COP26: why carbon pricing is crucial to China’s climate change pledges

China’s emissions trading scheme is a welcome development, but its size belies its narrow scope and lack of allure for investors
To reach its full potential, it needs to cover more of China’s emissions, go beyond the electricity sector and let prices reflect the true cost of carbon

Alicia Garcia-HerreroandJunyu Tan

Published: 2:30pm, 21 Oct, 2021

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China’s bold announcements to address climate change, namely to reach peak emissions by 2030 and achieve carbon neutrality by 2060, have been accompanied by several policy measures. A key one is carbon pricing, which was pushed forward in July by creating a nationwide emission trading scheme (ETS).

After nearly three months in operation, it is important to evaluate the scheme’s performance and how it might relate to China’s climate change goals down the road.

Size is a strong point of China’s national ETS market as it became the largest globally from its first day of operation. Roughly 4 billion tonnes of carbon dioxide emissions could potentially be traded – more than twice the size of the carbon allowance in the European Union’s ETS, which has been in place for 16 years.

This might look like a great immediate success, and many have focused on the scheme’s size as a signal of its effectiveness, but size is not all that matters. In reality, China’s ETS size reflects the country’s role as the world’s largest carbon dioxide emitter, accounting for about 30 per cent of the global emissions.

The scheme only covers about 40 per cent of China’s total emissions and involves just one sector – power generation. Furthermore, the amount is more nominal than real as the market remains illiquid and has a rather small number of participants, around 2,000 polluters for the whole of China.

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Although more sectors are expected to be incorporated as the scheme rolls out, no timeline has been set for their inclusion. This could take time as the quota allocation process can be complex for sectors such as metals and building materials, whose products are highly diverse.

Finally, the market is not yet open for third-party traders such as carbon trading companies, financial institutions and individual investors. As a consequence, carbon-related products are still scarce, making it hard to attract investors.

The absence of financial institutions and related products underscores policymakers’ wariness of speculative activities. This is bound to remain the case for some time, given the ongoing crackdown on excessive financial risks.

Beyond raising the efficiency of the ETS market in China, it is important that the carbon prices traded in the scheme rise to discourage the use of fossil fuels in China’s energy mix. This is all the more important for Beijing’s commitments to fight climate change, given existing subsidies on electricity, which is still mostly generated by coal.

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Unfortunately, the new ETS market has not brought about an increase in the cost of carbon as prices have remained at a low level since the market opened. The price today is less than US$10 per tonne compared to more than €60 (US$70) per tonne in the European ETS.

China’s carbon pricing is facing another important test as the country experiences an unprecedented power crunch. This crisis, stemming in part from local governments’ eagerness to fulfil the carbon reduction objectives set for them, is resulting in electricity being rationed for households and firms.

This is hurting China’s industrial and manufacturing capacity at a difficult juncture since economic growth is slowing after peaking in the first quarter of this year. China’s reaction to the power crunch is taking several directions.

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Some are welcome, such as President Xi Jinping’s announcement of an increase to the installed capacity for renewable energy and the lifting of some controls on electricity prices. Other measures, such as increasing the domestic production of coal, are more worrisome from the point of view of China’s fight against climate change.

Had a well-functioning market for carbon pricing been in place by now, the choice between resorting to coal or renewables would tilt towards the latter, as the cost of coal-related carbon emissions would be much higher than it is today.

In short, China needs a fully functioning carbon pricing market more than ever. The creation of a national EST market is clearly welcome, but it is not enough. It needs to cover a larger part of China’s carbon emissions and go beyond the electricity sector.

China’s energy crunch and the high economic costs of going green

It also needs to be liquid so carbon prices can go up and reflect the true cost of carbon for the economy. China has a golden opportunity in the run up to the United Nations climate change meetings to demonstrate that its commitments to fight climate change are achievable by further pushing carbon pricing as an essential part of the plan.

This will also mean that any additional production of coal to address the ongoing power crunch will become more expensive and therefore be discouraged in favour of greener options for generating electricity.

Introducing the market for carbon pricing is clearly the most effective way to achieve China’s climate change targets. Rationing electricity, and other tools seen in the past few months, will be too costly to maintain, and could risk missing China’s climate targets.

Alicia Garcia-Herrero is chief economist for Asia Pacific at French investment bank Natixis and adjunct professor at Hong Kong University of Science and Technology. Junyu Tan is an economist at Natixis specialising in Asia thematic research and is a CFA charterholder