How to decarbonise

by Akshay Jaitly and Ajay Shah, in the Business Standard, 1 November 2021

Governments are essential to the process of decarbonisation. Carbon dioxide is a pollutant, where emissions by one person impose a negative externality upon another. State coercion is required in order to reshape the incentives of the polluter. Fossil fuels are so deeply interwoven into the fabric of the modern economy that decarbonisation has far reaching impacts all across society. A large scale change in the mechanisms of production and consumption of energy is required. This change will be achieved at the lowest cost to society if it is not centrally planned.

The big idea of climate change is that CO2 is a pollutant. Each person that emits CO2 is imposing a negative externality upon every other person in the world. This is a market failure: if people are left to themselves, there will be excessive CO2 in the air. The state is essential in addressing this market failure. Hence, we look to meetings like COP26 where the governments of the world will hammer out agreements to bring about the required decline in emissions.

Energy and fossil fuels are deeply interwoven into the economy. At every location in India, there are local tradeoffs about the most efficient mechanisms for decarbonisation. As an example, near Bombay, the step function into the Western Ghats creates natural opportunities for energy storage by pumping water into natural and artificial reservoirs. Renewables + pumped storage hydropower (PSH) are quite attractive in these places. In Rajasthan, there is a lot of sunlight. All along the border with Nepal and Bhutan, there are natural opportunities to buy hydel power. Hydrogen can be made, using solar electricity in the Middle East, and shipped to locations all along the Indian coast.

Each of these situations demands local thinking on the part of both supply and demand. In the Indian climate and energy discussion, there is a lot of emphasis on the supply side. But there are equally important responses required on the demand side. The burden of adjustment will be much greater if all the adjustment has to only happen on the supply side. Time of day patterns of mismatch and pricing are going to change greatly. Owners of energy-intensive factories will put their facilities in locations where energy is cheap. Companies with ESG investors and those which export into developed countries will favour locations where they can buy cheap renewable energy.

A new generation of central planners likes to paint scenarios for energy, carbon and alternative technologies and so we have the National Solar Mission, the National Hydrogen Mission, the National Electric Mobility Mission Plan and others. Our path in India is one with physical targets established by the union government, and then command-and-control systems which try to force implementation of the target. There is an element of conceit in such planning, as nobody knows how the energy system of the future is going to look, after the dust has settled. The cost of decarbonisation is elevated owing to this central control.

Decarbonisation requires a process of search. Self-interest and the profit motive continuously guide buyers and sellers, in each sq.km. of India, to find innovative solutions to their problems. The only coordination required between multiple private people is the price of electricity, which should be determined in an electricity market. The richness of information, that the dispersed decision makers all across society see, is superior to what any central planner sees. In addition, the central planners are not maximising the objectives of the people, and are handicapped by low state capacity.

The carbon tax is the correct separation between the use of state power to address the negative externality while removing state control from the detailed process of decarbonisation. Taxation of the carbon content in fossil fuels is something that only the union government can do. This would drive up the price of fossil fuels. Once this is done, at every location, self-interested private people would look for the most efficient solutions. The range of solutions, and their evolution through the coming years based on technological advances, will surprise us. This process of discovery will deliver the required decarbonisation at the lowest cost to society.

Decarbonisation through the price system, backed by a carbon tax, has five strengths:

It induces responses on supply.
The economics of renewables producers would improve when compared with users of fossil fuels when carbon is taxed, based on market forces and not government coercion or subsidies.
It induces optimal responses on demand.
Prices of electricity -- which would vary by place and time -- would reshape demand-side decisions about energy efficient technologies and the very choice of production location. For example, data centres would move out from India into countries with a low cost of capital and high renewable energy opportunities.
It is a decentralised process.
The thinking and problem solving at each location of the country is done reflecting local conditions, with coordination taking place between private persons through prices, without requiring an omniscient central planner.
It involves constant adaptation based on technical change.
Private people will place bets based on the technologies visible today, some firms will fail owing to technical change in the future, and both supply and demand will ceaselessly respond to the changing global technological frontier. Risks will be taken, mistakes will be made, the economy will move forward.
It avoids the difficulties of the state.
The heavy lifting is done by private people, who are self-interested, as opposed to the state which has its own objectives and has low capabilities.

The job of the state is to establish present and future values of the carbon tax, and then stand back and watch the decarbonisation happen. A review of tax rates would be required every five years, to ensure that the overall CO2 emissions are on the desired path.

For us as thinkers and analysts, it is important to engage in intellectual analysis, to envision the future, to think about megatrends, and to place speculative investment bets based on the point of view. But we should watch and protect against crossing the line into central planning, into the use of state power to control the detailed technological structure of the economy, into industrial policy. If grand schemes are imposed upon the economy, the cost of decarbonisation will be higher, as opposed to the organic and bottom-up process of local analysis, local innovation, local entrepreneurship and local risk taking.

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