The success that China has in reducing greenhouse gas emissions will play a major role in how the rest of world fares when it comes to limiting climate change as outlined in the 2015 Paris Agreement. China has stated that it would like its carbon dioxide emissions to peak by 2030 and reach carbon neutrality by 2060. To help it get there, China brought in an emissions trading system (ETS) in July 2021.
It also asked the Paris-based International Energy Agency (IEA) to co-operate on carbon emissions trading systems. In response to that invitation, the IEA produced a report that examines how introducing auctioning — selling emissions allowances to the highest bidder — to China’s ETS could make it more effective and accelerate progress.
While providing insights specific to China, it also speaks to other jurisdictions exploring the option.
Organizations
The executive summary for “Enhancing China’s ETS for Carbon Neutrality: Introducing Auctioning,” is republished below under a Creative Commons license.
Readers can also download the full report, originally published in May 2024.
Executive summary
In September 2020, President Xi Jinping announced that China will “aim to have CO2 emissions peak before 2030 and achieve carbon neutrality before 2060” (the “dual carbon” goals). In so doing, China set a clear vision for a profound transformation as well as a framework for sustainable socio-economic development. The pace of China’s emissions reductions over the coming decades will be an important factor in global common efforts to limit global warming in line with the Paris Agreement, as the country accounts for one-third of the world’s annual CO2 emissions from the energy sector.
China’s national emissions trading system (ETS) – which came into operation in July 2021 – is an important policy instrument for achieving the country’s “dual carbon” goals. The system covers around 4.5 Gt CO2 of annual power sector emissions – about 40% of China’s energy sector CO2 emissions1 in 2020 – which makes it the world’s largest ETS in terms of covered emissions. Coverage is expected to expand further in the coming years to include energy-intensive industrial sectors, which are responsible for another 30% of China’s energy sector CO2 emissions. Strengthening the national emissions trading system can send a robust price signal for decarbonisation, drive cost-effective emissions reductions and guide low-carbon investments – all of which can help to accelerate the clean energy transition and China’s progress towards its climate ambitions.
While China’s national ETS currently allocates all allowances for free, it has indicated its intention to explore the introduction of auctioning of emission allowances (China, MEE, 2021a; China, State Council General Office, 2021). In response to the Chinese government’s invitation to the IEA to co-operate on carbon emissions trading systems, this report analyses international experiences in implementing allowance auctioning, with a focus on policy aims and outcomes, key design and implementation elements, and the use of auction revenues. The report aims to inform policy makers in China and other jurisdictions where allowance auctioning is being considered in the design or development of emissions trading systems. It includes a series of policy insights tailored to China’s national circumstances to inform the domestic policy process.
Key lessons from international experience
In jurisdictions that have adopted emissions trading systems, the use of allowance auctioning has gradually replaced or complemented free allowances over time.
This has been motivated by the many advantages of allowance auctioning, primarily:
- enhancing environmental effectiveness of an ETS by changing how emitters perceive carbon costs and strengthening incentives for cost-effective emissions reductions
- creating an additional revenue stream that can be used to invest in clean energy deployment and innovation as well as energy efficiency, and which can be redistributed to companies and/or citizens to address social and competitiveness concerns
- addressing windfall profits, a problem that can arise with free allocation
- increasing liquidity and transparency of the carbon market, which strengthens price discovery, reduces non-compliance risks and facilitates the implementation of price and supply adjustment measures
- preparing domestic industry for potential other international climate policies by strengthening domestic climate policy and supporting cost-effective decarbonisation.
As jurisdictions introduce allowance auctioning, they generally face three main areas of concern: carbon leakage, adverse economic and social consequences linked to cost increases for emitters, and challenges related to lack of cost passthrough in regulated markets. The key instruments used to address such concerns include the recycling of auction revenues (for clearly earmarked purposes), the targeted use of free allowances, and more recently, border carbon adjustment measures on imports. Consignment auctions (described in detail below) could be another way to combine certain advantages of conventional auctioning and partially address the concerns above, since any auction proceeds would eventually be returned to covered entities.
More mature ETS systems have converged towards adopting auctioning as the default allocation method for emission allowances. However, free allowances are often still granted in a limited number of sectors after an assessment of the underlying economics, the exposure to carbon leakage risks, the effects on competitiveness and the capacity for covered entities to pass on their carbon costs. These assessments are typically conducted using standardised and quantitative criteria and focus on two dimensions: emissions intensity and trade exposure. The appraisal results also provide a basis for determining the pace of introducing auctioning as well as the balance of auctions versus free allocations in different sectors. While details vary by jurisdiction, the process often includes a more rapid introduction and higher share of auctioning in sectors that face little or no leakage risk and can pass on their carbon costs (e.g. the electric power sector and fuel suppliers). This is followed by a progressive phase-in of auctions for sectors facing moderate leakage risks, and a slower introduction for highly emissions-intensive and trade-exposed (EITE) sectors. Even for sectors eligible for free allowances, some jurisdictions have found alternative ways to phase down free allowances to incentivise more efficient production and investments in decarbonisation. Such methods include introducing increasingly stringent benchmarks for the allocation of free allowances as well as other reduction or correction factors.
Auction revenues have increased in importance and are seen as a major benefit of this approach. The jurisdictions analysed have increasingly converged on solutions that deploy auction proceeds through dedicated funds that earmark spending for specific purposes. These investments can finance additional
investments in greenhouse gas mitigation, help address competitiveness concerns or lower the long-term costs of decarbonisation through enhanced innovation. They can also be used to reduce the impact of carbon costs on vulnerable citizens, or to support economic development programmes in regions affected by industrial transitions. Appropriate and transparent governance arrangements for the use of auction revenues are widely seen as essential for achieving the intended objectives, strengthening public acceptance, and minimising administrative costs. Such arrangements often involve crossministerial collaboration between the ETS regulator and the finance ministry. In addition, governance frameworks for auction revenues may need to evolve over time as the emissions trading system matures and as priorities shift for the use of revenues.
Policy insights for China
Adopting partial allowance auctioning in China’s emissions trading system could strengthen its environmental and cost-effectiveness, and its role in supporting the achievement of China’s “dual carbon” goals. A gradual introduction of auctioning, with a share of around 25% for the power sector by 2035, could potentially double emissions reductions in the sector (reducing CO2 emissions by an additional 840 Mt in 2035) compared to an entirely free allocation system. This approach – which would have a limited impact on total system costs – could create a new annual revenue stream of about USD 39 billion (CNY 260 billion) (IEA, 2022a). Auctioning can also improve the functioning of China’s carbon market and help address certain challenges experienced in the first compliance period by increasing market liquidity, strengthening carbon price discovery, and enabling the implementation of price and supply adjustment measures. The main issues to tackle in introducing auctioning relate to the structure of the power market, competitiveness and leakage risks, as well as potential social impacts and governance complexities. Considering the benefits and challenges related to introducing auctioning of emission allowances in China, the following insights could help guide policy decisions going forward:
- Rapid but limited introduction of auctioning. Introduce, as soon as possible, a small share of allowance auctioning (e.g. 5% to 10%) for electricity production. Increase the share gradually, in line with power market reforms, to account for the increased ability of power entities to pass their carbon costs through to customers. Emissions trading in the power sector could adopt either conventional auctioning or employ consignment auctions as a transitional method, whereby revenues are returned to covered entities. This could help facilitate political acceptance and reduce the need for cross-ministerial coordination for revenue governance.
- Establish quantitative EITE criteria in tandem with the extension of emissions trading to industry, to determine the sectoral coverage of allowance auctioning. These criteria would also help ensure that decisions on how fast to introduce auctions for industry are made within a predictable and transparent framework.
- Use leakage risk assessments for EITE sectors to determine industry auctioning share. Consider starting with a moderate share of auctioning for emissions-intensive and trade-exposed industries, including through consignment auctions, to ensure sufficient decarbonisation incentives for industry while maintaining competitiveness in an evolving international context.
- Implement price or supply adjustment measures alongside the introduction of allowance auctions. Auctioning provides an opportunity to introduce an auction reserve price or cost containment mechanisms to help stabilise the allowance price signal and provide greater visibility for investment decisions.
- Establish a dedicated auction revenue fund with cross-ministerial participation led by the Ministry of Ecology and Environment (MEE) and the Ministry of Finance (MOF) to ensure harmonised, fair, transparent and effective use of revenues. If a consignment auction method is adopted, establish clear rules in advance on how covered entities can use the revenue and be sure to enforce this through monitoring and reporting.
- Earmark auction revenues for the support of climate mitigation investments as well as social and economic development in provinces that are most affected by carbon costs. This includes financing clean energy deployment, research and development (R&D), energy efficiency in covered sectors as well as support for workers, industrial and economic diversification and for communities in fossil-fuel dependent provinces. Depending on China’s progress towards power market reform and the deregulation of its electricity markets, direct support to electricity intensive industries and/or households might become necessary.
Citation: Enhancing China’s ETS for Carbon Neutrality: Introducing Auctioning, IEA, Paris https://www.iea.org/reports/enhancing-chinas-ets-for-carbon-neutrality-introducing-auctioning, Licence: CC BY 4.0
