Incorporating Energy Cycle Externality Costs and Benefits in India’s Power System Planning Mechanisms
Prepared by Stephen Powell[1]
April 11, 2007
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Table Of Contents
Executive Summary………………………………………………………………………………………...1
1 Introduction 4
1.1 Background 4
1.2 Scope of the Paper 5
2 Conclusions of the Markandya Paper 7
3 The Power Sector Planning Framework 10
3.1 Industry Structure 10
3.2 Electricity Act, 2003 11
3.3 Current Generation Expansion Planning Process 12
3.3.1 Central Electricity Authority 12
3.3.2 State level planning 13
3.4 Procurement 15
3.5 Summary and Conclusions 16
4 Internalisation of Environmental Externalities 17
4.1 Background 17
4.2 Changing Sector Structure 18
4.3 Options for the Internalisation of Environmental Externalities 18
4.3.1 Inclusion of adders 18
4.3.2 Tighter standards 20
4.3.3 Economic instruments 21
5 Conclusions & Recommendations 31
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Incorporating Externalities in India’s Power Sector Planning Mechanisms / Executive SummaryIncorporating Energy Cycle Externality Costs and Benefits in India’s Power System Planning Mechanisms
Executive Summary
Introduction
The power sector in India plays a fundamental role in the economic development process. The country faces formidable challenges in meeting its energy needs in an environmentally sustainable manner and at reasonable costs. The planning and operation of the sector has hitherto been conducted without due regard to the environmental consequences. As a result, additions to capacity in recent years have been sub-optimal. Moreover different types of capacity are treated differently. Hydropower is required directly to bear more of its external environmental costs than other sources. The recent Supreme Court ruling has reinforced this tendency. Looking forward, much of the large capacity additions required over the next few years are likely to be coal-fired, with concomitant effects on the country’s environment.
Against that background, the paper looks at India’s power generation planning process; whether and how it might adapt in the light of increased attention to environmental costs and benefits; and if there are other, better ways of internalizing environment externalities. It takes as its starting point the conclusions of the companion paper by Anil Markandya. These are that the external environmental costs of fossil fuel generation are as high or higher than estimates derived for developed countries; that estimates of the external costs of both fossil-fuelled and hydro for India should now be determined more precisely and used at the strategic level in planning, at the regulatory level in setting standards, in designing economic instruments and in plant siting decisions; and that the polluter pays principle, which currently applies in the case of hydro, should also be applied in other power sector developments.
Planning
Under the Electricity Act 2003, planning of the power sector as a whole is formally undertaken by the Central Electricity Authority. But it would be misleading to describe the planning done by the CEA as central planning. The CEA no longer has the ability to influence the choice and location of generation additions. It is at the State level that the real planning decisions about future additions to capacity now get made. The State Electricity Boards (or their unbundled successors) are the de facto single buyers of electricity. It falls to them to plan to acquire the necessary means to meet anticipated future growth in demand for electricity.
Generation and transmission expansion planning and procurement are currently based entirely on the financial costs of additions to capacity. No allowance is made for economic costs (i.e., including the external environmental costs). This is because only the actual project costs incurred by the SEBs can be recovered through the tariff.
Internalizing externalities
Internalizing an environmental externality refers to the process of incorporating environmental costs in the private decisions of producers and consumers, thereby offsetting the tendency to treat the environment as a “free good.” This can be done directly, effectively by raising the cost of the activity in question, e.g., by taxing the cause of the environmental externality or by setting higher standards. Or it can be achieved indirectly, by ensuring that the environmental externality is acknowledged in the planning process, through the use of so-called ‘adders’, even if private costs remain unaffected.
The indirect method will work, but only for as long as planning has a role to play in effecting capacity additions and only if the regulatory commissions accept the resulting plan. As the single buyer structure disappears, using ‘adders’ in the planning process will have progressively less effect. Moreover, international experience of their use is not encouraging.
Of the direct methods, a tightening of emission standards would have the advantage of building on the existing approach to environmental regulation. It would also be the most direct way of internalizing environmental externalities, in the sense that tighter environmental standards would be directly reflected in higher capital or operating costs and would thus directly alter the relative costs of generation sources. And, if compliance was strictly enforced, it would result in lower emissions. On the other hand, the command and control approach is economically inefficient, since additional emission reductions that could economically be made are not made. And it creates free rider problems if enforcement is weak.
Direct methods which create financial incentives for emissions abatement by putting an explicit or implicit price on emissions, but which do not themselves dictate abatement decisions, are referred to as economic instruments. They work by changing the commercial incentives that generators face, thereby influencing their behavior. Those with low abatement costs have an incentive to emit less than those with higher abatement costs; and are continuously incentives to do so. This makes economic instruments more cost-effective than the traditional command and control approach. The main examples of economic instruments are the removal of subsidies; environmental taxes; emissions fees and tradable emission schemes.
The removal of subsidies on activities associated with environmentally harmful emissions has the same impact as an environmental tax, since it will raise the cost of inputs and outputs, just as an environmental tax would; and the removal of subsidies and cross-subsidies at the end-user price level would reduce demand, thereby indirectly reducing pollution. The Indian energy sector suffers from distorted pricing at several levels. Removing long-standing fuel subsidies elsewhere has done more by all accounts to improve environmental quality than any explicit environmental policy. The existing extent of subsidization and cross-subsidization in the Indian energy sector suggests that a similar step could have a significant impact.
The most common economic instrument is the environmental tax. There are generally three types: taxes on final products associated with a polluting activity (i.e., electricity); taxes on inputs into the polluting activity (i.e., oil, coal); and taxes on polluting substances contained in inputs (e.g., the carbon content of coal). Environmental taxes are less demanding of environmental regulators than instruments that rely on monitoring and compliance enforcement for their effectiveness; and they are easy to administrate. But they do not create incentives to abate emissions per se, only to limit purchases of an input or an output linked with harmful emissions. But this should not rule them out: for example, an environmental tax on the consumptive use of water by thermal generation in India would internalize the cost and provide operators with better incentives to manage their use of water.
Emission fees are fees paid by generators per unit of emissions of a particular pollutant (e.g., ash, CO2, NOx etc.). Emission fees directly reduce emissions by creating incentives to reduce emissions; and they reduce emissions at lower aggregate costs than a command and control approach would do. But fees need to be set high enough to have an impact, which may be politically difficult to do. And they require some minimum level of credible monitoring and enforcement, which could require the installation of costly continuous monitoring systems.
Taxes (or fees) and tradable allowance schemes are, in principle, very similar. All rely on price signals and on financial incentives for generators to reduce the external costs they impose. The majority of countries using economic instruments for environmental policy purposes have hitherto relied more on taxes or fees than on tradable allowances. This may be because taxes are a more familiar tool than tradable allowances; and because a tradable allowance scheme imposes greater administrative costs than using the tax system. This is because participants must have confidence in the integrity of the monitoring, measuring and verification/certification systems put in place. These systems are required to ensure that the prices of permits in the market truly reflect the fundamental drivers of the price. Without confidence in those systems, the scheme will not work effectively, if at all.
Conclusions and recommendations
First, the environmental consequences of generation in India are best mitigated by pushing ahead with power sector reform. This will yield environmental benefits from raising end-user tariffs in real terms; reducing technical losses in the transmission and distribution systems; increasing the efficiency of state-owned thermal plants; reforming the structure of tariffs; restoring the financial health of the sector; and eliminating the health impacts of small diesel generators in highly populated urban areas by reducing shortages through adequate grid-based generation.
Second, ensuring that fuels are priced at their economic cost is another step that could be taken to ensuring that the environmental costs of generation are internalized.
Third, using externality adders in power sector planning at either the state or central level to reflect environmental externalities is unlikely to be either feasible or effective.
Fourth, tightening emission standards, both for existing plants and for new plants, is unlikely to have much effect. The priority must be to ensure compliance with the existing limits, before contemplating tighter ones.
Finally, of the economic instruments an environmental tax high enough to have an environmental impact is likely to be difficult for political reasons; emissions fees depend for their effectiveness on the institutional capability and political will to provide a minimum level of monitoring and enforcement, but are a viable option if those demands can be met; and an emissions trading scheme is unlikely to be feasible in the foreseeable future in India, where a lack of monitoring, enforcement, and administrative capabilities is a critical constraint
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Incorporating Externalities in India’s Power Sector Planning Mechanisms / IntroductionIncorporating Energy Cycle Externality Costs and Benefits in India’s Power System Planning Mechanisms
1 Introduction
1.1 Background
Environmental issues in the power sector are of major importance in India, where electricity plays a fundamental role in the economic development process. As the Planning Commission’s recent Draft Report of the Expert Committee on Integrated Energy Policy says, India faces formidable challenges in meeting its energy needs and providing adequate energy of desired quality in various forms to users in an environmentally sustainable manner and at reasonable costs.
According to that Report, India needs to sustain an 8% to 10% annual rate of economic growth to eradicate poverty and meet its economic and human development goals. To deliver that growth, India would need to see its power generation capacity increase by 2031-32 to almost 800GW (compared with installed capacity in mid-2006 of 125GW). The environmental consequences of this growth in generating capacity will be significant.
Yet in India, as in many developing countries, the planning and operation of the generation and transmission system has generally been conducted without due regard to the environmental consequences. The root causes of this include:
(i) the perpetual shortage of supply capacity, owing to a combination of factors, including low and distorted tariffs, leading to inadequate financial resources in the sector, resulting in the difficulty of acting against power stations not in compliance with central or state environmental regulations;
(ii) a distorted system of incentives which throws the burden of meeting electricity needs heavily onto supply from conventional coal-fired power stations;
(iii) the failure of power-system planning at the level of the states to incorporate the environmental effects of alternative policy options;
(iv) the failure of the environmental regulatory system, in which environmental impact assessments (EIAs) are more of a justification than a meaningful analysis and which fails to monitor or enforce compliance.
Heightened sensitivity about the environmental implications of power generation technology choices in India have resulted in additions to capacity in recent years have been sub-optimal, both in terms of the generation mix and of the total amount of capacity that has been commissioned.
Moreover, the cost structure for generation and transmission projects going forward may be influenced by the recent Supreme Court ruling that:
· hydro-electric generation project developers should compensate the state for the diversion of forest land used to fund environmental protection, including regeneration of forest, the maintenance of ecological balance and eco-systems and forest conservation; and
· that the level of compensation paid should reflect the net present value of the land diverted will influence.
The impact is relevant for large storage hydro projects, which are likely to be sited in protected areas and which could cause a large loss of forested land due to inundation, and which already face a 10% ‘tax’ imposed on hydro generation by many State Governments (in the form of the requirement on a hydro generating station to provide 10% of its output free to the State in which the project is based). Moreover, certain transmission projects, particularly those that would link hydro projects with market areas, could also see their cost structures change depending on the methodology for calculating the NPV of forests. This could result in unintended consequences, such as less hydro being developed and, as a consequence, an even greater reliance on coal-fired power plants to meet demand, though in current circumstances (i.e., high world oil and gas prices), hydro project costs would have to be significantly increased by these factors before they became uncompetitive with gas-fired combined cycle peaking plant.
While the immediate concern of the two papers is with the effects of the recent Supreme Court decision, a strong case can be made that now is also an appropriate time to focus on the whole issue of the environmental impact of power generation in India. The demand for power in India is growing at a significant rate. Much of the capacity additions required to meet increments in demand and to satisfy currently unmet demand is likely to be coal-fired. While India’s large reserves of coal are a major asset, excessive use of this form of energy production will cause the country’s air, land and water resources to deteriorate, threatening human health and property. Disposing of the ash that is produced will require large amounts of land and leaching ash can contaminate ground water. Finally, CO2 released from the combustion of coal will contribute to global warming and climate change.