Internal Carbon Pricing in the Multidivisional Firm∗

In response to environmental concerns, multidivisional firms running 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 for this phenomenon. Modeling two vertically related subsidiaries located in different jurisdictions, we examine how transfer prices would convey carbon taxes, and consider the impact on each subsidiary’s production and emissions abatement. Thereby, we also show how the firm’s environmental strategy might interact with fiscal compliance. Through transfer pricing, finally, a carbon tax in one jurisdiction can have an incidence on the other jurisdiction’s subsidiary; implications for environmental governance are discussed