Compliance emission trading schemes have the potential to help Asian countries unlock hundreds of billions of dollars to finance their decarbonization, but the premise is to set long-term, absolute caps of their emissions, Alistair Ritchie, Director of Asia-Pacific Sustainability, Asia Society Policy Institute, told S&P Global Commodity Insights in a recent interview.
Ritchie is an international expert in ETS design. He has led the European Commission's projects to support ETS development in South Korea and China.
Except South Korea, absolute ETS caps have not been introduced in the rest of the Asian markets, notably China, Japan and Indonesia, Ritchie said. For upcoming markets, Vietnam plans to set an absolute cap, but India may introduce a mechanism based on carbon intensities.
"Really the fundamental problem is the cap setting. It's the ambition of the cap setting, and it's the long-term visibility of the cap setting...In most ETS in Asia, there isn't [such visibility]," he highlighted.
"There's no reason why you can't have an absolute cap, even if emissions are still growing. Turkey is planning to have an absolute cap, even though it's not yet peaked. You can set the cap higher than the current emissions. South Korea's caps went up, because South Korea peaked in 2018, but it started its system in 2015."
The common concerns were whether capping emissions would hinder economic growth, and whether a right cap can be found amid unpredictable economic shocks, he pointed out. However, if designed scientifically, a cap-and-trade system will be able to address these concerns, he emphasized.
"What you do need to do is have the flexibility mechanism to deal with economic shocks, like the market stability measure," he explained. EU ETS has a Market Stability Reserve for its cap-and-trade system, which balances the supply and demand of carbon allowances amid unexpected shocks.
"In a proper ETS, you also have a new entrance reserve. You have a reserve of allowance for new companies and new factories," he said, addressing the concern over slowing economic growth. He said EU and South Korea both have such reserves.
"So, it's a fallacy. It's wrong to think the absolute cap is anti-growth. It's not," he said.
Liquidity issues
One of the key issues in most compliance markets is the shortage of liquidity as market participants lack longer-term visibility on their emissions obligations.
Introducing a firm, long-term cap that goes beyond 2040 gives companies the certainty and confidence to make more informed decisions for both investments in emission allowances and decarbonization technologies. This also incentivizes more robust trading and liquidity, Ritchie pointed out.
In the absence of a long-term emissions goal, market participants hoard emissions allowances and carry them over to the next trading cycle, a practice called allowance banking. ETS regulators also end up resorting to short-term solutions like restricting allowance banking, instead on focusing on long term goals.
Ritchie said South Korea had attempted to improve ETS market liquidity by restricting allowance banking, which resulted in oversupply and a significant price decline. In China's latest ETS plan for 2024-2025, a similar restriction was introduced.
South Korea had an ETS price of around KRW 40,000/mtCO2e or $30/mtCO2e back in 2019, similar to the current price increase that China is talking about, but the prices could be artificially high because nobody is selling, Richie said.
"But it [restricting allowance banking] is not addressing the fundamental problem of market participants wanting long-term certainty in the market direction," he said, emphasizing the importance of setting long-term caps.
Political pressure
He said another reason that hinders Asian countries to set an absolute cap is political pressure, especially when the ETS is supervised by a country's environment ministry.
"In most jurisdictions, the environment ministry is not the most powerful ministry compared to finance, strategy and industry," he said, adding that other ministries may have different priorities, such as economic growth and energy security, leading to inevitable conflicts.
"In China, an intensity-based cap -- my understanding is that it is politically motivated. It's easier politically to persuade other ministries to introduce the ETS if you have an intensity-based system."
South Korea has managed to address such conflicts through intensive negotiation and highest-level political supports, he shared.
Power sector challenge
Most global ETS markets focus on power sector emissions due to its large share of emissions and relative ease to decarbonize. But power markets in Asia are closely linked to political and social issues, significantly complicating the implementation of long-term emissions caps.
In some Asian countries, such as Indonesia, costs of emissions cannot be reflected in electricity prices, Ritchie said. Their rigid power market structures hamper setting of absolute caps because ambitious targets impose a financial burden on generation utilities, he added.
"The solution to the Indonesian problem is to pass at least some of the costs to electricity consumers and then power plants can start to make the targets tightened," he said.
China's power market reform has nurtured a spot market and enabled generation utilities to pass some costs of emissions to electricity users, he highlighted.
When electricity prices go up, it is important to support vulnerable communities, he said, adding that the EU's social climate fund is an example of solutions.
