China’s Emissions Trading Scheme at a Crossroads
The world’s biggest ETS is on track to expand, but will that be enough to give it real carbon-cutting teeth?
Back in April, carbon market nerds around the world let out a collective cry of joy.
The reason for their jubilation was that one tonne of carbon dioxide under China’s emissions trading scheme (ETS) had shot past the ¥100 (US$14) mark for the first time.
Admittedly, that’s not awfully high by global standards. Carbon currently trades at double that figure in California and five times in the EU.
But for China’s nascent ETS, it was a sign that tighter regulation was beginning to have the intended effect. The biggest ETS in the world by emissions covered might develop some teeth after all.
Luyue Tan, a Senior Carbon Analyst at the London Stock Exchange Group, was watching the price at the time, and joined in the celebrations. “It was a very exciting day for the market,” she says.
The likely cause for the price spike was that on 1 May, Beijing enforced new rules known as the “interim regulation”, resulting in higher penalties for non-compliance.
“There were a lot of companies not complying before the official deadline,” Tan tells ESG Investor. “But when the interim regulation took effect, stricter penalties really kicked in.” This caused a dash for allowances in the days leading up to the deadline, pushing up the price.
For an ETS to function properly, it needs a high carbon price. But while the spike was a cause for optimism, Tan says it was a momentary high point in a long and gruelling journey.
China’s ETS, she says, is still a considerable distance from putting meaningful downward pressure on the country’s eyewatering greenhouse gas emissions. It remains dogged by technical difficulties, oversupply of allowances, low trading volumes, and political tussles.
Three years on from its launch, and with an extension beyond the power sector imminent, now seems like a suitable time to take a deep dive into China’s ETS.
Work in progress
On climate, China is a bundle of contradictions. It has installed more renewable energy than any other country, accounting for almost 40% of the global total. It controls much of the supply chain of solar panels, green metals and electric vehicles, and has done more than any nation to bring down their cost.
But it also produces a third of the world’s greenhouse gases from its coal-dependent economy, with emissions still rising. Reducing them is crucial to fending off climate breakdown, and the ETS is one of Beijing’s key tools to achieve this.
Greenhouse gas emissions by country
After a decade experimenting with smaller regional schemes, the national ETS was launched in 2021. Like the EU’s world-leading scheme, it provides emitters with carbon emission allowances (CEAs) worth one tonne of carbon dioxide.
Companies that exceed these allowances must purchase more CEAs from their peers at a price set by market forces. Those that under-emit can sell their surplus CEAs. This creates a double incentive to reduce emissions.
But China’s ETS has some fundamental differences to the EU scheme. Firstly, it is currently limited to the power sector and does not yet cover big industrial emitters like cement, steel, aluminium and chemicals.
Secondly, emission allowances are calculated by intensity rather than in absolute terms – meaning the scheme as it stands is not designed to bring total emissions down, but rather limit their rise. Furthermore, CEAs are allocated for free rather than sold by auction, which means companies only pay a carbon price if they exceed their allowances.
These factors mean China’s ETS has so far had limited effects, according to Byford Tsang, Senior Policy Advisor at think tank E3G.
“The ETS entered into force a couple of years ago, and you can see that coal plants are still getting approved,” he tells ESG Investor. “Command and control policies remain more of a central driver of China’s decarbonisation efforts than market-based mechanisms.”
Opinions vary on how effective China’s ETS could become. Where Tsang is cautious, analysts at Lombard Odier Investment Management are bullish.
“China’s ETS has the potential to fundamentally reshape international climate policy and finance,” Lorenzo Bernasconi, Head of Climate and Environmental Solutions at the firm, wrote in a report in April. “In our view, it is only a matter of time before it transforms from not only being the biggest carbon market in the world – which it already is – to also being the most valuable.”
Introducing auctioning of 100% permits – thereby making emitters pay a price for every tonne of carbon they emit – is key to strengthening the ETS, according to a recent paper by the International Energy Agency. So is switching from an intensity-based scheme to a cap-and-trade scheme, and eventually launching a futures market in CEAs.
Also key is the expansion of China’s ETS to other high-emitting sectors – which is likely to be the first reform implemented.
Expansion to industrial emitters
In March, Chinese news outlet Caixin reported that Beijing would extend the ETS to cover aluminium producers with almost immediate effect. Cement would follow later in the year, while steel would likely come into the regime’s scope by 2025.
But four months on, the expansion has not yet occurred, in part due to a fear that an oversupply of allowances could crash the market, Tan argues.
China’s carbon emissions by sector (2020)
Unlike in the EU system, China’s CEAs have no expiry date, which has enabled companies to hoard their unused permits as they wait for prices to increase. Bringing new sectors under the ETS would mean issuing new CEAs, and could result in an oversupply.
“If we hand out a lot of new allowances we would expect a very volatile market,” Tan says. “There may even be a crash in the markets.”
An obvious fix would be to introduce expiry dates, but this has proven politically difficult due to the legal definition of CEAs and the way they are treated on companies’ balance sheets.
This, says Tan, is one of the many governance problems that China’s ETS faces. Others include different government departments competing for regulatory oversight, and even fights between the Shanghai and Guangdong stock exchanges over who gets to host a potential futures market.
Tim Buckley, Director of Sydney-based Climate Energy Finance (CEF), supports extending the ETS to other sectors. But China’s National Development and Reform Commission (NDRC) has so far delayed doing so “due to fears that the industry was not in any position to do this credibly, and they didn’t want the risk of fraud undermining the scheme’s importance”, he says.
Tan agrees a rollout this year may be “too much work” for the sectors involved – but predicts that aluminium, steel and cement will be brought under the ETS by next year. A major reason for the urgency, she argues, is the EU’s Carbon Border Adjustment Mechanism (CBAM), which comes into full force in 2026.
The CBAM effect
When in 2021, the European Commission announced it would put a carbon levy on emission-intensive imports, an angry China threatened to challenge the move at the World Trade Organisation. But over time, discussions became more constructive.
Emission allowance prices in key markets 2023 (local prices converted to euros)
“From a diplomatic point of view, we see the rhetoric has toned down form China’s side, and last year the EU and China set up a formal channel to talk about the CBAM – which includes policymakers and industry talking about how the industry can get ready,” says Tsang. “Europe has explained that this is not to penalise anyone, but rather to create a level playing field.”
The result of these exchanges, Tan says, is that high-emitting Chinese industries are now lobbying Beijing to be included in the ETS.
“The aluminium and steel sectors want to be included in the national ETS because according to the EU CBAM rules, if you have an ETS, you have the chance to just pay the gap in between [China’s carbon price and the CBAM levy],” she says. “So that would be a relief for them from financial costs.”
This constructive coordination between two of the world’s biggest trading blocs has prompted some to predict a world in which carbon pricing would become a condition for international trade – creating something akin to the climate club imagined by economist William Nordhaus in 2015.
CEF’s Buckley says China is in a position to push for this outcome. This could be done in collaboration with other nations such as South Korea (which has an ETS) and Japan (which is contemplating one) to create an Asian CBAM.
“Or China could move alone, leveraging its growing climate alliance with the EU – particularly if Trump gets back into the White House and American isolationism takes even greater hold,” Buckley adds.
Investor outcomes
For asset owners looking to exercise stewardship to push for an extension of China’s ETS, scope is somewhat limited. While Chinese companies dominate global steel and cement emissions, most are state-owned enterprises. Even when they are part-listed on the stock exchange, the Chinese state remains by far the dominant shareholder.
Investor engagement in China is a different process than in more open markets, says Valerie Kwan, Director of Stewardship & Corporate Engagement at the Asian Investor Group on Climate Change (AIGCC). Openness varies from company to company, and access to the government can be extremely limited.
An example of positive engagement is the work the AIGCC is doing through Climate Action 100+ with Baowu Steel – the world’s largest steelmaker, and one of a handful of large Chinese firms on the initiative’s list of companies.
“With steelmakers in China, the biggest problem is the huge fleet of blast furnaces,” says Kwan. “And to talk about the phase-out of blast furnaces, we definitely need to think about what to replace them with in terms of capacity.”
Work is underway to trial steelmaking techniques using hydrogen, electricity and carbon capture and storage, but those methods remain far more expensive than carbon-intensive ones. Carbon pricing is key to bringing down the costs of clean technology.
Kwan says Baowu has had constructive conversations with investors, and is already pricing carbon internally in anticipation of the ETS’s expansion. But progress is slow, and shareholders need to be cognisant of the size and scale of the task facing China’s steel and other sectors.
“Investors are being quite targeted in their engagement in reaping the low-hanging fruits – and I think our lead investor for Baowu is quite good at that,” says Kwan.
All this adds up to a mixed picture for China’s ETS. While there are hopeful signs – including recent price rises, an imminent expansion and fruitful collaboration with the EU – most agree with Tan that progress has been “slower than expected”.
“It’s the largest ETS in terms of covered emission in the world, and it ought to have a very great impact to push decarbonisation,” she says, adding with a mix of hope and scepticism: “We’ll see how it goes.”
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