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Charting China's Carbon Horizon

Adapted from China Carbon Download

Discussions around China’s carbon emissions reached a fever pitch throughout September’s UN Climate Summit, punctuated by a new report from the Global Carbon Project estimating the country’s total emissions at 9.9 billion metric tons of CO2 (MTCO2) in 2013, or 28% of the global total. The figure follows high level National Development and Reform Commission (NDRC) signals regarding a prospective national carbon market formation by 2016, with potential coverage upwards of 4 billion MTCO2. According to official NDRC estimates, a national carbon market in China could reach an aggregate value of $65 billion by 2020. 

Existing carbon trading at the sub-national level already covers roughly 1.2 billion MTCO2, with more than $140 million swapping hands in carbon trading transactions to date, adding true currency to climate policy talking points delivered by Beijing and beyond. Additionally, municipal government reports out of Shenzhen and Beijing suggest that carbon trading directly contributed to the much sought after net reductions in absolute carbon emissions, to the tune of 11% and 4.5%, respectively. Other pilot programs remain mum on actual abatement figures, touching on one key criticism around institutional transparency.

Still, net reductions at the pilot level are consistent with a speech delivered by China’s Premier Li Keqiang in September, who noted that China’s overall carbon emissions per unit of GDP (carbon intensity) dropped 5% in the first six months of 2014. Premier Li also acknowledged that cumulative cuts in carbon intensity have amounted to a roughly 28.5% overall carbon intensity reduction since 2005, all but ensuring successful attainment of the Copenhagen pledge to reduce carbon intensity by 40-45% from 2005 levels by 2020, ceteris paribus—that is, barring any financial event in which a surge of new credit ramps up industrial output.

In theory, a national carbon market would formalize carbon intensity reductions along the Copenhagen trajectory into 2020. To be sure, the objective behind carbon trading in China has never been that of international appeasement, given domestic economic growth imperatives, but rather a showcase of political resolve to unilaterally pursue and innovate carbon trading, especially as Washington idles in partisan division. In a Chinese context, carbon trading could serve as a catchall policy mechanism, potentially remedying key concerns, namely particulate air pollution, coal consumption, fuel-switching, and modernization of the power grid.

Our view is that China’s carbon horizon relies less on formal multilateralism in certain posh venues, and instead relies on the ongoing inputs being rigorously engineered and contemplated domestically for inclusion in China’s subsequent 13th Five Year Plan, due out in March 2016. The inputs are too often overlooked in lieu of what NDRC climate officials say, or moreover, do not say, in official statements to the public. 

13th Five Year Plan Outlook

China’s familiarity with carbon trading parallels early Clean Development Mechanism (CDM)  offset projects, which groomed a fairly sophisticated technical and conceptual grasp of the nuances behind prioritizing carbon emissions, let alone an understanding of the financial value associated with one metric ton of carbon dioxide in a global system. While the prospect of a global system lingers in uncertainty, forthcoming signals that may arise from international climate negotiations in Peru and Paris may inform how China manages and leverages the prospect of foreign participation within it’s own domestic market, which is key driving to liquidity.

Realistically, deliberations in the U.S. regarding the EPA’s proposed Clean Power Plan will likely have little bearing on what exactly China chooses to include in the 13th Five Year Plan, based on the timeline alone. In this way, the common refrain that is a certain tit-for-tat carbon policy domino effect between the U.S. and China ultimately overstates bilateral talks over China’s internal credo to serve the well-being of its own domestic social and commercial interests.

Current signals on the contents of the 13th Five Year Plan suggest a somewhat honest approach to slowing coal consumption, which is economically practical given China’s industrial overcapacity. Industrial utilization rates have weakened on sluggish demand-side activity from the steel and cement sectors, which are among China’s largest consumers of coal. Although the fundamental levels of China’s coal consumption will continue along absolute increases, China’s National Energy Administration (NEA) Planning Board Division nonetheless recommended that the 13th Five Year Plan contain a 60% coal consumption target by 2020—a sizable decrease from 67% in 2013.

The NEA note echoes a draft regulation published by China’s State Council to limit long-term overall coal consumption, as well as certain low-quality coal imports commonly used by state power generators. China’s State Council has actively pursued and published new regulatory material with respect to coal and climate, having also approved the National Climate Change Plan (2014-2020) draft legislation in late September, which lays out general checkpoints aimed at carbon abatement. Although the plan itself presented few specifics, it offers a new degree of institutional confidence that China’s highest governing body is actively considering a medium-term timeframe for scale up of a national carbon policy, consistent with the 13th Five Year Plan (2016-2020).

Defining a Regional Approach 

Relics from China’s CDM days have partially informed the implementation of pilot trading programs, with existing CDM infrastructure now converted into Certified Chinese Emission Reductions offsets for strict use within China’s domestic carbon market. With CDM as a precursor to pilot carbon markets, the next step could come in the form of larger regional carbon trading blocs, centered around build outs from existing pilot exchanges. One possible scenario could see the lateral integration of current pilot markets in a North-Central-South alignment. This is a technically feasible and pragmatic proposition given regional power grid structures, and overall compositional similarities in regional political economies.  

The next step beyond regional integration would require the development of a carbon futures trading market, the parameters of which could permit carbon trading fungibility across regional blocs. The value of carbon assets circulating within a futures market could also help retain the value lost to the industrial sector from tighter, more costly carbon and environmental regulations, provided that non-compliance penalties are set higher than some regional average cost of abatement. Still, the regulatory structure of these prospects remain dubious in the absence of national or trans-provincial legislative coordination.

Service Sector as Carbon Catalyst

According to the World Bank’s most recent economic outlook, China’s economic growth is projected to settle at 7.4% growth rate in 2014 on lower industrial output, down from the initial 7.6% forecast. The marginal decrease is not surprising, remaining consistent with annual declines in industrial growth rates. The opposite is true, however, for China’s service sector, where growth rates have remained steadily above 12% annually over the ten-year.Taken together, service sector growth exhibits a strong inverse relationship with carbon emissions growth. While this is a fairly obvious observation, it is nonetheless noteworthy as one additional economic element underpinning the likelihood of a national carbon market. Assuming that low levels of auction-based allocation in China’s pilot markets transfer into a national program, carbon compliance costs on industrial entities would not necessarily engender a significant behavioral shift in industrial output beyond that which is already occurring under current market conditions. 

Ongoing and future financial and economic reforms from Beijing will likely hasten the evolution of China’s service sector. In this way, it is possible that China’s service growth can catalyze a carbon emissions plateau faster than expected, as more wealth is generated through less carbon-intensive economic activity, to include carbon trading itself.

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