China introduces world’s largest carbon trading market

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With the first deal of 160,000 tonnes carbon certificates sold on Shanghai Environment Energy Exchange on 16 July, China expanded previous emission trading pilot areas nationwide as the country sets about keeping its carbon-neutral pledge by 2060 via launching the market-oriented pricing mechanism.

Carbon trading allows companies to buy and sell emission permits of carbon dioxide or other greenhouse gases, and gives them incentives to cut pollution. The long-awaited national carbon emission trading scheme (ETS) covers more than 2,000 companies responsible for more than 4 billion tonnes of carbon dioxide emissions per year, making it the world’s largest emissions trading market.

Ben McQuhae
Ben McQuhae & Co

The first stage involves the power sector, which accounts for 41% of China’s CO2 emissions, according to the National Energy Administration. “The carbon emission of power companies is comparatively large while their products are relatively homogeneous,” said Zhou Yacheng, a Beijing-based partner at Zhong Lun Law Firm.

“Power companies are equipped with complete data measurement instruments and their management of data is standardised. Hence, it is easier to verify and inspect the data, and more convenient to allocate these allowances.”

Lui Kanyi, a Beijing-based partner at Pinsent Masons, said: “The strength of China’s new ETS is its scale and flexibility.” The new scheme is operating on a flexible emissions cap (FEC), which, different from the cap-and-trade approach, is adjusted annually based on intensity and output of the participant, as well as the overall covered emissions, which “gives the government room to really fine-tune things”, said Lui.

Lui Kanyi
Pinsent Masons

But the new design has failed to stimulate the subdued trading activity of the national carbon market. “The FEC is complex, and the currently generous penalty levels appear to be intended to encourage reporting and voluntary compliance, both of which are reflected in the current trading price and limited trading activities,” said Lui.

“However, given China’s 2060 carbon neutrality pledge, we can expect things to be tightened fairly rapidly, especially on the legal and regulatory aspects, which will provide more guidance and clarity to the participants.”

The weak demand was also due to the lack of foreign investors and future products, according to Grace Hui, head of green and sustainable finance at Hong Kong Exchanges and Clearing (HKEX). That unleashes huge opportunities for Hong Kong to develop itself into a regional carbon trading centre in the Greater Bay Area.

Hui said the Securities and Futures Commission and HKEX are exploring ways to bring foreign investors to the mainland carbon market by the Bond Connect and Stock Connect investment channels.

Zhou Yacheng
Zhong Lun Law Firm

“China’s decarbonisation journey involves raising a huge amount of green capital and attracting significant offshore investment,” said Ben McQuhae, the founder of sustainability-focused law firm Ben McQuhae & Co. “We see the carbon market as a great opportunity to attract foreign capital. At this time the carbon market infrastructure – including price discovery, futures, etc. – necessary to be a fully functioning market is not in place.”

The Hong Kong-based boutique firm has become the first offshore buyer of China’s carbon credits, after it bought nearly 10,000 tonnes of China Certified Emission Reductions (CCERs) from Elion Resources on 9 August.

“With investor and consumer expectations increasingly fixated on companies’ ESG performances, businesses sooner or later will need to develop a decarbonisation strategy, of which carbon credits will play a role,” said McQuhae. “Businesses that recognise and factor this into their business strategy can establish a competitive advantage, with potential to arbitrage the opportunity to service an increasing demand for low-carbon services or products.”

Lawyers foresee that as more high-emission sectors are expected to be included in the carbon trading scheme, related enterprises should prepare for upcoming carbon compliance.

“The first batch of participants only includes power plants and already accounts for 20% of global carbon emissions,” said Lui. “The ETS is expected to expand in time to cover other sectors such as petrochemical, chemical, building materials including cement, steel, non-ferrous metals, pulp and paper, and aviation, which will cover around 70% of China’s carbon emissions.

“Over 90% of the covered participants are new participants, so some learning curve must be allowed for all of the stakeholders,” he said.

Zhou said the key emission units should take the initiative to understand the rules and processes of the carbon emission trading system, including the allocation of allowances, the preparation and verification of greenhouse gas emission reports, the participation in trading, carbon emission allowance clearing, information disclosure, as well as regulation and penalties, and proactively carry out compliance management regarding carbon emission trading. “Enterprises should prepare as early as possible, and plan in advance, to prevent penalties for breach of carbon compliance obligations, or higher costs to fulfil their clearance obligations,” he said.

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