Understanding the internal carbon price for businesses

Understanding the internal carbon price for businesses

Faced with the urgency and the tightening of climate regulations, more and more companies are adopting internal carbon pricing systems. What are the best practices and advantages for companies? Is this a viable solution to decarbonize its activity?

Naal Narayanan

Naal Narayanan

Climate Content Manager

26/4/2023

The price of carbon, a lever for accelerating decarbonization.

Today's economic systems are mainly driven by finance. This is why assigning a financial cost to a ton of CO2 emitted, i.e. a carbon price, facilitates the adoption of climate issues by economic actors.

There are a wide variety of carbon prices, but all have the objective of accelerating the reduction of carbon emissions . Some carbon prices are called "external" to companies, meaning they are imposed by governments in order to reduce greenhouse gas emissions in their jurisdictions. Other carbon prices are referred to as "internal" to companies, as they are voluntarily implemented and enforced by the companies themselves.

States were the first to implement external carbon pricing instruments in the carbon market. Today, there are two main external carbon pricing tools:

  • Carbon tax. It is a direct tax proportional to the quantities of greenhouse gases emitted by companies.
  • The emission allowance system. This system, which sets an overall limit on GHG emissions in a given region, distributes emission rights to the various players and provides a framework for trading allowances among them. The European Union Emissions Trading Scheme (EU ETS) is the most extensive and advanced carbon trading scheme in the world. Not least because it is already gradually reducing the amount of CO2 emissions by lowering the cap on available allowances over time.

The rise of external carbon pricing schemes and the climate emergency have led more and more companies to implement more or less similar carbon pricing mechanisms at their own scale. By 2021, more than 2,000 companies worldwide were using or planning to implement an internal carbon price. Setting one or more internal carbon prices is a strong lever for decarbonisation and, in the long term, for competitiveness, as we will see later.

The different types of internal carbon prices.

The internal carbon price is a flexible tool for corporate decarbonization ; it is currently based on voluntary participation and can be adapted to the objectives of companies. Three main forms of internal carbon prices for companies can be distinguished:

  • TheShadow Price. It assigns an economic value to the carbon footprint of companies' investment or purchasing decisions, without generating concrete financial flows. It is a theoretical value that makes it possible to understand the impact that a carbon price would have on a company's strategy and on the calculation of its internal rate of return (IRR). For example, during calls for tenders the use of a guide price allows for a more complete rating of suppliers by integrating the suppliers' carbon emissions into the financial rating.
  • The Explicit Price or Internal Carbon Tax. This price directly links the greenhouse gas emissions due to the company's activities to its operational costs. By following this carbon price, the company will self-impose a financial tax on the emissions of its activities. The objective of this tax is generally to constitute a fund to finance projects to control and reduce CO2 emissions. By voluntarily increasing its OpEx, the company finances its direct decarbonization in the short term and stimulates innovation for long-term low-carbon solutions.
  • The Implicit Price or Real Cost of Decarbonation. This carbon price reflects the cost of actions and measures that a company implements to reduce its carbon emissions. Calculated a posteriori according to the decarbonization actions and measures actually taken by the company, it represents a real measure of the costs of the low-carbon transition. In particular, it allows for the a posteriori adjustment of the other prices mentioned above. For example, when a company integrates maximum emission standards for its fleet of vehicles into its purchasing policy, the price of carbon is not explicitly mentioned. Nevertheless, the introduction of this standard may lead to an increase in expenditure on this item; hence the implicit term.

These three main types of internal carbon prices are not fixed and immutable categories. Each company is free to adopt one or more internal carbon prices and to set a different value for each of the prices it adopts, depending on its needs and challenges.

The choice of companies to adopt different versions of internal carbon pricing may depend on the industry sector. High-emitting sectors, such as energy, chemicals and materials production, will generally prefer to adopt only a guideline price, as an internal carbon tax would involve very large cash transfers. On the other hand, lower-emitting sectors, such as finance and services, may also opt for an internal carbon tax, in particular to raise awareness of their impact throughout their operations.

Why implement an internal carbon price in your company?

Implementing an internal carbon price has five major interests for companies:

  1. Accelerate the decarbonization of activities, by directing decisions towards solutions with a lower CO2 impact. By reconciling financial and climate languages the internal carbon price allows for a better consideration of the negative environmental externalities of the company's activities.
  2. Anticipate the evolution of regulations, external carbon taxes or carbon market prices, which will increase over the next decades. Indeed, companies with an internal carbon price will be able to avoid investing in carbon projects that may become more expensive and unsustainable in the future.
  3. Facilitate access to low-carbon funds and investments, by improving their ESG scores and extra-financial reporting;
  4. Reduce costs and identify low-carbon development opportunities, thanks to the new reading grid of activities and flows offered by the carbon price.
  5. Supporting the change in behavior of internal employees by translating the carbon footprint of the company's activities into a financial cost that is easier to understand for everyone.

The 3 criteria to understand to choose the internal carbon price most adapted to your company.

Internal carbon prices are made up of three components, all of which are essential to a good understanding of the subject: the price, the scope covered and the level of influence . It is the combination of these three criteria and the types of internal carbon prices that allows each company to adopt the internal carbon price or prices that correspond to it. This is why a good understanding of these parameters and categories is necessary.

First component: the price

Companies generally adopt their own internal carbon prices, depending on their context, organization, sector of activity and GHG emission reduction objectives. For the implementation of an internal carbon price to be effective, it must be well adjusted:

  • An underpriced carbon price can hurt a company in the long run by reducing its ability to assess future carbon costs.
  • an overestimated price can harm the company's short-term competitiveness by pushing it to finance projects that are too ambitious and have a low Internal Rate of Return (IRR).

However, while a customized internal carbon price is more effective at the company level, it should be noted that a uniform carbon price would be more appropriate at the global emissions level. Indeed, a ton of carbon emitted by a Chinese company will have the same impact on the climate as a ton of carbon emitted in Europe, whereas the price of carbon is currently 10 times higher in Europe than in China.

Second component: the scope covered

According to the CDP, in 90% of cases, the internal carbon price only covers the company's direct emissions (scope 1).

However, the challenges of climate transition and competitiveness of companies require that indirect emissions related to energy (scope 2) and its value chain (scope 3) be taken into account. Indeed, accounting for scopes 2 and 3 enables companies to strengthen their value chain, make savings and improve their brand image.

Third component: the influence of the internal price on decisions

Although the development of this tool is voluntary, it is essential that it be adopted by all decision-making levels of a company. Indeed, if the internal carbon price is only used by the CSR department, its capacity to influence the company's decisions in the long term will be almost nil.

To ensure a real transformation and decarbonization of the company, the departments concerned, in particular the financial department and the employees of the various subsidiaries, must appropriate the tool and use it concretely in their analysis and decision-making process.

How to implement a carbon price internally in your organization?

Although it is a very effective and flexible tool for reducing emissions, the vast majority of companies still struggle to implement effective carbon pricing mechanisms.

Nevertheless, knowledge and best practices are gradually developing, accelerating the adoption of internal carbon pricing by companies. The recommendations of the Institut Montaigne, the result of their study on the subject and summarized below, are a perfect example of progress in the field.

The 5 recommendations of the Institut Montaigne to facilitate the implementation of an internal carbon price.

  1. To maximize the effectiveness of the internal carbon price, the company will need to base its pricing policy on the market price and incorporate an internal price increase trajectory to anticipate market price changes.
  2. Including scope 3 emissions in the internal carbon pricing scheme is a decision that must be made with the company's stakeholders: suppliers, customers and society.
  3. Discussing with the financial department the relative place of the carbon price vis-à-vis the different decarbonization tools mobilized is a good first approach.
  4. The European Commission's work on carbon tax and pricing is worth watching and studying. This is a key topic on the European agenda, as evidenced by the upcoming implementation of the world's first border carbon tax.
  5. In the same way, initiatives to share data and hypotheses among the various economic actors in a spirit of "cooperativeness" are to be monitored.

Some concrete examples of internal carbon pricing for inspiration.

In 2020, the CDP observed a 30% increase in Europe compared to 2019 in companies that have implemented or plan to implement an internal carbon price within 2 years . This trend is confirmed year after year and is spreading to all regions of the world, with multinationals leading the way.

Below you will find 4 examples of companies each illustrating different visions of the internal price of carbon.

LVMH: the internal carbon tax model.

As part of its LIFE program, the LVMH Group created an internal carbon fund in November 2015 to help reduce the greenhouse gas emissions of its Houses.

The fund is financed by annual contributions from each House, calculated according to their greenhouse gas emissions and the internal price of carbon, which increased from €15 per ton of CO2 in 2015 to €30 per ton of CO2 in 2018.

The projects funded aim to improve energy efficiency, renewable energy production, and carbon accounting. In 2018, the fund financed 112 projects and avoided the emission of nearly 2,500 tons of CO2 equivalent per year.

Ben and Jerries: an internal carbon tax to decarbonize its scope 3.

Unilever's Ben & Jerry's ice cream company has introduced an explicit $10 price across its value chain. All GHG emissions emitted between the production phase on the farm and the waste management phase in the landfill are covered by this carbon tax.

The funds raised are then used to finance initiatives and strategies to reduce direct and indirect GHG emissions.

Indeed, 42% of Ben & Jerry's ice cream emissions are attributable to dairy products. So the company is working with farmers to develop and implement various decarbonization strategies, including manure separators that turn methane into bedding for cows.

Veolia: a guiding price to guide investment decisions

Veolia's strategy is to introduce a guiding carbon price in all geographical areas where carbon prices exist or will come into effect soon (Europe, China, Korea, USA...).
Thus, business units in the relevant geographical areas make forecasts of future carbon prices, which enrich the risk matrices used when building business models. This internal carbon pricing, launched in 2015, has been rapidly adopted and has generated strong internal commitment, thanks to the support of the CEO and shareholders.

This virtual price, which is expected to reach €31/tCO2e by 2030, makes it possible to integrate CO2 emissions into investment decisions.

The SNCF: a carbon price to rate its suppliers.

80% of the SNCF's greenhouse gas emissions are attributable to its purchases, so the group has decided to apply a guiding price to the rating of its suppliers in order to eventually reduce the emissions of its Supply Chain.

The SNCF aims to gradually introduce carbon rating criteria in all its calls for tender until 2025. This rating will be based on the SNCF group's internal carbon price, which will be set at €100 per tonne of CO2 equivalent by 2023.

The idea is to "bonusser" or "malusser" the suppliers' offers according to their CO2 equivalent emissions.

These different examples of carbon pricing implementation illustrate the diversity and adaptability of this mechanism for competitiveness and the fight against global warming.

Traace facilitates the definition of internal carbon prices and the financial management of decarbonization for companies.

At Traace, we are convinced that the reduction of the emissions of companies will not be achieved without a financial management of the climate strategy. Our platform responds to this issue by allowing companies to model finely the CapEx & OpEx flows as well as the amortisation periods of the decarbonisation levers.

This financial modeling of the decarbonisation plan allows:

  • optimize collaboration between climate and finance teams by basing the discussion on reliable and accurate data.
  • define a carbon price by consolidating its cash flow with its carbon emission reduction forecasts.
  • easily prioritise its decarbonisation action plan according to both its carbon emission and financial forecasts. Any action with decarbonation costs lower than the carbon price the company sets for itself will be easily identified and "prioritized".

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