FEATURE: China must develop market-based carbon trading system: think tank

China's state-backed think tank has proposed accelerating the development of a market-based regime around the country's carbon market, providing clear carbon price signals, managing long-term expectations, and incentivizing low-carbon technology investment, according to a report on Sept. 14.

The report by China Council for International Cooperation on Environment and Development, or CCICED, also suggested an absolute emissions cap, the introduction of carbon auctions, developing a hybrid carbon pricing system that integrates carbon trading and carbon tax, and withdrawing from overseas and domestic coal investments.

The recommendations shed light on the future roadmap for China's carbon market and highlight some of the most high-profile discussions yet around topics like a national emissions cap that were once considered taboo.

"Assessing a potential emission's cap, increasing the share of allowances with auctions, and expanding [carbon trading] to other sectors are all future steps on the way to a very effective carbon trading system," Kate Hampton, CEO of Children's Investment Fund Foundation, co-lead of the report said at CCICED's 2021 annual meeting on Sept. 10.

The CCICED, founded in 1992 and backed by China's State Council, the country's highest executive body, is a policy think tank. Its report is part of a project initiated in 2018, titled Global Climate Governance and China's Role, tasked with making recommendations on climate policy.

Absolute carbon cap

The key recommendations from CCICED's report include a shift from an intensity-based approach to an absolute cap for China's carbon market that will tighten supply of carbon credits, boosts carbon prices and allow targeted emissions cuts, similar to the European carbon market.

However, the challenge in China's context is to establish a fair cap, which can be reasonably allocated to each province and each sector under different stages of economic development.

CCICED recommended a dual control system that evaluates emission performances based on two benchmarks -- "absolute carbon emissions" and "emission intensity" -- during the 14th five-year plan period (2021-2025), which is expected to be gradually expanded.

"When it comes to cities and provinces, you obviously take account of population dynamics, industry and wealth levels. All of those will be really important in deciding the allocation system," Hampton said.

In the next five years, China's carbon market will cover more emission-intensive sectors, such as steel, non-ferrous metal, petrochemical, and transportation. It is crucial for the government to determine whether to set an absolute cap or retain the current method in the long term.

Hybrid carbon trading and reasonable carbon price

Besides a carbon cap, a reasonable carbon price is also vital for China to meet its decarbonization goals, and CCICED's report suggested the introduction of carbon auctions and carbon taxes to construct a more effective carbon pricing system.

Currently, emission quotas in China's carbon market are allocated for free. Companies with coal-fired units only need to pay for 20% of emissions above their quotas while companies with gas-fired units do not have to pay for excess emissions.

CCICED said the free allocation method lowers companies' costs but neglects their climate responsibility and liability.

It said the current national carbon market is exposed to risks of market failure, which may result in an ineffective carbon price. An effective carbon price relies on well-established legal frameworks, tightened allowances, diverse investor types, and sufficient trade volumes, which will take time to develop in China.

Hampton said China needs to consider developing a hybrid carbon pricing system based on the principle of controlling transaction costs.

CCICED said a carbon tax can be a supplementary policy instrument that hedges against market failure risks and covers less emission-intensive sectors that cannot be enrolled in the national carbon market.

Withdrawing from coal

China's decarbonization journey is closely associated with coal reduction. CCICED's report highlighted the importance and urgency of reducing coal use and coal financing.

Domestically, in the power sector, China should control the addition of new coal-fired power generation, and phase out small-scale burning of coal within the 14th Five-Year Plan period, the report said.

"President Xi already committed to control coal and reduce coal. This has to be something that the whole world does, because there are so many countries depending on coal historically that need to move to a new power system. China can help lead the way," Hampton said.

CCICED recommended strictly controlling capacity expansion in pollution-intensive and energy-intensive industries such as steel, non-ferrous metals, cement, chemicals and petrochemicals, and promote zero-carbon technologies like carbon capture.

On a global scale, China must cut back on financing overseas coal-fired electricity including Belt and Road investments, CCICED said, adding that there were opportunities too.

"We need renewable energy at the center of the power system, and China is a real leader in renewable energy," Hampton said. "As China moves to net zero, China's technology and expertise is only going to be of greater and greater use across the world, especially along the Belt and Road," she concluded.