COMMENT: Sink or swim – China needs to strengthen trading practices in its ETS

Published 04:01 on September 9, 2016  /  Last updated at 04:01 on September 9, 2016  /  Asia Pacific, China, Contributed Content, Other Content  /  No Comments

If China's national emissions trading scheme is to be a success, regulators must design trading rules that help - not hinder - market liquidity and ensure transparency.

By Jeff Huang, Beijing-based independent consultant and advisor to IETA

There are important lessons learned from China’s ETS pilots over the past few years. Most observers would agree that trading liquidity is one critical area that needs to be improved.

Here, I’d like to cover five trading-related issues that must be addressed for China’s national emissions trading system to be successful.

1. Data transparency needs to be enhanced

None of the pilots published even basic data such as the number of allowances each compliance company received from the local governments. In comparison, the European Commission operates a single EU registry covering all 31 ETS-participating countries. It holds accounts for stationary installations and aircraft operators. It lists facility-level emissions, amount of allocation and surrendered permits, all available to the public.

Without timely publication of accurate fundamental data, market participants have no way to analyze supply and demand trends, and trading becomes akin to throwing darts in the dark. Liquidity, therefore, quickly dries up.

2. Compliance companies’ capacity building needs to be expanded

Over the past few years, companies covered in the pilots have been focused on the compliance aspects, including allowance allocation, acquiring expertise in emissions monitoring, reporting and verification, as well as participating in the auction experiments. Little bandwidth was left for capacity building in trading and carbon risk management.

There are positive developments in this regard. Take the China Iron and Steel Association, for example. Until very recently, the powerful lobby group has been a most vocal opponent against Chinese steel companies trading futures – iron ore futures, steel futures and others. But now the Association has started to urge their members to actively hedge with futures instruments, based on their members’ increasing success and confidence over the years. These steel companies could be expected to incrementally apply the skills already acquired to carbon risk management in the national ETS.

Meanwhile, the continued push this year by the Ministry of Finance to update the Chinese hedging accounting rules and bring them more in line with international standards, will conceivably encourage compliance firms to actively participate in carbon price discovery with a clearer accounting framework.

3. Financial sector participation has been minimal in the pilots

Chinese broker-dealers and futures companies have accumulated valuable hands-on experiences in trading futures and helping industrial companies develop and implement hedging strategies. A simple, clear, consistent, and well thought-out ETS design framework, free of arbitrary and unnecessary intervention, is imperative for financial firms to develop simple and proper instruments to serve their clients’ hedging needs, in a regulated and transparent setting.

About one month ago, the Shanghai-based and publicly listed Guotai Junan Securities Ltd., one of the largest broker-dealers in China, officially joined the International Emissions Trading Association. This is mainland China’s first legal entity to join IETA. Increased awareness among financial firms about climate change issues as well as about the business opportunities for these firms to assist compliance companies in better managing their carbon exposures will hopefully enable the financial sector to play a larger role in the coming years under the national ETS.

4. Instruments

Last week, seven Chinese government agencies published guidelines for a green finance system ahead of the G20 Summit in Hangzhou. Among other things, the guidelines listed a number of financial instruments or products to be developed for the national ETS, including forwards, swaps, options, bonds and carbon asset securitization. The guidelines also called for exploration and research on a carbon futures instrument. The guidelines DO NOT mean that policy-makers and financial regulators in Beijing favor over-the-counter instruments over the listed derivatives (i.e., futures) for carbon trading, as some analysts argued.

Ultimately, as the European experience indicates, a simple, transparent and liquid futures market is the best in serving compliance companies’ needs for hedging.

In China, regulated commodity futures markets started over two decades ago, while regulated commodity OTC trading – much more complicated in nature – is still in its infancy.

The lessons learned from the limited experiment with carbon “forwards” in the Hubei provincial pilot are three-fold:

– There is a need for a clear understanding of what a particular instrument is meant to do, and for a close alignment between the instrument design and the risk management requirements of the compliance firms, before any success can be achieved.
– Well-established rules and regulation for trading and clearing of the instrument must be in place, with active participation of regulated financial intermediaries.
– Simply, carbon derivatives trading must take place in a regulated environment.

5. Exchange platforms

Without a strong and competitive regulated exchange platform with deep liquidity, a cap-and-trade system will not be able to function, as demonstrated in the EU ETS.

In China, none of the existing seven trading platforms in the ETS pilots have any equity ownership from non-state, or private investors, while provincial allowances are traded exclusively on each designated trading platform, with no competition. This is one of the fundamental reasons why all seven pilots have suffered poor liquidity.

In Europe, regulation and competition among exchanges drive market operators to strengthen their corporate governance with proper checks and balances. Exchanges compete in product and service innovations, which ultimately benefit exchange users (i.e., compliance companies).

With China’s national ETS to be launched next year, existing carbon exchanges are better served to beef up their governance structure by attracting equity ownership from the private sector, improving transparency, and adopting an independent Board of Directors.

Ultimately, only market forces should be relied upon to pick the winning or losing exchanges, not government agencies.

China’s ratification of the Paris Agreement last week will be a big boost in momentum for China’s efforts to put its national ETS in place. Trading cannot afford to remain a weak link.

This text is a slightly modified version of a speech given at the Asia-Pacific Carbon Forum on Jeju Island, South Korea on Sep. 6.