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The world’s biggest carbon market is inching towards launch

China’s long-awaited national carbon market will start this month, after a series of false starts to create the world’s largest emissions trading system.

China’s highly anticipated nationwide carbon emissions trading system, or ETS, is expected to start trading in July, Premier Li Keqiang said at the State Council’s executive meeting on Wednesday. 

The country’s carbon market could become the world’s largest by volume of tradable carbon allowances when it covers all key sectors under its purview, eclipsing the European Union’s (EU) ETS.

The market as currently designed, is unlikely to make much of a dent in the world’s largest carbon emitter, or significantly change its energy mix. But its soft initial design, which will allow China’s biggest corporate polluters to buy credits from those who emit less, is a step closer to achieving the nation’s carbon neutrality by 2060.

The road to a national carbon market

China committed to start its national ETS in 2017, when it was touted to become the largest of its kind, covering about a third of China’s national emissions, according to the International Carbon Action Partnership (ICAP).

The launch was pre-empted with eight regional pilots that began operating in 2013 to study the technical details of carbon trading, such as how credits would be allocated to emitters.

A decade in the making, the proposed scheme has required careful navigation to appease bureaucrats, environmental advocates, and fossil fuel interests. The scheme has also been beset by technical difficulties.

Data collection to establish targets and carbon credit allocation, has been a challenge. Participants were not fully prepared for the 2017 launch, according to HSBC’s global head of environmental, social and governance research Wai-Shin Chan.

Despite the experience gained from the pilot schemes, it was challenging to verify that greenhouse gas (GHG) emissions information was accurate, especially in the eight sectors slated for inclusion in the market.

The plan’s scope has since been pared back with credit trading initially limited to power generation, where Chan says GHG information is considered more accurate and easier to verify. 

Zhang Jianyu, who is founder, chief representative and vice president of the Environmental Defence Fund’s China programme, said those learnings were a normal part of the capacity building process. Preparing for the launch in the power sector alone involved collecting data from 10,000 different entities.

Work to build out the exchange’s monitoring, reporting and verification capabilities continued against the backdrop of “huge turmoil”, Zhang said, including a global pandemic and a major institutional transfer of power that saw the authority for the carbon market shifted from National Development and Reform Commission (NDRC) to the Ministry of Ecology and Environment (MEE), an enforcement agency.

The focus on data collection could bring improvements in Chinese corporates’ climate reporting abilities, predicted Zhang. Better data collection and carbon accounting will help companies understand how to decarbonise their operations because “whatever you monitor, you manage.” 

Long march to zero carbon

Under the trading scheme, carbon emissions allowances will be allocated to regulated entities in the power sector with annual emissions of over 10,000 tonnes of coal equivalent, according to the environment ministry in January.

The first raft of national ETS participants includes 2,225 entities will initially receive allowances equivalent to 70 per cent of their 2018 emissions multiplied by a benchmark factor based on size, fuel, and technology used. 

If a company’s emissions exceed its allowances, it will have to purchase additional allowances on the open market to meet compliance obligations by a year-end deadline. Allowances will initially be free but costs may be levied in the future, according to analysts at Fitch Ratings.

International critics have focussed on the market’s focus on intensity and lack of an absolute cap on emissions, which is a key feature of Europe’s ETS. Yan Qin, lead carbon analyst at Refinitiv, says the ETS in its current design could reduce emissions by about 200-300 million tonnes per year. With an absolute cap on carbon emissions, that could increase to 300-400 million tonnes per year—or just around 2-3 per cent of China’s 14 billion tonnes of carbon emissions in 2019.

While an intensity target will improve efficiency, it won’t drive a transition away from coal. China relies on coal for most of its energy needs and has consumed more coal that the rest of the world combined since 2011, according to the US Centre for Strategic and International Studies.

The scheme could even incentivise the construction of new coal plants, which are more efficient. Credits are allocated on the basis of benchmarks that are tied to carbon intensity. More efficient plants will have surplus allowances that they can sell on the market for a profit. This will incentivise higher output from more efficient coal plants as well as the construction of newer, lower carbon intensity plants to replace the older ones.

“The role of the ETS in greening the power sector, as [it is] designed now, is very limited,” said Yan Qin. Government signals suggest policy for the next five years will be to “strictly limit” the increase in coal consumption, followed by a move to scale back the existing fleet after that.

Experts are generally confident that China will implement an absolute cap before 2030—the year by which Refinitiv figures the transition is needed if China is to meet its goal of peak carbon emissions. But the current design signals that authorities are still wary of moving too quickly and hampering China’s growth.

Fossil fuel industry lobbying may also have prevented the scheme from being more ambitious at the outset. As a result, by Refinitiv’s estimate, prices will begin at a low 40 yuan/tonne (US$6) before rising to $160 yuan/tonne (US$25) by 2030.

A separate hurdle is that China still lacks a fully liberalised power sector. Carbon prices cannot be passed through to power prices, weakening the incentive for power generators to cut their emissions in the face of rising carbon prices.

Future outlook

Over the next five years, the market is set to bring in most of China’s major industries, with cement and aluminium tipped to join next year. The government has authorised industry associations to start preliminary work to include refining and petrochemicals, chemicals, steel, cement and nonferrous metals in the ETS.

In the meantime, the pilots are expected to run alongside the national scheme. Longer term, they will be incorporated into the national programme, according to ICAP.

However, further development is required for both the regulatory and the finance aspects, experts believe.

The exchange is also thought to be awaiting legislation from the State Council, currently in draft form, which would introduce higher penalties for failing to submit emissions information on time or for falsifying emissions data, up to 500,000 yuan (US$4,365) from a maximum of 30,000 yuan currently.

The European ETS has faced fraud in the past, including a case in 2011 where criminals stole 267,991 emissions permits, and a 2013 Interpol report warned that the expansion of emissions trading systems in China could open the door to more such cases.

“The role of carbon pricing boils down to green finance,” said Qin of Refinitiv. In the regional pilot schemes, the creation of financial derivatives based on carbon credits has been lacklustre—a potential challenge for the national market when it is up and running.

Financial sector participation is seen as important for building a robust national exchange and boosting liquidity. Accordingly, domestic financial firms are expected to be roped into the scheme next year.

The environment ministry is overseeing the trading scheme, but financial regulators are watching keenly, too. They hope to use the market as a tool in the overall green finance framework, to divert investments toward greener projects.

In Chan’s view, the long, slow process is evidence that authorities are determined to “get it right this time.” But the first trades will be just a small step towards decarbonisation. “I don’t think ETS is the end,” said Zhang of EDF. “We still have a long journey.”

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