Written by Alex Lo.

A new carbon market is emerging in China, the world’s largest greenhouse gas emitter. According to the World Bank, China now houses the world’s second largest carbon market, after the EU. Carbon markets allow the trading of the rights to emit greenhouse gas (GHG) emissions among GHG-emitting entities. Seven pilot emission trading schemes are up-and-running in China, but they operate in a very different context from their European and North American counterparts. The Chinese carbon market can potentially take leadership in the region, but internal effectiveness is open to question.

The Chinese carbon market has gained momentum since 2011, when the central government announced its intention to introduce a national emission trading scheme (ETS). Seven pilot sites were appointed across the country to implement emission trading trials. These pilot sites include two provinces (Guangdong and Hubei) and five cities (Beijing, Tianjin, Shanghai, Chongqing, and Shenzhen). Collectively these ETSs cover 7% of China’s total emissions. By June 2014, all seven pilot ETSs had started trading. The first pilot phase is expected to be completed in mid-2016. It is intended to build experience and provide lessons for moving to a national system in the following years.

At first glance, these ETSs all appear similar to what we see in Europe and North America. ETSs are market-based mechanisms. They create incentives for emissions reduction by requiring polluters to buy emission permits that can also be traded between firms. Such a market-based approach is regarded as an effective way for reducing the costs of climate change mitigation.

These schemes have found their way into a number of advanced economies in Europe, New Zealand, Tokyo, California and the north-eastern states of the US, Canadian provinces (British Columbia, Quebec, and Alberta) and South Korea. These schemes all operate in mature capitalist economies governed by a liberal democratic state.

But now emission trading has arrived in non-traditional capitalist states. Plans for implementing an ETS have emerged or are being considered in other major developing countries such as Kazakhstan, Mexico, Brazil, Thailand, Turkey, Ukraine and Chile (see Figure 1).

China is the most prominent newcomer. As a so-called “socialist market economy” it will operate in a political-economic context significantly different from those western capitalist economies. This is important because significant variations in political, regulatory and institutional traditions have profound implications for delivering the expected environmental results.

Carbon markets usually need a healthy financial sector to help with emission trading activities. In China, private finance has not played a key role in the domestic carbon markets – perhaps because it isn’t able to. China’s carbon markets are created, financed, and operated by Chinese government, either directly or indirectly.

In July this year, I conducted interviews with several Beijing-based senior executives from top domestic entreprises with established operations in carbon finance. They are all keen on getting involved in the domestic carbon market, but do not find the current market financially attractive. The market remains illiquid.

The private sector in China is generally not very keen to reduce GHG emissions voluntarily. Certainly, businesses included in the ETSs are motivated to curb emissions, but they mainly seek to comply with regulatory requirements. Most of them have poor sense of comprehensive corporate carbon management and low interest in trading emission credits. As a result, corporate demand for advanced financial products linked to emission trading is weak. Many financial institutions, notably banks, lack the motivation to engage with the domestic carbon market. The market therefore has little energy to thrive.

In addition, many of the firms participating in China’s emissions trading schemes are state-owned. The regulated parties are not all “private” actors. Power companies are not entirely free to pass the cost impacts of carbon prices to electricity users by raising retail prices; the central government has the authority to decide.

Further, environmental NGOs are neither politically influential nor financially capable of playing an active role. To secure environmental benefits, efforts by the government are therefore profoundly important. But the reality is that the Chinese ETSs, and climate change policy generally, are not principally coordinated by a designated environmental authority. The Ministry of Environmental Protection, China’s national environmental agency, does not play a lead role in formulating climate change policies or setting up carbon markets.

The main player is the National Development and Reform Commission (NDRC), the peak macro-economic planning agency of China. The first priority of the NDRC is economic and social development. National climate change policies, including the ETS programs, are formulated and implemented by its subsidiary climate change department. This organisational arrangement suggests that environmental imperatives are subordinate to economic and social objectives.

There is room for some cautious optimism, however. In theory, the larger the market, the greater the potential for reducing the costs of GHG mitigation. And the lower the costs, the more attractive it is, both politically and economically. Now an increasing number of developing countries have put emission trading into consideration. If China – the world’s largest GHG emitter and a key market player – introduces a national ETS, it could become the cornerstone of a regional carbon trading network in Asia or the developing world in the next 10 or 15 years or so. The Chinese carbon market – if well managed – can potentially take leadership in the global scene.

This is particularly important as the Kyoto Protocol looks fragile. Several original signatories, such as Japan, New Zealand, Canada, and Russia, have withdrawn from the Protocol. Demand for carbon credits created under the Protocol has declined as a result of the weak national commitment to GHG mitigation under the UNFCCC. So domestic initiatives, such as these nationwide ETSs, become important. Such a ‘bottom-up’ approach, like what China is planning for, may be able to drive regional and perhaps global actions.

The caveat is that the Chinese emission trading programme might operate quite differently to the European Union ETS or what is currently operating in the U.S. Prospects for international linking are uncertain. Transaction costs are high, because the state-led system is not originally designed to run market mechanisms. And most importantly, there’s no way of knowing whether the initiative can really deliver substantive environmental and economic outcomes.

Alex Lo is Lecturer in the School of Environment at Griffith University, Australia.