China has implemented the world’s largest emissions trading system in an effort to reduce national greenhouse gas emissions. New research assesses the system’s benefits, costs, and effectiveness.
China’s emissions trading system, already the world’s largest trading program for carbon dioxide emissions, is expected to make a major contribution toward the nation’s goal of achieving net-zero emissions by 2060. The system takes the form of a tradable performance standard (TPS), a policy approach under which the government gives firms that are covered by the program a certain number of emissions allowances that entitle these firms to emit given amounts of carbon dioxide in corresponding compliance periods. The allowances offered are based on a firm’s assigned “benchmark”—the maximum allowable ratio of carbon dioxide emissions per unit of intended output (e.g., electricity, steel, or aluminum)—that is assigned to each firm by the government. This ratio of emissions to output also is known as a firm’s “emissions intensity.”
Importantly, firms can trade their allowances. Trading promotes larger emissions reductions by the firms that can reduce emissions at the lowest cost. This system resembles cap and trade, the emissions trading system that is most prevalent worldwide, but differs in that compliance under a TPS requires each covered firm to achieve an assigned emissions intensity (i.e., a benchmark), whereas compliance under cap and trade requires each covered firm to stay below a given absolute quantity of emissions determined by the number of allowances allocated to the firm..
In a recent working paper, we assessed the potential environmental and economic effects of China’s TPS, using an approach that enables us to consider important interactions across sectors of China’s economy, known as a general equilibrium approach. A distinguishing feature of our model is its recognition of major institutional and regulatory features of China’s economy, including the administered pricing of electricity and the presence of state-owned enterprises, which receive preferential tax treatment. Major elements of China’s tax system also are considered in the model; these elements influence the outcomes of the TPS, as we discuss later.
For our paper, we examined the three planned phases of China’s TPS that span from 2020 to 2035. The first phase was introduced preliminarily in 2020 and covered only the electricity sector, which accounted for about 43 percent of China’s total carbon dioxide emissions in 2020. The second phase is expected to begin this year and will expand coverage to include the aluminum, cement, and iron and steel sectors; together with the electricity sector, these sectors account for about 67 percent of China’s carbon dioxide emissions. The third phase is expected to begin in 2026, with coverage further expanding to include all emissions-intensive industries and around 70 percent of China’s carbon dioxide emissions. The emission-intensive industries likely to be included in the third phase include pulp and paper, other nonmetal products, other non-iron metals, raw chemicals, and petroleum refining.
How Large Are the Emissions Reductions?
China’s baseline emissions—a projection of China’s emissions in the absence of the TPS—are projected to grow by approximately 2.3 percent annually between 2020 and 2035, from 10,800 million tons in 2020 to 15,300 million tons in 2035. (These projections include carbon dioxide emissions from fuel combustion and various production processes.) The projected emissions reductions under the TPS become larger as the system’s coverage expands and the benchmarks are tightened (Figure 1). By 2035, we estimate that emissions will decrease by about 20 percent relative to the projected baseline in the scenario without the TPS.
Figure 1. Projected emissions reductions in China relative to a scenario without the tradable performance standard
Notes: The projected emissions reductions result from the central values of parameters in our model. The numbers in italics below the x-axis indicate the average percent emission reductions in each phase.
Clearly, China’s goal of achieving net-zero emissions by 2060 will require more extensive emissions reductions. The acceleration of emissions reductions in Figure 1 can be viewed as consistent with China’s expectation that the TPS will contribute about half of the emissions reductions that will be needed to achieve net-zero emissions by 2060.
How Do the Program’s Benefits Compare with Its Costs?
We find that the environmental benefits from the TPS well exceed the gross economic costs (Figure 2). Using plausible parameters in our model, the estimated benefits from the cumulative reductions in carbon dioxide emissions from 2020 to 2035 are in the range of 6 trillion–43 trillion renminbi (RMB; the official currency of China), which is 3–22 times greater than the cumulative costs. The central estimate of the benefit to the environment is 10 trillion RMB, around 5 times greater than the cost of the TPS. These ratios apply when we employ the Biden administration’s estimate of the social cost of carbon—a projection of the benefit to society of avoiding one additional ton of carbon dioxide emissions. Recent studies project estimates of the social cost of carbon that are considerably larger. Employing these most recent estimates yields even higher benefit-cost ratios.
The net benefits of China’s TPS also are considerably higher when the health benefits from reductions in local pollution are accounted for. The central estimate is that the TPS could prevent 2.3 million–2.5 million premature deaths from 2020 to 2035 due to reduced exposure to PM2.5, which is particulate matter pollution that is smaller than 2.5 microns in diameter. In monetary terms, the present value of the environmental and health benefits of the TPS over this time interval is 19 trillion–122 trillion RMB, and the central estimate is 53 trillion RMB, which is 26 times greater than the central estimate for the cost of the TPS.
Figure 2. Benefits and costs of China’s tradable performance standard
Notes: RMB is an abbreviation for renminbi, which is the official currency of China.
We also find that the planned stringency of China’s TPS is less than the level of stringency that would maximize the efficiency of the program. Maximizing efficiency requires that the cost of reducing emissions by a given unit (e.g., one ton of carbon dioxide emissions), also known as the marginal cost, is equal to the environmental benefit that’s derived from the reduction of that unit of emissions, which is known as the marginal benefit. Our results indicate that the average marginal cost from 2020 to 2035 (when we account for the difference in the valuation of impacts experienced in the future versus impacts that are experienced today) is well below the Biden administration’s central estimates of the marginal benefits from emissions reductions during this interval, which is expressed by the administration’s estimate of the social cost of carbon.
Using these figures, the benchmarks in China’s TPS would need to be 9 percent lower than the current and planned benchmarks to maximize the efficiency of the program. Efficiency-maximizing benchmarks would double the emissions reductions, relative to the expected reductions with the current and projected benchmarks, over the interval 2020–2035.
Using the higher estimates of the social cost of carbon from recent studies would call for still greater stringency and associated emissions reductions, if the goal is maximizing efficiency (i.e., maximizing net benefits).
Would Cap and Trade Be More Cost-Effective?
An important choice for China’s policymakers on emissions trading is whether to maintain the TPS or switch to cap and trade. One of the principal methods for reducing emissions is a reduction in intended output (e.g., generated electricity). Prior studies have shown that the TPS gives firms weaker incentives to employ this channel, because a reduction in output implies a reduction in the number of emissions allowances that firms receive.
Prior studies have pointed out that this weaker incentive disadvantages the TPS relative to a comparably stringent cap-and-trade system in terms of cost-effectiveness. However, we show that other factors can moderate or even eliminate this potential disadvantage.
Because China’s TPS imposes an extra cost on reductions in intended output, the supply of this output is larger (i.e., the reduction in output is smaller). Correspondingly, output prices are lower under the TPS than under cap and trade. We show that, in the presence of prior taxes on labor and capital, these lower prices yield smaller tax-related distortions to China’s economy than a cap-and-trade system would yield; as a result, the economy-wide costs of the TPS are not significantly higher than those under cap and trade. Indeed, the costs virtually are the same in the near term (Figure 3).
Figure 3. Comparison of the costs of a tradable performance standard and cap and trade
Notes: Baseline GDP refers to the China’s projected GDP in the absence of a tradable performance standard and cap and trade. The numbers below each year denoted on the x-axis indicate the percent that emissions are reduced during each interval relative to a scenario with neither a TPS nor a cap-and-trade system in place.
Trade-Offs between Efficiency and Fairness
China’s policymakers aim to achieve cost-effective emissions reductions while ensuring fairness across sectors, regions, and demographics. These objectives can be in conflict, and we identify trade-offs between cost-effectiveness and fairness in our working paper.
Figure 4 shows the economic costs in cases that differ in terms of the benchmarks. Employing a single benchmark for the electricity sector would reduce costs by 34 percent from 2020 to 2035 relative to the four-benchmark system that currently is in place. Greater uniformity across facilities reduces the aggregate cost by reducing the variation in the implicit subsidy for output from the TPS; uniformity also reduces the difference between output price and the cost of producing an additional unit of electricity (e.g., one megawatt). These reductions lead to a more efficient allocation of electricity generation across facilities.
Figure 4. Cost of the tradable performance standard as function of the number of benchmarks
Note: TPS = tradable performance standard. Baseline GDP refers to the China’s projected GDP in the absence of a tradable performance standard and cap and trade.
However, the use of multiple benchmarks can help distribute the benefits of the TPS more evenly across China’s provinces. Provinces differ significantly in terms of the composition of their economic sectors and the associated average emissions intensity of production. If a single benchmark were applied across sectors, the provinces with higher average emissions intensities would experience overall costs of compliance that are especially high.
Policymakers in China employed four benchmarks in the electricity sector to reduce disparities in compliance costs across sectors and provinces. For example, coal-fired electricity generators, which have relatively high baseline emissions intensities, face benchmarks that are higher (i.e., less stringent) than the benchmarks for natural gas–fired generators.
Although the four-benchmark system involves higher aggregate costs, this system leads to a more even distribution of the benefits and costs of the TPS across provinces. We compared the impacts on facility profits across economic sectors and provinces under alternative benchmark specifications by analyzing data on how provinces differ in their reliance on different types of electricity generation. We find that the four-benchmark approach leads to more evenly distributed impacts on profits across provinces. Decreases in income across provinces also vary much less: the standard deviation of percentage income losses across provinces is more than 40 percent lower in the four-benchmark case than in the one-benchmark case.
The Significance of China’s Tradable Performance Standard
China’s nationwide TPS is ambitious, with the potential to contribute significantly to the achievement of China’s goals for reducing emissions of carbon dioxide. And the implementation of this program is important for the world, given China’s status as the world’s largest emitter of greenhouse gases. Our findings can help policymakers in China as they continue to make decisions about the design of the evolving TPS. Decisionmakers in other nations that are considering the introduction of emissions trading systems in the form of a TPS may benefit from our findings, as well.
