6 May, 2021 / Research
Q&A: Understanding carbon pricing
By Professor Gianfranco Gianfrate, professor of finance, EDHEC Business School
Professor Gianfranco Gianfrate explains the benefits of internal carbon pricing, how it is calculated and the risks for businesses
An increasing number of companies are looking at internal carbon pricing for risk management as well as supporting climate policy. But what is it and how does it work?
Professor Gianfranco Gianfrate, professor of finance at EDHEC Business School, answers ESG Clarity Intelligence‘s questions.
How does internal carbon pricing work?
An increasing number of global companies are adopting internal carbon pricing—also referred to as “shadow carbon pricing”— to make key decisions about their daily operations and long-term business models. Pricing carbon internally is a voluntary method for companies that allows them to measure the opportunity cost of emitting GHG emissions and to internalise the impacts of those emissions, even when all or part of their operations are not subject to external carbon regulations.
Carbon pricing is a source of both risk and opportunities for companies. Scenario-planning techniques and rigorous analysis of climate policy risks can provide executives with an overall view of how their business might evolve under different carbon pricing regimes. Developing this sophisticated information can enable managers to more effectively engage with regulators and policy-makers, investors, customers, and suppliers. They can identify investments and strategies that are robust to alternative future climate policy scenarios and those that can establish a stronger competitive position in the company’s markets.
Which businesses are doing it and what are the latest developments?
According to the Carbon Disclosure Project, nearly 2,000 in the world currently use internal carbon pricing or plan to do so in the near future. Many companies do not price carbon as a part of their business operations yet. This may reflect a number of factors. Some companies may be fairly energy and carbon-lean and thus changes in energy prices due to carbon pricing policies will have a limited expected impact on the company’s cash flows. Other companies do not have the capabilities to understand potential future climate-related regulations and policies, and they do not fully realise how exposed they are to climate change risks.
The growth in the use of internal carbon pricing following the 2015 Paris Agreement suggests that more and more firms recognise internal carbon pricing as an important tool in their operations. This trend also provides more opportunities for learning about the practice from those that have implemented internal carbon pricing. Only companies able to understand and to proactively manage carbon risks will sustain their competitive advantage in the long-term.
What are the key benefits from a business perspective?
Internal carbon prices are used in various settings. First, they are factored into the decisions about capital investments (especially when projects involve emissions reductions, energy efficiency improvements or changes in the portfolio of energy sources).
Second, the internal pricing of carbon is an instrument of risk management. As companies are increasingly exposed to regulatory and financial risks attached to the (potential) implementation of governmental carbon pricing regimes, they seek to measure, model, and manage such risks.
Third, internally defined prices of carbon integrate strategic planning activities in companies. Carbon prices are an important input for defining the long-term business model of a company, particularly for the identification of new strategic risks and opportunities.
How should firms calculate their internal carbon prices? Map emissions, & assess exposure to current and future carbon prices?
Companies should also quantify and locate both the direct and indirect carbon footprint. Direct GHG emissions (aka Scope 1 emissions) occur from sources owned or controlled by the company, for example, emissions from combustion in company boilers or furnaces.
Indirect emissions (Scope 2) consist of the CO2 released into the atmosphere because of a company’s consumption of purchased electricity, heat, steam and cooling.
Other indirect emissions (Scope 3) are a consequence of the activities of the company throughout its supply chain. Some examples of Scope 3 activities are the extraction and production of purchased materials, the transportation of purchased materials and fuels, and the waste disposal.
The distinction between direct and indirect emissions shows how even companies not operating in carbon intensive industries may actually be indirectly accountable for relevant carbon footprints and may have a supply chain that is highly exposed to carbon pricing risks.
What are the risks for businesses that don’t set internal carbon prices?
Many companies do not price carbon as a part of their business operations yet. This may reflect a number of factors. Some companies may be fairly energy and carbon-lean and thus changes in energy prices due to carbon pricing policies will have a limited expected impact on the company’s cash flows. Other companies do not have the capabilities to understand potential future climate-related regulations and policies, and they do not fully realise how exposed they are to climate change risks.
What should investors be asking businesses when it comes to carbon pricing?
Internal carbon prices enhance decision making for internal projects with cash flows impacted by carbon risks and allow better interactions between companies and their stakeholders, especially investors, concerned with carbon risks.
Carbon risks are impacting the cash flows of companies, especially large emitters. For instance, McKinsey finds that carbon-abatement efforts will put dramatically different levels of stress on the cash flows of different industries. The immediate impact on cash flows might be limited for now, but it will eventually be relevant in many industries. As carbon pricing influences current and future cash flows, firm valuations are affected as well. Therefore, effectively accounting for carbon pricing risk when measuring corporate value becomes of paramount importance for both executives and investors.
Part of the Bonhill Group.