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Carbon Pricing – A tool to subdue doomsday?

In days to come it is understood that the human race is going to severely suffer because of increased heat, drought, flood, reduced agricultural yield, insect outbreaks, and health hazards all due to climate change resulting from the unabated release of greenhouse gases into the atmosphere. These happenings are clearly seen in recent observational records of rainfall, and temperature and also through well-validated climate models. But, most human activities still look business-as-usual unmindful of these fallouts. Heartening to note that few mitigatory measures are being implemented by various countries. The answer to the question “How to reverse the trend?” is the subject matter of this article i.e., Carbon Pricing. This tool appears to have the potential to bring down emissions and also drive humanity towards benign nature-friendly cleaner options.

Emission of CO2 as heavy smoke into the atmosphere from a Factory close to a farmland where a farmer with a cow
CO2 Emissions

What is Carbon Pricing:

Carbon pricing is an instrument that accounts for the external costs of greenhouse gas (GHG) emissions, where external costs refer to the costs of emissions paid by the public or user (private transport for instance) usually in the form of a price on the carbon dioxide (CO2) emitted. This includes capturing costs corresponding to health care costs from air pollution, contaminated water, consequences of climate change like the heat waves, loss of property from sea-level rise, etc.

A carbon price, therefore, encourages polluters to reduce the number of greenhouse gases they emit into the atmosphere by shifting the burden for the damage arising from the emissions back to those who are responsible for it.

Carbon Pricing Explained and Why a price on Carbon (CO2)?

The idea of convening carbon pricing, which is a Pigovian tax, came up in 1997 during the United Nations Framework Convention on Climate Change (UNFCCC) in Kyoto commonly known as the Kyoto Protocol. All parties across the globe found carbon credits as a good way of reducing greenhouse gases. Later, it was in 2001 in Germany during the Bonn Climate Change Conference, that the idea of a cap-and-trade system and a carbon credits market were brought to the table.

The carbon price does not direct emitters to reduce emissions, but provides an economic signal to them, which allows them to decide whether to transform their activities and lower emissions or to continue to emit and pay for their emissions. Thus, it helps to move towards net-zero goals, and stimulate the development of new, greener, more efficient, and low-carbon technologies in the most flexible and least- expensive way.

It plays a critical role in internalising the external costs in economic decision-making and creating economic incentives for clean development.

It not only encourages a lower-carbon behaviour like switching to a bicycle than driving a car but also helps in generating money that can be used to fund a clean-up of ‘dirty’ activities like investment in research on fuel cells that can help cars in producing less pollution.

For governments, carbon pricing serves as an instrument of the climate policy needed to reduce emissions. Therefore, it can be instrumental in effectively mobilising the financial investments required to encourage clean technology and low-carbon drivers of global economic growth.

Benefits of Carbon Pricing - Emission Pathways, Clean Technology, Sustainable Development, Green Economy, Reduce air pollution

The current state of carbon pricing:

The recently released report by the IPCC (Intergovernmental Panel on Climate Change) paints an ugly picture of climate change including life loss, humanitarian crises, and irreversible damage to ecosystems. It stresses the need for arresting the rising emissions to prevent the looming climate danger. Meeting this challenge will require rapid reductions in emissions across the economic sectors.

Carbon Pricing or Carbon Pricing Instruments (CPIs) address price barriers to low-carbon developments. There are two main ways to establish the price. CPIs can broadly be grouped into two categories- direct and indirect carbon pricing.

Direct pricing applies a price incentive directly proportional to the emissions generated by a product or an activity.

How does Carbon Pricing work? - An infographic to explain Carbon Pricing framework

Indirect CPIs include instruments that change the price of carbon emissions causing products in ways that are not directly proportional to those emissions. Examples include fuel and commodity taxes that by applying a flat tax to gasoline place an indirect price on the emissions from its combustion.

Direct carbon pricing is done primarily through a carbon tax or an ETS. A carbon tax is an instrument through which a government levies a fee on GHG emissions, or on the distribution, sale, or use of fossil fuels, based on their carbon content. Due to increased costs, this provides a financial incentive to lower emissions and encourages businesses and individuals to switch to less carbon-intensive production and consumption.

Under a carbon tax, the price of carbon is set by the government, and the market determines the level of emission reductions incentivized by the price.

Major Types of Carbon Pricing Explained- Carbon Tax and Emission Trading System (ETS)

The second approach is referred to as an emissions trading system or cap-and-trade. In this model, the total allowable emissions in a country or region are set in advance (‘capped’). It involves placing a limit or cap on the total volume of GHG emissions in one or more sectors of the economy or in a country or region. A government then auctions or distributes tradable emission allowances to entities covered by the cap, where each allowance represents the right to emit a certain volume of emissions (typically a metric ton of carbon dioxide equivalent), and the total volume of allowances equals the emissions cap.

In ETS, covered entities can “earn” emission credits if they produce fewer emissions. These credits can then be traded with covered entities that need additional credits to cover their surplus emissions relative to the baseline. Examples of the systems include intensity standards and tradable performance standards.

A carbon price under an ETS is determined by the supply and demand of emission allowances and is not regulated by any government authority.

Despite the several benefits, the adoption of CPIs remains limited. Direct carbon pricing systems so far are concentrated in high- and middle-income countries only. Indirect systems, like fuel excise systems, are more common in developing countries.

Another challenge is the rise in carbon prices that are generally too low. Though the prices have escalated across multiple jurisdictions mostly in advanced economies, the prices in most jurisdictions remain below the required levels needed to meet the Paris Agreement’s goals.

Countries considering new CPIs have started to emerge but gradually.

At present, only 23% of total global GHG emissions are currently covered by operating CPIs.

While developed economies like Austria, Indonesia, and Washington State have CPIs scheduled for introduction others like Israel, Malaysia, and Botswana have stated their plans to develop new CPIs.

  1. Austria for instance will implement a carbon levy of EUR 30 (USD 33)/tCO2e in July 2022 under its national ETS as part of broader fiscal reforms in the Eco-Social Tax Reform Act 2022.

  2. In Botswana, the parliament has approved the National Climate Change Policy in 2021,(PDF) which commits to exploring the development of a carbon price, including adopting and enforcing a carbon tax.

  3. The Chilean government in 2021 recommended a carbon tax of at least USD 35/tCO2 as part of an updated Energy Policy 2050.

  4. In Finland, the Finance Act 2020 establishes an annual increase in carbon tax to EUR 100 (USD 111)/tCO2 by 2030.

  5. Following the recently held COP26, the government of Thailand is in the process of developing rules and guidelines for carbon credit trading.

A number of other jurisdictions in Africa, Central Europe, and Asia are in the process of assessing its potential.

  1. China currently hosts the world’s largest carbon market by emissions followed by the EU.

  2. The approach has thus started to gain traction across the globe with countries like Canada and the United Kingdom (UK) exploring CPIs and cross border approaches like border carbon adjustments (BCAs), climate clubs, and minimum carbon pricing arrangements.

  3. Canada for instance has the fuel charge rates based on a carbon price of CAD 50 (USD 40)/ tCO2e in 2022.

  4. Germany has also released its national fuel ETS in 2021 at a fixed price of EUR 25 (USD 28)/tCO2e and the sale of National Emissions Trading Scheme (EHS) allowances. The establishment of “an open and cooperative international climate club” by Germany for its presidency at G7, 2022, and the considerations of broadening the proposal to the G20 mark an opportunity for India too (World Bank, 2022).

As of April 2022, a total of 68 CPIs which includes 37 carbon taxes and 34 ETSs are in operation with three more scheduled for implementation.

A rise in carbon pricing revenue creates an opportunity to support a sustainable recovery, or to finance broader fiscal reforms.

However, the current economic context presents both challenges and opportunities for carbon pricing. In developing economies, new or increased carbon prices can put additional price pressure on consumers in a context where citizens and businesses are already struggling to pay their energy bills.

Research suggests that introducing CPIs in countries with high inequalities and lower socioeconomic status triggers an aggressive reaction (Abdurasulov, 2022.).

Supporting carbon pricing and related policies for a “just transition” is thus central to building and sustaining support during high demand and prices for energy, inflation, and the need for transformation. Just transition must create quality work and work that is reliable and must ensure that at-risk communities, industries, workers, and consumers benefit from the transition. It is increasingly recognized that just transition is needed not only to ensure equity in climate policy but also in building the support needed to adopt and sustain it.

Carbon pricing revenues can be used to finance the implementation of just transition strategies and thus encourage its uptake in developing economies as well. Governments can also use carbon pricing for supporting a long-term incentive to enhance domestic production of renewable energy, thus reducing reliance on foreign energy and providing protection against shocks from global energy price fluctuations.

Carbon pricing markets shaped by new financial services, technologies, and governance frameworks have also started to emerge across sectors and geographies. Thus, it is important that benefits be maximised and carbon price signals are sustained, supported, and extended to a larger part of global emissions, more than half of which is currently untouched by carbon pricing instruments. The success of carbon pricing techniques the world over should typically be supplemented by investments in research and development, technologies and infrastructure, sector-specific regulations, removal of regulatory blocks, and market reforms to facilitate incentive-based approaches.

Relevance in Indian Context:

Reduction of carbon emissions is one of the primary goals of the countries that are signatories to the Paris agreement which aims to achieve carbon neutrality by 2050. India has also ratified the agreement and is taking substantial policy actions to mitigate GHG emissions. India has committed to lowering the ratio of emissions to GDP by one-third from 2005 levels.

At the recently held COP 26, India pledged to cut its total projected carbon emission by 1 billion tonnes by 2030, fulfilling 50 percent of its energy requirements from renewable energy by 2030, and cut its emissions to net zero by 2070.

It is thus in the country’s interest to take stronger action for no net carbon increase by 2050. A smart approach would be pricing carbon.

However, India does not have an explicit carbon tax in place. As per OECD, a total of 58.1% of CO2 emissions from energy use are currently priced in the county. The road sector has the highest effective carbon rates in the country but accounts for only 8.6% of the country’s total CO2 emissions from energy use. Fuel excise taxes, an implicit form of carbon pricing, falls under the road sector and covered 58.1% of emissions in 2021.

The coverage remains unchanged since 2018 (OECD, 2021). Though carbon prices have increased since 2018, sectors like industry, building, and electricity that form the lion’s share of emissions from energy use do not have any CPIs in place in India. In 2021, fuel excise taxes amounted to EUR 14.43 on average, up by EUR 4.33 relative to 2018 (in real 2021 euros).

The main challenge is the diffused benefits of the pricing, and resulting concentrated costs. In a country like India with the context of vast socio-economic disparity, carbon pricing can create a divide between those who benefit and those who suffer loss from the CPI.

As opposed to impacting middle- and higher-income households, this policy is considered regressive as it primarily affects the lower-income groups who can afford high-priced energy-incentive goods and services.

Further, it has been observed that the revenue generated remains mostly unused or is used for purposes other than those earmarked by the government.

For instance, the Indian Government introduced a Clean Energy Cess in 2010 to encourage the use of clean fuels by increasing the cost of coal formed a significant part of the Clean Energy Fund. A portion of the revenue collected was apparently meant to fund research and clean energy projects. The amount, however, remained largely unutilized.

Bar chart infographic - Allocation of NCEF in Crores INR (National Clean Energy Fund), Total cess collected between 2010 an 2018
Allocation of NCEF (Image: TOI)

It was in 2017 that the cess was abolished and replaced by Compensation Cess on coal production. Yet, the elephant in the room continues to remain unaddressed. The cess applies to the usage of coal and not the number of carbon emissions produced from its usage of coal. The tax, therefore, fails to reduce the amount of coal used and subsequently the carbon emitted, and it punishes taxpayers even if they use cleaner variants of coal. The system of carbon pricing in India can be best described at its elementary stage. It not only has an effect on India's economy by not properly capturing the external costs of carbon, but it also has the ability to affect its international trade.

Given that India is among the nations to be hardest hit by the impacts of climate change, the need for growing public support and policy action is imminent with solutions that are best suited to India’s diverse interests.

To reduce carbon emissions, India needs to introduce a carbon tax and trade carbon at the domestic level along with actions to induce similar strategies at the international level through trade and diplomacy.

This carbon pricing may not be the complete solution to restore order on the planet. It needs more intense dedicated effort from every stakeholder i.e., political leaders, governments, industrialists, administrators and above all citizens of each country. Carbon Pricing is only the first mechanism in the process, somewhere we have to start lest we are leading way to our own peril. Authors: Reashma PS, Dr.Krishna Raj, Dr.Srinivasa Chakragiri Infographic: Kawin Kumaran Further Read: Discussion Paper on Carbon Tax Structure for India

Works Cited

Abdurasulov, A. (2022., January 6). Kazakhstan Unrest: Government Restores Fuel Price Cap after Bloodshed.

Bank, T. W. (2022). State and Trends of Carbon Pricing 2022. Washington, DC: The World Bank. doi:10.1596/978-1-4648-1895-0.

Download the complete Infographic on Fundamentals of Carbon Pricing:

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