China lays foundation for compliance carbon market financialization, but policy uncertainties remain

China has started to differentiate emission allowances in its national compliance market by vintages, laying the foundation for financial derivatives, but the financialization of the market remains a massive puzzle amid crucial pieces missing, especially long-term policies and concrete timelines for key developments.

From Aug. 28, the Shanghai Environment and Energy Exchange, or SEEE, which hosts the trading system of China's national compliance market, announced to begin labeling vintages of the emission allowances, called CEAs.

The vintage of a carbon asset refers to the year in which it was issued. In other more mature markets, products with the newest vintage labels usually enjoy a price premium, as they represent either the most recent emission rights in a compliance market or the latest decarbonization efforts in a voluntary market.

China's compliance carbon market currently follows a two-year, retrospective compliance cycle.

In the first cycle, compliance entities were required to surrender CEAs equivalent to their 2019 and 2020 emissions by the end of 2021. In the second, ongoing compliance cycle, they are required to surrender CEAs equivalent to their 2021 and 2022 emissions by the end of this year.

Accordingly, SEEE introduced three vintage labels: 2019-2020 vintage for all CEAs left from the first compliance cycle, 2021 vintage and 2022 vintage for CEAs issued for compliance years 2021 and 2022, respectively.

"It sends the market a signal that vintages are not truly fungible. And it also provided better transparency of market supply/demand and trading activity of different vintage CEAs," said Caroline Zhu, senior analyst with S&P Global Commodity Insights.

The government has yet to set any restrictions in terms of whether CEAs from former compliance cycles can be carried forward. For this cycle, compliance entities have been allowed to surrender 2019-2020 CEAs for their emissions in 2021 and 2022, according to a government announcement in July.

Zhu said the new rules send a market signal that carbon allowances with certain vintages may not always be fully tradable at all times. They also provide better transparency of supply, demand and trading activity of CEAs with different vintages, she added.

She said in the long term, the market expects restrictions on whether CEAs from certain years can be carried forward from years of surplus to years of deficit. These restrictions could include limiting the use of vintages to certain years or not allowing carry-over altogether. So far, the market lacks visibility as details on how vintages will be dealt with have not been announced and there's no clear timeline for such an announcement, she added.

The SEEE's move, which is expected to stop compliance entities from relentlessly hoarding their outdated CEAs, has stimulated their interest in strategies and tools that can hedge against price volatility in the long run, market participants said.

"Vintage-specific trading lays the foundation for a potential futures market and the entry of financial players in the national CEA market," said Bai Bo, chairman and co-founder of Singapore-based exchange MetaVerse Green Exchange.

The government has appointed Guangzhou Futures Exchange to develop futures products for emission allowances. Although the China Securities Regulatory Commission has approved several securities companies to trade CEAs, they need to wait for another approval from the Ministry of Ecology and Environment. There are no clear timelines for both agendas.

Insignificant price spreads

Despite some arbitrary price spreads observed right after SEEE's announcement about vintage-specific labeling, the price spreads among different vintages have become insignificant in recent trading days.

As of Sept. 19, daily weighted average prices were Yuan 75.08/mtCO2e ($10.47/mtCO2e) for 2019-2020 CEAs, Yuan 75.30/mtCO2e ($10.50/mtCO2e) for 2021 CEAs, and Yuan 75.01/mtCO2e ($10.46/mtCO2e) for 2022 CEAs, SEEE data showed.

Theoretically, sellers in the CEA market should ask for a higher price for their newer vintages, as those are more likely to be allowed to use in future compliance cycles and help them cope with risks of supply shortages and price volatility.

However, a meaningful price spread can only be formed with a clearer policy signal, market participants said, especially whether the oldest, 2019-2020 CEAs can still be carried forward to the next compliance cycle.

In line with SEEE's move, the government is constructing a policy about whether and how CEAs can be carried forward in the future, which is expected to be released soon, local media Eleven Finance Men reported Aug. 29.

Even with policy ambiguity and lags, compliance entities have shown preferences in terms of how to manage their CEAs of different vintages, according to a report from CSC Financial, one of the securities companies approved by CSRC to trade CEAs.

2019-2020 CEAs are likely to be prioritized for trading and meeting compliance obligations in this compliance cycle, while 2021 and 2022 CEAs may be kept for future use, CSC Financial said.

The emerging CEA-specific studies from potential financial players also indicate their growing interests, driven by recent market developments and liquidity boom.

According to Bai, 2021 and 2022 CEAs may still be allowed to be carried forward to the next compliance cycle.

"Considering the MEE retrospectively granted compliance eligibility to the oldest 2019-20 vintage [for this compliance cycle], it is difficult to imagine that the MEE would not grant the potential surplus CEAs from the current 2021 and 2022 vintages compliance eligibility for at least the next compliance cycle," Bai said.

From Aug. 28 to Sept. 15, the three-week CEA trade volume totaled 27.03 million mtCO2e, up nearly 300% from the total trade volume in the last three weeks over Aug. 7-25, before the vintage labels were introduced.

Zhu said the move of SEEE has contributed to the recent improvement in market liquidity, as it made some compliance parties increase their sales of older-vintage CEAs held by them with the concern that those may not be carried over in the future.