The cost of carbon: How companies can tackle building emissions through internal carbon pricing

In this article, Fabrizio Varriale, RICS Place and Space Analyst, explores the different ways organisations can implement internal pricing mechanisms to measure and reduce emissions across their operations.

The first article of this series ‘The cost of carbon’ looked at how public authorities use carbon pricing, together with conventional command-and-control policies, to regulate emissions from the built environment. Access it here.

Just like in public policy, the application of carbon pricing within companies provides a way to internalise the cost of environmental externalities (i.e., emissions) caused by business operations. Companies assign an ‘internal price’ to the carbon they produce, measuring and tracking those emissions as they occur across their departments. This can be done in different ways:

• A shadow price can be assigned to carbon to represent its hypothetical cost, using it as an indicator of what emissions might cost if they were to be taxed or offset. This allows a company to evaluate the impact of their operations and potential future costs, but without changing their financial model.
• An implicit price can be calculated to quantify the marginal cost that a company is spending to abate or offset its emissions. This does not change the financial model, but simply makes visible the current cost that a company is incurring in due to its emissions.
• An actual price can be set to incentivise company departments to manage and reduce their emissions. This can be implemented though a direct internal fee, or through an internal trade system. The financial model of the company is affected in both cases since each department needs to budget for its emissions.

In the case of a shadow price, the cost per tonne of carbon is usually set in one of two ways. It can be set high, to reflect future changes, or based on an external source to reflect the element of risk, such as the Carbon Disclosure Project (CDP) Pricing Corridors.

In the case of an actual price, the cost is usually set low, taking into account the capabilities of the company. Of course, companies are also free to variate the cost across departments and over time, to reflect external changes and/or adjust the impact that internal pricing has on business operations.

The benefits of internal carbon pricing

Depending on the type of implementation, internal carbon pricing can have several benefits:

• Generally, it forces companies to assess their emissions periodically and consistently. This highlights which parts of the business are most carbon intensive and translates environmental impact into a more understandable metric to raise awareness and inform decision-making. It also signals that a company is taking its environmental impact seriously and can attract investors looking for ESG credentials.
• Shadow and implicit pricing help modelling and managing financial and regulatory risks posed by current and future carbon taxes and trade systems.
• Actual pricing drives innovation and carbon savings, and the internal revenue can be reinvested to fund carbon offsetting or carbon saving initiatives.

The adoption of internal carbon pricing is a recent but rapidly growing phenomenon. In 2014 only 150 of those companies reporting to the CDP declared themselves to have internal pricing or were planning to implement it soon. By 2020, that number grew to almost 2,000.  The majority of these firms operate in the services and energy sectors, and are located in Europe, Asia and the Pacific. By far, most of these companies have implemented shadow pricing initiatives rather than actual pricing.

According to CDP, the top factors motivating companies to adopting internal carbon pricing are driving low-carbon investment, driving energy efficiency, and changing internal behaviour. Notable examples of companies that have adopted internal pricing are Microsoft and Mitsubishi. The latter uses an internal shadow price that covers only Scope 1 and Scope 2 carbon (i.e., direct and energy-related emissions), while the former implemented an actual internal pricing scheme which also covers their Scope 3 carbon (i.e., indirect emissions).

CDP data for 2020 indicates that there is considerable uptake in the construction sector and its supply chain. However, only a small minority of companies operating in the real estate sector have adopted internal pricing initiatives. Sentiment is changing: several large real estate firms have recently announced the implementation of such initiatives. For example, LaSalle (real estate investment managing company subsidiary to JLL) included the development of an internal shadow price in its 2023 Net Zero Carbon Pathway for Europe.  A similar initiative has been adopted by Landsec, the largest commercial property development and investment firm in the UK. NREP, one of the largest real estate investors in the Nordic countries, established an internal carbon tax as part of its strategy to reach net zero by 2028.  Similarly, Great Portland Estates (GPE), one of the UK’s largest investor and developer, implemented an internal carbon tax (at £95 per tonne) covering its emissions across Scopes 1, 2 and 3. In its first two years, this internal tax raised £925k for the GPE decarbonisation fund, which was reinvested into energy-efficiency improvements across the company portfolio.

Aside from the generic benefits described above, the example of GPE shows the main distinctive advantage of applying an internal carbon tax to a real estate company.  The revenue can be reinvested to improve the carbon performance of the company’s properties. This creates long-term energy and carbon savings, with beneficial impacts that can extend beyond the ‘boundary’ of the company (e.g., reduced energy cost for tenants).

The devil in the details

The real estate sector also faces some unique challenges in adopting internal carbon pricing, which also apply to the construction sector. Primarily, this comes down to the difficulty of measuring emissions across the portfolio and the capability to reduce those emissions through direct action.

Consistently measuring a building’s embodied carbon – emissions due to manufacturing, construction, and demolition activities – can be resource-intensive. It is notoriously difficult for several reasons: from the lack of accurate data to the variation of results due to methodological choices. Companies that are intent on measuring embodied carbon may struggle to arrive at reliable results, so the prospect of ‘charging’ business departments on the basis of inaccurate data can be deterring. Measuring operational carbon is comparatively easier, but only if a company has access to a breakdown by source for the energy consumed to operate its building. 

Taking action to reduce emissions can be difficult for both embodied and operational carbon. Depending on the nature of the company, some emissions may occur upstream or downstream from business operations. For example, a construction firm has no direct way to affect how a building is operated during the use phase (addressing operational emissions) and can only do its best to build an asset that is designed for efficiency. Conversely, a company managing existing buildings has no control on the carbon embodied during the construction of those assets. It may also be unable to affect operational emissions associated with the tenants’ energy use unless specific clauses are included in the lease.

More generally, the fragmented structure of the industry, especially the construction sector, does not help tracking and reducing emissions. In the absence of an integrated mechanism (i.e., a common framework of metrics and requirements), the project-based, short-term nature of construction activities, alongside their reliance on complex supply chains, are additional obstacles to implementing internal carbon pricing. The low margins that are typical of the construction sector can also disincentivise the adoption of carbon pricing due to its cost.

Adoption in the built environment

Despite these challenges, the use of internal carbon pricing is spreading across both the construction and real estate sectors. This adoption is likely to accelerate as carbon pricing becomes more common as a policy instrument.

In our next article in this series on ‘the cost of carbon’, we turn back to carbon pricing in public policy. We will look at the EU Emissions Trading System (ETS) and its planned application to buildings and transport.