In this Year of the Tiger, China, the world’s largest carbon emitter, is signaling more aggressive climate action on several fronts, including expanding its national carbon emission trading system (ETS).  Since the launch of the program on July 16, 2021, results have been encouraging; carbon intensity fell three and a half percent in the second half of 2021 and total carbon emissions only grew by four percent, compared to nine percent in the first half of the year. However, China’s implementation of ETS has triggered criticism for having low penalties, loose restrictions, and too low a carbon price. Like a tiger in tall grass, it is vital that Chinese policymakers pounce on the obstacles to expanding ETS coverage and transition from an intensity-based cap to an absolute cap. Signs show this can happen sooner as opposed to later.

The idea of using markets to limit carbon emissions is not new. Launched in 2005, the European Union’s ETS is now trading carbon emissions from power and heat generation, energy-intensive industrial sectors, and even aviation. By the end of 2021, the carbon price in the EU surged to 90.75 euros ($102.36) per ton — nearly 14 times higher than the Chinese market, at 48 yuan ($7.51) per ton. 

While China’s ETS is currently limited to the power sector, the market is still massive. The cumulative trading volume hit 179 million tons in its first six months, surpassing the EU and making China’s market the largest emissions trading system in the world.

Different from the EU ETS, the Chinese system’s intensity-based cap focuses on increasing energy efficiency; i.e. reducing the amount of carbon emitted per unit of economic output. In addition to setting a cap on carbon intensity, China’s ETS works in parallel with decentralizing the electricity market and, importantly, training local regulators to run the measurement, recording, and verification systems. China is the first developing country to submit Nationally Determined Commitments (NDCs), including an intensity-based cap.  The design and practice of China’s ETS might serve as a model for other developing countries to create carbon markets.

Intensity-based cap: “Crossing the river by feeling for stones” 

Carbon price is the most important factor in reducing carbon emissions, but other factors are also important when evaluating an ETS system. As a developing country that relies heavily on manufacturing, one of the biggest challenges to implementing an ETS is avoiding an economic slowdown. China’s use of an intensity-based cap ETS aims to prevent a significant drop in industrial output levels.  Different from an absolute cap, which is widely used by ETS pioneers such as the EU and California, an intensity-based cap rises and falls according to the production level, thus, in theory, maintaining GDP growth.

The intensity-based cap is a softer ETS pathway that CSIS and other international energy watchers have called a “less ambitious” strategy in combating climate change. However, China’s ETS is still in its infancy. And “it’s not very fair to compare the carbon price and trading volume between China and the EU ETS, since it took the EU several years to have a matured carbon trading system,” said Yan Qin, a senior modeling analyst at Refinitiv, in an interview.

Synergies between ETS and electricity market decentralization 

As carbon markets become the buzzword for climate change policy, ETS could be viewed as the center of China’s decarbonization schemes, but it is important to see ETS in context. “There are many different components of decarbonization strategies. Carbon pricing can be one part of that,” said Max Dupuy, the Principal of the Regulatory Assistance Project, at a recent China Environment Forum. 

Since China’s decarbonization strategies need to work together, it is important to examine how the current carbon market interacts with other policies, especially electricity market liberalization. When fuel prices are highly controlled by the power market, fuel cost do not “pass-through” to consumers. Hence, consumers do not receive a higher price signal when using carbon-intensive electricity. Power market decentralization could work in parallel with the ETS to send higher carbon price signals and increase incentives for renewables and other cleaner electricity.

Encouragingly, China’s power market reform is pushing toward decentralized electricity markets, which creates an environment for carbon trading. The province of Guangdong is the furthest along with power market reform and is home to China’s longest functioning spot market. With the enabling environment, Guangdong ETS is the most active pilot with the largest market share of spot trading and the first pilot auctions into the allowance allocation.

China’s ETS gets ready to roar

In the 2022 Government Work Report, Premier Li confirmed China’s commitment to decarbonization, sending positive signals to ETS markets. This followed a 2021 high-level Central Economic Conference, where China’s top leadership and energy experts expressed the ambition to expand coverage of carbon markets beyond the power sector. The 14th Five-Year Plan (2021-2025) includes the non-ferrous metal and building material sectors in the ETS. These developments signal that China is starting to consider a transition to an absolute cap on carbon across the broader economy.

With the floor price set, the number of sectors expanding, and auctions of emissions credits starting, China’s ETS tiger is crouched in the tall grass and ready to pounce. The market is now able to respond to carbon intensity with potential for an absolute cap on total emissions nationwide. Should China continue its commitment to address issues of carbon emissions with an ETS and other means, 2022 could really become the year of the decarbonizing tiger.