With China poised to launch the world's largest carbon market this summer, researchers say the emissions trading program's use of carbon intensity standards—rather than emissions limits—could incentivize some of the country's least economic coal plants to boost their power production.

In a report released last month, researchers with Resources for the Future (RFF), a Washington, D.C.-based energy and environmental think tank, also found that the Chinese carbon program will initially cost the country's economy and power sector 47 percent more in terms of cleanup costs than would a traditional emissions cap-and-trade mechanism used in Europe and other parts of the world.

However, the program—which generally sets carbon intensity standards for smaller, less efficient plants that are less stringent than those for bigger, more modern plants—is designed to keep electricity prices down and the economy growing, also priorities for the country's leaders.

Moreover, the market's use of allowances based on carbon intensity tracks China's formal commitments under the Paris climate agreement, which do not call for near-term emissions cuts but rather commit the country to peaking its emissions by 2030 by reducing economy-wide carbon intensity.

While China is the world's largest emitter, the country said that goal was appropriate because developed nations contributed most of the greenhouse gas already in the atmosphere and China needs to keep growing its economy to lift millions of its citizens still mired in poverty.

China's national carbon market will initially cover some 2,000 coal-burning plants when it begins to operate in the third quarter of this year. Together those plants account for nearly 40 percent of the country's greenhouse gas emissions.

Under the program, the government will set differing carbon intensity standards for coal plants based on their size and technology. In general, the tradable performance standards will be less stringent for smaller and less efficient plants than larger, more modern plants.

Thus, smaller, less efficient plants may find it easier to make performance improvements that enable them to get below their carbon intensity standards. That, in turn, will create surplus allowances that they can sell to other plants—incentivizing them to run more.

Such implicit subsidies can induce uneconomic coal plants to stay in business and even increase their output, said Richard Morgenstern, a senior fellow with RFF and a co-author of the recent report, China's Unconventional Nationwide CO2 Emissions Trading System: The Wide-Ranging Impacts of an Implicit Output Subsidy.

"In our modeling, one of the points we make is that with some inefficient plants, you wouldn't expect to see expanding output at a time when you're trying to reduce emissions—they nonetheless do that because the incentives are there," he said.

Even so, China's national carbon market should bring substantial environmental benefits that will ultimately outweigh costs by a factor of three, Morgenstern and his colleagues found. For their calculation, they used the "social cost of carbon" that a working group established under President Obama set at $44 per ton and which has since become a widely accepted metric.

"If you value the tons that way, benefits will exceed the cost of the program," he said. "It's like trying to get from point A to point B and not taking the shorter way; you still get there. It wasn't the cheapest way to get there, but they get there."

The first phase of the national market focusing on coal plants is expected to cover about 4 million tons of carbon dioxide equivalent, more than twice the allocation of the European Union Emissions Trading System.

Lauri Myllyvirta, a lead analyst with the Centre for Research on Energy and Clean Air based in Finland, echoed the RFF findings in a recent blog post. He said the design of the Chinese carbon market could allow a small and inefficient "subcritical" power plant to make money by over-performing relative to the carbon-intensity benchmark set for smaller facilities. In contrast, a large "ultra-supercritical plant that underperforms relative to its benchmark loses money, even though it is far more efficient," he said.

He suggested that problem could be solved by setting the benchmark for small plants high enough to prevent those heavily polluting facilities from easily meeting their goals.

"This would help push older plants out and clear some of the excess capacity that currently plagues the sector," Myllyvirta wrote. "However, it has proven politically difficult to force coal plant retirements, with far fewer plants having been retired this decade than expected."

China also has as much as 121.3 gigawatts of new coal capacity under construction, according to the San Francisco-based Global Energy Monitor, an expansion that could make it difficult for the country to meet its Paris goals even though many of its coal plants are not running at full capacity.

Reprinted from The Energy Daily. For more comprehensive daily coverage of US energy policy, regulatory, and business trends from IHS Markit, visit The Energy Daily website.

Karin Rives is a senior journalist at IHS Markit.

Posted 10 February 2020.

This article was published by S&P Global Commodity Insights and not by S&P Global Ratings, which is a separately managed division of S&P Global.