Calculating Marginal Abatement Cost — The Right Way

2024-05-20 09:00

As global sustainability regulations tighten and reporting standards such as TCFD and IFRS ISSB becoming commonplace, corporations worldwide are compelled to develop robust climate transition plans. A common element in these plans is the marginal abatement cost (MAC) curve — a useful yet often misunderstood tool for visualising and prioritising emissions reduction strategies.

Demystifying marginal abatement cost

Understanding what exactly MAC is forms the cornerstone of producing an accurate MAC curve.

The marginal abatement cost of an abatement lever is the constant carbon price that would result in the net present cost of implementation equaling zero.

In practical terms, if a carbon tax were imposed, an abatement lever would prevent the associated costs. However, the implementation of the initiative likely involves initial and ongoing expenses. The marginal abatement cost, then, is the carbon price at which these costs and savings balance out.

Calculating marginal abatement cost

To put it mathematically:

To calculate the marginal abatement cost of an abatement lever, divide the net present value of all incremental costs and financial benefits by the net present value of emissions abated.

Many point out that discounting emissions to derive a net present value is illogical — and they're right.

Clarifying misconceptions about discounting

The above formula may give the impression that emissions are being discounted but this is a simplification for practical application. Here is a more detailed version of the MAC equation:

As you can see, emissions are not initially discounted, but simplifying the equation to make it more workable makes it appear as such.

Important considerations

Bake in existing carbon costs: The above equation is best suited for countries without a carbon price in place, or a carbon price that's only applied to emissions above a certain threshold. In jurisdictions with an established price on every tonne of carbon emitted, adjust the equation to reflect the additional constant cost of carbon needed for the net present cost to equal zero.

Capture all benefits: While the primary focus of the equation is on the benefits of avoiding a hypothetical carbon tax, other benefits, such as reduced operational costs, should also be integrated into the calculation.

Set the period: The equation above sums abatement and cash flows over an indefinite period for simplicity but in practice should set a fixed period, such as 20 years.

Learning from the energy sector

Energy sector professionals may recognise the parallel between MAC and the levelised cost of electricity (LCOE), the average cost of electricity generated by a power plant over its lifetime.

The LCOE is calculated by dividing the discounted sum of costs over the lifetime of the plant by the discounted volume of electricity generated during that period. The MAC formula simply replaces electricity produced with greenhouse gas emissions avoided.

While approximate MAC calculations may suffice for deciding the order of abatement lever implementation, precise calculations are crucial for informed capital allocation and effective net-zero strategies. In the evolving landscape of mandatory climate reporting, mastering MAC calculations is becoming an essential skill.

James Tilbury