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Chinese national carbon trading market off to a good start amid hopes of further reforms

17 December 2021 Max Tingyao Lin

China's fledgling national emissions market enjoyed a trading boom in recent weeks, but industry experts say Beijing needs to push ahead with further regulatory reforms to achieve decarbonization targets.

Trading volume in China Emissions Allowances (CEA) is up to nearly 87.4 million metric tons (mt) of CO2e in December, according to the Shanghai Environment and Energy Exchange, which manages the national market.

Daily volume hit 20.5 million mt of CO2e 16 December, the current record high.

Since trading started 16 July, cumulative volume has totaled 131 million mt of CO2e. Those CEAs changed hands for CNY 5.36 billion ($840 million).

Observers said the recent buoyancy comes as electricity firms rush to acquire carbon credits to meet their year-end emissions targets.

The national emissions trading scheme (ETS) covers 2,162 Chinese utilities that reported at least 26,000 mt/year of CO2 for any calendar year from 2013 through 2019. Each company has an emissions quota calculated every year based on carbon intensity rules in China.

According to the government's regulatory design, Refinitiv estimates that 95% of the power companies had to hold sufficient allowances to stay compliant in their yearly cycle by 15 December, while the rest need to do so by 31 December.

Yuan Lin, lead carbon research analyst at Refinitiv, said the Chinese carbon market is off to a strong start despite utilities only being allowed to carry out spot trades in the current iteration.

"The liquidity level is beyond our expectations," Lin told Net-Zero Business Daily.

But the increase in demand failed to provide much of a boost to carbon pricing. CEA closed at CNY 44.20/mt ($6.93/mt) 16 December, compared with an opening price of CNY 48/mt on the first day of trading.

Experts say the price weakness results from ample CEA supplies, with the government opting to allocate emissions under a loose cap initially, rather than hold auctions.

Also, China's utility sector is dominated by state-owned enterprises, and each of them owns many power plants covered by the ETS. Consequently, there have been many intra-group trades that tend to drive down the price, thinktank SinoCarbon Innovation & Investment Analyst Zhibin Chen said.

Spillover effects

The voluntary carbon market for China Certified Emission Reductions (CCERs), generated from Beijing-sanctioned carbon offset projects, is also seeing increased liquidity due to demand from electricity generators.

Under the current ETS rules, 5% of the emissions quota can be met by CCERs, which are generally priced below CNY 40/mt.

"Many emitters prefer the use of cheaper offsets to fulfil their compliance requirements," said IHS Markit Research Analyst Xiaonan Feng.

Refinitiv estimated 39 million of CCERs changed hands in November, around two and a half times the total volume traded in October.

"I believe the national ETS will provide a major demand boost for CCERs. It is happening right now," Chen said.

Xiaolu Zhao, global climate change director of non-profit Environmental Defense Fund, expressed concern that the ETS currently allows the use of CCERs from all official projects regardless of decarbonization methods and timespans.

"We hope the Ministry of Ecology and Environment will release detailed rules soon to ensure high quality offset credits are encouraged to be used," Zhao said.

The Chinese central government has stopped approving new CCER projects since 2017, citing a need to enhance the regulatory framework.

This, coupled with the introduction of the ETS, has sharply reduced spot CCER availability, according to Lin. "After the [current] compliance phase … there will be barely any spot CCER supply in the market. The government has to open CCER registration again in early 2022," she said.

There is speculation that Beijing will seek to harmonize the CCER regulation with international rules for carbon offset projects developed under the Paris Agreement's Article 6.4, which are due to be hammered out in UN Framework Convention on Climate Change meetings next year, and that China could create a domestic market for offsets from projects in Belt-and-Road countries.

But Feng said the government is unlikely to have a strong appetite for folding carbon credits from foreign offset projects into the national scheme. "The primary purpose of the ETS is to promote decarbonization domestically instead of elsewhere," she said.

With more Chinese firms setting voluntary emissions targets, demand for carbon offsets from companies outside of the ETS is also growing. Lin estimates annual CCER demand amounts to 200 million mt of CO2e, including 150 million mt for compliance needs and 50 million mt for voluntary buyers.

Lina Li, a senior manager specializing in carbon markets at Berlin-based thinktank adelphi, predicted that such Chinese buyers will prefer domestic offsets recognized by Chinese authorities to international voluntary credits such as Verified Carbon Units.

"Unless for some reasons like international public relations," Li said, then "some firms would be looking for more internationally recognized offsets."

More rigorous rules

While the companies covered by the ETS account for 40% of China's CO2 emissions, or nearly 4.4 billion mt/year, most of which are from coal-fired plants, experts believe the current rules are not designed to trigger large-scale decarbonization efforts.

For one, non-compliant firms currently only face a fine of up to CNY 30,000, even though Beijing is proposing to increase this threshold to CNY 500,000.

Moreover, the Chinese ETS does not impose a hard cap on total CO2 emissions, in contrast to most national or regional trading programs elsewhere.

Under the scheme, the companies receive allowances according to their CO2 emissions per unit of output, which, according to some observers, are calculated somewhat generously by the authorities. They are allowed to emit more by improving energy efficiency theoretically.

"Even though China aims to reach peak coal consumption by 2026, the current allocation plan does not consider this target," Chen said. "With such a loose cap and free allocation, it will be very difficult to influence the companies."

Li said the government has yet to position carbon trading as a crucial policy driver in decarbonizing China's power sector.

"The key for the government for this first compliance period is a smooth start, and that's why the current ETS design is rather soft," she added.

At the latest annual Central Economic Work Conference, government officials concluded that China's dual-control policy should regulate carbon intensity and CO2 emissions in the future, rather than energy intensity and consumption as it does now.

Experts said the policy announcements suggest Beijing could introduce an absolute emissions cap in the ETS eventually, but that such a change is likely to only happen in the 2026-2030 period. For the first half of this decade, the government is expected to tighten its carbon intensity benchmarks gradually.

Wider scope

With its national climate targets of CO2 emissions peaking by 2030 and carbon neutrality by 2060, China wants to cap emissions from some energy-intensive sectors like steelmaking in the next decade.

Aside from the power sector, Beijing plans to include the refining and petrochemicals, chemicals, building materials, steel, nonferrous metals, paper, and aviation sectors in the ETS.

Some observers say the building materials, nonferrous metals, and refining and petrochemicals sectors are next in line. All eight industries are expected to be rolled into the scheme by 2025.

The ETS will be able to cover 72% of China's emissions at that point, according to the International Carbon Action Partnership, a coalition of governments that share knowledge on running trading schemes.

"The ETS has a lot of potential to be further tightened up so that it plays a key role for the coal peaking [target] and industry sectors' [emissions] peaking … in the coming years," Li said.

Moreover, China pledged to develop a national methane reduction plan by COP27 next year in its recent climate deal with the US.

The ETS currently only covers CO2 emissions. However, government-sanctioned projects that cut methane emissions are able to generate CCERs in China.

"Given this new emphasis on addressing the [more potent] greenhouse gas … we expect methane reduction offset projects to play a bigger role in the new CCER system," Refinitiv said in a research note.

In efforts to enlarge the trading scale, Chinese authorities have also been mulling rules for derivatives for carbon credit and could allow financial firms and speculators to participate in the ETS at a later date.

Guangzhou Futures Exchange said it is planning to launch CEA futures contracts, though this will only happen after the regulatory framework is in place.

"The national ETS will eventually open to more types of participants, likely starting from large financial institutions" and later expanding to individual investors, Feng said.

"But this will likely happen at a controlled pace to prevent excessive speculation and large price volatility when the market itself is at an early stage," she added.

Posted 17 December 2021 by Max Tingyao Lin, Principal Journalist, Climate and Sustainability

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