China’sNationalcarbonmarkethaslaunchedChinaMainland(“theMainland”)hasnowlauncheditsNationalemissionstradingscheme(“ETS”),anticipatedtobecometheworld’slargestcarbonmarketbytradingvolumeandvalue.WhilstaunifiedNationalETSisnewtotheMainland,theconceptandoperationofacarbonmarketisnot.TheMainlandstartedtoexplorecarbonemissiontradingadecadeagowhentheNationalDevelopmentandRegulatoryCommissionapprovedseveralregionalpilotmarketsfortradingcarbonemissionsallowances(“CEAs”)in2011.ThosepilotschemeshavebeensuccessfulandcontinuetooperateinparallelwiththenewNationalETS.ThelongtermgoalisfortheregionalpilotstobeconsolidatedintotheNationalETSwhichwillbeacornerstoneintheMainland’spolicyforcombattingclimatechange.Inthisalert,weexplainhowtheNationalETSworksandconsiderwhat’sahead,lookingatthekeyquestionsourclientsareasking:•howdoestheNationalETSwork;•howwilltheregionalpilotschemesbeconsolidatedintotheNationalETS;•whatbarriersaretheretoforeigninvestorparticipationandhowwillthesebeovercome;•whatwecanexpecttoseeinrelationtothedevelopmentofinnovativefinancialandderivativeproductsfortradingontheNationalETS;and•howdoestheNationalETScomparetothecurrentlargestcarbonmarketintheworld–theEuropeanUnion’sETS?Why?Butfirst,why?WhydoesChinaneedaNationalETS?TheEarth’sclimateischangingrapidly.Thesciencetellsusthatwehaveachanceofavoidingthemostdangerousandirreversibleeffectsofclimatechange,butwemustlimitwarmingtowellbelow2°Cabovepre-industriallevelstodoso.TheParisAgreementsetthegoalat1.5°C.TheEarthis1.1°Cwarmerthanitwasinthe1800s.Onthecurrentpath,temperaturescouldincreaseby4.4°Cbytheendofthecentury.2010-2019wasthewarmestdecadeonrecord.Bushfires,tropicalcyclones,coastalinundation,heatwavesandmorearenowcommonnewsoccurrences,theyareneithertheoreticalnorrare.WearenotontracktomeettheParisAgreementtargettokeeptheglobaltemperaturefromexceeding1.5°Cabovepre-industriallevels.ScienceshowsthattheParisagreementgoalsareachievableonlyifemissionsarecutbyaround50%by2030andreducedtonet-zeroby2050.AkeymechanismtoachievetheParisAgreement1.5°Cgoaliseachjurisdiction’sNationallyDeterminedContributions.China’sNationallyDeterminedContributionistoachieve“carbonneutrality”by2060(iebalancinghumanemissionsandabsorptionofcarbon,withthegoalofachievingnetzerocarbonemissions)and“carbonpeaking”by2030(iepeakingcarbondioxideemissionswithanannualdeclinetofollow).IntroducingaNationalETSaimstoprovideamarketmechanismforachievingtherequiredemissionsreductions.2Howdoesaregulatedcarbonmarketwork?InouralertCarbontrading-Practicalinsightswedescribedthedifferencebetweenregulatedandvoluntarycarbonmarkets.TheMainland’snewNationalETSisaregulatedcarbonmarket,otherwiseknownasa“capandtrade”scheme.Howacapandtradeschemeworksissummarisedbelow.TheregulatordeterminesaEntitieswithinthatsectorParticipantsareallocatedorcapontotalemissionsthatthatemitaboveacertainpurchase“carbonemissioncanbemadebyspecifiedthresholdofcarbonareallowances”orCEAsissuedbytheregulator.ThetotalsectorsrequiredtoparticipatesumofallowancesmatchesthecapEachCEAisequivalenttoEachparticipantmustholdIfanentity(FactoryAbelow)onemetrictonneofcarbonenoughCEAstocovertheirholdssurplusCEAsbecauseactualemissionsitisemittinglessthanitsallowancespermit,itssurplusCEAscanbesoldonthecarbonmarketIfaparticipantdoesnotholdIfFactoryBdidnotpurchaseenoughCEAstocoveritsadditionalCEAsitisinemissions,itmustpurchasebreachoftheschemeandmore(FactoryBbelow).subjecttoapenaltyCarbonMarketBuycreditsCarbonEmissionsCapSellcreditsFactoryAFactoryB3AnoverviewoftheMainland’scarbonmarketsTradingontheMainland’sNationalETScommencedon16July2021.WhilsttheNationalETSisnewtotheMainland,emissionstradingisnot.TheMainland’sjourneyintoemissionstradingstartedin2011,whentheNationalDevelopmentandRegulatoryCommissionapprovedsevenpilotmarketsfortrading“carbonemissionsallowances”,afurtherpilotwaslateradded.Eachapprovedregionalschemehasdifferentfeatures,includingsectorcoverage,thetypesofparticipantsallowedandpricingbuttheyalloperateunderthesameideaofaregulatedcapandtrademarket.CEAsindifferentexchangescannotbetradedonacross-exchangebasis,sothelocalexchangesareallcurrentlysegregatedmarkets.Onalongtermbasis,itisexpectedthattheregionalpilotswillbecombinedintotheNationalETStoallowtradebetweenregions.RegionalETSNationalETSpilotsOperationalphaselaunchedin1Beijing-NovemberFebruary2021201312Shanghai-November20132Tradingcommencedmid-July3Shenzhen-June202120134Tianjin-December20135Guangdong-December20136Hubei-April20147Chongqing-June20148Fujian-September2016NationalETSlegalframeworkInMarch2019,theMinistryforEcologyandEnvironmentofChina(“MEE”),thegoverningbodyfortheNationalETS,announcedthedraftTentativeRegulationsfortheAdministrationofTradingofCarbonEmissionsRights(RevisedDraft)(“TentativeRegulations”).TheTentativeRegulationswereupdatedinMarch2021andareexpectedtobefinalisedsoonbytheStateCouncil(thehighestexecutivebodyinChina).Onceinforce,thiswillbetheprimaryoverarchinglegislationfortheMainland’sNationalETS.InJanuary2021,theMeasuresfortheAdministrationofTradingofCarbonEmissionsRightswereissued(“TrialMeasures”).TheTrialMeasuressetoutthegeneralrulesandprovisionsrelatedto,forexample,allowanceallocationandregistration,emissionstrading,compliance,offsets,supervisionandpenaltiesfornon-compliance.InMay2021,detailedimplementationrulesfortheregistration,tradingandsettlementofCEAs(“ImplementationRules”)wereissued.TheTrialMeasuresandtheImplementationRulesformthebasisforoperatingtheNationalETS4pendingpromulgationoftheTentativeRegulations.KeyfeaturesoftheregionalETSCompetentauthority–theMEEisauthorisedtoestablishaNationalplatformtoregisterCEAsandaNationalplatformtotradeCEAs.Exchanges–theNationalETSusestwoexistingpilotexchangestooperate.TheShanghaiEnvironmentandEnergyExchangeisresponsiblefortradingandChinaHubeiEmissionExchangeisresponsibleforregistration.Products–OnlyCEAscanbetraded,thisisbyenteringintoprivateagreement,biddingand“othertradingmethodsaccordingtotherules”.ChinaCertifiedEmissionsReductions(“CCERs”),anotheraformofcarboncredittradedontheregionalpilot,arenotcurrentlyincluded.CCERsareprojectbasedvoluntarycarboncredits.Participants–Only“KeyEmissionsEntities”subjecttoobligationstosurrenderCEAsareallowedtoparticipate.KeyEmissionEntitiesareidentifiedbytherelevantprovincial-levelEcologyandEnvironmentBureauandapprovedbytheMEE.Foreigninvestorsarenotcurrentlypermitted.Allocation–CEAsareallocatedtoparticipantsforfreebasedoncarbonintensitybenchmarks.Atfirst,participantswillreceiveallowancesat70%oftheir2018outputmultipliedbyacorrespondingbenchmarkfactorbasedonenergysource(egcoalorrenewableenergy)andactualenergyoutput.Trade–ParticipantssurrenderCEAstooffsettheiractualemissions.ParticipantsmaythenvoluntarilychoosetosellsurplusCEAs.ThosethatdonothavesufficientCEAstocovertheiremissionsmaychoosetopurchasemoreontheexchange.Tradeisonlyonspotdeliveryterms,over-the-countertransactionsarenotyetcovered.Compliance–participantssurrenderCEAstooffsetemissionsvolumeastheprimarymethodofcompliance.Upto5%ofverifiedemissionscanbeoffsetusingCCERsontheregionalmarkets.Cap–Thecapissetbottom-up,i.e.,thesumofthetotalallowanceallocatedtoallcoveredentities,informedbytheiroutputandapplicablebenchmarks,formsthecap.Itisanintensity-basedcap,whichchangesaccordingtotheactualproductionlevels.Price–determinedbymarketfactors55HowwilltheNationalandregionalETSsbecombined?ItisexpectedallexistingregionalETSpilotswillgraduallytransitionintotheNationalETSalthoughtheroadmapandtimelineareyettobereleasedbytheMEE.Inthemeantime,existingregionalETSpilotswillcontinuetooperateinparalleltotheNationalETS.Therearecurrentlysomekeydifferences:•Sector–theNationalETSonlyincludesthepowersector,comprising2,225coalandgas-firedpowerplants.Inthelongterm,otheremission-intensiveindustrieswillbecoveredbytheNationalETSscheme,althoughthiswilltakeplaceonagradualbasis.Thetablebelowdemonstratesthenumberofindustriesalreadycoveredbythepilotschemes.•Products–onlyCEAscanbetradedontheNationalETS.Bycomparison,CCERsandotherproductscanbetradedontheregionalETSs.AnewNationalmarketfortradingCCERsisduetobeestablishedinfuturesoitappearsthattherewillbetwoseparateNationalcarbonmarkets,onededicatedtothetradingofCEAsandoneforCCERs.•Price–certainlocalmarkets,suchasGuangdongandHubeireservecarbonemissionsquotaswhichmaybefedintothemarkettoapplydownwardpressureonprice,theNationalETSdoesnothaveasimilarmechanism.EachregionalETShasbeendesignedbasedonthelocalindustries,localcarbonreductiontargetsandeachhasitsownuniquefeaturesthathaveledtodifferentlevelsofliquidityandprice.Pricedifferencesforthe2020mid-rangeareshownebelow.•Foreigninvestors–arenotcurrentlypermittedtoparticipateintheNationalETS.Theyarepermittedincertainpilotschemes,asshowninthetablebelow.SectorscoveredandforeigninvestmentForeigninvestorsPricepert/CO2eBeijingIndustrialandnon-industrialcompaniesandentities,USD12-14includingelectricityproviders,heatingsector,cement,USD5-6USD3-5petrochemicals,otherindustrialenterprises,USD4manufacturers,servicesector,publictransport,anddomesticaviation.ShanghaiAirports,domesticaviation,chemicalfibres,chemicals,commercial,powerandheat,watersuppliers,hotels,financial,ironandsteel,petrochemicals,ports,shipping,nonferrousmetals,buildingmaterials,paper,railways,rubber,andtextiles.HubeiDifferentfromotherChinesepilots,Hubeidoesnotpre-✓definewhichsectorsarecoveredunderitsETS;rather,itsetsathresholdwhichappliestoallpowerandindustrialsectors.Thosesectorswithentitiesabovethethresholdthenarecovered.GuangdongPower,ironandsteel,cement,papermaking,aviation,✓andpetrochemicals.ChongqingPower,electrolyticaluminium,ferroalloys,calciumUSD3-5carbide,cement,causticsoda,andironandsteel.ShenzhenPower,water,gas,manufacturingsectors,buildings,port✓USD3-5andsubwaysectors,publicbuses,andothernon-USD2-4USD2-46transportsectors.6TianjinHeatandelectricityproduction,ironandsteel,Fujianpetrochemicals,chemicals,oilandgasexploration,papermaking,aviation,andbuildingmaterials.Electricity,petrochemical,chemical,buildingmaterials,✓ironandsteel,nonferrousmetals,paper,aviation,andceramics.Datasourcedfromhttps://icapcarbonaction.com/en/ets-map?etsid=53ForeignInvestmentWillforeigninvestorsbeabletoparticipateandwhatbarriersfirstneedtobeovercome?TheTentativeRegulationsprovideforqualifiedinstitutionsandindividualstoparticipateintheNationalETSbutitremainsunclearwhattheeligibilitycriteriawillbe.Foreigninvestorsarenotcurrentlyincluded.However,allsignspointtotheNationalETSopeninguptoforeigninvestorsinthefuture,withtheGreaterBayArea(“GBA”)likelytofeaturestrongly:•InMay2020,thePeople’sBankofChina(“PBOC”),StateAdministrationofForeignExchange(“SAFE”),ChinaBankingandInsuranceRegulatoryCommissionandChinaSecurityRegulatoryCommission(“CSRC”)issuedajointcircularlayingoutvariousfinancialsupportmeasuresfortheconstructionoftheGBA.Twoofthemeasuresrelatedtocarbontrading.Firstly,anonlineenvironmentalintereststradingandfinancialservicesystemwillbeestablishedusingGuangzhouETS’splatform.Secondly,allowingqualifiedforeigninvestors(includinginstitutionalinvestorsandindividuals)toparticipateincarbontradingusingRMBorforeigncurrency.•Inaddition,reportsindicatethatHongKongisplanningtoestablishaunifiedcarbonemissionstradingmarketinGBAleveragingtheGuangdongETSandShenzhenETStoattractforeigninvestors.ThekeybarrierstoforeignparticipationrelatetotheMainland’scapitalcontrols.Policieswillneedtobeadoptedthatallowfundstomoveinto,andoutof,theMainlandwithsupportingcurrencyconversiongiventheotherwisestrictcapitalcontrols.In2018,thePBOCreleasedtheNoticeonFurtherImprovingPoliciesforCross-borderRMBBusinesstoFacilitateTradeandInvestments(YinFa[2018]No.3)clarifyingtheproceduresforforeigninvestorsusingRMBcross-bordersettlementforcarbontradinginChina.Foreigninvestorsmayopennon-residentRMBaccountatonshorebankstodepositinvestmentfundsandreturns.Whatisnowneededisanationalpolicytoallowsettlementinforeignexchangeandcross-borderpayment.WillforeigninvestorsbeabletoaccesstheNationalETSundertheQFII/RQFIIandQFLPSchemes?Thereisnoobviousalignment.FuturemarketsaresubjecttooversightbytheCSRC,notbytheMEE.FollowingtheexpansionofinvestmentscopeinSeptember2020qualifiedforeigninvestorsareeligibletotradeundertheQFII/RFQIIScheme,amongothers,commodityfuturescontractslistedandtradedonfuturesexchangesapprovedbytheCSRC,oroptionslistedandtradedonfuturesexchangesapprovedbytheStateCouncilorCSRC.WhetherornotcarbonfutureswillfallundertheQFII/RQFIISchemefor“commodityfuturescontracts”issubjecttodeterminationbytheCSRCandtheStateCouncil.TheGuangzhouFuturesExchange(“GFEX”)iscurrentlylookingintocarbonfuturesundertheguidanceoftheCSRC.However,thisisaseparatemarkettotheNationalETS(andisnotapilot).WenotetheGFEXhassignedaMemorandumofUnderstanding(MOU)withtheStockExchangeofHongKongforstrategiccooperationinpromotingsustainabilityandfacilitatingthedevelopmentof“agreenandlow-carbonmarket”fortheGuangdong-HongKong-MacaoGreaterBayArea.The7anticipatedHKEX-GFEXcooperationmaydevelopintoanotherConnectchanneltofacilitateforeigninvestorsaccesstoonshorecarbonfuturesandrelatedderivativestrading.WhatproductsarewelikelytoseeinfutureontheNationalETS?Currently,onlyCEAsmaybetradedontheNationalETS.Ourclientsareexcitedaboutdevelopingnewandinnovativegreenproducts.Tradingofsuchproductsisalreadyavailableoncertainoftheregionalpilots.Forexample,theover-the-counter‘ShanghaiEmissionAllowanceForward’contract,withcentralcounterpartyclearingisavailableontheShanghaiEnvironmentandEnergyExchangeinadditiontocarbonfunds,carbontrusts,greenbonds,andcarbonmargintrading.DevelopmentofgreenderivativesandstructuredproductsisinprincipleencouragedbytheMainlandGovernment.Forexample,inMay2021,China’stopfinancialgoverningbody,theCentralCommitteeforOverallDeepeningReform,issuedacircularprovidingforthedevelopmentofcarbonemissiontradingfutures.InAugust2021,theCSRC'sspokespersonGaoListatedthatcarbonemissionfutures,whichareanintegralpartofcarbontrading,willberolledoutwhenthemarketfurthermatures.However,therearehurdlestoincludingdifferentfinancialproductsontheNationalETStobeovercomefirst,including:•Classificationofcarbonassets.Thelegalnatureofcarbonassets(whetherasapropertyrightoranadministrativepermission)remainsuncertainandthiscouldhaveimplicationsonproductdesign.Forexample,ifasecurityisperfectedoveraCEA,whatremedyandenforcementactionisavailabletoinvestors?Whataccountingrulesandtaxationrulesapply?•Verificationandcredibilityofemissionsdata.Thereareconcernsabouttheintegrityofemissionsdata.Carbonemissionbasedfinancialproductsrequiremonitoring,reportingandverificationofemissions,toensurethatthedataunderpinningthemarketoperationiscredible.•Lackofpledge/mortgageregistration/deregistrationsystem.UnlikesomeregionalETSpilots,theNationalETSdoesnothaveapledgeregistration/de-registrationsystemyet.•Lackofmaturecreditassessmentmethodology.FundraisingonemissionrightsisnewinChina.Experienceinothermaturemarketsmustbeappliedtotheassessmentofcreditrisks.•Primaryunderlyingmarkethasnotmatured.Exchangebasedderivativesareusuallystandardisedanddeveloped.Duringtheformativeyearsofamarket,OTCtransactionsallowparticipantstocustomisetheirtransactions,whichmayenablenewproductstoemergethatcanbecomestandardisedoveralongtermbeforemovingontoanexchange.CCERsarecarboncreditsthatareaproductofdomesticemissionreductionprojectswhichsubstitute,neutraliseorreducegreenhousegasemissions.KeyEmissionsEntitiesarenotcurrentlyabletotradeCCERsontheNationalETSbuttheyarepermittedtooffset5%oftheiremissionsallowancesusingCCERspurchasedonothermarkets.ItisalsoworthnotingthataseparateNationalmarketforCCERsiscurrentlybeingplanned.On10March2021,theGeneralOfficeofCPCBeijingCommitteeandGeneralOfficeofBeijingPeople’sGovernmentjointlyissuedtheBeijingMunicipality,ImplementingPlanonBuildingaModernEnvironmentalGovernanceSystemwhichprovidesthatBeijingwillleadtheestablishmentofaNationalCCERtradingcentre.“Derivativesplayanessentialroleincarbonmarkets.Companiessubjecttocarboncomplianceprogramsusecarbonderivativestomeettheirobligationsandmanageriskinthemostcost-effectiveway.Derivativescanalsobeusedbyavarietyofbusinessesthathavefinancialpositionsindirectlytiedtocarbonprices.Investorscanusethepricesignalsfromcarbonderivativestoassessclimatetransitionriskintheirportfoliosandcanthenaccessliquiditypoolstomanageriskandallocatecapitaltobenefitfromenergytransitionopportunities.”ISDA,theRoleofDerivativesinCarbonMarkets8HowdoestheNationalETScomparetotheEuropeanUnion’sETS?TheEU’sETSisthelargestregulatedcarbonmarketintheworld.ItcoversallEUcountriesplusNorway,LiechtensteinandIceland.UnlikeChina’sNationalETSthatcurrentlycoversonlythepowersector,theEUETScoversanumberofenergy-intensiveindustriesincludingoil,steelworks,papermakingandthecivilaviationindustry.Oneofthekeydifferencesthathasattractedcommentisthewayinwhichthe“cap”onemissionsisset.Wesetoutacomparisonbelow.EU’sETSChina’sETSTheEUusesa“top-down”approach,applyinganabsoluteChina’scapisset“bottomup”.EachpowerplantreceivesemissionscapfortheEUasawhole.Thismeansaset70%oftheir2018emissionsoutputmultipliedbyanumberofCEAsisavailableforallocation.correspondingbenchmarkfactor.ThebenchmarkfactordependsonhowmuchenergyitproducesandthesourceofTheEUwidecaphasdecreasedyearonyearby1.74%thatenergy.Thetotalcapisthesumofthoseallowancessince2013,from2021onwardsitswilldecreaseby2.2%.thathavebeendrivenbyactualemissions.ThismeansthesetnumberofCEAsavailableforallocationreducesyearonyear,inevitablyleadingtothepriceofCEAsEntitieswillinitiallyreceiveallowancesat70%of2018increasingunderusualsupplyanddemandpressure.outputmultipliedbythecorrespondingbenchmarkfactor.Allocationswillsubsequentlybeadjustedinaccordancewithverifiedemissionsfor2019-2020asreportedbytheentities.Underthismechanism,thecapisnotforcedtoreduce.ThedefaultpositionisthatallowancesareauctionedsoAllocationisfree.Thereisno“paytopollute”currentlyinparticipantshavetopurchasethemmakingthem“paytoplace.pollute”.Certainallocationsarestillgivenforfreebutthisisreducing.Powergeneratorsforexample,donotreceivefreeallocationasadefault.ThequestionishowtheNationalETSwillreduceemissions,theultimateandnecessarygoalfortacklineclimatechange.Asisshowninthediagrambelow,theNationalETShasstartedinaverysimilarplacefromwheretheEUdidbackin2005whenitsETSlaunchedwithabottomupapproach,mostlyfreeallocationandcoveringthepowerindustryonly.Itmakessensethatthisisneededatthestarttoallowtheschemeandthoseinittocontinuetooperate.WhilstChinamayhavestartedlate,itwillbuildonknowledgegainedthroughitsregionalpilotsandnodoubtdrawfromglobalexperienceinitsdevelopmentandexpeditechangeneededtomeetitsParisAgreementcommitments.9ThefutureforcarbontradingintheMainlandChina’sNationalETSisnowupandrunning,afteradecadeoflearningandgatheringdatafromtheregionalpilots.Chinamaylooktoincreasetheliquidityofthemarket,enhancetheimpactonslowingclimatechangeandaccelerateachievingitsParisAgreementcommitmentsby:•expandingcoveragetoadditionalsectors,lookingtothepilotschemesformethodologiesinrelationtootherindustries;•coveringothergreenhousegasemissions,ratherthanjustcarbon;•settinganabsolutecaponemissionsthatreducesinalinearfashionyearonyear,drivingdowntotalemissions;•havingparticipantspaytopollutebyimplementinganauctionsystemforCEAsratherthanfreeallocation;•introducingavarietyofmarketparticipants,includingforeigninvestors;•adoptingdiversederivativesproducts;and•exploringopportunitiesforinternationalconnectionstoothercarbonmarkets,includingtheEU’sETS.NextstepsAsoneofChina’sleadinglawfirms,KWMisadvisingourclientsonhowtheymightparticipateintheseismicchangesthatarenowtakingplaceinChina’semissionstradingschemes.Pleasecontactusifyouhaveanyquestions.RichardMazzochiMinnySiuPartnerPartnerT+85234431046T+85234431111richard.mazzochi@hk.kwm.comminny.siu@hk.kwm.comGuJieyuSuMengPartnerPartnerT+8602558720808T+862124126057gujieyu@cn.kwm.comsumeng@cn.kwm.comLeonieTearClairePotterCounselRegisteredForeignLawyerT+85234438375T+85234431093leonie.tear@hk.kwm.comclaire.potter@hk.kwm.com10
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