Editor's note: This post originally appeared on the ChinaFAQs blog.

When Tianjin launched its carbon emission trading scheme (ETS) on Dec 26th 2013, it became the fifth ETS operating in China, following Shenzhen, Beijing, Shanghai, and Guangdong. Now that five of seven pilots have started trading and the rest are expected to start in 2014, the aggregate of all emissions regulated in China through the seven pilots will be the second largest in the world, following only the European Union.

The Chinese emissions trading pilots come at a time when environmental and climate issues are increasingly at the top of the Chinese agenda. In September 2013, the central government released its Air Pollution Control Action Plan, which included a target of limiting coal to 65 percent of primary energy consumption and a ban on new coal fired power plants around Beijing, Shanghai, and Guangzhou. Last year also saw China announce an investment of $277 billion to clean up air pollution over the next five years. Taken together, the events of 2013 show that emissions trading is just one of the ways in which China is trying to tackle it many challenges involving climate and environmental issues.

ETS with Chinese Characteristics

So far, it seems the pilots have made significant progress in experimenting with how to use ETS in a Chinese context. The five launched pilots have successfully designed essential building blocks such as: determining how the ETS would apply to various greenhouse gas types, sectors, emissions sizes, and accounting boundaries; choosing how emissions allowances will be allocated; establishing the size of cap and reduction trajectories; the monitoring, reporting, verification (MRV) of emissions; and several other components.

Focusing only on carbon dioxide, the pilots cover roughly 40 to 60 percent of a city or province’s total emissions, and apply to power and other heavy manufacturing sectors such as steel, cement, and petrochemicals. Since electricity prices are heavily regulated in China, power plants cannot pass their carbon costs on to consumers through electricity prices. This policy therefore provides little incentive for demand-side electricity management. To address this issue, the Chinese pilots also require large electricity users to submit emissions permits to the government. This is a distinct feature that complicates the carbon accounting, since it means counting emissions from power plants and from electricity users, generally resulting in double counting. A typical Chinese pilot also requires third party verification of emissions data, allows participants to purchase offsets for 5-10 percent of their emissions, reserves allowances for carbon price stabilization, and has a one-year compliance period.

Differences Amongst the Pilots

Despite some similarities, such as those mentioned above, the Chinese pilots are very different from each other—due in part to varying economic contexts. Beijing and Shenzhen have small industrial emissions and a large service economy, and are more likely to peak their emissions in the near future. In order to increase the percentage of emissions covered by the ETS, both Beijing and Shenzhen have required key companies in the service sector to join the scheme. Beijing is the only pilot that requires annual absolute emission reductions for existing facilities in the manufacturing and service sectors. Companies in these sectors will receive fewer allowances each year—starting with 98 percent of their average 2009 to 2012 emissions in 2013 and dropping to 94 percent in 2015. Although power and heating plants are not expected to reduce absolute emissions through the ETS, Beijing plans to replace all of its coal-fired power plants with natural gas plants by 2017, putting it on a path to peak emissions very soon as a result of a combination of market and administrative policies. Companies in Shenzhen are not required to make absolute reductions, but will need to reduce their carbon intensity per unit of Industrial Added Value (gross domestic product GDP due to industry) by 32 percent below 2010 levels over the next three years while limiting their annual absolute emissions growth to less than 10 percent, using 2013 as a baseline.

Shenzhen and Tianjin allow individual investors and entities that are not covered in the ETS, such as financial institutions, to participate in trading, resulting in higher trading frequency and potentially larger price fluctuations. In fact, Shenzhen’s carbon price has already fluctuated dramatically, ranging from RMB 28 to RMB 130 ($4.5-$20) over the past six months.

With a total emissions cap around 388 million tons (Mt), Guangdong is the largest ETS in China and second largest in the world in terms of emissions covered.1 Guangdong is the most transparent ETS pilot in disclosing not only the number of allowances allocated, but also those reserved for new entrants and government interventions to stabilize the market. This information is typically kept private in China’s other ETS pilots. Guangdong is also the only pilot requiring companies to buy a portion of their allowances through auction (3 percent of total in 2013, increasing to 10 percent by 2015), which will generate at least RMB 630 million ($101 million) a year to finance emission-reduction actions.

Shanghai expanded its ETS coverage to require six Shanghai-based airlines to submit emissions permits for their domestic commercial flights. Theoretically, Shanghai’s effort to regulate aviation emissions can be scaled up as a measure comparable to the EU’s attempt to include aviation in the EU ETS. Shanghai also stands out from the other pilots by recognizing companies’ energy saving efforts retrospectively. According to the Shanghai allocation rule, companies can be awarded extra carbon dioxide allowances for energy saving actions taken between 2006 and 2011.

Going Beyond Pilots

While two of the seven pilots haven’t started trading yet, local and national officials are already studying how to potentially go beyond pilot programs. Development and reform commissions from Beijing, Tianjin, Inner Mongolia, Hebei, Shanxi, and Shangdong recently signed a memorandum, agreeing to join hands to research cross-region emission trading. At the national level, the government has also commissioned research to explore what a national scheme would look like.

One of the practical obstacles for scaling up to a national ETS is that all of the pilots are using slightly different approaches. Given the diversity of existing pilots and local circumstances in China, an expanded or national ETS might be built on some common elements such as MRV, while allowing local authorities some flexibility on other building blocks.

The National Development and Reform Commission (NDRC) is already working to create some common ground. In November 2013, NDRC published the GHG accounting and reporting guidelines for 10 industries, while guidelines for 10 other industries are being developed. NDRC is also working to roll out a national system to register GHG emissions from key enterprises as soon as 2014. On the other hand, the differences in the pilots may be significant enough that the national government will not attempt to scale up by linking them, but rather, will design a uniform national system based on the lessons learned from the pilots.

The legal basis for emissions trading is another puzzle that needs to be solved. Beijing and Shenzhen have passed local legislation to support ETS, while others set up ETS through administrative orders. A solid legal foundation is needed at the national level to scale up ETS. NDRC is leading an effort to finalize development of a Climate Change Law which may provide the legal authorization needed.

For fear of market risks, all pilots are currently banned by the national government from developing derivative products such as futures. However, for ETS to be an effective mechanism for driving down emissions-reduction costs, the market needs to have reasonable liquidity to provide credible price signals and accommodate different compliance strategies.

The First Step of a Thousand-Mile Journey

While pilots are generally functioning as designed so far, it remains to be seen whether China’s ETS experiment is successful. This year could provide early indications: most ETS pilots will finish their first compliance period, where the whole cycle of activities like allowance allocation, permit trading, and allowance submission can be evaluated for the first time. Lessons learned from these pilots can help determine how ETS schemes will impact China’s emissions and appetite for coal—and may provide early indications of whether the country will approach a national carbon-trading scheme.

1. Guangdong is also cooperating with California on emissions trading by sharing emissions data and other information. California is also cooperating with Shenzhen on their ETS pilot.