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How do you calculate abatement cost per tonne of CO2?

Building a marginal abatement cost curve for a portfolio company, and the two shortcuts that rank the actions wrongly.

Julian R. Sterling · from The ESG Manager in Private Equity

Annualise the capital cost over the asset's life at the company's cost of capital, add any extra running cost, subtract the yearly energy saving, and divide by the tonnes abated each year. On an illustrative heat pump replacing a gas boiler, 1.2 million euros of capex becomes 140,195 a year, the energy bill rises by 15,000, and 356 tonnes are abated: 436 euros per tonne. Dividing the capex by annual tonnes gives 3,371, and dividing it by lifetime tonnes gives 225. Both are wrong, in opposite directions.

Worked in full in The ESG Manager in Private Equity by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →

A marginal abatement cost curve ranks a company's decarbonisation actions by cost per tonne, cheapest first, with the width of each bar showing the tonnes. It is the document a portfolio company's board and the deal team use to decide what to fund. Every bar on it is the same calculation, and every bar is only as good as that calculation's treatment of capital.

The assumptions

An illustrative packaging manufacturer. Prices and emission factors are illustrative.

Input	Value
Cost of capital	8%
Electricity price, EUR per MWh	150
Gas price, EUR per MWh	45
Grid emission factor, tonnes per MWh	0.25
Natural gas emission factor, tonnes per MWh	0.202

The four actions.

Action	Capex, EUR	Life, years	Electricity saved, MWh	Gas saved, MWh	Extra opex, EUR
Compressed air leak repair	40,000	5	200	0	0
LED lighting	180,000	10	140	0	0
Rooftop solar	600,000	20	700	0	9,000
Heat pump replacing gas boiler	1,200,000	15	−1,000	3,000	0

The calculation, step by step

The capital recovery factor turns a one-off cost into the level annual payment that would repay it, with return, over the asset's life. It is what makes a five-year leak repair and a twenty-year solar array comparable on one axis. Without it, the curve compares money spent once with savings that recur.

The result: the curve

The four actions ranked by annualised cost per tonne.

Action	Annualised capex	Net annual cost	Tonnes a year	EUR per tonne	Cumulative tonnes
Compressed air leak repair	10,018	−19,982	50	−400	50
Rooftop solar	61,111	−34,889	175	−199	225
LED lighting	26,825	5,825	35	166	260
Heat pump	140,195	155,195	356	436	616
All four		106,150	616	172

The first 225 tonnes, 36.5 per cent of the total, pay for themselves, saving 54,870 a year after their capital charge. The heat pump is the most expensive action and also the largest: 57.8 per cent of the abatement. That is the usual shape. The cheap actions are small, and the action that moves the company's footprint costs real money per tonne, which is why a programme that funds only the left of the curve reports quick wins and a flat emissions line.

The two common mistakes

The same four actions on three bases, EUR per tonne.

Action	Capex ÷ annual tonnes	Capex ÷ lifetime tonnes	Annualised, correct
Compressed air leak repair	800	160	−400
LED lighting	5,143	514	166
Rooftop solar	3,429	171	−199
Heat pump	3,371	225	436

• Capex over annual tonnes charges the whole investment against a single year of abatement. Every action looks prohibitive and the ranking is meaningless.
• Capex over lifetime tonnes ignores both the cost of capital and the energy effect. It makes the heat pump look cheaper than it is, 225 against 436, because the higher electricity bill never enters, and it makes the solar array look like a cost when it saves money.

What if prices move

An electrification project is a bet on the spread between gas and electricity prices, and a move of one fifth in the gas price shifts its cost per tonne about as much as a move of one fifth in its capex.

Heat pump cost per tonne, EUR, by energy price.

Gas price	Electricity 120	Electricity 150
35	436	520
45	352	436
55	267	352
65	183	267

At an electricity price of 150 the heat pump pays for itself only at a gas price of about 96.7. The grid factor matters as much: on a grid emitting 0.10 tonnes per MWh the heat pump abates 506 tonnes at 307 per tonne, while at 0.40 it abates 206 at 753. The same solar array goes the other way, from 70 tonnes to 280, because it displaces grid power. State the grid factor on the curve, and rerun it when the grid changes.

Read a positive cost per tonne as the carbon price at which the action breaks even. At 436 euros, the heat pump needs either a carbon cost of that size, a customer requirement, or a change in the energy spread. The curve tells the board which of those it is relying on.

Takeaway

Annualise the capital, net off the energy, divide by the tonnes: 436 euros per tonne for the heat pump, minus 400 for the leak repair, and 172 on average across the programme. The free companion files for this book include a case that draws the curve for a food manufacturer chapter 12 describes, and a related article carries an ESG programme through to enterprise value.

Questions readers ask

What is a marginal abatement cost curve?

A chart ranking a company's emission reduction actions by cost per tonne, cheapest first, with each bar's width equal to the tonnes it abates. In this illustrative case four actions abate 616 tonnes a year at an average of 172 euros per tonne; the first 225 tonnes save money, and the largest action, a heat pump, costs 436 per tonne.

Why can abatement cost per tonne be negative?

Because the energy saved is worth more each year than the annualised capital. A 40,000 euro compressed air leak repair over five years costs 10,018 a year at 8 per cent and saves 30,000 of electricity, so it abates 50 tonnes at minus 400 euros per tonne. Negative-cost actions should be funded on their payback alone.

How does the grid emission factor change abatement cost?

It changes the tonnes, and so the cost per tonne. A heat pump that raises electricity use abates 506 tonnes at 307 euros per tonne on a 0.10 grid, but 206 tonnes at 753 on a 0.40 grid. Solar moves the other way. Always state the factor used and update it when the grid decarbonises.

Also on this site

• What does an ESG value creation plan actually add to enterprise value?An industrial services case: €1.1 million of delivered EBITDA at an 8.5× exit multiple is €9.4 million of enterprise value against €830,000 of cost.
• How do you calculate financed emissions for a private equity fund?Attribution factor times emissions: equity held over total equity plus debt. An illustrative fund finances 33,074 tonnes, not the 73,990 ownership implies.
• Can a fund call more than the commitment I signed?It can, and this one did: 151,970,000 called against a 150,000,000 commitment. The 1,970,000 excess is recycled capital, not a breach.
• Does diversifying a concentrated stock position repay the tax?Selling $300m of a nil-basis stake costs $71.4m of tax. Lower volatility drag repays it in 5.3 years of median growth, though never on expected values.
• Does higher leverage dilute the operating partner's contribution?No. Organic operating improvement contributes 59.85 million at every entry leverage from 3.5 to 6.5 times, and its share rises to 44.1 per cent.
• What goes in the bridge from enterprise value to equity value?Debt at repayment amount, free cash only, leases, pensions, deferred items, minorities. On 120.0 of EV, equity is 53.32, not the 80.00 loans less cash gives.

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