While the terminology of ETS is used generally, we present a summary of the discussions in the context of the India Carbon Market (ICM) as most of the questions were related to how ICM would evolve and its various associated aspects. Within the ICM, we expect to have an ICM cap-and-trade (ICM-Compliance) market, which is essentially an ETS kind of system, and an offset market (ICM-voluntary) where the Government of India will approve projects and issue carbon credits through its own monitoring, reporting, and verification (MRV) system. This section discusses some interesting and important questions that were raised during discussions across the three simulation workshops.

What would be the price of carbon in the ICM-Compliance market?

A question that was echoed by many participants was related to the trajectory and level of carbon prices that the ICM-Compliance market could witness. It was clarified that the objective of the ETS simulation exercise was not to forecast prices in the ICM-Compliance market. However, there are some key aspects that would impact the long-term trajectory of carbon prices in the ICM-Compliance market. These are as follows:

• Carbon prices are a function of two variables in an output-based ETS with emissions intensity targets — the level of overall (cross-sectoral) emissions cap and the marginal cost of abatement across participating entities (designated consumers). These two variables would collectively determine the level of demand and supply of credits in the ICM-Compliance market. The more stringent is the overall emissions cap, the higher would be the carbon prices. The lower the cost of abatement across sectors and entities, the lower would be the carbon price.
• The lower-cost abatement opportunities are harnessed first across sectors and get exhausted; therefore, the time path of carbon price is increasing in nature, reflecting that is it more expensive to mitigate the next unit of carbon compared to the last one.
• Technology breakthroughs lead to lowering the cost of abatement and hence lead to decrease in carbon prices.
• If credits from the offset markets (ICM-voluntary market) are allowed in the ICM-Compliance market, this would imply an increase in the supply of credits and hence a downward pressure on carbon price in the ICM-Compliance market and an upward pressure on carbon price in the ICM-voluntary market.
• If the ICM credits, be it from the offset market or the ICM-Compliance market, are allowed to be imported in the EU ETS or any other international carbon market system, it would lead to a higher demand of ICM credits and hence an increase in their prices.

All the points mentioned relate to the long-term price trajectory of carbon, but the short-term dynamics and fluctuations around the trend are impacted by many other factors.

Should financial players be allowed in the market?

This was one big question that was evident during the discussions across the three cities.

As the ICM market evolves, it is reasonable to expect that multiple types of players may participate in the market:

• Liable entities: These are typically companies that are regulated under the ETS, often by virtue of their emissions type (i.e., a GHG such as CO₂, CH4, SF6, N2O, etc.) and volume, that are obligated to measure, monitor, and verify their emissions. Such entities are also afforded the option to use their carbon portfolios to manage their emissions by either reducing emissions (via on-site abatements) and/or surrendering eligible allowances (secured from the government via allocations or through the secondary market) and/or buying offsets (secured from the market) in order to meet ETS-specified absolute or intensity-based goal(s).
• Financial traders: Financial traders are sometimes called ‘speculators’ who manage positions with the intent of making profits, mitigating losses, and managing risks. Like a liable entity, a financial trader is a principal in an allowance or offset transaction. Unlike a liable entity, a financial trader does not have the responsibility to monitor or manage emissions nor to surrender allowances or offsets.
• Market-makers: These entities provide market liquidity by posting bids and offers that can be hit and lifted (accepted) by counterparties. Such entities generally are principals in allowance and offset transactions.
• Brokers: These players introduce and sometimes facilitate transactions between buyers and sellers. Unlike liable entities, financial players, and market-makers, brokers are agents for trade counterparties (e.g., buyers and sellers) and are generally not principals at risk for transactions. In such cases where brokers clear trades (i.e., provide escrow-like functions where they receive monies from a buyer, allowances/offsets from sellers, and subsequently deliver allowances/offset to buyers and purchase monies to sellers), they may take title to allowances/offsets for only so long as it is necessary to provide such clearing functions.

The roles, responsibilities, and privileges of each of these participants will generally be defined by specified ETS rules and/or the responsible regulatory entity and should be set in accord with considering the overall objectives of the ETS. For instance, California establishes holding limits, which serve to limit the number of allowances that participant players, liable entities, and financial players can hold. Policymakers can also impose restrictions that serve to limit market volatility, arbitrage opportunities, prices, and windfall gains that could otherwise be earned by participants. Moreover, given that the government is risk-averse, it may elect to come in and closely monitor the participation of financial players until such time as it decides that their broader engagement clearly contributes to the realization of underlying ETS goals.

One key concern that was highlighted was that financial players can influence the market in ways that could end up being detrimental to the Indian industry as the industry representatives are not experts in aspects like estimating/forecasting future carbon price trajectories. Regulating these players, therefore, would be essential in the long term. However, it should be understood that restricting financial players from the market can reduce liquidity, make it more difficult to manage market risk, and result in unnecessarily high prices. As such, regulators may seek a solution that tightly prescribes the roles, responsibilities, and prohibitions applicable to financial players who may wish to participate in the market.

As noted earlier, financial instruments can also play a significant role in the ICM. For instance, in particular, options (including puts and calls), futures contracts, and ‘carbon contracts for difference’ (CCfD) can be used to allow participants to secure the rights to allowances and offsets without having the need to secure title to such instruments on a spot basis. When appropriately included in carbon portfolios, such instruments can be used to hedge/manage risk, reduce volatility, moderate prices, and minimise calls on capital.

Should the allocation mechanism in the ICM-Compliance market be free allocation or auctioning?

The decision on free allocation or auctioning needs to be guided by the stage at which ICM-Compliance market is and the carbon leakage risk of the covered entities. The knowledge about ICM-Compliance market will be very limited among market participants in the initial phases of the programme. The focus of this stage should be on capacity building with a motive of developing an understanding on basic mechanics of an ICM-Compliance market among the market players. Therefore, emission cap might be comparatively relaxed with free allowance allocation (either through grandfathering or benchmarking methods) provided to the participating entities. Such policy decisions of free allocation to companies will play a key role in shaping the ICM-Compliance market efficacy for India.

In the medium to long term, however, emissions caps should evolve to be much tighter. In place of intensity-based caps, India might also use absolute control caps. Additionally, the government could decide to limit the level of free allocation and gradually move towards an increased level of auctioning of allowances for sectors that can pass through their carbon costs.

Auctioning of allowances is a more transparent way of allowance allocation than free allocation. It strengthens the carbon price signal (embodying the polluter pays principle) and, as discussed in section 2.2, allowance auctioning can also generate revenue for the Indian government that can then be used towards providing valuable climate finance as well as towards supporting vulnerable communities and just transition.

Should companies choose in-house mitigation or buy allowances from the carbon market?

Under the ETS, usually, there is a single emissions cap across sectors, while allocation of allowances or targets at the entity-level may be sector- or industry-specific. However, abatement costs are different across sectors as well as across entities within a sector. In the ICM-Compliance market as well, company-level abatement choices (including energy efficiency, fuel switching, and GHG emission reduction technology) would be based on their individual marginal abatement cost curves. For instance, two entities in the same sector facing similar caps might have different MAC curves wherein one might find abatement more cost-effective than trading in the market and vice versa. An ICM-Compliance market system by default will incentivise best-suited strategy at the firm level through clear signals.

If an entity faces a higher cost of mitigation in-house as compared to the price of emission allowances, it could decide not to implement an emission mitigation strategy in-house and instead would be a buyer of carbon allowances. On the other hand, if mitigating in-house is cheaper than the carbon price, the entity would decide to mitigate in-house and can generate significant revenue by selling allowances. An entity’s investment decision should ideally be based on the expected future carbon price that would apply to its investment, considering the time to implement the investment and its operating life, which is likely to be greater than the current market price. Entities have the option to delay implementing emission mitigation options in-house if they are very costly to do so and as emission reduction targets get tighter. Therefore, whether an entity decides to mitigate emissions sooner or later is a significant entity-level strategy that needs to be considered.

Should India implement an emission-intensity-based cap or an absolute emissions cap?

The ICM-Compliance market is expected to be based on emission intensity-based targets in the near future. Emission reduction targets are set based on GHG emissions (tonne of CO_2e per tonne of the product). The absolute cap on an entity in this case will therefore be

Prescribed emission intensity (tCO_2e/t of product) * total production (in tonnes)

This number also is rendered in tonnes of CO_2e similar to an absolute emission cap.

While the mature ETSs have absolute emissions caps, there are good reasons for the same pattern not being followed in the ICM-Compliance market in its initial phase. The choice of absolute versus intensity-based cap has to depend on the context of a country. Emissions are heavily determined by the growth in GDP as shown in Chaturvedi (2021). For a fast-growing developing economy like India, it is very challenging to set absolute emissions cap due to uncertainties related to future economic growth forecasts. Once the GDP growth rate starts tapering with increasing per capita income, ICM-Compliance market can start shifting towards an absolute emissions cap, with adequate flexibility potentially including market stability measures and adjustments in allocations in line with actual production. Even jurisdictions that employ an absolute emissions cap can provide flexibility in terms of variability in emissions induced by an increase or decrease in production volume. For example, in EU ETS, if an entity’s production increases or decreases by 15 per cent of what was forecasted at the time of setting the emission cap, the allocation level can be adjusted.

What could be the role of offset markets in the cap-and-trade market debate?

As noted earlier, allowing liable entities to meet their compliance obligations by surrendering either offsets or allowances can provide increased flexibility and cost relief while also encouraging reductions from sources that are outside of the cap. To help achieve underlying ETS objectives, it is possible to narrowly prescribe the methodologies that can be used to create offsets, the geographic areas (both Indian and international) from which they can be secured, measures that must be used to minimise leakage, and the relative proportion that can be used to satisfy compliance obligations.

The Indian offset market will comprise the compliance offset market and the voluntary offset market. The compliance offset market will consist of offset market under the government-led ICM (ICM-voluntary) and the UN-driven market under Article 6 of the Paris Agreement. The ICM-voluntary market, in alignment with the ICM-Compliance market, will be used by policymakers to help India achieve its NDC. Under Article 6.2, two jurisdictions can come together under an agreement and bilaterally decide the nature of transactions between them with the aim of cost-efficient emission reduction. The Indian government recently published a list of 13 sectors that can generate credits and be transacted under Article 6.2. Similarly, offset trading can also happen under Article 6.4 and the rules for this trading are being finalised.

The voluntary offset market, on the other hand, is driven entirely by private players including project developers, accreditors, verifiers, and corporations seeking to meet their voluntary targets and local communities. The voluntary offset market should work independently of the compliance market.

The share of offsets (from ICM-voluntary market or Article 6) that will be allowed for surrendering against compliance targets under the ICM will entirely be a policy choice. However, offsets are expected to play an important role in accelerating the pace towards net-zero targets at the country level. Therefore, the government’s decision on the potential quota of offset usage in ICM-Compliance market will be crucial for market players.

Credits from the ICM-voluntary market will essentially increase the supply of credits in the ICM-Compliance market. How big or small this supply is in absolute sense, and to what extent will it impact the dynamics of carbon price within the ICM-Compliance market, will be determined by the magnitude of offsets allowed in the ICM. A decision to import up to 5 per cent of ICM-voluntary market credits in the ICM-Compliance market would have a much lesser impact on carbon price within the ICM-Compliance market as compared to a higher value of 20 per cent.

How to ensure equity in CBAM?

To protect their industrial competitiveness against rising carbon prices, the EU has announced the Carbon Border Adjustment Mechanism (CBAM), and similar mechanisms are also being considered by other jurisdictions including the United States. Under CBAM, the EU will levy carbon prices on the import of goods and commodities covered by the EU ETS, so that both EU-produced and -imported goods would effectively be covered by the same carbon price. EU views CBAM as a decarbonisation mechanism. However, an absolute carbon price on every country’s export defies the principle of Common but Differentiated Responsibilities (CBDR). Under CBDR, technology and finance should flow from the Global North to the Global South, but CBAM will result in capital flow from the Global South to the Global North. This arena is still evolving to assess its impacts. However, it is clear that the ICM-Compliance market will play a role in reducing the cost impacts of the EU’s CBAM for Indian exporting companies by imposing carbon costs on covered entities, as well as enabling cost-effective compliance with India’s 2030 NDC and longer-term net zero targets.

Could micro, small, and medium-sized enterprises (MSMEs) be impacted and how to safeguard them?

Like in the PAT scheme, there is a pre-determined threshold for entities to be able to participate in an ICM-Compliance market. These are usually large installations with significant levels of emissions. Therefore, in all likelihood, MSMEs will not be a part of an ICM-Compliance market and therefore there should be only a minimal direct impact on these entities. The indirect impact, however, needs to be better understood, especially for MSMEs that are a part of the supply chain of sectors that are going to be covered under the ICM-Compliance market.

What could be the role of policymakers in successful implementation of the ICM?

It will be essential for policymakers to ensure the efficiency and reliability of the market structure. Consequently, strategic choices concerning emission caps, allocation regime, and MRV systems will be crucial for government stakeholders. MRV for ICM-Compliance market can be built upon the monitoring systems operational under the PAT scheme wherein energy-related information (e.g., fuel mix) is already recorded. Policymakers will also have to provide clear market signals in order for entities to devise long-term decarbonisation strategies.

Indian policymakers also need to ensure efficient preconditions in order to give out a best-suited ICM-Compliance market design aligned with the economy’s overall objectives. Cross-country learnings will play a key role, especially while deciding cap stringency, allocation method, role and scope of operation for financial players, and providing a transparent platform for trading of allowances, including over-the-counter (OTC) trades with a motive of minimising inefficiencies. However, replicating the exact ETS parameters as being done across jurisdictions like the EU, California, or Korea might not be the best option for India. India’s strategy should balance cross-country learnings, the economy-wide cost-effectiveness objective, and socioeconomic trade-offs. Additionally, liquidity under the ICM-Compliance market will depend on the level of cap in place as it will impact the long/short position of companies, which in turn will determine their demand for credits. A more stringent cap and policy certainty will also influence entities investing in entity-level in-house emission mitigation measures through technological innovations. This will mean that eventually entities may move from being allowance buyers to allowance sellers in the long term, thus impacting both the supply and demand sides. Therefore, through policy design, supply, and demand for credits and therefore liquidity in the market can be moderated by placing a stringent cap, providing policy certainty, and including sectors not covered under the PAT scheme at present in India.