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The latest World Bank report on carbon pricing indicates that the world's emissions trading schemes (ETSs) are currently worth about US$30 billion (ref. 1). These ETSs create a market in which the rights to emit greenhouse gases (GHGs) are traded among GHG-emitting entities. The trading of emissions allowances or credits in these carbon markets creates a price on carbon and can help mitigate GHG emissions at lower costs. The world's largest carbon market is built on the European Union (EU) ETS, with an emissions cap of 2,084 Mt of CO₂-equivalent (CO₂e) in 2013. China houses the second largest one, covering 1,115 MtCO₂e (ref. 1).

China pledges to reduce its CO₂ emissions per unit of GDP by 40–45% by 2020 (compared with 2005 levels), embarking on one of the largest endeavours in tackling climate change. In 2011, China announced a plan to introduce mandatory ETSs to support GHG mitigation. Seven cities and provinces were appointed across the country to implement pilot emissions trading. These pilot sites are located in various parts of China — Beijing, Tianjin, Shanghai, Chongqing, Shenzhen, Guangdong and Hubei — with different economic structures and development trajectories. By June 2014 all seven pilot ETSs had started trading at varying trading prices and levels of activity (Table 1). The first pilot phase is expected to complete at the end of 2015 or 2016; it is intended to build experience and provide lessons for moving towards a national cap-and-trade system in the coming years.

Carbon markets should provide favourable conditions and incentives for financial institutions to offer financial services and produce new products. Yet there is a feeling among the industry representatives that the Chinese authorities are reluctant to open up the market to financial institutions, due to risk control considerations. The institutional environment is deemed to be not adequately supportive.

Local governments are primarily responsible for designing and implementing the pilot ETSs. The problem is that not many government officials have adequate knowledge and relevant expertise in managing trading activities and the market generally. Financiers possess the expertise required to offer advice, but few of them have been brought into the decision-making process that determines how the ETSs will be set up and operated. It is not clear whether financial institutions have made significant contributions to institutional development. In comparison with the Western carbon markets, the level of finance involvement is relatively low in China.

Some of the impediments are related to the top-down approach by which the ETSs are set up. In Europe, pro-trading business coalitions played a decisive role in in the establishment of the EU ETS. In contrast, the Chinese carbon market is established and managed by administrative means, rather than being driven by businesses' voluntary commitments to GHG mitigation⁸. Most of the firms affected by the ETSs are large state-owned enterprises; they are generally willing to reduce their polluting operations to lower costs of production and cooperate with regulators⁴. Although the new policies and regulations have created some market demand for emissions allowances and credits, these firms concentrate on complying with regulatory requirements and have poor sense of comprehensive corporate carbon management and low interest in trading emissions credits as a form of financial investment. As a result, corporate demand for advanced financial services linked to emissions trading is weak. Many financial institutions, notably banks, lack motivation to engage with the domestic carbon markets.

In addition, current policies unnecessarily reduce profitable investment opportunities. For example, futures markets account for a much larger share of global carbon trades than spot markets do. The former involve the trading of futures contracts, which allow delivery of a commodity (for example, carbon credits) at a specified price and time in the future, whereas the later involve immediate delivery at a given price. However, only spot markets are currently allowed to operate in China. The spot markets are less attractive to financial service providers and investors, because they do not allow them to gamble on prices going up or down in the future and increase profit margins by speculation and risk-taking. This significantly reduces incentives for making financial investment in the carbon markets⁹. From a financial point of view, therefore, the limited trading opportunities are the main problem, rather than the lack of expertise on the part of financial institutions themselves. As one of our interviewees put it “The problem is not actually with financial institutions, but with the scale of the market being too small to attract financial institutions”.

Low liquidity is currently the main weakness of the Chinese carbon market. The market scale has been compromised by weak corporate demand and excessive regulatory constraints. The variety of trading options and the number of trading partners are limited. Consequently, the Chinese carbon market remains narrowly defined and small, relative to other businesses and trading opportunities, and is still in a pilot phase and subject to future policy change. Expectations of low rates of return and policy uncertainties have reduced the motivation of investors and financial service providers to participate in emissions trading.

A robust financial system is essential for a carbon market to thrive. Low-carbon projects and technologies are capital-intensive and typically have long payback periods. Both initial costs and investment risks are high. The government is in a position to provide short-term solutions to the shortage of domestic finance for GHG mitigation. In the past few years, the Chinese government has made massive investments in developing renewable energy sources and improving energy efficiency⁷. To leverage these successful official efforts, more private capital should be identified and mobilized, and eventually given a central role in financing GHG mitigation. For example, banks need support from government, in the form of subsidies or tax benefits, to low their risks in providing low-carbon finance to firms. Carbon emissions disclosure systems should be established to help investors and banks assess the risks of investment in low-carbon projects. Professional training is needed for corporate environmental managers and technical bureaucrats to build capacity in emissions control, monitoring as well as trading emissions credits. The carbon market should be made open to a variety of trading options, such as futures contracts, to promote financial product innovation and attract capital.

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