Role of accounting & finance pros to determine internal carbon pricing is increasingly necessary

Efforts to combat the climate crisis are falling short. A substantial disparity exists between corporations’ global commitments for climate mitigation and finance and the actual requirements necessary to keep global warming within the 1.5°C threshold, according to the Science-based Targets Initiative (SBTi).

In fact, current projections indicate that yearly mitigation funding must exceed US $8.4 trillion from 2023 to 2030, escalating to US $10.4 trillion annually in the subsequent 20 years. This stands in stark contrast to the present allocation of merely US $1.2 trillion per year.

Voluntary carbon markets were seen as a key mechanism for companies to mitigate their carbon emissions, but recent controversies continue to stall efforts to restore integrity to these markets. Earlier this year SBTi advocated for companies to assign a specific internal carbon price per ton of carbon to its operations and supply and then funnel the total amount into a mechanism that would be used to remove carbon from the atmosphere by using technology or investing in natural carbon mitigation efforts, such as tree-planting.

Determining an accurate carbon price

While it sounds good, determining an accurate internal carbon price (ICP) is a challenge. ICP is a voluntary strategy that involves assigning a monetary value to carbon emissions, whereas carbon accounting is systematic way to measure and monitor how much carbon dioxide equivalent (CO2e) an entity emits. (In 2023, the U.S. Environmental Protection Agency (EPA) estimated that the social cost of carbon is $190 per metric ton.)

Overall, two categories of methodologies exist to pay for the social costs — taxation and ICP — and each mechanism to is imperfect; and because the total cost estimates are based on models, they do not account for variations of carbon emissions across sectors. This is why ICP might be a better option.

Today, there are three well-known methods to conduct internal carbon pricing:

Using an external benchmark — Commonly called shadow pricing, this method involves the organization setting a monetary value on its greenhouse gas emissions on a per ton basis. Sometimes an organization will get this value from an external source, such as the EPA; or they will base it on an industry estimate. This method helps companies assess the potential costs and benefits of various methods to reduce emissions. While no actual money is exchanged, using this approach in capital planning can help effective decision-making in long-term investment decisions. Typically, finance and strategy professionals are involved in these decisions.

Setting an internally calculated price — This method involves assigning an internal carbon fee associated with each metric ton of emissions produced. The pricing is then applied at the business unit level based on specific emissions-generating activities or consumption. In this system, a company imposes a fee on itself for each ton of emissions produced. ICP consolidates these values into a standardized metric, such as carbon costs or benefits. This approach allows financial decision-makers, including corporate chief financial officers, to bring these low-carbon metrics into the organization’s rational, economic decision-making processes. The details of this method are usually determined through collaboration among internal operations, accounting, finance, and sustainability teams.

Calculating a spend-based approach — Finally, companies can calculate an implicit carbon price based on what the organization spends on emissions reduction targets. In many cases, commitments by companies to reduce emissions already exist, but multiple carbon prices also may exist under this method. This methodology can be problematic because it is not actually accounting for the social cost of carbon.

While use of ICP methods by companies has increased, too few companies are using ICP, whatever the method they pursue, and there is still a long way to go, according to a McKinsey & Co. report. Looking at the top 100 companies by revenue in each sector, nine sectors show an average increase of 10% or more in ICP usage, between 2019 and 2021, the report showed. In the energy and materials sectors — which together account for approximately 60% of global CO₂ emissions — ICP take-up is highest but still is used only half or less of those companies.

Varying use by region

An analysis of market-based pricing mechanisms in the McKinsey report showed that the use of internal carbon charges also varies widely by region. In the Europe Union, where ICP is most prevalent, 40% of large companies use this approach to promote sustainability. The EU Emissions Trading System (ETS) also has higher prices than other regions, although only 40% of European companies that use ICP have internal charges exceeding the current ETS price of $87 per metric ton. By contrast, only 26% of Asian companies and 17% of US companies have implemented ICP.

This is where corporate finance professionals can contribute their expertise to determine their own internal prices for carbon, based on the company’s unique operating model, its geographic dispersion, and its own supply chain.

To get started, KPMG recommends the following actions:

• • • • determine why creating an ICP strategy and a specific objective would be important to your organization;
      • define how government-supervised pricing can affect your organization;
      • calculate an internal price;
      • run a pilot exercise; and
      • develop a plan to scale the process across the organization.

One added benefit of using ICP is the ability to integrate sustainability into core business operations. In fact, the best practice approaches to ICP are those that contribute to a journey of bringing a company’s business strategy in line with its transition to a low-carbon economy. By using these best practice approaches to ICP, companies can embed the trajectory of a low-carbon transition into their daily decision-making, determine the most effective strategy in changing market environments, and stay ahead of the curve.

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You can find more about carbon pricing and carbon credits here.