There are obvious reasons to commend the decision, at least from an environmental perspective. Coal accounts for nearly 70 per cent of India’s electricity generation, and the country expects to consume 787 million tonnes of it this fiscal year. If this forecast is accurate, the increased coal tax will funnel an additional 39 billion rupees (US$645 million) into India’s National Clean Energy Fund (NCEF). The NCEF supports research and development initiatives for and the financing of renewable energy-based electricity generation. It is easy to see the appeal of the tax, as it supports low-carbon energy sources at the expense of ‘dirty’ coal.

But three things temper the positive interpretation of the coal tax as a policy that will make India’s energy sector greener. First, the NCEF empowers the central government to pick technological winners for its decarbonisation program. The government has already slated these funds largely for solar and wind energy projects, but this selection may be economically inefficient. Of course, top-down technology choice can improve a country’s economy by coordinating clusters of economic activity or allowing domestic manufacturers to gain experience and thereby increase productivity and reduce costs.

In general, however, top-down prescriptions of the types of clean energy technologies to deploy are unlikely to allow India to achieve its clean energy targets at minimum cost. Estimates of the cost of different types of abatement by McKinsey & Company show a large number of abatement options in India that are lower in cost than solar and wind power.

Moreover, the NCEF consolidates support for clean energy at the central government level without any apparent consideration for the source of the revenue. This strategy promises to create regional winners and losers. The coal-rich states of the east stand to lose while the solar-rich states of the west are poised to win. In addition, if the burden of the coal tax is passed on to end-users, the policy would negatively affect residential consumers for whom electricity purchases comprise a large share of total expenditure. The coal tax thus raises both efficiency and equity issues that could detract from its environmental and economic gains.

More fundamentally, even though the coal tax alludes to the ‘polluter pays’ principle that is generally accepted as a rationale for addressing externalities such as environmental degradation, India’s coal tax affects coal suppliers and not polluters themselves, or those who produce coal-fired power. A broader tax on the source of the externality itself, greenhouse gas emissions, would more directly address the externality and pave the path to a low-carbon economy.

There is one fundamental problem at the core of the coal tax strategy. A coal tax-financed clean energy fund is an inadequate substitute for a market-based mechanism for clean energy deployment. The tax will no doubt lead to greater use of renewable energy technologies. But the chief reason this is a desirable policy outcome is that it will mean lower greenhouse gas emissions.

This outcome can be obtained by other, more cost-effective means, and India should look instead towards market-based policies that abate emissions at the lowest possible cost. Two obvious examples are taxes or cap-and-trade systems on emissions themselves. Of course, these examples have proved to be virtually politically infeasible across a wide range of jurisdictions. Even if one were to accept the coal tax as a response to political realities, the NCEF could be better applied to guide India’s decarbonisation.

In particular, the NCEF could be used to provide low-cost financing for all low-carbon options, not just those employing preferred renewable energy technologies. This strategy could lower the costs of low-carbon energy options in India towards levels enjoyed in the developed world. The NCEF could alternatively be used to fund accelerated depreciation allowances, investment tax credits, or subsidies equal to the avoided cost of emissions. Such energy policies could provide India a lower-cost pathway to a clean energy future by assessing all of its options in the low-carbon portfolio.

While an energy policy funded by the coal tax and NCEF would provide meaningful abatement and support to the renewable energy industry, it may come at the expense of more efficient and equitable pathways to a low-carbon Indian economy. A policy that directs NCEF funds to clean energy projects that the market deems efficient could be a better policy option for the Indian government and others that have considered mimicking its coal tax.

Anshuman Sahoo is a Research Associate at the Stanford Graduate School of Business.