China Launches its Long-Awaited National Emissions Trading Scheme

China just launched a long-awaited national emissions trading scheme (ETS). As the largest current emitter accounting for more than a quarter of world’s total carbon emissions, this move can potentially have major repercussions. The official commitment to the scheme was initiated in 2015 as part of China’s plan to peak emissions by 2030 and become carbon neutral by 2060. After several delays, trading of emission permits commenced in July 2021. This marked the beginning of the world’s largest carbon market by volume, covering more than four billion tons, or 40% of China’s national carbon emissions.

An ETS is a market-based mechanism – an example of a cap-and-trade system – designed to reduce carbon emissions by granting factories and power plants “allowances” or “permits” to emit a certain amount of carbon. Importantly, firms can trade these permits like any other commodity. At the end of each compliance period (typically a calendar year), participants must submit allowances equal to their actual emissions or be penalized. The idea is that entities with a relatively higher cost of reducing emissions can purchase permits from those that have relatively lower cost of abatement. By gradually decreasing the total amount of carbon allowances available on the market, total emissions can be reduced. Because the ETS generates a price signal for carbon that is reflected by the participants’ opportunity costs of abatement, many economists believe that it is the most cost-effective way to reduce carbon emissions compared to direct government mandates or a carbon tax.

Carbon ETSs have been successfully implemented before, with the European Union’s ETS being the trademark example. Established by 27 EU member states, the market accounted for over 75% of all international carbon trading before 2021. By 2019, the EU ETS reduced emissions to 24% below the 1990 levels. The success behind the EU ETS can be attributed to the targeted policy changes that effectively addressed some of the structural design flaws evident during the initial phases of the scheme. In response, the European Commission in 2013 implemented several structural adjustments, such as making auctioning the default method of allowance allocation, allowing firms to bank allowances in between phases, and introducing more sectors and greenhouse gases to the market. Since then, the price of EUA has rebounded to reach $65 per ton of CO₂ in 2021.

China’s national ETS shares the same principle as the EU ETS. However, some key differences in its current design may limit its effectiveness in cutting China’s carbon emissions in the short-term. The initial phase of China’s ETS covers only the power sector and 2,225 coal and gas-fired power plants. This is only a fraction of the 10,000 sites that were previously considered and does not include other carbon-intensive sectors such as cement, steel, and aviation. In stark contrast to the EU ETS, the China ETS also does not have a cap on total emissions, as the allowances for each power plant are allocated for free based on a series of officially determined adjustment factors and emissions intensity benchmarks (the amount of emitted carbon per unit of energy produced). Combined with lax compliance obligations and little to no penalty for firms that fail to comply, the price of carbon in China’s national ETS by the end of 2021 was a mere $9/tCO2. Critics argue that this current design not only provides minimal economic incentive for firms to abate their carbon emissions, but also it functionally subsidizes some of the participating coal and gas power plants with freely allocated emissions permits.

Moreover, China’s national ETS begins at a time when the power sector is undergoing market reforms that carry significant implications for the scheme’s effectiveness in curbing emissions. Because current operations of the power plants continue to be largely governed by administrative mechanisms as opposed to market forces, price signals generated by the ETS could be ineffective in adjusting the electricity market dispatch (the process of switching individual power plants on and off to meet electricity demand). Without the accompanying development of a competitive electricity market, scholars agree that the market-based instrument may do little to induce meaningful reductions in emissions.

While there is considerable uncertainty in whether the ETS can be effective in the short-run, many experts believe that it has the potential to transform the power sector and drive deep emissions cuts in the medium to long-term. Compared to the EU ETS, which consists of sovereign member states, China’s national ETS has the advantage of being more flexible and adaptable to changes in its design. If the emission intensity benchmarks are tightened and power market reforms accelerated, then the price of carbon from the ETS would increase costs for inefficient coal power plants, thereby incentivizing lower-emitting plants to increase their operations. This could further support ongoing power sector reforms by promoting the use of efficient and low-emissions resources. The International Energy Agency (IEA) estimates that the carbon price will gradually rise to reach $28/tCO2 in 2025 and the ETS will make the power sector emissions peak before 2030, assuming that benchmarks are tightened by 3% before 2025 and 6% before 2030. Furthermore, if auctioning is phased in for some of the allowances beginning in 2025, power sector emissions would peak well before 2030 and even fall below 2020 level by 2035.

Even though its contingencies and current lack of ambition cast doubt over its prospects, the ETS is a promising policy instrument that has the potential to help China achieve its climate goals. While it’s difficult not to stand opposed to the scheme given its undesirable features, it should be reminded that the EU ETS also required years of testing and development before having any real impact. The aim of the initial phase for both the EU and China ETS is to encourage participation and compliance for all regulated entities. Considering the dire need for the world’s largest current emitter to take immediate action in order to avoid climate catastrophe, it’s important to bear in mind that the perfect should not be the enemy of the good.

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Liu, Hongqiao. “In-Depth Q&A: Will China’s Emissions Trading Scheme Help Tackle Climate Change?” Carbon Brief, 24 Sept. 2021, https://www.carbonbrief.org/in-depth-qa-will-chinas-emissions-trading-scheme-help-tackle-climate-change.

Cassisa, Cyril, et al. IEA Communications and Digital Office, 2021, The Role of China’s ETS in Power Sector Decarbonisation. https://www.iea.org/reports/the-role-of-chinas-ets-in-power-sector-decarbonisation

International Carbon Action Partnership (ICAP), 2021, China National ETS. https://icapcarbonaction.com/en/?option=com_etsmap&task=export&format=pdf&layout=list&systems%5B%5D=55