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Facing expectations from stakeholders to help address the climate challenge, more and more businesses are making efforts to monitor the carbon emissions of their operations and supply chains. Less obvious than the emissions themselves, though, are the financial costs of those emissions—in particular, the costs embedded in the price of goods as a result of carbon taxes, cap-and-trade systems and other mechanisms that charge companies for the greenhouse gases (GHGs) they produce. Because those costs can be difficult to track, we’ve come to think of them collectively as the hidden cost of carbon.
To shed light on carbon’s hidden cost, we developed a global model covering 65 economic sectors in 141 countries and regions. The model provides an indicative estimate of the hidden cost of carbon at current carbon prices, along with the hidden cost under two alternative carbon price scenarios. The findings suggest that in the G20’s individual member countries, the hidden cost of carbon today can amount to more than 1.5% of the production value of carbon-intensive goods such as steel, cement and chemicals, and as much as 10% for electricity.
What’s more, carbon costs look likely to rise—and would have to rise even further if the world is to meet the Paris Agreement’s net-zero targets. More than 40 national jurisdictions, in addition to many subnational governments, accounting for almost one-quarter of global emissions, already put a direct price on carbon. Of these, Canada, Denmark, the Netherlands and others have scheduled price increases. The EU Emissions Trading System (EU ETS), for one, is set to decrease the amount of free emissions allowances, which will tend to raise their price. Another 35 jurisdictions are considering implementation of a carbon price, including major economies such as Brazil, India and Indonesia.
New carbon pricing mechanisms are also emerging—notably, carbon tariffs. These levies require importers to pay the same carbon price as domestic producers, as a way of eliminating the cost advantage that carbon-intensive imports might otherwise enjoy. The first carbon-tariff system, the EU Carbon Border Adjustment Mechanism (CBAM), takes effect in October 2023 for reporting purposes, and it becomes chargeable in 2026. As the CBAM ramps up, our model estimates that it would increase the hidden cost of carbon for many goods by a factor of five or more.
As carbon prices rise, businesses that produce or purchase carbon-intensive goods could find their competitive position shifting. But by anticipating movement in the hidden cost of carbon, executives can begin to prepare. In this article, we look at some examples of how the hidden cost of carbon builds up in supply chains today, how it might change as carbon pricing expands and evolves, and how companies can maintain an edge amid these dynamics.
Our work started with a simple question: how does the hidden cost of carbon vary for energy-intensive, globally traded goods? Discussed below are the results for two sectors: the ferrous metals sector, which includes steel, and the power sector, a key supplier of energy to nearly every industry.
At current carbon prices, the hidden cost of carbon for the average ferrous metal producer varies by a factor of almost 17 among the top five producing countries, ranging from 0.09% of sales in Japan to 1.52% of sales in Germany (see chart below). Consequently, the average producer in Germany faces a cost disadvantage of 1.43% (1.52% less 0.09%) of sales relative to the average producer in Japan.
Full implementation of the CBAM, however, would raise the cost of ferrous metals exported to the EU—reducing the carbon cost disadvantage now faced by producers in Germany. And in the net-zero scenario, in which the price of carbon is set at the 2030 level, consistent with achieving net-zero emissions in 2050, the average ferrous metals producer in Germany would no longer bear a higher carbon cost than its competitors in China, Japan and the Republic of Korea, and would nearly be at parity with US producers. This example shows how a uniform global increase in carbon prices could result in a cost advantage for companies whose products are low in emissions intensity.
Under current policies, carbon prices generally affect only a limited portion of emissions and are set at a relatively low level compared with the net-zero scenario. However, under both the CBAM and net-zero scenarios, more emissions are subject to a carbon price, and the price imposed would be higher than under current policies.
For the five largest electricity-producing countries, the average hidden cost of carbon ranges from 0.03% of sales in Russia to 1.97% in China. The difference of 1.94% of sales (1.97% less 0.03%) creates a cost disadvantage for electricity-using companies in China that either compete with imported goods or export products to foreign markets. (Although China’s current carbon price is relatively low, the hidden cost of carbon for Chinese electricity is relatively high because the power sector relies heavily on coal-fired generation.)
In the net-zero scenario, the cost of carbon for electricity in China would increase to 86% of sales—a cost disadvantage of 40 percentage points, compared with Russia (see chart below). The cost of carbon in India’s electricity sector in this scenario is less affected, because the 2030 carbon price in the IEA’s 2021 model is lower for India and other developing countries than for major emerging market countries (including China and Russia) and advanced economies (including Japan and the US).
Since 2010, the average global carbon price has risen, along with the proportion of the world’s carbon emissions that are subject to carbon prices. Both trends will likely continue; many countries plan to increase their carbon prices or institute pricing mechanisms. Knowing this, forward-looking companies are taking steps to manage their carbon costs. Here are four practices that have proven useful at some of the world’s leading organisations.
Successfully navigating the transition to a sustainable economy means anticipating new climate and environmental policies that could dramatically affect your business. Although uncertainty surrounds these potential developments, the price and cost of carbon will likely continue to rise. By identifying where carbon costs hide in your company’s supply chain, you can factor potential price increases into business decisions in a way that helps your company create more value over the long term.
Footnotes:
[1] World Bank Carbon Price, https://www.worldbank.org/en/programs/pricing-carbon.
[2] See the case study for Mosaic: https://www.pwc.com/us/en/library/case-studies/mosaic-climate-modeling.html.
[3] See https://iea.blob.core.windows.net/assets/932ea201-0972-4231-8d81-356300e9fc43/WEM_Documentation_WEO2021.pdf, page 17, Table 5.
Partner, Global Sustainability Tax, Legal and Workforce Leader, PwC United Kingdom