Market discovered carbon price more effective for emission reduction

The price discovery in the markets for carbon emission reduction units will make carbon prices integral to the balance sheets of corporates as these businesses would now either become carbon positive or negative under a cap and trade regime.

As climate change disrupts weather, monsoon and rainfall pattern and causes more frequent extreme weather incidences, it is not only likely to disrupt India’s agricultural sector, and it will also disrupt the performance of the manufacturing and the services sector, thereby impacting the growth potential of the Indian economy. While one may blame the emissions squarely, only a few realise that it is essentially an output of the economic growth process unmindful of carbon emissions. Hence, the challenge for policymakers is how to keep the growth engines running and, at the same time, keep carbon emissions under check.

Subsidies To Go Green

Many policy options are available for policymakers to ensure that growth continues to chug along with lower and lower emissions. One amongst them is subsidies that can be used to cut the cost of greener technologies and green raw materials from either the fixed or the variable cost perspective to achieve lower emissions while increasing the production of goods and services that adds to the GDP. Such a cost reduction will make green and sustainable goods/services economically competitive, increasing their adoption. While it will contribute to reducing carbon emissions, it will also keep economic activities competitive to keep the growth momentum. However, how much and what to spend on will remain a key question from policymakers’ perspectives. Further, the state’s fiscal capacity may also limit its spending and, thereby, the limitations on using subsidies as the only tool to reduce carbon emissions. Also, what to spend on and how much to spend are two critical policy decisions that could potentially lead to increasing social inequality and impede growth momentum in the medium to long term.

Carbon Taxes Are Inflationary

The other tool in the hands of the policymakers is carbon taxes. The logic is that the higher cost of these goods arising from the new carbon tax is expected to discourage the consumption of these goods/services by making them expensive. The irony is that what is most essential goods/services are also the major cause of emissions, such as paddy cultivation. In the case of taxes on essential goods/services, it could widen the inequality between the haves and have-nots. Besides, taxes levied across a wide array of goods/
services that contribute to carbon emissions would lead to an overall price rise and hence the inflation problem. In short, with tax as a principal instrument to control emissions, economic growth would inevitably be chased by inflation, reducing the economy's growth capacity and increasing inequality amongst the economic stakeholders. It is justified to have taxes as a limited instrument to reduce the consumption of luxury goods, thereby reducing carbon emissions. However, in the case of essential goods, it is better to have a market mechanism that can guide the stakeholders toward sustainable carbon emission reductions.

Cap And Trade As An Alternative

The fact that there are alternative goods/services or alternative and less emitting technologies/ processes leads one to the concept of cap and trade. A cap on emissions based on a techno-economic estimation at the macro-economic level would be incentivised by the carbon credits that an economic entity may earn for that much amount of emissions below the cap. These carbon credits earned by them can be sold in the market to those buyers who have obligations to meet the emission limits by purchasing and extinguishing the purchased credits, i.e., those who have saved carbon emissions lower than the floor for a particular sector/industry.

A robust emissions auditing mechanism for all participating industries and businesses in line with international standards will make the markets more robust. This activity of buying and selling carbon emissions would inevitably lead to not only the discovery of a price for saving one unit (usually a tonne) of carbon emissions from being emitted but also to economical ways of meeting the emission norms by investing in greener technology and raw materials. The market facilitates the transfer of emission reductions intra-sectoral while also enabling the inter-sectoral transfer of certified emission reductions. Instead of the policy wisdom directing the process of emission reductions from diverse sectors in the Indian economy using various types of technologies, a market will efficiently shift the emission mitigation burden to those who can achieve it at the lowest cost.

Transparent Markets Can Guide

Besides, the price discovery in the markets for carbon emission reduction units will make carbon prices integral to the balance sheets of corporates as these businesses would now either become carbon positive or negative under a cap and trade regime. For firms producing green technologies, the existence of carbon pricing will make it easier to do economic feasibility assessment to arrive at appropriate pricing. Overall, the economic burden of meeting the nationally determined contribution leading to appropriate financial planning, and prudent allocation of resources can be achieved through transparent markets guiding choices among alternatives. The carbon price discovered in a market with stakeholders from various sectors trading under a transparent and stable policy regime will contribute to the development of a robust carbon auditing ecosystem in line with international norms.

As carbon prices become integral to the pricing of goods and services, it could avoid future trade war-like scenarios that the country is entering into, especially with the EU.  Lack of contribution to emission reductions through a transparent market-based system wherein goods and services absorb those costs and reflect it in their pricing could lead to nations entering into trade wars due to fear of 'Carbon Leakage'.  In simple terms, as nations start adopting markets' way of emission mitigation, the
competitiveness of businesses reflecting carbon prices would be impacted and hence lack of transparently traded emissions markets would create trade friction as well.

The existence of a cap and trading regime and prices for emission reduction units arising out of it will have a multi-dimensional impact on the economic stakeholders, i.e., on their planning process to the process of decision-making. More importantly, the emission intensiveness of the goods/service will start influencing the decision-making of the economic stakeholders as they become aware of the cost of their economic activities.

V Shunmugam is Adjunct Faculty with the National Institute of Securities Markets. Views are personal, and do not represent the stand of this publication.