China and The Greater Bay Area Carbon Market Potential and Challenges

Christopher Tung, a partner in the K&L Gates Hong Kong office, analyses the development of the Chinese carbon market from 2004 to beyond the most recent UN Climate Change Conference (COP27), with a specific focus on China’s Greater Bay Area.

Published on 15 December 2022
Christopher Tung, K&L Gates, Chambers Expert Focus
Christopher Tung

Insights and views are given on China’s domestic emissions trading schemes, the trading of different and new carbon assets and their derivatives, as well as the likely operationalisation of Article 6.4 of the Paris Agreement (A6.4) in China, to enable both foreign and local entities to participate in A6.4 project activities and generate A6.4 emissions reductions and carbon removals. The implementation of A6.4 project activities in China would boost the country’s efforts to grow a robust domestic carbon market and reach its 2060 carbon neutrality goal.

China and the global carbon markets

China has benefitted from engagement in the Clean Development Mechanism (CDM) of the Kyoto Protocol with the implementation of emissions reduction projects of different types throughout China since 2004 under the Interim Measures for Operation and Management of Clean Development Mechanism Projects In China of 2004 (superseded by The Measures for Operation and Management of Clean Development Mechanism Projects in China of 2005 (CDM Measures). The CDM Measures applied nationally and provided clear routes for foreign participation and investment in Chinese CDM projects and the trading of Certified Emissions Reductions (CERs). Both domestic and foreign actors participated actively in Chinese CDM projects to generate and trade CERs. China, as per UN figures, hosted the most CDM projects and generated the largest volume of CERs in the world. The predominant drivers for the demand for CERs from Chinese CDM projects were entities owning installations covered by the European Union Emissions Trading Scheme (EU ETS). CERs were intended to provide impetus for a global carbon market and to provide a cheaper source of carbon offsets for compliance with the EU ETS. Unfortunately, a change in the rules of the EU ETS after 2012 meant that only CERs generated from CDM projects in the least developed countries could be used for compliance in the EU ETS.

Development of the Chinese domestic carbon market

This change was a key factor that led the National Development and Reform Commission (NDRC) to develop pilot emissions trading schemes in 2011, and in 2012 to issue the Interim Measures on the Management of the GHG Voluntary Emissions Reduction Program (Voluntary Emissions Reduction Program) to support the development of emissions reduction projects that could no longer rely on the CDM. The pilot emissions trading schemes (the “Pilot ETSs”) commenced in 2013 in five cities (Beijing, Tianjin, Shanghai, Shenzhen and Chongqing) and two provinces (Guangdong and Hubei). While the Pilot ETSs served as test-beds for different scheme designs (for example, different covered industry sectors, allowance allocation methods, and percentages of offsets allowed for compliance in the Pilot ETSs) prior to the commencement of the China National Emissions Trading Scheme (the “China ETS”) in 2021, and continue to operate, the Voluntary Emissions Reduction Program was abruptly suspended by the NDRC in 2017. Responsibility for the climate change portfolio was handed over from the NDRC to the Ministry of Ecology and Environment (MEE) in 2018. The MEE took over the development of the China ETS and is expected to reintroduce the Voluntary Emissions Reduction Program in the near future.

“The governments of the GBA are actively exploring the facilitation of emissions trading that envisages the participation of both institutional and individual foreign investors.”

The China ETS is a mandatory scheme that initially covered the power sector; eight sectors are now targeted by the China National ETS: power, petrochemicals, chemicals, building materials, steel, non-ferrous metals, paper and domestic aviation. The trading unit of the scheme is the China Emissions Allowance (CEA). To the extent that covered entities require more allowances to meet their emissions quotas, they must acquire CEAs or risk having penalties imposed for non-compliance. Up to 5% of the annual verified emissions of the participant may be offset by Chinese Certified Emissions Reductions (CCERs). At the outset, the use of CCERs has been possible in the Pilot ETSs but with different conditions set for usage under each Pilot ETS, the ability to use CCERs has in practice been limited. In comparison, the China ETS has no geographical or project type restrictions on the use of CCERs. In the China ETS, CEAs are traded on the Shanghai Environment and Energy Exchange, and CCERs are traded on the China Beijing Green Exchange or CBGEX. An area that has been subject to considerable attention is the extent to which foreign parties may be able to participate in the China ETS and the expansion of the Chinese carbon market.

Developments in the Guangdong-Hong Kong-Macao Greater Bay Area (GBA)

The governments of the GBA are actively exploring the facilitation of emissions trading within the GBA that envisages the participation of both institutional and individual foreign investors (see Opinions of the People’s Bank of China, China Banking and Insurance Regulatory Commission, China Securities Regulatory Commission, and the State Administration of Foreign Exchange on Financial Support for the Construction of the Guangdong-Hong Kong-Macao Greater Bay Area (2020). To date, foreign involvement in the Pilot ETSs has been very limited. A clear legal framework will be required to set out the precise extent to which a foreign investor can participate in GBA-based trading platforms to access the China ETS. Foreign investors may trade CCERs on the China Emissions Exchange. Trading on GBA platforms in the future might encompass spot and forward trading of CEAs, CCERs, A6.4 emissions reductions and removals (A6.4ERs) and derivatives to increase liquidity in the Chinese carbon market. In 2021, the China Securities Regulatory Commission (CSRC) approved the launch of the Guangzhou Futures Exchange or GFEX. The CSRC approved carbon emissions allowances futures for trading on the GFEX for risk management, hedging and investment purposes. It may also allow covered entities in the China ETS to manage and hedge carbon price risk (see Article 20 of the Trial Measures for Carbon Emissions Trading [MEE No 19] 31 December 2020 (the “China ETS Trial Measures”).

New global carbon market impetus: Article 6.4 of the Paris Agreement

Article 6.4 of the Paris Agreement (specifically the Article 6 Rulebook agreed at COP26 Glasgow, Decision 3/CMA.3) is a potential new impetus to encourage foreign investors to invest in projects and purchase A6.4ERs from such projects implemented in China in a similar manner as under the CDM. An important difference is that the Paris Agreement created the requirement for a “corresponding adjustment” to the Nationally Determined Contribution of a country when an A6.4ER is internationally transferred outside the host country (China). Where A6.4ERs are used domestically, such as, in the China ETS, a corresponding adjustment is not required. While there is currently no specific Chinese legal basis to pursue Article 6.4 projects and purchase A6.4ERs(CDM projects are covered by the CDM Measures), early action by foreign investors in China is possible with the issue of detailed international rules and methodologies for A6.4 projects. Essentially, the new Chinese A6.4 rules would have similarities with the CDM Measures; they make it clear how A6.4 projects would be implemented and how foreign investors would participate. If China does introduce new rules to facilitate A6.4 projects, A6.4ERs should be allowed for use by covered entities in the China ETS. The China ETS could become a major driver of demand for A6.4ERs.

What’s next?

There is great potential for the Chinese carbon market but there are also significant challenges. While the Pilot ETSs have experimented with different designs, rules, and criteria, this has also created uncoordinated and divergent schemes. At present, the Pilot ETSs are effectively running in parallel with the China ETS (covered entities in the China ETS stopped participating in the local pilot ETSs, see Article 13 of the China ETS Trial Measures). Although experimentation may be helpful initially, the continuation of these pilots may now be a significant distraction from the development of the China ETS. Indeed, for successful implementation domestically, and to increase liquidity by involving foreign investors, it is time to focus on a single national ETS with clear regulations and rules which would give covered entities, as well as local and foreign investors, much more confidence in the Chinese carbon market. This in turn would make it easier to design and set up a trading platform for carbon assets in the GBA (this is likely to involve several exchanges within the GBA). The rollout of part of the trading platform in Hong Kong would also avoid problems with Chinese foreign exchange controls that would impede the speedy settlement of international carbon asset transactions.

“The embrace of A6.4 projects by China would have the potential to provide a substantial boost to both the global and Chinese carbon markets.”

If China proceeds to implement a legal basis for the application of Article 6.4 of the Paris Agreement, it would provide additional momentum to the development of the Chinese carbon market and a familiar mechanism to increase foreign participation by facilitating investment in projects that produce A6.4ERs, which can then be used in the China ETS. The embrace of A6.4 projects by China would have the potential to provide a substantial boost to both the global and Chinese carbon markets.

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