Difficulties and Solutions of Emissions Trading in China
[Author] Shi Qinghao, associate professor of Shanghai Administration Institute
[Abstract] Emissions trading is a market-based instrument used to cope with environmental issues,
especially the market failure of externality. In implementing emissions trading, there are
difficulties in setting the cap, monitoring, information disclosure, punishment, etc. But these
difficulties can be overcome, and pilot programs may be carried out by local governments.
[Key Words] emissions trading, difficulties, solutions
Emissions trading is also called “cap and trade”, which is a market-based approach used to
control pollution by providing economic incentives for achieving reductions in the emissions of
pollutants. In the world, economists consistently have urged the use of “market-based” or
“economic-incentive” instruments to address environmental problems, rather than so-cal
“command-and-control” instruments.1 In the past, the “command and control” regulation was
mainly used in China to address environmental problems instead of “market-based” instruments.
Command and control regulation is criticized for being excessively rigid, insensitive to
geographical and technological differences, and inefficient. Since 2008, the local government of
Pudong Shanghai has prepared to implement emissions trading. Difficulties have been come
across by the local government of Pudong, and solutions must be found.
Introduction of Emissions Trading
Due to the theoretical contribution of Coase, Crocker, Dales, Montgomery etc, emissions
trading over the course of its history can be divided into several phases:
1. Externality
In 1920, the British economist Arthur Cecil Pigou published his work Welfare Economics. He
put forward a new concept “externality”------an activity of one entity that affects the welfare of
another entity in a way that is outside the market mechanism. For example, when a private firm
polluted the environment, the cost of pollution is paid by the whole society. Such a phenomenon is
regarded as one of the market failures-----the market mechanism fails to impose the environmental
cost on the polluter, which provides the reasons for government intervention. In order to
compensate the market failure, Pigou proposed a well-designed pollution tax.
2. Property Rights
In 1960, Ronald Harry Coase published his paper The Problem of Social Cost, in which
Coase developed Pigou’s viewpoint that the function of the government is not to take the place of
the market but to help the market to overcome its failures. In order to overcome the failure of
externality, the government should help the market to define the property rights, and if the
transaction cost is low enough, the market mechanism will restore its function.
1
Stavins, Robert N: "What Can We Learn from the Grand Policy Experiment? Lessons from SO2 Allowance
Trading", The Journal of Economic Perspectives.1998. 3, p69.
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3. Proof of Principle
In 1968, John H Dales published his work Land, Water, and Ownership. Dales put the
theoretical principles into practice. Beginning in the 1970s, the political process has gradually
become more receptive to market-oriented environmental tools. The Environmental Protection
Agency (EPA of U.S.A.) offered states the option of employing variants of tradeable permits for
the control of localized air pollutants. Tradeable-permit systems were used in the 1980s to phase
leaded gasoline out of the market and to phase out ozone-depleting chlorofluorocarbons (CFCs).
But by far the most ambitious application of these instruments has been for the control of acid rain
under Title IV of the Clean Air Act amendments of 1990, which established a sulfur dioxide (S02)
allowance trading program intended to cut nationwide emissions of S02 by 50 percent below 1980
levels by the year 2000.1
4. Prototype
In the 1990s, “cap-and-trade” became the prototype worldwide. Especially, in 1997, the
Kyoto Protocol was adopted, which came into force in 2005. According to the treaty, most
developed nations (“Annex I” countries) agreed to reduce the overall emissions of six major
greenhouse gases by 5.2% from their 1990 levels by the end of 2012, while the developing
countries (“non-Annex I” countries) are not subject to caps on emissions. Annex I countries may
also use International Emissions Trading (IET). Annex I countries that exceed their quotas can buy
quotas from countries that emit less than their quota. It is also possible for Annex I countries to
sponsor carbon projects that reduce greenhouse gas emissions in other countries. These projects
generate tradable carbon credits that can be used by Annex I countries in meeting their caps. The
project-based Kyoto Mechanisms are the Clean Development Mechanism (CDM) and Joint
Implementation (JI).
In the 1990s, China has started the research on emissions trading. Since 2001, trades were
tried in the cities such as Nantong, Taicang, Nanjing in Jiangsu province. In 2007, the first Climate
Exchange was established in Jiaxing, Zhejiang province. And In 2008, Climate Exchanges were
also established in Beijing, Tianjin, Shanghai. Under such a situation, “cap-and-trade” method was
going to be implemented since 2008 in Pudong Shanghai. The paper is based on the investigations
in Pudong.
The Necessity for Emissions Trading
Emissions trading is an important measure to protect the environment. There are several
reasons to implement emissions trading:
1. The “cap-and-trade” method can help the market to overcome the failure of externality.
Environmental capacity is an important productive factor, which is the welfare of the people. Now
since the property rights of environmental capacity are not defined, so the capacity of environment
has no prices, the public welfare is polluted at the will of the polluters. The producer can reduce
cost by polluting the environment to gain more profit; one the contrary, for an
environmental-friendly enterprise, it would increase its cost to protect the environment, and thus
profit is cut off. As a result, the market is expelling the environmental-friendly enterprise, while
1
Stavins, Robert N: "What Can We Learn from the Grand Policy Experiment? Lessons from SO2 Allowance
Trading", The Journal of Economic Perspectives.1998. 3, pp 69-70.
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encouraging the polluter. Such a phenomenon is called externality of the market. Under such a
situation, the enterprises can gain profit by polluting, so they don’t have the drive to innovate. So
it is necessary for the government to use its “visible hand” to help the “invisible hand” of the
market to overcome the market failure, and emissions trading is an instrument to cope with the
market failure of externality. By the mechanism of the “cap-and-trade”, enterprises are forced to
innovate, to adopt measures to reduce pollution, to turn from polluters into environmental-friendly
enterprises.
2. The property rights of environmental capacity are not defined, which increases the
opportunities for the government officials to make mistakes. The market is encouraging the
polluters while driving off environmental-friendly enterprises; but the government should protect
the environment. It means that the “visible hand” of the government and the “invisible hand” of
the market are fighting against each other. The “invisible hand” is so powerful that it is impossible
for the “visible hand” to win. So in the official circle, there happen the same stories: those officials
tolerating pollutions are promoted while those officials insisting on environmental protection are
driven off-----since GDP plays a very important role in officials’ record of achievements. So it is
necessary to use “two hands” to construct ecological civilization, and emissions trading is a
solution.
3. The property rights of environmental capacity are not defined, which causes the public
welfare vulnerable to violations. In public decision-makings, the people’s environmental rights are
not fully considered. These decisions would be strongly opposed by the masses in implementation,
such as the “the PX Issue in Xiamen”, “the Landfill Issue at Panyu Guangdong”, “the Issue of
Magnetic Suspension in Shanghai”. Even if the government attached importance to the
environmental rights of the relative interest groups, there isn’t a mechanism to evaluate and
compensate the loss of the relative interest groups; the more radical they are, the more they get, so
the masses are encouraged to act more radically. In order to build up a harmonic society, it is
necessary to establish the “cap-and-trade” mechanism, which will evaluate and compensate the
environmental loss in market-based way.
Difficulties and Solutions of Emissions Trading in China
Both the 12th Five-Year Plan1 of China and the report of the 18th Congress of the CPC2
make it clear that market-based instruments should be employed to cope with the environmental
issues. Emissions trading is one of the market-based instruments besides the extended producer’s
responsibility and the ecological compensation mechanism, etc.
Emissions trading is also called “Cap-and-trade”, which is used to address environmental
problems such as green-house effect, acid rain and eutrophication in waters. “Cap-and-trade”
method is composed of the following steps:
1. Cap
Usually by a political process, a government sets a limit (or a cap) on the total amount of a
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2
the 12th Five-Year Plan of China，http://news.qq.com/a/20101027/001797_2.htm。
the report of the 18th Congress of the CPC, Beijing China， the People’s Publishing House 2012, p41.
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pollutant that may be emitted, and the individual companies are free to choose how or if they will
reduce their emissions. The cap is usually lowered over time according to the national emissions
reduction target. Firms are required to hold a number of permits (or allowances or credits)
equivalent to their emissions. The total number of permits cannot exceed the cap, limiting total
emissions to that level.
2. Allocation of the cap
The limit (or cap) is allocated freely or sold to firms in the form of emissions permits, which
represent the right to emit a specific volume of the specified pollutant.
3. Measurement
In order to trade, precise measurement is requested. The traditional method of hand-sampling
can’t meet the request of “cap-and-trade”, on-line monitors are to be used to meet the demand.
4. Punishment
After a cap has been set, firms emitting more than its permits would be punished at
progressive rate by government, which increases the costs of production. Firms will choose the
least-cost way to comply with the pollution regulation, which will lead to emissions trade in the
market.
5. Trade:
Firms who require fewer permits can sell them in the market. Who will buy? Firms that need
to increase their volume of emissions would have to buy more permits; new firms should buy
enough permits; organizations which do not pollute and therefore have no obligations may also
participate in trading to purchase emission permits and hence drive up the price of the remaining
permits according to the law of demand; firms can also donate emission permits to a nonprofit
entity and then be eligible for a tax deduction; the government can also buy-back the extra permits
as reward to firms that emit less. In effect, the buyer is paying a charge for polluting, while the
seller is being rewarded for having reduced emissions, which forms a market mechanism
encouraging those who can reduce emissions most cheaply.
The above-mentioned steps compose an integrated chain of “cap-and-trade”. Difficulty or
barrier at any step would cause the whole trade unaccomplished. Since 2008, Shanghai is
preparing to implement emissions trading in Pudong. Investigation shows that there are difficulties
to be overcome:
1. How to define the cap
Theoretically speaking, the environmental capacity of an area is limited. There exists a valve
in the ecological system, which would be under pressure or even collapse when emissions of
pollutants exceed the valve. But in practice, how the cap is defined?
According to the reality in China, there several ways to define the cap:
(1) Pollution Source Census: From December 31, 2007 to February 9, 2010, China launched
the first Pollution Source Census at the cost of 4.1 billion RMB Yuan. Databases have been
established covering 4 levels: nation, province, city and county. Information can be retrieved
according to the category of industry, area, polluting factor etc. The Pollution Source Census
provided scientific base to set the cap.
(2) The National Five-Year Plan: Cap is to be set according to the National Five-Year Plans
in China. For example, the 11th Five-Year Plan set up an aim that the main pollutants should
reduced by 10% at end of 2010; the 12th Five-Year Plan set up an aim that the consumption of
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non-fossil energy will cover 11.4% of the total energy consumption, the energy consumption per
unit GDP is to be reduced by 16% while the CO2 emission per unit GDP is to be reduced by 17%,
the emission of the main pollutants is to be reduced by 8-10%.1
(3) Legislation of the People’s Congress: When the cap is set, it should not be changed. If it
were changed, the permits would lose scarcity, and trade becomes impossible. So it is necessary
for the People’s Congress to set the cap through legislative procedure, then the cap becomes law,
which can’t be changed easily. Without permits, no firms can be established, even if it is very
profitable; the only way to attract new investment is to close down backward productions to make
space for advanced productions. Up to now, the national People’s Congress and the local People’s
Congress still lack of such legislative activities on “cap-and-trade”.
2. The Ability of Monitoring
“Cap-and-trade” requests precise monitoring. In China, emissions are mainly monitored by
the government， whose ability of monitoring is far from “cap-and-trade” requests. For example,
in 2008, Pudong Shanghai covers an area of about 570km2, with over 6000 pollution sources;
while the Pudong Environmental Monitoring Station has a staff of less than 60. On average, a
person should have to monitor 100 polluting firms in an area about 10km2. Furthermore, according
to the regulation on monitoring, 2 staff members must be present at hand-sampling in order to
avoid corruption. It is impossible for so few staff to get precise data by hand-sampling. In reality,
what the Pudong Environmental Monitoring Station can do is to classify the polluting firms into
several classes: the seriously polluting firms may be monitored twice every month, the average
polluting ones may be monitored once a month, while the “good” ones are monitored once 2
months. So it is crystal clear that it is impossible for so few staff to get accurate data in such a
primitive hand-sampling method.
On-line monitoring is the solution, which can save monitoring staff and provide accurate data.
But another difficulty occurs----now the on-line digital data doesn’t have legal validity in China
mainly because there are so many different types of on-line monitors in China: some use the U.S.
system, some use the European system, some use the Japanese system, and some use the Chinese
system. The different system use different standards, different chemical agents and different
testing methods. Which system should be regarded as the standard in law-making on the legal
validity of on-line data? So before the on-line digital data have legal validity, it is necessary for
China to establish the technical standard for the various types of monitors. Now it is still not the
time to establish the same standard throughout China, but some local government can carry out
some pilot project.
3. Information Disclosure
Symmetry of information is a premise for trade. If information is not fully disclosed, people
are unwilling to trade. Now the environmental information disclosure in China still can’t meet the
demand of emissions trade. For example, from May1 2008, the Regulations on Government
Information Disclosure of the People’s Republic of China took effect. According to the
explanation of the Ministry of Environmental Protection, the government may disclose a firm’s
polluting information only under 2 situations: firstly, the government has punished a firm for
pollution; secondly, the firm itself is willing to disclose pollution information------it is clear that
1
the 12th Five-Year Plan of China，http://news.qq.com/a/20101027/001797_2.htm。
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most firms are not willing to disclose their pollution information. So such a regulation on
environmental information disclosure can’t meet the demand for emissions trading.
Why is the government hesitating to disclose environmental information? The most
important reason is that the government’s environmental data is undependable because of the
above-mentioned hand-sampling method. Information disclosure would cause law case against the
government, and the government has little confidence in its data. But such a situation will be
changed if on-line monitors are installed. So some local government may carry out pilot project to
install large amount of on-line monitors, and amend the regulations on information disclosure that
the government has the authority to disclose the over-all information of the polluter. Or the
government can entrust the third party (some monitoring institution) to monitor the emission of
the producer.
4. Punishment
Emissions trading requests the government imposing aggressive punishment on the polluters
so as to force the polluter to reduce emission or buy permits in the market. But the current
environmental punishment is too light. For example, according to the relative environmental law,
the highest punishment is only 1000,000 RMB Yuan, which is nothing to a large firm; and
according to latest law on water protection, the highest punishment is 500,000 RMB Yuan, but
such a punishment needs a lot of harsh conditions------too harsh to make the punishment possible.
So long as the cost of breaking the law is low, illegal behavior will thrive. The current
environmental laws are encouraging the producers to pollute. Such environmental laws cannot
meet the demand for emissions trading.
In order to implement emissions trading, the current environmental laws have to be amended,
especially more severe punishment are to be imposed on the polluters. Such amendments of law
may be tried by some local governments.
In implementation of emissions trading, there are difficulties in setting the cap, monitoring,
information disclosure, punishment, etc. These difficulties can be overcome, but some concern
various departments of the government and are beyond the power of the Environmental Protection
Department. For example, some difficulties are to be overcome by amending the current law,
which needs the joint efforts of the relative departments. China is a large country, different area
has different situation, so it is reasonable for pilot programs to be carried out by local governments,
such as Beijing, Shanghai, Tianjin and Guandong Province.
Shi Qinghao
shiqinghaopku@163.com
0086-18918989173
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