The carbon currency: Internalising global warming's cost

The world surpassed the critical 1.5°C warming threshold for the first time in 2023. This serves as a sharp reminder that we are still on a high-warming trajectory, with expectations of global warming upwards of 2.7°C, above pre-industrial levels, by 2100.

The issues associated with this are many. The concept of planetary boundaries best demonstrates the environmental consequences of unmitigated warming. This concept outlines nine planetary boundaries that represent the complex biophysical Earth system, such as climate change, land-system change and biosphere integrity. Crossing the boundaries of these systems increases the risk of causing irreversible environmental changes, of which six have already transgressed. Abrupt change will not necessarily happen overnight, but collectively the boundaries represent a critical threshold for increasing risks to people and our ecosystem.

While these changes are often slow and non-visible, it is still essential that action is taken as early as possible to help prevent further warming and disruption. This action needs to be both public and private.

One way environmental impact can be made more tangible to companies is through carbon pricing. Carbon pricing instruments have been designed to help markets realise the true environmental damage of products and services. It captures this by placing a price on the carbon dioxide (CO2) emitted and then charging companies based on their activity. This is either done via direct taxation or through a cap-and-trade system, such as the EU Emissions Trading System (ETS) or the UK’s equivalent.

Carbon pricing can be an effective way to send economic signals to high emitters to consider changing their practices for more environmental ones. However, this method is subject to public policy and may not fall into the purview of a company’s climate strategy. To help those keen to stay ahead of the curve, a solution does exist: internal carbon pricing (ICP).

ICP is an extension of the external carbon price thinking. It is a tool to help companies understand the cost of carbon associated with existing or future projects, so helps to incentivise companies to direct their capital towards lower-carbon activities. ICPs therefore represent an ownable method to start introducing carbon as a key factor in decision-making. Implementing an ICP is not only an action to mitigate future warming through decarbonisation, but also a mitigation for future financial risk.

Currently, some companies will not be directly affected by carbon pricing mechanisms. Consequently, some may question the relevance of including an ICP in internal processes. However, more companies will begin to feel the effects indirectly as the cost is passed through the value chain. In addition, using an ICP presents an opportunity to strengthen the business case for investment in decarbonisation. As carbon pricing begins to expand to more sectors and its price increases, those companies that have remained stagnant in preparing for high carbon costs will be significantly impacted. The EU ETS is expected to reach ~€100/tCO2e. Companies that have integrated an ICP within decision-making are more likely to avoid future carbon-related costs, as they will have minimised their exposure through decarbonisation.

The challenge around seeing the short-term relevance of an ICP is therefore met with the opportunity to strengthen the business’s long-term financial position. Consequently, to deliver the most effective ICP, it requires the collective effort of a business and not solely the sustainability function. Without close internal co-ordination on the purposes of an ICP, different intentions will likely lead to a dysfunctional tool and poor decision-making.

Companies should not rely on public policy alone to signal action on mitigation. To be agile in the event of quick policy introductions, such as expansions in carbon pricing, it is crucial companies begin to develop their own plans and strategies for mitigating climate change. Transition planning encapsulates this remit, and ICPs are a practical method for developing a credible and actionable strategy.