Explaining China’s Emissions Trading System, Now the World’s Largest Carbon Market
By Hengrui Liu
On January 5, 2021, China’s Ministry of Ecology and Environment (MEE) issued the “Measures for the Administration of National Carbon Emission Trading (trial)” to be effective on February 1, marking the official launch of the long-awaited China National Emissions Trading System (ETS). The “measures” as a ministry-level regulatory policy completed the Chinese ETS's core element to open for business. The first phase of Chinese ETS targets the power sector. There are 2,225 power generating enterprises that are covered, accounting for over 40% of China’s national carbon emissions. With the official launch, Chinese ETS becomes the largest emissions trading system in the world. China’s move on carbon pricing is a significant step to addressing its growing carbon footprint as the world’s largest carbon emitter since 2007.
The conception of Chinese ETS dates back to 2011 when the Chinese government selected seven pilot regions to experiment with the emissions trading systems. The seven regions, spanning from the north to the south and the coastal to the inland, were at various stages of development and therefore covered different income per capita levels and diverse economic compositions. Inspired by Deng Xiaoping’s spirit of “Crossing the river by feeling the stones,” each pilot region was selected to test innovative measures for running an emissions trading system. The essence of the pilot programs was to determine which polices were most effective in incentivizing lower emissions, in order to accumulate enough successes and failures for establishing the national ETS. This kind of micro-level policy experiments have been long proven to be effective in China before implementing an innovative, disruptive, and market-based policy.
Market-based policy tools like the emissions trading system are a new endeavor for China, which has generally relied on command-and-control policies to regulate the environmental protection since the establishment of pollutant discharge fees in 1978. However, new approaches became more pressing as air pollution rose to be a major focus of Chinese society starting in 2008 and concerns about climate change issues increased over time. Adding costly and ineffective environmental regulations were seen as clashing with China’s economic policies and GDP goals. This paved the way for a market-based environmental policy like ETS that is inclusive enough to achieve goals of environment, energy and economy, the trilemma for the Chinese government 5-year plans.
A typical ETS includes two parts, a cap on total emissions and a trading system. A central authority sets total emissions target and distributes emission allowances either freely or through auctions to covered polluters based on their historical pollutions or industrial benchmarks. The cap is decreased over time to achieve system-wide emissions reduction. Polluters with different emissions reduction technology and abatement costs can then trade their allowances under the ETS. The idea is that polluters with lower abatement costs can take on larger reductions, earning more pollution credits than they need and then selling unneeded permits in the market, allowing polluters with high abatement costs more time for compliance. High-cost emitters can, in turn, choose to buy permits from the market, make capital investments to reduce emissions, or shut down their businesses. Thus, the overall total emissions reduction is achieved with a lower optimal abatement cost while technology innovation is incentivized, which is the big selling point proponents of a cap-and-trade system suggest in comparisons to a straightforward carbon tax. However, economists argue that a carbon tax could be more efficient in terms of overall economy-wide burden.
Although the principles of emissions trading systems in different locations of the world are generally the same, each ETS has its unique features. Technically, China’s emissions trading system is not a typical cap-and-trade credit market. Instead, China has selected to implement a tradable performance standard (TPS). China’s system is based on performance standards, that is, benchmark emissions rates per unit of output, set by China’s Ministry of Ecology and Environment. Emission allowances for each of China’s power producers will be allocated based on their annual electricity outputs and emissions baselines. China’s emissions trading system mirrors other tradable performance standards that have been applied in various contexts, including U.S. Corporate Average Fuel Economy Standards and California’s Low Carbon Fuel Standard. The U.S. Clean Power Plan, proposed by President Barack Obama, but never fully implemented in the United States due to political and legal challenges, would have operated in a similar fashion.
One of the major differences between China’s tradable performance standard (TPS, hereinafter, is used interchangeably with Chinese ETS) and a conventional cap-and-trade is the flexibility in adjusting to the business cycle. By regulating the emissions rate per unit of electricity output rather than actual emissions, the TPS allows power entities to expand their production when the economy is booming while a cap-and-trade does not. As a result, the increase of electricity price will be low. This design has the potential to reduce carbon leakages through imports from countries with even lower energy prices if those suppliers do not have carbon markets. But it means that Chinese electricity users will not be incentivized to make energy efficiency investments that might have been stimulated by rising electricity costs. In addition, the current TPS, as structured, will in effect implicitly subsidize emissions by encouraging efficient but not clean power plants to produce more and thereby fail to give an incentive for Chinese power producers to transition away from coal power plants to low carbon fuels. Furthermore, in the first phase of the Chinese ETS, the allowances will be allocated freely, as often happens in the launch of emissions trading systems, to reduce political resistance and economic impacts.
It is not yet clear what level of average carbon prices will emerge from the launch of China’s TPS or how much the cap will need to be lowered before the new TPS begins to incentivize the retirement of coal plants or discourage construction of new ones. China currently has close to 250 gigawatts (GW) of coal fired generation under development. In line with the saying “there is no such thing as a free lunch,” the benefits of TPS could come at the expense of cost-effective carbon emissions reduction. Economists estimated that to achieve the same carbon dioxide emission reduction, the economy-wide costs of emissions reduction under the TPS are 47% higher than those under a more common style of auction cap-and-trade program such as the European trading scheme or California cap and trade system. Even with such higher costs, the environmental benefits from the TPS would exceed the costs by a factor of three when carbon dioxide emission reduction is valued at about $44/ton. Given the complexity of establishing and running a nation-wide emissions trading system, in a recent China Carbon Pricing Survey, only 12% of 567 responses from experts expected a “fully functional” market by 2021 but 75% of respondents expected a “fully functional” market by 2025 as elements like MRV (monitoring, reporting, and verification) and legislation become ripe. The average expected prices from respondents for China national ETS starts at CNY (Chinese Yuan) 49/ton in 2020, to CNY 71/ton in 2025, and CNY 93/ton by 2030.
Still, despite its lack of ambition, the initial official launch of China’s national emissions trading system remains significant because of its magnitude and policy implications. Its mere existence could encourage other countries to implement their own carbon pricing policies or climate policies and gives China a leg up in global climate diplomacy. For countries that have already implemented or planned to implement some form of carbon pricing schemes, China’s action on carbon pricing could allay concerns that domestic energy-intensive trade exposed (EITE) industries might migrate to China. To address migration of carbon-intensive industry to “carbon heaven” countries who have lax climate policies, some countries, like the EU, are considering output-based rebates and border carbon adjustments.
It remains to be seen how the new Chinese ETS will be handled by the EU, which intends to impose carbon border adjustments on certain imported goods. The EU emissions trading system is a cap-and-trade system that is structured to force companies to surrender sufficient allowances based on an auction system. Still, a limited number of free allocation of allowances continues for some industrial sectors, based on technological progress to new, lower cost options for abatement. The EU system allows for permits from international offset schemes like the Clean Development Mechanism but has not yet linked to the Chinese system. A recent study done by Chinese scholars estimated that additional 5% overall emissions reduction could be achieved by the linkage between Chinese ETS and EU ETS and could potentially slightly increase social benefits. The United States does not have a national emissions trading system but key regions have local carbon markets, including a long-standing, successful system in California.
Hengrui Liu is a predoctoral research fellow at The Fletcher School, Tufts University.