China needs investors to supercharge the world’s largest carbon market

For investors, the emissions trading scheme is the gateway to a sprawling new market with a multitrillion-dollar cap, while, for environmentalists, the new carbon market is a huge step toward decarbonizing the world’s leading polluter. 

For the time being, neither group is getting what they want. Beijing has blocked investors from trading on the ETS to prevent speculators from derailing the nascent market. And without investors, the ETS doesn’t have enough liquidity to function, making it a poor tool for reducing pollution.

“At the outset, China regulators seem to be focused on introducing the ETS to one of China’s key carbon-emitting constituencies: thermal power generators,” says Alexander Burdulia, a registered foreign lawyer at law firm Mayer Brown. 

Policymakers first proposed the ETS in 2011 and began operating regional pilot schemes in 2013. By 2017, the government was convinced a national carbon market was feasible and prepared to launch the ETS, but its debut was delayed several times as regulators found creating the rules necessary to manage the market a trying task. A final deadline to launch by the end of June this year was missed, reportedly because the date clashed with the centenary anniversary of the Chinese Communist Party (CCP). Either not wanting to upstage or upset the CCP’s 100-year celebration, the SEEE delayed the market’s launch until July 16, when the national carbon market finally went live.  

For the time being, trade on the ETS is limited to companies Beijing has compelled to participate, namely polluters from the domestic power industry. The Ministry of Ecology and Environment (MEE), which operates the ETS, assigns polluters a quota on how many tonnes of carbon their business can emit during a year. Companies then offset any excess by purchasing carbon emission allowances (CEAs) on the ETS.

Currently there are 2,225 companies enrolled on the ETS, picked from the nation’s power sector—which produces some 40% of China’s carbon emissions. Seven more industrial sectors, including petrochemicals, aluminum, and steel, will be added to the ETS before 2030, the year China has said it will reach peak carbon emissions. With all eight sectors on board, the ETS will cover over 70% of China’s total emissions.

“It is important to get these stakeholders on board and comfortable with the system early, which means, from a regulatory perspective, prioritizing their needs over the needs of investors,” Burdulia says. 

Beijing worries that speculators could push the price of carbon too high, prompting a revolt from corporations that are then required to buy back inflated CEAs. But institutional investors—speculating as they are—would introduce much-needed liquidity to the nascent market.

On Aug. 16, a month after the ETS launched, the volume of carbon traded on the SEEE was just 10 tonnes—a fraction of the total 160,000 tonnes of carbon the 2,225 companies covered by the ETS emit per day. Eyeing the low trade volumes, Lai Xiaoming, chairman of the SEEE, told reporters he hoped institutional investors—speculators looking to make money rather than polluters required to reduce emissions—would be permitted entry to the market before the end of the year.

“Institutional investment helps drive the trust and confidence, diversification, and stability required for the proper development and maturity of any market,” says Mark Uhrynuk, a partner at Mayer Brown’s office in Hong Kong.

The market needs liquidity in order to allow for price discovery, and to ensure there’s a pool of CEAs available for polluters to draw from when necessary. Although, currently, it’s likely few companies registered on China’s ETS will need to purchase carbon credits at all. 

In order to scale the ETS, the MEE allotted all 2,225 companies enough CEAs to cover their individual emission quotas freely. Analysts say the quotas have also been calculated in such a way that most of the companies on the ETS won’t exceed their limits if they continue business as normal this year. So with every company on the ETS receiving more CEAs than they need, there’s little reason for anyone to trade.

“Theoretically, the fair price of carbon in an oversupplied market is zero,” says Yan Qin, senior carbon analyst at Refinitiv. A zero-dollar value on carbon makes China’s ETS a poor incentive for decarbonization, as it stands. To be effective in reducing emissions, the cost of carbon needs to be higher than the cost of mitigating emissions. 

Investment manager Schroders predicts China’s ETS could reduce Chinese carbon emissions between 30% and 60% by 2060—the year Beijing has said China will become a net-zero economy. That would require the cost of carbon on China’s ETS rising to at least $34 per tonne. Investors could help push the price up a little, but ultimately the value of China’s carbon will be determined by policy.

Cap and trade

Critics say that, as it stands, China’s ETS policies aren’t enough to ensure a high carbon price or enough to ensure companies actually reduce emissions. That’s because China’s ETS is focused on reducing carbon intensity—meaning the volume of carbon energy suppliers emit per unit of energy produced—rather than reducing actual carbon emissions.

Unlike some other carbon markets, China’s ETS deploys a benchmark system to allocate carbon allowances for each company included on the ETS. The quota is determined by the business’s historical emissions, multiplied by a benchmark assigned to different fuel types. Coal has a higher benchmark than gas, for instance. That means a company can perform below its quota by switching fuels rather than reducing emissions.

In the EU, for comparison, the European Commission operates a “cap and trade” carbon market, where a central regulator—in this case, the European Commission—sets a total cap on emissions across all participants, which then trade allowances as needed. Over time, the regulator lowers the total cap, forcing companies to cut emissions further. According to the European Commission, the EU ETS reduced emissions in the European bloc 35% by 2019.

Last year, the EU strengthened its emission reduction goals, targeting a 55% cut in emissions over 1990 levels by 2030, which ignited demand in the EU ETS. By June, the cost of carbon on the EU ETS had surged 135% in 12 months, topping around $70 per tonne—10 times the current rate in China. 

The EU’s spiking carbon costs have provided strong returns for investors. According to the Wall Street Journal only lumber outperformed carbon as a commodity in that 12-month period. 

Without a declining cap, China’s ETS won’t force companies to reduce emissions, and the effective carbon price will remain at zero. Although policymakers will ensure the price maintains at least some value on paper. 

“Regulators are fully aware they have to balance the price of carbon to be an incentive but not a burden on industry,” Qin says. In China, regulators have already set a circuit breaker on the SEEE at 10% above or below the day’s opening trade price, so the cost of carbon can never fluctuate too much.

Even ETS advocates worry that if carbon prices soar too high, industry lobbyists will push regulators to force the price down again, and the whole ETS system will break. 

“We need to remember that the whole point of the ETS is to drive emissions down, not to create value for investors or create a market,” says Tom Arup, director of strategic projects at the Asia Investor Group on Climate Change (AIGCC). But a good ETS delivers investors advantages beyond creating a new commodity to trade.

ESG portfolios have enjoyed soaring attention as investors grow increasingly aware of climate change risks. In China, ESG benchmarks surged 35% through the end of July, even as other major index funds collapsed under a regulatory crackdown. China is also the world’s leading issuer of green bonds, raising $194 billion in “sustainable” debt in the first five months of the year.

Yet verifying funds and bonds are as green as they claim is difficult. ESG ratings are fractured, and many companies simply self-report compliance, without providing audited materials. 

As the market matures, the potential for it to become a breeding ground for secondary financial products—such as CEA-backed loans, carbon futures or arbitrage—is enormous. If successful, China’s carbon program could become the biggest carbon market in the world, Arup notes.

“A government-run ETS that has large sectoral coverage provides more transparency to the system and makes it easier for investors to run their portfolios through different scenarios and test their exposure to climate risk,” Arup says. 

Beijing is also pressuring banks to take carbon quotas, issued on the ETS, as collateral for loans, although banks say the ETS is too immature to use as a basis for secondary financial offerings. China’s ETS doesn’t even allow for trading carbon futures yet, and there are other regulatory issues preventing investors from tapping the market’s potential as a benchmark for green financing. 

For starters, analysts say, oversight of the ETS needs to be removed from the Ministry of Ecology and Environment and placed under the country’s financial regulator, the Ministry of Finance (MoF). Until then, China’s loftier ambitions for its ETS—such as linking it with the EU ETS, so that carbon quotas can be traded internationally—won’t materialize, because the MEE isn’t equipped to regulate cross-border transactions. But linking the two markets would benefit both sides, Refinitiv’s Qin says, by reducing the cost of abatement in Europe and increasing the cost of pollution in China. 

“It’s like using a pipe to connect two bathtubs with differing water levels,” Qin says. “Once they are connected, the water level will even out. In the same way, connecting global carbon markets will provide a truer price for carbon pollution.”

But without these initiatives or broader regulatory reform, China’s carbon market will remain a walled garden where outside investors are unable to tap the vast wellspring of green finance derivatives, and polluters have little incentive to actually buy and trade carbon credits.

More finance coverage from Fortune:

• Unvaccinated Americans cost the health system $5.7 billion
• “Big Short” investor Michael Burry returns to Twitter to warn about passive investing
• Lumber’s epic boom and bust, explained in 8 charts
• Cara Delevingne wants to normalize sexual wellness with sex-tech company Lora DiCarlo
• Thanks to SPACs and VCs, the world’s biggest ad agency is growing again