Abstract: In this paper, the author reviewed the economic thinking of Zhou Xiaochuan, the former governor of China’s central bank, on low-carbon development, which he summarized into three aspects: the necessity and feasibility of low-carbon transition, the choice and design of carbon reduction mechanisms, and solutions to conflicting interests among countries.
At the UN General Assembly last year and and the Climate Ambition Summit, Chinese President Xi Jinping put forward China’s targets of having carbon emissions peak by 2030 and achieving carbon neutrality by 2060.
In May this year, A Collection of Zhou Xiaochuan’s Economic Analyses on Carbon Neutrality was published.
This book is a reflection of Governor Zhou’s international perspective, innovative thinking and forward-looking insights on the topic. In 2009, I was among the audience at Peking University when he delivered a speech about the economic aspect of carbon quota trading and carbon reduction financing. But like other attendants, I didn’t quite understand why the governor of China’s central bank was concerned about this issue.
Low-carbon development is complex and multi-faceted, yet Governor Zhou had a clear understanding of this issue a dozen years ago, primarily because he developed a complete framework to analyze it from an economic perspective. Based on the analyses, he concluded that China could benefit from a low-carbon transition and in fact has certain advantages over other countries; using a general equilibrium model with quotas, he found that carbon trading is the top choice when it comes to emission reduction mechanisms; in terms of carbon market connectivity and carbon border adjustments, he also offered advice on mechanism design from an international governance point of view.
I. The necessity and feasibility of low-carbon transition
A transition to low-carbon development requires first and foremost a shift in mindset, which took the Chinese society many years to achieve.
In 2005, President Xi Jinping, then Party Secretary of Zhejiang Province, first put forward the idea that “l(fā)ucid waters and lush mountains are invaluable assets”. But the mainstream view on low-carbon development was different at that time. For example, during the 2009 Copenhagen climate talks, the prevailing domestic view was that low-carbon development could hamper the rapid growth of the Chinese economy. Skeptical about the intentions of developed countries, especially when they had failed to deliver the promised financial and technical support, many also advocated against any absolute mitigation target. It wasn’t until the end of 2020, after President Xi pledged twice to the international community to achieve the 30/60 goals, that the shift in mindset was complete.
As early as in 2008 or 2009, Governor Zhou had already explained the necessity of low-carbon transition and corrected the misconceptions on the issue based on economic analysis.
First, he pointed out that when considered in the Bayesian decision model, low-carbon transition is still the optimal solution to climate change despite the uncertainties over its existence. There have been arguments that climate change theories could be wrong and any action based on wrong assumptions would be an exercise in futility. However, if we express uncertainties in probabilistic terms in a Bayesian model and solve for the optimal cost-benefit solution, low-carbon transition remains the best pathway since there is over 90% probability that climate change theories are valid.
Second, he assessed the impacts of low-carbon development on GDP. While the phase-out of carbon-intensive industries could put a dent on GDP growth, the deployment of wind turbines, solar panels and nuclear power plants could create new demand in the economy. When combined, the impact of decarbonization on GDP could be neutral or even positive.
Third, he demonstrated that GDP growth from low-carbon development brings new wealth instead of waste. Some argue that the growth in GDP generated by replacing one type of demand with another could be a waste. Although the premature retirement of equipment like coal-fired generators could bring waste, improvement in the environment should be considered as additional wealth and the latter far outweighs the former. More often than not, GDP growth comes with some level of waste, what matters is whether this waste could bring additional wealth.
Fourth, he believed that China enjoys certain advantages in low-carbon development. One common misconception is that low-carbon transition is driven by the development of advanced technologies where Western countries enjoy dominating advantages. But in reality, low-carbon pathways are primarily about the choices of engineering technologies and production routings, and only marginally about advanced technologies. As a manufacturing powerhouse, China has an edge in solving engineering and production process issues.
In addition to the above analysis, Governor Zhou called for the transition to the low carbon economy during 2008-2009 to alleviate the impact of the financial crisis. The 2008 global financial crisis dealt a huge blow to China’s export sector, leading to a decline of demand, but it also created a window of opportunity for China to create new demand and facilitate economic transition through the adoption of low-carbon technologies.
At present, flagging momentum presents another opportunity for China to promote low-carbon development. China currently faces multiple challenges, including the disappearance of demographic dividends as its population ages, the relocation of production away from China under the trend of de-globalization and economic decoupling, and the slow recovery of service sector from the COVID-19 pandemic. Against this backdrop, accelerating China’s low-carbon transition could serve the dual purposes of stimulating growth and facilitating economic upgrading.
II. Emphasizing top-level planning and the importance of carbon price in the design of emission reduction mechanisms
Emission reduction mechanisms lie at the center of low-carbon development. However, no clear consensus on mechanism arrangements has emerged so far. Governor Zhou was the first to propose an economic framework for analyzing this issue, showing that establishing a carbon market is the optimal choice.
There are at least two paths governments can take to cut emissions: the first employs administrative measures to decentralize emission reduction tasks to regions, sectors and firms, and the second uses fiscal, taxation and financial measures, mainly carbon taxes and carbon markets, to allocate carbon resources. The administrative approach received much support in early days because it’s simple and easy to control. Meanwhile, carbon tax still enjoys a level of popularity today.
A discussion of mechanism choice with no economic analysis could hardly produce any meaningful conclusion. In his early years, Governor Zhou did research on textile quotas and developed an effective analytical framework. Given the similarity between carbon quotas and textile quotas, he applied the general equilibrium model with quotas to carbon reduction analysis, demonstrating that a general equilibrium can still be achieved when the price of carbon is determined by supply and demand in the market, and that the carbon market is a better mechanism than administrative intervention or carbon tax.
How to incorporate carbon emission into the general equilibrium framework has important theoretical and policy implications. In the classical model that disregards market failure caused by externalities, a free competition market would arrive at general equilibrium and optimal resource allocation through the adjustments of prices. However, global warming as a result of carbon emission is the biggest negative externality facing the human society, and the reduction of carbon emission is the largest-scale market intervention in human history, which will have a profound impact on economic growth, prices, investment and financing, consumption, international trade, among other economic dimensions.
Governor Zhou came up with a general equilibrium model with quotas. This innovative framework is based on the equivalent relation between the simplified general equilibrium (s-GE) model and the simplified recursive programing (s-RP) model. By inserting carbon emission constraints into s-RP and deriving its equivalent expression in s-GE using the Kuhn-Tucker method, carbon emissions can now be considered within the general equilibrium framework, and specifically, presented in the income function and the distribution of income. The Lagrange multiplier (or shadow price) of the carbon emission constraint corresponds to the price of carbon quotas,which is equivalent to the marginal contribution of carbon quotas to net value-added (usually negative). In this sense, mechanisms to curb carbon emissions make carbon a resource constraint with negative contribution.
According to the general equilibrium model with quotas, price signals from carbon markets are most effective in guiding society-wide mitigation efforts. However, without a pre-determined cap (a ceiling on aggregate emissions allowed) in place, markets cannot form effective carbon prices. Governor Zhou has repeatedly called for attention to these two issues which he considers critical to the design of emission reduction mechanisms. Carbon prices must be strong enough to provide incentives and stable enough to guide long-term investment and technological innovation.
First, a cap on total emissions is a prerequisite for effective carbon pricing, which makes top-level design all the more important. According to the model, there must be an estimate of aggregate emissions before the amount of quotas could be determined and appropriate price signals formed. The price formed in the Chicago Climate Exchange was not effective because the trading system was voluntary with no emission cap in place. To date, China has yet to set a total reduction target, top-level design in this regard must be strengthened. Furthermore, once the reduction target is established, enough quotas should be released into the carbon market for trading to ensure price stability.
Second, price signals are the most accurate and provide the strongest incentives when the size of total emissions is capped in a carbon market.The price of emission permits reflects the combined effect of multiple factors including output growth, emission quota allocation and technological advances, and the allocation of social resources is optimal when it’s motivated by carbon prices emerging from quota trading markets.
A carbon market with proper price signals could solve two financing issues: how firms finance their emission cuts, and how to provide financing for low-carbon technologies. The first issue can be addressed through carbon quota trading, where buyers buy emission allowances from the sellers who then invest the money received in their own low-carbon transition. The second issue can be addressed when there are robust price signals in the market. Because the price of carbon reflects the market value of low-carbon technologies, higher carbon prices boost private investment and promote the R&D and commercialization of low-carbon technologies such as new energy, carbon capture and sequestration, clean coal, etc.
Compared with the carbon market, carbon tax has no efficiency advantage and provides little incentive for the development and adoption of low-carbon technologies. That is why carbon markets should play a primary role in low-carbon transition. If both are implemented, the level of tax rates should be determined based on the prices in the carbon markets.
The carbon market is essentially a financial market, and the carbon quota market is essentially an auction market. Functions such as a full term structure and risk management are essential to the carbon market, upon which the trading of derivatives such as forwards and futures could be developed to guide inter-temporal investment and risk management. A recent OECD report also shows that carbon markets with in-built mechanisms for price stability can foster expectations of continued price increases among investors, which make them a more effective mitigation instrument than carbon taxes.
To provide a clear signal that can guide society-wide decarbonization efforts, smooth transmission, in which the power system plays a central part, would be critical. The power sector contributes almost half of the emissions and thus has a key role to play in the transmission of carbon price. Because the pricing of power rates in China is not entirely free of administrative intervention.Price signals from the carbon market, no matter how strong they are, could not be effectively transmitted to other economic sectors through power prices. It is therefore imperative to carry out marketization reforms of energy prices.
In addition, Governor Zhou noted that through the power grid, the price of carbon can be broken down into components among electricity suppliers, storage service providers, dispatchers and end-users, and in this process, sends out signals to different players in the system. This process should be properly managed to ensure that right incentives are given.
III. Viewing carbon market connectivity and carbon border adjustments through the lens of international governance
Governor Zhou realized early on that different national interests makes low-carbon transition an international governance issue.In particular, he stressed the importance of a compensation mechanism through which the developed countries pay for the losses suffered by developing countries.
Climate change is a negative externality that affects all (a tragedy of the commons). Historically, developed countries have been heavy emitters, and it would not be fair for developing counties to give up economic development to lower their emissions. It is for this reason that the principle of ‘common but differentiated responsibilities’ has gained broad support internationally.
Of course, the conflict of interests between countries goes far beyond this. For example, major oil producers such as Iraq, Libya, Nigeria, Venezuela, Iran and Kazakhstan stand against emission cuts because their economies and sources of government revenues rely overwhelmingly on the oil sector. Oil provides 90% of Iraq’s fiscal revenue, and contributes half of the fiscal revenue and almost all foreign exchange in Nigeria. They obviously have much to lose from abatement actions.
To address the tragedy of the commons through concerted climate mitigation actions, mechanisms must be designed to pool public resources and balance various interests. Given tightened fiscal conditions in developed countries after the financial crisis, which have been further exacerbated by COVID-19, only through creative mechanisms can we ensure that the compensation to developing countries and resource-based countries is duly delivered.
Mechanism arrangements like carbon market connectivity and carbon border adjustments could be better assessed when viewed through the lens of international governance. Many developed countries have already seen their emissions peak, while the emissions of developing countries are still on the rise. The price of carbon should be different for countries at different stages. Integrating carbon markets across the world could drive up the carbon prices in developing countries beyond what they can afford.Therefore, emission reduction must be carried out at a reasonable schedule so as to find a balance between creating demand and controlling cost.
To ensure controllable connectivity between different carbon markets, Governor Zhou suggested applying the model of stock exchange connects and establish small-scale channels between the markets similar to the Clean Development Mechanism, whereby developed countries can buy emission reductions from developing countries to offset their own emissions. The same principle applies to carbon border levy: revenues from border adjustments should be given back to developing countries or resource-based countries to support their low-carbon development.
In addition to the conflict of interests between countries, the interests of domestic stakeholders are often in conflict too. In the United States, for example, Biden’s mitigation policies, especially the halt on oil leasing, have been strongly resisted in New Mexico, which receives one third of its state revenue from oil production. The inability to reach consensus at the national level has raised concern in the United States that it may lag behind in the race towards a renewable energy-powered economy.
Within China, regions may have divergent interests too, which makes allocation of public resource for low-carbon development a tough issue. China has severe regional disparities in economic development and resource distribution. Regions well-endowed with fossil fuels are often less prosperous. Coals are mostly concentrated in Inner Mongolia and Shanxi, crude oil in Shaanxi and Heilongjiang, and natural gas in Hebei and Shanxi. Given their chronic over-reliance on sectors such as coal mining, oil and gas extraction, these traditional northwest energy bases would experience huge shocks from the low-carbon transition. Public resource is needed to help resource-based provinces deal with the adverse impacts and engage in the transition. Given the fiscal constraints at both central and local levels, auction revenues from the national carbon market or carbon tax levies could provide new source of funding. In the meanwhile, the central government should have other emergency fiscal plans in place.
Governor Zhou also considers green finance an important pillar for low-carbon transition and has called for the rapid development of green finance in China.
Chinese financial authorities including the People’s Bank of China (PBC) have been following the development of green finance overseas. Given different national conditions and the lack of ESG investors in China, they have proposed to foster the development of green finance through a combination of top-down planning and bottom-up experiment. A policy framework for green finance began to take shape, marked by the joint release of the Guidelines for Establishing the Green Financial System in 2016 by several ministerial agencies. The document for the first time set forth the official definition of green finance, incentive mechanisms, development plan for green financial products, and risk mitigation measures. In 2017, China set up a number of pilot zones for green finance reform and innovations.
Moreover, the PBC has actively participated in international cooperation on green finance, introduced green finance into the G20 agenda and initiated the formation of the G20 Green Finance Study Group in 2016. In 2017, it co-founded the Network of for Greening the Financial System (NGFS) with seven other central banks and financial regulators.
With these policy thinking and frameworks, green finance has flourished in China. By the end of 2020, China became the largest green credit and the second largest green bond market in the world.These accomplishments were made possible because Governor Zhang recognized the importance of green finance early on and laid out the theoretical framework and PBC carried out continued efforts in this field.
