CAFE-III draft norms: Will carbon credit trading for the auto sector help reduce emissions?

India’s Corporate Average Fuel Efficiency-III (CAFE-III) norms are set to come into effect next year, with the government unlikely to extend the deadline. Come April 1, 2027, automakers will have to adhere to stricter fuel efficiency norms.

In an unprecedented move, the Centre has proposed a draft bill that would effectively allow automakers to buy carbon credits directly from the regulator – the Bureau of Energy Efficiency (BEE). Reports say the government plans to ease penalties and allow automakers to trade carbon credits to meet emission targets under the CAFE-III norms.

Let’s take a deep dive.

What is the Bureau of Energy Efficiency?

The Bureau of Energy Efficiency, or BEE, constituted under the Energy Conservation Act of 2001, falls within the Ministry of Power and operates as a statutory institution.

Unlike regulators such as the Reserve Bank of India (RBI) or the Securities and Exchange Board of India (Sebi), it does not possess quasi-judicial powers. Its role is largely confined to framing norms and recommending penalties, while actual enforcement is routed through the broader legal system. This distinction is significant: Any legal contestation has the potential to stall implementation midway – a vulnerability that now looms over the proposed credit trading mechanism.

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Why is trading carbon credits an unprecedented move?

CO₂ emission levels are established to set a maximum permissible limit of average CO₂ per manufacturer. However, these are not uniform and are tailored to individual manufacturers based on the average kerb weight of a manufacturer’s vehicle portfolio. This means that manufacturers with heavier cars are given more latitude in the emission-cap department.

CAFE-III breaks new ground by allowing companies not just to trade credits among themselves – a global norm – but to purchase them directly from the regulator, BEE.

This is, by most expert accounts, unprecedented. The draft proposes a fixed price band – Rs 2,500 to Rs 4,500 per gram of CO₂/km between 2028 and 2032 – for such purchases. In effect, the government becomes a market participant, creating a parallel compliance channel. There are effectively two pre-defined “block” periods – the first from FY2027 - 2028 to FY2029-30.

The second block period is from FY2030 to FY2032, with credit prices for each block period fixed.

What are the pros and cons of the system?

In a typical credit trading system, compliance depends on the availability of credits in the market. If you overshoot your emissions target, you must go out and find another automaker that has excess credits to sell. If no one has a surplus – or if they choose not to sell – you are stuck. Prices can spike, liquidity can dry up, and compliance becomes uncertain.

By allowing automakers to buy credits directly from BEE, the government effectively positions itself as a permanent counterparty in the system. This ensures that even in scenarios where no manufacturer has surplus credits to sell or where larger players choose to hoard credits strategically, compliance does not become contingent on market dynamics. Instead, automakers retain a guaranteed fallback – one where they can meet their obligations by purchasing credits from the regulator at a pre-declared price.

Although credit prices are designed to become more expensive over time, they do come with a risk. Automakers may choose to purchase credits rather than invest in R&D, which would lower their long-term CO₂ footprint. It effectively allows companies to pay to pollute.

There is also a three-year penalty-deferral window, effectively taking away the pressure from manufacturers to get their credits in order.

The effectiveness of CAFE-III will hinge on a built-in mechanism to push credit prices beyond Rs 4,500 after FY32, clear statutory backing for the BEE’s role in issuing and monetising credits, and a differentiated compliance framework that eases the burden on smaller automakers.

Even if no other company is selling credits, a small manufacturer can approach the government and buy them at a fixed price. So they won’t get penalised or pushed out of the market. It’s like having a guaranteed backup option – there’s always a way to stay compliant.

Rather than committing significant capital toward developing cleaner, more efficient vehicles, smaller manufacturers may find it more practical in the short term to simply purchase credits to meet regulatory requirements.

At the same time, larger automakers that are already better positioned with stronger electric vehicle (EV) portfolios are likely to generate surplus credits and monetise them through sales.

Over time, this dynamic could widen the gap between the two, with larger players accelerating their technological edge while smaller firms risk lagging.

Greenpeace activists carry a cut-out depicting a 'fuel-efficient' car through a street in Mumbai. The CAFE-III norms are aimed at making passenger vehicles less polluting. File photo/Reuters

How does the credit trading system work in other countries?

In the US state of California, automakers operate within a transparent credit trading system – firms that exceed the requirements can sell their extra credits to those that fall short. There is no concept of buying compliance from the state; the market clears itself.

The European Union (EU) adopts a different approach: pooling. Manufacturers can form alliances to meet collective targets, effectively averaging out emissions across a group. Again, no regulator is acting as a seller of credits.