This would be an important development, as it would put us in a select group of countries such as the EU, UK, China, Indonesia, South Korea, Australia, etc. that have introduced similar schemes to reduce emissions.
A CCTS is essentially an alternative to a carbon tax. The tax operates through prices, raising the cost of fossil fuels, which reduces their use and therefore emissions. A CCTS operates directly on the quantity of emissions by setting a limit on the emissions allowed per unit of output.
Economists agree that a carbon tax should be the preferred instrument, but it has little political support because it is seen as directly affecting all producers and raising costs.
The CCTS is more politically acceptable because it is limited to larger units, leaving small producers outside its ambit. The higher costs of larger units will of course be passed on to consumers, but it is less immediately evident.
A crucial component of the CCTS is trading of carbon credits. Producers that emit less than they are allowed receive carbon credits and these can be sold to those who find it very costly to reduce their emissions to the required level.
The ability to trade credits increases the efficiency of the system, and the price of carbon credits that emerges from the system would reflect the lowest cost of reducing emissions across all entities.
For the CCTS to be a major step forward towards decarbonizing the economy, it is essential that the system is properly designed. The Bureau of Energy Efficiency (BEE), which will administer the system, has been tasked with developing the design.
The BEE has experience in operating the Perform, Achieve and Trade (PAT) scheme, which was designed to improve energy efficiency. This is an advantage, but the demands of a CCTS will be much more complex.
In this article, we list six critical areas that need to be addressed for the CCTS to be successful.
The first challenge is how to determine the emission allowance for each unit. This task has been entrusted to a National Steering Committee, co-chaired by the power and environment secretaries, with representatives from key ministries, central agencies and some states.
However, the committee will need to establish the principles to be used in making this decision. Relying on a ‘bottom-up’ negotiation process will be far from optimal.
Ideally, the emission allowance for each entity should approximate what would be the outcome of applying a common carbon tax to all entities covered.
For this, the committee should be advised by technical teams drawn from research institutions capable of modelling the response of different industries. They should also consult representatives of the private and public sectors in each industry, as these may have different views.
The second issue relates to the coverage of the CCTS. At present, it is proposed to cover large producers in the iron and steel, cement, petrochemicals and pulp and paper industries.
The power sector, which is the single largest contributor to the country’s carbon emissions, is not expected to be covered yet. This differs from the practice in other major countries that have such a system. The fertilizers sector is also excluded, which is illogical.
It is possible that power is excluded because decarbonization of this sector is being separately pushed by imposing Renewable Purchase Obligations (RPOs) on distribution companies (discoms) and large industries, forcing them to source an increasing share of electricity from renewables.
This may work well for a while, but it is not the most cost-effective way to cut emissions. Specifically, it does not ensure that the cost of reducing emissions in power generation is aligned with the costs in other sectors. This problem would be solved if the power sector is brought under the CCTS, which should be done as soon as possible.
The third issue is that if our objective is to reach net-zero by 2070, the emission allowances for each industry should be reduced over time in line with this objective. This is not simply a matter of reducing allowances for each industry at the same pace.
Instead, the rate at which allowances are reduced should reflect the rate at which technology reduces the cost of reducing emissions in different sectors. In other words, sectors where the cost of emission reduction is falling faster should decarbonize sooner.
The fourth issue is whether the CCTS should be designed to generate revenue, like a carbon tax. This is possible if emission allowances are auctioned.
The revenue realized can be used to finance climate-related expenditure and replace the loss of tax revenue that is expected as fossil fuels are phased out.
We can follow the EU’s practice and start with free allowances, but then move to auctioning an increasing proportion of allowances over time. The Finance Commission could be asked to recommend a way of sharing the revenue from this source between the Centre and states.
The fifth aspect of design is to ensure that the CCTS can help shield our exports from the carbon border adjustment taxes that the EU plans to phase in from 2026 (and the UK from 2027).
Introducing a CCTS by itself will not suffice, as the EU would argue that if the carbon price yielded by our CCTS is lower than in its own (which is likely), it will impose a countervailing duty on imports to make up the difference.
We should make the case that the introduction of a CCTS is an indication of our seriousness in accepting our mitigation obligations, but that developing countries should be allowed to have a lower carbon price than developed countries.
An IMF staff paper had suggested that the carbon price in lower-middle income countries (such as India) should be about one-third of the carbon price in advanced countries (like the US and EU), while for upper-middle income countries (such as China), it should be two-thirds.
We have traditionally opposed differentiation among developing countries, but differentiation based on per capita income is logical and we should push for it.
The sixth aspect of the CCTS that needs to be accepted is that the new system will increase production costs for the sectors covered until low-carbon technologies become cheaper than fossil fuel-based options.
Following the ‘polluter pays’ principle, higher costs will need to be passed on to end consumers. This will also be true in the power sector, whether we attempt decarbonization by relying on steadily rising RPOs, as presently envisaged, or by including it in the CCTS.
There will be political compulsions to protect low-income households from higher electricity tariffs. However, this should not lead to discoms being prevented from raising electricity tariffs, as this will only weaken discoms financially and worsen the quality of electricity supply over time.
This outcome would mostly damage small and medium enterprises. The solution is to let electricity tariffs reflect costs, while introducing direct compensatory cash transfers targeted at the poor.
It may not be possible to resolve all these problems satisfactorily at the outset. However, there is merit in introducing the CCTS as soon as possible, with a clear promise that its performance will be reviewed and modified with time. A reasonable medium-term goal would be to have a fully effective system in place well before 2035.
Montek Singh Ahluwalia & Utkarsh Patel are, respectively, former deputy chairman of the Planning Commission and distinguished fellow at Centre for Social and Economic Progress; and associate fellow at CSEP.
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