The design method and form of internal carbon pricing (ICP)

Internal Carbon Pricing (ICP) is a strategic tool used by companies to internalize the cost of carbon emissions. This approach can help companies consider the cost of carbon emissions in their financial and operational decisions, thereby promoting their reduction in emissions and achieving sustainable development goals.

 I. Connotation of Internal Carbon Pricing

 Internal carbon pricing is a strategic tool that enables businesses to quantify the cost of carbon emissions in their internal financial decision-making processes. This concept involves setting a price for each unit of carbon emissions generated by a business's operations, which reflects the cost of reducing or emitting these carbons. This approach encourages companies to identify and invest in the most cost-effective ways to reduce emissions. 

The core purpose of internal carbon pricing is twofold: 

• Economic incentives: By materializing the cost of carbon emissions, companies have stronger economic incentives to seek ways to reduce carbon emissions, such as investing in energy-efficient technologies or shifting to more sustainable operations and production methods. 

• Risk management: Help companies anticipate and respond to external carbon pricing policies they may face in the future, reducing the economic impact caused by external economic environment and external policy changes. 

II. Strategic Application of Internal Carbon Pricing 

When setting internal carbon pricing, companies consider multiple factors, including existing and expected regulatory requirements, industry standards, market competitive conditions, and the company's climate action goals. The implementation of this strategy can involve the following specific steps:

•  Setting a carbon price: Choose an appropriate carbon price, which can be based on external market carbon prices, industry comparisons, or expected carbon taxes. This price should reflect the costs and investments required to achieve the company's climate goals. 

• Determination of Scope and Coverage: Clarify which business units or activities should be included in the scope of internal carbon pricing. This can start with direct emission sources and gradually expand to indirect emission sources such as electricity purchases and supply chain activities. 

• Data Management and Reporting: Establish effective carbon emission data collection and management systems to ensure accuracy in calculations and reporting. This includes monitoring and recording carbon emissions at various stages, from infrastructure operations to product lifecycles. 

• Performance Evaluation: Regularly evaluate the effectiveness of internal carbon pricing strategies, including their impact on reducing carbon emissions, improving energy efficiency, and enhancing economic performance. 

III. Common internal carbon pricing methods mainly include the following: 

1. Internal Carbon Tax:

 Internal carbon tax is a mechanism implemented internally by enterprises to internalize the cost of carbon emissions, thereby encouraging business units and employees to reduce carbon emissions and adopt more environmentally friendly practices. This mechanism converts the external cost of carbon emissions into direct financial costs within the enterprise by imposing taxes on carbon emissions within the enterprise. 

PS. The internal carbon tax system (Carbon Tax) and the internal carbon fee system (Internal Carbon Fee) seem to be the same but there are some differences, please refer to the following "Is there a difference between the Internal Carbon Fee system and the Internal Carbon Tax System?" for detailed distinction. 

1.1. How internal carbon tax works

A. Carbon tax rate setting: 

•  Companies set a carbon tax rate, which is the fee they pay for each amount of carbon dioxide released, usually measured in tons. This tax rate can be determined based on factors such as the company's climate goals, cost structure, and external carbon prices. 

• The carbon tax rate should be high enough to prompt business units to consider the environmental impact of their operations, thereby incentivizing them to look for ways to reduce emissions. 

B.  Monitoring and billing of carbon emissions:

•  Companies need to establish a carbon emission monitoring and reporting system to ensure that the carbon emissions of each business unit can be accurately measured and recorded. 

• Based on these records, companies bill carbon emissions, which are calculated based on the carbon tax rate and the actual emissions of each unit. 

C.    Fee collection and use: 

• The carbon tax collected is usually centrally managed to fund internal climate action projects, such as energy efficiency improvement, renewable energy projects, or other emission reduction technologies. 

•  Additionally, some companies may choose to use these funds for external carbon offset projects to achieve carbon neutrality or other climate-related commitments. 

1.2. Benefits of internal carbon tax

A. Internalization of Environmental Responsibility: 

•  By directly reflecting the cost of carbon emissions in the financial performance of the business, internal carbon taxes hold business units accountable for their environmental impact, enhancing the overall environmental responsibility of the enterprise. 

B. Drive behavior change: 

•  When carbon emissions are directly linked to costs, business units are more motivated to find innovative ways to reduce emissions to reduce costs and improve overall economic efficiency. 

C. Flexibility and Adjustability: 

• Internal carbon taxes offer a high degree of flexibility, allowing companies to adjust their carbon tax rates according to their specific circumstances and goals to achieve their climate action goals most effectively. 

D. Financial and environmental benefits:

• A properly implemented internal carbon tax not only reduces the overall carbon emissions of the enterprise but also improves operational efficiency and innovation by funding internal emission reduction projects, leading to financial savings. 

1.3. Internal Carbon Tax Challenges 

•   Accuracy and fairness: Ensuring the accuracy of carbon emissions measurement and reporting is a major challenge in implementing internal carbon taxes, requiring appropriate resources to establish and maintain monitoring systems. 

•  Internal Acceptance: Changing the behavior patterns of business units may encounter internal resistance, especially in the short term, which may increase the operating costs of some business units. 

An internal carbon tax is an effective tool that can help businesses achieve their environmental goals while pursuing financial performance. However, ensuring the successful implementation of this regime requires careful planning and management at all levels, from strategy design to execution. 

2. Cap-and-Trade: An internal carbon trading system (Cap-and-Trade) is a market mechanism used for internal carbon management within a company, which sets a total carbon emission cap (CAP) and allows business units to achieve optimal total carbon emission control by buying and selling carbon emission rights (TRADE) within this cap. This strategy aims to promote the most cost-effective ways to reduce emissions and encourage innovation and efficiency. 

How the internal carbon trading system works

A.   Setting the Cap 

First, companies set an overall carbon emission cap, which is usually based on the company's climate goals and past emissions record. This cap should be challenging and facilitate the entire enterprise's transition to lower carbon emissions. 

B.  Allocation of Emissions Allowances

Depending on the set cap, companies allocate emissions allowances to different business units or departments. The allocation method can be based on historical emissions data or through auctions or fixed quotas.

 C. Operation of the Internal Carbon Market 

Once carbon credits are allocated, business units can buy and sell carbon credits in the company's internal carbon market. If a business unit is able to operate below its quota, it can sell its remaining carbon credits; If emissions exceed the quota, additional carbon credits need to be purchased in the market to achieve compliance.

 D.  Monitoring, Reporting, and Verification 

Companies need to establish strict monitoring and reporting mechanisms to ensure the accuracy of carbon emission data. Third-party verification is also usually required to ensure data objectivity and transparency. 

2.1. Benefits of internal carbon trading system

A. Facilitating Cost-Effective Emissions Reductions: By allowing business units to trade carbon credits, businesses can achieve their emission reduction targets where the cost is lowest. 

B. Incentivizing Innovation and Technological Advancements: To reduce the need to purchase additional carbon credits, business units may seek innovative emission reduction technologies and methods. 

C. Increased Flexibility: The internal market mechanism provides flexibility, allowing business units to choose the most suitable emission reduction strategies based on their own circumstances. 

D.Enhance the standardization of internal carbon management: By establishing internal markets and trading systems, companies can better track and manage their carbon footprint. 

2.2. Implementation Challenges 

• Equity Issues: Ensuring equitable distribution of emission rights is one of the challenges, requiring consideration of the size, function, and historical emissions of business units.

• Management of the internal market: Ensuring market transparency and efficiency, avoiding manipulation and unfair trading, is key to the success of the internal carbon market.

•  Cultural and Organizational Change: It may take time and resources to drive cultural change within the organization, making all employees understand and accept the carbon trading system. 

Overall, internal carbon trading systems are an effective tool to help companies achieve their carbon reduction goals in a market-driven manner, while incentivizing business units to seek innovative and efficient ways to operate.   

3. Shadow Pricing: Shadow pricing is a common method in internal carbon pricing strategies, primarily used to internalize external costs that may be implemented in the future, such as carbon taxes or carbon trading costs, to help policymakers better assess the potential economic impact of long-term investment and operational decisions. Shadow pricing does not involve real monetary transactions but serves as a calculation tool used to simulate the impact of carbon emission costs on a business's finances and operations. 

How shadow pricing works

A.    Determining the carbon price: 

• Companies choose a hypothetical carbon price, which may be based on existing market prices, expected policy changes, or corporate climate action goals.

•  This price is used to assess the assumed cost per unit of carbon emissions from business operations and new investments. 

B.    Application to financial models: 

•  Applying shadow carbon prices to corporate financial analysis and investment evaluations helps predict the impact of carbon emission costs on project economics.

• This approach is particularly useful for evaluating the cost-effectiveness of long-term projects, such as infrastructure investments, new product development, or energy procurement decisions.

 C.    Decision Support:

• Shadow pricing provides a tool for decision-makers to consider the financial impact of environmental policies or market changes that may be implemented in the future.

• In this way, businesses can proactively adjust their strategies to reduce risks and improve the sustainability of their projects and operations. 

3.1. Benefits of Shadow Pricing

A.    Risk Management:

• Shadow pricing helps businesses identify and manage potential financial risks associated with carbon emissions, especially in a global environment with increasingly stringent carbon pricing policies.

 B.    Incentive emission reduction: 

• By internalizing carbon costs, businesses are incentivized to find ways to reduce carbon emissions, leading to improved operational efficiency and innovation. 

C.    Support for the Sustainable Development Goals: 

• Shadow pricing supports businesses in incorporating considerations for climate action into their operations and strategic decisions, promoting contributions to sustainability goals.

 D.   Increased transparency and predictability:

• Through shadow pricing, companies can more transparently demonstrate their readiness and response strategies to future carbon price changes, enhancing trust among external stakeholders.

3.2. Implementation Challenges 

Carbon price options:

• Determining a reasonable shadow carbon price is challenging, considering market trends, policy changes, and corporate environmental commitments.

Internal Acceptance and Understanding: 

• Ensuring acceptance and understanding of shadow pricing within the business, especially if it may indicate increased costs, requires adequate communication and education. 

Shadow pricing is an advanced strategic tool that can help businesses anticipate possible market and policy changes while fostering innovation and leadership in environmental stewardship. Proper implementation of shadow pricing strategies is crucial for businesses to stay competitive in global competition. 

4. Baseline and Credit: In internal carbon pricing strategies, the Baseline and Credit system is a method used by companies to manage carbon emissions and incentivize emission reduction behaviors. This system establishes an internal carbon baseline where different departments or projects can achieve carbon emissions below this baseline and receive carbon credits, which can be used for internal incentives or trade, thereby achieving cost-effectiveness and incentivizing emission reduction goals. Operating mechanism of the fund system (Baseline and Credit): 

A.   Setting the Baseline 

• The baseline is the amount of carbon emissions that each unit should achieve within a specified period. This is usually set based on historical data, industry averages, or target emission reduction levels.

• his setting aims to establish a goal that is both practical and challenging, driving departments or projects to find ways to reduce carbon emissions. 

B.  Monitoring and Reporting of Carbon Emissions 

•  Businesses need to continuously monitor and calculate their carbon emissions and evaluate them against baselines. 

• This requires ensuring that there are effective data collection and management systems in place to provide accurate and timely emission information. 

C.  Earning and Using Credits 

• If a department or project has emissions below the baseline, carbon credits can be obtained. These credits reflect the difference between actual emissions and the baseline. 

• The carbon credits obtained can be traded within the company or used to achieve higher-level corporate climate goals, such as compensating for excess emissions from other sectors. 

D.  Internal Market and Incentives: Companies can establish an internal market to buy and sell carbon credits, so that departments can buy or sell carbon credits on demand to meet their respective emission targets.

•  Additionally, companies can combine the acquisition of carbon credits with financial incentives, such as bonuses, budget increases, or other forms of recognition, to encourage departments to actively seek emission reductions.

 E. Benefits of the fund system

1. Cost-effectiveness: Allows businesses to reduce emissions where they are at the lowest costs, reducing the overall cost of meeting emission reduction targets. 

2. Increased Accountability and Engagement: By setting clear emission reduction targets and incentives, departments and employees are more engaged and accountable.

 3. Flexibility: Enterprises can design baselines and credit systems based on their operational characteristics and needs, making them more targeted and flexible. 

4. Support corporate climate strategy: Contribute to the implementation of a company's overall climate strategy, especially in a business environment where carbon emissions regulations are becoming increasingly stringent. 

The fund system needs to consider the specific circumstances of each department when implementing it within the enterprise to ensure that the system is fair and effective, while also requiring continuous monitoring and evaluation to ensure that the goals are achieved. In addition, the successful implementation of this system requires high-level support and cross-departmental collaboration.  

Is there a difference between the internal carbon fee system and the internal carbon tax system?  

Internal carbon fee and internal carbon tax are often regarded as similar concepts in corporate practice, and they seem to be the same internal carbon price system that involves monetary quantification or cash flow (both are handed over to the company's collection and governance unit after final settlement), but they may have slight differences in definition and implementation. These differences mainly lie in their purpose, how they are managed, and how they influence the financial and operational decisions of businesses.

 Here are the key differences between the two: 

1.Internal Carbon Fee: 

• Definition :

An internal carbon fee is a fee set by a company itself, charging the carbon emissions of its business units or projects at a specific price. 

• Purpose: 

The aim is to incentivize carbon emission reduction by creating an internal funding pool, which is usually reinvested in sustainable development projects within the company, such as energy efficiency improvements, renewable energy projects, etc. 

• How it works:

 Fees are typically calculated based on actual carbon emissions and are used to fund environmental or energy-saving projects within the company. 

2. internal carbon tax :

• Definition :

 Internal carbon tax is a tax rate set by enterprises to simulate the impact of external carbon taxes, and prices carbon emissions. 

• Purpose: Mainly to make the internal cost structure of the enterprise reflect the carbon tax policies that may be implemented or have been implemented in the real world, so as to prepare for the impact of external carbon tax norms. 

• How it works: Carbon tax fees are typically calculated based on preset or simulated carbon tax rates and these costs are included in product pricing or operating costs, but they do not necessarily involve actual capital flows or reinvestment. 

• Key Differences 

Financial Flows: Revenue from internal carbon fees is often explicitly reallocated to other sustainability projects, while internal carbon taxes may be accounted for solely as a cost factor to influence budgets and financial decisions.

Strategic Purpose: Internal carbon fees emphasize incentives and capital reinvestment, aiming to directly promote emission reduction behaviors and environmental protection projects. Internal carbon taxes are more for cost simulation and risk management, helping companies anticipate and adapt to the impact of external policy changes. 

Overall, both are tools used by businesses to manage and reduce carbon emissions internally, and the choice depends on the specific goals and strategic needs of the company. 

3. The following distinguishes and compares the two: 

Although internal carbon fees and carbon taxes are both forms of internal carbon pricing mechanisms, there are still some differences:

 1.1 Different pricing methods 

Internal carbon fees are usually set by enterprises independently, and the price is determined based on factors such as the company's emission reduction costs and carbon trading market prices. The internal carbon tax is levied according to the government's tax rate with reference to the carbon tax policy issued by the government. 

1.2 Different purposes of use

 The main purpose of internal carbon fees is to incentivize internal emission reduction and drive enterprises to independently adopt energy-saving and emission reduction measures. The internal carbon tax is more of a cost expense for enterprises, and the funds are usually eventually handed over to the government.

 1.3 Revenue distribution 

The income from different internal carbon fees is generally retained by the enterprise itself and is used to support internal carbon management and emission reduction projects or other incentives, as well as investment project support for the medium- and long-term low-carbon transition economy. The funds paid by the internal carbon tax belong to the government, and after internal accounting, the same collection will eventually be paid to the government according to the government's official collection mechanism, and enterprises cannot use it directly.

 1.4 Management Flexibility 

Internal carbon fees are managed independently by enterprises, with greater flexibility in pricing and usage. The internal carbon tax needs to follow government policies and regulations, and the management is relatively more rigid.

 In general, internal carbon fees are carbon pricing mechanisms spontaneously established by enterprises, with more emphasis on incentivizing internal emission reductions. The internal carbon tax is a policy tool introduced by the government, which focuses more on increasing corporate carbon costs. Companies can choose the appropriate carbon pricing method according to their own situation 

The fund system (Baseline and Credit) and the internal carbon trading system (Cap-and-Trade) look very similar, how to distinguish them? 

Baseline and Credit and Cap-and-Trade are both internal mechanisms used by companies to manage and reduce carbon emissions, both aiming to internalize the environmental cost of carbon emissions by setting costs or values. Although the two regimes are similar in purpose, they have fundamental differences in their operations, management strategies, and scope of influence. The following details the characteristics, how they work, and the main differences between the two systems. 

1. Fund System (Baseline and Credit) 

1.1 Definition and Objectives: 

The fund system is a carbon emission reduction incentive where companies set a carbon emission baseline, usually based on historical data or industry averages. If the company's carbon emissions are below this baseline, it can obtain carbon credits; If it is exceeded, compensation measures may be required. 

How to operate: 

• Set a baseline: Businesses set a baseline based on past carbon emission records or industry standards. 

• Measurement and Reporting: Regularly measure and report actual carbon emissions, comparing them to a baseline.

•  Credits and penalties: Units emitting below the baseline receive carbon credits, which can be sold on the internal market or reserved for future use. Units that exceed the baseline will need to take compensatory measures, such as purchasing carbon credits or conducting additional emission reduction projects. 

Management strategy: Enterprises can establish a carbon credit bank or fund to manage carbon credits generated by low-carbon performance units and carbon credits required by high-carbon performance units. This system encourages departments or units to reduce carbon emissions through efficiency and innovation. 

2. Internal Carbon Trading System (Cap-and-Trade)

 2.1 Definition and Objectives: 

Cap-and-Trade is a more formal carbon emission management mechanism that involves setting an overall carbon emission cap (CAP) and allowing the trading of carbon emission rights between departments or units within this cap. In an internal carbon trading system, companies first set a total carbon emission cap, which is the maximum total carbon emissions that the company can accept. Then, companies allocate emission permits to various departments or business units according to some fair allocation mechanism. These permits represent the right to emit a certain amount of carbon dioxide. 

Steps: 

• Set a total emission limit: The company determines the total emission limit within a time frame, which is set based on the company's sustainability goals and possible legal requirements. 

• Assign (issue) emission permits: Businesses assign emission permits to various departments or units, which can be based on historical emissions data, department size, or production volume. 

• Trading mechanism: If a permit holder finds that their emissions are lower than what their permit allows, they can choose to sell the remaining permit to other units that need more space to emission space. Similarly, if a sector exceeds its permitted emissions, it needs to purchase additional permits from the market to legalize its emissions.

 Management Strategy: 

• Trading Platform: Businesses need to establish an internal trading platform that allows departments to freely buy and sell licenses. This platform should provide transparent price information and transaction records. 

• Audit and Regulation: Companies should regularly audit their emissions data and transaction records to ensure that all departments comply with carbon emission regulations. This may require verification by a third party to add transparency and credibility. 

• Incentives: By allowing departments to benefit from savings in license sales, businesses can incentivize their departments to adopt energy-saving and emission reduction measures. 

3. Main differences between the fund system and the internal carbon trading system: 

• The fund system focuses on rewarding behaviors below a certain baseline, rather than actually establishing a market mechanism. 

• The internal carbon trading system establishes a more formal market environment, where the buying and selling of permits reflects the real market supply and demand conditions, helping to determine the market price of carbon emissions. 

Such a system not only helps in internal carbon management but also prepares for external carbon market regimes that may be implemented in the future. In this way, companies can effectively control their overall carbon emissions while incentivizing departments to take more autonomous actions to reduce emissions. 

3.1 Comparison of Differences 

Differences between the two internal carbon pricing mechanisms, Cap-and-Trade and Baseline and Credit: 

1.Overall mechanism:

•  Cap-and-Trade: A company or department has an overall carbon emission quota cap (Cap), and employees/departments can buy and sell emission allowances in the internal trading market.

•  Baseline and Credit: The company sets a carbon emission baseline, and the excess must pay a carbon fee, below which carbon credits can be obtained. 

2.Carbon Emission Certificates (Licenses): 

• Cap-and-Trade: The company issues tradable carbon emission permit certificates, which employees/departments can buy and sell. 

• Baseline and Credit: Does not involve the issuance of tradable carbon emission certificates, only the record of carbon credits. 

3.Carbon Price Mechanism: 

• Cap-and-Trade: Carbon prices are determined by supply and demand in internal trading markets, with no fixed price. 

• Baseline and Credit: Emissions beyond the baseline pay a carbon fee at a fixed price, such as $300 per ton. 

4.Carbon Credit Usage: 

• Cap-and-Trade: Excess allowances can be sold on the internal trading market. 

• Baseline and Credit: Carbon credits from low-emission sectors can be used to offset carbon debt from other sectors. 

5.Operational level: 

• Cap-and-Trade: Established an internal carbon trading market. 

• Baseline and Credit: More reflected in the company's internal accounting and incentive mechanisms.