Pricing Carbon: The Birth of British Columbia's Carbon Tax (Sequel) Net Present Value (NPV) / MBA Resources

Introduction to Net Present Value (NPV) - What is Net Present Value (NPV) ? How it impacts financial decisions regarding project management?

NPV solution for Pricing Carbon: The Birth of British Columbia's Carbon Tax (Sequel) case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Pricing Carbon: The Birth of British Columbia's Carbon Tax (Sequel) case study is a Harvard Business School (HBR) case study written by Henry Lee, Anjani Datla. The Pricing Carbon: The Birth of British Columbia's Carbon Tax (Sequel) (referred as “Tax Carbon” from here on) case study provides evaluation & decision scenario in field of Leadership & Managing People. It also touches upon business topics such as - Value proposition, Sustainability.

The net present value (NPV) of an investment proposal is the present value of the proposal’s net cash flows less the proposal’s initial cash outflow. If a project’s NPV is greater than or equal to zero, the project should be accepted.

NPV = Present Value of Future Cash Flows LESS Project’s Initial Investment

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Case Description of Pricing Carbon: The Birth of British Columbia's Carbon Tax (Sequel) Case Study

This sequel accompanies case KS1170. In 2008, British Columbia became one of the few jurisdictions in the world to successfully implement a comprehensive carbon tax. The architect of the tax, Premier Gordon Campbell, championed the broad-based carbon tax that applied to nearly all fossil fuels and made it "revenue neutral." Every dollar raised from the tax would be returned to BC residents and businesses in the form of personal income and corporate tax cuts. Campbell was an unlikely proponent of the carbon tax. As the leader of the traditionally conservative BC Liberal Party, he had cut taxes in the past, but now he had reason to believe a revenue neutral carbon tax could be a winner for both the environment and the economy. But with elections just months away and growing public distrust of the tax, combined with a noisy campaign against the tax mounted by the opposition New Democratic Party, the tax's fate, and that of Campbell's political career was far from certain. This case provides an insider's account of how the carbon tax was designed, with the strong role Premier Gordon Campbell played in its creation. It also explores political and other challenges the government faced when designing and implementing the tax.

Case Authors : Henry Lee, Anjani Datla

Topic : Leadership & Managing People

Related Areas : Sustainability

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Calculating Net Present Value (NPV) at 6% for Pricing Carbon: The Birth of British Columbia's Carbon Tax (Sequel) Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10006933)	-10006933	-	-
Year 1	3460735	-6546198	3460735	0.9434	3264844
Year 2	3957143	-2589055	7417878	0.89	3521843
Year 3	3958744	1369689	11376622	0.8396	3323838
Year 4	3224232	4593921	14600854	0.7921	2553894
TOTAL			14600854		12664419

The Net Present Value at 6% discount rate is 2657486

In isolation the NPV number doesn't mean much but put in right context then it is one of the best method to evaluate project returns. In this article we will cover -

Different methods of capital budgeting

What is NPV & Formula of NPV,
How it is calculated,
How to use NPV number for project evaluation, and
Scenario Planning given risks and management priorities.

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Capital Budgeting Approaches

Methods of Capital Budgeting

There are four types of capital budgeting techniques that are widely used in the corporate world –

1. Payback Period
2. Internal Rate of Return
3. Net Present Value
4. Profitability Index

Apart from the Payback period method which is an additive method, rest of the methods are based on Discounted Cash Flow technique. Even though cash flow can be calculated based on the nature of the project, for the simplicity of the article we are assuming that all the expected cash flows are realized at the end of the year.

Discounted Cash Flow approaches provide a more objective basis for evaluating and selecting investment projects. They take into consideration both –

1. Timing of the expected cash flows – stockholders of Tax Carbon have higher preference for cash returns over 4-5 years rather than 10-15 years given the nature of the volatility in the industry.
2. Magnitude of both incoming and outgoing cash flows – Projects can be capital intensive, time intensive, or both. Tax Carbon shareholders have preference for diversified projects investment rather than prospective high income from a single capital intensive project.

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Formula and Steps to Calculate Net Present Value (NPV) of Pricing Carbon: The Birth of British Columbia's Carbon Tax (Sequel)

NPV = Net Cash In Flowt1 / (1+r)t1 + Net Cash In Flowt2 / (1+r)t2 + … Net Cash In Flowtn / (1+r)tn
Less Net Cash Out Flowt0 / (1+r)t0

Where t = time period, in this case year 1, year 2 and so on.
r = discount rate or return that could be earned using other safe proposition such as fixed deposit or treasury bond rate. Net Cash In Flow – What the firm will get each year.
Net Cash Out Flow – What the firm needs to invest initially in the project.

Step 1 – Understand the nature of the project and calculate cash flow for each year.
Step 2 – Discount those cash flow based on the discount rate.
Step 3 – Add all the discounted cash flow.
Step 4 – Selection of the project

Why Leadership & Managing People Managers need to know Financial Tools such as Net Present Value (NPV)?

In our daily workplace we often come across people and colleagues who are just focused on their core competency and targets they have to deliver. For example marketing managers at Tax Carbon often design programs whose objective is to drive brand awareness and customer reach. But how that 30 point increase in brand awareness or 10 point increase in customer touch points will result into shareholders’ value is not specified.

To overcome such scenarios managers at Tax Carbon needs to not only know the financial aspect of project management but also needs to have tools to integrate them into part of the project development and monitoring plan.

Calculating Net Present Value (NPV) at 15%

After working through various assumptions we reached a conclusion that risk is far higher than 6%. In a reasonably stable industry with weak competition - 15% discount rate can be a good benchmark.

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 15 %	Discounted Cash Flows
Year 0	(10006933)	-10006933	-	-
Year 1	3460735	-6546198	3460735	0.8696	3009335
Year 2	3957143	-2589055	7417878	0.7561	2992169
Year 3	3958744	1369689	11376622	0.6575	2602938
Year 4	3224232	4593921	14600854	0.5718	1843465
TOTAL					10447907

The Net NPV after 4 years is 440974

(10447907 - 10006933 )

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Calculating Net Present Value (NPV) at 20%

If the risk component is high in the industry then we should go for a higher hurdle rate / discount rate of 20%.

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 20 %	Discounted Cash Flows
Year 0	(10006933)	-10006933	-	-
Year 1	3460735	-6546198	3460735	0.8333	2883946
Year 2	3957143	-2589055	7417878	0.6944	2748016
Year 3	3958744	1369689	11376622	0.5787	2290940
Year 4	3224232	4593921	14600854	0.4823	1554896
TOTAL					9477797

The Net NPV after 4 years is -529136

At 20% discount rate the NPV is negative (9477797 - 10006933 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Tax Carbon to discount cash flow at lower discount rates such as 15%.

Acceptance Criteria of a Project based on NPV

Simplest Approach – If the investment project of Tax Carbon has a NPV value higher than Zero then finance managers at Tax Carbon can ACCEPT the project, otherwise they can reject the project. This means that project will deliver higher returns over the period of time than any alternate investment strategy.

In theory if the required rate of return or discount rate is chosen correctly by finance managers at Tax Carbon, then the stock price of the Tax Carbon should change by same amount of the NPV. In real world we know that share price also reflects various other factors that can be related to both macro and micro environment.

In the same vein – accepting the project with zero NPV should result in stagnant share price. Finance managers use discount rates as a measure of risk components in the project execution process.

Sensitivity Analysis

Project selection is often a far more complex decision than just choosing it based on the NPV number. Finance managers at Tax Carbon should conduct a sensitivity analysis to better understand not only the inherent risk of the projects but also how those risks can be either factored in or mitigated during the project execution. Sensitivity analysis helps in –

What will be a multi year spillover effect of various taxation regulations.

What are the key aspects of the projects that need to be monitored, refined, and retuned for continuous delivery of projected cash flows.

What can impact the cash flow of the project.

What are the uncertainties surrounding the project Initial Cash Outlay (ICO’s). ICO’s often have several different components such as land, machinery, building, and other equipment.

Understanding of risks involved in the project.

Some of the assumptions while using the Discounted Cash Flow Methods –

Projects are assumed to be Mutually Exclusive – This is seldom the came in modern day giant organizations where projects are often inter-related and rejecting a project solely based on NPV can result in sunk cost from a related project.

Independent projects have independent cash flows – As explained in the marketing project – though the project may look independent but in reality it is not as the brand awareness project can be closely associated with the spending on sales promotions and product specific advertising.

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Negotiation Strategy of Pricing Carbon: The Birth of British Columbia's Carbon Tax (Sequel)

References & Further Readings

Henry Lee, Anjani Datla (2018), "Pricing Carbon: The Birth of British Columbia's Carbon Tax (Sequel) Harvard Business Review Case Study. Published by HBR Publications.