The establishment of carbon trading market in People’s Republic of China: A legislation and policy perspective

The Kyoto Protocol, which seeks to reduce global greenhouse gas emissions, established three flexible mechanisms for international cooperation: International Emissions Trading, Clean Development Mechanism (CDM) and Joint Implementation (UNFCCC, 1998). CDM, in particular, allows investors from the industrialized countries to obtain Certified Emission Reduction (CERs) units, which are permits for projects that contribute to reductions in emissions for developing countries (Ren and Socacool, 2015). According to The World Bank (2012), around US$4bn is provided to the developing countries through CDM projects annually.

China, as the largest supplier of CDM projects in the world, is also a market that has the most potential in carbon mitigation, with annual carbon emissions-trading reaching US$2.25bn (Han et al., 2012). The establishment of carbon trading market has been experimented in China since 2011 (Duan et al., 2014; Han et al., 2012), with plans to scale-up to a nationwide market taking shape (Zhang, 2015a). While the development of carbon trading market has promising prospects and is likely to play a decisive role in China’s low-carbon economy, how such a market would work efficiently, given China’s socialist economy context, is still raised as a caution by analysts (Lo, 2013; Zhang, 2015b).

The aim of this paper is to recommend legal, public-policy and institutional steps and mechanisms that China may follow to establish a nationwide carbon trading market. As an exploratory study with emphasis on policy recommendations, it elucidates the importance for both strategy and practice for China to establish laws and institutions to govern and regulate such an emerging carbon market.

The analyses and recommendations of this study rest on an analytical framework built on several theoretical approaches, including institutional and welfare economics, law and economics. According to welfare economics, externalities occur in economic activities where the costs of social production and private production differ, which often lead to a spill over of the costs or benefits onto third parties. When third parties benefit from an activity in which they are not directly involved, the benefit is called a positive externality. However, when such an activity is considered an imposed cost on third parties, it is a negative externality (Pigou, 2013). In the context of environmental protection, the development of low-carbon emissions technology is an activity that has positive externalities. The cost of developing such technology, however, is not necessarily paid by the beneficiaries. On the other hand, the behaviour of some enterprises that emit a large amount of greenhouse gas creates negative externalities. While these enterprises enjoy the profits of their production, the cost of environment protection is borne by the whole economy (Lin, 2012).

Economic perspectives offer two primary approaches to the internalization of environmental costs. One approach suggests that Pigouvian tax can be levied on enterprises that emit greenhouse gas to increase their production costs, to achieve emissions reduction. However, this approach may be difficult to implement due to the incomplete or unreliable information about the costs and profits of those enterprises.

Institutional economics advocates that property rights are the crucial determinants of the efficiency of markets and through establishing a carbon emissions-trading market, the negative externalities can be addressed through market mechanisms (Lin, 2012). Due to the rapid growth of population and economic development, environmental capacity has increasingly become a scarce resource, although as a public good it can be used without a cost. This is due to the lack of proper institutions which can help establish a sound system of environment property rights, resulting in an inefficient allocation of said capacities. Defining property rights in the first place, along with the introduction of transaction costs, affects the allocative efficiency of resources (Coase, 1960). Following the arguments of institutional economics, if environment capacity resources are clearly defined and are allowed to be traded in the market, owners of the resources will get additional benefits through market transactions, which provide incentives for them to further reduce emissions. On the other hand, the users will have to purchase emission rights at market prices and hence will be pushed to reduce their emissions.

Institutional economics theories also connect the discipline of economics with law. The field of law and economics involves the application of economic theories and methods to assess whether the legal and institutional arrangements are efficient. The carbon trading market under the Kyoto Protocol is a good application of the theory of law and economics within an environmental protection context, which suggests that the minimization of transaction costs, optimization of resource allocation and maximization of economic benefits are key elements in establishing a legal system for carbon trading markets (Han, 2009). The careful design of a legal system will lay the foundations for an optimal allocation of carbon emissions initially, help define property rights, minimize transaction costs and promote market mechanisms. This will overcome the shortcomings of the administrative approach currently practiced in China’s environment protection (Liu, 2012).

This present study forms a part of a regional research project aiming to identify sound policy approaches for the establishment of a carbon emissions-trading market in China. It primarily uses a qualitative approach to data collection and analysis, which includes the following specific components:

• a literature review undertaken to draw theoretical and empirical background for the current study;

• secondary data collection and analysis, including statistics of national and industrial carbon emissions, national and provincial socioeconomic indicators;

• collection and analysis of relevant laws, regulations and policy documents on carbon trading and environment protection;

• comparative analysis conducted to examine how emissions trading system of the European Union and the Chicago Climate Exchange were established and operated; and

• semi-structured interviews were conducted with government officials, key informants at carbon emissions-trading pilot programs in Beijing, Shanghai and Tianjin, as well as industrial experts in the real estate, steel and electricity generation industries. This was done to gain an in-depth understanding of the potential challenges that such a market in China would face. In the end, a triangulation approach was used to analyze information from the above primary and secondary sources.

The technological revolution associated with the low-carbon economy has gained momentum and recently become a major force in the recovery process of the global economy (Wong et al., 2014; Zhang, 2000). The low-carbon economy has stimulated the transition of the traditional financing model towards an innovative, green financing model. Such mechanisms have been created under the low-carbon economy, which have become the cornerstone of the emerging international order (Nakamura and Hayashi, 2013; Shafiei et al., 2014).

Currently, countries around the world are actively promoting their own currency to gain dominance in the global carbon trading. For example, with the rapid development of the European Union’s (EUs) emissions trading system, the EU has succeeded in raising the power of the euro (€) on pricing and account settlement in the global carbon market (Beck et al., 2015). Analysts argue that once the global carbon trading market is fully developed, the current international monetary systems may be reconstructed around the carbon currency based on the carbon emissions permits. Countries that dominate the international carbon trading market will likely enjoy a leading position in this new economy (Wen et al., 2015).

China faces challenges of both poverty eradication and climate change. Ways to reduce carbon emissions, while achieving a balance between environment protection and economic development, is a top policy concern for China (Ahuja and Tatsutani, 2009; Qi, 2011). Coal, has been and remains to be, a major source of energy for China in the foreseeable future. However, coal combustion releases significant amounts of nitrogen oxides and other pollutants, and it is the leading source of carbon dioxide emissions (Wang et al., 2014). With the arrival of the low-carbon era, China’s traditional energy structure will have to include more green and renewable energy (Meyar-Naimi and Vaez-Zadeh, 2012).

Given the increasingly intensified climate crisis and energy crisis in China, the best way forward is to accelerate the low-carbon transition with the establishment of a full-fledged carbon trading market. Carbon trading can promote the development of renewable and clean energy and, therefore, change the energy structure of China. It can help reduce the demand for energy without a substantial negative impact on the economic growth (Garg et al., 2015; Zhang, 2012). The establishment of carbon emissions-trading systems will also provide establishments with systematic information to make informed decisions on investment related to emission reduction (Zhang, 2000).

At the end of 2009, under the Copenhagen Accord, the Chinese Government pledged its national plans to lower carbon emissions per unit of GDP by 40-45 per cent from 2005 to 2020 (Sun et al., 2015). In the 12th Five-Year Plan, China set an interim target to reduce domestic carbon dioxide emissions per unit of GDP by 17 per cent from 2010 to 2015. In 2011, the State Council issued the Work Plan for Controlling Greenhouse Gas Emissions, cascading the national reduction target of 17 per cent down to the provinces and signalling a plan to set-up a carbon trading market in phases.

In November 2012, the 18th National Congress of the Communist Party of China further included the development of ecological civilization in government strategies and polices, and specifically pointed out the important task of initiating carbon trading pilots. In 2013, the Chinese Government issued its National Climate Change Strategy, which clearly located climate change-related policies and measures on top of the medium- and long-term national economic and social development plan and strategies (He, 2013). By October 2011, the National Development and Reform Commission formally approved five municipalities and two provinces, including Beijing, Shanghai, Shenzhen, Tianjin, Guangdong, Hubei and Chongqing, to launch pilot programs for carbon emissions trading. These pilot platforms have already entered the substantive cap-and-trade phase (Table I).

Such programs cover between 35 to 60 per cent of emissions within their respective jurisdictions (Hu et al., 2014). The experience and lessons learned from the pilot programs are valuable to the establishment of a nationwide carbon trading market (Han et al., 2012; Munnings et al., 2014; Zhang, 2015a). However, these pilot schemes operate independently and are different from each other, as they have established their own carbon trading regulations that are tailored to their regional or local circumstances (Table II). This prevents an efficient and effective development of a unified national carbon market throughout China (Munnings et al., 2014; Qi et al., 2014).

The first considerable step towards the establishment of a national carbon market was seen in 2014, when the National Development and Reform Commission issued Interim Procedures of the Administration of Carbon Emissions Trading based on the experience and lessons learned from the seven pilot trading schemes. The Regulations for the National Carbon Market was then issued, which planned to start and improve a national carbon trading market during 2016-2020.

A series of laws have also been passed to guide the efforts to reduce carbon emissions and generally to improve the environment. Among these laws, the Air Pollution Prevention Act and the Water Pollution Prevention Act had set specific stipulations concerning the emissions cap and control system and the pollutant discharge permit program. These two laws have provided a solid foundation for the pollutant discharge permit trading pilot schemes.

However, to date, there is no specific law passed by the People’s Congress or by its Standing Committee to regulate the emerging carbon trading market (Tang et al., 2015; Zhang, 2015a). All the relevant rules and guidelines are seen strictly within other laws related to environmental protection and the administrative regulations set by the National Development and Reform Commission.

China has maintained a “command-control” style of administrative mechanisms for carbon emissions reduction (Han et al., 2012). The mechanisms comprise regulatory frameworks on emission standards, energy standards and emissions permits. This represents a “one-size-fits-all” approach, and have been applied to economic entities directly without any necessary differentiation. In reality, local governments tend to rely heavily on compulsory administrative measures, forcing high pollution and high-energy consumption enterprises to reduce pollution (Zhang et al., 2013). While this approach may achieve good reduction results in the short term, it brings substantial negative implications for the economy in the long term (Carson, 2010).

On the other hand, the market-oriented approach for emissions reduction is based on market mechanisms providing incentives for voluntary mitigation. It aims to promote the use of low carbon technologies and offers incentives to enterprises through setting the trading rules, defining property right and developing favourable fiscal and taxation policies (Perdan and Azapagic, 2011). It has been adopted by increasingly more countries due to greater flexibility and higher autonomy.

Government functions in China’s environment protection, therefore, should shift from administration to service orientation and from the unitary administrative to a motivational model, led by market coordination and safeguarded by government supervision. Government’s compulsory measures should only be applied to issues pertaining to the basics of environment protection and the development of a robust and vibrant market. Based on these considerations, the following steps are proposed for the establishment of a nationwide carbon trading market in China.

A sound institutional set-up should start from the top-level design. The top-level design refers to the overall roadmap and planning at the national level to address the strategic development direction and other key issues for the future carbon market in China. Specific government policies and measures are to be derived from the national planning and strategic framework ensure a successful establishment of the nationwide carbon market that aims to take advantage of the global carbon trading for sustainable development of the Chinese economy (Bor and Zhang, 2010).

In general, the establishment of the Chinese carbon trading market should combine the top-down approach with the bottom-up approach in an integrated manner. In the bottom-up model, carbon trading is implemented on a trial-basis in some provinces and cities that differ in their energy resources structure and economic conditions. Through monitoring the accuracy of emissions data and the transaction efficiency, the local governments adopt a pragmatic approach in finding suitable solutions which facilitate the establishment of a unified national carbon trading market at a later stage.

The top-down model takes the national voluntary carbon emissions-trading platform as the starting point to collect the transaction and price data, to explore the feasibility of establishing a unified transaction model at the national level and to cultivate third-party certification institutions. The government encourages enterprises and financial institutions to actively take part in trading by adopting favourable legislations and policies on tax, credit and investments. Attempts should also be made to gradually switch voluntary carbon emissions trading to ones deemed compulsory.

The institutional set-up for China’s carbon trading can be improved through the following aspects. A new carbon emissions trading law may be legislated by the National People’s Congress or its Standing Committee, specifying the total amount of carbon footprint and initial allocation through law and detailing the rules and regulations for carbon trade. The legal attributes of carbon emissions permits may be further highlighted through amending the environment protection law. Other relevant regulations such as improvements to the carbon trading registration system and data dissemination system should also be duly explored. It is important that efforts should be made to ensure that the new laws and regulations are well-connected with the Administrative Licensing Law, Company Law, Property Right Law, Contract Law and other related laws (Gao et al., 2015).

An additional focus is to improve the monitoring mechanisms for the carbon trading market. This could be done through strengthening the risk prevention capacity and clarifying the legal responsibilities of concerned parties (Zhang, 2000). China should establish a set of regulatory standards for greenhouse gas emissions for mitigation of its domestic emissions. These standards should be self-measurable, self-reportable and self-verifiable. Efforts should be made to gradually align these domestic standards with international emissions standards, as it is a necessary part of the legal framework that prepares the nation to shoulder its obligations of future mitigation of global emissions (Vennemo et al., 2014). With the methods of mitigation validation being put into place, approval criteria and authentication rules for emissions mitigation projects being enforced and the third-party certification system being improved, carbon emissions reduction in China can then be measured, reported and validated.

At the same time, a “national carbon trading regulatory commission” should be established to monitor and oversee those carbon trading pilot schemes and to plan for the future of such a national carbon trading market. The commission should be tasked to study the key problems related to the establishment of the carbon trading market and steadily carry out those foundational works, including the improvement of the Measurement, Reporting and Verification (MRV) of greenhouse gas emissions statistics system and the formulation of market supervision systems (Han et al., 2012; Zhang, 2010).

China should establish its national control system for carbon footprint and the associated distribution and implementation mechanisms (Tang et al., 2015). It needs to pay attention to the following issues when setting the target for the country’s carbon footprint:

• First, China remains a developing country and its primary goal in the foreseeable future is still to eliminate poverty and to improve people’s living conditions. Therefore, setting the total amount of carbon footprint has to take into account the growth of the social and economic development.

• Second, the fundamental work of data collection and reporting for greenhouse gas emissions, indicators for measuring industrial development, utilization or consumption of energy and carbon sequestration in forests needs to be strengthened to allow the preparation of greenhouse gas emissions inventories. Accounting systems should also be established and improved to ensure the objectivity, reliability and accuracy of statistics and the standardization of data management, which helps concerned authorities make informed decisions.

• Third, with a total emissions quantity control in place, it is suggested to include in the mandatory category those high-greenhouse gas emissions regions and industries and to leave other regions and industries operating on a voluntary basis to set their emission quotas. This will make carbon emissions permits to become scarcer in the market, facilitating the efficient allocation of surplus emissions quota through the trading market.

The establishment of the Chinese carbon trading market is proposed to follow a gradualist strategy. From 2015 to 2020, a unified compulsory quota market should be established step-by-step and the carbon emissions trading law be introduced. Legal provisions are necessary to standardize and regulate the carbon trading process and to legally enforce or bind enterprises entering the trading process. This five-year period should also see the establishment and improvement of systems related to the MRV of greenhouse gas emissions, in which the measurement standards are unified and an information management system concerning industrial carbon emissions are improved.

By the 2020-2030 timeframe, China should endeavour to connect its domestic carbon trading market with the global market to develop an international carbon financial centre. On the one hand, China should focus on the improvement of emissions standards and trading rules so as to accelerate the internationalization process of its domestic market. On the other hand, China should expand the parties involved in carbon trading by attracting more domestic and foreign financial institutions, encouraging innovations in the carbon financial products, releasing more financial products like futures, options, forward contracts and others. These instruments can enrich and extend the carbon finance market. Eventually, China should form a multi-level carbon market, which is supported by a comprehensive financial and security system.

To commence with a paid scheme for the allocation of carbon emissions quotas in the initial stages, enterprises are unlikely to be encouraged to reduce emissions. It would give them additional burden instead and would be harmful for their transition to a low-carbon production. As a result, during the initial stages of building its carbon trading market, China should opt for a free allocation scheme to allow a transition period for enterprises to adapt to the carbon trading initiative. While the initial allocation of China’s carbon emissions quotas may be free, it should gradually be shifted to a paid scheme (Hickman, 2010; Munnings et al., 2014; Tang et al., 2015). After the transit period is over, a paid allocation scheme may be implemented in certain selected cities or regions on a trial basis, and later be gradually extended nationwide.

China’s paid allocation of carbon emissions quotas may be adopted in the form of public auctions, as they offer an effective channel to ascertain the prevailing market prices for carbon emissions permits and also to gauge the ultimate cost of environment protection and improvement. This facilitates the government’s effort to plan for emissions reduction and to set targets. Public auctions also assist in the distribution of environment resources to the highest bidder, to the enterprises that are in dire need, thus archiving the optimal allocation of resources.

As for the specific methods for the distribution of carbon emissions quotas within China, a multi-echelon distribution network may be adopted. The National Development and Reform Commission carries out the first layer distribution, allocating emissions quotas to the provinces, autonomous regions and municipalities based on their levels of economic development and current amount of carbon emissions (Wang et al., 2012). The local governments then redistribute these quotas to their industries and enterprises according to their local circumstances.

Given that different industries and enterprises are in various stages of development, it is therefore necessary for the local governments to examine the cases thoroughly before the allocation of emissions quotas to ensure fair distribution towards efficient functioning of the market. Additionally, local governments should report carbon emissions statistics to the National Development and Reform Commission in a timely manner, where necessary adjustment can be made to the national emission mitigation strategies at the macro-level in the light of such disclosures (Gong et al., 2015).

A comprehensive framework for greenhouse gas monitoring, reporting and assessment should furthermore be created, with reference to the existing Implementation Plan for Unit GDP Energy Consumption Statistical Indicators System, the Implementation Plan for Unit GDP Energy Consumption Monitoring System and the Implementation Plan for Unit GDP Energy Consumption Assessment, which were formulated in 2007.

A region-, industry- and sector-specific data-reporting system should be established with a bottom-up reporting mechanism (Li et al., 2013). Such a data-reporting system helps ensure that data reported will be scientifically accurate, comprehensive and will lend support to national agencies to compile emissions statistics in preparation for future reduction plans.

Necessary administrative measures taken may also help improve the mitigation performance and encourage those responsible to verify the data level-by-level. Based on the Statistics Law, the Provisions on the Punishment of Violations of Law and Discipline in Statistics and other related laws and regulations an effective administration accountability mechanism should be put into place, to prevent statistical distortions or any manipulations from occurring.

The low-carbon economy represents the strategic direction of China’s economic development in the future. In the transition towards a low-carbon economy, the carbon trading market stands out as a highly efficient, low-cost and market-oriented system to continuously energize the low-carbon economy.

Although China has started late in the establishment of its carbon trading market, it has rich carbon emissions resources that provide a solid foundation for the development of its domestic carbon market. The development of China’s carbon trading market stands at the core of the measures taken by the government to cope with climate change (Han et al., 2012). The establishment of a national carbon trading market, however, is a systemic and complex process which requires coordination among various concerned government agencies and supporting mechanisms.

This paper suggested a concerted and gradualist approach to developing a nationwide carbon trading market in China, highlighting the important role of legal, institutional and policy arrangements. It argues that it is necessary for the Chinese government to expedite efforts to establish a unified national carbon trading market, thereby gaining a fair share in the global carbon market – eventually facilitating a smooth transition to a low-carbon economy.