A cap-and-trade system will help slash emissions more efficiently

A missing element in the discussion thus far is the potential role of relative prices in incentivizing a shift from fossil fuels to renewable energy (RE). If low/zero-carbon alternatives were fully price-competitive with conventional fuels today, the shift would be reflected in all new investments automatically. But this is not the case. Both solar and wind power plants have shown sharp declines in cost, but both are intermittent, which means investment in grid-scale batteries or pumped hydro storage is needed to ensure a stable supply of electricity. When these costs are added, RE is more expensive than coal-based power at present.

Left to themselves, discoms would not want to shift to the more expensive option. The government has therefore stepped in with administrative directions forcing discoms to purchase a portion of their electricity from RE sources and also announced that this will rise over time. Something similar is being considered for fertilizer and oil refineries to meet part of their hydrogen needs from green hydrogen.

A price-based solution would be to impose a carbon tax on emissions. Such a tax, applied at an appropriate rate, would ensure that all units would shift to RE. It would also generate additional revenues that could be used to finance climate- related public expenditures and also to offset any adverse distributional effects of the additional tax incidence.

Whatever its theoretical benefits, direct carbon taxation is not a practical option. It has few takers around the world and is unlikely to be accepted in India. However, a cap-and-trade system has wide international acceptance. It is effectively an indirect form of carbon taxation and it can be implemented in India thanks to a recent amendment to the Energy Conservation Act, 2001.

The Bureau of Energy Efficiency (BEE) is currently working on the system’s detailed design. We suggest it should have the following features.

It should have wide enough coverage to make a difference. The BEE has been managing the Perform, Achieve and Trade (PAT) scheme for several years. This scheme aims at improvements in energy efficiency and covers large units in thermal power generation, iron and steel, pulp and paper, aluminium, cement, chemicals, fertilisers, and textiles. If the cap-and-trade system has the same coverage, it would ensure sufficient width.

Each unit will have to be allocated an emissions allowance. This could be fixed initially at the average emissions per unit of output for all units in that industry in the base year. Units emitting less than the allowance would receive emission credits, which could be sold to those emitting more. Sectors where emission reductions is costly or difficult due to technological limitations would buy credits from sectors where it is cheaper. This effectively equalizes the marginal cost of abatement across all units.

A key feature must be a steady reduction in allowances per unit of output over time, calibrated to the net-zero target. To ease the transition, the pace can be moderate at the start, allowing total emissions to increase as production increases but at a decreasing rate. Thereafter, allowances will have to be reduced faster as the system stabilizes.

Measuring emissions from each unit accurately will be a major challenge. It would have to include all greenhouse gas emissions from both direct use of fossil fuels and also indirect use via consumption of grid electricity, which is largely coal-based. Including indirect emissions via grid electricity would incentivize industries to switch to RE from captive power plants or independent suppliers, or to buy RE certificates from exchanges. The establishment of an independent and credible mechanism to certify the actual emissions of each unit is a major capacity building task.

There may be situations where the price of credits shoots sky-high. This could be handled by allowing units to pay an appropriate penalty for over-emitting. This would effectively put a ceiling on the market price of credits, thereby allaying fears of price uncertainty. This ceiling price could be gradually raised.

The system described above could initially operate in parallel with administrative mandates setting specific targets for RE use in different sectors. However, as the system matures and glitches are ironed out, the mandates could be withdrawn, leaving the cap-and-trade system as the sole policy mechanism for reducing emissions. This would reduce the administrative as well as compliance burden.

A key issue is whether allowances should be given free or auctioned. Auctioning would generate much-needed revenue for the government to finance climate-related public expenditure, such as on adaptation measures and the reskilling of human capital in declining sectors like coal mining. We could start by auctioning a small proportion of allowances and increase it gradually as the system stabilizes.

The need for additional revenue for managing climate change is especially important considering that petrol and diesel consumption will fall as transport gets electrified leading to revenue loss as these are high revenue yielding items. The additional revenue from auctions will, of course, raise questions about revenue sharing with the states. This could be referred to the Finance Commission.

An important advantage of the system is that it could help shield our exports from the EU’s Carbon Border Adjustment Mechanism (CBAM), which comes into effect on 1 January 2026. This will depend on the extent to which the implicit carbon tax in our system is equivalent to that in the EU’s. The EU’s current position is that if our carbon price is lower, then a countervailing duty on imports would be levied to cover the difference. We should try to persuade the EU that countries at lower levels of development should be allowed lower carbon taxes. The EU does have supportive provisions for lower income countries in the EU; for example, an exemption from obligatory auctioning of allowances under certain conditions.

Regardless of whether we can reach an agreement with the EU, there is a strong case for implementing a cap-and-trade system as soon as possible as part of our own long-term transition to net zero.