Balancing Emissions Trading with Overlapping Policies: Lessons from China's Climate Strategy

The World Bank's paper analyzes the impact of overlapping policies, like renewable energy subsidies, on emissions trading systems, finding that while such overlaps can reduce costs, they may introduce inefficiencies. The study emphasizes the need for integrated policy design to enhance economic efficiency and effectively reduce emissions, particularly in China's climate strategy.

In a recent study by the World Bank’s Development Economics Research Group, economists Carolyn Fischer, Chenfei Qu, and Lawrence H. Goulder explore the intricacies of emissions trading systems (ETS) when combined with other environmental and energy policies, focusing on China's climate policy. The paper delves into how various jurisdictions manage emissions using different forms of ETS and how these systems interact with additional policies like renewable energy subsidies and electricity consumption taxes.

Expanding Beyond Traditional Cap-and-Trade

Traditionally, emissions trading has been managed through cap-and-trade (CAT) systems, where a fixed cap is placed on total emissions and emission allowances are traded, allowing prices to fluctuate based on market conditions. These systems ensure that emissions remain within a predetermined limit, with prices adjusting to reflect the cost of abatement. However, the authors extend the analysis to include rate-based emissions trading systems, which are becoming increasingly popular. These systems, unlike CAT, allow for flexibility in both emissions quantities and prices, which vary depending on economic activity levels. This flexibility makes the interactions between overlapping policies and ETS more complex and less predictable.

The Complex Impact of Renewable Energy Subsidies

The paper’s theoretical model focuses on the electricity sector, a critical area given its significant contribution to global greenhouse gas emissions. The model demonstrates how overlapping policies can lead to different outcomes depending on the type of ETS implemented. For instance, when a renewable energy subsidy is introduced, it generally lowers emission prices across all types of ETS. However, its impact on emissions can vary significantly. Under a cap-and-trade system, the total emissions remain unchanged because the cap is fixed. The subsidy, in this case, only affects the price of emissions allowances. In contrast, under a uniform sector-wide performance standard (USPS), which mandates a specific emissions intensity across the entire sector, the same subsidy could lead to an increase in emissions. This occurs because the subsidy reduces the cost of renewable energy, leading to an overall increase in electricity production, which, under the USPS, translates into higher total emissions. Conversely, under an emitter performance standard (EPS), which only regulates high-emitting sources and excludes renewables, the subsidy could lead to a decrease in emissions. In this scenario, the subsidy encourages a shift from high-emission sources to renewables, thus reducing the overall emissions.

Applying the Theory to China's Climate Policy

The paper goes beyond theoretical analysis by applying a numerical general equilibrium model to assess the impact of overlapping policies on China’s planned ETS, which is primarily a differentiated emitter performance standard (DEPS). China’s national ETS, introduced in 2021, initially covers the electricity sector and is expected to expand to other industries, eventually encompassing most significant energy-intensive sectors. The model simulates how different overlapping policies might affect emissions, production, prices, and costs within this framework.

Significant Cost Reductions Through Policy Overlaps

One of the key findings is that the overlapping policies currently in place in China, such as renewable portfolio standards and electricity consumption taxes, could significantly reduce the cost of achieving emissions reductions. Specifically, the paper finds that these overlaps could lower the cost per ton of emissions abatement by 20-30% under China’s current DEPS. Further optimization, such as aligning renewable energy targets more closely with emissions reduction goals or transitioning to uniform benchmarks for emitting power generators, could yield additional cost savings of 10-15%. Despite these potential benefits, the research concludes that a cap-and-trade system without overlapping policies would likely be the most cost-effective approach overall. This finding highlights the potential inefficiencies introduced by overlapping policies, even when they are well-intentioned.

Navigating the Future of Climate Policy Design

The paper’s insights are particularly relevant as China and other jurisdictions continue to refine their climate policies to meet increasingly ambitious emissions reduction targets. The research suggests that while rate-based ETS systems offer flexibility, they also introduce complexities that can lead to unintended consequences when combined with other policies. Policymakers must carefully consider these interactions to design systems that maximize economic efficiency and effectively reduce emissions. The study ultimately calls for a more integrated approach to policy design, where the choice of ETS and overlapping policies are considered together rather than in isolation. By doing so, jurisdictions can better navigate the trade-offs involved and develop more cost-effective strategies for mitigating climate change.