Trade-offs in carbon trading: Can a carbon market yield benefits for India?

The creation of a national carbon market in India, depending on its institutional setup, policy integration, and design could offer a mechanism for reducing emissions, or it could result in serious economic costs. Srivastava and Swain put forth seven key considerations for its design – including India's growth objectives, trade balance, fiscal revenues, and the effect on its MSMEs. To ensure its success, they highlight the need to integrate it with a comprehensive policy package to quell broader political economy challenges.

In August 2022, India’s Lok Sabha passed the Energy Conservation (Amendment) Bill (ECA Bill), which if enacted will empower the union government to specify a carbon credit trading scheme or a national carbon market (NCM). Such a carbon market could potentially be a significant new policy instrument for low-carbon development, with wider implications for the economy and society.

A carbon market is a market-based response to the framing of carbon-intensive growth as a market failure; it is an attempt to express the true social cost of emissions using the market price of carbon-intensive goods. In a carbon market, the authorities set caps on permitted emissions, issue emission allowances to regulated firms, and allow the firms to trade their allowances. Trading allows regulated firms to either reduce their own emissions and sell excess allowances, or to buy the extra allowances they need from other firms – whichever is cheaper. While the governments determine the pace and extent of emission reduction by setting the caps, the market discovers the price.¹

Proponents claim that such instruments can offer the most cost-effective means of reducing emissions by unleashing innovation, spurring investment in new technologies, and concentrating action on the least cost solutions (Center for Climate and Energy Solution, 2010). However, critics contend that “...carbon markets serve to sustain the status quo… interest groups mobilize around carbon pricing schemes to render them ineffective or even counterproductive…” (Tooze 2021). Literature increasingly finds that the emissions and economic outcomes from carbon markets vary depending not only on the design of the markets, which has been comparatively more researched (see International Bank for Reconstruction and Development, 2016), but also on how such markets complement other national and sectoral low-carbon policies which have been incrementally developed to reflect local contexts, as well as on the political economy conditions under which these markets operate. Support from organised political interests – which is, voters sensitive to cost inflation, incumbent high-carbon industries, and political leaders – and the institutional arrangements to mediate these interests are critical forces in shaping the structure and performance of carbon markets (Cullenward and Victor 2021), and studies have found such support to be missing (Narassimhan et al. 2022).

As India prepares to design its NCM, we illustrate seven key questions and implications to consider in developing such a market-centric approach to decarbonisation, relating to a carbon market’s environmental, economic, regulatory, and institutional aspects.

Will an NCM force emissions reduction at the expense of India’s economic growth objectives?

Although the primary purpose of an NCM is typically to support climate targets, pursuing this rapidly may risk steep economic costs. Progress towards emissions reductions depends on the breadth of the NCM’s coverage of sources and shares of national emissions, the stringency of its emissions caps initially and over time, exemptions provided to emissions-intensive trade-exposed (EITE) sectors and firms, and the stability of prices of the tradable permits.

While emissions trading schemes (ETS) globally have typically started with a limited coverage of sectors and built up over multiple phases of operation in order to learn and build from experience, this approach has resulted in limited initial emissions impacts and kept the environmental benefits of such schemes marginal. Broader coverage upfront, on the other hand, would impose regulatory costs (regulatory shocks for firms and administrative burdens on authorities), as well as economic costs (higher transaction costs on smaller firms). It may, for instance, force medium and small firms out of business, with production shifting to big industrial houses, which will have implications for market structure and jobs.²

How India sets its allocation of carbon credits is an important decision. Given that India’s climate pledges are in the form of intensity targets rather than absolute ones³, absolute emissions caps such as in the European Union’s emissions trading scheme (EU-ETS)⁴, while maximising environmental gain, would run counter to its stated climate pledge, which takes its economic growth objectives into account. An output-based allocation like in China’s ETS⁵ may be more realistic because it can help support energy demand growth while keeping a check on emissions growth, although with less effect on the pace of decarbonisation.

Prices of permits will also need to be kept stable over time, by avoiding an oversupply of credits; this requires ensuring a balance between demand and supply by including both, sectors that are likely to be significant emitters (buyers, such as cement and steel), and sectors that are likely to easily overachieve their targets (sellers). It also requires careful consideration of whether permits are issued for a fixed or flexible duration, and whether they can be ‘banked’ – or their supply built up – for use in subsequent trading periods (Vollebergh and Brink 2020). These issues of coverage, scope, and validity may thus present a trade-off between the value added by an NCM to India’s decarbonisation policies, and the costs and political feasibility of disruptive shifts to sectors that are included along with it.

Will an NCM promote green industrialisation without harming the MSME sector?

An equally important objective is to reap economic benefits such as rapid green industrialisation. Though a carbon market could be seen as an instrument for redirecting investments to green industries by creating competitive disadvantages for polluting industries, India is already seeking to create competitive advantages for green industries, including clean energy components, electric vehicles, and hydrogen fuel, through production-linked incentives (PLIs) and other concessions. This has resulted in a shift to greener industries and industrial processes among the large incumbents. The interaction between these two approaches needs to be understood better.

While an NCM could potentially complement the PLI scheme, PLIs have the advantage of being more directly targetted and able be scaled up. Yet they are available to fewer industries and require a government to be able to make informed strategic choices. An NCM is expected to have a much broader coverage and does not require strategic choices. However, the magnitude of incentive depends on the actual carbon price. Although there is no clarity on, if and how an NCM will cover the micro, medium and small enterprises (MSMEs),⁶ it may help to expedite green industrialisation and emissions reduction. On the other hand, it might also hurt the economy by making MSMEs economically unviable. One opportunity for MSMEs is the promise of earnings from carbon trading, which in turn is dependent on the relative profitability of and access to investments. Simultaneously, governments can allocate part of the potential earnings from an NCM to support ‘greening’ of MSMEs. In the absence of a clear path to manage these uncertainties and adequate support for a transition, a market-centric approach may adversely affect the MSMEs and related livelihoods. Moreover, enforcing compliance for MSMEs will add to the regulatory burden. How an NCM interacts with the MSME sector requires careful additional consideration.

Will an NCM generate fiscal revenues while managing economic costs and preserving fiscal federalism?

An NCM could be a potential source of fiscal revenues for governments. To generate revenues, at least some share of the tradable permits will need to be auctioned, rather than freely allocated, with auction prices going up as fossil fuel use declines. Auctioning permits rather than allocating them freely will however impose high economic costs for firms (including potentially MSMEs) which can risk creating inflationary pressures if these higher production costs are passed on to consumers.⁷ Such distributional impacts will need to be managed, possibly using the fiscal revenues generated. Perhaps for these reasons, the free allocation of permits has been the norm in most carbon markets.

How permits are issued will be critical to fiscal revenue, domestic competitiveness, and cost of living considerations. If these potential revenues are to compensate for the loss of tax revenues from fossil fuel, an important consideration is how these revenues are divided between the union and the states.⁸ An NCM may not allow differential pricing to accommodate varying fiscal needs of the states, and thus hurt the low-income states. An alternative option is to pool these revenues at national level and allocate to states based on their needs.

How will an NCM affect India’s trade balance?

While attempting to serve as a response to border carbon measures, will an NCM hurt India’s trade balance, and place a disproportionate mitigation burden on the country? Regions such as the EU and US, which have established cap-and-trade markets, are exploring ways to prevent carbon leakage through the offshoring of production with potential initiatives such as a carbon border adjustment mechanism (CBAM) and climate clubs (Wnuck 2016, Sapir 2021). These initiatives, criticised as being protectionist and undercutting the principle of common but differentiated responsibility and respective capability (CBDR-RC)⁹, will apply a tax equivalent to the local price of carbon upon imported goods that are competing with domestic production in these regions but are produced in countries with lower (or no) carbon prices.

A NCM in India could attempt to serve as a response to such initiatives and reduce the tariff burden to exporting firms while retaining carbon revenues domestically. Aside from the complexities of shifting from fossil fuel taxes to an NCM and managing implications for states’ revenues, this would require it to include all the sectors under the scheme that currently export to the EU and US and that are covered under the equivalent schemes there, this may lead to carbon prices converging with major export destinations. Doing so might run counter to India’s position in international climate negotiations on the principle of CBDR-RC, while offering a trade advantage to countries that have less carbon-intensive production processes. It may also affect India’s trade competitiveness with countries that have lower (or no) carbon prices in relevant sectors. India’s balance of trade may thus be significantly affected by the rollout of an NCM and considerations such as its coverage, cap, and pricing.

Will an NCM ease (or increase) the regulatory regime while retaining public responsibility to manage a just transition?

An NCM could be intended as an approach to regulatory consolidation in managing market-based decarbonisation schemes. Given the growing appetite for climate action among the private sector in India, the rollout of an NCM could provide a platform for companies to demonstrate progress, expedite action, and reap economic benefits in the process. However, the NCM, in attempting to provide a market solution to the emissions challenge, will incentivise emissions reductions strictly at lowest cost, which may prove detrimental to managing a just transition. It should thus not reduce the role of the State in confronting the multifaceted challenges of mitigation, which remain issues of public welfare, and cannot be addressed by an NCM.

Domestic experiences with market mechanisms, like Perform, Achieve and Trade (PAT), Renewable Energy Certificate (REC), and other pilots carry important lessons. Despite controlled regulatory settings, a common challenge across these experiences has been poor compliance, causing oversupply and low demand, in turn leading to a market collapse. While designing an NCM, India will not only have to find ways to integrate existing schemes into a common and internationally verifiable metric, but also have to plan institutional structure, capacity, and oversight to manage a more complex trading system and seek greater coordination across departments and jurisdictions. While a market approach holds a promise of regulatory ease in the long-term, it will come at a cost of significant regulatory burden and investments upfront.

Is the projected institutional structure for an NCM robust?

Global experience suggests markets require robust institutional underpinnings to manage allocation of permits, monitor their quality (particularly when offsets are included) and ensure credible transactions. So how is India approaching the question of institutional design for an NCM?

India seems to be somewhat opportunistically shoe-horning a comprehensive instrument like an NCM into a legislation on energy conservation. A draft blueprint for an NCM, prepared by the Bureau of Energy Efficiency (BEE), suggested a phased approach to the carbon market, including building on the PAT scheme – a market-based energy conservation scheme implemented by the Bureau. The ECA Bill also identifies specific functions for the BEE, including recommending the requirements to be specified in the NCM and empanelling technical experts to promote carbon credit trading activities. While the blueprint provides a useful basis to start the conversation on NCM, is the proposed institutional approach appropriate for a market that might subsume RECs, industrial activity, transport, and other related sectors? Is the BEE the appropriate regulatory body for an NCM? This complex set of objectives and trade-offs imply that an operational carbon market would require oversight and coordination among multiple ministries and agencies. The options include layering of objectives and responsibilities onto existing institutions (as is the case in the ECA Bill) or creation of new institutional structures with specific purpose and mandate.

Will an NCM complement existing low-carbon policies?

Finally, a layering of policy priorities has resulted in multiple sectoral interventions towards the reduction of the energy and emissions intensities of the Indian economy. Many of these interventions are designed specific to the context and requirements of the sector in which they are applied, and have been suitably revised or replaced over time in response to changing conditions. Has the NCM been proposed as a one-size-fits-all solution, or will it be part of an integrated policy package complementing the various sector policies, so as to maximise India’s emissions reductions while realising its development objectives? Is there a risk of the NCM being a redundant tool while continuing to impose administrative costs, if India’s current climate policies already effectively reduce emissions from their respective sectors below the NCM’s caps?

These questions, and the trade-offs that they present, will need to be carefully considered when determining the institutional structure and design of the NCM. Additionally, an NCM will need to be a part of a comprehensive and complementary policy package that can strategically leverage current climate progress and address compliance barriers towards a common objective of low-carbon development. A market-based instrument such as an NCM can prove useful, but may not be solely sufficient to manage the transition to net-zero emissions. We suggest that there are a wide range of conceptual and design considerations that need to be addressed if an NCM is to make a productive contribution to India’s low-carbon future.

The authors are grateful to Navroz K Dubash for his valuable insights in structuring and conceptualising this article, and to Easwaran Narassimhan for additional feedback.

Notes:

An alternative approach is a carbon tax that specifies the price and lets the market discover the volume of emission reduction
To align with other objectives, China’s ETS provides free allowances to the power sector, and given its ambition to increase the share of gas in power and heat generation, gas-fired power generation does not have to procure additional allowances if in deficit (International Energy Agency, 2020).
Such targets aim to reduce emissions as a percentage of GDP rather than on an absolute basis – this approach provides a country with the flexibility to continue growing economically while gradually decoupling that growth from emissions
The EU-ETS has an annual cap, that in 2013−2020 was meant to be reduced annually by 1.74% of the average total quantity of allowances (Vollebergh and Brink 2020). This was further tightened to 2.2% in 2018, based on which the supply of allowances is expected to be zero in 2057.
China’s ETS uses an output-based allocation, wherein allowances are allocated using an emissions intensity benchmark to ensure flexibility in operation and reduction in overall emission intensity; this is less likely to restrain energy demand growth (International Energy Agency, 2020).
About 44 million MSMEs in India account for 45% of national manufacturing output and more than 35% of exports and consume more than a quarter of industrial energy demand.
For instance, if decarbonisation investments and policy costs are domestically mobilised by the government (through carbon pricing and taxes) and private industries (through borrowings) in India, a recent analysis by Asia Society Policy Institute (2022) finds, households consumption could reduce by 1-2 percentage points from current level over the next 35 years.
Taxes on fossil fuel, particularly petroleum products, coal and electricity, are important sources of revenue for the state governments and their welfare functions. States have varied taxes on these products and have been resisting a uniform tax regime like the Goods and Services Tax (GST).
CBDR-RC is a principle that emerged in climate negotiations as a result of compromise between developing and developed countries. It acknowledges a common obligation to address climate change but doesn’t place equal responsibility on each nation to tackle it. It places a larger burden on industrialised nations with historical responsibility