Saranya Ravindran

This article is an analysis of the various stages involved in implementing a cap-and-trade system in light of the blueprint released by the Bureau of Energy Efficiency and the 2022 Amendment to the Energy Conservation Bill, 2001, which gives the central government the power to establish such a system. It details certain omissions and shortfalls in the implementation steps adopted by the BEE for a carbon market, suggests alternative means of establishing a cap-and-trade system, and concludes with a note on the interaction of BEE’s proposed model with existing carbon-offset markets in India. 

Introduction

The Energy Conservation (Amendment) Act 2022 seeks to amend the two-decade-old Energy Conservation Act 2001 and introduce a carbon trading scheme similar to the EU’S European Trading System (ETS). On August 9, the Lok Sabha passed the amendment, thus giving the green light to establish a “cap-and-trade system” (detailed below) in India. It empowered the central government to facilitate the sale and purchase of tradable carbon credits to registered entities. The cap-and-trade alluded to in the amendment gives legal effect to a draft blueprint published in October 2021 by the Bureau of Energy Efficiency (BEE), which details the nuts and bolts for implementing such a system in India. This article presents a brief of the blueprint before conducting a review of important stages outlined in the BEE for a carbon market. It extends from setting the total emissions allowed to punitive measures for non-compliance.

The Blueprint

The carbon market, as per the latest blueprint, contains the barebones of a standard regulatory framework — an agency authorized by the government will issue certificates (also known as “credits” or “permits”) to registered entities that prescribe a carbon limit (a “cap”) for that entity. If they emit less than prescribed, they can sell the excess carbon permits they hold to entities needing additional credits to compensate for their deficits.

Such a market that puts a price on carbon creates a market incentive to reduce emissions in place of the present system, which incentivizes cost-cutting through unchecked pollution. While the net benefits of a standard carbon market are widely documented in previous literature, both empirically and analytically, there is also growing work on its demerits. The assumption that carbon emissions are equally valuable (measured through a uniform carbon price for every metric ton emitted), the economic cost on developing countries yet to industrialize, the shift of emissions to areas where leakages are hardest to account for, and the increase in air toxic emissions with the onset of carbon markets are notable criticisms. Notwithstanding whether a carbon market is net-beneficial, this article aims to analyze the various stages and procedures involved in establishing a cap-and-trade system that BEE lays out in its report, starting from setting the carbon cap to penalties in events of non-compliance and propose suggestions to make the implementation tighter.

Implementing a Carbon Market

1. Setting The Cap

India has experimented with market systems before. Under the Perform, Achieve and Trade (PAT) Scheme, specific industrial sectors are given energy utilization targets to adhere to. When they emit less than their allowance, they are awarded Energy Saving Certificates (ESCerts) that they can trade to entities that use more energy than their target amount. However, the low targets set for energy efficiency under the PAT Scheme led to most entities consistently performing well below their limits, resulting in an excess supply of ESCerts and a low demand for them. The Center for Science and Environment (CSE) reports that the scheme accounted for a 3 per cent reduction in the industry’s annual emissions, a modest result equally attainable by slightly higher energy prices.

While the blueprint acknowledges the issue of excess supplies in the PAT system, the solution proposed by BEE is to bring more actors (voluntary buyers, state-designated agencies, etc.) within its fold. This, according to the report, would raise demand in the market, commensurate to supply, consequently stabilizing prices. However, the current voluntary trade scheme for EScerts has progressively expanded into most sectors, making the scope for the inclusion of more voluntary buyers in the new carbon market rather narrow. Furthermore, state-designated agencies, already crunched for funds, are unlikely to participate effectively in the trading system. 

A more sustainable approach is to set demanding emissions targets, making it more difficult for actors to meet targets consistently. Suppose, industry A has a high emissions-reduction target similar to most other industries. This would imply that A, along with others, would need more carbon permits to meet its targets given that it would have to reduce emissions significantly to meet its goals. Simultaneously, because the price of carbon permits in the market would be high (since all industries, much like A would be needing and demand more permits), industries would be equally incentivized to cut down on their emissions beyond their targets to sell their additional permits for higher prices. This doubly incentivizes firms to lower emissions. However, such a restrictive carbon emissions cap has to perform a delicate balancing act. It has to balance industrialization with sustainable development.

The approach taken by BEE is to use current and expected emissions of businesses to determine “Business as usual emissions (BAU)”. The BAU is then used as a reference point to determine emissions reduction targets, keeping in mind the targets necessary to meet India’s Nationally Determined Contributions (NDCs). While this system is similar to the NDC-aligned cap set by the EU, it is suggested that instead of NDCs, net zero goals (where the total carbon emissions by a country are balanced by carbon removals/absorption to create a “net-zero” emission) be taken as the basis of carbon permit allowances. For instance, India’s 2070 net zero goals can be taken as a benchmark for the same.

NDCs (Nationally Determined Contributions) as per the Paris Agreement have to be revised every five years. This implies that the targets that industries will be expected to meet will change every five years. Consequently, there would be a lack of certainty and stability in what the emissions targets at the end of every five years are likely to be. A more long-term goal, such as a net zero target by 2070, with yearly permits allocated to firms based on meeting a net zero target by 2070 provides stability for firms. Instead of a fixed target every five years, if a firm has to reduce emissions by 40% and absorb “x” metric units of carbon through sequestration over the next 30 years to be in line with its net-zero goal, the firm has more leeway to choose how to go about reducing emissions. A firm may choose to pollute more in the short term while saving up permits for the long run to grow economically before shifting into cleaner technology. Other firms may choose to sell permits in the short term where demand and consequently prices for permits are high, and thus opt for quicker transitions.

A net-zero goal with an understanding of the long-run emissions targets enables firms to make these decisions on how much cost they are willing to absorb right now rather than a moving goal post that changes every 5 years. Thus, defining targets in line with long-term net zero goals and then allocating permits yearly based on meeting long-term goals would enable firms to plan better on how they would participate in the carbon market. This also ensures that the short-term industrialization needs are met by setting lower reduction targets in the beginning and then slowly increasing the extent of reduction necessary in line with reaching a net-zero target by 2070. 

However, none of this suggests that net-zero allocations are without their fair share of criticisms. Net-zero caps only work when the emissions targets are dialed up every few years in line with what is needed to be carbon neutral by 2070. That relies on periodic review of the net-zero targets and successive governments not succumbing to political pressures not to make carbon caps more restrictive than it presently is. Additionally, it can be argued that the worsening nature of climate change in the short run and uncertainty about how industrial emissions will change by 2070 require short-term policies targeted at reducing emissions.

Nevertheless, even in an NDC-based emissions system, a periodic review is necessary to ensure that emissions targets are not stagnated at a particular point in time without accounting for changing circumstances. Thus, any system would rely on governments willing to make revisions to the system. Additionally, while it is true that the effects of climate change worsen over time, such consequences are exacerbated by poverty and poor economic growth. Thus, any sustainable policy to reduce emissions has to account for short-run economic development, which can only happen in a system that allows India to gradually scale up reduction targets as it grows, with a long-term target to reach net zero by 2070 rather than ambitious, five-year NDCs that do not meet the short-term industrialization needs of the country. Conversely, low targets in the short run based on NDCs that are not revised upwards based on a benchmark like the net-zero goal are also ineffective given their failure to meet climate change targets. Thus, having a long-term target, such as net zero by 2070, is critical to meet both the industrialization and emissions targets of India.

Allocation of Credits

Once a cap is set, an initial allocation of permits has to be done. However, the blueprint is silent on how the initial allocation of credits will be made. The EU follows an auction system, giving allowances to the highest bidder. However, the cost of such a system would be a heavy penalty on the growth of a manufacturing sector already being transferred overseas to Vietnam and Bangladesh. Thus, the initial allocation must be free of cost, at least for the short term. While there exist alternatives such as progressive pricing based on the ability of firms to pay, the transaction cost of such a system in addition to determining emissions targets as outlined below would be inefficient.

Furthermore, the MSME sector (often ignored in discussions around climate change in India) contributes approximately 50 million metric tonnes of oil usage per year. They also form the backbone of a third of India’s GDP. Therefore, a differential allocation model that gives permits according to the financial capacities of firms to decarbonize and their contributions to greenhouse gas emissions (GHGs) must be considered. The EU has recently proposed a similar model, where sectors that need sharper emissions reductions are proposed to be governed under separate emissions trading schemes with higher targets.

2. Monitoring Carbon Emissions

A critical part of any carbon market is robust Monitoring, Reporting and Verification (MRV) systems. Currently, India lacks standard emissions factors that can be used to determine the emissions of individual entities. The use of proxies instead of clearer emissions counts has led to adverse impacts. For instance, the cess imposed on coal was not linked to the quantum of carbon emissions but rather to the quantum of coal usage regardless of whether the coal used was clean coal or not, resulting in a system that put factories with low emissions at equal footing with those that had significantly higher emissions.

Phase 2 in the blueprint on increasing supply charts out a monitoring plan—once a project developer makes concrete plans in a “Project Design Document”, they have to give information on anticipated emissions which are “validated” by an auditor, post which the project will be implemented and monitored over a period with another auditing process. Such a compliance model would work for explicit carbon reduction schemes. However, year-round carbon monitoring with mandatory site visits must be implemented to hold over-emitters accountable for their emissions rather than relying only on emission target reports for specific projects implemented by private actors. A cornerstone of the EU-ETS is the monitoring plan— a live document that has to be “updated regularly, when changes in the monitoring methodology occur” and “any significant changes have to be approved by the Competent Authority”. The monitoring cycle also becomes more precise through the chart attached above. Such continuous, year-round monitoring of emissions is critical to ensure market compliance and incentivize more actors to join the market. The huge upfront costs for the maintenance of such a monitoring system would have to be funded through additional resources devoted to the BEE for an effective carbon trading scheme. A lax monitoring regime would, apart from reducing efficiency, disincentive actors from participating in the system owing to a lack of good monitoring systems. Thus, the harms of not having such a robust system would far outweigh the costs of its maintenance.

3. Compliance Period

The BEE blueprint rightly identifies that a drawback of the PAT Scheme was the short window of trade. A compliance cycle under the PAT Scheme was three years, with ESCerts allocated and actual trade of ESCerts happening at the end of three years. This meant a trading cycle barely lasted four months at the end of the three-year interval. A long window like that of three years results in a poor reflection of cost since the price of credit is only visible once in three years rather than changing as the demand for credits changes. It also leads to an excess supply of credits in the market at the end of three years, when everyone has to sell their credits, given that that is the trade window prescribed.

The blueprint rightly shifts to a one-year compliance cycle, at the end of which carbon emissions will be checked and new allowances allotted. However, the blueprint is silent on when the actual trade can happen. Following the PAT scheme of having a trade window would result in the same excess supply issues since everyone will sell at that specific time period. Thus, it needs to be clear that permits can be traded all-year round rather than during a specific monthly window. At the same time, only permits earned through reduced emissions can be traded, and the initial carbon allotments made for that year cannot be traded. An alternative policy would lead to companies prematurely trading their limits, even when they have not reduced their emissions.

4. Penalties for Compliance

While the document does not mention penalties, entities that do not meet carbon targets must be fined punitive rates for every metric tonne of carbon emitted, with a commensurate reduction in allowance in the following year to maintain the overall net-zero targets in the long run. The EU , for instance, follows a similar system of heavy punitive fines for non-compliance with the carbon limits.

5. Price Stability

A common problem the market runs into is price volatility. The covid-pandemic and the Greek Sovereign Debt crisis forced the price of credits to plummet due to reduced carbon use. Therefore, a lack of a price cushion inbuilt into the BEE blueprint is concerning. While the EU pursues a backloading process by reducing future allowances in the short term to restrict supply, countries like Germany and South Korea have placed a price floor on their trading systems. Such a floor would be a better system since it ensures continued interest in reducing emissions due to the stability of prices in the market (because there is a floor) rather than sudden shocks in prices.

Additionally, the BEE plan exclusively speaks of additional credits being sold, rather than the EU approach of a “bank” where countries can carry forward the allowances they have saved for the next phase. The EU’s approach would be a better system since it helps deal with an over-supply of credits by allowing countries to retain their permits if they believe the price at the market currently is unsatisfactory.

6. Fungibility of Credits

BEE’s report extensively discusses the transition from the current ESCerts regime under the PAT Scheme to a complete transition into ERUs (Emission Reduction Units), the equivalent of ESCerts in the carbon market. This is critical—instead of multiple market schemes that increase compliance and monitoring costs, it is critical to standardize the different schemes (including carbon taxes in the form of coal taxes currently imposed) into a single tradeable market. Apart from PAT, it is also essential to harmonize the REC (Renewable Energy Certificate) currently issued for generating electricity through renewable sources into the carbon market and establish conversion rates for REC-ERU transactions.

The Carbon-offsets Market

The Global Offsets Market

An additional fungibility aspect that needs to be considered is the current participation of India in the Clean Development Mechanism defined in Article 12 of the Kyoto Protocol. Under this project, a country with an NDC can “make up” for the emissions it releases by funding emissions reduction projects in a developing country. In other words, if the EU releases an additional metric tonne of carbon in defiance of its emissions targets, it can offset this emission by either reducing its emissions or by funding a carbon sink (through projects like reforestation) that absorbs carbon in developing countries (thus offsetting its actual emission).

While the bill does not mention such a market, R.K Singh, when introducing the bill, notes, “We have decided to not export our carbon credits. There is no question about this. This is because we have already set our climate mitigation goals through the Nationally Determined Contributions (NDCs). Now unless we meet our own goal, we will not export our carbon credits.” It is unclear whether he meant this concerning any carbon credit generated or the credits generated under the domestic carbon market India intends to set up. Note that with billion-dollar investments in carbon-reduction schemes, a blanket ban on exports would be detrimental to the growth of private actors in India. They currently contribute to 30 million carbon credits globally by funding carbon absorption projects in India. Given that a carbon reduction or absorption, regardless of where it happens, has positive ramifications globally (owing to the global nature of climate change), even if it technically makes it harder for India to reach its NDC, an outright ban on it should be discouraged.

Domestic Carbon Offsets

It is also important to note the glaring omission of the offsets market in BEE’s blueprint. It speaks of offsets, not in the context of its present policy proposal, but exclusively in terms of prior policies implemented. The language of the proposal “avoids emissions leakage” and says that “each entity needs to set up a GHG emissions inventory”. This is indicative of an approach that relies extensively (if not exclusively) on direct, absolute emissions rather than net emissions. Note that sequestration techniques such as reforestation, the creation of additional carbon sinks, and technology-based removal of carbon dioxide from the atmosphere are all legitimate means of reducing emissions (A metric-tonne unit of carbon absorbed is a unit that is not being emitted into the atmosphere).

In other words, any carbon-market proposal must involve provisions that allow companies access to additional credits proportional to the extent of absorption of carbon they undertake through their investments. This enables easier, cost-effective compliance without defeating climate change goals while also incentivizing the local development of sequestration technology currently concentrated in the West. However, this also means that more nuanced compliance and monitoring systems must be adopted to avoid double-counting. For instance, if A pays B for an offset project, the emissions reduction cannot be counted in the books of both A and B.

Conclusion

The strategy paper of BEE in its present form also raises other, more general concerns ranging from the lack of clear timelines for when the market is expected to be implemented, agencies involved in the allocation and distribution of permits, cost of implementing such a cap-and-trade, and raising costs for local industries that are likely to be hurt by a domestic carbon market with an increasing cost of production. There is also the predictable concern with the Indian state pursuing lofty and, at many times, contradictory goals, with the stated aim of increasing the manufacturing sector’s contribution to the GDP from 16% to 25% by 2025, which from the Chinese experience, is a sure way of increasing emissions. However, it is equally important to acknowledge the benefits of a market—sulphur dioxide trade markets in the US and the ETS in the EU have achieved tremendous outcomes (43% reductions from 1990 levels and 41% from 2005 levels, respectively). A carbon price is the first step, but moving beyond that to designing an effective and implementable carbon market has to be next on the checklist on our road to net-zero emissions.

The author is a second-year law student at NALSAR University of Law, Hyderabad.