Energy Economics 81 (2019) 741–753

Contents lists available at ScienceDirect

Energy Economics

journal homepage: www.elsevier.com/locate/eneeco

China's emissions trading system and an ETS-carbon tax hybrid☆

Jing Cao, Mun S. Ho ⁎, Dale W. Jorgenson, Chris P. Nielsen
Harvard-China Project on Energy, Economy and Environment, United States of America

a r t i c l e i n f o a b s t r a c t

Article history: China is introducing a national carbon emission trading system (ETS), with details yet to be finalized. The ETS is
Received 7 August 2018 expected to cover only the major emitters but it is often argued that a more comprehensive system will achieve
Received in revised form 17 March 2019 the emission goals at lower cost. We first examine an ETS that covers both electricity and cement sectors and con-
Accepted 30 April 2019
sider an ambitious cap starting in 2017 that will meet the official objective to reduce the carbon-GDP intensity by
Available online 7 May 2019
60–65% by 2030 compared to 2005 levels. The two ETS-covered industries are compensated with an output-
JEL classification:
based subsidy to represent the intention to give free permits to the covered enterprises. We then consider a hy-
C68 brid system where the non-ETS sectors pay a carbon tax and share in the CO2 reduction burden. Our simulations
H22 indicate that hybrid systems will achieve the same CO2 goals with lower permit prices and GDP losses. We also
H23 show how auctioning of the permits improves the efficiency of the ETS and the hybrid systems. Finally, we
Q48 find that these CO2 control policies are progressive in that higher income households bear a bigger burden.
Q54 © 2019 Elsevier B.V. All rights reserved.
Q58

Keywords:
Emission trading
Carbon tax
Energy modeling

1. Introduction
In its Nationally Determined Contribution (NDC) coming out of the
Paris Agreement reached at the 21st Conference of the Parties (COP-
21) of the United Nations Framework Convention on Climate Change
in 2015, the Chinese government set a goal to cut CO2 emissions per
unit of GDP by 60 to 65% by 2030, compared to 2005 levels. In 2016,
the government also announced the 13th Five-year Plan with the
goals to reduce energy per unit GDP by 15% between 2015 and 2020
and to reduce CO2 per unit GDP by 18%.
In the years since COP-21, China's government has signaled its inten-
tion to introduce a national Emission Trading System (ETS) for carbon as
part of its efforts to meet these CO2 targets, finally announcing plans for
a first phase in December 2017. The ETS will require certain enterprises
to obtain permits for their CO2 emissions, including purchasing them
from carbon markets. China currently has pilot ETSs in seven regions and
☆ This project is supported by the Harvard Global Institute under an award to the
Harvard-China Project titled China 2030/2050: Energy and Environmental Challenges for
the Future. Cao is supported by the National Key Research and Development Program of
China under grants 2016YFA0602604 and 2017YFA0603600, National Natural Science
Foundation of China (project 71461010701), and a Volvo Group project at the Research
Center for Green Economy and Sustainable Development, Tsinghua University.
⁎ Corresponding author at: Harvard-China Project on Energy, Economy and
Environment, Harvard John A. Paulson School of Engineering and Applied Sciences, 29
Oxford St., Cambridge, MA 02138, United States of America.
E-mail address: munho@seas.harvard.edu (M.S. Ho).
the national system is intended to expand on and supersede this earlier
CO2 control effort. Various national ETS proposals of the powerful National
Development and Reform Commission (NDRC) have been discussed in the
media and by experts advising the government over these years. The ear-
liest proposals suggested a system with a first stage that would cover the
largest emitting enterprises in eight of the most energy-intensive sectors:
electricity, petroleum processing, ferrous metals, non-ferrous metals, non-
metallic mineral products (cement), chemicals, paper and aviation. Enter-
prises that emit more than 26,000 tons of CO2-equivalent would be
covered; the emissions from enterprises in these eight sectors are esti-
mated to be about 45–50% of national emissions (Zhang, 2015). In this am-
bitious early thinking, expansion of coverage would occur in a second
stage, beginning as early as 2020. A May 2017 draft submitted by the
NDRC suggested a more cautious approach of including only three indus-
tries in the first phase: electricity, cement and aluminum electrolysis.1 The
plans ultimately announced by NDRC in December 2017, however, indi-
cated that the ETS would begin only in the electric power sector, given
the continuing challenges of obtaining accurate data for the other sectors
(Feng, 2017). That announcement did not specify a date when the national
ETS might begin, nor give the details about the exact rules and allocation
formulas. It should be noted that responsibility for carbon control and
the ETS have been transferred from the NDRC to the expanded
1
See the NDRC draft plan translated by GIZ (2017) and discussed in Buckley (2017).

https://doi.org/10.1016/j.eneco.2019.04.029
0140-9883/© 2019 Elsevier B.V. All rights reserved.
742 J. Cao et al. / Energy Economics 81 (2019) 741–753
environment ministry in March 2018, when the government reorganiza-
tion renamed it the Ministry of Ecology and Environment.
There is now a sizable literature on the general design and operation
of an ETS and analyses of the impacts, including a big subset that focuses
on China-specific issues. Jiang et al. (2016) survey the China ETS litera-
ture, discussing mechanism design, linkages with other energy policies
and institutional issues, and summarizing papers simulating the ETS im-
pacts. The complexities of an ETS have been much discussed (for exam-
ple, Climate Reality Project, 2017), and for China these would include
the regional equity effects noted by Wu and Tang (2015) and Fan
et al. (2016). The interaction of the ETS with other policies is a major
concern; Baron et al. (2012) and Teng et al. (2014) discuss how the
ETS interacts with electricity sector reform, while Dai et al. (2018) dis-
cusses the interaction with renewable energy targets.
Many parallel policies have to be chosen to implement an ETS; these
include the size of the cap, the share to be allocated free or auctioned,
the formula to allocate free permits, the use of auction revenue and pen-
alties for non-compliance. Tang et al. (2016) examine some of these par-
allel policies using a CGE model of China after summarizing other earlier
analyses of the China ETS. Zhang et al. (2018) compare the effect of allo-
cating free allowances based on historical emissions versus CO2 emission
intensity. The proposed system in China uses intensity targets instead of
an absolute cap on emissions, which has raised some concerns about
the ability to reduce emissions. Weng et al. (2018) suggest the use of a
carbon price floor to ensure a minimal level of emission reduction. Lin
and Jia (2017) examine the impact of covering different sets of industries
in the ETS with carbon prices ranging from US$10–57 per ton by 2030.
Prior to the detailed discussion of a national ETS, China introduced
seven provincial and city-level pilot trading programs in 2011, each
experimenting with different policies and structures in parallel. Many
papers have now described and analyzed their operation: Zhang et al.
(2014) give a good summary of the early progress of the pilot system
and Wu et al. (2016) is an analysis of the Shanghai ETS showing how
it lowers the carbon price dramatically compared to a no-trade scenario.
Yu et al. (2018), using the same model of Shanghai (and rest-of-China),
examine the impact of different methods of allocating allowances to
each sector, finding carbon prices as high as US$160 per ton.
Even if the challenges to implementation of the national ETS,
reflected in the recent reductions of scope and repeated delays in its
rollout, can be addressed, the most ambitious of the proposals to date
would cover only about 50% of national CO2 emissions. Many policy an-
alysts have argued that covering more sources of emissions would be
more efficient (e.g., Lin and Jia, 2017), allowing the burden to be shared
more equally and finding the lowest cost method of reducing national
emissions. It would also reduce the unfair treatment producers of the
same product might experience, since smaller firms are exempted
from the emission permit requirements. Emission trading systems
throughout the world are almost always restricted to the largest firms
to avoid having small firms incur the costs of accounting for emissions
and learning to trade in complex markets.
One way to extend the coverage of CO2 limits, and limit the admin-
istrative burden of the ETS, is to have a carbon tax for sectors outside the
ETS. Such an ETS carbon-tax hybrid system might be complicated, but
already exists in some form. The California cap-and-trade system is an
example of an ETS with an implicit carbon price for those outside the ex-
plicitly regulated entities. There, distributors of natural gas and trans-
portation fuels are required to obtain permits for the fuels they sell,
which means that all users of these fuels, not just the large enterprises
in sectors covered by the ETS, face a carbon price. Combining this feature
and the fact that California uses little coal, its cap-and-trade system is
expected to cover some 85% of state CO2 emissions.2
2
Climate Reality Project (2017) gives a good description of the California system as well
as a comprehensive discussion of carbon pricing instruments. See also Hsia-Kiung and
Morehouse (2015).
Given the much greater reliance on coal in China, a hybrid system
there would be more complicated than the California system if is to
achieve similar coverage. It would have to impose a carbon price on coal
(in addition to oil and gas) that is purchased by entities not covered by
the ETS. One way would be to impose an upstream carbon tax on all fossil
fuels, with an exemption for the sectors covered by the ETS. Such a hybrid
ETS carbon-tax system would encourage the smaller enterprises, house-
holds and government agencies to conserve energy. It is likely that many
smaller units would be able to cut their first ton of emissions at a lower
cost than the last ton cut by the large enterprises under the ETS. In that
case, the total national cost of meeting a particular cap would be lower.
The aim of this paper is to compare the economic costs of
implementing an ETS with the costs of a hybrid ETS carbon-tax system
that achieves the same level of CO2 reduction. This contrasts with
much of the literature that has examined only the ETS, as cited above,
or simulated pure carbon taxes in China, as reviewed in Nielsen and
Ho (2013) and Zhang et al. (2017).3 There are fewer papers considering
a mixed policy system. Shi et al. (2013) compare an ETS covering five
sectors with a pure carbon tax and a hybrid system where the tax is
fixed at 40 yuan per ton, finding that the GDP losses are slightly smaller
in the hybrid system where a small part of the burden is shifted off the
ETS sectors. Bi et al. (2018) compare a mixed system with a pure ETS
that starts with the electricity sector and expands to cover seven others,
using a model that incorporates short-run unemployment effects. Their
framework sets the carbon tax at 25 yuan/ton and assumes that the ETS
will stimulate increased energy-saving innovation while the carbon tax
will not, and thus the ETS policy has the lowest cost. Sun (2014) also
considers a hybrid system, discussing this in the context of duopolistic
markets and not using an economy-wide model.
Our approach to comparing a hybrid system with a pure ETS is to care-
fully impose the same national emission reduction under the two policies,
making welfare comparisons straightforward. This is achieved by using an
endogenous carbon tax rate and adjusting the CO2 cap on the ETS sectors
in the hybrid system compared to the cap under the pure ETS. Our setup
contrasts with both the Shi et al. (2013) and Bi et al. (2018) analyses that
impose fixed carbon tax rates, which result in different reductions in CO2
emissions under the three pricing alternatives – pure ETS, pure carbon tax
and hybrid ETS-tax system – making it harder to draw inferences from
their comparison. The endogenous tax rate in our hybrid system is chosen
to harmonize the carbon price in ETS and non-ETS sectors to equalize
their burdens, resulting in smaller GDP losses compared to a hybrid sys-
tem with two carbon prices. Different carbon prices on ETS versus non-
ETS sectors would lead to inefficient carbon abatement and need to be
carefully justified. Our approach also incorporates the requirement that
ETS firms obtain permits for CO2 embodied in their electricity consump-
tion, a feature designed to encourage electricity conservation. These pre-
vious hybrid modeling exercises did not discuss the effect of permits for
CO2 embodied in electricity inputs.
We begin our comparison with an ETS that begins in 2017 and is im-
plemented through 2030, covering two sectors mentioned in the May
2017 NDRC draft: electric power and cement. (Inclusion of the former
was officially announced in late 2017, as noted, and addition of the latter
to the ETS first phase is now being considered.) In the hypothetical hy-
brid systems that we compare to the ETS by itself, we add a carbon tax
on fossil fuels at a rate set to equal the price of the emission permits.
This carbon tax is payable by all non-ETS sectors, including households.
We do not include other industries in the ETS during our period of anal-
ysis (2017–2030) since the official plans have not specified any date for
extension beyond the December 2017 announcement.
3
Zhang et al. (2017) discuss carbon leakage and competitiveness; Liang et al. (2007)
discuss exemptions for trade-intensive sectors to reduce the competitiveness effects of
carbon taxes; Lu et al. (2010) discuss the effect of combining a carbon tax with cuts in in-
direct taxes; Jiang and Shao (2014) discuss the distributional impacts; and Guo et al.
(2014) estimate that an 81 yuan/ton tax is needed to reduce emissions by 20%.
 J. Cao et al. / Energy Economics 81 (2019) 741–753
Because a hybrid policy incorporates the ETS, how the latter is struc-
tured will affect the outcomes of both carbon pricing policy options.
While the complex details of a national ETS have not been made official,
we consider three features that have been discussed by the NDRC and
advisors to the government.4
First, we assume in all policy cases that the quantity of allocated per-
mits will be based on carbon intensities. In the government proposals, the
coal generators will be divided into classes and each generator will be al-
located permits based on the carbon intensity of the most efficient gener-
ators in its class. In our model simplification we compute the historical
average intensity of the entire sector and allocate permits based on that.
Second, we consider the effects of counting the CO2 embodied in elec-
tricity consumed by the covered sectors under the cap coupled with an
output subsidy to the electricity sector, versus not counting the embodied
CO2 and removing the output subsidy. This feature is proposed for the ETS
because the government wants covered enterprises to incorporate the
shadow carbon price in their electricity use decisions even though actual
electricity prices are not expected to change under the ETS because gen-
erators are given free emission permits. This choice of requiring
embodied-CO2 permits, or not, has a particularly large impact for hybrid
policies since electricity is used by every sector and the cost of electricity
depends on the subsidy. We thus focus on comparing this condition—in-
cluding or not including electricity subsidies—in the hybrid scenarios.
Third, we consider free allocation versus partial auctioning of
emission allowances. Our initial cases (both ETS-only and hybrid) as-
sume that enterprises subject to the CO2 cap are allocated free quotas
of permits, which we represent as subsidies to output, throughout
the entire 2017–2030 policy timeframe. This means that the pur-
chasers of electricity and cement are cushioned from the full impact
of the carbon price. While this aspect reduces opposition to the plan
(and is common in the initial years of other ETS programs around the
world), it significantly reduces the incentives to conserve electricity
and cement. Our final policy cases replace 100% free allocation with
partial auctioning of permits, in a share that rises linearly over time
to 100% in 2030.
To heighten the contrast between the two carbon policy approaches,
we consider an ambitious emission cap that would achieve a 62.5% re-
duction in carbon intensity in 2030 compared to 2005, the midpoint of
China's 60–65% commitment under the Paris Agreement. In the ETS-
only case, 2030 CO2 emissions compared to the base case would decline
950 million tons (or 20.6%) in the two covered sectors and 1000 million
tons (7.7%) in the economy as a whole. This target requires an extremely
high carbon permit price of 570 yuan/ton in 2030 and the impact on
GDP is −0.26% in that year.
When we combine the ETS with a carbon tax in a hybrid system that
has the same total national CO2 emissions in 2030, i.e., a reduction of
1000 million tons, the required carbon price (now both permit price
and carbon tax) is only 90 yuan/ton and GDP loss is a smaller 0.13%. In
this hybrid system the two covered sectors need to reduce emissions
by only 290 million tons instead of 950 million, spreading the burden
of meeting the national targets much more evenly. In all our cases, the
tax revenue and any auction revenue are completely recycled by reduc-
ing existing taxes.5
4
While the discussions during the planning stage include various flexible versus fixed
cap options and different rules about ex-post versus ex-ante adjustments for the quotas
given to each enterprise (see Pang and Duan, 2016), we analyze a simple system. The dis-
cussions of the various options deal with the real-world issue of uncertainty about output
levels for the economy and for each firm, i.e., how a flexible system would allow a minimi-
zation of costs in an uncertain environment at the expense of some slippage in meeting the
emission target. In our model there is no uncertainty so the issues about ex-post or ex-ante
adjustments are not relevant.
5
The issue of efficient recycling of carbon tax revenues has been discussed extensively
(e.g., Babiker et al., 2003 and Jorgenson et al., 2013 generally, and Nielsen and Ho, 2013 for
China); this literature showed how reducing existing tax rates is more efficient than lump-
sum transfers to households or firms. To keep the focus of this paper on other objectives
we use only one approach to revenue recycling: reducing current taxes on capital, value
added and output.
743
The benefits of a carbon price have been discussed along addi-
tional dimensions, including consideration of immediate local envi-
ronmental benefits in addition to the long-term impacts on risks of
climate change. For example, Nielsen and Ho (2013) estimate the
impact of a carbon tax on reducing local pollutants, improving air
quality and reducing health damages. In this paper we focus on the
economic impacts and emissions and leave these health benefit cal-
culations for future work.
2. Carbon policy assessment methodology
2.1. Defining the carbon pricing policy scenarios
The ETS that we simulate here covers the electricity and nonmetallic
mineral products (NMM) industries; cement makes up a large part of
the NMM sector and henceforth we use the more familiar term “ce-
ment” to represent NMM. For simplicity we cover the entire industries
instead of just the large enterprises. Our model has only one electric sec-
tor that includes all generation types and distribution; the impact of car-
bon prices on generation choice happens through substitution in the
industry production function in our China economic model.
The ETS requires covered units to obtain permits for the CO2 emis-
sions from fossil fuels and also, in our main case, the CO2 embodied in
the electricity used. The embodied carbon requirement is included be-
cause the ETS scheme does not anticipate significant changes in the
price of electricity due to the free allocations, and is designed to create
an alternative incentive to conserve electricity. The ETS also requires
the cement sector to have permits for process emissions (i.e., those
not from combustion of fuels but from chemical conversion in the
cement-making process, which are significant). On the compensation
side, our initial assumption is that no permits would be auctioned
through 2030, instead allocating them gratis to firms (an assumption
that we vary in later scenarios). The government ETS proposals set the
number of free permits by “benchmarking” CO2-intensities, i.e., based
on the CO2 emissions per unit output of the most efficient units in
each class of producers. We do not attempt to estimate this benchmark
but instead calculate the average emission intensity and apply it to the
output in the current year. This acts effectively as an output subsidy.
Some of the ETS proposals include rules about banking and borrowing,
and what offsets may be allowed. These rules are important in actual
operations, but in our simplified model with no uncertainty, the bank-
ing, borrowing and offset rules are less important and are ignored; we
assume that the number of permits allocated and submitted in any
year is exactly equal to emissions in that year.
The above assumptions form our main ETS scenario, labeled “ETS-
NoA” (for “No Auction”) in Table 1. Since the proposals do not give an
explicit target for the cap, as noted we chose one that would generate
a reduction in the 2030 national carbon intensity of 62.5% compared
to 2005 levels, based on China's NDC under the Paris Agreement. This
means that the national CO2 emissions in 2030 are lowered to 11,940
million tons compared to 12,940 in the base case. Using a simple search
procedure, the cap turns out to be 3670 million tons of CO2 for the two
ETS sectors compared to 4620 in the base case. The cumulative emis-
sions over 2017–2030 for the ETS sectors are 61,350 under the cap com-
pared to 69,040 in the base case. This is a huge burden to put on the two
ETS sectors alone, but a more reasonable burden if distributed across the
economy in the hybrid cases discussed below.
The emission caps are shown in detail in Table 2. In the hybrid
system we impose a carbon tax on all fossil fuels, where the tax
rate is set equal to the permit price in the ETS market. All sectors out-
side of the ETS, including the household sector, are required to pay
the carbon tax. The level of the cap for the ETS-sectors is set such
that the national emissions under the hybrid policy are equal to the
pure ETS case in all years (10,950 million tons in 2017). Since the
non-ETS sectors are now obliged to pay a carbon price in the hybrid
cases the burden on the ETS sectors is reduced and they are allowed
744 J. Cao et al. / Energy Economics 81 (2019) 741–753

Table 1
Carbon policy cases compared.

Scenario Auction of permits Permits required for Carbon tax on non-ETS Revenue offsets National CO2 ETS sector CO2
electricity inputs sectors 2030 2030

Base N.A. N.A. 0 N.A. 12,940 4620

ETS-NoA No Yes 0 Output subsidy 11,940 3670
Hybrid-NoA-Emb No Yes CO2 tax = permit price Output subsidy; VAT, capital tax cut 11,940 4330
Hybrid-NoA-NoEmb No No CO2 tax = permit price Output subsidy; VAT, capital tax cut 11,940 4290
ETS-A Yes Yes 0 Output subsidy; VAT, capital tax cut 11,940 3660
Hybrid-A-Emb Yes Yes CO2 tax = permit price Output subsidy; VAT, capital tax cut 11,940 4250
Hybrid-A-NoEmb Yes No CO2 tax = permit price Output subsidy; VAT, capital tax cut 11,940 4260

Note: CO2 emissions in million tons.

to emit more CO2 than in the pure ETS case, 4330 instead of 3670 mil- permit price or that of the previous year is not so important to our
lion tons. results.
Like any other real-world market for ordinary goods, in the actual In an actual market there is also uncertainty about future prices.
operation of the ETS markets the permits are traded continuously and Firms may adopt strategies to deal with this uncertainty including
prices change constantly. Our model of the economy is on an annual stockpiling permits or even choosing different technologies. This is an
scale, describing annual output and annual average prices. We thus as- important but complex issue and has to be addressed separately. Here
sume that the government sets the carbon tax rate annually, equal to we work in a deterministic framework to focus on the price effects.
the average price of permits for equivalent emission quantities. In prac- We first consider two versions of the hybrid system. In Hybrid-NoA-
tice one can only calculate the average price at the end of a period, and Emb we continue to require the ETS sectors to obtain permits for the
such implementation issues as the actual frequency of changes in the emissions embodied in their electricity use and continue to subsidize
carbon tax rate to match the permit price have to be worked out. The the electricity sector with free permits. In Hybrid-NoA-NoEmb, we
key element for our purposes is that the tax rate is fixed and known to stop subsidizing the electricity sector and stop requiring permits for em-
buyers before the transactions; whether it is set equal to a current year's bodied CO2; all non-ETS sectors will also have to pay for the unsubsi-
dized electricity. The main features of the policies are summarized in
Tables 1 and 2.
Finally, after comparing these no-auction policies, we then compare
Table 2
the ETS with the hybrid systems in the case where permits are gradually
CO2 emissions targeted under the ETS-only and hybrid policies without auctioning.
auctioned. In the ETS-A (for “Auction”) case we introduce permit auc-
Scenario 2017 2030 Cumulative 2017–2030 tioning and raise the auctioned share in a linear fashion, from 7% in
(million tons) 2017 to 100% in 2030. Hybrid-A-Emb and Hybrid-A-NoEmb are the cor-
Base
responding hybrid policies with permit auctions, subsidizing or not sub-
National CO2 11,050 12,940 168,300 sidizing electricity respectively.
ETS sector CO2 5130 4620 69,040
ETS-only policies
National CO2 10,950 11,940 160,200
2.2. Economic-energy model
ETS sector CO2 5040 3670 61,350
Hybrid policies We simulate the ETS and hybrid systems using an economic-energy
National CO2 10,950 11,940 160,200 model of China that identifies 33 sectors including 6 energy related sectors
ETS sector CO2 5090 4330 66,430
(see Table 5 for the list of sectors). We distinguish gas mining from oil
Note: National emissions include those from fossil fuel combustion and cement processes; mining unlike some models that combine the two, allowing us to track
ETS sectors: electricity and nonmetallic mineral products. the substitution between these two fuels. This is an economic growth
model where output growth is driven by capital accumulation, population
growth and total factor productivity (TFP) growth. An earlier version of
Table 3
Base case projection of output and energy use. the model is described in Nielsen and Ho (2013, Appendix A) and we
summarize the key features of the current version in the Appendix here.
Variable 2017 2020 2030 2017–30
The model is a dynamic recursive one where an exogenous savings
growth rate
rate determines investment. Enterprises pay VAT and taxes on capital
Population (million) 1387 1403 1416 0.16% income, and retain part of the profits for investment, resulting in a “div-
Effective labor supply 27,624 27,433 25,527 −0.61%
(billion 2014 yuan)
idend payout” rate that is smaller than 1. A change in tax rates due to a
GDP (billion 2014 yuan) 77,394 92,975 151,034 5.28% carbon policy would thus affect the after-tax income and investment.
Consumption/GDP 0.42 0.46 0.53 The GDP growth rate in the base case is thus affected by the savings
Energy use (million tons scea) 4498 4754 5508 1.57% rate, the dividend rate, the TFP growth rate and the growth of effective
Coal use (million tons) 4173 4214 4691 0.90%
labor. The parameters for these growth factors are discussed in the
Oil use (million tons) 556 613 739 2.22%
Gas use (million cubic meters) 234,286 289,087 456,476 5.26% Appendix and given in Table A1.
Electricity use (TWh) 5947 6267 7033 1.30% The main variables of the base case path are given in Table 3. GDP
CO2 emissions (fossil fuel, 9397 9743 11,262 1.40% grows at 6.5% during 2014–2020, then decelerates to 5.0% in 2020–
million tons) 30.6 Energy consumption is calibrated to the projections in IEA (2016)
CO2 emissions (total, million tons) 11,048 11,433 12,938 1.22%
Carbon intensity (kg CO2/yuan) 0.143 0.123 0.086 −3.85%
and total energy use grows at 1.6% during 2017–30 with a substantial
Primary PM emissions (million tons) 17.5 17.6 16.6 −0.41% switch from coal to oil and gas. With this fall in coal use, total CO2 emis-
SO2 emissions (million tons) 19.4 18.8 16.6 −1.20% sions only grow at 1.2% per year during 2017–30.
NOX emissions (million tons) 20.0 19.1 16.8 −1.29%
GDP per capita (2014 yuan) 55,794 66,276 106,697 6
This is consistent with the deceleration observed during 2010–2016, and with the
GDP per capita; PPP US$2005 9869 11,723 18,872
government target of 6.5% growth for the 13th Five Year Plan. These growth projections
a
Note: sce denotes “standard coal equivalent”. are also similar to those in World Bank and DRC (2013) and IEA (2014).
 J. Cao et al. / Energy Economics 81 (2019) 741–753
2.3. Implementing CO2 policies in economic model
In the economic model, we assume competitive markets and pro-
duction in each industry is represented by a constant returns-to-scale
function that implies zero profits. This means that the output price ex-
actly covers unit costs, here including carbon permit payments. The out-
put price reflects any subsidies or free permits from the government.
The complete set of equations is given in a technical report (Cao and
Ho, 2017); here we note the main aspects to clarify the implementation
of the policies as summarized in Table 1.
2.4. ETS case without auctioning: ETS-NoA
The equation setting industry revenue equal to total costs plus sub-
sidies is expressed as:
X of: (1) the direct carbon emissions due to the combustion of fossil
PIjt QIjt ¼ PKDjt KDjt þ PLjt LDjt þ PBij Aij þ txuCO2;t ALCO2
jt ð1Þ
i ity used; and (3) in the cement industry, process emissions. Using EM to
where PIjt and QIjt represent the (seller's) price and quantity of industry
j's output at time t; KD and LD represent the capital and labor input
costs; Aijt is the quantity of intermediate input i and PBij is the price of
i to buyer j. The value of free permits given to the producers in industry
j is the permit price (txuCO2, t) multiplied by the freely allocated quantity
(ALCO2
jt ).
7
The mechanics of the ETS in all cases involve allocating permits to
enterprises at the beginning of the year (gratis here, but partially auc-
tioned in later scenarios). They then submit these permits over the
course of the year to cover emissions, buying more if their emissions ex-
ceed the allocation or alternatively selling any unneeded ones. At the
end of the year there is a final accounting of the number of permits to
which each enterprise is entitled based on actual production. We imple-
ment this ETS in a manner that highlights the way the economic incen-
tives are supposed to work. We regard the permit requirement as a
carbon price that has to be paid when fossil fuels and electricity are
used (and when process CO2 is emitted), and regard the free allocation
based on output as an output subsidy. While there will be little actual
cash payments under this system, our shadow carbon price (explained
in detail below) is the best representation of the incentives. We create
shadow accounts of a flow of payments for permits to the government,
and a flow of subsidies from the government to the covered enterprises,
where the net flow would equal actual net cash payments.
The buyer's price for inputs such as coal, paid by the ETS-covered
sectors, is the regular price paid by the non-covered sectors (PS) plus
the carbon price (tCO2
ijt ). The carbon price for the coal input is the permit
price multiplied by the number of permits required per unit of coal
combusted; in general, for input i:
PBijt ¼ PSit þ t CO2 ρcmb
 CO2 ijt ij
CO2 t it j ∈ covered industry ð2Þ
t ijt ¼
0 otherwise
t CO2
it ¼ txuCO2;t XP CO2
i ð3Þ
The number of permits per unit of input i (per unit of Aij) is given by
the emission factor XPCO2 i . The price of the permit is txuCO2, t (yuan/ton
CO2), and after adjusting by the combustion ratio ρcmb ij , the final carbon
price for combusting one unit of i is tCO2 cmb
it ρij (yuan/unit Aij). The com-
bustion ratio is 1 for all inputs except for the Petroleum Refining sector,
which includes products such as lubricants that are not combusted and
has a ratio less than 1.8
7
The tx notation refers to an externality tax, and the u superscript denotes a “unit tax”
on the quantity of fuel, as opposed to an ad valorem tax on the value of the fuel.
8
In ETS systems that include the chemical industry, gas bought as feedstocks would be
similarly exempt.
745
For the CO2 embodied in electricity inputs, the number of permits re-
quired per unit of electricity consumed by ETS-covered sectors depends
on the average carbon content of generated power, i.e., the national av-
erage including coal-fired, gas-fired, nuclear and renewable power. This
CO2 emission factor (XPCO2i=elect, t) declines over time in the base case as
the generation shares of lower carbon sources (e.g., renewables) grow
at the expense of the coal-fired share. We include this in the price of
electricity for the ETS sectors:
PBelec;jt ¼ PSelec;t þ txuCO2;t XPCO2
elec;t j ¼ ETS sectors ð4Þ
The ETS also requires that cement producers buy permits for their
process emissions of CO2, i.e., emissions from chemical conversion in
cement-making that are separate from those due to combustion of fossil
fuels. The total permits required by industry j must thus total the sum
fuels; (2) the indirect emissions due to the carbon embodied in electric-
denote primary emissions, and EME to represent primary and embodied
emissions, we have:
EMCO2jt ¼ CO2jt ðdirectÞ þ CO2 j¼cement;t ðprocessÞ
EMECO2
¼ CO2jt ðdirect Þ þ CO2jt ðembodied elect Þ þ CO2 j¼cement;t ðprocessÞ
X jt h i ð5Þ
¼ ρcmb CO2 CO2 proCO2
ij XP it Aijt þ XP elect;t Aelect;jt þ XP cement QIcement;t for j ¼ cement
i∈fossil
where XPCO2
it are the CO2 emission factors per unit input or output. The
purchaser price for cement is then equal to the sum of the seller price
plus sales taxes (ttj ) and the process emission permit price, effectively
also a tax:
 
PItj ¼ 1 þ t tj PI j þ t xpu
j j ¼ cement
ð6Þ
t xpu ¼ txuCO2 XPproCO2
j j
The cap on the two covered sectors (denoted by “cov”) means that:
X CO2;ETS
EMECO2
jt ≤CAP cov;t ð7Þ
j∈ cov
As we noted above, our accounting of shadow prices and subsidy
payments is set up to accurately represent the economic incentives of
the ETS. Eqs. (1)–(7) represent the payments by enterprises in the
ETS. The compensation side of the ETS envisions either 100% free alloca-
tion of permits to the covered sectors or a declining share of free permits
with the remainder auctioned, the latter discussed in a section below. In
our first policy case (ETS-NoA), we have no auctioning throughout
2017–2030 and no net carbon revenues to the government. These per-
mits are allocated based on the output of each sector; this is an incentive
that is best represented as a subsidy scaled to the current year's output.
In order to mimic the actual ETS operation of having zero net govern-
ment revenues from the permit system we choose the shadow subsidy
rate such that the value of total subsidies is exactly equal to the total
value of the implicit carbon price revenues. That is, the subsidy rate,
sCO2
jt , is given by the value of free permits divided by the output value,
as elaborated below:
txuCO2;t ALCO2 ¼ sCO2 ð8Þ
jt jt PI jt QI jt
The government's ETS proposals set the number of permits based on
industry benchmarks, i.e., each enterprise will be given a subsidy rate
that depends only on the most carbon-efficient enterprise in that sector
or class. We do not estimate this benchmark and simply calculate the in-
dustry average carbon intensity to determine the subsidy rate. That is,
we first calculate total emissions by sector j, EMECO2
jt , for the model
746 J. Cao et al. / Energy Economics 81 (2019) 741–753

base year (t0 = 2014) using the actual fuel consumption data, and then such that national emissions in the hybrid scenario are equal to those
divide by the value of industry output in the base year9: in the ETS-only scenario for all years.
X
EMECO2
j0 EMCO2
nat;t ¼ EMCO2
jt ; EM CO2;H1
nat;t
CO2;ETS
¼ EMnat;t ð13Þ
sCO2
j0 ¼ t0 ¼ 2014 ð9Þ j
PI j0 QI j0

We implement the budget neutrality condition (Eq. (8)) for each This requires a different cap for the ETS sectors, more generous than
year t by scaling these base year rates (Eq. (9)) with a common factor, the one given in Eq. (7) for the ETS-only case:
λsub
t : X CO2;H1 CO2;ETS
EMECO2
jt ≤CAP cov;t NCAP cov;t ð14Þ
j∈ cov
txuCO2;t ALCO2
jt ¼ λsub CO2
t s j0 PIjt QIjt ð8bÞ

In the ETS-only case the permit price and subsidies were endoge-
That is, the effective subsidy rate for industry j in year t is: sCO2
jt =
nously calculated to hit the exogenous ETS cap. In the hybrid case, the
λsub CO2
t s j0 ; where the scale factor λsub is calculated endogenously so
t
new cap for the ETS sectors, CAPCO2; H1
cov, t , is chosen for each year such
that the total subsidy (GETS_SUB
t ) is equal to the revenue from the im-
that the common carbon price (ETS permit price and carbon tax rate)
plicit payments by emitters for the permits (RETS t ) in each year:
will result in national emissions hitting the target given by Eq. (13).
X The carbon tax on the non-ETS sectors will raise some new revenue
RETS
t ¼ txuCO2;t EMECO2
jt for the government. To maintain comparability with the base and ETS-
j∈ICOV
X sub only cases, we maintain fiscal neutrality by cutting existing taxes on
ETS SUB
Gt ¼ CO2
λt s j0 PIjt QI jt ð10Þ
j∈I COV
capital and value added. The VAT tax rate (tVt ) and capital income tax
RETS ¼ GtETS SUB rate (tKt ) are cut by a tax scaling factor λtaxscale
t :
t

t Vt ¼ λtaxscale
t t Vt;Base ; t Kt ¼ λtaxscale
t t Kt;Base ð15Þ
If we had the actual benchmarks for calculating the subsidy rate, the
subsidy rates would be smaller than those given by Eq. (9), and output
prices of the covered sectors would rise by a bit more. This tax cut factor is determined endogenously to maintain “real rev-
We note that the electricity sector in our China model covers both enue neutrality” by requiring government expenditures to equal the
generation and distribution. The value of delivered electricity is about ETS case levels in real terms.10
twice the value of the generators' output according to our estimates
from the 2012 Input-Output table. This means that the subsidy rate for 2.6. Hybrid case with no electricity subsidies: Hybrid-NoA-NoEmb
delivered electricity is much smaller than the subsidy for generators.
In Hybrid-NoA-NoEmb, we maintain the same shadow prices for fos-
2.5. Hybrid case with electricity subsidies: Hybrid-NoA-Emb sil fuels as in Eqs. (11) and (12) for Hybrid-NoA-Emb but drop the per-
mit requirement for CO2 embodied in electricity use by ETS-covered
In the hybrid policies the ETS continues as described but, in addition, sectors (Eq. (4)). At the same time the electricity sector no longer gets
all non-ETS sectors are required to pay a carbon tax on fossil fuels the free permit allocations, i.e., the subsidy represented in Eq. (8) now
combusted. The tax rate is set equal to the permit price paid by the only applies to non-electricity ETS sectors, cement in our case. These
ETS sectors, a carbon price that will be different from that calculated changes simplify the functioning of the ETS. Electricity generators now
in the ETS-NoA case. Eq. (2) is thus modified to: pass on the cost of paying for CO2 emission permits without any output
subsidies, and all non-ETS sectors now face a higher electricity price
PBijt ¼ PSit þ t CO2
ijt ρcmb
ij i∈ICO2
COM
compared to Hybrid-NoA-Emb. The non-ETS sectors face higher fossil
¼ fcoal mining; oil mining; gas miningg ð11Þ fuel prices, just like in Hybrid-NoA-Emb compared to the ETS-only case.
The cap for the ETS sectors would be different from that for the
 Hybrid-NoA-Emb case. That is, we need to endogenously calculate a
t CO2 j ∈ covered industry
t CO2
ijt ¼ it
new CAPCO2; H2
such that the national emissions are equal to the ETS-
t CO2
it otherwise cov, t
only case and the carbon tax is equal to the permit price:
Households also pay the carbon tax on their fossil fuel purchases X
EMCO2
nat;t ¼ EMCO2
jt ; EM CO2;H2
nat;t
CO2;ETS
¼ EMnat;t ð16Þ
(denoted by a C superscript to represent Consumption):
j

  X CO2;H2
P C;IO
it ¼ 1 þ t cit PSit þ t CO2
i;hh;t ð12Þ EMECO2
jt ≤CAP cov;t ð17Þ
j∈ cov

The common carbon price will be different from that in the Hybrid-
The ETS sectors continue to have to acquire permits for CO2 embod-
NoA-Emb case and this means a different level of revenue recycling is
ied in their electricity use, i.e., Eq. (4) continues to apply. The non-ETS
required. We still maintain the same fiscal neutrality constraint that
sectors only pay the market price for electricity and do not face this
real government purchases are equal to those of the ETS-only cases.
shadow carbon price.
To maintain comparability with the ETS-only case we set this com-
2.7. ETS and hybrid cases with auctioning: ETS-A, Hybrid-A-Emb, and
mon carbon price (ETS permit price and carbon tax rate) in a way
Hybrid-A-NoEmb

9
While the official plan announced in December 2017 does not men-
The economic model is based on an input-output table for 2014 that we estimated
tion auctioning of permits, a gradual shift away from free permits is
based on the official IO table for 2012, and data from the National Accounts for 2014. This
includes information on the output value of each sector. This IO table is supplemented by
10
energy consumption data that includes the tons of coal consumed in each sector (details in This targeting of real purchases is explained in Eq. (A62) in the Model Appendix (Cao
Cao and Ho, 2017). and Ho, 2017).
 J. Cao et al. / Energy Economics 81 (2019) 741–753 747

Table 4
The effects of the ETS and hybrid ETS-carbon tax

2020 2030

Base case 2020 ETS-noA Hybrid-NoA-Emb Hybrid-NoA-NoEmb Base case 2030 ETS-noA Hybrid-NoA-Emb Hybrid-NoA-NoEmb

(percent change) (percent change)

GDP (billion yuan 2014) 93,000 −0.032 −0.021 −0.015 151,000 −0.27 −0.13 −0.10
Consumption (bil yuan 2014) 41,000 −0.061 −0.020 −0.016 75,600 −0.43 −0.12 −0.12
Investment (bil yuan 2014) 39,500 −0.015 −0.017 −0.009 56,700 −0.25 −0.12 −0.08
Government consumption (bil yuan 2014) 10,300 0.00 0.00 0.00 13,300 0.00 0.00 0.00
Energy use (million tons of sce) 4,750 −2.75 −2.60 −2.65 5,510 −7.93 −7.06 −7.25
Coal use (million tons) 4,210 −4.22 −4.02 −3.98 4,690 −11.84 −11.26 −11.13
Oil use (million tons) 613 0.09 −0.13 −0.17 739 0.14 −0.48 −0.54
Gas use (billion cubic meters) 289,100 −0.24 −1.21 −1.18 456,500 −1.45 −3.13 −3.04
Electricity (billion kWh) 6,270 −1.10 −0.50 −1.00 7,030 −5.88 −1.51 −3.16
CO2 emissions (inc cement; mil tons) 11,400 −2.78 −2.78 −2.78 12,900 −7.71 −7.71 −7.71
CO2 emssions from ETS sectors (mil tons) 4,910 −6.00 −2.32 −2.18 4,450 −20.58 −6.24 −6.03
SO2 emissions −3.11 −2.62 −2.37 −8.81 −6.67 −5.89
NOx emissions −3.12 −1.73 −1.65 −7.44 −4.19 −3.96
PM emissions −0.88 −1.20 −1.14 −2.12 −3.40 −3.37
(yuan/ton CO2) (yuan/ton CO2)
Emission permit price (Y/ton CO2) 86.3 25.7 23.4 574.1 91.3 83.6
(percent) (percent)
Permit value + carbon taxes as percent of total revenue 1.26 0.88 0.76 3.34 1.94 1.72

envisaged in most proposals that have been discussed. In this ETS-A sce- 3. Comparing impacts of the ETS-only and hybrid policies
nario (for “Auction”), we have a gradual phase out of free allocation of
permits where some permits are auctioned off. We assume that the auc- 3.1. ETS without auctioning, ETS-NoA
tion share rises linearly from 7% in 2017 to 100% in 2030. The cap for the
two covered sectors remains the same as in the ETS-NoA case but with We first simulated the model with no carbon prices (ETS or carbon
the dwindling free quotas, the output subsidy, sCO2 jt , gradually falls to tax) to establish the base case as summarized in Table 3. National CO2
zero. The sum of the freely allocated permits (ALCO2
jt ) and the auctioned emissions from fossil fuel combustion and cement production rises
permits (ACCO2
jt ) must be no less than the covered emissions: from 11.0 billion tons in 2017 to 12.9 billion tons in 2030. During this
period GDP rises by 1.95 times and CO2 intensity thus falls significantly
X X X from 0.143 kg/yuan to 0.086 in 2030. This projected 2030 intensity is
ALCO2
jt þ AC CO2
jt ¼ EMECO2
jt ð18Þ
j∈ cov j∈ cov j∈I COV
59.5% lower than the intensity in 2005, just short of the lower end of
the announced 60–65% reduction target.
We then simulated the pure ETS case with no auctioning of permits,
In the actual markets, permits will be traded continuously but the as described in Section 2 above: we selected a steadily tightening cap for
auctions will be held infrequently. In the annual accounts of the the ETS sectors such that the national emissions of CO2 only rise to 11.9
model, we assume that the annual average price for permits and auc- billion tons in 2030 (see Table 2), giving a 62.5% reduction of the CO2 in-
tioned quotas are the same. Thus the revenues to the government tensity compared to the 2005 level. The impact of this ETS cap on the na-
from the implicit permit payments (RETSAL ) and actual auction receipts tional economy is given in Table 4 in the columns marked “ETS-NoA”;
(RETS
AC ) are: we report the percent change in the key variables between the base
case and policy case for 2020 and 2030. Table 5 gives the impacts on in-
dustry output and prices in 2030, with the two ETS sectors in italics [ce-
X RETS ¼ RETS þ RETS
AL X AC
ð19Þ ment (NMM) and electricity].
¼ txuCO2;t ALCO2
jt þ txuCO2;t AC CO2
jt
j∈ cov j∈ cov
The policy raises the cost of fuel inputs into electricity and cement
production but subsidizes the output price. The price of electricity
rises significantly, and the output of electricity falls by 6% by 2030.
Instead of Eq. (10), the total subsidies in this scenario are now This induces a substitution away from electricity to other inputs, includ-
limited to the allocated portion: ing capital. The fall in electricity output together with the rise in coal
prices for the ETS sectors reduce the coal mining output by 12%. This
RETS ETS SUB also induces a substitution towards less carbon-intensive fuels and the
AL;t ¼ Gt
X X sub
ð20Þ use of oil does not change much even though it is subject to a carbon
txCO2;t ALCO2
u
jt ¼ λt sCO2
j0 PI jt QI jt price. These changes in relative prices—higher prices of electricity and
j∈ cov j∈ICOV
electricity-intensive goods—lead to a reallocation of capital and labor to-
wards less electricity-intensive sectors. This results in a small GDP loss
We assume that the auction revenue is used to cut existing taxes in the early years. This loss of GDP is accompanied by reductions in con-
proportionately: the VAT, tax on capital income and tax on sales.11 sumption and investment; recall that we require government purchases
The cut in taxes is chosen to maintain fiscal neutrality as in the hybrid to be held constant. The fall in investment each year cumulates into a
policy cases, i.e., to maintain real government purchases at ETS-NoA smaller capital stock by 2030 and the GDP loss rises to 0.27% by 2030.
levels. Hybrid-A-Emb and Hybrid-A-NoEmb are then analogous to the The output of cement rises despite the permit requirements because
hybrid cases above but introducing rising permit auctions in the ETS- of the subsidy policy; we have required fiscal neutrality that returns all
covered sectors per above. permit revenue back to the two ETS sectors and this results in a lower
cement price. A less generous policy, such as the ETS-A one discussed
11
This recycling method is the same as in the hybrid cases discussed in Eq. (15) above. below, will generate a different output response. This unexpected effect
748 J. Cao et al. / Energy Economics 81 (2019) 741–753

Table 5
Industry effects of ETS and hybrid (no-auction) polices in 2030 (percent change from base case).

Scenario ETS-NoA Hybrid-NoA-Emb Hybrid-NoA-NoEmb

Percent change in Percent change in Percent change in Percent change in Percent change in Percent change in
price quantity price quantity price quantity

Agriculture 0.13 −0.06 0.24 0.04 0.25 0.02

Coal mining 0.32 −12.25 2.45 −12.53 2.25 −12.31
Crude petroleum mining 0.54 0.06 0.29 0.39 0.23 0.55
Natural gas mining 0.40 −1.10 0.08 −1.64 0.06 −1.48
Nonenergy mining 0.70 −0.64 0.45 −1.17 0.53 −1.33
Food products, tobacco 0.31 −0.32 0.19 −0.02 0.14 −0.01
Textile goods 0.53 −0.33 0.43 0.73 0.42 0.88
Apparel, leather 0.43 −0.05 0.20 1.13 0.17 1.36
Sawmills and furniture 0.53 −0.51 0.33 0.41 0.32 0.49
Paper products, printing 0.54 −0.45 0.53 −0.18 0.50 −0.09
Petroleum refining, coking 0.52 0.24 0.55 −0.33 0.47 −0.36
Chemical 0.60 −0.65 0.75 −0.73 0.75 −0.73
Nonmetal mineral products −0.86 1.95 0.01 0.68 0.58 −0.14
Metals smelting 0.74 −1.17 2.12 −3.41 2.07 −3.35
Metal products 0.80 −1.35 1.06 −1.84 1.11 −1.96
Machinery and equipment 0.62 −0.74 0.77 −0.92 0.77 −0.89
Transport equipment 0.53 −0.42 0.54 −0.20 0.53 −0.10
Electrical machinery 0.60 −0.95 0.76 −1.22 0.76 −1.26
Electronic & telecom. equipment 0.49 −0.21 0.54 0.11 0.56 −0.12
Water services 0.86 −0.77 0.31 −0.11 0.45 −0.32
Other manufacturing 0.66 −0.61 0.69 −0.93 0.67 −0.85
Electricity, steam, hot water 9.81 −6.01 1.80 −1.40 5.17 −3.13
Gas production and supply 0.51 −0.11 4.70 −3.61 4.32 −3.28
Construction 0.28 −0.15 0.28 −0.02 0.32 −0.02
Transportation 0.34 −0.31 0.54 −0.51 0.48 −0.45
Communications 0.39 −0.29 0.18 0.08 0.16 0.13
Trade 0.31 −0.23 −0.09 0.40 −0.19 0.54
Accommodation & food 0.25 −0.24 0.11 0.02 0.07 0.04
Finance and insurance 0.40 −0.37 0.02 0.14 −0.07 0.23
Real estate 0.33 −0.10 0.20 0.10 0.19 0.16
Business services 0.31 −0.21 0.20 0.08 0.17 0.11
Other services 0.20 −0.07 0.12 0.06 0.11 0.09
Public administration 0.17 0.04 0.11 0.04 0.10 0.04
Household coal use −0.10 −21.5 −19.9

has implications for emissions of pollutants. The fall in fossil fuel use re-
sults in lower emissions of pollutants: by 2030 SO2 emissions are 8.8%
lower and particulate emissions are 2.1% lower. These reductions, how-
ever, are smaller than the fall in coal use since cement output is higher
than in the base, and cement is a major producer of process emissions.
Our economic model distinguishes households by demographic
characteristics such as region, household size and incomes. Households
are affected differently by policy shocks even if they face the same prices
since they buy a different bundle of goods and services. We define a
money measure of the welfare impacts for each type of household
(see Appendix) and these are reported in Table 6 for the three main pol-
icies considered.
The ETS policy (first column of Table 6) results in a national average
loss equal to 0.26% of the base case level of consumption welfare in
2030. The impact is progressive in that the richer income groups suffer
a slightly larger loss, 0.273 for the top quintile versus 0.257 for the
poorest quintile.12 The regional impacts do not differ much given the
small variation in consumption patterns that we could identify; the re-
gions of course differ by average income levels, and to that extent the
richer East region suffers a slightly larger loss due to the progressivity.
Urban households are much richer and thus suffer larger losses from
the carbon price. Larger households with children and other dependents
12
This may be somewhat unintuitive given that most analysis of US carbon prices indi-
cates a regressive impact since a larger share of consumption of the poor there goes to
energy-related expenditures. Our result here comes from the nature of our consumption
model and the underlying consumption patterns of China. First, our household model only
identifies four major baskets (food, consumer goods, services and housing); the expendi-
tures on energy are part of services and housing and not explicitly linked to demographic
characteristics. Secondly, the China basket is still dominated by food given its stage of de-
velopment; a private car and gasoline expenditures are common only for the higher in-
come groups.
suffer losses larger than 2-person homes since they consume relatively
more housing and services (compared to consumer goods), which in-
clude the energy-intensive utilities and transportation.
The cap path that we have chosen is a severe one for this narrow ETS
policy, as we have noted above; a more generous cap would have re-
duced the price and reallocation effects. We chose this tight cap to high-
light the policy impacts. The emission permit price starts at a low level
but rises rapidly as the cap is tightened. By 2020 the permit price is 86
yuan per ton of CO2 (in 2014 yuan) and rises to more than 500 yuan
by 2030. This high price is due to subjecting only two sectors to emis-
sion trading to achieve the ambitious goal of a 62.5% reduction in CO2 in-
tensity. The free allocation of quotas via an output subsidy makes the
reduction in emissions more difficult by not raising cement and electric-
ity prices more to encourage conservation. This impact is shown clearly
when we contrast these cases with the auction cases below.
3.2. Hybrid with electricity subsidies, Hybrid-NoA-Emb
In the Hybrid-NoA-Emb policy we require all non-ETS sectors, and
households, to pay a carbon tax on fossil fuels combusted. As explained
in Section 2, we chose a cap for the ETS sectors such that the hybrid policy
case also reaches the same reduction in national CO2 as in the pure ETS
case each year. The carbon tax rate is set equal to the endogenous carbon
permit price. The new cap for the ETS sectors works out to be 4329 million
tons of CO2 in 2030 compared to the severe 3667 million-ton cap in the
ETS-only case. The impact on the economy and industries are given in
Tables 4 and 5 in the columns marked “Hybrid-NoA-Emb”.
The inclusion of all sectors in the goal to reduce CO2 emissions re-
sults in a carbon price that is only 91 yuan/ton in 2030, compared to
574 yuan/ton in the ETS-NoA case. The total carbon price revenue,
from permit sales and carbon taxes, is only 1.9% of government revenue
 J. Cao et al. / Energy Economics 81 (2019) 741–753 749

Table 6 The demographic effects of the hybrid policy are similar to the ETS-
Impact of carbon taxes on different household groups; equivalent variation in 2030 (per- only case, at a slightly lower level of losses. The policy hurts the richer
cent change in money measure of welfare from base case).
households more, as well as the urban households. There is very little
ETS-NoA Hybrid-NoA-Emb Hybrid-NoA-NoEmb difference across the regions.
(percent change)
3.3. Hybrid without electricity subsidies, Hybrid-NoA-NoEmb
National −0.264 −0.260 −0.221
Income groups
1st quintile (low) −0.257 −0.256 −0.220 In the Hybrid-NoA-NoEmb case, we do not require the cement sector
2nd quintile −0.263 −0.259 −0.221 to obtain permits for CO2 embodied in electricity consumption but also
3rd quintile −0.266 −0.261 −0.221 do not give subsidies to the electricity sector. This results in two major
4th quintile −0.269 −0.262 −0.222
5th quintile (high) −0.273 −0.264 −0.223
differences from Hybrid-NoA-Emb. First, the price of electricity rises
Region substantially more, 5.2% versus 1.8%. Second, the price of cement in
East −0.264 −0.260 −0.221 2030 changes by +0.6% compared to 0% in the Hybrid-NoA-Emb case
Central −0.263 −0.260 −0.222 and −0.9% in the ETS-only case. The output of cement falls by 0.1% com-
West −0.263 −0.260 −0.221
pared to a rise of 0.7% in Hybrid-NoA-Emb.
Location
Urban −0.266 −0.261 −0.222 The higher electricity prices mean a major conservation of electricity
Rural −0.262 −0.259 −0.221 use by all sectors and electricity output falls by 3.1% compared to 1.4% in
Household size Hybrid-NoA-Emb. The carbon price is slightly lower than that in Hybrid-
1–2 −0.260 −0.258 −0.220 NoA-Emb, 84 yuan/ton in 2030 compared to 91 yuan. This means that
3 −0.266 −0.260 −0.221
4+ −0.263 −0.259 −0.221
the impact on fossil fuel use by the non-ETS sectors as a whole is similar;
total coal output falls 12.3% compared to 12.5 in Hybrid-NoA-Emb and
12.2 in ETS-NoA. However, the divergence in behavior among the ETS
sectors and electricity prices between the two hybrid cases means that
in the Hybrid-NoA-Emb case in 2030, compared to 3.3% in the ETS-NoA there is a different pattern of industry impacts. Some electricity-
case (Table 4, last line). The much lower ETS cap and carbon price result intensive sectors including metal products and water services fall by a
in changes in electricity and cement prices that are much lower; the bit more in Hybrid-NoA-NoEmb than in Hybrid-NoA-Emb. The general
price of electricity in 2030 is now 1.8% higher than the base case com- pattern, however, is a smaller contraction of manufacturing and a bigger
pared to 9.8% higher in the ETS case, shown in Table 5. These smaller expansion of the service sectors, for example, paper (−0.09% vs.
price effects result in the output of electricity falling 1.4% compared to −0.18%), transport equipment (−0.1% vs −0.2%), trade (+0.54% vs
6.0%, and cement output rising 0.7% instead of 1.9% in the ETS case. +0.40%) and finance (+0.23% vs +0.14%).
The carbon tax results in much higher prices for coal, +2.4% instead The net impact on GDP by 2030 is a smaller loss, −0.10% compared to
of +0.3%, encouraging all consumers to reduce coal use. The output of −0.13 in Hybrid-NoA-Emb and −0.27 in ETS-NoA. There is a different im-
coal is very similar, −12.5% versus −12.2%; this is due to higher coal pact on the composition of final demand; since we no longer subsidize
consumption in the electricity sector under Hybrid-NoA-Emb offset by electricity, the bigger tax cut in VAT and capital taxes from the electricity
lower coal consumption by the non-ETS sectors. The reduction in coal sector permit revenue in Hybrid-NoA-NoEmb means a greater allocation
consumption is especially large for households, 21% versus 0.1%, in the to investment, and GDP shifts from consumption to investment. This re-
ETS-only case (Table 5, last row). sults in a much smaller impact on the capital stock and the small impact
The higher cost of fossil fuels in Hybrid-NoA-Emb causes the coal- in out years as shown in the column for 2030 in Table 4.
and oil-intensive industries to shrink more than in the ETS case; metals The different impacts on electricity and cement also mean a difference
smelting falls by 3.4% versus 1.2%, and transportation falls by 0.5% versus in pollutant emissions. While total NOX and PM emissions are very simi-
0.3%. Since the electricity price is lower in the Hybrid-NoA-Emb case, lar, SO2 emissions in 2030 are lower (5.9%) compared to in Hybrid-NoA-
the net impact of total energy costs is different for different industries; Emb (6.7%). This is due to different offsetting effects: the bigger reduction
for electricity-intensive sectors such as apparel, sawmills and paper, in electricity output in Hybrid-NoA-NoEmb means less coal consumption
the output reduction is smaller, or even becomes an increase. The im- in power generation; the higher level of aggregate output, however,
pact of these changes in relative prices and output is to lower GDP in means higher coal consumption in the other sectors. The output of ce-
the early years by an even smaller extent compared to the ETS case, ment is very similar and the total use of coal, oil and gas are similar.
0.02% versus 0.03% in 2020. This means a smaller reduction in invest- The demographic effects of the Hybrid-NoA-NoEmb policy are a bit
ment and a smaller impact on capital accumulation. Thus the 2030 different from the Hybrid-NoA-Emb and ETS-NoA cases. The progressiv-
GDP impact is only −0.13% versus −0.27%. This smaller loss of aggre- ity of the impact is very slight and the urban-rural differences are also
gate output is seen in the different pattern of industry output impacts smaller. The national welfare loss is only 0.22% compared to 0.26% in
in Table 5. In the ETS case, almost all sectors see a fall in output in the other two policies.
2030; in the Hybrid-NoA-Emb case, however, the services expand a lit-
tle while the manufacturing industries contract. 3.4. ETS with auctioning, ETS-A
The slightly higher GDP in the Hybrid-NoA-Emb case means a higher
demand for fossil fuels and thus require a slightly greater effort to main- While the government proposals have sought to keep the initial ETS
tain CO2 emissions at the ETS-only levels than otherwise. However, the program attractive to enterprises and simple to administer by giving out
net impact on aggregate outcomes is clear; the smaller loss in GDP is ac- free allocations of permits, the program designers recognize the argu-
companied by a smaller loss in consumption. ments that auctioning the permits would allow the revenues to be bet-
The impact of these different changes on local pollutants is complex ter targeted. The free allocations, in the output subsidy form that we
(Table 4). On one hand coal use is about the same in Hybrid-NoA-Emb simulated, reduce the changes in carbon-intensive goods prices that
as in ETS-NoA, while on the other hand oil and gas use are lower. Ce- would encourage more conservation. By cushioning the price of elec-
ment output is lower in Hybrid-NoA-Emb, which lowers SO2 and PM tricity after generators are required to obtain permits for their CO2 emis-
emissions, but the higher output of electricity and many manufacturing sions, the general users of electricity (i.e., non-ETS sectors) are not
sectors (textile, sawmills, paper, etc.) means higher emissions. The net incentivized to conserve electricity use. Our comparison of Hybrid-
result is that SO2 emissions in 2030 fall by only 6.7% compared to 8.8% NoA-NoEmb with Hybrid-NoA-Emb above shows the substantial gain
in ETS-NoA but PM falls by 3.4% compared to 2.1%. in efficiency when we stop subsidizing electricity.
750 J. Cao et al. / Energy Economics 81 (2019) 741–753

Table 7
Comparing the ETS with and without auctioning of permits, 2030

Base case 2030 ETS-noA Hybrid-NoA-Emb Hybrid-NoA-NoEmb ETS-A Hybrid-A-Emb Hybrid-A-NoEmb

(percent change)

GDP (billion yuan 2014) 151,000 −0.266 −0.126 −0.101 −0.185 −0.121 −0.119
Consumption (bil yuan 2014) 75,600 −0.433 −0.118 −0.123 −0.298 −0.114 −0.112
Investment (bil yuan 2014) 56,700 −0.247 −0.120 −0.082 −0.232 −0.140 −0.133
Government consumption (bil yuan 2014) 13,300 0.000 0.000 0.000 0.000 0.000 0.000
Energy use (million tons of sce) 5,510 −7.93 −7.06 −7.250 −7.79 −7.12 −7.10
Coal use (million tons) 4,690 −11.84 −11.26 −11.13 −10.46 −10.83 −10.88
Oil use (million tons) 739 0.14 −0.48 −0.54 −0.45 −0.60 −0.59
Gas use (billion cubic meters) 456,500 −1.45 −3.13 −3.04 −1.38 −2.91 −2.93
Electricity (billion kWh) 7,030 −5.88 −1.51 −3.16 −9.56 −3.41 −3.10
CO2 emissions (inc cement; mil tons) 12,900 −7.71 −7.71 −7.71 −7.71 −7.71 −7.72
CO2 emssions from ETS sectors (mil tons) 4,450 −20.58 −6.24 −6.03 −20.76 −7.94 −7.65
SO2 emissions −8.81 −6.67 −5.89 −8.50 −6.80 −5.90
NOx emissions −7.44 −4.19 −3.96 −6.92 −4.38 −4.03
PM emissions −2.12 −3.40 −3.37 −5.27 −4.38 −4.04
(yuan/ton CO2)
Emission permit price (Y/ton CO2) 574.1 91.3 83.6 312.1 79.0 80.1
(percent)
Permit value + carbon taxes as %total revenue 3.34 1.93 1.72 1.97 1.7 1.67

To show how the ETS-only policy would perform under an auction sys-
tem we simulated a scenario where a rising share of the ETS permits is auc-
tioned. By 2030 all permits are auctioned and the auction revenue is used
to cut existing taxes (VAT, capital and output taxes). The non-auctioned
portion continues to be given to the ETS sectors in the form of an output
subsidy (Eq. (8)). In the ETS-NoA case reported in Table 4, the total permit
revenues come to 3.3% of total government revenues by 2030, and elimi-
nating the free allocation is thus a substantial reduction in output subsi-
dies. The aggregate results of comparing the no-auction and auction
cases are given in Table 7 and industry impacts given in Table 8.
In the ETS-A case, where the ETS subsidies are reduced over time, the
price change for cement (NMM) is +5.5% versus −0.86% in the no-
auction case, and the price of electricity is +17% versus +9.8%
(Table 8). These big price shocks to the ETS goods reduce the demand
for them and thus output falls significantly: cement −6.7% and electric-
ity −9.8%. Some electricity-intensive sectors suffer a relatively bigger
shock: metals smelting −1.4% (versus −1.2% in the no-auction case),
metal products −1.6% (versus −1.3%). The big reduction in ETS sector
output means that their CO2 cap is partly met by a direct lowering of
coal use, not completely via a substitution towards other fuels or inputs

Table 8
Industry effects of ETS with and without auctioning of permits, 2030 (% change from base case).

Scenario ETS-NoA ETS-A

Percent change in price Percent change in quantity Percent change in price Percent change in quantity

Agriculture 0.13 −0.06 0.24 −0.05

Coal mining 0.32 −12.25 0.16 −10.67
Crude petroleum mining 0.54 0.06 0.22 0.86
Natural gas mining 0.40 −1.10 0.23 −0.31
Nonenergy mining 0.70 −0.64 0.80 −1.62
Food products, tobacco 0.31 −0.32 0.08 −0.15
Textile goods 0.53 −0.33 0.42 0.89
Apparel, leather 0.43 −0.05 0.17 1.42
Sawmills and furniture 0.53 −0.51 0.42 0.28
Paper products, printing 0.54 −0.45 0.39 0.13
Petroleum refining, coking 0.52 0.24 0.20 −0.19
Chemical 0.60 −0.65 0.61 −0.52
Nonmetal mineral products −0.86 1.95 5.54 −6.73
Metals smelting 0.74 −1.17 0.94 −1.37
Metal products 0.80 −1.35 0.98 −1.64
Machinery and equipment 0.62 −0.74 0.67 −0.56
Transport equipment 0.53 −0.42 0.48 0.04
Electrical machinery 0.60 −0.95 0.70 −1.14
Electronic & telecom. equip 0.49 −0.21 0.63 −1.13
Water services 0.86 −0.77 1.08 −1.18
Other manufacturing 0.66 −0.61 0.63 −0.37
Electricity, steam, hot water 9.81 −6.01 17.51 −9.88
Gas production and supply 0.51 −0.11 0.36 0.05
Construction 0.28 −0.15 0.86 −0.52
Transportation 0.34 −0.31 0.19 −0.17
Communications 0.39 −0.29 0.26 0.00
Trade 0.31 −0.23 −0.20 0.54
Accommodation & food 0.25 −0.24 0.07 −0.09
Finance and insurance 0.40 −0.37 −0.05 0.15
Real estate 0.33 −0.10 0.34 0.14
Business services 0.31 −0.21 0.19 0.00
Other services 0.20 −0.07 0.13 0.10
Public administration 0.17 0.04 0.12 0.02
Household coal use −0.10 0.00
 J. Cao et al. / Energy Economics 81 (2019) 741–753
as in the no-auction case. This results in a much lower permit price, 312
yuan/ton versus 574 yuan in the no-auction case (Table 7).
The overall structural change in comparison to the no-auction case is
thus quite complex. First, note that our target is to reduce national emis-
sions by the same amount in both auction and no-auction cases, it is not
to have the same ETS caps for the covered sectors. The much lower per-
mit price in the auction case combined with changes in the rest of the
economy result is a slightly bigger reduction of CO2 emissions from
the two ETS sectors. Second, the auction revenues that no longer need
to be spent as output subsidies come to 2.0% of total government reve-
nues in 2030 and thus allow a significant cut in existing taxes. These
changes reduce the distortions in the economy, allow greater retained
earnings and investment, and thus by 2030 there is a smaller GDP
loss, 0.18% versus 0.27%.
The bigger GDP and different goods prices compared to the no-
auction case result in some industries expanding output by 2030 as cap-
ital and labor are shifted out of the cement and electricity-intensive sec-
tors, and there is more capital available for the whole economy. In
contrast, in the ETS-NoA case, all but one sector shrank. The net effect
of reduced coal demand by the two ETS sectors and higher coal demand
by the expanding sectors is that the reduction in coal output is only
10.6% in 2030, compared to a 12.2% fall in the no-auction case. The
smaller substitution towards coal also leads to a slightly smaller use of
oil in ETS-A compared to ETS-NoA.
These differences in industry output and fuel use lead to differences
in local pollutant emissions. The reduction in SO2 and NOX emissions are
quite similar, slightly smaller reductions than in ETS-NoA given the
smaller reduction in coal use. The bigger reduction in cement in the auc-
tion case, however, leads to a larger reduction in national PM emissions,
5.3% versus 2.1%.
We may summarize the effects of auctioning and curtailing subsidies
as follows. The smaller subsidies for ETS sectors lead to higher prices
and more conservation of CO2-intensive goods. This lowers the fuel de-
mands in the two ETS sectors and thus lowers the CO2 permit prices
which reduce the amount of fuel substitution. Revenues from the per-
mit auction help cut existing taxes and reduce distortions; all these
lead to a smaller GDP loss for similar environmental gains. The shrinking
of the CO2 -intensive sectors and higher aggregate GDP means there are
more expanding sectors in the auction case.
3.5. Hybrid with auctioning, Hybrid-A-Emb and Hybrid-A-NoEmb
To complete the discussion of the impact of auctions in the ETS, we
also consider how they would affect hybrid ETS carbon-tax policies.
The impacts on the macro aggregates are given in Table 7 in columns
marked “Hybrid-A-Emb” and “Hybrid-A-NoEmb”. In all cases, the na-
tional CO2 emissions are required to achieve a carbon intensity that is
62.5% lower than in 2005, consistent with the government's goal. This
is equivalent to a projected 7.7% reduction of carbon emissions in
2030. Recall that this requires that the cap on the ETS-sectors be ad-
justed for each scenario so that there is a common carbon price between
the permit price and carbon tax rate.
The overall impact in Hybrid-A-Emb is similar to that in the no-
auction case: there is a big reduction in CO2 prices when the carbon
tax is added compared to the pure ETS case. This leads to a smaller dis-
tortion of economic incentives and a smaller loss of GDP. However, the
gain introduced by the carbon tax is now smaller; comparing ETS-NoA
to Hybrid-NoA-Emb, the 2030 GDP loss fell from 0.27% to 0.13%; com-
paring ETS-A to Hybrid-A-Emb, however, the loss falls only from 0.18%
to 0.12%. Similarly, the changes in local pollutant emissions of SO2,
NOX and PM caused by adding a carbon tax to the ETS are smaller in
the auction case (e.g., for PM, the no-auction case improves from
−2.1% to −3.4%, while the auction case diminishes from −5.3 to
−4.4). The auctioning of permits is doing some of the pricing incentive
work that is introduced by the carbon tax and rebate system.
751
In Hybrid-A-NoEmb we remove the requirement for permits for CO2
embodied in electricity and remove the electricity subsidies. In the ETS-
A case, by the end of the period in 2030, 100% auctioning also means
that subsidies to ETS sectors drop to zero. The differences between
Hybrid-A-Emb and Hybrid-A-NoEmb are thus smaller than in the anal-
ogous no-auction cases. For example, GDP loss is 0.12% in both Hybrid-
A-Emb and Hybrid-A-NoEmb. The reduction in coal, oil and gas use are
also very similar. In other words, the benefit of removing electricity sub-
sidies in the hybrid policies is diminished in the auction scenarios com-
pared to the no-auction world.
4. Summary of results
We compared various carbon control policies that reach the same
cumulative 2017–2030 reduction in national CO2 emissions, and
achieve a goal to reduce the 2030 CO2-GDP intensity by 62.5% percent
compared to 2005 levels. ETS-NoA denotes a cap-and-trade system
that covers only the electricity and cement sectors where all firms are
compensated with an output subsidy equal to the value of CO2 emission
permits, with no auctioning of permits. Firms in the cement industry are
also required to acquire permits for the CO2 embodied in the electricity
they consume. The hybrid system (Hybrid-NoA-Emb) imposes a carbon
tax on all sectors outside the ETS where the tax rate is equal to the per-
mit price and the ETS caps are adjusted so that the national emissions
are the same as in the pure ETS case. The second hybrid system (Hy-
brid-NoA-NoEmb) also imposes a carbon tax on non-ETS sectors but
no longer require ETS firms to acquire permits for CO2 embodied in
electricity.
We find that the ETS-NoA case requires a very high carbon price
(570 yuan/ton in 2030) to reach a 62.5% national intensity target be-
cause the carbon pricing burden falls on only two sectors. The Hybrid-
NoA-Emb case requires a carbon price of only 91 yuan/ton and the
Hybrid-NoA-NoEmb case an even lower 84 yuan/ton. When the permits
are auctioned in the pure ETS case (ETS-A), output subsidies fall, there is
more electricity conservation throughout the economy, and the CO2
price falls to 310 yuan/ton.
The 2030 cap on the ETS sectors in the ETS-NoA case is very tight at
3670 million tons compared to 4620 in the base case. In the Hybrid-
NoA-Emb case the cap on the ETS sectors is relaxed to 4330 because
non-ETS sectors are taking a big share of the burden of achieving the na-
tional target. In the Hybrid-NoA-NoEmb case, when the cement sector is
no longer required to acquire permits for CO2 embodied in its electricity
consumption, the ETS cap has to be tightened a bit more, to 4290 million
tons.
Given the very different carbon prices in the three No-Auction cases,
the GDP losses in 2030 are correspondingly different: 0.27%, 0.13% and
0.10%, respectively. In the three Auction cases, the carbon prices are
lower and the GDP losses are 0.12–0.18%. These estimates are of the
same order of magnitude as those in Shi et al. (2013) for their mixed
policy. The carbon prices and CO2 reductions in the hybrid system in
Bi et al. (2018) are lower than those considered here and thus their
GDP losses are somewhat smaller, but of the same order of magnitude.
In our setup, all carbon tax and auction revenues are recycled by cut-
ting taxes on capital, value added and output. The cuts in these taxes
benefit enterprises and lead to higher retained earnings and invest-
ment. The pure ETS has no revenue to recycle whereas the hybrid
cases do, and thus the different paths of investment contribute to bigger
GDP differences between these polices over time.
The differences in GDP and consumption lead to differences in our
measure of household welfare. When we examine the welfare impact
on different types of households we find a mild progressivity in all
cases unlike many carbon price analyses for richer countries. This is
partly due to the use of gasoline mostly by the richest quintile in
China, unlike the widespread use of cars by all income groups in high-
income countries. In ETS-NoA the change in the monetary measure of
welfare (the equivalent variation) is −0.264%, while Hybrid-NoA-Emb
752 J. Cao et al. / Energy Economics 81 (2019) 741–753
and Hybrid-NoA-NoEmb have losses of 0.260 and 0.221% respectively.
The degree of progressivity is similar across the policies.
5. Conclusion and policy considerations
The initiative to introduce a carbon emissions trading system by
China's government is a bold one for a middle-income country given
that existing ETSs are in developed market economies. The willingness
to try market mechanisms instead of relying only on traditional
command-and-control regulations to achieve energy and environmen-
tal goals is lauded by many policy analysts. While details of the program,
such as the coverage and timing, are still to be ironed out, if successful,
China's national ETS could evolve into the world's largest CO2 control
program and set an example for other countries. It would be a big step
to meeting the national goal of reducing the CO2 per unit GDP in 2030
by 60–65% compared to 2005 levels.
Our first goal here is to examine how a national ETS could work and
the impact on all sectors of the economy. We find that an ambitious re-
duction target that is limited to only electricity and cement, similar to
the scaled down national ETS now being prepared, would likely require
a high carbon permit price, but a system of subsidies to compensate en-
terprises would limit the damage to output in the ETS sectors. Our
model simulations indicate that such an ETS policy to reduce the na-
tional carbon intensity by 62.5%, the midpoint of the official 60–65%
range, would reduce coal use by 12% in 2030 and reduce GDP by 0.3%.
This reduction in fossil fuel use will also reduce the emissions of sulfur
dioxide, nitrogen oxides and particulate matter significantly. We have
examined the case of covering only two major industries in the ETS as
envisaged in the government plans for the early phase; the case for cov-
ering more sectors to share the mitigation burden and lower total costs
is clear, assuming implementation challenges can be solved, and has
been discussed by others, for example, Lin and Jia (2017).
Given the high estimated cost of an ETS that is limited to only two
sectors but also achieves the ambitious carbon targets, our second goal
is to discuss how extensions of carbon pricing to all other sectors
might achieve these carbon goals at a lower cost to the whole society.
We give four examples of hybrid systems where the ETS is combined
with a carbon tax for users of fossil fuels outside of the sectors covered
by the ETS. In the simplest extension that keeps the ETS rules un-
changed but with a less severe cap, the economy-wide coverage of the
hybrid system will reduce the carbon price from 570 yuan per ton to
90 yuan and reduce the GDP loss in 2030 from 0.3% to 0.1%. In this
case, the ETS sectors suffer much smaller losses while the rest of the
economy shares in the carbon reduction burden. We thus recommend
that policymakers consider such alternative methods of extending the
coverage of industries facing a price on carbon and sharing in the bur-
den so each sector suffers less.
In the proposals for the ETS, electricity producers receive a generous
subsidy but carbon emissions embodied in electricity consumption by
ETS sectors are also subject to permit requirements. In an alternative hy-
brid system, we examine the impact of removing the embodied permit
requirement and the electricity subsidy in order to encourage electricity
conservation by all sectors. We showed how this improves the effi-
ciency of the system even more.
Finally, we recognize the rationale for giving the permits free ini-
tially, either as a grant based on historical performance or in the form
of output subsidies as we modeled here; the results emphasize the
large gains from having higher electricity prices to encourage conserva-
tion and thus a plan to eventually phase out free allocations or subsidies
to electricity should be carefully considered. We show how auctioning
the permits instead of allocating them free to the covered enterprises
will change product prices and output patterns, in both ETS-only and
hybrid policies. We find that auctioning would provide revenues for
the government to cut other taxes and reduce the losses of the ETS-
only system.
While a hybrid system of permits and taxes at first may seem more
complicated to administer than a pure ETS system, the latter invites its
own implementation challenges when extended to sectors with more
dispersed and smaller sources than is typical for major industrial sec-
tors. The concentration of production in a small number of firms and
large plants in industries such as electricity and cement facilitates
their oversight by ETS authorities and provides the firms with greater
organizational capacity to participate in complex emission markets.
Less concentrated industries and sectors lack these advantages to sup-
port effective ETS implementation. Such challenges have arguably al-
ready affected China's national ETS plans, delaying its roll-out and
reducing the number of sectors in its initial phase from eight to one
(electricity) in the December 2017 announcement.
Applying a carbon price in many sectors, including extending cover-
age to small emitters, may be much easier to implement with a tax, in
China as elsewhere. We note that the highly touted cap-and-trade sys-
tem in California is in some sense already a hybrid pricing framework
with a separate carbon price on gasoline and natural gas. China's case
is more complicated given its heavy reliance on coal and the need to
put a carbon price on it, but the substantial benefits of a broader system
illustrated here should prompt careful thinking about how carbon pric-
ing might most effectively and practically be extended throughout
China's economy.
Appendix A. Supplementary data
Supplementary data to this article can be found online at https://doi.
org/10.1016/j.eneco.2019.04.029.
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