Will the global effort to contain greenhouse emissions kick into high gear in time to prevent climate disaster? Much will depend on the success of China — currently the largest emitter by far — in meeting its pledge to begin reducing total carbon emissions by the end of the decade and to achieve carbon neutrality by 2060. That’s why so much is riding on the implementation of China’s nationwide CO₂ emissions trading system, which requires covered enterprises to limit their emissions.

Establishing a nationwide ETS in China is a monumental challenge in light of the country’s size and industrial heterogeneity, as well as the disparities in income and institutional capabilities across its provinces. The presence of state-owned enterprises poses additional difficulties, as do the administrative and political complexities of developing and operating the necessary monitoring, reporting and verification systems.

The new ETS, which began operation in mid-2021, builds on China’s experience during the past 10 years with seven provincial and municipal pilot programs for controlling CO₂ emissions. In its current phase, the system embraces only the power sector. But the plans are for the system to expand within a few years to cover most of China’s major industries. Here, we lay out the key features, with a focus on its major differences from the trading systems used in other countries.

How China’s Carbon Trading Stands Apart

As we’ll discuss in detail below, China’s nationwide ETS differs fundamentally from those used elsewhere. With the sort of capand- trade system used in Europe, each “covered facility” — think power plants, steel mills and cement plants — is assigned a specific cap below which it must keep its emissions in order to be in compliance. Those exceeding the cap must purchase emissions allowances from other facilities that, one way or another, manage to stay below their own caps.

China, by contrast, uses a rate-based mechanism, known as a “tradable performance standard” (TPS), where compliance depends on staying below a limit expressed as a ratio — in this case, the ratio of CO₂ emissions to output. The government assigns this ratio, or “benchmark,” to each facility covered by the performance standard. Because a facility’s compliance only depends on preventing the emissions-output ratio from exceeding the benchmark, there is no unique level of emissions from a facility that is consistent with meeting the standard.

In order for the government to achieve its pledged emissions reductions, the benchmarks are set at levels below the average emissions intensities of the range of covered facilities. A covered facility is granted total emissions allowances consistent with its assigned benchmark and based on its target output over the compliance period. So, since the allowance allocation is proportional to output, a facility can augment its emissions allocation by raising its output.

This feature reveals a critical difference between the Chinese TPS and cap-and-trade: increased enterprise output is effectively encouraged (economists would say: implicitly subsidized) because it allows larger emissions. And this indirect subsidy implies lower total costs for the firm than it would face under an equivalently stringent cap-and-trade program. As discussed below, this subsidy also implies significant differences in the impacts of the TPS and a cap-and-trade approach — differences in terms of the costs of achieving given targets for economy-wide emissions reductions, differences in the ways the economic impacts are distributed across producers and differences in the responsiveness of the policy to changes in macroeconomic conditions like recessions or booms.

More about all that later.

A Little History

China’s experience with carbon markets dates to its participation in the early 2000s in the Clean Development Mechanism, a U.N.-run voluntary carbon offset scheme allowing one country to fund greenhouse emissionsreducing projects in others and claim the saved emissions as part of its own efforts to meet international emissions targets. From the start, China was quite aggressive in its use of the CDM. Indeed, U.N. data indicates that by 2021 China had hosted more CDM projects than all other nations combined.

China’s first experience with mandatory carbon trading, as opposed to voluntary offsets, was in a series of pilot programs in major cities and provinces initiated in 2013-14. The origins of these programs can be traced to the 12th and 13th Five-Year Plans, which established initial targets for reducing both energy intensity (energy/GDP) and overall carbon dioxide intensity (CO₂/GDP), while increasing renewable energy’s share of total energy consumption.

These targets were meant to complement China’s broader strategic goals of restructuring the economy, enhancing energy security and addressing local air pollution. The targets also supported China’s pledge at the 2009 Copenhagen climate change meetings of a 40-45 percent CO₂ intensity reduction from 2005 levels by 2020 and the more ambitious Paris target of a 60-65 percent reduction in CO₂ intensity by 2030, as well as the latest goal of achieving peak emissions — that is, decoupling emissions from GDP growth — by the end of the current decade.

To gain practical experience with emissions trading, the National Development and Reform Commission (NDRC), the Chinese agency originally tasked with climate policy, selected five major cities — Beijing, Chongqing, Shanghai, Shenzhen and Tianjin — and two provinces — Guangdong and Hubei — with varying economic structures for the pilot programs. Program designs were a mixture of rate-based TPS (described above) and cap-and-trade where total emissions are capped, rather than emissions intensity.

While each program covered primary heavy industries — electricity and steam, petrochemicals, iron and steel, nonferrous metals, pulp and paper, glass and cement — the inclusion of other industries differed substantially across the pilot cities and provinces, reflecting, in part, the differing structures of the local economies. The pilot program in Shenzhen, a major financial and high-tech center in southern China, included commercial buildings and road transportation; Shanghai included commercial buildings, railways, ports, airports and aviation; Beijing included hotels, universities and medical facilities.

The pilots varied considerably in size, with the greatest emissions coverage (in terms of tonnage) in Guangdong and Hubei. Marketbased allowance prices generally ranged from $5-6 per ton of CO₂ and varied over time. The highest prices for traded allowances (as much as $10 per ton) were observed in Beijing, Guangdong and Shenzhen. The pilots also experimented with alternative approaches to measurement, reporting and verification (MRV, for short).

Although the data are limited, there is growing evidence that the pilots did succeed in reducing CO₂ emissions. A recent study in the Proceedings of the National Academy of Sciences compared firms participating in the pilot programs to similar firms outside the pilot areas and estimated the pilots’ average emissions reductions at 16.7 percent in the early years. The same study estimated reductions in participating firms’ average emissions intensity (CO₂/output) of 9.7 percent relative to the control group. Overall, the pilots provided key information needed to shape the subsequent ETS, which covers all of China, in contrast with the more narrowly focused pilots that applied only to the moredeveloped coastal and central areas of the country.

In 2015, a time of growing U.S.-China cooperation on environmental matters, a joint presidential statement from the two nations committed China to a national carbon ETS beginning in 2017. As was widely understood, a nationwide ETS in China would require new institutional capacity and infrastructure, along with consistent MRV approaches across covered sectors and regions. Developing these capacities over the course of only a few years would prove to be a major challenge for China’s public and private sectors.

It is noteworthy that the Chinese government committed to an ETS rather than a carbon tax, another form of CO₂ emissions pricing. Some factions, led by the Ministry of Finance, advocated for the carbon tax, arguing that it was a simpler and more efficient way to price emissions. At the same time, there was concern about the potential impact a tax would have on industry profits. Others claimed that, rather than reduce emissions, companies would simply pay the tax (or avoid it altogether) and thereby undermine the government’s ability to achieve its emissions- reduction goals.

The conflict over the form of emissions pricing was not simply a disagreement about the most effective approach; it was also a contest for authority over climate policy. Given the defined institutional responsibilities, the NDRC would clearly have domain over an ETS. In contrast, authority over a carbon tax would reside with the Ministry of Finance. The NDRC prevailed in this debate, although responsibility for operation of the ETS was later transferred to its current home in the Ministry of Ecology and Environment.

Nuts and Bolts

Compliance under the TPS depends on whether a covered facility’s emissions-to-output ratio does not exceed the governmentspecified benchmark. This differs from cap-and-trade, where compliance depends on whether a facility’s level of emissions does not exceed some specified emissions quantity in terms of tonnage.

Thus, a key design decision is the choice of the benchmarks to be applied to the various facilities covered. Under China’s TPS, the benchmarks generally differ across electricity- generating technologies, implying that units with different technologies receive different allowance allocations per unit of output. This reflects concerns about the costs of compliance.

In particular, less stringent benchmarks have been applied to coal-fired generators than to natural-gas-fired generators, bowing to the reality that coal-fired generators would otherwise experience higher compliance costs than competing sources of power. That’s a political plus because it can help address concerns about the distribution of costs. At the same time, greater variation of benchmarks tends to raise overall costs of the ETS. Greater uniformity of benchmarks would tend to reduce disparities in facilities’ marginal costs of emissions reductions, which, in turn, would imply lower economy-wide costs of the TPS.

Auctioning of allowances could provide an additional channel for allocating emissions allowances and fine-tuning the distribution of burdens. Virtually all the programs in the West have embraced auctioning as a supplement to free allocation. Currently, China’s TPS does not, although the planners are considering including it in the future. An auction can be used as a mechanism for controlling the overall supply of allowances and thereby controlling the market price of allowances.

Measurement, Reporting and Verification

The credibility of any ETS depends crucially on the quality of the emissions data used to design the program (e.g., establish the emissions limits) and assess compliance. Clearly, poor-quality data can undermine the effectiveness of an ETS. China’s national government has established guidelines for calculating CO₂ emissions from the power sector and other sectors to be covered in the future. Covered companies are themselves responsible for developing monitoring plans based on the national guidelines and measuring emissions based on the guidelines. At the end of each compliance period, third-party verifiers are to review the emissions reports and assess their accuracy.

Provincial governments — not the national government — are responsible for implementing the MRV program, including collecting and reviewing monitoring plans from covered companies, enforcing measurement and reporting rules, accrediting third-party verifiers, validating emissions reports, and reporting performance data to Beijing. Unfortunately, the national government’s guidelines are currently quite vague regarding the qualifications and accreditation of third-party verifiers. The provinces will likely have to take on those responsibilities, which, in turn, could result in inconsistent rules and incentives for thirdparty auditors.

To facilitate compliance assessment, the interim guidelines call for the national government to operate a national allowance registry that serves as the official record of allowance ownership. Provinces will use information from the national allowance registry, along with each company’s verified emissions, to determine whether the company complied with the allowance-holding requirements of the ETS.

Importantly, the Chinese authorities have set up training programs to build administrative capacity in government and industry across the country. However, it is not yet clear how the system will work in practice, as there is no statutory authority to determine financial or criminal violations for non-compliance. Thus, administrative penalties will be required, but how they’ll be applied — especially to state-owned enterprises which remain a big and politically influential part of China’s industrial base — is uncertain.

The First Phase: Focus on the Power Sector

When fully implemented, China’s TPS promises to become the world’s largest CO₂ pricing regime, more than doubling the total global emissions covered by a carbon price. But, as noted, the TPS covers only the power sector in its initial phase, which began last July. Although details have yet to be announced, the cement, aluminum, iron and steel sectors are next in line, to be followed by nonferrous metals, petroleum refining, chemicals, pulp, paper and aviation. Currently, the trading of emissions allowances is permitted among all covered facilities in the power sector. It is expected that the system will also allow for intersectoral trading once it is broadened to multiple sectors.

China’s power sector accounts for more than 40 percent of the country’s total CO₂ emissions. And while the TPS covers only fossil-fuel generators, these generators are pretty much all that counts in this context since nearly all emissions from power producers come from a mix of coal-fired and natural-gas-fired generating units as well as modern circulating fluidized bed reactors. (Hydropower accounts for about 20 percent of electricity production, with small percentages from nuclear, wind and solar.)

The role of market pricing in the power sector has increased steadily over the years, consistent with the continual reforms of the sector since 1985, when the state monopoly ended. Today, about one-third of the electricity produced in China is sold at free-market prices. As discussed below, the economic outcomes from the TPS reflect the system’s impacts on electricity prices.

TPS Incentives, Attractions and Limitations

All ETSs establish a market for emissions allowances, where each allowance entitles a covered facility to a certain quantity of emissions of a pollutant (in this case, CO₂) within the compliance period. The allowance price “internalizes” the environmental cost of their emissions and gives them incentives to reduce emissions.

The Chinese TPS shares several of the attractions enjoyed by other sorts of ETSs. As with cap-and-trade, it offers covered facilities considerable flexibility in determining how to reduce emissions. This is an oft-touted advantage of ETSs as compared to technology mandates — say, a requirement to burn gas rather than coal — and other direct controls on production.

In addition, as with other sorts of ETSs, the TPS’s provisions for allowance-trading tend to lower the cost of achieving aggregate emissions-reduction targets. In general, facilities for which the costs of compliance are especially high will have incentives to purchase emissions allowances on the market in order to sustain production, while facilities for which the costs of compliance are low will gain by selling some of their allowances and reducing emissions further.

Note that even the facilities receiving allowances at no cost implicitly face a price at the margin, because every additional ton of emissions either obliges the company to purchase an additional allowance or reduces the number of allowances it can sell for a profit to other polluters. Trades benefit both buyers and sellers, and they lead to more of the value-added being undertaken by facilities whose costs are relatively low. This reduces society’s overall costs of emissions abatement.

With the TPS’s intensity-based approach, covered facilities can achieve compliance by reducing emissions intensity, purchasing extra emissions allowances, or reducing intended output. The attractiveness of the third channel marks a difference between TPS and cap-and-trade.

Under both systems, reducing intended output reduces emissions. This in turn reduces compliance costs by lowering the number of emissions allowances that need to be purchased to meet government requirements. However, the output-reduction channel is a somewhat less attractive option under the TPS than under an equivalent cap-and-trade system. This is because reducing output involves an extra sacrifice under the TPS: the emissions-allowance allocation declines proportionately with the scale of output.

Consequently, compared with cap-andtrade, facilities under a TPS can be expected to rely less on output reduction and more on the other channels to reduce emissions. Studies show that this causes the TPS to be less costeffective — that is, the cost to society of reducing a ton of CO₂ is higher than in an equivalently stringent cap-and-trade system.

Moreover, under the TPS, facilities with emissions intensities below their benchmarks will have incentives to increase production in order to receive more emissions allowances — extra allowances that can be sold on the secondary market to the more emissionsintensive facilities that need them. And this higher production leads to increased emissions. This outcome differs from cap-and-trade, which generally encourages all covered facilities to reduce emissions.

Notwithstanding its limitations in terms of cost-effectiveness, the TPS’s intensity-based approach does have some important attractions. One is that the absolute reductions in emissions needed for compliance automatically adjust with the ups and downs of the business cycle. In boom times, a covered facility that expands its intended output (e.g., electricity) to meet market demands will receive more emissions allowances in keeping with the increase in output. This automatic adjustment in the number of allowances allocated helps reduce the sensitivity of compliance costs to the state of the economy.

Another appealing aspect of the TPS is its reduced impact on firm production costs. Because of its implicit subsidy to raising output, the TPS gives rise to smaller increases in output prices than does the equivalently stringent cap-and-trade system. Electricity prices, in particular, are likely to go up by less under the TPS than under cap-and-trade.

Consider, too, that in any market-based emissions-constraint system, the higher cost of the outputs of the covered sectors can cause demand to shift to other sectors. This leads to domestic “emissions leakage” from covered to exempt sectors.

International leakage can occur as well: to the extent that regulation of China’s emissions raises the prices of its outputs relative to foreign goods, consumers will tend to shift toward imports, potentially offsetting the global emissions-reduction goals of the domestic regulation. Thus, because the TPS’s impact on output prices is smaller than that of an equivalent cap-and-trade system, the extent of leakage is smaller.

A third attraction is the compatibility of the TPS’s rate-based structure with China’s international negotiation strategy on climate change, which, because it is committed to rapid economic growth, has emphasized reductions in emissions intensity rather than absolute emissions reductions. Further, the TPS has the virtue of familiarity: its rate-based structure matches that of several of the country’s previous provincial- and city-level pilot initiatives for reducing CO₂ emissions, along with other environmental control programs.

Where They Stand Now

At this early stage, the principal data available on the actual performance of China’s new ETS are the market prices of allowances observed in the initial, relatively low-volume transactions in the Shanghai Environment and Energy Exchange. These prices are roughly similar to the prices in the Chinese pilot trading programs, in the range of $5-$8 per ton of CO₂.

Our recent simulation study, keyed to the design of the Chinese TPS, allows some educated guesses about future performance. Based on the design and announced benchmarks for the different technologies in Chinese power plants, the study estimates that in its first (power-sector-only) phase, the TPS will produce a 3.1 percent reduction in CO₂ emissions compared to baseline levels. Clearly, much more extensive reductions would be needed in future phases to be consistent with China’s pledge to achieve net-zero emissions by 2060. But it is also clear that, with greater coverage and stringency, the TPS’s allowance prices could increase significantly.

The study also estimated the economywide costs under the TPS to be about onethird higher than under a comparably demanding cap-and-trade program. The costs differed significantly across provinces, reflecting differences in the provinces’ relative reliance on technologies with initial emissions intensities above or below the benchmarks. The northern, northwestern, northeastern and southwestern provinces are estimated to experience higher costs than others, with the largest percentage cost increases estimated for Shandong in the North and Heilongjiang in the Northeast.

Overall, despite the higher costs compared to a cap-and-trade system, our calculations indicate that the TPS’s environmental benefits in terms of avoided climate damages are many times the economic costs when CO₂ emissions reductions are valued at $44 per ton — the “social cost of carbon” estimated by the Obama administration’s Interagency Working Group in 2016. Note, too, as a bonus, that the TPS is also expected to reduce fine particulate matter and several other dangerous non-global air pollutants correlated with CO₂ emissions. Indeed, accounting for the reductions in air pollution and associated health benefits would raise the benefit-cost ratio considerably.

What Next

China’s CO₂ ETS really has the potential to make a major contribution to the global battle against climate change. Even though the chosen instrument, a tradable performance standard, is not as cost-effective as cap-andtrade, China’s commitment to emissions pricing along with the wide geographical scope of the system means that it could achieve emissions reductions on a broad scale at a cost far below the benefits produced.

The Ministry of Ecology and Environment, now at the helm of the TPS, plans to expand the TPS’s coverage to the cement, aluminum, and iron and steel sectors in the near future. This will be important to achieving significant emissions reductions — cement alone accounts for 8 percent of global carbon emissions. It will also be an important test of the flexibility of the system: the expanded TPS will embrace several industries with a wide mix of products and highly varying emissions intensities.

The ministry has begun to consider adding an auction to supplement the supply of allowances distributed at no cost to firms under the TPS. Auctioning offers several attractions, among them a way planners can effectively put a floor and ceiling on the market prices by adding or subtracting fresh allowances. A further possible reform now being considered: an eventual transition from the rate-based TPS to a cap-and-trade system.

China’s ETS would also benefit from improvements in emissions monitoring, reporting and verification. Currently, there are significant limitations in data and in the transparency of reporting. Along with the provision of improved data, constructive efforts might include requiring third-party verifiers to undergo periodic training and re-certification, as well as the addition of fourth-party checking of the third-party verifiers.

But none of the limitations of the current ETS should be allowed to obscure the fact that China is proving it is seriously in the game: the world’s largest economy and carbon emitter is now clearly taking a leadership role in the fight to contain climate change.