Managing risks of a green economy

The latest report of the United Nations Intergovernmental Panel on Climate Change makes it clear that human activity is affecting the climate in an unprecedented manner, and part of the damage could be irreversible. Climate change will affect lives and livelihoods across the globe with some countries getting disproportionately impacted. According to a recent report by the Swiss Re Institute, climate change could reduce global gross domestic product by 18 per cent by 2050 if no mitigation action is taken. India would also suffer significantly. A 2019 International Labour Organization study noted that productivity loss because of heat stress could be equivalent to 80 million full-time jobs globally in 2030. Clearly, more needs to be done to contain the risk of climate change. 

The upcoming United Nations Climate Change Conference is expected to assess progress on this account and set the future agenda. Although the risk of a business as usual approach is well understood, including in India, there is not much discussion on disruptions that a rapid transition to a green economy could entail. Since such a transition cannot be avoided anymore, it makes sense to start preparing. This piece focuses on three areas in the Indian context.

Green business risks: A rapid transition to renewable energy, which is necessary, will disrupt a number of businesses. India, for instance, produces the bulk of its power through coal-fired plants and experts argue that it will need to build more such plants to meet its energy requirements in the next few years. But as India moves rapidly towards renewables, capacity utilisation in coal plants would decline, affecting return on investment. This will have implications for both debt and equity holders. Similarly, India has a large automotive industry base. As the business moves towards electric vehicles, the market will be disrupted with some legacy manufactures and component makers going out of business. Aside from financial losses, it could also affect employment. Since electric vehicles have fewer moving parts, they need less labour. Thus, from a policy perspective, it will be important to assess businesses, both in terms of the impact of climate change and their ability to manage the transition.  

Monetary policy and central banking:  Some central banks have started doing climate stress tests. Besides financial stability, the objective of maintaining price stability could also get affected, especially in a country like India where food is a large part of the consumption basket. In a recent column in this newspaper, former Reserve Bank of India (RBI) governor Urjit Patel argued that not adjusting the central bank reaction functions to climate change will result in suboptimal policy choices. The issue is likely to be debated all over the world in the near to medium term. 

More research will perhaps be needed to gauge how central banks can respond to climate risks and maintain price stability. It will be important to avoid the risk of permanently damaging output, which could affect investment and exacerbate climate risks. It would help if the RBI undertakes research in this context as it would enable designing an appropriate response. Central banks are now also expected to support sustainable growth through market interventions. However, as another former RBI governor Raghuram Rajan has argued, they should stay away from such an objective as it is primarily a fiscal issue.

Fierce fiscal risks: India’s transition to a green economy will pose serious fiscal risks, both at the central and state level. Both levels of government depend significantly on revenue from petroleum products. In the last fiscal year, for instance, the contribution of the petroleum sector to general government revenue was over Rs 6.7 trillion. The central government’s total tax and non-tax revenue from the sector was over Rs 4.5 trillion. Theoretically, if petroleum products are replaced by other sources, this stream of revenue will be wiped out. If part of the demand shifts to the power sector as incentives for electric vehicles aim, it would create even bigger fiscal complications. India’s power sector is in complete disarray. The debt of state-run distribution companies is likely to cross the Rs 6 trillion mark in the current year. They owe about Rs 1 trillion to power generation companies, and this is after the central government provided liquidity support worth Rs 90,000 crore last year to clear dues. The state of power distribution companies poses significant risks to state government finances. 

Thus, a meaningful demand shift in the automotive sector from petroleum to power can create enormous complications for government finances. It’s not clear if the ramifications are well understood. In this context, two broad areas would need massive reforms. First, both the central and state governments will have to reduce dependence on petroleum products for revenue generation. Higher taxes on petroleum products make sense as they would incentivise the transition to renewables, but it should not be a fiscal compulsion. For this to happen, both direct tax and the goods and services tax system will need to be overhauled. Second, the mess in the power sector will need to be fixed once and for all. It is important to recognise that consumers will have to pay — there is no other way. If these two issues are not addressed immediately, any meaningful attempt to move towards a green economy would create serious fiscal, growth, and financial stability risks. This could eventually end up increasing climate risks and diminishing India’s global standing.