Adopt an internal carbon price to drive decarbonization

Internal Carbon Pricing (ICP) is a strategic planning tool that companies can adopt on a voluntary basis (hence internal), thereby assigning a value to each unit of CO2 emissions. Corporations have recognized the efficacy of internal carbon pricing as a potent instrument for identifying climate-related value, managing climate-related business risks, and proactively preparing for the shift toward a low-carbon economy.

There are four main mechanisms through which a company can implement an internal carbon price:

• Shadow carbon price: This type of ICP is an informative hypothetical cost per tonne of carbon emissions. This enables decision-makers to consider carbon costs when making investment decisions, although no actual financial flows are generated. Typically, shadow pricing is applied to capital expenditure (CAPEX) decisions, but can also be used in research and development (R&D), procurement decisions, and elsewhere. It may help organizations assess the financial impact of future carbon regulations, or market changes towards low-carbon products, and plan for potential operational changes in the future.

  This type of carbon price supports the selection of projects or products, and can be easier to implement.

• Implicit price: This type of ICP is used as a notional value and critical decision-criteria, without necessitating explicit charges per ton of carbon emitted. Implicit prices are estimated costs of carbon emissions that are used for strategic planning and internal assessments. It supports decision-making, by integrating a carbon price into business processes to guide strategic investments and project approvals, by merging emissions costs into overall financial evaluations. It is advantageous as it encourages low-carbon strategies, supports financial risk management by anticipating future carbon costs in the market, and prepares companies for potential stringent carbon emissions regulations.

• Internal Carbon Fee: A direct charge that is self-imposed by the organization on business units based on their carbon emissions. This approach allows companies to internalize the environmental cost of their operations. The collected fees can be and often are used to fund sustainability projects within the company, such as energy efficiency upgrades or renewable energy initiatives. It creates a clear financial incentive to reduce emissions.

  • Internal Carbon Tax: A carbon tax represents an actual cost per ton of carbon emissions. The tax is levied across business departments, with money being transferred within the business. This results in actual financial flows and the fee earned may either be redistributed within the business or utilized to create a fund (for any purpose in theory, but can be used to further emissions reductions such as for the compensation of residual emissions, for example). This approach can also be implemented through an internal system of allowance and trading (see next).

  • Cap & Trade: Within a company, this system sets a cap on the total amount of greenhouse gasses that can be emitted by a business unit. Business units may then trade emissions allowances among each other, just like in any other trading system. The market thus incentivizes business units to cut emissions from their operations and products. Some companies have piloted cap-and-trade internally.

• Hybrid approach: Some of these approaches can be combined within a single company, as they may serve different purposes. For example, a shadow price can be applied to projected emissions of future investments, while a carbon tax can be applied to current emissions.

In summary, internal carbon pricing can be a powerful tool for incentivizing low-carbon behavior and decision-making, and thus help companies meet external regulations. More than an information tool, an effective carbon price can and should be an integral element of decision-making processes (financial and otherwise), with the ability to garner buy-in from key stakeholders.

According to CDP, in 2020, more than 2,000 companies – including nearly half of the world’s largest companies by market cap – disclosed that they are currently using or planning to implement an internal carbon price within two years. This represents an 80% increase in the number of companies planning or using an internal carbon price in just five years. This is expected to continue increasing alongside external pressures from climate regulation and carbon taxes.

• Internal Carbon Fee: Microsoft has been using an internal carbon fee since 2012 to fund its carbon reduction and renewable energy initiatives. In 2022, Microsoft increased its carbon fee to 100$/tCO2eq for its scope 3 business travel emissions, as part of its goal to become carbon negative by 2030.

• Implicit Price: Bayer has set an implicit carbon price of €100 per metric ton when calculating capital expenditure projects. This approach is used to assess the net present value of climate-forward projects and increases their priority. The value was based on abatement curves for emissions reduction, energy taxation trends, and comparison with high-quality energy attribute certificates for renewable gas.

• Shadow price & internal carbon tax: Unilever in 2021 decided to make the use of an internal carbon price signal mandatory for all capital investment projects where the investment is >€1M, covering approximately 80% of their total capital investment. In parallel to the company-wide approach, two brands use internal carbon pricing to create their own sustainability investment funds. Ben & Jerry’s and Seventh Generation both apply a carbon tax to their lifecycle emissions to create dedicated sustainability funds.

• Carbon levy: Swiss Re set an internal carbon levy of 100$/tCO2eq in 2021, with the aim of linearly increasing to 200$ by 2030, including scope 1, scope 2, and part of scope 3 (business travel). The company aims to incentivize concrete actions on emissions reduction and to finance the compensation of residual operational emissions through 100% high-quality carbon removal projects by 2030.

Addressing Scope 3 emissions, beyond business travel, using internal carbon pricing, presents unique challenges. To effectively incorporate carbon cost into decision-making, businesses may:

• Integrate the internal carbon price into procurement tenders, investment evaluations, and product development processes.

• Use a carbon shadow price to evaluate low-carbon switches between suppliers.

• Use internal carbon pricing as a way to engage suppliers in the company’s decarbonization efforts.Implement complementary policies and targets, such as effective carbon accounting, ensuring a comprehensive approach.

Climate impact

Targeted emissions sources

• Scope 1 & 2: ICPs can inform the prioritization of projects that lower emissions from direct operations

• Scope 3: ICPs can facilitate the selection of low-carbon products and services across the supply chain

Business Impact

Benefits

ICPs are a powerful approach to integrate climate into existing financial processes because they are customizable to achieve climate goals; flexible to evolve with changing needs; and informative as they provide transparency as a critical input for climate-related decision-making. Depending on ICPs are implemented, they can help companies to:

• Place carbon and emissions considerations at the center of regular business operations and decision-making

• Ensure (some) actions to reach reduction targets become cost-positive/cost-neutral

• Diminish risks of future imposed carbon prices

• Understand carbon risk in your operations

• Generate financing for sustainability initiatives

• Raise awareness, both internally and externally

• Reduce GHG emissions

Costs

An internal carbon price might require upfront investment and additional FTEs to adjust current companies' processes and tools. The cost implication depends on the type of ICP implementation, for example:

• Shadow price: no financial implications; is used purely for evaluating potential costs without affecting financials directly.

• Implicit price: may impact decision-making and could involve some upfront costs, although primarily used for internal calculations.

• Internal carbon fee (internal carbon tax or cap and trade): may have upfront costs but can lead to significant savings over time by encouraging more sustainable practices.

Key parameters to consider

Besides the internal carbon price mechanism, companies must reflect on additional dimensions:

• Emission sources: what are the GHG scopes that the ICP covers

• Business application scope: what is the process(es) or emission category to which the ICP will apply (e.g. capital expenditure decisions, portfolio decisions, operational decisions, remuneration decisions). ICPs can be implemented to specific decision processes or for entire business units, and should be embedded in performance management and budgeted to impact operational decisions

• Carbon price level: what carbon price (e.g. in USD/tCO2) will be used

• Update frequency: how frequently the ICP will be revised to remain aligned with market dynamics, regulatory frameworks, and organizational goals

• Indirect mitigation effect expected:

  how binding is the mechanism and how strong of an impact impact does it have on decision-making and company behavior, even if there is no enforced financial penalty.

• Cost implication: ICP might require upfront investment and additional FTEs to adjust current companies process and tools

Implementation and operations tips 

When designing an ICP there are key factors to consider and steps to take [See Figure 3. For an overview on guidance to design a tailored ICP]:

Figure 3: Key considerations with developing an internal carbon price (ICP) in an organization.

1) Identify your ICP use cases for decision-making, for example:

• Investment Analysis: Incorporate into investment valuations to better understand climate-related opportunities and risks, and the costs of emissions, guiding investments towards low-carbon technologies and solutions.

• Operational Processes: Apply as an operational expense at the business unit level to motivate driving towards sustainability targets, such as improved energy efficiency and embedded cost of emissions into financial planning.

• Procurement Evaluation: Factor emissions costs into procurement evaluation to encourage supply chain decarbonization and ensure supplier alignments with environmental standards.

• Regulatory Risk Mitigation: Use to manage financial and regulatory risks, adapt to regulatory changes, and meet stakeholder expectations, thus protecting compliance and enhancing market position.

2) Define the structure: ICPs vary widely in their complexity and maturity across companies. Organizations should select a structure that aligns with their strategic objectives, risk appetite, and operational frameworks. Companies should begin with an initial setup and remember that the type of ICP can evolve to better suit changing needs and insights over time; common structures include [See ‘Solution’ section for detailed description of approaches]

• Shadow Price

• Implicit Price

• Internal Carbon Fee

  • Internal Carbon Tax

  • Cap & Trade

3) Set and evaluate the price: The price level for an ICP can be set in various ways. Companies should consider a few key factors to determine the most appropriate carbon pricing strategy:

• Price variations: Decide whether the carbon price will be static or variable and whether it will differ by region or business unit, or be a single price across the entire company.

• Price benchmark: Companies are recommended to set realistic but ambitious prices, to put the financial pressure to drive internal change. The price can be guided by

  • Market prices (e.g., EU ETS)

  • Regulatory values (e.g., US Social Cost of Carbon)

  • Internally-derived figures linked to company-specific efforts (e.g., MACC-related efforts) or set prices, which are ambitious but still practical and simple to communicate (e.g., ~$100 / ton of CO2, as a few companies have done); companies should first gather accurate baseline emissions data and benchmark carbon prices against regional, industry, or company-specific standards and benchmark against competitors and other peers to assess effective price ranges. [See article on how to Leverage MACCs to Inform Decarbonization Strategy]

• Price effectiveness: To assess price feasibility and impact, companies could use forward-looking models or back-test scenarios to evaluate how the price could influence past decisions, thus gauging its likely influence on future strategies.

• Other considerations to find the appropriate internal carbon price include

  • Investment required to reach target

    • Base the ICP level on total decarbonization investment needed and the total GHG emitted. Creates a direct link to the established CO2 abatement targets; Does not directly consider the impact on individual business decisions.

• Regional regulation analysis

  • Leveraging current and planned regulatory carbon prices (e.g., EU ETS, China ETS). Ensures that price levels factor in the regulatory environment and addresses regularity risk. Does not guarantee that objectives will be met.

• External reference

  • Recommendations from external research institutes and agencies (e.g., CDP Carbon Price Report, CDP carbon pricing corridors). Can help provide credibility for the chosen price level.

• Historical testing

  • Testing what price would have been needed to change historical decisions.

    Beneficial as the price level is tested on real-world cases to ensure that objectives are met

All told, getting started with a price is key; prices can advance over time to meet climate targets and can be adjusted as needed.

4) Embed the ICP in the company: Companies should ensure it is embedded across all business units including strategy, finance, HR/incentives, risk & compliance, and operations. Establishing robust monitoring and reporting processes is crucial to maintaining the ICP's relevance and effectiveness in driving climate action.

Tip: The key to successful carbon pricing is to keep it simple. Companies should start with implementing a straightforward and impactful ICP so it is easy to adopt across the business. The ICP can evolve o meet growing business and climate needs.

Tip: Remain flexible to test & learn with an ICP—no one-one-size-fits-all.

Gain stakeholder support: To successfully implement an Internal Carbon Price (ICP), companies often need to overcome the challenge of securing executive management buy-in and support from key stakeholders. This process typically involves engaging and persuading decision-makers about the benefits and strategic importance of the ICP, which may require:

• Demonstrating the benefits of internal carbon pricing for different functions and the organization as a whole.

• Integrating the internal carbon price into existing processes and fostering collaboration among various organizational units.

• Conducting a business scenario analysis showcasing the anticipated CO2 price in the medium and long term.

• Linking variable compensation targets to the implementation of the internal carbon price.

• Starting with pilot projects focused on high-impact areas and scaling up, while prioritizing based on business value

• Demonstrating the purpose of the initiative (i.e., funding carbon reduction and removal efforts)

[For additional resources related to this topic see Build partnerships through alliances and co-investments - Action Library (EN)]