Pricing carbon dioxide into your supply chain

By Gurram Gopal

Executive Summary
Supply chain managers use economic order quantity (EOQ) models to minimize the overall cost of inventory management, procurement and production. But with increasing concerns over climate change and more regulation on the way for carbon dioxide emissions, companies are going to need tools to integrate the costs of emitting carbon dioxide into their supply chains. And easy-to-implement models can be used to make supply chain decisions while incorporating such considerations.

Managing the carbon footprint of products, measured as carbon dioxide equivalent emissions (CO2-e), across the supply chain is becoming an important success factor for organizations. Several issues are driving businesses to take action, including increases in direct energy costs and the energy costs of suppliers, existing and planned legislation that penalizes high energy consumption and rewards emission reduction, and changing consumer attitudes to climate change.

The Interagency Working Group on the Social Cost of Greenhouse Gases created by the United States government estimated the "social costs" of carbon dioxide to be in the range of $31 to $69 per metric ton of carbon dioxide between 2010 and 2050, assuming a 3 percent discount rate for costs. However, two Stanford researchers estimated the costs to be closer to $220 per ton. While individual companies have not had to pay the carbon-related social costs, governments and legislators worldwide are tackling these issues. There is a push to make companies pay for the carbon dioxide footprint instead of socializing it and placing the burden on the public. In a carbon-constrained future, businesses will have to meet customer needs in a way that generates lower carbon dioxide emissions. Based on the Climate Policy and Industrial Competitiveness report (2010) on lessons learned from the EU experience, introducing a cap-and-trade system has had a significant impact on carbon dioxide emissions, with reductions of up to 5 percent since 2005 in the covered sectors. Further, this reduction in emissions has had a limited economic impact, with the imposed caps estimated to cost less than 1 percent of total GDP by 2020.

Companies in nearly all sectors covered by emission caps have been able to profit from the introduction of a cap-and-trade system, either from selling some of their emission allowances, undertaking cost-efficient emission reduction measures or by passing the cost of carbon dioxide to consumers. Despite generous emission caps, companies in many sectors, most notably the cement industry, have found simple and cheap ways to reduce their energy consumption significantly.

EU ETS and greenhouse gas protocol

In order to balance supply and demand of the carbon dioxide emission allowance, the European Union Emissions Trading System (EU ETS) was launched in 2005. The EU ETS is the world's largest carbon dioxide trading arena, and this market-based system primarily is aimed at achieving cost-minimal compliance with a given greenhouse gas (GHG) emission target. With recent carbon footprint calculators and efforts to measure GHG emissions, several notable voluntary carbon dioxide reporting schemes apply to the carbon dioxide footprint boundary within supply chains.

The greenhouse gas protocol was developed jointly by the World Business Council for Sustainable Development and the World Resources Institute to "build credible, effective and robust GHG accounting and reporting platforms that serve as a foundation to address climate change." The World Business Council for Sustainable Development is composed of more than 200 leading companies in the world and focuses on developing carbon dioxide management solutions for energy, food, land use, cities and mobility and redefining value.

The GHG protocol is focused on Scope 2 emissions, which are energy indirect GHG and are defined as "emissions from the consumption of purchased electricity, steam or other sources of energy (e.g., chilled water) generated upstream from the organization," according to iCompli Sustainability, a division of BPA Worldwide. Scope 1 emissions, also referred to as direct GHG, are defined by the same source as "emissions from sources that are owned or controlled by the organization."

This article focuses on Scope 3 emissions, the other indirect GHG, which are defined as "emissions that are a consequence of the operations of an organization but are not directly owned or controlled by the organization." Scope 3 includes third-party distribution and logistics, production of purchased goods, emissions from the use of sold products and several more. According to iCompli, Scope 3 GHG are by far the largest component of most organizations' carbon dioxide footprint.

Managing carbon dioxide across the supply chain

There are several insights from Europe's emission trading system. MIT estimated that the EU ETS has cut European emissions by 120 million to 300 million metric tons of carbon dioxide during its first, highly imperfect phase – up to 5 percent of emissions from the covered sectors, despite excessive allocations of emissions allowances.

For most manufacturing sectors, cost differentials due to labor and other inputs far outweigh those induced by international differences in the cost of carbon. The cost uncertainty induced by emissions trading is correspondingly very small compared to those arising from, for example, fluctuating exchange rates and energy costs. As a result, most sectors can accommodate carbon costs without significant impacts to their profits, sales or competitiveness. Increasing energy efficiency of products will continue to play an important role, but more fundamental solutions need to be considered. Managing the carbon footprint of products across the supply chain and minimizing the carbon dioxide emissions required to create and deliver the products to the end consumer are approaches that are gaining traction among leading companies like Apple and BMW. These changes also present forward-thinking companies with an opportunity to develop and market low-carbon products.

The carbon footprint of a product is the carbon dioxide equivalent emissions across the supply chain for a single unit of that product. This includes all direct (on-site, internal) Scope 1 emissions and indirect (off-site, external, upstream and downstream) Scope 2 and Scope 3 emissions. A life cycle perspective that traces impacts through the entire production and supply chain of the business is needed to measure the carbon footprint accurately.

In order to evaluate a company's carbon footprint as accurately as possible and integrate carbon dioxide emissions into managerial decisions, it is critical to identify and measure direct and indirect carbon emissions. Developing carbon risk-mitigated supply chain management requires managing the downstream consequences of the use of a company's products along with inputs from upstream suppliers. Carbon footprint and emissions totals vary depending upon how they are calculated and the degree of responsibility the company is willing to take. Managing carbon emissions across the supply chain involves identifying and securing support of key suppliers and customers, along with developing a carbon footprint map that identifies and measures product carbon footprints and carbon risks across the supply chain.

Reducing supply chain carbon dioxide emissions may be more cost-effective for companies than reducing direct or purchased electricity-related Scope 1 emissions, as there may not be many cost-effective low carbon alternatives. The Carbon Trust also reported on current carbon management and supply chain business practices by stating, "If they are willing to broaden their horizons to work collaboratively with other companies in their supply chain, then there are additional opportunities to build influence, create knowledge, reduce carbon emissions and generate financial returns."

Including carbon costs into lot sizing models

Lot-sizing models are widely used in inventory management in procurement and production to determine the optimal lot or order size, also known as the economic order quantity (EOQ), which minimizes the overall cost. Lot sizing models are implemented in almost all of the inventory management tools that companies use. These models are commonly used to determine the optimal quantity of a purchased part, raw material or finished product to order from a supplier. The supplier can be external or internal.

The EOQ models consider the tradeoffs between ordering large quantities and incurring higher inventory holding costs but lower ordering costs or placing more frequent orders and incurring higher ordering costs but lower inventory holding costs. The cost of transportation is one of the largest components of the ordering cost. Both transportation and inventory handling and storage can be carbon-intensive tasks; however, conventional EOQ models do not take carbon dioxide costs into account, or equivalently, the carbon price is assumed to be zero when calculating optimal order quantities. This has an important consequence for transportation choices. Air transport has the highest carbon footprint among all modes of transportation and an air freight shipment from Shanghai to Los Angeles has nearly 10 times the carbon footprint when compared to the same shipment by ocean freight.

Saif Benjaafar, Yanzhi Li and Mark Daskin presented inventory management models that integrated carbon considerations into lot sizing decisions in "Carbon Footprint and the Management of Supply Chains: Insights from Simple Models." The simplest model involves just one company with carbon dioxide emissions from the lot sizing activity that are capped. In this model, the carbon dioxide emissions are modeled as a constraint. In another model the carbon dioxide cap is replaced by a carbon tax (price paid per unit of carbon emitted). In this model, the cost of carbon dioxide is included in the total cost that is minimized.

The authors of the IEEE Transactions on Automation Science and Engineering paper also modeled the use of carbon offsets, which are emission allowances that the company can buy. In this model the company buys a certain number of offsets to cover its emissions. The authors show that, theoretically, the company can significantly reduce emissions without significantly increasing cost through changes to order quantities and other decision variables. However, these models were not implemented for practical scenarios with real costs.

Dealing with carbon dioxide's lack of price

Currently, there is no constraint on carbon dioxide emissions in the United States, China and India, three major geographies involved in many supply chains. In this scenario, can corporations make an impact on their carbon footprint without dramatically increasing their costs?

Companies have been focusing on Scope 1 initiatives that lower their operating costs while also lowering their carbon footprint, the "win-win" situation. As an example, all companies can lower their carbon footprint by selecting renewable or less carbonintensive sources to meet their facilities' energy requirements. While this act does not require customer cooperation, companies may not have much choice in alternative energy sources and may also have to pay a premium. Companies also can focus on modifying products to lower their carbon dioxide emissions during production.

For some companies in the consumer sector, raw material choices have a big impact on their carbon footprint. Switching to recycled fabric, for example, can significantly reduce carbon dioxide emissions for apparel firms. However, changing the material of consumer products could be affected if consumers do not accept the recycled materials, and that's not even considering whether recycled material is available.

Companies also can become more efficient in all energy consumption areas in facilities, including lighting and refrigeration. However, these efforts might need significant investment and can be limited by the effects on products and employees. Making changes to the supply chain to lower carbon emissions need not affect end-consumers and can be done with existing technologies and methods. In this research, a number of inventory cost analyses were carried out for two different products using realistic cost scenarios. Two modes of transport were considered, air freight and ocean freight. In all cases, the products were assumed to be shipped from Shanghai to Los Angeles. In determining the transportation and warehousing costs, data were obtained from multiple industry sources, including published data by shippers like UPS, FedEx and Hamburg Süd, and then revised after discussions with two global logistics providers based in Chicago.

The annual carbon dioxide equivalent emissions (CO2-e) were calculated for the EOQ for both the air freight and ocean freight scenarios. Data for CO2-e emissions for the different transport methods came from Martin Schmied's and Wolfram Knörr's authoritative "Calculating GHG Emissions for Freight Forwarding and Logistics Services." An excellent reference for finding carbon calculator methodologies compiled by the ENVIRON International Corp. was used to validate the emission calculations. It was assumed that shipments were consolidated into carrier-approved unit load devices (ULD) for air freight and Grocery Manufacturers Association's (GMA) standard pallets for ocean freight.

In the first example, a company was planning to ship 50,000 premium priced single-room humidifiers, weighing 2.2 kilograms (4.85 pounds) each. Two different modes of transportation were considered for analysis, air freight and ocean freight. Items were assumed to be shipped in unit load devices (ULD) for air freight and in standard GMA pallets for ocean freight. The EOQ solution was calculated for each mode, as was the solution that minimized carbon dioxide emissions.

For each of the solutions, the logistics costs to the company, as well as the total cost to society, including carbon costs, were calculated. The results are shown in Figure 1. At a carbon price of zero dollars, the EOQ and carbon minimization solutions are obviously the same. As the unit price of carbon dioxide emissions increases, there are significant cost savings to society if the company used an ordering schedule that minimized carbon dioxide emissions instead of using the traditional EOQ methods that assume zero carbon costs. The EOQ cost (assuming a carbon price of zero) when using air freight is $696,880, with associated carbon dioxide emissions of 1,665 metric tons. At the carbon price of $32 per metric ton, the cost of these carbon dioxide emissions is $53,280. The minimum carbon emission solution for air freight increases company logistics costs by $2,216 while reducing carbon dioxide costs by $6,260.

A similar analysis was performed for a smartphone maker importing 100 million items from China. As in the first example, ULDs and GMA pallets are used for air and ocean freight, respectively, and the same cost assumptions are used. The results are shown in Figure 2. The analysis confirmed that while total carbon costs increase significantly as the price of carbon increases, small changes to the company's ordering and logistics costs can decrease carbon costs significantly. In this example, the EOQ cost (assuming a carbon price of zero) when using air freight is $217,063,246, with carbon emissions of 424,709 metric tons. At the carbon price of $32 per metric ton, the minimum carbon solution for air freight increases company logistics costs by $54,650 while reducing carbon costs by $247,236.

Figure 3 presents a different perspective of the analysis. Rather than putting a specific price on carbon and reducing the dollar carbon costs, the focus here is on reducing carbon emissions. For each product, the difference between the carbon emissions when using EOQ and the minimum carbon emissions possible was calculated for each transport mode. This provides an estimate of the premium in carbon emissions paid by using the EOQ solution rather than minimizing carbon emissions. The logistics costs to the company for each case, EOQ and carbon minimization, were calculated. This gives an analyst the premium to be paid in logistics costs if the goal is to minimize carbon emissions.

In the case of shipping smartphones by air freight, EOQ cost (assuming a carbon price of zero) is $217,063,246 with carbon emissions of 424,709 metric tons, while a carbon minimization solution has logistics costs of $217,834,533 and carbon emissions of 414,545 metric tons. Therefore, to gain a reduction in carbon of 10,165 metric tons, the company has to spend $771,288 in additional logistics costs. The blue line in Figure 3 shows the percent of the $771,288 cost premium that has to be paid to achieve a given percentage reduction of the 10,165 metric tons maximum carbon reduction that is possible. Figure 3 also shows similar data for smartphones while using ocean freight and the results of similar analyses for humidifiers. This figure shows that by paying 2 percent to 9 percent of the premium in logistics costs, the company can gain 50 percent of the maximum carbon reduction benefit.

Change transportation mix; alter order sizes

This research highlights a few important implications for organizations. Ocean freight has been known to be significantly less expensive than air freight. What is important to recognize is that it is far less carbon intensive as well. Hence, a company can significantly reduce its carbon footprint in logistics by changing the shipment mix, even slightly, toward ocean freight where feasible. This results in a win-win situation as it also lowers direct shipment costs.

Another important conclusion is that small changes in the order quantities and number of orders can enable a company to make significant progress toward carbon minimization goals for a specific demand level, while assuming small cost increases. If a CEO assumes even a modest price for carbon, small increases in logistics costs will reduce total carbon costs significantly.

Perhaps the most important point this research highlights is that there are easyto- implement models that can be used to make supply chain decisions while incorporating carbon considerations.

Call it the 4 M's of management, mindset, models and mechanics. Managers need to have a mindset that focuses on the long-term sustainability of the eco-system, without which no companies would survive. Lee Scott, the former chief executive of Walmart said: "There is a simple rule about the environment. If there is waste or pollution, someone along the line pays for it."

Management, from the CEO to the line manager, should focus on delivering returns across the triple bottom line, i.e., the economic, social and environmental areas. Going from such a mindset to the supply chain planning models reveals a plethora of solutions a company might pursue. The line managers and workers can then execute the mechanics or plans suggested by the models while being proud of the fact that they are making economically effective, socially conscious and environmentally friendly supply chain decisions. This is quite important as businesses compete for talent.

In the words of Richard Branson, founder of Virgin Group, "I think if the people who work for a business are proud of the business they work for, they'll work that much harder and, therefore, I think turning your business into a real force for good is good business sense as well."