Analysis and Implications of China’s Carbon Trading

MEN Ming, ZHANG Qiu-li, ZHU Song-ge University of International Business and Economics

Beijing, 100029, China Abstract—With "Kyoto Protocol" gradually take force, carbon trading was born and developed rapidly. In contrast to prior studies on China's carbon emissions trading, we conduct a systematic research. First of all, we analyze the status of China’s carbon trading. Second, we explore the production function model for relevant carbon trading and analyze the advantages and disadvantages of the carbon trading production function. Finally, based on the above discussion, several policy implications are exploited from four different perspectives, to promote the development of China’s carbon trading.

Key Words— Carbon Trading, CDM, Carbon Emissions Reduction, Putty-Clay Vintage Model

I. INTRODUCTION

It has been the consensus of the world to promote carbon emissions reduction, develop low-carbon economy and achieve sustainable economic development since various extreme weather events frequently occurs. Carbon trading serves as the core economic instrument to reduce carbon emissions. By closely integrating climate change (a scientific issue), carbon emissions reduction (a technical issue) and sustainable development (an economic issue), carbon trading applies the market mechanism to manage the comprehensive issue. On February 16, 2005, “Kyoto protocol” took effect. CDM (Clean Development Mechanism) is one of three flexible mechanisms set by the "Kyoto Protocol". Under CDM, firms and government agencies in developed countries assuming the obligation of emissions reduction can cooperate with developing countries in projects by technology transfer or capital investment to offset the amount of emission reduction with CERs (Certified Emission Reductions). Developing countries can sell their emissions reduction to developed countries since they are not obligated of reducing emissions before 2012. China is currently the world's second largest emitter of greenhouse gases, which also means a large potential for emission reduction. Besides, the reduction cost in China is relatively low. However, as the world's largest supplier in the

This paper is sponsored by Scientific Research Construction Projects of Beijing Municipal Education Commission "Carbon Credit Trading Mechanism and Development Strategy" , and Postgraduate Innovative Research Fund of University of International Business and Economics.

international carbon trading market, China is still involved on the stage of CDM projects and enterprises can not participate in secondary market of carbon emission allowances. Moreover, China does not have a domestic trading system, which is not conducive to compete in the international carbon market pricing. Thus, to reduce CO2 emissions fundamentally and save energy, China needs to build the platform and encourages enterprises to trade in the internal carbon market.

In this paper, we conduct a systematic research on China's carbon trading. Section II sets a brief review of relevant literatures. In section III, we study the carbon emissions trading production function model and make a brief comment on the model. Finally, several policy implications are explored in promoting healthy and sustainable development of China’s carbon trading market.

II. LITERATURE REVIEW

Following an early theoretical discussion of sewage drainage trading theory (Dale, 1968), quite a large number of domestic and foreign scholars have conducted research on carbon emissions trading.

On theoretical level, Croker (1996) presented the possibility of applying property rights to air pollution prevention and established the theoretical basis for carbon emissions trading. Stavins (1995) examined the trading issues of emission allowances when considering the transaction costs, believing that deal costs can decrease trading efficiency. Wolf Fichtner (2006) measures the various effects of carbon trading by creating an European energy model. As “Kyoto Protocol” took effect since 2005, the global carbon trading grew rapidly as a result of the three flexible trading mechanisms. At the same time, several literatures began to focus on the carbon trading mechanisms. These include Sven Bode (2006), Cames and Weidlich (2006), Grubb (2004), Neuhoff (2006) discussing trading mechanisms design in developed countries; and M. Germain et al.(2007), Wang et al.(2005), Li (2006) specifying on the problems of using CDM in China and other developing countries. They all argue that CDM provides a good opportunity for both the developed and developing countries to reduce emission and get a sustainable development. To make a profit in carbon trading, firms should deal with the production maximum problem with the lowest

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cost. However, previous researches are done from the macroscopic perspective. Little attention has been payed to the construction of firms’ production model. We address the research gap, introducing the Putty-Clay Vintage model and exploring how it can be applied to China’s carbon market.

III. PUTTY-CLAY VINTAGE MODEL

A flexible market mechanism encourages firms to produce fewer emissions by investing in more efficient technologies. It is worth to explore a production function for such firms with relevant new input variables. In this section, we introduce the production model of carbon emissions trading that originally created by Peter L, Sandra W (2006). The key purpose of doing this is to initiate applications of the model to China’s carbon trading.

Studies on the Putty-Clay model have arising ever since Leif Johansen created the model in 1959. Leif Johansen (1959) divided production functions considering technology investment into two different forms: the ex ante production function (Putty) and the ex post production function (Clay). Johansen believes that there are substitution possibilities between capital and labor in the Putty function, which is widely used to the long-term production planning of firms. The corresponding point is that, in the short term, firms produce with existing technology and a constant series of procedures and there are no ex post substitution possibilities. Namely, in the short-term, firms choose the optimal output in order to achieve profit maximization.

By combining the Vintage production function and Putty-Clay model, Peter Letmathe and Sandra Wagner point out that technical progress rates, timing of investment and prices of allowances play an important role in defining the optimal strategy of firms in order to cope with emissions trading. The essence of the model is that each emission unit generates costs equal to the value of the equivalent allowance. Therefore, carbon trading has the similar impact as a change of price ratios between capital and labor on firm’s production. Short-term production planning deals with the adoption of market signals by optimizing the utilization of existing technologies. From the long-term perspective, certain influential factors such as innovation of new knowledge and investment or capital accumulation play an important part in promoting a firm’s technical progress. As stated above, we will analyze the model in the short term and the long term, respectively.

A. Short-term production model

In the model, we assume that: the firm is producing with existing technology; the firm produces a single product in one period only; the period can be divided into several sub-periods, τ = 1，2，…, D. To obtain profit maximization, the firm

identifies the product quantities τx in sub-periodτ to make the difference of revenues and costs—including the costs of emissions trading— reach its maximum. If iq represents the input factor quantities and ir the corresponding factor prices, then the cost of factor inputs is

∑=

=I

iiiqrR

1

, i =1，2，…，I (1)

When a firm is obliged of reducing carbon emissions, the costs of emissions trading may come from three parts: the firm’s costs of reducing carbon emissions by themselves, the expenditures of buying additional allowances and the penalty costs when the firm’s emissions exceed the given amount. We assume that there are N types of carbon emissions. The first part of the emissions trading costs can be calculated as the total amount of emission n ne times the selling price np per unit of emission n. If the firm has to buy additional allowances ne~ , it can purchase them at the price nn pp ~+ . If the firm’s emissions of a given type exceed the given allowances plus the amount ne~ , it will have to be penalized at nn pp

~~+ for the amount of emissions ne~~ , which

constructs the penalty costs. We also need to note that, the factor costs of the input factor as well as the fixed costs FC and the costs of emissions trading should be subtracted from the revenues represented by the revenues function as )( τxR to get a firms’ profit.

With the given parameters and the decision variables, subjected to necessary constraints, the function of profit maximization for one period consisting of the sub-periodτ can be expressed as follows:

Max ∑∑∑===

×+×+×−−−N

nnnnnnn

I

iiiF

D

epepepqrCxR111

)~~~~~~()(

ττ

ts. nnAnn eeee

~~~ ++≤

∑∑∑

∑∑ ∑

== =

= = =

×+×××

+××=

D

n

P

p

DTPPnp

I

i

P

p

D

pFTipnin

xdzxac

yabe

11 1

1 1 1

ττττ

τ

ττ

∑=

=P

ppz

1

1τ

ττ ii qq ≤

0≥τpz (2)

B. Long-term production model

In the long run, technical progress plays an important role in the production. When it comes to the decision making regarding emissions trading, it is helpful to take into account the Vintage Production Function (VPF) and Putty-Clay model. As Solow hypothesis suggests, with different level of technical progress at hand, the same quantities of input factors can produce varying output quantities. What’s more, the current ratios between input factors and embodied technical progress should be considered. Suppose price ratios of input factors change unexpectedly, optimal investment in machines will change correspondingly. According to the above statement, emission trading affects factor prices with the consequence that the unit price of CO2 influences long-term decision making as well. So, we can take the Cobb-Douglas production function here to explain the long term production planning. We assume that technical progress can be expressed by the form βτe with βe representing the technical progress rate per period andτ the period. In accordance with the usual expression, we express the elasticity of production factors i as iα . Then, a Vintage Production Function can be expressed as follows

∏=

×××=I

iij

irrex2

101 ααβτ

τ α

0,11

≥≤∑=

i

I

ii αα ( i=1，2，…，I ) (3)

According to Solow’s hypothesis, for each vintage and type of technology, there exist different production functions. If technologies of different vintages and types can be separated, their outputs can be added. Then tx will be obtained:

∑ ∑ ∏−

−= = =

×××=1

1 210

1

t

Tt

J

j

I

iit

irrexτ

ααβτα (4) The long-term production model has shown the high

degree to which production planning and investment decisions are connected. Using the function of profit maximization in the short-term production model and adding the investment costs jtjt Cg * ( jtg the number of units of technology j purchased in period t and jtC the costs for each unit). The present value PV of a set of different investments can be calculated:

⎥⎥⎥⎥⎥⎥⎥

⎦

⎤

⎢⎢⎢⎢⎢⎢⎢

⎣

⎡

−

×+×+×−

−

⎟⎠

⎞⎜⎝

⎛ −×−×−

= ∑∑

∑

=

−=

−=

T

t

t

N

nntntntntntnt

t

I

iFtjtjtititt

i

epepep

i

CgCrqxR

PV1

1

1

)1(

)~~~~~~(

)1(

)(

The maximization problem can be expressed as follows:

PVMaxtx (5)

ts. ntntAntnt eeee ~~~ ++≤

tn

P

pptnp

I

iitnint xdycrbe ×+×+×= ∑∑

== 11

In the long-term production model, firms can choose to invest in new technologies and technical progress can be embodied in a wider range of operating procedures.

C. Comments on the model

Within the context of global carbon trading, firms need a theoretical model to take the carbon emissions reduction costs into account when making optimal production planning. Putty-Clay Vintage Model fills this vacancy. It gives a method to measure the three different parts of the costs of carbon trading-- The trading costs of emission allowances, the cost of buying additional emissions and the penalty. Then, the adjusted total cost is obtained by adding the costs of carbon emissions trading with other fixed and variable costs. This will be more in line with the actual situation of the firms and help them develop an efficient production planning.

However, there are still some shortcomings in the model. As the model is the amendment and development of the Putty-Clay Model under the emerging carbon trading market, the applicability and accuracy are major issues to consider. First, due to the complexity of the problem, it seems not able to get a specific solution at present. Second, measuring the carbon emissions costs accurately or making optimal planning is often subjected to a large number of constraints. Therefore, how to solve this complex optimization problem provides a new field for researchers concerned carbon trading.

IV. POLICY IMPLICATIONS

The Putty-Clay Vintage model is a theoretical innovation in carbon trading. With regard to applications of this model to China's carbon trading, we try to explore the following policy implications.

For one thing, from the production point of view, firms can use this model to conduct the input-output and cost-benefit analysis. To accelerate their growth in the time of low carbon economy, firms could choose the optimal carbon-trading volume and amounts of products to maximize short-term and long-term profits. China is currently the world's largest supplier of CDM projects and has a low cost of carbon emission reduction. Market mechanism is the best way to allocate social resources, so China should make effort to reduce carbon emissions and develop its low-carbon economy through market mechanism. The production model clearly reveals that carbon trading can bring lower reduction cost, which encourages firms to reduce emissions by standard carbon trading. As China is not obliged of emissions reduction before 2012, similar system as EU ETS is difficult to establish. But, there is conducive to the formation of China's voluntary emissions reduction market (VER). With the rapid increase of

Chinese economy, more firms and individuals have strong sense of social responsibility. The VER platform provides them with such an opportunity. By trading in VER market, firms can transform their responsibility into the firm value.

Secondly, from the perspective of the financial markets, the model can serve as a basis for the pricing of carbon emission allowances. According to cost-based pricing theorem, the costs of carbon emissions should be the basis for pricing carbon emission allowances. As the prices of various carbon emissions financial derivatives are based on spot prices of carbon allowances, a scientific and reasonable price of carbon emission allowances is an effective guarantee of a healthy carbon trading market. The development of carbon trading market can be divided into three phases: the project phase, commodity phase and the phase of carbon finance. At present, China’s carbon trading market is still in the project phase, while the United States and Europe are already in the phase of carbon finance. Moreover, the current carbon trading price per ton in China is 2 to 3 euro less than in India and less than half of the price in Europe. This implies that China must establish its own trading standards and make effort to win more power in pricing carbon emission allowances in the market.

Thirdly, for macro-economy development, the government should improve the efficiency of social resources allocation by taking into account the comprehensive economic, social and environmental factors as well as developing the low-carbon economy. The industrial economy in China is now experiencing unprecedented growth. The fast growing economy has resulted in excessive consumption of resources and deterioration of the environment. Therefore, how to develop the economy harmoniously is the major concern of China. Traditional resource allocation does not consider the destruction of industrial pollution on the environment. As a negative economic externality, air pollution reduces the whole allocation efficiency to some extent. When we take the environmental factors into account, emissions allowance as a kind of scarce resource can be traded in the market. Coase theorem shows us that, carbon trading can integrate the social resources and make the external costs internalized, which contributes to the overall allocation efficiency.

Finally, in the aspect of quota allocation, it has been shown that the initial allocation of emission quotas will significantly affect the transaction efficiency. The emission costs consist of the information costs and implementation costs. Firms can determine the cost of reducing emissions based on this model much more accurately, which is also helpful for the government to allocate quotas fairly. Once the initial quotas are determined, firms will decide the trading size of allowances according to their own abatement costs and

the market price. Through emission trading, the difference between the individual abatement cost and social cost (the market value of emission allowances) are almost diminished so that the allocation is the most effective.

To sum up, we hold the following opinion for the future prospect of carbon emissions reduction business in China: the dispute arising from international negotiation on climatic cooperation will not alter the fact that the practical application of global emission reduction is based on the market transactions that are economical, applicable and create win-win situation. No matter how fierce international society disputes are, market-oriented emission reduction trading mechanism has to be utilized to minimize the costs involved in emission reductions and maximize the emission reduction goal. “Survival of the fittest applies to the market as well and after what the market has been through, some genuinely powerful and influential organizations involved in emission reductions in China are going to accomplish better development, making contributions to the business of dealing with global climate change.”

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