Repeating European Carbon Market Mistakes

BMI View: As China rolls out its pilot carbon markets, the risks that it will repeat some of the same mistakes that have been made in Europe appear to be growing. The issuance of too many permits at a time when both the economy and demand for power is slowing will depress carbon prices and do little to reduce emissions or deter coal use in power generation.

We continue to question the efficacy of China's plans to establish a nationwide carbon emissions trading scheme. Although there is considerable political pressure to reduce emissions and curb pollution, we believe there is a risk that China is already repeating some of the mistakes that have been made in Europe. The European Emissions Trading Scheme (ETS) has been ineffective because of a glut of permits - which has depressed prices and meant there is no real deterrent to coal-fired generation.

This glut of permits in Europe is a symptom of weak demand for power but also - critically - the issuance of too many permits in the initial stages of the ETS rollout. In our view, reports from China indicate that the government may be making the same mistake - giving out too many free permits as it seeks to establish its seven pilot carbon markets (Beijing, Guangdong, Shanghai, Shenzhen, Chongqing, Hubei and Tianjin) in an effort to ensure large polluting companies in both industry and the power sector sign up.

Too Many Permits, Not Enough Demand
European Climate Exchange OTC 1st Year CO2 Emission EU ETS Px - Mid Price (EUR/Tonne of C02)

Repeating European Carbon Market Mistakes

BMI View: As China rolls out its pilot carbon markets, the risks that it will repeat some of the same mistakes that have been made in Europe appear to be growing. The issuance of too many permits at a time when both the economy and demand for power is slowing will depress carbon prices and do little to reduce emissions or deter coal use in power generation.

We continue to question the efficacy of China's plans to establish a nationwide carbon emissions trading scheme. Although there is considerable political pressure to reduce emissions and curb pollution, we believe there is a risk that China is already repeating some of the mistakes that have been made in Europe. The European Emissions Trading Scheme (ETS) has been ineffective because of a glut of permits - which has depressed prices and meant there is no real deterrent to coal-fired generation.

This glut of permits in Europe is a symptom of weak demand for power but also - critically - the issuance of too many permits in the initial stages of the ETS rollout. In our view, reports from China indicate that the government may be making the same mistake - giving out too many free permits as it seeks to establish its seven pilot carbon markets (Beijing, Guangdong, Shanghai, Shenzhen, Chongqing, Hubei and Tianjin) in an effort to ensure large polluting companies in both industry and the power sector sign up.

To put the scale of the problem in context, the vice mayor of Shenzen said in January that the city's pilot carbon market had a 10% surplus of permits in 2013, according to Reuters. Similarly, on August 19 it was reported that Guangdong, the biggest of China's seven pilot carbon trading markets, will allocate 6% more emission permits to companies than in 2013, potentially exacerbating oversupply.

Critically, this is happening at a time when the Chinese economy looks to be losing steam - as the country undergoes economic rebalancing ( see 'Credit Creation Plummets In Sign Of Renewed Economic Weakness', August 14). Our Country Risk team continues to expect a slowdown as H214 progresses and - in line with this view - we are also forecasting annual average growth in power generation of 5.9% between 2014 and 2023, as opposed to growth of 10.6% between 2004 and 2013.

Too Many Permits, Not Enough Demand
European Climate Exchange OTC 1st Year CO2 Emission EU ETS Px - Mid Price (EUR/Tonne of C02)

Under these circumstances, the parallels with the European ETS are clear. During the financial crisis carbon prices in Europe collapsed and are only now rebounding after politicians voted to withdraw permits (see chart). However, the ETS is still some way from functioning effectively - with prices needing to rise to EUR30-40 per tonne of CO2 to deter coal burning in power generation.

We highlight that, although China is in the early stages or rolling out its carbon markets, a glut of permits would raise major questions about plans to launch a national market by 2015 ( see 'Carbon Trading Schemes Gaining Momentum', November 29 2013). If it does ultimately prove to be the case that too many permits have been issued, questions over commitment to the project will continue to surface ( see 'Beijing Clears The Air But Broader Impact To Be Limited', September 16 2013).

Still Burning Through The Black Stuff
Increases In Energy-Related C02 emissions by fuel type (non-OECD), 1990-2040 (billion metric tons)

We emphasise that much will depend on the ability of local governments in the cities that host the seven pilot markets to monitor permit allocation and the compliance of the companies involved. We have highlighted that Beijing's municipal government is set to play a decisive role in reducing air pollution - announcing that it will ban the consumption of high-polluting fuels in its six main districts by the end of 2020 - and it will likely have to do the same when managing the city's carbon market ( see 'Beijing: Local government Key To Coal Reduction', August 7 2014).

The biggest risk to this view is that, while big cities like Beijing and Shanghai might register some success, it is unclear if smaller cities and governments have the funding or organisation to meet the challenges involved in implementation. At this stage, the ability of local governments to keep accurate and transparent records, and release data on emissions levels, is still in doubt. This would crimp the trading of permits because it inhibits price forecasting - deterring trading houses or banks from entering the carbon markets.

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