Taxing or trading our environmental sins?

Record-breaking temperatures and extreme weather events leave no choice but to act on climate change. At the United Nations, the prime minister announced a higher target of 450 gigawatts of renewables. India takes climate action seriously. But the less others act, the more India’s development options get constrained by a shrinking global carbon budget. Renewables and energy efficiency are not enough; emissions must be reduced in industry and transport too. If India were to be more aggressive on mitigation — in the most cost-effective way — what instruments should it choose? Should we tax or trade our environmental sins?

India has used several measures in recent years: Perform, Achieve and Trade (PAT) for energy efficiency in major industries; Renewable Energy Certificates trading scheme; coal cess; and sectoral incentives (monetary and regulatory) to promote clean and efficient electricity. But these measures are not economy-wide and do not always translate directly into greenhouse gas mitigation. For more than a year, representatives from industry, academia and think-tanks have discussed direct mitigation instruments and developed a framework to evaluate options*.

The first option is an Emissions Trading Scheme (ETS). An absolute cap on emissions combined with trading gives flexibility to businesses, promotes innovation and reduces pollution. Globally, over 50 jurisdictions have ETS markets. Complementary policies increase effectiveness. Policies that promote renewables, energy efficiency, incentivise fuel switching, improve building standards, or increase public transport have helped the EU and Californian schemes. Their experience suggests that administrative costs could be less than 1 per cent of total abatement costs. 

India, too, has similar complementary policies. The PAT scheme showed that effectiveness increases when there are relatively fewer regulated entities. Regulating fewer upstream entities (say, a refinery) reduces administrative costs compared to many dispersed downstream points of emissions (say, millions of small industrial units). For its stage of development, India should choose either an increasing emissions cap, or one based on emissions intensity of production. While consistent with its current policies, the choice would ultimately depend on international ETS market developments. Whether emissions permits are allocated by government or auctioned, it must be fair and transparent. If there were no global and equitable allocation of emissions allowances, could an ETS in India trade with other markets in China, Europe or North America? Could carbon and non-carbon credits be linked, to capture co-benefits of mitigation and adaptation? Answering such questions would help India design more fit-for-purpose ETS markets, with robust monitoring and verification, while continuing to reduce abatement costs.

A second option is a carbon tax. There are 26 carbon tax systems worldwide, which raised $33 billion in 2017. By 2020, existing and planned taxes will cover about 5 per cent of global CO2 emissions. Economists debate whether a carbon tax should apply to two or more sources using the same rate per tonne of CO2 equivalent (tCO2e). Such a definition would exclude India’s coal cess or excise duties on petrol and diesel. The real question should be: What tax would nudge behaviour? Relative prices that shift behaviours vary across sectors. From a sectoral perspective, carbon taxes have worked best when alternatives are readily available. Otherwise, the cost imposition does not translate into desired mitigation outcomes.

The hardest decision concerns the tax rate. It varies from $3 per tCO2e in Japan, $5 in Chile to $132 in Sweden. India’s choice would depend on its priority: Social cost of carbon; GHGs abated; targeted revenues; or benchmarking against trading partners to maintain competitiveness. Tax rates could be further indexed to inflation (Iceland), gradually increase (France) or have formula-based adjustments to factor in macroeconomic conditions and technological advances (Switzerland).

Carbon tax revenues must be deployed justly and transparently. A revenue-neutral approach would reduce other taxes. Alternatively, governments could spend revenues on low-carbon infrastructure. The least favoured option would be transferring revenues to fund the general budget.

Thirdly, the Paris Agreement’s Article 6 permits transferring mitigation results from one country towards meeting another’s low-carbon goals via Internationally Transferred Mitigation Outcomes (ITMOs). The challenge would be to account for mitigation consistently when some countries have a single-year (2030) target and others have multi-year trajectories. Furthermore, the experience of the Clean Development Mechanism has soured trust in such processes. It is critical that ITMOs are not only accounted for transparently but that transactions are honoured.

A fourth route is via company-level initiatives. Some Indian industries have used internal carbon pricing to finance energy efficiency and clean energy. When it makes business sense, companies adopt sustainable practices. Some firms (Mahindra, Wipro, among others) have adopted science-based targets to align with the global imperative for net carbon neutrality by 2050 or earlier.

But a wider portfolio of policies, applicable to all competitors, are needed before businesses consider deep mitigation actions. Even a low internal carbon price, if combined with supporting policies, could assist firms in choosing best available technologies and deliver significant outcomes. As with ETS and carbon taxes, greater transparency (starting with voluntary reporting on internal carbon prices) would help to design responsive policies.

No single instrument will suffice. Nor will one option optimise across several dimensions: Co-benefits and co-costs, distributional impacts, alignment with economic structure, feasibility of implementation, revenues and administrative burden, and links with global developments. India’s low-carbon transition must be linked to broader sustainable development priorities. It is time to experiment with price and quantity nudges to drive innovation and climate leadership, while remaining competitive. 

Ghosh is CEO and Chaturvedi is research fellow, Council on Energy, Environment and Water. Follow @GhoshArunabha@CEEWIndia;

* Mitigation Instruments for Achieving India’s Climate and Development Goals: A White Paper by the Working Group on Mitigation Instruments