Exporting into a world that has carbon taxes

by Akshay Jaitly and Ajay Shah, Business Standard, 1 May 2023

There is concern in India as the first tangible implementation steps of the European `Carbon Border Adjustment Mechanism' (CBAM) kick in from 1 October 2023. Critics of the CBAM view it as protectionist. What is more important is detailed Indian responses at the policy level and the firm level.

Once Trump got the US out of the Paris accord in 2017, many countries shifted gears to making progress on reducing carbon emissions on their own. In Europe, dramatic moves have been made where governments are forcing decarbonisation. In their most important country, Germany, per capita annual CO2 emissions have come down from the peak of 14.3 tonnes in 1979 to 8.1 tonnes in 2021. At its peak, in 1897, Germany made 17% of world emissions, in 2021 this was down to 1.82%.

Decarbonisation in the European Union produces a global public good. As an example, it reduces the rate of sea levels rising, and thus fosters social stability in coastal India. This decarbonisation, however, comes at a cost. EU voters are conscious that they are paying more for goods, in return for reduced emissions. If carbon-intensive production merely shifted out of the EU, the global public good of decarbonisation would not be delivered, and jobs in Europe would be lost.

Thus, every carbon tax needs to be accompanied by a "carbon border tax": imports into the EU should suffer a tax at the border which reflects the market price of carbon within the EU, thus achieving neutrality in the decision of a firm to locate in the EU or outside it. This is reminiscent of the way the GST is neutral to international production: the full burden of domestic GST (including all upstream steps of production) is refunded to the Indian exporter, and the GST-on-imports is imposed at the recipient country. Zero-rating of exports is not an export subsidy: it's just the principle "you do not tax foreigners". GST on imports is not protectionism: it just removes GST from the list of considerations that shape location decisions of firms.

The EU's "Carbon Border Adjustment Mechanism" (CBAM) will kick in from 1 January 2026 for a few industries. The two industries that matter today for Indian exporters are steel and aluminium. The first implementation work towards this is taking place in India: from 1 October 2023, firms that bring steel and aluminium into the EU are required to establish measurement systems about carbon intensity, and deliver statements of carbon intensity.

There is an instinct with some in India to drag our feet, or to try to use India's diplomatic influence to ask the EU to roll back its CBAM. This is likely to be an inferior strategy. The EU is only the first to introduce a carbon tax. Many other countries will follow. Every country with a carbon tax will have a CBAM-like border tax in order to ensure neutrality for the location decisions of firms. Policy makers need to recognise this emerging landscape and better embed the Indian economy within it. The great asset for India is the plentiful sunshine, which gives a strong position on renewables.

The EU CBAM documentation, Annex III, describes the information systems required to track upstream ("embedded") emissions. There are natural analogies in this field with the GST system, and its tracking of upstream taxation, that leads to its full refunding of all embedded taxation to the Indian exporter. We in India need to work on building these carbon-tracking information systems.

Policy makers and firms in India have known about these moves from the proposal stage in 2021, and many responses are in motion. The Ministry of Steel has, for example, run a `Green Steel' initiative. Electricity policy has created growing flexibility for buyers to get renewable electricity if they so desire. Indian firms in numerous industries have moved towards sourcing renewable electricity. These steps have helped prepare the ground for this day.

With carbon taxation, and ESG investment, many Indian firms want renewable electricity. It is the job of electricity policy to create freedom: where a desirous buyer is able to get renewable electricity at will. The union government's Interstate Transmission System (ISTS) helps greatly. ISTS correctly cracks open the barriers faced by private buyers and renewables generators. As yet, ISTS is not physically everywhere, but it is expanding continuously.

It has always been clear that electricity is a state subject, and that local conditions diverge greatly all across the country. Subsidies for farmers are an issue in Haryana but not in Delhi. Private distribution companies, which improve conditions for electricity reform, are unevenly present. The technical possibilities vary by locale: hydel in the Himalayas, solar in Rajasthan, pumped hydel storage in the Western Ghats, and offshore wind in Gujarat and Tamil Nadu.

Carbon taxation in the world is one more important factor which varies by locale. For Gujarat, Maharashtra, Karnataka and Tamil Nadu, exporting is unusually important. The emerging world of carbon border taxes requires a greater response in these states, than is the case elsewhere. These states need to become the pioneers in India of putting their electricity sector on a sound footing, so as to be fully supportive of the requirements for renewable electricity of their export sector at efficient prices.

Two paths can get us to the required decarbonisation of India: one based on central planning (where officials design the electricity system, and also establish technical rules such as the minimum efficiency of air conditioners) vs. a path based on carbon taxation. The carbon tax harnesses private self interest, and is the path to the lowest cost decarbonisation of India. This is a good time for India to build the fuller electricity sector reform, grounded in a carbon tax.

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