Internal carbon pricing sets the right incentives to reduce carbon emissions

Gone are the days when uncommitted CO2 roadmaps sufficed for a green image. Companies are under heavy pressure to actually reduce greenhouse gas emissions – not only their own emissions, but also those caused by their supply chain. Economic incentives in the shape of internal carbon pricing are necessary to achieve this.

Companies are being urged more and more to contribute significantly to a climate neutral economy. The Climate Change Act, emission trading systems and carbon border tax mechanisms are just harbingers of what will follow.

Sooner or later companies will be forced via regulations to drastically reduce the emissions within their supply chain. In fact, the majority of most companies’ emissions are Scope 3 emissions, i.e. those caused by the manufacturing, transport and use of the product. These emissions are largely caused or influenced by the supply chain.

In addition, investors are heavily pushing for carbon reduction, as we have seen with the warnings of Larry Fink, CEO of the world’s largest asset manager, Blackrock. But also, customers and employees are increasingly demanding greener solutions.

For companies this may result in enormous financial risk. Systematic approaches are needed as suppliers are unlikely to bear the burden of the upcoming transformation by themselves.

By using specific incentive schemes for suppliers and holistic systems to identify cost-efficient reduction measures, companies can already now set the course for an ecologically and economically sustainable Procurement function.

Re-defining comparability

In view of the expected cost increases which go hand in hand with carbon emissions, it is not sufficient to define the supplier selection basis purely on cost and quality to end up with an economically reasonable decision-making process. Carbon emissions must be integrated into sourcing decisions, and suppliers must be compared holistically with regards to cost, quality, and carbon footprint.

It is, of course, not obvious how much weight carbon should have in the sourcing decision. Companies, as well as suppliers, are still only starting the process of considering carbon in their business case. The question is how a gradual consideration of carbon emissions can be designed such that companies, but also suppliers, are led to the true cost of carbon and the consequences that come with it.

From qualitative criteria to incentive schemes

An obvious starting point would be the consideration of qualitative criteria. Does the supplier already report emissions transparently? Have they any net-zero commitments and carbon reduction roadmaps with a time-action plan in place?

By simply introducing these criteria, suppliers’ attention is drawn to sustainability topics. However, this can only be a very first step. It will get a lot more interesting when Procurement enforces consequences if suppliers are not satisfying certain sustainability conditions, for instance, by excluding suppliers from future tenders or assigning a disadvantage compared to more sustainable competitors.

Pioneers in this area already go beyond that. They already attach a value to the emissions a supplier is causing by an internal price equivalent per tonne of carbon. Suppliers causing more carbon compared to their competitors will get a ‘penalty’ in in the sourcing decision process, whereas suppliers with greener products will be assigned with a ‘bonus’. This monetary bonus or penalty relates to the willingness to pay for carbon reductions. Suppliers are then compared on price, adjusted by the cost of carbon.  

Using this method, companies not only signal to consider the carbon footprint of their suppliers qualitatively, but they communicate in a committed way how much more expensive a product may be if it causes carbon emissions of x tonnes.

The search for the true price of carbon

The derivation of the ‘true’ internal carbon price is by no means trivial. The willingness to pay for carbon reductions differs from company to company and is influenced by many factors: Which carbon reduction commitments has a company publicly made? Will the company be affected by regulatory compensation or certification schemes? How big is the potential to realise carbon savings?

A first anchor for an internal carbon price can be set by voluntary carbon offsets. Each tonne of carbon which cannot be avoided must be compensated via certificates from climate protection projects if a company has the aim to be ‘carbon neutral’. These carbon credits are relatively cheap, however, for various reasons they are not seen as an adequate one-to-one alternative to actual reductions. In climate protection strategy, the principle ‘avoid – reduce – compensate’ is well established. According to this logic, the internal carbon price has to be higher than the cost for voluntary carbon offsets.

An upper limit for the internal carbon price could be defined by the internalisation of the social cost caused by the emission of each tonne of carbon. This is particularly relevant for public Procurement. A recent policy paper* published by the BEIS estimates the social cost of carbon within a range of £124 to £373, with a medium value of £245 per tonne.

To find a middle ground, it is also common practice for many companies to relate to the current market price for carbon, which is traded within the scope of the UK ETS at over £80 (August 2022).

How does the application of an internal carbon price translate to a purchasing project in practice? Let’s look at a simple example:

Supplier A offers a product for £9,800, Supplier B for £10,000. Whereas Supplier A is causing 12 tonnes of CO2 equivalent, Supplier B only causes 9 tonnes. Now let the buyer assume a carbon price of £100 per tonne. For Supplier A, this translates to a penalty of £1,200, for Supplier B only to a penalty of £900. In terms of the overall adjusted price, Supplier A comes out more expensive at £11,000 compared to Supplier B at £10,900.

Taking a chance to set incentives

Assigning an internal price to carbon defines clear incentives to invest in green solutions, and signals the company’s commitment to pay a premium for these. This commitment gives suppliers security to invest in green products – a win-win situation for everyone.

Naturally, the determination of an internal carbon price is a complex task, even more so because the price will not stay constant over time. However, it is not unusual for sourcing decisions to be made years in advance. Most companies are still at the very start of their carbon journey and have not yet a willingness to pay for greener supply chains. Any carbon price, no matter how low or high it may be in the beginning is therefore a starting point. Over time, the price will inevitably have to approximate the true cost of carbon a company will be exposed to as per regulations.

The early bird catches the worm

Even more important for Procurement management is the reverse conclusion. A company not willing to give their suppliers the commitment that green solutions are not only important, but have a value, will not set incentives for innovation and investment in its supply chain. Worst case scenario, this will instead be done by competitors. In markets where green solutions are still a rare commodity, only early adopters will benefit. There are many examples in various industries as the current shortage of green building materials, packaging, energy sources or transport fleets shows.

*https://www.gov.uk/government/publications/valuing-greenhouse-gas-emissions-in-policy-appraisal/valuation-of-greenhouse-gas-emissions-for-policy-appraisal-and-evaluation