Bringing externalities in-house: what is an internal carbon price and should my business be implementing one?


Carbon emissions don’t respect national borders, so tackling a global problem like climate change is ultimately going to require a global solution. And slowly but surely the prospect of a worldwide price on carbon emissions is beginning to seem more likely, particularly following the latest international climate change agreement coming out of the Paris COP 21 talks.  This lays the groundwork in Article 6 for creating mechanisms and markets to reduce carbon emissions, both multilaterally and globally.

There is already considerable momentum behind carbon pricing around the world, with existing regional, national and subnational schemes currently covering around 12 percent of global emissions. Carbon taxes or emissions trading schemes are either operational or planned in the EU, USA, China, Japan, South Korea, Switzerland, Norway, Turkey, Mexico, Chile, Thailand, Ukraine, Kazakhstan and South Africa.

With a strong global commitment to limit global warming to no more than 2 degrees, alongside the urgency of the challenge of addressing climate change, there is every reason to expect carbon pricing to continue its expansion.

The volume of emissions covered by such schemes has trebled over the past decade. China’s regional pilots are expected to turn into a national scheme from 2017. States in the USA and provinces in Canada are already linking their cap-and-trade schemes, with Mexico currently looking to get involved from 2017.

These are markets that matter for many companies, where paying for carbon emissions is becoming part of the cost of doing business.

In response to these schemes, or in anticipation of future carbon pricing legislation, this year the CDP reported that 437 large companies say they now use an internal carbon price in decision-making. This is an increase from just 150 in 2014. A further 583 companies reported that they intend to use an internal carbon price in the next two years.

But what actually is an internal carbon pricing and what are the advantages of implementing one?

There is no single method or price that is used. Broadly speaking, internal carbon pricing is most frequently used as a shadow price which can be added to future investments and operational costs as a way of hedging against future policy decisions to implement any carbon pricing mechanisms. 

As described in company testimonies contained within CDP studies, some of the key benefits of doing this include:

  • To anticipate government legislation on carbon pricing

  • To comply with existing government legislation

  • To avoid intermediary/transaction costs associated with trading permits in national schemes in favour of factoring in these prices internally

  • To justify investments that may have smaller margins without a carbon price

  • To manage risk for future investments

  • To monetise and record social cost

In some exceptional circumstances, a carbon price can underpin a more expansive company scheme. In 2012, Microsoft made the decision to use an internal carbon fee which was charged individual business groups using Microsoft services. The funds from this internal tax were then used to invest in energy efficiency initiatives, renewable energy and carbon offset projects in order to meet net carbon neutral targets.

Since 2014, 100% of Microsoft’s energy consumption is sourced or offset due to these projects. In just three years, the company has reduced its emissions by 7.5 million tonnes of CO2 and saved more than $10 million on energy costs. This year it expects its scheme to amount to $20 million of internal charges.

Useful work on carbon pricing implementation is starting to emerge to address these questions such as a recent study from the World Resource Institute and Caring For Climate. This finds one of the common challenges to setting an internal carbon price is a lack of guidance in knowing what price to set. This is related to a lack of clarity and certainty from climate policies at a national level. There are also issues with prices being set too low to actually affect investment decisions.

The good news is that it may be getting easier to predict the future. Many countries have now pledged to implement a carbon pricing mechanism as part of their Intended Nationally Determined Contributions to action on climate change, submitted in Paris. The agreement by governments in Paris, alongside demands for action from the broad coalitions of corporates that came together, suggests that legislative action on carbon pricing will only become stronger.

Analysis by the UK government’s Department of Energy and Climate Change and the Carbon Trust estimates that in a scenario where warming is limited to less than 2 degrees, the global price of carbon is expected to converge at $140 per tonne of CO2 by 2030 and $400 by 2050.  In a 1.5 degree scenario these costs would be considerably higher.

Predicting the future and making decisions is one of the great challenges faced by the executives and non-executives responsible for long term corporate strategy. Climate change will create both winners and losers, but setting an internal carbon price will help companies to better address the risks they face and choose the path needed for success in a sustainable, low carbon future.