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Emissions trading with Chinese and Korean characteristics
posted by Bryony on 6th Nov 2012

While the EU tries to muster enough political will to fix its ailing Emissions Trading Scheme (ETS) several thousand kilometers to the East there is a lot of energy going in to the preparations for new ETSs in both China and Korea.

The furthest advanced is undoubtedly Korea, which in May of this year passed legislation establishing an ETS with bipartisan support, despite stiff opposition from some quarters. A Presidential decree, expected on the 15th November, will be the final piece of the political puzzle, which sees a mandatory ETS introduced from 2015 for 60% of South Korea’s total greenhouse gas emissions.

In China, pilot projects are in the process of being developed in five municipalities - Beijing, Chongqing, Shanghai, Shenzhen and Tainjin - and two provinces - Guangdong and Hubei. Currently Beijing, Shanghai and Guangdong are most developed in their preparations. Each of the pilots are currently being set up as discrete markets with a unifying national scheme expected sometime before 2020. Their small size and city focus means they have adopted an interesting variant of the ETS pioneered in Europe that combines trade in both upstream (direct) and downstream (indirect) emissions from electricity use. Korea is also taking this approach.

The decision to include indirect emissions is based on a desire to include the largest companies in the market, many of whom are large manufacturers with big electricity bills but few direct emissions. It also helps to boost the size of the market helping to increase liquidity. It raises many interesting questions, however, not least how to cope with the double counting that may arise as a result of crediting two companies with the same tonne of emissions - one upstream and one downstream.

The answers will lie in clear reporting and labeling of the different capped commodities. The Chinese and Koreans are in effect creating two emissions trading schemes in one, with the upstream system designed to encourage fuel switching and efficiency improvements in the power sector and heavy industrial sectors, like steel and cement; and the downstream scheme uncovering energy efficiency and demand reduction measures amongst big consumers of electricity. It is like the UK’s Carbon Reduction Commitment (CRC) and the EU ETS combined.

Our recommendation to the bodies setting up these schemes would be to proceed on the basis that the market is made up of two parallel policies each creating separately labeled but fungible credits. By expressly considering the market in this way it will be possible to disentangle the upstream and downstream savings for reporting purposes. It will also allow for adjustments later as experience of how the market operates is increased, this is after all the first time anyone has attempted such a hybrid scheme. For example, although the exchange rate at the start may be one for one, it may prove useful to be able to apply a different exchange rate later on making one upstream credit equivalent to two downstream, if evidence emerges of the cost of compliance deviating significantly in the two markets. Since only upstream allowances are likely to be able to be traded in other markets in the future (such as the EU, Australia and Californian schemes) it also makes sense to create a gateway between the upstream and downstream markets, so that it can be closed off at some point in the future, if necessary to allow for international linking.

In addition to clear, separate labeling and reporting, the inclusion of indirect and direct will also have to be reflected in the cap setting and allocation process. In the EU ETS, downstream policies are taken into account in the cap setting process to give a more accurate BAU projection that takes into account the effect of other policies on emissions under the cap (ie the Renewables Directive). Korean and Chinese hybrid ETSs will need to reduce the upstream cap to take account of the savings uncovered downstream or risk the incentive to abate upstream being completely eroded by downstream activity. It would be possible in theory for the power sector to increase its emissions (by increasing its carbon intensity say or to provide uncapped sectors with more power) using the savings down stream to offset the increase, thereby negating the effect of the downstream saving. This is an important issue because it is the emissions upstream that count towards international climate efforts, so if they fail to reduce as expected it will be hard to hit international targets.

Another issue is the impact of incorrect projections in a hybrid ETS will have an inflated effect on the balance of supply and demand. In the EU ETS we have seen how, when expected growth forecasts turned into recession, it reduced demand for energy, releasing huge volumes of spare allowances on to the market. In a hybrid trading scheme the impact will be greater since for every actual tonne of emissions from electricity generation, there are in effect two tonnes of allowances. A significant economic slow down, compared to projections, will therefore release two allowances for every tonne avoided from reduced economic activity.

The Korean ETS and most of the Chinese pilots having watched the EU ETS become swamped with excess credits due to inaccurate economic forecasting, have stated that they will include the use of market stabilization measures in their policies to provide flexibility to adjust to external factors such as significant and sustained changes in GDP. Sample measures include: a strategic reserve, limitations on banking and borrowing and setting a ceiling and/or floor price. Given the problem of inflated impacts in hybrid systems it would be sensible to make any strategic reserve quite large, erring on the side of scarcity initially but with the possibility to release more allowances if prices reach high pre-determined levels. Any strategic reserve would be best removed from the power sector where the issue of double counting described above is most likely to arise.

These are just some of the issues that arise when direct and indirect emissions are mixed in the same traded policy mechanism. It is clear that the Eastern versions of emissions trading are not going to be carbon copies of the EU scheme and that they have decided to take a path that is relatively complicated. However, if they can successfully navigate the problems, then they will have created a policy which could solve the problem of how to uncover downstream energy savings in industry, something that the EU has so far failed to do comprehensively. Having just spent two weeks in China and Korea with the teams of people tasked with making it happen, I can say that there is no shortage of energy and desire to succeed and I wish them well in the coming months as they grapple with the many complex issues involved in establishing effective trading policies. At least they have the benefit of learning from Europe’s mistakes. Finally I hope that the pace at which both China and Korea are working to implement their respective ETS will help galvanize EU support for re-establishing its own emissions trading policy as the cornerstone of EU climate policy.

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