Understanding the internal carbon price for businesses

Carbon pricing, a lever for accelerating decarbonization.

Today's economic systems are mainly financially driven. That's why assigning a financial cost to each tonne of CO2 emitted, i.e. a carbon price, makes it easier for economic players to adopt climate issues.

There are a wide variety of carbon prices, but all aim to accelerate the reduction of carbon emissions. Some carbon prices are said to be "external" to companies, i.e. they are imposed by governments with the aim of reducing territorial greenhouse gas emissions. Other carbon prices are described as "internal" to companies, as they are set up and applied voluntarily by the companies themselves.

Governments were the first to set up external carbon pricing instruments on the carbon market. Today, there are two main external carbon pricing tools:

• Carbon tax. This is a direct tax proportional to the quantities of greenhouse gases emitted by businesses.
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• The emission quota system. This system, which sets a global limit on GHG emissions in a given region, distributes emission rights to the various players and oversees the trading of allowances between them. The European Union Emissions Trading Scheme (EU ETS) is the most extensive and advanced carbon trading scheme in the world. Not least because it is already progressively reducing the quantity 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 more or less similar carbon pricing mechanisms on their own scale. By 2021, over 2,000 companies worldwide were 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 shall see later.

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The different types of internal carbon price.

Internal carbon pricing is a flexible tool for corporate decarbonization , based today on voluntary participation and adaptable to corporate objectives. Three main forms of internal carbon pricing can be distinguished:

• TheShadow Price. This assigns an economic value to the carbon footprint of a company's investment or purchasing decisions, without generating any concrete financial flows. It's a theoretical value that makes it possible to 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, during calls for tender, the use of a guide price enables a more complete rating of suppliers by integrating suppliers' carbon emissions into the financial rating.
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• The Explicit Price or Internal Carbon Tax. This price directly links the greenhouse gas emissions generated by the company's activities to its operating costs. By following this carbon price, the company applies a self-imposed financial tax on the emissions generated by its activities. The purpose of this tax is generally to set up a fund to finance projects to control and reduce CO2 emissions. By voluntarily increasing its OpEx, the company finances its direct decarbonization in the short term and stimulates innovation for low-carbon solutions in the long term.
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• The implicit price or real cost of decarbonization. This carbon price reflects the cost of the actions and measures a company implements to reduce its carbon emissions. Calculated a posteriori according to the decarbonization actions and measures actually taken by the company, it represents a real measure of the costs of the low-carbon transition. In particular, it can be used to adjust a posteriori the other prices mentioned above. For example, when a company incorporates maximum emission standards for its fleet of vehicles into its purchasing policy, the price of carbon is not explicitly mentioned. Nevertheless, the introduction of this standard may lead to an increase in expenditure on this item; hence the implicit term.

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

Whether companies choose to adopt different versions of internal carbon pricing may depend on the sector in which they operate. High-emission sectors, such as energy, chemicals and materials production, will generally prefer to adopt only a guide price, as an internal carbon tax would entail very substantial transfers of funds. On the other hand, sectors with lower emissions, such as finance and services, may also opt for an internal carbon tax, in particular to raise awareness of their impact across all internal activities.

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Why set up an in-house carbon price?

Implementing an internal carbon price has five major benefits for companies:

1. Accelerate the decarbonization of activities, by directing decisions towards solutions with a lower CO2 impact. By reconciling financial and climate languages, the internal price of carbon enables better consideration of the negative environmental externalities of a company's activities.
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2. Anticipate changes in regulations, external carbon taxes or carbon market prices, which will increase over the coming decades. Companies with an internal carbon price will be able to avoid investing in carbon projects that are likely to become more costly and unsustainable in the future.
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3. Facilitate access to low-carbon funds and investments, by improving their ESG scores and extra-financial reporting;
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4. Reduce costs and identify low-carbon development opportunities, thanks to a new way of looking at activities and flows based on carbon prices.
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5. Help employees change their behavior internally, by translating the carbon footprint of the company's activities into a financial cost that is easier for everyone to understand.

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The 3 criteria you need to understand to choose the internal carbon price best suited to your company.

Internal carbon prices are made up of three components, all of which are essential to a proper understanding of the subject: the price, the scope covered and the level of influence. It is the combination of these three criteria and types of internal carbon price that enables each company to adopt the internal carbon price or prices that best suit its needs. That's why it's essential to have a good grasp of these parameters and categories.

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First component: price

Companies generally adopt their own internal carbon prices, depending on their context, organization, sector of activity and GHG emission reduction targets. For the implementation of 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 a company's short-term competitiveness by pushing it to finance over-ambitious projects with too low an Internal Rate of Return (IRR).

However, even if a customized internal carbon price is more effective at company level, it should be noted that a uniform carbon price would be more appropriate at the scale of global emissions. Indeed, a tonne of carbon emitted by a Chinese company will have the same impact on the climate as a tonne of carbon emitted in Europe, whereas the price of carbon is currently 10 times higher in Europe than in China.

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Second component: scope of coverage

According to the CDP, in 90% of cases, the internal carbon price only covers the company's direct emissions (scope 1).

However, the challenges of climate transition and corporate competitiveness mean that indirect emissions linked to energy (scope 2) and its value chain (scope 3) need to be taken into account. Indeed, accounting for scopes 2 and 3 enables companies to strengthen their value chain, make savings and improve their brand image.

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Third component: the influence of internal pricing on decisions

Although the development of this tool is voluntary, it is essential that it be adopted by all levels of corporate decision-making. Indeed, if the internal carbon price is only used by the CSR department, its ability to influence corporate decisions in the long term will be virtually non-existent.

To ensure a real transformation and decarbonization of the company, the departments concerned, in particular the finance department and employees of the various subsidiaries, need to take ownership of the tool and use it concretely in their analysis and decision-making processes.

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How do you set up an internal carbon price within your organization?

Although this is a highly effective and flexible tool for reducing emissions, the vast majority of companies are still struggling to implement effective carbon pricing mechanisms.

Nevertheless, knowledge and best practices are gradually developing, accelerating the adoption of in-house carbon pricing by companies. The recommendations of the Institut Montaigne, the result of their study on the subject and summarized below, are a perfect example of progress in this field.

Institut Montaigne's 5 recommendations to facilitate the implementation of an internal carbon price.

1. To maximize the effectiveness of the internal carbon price, the company will need to base its pricing policy on the market price and incorporate a trajectory of internal price increases in order to anticipate changes in market prices.
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2. Including scope 3 emissions in the internal carbon pricing scheme is a decision that needs to be taken with the company's stakeholders: suppliers, customers and society.
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3. Discussing with financial management the relative place of carbon pricing vis-à-vis the various decarbonization tools mobilized is a good first approach.
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4. The European Commission's work on carbon tax and pricing is one to watch and study. This is a key topic on the European agenda, as evidenced by the forthcoming implementation of MACF, the world's first border carbon tax.
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5. Similarly, initiatives to share data and hypotheses between different economic players in a spirit of "cooperativeness" should be monitored.

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Some concrete examples of internal carbon pricing for inspiration.

In 2020, the CDP observed a 30% increase in the number of companies in Europe having implemented or planning to implement an internal carbon price within 2 years, compared with 2019. This trend continues year on year and is spreading to all regions of the world, with multinationals leading the way.

Below you'll find 4 examples of companies with different visions of the internal price of carbon.

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LVMH: the internal carbon tax model.

As part of its LIFE program, the LVMH Group created an internal carbon fund in November 2015 to help reduce the greenhouse gas emissions of its Houses.

The fund is financed by annual contributions from each House, calculated according to their greenhouse gas emissions and the internal price of carbon, which has risen from €15 per tonne of CO2 in 2015 to €30 per tonne of CO2 in 2018.

The projects financed aim to improve energy efficiency, renewable energy production and carbon accounting. In 2018, the fund financed 112 projects and avoided the emission of almost 2,500 tonnes of CO2 equivalent per year.

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Ben and Jerries: an internal carbon tax to decarbonize scope 3.

Unilever's Ben & Jerry's ice cream company has introduced an explicit price of $10 across its entire value chain. All GHG emissions emitted between the production phase on the farm and the waste management phase at the landfill are covered by this carbon tax.

The funds raised are then used to finance initiatives and strategies to reduce direct and indirect GHG emissions.

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

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Veolia: a guiding price to guide investment decisions.

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

This virtual price, which is expected to reach €31/tCO2e by 2030, makes it possible to integrate CO2 emissions into investment decisions.

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SNCF: a carbon price to rate suppliers.

80% of the SNCF's greenhouse gas emissions are attributable to its purchasing, so the group has decided to apply a guide price to the rating of its suppliers in order to eventually reduce its supply chain emissions.

The SNCF aims to gradually introduce carbon rating criteria into all its calls for tender by 2025. This rating will be based in particular on the SNCF group's internal carbon price, set in 2023 at 100 euros per tonne of CO2 equivalent.

The idea is to "bonusser" or "malusser" suppliers according to their CO2equivalent emissions.

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These different examples of carbon pricing illustrate the diversity and adaptability of this mechanism for competitiveness and the fight against global warming.

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Traace facilitates the definition of internal carbon prices and the financial management of decarbonization for companies.

At Traace, we are convinced that reducing corporate emissions will not be possible without financial management of the climate strategy. Our platform responds to this challenge by enabling companies to accurately model CapEx & OpEx flows and the amortization periods of decarbonization levers.

This financial modelling of the decarbonization plan enables :

• optimize collaboration between climate and finance teams by basing discussions on reliable and accurate data.
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• define a carbon price by consolidating its cash flow with its carbon emission reduction forecasts.
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• easily prioritize its decarbonization action plan according to both its carbon emissions forecasts and its financial forecasts. Any action with decarbonization costs lower than the company's carbon price will be easy to identify and "prioritize".

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