A beginner’s guide to internal carbon pricing

As regulatory pressures continue to intensify, companies are adopting a variety of pathways to decarbonise and meet ambitious climate targets.

Beyond actively mitigating and avoiding emissions, one impactful instrument to implement is internal carbon pricing (ICP), a carbon reduction mechanism gaining traction for its capabilities to drive transparency, improve reputation and protect businesses against climate regulations.

Real climate impact requires commitment, even if companies perceive short-term financial implications. By being an early adopter of internal carbon pricing, companies can better understand risks and opportunities related to upcoming regulations.

This article discusses the ICP concept, the regulations driving increased ICP adoption, ICP types, and how to set an appropriate price to meet business objectives.

Internal carbon pricing is a tool to allow businesses to assign a monetary value to their own carbon emissions. ICP mechanisms are highly variable across businesses and business sectors.

Choosing an ICP mechanism depends on several factors including: the emissions covered, the company’s goals, the chosen type of ICP, potential financial impacts, and other market factors such as regulatory and competitive landscapes, carbon market prices, carbon abatement costs, and price projections.

By 2021 almost 50% of the world’s 500 biggest companies either planned or implemented an ICP scheme, according to a CDP report. This is more than twice the number of companies since previously reported in 2017. Similarly, of the 8,403 companies reporting to CDP in 2022, 15% reported implementing an ICP.

Most decarbonisation efforts are influenced by the regulatory landscapes, as carbon taxes and emissions trading schemes (ETS) continue to grow across countries. The World Bank’s Carbon Pricing Dashboard records 73 existing carbon pricing initiatives in 2023 covering 23% of global greenhouse gas emissions.

The most common systems include the European Union’s ETS, Japan’s carbon tax, and South Africa’s carbon tax. In the USA, states such as California and Pennsylvania started or scheduled a cap-and-trade system or ETS.

By translating carbon emissions into financial terms, ICP can be valuable in assessing financial impacts of future carbon-pricing mandates as well as market risks and opportunities.

Most companies adopting an ICP do so to achieve specific objectives, such as improving low-carbon investments, operational energy efficiency, or internal behaviour. Most specifically, ICP is effective to:

• Drive decision-making: By looking at emissions in financial terms, emission reductions help evaluate the viability of investments and changes to the business
• Assess climate-related risks and opportunities: ICP can help future proof businesses by translating potential impacts of carbon prices on operations
• Drive investments to internal decarbonisation: By charging a carbon fee, those funds can be invested in research and development (R&D), technology, or energy efficiency
• Promote behavioural change: With a budget based on emissions, businesses are incentivised to improve operational efficiency, foster innovation, and advocate for sustainable solutions
• Meet stakeholder expectations: Investors and consumers demand transparency around climate actions. Tying emissions to finances allows companies to demonstrate a greater sense of commitment

Setting an ICP can be complex due to the number of factors to consider, as mentioned above. Depending on your objectives, companies can adopt three types of ICP:

1. Shadow price: Used by over 60% of CDP respondents, shadow pricing assigns a hypothetical price per unit of carbon emissions, with no tangible emissions-related payments made. A shadow price can evaluate the financial implications of carbon emissions on the company's operations, future capital investments, and aid in strategic decision-making. Shell, for example, implemented a shadow price of $40 per tonne on all emissions since 2000. This influences their project and operational decisions, encouraging engineers to find emissions-saving opportunities below the $40/tonne threshold.
2. Implicit price: An implicit price places an estimated value for carbon based on a retroactive calculation, meaning actual costs of carbon emissions is incurring, without directly imposing an ICP. It reflects the costs and risks associated with carbon emissions the company faces, even if not explicitly accounting for them using a shadow price. This ICP type incentivises emissions reductions and is used as a reference point for subsequent carbon fee implementation. Harmony, for instance, implemented an implicit carbon price in 2016 anticipating the 2019 South Africa’s carbon tax. By factoring the price of carbon into operations plans, Harmony identified “more marginal assets would no longer be profitable” once taxation began. When the tax came, Harmony reported a full-year loss, offsetting gains from the expected rise in gold prices. This highlights how important it is to not only account for a carbon tax, but proactively act on it.
3. Carbon fee: A company assigns a carbon fee to a unit of carbon emissions, and then charges that fee its responsible business unit. Business unit fee payments are sent to a central funding pool to reinvest in the company’s decarbonisation efforts. With a direct cost, carbon fees can effectively encourage department leaders to take ownership over emissions reduction efforts. As part of their 2012 commitment to carbon neutrality, Microsoft introduced a carbon fee. Microsoft tracked emissions to ensure each business unit was financially accountable for their emissions. With a $15 per metric ton carbon fee, Microsoft soon funded clean-energy projects producing 10 billion kWh of power, and plan to invest $50 million over the next three years.

Other types of ICP include carbon offset pricing, where an organisation would set a price on carbon based on the total cost of carbon offsets that would be required to decarbonise, and internal trading (like a cap-and-trade system) where a definite amount of carbon credits is allocated to a business unit based on respective emissions.

It is possible for a company's pricing type to evolve over time. For example, you may begin with a shadow price to serve as a benchmark for understanding and preparing for actual monetisation of a carbon fee, especially when at risk of future mandates.

As a best practice, an internal carbon price should evolve in parallel with the organisation’s climate ambitions, as well as internal and external factors impacting business operations.

ICP implementation considerations

ICP requires buy-in and support from all impacted stakeholders. Business units with the greatest stakes and financial liabilities may show resistance, which is why it is crucial to set a price. Unaffordable prices can result in financial burdens for specific departments, while low prices may be insufficient to meeting ICP objectives.

The type of ICP can impact internal stakeholders. While a shadow price primarily involves the strategic and financial planning teams, an implicit price could have broader implications across departments managing regulatory compliance and risks. A carbon fee potentially impacts various departments and job levels, as it involves direct accountability for carbon emissions and could lead to significant changes in operations, procurement, and budgeting.

To price carbon appropriately, organisations must develop processes to quantify and track emissions over time. This may require the integration of modern technologies, data collection systems, and personnel.

In embracing early adoption of internal carbon pricing, companies can gain a comprehensive grasp of the potential risks and opportunities tied to future regulations, underscoring the necessity of unwavering commitment to addressing real climate impact.