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China’s Emerging Policies for Emissions Reductions

In this episode, host Daniel Raimi talks with RFF Senior Fellow Dick Morgenstern about the ambitious new emissions reductions program that China is pursuing. Rather than employing a cap-and-trade model with a hard limit on emissions, China has opted for a “tradable performance standard,” which sets a ratio of emissions to output that individual firms have to meet. While the standard is not as efficient as more typical models, it stands to significantly reduce emissions once it expands beyond the power sector—without necessarily curbing China’s economic growth.

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Notable Quotes

  • A far-reaching emissions reduction effort: “When [China] announced this program back several years ago, they said it was going to cover seven sectors, which the biggest and first one of course would be the electric sector … But they also identified major industrial sectors—for example, iron and steel, petroleum refining, cement, and several others—that would be included in their emissions trading system.” (8:24)
  • Concerns over a system that might constrain economic growth: “China and other developing countries for some time have been going to negotiations and discussing the importance of economic growth for their future. They are afraid … to lock in to some fixed cap that they fear might limit their economic growth. By defining their goals as this ratio, they have allowed themselves the opportunities to grow economically, while at the same time becoming more efficient … I have heard talk in international circles that some other countries have started to think about this. I think many countries are waiting to see how the Chinese system actually works out.” (20:28)
  • Inefficiencies aside, the program is poised to reduce emissions: “What the environment really cares about is that total emissions are reduced. There are different ways and different incentive structures that one can set up to reduce total emissions. A cap and trade is a very clear, transparent way of limiting emissions, but a tradable performance standard has the potential to reduce emissions, as well. It [is not] quite as limiting on emissions and on the economy as cap and trade, to be sure, but if it has the intended effect—which is to make emissions more expensive and less attractive for firms—then it’s a good thing.” (22:31)

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The Full Transcript

Daniel Raimi: Hello, and welcome to Resources Radio, a weekly podcast from Resources for the Future. I’m your host, Daniel Raimi. This week, we talk with RFF Senior Fellow Dick Morgenstern. Along with several co-authors, Dick has recently released an RFF working paper on China’s new emissions trading program. We’ll talk about that trading program today, including what its goals are, how it’s designed, along with some of its strengths and weaknesses.

We’ll also talk about how this policy fits into the framework of international negotiations on climate change. One quick note: this episode was recorded well before the extent of the coronavirus pandemic had become clear. Stay with us. Okay. Dick Morgenstern from resources for the future. My colleague. It’s great to have you here on the podcast. Thanks for joining us today.

Dick Morgenstern: Thank you.

Daniel Raimi: Dick, we always like to get a general sense of how people got into the world of energy and environmental policy when we talk to them on the podcast. What’s your story? How did you get into this field?

Dick Morgenstern: Let’s think, well, I guess you can probably date it to when I was back in grade school. I used to go fishing at five o’clock in the morning with a close friend of mine, and I really enjoyed being out in the water and all the elements. I went to college in Oberlin, Ohio, which is right near Cleveland, of course, and Cleveland was the site of the major fires in the Cuyahoga River around 1970.

That certainly raised my awareness. But I guess probably the biggest influence was when I first came to Washington, which was in the mid-70s. I went to work as an analyst at the Congressional Budget Office. It was a very exciting time for energy and environmental issues to come into the national spotlight. I really got engaged in them, and I realized that economics could make a huge contribution. I jumped in and I’ve held various positions mostly in Washington since that time. I really enjoy working on environmental and energy issues from an economic perspective.

Daniel Raimi: Right. For sure. I’m curious, where did you grow up that you would go fishing so often?

Dick Morgenstern: Well, I grew up on Long Island actually, but the place where we used to go fishing, my friend’s father would take us down to Sheepshead Bay in Brooklyn. We would go out in a small boat. He had an outboard motor and we put it on a back and we’d go out pretty far out where there weren’t very many small boats actually, but it was a really exciting thing.

Daniel Raimi: Very cool. I’ll have to ask you more stories about fishing in Brooklyn some other time but for now, we’re going to focus in on a recent paper that you’ve coauthored with a number of colleagues, and the name of the paper so people can look it up we’ll have a link to it, of course in the show notes. But if you’re listening now and want to find it, the name of the paper is “China’s Unconventional Nationwide CO₂ Emissions Trading System: The Wide-Ranging Impacts of an Implicit Output Subsidy.” We’re going to break that down over the next 25 minutes or so, and talk about what that means but as a preface to my first question, I was thinking about this as I was reading the paper myself and many people know that China has been developing a nationwide emissions trading program for a number of years.

Many of them including myself, have referred to it at times as a cap-and-trade program. But reading this paper, I realized that’s not quite right. The government has instead opted to use a tool called “tradable performance standard,” which is different from a cap-and-trade programs in a number of ways, and it has different implications, and those are really the topics that we’ll focus on today. To start off, I think it would be useful if you could explain to us the difference between a cap and trade system and a tradable performance standard approach.

Dick Morgenstern: Happy to do so. Let me just start out with a shoutout to my coauthors here: Larry Goulder, who’s a professor at Stanford; Xianling Long who is a graduate student at Stanford; Jieyi Lu, who has been working at RFF and is now a graduate student at Yale. They were all coauthors. The four of us worked fairly intensively to put this quite detailed paper together. But let me turn to your question. What’s the difference between a cap and trade and a tradable performance standard?

A cap and trade is a fixed limit on the emissions—on the tons of emissions—that can be emitted by covered facilities. Covered facilities in this case apply to the electric sector initially, which is where the Chinese are regulating at the outset. Cap and trade differs from a tradable performance standard, which does not have a fixed limit on the tons of emissions.

Instead, it fixes the ratio of emissions to output. What the authorities do is they establish a policy where the new ratio is below the existing ratio or the expected or predicted ratio. Of course this is on an average basis. What that means is the new ratio, which is called the benchmark, has some facilities that are operating below it and some that are operating above it. The difference between the facilities below the benchmark and above the benchmark creates the potential for trading among them. There are of course, many pros and cons of the standard. I imagine you will get into those as we go along.

Daniel Raimi: We will. A couple of terms that people sometimes use to describe the difference between these two approaches that I think applies here and I’ll ask you whether they actually do, but cap-and-trade programs are often or sometimes referred to as mass-based programs. There’s a certain mass—a quantity of CO2—that can be admitted under the program and that is a fixed number, whereas a tradable performance standard is more of what’s called a rate-based program where each firm or power plant, or however you want to think about it has a particular CO2 emissions rate that they’re allowed to produce for every megawatt hour of electricity they produce. Is that a useful way to think of it as mass-based?

Dick Morgenstern: That’s exactly right. A mass-based really means that you’re fixing the number of tons, the mass of tons that come out of in this case, power plants are restricted. Plain and simple. A rate-based system, which is a correct term to use really relates to this ratio. It’s really you’re regulating the ratio of the mass to output levels. As I say, you can bring the ratio down by either reducing the numerator, the mass, or by increasing the denominator, which is the output level of the facility.

Daniel Raimi: Right. Got it. Okay. Let me ask you one more background question before we dig into the policy itself. The background question is a high level one, which is: Has the Chinese government articulated a specific emissions reduction goal for the power sector that this program is designed to meet? The program only applies to the power sector if I’m remembering things correctly. Is there an end goal that this thing is supposed to achieve in a certain number of years, or is that not defined at this point?

Dick Morgenstern: Well, it is and it isn’t. The Chinese have defined an overall goal for their economy, which would extend beyond the electric sector. That goal is to reduce their emissions intensity, which is to say the ratio of emissions to output by 60 to 65 percent below the 2005 levels by the time they get to 2030. Now they’re already well along in meeting that goal, but that doesn’t precisely address the question that you asked which is: Is there a goal for the electric sector per se?

I’m not aware of a specific goal for that sector. However, the Chinese, when they announced this program back several years ago, they said it was going to cover seven sectors. Which the biggest and first one of course would be the electric sector. Which is what they’re now in the process of rolling out. But they also identified major industrial sectors, for example, iron and steel, petroleum refining, cement, and several others that would be included in their emission trading system. That’s going to be rolled in the future, although there’s very little detail that I’m aware of on the design of those systems.

Daniel Raimi: Great. Got it. We know this particular policy plays into that larger goal, but we at least at this point are not sure about what the specific power sector target is.

Dick Morgenstern: That’s correct.

Daniel Raimi: Okay. That’s really useful to know at the outset. Let’s dive in a little bit to talking about the tradable performance standard and some of its benefits and drawbacks relative to a cap-and-trade approach or some other policy approach that one might take to reduce emissions. The paper points out that a tradable performance standard encourages generators to produce more electricity than they otherwise might. You’ve already touched on this a little bit, but can you expand a little bit and maybe give us an example of a hypothetical power plant, and how it might be incentivized to produce more electricity under a tradable performance standard than it might under a cap and trade or a carbon tax or something like that?

Dick Morgenstern: Sure. With cap and trade, the only thing a firm can do is reduce its emissions as I mentioned. With the tradable performance standards, they have that second option, which is to increase output. I’m thinking about the incentives on the electric power producers. It’s useful to recall that the benchmark that was set is an average. As in any average, some people are below average and some people are above average. Below average in this case means more efficient and above average means less efficient.

The incentives that this system creates are that those who are more efficient— that is, below the average—have an incentive to expand their output because they know that they will earn emission allowances at the level of the benchmark, even though their actual emissions-to-output ratio is below the benchmark. That will create a surplus for them in emission allowances, and they can turn around and sell that surplus to the producers who are above the benchmark, above the average that forms, as I mentioned, the basis of trading. However, it also creates a situation where their output of the entire system of producers is higher than it was before.

Essentially the mechanism by which the tradable performance standard works is it incentivizes the producers who are highly efficient to produce more than they might have and sell the surplus allowances that they earn to the less efficient producers who are above the benchmark. In the course of doing this, as I say, the total output increases and with total output increased in the system, there is less pressure on electricity prices. That turns out to be an important point because it will have some effect on the extent of leakage that occurs in the system,

Daniel Raimi: Right. So, a given firm might, for whatever technical reason that we don’t need to go into, the company or the firm or the power generator or whatever term we’re thinking about could increase its overall production, which could actually lower its rate of emissions, even if its total level of emissions increases.

Dick Morgenstern: Correct.

Daniel Raimi: Is that right? Another question that comes to mind is the title mentions this phrase, “implicit output subsidy.” Can you help us understand how a tradable performance standard could be seen as an implicit output subsidy?

Dick Morgenstern: You are correct that there is an output subsidy involved in this system, and we call it an implicit output subsidy. The way it works is, as I mentioned, for those units who are more efficient than the benchmark, they have an incentive to produce more in order to gain more emission allowances and they won’t need them all because their efficiency is below that benchmark so they are incentivized to produce. Period.

Daniel Raimi: Got it. Okay. You also talk in the paper with your colleagues, of course, about the potential advantages of using a tradable performance standard, where different firms have different targets in terms of their emissions output per unit of electricity. You’ve talked about how, or in the paper you talk about how this could reduce economic efficiency. The overall economic efficiency of the program, and as we’ve talked just now, it could lead to higher emissions than otherwise might occur, but you also discuss some potential benefits of this type of policy design. What are the benefits that you see to using this approach?

Dick Morgenstern: Sure. First of all, we’ve done an overall calculation as to the benefits of the program, quite apart from the mechanics, but the overall benefits associated with the emission reductions, and those benefits when you value the tons reduced by using the social cost of carbon, we find that the benefits of the reductions are roughly three times the cost of operating the system. The Chinese are clearly operating in a favorable territory here.

As for the specific design elements, the use of a tradable performance standard means that the goal will vary with the state of the business cycle. If the economy is booming, and there’s a big demand for electricity, then the firms will have a higher target if you will. If the economy is not booming, then the target will come down, as opposed to cap and trade where the target is set in advance, and it doesn’t vary with the state of the business cycle. But because of that ratio, you’re getting a variable target, which presumably reflects the difficulty of meeting the standard and is a favorable thing.

A second favorable aspect of the system is that because it’s going to result in fewer electricity price increases or pressures for electricity price increases that would normally occur, the amount of emissions leakage that’s likely to result is lower. Emissions leakage is a concern in any system because you’re—unless it’s a truly global system—if only some nations or some entities are adopting it, then their cost of production will rise and others will not. But the tradable performance standard tends to mute the price increases.

By muting price increases, it will reduce leakage. There’s a number of different things going on here. As I say, the benefits do exceed the cost by a substantial amount. It is quite responsive to the business cycle. It does reduce leakage, but it is less efficient. You could think of it if you plotted a course and you were going to go from saying New York to California by car, and getting to California was the goal and you value that enormously, then there are many different routes you could take. What the Chinese are doing is they’re not taking the most efficient or the least cost route to get there, but still in all, the benefits of getting there still outweigh the costs. That’s the way to think about how these pieces fit together.

Daniel Raimi: Got it. Also, maybe if you’re not taking the interstate from New York to California, you can take the back roads in there. Even though it’s not the most efficient way, there are probably some benefits to doing that as well. Right?

Dick Morgenstern: Correct. There are better restaurants, sure and that corresponds, if you will, to less leakage perhaps or more adaptability to business cycles.

Daniel Raimi: Got it. One other just quick technical question on the benefits and costs, you mentioned that you used the social cost of carbon in the paper. Are you using the US government’s 2015 or 2016 social cost of carbon?

Dick Morgenstern: Correct.

Daniel Raimi: That’s $42 a ton.

Dick Morgenstern: We adjust it for inflation. It’s about $44, but that’s correct.

Daniel Raimi: Okay, great. I’m sure some of our listeners will want to know what is the cost of carbon they’re using. Great. That’s all super useful. I had a couple of questions that popped into my mind as I was reading the paper about the international climate negotiations implication of using a tradable performance standard rather than some other hard cap. This is relevant, not just for this program, but to the goal that we talked about for the Chinese economy overall as being an emissions intensity goal rather than a hard cap.

The question is because they’re not using a hard cap on emissions, which some other countries are doing in the context of international climate negotiations, does that create challenges with comparing the reductions achieved in China with the reductions achieved in say Europe or any other country, and do you think that difference in design could create challenges going forward in international negotiations when countries are trying to compare their level of effort against one another?

Dick Morgenstern: Well, I think there is some additional complexity here, but at the end of the day, there are emissions reductions expected to take place under the system and one can measure them. It should be possible to compare the emission reductions that occur in this system, in the Chinese system to those reductions that are occurring elsewhere, not quite as transparent and takes a little more complexity doing the calculations, but it certainly is plausible and feasible to do those calculations. Will this create challenges down the road in international negotiations?

Well, there are many challenges in international negotiations as you well know. I suspect that this is probably one of the more modest challenges that needs to be addressed.

Daniel Raimi: Okay. Well, that’s good to hear. It actually came to mind as I was asking that question. I think there was a paper a few years ago that Joe Aldy and Billy Pizer put out about comparing levels of ambition across these different types of policy design. It’s a very much in the weeds, technical thing to figure out, but as you say it’s not the most daunting hurdle that we could see ahead.

Dick Morgenstern: Correct.

Daniel Raimi: One other question about this particular type of policy choice of using the tradable performance standard is when we think about climate policies that are happening around the world, one of the most popular tools that different countries and states in the United States have used over the last five or 10 years have been cap-and-trade programs, these hard cap programs that have training elements within them. They’ve been pretty popular. They’ve been growing in recent years.

Do you think this model of a tradable performance standard has the potential to provide a new model for other nations that might be looking for ways to address emissions with a little bit more flexibility, particularly if we’re thinking about developing countries?

Dick Morgenstern: Well, I think that’s where the opportunities probably do lie. China and other developing countries for some time have been going to the negotiations and discussing the importance of economic growth for their future. They are afraid, if you will, or they appear afraid to me to lock into some fixed cap that they fear might limit their economic growth. By defining their goals as this ratio, their national goals as a ratio, they have allowed themselves the opportunities to grow economically while at the same time, they’re becoming more efficient.

The design of this electricity focused trading system, which they are now embarking on is a way to implement that broad-scale goal of an emissions intensity target, and to apply it down in the weeds, if you will, to individual facilities and to see how it will work. I have heard talk in international circles that some other countries have started to think about this. I don’t know how seriously. I think many countries are waiting to see how the Chinese system actually works out.

Daniel Raimi: That makes sense. I guess as you’re answering that question, I’m thinking some people might be listening and thinking about this question and thinking, well, the climate doesn’t care about the rate of our emissions relative to our output. The climate cares about the number of tons that are put into the atmosphere. Is this potentially a concerning development that major emitters like China and potentially other countries, if they were to choose to adopt this approach, might be moving away from a hard cap to this rate question? Is that something that should give us pause?

Dick Morgenstern: You’re raising a very good point. My thought is that what the environment really cares about is that total emissions are reduced. There are different ways and different incentive structures that one can set up to reduce total emissions. A cap and trade is a very clear, transparent way of limiting emissions, but a tradable performance standard of this sort has the potential to reduce emissions as well.

It doesn’t sound quite as limiting on emissions and on the economy as cap and trade to be sure, but if it has the intended effect, which is to make emissions more expensive and less attractive for emitters, for firms, then it’s a good thing. My answer is that there’s a lot of potential here. How it works out in practice remains to be seen. I think we’re all optimistic, but probably cautiously optimistic.

Daniel Raimi: To be clear one could certainly achieve deep decarbonization under a tradable performance standard, but the rate that firms would be tasked with achieving would just be a very low rate or potentially a rate of zero emissions per unit of electricity generation or whatever other output you want it to measure.

Dick Morgenstern: Well, it really depends on how dramatic the targets are set. The Chinese have set this target of a 60 or 65 percent reduction in their emissions per unit of output. Let’s be clear. What we’re saying is that reduction over a 25 year period, some people might’ve said they should’ve had a higher reduction target, and that’s certainly plausible. But this is what they’ve chosen. This is what they’ve offered up at the Paris and other international agreements.

Daniel Raimi: Just so people are clear, sorry, when you say output, just so everybody knows what we’re talking about it, you’re talking about economic output, like GDP or something like that.

Dick Morgenstern: Correct. I’m talking about the economic output. In the case of this particular trading system that’s focused on electric utilities, you’re talking about the output of electricity. But as they move to apply this to the other sectors that I mentioned, they are going to face issues about what is the contribution of this deal sector and what is the contribution of the chemical sector, et cetera, and it’s all going to boil down I expect to economic output.

Daniel Raimi: Well, Dick, this has been so interesting. There are so many more questions that I would love to ask you about climate policy in China, more broadly when we saw each other a few weeks ago, I did ask you a bunch of questions and I’m sure I’ll do so the next time I see you but now I think we’re going to close it out and I’m going to ask you the same question that we ask all of our guests, which is what have you read or heard or watched lately related to the environment or energy that you think is really interesting, and that you’d recommend to our listeners. I’m just going to start with a very brief and somewhat repetitive recommendation.

During our podcast a few months ago with Sarah Ladislaw from the Center for Strategic and International Studies, Sarah recommended the book, The Wizard and the Prophet by Charles Mann. I picked up that book on her recommendation and I’m about three quarters of the way through it. It’s just fantastic. It’s not only a really interesting way of thinking about the world and technological and sociological challenges, it’s also got all sorts of really fascinating historical nuggets sprinkled throughout about the discovery of the greenhouse effect or the history of coal and all sorts of other fascinating energy and environmental topics. If you haven’t read The Wizard and the Prophet yet, I would really recommend it. How about you Dick? What’s on the top of your literal or metaphorical reading stack?

Dick Morgenstern: I have not read that book, but I’ve been getting increasingly interested in glaciers. I had the opportunity to do some glacier hiking in recent years. Most recently I was down in Patagonia where it’s absolutely gorgeous, but I’ve been following a series that the National Geographic has put out where they have been reporting up in Alaska that glaciers are melting about a hundred times faster than previously thought.

That’s pretty frightening. A friend of mine is actually doing some work measuring the release of methane from the permafrost. Some of the numbers that he’s come up with are also quite frightening. I guess I would refer your listeners to some of the National Geographic papers, I guess last summer was when they first started appearing that I noticed them. I think that they’re really fascinating.

Daniel Raimi: Great. Well, we’ll make sure to find some of those and put links to them on the webpage and on the show notes so people can look them up. With that, we’ll close it out and say, once again, thank you Dick for joining us on Resources Radio, talking to us about Chinese emissions trading system and your history of fishing and glaciers and all the other stuff we’ve talked about.

Dick Morgenstern: Great. Well, thank you very much, Daniel.

Daniel Raimi: You’ve been listening to Resources Radio. If you have a minute, we’d really appreciate you leaving us a rating or a comment on your podcast platform of choice. Also, feel free to send us your suggestions for future episodes. Resources Radio is a podcast from resources for the future. RFF is an independent nonprofit research institution in Washington, DC. Our mission is to improve environmental energy and natural resource decisions through impartial economic research and policy engagement. Learn more about us at rff.org.

The views expressed on this podcast are solely those of the participants. They do not necessarily represent the views of Resources for the Future, which does not take institutional positions on public policies. Resources Radio is produced by Elizabeth Wason with music by me, Daniel Raimi. Join us next week for another episode.

Morgenstern_5x7.jpgRichard D. Morgenstern

Senior Fellow

Raimi_8787_web.jpgDaniel Raimi

Senior Research Associate

Headshots-4.jpgElizabeth Wason

Managing Editor

This post was originally posted on resourcesmag.org:
https://www.resourcesmag.org/resources-radio/chinas-emerging-policies-emissions-reductions-dick-morgenstern/

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