The rules around how global businesses account for their carbon emissions are changing, and companies need to adapt. Carbon from manufacturing, transport and production of goods and services have historically been treated as an unpriced externality, but many governments and sustainability frameworks are now encouraging — or even requiring — companies to include a price on their emissions.
The Paris Agreement is explicit about carbon pricing playing the “important role of providing incentives for emission reduction activities.” Governments and compliance regimes around the world are increasingly implementing carbon pricing mechanisms (such as the EU’s Emissions Trading System) and are constantly creating new regulatory regimes.
ICP is a mechanism by which organizations incorporate carbon prices into their operational and strategic decision-making processes to assess the potential impacts of future mandatory carbon prices and market changes on the profitability of their current operations and the economics of longer-term capital deployment under forward-looking scenarios.
To prepare for these impending policy changes, many global businesses have already implemented or are actively considering incorporating ICP into their decision-making frameworks. According to CDP, the number of companies now using ICP in their operational decision-making doubled from 2016 to 2021, and hundreds more are planning to implement it soon. Companies adopt ICP mechanisms to help them not only meet regulatory requirements but also to benefit from ICP’s ability to enable more cost-effective decarbonization decision-making, as well as to allow for pricing of transition risks and opportunities into strategic considerations.
Businesses that have not yet implemented ICP systems are effectively assuming that the cost of their carbon emissions is zero and will continue to remain so. This is an increasingly risky assumption to make. As more regional and national governments around the world bring a growing share of global carbon emissions under a carbon price (through compliance markets or carbon taxes), ever more businesses will be required to pay regulators for their emissions. By putting a price on carbon, an ICP ensures that the likely future cost of emissions to a business is reflected in its operational and strategic decision-making today.
ICP systems come in many shapes and sizes, but they fall broadly into two categories depending on how they are monetized. Under a shadow pricing ICP system, for example, a business would use a hypothetical carbon price and assess its impact on operational cash flows and the financial return of capital projects to guide decision-making. However, no direct emission-related payments would be made under this type of ICP system. On the other hand, ICPs that implement carbon fees might require units of a business to make payments to one another or to central funds. An ICP mechanism can also begin as a shadow pricing system to provide a reference point and evolve into a mechanism of actual monetization further down the line once the business is comfortable with the concept of pricing carbon.
As noted above an ICP is essential to preparing for potential future regulation and updated disclosure requirements. It is also a key enabler of business decarbonization strategies and action plans.
An ICP can be a successful enabler of a business’ decarbonization strategy and action plan. Pricing carbon helps align different stakeholders around the common language of financial cost and savings of an activity or action, rather than simply talking about emissions generated or saved. If an entity or business unit incorporates the price of carbon into its activities, then decarbonization will begin to be part of everyday, and perhaps more importantly, long-run decision-making.
Without an ICP system in place, a business is more likely to make capital investment decisions that result in stranded assets in the future. Stranded assets occur when capital projects do not anticipate the cost of carbon and are suddenly faced with higher costs or operating restrictions because of future compliance with carbon markets or changing market preferences. An internal carbon price can mitigate potential investment in assets that may become stranded by properly evaluating the future cost of carbon from those capital expenditure decisions upfront.
Governments are rapidly adopting carbon pricing programs. For example, the European Union is set to launch the Carbon Border Adjustment Mechanism (CBAM) in October 2023. This new carbon pricing mechanism will affect any global businesses importing certain products into the EU, and by 2026 will introduce costs to cover the emissions embedded in carbon-intensive products such as steel and fertilizer. The proposed mechanism is intended to prevent the EU’s own carbon pricing established in the EU Emissions Trading System from negatively impacting the region’s trade competitiveness. CBAM is also designed to deter EU companies from simply relocating or moving to countries that do not price in carbon. CBAM will certainly have major implications for domestic industries importing carbon-intensive commodities into the EU, as well as for those exporting such goods to the EU — who will be incentivized to create lower-carbon products. Any company that trades with the EU will be inclined to establish its own ICP in order to ensure future decisions are in line with these impactful trade policies.
On a country level, Singapore has formalized a nationwide carbon tax. The tax has been set at an intentionally low S$5 per ton initially, but it will increase to S$25 per ton in 2024, and then to S$45 per ton in 2026, and may reach S$80 in 2030. In the U.S, states like California and Washington have established cap-and-trade auctions which directly connect carbon emissions with a dollar amount.
And while businesses are obliged to comply with carbon pricing regulations, companies with ambitious climate change programs are likely to come under increasing pressure to report their emission reduction progress. There are many established sustainability reporting frameworks that now stress and inquire about ICPs, including the Carbon Disclosure Project (CDP) and the Task Force on Climate Related Disclosures (TCFD). In the U.S., the Securities and Exchange Commission (SEC) — as part of their 2022 rule proposal to standardize climate-related disclosures — acknowledges the value of an ICP but is yet to require it as part of disclosures.
ICP systems work best when they are customized and adapted to factor in a business’s unique strategic objectives and goals. Regardless of the specific details of any one program, the following best practices are generally common to the most well-functioning ICP systems:
An ICP can be a relatively versatile tool, but not all ICP approaches accomplish the same goals. It is important to first understand the organizational objectives and build the program accordingly.
Just like a decarbonization strategy, an ICP implementation requires education, buy-in, and ongoing involvement from various stakeholders at all levels across the organization.
As noted above, ICPs must be carefully customized and tailored to a business’s specific objectives, goals, and nature of activities. In the early phases of an ICP’s implementation, focusing on the specificities of the ICP mechanism is more important than making sure that a “right” carbon price point is selected. Well-designed and implemented ICPs would be able to take “drop in” carbon price curves, as these are continuously revised and updated due to both regulatory and market changes.
Not only will there be challenges along the way as behaviors change, but it will be important to iterate and adapt the process along the way. Even if an organization is not currently ready for an ICP, it can begin laying the groundwork for future implementation now.
In order to track and price carbon emissions, an organization has to have a proper carbon data management foundation in place. More than just collecting the metrics, a robust carbon data management program to identify anomalies and validate data is essential.
As regulators around the world price an ever-larger share of global carbon emissions, more and more businesses will be required to pay for carbon emissions in the future. Businesses can prepare by implementing an internal carbon price that will not only ready them for future policy changes but will also enable more successful corporate decarbonization.
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