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Developing Markets: China’s Emissions Trading Scheme and European Carbon Border Tariffs

August 2, 2023

Recent heatwaves in China, Europe and elsewhere have intensified calls for action on climate change. On July 3—a day which saw the average global temperature surpass all previous recorded highs—Executive Vice-President of the European Commission Frans Timmermans stressed the importance of making polluters pay for their emissions. “Carbon pricing is widely recognized as the most cost-effective policy to cut greenhouse gas emissions,” he told students at Beijing’s Tsinghua University.

Like the European Union, China places a price on carbon through a national emissions trading scheme (ETS). Days before trading commenced in July 2021, Vice Minister of Ecology and Environment Zhao Yingmin described the ETS as “an important policy tool” for achieving China’s targets of peak CO2 emissions before 2030 and carbon neutrality before 2060. However, assessments of the ETS to date have been mixed. A 2022 report by the Oxford Institute for Energy Studies, for example, commented that “the ETS has had little if any impact on CO2 emissions.” What are the scheme’s current limitations, and how might it evolve with the EU’s upcoming carbon border tariffs?

China’s National Carbon Market: The First Two Years

Overseen by the Ministry of Ecology and Environment (MEE), the ETS requires participating entities to surrender permits equal to their verified emissions at the end of each compliance period; they can also be traded (spot transactions only). The permits, or carbon emissions allowances (CEAs), are allocated free of charge and calculated for each entity on the basis of emissions intensity. This is different from the EU system, in which allocations follow an absolute emissions cap.

The market has seen low prices and trading volumes since its launch, which analysts have attributed to an oversupply of CEAs. Prices averaged CNY 46.61 (USD 7.23) a ton in 2021 before rising to CNY 55.30 (USD 8.20) in 2022. In contrast, prices on the EU ETS climbed above EUR 100 (USD 106.57) earlier this year. Participation in the market has remained restricted to around 2,200 large firms in the power sector, with an anticipated expansion to seven other carbon-intensive industries yet to occur. Financial institutions are also excluded from the market, limiting liquidity.

These issues are not unique to China; the EU ETS also grappled with low prices due to oversupply during its early years. Some limitations also suit Beijing’s purposes: low prices help ensure buy-in from participating entities, while the power sector is a useful first step given its concentrated market and comparatively simple emissions accounting process. However, authorities have faced problems with emissions data, including fraudulent reporting. In 2022, Chinese media outlet Caijing reported that unresolved data quality issues will delay the ETS’ expansion to other industries by one to two years.

CBAM on the Horizon

While relatively few enterprises in China are subject to the country’s ETS obligations, many will soon feel an impact from EU carbon pricing via the Carbon Border Adjustment Mechanism (CBAM).

Designed to prevent EU products being replaced by those from markets with lower carbon prices (an issue known as “carbon leakage”), the CBAM will impose a levy on certain imports to address the difference between the markets’ carbon prices. From the beginning of the transitional phase on October 1 this year, producers in six industries (iron and steel, cement, aluminum, fertilizers, electricity and hydrogen) will be expected to report information on their products’ embedded emissions to European importers. The EU will review the feasibility of adding other industries before the phase-in of payment obligations starts on January 1, 2026.

Though the CBAM will only apply to a small share of China’s exports to the EU, experts have expressed concerns about its impact on particular industries. Fan Tiejun, president of the China Metallurgical Industry Planning and Research Institute, told China Environment News that the CBAM could mean additional tariffs of USD 200 million to 400 million per year for China’s steel industry, one of the biggest exporters among the six sectors listed. Chinese exports of organic chemicals and plastics could face similar costs if added to the scope of the mechanism.

China’s Next Steps

Chinese officials have expressed opposition to the CBAM for years. At a recent WTO review of EU trade policies, Chinese representatives warned that such measures will restrict market access and discriminate against imported products, especially from developing countries.

While it remains to be seen how these disagreements will play out at the WTO, China and the EU remain open to dialogue on the issue. Following his meeting with Vice Premier Ding Xuexiang in early July, Timmermans told Caixin that another EU official will visit China in the autumn for talks on the CBAM.

Domestically, the challenges posed by the mechanism could provide added impetus for changes to China’s ETS that are already under consideration. With reporting obligations just months away, efforts led by the MEE to formulate emission accounting methods for multiple products (including steel, cement, aluminum, and electricity) should have immediate significance for China-based enterprises. The MEE also recently announced that research on expanding the scope of the ETS is underway. Given the costs facing iron and steel under the CBAM, they could be likely candidates for inclusion. Other possible changes include steps to increase carbon prices, which several influential voices have raised this year.

Recommendations for Businesses

  • European importers and China-based producers in CBAM industries are advised to monitor developments before and during the mechanism’s transitional phase, including the upcoming publication of detailed reporting requirements in the Implementing Regulation.
  • They should also ensure that monitoring and reporting procedures are in place to provide accurate data on products’ embedded emissions.
  • China-based producers are advised to explore options for accelerating emissions reduction, such as the application of green technologies.
  • Those operating in industries seen as likely candidates for inclusion in China’s ETS should monitor for policy announcements on expanding the scheme.

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