By Lauri Myllyvirta, Lead Analyst, Centre for Research on Energy and Clean Air. This is a joint article with Huw Slater, Lead Climate Specialist, ICF

The world’s largest emissions trading system, at least in terms of the amount of emissions covered, is due to go live in China this year. At the same time, the pledge to target carbon neutrality by 2060 has raised the expectations towards China’s climate action. Meeting China’s climate targets requires effective policy mechanisms to boost zero-carbon energy and energy efficiency.

The system’s role in the short term is going to be limited, due to a market design that doesn’t really put a price on carbon in the conventional sense. In this article, we look at how the system works, what it means for companies in China and how it’s likely to evolve in the coming years.

The long march to a national trading scheme

China’s premier Li Keqiang announced already in 2015, in the run-up to the Paris climate conference, that China would launch a national carbon trading scheme by 2017. The groundwork had been laid from mid-2013, as eight regional emissions trading systems (ETS) were consecutively introduced in different parts of China (Shenzhen, Shanghai, Beijing, Guangdong, Tianjin, Hubei, Chongqing and Fujian).

In January 2016, the National Development and Reform Commission (NDRC) circulated a notice about China’s national carbon market, specifying that firms from eight sectors and 18 sub-sectors, which consume over 10,000 tonnes of coal equivalent per year, would be included in China’s national ETS, namely: power generation, petrochemicals, chemicals, iron and steel, non-ferrous metals, building materials (inc. cement), pulp and paper and aviation.

In December 2017, the NDRC released a “Development Plan” for an ETS covering only the power sector. The likely reasons for initially limiting the scope of the national carbon market to the power sector include that the power sector was the best prepared of the key emitters, and that allowance allocation in other sectors would be more complex given the wider variety of industrial processes. The plan outlined a roadmap with three phases: foundational; simulation trading (without compliance obligations); and full market operation with compliance obligations.

In 2018, China undertook a major governmental restructure, after which responsibility for the ETS transferred from the NDRC to the Ministry of Ecology and Environment (MEE). In late 2019 the MEE conducted nationwide capacity building for the power generation sector, and communication of the allowance allocation mechanism, and in early 2021 it published the ministerial regulation which would govern the market effective from February 1. MEE Minister Huang Runqiu has since commented that he hopes that the market infrastructure (the exchange and the registry) will be in place to facilitate trading in the market by June this year.

How the system works

The textbook concept of carbon pricing is to put a uniform price on every tonne of emissions, and to let the market find the least-cost opportunities for emissions reductions. Emission allowances can be dealt out for free or auctioned, but at the end of each compliance period market participants have to retire allowances equal to the amount of emissions they generated.

China’s system currently differs from this model in one crucial way: The available emissions quota is not fixed before each year, but the allowances every plant receives is adjusted based on actual output of electricity and heat—the more energy the plant generates, the more free allowances it gets. The allocation is based on emissions benchmarks which are broadly reflective of the average emissions per unit of electricity and heat from coal-fired power plants.

This means that for a power plant with emissions performance exactly equal to the benchmark, the emissions trading system will be entirely cost-neutral and the plant will face an effective carbon price of zero, no matter how high or low the price of allowances is in the trading system.

The benchmark is 0.877tCO2/MWh for coal plants over 300MW and 0.979tCO2/MWh for coal plants below 300MW. For less common plants that burn coal gangue or coal water slurry, the benchmark is 1.146tCO2/MWh, while for gas-fired power plants it is 0.392tCO2/MWh.

A power plant that outperforms the benchmark will receive more allowances than it needs to cover its emissions, meaning that it will have an incentive to operate at a higher utilization. This results in larger emissions from the power plant, but could reduce the average emissions intensity of coal-fired power generation overall, as there will be lower requirement for electricity supply from plants that fall below the benchmark.

The benchmarks are differentiated based on the size and type of the power plant. Some power plants with emissions intensity above the average for China’s coal fleet will have the incentive to run more. The system can also create a small additional incentive to build new coal-fired power plants as new ultra-supercritical coal plants can easily beat the benchmark.

For plants that can’t reach their benchmark, the incentive to reduce power generation from coal will be very limited: at the extreme case, 20% of the sticker price of allowances. For a highly inefficient, small coal-fired unit, at an allowance price of 70 yuan per tonne, which is at the very high end of market expectations, this would translate into a 4% increase over the typical generating tariff of 0.4 yuan/kWh. In the European system, the same plant would face a 20% increase in costs at the same allowance price.

Overall, the system is designed to create an incentive for every plant operator to enhance thermal efficiency, or choose less carbon-intensive fuels, if possible. Its design does not incentivize changes to the energy mix, because the carbon intensity-based allocation simply changes the cost distribution within the coal power sector itself, not between coal and its alternatives.

In a standard ETS, fuel switching can be achieved through 1) impacting the short-term dispatch decisions of a grid operator, by making high emission sources more expensive, and 2) impacting longer term investment decisions as power companies invest in zero carbon energy sources and stop investing in high carbon energy. For China’s national ETS to play this role, it would need to 1) go hand-in-hand with reform of electricity dispatch, and 2) shift from an intensity-based allocation to an absolute cap.

On the first point, pilot reforms have been happening at the regional level, notably in Guangdong. In March, the number of pilot regions grew from 8 to 13. On the second point, senior government advisors have previously suggested that this shift may take place in the second half of this decade. Paving the way for this, the environmental ministry recently introduced a draft revision on carbon trading regulation that would give the State Council the power to set absolute emissions caps for the trading system, without specifying a timeline for this to happen.

What does the system mean for companies on the ground

Introducing the concept of a carbon cost across the country to local level environmental officials and small power companies is an important and positive step. An ETS can affect company decisions in many ways. The process of monitoring and reporting of emissions, the establishment of compliance departments and of reporting on carbon liability in annual reports puts it on the agenda of company boards. In the early stages, it also allows for identification of low hanging fruit in terms of efficiency improvements that may otherwise not have been prioritised, even before a substantial carbon price is realised. Beyond that, if there is confidence that the price of carbon will rise over time, it will affect asset values well before we see a high price on carbon. Of course, not all boards, financial institutions and investors deal with carbon risk in a rational and far-sighted way, but the fact that we have seen a series of Chinese SOEs announce carbon peaking and neutrality targets recently suggests that some do, and that this may lead others to do the same.

Under the national ETS, companies will first be required to submit an annual emissions monitoring report to the province-level government, which will conduct a review. Provincial governments may authorise third-party verification of reports, though whether this will be extensive or spot-checks is not yet clear. If verifiers identify issues, they can conduct site inspections.

Different ETS jurisdictions take various approaches to the transparency of emissions and carbon market data. Emissions trading systems in Europe and California allow for public disclosure of emissions at the facility level, while protecting entity-specific product data and allocation numbers as confidential business information. Public interest groups also have the opportunity to seek more specific data through freedom of information channels. China’s pilot regional systems have generally taken a more cautious approach, whereby emissions reports and data are only seen by the companies, local government and third party verifiers. At the same time, five provinces have already introduced specific requirements for companies above the ETS compliance threshold to disclose GHG information.

With responsibility for the national ETS now with the MEE, the monitoring of carbon emissions from energy production is being incorporated within the broader environmental monitoring system, rather than as a stand-alone process. The MEE already makes both real-time and annual air pollutant emission data available from all emission permit holders, so CO2 emissions disclosure is likely to be integrated into the same system.

What will allowances cost?

Most emissions trading systems, including the European Union trading scheme where prices recently exceeded 40 EUR/tonne, have initially suffered from over-allocation. This appears to be a major risk in China as well.

The 13th Five-Year Plan (2016–20) set average coal consumption targets of 310 grams of coal equivalent per kilowatt hour (gce/kWh) for operating coal power plants and 300 gce/kWh for newly built plants by 2020. This means approximately 0.870 and 0.840tCO2/MWh, which is well below the average benchmark of around 0.90tCO2/MWh (based on 25% of China’s coal-fired capacity comprising units 300MW and below).

The IEA concurs, with the agency’s analysis projecting a substantial surplus of allowances. However, the IEA analysis also indicates that many provinces and generators will face a shortfall, so trading volumes could be significant even if the prices initially reflect only transaction costs rather than a shortage of allowances.

These issues are reflected in the expectations of market participants. The 2020 China Carbon Pricing Survey foundthat about one third of power sector respondents expect to face a shortage in allowances at the start of the national carbon market.

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The average price expectation, across all stakeholders, starts at CNY 49/t, close to the price in Shanghai’s regional market at the time of the survey. Shanghai has one of the more diverse markets, with the financial centre introducing a wider range of carbon finance products than other regional pilots. The price in Beijing is much higher (around CNY 100/t), but with less trading activity. The price is lower in Guangdong, Hubei and Shenzhen, but the markets there have significantly more market liquidity and trading value. Survey expectations for the carbon price in 2030 rise to CNY 93/t for the national market, and a range of CNY 82-172/t for the regional markets.

Feedback from power sector representatives gathered through a focus group held in September 2020, suggested that, in their view, the carbon price should not exceed 30 yuan per tonne. State-owned enterprise leadership is concerned that if the cost impact on their businesses is excessive, it will impact on their annual performance assessment. This illustrates one of the challenges to operating an effective emissions trading system in China. SOEs have not yet fully internalised the concept that a carbon price isn’t intended to be simply a short term cost to be absorbed, but is rather a factor to influence long-term investment strategies. If an emitter effectively incorporates the cost of carbon into their business model, it should facilitate a transition to zero emission operations that will ultimately be more profitable.

Signals about the future

Xi Jinping’s recent speech at the Finance and Economic Committee of the Communist Party positioned carbon peaking and carbon neutrality as one of the two headline tasks for the party. It also singled out accelerating the progress on carbon trading as a tool for the first time, instead of a more general reference to market-based measures.

It’s therefore clear that carbon trading is a part of China’s policy toolbox, but there is as yet no clarity on when and how the system will be enhanced. In order for the system to play an important role in China’s long-term decarbonization effort, the intensity-based allocation would have to be reformed to create an incentive for the power sector to switch to zero-carbon energy sources, and other key emitting sectors would have to be included.

Li Gao, the director of the climate department at the environmental ministry said in January that the steel industry will be included in the carbon emission trading market as soon as possible during the current five-year plan period (2021–2025). Shifting to a market mechanism that puts a price on total emissions rather than only encouraging lower emissions intensity could take longer.

The introduction of carbon pricing can however be seen as a systemic reform – it puts carbon on the books of emitters and ambition can be increased depending on political will. Getting it started, then, is an important step. While there are many hurdles to achieving a carbon price which is representative of the social cost of carbon, the high level policy endorsement means that emitters and regulators must grapple with the intent of the policy, and its implications for future investments in any of the eight sectors slated to eventually be covered.

In the meantime, the most important point to bear in mind is that the carbon market is not the only tool in the government’s toolbox—China is currently leading the world in investments in zero-carbon power generation and these investments will be substantially scaled up further over this decade. Administrative measures, targets and quotas, buttressed by inspections and enforcement, will remain central.