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October 16, 2023

Natural Resources|Climate Change

Carbon Pricing Challenges

By Nitin Desai






Market-based solutions to carbon mitigation have spread rapidly, particularly since the Paris agreement of 2015. According to a recent World Bank report, they are now implemented or planned in 73 national and subnational jurisdictions and cover 11.66 billion tonnes of Carbon dioxide equivalent or CO2e, which amounts to about 23 per cent of the global greenhouse gas emissions.

Market-based solutions have basically two broad forms. One is the pricing of carbon emissions in specific sectors without specifying a target level. It relies on the cost of carbon emissions to encourage mitigation activities. The second is a cap-and-trade (CaT) system in which a target level is specified. In this approach, producers who exceed the target can sell carbon credit to those whose emissions are above the permissible level. There are a few other forms that involve tradable credits or taxes on emissions that are below or above specified norms.

The two most striking examples are carbon pricing and emissions trading in the EU and the UK, and the CaT mechanism in China. In Europe, Sweden took an early lead in 1991 in setting a carbon price for designated emitters, who account for 40 per cent of emissions. The carbon price charged is now about $100 per tonne. The impact of this can be seen in the 25 per cent reduction in Sweden’s carbon emissions since then. China set up the CaT mechanism in eight regions in 2021, and it now accounts for over one-third of the emissions covered. However, the carbon price emerging from emissions trade is only $8 per tonne of CO2e.

The US has not enforced any carbon price or CaT system at the national level, though California has set up a particularly ambitious CaT system with widespread sectoral coverage and ambitious mitigation goals. However, from Barack Obama onwards, the US Environment Protection Agency has made estimates of the Social Cost of Carbon (SCC). The estimate made during the Obama regime was $43 per tonne of CO2e, while in the Trump era, the estimate came down to $3-5 per tonne of CO2e on the assumption that only the impact of carbon emissions within the US should be considered rather than the global impact. There is a trend towards increased realism as recently the US Environmental Protection Agency suggested a rate of $190 per tonne of CO2. These estimates are used to compare the cost involved in any specific proposal for carbon mitigation with the estimated social cost of carbon, so that only options whose costs are below the SCC are pursued.

This dependence on estimates of the social cost of carbon does not seem very sensible. The impact of greenhouse gas emissions on welfare are subject to many uncertainties, including risks of crossing tipping points that are central to ecological and human health and an intergenerational impact that requires a welfare assessment that runs into centuries, and which should not be discounted at the current real interest rate. Many impacts of carbon emissions like those on heath, living conditions in settlements, species loss, and ecosystem impact cannot be valued easily. These are seldom taken into account in calculating the social costs of carbon. The SCC-based approach also rests on the unrealistic assumption that market optimality would be realised by the single corrective action that imposes the social cost of carbon on all emitters without considering other market failures that affect carbon emissions.

The use of market forces to influence production and consumption decisions in a climate-friendly direction is certainly worth considering, but not from a social cost of carbon assessment. Prices, taxes and subsidies to influence behaviour should be designed to promote emission targets, which should be met if we are to stay below the agreed limit of temperature change. This argument has been presented convincingly in a paper by Nicholas Stern and Joseph Stiglitz.1 (Do read the first part of the paper which is accessible to the lay reader).

India does not have a formal carbon pricing system or a carbon-oriented CaT programme. However, it does have a cess and goods and services tax (GST) on coal, collecting around ~600 billion in 2019-20. Considering the CO2 emissions from coal consumption that year, totalling 1,678 million tonnes, the tax collection, when converted to dollars using the exchange rate for that year, estimates an implicit carbon tax of $5 per tonne of CO2e. This compares reasonably with the explicit carbon rates set in the developing countries of Latin America and South Africa, which have introduced carbon pricing.

The taxation of petroleum products and natural gas yields a much higher implicit carbon tax. In 2019, they accounted for about 800 million tonnes of CO2 emissions and yielded a tax revenue of ~4.9 trillion. This implies a carbon price rate of $87 per tonne of CO2e, which is quite high by prevailing global standards. However, one must acknowledge that the taxation of petroleum products has been driven more to raise revenue than to promote economy in petroleum and gas use.

The point about this calculation is more to suggest that the introduction of carbon pricing either directly or indirectly through a CaT system will be less disruptive. It may just involve a partial shift in sources of budgetary finance from the coal cess, GST, and excise to a different category, assuming that the revenue-raising taxation on petroleum will continue, perhaps in an attenuated form. It may also involve an increase in the cost of coal as the carbon tax and the determinant of carbon price in CaT will be based on the CO2 impact. There will be some political complexity because fossil fuels are taxed both by the Union and state governments. Another more difficult challenge is the fact that the main user of coal is the electricity sector, whose finances are in shambles right now.

India will have to consider carbon pricing options soon because of growing global pressure. Its exporting sectors may face carbon emission-linked trade barriers. Europe is implementing a Carbon Adjustment Border Mechanism (CABM), which will levy a duty on imports from countries where the exporter does not have to bear the burden of paying for carbon emissions. It seems the Indian government has recognised this and is contemplating a directed export tax that will counterbalance the CABM. A piecemeal approach to carbon pricing based on emerging trade barriers is not a long-term strategy. India needs to consider starting with a sectoral carbonoriented CaT mechanism in a few sectors, such as electricity generation, steel and cement production. Since carbon emissions have a global impact, restricting it to producers in a few geographical areas, as China has done, may not be feasible in India or desirable. What we need is a national system that will not just stimulate carbon mitigating production but also provide returns to R&D in relevant technology development.

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