By  Zhang Shouzhi  Hu Ke  and Xu Beibei  King&WoodMallesons’ Dispute Resolution Group

Being the world’s largest developing country and largest emitter of greenhouse gases, China started in 2009 an ambitious campaign, largely on its own initiative, to reduce its carbon intensity (measured by emission per unit of GDP) by 40-45% in 2020 from 2005 levels. The 12th National Five-year Plan set two mandatory goals of reducing energy intensity by 16% and reducing carbon intensity by 17% in the term of 2011-2015. The Chinese government is taking measures to further adjust the industrial structure, to optimize energy structure, to improve energy efficiency, and to control energy consumption and greenhouse gas emission.

On 29 October 2011, the National Development and Reform Commission (the “NDRC”) issued the Notice of the General Office of the National Development and Reform Commission on the Pilot Trading of Carbon Emission Rights, according to which that Beijing, Tianjin, Shanghai, Chongqing, Hubei, Guangdong and Shenzhen would start pilot carbon emissions trading. From 2013 to 2014, the pilot provinces and cities (the “Pilot Regions”) have respectively developed carbon emissions trading schemes, set out management and trading rules, and launched the carbon emission trading systems; moreover, in July 2014 Beijing, Tianjin, Shanghai, Guangdong and Shenzhen completed the first compliance audit after regulated emitters surrendered their allowances.

In carrying out pilot carbon emissions trading programs(the “Pilot ET Programs”), the local authorities of the Pilot Regions built their carbon emissions trading platforms, set up allowance allocation plans and compliance rules, and made complete operating schemes according to local conditions.

Below is a brief and general introduction to these Pilot ET Programs in China.

1. Market Participants

The qualifications of participation in the carbon market vary in each Pilot Region, but they can be roughly divided into two groups: mandatory participants and voluntary participants.

1.1 Mandatory Coverage of the Pilot ET Programs

The mandatory coverage of the Pilot ET Programs was determined by each Pilot Region taking account of local economic conditions. Industrial sector and amount of annual emission are the key criteria: firstly, enterprises in certain industrial sectors, such as iron and steel, petrochemicals, chemicals, nonferrous metals, electricity, construction materials, textiles, paper-making, rubber and chemical fiber, are major emitters and are included in every region; secondly, industrial or non-industrial companies and organizations with direct or indirect annual emission over a certain amount, would be included too. For example, in Shenzhen, large public building with construction area over 20,000 square meters and government office buildings with construction area over 10,000 square meters are also included in the emission limitation scheme.

1.2 Other Participants

Companies not mandatorily covered may nevertheless participate in the trading of emission allowance and other credits on a voluntary basis.

Noticeably, enterprises and organizations whose current annual emissions are less than the standard for mandatory inclusion but exceeding a certain amount, are required to implement a monitoring and reporting system.

1.3 Participation in Carbon Exchanges

Each region has a regional, separate and independent carbon exchange. To trade in these exchanges, membership in the exchange is a prerequisite. Mandatory participants of a regional emission limitation scheme, are not necessarily members in the corresponding exchanges; however, emission allowances can only be traded in exchanges, while credits deriving from voluntary emission reductions may be traded over the counter.

The categories of and requirements for membership are different. In Beijing, there are two kinds of membership: mandatory participants and non-mandatory participants. In Shanghai and Guangdong, memberships are categorized as self-operated participants and comprehensive participants, the former undertaking principal transactions only and the latter undertaking agency transactions too.

In Beijing and Hubei individuals are excluded from the exchanges due to the requirements for membership in the rules of the exchanges.

The registered capital is often a key requirement for an institutional member, but in Shenzhen, no threshold on registered capital is set.

2. Allocation of Allowances

The total emission allowance consists of initial allowance and reserve allowance, and is allocated either free of charge or on a payable basis. However, the proportion of free allowance will be reduced gradually, instead to impose more strict emission limitations, to encourage reduction efforts and to promote the liquidity of the market.

2.1 Initial Allocation

Basically, the initial allowances are allocated to mandatory participants free of charge at the beginning of a compliance year. However in Shenzhen and Guangdong, the allocation is made largely free of charge, with a small portion distributed by fixed-price sale or by auction.

In principle, in setting up the allowance, the regulatory body of a Pilot Region (usually local DRC) will take into account specific conditions of each industry, including the historical emission level, the advanced emission level, technological development in the industry, economic restructuring of the region, the policy of eliminating outdated capacity, and the need of energy conservation and emission reduction. The regulatory body will also give due consideration to the reasonable growth of the industry, as well as the energy conservation and emission reduction initiatives of the Pilot Enterprises under BAU (business-as-usual) scenarios.

The two principal methods for determining allowance are historical method and baseline method. The former is to allocate allowance based on the enterprise’s historical carbon emission level as well as its early contribution in emission reduction; the latter is to allocate allowance based on the energy efficiency and the total production of the enterprises. Generally, the allowances for enterprises in energy-intensive industries (such as electricity, cement and steel) are allocated according to the baseline method, and these for enterprises engaging in other industries and commercial buildings are allocated largely according to their historical emission levels. But, understandably, each Pilot Region has its particular economic, social or environmental concern in the setting of its emission limitation, as reflected in its distribution method.

2.2 Reserve Allowances

There are two types of reserve allowances for different purposes: new entry reserve and government reserve. The new entry reserve is kept to meet the needs of the Pilot Enterprises’ newly increased capacity and new emitters, and is distributed free of charge; the government reserve, making up only a small proportion of the total amount, is prepared for stabilizing prices and may be sold by auction or at a fixed price.

3. MRV, Surrender and Trading

All mandatory participants are required to implement a monitoring system, report their annul emissions and have the report verified by an accredited verifier within given periods.

For compliance with local rules, a mandatory participant shall surrender sufficient amount of allowances, equivalent to the volume of its actual carbon emissions of the compliance year. The penalty for non-compliance varies from region to region.

A Pilot Enterprise is not allowed to “borrow” the allowances of the next year for the compliance, but may reserve the surplus allowances of a given year to subsequent years. Allowances can be traded in the carbon exchanges, though in some Pilot Regions restrictions are set (for example, in Chongqing, sale of allowances in a year shall not exceed 50% of the total amount of the annual allowances). Enterprises whose allowances are insufficient for compliance may purchase allowances on the carbon exchanges.

The carbon emission allowances shall be traded on the designated carbon exchanges, referring to CBEEX (Beijing), SEEE (Shanghai), CEEX (Shenzhen), GZEEX (Guangdong), TCX (Tianjin), CHEEX (Hubei) and CCER (Chongqing). The credits eligible for trading are carbon emission allowances, CCER and other voluntary emission reductions and carbon credits certified or approved by relevant local authorities. Depending on the local rules, participants may trade carbon credits by listed trading, biding, auction, block trading, negotiated transfer and in other methods approved by the authorities. Trading price is fixed by negotiation between the parties; index/market price would be calculated every business day; and government may stabilize the price by throw-in or buy-back allowances when the price fluctuates sharply.

4. Operations in the First Year

Up to 25 July 2014, Beijing, Shanghai, Guangdong, Shenzhen, Tianjin, Hubei had completed the compliance audit for the first time. Results were announced in Shanghai, Guangdong, Shenzhen and Tianjin. In these four Pilot Regions, the average rate of compliance is 98.85%. Chongqing will complete its first compliance year on 20 May, 2015.

Carbon trading was still new to market players: in Beijing, the carbon trading in the period from 28 November 2013 to 25 July 2014 had only a cumulative volume of 2 million tons in quantity and RMB 98.63 million in value.

End Note

To be successful, the pilot ET Programs still need to establish a comprehensive, transparent, reasonably detailed and consistent regulatory framework, collect reliable emission data and statistics, build wide social recognition, and conduct extensive capacity building in the related industries.

The launch and operation of the Pilot ET Programs, and the systematical innovation in the Pilot Regions, however, have laid a solid foundation for the future development of China’s carbon market. Hopefully the second year of the Pilot Programs will present a more prosperous domestic carbon market in China.