India needs to build a credible carbon market, minus an offset mechanism

Not including all hard-to-abate sectors in carbon emission intensity targets will reduce market size and impact liquidity. Offset mechanism isn't a solution

The Carbon Credit Trading Scheme (CCTS) was notified by the Government of India in June 2023, and several steps have since been taken to operationalise it. Trading is expected to begin in 2026, with market stabilisation expected by 2027.

 

This article analyses the government’s approach to developing a carbon market and highlights key challenges in making it a successful initiative. Admittedly, this is a complex and evolving subject, and several additional issues will need to be addressed going forward.

 

Let’s begin with the basics. A genuine and fairly estimated demand is essential for the development of a market for any commodity. Suppliers then come into the picture, make their own estimations of demand and pricing, and take the necessary actions to meet that demand. This applies to carbon markets as well.

 

The Ministry of Environment, Forest and Climate Change (MoEF&CC) has recently notified carbon emission intensity targets for a few identified entities in certain sectors. Broadly speaking, the obligated entities will have to reduce their greenhouse gas (GHG) emission intensity and achieve those targets, or face penalties and other legal actions.

 

Naturally, each of the notified entities would face its own challenges in terms of existing technology, the need for upgrade, or fuel choices, and analyse the financing costs to bring in the required changes. Different entities would face varying marginal costs to lower their emission intensity. An economically efficient solution to meet the overall emission intensity reduction would be to have a well-functioning carbon market, wherein entities with relatively high marginal costs could explore the option of purchasing carbon credits from the market to meet their targets.

 

On the supply side would be entities with relatively low marginal costs, which see an opportunity to make money by overachieving their targets and selling carbon credits. The most crucial element for this to work would be the carbon credit price, and how transparently and credibly it is determined. This is the basic pre-requisite for a successful carbon market to come up.

 

The emission intensity targets set by MOEF&CC are both sector-specific and tailored for the obligated individual entities in that sector. The overarching guiding principle for fixing the targets has been India’s nationally determined contribution (NDC) commitment to reduce the emission intensity of its gross domestic product (GDP) by 45 per cent by 2030, compared to 2005 levels. For individual entities, historical emissions — with 2023–24 as the baseline — have also been taken into consideration.

 

The MOEF&CC ought to have included all “hard to abate sectors” in one go while fixing the emission intensity targets, to be subsequently followed by obligating entities in the other sectors. Why has the steel sector — which contributes the most GHG emissions among all industries — been left out? Furthermore, the thermal power sector, which has the highest carbon footprint across all sectors, has presumably been excluded on the grounds that it is already covered under the Perform, Achieve and Trade (PAT) scheme.

 

It is a wrong presumption as improvement in energy efficiency does not necessarily lead to a corresponding reduction in GHG emission intensity. Besides, running two schemes with similar objectives in parallel has its own problems. More on the PAT scheme later in this article. Suffice it to say that limiting the obligated sectors in the scheme will not only reduce the market size but also impact liquidity.

 

As for individual entities, fixing the targets based on their historical emissions is an erroneous approach. This shows a lack of ambition in lowering GHG emission intensity and is unlikely to generate sufficient demand for carbon credits. Why give a long rope to entities with a poor emission history? The right approach would be to categorise similarly placed entities within a sector — say, based on a range of production capacity — and set the same target for all entities in that bucket. This would lead to benchmarking and push the industry to utilise resources efficiently, adopt optimal technologies, and make appropriate fuel choices. That’s how a carbon market would develop.

 

The CCTS has also come up with an “offset mechanism” to allow participation of non-obligated entities in carbon credit trading. However, based on global experience of emission trading schemes (ETS) in different jurisdictions, including EU-ETS, allowing voluntary participation can lead to carbon leakage and compromise data integrity, thereby impacting the very credibility of the scheme itself.

 

Recall the Clean Development Mechanism (CDM) experience: It was plagued by serious issues, including double counting of carbon credits and poor verification. The oft-used argument to allow voluntary participation to facilitate market liquidity in the initial phase of the scheme, to be tapered down later, isn’t a sound one. This is like erecting a building on a weak foundation. Instead, let there be a sizeable number of obligated entities from the very beginning, supported by a robust monitoring, reporting and verification mechanism and strict enforcement. Reportedly, the offset mechanism has already been banned under EU-ETS.

 

Coming to the all-important issue of the interlinkage between the existing PAT scheme and the CCTS. The CCTS is largely modelled on the PAT scheme, which has been operated by the Bureau of Energy Efficiency (BEE) since 2012 as a market mechanism to improve energy efficiency among obligated entities. However, there are implications to following this approach.

 

Will the PAT scheme, covering sectors also identified under the CCTS, continue in parallel? The PAT Cycle VIII has already been notified for 2025–26. How will this coexistence work? Why fragment the market? Instead, why not only have CCTS, which directly targets the reduction of GHG emission intensity?

 

The PAT scheme has come in for criticism in the past, including for fixing lax targets, an excessive supply of energy saving certificates (ESCERTs) in the market leading to a drop in certificate prices, unsatisfactory implementation, and poor enforcement.

 

Apparently, from the PAT III cycle onwards, the required actions to close various rounds are still pending. Remember that the PAT III cycle was for the 2017–2020 period, and subsequently, PAT IV to VIII cycles have been notified. Will the obligated entities covered in these rounds be allowed under the CCTS only after those rounds are closed? What would be the mechanism for converting outstanding ESCERTs under PAT to carbon credits under CCTS? Considering the poor MRV practices prevalent under the PAT regime, what is the credibility of these ESCERTs? Will they be considered as normal carbon credits, or will there be a different categorisation and a separate trading segment for them on the exchange?

 

All these issues need to be properly thought through and thrashed out to realise a robust and credible carbon market in the country.

 

 

The author is a distinguished fellow at the Observer Research Foundation, and former chairman, Sebi