The Indian Economy Blog

April 23, 2007

Would A Cap-And-Trade Mechanism Work In India?

Filed under: Business,Energy,Environment — Kiran @ 12:42 am

In the posts on a case for a carbon tax we saw a deliberate exclusion of existing power plants from the ambit of a “cleanup”. This made sense for a few reasons. Primarily since the plants are already up and running, it would be economically and politically more difficult to get them to cleanup. Since new power capacity is expected to rapidly overtake the currently existing capacity, even targeting only the new capacity would make a significant difference. Moreover, since power from existing plants would remain cheap, the cost to consumer would see a more gradual rise.

Importantly though, a carbon tax by its very nature does not provide great incentives to an old and highly polluting power plant, with completely depreciated equipment, to reduce emissions. In the developed nations relatively little new power capacity has been added in the last 2 decades. Therefore the primary means to cut emissions in such nations has not been a carbon tax, but a cap-and-trade mechanism.

How does Cap-and-Trade work?

The Cap-and-Trade mechanism (CAT) has two components. First there is the cap. So the government takes a count of the CO2 being released by all companies in an industry – say coal-based power plants. For simplicity sake, let us consider a two company scenario – company Newex and Oldex, each emitting about 500 tonnes each, for an industry total of 1000 tonnes. Now the government applies the cap, and a reduction limit – the industry should cut down emissions by 10%. This would obviously imply that both Newex and Oldex should reduce emissions by 50 tonnes each. However, Newex has only recently already applied some expensive changes to its plants which have reduced its emissions significantly, while Oldex has not done so. So to cut additional emissions would be far more expensive for Newex than it would for Oldex. Thats where the “trade” in cap-and-trade comes in.

Newex can thus finance Oldex 50% of the cost of a total reduction of 100 tonnes – thus meeting the industry target at minimum cost, by the government set date. Once this deadline is met, the govt applies an additional limit of 10%, at which time Newex might find it cheaper to cut emissions that Oldex does. Thus the trade, helps meet the cap at minimal cost.

Will this work in the Indian context?
The problem with applying this to India is that the power sector is growing. Limiting emissions by an industrial sector as a whole would essentially mean that new companies would have to come in with zero emissions – or even negative emissions so that the sector as a whole meets the overall emission limits. Thats one reason why India refuses to accept emission caps under Kyoto. (China on the contrary remains “open” to accepting some caps, while it continues building one new coal power plant every week.)
One option would be to make a distinction for existing power plants. There too there are problems. For one it would immediately increase the cost to consumers, as against a more gradual increase as with the case of a carbon tax exclusively on new capacity. Secondly, the existing power producing sector is already in a mess of sorts, with low capacity utilization either because of maintenance or fuel supply issues. With India undergoing one of the worst power crises in recent history, it would be practically very difficult to push in such reforms.

But that still leaves us with an interesting scenario of how a CAT mechanism could co-exist with a carbon tax in a developing country. Thus the developing country would not cap emissions as a whole but still ensure that strong mechanisms are in place to control emissions within the country.


  1. Since carbon taxes and caps excite you so much(an economist with a new tax proposal is like a child with a new toy), here is something for you to mull over-

    “Companies and individuals rushing to go green have been spending millions on “carbon credit” projects that yield few if any environmental benefits.

    A Financial Times investigation has uncovered widespread failings in the new markets for greenhouse gases, suggesting some organisations are paying for emissions reductions that do not take place.

    Others are meanwhile making big profits from carbon trading for very small expenditure and in some cases for clean-ups that they would have made anyway.”
    (,dwp_uuid=3c093daa-edc1-11db-8584-000b5df10621.html )

    Comment by Gurmeet — April 28, 2007 @ 1:26 am

  2. A cap by definition refers to the total emissions, which of course does not apply to a growing economy. However we can think of a cap on ‘rate of emission.’ Such a cap on ‘rate of emission’ spurs research towards cleaner technologies.

    From we find that coal plants emit 2.117 lbs of CO2 per KWH (1998 data). In Carbon equivalent this works out to 0.577 lbs of C per KWH. India could start with this rate and as she develops cleaner technologies, this rate could be reduced.

    Alternately a coal-fired power plant could buy 0.577 lbs of Carbon for every KWH generated and give that carbon to environmental protection authorities to safe keep. We suggest packing the carbon in non-degradable plastics and use it as landfill. Such coal-fired power-plants indeed add no CO2 to the atmosphere at all and thus India is free to build as many coal-fired plants as desired.

    Comment by Mohideen Ibramsha — May 15, 2007 @ 2:28 pm

  3. hi ……….sorry your cap and trade example beats me….coz if newex uses newer tech to improve its emissions then it must be more costly to the oldex to cut its emissions ………then if newex finances a 50% of the total to reduce emissions ,is it obligatory or depends on the whims of the newex,and why not oldex like companies must be forced to use newer tech or be declared sick???? could you please expand your example??

    Comment by ashank — July 5, 2007 @ 11:22 am

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