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Internal Carbon Pricing: A Powerful Tool for our Carbon Constrained Future

Emergent climate action, like carbon border tariffs, will increasingly challenge many Australian businesses. In response, many leading firms are turning to Internal Carbon Pricing (ICP)[1] to plan their response and efficiently guide future investment decisions for a carbon-constrained future.

“By setting an internal carbon price, companies can prepare for uncertain external pricing in the future, and investors can get a clearer picture of a firm’s ability to compete in a low-carbon world.”    

– Harvard Business Review, 2019

ICPs work by applying a risk-based price to greenhouse gas (GHG) emissions that are currently freely released into the atmosphere. By doing this, the true cost of doing business becomes clearer, meaning that different opportunities can be evaluated on a like-for-like basis. This drives rational decarbonisation, informed investment decisions, and sustainable profits.

The business case for setting an Internal Carbon Price

For any forward-looking business, setting an ICP is a logical course of action. We anticipate a growing uptake this decade echoing the recent rise in reporting under the Task Force on Climate-related Financial Disclosures (TCFD). However, like TCFD reporting, there are costs as well as benefits to implementing an ICP.

An ICP can add additional complexity to decision-making. This may cause a company to make investments in low carbon technologies that peers and competitors are not yet making. Similarly, it may cause businesses to identify that currently profitable markets are not sustainable in the longer term, causing short term profits to be foregone. Or, it may reduce reliance on (currently cheap) carbon offsets in favour of structural decarbonisation.

Against these issues, there is also a clear benefit to being ahead of the curve. Businesses with an ICP will be prepared for sudden impositions of external carbon prices (or carbon tariffs) and may avoid hostile investor actions. They could also lead future markets and exit others while the going is still good. To many, such benefits are becoming hard to look past.

“38% of respondents who work for a company with significant greenhouse gas producing activities are factoring in a carbon price in investment and/or operational decisions”
– The Carbon Market Institute Survey Report 2020

What price is the right price?

Once a company has decided that it is ready to implement an ICP, the next challenge is choosing the right price. Ndevr Environmental has worked with numerous companies to establish their ICP and some team members were involved in Australia’s billion-dollar Carbon Pricing Mechanism. Through our experience, we have distilled three principles that are key to setting the right carbon price for any business:

Figure 1. Principles for setting an ICP (Ndevr Environmental, 2021)

Our experience suggests that an ICP that increases over time is preferable, given the rise in demand for the residual global carbon budget and the tightening regulatory environment. This approach also means that short term, low-cost decarbonisation initiatives are pursued first, while higher cost, more marginal decarbonisation is delayed, often until technology matures. Getting the balance right is key to managing risk and prospering through the transition to a carbon constrained economy.

“Companies are preparing for inevitable carbon pricing reforms whether they be direct or indirect. There was a significant increase in internal carbon prices being reported, in 2020 75% use $20 or more, up from 63% in 2019 and 45% in 2018.”    

Australian Climate Policy Survey 2020, Carbon Market Institute 2020

Operationalising an Internal Carbon Price

Initially, ICPs tend to be used only to test the viability of major investments. However, they are most effective when treated akin to an externally applied carbon price. That is, all capital and operational expenditure is exposed to the ICP, with resulting revenues passed to a central accounting function, to fund broader decarbonisation initiatives. In this way, all cost managers are incentivised to reduce carbon emissions, and investments are truly stress tested against an externally imposed carbon price.

Figure. 2. Organisational Maturity and Operationalising an ICP. (Ndevr Environmental, 2021)

The transition from first implementing a limited ICP, to eventually allowing it to function as a fully-fledged shadow carbon price, is a long journey for many organisations. However, it is a process not unlike many other change management exercises. Executive buy-in, stakeholder engagement, and effective communication are key and the only path to success.

Ndevr Environmental has extensive experience designing and implementing sustainability initiatives including ICPs and guiding leading organisations on that journey. If you would like to know more about setting and implementing an ICP, please get in touch with us to find out more.

[1] Also known as a shadow carbon price

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