Carbon Pulse Dialogues are discussions about carbon markets and climate policy by a selection of leading experts.

China has been operating pilot emissions trading schemes for two years to gain experience ahead of the 2016/2017 launch of the national carbon market. What are the main takeaways so far for Beijing as it designs what will eventually become the world’s biggest ETS?

When Chongqing emitters today presumably hand over allowances to the local government to cover their 2013 and 2014 emissions, it marks the end of the second compliance cycle for the Chinese pilot CO2 markets.

The markets have had their fair share of challenges amid over-allocation and dwindling prices, but are also seeing steadily growing liquidity and high compliance rates.

So which lessons do they provide for the central government as it is drawing up rules for the national ETS? We asked some of the market analysts, and will update with their comments as they come in.

Richard Mao, Executive Director, The Environomist

Sophie Lu, Analyst, Bloomberg New Energy Finance – @BloombergNEF

Jian Wei Lim, Director, Chinese carbon markets, ICIS-Tschach

Chai Hongliang, Senior Analyst, Thomson Reuters Point Carbon – @HongliangC

Josh Margolis, Managing Director, Environmental Markets, China Program, EDF – @EnvMkts

Richard Mao – 0930 CST: Two years of ETS pilot operations have provided the central government with continuous feedback so it can adopt a better-designed national ETS. Some of the key lessons we have seen are:

1. The level of which regulators reinforce their power to ensure compliance directly affects the compliance rate of the regulated entities. The ETS pilot authorities that sent strong signals from the start and frequently interacted with regulated entities achieved very impressive compliance rates, which should be a role model for the national ETS.

2. The total amount of emissions covered has not been proportional to total allowance trading volume, based on publicly available data. For example, many anticipated that the small size of the Shenzhen pilot would make it insignificant in the market place; however, Shenzhen’s overall trading volume has surpassed many other ETS pilots that are bigger in terms of total allowances covered.

3. The market regulators’ administrative capacity is stronger than their financial market supervision abilities. Some compliance entities have asked ETS authorities to provide better tools for them to hedge the risks involved in emissions trading; however, the type of financial market tools being called for are beyond the expertise and comfort zone of the authorities that operate the markets. This has been interpreted as other governmental bodies with more financial expertise should be involved in the governance of the ETS.

Designing and operating a large-scale ETS is very challenging, not only for the Chinese government, but for the international community. We are pleased to see more and more governments making ambitious GHG management commitments and adopting carbon pricing.

Sophie Lu – 1000 CST: After the last two years of carbon trading piloting, I believe there are three key challenge areas for China’s government to address:

• Over-allocation and the uncertainty of growth:
When originally setting up ETS pilots, China’s planners set up reserves to buy and sell credits in order to maintain carbon prices in a certain threshold. However, they have not really had to deploy reserves to ensure prices stay under the top-end of range because of muted need and low-econ growth driving lower than expected emissions from industrials. If anything, China is now challenged with over-allocation, and the prospect of avoiding a European style market collapse and having to instill a MSR to absorb excess supply out of the market. We will continue to see restrictive offset eligibility policies. The NDRC will also likely continue delaying rules for de-listed CDMs to qualify for CCERs, for fear of flooding the nascent Chinese market with global offset surplus.

• Building capacity and improving access:
Unlike coastal cities like Beijing, Shanghai and Shenzhen, carbon exchanges in interior cities will have to cover a much larger geographic region with underdeveloped financial infrastructure. For example, early in July, Chongqing had to delay its compliance deadline by one month and issued new rules allowing companies to arrange offline trades to meet their compliance needs, instead of being required to conduct trades online via the platform. Reportedly, the reason for this is that many of the companies covered in Chongqing’s emissions cap are located in remote areas and could not access the platform’s resources.

• Carbon markets used as taxes / fines for non-compliance on other energy and environmental policies, not emissions abatement costs
Prices are controlled in a range that essentially serve as a tax on certain companies for their emissions, rather than an effort to price the cost of abatement. An example of this is Hubei, which announced earlier this year that power companies who don’t meet their renewable energy targets under the provincial RPS targets will be required to purchase carbon credits. Our calculations show that even with the added carbon cost, coal power generation is still cheaper than gas, wind, and solar. Thus, carbon prices currently are not priced to affect meaningful emissions abatement, but rather, function more like a carbon tax.

Jian Wei Lim – 1045 CST: The Chinese pilots have indeed provided many valuable experiences for the national government when designing the national market. I’ll focus on three market/trading-related experiences which the national government should take note of.

1) Trading behaviour and attitude of compliance companies
The trading behaviour and attitude towards carbon trading depends a lot on the ownership of the company (state-owned or private), sector, etc. In general, SOEs are more willing to comply and fulfil their compliance obligations than privately-owned companies. Therefore, the national government needs to ensure (and enforce) that there is stringent regulations and penalties to motivate these ‘problematic’ companies to participate in the ETS. Despite SOEs’ higher ‘willingness’ to participate, their trading behaviour is normally passive and/or lack proper management/trading strategies (e.g. buying/selling in huge volumes only once a year). Therefore, through organising workshops and seminars, the NDRC can assist these companies to better prepare for the national market. Also, the introduction of market makers and institutional investors can help fill the gap of an illiquid market caused by companies’ passiveness.

2) The role of institutional investors, market makers, individuals
Most pilots allow the participation of institutional investors and individuals (Guangdong, Hubei and Shenzhen also allow foreign companies’ participation). This has helped improve the liquidity of the pilots. For example, Shanghai experienced a two-month ‘drought’ period with no trading activity in July and August 2014. Trading activity only resumed after Shanghai opened its doors to institutional investors in September 2014. Institutional investors have also provided Chinese compliance companies with many compliance and trading solutions, such as providing buy-backs, swaps, etc.

3) Auction mechanism
Auctioning is an important element of an ETS as it attaches a cost to carbon as compared to free allocation. Out of the seven pilots, Guangdong is the only pilot that organises regular auctions. Guangdong implemented a mandatory auction mechanism with a floor price of CNY60 in 2013, a voluntary auction mechanism with a stepped floor price between CNY25 – 40 in 2014, and a voluntary auction mechanism with no floor price in 2015. These different mechanisms can provide the national government with valuable experiences on how best to design the auction mechanism for the national scheme. These experiences include compliance companies’ reaction to mandatory auctions, primary market price consistently higher than secondary market price, etc.

Chai Hongliang – 1355 CST: I would argue the most tangible impact of the pilots is that the schemes have raised carbon awareness in the society. According to our interviews and survey, most domestic carbon practitioners are optimistic about the prospect of the national market. Up to now, local participants have accepted that pilots operate under opaque data and regulations announced on short notice.

Nevertheless, I doubt the character of the pilots will be endured by participants in the national scheme. In my view, the imperative of China’s national scheme is to help the country meet its overall emissions reduction targets for 2020 and beyond. This imperative requires the national scheme to contain at least three features to qualify as a market: data transparency, regulation consistency and accountability.

As the carbon market will also be impacted by other markets and policies, such as China’s ongoing power sector reforms and clean air campaigns, an overarching approach is desired in the design of the carbon scheme. That will require coordination between the NDRC and other regulatory agencies. This may call for political will from the state council, the top administrative authority.

Unlike regional regulators, the central government will have to take into account the offset sector. The domestic offset market, if flourishing, can improve energy efficiency and increase renewable production, which aligns with the country’s 2020 and 2030 non-fossil targets. However, the offset market can flourish only if project developers expect demands from compliance companies. The emitters’ appetite for offsets will largely be decided by the stringency of the cap.

Josh Margolis – 2330 CST: It is premature to draw definitive lessons from the seven carbon pilots. Let’s remember the first was launched in June of 2013, the last barely a year ago, and early year compliance results are only in for five of the programs. Further, the pilots themselves have gone through some fundamental post-launch changes. Finally, the pilots are vastly different in terms of underlying industrial base, scope, design, and method of administration. Prudency suggests that we should give the programs – and the policymakers – a bit more time before trying to divine the import of the pilots to China’s efforts develop a national ETS.

Nonetheless, we can make some inferences from efforts to date – the pilots, China’s prior experience with SO2 trading, and the West’s 45 years of experience with ETSs. China can gain the maximum benefits from an ETS that:

• Features a central goal (e.g., reducing carbon emissions in the most certain and cost effective fashion while accommodating economic growth) while also embracing auxiliary goals (e.g., reducing PM2.5 and other conventional pollutants, transitioning to low carbon fuels, conserving water, greening the supply chain, creating jobs).
• Is based on accurate data and is appropriately adjusted over time as the data improves.
• Features an absolute cap and whose integrity is maintained.
• Ensures program transparency for the benefit of covered entities, regulators, and relevant third parties.
• Encourages long-term decisions through the use of multi-year allocations, clear and stable rules, emission banking, and the ability to use risk hedging instruments.
• Recognizes that scarcity of allowances is necessary to encourage investments.
• Provides for the use of high quality offsets which are derived from projects that can be subject to rigorous MRV and whose proponents are subject to enforcement action.
• Is based on a solid legal foundation that provides clarity to enterprises that ETS administrators have the authority to implement and enforce.

Already we see signs that carbon trading could be a powerful tool. A cap has been put on 1.2 billion tonnes of GHGs in areas with a population exceeding 250 million and that represent about 26% of China’s GDP. A price on carbon has been established. Enterprises have new methods to manage their emissions, costs, and profits. Policy-makers have a powerful tool that will help them deliver on their obligations. These are all positive indications that China may be able to use the pilots to design an ETS with Chinese characteristics that serves its climate, environmental, energy, and economic goals.

Compiled by Stian Reklev – stian@carbon-pulse.com