The secondary level rules, guidance, supplementary measures, orders or notices that should follow once the Interim Regulations are approved by the PRC State Council include:

1. the sectoral coverage of the Chinese ETS, which of the seven greenhouses gases (GHGs)¹  will be covered by the Chinese ETS and the compliance entities within the scope of the Chinese ETS (Key Emission Entities);
2. the criteria for determining Key Emission Entities and a list of such entities;
3. the allocation methodology for emission allowances (‘CEAs) under the Chinese ETS;
4. the monitoring, reporting and verification methodology for the Chinese ETS;
5. publication of the list of approved verifiers and the verification manual;
6. eligibility requirements for carbon emission reductions (Offsets);
7. qualification criteria for entities other than Key Emission Entities to participate in the Chinese ETS; and
8. publication of the national exchange for the Chinese ETS, the national carbon registry² for the Chinese ETS, and specific rules in respect of trading, registration, market abuse and other risk management tools, such as price fluctuation restrictions.

As the list above suggests, the information that should follow from the publication of the above items will be needed to truly operationalise the Chinese ETS. Although there is speculation surrounding many of the above items, apart from an expectation that the Chinese ETS will lunch with the power sector and CO2 as its initial scope of coverage, very little is otherwise officially confirmed at this stage regarding the Chinese ETS. The timing of its launch is also unclear, although similar speculation suggests that it may happen at some point in 2020.

The NDRC, when it preceded the MEE, had suggested that the first year of the Chinese ETS will be a trial/mock-trading year with no entities other than Key Emission Entities participating. However, as in the past, only once the Interim Regulations are approved by the State Council and the MEE publishes the secondary materials will a clear picture emerge of the shape, scope and trading environment supporting the Chinese ETS.

We expect that the MEE has avoided controversy in the Interim Regulations with a view to easing the path for its smoother adoption by the State Council. This explains the lack of detail, at this point in time, on many aspects of the Chinese ETS. 

Positives to note from the Interim Regulations

Within the bare bones of the Interim Regulations, a number of points are worth noting:

• A coordination mechanism will be established to support the resolution of and research into issues related to carbon emissions trading. It is hoped that this mechanism may have the authority to consider issues such as carbon leakage, the indirect impact of other PRC environmental policies on the Chinese ETS, etc.
• The MEE will operate the national carbon registry.
• Verifiers approved by the MEE will be paid for their services to Key Emission Entities out of the central government budget. This will reduce the cost of compliance on compliance entities.
• The Interim Regulations recognise CEAs and, presumably, Offsets as an asset and they treat the national carbon registry as a record of ownership of such asset. This is consistent with the PRC requirement for property rights, specifically rights (wu quan, in Chinese, “物权”) under PRC law that are akin to a right in rem under English law. 
• Security interests may also be created in CEAs and Offsets.
• Key Emission Entities will be permitted to sell or bank surplus CEAs.
• Eligible Offsets will be permitted to be used towards compliance (which we assume will be subject to a quantitative limit).
• Entities other than Key Emission Entities (Non-Compliance Entities) will be permitted to participate in the Chinese ETS subject to their meeting the relevant eligibility requirements.
• Although there is little information about the type of CEA or Offset products that will be permitted within the Chinese ETS, the Interim Regulations propose that CEAs and Offsets may be traded by way of bidding or bilateral agreement.
• Where it is necessary to stabilise the market, the MEE may act as a purchaser of CEAs and intervene in the market.
• The penalty for non-compliance by a Key Emission Entity will be a fine of two to five times the average market price for CEAs during the compliance year in question.
• Offsets can only be generated from sectoral areas that are not within the scope of the Chinese ETS.

The known unknowns arising from the Interim Regulations

Although the Interim Regulations tell us some things about the Chinese ETS, the length of the list of things we don’t know, based on what has been disclosed, currently exceeds the length of the list of things we do. This is without even including the questions that arise from monitoring, verification or allocation. For example:

• Does the reference to “bilateral agreement” in the permitted transaction types mean over-the counter (OTC) transactions, and if so, do they have to be settled through the national carbon exchange that is under development (National Platform)?
• How will the national carbon registry be linked to the National Platform? Will trades executed on the National Platform be settled the same way that transactions on the pilot carbon exchanges involving Chinese Certified Emission Reductions (CCERs) are currently settled?
• What is the role of the National Platform in the context of bilateral trading arrangements? Will it be necessary to execute a separate spot transaction on the National Platform to settle a bilateral OTC transaction executed outside the National Platform as is required under some of the pilot exchanges?
• What, if any, will be the role of the various pilot exchanges following the coming into force of the Interim Regulations?
• What is to be the status of allowances issued under the programmes operated by these pilot exchanges? To the extent that a sector or gas is not yet incorporated into the Chinese ETS, do the pilot exchanges retain a role in respect of that sector or gas?
• Precisely what types of products that will be available for trading under the Chinese ETS? This will be important in answering the question of whether adequate price signals can be obtained from emissions trading on the Chinese ETS. For example, even if only spot products are permitted on the National Platform, and there is no prospect of a futures market in the near term, so long as OTC forward transactions are not prohibited, a forward curve can be developed using broker quotes for forward transactions in CEAs or Offsets. However, a lack of clarity on this will impede the creation of a forward curve and therefore a price signal.
• When will the additional sectors (besides power) be brought within the scope of the Chinese ETS? How far in advance will this be announced? If Offsets can be generated in areas that are not within the scope of the Chinese ETS but not all sectors will be within scope from the outset, then the timetable for bringing such additional sectors (i.e., target sectors) within the scope of the Chinese ETS is very important. This is because, clearly, certain vintages of target sector Offsets will be valid until such time as those sectors come within scope.
• What eligibility criteria will apply in determining which type of Non-Compliance Entities can participate in the Chinese ETS and when will this be known? The fragmented system of regulation in the PRC, with different regulators responsible for different types of market participants, means that questions may arise as to which participants qualify as Non-Compliance Entities. For example, PRC banks, regulated by the Chinese Securities and Regulatory Commission, are not permitted to participate in proprietary trading of commodities. However, if a CEA or Offset is not classified as a commodity under PRC law, will PRC banks be allowed to qualify as Non-Compliance Entities?
• Will the national carbon registry merge with the existing national CCER registry³ or will two separate but linked registries be maintained, one for CEAs and one for Offsets? Currently the impression is that they will remain separate but this seems inefficient.

Conclusions

There is little doubt that the Chinese ETS, when fully ready, will not operate in a manner identical to or even similar to existing cap-and-trade emissions trading schemes that exist outside of the PRC. This is because experience from other sectors suggests that China learns from international approaches but typically incorporates those lessons into its own specific national approaches, thereby creating a hybrid system. Often this hybrid system looks odd from the outside but makes complete sense from a PRC perspective.

From a market development perspective, clarity around the secondary level rules, guidance and measures is now key. If this market is truly to become operational during 2020, that clarity cannot come soon enough.

1.  The GHGs are: carbon dioxide (CO2), methane (CH4), nitrous oxide (N20), hydrofluorocabrons (HFCs), perfluorinated compounds (PFCs), sulphur hexafluoride (SF6) and nitrogen triluoride (NF3).
2. Formally called the National Emission Right Registration System for the national ETS.
3. Formally called the National Voluntary Emissions Reduction Trading Registration System.

Client Alert 2019-144