Funding a green future: Fiscal planning for green power

To execute climate mitigation plans, the economy will have to undergo an overhaul

In transport, all two and three wheelers, three-fourths of total buses and cars, and at least half the overall trucks sold would need to be electricity- or hydrogen-based by 2050 as compared to the present one-fortieth of total vehicle sales.
In transport, all two and three wheelers, three-fourths of total buses and cars, and at least half the overall trucks sold would need to be electricity- or hydrogen-based by 2050 as compared to the present one-fortieth of total vehicle sales.

By Renu Kohli, Deepthi Swamy & Varun Agarwal

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Climate change has propelled the global economy to an inflexion point. The world’s energy supply, industry, and transport systems, still largely reliant on fossil fuels, are set for a massive transformation over the next three decades as countries endeavor to cut greenhouse gas emissions for climate change mitigation. In November 2021, India too announced its goal to reach net zero emissions by 2070 at the 26th Conference of Parties (COP-26). The required low-carbon development pathway to achieve this target, according to our analysis, implies a deep structural alteration of the economy. By 2050, for example, at least three-fourths of India’s electricity would need to be generated from fossil-free sources against the under one-fourth at present. The share of electricity and green hydrogen in the Indian industry’s fuel-mix would need to increase beyond 50% from less than one-sixth at present. In transport, all two and three wheelers, three-fourths of total buses and cars, and at least half the overall trucks sold would need to be electricity- or hydrogen-based by 2050 as compared to the present one-fortieth of total vehicle sales.

Undoubtedly, the transition away from fossil fuels opens up opportunities and brings benefits, inter alia, a notable reduction in oil-import dependency, improved human health due to lower particulate matter pollution, and economy-wide saving of costs that could be as much as Rs 60 trillion ($877 billion) by 2050 compared to a business-as-usual pace of transition. At the same time, it also poses challenges, a potentially critical one being fiscal. In the dynamics of energy transition, this has perhaps received less policy attention than that indicated by the exceptional and high public revenue-dependency upon fossil fuel levies. A progressive decline in fuel revenues over time, howsoever gradual this may be, could be a severe constraint upon public finances in the course of transition.

Fossil fuels, mainly petroleum products, are well-known and prominent contributors to both central and state government revenues. The Prayas Energy Group estimates the share of energy taxes in central government revenues at around 25% during FY20, increasing to an astounding 35% in FY21; petroleum product taxes fetched more than three-fourths of the energy revenues. The transition from fossil fuels, primarily driven by substitution in the transport sector that could result in nearly a two-thirds reduction in projected consumption of petroleum products by 2050, implies significant public revenue losses therefore. Our analysis, based upon the present taxation structure and assuming a decarbonisation pathway aligned with our climate goals, shows a reduction in fuel revenues by `16 trillion ($234 billion) by 2050 (relative to business-as-usual), or 1.8% of the projected GDP in that year.

Besides these expected losses, fuel revenues are also subject to numerous uncertainties; notably, the pace of private sector transition (which is not under government control and entirely driven by market forces), and relative price changes, competitiveness reasons, amongst other factors. Firms, particularly those with heavy fossil-fuel dependency and external exposure, will respond to pressures sooner than delay energy and technology changeovers; households’ mobility and transport choices will likewise be governed by the evolution of technology and acquisition costs. Innovation shocks and unanticipated surprises in either direction cannot be ruled out in a context of global turn to resolve climate-related issues.

The management of public finances is thus likely to be fraught with multiple challenges ahead. It is aggravated by the timing of energy transition, which coincides with an exceptionally weakened financial position that pre-dates the pandemic and exacerbation therefrom. An enlarged fiscal gap and elevated public debt have tightened the belt on sovereign borrowings. Then, in addition to the expected losses of fuel revenues, there is the escalated need for transition-related public spending; this would be over and above the usual budgetary claims of education, healthcare, and social security. Such spending includes public investment in low-carbon technologies, supporting infrastructure, research, and transfers to shield the most vulnerable households from the impacts of the transition.

Financial constraints will not just squeeze productive expenditures that exert a strong multiplier force upon labour and capital but could potentially delay or hinder the climate transition. Either outcome is undesirable. Our analysis identifies a critical role for public expenditure multipliers, which combine with growth in green sectors such as clean electricity and hydrogen production to exceed contractions in the brown or carbon-intensive sectors and result in net increases in GDP and employment compared to a business-as-usual scenario.

All these forces underscore the need to explore alternative revenue options. Carbon pricing plays a central role in every country’s climate mitigation plans. It is not any different in India and the present fuel taxes are a useful starting point. There is merit in considering a part of these as carbon taxes. Fiscal planning can adjust and finetune these over time and in different scenarios to preserve or augment revenues; a dynamic mix that covers all emissions-causing uses of fossil fuels to incentivise a gradual shift can be designed as well. Taxes on electricity can be tapped as a gradual, long-term replacement—electricity demand is expected to increase beyond the conventional rise in living standards due to larger electrification in industry and transport. On the direct taxes side, raising personal and/or corporate income tax rates is governed by both structural and cyclical factors. Potentially higher economic growth (compared to business-as-usual) spurred by the low-carbon transition could improve long-term direct tax revenues.

These examples are limited to illustrate that at the very least, fiscal planning under different transition scenarios, allowing for anticipated and unexpected shocks, must begin at the outset. It is also needed to ensure the potential regressive effects associated with indirect taxes, for example, the impact on energy prices for the poor, are avoided through careful evaluation and design. Analysing all such challenges and available options, quantifying them under different scenarios, and putting these out for public debate for further enrichment are useful steps forward.

(Kohli is an economist who has formerly worked with the IMF & RBI. Swamy & Agarwal are respectively the lead and senior project associate, Climate Program, World Resources Institute, India. Views are personal.)

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