Shadow price, or shadow pricing, is the real economic price of projects, activities, goods and services that either have no market price, have prices that are difficult to estimate, or whose prices do not reflect the true sacrifice made. The shadow price is the opportunity cost – what had to be given up when a choice was made.
The shadow price is the proxy value of a good or project, frequently defined by what a person has to give up to gain an extra unit of that good.
However, the impact resulting from a project or the value of a good when measured using the shadow price may differ from its value when measured using market prices. This is because it has not been properly priced by the market in the first place.
The shadow price can also mean the highest price that a company should be willing to pay for one extra unit of some type of a resource.
Shadow pricing involves determining whether doing something will bring in greater benefits than the costs incurred. When the shadow price has been estimated, the management then decides whether or not to go ahead with a plan, and if they do, how much they are willing to spend on it.
For example, when calculating the cost of paying overtime to workers to remain on the job to operate a production line for an extra hour, if the shadow price – the benefit obtained after keeping the production line working longer – is greater than the cost of running the line, then management should go ahead.
In this case, the shadow price is the contribution margin that a company will lose if it does not keep the production line going for another hour.
Shadow price may refer to the actual market values of a money market fund, which basically refers to securities that are accounted for based on amortized cost instead of a value that the market assigns.
Shadow price – some examples
– Labor: the shadow wage is lower than the market wage when there is unemployment. This is because there is no loss in output elsewhere when a worker gains employment, so the marginal social cost of hiring him or her is lower than the market wage.
– Labor 2: a company is considering paying one of its delivery workers overtime to transport a shipment to a customer early. If it does this, it has a good chance of getting much more business from the customer.
The company assigns a shadow price of $10,000 as the benefit of having an improved business relationship with the buyer. Therefore, its management is willing to pay up to ten thousand dollars to the dispatcher to make the delivery.
– Steel: the shadow price is higher than the market price, because the steel producer has not accounted for the marginal social cost of pollution in steel’s production costs.
– Capital: the shadow interest rate exceeds the market interest rate when rationing exists in capital markets. This is because the expected return is higher than the interest rate as companies wish to borrow more at a given interest rate than they can – the opportunity cost of funds is larger than the interest rate.
Shadow price in accounting
Before there is proper market pricing or adequate regulation for some commodity items, conservative companies and other entities will place a value they believe to be an accurate reflection of the value of those items to their business on their balance sheets.
Most companies with a large carbon or water footprint do this.
For example, Microsoft Corporation, the Washington-based multinational that develops, manufactures, licenses, supports and sells computer software, personal computers, consumer electronics, and related services, placed a $27/ton price on its carbon emissions – this was then billed to the P&L (profit & loss) of each individual business unit and used to fund the corporation’s renewable energy and efficiency programs.
In an article published in Climate Money Policy – Carbon Shadow Pricing – Brian Reynolds wrote:
“118: There are 118 buildings on the Microsoft campus (15M sq ft). Each with different requirements for heating, cooling, lighting and energy. Each with different potential needs and strategies for efficiency. Each with different capital needs.”
“30,000: There are thirty thousand different pieces of mechanical equipment and seven different and unique building management systems housed in those 118 buildings. None of them designed to speak with one another.”
“$1.5M: in savings Year-1: That’s the bottom line number Microsoft realized following the adoption of carbon shadow pricing.”
Shadow pricing – pros and cons
When a company has to make incremental decisions, determining the shadow price is useful. Before deciding whether or not to go ahead with a plan, you have to weigh the cost of extending the usage of a resource against the potential benefit you or your business will derive.
Shadow pricing is often no more than calculated guesswork, especially when dealing with intangible goods.
When you are not sure how accurate your guesstimates are, you should use a range of estimates, and link them to the most likely benefits.
Regarding the disadvantages of using a shadow price approach, AccountingTools.com writes:
“Even using a range analysis, there is a good chance that any estimates proposed will be incorrect, and possibly by substantial amounts. Shadow pricing is a limited concept that should only be applied to very specific financial analysis situations. ”
Shadow prices may be derived from anything, from a good or service to a resource. While economists tend to use the markets when making valuations, their research is not necessarily limited when there is no market price for something.
Video – Shadow cost of carbon
In this Energy & Mines video, taken at the World Congress in Toronto, Canada, Frank Roberto, Chief Metallurgist at Colorado-based Neumont Mining Corporation, talks about how his company is implementing a shadow cost of carbon.