India’s upcoming budget announcement on 1 February is expected to provide further direction for India’s clean energy transition. With parliament having approved the Energy Conservation (Amendment) Bill in December 2022, the federal government is empowered to create a national carbon market (NCM). The NCM could start trading within the next six months and be fully operational by 2026. How can this NCM be designed to deliver real emissions cuts without hampering other development objectives such as economic growth, employment and inflation.
Let’s begin with what a carbon market is: it’s a market that allows entities whose greenhouse gas (GHG) emissions fall below a prescribed limit to sell their emissions savings to other entities, allowing the latter to meet their emissions targets. The buying and selling of such emissions savings – called permits, allowances or credits – leads to the discovery of a carbon price.
Several countries are proposing carbon markets as key elements of their decarbonisation strategies, but real-world experience has been less than encouraging. The European emissions trading scheme (ETS) only started cutting emissions after over a decade of operations, while China’s carbon market is currently not reported to be reducing emissions at all.
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Often, vested interests make carbon pricing schemes ineffective or even counterproductive. Emissions cuts, if any, are achieved at the lowest cost, without considering the requirements for managing a just transition.
This then begs the question, is carbon pricing desirable, and what are the conditions for a robust carbon market?
Key considerations and trade-offs
The technical design elements – relating to coverage, caps, pricing, reporting, and so on – are often the first thing that comes to mind when thinking about how to make a carbon market useful and effective. Two other considerations, however, are arguably more important.
The first is ensuring that a carbon market is one of a suite of policy instruments, each of which works in a complementary way to support climate ambition and manage any adverse impacts of the market.
The second is creating a stable institutional and regulatory structure that is able to balance competing interests and ensure a functional carbon market.
The main function of an NCM will be to lower emissions – that is, it must deliver avoided emissions. The stringent way of doing this is by imposing absolute caps on emissions, which are tightened over time. An alternative is to impose caps on the emissions intensity per unit of output. Though this would allow energy demand to keep growing, emissions would also continue to rise, albeit at a reducing rate. In either case, an important question is whether the caps are able to deliver emissions reductions additional to those that would have happened in the absence of a carbon market, and how such additionality is determined.
If the caps aren’t stringent, entities can meet them too easily – raising the risk of an oversupply of permits and a collapse in prices. Firms will then find it cheaper to buy permits than to actually reduce emissions, rendering the NCM ineffective.
To address this risk, the federal government is expected to set up a stabilisation fund, though how it functions and how it will be funded are yet to be determined.
Beyond avoided emissions, an NCM can have significant economic impacts, particularly for a developing country such as India. The imposition of a more stringent carbon price may impose a heavier burden on some companies – particularly disadvantaging those in emissions-intensive and trade-exposed sectors, and small and medium enterprises – impacting jobs and competition. If companies try to pass on such burdens to consumers, prices will rise and create inflationary pressures in the economy. Managing the impacts on companies and consumers will be central to ensure buy-in for the NCM.
Some vulnerable sectors could be given free credits or permits to begin with, helping alleviate some of this burden. But auctioning permits at a price can help the government offset some of the tax revenues it will lose as the use of fossil fuels declines (taxes on fossil fuels constitute large shares of revenues for both the federal and state governments). It is not yet clear how the federal and state governments will share any revenues from an NCM.
Clearly, an NCM will have large implications for emissions, employment, inflation, trade, fiscal health, etc., and could end up presenting uncomfortable trade-offs between various policy priorities. To actually cut emissions while balancing India’s development objectives, an NCM would need:
- A sound design, coupled with;
- An integrated policy package – including new and existing interventions that are designed and revised specific to the requirements of the sector in which they are applied, and;
- An appropriate institutional and regulatory structure to manage a complex system and coordinate across departments and jurisdictions.
Aman Srivastava is a fellow at the Centre for Policy Research, New Delhi