Carbon pricing mechanism

Context:

• 2021 Conference of Parties 26 (COP26) propelled nations to ramp up their climate targets and the concomitant Nationally Determined Contributions (NDCs) to reduce global greenhouse gas emissions(GHGEs).
• However, the updated NDCs and the announced pledges for 2030 remain insufficient and poorly aligned with the targets of the Paris Agreement.
• Actual reduction is estimated to be 7.5%, while the target required is 30% (to limit warming to 2°C) and 55% (to limit global warming within the 1.5°C).

Challenges to mitigating climate change:

• Climate change is a product of both market and policy failure such as fossil fuel subsidies and a distortionary tax system.
• The cost of emitting GHGs is not reflected in the price of goods and services.
• Poor incentives for potential innovators and the inadequacy of public infrastructure, energy networks, and finance have impeded investments in research, development and deployment of clean technology.

Carbon Pricing:

• The idea dates back to 1920 to Arthur Pigou in his book ‘The Economics of Welfare’. A Pigouvian tax on carbon ensures that the cost of emitting GHGs is reflected in the price of the commodity or service.
• It embodies a laissez faire ideology offering a market-friendly mechanism that allows firms and consumers the flexibility to choose between the costs of cutting emissions and the benefits accrued from continuing to emit.
• Carbon pricing is considered a cost-effective measure to internalise the externalities associated with CO2 emissions and maximise emission reduction per dollar at the lowest possible cost.

Approaches to carbon tax pricing:

• Abatement approach— It is the marginal cost of reducing each additional unit of emission and is contingent on various factors including the pace of low carbon technological innovation, cost of compliance, as well as the ability of firms and consumers to substitute low-carbon products for high-carbon ones. Carbon pricing mechanisms are predicated on the basis that profit-making firms will continue to cut emissions to the point where the marginal abatement cost is lower than the social cost of carbon.
• Revenue approach – where the tax rate is based on the revenue considerations of the regulating authority or by simply following a benchmarking approach where the tax rate is linked with the rate in neighbouring jurisdictions, among trading partners or competitors.
• International Crediting Mechanisms/ Baseline and Credit system – According to Kyoto Protocol, industrialised Annex B countries can purchase certified emission reduction (CER) credits from developing countries (each credit equivalent to one tonne of CO2).
• The Clean Development Mechanism – is the international standardised emissions offset instrument governed by the UNFCCC to facilitate the trade on the global scale.
• Internal Carbon Prices – It is being used voluntarily by companies and organisations to safeguard against future shocks, climate related risks and prospective government regulations. It is commonly done via shadow carbon pricing where a hypothetical carbon cost is associated with each ton of CO2 emissions.

Implicit carbon pricing:

• Do not directly put a price on emitting carbon but set uniform performance standards for GHG abatement.
• Command-and-Control Regulations – employs technology and performance-based standards to control emission levels and protect environment quality.
• Clean Energy Standards (CES) – is a market-based and technology-neutral approach to encourage the power sector to switch to non- or low-emitting sources of energy.
• Eliminating Fossil Fuel Subsidies – gradual elimination of fossil fuel subsidies can be an effective way to achieve an optimal price for the fuel as well as provide incentives for energy efficiency and fuel-switching technologies.

Explicit carbon pricing:

• It is usually mandated by the government.
• It acts as a market signal for producers and consumers to move towards cleaner sources of production.
• These can be achieved through carbon taxes and/or an ETS (emission trading system)

• Carbon tax – A carbon tax imposes a fixed price on carbon emissions while the quantity of emission reduction is left to the market forces. The objective is to increase the cost of fossil fuel and provide an incentive for investments in fuel-switching strategies and energy-efficient technologies.
• Emission Trading System (ETS) – In a cap-and-trade model, the government sets a limit (cap) on quantity of permissible emissions. While the quantity/volume of emissions is regulated, the price is determined by the market.

Global Carbon Pricing Mechanisms:

• Globally, 68 carbon pricing instruments (CPIs) are operating including countries like Chile, Switzerland, New Zealand, China, European Union etc.

Carbon pricing in India:

• In the case of India, the relevance of carbon markets has been underlined by the recent Energy Conservation (Amendment) Bill, 2022 which is momentous in its scope, empowering the government to establish a carbon credit trading scheme and laying the ground for a formal carbon market that can be instrumental in India’s pathway towards a net-zero economy by 2070.
• PAT scheme – introduced in 2012, it is the flagship programme of the Bureau of Energy Efficiency (BEE), Ministry of Power.

• Energy-intensive industrial production units, called “designated consumers” (DC) are allotted Specific Energy Consumption (SEC) reduction targets over a cycle of three years.
• The units that exceed the targets are awarded Energy Saving Certificates (ESCerts), each equal to one metric tonne of oil.
• DCs that are unable to meet these targets can purchase the difference in ESCerts from the units that have exceeded their targets.
• The ESCerts can be traded on two power exchanges, namely, Power Exchange Indian Limited (PXIL) and Indian Energy Exchange (IEX)

• Emission trading scheme on an air pollutant – This is an innovative emission trading scheme on respiratory solid particulate matter(RSPM), the first particulate trading system in the world.

• The scheme has been piloted in Gujrat, Maharashtra, and Tamil Nadu.
• Pollution targets are set for areas based on ambient air quality standards and permits are allocated which can be traded, after verification, based on the gains and shortfalls from compliance.
• The scheme relies on a continuous emission monitoring system (CEMS) for setting the baseline and verification purposes.
• CEMs is an intrinsic element in the scheme’s design as it provides real-time information and helps avoid issues pertaining to spot checking and/or spurious reporting by third party auditors.

• Carbon Cess – Introduced in 2010, levied on coal, lignite, and peat in the form of an excise duty.

• With the introduction of the GST Compensation Cess, the carbon cess was abolished .
• CO2 emitting products such as coal, kerosene, naphtha, lubes and LPG are included in GST with exceptions for five petroleum products, i.e., petrol, diesel, natural gas, ATF and crude oil. These are instead subjected to excise duties and VAT.
• Concern: The tax rates do not correspond with the carbon footprint of the fuels and thus fail to provide the right price signals to producers and consumers to reduce consumption and switch to low carbon-emitting sources of energy

• Renewable Purchase Obligations (RPO) and Renewable Energy Certificates (REC)

• Electricity DISCOMS, open access consumers and captive power producers have to purchase a percentage of their electricity from renewable energy (RE) sources.
• These are termed as renewable purchase obligations (RPO) and are mandated by the Electricity Act (2003).
• The State Electricity Regulatory Commission is responsible for fixing the minimum RPO for each state.
• Obligated entities can purchase RECs on the national energy exchanges to meet their RPO targets without actual procurement of RE-generated power.
• It overcomes geographical disparity in renewable energy production and incentivising electricity generation from RE sources beyond the RPO state limits.
• Concern: The enforcement and compliance with RPO remains weak and is a persisting obstacle to India’s ambitions of expanding renewable energy production and procurement

• Excise taxes on Diesel and Petrol –

• As of May 2020, India had the highest taxes on petrol and diesel in the world.
• Concern: The high taxes are on account of the Centre’s revenue requirements and not environmental considerations and do not account for the carbon footprint of the fuels.

Significance of Carbon pricing:

• Putting a price on carbon internalises the social cost of carbon, and compels companies to adjust their investment portfolio and production methods while encouraging consumers to alter behavioural patterns.
• A carbon price is deemed as an effective tool to incentivise future investment, consumption and innovation towards sustainable and climate-friendly pathways, and support a sustainable pandemic recovery. In 2021, approximately USD 84 billion was recorded in carbon pricing revenue, as a result of higher carbon prices, increased auctioning from emissions trading, and revenue from new instruments.
• Moreover, carbon pricing can be a useful fiscal tool and a prominent source of augmenting government revenues.
• Typical carbon pricing policies allocate government revenues in three ways: investment in climate-related clean technologies, general budget, and income tax cuts or rebates.
• Investments in sustainable industries can generate jobs three times of the full-time jobs from government spending in fossil fuels.
• In the context of developing economies, these investments become particularly critical for supporting vulnerable sectors and communities to adapt to climate change and achieve just transitions.
• Pre-emptively, designing effective domestic climate policies inclusive of carbon pricing mechanisms—such as the EU Carbon Border Adjustment Mechanism—can also help offset the implications of border tariffs.
• The revenues generated from selling allowance certificates will augment fiscal revenues and can be used to reduce distortionary taxes or finance investments in clean-tech programs.

Suggestions:

• For trading purposes, the ESCerts should be converted into carbon-denominated allowances based on carbon intensity benchmarks.
• Deploying price containment measures in the ETS design can help incorporate greater flexibility and price predictability such as establishing a price corridor, i.e., introducing a price floor and a price ceiling,
• In order to contain price volatility – have a Cost Containment Reserve (CCR) which allows the regulator to release a fixed additional supply of allowances if the sale of CO2 allowance prices exceeds a certain price threshold, also called the trigger price,
• Banking and borrowing unused emissions as well as the use of offsets which allows regulated businesses to buy emissions reduction credits from outside the market, can help provide greater flexibility to business owners.

Way forward

• Careful planning is essential using rigorous quantitative modelling and analysis from the data collected via the pilot projects.
• Both the GST regime and the PAT scheme provide a well-functioning machinery which India can leverage to build upon a strong carbon pricing framework using a combination of both a carbon tax and an emission trading system.
• In the context of India, it can help meet its ambitious current and future climate goals, offer emission reduction at the lowest possible cost, and accelerate progress on the Sustainable Development Goals (SDGs)
• Global climate policy groups have been debating the inception of a Climate Club, seeking to establish an international target carbon price (incremental in nature),
• The current G20 Troika, led by three developing countries – Indonesia, India and Brazil, presents a unique and apposite moment to push forward a global carbon pricing framework built with a redistributive mechanism
• The principles of Common but Differentiated responsibilities (CBDR) and the Just Transition Declaration, climate policy architecture and designing domestic carbon policies will hold India in good stead in an increasingly decarbonising future.

Source: Observer Research Foundation