China announced the long-anticipated national rollout of its emissions trading scheme (ETS) in January, extending the efforts of pilot programs in seven regions over the past seven years. The rollout will be conducted in phases, with the first phase spanning seven sectors including utilities, petrochemicals, paper, and airlines. The Ministry for Ecology and Environment already allocated quotas covering 2,225 utility companies in January, with trading commencing in February and mandatory compliance by year-end.
Even within this initial phase, the scope of this rollout already sets China up to overtake the European Union as the world’s largest carbon market. At the moment, the allocation of free carbon credits implies 1% efficiency gains on average for the sector, and 3–5% of payable credits. This means that companies that fail to achieve emissions reduction of 4–6% would have to purchase credits in the market. Over time, the allocation of free credits would decrease, which would further boost trading volumes in the market. For this initial phase, the largest earnings impact would be for the power sector, from an estimated –9% for inefficient thermal power plants, to +7% for hydropower plants, based on the current carbon price of CNY 30 per ton. Outside of the power sector, we expect a low-single-digit earnings impact on heavy power usage industries such as aluminum, steel, and cement. While this may seem manageable in the near term, sensitivities could arise significantly should carbon pricing in the official national ETS rise higher than that in the pilot, or if credit allocations are tightened more aggressively in the coming years.
Carbon pricing has been an area of extensive research and policy study for decades, and have gradually gained prominence as a policy tool in climate mitigation globally. Emissions systems provide a market-based, two-way reward and penalty system to incentivize companies to reduce emissions, and is more progressive than simple carbon taxation. Furthermore, they can develop to become additional sources of fiscal revenue—estimated to already exceed USD 45 billion in 2019, based on World Bank data. The full potential of carbon pricing as a policy tool hinges on the establishment of a liquid, functional market. Currently, the global carbon market remains nascent and fragmented, with over 60 carbon pricing initiatives at local, national, and regional levels. According to the World Bank, market volume makes up just over 20% of total global emissions, and even in the most developed market, the EU ETS, market volumes still only meet 40–45% of total emissions in the region.
More important, current carbon price levels remain too low in most parts of the world. As mentioned earlier, carbon prices have averaged CNY 30/t (USD 4.6/t) in China, and even in Europe, estimated 2021 prices of USD 30–35/t still fall short of the EPA's estimate of USD 41/t carbon cost to society. Furthermore, the High-Level Commission on Carbon Prices targets carbon prices of USD 50–100/t by 2030 to achieve Paris Agreement outcomes.
Apart from financial alignment and incentives, a welcome byproduct of China’s ETS is increased data transparency in related issues. As part of the infrastructure build, there are now legal liabilities and fines that force Chinese corporates to accurately report emissions data, based on official standards, which would also be made public.