China heads for a price on carbon amid an energy market overhaul

19 September 2014

By Frank Jotzo, Australian National University

In the lead-up to the UN leaders' summit on climate change, China is shifting up a gear in its drive towards national emissions trading. Yet for carbon pricing to be effective, market reform in China's energy sector will be needed - a big task that will bring benefits not only for the environment but also to the quality of China's economic growth.

China's National Development and Reform Commission last week stated that China's national carbon market will encompass between 3 billion and 4 billion tonnes of carbon dioxide by 2020 - twice the size of the European Union (EU) emissions trading scheme - and that it would expand after that. Many regulatory policies to clean up the energy system are already in place, most recently a new standard for the quality of coal.

China is signalling that it is serious about addressing climate change, and serious about using market mechanisms to do so. It is a timely signal, at a time when countries are deciding what post-2020 emissions targets they will put on the table in climate negotiations. It appears that China and the United States are taking a co-ordinated approach.

China's statement did not only give numbers for the likely extent of the scheme, but also an implicit expected price range: the market would be worth between 60 billion and 400 billion yuan (A$11 billion to A$73 billion). This implies an average price of 20-100 yuan, or between A$4 and A$18, per tonne of carbon dioxide at the current exchange rate. So it could be as much as double the current EU trading price.

Any carbon price can potentially have a much larger effect in the Chinese economy than in Europe or other Western countries. That is because the emissions intensity of China's economy - the ratio of carbon dioxide to gross domestic product (GDP) - is three to seven times higher than the emissions intensity of Europe (depending on whether GDP is measured in terms of purchasing power or exchange rates).

Reforming China's power sector

If companies can save money and increase profits by cutting emissions, they will have incentives to shift to lower-carbon energy and to further improve their energy efficiency.

Yet it will be fully effective only if markets are allowed to work. If prices are locked in by regulation, if investments are decided more on political objectives than future earning potential, and if operation of industrial installations is guided tightly by regulations, then a carbon price will not do much to cut emissions.

Pervasive government direction is still the norm in China's energy sector, especially in the power sector where much of China's emissions savings could be made. Electricity prices are fixed, many power plants have government-determined annual running times, and investments in new power plants by state-owned enterprises are not necessarily optimised for lowest cost and highest returns.

This highlights the need for energy-sector reform. It is right in line with the Chinese leadership's stated ambition for the market play a more central role in determining economic decisions. And market reform does not need to be completed before a price tag is put on emissions; the two can proceed in parallel. Indeed, carbon pricing could act as a catalyst for energy reform.

Markets will show up what is economical and what is not in China's energy sector. The benefits are likely to be large indeed. An energy sector that reacts nimbly to changes in prices will find enormous opportunities to save energy, and will make better use of the ample investment funding that is available in China.

And most of the changes will benefit the environment. It is a case of less cost and less pollution for the same amount of energy produced, which in turn can power more economic output.

Putting a price tag on emissions could also help improve the quality of China's economic growth. As my colleague Prof Teng Fei of Tsinghua University and I have argued, the benefits of shifting China's economy to a greener type of growth are often ignored in economic analyses. The global New Climate Economy report, launched in Beijing this week with support from Chinese cabinet-level officials, makes those points in the broader context.

One benefit is more predictable energy system costs when more renewables or nuclear power rather than coal, oil and gas are used. Another is to help re-orient the economy towards a greater share of high value added manufacturing and services. A third is the potential for economy-wide productivity gains as a result of greater energy productivity.

The design of market mechanisms and policy reform for emissions control in China is the topic of a collaborative research program on climate and energy policy between the Australian National University and Tsinghua University, and other top Chinese and Australian universities.

The Tsinghua-ANU Forum on climate and energy policy in Beijing earlier this week heard about preliminary evaluations of China's pilot emissions trading schemes that could inform choices for a national scheme, the modelling of electricity sector investment under a carbon price, the distributional effects of carbon policies and the responsiveness of China's energy demand to prices and income.

The politics of power

Of course, the mere existence of economic and societal gains from market reform and emissions reductions policies does not guarantee they will be implemented. The experience of many countries, rich and poor, is that powerful vested interests can block the way. Changing energy prices, regulatory and ownership structures can have big impacts on the profitability of established industries.

The present Chinese leadership, however, seems determined to make things happen even if it proves to be difficult. Cutting carbon emissions is clearly high on the political agenda. The fact that the central government is pushing hard on a national emissions trading scheme is a sign of that determination. Sweeping change could come quickly.

Frank Jotzo receives funding from the Australian Research Council. The Australia-China research collaboration mentioned in the post is partly funded by an Australian government grant.

This article was originally published on The Conversation.
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