A lax carbon market will be flooded with cheap credits that do little to reduce emissions. Too strict a system and companies may resist participation.
The Print18 December 2024
The idea of carbon markets has come back into focus after COP29, which finalised the rulebook under Article 6 of the Paris Agreement. India has already made efforts toward the establishment of a voluntary national carbon market. Carbon markets may look compelling in theory, but implementation challenges raise doubts over its feasibility. Globally, these markets have had a tough time gaining momentum, and the hurdles are likely to be even higher in India, given our constraints on regulatory state capacity. The other policy alternative is a carbon tax. While it can become onerous, its appeal lies in its relative clarity and simplicity.
Challenges of carbon markets
The item for purchase and sale in a carbon market is a carbon credit. This is a certificate that represents the reduction of one ton of carbon dioxide or equivalent gases. Imagine if two firms had a target of reducing 100 tons of carbon emissions each. Reducing emissions requires investments in technology that may be expensive. Some firms may be able to do so more effectively than others. Let’s say that firm A ended up reducing 150 tons. It could sell these “credits” of 50 tons to Firm B which was only able to reduce emissions up to 50 tons. A market-based mechanism of carbon credits offers the flexibility to find the most cost-effective ways to reduce emissions. The firm that can reduce emissions is incentivised to do more, and the firm that isn’t able to, pays the firm that does. The European Union’s Emissions Trading System (EU ETS) is one of the most well-known carbon markets.
There are two reasons why this may not work as smoothly in reality. The first is incentives. Carbon markets work best when there are targets for firms to reduce emissions. There needs to be a clear incentive for companies to either buy credits (to offset emissions) or sell them (after making reductions). In the absence of targets, voluntary markets will not have sufficient demand for carbon credits.
The second is known as “greenwashing”, which refers to the practice where carbon credits are fake and do not represent actual emissions reductions. Companies engage in marketing themselves as environmentally responsible by buying low-quality or fraudulent carbon credits, undermining the credibility of the entire system. The EU ETS, for example, also struggled with problems like giving out too many credits and unstable credit prices, which hurt its effectiveness in the initial years. Its experience suggests that designing an effective carbon market requires a careful balance between economic incentives and regulatory stringency. Too lax a system and the market will be flooded with cheap credits that do little to reduce emissions. Too strict a system and companies may resist participation or simply pass on the costs to consumers, leading to inflationary pressures. Despite their generally higher governance standards relative to India, greenwashing remains a problem.
The promise of carbon taxes
Given these challenges, it is worth considering an alternative such as a carbon tax. The tax imposes a price on carbon emissions and provides clear and predictable incentives for companies to reduce their carbon footprint. Firms know exactly how much they will need to pay based on their emissions, eliminating the uncertainties associated with assessing and trading carbon credits. It provides a more stable and predictable price signal, which might encourage long-term investments in cleaner technologies. The government gets a steady revenue stream that can be used to cushion the social and economic costs of transitioning to a low-carbon economy. Further, a carbon tax overcomes the issue of greenwashing as companies cannot offset their emissions by buying dubious credits. However, carbon taxes are not without their own challenges. They are often politically contentious, as they are an additional cost to businesses and consumers, and are likely to face stiff resistance.
Carbon market or tax
Both carbon markets and carbon taxes present inherent challenges. Carbon markets often face issues of complexity in design, enforcement, and susceptibility to price volatility, which can undermine their efficacy. For example, if we have to set targets then we need to answer questions like which sectors should have what targets, and how these should be allocated. Voluntary markets are even more difficult as they first need to confront the demand question. In a country such as India which is still dominated by coal, companies may continue using coal-based energy rather than invest in cleaner alternatives or buying credits. The incentives of small and medium-sized enterprises (SMEs) are even more skewed—given the generally low-profit margins of Indian firms, purchasing credits will be seen as an unnecessary expense. Further, ensuring that the credits traded in these markets reflect genuine carbon reductions is a governance one. This is a difficult problem to solve in India given our challenges with rent-seeking and low state capacity. It is entirely possible that we may create more problems than we solve with carbon markets. Carbon taxes, while simpler, encounter political resistance and risk disproportionate economic burdens if not carefully structured. India should make the choice not based on which system is theoretically superior but on whether a framework aligns best with its economic structure, governance capabilities and political constraints.
