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1.Introduction
A price-based mechanism to mitigate anthropogenic GHG emissions can trace its origins to the 1997 Kyoto Protocol. It operationalized the United Nations Framework Convention on Climate Change by committing industrialized countries to limit and reduce GHG emissions in accordance with individual targets.
Carbon markets aim to reduce GHG emissions by introducing a price on carbon emissions. There are two types of market-based instruments: (i) Emission allowances: It is a tradable permit to emit one metric ton of CO2 equivalent GHG per allowance, and (ii) carbon credits represent one metric ton of CO2 equivalent emissions avoided or removed from the atmosphere. The distinction in carbon marketplace instruments affects the type of carbon market in which an organization may decide to trade. The major types of markets are as follows:
A. Compliance Market: also known as “cap and trade” or ETS (Emission Trading Scheme) markets It deals with a quantity-based instrument where a regulator outlines the maximum level of GHG emissions (cap) for a specified entity.
B. Voluntary Markets: Here, an entity can buy carbon credits to offset some of their own GHG emissions. These carbon credits purchased are voluntary (rather than for compliance purposes). Voluntary carbon credits direct private financing to climate action projects.
C. The compliance offset market, also known as baseline and credit systems, is a project-based mechanism where emission reduction is measured in reference to a baseline (counterfactual) scenario that is estimated based on the assumption that emissions will be higher if the proposed project does not materialize.
1.1. Understanding Emissions Trading Scheme Approach
ETS functions as a quantity-based mechanism in which a regulatory body sets a maximum limit, or "cap," on greenhouse gas (GHG) emissions for a designated group of entities like companies, countries, or facilities. The cap is then divided into a specific number of emission allowances and distributed among the entities that fall under the purview of the ETS, preferably through an auction system. The regulated entities are obligated to surrender one emission allowance for each ton of CO2e (carbon dioxide equivalent) released during the compliance period.
The following aspects are important for an ETS to function:
1. Cap setting approaches: The cap can operate in two different ways. In a bottom-up approach, the maximum level of emissions is tied to the emissions factor of the covered installations. This means that the total allowable emissions will vary based on the output of these installations. On the other hand, in a top-down approach, the maximum level of emissions is linked to the overall quantity of emissions permitted under the ETS. In this case, there is an absolute limit on total emissions that is not influenced by the output of covered installations. An example of the former approach is China’s initial design of its national ETS. Examples of the latter are the EU-ETS, Korean ETS (K-ETS), California Cap-and-Trade Program, etc. There is an expectation that China’s national ETS will also transition to the latter type due to its greater economic efficiency and ability to reduce GHG emissions.
2. Cap across sectors: Ideally, it is preferable to have a comprehensive cap on emissions that encompasses multiple sectors. For instance, the regulatory authority could establish a unified cap of X million metric tons of CO2e for the year 2025, applicable to all major industrial entities operating in sectors such as steel, cement, power, and petrochemicals in India. Instead of implementing separate caps for each sector, the determination of the overall cap and allocation amounts to entities can take into account sector-specific greenhouse gas (GHG) mitigation potential and costs. This approach is similar to the K-ETS model, where the consideration of sector-specific factors aids in establishing the cap and allocation. By having a single cap across sectors, the emission trading system (ETS) can fully leverage its inherent cost-efficiency, allowing for emissions reductions to occur in the most economically advantageous manner across all covered sectors (IEA 2022).
3. Certainty: To promote effective long-term investment decision-making, it is advisable for the regulatory authority to announce a cap trajectory that spans a significant period. This helps establish policy certainty. A clear link between the ETS cap level and the country's Nationally Determined Contribution (NDC) target, as demonstrated in the K-ETS model, can also achieve this objective. For instance, the regulator could declare a cap trajectory in 2019, outlining the emissions limit for the period spanning from 2021 to 2030. By providing a 10-year timeframe, market Participants gain a sense of assurance and stability when planning and engaging in the market.
4. Allocation: The regulated entities need to submit one allowance for each tonne of CO2e emitted during the compliance period. Initially, ETSs often grant significant amounts of free allowances to facilitate a gradual and financially manageable start. However, this approach carries the risk of generating undeserved profits, as entities can pass on carbon costs to product prices. To address this issue, the allocation of free allowances is progressively reduced and replaced with auctioning. This transition strengthens the carbon price signal, driving greenhouse gas (GHG) emission reductions and generating revenue from auctioning that can be utilized to support investments in low-carbon technology and protect vulnerable stakeholders from higher energy costs. It is important to maintain a level of free allocation to safeguard the international competitiveness of energy-intensive and trade-exposed sectors as well as to prevent "carbon leakage." The most popular method of free allocation is based on benchmarks that consider the intensity of GHG emissions.
5. Complementary policies: An effective ETS relies on a supportive policy ecosystem with a competitive carbon price and incentives for emissions reduction. Complementary policies enhance ETS efficiency by providing infrastructure, market certainty, and innovation incentives. ETS coverage is limited to large point sources due to administrative constraints. In India, the power sector contributes to 50% of CO2e emissions. Complementary sectoral policies are needed to address the remaining 50% and can include equipment standards, EV subsidies, and measures like RPO and feed-in tariffs. Complementary policies within and outside the ETS sectors drive innovation and policy objectives. While ETS is crucial for decarbonization, complementary policies are equally important (IEA 2022).
2.Understanding PAT
The Government of India has passed an amendment to the Energy Conservation Act, 2001, which leads to establishment of a carbon credit market in India (The Energy Conservation (Amendment) Bill, 2022). This led to the formation of the National Action Plan for Climate Change (NAPCC) in 2008 to mitigate and adapt to the adverse impact of climate change. The NAPCC identifies measures that promote development objectives while also yielding co-benefits for addressing climate change effectively. The missions are aimed at fulfilling India's developmental objectives, with focus on reducing emission intensity of its economy. The plan will rely on the support of developed countries, with the prime focus of keeping its carbon emissions below those of developed economies at any point in time.
The National Mission for Enhanced Energy Efficiency (NMEEE) is one of the sub-missions that is responsible for mandating specific energy consumption decreases in large energy-consuming industries and creating a framework to certify excess energy savings along with market-based mechanisms to trade these savings. Perform, Achieve, and Trade (PAT) is the flagship program under the mission, implemented by the Bureau of Energy Efficiency (BEE).
Perform, Achieve, and Trade (PAT) is a regulatory instrument to reduce Specific Energy Consumption in energy-intensive industries, with an associated market-based mechanism to enhance the cost effectiveness through certification of excess energy savings that can be traded. PAT is a mechanism for improving the energy efficiency of energy-intensive industries. Specific high-energy-intensive industries are identified as Designated Consumers (DCs) within certain key sectors, who are required to appoint an energy manager, file energy consumption returns every year, and conduct mandatory energy audits regularly. The key tasks in the PAT mechanism are to set the methodology for deciding the Specific Energy Consumption (SEC) norms for each designated consumer in the baseline year and in the target years, devise a verification process for SEC, find ways of issuing Energy Savings Certificates (ESCerts), and operationalize the trading process for ESCerts in addition to the compliance and reconciliation process for ESCerts. At the end of the PAT cycle (three years), ESCerts are provided to DCs. The Perform Achieve Trade (PAT) Scheme is a regulatory instrument used to reduce specific energy consumption (SEC) in energy-intensive industries. The number of ESCerts provided is defined as the difference between the specific energy consumption notified for the target year and the energy consumed in the target year multiplied by production in the baseline year. Example: Referring to the below-mentioned snippet of a PAT cycle-VI notification
The company mentioned in Figure 2 has new baseline for target year 2022-2023 at 0.0880. The difference between baseline mentioned and energy savings achieved post-audit multiplied by Equivalent major product output gives the number of ESCerts the company is issued after 3 years of target completion
If a DC fails to achieve its SEC target, it has to buy ESCerts from a DC that has outperformed to fulfill the target. The trading happens on the platforms provided by Indian Energy Exchange (IEX) and Power Exchange India Limited (PXIL).
2.1. Expectations with PAT:
The intention for Performance, achievement, and Trade can be understood using a scenario from PAT cycle I. The success of PAT cycle I resulted in 8.67 million TOE of energy savings. In lieu of these energy savings, over and above the target, the DCs were awarded tradable Energy Saving Certificates (ESCerts). From the assessment of PAT-I, 309 DCs achieved in excess of their targets, thereby adding to a total of 3.825 million positive ESCerts.
On the other hand, 110 DC could not achieve their target and were entitled to purchase a total of 1.425 million ESCerts. For PAT-I, out of 110 DCs who failed to achieve their target, 96 complied by purchasing ESCerts. A trade worth around 1 billion INR took place in 17 sessions, with 1.29 million ESCerts being traded.
The trade price of the ESCerts was far less than the actual price of one tonne of oil equivalent, and the money invested in saving one tonne of oil equivalent The low price of ESCerts indicates that most of the energy savings have been accrued with the least investment or by improving the operation and maintenance practices in the plant, and ESCerts are a means to obtain additional revenues. The figure below explains three scenarios that justify the investment made for the savings.
In scenario 1, the DC invests 3.01 million INR, just the amount needed to meet the target of 100 ton equivalent. The DC doesn’t get any ESCerts, and neither does it pay the penalty. However, the actual savings against the investment made over the past five years are 5.48 million INR, which is far more than the investment. In scenario 2, the DC doesn’t invest to achieve the target. The DC has to either pay the penalty of 1.197 million INR or purchase the ESCerts from the market at 0.08 million INR.
Therefore, in five years, the DC gains nothing but loses money in the way of penalties or trading. In scenario 3, the DC invests 5.00 million INR, which is more than the amount required to meet the target. Obviously, the DC exceeds the target and gets ESCerts equivalent to the extra savings. The DC incurs a savings of 9.11 million INR at the end of five years against the savings made. Additionally, the DC also earns money through the sale of ESCerts. It could be seen that investing in energy-efficient technologies in and of itself is rewarding. ESCerts may add additional revenue and bring down the payback period of the investment. However, the price of ESCerts is completely market-dependent, based on demand-supply economics.
2.2. Price discovery of Energy savings certificates (ESCerts):
Different price discovery algorithms are used across different contracts at IEX. ESCerts are traded as per Double-sided open/close bid uniform price step auction Algorithm. Price matching will take place if there are crossing prices (buy price > sell price) in the order book, that is, if the best bid price is equal to or higher than the best ask price. In that case, the equilibrium price is determined according to the following criteria:
1. Maximum tradable volume: The Equilibrium Price will be the price at which there is maximum tradable volume.
2. Minimum unbalance: If there is more than one price with equal value for maximum tradable volume, the price that leaves the least volume untraded at its level is chosen as the equilibrium price.
2.3. Current market situation of ESCert Trading under PAT:
The trading for PAT Cycle can be understood by taking a look at past two trading cycles: Trading data for PAT Cycle-1 and current market data for PAT Cycle-2. Details such as market clearing volume (MCV) and market clearing price (MCP) are provided in figure below:
Inference:
1. The ESCerts market is a buyer’s market. During PAT Cycle-1's trading cycle, the demand for the ESCert remained muted during the first months of trading and picked up only during the last month of compliance. A similar trend can be seen in PAT Cycle 2, but the trade volume has significantly declined since the last trading cycle.
2. Trade was halted in November 2021 and resumed in January 2023.
3. The price for the traded ESCert has remained INR 1,804 since the Introduction of base floor price in PAT Cycle 2. As per the ministry of power, “The floor price for the trading of Energy Saving Certificates as mentioned in the Energy Conservation Rules shall be fixed at ten percent of the price of one metric tonne of oil equivalent of energy consumed as may be notified by the Central Government by notification in the Official Gazette for every Perform, Achieve and Trade Cycle.”
4. Purchase bids for ESCerts have remained stagnant with negligible trade volume.
2.4. Recommendation for ESCert regulation:
1. The need for a basis for the determination of the floor price The floor price as ten percent of the price per ton equivalent of fuel seems arbitrary and does not reflect the economics of market conditions. In competitive and liquid markets, the need for a minimum floor price may not arise. A floor price may provide comfort in financing of the projects by Direct consumers or organizations as lenders seek certainty in revenue.
2. Value of floor price: Linking the floor price to a market price/index that is available publicly and is derived in a transparent manner can be implemented instead of additional notification released by ministry of power. This can bring transparency to the ESCert floor price. For example,The price of oil commodity or weighted average of domestic or imported crude of identified quality.
3. Price Notification: A formal calendar for a price notification, if required, should be announced beforehand to remove uncertainty. If the floor price is linked to an available price/index, a case of such uncertainty would not arise.
4. Equivalence in the floor price for REC and ESCert
5. Implementation of MSR (Market Stability Reserve): A surplus of ESCerts has built up
2.5. Major Barriers to ESCerts Trading
As per the draft blueprint released by Bureau of Energy Efficiency. Major barriers identified based on the experience of two PAT cycles are provided in figure below:
1. Limited Participation: Only DCs In EScerts trading, only designated consumers (DCs) with targets under the Perform, Achieve, and Trade (PAT) cycle can participate. DCs purchase EScerts based on their current cycle obligations or anticipated shortfalls in the next cycle.
2. Limited Trading period The ESCerts are traded at the power exchanges at the end of each PAT cycle of three years. During PAT cycle 1, the trading lasted for around 4 months. Such a short window for trading makes it difficult to attract a significant number of buyers as well as sellers on exchanges to increase traded volume and improve price discovery.
3. Compatibility challenge for voluntary demand due to unit of trading EScerts are not typically measured in terms of greenhouse gas (GHG) reductions, which is the standard trading unit in most compliance-based and voluntary carbon markets worldwide. Introducing a provision for fungibility, allowing the trading of units from energy savings to emission reductions, could attract voluntary buyers (and potentially sellers in the future) to participate in the ESCerts market. This would enhance the fungibility of the trading instrument in the short and medium term and potentially lead to increased international participation as the instrument gains wider adoption.
4. Compatibility with standards of issuance and verification in the International VCM There are four major groups, namely ART, Verra, Gold Standard, and American Carbon Registry (along with some smaller ones), that play a significant role in setting standards and providing process guidance for the issuance of carbon instruments traded in voluntary and compliance markets. However, the validation, verification, and issuance processes associated with these standards can be costly. In the Indian context, where the Measurement and Verification (M&V) process of the Perform, Achieve, and Trade (PAT) scheme has unique local requirements, ensuring compatibility with fungible ESCerts used as offset instruments on a global scale may pose challenges. Additionally, each standard faces difficulties in effectively addressing additionality, permanence, and leakage prevention.
2.6.Case Study taken from the European ETS
The EU’s ETS market is the first of its kind, covering over 31 countries and 45% of CO2 and GHG emissions in EU. The EU countries participating in the market represent 20% of global GDP. Since its launch in 2005, the EU ETS has gone through many changes to adapt to the market situation.
Just like India’s planned ETS, the EU also launched the program in a phased manner. The first phase was between 2005 and 2008. This was a pilot phase where a ‘watch and learn’ approach was followed. The second phase was 2008–2012; in this phase, more industries were added. The third phase was 2013–2020, which broadened the scope of industries further.
The second phase coincided with the 2007–2012 financial crisis, and the demand for buying allowances decreased whereas the supply remained constant. This created a surplus of allowances. This surplus caused a collapse in the EU ETS emissions system. At the start of phase 3, 2013, the surplus allowances amounted to $2 billion. Allowances, which were trading at €30 per cerdit in 2008, fell to a price of €2.75 in April 2013. Further, with the availability of cheap credit in developing countries, the situation was further exacerbated. To address the surplus supply, the EU ETS opted for two solutions: backloading auctions as a short-term solution and a Market Stability Reserve (MSR) as a long-term solution.
Under the backloading approach, the number of allowances to be auctioned remained constant, but the time when the auctions took place was spaced out evenly over a period of time to address oversupply. For instance, the EU postponed auctioning 900 million allowances until 2019–2020. The auction volume was reduced by 400 million allowances in 2014, 300 million in 2015, and 200 million in 2016. This allowed the market to absorb surplus and give allowances a relatively better price while transitioning into phase 3. However, this was just a short-term solution to absorb some surplus, but over the long run, postponing credits was not sufficient; hence, the MSR strategy came into effect in 2019.
Under MSR, allowances from the total number of allowances in circulation (TNAC) would be kept as reserves to better adjust market demand and supply. The MSR functions in the following way:
If TNAC is above $833 million, then surplus allowances would be placed in MSR
If TNAC fell below $400 million, then allowances would be released from MSR
Further, EU took the decision to place a set percentage, i.e., 12% of TNAC, in MSR. The percentage was temporarily doubled to 24%
Implementation of the EU ETS reforms designed to tackle the surplus of allowances brought tangible results. Approx. 30% fewer allowances were auctioned in 2019 compared to 2018, and the MSR surplus indicator led to a reduction in auction volumes by nearly 40% (or some 397 million allowances) in 2019.
3. Planned evolution of the existing PAT Scheme to ETS
Early in 2022, the BEE published a white paper with a detailed phase-wise plan for moving from a PAT system to an ETS. This plan has been designed in three phases:
1. Phase 1: Increasing demand in the voluntary carbon market (Short term) This phase focuses on increasing demand in the existing EScerts market by focusing on making the instrument more fungible, adding more participants to the pool, and linking other markets in India with the proposed VCM. The overview of phase 1 operations is shown below:
The demand for the envisioned market would come from five main sources: voluntary buyers, existing Designated Consumers (DCs) participating in the Perform, Achieve, and Trade (PAT) Scheme, State Designated Agencies (SDAs) joining the Voluntary Carbon Market (VCM), DISCOMs fulfilling Renewable Purchase Obligations (RPO), and the inclusion of the airline sector.
Corporate agencies in India, including those committed to global initiatives like SBTi, can be lucrative voluntary buyers in the VCM.
The airline industry, facing increasing emissions concerns, can participate in the VCM to comply with schemes like CORSIA and offset its CO2 growth. Indian airlines alone emitted 11.8 million tons of CO2 domestically and 7.05 million tons internationally in 2019, creating a significant demand for emission reduction units (ERUs).
States and cities can incentivize energy-efficient procurement to improve their rankings and gain a competitive advantage.
DISCOMs with strict RPO compliance requirements may also contribute to the demand in the proposed VCM.
2. Phase 2: Increasing supply in the voluntary carbon market (medium term)
This phase focuses on increasing supply in the VCM market after the completion of phase 1. The crucial supply-side push would come from project-level registration and their proper validation, verification, and issuance of emission reduction units (ERU). For CCS, the reference case will be zero sequestration. Once implemented, the performance of the activity will be monitored, and respective amounts of credits will be issued by the regulatory body. In order to generate credit, a project developer must complete a rigorous process in order to ensure that real, quantifiable emissions reductions have been achieved. Although the process can vary, most follow a similar series of steps:
3. Phase 3: Moving to an ETS (long-term)
This phase aims to transition to a cap-and-trade system where specific sectors and companies within sectors are allocated a limited emissions quota. Under this approach, each entity's greenhouse gas (GHG) emissions intensity factor is determined based on current conditions, such as t CO2/MWh of electricity output or t CO2/t of aluminum. The expected sectoral growth for upcoming years is used to establish a reference for the initial crediting period, known as "business as usual (BAU) emissions." To align with India's Nationally Determined Contribution (NDC), an NDC-alignment coefficient (NAC) is introduced. For example, if the NDC calls for a 30% reduction compared to BAU, the NAC would be set at 0.3. Alternatively, alignment could be based on sector competitiveness, abatement costs, or potential. Crediting is determined based on actual production volumes, with the NAC applied.
To participate, each entity must establish a GHG emissions inventory and a monitoring, reporting, and verification (MRV) scheme. This approach is relatively simple to implement and maintain, as one parameter (t CO2/unit of output) can capture various measures. It enables large companies to address their entire value chain through a straightforward, high-level approach. Notably, this approach is unique and has not been implemented in any credit and offset scheme globally, making the Indian scheme groundbreaking.
Meet The Thought Leaders
Ashray Gupta, BCG consultant and SRCC alumni with a passion for leadership development. In addition to his professional work, he also dedicates time to mentoring individuals and helping them unlock their true potential. Through this experience, he has honed his abilities to provide guidance, encouragement and support to those seeking to accelerate their growth.
Meet The Authors (GGI Fellows)
Vinay Mane is currently pursuing a master's in renewable energy at KTH in Sweden. Prior to joining KTH, Vinay was a Project Engineer at ExxonMobil Services and Technology, where he executed brownfield oil and gas projects in East Africa and India. He is also an avid podcast listener and editor at the Innostation Podcast. He joined GGI to pursue a career in sustainability and public policy. His long-term goal is to be a consultant in the field of renewable energy.
Aneesh Dhotrikar is currently working as Senior Manager with Farmers for Forests, a start-up working to leverage carbon financing to make forests financially viable for the farming community. Prior to joining Farmers for Forests, he was working in Deloitte as Audit In-Charge working on Public and Private audit engagements. He is also a musician who likes to decode old hindi music. He joined GGI to learn skills essential for a career in consulting and his long term goal is to build a start-up focused in the Environment space.
Jaskaran Singh is working with Mercer Mettl as a Senior Associate in its International Sales Division. He is helping large conglomerates in South Africa, Egypt and Nigeria make better hiring decisions using industry leading assessments. Prior to joining Mercer Mettl, he interned with Buddy Cabs: A startup aimed at proving affordable transportation services for the specially abled.
He joined GGI to up-skill himself and pivot to Management Consulting.
If you are interested in applying to GGI's Impact Fellowship program, you can access our application link here.
References
1. Bureau of Energy Efficiency. 2022. National Carbon Markets. New Delhi: BEE.
2. CEEW. 2022. Understanding carbon markets. Available at https://www.ceew.in/sites/default/files/carbon-credit-markets-in-india-prospects-stakeholde r-perspectives.pdf
3. Indian Energy Exchange. 2022. Renewable Energy Certificates. Available at: https://www.iexindia.com/products.aspx- ?id=5%2FPXgqPnjo0%3D&mid=IT8b%2BZM5cBA%3D [Accessed on 11 April 2023].
4. Bureau of Energy Efficiency. 2021.Lessons learnt in ESCerts Trading under PAT scheme: BEE