As an important milestone in its progress on climate action, China's national exchange for carbon emissions trading began operations in 2021. The national carbon market celebrated its first anniversary in July and has now replaced the European Union Emissions Trading System — the EU ETS — as the world's largest carbon trading system by coverage, including over 2,000 companies in the power sector and involving more than 4.5 billion metric tons of carbon dioxide per year, said China's Ministry of Ecology and Environment.

Despite its sheer size, China's national carbon emissions trading market is still nascent and has much to learn from Europe's experience in developing a robust carbon market.

Over the years, emissions trading — a common method for countries to control and limit their emissions — has emerged as a key component of the global low-carbon transition campaign.

Established in 2005, the EU ETS is the largest cap-and-trade program in the world and covers around 40 percent of greenhouse gas emissions from the EU. The EU ETS is currently in its fourth phase, sets a single EU-wide cap on emissions and adopts auctioning as the default method for allocating allowances, instead of free allocation.

In contrast, China does not set an absolute cap for the national carbon emissions market. Instead, it allocates carbon allowances free of charge to each emissions entity based on a benchmarking method that compares the average carbon intensity of the power sector with that of an individual emissions entity.

This more lenient approach is crucial to the market's initial years of operation because it creates a more supportive market for emissions entities and also allows the market to test its infrastructure and collect trading data for future development. The intensity-based allocation method also creates incentives for power sector entities to run more efficient coal-fired plants over less efficient ones.

As China's carbon market grows, we expect the current allowance allocation policy will tighten up, shifting to a cap-based system over time and gradually reducing the proportion of allowances allocated free of charge.

The evolution of the EU ETS has shown that lowering caps for allowances and adopting auctioning as the main allocation method are the key drivers of carbon prices over the long run. It is understood that a key factor behind an effective carbon market is that the price of carbon allowances is high enough to incentivize emitters to reduce emissions.

The weighted average price of the China Emissions Allowance, or CEA, in the national carbon market was 43.85 yuan ($6.16) per ton for 2021, compared to the average EU Allowance (EUA) price of over 50 euros ($48.2) on the EU ETS for the same period.

Derivatives can play an essential role in carbon markets. The EU ETS is dominated by derivatives — it is estimated that around 85 percent of trades in allowances involve the use of derivatives in the form of futures, forwards and options.

Emissions entities subject to carbon compliance programs can use carbon derivatives to meet their obligations and manage risk in the most cost-effective way. A derivatives market will also contribute to significant capital raising and investing required to transition to a low-carbon economy.

Carbon derivatives are not new in China. A few pilot regional carbon exchanges in China already offer such products, including carbon swaps and carbon-linked bonds and structured deposits, although most are nonstandard products and of limited trading volume.

In its current phase, China's national carbon market only supports spot trading of CEAs, but as the market expands to include other entities — in particular, financial institutions — it is likely that a greater variety of products will be available, which could potentially include derivative products.

Importantly, the development of a futures market for carbon emissions is already underway. The Guangzhou Futures Exchange, the fifth futures exchange in China launched in 2021, has received regulatory support and is expected to launch carbon futures products later this year.

China's carbon futures market can also potentially learn from the EU's experience. As of the end of phase two of the EU ETS, the trading volume of EUA futures accounted for over 85 percent of the aggregate EUA trading volume and over 90 percent of the on-exchange trading volume.

Standardized carbon futures products play a major role in enhancing price transparency and discovery by providing forward information on carbon. The development of a carbon futures market is therefore an important step for China in ensuring a mature and fully functioning carbon market.

Looking at the longer term, China's carbon market can greatly benefit from the participation of international institutions.

A few of the existing pilot carbon trading markets in China allow participation of international institutions, but due to limitations in entry thresholds and cross-border flow of funds, carbon trading activities of foreign institutions have been limited. This, however, may change with the proposed creation of a unified carbon market in the Guangdong-Hong Kong-Macao Greater Bay Area.

Hong Kong, being a gateway between the mainland and international markets, has a unique role to play in this GBA platform.

Apart from direct participation of international institutions, the GBA carbon market could potentially be connected to the national carbon market to allow international institutions to trade on the national market through their accounts with the GBA carbon market — in some ways similar to the regimes of Stock Connect for A shares or Bond Connect for the interbank bond market, which have been established between Hong Kong and mainland exchanges.

A "Carbon Connect" mechanism can potentially bring the required funding for a more robust carbon market and also contribute to the internationalization of China's carbon market.

Developing a mature and effective carbon market is a complex endeavor, but many of the challenges are not unique to China. Many of the major emissions trading systems in the world such as the EU ETS have endured many twists and turns and could offer valuable lessons to the Chinese carbon market.

A closer partnership with global ETS operators will enable China to develop its own unique carbon market without having to move blindly every step of the way.