Understanding the Internal Carbon Price for Businesses

Carbon pricing: a lever for accelerating decarbonization.

Today, economic systems are primarily driven by financial considerations. This is why, assigning a financial cost to a tonne of emitted CO2, or a carbon price, makes it easier for economic actors to embrace climate challenges.

There is a wide variety of carbon prices, but all of them aim to accelerate the reduction of carbon emissions. Some carbon prices are considered "external" to companies, meaning they are imposed by governments to reduce greenhouse gas emissions in specific regions. Other carbon prices are referred to as "internal" to companies, as they are voluntarily implemented and applied 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. This is a direct tax proportional to the amount of greenhouse gases emitted by companies.
  ‍
• The emissions trading system. This system sets an overall limit on GHG emissions in a given region, distributes emission allowances to various actors, and regulates the exchange of allowances among them. The European Union Emissions Trading System (EU ETS) is the most extensive and advanced carbon allowance system globally. This is notably because it already progressively reduces the amount of CO2 emissions by lowering the cap on available allowances over time.

The rise of external carbon pricing systems and the climate emergency have prompted more and more companies to implement carbon pricing mechanisms, more or less similar, at their own scale. In 2021, over 2,000 companies worldwide were either using or planning to implement an internal carbon price. Setting one or more internal carbon prices is a powerful lever for decarbonization and, in the long term, for competitiveness, as we will see later.

‍

The different types of internal carbon prices.

Internal carbon pricing is a flexible tool for corporate decarbonization ; it is currently voluntary and adapts to companies' objectives. Three main forms of internal carbon pricing for businesses can be distinguished:

• The Shadow Price or Shadow 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 helps understand the impact a carbon price would have on strategy and on the calculation of a company's internal rate of return (IRR). For example, in tender processes, using a shadow price allows for a more comprehensive evaluation of suppliers by incorporating their carbon emissions into the financial score.
  ‍
• The Explicit Price or Internal Carbon Tax. This price directly links greenhouse gas emissions from a company's activities to its operational costs. By adopting this carbon price, the company will self-impose a financial tax proportional to its activity emissions. The objective of this tax is generally to create a fund to finance projects for controlling and reducing CO2 emissions. By voluntarily increasing its OpEx, the company funds its direct short-term decarbonization and stimulates innovation for long-term low-carbon solutions.
  ‍
• The Implicit Price or Real Cost of Decarbonization. This carbon price reflects the cost of actions and measures a company implements to reduce its carbon emissions. Calculated retrospectively based on the decarbonization actions and measures actually taken by the company, it represents a real measure of the costs of the low-carbon transition. It also allows for retrospective adjustment of the other prices mentioned previously. For example, when a company integrates maximum emission standards for its corporate fleet vehicles into its purchasing policy, the carbon price is not explicitly mentioned. Nevertheless, the introduction of this standard can lead to increased expenses in this area; hence the term implicit.

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

Companies' choice to adopt different versions of internal carbon pricing can depend on their sectors of activity. High-emitting sectors, such as energy, chemicals, and materials production, will generally prefer to adopt only a shadow price, as an internal carbon tax would lead to very significant fund transfers. In contrast, less-emitting sectors, such as finance and services, may also opt for an internal carbon tax, particularly to raise awareness across all internal activities about their impact.

‍

Why implement internal carbon pricing in your company?

Implementing internal carbon pricing offers five major benefits for companies:

1. Accelerate the decarbonization of activities, by guiding decisions towards solutions with a lower CO2 impact. By reconciling financial and climate languages, the internal carbon price allows for better consideration of the negative environmental externalities of the company's activities.
   ‍
2. Anticipate changes in regulations, external carbon taxes, or carbon market prices, which will increase over the coming decades. Indeed, companies with an internal carbon price will be able to avoid investing in carbon-intensive projects that are likely to become more costly and unsustainable in the future.
   ‍
3. Facilitate access to low-carbon funds and investments, by improving their ESG scores and non-financial reporting;
   ‍
4. Reduce costs and identify low-carbon development opportunities, thanks to the new framework for understanding activities and flows that the carbon price provides.
   ‍
5. Support internal employee behavioral change, by translating the carbon footprint of the company's activities into a financial cost, which is more easily understood by everyone.

‍

The 3 criteria to understand for choosing the internal carbon price best suited to your company.

Internal carbon prices are made up of three components, all essential for a thorough 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(s) that suit it best. This is why a good understanding of these parameters and categories is necessary.

‍

First component: the price

Companies generally adopt internal carbon prices tailored to their specific context, organization, sector, and GHG emission reduction targets. For an internal carbon price to be effective, it must be well-adjusted:

• an underestimated price can harm a company in the long term by reducing its ability to assess future carbon-related costs.
• an overestimated price can harm the company's competitiveness in the short term by pushing it to finance overly ambitious projects with too low an 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 for global emissions. 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, even though the carbon price 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 direct emissions of the company (scope 1).

Yet, the challenges of climate transition and corporate competitiveness require the ability to take into account indirect emissions related to energy (scope 2) and its value chain (scope 3). Indeed, accounting for scopes 2 and 3 allows companies to strengthen their value chain, achieve savings, and improve their brand image.

‍

Third component: the influence of the internal price on decisions

Although the development of this tool is based on a voluntary act, it remains essential that it be adopted by all decision-making levels within a company. Indeed, if the internal carbon price is only used by the CSR department, its ability to sustainably influence the company's decisions will be almost nil.

To ensure a real transformation and decarbonization of the company, the relevant departments, particularly the finance department and employees of the various subsidiaries, must to adopt the tool and use it concretely in their analysis and decision-making process.

‍

How to implement an internal carbon price within an organization?

Although it is a highly effective and flexible emissions reduction tool, 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 from the Institut Montaigne, which are the result of their study on the subject and summarized below, are a perfect example of progress in this field.

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

1. To maximize the effectiveness of the internal carbon price, companies should base their pricing policy on market prices and incorporate a rising trajectory for the internal price to anticipate market price evolution.
   ‍
2. Integrating Scope 3 emissions into the internal carbon pricing mechanism is a decision that must be made with the company's stakeholders: suppliers, customers, and society.
   ‍
3. Discussing with the financial department the relative importance of carbon pricing compared to the various decarbonization tools being deployed is a good first approach.
   ‍
4. The European Commission's work on carbon tax and pricing should be monitored and studied. This is a key topic on the European agenda, as evidenced by the upcoming implementation of the MACF, the world's first cross-border carbon tax.
   ‍
5. Similarly, initiatives for pooling data and assumptions among various economic actors in a spirit of "coopetition" should be monitored.

‍

Concrete examples of internal carbon pricing for inspiration.

In 2020, CDP observed in Europe a 30% increase compared to 2019 in companies that have implemented or plan to implement an internal carbon price within 2 years. This trend is growing stronger 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 approaches to internal carbon pricing.

‍

LVMH: the internal carbon tax model.

As part of its LIFE program, the LVMH group created an internal carbon fund in November 2015 to contribute to the reduction of greenhouse gas emissions from its Maisons.

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

The funded projects 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 & Jerry's: an internal carbon tax to decarbonize its Scope 3 emissions.

Ben & Jerry's, the Unilever ice cream company, has implemented an explicit $10 price across its entire value chain. All GHG emissions from the farm production phase to waste management at the landfill are covered by this carbon tax.

The funds collected are then used to finance initiatives and strategies for reducing direct and indirect GHG emissions.

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

‍

Veolia: a guiding price to inform investment decisions.

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

This virtual price, expected to reach €31/tCO2e by 2030, allows for the integration of CO2 emissions into investment decisions.

‍

SNCF: a carbon price to rate its suppliers.

80% of SNCF's greenhouse gas emissions are attributable to its purchases, so the group has decided to apply a guiding price to its supplier ratings to ultimately reduce its Supply Chain emissions.

SNCF aims to progressively introduce carbon-related scoring criteria into all its calls for tenders by 2025. This scoring will notably be based on the SNCF group's internal carbon price, set in 2023 at 100 euros per tonne of CO2 equivalent.

The idea is to "bonus" or "penalize" supplier offers based on their CO2 equivalent emissions.

‍

These various examples of carbon pricing implementation clearly illustrate the diversity and adaptability of this mechanism for competitiveness and combating global warming.

‍

Tennaxia facilitates the definition of internal carbon prices and the financial management of decarbonization for businesses.

At Tennaxia we are convinced that reducing corporate emissions will not happen without a financial management of the climate strategy. Our platform addresses this issue by enabling companies to finely model CapEx & OpEx flows as well as the amortization periods for decarbonization levers.

This financial modeling of the decarbonization plan allows for:

• optimizing collaboration between climate and finance teams by basing discussions on reliable and precise data.
  ‍
• defining a carbon price by consolidating its Cash Flow with its carbon emission reduction forecasts.
  ‍
• to easily prioritize its decarbonization action plan based on both its carbon emission forecasts and financial projections. Any action with decarbonization costs lower than the internal carbon price set by the company will be easily identifiable and "prioritizable".

If you want to accelerate your decarbonization by managing it financially, we'll show you how here: -> request a demo