More Than Just Hot Air?

Oct 16 , 2015

In the increasingly complex U.S.-China relationship, climate change stands out as an area of cooperation. Climate change figured prominently as a good deliverable in the November 2014 meeting between Chinese President Xi Jinping and U.S. President Barack Obama, when the two leaders issued a joint statement to peak carbon emissions by 2030 and transition to a lower-carbon future. This year was no exception. On September 25th, at the White House, President Xi announced that China would introduce a nationwide carbon emissions cap-and-trade system in 2017.

Cap-and-trade programs limit the amount of pollution that companies are allowed to emit by issuing quotas. Companies that do not use their entire quotas can sell the remainder, while others that need more can buy additional permits. The system helps put a price tag on emissions and aims to encourage companies to reduce their emissions. According to Xi’s announcement, China’s cap-and-trade system will cover polluting industries such as power generation, iron and steel, chemicals, as well as building materials, which together account for 75% of China’s energy-related carbon emissions. The transport sector, however, will not be covered initially. When launched, it will be the largest cap-and-trade system in the world.

Yet the cap-and-trade scheme in China is not new, and the pilots launched thus far have not terribly successful. The EU’s decade-old scheme has also been fraught with challenges. Will China’s next attempt be any different?

Indeed, the emission trading system (ETS) was first announced by the State Council in 2010 and introduced in the 12th Five-Year Plan (2010-2015). The legal and regulatory framework was developed rapidly given the government’s commitment to tackling air pollution, which has now become an issue of political and social consternation. In May 2012 the government issued the draft Law on Addressing Climate change, which laid the groundwork for both a cap-and-trade scheme and a carbon tax and shortly thereafter, between 2013 and 2014, seven pilot emissions trading schemes were launched in five cities (Chongqing, Beijing, Shanghai, Shenzhen and Tianjin) and two provinces (Guangdong and Hubei). The pilots cover between 40-60% of the city or provinces’ total emissions from the power sector and heavy industry. The specifics, however, vary across jurisdictions to reflect the different economic structures.

Nonetheless, thus far, there seems to be some capping and very little trading. Liquidity in the carbon market is constrained by tepid enthusiasm from participants and by regulatory caution: The ETS frameworks restrict the number of buyers and sellers that can interact; the local exchanges operate on spot markets but derivatives trading remains off-limits. The government is also lukewarm about letting Chinese banks participate in domestic carbon markets, impeding competitive price discovery and making trading illiquid. Beijing, Shenzhen, Tianjin, and Guangdong have, nonetheless, found ways to work around this and have gradually allowed individual investors to trade. Shenzhen has already opened trading to foreign investors.

Trading has still been lacklustre, with only several trades reportedly made every day. According to the NDRC, by May 2014, the pilot projects had traded 13.75 mn tonnes of carbon emissions quotas but they varied widely among pilot schemes: according to the World Bank, in the first year of the Hubei scheme, companies traded 1.6 mn tonnes of carbon dioxide while only 96,000 tonnes were traded in the Beijing scheme. Prices have also varied significantly between jurisdictions with Shenzhen allowances trading peaking at RMB120 per ton, while Hubei allowances have traded for as little as RMB20 per ton. At the lower end of the cost curve, the cap-and-trade scheme is unlikely to raise the costs for polluters, or encourage the efficiencies and innovation that it should. But while Beijing experiments with the market mechanisms of the ETS, emissions will gradually slow because of the economic downturn and Beijing’s efforts to consolidate industrial overcapacity.

Despite these hurdles, the NDRC has been working out the design of the national ETS, which now, according to Xi Jinping, will be launched in 2017. In December 2014, the NDRC released the first legal elements of a national ETS: It will cover six greenhouse gases (CO2, CH4, HFCs, PFCs, SF6 and NFC) and include national and provincial emissions quotas, leaving room for local governments to adapt the requirements to the local economic structure and development level. Indeed, the ETS must remain manageable for provinces that rely more prominently on heavy industry for growth and employment and could therefore resist cap-and-trade schemes that will further raise costs for them.

The NDRC’s current guidelines are deliberately vague, leaving room for Beijing to experiment with various schemes in the coming years. As the preliminary lessons from the existing ETS highlight, pricing carbon and introducing a unified measurement, reporting and verification system will be very challenging. Already the task of setting emission caps and allowances is complicated by SOE’s reluctance to disclose historic emissions data, if they have kept a record of it to begin with. Companies are also trying to inflate their credit allowances while putting pressure on authorities to overestimate the emission cap. To be sure, these growing pains are to be expected. Other carbon schemes have also grappled with the aftermath of the global financial crisis, and now with the fall in oil prices and the availability of cheap coal exports from the U.S. The EU’s ETS is on life support, the Australian government has scrapped its carbon tax and the U.S. has repeatedly failed to introduce a nation-wide system.

Despite the initial challenges in China’s pilot schemes, the Chinese leadership remains committed to picking the best practices from these pilots and structuring a workable nationwide ETS. If the various provincial schemes fail to add up to a mature trading system and a national benchmark for carbon prices, a carbon tax may be introduced in order to introduce a direct tax on emissions and meet China’s coal of peaking emissions before 2030. But the ETS will continue to expand and develop, with Chinese characteristics.

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