Policy makers and corporate executives alike are interested in quantifying just how much a tonne of carbon dioxide will cost in the future. While it’s intuitive why policy makers, tasked with securing the long-term welfare of a country, are interested in CO2’s dollar value, large corporations are also spending money on predicting the future. Why do they care? A misestimation in the exact cost of carbon could turn a multi-million dollar profitable venture into an expensive sunk cost several years down the road.
Carbon Cost’s Effect On Profit
Corporations, particularly those in industries with long-lived assets, use economic and financial models to determine whether a particular investment will be profitable. In order to account for the risk of environmental regulations in the future, some companies are using a “shadow carbon price” in their projections. Shadow carbon pricing, as defined by Sustainable Prosperity, is
“the voluntary use of a notional market price for carbon in internal corporate financial analysis and decision-making processes. A shadow carbon price is generally expressed in terms of dollars (currency) per tonne of carbon dioxide (CO2) or carbon dioxide equivalent (CO2e).”
By using a shadow price, a carbon-expensive project that is financially viable (based on non-carbon factors) will not be pursued if the expected future cost of carbon wipes out the profitability of the project.
How Much Are Companies Allocating?
Sustainable Prosperity surveyed companies in the Canadian oil and gas sector and found that they are benchmarking carbon anywhere from C$15 to C$68 per tonne in forecasts that go out to 2040. If you think this range sounds reasonable, a Stanford study, previously profiled by CleanTechnica, would disagree. Stanford estimates that the social cost of carbon is closer to US$220 per tonne. How did the researchers arrive at such a different number than the U.S. Government’s US$37 per tonne estimate? For one thing, Stanford’s model allows for economic growth rates to be affected by climate change. They also separated the effect climate change has on high and low income countries, as well as integrated the effects of adaptation into the model. While this refinement is a step in the right direction in determining the true cost of carbon, researchers admit that there are still limitations. In particular, the time lag of mitigation efforts and their effect on the economic growth rate are not integrated – two factors that the writers believe should be included in the model.
Microsoft has even gone so far as to provide an open-source carbon-fee frameworkfor other companies to use in their carbon accounting.
In An Uncertain World, What Is A Company To Do?
According to DIW Berlin, future carbon expectations affect company decision-making in two ways. In the first way, companies that use shadow carbon pricing will favour investments that tread lightly on the environment over heavier projects, all other financial factors being equal. In the second way, companies can hedge their carbon bets. Say a company wants to invest in a project that, given a range of carbon cost estimates, may or may not be profitable. What the company can do is buy carbon contracts in the futures market in order to lock in a set price. This increased demand for the ability to pollute raises the price of emissions on the exchange. An increase in the price draws technological innovation; carbon-efficient projects are pursued that would not have been financially viable at the previous price. Whether the investments that companies make in carbon-efficient technology are direct or indirect through future markets, the incentive now exists to uncover more resourceful ways of production.
Interestingly, if the perceived risk of regulation is real, risk-averse companies will try to mitigate this risk by either directly or indirectly investing in carbon-efficient technology. However, experts do caution that regulation is still required, since companies can change their expectations and their decision-making process if the perceived risk of environmental regulation disappears. Nevertheless, it is interesting to note that not only are company incentives affected by environmental regulation, but they’re also affected by the threat of regulation.
Picture credit: Carbon Visuals, from https://www.flickr.com/photos/carbonquilt/15101137337/ – Edited.