China’s recently launched national emissions trading system (ETS) has been both lauded and loathed by pundits. Some see it as hugely important, while others see it as little more than virtue signalling. The reality is somewhere in the middle.

Carbon pricing has reached critical mass

China’s ETS will initially cover electricity, covering the emissions of 2,225 entities. Generators are allocated allowances based on fuel and plant type. If their facility exceeds its carbon intensity benchmarks, they will need to purchase allowances from more efficient facilities. China's carbon market will eventually cover eight sectors by the end of 2025, including: electricity, petrochemicals, chemicals, building materials, steel, nonferrous metals, paper and aviation.

With the inclusion of China, carbon pricing efforts have now reached critical mass globally. China produces around half the world's coal power, meaning two-thirds of the global coal fleet is covered by a carbon price when other existing carbon markets are included. China also produces about half of the world’s industrial goods. Therefore, by 2026 nearly two-thirds of stationary sources of direct carbon emissions will be priced.

Not all carbon prices are equal, however. Carbon pricing is a complicated business, as it can be designed to arise explicitly or implicitly. An explicit carbon price is provided by trading or taxation, while an implicit carbon price is embedded in other policies that influence abatement opportunities. Mandates for renewable carbon energy, for instance, have an implicit carbon price which can be expressed as the net cost of investing in renewable energy divided by the amount of carbon abated over the project lifetime. China has a huge and world leading renewable energy industry, which obfuscates the role of China’s explicit ETS price. Based on TransitionZero analysis, with power market reform, the switch from coal to renewables could be negative $20/tCO2.

More importantly, due to free allocations, the traded price is rarely what regulated entities actually pay. Regarding China’s ETS, those efficient coal generators whose units operate under the carbon intensity benchmark will pay a negative carbon price, meaning they now have an additional revenue stream from burning coal. A similar situation is present in South Korea’s ETS, where coal generators are compensated via both free allocations and out-of-market payments.

Oversupply is a feature of early markets

Oversupply tends to be a feature, not a bug of new carbon markets. China’s ETS is likely no exception. Based on TransitionZero analysis, the market will be oversupplied by 1.6 billion tonnes in total in 2019 and 2020. Getting buy-in from regulated entities is easier if the rules are relaxed. Regulated entities also tend to have a monopoly over facility-level emissions data, unless previously mandated to make the data publicly available. Due to this, companies tend to provide an optimistic outlook for future emissions to maximise the allocations they receive. This was the case with the EU ETS, which was initially oversupplied due to generous free allocations. It is for this reason that carbon markets should be judged by the cap, not the price they generate.

If China intends to rely on its ETS to drive abatement, it will need to overhaul the intensity benchmarks and replace them with an absolute emissions cap as soon as possible. At the same time, the government will need to pay particular attention to the ability and willingness of local governments to undertake the monitoring, reporting and verification process effectively. Making emissions data publicly available would help. But we believe the government will also need to harness its surveillance capabilities to minimise data falsification.

Policy portfolios, not silver bullets

Economists have consistently argued that when there are multiple market and policy failures, several policies are needed to reduce emissions as cheaply as possible, with each policy targeting a particular market failure. It is for this reason that governments almost always pursue a portfolio approach, including:

1. Energy efficiency policies to unlock abatement potential otherwise untapped by a carbon price signal;

2. Technology deployment policies to drive existing options down the abatement cost curve; and

3. Research and development to bring forward new mitigation options.

The role of carbon pricing tends to be limited to driving marginal cost decisions in mature technologies. The most obvious example is incentivising fuel switching from coal to gas in electricity generation. Historically, coal generation has been cheaper than gas. Since gas has a lower carbon intensity than coal, if the carbon price gets high enough it can become more profitable to burn gas than coal. This level is termed the fuel switch price.

This dynamic is one of the reasons for the UK’s dramatic decline in coal use, from 40% of the electricity mix in 2012 to effectively nothing today. Renewable energy is becoming increasingly mature and therefore carbon pricing is likely to incentivise a switch from coal and gas to wind, solar and storage by keeping wholesale power prices sufficiently high to incentivise merchant investments in these technologies.

Expecting carbon pricing to do more than drive decision making in mature technologies is misguided. The reason is nascent zero carbon technologies benefit from learning by doing. The more we produce and consume them, the cheaper they become. This is something ignored by carbon pricing, which prices the carbon produced today but does not take account of the carbon we might save tomorrow.

China and Asian economies will decarbonise via industrial strategies

The net zero transition is an economic transformation. Asian governments are masters of using industrial strategies to transform their economies. The previous interventions used by Japan, South Korea, Taiwan, and China to speed up economic development involved a complex mix of supply side investments and regulation targeted at specific sectors.

This reality, coupled with the primacy of growth targets in decision making and the tendency to subsidise electricity prices, leads us to conclude China and other Asian nations will decarbonise primarily through industrial strategies rather than market mechanisms. Given the increasingly known limitations of carbon pricing, this is neither a good or bad thing, but reflects a 21st Century trend: decarbonising is as much about competition as collaboration. Competing to decarbonise, and receiving the economic prize that comes with it, should be lauded.

This article was originally posted on Carbon Pulse, an online, subscription-based B2B service dedicated to providing in-depth news and intelligence about carbon pricing initiatives and climate change policies around the world.