Four Challenges for China’s Cap and Trade Program

October 7, 2015
Ken Kimmell
Former contributor

When Congress failed to pass national climate legislation in 2010, many said that marked the end of so-called “cap and trade” programs, —in which government sets an overall limit on pollution and issues pollution “allowances” that individual companies can use or trade with others. The naysayers couldn’t be more wrong, as demonstrated by the recent announcement that China will start a national cap and trade program in 2017 as a primary tool to lower its emissions of the heat trapping gases that cause global warming.

Pollution in China

Photo: Flickr/Andy Enero

Cap and trade is an ingenious solution to a problem economists refer to as “the tragedy of the commons,” in which no individual has an incentive to improve a shared resource (such as the earth’s atmosphere), even though everyone benefits collectively from the resource’s improved health. Cap and trade solves the problem because it gives those who pollute a stake in lowering pollution: not only can they reduce the number of allowances they need by polluting less, but they can even sell those they don’t need to others.  Well-designed cap and trade programs combine what government does best (setting collective goals) with what the private sector does best (finding the most cost-effective means to reach those goals).

No wonder the idea has spread. The United States has used it to cut the pollutants that cause acid rain and, since then, 28 countries within the European Union, nine eastern U.S. states, California, Quebec, and South Korea have all established cap and trade programs to cut global warming gases. Ontario and Washington state are actively exploring cap and trade programs as well.

Still, no one has tried such a system on the scale China proposes. While I am no expert on China, I chaired the nine eastern state cap and trade program known as the Regional Greenhouse Gas Initiative (RGGI). And, with an appropriate degree of humility about the potential of applying lessons from the RGGI experience to China, here are the challenges I foresee for China in implementing this program:

Cultural. China’s economy is a hybrid of heavy government mandates and private markets, and the concept of a “market” for the right to pollute may need time to take hold. In fact, when I chaired RGGI, a Chinese delegation visited to learn more about the RGGI program, and they seemed surprised that, under RGGI, the government did not tell individual power plants how many allowances to purchase. It seems likely that a major public education effort will be needed despite the fact that China has already undertaken smaller pilot cap and trade programs in several Chinese provinces and cities.

Establishing the Initial Cap. Setting the initial cap of allowances is very difficult, and other cap and trade programs have gotten this key element wrong. If too many allowances are offered, the price for allowances drops to a level that is too low to incentivize lower carbon alternatives like renewable energy. If too few allowances are offered, it can cause price shocks and disruptions that might engender a backlash against the program. China should seek to start out with an initial cap that roughly corresponds to the current emissions from the covered sectors, but this may involve a great deal of guesswork as China has repeatedly stated that they do not have an up-to-date inventory on emissions.

Auctioning and Transparency. Closed and secretive processes don’t work for cap and trade. The key to a successful cap and trade program is a transparent process for the auctioning of allowances to the highest bidders. This prevents so-called sweetheart deals in which politically connected actors get allowances on a preferential basis. It also ensures that the public reaps the benefit of the allowances because the funds are held by government, not private parties. Similarly, China will need to develop rules to make sure that no single company (or a small number of companies) holds an excessive number of allowances and can use monopoly power to re-sell allowances at an inflated price.

Mechanisms for Flexibility. One of the lessons learned from cap and trade programs so far is that it is impossible to predict the future of energy markets. In the United States, for example, few predicted the shale gas revolution and the plunging price of natural gas which had profound unforeseen effects on the RGGI program. Similarly, the European Union failed to predict the effect of the global recession on its trading program. The lesson here is that, as China designs its cap and trade program, it will want to put in place mechanisms that allow it to rapidly make changes (such as to the number of allowances to be provided) if reality does not match the program’s initial predictions.

What can we do?

All of us who care about addressing global warming should be strongly rooting for the success of China’s program as a key means to cutting emissions from the world’s largest emitter of heat-trapping gases. We should also offer whatever help we can. Those of us in the United States, and elsewhere, who have designed and implemented successful cap and trade programs should stand ready and willing to offer China the benefit of our experience.

Good ideas are like seeds dispersed by the wind. You can never tell where they will lodge and take root. Cap and trade is a great idea developed and first implemented in the market economies of the West. It is exciting to watch it now find fertile ground in the largest economy in the East.