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.

Regulatory Policy in India: Moving towards regulatory governance

by Lalita Som.

Regulatory policy, a comparatively young discipline, is evolving in different ways across the world, reflecting the diverse range of legal, political and cultural contexts on which countries have built their public governance. Regulation, one of the key levers of state power, is of critical importance in managing the economy, in sequencing business behaviour, implementing social policy and influencing behaviour. Regulatory policy thus helps to shape the relationship between the State, citizens and businesses.

In OECD countries, policies to increase competition in markets, and to "roll back the frontiers of the state" in the 1980s and 1990s, broadened to become regulatory reform. Regulatory reform became an essential adjunct to structural reforms, reaching out beyond the network sectors to encompass product market reforms and the liberalisation of professional services. Independent regulatory agencies were developed to manage key aspects of economies and society at an arm's length from the political process. This became known as the regulatory state. The regulatory state paved the way for the idea of regulatory governance (OECD, 2010a).

In OECD countries. regulatory policy has made a significant contribution to economic growth and societal well-being - through its contribution to structural reforms, liberalisation of product markets, international market openness, and a less-constricted business environment for innovation and entrepreneurship. Regulatory policy has supported the rule of law through initiatives to simplify the law and improve access to it, as well as improvements to appeal systems. Increasingly, it has supported quality of life and social cohesion, through enhanced transparency which seeks out the views of the regulated, and programmes to reduce red tape for citizens.

Many OECD countries are concerned about distributional equity – to maximise the welfare of the most disadvantaged, paying attention to distributional consequence of policy actions, albeit not beyond the point at which they would impede on overall prosperity. These insights have had a strong practical influence on approaches to the impact assessment of regulations and especially, analysis of costs and benefits, including distributional aspects and under conditions of uncertainty (OECD, 2010a).

Regulatory reform can be viewed strategically, in both developed as well as emerging markets, as one of the core instruments at the disposal of policy makers. The modern State will have to utilise its regulatory power wisely if it expects to be smarter in order to face challenges like the growing fiscal burden for providing key public services such as health, education and social insurance schemes, in establishing governance arrangements and rationalising complexities to manage the consequences of decentralisation, in supporting the investment climate and in reducing the state's role as an active investor in the economy.

In fulfilling these objectives in an effective way the overall framework of the formulation of laws and regulations requires an explicit whole-of-government approach for regulatory policy, including: responsibility for co-ordination and oversight of regulatory policy; a commitment to assess the cost-benefit of new regulatory proposals and existing regulations, and; the effective implementation of the principles of transparency and public consultation in regulatory decision making (OECD, 2010a).

In emerging markets, extensive state ownership and interference have led to regulatory uncertainty and a business climate that is not conducive to fair competition in open markets. The state's dual role as an active investor and referee has meant that the government is uniquely positioned to shape the applicable legal regime with its interests as shareholder in mind. In many cases, state ownership has created conflicts of interest for the authorities and distorted or suppressed competition. Regulatory institutions and processes are still young in emerging markets, and often regulatory authority is fragmented across a number of bodies, some of which have conflicting mandates. Inadequate co-ordination among government bodies at the national and sub-national levels is a widespread problem, leading to unclear, duplicative, and often conflicting efforts in a number of areas. The lack of sound regulatory governance has meant that popular perceptions of endemic patrimonial politics have persisted, with vested interests and collusion being assumed to operate at the expense of the national interest.

A recent OECD Regulatory Policy Working Paper, Regulatory Policy in India: Moving towards regulatory governance, looks at India’s existing regulatory regime and its evolution in the last two and half decades. The mechanisms of regulatory governance have weaknesses, and in some cases have fallen short of expectations. The paper looks at India's uneven regulatory environment and how its legacy features constrain the evolution of regulatory governance.

Foremost is the difficulty in designing and implementing regulatory policies given the government's inclination to maximize its revenue at the expense of social welfare. This trade-off has compromised effective regulation in the country because of a lack of understanding of what constitutes the objectives of regulatory governance. The paper highlights how the dichotomy between the interests of governments and businesses, as well as that of citizens, has manifested itself over the years in four distinct sectors i.e. mining, hydrocarbons, power and telecoms.

Basic regulation in India is implemented via the concerned line ministries, which may proceed to create industry-specific regulatory authorities that have varying degrees of autonomy, functions, and power. There are significant variations in the structure of the governing bodies, tenure of the members, sources of finances, and interface with the government. A noticeable feature of many of the regulators in India is that they are charged with the promotion and development as well as the regulation of a certain industry. That can result in the regulator thinking of the interests of the industry rather than the users of the industry.

In sectors like insurance, coal, petroleum, telecoms, banking, regulatory strategies are hampered by the presence of State owned firms. The inadequate institutional distance between regulators and state-owned firms, especially when there are no firewalls between them, has meant that the regulators have not promoted enough competition.

In these areas, the State is obliged to play a dual role: i.e. that of market regulator when it is also the owner of commercial SOEs, particularly in newly deregulated, often partially privatised industries. Whenever this happens, the State is inevitably conflicted in its opposing interests as: first, a major market player/firm owner in its own right, and second, as an arbitrator in the (supposedly) neutral, impartial, dispassionate role of regulator.

Regulators are expected to behave independently, and the challenge of independence is to avoid capture by interest groups who stand to benefit from regulation. It is equally significant to avoid regulatory capture by local politicians. Local politicians are attracted by the possibility of large economic rents in perpetuity. Too often, regulators have actively internalised political sentiments in their decision-making. In addition, the elite governmental bureaucracy has a ubiquitous presence in regulatory bodies. Regulatory independence from the executive is difficult to administer if regulators themselves come from a career backdrop of directing political decisions. This strain is exacerbated when regulators are appointed directly from senior governmental positions, requiring them to shift, from administering and defending government positions, to acting as an impartial referee (Dubash, 2008).

Many areas, such as agricultural markets, warehousing, or land, require coordinated approaches to regulation (both rule-making and enforcement) by the central government, and sub-national governments at the state and city levels. Economic liberalisation, coming on the heels of political federalisation, has transformed federal –state relations unleashing unintended and unplanned decentralisation (Sinha, 2004). Any regulatory reform agenda depends crucially on a close co-operation between different levels of government. Federal-state relations have been affected significantly with the rise of multi- party coalition governments and alliance politics in the 1990s. Coalition and alliance partners from states have become progressively more powerful at the national level and more capable of bargaining with the national government. That political reality has added considerable complexity to the environmental and social dimensions of economic decision-making which need the cooperation, and an explicit ethos for regulatory governance, of both national and state governments. The need for multi-level policy coordination has been felt making way for the creation of technical and regulatory agencies at various levels, at times adding to the complexity of policy processes, at others to the bypassing of traditional forms of accountability at all levels (Arora, 2014).

In addition to the legacy features of India’s regulatory environment, the country lacks a coherent policy on regulation. A whole of government policy towards "regulating" would provide the connectivity of different reform efforts and help the concerted effort towards regulatory governance instead of disconnected regulatory reforms. This may include a combination of creating or enabling institutions to embed good regulatory principles into their functioning, but also include the systemic implementation of good regulatory practices such as regulatory impact assessments, public consultation and administrative simplification in priority sectors.

Some sub-national regulators in the power sector and the airports regulator have embedded stakeholder engagement with discernible positive outcomes. the more active use of Regulatory Impact Assessment (RIA) and stakeholder consultation, can inform the government on the cost of some of the trade-offs that India faces in the design of its regulatory policy. Although there exists a certain consensus on the importance of RIA and half-hearted efforts have been made so far to implement it, lack of political will, capacity constraints and limited awareness amongst other stakeholders are impeding its further application. Experience with regulatory governance in the last two decades has resulted in the Regulatory Reform Bill 2013 which intends to legislate an overarching regulatory law to introduce further regulatory reforms and standardise some basic institutional features and processes across all regulatory bodies. The OECD would welcome the opportunity to engage with the NITI Aayog during the redrafting process of this bill.

In addition, India could learn from the experience of both mature and young regulatory governance countries in implementing its regulatory policies. Malaysia which has undertaken large market reforms leading to initiatives for greater regulatory coherence. Australia and New Zealand’s Productivity Commissions, show, most importantly, that the regulatory environment needs to be constantly evaluated to make sure it is keeping pace with the changing technology, business environment, and consumer needs and demands (OECD 2010b). The United Kingdom’s Regulatory Policy Committee provides opinions and scrutiny over the quality of analysis by government departments and are engaged in setting "regulatory guidance" across the government. Korea's Regulatory Reform Committee drives forward the regulatory reform agenda (OECD, 2015).

Bibliography

OECD (2010a). 'Regulatory Policy and the Road to Sustainable Growth', OECD Publishing, Paris.

Dubash, Navroz (2008). 'Institutional Transplant as Political Opportunity: E-Practice and Politics of Indian Electricity Regulation', Comparative Research in Law & Political Economy Research Paper No. 31/2008.

Sinha, Aseema (2004). 'The Changing Political Economy of Federalism in India: A Historical Institutionalist Approach', India Review, Vol. 3, No.1.

Arora, Dolly (2014). 'Trends in Centre-State relations', Indian Institute of Public Administration, New Delhi.

OECD (2010b). 'Review of Regulatory Reform: Australia', OECD Publishing, Paris.

OECD (2015). 'Regulatory Policy Outlook', OECD Publishing, Paris.

 

Lalita Som has worked for the Organisation of Economic Cooperation and Development, Paris. She can be reached at lalita.som@gmail.com