Explained: What are Carbon Markets and How They Work

The Gujarat government signed a Memorandum of Understanding with Energy Policy Institute at the University of Chicago and Abdul Latif Jameel Poverty Action Lab on May 23, 2022 to set up India's first carbon market.

Carbon dioxide helps trap heat in the atmosphere and is also the primary greenhouse gas accounting for about 76% of total greenhouse gas emissions in the world.

Why are Carbon Markets Needed?

Since the beginning of the industrial era, human activities have raised atmospheric concentrations of CO2 by about 50%, according to the National Aeronautics and Space Administration. To tackle this, political authorities from nations across the world adopted the Kyoto Protocol, which committed to reducing greenhouse gases by implementing a strategy called carbon trading. The Protocol called for 38 industrialised economies to reduce their GHG emissions between 2008 and 2012 to levels 5.2% lower than 1990.

In 2015, a structured framework for carbon markets was put in place through the latest international treaty on climate change under Article 6 of The Paris Agreement. If executed correctly, international emissions trading could nearly double emissions reductions between 2020 and 2035, according to the Environmental Defence Fund (EDF).

What are Carbon Markets?

Carbon markets are created to discourage polluters from emitting more carbon into the atmosphere. Like any other trading market, a carbon market is a trading system in which carbon credits are either purchased or sold by regulated entities, mainly companies.

"Carbon markets are one of the instruments of pricing carbon," Vaibhav Chaturvedi, an economist and Research Fellow at the Council on Energy Environment and Water (CEEW), told FactChecker. "In any market, there is a commodity, a demand and supply of that commodity and then it's price. Here, carbon is the commodity. However, it is not an inherent market like the food market. Carbon markets are born out of externalities (unintended consequence of any production or consumption). Hence it will need strict regulations."

This approach to reducing carbon emissions focuses on putting a price on carbon. Assigning monetary value to carbon could potentially create responsibility within polluting companies for emissions that were previously unaccounted for.

How Do Carbon Markets work?

There are two ways of implementing carbon pricing: the emissions trading system, also known as the 'cap and trade' scheme, and carbon tax.

In the 'cap and trade' system, a regulator, in most cases the government, fixes an upper limit on emissions allowed across a given polluting industry. The government then issues a limited number of permits to these industries to cap the amount of carbon they are allowed to emit in a period of time. Each entity is either allotted a specific allowance of carbon it can emit (grandfathering) or has to buy emission rights through an auction process.

For instance, if a group of fossil-fuel fired power plants emit 1 lakh tonnes of carbon a year, the cap would mean that the government would allow the collective emissions across these plants to be 80,000 tonnes. If a plant manages to reduce its carbon emissions to levels lower than its emission rights, it is allowed to sell its carbon credits to another power plant that is finding it expensive to mitigate emissions in-house. Here, carbon credits are used as a currency or trading unit to trade carbon.

Carbon tax, on the other hand, is imposed on polluting industries that use coal, oil and natural gases for each tonne of CO2 they emit. The CEEW researcher explained that by placing higher taxes polluting industries are compelled to reduce the level of pollution and look to alternatives that impact the environment less. Since these taxes are imposed directly and do not require trading, they act as revenue for the government to fund various other sustainable development projects.

As of April 2021, the global rate of carbon ranges from less than $1 (Rs 77.70) to as high as $137 (Rs 10,647) per metric tonne of CO2, according to the World Bank's Global Carbon Pricing Dashboard.

How Effective is Carbon Pricing?

While carbon pricing has been hailed as an effective tool in reducing carbon emissions, environmentalists argue that the challenges lie in applying the strategy. According to findings of the Stockholm Environment Institute, around 80% of projects under the carbon trading scheme in both countries were of low environmental quality and that the system had actually increased emissions by 600 million metric tonnes.

The one common concern is the possibility of double counting, which is a situation where two parties claim the same carbon removal or emission reduction. All countries have emission targets. For instance, if a developing country reduced its carbon emissions by 1 metric tonne through an energy efficient scheme, and sold its reduction to a developed country and also counted the reduction in its own target, it would lead to double counting. According to Carbon Market Watch, it is equivalent to "cheating" the atmosphere.

Secondly, political and corporate corruption could lead to a carbon market collapse. In 2015, companies in Russia and Ukraine abused the system in this manner. It is imperative to look at carbon trading from the context of every economy, said Chaturvedi while adding that although carbon markets as an instrument to reduce emissions is useful, it is the relaxed regulations that could make it ineffective. "It is not the fault of the instrument but the relaxation in caps by regulators that lead to lower mitigation of emissions," he said.

Where Does India Stand in Carbon Trading?

While India does not have a formal mechanism or policy for carbon markets yet, it has four schemes that place a price on carbon in one way or another, according to the Bureau of Energy Efficiency, a statutory body under the Ministry of Power.

1. Coal Cess: A tax on coal was introduced by the Indian government in 2010. Under this scheme, tax was to be levied as excise duty on items such as coal, lignite and peat. The cess rate steadily increased from Rs 50 in 2010 to Rs 400 in 2016.

While the scheme was aimed at utilising the collected revenue to finance clean-energy initiatives and research via the National Clean Energy Fund, it failed. Of the Rs 86,440 crore collected as cess, Rs 15,911 crore ended up being utilised for the desired purpose.

In 2017, the coal cess was abolished and replaced by the GST Compensation Cess. Currently, the proceeds from this tax are used for compensating states for revenue losses.

2. Perform Achieve and Trade Scheme: Under this scheme which was launched in 2008, the government assigns specific energy reduction targets to major polluting industrial sectors. Those exceeding the targets are awarded Energy Saving Certificates (ESCerts) while industries that don't meet these targets are required to purchase ESCerts from industries that have exceeded their targets through a centralised online trading mechanism hosted by the Indian Energy Exchange.

3. Renewable Energy Certificates: Renewable Energy Certificate (REC) which was introduced in 2010 is a market-based instrument meant to promote renewable energy and facilitate compliance of renewable purchase obligations. Under this scheme, electricity distribution agencies are required to purchase or produce a minimum specified quantity of their requirements from renewable energy sources. Under this scheme, one REC is created when 1 MWh is generated from renewable energy.

In the last decade, India's REC market has recorded net sales of Rs 9,266 crore, according to a study conducted by CEEW. The study highlighted that RECs saw a linear trend line in volume growth till 2020, but due to inadequate demand and supply, the scheme was later suspended.

3. Internal Carbon Pricing (ICP) Scheme: ICP is a mechanism for private companies to voluntarily reduce emissions so they can channel investments towards clean and energy-efficient technologies and meet corporate sustainability goals. As of 2019, more than 1,600 companies worldwide were practising ICP strategies. In India, in 2019, 697 companies practised internal carbon pricing.

Avantika Goswami, Programme Manager, Climate Change, Centre for Science and Environment, wrote in an article on Down To Earth, that between 1990 and 2019, China, along with the original seven, was behind 67% of the world's emissions. The remaining world, which is home to about 66% of the world population, emitted only 33%.

China and the developed world will continue to grab the lion's share of the carbon budget in 2020-30 and the burden of reducing emissions will be borne by developing countries.