It is tough to implement carbon market

An ambition to develop carbon market—the government recently announced a National Steering Committee—is a welcome development. It reflects political and economic maturity to use competition as the preferred option to achieve the desired policy objectives. It is particularly interesting because the tradeable commodity i.e., carbon emission reduction, is a notional construct. It was devised to internalize an externality (negative consequence of a process, in this case emission of greenhouse gases) into prices of goods and services.

However, the proposed design and architecture requires refinement on multiple fronts, including economic, legal, financial, and administrative.

First and foremost, while the Nationally Determined Contribution (NDC) was updated almost a year ago, there was no explicit recognition that the carbon market will serve as the primary mechanism to drive NDC commitments. Not linking the policy objective to the instrument will be a missed opportunity, likely resulting in higher economic cost.

Economic theory prescribes compliance (carbon tax) route or market mechanism route to internalize externalities. These two options, developed by two famed British economists i.e., Arthur Cecil Pigou (Pigovian Tax) and Ronald Coase (Coase Theorem), are considered as two ends of the spectrum and mutually exclusive.

India already imposes high implicit carbon taxes on all forms of fossil fuels. Therefore, development of a carbon market must go hand in hand with rationalizing taxes by bringing energy in the GST framework. Since there is no recognition of this fact, it is likely that carbon market and high taxes may co-exist.

Further, the framework proposes that existing compliance mechanisms such as Renewable Portfolio Obligations and Energy Efficiency Targets may remain applicable. Therefore, targets under the carbon market appear additional, over, and above existing requirements. Hence, some key sectors of the economy may be subject to multiple requirements. This will increase the cost of production, directly by increasing the cost of energy, and indirectly through multiple compliance requirements.

From economic standpoint, this construct appears inconsistent with the ambition to accelerate growth, in-particular to rapidly expand manufacturing. It has also been proposed that carbon market is a response to EU’s Carbon Border Adjustment Mechanism (CBAM). This appears stretched, because an easier approach would be to simply rename the existing taxes as carbon taxes.

Carbon markets in Europe and US evolved because of lack of political consensus on national policy for mitigation and regulatory provisions, such as carbon tax. In India, that is not the case. We have an ambitious mitigation plan combined with high implicit carbon taxes. Therefore, we believe that carbon market is a strategic policy choice, adopted as a conscious strategy. The need to rationalise energy taxes is a consequence of this strategic choice.

More broadly, while markets are generally better than alternatives such as taxes, we need to recognise that real world markets need to be designed well to minimise inefficiencies and maximise the desired outcomes. So, details matter. Following aspects need to be carefully considered.

First, the fundamental design principle is to minimise the transaction costs by keeping rules simple. This improves viability, enabling higher investment and innovative business models. Operationalising the proposed scheme appears administratively complex due to involvement of multiple ministries (ministry of power, ministry of environment, forests, and climate change) and agencies (the Central Electricity Regulatory Commission, the Bureau of Energy Efficiency, the Steering Committee, etc). This will likely increase costs and reduce demand. Instead, focus should be on maximising carbon mitigation through discovery of least cost options.

Second, should the existing emissions be allocated free and grandfathered? There are pros and cons. Grandfathering is more acceptable and administratively simpler. On the other hand, while a detailed baselining requires effort, it is fairer since it encourages innovators and early movers. We recommend free allocation to start with, benchmarked to the industry best practice. Beyond best practice, permits should be purchased. For hard-to-abate sectors, baselines can be adjusted gradually as technologies evolve and pilots demonstrate success.

Third, generating meaningful demand will be the key to success. Experience from the REC and ESCert markets indicates that a combination of flexible regulation, financially unviable buyers (power distribution companies) and supplier enthusiasm resulted in an oversupplied market. Therefore, the market design needs to identify buyers with willingness and capability. Further, clear financial penalties need to be applied to those failing to meet the regulatory requirement.

The regulatory framework for the scheme requires further refinements. The CERC has been designated as the regulator. However, this may be challenged since the carbon market is being implemented under the Energy Conservation (Amendment) Act, 2023, while CERC derives authority under the Electricity Act, 2003.

Further, clarity is required on the regulation of carbon derivatives, such as futures and options. Since mitigation projects take several years, a market mechanism for trading in futures is essential. It is integral for efficient mitigation options to be discovered and adopted. We need to learn from the previous experience of jurisdictional conflict between CERC and FMC/SEBI.

Last but not the least, fungibility of various instruments (RECs, ESCerts) will need to be specified domestically, at-least till carbon credits become the standard. Likewise, market participants will expect international fungibility to optimise meeting their obligations. Therefore, monitoring and verification protocols will need to be aligned to global standards.