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Uniform CO2 prices in the EU and China

By Malte Winkler

A broad and uniform pricing of greenhouse gas (GHG) emissions is a core element of an effective and efficient global climate policy. A major step has now been taken in this direction: After a long planning phase, a national emissions trading system (ETS) will be launched in China on February 1, 2021. Although it will initially only cover the electricity sector, it will put a price on 3500 million tons of CO2, replacing the EU ETS, under which just under 2000 million tons of CO2Eq are regulated, as the largest ETS in the world. The share of GHG emissions that are priced globally makes a jump from about 16 percent to 22 percent. In the future, the Chinese system will be expanded to include other sectors.

Great opportunities of the Chinese ETS

Therefore, the launch of the Chinese ETS is an important step for international efforts to combat climate change. It holds an even greater opportunity: If a common market for emission certificates between the Chinese and European ETS could be established, about ten percent of global GHG emissions would already be priced uniformly. An as yet unpublished study with IfW participation shows that under the given national emission targets (NDCs) in the framework of the Paris Agreement, such a link would already realize about two-thirds of the potential global efficiency gains that would be possible through a global CO2 price compared to purely national CO2 price.

Such a link would be particularly attractive for Europe. Emission reductions are significantly cheaper in China, so the purchase of Chinese certificates would lead to a lower certificate price and thus to savings for European companies in the ETS. According to IfW estimates, the EU allowance price in 2030 could be about 80 percent lower through a link to the Chinese ETS, and the economic costs of the EU ETS would be reduced by about 35 percent. In addition, the border adjustment for Chinese products currently under discussion in the EU Green Deal, which is intended to compensate for the shifting of emissions in the case of different strict climate policies, would become obsolete.

However, a number of hurdles would have to be overcome before such a link could be established. The road to a national Chinese ETS was already long: seven smaller pilot systems were announced in 2011, in which certificates were traded from 2013. The official launch of the national ETS in China took place at the end of 2017, but still without actual emissions trading. Now, on 01.02.2021, the system will come into force, the first trading period has been running since the beginning of this year.

Two similar systems in China and the EU

The design of the Chinese ETS is similar to that of the EU ETS, but there are also differences. Both ETSs cover the power sector and refineries, as well as emission-intensive industries (although the latter are added later in the Chinese ETS). Offsets, i.e., the crediting of emission reductions from sectors outside the ETS, are no longer provided for in the EU ETS from 2021, while installations in China can credit up to five percent of their emissions from so-called CCERs (China certified emissions reductions). While the EU sets an absolute amount as a cap, China aims to improve emissions intensity. This makes a link more difficult but does not rule it out.

Advantages and disadvantages for China

The EU is open to a common ETS. The aim of linking the EU ETS with other systems is set out in the relevant directive. A functioning link between the EU and Swiss ETS has been in place since 2020. The potential efficiency gains for the EU have already been mentioned. On the other hand, China could generate profits by selling allowances to the EU. However, there is a second counter-effect: The link to the EU ETS would result in a higher allowance price in China (in the IfW calculations, this rises by almost 30 percent in 2030), which would make Chinese products more expensive and thus worsen their international competitiveness. The advantage that China would have from a joint ETS would be significantly diminished or even turned into a negative one by this effect.

But there are solutions that make the common allowance market interesting for China as well: Limiting the amount of allowances traded between the two ETSs can increase the welfare gain in China compared to an unrestricted link. According to IfW calculations, halving the number of allowances traded between China and the EU doubles the welfare gain in China compared to an unrestricted allowance trade. The positive effects for the EU would be smaller (the EU ETS price would only fall by about 50 percent, the economic costs by just under 15 percent) but still significant.

Disadvantage of compensation payments

As a further option, compensation payments from the EU to China could be used to guarantee China additional profits. In this case, too, both partners benefit from the linking of the systems, even with relatively high payments. However, this raises a conflict of interest between the EU and China: While the EU would prefer unrestricted emissions trading (regardless of any compensation payments), China benefits more from a limitation of traded allowances than from compensation payments. However, a limited link implies overall efficiency losses, so that compensation payments would be preferable.

A unified position could also be difficult to find at the EU level: Individual member states benefit to a greater or lesser extent from the cheap certificates from China. While Germany, as a major exporting country, would clearly benefit from a common system, the situation is less tempting for many Eastern European states, for example. Intra-European compensation mechanisms are therefore likely to be necessary to develop a common European position.

Better than border adjustment

In addition to these conflicts of interest, numerous technical (such as the different handling of offsets and reduction targets) and political (such as the “circumvention” of national targets in the EU through “indulgence trade” with China) hurdles would also have to be overcome. It is to be hoped that this will succeed. For not only would the efficiency gains of a common market be enormous in the aggregate, it would also be a valuable stimulus for international efforts to reduce GHGs. For the EU, a harmonized climate policy with one of its most important trading partners would also significantly reduce the risk of carbon leakage. Studies have shown that this risk can be reduced by the border mechanisms now under discussion, but at a massive cost to the countries concerned; a common CO2 price is always preferable. Moreover, it is becoming apparent that the practical problems of border adjustment dwarf those of linking ETSs. At best, the EU’s discussions on this will be a further incentive for China to come out in favor of the linking option. Either way, the EU should invest at least as much in linking the EU and China ETS as in border adjustment.

Sonja Peterson and Malte Winkler conduct research on climate economics at the Kiel Institute for the World Economy (IfW Kiel) and regularly advise national and international institutions.

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