Carbon price thinking, fast and slow

Your organisation can look to the human brain for lessons about how to manage its carbon price risk.

Ten years ago, Nobel Laureate Daniel Kahneman published a book called Thinking, fast and slow which summarised decades of his research into how the human brain makes decisions. He proposed two ‘systems’ of human thought – ‘System 1’ is fast and instinctive, whereas ‘System 2’ is slower and more considered. While Kahneman’s research and writing were about human behaviour, there are lessons in his work for how organisations might best set themselves up to manage their carbon price risk over the short- and long-term.

Two complementary systems

According to Kahneman, System 1 is constantly in action and controls much of our day-to-day analysis and decision-making. For example, System 1 thinking can read simple sentences or drive a car along a quiet road. Because System 1 thinking is almost hard-wired into our brains the activities that it looks after aren’t mentally taxing. System 2 looks after the thinking that isn’t routine or straightforward and therefore can’t be handled by System 1. System 2 thinking needs to be engaged in order to interpret complex sentences or drive a car along a busy road.?

These two different systems have proved to be a highly successful setup for humans even though it is easy to find flaws with each system when it acts by itself. If humans only had System 1 thinking, we wouldn’t have the capacity to think about complex ideas. If we only had System 2 thinking our day-to-day lives would be so mentally taxing that we wouldn’t have the time or energy to think about the big picture.

Re-thinking carbon price risk management

Kahneman’s concepts can be applied to help organisations manage the carbon price risks which they might face. Our System 1 processes and tools for managing carbon price risk need to act rapidly, instinctively and almost continuously, whereas System 2 systems and processes can be slower and more considered as they are needed less frequently.?

As a practical example of what an effective System 1 setup could look like, let’s look at a bakery that that needs to cover the carbon costs associated with its day-to-day business. Let’s assume that the major costs faced by the bakery are for flour, natural gas and trucking and that all these activities need to pay a carbon price. Imagine this bakery is currently in contract negotiations to deliver bread to a new customer every day for the next two years. An effective System 1 for this bakery would:

1. Measure the carbon associated with the supply of this bread, including carbon emitted by its flour, natural gas and trucking suppliers.
2. Analyse the pricing details of its contracts with its suppliers to understand how much of the carbon in its supply chain that the bakery is liable for.?
3. Look up the carbon prices that its supply chain faces right now.
4. Evaluate and select the actions that can best manage its carbon price exposure.
5. Price the bread supply contract appropriately and take all the actions chosen in step 4.
6. Get ready to repeat the process for the next bread supply contract.?

You could easily be forgiven for looking at this list of actions and thinking that there doesn’t seem to be much ‘System 1’ about any of them – they might all seem to require deep thought. However, these steps should already be part of the bakery’s System 1 for managing its flour price risk, its natural gas price risk and its trucking price risk. Managing carbon price risk should just be an extension of these existing business processes. Putting together appropriately-priced bread supply contracts needs to be System 1 thinking for the bakery because it has to do this continuously as part of its day-to-day business. A well-designed and operated System 1 within a business can free up time and energy to devote to the more difficult questions which require System 2 thinking.

What is System 2 thinking for carbon prices?

As mentioned earlier, System 2 thinking about carbon price risk needs to be slower and more considered than what was needed for System 1. While a well-designed System 1 for carbon prices focuses intently and almost robotically on the prices that exist right now, System 2 thinking almost needs to ignore them completely. There are two reasons for this.

Firstly, there is no guarantee that the carbon prices which exist today will be reflective of the carbon prices that organisations will face in the future. For example, oil companies do not base their long-term investment decisions solely on the current market price for oil. This is because if they were to operate their System 2 in this manner then they might have to start and stop major capital projects several times per year as the market price moved around. This approach clearly isn’t a viable way to run their businesses.?

The second reason why System 2 needs to try to ignore current market prices is the benefit to organisations of considering a wider range of decarbonisation drivers beyond price. Let’s look at an example of an organisation that pays a carbon price for operating a coal boiler and think about some of the potential challenges that it might face in the future:

• The carbon price could rise and its operating costs could increase.
• Customers might be less willing to purchase its products.
• Government policies on coal boilers and/or air quality might impose operating restrictions.
• It could become difficult to find spare parts for the boiler.
• It could become difficult to find technicians with the skills needed to service the boiler.

While some of these challenges might be more likely or long-term than others, the key message here is that only the first item on that list is driven by the actual carbon price that the coal boiler operator faces. It could be useful to think of a System 2 carbon price forecast as being a forecast for the actual carbon price that you expect your organisation to face in the future, plus an additional charge to act as a placeholder for any of these other non-price effects on your organisation which you consider relevant. This type of carbon price is often referred to as a ‘shadow’ carbon price. Shadow carbon prices can be used by organisations as a way of thinking about what the overall cost of choosing not to decarbonise might be for them in the long-term.?

Judging right from wrong

While there is often a right and wrong way of carrying out System 1 thinking, a judgement of right or wrong is much more difficult to make for System 2. If we take a System 1 activity for humans, such as driving a car along a quiet road, most people would be able to come up with some simple rules to judge whether this is being done correctly. If the car stays on the road, doesn’t swerve from side to side and doesn’t speed then most people would say that it is being driven acceptably. But if we look at a System 2 decision then saying what is ‘right’ or ‘wrong’ about this type of choice is much more difficult to do. Let’s take a System 2 question such as where you should go on a car journey. You might think that your family should drive to the forest but your kids might think that the family should go to the beach. Everybody will bring their own criteria for judging what is ‘right’ and ‘wrong’ when it comes to System 2 decisions.

These same lessons about right and wrong also apply to our carbon price thinking. It is relatively easy to judge whether our System 1 tools and processes are working well because so much of what they need to do is quite mechanical. System 1 is all about having easy access to quality data, reporting this data to the appropriate decision-makers and taking prompt and logical actions based on that information. System 2, in contrast, while crucial to the long-term competitiveness of organisations, is difficult to get right. It can even be challenging to measure what ‘right’ is. For this reason, effective System 2 thinking often tries to understand if an organisation is resilient to a number of future decarbonisation scenarios, rather than focussing on a single (shadow) carbon price forecast.

What does all this mean for your organisation?

The division between System 1 and System 2 thinking could be a useful construct to help your organisation navigate a future world of higher carbon prices. Some of the key strategies that it could deploy include:

• When your organisation is dealing with a new carbon price question, first try to decide whether it is a System 1 or a System 2 question.
• Find the right people for each type of question. The best people to help you with a System 1 question might not be the same people that you would take a System 2 question to.
• Be pedantic about improving your System 1 tools and processes until they are working effectively. The improvements that you add to these systems will make your organisation more resilient to carbon price movements and they will give you a better starting point to understand your System 2 questions.
• Get yourself and your organisation comfortable with the idea that while System 2 thinking is crucial, it will always be difficult to know if your System 2 thinking is heading in the right direction. Use a range of carbon price scenarios for your long-term planning rather than trying to agree on a single price case.