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5 January 2022

Carbon trading the Chinese way

The world’s largest emitter has launched the world’s largest emissions trading system, which will play a fundamental role in peaking and reducing China’s carbon emissions.

By Renato Roldao

China does not do things by halves. Its national emissions trading system (ETS), launched on 16 July 2021, so far covers only one sector: power generation. However, the 2,162 companies it includes produce an estimated 4.5 billion tonnes of CO2 emissions annually. That compares with an EU ETS emissions cap in 2021 of 1.6 billion tonnes of CO2.

The key objective of China’s ETS is to cover the majority of energy-related emissions and provide cost-effective, market-driven support to greenhouse gas (GHG) emission reduction targets that are integral to China’s plan to peak its emissions by 2030 and become climate neutral by 2060. The system – which follows a number of regional pilots established since 2013 – is designed to provide incentives to businesses, investors and other market participants to contribute to China’s decarbonisation and clean energy transition.

China’s ETS is in its infancy. In December 2021, daily trading in Chinese emissions hit a record of 15 million tonnes of CO2 – in the EU market, in contrast, an average of around 40 million tonnes of allowances change hands daily. (Photo by Anton Watman/Shutterstock)

How China’s ETS differs from the EU ETS

There is as yet no absolute cap in China’s ETS. That is its biggest difference with the EU ETS. China currently applies a bottom-up approach, by which all covered companies are allocated their emission allowances free of charge. This allocation is based on a national benchmarking method, whereby the average carbon intensity of key sectors and products is calculated and compared with that of individual emitters. Each emitter will be allocated allowances equal to its verified emissions. Given this approach, China’s national ETS is actually not yet a cap-and-trade system.

Nonetheless, those companies that are able to reduce the carbon intensity of their production can generate a surplus of allowances to sell. The allowance price is dynamic and varies daily. Since the official start of trading under the national ETS in July, the average listing price has been 41–61 yuan per tonne, equivalent to €5.70–8.48 per tonne (€/t). This is a fraction of prices in the EU, which are currently above €80/t.

Another important differentiator of the Chinese ETS is that the key incentive it creates is to run more efficient coal-fired plants over less efficient ones. The intensity-based allocation does not create an explicit incentive to switch from coal to renewables – apart from for generators whose entire fleet is inefficient and who are likely to lose money if they continue operating. China's ETS is therefore likely to encourage the earlier closure of very inefficient coal plants that are already operating at low rates of capacity. Perversely, this should bolster the profitability of the coal power sector overall, as there is currently considerable cross-subsidisation that would be reduced.

The lack of an incentive for fuel switching from coal to renewables is the case because an intensity-based cap simply incentivises more efficient coal plants over less efficient ones. The same overall volume of electricity would be generated by coal as without the ETS, but the increased efficiency would lead to lower emissions overall. With an absolute cap, in contrast, every ton of carbon over the cap faces a financial penalty. If companies have renewable assets, they can sell those into the grid without affecting their ETS compliance obligation, giving them a reason to shift their overall generation portfolio away from coal and towards renewables as the price of carbon is expected to rise over time.

Local government in charge of MRV

While it does not yet set an absolute cap, China’s carbon market encourages emitters to begin managing emissions, introducing a sense of scarcity and stringency for the first time, while providing market-driven instruments to reduce the cost of mitigation. Once the cost of carbon is fully reflected in the cost of energy, it will change power plant cost structures, which is likely to accelerate reform of the Chinese power market, leverage green financing and galvanise the uptake of emission reduction technologies.

A key role for China’s ETS is to improve the quality of GHG emissions accounting and reporting. This will help policymakers forecast and monitor progress towards China's climate targets.

However, China’s ETS takes a different approach to monitoring, reporting and verifying (MRV) emissions compared with other markets. In Europe, third-party auditors are tasked with verifying emissions; in China, the Ministry of Ecology and Environment assigns verification to provincial government ecology and environment bureaus, who must undertake desk reviews of emissions reports submitted by companies, and require those with questionable data to carry out third-party verification. There are questions regarding the technical capacity of these bureaus to undertake the work and, given that most emitters are state-owned, possible issues around conflicts of interest.

Energy-intensive industries and carbon border taxes

There are other metrics that need to be considered when measuring the size and robustness of an emissions market: the total trading volume (in tonnes) and the total transactions (in money). By these two indicators, China's ETS is in its infancy. In December 2021, daily trading in Chinese emissions hit a record of 15 million tonnes of CO2 – in the EU market, in contrast, an average of around 40 million tonnes of allowances change hands each day.

China's ETS is expected to gradually expand its sectoral coverage during the 14th five-year plan, which runs from 2021–25, to additional sectors such as steel, non-ferrous metals and cement. This would mean following in the footsteps of the pilot programmes, which included chemicals, petrochemicals and large electricity consumers, for example.

The Chinese authorities are working on a State Council Law in order to give the ETS a more robust legal framework. They also plan to improve the MRV system, allow the introduction of carbon financial products – in addition to existing spot trades – and move towards setting an absolute cap.

China’s experience is of great relevance and interest to other geographies and jurisdictions, primarily across Asia but also worldwide.

In particular, it is of relevance to jurisdictions that are considering introducing carbon border levies. Introducing carbon pricing could allow Chinese exporters to avoid such levies, but the corollary is that the price of exports from China could surge, impacting supply chains and transforming international trade. As carbon border adjustments are introduced, the Chinese model for emissions trading may be one that other emerging economies emulate to avoid tariffs.

A successful and robust Chinese ETS could represent a milestone in the long-term process of consolidating more than 64 carbon prices that coexist around the globe. Its failure, on the other hand, would be a big setback for the embrace of carbon markets worldwide.

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