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Commerce · VII.02 · MMXXVI · daylight

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A timber room with a low fire and floor cushions, a wall of glass framing snow-capped mountains.
Plate VII.02 · Workbook — the executiveThe Thermometer on the Balance Sheet.Climate economics is not the study of a catastrophe. It is the study of a quantity that has a physical unit and no price, and of what happens to a balance sheet when somebody finally writes one in.

WORKBOOK — THE CORPORATE EXECUTIVE

Chapter VII.02 · Climate as an Economic System

For the person with a P&L, a capital committee and a board calendar. The proposition here is not that you should care more. It is that a quantity you already own is currently unpriced on your own management reports, and that pricing it is a governance act you can complete in one quarter.

THE PREMISE, STATED COMMERCIALLY

Your firm holds a physical position — tonnes of CO₂e — that has a partial market price today, a wider price in the near future, and a modelled social cost roughly three times the widest price you currently face. You are long that position and you have not marked it.

Here is the arithmetic on a firm of ordinary size. 250,000 tonnes of scope 1, of which 60 percent falls under a compliance scheme at the EU price of $70.4:

  cash carbon cost      250,000 x 0.60 x 70.4  =  $10.56 m      8.8 % of EBITDA
  at a $190 shadow price  250,000 x 190        =  $47.50 m
  unpriced exposure                               $36.94 m     30.8 % of EBITDA

on EBITDA of $120 million. The 8.8 percent is why this currently sits with procurement. The 30.8 percent is why it belongs on your agenda. The gap between the two percentages measures how much of your carbon position is invisible to your own reporting, and closing that gap costs one quarter of work and no capital at all.

Note what is not being claimed. Nobody is suggesting the $190 will be charged to you. It is a shadow price: a number used to rank your own capital, the way a hurdle rate is used, and no more speculative than one.

PART ONE — DISCOVERY

Days 1–30: find what your own numbers already say

Exercise 1.1 — The tonnage close (two weeks, with your controller)

Before any price, a reliable quantity. Scope 1 and 2, monthly, reconciled to meters and invoices rather than estimates, with a named owner and the close discipline of the management accounts.

Ask one question in the review: would I sign this if it were a revenue line? If the answer is no, the price you apply to it will produce confident nonsense, and every downstream figure is a multiplication by this number.

Exercise 1.2 — Find the decisions that already priced carbon (half a day)

Every firm has made carbon-priced decisions without saying so: a fuel switch, an efficiency retrofit, a site closure, a logistics redesign. Pull the last five years of approved capital with an energy component and reverse-engineer the implied price per tonne avoided in each.

You will find a distribution, not a number, and it will be wider than anyone in the room expects. That distribution is the single most persuasive exhibit you will have, because it shows the firm has been pricing carbon inconsistently rather than not at all, and inconsistency is a governance problem your board already knows how to solve.

Exercise 1.3 — Where the compliance price is going (half a day)

Map your tonnes to the schemes they actually fall under, with their prices at 1 April 2025: EU ETS $70.4 covering 40 percent of EU emissions, UK ETS $57.2, Canada federal OBPS $66.2, California $29.3, China national ETS $11.8, Sweden $144.6, Switzerland $136.0. Note coverage as well as price — the $19 global average across covered emissions and $5 across all emissions are the two numbers that tell you how much of the world's tonnage is still free.

Exercise 1.4 — Benchmark what your peers set (two hours)

Internal carbon pricing is now common enough to benchmark. A quarter of organisations with an internal price set it below $20 — which is 10.5 percent of the EPA's central figure and below the month-to-month movement in the fuel prices you already manage. 15 percent set it above $130, up from 11 percent a year earlier. Record where you would sit and what that would say.

PART TWO — THE ARITHMETIC

Days 31–45: get the number right before you get it approved

Exercise 2.1 — Build the three candidate prices (one day)

Your board will choose among exactly three defensible bases. Price all three before the meeting.

  1. Regulatory expectation. What your tonnes will actually cost under the schemes they fall under, over asset life. Lowest, most auditable, and the one your finance function will reach for first.
  2. Published social cost. The EPA triple — $120 at 2.5 percent, $190 at 2.0, $340 at 1.5, in 2020 dollars — used as a floor with the other two as sensitivities.
  3. The constraint's shadow price. If you have a temperature-aligned target, the number is what meeting it costs, and in DICE that is 5.91× the marginal-damage figure — $184.4 against a baseline of $31.2.

The diagnostic to bring to the room: a firm with a 1.5 °C target and a $20 internal price is holding two positions that do not multiply out. That is not an argument about climate science. It is an internal inconsistency, and boards act on those.

Exercise 2.2 — Run the sensitivity yourself (two hours)

Do not let this be delegated. 340 / 120 = 2.83× across one point of discount rate; the half-point steps are 1.58× and 1.79×, a mean of 1.68×; the elasticity is 1.04 percent per basis point. Inside Nordhaus's own model, 128.5 / 19.7 = 6.52× across 2.5 points — 2.12× per point.

Take one live capital project and run it at all three EPA prices. On a project abating 40,000 tonnes a year, the shadow value moves from $4.80 million a year at $120 to $13.60 million at $340 — a difference of $8.80 million a year, or $176 million over twenty years undiscounted.

Exercise 2.3 — Know what the number cannot see (one hour)

You will be asked whether the estimate is robust. The honest answer, which is also the strongest one:

Therefore the number is a floor, not a point estimate. A project that fails at $190 fails. A project that passes has cleared a lower bound. Say exactly that in the paper; it is more credible than confidence and it survives challenge.

Exercise 2.4 — Answer the competitiveness objection with evidence (two hours)

Somebody in the room will say that pricing carbon costs output and jobs. The firm-level evidence is unusually good and it does not support the claim. Colmer and colleagues matched regulated French manufacturers against comparable unregulated ones and found emissions 14 to 16 percent lower with no detectable contraction in output or employment and no evidence of outsourcing; the abatement came from targeted investment in emissions intensity. Bayer and Aklin found the EU system cut about 1.2 gigatonnes between 2008 and 2016 — 3.8 percent of EU emissions, 133.3 million tonnes a year — during the period when its price was dismissed as too low to matter. Leroutier found British power-sector emissions 20 to 26 percent below counterfactual, with 143 to 191 million tonnes abated in five years.

And the whole literature at once: 80 causal evaluations, 21 schemes, 483 effect sizes, reductions of 5 to 21 percent — 4 to 15 after correcting for publication bias — with immediate effects in 17 of 21 schemes, or 81 percent.

Then give the other half, because your credibility depends on it. Applying the bias-corrected midpoint of 9.5 percent to the 15 gigatonnes covered gives 1.43 gigatonnes a year, 2.74 percent of global emissions, against a 1.5 °C requirement of about 22.36 gigatonnes — 6.4 percent, one part in 15.7. Carbon pricing works and is too small, and an executive who says both sentences is the one people believe on the third.

PART THREE — DESIGN

Days 46–60: the instrument

The carbon liability reserve with a price-linked drawdown.

The number that decides it — where your own curve clears. For the worked firm, 45,000 tonnes clear below $70.4 and 115,000 below $190, so the shadow price puts an incremental tranche of 70,000 tonnes a year into the money. At an average abatement cost of $130 the tranche costs $9.10 million a year and releases $4.20 million a year of value at the shadow price. The tranche clears at 1.85× today's market price and 0.68× the shadow price.

Read that last ratio carefully, because it is the whole commercial case. You do not need the market to move. You need to decide which of two prices governs your own capital, and that decision is entirely inside the building.

PART FOUR — DESTINY AND DELIGHT

Days 61–90: make it survive you

Exercise 4.1 — Put it in the pack, not in a presentation. Anything reviewed monthly persists. A carbon column in every capital paper above a threshold is worth more than any board session you will ever run.

Exercise 4.2 — Make one person's objectives move with it. Not sustainability's — operations'. An unpaid metric is a hobby, and the tranche above is an operational programme, not a reporting one.

Exercise 4.3 — Minute the price and the basis. The price memo is a governance artifact: the number, the basis, the escalator, the decision it governs, the review date, the approver. A firm that has written down its own rate has converted a permanent argument into a settled policy, and can now spend its attention on the abatement curve, which is where emissions actually fall.

The failure modes, named so you see them coming.

And the delight, which is real. The first project whose rank changes will not be one anybody argued about. It will be a routine retrofit that sat at position eleven on a list of eight funded items and now sits at three. Nobody has to be persuaded. The arithmetic simply moves it.

BOARD PAPER TEMPLATE

One page. In this order.

  1. The position. Tonnes, by scheme, with coverage. One table.
  2. The two costs. Cash carbon cost and cost at the proposed shadow price, each as a share of EBITDA. For the worked firm: 8.8 percent and 30.8 percent.
  3. The proposed price and its basis. One of the three, named, with the sensitivity: $120 · $190 · $340, and the multiplier 2.83× stated so nobody is surprised later.
  4. What the number cannot see. Three lines: the coefficient's dispersion, the Monte Carlo spread of $31.5 against $31.2, and the EPA's own statement on omitted damages. Conclude: a floor, not a point estimate.
  5. The decision it governs. Which threshold, which papers, from when.
  6. The reserve. Size, accounting treatment, drawdown rule, escalator.
  7. The first tranche. 70,000 tonnes at $130, costing $9.10 million, releasing $4.20 million a year of shadow value.
  8. The review date. And the name of the second owner.

APPRECIATIVE QUESTIONS FOR YOUR LEADERSHIP TEAM

  1. Which of our last five capital approvals already priced carbon implicitly, and what price was in the room when we made them?
  2. Where has a long-dated parameter — our cost of capital, a residual value — settled an argument here rather than starting one, and what made it stick?
  3. If our capital papers carried a carbon column as routinely as a payback, what would we have approved last year that we did not?
  4. What would we want people to conclude if we published our shadow price beside our cost of capital?
  5. Which of the three bases best fits what we have actually committed to, and who signs it?
  6. Where does our own abatement curve clear today, and what would move the next tranche below the line?
  7. What is the smallest threshold above which every paper gets the second column, starting this quarter?
  8. What would have to be true for this price to survive a change of chief executive?
  9. Who outside the sustainability function would notice first if we quietly stopped applying it — and what would they be looking at?
  10. What do we want our successors to find written down about how we chose this number, so that they can revise it well rather than start again?
  11. Which of our suppliers or customers is already managing this well, and what would it take to ask them how?
  12. If the compliance price doubled within three years, which of our decisions made this quarter would we wish we had made differently?