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■ Date: Jul 27th, 2022
China's Emissions Trading: The Opportunities Ahead
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In brief:
1. Although financial investors both home and abroad are temporarily excluded from the national ETS, they will likely be introduced in the near term
2. Once financial investors are involved and derivative products are adopted, the national carbon market could grow further and the price of CEA may rise from the current ¥49/t to around ¥93/t by 2030, according to China Carbon Forum’s estimation. A similar trend could be also expected for CCER.
3. For those participants who are eyeing the relaunch of CCER and seeking business opportunities in China, the international voluntary carbon market provides a valuable reference in terms of credit issuance projects, carbon credit business model, scope 3 emission reduction strategy, etc.
4. Looking forward, China’s carbon market is likely to embrace new projects that support cutting-edge technologies such as Carbon Capture, Utilization and Storage (CCUS), hydrogen storage, and commercial fuel cell vehicles to align with the country’s carbon neutral pledge. Innovative business models that reach beyond the corporate level and further down to end-consumers could be an emerging trend to watch.
Keywords: #EmissionTradingScheme  #ETS  #ChinaEmissionAllowance #CEA  #ChineseCertifiedEmissionReduction #CCER #CDM #VerifiedCarbonStandard #VCS  #VCU #Carbon-neutral Liquefied Natural Gas (LNG) 
If you like this article, please also refer to our comprehensive analysis report "Emissions Trading Scheme in China" in our database. And also our podcast "Episode 1: China's Carbon Market Quick Updates".
July 16th, 2022 marked the one-year anniversary of the launch of China’s national emission trading scheme (ETS). A year ago, China’s ETS has officially entered the operational phase after a decade of preparation, becoming the world’s largest carbon market. The establishment of this long-awaited ETS has gone through multiple stages since 2002, starting by getting involved in the United Nations Clean Development Mechanism (CDM), to launching nine provincial markets, and finally entering to build a national unified market. Yet, this just marks the very beginning of an emerging market that could bring huge opportunities both home and abroad.
By walking through the key design elements of the national ETS, this article takes an in-depth look at the voluntary carbon market, aiming to unlock the business potential and capture the opportunities ahead.
First year's performance snapshot
To begin with, let’s take a quick review of the national ETS in its first year of performance. Several features could be summarized:
Figure 1: Daily transaction volume and closing price in national ETS in its first year of operation
  • Last-minute purchase
Transactions mainly took place near the end of the implementation period, which took up around 75% of the total transaction activities. 90% of the participants were newcomers. Many of them were not well-prepared and have not yet developed a routine strategy in emission trade. 
Also, adjustments to the allowance allocation were made throughout Oct. and Nov., and only then could the allocation amount be formally confirmed. This left only less than two months for emission entities to prepare for compliance and complete transactions. 
  • Low turnover rate
The turnover rate in the national ETS is around 3%, which means that only 3% of the allowance in the total allocation is traded in the market. Whereas in EU ETS, the world’s most mature ETS, the turnover rate has risen from 4.09% from the initial phase to 417% today. 
  • Overally low transaction price
The current marginal cost of emission reduction is about US$7 (around 49 RMB) in China, slightly higher than the ETS transaction price. A relatively low transaction price may have little impact on emission entities’ operation, lowering their incentives to reduce emissions. The transaction price is expected to increase as the market becomes more mature.
The three features unveil some of the critical issues that China’s ETS is facing, including lack of diversification in market participants, limited trading products, and imbalance development between the compliance market and the voluntary market. The root of these issues could be the regulations and market designs that carry “Chinese characteristics”, and thus operate in a different way than other ETS around the world. 
Key design elements in China’s ETS
China’s ETS consists of a compliance market and a voluntary market. The compliance market is highly regulated by the national ETS administrator, Chinese Ministry of Ecology and Environment (MEE), and its provincial subsidiaries in terms of market entry criteria, emission allowances allocation, compliance regulations, etc. Whereas the voluntary market is relatively flexible, functioning as a supporting system to the compliance market. 
Market participants and trading products in the compliance market:
At the current stage, only key emission entities (KEE, 重点排放单位) are allowed to open the transaction accounts and complete spot transactions on China emission allowances (CEA), where one unit of CEA gives the right to an entity to emit one tonne of CO2, or the equivalent amount of other greenhouse gases (GHG). Other participants like financial institutions and individual investors, both domestic and foreign, are temporarily excluded from CEA transactions. Derivative products, such as futures, are not yet included either and are subject to the approval of the State Council before being traded in ETS. 
The limitations set on market entry are mainly from the consideration of risk management and stable market operation, given that the government prefers to take a steady and smooth development approach to avoid irregulated speculative behaviour. In addition, the legal attributes of carbon emission rights (i.e. CEA) are still unclear and needed to be further clarified. The involvement of financial institutions and adding derivative products may make things even more complex at the initial stage from policymakers’ perspective.
Blocking financial institutions out the door, however, inevitably lowers the market liquidity. The investment nature of financial investors pushes them to trade more frequently and willing to take more risks than emission entities, playing an irreplaceable role in activating the market transactions. To ensure healthy development of the carbon market, it could be anticipated that the restrictions placed on financial investors were just a temporary approach in the initial stage.  Once the market begins to operate on the right track, the restrictions would be lifted and financial investors, both domestic and foreigner, would act as a critical role in the carbon market.  Bringing derivative products to the carbon market would also help to effectively lower the risks of price fluctuations and increase market liquidity.
KEE sectors and thresholds:
The current sectoral scope is only limited to the power sector (including combined heat and power, as well as captive power plants of other sectors), which accounts for 40% of China’s emissions and one-seventh of global COemissions. Plus, the threshold for KEE is set at an annual emission of 26,000 tCO2 in any of the year between 2013 and 2019. 
Figure 2: China's COemissions in 2020, by sector
The total number of entities in the compliance market sat at 2,162 in the first compliance period, and almost all of them were coal-fired power plants. The scope is expected to be gradually expanded to cover seven other high-emissions sectors by 2025: petrochemicals, chemicals, building materials, steel, non-ferrous metals, paper, and domestic aviation.  Cement and non-ferrous metal sector initially planned to be included in the national ETS in 2022, while due to emission data quality issues, the expansion to cement and aluminium sectors may delay till 2023
Transaction platforms: 
The two markets, compliance and voluntary, operate in parallel on different exchange platforms in the national ETS. Compliance market transactions take place on Shanghai Environment and Energy Exchange (in charge of transactions), and China Hubei Emission Exchange (in charge of registration and settlement). Voluntary market transactions take place on any of the provincial exchanges (Beijing, Tianjin, Shanghai, Chongqing, Guangdong, Hubei, Shenzhen, Fujian, and Sichuan exchanges). 
Market mechanism and the link between compliance and voluntary market:
In the compliance market, a KEE who emits more than the allowances it receives has to purchase CEA from entities who under-emit. Although CEA can be resold, under-emitted KEEs tend to keep the allowances for their owned-used for the sake of risk management, instead of selling them in the secondary market. Lacking engagement from investors further lower the market turnover (an important factor to measure how frequently CEA transactions take place). 
The voluntary market, on the other hand, captures a diverse group of participants, mainly comprising end-buyers (usually sustainability-driven corporates) that voluntarily purchase carbon credits to offset their emissions, credit issuers (e.g. project developers) that develop emission reduction projects, and intermediaries (i.e. investors, traders, retailers). 
China Certified Emission Reduction (CCER) is the main product in the national voluntary market. CCER is issued on a project-based, and each project has to go through approval and certification by the national administrator before CCER issuance. 
For over-emitted KEE who face allowance deficits, except for buying CEA, they can also purchase CCER to offset up to 5% of their total allowances. According to the interview with Beijing Green Exchange, currently, there is no expiry date for CCER, which means that CCER issued by projects that operate years ago are still valid for offsetting today, as long as they are certified carbon credits by the national administrator. 
Voluntary participants, both domestic and overseas, who register as a legal enterprise person (企业法人) in mainland China, and satisfy the market entry criteria of any of the nine provincial pilots are eligible to open CCER transaction accounts and join the voluntary market in the national ETS. 
Figure 3: China’s ETS market mechanism
National voluntary carbon market: CCER program at a glance
Although the national compliance market has already taken off, the voluntary market does not develop as smoothly as expected. 
In March 2017, CCER project registrations were suspended due to inactive market performance and lack of standardization in credit issuance, and the relaunch had not yet been announced until further notice. Though the idea of resuming the CCER program has been gathering steam since the national ETS launched, no official timeline has been put forward by far. However, it is still worth taking an in-depth look at the CCER program to seize the opportunity ahead. 
CCER projects classification:
At the moment, tradable CCERs are all issued by projects that got approval before the suspension. Based on the previous criteria, a project that kicked off construction after Feb 16th,2005 in China and falls into either of the following four categories was eligible to apply:
Figure 4: Classification of CCER project types 
Simply put, except for type 1, the rest three types are all CDM-converted projects that are kind of the “leftover” projects from CDM. China used to be the largest supplier of Certified Emission Reduction (CER), carbon credits of CDM. However, as the EU ETS stipulated that only credits issued by projects located in the least developed countries would be accepted for compliance after 2013, the number of CDM projects in China dropped sharply, and almost zero projects registered in CDM in recent years. 
Given this situation, a majority of CCERs in the current market are issued by type 1 projects, projects developed by NDRC-approved methodology, and it could be the dominant project type once the CCER program resumes. So far, there are 200 CCER methodologies, of which 173 are created by referring to CDM’s methodologies, and 27 are proposed and added by project developers or third parties. Although a large percentage of the methodologies are CDM-converted, one important issue is that these methodologies are not up-to-date. New methodologies of many cutting-edge carbon-neutral technologies (i.e. CCUS, hydrogen storage, etc.) are yet to develop, and the proponents of these new methodologies are likely to gain first-mover advantages and take the lead in forming industry standards within their field
Additionality - a critical criteria in CCER project eligibility:
To further understand, a methodology is a go-to-standard to evaluate whether a project can generate real reductions. It consists of four aspects, project baseline, additionality, reduction monitoring plan, and estimation of emission reductions, among which additionality is a key factor to determine whether a project can be approved to issue CCER or not. 
Figure 5: Additionality is a key factor to determine whether a project can be approved for CCER issuance or not
Additionality essentially means that the only way the project would exist is because of the funding from CCER issuance. If an emission reduction project can be financially sustainable without CCER’s revenue, there is no additional effect to the project reductions and therefore would not meet the eligibility. 
To assess additionality, a common way is to use the industry internal rate of return (IRR, 全投资税后财务内部收益率) as a benchmark. According to the “Interim Rules on Economic Assessment of Electrical Engineering Retrofit Project (Trial)” (电力工程技术改造项目经济评价暂行办法(试行)) issued in 2002 by State Power Corporation (the top managing body in the power sector before the national power sector reform in 2002), the IRR of power industry was set at 8% of the total investment. For a project whose estimated IRR is lower than 8% before CCER issuance, it can prove that the project is not financially attractive, and would otherwise not be able to survive without CCER funding, and thus the project has additionality. 
While problems have been raised about the criteria of additionality if the CCER program is about to relaunch. The industry baseline IRR has not been changed for almost 20 years, not to say whether the 8% benchmark is a realistic figure that can represent the real situation, as there are no details of how this benchmark is arrived at back then, but the power industry in China has dramatically changed and experienced a series of reforms, including coal-fired power market reform (see more on China Raises Cap on Electricity Price: What has Changed and Possible Impact for Business ), and the launch of renewable energy grid parity program. Many projects who previously demonstrated additionality and issued CCER may already be financially sustainable throughout years of development, and can no longer satisfy the additionality criteria today. 
The core idea behind additionality and CCER as a whole is to better allocate the resources, such as capital and technical support, to projects that are most in need to achieve carbon neutral (i.e. CCUS, hydrogen storage, commercial fuel cell vehicle, hydrogen reduction). It is reasonable to anticipate that CCER may adjust to better support those cutting-edge technologies to align with the carbon neutral goal. 
Some leading players have already taken action to gain first-mover advantages. For instance, Feichi Vehicle, a subsidiary of Meijin Energy and the largest commercial fuel cell vehicle manufacturer in Southern China, has signed an agreement to co-develop the first-ever Hydrogen Fuel Cell Vehicle Emission Calculation Methodology in China with Qingshan Technology, a data management software provider for fuel cell vehicle, and China Classification Society Certification, a third-party verification institution, in June 2021. Once the methodology is released, it could potentially lead the path for fuel cell vehicles to issue carbon credits and trade those credits in the carbon market in the foreseeable future. 
According to the latest update, Meijin Energy Asset Management (another subsidiary of Meijin Energy) and Qingshan Technology have obtained a patent for monitoring method of fuel cell vehicles emission reductions, marking a solid step toward developing a comprehensive methodology in the fuel cell vehicle sector.
International voluntary carbon market: VCS program at a glance
For those participants who are eyeing the relaunch of CCER and seeking potential business opportunities in China, the international voluntary carbon market could provide a valuable reference in terms of future strategy and business model. One leading program in the international market is Verified Carbon Standard (VCS), a non-for-profit program supported by The Climate Group, International Emissions Trading Association (IETA), World Economic Forum, and World Business Council for Sustainable Development (WBCSD). It is currently the most widely used voluntary offset program with more than 1,806 certified projects around the globe, and 345 certified projects in China. 
Figure 5: Overview of VCS market mechanism 
VCS project eligibility in China:
VCS program includes a wide variety of projects ranging from renewable energy to forestry. Wind and hydropower projects combined take up more than 60% of the total projects in China. In fact, the type of VCS projects in China follows a similar pattern as CER projects, as many of the VCS projects were previously registered as CDM projects in China, but since the CDM market diminished, these ex-CDM projects have turned to issue credits under VCS. 
Figure 6: CER registered projects and VCS issuance projects located in China
To apply for VCS, a newly-developed project should belong to any of the 16 sectoral scopes, including renewable energy (wind, solar, hydro, biomass, geothermal), forest carbon sink, carbon capture and storage (CCS), mining/mineral production, fugitive emissions, livestock and manure management, etc. It should be notable that since 2020, VCS excludes several projects that are very likely to be market-ready (as shown below). To take an example, newly-developed grid-connected hydropower projects in China (and located in any other non-LDC country) are no longer eligible for VCS application. However, the newly-developed hydro, wind, solar, and geothermal projects that deliver electricity to a micro-grid are not counted, and such projects located in China are eligible to apply. 
Figure 7: VCS excluded project types
Carbon-Neutral LNG business model -- VCS case study:
Carbon-neutral liquefied natural gas (LNG) has emerged as an innovative way to sell natural gas while mitigating its environmental impact. It involves offsetting the carbon emissions from the LNG supply chain through the purchase of carbon credits. Shell is the pioneer in applying the carbon-neutral LNG business model in its operation. In June 2020, China National Offshore Oil Corporation (CNOOC), a Chinese state-owned oil company, signed an agreement with Shell to procure carbon-neutral LNG from Shell. CNOOC then retired the carbon credits VCU (Verified Carbon Unit, VCS’s carbon credit label) through VCS platform to offset the emissions in Nov. 2020. 
It can be assumed that Shell first purchases VCU issued by Xinjiang Makit County Afforestation Carbon Sink project, and then resells the VCU to CNOOC, together with the LNG cargo. By doing so, CNOOC can purchase and retire the carbon credits while buying regular fossil-fuel LNG from Shell, claiming that the product is “carbon neutral”. 
Figure 8: Shell’s carbon neutral LNG business model
In fact, Shell has developed a carbon offset portfolio named Nature-based Solutions that comprises a group of global emission reduction projects certified by VCS. These projects are mainly located in developing countries such as China, India, and Peru and many of them are forest carbon sink projects. Currently, there are seven forest carbon sink projects located in China, Xinjiang Makit County Afforestation Carbon Sink Project is one of them. To develop this portfolio, Shell collaborates with project developers and local government to keep track of project development and credit issuance progress. A recent move has shown that Shell is diversifying its portfolio. In June 2022, Shell signed a MoU with CNOOC, Guangdong Government, and ExxonMobil to explore the feasibility of developing an offshore carbon capture and storage hub in Guangdong province. It could be predicted that this project would have the potential to issue carbon credits in the future if it successfully progresses.
Figure 9: Shell’s global offset portfolio. Source: Shell’s website
One key driver of Shell’s carbon-neutral LNG business model is to reduce its Scope 3 emissions. Emitting from the products that Shell sells to its customers, Scope 3 emissions is the largest scope that taking up nearly 95% of Shell’s total emissions. Thus, Shell has to work with its customers to reduce its Scope 3 emissions to achieve its carbon neutral target. 
Potential CCER business model on end-consumer side:
Shell’s business model and the concept of carbon-neutral LNG are quite new in China and the market is yet to be educated. In the future, if the CCER program relaunches, Shell’s business model could provide a good reference both on the seller side and the buyer side, and the concept of “carbon-neutral product” could expand to various types of products, not limited to natural gas. 
Moreover, the business model could reach beyond the corporate level and further down to the end-consumers. Feichi Vehicle, the company that is working on to develop the Hydrogen Fuel Cell Emission Calculation Methodology, is planning to help its end-users (fuel cell vehicle users) to sell carbon credits in the carbon market, adopting a similar model as Shell did. What Feichi is trying to do is, for those fuel cell vehicle users who can potentially issue carbon credits (i.e. CCER) and are willing to sell their credits, Feichi will act as a retailer to help them find the buyers and sell the credits, and share the revenue with end-users. In such a case, Feichi could benefit from CCER funding and diversify its revenue stream to better support its fuel cell vehicle business. In the future, not only corporates but also end-consumers who make actual contributions to reduce emissions would be able to involve in the carbon market to progress towards the carbon neutral target. 
Inside every challenge lies an opportunity. China’s carbon market is at the early stage of development that requires a certain amount of time and effort to be put in. While strong market signals have been sent out and actions should be taken to seize the future opportunities.
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If you like this article, please also refer to our comprehensive analysis report "Emissions Trading Scheme in China" in our database. 
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