This post originally appeared  on WRI's ChinaFAQs blog.
China launched its first pilot emission trading program this past June. This development is potentially a major marker in the country’s efforts to reduce greenhouse gas (GHG) emissions.
The Shenzhen Emissions Trading Scheme (ETS)  program will cover some 635 industrial companies from 26 industries. This is the first of seven proposed pilot GHG cap-and-trade schemes  in China, which the country has been developing since 2011. Besides Shenzhen, four of the other pilots are expected to start trading this year.1
In 2010, these 635 industrial companies emitted 31.7 million tons of carbon dioxide and contributed 59 percent of the Industrial Added Value (gross domestic product (GDP) due to industry) and 26 percent of Shenzhen’s GDP.
While most experts agree that the ETS will not be a major driver of emission reductions in the immediate future, these pilots are an important capacity-building mechanism for the government, companies, and third parties to test relevant methodologies and procedures.
Traditionally, China has been better at using administrative measures rather than market-based measures to meet its carbon emissions reduction goals. For example, China reduced its energy intensity by 19 percent during the 11th Five Year Plan (11FYP) period (2006-2010), mainly through top-down, national policies, such as closing down small plants; disaggregating reduction targets to large companies, provinces, and cities (this is important because it places responsibility for meeting the targets directly on individual government officials and large companies, see: Top-1000 program and Energy-Saving Target Responsibility System ); and setting up product energy performance standards.
An Ambitious Target
Shenzhen has set up quite an ambitious target for its ETS compared to existing national or local commitments. The 635 companies will be given a roughly 100 million metric ton CO2 emission allowance for free over the next three years. If the companies only emit their allotted amount, this would be equal to a 32 percent reduction in terms of GDP emission intensity. To put things into perspective, China is committed  to reduce its emission intensity by 40 to 45 percent by 2020, and Shenzhen’s carbon intensity reduction target during the current Five-Year Plan period (2011-2015) is 21 percent. It is worth noting that the allowances are determined by emissions intensity rather than in absolute terms, meaning the government will review companies’ Industrial Added Value on an annual basis and increase or decrease the absolute emission allowance to maintain a fixed emissions-to-GDP ratio. Intensity-derived allowances are a novel concept and could hold lessons for other developing countries.
One of the main challenges that the ETS pilots face is their legal basis. For energy conservation, the national Energy Conservation Law provides a solid legal basis for the government. The law allows the government to collect energy-related data and set conservation targets for enterprises, as well as to stipulate legal consequences for non-compliance. The ETS pilots, however, are based on ordinances from local legislatures. As a result, the regulation has fewer teeth. Ensuring that there are strong, enforceable penalties for non-compliance will be important for the success of the program.
Data quality is another frequently cited challenge. The national government has not yet mandated a unified methodology to account and report GHG emissions. Although the ETS pilots are adopting internationally recognized GHG accounting and reporting frameworks, each ETS pilot is likely to develop similar but slightly different methodologies, making it more difficult to link between pilots or scale them up to the national level. Furthermore, the ETS pilots are generally hesitant to put in place stringent data-quality requirements out of the fear that companies don’t have enough capacity. The fact that caps are derived from intensity targets adds another layer of uncertainty, as economic data such as Industrial Value Added may also be subject to manipulation. The pilots will provide an opportunity for China to address data quality issues.
Last but not least, the political will to reach the ambitious reduction target is yet to be tested. Chinese officials have estimated  China’s emissions will peak between 2030 and 2040. However, there are influential experts advocating  for the 2025 timeline, and at least one ETS pilot is studying the possibility of peaking as soon as 2015. Building support for the ETS pilots will come from showing that the pilot programs are compatible with economic growth, which continues to be a priority in China. In 2012, Shanghai’s economy grew its GDP by 7.5 percent, which was the slowest economic growth of any pilot site. Four of the seven pilot sites had double-digit GDP growth.
While these are some of the obstacles to overcome, the ETS projects can offer a strong starting point for a market-based approach  to constrain emissions in China. If successful, these pilots can then be scaled up nationally, and will help show that China is serious about tackling its emissions and addressing the growing threat of climate change.
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