Exporting into a world with carbon tax

Policymakers should help embed India in the growing presence of this tax worldwide

There is concern in India as the tangible implementation of the European “Carbon Border Adjustment Mechanism” (CBAM) kicks in on October 1 this year. Critics of this European action view this as protectionism. What is more important are detailed Indian responses at policy level and firm level.

Once Donald Trump got the US out of the Paris accord in 2017, many countries shifted gear to making progress on reducing carbon emission on their own. In Europe, dramatic moves have been made, by which governments are forcing decarbonisation. As an example, in Germany, per capita annual carbon dioxide emission has come down from the peak of 14.3 tonnes in 1979 to 8.1 tonnes in 2021. At its peak, in 1897, Germany accounted for 17 per cent of the world’s emission; in 2021 it was down to 1.82 per cent.

Decarbonisation in the European Union (EU) produces a global public good. As an example, it fosters social stability in coastal India. It comes at the expense of European industry. EU voters are conscious that they are paying more for goods in return for reduced emissions. If carbon-intensive production merely shifted out of the EU, the global public good of decarbonisation would not be delivered, and jobs in Europe would be lost.

This context has led to the idea of the “carbon border tax”: Imports into the EU should suffer a tax at the border, reflecting the market price of carbon within the EU, thus achieving neutrality in the decision of a firm to locate in the EU or outside it. This is reminiscent of the way goods and services tax (GST) is neutral to international production: The full burden of domestic GST (including all upstream steps of production) is refunded to the Indian exporter, and GST on import is imposed at the recipient country. GST on import is not protectionism; it removes GST from the list of considerations that shape location decisions of firms.

The EU’s CBAM will kick in on January 1, 2026, for a few industries. The two industries that matter today for Indian exporters are steel and aluminium. The first step in the path to the CBAM is right now: From October 1, 2023, firms that take steel and aluminium into the EU are required to establish measurement systems about carbon intensity, and deliver statements on it.

There is an instinct with some in India to drag our feet or to try to use India’s diplomatic influence to get the EU to roll back its CBAM. This is likely to be an inferior strategy. The EU is only the first to introduce a carbon tax. Many other countries will surely follow. Every country with a carbon tax will have a CBAM-like border tax in order to ensure neutrality for the location decisions of firms. 

Policymakers need to recognise this emerging landscape and better embed the Indian economy within it. The great asset for India is the plentiful sunshine, which gives a strong position on renewable energy.

The CBAM documentation, “Annex III”, describes the information systems required to track upstream (“embedded”) emission. There are natural analogies in this field with the GST system, and its tracking of upstream taxation, which leads to its full refunding of all embedded taxation to the Indian exporter. We in India need to work on building these information systems.

Policymakers and firms in India have known about these moves from the proposal stage in 2021, and many responses are in motion. The Ministry of Steel has, for example, run a “Green Steel” initiative. Electricity policy has created growing flexibility for buyers to establish exclusively renewable electricity-purchase mechanisms. Indian firms in numerous industries have moved towards sourcing renewable electricity. These steps have helped prepare the ground for this day.

With carbon taxation and ESG (environmental, social and governance) investment, many Indian firms want renewable electricity. It is the job of electricity policy to create freedom, by which a buyer is able to get renewable electricity at will. The Union government’s Interstate Transmission System (ISTS) helps greatly. The system correctly cracks open the barriers faced by private buyers and renewable-energy generators. As yet, the system is not physically everywhere, but it is expanding continuously.

It has always been clear that electricity is a state subject, and that local conditions diverge greatly all across the country. Subsidies for farmers are an issue in Haryana but not in Delhi. Private distribution companies, which improve conditions for electricity reform, are unevenly present. The technical possibilities vary by locale: Hydel in the Himalayas, solar in Rajasthan, pumped hydel storage in the Western Ghats, and offshore wind in Gujarat and Tamil Nadu.

Carbon taxation in the world is one more important factor that varies by locale. For Gujarat, Maharashtra, Karnataka, and Tamil Nadu, exporting is unusually important. The emerging world of carbon border taxes requires a greater response in these states than is the case elsewhere. These states need to become pioneers in India in putting their electricity sector on a sound footing, so as to be fully supportive of the requirements for renewable electricity of their export sector at efficient prices.

Two paths can get us to the required decarbonisation of India: A path based on central planning (where officials design the electricity system, and also establish technical rules such as the minimum efficiency of air conditioners) vs. a path based on carbon taxation. The carbon tax harnesses private self-interest, and is the path to lowest-cost decarbonisation in India. This is a good time for India to build the fuller electricity sector reform, grounded in a carbon tax.

Shah is a researcher at the XKDR Forum and Jaitly is a strategy and policy advisor