Energy market reform needed as China heads for national emissions trading

Author: Frank Jotzo, ANU

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 recently announced that a national emissions trading scheme would start as early as 2016. This surprised many experts who had expected a later start, perhaps around 2020.

Smoke is discharged from chimneys at an oil refining and chemical plant of Sinopec in Qingdao city, east China’s Shandong province, 9 February 2014. China has announced that its national emissions trading scheme will begin as early as 2016. (Photo: AAP)

This was followed up last week by an announcement that China’s national carbon market will encompass three to four billion tonnes of carbon dioxide by 2020 — twice the size of the EU emissions trading scheme — and that it would expand after 2020.

The 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 RMB60–400 billion (about US$10–65 trillion). This implies an average price of RMB20–100, or between US$4–17, per tonne of carbon dioxide at the current exchange rate. So it could be as much as double the current EU trading price.

Any given 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 — the ratio of carbon dioxide to GDP — of China’s economy is three to seven times higher than the emissions intensity of Europe (depending on whether GDP is measured in terms of purchasing power parity or exchange rates).

But an emissions trading scheme will be effective only if markets are allowed to work. If companies can save money and increase profits by cutting emissions, they will have effective incentives to shift to lower carbon energy and to further improve their energy efficiency.

On the other hand, if prices are locked in by regulation, if investments are decided more on political objectives than future earnings 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 come from. Electricity prices are fixed, 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 spells the need for energy sector reform to make emissions trading — or a carbon tax — work properly. Such reforms are right in line with the Chinese leadership’s stated ambition to allow the market to play a more central role in determining economic decisions. And they do not need to be completed before a price tag is put on emissions, the two can proceed in parallel.

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 to 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 Teng Fei of Tsinghua University and I have argued, the benefits of shifting China’s economy to ‘greener’ growth are often ignored in economic analyses.

One benefit is more predictable energy system costs when nuclear power or more renewables are used instead of coal, oil and gas. 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 resulting from greater energy productivity.

Of course, the mere existence of large economic and societal gains from market reform does not guarantee such reform is implemented. The experience in many countries — developed and developing — has been that powerful vested interests or popular opposition stand in the way of energy sector reform, whether to cut carbon emissions or other objectives. Changing energy prices, and changing regulatory and ownership structures can have large effects on established economic interests.

But, despite the difficulties, the present Chinese leadership seems determined to make things happen. Cutting carbon emissions is clearly high on the political agenda. The fact that the central government is pushing hard for a national emissions trading scheme when the seven pilot trading schemes have been in operation for only about a year is a sign of that determination.

Sweeping change could come quickly.

Frank Jotzo is Director of the Centre for Climate Economics and Policy (CCEP), Crawford School of Public Policy, the Australian National University and receives funding from the Australian Research Council.

CCEP is involved in a collaborative research program on China’s climate and energy policy with Tsinghua University. The program is partly funded by an Australian government grant.

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