India should use markets to decarbonize

Climate change is bound to affect human life and the global economy on an exceptionally high scale in the not too distant future. The last Conference of the Parties (CoP-26) to the United Nations Framework Convention on Climate Change held in Glasgow in November 2021 saw significant inactivity from many partner countries in committing to concrete action plans to contain global warming below the 1.5°C threshold. After China and the United States, India, which emits 2.44 billion tons of carbon dioxide annually, is the third largest emitter of greenhouse gases, making it a major player in reducing emissions.

Economic growth is closely related to energy consumption. The International Energy Agency (IEA) 2017 World Energy Outlook estimates that India will account for nearly a quarter of global energy demand by 2040. Achieving sustainable economic growth requires a strategy to aggressively reduce carbon emissions while also focusing on efficiency and equity, and behavioral aspects.

According to the 2021 India Energy Outlook report from the International Energy Agency, India’s energy system is highly dependent on fossil fuels – coal, oil and bioenergy – which provide about 90 percent of the country’s demand. About 38 percent of primary energy is consumed for power generation, which means that the level of electrification remains low in the country. Power generation relies heavily on coal—about 78 percent of it comes from this fossil fuel—and transportation depends almost entirely on oil. Thus, the Indian energy ecosystem is carbon-intensive.

There is consensus that climate change is a feature of market failure. Economic activities by consumers (driving or air conditioning, for example) and producers (such as electricity generation and manufacturing) cause emissions, leading to pollution and global warming. These negative externalities, which cause ineffective results, are not reflected in the costs incurred by consumers or producers. In other words, the real costs to consumers, producers and society are not reflected in market interactions. This leads to an uncontrolled rise in emissions and also generates apathy towards mitigation efforts. Solving the problem of market failure calls for government intervention.

The cost-benefit analysis of emissions reduction is based on the premise that the costs incurred by a company—whether manufacturing or power generation—in investing to reduce emissions have long-term benefits to society. Some companies may require less money to reduce the same amount of emissions as others.

The most natural option for government intervention to reduce emissions is to set emissions limits through regulation, taking into account the nationally determined contribution targets set by the country under the Paris Agreement. But there is another side to this. Experts have shown that wrong emission levels can lead to cost-effective results. It makes it difficult for the regulator to obtain information about each company’s mitigation cost schedules and damage cost in advance. Hence, it will not be known that for a given amount of capital the firm will be able to reduce the maximum emissions and thus provide the highest benefit to the society. Therefore, setting emissions targets and regulating emissions through command and control may only be a good thing during the initial phase of a mitigation strategy.

A carbon tax is a better option than regulating pre-determined levels of emissions. The marginal cost of mitigation rises as firms continue to reduce emissions further, and the firm will stop reducing emissions and choose to pay taxes at the point where the mitigation cost becomes higher than the tax rate. This option will produce semi-effective results.

However, the possibility that the tax is too high or too low cannot be excluded. This issue can be addressed by introducing an auction-based carbon trading system. The trading scheme will achieve higher efficiency as the price of the certificates will be set by allowing firms facing low and high anti-control costs to compete in the free market according to their abatement cost and damage schedules.

An effective policy framework to reduce emissions must be rooted fundamentally in the Indian energy ecosystem and be cognizant of the causes of market failure. Significant investments are needed to transition to a green energy economy, and market-based tools are the most efficient tools to achieve this. An emissions trading scheme will determine the optimal and cost-effective levels of emissions reduction by providing companies with a choice to either mitigate or trade – and the net effect of this reduction will be. Low-cost companies will continue to reduce emissions because they will benefit from certificate trading. In the process, they will provide signals to the market about efficient capital flows and resource allocation for the adoption of green technology, renewable energy, electricity and energy efficiency measures.

Equitable access to energy must be addressed by channeling the revenue generated from carbon pricing to households and businesses affected by carbon trading and the carbon tax – this could be through incentives or aggregate transfers. The social and economic impact of decarbonizing the economy and the way humans live will be crucial to our prioritization. We have limited time and scarce resources.

This column first appeared in print on May 2, 2022, under the headline “Using Markets to Decarbonise”. The writer is the Chairman of the Rajasthan Tax Board and served as the Chairman of the Raj. Renewable Energy Company. Opinions are personal.

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