Internal Carbon Pricing: A Catalyst for Sustainable Business

Carbon pricing is a mechanism designed to reduce greenhouse gas emissions by assigning a financial cost to them. This cost can be implemented through various methods, including carbon taxes, cap-and-trade systems or internal carbon pricing (ICP). While the former two are typically set at the government level, ICP is a corporate strategy and the focus of this month’s newsletter.

The cost of carbon is influenced by a complex interaction of economic modelling, market mechanisms and policy decisions. This cost represents the emissions of CO2 into the atmosphere as well as the removal, avoidance or reduction of these emissions. In cap-and-trade systems, the market price is set by the supply and demand for emissions allowances. Carbon taxes, on the other hand, are fixed by governments to reflect environmental goals. The greatest variability in carbon pricing occurs at the company level where ICPs are often determined by factors such as anticipated regulations, sustainability objectives, stakeholder expectations and the extent to which carbon ‘revenues’ are to be collected and allocated.

The Mechanics of Internal Carbon Pricing

The concept of an ICP allows companies to align their strategic objectives and operations with sustainability goals by assigning a monetary value to the cost of emitting carbon. This approach considers carbon emissions as a tangible factor, incentivising decarbonisation efforts across business operations and value chains. By adopting an ICP, companies can more effectively plan for and manage regulatory and market-based risks, while seizing the opportunity to lead the transition towards a low-carbon economy.

ICPs are a strategic tool for businesses to align their operations with sustainability goals. They involve assigning a financial value to carbon emissions and encouraging more environmentally conscious decisions. There are two primary types of ICPs: actual and hypothetical (often know as shadow pricing).

Actual ICPs involve a company charging itself (different sub-companies, divisions, or departments) a fee for each tonne of carbon emitted. These funds are typically allocated towards emissions reduction initiatives, such as investing in carbon removal projects or improving energy efficiency. This approach directly links carbon emissions to financial costs, incentivising more sustainable practices.

Shadow ICPs, on the other hand, assign a hypothetical value to carbon emissions without collecting actual fees. This allows companies to assess the environmental impact of their operations without incurring immediate financial costs. While it doesn’t involve direct financial transferal, shadow pricing can raise internal awareness and inform future investment decisions.

Both actual and shadow ICPs aim to reduce corporate carbon footprints. However, they differ in their approach. Actual ICPs are directly tied to market conditions, reflecting the real-world value of carbon. Shadow ICPs offer more flexibility, allowing companies to set prices based on internal factors and future projections.

Why Implement an ICP?

Adopting an Internal Carbon Price (ICP) demonstrates a company’s commitment to sustainability and positions it for future climate challenges. By proactively addressing carbon emissions, businesses can mitigate risks associated with changing regulations and capitalise on emerging opportunities in the low-carbon economy. Key benefits include:

Risk Management. ICPs can help companies prepare for future regulatory changes and market risks associated with carbon emissions. By incorporating carbon costs into decision-making, businesses can mitigate potential financial penalties and ensure long-term sustainability.

Cost Reduction. ICPs can drive efficiency and process optimisation, leading to long-term cost savings. By identifying carbon-intensive activities, companies can explore more efficient alternatives and reduce their overall environmental footprint.

Innovation. ICPs can incentivise the development of low-carbon products and services, fostering innovation and positioning companies as leaders in the sustainable market.

Reputation Enhancement. Adopting an ICP can improve a company’s reputation among stakeholders, including investors, customers and employees. It demonstrates a commitment to sustainability and aligns with growing consumer and investor expectations.

The Growing Adoption of ICPs

ICPs are gaining significant traction, with nearly half of the world’s top 500 companies incorporating carbon accounting into their business strategies. Companies like Microsoft, Orsted and Mitsubishi Corporation are leading the way by implementing ICPs and using the generated revenue to fund emissions reduction projects.

This trend is reflected in the growing number of companies setting internal carbon prices, with other notable examples including Apple, Google, and Unilever. These companies have established ICPs to align their operations with sustainability goals, reduce their carbon footprints and uphold their reputations as good corporate citizens in the increasingly climate-conscious market.

Challenges and Future Outlook

Despite the growing adoption of ICPs, one of the primary challenges lies in determining an accurate carbon price. While guidelines and frameworks exist, there is no universal standard, leading to variations across industries and regions. This makes it difficult for companies to compare and benchmark their efforts effectively.

Furthermore, the social cost of carbon, representing the economic damage caused by each tonne of carbon emitted, is often underestimated. Many ICPs are significantly lower than the true environmental cost, potentially hindering effective emissions reduction.

Another concern with ICPs is the potential for greenwashing. While companies may announce impressive internal carbon prices, there is a risk that these are merely symbolic gestures without underlying emission reduction plans. If companies fail to disclose how and when ICP funds will be used, it raises concerns about the lack of meaningful environmental action. To ensure ICPs are genuine tools for climate action, companies must be transparent about their carbon pricing practices and demonstrate how they are driving emissions reductions, regardless of whether the ICP is actual or theoretical.

As the world confronts the urgency of climate change, Internal Carbon Prices (ICPs) will play an increasingly vital role. By accurately valuing carbon emissions, companies can make informed decisions, reduce their environmental impact and contribute to a more sustainable future. To ensure the effectiveness of ICPs, it is essential that they are implemented transparently, aligned with the true social cost of carbon, and used to drive concrete emissions reduction initiatives.