China's carbon trading market to evolve effective pricing mechanism

• Besides power sector, eight other sectors to be included under ETS
  
  
• Participation of banks, financial institutions vital to improving liquidity
  
  

China's national carbon emission trading system (ETS), which was launched on 16 Jul'21, initially covers the power sector in seven pilot provinces and cities of the country. The country's mammoth power sector contributes to around 12% of global CO2 emissions. Built on the official principle of "dual carbon" - peaking emissions by 2030 and attaining carbon neutrality by 2060 - carbon emission trading combines the government's mandatory emission reduction system and a market-oriented trading mechanism.

Ways of reducing emissions

For companies looking to reduce emissions, there are four main ways of tackling the problem:

• To achieve reduction in emissions by limiting production. This method has great economic costs. Profits are likely to be reduced, economic growth will slow down and inflationary pressures due to insufficient supply of goods will have to be endured.
  
  
• To purchase carbon emission rights from companies with surplus allowances, change the subject of the allowances, and form a compensation mechanism between companies that compulsorily reduces emissions. The total carbon emissions of both parties in the transaction are equal to the total carbon emissions allowances.
  
  
• To develop or purchase energy-saving and emission-reduction technologies or the use of clean energy, which will directly bring about emission reductions, accelerate the realisation of "carbon peak", and have a small impact on the economy. In the long run, this is the fundamental way to achieve the "dual carbon" goal.
  
  
• To purchase the emission reductions of carbon offset projects such as the National Certified Voluntary Emission Reduction (CCER) and the Provincial Carbon Inclusive Certified Carbon Reduction (PHCER) as a hedge against carbon emissions.
  
  

Price signal & corporate decision-making

Changes in the price of emission rights will change the cost relationship. Therefore, the price signal of emission rights is an important factor in corporate decision-making and is directly related to the "dual carbon" goal.

However, the price signal has limitations. Technological innovation is a long-term process with long cycles, high costs and uncertainties, while the price signal of carbon emission rights is short and fluctuating. Affected by the market scale and trading system, the signal may distort the allocation of resources. The price signal is inevitably affected by administrative factors such as relevant policies and regulations.

Carbon offset projects

With the "dual carbon" target in view, the annual growth rate of carbon emission allowances will gradually slow down and even reduce allowances. The amount of allowances for transfer will become tighter and the price of carbon emission rights will show an upward trend. However, the excessively high cost of corporate emission reduction is detrimental to the steady growth of the economy and the stability of prices.

The forward price signal provided by the carbon emission rights futures market can circumvent the defects of spot signals and guide the effective allocation of resources. However, unilateral market expectations are likely to be amplified by the highly leveraged futures market.

The ETS can be improved by increasing the scale of carbon offset projects entering the market, besides quotas, and increasing the proportion of carbon offsets that can be used. At present, from the perspective of pilots in various regions, it is usually stipulated that the proportion of carbon offset using CCER cannot exceed 5% to 10% of the initial allowance.

Including other sectors in ETS

Increasing support for energy conservation, emissions reduction, and clean energy technology innovation can increase the willingness of companies to achieve self-emission reduction through technological innovation. This will objectively reduce the demand for carbon emission reduction rights and avoid rapid price increases.

Apart from the participation of mandatory carbon reduction companies and carbon offset companies, it is possible to gradually realise the diversification of participating entities, allowing banks, funds and other financial institutions to join, increasing market liquidity and promoting effective price formation. In addition to the national market, the regional voluntary carbon emission reduction trading market can also play a supplementary role.

In addition to the existing large-scale power and other key industries, more companies and industries should be included in the scope of mandatory emission reduction. Lai Xiaoming, Chairman of Shanghai Environment and Energy Exchange, has suggested that during the current five-year plan period "all eight key industries will be included in the ETS, the paid quota will be gradually increased, the market maker system will be introduced, and institutional investors will be encouraged to enter the market to boost liquidity."