Input substitution in electricity generation and industrial production: Evidence from India

Abstract

Carbon taxation is suggested as an efficient instrument for the clean energy transition. However, high resulting prices for coal and electricity could adversely impact industrial performance and employment by raising production costs. Integration of renewable energy in the electricity grid could stabilise electricity prices. We estimate the elasticity of substitution between labour and electricity among the formal and informal manufacturing sector in India. The results show labour and electricity are strong complements in manufacturing, with elasticities significantly below one, which suggests a carbon tax that raises electricity prices may reduce employment in firms. On the contrary, we find high substitutability between thermal (coal) and renewable energy-based electricity generation, with the elasticity of substitution estimated at 2.0–3.3. Our results suggest that electricity derived from renewable energy sources and supplied to industry at affordable prices could mitigate the adverse effects of a carbon tax in Indian industry.