Emissions trading scheme (ETS), also commonly called carbon market, is regarded as an effective policy measure to incentivize reduction of greenhouse gas (GHG) emissions. Generally, governments or other designated authorities determine a limit on GHG emissions for participants in the carbon markets and allocate emissions allowances within a timeframe to each company. Participants exceeding their allowances could purchase emissions quotas from those with spare volumes. In turn, participants emitting under their limits could sell those extra quotas at the market price. This cap-and-trade mechanism places a financial incentive on businesses to drive down emissions as far below the allowances as possible.
The origin of the cap-and-trade model for pollution reduction comes from the US in the 1980s and 1990s, when the model was successfully used to phase out lead in petrol and sulfur dioxide (SO2) and nitrous oxide (N2O) to combat acid rains. Today, this cap-and-trade model is widely deployed to drive down GHG emissions in key sectors. While ETS is often called carbon market, carbon dioxide (CO2) is far from the only GHG accounted. There are many types of GHG emitted to the atmosphere that have much higher global warming potentials (GWP) than CO2. For example, methane (CH4) is another commonly emitted GHG with a GWP 28 times higher than CO2. In other words, emitting one unit of CH4 is equivalent to emitting 28 units of CO2. Therefore, carbon markets generally trade in the unit of CO2 equivalent (CO2e) to account for various kinds of GHG.
Carbon Tax vs. Carbon Market
It is common to combine carbon tax with carbon market in climate policy discussions. Both methods put a price on carbon and aim to decrease GHG emissions and stimulate investment and development in low-carbon technologies. If ETS chooses to auction emissions allowances off to companies, both carbon tax and ETS will generate government revenue which can be channeled towards more green development projects.
While carbon tax and carbon market may sound similar, there are key distinctions between the two. Carbon tax is a government-mandated strategy which requires public authorities to assign a fixed price on GHG emissions, charging an amount for every unit of emissions produced. The market eventually adjusts its emissions output according to this added cost. As a result, the final emissions volume under a carbon tax policy is determined by the market and is more unpredictable. A carbon market allows public authorities to determine the desired final emissions volume each year and allocate emissions allowances accordingly, letting the market determine the price of GHG emissions. Within the carbon market, the price of GHG emissions fluctuates.
The table below highlights some key advantages and disadvantages of carbon tax vs. ETS:
These two methods may be applied in conjunction to motivate different industries more effectively. In general, carbon tax is more suitable for managing emissions in smaller-scale industries, whereas carbon market is for managing larger and heavy-polluting industries.
Development of ETS in China
The plan for a carbon market in China has been in motion since 2011, when seven pilot schemes were established at local jurisdictions, including Beijing, Tianjin, Shanghai, Chongqing, Hubei, Guangdong, and Shenzhen. By November 2020, the pilot markets have covered about 3,000 key emitters in over 20 industries, with a total trade volume of 430m tons of CO2e valued at nearly RMB10bn. Companies within these pilot markets reported both a drop in total absolute emissions as well as emissions intensity, suggesting that ETS is a viable climate strategy for China.
Launch of National Carbon Market
China’s national ETS officially began trading on July 16, 2021. As the largest ETS in the world, China’s national ETS currently covers over 4bn tons of annual emissions. The first phase targets 2,225 coal-fired and gas-fired electricity generation enterprises, with the intent to include other energy-intensive and high-pollution industries in the coming years, such as iron and steel and chemicals. Provincial department of ecology and environment determine and allocate emissions allowances to the participating firms in their jurisdictions.
At the initial stage, the emissions cap is set at an amount close to companies’ actual emissions volumes, hence does not inflict huge emission reduction costs on those companies. This gentle start is to leave room for the companies and the market to adapt to this new system, a common practice in the initial stage of most ETS. The emissions cap is expected to lower, leading to price increases in GHG emissions and stronger emission reduction measures of companies, as China progresses along its decarbonization pathway.
Focus on Emissions Intensity
What sets China’s ETS apart from other ETS is that it focuses on the reduction of emissions intensity instead of absolute emissions volumes. In other words, the current objective values a reduction in GHG emitted to produce the same amount of energy. An energy producer making progress in the carbon market may still experience an increase in absolute emissions as their energy output increases, even if they lower the emissions per unit of energy.
China’s selection of emissions intensity instead of absolute emissions as the benchmark for its national ETS is a result of energy security concerns and continual need for development. Energy security remains a major challenge for the country, and China’s energy demand for the industrial and residential sectors continues to grow. As a result, the country requires rising domestic energy production in order to meet growing demand and support economic development, while its climate actions cannot incentivize the weakening of domestic energy supply. The intensity approach could dissuade companies from gaining excess emissions quotas by solely reducing energy output and encourage them to improve production efficiency and increase supply of low-carbon, high-quality energy.
Part 2 of this article will introduce several other ETS in the world, as well as analyze common challenges in ETS development.
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