China's new carbon market aims to  substantially reduce its emissions. Here's how

The world’s largest contributor to CO2 emissions is now implementing the world’s largest market to reduce such emissions.

China has recently set forth a 'dual carbon' national goal – reaching peak carbon emissions by 2030 and achieving carbon neutrality by 2060. These bold objectives, a part of President Xi Jinping’s 'ecological civilization' policy vision, are being promoted by the country’s newly formed nationwide CO2 emissions trading system – a system that harnesses market forces to achieve significant reductions in CO2 emissions.

China’s system is known as the tradable performance standard (TPS). Launched in July 2021, this nationwide programme succeeds earlier regional pilot programmes and is expected to contribute approximately half of China’s CO2 emissions reductions by 2060. Currently the TPS covers only China’s power sector, but once fully implemented it will embrace eight carbon-intensive sectors.

Economic analysis supports emissions trading systems as a cost-effective way of reducing emissions. Such systems establish a market for emissions allowances, where each allowance entitles a covered facility to a certain quantity of emissions of a pollutant (such as CO2) within a given period of time. The market yields a price for these allowances, and as a result covered facilities face a cost for their emissions. The allowance price causes such facilities to 'internalize' the environmental cost of their emissions and thus induces them to emit less.

One attraction of emissions trading systems is the provision for trading. In general, facilities for which the costs of compliance are especially high will wish to purchase emissions allowances on the market in order to emit more, while facilities for which the costs are low will gain by selling some of their allowances and reducing emissions further. Trades benefit both buyers and sellers, and they lead to more of the work being undertaken by facilities whose costs are especially low. This reduces society’s overall costs of emissions abatement.

While the benefits of trading apply both to China’s emissions trading system and to the systems used in other countries, China’s TPS differs from emissions trading systems used elsewhere. Other nations have tended to employ mass-based systems, in which compliance depends on keeping the absolute level of emissions below some value – cap-and-trade is one example. In contrast, China’s system is intensity-based: a facility’s compliance depends on a facility’s achieving an emissions intensity – in other words, its emissions-output ratio – that does not exceed a benchmark ratio set by the government.

Covered facilities can achieve compliance in three ways:

1. Reducing emissions intensity.

2. Purchasing emissions allowances.

3. Reducing intended output.

The third channel is important for facilities whose initial emissions-output ratios exceed their benchmarks. For such facilities, reducing output reduces the number of allowances that must be purchased.

This intensity-based approach has both attractions and limitations. One attraction is that the effective stringency of the system – the fraction by which a facility must reduce its emissions-output ratio – is not influenced by the ups and downs of the business cycle. In boom times, a covered facility that increases its intended output (of electricity, for example) to meet market demands will receive more emissions allowances, in keeping with the increase in output. This automatic adjustment in the number of allowances allocated helps reduce the sensitivity of compliance costs to the state of the economy.

This is an important attraction of the TPS: when macroeconomic conditions change, the levels of production can change without directly changing compliance costs. This contrasts with cap and trade, where the quantity of emissions consistent with compliance does not change based on macroeconomic conditions.

At the same time, a limitation of the TPS is that it achieves a given reduction in CO2 emissions at somewhat higher cost than cap and trade. The reason is that the TPS does not exploit output-reduction as fully as cap and trade as a channel for reducing emissions. This is because reducing output involves an extra sacrifice under the TPS: the number of emissions allowances allocated declines proportionately with the scale of output. As a result, covered facilities must rely much more on reduced emissions intensities as a channel for compliance. Economic analyses indicate that this compromises the TPS’s cost-effectiveness. A recent paper estimates that the cost of achieving the desired reductions in the first phase of the TPS is about 35% higher than would be the case under an equivalently stringent cap-and-trade system.

Another potential limitation of the TPS is that it leaves uncertain the allowance prices that the system will produce. This uncertainty applies to other emissions trading systems as well. China’s Ministry of Ecology and Environment, the ministry charged with implementing the TPS, is seriously considering introducing an allowance price floor. To establish the floor, the government would reduce the supply of allowances as needed to prevent the market price from falling below the floor price. The supply could be adjusted through an allowance auction, where the number of allowances offered through auction would be set at levels consistent with maintaining prices above the floor. Reducing the uncertainty about allowance prices can be a boon to investors in the energy industries.

Although many regard China’s new TPS venture as off to a good start, there remains considerable uncertainty about its future environmental and economic impacts. The first, power-sector-only phase of the TPS is expected to reduce power-sector emissions by about 5%. Future costs and environmental impacts will depend on the stringency of the power-sector benchmarks as well as the choice of benchmarks for the additional sectors to be covered in the future. At present, the future benchmarks are uncertain. It is clear, though, that the system’s stringency would need to be increased substantially for the TPS to meet its aim of contributing half of the CO2 emission reductions China needs to meet its 2060 net-zero target.

The TPS is a critical part of China’s effort to address climate change. This new policy commitment holds great promise, but much remains uncertain about its future evolution. Still, this nationwide effort is a major step forward in China’s commitment to a green economic future.