China’s Emissions Trading Scheme

2020 is proving a watershed year for the development of China’s energy system. The vital work of setting targets and priorities for the 14th Five-Year Plan (2021-25) would have been challenging enough, without the myriad impacts from the emergence of Covid-19. However, it is clear this has become an even more important moment for China’s policy makers to embrace the expanded use of market mechanisms.

Calibrating and effectively co-ordinating the introduction of a nationwide emissions trading scheme (ETS) could prove to be a key factor in aiding China’s recovery from the economic effects of coronavirus, while at the same time accelerating a clean energy revolution. In our ever more interconnected and interdependent world, the success of China’s ETS has implications for us all.

China started the implementation phase of the national ETS in 2017 to limit and reduce CO₂ emissions in a cost-effective manner. The ETS could become a major climate policy tool to help China realise its Nationally Determined Contribution (NDC) to the Paris Agreement on climate change and its long-term low-carbon strategy. The first compliance period is expected to start in 2020.

The national ETS will initially cover coal- and gas-fired power plants. Allowances to emit CO₂ (also known as permits) will be allocated based on each plant’s generation output, with specific benchmarks for fuel and technology.

Coal-fired power plants account for almost half of China’s CO₂ emissions from fossil-fuel combustion. Reducing emissions from coal-fired power plants will therefore be essential to reach China’s low-carbon goals, and these plants will be the key sources covered by the ETS.

This report investigates the potential implications of the proposed ETS design for China’s coal-fired power fleet. It is part of an ongoing project examining how the national ETS can contribute to China’s clean energy transition. Supported by the IEA Clean Energy Transitions Programme, it will be followed by an in-depth analysis of the ETS, including effects on gas-fired power plants and the entire power sector to 2035.

The ETS will co-exist with current policies that directly affect coal-fired power plants in China. This reports begins by clarifying the institutions and policies regulating coal-fired plants, and by analysing coal-fired plant development trends. It then assesses the effect of the ETS design on coal-fired plants by sub-technology at national, provincial and company levels, and identifies key findings and recommendations.

China’s coal-fired power sector has experienced remarkable growth over the past 18 years, guaranteeing energy security and affordability while keeping pace with growth in demand for power and heat. The key challenges now are reducing overcapacity and the environmental footprint of coal power.

Installed coal power capacity has quadrupled since 2000 from 222 gigawatts (GW) to 1 007 GW in 2018, mainly driven by the deployment of larger and more efficient supercritical and ultra-supercritical plants since 2005. As a result, average coal plant efficiency improved from 30% in 2000 to 39% in 2018, making China’s coal fleet one of the world’s most efficient.

China also has the largest and one of the youngest coal power fleet. Nevertheless, subcritical plants still account for a large part of China’s coal power capacity, of its power and heat generation, and of its CO₂ emissions. CO₂ intensity improvements have been slowing down in recent years and large amounts of CO₂ emissions may be locked in for decades.

CO₂ emissions from coal-fired power plants reached 4.6 gigatonnes (Gt) in 2018, surpassing the emissions from fossil-fuel combustion of the European Union and Japan combined. Ten of China’s provinces account for two-thirds of the country’s CO₂ emissions from coal-fired power plants and the “big five state-owned power companies by capacity (CHN Energy, Huaneng, Huadian, Datang and State Power Investment Corporation) account for 50%.

Managing the existing coal-fired power fleet to reduce emissions will be key to China’s clean energy transition. Emissions could be reduced by managing plants better; retrofitting plants, including with carbon capture, utilisation and storage (CCUS); and retiring inefficient plants before the end of their expected lifetimes. Any newly built coal capacity will make a successful clean energy transition harder to achieve.

China is still planning to build new coal capacity for various reasons such as to provide jobs, increase local economic growth, provide flexibilty for greater integration of renewables, as well as satisfy heat demand while improving the efficiency of its existing fleet of combined heat and power (CHP) plants. One option to manage emissions reductions is to match each new coal capacity addition with a retirement plan for old and less efficient units, to keep a balance of zero net coal capacity additions.

Retirement of coal-fired power plants in China will have to move beyond small plants and increasingly focus on large, as well as aging, CHP plants. Repurposing existing efficient supercritical and ultra-supercritical electricity-only units to CHP could be an alternative way to avoid the construction of new CHP units.

Regulation and market-based measures could be mutually supportive ways to reduce CO₂ emissions significantly in the medium to long term. China’s national ETS, and particularly its monitoring rules, should dramatically improve the availability and quality of emissions data, which in turn can improve plant operation and emissions management overall. Based on experience elsewhere, covered companies will also build up carbon management capacity and integrate a carbon cost for their medium- to long-term decision making.

The chosen allowance allocation, output-based and relying on benchmarks, will create incentives to increase the efficiency of existing coal-fired power plants. In the short term, the ETS creates an incentive for high-emission coal plants to improve their CO₂ emission factor, for example by investing to improve efficiency or by burning higher-quality coal. It could also encourage companies to shift generation from less efficient to more efficient plants within their portfolio. In the longer term, the ETS will motivate companies to shift investments from subcritical (or even less efficient) plants to supercritical and ultra-supercritical plants. In addition, the ETS would favour the phase-out of smaller and less-efficient circulating fluidised bed (CFB), high pressure and subcritical coal plants.

The CO₂ fuel factor (the amount of CO₂ emitted per unit of fuel) that is used for monitoring emissions from coal will be decisive for the stringency of the entire ETS given the dominance of coal-fired power plants. A high default factor is applied to plants that do not monitor their CO₂ fuel factor, which is a good incentive to improve monitoring. However, the more units are monitored, the higher the surplus of emissions allowances will be, as monitored fuel factors will be well below the default value.

Among the benchmark options currently considered by Chinese regulators, a single benchmark for conventional coal (Option 1) would result in a more stringent ETS than two benchmarks differentiated by plant size (Option 2) 1. Moreover, two benchmarks may produce counterproductive outcomes by encouraging generation from less efficient plants covered by a weaker benchmark, rather than from more efficient ones covered by a more stringent benchmark.

The benchmark values are the most lenient for larger conventional coal-fired power plants, no matter the option or whether fuel factors are monitored. This results in an overall allowance surplus.

Distributional questions on a provincial level arise as units in some provinces generate large allowance surpluses, while others generate large deficits.This is especially true for three of the “big five” state-owned power companies that will generate monetised allowance surplus of CNY 1.75 billion (Yuan renminbi), while all other companies combined would face a carbon cost of CNY 1.5 billion in the Balanced Case, in which only a share of coal power units monitor their CO₂ fuel factor.

Policymakers should pay close attention to the large extremes of allowance surplus and deficits on a provincial and company level, especially for the ten provinces and five state-owned power companies with the largest coal-fired power capacity.

The ETS needs to be designed so that it can be adjusted and adapted to policies that affect its functioning. For example, any rapid changes in the capacity mix – such as a plan to retire large amounts of coal-fired power capacity over a short period (e.g. by the end of 2021) – will increase the allowance surplus dramatically if this possibility is not taken into account in the benchmark setting.

The effectiveness of the ETS will be closely related to progress with power market reform, in particular for power dispatch. Dispatch is currently governed by the “three equals system” that allocates each plant a defined full load hours by technology. Without a reform of dispatch, the ETS will have a limited role in reducing power sector emissions, because coal-powered units will not be able to adjust their operation in response to the price signal stemming from the ETS allowance allocation.

A clean energy transition of the power sector will also require policies that support low-carbon energy generation. Since the current ETS covers only coal- and gas-fired power plants, it will have limited influence on reducing the share of coal power in the total generation mix. Entities can receive surplus allowances for their supercritical and ultra-supercritical plants, but currently receive no surplus by investing in low-carbon power technologies such as renewables. This situation may even have the perverse outcome of making the most efficient coal power plant more economically competitive than renewables.

Improving the current benchmarks

The benchmarks for coal-fired power plant CO₂ emissions should be enhanced to better reflect the expected policy ambitions regarding the existing coal plant fleet and to avoid significant overallocation of allowances, which would jeopardise the functioning of the ETS.

The high default CO₂ fuel factor, which is 20% higher than the worse type of coal in term of CO₂ emissions, is a good incentive for power entities to monitor their CO₂ fuel factors. However, it should not increase the value of the benchmark, which would result in an oversupply of allowances.

Implementing fewer benchmarks for different coal sub-technologies would result in higher effectiveness and greater equity with regard to the allowance allocation and reduction of CO₂ emissions. Multiple benchmarks are usually used to address distributional effects of allowance allocation between technologies. However, equity issues could be resolved by other means (e.g. financial support). Avoiding the use of multiple benchmarks would support power sector reform, since it would encourage reducing the use of less efficient plants and increasing operation of more efficient ones.

Options for ETS design

Introducing allowance auctions could create a new revenue stream that could be used to address equity issues between provinces and between entities. Before a full auction system is in place, earmarking funds generated from allowance surpluses for low-carbon investments can also help finance China’s clean energy transition in various ways, including research and development (R&D), innovation, and labour force retraining and redeployment.

The ETS could be a central pillar of China’s power sector transformation if designed differently. Merging coal and gas benchmarks, including with CCUS, and expanding the ETS to cover low-carbon energy sources, such as wind and solar photovoltaic (PV), could greatly reduce power sector CO₂ emissions, and could support or even substitute policies such as coal consumption targets or feed-in-tariffs for renewables.

Using the current rate-based allowance allocation system when expanding the ETS to manufacturing sectors would increase complexity and therefore be more challenging. A system with an absolute cap and a mass-based allocation design could be considered as an alternative.

The 13th Five-Year Plan (2016-20) set average coal consumption targets of 310 grams of standard coal equivalent per kilowatt hour (gsce/kWh) for operating coal power plants and 300 gsce/kWh for newly built plants by 2020. These targets can also be translated into emissions intensity levels, which would act in parallel with the ETS allocation benchmarks. Achieving the energy conservation targets would result in an average CO₂ intensity for operating coal-fired power plants far below the benchmark levels for both allowance allocation options, thus increasing allowance surplus. Aligning the ETS benchmarks with the more stringent energy conservation targets would avoid this counterproductive effect. With the benchmarks aligned with coal consumption targets, the ETS could be a market-based means of achieving the binding Five-Year Plan targets.

Better plant management, retrofitting and retirement of less efficient plants will also be needed to achieve a clean energy transition. Complementary regulations and measures, such as ministry, industry or local government plans for retiring coal plants, will be required to avoid the potential lock-in of CO₂ emissions. However, these will always need to be taken into account in the ETS design.

The ETS and power market reform could – and should – be mutually supportive. Dispatch reform could enable and amplify the expected operation and investment impacts of the ETS, while ETS allocation design and any future use of auction revenues can support power market reform. These measures can accompany decreasing coal plant use by allowing plants to operate more flexibly and provide ancilliary services.

More co-ordination between the ETS and policies regulating the energy sector could be mutually supportive to achieve the most efficient and effective emissions reductions and distributional outcomes.

The 14th Five-Year Plan (2021-25) provides a great opportunity to guide coal power development in line with China’s concept of ecological civilisation. Measures to be considered include more stringent energy consumption targets for the coal fleet in operation and for newly built units; large-scale retirement of old and less efficient high pressure and subcritical plants; defining goals and targets for the national ETS with more ambitious benchmarks; and accomplishing the power market reform. For example, a zero net coal capacity addition target by 2025, coupled with an inspirational long-term coal capacity vision for 2050, could provide a clear and stable signal to guide investment and operation decisions.