Adding a monetary value to carbon can incentivize or disincentivize some sectors; setting performance standards can create a race for innovation

Financial Express

“Bending the curve”, or the process of changing the direction of a country’s annual emissions curve from sloping upward to making it go down, requires important policy choices. Policies need to set right incentives for industry while keeping energy and other materials affordable for general population. We look at two different approaches to policy pathways to reduce greenhouse gasses: (a) price and (b) standards.

Making a choice

This year, the world has witnessed the challenge of balancing commitment to climate goals while providing energy security to citizens. Policy choices, hence, must consider the long-term objective of reducing emissions while not being very difficult to implement socially. Imposing high economic costs on the society to meet long-term climate goals can have political repercussions.

Countries have started to make the transition to green technologies easier and faster using fiscal and regulatory means. The recent Inflation Reduction Act in the USA offers some of the largest fiscal incentives for green transition for both industry and consumers. India has created fiscal incentives in electric mobility (via the FAME scheme) and offered regulatory priority to renewable generation (for example, via priority dispatch, “always on”, etc.) Such regulatory and fiscal measures typically impact chosen sectors in the host countries.

Since climate change is a global issue, industries catering to mitigation, adaptation, and resilience are coming up in all countries. Even in the currently frayed geopolitical situation in the world, global trade still largely follows the theory of competitive advantage: countries which can produce goods or services most efficiently become large suppliers. As decarbonization efforts take root in various parts of the world, countries are choosing different policy pathways: some countries are pricing carbon via markets (typically accompanied by emission caps for sectors), others have put a tax on carbon, while some are optimizing their policy response.

Price is a function of market design

Whether carbon is priced in the market, or a price/tax is set by the government, the value of carbon can be very different across countries. This can be seen vividly in the difference in the price of carbon in Europe which trades at around USD 60/ton while in China the price is closer to USD 6/ton. This large variation rests of many factors including the amount of carbon credits allowed and the structure of the markets. For example, India’s proposed voluntary carbon markets may discover a price quite a variance with these two.

In case of other commodities, as the various parameters of market have standardized over a period, a global price is set based on the marginal producer’s cost (think wheat or oil). In the case of carbon where the standardization of market structures it yet to take place, this leads to large variations in prices discovered by each market. This has important implications for global trade.

Countries, especially the European Union (EU), are considering a carbon border adjustment mechanism (CBAM). The idea behind this policy response is that producers in Europe may become uncompetitive if they face a higher price of carbon compared to their competitors in other jurisdictions. In such cases, the plan is to impose a duty on goods entering Europe which seeks to equalize the price of carbon. An objective of this policy is that over time the price of carbon across the world rises which creates incentives for decarbonization.

Standards for quantity of emissions

Prices have a way of spurring innovation by sending out appropriate signals to industry and consumers. If for a good, demand is higher than supply, prices go up. The price of carbon may go up not so much because carbon is suddenly in higher demand (it cannot be so in a warming world!) but because of a tweak in the market architecture (lower supply of carbon emission allowances by a jurisdiction, for example). Alternatively, prices of carbon may suddenly fall if emission allowances are relaxed (say, in the times of a conflict when energy security requires reopening of coal-fired plants.)

An alternative way to consider aligning the global efforts on decarbonization is to consider setting tighter standards on the supply chain. This framework uses standards, rather than price, as the mechanism for aligning response from producers. A note on ‘Industrial Decarbonization and Competitiveness: A Domestic Benchmark Intensity Approach’ by Resources for the Future details this policy response. “This policy would define a performance metric for a selected set of industrial sectors and apply a fee based on the greenhouse gas (GHG) content of produced goods in those sectors, but only to the extent the goods’ GHG content exceeds the metric. The fee would be applied equally to both foreign and domestically produced goods, maintaining a level playing field.”

Mind your Ps and Qs

An analogy to understand this difference can be useful. Towards the end of the last century, as production shifted to the developing world, there were concerns regarding the sweatshop nature of some factories. The policy response that the world chose was to enhance and ensure working standards rather than mandating that the wages in the developing world be the same as in the developed world. If wages were sought to be equalized, the cost advantage that the developing world had would not stand.

As India considers its policy response to taking carbon emissions to Net Zero, it will be useful to consider the merits of setting standards of the GHG intensity in various sectors and putting a mechanism for the price of carbon. India should be clear on which framework (price or quantity) is to be used to bring greenhouse gasses emission under control and eventually to zero.

The author is with National Investment and Infrastructure Fund Limited. Views are personal.