The Sustainability Buzz

How Shadow Pricing Can Improve the Outlook for Sustainability Projects

Shadow Pricing and SustainabilitySuppose you have a project that you’d like to undertake that, based on standard cost/benefit analysis, doesn’t quite meet the payback period that your company requires. However, you know that in addition to the easily quantifiable benefits of the project there is one more, less obvious, benefit. The completed project will reduce the company’s carbon emissions by a substantial amount. You know that your company has recently made it a priority to reduce just those types of emissions. How do you convince the higher-ups that this is a valuable project to approve?

In pre-sustainability days, you just would have been out of luck unless you had a management willing to do something because it was “the right thing to do.” But as companies come to better understand the risks associated with certain environmental conditions such as increasing CO2 emissions and dwindling water supplies, many have introduced the concept of shadow pricing into their cost/benefit analysis process.

To take the definition used in the 2014 State of Green Business Report, “a shadow price is . . . the estimated price of a good or service for which no market price exists, or where the market price doesn’t reflect the full replacement cost.” Let’s consider that in two applications. For CO2 emissions, there is not a carbon market for the United States so it is correct that there is no “price” for carbon in our country. However, there are 19 established emissions trading systems (ETS) in the world, including one in California and one in Alberta.  Based on the prices set by these various carbon markets it is possible to estimate the value of one tonne of “saved” carbon emissions.  Currently prices range from $6 to $60 per tonne.

Shadow pricing is, not surprisingly, used extensively in the energy industry to factor in the impact of future carbon controls that might be imposed. More surprisingly, some 150 companies including Microsoft, Dow, Disney and Delta, outside of the energy field, have disclosed to CDP (formerly the Carbon Disclosure Project) that they are already using a shadow price for carbon to inform business decisions.

How does this apply to your project? If the end result of implementation is a reduction in carbon emissions in addition to whatever other cost savings the project yields, it is now possible to assign a monetary value to those reduced carbon emissions on the benefits side of the cost/benefit analysis. Those additional benefits may tip the scales to clear your company’s hurdle.  Some companies do this informally by, rather than assigning an actual price, allowing longer acceptable payback periods if the project reduces carbon emissions.

Let’s look at the second half of the definition of shadow pricing – where the market price doesn’t reflect the full replacement cost. Projects related to water or other critical raw materials often fall into this category.  A project designed to reduce water consumption may not reach the desired breakeven point because of a relatively low price of water in the area. However, if your product is highly dependent on the reliable availability of water – perhaps in the baking or brewing or bottling industries – then the risk of not reducing water consumption is much higher than that represented by the cost of water. Disruptions to the production line and to the customer need to be considered. If your plant is located in an area where drought is prevalent, which unfortunately now means a significant portion of the U.S., good risk management dictates that you should assign a shadow price to the water to factor in the risk of drought disrupting your water supply. In this situation, the shadow price represents the costs (risk) avoided by the implementation of the project and the reduced consumption of water.

Shadow pricing is a not unfamiliar accounting concept. Businesses already routinely quantify items for which there is no price. “Good will” and “brand value” are often factored into the valuation or sale price for companies. But there are far more opportunities for pricing the cost of externalities – the costs not born by the producer, such as air pollution or depletion of raw materials – into the financial model. In Europe, The Prince of Wales’s Accounting for Sustainability Project has been providing an opportunity since 2013 for the CFOs of many of Europe’s biggest corporations to work together to define how integrating environmental and social issues into financial modeling can improve decision-making and reduce risk and uncertainty.

Next time you have a project with a strong sustainability component that doesn’t quite clear the hurdle, consider factoring in the cost of the carbon emissions you’ll save. Show the monetary value of those avoided emissions. Just the argument alone could make the difference.

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