The Chinese Emissions Trading System (ETS): An Overview

Introduction and Background

I don’t think it is an overclaim to say that China’s Emission Trading System (ETS) will serve as the anvil upon which its carbon-neutral future will be forged. The ETS is perhaps the single most powerful tool China has to reduce emissions and tackle climate change. It’s not just important for China that Beijing gets its ETS policy right; it’s important in a global context too—China’s emissions make up ~31% of the world’s total, so any delta in emissions will be significant in trying to meet the Paris Agreement.

A recognition of this importance is partly why the EU thought it was critical to share the lessons they had learned from their own ETS with Beijing so that the ramp-up process would be faster and smoother than the likely counterfactual. Unfortunately, the Chinese ETS has not quite been the lodestar we might have hoped it would be.

In line with China’s goal to reduce its carbon footprint, in 2011, the Chinese government announced plans to develop a domestic CO₂ emissions trading market. Over the next several years, China established eight pilot emissions trading programs in eight cities and provinces between 2013 to 2016 as preludes to the national emissions trading system’s (ETS) construction. The ETS launched in 2017, with operations starting in 2021 following the Ministry of Ecology and Environment publication of the system’s legal foundations.

What is an ETS?‎

An ETS is a market-based approach to reducing emissions by putting a price on the right to emit pollutants. The EU ETS is close to an ideal ETS design. How does an ideal ETS work?

• Companies are distributed allowances—the right to emit a certain amount of pollutants—by the government. These allowances can be traded.

• There is an absolute cap on the number of allowances distributed, meaning the yearly total emissions are fixed. Over time, this cap is lowered to reduce emissions.

• The fixed supply of allowances creates a financial incentive for companies to reduce their emissions. Companies that can reduce their emissions more easily than others can sell their surplus allowances, while companies that cannot reduce their emissions as easily will have to purchase extra allowances.

• As the cap is lowered, the supply of allowances is reduced, pushing up the price. This further incentivizes companies to cut emissions.

• In order to make sure companies aren’t cheating, their emissions are checked and verified. At the end of a compliance cycle, companies are required to surrender their allowances to match their verified emissions.

• Companies that fail to surrender sufficient allowances are subject to penalties.

What is the current purpose of the ETS?‎

Make no mistake, while the ultimate goal of an emission trading system is to reduce emissions, Chinese regulators have made a deliberate trade-off to prioritize the improvement of the ETS’s robustness over immediate emissions reduction. This trade-off was made to achieve participation in the ETS. Recognize that enhancing participation and ensuring accurate measurement of emissions are preconditions for success in reducing emissions in the long term. Therefore, regulators in China are presently dedicated to addressing teething problems related to participation by regulated entities and data collection, as well as improving the ETS’s monitoring systems to enhance baseline market functionality. The ETS has been deliberately designed with these priorities in mind.

The initial scope of the ETS was limited to the power sector, and trading activities were limited to ease firms into the new ETS. Additionally, the first compliance cycle set generous emission benchmarks for the power sector, allowing most power plants to have adequate allowances to meet their compliance requirements. This obviated the need to buy additional allowances. These steps were taken to hedge against resistance by firms joining the new ETS and encourage participation.¹

As time progresses, the exact calculus regulators use will shift to prioritize reducing emissions. While the ETS has been operational for two years, its impact on reducing emissions has been negligible. This should not be interpreted as regulators missing the woods for the trees. Rather, it reflects the strategic prioritization to build a strong foundation for achieving a greater delta in emission reduction in the long run.

Details of the Chinese ETS

Chinese ETS Design—Encouraging Participation

The current state of Chinese ETS differs from the EU ETS in several ways. These differences are directed at increasing participation and ensuring the basic foundation of the ETS is robust.

1. There is no absolute cap: The total number of allowances that can be distributed does not have an absolute value. This means there is no limit on how much firms can emit in China, as allowances are based on how much power the firm outputs. This is unlike the EU ETS, which holds firms accountable for their absolute emissions. On one hand, output-based allowances are problematic because they don’t generate a strong incentive to reduce emissions and likely reduce the price of allowances. On the other hand, the lack of an absolute cap on emissions is less likely to restrain energy demand growth, which is still high in China, given continued economic development and industrial capacity expansion.²

2. Small ETS scope: Only the power sector is currently included in the ETS, covering 2225 entities that emit at least 26,000 tons of CO₂ per year.³ Comparatively, the EU ETS includes power, steel, metals, oil refining, aviation, and several others. While including only the power sector is not ideal, only including a single sector for the moment is not to be sniffed at, as this includes about 46% of all of China’s emissions.

3. Intensity-based allowances: The allowances—representing the right to emit one tonne of CO₂—were based on using CO₂ emission intensity benchmarks, in tonnes of CO₂/MWh for electricity and tonnes of CO₂/GJ for heat generation. The formula to calculate each firm’s allowances is found by multiplying their actual power generation by the reference value and a correction factor. Comparatively, the EU ETS sets at the EU level exactly how many tonnes of CO2 will be emitted each year, meaning firms are held accountable for their absolute emissions, rather than the intensity of their emissions.^{4 5 6 7}

2019-2022 Carbon Emission Baseline Values for Each Type of Power Plant
Category	Category Scope	Electricity Reference Value (tCO2/MWh)			Heating Reference Value (tCO2/GJ)
		2019-2020	2021	2022	2019-2020	2021	2022
I	Conventional coal plants above 300MW	0.877	0.8218	0.8177	0.126	0.1111	0.1105
II	Conventional coal plants below 300MW	0.979	0.8773	0.8729
III	Unconventional coal plants (includes CFB plants)	1.146	0.935	0.9303
IV	Gas plant	0.392	0.392	0.3901	0.059	0.056	0.0557

The formula is: $ Allowances = Q_{e} * B_{e} * C + Q_{h} * B_{h} $

• Q_e is the actual quantity of electricity produced
• B_e is the benchmark value for electricity
• C is a general correction factor dependent on several factors, e.g. what type of cooling a plant has
• Q_h is that actual quantity of heat produced
• B_h is the benchmark value for heat.

Notice the declining reference values for both electricity and heat generation over time. The declining reference values practically amount to a net reduction of allowances given to firms, forcing power plants to upgrade to more efficient equipment or to buy more allowances on the spot market. This financial incentive drives increased efficiency.

Free Allocation—Encouraging Participation

There are broadly two methods to allocate allowances. Governments can either allocate them for free or auction them off. There are advantages and disadvantages to both systems. The decision to choose one or the other depends on what you are willing to trade-off. China’s ETS does not auction the initial distribution of permits, distributing them all entirely for free. Given the ETS is relatively new and participation remains the primary goal, this free allocation is sensible.

• Participation: The decision to distribute permits for free was made to encourage firm participation in the ETS, as auctioning could have led to resistance. This approach eliminates another potential barrier to entry.

• Low trading capacity: In the early days of ETS trading, firms may make mistakes or fail to comply, leading to low trading capacity. The first compliance cycle allows China to resolve teething problems and improve the robustness of its monitoring system. This is a crucial capability to have. The entire ETS only works if the data is accurate and firms are not shirking their responsibilities by lying to regulators about the true amount of their emissions.

It’s worth pointing out that free allocation reduces the price of allowances and, with it, the magnitude of the financial incentive to switch to more efficient or greener forms of energy. Additionally, it doesn’t encourage firms that already have low emissions to reduce them any further. Efficient power plants—and particularly gas power plants—can simply sell their surplus each year and not make any efforts to reduce their emissions. Comparatively, if firms were required to buy every allowance they would need, even efficient power plants would have the incentive to reduce their emissions to pay for fewer allowances. For the time being, Beijing has decided that this is an acceptable trade-off for them to make.

Auctioning is the other standard allocation method, where allowances are auctioned off to firms and other market participants. This is the most preferable method because it means abatement can happen where it is most efficient and allows prices to reflect the true marginal costs to firms. Additionally, it also generates revenue, which the government can use for other purposes.

Policymakers have introduced a proposal to allow enterprises to “borrow” their allowances from next year to meet their compliance requirements this year. The thinking behind this is to reduce the financial burden on companies as the allowances distributed to firms are decreasing (see table with reference values). This move

Considering that the price of allowances is already low, this seems unwise. The point of the ETS is to incentivize firms to reduce their emissions by making them pay to emit. Allowing firms to borrow from next year only increases the supply of allowances in the short term, further lowering carbon prices.

CCER

The China Certified Emission Reduction (CCER) is a scheme to allow companies to voluntarily reduce their emissions, for example, by building renewable power sources. Upon being certified, the firm is given a credit which the firm can use to meet its compliance obligations for up to 5% of its verified emissions. These credits—just like allowances—can be traded between firms, although their trading price was lower price at around 20 RMB per tonne of CO₂ compared to around 40 RMB per tonne of CO₂ for allowances. As CCER credits are cheaper than CEAs, we should recognise that they are cheaper substitutes and contribute to lowering the price of CEAs as they expand demand. Yet, CCER credits are a useful tool to have in the MEE’s toolbox as they allow firms to redirect finance into mitigation efforts, supporting industries like renewable energy which are currently not covered under the ETS.⁸

The CCER was gutted and suspended in 2017 by the National Development and Reform Commission (NDRC, China’s macro planner) because of issues of standardisation in carbon audits and low trading volumes. There are a few signals which suggest that the CCER will be restarted soon.⁹

• The new compliance cycle document has been released. The CCER needs to work in lockstep with the allocation of CEAs to avoid adding too much supply into the market and reducing the price of carbon—this is what happened in the first compliance cycle.

• The CBGEX has built a new trading centre for CCERs and is ready to begin trading.¹⁰

• On March 30, the MEE asked for suggestions on how to improve the methodology of voluntary greenhouse gas emission reduction projects.¹¹

Exchanges

The role of the exchange in the ETS is to enable the trading of allowances between companies and other market participants. While there are several regional exchanges in operation in China, there are three that are worth paying attention to.

• Shanghai Environment and Energy Exchange: This is the national trading platform where firms trade allowances.

• The Beijing Green Exchange: This is the national trading platform for voluntary carbon credits and for domestic offsets (CCERs)

• The Hubei Carbon Emissions Exchange: This exchange handles the registration of different companies until a new official national ETS registry is established.¹²

The only trading that currently takes place is spot trades. No derivatives are currently traded.

Challenges of the ETS

Data quality and monitoring, reporting, and verification (MRV) issues are the largest issues facing the ETS. The voracity of emission data is crucial for the ETS to function. Some of the emission data is fraud, i.e., firms deliberately misrepresenting their emissions. For example, companies can buy small amounts of high-quality coal and submit it for examination but then actually burn cheaper, low-quality coal to generate power.^{13 14} Yet, it’s not necessarily that (all) firms are trying to commit fraud either. Prior to the creation of the national ETS, the pilot Beijing ETS had random inspections to verify emission reports. They found that the self-reported emissions data deviated in both directions, suggesting that firms lack the ability to accurately measure their emissions.¹⁵ Regardless, the MEE has noted that inconsistencies have been found in ~80% of the power companies’ data. New regulations that aim to correct the poor data have been implemented this year. These regulations should improve data quality and serve as a template for future sectors that will be brought into the ETS’ fold.¹⁶

A large problem with the ETS is the omission of a credible deterrent. The penalty for violations is a maximum of 30,000 RMB, or about 4000 USD. Beyond deterrence, there are still conflicts of interest between those who inspect firms to ensure their emissions are accurate. The problem arises because the MEE has delegated inspection duties to provincial governments, which are all competing to secure maximum economic growth. Additionally, the ability of provincial governments to carry out inspections is dubious as there are questions if they have the manpower or technical ability. One approach to sidestep this issue would be to use independent third-party auditors to interrogate the data each firm produces. This is currently the approach the EU uses.

Looking towards the future, industry-specific emissions calculations are a large obstacle. There have not been any robust mechanisms or carbon emission statistical accounting plans drawn up to calculate the emissions that are produced from other industries—currently, it has only been for the power sector. For many of the most polluting sectors like cement, steel, aluminium etc. it is relatively straightforward to calculate. A similar intensity-based metric for these sectors may be appropriate for many of the reasons flagged previously. Regardless, the absence of a clear mechanism to calculate emissions in other industries creates another obstacle for the ETS to expand into other sectors and ultimately slows down the process of emission reduction in China.

Demand and Supply Dynamics

The price of the CEAs depends on demand and supply. However, when compared to other ETS, the price is unusually low (~7 USD a ton) in an international context, cf. the price of allowances in the EU ETS is ~100 EUR a ton.

Broadly the low price is due to three reasons:

• Oversupply of permits. The first compliance cycle generously distributed more than enough allowances for the power sector to cover all of its emissions. The oversupply of allowances drove the price down as most power plants had enough allowances to cover their compliance requirements. Additionally, the free allocation of permits dented the enthusiasm of firms to purchase more permits.¹⁷

• Weak demand by firms for allowances as a result of the low cost of improving the efficiencies of many coal plants. Many coal plants in China are quite old and inefficient, so the cost of upgrading equipment or changing coal is very low, making demand for allowances weak. ¹⁸

• Low Liquidity: This reduces the incentive of companies to save or trade their allowances because it means they have to potentially discount the value of the allowance in order to sell it quickly.

Notice, the higher average price of allowances in 2022 (58 RMB per ton) compared to 2021 (46 RMB per ton) likely reflects expectations about future demand, not by actual demand.¹⁹

The trivial trading volumes in the graph above are partly a consequence of limited market participants and limited carbon products. Only spot trades are allowed, meaning there is only an incentive for firms to purchase allowances near the compliance deadline. Highlighted in yellow is December, the final month before the compliance cycle ended on December 31st, 2021.

How will the ETS develop in the future?‎

Based on policy documents and news developments, we can expect to see several developments soon.

• Sector expansion. Since the ETS was founded, it has been the goal of the MEE to cover eight sectors that are highly polluting. While it probably won’t happen in 2023, the third compliance cycle will likely see the incorporation of other sectors into the national ETS, now that the government has more flexibility to focus on other issues. We expect the industries like iron and steel, cement, and aluminium sectors to be added first, due to their relative simplicity in calculating emissions. Additionally, the EU’s new Carbon Border Adjustment Mechanism (CBAM) will likely accelerate the inclusion of sectors like iron and steel into the ETS sooner rather than later.

• Auctioning. The ETS will eventually move away from the free distribution of allowances and move towards auctioning off the allowances. Both the Interim Regulation and the Administrative Measures policy documents suggest that the system will shift from free to purchased allowances over time.^{20 21}

• Absolute Cap. The ETS may move away from an intensity-based metric and move towards an absolute cap on emissions that will decline over time, transforming into a true Cap and Trade ETS like the EU ETS.

• Carbon derivatives. The introduction of carbon derivatives is long overdue at this point. Carbon derivatives are a relatively easy addition to make and will grant firms more flexibility to hedge for risk. Expect the introduction of these new financial products.

• Market expansion. More financial institutions and potentially other market participants will be allowed to trade allowances. The participation of more financial institutions married with the introduction of new carbon derivatives will go a long way to improving liquidity and market depth. The trajectory for market expansion is positive: on February 6, eight securities firms received permission to participate in emissions trading in pilot ETS. This is a critical step forward.²²

• Restart the CCER. While there were few details about it in the most recent regulations about this year’s compliance cycle, the presence of several strong signals suggests the CCER should make an appearance soon.

Where do we stand now?

China’s period of leaning into each twist and turn of the ETS, of seeing what works and what doesn’t, hasn’t come to an end yet. In the next few years, we can expect several reforms that will begin a new chapter in the story of China’s ETS. This chapter will be about reducing emissions. By taking the appropriate steps, your firm can ensure that it will stay ahead of developments.