101: Internal carbon pricing
The 3 best practice options
Today, carbon pricing is back in vogue.
For most Australians, carbon pricing may conjure up memories of hyper partisan public policy debates around carbon taxes and failed emission trading schemes that did little to progress our national climate agenda.
Subsequently the failure to get carbon pricing right also led to the end of four prime ministerships.
This time, a resurgence in carbon pricing is being led by individual companies rather than governments.
Dubbed ‘internal carbon pricing’ this new method of measuring and pricing emissions equips businesses with a way to create incentives for staff to reach net zero sooner, while still remaining profitable.
So what is a carbon price again?
A carbon price refers to a regulated fee (e.g. a tax or a levy) on carbon emissions from organisations in a certain region and sector.
For example, the federal government may charge a fee of $20 per tonne of CO2 produced from all electricity generators in Australia. The aim here is to make polluting CO2 more expensive, reducing the amount of emissions that electricity generators will produce.
And how is an ‘internal carbon price’ different?
In a world where many countries don’t have the political appetite to implement a carbon price, some private companies are leading the charge and setting an internal carbon price for their organisations.
This is where the company charges itself a fee for each unit of GHGs it emits - which can be used to influence investment and business operations decisions.
Usually used in conjunction with a science based target, many ASX listed companies like BHP, Westfarmers, and NAB and are taking carbon pricing into their own hands.
There’s three ways to set up an internal carbon price within an organisation. Each has its pros and cons.
Method 1: Choosing a shadow price
The first option is to set up a shadow price on carbon.
This is a hypothetical cost item (measured in $ per tCO2-e) added to an organisations P&L statement that tracks the total charge for each business unit. This charge is monitored in the same way as other cost line items (e.g. monthly or quarterly).
This allows each business unit for calculate their EBITDA both with and without a carbon price applied.
The key benefit of this method is it allows business leaders to understand their risk to emissions reduction policies or the price of offsets, and how that risk changes over time.
Method 2: Charging an internal carbon fee
The second method goes a step further with the creation of an internal carbon fee.
Here, each business unit is charged a fee (reviewed annually) by the organisation's corporate services (or some central finance function) for each tCO2-e produced. These fees are taken away from the individual business units budgets throughout the year.
At year end, fees are collated by head office then spent on emissions reduction activities (e.g. offsets or project financing carbon removal).
This method is interventionist - but also creates perfect incentives alignment and encourages each BU to take responsibility for its own emissions.
Method 3: Calculating an implicit price
The third method, an implicit price, involves an organsiation estimating their total annual cost to meet emissions reductions targets (including buying offsets).
This cost is then divided by the total emissions quantity. This creates an implicit price paid per tCO2-e produced in that year.
The benefit of this method is that the internal carbon price reflects the organisations specific costs faced to reduce each tonne of emissions - rather than guessing a price or using an industry average.
Over time as the cost to offset or reduce emissions changes, the implicit price also responds to reflect the conditions on the ground.
Where's next for internal carbon pricing?
Increasingly we're seeing financial institutions use an internal carbon price as a step for evaluating new investments.
The negative externality of CO2 emissions is considered as part of a project appraisal, including the resulting impact on the investments internal rate of return.
The same exercise can also be completed for the financial institutions current portfolio, giving an estimated of their 'financed emissions'.
This allows financial institutions to support low-carbon solutions through their investment choices, creating incentive alignment for companies seeking capital.
