What will financial institutions do to China’s carbon market?

Li Gao, the vice minister of ecology and environment, hopes to see a first group of financial institutions trading on China’s national carbon market by the end of the year.

At the moment, market participants are mainly heavily emitting firms required to surrender enough carbon allowances to cover their emissions. So far, institutions such as banks have only been able to provide associated financial services to those traders.

If financial institutions begin buying and selling carbon allowances directly, what will it mean for the market? What challenges might lie ahead? Dialogue Earth spoke to the experts and compared it to how things work in Europe.

Why add financial institutions to the carbon market?

Many of the experts said financial institutions are being brought in to add liquidity to the market, to help companies manage carbon assets, and to improve the accuracy of carbon-pricing signals.

The major emitters the carbon market is made up of are obliged to cancel enough carbon allowances to cover their emissions, usually once a year. They’re not doing so to make money but to balance their carbon books. Their trades therefore cluster around the compliance deadline, or in line with internal accounting periods. This means buyers and sellers are often looking to trade at different times.

He Qing is carbon finance director for Guotai Haitong, one of the first securities companies to be granted a carbon trading licence. He told Dialogue Earth that financial institutions’ most important role will be to provide extra liquidity by acting as a buffer between supply and demand.

“Once there’s more liquidity, we’re likely to see price fluctuations ease,” he said.

More liquidity will also help price-discovery mechanisms, so prices better reflect supply and demand. He Qing said the carbon price isn’t just reflective of companies’ compliance costs – it also informs their investments in cutting emissions. “Price discovery will help companies decide, for example, whether or not to buy new technology and to calculate the return on investment once the purchase is made,” he said.

Alongside making for a more efficient market, financial institutions can also help companies participate on that market – particularly smaller business which might lack the necessary expertise. Qin Yan, chief analyst for carbon markets consultancy ClearBlue Markets, said that on mature markets like the European Union’s, financial institutions play an important role by providing market access and agency services.

She explained that many companies don’t have dedicated teams tracking carbon prices, and some can’t make the trades they need themselves. For example, a company might need 1,522 tonnes of carbon allowances when carbon is traded in units of 1,000 tonnes. A financial institution could split trades up to meet those specific needs.

Chen Zhibin is senior manager for carbon markets and pricing at Adelphi, a think-tank headquartered in Berlin, and a member of the secretariat of the International Carbon Action Partnership. He says financial institutions can act as “market-makers”, providing supply and demand when needed and so reducing irrational behaviour.

“Investment institutions will always want to sell what they’ve bought, so they help lubricate the market,” he said.

Some companies hold on to carbon allowances because they lack the skills to trade them or fear they may need them in the future, he elaborates. This reduces liquidity on the market. But a financial institution, trading for profit on the market, needs to be making ongoing trades and will serve as middleman between different companies.

How will it work?

Experts told Dialogue Earth they expect financial institutions to invest on their own account and also provide services on behalf of clients.

He Qing said the first ones working on the carbon market are very likely to be banks and securities traders using their own funds.

Alongside that profit-driven trading, they could also make trades on behalf of clients. For example, if a company expects to need carbon allowances in a future compliance period, the financial institution could buy and hold those, with the trade completing when the allowances are needed. This avoids the company having to pay higher prices in concentrated trading around the compliance deadline.

On the European market, financial institutions provide a wider range of risk-management tools. Companies can use futures contracts to manage carbon costs, explains Qin Yan. An industrial firm could, for example, buy futures contracts across the course of a year, rather than purchase all its carbon allowances at once at year’s end. Banks can also design structured products combining spot and futures purchases to help companies spread risk.

Chen Zhibin says financial institutions could help companies push carbon costs into supply chains. For example, long-term contracts in the steel and shipping sectors could include carbon prices as part of their costing, allowing companies to better manage their carbon spending. “Institutions can help companies come up with ways to put the cost of carbon into the cost of the end product. For example, special long-term carbon price contracts or locking in long-term costs, so long-term carbon prices are included in contracts,” he said.

A steel production line in Dazhou, Sichuan province. Long-term contracts in the steel and shipping sectors could include carbon prices, helping companies to manage their carbon spending (Image: Xinhua / Alamy)

What changes will financial institutions bring?

The experts say the financial institutions will not only bring more trading, but also changes to how the market operates.

He Qing says the most direct impact will be in greater stability, which “can arise from liquidity”. When markets are busier, the carbon price will more accurately reflect supply and demand, sending a clearer signal to companies on how they should be investing in emissions reduction.

Qin Yan pointed out that financial institutions may change how companies think about carbon allowances. Traditionally, these purchases have been seen as a cost arising from regulatory requirements, while companies that cut emissions can profit by selling surplus allowances. With financial institutions on the scene, however, allowances may increasingly be seen as an asset that companies can manage more actively and strategically, she explains.

But some interviewees pointed out that bringing financial institutions on board won’t automatically remove risk. The biggest concern is how to prevent manipulation of the market.

He Qing said the market is still quite small, and financial institutions have significant financial resources. If regulation is lacking, a small group of institutions could coordinate trades to manipulate prices. Regulators may therefore choose to put restrictions on the proportion of the market that a single institution can hold, as well as the trade sizes, and require financial institutions to put their own risk-management mechanisms in place.

Another challenge, according to Qin Yan, is that regulators themselves will need to adapt to the changes financial institutions bring. She pointed out that carbon markets aren’t just about financial trades. By putting a clear price signal on emissions, they can create incentives for companies to cut emissions, contributing to national emissions targets, so there needs to be a balance between liquidity and risk.

Chen Zhibin stressed that welcoming in financial institutions will require multi-agency cooperation.

“More financial institutions trading on carbon markets is bound to require cooperation between regulators. It can’t be managed just by one agency,” he said. Currently, carbon markets are overseen by the Ministry of Ecology and Environment, which is expected to need to cooperate with financial regulatory bodies.