Better data is key to the success of China’s carbon market

Richard L Sandor, the “father of carbon trading” and founder of the Chicago Climate Exchange, quoted Victor Hugo to explain the resilience of global emission trading development: “No force on Earth can halt an idea whose time has come.”

As concern about climate change increases, a growing number of countries have pledged to reduce carbon emissions by implementing one of the most cost-effective solutions, an emissions trading system (ETS). So far, jurisdictions accounting for 55% of global GDP are using emissions trading.

China’s recently established national ETS has drawn tremendous attention worldwide. It is expected to serve as China’s primary tool to meet its “dual carbon” targets of CO2 peaking before 2030 and carbon neutrality before 2060. The largest ETS globally, it accounts for 40% of China’s emissions and more than 10% of worldwide emissions, with the potential to double in size once industrial sectors are added to the already-covered energy sector. It is also the first nationwide ETS in a large developing country.

How does China’s ETS work?

China’s national emissions trading system (ETS) gives each covered company the right to emit a certain amount of CO2.

The amount is based on an emission intensity benchmark and the company’s level of output.

If a company then emits less than its allocated allowance, it can sell the excess on the market.

If more, it must purchase allowances or offsets from the market.

Thus, companies are incentivized to reduce emissions from production activities.

July 2022 saw the first anniversary of trading under China’s ETS, by which time 194 million tonnes of carbon emissions allowances worth over US$1 billion had been traded on the market. The first compliance cycle saw over 99% compliance out of 2,162 power companies.

Despite these achievements, there are some key roadblocks. At the top of this list is data quality and integrity.

In July 2021, a power plant in Inner Mongolia was found to have falsified its emissions report by doctoring the date of carbon content testing of the coal it was burning, affecting at least 1 million tonnes of emissions allowances worth $7 million. Additional cases were also found and the Ministry of Ecology and Environment (MEE) issued a notice requiring provincial environment departments to comprehensively examine data quality. If data was found to be false, they should make adjustments and impose sanctions, stated the notice.

194 million tonnes

of carbon emissions allowances were traded in the first year of China’s national carbon market, worth over $1 billion

Some observers blamed the frauds on the December 2019 announcement of an extremely high default value for the carbon content of coal used in the first compliance cycle. This high value was intended to encourage companies to submit actual testing data rather than using the default. But it came too late to drive more testing for 2019 and instead tempted companies to risk faking test reports.

At a broader level, multiple factors have increased the risk of this type of event.

Firstly, sanctions: the fine for fraud, at $3,000 to $4,500, is insignificant compared to the potential gain from fraud. The boundaries of responsibility for data quality are insufficiently clear among different participants, including companies, verification agencies, testing agencies and consultancies.

Secondly, verification: provincial governments are responsible for selecting verification agencies and tend to prefer local ones. This can rule out more experienced and better qualified agencies from other provinces. Furthermore, provincial governments have allocated limited funds for paying for verification, and there are not yet settled qualification requirements for verifiers.

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Thirdly, monitoring and reporting: the regulations and guidelines are not sufficiently clear or detailed. For example, in detecting coal carbon content, there appears to be room for tampering with coal samples during collection and preparation.

Data quality and integrity have been high on the government’s agenda. Improved reporting guidelines were published in December 2021 and March 2022; verifiers found guilty of misconduct have been named and shamed; the extremely high default value of carbon content in coal has been replaced; and ETS legislation has been included in this year’s State Council legislative work plan, which would provide the stricter penalties for non-compliance that the ETS needs.

Improving data quality will be the main priority of the MEE in 2022 and 2023, including accelerating further amendments to monitoring, reporting and verification (MRV) guidelines; enhancing emissions data supervision by regular checks at national, provincial and municipal levels; increasing information disclosure; building a system to classify organizations according to their compliance history and supervising them accordingly; and increasing the penalties for violations.

China should look again at best practices in South Korea and the European Union’s ETS

These are big steps in the right direction. However, it appears that China’s priorities on zero-Covid and economic recovery may be complicating efforts to address integrity issues. For example, in view of these priorities, the MEE issued a notice in June 2022 to adjust MRV requirements during the second compliance cycle. It stated that companies with three or more months of carbon content test results per year can use the average of these results to calculate emissions for any months that have no test results, instead of using a high default value under the previous requirements. This adjustment appears to leave room for companies to test during months when they are using coal with a lower carbon content.

A fundamental necessity for China’s National ETS is a robust MRV system. This needs to be supported by efficient IT systems, strong security measures and effective sanctions for non-compliance. This will promote market participants’ confidence, sectoral expansion, and international support and credibility.

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China is making progress in improving the integrity of its MRV system, but more work is urgently needed. The ETS law at the State Council level needs to be adopted; a strong accreditation system for verification agencies needs to be established to ensure consistent and high-quality verification across provinces; fees for verification should be sufficient to do a thorough job; and MRV regulations and guidelines need to be clearer and more detailed.

China should look again at MRV best practices in the European Union’s ETS and the MRV system in the South Korean ETS, the frontrunner in Asia. At the same time, the system’s integrity should be protected from being compromised by other policy drivers.

China is not alone in facing integrity issues in the early stages of an ETS. There were some major fraud cases during the initial phases of the EU ETS. However, lessons were learned quickly and effective controls were established. China must also overcome these challenges quickly to pave the way for its ETS to expand to the industrial sectors, achieve significant greenhouse gas emissions reductions and realize its potential in helping the country achieve its dual carbon targets cost-effectively.

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