Internal Carbon Pricing in the Multidivisional Firm

In response to environmental concerns, big corporations, which largely allocate resources through so-called "internal markets", often seek to have the associated internal (or transfer) prices incorporate their social cost of pollution. We develop a theoretical rationale and framework to analyze this phenomenon. Our model involves two vertically related subsidiaries located in different jurisdictions. We examine how transfer prices would convey the mandatory carbon fares holding in each jurisdiction, consider the impact on each subsidiary's production and emissions abatement, and point out the ramifications for the organization of the firm and public policy. Thereby, we also capture how the firm's internal carbon pricing interacts with fiscal compliance. Through transfer pricing, finally, a carbon fare in one jurisdiction can have an incidence on the other jurisdiction's subsidiary; implications for environmental governance are briefly discussed.