The UN Climate Change Conference in Glasgow (COP26) served as a global reminder of the uphill battle to meet the world’s decarbonization commitments by 2050. Businesses will play a major role in a lasting climate solution, meaning any chance for progress will require every industry to mobilize. Retail was late to the party, but it has begun to make up for lost time. In 2016, there were only a small handful of major retailers—including Walmart—with a science-based target to reduce carbon emissions. Just five years later, more than 65 global retailers set such targets, and the number is more than doubling each year (Exhibit 1).
Retail executives are increasingly recognizing that these commitments come with a steep price tag, and the funding sources and path forward are still unclear. As in other industries, retailers must confront their own direct and indirect emissions as well as those of their far-flung supply chain. More vexing, the cost of decarbonization will be borne, to varying degrees, by stakeholders across the value chain, including suppliers, workers, the public sector, investors, and consumers. To add to the degree of difficulty, the distribution of costs will vary significantly by retail subsector, and the investment timeline will be measured in decades rather than quarters or fiscal years.
Despite these challenges, retailers must now prepare to develop a climate strategy that includes a pathway to decarbonization and the funding sources to pay for it. The good news is they have access to a range of existing and new funding sources. Retailers can also lay the groundwork to engage their industry, form partnerships, and forge alliances so they aren’t tackling the problem on their own.
Calculating the cost of decarbonization
Before retailers can identify how to finance their climate strategy, they must first understand its total cost. The Greenhouse Gas Protocol segments emissions into three categories:
Scope 1 and 2 emissions are produced directly by companies in their operations and indirectly through the purchase of energy, respectively. To lower these emissions, retailers could seek to improve the energy efficiency of stores with LEDs; more efficient heating, ventilation, and air-conditioning (HVAC) motors; heat pumps; on-site solar-power generation; and battery energy storage. They might also decarbonize their owned transportation fleet by upgrading to zero-emissions vehicles (for example, those that run on batteries or fuel cells). For grocers, refrigeration in stores is a particular emissions concern and will require efforts to identify and manage refrigerant leaks and, in extreme cases, the complete overhaul of store systems.
Scope 3 includes emissions generated across the value chain and not directly in the control of the retailer. This category includes the emissions of suppliers in the manufacture and transportation of products and those of consumers in the use of products. Scope 3 emissions can account for 80 percent of the total carbon footprint for many companies and as much as 98 percent for home and fashion retailers (Exhibit 2). The direct costs of abating these emissions would fall primarily on suppliers—for example, to install heat pumps, solar-power generation, and energy storage in their manufacturing facilities or switch to green materials and sustainable, low-carbon packaging for products. A large part of Scope 3 emissions can be reduced by focusing on the downstream emissions from the use of products once they are sold. Measures include decarbonizing the grid by switching to cleaner sources of energy and encouraging consumers to trade in older, less energy-efficient products for newer, more energy-efficient ones.
Since Scope 3 emissions are beyond a company’s direct control (except through assortment decisions and supplier selection), organizations are exploring a range of options to raise awareness and increase decarbonization efforts in their supply chain. For example, IKEA has committed to zero-carbon fuels for container shipping by 2040, meaning shipping vendors will need to adopt such fuels.1 Global shipping accounts for almost 3 percent of the world’s CO2 emissions, so this move is likely to have an impact. In fact, Maersk Chairman Jim Hagemann Snabe asserts2 that the entire industry could be decarbonized through “power-to-x,” a process of turning green energy into green liquid fuel, with minimal cost increase per unit of good shipped. For example, Snabe noted that this approach would increase the cost to ship a pair of sneakers from Asia to Europe or the United States by just five cents.
Other costs beyond abating Scope 1, 2, and 3 emissions include staffing the new teams and roles required to internally manage the decarbonization process and the transition, as well as the cost of paying carbon taxes on residual emissions.
Considering the above, over the next five to ten years, retailers could see increases of at least 10 to 15 percent in their annual capital budgets and up to 8 percent in cost of goods sold (COGS) in select categories. While these costs will be partially offset by savings of 1 to 3 percent in facilities’ operating costs, the retail value chain is still likely to see a net cost increase. Retailers will need to create transparency around the implications for their own P&L and balance sheets and assess what share of these costs they will have to bear.
The profile of emissions abatement costs will vary significantly among retail subsectors. For example, apparel retailers often have stores located in malls and other multiunit buildings, where the cost to convert stores to heat pumps may be prohibitively high and the operational feasibility highly dependent on the landlord. For grocers with owned transportation fleets, the conversion to fuel cell electric vehicles (FCEVs) will be more costly due to the cold chain required for perishables.
Financing the decarbonization transformation
Given the momentum of change and the emerging clarity of costs along the value chain, retailers need to understand how the transition to a low-carbon economy will affect their bottom line. Each stakeholder group has the potential to shoulder a portion of the costs, but retailers must evaluate the broader impact to understand trade-offs and interdependencies.
Given the momentum of change and the emerging clarity of costs along the value chain, retailers need to understand how the transition to a low-carbon economy will affect their bottom line.
Vendors and suppliers
Vendors will be the starting point for most stakeholder engagement efforts. As carbon emissions become more transparent and therefore embedded in procurement criteria, some vendors and suppliers will look to protect their own bottom line and pass on at least some cost to retailers. Given the pressure from consumers and investors to support decarbonization, however, many national vendors may absorb their cost in the short term and gradually pass a part of the increase to retailers. Some vendors with strong brands are already making bold public sustainability commitments. Nike, for example, has announced 29 target initiatives that it will seek to complete by 2025. For climate, Nike aims to achieve a 70 percent absolute reduction in greenhouse-gas (GHG) emissions in its owned or operated facilities. It also seeks to cut GHG emissions from the manufacturing and transportation operations of key suppliers to 2020 levels or below through a greater reliance on renewable energy, energy efficiency, and alternative fuels.
Vendors with lower brand recognition may not experience consumer pressure to decarbonize but could come under pressure from major retailers to bear the cost of Scope 3 decarbonization. Smaller retailers may be able to harness this dynamic by maintaining current pricing with these vendors—an example of the free-rider effect.
Large vendors of private-label products with a few major retailers accounting for a disproportionately high share of the order book may experience similar pressure. Smaller retailers that get their private-label goods from these suppliers may again benefit from more stable pricing for a greener offering. Ultimately, many vendors, particularly small vendors and those manufacturing private-label products, will not be able to bear the cost of decarbonization and green materials on already slim margins. To maintain these partnerships and the assortments they provide, retailers may need to finance their decarbonization by paying more for sourced products.
Governments and regulators
While the activities of governments and regulators have often increased the cost of compliance for business, particularly with respect to a carbon tax, these stakeholders could also become a source of increased funding for retail sustainability efforts. Governments across the world have set net-zero commitments, with accompanying spending plans to decarbonize parts of the economy. Some of this spending may go to promote consumer adoption of green products through public stimulus such as financing support for energy efficient products, and other funds could support innovation through grants to technology companies, academic funding, or directed government procurement. For example, the US Department of Energy recently partnered with six industry players to launch a technology challenge to spur innovation by improving the performance and efficiency of next-generation cold-climate heat pumps.3 Such government spending will likely lower the cost of capital required to invest in space heating and cooling as well as the electrification of transport. Of course, the imposition of a carbon tax may offset these savings for retailers.
Investors are poised to play a dual role in retail’s transition to a low-carbon footprint. First, they are clamoring for an environmental, social, and governance (ESG) strategy from the retailers in their portfolio. For example, in BlackRock CEO Larry Fink’s 2021 and 2022 letters to CEOs, he asked all companies in which the firm invests to detail and report on their sustainability efforts.4 Complying with the standards requested by investors—such as the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD) and the Sustainability Accounting Standards Board (SASB)—will increase costs for retailers, which must develop detailed decarbonization plans while meeting expectations for profits. However, a significant amount of capital is being reallocated to ESG-focused funds, which now have more than $1 trillion under management. Many investors believe this trend is only the beginning and expect prices for high-sustainability companies to increase, while those for low-sustainability assets decline.5 This trend may already be playing out in the oil and gas sector.
The impact of this potential green-asset premium for retailers is not yet clear. While stock issued at a premium may finance decarbonization plans, it may come with higher earnings expectations from investors during the transition period to a lower-carbon supply chain and assortment. Some investors may accept a lower return on equity in the short to medium term, effectively financing decarbonization, while others may punish the stock if or when the transition’s costs affect the bottom line.
Debt investors also have a role to play. Lower yields on green bonds could allow retailers to tap cheaper financing of decarbonization efforts. Although still relatively small, the market for green bonds was estimated at $500 billion in 2021, a 46 percent increase from 2020.6 With a typical price premium of one to six basis points compared with traditional bonds, green bonds have a lower cost of borrowing for the issuer.7 Retailers have already started to play in this market; in 2021, Couche-Tard was the first convenience and fuel retailer to issue a green bond, raising $350 million to support initiatives in clean transportation, energy efficiency, renewable energy, pollution prevention and control, sustainable water and wastewater management, and green buildings.8
Notably, the distribution of costs across the value chain will vary by retail subsector. Grocers, for example, already operate with slim margins and will be unable to absorb significant decarbonizaton costs without passing along costs to other parts of the value chain. On the other hand, luxury-apparel players may have not only more room to endure added costs but also more pricing and purchasing power.
What retailers can do now to prepare
While the roles each stakeholder will play in the carbon-free transition are still in flux, retailers can take a series of no-regrets actions to lay the foundation for a decarbonization strategy and assess potential funding sources for the transition.
Incorporate sustainability into consumer research. Research, pricing, and strategy teams need to start building a deeper understanding of consumer sentiment—how expectations will evolve and how high a premium shoppers would be willing to pay for sustainable products. The research should be accompanied by real-world experimentation with pricing to verify the actual intent to purchase among different consumer segments.
Test green products. Private-label teams should get a head start on developing new product versions that explicitly use decarbonized materials and a lower-carbon supply chain, as well as directly testing the consumer uptake and pricing power of such products. Where possible, partnering with vendors on similar products could ease future sourcing negotiations. In addition, retailers should test the positioning of green products to see what might resonate with consumers and drive adoption. In grocery, for example, “design to health and sustainability” might be a much more powerful overarching belief than “doing good for yourself, your health, and the environment.”
Create emissions transparency at a product level. Retailers should start tracking emissions profiles at a product or subcategory level to help prioritize efforts to decarbonize and enable customers to make sustainable choices. This approach would require action at two levels. First, retailers would have to partner with vendors and third-party emissions-tracking providers and form internal teams to create emissions databases. Second, they would need to invest in technology to make the emissions information readily available to customers. Carrefour,9 for example, is investing in blockchain technology to trace textile products across the life cycle. It can then allow consumers to use a QR code to see product-related information, such as place and date of production, the product’s composition, method of cotton cultivation, and environment-related certificates.
Include decarbonization in all procurement discussions. Retailers can build emissions criteria into sourcing and procurement processes and begin rigorous tracking of pricing from vendors to identify decarbonization-related cost increases. Developing robust clean sheets of decarbonized materials and processes will ensure fact-based negotiations in the carbon transition with suppliers.
Engage key investors on decarbonization strategy and planning. Retailers can work with their boards to open a dialogue with key institutional investors and provide updates on climate strategy. Investors that prioritize ESG efforts may be willing to share ideas about and expectations for decarbonization timelines. Retailers may also have an opportunity to secure funding through green bonds for selected short- to medium-term projects. They should make this effort an urgent priority while green bonds still command a premium in debt markets.
Join public-sector efforts at decarbonization. Retailers should identify government agencies that will govern the relevant jurisdictions for decarbonization plans and offer to participate in pilot projects. Because they play a massive role in the economy, retailers need to have a seat at the table as decarbonization policies are set and funding for the transition is allocated. In many cases, major retailers are the economic anchor of communities and could provide leadership in spurring the adoption of heat pumps, renewable-energy technology, and EV technologies. Major retailers could help smaller local shops with similar efforts by providing expertise and sourcing support—for example, coordinating the purchase of equipment to save on supply chain costs or take advantage of volume discounts where available.
Develop and lead relevant industry partnerships. Only a handful of retailers have the scale and influence necessary to encourage vendors to switch to green materials in production. Even the largest global retailers would benefit from an industry-wide effort to get individual suppliers to decarbonize their supply chain. A standard industry approach would also blunt the free-rider effect, as all competitors would benefit from vendors moving up the learning curve. Industry associations could help to set common standards and offer guaranteed order quantities to participating suppliers in the short term. This approach would benefit suppliers that shoulder the cost of green products, enabling them to offer competitive pricing.
Even the largest global retailers would benefit from an industry-wide effort to get individual suppliers to decarbonize their supply chain.
The consumer question
A key stakeholder not discussed above as a potential source of funding decarbonization is the consumer. As costs rise along the value chain, pricing is often discussed as a potential offset to the impact on margins. However, the most significant unknown in the “who pays for sustainability?” puzzle is the consumer’s willingness to pay for decarbonized products.
Consumer research suggests that consumers are willing to pay a premium for environmentally friendly products, sometimes as high as 60 percent.10 This sentiment is most prevalent among Generation Z and higher-income shoppers, who are quickly becoming the dominant consumer cohorts globally (Exhibit 3). McKinsey’s October 2021 survey of German consumers points to an increase in stated willingness to pay more across different categories, largely due to improved assortment: increases of 11 percentage points in food, 16 percentage points in home care, 16 percentage points in personal care, and 12 percentage points in consumer health, as compared with December 2020. However, stated and derived intent have historically diverged significantly, and research that conclusively confirms consumers will actually pay a “green premium” is scarce.
Despite the uncertainty around willingness to pay, an emerging view expects that the transition to a low-carbon economy will create new value pools and that demand for low-emissions products and services will continue to grow. First movers in all sectors are already adjusting their strategies to target these growth opportunities and transforming their business portfolios to build green businesses. Therefore, while it is important for retailers to develop robust decarbonization plans that include views on how they will be financed, with a focus on mitigating risks, such a plan is only a first step. The next natural step is identifying and capturing the “green” opportunities that emerge. (For more on this topic, see “Hunting for value in the net-zero transition,” forthcoming on McKinsey.com.)
For a long time, climate sustainability efforts across all sectors were held hostage to the question of who pays. Pioneers in the retail and consumer sector were often punished by customers for higher prices and by investors for increased operating costs. Now, the shift in global sentiment has made action more urgent. Until the distribution of costs across the retail value chain is resolved, retailers that act early will help to shape the landscape and have the potential to create more value for their customers, their investors, and the planet.