New trade arrangement incentivizes power operators to be more energy-efficient.

By Paul A. Davies, R. Andrew Westgate, Qingyi Pan, and Jacqueline J. Yap

On January 1, 2021, the long-awaited China Emissions Trading Scheme (ETS) commenced operation, with 2,225 coal-fired power plants participating. Under this new ETS, China’s power operators will have to buy emissions permits if their coal plant exceeds carbon intensity benchmarks, giving power operators an incentive to improve efficiency. Since 2011, China has developed pilot emissions trading platforms in nine cities and provinces, paving the way for a national trading scheme that was first announced in 2017, along with an emissions trading market development plan for the power generation sector. After almost four years of development, the first annual compliance cycle officially began on January 1. China’s Ministry of Ecology and Environment (MEE) has published several policy documents on the national ETS that establish regulatory authority and specify general rules for key areas of market operation and design, including the Carbon Emissions Rights Trading Regulations (Trial), which was published in November 2020.

The ETS market will initially only cover the thermal power industry, which last year accounted for about 40% of China’s total emissions, rather than eight key industrial sectors, as originally envisioned. But China’s power sector is significant on its own, with twice the emissions of the EU carbon market, which until now had been the world’s largest carbon market.

Trading in China’s ETS is expected to begin mid-year. Carbon Pulse reported that “some companies — domestic and foreign — have already bilaterally agreed on several transactions that will remain undisclosed until the trading platform launched.” China has elected to only allow spot trading initially due to concerns that futures trading could drive market manipulation and costly price spikes. Such restrictions are expected to be eased or removed once the scheme matures.

Sectors Covered Under China’s ETS

The first compliance period for China’s ETS will only cover the thermal power plants, including combined heat and power facilities and captive power plants at other types of facilities. Entities with annual emissions of at least 26,000 metric tons of CO2 in any year during the period 2013-2019 will be covered under the ETS. A total of 2,225 entities and operators have been registered in the new carbon market and will retroactively receive pollution allowances for the market’s first compliance cycle, which started on January 1, 2021, and covers CO2 emitted during the 2019-2020 period.

Experts from the China Council for International Cooperation on Environment and Development confirm that China’s ETS will gradually expand to cover a total of eight sectors: petrochemical, chemical, building materials, steel, nonferrous metals, paper, and domestic aviation. However, MEE has not provided any specific timeline for this expansion.

Allowance Allocation

Under the current regulations, allowances will be allocated for free. No auction function has been introduced yet. Provincial governments will be responsible for calculating and distributing permits to emitters within their jurisdictions, based on the rules set by MEE. The benchmark for conventional coal-fired plants above 300 MW has been set at 0.877, meaning they will receive 0.877 allowances for every megawatt hour of electricity generated. However, around three-quarters of all Chinese coal facilities are operating at less than 85% of their capacity, and as a result these facilities have a benchmark of 1.00 or higher. The benchmark for conventional plants with capacities lower than 300 MW has been set at 0.979, while for non-conventional coal plants the benchmark is 1.146. Gas-fired plants have been given a benchmark of 0.392. Gas-fired plants will not face any compliance obligations under the ETS initially, but will be issued allowances that they can sell into the market if they exceed their benchmark.

Allowance Pricing

Analysts with Refinitiv have calculated that around 8-8.5 billion allowances will be distributed to market participants for the first two years of China’s ETS, making it by far the world’s biggest carbon market in terms of coverage. Analysts, traders, and officials expect Chinese CO2 permits to trade at around 35 to 50 yuan (US$5.36 to US$7.66) at the outset. This price level would be similar to the clearing prices at recent auctions for the Regional Greenhouse Gas Initiative, a program run by 11 states in the eastern United States that also covers only power plants. However, given a benchmark of 0.392, the prices would be less than the allowance prices in the California or EU programs.

Offsets and Credits

China’s ETS allows companies to generate emissions credits to be used as offsets. Each emissions unit (or company) may use China Certified Emissions Reduction (CCER) credits to offset up to 5% of its carbon emissions. However, the types of offsets that will be available under the national ETS and the requirements for generating them have yet to be released.

Compliance Mechanisms

The draft ETS regulations include various compliance mechanisms such as annual reporting, third-party verification, disclosure of reports, allowance reassignment, etc. More mechanisms are expected to be established and specified by MEE. Compliance with the ETS will be integrated into China’s social credit system. See Carbon Emission Rights Trading Regulations (Trial), Art. 34.

Enforcement

Noncompliance will result in certain penalties, which may include recording the noncompliance information in the national credibility information sharing platform, although, again, details have not yet been released. See Carbon Emission Rights Trading Regulations (Trial), Art. 46. Currently, the maximum fine is approximately US$3,500 (See Art. 43 – 44). The ETS released guidance on January 11, 2021, that pledges to “coordinate and promote the formulation and revision of relevant laws and regulations.” This brings some momentum to China’s work in climate change law, which has been underway since 2014. It also provides an opportunity to base the ETS in legislation by China’s National People’s Congress rather than MEE regulations. Because currently ETS is established and based on MEE regulations, violation fines are limited by China’s Administrative Penalty law, which sets a maximum administrative fine at approximately US$3,500 and contains very limited enforcement measures. Therefore, a potential consequence is that the legislation would give the government more control and the fines may increase.

Pilot Program Integration

The ETS pilot programs will gradually merge with the national plan. In the short term, the existing ETS pilot programs are expected to operate in parallel with the national market, covering the non-power sectors. In the medium to long term, the ETS pilot programs are expected to be integrated into the national market once it is fully operational.

Future Developments

China’s ETS is considered one part of the process for implementing President Xi’s pledge to first curb China’s carbon emissions before 2030 and then reach carbon neutrality by 2060. Since its launch, China’s ETS has become the world’s largest carbon market for the power sector. However, the current regulations and contain certain uncertainties and ambiguities. As well as the issues flagged above, there is ongoing concern about how confidential business information will be protected, given annual disclosure obligations. Another issue of note is that entities emitting less than 26,000 metric tons of CO2 are not yet included in the ETS, despite the fact that voluntary participation is an important pillar of the carbon market and is expected to grow quickly over the years.

Latham & Watkins will continue to monitor developments in this area.