Two years of transactions in China‘s national ETS

article second anniversary and banking rules

China's national ETS - Monthly volume and average price (2023)

July 2023 marked the second anniversary of the start of trading in China’s national ETS, whose allowance units (China Emission Allowance or CEA) have increased in value since then. Particularly in the last two months, both liquidity and CEA prices have grown more significantly. Until mid-July 2023, a total of nearly 

 of CEAs had changed hands at the Shanghai Environment and Energy Exchange (SEEE). After fluctuating between RMB 40-58/t (EUR 5.1- 7.5/t) during the first compliance period (compliance deadline on 31 December 2021), closing prices had stalled within a small range of RMB 55-60/t (EUR 7- 7.6/t) during 2022 amid low liquidity.

Since the second half of July, however, CEAs began to break the RMB 60/t benchmark: they reached RMB 75/t (EUR 9.5/t) by the end of August. This bullish trend in the national market can be attributed to two main drivers: clarification of banking and borrowing rules by the Ministry of Ecology and Environment (MEE), and the upcoming compliance deadlines.

Clarification of banking and borrowing rules

, rules on how covered entities may borrow allowances are laid out in Article 7.2.3 of the 

. To allow emitters some flexibility in compliance, they enable companies with a quota shortfall of 10 % to use for compliance in 2022 some of the allowances for 2023, provided that the total pre-allocated volume does not exceed 50 % of their shortfall. In other words, companies may borrow from their future year’s allowance allocation to help satisfy their current year’s compliance requirement – but only to help, so only up to half of the shortage may be filled by borrowing. The rationale for this was to relieve financial pressure for Chinese power generators who were complaining that buying emission allowances was adding to their cost of doing business, which was already higher due to rises in fuel costs. This ability to 

 from future years, however, did not incentivize transactions - most covered entities rather “hoarded” the allowances they already had for the current compliance period. The ability to 

 allowances into future compliance periods created more of an incentive to trade, as companies then know that their unused permits from the previous compliance cycle can be carried forward.

, the MEE issued a notice regarding the 2021-2022 annual emission allowances in the national carbon market, whose Article IV.4 briefly mentions that the 2019-2020 and 2021-2022 units can be used for both compliance and trading purposes during the second compliance cycle. This makes sense given that the first compliance period only lasted six months (from July through December 2021), and that allowances distributed during that short period were calculated based on electricity generation and heat production in both years of 2019 and 2020, leading to a large surplus of units still being available in the national market. Since those units belong to covered entities, their expiration (not allowing them to be carried forward) creates a financial burden from the companies’ perspective in the form of stranded assets. Market players were not willing to buy or sell units that did not have value going forward.

Indeed, market liquidity increased noticeably after the release of new banking rules: July’s total transaction volume was 31 % higher than that of June. CEA prices, which sat within a tiny range of RMB 58-60/t during the previous months, went up after July to reach an all-time high of nearly RMB 75/t on 23 August 2023.

Although it was more “generous” with banking, the notice placed some specific restrictions on the already-allowed borrowing rules: firms may not borrow emissions units allocated to facilities that have closed or been eliminated, nor may units be allocated to firms facing litigation or debt.

As China’s national market is still young and covers only one sector (power sector), transactions are still largely compliance-driven. Thus much of the increase in liquidity is simply due to the fact that the compliance deadline of 31 December is approaching. As per Article III.1 of 

, provincial ecological and environmental departments must ensure the completion of compliance tasks by 95% of their local key emission units before 15 November 2023. With that de facto compliance deadline only around two months away, it is no wonder that trading activity in the national market has become livelier.

Given that compliance deadlines were a primary liquidity driver last year, when there was a clear “late rush pattern” featuring the largest monthly volumes in December (see charts above) ahead of the deadline, we expect traded volumes to continue increasing in the coming months.

In the longer term, we expect firms’ new ability to bank allowances into the future to be a major liquidity driver, as there is no longer an incentive to hoard allowances. In the much longer term, however, allowing banking of course 

 in subsequent compliance cycles. Oversupply makes for lower CEA prices. The MEE’s notice on 

 does not touch upon whether these banked permits will also be eligible for the next compliance cycles. Similar to the 2019-2020 allocation plan, the 2021-2022 plan specifies pre-allocation of allowances. The official total number of final distributed allowances will only be decided based on actual electricity generation and heat production, multiplied by the already-determined benchmarks and correction factors. This calculation will be done by the local ecology and environment departments after the end of the second compliance cycle. The final amount of allowances in the market thus remains unclear until the beginning of 2024 at the earliest, as all the data from individual provinces and municipalities will not come in until then. Before that, it would not make sense for the MEE to decide whether the 2019-2020 units can also be used in the next compliance cycle.

However,the SEEE recently issued a notice that constitutes a clear policy signal that Chinese regulators are concerned about (and beginning to tackle) oversupply. The notice, issued on 

 and in force as of 28 August, introduced vintages for traded CEAs. The three vintages include CEA 19-20, CEA 21 and CEA 22. The weighted average of the three vintages’ prices will constitute the CEA closing price. In a potential next step in this direction, regulators might put expiration dates on unused units.

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July 2023 marks the second anniversary of the start of trading in the national ETS. Since then, both liquidity and prices of China Emission Allowance (CEA) have increased significantly. We explain two recent drivers of the trend toward higher prices and more trading: the regulatory updates regarding banking and borrowing rules released on 17 July 2023, as well as the impending compliance deadlines for the national ETS. While the bullish trend will likely continue in the short term, the effective implementation of borrowing and banking rules will play a role in keeping up liquidity in the longer term. 