China is the world's largest emitter of greenhouse gases, far surpassing the total emissions of the second place nation, the United States. But despite this status, Beijing has been reluctant to join international treaties or protocols seeking to check greenhouse emissions. As a developing nation, China was exempt from the Kyoto Protocol, but it should not expect a similar exemption from the December summit in Paris; world powers are well aware that any binding deal without China would be insufficient. But sentiments in Beijing are changing, as China's intended action plan, submitted ahead of the Paris summit, shows. Beijing has set lofty goals for itself, including reducing CO2 emissions by at least 60 percent by 2030 and increasing the share of its renewable energy to 20 percent. However, there will be obstacles, especially at the local level, for Beijing to overcome before it can reach its goals. Still, the cap-and-trade plan is a considerable step in the right direction.
How Cap and Trade Works
Caps place limits on the emissions from a particular company or sector. To create an economic incentive to meet these targets, the allowances or permits on emissions can also be traded between entities. If one company is easily able to meet emissions targets, it could then sell the remainder of its allowances to corporations that need them. Beijing first began testing cap-and-trade pilot programs in June 2013 in the city of Shenzhen. Since then, similar programs have been implemented in Shanghai, Beijing, Guangdong, Tianjin, Hubei and Chongqing, which collectively account for 25 percent of China's GDP. Later, in August 2014, China announced that it would begin a national trading system in 2016, although the Sept. 25 announcement by Xi indicates that implementation will not occur until 2017 and some experts do not expect a national rollout until 2020.
The national program would include six sectors: power generation, metallurgy and nonferrous metals, building materials, chemicals, and aviation. Since 2013, pilot programs have followed Beijing's guidelines but have been tailored to specific provincial requirements as well. These pilot programs are all limited to CO2 emissions and cover the power sector and certain industrial sectors, which depending on the province or city can include steel, cement, petrochemicals, textile, oil and natural gas, mining, and the construction sectors. They cover between 35 and 60 percent of each region's total emissions. But there are key differences between the programs; for example, some require third party audits while others do not, and the allocation of credits varies significantly from case to case. In total, these pilot programs are the world's second largest emissions trading system — and a stepping stone to the envisaged national trading system.
Pilot areas were selected purposefully. The locales are all among China's most polluted, and Shenzhen, Guangdong, Shanghai, Tianjin and Beijing in particular have local leaders that have supported the programs. They also represent a variety of different economies: landlocked Hubei and Chongqing have different economic drivers than has coastal industrial and shipbuilding powerhouse Tianjin.
In a place such as China, it is far easier to set up an emissions trading platform than to enforce it. One of the most difficult parts of designing an effective emissions trading system is having a robust mechanism that monitors, reports and verifies results, doubly important in a country that already has difficulty tracking data and statistics. A lack of transparency over quotas and prices of traded permits has already plagued the local programs, and oversight will become more difficult as the program expands. For now, there are about 2,000 firms participating in the pilot programs: To put that into perspective, there are about 4,000 companies in China's steel sector alone.
Beijing lacks the experience and capabilities to adequately verify and monitor real emissions. The second compliance period for the pilot programs ended in July 2015, and the trial period met with mixed results that varied depending on province. Beijing, Shanghai, Shenzhen and Guangdong were deemed highly compliant, while there was more pushback in Chongqing and Hubei. The level of tangible success is unclear, as only Guangdong and Beijing have reported emissions reductions — 1.5 percent and 6 percent respectively — for 2014. And as Xi attempts to implement cap-and-trade programs on a national level, we can expect the compliance issues in several of the trial programs to come under increased scrutiny, limiting the central government's ability to meet its stated goals.
Xi's plans to standardize the seven pilot emissions trading systems and to expand them into a national one is probably overly aggressive; there is no one-size-fits-all solution for a country as diverse as China. The sheer scope of a national emissions trading system is staggering. China's industrial sector — which includes chemicals, refining, iron and steel, and similar industries — is by far the biggest source of emissions. However, China has consistently failed to force the sector to comply with national policy, especially when it comes to overseeing the plans of individual firms.
This difficulty can largely be traced back to Mao Zedong's policy of regional self-sufficiency, which resulted in the proliferation of small-scale industrial factories and plants across China. These firms would produce a wide array of products such as low-quality steel for the local construction industry, but most industrial sectors ended up dispersed and extremely fragmented. For at least 15 years, Beijing has been attempting to consolidate those sectors, but doing so has been difficult because local politicians oppose many of the attempts for fear they could disrupt the local economy, hurt local tax revenue and contribute to regional unemployment.
China's fragmented industrial sector is going to be a significant hurdle to implementing and enforcing any emissions trading system. Several of the pilot zones were in regions that are more economically liberal and have been the primary places for enacting more aggressive new programs such as special economic zones and or other laissez faire-stylized platforms. As a result, emissions trading systems in places like Guangdong, Shanghai and certainly Shenzhen are going to have far more political support to make their implementation easier. Other places, such as Beijing and Tianjin, also have strong local support because of the high levels of pollution and smog already tainting the cities' air quality.
China's fragmented industrial sector is going to be a significant hurdle to implementing and enforcing any emissions trading system.
Expanding this type of system into areas without similarly strong local political support, however, will be much more difficult. Other heavily industrialized provinces such as Hebei, Shandong, Jiangsu, and Liaoning will confront challenges. Even farther inland and in the north, the economy is less developed, and these areas will have a harder time adjusting than will the relatively more progressive southern, coastal or Yangtze River-based economies. Hebei is the heart of China's steelmaking industry and seven of China's 10 smoggiest cities are located in the province. While Hebei's provincial government has been supportive of curtailing pollution, it will be difficult to monitor the programs to ensure compliance because of the sheer number of firms located there.
Historically, under pressure from the government to close down, many companies have either expanded capacity to meet minimum capacity regulations, have invested in more environmentally friendly platforms to meet emissions standards or have fit under their carbon (or other environmentally linked) caps, which has been only nominally effective. Further complicating the situation, these companies are now being saddled with low commodity and steel prices because of China's declining economy, making it difficult to raise the cash needed to finance expansion or new equipment purchases. These companies have not responded to market forces but have instead used loan restructuring and other measures to avoid running out of business — often with the backing of local officials. So, while Beijing plans on using economic forces to shutter inefficient production and to establish cleaner production practices, companies will inevitably find creative ways to work around the regulations.
Beijing must try to balance its final cap allotment and trade mechanism with China's overall economic needs. The amount of carbon emissions allowed must be set where the price of carbon is high enough to make it economically attractive to invest in technologies that reduce emissions. If the price is too low, the system will not work. As we have seen in the case of the EU cap-and-trade system, an initially high cap level can result in the market price of carbon flat-lining when industrial production deteriorates in poor economic conditions — something witnessed in the wake of the financial crisis in Europe. As industrial production falls, there are more cap allotments to go around, since reduced production typically means reduced emissions. The European Union's carbon price fell from a peak of 30 euros per ton of CO2 equivalent in late 2008 to the 5 to 10 euro range that it has hovered between since late 2011. This can render a cap-and-trade system ineffective. It is estimated that the cost of carbon must exceed 40 euros before industries begin to see a large push toward renewable sources of energy and to investment into cleaner industrial systems.
There are already signs China will fall into the same trap as Europe. Beijing is expected to set the initial market price for carbon at around 39 yuan (roughly $6.10) per ton of CO2 equivalent, which is compared to the current price of about $9 in Europe. This is just the initial price, but once carbon allotments are set and are freely traded the price could fall much lower. For example, right now the carbon prices in Guangdong, Hubei and Shanghai — China's three largest pilot markets by emissions size — are $3.76, and $2.01, respectively. These are not only far below Europe's level, they are not even close to the level needed to economically-incentivize investment into cleaner emissions protocols. As China's economy undergoes a structural shift away from being dominated by the industrial and low-end manufacturing sectors, high-emitting production should in theory decline, putting China as a whole at greater risk for a drop in carbon prices. China has the additional constraint that many of the products or services derived from emissions heavy industries — such as electricity — are heavily regulated. This means that the cap-and-trade system will cause even more economic distortions if Beijing does not also liberalize linked products, allowing producers to pass the costs onto the consumers.
As we have seen in Europe, organizing a system to remove carbon allowances from the market to drive up the price of carbon is a difficult proposition. The Europeans are hoping to establish a market stability reserve, which would add or subtract carbon to the market beginning in 2021. Even then, in Europe's case, it is only expected to raise carbon prices to 30 euros by 2030. The United States, for its part, failed to get a nationwide cap-and-trade proposal though Congress.
It remains to be seen how effective China's cap-and-trade program will be at limiting emissions in the future. However, if the current prices of carbon hold, a push toward green energy and green industry is unlikely. China will likely remain the world's largest emitter of carbon — and a growing one at that. The cap-and-trade system will effectively act as an additional tax burden on companies that do not reduce their emissions. In the long term, companies that have, or have invested in, more efficient equipment will be more profitable. Those with the most outdated and inefficient equipment and standards will be forced to buy more carbon allowances. But it will take a significant amount of time before the pressure will force these companies to either consolidate or shut down.
If we see the environmental movement gain traction at the local level across China's second, third and fourth tier cities, we can expect emission reduction plans — like those in Beijing — to become more effective. Once the local political and social benefits begin to outweigh potential local tax revenue or other concerns, we could see local officials begin to support Beijing's emissions agenda, though change would not be immediate. Rather, it would likely be a gradual spread throughout China spanning years, if not a decade or two. China's provinces and municipalities have wide-ranging and varying degrees of development, in contrast to those in other countries, such as Japan, that have experienced similar industrial-linked pollution growth and have sought to reduce emissions in the past.
Though there is little doubt that Xi is sincere about trying to control China's emissions, the fact is that China is in the middle of a structural economic shift, forcing Beijing to simultaneously tackle a multitude of issues. Xi is attempting to liberalize the country's financial system, liberalize its economic system, reform the state-owned enterprises, conduct an anti-corruption campaign and implement a more active foreign policy, all while dealing with a slowing domestic and international economy. We have long said that Xi's anti-corruption purge is linked to the centralization of Beijing's political structure under Xi's control, but he still has a finite amount of political capital and bandwidth and must use it wisely. Xi's economic and financial reforms are by far Xi's most important. A market-based carbon trading platform does not contradict that agenda, but as the Chinese economy continues to slow down — perhaps even more in Chinese core industrial zones — the local governments that enforce policies will hesitate to do so, fearing it will worsen the already poor economic situation. Although we may see isolated success, China is unlikely to hit its targeted emission reduction goals because of these limitations.