A market for carbon credits can be a significant step toward decarbonizing the economy, but only if it is correctly organized. We must consider all aspects of the system, including emission quotas, reduction pathways, and sectoral coverage, as well as income, export, and cost consequences.

In his budget address, the finance minister said that a Carbon Credit Trading Scheme (CCTS) will be introduced shortly in India.

This would be a significant move since it would place us in a narrow club of nations that have implemented such emissions-reduction systems, including the EU, UK, China, Indonesia, South Korea, and Australia.

In essence, a carbon tax substitute is a CCTS. By driving up the price of fossil fuels, the tax lowers their consumption and hence their emissions. By imposing a cap on the amount of emissions permitted per unit of production, a CCTS directly affects the amount of emissions.

Although most economists believe that the best policy would be a carbon tax, political support for the idea is limited since it is perceived as directly impacting all producers and driving up costs.

Carbon credit trading is a critical component of the CCTS. Producers who pollute less than permitted obtain carbon credits, which may be sold to others who find it too expensive to decrease their emissions to the required level. The ability to trade credits improves the system's efficiency, and the price of carbon credits generated by the system reflects the lowest cost of decreasing emissions across all businesses.

For the CCTS to represent a significant step forward in decarbonizing the economy, it must be correctly constructed. The Bureau of Energy Efficiency (BEE), which will manage the system, has been charged with devising the design.

The BEE has expertise in running the Perform, Achieve, and Trade (PAT) program, which was created to increase energy efficiency. This is a benefit, but the requirements for a CCTS will be far more difficult.

Here are the six essential areas that must be addressed for the CCTS to be successful

Finding the emission allowance for each unit is the first challenge. The National Steering Committee, which includes members from important ministries, federal agencies, and a few states, has been given this responsibility. It is co-chaired by the secretaries of power and the environment.

The power industry, which accounts for the majority of the country's carbon emissions, is not likely to be covered yet. This is different from the practice in other major countries with such a system.

The fertilizer industry is also excluded, which is outlandish. It is probable that power is omitted since decarbonization in this sector is being pushed independently by imposing Renewable Purchase Obligations (RPOs) on distribution firms and major enterprises, compelling them to source an increasing percentage of their electricity from renewables. This might be helpful for a while, but it is not the most cost-efficient strategy to reduce emissions. Specifically, it does not assure that the cost of decreasing emissions in power generation is consistent with the costs in other sectors. This problem would be alleviated if the power industry was included in the CCTS, which should be done as soon as practicable.

The third concern is that, should we want to achieve net-zero emissions by 2070, then each industry's emission permits ought to be gradually decreased to align with this goal. It goes beyond just cutting allowances for every industry at the same rate. Rather, the pace at which permits are lowered need to correspond with the speed at which technological advancements lower the cost of cutting emissions across various industries. To put it another way, industries that see a quicker decrease in the cost of reducing emissions need to decarbonize sooner.

The fourth query is whether the CCTS, like a carbon tax, should be intended to generate income. If emission permits are put up for sale, this may happen. The money raised can be utilized to cover climate-related expenses and make up for the anticipated decline in tax income as fossil fuels are phased out. We can begin with free allowances, as the EU does, and gradually transition to auctioning off an increasing percentage of allowances. One possibility is to ask the Finance Commission to suggest a formula for allocating the money from this source to the states and the federal government.

The fifth part of the concept is to guarantee that the CCTS can protect our exports from carbon border adjustment taxes, which the EU intends to implement in 2026 (and the UK in 2027). Introducing a CCTS alone will not be enough since the EU will claim that if our CCTS yields a lower carbon price than its own (which is inevitable), it will apply a countervailing charge on imports to compensate.

According to an IMF staff report, the carbon pricing in lower-middle-income countries (such as India) should be around one-third that of advanced nations (such as the United States and the European Union), whereas in upper-middle-income countries (such as China), it should be two-thirds. We have generally opposed developing-country distinction, but per capita income divergence is rational and should be encouraged.

The sixth component of the CCTS that must be understood is that the new system will raise production costs in the covered sectors until low-carbon technologies become more affordable than fossil fuel-based alternatives. Following the 'polluter pays' principle, additional expenses must be passed on to end users. This will also be true in the power industry, whether we undertake decarbonization by slowly rising RPOs, as currently planned, or by including it in the CCTS.

There will be political pressures to protect low-income households from rising power rates. However, this should not prohibit discoms from boosting power bills, since doing so will only weaken them financially and impair the quality of electricity delivery over time. Small and medium-sized businesses would suffer the most from this consequence.

The approach is to allow power pricing to reflect costs while offering direct compensating cash handouts to the needy. It is probable that not all of these issues can be resolved properly right away. However, there is virtue in implementing the CCTS as quickly as feasible, with the explicit guarantee that its performance would be assessed and adjusted over time. A plausible mid-term aim would be to have a fully operational system in place long before 2035.