Abstract: China needs to place a greater emphasis on innovation-driven decarbonization to achieve the 2030/60 carbon peaking and neutrality goals. While ensuring energy supply and security, it should provide greater incentives for low-, zero- and negative-carbon products and technologies with a three-pronged approach: 1) build a comprehensive growth-oriented carbon market that could effectively boost green technological innovation; 2) build a regional, independent accountability system for decarbonization; 3) build a sound set of basic green institutions and systems at the micro level with a focus on carbon accounting and accounts.
I. TWO DIFFERENT DECARBONIZATION STRATEGIES
Translating the pressure from China’s 2030/60 carbon peaking and neutrality goals to a force driving economic growth is no easy task, as attractive and inspiring as it is. We observe three types of decarbonization in practice.
First is “regressive” decarbonization which essentially reduces carbon emission by reducing production. This is the least painstaking way toward the target, but it is also the least practical because we simply cannot put production at a standstill. That’s said, production was indeed halted at some of the places in China previously just to achieve short-term decarbonization goals.
Second is productivity-oriented decarbonization, which means to elevate carbon productivity so that higher output can be achieved with the same level of carbon emission, or less carbon is emitted for the same level of production. Energy conservation and emission reduction follow this logic.
Third is innovation-led decarbonization that leverages new technologies and techniques to enable the same level of output with lower, zero or even negative emission, such as to generate power with renewable energies like wind, light, water or biomass. Replacing high-carbon technologies with renewable ones could reduce carbon emission while ensuring production output.
The first two types rely on existing technologies and industrial systems. Compared with regressive decarbonization, productivity-oriented decarbonization is more proactive, and the room for improvement with energy/carbon productivity is pretty big especially in technologically laggard and extensively run sectors.
In fact, China has made remarkable progress with energy conservation and emission reduction over the years. But productivity-oriented decarbonization has limitations: first, as technology and management improve, the increase in carbon productivity will slow and the room for further improvement will contract; more importantly, these changes are confined to existing technological and industrial frameworks, which means that technological innovations are reinforcing, rather than disruptive; besides, while carbon productivity can reach a high level, the resources used remain carbon-intensive. For example, coal-fired power plants that lead the world in energy conservation and carbon reduction still use coal.
We also need to understand the priority of energy conservation from an economic perspective. Energy and resource conservation is worth advocating as a social moral. Economics essentially is a subject about conservation, but it explains conservation from an overall point of view with a focus on optimal distribution of resources across the entire society. Energy conservation in the general sense is about reducing the cost of production, including that for raw materials, transportation, warehousing and labor; it also seeks the minimum level of cost per unit of output. Whether conservation should be prioritized is determined by such overall estimate and comparison which is usually market-based. If we are to put energy conservation as the top priority, especially to make energy conservation indicators an indirect gauge and basis for decarbonization, it would inevitably distort resource allocation and economic performance. This is also why policymakers have begun to drive a shift of focus from controlling energy consumption to reducing carbon emission.
Innovation-driven decarbonization, in contrast, jumps out of the box to explore possibilities with new technologies, techniques and production methods. This makes it different from the previous two types of decarbonization.
First, innovation-driven decarbonization can phase out traditional carbon-intensive technologies and industries over time. Green transformation is essentially a process of technology replacement, where carbon-intensive technologies are replaced by low-, zero- or negative-carbon ones.
Second, there is no predetermined boundary to innovation-drive decarbonization. The internal impulsion and uncertainty of innovation means that there could be no artificially engineered boundary to it. If one day we manage to make controlled nuclear fusion come true and successfully market it, it would disruptively reinvent the world of renewable energy.
Third, such innovation can slash the cost incurred to cope with climate change. Green products are usually expensive at the early stage with the so-called “green premium”. As innovation competition intensifies, price has come down, dragging the premium to negative for many green products. The most typical example is photovoltaic power generation. It was beyond imagination a decade ago that it could one day challenge coal-fired power generation, but over the past ten years, its cost has declined by 80-90% to lower than that of coal-fired power generation with room for further reduction. An important roadblock hindering our efforts in coping with climate change is the cost shock; the reduction in cost as a result of technological innovation would greatly increase our confidence and ability to tackle climate change.
Fourth, the original intention of innovation is to reduce carbon, but once it materializes into products, it would generate more additional utilities or benefits and create higher consumer surplus. Take new energy intelligent cars for example. In Q1 2022 nearly 20% of total automobile sales came from new energy cars, beating market expectations. Most of the consumers, while also caring about decarbonization, choose these cars mainly because they are cheap, comfortable, user-friendly, agile, and autonomous. These cars are electrified, smart and sharing. In other words, it’s the features beyond low carbon of new energy cars that are attracting buyers, and that’s an additional social benefit.
Finally, it has triggered and accelerated the digitalization of carbon-intensive sectors including energy. Digital economy is a new form of economy following the agricultural economy and the industrial economy. Our entire socio-economy is experiencing the digital transformation, including carbon-intensive sectors such as energy, industry, transportation and construction, the transformation of which has been accelerated by the 2030/60 decarbonization drives. Innovation-driven decarbonization has triggered and injected new impetus into the digitalization of these areas, giving them the potential to lead the entire digital transformation.
To sum up, innovation-driven decarbonization has opened up different possibilities from the other two types of decarbonization with the potential to trigger and lead green and digital transformation of the socio-economy that might go way beyond expectation under the current decarbonization roadmap. If regressive and productivity-oriented decarbonization are “defensive” strategies, innovation-driven decarbonization would be a proactive one. That said, we are still in the defensive stage in practice, and must step up efforts implementing the more proactive strategy.
II. INNOVATION-DRIVEN DECARBONIZATION: LACK OF MARKET INCENTIVES
Different strategies are manifested as different goals and policies, and more pragmatically, different incentives. I would like to focus on the carbon emission trading market here. For carbon emission with global externalities, we cannot expect the market to work on its own; rather, the government should step in to “create” a market. William Nordhaus, Nicholas Stern and other world leading climate change economists are all advocators of pricing carbon, in different ways including quota trading and carbon tax, giving a major role to the carbon emission permit market. However, none of the carbon markets as of today has been functioning as desired, be it the world’s first European Union Emission Trading System (EU ETS) or the recently launched Chinese carbon trading market. While external factors are at play, it’s more owed to these markets’ structural deficiencies: only some of the carbon-intensive industries and businesses are included, which is narrow, biased and unequal; the quotas are primarily distributed for free, with no cost incurred until redistribution where surplus quotas are transferred to places they are needed; the quotas are now allocated based on the industry benchmark emission intensity rather than the historical level of emission which is a progress, but considering supply safety and stability, it could be improper to slash the quota in a short period of time. In practice, it’s usually hard for regulators to distinguish real supply safety concerns from excuses used by producers. These factors could severely impair the role of the carbon trading market including price discovery, demand/supply adjustment and boosting innovation.
A more important question is that the current carbon trading market seems to be serving the “defensive” strategies as illustrated above. For producers in the carbon trading market, their top concern is how to improve carbon productivity, save energy and emit less so that they can sell their surplus quotas for profits. The market is also engineered with the hope to encourage producers to invent new technologies and deliver low- or zero-carbon products. But the reality is that existing producers usually have path dependence with a lack of motivation or ability to innovate. Disruptive innovators are usually outside the “circle”. Meanwhile, emitters could continue to emit as long as they purchase carbon sinks, and to prevent this, the carbon market has put restrictions on the weight of carbon sink transactions under the China Certified Emission Reduction (CCER) mechanism. The weight is now set at 5%, which is immaterial for the market as a whole. As such, the most vigorous innovation-driven decarbonization has been subject to a lack of market incentives.
III. THE THREE-PILLAR SYSTEM WITH A PROACTIVE STRATEGY FOR CARBON REDUCTION
To achieve the goal of carbon reduction and carbon neutrality, China has to focus on innovation and adopt a proactive strategy. China has learnt from the course of reform and opening up a lesson that the correct understanding and handling of the relationship between the incremental and the existing is crucial to the success of transformation. In the early days of reform and opening up, the private economy experienced rapid development by filling in the gaps. Thanks to its endogenous vitality, resilience and competitiveness, private economy has gradually grown into an important new force in the national economy, and even driven the reform and development of the state-owned economy. At the beginning of opening up, China was engaged in compensation trade that featured three “supplied”, which are "processing with supplied materials", "assembly with supplied parts", and "processing with supplied samples". In China, foreign trade started in a few coastal areas. With years of development, the country has gradually become a global trade and investment power.
Energy transformation in China has to follow a path guided by the strategy of proactive carbon reduction. The transforming path has the following features: taking increments as the priority, replacing old energy with new energy, encouraging innovation and being market-driven. The economic logic is that despite the space for carbon reduction that traditional high-carbon energies still enjoy, their potential will be regressive. In the later stages, carbon reduction will become increasingly more difficult and costly. Meanwhile, the low-carbon or zero-carbon new energies as an increment will see accelerated cost reduction due to the expansion of production and technological improvement. The green premium of some products will change from being positive to negative. Replacing old energy with the new one will see growing cost advantage, which will speed up the shift of the proportions of new and old energies. The implementation of a proactive carbon reduction strategy is to encourage more rapid expansion of increments and provide strong incentives to low-carbon, zero-carbon and negative-carbon products that can increase production and stimulate growth on the premise of stabilizing the existing energy production and ensuring the stability and security of energy supply. Such incentives should not be limited to a few measures, but be a system boasting three interdependent pillars.
First, establish a growth-oriented carbon sink market that supports green technology innovation in an all-round way. Growth-oriented carbon sink refers to the reduction or offset of carbon emissions compared with the existing high-carbon production under the condition of producing the same output by using low-carbon, zero-carbon and negative-carbon technologies. The growth-oriented carbon sink market can coexist with the current carbon market for emission rights, whose main task is to incentivize reduction of existing emissions. The growth-oriented carbon sink market should focus on encouraging technological innovation in the incremental part. This market can be highly inclusive, covering not only green energy products such as green electricity, but also products in other industries that can create growth-oriented carbon sinks. In a growth-oriented carbon sink market, products should be allowed to transaction at a certain price through the issuance of government bonds or the special funds provided by the central bank, and then transfer to the market for circulation. The price of carbon sink in the market represents an assessment of value and a payment method for the contribution of technological innovation to emission reduction. By increasing or reducing the scale of investment funds, the government can adjust the incentives for innovation. The development of growth-oriented carbon sinks must comply with relevant technical standards and rules at home and abroad. Digital technologies such as blockchain can be used to reduce costs and standardize processes.
Second, form a regional liability system for autonomous emission reduction. The key to prioritizing increments is to expand the market demand for technologically innovative products, which in turn relies on the effectiveness of the liability system. China can learn from the principles of the Paris Agreement and encourage localities to take the initiative to propose emission reduction targets that are both in line with local realities and are challenging enough. The targets should be in line with the “1+N” policy for realizing the carbon reduction target. Regional emission reduction plans and a traceable liability mechanism at the provincial, municipal, district and county levels must be put in place. A region or enterprise can meet its emission reduction target by directly reducing emission, or creating growth-oriented carbon sink products, or purchasing such products from the market. In this way, the liability system for carbon reduction can press a continuous demand for green technology products, and speed up the incremental expansion and the process of replacing the old energy with the new.
Third, accelerate the construction of green micro systems focusing on carbon accounting and carbon accounts. Whether it is to promote the construction of a growth-oriented carbon sink market or to improve the liability system for emission reduction, the premise is to have a qualified carbon accounting basis, which is precisely what China lacks at the moment. In the initial stage of carbon accounting, a top-down approach can be adopted to get a holistic picture of the general situation. At the same time, carbon accounts must be established everywhere, including carbon accounts of enterprises and other institutions, and individual carbon accounts can also be established where conditions permit. Efforts must be stepped up to promote ESG assessment in the corporate sector, and form a stable and standardized ESG assessment disclosure system among listed companies and large enterprises. It is recommended to bring more financing activities to green finance, develop various types of financial products based on the growth-oriented carbon sink so as to provide practical and effective support for green technology innovation.
To promote green innovation, both technological innovation and institutional innovation are indispensable. The three-pillar system guided by a proactive carbon reduction strategy discussed above falls into the latter category. For innovative policies and practices that are controversial in the short term, pilot projects can be carried out in places where suitable under the guidance of national top-level design. In this process, space for trial and error must be given. When pilot projects are completed successfully, there must be efforts to improve the projects and then promote them more widely. This important experience still has practical significance in green innovation and transformation today.
This is the keynote speech made by the author at the 2022 ESG Global Leaders’ Summit. It is translated by CF40 and has not been subject to the review of the author himself. The views expressed herein are the author’s own and do not represent those of CF40 or other organizations.
