Trading places?

Europe’s emissions trading scheme is no longer the only game in town. A new report considers the challenge posed by China’s carbon market pilots, writes Rob Elsworth.

The European Union (EU) has long seen itself in the vanguard of action on climate change. At the centre of its climate policy is the EU emissions trading scheme (ETS). Covering around half of the EU’s emissions of CO2, it is designed to put a price on carbon, incentivising companies to reduce emissions and drive investment in low-carbon technologies.

But while the EU’s scheme is the biggest in the world, it is struggling to maintain traction. Awash with too many carbon allowances due to over-allocation and the effects of an unforeseen recession, the scheme looks to be fundamentally failing to achieve what it was designed to do.

Pressure to fix the scheme is mounting and there is growing political consensus – supported by a raft of progressive business voices including Shell, Philips, Doosan and Unilever amongst others – that the European Commission should take appropriate action to reduce the oversupply of allowances in order to bolster the carbon price, giving a clearer investment signal to businesses.

Once the only game in town, the EU ETS is being joined by a range of new regional emissions trading schemes: New Zealand, Australia, South Korea – and now China. A new report on emissions trading in China, by my organisation Sandbag, a UK-based NGO focused on the issue of carbon trading, shows the speed at and extent to which things are changing. The report argues that Europe must now fix its own faltering scheme by removing the large oversupply of allowances currently flooding the market and preventing it from functioning correctly.

It will come as no surprise to those who follow international climate negotiations that the EU’s preferred climate policy is emissions trading. With this in mind, an internationally linked carbon market based on mandatory national ETSs is the proverbial “holy grail”. However, the failure of the United States to ratify the Kyoto Protocol and its subsequent reluctance to adopt a national emissions trading scheme has left the EU without a natural partner.

Developing countries not bound by emissions reduction commitments looked to the Kyoto Protocol’s clean development mechanism (CDM) as a way to engage with carbon markets and bring in much needed investment. While the CDM has provided an important learning curve and source of investment for developing countries, its “baseline and credit” approach means carbon credits are generated for emissions reduction set below a baseline. This approach maintains a dependency on mandatory schemes to sell credits into, notably the EU ETS.

The EU has increasingly sought to wean countries off baseline and credit mechanisms – such as the CDM – in favour of mandatory emissions trading schemes with a fixed cap on emissions, or “cap-and-trade” schemes. To this end, the EU and its member states have invested in projects to assist countries, including China, with capacity building and knowledge sharing in developing and setting up emissions trading schemes.

However, neither the EU nor the rest of the international community counted on China moving to implement its own ETS as part of its domestic policy. Over the past 30 years, China has experienced unprecedented economic growth. Its ability to provide cheap goods for western export markets, coupled with the opening up of domestic markets, has transformed the country.

Yet a reliance on low-skilled labour coupled with high resource use is bringing with it increasingly unwelcome social, environmental and political tensions. The Chinese authorities are acutely aware that environmental pressures can overflow into social unrest and so any future economic growth must be done in a sustainable way.

China is also increasingly conscious that its ability to deal with escalating environmental concerns through traditional command and control measures are ever more inadequate. China’s economy has become too sophisticated to be managed in a traditional style. Command and control measures are no longer able to deliver the desired results and attitudes need to change fundamentally to embrace innovation and sustainability.

This has led China to pursue a more sustainable economic model focusing on qualitative economic and social development. The newly adopted 12th Five Year Plan (FYP) plan includes prominent energy efficiency and carbon intensity targets. Touted as the greenest FYP ever, it introduces emission trading as one of the innovative new policy tools to be tested. China has already announced pilot projects to be implemented in five municipal areas, Beijing, Chongqing, Shanghai, Shenzhen and Tianjin, and two provinces – Guangdong and Hubei – from 2013.

The diverse locations of these seven projects means that they will reflect different levels of economic activity and development, allowing China to test various emissions trading models and meaning that experience can be gathered on a municipal and provincial level before any such scheme is implemented on the national level in 2016.

While the Chinese pilot projects are taking shape faster than many may have envisaged, it’s important that expectations are managed. For all the hype, these pilots are still a long way from being implemented successfully. Moreover, these pilots, being the first to look at the practicalities around implementing emissions trading in China, face a range of technical and practical challenges. 

report by China’s Development Research Centre highlighted a number of pressing concerns, including: issues surrounding the distribution of allowances; market behaviour; trading regulations; responsibilities of parties; and legal infrastructure. Further concerns remain around how to establish a cap based on an energy intensity target, determining which sectors are to be included and how to incorporate downstream as well as upstream emissions into any scheme.

Another key challenge for China is how to bring the power sector into an emissions trading scheme when the price of electricity is regulated. Finally, and perhaps most importantly in emissions trading, all market participants must have confidence that what they are trading is genuine. This places a high degree of importance on the monitoring and verification of the activities of the participants. 

While the EU ETS is struggling to remain relevant under the weight of excess carbon allowances, it has still gathered a vast amount of experience. Operational since 2005, the EU ETS has the dubious honour of being the first such scheme and it can boast a range of learning-by-doing experiences. With the luxury of hindsight, it’s unlikely that the EU would make the same mistakes twice. Likewise, China must think if the same could happen to its scheme in the future – and how similar issues could be avoided.

The challenges facing China mean that in developing Chinese solutions, the experience and expertise gathered by the EU will be invaluable. As will a strengthened partnership between the EU and China on climate-change issue. But the world does not stay static for long and China’s ambitions are clear. Failure by the EU not to fix its own ailing ETS would be nothing more than misguided complacency, which would risk leaving the EU ETS trailing other more flexible schemes.

Rob Elsworth is a policy officer at Sandbag.

This article is published as part of our Green Growth project, a collaboration between chinadialogue and The Energy Foundation.

Homepage image by Greenpeace