What role does pricing play in sustainability
Steven Forth is a Managing Partner at Ibbaka. See his Skill Profile on Ibbaka Talio.
Over the past year, Ibbaka has been adding sustainability models to Valio. This has been driven by our customers, who understand how models are needed to measure the impact of a solution and who have solutions that contribute to sustainability.
This opens the whole question of what role, if any, pricing has to play in the shift of the economy towards more sustainable configurations, where the economic activity that we rely on contributes to biodiversity, ecosystem health, and resilience rather than undermining it.
Last week I asked, “What role should pricing play in nudging buyers to more sustainable solutions and users to more sustainable choices.”
This poll was posted on the LinkedIn group of the Professional Pricing Society, so the respondents are people actually involved in setting prices and advising on pricing strategy.
That almost 40% of people felt that pricing should be used for this purpose ‘whenever possible’ is a good sign. There is still a large minority of sceptics, with 22% of people saying this is not the role of pricing and 5% saying very selectively. But almost three-quarters of the respondents (73%) are open to having pricing nudge us towards more sustainable solutions.
Sustainability models on Ibbaka Valio
At Ibbaka, we are working with several of our customers to layer in sustainability models. At present, these are companies in the water management space (where water conservation, more efficient water use, and leak management are part of the basic value proposition) and mining software (where decarbonization and electrification have become strategic goals), but we expect sustainability models, and more generally ESG models (Equity, Sustainability, and Governance) to become a standard part of Ibbaka Valio.
Below are the four models and their interactions. Each of these models is a system of equations. As these equations can share variables they interact in important ways that can change with scale.
Our focus in this post is the sustainability model.
For Ibbaka, the origin of this approach is earlier work we had done in health economics, where we used our modeling software to build models for how a treatment could impact QALYs (Quality Adjusted Life Years). The goal is to create models where the outputs are something other than a dollar value.
In sustainability models, the outputs are generally one of the following metrics …
Energy savings
Resource savings
Water savings
Greenhouse Gas (GHG) emission reductions
Habitat preservation
One can find many ideas for sustainability metrics in the GRI standards, which is one of the most commonly used standards for reporting sustainability. GRI is currently developing sector-specific standards for Oil & Gas, Coal, Agriculture Aquaculture and Fishing, Mining, Financial Services, and Textiles and Apparel.
We are finding that the most relevant sustainability metrics are often based on intensity. Rather than total water consumption, understanding water consumption per square meter or water consumption for some action can lead to more actionable insights.
An interesting meme that has accompanied the popularity of ChatGPT is ‘How much water does ChatGPT drink?” Google will tell you that …
“ChatGPT drinks 500ml of water for every conversation. For every conversation of about 20-50 questions and answers you have with ChatGPT, the chatbot drinks 500ml of water.”
This comes from a paper from researchers at UC Riverside ‘Making AI Less “Thirsty”: Uncovering and Addressing the Secret Water Footprint of AI Models’ by Pengfei Li et al.
Companies that consume resources (and that is virtually all companies) will have to start answering questions on how their day-to-day operations are impacting the environment.
The sustainability model can inform the value model
You will notice that the model architecture has the sustainability model as an input into the value model. In our approach, the outputs of the sustainability model are NOT measured in dollars. They are measures of an environmental impact. Of course, many of these impacts do have economic consequences.
There are direct impacts. Saving water can reduce water bills; saving energy reduces energy bills.
There can also be indirect impacts. Many companies have regulatory and legal obligations to prevent environmental damage. A leak can trigger not only wasted spending on water but fines and other sanctions.
One thing we are looking for when building these models is shared variables.
When deriving pricing from a value model the first thing we look for is variables in the value model that can be used in pricing.
In the same way, there are often variables in the sustainability model that show up in the value model. In this way, sustainability can tie directly to economic value and from there can cascade down into the pricing metric. Sustainability can influence the price.
Is that all there is to this? No. We need to go a step further.
Pricing can nudge buyers toward more sustainable solutions and users toward more sustainable behaviors
In their classic book Nudge, Robert Thaler and Cass Sunstein ask how economic information and incentives can encourage more productive choices, including choices that impact sustainability.
An obvious example is carbon pricing and other Pigouvian taxes (taxes that are meant to capture negative externalities - harms to others or society as a whole that are not captured in the transaction between buyer and seller).
Business solutions developers can also design pricing in a way that encourages and rewards behaviors that drive up sustainability metrics.
For example, one way to design a value-based price for water sustainability is to charge for water conserved. The more water conserved the more the buyer pays for the solution. But in some cases, this can be counterproductive. The more water saved the more that is paid for the solution, reducing the reward of conserving water. Can we come up with a better pricing design?
One idea is to flip the pricing so that the vendor of a water conservation solution gets paid more as water consumption goes up and less as water consumption goes down. This inverts the common assumption that unit prices should go down as consumption increases. This is an assumption we are going to have to question more often as we move into a circular economy. Experiment with pricing models that reward conservation and the more efficient use of resources.