Abstract: In this paper, the author points out that the financial sector can play a vital role in China’s transition to a low-carbon economy and that trading of carbon permits is the most effective approach to carbon reduction. Essentially a financial market, the carbon trading market should be developed in accordance with the laws underlying the development of financial markets.
In September 2020, Chinese President Xi Jinping put forward targets of having China’s carbon emissions peak by 2030 and achieving carbon neutrality by 2060 at the United Nations General Assembly. This climate commitment has elevated low-carbon transition to a national development strategy.
On many occasions China’s financial regulators have had intensive discussions on this issue. Why do the central bank and financial regulatory authorities care so much about the climate targets? Because the low-carbon transition has a financial dimension.
The National Association of Financial Market Institutional Investors has always highly valued green development, and devoted considerable efforts to aligning China’s green bond standards with international best practices. It has rolled out green bonds and the first carbon neutral bond, and will continue to bring out product innovation and institutional arrangements within the year.
Today I would like to take this opportunity to explore the relations between low-carbon transition and the financial system, and explain why we should fully recognize the role of the financial sector in developing the carbon trading market.
I. Fully recognize the vital role of the financial system in low-carbon transition
The financial system has a crucial part to play as China moves to a low-carbon future, and a healthy and active financial system is essential to this transition.
First, the financial system is needed to manage risks during the low-carbon transition. In this process, a large number of high-carbon assets will see accelerated depreciation and stop to produce economic benefits before the end of their normal service life. Such assets will become "stranded" and increase the risk exposure of financial institutions. A successful and swift transition will inevitably require a proper match between the financial system's loss-absorption ability and the speed of transformation. In addition, the low-carbon transition may pose risks to certain regions and sectors, so stress tests and response plans must be put in place.
Second, low-carbon transition needs sound expectation management. Considering the massive impact the transition will bring about, all sectors and industries should form reasonable risk expectations, so that credit pricing and product pricing will not be affected.
More importantly, as large-scale financial support is needed to address climate change and achieve carbon neutrality, an important task is to guide efficient allocation of financial resources and provide the investment and financing needed for low-carbon development.
Third, low-carbon transition has a potentially important impact on macro policies. The policy measures for low-carbon transition may cause the prices of some products to rise, push up the overall inflation level, and exert an impact on the potential growth rate. It is therefore essential to include such policies in the monetary policy framework.
Fourth, low-carbon transition requires a society-wide change of investment philosophy. Sustainable investment should move from niche to market mainstream, and environmental, social and corporate governance (ESG) investment funds should gradually increase. During this process, relevant departments have to roll out more policy tools and financial regulatory measures to support and guide domestic low-carbon transition.
Low-carbon transition touches all aspects of the financial system such as risk management, expectation guidance, macro policies, and investment concepts. That’s why the central bank and financial regulatory authorities have attached great importance to emission peaking and carbon neutrality targets. In addition to providing the necessary fundamental support for low-carbon transition, it also satisfies the need for high-quality development and risk prevention of the financial system itself. A key factor is the price signal of the carbon trading market, and the role it can play is significant.
II. Make full use of market-based mechanisms such as the Emission Trading System (ETS) to achieve low-carbon transition
Among all the means to reduce carbon emissions, carbon emission permit trading is the most effective market-based approach.
At present, there are three ways to reduce carbon emissions around the world, carbon emission quotas, carbon taxes and subsidy policies implemented by some countries.
In general, carbon emission quota is the most widely adopted pricing method. Prices formed via market transactions are also needed for the design of carbon taxes and subsidies.
The Kyoto Protocol offers three market-based mechanisms to reduce emissions, namely emissions trading, clean development mechanism and joint implementation. Countries around the world set up corresponding emission trading systems (ETS) according to their own conditions. Companies can get emission quotas from government allocation or trading with other companies. The carbon price is formed during the process of quota allocation and trading which also serve as the basis of the emissions trading market.
In addition to the emission permits granted by the government, the emission trading system of some countries or regions also allow the use of carbon offsetting to reduce emissions. Clean development mechanism and joint implementation are common methods for carbon offsets.
Emission permit trading can properly guide resource allocation of the whole society in a long-term, sustainable manner. Under the emission quota regime, businesses can adopt low-emission equipment, upgrade their existing equipment to reduce the emission, or purchase emission quotas from other businesses.
The price of carbon emission permits reflects the combined effect of multiple factors including output growth, emission quota allocation, and technological advances. Under the guidance of the price signal, businesses will decide on their own whether to reduce carbon emission or to purchase quotas, and seek to finance their decarbonization endeavor.
Financing for carbon reduction involves two aspects: how do businesses finance their own equipment upgrading to cut emission, and how to pool enough funds for developing low-carbon technologies.
The first can be addressed through carbon quota trading where quota sellers spend the revenue from the sales on equipment upgrading to reduce emission, while buyers pay for more emission rights.
As regards the financing for carbon reduction technologies, for investors, the price of carbon is the market value of low carbon technologies, and so higher carbon prices will push up private investments and boost the R&D and commercialization of low carbon technologies including new energy, carbon capture and sequestration, clean coal, etc. Resources are reallocated via market-based means like carbon quota trading, providing the required funds for decarbonization.
From an overall point of view, carbon quota trading, a commercially sustainable approach, should serve as the major method to finance low-carbon transformations, which could significantly reduce the need for fiscal subsidies.
III. It’s critical to build a carbon trading market in accordance with the laws underlying financial market development
In essence, the carbon trading market is a financial market. We must follow the laws underlying financial market development to forge a sound carbon trading market.
From a practical view, efficiency of pricing on the carbon trading market is critical, which has to be based on sufficient trading mechanisms, investor base, derivative products, and regulatory rules and regulations. The absence of financial institutions in the market will significantly impair its roles in price discovery, expectation guidance, risk management, etc., or even impede the progress toward the carbon reduction goal.
At the same time, management and regulation of spot and derivative transactions of carbon emission rights should follow the logic and rules of the financial market to prevent manipulation and insider trading. It’s important to give greater play to financial institutions of various sorts, promote the integrated development of the floor and over-the-counter (OTC) markets, and reinforce regulation to ensure sound market operation.
At present, price adjustment in pilot markets for carbon trading in China relies more on regulation and control. Only a few of them have introduced carbon forward contracts, but with low transaction volumes and insufficient investor bases and trading mechanisms.
If we look at international experience, all transactions in the spot carbon market in the European Union (EU) that involve financial transactions or financial risks would be subject to financial regulation, and there are wide varieties of objects of transactions including emission quotas, forward contracts, options, futures, swaps and other derivatives.
Carbon traders in the EU include not only energy and industrial companies with emission needs, but also financial institutions such as banks and private-equity firms. Considering that the price of carbon is not much relevant to the price of other assets, investors could invest in carbon to disperse risks. Financial institutions in EU countries can actively participate in carbon trading themselves while providing intermediary services for businesses.
Going forward, China needs to draw on international experience in building its carbon trading market. Derivatives such as futures could be rolled out in tandem with or prior to spot products, which will serve as a tool for risk management for businesses and financial institutions, lower uncertainties at the inception of the carbon market; more importantly, the price discovery function of futures provides an important reference for the initial pricing of spot products, thus reducing related risks.
Additionally, it’s important to develop OTC forwards, swaps and other derivatives, so as to meet the increasingly diversified need of investors, spur the integrated development of OTC and floor markets, while enhancing financial regulations to prevent market manipulation and insider trading.
IV. Give full play to the carbon trading market in stabilizing market expectations and risk management
The price signal released by the carbon trading market is very important to stabilizing market expectations. It can help market participants develop clearer and more rational expectations and avoid the herd effect.
Almost 90% of the total carbon emission in China in 2017 was contributed by the top8 carbon-intensive sectors, including power (44.4%), steel (18.1%), construction materials (12.6%) and transportation (7.8%, aviation included). Some experts predicted that the default rate of sample coal electricity producers in China will surge from 3% in 2020 to 22% in 2030. But absent a sound price signal from the carbon market, this kind of predictions could be biased and trigger misinterpretation among market players of the 2030/60 goals.
The above-mentioned sectors are usually clustered geographically. For example, coal plants are mostly found in Inner Mongolia and Shanxi, crude oil producers concentrate in Shaanxi and Heilongjiang, while natural gas producers are mostly distributed in Hebei and Shanxi. Many of the provinces are facing mounting risks ever since the default of the Yongcheng Coal & Electricity Group, which could be worsened by the herd effect as a result of market misinterpretation of the 2030/60 goals without proper guidance.
To help market participants develop clear expectations, it’s urgent to define the top-level design with an un ambiguous aggregate target for carbon reduction; and on the basis of that, the price signal released by the carbon market should be given full play in guiding and stabilizing expectations so that the opinions of individual institutions or experts will not cause market turbulences.
The carbon trading market can guide expectation and investment while containing risks; at the same time, the auction revenue from the primary distribution of carbon quotas can also be used to manage risks.
The 2030/60 goals represent a mid to long-term strategic transformation. During the process, sectoral and regional risks as well as non-performing assets of financial institutions will emerge. Guidance in advance and emergency response plans are both necessary to address these risks.
In the primary distribution of carbon quotas, it’s essential to gradually introduce a paid auction mechanism over the long term, and the revenues from the auctions can only be used to support low carbon development. A proposal worth consideration would be to use the revenues from the auction to subsidize high-risk areas so as to prevent potential regional or systemic risks. That said, in the short run, the auction revenues will be hardly enough to serve these purposes, so the central government needs to provide favorable policies or subsidies to high-risk areas and prepare emergency response plans in advance.
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