This is how China aims at becoming a leader on environmental issues

China will be launching its first nationwide carbon market by the end of 2017.

Leveraging on the experiences gained from the development of the domestic regional emissions trading scheme (ETS) since 2013, and the lessons learned from the European Union ETS’s, China National Development and Reform Commission (NDRC) will probably remain the key driver of the carbon prices during the initial phase.

Will carbon markets offer an attractive field for financial innovation? Can vested interests of large emitters impact the carbon price signal and keep prices at a low level? The stakes are high for this major initiative to succeed in the country taking the role of global climate leader.

Climate change has risen up the political and economic agendas in China. In June 2015, the government released a climate pledge prior to the 21st Conference of the Parties (COP 21) that led to the Paris Agreement in December that year. China’s pledge reiterated targets of a 40-45% reduction in carbon intensity (emissions/GDP) by 2020 from 2005 levels, and extended this to 60-65% by 2030, the year around which they plan for emissions to peak. China is considering the imposition of a carbon tax at the horizon of 2020, but will first leverage on its initial experience of developing regional ETSs since 2013. The launch of a nationwide carbon market and pilot ETS is expected to happen by the end of 2017. It is time to step back and look at the opportunities offered by the pricing of carbon in the largest carbon emitter country in the world.

20 years ago, the Kyoto Protocol introduced carbon markets as a robust institutional and legal framework to put a price on carbon. Since then, more than 40 ETSs have been developed around the world. So far, the EU ETS has been the largest ETS scheme in terms of volume and carbon transactions.
Under such a controlled allocation of allowances and a power market not yet liberalised, the carbon price signal may become effective post 2020. It is important to realise that in that process, the price will be strongly guided by China NDRC. At the same time, the vested interests dominating the largest emitters’ industrial strategies will most likely put downside pressure on carbon prices.

The launch of a nationwide ETS will also support financial innovation. Shenzhen Carbon Exchange (CEEX) highlighted during our recent meeting the development of carbon bonds, carbon-linked financial products (interbank dealers), green structured deposits or carbon pledge contracts as potentially promising green finance innovations. Nevertheless, price volatility risk during the initial phase of the national ETS should prohibit retail investors’ exposure to such products.

The regulatory risk is emerging for Chinese corporates. At the same time, thanks to the strong government support and a Rmb 10trn (USD 1.5tr) investment in environmental protection industries under the 13th Five Year Plan, half of them targeting air and climate related initiatives, the perspectives bode well for the companies that are beneficiaries of China’s transition toward a less carbon-intensive economy. Energy supply and energy mix transformation, alternative energies, clean transportation, and energy efficiency are all sectors that offer very attractive investment opportunities currently trading on average at a Price Earning to Growth ratio of 0.8.

François Perrin - Portfolio Manager - East Capital