On July 16, 2021, after nearly two decades of research and preparation, China finally opened what is now the world’s largest national emissions trading scheme (ETS). The much anticipated move follows the central government’s ambitious pledge to reach peak CO2 emissions before 2030 and achieve carbon neutrality before 2060. Several Chinese cities and provinces, including Shanghai, have been operating ETS pilots for several years. For Shanghai, the rollout of China’s national ETS bolsters its existing carbon marketplace and complements the multitude of other local and national decarbonization initiatives the city is undertaking. The national scheme is an encouraging step in China’s climate action, but on its own it is not a silver bullet to decarbonize the economy.

Laying out the pieces of carbon ETS

An emissions trading scheme is a policy instrument that incentivizes polluters to reduce greenhouse gas emissions through market driven pricing. Governments cap the amount of carbon dioxide companies are allowed to release and require companies to pay for permits to cover any carbon dioxide they release over this cap. These over-emitting firms can buy permits from companies that emit less than their emission cap. Emission caps become more stringent over time, encouraging companies and manufacturing plants to be more energy efficient, switch to cleaner fuels, or simply close down. The United States and China, for example, implemented successful ETS for sulfur dioxide, demonstrating that trading markets can effectively lower emissions.

Carbon markets are not a new tool. The Kyoto Protocol in 1997 initiated the first attempt at carbon trading. The contentious carbon credit and trading system never came to full fruition, but this early ETS attempt helped future regional and national regimes gain policy interest.

Chinese policymakers and research institutes started exploring ETS in the early 2000s, but it was not until 2011 that the Chinese government announced the establishment of local-level pilot ETS. Pilot ETSs were implemented in not only Shanghai but also in Beijing, Tianjin, Chongqing, Shenzhen, Guangdong, and Hubei. Fujian was added as the eighth pilot ETS in 2016.

Shanghai, China’s international trade and enterprise hub, was China’s second pilot ETS. Shanghai’s ETS covers 45 percent of the city’s total carbon emissions and has maintained 100 percent compliance since its launch in 2013. Due in part to this success, in 2017 Shanghai was chosen to lead China’s budding national ETS.

Piecing together Shanghai and national carbon markets

The Shanghai regime and China’s national regime have several key differences. First and foremost, the scale of China’s national ETS dwarfs that of Shanghai’s ETS. In 2019, Shanghai’s ETS had a cap of 158 million metric tonnes of CO2. China’s carbon market’s initial cap is over 4 billion metric tonnes of CO2, which is roughly equivalent to twice the total annual carbon emissions produced by Russia. In addition to size, the two differ in scope. Whereas Shanghai’s ETS covers emissions from both industrial and non-industrial sectors, China’s national ETS covers only the power sector in its first compliance cycle. Even though China’s national ETS is projected to eventually expand to additional sectors, including the petrochemical, chemical, building materials, steel, nonferrous metals, paper, and domestic aviation sectors, the current model is comparatively restrictive.

The Shanghai market, like other carbon markets, is operating separately from the national market. Eventually, the Shanghai market is projected to join the national regime, but in the meantime the national regime is destabilizing the function and stability of Shanghai’s market. This year, Shanghai announced that its municipal trading carbon cap had been reduced by a third to account for a number of coal-fired power plants that had moved to the national trading scheme. As more covered entities migrate to the national market, Shanghai’s regional carbon market will continue to shrink, which will in turn affect its liquidity. The implications of this could be far reaching if there is no government intervention and Shanghai ETS prices could fall to the point where the whole regional ETS could collapse.

Results of assembling a carbon market

While a national carbon market could threaten the Shanghai and other regional ETS regimes without effective government planning and intervention, the national ETS is still a great option for China as it aims to reduce energy sector emissions. In addition to direct pollution reduction, China aims to spur eco-innovation. A recent London School of Economics Study of the EU ETS outlined how ETS carbon pricing has the potential to drive renewable power and energy efficiency innovations.

Besides helping the country get closer to meeting its short- and long-term mitigation goals, ETS offers new market growth opportunities. China’s national ETS is projected to be worth US$800 million in the first year and grow to over US$25 billion by 2030. Carbon credit trading is a big business with huge value creation potential. A national ETS spurs credit purchasing and trading, downstream development of different product lines, supply chain innovation, and market creation. A recent study on the EU ETS shows that abatements can turn into profits, providing proof that market incentives work.

In the case of Shanghai, the city’s pilot ETS has proven to be a mixed bag of both positive and negative results. Shanghai showed a rapid reduction in CO2 emissions. In fact, by 2015, Shanghai recorded a 9.5 billion tonne decrease in CO2 emissions. However, by 2015, ETS implementation had resulted in a 4.08 percent reduction in industrial output, which equated to a loss of about US$108.72 billion.

A Few Pieces Are Still Missing

On July 16, 2021, the first day that China opened its carbon market, 4.1 million tonnes of CO2 credits worth $32 million were traded. At the conclusion of this first day of trading, CO2 was trading at $7.89 per metric tonne, more than Shanghai’s pilot carbon market pricing but much less than EU pricing.

As noted by Carbon Brief China expert and analyst Hongqiao Liu, China’s national ETS regime is still a long way from making real change. According to The National Measures for the Administration of Carbon Emission Trading, firms that fail to report emissions are subject to a total fine of only US$1,449-$4,347, and firms that fail to meet their caps are subject to a similarly small fine of US$2,898-$4,347. In contrast, the EU ETS sets noncompliance penalties higher at more than $100 per tonne of CO2. Furthermore, the current Chinese scheme does not put a fixed cap on emissions, nor does it promise a declining cap over time; therefore, even if firms comply with regulations, the scheme will not immediately lead to carbon reductions.

Other key pieces are in place to push decarbonization

China’s national ETS has the potential to usher in several real benefits, but it should not be framed as the primary decarbonization solution—but rather as one part in a larger Chinese government portfolio pushing carbon neutrality. While applauding the ETS, Max Dupuy from the Regulatory Assistance Project stressed in an interview that even more vital are the power sector reforms that the Chinese government is also working on across the country, such as improved oversight over spot markets, implementing scarcity pricing, and encouraging building energy efficiency.

Energy efficiency in buildings is a crucial component to reducing China’s carbon emissions. Buildings in China are responsible for 28 percent of the country’s energy consumption and 39 percent of CO2 emissions. Shanghai’s Changning district’s pilot is one of China’s largest efforts to scale up energy efficient buildings that, according to speakers at an April Wilson Center panel, could be a model for the technologies, management, and monitoring needed to reduce their footprint nationwide. Massive investment into grid modernization and battery technologies will also be key in helping China bring more of its wind and solar farms online. These initiatives, while not as flashy as a national ETS, could pack a stronger decarbonization punch in the near-term.