To Inspire Action on Net Zero, Set a Price for Carbon

The bottom line: companies continue to fall short in virtually every aspect of the journey toward net zero. To get there, business leaders must rally their broader organizations behind the decarbonization agenda and initiate ambitious actions to reduce their carbon footprint. This requires more than just measuring and disclosing carbon footprint data and defining actionable reduction goals and a timeline for the effort. Companies must also embed carbon footprint reduction targets in every aspect of their strategy, governance, corporate steering, investment decisions, and operations.

The most effective way to accomplish this is by assigning to all corporate GHG emissions an ICP—typically the conversion of tons of CO₂ equivalents (CO₂-e) to a monetary value. This allows for a high level of comparability among planned initiatives and investments, and in turn enables a direct assessment of the impact of carbon reductions on both opex and capex decisions. In fact, according to the CDP, in 2022 more than 2,000 companies were using or planned to use internal carbon pricing in their efforts to establish and meet their carbon abatement goals.

The corporate CFO and the finance function have expertise in financial planning and analysis, as well as investor relations, that is well-suited to assessing the ICP and managing its implementation across the company.

The Price Is Right

The great virtue of an ICP in reducing GHG emissions is that companies can apply it in a number of ways, taking into account both current and future emissions across their operations. In our experience, companies do best when they follow a consistent path to the full use of an ICP, which ensures that they gain the most value; however, each company’s ICP journey will be different.

Many start by using the ICP to reflect the cost of future emissions in investment decisions, effectively improving the economics of any low-emissions projects while penalizing high-emissions projects. This will help companies build a future-ready portfolio of low-carbon assets. At the same time, it is also critical to begin to accelerate the decarbonization of all current assets by charging each asset for the cost of the carbon it emits, and tying emissions to each asset’s P&L performance.

Depending on the ICP model used, the funds raised from the charges placed on assets can be spread evenly over years to finance the abatement of each asset’s carbon footprint and to invest in new low-carbon businesses and products. Companies can also embed the ICP in the procurement process for emissions-intensive materials, utilities, and services to reduce their scope 2 and scope 3 emissions and decarbonize their supply chains.

Ultimately, companies should be monitoring their ICP-adjusted P&L at both global and brand levels, and fully integrate the cost of carbon into their cost of goods sold, current and forecast commodity prices, margins, and other key financial metrics. Charging the CFO and the finance function with the responsibility for managing the ICP process, in conjunction with the sustainability and strategy teams, will ensure that adequate rigor is brought to the task.

Setting the Price

The ICP journey begins with companies determining the most appropriate model for pricing carbon—based on how the ICP will be used—and then integrate it into their operations. There are three possible models for the ICP, each with varying applications and benefits, depending on the circumstances. Some companies may choose to mix models to achieve their desired goals.

• Shadow Price. In this model, companies assign a pre-determined carbon price to the likely GHG emissions of all procurement and investment decisions. This may be a regulatory price as determined through external carbon tax, the price of offsets in voluntary markets, or a function of total estimated abatement costs. Shadow pricing enables the company to determine the cost of their GHG emissions and integrate it into future decision-making. This includes the potential abatement costs involved in reaching corporate net zero goals and all future savings. A shadow price calculated for procurement decisions aims to account for and control upstream scope 2 and 3 emissions by choosing suppliers that are willing and able to provide low-carbon materials and components.
• Carbon Fee. By charging a dollar amount for every ton of CO₂-e emitted on every asset’s scope 1 and 2 emissions—and collecting actual cash as an internal tax—companies can encourage emissions reductions and use the cash flow to support abatement actions throughout the organization. The carbon fee is intended to directly impact the bottom line of each asset and should be part of the incentive scheme for the leadership of the asset. (See “Implementing a Carbon Fee.”)
• Cap and Trade. It is also possible for companies to allocate carbon credits to each business area and then devise a system that allows them to trade credits internally. If a business unit exceeds its allotted credits, it must buy additional allowances from other business areas. On occasion, a business unit might choose to offset its emissions using publicly traded credits, and then sell its remaining internal credits into the company’s trading scheme. Few companies, however, are likely to implement a cap-and-trade system given the high level of complexity involved in setting up an internal trading system that merely replicates available public trading systems.
  

Which model to use, and how high to set the actual price, depends on the activity, asset, and geography where it is being applied. Companies should use a shadow price in the procurement process when the goal is to control immediate scope 2 and upstream scope 3 emissions—and an investment process when the goal is to account for the cost of future carbon regulations and the social impact of carbon emissions in current investment decisions. Higher prices could be applied on assets with greater carbon intensity to incentivize decarbonization and improve the competitiveness of those assets. Companies with assets and supply chains in regions with stringent regulations could also adopt higher prices to ensure their overall long-term competitiveness.

Companies can set the actual ICP in three different ways. One option is to calculate an implicit price based on the company’s average cost of abatement across all assets. The total amount needed to abate all assets is then translated back to a set carbon fee, and the funds collected are then used to fully fund the abatement initiatives required.

Alternatively, an external regulatory price, such as a carbon tax or the EU’s Carbon Border Adjustment Mechanism, can be used as an ICP if the organization has high exposure to such markets, either through assets located there or by selling products into them.

Finally, companies could use an external offset price as another reference point if they are relying heavily on carbon offsets as part of their net zero strategy. However, certification standards such as Vera and Gold Standard are evolving quickly, so companies need to track them carefully and regularly update the ICPs derived from them.

The ICP in Practice

To ensure successful implementation, the ICP must be revised regularly in response to changes in market and business conditions. When regulatory carbon prices or external carbon offset prices change, for example, it is critical that companies reflect the change in both their current ICP and their forecast of future prices. Companies should also maintain a rolling forecast of the likely future ICP and embed it in their business planning processes, much like they forecast future commodities prices. This will allow them to better direct corporate steering and investments decision-making as markets and business conditions change.

To effectively implement and manage the ICP, appropriate procedures and policies must be put in place. To ensure proper collection and use of carbon fees, for example, companies could create a central carbon fund, cost center, and accounting procedures for deducting the fees from all assets and crediting them to the central fund. To determine how the collected fees should be used to fund GHG reduction initiatives, the proper investment criteria must be defined in line with the company’s decarbonization roadmap. This could include current emissions and intermediate abatement targets and the marginal cost of abatement. Finally, the ICP and associated processes should be incorporated into the annual capital allocation and business planning process.

Companies choosing to implement a shadow carbon price need to consider how to incorporate it into both their procurement and investment decisions. For procurement, companies should establish processes and tools to gather emissions data from suppliers for critical categories of goods and services. This is particularly important in developing or underdeveloped markets, where companies and suppliers may not openly report their emissions. Then they will need to define a mechanism for incorporating the shadow price into the commercial evaluations of supplier bids. It is important to openly communicate to suppliers the company’s plans and procedures for using the ICP as part of the procurement process.

The Change Factor

Establishing an internal carbon price involves changes in the way an organization does business and how its employees work. As with most change management efforts, companies essentially have two options for implementing an ICP regardless of the pricing model they decide to use.

The first approach is to run small-scale pilots, either across individual business units or specific assets, to iron out the kinks, especially at a large organization. This can help to demonstrate that ICP activities can be successfully integrated across all supporting activities—such as finance, investments, and business planning—before rolling it out to the wider organization.

The second approach involves launching the ICP uniformly across the company from the start. This can help to drive immediate action, allowing the entire organization to stand behind the sustainability objective. An immediate full roll-out is best suited to organizations that require less differentiated ICPs, such as for all assets within a single geographic area.