Unofficial translation by CCICED Secretariate International Support Office. Original Chinese article HERE.
Two decarbonization strategies
It is appealing and inspiring to turn the stress of reaching carbon peak and carbon neutrality into drivers of economic growth, but this is hard to achieve. In reality, we can identify three ways of decarbonization.
The first way of decarbonization is based on degrowth, which is achieved through reducing production. This is the easiest and least effort-taking way of decarbonization. Since production shall not be halted, this way of decarbonization is usually unfeasible and even perceived as unthinkable. However, it still takes place under specific circumstances. For example, some regions previously shut down their production to fulfil short-term energy conservation and emission reduction objectives.
The second way of decarbonization is based on efficiency, through which carbon productivity is improved. Efficiency means increased output while the level of carbon emissions stays the same. Alternatively, it means reduced carbon emissions while the output stays the same. This way of decarbonization matches with the oft-mentioned principles of energy conservation and emission reduction, or prioritizing conservation.
The third way of decarbonization is based on innovation. Innovation creates new technologies, techniques, and methods, which achieve low-carbon, zero-carbon, or even carbon negative results while the output stays the same. Examples include renewable energy generated by wind, sunlight, water, and biomass. Carbon emissions can be decreased while the output stays the same if the existing carbon-intensive technologies are replaced by these new technologies.
Among the above three ways of decarbonization, the first and the second ways operate within the existing technological and industrial systems. Compared to degrowth-based decarbonization, efficiency-based decarbonization presents a positive direction. There is considerable room for improvement in energy and carbon productivity especially when the technology falls behind and the management is extensive. In fact, over the past decades China has made impressive achievements in energy conservation, emission reduction, and efficiency improvement. However, there are apparent limitations to the efficiency-based way of decarbonization. First, along with advancing technology and management, the growth in carbon productivity will slow down, and the space for continuous improvement will shrink. More importantly, these changes are mostly limited to the existing technological and industrial frameworks. Even if technological innovations are created, they are the so-called incremental innovations rather than radical innovations. Despite the fact that carbon productivity can reach a significantly high level, production still relies on carbon-intensive resources. For example, coal-fired power stations in China can be internationally advanced in energy conservation and emission reduction, but that does not change the fact that these stations are powered by coal.
Here we need to discuss how to interpret the prioritization of energy conservation from an economic perspective. Prioritization of energy conservation, or more broadly the prioritization of conservation, are worth being advocated as part of public morality. Essentially, economics is a study of conservation, although economics provides a holistic perspective to examine conservation and focuses on the optimal allocation of resources in society. In the general sense, energy conservation can be interpreted as cost reduction in one company’s production and business operations, which could mean cost reduction in raw materials, transportation, storage, and labour. At the same time, it takes account of output and seeks the lowest cost per unit of output. Whether or not to prioritize energy conservation depends on a holistic and comparative assessment, which is usually determined by market mechanism. If energy conservation must always be placed as top priority, especially if regarding the indicators of control of energy consumption as indicators of indirect control of carbon emissions, then distortion and misallocation are hard to avoid in resource allocation. This will bring negative disruptions to the economy, which explains the urgency to re-orient policy focus from energy consumption control towards carbon emission control.
Innovation-based decarbonization goes beyond the existing technologies and industrial circles and creates a new pathway with new technologies, techniques, and methods. Because of these changes, innovation-based carbon reduction has features not found in the other two ways of decarbonization.
First, innovation-based decarbonization in the long run can replace traditional carbon-intensive technologies or industries. The so-called green transition essentially implies the technological substitution, i.e., replacing existing carbon-intensive technologies with low-carbon, zero-carbon, or carbon negative technologies.
Second, it is impossible to pre-determine the potential of innovation-based decarbonization. The innate impulsiveness and uncertainty of innovation indicate that the boundaries of its development cannot be defined. It is conceivable that much of our understanding of renewable energy will be changed if controllable nuclear fusion can succeed and be commercialized.
Third, this kind of innovation can significantly decrease the cost of climate change adaptation. Green products tend to be initially expensive with a so-called “green premium”. Prices start to drop as the competition between innovations intensifies, and the green premiums of many products have become negative. Photovoltaics are a typical example in this regard. Ten years ago, it was inconceivable to compete with coal-fired power generation. However, during the past ten years, the cost of photovoltaic power generation has decreased by 80%-90%, which has now become lower than the cost of coal-fired power generation and still has the potential to further decrease. Cost shocks are an important challenge to climate change adaptation, and the innovation-driven cost reduction can immensely improve our confidence and capacity to adapt to climate change.
Fourth, innovation initially originates from the motivation to reduce carbon emissions. Once a product is invented, it will usually generate additional utilities or benefits, creating more consumer surplus. Take the example of new energy smart vehicles. The total sales in the first quarter of 2022 have almost reached 20% of the total vehicle sales, exceeding market expectation. It is hard to say that consumers of new energy vehicles do not pay attention to carbon emissions, but what are directly tangible to most consumers are the low costs, easy-to-navigate digital devices, high comfort, significantly different steering experience, and improved autonomous driving. In addition to the transition to electricity, new energy vehicles have smart features. Simply put, what appeals to consumers are the advantages other than carbon emission reduction. This means that (new energy vehicles) provide society with benefits beyond expectations.
Last, innovation catalyzes and accelerates the digitalization process of the energy industry and other carbon-intensive industries. Digital economy is another form of economy succeeding the agricultural economy and industrial economy, and our economy and society as a whole is transitioning towards the digital economy. Even without the stress of achieving carbon peak and carbon neutrality, carbon-intensive sectors including energy, industry, transport, and construction will embark on digitalization, although the process may be relatively slow. Innovation-based decarbonization catalyzes and accelerates the digitalization process in these sectors and may mobilize these sectors to become leaders of digitalization.
In sum, innovation-based decarbonization creates possibilities distinctly different from the other two ways of decarbonization. It has the potential to catalyze and to lead the greening and digitalization of economic and social development beyond the expectations of decarbonization. If a distinction must be made, the degrowth-based decarbonization and efficiency-based decarbonization are defensive strategies, while innovation-based decarbonization is a proactive strategy. For a relatively long period of time, we have understood and been looking forward to the proactive strategy, but our ideas and practices mostly remained defensive. The challenge is how to adopt the proactive strategy as quickly as possible.
Lack of market incentives for innovation-based decarbonization
Different strategic tendencies manifest in goals, policies, and more realistically in incentives. Here we focus on analyzing the carbon emissions trading system (ETS). Goods that have global externality (including carbon emissions) cannot directly depend on the market. The government must first step in to “create” a market. Leaders in Climate Change Economics such as William Nordhaus and Nicholas Stern have mentioned carbon pricing. Specific methods of carbon pricing include emission quotas, trading, and carbon tax, and they hope that ETC can play an important role. However, both the first-established EU Carbon Trading System and the recently started and the world’s largest ETS in China have appeared to perform less well than expected. In addition to various external factors, these markets are structurally flawed. If only some of the high-emitting industries and companies participate in the market, that is much narrower than what the market should have involved. Not only the market fails to involve all actors, but it also raises an obvious question about fairness. The initial allocation of quotas is mostly free, and the actual payment only occurs when “adjusting surplus and deficiency”. The method of quota allocation being shifted away from the historical method to the benchmark method is an improvement. However, considering supply-side security and stability, it is difficult for regulators to differentiate between actual supply security and the excuses made by producers. Such factors complicate the price determination of the emissions trading market and undermine the market’s role in adjusting supply and promoting innovation.
A problem worthy of more discussion is that the existing ETS appears to mainly serve the previously mentioned defensive strategy. For producers that have entered the carbon emissions trading system, it is important to increase carbon productivity and to conserve energy while reducing emissions so that they can profit from selling saved emission quotas. For the designers of the emissions trading system, they expect producers to provide low-carbon or zero-carbon products by innovation and by adopting new technologies. However, the reality is that most existing producers show evident “path dependence” and that they lack both interest in and skills for technological innovation. The radical innovators are mostly not part of the “circle”. At the same time, in order to prevent carbon-intensive producers from relieving their stress of energy conservation and emission reduction by purchasing carbon credits, ETS has set a cap on the Chinese Certified Emission Reduction (CCER)-type carbon credit trading. Currently, the CCER-type credit trading is capped at five percent of the producer’s compliance obligation and this cap means that the credit trading hardly has any significant impact on the overall market structure. Therefore, we observe that the most dynamic, innovation-based way of decarbonization is rarely favoured by market incentives.
Three pillars of the proactive decarbonization strategy
To achieve carbon peak and carbon neutrality goals, there is a need to shift the focus to the innovation-based way of decarbonization and to the proactive strategy. As shown in China’s historical experience in the economic reform and in development, a good understanding of the relationship between existing economic activities and new ones reflects strategic wisdom and a forward-thinking mind. This understanding is critical to the success of past transitions. In the early stage of the Chinese economic reform, the private sector gained opportunities to develop by filling a vacancy. Thanks to its innate vitality, resilience, and competitiveness, the private sector has slowly become the influential main force of national economic development. It has also catalyzed the reform and development of the state-owned economy. Initially the opening of China started with the “three-plus-one trading mix” (sanlai yibu) and was first implemented in several coastal regions, which later enabled China to become a great power in global trade and investment.
China’s energy sector should also follow a pathway that “prioritizes new energy sources, replaces existing ones, encourages innovation, and leverages the market”. This is the main principle of the proactive strategy. The underlying economic rationale is that the traditional carbon-intensive energy sector represents the existing energy sector. Even though it has some emission reduction potential, this potential tends to regress, as the room for improvement diminishes, the challenges increase, and the costs rise. On the other hand, low-carbon or zero-carbon energy as the new energy sources will experience decreasing costs as the production increases and the technology improves. The green premium of some new energy products will turn from positive to negative. The cost advantage in emission reduction will increase as new energy replaces existing ones, accelerating the energy transition. To implement the proactive emission reduction strategy is to focus on expanding the new energy sector while maintaining the existing energy sector, energy supply, and energy security. It also creates strong incentives for low-carbon, zero-carbon, or carbon negative products which can improve productivity and stimulate growth. These incentives are not limited to a few measures but comprise three pillars.
The first pillar is to establish a growth-oriented carbon credit market that provides all-around support for innovations in green technologies. The so-called growth-oriented carbon credits are carbon emissions reduced or offset by adopting low-carbon, zero-carbon or carbon negative technologies in comparison to existing carbon-intensive production. Growth-oriented carbon credit market can co-exist with the emissions trading systems, as the latter focuses on incentivizing reducing emissions in the existing energy sector. Growth-oriented carbon credit market should focus on incentivizing technological innovations in the new energy sector. This market should be highly inclusive as it includes both green energy products such as green electricity and products in other industries or areas that can generate growth-oriented carbon credits. Government bonds or special funds provided by the central bank can be used for the initial purchase of such products entering the growth-oriented carbon credit market before secondary market circulation. Prices of carbon credits in the market reflect the value assessment of the contributions to emission reduction by technologically innovative products. The government can adjust the incentives for innovations by increasing or decreasing the volume of investments in the market. The set-up of growth-oriented carbon credits must comply with domestic and international standards and rules concerning these technologies. Digital methods such as blockchain technology can be used to reduce costs and to standardize the procedure.
The second pillar is to develop a regional, voluntary emission reduction responsibility system. The key to prioritize the new energy sector is to expand the market demand for technologically innovative products, and this directly depends on the efficacy of the emission reduction responsibility system. This system can draw on the principles of the Paris Agreement and encourages local initiatives. It should set emission reduction targets which are both challenging and in line with the local conditions. It should also coordinate with the “1+N” policies that will be enacted to implement carbon goals. This will lead to regional emission reduction plans at the provincial, municipal, district, county, and development zone levels, creating traceable emission reduction responsibilities. Regions or enterprises can fulfill their emission reduction responsibilities by reducing emissions themselves, or producing growth-oriented carbon credits, or purchasing these credits in the market. In so doing, the emission reduction responsibility system can animate consistent demand for green technology products and stimulate the transition that expands the new energy sector and replaces the existing one.
The third pillar is to accelerate the formation of micro-level green institutions for carbon accounting and carbon accounts. A solid foundation of carbon accounting is necessary for the development of the growth-oriented carbon credit market and for establishing the emission reduction responsibility system. However, this happens to be a major shortcoming at present. At the initial stage of carbon accounting, a top-down method is recommended to get the basics right. At the same time, carbon accounts should be established, including corporate accounts, other institutional accounts, and even personal carbon accounts in qualifying regions. Environmental, social, and governance (ESG) assessment should be promoted among enterprises and formal rules about ESG assessment disclosure should first be established in publicly listed companies and large enterprises. Financing activities should be increasingly integrated into green finance. Growth-oriented carbon credits should be deployed to develop diverse financial products in order to provide effective support for innovation in green technologies.
Green innovations include both technological innovations and policy innovations. The above three pillars of proactive decarbonization strategy are policy innovations. If innovative policies or practices in green transition are controversial or hard to judge in the short run, they can be piloted in willing and capable regions, under the guidance of state planning. This allows trial and error, and success can be replicated after further improvement. This has been an important lesson for success from the Chinese economic reform, and it still has practical implications for the current green innovation and transition.