The statement by President Xi Jinping in September 2020 that The People’s Republic of China (hereinafter, “China”) will “aim to have CO₂ emissions peak before 2030 and achieve carbon neutrality before 2060” sets out a clear vision and timeline for a profound transformation of the country’s socio-economic development. The pace of China’s emissions reductions over the coming decades will be an important factor in global efforts to limit global warming to 1.5°C. The power sector, responsible for nearly half of the country’s energy sector CO₂ emissions,1 is central to achieving China’s climate ambition. Policy makers need to set the incentives and market structures which ensure that power sector actors can capture the dynamic development and rapid cost reduction of low-carbon technologies, and improve the management of the existing fleet of fossil-based generation through retrofitting, repurposing and retirement.

Accelerating power sector decarbonisation in support of the carbon neutrality goal requires an effectively co-ordinated policy mix. This report responds to the Chinese government’s invitation to the IEA to co-operate on carbon emissions trading systems (ETS) and synergies across energy and climate policies. It explores the interactions and effects of China’s national ETS with its renewable energy policy in the electricity sector, namely renewable portfolio standards (RPS). The report demonstrates how the policy mix could be better co-ordinated and explores possible pathways that an enhanced ETS could lead the electricity sector toward an emissions trajectory that is in line with China’s carbon neutrality target.

China’s national ETS came into operation in 2021 and is the world’s largest ETS, covering annual power sector emissions of around 4.5 Gt CO₂. It currently employs an intensity-based design with free allocation. This means that allowances are allocated to covered entities for free according to actual production levels of coal- and gas-fired power plants (e.g. kWh of electricity generated) and predetermined emissions intensity benchmarks (e.g. in g CO₂/kWh) covering only coal- and gas-fired power plants. This is different from most ETS systems such as the EU ETS, which set a predetermined absolute cap on covered emissions. Four emissions intensity benchmarks are currently defined in China’s national ETS for coal- and gas-fired power plants, and are differentiated based on fuel, sub-technology and plant size.

Against this backdrop, this report analyses five policy scenarios for the electricity sector for 2020 to 2035, consistent with China’s 14th Five-Year Plan (2021-2025) and the Long-Range Objectives through the Year 2035 (China, State Council, 2021a). In order to test the impact of different ETS designs, assumptions regarding electricity demand growth, exogenous technology cost evolutions and the current RPS policy set-up are kept identical across all scenarios. Taking into account China’s ongoing electricity market reform, all scenarios assume economic dispatch from 2025 – an important element to effectively integrate the CO₂ price signal in operational, investment and consumption decisions.

The first two scenarios establish a counterfactual and examine current policy. The RPS Scenario establishes a hypothetical counterfactual scenario with the current RPS policy set-up, including a target on the share of non-hydro renewables which is assumed to increase to 25.9% in 2030 and 36.0% in 2035, but no emissions control or carbon pricing policy.2 This scenario provides a point of comparison for isolating and evaluating ETS effects. The RPS-ETS Scenario is a current policy scenario with the same RPS policy assumptions, and an intensity-based ETS with free allocation as currently implemented. The scenario assumes moderate tightening of allowance allocation benchmarks over time.

In addition, three Enhanced ETS (ETS+) Scenarios explore different ETS design enhancements after 2025, while keeping the same RPS policy assumptions as the RPS and RPS-ETS Scenario: ETS+Benchmark (BM) Scenario maintains the intensity-based free allocation but with significantly tighter benchmarks; ETS+Auction Scenario maintains intensity-based allocation with moderate benchmark tightening and introduces partial allowance auctioning; and ETS+Cap Scenario changes ETS design significantly through a transition from the intensity-based ETS to a cap-and-trade system. The three ETS+ Scenarios are designed to achieve an electricity sector emissions trajectory after 2025 that is better aligned with China’s stated goal of carbon neutrality before 2060. All ETS+ Scenarios use the same emissions trajectory of the IEA’s Announced Pledges Scenario (APS)3 as input, and demonstrate the impact of potential future ETS designs.

The table below summarises the key ETS design features and outcomes of each scenario, excluding the hypothetical counterfactual scenario:

Stronger decarbonisation than in the RPS-ETS Scenario would better align the electricity sector with China’s carbon neutrality goal. In order to support economy-wide carbon neutrality before 2060, China’s power sector would likely need to achieve net zero CO₂ emissions before 2055 (IEA, 2021a). Accelerating the transition of the electricity sector would not only further reduce CO₂ emissions from the biggest source in China but also maximise the sector’s role in decarbonising end-use sectors, as growing electrification with an increasingly decarbonised electricity sector would further reduce overall emissions. Avoiding new unabated coal capacities and a faster transition also increase the chances of reaching carbon neutrality in an orderly fashion and reduce the potential burden of emissions lock-in and stranded assets (IEA, 2021a).

ETS design changes can double the CO₂ reduction of the RPS-ETS Scenario and accelerate alignment with a carbon neutrality emissions trajectory. In the ETS+ Scenarios, electricity sector emissions are 38% lower by 2035 compared to 2020 – nearly double the reductions as in the RPS-ETS Scenario. Different ETS enhancements could drive these additional emissions reductions. If retaining the current design – an intensity-based ETS with free allocation – the benchmark tightening rate would need to be doubled in 2025-2030 and almost quadrupled in 2030-2035 (ETS+BM Scenario), compared to the RPS-ETS Scenario. This would reduce coal benchmarks to two-thirds of their 2020 levels by 2035. In the ETS+Auction Scenario, around a quarter of allowances would need to be auctioned by 2035 while maintaining the same tightening rate for coal benchmarks as in the RPS-ETS Scenario. A third option (ETS+Cap Scenario) is to introduce an absolute emissions cap that is aligned with a carbon neutrality pathway. 

All three Enhanced ETS Scenarios can achieve the same emissions trajectory for the electricity sector, but at different costs. Total system cost4 increases significantly over time across all scenarios due to increasing electricity demand: in the RPS-ETS Scenario, total system cost increases from 2.80 trillion yuan renminbi (CNY) (USD 434 billion) in 2020 to CNY 4.28 trillion (USD 664 billion) in 2035. With the same electricity demand growth assumption, the ETS+Cap Scenario leads to the lowest total system cost for the electricity sector across all Enhanced ETS Scenarios. In 2035, it has the same system cost as the RPS-ETS Scenario but with almost 20% additional CO₂ emissions reductions. This is followed by the ETS+Auction Scenario with slightly higher costs (CNY 4.34 trillion, USD 673 billion), and the ETS+BM Scenario which is 5% more costly than the RPS-ETS Scenario (CNY 4.49 trillion, USD 698 billion). In addition, auction revenues generated in the ETS+Auction Scenario could reach CNY 260 billion (USD 40 billion) in 2035, which can be used to address affordability or competitiveness concerns of electricity consumers, as well as to invest in technology innovation and energy efficiency to reduce future decarbonisation cost. 

The cap-and-trade system achieves this cost-effectiveness by prioritising the lowest-cost abatement opportunities, especially fuel switching. By allowing power sector actors to freely choose the cheapest abatement technology, the cap-and-trade system introduces technology neutrality which, in turn, drives fuel switching from unabated coal generation to renewables. In contrast, the ETS+BM Scenario results in a much more costly generation mix as it would primarily encourage a shift from unabated coal to coal power with CCUS, a less mature and more expensive abatement option. Introducing auctioning into the intensity-based ETS (ETS+Auction Scenario), raises the effective CO₂ cost that generators face and encourages both some fuel switching to renewables and intensity improvements in the coal fleet including through CCUS. Consequently, in the ETS+Cap Scenario, fuel switching to mature renewables can be encouraged already with a relatively low allowance price level of CNY 100/t CO₂ (USD 16/t CO₂) by 2035. In contrast, an intensity-based ETS (in both ETS+BM and ETS+Auction Scenarios) would lead to a higher allowance price of around CNY 300/t CO₂ (USD 47/t CO₂) by 2035 to achieve the same emissions trajectory. This is because the ETS design drives emissions reductions at least in part through CCUS deployment which requires higher financial support.

As China’s carbon neutrality target shifts the policy focus from improving emission intensities towards achieving absolute emissions reductions, policy makers could consider the following insights to accelerate the alignment of the electricity sector with a 2060 carbon neutrality target through an enhanced ETS:

• Carefully examine different ETS design options in line with the intended policy objectives, in particular with a view to the resulting costs, the carbon price and the technology mix. While different design approaches can achieve the same emissions trajectory, they could serve different policy priorities, such as supporting different technologies from renewables to CCUS. Consequently, they would also require different levels of co-ordination and companion policies (e.g. adjusting target level and RPS focus on less mature renewables, support for transport and storage infrastructure necessary for CCUS deployment).
• Communicate future plans on China’s ETS design well in advance, including the medium-term benchmark and/or cap trajectory (e.g. for the next 5-10 years), to provide visibility and planning certainty for market participants. This will guide plant management and investment decisions (including for technology innovation), and accelerate alignment with carbon peaking and carbon neutrality goals.
• Establish a policy co-ordination process involving all relevant government institutions that aims to analyse ex-ante the impact of different policy mixes to avoid unintended side-effects, and which regularly reviews policy outcomes. Consider introducing flexibility mechanisms such as allowance reserves or price corridors to help accommodate unexpected policy interactions and external shocks.
• Consider gradually introducing allowance auctioning in the current 14^th Five‑Year Plan (FYP) period (2021-2025) to incentivise more diversified and lower-cost emissions abatement options, encouraging renewables in addition to fossil-based generation improvement and CCUS deployment. This would also enable the use of auction revenues to address distributional impacts and competitiveness concerns, as well as to directly invest in climate actions such as low-carbon technology innovation and energy efficiency.
• Consider transitioning to a cap-and-trade system with a stringent cap later in the decade to position the ETS as a key instrument in China’s path to carbon neutrality, to reduce the number of additional policies targeting renewables, and to lower the cost for decarbonisation. The deployment of CCUS could still be incentivised through special provisions within an ETS, such as additional free allowances, or through companion policies dedicated to CCUS uptake.
• Swiftly implement announced plans to extend the ETS to other sectors, and consider opening market participation to non-compliance entities such as financial intermediaries. Sectoral extension would reduce costs by expanding possible options for emissions reductions, and establish a cross-sectoral carbon price signal to help achieve carbon neutrality. Opening participation would also increase the ETS’ liquidity and facilitate price discovery through a larger number of actors trading allowances.