Internal Carbon Pricing (ICP): Decarbonization Investment Decision Making Process

Internal Carbon Pricing

Internal Carbon Pricing (ICP) is a strategic tool that companies use to make rational decisions for decarbonization investments. By putting a price on their carbon emissions, businesses can include environmental costs in their financial planning.

This helps prioritize investments that have the best environmental and financial impact. ICP aids in identifying strategies to reduce carbon footprints and prepare for future regulations. This proactive approach supports sustainability goals while fostering innovation and competitive advantage.

Diagram 1: Explanation of ICP

Internal Carbon Pricing (ICP) is a voluntary mechanism companies adopt to promote decarbonization and sustainability within their operations. Unlike traditional carbon pricing systems, which are imposed by governments to compel corporations to reduce emissions, ICP is set voluntarily by companies themselves.

This proactive approach demonstrates a commitment to sustainability by incentivizing departments to invest in carbon reduction efforts.

REANGLE interprets ICP as a powerful tool that encourages decarbonization within organizations, aligning business practices with sustainability goals.

Function of ICP

• Promotes Decarbonization: Encourages departments to invest in carbon reduction efforts.

• Voluntary Commitment: Unlike government-imposed carbon pricing, ICP is set by the company.

• Benchmarks for Effectiveness: Measured against implicit carbon costs to refine strategies.

Dynamic Decision Making Based on Global trend propelled by Sustainability Policies

Diagram 2: Carbon Abatement Cost and ICP

ICP allows companies to adapt their strategies based on various factors, including carbon abatement costs and projected climate risks. This flexibility enables companies to make informed decisions that align with both their sustainability goals and global trends.

The carbon abatement cost can vary under different scenarios, such as the 2°C scenario, which often requires stricter measures and advanced technologies to reduce CO₂ emissions significantly.

Adaptability of ICP

• Adjustable Pricing:

• Lower Price: When decarbonization efforts weaken, the price can be lowered to maintain normal activities.

• Raise Price: When efforts strengthen, the price can be raised to further promote climate change management.

• Adaptability: Allows companies to align their activities with global trends and decarbonization efforts.

Effects of Implementing ICP on Stakeholders

Implementing ICP benefits both internal and external stakeholders by facilitating future-oriented decision-making and demonstrating a commitment to sustainability.

Internal Effects:

• Future-Oriented Decisions: Focus on long-term low-carbon investments and strategies.

• Enhanced Flexibility: Adapts investment strategies based on global trends.

• Standardization: Visualizes CO₂ reduction contributions, ensuring fair rewards and penalties.

External Effects:

• Public Commitment: Articulates the company’s carbon price, balancing economic performance and climate initiatives.

• Compliance and Transparency: Aligns with initiatives like the Carbon Disclosure Project (CDP) and the Task Force on Climate-related Financial Disclosures (TCFD).

Three Types of ICP

Diagram 3: 3 types of ICP

Shadow Pricing

Shadow pricing assigns a hypothetical cost to carbon emissions to guide investment decisions without actual financial transactions.

• Hypothetical Cost: Evaluates and influences investment decisions.

• Assumption-Based: Utilizes external prices like Carbon Credits Prices (EU ETS).

Implicit Pricing

Implicit pricing reflects the indirect cost of carbon in operational or investment decisions, often through energy efficiency initiatives.

• Indirect Costs: Reflected in operational decisions.

• Performance-Based: Calculated from past performance, encouraging cost-efficient decarbonization standards.

Internal Fee

An internal fee sets a price on carbon emissions charged to business units within the company, creating a financial incentive to reduce emissions and fund sustainability projects.

• Financial Incentive: Charges business units to fund sustainability projects.

• Actual Cost: Based on the cost of low-carbon investments and decarbonization activities.

Pricing process selection based on difficulty of pricing and effectiveness of decarbonization project

Diagram 4:  Accuracy of Carbon Prices and Feasibility of Decarbonization

External Price/Benchmark (Shadow Price) 

This involves using prices such as Carbon Credits Prices (EU ETS) to set a hypothetical cost for carbon emissions. Companies often use this external benchmark to estimate the financial impact of their carbon emissions and to inform strategic decisions on sustainability investments.

Industry Comparable (Implicit Price) 

This method uses the $/t-CO2e reduced published by companies in the same industry or sector. By referencing peers, organizations can gauge their own carbon pricing in relation to industry standards, ensuring they remain competitive while pursuing decarbonization efforts.

ICP  (Implicit Price) 

An example is Temasek increasing its ICP to USD $100. This approach involves setting an internal price on carbon emissions to drive investment in low-carbon technologies and processes. By doing so, companies like Temasek can integrate carbon costs into their financial planning, encouraging more sustainable practices and reducing their overall carbon footprint.

Quantitatively Calculated Price (Internal Fee) 

This price is calculated based on the company’s CO2 reduction target and marginal cost curve. By using detailed internal data and cost curves, companies can determine the most cost-effective ways to achieve their emissions reduction goals, ensuring that financial resources are allocated efficiently towards the most impactful decarbonization projects.

REANGLE interprets these carbon pricing methods as varying in their reliance on external data for internal decision-making processes. Companies should evaluate the efficacy and complexity of different carbon pricing approaches to select the most suitable method aligned with their current organizational stage.

The higher the difficulty in obtaining accurate carbon pricing, the greater the feasibility of decarbonization projects becomes because such projects often require more detailed and sophisticated analyses to identify cost-effective measures.

These challenging pricing methodologies, like those derived from the marginal abatement cost (MAC) curve, ensure that decarbonization efforts are both financially viable and strategically prioritized, leading to more successful implementation of sustainability initiatives.

Marginal Abatement Cost Curve (MAC Curve)

Diagram 5: MAC Curve

The Marginal Abatement Cost Curve (MAC Curve) is a graphical representation showing the cost-effectiveness of various carbon abatement options. It illustrates the incremental cost associated with reducing one additional unit of carbon dioxide (or other greenhouse gases) through different technologies or strategies.

Steps to Create MAC Curve:

1. Identify Abatement Options: List all available options for reducing emissions within the company or sector.

2. Estimate Costs: Calculate the cost of implementing each option, including capital, operational, and maintenance expenses.

3. Estimate Emission Reductions: Determine the amount of emissions each option can potentially reduce.

4. Plot the Curve: Arrange the options in ascending order of cost per unit of carbon abated and plot them on a graph, with cost on the vertical axis and the quantity of emissions abated on the horizontal axis.

How to Use MAC Curve:

• Prioritization: Helps identify which abatement measures are the most cost-effective by comparing the cost of reducing an additional unit of emissions across different options.

• Investment Decisions: Guides investment by highlighting the most economically viable measures to implement, maximizing the impact of available resources.

• Policy and Strategy Development: Assists in developing policies and strategies by providing a clear picture of the economic trade-offs and potential for reducing emissions.

• Benchmarking: Provides a benchmark for assessing the cost-effectiveness of various decarbonization efforts and comparing them against industry standards or targets.

ICP in Investment Decision-Making

Diagram 6: ICP in investment decision-making

To use ICP for decisions to invest in decarbonization, companies first set an ICP to internalize the cost of emissions. This price is used to evaluate the greenhouse gas emissions of potential projects. By calculating the carbon costs for each project, companies can compare and prioritize investments based on their environmental and financial impact.

Projects with carbon costs below the ICP are prioritized, as they are more economically viable and environmentally beneficial. Conversely, projects with higher carbon costs are rejected.

Incorporating Payback Periods

When considering the payback period, companies estimate the initial costs and expected financial returns of projects, along with their emission reductions.

By applying the shadow carbon price, the carbon cost savings or expenses are factored into the financial returns. This adjusted payback period helps companies make informed decisions, ensuring investments meet both financial and sustainability criteria. Projects with shorter adjusted payback periods are preferred, while those exceeding standard criteria are not pursued.

Conclusion

Implementing ICP offers a strategic approach for companies committed to sustainability. By setting a price on carbon emissions, organizations can drive decarbonization efforts, make informed investment decisions, and align with global climate goal.

Ultimately, ICP not only fosters a culture of sustainability within companies but also demonstrates their commitment to stakeholders. By integrating ICP into their financial and operational strategies, companies can achieve long-term environmental and economic benefits, positioning themselves as leaders in the transition to a low-carbon economy.

Disclaimer: 

The information provided by REANGLE in this article is for informational purposes only and does not constitute investment advice. Any investment decisions made based on this information are solely the responsibility of the investor. REANGLE disclaims any liability for financial losses or legal consequences resulting from investments in any companies or assets discussed in this article. Readers are advised to conduct their own thorough research and seek professional financial advice before making any investment decisions.

REANGLE Services

REANGLE extends its Green Finance Consulting services to institutional investors and corporations across Southeast Asia, Japan, and beyond, harnessing Singapore’s pool of talent. With global sustainable finance platforms and highly motivated green talent, REANGLE delivers Green Finance Analysis and Green Data Analytics services quantitatively, alongside providing Green Investor Relations advisory service to drive authentically sustainable investment decisions.

Do check out REANGLE’s past articles for further clarification or reach out to us at kazu@reangle.co (Kazu Watanabe).