Abstract
Sustainable development frameworks, formulated over the decades such as the Kyoto Protocol and the Paris Climate Agreement are underpinned by the Polluter’s Pay Principle, which mandates that polluters bear the full cost of the environmental impacts of their activities, including mitigation and prevention expenses. In this regard, carbon pricing has emerged as a pivotal financial instrument within these frameworks, operationalized through both market-based and tax-based mechanisms to curtail Green-House Gas (GHG) emissions, devised in the form of Emissions Trading Systems (ETS), baseline-and-credit systems and voluntary markets, which have been implemented for the same. Examining, the recent implementation of the Carbon Credit Trading System (CCTS) in India earlier in 2023, this blog postulates the CCTS as a significant advancement in the development of the Indian Carbon Market (ICM). Noting that for ensuring effective implementation of the CCTS, overcoming the shortfalls of the erstwhile Perform, Achieve, and Trade (PAT) scheme is imperative, along with enhanced transparency in reporting standards and robust penalty frameworks, and that addressing these challenges and leveraging previous experiences can pave the way forward in India, for effective utilization of the carbon markets for mitigating climate change.
Introduction
Reliable research around the world confirms that human activity is the primary cause of rising global temperatures. As human activity expanded, large and intensive volumes of greenhouse gas (‘GHG’) emissions were distributed, trapping heat in the atmosphere. Consequently, sustainable development frameworks have been formulated over the last three decades through multilateral international agreements. The Kyoto Protocol, 1997, and the Paris Agreement, 2015 (collectively ‘Agreements’) set binding targets on parties to reduce their GHG emissions. To assign responsibility, the Agreements had infused the environmental economic theory of cost allocation called the “Polluter-Pays Principle.” The principle states that the polluter is responsible for paying for all the external costs associated with polluting the environment which includes mitigation, prevention, and public costs (healthcare, loss of movable and immovable property, etc.). This meant that the burden of reducing GHG emissions was on the polluter. To ensure the effectiveness of this burden, the Agreements created provisions that led to the development of a financial tool called Carbon Pricing.
Carbon Pricing and Market-based Mechanisms: The Way Forward?
Carbon pricing has been widely operated as a market-based mechanism, and as a tax-based mechanism (a direct carbon tax on GHG emissions) to reduce GHG emissions. Specifically, Article 17 of the Kyoto Protocol recognized the significance of trading carbon (a market-based mechanism) as a commodity to reduce GHG emissions.
Market-based mechanisms are structured in three ways. First, it can exist as a cap-and-trade system (commonly known as the Emission Trading System (ETS). Second, it can exist as a baseline-and-credit system. Third, it can exist as a voluntary market.
In the cap-and-trade system (ETS), the government sets an emission ‘cap’ on the total volume of GHG emissions by allotting a specific number of carbon credits to each polluter. Wherein, 1 Carbon Credit is equal to 1 metric ton of CO2. If a polluter exceeds the emissions cap (that is, exhausts the allotted number of carbon credits), the polluter must purchase additional carbon credits to pollute further. Conversely, if the polluter’s emissions are below the emissions cap (that is, the polluter has additional carbon credits), the polluter can sell its additional carbon credits. This regulatory nature of the cap, therefore, results in the establishment of a carbon market where carbon credits are ‘traded’ between purchasers and sellers.
Theoretically, the market price of 1 metric ton of CO2 equals the consolidation of all external costs of emitting GHG. Undoubtedly, a scarce supply of carbon credits and a demand for these credits will further influence the carbon credit market price. In the baseline-and-credit system, GHG emissions intensity or volume targets are set to act as a ‘baseline’. If the polluter exceeds the intensity or volume target, they must purchase carbon credits to meet the shortfall. Conversely, if the polluter achieves the intensity or volume target below the baseline, carbon credits are issued to them by the government which may then be sold.
Specific industries are identified as obligated entities (sector-wise or individually) under the cap/baseline system. This would mean carbon markets under the two systems will only contain obligated entities as purchasers and sellers of carbon credits. In other words, the carbon markets under the two systems would be a mandatory market. However, there are additionally established markets known as voluntary markets where ‘carbon offset credits’ are traded between purchasers and sellers.
Unlike mandatory markets, both obligated and non-obligated entities (including individuals) could participate in the voluntary market. Carbon offset credits are issued by either governments or accredited organizations to those who voluntarily engage in activities that remove GHG emissions from the atmosphere. Activities include reforestation, renewable energy, landfill operations, etc. Non-obligated entities obtain carbon offset credits by merely engaging in activities that remove GHG emissions from the atmosphere. For every 1 metric ton of CO2 removed from the atmosphere, 1 carbon offset credit is issued.
System for Carbon Credit Verification
The trustworthiness of these activities must be verified. The verification is either conducted by the government or by accredited organizations such as Verra and Gold Standard. After obtaining the carbon offset credits, the non-obligated entity can sell these credits in the voluntary market. The offset credits may then be purchased by obligated entities that require additional carbon credits for complying with the cap/baseline system depending on the laws of the jurisdiction. Alternatively, the obligated entities could develop their own GHG reduction projects or enter into contracts with such projects to obtain carbon offset credits. However, most jurisdictions do not allow voluntary offset credits to be utilized for compliance requirements. For countries with mandatory and voluntary markets, the carbon market price will vary between the mandatory and voluntary markets.
The three systems have different structures but the functioning and the outcome are the same. The market systems have a primary goal: to reduce GHG emissions. The three systems adopt the same formula, which is to create a market, based on artificial supply and demand. Countries may adopt a standalone system (that is, only one market-based system) or a variation of the three systems. Now, the effectiveness of the market-based mechanism is, however, dependent on how efficient the incentives and the disincentives are.
For instance, the incentive here is the utility of carbon credits as a financial instrument to generate revenue. Alternatively, the polluter’s disincentive here are the costs associated with breaching compliance and the economic costs associated with emitting more. Carbon market case studies have shown compelling reasons to continue with carbon trading as a method to combat GHG emissions. However, it has also revealed that discretionary and partial implementation can render the carbon market futile. In other words, a lack of regulatory discipline results in an unbalanced set of incentives and disincentives. A suitable example that addresses this concern lies in India’s regulatory carbon market, which is said to commence in 2025-26.
The Indian Carbon Market:
On 28 June 2023, the Central Government of India through its Ministry of Power, and in consultation with the Bureau of Energy Efficiency (‘BEE’) issued a notification introducing the Carbon Credit Trading Scheme, 2023 (‘CCTS’). The Indian CCTS is a framework to “reduce, remove or avoid GHG emissions from the Indian economy by pricing GHG emissions through the trading of carbon credit certificates.” To achieve this objective, the CCTS established the Indian Carbon Market (‘ICM’), through which carbon credits are purchased and sold.
Like China, the Indian CCTS framework is structured as a baseline-and-credit system. Section 11(4) of the CCTS framework acts as the baseline provision wherein the compliance mechanism sets GHG emission intensity targets as the baseline. However, Section 11(5) appears to be a non-exhaustive provision. It allows the regulator to set “any other target” as it may see fit. This would only indicate that the CCTS framework is flexible to incorporate the cap-and-trade system. Sections 11(6) and 11(7) act as the carbon credit provisions of the compliance mechanism. Under Section 11(6), if the obligated entities reduce their GHG emissions intensity below the baseline, the regulator issues carbon credit certificates. Under Section 11(7), if the obligated entities do not achieve their GHG emissions intensity target, they must purchase carbon credit certificates from the ICM.
The CCTS framework is undoubtedly a mandatory system where the obligated entities are the purchasers and the sellers. However, on 19 December 2023, the Ministry of Power amended the CCTS framework by inserting an offset mechanism provision. Under Section 11A, non-obligated entities can now be issued carbon credit certificates for the reduction, removal, or avoidance of GHG emissions. With the introduction of non-obligated entities, India now has a voluntary carbon market where carbon credits can be purchased or sold between obligated and non-obligated entities.
Now, an efficient development of this Indian carbon market depends on how closely it pays attention to its implementation gap. For instance, a record of its predecessor “Perform, Achieve and Trade” Scheme (‘PAT scheme’) offers us some insights into the pitfalls that the CCTS framework can likely face.
The Perform, Achieve and Trade (PAT) Scheme
The BEE launched the Perform, Achieve, and Trade (PAT) scheme in 2008. The PAT scheme aimed at reducing specific energy consumption among energy-intensive industries. To do this, the PAT scheme also established a baseline-and-credit system where Energy-Saving Certificates (‘ESCerts’) are issued to industries that have overachieved their targets. These industries sell their additional ESCerts on the Indian Energy Exchange and Power Exchange India Limited. Likewise, industries that have failed to reduce will purchase these ESCerts from the market. While the PAT scheme shows a market-based resemblance to the CCTS framework, the objective and the compliance mechanisms within the PAT scheme had implementation drawbacks. This becomes a useful implementation study for the efficient functioning of the ICM.
Applying PAT Scheme Insights to Improve CCTS Compliance and Efficiency
First, energy consumption reduction targets set under the PAT scheme were too low. In the first compliance cycle of the PAT scheme, a Centre for Science and Environment (‘CSE’) study revealed that most obligated sectors overachieved their targets by 41% to 142%. Furthermore, the power sector had the lowest target of 3.07%, but still failed to achieve that target.
It was found that there was only a 3% reduction in GHG emissions from the power sector. This offers us three implications. First, the CCTS framework cannot be complacent in setting low targets like the PAT scheme. Second, the question remains: why did the power sector underachieve, despite having the lowest target out of all sectors? Even though the CCTS framework is currently being developed for the cement, steel, pulp, and paper sectors, this question will likely continue if it is not addressed. Third, the CCTS framework must be conscious of any economic shocks that may arise to the industries if the targets are too high.
Second, when the supply of ESCerts is more than the demand, the price of ESCerts will fall. The supply of ESCerts became abundant because the target levels were too low. When target levels are too low, energy reduction compliance can be easily shown as we saw above. Consequently, the supply of ESCerts increased, while demand reduced, making the price low. This would mean that the industries that could not comply could emit more while buying ESCerts at a lower cost. As a result, there is no financial disincentive for industries to pollute less. This was the exact scenario during the second PAT Cycle. 5.7 million ESCerts were issued against a demand of 3.6 million. During the 1st PAT cycle, the price fluctuated between INR 200 and INR 1200 which was considered too low for an ESCert. To avoid this fluctuation, a floor price of INR 1840 was set in the 2nd cycle. The first ETS established by the European Union in 2005, also faced a similar crisis.
During Phases 1 and 2 of the EU ETS, additional allowances were issued freely to industries as there was political pressure to ensure economic competitiveness. This resulted in higher emissions and the additional allowances were sold for a profit to other entities, despite a fall in the prices of CO2. However, later studies showed that economic shocks were not as significant as it was assumed and in fact, indicated that the ETS offered greater benefits including innovation and higher investments. This supply-demand imbalance is equally applicable to the ICM. If the target is set too low, the price of carbon credits will face the same path.
Third, the CSE had indicated that the regulator did not enforce the PAT compliance deadlines strictly. The regulator allowed industries to delay their compliance and timely penalties were not levied against them. For instance, it was found that 56% of compulsory ESCerts were not yet purchased. Compliance or non-compliance documents were filed in an untimely manner. The CSE also pointed out that these documents were confidential and were not allowed for public review. The Chinese Carbon Market faced similar compliance issues including manipulating emissions data, side-deal agreements with verification agencies, and a delay in submitting the compliance data. It was noted that there was no trust in the functioning of the market which led to the fall in carbon credit prices. These implementation issues were dealt with by enhanced reporting requirements, incorporating higher penalties for non-complying entities, and setting up additional monitoring systems. Here, it is suggested that the reporting requirements for obligated entities under the CCTS framework should be akin to a higher reporting standard required under Securities Exchange Board of India (‘SEBI’) laws.
Alternatively, additional reporting mechanisms could be established. For instance, publicly listed companies in the National Stock Exchange (‘NSE’) or the Bombay Stock Exchange (‘BSE’), which are also obligated entities under the CCTS framework could be required to file compliance documents to SEBI. Just as how listed companies need to make a mandatory disclosure of their CSR activities, obligated entities could be mandated to disclose detailed compliance reports on their website. The BEE must also provide a regular update as to the CO2 targets set, the deadlines for compliance, the methodology used for setting the targets, the number of carbon credits issued to obligated and non-obligated entities, the names of non-complying entities, and the penalties levied on those entities. Additionally, the ICM must summarize the day-to-day trading of carbon credits such as the volume and the price. Therefore, the motivation is to create timely and accurate disclosures, resulting in greater accountability.
Fourth, the compliance reporting cycle of the PAT scheme was three years, while the CCTS reporting cycle is now 1 year. The three-year requirement, under the PAT scheme, was found to be inefficient. First, companies would have to wait for three years, at a time, before they start trading ESCerts. This would mean that there is illiquidity in the market. Second, due to a three-year-long compliance period, the obligated entities failed to implement a consistent energy-saving framework. This led to a delay beyond the compliance period. Learning from this mistake, the CCTS now seeks to reduce the compliance period to a year. Here, it is also suggested that the obligated entities could submit quarterly reports. This allows for faster liquidity in the market and also pressurizes the obligated entities to create consistent plans for reducing GHG emissions.
Fifth, the efficiency of the credit-and-baseline mechanism has been questioned for several reasons. First, as emissions intensity is the focus of reduction, a baseline has to be set for every emissions activity in the industrial process. In a cap-and-trade system, the regulator would merely place a total emissions volume cap across the process and not for each activity. Second, this causes concern for the complexity that may arise from the credit-and-baseline mechanisms. A complex layer of baselines may cause these industries to manipulate their emissions intensity formula to adjust with the baseline formula. This would mean that the regulator must pay close attention to the functioning of every industry, and then standardize the formula for calculating proper emission intensity reduction. A generalized formula encompassing all industries will, therefore, not be efficient. For instance, highly intensive industries should be set high targets, in comparison to the lesser intensive industries. Third, it has been argued to cause market illiquidity because entities must wait until the end of the year to trade in the market.
Sixth, under the PAT scheme, if the obligated entities failed to reduce their energy consumption or failed to buy ESCerts, they would be subject to penalties. However, this was not the reality. For instance, the BEE never collected any penalty from the violators for the last ten years. If the BEE is not strict in complying with its procedures, it is unlikely that the “too big to fail” industries will follow. Now, the CCTS framework does not have a penalty provision. The draft compliance procedure merely acknowledges that non-complying entities should be penalized. Here, it is suggested that the penalties that may be imposed could be akin to the penalty procedure followed by SEBI. Additional penalties could also be levied by SEBI. The CCTS framework is also unclear as to whether carry-forward provisions will apply. Here, are carbon credits achieved in a financial year allowed to be carried forward to another year? Likewise, will entities that have not complied be required to fulfill a higher target in the next financial year?
Seventh, data from the CSE have shown that the PAT scheme had little influence on reducing GHG emissions, even though several obligated industries reduced their energy consumption. 1 ESCert = 1 metric ton of oil equivalent of energy consumed. In other words, the PAT scheme is broadly oriented towards the efficient use of energy, rather than emission reduction as the main objective. This means that the scheme uses reduced energy consumption as the financial unit (that is, the lesser the energy consumed from the baseline, the greater the number of ESCerts that will be issued). Therefore, under the PAT scheme, any emission reduction is a mere implication of the broader goal of efficient energy consumption. In contrast, 1 carbon credit equals 1 metric ton of CO2 emitted in the atmosphere. In other words, the CCTS framework is more streamlined by focusing exclusively and directly on removing GHG from the atmosphere. This makes the CO2 reductions as the unit, instead of energy savings. Institutionalizing CO2 as a unit is better suited than energy savings because it compels industries to innovate and remove GHG emissions from the atmosphere.
Conclusion
India is the 3rd largest CO2 emitter in the world and is said to have lost 8% of its GDP in 2022, due to climate change. India had established the PAT scheme with the aim that it would reduce GHG emissions. However, its implementation flaws prevented its reduction. Now, it has established a $1.2 billion Carbon Market intending to reduce CO2 emissions from the atmosphere. With more than 15 years of experience under the PAT scheme, the BEE should strive to create efficiency in the Indian Carbon Market. At this point, the BEE must recognize that a lack of strong implementation is the cause of inefficiency. It cannot afford to make the same mistakes as it did under the PAT scheme as there is an urgent need to combat climate change and global warming. The Indian Carbon Market is, therefore, at the perfect stage of influencing industries to emit less and to also act as an economic incentive for investors.
Authors:
Anirudh Ramakrishnan is a dual-qualified attorney licensed to practice law in India and California, United States. He holds a B.A., LL.B (Hons.) from NALSAR University of Law, Hyderabad, and an LL.M. with a Certificate in Business Law from UC Berkeley, California. Presently, Anirudh practices independently before the Madras High Court. He is set to join Wingert Grebing Brubaker & Walshok LLP as a litigation attorney in California.
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