On December 19, 2017, the government of China announced that it is commencing development of a nationwide CO2 trading system, that when launched will become the world’s largest carbon trading system, annually covering about 3.5 billion tons of CO2 emissions in China’s electric power sector. That approaches twice the size of what is currently the world’s largest carbon trading system, the European Union Emissions Trading System, which accounts for about 2 billion tons per year, and is nearly nine times the size of the largest U.S. system, the California AB-32 cap-and-trade system, which covers about 400 million tons of annual emissions.
The ultimate purpose of the newly announced Chinese trading system is to help the country meets its emissions and renewable energy targets which are part of its Nationally Determined Contribution under the Paris Agreement, in particular, peaking its CO2 emissions by 2030, and achieving 20% of the country’s energy supply from renewables. Note that coal currently accounts for 65% of China’s electricity generation. Wind and solar capacity have been growing rapidly, but still account for only 4% and 1% of generation, respectively.
The Chinese carbon market will double the share of global CO2 emissions covered by worldwide carbon-pricing systems to almost 25 percent. For this and other reasons, the December announcement was greeted with excited praise from climate activists (but simultaneously with disregard and skepticism from conservative opponents of climate action). The most reasonable assessment, however, is between those two extremes, as I explain in this essay. That said, the December announcement by China of its plan to develop and launch a nationwide CO2 trading system is an important landmark on the long road to addressing the threat of global climate change.
Some Brief History for Context
In 2011, China’s 12th Five-Year Plan (2011-2015) first included a statement about the government’s intention to develop – gradually – a nationwide carbon market. Subsequently, in 2013 and 2014, seven pilot emissions trading programs were launched in the cities of Beijing, Chongqing, Shanghai, Shenzhen, and Tianjin, plus two provincial systems in Guangdong and Hubei. In total, these covered some 3,000 sources, with total annual CO2 emissions of 1.4 billion tons. The designs of the systems were intentionally varied, to facilitate learning, and allowance prices ranged from $3 to $10 per ton of CO2.
Then, in the lead-up to the Paris climate negotiations, on September 25, 2015, President Xi Jinping met at the White House with U.S. President Barack Obama, and announced that China would launch its nationwide CO2 trading system in 2017, presumably covering electricity, iron and steel, chemicals, cement, and paper production.
The announcement last month was the culmination of this brief history, as China seeks to move ahead with its “pledges” under the Paris Agreement, at the same time as the Trump administration in the United States intends to withdraw altogether from the Agreement (in November, 2020, the soonest that such withdrawal can take place under the rules of the Agreement).
What’s Known about the Chinese Carbon Trading System
China’s December announcement that it is commencing development of a nationwide CO2 trading system, beginning with the electric power sector only, provided few details. Apparently, the system is intended to eventually include electricity, building materials, iron and steel, non-ferrous metal processing, petroleum refining, chemicals, pulp and paper, and aviation, but will start with the electricity sector alone. Like most operating systems in the world, it will regulate only CO2, not other greenhouse gases (GHGs), which in China’s case means potentially addressing more than 80% of its total GHG emissions.
The system will not be a cap-and-trade system per se (unlike the CO2 trading systems in Europe and California, for example), because there will not be an administratively set mass-based cap of some quantity of emissions. Rather, the trading system will be rate-based, meaning that it will be in terms of emissions per unit of electricity output. This is also called a tradable performance standard, whereby the government sets a performance standard (a benchmark emissions rate per unit of output), sources receive permits (allowances) based on their electricity output and their benchmark, and sources are allowed to trade. Such tradable performance standards have been used previously in a variety of contexts, including the U.S. EPA leaded gasoline phasedown in the 1990s, U.S. Corporate Average Fuel Economy (CAFE) standards to regulate motor-vehicle fuel efficiency, the Obama Administration’s Renewable Fuel Standard, and California’s Low Carbon Fuel Standard.
One objective of using this approach is to insulate – or at least cushion – the (electricity) sector and the larger economy from “carbon market shock.” By regulating the emissions rate (per unit of product output), rather than emissions per se, the rate-based approach may help mitigate the political worry about constraining economic growth, but does so by essentially rewarding (subsidizing) higher levels of output. This relative inefficiency of China’s rate-based system, compared with a mass-based cap-and-trade approach is highlighted in a new paper by Lawrence Goulder (Stanford University) and Richard Morgenstern (Resources for the Future) and one by William Pizer (Duke University)and Xiliang Zhang (Tsinghua University). (There is a parallel impact and concern – in cap-and-trade systems – with an output-based updating allocation, which can address competitiveness impacts but also introduces inefficiencies by subsidizing dirty production. This mechanism – which affects only energy-intensive and trade-exposed industries – was proposed in the Waxman-Markey climate legislation and is employed in California’s system.)
The rate-based approach is intended to have a smaller impact on marginal production costs than the mass-based cap-and-trade approach, and thereby is likely to have a smaller impact on the price of products (whether electricity or manufactured goods). This is the motivation for using this approach in an output-based updating allocation, as described above, and it carries with it the parallel disadvantage of insulating consumers from (some of) the social costs of their consumption decisions. The problem is exacerbated in the case of China’s evolving system because the performance standards (emission benchmarks) are set not only by sector, but by various categories of electricity production within the sector. As some categories are, in effect, subsidized by other categories, the cost-effectiveness of the overall system declines. There is a lack of incentive for the carbon market to move energy consumption from coal to natural gas, for example, because of the multi-benchmark approach.
Finally, it appears that allowances will be allocated without charge, at least in the early stages of the program, which has been typical of emissions trading systems in other parts of the world, and may lessen political resistance while also sacrificing potential efficiency gains associated with auctioning allowances and recycling revenues.
What’s Unknown about the Chinese Carbon Trading System
Among the key design elements that are unknown as of now (at least to me) are the following:
(1) What will the total allocation of allowances initially be and how will it change (presumably decrease) over time? Apparently the overall “cap” will be set by adding up the expected emissions of compliance entities, based on their historical emissions. Then, allocations will be reduced, presumably based on technology performance benchmarks.
(2) When will trading commence?
(3) What share of allowances will be distributed for free, and how many – if any – will be auctioned (and how will any auctions operate)?
(4) What provisions will there be for monitoring and enforcement, and will there be fines or other penalties for non-compliance?
(5) How will the system interact with other Chinese climate policies? This is an important question, because so-called “complementary policies” that seek to regulate sources under the cap of a cap-and-trade system can lead to perverse outcomes, as in the European Union and California.
(6) What is the time-path for expanding the scope of the system to include more sectors, and what sectors will be added?
(7) When and how, if at all, will China seek to link its system with carbon-pricing and other climate policies in other parts of the world?
Given all of these open questions plus the limited sectoral scope of the announced system, it is reasonable to ask: what should we make of all this?
How Significant was the Chinese Announcement?
The announcement, despite all the caveats, was a significant step along the road of climate change policy developments, because the Chinese system will eventually be very important, because of its magnitude and because of the importance of China in CO2 emissions and climate change policy. However, the announcement was not a launch per se, but a statement about a forthcoming launch.
More broadly, the announcement and the eventual launch of the system will have significant effects on other governments around the world – regional, national, and sub-national. Some will be encouraged to launch or maintain their own carbon trading systems, and to increase the ambition of their systems. Why do I say this?
A frequently stated fear of adopting climate policies, including carbon pricing, is the competitiveness effects of those policies, due to emission, economic, and employment leakage. This is more a political issue than a real economic one, but it is nevertheless important. Since the greatest fear in this realm is that domestic factories will relocate to China, that concern will be greatly reduced – or at least it should be – when and if China has put in place a serious climate policy, whether through carbon markets or otherwise.
China is moving slowly and cautiously, which is wise. Not long ago, they were considering launching a system that would initially cover 7,000 companies in several sectors, but the 2017 announcement is of a system that covers 1,700 companies in the electricity sector alone. Of course, it is still important, given that the electricity sector (with its large coal and natural gas plants) accounts for fully a third of China’s CO2 emissions.
During the next two years, the Chinese government – apparently through its National Development and Reform Commission (NDRC), which will administer the trading system – will begin by developing systems for data reporting, registration, & trading – gathering and verifying plant-level emissions data. This will facilitate the establishment of baselines for allocations of allowances. Beyond this, a wide range of rules will need to be established. Following some tests, the actual spot market may launch in 2020 (the same year the Paris Climate Agreement essentially replaces the Kyoto Protocol).
The Path Ahead
As inevitably seems to be the case, the best assessment of this new policy lies somewhere between the extremes. The December announcement by China was neither as exciting as some of the applause from climate activists might suggest, nor was the announcement as meaningless as conservatives have claimed.
Rather, cautious optimism seems to be in order. China is serious about climate change, and is thinking long-term. The country appears to be methodically working to develop a meaningful carbon trading system. What is important now is developing a robust system that can be effective, expanded in scope, and gradually made more stringent. Among the greatest challenges will be achieving the cooperation of the provincial governments, not to mention the compliance of the regulated entities.
Development of the system has begun, with the real launch of trading likely to take place in 2020, which is a key year for Chinese climate policy for other reasons, as well. In that year, China will release its next Five-Year Plan, and it will submit its updated Nationally Determined Contribution to the UNFCCC under the Paris Agreement. What will the United States be doing that year? Not much, just electing a President!