China’s New Carbon Market

October 2021

Economists have long argued for Carbon Markets as a tool for reducing Greenhouse Gas emissions, yet politicians have been reluctant to follow their advice.  Many economists must have celebrated on July 20 of this year, when China launched what is potentially the world’s largest Carbon Market.  With China now accounting for over 25% of the world’s total GHG emissions, if economists are right, this might be a huge step towards slowing climate change.  A hundred days into this grand experiment, Infrastructure Ideas takes a look at how start-up is going.

Headquartered at the Shanghai Environment and Energy Exchange, China’s new National Emissions Trading Scheme (ETS), or Carbon Market, is based on a cap-and-trade model.  Some 2,000-plus coal and gas-fired electricity generation plants – initially the sole participants in the ETS – have been allocated emissions allowances up to a government-set maximum, and are now free to either sell these allowances if they keep emissions below their cap, or forced to purchase additional allowances if they will exceed their maximum.  The new national market is the successor to a series of city and provincial-level emissions trading schemes in operation in China since 2013.

While the new Carbon Market have drawn considerable fanfare as an important part of China’s energy transition, reviews to date of its impact have been mixed.  Concerns about the scheme maybe being a mouse rather than a lion have centered on the ETS’ (a) design, (b) prices and trading volumes, and (c) enforcement and penalties.

• Design.  Most national carbon trading systems work by giving participants an absolute level of emissions – this absolute cap cannot be exceeded without either penalties or the purchase of further allowances.  The Chinese ETS instead is designed to limit the intensity of emissions per unit of energy, and not aggregate emissions.  This means that as consumption and production of energy grow, emissions are also potentially allowed to grow, albeit more slowly than production.  Clearly in the short run, at least, this means carbon dioxide emissions are likely to exceed what they would if firms were given a starting “hard cap.”  Greater efficiency, or lower carbon-intensity in electricity production is a good thing, but whether and when it actually reduces emissions will depend on how incentives – and therefore prices for allowances and penalties for non-compliance — evolve.  Chinese authorities would have to force significant efficiency gains – by, for example, reducing the allowed emissions per unit of energy – from the system’s starting point for the market to be a major force.
• Prices and trading volume.  Trading in the new market was launched in July at a unit price of just over $7 per ton of carbon dioxide emitted.  Prices since then have declined slightly from that level, and ranged generally between $5 to $8/ton.  This is one of the lowest levels for carbon prices on any of the 45 existing carbon exchanges worldwide, higher than only those for trading in Japan and Kazakhstan.  Prices in the EU carbon market have been ranging from $50 to $70/ton (though one should note that prices in the US Regional Greenhouse Gas Initiative market are also around $7-8/ton).  The International Monetary Fund also estimates that the price of carbon credits will need to reach around $50/ton to effectively drive down the country’s carbon emissions.  The low prices to date are a direct result of the issuance of large starting volumes of allowances, which come close to matching the overall emissions of the participants.  The large supply of allowances, along with low prices, has also contributed to very limited trading volumes – with few emitters feeling the incentive or need to participate yet.  While one can understand why authorities may have preferred to see low prices initially to minimize disruptions for participants, disruption for emitters is precisely the outcome which many would like to see (for more, see Nature’s “Is China’s new carbon market ambitious enough?”).  The impact of the market in the future will likely depend to a great extent on the evolution of allowance prices: if allowances to firms are kept at initial levels (or even reduced) over time, while production grows to accommodate economic growth and additional demand for electricity, then prices may rise substantially – in turn creating a much stronger incentive for producers to find efficiencies and not allow GHG emissions to grow.

• Enforcement and Penalties.  The verdict remains very much out as to whether enforcement of emission limits under the ETS will be substantive, or not.  On the one hand, in general China’s enforcement of central government policies tends to be fairly strong.  On the other hand, there have been widespread reports of companies in the earlier regional and local carbon trading schemes falsifying emissions data.  The new national scheme is said to put a greater emphasis on monitoring and evaluating emissions data, and features the use of independent monitoring firms.  The future will tell whether this, combined with potentially higher trading prices over time, is enough to help the market have a significant impact.

In spite of the underwhelming start and these concerns, there remains considerable hope that this new Carbon Market will begin to have a much greater influence, and an impact in reducing GHG emissions.  Hopes rest mostly on (a) market size, (b) the design of annual adjustments, and (c) signaling effects. 

• Size.  While the initial participants in the market are only one part of one sector in a large and complex economy, they are still an enormous part of the world’s carbon dioxide problem.  Between them, the 2,000+ coal and gas-fired generation companies involved in the market’s launch emit some 4 billion tons of CO2 annually, about 10% of all global emissions from all sources.  This already dwarfs the potential reach of all existing carbon markets.  And while no firm timetable has been disclosed, it has been announced that the ETS will expand to cover large Chinese firms in seven additional sectors: petroleum refining, chemicals, non-ferrous metal processing, building materials, iron and steel, pulp and paper, and aviation.  These sectors have combined emissions on a par with the power companies.  So if the initial issues with the market can be overcome, the impact on curbing emissions from the world’s biggest GHG emitting country could be major.
• Design.  While the basic design choice of not using absolute emissions caps gives rise to concerns, much hope lies in another element of the system’s design.  Each year, companies’ allowed per-unit GHG emissions are to be recalculated and reduced, which would drive greater efficiency by requiring them to reduce the amount of emissions they generate for the energy they produce.  This means that the Government has a clear, simple and repeatedly available tool to shape the speed at which the companies reduce their carbon-intensity.  Should policy-makers decide that emissions need to be reduced faster than the pace being delivered by the market, they can force more action, and can do so on an ongoing basis.  In this sense, China’s Carbon Market is very Chinese – a market which expects frequent government intervention.
• Signaling.  The explicit features of the new Chinese Carbon Market do not point to a big early impact on emissions.  Yet China being China, it would be a mistake to underestimate the effect of the system’s implicit features.  The Chinese leadership, and Xi Jinping personally, have taken highly visible positions on China’s climate targets, and the link from Xi’s commitments and the ETS has not gone unnoticed.  Several generation companies trading on the new exchange have accordingly pledged to accelerate a strategic “green” shift, including two of China’s “Big Five,” China Huaneng and China Huadian.  The country’s coal sector is, after all, dominated by state-owned enterprises.  The signals from the top may sound a lot louder to these SOEs than they sound to economists.

A hundred days in to the world’s largest emissions trading scheme, reactions are pretty muted.  Most experts expect it will take years before China’s program matures into an effective tool for curbing emissions.   Yet, again, this is China.  In terms of containing emissions, and moving towards the stated national goal of carbon neutrality by 2060, the explicit mechanisms of the Carbon Market are probably less important than the country’s formal planning process, and China’s 5-year plans at national, regional and sectoral levels.  With nudging from the top, China’s Carbon Market may yet turn into a very big deal.