Stanford economist consults with Chinese government on CO2 emissions reduction
China is the world’s largest contributor to carbon dioxide (CO2) emissions. It also can be a leading force in the fight against climate change by reducing these emissions.
The country plans introduce what will be the world’s largest “CO2 emissions trading” system for reducing CO2. When fully implemented, this nationwide system will more than double the amount of CO2 emissions covered worldwide by some form of emissions pricing.
This new system is a focus of research by Lawrence Goulder, the Shuzo Nishihara Professor of Environmental and Resource Economics, and a faculty affiliate of the Stanford King Center on Global Development. Some key decisions on the specific design of the new nationwide CO2 emissions trading system have yet to be made, and Goulder hopes that his work will shed light on the potential economic and environmental impacts of the new system under different designs and influence the design choices.
Goulder is collaborating closely with researchers at Tsinghua University in China and has been presenting his work to members of the Ministry of Ecology and Environment, the ministry charged with implementing the new trading system.
Early seed funding from the China Program at the King Center has helped advance Goulder’s research.
Potential for global and local environmental improvements
Although China’s rapid industrialization has lifted millions out of poverty, it has come at severe environmental cost. Thick smog and air pollution envelop the nation’s major cities, which leads to an estimated 1.2 million premature deaths each year. More than a quarter of China’s key rivers are “unfit for human contact,” and around 1.05 million square miles of China’s landmass are turning into deserts.
However, efforts to address the environmental problems are expanding.
“Two decades ago, China’s focus was on material output and incomes, as opposed to environmental quality,” said Goulder. “Over time, concerns by the government and Chinese citizens about environmental quality have increased significantly. This reflects both increased incomes and the fact that environmental quality has gotten worse, particularly air and water pollution.”
China’s recently unveiled market-based system is in keeping with the expanded environmental concerns. The new system has the potential not only to make a critical contribution to the global effort to address climate change but also to improve local air quality significantly, since reductions in “local” pollutants such as sulfur dioxide and particulate matter accompany reductions in CO2.
A new emissions trading approach
The new emissions trading system will differ from most other trading systems. The approach most widely used in other countries is “cap and trade,” an emissions trading system that introduces an absolute limit on total emissions. Under cap and trade, a regulatory body gives companies a certain number of emissions permits (or allowances), with each allowance entitling the owner to a given quantity of emissions. A company can then sell some of its permits or purchase additional permits from another company. But such trades do not alter the total number of emissions allowances in circulation, so the total allowable emissions is set by the regulator’s choice of how many permits to give to firms.
In contrast, under the China’s tradable performance standard system (TPS), covered facilities in China face requirements to reduce emissions intensity, or the ratio of their emissions to their planned output, below some given “benchmark” levels. So the regulator does not fix the total amount of emissions. Goulder’s research indicates that, relative to cap and trade, the TPS has both advantages and disadvantages. It tends to involve higher overall costs than an equivalently scaled cap-and-trade system. On the other hand, for China it can be easier to implement and can be more responsive to changes in macroeconomic conditions.
Goulder offers two reasons why China has decided to adopt the TPS approach rather than cap and trade.
“First, the TPS system is closer to the kind of direct regulation that the Chinese are used to. China is more familiar with intensity based approaches; under the TPS, no entity has an absolute cap on their emissions, but instead work with managing ratios. Second, the system aligns with China’s five-year plan to reduce its overall emissions intensity (ratio of emissions to GDP) rather than achieve a given emissions level.”
The critical role of benchmarks
A key feature in the design of the TPS is the choice of the benchmarks – the maximum allowed ratios of emissions to intended output – assigned to power plants or to manufacturing firms in different sectors. Tighter benchmarks imply greater emissions reductions, but they also generally imply higher costs to producers. The Chinese planners face the challenge of determining the stringencies of the benchmarks assigned to various producers.
Goulder has developed both theoretical and quantitative economic models that reveal the costs of the TPS, depending on the number of benchmarks and how the different benchmarks are distributed across technologies or geographical locations (provinces).
“These benchmarks are an essential design feature,” Goulder explains. “The challenge is to decide how many benchmarks to employ, which types of power plants or factories face what benchmarks, and how stringent each of those benchmarks are.”
Although overall economic costs might be lowest if all producers faced the same benchmark, a one-benchmark approach could impose unacceptably high costs on certain provinces, particularly those in which the production technologies in place involve especially high emissions-output ratios.
The Chinese planners have considered a three-benchmark system for the power sector, which applies different benchmarks to natural-gas-fired power plants and to two main categories of coal-fired power plants.
Goulder’s work indicates that this three-benchmark system would introduce especially high costs to certain provinces in northern and northeast China. It shows that adding a fourth (less stringent) benchmark for the provinces that otherwise would face especially high costs can significantly ease the cost burden to these provinces. However, doing so raises the overall economic cost of the emissions trading system. This exemplifies a basic trade-off -- between the competing goals of keeping overall economy-wide costs low and achieving a fair distribution of the burdens across provinces or types of firms.
Policymakers hope that the market prices of emissions permits under the TPS will be high enough to elicit significant reductions in CO2 emissions. One way to reduce the price uncertainties is to include a “price floor” in the TPS system. In future work, Goulder plans to examine the environmental and economic implications of alternative potential designs of a price floor. Planned future work also includes an assessment of how anticipated reforms of electricity pricing and dispatch are likely to influence the performance of the TPS.
Collaborating for a cleaner environment
The research conducted by Goulder and his colleagues at Tsinghua University has led to two published papers and a recent working paper. In the short term, Goulder and his collaborators will continue to refine the research and consult with Chinese officials at the Ministry of Ecology and Environment. The Chinese government is expected to finalize the benchmark ratios this year. Goulder is encouraged by the reception his research has received at the Ministry of Ecology and Environment.
“I get quite a bit of satisfaction knowing my work is addressing a very important problem and is being examined closely by the policy-makers as they make their important policy choices,” said Goulder.