Cross-industry climate-related metric: Internal Carbon Price

 The Task Force on Climate-related Financial Disclosures (TCFD), an initiative by the Financial Stability Board (FSB), recommends disclosing climate-related metrics to cover three broader topics (2017): a. Disclose metrics used to assess climate-related risks and opportunities in line with the strategy and risk management process.In addition, the TCFD recommends that organizations clearly disclose metrics used to assess progress against their decarbonization targets, including related operational and financial performance metrics, metrics aligned with "the cross-industry" **, climate-related metric categories, and industry-specific or organization-specific metrics (TCFD, 2021).

** Internal carbon price is a cross-industry climate-related metric.There are two variants of Internal Carbon price , which being, Shadow Carbon pricing and Internal Carbon pricing. Let me explain these two types of pricing: 

1. Shadow Carbon Pricing:

Shadow carbon pricing is a mechanism used by organizations to estimate the cost of carbon emissions as if there were a real, external price imposed on them. This hypothetical price is used for internal planning, risk assessment, and decision-making. It is called "shadow" pricing because it is not an actual market-based carbon price but a tool to help organizations understand the financial implications of their emissions. Shadow carbon pricing is often used to assess potential risks and opportunities associated with carbon emissions and to evaluate the financial feasibility of emission reduction strategies.

2. Internal Carbon Pricing:

Internal carbon pricing is the practice of assigning a monetary value to carbon emissions within an organization's operations. Unlike shadow carbon pricing, internal carbon pricing is a real cost applied internally to incentivize emission reduction efforts and guide investment decisions. It serves as a mechanism to incorporate the cost of carbon emissions into business planning, budgeting, and decision-making processes. Organizations use internal carbon pricing to make emissions reduction projects more economically viable and to integrate sustainability considerations into their operations.

Key Differences between Shadow Carbon Pricing and Internal Carbon Pricing:

1. Purpose:

   - Shadow Carbon Pricing: It is used for estimating the hypothetical external cost of carbon emissions and assessing financial risks and opportunities.

   - Internal Carbon Pricing: It is applied internally to incentivize emission reduction efforts and guide investment decisions.

2. Market Reality:

   - Shadow Carbon Pricing: It is not an actual market-based carbon price but a theoretical construct.

   - Internal Carbon Pricing: It represents a real, internal cost assigned to carbon emissions.

3. Application:

   - Shadow Carbon Pricing: Primarily used for risk assessment, scenario analysis, and external reporting.

   - Internal Carbon Pricing: Used to drive internal behavior change, prioritize emissions reduction projects, and allocate resources.

4. Incentives:

   - Shadow Carbon Pricing: Does not directly incentivize emission reduction efforts within the organization.

   - Internal Carbon Pricing: Provides a financial incentive for departments or business units to reduce emissions to avoid incurring internal costs.

5. Decision-Making:

   - Shadow Carbon Pricing: Helps organizations make informed decisions regarding climate-related risks and opportunities.

   - Internal Carbon Pricing: Guides investment decisions and helps prioritize sustainability initiatives.

6. Timing:

   - Shadow Carbon Pricing: Typically used for long-term planning and assessing future risks.

   - Internal Carbon Pricing: Implemented in real-time and impacts immediate budgetary decisions.

In summary, shadow carbon pricing is a tool for assessing the hypothetical external cost of carbon emissions, while internal carbon pricing is a real, internally applied cost aimed at driving emissions reduction efforts and shaping internal decision-making. Both serve important roles in a company's sustainability and climate risk management strategies.

Let us understand the concept through an example:

Background:

TJ Corp, a multinational manufacturing company, is assessing the financial implications of carbon emissions associated with one of its production facilities. The facility emits 10,000 metric tons of carbon dioxide equivalent (CO2e) annually. TJ Corp is considering both shadow carbon pricing and internal carbon pricing.

1. Shadow Carbon Pricing: TJ Corp wants to estimate the cost of carbon emissions using shadow carbon pricing. The current market-based price for carbon emissions is $50 per metric ton of CO2e.

2. Internal Carbon Pricing: TJ Corp has also implemented an internal carbon pricing mechanism. It charges its facility $30 for every metric ton of CO2e emitted as an internal cost to encourage emissions reduction efforts.

Questions:

a. Calculate the total cost of carbon emissions for the facility using shadow carbon pricing.

b. Calculate the total internal cost of carbon emissions for the facility using TJ Corp's internal carbon pricing mechanism.

c. Compare the results from parts (a) and (b) to assess the difference between shadow carbon pricing and internal carbon pricing in this scenario.

Answers:

a. Calculating Shadow Carbon Pricing:

   Total emissions = 10,000 metric tons of CO2e

   Market-based price per ton = $50

   Total cost of carbon emissions = 10,000 tons * $50/ton = $500,000

   Therefore, using shadow carbon pricing, the total cost of carbon emissions for the facility is $500,000.

b. Calculating Internal Carbon Pricing:

   Internal cost per ton = $30

   Total emissions = 10,000 metric tons of CO2e

   Total internal cost of carbon emissions = $30/ton * 10,000 tons = $300,000

  Therefore, using internal carbon pricing, the total internal cost of carbon emissions for the facility is $300,000.

c. Comparison of the two pricing:

   The key difference between shadow carbon pricing and internal carbon pricing in this scenario is as follows:

   - Shadow carbon pricing estimates the cost based on the market price, which is $50/ton in this case. It calculates the hypothetical external cost.

   - Internal carbon pricing, on the other hand, represents a real, internal cost imposed by the company to incentivize emissions reduction. In this case, it is $30/ton.

The comparison shows that the total cost estimated using shadow carbon pricing ($500,000) is higher than the internal cost assigned by TJ Corp's internal carbon pricing mechanism ($300,000). This difference reflects how internal carbon pricing can be used as a tool to encourage emissions reduction within the organization and allocate resources to sustainability initiatives.

Some sample questions

Question 1:

Which of the following best describes the primary purpose of shadow carbon pricing and internal carbon pricing, respectively?

a. Shadow carbon pricing is used for incentivizing emission reduction efforts, while internal carbon pricing assesses hypothetical external costs.

b. Shadow carbon pricing assesses hypothetical external costs, while internal carbon pricing is used for internal planning and risk assessment.

c. Shadow carbon pricing and internal carbon pricing serve the same purpose and are interchangeable.

d. Shadow carbon pricing is used for external reporting, while internal carbon pricing calculates the actual market price of carbon emissions.

Answer: b. Shadow carbon pricing assesses hypothetical external costs, while internal carbon pricing is used for internal planning and risk assessment.

Explanation: This option accurately describes the primary purposes of shadow carbon pricing and internal carbon pricing. Shadow carbon pricing assesses hypothetical external costs, while internal carbon pricing is used for internal planning, risk assessment, and decision-making.

Question 2:

Which of the following is a key difference between shadow carbon pricing and internal carbon pricing?

a. Shadow carbon pricing is applied to actual carbon emissions, while internal carbon pricing is a theoretical concept.

b. Shadow carbon pricing is used for external reporting, while internal carbon pricing guides internal budgeting.

c. Shadow carbon pricing is used only by governments, while internal carbon pricing is used by corporations.

d. Shadow carbon pricing and internal carbon pricing are identical and serve the same purpose.

Answer: b. Shadow carbon pricing is used for external reporting, while internal carbon pricing guides internal budgeting.

Explanation: This option highlights a key difference between shadow carbon pricing and internal carbon pricing. Shadow carbon pricing is often used for external reporting, while internal carbon pricing is primarily used to guide internal budgeting, investment decisions, and incentivize emissions reductions.

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