October 23, 2012

The Benefits of Carbon Shadow Pricing

Jim Harris
Magazine Article

Placing a shadow price on carbon can help a company cut costs, while dramatically reducing its risk and exposure to rising energy prices and a price being put on carbon.

One of the roles of corporate strategy function is to assist the CEO and board in managing strategic uncertainty and risk. Knowing that it’s impossible to accurately forecast future events, one of the jobs of corporate strategy is to develop scenarios of potential future realities, strategies for these scenarios, and a portfolio of options that may be exercised in the event that a scenario comes into being.

Royal Dutch Shell is perhaps the best known example of a company using scenario planning to prepare for future events, beginning in the 1970s. Shell’s scenario planning prepared it for the first oil crisis in 1973 — when the price of oil quadrupled in just 18 months. Most recently Shell has been using scenario planning for developing strategies mitigating the effects of climate change.

The greater the value of resources and time invested in a strategic commitment — such as developing a new oil field or pipeline — the greater the value of scenario planning is to an organization. But a firm doesn’t have to be a multinational oil company to get value from managing the risk that is implicit in any business strategy.

Planning for a Carbon-constrained Economy

Placing a price on carbon of anywhere from $10 to $80 a tonne can have a profound effect on business planning. It immediately highlights the areas of business operations that will be negatively affected when a price is finally put on carbon. Using a shadow price can assist management in quantifying and identifying material risk and making strategic decisions on how to take action to mitigate that risk — such as by reducing the energy and carbon associated with material composition of products, manufacturing process, product sourcing and transportation decisions and other business activities.

Doing so identifies “hot-spots” in the value chain and often opportunities for reducing risk where it is currently profitable to do so, financing the mitigation of future commodity and carbon price-risk via energy savings and cost avoidance today.

Canadian Tire has been doing this for four years. Managers coined the term “carbon price-risk” and defined it as the potential economic cost to the value chain of carbon being priced. Managers can tell their executives and the board how a price on carbon will affect the average cost of goods sold, which product categories will be hardest hit, whether or not the energy mix in one country versus another should affect sourcing decisions, and how it could affect transportation practices. And, most importantly, what strategies the company can put in place today to mitigate and prepare for a carbon-constrained world.

The right mind-set makes all the difference

Upon framing the issue in terms of business performance and risk — as opposed to the traditional language of corporate social responsibility (CSR) — the concept of carbon price-risk becomes real and relevant to strategy, the C-suite and the board. Two things become immediately apparent:

First, one does not have to “believe” in climate change to see the value in developing strategies and options for addressing risk. Whether one believes in climate change is irrelevant when the risk is 1) rising energy prices (which are inevitable over the long-term) and 2) legislative and likely to be a significant issue in international trade.

Second, it establishes the value chain as the appropriate scope for strategic thinking, scenario planning, and mitigation — far beyond the traditional corporate mindset and boundaries of “responsibility.” After all, it does not matter if your corporation is “responsible” for the carbon emissions or if it is in a distant third-party in your value chain; in the end, the cost will be passed on to the consumer, like all costs — which is a good thing, because it promotes better decision-making.

Placing a shadow price on carbon is a powerful tool for corporations to use. It exposes the carbon risk inherent in operations, and it allows management to communicate that risk to the Board and executives — who are tasked with mitigating risk and ensuring the long-term competitiveness of the company. Which brings us to an important question…

What’s your company’s carbon price-risk and what are you doing about it?

Original Article

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