The lowest hanging fruit on the coconut tree: India's climate transition through the price system in the power sector

by Akshay Jaitly and Ajay Shah.

The world is projected to emit about 50GT of CO2 per year by 2055. Climate scientists say (net) emissions need to be ended by 2055, in order to avoid catastrophic events with reasonable probability. At present, India is emitting 2.5GT per year with a long term trend growth rate of about 5%. India is the 4th largest source of CO2 in the world, accounting for 7\% of emissions, with emissions that are roughly as large as those of the European Union. In a new paper, The lowest hanging fruit on the coconut tree: India’s climate transition through the price system in the power sector, we engage in strategic thinking about India's decarbonisation.

Decarbonising any economy is a large and complex problem. The electricity sector is a key site of the carbon transition, as it directly makes CO2 (e.g. by burning coal and gas), and because decarbonisation in other areas (e.g. cooking) involves switching away from fossil fuels to electricity. The sector is formally organised, which makes it more susceptible to policy intervention. Thus, in every country, decarbonisation calls for a large modification of the resource allocation in the electricity sector. Technical and business model decisions are required at each location in an economy about the optimal mix of renewables, storage and demand-side adjustment for the zero emissions world.

The Indian electricity sector is poorly placed to perform the required modification of this resource allocation. At present, it is a centrally planned system that is under growing financial stress. The process of private investment in electricity has lost momentum. Resource allocation is inefficient owing to multiple prices and a command-and-control system, rather than one based on producers and users that respond to prices. The command-and-control system works poorly in steady state, and particularly poorly when large changes in the resource allocation are required. By imposing enlarged costs upon the economy, a centrally planned decarbonisation runs the risk of greater political difficulties. The electricity sector is thus the critical choke point in India's climate transition.

Looking forward, the problems of the electricity sector are likely to deepen. Rising Indian emissions in coming years will sit uneasily alongside a decarbonising world. Regardless of the speed at which Indian policy makers might desire a change in course, there are forces reshaping the behaviour of Indian firms which are narrowing the options. Indian firms now operate under international asset pricing, and ESG investment has changed the incentives of Indian firms to favour buying and selling renewables. Some large economies could, in coming years, introduce trade taxes upon the carbon content of Indian exports. This would additionally induce Indian firms to desire reducing emissions in their supply chain. The cross-subsidy system within the electricity sector will come under increasing stress when buyers see renewables inducing some combination of a lower cost of capital, a lower operating cost and reduced trade barriers.

For 30 years now, political and fiscal resources have been expended in periodic incremental reforms of the electricity sector. These have not delivered the desired results. It is unlikely that similar efforts will work in coming years. In the meantime, 2021 is likely to be a turning point in the demands made upon the electricity sector owing to the carbon transition.

The climate transition is one of the most complex problems in Indian public policy and will now be subject to the new commitments made at COP26. A coherent strategy needs to be established and articulated, which can reshape the behaviour of a billion private persons across space and time.

This involves going with the grain of the price system, i.e. stepping away from the command-and-control system. All firms in the electricity sector need to be creatures of the market economy, which constantly reshape technology and business models in response to prices. Such firms have the incentive and the ability to look at the changing landscape of technology, financing and carbon taxation, and solve local maximisations that yield the correct engineering and business solutions all across the country. This distributed intelligence, this self-organising system, processes information better, values profit over conservatism and populism, engages in a process of search with risk-taking where some win and some lose, and avoids the state capacity constraints that hamper the central planning system. It will achieve the required Indian climate transition at a lower cost to the economy when compared with a centrally planned path.

Under an electricity sector that is grounded in the price system, there is a clear pathway to the climate transition: the single instrument of the carbon tax. Following a 5-10 year reform process of the electricity sector, the Indian state would announce levels of carbon taxation for the next 25 years, based on international commitments towards decarbonisation and net zero. Private persons would respond to these numerical values with business and technological strategies that are optimal at every location in the country. Every five years, policy makers would review the emissions, and modify the trajectory of taxes for the coming 20 years. Policy makers would control this one lever -- the carbon tax -- and the decarbonisation of the economy would be achieved through private decisions on the demand side, in generation and in storage.

Without a carbon tax, the union government lacks instruments for carbon policy, and intricate regulatory activities will induce enhanced costs upon the economy. Without an electricity sector that is organised around the price system, the resource allocation will be distorted thus enhancing the economic cost of decarbonisation. The optimal way forward is a combination of electricity regulation at state governments, a carbon tax led by the union government, and a private electricity sector organised around the price system.

While this appears to be an attractive vision, it is also a difficult policy project. Immense effort has been put into electricity reform in the past, by insightful policy makers. These leaders of Indian electricity reform, of the last 30 years, stayed within the strategy of a centrally planned electricity system. Why do we believe that things could work differently today?

There are six aspects in which the present situation is different, which creates a pathway to the fundamental reform that was elusive for the last 30 years: (1) There is greater understanding of the political economy landscape, and it is possible to design bargains where the losers from the reform are compensated. (2) State capacity in regulation is essential for the operation of an electricity sector organised around the price system, and there is now a greater understanding in India of how to establish the objectives and methods of regulation. (3) There is a path to electricity reform, one state at a time, which is more tractable and feasible when compared with grand schemes led by the union government which apply to the entire country. (4) The materiality of climate policy in the international discourse has shifted the political salience of domestic electricity reforms. Alongside this, the domestic policy envelope on establishing more market-led solutions has improved. (5) It is possible to fund the transition. (6) The fiscal cost of upholding the status quo in the electricity sector is likely to rise.