Underwriting the Cost of Carbon

Carbon pricing puts a quantitative value on emissions and when appropriately applied, holds great promise for facility management leaders tasked with driving changes in their building portfolios. By modifying their existing internal business case templates and processes to include carbon pricing, companies can make smarter, faster and more responsible financial decisions for the long-term health of their employees, their organization and the planet.

There are decision models in place today, but they can be improved for integrating carbon pricing into business decision making based on the net cost of carbon. The following chart depicts this decision-model landscape:

Figure 1: Company models for project decisions

By shifting from the traditional model, which does not consider carbon, organizations can consider two additional evaluative methods: the assigned cost of carbon — the price a company believes will approximate the true cost in a particular year — and the net cost of carbon, which helps organizations understand the risk premium paid to complete necessary retrofit projects.

Leave the traditional model behind

Models that fail to include the cost of carbon will not address looming regulatory and taxation changes announced by the EU, national governments and even local authorities. Here are some examples of carbon pricing in the shifting regulatory landscape:

• In 2008, British Columbia, Canada, introduced a carbon tax on gasoline that has since expanded to all fossil fuels.

• In 2019, New York City enacted Local Law 97 as part of the Climate Mobilization Act.

• Also in 2019, Singapore became the first country in Southeast Asia to introduce a carbon price via the Carbon Pricing Act and will facilitate a five-fold increase in carbon taxation by 2024.

• In 2021, the European Union announced a carbon border tax, which will be in full effect by 2026.

• Also in 2021, Boston, Massachusetts, USA, updated its Building Emissions Reduction and Disclosure Ordinance (BERDO) to give the city authority to set emissions standards and place commercial buildings on a path to net zero by 2050.

This changing landscape means more external costs will be added to facility budgets going forward. Companies that act to adjust the physical operation of their facilities can limit, and in many cases, avoid these regulatory costs. But those keeping traditional simple-payback or decision-making models that ignore the cost of carbon (or its likely future cost) will have an expensive and more carbon intensive portfolio.

Organizations that adopted Science Based Targets Initiative (SBTi) will need to be even more proactive in adjusting decision-making models to deliver absolute emissions reductions via changes like electrification and on-site renewables. For these companies, carbon offsets can address residual emissions, but not the emissions from core operations (i.e., owned and leased buildings). As a result, the procurement-only approach is not an option for these firms.

This leaves FM leaders facing a shared challenge of knowing what technologies are available and what needs to be done in buildings, but not having financial models approved when retrofits are proposed.

Basic: Assigned cost of carbon

Organizations can adopt an assigned cost of carbon model in which the value of carbon avoided through project implementation is included as an input in the business case analysis. Projects are compared using a company’s typical financial evaluation methods (e.g., net present value or internal rate of return). Projects are approved for funding and implementation if the evaluated financials exceed the company’s business case threshold or hurdle rate.

A company’s existing internal business case templates and frameworks can be modified to include an assigned cost of carbon. This simply requires organizations to determine a price of carbon for future analyses. Some external benchmarks for selecting an assigned cost of carbon are:

• UN Global Impact has called for companies to adopt an internal carbon price of at least US$100 per metric ton of equivalent CO2 emissions.

• The IPCC’s minimum estimate of marginal abatement costs is US$135 per metric ton.

• The European Union Emissions Trading System (EU ETS) has accelerated these efforts by adopting a price of 96 euros per metric ton (US$101.36) as of February 2022.

• Sweden’s Carbon Tax is at 118 euros (US$124) per metric ton.

• New York City’s Local Law 97 has a penalty of US$268 per metric ton above allowed amounts.

• Some organizations are already adopting an internal carbon price of US$100 per metric ton (for example, companies have published internal carbon prices ranging anywhere from US$12 to US$440 per metric ton).

• These prices are expected to rise as demand exceeds supply and as scrutiny on quality increases.

Why does it matter? Putting carbon pricing into decision-making processes and business case models generates investments that allow companies to meet targets and mitigate risk.

Imagine an organization adopting a US$100 price of carbon. Under the traditional return on investment (ROI)-focused model, a project costing US$4 million and saving 2,750 metric tons of carbon dioxide has an internal rate of return (IRR) of 2 percent and is unlikely to be approved. Including the US$100 price of carbon increases this return to a reasonable 11 percent, making the project viable. Per these examples, adopting an assigned cost of carbon approach unlocks increased returns on decarbonization investments. The additional returns fuel more investments that increase building efficiency, making them more reliable, resilient and easier to operate.

Advanced: Net portfolio cost of carbon

Applying an assigned cost of carbon is a critical first step, but it is important to recognize that the methodology has limitations. Even with a US$100 (or more) assigned cost of carbon factored into the process, the deep retrofit projects necessary for portfolio decarbonization will not happen because organizations are not appropriately valuing the risks posed by failing to decarbonize. An additive decision-making framework can help simplify the process of valuing risk on a project basis, and moreover, provide a dynamic framework for reviewing multiple decarbonization projects as part of one decision-making process, the net portfolio cost of carbon.

Figure 2 illustrates how projects required to complete a credible carbon-reduction plan (e.g., electric boilers, thermal solar or heat pumps) are more expensive to implement with less savings than projects implemented earlier in the decarbonization journey and are less likely to be approved on a standalone basis. Yet, given the outsized impact of these technologies, organizations will not meet their decarbonization goals without them.

 

Figure 2: Cost of carbon required to justify investments

Considering Figure 3 shown below, imagine an organization chooses to adopt an assigned cost of carbon equal to US$100 per metric ton of CO2 equivalent (tCO2e).

• The organization has a 10 percent IRR hurdle rate

• The cost of carbon (expressed as USD per tCO2e) necessary for each project to achieve this hurdle rate is shown as (B) decarbonization factor (Note: this factor can be more or less than an organization’s assigned cost of carbon)

• The net cost of carbon equals the organization’s assigned cost of carbon (A) minus decarbonization factor (B), which is represented in Figure 3 as (C)

In this example, two projects have returns in which the net cost of carbon is positive, meaning these projects would likely be approved for implementation on a stand-alone basis. However, the solar thermal project has a net cost of carbon of US$95.96/tCO2e, and on its own would only be approved if the organization values the risks associated with a failure to meet public targets at or above US$95.96.

Figure 3: Decarbonization project examples

When the net cost of carbon per tCO2e is multiplied by the quantity of carbon avoided for each project, this yields the total net cost of carbon, which crucially can be pooled across all decarbonization projects under consideration as the net portfolio cost of carbon. In a portfolio approach, projects with a surplus net cost of carbon can help fund projects with a deficit.

A proposed framework for applying the net portfolio cost of carbon approach is shown in Figure 4. Additional risk factors — those already stated and committed to by an organization — are included within the decision-making framework. Properly implemented, this framework helps FM leaders better understand which projects to develop, how to manage the approval process, and how to pool risks and rewards to reach decarbonization goals.

Figure 4: Organizational decision matrix for projects considering the net cost of carbon

Some leaders will challenge the application of these factors. For these individuals, referencing internal corporate social responsibility reports, public reporting or internally stated sustainability targets can be helpful to align goals within a practical decision-making template.

A decision framework should be agreed upon upfront by all decision makers, and once the framework is settled, the introduction of specific projects can begin. With consistent application over time, organizations will develop an efficient decision-making process grounded in shared investment parameters.

What next?

FM leaders can start a conversation with executives, as it is critical to align with corporate real estate, tax, finance and business leaders on acceptable language, models and decision-making frameworks.

Executives are likely to be more receptive to this conversation than ever before. Leaders are shifting away from quick payback thinking toward a broader and longer-term perspective, pushed by regulators and their own boards of directors.

To further facilitate discussion, FM leaders can stress urgency. As Figure 5 illustrates, delaying action increases the costs of achieving targets and the risks of not doing so. These are quantifiable, timely issues for every organization.

Figure 5: Illustrative cost of waiting

Another important step for organizations is to ensure funding to develop a program and propose actionable projects, particularly those that consider an entire real estate portfolio and the need to track, monitor and report emissions. Leaders must fight for budget allocation to drive site auditing, asset data collection and program development, as these granular inputs will be necessary and integral to identifying, prioritizing and advocating for projects.

Per the World Bank, putting a price on carbon emissions is fundamental to internalizing the external costs of climate change. It will create economic incentives and drive investments in low-carbon economic growth.

FM leaders can make this happen within their own organization.