Is carbon trading the next step towards decarbonisation?

Reducing greenhouse gas emissions, such as carbon dioxide, is a key element in the fight against climate change. One way governments and companies are trying to reduce their emissions is through carbon trading.

Carbon trading is a market-based system that aims to provide economic incentives to encourage organizations to reduce their environmental footprint. Unlike voluntary offsets, where consumers can choose to pay to compensate for their carbon footprint, carbon trading is a legally binding scheme. Calculated by individual governments and policymakers, it aims to put a price on CO2 following the principle of caps and trade. The government sets a limit, or cap, on emissions permitted per industry. Emission certificates in the amount of this total quantity are placed on the market by auctioning them or allocating them to polluters. At the end of a predefined period, participating polluters must submit allowances equal to their emissions. They can buy or sell allowances on the market. Prices are regulated by markets, there isn’t a consensus on how to implement a cap-and-trade scheme globally.

This results in carbon prices that vary from less than $1 up to more than $140 for one ton of CO2 equivalent. In Germany, the price increased from €37 per ton in January 2021 to €88 per ton in January 2022 and it’s similar in other countries. Due to cap-and-trade mechanisms and the reduction of available emission credits, the price will increase over time. For large manufacturing companies that emit several million tons of CO2 per year, the business case is clear, as is the operational and financial risk.

When it comes to carbon trading, working in silos within one’s own company borders is an issue. Many companies still try to do this on their own. While this may be possible with internal processes and those that companies have control over, it’s not an option in a global network of businesses. Lack of standards and varying regulations make these efforts slow and complicated, heavily impacting effectiveness.

Although companies strive for insights and transparency, they struggle with four major challenges: energy transition, digitalisation, sustainability and political agendas.

Looking at the bigger picture of decarbonisation, which is connected to all domains, carbon trading is just one piece of the puzzle. Companies must consider their Scope 1, 2, and 3 carbon emissions, which describe their direct and indirect emissions – those that the company is indirectly responsible for, up and down its value chain.

Managing Scope 1 and 2 emissions is already a challenge due to the lack of data and the consequent need to use assumptions for reporting. This may work for now, but the sheer amount of data will be unmanageable in the future. New approaches are needed, particularly to handle the even more complex Scope 3 emissions.

“Scope 3 emissions are a headache for many companies for a variety of reasons,” explains Richard Philcox, Product Area Lead and Chief Product Owner, Commodity Management Solutions at SAP. “First, they fall outside of a company’s direct ownership, which makes them difficult to control. Second, it’s challenging to collect the necessary data and third, it’s not clear who in the supply chain is responsible for these emissions and thus for reducing them.”

Of course, the focus on these efforts depends heavily on the industry. The energy transition cannot be reduced by switching production from fossil fuels to hydrogen or other, greener resources. It affects the energy consumption of plants and operations along value chains. In any case, companies that have decided to become carbon neutral by applying science-based targeting are aiming for a very different scope of transformation. They have chosen a transformation that is unique. Unlike companies that offset emissions, these companies are undergoing a complex, costly and time-consuming process to truly transform their operations. This means avoiding emissions in the first place rather than offsetting them.

Neither digitalisation nor sustainability can be mastered with technology and software alone. Skills are required and the use of ecosystems and networks is imperative. As-a-service business models are successful because they combine skills and knowledge.

In the future, we will see many more startups and businesses adopting an even broader understanding of as-a-service. Instead of buying software licenses, companies will increasingly buy the service as a deliverable, for instance, 'decarbonisation-as-a-service.'

This will not be the case anytime soon, however, as companies will have to grant access to their data and deep insights into their operations first. Over time, transparency will pick up speed. Being green is not enough, becoming greener will be at the forefront of buying decisions.

With carbon trading options, the ultimate goal of businesses will no longer be to sell goods by any means necessary. As CO2 pricing increases, sales and customer service will make the decision to sell or not to sell based on the total company costs. Production costs will be enriched by CO2 emission costs in real time. This may blow a deal instantly due to exploding costs for Scope 1, 2 and 3 emissions.

To play a significant role in decarbonisation, networks, competition and services must be rethought. Handling data inconsistencies, mapping standards, connecting processes and supply chains end-to-end will be critical to its success.