Carbon pricing in emerging countries: A reflection from Climate Policy Summer Academy
By Soyoung Oh & Tarun Gopalakrishnan
Carbon pricing is considered a key policy instrument to steer developing economies towards a lower carbon transition, but implementation can be politically arduous, slowing adoption in many locations, delegates to Climate Policy Lab’s Climate Policy Summer Academy suggest. Among the barriers cited are institutional limitations, strong opposition from emission-intensive industries, and the fear of the increased cost of living. Nevertheless, with the EU’s carbon border adjustment mechanism (CBAM) looming on the horizon, the impetus for adopting carbon pricing has become more compelling for developing countries as their trade competitiveness might be at stake. Further, studies have shown that adopting comprehensive carbon taxation could redistribute resources in the economy while creating economic opportunities. Governments’ long-term commitments to carbon pricing and energy transition ensures a favorable investment environment for low carbon technologies.
Deliberations of delegates during the Climate Policy Summer Academy highlighted distinctive political economy environments that have influenced the pace of progress in implementing carbon pricing. We outline the progress of three such carbon pricing initiatives in South Africa, Indonesia, and India here.
Source: World Bank (2022) and OECD (2021)
In the African context, South Africa was the first in implementing a carbon tax in 2019 despite its high reliance on coal for electricity and opposition from energy-intensive businesses. South Africa’s carbon tax covers approximately 80 percent of GHG emissions in the country. In the world, it is one of the highest shares of GHG emissions covered in the jurisdiction along with the carbon tax in Singapore. From June 2019, the first phase has been applied to activities in various sectors including the metal and chemicals industries. By implementing the carbon tax, South Africa is also aiming to gain first-mover competitive advantage gains among developing countries. Economic modeling of South Africa’s carbon tax in 2016 suggests that the carbon tax will have a significant impact on reducing emissions by 13 percent to 14.5 percent by 2025 even as the economy continues to grow. The carbon tax rate was set at R144 per ton (US$10/tCO2e) in 2022, progressively increasing every year to reach $30/tCO2e by 2030 and $120/tCO2e by 2050. During the first phase, the government collected R1.38 billion (US$83 million) in carbon tax revenue between April and November 2021. By setting its carbon price path definitively over the long term, the Treasury hopes to provide policy certainty to companies for future investment decisions.
In a planned second phase, South Africa is hoping to increase the carbon tax price, expand the sector scope, and reduce the basic tax-free allowances. However, the government announced during the Budget Speech 2022 that the first phase is now extended to the end of 2025. The extension effectively prolongs the existing support measures for companies affected in the first phase. Such support includes an energy efficiency saving tax allowance. The delay would also give more latitude to South Africa’s financially-troubled state power utility company, Eskom, as it has been exempted from the first phase of the country’s carbon tax. It is estimated that Eskom would need to pay about US$763 million per year when the second phase starts.
In Asia, Indonesia is taking a different approach – the country is planning to introduce a hybrid carbon pricing policy by mixing a carbon tax with cap-and-trade systems in the power sector. The carbon tax will be introduced this year before November to create the basis for the Emissions Trading System (ETS). Until the ETS starts in 2025, coal-fired power plants would be fully taxed at the rate of US$2.09/ tCO2e for their excess emissions above the cap. Through running the pilot program last year, the energy ministry noted that about 1 million tons of carbon emissions could be taxable.
Once the fully-fledged carbon market opens in 2025, companies would be eligible to either trade with those emitting below the cap or pay taxes (Figure 1). The companies can also purchase carbon offsets from other sectors like agriculture, forestry, and renewable energy. According to the tax regulations harmonization Law No 7/2021, the carbon tax rate should be higher than or equivalent to the carbon price rate at the market, but the carbon tax floor would remain at US$2.09/tCO2e. More details about Indonesia’s ETS will be released in the coming years.
In a variation from other carbon markets, Indonesia is likely to impose different intensity-based benchmarks for a range of coal-fired power plants instead of an absolute cap on emissions. In this way, the carbon pricing scheme in Indonesia will focus on how ‘efficiently’ power plants are running. Inefficient coal power plants with higher emissions than the upper cap must pay carbon tax or purchase additional credits. As it focuses on efficiency, Indonesia will not be able to control the total emission quantities unlike other hybrid emission regulation systems.
In fact, with a “low and slow” path to Indonesia’s carbon pricing, the cheap carbon tax rate has been called a “compromise to get buy-in from lawmakers amid challenging talks about the energy transition.” The government acknowledges that the current cap and the carbon tax rate are not ideal, but it hopes to lower the cap and increase the price in the future. Indonesia also wants to extend the scope of carbon markets to other sectors from 2024 onward. Still, it is unclear how fast it could increase the carbon price and expand beyond coal-fired power plants. A recent study shows that in response to the introduction of a carbon tax, Indonesia has faced institutional resistance, business influence, and political conflicts of interests.
Figure 1. Indonesia’s hybrid carbon pricing mechanism
Source: Climate Policy Summer Academy (2022)
The problem of low carbon prices in early carbon market development with allowances and exemptions is not new – this problem plagued the early years of the European Union’s Emissions Trading System (ETS) and remains a problem in the US East coast RGGI (Regional Greenhouse Gas Initiative). For instance, the RGGI’s allowance clearing price was around $2/tCO2e between 2010 and 2013 and has only risen to $13.90/tCO2e in 2022, still a very low level compared to the $60/tCO2e or higher that is needed to be effective in the United States. EU allowance in the EU ETS remained at less than $5/tCO2e in mid-2013. EU reforms of its ETS in 2019 have brought about trading reaching $77/tCO2e today. Although the prices have fluctuated due to economic dynamics and other political factors, most carbon prices in developed markets have increased over the years.
Figure 2. Price evolution in select ETSs from 2008 to 2021
To accelerate the speed of carbon market development in Indonesia and South Africa, policymakers might need to consider implementing complementary measures that help to facilitate the environment for carbon pricing mechanisms to succeed to contribute to a significant lowering on emissions. For instance, reforms to their state-owned enterprises would help them further raise ambition. A recent IMF report called for South Africa’s reforms on SOEs (e.g., network industries) that are vulnerable to the decarbonization pathways. South Africa’s Treasury suggested splitting Eskom into different companies for different functions such as creating an independent transmission entity.
In India, the prospect of a carbon price looks different. More than half the country’s emissions are covered by indirect carbon taxes in the form of cesses and fees on coal and gasoline. The rates, however – just under US$15 per ton of carbon dioxide - are lower than the carbon price levels of US$25-75/tCO2 recommended to align with the Paris temperature targets. Political and institutional barriers to instituting carbon pricing in India remain significant.
Politically for India, replacing fuel taxes with carbon taxation poses a ‘double-bind’ for the government. Imposing a carbon tax on top of existing fuel taxes hit sectors like household electricity, cooking gas, and low-cost vehicles (particular freight vehicles) the hardest, with significant downstream effects on food affordability, especially in rural areas. On the flip side, replacing downstream fuel taxes (generally levied on the consumer) with upstream carbon taxes (levied on the producer/seller) results in the government effectively cutting into its own revenue. This is because, unlike renewable energy, fossil fuel production and thermal power generation in India is state-dominated – the public sector accounts for more than 60 percent of thermal power capacity and 18 of the country’s 23 refineries. Coal mining was a government monopoly until last year and private demand for coal mining blocks is lower than anticipated.
This double bind is solvable – in theory – by good policy design. The gradual phased replacement of fuel taxes with carbon-based taxation could mitigate price shocks. It could also secure more sustainable revenue for the government in the long run. This is because domestic manufacturing is set to grow with government support and its process-based emissions will take longer to decarbonize than the energy consumption emissions from electricity and transport. Carbon taxation revenues can also be used to improve welfare such as lump-sum transfers or energy and food subsidies to rural households.
These design choices require tackling broader institutional questions. The Indian Constitution divides taxation powers between the central and state governments, necessitating a decades-long effort to implement a unified, complicated goods and services tax. In addition, the lion’s share of tax revenue is currently collected locally, cumulated nationally, and then re-distributed to states according to formulae prescribed by the federal Finance Commission. Carbon pricing will have to be integrated into this evolving ‘fiscal federalism’ in a manner that does not end up penalizing vulnerability.
Our work at CPL shows that a well-designed carbon price for India can potentially accelerate GDP growth and net job growth while flattening the emissions curve when combined with other conditions. Firstly, a carbon price would need to be a part of a broader climate policy suite; it is not a ‘silver bullet’ solution – politically, economically, or ecologically. Secondly, a carbon price alone cannot be effective to decarbonize sectors where viable, cost-effective technological alternatives do not currently exist, such as certain industrial processes so these sectors would have to be exempted until new technologies can be launched. Finally, developing nations will also have to consider the pace and nature of the development of carbon pricing in other locations in fashioning their own policies.
Despite political and design difficulties, carbon pricing can be a useful policy tool for the developing world. It can set a long-term signal for innovation in sectors where carbon-free alternatives are not yet available. It also gives a credible signal to regulated companies even at low carbon prices, which could lead to their behavioral changes to reduce CO2 emissions, as studies show. Finally, carbon pricing offers a decarbonization policy that improves the health of public budgets and raises finance for socio-economic priorities like Just Transition. In summary, carbon pricing provides a metric to coordinate differentiated climate ambition and sustainably linked national markets. As countries raise their ambition to address climate change, we believe carbon pricing will be more widely adopted. ∎
Soyoung Oh is an Assistant Researcher at the Climate Policy Lab at The Fletcher School, Tufts University.
Tarun Gopalakrishnan is a Junior Research Fellow at the Climate Policy Lab at The Fletcher School, Tufts University.