Climate change will impact human life and the global economy on an exceptionally large scale in the not too distant future. The last UNFCCC Conference of the Parties (CoP-26) held in Glasgow in November 2021 saw considerable inertia on the part of several partner countries in committing to concrete action plans to contain global warming below the threshold of 1.5 degrees centigrade. After China and the United States, India, which emits 2.44 billion tons of carbon dioxide per year, is the third largest emitter of this GHG, making it a key player in reducing emissions.
Economic growth is closely related to energy consumption. The International Energy Agency (IEA) World Energy Outlook 2017 Report estimates that India will account for almost a quarter of global energy demand by 2040. Achieving sustainable economic growth requires a strategy to aggressively reduce carbon emissions while time focus on efficiency, fairness, fairness and behavioral aspects.
According to the IEA’s India Energy Outlook 2021 report, India’s energy system relies heavily on fossil fuels (coal, oil and bioenergy) that supply around 90 percent of the country’s demand. About 38 percent of primary energy is consumed for power generation, which implies that the level of electrification is still low in the country. Power generation relies heavily on coal (about 78 percent comes from this fossil fuel) and transportation relies almost entirely on oil. The Indian energy ecosystem is therefore highly carbon intensive.
There is consensus that climate change is a feature of market failure. The economic activities of consumers (driving or air conditioning, for example) and producers (such as electricity generation and manufacturing) generate emissions, leading to pollution and global warming. These negative externalities, which cause results that are not efficient, are not reflected in the costs incurred by consumers or producers. In other words, the true costs to consumers, producers, and society are not reflected in market interactions. This leads to a runaway increase in emissions and also generates apathy towards mitigation efforts. The solution to the problem of market failure requires government intervention.
A cost-benefit analysis of emission reductions is based on the premise that the costs incurred by any company, whether manufacturing goods or generating energy, in investing to reduce emissions have long-term benefits to society. Some companies may require less funding to reduce the same amount of emissions than others.
The most natural option for government intervention to reduce emissions is by setting emission limits through regulation, taking into account the Nationally Determined Contribution targets set by the country under the Paris Agreement. But there is a flip side to this. Experts have shown that incorrectly set emission levels could lead to profitable results. It makes it difficult for the regulator to obtain information about each company’s cost reduction and cost of damage programs in advance. Therefore, it would not be known that for a certain amount of capital, which company will be able to reduce emissions the most and, consequently, provide the greatest benefit to society. Therefore, setting emission targets and regulating emissions through command and control might be good only during the initial phase of the mitigation strategy.
The carbon tax is a better option than regulating the pre-established levels of emissions. The marginal cost of abatement increases as companies continue to reduce emissions, and the company will stop reducing emissions and opt to pay taxes at a time when the cost of abatement is greater than the tax rate. This option will lead to almost efficient results.
However, the possibility that the tax is too high or too low cannot be ruled out. This problem can be addressed by introducing an auction-based carbon trading scheme. The commercial scheme will bring greater efficiency as the price of the certificates will be determined by allowing companies facing low and high abatement costs to compete in the free market based on their own damage and abatement cost schedules.
An effective policy framework for emission reductions must be essentially rooted in the Indian energy ecosystem and aware of the reasons for market failure. Large investments are needed to transition to a green energy economy, and market-based instruments are the most efficient tools to achieve this. The emissions trading scheme will determine the optimal and profitable levels of emission reductions by giving companies the option to mitigate or trade; the net effect of this will be a reduction in emissions. Companies with low cost of reduction will continue to reduce emissions, since they would benefit from the commercialization of the certificates. In the process, they will signal to the market about efficient capital flows and resource allocation to green technology, renewable energy, electrification, and energy efficiency measures.
The issue of equity in energy access needs to be addressed by channeling the revenues generated from carbon pricing to households and businesses affected by carbon trading and carbon tax; this could be through incentives or lump sum transfers. The socioeconomic impact of decarbonizing the economy and the way humans live would be crucial in setting our priorities. We have limited time and our resources are scarce.
This column first appeared in the print edition on May 2, 2022, under the headline “Using markets to decarbonize.” The writer is chairman of the Rajasthan Board of Taxation and has served as the Raj chairman. Renewable Energy Corporation. Views are personal.