Carbon pricing in a DCF: a worked, illustrative model

A carbon price only matters for a valuation if it changes cash flows. The way it changes them depends on the design of the scheme. Under a carbon tax, every tonne costs money. Under India's Carbon Credit Trading Scheme (CCTS), a plant pays only for the gap between its actual emissions intensity and its target. If it beats the target, it earns certificates it can sell.

This guide builds a small model to show the steps. All numbers are hypothetical. The point is the method: work out the chargeable tonnes each year, apply a price, allow for some cost being passed to customers, take off tax, discount, and add a terminal value.

The example also shows two things that surprise many analysts. Most of the value effect usually sits in the terminal value, and the best answer is often to compare the carbon cost with the cost of cutting emissions.

The set-up (hypothetical)

• A cement company produces 1 crore tonnes (10 million tonnes) of cement a year, flat for simplicity.
• Its emissions intensity is 0.62 tCO2e per tonne and does not change unless it invests.
• Its intensity targets tighten each year: 0.61, 0.60, 0.59, 0.58 and 0.57 for Years 1 to 5. After Year 5, the target stays at 0.57.
• Certificate price: ₹1,500 per tCO2e, flat.
• Tax rate: 25.17%. WACC: 11%. No pass-through to customers in the base case.

Step 1: chargeable tonnes and cost

Present value of Years 1 to 5 = about ₹115.8 crore.

Step 2: terminal value

If the Year 5 after-tax cost of ₹56.12 crore continues with no growth:

• Terminal value at the end of Year 5 = 56.12 ÷ 0.11 = about ₹510.2 crore
• Present value of the terminal value = 510.2 × 0.5935 = about ₹302.8 crore

Total present value of the carbon cost = 115.8 + 302.8 = about ₹418.6 crore. For a company with an equity value of ₹25,000 crore, that is about 1.7% of value. Note that about 72% of the effect comes from the terminal value.

Step 3: pass-through and price sensitivity

If competitors face similar costs, part of the cost may be passed to customers through higher cement prices. Present value of the carbon cost, including the terminal value (₹ crore):

The range runs from under ₹30 crore to over ₹800 crore. Price and pass-through matter as much as the emissions gap.

Step 4: the cost of cutting emissions

Suppose the company can spend ₹250 crore now on waste heat recovery and alternative fuels to cut its intensity to 0.58 from Year 1. It then beats the target in Years 1 to 3, meets it in Year 4 and falls short only from Year 5.

• Present value with the investment, including the terminal value = about minus ₹10.5 crore
• Present value without it = about minus ₹418.6 crore
• Gain from the investment = about ₹408.2 crore, against a capex of ₹250 crore
• Net present value of the investment = about ₹158 crore, before any fuel savings or depreciation tax shield

In this example, cutting emissions is worth far more than paying for certificates. A real analysis would also include energy savings, extra running costs and the risk that the technology underperforms.

Other schemes, same method

• Carbon tax: chargeable tonnes are all emissions, not just the shortfall.
• EU CBAM for exporters: chargeable tonnes are the embedded emissions of goods sold to the EU, multiplied by the payable share for that year (2.5% in 2026, rising to 100% in 2034).
• Internal carbon price: a company's own shadow price used to test projects. It does not create a cash cost unless a real scheme applies.