China has just launched the world's largest carbon market. Here's what you need to know

In the lead up to the 2015 Paris climate summit, premier Xi Jinping announced China would launch a carbon market in two years. Today (Dec. 19), Xi delivered on his promise, opening up what will become the world’s largest carbon market. If wielded wisely, it could help the world’s biggest emitter of greenhouse gases hit the goals set under the Paris accord and avoid catastrophic climate change.

What is a carbon market?

Put simply, a carbon market is a marketplace where carbon emissions can be traded. It allows governments to put a price on carbon emissions, so companies can’t pass environmental costs on to the public, the way they do today.

Carbon markets can be implemented in many ways. The most popular is a cap-and-trade scheme, where the government sets a cap on a company’s emissions based on certain factors like the type of industry it belongs to and the ease with which the industry could feasibly reduce its emissions. Typically, the cap is reduced gradually each year to help the government reach its country’s emission goals.

If a company beats the government’s targets, it can sell any additional “saved” carbon emissions on the market. Other companies that failed to hit reduction targets can buy those saved emissions to artificially reach their goals. This incentivizes polluters to pollute less.

Why don’t governments just force companies to adhere to emissions limits?

Broadly speaking, a government has two three levers it can pull to address environmental problems: setting emissions limits, instituting carbon taxes, and facilitating a carbon market.

Sulfur emissions are a good example of how setting limits can work. Sulfur emissions cause of acid rain, which harms plants, fish, and infrastructure, and many governments simply regulate the sulfur emissions of industries burning fossil fuels. If companies in those industries want to stay in operation, they either have to burn fuels that don’t produce sulfur (like methane) or install equipment that traps sulfur before it gets into the air.

Strict regulations for carbon emissions are a much tougher ask of industry, because there is no fossil fuel that doesn’t emit carbon dioxide. Companies could capture all their carbon emissions and bury them underground, but critics of the carbon-capture process say it’s currently such an economic burden that it would put companies—and their industries—at risk of economic collapse. Advocates, on the other hand, argue that the cost of carbon capture is much lower than the harm the emissions are likely to cause in the future. In any case, it’s not yet palatable at the scale needed to rapidly reduce greenhouse gas emissions.

Ideally, we would strictly regulate carbon emissions, speed towards the end of fossil fuels, and live in a zero-carbon world. But fossil-fuel burning industries produce vital products—electricity, petrochemicals, cement, and steel, among many others—and we don’t have economical replacement for them.

What about a carbon tax?

Rather than limiting emissions, governments could use their second lever: levying a tax on the emissions. It’s a more market-friendly approach, especially if the carbon tax starts relatively low and increases only gradually.

In most countries, however, tax arguments don’t go down well. In the US, for example, Republicans typically argue for fewer taxes and Democrats for more. And though a small group of Republicans have come out in favor of a carbon tax, they can’t agree with Democrats on how best to use the potential tax revenue, so talks have stalled.

Because of these reasons, governments that want to reduce carbon emissions in their country often have no choice but to use their final lever: implementing a carbon market. One thing that makes carbon markets ideal is that they can work alongside emissions regulations and carbon taxes. So in China’s case, there’s a door’s open to implement other emissions-reduction schemes in the future.

Are there other carbon markets in the world?

The European Union runs an emissions trading scheme (ETS) which covers emissions from electricity, industry, and aviation—covering about 40% of all emissions from the region. In 2015, the market traded about €49 billion ($55 billion) worth of carbon allowances. The current price of one ton of emissions traded on the scheme is about €7 ($8.25).

How will China’s carbon market work?

The carbon market will at first only apply to emissions from power plants producing more than 26,000 tons of carbon dioxide per year—which means almost all of China’s power plants will be included. Those power plants are estimated to produce 39% of China’s national emissions.

The volume of emissions from China’s electricity sector is so large, that even without including any other industries, the country’s carbon market will rapidly grow to become larger than the world’s current biggest, in Europe.

What immediate environmental benefits will the market bring?

At launch, the government is likely to set the cap high, allowing most power plants to keep emitting as they do. If so, there won’t be much emissions reductions.

Crucially, however, all the power plants required to participate in the market will go through a rigorous verification process and then ongoing monitoring. That means, for the first time, the Chinese government will be able to build an accurate measure of the emissions coming from the power sector. It’s a huge benefit in a country notorious for lack of trusted data.

Already, companies are starting to respond. In the two years since Xi announced plans to launch the market, a number of industries have preemptively been getting ready for this day. Nicolette Bartlett, director of carbon pricing at the environmental charity CDP, told the FT(paywall) that the number of Chinese companies implementing or planning for mandatory carbon trading rose from 54 in 2015 to 102 in 207; that’s out of 336 companies that responded to CDP’s questionnaire.

In the long term, the government could lower the cap in increments small enough to raise the price of emissions and thus disincentivize polluters, without crippling the country’s energy sector. Increasing the cost of carbon emissions also makes zero-carbon renewable energy more competitive.

What will be the initial price of emissions on China’s carbon market?

China has been running trial carbon markets in seven provinces in order to figure out these sorts of details. A director at the China Emission Exchange in Guangzhou, who runs the Guangdong province’s carbon market and who asked not to be named, predicts the initial price will be about 50 yuan ($7.50) per ton of emissions. Trading won’t start on Dec. 19, because the government is only now announcing detailed plans of how the market will operate. It’s not clear when exactly trading will start, but the Guangzhou China Emission Exchange director expects the price to rise gradually to about 300 yuan ($45) per ton.

Economists estimate that every ton of carbon dioxide emitted today will likely cause $125 worth of damage to society in the future. This number is known as the social cost of carbon. The closer the price of emissions on the carbon market gets to this figure, the better chance there is of the market having a real impact mitigating climate change.

What could be the potential problems?

Like most in finance, the EU emissions-trading scheme (ETS) didn’t anticipate the 2008 crisis. The region’s economy took a sharp dive, but the scheme didn’t react by reducing the number of carbon allowances (or tradable emissions) on offer. The result was that the market’s supply stayed steady while demand fell. Trading prices dropped and they haven’t really recovered. In 2008, carbon emissions traded at €25 per ton on the ETS; the price dropped to below €5 per ton in 2013, and today it hovers at about €7 per ton.

The expert at the China Emission Exchange in Guangzhou says China’s trial markets were implemented with learnings gleaned from low price of emissions in the European scheme. That said, there’s nothing in place to ensure what happened with the ETS won’t happen in China—ultimately it’s up to Beijing to make decisions in response to changing markets. But he hopes the Chinese government won’t overreact to any future economic challenges by giving away too many allowances.

What’s the takeaway?

Among developing countries, China is the first large economy to implement a carbon market. Though the market may not produce a reduction in emissions immediately, it sends a signal to the world that China is serious about doing its part to help the planet avoid catastrophic climate change.

After Donald Trump pulled the US out of the Paris climate agreement, China has vied for the role of global leader on climate action that the US formerly played. It’s telling that, on the same day China launched a market-friendly tool to cut its own emissions and hit Paris goals, Trump signed a document that doesn’t acknowledge climate change as a real national-security threat.