Hal Harvey’s Insights And Updates – China Just Launched The World’s Largest Carbon Market. Here’s How It Can Succeed.

On Tuesday December 19th, China formally launched its national carbon market. By setting a carbon price on the country’s largest greenhouse-gas emitters, China has launched a new, crucial endeavor in its efforts to tackle pollution and climate change.

While the market’s first phase only covers power generation, this step will still create major climate benefits. China’s power sector generates 65 percent of its electricity from coal and accounts for more than 3.5 gigatonnes (GT) of annual carbon dioxide (CO2) emissions, meaning this new cap is almost double the European Union’s carbon market, and ten times the size of California’s cap and trade system.

If designed correctly, a carbon cap-and-trade system is a powerful policy to cost-effectively cut carbon pollution. While this early phase is a promising start, room remains for improvement, and Chinese policymakers are keenly studying the performance of other existing carbon markets to ensure continuous improvement.

China’s carbon market began its countdown to launch two years ago, when President Xi visited President Obama in September 2015. President Xi promised to launch a national carbon market in 2017 and this commitment was included in China’s pledge to the Paris Agreement on climate change.

But preparation for the national carbon market started earlier than that: Five cities and two provinces (including Beijing, Shanghai, and Guangdong) launched regional carbon market pilots in 2013 and 2014, with encouragement from the central government. The seven pilot markets cover over three thousand emitters with total annual emissions of 1.4 GT CO2, and market activity increased in 2016: Trading volume grew 106 percent while trading value grew 29 percent. The average carbon price across these seven markets in 2017 was $3-10 per ton of CO2, raising roughly $680 million in total transactions. These regional pilot programs have helped work out carbon allowance allocation, emissions monitoring and verification issues, are driving toward more market liquidity, developed government experience on market design and ability to implement, and built confidence to expand the carbon market nationwide.

The carbon cap aligns with the China Policy Solution study (conducted by Energy Innovation, China’s National Center for Climate Strategy and International Cooperation, and the Energy Research Institute of China’s National Development and Reform Commission), which found that a $10 carbon price would help reduce national emissions by a quarter or more below business-as-usual in 2030.

Just like the California cap-and-trade system, which started slow and expanded over time, China’s national carbon market is expected to eventually expand to cover eight energy intensive sectors across the Chinese economy: power, iron and steel, non-ferrous metals like aluminum, chemicals, petro-chemicals, paper, building materials, and civil aviation. Because of its economy-wide importance and responsibility for about a third of China’s total emissions, launching the carbon market by covering 1,700 emitters across the power sector (companies that emit more than 26,000 tons of carbon annually) makes sense.

China has been the world’s leading renewable energy investor for years, has the world’s largest installed renewable energy capacity, and is the biggest clean energy economy with 3.5 million green jobs, but its power sector still depends upon high-carbon sources. Electricity generation from wind and solar electricity, while growing at an astounding rate, is still marginal (4 percent from wind and 1 percent from solar in 2016) and, renewable power generators face the world’s worst curtailment rates, at 17 percent for wind and 10 percent for solar in 2016.  Thus, a carbon market starting with China’s power sector should help both reduce coal burn and boost the growing clean energy industry.

As with many new policy changes in China, the carbon market can develop incrementally, reflecting Deng Xiaoping’s phrasing to, “cross the river by feeling the stones.” Phase one of China’s national carbon market is just a starting point. For instance, allowances to emit carbon are expected to be distributed to power generators for free when the system launches, and allowance auctions are not expected to be introduced in phase one.  This runs contrary to most economists’ recommendations, but gives China’s power companies time to adapt without economic shock.

The system should evolve to be more effective.  Allocating too many permits has plagued other existing carbon caps—from Europe’s Emissions Trading System to the Northeast U.S. Regional Greenhouse Gas Initiative.  It remains to be seen whether China’s initial design will get the permit allocation right, but several good tools can obviate this worry.  Our organization has championed allowance auctions and establishing allowance price collars for cap-and-trade systems, which insure them against both under- and over-allocation of permits.  We also recommend policymakers be vigilant against allowance oversupply by steadily tightening the cap over time.

Carbon markets can reduce carbon emissions and create an opportunity to transform entire economies so that they are cleaner and more efficient.  China’s step is a great move in that direction.

Special thanks to EI Senior Fellow Hu Min for her contributions to this piece.

Hal Harvey’s Insights and Updates offers monthly thoughts and analysis on current energy and climate topics. These newsletters are written by Energy Innovation’s CEO Hal Harvey. Sign up here to receive Insights and Updates straight to your inbox.