What Should We Make of China’s Announcement of a National CO2 Trading System?

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 detailsApparently, 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!

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Trump’s Paris Withdrawal: The Nail in the Coffin of U.S. Global Leadership?

The announcement on June 1st by U.S. President Donald Trump that he will withdraw the United States from the Paris Climate Agreement was, in my view, misguided; and the justifications Mr. Trump provided were misleading, and to some degree, untruthful.  In this essay, I seek to explain why I believe that withdrawing from the Paris Agreement will be damaging both to the United States and the world.  Sadly, Trump’s withdrawal announcement gave the impression that the President has little understanding of the nature of the Agreement, the process for withdrawal, or the implications of withdrawal for the United States, let alone for the world.  Rather, Mr. Trump appears to be channeling talking points from his chief strategist, Stephen K. Bannon, and his supporters among Alt-Right nationalists, isolationists, and anti-globalists.

Some Context

Let’s start with a few numbers. The United States accounts for about 14% of global greenhouse gas emissions, with China the largest emitter at 30%, followed by the European Union (10%) and India (7%). But climate change is a function of atmospheric concentrations, and when looking at cumulative emissions since 1850, the United States is first with 29% of the total, then the European Union (EU) with 27%, and then Russia and China with 8% each.  With Trump’s announced withdrawal, the United States will join Syria and Nicaragua as the only countries among 195 that are not Parties of the Paris Agreement.

Global Implications of U.S. Withdrawal from the Paris Agreement

With the United States out of the Paris Agreement, it loses the ability to pressure other countries, such as the large emerging economies, to do more.  Worse yet, the announced departure may encourage some countries to do less than they had planned.  In the worst possible outcome, the U.S. announcement might eventually even lead to the broad Paris coalition unraveling.  However, initial indications from the EU, China, India, and other key Parties to the Agreement is that they will maintain their targets, and some may even make them more aggressive because of President Trump’s short-sighted action.  Only time will tell.

What Does President Trump’s Announcement Actually Mean?

In several ways, the President’s announcement was both confused and confusing.  The President stated that the country “will withdraw from the Paris climate accord but begin negotiations to re-enter either the Paris accord or an entirely new transaction on terms that are fair to the United States.  We are getting out. But we will start to negotiate, and we will see if we can make a deal that’s fair. And if we can, that’s great.”

First, the notion of re-negotiating the Paris Agreement is a non-starter.  Within hours of the President’s announcement, the idea of renegotiation was rebuked by French President Emmanuel Macron, German Chancellor Angela Merkel, Italian Premier Paolo Gentiloni, British Prime Minister Theresa May, and Canadian Prime Minister Justin Trudeau, among many other world leaders.

Second, what could Mr. Trump even mean by his assertions of the deal’s “unfairness” to the United States, and what should we to make of his statement that such unfairness could be addressed through renegotiation?  According the Paris Agreement’s own provisions, there is a required three-year delay from November, 2016 (when the Agreement came into force) before any Party (country) can even begin the process of withdrawing, and then there is another year of delay before that process is completed.  So, what the President actually announced – in effect – was the U.S. government’s intention to begin the process of withdrawing some two and a half years from now, and to complete that withdrawal process in November, 2020.

Thus, the announcement was equivalent to stating that the U.S. will remain a Party to the Agreement for virtually the entire term of this administration (which it will).  The administration could – in theory – submit a revised Nationally Determined Contribution (NDC) that is consistent with what the country can accomplish in emissions reductions (possibly a 15-19% reduction by 2025 compared with 2005, according to a recent Rhodium Group analysis, instead of the Obama NDC of a 26-28% decline), consistent with the broad rollback of Obama-era climate regulations that President Trump has initiated.  The country-specific NDC is the key element that can be thought of as affecting “fairness” of the U.S. role under the Paris Agreement, because it is only through the self-determined, voluntary, country-specific NDCs that any national targets or actions are specified.

Given that the Administration had already begun the process of unraveling Obama-era climate regulations (that were to be used achieve the Obama NDC), the announced withdrawal from the Paris Agreement has no additional effects on U.S. emissions mitigation actions.  Hence, it is fundamentally dishonest to claim as a justification for the withdrawal that this will reduce costs for the U.S. and save jobs.

Beyond the national targets and actions specified by the U.S. NDC, there is one other aspect of pledged action under the Paris Agreement that could be considered to affect fairness, and that is the set of pledges of financial contributions to the Green Climate Fund, to which industrialized countries have voluntarily pledged $10 billion since 2013 to help low-income countries reduce their GHG emissions and adapt to the effects of climate change.  If the U.S. were to fulfill its original $3 billion commitment to the Fund, this would amount to $9.41 per capita, ranking 11th among country pledges, starting with Sweden’s at $59.31 per person.  However, the President had previously announced that no funds will be going to the GCF (beyond the $1 billion already delivered during the Obama administration).  That makes the per capita U.S. contribution a bit more than $3 per capita, ranking close to the bottom of the list, only above South Korea’s pledge of about $2 per capita.  So, with this financial element, as well as with regard to domestic emissions mitigation actions, withdrawal from the Paris Agreement can have no real effects on the “fairness” of the U.S. role.

The Paris Agreement Was the Answer to U.S. Prayers

The very structure of the Paris Agreement itself was and is the answer to U.S. prayers, going back to the bipartisan Byrd-Hagel Resolution of 1997, in which the U.S. Senate – in a 95-0 vote – said that it would not ratify an international climate agreement that did not include the large emerging economies (China, India, Brazil, South Africa, Mexico, and Korea).  After more than 20 years of negotiations, an important breakthrough came with the signing of the Paris Agreement, which increased the scope of participation from countries accounting for just 14% of global emissions (under the current, second commitment period of the Kyoto Protocol) to countries accounting for 97% under the Paris Agreement.

Furthermore, in addition to including all countries, the Paris Agreement answered a second key U.S. demand by granting all countries the right to determine their own targets and their own paths of action (through their respective NDCs).

And the third of three U.S. wishes was also granted by the Paris Agreement by providing for transparency around how countries report their emissions and demonstrate progress toward their respective targets.

Thus, the Paris Agreement was truly the answer to bipartisan U.S. prayers going back at least twenty years, and was eminently “fair” to the United States.  What, then, can renegotiation possibly accomplish that would make this President happy?  Perhaps one option would be to rename precisely the same agreement the “Mar-a-Lago Accord” (or simply the “Trump Agreement”)!  That might change this President’s mind.

A Rebuke to Countries around the World … and to U.S. Businesses

Mr. Trump’s decision is a remarkable rebuke to countries and heads-of-state around the world, as well as corporate leaders in the United States, and some key senior officials in the Administration, including Secretary of State Rex Tillerson.  However, the announcement does attempt to fulfill the President’s campaign pledge to “cancel” the Agreement that he claimed would “destroy American jobs.”

But dropping out of Paris will have no meaningful employment impacts.  Again, Trump had already launched the process of undoing domestic climate regulations from the Obama administration.  Also, the much-talked-about coal jobs are not coming back.  The losses that have taken place over decades are due to increased productivity (technological change) in the coal sector, and more recently, market competition from low-priced natural gas for electricity generation, not environmental regulations — and certainly not CO2 regulations that had never been implemented.

Support for Trump to keep the United States in the Paris Agreement was broad-based within U.S. private industry – from electricity generators such as PG&E and National Grid, to oil companies such as Chevron, ConocoPhillips, Exxon-Mobil, BP, and Shell (the last two having large operations within the U.S.), and a very long list of manufacturers, including giant firms such as General Motors and General Electric.  Even some of the largest coal producers, such as Arch Coal, Cloud Peak Energy, and Peabody Energy, told the President about their support for the U.S. remaining in the Agreement. This broad support was due to a simple reality – leaders of successful businesses make decisions not on the basis of ideology, but based on available evidence.

Damages to U.S. International Relations

The potential damages to U.S. international relations are grave, but should we be surprised?  After all, this is the same President who withdrew from the Trans-Pacific Partnership days after inauguration, thereby handing over to China economic leadership in Asia; and the same President who just last month dismissed and diminished NATO and insulted our key European allies, thereby granting Russian President Vladimir Putin one of his greatest wishes.  Former Mexican President Vincente Fox may have summed it up best with the shocking assessment that “the United States has stopped being the leader of the free world.”

At a time when the U.S. wants and needs cooperation from a large and diverse set of countries around the world on matters of national security, trade, and a host of other issues, it is counter-productive in the extreme to willingly become an international pariah on global climate change, but that is what President Trump has accomplished.

Defining U.S. Climate Policy Geographically, Rather than by Federal Government Action

Of course, this is not the end of all climate change policy action in the United States.  Climate policies in California, Oregon, Washington, and the Northeast will remain in place, and quite possibly be strengthened. And more than half of all states have renewable energy policies; just since Election Day, the Republican governors of Illinois and Michigan have signed legislation aimed at increasing solar and wind generation. At the federal level, important tax credits for wind and solar power will likely continue to receive bipartisan support in the U.S. Congress.

But it is highly unlikely – in the absence of a significant economic recession – that those policies (plus others from cities across the country) will be sufficient to achieve the climate targets that made up the Obama administration’s anticipated contribution (NDC) under the Paris Agreement.

Trump’s Core and a Sad Bottom Line

For President Trump’s core supporters, the move was probably perceived in very positive terms.  As Cary Coglianese, a professor of law and political science at the University of Pennsylvania, has said, “For Trump supporters it looks like he’s delivering on a campaign promise — it looks like he’s standing up for Americans against the rest of the world.”  The opposition to Paris among Trump’s electoral core (and a considerable share of Congressional Republicans) seems to be linked with their admiration for his “America First” battle cry, which builds on nostalgia for an earlier (and whiter) America with its long-gone manufacturing-based economy, plus doses of xenophobia, hostility to immigration, fear of globalism, and opposition to multilateral agreements of any kind.

The President’s announcement of withdrawing from the Paris Climate Agreement will indeed appeal to his core constituency, and thereby may help galvanize his base, and that may be the central White House objective at this time when the administration is facing grave questions and challenges from Congressional hearings and Justice Department investigations. As Ban Ki-moon, former Secretary-General of the United Nations, and I wrote in April in The Boston Globe, “reducing emissions will not be cheap or easy, but the greatest obstacles are political.”

The announcement by President Trump that he will withdraw the United States from the Paris Climate Agreement was based neither on real science nor sound economics.  Rather, it was confused, misguided, and – in some ways – dishonest.  Sadly, that makes it consistent with much of this President’s behavior – in a variety of policy realms – during the campaign and since he assumed office.

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Why Trump Pulled the U.S. Out of the Paris Accord

I want to bring to your attention my article just published by Foreign Affairs, “Why Trump Pulled the U.S. Out of the Paris Accord – And What the Consequences Will Be.”  The article begins as follows:

President Donald Trump’s decision to withdraw the United States from the Paris climate agreement on June 1 was terribly misguided, and his justification for doing so was misleading and untruthful. As he announced in the Rose Garden that day, “The Paris climate accord is simply the latest example of Washington entering into an agreement that disadvantages the United States to the exclusive benefit of other countries, leaving American workers…and taxpayers to absorb the cost in terms of lost jobs, lower wages, shuttered factories, and vastly diminished economic production.” The reality is that leaving the accord will neither bring back jobs nor help the taxpayer, but will most certainly hurt the United States and the world.

The initial reaction from abroad was one of dismay and confusion over what the president was actually trying to say. Trump declared, without seeming to understand the terms and dynamics of the agreement, “I will withdraw from the Paris climate accord but begin negotiations to reenter either the Paris accord or an entirely new transaction on terms that are fair to the United States.” First of all, renegotiation is a nonstarter. If this was not already clear, it was made more so when within hours of the announcement world leaders rebuked the idea. British Prime Minister Theresa May, Canadian Prime Minister Justin Trudeau, French President Emmanuel Macron, German Chancellor Angela Merkel, and Italian Premier Paolo Gentiloni, among many other heads of state expressed their refusal to return to the drawing board …

To Continue Reading the Article in Foreign Affairs, just follow this link.

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