China’s carbon emission market explained

Trading began in China’s first formal carbon market on July 16. This is how it works.

Photo from CFP

Photo from CFP

By WANG Qing


China’s national carbon market started trading on July 16, poised to become the world’s largest emission trading scheme. The launch came after ten years of regional trials and is part of China’s plans to reach a carbon emission peak by 2030 and to achieve carbon neutrality by 2060.

The carbon market deals in rights to emit. It compels companies to account for emissions in the same way as they do for capital and labor. To actually combat global heating may take years of fine-tuning in prices, allowances, and information disclosure.

What is a carbon market?

Emissions are free at the point of production. They are a byproduct or waste and, inevitably, costs are involved in their reduction. Long-term environmental and economic consequences are generally not borne by the emitter. The offender does not pay for damage done.

The concept of using market forces to rein in emissions was raised almost 20 years ago in the United Nations Framework Convention on Climate Change (1992) and included in the Kyoto Protocol in 1997.

Carbon emission trading rewards companies that invest in clean technology and penalizes carbon-intensive ones that fail to adapt. It works by putting a value on emissions. The government allocates allowances, and companies decide for themselves how much to emit, based on their technological and financial capacities. Those who emit more than their allowances can buy more in exchange for those with surpluses. As allowances are reduced, liquidity dries up. Clean businesses have less to sell and dirty ones find it harder to meet their increasing needs. Over time, given the scheme works, the overall limit should get lower, as participants become more carbon-efficient.

How does it compare to a carbon tax?

The carbon tax is paid on greenhouse gases generated. It is fixed by a central authority, and not subject to supply and demand, said economist DUAN Maosheng of Tsinghua University. Without a hard limit, heavy emitters simply pay a lot and smoke a lot.

MA Jun of the Institute of Public and Environmental Affairs believes trading has more predictable outcomes while giving participants more flexibility. They also circumvent the often-cumbersome legislative processes necessary for new taxes. Empirical evidence shows that carbon trading will not impose an oversized burden on the affected industries.

How is the EU carbon market doing?

China’s carbon emission market is the 24th national emission trading program. The EU market, which started trading in 2005, is the oldest and biggest. It governs 40 percent of EU emissions.

There have been four allowance cuts. The EU carbon market has been effective in promoting decarbonization. Total emissions were cut 35 percent from 2005 to 2019, and another 9 percent in 2019 due to tightening caps and rising carbon prices. Total transactions reached 169 billion euros that year, 87 percent of all global volumes. In May this year, the price hit 50 euros per ton, the highest in EU carbon trading history.

Duan believes that higher prices reflect expectations of even more aggressive targets. The EU is aiming for carbon neutrality by 2050. Allowances will only get tighter.

How did the local trials go?

As of now, trading takes place in Shanghai, with administration in Wuhan. Eight local trials have run since as early as 2011. Shanghai and Wuhan are among the top performers.

Some trials used “intensity caps,” which limited emissions per unit of GDP instead of absolute emissions. This method has also been used in the UK and Canada and is seen as easier on the industries immediately affected. The central government started preparing a national scheme in 2017. The launch was delayed for one year by the pandemic.

There are concerns that the separation of trading and settlement will raise transaction costs, and the industry is closely following how the two-city model will unfold.

Why the power sector first?

The first stage involves 2,225 power plants, 186 of which have already taken part in local trials.

The power sector accounts for 40 percent of China’s emissions and already has a well-established data infrastructure to report production, consumption, and carbon emissions. Data, at least, is clean and sustainable.

Unlike other heavy emitters such as steelmakers and refineries, which have a large variety of outputs with widely different carbon footprints, power plants produce only electricity, making it easier for regulators to audit the reported emissions.

A market in derivatives such as futures will emerge, said Duan. Total transactions are expected to be around 6 billion yuan this year - 250 million tons of emissions – which should soon double if the market expands.

How do you price carbon?

The EU carbon market got a lot wrong and was beset by crises that were none of its makings. Allowances were initially set too high and the 2008 financial crisis crushed demand. It was only in the past few years when carbon prices really started to influence business decision-making.

In China, carbon prices differed widely in local trials, but typically ranged from 10 to 60 yuan per ton, generally believed to be underpriced due to oversupply. Only 5 percent of total allowances were traded in the pilot markets.

A report by economists Joseph Stiglitz and Nicholas Stern estimates that the price may be as high as 600 yuan per ton or more by 2030 if the investment is to switch from fossil fuels. Expectations in China are more moderate, rising to 70 yuan by 2025, and 90 yuan by 2030. The industry consensus is 30 to 60 yuan per ton in the early stages. Power companies complain that any more than 30 yuan per ton will severely hurt their bottom lines

There are plans to auction off allowances. Right now, allowances are given out for free, which, according to Duan Maosheng, keeps emission costs low and does not fully incentivize companies to cut emissions. Auctions will push carbon prices closer to the true cost of emissions, starting a race to adopt clean energy.

How will it affect companies?

The launch and expansion of China’s carbon market will have a significant impact on the global supply chain. Manufacturers will need to take into account the carbon footprint of every intermediate part and process that goes into their final products, whose prices not only reflect the cost of labor, equipment and capital but also their environmental impact. They will still be able to pay a price to emit, but when carbon prices are high enough, more companies will find it economically worthwhile to choose low-emission options.

Over a third of the firms surveyed by the China Carbon Forum expect the national emission trading scheme to have an immediate bearing on business. Carbon will become an important balance sheet item. Efficient companies will make money through carbon trading.

It will still take time for regulators to get things right, and for a functioning carbon market’s emissions-cutting impacts to show.

The EU carbon market initially set its caps too high to be truly binding, and the 2008 financial crisis further crushed demand. It was only in the past few years when carbon prices really started to influence business decision-making.

Ma Jun, of the Institute of Public and Environmental Affairs, also says that the scheme will also make emission disclosures more timely, accurate, and comprehensive. Currently, only five provinces have detailed regulations on emission disclosure, but this will be essential to a well-functioning carbon market in the long run.