Abstract: In this paper, the author points out that since China has established a unified national carbon market, the next priority is to have the market function effectively. Specific measures include specifying a cap on total emissions, gradually transitioning from free allocation of allowances to auctioning, promoting wider participation of financial institutions, forming relatively stable carbon prices with enough incentives, and pushing forward market-based reform of energy prices. The author also argues that revenues generated by the carbon border adjustment mechanism (CBAM) proposed by developed countries should be used to reduce emissions in developing countries. Otherwise, China should be prepared for the possibility that developed countries might use carbon border adjustments to practice trade protectionism.
Recently there has been some important progress in China’s carbon market. First, the national carbon market opened on July 16 with price closing at 52 CNY per tonne. Second, on July 14, the EU put forward a package of proposals as an important supplement to its emission trading system (ETS) in an attempt to further cut emissions. The proposals include stricter implementation of the ETS, expanding the scope of carbon trading and a carbon border adjustment mechanism aiming to prevent carbon leakage (covering imports in the five sectors of electricity generation, iron and steel, cement, aluminum and fertilizers). Based on these updates, I would like to share some of my thoughts.
I. Having established a unified national carbon market, the next priority for China is to form a more effective carbon market.
The development of China’s carbon market started with local trials in Beijing, Tianjin, Shanghai, Chongqing, Hubei, Guangdong, Shenzhen, and Fujian, before the national ETS was established. It is now the world’s largest carbon market though only the power sector is covered at this stage. A unified market is conducive to the formation of a national carbon price, which can improve the market’s liquidity and the efficiency of pricing. But improvements are still needed in the following areas.
First, a cap on total emissions should be specified as soon as possible. The cap on carbon emissions is the planned total emissions for a future period based on previous emissions and the overall target of emission reduction. Failure to set such an aggregate target will have a huge impact on the market.
After the financial crisis, carbon prices in the European market plummeted. During the crisis, lower demand for emission allowances due to dampened industrial and commercial activities built up a surplus of allowances and drove down the carbon price, undermining corporate motivation to cut emissions. As a short-term measure to tackle the allowance surplus problem, the EU deferred the auction of a certain amount of allowances. To further strengthen the resilience of the ETS, a market stability reserve began operating in January 2019, which adds or withdraws allowances based on the total number of allowances in circulation instead of price volatility.
China has yet to set an aggregate emission reduction target, which calls for action at the top level. Moreover, after the overall amount of emission reduction is determined, a considerable proportion of allowances should be put onto the market for trading. In addition, a price stability mechanism should be established to help investors form expectations that carbon prices will rise year by year, which is conducive to cutting emissions.
Second, the distribution of allowances should be improved. The distribution approach will decide the scarcity of allowances and thereby the price of carbon, so it is the first step in carbon price formation. Across existing ETS, auctioning has become the major method for distributing allowances. In the initial stage of China’s national carbon market, the power sector is the major player, and allowances are allocated for free to participating firms.
Since China’s national carbon market is still in its infancy, it is sensible to use free allocation of allowances. But as the market develops, the proportion of auctioned allowances should gradually increase, so as to promote rational pricing of carbon. Increasing the proportion of auctioned allowances, on the one hand, can enable the market to better play its role in carbon pricing; on the other hand, auction revenues can provide a source of government income which can be used for low carbon development.
Internationally, there are two approaches to distributing allowances, namely, free allocation and auction. Allowances can be allocated free of charge through grandfathering or benchmarking, or purchased though auctioning. At present, auctioning is the major method for allowance allocation in the EU market; a small portion is granted for free to prevent carbon leakage or incentivize certain sectors or companies, but this measure is expected to be gradually phased out. An important function of allowance auctioning is to create public resources to support low carbon development. The auction revenue generated by EU member states, UK, and European Economic Area countries between 2012 and 2020 exceeded 57 billion euros. In 2019 alone, the revenue was over 14.1 billion euros, 77 % of which was spent on climate and energy programs.
In China, the amount of natural resources and the level of regional development are negatively correlated. Coals are concentrated in provinces like Inner Mongolia and Shanxi, crude oil in Shaanxi and Heilongjiang, and natural gas in Hebei and Shanxi. These carbon-intensive regions need help to realize the transition towards low carbon development. Given the strained public finance at central and local government, auction revenues generated on the carbon market could be used to support low carbon transition.
Third, financial institutions should be encouraged to participate widely in the carbon market to help form relatively stable prices and provide sufficient incentives for emission reduction. And the carbon market should be managed and regulated as a financial market.
China’s national carbon market stipulates that all qualified institutions and individuals can participate. But so far only emitters are allowed in the market, no financial institutions have joined yet. Without financial institutions, the role of the carbon market in price discovery, expectation guidance and risk management will be undermined. Even worse, the realization of reduction goals might be affected. In the EU market, the participants not only include emitters, but also all types of financial institutions such as banks, funds, broker and dealers.
The carbon market is essentially a financial market and should be managed and regulated as such. We should strengthen the financial features of the trading products, mechanisms and participants, roll out derivative products, improve the market liquidity and incorporate carbon trading into the financial market system and risk management framework; the Futures Law currently being revised should add derivatives of carbon allowances to its list of trading products. Building on the existing financial infrastructure, we should use market-based professional methods to build the national carbon market, leverage previous experience in market management, increase participation of institutional investors and have market players improve self-regulation.
Fourth, whether carbon prices can effectively guide production and consumption depends on the smooth transmission of price signals. The power sector accounts for about half of the total emissions, thus electricity prices play a key role in the formation of carbon prices. Currently, China’s electricity price is partly controlled rather and not completely market-based, which could impede the transmission of carbon prices.
II. Revenues generated by carbon border adjustments proposed by developed countries should be used to reduce emissions in developing countries. Otherwise, the principle of “common but differentiated responsibilities” would be violated and the mechanism would simply be a disguised form of trade protectionism, for which China should be prepared.
Carbon emissions in many developed countries have peaked while the emissions of developing countries are still going upward. Therefore, at different stages of development, carbon prices should be different. Some developed countries have proposed the carbon border adjustment mechanism (CBAM) to prevent carbon leakage. Revenues generated under this mechanism should be used to support the low carbon development of developing countries as a compensation.
Although the EU currently accounts for only about 8% of global carbon emissions, its cumulative emissions since the Industrial Revolution are among the highest in the world, accounting for 24% of the global total; the United States accounts for 25%; China, with one-fifth of the world’s population, accounts for only 13% cumulatively. If developed countries do not have a proper arrangement for the revenues generated by the carbon border adjustments and only intend to use it to protect the competitiveness of domestic companies, such mechanism is not in line with the spirit of “common but differentiated responsibilities” and merely a disguised form of trade protectionism.
The climate issue is a typical “tragedy of the commons” problem in economics, thus requiring global collective actions to solve it. For a country that has just achieved moderate prosperity and still faces many challenges, China’s 30/60 pledge shows a remarkable sense of responsibility. In contrast, developed countries have failed to deliver the financial and technological support promised before, and now intend to implement measures like carbon border adjustments. This can hinder global consensus-building and collective action on climate change, and may lead to the “tragedy of the commons”.
If developed countries adopt the protectionist stance and insist on implementing the carbon border adjustment mechanism, China should quickly expand the scope of the domestic carbon market and carbon pricing and levy a carbon tax on commodities exported to developed countries so as to retain the revenue and support China’s low carbon development.
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