In Short : Four factors influencing our emissions trading system are:
- Regulatory Framework: Stringency of rules and penalties.
- Market Dynamics: Supply and demand for emissions allowances.
- Technological Innovation: Advances in clean technologies and energy efficiency.
- International Agreements: Global climate policies and agreements like the Paris Agreement shaping national targets and trading mechanisms.
In Detail : India is piloting a carbon credit and trading scheme this year with the target of making it fully operational in 2027. Among the things that need close consideration are the carbon pricing mechanism and sector specific targets
One of the much-anticipated news from this year’s budget was the financial outlay the Indian government gave to existing clean energy policies such as the promotion of green hydrogen, electric vehicles and rooftop solar systems. However, designing policy instruments that could potentially generate additional revenue for the government to contribute to climate finance while effectively reducing emissions is equally critical.
India’s carbon credit and trading scheme (CCTS) is one such policy instrument that will start its pilot phase this year. We delve into the four factors influencing India’s carbon price and emissions trading system.
The government launched the Indian carbon market in 2023. It consists of setting up a voluntary or offset market and the national emission trading scheme, dubbed the CCTS. The scheme obligates entities in chosen sectors to reduce their carbon emissions. After a transition period from 2024 to 2026 consisting of select entities, it will become fully operational in 2027.
Experience from other nations—the European Union, New Zealand, and South Korea, which started their emissions trading systems in 2005, 2008, and 2015, respectively—have shown designing an effective trading system is a tricky and continuous process, based on local nuances.
For example, the EU had to introduce a market stability reserve 10 years after its ETS came into place because surplus emission allowances led to low carbon prices in the market. And New Zealand is planning to disallow forestry offsets as emission reduction in their ETS. India’s journey is going to be unique in itself depending upon the industry’s experience and reaction to an emissions market, interaction and complementarity with other energy policies, and how the impact of the market is felt by industries and consumers.
Since emission trading schemes will only proliferate as the world goes net-zero, countries in the Global south, aiming for their own trading schemes, will look keenly towards India’s experience. A recent modelling-based assessment by the Council on Energy, Environment and Water shows key factors will influence the design of India’s emissions trading system and carbon price.
First, two variables will impact the carbon price. The first is the overall emissions cap. The tighter the overall emissions cap on key sectors, the higher the carbon price. Currently, the government has not announced an overall cap, but it is implicit in the sector-specific targets it plans to set. The second variable is the type and number of industrial sectors in the trading system. This is because different sectors have different marginal abatement costs, i.e., the emission reduction that can be achieved for each dollar of investment. Sectors like the power sector have a low abatement cost, given the lower capital costs for solar and wind generation. On the other hand, sectors like fertiliser have high abatement costs as green alternatives for manufacturing hydrogen are currently very expensive. This implies that whenever the carbon market expands from, say, four to 10 sectors, the carbon price will become higher if the marginal abatement cost across the new sectors is higher, or vice-versa.
Second, sector-specific targets will determine financial transfers across sectors. For example, setting a weak emissions reduction target on a sector with low abatement costs, such as power, will supply a large number of credits from this sector. Our assessment finds that owing to cheaper alternatives to coal—solar and wind—the power sector would emerge as the largest supplier of cost-effective emission reductions whenever it enters the market. This implies large financial transfers to this sector because other sectors would find it cheaper to just buy permits than reduce their own emissions. This implies that the sectoral target-setting process is one of the most critical design elements and requires complex assessment to ensure no one sector receives windfall financial gains.
Third, the decision to auction allowances or not will hold the key to transparency and efficiency of the market and generating revenue for the government. In the long run, it makes sense for the government to ultimately move away from a system of setting sectoral targets towards a complete auction-based system, i.e. auctioning emission allowances, to avoid the above pitfall. For comparison, the EU’s ETS auctions around 57 percent of its total emission allowances. This has two main advantages. First, the regulator only needs to be concerned about the total emission reduction it wants to achieve and not who should do how much—making the allocation process more straightforward and more transparent. Second, revenues from auctioning can be used to make the energy transition faster and more equitable, for example, to people and communities whom the transition will impact or to provide additional funds to the Green Hydrogen Mission.
Fourth, the ETS, specifically the carbon price, will affect and be affected by other climate and energy policies in the economy. Specifically, renewable purchase obligations (RPO) that mandate a particular share of renewable energy in the power sector could significantly influence the carbon price in an ETS. This effect should be considered while setting the ETS cap or RPO targets to avoid low carbon prices. Understanding the effects of such policy interaction would be critical for market design.
The road to operationalising an effective carbon market for India is long, with significant tests and trials. The success of the trading system is ultimately about good design choices. In doing so, India can emerge as a successful Global south model.
