How China's rising carbon price impacts the market

An ETS—and the carbon price signal that it triggers—must influence investment decisions if the system is to meet its main goal of reducing carbon emissions. The survey reflects realistic optimism from the respondents, who expect the trading of carbon emissions to increasingly affect investment decisions in coming years. Figure 2 shows how respondents expect the ETS to affect investment decisions in 2018, 2020, and in 2025.

However, the responses also indicate uncertainty in the medium term, with fewer respondents expecting a strong impact in 2020 than those surveyed in 2015 (15 percent down from 30 percent). This change in opinion reflects the formal launch of the national ETS roadmap by the Climate Change Department in December 2017, which outlines a phased introduction, and can be attributed partly to the relative lack of clarity regarding the underlying legal basis for the proposed system. In the long term, confidence remains high that the ETS will play an important role in shifting investment towards a low-carbon trend.

China’s commitment offers promising prospects for market participants

China’s ETS, which has learnt lessons (and received technical support) from the EU's ETS, will cover the power sector and the main energy-intensive industries which emit carbon dioxide. The EU's ETS has suffered from excess supply since the financial crisis, but after a series of reforms and the upcoming introduction of the Market Stability Reserve (MSR) in 2019, allowance prices have been on the rise again. China’s pilot regions developed an innovative approach to allowance allocation, using ex-post adjustment based on actual production data, helping to avoid a large surplus or scarcity in the event of changed economic conditions. In addition, China may consider an MSR-type mechanism to help reduce volatility. The government’s long-term commitment to ETS should provide the necessary confidence to market participants—a bold move for the largest generator of CO2 emissions in the world.

In 2017, China emitted about 10.5 billion tons of CO2—roughly 30 percent of the world's total (Global Carbon Budget, 2018). Tackling its reliance on coal consumption to power its significant economic growth is one of China’s highest priorities—a commitment that is gaining support as part of the country's broader efforts to mitigate climate change.

China readies itself for a nationwide carbon market

China has already gained over 12 years' experience with market-based instruments at a global level through its participation in the UN's Clean Development Mechanism (CDM) as a source of carbon offset projects. Over the last decade, it has also demonstrated that the enthusiasm to address its CO2 emissions is backed up by action.

Following on from the CDM, China committed to limiting its own heavy emitters, establishing a domestic carbon market initially with seven regional pilots that began in 2013-2014 which helped to provide the know-how and confidence to inform the roll-out of a nationwide ETS. Later this year, it is expected that the government will issue the regulatory framework that will govern the system’s operation.

The establishment of a national ETS comes at a crucial time of global interest in China’s climate action, given that the withdrawal of the U.S. from the Paris Agreement sparked fears that other countries would backtrack on commitments to reduce emissions. It also coincides with China unveiling the new Ministry of Ecology and Environment, which brings the benefit of consolidating personnel and functions from other ministries and merging them within one location, supported by a sizeable increase in staff.

For such a vast country, detailed preparation for the ETS is crucial. For companies that are significant emitters of CO2, mandatory requirements for reporting emissions data have been gradually raised, and are subject to independent verification. The reliability of this process is important for the integrity of the market, as without confidence in data reporting, companies may be reluctant to invest. Making sure that stakeholders in the carbon market understand its requirements has been paramount and they have been supported through training and capacity building, not least from the EU-China ETS Project, which recently entered its second phase.

Initially, the system will cover major emitters in the electricity generation sector, which is the largest source of carbon emissions. It also has the most reliable data on historical emissions, making allocation of allowances easier. Other sectors of the economy that are significant sources of emissions already have data monitoring and reporting obligations but will join at a later stage. Even limited to the power sector, China’s ETS will still be the largest market in the world by a wide margin, covering about twice the volume of emissions as the EU ETS.

A draft allowance allocation plan including benchmarks for different types of power generators was released for comment in May 2017. Revised benchmarks are expected to be announced and trialed soon. The benchmarks determine the allocation of free ETS allowances for each emitter, and for any company that emits more than its allowance allocation, additional permits must be purchased on the market.

Consummate skill will be required on the part of the ETS administrators to establish a successful national carbon market. They will need to avoid an over-allocation of allowances, otherwise demand for permits will be dampened and polluters will have limited incentive to reduce emissions. The fact that prices for purchasing additional allowances in the carbon market are often lower than those expected in our surveys suggests that there is room for more ambition on the part of the authorities.

There are 11 separate benchmarks for the different types of power plant. For less efficient plants, such as those with small coal turbines, the benchmark is higher than the average. Ideally, these allocations should incentivize companies to either retire or scale-down inefficient plants first, because it will be cheaper to do so. For example, provinces such as Shandong, Henan, and Inner Mongolia each have a substantial fleet of the smallest and least efficient coal-fired power plants. These plants also make up a big part of the power generation capacity in the north-east (Jilin, Heilongjiang, and Liaoning). The coal power sector represents a significant part of the economy in these northern provinces, so preparations over the past months have required meticulous internal negotiation focused on the appropriate allocation approach for different regions.

Furthermore, of importance to the design of the national ETS, recent efforts to reform electricity pricing provide an opportunity for the carbon price to be passed on to large electricity consumers in the future. In particular, Guangdong province is taking steps to establish a short-term trading market in power generation. Ideally, these reforms will be taken up quickly by other large power-consuming provinces such as Shandong and Jiangsu. In this way, the implementation of China’s carbon market and power market reforms can act together to mutually reinforce a clean energy transition.

China faces a greener, brighter outlook

In the coming decade, China’s ETS is expected to become a key driver to motivate companies to reduce greenhouse gas (GHG) emissions. If China progresses toward its target of peak emissions by 2030 (or sooner), this will send a significant signal to other countries and regions. It may also galvanize greater uptake of emissions trading and collaboration with similar systems, helping to combat the increasing threat of climate change. The implementation of an ETS in China promises to usher in a new chapter in climate policy. Our research shows that China’s ETS will become increasingly important in the battle to lower emissions. It also indicates that there is much work to be done if the ETS is to meet its full potential.

We’re turning China’s ambition into achievement

At ICF, we understand that our clients face challenges when making a difference in a world that’s constantly changing. We therefore provide best-in-class insights and expertise to help inform and advise decisions, policies and solutions that make a real difference in the world. To find out more about ICF services and guidance, please contact Huw Slater.