Internal Carbon Pricing Disclosures

‍Introduction

With the issuance of new environmental disclosure standards, such as the Securities and Exchange Commission’s (SEC’s) Climate Rule, the European Union’s Corporate Sustainability Directive (CSRD), and the International Financial Reporting Standard’s (IFRS’s) Sustainability Disclosures companies are now facing increasing requirements to disclose information about internal carbon prices in sustainability reports.

Carbon pricing involves recognizing the cost associated with a company’s emissions. It encompasses both external and internal carbon prices. External carbon prices typically refer to taxes imposed by governments based on companies’ emissions. A common example of this is a cap-and-trade program where the government charges companies for allowances that grant permission to emit a certain amount of carbon. An example of this is the EU’s Emission Trading Scheme (EU ETS). Additionally, external prices can take the form of a direct tax, where the government charges companies for all the carbon they choose to emit.

In contrast, internal carbon prices do not involve actual expenditures with third parties; instead, they serve as a pricing mechanism used for internal company reporting to advance specific business objectives.

Requirements for internal carbon pricing are appearing in so many standards because investors want more information about how companies are developing these prices and how they are being used in business operations. This has likely become a more important question for investors recently because of the increasing popularity of internal carbon pricing schemes. According to a study conducted by the Carbon Disclosure Project (CDP), 25% of North American, 39% of Asian, and 39% of European companies either used internal carbon pricing in some capacity by 2021 or had plans to do so by 2023. Moreover, within specific industries such as power, fossil fuels, and financial services, 50-70% of companies employ an internal carbon price.

Companies utilize internal carbon pricing in various ways, but they generally fall into two categories: shadow prices and internal taxes. According to IFRS S2, a shadow price “is a theoretical cost or notional amount that the entity does not charge but that can be used to understand the economic implications or tradeoffs for such things as risk impacts, new investments, the net present value of projects, and the cost and benefit of various initiatives” Essentially, companies can use an internally selected rate to represent the potential cost of emitting carbon in their operations. A company may do this to plan for a future where a carbon tax applies, or it could use it to encourage employees to consider more climate-friendly alternatives when evaluating projects.

Internal carbon taxes operate similarly to external carbon prices, but under this pricing scheme, the company charges subsidiaries, product lines, or other units a fee based on the amount of carbon they emit. Companies typically adopt this approach to encourage business units to seek emission reduction strategies, by making emissions impact their profitability. Alternatively, companies may impose these internal carbon prices to create a green fund, which can finance projects such as research and development for more sustainable operating procedures.

SEC Climate Rule

The SEC Climate Rule, which applies to all public companies registered with the SEC, requires companies to disclose information about internal carbon pricing schemes if those schemes are material. The rule clarifies that an internal carbon price is material if it materially influences how a company evaluates and manages climate-identified risks for their other disclosures.

If a company determines that any of its internal pricing schemes are material, it must disclose the following information: the price assigned to a metric ton of CO2e, the total price assigned to emissions, and the company’s estimate of future changes to the total price. The rule requires that companies disclose this information for the first time as soon as fiscal year (FY) 2025 for large accelerated filers, FY 2026 for accelerated filers, and FY 2027 for all other companies in scope of the rule. However, companies should be aware that the SEC has included a safe harbor to protect them from private securities litigation regarding the parts of their climate reports dealing with transition plans, scenario analysis, and internal carbon pricing.

European Sustainability Reporting Standards (ESRS)

On January 5th, 2023, the European Commission’s Corporate Sustainability Reporting Directive (CSRD) entered into force. The commission adopted this directive as part of its commitment to the European Green Deal. The directive requires that companies in its scope must report under the European Sustainability Reporting Standards. Companies without any exemptions or designations for reporting later will have to report for the first time in 2025 on fiscal year 2024. For more information about the ESRSs and the specific implementation dates and scoping requirements, see our in-depth article here.

These ESRSs like the SEC Climate Rule also require disclosures concerning internal carbon pricing. This requirement is outlined in ESRS E1, the standard dealing with climate change. Five key disclosures are required.

The entity must disclose the types of internal carbon pricing schemes it employs, specifying whether a particular scheme is a shadow price or an internal carbon tax.
The entity must disclose any critical assumptions made when setting internal prices and why those prices are relevant to the way the company uses them.
The entity must define the scope of its pricing schemes, including where they are applied and whether they pertain only to specific emissions or programs.
The entity must describe how its pricing schemes impact decision-making or encourage the adoption of carbon-related targets or policies.
The entity is required to disclose whether its carbon prices are consistent with those used in the financial statements, if applicable.

IFRS Sustainability Disclosure Standards

In 2021, the IFRS Foundation established the International Sustainability Standards Board (ISSB) and tasked it with developing the IFRS Sustainability Disclosure Standards. In June 2023, the ISSB published the final version of these standards. The ISSB created these standards to serve as a global baseline for other countries. The idea is that jurisdictions around the globe will either directly adopt these standards into law or use them as a basis when creating their own reporting requirements. Consequently, the standards are voluntary unless required by a particular jurisdiction. For more information on the IFRS Sustainability Disclosure Standards, please refer to our in-depth article here.

The IFRS Sustainability Disclosure Standards, like the other mentioned standards, require companies to disclose information about internal carbon pricing. However, the required disclosures are more limited. Companies must report the price they use per metric ton of greenhouse gas emissions and explain how they incorporate this price into decision-making. For companies opting to report under this standard, it becomes effective for reporting periods beginning on or after January 1, 2024.

Conclusion

Companies utilizing internal carbon pricing schemes should take the time to review whether they fall under the jurisdiction of any of these major ESG standards. If they do, they should start preparing now to understand the disclosures that will be required of them in terms of internal carbon pricing, so that they will be ready when companies are required to report for the first time in the near future.

Resources Consulted

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