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China is creating a huge carbon market—but not a particularly aggressive one

The biggest test of cap-and-trade to date may be too timid to make much of a difference for the world’s largest carbon polluter.
June 18, 2018
Kevin Frayer | Getty

China, the world’s largest communist country and its biggest climate polluter, has turned to a decidedly free-market approach to combating carbon emissions. Late last year, the government announced long-awaited plans for a national cap-and-trade program, following several years of regional pilot projects.

Clean-energy advocates trumpeted the creation of the planet’s largest carbon market, which will be nearly twice the size of the European Union’s.

But early signs indicate that China is taking an extremely cautious approach, driven by fears of undermining economic growth. That is likely to put off real emissions reductions until well into the next decade.

The ultimate success or failure of China’s program will be crucial because the nation emits more than a quarter of the world’s carbon dioxide, and levels are rising at their fastest rate in years, according to one recent analysis. Hitting worldwide climate goals will be nearly impossible unless China begins making sharp cuts soon. Moreover, the nation’s effort could influence how other countries pursue similar market-based approaches to cutting carbon pollution.

“Internationally, much is riding on this program,” Stanford economist Lawrence Goulder and a co-author wrote in a paper earlier this year. “Failure could impede the adoption of emissions trading programs in many parts of the world.”

A slow start

Many economists tout cap-and-trade programs as the most efficient way for nations to cut emissions.

Under such a program, a government agency gives away or sells a limited number of allowances for emitting greenhouse gases (this is the cap). Companies that produce less than allowed under their permits can sell excess allowances while those that want to exceed their limit must buy more from another party (that’s the trade).

The scheme essentially puts a price on carbon emissions, creating financial incentives for companies to cut pollution. While the theory sounds good, only a handful of such programs have been put in place, including in California and Europe, with mostly modest results to date.

"Failure could impede the adoption of emissions trading programs in many parts of the world."

Under the plan announced in December, China will spend a year building a national reporting system and another conducting “simulated” trading and analysis, pushing actual implementation to at least 2020.

The big surprise in the announcement was that the government backtracked on earlier plans for the program to encompass an array of industries. Instead, it will initially cover only the power sector, expanding to others like petrochemicals, building materials, and aviation “when conditions allow,” according to one translation of the announcement. The speculation is that these other industries and the agency representing state-owned enterprises pushed hard against being included in the initial rollout, and that the nation’s recent economic slowdown bolstered their cause.

To be sure, China’s power sector is still a huge carbon market, accounting for about three gigatons of carbon dioxide each year, or roughly 8 percent of global emissions, according to a recent “comment” in Nature Climate Change. If the program eventually incorporates the other planned industries, it will add up to five gigatons annually. By comparison, the European Union’s trading scheme covers 1.8 gigatons. 

Limited ambition

Nearly all cap-and-trade programs to date have eventually allocated permits through auctions and set an absolute cap on total emissions.

But at least as a first step, it’s widely expected that China will restrict the amount of carbon dioxide that a plant produces by unit of electricity—say, per megawatt-hour of electricity produced. It’s believed that the exact standards will also vary according to factors like plant size and fuel source.

In other words, power companies could still increase total emissions as new plants come online, so long as their plants are becoming cleaner on average within their categories.

This approach reflects the fact that the government’s goal for now is to reduce the rate of increase in emissions rather than to achieve absolute reductions, says Huw Slater, a senior consultant with ICF, an advisory firm that that has worked with the Chinese government and power companies.

It also allows for economic growth and limits the financial toll on an industry, like China’s electricity sector, that can’t pass higher carbon costs on to end consumers.

But while this approach will encourage plant operators to improve the efficiency of plants, it “weakens or eliminates the incentives … to shift from coal to gas or renewables,” according to the Nature Climate Change paper.

To play a “significant role” in cutting emissions will probably require shifting to an auction-based system, broadening the program to other sectors, and taking other steps to ensure that the carbon price is sufficiently high, the authors argue.

It is expected that China will eventually shift to auctions and to at least an informal absolute emissions cap. But making that approach effective may require broader market reforms. 

That’s likely to include a shift away from government-administered prices and generation plans and toward energy spot markets, where prices change in close to real time as generators and grid operators reach agreements to meet immediate demand.

It could take at least another decade for that level of liberalization to take hold broadly, says Michael Davidson, a research fellow at the Harvard Kennedy School, who studies China’s electricity markets.

“If you want the carbon market to work in electricity, the fundamental precondition is a spot market,” he says. “Since those are very far out, it’s not going to have a huge impact.”

Meanwhile, given past issues with environmental transparency and the considerable clout of some state-owned businesses, China will face a different set of challenges in establishing a national system to detect and punish companies exceeding their allowances.

Managing expectations

But despite these obstacles, it’s clear to most observers that Chinese president Xi Jinping is serious about reducing emissions and establishing the nation as a world leader on climate and energy issues, driven by concerns about air pollution, domestic energy, national security, and economic development.

China may be proceeding cautiously in establishing the cap-and-trade program, but the government could accelerate efforts rapidly if the early results are promising, or readily switch tactics if they aren’t.

Moreover, even though outside observers have pinned high hopes on the program, China’s leaders see it as just one in a “basket of policy measures” to fulfill their Paris commitment of reaching peak emissions by 2030, says Jeff Swartz, director of climate policy and carbon markets at advisory firm South Pole.

Indeed, given the aggressive rollout of renewables, reductions in coal use, and other steps, China may already be on track to beat that deadline.

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