By Analyst Ivy Yin and Eric Yep

June 19, 2021 - China's carbon market that starts trading in June is more likely to resemble a marathon with long-term goals rather than a 100-meter dash focused on immediate heavy-handed regulations to curb emissions, according to experts who have helped designed the system.

This is in line with the trajectory of how nationwide emissions trading systems have evolved in other countries, where carbon trading has taken years to develop, and particularly relevant in the case of China where economic growth is being prioritized and several other factors need to fall in place for a carbon market to be successful.

A measured start means that China's carbon prices will initially be low as emissions allowances granted to companies in the power sector, the first industry to come under the carbon market, will be generous and market participants will get time to build emissions measurement and mitigation mechanisms.

That is not to say that China's nationwide carbon emission trading scheme, or ETS, could be any less impactful in the longer term—its designers envisage a noose that tightens slowly as emissions allowances shrink and mitigation costs increase covering more sectors of the economy.

China ETS will surpass Europe to become the world's biggest carbon market, with nearly 4 billion tons of carbon allowances, Mei Dewen, managing director of Beijing Environmental Exchange, had said at an event hosted by the International Finance Forum in May.

Beijing Environmental Exchange was one of the participants in China's pilot carbon trading program that started operating in 2013 with eight pilot markets (Beijing, Chongqing, Fujian, Guangdong, Hubei, Shanghai, Shenzhen, Tianjin). Mei said around 445 million tons of carbon allowances were traded in the eight pilot markets in the past seven years.

The price discovery from these pilots will feed directly into pricing the nationwide ETS.

Average carbon prices under the pilots were around Yuan 25 ($3.9) per ton of CO2, out of which Beijing's price was higher at around Yuan 80 and more stable, while carbon prices in other pilots were lower and volatile, according to S&P Global Ratings data.

China's marginal carbon emission cost will however increase to $300-$350 per ton by 2060 in the nationwide program from around Yuan 50 ($7.8) in 2021 indicating the baseline carbon price needed to achieve net zero, Zhang Xiliang, Director of Institute of Energy, Environment and Economy, Tsinghua University, said at the Carbon Neutrality and Green Development Forum in May.

Zhang said his team, which designed Beijing's pilot market, now leads the design of the national carbon market. "In carbon market design, we need to balance efficiency, equality, and durability," he said.

Carbon Allowances to Shrink Over Time

China's carbon price will also be influenced by other elements in its design.

The first batch of national ETS participants includes 2,225 power plants with historical annual emissions exceeding 26,000 tons of CO2 equivalent, for which benchmark emissions per megawatt-hour will be specified by plant types, according to the environment ministry's action plan released in December 2020.

This is called a rate-based allocation mechanism where there's no fixed cap of carbon allowances for each plant -- as power output increases, emissions allowances can increase. This system differs from the mass-based approach adopted by the European Union that sets an emissions cap.

The rate-based approach is less efficient, but also less painful on the economy. It also means that the allowances are generous and results in lower carbon prices.

The environment ministry's emissions allowance benchmark is 0.877 mt of CO2/mWH for standard large-scale coal plants (over 300 MW), which is not difficult for most of China's young and modern coal plants to meet.

"That 0.877 mt of CO2/mWH benchmark is close to the average emission intensity of China's coal fleet. In addition, there's an exception: power plants do not (have to) pay over 20% of its shortfall, so highly inefficient coal plants will pay less than their actual emissions," Yan Qin, lead carbon analyst with Refinitiv, said.

However, the allowances are expected to tighten as China transitions, and Zhang expects the carbon market to eventually become a mass-based system with steadily higher prices and covering eight energy intensive sectors within five years, comprising 7,500 eligible companies with a threshold annual energy consumption of 10,000 tons of standard coal equivalent.

The sectors are power generation, petrochemicals, chemicals, building materials, steel, nonferrous metals, paper, and aviation.

Focus on Stability

While EU ETS carbon prices have shot through the roof due to financial market participation, China's ETS will initially limit the financial component that Zhang said could "result in a top-heavy market with volatile carbon prices."

The environment ministry's carbon market management guidelines do allow for individuals and business to open ETS accounts, but financial market participation will be introduced when regulators think the time is right.

"[For EU ETS] financial players now contribute 20% trade volumes and their contributions are increasing. In contrast, China's ETS is more of a regulatory market," Qin said.

Carbon Prices Across Some Key Markets

*CORSIA is Carbon Offsetting and Reduction Scheme for International Aviation

Note: Includes both regulated and voluntary carbon markets

Source: S&P Global Platts, S&P Global Ratings