On June 18 China’s pioneering city of Shenzhen is set to notch up another first. From that day 635 companies in the Shenzhen Special Economic Zone—which in 1979 became the vanguard for China’s capitalist revolution—will start using carbon markets to help meet greenhouse gas emissions targets.

This year, alongside the cities of Beijing, Shanghai, Tianjin and Chongqing as well as the regions of Guangdong and Hubei, Shenzhen is imposing greenhouse gas targets on hundreds of companies, ranging from power plants to airport operators. The goal is to develop a national carbon market over the next decade that could help put the brakes on the world’s largest carbon dioxide emitter.

“China has internationally pledged 2020 climate targets,” observes Chai Hongliang, an analyst at Thomson Reuters Point Carbon, an Oslo-based information-provider specializing in carbon markets. He is referring to a commitment first made by China ahead of the 2009 Copenhagen climate talks to reduce its economy’s overall carbon emissions per unit of GDP to 40 to 45 percent below 2005 levels by 2020. “It has two ways to reach the target: shut down factories in the last months of 2020 or use more market-based approaches like emissions trading,” Chai adds.

As with emission-trading programs elsewhere, polluters in China’s pilots have two options: First, they can meet their targets by reducing their own emissions—by investing in energy efficiency, say, or curbing production. Alternatively, they can buy carbon allowances or credits from companies that have spare allowances or from projects elsewhere in China.

Shenzhen faces the toughest target. The companies in its pilot emitted the equivalent of 31 million metric tons (Mt) of CO2 in 2010. They will be allocated around 100 Mt of allowances for the duration of the three-year trial, although expected economic growth means they will have to reduce their carbon intensity by an estimated 30 percent by 2015 compared with 2010.

Balancing the need for economic growth with carbon control is a challenge. Emissions in China are expected to rise for years, given the importance China’s political elite continue to place on economic growth. Some observers question how much pressure China’s planners are prepared to put on its big emitters. The pilots set emission limits from January 2013 through the end of 2015. “I think the emissions caps will be relatively lenient,” Chai says.

Certainly the regulators will be eager to avoid any “carbon leakage”—that is, driving industry out of their jurisdictions through imposing too stringent targets ahead of any national program. But at this point Chai can only speculate about their stringency. Limited information is available about participating companies, their historical emissions—and even the rules under which the pilots will operate. And part of the reason is that some of these data do not exist.

The problem with data
To run effectively markets rely on an unimpeded flow of information, clear rules and rigorous oversight. China could both benefit from the lessons of earlier efforts, such as Europe’s flagship carbon market—the world’s largest, known as the European Union Emissions Trading System, or ETS. It is under fire from some environmentalists because of its relatively lax targets and low carbon prices, along with its vulnerability to fraud and abuse.

For the regulators drawing up targets, “there are existing processes and mechanisms on energy consumption which could be drawn on, as well as local exercises in creating GHG [greenhouse gas] inventories,” says Lina Li, a Beijing-based carbon markets expert at Netherlands-based consultancy Ecofys. Her firm has advised local regulators and international donors on creating carbon market regulations and infrastructure in China. “But there are still challenges regarding emissions data at the company level.”

This is exactly where the E.U. was in 2005, when it embarked on the pilot phase of its ETS—and the lack of emissions data allowed companies to game the system. E.U. governments asked companies to provide their own, unverified historical emissions data, and many inflated their numbers so as to claim more free allowances from government. This practice created an overhang of surplus permits that led to a price collapse in 2007.

Generous allocations of allowances are probably inevitable as the price paid for industry acceptance, however, suggests Karl Upston-Hooper, legal counsel of GreenStream Network, a Finnish carbon asset manager that is active in China. “You will struggle to find an ETS that is not overallocated” in its early phases, he says. Indeed, he argues that the pilots in China are less about creating carbon markets and more about gathering data. “I’ve taken the view that they’re implementing an emissions-monitoring system, not a carbon market—and I’m okay with that as a first step on the road.”

Most observers—including from the environmental movement—are prepared to give China’s regulators time to get things right. “It is our view that the first step for Chinese ETS is to get the system right from the beginning—the trading platform; the monitoring, reporting and verification system; [emissions] inventories; getting companies informed and cooperative—and gradually shift toward more stringent caps,” says Li Shuo, a climate and energy campaigner for Greenpeace East Asia. Plenty of studies see China’s emissions peaking by 2030. Some are more optimistic: recent ones predict 2025 to 2030.

A further data challenge is whether China’s regulators will be sufficiently transparent and even-handed when it comes to the country’s carbon markets. “In Europe and elsewhere, ETS data are under public scrutiny. That may not be the case in China,” says  Point Carbon’s Chai.

Another concern is insufficient coordination among the seven pilots, Li says. Indeed, rivalry exists among the various authorities, with Beijing deliberately encouraging a degree of “policy competition” to test differing approaches to see which works best.

Last, despite a recent announcement by the powerful National Development and Reform and Commission (NDRC) that it is to propose a national carbon cap for China’s next five-year plan, which runs from 2016 to 2020, a national Chinese carbon market is not assured. Other methods could prove more effective. “In China the ETS is not the only tool,” says Wu Changhua, Beijing-based Greater China director of the nonprofit Climate Group. She notes that the nation’s finance ministry is promoting a carbon tax whereas other government ministries are considering a system for crediting and trading energy-efficiency improvements.

Wu also cautions that international media speculation around the introduction of a national carbon cap by 2016 is overblown. She argues that the NDRC is agitating for the inclusion of the concept in the next plan to ensure resources are available for more research and policy development. “One thing is for sure,” she adds. “The political leadership in China is much more serious, stronger and determined to tackle environmental problems. But it will be a journey. We’re not going to get there immediately.”