JK Capital Management: A crucial step towards China’s carbon neutrality goal

JK Capital Management: A crucial step towards China’s carbon neutrality goal

Energy Transition China
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By Mu Huang, Middle Office Manager, JK Capital Management Ltd., a La Française group-member company.

Background

As China’s latest efforts to drive decarbonization, the long-awaited national emission trading scheme (ETS) kicked off on July 16th at the Shanghai Environment and Energy Exchange. The grand opening was marked by a deal initiated by SOE giant China Petroleum & Chemical Corp (Sinopec) to purchase 100,000 tons of carbon emission quota from China Resources Group at RMB 52.92/ton.

Since 2011, 8 regional ETSs have been established in major provinces and cities across China as pilot programs to prepare for the launch of the nationwide carbon market. During the pilot phase, structural issues such as isolated markets and government over-intervention have caused huge price disparity (ranging from 10 to 80 RMB/ton) and low market liquidity.

Challenges encountered during the pilot phase forced the regulator to postpone the official launch date and reduce its original scope from more than 20 industries to focus only on the power generation industry as it has “more reliable and verifiable data.”

Although not as ambitious as the regulator originally planned, the national ETS still covers 2,162 key companies in the power generation industry that accounts for more than 40% of the country’s energy-related carbon emissions, making it the largest ETS globally.

Implications

Simply put, carbon quotas or the right to emit carbon are currently allocated to major power generating companies free of charge. The exchange serves as a marketplace where heavy polluters purchase additional quotas from less-polluting companies in order to fulfil their regulatory obligations. At the other end of the trade, cleaner generators sell their excess quotas in exchange for additional income, which they may invest in clean technology to further reduce their emission level.

Through this mechanism, as the supply of quota is reduced incrementally which inevitably drives up the price of carbon, all participants are incentivized to reduce their emissions to improve profitability.

The relatively sufficient amount of free quotas has led to a lower demand from polluting companies to buy additional quotas, which in turn results in a low trading price of carbon in China, around RMB 50/ton compared to other markets such as the European Union (EU) around EUR 50/ton. At the current price level, for companies that still largely depend on legacy coal-powered units, the cost of purchasing additional carbon quota is estimated to be between 5% to 25% of their overall production cost.

The status quo is expected to change in the coming years as carbon price increases due to reduced quota supply. This is precisely the point of establishing a carbon market to push heavy polluters to accelerate the transformation to cleaner forms of energy or adopt technological innovations such as Carbon Capture, Utilization, and Storage (CCUS) through a market-based mechanism.

Although the short-term implications of the national ETS may seem limited, the national ETS, more importantly, serves as a regulatory infrastructure to regulate other carbon-intensive sectors in China.

Other than electricity, it is expected to soon cover seven other industries, including petrochemical, chemical, construction materials, steel, nonferrous metal, papermaking and aviation, allowing the country to effectively regulate the emission activities of its heavy polluters. Through the pilot programs, the above-mentioned industries ended up facing many challenges. Having so many different industries involved created lots of technical issues. Many also found it difficult to absorb the additional cost of carbon.

For example, due to the cross-boundary nature of the aviation industry which currently accounts for 2% of the global carbon emissions, measuring and reducing emissions within the sector has proven by the EU ETS’s previous attempt to be both technically (specifically for the Monitoring, Reporting and Verification (MRV) system) and politically challenging. As China joins the club to reduce carbon emissions and as the MRV system gradually improves, we may expect multilateral cooperation on carbon trading with a wider industry inclusion to become more promising and viable. 

Future outlook

Going forward, the Chinese regulator is expected to leverage more experiences from its international peers to continuously fine-tune and expand its carbon trading scheme. Most importantly, setting the number of quotas within a reasonable range would allow the scheme to effectively facilitate technological innovation and emission reduction measures toward the reduction target, and avoid market crashes, which is what the EU ETS experienced during its initial stage.

The current attempt by the EU to include more international and complex businesses such as those within the maritime industry would also be exemplary for the Chinese regulator.

Coupled with a wider industry inclusion, the supply of free quotas is expected to be gradually tightened by the regulator, driving the price up and closer to the international average level. Allowing the entrance of more market participants and structured financial products would further facilitate price discovery, and ultimately support China’s goal to achieve carbon neutrality by 2060.

Furthermore, as an important supplement mechanism to the mandatory ETS, the voluntary market Certified Emission Reduction (CCER) is expected to reopen to provide more flexibility and incentives to a wider range of market participants.