Home / Opinion / Columns /  Assign market-based incentives a role in climate action

The surprisingly hopeful sci-fi book, Ministry for the Future, by Kim Stanley Robinson begins with a climate change induced scorching summer in Uttar Pradesh, India. The book features a digital reserve currency called Carboni, backed by the world’s central banks, designed to incentivize decarbonization. Companies are paid in Carboni when they mitigate emissions or remove carbon from the atmosphere.

My previous column n CoP-27 generated a lot of feedback on the need for market-based systems to help solve the climate crisis. Market-based systems will not alone solve the problem, but they can play an important role. Before we get into what these solutions might be, let me state the objective. The objective is to remove 30 gigatonnes of carbon dioxide equivalent (GtCO2e) by the year 2030. We may have no choice but to use multiple approaches to make a dent in this massive problem.

Market-based policy approaches encourage (behavioural) change through signals, focused primarily on price changes, rather than through government directives. Emissions of greenhouse gases (GHGs) impose costs on people who did not create the pollution. This economic ‘externality’ is a collateral effect that is not experienced by the originating entity. The cost to society of the climate change caused by this entity’s GHG emissions is not reflected in the price of its product or service. As a result, the consumption of this good is greater than it otherwise would be if this externality had to be factored into the price. When firms become explicitly aware of the societal cost of their actions, they are able to determine how best to meet environmental objectives. This is the basic theory of how market-based systems work.

There are a range of options that deliver on this idea of making the originating entity aware of the cost. Here is a brief description of each type of solution.

Carbon Tax: This is exactly what the name implies. In this case, there is an explicit tax to be paid for emissions. The tax itself can either be graduated to increase linearly or in step-function as emissions increase. Ideally, the cost of the tax would be set equal to the cost to society of the pollution created. It may be difficult, however, to determine this cost. Taxes can be placed directly on emissions or indirectly on goods that are GHG- intensive, like a carbon tax on petroleum distillates. The advantage of a carbon tax is that the unit cost and total costs are fully known, and they can be passed onto consumers so that demand adjusts to actual costs. A variation on the national carbon tax is to have a global carbon tax that can have both an annual and a cumulative amount going back to the beginning of the industrial era. This could be one way of incorporating an economic transfer from developed to developing countries without engaging the more contentious idea of loss-and-damage compensation, the details of which could make for difficult discussions in future multilateral climate conferences.

A cap-and-trade system: Instead of setting a price on each unit of pollution, the regulatory authority determines the total quantity (cap) that will be allowed. This cap can gradually ratchet down over time to incentivize the business to invest in technologies that reduce emissions in a step-function of decreasing caps. If the business does much better than it needs to, then it can trade its extra allowance with another that is not able to meet its objective that year. The dynamic price of such a ‘trade’ encourages an active innovation market for technologies to reduce emissions. In aggregate, the regulatory authority has a handle on the sum of all caps, a sum that decreases over time in line with national objectives. Compared to a tax, this method improves environmental compliance, but may cause business uncertainty. A market for carbon credits and offsets works broadly in the same way as this approach.

Renewable electricity standards: These are aimed at incentivizing the commercialization of renewable technologies in the otherwise carbon-intensive sector of electricity generation. These standards may be designed to incentivize an electricity utility to generate a certain proportion of its power from a defined set of renewable sources.

Payment for eco-system services (PES): This is an approach that compensates marginalized populations on the periphery of forests and incentivizes them not to flatten such greenery. This works in the opposite way to a carbon tax; i.e., by incentivizing the creation and expansion of natural carbon sinks.

India has primarily used government directives to manage environmental pollution. A pilot emissions trading system (ETS) was launched in Gujarat in 2019 for particulate matter pollution. Businesses participating in the scheme reduced their emissions by about 20% versus a control group of non-participants. The most prominent success of an ETS scheme has been the reduction of sulphur dioxide from power plants in the US. The EU’s ETS is the world’s largest carbon market and uses a cap-and-trade approach; in its current phase, emission limits decline by 2.2% a year. After several pilot programmes, China launched a national carbon market in 2021. Initially, the Chinese ETS will focus on electricity companies and large firms. Learning from all these initiatives, India should plan on launching a national carbon market by 2025.

P.S: “Tell me and I forget, teach me and I remember, involve me and I learn," said Benjamin Franklin.

Narayan Ramachandran is chairman, InKlude Labs

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