How Carbon Taxation Can Lead to a Cost-Effective Climate Change Mitigation Strategy in India

An induction of carbon taxes in the Indian economy has the potential to support efficient climate policy and showcase India’s stance towards the apparent dangers to a sustainable future.

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Climate change is no longer a “scary thing of the distant future”. The recently released Intergovernmental Panel on Climate Change (IPCC) report expounds that the world will probably reach or even exceed 1.5°C of warming within just the next two decades. Limiting this level of warming will require ambitious emission cuts and dedicated strategies towards creating a sustainable future.

One such strategy could be a reform in the taxation structure in India, with respect to its carbon taxation. Carbon tax policy in India is still evolving, though haphazardly through a carbon taxation regime which lacks overall consistency and does not seem to be linked to specific carbon emission targets.

We do not have an explicit carbon price or a market-based mechanism but have a number of schemes and mechanisms that put in place an implicit price on carbon. These include Perform, Achieve and Trade (PAT) scheme, the (now discontinued) clean energy cess, Renewable Purchase Obligations (RPO) and Renewable Energy Certificates (REC). However, while these mechanisms have seen some success, India is yet to realise benefits on par as to an explicit carbon pricing structure.

Also read: The Six Advantages of Imposing a Harmonised Carbon Tax

The benefits

Carbon pricing outweighs the economic efficiency costs of pricing with domestic environmental benefits. Accordance to an IMF-OECD 2021 report, the economic efficiency costs of carbon pricing are typically around 1% of GDP for a carbon price of $50/tonne of CO2 in 2030 for emissions intensive countries, and much less than that in other cases.

For most countries, the domestic environmental co-benefits of carbon pricing, which primarily includes reductions in local air pollution deaths and reductions in traffic congestion/accident externalities, are about as large, or in a few cases are much larger, than the economic efficiency costs.

Furthermore, carbon pricing offers significant potential revenue gains. As per the report, $50/tonne of CO2 carbon price in 2030 would generate revenue increases of around 1% of GDP for many G20 countries and substantially more than that in a few cases.

The design and actual implementation mechanism of a carbon taxation system will be tricky and experimental. The government could introduce carbon tax in the form a revised clean energy cess. This iteration of this previously diverted cess could include not just coal, but also other forms of fuels such as petrol, natural gas, etc.

As suggested by the Centre for Legal Policy, the new cess should be linked to the quantum of carbon emissions and not the procurement of fuel itself. This would make the rate of the cess vary on the basis of the capacity of a product to emit greenhouse gas. This will aid to incentivise usage of comparatively cleaner alternatives. It is vital that any form of carbon tax should be introduced in a realistic and gradual manner to ensure less or no chaos.

However, a mechanism for taxation of carbon is not the complete success story, the key question is the distribution of that collected revenue. The basic motive behind a carbon tax is not to just attach an economic penalty to pollution or emissions, but also to channelise the proceeds generated for investment in a sustainable and cleaner future.

Unlike the fate of environment cess, which was diverted from the use for energy and environmental purposes and used for compensating states for revenue losses in the wake of shifting to the new indirect tax regime, it is vital to ensure judicious use of carbon pricing revenues which will make climate policy more inclusive and effective while containing the costs of clean energy transitions to the economy.

There is a need to define the purposes where the collected revenue could be put to use. A defined approach will help to create a universal definition of “green” and close doors for any disparity as well as dispute. This redistribution aspect could fall under the ambit of the Finance Commission itself, through the creation of a nodal agency.

Also read: A Robin Hood Climate Tax for India

Proceed with caution

Despite their benefits, carbon taxes remain to be under speculation with respect to the efficiency gains provided. There have been multiple studies to understand this and the conclusion remains sceptical. Carbon taxes have been found to be simpler and more swiftly implementable, and thus, they are a more practical choice compared to the emission trading system (ETS) in the short to medium term for developing countries.

Research finds that impacts of implementation of a carbon tax are more obvious in developing countries as compared to developed nations. The analysis shows that developing countries experience higher contraction rates of real GDP than developed nations because emission costs compared to economy size are relatively higher in developing nations. Major polluting countries like China, the United States, India and Russia were also found to have low marginal abatement costs compared to other nations due to high emission levels and input substitution possibilities.

In addition, there have been concerns about carbon leakage. The European Union is advocating the introduction of a carbon border adjustment mechanism (CBAM) to reduce the risk of carbon leakage. The European parliament is also advocating connecting CBAM to a region’s emissions trading system, which allows businesses to buy and trade permits to emit greenhouse gases.

Then imports would be taxed equivalent to the carbon price paid in that trading system, unless that country had adequate environmental rules. In such a scenario, development of a carbon pricing mechanism in India would help to compete at the international front and protect domestic markets. It remains to be seen however if the benefits gained by few exporters outweigh the potential losses to many due to higher tax burden.

In sum, carbon taxes can prove to be an indispensable tool in any cost-effective climate change mitigation strategy, provided that it is inclusive and supports economic development. It is likely that the short-term burden of additional tax levy would be comparatively low as low-cost carbon abatement options are still within reach for many key economies.

However, long-term benefits of this move with respect to fuel switching or improved overall competitiveness by way of energy technology innovations, remains to be seen. An induction of these taxes in the Indian economy has the potential to support efficient climate policy and showcase India’s stance towards the apparent dangers to a sustainable future.

Amrita Goldar is senior fellow and Sajal Jain is a research associate at ICRIER. Views are personal.