Do carbon credits spell new opportunity for emissions producers?

China is now taking steps to roll out a nationwide carbon emissions trading scheme.

In the past, China relied mainly on administrative directives to curb carbon emissions. For many enterprises, however, the social cost of carbon emissions has not always been apparent. Moreover, companies may not see global warming as an imminent threat to their businesses. As such, they rarely have the incentive to act to save energy or reduce emissions.

Under the previous regulatory design, reducing emissions meant additional costs. These costs discouraged companies from taking proactive emissions reduction measures. The development of China’s national carbon emissions trading scheme officially started in 2017, with the goal of regulating carbon emissions through market mechanisms. As part of this scheme, large carbon emitters are assigned an emissions limit. If a company’s actual carbon emissions fall below the permitted level, then the saved credits become carbon assets that can be sold via the trading scheme for revenue generation.

Back in January 2005, the European Union officially launched the world’s first greenhouse gas emissions allowance trading system (the EU ETS), which is to date the largest cap-and-trade system in the world (covering over 10,000 companies and their subsidiaries across all of the EU countries). After years of operation, the EU ETS has played an important role in carbon emissions reduction, providing companies with a low-cost and highly incentive-based emissions reduction solution.

In September 2020, China announced that it would strengthen its contribution to reducing greenhouse gases, reach peak CO2 emissions by 2030 and become carbon neutral by 2060. A market-based mechanism is a sensible approach to achieving this goal, as it will give companies greater incentive to participate in the emissions trading scheme if they can benefit financially from it as part of the emissions reduction process.

Of course, it is a tremendous challenge to include companies all over China in this trading scheme. The United States, for example, has yet to develop a national carbon emissions trading market: an attempt was made in 2009 under the Obama administration, but it did not make it through US Congress. Instead, a regional carbon trading initiative was established with only a few participating states. Unfortunately, carbon emissions reduction requires systematic coordination, and the impact of sporadic local efforts tend to be limited.

China’s willingness to take proactive measures towards global climate change sends a clear message that demonstrates its commitment to the cause. Undoubtedly, the establishment of the national carbon emissions trading scheme is an important step in fulfilling this commitment. Moreover, China’s carbon emissions trading scheme is expected to become the world’s largest, with a total emissions reduction far exceeding that of the EU ETS.

Bringing the market mechanism into full play

China’s carbon emissions trading scheme is the result of long-term planning and development. Here are some of the key dates and steps taken:

During the first pilot phase (2014–2016), the inclusion (or exclusion) of an area in the pilot scheme had little effect on its atmospheric visibility. However, starting from the second phase (post-2016), a greater improvement in atmospheric visibility was observed in the pilot areas compared to that in non-pilot areas.

In the southern province of Guangdong, for example, the pilot emissions trading scheme covered four industries: coal-fired power plants, petrochemicals plants, steelworks, and cement plants. Enterprises in these four industries in Guangdong emitted over 20,000 metric tons of carbon dioxide annually between 2020 and 2012. Carbon emissions trading in Guangdong became very active in the second pilot phase, especially from 2018 onwards.

Prior to adopting the carbon emissions trading scheme, the atmospheric visibility in the surrounding areas of the regulated companies in Guangdong was similar to that in areas surrounding unregulated enterprises. In the first pilot phase, the atmospheric visibility was about the same between the two groups; however, in the second pilot phase (and especially since 2018), the atmospheric visibility in areas surrounding regulated enterprises has improved by approximately 4% according to our estimates.

These pilots also provided a useful point of reference for the establishment of a nationwide carbon emissions trading scheme. The difficulty of scaling such a scheme up nationwide is enormous. For one, the seven pilot areas are relatively more developed with a higher degree of marketization than other parts of China, and the gaps in economic development between different regions remain substantial. In addition, since most of the big emitters in China are state-owned enterprises with relatively low levels of marketization, it remains a challenge for them to efficiently participate in market-based carbon emissions trading.

It is worth noting also that it took several years for carbon emissions trading to gain traction in the pilot areas. In the future, it is predicted that less market-oriented areas will require longer periods of development time for inclusion in the emissions trading scheme. Key to market development is allowing carbon prices to better reflect companies’ emission reduction costs. If the trading price is too low, there will be no incentive for any company to reduce emissions or sell the emission credits saved. So, how do we increase trading prices? The best way is perhaps to develop an effective price mechanism driven by the dynamics of market supply and demand.

In short, the launch of a national carbon emissions trading scheme is an important step forward, but there is still a long way to go with enormous challenges ahead.

How can the electrical power industry better respond to the challenge?

It is an essential and logical decision to include state power companies amongst the first participants of the national carbon emission trading scheme. First, coal-fired power plants are big carbon emitters and are incompatible with the current nationwide clean energy strategy. And, second, the power industry is already subject to various regulatory requirements for energy saving and emissions reduction. Because electricity consumption and carbon emissions are somewhat positively correlated (the carbon emissions of e-commerce companies, for example, are primarily contributed by data centres housing high energy-consuming computers), major electricity consumers are also likely to be included in the national carbon emissions trading scheme in the future.

In addition, more supporting measures must be put in place. For example, China currently places strict controls on the price of electricity. Once power companies have been included in the carbon trading platform, they will be compelled to use cleaner energy for power generation, inevitably leading to a higher unit cost of generated electricity. However, if electricity pricing regulation is not relaxed, power companies will be less profitable and therefore have no incentive to advance their carbon emissions reduction efforts.

Furthermore, tightly controlled electricity prices (held to low levels) will deprive energy-intensive industries and companies of incentives to promote energy conservation and reduce power consumption. Therefore, to promote the implementation of a carbon trading scheme, it is necessary to put electricity price reform on the agenda and ensure that electricity prices are driven by market supply and demand.

In a nutshell, whether it is carbon pricing or supporting electricity price reform, it is imperative to let the market play a decisive role. As mentioned earlier, although a market-based approach to carbon emissions reduction is a viable and low-cost option from a global perspective, only the EU has succeeded in manner. China can also become a role model on a global scale if it achieves success in this area. There is still a ten-year window before 2030 when China’s carbon emissions are expected to peak, and the challenge remains for us to grasp this window of opportunity.

How do companies respond to the “grand challenge”?

For those companies that will soon be included in the national carbon trading scheme, it is important to embrace change and adjust their existing perceptions of costs. In the past, companies were more concerned about their own internal (private) costs and less so about environmental pollution and other social costs. In the future, companies need to take full consideration of both.

In addition, companies must also change their perceptions of benefits. In the past, energy saving and emissions reduction have had operating cost implications for companies. However, through a carbon trading scheme, companies can reduce their carbon emissions using various measures such as upgrading emissions equipment and proactively reducing energy consumption, and convert their saved emissions credits into carbon assets for revenue generation in the carbon market.

Of course, any carbon trading scheme will have a varying (and seldom immediate) impact on different types of companies. A scheme will not instantly reduce carbon emissions or enable companies to profit. Although it can generate positive benefits in the long run, it is not clear yet whether it can offset the additional costs to companies in the short term. In the EU, it also took a long time before carbon prices started to increase and play their expected role in emissions reduction. We will only be able to estimate the short-term impact of the national carbon trading scheme after its official launch.

Industrial upgrading will also accelerate with the establishment of a national carbon emissions trading scheme. Rather than taking a wait-and-see approach, companies should actively make use of this opportunity to promote the transformation of their business model and better respond to this “grand challenge.”