UPSC Prelims 2023 Q23: Carbon Markets and the State — Explained

Consider the following statements:

Statement-I:

Carbon markets are likely to be one of the most widespread tools in the fight against climate change.

Statement-II:

Carbon markets transfer resources from the private sector to the State.

Which one of the following is correct in respect of the above statements?

Both Statement-I and Statement-II are correct and Statement-II is the correct explanation for Statement-I
Both Statement-I and Statement-II are correct and Statement-II is not the correct explanation for Statement-I
Statement-I is correct but Statement-II is incorrect
Statement-I is incorrect but Statement-II is correct

Answer: (b) Both Statement-I and Statement-II are correct and Statement-II is not the correct explanation for Statement-I

Statement-wise explanation

Statement-I: correct — Carbon pricing is now one of the main climate policy tools in use worldwide. The World Bank's State and Trends of Carbon Pricing 2023 (released 23 May 2023) counted 73 carbon taxes and emissions trading systems in operation, covering about 23% of global greenhouse gas emissions. Ten years earlier the share was 7%. UNDP noted in 2022 that 83% of countries' NDCs say they intend to use international market mechanisms, and Article 6 of the Paris Agreement provides for such markets. The word 'likely' makes this a prediction, and the trend supports it.
Statement-II: correct — In a compliance market the State sets a cap and creates the emission allowances. When it auctions those allowances, money flows from polluting firms to the government. The IMF counts ETS allowance auctions, along with carbon taxes, as government carbon-pricing revenue. Carbon taxes and ETSs together raised about US$95 billion in 2022 (World Bank, 2023). It does not explain Statement-I. Carbon markets spread because they cut emissions at the lowest cost and give firms flexibility. Raising revenue for the State is a side effect, and many schemes give allowances away free, where no money reaches the government.

How to eliminate

Statement-I is hedged with 'likely' and matches what you see in the news (EU ETS, China's national ETS, Article 6 at COP26, India's Energy Conservation (Amendment) Act 2022). Accept it, which leaves only the first three options. Statement-II is the hard part. Basic knowledge settles it only if you remember that in cap-and-trade the government creates the allowances and usually auctions them, so firms pay the State. Without that fact, Statement-II looks wrong, because most trading happens between companies. That is why many candidates marked 'I correct, II incorrect'. Then apply the 'because' test: 'Carbon markets will be widespread because they move money from the private sector to the State.' Countries do not adopt carbon markets mainly to raise revenue. They adopt them to cut emissions at the lowest cost. So even if you accept Statement-II, it does not explain Statement-I. Fact to remember: auctioning allowances in an ETS raises government revenue, as a carbon tax does.

Know more

Carbon pricing makes polluters pay for the harm their emissions cause. That harm is a negative externality: a cost falling on people outside the deal. There are two main instruments.

Instrument	Who fixes what	Money flow
Carbon tax	State fixes the price. The quantity of emissions adjusts.	Firms → State
Emissions Trading System (cap-and-trade)	State fixes the quantity (cap). The market finds the price.	Firms → State (if allowances are auctioned); firm ↔ firm (trading)
Baseline-and-credit / offsets	Credits are issued for reductions below a baseline	Buyer → credit-generating project
Voluntary carbon market	No legal obligation. Buyers act by choice.	Private ↔ private

Compliance vs voluntary. A compliance market is created by law, as the EU ETS and India's CCTS are. A voluntary market runs on private choice, for example companies buying offsets to meet net-zero pledges.

Why markets spread. Firms that can cut emissions cheaply do so and sell their surplus permits. Firms facing high costs buy permits instead. The cap is met at the lowest total cost. This builds on the Coase theorem: once rights to emit are clearly defined, trading leads to an efficient outcome.

International layer: Article 6 of the Paris Agreement.

6.2: bilateral trading of emission reductions (ITMOs). India notified 13 eligible activities in February 2023, including green hydrogen and CCUS.
6.4: a UN-supervised crediting mechanism that replaces the Kyoto-era CDM.

India's path. The Energy Conservation (Amendment) Act, 2022 came into force on 1 January 2023. It empowers the Centre to specify a carbon credit trading scheme. The Carbon Credit Trading Scheme (CCTS) was notified in 2023. It has a compliance mechanism and an offset mechanism. The Bureau of Energy Efficiency (BEE) administers it, and the tradable unit is the Carbon Credit Certificate (1 certificate = 1 tCO₂e).

In the news

Parliament passed the Energy Conservation (Amendment) Bill in December 2022, and the Act took effect on 1 January 2023 with powers to set up an Indian carbon market. In February 2023 India listed activities eligible for Article 6.2 trading. The World Bank released its carbon pricing report, with revenue near $100 billion, on 23 May 2023, five days before Prelims.

NCERT Concepts to Revise

Carbon market: Both statements are about what carbon markets do. Know whether they trade credits, allowances, or both.
Compliance carbon market: In a market created by law, the State issues and can auction allowances. That is central to Statement-II's money flow.
Voluntary carbon market: Voluntary markets run on private choice. Ask where money flows in them when testing Statement-II's general claim.
Carbon credit: Understanding the tradable unit (1 tCO₂e) shows what is actually bought and sold in these markets.
Negative externality: Carbon markets exist to price a negative externality, which is the reason behind their spread in Statement-I.
Carbon Credit Trading Scheme: India's own compliance carbon market is a current example of the tool Statement-I describes.