The Gujarat government’s implementation of a cap-and-trade programme is an important milestone in India’s war against air pollution. Although the pilot project specifically targets particulate matter (PM) pollutants in Surat’s industrial belt, it has wider ramifications for the country.

The scheme is a departure from the traditional command and control approach to environment regulation. The past approach failed to curb emissions and instead bred a culture of non-compliance among companies. The pilot’s success could lead to the adoption of market-based approaches in tackling India’s other environmental challenges.

Indeed, China has already launched a national cap-and-trade programme for carbon dioxide (CO2) emissions.

Gujarat’s cap-and-trade programme sets an overall cap on the permitted PM emissions in Surat’s textile industry. The government then allocates permits to companies which enable them to discharge a specific amount of pollutants. As only a limited number of permits are available on the market, companies can buy and sell permits on an exchange. This makes it economically beneficial to invest in abatement technologies that will help cut down emissions. The scheme aims to lower the cost of compliance for industries, while meeting the state’s air pollution targets.

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Although the pilot project appears to be well-designed, its expansion will lead to many implementation challenges, which are explained as follows.

The transparent allocation of permits

The initial process of allocating permits to companies needs to be transparent to avoid allegations of corruption or favouritism. The government also needs to maximise revenues from permits to avoid controversy over a potential loss to the exchequer. The ‘2G licence scandal’ in the telecom sector demonstrates the political fallout of even a notional loss to the public exchequer from licence allocation.

Although an auction-based system ensures transparency, a high price for permits could damage the economic competitiveness of smaller and medium enterprises (SME). It could also prompt larger industries to stockpile permits to avoid reducing their emissions. The government needs to balance this need for transparency while ensuring equity in the allocation of permits. This can be achieved by creating a fixed formula for allocating permits and displaying the number of permits allotted to each company on a public website.

Balancing economic competitiveness with emissions reduction

Gujarat’s state government faces a conundrum in setting the initial emissions cap. A low cap could hurt the economic competitiveness of the industrial state, particularly as fears of slowing economic growth and unemployment are rising.

However, a high cap would delay emissions reductions and dilute the effectiveness of the program. The EU’s emission trading system has faced criticism due to the over-allocation of permits, enabling factories to easily pay to pollute.

Gujarat should start with a high cap and reduce it every year to enable industries to adapt to the tightening environmental norms. This would prevent a public backlash against the programme and help policymakers gauge its impact on economic competitiveness. Larger companies will be well-placed to invest in capital-intensive technologies to reduce their emissions, but these could be out of reach for SMEs.

Therefore, the Gujarat government must provide regulatory incentives and facilitate technological sharing to supplement the cap-and-trade programme.

Expanding the programme to highly polluting sectors of the economy

The current pilot programme only targets a few industries, such as textiles and dyeing. However, to effectively tackle air pollution, it needs to expand to highly-polluting industries, such as power generation. India’s coal power plants are considered to be the ‘unhealthiest’ in the world, and are also responsible for 60 percent of PM emissions from the industrial sector. A study has found that existing norms for PM emissions from power plants were well behind global standards.

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Although India could tighten environmental norms for new plants, this may result in higher electricity prices. Besides it would not cover the highly-polluting older state-owned plants. A cap-and-trade scheme could be an economically-efficient solution to tackle these challenges.

The US cap and trade scheme for acid rain is a good example of reducing power sector emissions. In 1990, the US successfully implemented a cap-and-trade scheme to solve an acid rain problem caused by sulphur dioxide emissions from coal power plants. Despite fear of economic losses, firms saved $240 million a year compared to a command and control alternative. The programme also reduced emissions from the power sector by 36 percent while coal-fired electricity output increased by 25 percent. The US example demonstrates that cap-and-trade does not have to hurt the economy or lead to a spike in electricity prices.

Policymakers must prevent the export of polluting activities to neighbouring states

A significant risk in implementing the cap-and-trade programme at the state-level is the potential export of polluting activities to neighbouring states with lax regulations. Even within Gujarat, the pilot program could prompt industrial units to shift from Surat to unregulated cities. This would mask the programme’s effectiveness, since emissions reduction in one region could be offset by increased emissions in another region.

Although there is limited research available on the export of emissions following a cap-and-trade programme, a study analysed the impact of tightening domestic environment regulations on international company behaviour. It found that in countries with tight environmental regulation, companies had 29 percent lower domestic emissions.

On the other hand, a tightening in domestic regulation resulted in 43 percent higher emissions abroad. These effects were stronger for firms in high-polluting industries, such as electricity, refining and mining. Therefore, a co-ordinated approach between the centre and states is essential to ensure that the program does not enable large companies with a presence in multiple states to move their polluting activities elsewhere.

Although the cap-and-trade programme can eventually become an important tool in fighting industrial air pollution, its implementation in India’s complex political economy is likely to be messy. Its success, however, could underscore the potential benefits of a market-based approach in tackling India’s many pressing environmental challenges, such as water scarcity and climate change.

Siddharth Goel is the founder and CEO of Rethinking Public Policy, a South Asia-focused public policy consulting firm. He writes about innovative public policy ideas on his blog.