As countries seek to reduce their national greenhouse gas emissions in a cost-effective manner, carbon pricing instruments are introduced in new jurisdictions and countries. The economic and financial implications for businesses go beyond the price tag that these instruments attach to their unabated emissions. There is more than meets the eye. Indeed, the financial burden, or “carbon cost”, borne by businesses is influenced by a range of factors, including the jurisdiction in which a company operates, the specific sectoral rules of the applicable carbon pricing regulation(s), or the market it competes in.
Carbon Price: What the Eye Can See
The carbon price applied to emissions is the most easily observable information associated with carbon pricing instruments. It is either determined by the market in cap-and-trade systems, such as the EU Emissions Trading System (ETS), or set by the government in the form of a carbon tax. Hence, it ascribes a financial cost per unit of emitted CO2 equivalent, in order to internalize (part of) the climate damage associated with carbon emissions.
Carbon Cost: Beyond What Meets the Eye
The carbon cost, on the other hand, is a broader term that represents the total financial impact of carbon pricing on a company. A company’s carbon cost can be decomposed into two key components: a direct carbon cost, which is the cost associated with a company’s own emissions, and an indirect carbon cost, which is the cost of emissions by a company’s suppliers emissions and is passed-through (in full or in part) to the company.
Direct Carbon Cost
The direct carbon cost is not only determined by the carbon price but also by (i) factors that affect the ‘effective’ price that a company pays for its emissions and (ii) the volume of direct emissions (Scope 1) effectively subject to a carbon price. To shed light on this, we analyze each of these items in turn.
Both variables depend on the design of the carbon pricing regime(s) in force in the jurisdiction(s) where the company operates. Hence, the location of the companies’ plants significantly influences the company’s carbon cost. In other words, two companies emitting the same amount of greenhouse gases may face significantly different carbon costs if they operate in different jurisdictions with different carbon pricing regimes.
(i) Effective Carbon Cost
- Carbon price: the price applied to emissions, either through a tax or emissions allowances.
- Subsidies and price rebates (taxes): Subsidies reduce the financial impact of carbon pricing. For instance, emission allowances received for free reduce the volume of emissions for which the company must purchase allowances in the market, thereby reducing the total—and average—cost of emissions. Similarly, certain sectors are granted rebates on the carbon price applicable to them.
- Ability to pass on the cost of emitting: A company’s ability to pass on the cost of carbon to customers can significantly affect its (effective) direct carbon cost. Assuming all other factors remain constant, the greater the company’s ability to shift these costs to customers, the lower the effective carbon cost borne by the company. Various factors might influence the ability to pass on the cost of carbon such as market structure (i.e., competition), trade exposure, etc.
(ii) Covered emissions
- Direct emissions (carbon footprint) and emissions reduction potential: The size of a company’s carbon footprint and its potential to reduce emissions through technological innovation or operational efficiency improvements also shape the carbon cost. Assuming all other factors remain constant, a larger carbon footprint would generally entail a higher carbon cost. However, if a company has significant potential to reduce its emissions, it can lower its carbon cost over time. The potential of a company to reduce emissions can be assessed by considering indicators such as the company’s marginal abatement costs, its investment in Research and Development (R&D), and any incentives it has in place that align with decarbonization objectives. Direct emissions are affected by the number of assets a company has subject to carbon pricing. Yet, the emissions intensity of assets in such locations may exhibit a more rapid decline due to the financial incentives introduced by companion policies, assuming the pricing signal remains robust and consistent enough to guide investment decisions over time.
- Compliance thresholds and exemptions: Regulations instituting carbon pricing mechanisms usually specify different rules for different sectors, including sector and/or fuel exemptions. Such specificities can significantly affect the carbon cost of a company.
The main challenge around the direct carbon cost
If a company is subject to regulation under a carbon pricing mechanism, it is likely to be acutely aware of its direct carbon costs. However, these types of obligations are often managed by the operators of the regulated installations, especially when the carbon pricing scheme applies at the facility level, as is the case with the EU ETS. These operators might, in turn, be subsidiaries of the company. Hence, this specific information, crucial as it is, might not always permeate other departments within the organization like financial, sustainability, or risk-management departments. Consequently, employees unfamiliar with the intricacies of the regulations of carbon pricing may remain uninformed, even though understanding it could benefit decision-making in their respective roles.
Indirect Carbon Cost
Besides the direct exposure to carbon pricing, businesses may also face indirect exposure to carbon pricing, which can significantly affect their carbon costs. This plays true for many companies down the supply chain, such as in the manufacturing sector. Indirect exposure arises through a company’s suppliers’ carbon cost (indirect carbon cost) and their ability to pass that cost through.
- Indirect carbon footprint: The indirect carbon cost is shaped by the indirect carbon footprint of a company, specifically Scope 2 (emissions associated with purchased heat and electricity) and Scope 3.1 (emissions embedded in purchased goods and services) as well as all other factors discussed above. All else equal, a product with a higher carbon footprint will result in a higher indirect carbon cost. Other stages of a company’s supply chain might also affect its indirect carbon cost. For example, with the expansion of the EU ETS to the maritime sector, shipping emissions will begin to have a price associated with them.
- Carbon cost pass-through: Frequently, businesses tend to overlook the indirect exposure related to carbon costs. This occurs because the carbon price is embedded within the expenses of the goods and services they procure. Although numerous studies have attempted to examine cost-pass through associated with carbon prices, it remains challenging to accurately determine the portion of the final price attributable to the carbon price. A cost pass-through less than 100% means that the full corrective effect of the carbon price is not realized. However, real-world complexities make this the general rule rather than the exemption.
In the context of the EU Carbon Border Adjustment Mechanism (CBAM), the dynamics differ slightly. This mechanism will reveal part of the indirect (supply chain) exposure to carbon pricing for EU businesses importing goods from third countries. Under this system, EU businesses will see the carbon price associated with each purchased good, similar to how regulated facilities under the EU ETS view the cost of their own direct emissions. However, a complete cost-pass through won’t materialize instantly. Measures like free allocation will gradually fade as the EU CBAM is phased in.
The educational challenge ahead
For businesses that do not have regulated facilities subject to a carbon pricing regime, the idea of a cost associated to their emissions might not be at the forefront of their priorities. Yet, they could have significant exposure through their supply chains. This strategic oversight can result in a lack of awareness, hindering these companies from making well-informed decisions because of their limited understanding of their suppliers’ carbon pricing exposure. From an environmental perspective, such businesses may lack the financial incentive to decrease their carbon emissions, leading to delays in mitigation choices and, in turn, increasing their vulnerability to transitional climate risks.
Distinguishing between carbon price and carbon cost is vital for businesses as they strategize their greenhouse gas emissions management. The carbon cost, considering the broader context, offers a more nuanced perspective on a company’s actual financial exposure.