Internal Carbon Pricing: very unsexy accounting tools for the climate transition

There are very exciting new clean technologies being developed - solar and wind power, battery storage and electric vehicles – but the solution to the climate crisis might just be some boring, unsexy accounting tools like Internal Carbon Pricing.

What is an Internal Carbon Price?

Internal Carbon Pricing (ICP) is a simple accounting tool where the estimated cost of carbon emissions can be used as a planning tool within a firm’s operations help improve decision making, reduce costs and support a reduction in carbon emissions.  The ICP allows carbon emissions estimates to be converted into dollars so that climate objectives can be directly integrated into financial decisions.  The ICP can be used as a tool to drive climate action, but it can also be used to provide pragmatic decision making that incorporates potential future carbon pricing mechanisms or expected value that customers will place on a product with a lower carbon footprint.

How to apply an ICP?

There are two primary ways that firms use ICP. Some firms use the ICP like an internal carbon tax where operations pay a carbon fee based on there carbon emissions to a central fund that can then use the funds to invest in equipment to reduce carbon emissions.  This provides a strong financial incentive for plant managers or product managers to improve the climate performance of their department so they can reduce the internal tax payment and maximize their profitability.

The more common way to implement an ICP is as a shadow carbon tax where there are no internal fees paid but the cost of carbon can be included in cost analysis and decision making.  This allows firms to test different possible scenarios and make decisions that reflect possible future carbon taxes or market preferences. For example, if a real estate company is designing a new building and needs to select a heating system, they can use a range of possible future carbon prices to make an informed decision about the choice between a low-carbon heat pump or a traditional, high-carbon natural gas furnace. Converting carbon emissions to possible future operating costs can help to make a pragmatic business decision instead of being caught up in a climate discussion with no clear way of comparing the two heating options.

What value should you use for the ICP?

Choosing a reasonable ICP value or range of values is critical to the success of an ICP program.  The range of values needs to be defensible and represent the real risks to the financial performance of the firm.  Firms will typically use values that could range from 

• A low value from voluntary carbon offset markets (typically < $25/tCO2e)
• Local carbon pricing mechanisms (Canada = $80/tCO2e, EU = €79.90)
• Expected future carbon pricing mechanisms (Canada =$170/tCO2e by 2030, EU = €500/tCO2e by 2044)
• To a high cost represented by the expected Social Cost of Carbon (SCC). SCC is the estimate of the cost, in dollars, of the damage done by each additional ton of carbon emissions. Estimates vary significantly with ranges from $ 270 to $1,300/tCO2e. 

ICP Use in Canada

In Canada, the use of ICP is still in the very early stages. Only 35 of the 500 firms listed in the Financial Post Top 500 Corporations in Canada reported that they have used an ICP in their business (as of 2022) and even the companies using ICP are only using it for limited parts of their business.

One interesting thing about the use of an ICP in Canada is that the majority of firms using ICP have reported using values for ICP that correspond to the current range of carbon pricing specified in the Greenhouse Gas Pollution Pricing Act (GHGPPA). These firms used a range of ICP values (reported in 2023) with a low value of $50 or $65/tCO2e and a high value of $170/tCO2e.  This indicates that the carbon pricing strategy in Canada is having a direct impact on how forward-thinking corporations in Canada are making decisions to manage their future carbon emissions and their future carbon costs. 

Moving Forward

Carbon emissions in Canada decreased about 7% since the 2005 baseline year but Canada has targets to achieve a 20% reduction by 2026 and a 40 to 45% reduction by 2030. If you look at the emissions reductions by industry sector (see the graph attached) you can see that the electricity sector is achieving over 50% reduction in emissions, but most other industry sectors have seen no significant reduction or increases in emissions since 2005. The only way for Canada to achieve our 2026 and 2030 emissions reductions targets is for industry to start reducing their emissions which will take better climate accounting and better decision making. And one way to achieve this is through the implementation of very unsexy tools like Internal Carbon Pricing.