Electrifying the furnaces: a shadow carbon price against a four-year payback screen
Meridian Forge Ltd, a £180m-turnover engineering business, runs eight gas-fired heat-treatment furnaces at its Sheffield plant. Its largest customer - an automotive OEM representing 31% of revenue - has told Meridian that from 2028 it will buy only from suppliers with a credible Scope 1 reduction trajectory. Electrifying the furnaces would cost £14.0m and cut energy and maintenance costs by £1.9m a year, abating 9,000 tCO2e against a current footprint of 46,000 tCO2e. The furnaces have 12 years of remaining life. If they are not replaced, a £3.0m mid-life refurbishment falls due in year 6. The board applies a 9% discount rate and a four-year maximum payback screen to all capital projects. The sustainability team's internal shadow carbon price is £85 per tCO2e. The CFO argues that “you cannot put a fictional cost into an investment appraisal” and recommends rejection. The group has a public target of net zero for Scopes 1 and 2 by 2040, with a 50% interim cut by 2030 against a 2021 base year.
1. Appraise the furnace project on the board's existing criteria, then with the £85 shadow carbon price applied. What decision framework should the board actually use?
Read the worked answer
Step 1 - the cash flows. Capex £14.0m at t0; savings £1.9m a year for 12 years; avoided refurbishment £3.0m at t6. The 12-year annuity factor at 9% is 7.161 and the year-6 discount factor is 0.596.
Without the carbon price: NPV = (1.9 × 7.161) + (3.0 × 0.596) − 14.0 = 13.61 + 1.79 − 14.0 = +£1.40m. Payback = 14.0 ÷ 1.9 = 7.4 years.
With the shadow price: 9,000 t × £85 = £0.765m a year, giving annual benefit of £2.665m. NPV = (2.665 × 7.161) + 1.79 − 14.0 = 19.08 + 1.79 − 14.0 = +£6.87m. Payback = 14.0 ÷ 2.665 = 5.3 years.
Step 2 - what this tells us. The project is NPV-positive on both bases, so the carbon price is not the swing factor for the investment itself. It fails the four-year payback screen on both bases. The binding constraint is therefore the payback screen, not the carbon price - and a four-year screen applied to a 12-year asset structurally rejects every long-lived retrofit. Payback also discards every cash flow after year 4, here more than £15m of savings, and it ignores the avoided refurbishment entirely.
Step 3 - the framework to recommend. Appraise strategic decarbonisation assets on NPV plus scenario analysis rather than payback: run the carbon price at £0, £50, £85 and £150 to show robustness (the NPV stays positive even at zero), and add the revenue at risk that is missing from the model. The OEM represents 31% of £180m, so a 10% volume loss following loss of approved-supplier status is £5.6m of revenue a year - larger than the entire annual saving. The board should also note that a 9,000 tCO2e cut is roughly 20% of the footprint, and the 2030 interim target requires a 23,000 tCO2e reduction, so this project is a large component of a public commitment. Recommendation: approve, subject to a documented strategic exemption from the payback screen agreed by the board in advance.
2. The CFO calls the shadow carbon price “fictional”. How should the finance team respond, and what should accompany the decision by way of disclosure?
Read the worked answer
Separate the three questions the CFO is conflating.
Is it a cash flow? No. A shadow price must not be posted to the ledger, built into budgets, or used to report divisional profit - doing so would overstate savings by £0.765m a year and distort divisional performance measures. The CFO is right on this narrow point.
Is it fictional? No. It is a proxy for costs that are expected to become cash: UK ETS allowance costs as free allocation tightens, the EU carbon border adjustment mechanism charging embedded emissions on imports of covered goods (relevant if Meridian exports to EU customers), and contractual penalties or lost business where customers require a reduction trajectory. The £85 figure is an estimate with a range, which is a different thing from a fiction, and the appraisal should show the range rather than a point estimate.
Where does it belong? In appraisal and scenario analysis as a sensitivity - not in the statutory accounts and not in the management accounts as a saving.
Disclosure. IFRS S2 requires an entity to disclose the internal carbon price(s) it uses, how the price is used in decision-making, and the climate resilience assessment. The sustainability statement should therefore state the price (£85/tCO2e), its source and escalation basis, and the range tested. The capex should be described consistently in the sustainability statement and the investment paper - the same number must appear in both, and the abatement claimed should be evidenced by a measured baseline rather than an engineering estimate alone.
Governance. The audit committee should approve the internal carbon price annually, minute the basis, and receive the sensitivity table. That converts a disputed management judgement into a controlled, documented policy - which is also what an assurance provider will ask to see.