By Jeff Huang, Beijing-based independent consultant and Co-chair of the International Emissions Trading Association’s China Working Group
President Xi Jinping last year announced a plan to launch China’s national carbon market in 2017. Now comes the first major deadline as local governments scrambled to submit, by the end of last month, to the national planning commission their lists of companies in sectors that are subject to carbon emission caps, including power, oil refining, petrochemicals, steel, and aviation.
By the end of June, historical emissions data at installation level for each company on the list must be submitted.
However, simultaneous attention needs to be paid to improving market infrastructure. Though carbon markets are intended to address scientific and moral issues, they are financial markets just the same.
The infrastructure, governance and rules for carbon price discovery and hedging activities must be further strengthened and upgraded for companies covered by the national CO2 cap, as China bolsters its emissions data monitoring, reporting and verifying procedures.
It all boils down to what I call the three “I”s.
Strong and transparent financial institutions are at the core of every properly functioning market, be it stocks, carbon or others. Markets function better when checks and balances exist in the eco-system of regulators, exchanges, financial intermediaries, and companies that use the marketplace for carbon price discovery and hedging purposes.
Many Chinese state-owned power and steel companies, for instance, spent the last few years not only gaining valuable hands-on experience with the cap-and-trade system in regional pilot programmes, but also trying at existing futures instruments in thermal coal and iron ore to better manage the price volatility of their raw material purchases. With improved risk culture company-wide and increasingly robust internal risk-control systems in place, strengthened institutional capacity lends itself to effective carbon pricing overall.
Last December, China’s Ministry of Finance published the “Interim Provision for Commodity Futures Hedge Accounting”, effective Jan. 1, 2016. This important update serves to make the accounting for hedges even more closely reflect industrial firms’ risk management activities, and more in line with international standards. This eliminates a key hurdle for more pro-active application of risk management tools by industrial firms, especially the state owned enterprises.
The last several years also witnessed a quickened pace by financial intermediaries in improving corporate governance with added transparency and financial strength by engaging in IPOs. This trend culminated with Guotai Junan Securities Ltd., the big Shanghai-based broker dealer, raising over 30 billion RMB through its IPO in Shanghai last June.
In developed countries, most established, regulated exchanges are publicly listed companies, operating in a transparent and competitive environment. In India, MCX became the first regulated commodity exchange to be publicly listed four years ago. Here in China, demutualisation of regulated commodity exchanges remains a discussion topic in academic circles.
In the longer term, effective pricing of any commodity, carbon included, would ultimately demand that exchange operators compete in an open and transparent way, with upgraded corporate governance structures.
When is “too soon” for a first trade? Pricing carbon entails building the “forward curve” with adequate liquidity from institutions – compliance entities, financial firms, and professional liquidity providers – no “retails”. The California emissions market officially started in January 2013, but the first centrally cleared forward trade of California carbon allowances was initiated 16 months prior.
It would not be too early, therefore, for capped companies and financial institutions in China to start working together towards building a carbon “forward curve” within the existing legal framework for both listed and over-the-counter derivatives trading, i.e., to launch a legitimate first trade.
As the new market evolves, institutions need to play a dominant role in terms of trading and open interests. This would be a complete break from the current commodity futures trading experience in China, which has been known as a retail market, even as institutions appeared to represent an increasing share of the open interests over the past few years.
INTERNATIONAL ACCESS AND LINKAGE
Three years ago, China started to explore launching a domestic crude oil futures contract to help its oil companies better manage oil price volatility. One key feature in designing the contract is to allow international traders direct access to trading the contracts. Since then, efforts have been under way to follow a similar template to “internationalise” the trading of the existing PTA futures contract in Zhengzhou and iron ore futures contracts in Dalian, respectively.
Carbon is a truly “global” commodity and direct access for qualified and experienced overseas participants would help the nascent carbon pricing efforts in the Chinese national scheme.
The first ever commodity futures trading in the US, wheat in this case, started in Chicago in 1848. In the US or EU, most hard work in launching a cap-and-trade scheme is focused on the “cap” part, while a long-running, battle-tested and regulated financial infrastructure for price discovery is already in place. In China, the challenges are doubled: monumental efforts are now under way with “cap” while “trade” is still evolving in a commodity market that started some 20 years ago.
No secret recipe exists for sustained success in pricing carbon. Good governance is the bedrock for any well-functioning commodity market. China would be no exception.
The stakes are high: a well-functioning national carbon market would not only deliver verifiable emissions reductions at lower cost, but also elevate domestic market infrastructure with higher operational standards.