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

Detail

1. Why pollution needs a price: externalities

• Externality: a cost (or benefit) that falls on people outside a deal. The buyer and seller do not pay for it.
• Pollution is a negative externality. It is a cost the polluter does not pay.
• A coal plant sells power at a price that covers fuel, labour and capital.
• The smoke harms nearby farms and people's lungs, and it adds to global warming. Nobody bills the plant for this.

• Result: the power looks cheaper than it really is, so society makes and uses too much of it.

• Private cost vs social cost:

• Marginal private cost (MPC): the cost to the firm of making one more unit.
• Marginal external cost (MEC) or marginal damage: the harm to others from that one extra unit.

• Marginal social cost (MSC) = MPC + MEC

• Internalisation of externalities means making the polluter bear the full social cost, so the cost shows up in its own accounts.

2. Three routes to internalisation

Route	How it works	Condition / weakness
Pigouvian tax (see taxation)	A tax per unit of pollution, set equal to marginal damage	The regulator must know the damage figure
Tradable permits	The government fixes total pollution and issues permits, which firms trade	Needs good monitoring and a registry
Coasean bargaining (see market-structures-competition)	The polluter and the victims negotiate privately	Works only where property rights are clear and there are few parties. It fails for climate, where billions of people are affected.

• Worked example: Pigouvian tax
• One tonne of CO₂ causes ₹2,000 of damage. The government sets a tax of ₹2,000/t.
• A firm keeps cutting emissions as long as cutting a tonne costs less than ₹2,000. It is cheaper to cut than to pay the tax.
• The firm stops when its marginal abatement cost (the cost of cutting one more tonne) reaches ₹2,000.
• At that point, what it costs to cut the last tonne equals the damage that tonne would cause. This is the efficient level of pollution.

3. Carbon pricing: tax vs cap-and-trade

• Carbon pricing puts a money price on each tonne of greenhouse gas (GHG) emitted, measured in CO₂e (carbon dioxide equivalent: other gases are converted into the amount of CO₂ that would cause the same warming).

	Carbon tax	Cap-and-trade (ETS)
What the government fixes	Price per tonne	Quantity: the cap on total emissions
What stays uncertain	How much emissions fall	The permit price
Main advantage	Steady revenue that can be recycled, e.g. into tax cuts or cash transfers to the poor	The 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 caps total emissions and issues that many allowances (1 allowance = the right to emit 1 t CO₂e).
• Firms that can cut emissions cheaply cut more than they need to, then sell their spare permits.
• Firms that find cutting expensive buy those permits.

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

• Worked example: cap-and-trade

• Firm A can cut CO₂ for ₹500/t. Firm B can cut CO₂ for ₹3,000/t. The cap requires a 100 t cut in total.
• 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 will settle between ₹500 and ₹3,000.

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

• Global spread

• Carbon pricing covers about 28% of global GHG emissions (2025).
• There are 80 instruments in operation: 43 carbon taxes and 37 ETSs [6].

• Jurisdictions with almost two-thirds of world GDP have a direct carbon price [6].

• Carbon pricing revenue exceeded US$100 billion in 2024 [5].

4. Benchmarks for the "right" price

• 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.
• US EPA estimate (2023): about $190/t. It was later withdrawn, so check the current status before you quote it.
• Formula (present value): PV = D / (1 + r)^t
  • D = damage in a future year
  • r = discount rate (how much less we value money in the future)
  • t = years from now

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

  • At r = 2%: PV = 10,000 / 1.02⁵⁰ = 10,000 / 2.69 ≈ ₹3,715
  • At r = 5%: PV = 10,000 / 1.05⁵⁰ = 10,000 / 11.47 ≈ ₹872
  • Lesson: the choice of discount rate changes the SCC more than any other assumption. This is an ethical question about how much weight we give future generations.

• Internal carbon price: a make-believe price per tonne that a company uses when it evaluates its own projects.

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

5. Green taxes and India's implicit carbon price

• Green tax: a tax on goods or activities that harm the environment.
• 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)
  • Rates: ₹50/t (2010), raised 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, a ₹400/t cess 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, to push owners to retire polluting vehicles.
• Delhi's Environment Compensation Charge (ECC) on trucks entering the city.

6. Fossil fuel subsidies: a negative carbon price

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

• Implicit subsidy: not charging for environmental damage, such as global warming and local air pollution.

• IMF global estimate: US$7 trillion in 2022, or 7.1% of world GDP [8].

• Explicit subsidies were 18% of this and implicit subsidies 82% [8].
• Consumers did not pay for over US$5 trillion of environmental costs [8].

• The IMF (NCERT scaffold) separates explicit from implicit subsidies; the IMF data above adds the size of each.

• India's reforms

• Petrol prices decontrolled in 2010, diesel in 2014. Oil companies now set these prices in line with market prices.
• LPG subsidy moved to DBT (Direct Benefit Transfer: the subsidy goes into the bank account, so less leaks to non-users).

7. Carbon markets: basic terms

• Carbon market: a market where carbon credits or allowances are bought and sold.
• Carbon credit: a certificate for 1 tonne of CO₂e reduced, avoided or removed.
• Carbon offset: buying credits to cancel out one's own emissions.
• Four integrity tests for an offset:
• Additionality: the cut would not have happened without the credit money.
• Permanence: the carbon stays locked away. A forest that later burns releases it again.
• No leakage: emissions do not simply move to another place.

• No double counting: the same tonne is not claimed by two buyers or two countries.

• Compliance carbon market: created by law. Covered entities must surrender allowances or credits equal to their emissions.

• Voluntary carbon market (VCM): buyers offset by choice, for example companies with net-zero pledges.
• Standards: Verra, Gold Standard, and ICVCM's Core Carbon Principles (a quality benchmark).
• Some REDD+ credits faced integrity scandals. The claimed deforestation "avoided" was overstated. (REDD+ means Reducing Emissions from Deforestation and forest Degradation, a forest-carbon programme.)

8. International lineage: Kyoto to Paris

• Clean Development Mechanism (CDM), under the Kyoto Protocol:
• Developed countries funded emission-cutting projects in developing countries and earned CERs (Certified Emission Reductions), which counted towards their own targets.

• India was the second-largest host after China.

• Paris Agreement, Article 6.2: ITMOs (Internationally Transferred Mitigation Outcomes)

• These are country-to-country transfers of emission cuts.
• They need "corresponding adjustments": the seller adds the tonne back to its own account, so the cut is not counted twice.

• India notified its list of eligible activities in 2023.

• Paris Agreement, Article 6.4: Paris Agreement Crediting Mechanism (PACM)

• This is a UN-supervised crediting system that replaced the CDM.
• Its rules were finalised at COP29 (Baku, 2024).
• Standards were adopted on:
  • the baseline: what emissions would have been without the project
  • leakage
  • a reversal standard: making sure stored carbon is not lost later [7]
• The UNFCCC says Article 6 could help save up to US$250 billion a year in the cost of carrying out national climate plans [7].

9. India's path to a domestic carbon market

• Step 1: PAT scheme (Perform, Achieve and Trade), 2012
• Energy-intensive plants get energy-saving targets.

• Plants that beat their target earn ESCerts (Energy Saving Certificates). Plants that miss their target buy them.

• Step 2: RECs (Renewable Energy Certificates)

• These are tradable proof that renewable power was generated.

• Power distribution companies (discoms) buy them to meet their renewable purchase obligations.

• Step 3: Energy Conservation (Amendment) Act, 2022

• This gave the government legal power to specify a carbon credit trading scheme.

• Step 4: Carbon Credit Trading Scheme (CCTS), 2023

• Notified in June 2023. It created the Indian Carbon Market (ICM) and a National Steering Committee for the Indian Carbon Market (NSCICM) [3].
• Aim: reduce or avoid GHG emissions by pricing them through tradable Carbon Credit Certificates (CCCs) [3].

• Institutions:

  • BEE (Bureau of Energy Efficiency) is the administrator.
  • Grid-India is the registry, which keeps the record of who holds which credits.
  • CERC (Central Electricity Regulatory Commission) regulates trading.

• (a) Compliance mechanism

• Obligated Entities must meet GHG Emission Intensity (GEI) targets, measured as tonnes of CO₂e per tonne of product, not an absolute cap [3][4].
• Entities that do better than their target earn CCCs and sell them. Entities that miss their target buy them [3].
• GEI targets were first notified for 7 sectors moved over from PAT: aluminium, cement, chlor-alkali, petrochemicals, petroleum refineries, pulp and paper, textiles [3].
• Later, GEI targets were notified for 208 more carbon-intensive industrial units [2].

• (NCERT scaffold: "notified sectors, verify". The official lists above now confirm this.)

• (b) 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. It produces 10 lakh t of cement.
• Allowed emissions = 0.60 × 10 lakh = 6 lakh t CO₂e.
• Its actual intensity is 0.57 t, so it emits 5.7 lakh t.
• It earns 30,000 CCCs (1 CCC = 1 t CO₂e) that it can sell.

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

• Trap: a Green Credit (under the Green Credit Programme; see Section 4 of the parent note) is not a carbon credit.

• A Green Credit rewards actions such as tree planting or water conservation.
• It is not a certified tonne of CO₂e.

10. Carbon leakage and CBAM

• Carbon leakage: production moves to countries with weaker climate rules.

• The cuts made in the strict country are cancelled out by higher emissions elsewhere.

• EU CBAM (Carbon Border Adjustment Mechanism): a charge on the embodied carbon of imports.

• Embodied carbon means the emissions released while making a product.
• Timeline: transitional phase (reporting only) from October 2023, definitive phase (payment) from 2026.
• Covers steel, aluminium, cement, fertilisers, electricity and hydrogen.

• Its purpose is to make importers pay the same carbon price as EU producers under the EU ETS.

• India's position

• India calls CBAM unilateral (imposed by one side without negotiation) and against CBDR.
• CBDR (Common But Differentiated Responsibilities) means rich countries, which caused most past emissions, should carry a bigger burden.
• Steel and aluminium exports to the EU are most exposed.
• Trade-law detail is in international-trade-policy.
• Link: a working domestic price (CCTS) can help Indian exporters argue for a deduction under CBAM, because carbon already paid at home can reduce the charge.

Prelims Hooks

• Pigouvian tax = tax per unit of pollution equal to marginal external damage.
• Carbon tax fixes the price and leaves emission cuts uncertain. Cap-and-trade fixes the quantity and leaves the permit price uncertain.
• EU ETS started in 2005. China's national ETS started in 2021.
• Social cost of carbon = present value of the damage from one extra tonne of CO₂. The discount rate is the key driver.
• CCTS 2023 was notified under the Energy Conservation (Amendment) Act 2022. Institutions:
• BEE: administrator
• Grid-India: registry

• CERC: trading regulator

• CCTS targets are emissions intensity (GEI), not absolute caps. The first 7 sectors came over from PAT: aluminium, cement, chlor-alkali, petrochemicals, refineries, pulp & paper, textiles [3].

• Worldwide there are 80 carbon pricing instruments (43 taxes, 37 ETSs), covering about 28% of global GHG emissions (2025) [6].
• IMF: fossil fuel subsidies were US$7 trillion (7.1% of GDP) in 2022, and 82% were implicit [8].
• Article 6.2 = ITMOs (country-to-country, with corresponding adjustments). Article 6.4 = PACM, the successor to the CDM, with rules finalised at COP29.
• 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. Green Credit ≠ carbon credit.

Mains Points

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

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

• Fixing negative carbon prices comes first

• Implicit subsidies (82% of the global total) act as a negative carbon price [8].
• India's fuel decontrol and DBT for LPG show that subsidies can be reformed if targeted cash support protects the poor.

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

• Integrity of carbon markets

• Additionality, permanence, leakage and double counting decide whether credits reflect real cuts.
• The REDD+ scandals show the risk of greenwashing (claiming green credentials that are not real).
• Corresponding adjustments under Article 6 and the COP29 standards (baseline, leakage, reversal) [7] strengthen integrity.

• India must build strong MRV (Monitoring, Reporting and Verification) for its offset mechanism.

• CBAM and CBDR (GS-II/III)

• CBAM tackles carbon leakage, but it hits developing-country exporters and shifts the climate burden onto them.
• India's response:
  • WTO and UNFCCC diplomacy against unilateral measures
  • a credible domestic carbon price (CCTS) to seek a CBAM deduction
  • green steel and aluminium technology