Carbon pricing

Topic: Environment and Sustainable Development · NCERT: Beyond NCERT

Meaning

Carbon pricing means putting a money price on every tonne of greenhouse gas (GHG) released, measured in CO₂e (carbon dioxide equivalent: other gases are converted into the amount of CO₂ that would cause the same warming). It is done mainly through a carbon tax or a cap-and-trade system (ETS), so that polluters pay the climate damage their emissions cause.

It matters because pollution is a negative externality, a cost the polluter does not pay. If carbon has no price, fossil fuel power looks cheaper than it really is, so society makes and uses too much of it. Carbon pricing makes the polluter bear the full social cost.

• Marginal social cost (MSC) = Marginal private cost (MPC) + Marginal external cost (MEC)
• Efficient carbon price = marginal damage from one more tonne (the Pigouvian tax rule)

Explanation

1. Why carbon needs a price: the externality problem

• Externality: a cost or benefit that falls on people outside a deal. The buyer and the seller do not pay for it.
• Example: a coal power plant
• Its selling price covers fuel, labour and capital.
• Its smoke damages farms and people's lungs, and it adds to global warming. Nobody sends the plant a bill for this.

• Result: power is under-priced, so it is over-produced.

• Key cost terms:

• MPC: what one more unit costs the firm itself.
• MEC (marginal damage): the harm that one extra unit does to others.

• MSC = MPC + MEC

• Internalisation of externalities means making the polluter's own accounts show the full social cost.

• Three routes to internalisation:
• Pigouvian tax: a tax per unit of pollution, set equal to marginal damage. Its weakness is that the regulator must know the damage figure.
• Tradable permits: the government fixes the total amount of pollution and firms trade permits. This needs good monitoring and a registry.

• Coasean bargaining: polluters and victims negotiate privately. It works only when property rights are clear and only a few parties are involved. It fails for climate, because billions of people are affected.

• Worked example: Pigouvian tax

• One tonne of CO₂ does ₹2,000 of damage, so the government sets a tax of ₹2,000/t.
• The firm keeps cutting emissions as long as cutting a tonne costs less than ₹2,000, because cutting is cheaper than paying the tax.
• It stops when its marginal abatement cost (the cost of cutting one more tonne) reaches ₹2,000.
• At that point, the cost of cutting the last tonne equals the damage that tonne would do. This is the efficient level of pollution.

2. The two main tools: carbon tax vs cap-and-trade

	Carbon tax	Cap-and-trade (ETS)
Government fixes	Price per tonne	Quantity (the cap on total emissions)
Uncertain	How much emissions fall	The permit price
Main plus	Steady revenue that can be recycled, e.g. into tax cuts or cash transfers to the poor	Market finds the cheapest cuts, and the total emissions are certain
Example	Sweden	EU ETS (2005), China national ETS (2021)

• How cap-and-trade works
• The regulator sets a cap and issues the same number of allowances. One allowance is the right to emit 1 t CO₂e.
• Firms that can cut cheaply cut extra and sell their spare permits.
• Firms that find cutting costly buy those permits.

• Result: the cap is met at the lowest total cost.

• Worked example: cap-and-trade

• Firm A can cut CO₂ at ₹500/t. Firm B can cut at ₹3,000/t. The cap requires a total cut of 100 t.
• Without trading, each firm cuts 50 t: (50 × 500) + (50 × 3,000) = ₹25,000 + ₹1,50,000 = ₹1,75,000.
• With trading, A cuts all 100 t for ₹50,000 and sells 50 permits to B. The permit price settles between ₹500 and ₹3,000.

• Society saves ₹1,25,000 and still meets the same cap.

• Global spread

• Carbon pricing covers about 28% of global GHG emissions (2025).
• 80 instruments are in operation: 43 carbon taxes and 37 ETSs [5].
• Jurisdictions with almost two-thirds of world GDP have a direct carbon price [5].
• Carbon pricing revenue was more than US$100 billion in 2024 [4].

3. How high should the price be? Benchmarks

• Social cost of carbon (SCC): the present value of all future damage from emitting one more tonne of CO₂. It is the benchmark for setting a carbon price.
• The US EPA estimate (2023) was about $190/t. It was later withdrawn, so check its current status before you quote it.

• Formula: PV = D / (1 + r)^t

  • D = damage in a future year
  • r = discount rate (how much less we value money received in the future)
  • t = number of years from now

• Worked example: a tonne emitted today causes ₹10,000 of damage 50 years from now.

• At r = 2%: 10,000 / 1.02⁵⁰ = 10,000 / 2.69 ≈ ₹3,715
• At r = 5%: 10,000 / 1.05⁵⁰ = 10,000 / 11.47 ≈ ₹872

• Lesson: the discount rate changes the SCC more than any other assumption. Choosing it is an ethical question: how much weight do we give future generations?

• Internal carbon price: an imaginary price that a company uses to evaluate its own projects.

• Example: a firm assumes ₹3,000/t. A coal boiler then looks costlier than solar-plus-storage, so the firm picks solar.
• It prepares the firm for future regulation. It is not a tax.

4. Negative carbon price: fossil fuel subsidies

• Fossil fuel subsidies make fossil fuels cheaper. They work as a negative carbon price: the state effectively pays people to pollute instead of charging them.
• The IMF uses two categories:
• Explicit subsidy: fuel sold below its supply cost.

• Implicit subsidy: no charge for environmental damage (global warming, local air pollution).

• IMF global estimate (2022): US$7 trillion, or 7.1% of world GDP [7].

• Explicit: 18%. Implicit: 82% [7].

• Consumers did not pay for over US$5 trillion of environmental costs [7].

• Carbon leakage is a side risk of carbon pricing. Production moves to countries with weaker climate rules, so the cuts made in one country are cancelled out by higher emissions elsewhere.

In India

• India has no explicit, economy-wide carbon tax. It prices carbon implicitly (indirectly, through other taxes):
• Clean Energy Cess on coal (a cess is a tax collected for a specific purpose)
  • It started at ₹50/t (2010) and rose to ₹400/t by 2016.
  • It was subsumed into the GST compensation cess in 2017. How coal is taxed after the 2025 GST changes needs verifying.
  • Illustration: if 1 t of coal gives off about 1.5 t CO₂, ₹400/t is roughly ₹270 per tonne of CO₂.
• Excise duty on petrol and diesel, which works like a carbon tax on transport.
• Green tax on old vehicles, which pushes owners to retire polluting vehicles.

• Delhi's Environment Compensation Charge (ECC) on trucks entering the city.

• Removing negative carbon prices

• Petrol prices were decontrolled in 2010 and diesel in 2014. Oil companies now set these prices in line with the market.

• The LPG subsidy moved to DBT (Direct Benefit Transfer: the money goes straight into the bank account, so less leaks to people it was not meant for).

• Steps towards a domestic carbon market

• PAT scheme (Perform, Achieve and Trade), 2012: energy-intensive plants get energy-saving targets. Plants that beat their target earn ESCerts (Energy Saving Certificates), and plants that miss it buy them.
• RECs (Renewable Energy Certificates): tradable proof that renewable power was generated. Discoms (power distribution companies) buy them to meet their renewable purchase obligations.
• Energy Conservation (Amendment) Act, 2022: gave the government the legal power to specify a carbon credit trading scheme.

• Carbon Credit Trading Scheme (CCTS), notified in June 2023: created the Indian Carbon Market (ICM) and the National Steering Committee for the Indian Carbon Market (NSCICM) [2].

  • Its aim is to reduce or avoid GHG emissions by pricing them through tradable Carbon Credit Certificates (CCCs) [2].

• Institutions under CCTS

• BEE (Bureau of Energy Efficiency): administrator
• Grid-India: registry (keeps the record of who holds which credits)

• CERC (Central Electricity Regulatory Commission): regulates trading

• Compliance mechanism

• Obligated Entities must meet GHG Emission Intensity (GEI) targets, measured in t CO₂e per tonne of product. These are not absolute caps [2][3].
• Entities that do better than their target earn CCCs and sell them. Entities that miss their target buy them [2].
• The first targets covered 7 sectors moved over from PAT: aluminium, cement, chlor-alkali, petrochemicals, petroleum refineries, pulp and paper, and textiles [2].

• Later, GEI targets were notified for 208 more carbon-intensive industrial units [1].

• Offset mechanism: entities that are not obligated can voluntarily register projects and earn credits.

• Worked example: intensity target
• A cement plant's target is 0.60 t CO₂e per t of cement, and it makes 10 lakh t. Allowed emissions = 6 lakh t CO₂e.
• Its actual intensity is 0.57 t, so it emits 5.7 lakh t and earns 30,000 CCCs (1 CCC = 1 t CO₂e) to sell.

• Total emissions can still rise if output grows. This fits India's NDC, which is an emissions-intensity-of-GDP target (emissions per rupee of GDP).

• International links

• Under the Kyoto Protocol's Clean Development Mechanism (CDM), India was the second-largest host after China.

• Under the Paris Agreement, India notified its list of activities eligible for Article 6.2 in 2023.

• CBAM exposure

• The EU CBAM (Carbon Border Adjustment Mechanism) charges for the embodied carbon of imports, meaning the emissions released while making the product.
  • Transitional phase (reporting only): from October 2023
  • Definitive phase (payment): from 2026
  • Covers steel, aluminium, cement, fertilisers, electricity and hydrogen
• India's steel and aluminium exports to the EU are most exposed.
• India calls CBAM unilateral (imposed by one side without negotiation) and against CBDR (Common But Differentiated Responsibilities: rich countries, which caused most past emissions, should carry a bigger burden).
• A working domestic carbon price (CCTS) can help Indian exporters argue for a deduction under CBAM.

Don't confuse with

• Carbon tax vs cap-and-trade: a carbon tax fixes the price and leaves the amount of emission cuts uncertain. Cap-and-trade fixes the quantity and leaves the permit price uncertain.
• Social cost of carbon vs internal carbon price: the SCC is the present value of damage from one more tonne, used as the benchmark for public policy. An internal carbon price is an imaginary price a company uses to choose between its own projects. Neither one is a tax.
• Carbon credit vs Green Credit: a carbon credit is a certificate for 1 t CO₂e reduced, avoided or removed. A Green Credit (Green Credit Programme) rewards actions like tree planting or water conservation. It is not a certified tonne of CO₂e.
• Compliance vs voluntary carbon market: a compliance market is created by law, and covered entities must surrender allowances or credits. In the voluntary market, buyers offset by choice, using standards such as Verra and Gold Standard.

Prelims Hooks

• Pigouvian tax = a tax per unit of pollution equal to marginal external damage. MSC = MPC + MEC.
• EU ETS began in 2005. China's national ETS began in 2021. Sweden is the classic carbon-tax example.
• Worldwide there are 80 instruments (43 taxes, 37 ETSs), covering about 28% of global GHG emissions (2025) [5]. Revenue was more than US$100 billion in 2024 [4].
• CCTS (June 2023) comes under the Energy Conservation (Amendment) Act 2022. BEE is the administrator, Grid-India the registry and CERC the trading regulator. Targets are emission intensity (GEI), not absolute caps [2].
• Trap: the Clean Energy Cess on coal went from ₹50/t (2010) to ₹400/t (2016) and was subsumed into the GST compensation cess in 2017. India has no explicit economy-wide carbon tax.
• IMF: fossil fuel subsidies were US$7 trillion (7.1% of world GDP) in 2022, and 82% were implicit [7]. Subsidies work as a negative carbon price.

Mains Points

• Tax vs trade in India's context
• A carbon tax brings certain revenue and is simple to run. This suits a country with limited monitoring capacity.
• An intensity-based ETS (CCTS) protects growth, because output can still rise, and it rewards efficient plants.

• The trade-off: intensity targets do not guarantee that absolute emissions fall.

• Fix negative carbon prices first

• Implicit subsidies (82% of the global total) act as a negative carbon price [7].
• India's fuel decontrol (2010, 2014) and DBT for LPG show that reform works when targeted cash support protects the poor.

• Carbon revenue can be recycled into a just transition for coal-dependent states.

• Integrity and CBAM (GS-II/III)

• Carbon prices only mean something if credits pass four tests:
  • additionality: the cut would not have happened without the credit money
  • permanence: the carbon stays locked away
  • no leakage: emissions do not simply move elsewhere
  • no double counting: the same tonne is not claimed twice
• The REDD+ scandals show the risk of greenwashing (claiming green credentials that are not real). Corresponding adjustments under Article 6 and the COP29 standards on baseline, leakage and reversal strengthen integrity [6]. India needs strong MRV (Monitoring, Reporting and Verification).
• CBAM shifts the climate burden onto developing-country exporters. India's answer:
  • WTO and UNFCCC diplomacy against unilateral measures
  • a credible CCTS price to seek a CBAM deduction
  • green steel and aluminium technology

Related concepts

• Internalisation of externalities
• Green tax
• Social cost of carbon
• Internal carbon price
• Fossil fuel subsidies
• Cap-and-trade
• Carbon market
• Compliance carbon market
• Voluntary carbon market
• Carbon credit

Read more

• Pricing pollution: carbon taxes, cap-and-trade and carbon markets