In early May 2021, Angela Merkel used her last appearance as German Chancellor at the annual Petersberg Climate Dialogue to advocate for the adoption of a global carbon pricing system.

Speaking at the summit, Merkel said, “From my point of view, it would be very desirable if we also had a CO2 price worldwide, which would have to be introduced step by step.”

Germany, like over 60 other national and subnational governments, has instituted carbon pricing mechanisms as a strategy to combat climate change, but a cohesive global system does not exist. Advocates argues that, by putting a price on carbon, polluters are penalized for their emissions, and therefore incentivized to decrease them.

While carbon pricing systems are gradually gaining the support of governments worldwide, many companies are taking matters into their own hands and adopting their own internal carbon pricing schemes. Like a government-mandated carbon tax, internal carbon pricing puts a tangible cost on a company’s emissions and creates incentive structures to develop more sustainable business practices.

As voluntary and self-governed “taxes”, however, internal carbon pricing differs from government-imposed levies. What, then, exactly is internal carbon pricing, and why is it beneficial to corporate sustainability?

What is internal carbon pricing?

An internal carbon price is when a company voluntarily imposes a monetary value on carbon emissions, whether it is a real financial cost or theoretical application. This allows companies to incorporate the financial impacts of carbon emissions on business decisions throughout their organizations.

In a survey of over 5,900 companies conducted in 2020, the Carbon Disclosure Project (CDP), found that 853 companies polled put a price on carbon, while 1,159 more planned to do so within the next two years. That means over one-third of respondents used or planned to use internal carbon pricing, representing an 80 percent increase in five years, including close to half of the world’s largest companies by market capitalization.

Usually, companies put an internal price on carbon for scope 1 emissions – CO2 emitted by a company’s direct operations – and sometimes scope 2 emissions, which refer to indirect emissions such as energy use. Companies rarely apply carbon pricing to scope 3 emissions, which refer to other emissions in the company’s value chain, though some companies, like Microsoft, are beginning to do so.

The most common method of carbon pricing is shadow pricing. A shadow price puts a theoretical value on CO2 emissions, which stakeholders use for making business decisions. Shadow pricing does not set a hard cost on CO2 emissions that is actually “collected” like a tax or trading scheme, and therefore does not need to be incorporated into departmental budgets.

Although shadow pricing does not put a hard price on carbon, it can be applied to inform decision-making, from investment priorities to procurement strategies. Further, it can be used as an indicator for emissions reductions targets for ESG reporting.

Another common method of internal carbon pricing is an internal carbon tax. Like a carbon tax instituted by a government, an internal carbon tax is a cost imposed on a company’s CO2 emissions—but voluntarily created and collected by the company itself.

Rather than pay tax collectors, though, the company taxes internal departments and uses the funds for other purposes, such as to seed investments into environmental initiatives or to purchase carbon offsets for their emissions.

How do companies determine a carbon price?

One challenge of setting an internal price on carbon is determining what exactly the price should be, as standards vary widely.

Globally, carbon taxes range from less than $1 per ton of CO2 in Poland to over $120 in Sweden. The UN Global Compact recommends that companies set an evolutionary internal price to reach, over time, at least $100 per ton, rather than a static price. According to the CDP, the median internal carbon price in 2020 was $25 per ton.

Companies may set an internal carbon price across their business, but operate in some jurisdictions that already have government-mandated carbon taxes. In such cases, companies may only apply the difference between the internal and external carbon prices, or account for both systems simultaneously.

Another option is to adopt multiple prices for different jurisdictions or business functions. For example, companies can apply a lower price for most day-to-day operations, and a higher one for long-term investment decisions. Similarly, companies may apply a higher rate to scope 1 and 2 emissions, and a lower rate to scope 3 emissions.

What are the benefits of internal carbon pricing?

Internal carbon pricing offers a number of benefits, from informing investments to spurring innovation.

Risk management

Implementing an internal carbon price is an effective way for companies to manage risk. With more and more countries and subnational jurisdictions adopting carbon pricing schemes—and the potential for a global pricing system to develop—putting an internal price on carbon allows companies to anticipate and incorporate future carbon costs into business decisions. This not only applies for internal operations, but also for calculating risk when acquiring outside assets.

Once government-mandated carbon pricing schemes, or other carbon reduction policies, are put into place, companies with an internal price on carbon will be best placed to transition. Further, those with internal carbon pricing systems are better positioned to influence the debate on government policy, due to their leadership on the issue, capacity to collect data, and ability to execute voluntary pilot programs.

Companies without an internal price on carbon could find themselves scrambling to comply with new regulations, putting them at a competitive disadvantage. This is especially true in industries where emissions are directly tied to core operations, such as in manufacturing and transportation.

Incentivize resource efficiency

An internal carbon price acts as an incentive for companies to reduce their emissions. Companies often commit to going green, but lack mechanisms to mobilize environmental priorities at all levels of the business.

By putting an internal price on carbon, departments face financial costs for their emissions that are included in their operating budgets. When emissions are priced in to budget constraints, departments have greater incentive to decrease them in order to improve their bottom line. This can lead to innovative emission reduction strategies that come from the “bottom-up” of the company, instead of relying only on top-down decisions from senior leadership.

Resource efficiency incentives are particularly powerful with internal carbon taxes, since they act as a hard cost that departments have to pay out of their own budgets. Still, shadow pricing can be effective if management commit to it as a metric for evaluations and reward departments with the best performance.

Promote innovation

Internal carbon pricing encourages innovation and R&D by promoting long-term business investments into low-carbon strategies.

Attaching a price to carbon encourages the design of practices that minimize these costs. Carbon prices penalize the most polluting products, services, and processes, while making carbon efficient ones more competitive. If the cost of an affordable but polluting status quo option increases due to a price on carbon, the business case for an investment into a low-carbon alternative becomes more compelling.

Companies that use internal carbon taxes are especially well positioned to promote innovation. Often, these companies will use the funds raised by internal carbon taxes to invest in R&D in more energy efficient products, services, and production processes.

Teams within an organization can compete for access to these funds by making a business case for an investment or as a reward for strong performance in reducing emissions. If successful, the carbon tax becomes an investment into innovations that make the company more competitive.

Transforming operational incentives

Putting an internal price on carbon can transform business practices by putting tangible costs on carbon emissions throughout all facets of a company. Yet, while it applies to diverse business functions, from finance to R&D to procurement, it is a consistent and objective standard.

Internal carbon pricing also requires companies to address a number of practical concerns. In order to properly implement a carbon pricing scheme, companies need to be able to accurately measure and report their emissions. Further, implementing a carbon tax involves financial transfers between company departments, and therefore requires compliance with relevant transfer pricing laws.

Like any voluntary carbon reduction initiative, however, internal carbon pricing requires buy-in from senior leadership and integration into the company’s overarching mission to be effective. Doing so successfully can help companies reduce their carbon footprints, grow more innovative, and navigate long-term business risks.