Carbon Markets: Benefits and Challenges – Explained, pointwise

Introduction

The Union Government has introduced the Energy Conservation (Amendment) Bill, 2022 in the Parliament. The purpose of the Bill is to strengthen the Energy Conservation Act, 2001. The Amendments are expected to facilitate the achievement of more ambitious climate change targets and ensure a faster transition to a low-carbon economy. The Energy Conservation Act, 2001 had powered the first phase of India’s shift to a more energy-efficient future. Over the years, the energy intensity (energy consumed per unit of GDP) of India’s economy has declined consistently. However, as India embarks on more ambitious climate action pledged under the Paris Agreement, there is a need to widen the scope of Act to include instruments that will aid the achievements of these ambitious goals. One of the proposed amendment is to establish domestic carbon market to facilitate trade in carbon credits.

What are the proposed amendments under the Energy Conservation (Amendment) Bill, 2022?

The Bill has two main objectives: (a) It seeks to make it compulsory for a select group of industrial, commercial and even residential consumers to use green energy. A prescribed minimum proportion of the energy they use must come from renewable or non-fossil fuel sources; (b) It seeks to establish a domestic carbon market and facilitate trade in carbon credits. It seeks to widen the scope of energy conservation to include large residential buildings as well. Till now, the energy conservation rules applied mainly on industrial and commercial complexes.

What is a Carbon Market?

Carbon Markets and Carbon Credits are components of emissions trading, a market-based approach to to reduce the concentration of Greenhouse gases (GHG) in the atmosphere. It works by providing economic incentives for reducing the emissions of the designated pollutants. A carbon market allows investors and corporations to trade both carbon credits and carbon offsets simultaneously. 

Carbon credits (or allowances) work like permission slips for emissions. When a company buys a carbon credit, they gain permission to generate more CO2 emissions. One tradable carbon credit equals one tonne of carbon dioxide or the equivalent amount of a different greenhouse gas reduced, sequestered or avoided.

Credits are measured against ‘benchmarks’ or allowed GHG emissions. If emissions are below the allowed limit, the emitter earns carbon credits (reducing 1 tonne of CO2 earns 1 carbon credit). If emissions are above the allowed limit, the emitter must buy carbon credits from those who have excess credits. Thus, crossing the emissions limit imposes a cost (amount spent on purchase of carbon credits) on the emitter. The idea is that this cost will force the emitters to be more efficient and reduce emission.

Source: climatechange.org

There are two types of carbon markets: (a) One is a regulated market, set by “cap-and-trade” regulations at the regional and state levels; (b) The other is a voluntary market where businesses and individuals buy credits (of their own accord) to offset their carbon emissions.

Carbon Markets were allowed under the 1997 UN Kyoto Protocol. Its Clean Development Mechanism (CDM) allowed industrialized countries to reduce emissions abroad where that might be cheaper than at home, such as by planting trees in the tropics.

Source: Visual Capitalist. Components of Carbon Market

How can companies offset carbon emissions?

There are multiple ways for companies to offset carbon emissions. They are broadly classified into (a) Carbon Avoidance/Reduction Projects (i.e., reduce the amount of carbon emitted); (b) Carbon Removal/Sequestration Project (i.e., remove the carbon already emitted from the atmosphere).

Source: climatechange.org

Investing in renewable energy by funding wind, hydro, geothermal, and solar power generation projects, or switching to such power sources wherever possible.

Improving energy efficiency across the world, for instance by providing more efficient cookstoves to those living in rural or more impoverished regions.

Capturing carbon from the atmosphere and using it to create biofuel, which makes it a carbon-neutral fuel source.

Returning biomass to the soil as mulch after harvest instead of removing or burning. This practice reduces evaporation from the soil surface, which helps to preserve water. The biomass also helps feed soil microbes and earthworms, allowing nutrients to cycle and strengthen soil structure.

Promoting forest regrowth through tree-planting and reforestation projects.

Switching to alternate fuel types, such as lower-carbon biofuels like corn and biomass-derived ethanol and biodiesel.

What is the status of Carbon Markets across the world?

National or Regional

Domestic or regional carbon markets are already functioning in several places, most notably in Europe, where an Emission Trading Scheme (ETS) works on similar principles. Industrial units in Europe have prescribed emission standards to adhere to, and they buy and sell credits based on their performance. China, too, has a domestic carbon market.

A similar scheme for incentivising energy efficiency has been running in India for over a decade now. This BEE scheme, called PAT, (or perform, achieve and trade) allows units to earn efficiency certificates if they outperform the prescribed efficiency standards. The laggards can buy these certificates to continue operating.

International

Under the Kyoto Protocol, carbon markets have worked at the international level as well. The Kyoto Protocol had prescribed emission reduction targets for a group of developed countries (Annex I Developed Countries). Other countries did not have such targets, but if they did reduce their emissions, they could earn carbon credits. These carbon credits could then be sold off to those developed countries which were unable to meet their reduction targets. This system functioned well for a few years. But the market collapsed because of the lack of demand for carbon credits. 

As the world negotiated a new climate treaty in place of the Kyoto Protocol, the developed countries no longer felt the need to adhere to their targets under the Kyoto Protocol. A similar carbon market is envisaged to work under the successor Paris Agreement, but its details are still being worked out.

What are the advantages of a Carbon Market?

First, it will help in mitigating the adverse impacts of climate change by reducing the GHG emissions.

Second, there are multiple co-benefits of offset projects such as: ecosystem management, forest preservation, sustainable agriculture, renewable energy generation in third-world countries, etc.

Third, the voluntary carbon market for offsets is smaller than the compliance market, but expected to grow much bigger in the coming years. It’s open to individuals, companies, and other organizations that want to reduce or eliminate their carbon footprint, but are not necessarily required to by law.

Fourth, consumers are increasingly aware of the importance of carbon emissions. Consequently, they’re increasingly critical of companies that don’t take climate change seriously. By contributing to carbon offset projects, companies signal to consumers and investors that they’re paying more than just lip service to combat climate change.

Fifth, it opens an additional revenue stream for environmentally beneficial businesses. For instance, Tesla, the electric car maker, sold carbon credits to legacy car manufacturers to the tune of $518 million in just the first quarter of 2021.

What are the challenges in the functioning of Carbon Markets?

First, there are concerns regarding the effectiveness of carbon markets in curbing emissions. Some companies simply buy credits without making any effort to reduce emissions themselves. It is cheaper for them to buy carbon credit than to invest in emission reducing technologies e.g., an analysis by the Center for Science and Environment of the PAT scheme for thermal power plants found that the value of one ESCert* is very less — INR 700 — compared to the actual investment of INR 4,020 that has to be made for reducing energy equal to one tonne equivalent. Unless, the price of carbon credits is higher than the cost of reducing emissions, there is no incentive for high emitters to make efforts to reduce their emissions (i.e., companies have to invest more in purchasing credits than investing in emission reduction technologies).

*(ESCerts are similar to carbon certificates that will be sold and purchased under the carbon market scheme).

Second, environmental activists argue that only high-quality carbon offsets are effective in reducing emissions. High quality carbon offsets have certain features like (a) Additionality: Emission reductions must be additional i.e., they would not have occurred in the absence of a market for offset credits e.g., a renewable project could be set up only because a high emitter paid for it; (b) Verifiable: There must be proper audits to ensure monitoring, reporting and verification of emission cuts; (c) Permanence: The emission reduction should not be reversed.

Source: Visual Capitalist

However, many credits available in markets are of poor quality i.e., they do not meet the above criteria. Most of the credits are not ‘additional’ i.e., the emission reduction projects would have happened even in absence of carbon credits (without any prospect for project owners to sell carbon offset credits). Also it is very difficult to establish ‘additionality’. According to a US-based environmental group more than 60% percent of credits on the market are from projects that have ‘questionable additionality claims’.

In some cases, the emission reduction is not permanent. There have been instances where afforestation projects were undertaken to buy carbon credits. However, later on the planted trees were cut-off, thus reversing the reduction.

Third, buying carbon credits can deviate the rich nations from the path of reducing emissions. They can simply continue to emit and buy cheap carbon credits from developing countries. 

Fourth, there has been huge surplus of carbon credits in the voluntary markets. According to an estimate, credits for about a billion tons of CO2 have been put up for sale on the voluntary market. But there have been more sellers than buyers. Supply exceeding demand suppresses the price of carbon credits and it become easier for emitters to offset, while continuing high emissions.

Fifth, It is difficult to establish the amount of carbon reduced by offset projects (like afforestation or wind energy project). The complexity is in establishing baseline emissions (Emissions baseline represents what would happen if your project did not occur i.e., the emissions in the absence of the project). This makes it difficult to verify emission reductions and assigning carbon credits.

India’s own PAT (Perform, Achieve, Trade) Scheme has failed to achieve meaningful emissions reduction. According to an analysis by the Center for Science and Environment, the emission reduction under the scheme has been only 1.57% and 1.44% over the two cycles.

What should be done going ahead?

First, there is a need to create a national level environment regulator on the lines of SEBi (Stock Market Regulator), RBI (Banking Regulator) in order to ensure carbon markets work efficiently. 

Second, there must be strong regulatory safeguards to ensure that the emission offsets traded are of high quality. Else, as experts contend, an ineffective carbon market can end up doing more damage.

Third, there is a need to develop environmental consciousness in the general public so as to make them understand their environmental responsibilities. For instance, consumers can purchase offsets for emissions from a specific high-emission activity, such as a long flight, or buy offsets on a regular basis to eliminate their ongoing carbon footprint.

Fourth, it’s crucial that cap-and-trade does not end up as an inspect-and-extort regime in India. For this, a tech-enabled model of open verification can be adopted by the government.

Conclusion

The establishment of a domestic carbon market is a progressive step. However, the actual benefit will depend upon the effectiveness of the market. For this, the Government must ensure that proper regulations are established. Moreover, there must be periodic assessment of its functioning and corrective steps its necessary. Climate Change is real and imminent, Government must take all possible steps to mitigate the challenges.

Syllabus: GS III, Conservation, environment pollution and degradation.

Source: Indian Express, The Guardian, Yale Environment360