Revving up for net-zero: the game-changing force of Internal Carbon Pricing

10 April 2024

It is truly encouraging to witness an ever-growing number of businesses ramping up their ambition levels by committing to bold climate targets. We’re all for it – but, as good as it is, there is much more that needs to be done. As the world won’t decarbonise on its own, mere aspirations will not suffice. A crucial next step is the implementation of tangible plans and initiatives to translate these targets into real-world impact.

Often, companies that fail to keep up with their climate targets share one common denominator as a root cause of inaction: financial constraints. There is a need to align finances with climate goals, or else mitigation cannot be achieved by countries nor organisations.

To address the issue, it’s time to let the climate target-setting trend meet another smaller but equally steadily growing trend within the climate realm, namely that of Internal Carbon Pricing (ICP).

There is no doubt that ICP is on the rise and becoming a popular buzzword among companies committed to climate action. The Carbon Disclosure Project (CDP) reports a rise of 80% in the adoption of ICP among companies globally between 2017 and 2020.

This is a very promising statistic as it infuses new hope for climate action becoming more aligned with finance. However, there is still a long way to go for it to become mainstream practice. We can’t act on something we do not know, so stick with us and let’s dive into the intricacies of ICP.

Let’s get down to the ABC of it

At COP26, Article 6 of the Paris Agreement’s rulebook on international cooperation through carbon markets was finalised, causing the public’s interest in ICP to spike.

ICP is described as a voluntary tool aimed at integrating the cost of GHG emissions into organisational financial decision-making. Companies can do so by setting an internal value for a unit of CO2e emissions. This price varies depending upon the trade regions as well as the individual company’s ambition level and objectives.

A carbon pricing scheme equips corporations with a concrete tool to curb emissions, manage climate-related business risks, and finance decarbonisation actions.

The monetisation of emissions allows decarbonisation to be considered in a company’s rational financial decision-making framework, seamlessly making low-carbon transition an integral part of the organisation’s business strategies, and effectively contributing to the progress of reaching those ambitious climate targets we were talking about before.

Companies are complex and nuanced, making it very hard to establish a one-size-fits-all approach – but that is precisely where one of the beauties of ICP lies. It allows companies to tailor their carbon pricing strategies to their own particular needs.

Connecting the dots: how can ICP help you reach your net-zero goals?

Article 2.1c of the Paris Agreement emphasises the commitment towards ‘making finance flows consistent with a pathway towards low GHG emissions and climate-resilient development’. However, as sustainability (for many) remains a side add-on and not a centralised imperative, there is still a clear misalignment between financial flows and sustainability. As a result, we typically encounter two issues when trying to implement climate action after commitments have been set:

  1. Limited budget: how much funding is available? How should one prioritise action among the many other important points on the sustainability agenda?
  2. The premium cost of sustainability: going for the less sustainable option is unfortunately oftentimes the most economically convenient one.

Assigning a price to an emission can cause it to either i) generate an actual financial flow on carbon, or ii) not generate a financial flow, but serve as input to inform critical decision-making.

In the first option, the collected amount can be used to fuel new sustainability funds that could help solve the above-mentioned limited budget issue. In the second case, the set emission price would be considered when making procurement and investment choices. This could cause the most sustainable (less carbon intensive) option to become the cheapest one, tackling the issue of premium prices of sustainability mentioned before. 

These two solutions represent the most commonly employed mechanisms of internal carbon pricing. In the official terminology used by CDP and the European Reporting Standards (ESRS), they are distinguished as carbon fees and shadow prices. Let’s dive a bit deeper into these two concepts.

The shadow pricing method helps to better understand how pricing GHG emissions affects the business case of projects. It is mostly used in capital expenditure (CAPEX) decisions.

A shadow carbon price might be used to anticipate future regulatory scenarios or assess the potential effects of implementing an internal climate fee on business operations. It is still important to keep in mind that while shadow price can provide valuable insights, it does not lead to direct financial flows. Hence, its true impact will depend on the wider decision-making criteria and cannot be used as the sole tool for initiating transformation.

By adopting a carbon fee ($ per unit of GHG emissions), a firm adds the cost of GHG emissions to its operational expenditures (OPEX).

When each operational unit of a firm factors the carbon fee into its decision-making, it creates incentives at a micro level to alter behaviour and implement changes, thus creating ownership for climate mitigation. The firm takes on the responsibility of ensuring that the right price is adopted. “The right price” will vary from company to company, but it should both possess the potential to create meaningful change whilst maintaining its ability to create the right incentives. The revenues from the carbon fee can be used to establish a low-carbon fund or be redistributed within the company.

Nothing worth having comes easy!

The road to ICP is not an easy one, often leading companies to fixate on any hurdles they may face rather than on the many advantages a solid carbon pricing scheme can offer. Therefore, we’d like to spotlight a case in which remarkable outcomes were achieved through the adoption of an ICP framework.

The example presents itself just around the corner from Copenhagen, namely in the Aarhus municipality located in East Jutland. There, an internal carbon tax was implemented on selected foods, air travel, and fossil fuel consumption. The results are astonishing:

  • Meat consumption in the municipality has fallen by 30%.
  • The amount of petrol and diesel consumption has also fallen by 13%.

And this has only been within the first year of implementation!

The takeaway: adopting an ICP comes with its unique set of challenges, and it certainly takes time to implement. But as the near-term target years approach, the need for action is becoming increasingly urgent. ICP can be a true force for change, finally bringing sustainability closer to the core of business strategy building and decision-making.

Author details

Caterina Krumbiegel

Consultant