The Hidden Toll: Integrating Carbon Costs into Corporate Investment Decisions

Concerns about corporate carbon footprints are not just for sustainability teams anymore. With governments and compliance regimes increasingly putting a price on carbon and creating mechanisms to make polluters pay, the greenhouse gas emissions (GHGs) within a business’s portfolio now come with real financial risks. GHGs generated by the operations, transport, and purchased goods and services of businesses and new assets, whether greenfield or to be acquired, can no longer be treated as an unpriced externality unrelated to the cost of ownership. The ‘future carbon bill’ will eventually come due. Companies need to plan for it now.

When developing their financial planning and investment strategies, some businesses underestimate or overlook the potential magnitude of the future carbon costs adhering to their acquisitions or expansions, exposing themselves to significant risks. This exposure is not surprising, as many of these costs are hidden. However, there’s a well-established mechanism called internal carbon pricing (ICP) that can unearth the hidden cost of carbon in a company’s operations and supply chains and integrate it into the long-term business case for a project or acquisition. Introducing an ICP program is a smart way to mitigate the risk of unexpected carbon expenditures and safeguard an organization's pathway to decarbonization.

The Growth of Carbon Pricing

Carbon pricing tools are being used by governments to reduce carbon emissions through a market mechanism to shift the burden of the costs of those emissions onto their emitters. The revenue generated can be used to invest in national decarbonization programs, climate adaptation, and innovation, among other initiatives. According to the World Bank’s 2024 report, in 2023, carbon pricing revenues reached a record $104 billion and covered 24% of global emissions with the use of 75 carbon pricing instruments worldwide. Governments are rapidly adopting carbon pricing programs, such as the EU’s Carbon Border Adjustment Mechanism (CBAM), which is in a transitional phase and will enter into force in 2026. As more regional and national governments implement carbon pricing, more businesses will have to pay regulators for their emissions.

Carbon pricing comes in two main forms: emissions trading systems (ETS)–also known as cap-and-trade–and carbon taxes. With an ETS, a regulator caps the total level of GHGs and sets a price at which emission allowances can be bought or sold on a market, effectively imposing ICP on that market. Carbon taxes also have two forms: an internal payment scheme, which might require business units to make payments to one another or to central funds based on its GHG emissions; or, more commonly, a shadow price, which is a notional carbon price businesses use to understand the economic implications of risk impacts, investment appraisals, and business decisions, without any cash transaction.

The purpose of carbon pricing is to enable long-term planning and investment decisions, encouraging low-carbon options. Businesses that have not yet implemented ICP systems effectively remain willfully unaware of the potential expenses headed their way. This is an increasingly risky position to take, particularly when making an investment decision.

The Risks of Not Pricing Carbon

The total carbon price may include long-term abatement costs or the social and reputational costs of carbon emissions. A more practical approach for corporations, as discussed here, may be to consider costs directly linked to expenses and revenue. We observe that corporations are typically exposed to two main carbon cost risks that ICP mechanisms consider when assessing business acquisitions:

1. Transitional Cost: The costs associated with transitioning to a low-carbon future due to evolving policies and market preferences, such as carbon taxes or emissions restrictive policies, that make carbon more expensive over time. Generally, the first public policy step will be the elimination of fossil fuel subsidies. The next step will be to tax the fuel itself. These taxes will mainly be aimed at large energy generators. Yet while many companies will not be directly taxed, they will still feel the impact of policy changes in the form of rising energy costs. If the financial assessment of a business to be acquired does not reflect the higher cost of emissions-intensive energy sources in the future, it cannot provide a complete picture of that business’ future health.
2. Cost of Decarbonization: These are the hidden costs that can be overlooked in financial valuations if a company is not using ICP. The reason they are hidden is that they depend on the decarbonization ambitions of the company and reflect hypothetical expenditures needed to meet those targets in the future. For instance, say a company has set an emission reduction target of 50% by 2030. Any new ton of carbon they bring into their business via an investment acquisition takes them further from that target, which means they will have to invest more in decarbonization levers or carbon offsetting mechanisms to meet their targets, at the risk of failing to meet their public commitments. ICP makes these expenses visible.

The risk becomes considerable when acquisitions or investments are in hard-to-abate sectors, such as mining, manufacturing, and power generation in markets with limited decarbonization levers (e.g., renewable energy capacity). In such cases, the difficulty of reaching decarbonization targets increases exponentially.

Hypothetical Case Study: Cosmetics Manufacturing Facility

In this hypothetical case study, we examine the carbon costs associated with acquiring a cosmetics manufacturing facility to demonstrate what an ICP analysis can reveal about future risks, and why finance functions should manage carbon-related considerations. In this study, an asset management firm is looking to acquire a cosmetics manufacturing facility. Below are the key elements of the carbon cost derivation:

• The asset management firm has a Net-Zero-by-2030 target, so any emissions introduced by the acquisition will have to be decarbonized from 2030 onwards.

• The firm has chosen to use carbon credits to offset their Scope 1 emissions (as part of the firm’s residual emissions that can be offset with high-quality carbon credits).

• The firm’s Scope 2 emissions will be decarbonized via Renewable Energy Certificates (RECs).

• The facility is located in a market with carbon taxes applied to power generators, so any Scope 2 emissions will incur additional costs due to energy companies passing these expenses on to their customers.

Any acquisition/investment will introduce new costs to the asset management firm and must be accounted for during the valuation stage. Three long-term scenarios are shown as the cost of carbon is expected to be the most “hidden” in the future. In addition to the current policy scenario (policy environment as of today), we ran a transition scenario, which considers a modest level of decarbonization above today’s commitments by the host country of the target, as well as a low-carbon scenario, which is more ambitious but falls short of the country achieving Net Zero by 2050.

The picture is very clear. Corporate finance functions need an ICP process or tool that efficiently integrates the cost of carbon into the investment decision-making process and provides valuable insight into the overall evaluation. Neglecting carbon costs and their risks can lead to unrealistic expectations and turn investments into liabilities, while companies that adopt ICP benefit from its ability to enable more cost-effective decision-making about decarbonization, as well as allowing for the pricing of transition risks and opportunities into strategic considerations.

Practical Steps for Implementing ICP

There are two main types of ICP that companies can implement: payment schemes and, more commonly, shadow pricing. Each is a key enabler of business decarbonization strategies and action plans, helping to align stakeholders on the idea of considering carbon in the cost-benefit analyses of all types of activities.

They are also helpful in avoiding capital investment decisions that could result in future stranded assets, where the failure to anticipate the cost of carbon and market preferences can lead to financial nonviability or non-compliance. Essentially, ICP can be viewed as a tool to bridge strategy and investment. Additionally, banks, rating agencies, and IFRS S2 Climate-related Disclosures are asking companies to share how they are pricing carbon internally and factoring it into decision-making.

Here is a four-step approach that businesses can use to incorporate carbon costs into the financial investment decision-making process:

Step 1: Baselining emissions – Establish an emissions baseline from which to gauge the investment’s exposure to carbon costs (via its emissions profile) in the first year of operations. This can be challenging during accelerated investment timeframes and may require a suitable proxy approach when actual emissions data is unavailable.

Step 2: Project emissions – Forecast the baseline emissions through the end of the investment’s lifetime to estimate its total carbon output and costs. This includes assigning value to carbon streams. Simple and reasonable proxies, such as operational data and targets, may be used for forecasting due to the complexities of accurately projecting emissions in the future.

Step 3: Calculate carbon costs – With a clear projection of the investment’s emissions across all relevant emission scopes in hand, it is possible to calculate the associated carbon costs over its lifetime, including the two types of costs discussed above: decarbonization costs and transition costs.

Step 4: Incorporate carbon costs into financial valuation – Insert the carbon costs as a new line item in the investment’s financial valuation or annual cash flow assessment. The investment team can then continue with their valuation (e.g., NPV or IRR derivation) and proceed with decision-making.

Taking this approach, the future price of carbon can be integrated into the company's current accounting, providing confidence that it is prepared for long-term decarbonization.

Complexity Is No Excuse for Inaction

Developing a suitable ICP mechanism can be highly complex. Nonetheless, ICP is crucial when it comes to gauging the viability of your investment strategy. Incomplete or limited data (e.g., for carbon price forecasts or emissions data) should not justify inaction, as an approximation of emission volumes can be made using operational data or revenue to identify a baseline of intensity factors in various sectors and give an indication of the associated carbon costs.

Similarly, the challenges of integrating future costs into existing business processes and obtaining stakeholder buy-in should be resolved efficiently to obtain the business’ carbon costs, as it is vital to conduct an assessment during the financial analysis.

Notwithstanding the multiple challenges of implementing an ICP mechanism, it is better to gauge the potential cost of carbon than to not conduct any cost assessment at all, as that would leave a company exposed to the risk of underestimating the hidden future costs. This lack of visibility could significantly erode profit margins and make projects financially unsustainable.

Companies cannot afford to delay the roll-out of an ICP mechanism. They should move swiftly to ensure that carbon costs are captured as soon as possible to gain visibility on their potential investments.