When I was a postgraduate student studying public policy in Singapore back in 2015, I took a class on the Economics and Governance of Climate Change. I remember writing a paper on Sino-US tensions on climate action, adaptation, and mitigation which included commentary on China’s attempts at establishing a carbon market.
Here is an excerpt from the paper –
The Chinese leadership announced the testing of an Emissions Trading System (ETS) that will be piloted in 7 regions/ cities between 2013 and 2015, with an intention to establish a nationwide carbon trading system by 2015 based on an evaluation of the pilot program. This was later revised to the year 2017 by President Xi Jinping in his second Joint Presidential Address (with President Barack Obama) in September 2015.
China officially launched its national Emission Trading System, not in 2017, but earlier this year. Live trading is expected to start later this week.
Another excerpt –
If the nationwide carbon trading market is established in China, it will result in 40% of the total carbon emissions covered by carbon markets, and China will join the existing list of 130 countries and the European Union that have frameworks for limiting emissions.
The national ETS is expected to cover the following sectors: Power Generation, Iron and Steel, Chemicals and Building Materials sectors, including Cement, Paper-making and Nonferrous metals.
Transport sector is a significant miss given the level of emissions it generates. Official indications suggest coverage of 10,000 companies and a market for up to 4 billion metric tons of carbon dioxide.
The national trading system is far, far smaller in scope and includes only the power generation sector. The market will onboard 2,225 coal and gas-fired power plants, which although account for ~15-20% of global emissions currently.
(Contrary to how it may seem, it is not such a bad thing)
There is obviously more to the Chinese carbon market, but here is what an emissions trading system is in a nutshell –
The government sets an emissions cap for each sector and allocates credits for each company within the sector, based on historic emissions. These credits (or allowances) are a free pass for companies to emit up to the permitted levels.
There are two scenarios that can play out for individual firms –
#1/ The firm’s emissions exceed the allocation
#2/ The firm’s emissions are lower than the allocation
Unutilised allowances are sold by companies that emit lower than their allocation on the carbon market and bought by those companies that have exceeded their allocation. At the end of every cycle, if companies hold appropriate number of permits for their emissions, either allocated or bought, they will avoid a non-compliance fine. This process ensures emissions do not exceed allowed limits for each sector.
Now that we understand emissions trading (slightly) better, back to the topic at hand.
In its first implementation cycle, China is not capping emissions for the power sector and is allocating permits based on historic emissions to power companies for free. That is, the companies do not have to pay and can continue emitting at existing levels with the consent of the government.
(Still not a bad thing)
Different countries have tried different approaches to trading carbon emissions on markets. China has gone down the free permits route, instead of auctioning it for a price like the European Union, the first ETS in the world setup in 2005.
Further, China has included a ‘voluntary’ carbon sub-market. Power companies can voluntarily offset 5% of their total emission volume by purchasing CCER (China Carbon Emission Reduction) Units. Each CCER unit will offset 1 ton of CO2e. The proceeds from the sale of CCER units to polluting companies will be directed towards renewable projects, carbon sinks and methane recovery. This is over and above the emission permits that they hold.
(Including only 5% and not more is somewhat a good thing.)
Carbon markets also serve one very important purpose – to price carbon. If # of permits are fixed and are traded freely on the markets, this should allow for an ideal price discovery. A carbon price survey conducted among stakeholders pegged the expected price at CNY 49 ($7.6) per tonne of carbon, compared to a July 12, 2021 price of $61 per tonne on the EU ETS. This is of course a survey response and only speaks to the sentiment, and not how it might play out once the markets are live or when China expands its coverage to include more sectors.
(Although these are very early days, this makes me a little uncomfortable)
The efficiency of carbon markets is ensured through robust systems that measure emissions. It is by and large reported by companies and verified audited by independent agencies. Non-compliance or misreporting attracts fines, and this ensures companies do not flout regulations. The maximum fine for non-compliance or forged data is CNY 30,000 ($4,605)
(Okay. This makes me very uncomfortable)
So, the sector coverage, # of companies, distribution of permits, carbon price, and compliance mechanisms and recourse, constitute the building blocks of China’s long-awaited national emissions trading system. Let us look at it in the context of the design and execution of other carbon markets.
Over 60 countries, cities, states and provinces have implemented or are planning to implement carbon pricing schemes, with a fairly balanced distribution between emissions trading systems and carbon taxes.
In defining the role of a trading system, policy makers could reflect on what the system is designed for and expected to do. For example, an emissions trading system could be intended to drive emissions reductions as its principal role … In practice the system may function somewhat differently than intended, such as a means to raise revenue for investing in further emissions reductions projects or in sectors other than those covered by the system.Implementing Effective Emissions Trading Systems, IEA
The scale of China’s new carbon market, despite its limited sector coverage, is encouraging because it ensures sustained participation without causing a lot of friction early on. The government has taken a lot more time in rolling out its national system after the pilots from also half a decade ago, but it has also looked at the interests of the companies covered under the scheme.
The choice of sector appears to be sound if the guiding principle is guaranteed uptake. China’s power sector is largely serviced by State-owned Enterprises, which cumulatively account for 48% of the country’s power capacity. This makes implementation relatively easier. Of course, this is not a luxury that other countries can benefit from. The hope is China will learn from this small-scale pilot and expand the coverage efficiently (and without friction) to other sectors.
Further, by giving away the permits for free and not auctioning them, China has done away with the ‘noise’ that surrounds accurate pricing. This hopefully (I realise I am using hope a lot here) means prioritising accurate measurement and reporting of emissions. Dear China, once bitten, twice shy? (Two words, GDP manipulation. One law, Goodhart’s)
Voluntary carbon offsets have been nothing short of controversial. I intend to write a separate post about it later, but there are looming questions about whether buying offsets is sufficient, when polluters should be held to higher accountability standards than to pass the responsibility by financing reforestation initiatives in emerging markets, well, with lax accountability. In the case of China, I’d say limiting voluntary offsets to 5% of total emissions is generally a good thing.
Now comes the bad.
For carbon markets to function efficiently, the price of carbon must be high enough that participants do not exploit the availability. In other words, not to buy at wholesale prices.
In other other words, the incentives should rest with those selling the credits so that more companies are nudged to reduce their emissions. The expected price of carbon in the Chinese markets, albeit based on a survey, is ridiculously low. Even if the price is revised up by 15-20% once the market is live, it would still trade well below the actual $ value of emissions.
Add to this, the low penalties for non-compliance for their emissions or misrepresenting their overall emissions, it is hard to see how the participating companies will take this seriously.
My overall opinion on China’s national carbon market is one of cautious optimism.
I am optimistic that the government’s convictions to be a climate leader are stronger than ever before. China spent a sizeable $27.5 billion on clean energy since the pandemic, which places it as the second-highest spender after Germany. Its commitment is further consolidated by the fact that China is leading the clean energy transition by positioning itself as the leading manufacturer of technologies, right from solar panels to electric vehicles, and is best placed to meet rising global demand.
The icing on the cake came when President Xi Jinping declared in March 2021 that China will ‘aim to have CO2 emissions peak before 2030 and achieve carbon neutrality before 2060’, which came as a surprise to a lot of international actors.
I am cautious because China’s history with system-saving responses reminds me strongly of ‘one step forward, two steps back’. International diplomacy is integral to establishing China as the leading global power and President Xi has a history of tacitly implying Chinese readiness to take over that role. China’s flagship Belt and Road Initiative that is expected to connect China with the rest of Asia, Africa and Europe, will create much wanted infrastructure in emerging markets. Under the BRI, approximately 44% of the overall spending (which is estimated to go up to $1.2 trillion by 2027) is dedicated towards energy projects, and no prizes for guessing whether it will be clean(er) energy. At least, it hasn’t been clean in the past.
That is not to say it will continue to be the case going forward. As recent as February 2021, China in no uncertain terms communicated that it will not fund coal mines and polluting power plants anymore. Anymore.
In a letter seen by the Financial Times, China’s embassy to Bangladesh informed the local Ministry of Finance that “the Chinese side shall no longer consider projects with high pollution and high energy consumption, such as coal mining [and] coal-fired power stations”.China turns its back on Bangladesh BRI Coal Projects, Financial Times
What is encouraging and frustrating about a low-carbon future in this world is that it is down to the seriousness of a few nations to follow through on their commitments. China’s geopolitical ambition, resources, and internal preparedness, leave it best placed to take over as a global climate leader.
Being a global leader comes with responsibilities that far exceed domestic carbon neutrality. All we can do is wait and watch, at a time when I am not certain how long the world can afford to wait.
I must however admit that a prototype national carbon market is a good place to start when you are the largest emitter of greenhouse gases.
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