Abstract: In this paper, the author discusses two mechanisms for carbon reduction, i.e. border adjustment tax and carbon pricing. He argues that revenue from carbon border tax should be used to purchase negative carbon quotas from developing countries and controllable connectivity should be established among various carbon markets. Moreover, carbon reduction efforts may cause inflation pressure and affect the interests of certain groups which policymakers need to deal with. In carbon price transmission, power grid will play the key role in the future.
As Vice Chairman of the Boao Forum for Asia and President of the China Society for Finance and Banking, a major part of my job is to set agendas and provide platforms for discussions. With regard to carbon neutrality, I propose two broad, mechanism-related topics which can be further divided into a number of subtopics. I hope they will serve as a catalyst for rigorous discussions.
I. International communication and voice are important
President Xi’s speech at the United Nations General Assembly, Climate Ambition Summit and the Leaders Summit on Climate were well received. However, since China produces 30% of global annual carbon emissions, international pressure remains high on China to reduce its emission volume, more so during certain periods. Western countries peaked their emissions relative early (European countries around 1990 and the United States in 2006-2007). For China, reaching its carbon peak by 2030 means that its emissions will continue to increase before the target year.
Overseas media pointed out that China has built quite a few coal-fired power plants in recent years and took part in the construction and financing of coal plants along the Belt and Road, which indicates large or even larger contribution to global emissions before China achieves its carbon peak. China’s response to this topic will involve a number of issues, some of which stand front and center in international debates. There is no doubt that we will face considerable pressure onwards, a lot of which will come in the form of criticisms and oppositional rhetoric.
To prepare for challenges ahead, we need to carry out forward-looking studies to provide analytical support for international negotiations. I’d like to stress two aspects: the first involves border adjustment tax, which concerns the calculation of carbon footprint and how to utilize the revenues raised through the tax; and the second is about the integration of carbon markets, which pertains to the international cooperation on carbon trading.
First, border adjustment tax.
Many Western countries, especially those in Europe, advocate carbon taxes on imported goods. In fact, some of them have also explored the possibility of an aviation carbon tax, which, of course, sparked intense controversy. The issue of carbon border adjustments has already been placed on the agenda for the G20 talks. This motion is well justified, but not without risk or danger.
It’s justified because when imports with high carbon footprints (mostly from developing countries) are cheaper and hence more competitive in the European markets, they could squeeze out domestic goods made with more costly low- or even zero-carbon technologies, creating a wrong incentive that discourages low- or zero-carbon production and encourages high-carbon production.
From this perspective, border adjustments could guarantee a level playing field and fair competition between domestic and imported products, and thereby protect local producers. Of course, rather than acting as an instrument of trade protection, carbon border tax is meant to protect low- or zero-carbon production technologies and producers.
Nevertheless, border adjustments could give rise to a number of risks, one of which is trade protectionism and trade war, since such taxes could trigger tit-for-tat escalation of tariffs or non-tariff barriers between trading partners and undermine the global free trade system.
Another issue is the abuse of carbon border tax as a tool for bridging fiscal gaps. Under the impact of the global financial crisis and the COVID-19 pandemic, soaring fiscal deficit and public debt to GDP ratio have given countries all the more incentives to achieve fiscal balance through additional taxation. Governments could adopt border adjustments as a carbon-reduction tool in name only and instead use them to fill the gap of public spending on pandemic control, healthcare, pension, and financial institution bailouts.
Economically, border adjustments are not entirely different from tariff hikes during US-China trade disputes in their impact on consumers, who have to pay more to buy the same products or services. In other words, domestic end-users, especially consumers, will end up paying the extra price. From this perspective, it’s not developing countries who have to pay the carbon border tax, but their products will become less competitive and enjoy smaller market shares.
We all know that under the United Nations Framework Convention on Climate Change (UNFCCC), developed countries are obliged to provide developing countries with financial and technical support to aid their carbon reduction efforts. This obligation has been a topic central to global carbon reduction discussions. But the commitment has remained largely unimplemented. That’s why we must ask Western countries to use all the revenues generated through border adjustments to buy negative emission quotas from developing countries, in other words, to support emission reduction in developing countries or specific exporting countries.
Developed countries should help developing countries mitigate emissions by improving the latter’s production technologies and processes that are carbon intensive as measured by carbon footprints. With the promotion of carbon markets worldwide, developing countries are also using carbon markets (despite some differences in the price) to encourage emission reduction. In this process, they generate negative emission quotas, whether through absolute reduction, carbon sequestration, or intensity cuts (i.e., phased reduction based on current carbon emission intensity target).
If all carbon border taxes are used to purchase these quotas, they could serve the dual purposes of providing financial support to developing countries as per UNFCCC requirements and prevent the use of funds in areas other than climate change mitigation.
Second, connectivity of carbon markets.
Globally, the EU has put in place a relatively large carbon market, with its carbon price surging to 52 euros per ton a few days ago, the US has yet to come up with a clear action plan for carbon market development, and the pathway to a unified global carbon market has so far remained elusive. In China, in addition to regional carbon markets initiated by a number of provincial governments, a national market is set to start trading this June, though how well it will function remains to be seen.
Many believe that too many small, scattered carbon markets could lead to inefficiency and poor pricing capability, whereas a unified carbon market could function better. Creating a unified market is of course one solution, but are there any alternatives?
Perhaps we can approach this issue from a different perspective, that is, follow the example of stock connects (e.g., SH-HK Stock Connect, SZ-HK Stock Connect, Shanghai-London Stock Connect, CEINEX D-share Market, etc.) and create controlled connectivity between different carbon markets. By way of analogy, if we imagine national markets to be water containers with different levels of water, connecting them with small tubes at the bottom could help even the levels.
Naturally, the size of the tubes and the presence or absence of regulating valves matter too as they provide control to the process. Unregulated connection from the very start could put strains on certain parts, but if we allow the flow to slowly increase, we can eventually achieve the outcome similar to that of a large, unified market.
By adopting the stock connect model in carbon markets, carbon prices in different countries and regions could gradually converge, which amounts to the transfer of financial aids from regions with high carbon prices to those with low prices. In this sense, this mechanism offers a channel for recycling the revenues from border adjustments back to developing countries, often along with technical support.
At the beginning, developing countries should be allowed to sell a certain amount of their negative quotas in the EU carbon market. In fact, China has already done so which provides encouragement for domestic efforts in emission reduction, carbon sequestration and carbon storage, as well as financial support. This mechanism has proved rather effective.
In short, we need to have a comprehensive assessment of carbon market integration and formulate a holistic plan for actions ahead so as to smooth the implementation process. Market connectivity may aid international efforts on carbon reduction, not only because it will contribute to a more robust carbon pricing mechanism, but also for the benefits it can bring to emerging markets.
II. Carbon price transmission mechanism is crucial
First, the demand side will bear some cost during low-carbon transition and policy makers need to be prepared for it.
We’ve been discussing a lot what low-carbon transition entails at the macro level, such as the enormous efforts and investments required. But a price-driven transition goes far beyond the production and supply side. Demand-side issues should also be considered as a substantial portion of the cost will eventually be borne by end-users, including businesses and consumers.
This means that technical upgrade and product innovation alone will not be enough to achieve low or zero emission. End-users must pay a much higher price for using products and services that generate or contain carbon emissions. That’s precisely why we need to pay attention to and actively confront the issue of cost transfer.
We can assume two transition scenarios:
The first is an easy, smooth transition. For example, because of technological advances, renewable energy becomes much cheaper than fossil fuels and gains broad-based popularity. If electricity from wind or solar energy costs far less than that from coal, no one would invest in coal plants or buy coal-fired electricity. If electric cars are cheaper and perform better than petrol cars and the cost of charging is lower than refueling, no one would buy or make petrol cars.
This scenario is ideal, but only limitedly feasible without support from macro polices or incentives. It would be too optimistic to imagine a large-scale automatic transition that can just happen so smoothly.
The other is a transition that requires tremendous efforts and comes at tremendous prices. It won’t be cheap, since on top of the prices paid and organizational resources committed to support supply-side transformation, strong incentives must be installed to change consumer behaviors. The adoption of mechanisms such as carbon emission quotas and carbon prices mean that consumers have to pay more for carbon-embedded products. In this scenario, the power, manufacturing, consumption and transportation sectors all have to undergo substantial transition.
Moreover, although low-carbon technologies could play a critical role, they will not come into existence without sufficient investments, so we need to account for the cost and return on these investments when measuring the cost of applying these new technologies.
From a macro control point of view, because some consumer products may undergo price hikes, there could be an inflation effect. The public may complain about the rise in living expenses, making low-carbon transition unpopular to some extent. Therefore, we should acknowledge and manage possible inflation pressure as we work toward carbon neutrality and address the grievances of groups whose interest would be negatively affected, among other issues. We must be prepared for a rough ride ahead.
Second, the power grid system plays a key role in the transmission of carbon prices.
Because society-wide efforts are required to achieve a carbon neutral future, a whole set of incentive mechanisms need to be instituted to mobilize industries and consumers. As such, we need to decompose and transmit the prices of carbon dioxide and other greenhouse gases to different parts of the economy and optimize this process as much as we can. This is why the power grid system matters and why we should study the role it could play.
The power sector has a very important part to play in carbon reduction. At present, power suppliers contribute roughly half of the carbon emissions. To cut more emissions, we need to use more green electricity, so the share of electricity in final energy consumption will further increase, by a significant margin. This means that we need to study the role of power grid and its multiple components including electricity generation, dispatching, distribution and storage which are all key elements in power sector reform.
From the perspective of price signals, the power grid will take the most central role in the transmission of carbon price, breaking it down into price components for electricity suppliers, storage service providers, dispatchers and end-users, similar to the transmission of monetary policy from base money to the other layers of money.
On the power generation side, because of the complexity of grid connection, which involves a number of factors such as dispatch capability, feasibility, cost and optimization, a decline in per-kilowatt installment cost of solar or wind projects does not necessarily equate with a decline in electricity price. Meanwhile, as intermittent sources of energy, solar and wind will only achieve a relatively smaller number of operating hours per year, which makes the on-grid price offered by grid operators, as well as the capability of the grid to manage the storage and dispatch of these energies very important. Since China’s power sector reform is generally oriented towards the separate accounting of individual firms and the reliance on market-based mechanisms, power grid must be able to form multiple price signals to guide operation and investment.
Upgrading grid technologies are important too. Traditional low-voltage, high-loss transmission systems are rather limited in their capacity to absorb solar- and wind-generated power, which inevitably leads to idle capacity. Today, the increasingly wide deployment of ultra-high-voltage AC and DC networks has vastly improved grid dispatch and removed grid-related barriers for green electricity feed-in and distribution.
Grid automation and smart dispatch technologies such as solar and wind forecast, storage management and peak shaving, are also highly pertinent as they can maximize the integration of renewable energies into the grid. This is in fact a process of optimization that can largely be transformed into the price of various components in the grid system.
In addition, power loss occurring in distribution and transmission needs to be minimized. Assessing the need to invest in new equipment and directing investment by way of price signals are an inherent part of grid technology development.
On the user side, mechanisms such as time-of-use pricing should be introduced to encourage electricity usage during periods when renewable energy generation is abundant and dissuade consumption when the renewable share is low and peaker units (which rely on fossil-fuel generation at least to some extent) have to kick into gear.
In summary, in addition to the role of power grid in optimizing power distribution and renewable energy integration, we need to recognize its critical role in price transmission, that is, how to achieve better pricing and dispatch, and therefore align supply and demand through the modern management of the grid system.
Furthermore, China has been pushing forward institutional reforms in its power sector geared mainly towards further marketization and the independent operation of enterprises in the vertically integrated power system. I hope to see more research on how these reform efforts could coordinate with the maximum penetration of non-fossil sources of electricity needed to deliver China’s carbon neutral transition.
Third, behavioral change and technology development on the consumption side could help reduce carbon emissions.
Many speakers mentioned consumption transition, which is of course a major part of low-carbon transition. Consumer awareness and attitude shifts are indeed important, but price signals could have a stronger influence.
The power sector is the number one contributor to carbon emissions in China, followed by the secondary sector, which is intimately connected to and supplies for end consumption. Substantial behavioral changes on the consumer end therefore could drive change in the supply model in the secondary sector.
From the perspective of consumption, three types of power consumption activities are closely related to carbon emissions. The first is air conditioning. Whether at home or in the office, we turn on air conditioners when its either too hot or too cold inside, and the need for air conditioning has much to do with the thermal insulation of the building and the material used. The second is cooking. If we all use electricity for cooking and the electricity is greener in the future, we can expect much fewer carbon emissions. The third is transportation, which involves the use of vehicles powered by fossil fuels.
Why rank air conditioning the first? From the supply side, about 30% of China’s annual carbon emissions occur in the secondary sector, of which three industries, namely, steel, cement, and electrolytic aluminum, contribute the most. The majority of the products from these industries are building materials used for constructing and insulating houses, as well as for urbanization-related infrastructure and utility projects.
It’s therefore safe to say that a considerable proportion of carbon emissions have been generated for urbanization and for providing housing. A new generation of technologies including building walls capable of heat exchange and storage, solar systems installed on the rooftop and building surfaces, should be applied to improve the thermal regulation of buildings.
As for households, there should be clear price signals through time-of-use rates and consumer-side incentives such as schemes promoting rooftop and residential solar systems. This way, residents would concentrate their use of electricity (e.g., charging electric vehicles) during periods when solar power is available and reduce the consumption of expensive electricity from the grid. In the future, building materials with heat exchange features, air conditioners, refrigerators, home lighting, etc., can all be designed to become renewable energy-friendly. This requires an efficient consumption system of renewable, intermittent power guided by price signals and incentives.
The same goes for the production side. Hydrogen is the fuel of the future, but of the three types of hydrogen, only the green hydrogen is produced by the electrolysis of water, grey and blue hydrogen comes from fossil fuels and the process releases carbon emissions.
China’s electrolytic aluminum industry also relies on an energy-intensive electrolysis process that generates around 500 million tons of carbon emissions annually. Smelters can purchase from large grids for more efficient and quality power. Or they may try small renewable installations that run intermittently when solar or wind energy is available and simply suspend operation when unavailable, since the electrolysis technique uses direct electric current which negates the need for frequency stability in alternating current. Such off-grid installations may not be able to provide consistent power and consequently compromise the efficiency and quality control of the aluminum plants, but they do remove or at least reduce the dependence and demand for grid transmission and dispatch.
In a broad sense, these are all consumption-side approaches. How various industries adapt to a future powered by renewable energies would be a topic worth pursuing.
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