Financial institutions are facing increasing pressure from the global community to incorporate climate change considerations into their investment lending practices. This report analyses the benefits of adopting an internal carbon price (ICP). ICP allows financial institutions to incorporate forward-looking costs associated with carbon such as future market carbon price and carbon abatement costs that enables firms to increase their resilience in a low-carbon transition. The authors interviewed investors, banks and other relevant stakeholders from around the world to gain insight into their awareness of ICP, perceived values, potential use cases and barriers to implementation.

ICP is a tool to assess the materiality of the hidden carbon risks and opportunities in finance. These risks are driven by changes in the economy caused by climate regulations, policies, market shifts and technological developments. These risks can be translated into financial costs, otherwise known as carbon costs. The paper provides an in-depth analysis of the investor investment process and bank lending processes which are categorised into five phases:

• Phase 1: Screening/origination – identifying and assessing climate risks and opportunities
• Phase 2: Analysis/credit assessment – transforming above findings into financial costs for evaluation
• Phase 3: Investment decision/credit committee and approval – integrating ICP findings into the investment process
• Phase 4: Monitoring/loan and portfolio performance review – tracking performance of ICP
• Phase 5: Exit/repayment – ICP involvement for a long-term strategy

This analysis shows how investors and lenders are able to incorporate forward-looking costs associated with carbon.

The paper introduces the implementation of ICP with four dimensions which are depth, width, height and time. This is the ICP framework that outlines the scope of how ICP should be implemented for actively managed investment and lending portfolios. Each dimension encompasses a variety of factors including geographic, sector characteristics and level of financial exposure which need to be considered within the ICP framework.

The four dimensions of ICP for financial institutions:

• Depth: how ICP can be implemented for lenders and investors
• Width: how much of ICP should be applied to each portfolio
• Height: defines price levels and time is the continuous refinement of ICP
• Time: how ICP should evolve including accounting for indirect carbon costs

The four dimensions are integrated within the investor and banking processes. The integrated approach shows how ICP can be used to track and stress test carbon risks under various circumstances over time. The “tragedy of horizons” where there is a misalignment of long-term climate risks and short-term financing is mitigated with the implementation of ICP as it allows investees and borrowers to prepare for future carbon costs. Understanding business rationales is key to the four dimensions as it determines the approach of ICP.

ICP has recently gained traction with corporations. In 2017 one-third of financial institutions that reported to CDP used or planned to use ICP. Further, more organisations are aligning their portfolios with the low-carbon transition. There has also been an increased interest for corporations to begin their transition to low-carbon practices due to regulatory pressure from international agreements and government legislation.

1. Financial institutions interviewed cited materiality as an important determinant for applying an ICP, dependent on both the width and height of the ICP. These two dimensions together show the potential carbon costs that companies may face in a low-carbon future.
2. It is important to consider both market price and the types of carbon prices that are associated for a business. The three types of carbon prices are operational, which is a removal of a fossil fuel subsidy, upstream where carbon prices are passed through the supply stream and downstream which is dependent on changes in revenue due to market shifts in demand.
3. Credit Agricole, a French financial services company, have developed a top-down methodology to apply ICP to measure carbon risks. The results of this operation has significantly changed their decision-making process and how they allocate capital.
4. ICP can be used as a tool that is in addition to any market price such as a carbon tax or international agreement such as the Paris Agreement. ICP can capture the potential costs for this transition and provide insights on how to better align portfolios.
5. ICP has been recommended by the Task Force on Climate-related Financial Disclosures (TCFD). With the United Nations Environment Programme Finance Initiative (UNEP FI) carrying out pilot projects with banks, asset managers and insurance companies based on climate-related risks recommendations from the TCFD.
6. ICP can be used as an environment, social and governance (ESG) screening criteria for both investors and lenders. Screening can be categorised into three categories which are negative, positive and norm-based. This allows investors and firms to prioritise how they choose to interact with financial markets based on their carbon risks.
7. The paper includes stakeholder testimonies, taxonomies, examples of the application of ICP and other resources on the definition and implementation of ICP.