In Depth: How China Plans to Harness Market Forces for Carbon Neutrality

Chinese authorities are gradually shifting from policy incentives to market forces to encourage the financial sector’s support of greener growth as the country’s push toward carbon neutrality creates new investment opportunities.

China’s top leadership set ambitious goals to address climate change. President Xi Jinping pledged in September that the world’s biggest producer of carbon dioxide — the chief greenhouse gas contributing to global warming — aims to top out such emissions before 2030 and achieve carbon neutrality by 2060. The target will require the transformation of the world’s second-largest economy to a low-carbon growth pattern.

While using industrial policies to advance changes, China’s push to revamp its massive heavy industries also needs strong financial support not only from the state but also from private sectors. According to Goldman Sachs, China will need to invest $16 trillion in new energy and pollution control-related projects over the next 20 years to reach its carbon neutrality goal. At least 75% of the investments should come from private sectors, the investment bank said.

China is already the world's largest green financial market. By the end of 2020, the country had outstanding green loans of nearly 12 trillion yuan ($1.85 trillion), ranking first in the world. The outstanding value of green bonds was 813.2 billion yuan, the second-most in the world. Meanwhile, financial products marketed in the name of greener growth, such as insurance, trust and investment funds, have thrived.

Large-scale state-owned enterprises are major players in China’s green financing market, partly reflecting their obligations to meet corporate responsibility and environment criteria, analysts said.

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In early February, six Chinese state-owned utilities and infrastructure companies issued the nation’s first batch of carbon-neutral bonds totaling 6.4 billion yuan. Proceeds from the borrowings will be used to fund green projects to reduce greenhouse gas emissions, including photovoltaic solar electricity panels, wind power, hydropower and green buildings.

Investors such as insurers, banks, wealth management firms, funds and securities companies have an appetite for the bonds, said Hu Kun, general manager of the investment banking and asset management department at Bank of China, one of the underwriters. Some offshore institutional investors also participated in the placements, Hu said.

China should cultivate the green financing market to lure more investors and encourage large asset managers such as sovereign wealth funds and pension funds to take part, said Chen Wenhui, vice chairman of the National Council for Social Security Funds.

But there are also concerns that the growing enthusiasm may brew market bubbles. Axel Weber, chairman of UBS Group, said high demand for green investments reflects insufficient supply of high-quality assets. Meanwhile, due to a lack of clear standards and adequate disclosure, some projects behind investment products that are marketed as environmentally friendly are misleading or hyped.

With a growing supply of green assets, the market will return to normal, Weber said.

Investments in green projects need to be rational, said Wang Xin, research chief at the People’s Bank of China. That will require thoughtful policy setting and adequate information disclosure to allow the market to play its role in resource allocation, Wang said.

Fledgling carbon trading

A key strategy for reducing emissions of carbon dioxide is to cap carbon emissions with regulations and allow businesses and institutions with unused carbon quotas to sell them. This puts a price on carbon dioxide emissions and creates a powerful financial incentive for reducing them.

Starting this year, China for the first time asked domestic companies to buy and sell emission quotas on a unified national carbon market as the world's largest carbon trading market started its first “compliance cycle.”

But compared with a mature market such as the European Union, China’s carbon market lacks active participation by financial institutions. The main obstacles include a lack of market liquidity, lack of transparency of information and unstable carbon quotas and policies, a financial institution source said.

There are still debates in China over whether carbon quotas should be traded as financial assets or as commodities. Each would be subject to different supervision and regulatory requirements.

According to documents on carbon markets (link in Chinese) issued Jan. 5 by the Ministry of Ecology and Environment, carbon emission rights are regarded as commodities. However, market participants say that as the market matures, demand for financial derivatives and investors from other fields will make carbon emission rights more like securities.

“We can put aside the dispute and let the market start running first, and then slowly adjust regulations,” one official said.

Regulatory preparations are already underway. In October 2020, the Ministry of Ecology and Environment, the National Development and Reform Commission, the People’s Bank of China, the China Banking and Insurance Regulatory Commission, and the China Securities Regulatory Commission jointly issued a guideline (link in Chinese) encouraging institutional and individual investors to take part in carbon trading. The guideline supports institutions to develop financial products and other derivative products related to carbon emission rights, and it explores the establishment of carbon investment funds.

In January, the Guangzhou Futures Exchange won approval to become the country’s first new futures exchange in 14 years. According to the plan for the new exchange, the bourse will be the first venue to trade in carbon futures.

The central bank in its fourth-quarter policy report said China would further promote carbon trading while developing financial instruments and mechanisms for the market.

"Environment and financial authorities have reached a consensus to trade carbon emission rights as financial assets as of the fourth quarter 2020,” said Sun Rui, managing director of the Green Finance Center and senior adviser of the Paulson Institute. “It is time to launch related products and derivatives.”

Sun said it is necessary to send clear policy signals to the market while working out a detailed timetable to expand carbon trading to more emitters. She also suggested that the carbon market open up and attract more foreign investors.

Sun Mingchun, the chief economist of Haitong International, said that if Chinese financial institutions enter the carbon market, they can account for 10%–15% of trading volume, helping to activate the carbon market and optimize pricing. An active market will have a great impact on new-energy companies and high-emission companies, he said.

Contact editors Han Wei (weihan@caixin.com) and Bob Simison (bobsimison@caixin.com).

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