As China begins to implement its emissions trading system, the country may look around the globe for regulatory guidance.

By Paul A. Davies and R. Andrew Westgate

China established its national emissions trading system (ETS) as a key component of the plan to meet its commitments under the Paris Agreement. The country’s participation in the Paris Agreement is significant not only because it contributes 15% toward total global carbon emissions, but because China was a key proponent of the agreement during its negotiation.

China’s initial hurdle was how to systematically collect the emissions data necessary to design and implement the emissions trading scheme. Accurate and comprehensive emissions data is critical not only for setting the level of the overall cap, but also in determining how free allowances will be allocated to regulated companies. Determining the rate at which the emissions cap declines also requires predicting future emission rates and market demand levels.

Many existing systems have been tightening their emissions caps to ensure continued reductions in greenhouse gas (GHG) emissions. For example, existing systems such as those in California, the European Union (EU), New Zealand, and the Regional Greenhouse Gas Initiative (RGGI) are taking steps to decrease their annual trading systems caps after 2020. In California, the trading cap will be reduced annually by an average of 4.8%, which will result in a 40% reduction by 2030 as the result of new legislation passed last year. RGGI’s cap will similarly decline by 3% annually, leading to a 30% reduction by 2030.

As China implements its ETS, the country will have many examples to draw on in drafting regulations to govern what will be the world’s largest emissions trading market, including the following:

Targeting free allocation: Most existing cap-and-trade programs have given away at least some allowances. The California Air Resources Board, for example, allocates a portion of the program’s carbon allowances outside of the auction process and without cost to certain companies operating in sectors found to be vulnerable to out-of-state competitors, which are not subject to equivalent climate regulations. The EU allocates allowances to certain sectors free as well, but recently the EU has reduced the number of such allowances by 60%.

Market stability: Price stability has been a key concern for regulators overseeing emissions trading programs. The legislation extending California’s cap-and-trade system through 2030, for instance, requires the Air Resources Board to maintain its existing price floor, but also to establish a new price ceiling. Additionally, California will create two “speed bump” reserves of allowances that will be offered for sale at price points between the floor and the ceiling. The speed bumps, as their names indicate, are intended to minimize rapid price swings between the price floor and the ceiling.

Offsets: Offsets are credits issued for activities that reduce GHG emissions not otherwise covered by the program. Offsets can provide a “safety valve” for allowance prices when demand is high, because they are not subject to the cap. However, environmental groups have raised concerns that offset programs will not be monitored closely enough to ensure verifiable reductions in GHG emissions, and regulators have increased restrictions on offset use in response. In the EU, covered entities will no longer have access to international credits after 2020. California and RGGI still allow offset credits to be used to satisfy compliance obligations, but the number of offsets that may be used towards an entity’s compliance obligation is limited (currently 8% of an entity’s compliance obligation in California and 3.3% under RGGI). The draft rules for China’s ETS system drafted by the National Development and Reform Commission provide for the issuance of offset credits.

Latham will continue to monitor developments in the new China Emissions Trading System.

This blog was prepared with the assistance of Olivia Featherstone in the London office of Latham & Watkins.