China relaxes compliance carbon market rules for coal-fired power plants

China has relaxed some of the rules under its national compliance emissions trading scheme for coal-fired power plants to reduce their financial burden after a year of record fuel prices and global energy disruptions.

The relaxation of some emissions obligations was in line with market interventions by other countries to cushion the impact of high fuel costs and ballooning losses at power utilities in the aftermath of the Russia-Ukraine war. It also signaled a temporary retraction from imposing carbon costs on energy companies.

China's environment ministry proposed the measures in the implementation plan for the second compliance period of the national ETS that covers emissions in calendar years 2021 and 2022, according to a notice issued March 15.

The key policies were -- setting a cap on the penalty for exceeding emissions targets, allowing power plants to borrow emissions allowances from future years to offset current obligations, tighter emissions benchmarks for coal-fired power plants and exemptions for gas-fired power companies.

"Capping the settlement obligations at 20% of verified emissions and allowing them to borrow from the 2023 allowance budget are two key measures introduced to ease the financial burden for coal-fired generators," said Feng Xiaonan, a senior research analyst with S&P Global Commodity Insights.

"In particular, the borrowing will help push some of the obligations into future cycles and give coal generators more time to restore their cash flows that have been heavily hit by the coal price surge," she said.

With coal prices already falling, policymakers are hoping that coal-fired power generators will be in a better financial position to handle their allowance deficits in the next compliance cycle, Feng said.

Coal-fired power plants are allotted a fixed volume of allowances called China Emissions Allowances based on their configuration, size and power outputs. These CEAs are surrendered to meet annual emissions targets and plants that exceed their permitted targets have to buy additional CEAs from the market.

"However, it remains to be seen how much borrowing will actually occur and whether this will lead to a tighter CEA supply in the next cycle," Feng said.

"Since those incurring the biggest deficits are also the ones that will be buying up the CEAs, capping their obligations will inevitably cast downside pressure on market liquidity and prices in the current compliance cycle," she added.

Tighter intensity benchmarks

China's carbon market is based on "intensity benchmarks" that refers to permitted emissions for each megawatt-hour of power generated. Some of these intensity benchmarks were tightened implying tightening emissions obligations.

"Free allowances will be tightened for all four groups of thermal generators compared with the first compliance cycle. However, the seemingly significant tightening mainly serves to eliminate the large allowance surplus in the previous cycle while still leaving the ETS market largely balanced," Feng said.

"This is because the benchmarks are either set on par, or only slightly lower than what otherwise will be needed to fully cover the thermal fleet's 2021 and 2022 emissions. We assess that the average deficit size will be just 0.7% for both 2021 and 2022 emissions, adding very limited cost at a system level," she added.

"Having said this, the marginal tightening will nonetheless push the least efficient generators into the deficit zone and expose them to much higher cost penalty," Feng said.

Market participants have previously said that China's carbon market has not imposed strict emissions targets or penalties, due to which companies are not compelled to trade CEAs leading to low trading volumes and liquidity in the compliance market.

Even the CEAs borrowed from future compliance periods should only be used to satisfy obligations instead of trading purposes, the government said in the plan.

This long-awaited implementation plan was designed cautiously to maintain continuity of the ETS without putting too much pressure on coal-fired power companies that are yet to resolve their financial problems.

Emissions benchmarks for coal plants in China's compliance carbon market:

(Unit: mtCO2/MWh)

*Unconventional refers to coal gangue or coal water slurry

Source: Ministry of Ecology and Environment

Markets were looking to the latest implementation plan for clarity on whether unused CEAs from the previous compliance period can be carried forward to the next compliance period. The environment ministry said this will be announced in a separate document. Carry forwards will increase CEA supply and pressure the carbon price.

Relatively loose benchmarks had resulted in many companies accumulating surplus CEAs. For example, the five largest state-owned power groups or "Big 5" have large surpluses totaling 16.2% for Huadian Group, 10.5% for China Energy Investment Corp, 10.4% for Huaneng Group, 9.5% for Datang Group and 8.4% for State Power Investment Corp, according to data from China's Tianjin University.

The daily average CEA price was Yuan 56/mtCO2e ($8.12/mtCO2e) on March 16, official exchange data showed.