Internal Carbon Pricing: When to implement ICP? Is ICP going to be worth it for me?

Introduction from Luca Taschini

Several countries have adopted some form of carbon pricing, yet explicit carbon pricing is not widely implemented. Many nations lack an emissions pricing system or carbon taxes. This gap has led some companies to establish their own carbon prices for internal use, known as internal carbon pricing. Internal carbon prices assist companies in understanding the pollution impact of proposed projects.

In the inaugural B-CCaS Thought Leadership series, Charlotte Challis, a Visiting Fellow at B-CCaS, delves into the relevance of Internal Carbon Pricing (ICP) for companies. She explores how ICP can be utilised in dealings with customers and contractors/suppliers, and provides insights on the best practices for companies looking to implement ICP.

Is Internal Carbon Pricing relevant to me?

Carbon Pricing is hailed as a key tool in addressing the climate crisis. Promotion of Internal Carbon Pricing as a tool for organisations to deploy in managing their carbon costs and risks follows closely on the heels of that discussion. It is important to clear up a few questions that might come to mind when considering whether ICP is relevant for you.

• What is the difference between Carbon Pricing and Internal Carbon Pricing? When we talk about Internal Carbon Pricing, we are making a distinction that the carbon price is applied internally to our own organisation and own decision processes. A carbon price as a government applied carbon tax or within a trading scheme (e.g. the EU Emissions Trading Scheme (EU ETS)), that we may be more familiar with, is applied across organisational boundaries: "Body X imposes a tax on Body Y". There is a key difference with internal carbon pricing in that we don't need to use the carbon pricing in a punitive way to ourselves, we are using it proactively to help ourselves be better informed and make better decisions.
• I’m not subject to an external tax – is ICP relevant? Being subject to a carbon tax (e.g. being part of an emissions trading scheme or part of a country specific tax system) is a good motivation to start using Internal Carbon Pricing, but it is only one reason from many. Internal Carbon Pricing is used to bring more visibility to the risks and costs that are currently externalities related to an organisation's decarbonisation journey. One of those risks / costs is the risk or reality of taxation, but others include the cost of achieving targets (consider how the purchase of Renewable Energy Certificates comes with a fairly clear £/tCO2e), reputational risk of not achieving targets, and stranded assets for example. If you have set a decarbonisation target, then internal carbon pricing is relevant. If you have identified transition risks from your climate risk analysis, then internal carbon pricing is relevant.

ICP is an implementation tool that most usefully builds on previous work done on understanding climate risk and target setting. If you have set a decarbonisation target, then there are costs associated with achieving that target that it is useful to be aware of in decision making. For example, when making decisions regarding investment in assets you may be considering options with varying carbon impacts and carbon costs. Often the "greener" option is more expensive and organisational pressures and tight margins push us towards the cheaper investment. But if we understand the cost of carbon reduction implied by our carbon target ("we have to reduce our carbon footprint by X tonnes and overall that will cost us £Y") then when looking at individual investment decisions we might find the "greener" option that is presenting itself is a much more efficient option than our backstop/planned suite of projects we will have to invest in to achieve the target.

The same principal applies with transition risks. Where you have identified transition risks, they are almost always associated with financial line items… "Risk A could result in impact B on financial line-item C" for example "if we don't upgrade our buildings to meet the higher performing energy certificates we run the risk of losing market share and impacting rental value, as clients look to other providers". Understanding more detail about what the carbon risk is, helps us identify a relevant a carbon price, and then the metric becomes useful perhaps in the due diligence and decisions around purchasing or constructing new buildings.

Are there organisations for which ICP is more or less appropriate?

In broad terms, Internal Carbon Pricing is relevant to any organisation that has a decarbonisation target or identified transition risks. It is a very simple principle that can be applied in numerous and flexible ways. But indeed, there are differences in how it might be applied, and there are types of organisation where it might be a more obvious solution than others. Three dimensions we might consider are: Small/Large, Service vs Physical product, and Public/Private.

• Small/large. Factors at play here are more about data and difficulty in communication. Smaller organisations may be further behind on decarbonisation journey and may not have the required data - though of course that is a generalisation and not always the case. Alternatively, smaller organisations may already find it possible to include carbon and cost in decision making because there is more of a unity in decision making principles so that ICP may be 'a sledgehammer to crack a nut'. An important benefit of ICP for larger organisations is that it brings a consistency of approach to how greener options are prioritised that can be communicated widely and built into different decision processes, across different departments and geographies with a unified logic or justification.
• Service vs Physical product. As a generalisation: where there is more investment in physical assets, there is a more straightforward case for ICP. ICP is certainly still relevant for service industries. The difficulty for a service industry is typically the sense of control over elements of footprint which rely much more on the interaction with clients and suppliers. ICP is still relevant here, but can sometimes appear more like an external carbon price that we talked about at the top (i.e. body A applies a tax to body B) than an internal carbon price.

  	Large	Small
  Physical product/assets	Definite sweet spot. These organisations typically have internal processes that work very well with ICP such as capital approval, innovation or R∧D processes.	Where data is available on carbon related impacts and there are needs to improve decision making processes, ICP is still relevant.
  Service	Plenty of opportunity and use for ICP. These can be at internal/external boundary that brings some additional complexity (e.g. in contracts with clients or suppliers), but still a good candidate for ICP).	ICP is relevant for all, but it is a question of is it too complex for your needs? Keeping the setting of the ICP price simple can help and starting with easiest to implement options such as application to business travel.

• Public/Private. This is another distinction that comes up in questions: i.e. "is ICP relevant in the public sector?". ICP is relevant to both public and private though there are far fewer examples of ICP being used in the public sector. This difference is not down to relevance to one rather than the other. There are some differences in drivers, but those drivers are of comparable weight. Public sector organisations may value how it supports decision making in the face of tighter budgets and greater expectations and demands around carbon reduction. And of course this is also relevant in the private sector, many of the same drivers act across both including: finding most cost effective routes to decarbonisation, reputation and importance of achieving targets, improving decision making processes to include decarbonisation. It can often be more straightforward for public sector organisations to set internal carbon prices as they are more likely to have governments as key stakeholders where there are already nationally set and calculated carbon prices e.g. the Green Book in the UK which provides structures, guidance, and calculated prices. The absence of a governmental stakeholder for the private sector doesn't mean ICP is irrelevant. For many private sector organisations the stakeholder drivers are just as strong, it is just that the relevant price is calculated differently.

Can ICP be used in interactions with customers, contractors/suppliers?

As just mentioned, there are a number of industries and organizations where the biggest parts of the footprint or the hardest to decarbonise are those that sit at a boundary between organizations: e.g. interactions with clients in persuading them to buy a lower carbon product or service or contract negotiation with suppliers during a construction project. It is recommended to avoid just imposing a tax on the other party, but rather to use the discussion of a carbon price as an opportunity to improve the relationship and understanding of shared goals. Perhaps your client has a net zero target, so when they ask you to design a particular product for manufacture and you can offer them a greener alternative, it can be helpful to show the difference between the options in terms of a carbon price. "Yes, option "B" is more expensive than "A" but at a carbon price of £15/tCO2e saved it offers an attractive option compared to perhaps some of your other decarbonisation investments”.

Overall what will I get out of ICP?

Internal Carbon Pricing provides visibility on climate risk and costs and the chance to develop strategy and steer business decisions in a way that protects the longevity of the business. ICP is a mechanism that allows organisations to link target setting exercises (such as Science Based Targets) and climate risk identification to ongoing decision making in the organisation. In doing so, these important initiatives aren't just one-off isolated activities but the basis of something that becomes woven through how the organisation operates. ICP provides a consistency of approach to how greener initiatives are prioritized through the organization and help to take away reliance on qualitative judgements.

How should I go about implementing ICP?

Getting an internal carbon pricing system right is about more than just getting the right price. It is important to consider it from a change management perspective in that we want decision making processes to change, we want the price to represent real and relevant costs, risks, or opportunities for our organisation.

The key steps are:

• Understand what drives your internal cost of carbon

  What are the priorities and concerns? Is it tax & legislation, reputation or other transition risks, achievement of targets. What are going to be the challenges? What are the biggest areas of footprint and hardest to decarbonise? Where are decisions made that conflict with decarbonisation aims? Understanding the answers to these questions will help make clear what type of ICP process to implement, which decision processes and parts of the business to focus on, and help in identifying the right price to use.

  An internal carbon price process is more than the price itself. It is important to put care into the choice of type of ICP process (e.g. carbon tax or shadow price) and where it is applied to ensure that the culture of the organization and the dynamics of the decision process are considered. Internal Carbon Pricing works well when applied to decision processes related to large parts of the carbon footprint and particularly to processes where there may be conflicts between sustainability aims and financial aims.

• Develop/research $/tCO2e metrics that can be used in decision making, reporting and/or budgeting

  The price used may be one single price or vary by geography and what department or scope area it is applied to. It should take into account differing time frames of decisions in how it is used, communicated, and updated. It may also take into account differing levels of uncertainty for example having low/medium/high scenarios. In terms of the price itself, external benchmarks may be relevant, but the calculation of the implicit price* is also often useful and relevant.

  The price to be used should relate to the decision process chosen and the understanding of drivers. A common form of price used is the implicit price which represents the cost for that organization to meet net zero targets (i.e. Net Zero target achievement is a primary driver). These costs may come from reductions across different scope areas. For example, a manufacturing organization may have a Net Zero target with outline plans for projects across:

  • scope 1∧2 emissions: reduction in energy use and the use of renewable energy
  • scope 3, category 1 purchased goods & services: purchase of materials, equipment, and consumables with lower embodied emissions
  • scope 3, category 5 waste in operations: investing in new manufacturing processes and materials
  • scope 3, category 6 business travel: promoting use of trains, improving ability to demonstrate facilities to customers virtually
  
  

  Taking the total cost of these projects and the total carbon savings as per the calculation in the box below* the overall implicit price can be calculated. This activity is useful, but it is also useful to understand how the price changes across the scope categories. When using the price in a business travel process it may be more appropriate to use just the implicit price for travel, though when used in a capital approval decision process, then the overall implicit price may work better.

• Consider the human factors, data, and process adjustments

  At its heart this is a change process. We want to create change in how decisions are made, what is prioritized, changes in attitudes and awareness, and make sure we are providing the right support for users. It is important that the people who will use ICP as a decision-making tool are consulted and considered. Review the data and tools (i.e. software or excel spreadsheets) that are currently used and consider how these may need to be adapted.

  A balance between ease of use and accuracy is to be found that is relevant for the process where ICP is being applied. This can relate to the price used; a less accurate but more universal price might be easier to use and communicate. It also applies to what is asked of the users of the process when it comes to calculating carbon emissions, for large capital approval projects it is more appropriate to go into greater depth on the carbon impact of decisions than it is with small and regular decisions.

• Create a process which integrates decarbonisation and climate risk into key decision-making, reporting and/or budgeting

  Having pulled all the previous elements together, we are looking to embed a process within the organisation that brings a consistent approach to prioritising and achieving carbon and climate goals.

  It is important to pilot, test and refine going forward to both build greater understanding of what the cost of carbon emissions are to your organisation and to continue to make the organisation truly sustainable.