The ascent of China’s national Emissions Trading Scheme

Context: the rise of climate to the top of China’s policy agenda 

Since 2003, China has been the world’s largest greenhouse-gas (GHG) emitter. In 2022, it was responsible for approximately one-third of total CO₂ emissions from energy and industrial sources, exceeding the total from the United States (US), EU and Japan combined.

FIG 1. GHG emissions, by country

Source: LOIM at March 2024. Source: EDGAR (Emissions Database for Global Atmospheric Research) Community GHG Database (a collaboration between the European Commission, Joint Research Centre (JRC), the International Energy Agency (IEA), and comprising IEA-EDGAR CO2, EDGAR CH4, EDGAR N2O, EDGAR F-GASES version 8.0, (2023) European Commission. Includes emissions from power, industrial combustion, buildings, transport, agriculture, fuel exploitation, industrial processes and waste. For illustrative purposes only.

China’s position as the world’s largest emitter reflects decades of government policy focused on economic growth. Starting in 1978, China’s economy has averaged 9% growth each year while lifting more than 800 million people out of poverty to become the world’s second-largest economy behind the US. During much of this period, little attention was given to the climate agenda domestically within China, as policymakers considered it a foreign-affairs issue.

This, however, has changed dramatically over recent years. In the face of increasing extreme weather events and record temperatures, the Chinese government has declared climate change “a severe threat to all mankind” and the nation as “one of the countries most adversely affected” by the risks of climate change¹. In 2022, for example, China faced record-breaking heat and droughts that resulted in a 342% increase in heatwave-related mortality and 24% increase in heat-related work loss². China also faces some of the worst air pollution levels in the world, responsible for an estimated 1.2 million premature deaths and increasing threats of food shortages exacerbated by low freshwater resources. According to a 2023 study by climate-risk specialists XDI, these threats are likely only to intensify going forward, with China home to 16 of the world’s 20 regions most vulnerable to climate change.

These so-called ‘dual carbon’ or ‘30-60’ goals remain China’s headline climate targets, forming the bedrock of current policy and climate action and imply a rapid and wholesale transformation of China’s economy. They have been incorporated into China’s 14th Five-Year Plan (2021-2025) and permeate the strategies and priorities of China’s leading government institutions, including the State Council, National Development and Reform Commission and many ministries. President Xi also announced a new series of government policy papers – known as ‘1+N’ documents – that specify the roadmap for achieving China’s 30-60 goals. In 2021, the ‘dual carbon’ goals were also included in China’s Nationally Determined Contributions (NDCs) to the Paris Agreement. Reflecting the influence of climate considerations across China’s policies, a government white paper in 2021 noted that “China has incorporated climate action into every aspect of its overall strategy for economic and social development.”

FIG 2. China’s carbon-neutral pathway
 

Source: Cambridge Econometrics modelling - Analysis: Going carbon neutral by 2060 ‘will make China richer’ (carbonbrief.org). Modelled CO₂ emissions in China under existing policies and technology trends (baseline, blue line) versus a pathway to net-zero by 2060 (ChinaNetZero, red), millions of tonnes of CO2 (2020).

As part of these efforts, in 2021 China officially launched its National ETS, dubbed by the central government as a “core policy tool” for achieving its 30-60 goals. This followed several years of experimentation of the use of carbon markets, starting in 2013 when China first launched a set of pilot ETS programs across several provinces and cities. Seven programmes (Beijing, Shanghai, Shenzen, Guangdong, Hubei, Chongqin and Tianjin) launched over 2013-2014 and an additional programme in Fujian began in 2016. With the launch of the National ETS, the government has announced that no new local carbon markets will be allowed and that entities with industries and gases covered under the national scheme will no longer participate in the local markets.

The launch of these pilot carbon markets and the roll-out of China’s national ETS are part of a broader policy shift towards the implementation of market-based solutions for financing China’s low-carbon transition and meeting its environmental and climate goals, versus the more traditional command-and-control approach. Starting in 2002, China implemented a pilot sulphur dioxide (SO2) trading programme that was later expanded across 11 provinces to contribute to cutting air pollution. In addition to the introduction of carbon markets, China also launched an independent market for renewable-energy certificates and has gradually introduced market-based reforms for its energy markets. In 2018, China instituted a Renewable Portfolio Standard (RPS) setting mandatory renewable-power quotas for provinces and electricity companies. If targets cannot be directly fulfilled through green-energy procurement, the RPS enables trading of Green Electricity Certificates (GEC) to meet their obligations. The RPS market has also facilitated the introduction of further market-based reforms to the power-sector that have been implemented alongside the launch of China’s ETS³. The latest set of reforms for the electricity sector – announced in 2022 – envision the establishment of a national electricity market by 2025 to further optimise resource allocation, including through increased interprovincial power trading and to better support renewables integration.4 As researchers from Fudan University in Shanghai have argued, these market-based policy instruments are expected to become the main driving force for China to achieve its ‘dual carbon’ goals⁴. 

Market structure and mechanics 

The National ETS currently covers the power sector, regulating approximately 2,200 coal and gas-power plants (the ‘covered entities’) with annual emissions above the threshold of 26,000 tCO₂ per plant⁵. It is an intensity-based or tradable performance standard (TPS) system meaning that the total amount of allowable emissions changes in proportion to output. This differs importantly from the more common cap and trade (C&T) approach as per the EU ETS and California’s cap-and-trade programme, where emissions need to fall below an absolute threshold.

For every compliance period, the government gives each covered entity a set of China Emissions Allowances (CEAs), each of which represent the right to emit one metric ton of CO₂. The allocated CEA volumes represent the product of an entity’s level of output in the previous year, and a government-assigned ‘benchmark’ of emissions per unit of output. These benchmarks are, in principle, set below the average initial emissions intensities across certain categories of the covered facilities to incentivise an overall reduction in the emissions per unit of output. At the end of each compliance cycle, which has covered a two-year period for the first and second compliance cycles, covered entities are required to report on their emissions and production levels and surrender the allowances corresponding to their emissions. If they do not, they face a financial penalty and may face a deduction from the following year’s allocation corresponding to their deficit.

Over the course of a compliance period, the ETS is designed to incentivise covered entities to enhance their efficiency to meet the CO₂ emissions intensity of their assigned benchmark. As illustrated in figure 3, a market is created via the trading of allowances as companies that become more efficient can sell excess allowances to companies that have yet to adopt cleaner technologies, and therefore need additional allowances to meet their compliance obligations. Trading of these allowances takes place on the Shanghai Environment and Energy Exchange.

FIG 3. An overview of China’s ETS


Source: LOIM at March 2024. For illustrative purposes only.

An important additional feature of the ETS is that covered entities can also use China Certified Emissions Reductions (CCERs) for up to 5% of their verified emissions. CCERs are carbon credits or ‘offsets’ from the country’s national offsetting programme which is administered by the government and where projects that voluntarily reduce or avoid carbon emissions or remove emissions from the atmosphere can earn CCER credits. To date, under the updated programme launched at the start of this year, methodologies have been approved for project activities relating to forestry, renewable energy, methane capture, and energy-efficiency improvements. CCERs generally trade at a discount to the listed price of allowances, offering covered entities a way to lower their compliance costs. They also help promote economic opportunities, achieve mitigation, and other social and environmental benefits in sectors not covered by the ETS.

China’s National ETS is not yet fully open to financial institutions or investors. While investors are allowed to invest in, and trade CCERs, they cannot yet directly trade CEAs, although the government has indicated that this could change in future and media reports have suggested that the government is actively looking into the matter. The latest regulations, published at the end of January 2024, note that in addition to covered entities, qualifying voluntary participants can also participate in allowance trading either by agreement or in auctions.

In addition, trading in the National ETS currently only includes physical CEAs or CCERs. Nonetheless, aligned with plans to open the market to financial participants, the government has taken proactive steps for introducing derivative products in the future. In 2021, the government appointed the Guangzhou Futures Exchange to explore options for the introduction of derivatives. More recently, regulators also introduced vintages to CEAs, a policy move that will support the introduction of new financial products into the market.

The initial design of China’s system included a set of design tradeoffs that prioritised economic growth and stability over effectiveness in reducing emissions. The intensity-based nature of the overall cap, in contrast to absolute caps of more traditional cap-and-trade programmes, means that firms receive a subsidy in the form of free allowances if they continue to generate electricity. This reduces the likelihood that the ETS could dampen economic growth and potentially reduces chances of emissions leakage from demand shifts to production outside of China due to higher electricity costs. Nevertheless, the system also reduces the potential for cost-effective emissions reductions from decreased power generation and use.

Also, rather than a single benchmark applying to all power generation, China use four benchmarks: three for different types of coal power plants (conventional coal plants below 300 MW; conventional coal plants above 300 MW; and unconventional coal) and one for all-natural gas-fired plants fall under a single, separate benchmark. This rewards plants for improving emissions performance relative to their own benchmark peer group but dampens incentives for reducing emissions in the most cost-effective way, either by cutting production or switching from coal to natural gas generation, for example. This limits the impact of the ETS price on reducing emissions but also reduces the potential for negative economic impacts in some of the poorer western and central regions of the country, which are more reliant on older and less-efficient coal-fired power plants⁶. 
 

The carbon market maturity curve 

As we have argued elsewhere, carbon markets tend to follow a similar evolution or market maturity curve⁷. 

During the early stages of a carbon market’s development, policymakers tend to focus on alleviating concerns about costs and easing industry and the public into a regulated market. This has usually translated into relatively loose caps, often with an ample share of free allocation of allowances to industry, and flexibility for the use of offsets. These conditions have led to the build-up of large surpluses or ‘banks’ of carbon instruments and generally to low market prices – though significant fluctuations are possible due to unreliable data, uncertain policies, and limited liquidity given the lack of allowance auctions and restrictions on the participation of non-compliance entities. 

During these early stages of a compliance carbon market, the system is thus in a testing phase and can result in lower-than-expected prices. Over time, however, measures are typically then taken to adjust the caps and market participation is often expanded to financial firms and other third parties beyond the regulated companies. During this ‘growth phase’, prices can rise steeply as markets transition from a perceived ‘surplus’ where the supply of allowances and other credits exceeds current emissions, to a ‘deficit’ with an increasing scarcity of allowances and credits. Once markets have matured to this point, price increases can continue as caps tighten and market management features bolster the price, but prices may be closer to fair value relative to the long-term caps. Significant jumps are still possible if caps further tighten or there are other shifts in market fundamentals.

FIG 4. Evolution of the compliance market maturity curve

Source: LOIM at November 2022. For illustrative purposes only.

A market in transition 

China’s National ETS has completed two compliances cycles: the first was finalised at the end of 2021 and the second at the end of 2023. During this period, China’s ETS was squarely in the ‘development’ phase. It is, however, a market in transition with recent policy announcements accelerating the market to the ‘growth’ phase.

With over 90% of regulated entities participating in a carbon market for the first time⁸, the first two compliance cycles were explicitly aimed at testing and learning as per the ‘development’ phase. Tellingly, the government heralded the first compliance cycle as a success due to achieving a compliance rate of 99.5% despite well-documented cases of negligence and fraud around data collection and a broad consensus that the first two cycles did very little – if anything – to reduce emissions. In addition to the limitations of the intensity-based cap and benchmark design, this was the result of several decisions by policymakers to implement rules aimed at limiting the cost burden on regulated entities of these first two cycles:

• Benchmarks for the first compliance period were set higher than the average CO₂ emissions factor for coal-powered power plants. This meant that most covered entities had sufficient allowances to cover their compliance needs in the first cycle. While these benchmarks were tightened for the second cycle, they were set only marginally lower than the average break-even intensity levels that coal power plants were forecast to achieve.
   
• Coal-fired generators had an upper limit on compliance obligations capped at 20% of verified emissions, and gas-fired generators had no compliance obligations. Entities were also allowed to borrow from their 2023 allowance budgets to cover potential shortfalls. These rules were maintained for the second compliance period with the addition of a third: if covered entities were unable to meet their compliance obligations, they could access a tailored relief programme with the approval of the regulator to “safeguard people’s livelihoods”.
   
• Entities were also allowed to use legacy, lower-cost CCERs, further loosening incentives to improve efficiency standards. It is estimated that 30 million of these offsets were used in the first compliance period which, in combination with excess allowances, meant that there was a surplus of 360 million allowances going into the second compliance period⁹. 
   
• Finally, fines for breaches were set very low, at only CNY 30,000 (around USD 4,200). This led to several instances of falsified data given that it was almost cheaper to violate the rules than to comply with them. For example, as compliance depends on the ratio of emissions to output, there were instances of fraud where companies temporarily switched to higher quality, less-polluting coal for examinations to then revert to again using cheaper, low-quality fuel.
   

The cumulative effect of these policy design decisions also meant that for the first two compliance cycles, prices for CEAs remained well below those of other, more mature markets.

FIG 5. CEA prices vs international benchmarks


Source: Bloomberg at March 2024. Past performance is not a reliable guide to future results. For illustrative purposes only.
 

Evolving to the growth phase

Starting towards the end of the second compliance period in December 2023, the government announced a set of long-awaited reforms to the ETS. This new wave of market reforms to strengthen and expand the ETS are a signal of the market shifting to a new ‘growth’ phase. The new reforms include:

• A strengthening of the legal framework. In February 2024, the government issued new regulations constituting the legal framework for the national ETS, which will come into force on 1 May 2024. This new regulatory framework establishes a much stronger legal foundation for the national ETS, moving it away from ministry-level rules to a new, national state council level management decree system. The new rules stipulate that no new regional carbon market should be established after the implementation of the new law, while supervision and management of existing pilot schemes should be strengthened to align with the standards of the national ETS. 
   
• Accelerated Market Expansion. Aligned with the government’s 14th Five-Year Plan to broaden the scope of the ETS to incorporate all eight emissions-intensive industrial sectors (power, petrochemicals, chemicals, building materials, iron and steel, nonferrous metals, paper, and aviation), the new regulations pave the foundation for the inclusion of civil aviation into the national ETS with a directive for the drafting of industry-specific management rules. In March 2024, China’s Ministry of Environment and Ecology (MEE) also released draft CO₂ emissions accounting and reporting guidelines for the aluminium smelting industry as part of preparations to “establish an institutional system to expand the industry coverage of the national carbon emissions trading market”. Press reports have also suggested government plans to incorporate cement into the ETS as early as 2024, followed potentially by iron and steel in 2025. 
   
• A relaunch and strengthening of the CCER market. After having been paused in 2017 amid a lack of volume and some quality concerns, in January 2024 the government officially launched the new CCER programme on the China Beijing Green Exchange, its dedicated exchange. This followed the introduction of a new regulatory framework and the approval for four new methodologies for credit issuance by the Ministry of Ecology and Environment in late 2023. 
   
• Larger fines for fraud. As part of these regulations, larger fines for entities found to be falsifying data on emissions reductions have been introduced. Participants found to have withheld or misreported emissions data face fines of as much as CNY 2 million (USD 278,000) and deductions from their future allocation of allowances. In addition, advisory firms that issue inaccurate or false reports may also be fined five-to-10 times more than they profited from the contract. 
   
• Higher standards and requirements for verifiers. Only entities meeting minimum size and work experience requirements can apply for approval to become verifiers.
   
• A reform of the power markets. Starting in 2015, China has launched several rounds of power-sector reforms to improve efficiency, reduce prices, and rationalise coal-power investment. The most recent set of reforms, announced in 2022, calls for the establishment of a national electricity market by 2025 with the inclusion of flexible pricing and interprovincial power trading. 
   

Market reports have also suggested that the government is actively considering other reforms, including the introduction of an auction mechanism, to move away from free allowances and opening the CEA market to financial institutions.

FIG 6. China’s ETS: potential market size


Source: LOIM at March 2024. Based on Energy Innovation at 2022. For illustrative purposes only.
 

The new world of carbon tariffs 

One of the likely catalysts for China’s reforms of its ETS is the recent introduction of carbon tariffs into international trade precipitated by the EU’s Carbon Border Adjustment Mechanism (CBAM). 

The EU is the market with the highest carbon price in the world. EU policy makers launched CBAM in 2023 to level the playing field for EU producers of carbon-intensive goods in the face of increasing obligations going forward to pay for their embedded emissions under the EU ETS. Covering an initial set of six carbon-intensive sectors, CBAM effectively imposes the EU’s carbon price on importers of goods from these sectors. However, if importers can demonstrate they have already paid a carbon price during the production of the goods, they will only need to pay the difference between the prices on EU ETS and what they have already paid. This puts pressure on nations exporting to the EU to raise their own carbon prices to reduce foreign levies on exports and instead retain those revenues domestically. 

Chinese officials have long expressed opposition to the CBAM, arguing that such measures restrict market access and discriminate against imported products from developing countries. However, as the world’s largest exporting country and the EU’s biggest trading partner, China has potential strategic reasons to want to expand the coverage of its ETS and increase prices to ensure its future competitiveness. As highlighted by Prof. Maosheng Duan, Director of the China Carbon Market Research Center at Tsinghua University:

“If the EU CBAM is fairly designed and carbon costs in other countries are reasonably credited, expansion of China’s national ETS to cover CBAM-related sectors could be one of China’s best policy instruments for responding to the mechanism … In addition to sectoral expansion, a higher carbon price is likely to reduce the overall adjustment Chinese exporters would face and thus mitigate the EU CBAM’s adverse effects. Therefore, measures should be taken in China to increase the carbon price in its national ETS, including tightening the emissions cap, gradually reducing the free allocation ratio, and introducing allowance auctioning, etc.”¹⁰

This rationale for China to expand coverage and increase prices will be only amplified as other countries introduce CBAM-like measures. The UK has already announced plans to introduce its own CBAM by 2027 and other countries – including the US, Australia, Japan, Canada, and New Zealand – are exploring similar carbon tariff measures. 

It is worth noting that expanding sectoral coverage and increasing prices under the national ETS are not the only options for China to maintain its competitiveness given the introduction of carbon tariffs. For example, India is considering imposing a domestic carbon tax on exports of carbon-intensive goods and using the revenue to support its green energy transition. However, as we explore below, China also has independent reasons for strengthening its ETS to achieve its low-carbon transition. In this sense, strengthening the ETS could help China achieve both its domestic climate and environmental goals while also supporting its international competitiveness.

FIG 7. Price of CEAs versus EUAs


Source: Bloomberg at March 2024. Past performance is not a reliable guide to future results. For illustrative purposes only.

A need to move beyond business as usual

China’s headline “dual carbon” climate commitments call for peak emissions before 2030 and carbon neutrality before 2060, but also include interim commitments enshrined in its Nationally Determined Contribution (NDC) to the Paris Agreement, updated in 2021 and in its 14th Five-Year Plan. The most important of these shorter-term commitments is that of an 18% reduction in carbon intensity per unit of GDP from 2020 to 2025, and a further reduction of at least 17% from 2025 to 2030¹¹.
 
FIG 8. China’s marginal abatement curve to achieve its ‘dual carbon’ goals

 
Source: Peking University at 2022. For illustrative purposes only.

Aligned with these carbon intensity goals, China has achieved a dramatic rollout of renewable power. In 2023 alone, China added more solar panels than the US had achieved in its entire history, and in 2022, China installed roughly as much solar capacity as the rest of the world combined.

Going forward, China’s growing demand for energy is projected to continue, with growth in industrial output and the roll-out of new green infrastructure (e.g. hydrogen, electric-vehicle charging points and electric heat pumps) that will require enormous amounts of power. While China’s rapid and at-scale deployment of renewables provides a critical foundation for a structural shift away from fossil fuels, as a next step, the growth in emissions from fossil fuels will need to further slow, and subsequently halt and reverse, if China is to peak its emissions before 2030 on the path to carbon neutrality. This will require additional incentives for reducing emissions from the existing fossil power generation mix. Alongside China’s overwhelming lead in the global clean energy economy, coal power generation made up nearly 70% of China’s total power generation in 2023. Power generation from thermal plants also rose 6.1% from a year earlier, faster than the 5.2% growth for total power generation.

In March 2024, China’s National Development and Reform Commission (NDRC), the third-ranked executive department of the State Council, published its annual report acknowledging that 2023 reductions in energy and carbon intensity “fell short of expectations” with a need to “redouble efforts in energy conservation and carbon reduction”. As part of this report, the NDRC also reaffirmed China’s commitment to “refine carbon pricing mechanisms, improve the national market for voluntary greenhouse gas emissions reduction, and see that the China Carbon Emission Trade Exchange covers more industries”. The NDRC also noted the goal of promoting clean and efficient use of coal as well as retrofitting and upgrading coal-fired power units, efforts for which the ETS could play a critical role.

Reflecting the importance of improving the efficiency of the use of fossil fuels to achieve its carbon intensity goals, in March 2024, China’s National Bureau of Statistics also removed non-fossil fuels from its definition of energy intensity. According to Ma Jun, Director of the Beijing-based Institute of Public and Environmental Affairs, this is a reflection of a “new reality” for China marking increased pressure for industry to boost energy efficiency and reduce fossil energy emissions in addition to promoting the roll-out of renewables as a means to achieve carbon intensity goals.

A need for higher prices 

The success of an ETS is measured by its success in limiting and reducing emissions, while promoting innovation and cost-effective mitigation investments over time, such that the ETS price per se is not an appropriate indicator of performance. Nevertheless, a broad set of modelling analyses suggest that China’s current ETS not only requires expansion beyond the power sector, but that a carbon price of ~USD 10/ton is below the estimated levels necessary to drive the economic transition needed to achieve China’s climate commitments. In general, the price of a CEA remains below the range of USD 40-80 per ton by 2020 and USD 50 – 100 per ton by 2030 that the High-Level Commission on Carbon Prices considers necessary to meet the Paris climate goals¹². It is also below the USD 122 per ton by 2030 average global carbon price that the Network for Greening the Financial System (NGFS), an expert group of central-bank and financial supervisors, has argued will be needed to achieve net zero by mid-century. 

Estimates for China specifically corroborate the need for higher prices and their application across a broader set of sectors. A 2019 in-depth analysis looking at the marginal abatement costs curves of China’s eight most energy-intensive sectors concluded that the price of CEAs needs to be at least CNY 345 per ton (USD 48 per ton) by 2030¹³. This analysis, however, was carried out before the announcement of China’s 30-60 goals. Projections from Tsinghua University published in 2021 suggest that, taking into consideration China’s 2060 carbon-neutrality goals, carbon prices may need to rise to between USD 300 – 350 per ton by 2060. More recent studies suggest similar magnitudes of mid-century price increases, in the range of USD 216 – USD 496 per tCO2e by 2060¹⁴. These figures reflect the increased costs of interventions to reduce carbon emissions as China moves up its marginal abatement curve. A 2023 study of the abatement costs across China’s most polluting sectors showed an average abatement cost for power, cement, iron and steel, buildings, and road traffic of USD 304 per ton with buildings and road traffic having marginal abatements costs as high as USD 506 per ton and USD 565 per ton to reach China’s carbon-neutrality goal¹⁵. While uncertainties abound with long-term projections, which are subject on a multitude of modelling assumptions, these estimates are indicative of the major economic changes required for low-carbon transition in China. 

Market sentiment, as gauged by participant surveys, also indicates a bullish outlook for carbon prices in China over the nearer term. The most recent survey, taken in late 2022, captured expectations about future of carbon pricing policies in China from 465 participants across a broad of set of market stakeholders. The results show that, on average, participants expect prices to rise steadily with the average price in the national ETS rising to CNY 87/ton in 2025 (+50% versus 2022 average prices) and CNY 130/t by the end of the decade (+124% versus 2022 average prices). While the survey does not claim to be representative and was taken before China’s rollout of its more recent reforms to the ETS, it nonetheless provides an indication of stakeholder views about future carbon pricing in China.

Additional geopolitical benefits 

The need to continue intensifying the low-carbon transition to achieve China climate goals, alongside the introduction of carbon tariffs into international trade precipitated by CBAM, provides an important catalyst for reforming China’s ETS. In addition, a robust Chinese Certified Emission Reduction (CCER) market that includes links to Chinese investments overseas could further support China’s strategic objectives, such as enhancing the renminbi’s role as an international reserve currency and expanding China’s investment opportunities through the Belt and Road Initiative.

Representing a potential market of over 200 Mt annually if covered entities maximise their ability to use offsets for 5% of their obligations, the size of China’s CCER market has the potential to become by far the largest compliance offset market in the world. For comparison, this potential market would represent a market size that is about two thirds of California or bigger than the entire size of the UK ETS in terms of covered emissions. With the expansion of China’s ETS to new sectors and the potential growth of China’s voluntary carbon market, the demand for CCER offsets is only expected to grow. 

Depending on the evolution of Article 6 negotiations under the Paris Agreement, a robust CCER market could develop in which the Chinese government and/or companies under the ETS could source CCER credits both within and outside China. In addition to reducing potential compliance costs, this could facilitate the use of the renminbi in global carbon trading, increasing worldwide demand for the currency. Article 6 of the Paris Agreement establishes a framework for international cooperation in achieving emissions reductions, including through market-based mechanisms that enable the trading of carbon credits across borders. Furthermore, a strong CCER market would create new avenues for China to strengthen its investment linkages abroad.
 

Future horizons: lessons from other markets 

The experience of other, more developed markets highlights how the implementation of specific policies as markets mature from one phase to another can stimulate significant increases in prices. In particular, the experience of the EU ETS and California’s cap-and-trade programme offers compelling case studies as each shifted from its development to growth phases.

FIG 10. EUAs and CCAs transition from development to growth phases


Source: LOIM at March 2024. Past performance is not a reliable guide to future results. For illustrative purposes only.

Case study: the EU ETS 

The EU ETS was launched in 2005 as a cornerstone of European climate policy, meant to drive ambitious decarbonisation of the bloc’s power and industrial sectors. However, throughout much of the 2010s, a combination of the 2008 economic crisis and a persistent oversupply of allowances (due to the high influx of affordable international credits) drove EU carbon prices down to EUR 5-8 per ton by 2018. This undermined the credibility of the ETS to drive meaningful emission reductions. 

In 2018, the EU introduced a comprehensive reform deal that took effect in 2019. It sought to boost the EU carbon price to align with its climate goals. The EU accelerated the overall decrease of the cap to 2% annually from 1.7% before. In addition, to address the large “bank” of allowances carried over from previous years, the Market Stability Reserve (MSR) was established to automatically adjust supply in case of oversupply or scarcity, depending on pre-determined thresholds for the total number of allowances in circulation. Also, allowances worth 900 million tons of emissions that had been temporarily withheld (backloaded) from auctions over 2014-2016 were placed into the new reserve rather than released to the market. 

These moves to tighten allowance supply resulted in a three-year 44% annualised increase in prices from 1 January 2019 when these reforms were first operationalized. This is proof of how pivotal policy recalibration of market dynamics can be to driving prices.

FIG 11. Evolution of EUAs


Source: Bloomberg, LOIM at March 2024. Paste performance is not a guarantee of future results. For illustrative purposes only.
 

Case study: California 

California’s cap-and-trade system launched in 2013 with a goal of supporting the state’s ambitious emissions-reduction timeline through 2030. In 2017, lawmakers passed SB-398, which accelerated these targets, requiring a 40% cut in greenhouse gases by 2030 compared to 1990 and extending the carbon market from 2020 to 2030. These new targets precipitated structural reforms of California’s ETS to align with the state’s more ambitious decarbonisation targets.

FIG 12. Evolution of CCAs


Source: Bloomberg, LOIM at March 2024. Paste performance is not a guarantee of future results. For illustrative purposes only.

In addition to reauthorizing the programme for at least another decade past 2020, the fourth compliance period (2021 – 2030) amendments saw California’s regulator introduce a series of reforms aimed at tightening the supply of allowances and providing stronger price signals. The cap was tightened to reduce 4% per year from 3.3% for the previous period, while the auction floor escalations were kept to an increase of 5% plus inflation. Among other reforms, the new regulation limited the use of offsets from 8% to 4% and specified that at least half of this quota must provide direct benefits to Californians. 

The programme extension and reforms reignited anticipations of scarcity amongst market participants, with prices climbing over 80% from December 2020 to December 2021 in contrast to the expectations of oversupply that had characterized California’s carbon market for years prior.

Navigating the unknown: risks and uncertainties 

While the experiences of the EU and California offer a compelling view of the potential of China’s market, China has followed a deliberate, stepwise approach to developing the ETS and its climate policies could still evolve in multiple ways. China could decide to pursue a range of other policy measures to reduce emissions alongside its ETS. How quickly and to what extent China strengthens its ETS will depend on the implementation of its current reforms and over time, additional measures, including eventual links to international carbon markets. Near and medium-term reforms include: 

• Capacity strengthening. As first step, government officials will need to ensure the effective implementation of proposed reforms and on-the-ground capacity building to ensure the market’s integrity, including monitoring, verification and combating fraud. 
   
• Lowering benchmarks. For the ETS to be effective as well as see sustained higher prices, benchmark levels will need to be tighten to below, rather than above, average carbon-intensity levels and gradually decrease over time. 
   
• Effective and timely introduction of new sectors. An important test for the market will be how effectively and over what timeframe new sectors are introduced. 
   
• Opening of the market to investors and introduction of new financial products. To achieve the depth and liquidity of more developed markets such as the EU ETS and California’s system, China will need to expand market participation and follow through with its plans for the introduction of derivative instruments. 
   
• Additional program design reforms. Over time, regulators will need to ensure that the ETS remains fit for purpose. This will require a set of additional design reforms. Potential reforms could, include: the introduction of auctions, establishing an auction reserve price and other price and supply management mechanisms, the merging of benchmarks and the introduction of an absolute cap. All of these reforms have already been discussed and are being actively considered by the government. Notably, China’s 14th Five Year Plan included for the first time the proposal of a dual-cap system based primarily on carbon intensity control, with an absolute carbon cap as a supplement. In addition, China’s Ministry of Ecology and Environment has signalled plans for the “timely introduction of paid allocation according to national requirements, and gradually expanding the proportion of paid allocation” although no definite timeline has been proposed
   

Beyond these reforms, the potential impact of China’s ETS in reducing power emissions is also dependent on how quickly and effectively the government chooses to follow through on its reforms of the power sector – particularly around facilitating least-cost dispatch. While the government has introduced wide-ranging reforms to establish a market-based mechanism for setting electricity prices, including pilot spot markets, prices are still predominantly administratively set. Accelerating these reforms will amplify the ETS’s value as a flexible market-based price setter and create the incentives for covered entities to adjust their investment and operations to carbon prices. 

Finally, the price in the ETS will – as with all carbon markets – also depend on demand dynamics. A potential slowdown in industrial production could accelerate a reduction in emissions but could loosen the supply-demand balance, moderating an increase in prices over the near to medium term.