Delivering on Decarbonization? Evaluating China's New Emissions Trading System [ 6 min read ]
Insights
- China’s nationwide CO2 emissions trading system is projected to make a serious contribution to global reductions of CO2.
- In its first phase, in which China’s system covers only the power sector, the climate-related benefits are likely to exceed the economic costs by more than a factor of three.
- Unlike the cap and trade (C&T) systems used in other countries, compliance under China’s system depends on emissions intensity: a covered facility’s ratio of emissions to intended output (e.g., electricity) rather than its absolute level of emissions.
- The intensity-based approach implies lower impacts on prices to consumers and greater flexibility in responding to changes in the state of the overall economy.
- At the same time, this approach implies higher overall economic costs. Central estimates from this research are that in the system’s first phase, the costs will be about a third higher than what would occur under an equivalent C&T system.
Lawrence Goulder et al. (forthcoming). Trading Carbon: China’s Ambitious New System. Milken Institute Review.
China, the world's largest emitter of greenhouse gases, has pledged to have its CO2 emissions peak no later than 2030 and to achieve net-zero carbon emissions by 2060. To reach these goals, China is implementing what will be the world's largest CO2 emissions trading system. China’s approach, called a tradable performance standard (TPS), differs from the more conventional cap and trade (C&T) systems used in the U.S. and Europe. How does China’s TPS system function? How are the costs distributed across industries and consumers, and what scope of emissions reductions will the system bring about?
The data. This research focuses on the TPS’s impact in its first phase, which only covers China’s power sector and was launched in July 2021. Employing a unique dataset of cost, revenue, and emissions from most of the power plants supplying China’s electrical grid, researchers constructed two models to compare the TPS to C&T and predict the costs and impacts of the TPS system under various conditions.
The TPS is more reliant on reduced emissions intensities. Both the TPS and C&T include provisions for allowance trading, which helps reduce the system-wide costs of achieving economy-wide reductions in emissions. But there are important structural differences between the systems. For the covered facilities, the TPS establishes ceilings on emissions intensity (the ratio of a plant’s CO2 emissions per unit of intended output such as electricity), while C&T imposes limits on the absolute volume of emissions. These differences have important implications for the costs of achieving emissions reductions and for the ways that these costs are distributed across regulated firms.
Under both systems, a covered facility can achieve compliance by utilizing some combination of three channels: 1) reducing emissions intensities; 2) reducing intended output (e.g., electricity); and 3) purchasing emissions allowances from other facilities. The third channel expands a facility's allowance ownership beyond the number initially granted to the facility by the government.
The incentives to reduce emissions through reduced intended output are much weaker under the TPS than under C&T because the number of emissions allowances offered to the firm by the government declines proportionately with the scale of output. In contrast, under C&T, reducing output does not prompt a similar reduction of allowances. Consequently, compared with C&T, covered facilities under the TPS rely less on output reduction and more on the other channels to reduce emissions.
Differing channels for reaching an emission-reduction target
China’s emissions trading system less cost effective than C&T. The TPS’s weaker incentives for achieving emissions reductions through reductions in intended output underlie its disadvantage in terms of cost-effectiveness. The TPS’s extra reliance on reductions in emissions intensity, in particular, is excessive from the perspective of economic efficiency. A central estimate from this research is that the overall economic cost of the first phase of the TPS is about a third higher than that of a C&T system with the same coverage.
Comparing the costs of the TPS and C&T in reaching emissions reductions
China’s higher-cost TPS offers some advantages. Although less cost-effective than C&T, the TPS has offsetting attractions. Compared to C&T, the TPS leads to smaller increases in output prices in the covered sectors. This mitigates the shifts in demand toward other sectors and the "emissions leakage" that can result from higher output in those sectors.
A second attraction is that the TPS’s stringency adjusts in response to the broader economic environment. For instance, when the economy is booming and demand for electricity is relatively high, the expanded output entitles firms to a larger number of emission allowances, since allowance allocations are a function of output. C&T programs do not have this attribute.
A third attraction relates to how the costs of the TPS and C&T are distributed. Because producers under the TPS make less use of output reduction as a means of reducing emissions, the supply of electricity is higher and electricity prices do not rise as much as they would under C&T. As a result, the share of the overall cost burden borne by consumers is smaller under the TPS than under C&T.
Environmental benefits of the TPS likely outweigh the higher costs. Despite higher aggregate costs, the TPS can generate significant net gains once environmental benefits are counted. A central finding in the analysis is that the TPS’s benefits in terms of avoided climate damages are several times the policy cost when CO2 emissions reductions are valued at 290 RMB (44 $US) per ton. In addition to reducing CO2 emissions, the TPS will yield lower emissions of local air pollutants correlated with CO2. Accounting for the reductions in air pollution and associated health benefits would raise the benefit-cost ratio considerably.