Podcast
September 19, 2023

SoS #4: Avoid Unexpected Spend on Initiatives with Carbon Pricing

Podcast
September 19, 2023

SoS #4: Avoid Unexpected Spend on Initiatives with Carbon Pricing

Podcast
September 2023

SoS #4: Avoid Unexpected Spend on Initiatives with Carbon Pricing

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Transcript

Hey, everyone, welcome to State of Sustainability, where we deliver key information to sustainability professionals to help them navigate sustainability transformations within their organisations. Hopefully, you're set up well for this podcast. I've got some tea here. Get your favourite beverage, your favourite snack.

We're going to go through some fairly dense topics. I'm going to try and kind of move quite slowly, and give some practical examples as well. We're going to discuss two closely related topics.

  1. One is how you build business cases for sustainability change in your organisation. Everything from how you think about return on investment, how you communicate, how you prioritise, etc.
  2. We're also going to talk about carbon pricing. because this is an effective tool to prioritise between different business cases, and it will also help you to align different stakeholders within the organisation.

I'll unpack a few different strategies for setting carbon prices, and I'll offer some suggestions of pitfalls to avoid, shortcuts, tips, etc.

Hopefully, this is going to be useful for you in building your sustainability strategy and plan, but also just getting it moving in language that the rest of the organisation can readily understand or can ramp up on quickly. So hopefully this is useful.

Any feedback, or suggestions, please message me or put something in the comments wherever you're accessing this. And of course, enjoy.

Chapter 1: Business Case

Let's start with talking about business cases. Internal research that we've conducted at Altruistiq has flagged that the top pain point for most organisations working on sustainability is driving internal engagement, alignment, call to action, or whatever you want to call it. This is one of the top challenges for over 90% of sustainability professionals.

So let's go through a tried and tested three-step process to start to get internal buy-in and where you can really put your focus and emphasis.

Step 1: Start with the why.

This is always a good idea, and this is always the right place to start. Focus on the business problem that you want to solve and the upside value that you expect to see. So for example, what is the consumer value proposition? What is the win? What is the reward, whether it's in terms of better brand positioning, higher revenue, maybe its cost reduction, or maybe it's risk related. Maybe it's investor positioning. There can be a range of different levers.

Start with that. That's going to be important because that is typically more aligned with the lodestone or the north star of the organisation. That should be our reference point whenever we talk about sustainability.

For example, if you're let's say a pre IPO business, you're owned by a private equity fund or some other investors who want to bring the company to market and have a listing. And actually, the whole organisation is geared towards that IPO moment that's really pivotal and the whole management team is incentivised towards this, then actually, the best way for you to start thinking about communicating your sustainability business problem internally is going to be in terms of that IPO, that big milestone event, it might be something else, right?

The organisation might have it's DNA, a particular consumer oriented milestone, a market share, for instance, or some other value proposition, but really orienting around the why that is at the core of your business. And putting that at the core of your sustainability strategy will make you friends in the organisation.

Try to lean in to speaking about value creation in this way because you're going to need to also contrast this with costs. We'll come on to carbon prices. But if you lean in first to that return aspect that will help make the the cost easier to swallow and more palatable for organisations.

Step 2: Choose where you want to win.

The next step is to choose where you want to win and what the key battlegrounds are going to be for you.

You will not be able to win everything in sustainability. There are going to be some areas where you want to excel because it's core to your business strategy. It's core to your brand. And there are some areas where you just need to be good enough. I know most of us have an allergic reaction when we say “don't go for great, go for good enough”.

But the honest truth is you will not have the resources. You will not have the time, you will not have the energy, you will not have the money to go after every different sustainability goal that's out there to achieve. So pick the two to three impact areas where you really want to excel.

I speak with a lot of companies in the food and beverage space, for example, and usually what I hear is; emissions is number one, waste is number two, and maybe something oriented to land use or deforestation is number three, and if you think about circularity that can dovetail often with the waste element.

But those three are clearly most important and maybe a half a dozen other metrics that you might think about for that individual company are not so important.

One thing that I've seen companies do quite well is create a matrix, where they say on this matrix, there's something around the importance for us of getting this right. And there's something around the effort for us of getting this right, and they plot that on the matrix.

Most large companies are creating some version of this matrix today. And so they'll have maybe 20 or 30 different priorities placed on that matrix. Where they usually fall short is that they let that sit in a file somewhere and they actually don't make that a core part of how they're communicating and aligning stakeholders behind this problem.

But if you think about that matrix, identify what are the key initiatives that you really want to win at? And this will usually take us to the, the quadrant that is the lowest difficulty and the highest impact. That's traditionally how strategies work.

What I'd also encourage you to do is think about anything that is actually in the low effort space altogether.You might want to already start thinking about a few quick wins. But identifying the generally low cost, high impact areas is a good place to go for the long term strategy thinking.

Step 3: Implement the how

Let's focus on how this is all going to happen. You're going to need to start placing bets. You're going to have scarce resources to bet behind your initiatives and hope that they work. The business of making bets relies on data. You need to have some level of confidence that whatever resources you're going to invest behind this particular initiative are going to pay off, not just in terms of any financial impact that you're looking for, but also in terms of, let's say, the carbon impact that you're looking for.

This is difficult for you to, with confidence commit to. The reason for that is that a lot of your data is going to be skewed and wrong. You're going to have a lot of data related challenges. Let's just take emissions, right? As the example, your emissions data is going to be generated using different assumptions to those of your peers.

So benchmarks will be different. Internal year to year benchmarks will vary based on granularity, coverage, value chain engagement, etc. So there are a lot of things that will move around. And again, your suppliers may be gathering data in ways that are different to you. Assumptions may change. Emissions factors may change.

Bottom line is, there are a lot of caveats that you need to package in with the sort of communication around how you're investing behind sustainability.

Let's just take a step back and recap what we're talking about. We're talking about building a business case or a few business cases that you can communicate to the organisation as a way to galvanise energy, action and motivation.

And so, what we first talked about is speaking the same language as the business. Identify the why, identify what winning looks like for your business, and start communicating your sustainability agenda in the context of that why, of that version of winning.

The second is prioritise and take a few interventions or a few areas or a few topics, not more, and look to win on those topics first.

The third is when you work out how much this is going to cost for you to get, get something done. In terms of the return, always have caveats that this data is subject to change and will get better or will get worse because you're going to need that later on when things don't turn out as planned. And frankly there will be those instances.

Chapter 2: Carbon Pricing and Why is it Useful

So having laid out a little of how we think about business cases, I want to start looking at the next piece, which is what are some devices that we can use to really start putting all the different business cases that we might be approaching into context with each other to make them comparable.

And in this vein, I usually think about carbon pricing because carbon pricing I think is the best way to compare apples to oranges.

Let's talk about why carbon pricing is useful first. And so carbon pricing has the potential to be one of the biggest developments in corporate finance of the last few decades.

Data from CDP suggests that roughly half of Fortune 500 companies are using some form of carbon pricing today. This data is a couple of years old and I think there's a bunch of companies that are already using it as of then and want to use it over the next couple of years, so round about half of fortune 500 companies.

I expect this number to rise very significantly. especially across the UK, Europe, the US, and Japan. What is startling for me is how little information is out there on carbon pricing today in terms of standards, norms, methodologies, comparability. It's not a blank space, but it's a very noisy space with lots of very high level opinions and very little on what it should actually do and how you should use one and how you should create one.

Let's dispel one myth from the get go. There is not a single carbon price across companies, and while carbon prices may be influenced by carbon taxation, this is not the same thing. Carbon pricing is, in most cases, an internal assumption similar to a discount rate for those who are familiar with building a business cases using net present value, NPV, or IRR.

And this internal assumption of a carbon price is informed by the company's own analysis and experience. It is unique. In its best form, a carbon price for your business should represent the aggregate cost of all of the different decarbonisation interventions you're going to be deploying and this price will not be static.This price will evolve and change fairly rapidly in line with the changing cost profiles of your decarbonisation interventions.

In my view, a better way to term it is actually a carbon cost, because it represents this cost of decarbonisation, rather than a price that you're paying to acquire carbon. What's exciting is a lot of the largest companies that are especially in the consumer goods related areas where they're purchasing a lot of ingredients and materials have started to already incorporate this sort of thinking and factor it into their procurement exercises where they're asking suppliers for the carbon cost of the product that the supplier is selling to them.

And I think that's the right way to think about it. There's a carbon cost represented within this business or within this product, which is the cost to decarbonise it. So, 2hat purpose does a carbon price serve for a business? There are two purposes in my view.

One is that it allows you to estimate the total cost of decarbonisation for your business.

So if you think about the targets that we're all putting out there, right now, almost no company that I have ever seen or worked with has a reasonable idea of what the achievement of their SBTs are going to cost them. Let me just rephrase that and say that again because it's startling every time I think about it.

Almost no company that I'm aware of or have worked with that is setting a science-based target or has set one actually knows what that target is going to cost them.

This is something that no business would ever engage with in any other topic at any other time in history where they make a massive longterm commitment that is going to reshape their entire business in unpredictable ways and cost something that they have no idea how to put a number on.

That's a bit mind-boggling when you think about it. And so if you actually work out a carbon price for your business as an aggregate of the different interventions that you're going to be deploying, that allows you to already start costing up what the bill is going to be for your target achievement.

And I think that's something super important for most organisations to engage with. Your business, whichever business you're in has probably not thought through this enough. We'll talk about this a bit more later.

The second, purpose of a carbon price or the second use you'll have from a carbon price is that it's one of your best ways to prioritise across decarbonisation initiatives in your portfolio of initiatives.

So in the strategy that you've made, maybe dozens, maybe even hundreds of different initiatives, you could actually start weighing one against the other using a comparable number. And so, by working in a carbon price and using carbon-weighted monetary values in your business case development, you can actually make sure that your cash investments are going furthest in terms of their impact.

The tip I would suggest is apply carbon pricing at the level of an initiative category rather than en masse. What I mean by that is, let's say that you're a food business, and you do some agricultural growing, and you do some processing, and you do some retail activity, for example. These are three simplified categories, but you might have many other categories. You should work out the carbon price at the level, ideally at the lowest level that you can get to.

So within the growing or agriculture environment, you might want to have something at the level of individual activities on the field. You might want to have other activities there as well. But ideally work this out at the activity level because by getting some level of granularity and some level of accuracy at that granular level, you can aggregate up to a number that is more accurate than if you do it at the, at the parent level, at the company level.

And it'll minimise inaccuracies overall. So let's, let's talk a little bit about now how you sort of set that carbon price, having established what the use is of a carbon price to you.

Chapter 3: How to set a carbon price

A carbon price, as I said, should reflect the cost of decarbonisation or abatement overall for the business. There's no standard way to do this right now, so I'm reflecting a little based on my own experience, having deployed carbon pricing as a mechanism across companies over the last several years, both as a consultant at McKinsey and also more recently in the context of Altruistiq.

In my experience, the best approach is to create a net present value or an NPV at the level of an initiative and divide it by the emissions impact that you're having. The reason that I use NPV is that it captures all of the outflows. So it captures capital expenditure, operating expenditure, one off recurring items, and it also captures all of the inflows.

New revenue streams, costs avoided, etc. It also incorporates the weighted average cost of capital specific to your company, and that's important. Because each business will have a very different cost of capital. I've worked with some businesses where the actual cost of capital was super high because the business was was literally printing money.

I think of one example where I was working with a state monopoly in the power sector, and they almost had a license to print money. It was that profitable, which meant that the cost of their capital was pretty high because they could deploy it towards super profitable activities.

By contrast, you'll have many other businesses where it can be different, for instance. And so you want to be able to work in the cost of capital into your calculation of carbon prices as well. This will give you then the true sense of the financial impact to your business as compared to the carbon impact.

It's also possible for you to price in risk or implementation difficulties, for example, by inflating the outflows, or factoring in the uncertainties over carbon impact, by discounting the emissions reduction, for example.

Let me also share one shortcut and one tip.

Here's the shortcut: for many organisations, it can be a lot of work to calculate a carbon price for each initiative.

This isn't necessarily true. It's possible to create a reasonably good estimate for a dozen initiatives in a couple of days using desktop research. But it's an impression that most organisations will have where it seems like it's a lot of work if you're looking for a way out.  Try pulling publicly available initiative data, which you can usually get from, for example, a sector specific marginal abatement cost curve. These might be slightly out of date, they might be slightly context inappropriate, but it's usually easier for you to stress test these existing numbers internally, rather than building them out from scratch.

One example that comes to mind is that there's a really good marginal abatement cost curve available for the agriculture sector published by McKinsey around 2020, and it has a good holistic view on what standard initiatives are that could be deployed within the agriculture space to decarbonise it. The estimated cost for each of those initiatives is obviously going to be broad brush aggregate.

It's going to be a point in time and it's not going to be geography specific or, you know, within the agriculture space, which is obviously big and complicated. It won't be specific for every type of business, but it at least gives you a starting point that you can iterate. That's the shortcut.

Let's go with the tip as well: I would stack rank the initiatives based on the carbon price, which will give you the next best initiative that you want to go with to achieve impact. This is classically building your own marginal abatement cost curve. What you should bear in mind, though, is that this picture is going to change, like I said earlier, based on how the cost and revenue assumptions in your business evolve as well.

And so In the absence of a digitised approach, you should highlight initiatives, where you think costs are going to go down or they're going to go up or they're going to stay flat. You should have some sense of what's going to evolve and how much you think it might evolve by.

A good example is, you know, anyone looking at any initiative based around green hydrogen, for example. This was certainly true a few years ago. I don't know if it still is, but the cost of electrolyses was estimated between 2018 and 2023 or 24 to go down by high double digit percentage points. Cost was expected to go down by maybe 40, 50, 60 percentage points due to the increasing scale of electrolyser production, which would in turn drive down the cost of, uh, green hydrogen potentially.

And so, you want to be able to highlight some of these areas where there might be a radical shift upwards. A radical shift downwards or relative predictability in what the cost profile is going to look like. So highlight, make those highlights. The next bit is you should also plan on refreshing the analysis at least annually.

If your decarbonisation has a heavy implication for your cash flow, then you should definitely look at doing this at least annually, maybe even a bit more frequently. Otherwise, for most companies, every couple of years should really be fine.

One more thing worth talking about is that if you have multiple business units, life will be much, much easier if you perform this exercise at the level of each individual business unit. This is even more true if the business units are quite distinct.

I worked at one point with a big energy conglomerate. And they had divisions that were really very different. One was, for instance, fuels. One was specialty chemicals. One was mobility. There were a couple of others as well, all really very distinct. Different geographies, different processes, different teams, and very differently minded engineers can be quite an important thing to bear in mind. And so in this context, having one way of, let's say, building a marginal abatement cost curve, or one cost curve you're trying to get everything onto, and one sort of carbon price you're trying to aggregate for the whole business all in one go, became just an impossible stakeholder management exercise, where you ended up with, I remember we ended up with these multiple workshops of 30, 40 people at a time, all effectively debating something that is inherently reasonably abstract.

So I would compartmentalise this activity at the business unit level and then aggregate up rather than trying to do it in one go.

Summary

Just to summarise what we've covered, we've talked first about building business cases and there we've said the most important thing is to start with is: why we're doing this. What is the lodestone for the business? How do we dovetail with that lodestone?

We then moved on to how do we pick the two or three battlegrounds that we want to fight this game on? What are the two or three categories of intervention, two or three goalposts we're going for in the context of that broader why?

We've then talked about being able to actually bring that together in the context of a few initiatives where we really work out what the costs are going to be, what the return is going to be. But importantly, we caveat the data shortcomings that mean that all these numbers are going to change a bit from there.

We've gone on to what are some tools and tips that we can use. To really make those business cases more comparable and there we've gone into carbon pricing There are many different ways to carbon price and again, there are many different strategies:

  • Some people will actually just take a carbon tax and use that as a starting point and spread the spread the carbon tax across the business.
  • Others will take a carbon offset price, or a voluntary carbon offset price and use that as a starting point.
  • Others will take maybe a cap and trade based credit cost and use that,

What we've talked about is actually using a carbon costing approach where you cost each initiative and aggregate upwards to create a carbon cost for decarbonisation of the business and we've called that our carbon pricing strategy.

And hopefully we've also talked through how you can make this carbon pricing approach work in the context of your business.

But before I leave you, let me just give you one final suggestion, which is if all of this sounds too much in terms of carbon pricing, and you really don't want to go to the effort of kind of working out all these numbers and, and none of them seem intuitively right, then you could do worse than using 75 per ton as your carbon price.

The reason I put forward that number is that it's roughly halfway between the range of what experts estimate we need to have carbon pricing at to be Paris Agreement compliant.

So happy to talk more about that as well. If you're interested. Thanks for listening in to today's episode of State of Sustainability. If you have any questions or on the points I've just shared, please get in touch, follow me on LinkedIn. If you want to follow more of what we're talking about, join our next LinkedIn Live.  Looking forward to seeing you there, or otherwise, please just enjoy listening.

Thank you.