The trillion-rupee formula to solve India’s climate challenge

Crossing these milestones would require the country to act on two fronts simultaneously. Investing in clean energy and industries will drive growth, jobs, better air quality and lower emissions; investing in resilience through climate-smart farming, cooler cities and flood defences will protect people and assets. Financing this dual transition will cost trillions of rupees, but the cost of inaction would be even higher, with losses borne by our GDP, competitiveness and macro-financial stability.

To finance this transition and attract private investment, we propose that the 16th Finance Commission introduce a climate criterion into the Centre-state devolution formula, with an initial weight of 5%. It would take into consideration climate exposure, climate sensitivity and the adaptive capacity of states. Over time, new indicators that reflect the clean-growth investment needs of states should be included and the weight increased.

From heatwaves that push electricity demand to unprecedented peaks almost every year to the recent floods in Punjab, Delhi-NCR and other regions, climate shocks have become a recurrent feature of India’s development landscape. This challenge is magnified by India’s vast and varied geography; climate risks are unevenly distributed and adaptation needs differ sharply. In such a federal system, much of the responsibility for climate-related investment falls on states.

India’s system of Centre-to-state revenue transfers is designed to balance resources, with the Finance Commission assessing costs both vertically (between the Centre and states) and horizontally (across states).

Yet, two imbalances persist. Vertically, the Union collects most revenues, while states bear the bulk of climate-sensitive expenditure. Horizontally, the poorer and more climate-vulnerable states face higher risks, but have lower revenue-raising capacity, while the richer states enjoy both greater resources and stronger capabilities to invest in clean energy and innovation.

Unless addressed, these imbalances could deepen inter-state inequality and erode the fiscal foundations of cooperative federalism.

Successive Finance Commissions have tried to bridge this gap. Early Commissions focused heavily on equalization by using population and per-capita-income distance as the principal criteria for horizontal revenue distribution. Over time, efficiency considerations such as taxation efforts and fiscal discipline were added.

The 14th Finance Commission marked a turning point by raising states’ vertical share of the divisible pool of revenue to 42% and by introducing an explicit ecological criterion: the proportion of the state’s area under forest cover. The 15th Finance Commission raised the forest cover and ecology weight from 7.5% to 10%.

Although the Finance Commission’s horizontal devolution formula has undergone incremental evolution to improve inter-state fiscal equity, the existing architecture of the 15th Finance Commission leaves a significant gap: there is no direct measure of climate action in the devolution formulae.

From an adaptation perspective, states recurrently affected by floods, droughts or heatwaves and those facing chronic risks such as coastal erosion or Himalayan fragility receive no systematic recognition of the fiscal pressures these hazards impose.

From a clean growth perspective, the cost of a just energy transition varies across states by their drivers of economic growth, potential to diversify their economic base and their resources and capabilities. States with climate-exposed agriculture or carbon-intensive industrial bases, for example, face higher adjustment costs and a chronic productivity drag.

The metrics used in the current horizontal devolution formulae are reactive rather than anticipatory. Growing structural climate disadvantages only get reflected in these formulae in the form of increased income inequality among states, which shows up only after climate shocks and weak responses have eroded output, revenues and service delivery capacity.

The policy challenge today, therefore, is one of institutionalizing climate change within our fiscal decision-making frameworks, so that inter-governmental transfers function not just as mechanisms of income redistribution, but also as instruments for achieving clean and resilient growth pathways—arguably the most important stated policy goal of the government.

Including climate change in the Centre-state devolution mechanism would put clean and resilient growth right at the heart of India’s fiscal federalism, establishing a new standard for policy innovation. It will provide a replicable model for other decentralized countries in the Global South and offer an additional lever for climate diplomacy, ahead of India’s CoP presidency.

Above all, it will fill a critical investment gap towards clean and resilient growth by guaranteeing stable flows of domestic funds based on rules that are consistent with our constitutional provisions of fiscal fairness.

The authors are, respectively, honorary chairman, Institute for Competitiveness and director, climate change at the Children’s Investment Fund Foundation.