Earlier this month, the Ministry of Ecology and Environment (MEE) published a draft policy stating that by the end of this year, China’s ETS will be expanded from covering only the power sector to also cover steel, aluminium and cement.
The new plan will raise the share of national carbon dioxide (CO2) emissions covered by the market from 40 per cent of China’s total to 60 per cent, according to the MEE.
Between 2024 and 2026, companies from the three new sectors will receive free allowances for their CO2 emissions, with no cap on total allowances, which represent emissions that the government authorises companies to emit. Allowances will then be tightened from 2027.
While the expanded ETS could boost China’s carbon-cutting efforts, analysts tell Carbon Brief that its focus on emissions “intensity” instead of overall emissions is limiting its impact.
Adding to the glut
Yan Gang, vice-dean of the MEE’s China Academy of Environmental Planning, has told the state-supporting newspaper Economy Daily, that the sectors were chosen in part due to the relative “urgency” of reducing their emissions.
However, in contrast to other carbon markets, China’s ETS is based on carbon intensity – the emissions per unit of output – rather than total emissions. This means it has only a limited effect in incentivising less carbon-intensive production.
Lauri Myllyvirta, senior fellow at Asia Society Policy Institute’s China Climate Hub, tells Carbon Brief this is the “fundamental” issue limiting the scheme’s ability to penalise high carbon emitters.
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There is not a lot of low hanging fruit that hasn’t been picked yet…[so] you can’t really ratchet the benchmarks low enough to get strong incentives and get a strong carbon price.
Lauri Myllyvirta, senior fellow, Asia Society Policy Institute
He has written on Twitter that this means carbon-intensive enterprises “face a carbon price…a fraction of the price of the emission allowances”, adding that they may even profit from increasing output if their emissions intensity falls below their industry’s benchmark – the government-set standard at which companies are expected to emit CO2.
Even assuming the system shifts to a total emissions cap, setting a ceiling on the total amount of CO2 companies covered by the ETS could emit, this “would only be meaningful if the cap was strong enough to actually drive up carbon prices to then push emissions down”, he tells Carbon Brief.
Furthermore, many companies in the newly-added sectors have already been under pressure to significantly improve efficiency, bringing down their emissions intensity, Myllyvirta adds, saying:
“There is not a lot of low hanging fruit that hasn’t been picked yet…[so] you can’t really ratchet the benchmarks low enough to get strong incentives and get a strong carbon price.”
“We haven’t seen allocation plans, so it’s hard to evaluate” the expansion’s impact, says Chen Zhibin, senior manager for carbon markets and pricing at consultancy Adelphi. But, he tells Carbon Brief that he does not expect “high pressure” on industry to start cutting emissions immediately.
The provision of generous allowances in previous years has led to an oversupply in the market.
For example, a 2021 report by the thinktank TransitionZero estimated that power companies, on average, received 17 per cent more allowances under the ETS than they needed to cover their emissions in the 2019-2020 compliance cycle.
The release of even more free allowances could add to this problem of oversupply, suppressing prices and reducing incentives to trade, Xu Nan, member of the All-China Environmental Federation’s Green Inclusivity Committee, has written for Dialogue Earth, ahead of the policy’s release.
Data verification
Meanwhile, data collection – one of the principal reasons that the original launch of the ETS was severely delayed – has continued to pose challenges.
In 2022, the MEE released information on “cases of negligence and fraud” in measuring the emissions of thermal power plants, including “falsifying emissions data and coal sampling”.
It followed up in February 2024 with new regulations to tackle emissions data fraud. China’s plan for dual-control of carbon says the country aims to establish a “completed” system for measuring CO2 emissions by 2025. Chen tells Carbon Brief:
“Compared to two years ago, the [data verification] requirements have changed, and are much higher than two years ago. The MEE has put a lot of resources into [this], including sending people to different provinces [to check the accuracy of information provided].”
The new draft policy for ETS this month has added a three-tier national-provincial-municipal review mechanism, which will further improve China’s ability to verify emissions data, he says.
Managing steel output
Myllyvirta thinks that the addition of steel to the market could create an opportunity to improve the benchmarking system, due to the growing adoption of electric arc furnaces (EAFs) – a method of steelmaking that significantly reduces carbon emissions.
Having the “same benchmark” for EAFs and blast furnace-basic oxygen furnaces (BF-BOFs) “could drive much more utilisation of EAFs”, which would also support China’s drive to meet targets for EAF steel production targets, he explains.
But if the existing design for power plants is anything to go by – with different types of plant receiving different benchmarks – this is unlikely to happen, he adds.
Luyue Tan, senior carbon analyst at the London Stock Exchange Group, and Chen both argue that the ETS’s current focus on emissions intensity may also be part of an intentional drive to push less efficient and smaller manufacturers out of the overcrowded steel production market.
This would reduce the number of steel manufacturers and therefore lower overall emissions in the industry.
At the same time, Tan adds, this consolidation would reduce the supply of allowances in the carbon market, improving its attractiveness to market participants.
The long game
Currently, Chen says, the ETS is just one of the climate policy tools available to China, with other elements, such as rapid renewable installations, playing a larger role.
However, Zou Ji, CEO and president of the Energy Foundation China, has previously told Carbon Brief that the ETS is key to making China’s energy transition more cost-effective.
A May 2024 report by the International Energy Agency (IEA) also cited the potential benefits of China’s ETS, particularly if it is strengthened by starting to auction allowances rather than giving them away for free. It said:
“Strengthening the national emissions trading system can send a robust price signal for decarbonisation, drive cost-effective emissions reductions and guide low-carbon investments – all of which can help to accelerate the clean energy transition and China’s progress towards its climate ambitions.”
The IEA report noted that, while China currently allocates all ETS allowances for free, it has “indicated its intention to explore the introduction of auctioning of emission allowances”.
Adopting partial allowance auctioning under the ETS “could strengthen its environmental and cost-effectiveness, and its role in supporting the achievement of China’s ‘dual carbon’ goal”, the IEA said, potentially doubling carbon savings in the power sector by 2035.
It is expected that the oil refining, chemical, paper, aviation and other building materials and non-ferrous metals industries will eventually be added to the ETS, bringing total coverage up to 75 per cent of emissions.
In the long run, instating a cap based on total emissions for market participants could be particularly important. China’s recent “dual-control of carbon” policy says China’s climate policy will switch from focusing on carbon intensity to total carbon emissions after the fifteenth “five-year plan” period (2026-2030).
Myllyvirta expects the ETS to also switch to a total emissions cap after 2030, after China’s emissions peak is confirmed.
Chen agrees with the timeline, adding that he does not see any signals in the draft indicating that a cap would be set any earlier. Part of this, he tells Carbon Brief, is due to the MEE’s limited influence over economic policy, compared to other government organisations, such as the National Development and Reform Commission, China’s top economic planner.
At the same time, Tan notes that there is “top-down” pressure to further expand the ETS’s coverage to other sectors.
This is driven by the EU’s carbon border adjustment mechanism (CBAM), as well as calls for China to adopt more ambitious international climate pledges, she says.
Elements of the draft, such as the focus on direct emissions and the first phase’s conclusion in 2026, have clear links to CBAM, which comes into effect the same year.
Industries covered by the ETS might be able to avoid CBAM charges when exporting to Europe, as Xu has written, which would make the ETS “a plus [for those companies] rather than a burden, as it will make exports easier”.
This story was published with permission from Carbon Brief.
