Written by Frank Jotzo.

China has long had a string of regulatory policies that constrain its growing thirst for energy, and that aim to reign in coal consumption. But it looks like the country may be about to enter a new era, where market mechanisms are harnessed in pursuit of environmental and broader economic objectives.

This month saw China’s National Development and Reform Commission announce that a national emissions trading scheme would start in 2016. This surprised many in the expert community who thought a later start more likely, perhaps around 2020.

This was soon followed up 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 guessing is never over until the regulations are in place, but these latest statements certainly put paid to doubts about China’s resolve. Not that the insiders had much doubt: our survey of Chinese carbon market experts in October 2013 indicated that over 80% of experts expected an emissions trading scheme to be in place by 2020. The surprise now is mostly about the early start.

But it might be paper tiger, we hear some say: the scheme might be over-allocated with free permits like many of the pilot emissions trading schemes and ambition might be low, resulting in low prices that will not do much to affect companies’ investment and operations.

But this week’s statement was surprisingly specific about the Chinese government’s expectations about prices: the market would be worth between 60 and 400 billion yuan, implying an average price of 20 to 100 yuan or 3 to 13 euros per tonne. So it could be as much as double the current EU trading price.

And any given carbon price can have a much larger effect in the Chinese economy than in Europe or other Western countries. That is because the emissions intensity of China’s economy – the ratio of carbon dioxide to GDP – is three to seven times higher than that the emissions intensity of Europe (depending on whether GDP is measures at purchasing power or exchange rates). So a given price signal can be much more powerful.

Note I write it “can”, not it “will”, because it 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. And they will do so. The same goes for consumers.

But 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, and in particular 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 optimized for lowest cost and highest returns.

This spells the need for energy sector reform to make emissions trading – or indeed a carbon tax which is also being contemplated in Beijing – work properly. It is right in line with the Chinese leadership’s stated ambition to the market play a more central role in determining economic decisions.

But it won’t be an easy road. In fact, introducing an emissions trading scheme is probably going to be a much easier task than comprehensive market reform of the energy sector.

Emissions trading brings complexities of mechanism design, demands on accounting systems and it has implications for companies’ bottom lines. But its effects in shaking up established patterns of economic and commercial interests is unlikely to be anywhere near as large as that of market reform of the energy sector.

The pilot emissions trading schemes seem deliberately designed so as not to cut across powerful business interests, by giving most of the permits away for free – at the cost of potential revenue for governments. The same will not be possible if markets are liberalized. Markets will show up what is economical and what is not in China’s energy sector, and there will be winners and losers – quite possibly at a very large scale.

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.

Emissions trading could help accelerate China’s march towards cleaner growth. As my colleague Prof Teng Fei of Tsinghua University and I recently argued, the benefits of shifting China’s economy to a “greener” type of growth are understated in the economic tools commonly used. Economic analyses habitually ignore the health benefits of less air pollution.

They almost always ignore the benefits from the more predictable energy system costs in a system dominated by renewables or nuclear power rather than coal, oil and gas with their uncertain future fuel prices. And they usually do not even attempt to gauge the economy-wide effects of greater energy productivity.

Of course, the mere existence of large economic and societal gains from market reform does not guarantee such reform gets implemented. The experience in many countries – developed and developing – has been that powerful vested interests or popular opposition stand in the way of reform.

China however, under its present leadership, seems determined to make things happen even if they are difficult. Cutting carbon emissions is clearly high on the political agenda. Sweeping change could come more quickly than most expect.

Frank Jotzo is director of the Centre for Climate Economics and Policy at the Australian National University’s Crawford School of Public Policy. He leads a collaborative research program on climate and energy policy with Tsinghua University.