Darley Shen / Reuters A statue of Mao Zedong in front of smoking chimneys at a factory in Wuhan, March 2013.

China's Carbon Markets

How Beijing Is Leading With Cap-and-Trade

China was deathly hot and fevered with excitement about the Olympics, which it was about to host. I was there for a celebration of another sort: the ceremonial signing of an agreement I had helped negotiate to create the Tianjin Climate Exchange (TCX), the first of China’s seven pilot carbon markets. At the time, it was a landmark in the integration of environmental and economic imperatives. TCX would explore how to use a cap-and-trade system and carbon pricing to encourage the reduction of greenhouse gas emissions.   It was a joint venture between China National Petroleum Company (CNPC), a subsidiary of PetroChina, the vast state-owned oil company; the City of Tianjin, eager to establish itself as a modern financial hub; and the Chicago Climate Exchange (CCX), whose founder was financial innovator and economist Richard L. Sandor, who was eventually awarded the Légion d’honneur by the government of France for his pioneering work in environmental markets.

Now eight years later, after observing the seven pilot programs and signing on to a bilateral climate change initiative with the Obama administration, China is poised to launch a national cap-and-trade system and national “carbon market” in either late 2016 or early 2017.  The rules of the national market are being developed, and will draw upon lessons from the pilots, such as which sectors will be covered and whether to auction initial allowances. Overall, the Chinese market will be similar to other commodity markets worldwide and to the European Union’s own climate change cap-and-trade program (EU ETS).

But the Chinese carbon market will soon dwarf all the others, and it is likely to set the de facto benchmark price, which all other markets, traders, emitting companies, and financial institutions will have to consider. In turn, China’s carbon market could change the foreign policy landscape; establishing a viable global trading system for greenhouse gas emissions will require significant international cooperation, capacity building, transparency, and inter-governmental trust.

The irony is apparent: the United States invented cap-and-trade in the 1970s to address the acid rain problem largely caused by sulfur dioxide emissions. The Clean Air Act was superbly successful, and as the climate change problem grew, the United States exported its cap-and-trade know-how to the European Union. But then, the United States lost ground. In 2010, Congress failed to establish a national carbon market when the Waxman-Markey legislation, which had passed the House of Representatives, failed to reach the Senate, giving China much room to lead.

In cap-and-trade programs, a regulatory body generally sets a maximum national “cap” on greenhouse gas emissions, which include carbon dioxide and five other major gases, and are measured in terms of carbon dioxide equivalent (CO2e), gradually ratcheting down permissible emissions, as if putting a nation on a “low-carbon”  diet. Known emitters, such as utilities and large industrial companies, can buy allowances to emit but must also compete with each other to reduce emissions, on the theory that the cost of allowances will rise as emissions caps are tightened. Theoretically, when the cost of buying an allowance to continue emitting a ton of CO2e becomes higher than the cost of eliminating that ton by implementing a non-fossil fuel or less polluting alternative, the company will opt for the substitute.  Cap-and-trade systems are complicated but workable, and require commodities trading expertise, clear regulatory rules, and transparency and symmetry of information. These basic components of a financial services system are nascent in China, but will be strengthened by the emergence of a cap-and-trade.

Also, in a linked global carbon market, carbon pricing could become a critical new international language, in that a ton of greenhouse gas reductions is the same physical measurement no matter where it’s emitted. This means that although carbon prices may vary country to country, the underlying commodity—the ton—is the same.  So carbon prices might be expressed in the same manner as other currencieswith prices fluctuating with regional variations.  As long as the underlying physical measurements are reliable, carbon pricing instruments could become fungible across borders. 

Of course, effective carbon markets are inextricable from the implementation of the United Nations’ Paris Agreement, concluded with much public fanfare in December 2015, which secured commitments to address climate change (termed “intended nationally determined contributions,” or INDCs) from developed and developing countries and spelled out a proposed action plan. Among the now nearly 190 INDCs filed with the UN, 90 include a reference to using some form of market-based mechanism. But, the accord is still a grab bag of mixed objectives and priorities. Carbon pricing and fungible carbon trading units could thus be a tool to harmonize disparate approaches, especially given that climate change is a global problem that nevertheless must be addressed via clear and linked national actions.

Further, many companies doing business worldwide have already largely accepted the notion that broad and universal carbon regulation is inevitable, despite the spotty current regulatory landscape. According to CDP, formerly known as the Carbon Disclosure Project, which is the sole source of standardized information on how multi-national public companies may be using internal or “shadow” carbon prices for operational and financial planning, there was a “tripling in the number of companies reporting that they price their greenhouse gas (GHG) emissions over last year (437 up from 150 in 2014)” between 2014 and 2015. CDP reports that an additional nearly 600 companies, including China’s large power company CLP Holdings, disclosed that they plan to use internal carbon pricing within the next two years. Very often, such internal carbon prices are pegged to prices in established or emerging carbon markets, including in Canada and South Korea. Given that, to achieve the necessary environmental improvements, all the world’s emissions must ultimately be covered by a standardized regime, these markets will have to be linked.

A man walks between constructed solar panels under construction in Xinjiang, April 2012.

A man walks between constructed solar panels under construction in Xinjiang, April 2012.

And that will only come though foreign policy, diplomacy, and practical cooperation—cooperation that can become a platform for the discussion of a host of other international issues.

History offers some examples, perhaps the most notable being the first wheat deal between the United States and the USSR, in 1963. The agreement was controversial, but it was nevertheless the first commercial grain transaction between the two nations since the Russian Revolution, and it offered a channel for discourse that had not existed before. Similarly, throughout the years of enmity and blockade between the United States and Cuba, Cuba nevertheless continued to address environmental concerns through the UN Environment Program, which led to contact between U.S. and Cuban scientists, providing a cultural and intellectual community upon which efforts to reach the  recent thaw in relations could build.

So, for example, in the development of global carbon pricing mechanisms, there could be room to address cybersecurity issues generally; after all, a hacked or gamed carbon market would soon be exposed as fraudulent, carbon prices would tumble, and there would be little demand for allowances. Weak demand for allowances would mean weak trading volume, and it is trading volume that drives profits in a well-managed cap-and-trade scheme. Without the profit motive, trading would not be robust and low prices for allowances would also fail to stimulate environmental improvements: the core purpose of a carbon market would be lost.

And if China wants the world’s commodities traders to enter their carbon market to provide liquidity and the transaction volumes that are essential to robust markets, it will have to submit to an unprecedented level of audits and emissions monitoring, which could help strengthen financial transparency overall. Such openness would have spillover benefits throughout China’s economy and the world. Similarly, carbon pricing is key to China’s new “Green Finance” initiative, spearheaded by the People’s Bank of China, which aims for nothing less than a full-fledged “greening” of all banking transactions, including loans, which will also trigger new transparency requirements in keeping with international best practices. The need to work together seamlessly will pull together sectors that are normally separated, such as environmental policy, financial services, and infrastructure planning.

As climate problems multiply, environmental policy is likely to become an even stronger surrogate through which other concerns are negotiated or expressed, including foreign aid, foreign investment, and other knotty issues. In this sense, carbon pricing may provide fresh foreign policy perspectives. Given expanding global tensions, new gateways for dialogue among trusting contacts can never be too many—and all days, we can hope, will be as auspicious as the one on which the TCX came into being.

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