Big Steps, High Stakes: Preparing to Trade Carbon Dioxide in China

China is preparing to launch the world’s largest emissions trading system (ETS) for carbon dioxide (CO₂) before the end of 2017. This ambitious venture will have implications not only for China’s energy system and economy, but also for climate policy across the globe. At full scale, the Chinese ETS would increase the share of global CO₂ emissions subject to controls by over 50 percent.

Will the experiment be successful? According to contributors for a newly-released special issue of the journal Economics of Energy and Environmental Policy, the outcome will depend critically on system design choices. Prior international experience with emissions trading—for example, systems in the European Union and California that target greenhouse gases or sulfur dioxide trading in the United States—offers important lessons that, if learned, can help assure success of the program.

At the same time, China will confront unique challenges because its economy differs in important ways from the settings where emissions trading has been introduced previously. It is less developed, a larger share of its economy is subject to state control, and markets still play a limited role in many aspects of energy sector operation. Designing a robust emissions trading system thus requires combining the lessons from other systems with on-the-ground, local expertise.

In China’s ETS, emissions rights (allowances) are awarded each year based on government-set benchmarks for the ratio of emissions to physical output. This structure gives firms incentives to use less energy and emit less CO₂ per unit of output, since firms can sell allowances to the extent that their emissions-output ratios are below the benchmark. Firms with emissions-output ratios above the benchmark will need to purchase allowances to validate the extra emissions. The system does not impose any particular production method on firms. Instead, it gives firms considerable flexibility, allowing them to determine the least-cost way to reduce emissions.

At full scale, the Chinese system is expected to cover around 7,000 enterprises in the electric power, energy-intensive manufacturing, and civil aviation sectors, although it may launch initially with a subset of the longer list.

This impressive initiative holds great promise. At the same time, successfully establishing the program will not be easy for several reasons.

For one, the administrative challenges are huge. A robust nationwide emissions accounting system will be essential, as current uneven measurement, reporting, and verification capabilities and incentives could leave the system porous and ineffective. In addition, large differences in per-capita income and local economic priorities will challenge efforts to converge on a system that is both equitable and regionally consistent. Finally, state monopolies and fixed pricing for some energy types could interfere with system function, as an ETS relies on increasing the marginal cost to consumers of consuming CO₂-intensive energy sources.

The experts contributing to the special issue have offered important recommendations, combining insights from foreign and domestic experience. These include establishing a strong and uniform legal basis for the system to help ensure that firms provide accurate data and meet reduction obligations or face sufficiently steep penalties. Early evidence from seven regional pilot emissions trading programs in 2013–2015 suggests that places with greater buy-in from local officials, stronger enforcement capabilities, and well-functioning markets have fared best. The need to build institutional foundations along with the system itself implies that the system will take time to realize its potential. Much will be learned as the system evolves, and a long-term commitment to periodic evaluation and improvement will be essential to achieving the best program over time.

China’s emissions trading system has the potential to be a model for achieving CO₂ reductions in an environmentally effective, economically efficient, and equitable way in a developing country.

The contents of the special issue of the Economics of Energy and Environmental Policy are based on an expert dialogue hosted by Resources for the Future and the Stanford Environmental and Energy Policy Analysis Center.