Does china’s national carbon market function well? A perspective on effective market design

Abstract

The emissions trading scheme (ETS) has piqued substantial interest among economists and policymakers. China officially launched the electricity sector’s national carbon emissions trading market in 2021, making it the world’s largest compliance carbon market. In contrast to the cap-and-trade (C&T) system prevalent in other economies, China’s national carbon market employs a rate-based mechanism that implicitly subsidizes the output of regulated entities; however, is it effective? This study uses a market-design theoretical framework to explore whether China’s national carbon market functions effectively and, more critically, what leads to its (slight) underperformance. We discover that policy design, policy conflicts, policy uncertainty, inexperienced market regulation, and excessive or inappropriate government intervention are the primary constraints on this emerging market, resulting in shrinking market thickness, congested market transactions, and lack of safety. For China to establish a better national carbon market, stronger market-oriented rules, appropriate market regulation, improved policy coordination, and greater electricity market reforms are required.

Keywords:

• Emissions trading scheme (ETS)
• carbon market
• market design
• China
• electricity sector

Disclosure statement

No potential conflict of interest was reported by the author(s).

Geolocation information

Nanjing, China

Data availability statement

Data will be made available on request.

Notes

1 See, for example, Stavins, “Policy Instruments for Climate Change,” 293–330.

2 See, for example, Stranlund et al., “Enforcing Emissions Trading Programs,” 343–361.

3 See, for example, Zhu, “Understanding China’s Growth,” 103–124; Guan, “Journey to World Top Emitter.”

4 See, http://www.xinhuanet.com/english/2021-07/16/c_1310064614.htm.

5 At the United Nations General Assembly (UNGA) on September 22, 2020, Chinese President Xi Jinping pledged to the world that China will peak CO2 emissions by 2030 and achieve carbon neutrality by 2060. http://www.xinhuanet.com/politics/leaders/2020-09/22/c_1126527652.htm

6 Carbon markets are divided into two categories: primary and secondary. This paper focuses on the secondary market, where carbon allowances are traded between market participants (currently primarily emission-controlling enterprises), which is of greater public interest.

7 See, for example, Lo, “Carbon Trading in a Socialist Market Economy,” 72–74; Lo, “Challenges to the Development of Carbon Markets in China,” 109–124.

8 See, for example, Cao et al., “When Carbon Emission Trading Meets a Regulated Industry,” 104470; Cui et al., “The Effectiveness of China’s Regional Carbon Market Pilots in Reducing Firm Emissions.”

9 These studies cover not only traditional pollutant-based ETS (e.g. Zhang et al., “The Indecisive Role of the Market in China’s SO2 and COD Emissions Trading,” 875–898), but also ETS based on greenhouse gases, i.e. carbon markets (e.g. Lo, “Challenges to the Development of Carbon Markets in China,” 109–124; Munnings et al., “Assessing the Design of Three Carbon Trading Pilot Programs in China,” 688–699).

10 Roth, “The Art of Designing Markets,” 118–126; Roth, “What Have We Learned from Market Design?,” 285–310.

11 See, for example, Tietenberg, “Emissions Trading: Principles and Practice,” 204.

12 See, for example, Dudek et al., “Environmental Regulation Capacity Analysis”; Shin, “China’s Failure of Policy Innovation,” 918–934; Zhang et al., “Policy Interactions and Underperforming Emission Trading Markets in China,” 7077–7084.

13 In addition to the ETS, another important market-based environmental policy tool, usually compared with the ETS, is the environmental tax. See, for example, Bosquet, “Environmental Tax Reform,” 19–32.

14 It is worth noting that in addition to conventional pollutants (such as sulfur dioxide), greenhouse gases (such as carbon dioxide) are also included, especially after the Kyoto Protocol.

15 See, Montgomery, “Markets in Licenses,” 395–418.

16 See, for example, Stavins, “What Can We Learn from the Grand Policy Experiment,” 69–88; Martin et al., “The Impact of the European Union Emissions Trading Scheme on Regulated Firms,” 129–148.

17 See, for example, Crocker, “The Structuring of Atmospheric Pollution Control Systems,” 81–84; Dales, “Land, Water, and Ownership.” 791–804.

18 See, Yang and Schreifels, “Implementing SO2 Emissions in China.”

19 Dudek et al., “Environmental Regulation Capacity Analysis.”

20 This is also known as the “4 + 3 + 1” program. See “Notice on Beginning the Pilots of Promote the Research Program on China’s Sulfur Dioxide Control and Emissions Trading Policy,” State Environmental Protection Bureau (SEPA). This program was launched when the TEC was formalized during the 10th FYP period (2001–2005).

21 In particular, Jiangsu, Zhejiang, Tianjin, Hubei, Hunan, Inner Mongolia, Shanxi, Chongqing, Shaanxi, Hebei and Henan are included.

22 See, “Suggestion on the Improvement of Emissions Trading Policy,” Ministry of Environmental Protection (MEP).

23 See, for example, Shin, “China’s Failure of Policy Innovation,” 918–934; Zhang et al., “Policy Interactions and Underperforming Emission Trading Markets in China,” 7077–7084.

24 See, for example, Hart and Zhong, “China's Regional Carbon Trading Experiments,” 577–592.

25 See, for example, Sorrell and Sijm, “Carbon Trading in the Policy Mix,” 420–437; Chang and Wang, “Environmental Regulations and Emissions Trading in China,” 3356–3364.

26 See, for example, Tao and Mah, “Between Market and State,” 175–188; Zhang et al., “The Indecisive Role of the Market in China’s SO2 and COD Emissions Trading,” 875–898.

27 The Clean Development Mechanism (CDM), defined in Article 12 of the Protocol, allows a country with an emission-reduction or emission-limitation commitment under the Kyoto Protocol (Annex B Party) to implement an emission-reduction project in developing countries. (UNFCC: https://unfccc.int/process-and-meetings/the-kyoto-protocol/mechanisms-under-the-kyoto-protocol/the-clean-development-mechanism) Studies have examined the impact of CDM on China, such as technology transfer and poverty. (See, for example, Dechezleprêtre et al., “Technology Transfer by CDM Projects,” 703–711; Du and Takeuchi, “Can Climate Mitigation Help the Poor,” 178–197.

28 See, State Council of the People’s Republic of China, “Notice of the State Council on Issuing the Work Plan for Controlling Greenhouse Gas Emissions during the Twelfth Five-Year Plan.”

29 The National Development and Reform Commission (NDRC), “Notice on Issuing the Implementation Plan for Energy Conservation and Low-Carbon Action of Ten Thousand Enterprises.”

30 The National Development and Reform Commission (NDRC), “Notice on Carrying out the Pilot Project on Carbon Emissions Trading.”

31 See, for example, Chen and Xu, “Carbon Trading Scheme in the People’s Republic of China,” 131–152; Zhang et al., “Lessons Learned from China’s Regional Carbon Market Pilots.” 19–38.

32 Geographically, at least one pilot market is located in each of China’s eastern, central, and western regions, reflecting the Chinese government's strategic approach to exploring experience in a differentiated manner.

33 The overall average price in the review period was 32.11 yuan/ton.

34 The overall cumulative trading volume in the review period was 290.81 million tons (cumulative turnover is 7.77 billion yuan).

35 See, for example, Cao et al., “When Carbon Emission Trading Meets a Regulated Industry,” 104470; Zhu et al., “Low-carbon Innovation Induced by Emissions Trading in China,” 1–8; Liu et al., “Has Carbon Emissions Trading Reduced PM2.5 in China?” 6631–6643; Yu et al., “Does the Emissions Trading System in Developing Countries Accelerate Carbon Leakage Through OFDI,” 105397; Almond and Zhang, “Carbon-trading Pilot Programs in China and Local Air Quality,” 391–395.

36 See, The National Development and Reform Commission (NDRC), “National Development and Reform Commission on the Issuance of the National Carbon Emissions Trading Market Construction Plan (Power Generation Sector).”

37 http://www.gov.cn/zhengce/2018-03/21/content_5276191.htm#1 (accessed 24 December 2021)

38 Data source: Shanghai Environment and Energy Exchange (https://www.cneeex.com/).

39 See, for example, Liu et al., “Energy Policy: A Low-carbon Road Map for China,” 143–145.

40 http://www.nea.gov.cn/2021-06/05/c_139993076.htm (accessed 24 December 2021).

41 Balietti (2016) studied the permit price volatility–trading activity link in the EU ETS Phase I and concluded that industrial enterprises seem to have traded more frequently when volatility levels were lower.

42 Approximately three-quarters of the transactions took place in December.

43 The average EU carbon price of 2021 exceeds 50 euros per ton and even hits a record above 90 euros per ton in February 2022. Data source: Trading Economics (https://tradingeconomics.com/).

44 Xiao et al., “Decarbonizing China’s Power Sector by 2030,” 112150.

45 See note 10 above.

46 See, for example, Roth, “A Natural Experiment in the Organization of Entry-Level Labor Markets,” 415–440; Roth et al., “A Kidney Exchange Clearinghouse in New England,” 376–380; Abdulkadiroğlu et al., “The New York City High School Match,” 364–367.

47 See, for example, Gans and Stern, “Is There a Market for Ideas?” 805–837; Xu, “China’s Functioning Market for Sulfur Dioxide Scrubbing Technologies,” 9161–9167; Zhang et al., “The Indecisive Role of the Market in China’s SO₂ and COD Emissions Trading,” 875–898.

48 See Gans and Stern’s “Is There a Market for Ideas?” for more information on the idea market; for the technology market, see Xu, “China’s Functioning Market for Sulfur Dioxide Scrubbing Technologies,” 9161–9167; for the pollution trading market, see Zhang et al., “The Indecisive Role of the Market in China’s SO₂ and COD Emissions Trading,” 875–898.

49 See note 10 above.

50 See Article 39 of the Measures for the Administration of National Carbon Emission Trading (Trial) for details.

51 For example, the number of participants in the study by Roth (2005) does not exceed 100.

52 Enterprises in the electricity sector (including autonomous power plants in other industries) that emit ≥26,000 tons of carbon dioxide equivalent (with a total energy consumption of ∼10,000 tonnes of standard coal) in any one year from 2013 to 2019 were selected to participate in the first compliance cycle of the national carbon market.

53 See, Gans and Stern, “Is There a Market for Ideas?” 805–837.

54 See, Dickhaut et al., “Commodity Durability,” 1425–1430.

55 In the first phase of the market, benchmark ratios are divided into four categories based on the various fuel and technology of the facilities, with gas-fired facilities being the lowest.

56 Although the allowance granted to a given coal-fired facility for a given compliance cycle is pre-established based on its output from the previous compliance cycle with an “initial allocation factor” (0.7 set in China’s nationwide carbon market in the electricity industry), the ultimate allowance will be updated upon its output during the given compliance cycle. Thereby, the allowance allocation is a rate-based, not a mass-based system. (See the Implementation Plan for Setting and Allocating the Total Amount of Carbon Emission Trading Quotas in 2019–2020 (Power Generation Sector), and Goulder and Morgenstern (2018).)

57 Indeed, the actual correction factor considers the cooling method, heat supply, and load factor.

58 Here, assume that this firm has only one facility.

59 The CESD is the most comprehensive and extensive nationwide environmental database at the firm level in China. Since approximately 1998, the Ministry of Environmental Protection (MEP) has begun to establish a bottom-to-up system to collect environmental information covering all the major industrial emission sources all over China. All the data are self-reported by the point sources and then compiled by the MEP. Due to strict data collection procedures, the CESD is China’s most reliable environmental microdata set. It is updated annually and contains >400 data fields, including (1) basic plant information; (2) basic production information; (3) pollution emissions; (4) pollution abatement equipment; and (5) other environmental-relevant information, including total operating costs for pollution treatment. In this study, we mainly use the information on consumption of five types of energy (i.e. coal, fuel oil, natural gas, coke, and electricity) and the output value from this dataset to calculate the energy intensity.

60 The list of enterprises included in the national carbon market was obtained from the NDRC. And autonomous power plants are not included.

61 Several studies have studied these emissions trading markets’ thickness or efficiency. See, for example, Montagnoli and de Vries, “Carbon Trading Thickness,” 1331–1336; Sabbaghi and Sabbaghi, “Carbon Financial Instruments,” 399–407; Wang and Wu, “Carbon Trading Thickness and Market Efficiency,” 109–119.

62 See, for example, Xu et al., “Engineering and Optimization Approaches to Enhance the Thermal Efficiency of Coal Electricity Generation in China,” 356–363.

63 See, http://www.gov.cn/zhengce/zhengceku/2021-11/03/content_5648562.htm.

64 See, http://www.reformdata.org/1996/0903/16954.shtml.

65 See note 7 above.

66 The evidence can be found, for example, Zhang et al., “The Indecisive Role of the Market in China’s SO₂ and COD Emissions Trading,” 875–898.

67 See, http://www.gov.cn/xinwen/2021-03/13/content_5592681.htm.

68 Yu et al., “A General Equilibrium Analysis on the Impacts of Regional and Sectoral Emission Allowance Allocation at Carbon Trading Market,” 421–432.

69 Zhang et al., “Quantifying Regional Economic Impacts of CO₂ Intensity Targets in China,” 687–701.

70 See, Gilley, “Authoritarian Environmentalism,” 287–307.

71 See note 7 above.

72 See, for example, Zhang et al. “Lessons Learned from China’s Regional Carbon Market Pilots,” 19–38.

73 See note 53 above.

74 See, Guangdong Carbon Market’s Transaction Data Report for the 2019 Compliance Year.

75 See note 56 above.

76 Different from Goulder and Morgenstern (2018), we consider three categories’ input (i.e. fuel, technology, and other inputs) here instead of one single input, taking into account the means of potential emission reductions in power plants.

77 See, for example, Ngan, “Electricity Regulation,” 2142–2148.

78 See, http://www.gov.cn/ztzl/2006-07/01/content_324604.htm.

79 See, for example, Ngan, “Electricity Regulation,” 2142–2148; Mun et al., “China’s Power Generation Dispatch,” Resources for the Future (RFF).

80 See note 56 above.

81 Mun et al., “China’s Power Generation Dispatch,” RFF.

82 See, for example, Kim et al., “Impact of Carbon Cost,” 3441–3448.

83 See, for example, Burtraw, “Regulating CO2 in Electricity Markets,” 588–606; Chen et al., “Economic and Emissions Implications,” 696–712; Neuhoff et al., “Allocation, Incentives and Distortions,” 73–91; Sijm et al., “CO₂ Cost Pass-through,” 49–72.

84 Therefore, the carbon price is insufficient to guide firms' production decisions.

85 See, for example, Liu et al., “Impact of Carbon Market on China's Electricity Market,” 1–5; Song et al., “Linking Carbon Market and Electricity Market,” 118924.

86 See note 66 above.

87 See, Heyes, “Implementing Environmental Regulation,” 107–129.

88 See, for example, Duflo et al., “Truth-telling by Third-party Auditors,” 1499–1545.

89 See, Zhang et al., “Integrity of Firms’ Emissions Reporting,” 164–169.

90 See, https://www.mee.gov.cn/ywgz/ydqhbh/wsqtkz/202203/t20220314_971398.shtml.

91 Approximately 34 million tons of CCERs were used for offsets in the first compliance cycle of the national carbon market.

92 Zhang et al., “Regulatory Uncertainty and Corporate Pollution Control Strategies,” 118–135.

93 The Big Five power generation companies in China, namely State Power Investment Corporation (SPIC), China Guodian Corporation (Guodian, GD), China Huaneng Group (Huaneng, HN), China Huadian Corporation (Huadian, HD), and China Datang Corporation (Datang, DT), together account for almost half of the total generation assets in the country.

94 Aside from the electrical and industrial sectors, green transformation in other sectors (such as agriculture) is critical to China's carbon neutrality aspirations. See, for example, Wang et al., “China’s Agricultural Green Transition,” 240–272; Zhao et al., “The Pathway to China’s Carbon–Neutral Agriculture,” 304–324.

95 See, http://www.gov.cn/zhengce/2022-04/10/content_5684385.htm.

96 The achievement of carbon neutrality targets requires good coordination between different sectors and provinces in terms of emission reduction targets. See, for example, Chen et al., “Emission Reduction Tournament Would Postpone Carbon Peaking in China,” 273–303; Zhou et al., “Improvement of Environmental Performance,” 435–455.

97 See, the Notification on Key Points for Management of Enterprises’ Greenhouse Gas Emissions Reporting in 2022.

98 See, for example, Wu et al., “Temporal Changes in Sectoral Carbon Productivity and Corresponding Driving 77Factors,” 19.

Additional information

Funding

The work was supported by National Natural Science Foundation of China [Grant no. 71921003]

Notes on contributors

Yu Zheng

Yu Zheng is a PhD candidate at School of Environment, Nanjing University.

Bing Zhang

Bing Zhang is a professor at School of Environment, Nanjing University. His research focuses on energy and environmental governance and policy system in China. He mainly examines detail regulation design on regulating pollution and GHGs in China, as well as its impacts on industrial competitiveness, structure dynamic and social welfare.