Designing an Optimal Carbon Pricing System for India

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While the world remains divided on what should be the ideal outcome from the Glasgow Climate Summit; two clear messages are coming across: (a) a credible trajectory towards the achievement of a global compact is needed which would include sectoral strategies as well, and (b)carbon pricing mechanisms are a pre-requisite to attract clean investments and ensure stable rate of returns. Efforts towards domestic carbon pricing initiatives have also been spurred by two recent developments: firstly, carbon border adjustments are back on the negotiating in Europe, and secondly, IMF has recently submitted a proposal for an International Carbon Price Floor among large emitters. Given the heat that India will no doubt feel in the upcoming few weeks, it might be interesting to delve deeper into the carbon pricing issue in some detail from the Indian perspective.

Recent data published by the World Bank shows that internationally there are around 61 carbon pricing initiatives in place or scheduled for implementation. These initiatives cover about 12 gigatons of carbon dioxide equivalent (GtCO2e) or about 22 percent of global greenhouse gas (GHG) emissions. While the jury remains divided on the better option between carbon taxes and ETS, India has had some experience dealing with both. It is a well-known fact that while India does not have an explicit carbon price or a market-based mechanism such as cap-and-trade, it has put in place several schemes and mechanisms that serve as an implicit price on carbon. These include the perform, achieve and trade (PAT) scheme, coal cess (now discontinued), renewable purchase obligations (RPO) & renewable energy certificates (REC), and an excise duty on petrol and diesel. India therefore stands at an important crossroad vis-à-vis how to design its carbon pricing policy.

Going back to undergraduate public finance, taxes in the fiscal system burden the economy by creating two sorts of distortions to economic activity. Firstly, the tax system distorts factor markets and lowers returns on investments, thereby reducing the overall level of economic activity and causing a contraction. Secondly, taxes distort the composition of economic activity, by providing an incentive for more activity in the informal sector that may be less productive.  However, when looking at carbon taxes or similar instruments, the state of play changes a bit. Literature seems to suggest that the imposition of carbon pricing instruments may lead to large efficiency gains when revenues are used to lower other distortionary implicit taxes or fund welfare-inducing transfers, also termed as the ‘revenue-recycling’ effect. Additionally, if designed well, ‘efficient’ carbon prices, may be able to factor in externalities or co-benefits of reducing fossil-fuel use which would lead to virtuous cycles of their own (see figure 1).

Additionally, these are only the static or at best short-term impacts of carbon pricing. There are dynamic or long-term gains to be reaped while looking into the innovation compensation effects of these prices following the Porter hypothesis. This effect essentially means that firm compliances to environmental regulations (or higher carbon prices in this case) would catalyse innovation benefits for enterprises which would then be induced to improve their productivity and/or trade competitiveness to keep up.

Figure 1: Net benefits from a Pre-Existing Fuel Tax
(Source: Parry, I; Veung, C. & Heine, D; “How Much Carbon Pricing is in Countries’ Own
Interests? The Critical Role of Co-Benefits”, IMF Working Paper)

However, is carbon pricing the panacea as it sounds? While the present piece does not argue against the importance of pricing carbon to take the mitigation ambition a step farther, the gains of carbon taxes often extolled in literature definitely need to be looked at critically. The above premise of gains to the system presupposes two elements in its design- (a) an ability of the system to regularly incorporate social cost of emissions into its pricing, and (b) recycling of collected funds to improve either social welfare outcomes or add to natural capital. In fact, a paper by Ojha (2005) looked at the impact of a domestic carbon tax policy on carbon emissions, GDP, and poverty in India. Using a CGE model, the study found that a carbon tax policy would impose substantial costs in terms of lower economic growth and higher poverty. However, the fall in GDP and rise in poverty could be minimized or even prevented if either emission restriction targets were mild or tax revenues were transferred to the poor. The second option of using collected tax revenues for environmental or climate-related projects would not only add further impetus to the set climate trajectory but could also potentially ‘crowd-in’ private investment into the same. Unfortunately, on both fronts India’s previous track records have not been the greatest. 

Given the above context, it is my opinion that it might be easier to scale-up the PAT scheme as a prototype for an emission trading system rather than impose a separate carbon tax given the political economy consideration. One could however also argue that this need not be an either-or decision, and both can co-exist parallelly.  Let’s discuss each of these points here. The PAT scheme was designed as a means to achieve energy efficiency interventions in critical sectors cost-effectively. The process involved the identification of high energy consuming sectors and firms, setting up of consumption baselines and targets, and designing of a trading mechanism for energy saving certificates (or ESCerts) as a means for meeting targets. Given the coverage of the PAT which includes power, several energy-intensive industries, refineries and discoms as well as its dynamic mechanism for cap setting and reductions; it provides for a good base case for the emission trading design. From the fiscal policy perspective as well, the incidence of the ‘tax’ is clear and direct.

For the design to be fleshed out further, two additional critical elements need to be brought into the fold. The first refers to India’s own strategy (either independent or based on a global compact) for emission reduction and its devolution in the form of sector-specific targets. These sectoral targets form the basis for the baseline identification and future cap setting (linear or performance-based) for the aforementioned emission trading system. The second refers to the setting up of a national registry of emissions to periodically collect and verify data at a firm-level and sectoral emissions using a bottom-up approach. Mexico is currently undergoing the process of setting up a national emissions trading system and there could be lessons there for India.

An alternative line of thinking in this regard could be capping state level emissions and allowing them to think about the choice between emission trading or taxes and also decide upon the design, which is the approach being tried out both in China and Canada. However, the state-level proposition would need much deeper analysis taking into consideration not just the state’s energy consumption and production patterns but also its developmental imperatives while deciding the emission caps and trajectories of allowances in the future.

In sum, speculations are rife about how the climate negotiations would pan out from the developing countries’ perspective. But one thing is certain, India would need to do some soul searching, albeit reluctantly, about how to mainstream carbon pricing in its own fiscal and climate policy. Of the two options i.e., carbon tax or emission trading system, the second option seems to be preferable given the political economy of additional tax imposition and the good track record with PAT scheme.

(Views expressed are the author’s own and don’t necessarily reflect those of ICRIER.)

Published by Amrita Goldar

Dr. Amrita Goldar is a Fellow at ICRIER and has more than 10 years of experience working on projects related to energy, environment and climate change for both government and non-governmental clients. Within ICRIER, she has worked on and led projects related to G-20 negotiations, municipal bonds for financing urban solar rooftop projects, climate change impacts on urban economic competitiveness, cost-benefit analysis of urban local public health interventions, MSMEs and sustainability standards, techno-economic analysis of various renewable energy technologies for telecom towers, and impacts of rationalizing fossil fuel subsidies in India. Her ongoing projects include estimating the financial requirements for meeting India’s NDC commitments, analyzing the impact of waste management on tourism revenues for Himalayan states using CGE model, and studying the impact of renewable policies on jobs created in the economy and industrial competitiveness. She also manages a team of 5-6 researchers working on the theme of ‘climate change and sustainable development’.

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