Tag: linkage of cap-and-trade systems

Climate Negotiations in Poland Advanced Implementation of the Paris Agreement

During two weeks of sometimes boisterous plenary sessions and equally energetic backroom discussions, the 197 Parties of the Twenty-Fourth Conference of the Parties (COP-24) of the United Nations Framework Convention on Climate Change (UNFCCC), meeting in Katowice, Poland, sought to reach consensus on rules and guidelines for implementing the Paris Agreement.  That landmark 2015 accord came into force in 2016, and is scheduled to begin operations in earnest in 2020.  The fault lines at the Katowice negotiations were, as usual, largely between two groups:  the 43 industrialized countries, and the 154 developing nations.

Hanging over the negotiations was the reality that U.S. President Donald Trump announced in June 2017 that the United States would withdraw from the Paris Agreement (in November, 2020, the soonest that any Party can actually withdraw).  Since Trump’s announcement, the former co-leadership by the United States and China, which had been critical to the passage of the Paris Agreement, has evolved into something between sole leadership by China and co-leadership by China and the European Union.

Not long before midnight on Saturday, December 15th, a full 24 hours after COP-24 was scheduled to conclude, consensus was reached on the 156-page Rulebook, with considerable credit due to the Polish presidency of the Conference (not to be confused with the presidency of the Polish nation), in the person of Michał Kurtyka, Poland’s Deputy Minister of Energy. As Jean Chemnick wrote in E&E News, the Rulebook represents a transition from an “idealized expression of world solidarity” in the Paris Agreement to a “set of mechanisms that countries hope will deliver results.”

But was COP-24 Really a Success?

A simple “yes” or “no” response to this question would be misleading.  There were literally dozens of aspects of the Paris Agreement on which the delegates to the Katowice meetings wanted to make progress by filling in details in the 29 articles of the skeletal Paris Agreement.  In my mind, two areas stood out.  One is referred to as “transparency,” and other is characterized (somewhat inaccurately) as “markets.”  Combining the achievements and lack thereof on both fronts, I assess the outcome of the Katowice talks to be more than a half-full glass of water (or wine, if you prefer).

First of Two Key Issues:  Transparency

Transparency refers to the credibility of each nation’s measurement of its own performance – in terms of its emissions and its policies.  The Paris Agreement gave significant wiggle room to the vast majority of countries – the 154 developing countries – by granting them flexibility in meeting the transparency requirements (which were to be established for the industrialized countries).  The U.S. delegation – consisting of civil servants led by long-time State Department official Trigg Talley – again worked closely with the Chinese delegation to foster a remarkable consensus that all countries must follow uniform standards for measuring emissions and tracking the achievement of their respect targets (Nationally Determined Contributions or NDCs).  This was a significant achievement, and a major step forward toward a level playing field among the countries of the world.

Conceivably, it could make it easier for the Trump administration to remain in the Paris Agreement (if the President were to become convinced that such action would be politically advantageous in the run-up to the November 2020 U.S. presidential election).  And, likewise, it will make it easier for a future (Democratic or Republican) administration to rejoin the Paris Agreement if the current President follows through on his promise to withdraw.  That is a significant success.

Second of Two Key Issues:  Article 6.2 and Carbon Markets

Turning to the second key set of issues at COP-24, I have frequently written that there are two necessary conditions for ultimate success of the Paris Agreement:  adequate scope of participation, and adequate ambition of the individual national contributions.  The first condition has surely been met, with 97% of global emissions associated with countries taking on responsibilities under Paris, compared with 14% under the current commitment period of the predecessor international agreement, the Kyoto Protocol of 1997.  But the factor that brought about such broad participation – namely, that each country’s target is anchored in its own national circumstances and colored by its domestic political reality – suggests that the individual contributions will not be collectively sufficient (due to the global commons nature of the problem).

Because of this, a key question has been whether there are ways that the Paris Agreement itself, as it is fleshed out, can enable and indeed facilitate increased ambition over time?  One answer, on which I have carried out extensive research with colleagues, can be provided by the linkage of regional, national, and sub-national policies – connections among policy systems that allow emission reduction efforts to be redistributed across systems.

Heterogeneous Linkage

Linkage is typically framed as between cap-and-trade systems, but regional, national, and sub-national policies will be highly heterogeneous, including a variety of types of emissions trading systems, carbon taxes, and conventional performance and technology standards.  As my research in this area with Michael Mehling (M.I.T.) and Gilbert Metcalf (Tufts University) has found, linkage among such heterogeneous policies is not trivial, but is – in many cases – feasible.

This is important because linkage fosters: cost savings by allowing firms to take advantage of lower cost abatement opportunities in other jurisdictions; improved functioning of markets by reducing market power and price volatility; political benefits to linking parties; administrative economies of scale; and – perhaps most important – the possibility of satisfying the UNFCCC’s key criterion of distributional equity – “common but differentiated responsibilities” – without sacrificing cost-effectiveness.

Fortunately, such linkage can be consistent with the Paris Agreement, under the authority of its Article 6, focused on international cooperation.  In particular, Article 6.2 provides for cooperative approaches among Parties, with Internationally Transferred Mitigation Outcomes (ITMOs) potentially serving as an accounting mechanism to ensure that international linkages do not result in double-counting or other errors when comparing each country’s emissions to its stated target.

So, What Happened in Katowice?

In Katowice, the delegates sought to write guidelines for Article 6 that could make its promise a reality.  Negotiators had an opportunity to define clear and consistent guidance for the accounting of emissions transfers under Article 6.2.  My view in advance of the Katowice talks was that a robust accounting framework for ITMO transfers could foster better linkage of climate policies across jurisdictions, but that if the guidance extended much beyond basic accounting rules, restrictive requirements could actually impede effective linkage, and be counter-productive.

In precisely this regard, two potential impediments arose in Katowice.  Proposals were introduced to place an explicit tax on ITMO transfers under the rubric of “Share of Proceeds,” meaning a payment by the transferring parties to a fund intended to help vulnerable developing countries meet their costs of adaptation to climate change.  Whereas the objective of financing adaptation has great merit, it is well covered and belongs in other parts of the Paris Agreement, not as a tax on trading.

The other potential impediment was in the form of proposals for an implicit tax on transfers, known as “Overall Mitigation in Global Emissions,” meaning that each transfer must result in a net reduction in overall emissions.  Again, increasing ambition over time is important, but that is dealt with appropriately in other parts of the Agreement, not by making it an implicit tax on market activity.

Last-Minute Maneuvers

As the end of the second week of negotiations approached, it appeared that both of these potential impediments might be finessed, if not completely avoided.  But then a single country – Brazil – decided to hold up the talks all night on the final Friday by insisting that it would not let there be any progress on rules for Article 6.2 unless the Conference agreed to state – under Article 6.4, viewed by most as an extension of the Kyoto Protocol’s Clean Development Mechanism (CDM) – that it could use its large surplus of CDM credits (of questionable credibility) to help meet its Paris commitments in a manner that would have resulted in double-counting.  The Brazilian delegation refused to budge, and the result was that Article 6 was not included in the Katowice decision.  Rather, it was punted to COP-25, to be held next year in Santiago, Chile.

So, the outcome with this second issue was clearly not a great success, but was it a complete failure, or was it something in between?  This gets quite interesting.  On first blush, a lack of agreement on the rules of the road for Article 6.2 would seem to render ITMO transfers impossible – and hence reduce the scope for bilateral international linkages.

Does the Cloud Have a Silver Lining?

As Nathaniel Keohane (Environmental Defense Fund) has pointed out, countries can move ahead with international transfers even without guidance under Article 6.2, because that article is explicit that countries may use transferred mitigation outcomes toward meeting their national targets whether or not additional rules have been written.  The crucial phrase is that any transfer must be “consistent with guidance,” meaning that if guidance exists, it must be followed, but meaningful action does not depend on the existence of guidance.  Keohane indicates that this language was intentionally written into the Paris Agreement precisely because the United States and others feared that Brazil would try to hold Article 6.2 hostage to Article 6.4 — exactly as they did in Katowice.

I hope very much that Dr. Keohane’s interpretation is correct.  My lingering concern, however, is that in the absence of knowing what some potential future guidance and rules might bring, Parties may be very hesitant to pursue bilateral linkages (and try to justify those in the context of their national targets via ITMO transfers).  Only time will tell.

A Sideshow:  The IPCC 1.5o C Report and U.S. Schizophrenia

            There were several sideshows at the climate talks.  One revealed the schizophrenia that has marked U.S. participation in the annual negotiations during the Trump years.  The State Department civil servants who continue to represent the United States in the climate negotiations, again played a helpful role, working constructively with other delegations, and in some cases, even played a (admittedly diminished) leadership role, as in the work on transparency I described above.  But, in addition, the White House again sent a group of political people to make symbolic statements supporting the use of coal and doubting the urgency of action on climate.

This resulted in the bizarre reality of the United States joining Russia, Saudi Arabia, and Kuwait to block language that would have endorsed the findings of the recent Intergovernmental Panel on Climate Change (IPCC) report on the Paris Agreement’s aspirational target of limiting warming to a 1.5o C increase this century.  All other countries wanted to include text that would “welcome” the IPCC report, which would indeed have had the effect of endorsing it.  The group of four countries maintained that the report should simply be “noted.”  In what has become classic climate diplomacy, the final language said that the Conference “welcomes the timely completion” of the report, not necessarily its findings.

The Bottom Line

Any sound judgment of the ultimate success or failure of the Katowice climate talks – and more important, the success or failure of the Paris Agreement – will depend upon future climate negotiations and upon the domestic policy actions of the key countries of the world.  For that, it remains too soon to observe or even predict the long-term outcome.

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A Few Additional References:

For a much more succinct assessment of the Katowice climate negotiations, see my column in The Conversation:  “An Economist’s Take on the Poland Climate Conference.”

For a summary of the outcomes of the Katowice meetings, see this report from the Center for Climate and Energy Solutions.

For a detailed summary and assessment of the Katowice outcome, see Axel Michaelowa’s slide deck.

For an assessment that focuses on the process and outcome of the Katowice negotiations with regard to the role of carbon markets, see the COP24 Summary Report of the International Emissions Trading Association (IETA).

For a detailed description of the processes and outcomes on transparency, finance, and stock taking, see Jean Chemnick’s story in ClimateWire.

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Will the Paris Agreement Help or Hinder Cooperation among Nations?

I just returned from Florence, Italy, where I participated in the Second Carbon Market Workshop, organized by the European Commission, and hosted by the European University Institute.  This workshop, which brought together government representatives from around the world (with a sprinkling of academics and NGO representatives to add some spice to the discussion), was convened to examine how regional, national, and sub-national jurisdictions can cooperate in ways that could increase the effectiveness and/or reduce the costs of their respective climate change policies.  One of my tasks at the workshop was to make a brief dinner speech.  Jos Delbeke, the long-time,  legendary Director-General of Climate Action for the Commission, asked me to talk about how the Paris Agreement might help or hinder practical climate policy cooperation around the world.  I drew extensively upon my research with Michael Mehling and Gilbert Metcalf.  Here is the gist of what I said in my dinner speech.

Some Paris Agreement Fundamentals

The hybrid design of the Paris Agreement was key to its successful enactment in 2015 and its coming into force in November, 2016.  The hybrid design to which I refer is the combination of top-down (centralized) and bottom-up (decentralized) elements.  The top-down elements include, for example, the requirement that countries state their national contributions every five years, a schedule which is binding under international law for those jurisdictions that have ratified the Agreement.  The key bottom-up element is the set of individual Nationally Determined Contributions (or NDCs) themselves, which are not part of the Paris Agreement itself, but rather are listed in a separate Registry.  These are not binding under international law, but rather are left to the domestic authority of the respective countries.

This dual structure led to the achievement of one of two necessary conditions for ultimate success of the Paris Agreement, namely adequate scope of participation, which now includes countries accounting for 97% of global emissions, compared with the 14% that are covered by the current, second commitment period of the Kyoto Protocol.

But adequate scope of participation is only one of two necessary conditions; the other is adequate collective ambition.  Unfortunately, the fundamentally voluntary nature of the NDCs – which is precisely what facilitated the exceptionally broad scope of participation – works against adequate ambition to address this global commons phenomenon, which is plagued by free rider problems.

The Challenge for Climate Negotiators

This raises the key overall challenge that faced the negotiators in Bonn in May and will face them in Katowice, Poland, in December (at the Twenty-Fourth Conference of the Parties of the United Nations Framework Convention on Climate Change):  What can they do, when writing rules to put flesh onto the skeletal Paris Agreement, to encourage countries to increase their ambition over time?  That’s where carbon markets and cooperation among jurisdictions potentially come in.

International Cooperation under the Paris Agreement

Largely because cooperation among jurisdictions — including through carbon markets — can lower abatement costs, such cooperation may be essential for the ultimate success of the Agreement.  This cooperation might take the form of international linkage, where by “linkage,” I mean connections among policy systems that allow emissions reduction efforts to be redistributed among those systems.

Such linkage is typically framed as between cap-and-trade systems, but regional, national, and sub-national policies are and will be highly heterogeneous, including not only cap-and-trade, but offset systems, carbon taxes, performance standards, and technology standards.  Note that we already see this sort of heterogeneity within the European Union’s own set of climate change policies, as well as within California’s suite of climate initiatives.

The good news is that linkage among highly heterogeneous policies is eminently feasible, as I have written about previously in this blog, drawing on my research with Michael Mehling (MIT) and Gib Metcalf (Tufts University).  The even better news is that one part of the Paris Agreement provides a potential home for such international cooperation, linkage, and carbon markets – Article 6.  (If you are interested in the details, I recommend a recent report from the Asian Development Bank, “Decoding Article 6 of the Paris Agreement.”)

The Promise and Problems of Article 6

In the negotiations that led up to the 2015 Paris climate talks, it was by no means clear what role — if any — market mechanisms would play in the Paris Agreement.  In the negotiations, the European Union, Brazil, and other countries played crucial roles in generating the compromise that became Article 6 of the Agreement.

That compromise resulted in text that — to put it kindly — is very much subject to interpretation.  Now, as Benito Müller, Kelley Kizzier, and their colleagues have observed, intentional vagueness and ambiguity of text can be quite helpful in achieving a negotiated compromise, but such vagueness is decidedly not helpful when it comes to making an agreement operational.

This compromised home for markets emerged in Article 6 despite the entrenched opposition of a small set of vocal countries — including some Latin American socialist economies (the so-called ALBA coalition) — who wanted nothing of the kind to appear in the Paris Agreement.  They succeeded in keeping the word “market” out the Paris Agreement, but the concept and the potential reality is very much there!  (Ironically, at their insistence, the phrase “non-market” does appear in the Agreement.)

In any event, provision for markets and international cooperation is implicit in Article 6.2, which allows for cooperative approaches involving Internationally Transferred Mitigation Outcomes (or ITMOs), which are vague and without definition, but can function as an international accounting mechanism for international trades, exchanges, and cooperation.  And Article 6.4 establishes a more centralized mechanism to contribute to emissions mitigation and support sustainable development, essentially as a successor to the Clean Development Mechanism (and may soon come to be called the “Sustainable Development Mechanism” or SDM).

Advantages and Concerns about Cooperation and Linkage

Despite the opposition I mentioned, most parties to the Paris Agreement are supportive of cooperative approaches (and more than half explicitly mentioned carbon markets in their respective NDCs).

This may be because of six important advantages of such cooperation:  first, cost savings by allowing firms to take advantage of lower cost abatement opportunities in other jurisdictions; second, reducing market power of individual firms by enlarging the market’s scope, and reducing total price volatility by thickening markets; third, political benefits to Parties, by providing a sign of “momentum” as jurisdictions band together, possibly influencing other parties to participate; fourth, administrative economies of scale through knowledge sharing in design and operations, as well as shared administrative and oversight costs; fifth reducing leakage and competitiveness impacts by harmonizing the shadow price of carbon across jurisdictions; and sixth, allowing for the achievement of the UNFCCC’s critical principle of “Common but Differentiated Responsibilities” without sacrificing cost-effectiveness.

There are also real concerns about linkage:  first, distributional impacts within and across linked jurisdictions; second, automatic propagation of certain design elements, in particular, cost-containment elements (banking, borrowing, and price collars); and third, decreased national autonomy.

Back to the Article 6 Negotiations and International Policy Linkage

Article 6 can be a home both to linkage of the sort we usually talk about, as well as “soft linkage,” such as an agreement — explicit or implicit — to harmonize carbon prices either at some level or within overlapping bands.

Thinking about the UNFCCC negotiations taking place now, most types of heterogeneity – of policy instruments, level of political jurisdiction, and nature of NDC targets – do not present insurmountable obstacles to linkage, but some do present real challenges, and indicate the need for specific guidance as the rulebook of the Paris Agreement is written.

Unfortunately, some countries want the Article 6 guidance to go beyond fundamental issues of accounting and environmental integrity to broader matters of environmental ambition, which properly belong in other parts of the Paris Agreement.  Whereas, accounting provisions to avoid double-counting of NDC actions through ITMOs surely belong in the Article 6 rulebook, some countries have proposed, for example, that all ITMO exchanges themselves must actually reduce net emissions.

This sounds very much like the U.S. Environmental Protection Agency’s 20% rule in its 1970’s Emissions Trading Program, which required that net emissions fall by 20% with each trade.  This was a tax and an inhibition on trading, and the result was that virtually no trading occurred.  This reminds me of a corrupted version of George Santayana’s admonition that those who do not learn from history are doomed to repeat it.  Instead we have, “I’ve learned from my mistakes, and I can repeat them exactly the same again.”

The general problem is that if the guidance extends much beyond basic accounting rules, then restrictive requirements could actually impede effective cooperation.  True to the nature and spirit of the Paris Agreement, less can be more!

UNFCCC Update from Bonn

I closed my dinner comments in Florence with a brief update on the negotiations that concluded the previous week in Bonn.  The two weeks of meetings of the Article 6 group were reported to be much tougher than they had been previously, yet the progress on the Article 6 work is actually ahead of that of groups focused on other parts of the Paris Agreement.  Although positions on Article 6 are hardening, there is no clear blocking party or coalition (unlike in the work on some of the other parts of the Agreement).  There may be less resistance to agreement simply because participation in Article 6 instruments would ultimately be voluntary.

The Path Ahead

So, as the negotiations proceed, a combination of common accounting rules and an absence of restrictive conditions can accelerate linkage, allow for broader and deeper climate policy cooperation, facilitate the emergence of a robust global carbon market, and – most important – increase the latitude of the Parties to the Paris Agreement to scale up the ambition of their long-term contributions to global greenhouse gas emission reductions.

Whether that will come to pass, we simply do not know as of now.  As usual, only time will tell.

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What Should We Make of China’s Announcement of a National CO2 Trading System?

On December 19, 2017, the government of China announced that it is commencing development of a nationwide CO2 trading system, that when launched will become the world’s largest carbon trading system, annually covering about 3.5 billion tons of CO2 emissions in China’s electric power sector.  That approaches twice the size of what is currently the world’s largest carbon trading system, the European Union Emissions Trading System, which accounts for about 2 billion tons per year, and is nearly nine times the size of the largest U.S. system, the California AB-32 cap-and-trade system, which covers about 400 million tons of annual emissions.

The ultimate purpose of the newly announced Chinese trading system is to help the country meets its emissions and renewable energy targets which are part of its Nationally Determined Contribution under the Paris Agreement, in particular, peaking its CO2 emissions by 2030, and achieving 20% of the country’s energy supply from renewables.  Note that coal currently accounts for 65% of China’s electricity generation.  Wind and solar capacity have been growing rapidly, but still account for only 4% and 1% of generation, respectively.

The Chinese carbon market will double the share of global CO2 emissions covered by worldwide carbon-pricing systems to almost 25 percent.  For this and other reasons, the December announcement was greeted with excited praise from climate activists (but simultaneously with disregard and skepticism from conservative opponents of climate action).  The most reasonable assessment, however, is between those two extremes, as I explain in this essay.  That said, the December announcement by China of its plan to develop and launch a nationwide CO2 trading system is an important landmark on the long road to addressing the threat of global climate change.

Some Brief History for Context

In 2011, China’s 12th Five-Year Plan (2011-2015) first included a statement about the government’s intention to develop – gradually – a nationwide carbon market.  Subsequently, in 2013 and 2014, seven pilot emissions trading programs were launched in the cities of Beijing, Chongqing, Shanghai, Shenzhen, and Tianjin, plus two provincial systems in Guangdong and Hubei.  In total, these covered some 3,000 sources, with total annual CO2 emissions of 1.4 billion tons.  The designs of the systems were intentionally varied, to facilitate learning, and allowance prices ranged from $3 to $10 per ton of CO2.

Then, in the lead-up to the Paris climate negotiations, on September 25, 2015, President Xi Jinping met at the White House with U.S. President Barack Obama, and announced that China would launch its nationwide CO2 trading system in 2017, presumably covering electricity, iron and steel, chemicals, cement, and paper production.

The announcement last month was the culmination of this brief history, as China seeks to move ahead with its “pledges” under the Paris Agreement, at the same time as the Trump administration in the United States intends to withdraw altogether from the Agreement (in November, 2020, the soonest that such withdrawal can take place under the rules of the Agreement).

What’s Known about the Chinese Carbon Trading System

China’s December announcement that it is commencing development of a nationwide CO2 trading system, beginning with the electric power sector only, provided few details.  Apparently, the system is intended to eventually include electricity, building materials, iron and steel, non-ferrous metal processing, petroleum refining, chemicals, pulp and paper, and aviation, but will start with the electricity sector alone.  Like most operating systems in the world, it will regulate only CO2, not other greenhouse gases (GHGs), which in China’s case means potentially addressing more than 80% of its total GHG emissions.

The system will not be a cap-and-trade system per se (unlike the CO2 trading systems in Europe and California, for example), because there will not be an administratively set mass-based cap of some quantity of emissions.  Rather, the trading system will be rate-based, meaning that it will be in terms of emissions per unit of electricity output.  This is also called a tradable performance standard, whereby the government sets a performance standard (a benchmark emissions rate per unit of output), sources receive permits (allowances) based on their electricity output and their benchmark, and sources are allowed to trade.  Such tradable performance standards have been used previously in a variety of contexts, including the U.S. EPA leaded gasoline phasedown in the 1990s, U.S. Corporate Average Fuel Economy (CAFE) standards to regulate motor-vehicle fuel efficiency, the Obama Administration’s Renewable Fuel Standard, and California’s Low Carbon Fuel Standard.

One objective of using this approach is to insulate – or at least cushion – the (electricity) sector and the larger economy from “carbon market shock.”  By regulating the emissions rate (per unit of product output), rather than emissions per se, the rate-based approach may help mitigate the political worry about constraining economic growth, but does so by essentially rewarding (subsidizing) higher levels of output.  This relative inefficiency of China’s rate-based system, compared with a mass-based cap-and-trade approach is highlighted in a new paper by Lawrence Goulder (Stanford University) and Richard Morgenstern (Resources for the Future) and one by William Pizer (Duke University)and Xiliang Zhang (Tsinghua University).  (There is a parallel impact and concern – in cap-and-trade systems – with an output-based updating allocation, which can address competitiveness impacts but also introduces inefficiencies by subsidizing dirty production.  This mechanism – which affects only energy-intensive and trade-exposed industries – was proposed in the Waxman-Markey climate legislation and is employed in California’s system.)

The rate-based approach is intended to have a smaller impact on marginal production costs than the mass-based cap-and-trade approach, and thereby is likely to have a smaller impact on the price of products (whether electricity or manufactured goods).  This is the motivation for using this approach in an output-based updating allocation, as described above, and it carries with it the parallel disadvantage of insulating consumers from (some of) the social costs of their consumption decisions.  The problem is exacerbated in the case of China’s evolving system because the performance standards (emission benchmarks) are set not only by sector, but by various categories of electricity production within the sector.  As some categories are, in effect, subsidized by other categories, the cost-effectiveness of the overall system declines.  There is a lack of incentive for the carbon market to move energy consumption from coal to natural gas, for example, because of the multi-benchmark approach.

Finally, it appears that allowances will be allocated without charge, at least in the early stages of the program, which has been typical of emissions trading systems in other parts of the world, and may lessen political resistance while also sacrificing potential efficiency gains associated with auctioning allowances and recycling revenues.

What’s Unknown about the Chinese Carbon Trading System

Among the key design elements that are unknown as of now (at least to me) are the following:

(1)        What will the total allocation of allowances initially be and how will it change (presumably decrease) over time?  Apparently the overall “cap” will be set by adding up the expected emissions of compliance entities, based on their historical emissions.  Then, allocations will be reduced, presumably based on technology performance benchmarks.

(2)        When will trading commence?

(3)        What share of allowances will be distributed for free, and how many – if any – will be auctioned (and how will any auctions operate)?

(4)        What provisions will there be for monitoring and enforcement, and will there be fines or other penalties for non-compliance?

(5)        How will the system interact with other Chinese climate policies?  This is an important question, because so-called “complementary policies” that seek to regulate sources under the cap of a cap-and-trade system can lead to perverse outcomes, as in the European Union and California.

(6)        What is the time-path for expanding the scope of the system to include more sectors, and what sectors will be added?

(7)        When and how, if at all, will China seek to link its system with carbon-pricing and other climate policies in other parts of the world?

Given all of these open questions plus the limited sectoral scope of the announced system, it is reasonable to ask:  what should we make of all this?

How Significant was the Chinese Announcement?

The announcement, despite all the caveats, was a significant step along the road of climate change policy developments, because the Chinese system will eventually be very important, because of its magnitude and because of the importance of China in CO2 emissions and climate change policy.  However, the announcement was not a launch per se, but a statement about a forthcoming launch.

More broadly, the announcement and the eventual launch of the system will have significant effects on other governments around the world – regional, national, and sub-national.  Some will be encouraged to launch or maintain their own carbon trading systems, and to increase the ambition of their systems.  Why do I say this?

A frequently stated fear of adopting climate policies, including carbon pricing, is the competitiveness effects of those policies, due to emission, economic, and employment leakage.  This is more a political issue than a real economic one, but it is nevertheless important.  Since the greatest fear in this realm is that domestic factories will relocate to China, that concern will be greatly reduced – or at least it should be – when and if China has put in place a serious climate policy, whether through carbon markets or otherwise.

China is moving slowly and cautiously, which is wise.  Not long ago, they were considering launching a system that would initially cover 7,000 companies in several sectors, but the 2017 announcement is of a system that covers 1,700 companies in the electricity sector alone.  Of course, it is still important, given that the electricity sector (with its large coal and natural gas plants) accounts for fully a third of China’s CO2 emissions.

During the next two years, the Chinese government – apparently through its National Development and Reform Commission (NDRC), which will administer the trading system – will begin by developing systems for data reporting, registration, & trading – gathering and verifying plant-level emissions data.  This will facilitate the establishment of baselines for allocations of allowances.  Beyond this, a wide range of rules will need to be established.  Following some tests, the actual spot market may launch in 2020 (the same year the Paris Climate Agreement essentially replaces the Kyoto Protocol).

The Path Ahead

As inevitably seems to be the case, the best assessment of this new policy lies somewhere between the extremes.  The December announcement by China was neither as exciting as some of the applause from climate activists might suggest, nor was the announcement as meaningless as conservatives have claimed.

Rather, cautious optimism seems to be in order.  China is serious about climate change, and is thinking long-term.  The country appears to be methodically working to develop a meaningful carbon trading system.  What is important now is developing a robust system that can be effective, expanded in scope, and gradually made more stringent.  Among the greatest challenges will be achieving the cooperation of the provincial governments, not to mention the compliance of the regulated entities.

Development of the system has begun, with the real launch of trading likely to take place in 2020, which is a key year for Chinese climate policy for other reasons, as well.  In that year, China will release its next Five-Year Plan, and it will submit its updated Nationally Determined Contribution to the UNFCCC under the Paris Agreement.  What will the United States be doing that year?  Not much, just electing a President!

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