Reason 3: Enhance employees’ awareness of carbon and climate risks

It is often the case that climate risks are well-understood by top executives and senior managers as they are the strategy setters and decision-makers. But when it comes to implementations, how well could climate considerations be incorporated into everyday business operations ultimately depends on whether employees are able to integrate climate risks into business processes. For example, when an employee in a bank is assessing a client’s default risk for the issuance of a loan, is he/she able to look at the company’s emission data or ESG report and estimate how much climate risk the client is exposed to in the future? Although ESG scores and quantitative criteria could be set to guide the assessment process, there are many qualitative considerations that are business-specific and need to be taken into account. The climate awareness of employees, therefore, is a deciding factor of a business’s climate risk readiness. Setting an ICP means every project team are involved in the carbon emission evaluation process, therefore they have to thoroughly understand carbon concepts.

Other reasons could include:

Reason 4: Raising external awareness and building your brand image

Reason 5: Answering investors and consumers and responding to their concerns regarding the climate emergency

3. setting the right price

As the name “Internal” suggested, there is no standard level for ICP and it is subject to business-specific circumstances.

So you might ask, what price should I set?

Before setting the price, you need to first decide which type of pricing will you adopt. There are three commonly used methods: shadow pricing, implicit pricing and internal carbon fees.

Shadow pricing is a hypothetical cost on carbon emission, which a company uses to adjust the cost and return of investments and evaluate their investment decisions. They are not really paid by the project team but used as an evaluation tool, for example, if a business is comparing fossil-based power to a renewable energy source, the current market energy price might suggest that fossil-based power is the cheaper option, but renewable energy is likely to win when emissions are given a shadow price.

On the other hand, implicit pricing is a measure of the financial capital investments needed to achieve a certain climate target, for instance — carbon neutrality. If a project is estimated to emit a certain amount of carbon dioxide equivalent, ICP should answer how much does it cost to buy emission permits from the carbon market to offset them.

And lastly, internal carbon fees involves real dollars, it is applied throughout different divisions of the business and they really have to pay for the emission of their projects. These payments are collected into a fund that gets reinvested by the business into low-carbon investments.

The actual price that companies set varies across industries and regions. Among all firms that reported their ICP to CDP, the price ranges from USD 6 to USD 918. The average shadow price was 28 USD, for implicit price it was 27 USD and for internal carbon fees it was only 18 USD. This is in fact not satisfactory at all, the High-Level Commission on Carbon Prices has recommended that companies need to set ICP between 40 to 80 USD per metric ton in 2020 and raise it to 50 to 100 USD per metric ton by 2030 in order to keep in line with the standards set in the Paris Agreement.

source: the World Bank — State and Trends of Carbon Pricing 2021

The internal heterogeneity and external volatility in carbon pricing make it difficult to set ICP, companies could also set different prices for different operation units depending on geographical locations and the product produced, but I would suggest companies take into consideration of the following aspects:

  • How ambitious is your company’s climate target?
  • What is the carbon price in your region?
  • What is the average ICP in your industry?
  • What is the level of climate risk you’re exposed to? ( for example, does your supply chain depends heavily on agriculture products from regions vulnerable to climate risks?)

4. Case Study: Microsoft’s ICP

To provide you with an example of the implementation of ICP, in 2012 Microsoft adopted an internal carbon fee system, which was implemented in all business units, covering emissions from scopes 1, 2 and 3. The price was set at a range from $5 to $10 per ton, and the collected funds are pooled for investments in internal efficiency projects, green energy, and carbon offset programs. Overall, Microsoft has reported more than $10 million in energy cost savings each year and emissions reductions of nearly 10 million tons since 2012.

With increasing cooperation and conversation between international regulatory bodies, governments and businesses, there is no doubt that the age of zero-carbon businesses is coming. Companies need to re-evaluate their investments, manage risks and reconsolidate strategy based on ICP. Be a futurist and get prepared for the upcoming carbon risks and opportunities.

About Me

I am an Associate Member of the World Institute of Sustainable Development Planner, currently working with UNESCO Hong Kong Association and its secretariat — Hong Kong Institute of Education for Sustainable Development. While pursuing a statistics degree at University College London, I have a strong passion for sustainability and technologies. Therefore I am dedicated to writing and publishing articles on topics related to SDGs, innovative technologies such as AI and Blockchain, and economics. I aspire to bring digital technologies and sustainability together and inspire more people for a better future for all.

My Work

Contact:

Email: americanachen@unesco.hk

LinkedIn: Americana Chen

Instagram: @africcccana

Facebook: Americana Chen

References:

  1. Fan, J., Rehm, W., & Siccardo, G. (2021, February 19). The state of internal carbon pricing. McKinsey & Company. Retrieved January 22, 2022, from https://www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/the-state-of-internal-carbon-pricing
  2. A guide to internal carbon pricing — anthesis group. Anthesis. (2021, September 9). Retrieved January 22, 2022, from https://www.anthesisgroup.com/internal-carbon-pricing/#why
  3. Microsoft will be carbon negative by 2030. The Official Microsoft Blog. (2020, July 23). Retrieved January 22, 2022, from https://blogs.microsoft.com/blog/2020/01/16/microsoft-will-be-carbon-negative-by-2030/
  4. Newson, P., Edited by Thomas Kaiser, Edited by Bill Coen and D. R. Maurice, Pitacco, E., Lorenzo Migliorato 24 Sep 2021, Migliorato, L., & 2021, 24 S. (2021, September 24). Default risk set to rise from climate inaction — ECB. Risk.net. Retrieved January 22, 2022, from https://www.risk.net/risk-quantum/7880281/default-risk-set-to-rise-from-climate-inaction-ecb
  5. What is carbon pricing? What is Carbon Pricing? | Carbon Pricing Dashboard. (n.d.). Retrieved January 22, 2022, from https://carbonpricingdashboard.worldbank.org/what-carbon-pricing
  6. “World Bank. 2021. State and Trends of Carbon Pricing 2021. Washington, DC: World Bank. © World Bank. https://openknowledge.worldbank.org/handle/10986/35620 License: CC BY 3.0 IGO.”

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Americana Chen

Americana Chen

UNESCO Hong Kong Association/ UCL / AwiSDP — write for sustainability and technologies. Experienced in event reporting — contact: americanachen@unesco.hk

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