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How an Internal Cost of Carbon Influences Corporate Decarbonization Plans

by: Shehzad Wadalawala

What does it mean for a company to have an internal cost of carbon? 

A company’s internal cost of carbon is the price the company assigns to its greenhouse gas (GHG) emissions. The cost is typically not mandated by any external regulation but is a voluntary move by the company to guide its operational, financial, and strategic decisions to reduce its carbon emissions. 

Businesses can use their internal cost of carbon as a tool to quantify the economic impact of their carbon emissions, which integrates the consideration of climate change into business practices. A 2021 report by CDP showed increasing corporate adoption of internal carbon pricing (adoption grew by 80% in just over five years), including by many of the world’s largest companies. One of the report’s findings was “a correlation between the companies putting a price on carbon and those taking other strategic actions to integrate climate change issues into their business strategy as a means to reduce risk.” In other words, the report found that “internal carbon pricing goes hand in hand with emissions reduction activities.”

Why would a company set a cost of carbon? 

There are several reasons a company that is serious about achieving net zero goals or decarbonizing its processes would assign a cost to its carbon emissions. 

First, an internal cost of carbon encourages lower-carbon investments. It allows companies to evaluate investment decisions through a lens that favors low-carbon technologies and practices, reflecting the true environmental costs of their operations. 

  • It can influence the pricing of products or services by accounting for the GHG emissions associated with their lifecycle.
  • It encourages financial and operational decisions (e.g., where to site a new facility, or whether to invest in more sustainable designs or technologies) to favor options with lower emissions.

For instance, let’s say Company A is deciding where to site its next manufacturing facility. Facility X costs less on a dollar per MWh basis but emits more carbon; Facility Y is more expensive but has lower emissions. Depending on how much value the company attributes to carbon intensity based on its internal cost of carbon, it might prioritize the facility with cleaner operations.

A 2021 McKinsey report on “The State of Internal Carbon Pricing” noted that “internal carbon pricing was a key factor… in a European energy company’s decision to close several power plants, as the internal charge on increased carbon emissions cut into the expected profitability of those plants.” The smaller the internal cost of carbon, the more likely the company will just follow the dollars. The higher the internal cost of carbon, the more likely it will make decisions based on the carbon emissions. For instance,Microsoft did a blog post and webinar in 2022 about its internal cost of carbon and how that helped accelerate its decarbonization efforts.

Setting an internal cost of carbon also supports strategic planning and risk management by positioning a company for compliance with evolving carbon regulations (e.g., pricing mechanisms, taxes, or cap-and-trade systems). According to the aforementioned CDP report, more than 1,000 companies disclosed that “they are subject to carbon regulations, and an additional 717 companies expect such regulation within the next three years.” The authors conclude that “there is a direct correlation between [a company’s exposure to carbon pricing regulation systems] and the proportion of companies using or planning to use an internal carbon price.”

How does a company determine the cost of its carbon emissions?

There is no one-size-fits-all method for setting an internal cost of carbon. (However, the 2021 McKinsey article and a 2017 article from the Environmental Defense Fund suggest carbon pricing thresholds, which are arbitrary and lack a defined global standard, are too low and do not account for the true cost of carbon emissions.) The process typically includes:

  • Estimating the company’s current and future GHG emissions (both direct and indirect).
  • Setting the right emissions reduction (and clean energy) goals for the organization.
  • Considering the costs and benefits of various mitigation strategies. 
  • Considering current and possible future regulations, market conditions, and the cost of carbon in voluntary and mandatory carbon markets. 
  • Setting the price, typically based on external carbon pricing mechanisms, the cost of local carbon offset projects, or the estimated cost of in-house decarbonization.

What are some implementation challenges?

Assigning a price to a company’s carbon emissions can be tricky because it requires the right data (historical and forecasted), policy knowledge, and internal buy-in. A company must: 

  • Accurately measure its emissions (both direct and indirect), which can be challenging for businesses with significant supply chains;
  • Predict how those emissions will evolve (including both the company’s emissions and the emissions intensity of relevant electricity markets);
  • Anticipate regulatory changes; and 
  • Ensure internal and stakeholder buy-in.

Companies will also need to regularly review and adjust their internal carbon pricing to reflect changes in market conditions, regulatory landscapes, and their own operations. 

What’s the potential impact on decarbonization plans? 

The impact of setting an internal price on carbon depends on what a company is solving for. 

Let’s say a company is using the Valuation app in our Aria platform to solve for a 100% RE goal. In that case, the company wants to secure renewable energy credits at the lowest cost. A company with a 100% RE goal deciding between multiple clean energy projects would sort its options by each project’s implied REC cost (i.e., the net spend per MWh of renewable energy). The company wouldn’t consider the composition of the electric grid in terms of carbon intensity – it’s looking for a MWh of renewable energy in any grid and the most cost-effective way of purchasing it. Therefore, an internal cost of carbon, which does consider a grid’s emissions intensity, wouldn’t be meaningful for a company focused on 100% RE. 

Another metric a company can solve for in our Valuation app is GHG mitigation cost. This is effectively an implied carbon price. In solving for this goal, a company wants to know “What is my net spend per avoided or displaced emissions?” If the company is trying to prioritize potential decarbonization pathways and doing carbon accounting based on emissions rather than MWh of renewables, it will consider the emissions it’s avoiding relative to the net spend.

Solving for GHG mitigation cost typically shows that dirtier grids have more bang for the buck than cleaner grids. With this information, the company can prioritize investments and build a roadmap based on the decarbonization supply curve. For instance, many energy efficiency programs are to the left of the supply curve because they save money and reduce emissions; that is why most companies start their decarbonization journeys there. Clean energy procurement falls somewhere in the middle of the supply curve, with more advanced technologies (e.g., carbon capture and sequestration) to the right. 

Ultimately, the benefit of setting an internal cost of carbon depends on where a company is in its clean energy journey and what its goals are. It can be challenging to implement but can meaningfully aid a company in prioritizing its decarbonization roadmap and investments.