Cop26 featured

China Waves Red Flag at Emissions Growth

But ETS will need to mature quickly to support carbon neutrality targets.

The success of next month’s COP26, and indeed the global fight to limit climate change, depends heavily on China. If the world’s largest manufacturer and greenhouse gas (GHG) emitter can sharply reduce its carbon intensity, it could be a game-changer.

As well as having a direct impact on global CO2 emission levels – China produced 28% of total emissions in 2019 – it would send a signal around the world. But history suggests we should not expect surprises.

China has not yet submitted its final nationally determined contribution (NDC), outlining its efforts to meet the goals of the Paris Agreement, ahead of the Glasgow summit. Other large G20 countries yet to submit include Saudi Arabia, India and Turkey, with several appearing to be heading in the wrong direction.

Climate Action Tracker currently rates China’s performance on reducing emissions as “highly inadequate”, calculating that its policies and targets are consistent with global warming of three degrees Celsius.

As they stand, the NDCs of all Paris Agreement signatories could lead to a temperature rise of 2.7 degrees by the end of the century, according to a report published last month by the UN Framework Convention on Climate Change, which will soon be updated to reflect further NDCs received by 12 October.

A separate report from the World Resources Institute says global warming can be kept to 1.7 degrees by century-end, if G20 countries alone commit to 2030 emissions reduction targets aligned with 1.5 degree net-zero 2050 pathways.

China’s net-zero strategy, unveiled in September 2020, commits the country to peak emissions in 2030, achieving carbon neutrality by 2060. In March, China’s 14th five-year plan outlined plans to cut carbon intensity (emissions per unit of GDP) by 18% and boost non-fossil energy usage by 20%, followed in April by a coal phase-out plan that puts its 2030 targets in realistic range.

But even to become compatible with two degrees of global warming, says Climate Action Tracker, China would need to peak emissions “as early as possible and decrease coal and other fossil fuel consumption at a much faster rate than currently planned – and set clear phase-out timelines”.

Too little, too late?

While some consider China’s current policies and targets insufficiently ambitious, others doubt even these limited goals can be reached without more stringent action.

Alongside heavy investment in renewables, especially solar, and low-carbon innovation, such as new energy vehicles (NEVs), a key plank of China’s climate-focused economic strategy is the long-delayed launch of its national emissions trading scheme (ETS) in July.

Explicit carbon pricing is widely seen as fundamental to effecting transition from fossil fuel dependency, both in China and globally, with carbon taxes less favoured than ETSs, which set the price paid by carbon emitters based on a target level of emissions set by the government.

But despite being the world’s largest national market, already covering four billion tonnes of CO2 emissions, China’s ETS could be too small and immature to have a short-term impact, and may even struggle to meaningfully drive carbon-intensive processes out of the Chinese economy before 2030.

Including only heat and power utilities at present, China’s ETS covers around 40% of national emissions, levies a less-than-punishing average price (€6-8 t/CO2) and imposes no formal emissions ceiling as yet.

The explicit policy objective targeted by the Chinese government is to reduce carbon intensity, rewarding the generation of fewer emissions per unit of output. Firms that meet a pre-set benchmark initially receive the free carbon emission allowances (CEAs) needed to cover their emissions, with those that fail to reach the benchmark receiving fewer, forced to reduce emissions or buy additional allowances. As the scheme develops, the intention is to move towards auctioning of all allocations.

It has been estimated that Chinese coal-powered plants over 300MW will achieve carbon-intensity requirements without needing to reduce emissions or purchase additional quotas, implying over-allocation and thus surplus of CEAs in the First Compliance Period. This focus on a benchmark emissions rate will lead power-generating utilities to improve the efficiency of existing plants, experts believe, rather than transition to cleaner energy sources.

Delicate balance

Daryl Liew, Chief Investment Officer, REYL Singapore, says China is following the lead of Europe, noting the EU ETS did not impose a cap at first. “It took the EU ETS several iterations before it started to make a tangible difference,” he says, predicting a similar developmental path. “As such, expect industrial players and a hard emissions cap to be included in the not-too-distant future.”

The “delicate balance” between reducing carbon emissions and meeting the country’s ongoing energy needs means a cap is unlikely soon, says Liew, who nevertheless regards China’s ETS launch as an important signal to energy producers of the need to “start making the necessary adjustments” in order to reduce their emissions.

China already has plans to extend its ETS to large emitters in the steel, cement, chemicals and aluminium sectors, but there is no fixed timeline. A recent analysis by Schroders and the Asian Investors Group on Climate Change says these sectors should be included by 2025, increasing coverage to approximately 80% of total emissions, in order for the ETS to make a significant contribution to China’s 2060 carbon neutrality ambitions.

Yan Qin, Lead Analyst at Refinitiv Carbon Research, says a declining cap must be introduced to drive up prices to incentivise covered enterprises to reduce their emissions. However, she suggests that the market will need time to evolve, climate crisis or not.

Capacity building and expertise needs to be ramped up, especially at the local level, Qin says, noting also the under-development of China’s commodities markets, particularly short-term power and fuel trading.

“Spot power trading has been tested in eight pilot provinces, but only covers 5-10% of generation,” she says, pointing also to the absence of derivatives markets. “Since the utilities are not active in hedging and trading power, their appetite for trading carbon allowances will also be limited, in contrast to Europe.” Carbon futures could take two years or more to become available, she adds.

Europe’s example

Launched in 2005, the EU ETS is being credited with driving low-carbon innovation and transition, as the prevailing carbon price of around €60 per t/CO2 becomes increasingly punitive on heavy emitters. A total of 68% of emitters say the EU ETS is an important driver of emissions reductions, according to the Refinitiv Carbon Market Survey 2021.

Under the European Commission’s Fit for 55 climate reduction strategy, the EU ETS is being reformed and extended, targeting a 61% emissions cut across in-scope sectors by 2030. To prevent carbon leakage, ie high-carbon imports undercutting domestic producers, the ETS will be bolstered by a Carbon Border Adjustment Mechanism CBAM), which levies a carbon price on comparable goods coming into Europe.

China has been studying the EU ETS closely, but it must learn from Europe’s mistakes quickly for its own ETS to be effective. Markus Zimmer, Senior ESG Expert at Allianz, warns that the issuance of free allowances is storing up problems for the future, noting that Europe is still dealing with the “messy” issue of retiring certificates, which has become more urgent due to the planned CBAM.

Of more immediate concern is the question of balancing incentives to emitters with economic realities. A mix of policy objectives for any ETS dictates the need for the setting of price corridors, says Zimmer, to allow for planning by economic decision-makers. “You don’t want the prices to crash to zero,” he observes.

Going global

The CBAM effectively takes Europe’s carbon emissions market global, with far-reaching implications. As noted in a recent blog by the Climate Bonds Initiative, this is significant step globally because Europe’s “trade reforms have the potential to create a domino effect of policy responses and green capital flows beyond its own borders”.

Nishad Majmudar, Sovereign Risk and Credit Strategy and Research at Moody’s Investors Service, sees a range of impacts for China. “We think the EU’s proposed border adjustment mechanism would be credit negative for exporters in not just China but elsewhere in Asia, given the relative stringency of the EU’s carbon regulations. However, China’s ETS could facilitate a convergence with European carbon prices over time that can mitigate these competitive pressures,” he says.

Allianz’s Zimmer says agreement on the direction of travel across major markets is both realistic and necessary, but predicts only a loose convergence between carbon pricing mechanisms for the time being.

“It’s totally out of scope to link the EU ETS to non-European ETSs while extending the European ecosystem, for example to shipping and air transport,” he says, noting also the growing consensus espoused by the International Energy Agency and others of prevailing carbon levels are likely to remain divergent between developed and developing economies.

“We don’t necessarily have to fully coordinate on carbon prices, but we should coordinate on ambitions,” says Zimmer, suggesting the CBAM concept could even provide the basis of international agreement on a net-zero free trade zone, ideally including China.

In a recent report, Credit Suisse’s ESG Research team suggested that initial Chinese criticism of CBAM should not be considered its final word on the initiative. “It is inevitable that a global carbon market ultimately follows with increasing prices resulting from the emissions gap that remains, accelerating the transition to lowest cost abatement in developing economies,” it said.

No surprises?

Many China watchers attest to the country’s ability to over-deliver on commitments once made and to relentlessly pursue long-term strategic goals. As noted in a recent blog by LGM, the emerging markets arm of BMO Global Asset Management, this record extends to previous energy efficiency and emissions reduction targets.

This gives cause for optimism, but does not mean the journey will be smooth, nor that it would have been easier had it started earlier. A recent comparative analysis by Moody’s puts the EU well ahead of China and the US on climate policy and ambition, noting “there remains significant uncertainty as to how emissions will be reduced” in both countries.

China’s economy remains highly carbon intensive, with higher emissions relative to GDP than the EU or the US, despite steady falls since the mid-1990s.

The future challenges of the three regions are very different, with power generation, manufacturing and construction contributing a higher proportion of China’s overall emissions, according to the Moody’s analysis, which also notes their continued upward trajectory.

“Whle China’s targets for the next decade put emissions on course to peak by 2030, this indicates that more aggressive and potentially disruptive actions will occur after 2030 to achieve carbon neutrality by 2060,” says Moody’s.

As recent research from Columbia University’s Centre on Global Energy Policy notes, China’s heavy emitters have so far been slow to respond to policy stimulus. “Nine months after the ‘30-60’ announcement, target-setting efforts by major firms and industry associations have been modest,” the report says.

All this implies a significant and expanded future role for China’s ETS over the next decade and beyond to incentivise transition. This could include greater global coordination on carbon pricing over time. As Refinitiv’s Qin notes, China has committed to discussing market-based mechanisms to fulfilling Article 6 of the Paris Agreement at COP26.

Speaking via video link to this week’s COP15 biodiversity summit, President Xi pledged to accelerate China’s path to renewable energy usage, saying China would “continuously push for adjustments in the industry structure and the energy structure”.

Xi, whose personal attendance in Glasgow is in doubt, made no reference to bringing forward China’s date for carbon neutrality. This may disappoint, but we should not be surprised if China over-delivers on its stated plans.

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