Weekend Long Read: Enabling Market-Driven Pathways for Net-Zero Ambitions

There are eight key issues to address on the way to reaching the climate goal, with incentive mechanisms like carbon markets playing a particularly important role

At the United Nations Climate Change Conference (COP27) held in Sharm El Sheikh, Egypt, last November, a significant milestone was achieved with the establishment of the Loss and Damage Fund. However, conference attendees only made limited progress in boosting global ambitions in the fight against climate change.

This development reflected the current priorities of governments, corporate strategies, and the challenges inherent in pursuing climate goals within a framework of multiple objectives. For China, the journey to attain its “dual carbon” goals is a complex endeavor that necessitates carefully charted paths to ensure energy security and mitigate the impact on regions and communities affected by the transition.

This report, written by the Boao Research Institute, addresses eight key issues on enabling an effective path to achieving net-zero emissions. It attempts to explore the use of incentive mechanisms, particularly carbon markets, in search of better ways to reach net zero.

Choosing a path

One approach is to adopt dynamic programming to design macro-level carbon neutrality pathways and establish a roadmap with a specific timeline. Utilizing dynamic programming allows countries to break down their emission reduction targets into those for critical years based on optimality principles. In order to solve the optimization problem and calculate the social carbon cost, these targets need to be added as constraints on traditional GDP growth targets.

However, it's important to acknowledge the inherent complexity of real-world scenarios. Any future breakthroughs in key energy technologies could significantly reduce carbon reduction costs.

Furthermore, financial markets play a pivotal role in funding the pursuit of carbon neutrality. Achieving carbon neutrality requires sector-specific planning, with the energy sector at its core. In 2021, the International Energy Agency (IEA) outlined road maps for the energy sector to reach net zero, including electricity generation as well as three major energy end-use sectors — industry, transportation and commercial and residential property. In China, a “1+N” policy framework for carbon peaking and carbon neutrality has been established. The “1” represents top-level design policy documents setting the main targets for 2025, 2030, and 2060, while “N” includes implementation plans for subsectors and industries, including energy and transportation.

Moreover, residual emissions need to be considered for the net-zero pathways, which can be accomplished by analyzing how much carbon will still be emitted after achieving the carbon neutrality target.

This involves research and development (R&D) and investment in technologies that will absorb future residual carbon emissions, which can in turn affect the design of emission reduction pathways. According to calculations by researchers at Tsinghua University, from 2019 to 2060, the share of fossil fuels in China’s energy mix will fall from 85% to 13%. During this period, coal usage will drop significantly while a share of natural gas and oil will remain.

In addition, if the emission reduction efforts of developing countries progress at a slower pace, developed countries must accelerate their actions to ensure the 1.5 C target is achieved.

At the national level, three main approaches are available to achieve net-zero goals: self-awareness, administrative planning, or market mechanism. Despite current unresolved long-term issues, there will be a need for a carbon market mechanism. Recent experience indicates that most commercial entities lack the internal drive and external constraints and monitoring mechanisms required to act independently. And administrative planning does not accurately reflect market prices, which may lead to distortions and ineffective implementation.

The market mechanism can guide enterprises to reduce emissions, upgrade to cleaner technology and achieve the low-carbon transformation. However, market mechanisms face complex issues. In reality, there are two main reasons for the lack of effectiveness in China’s carbon market mechanisms: low carbon prices that do not truly reflect the social carbon cost, and interference in transmitting the carbon price to end consumers.

A difficult balance

Addressing climate change and transitioning to net zero requires balancing economic development with the low-carbon transformation.