As the Xi administration pushes for energy sector reform, US firms ask what role they will play in China’s long-term climate policy.

As China’s central government grapples with the looming impact of climate change and other environmental issues, it faces a difficult trade-off between rapid development and conservation. Over the course of this cost-benefit analysis, China has implemented short-term solutions that involve borrowing and modifying existing institutions and policies from other countries.

Climate change is anticipated to affect areas of China’s economy that are already under environmental stress. Water availability, maize yields in northern China, and rice yields in eastern China are all projected to decrease in in the coming century, according to the Intergovernmental Panel on Climate Change’s most recent report.

Since 2007, China has been the world’s largest emitter of carbon dioxide, and it is projected to surpass the United States on a per capita basis by 2017. By 2030, Chinese annual CO2 emissions are projected to reach approximately 11 billion metric tons—compared to about 36 billion worldwide in 2013. In light of China’s large contributing role and its potential vulnerability to this global problem, the central government considers mitigation a major component of its policy agenda in the 21st century.

Global CO2 Emissions from Energy Consumption, 1980-2011

One proposed solution to reduce carbon emissions is the emission trading system (ETS)—a common mechanism used worldwide to mitigate the effects of climate change by reducing net greenhouse gas (GHG) emissions. Popularly known as cap-and-trade, ETSs involve setting a “cap” on permits to engage in carbon pollution, which are then traded publicly and must be turned in by polluters at the end of a given period. In China’s 12th Five-Year Plan (2011-15), the Chinese government mandated the establishment of seven regional ETSs in the cities of Beijing, Tianjin, Shanghai, Shenzhen, and Chongqing, as well as the provinces of Guangdong and Hubei. Most of the ETS exchanges came online over the course of late 2013 and early 2014, with the final market coming into effect in Chongqing on June 19 of this year.

Map of China’s 7 Pilot Emission Trading Systems

ETS map

By adopting ETS as its chief tool to reduce greenhouse gas emissions, China has joined the European Union, California, Quebec, and other cap-and-trade jurisdictions across the globe. Provided that the rest of the world can meet sufficiently ambitious GHG reduction targets, Chinese leaders hope that their nascent ETS framework can be scaled up to provide major emission reductions and long-term energy efficiency gains for China’s economy. By putting a price on carbon at the local level now, China intends to take its first steps on a long path towards carbon neutrality.

However, there is a cost to carbon pricing, especially that which occurs on a scale likely to significantly affect climate outcomes. Given a potential threat to businesses’ bottom lines, Chinese industrial firms have pushed back. In Guangdong, although 97 percent of emission allowances are given away for free—also known as “grandfathering”—emitters are required to purchase 3 percent of allowances via auction. Media reports suggest that some firms may be unable to afford such an expense and may simply refuse to obey ETS requirements, choosing instead to pay the resulting fines.

High price volatility has also been cited as a potential problem, although it has died down considerably since the early stages of the pilot ETSs. Although Shenzhen ETS allowance prices spiked to more than ¥120 ($19) per ton in late 2013, they have since dropped to about ¥60-80 ($10-13). A similar spike in Tianjin ETS allowances occurred in April 2014, but prices have since flattened out.

Additionally, there have been concerns about the pilot programs’ viability in terms of real emission reduction and market stability. Industry sources suggest that firms in China have been slow to grasp the concept of emission trading, in some cases even mistaking their allocated allowance certifications for local government awards. The Financial Times referred to China’s ETSs as a “black hole,” citing low traded volumes and high price differentials across jurisdictions. For example, Shenzhen allowances have traded for as much as ¥120 per ton, while Hubei allowances have traded for as little as ¥20 ($3).

Daily Prices for Chinese ETSs, August 2013 – May 2014

The large spread between allowance prices in different jurisdictions may not be cause for concern. Melanie Hart, China climate policy specialist at the Center for American Progress, cites fundamental differences in the structure of each ETS as a reason for such incongruence. “[The governments running] the different pilots can each decide how they want to design their system,” in keeping with the Chinese state’s common policy approach of “letting a thousand flowers bloom” and watching to see which one blooms best, Hart says. To some extent, the pilot ETSs are designed to compete against each other with the intention of determining best practices in the long run.

The resulting absence of harmonized standards across jurisdictions has been a major factor in the observed price differences. “It will be a while before you see any uniform carbon price, whether that comes from cap and trade or a carbon tax,” says Sieren Ernst, a DC-based climate consultant who has worked in China.

The dominant role of state-owned enterprises (SOEs) has inhibited competitive price discovery on China’s ETS exchanges, which may also explain the price differences. Most of the ETS exchanges only permit participation by regulated firms, according to Larry Liu, a Chinese climate policy researcher for Warwick McKibbin of the Brookings Institution. Only Shenzhen, Tianjin, and Guangdong allow individual investors, such as financial institutions, to trade, and Liu believes there have been virtually no market-drive trades so far.

A national carbon tax is the likely outcome, if the pilot ETSs do not ultimately mature to a point where they can be scaled up to a national level. Jiang Kejun, a researcher with the National Development and Reform Commission’s Energy Research Institute, refers to carbon taxes as a “Plan B” in the event that serious problems arise in the pilot ETSs.

The European Union’s cap-and-trade program has faced a chronic problem of supply gluts, low prices, and inaccurate forecasts over the past several years. If China’s cap-and-trade systems meet with the same types of issues, both domestic and foreign industrial firms should prepare themselves to face a direct tax on emissions. Regardless of the national climate policy trajectory, large foreign firms operating in major industrial areas like Guangdong and Shenzhen will face some impact from the pilot ETSs alone.

Bloomberg analyst Charlie Cao says foreign manufacturers with Chinese subsidiaries and suppliers will be affected both directly and indirectly. “As the ETS coverage expands, these China-based factories will be covered under the obligation for emission reductions,” Cao says. “And given the significant trade ties between China and the US, the incremental carbon costs—in various forms—would eventually be passed through to the downstream players and end-users in the US.”

Despite facing some added short-term costs, US firms increasingly recognize the need for action on climate change, as well as the economic benefits of acting sooner rather than later. “The Chinese central government has been very clear that the environment is a national priority,” says Sharon Basel, environment and energy communications manager for General Motors, which sold 3 million vehicles in China last year. “We applaud these efforts and have the technologies in our product portfolio to help see these efforts realize intended clean air benefits in China.”

US firms can expect to be relatively unaffected by these trading systems in the short run. “The effect will be somewhat limited just because of the scope of the schemes,” Ernst says. “I doubt prices will be significant enough in the early stages to have any real impact on supply chains in the US.”

Even if a national carbon tax is implemented concurrently with existing ETSs, analysts anticipate that the combined cost per ton will be low enough to avoid debilitating effects on domestic industry. “At the current stage firms won’t be affected much because most or even all of carbon permits in these pilots are allocated for free, and the carbon tax is expected to be very low at the beginning even if it is in place,” Liu says.

In the long run, the pilot ETSs and other climate change mitigation measures may benefit US firms by pushing for greater competitiveness among Chinese suppliers of raw materials and energy. “I see the ETSs as China trying to find a market mechanism for doing what they were going to do anyway—increasing energy efficiency and consolidating markets that were bloated, like steel and cement,” Hart says. Ultimately, China has given clear indications that it intends to move quickly towards the establishment of more concrete, standardized national climate policy. If China is successful in achieving such standardization, the resulting predictability and level playing field will be a positive development for US firms.

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Frequently Asked Questions: Emission Trading Systems

What is an emission trading system (ETS)?

Under an ETS, also known as cap-and-trade, a government sets a maximum number of greenhouse gas emission allowances, which represents a cap on total industry emissions.

Who determines the cap?

Each government implementing an ETS determines an individual cap. The Chinese pilot programs have various ways of determining this figure for each compliance year. The Chongqing pilot program, for instance, places an absolute cap on all emissions in the municipality—“absolute” in this context simply referring to a flat, predetermined quantity of emissions. The Shenzhen ETS, on the other hand, bases its cap on carbon intensity.

What does carbon intensity mean?

Carbon intensity is a ratio of greenhouse gas emission to economic output. In the Shenzhen ETS, use of this measurement means that firms are not required to cut emissions by any absolute quantity, but only as a percentage of their industry’s estimated value-added output within the Shenzhen economy. Policymakers in emerging markets often prefer this measurement to an absolute cap, because it allows them to leave room for rapid economic growth within the carbon-pricing framework.

What exactly is an allowance?

An allowance is a government-issued permit that allows the holder to pollute a given quantity of greenhouse gases in a given period. ETSs allot emission allowances based on the types of greenhouse gas emitted and the potential of each gas to alter global temperatures.

Who gets these allowances?

Under the current design of most ETSs worldwide, the bulk of allowances are given away for free to firms and plants based on historical emission estimates. This practice is also known as “grandfathering.” Each emitter above a certain size is required to turn in a number of allowances in accordance with their emissions each year.

What if an emitter exceeds that allotment?

They must either pay a fine, or buy more allowances for the “right to pollute.” The emitter can buy allowances from other firms that stay below their quota, or they can buy offsets.

What are offsets?

An offset represents a reduction in net emissions through some activity that may not be directly related to a firm’s operations. It may not even be in the same jurisdiction as the firm in question. These offsets can be used to meet a certain portion—in the Chinese ETSs, between 5 and 10 percent—of a firm’s obligations. For example, the avoided emissions generated by hydroelectric power investment in inland Sichuan province could be monetized and then purchased by a firm in industrial Shenzhen. The Shenzhen firm would then use the resulting offsets to meet its emission cap obligations under the Shenzhen ETS.

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[author] Gabriel Nelson ([email protected]) is an independent consultant specializing in agriculture, energy, and emissions market research. He is a graduate of the Johns Hopkins University School of Advanced International Studies (SAIS), where he focused on climate economics in emerging Asia. [/author]

(Photo by Ian Britton via Flickr)

Posted by Christina Nelson