Towards a national ETS in China: Cap-setting and model mechanisms

China is moving from regional Emissions Trading Schemes (ETSs) to a nation-wide ETS. Although a larger ETS will be more efficient, the literature warns that it could make net permit selling regions worse off. We use a CGE model to simulate the linking of two provincial ETSs, namely those of Hubei and Guangdong. Our simulations suggest a trade-off between efficiency and equity as the richer regions (typified by Guangdong) will benefit from linking but the poorer regions (typified by Hubei) may lose. This is because poorer provinces in China tend to be more emissions intensive and therefore likely to face a carbon price rise upon linking, the costs of which may be only partially offset by trading, if indeed trading is permitted. We show this, and explain why it is the case by improving on the stylized model suggested by Adams and Parmenter (2013). Following Atkinson (1970), we find that worsened equity from linking may dominate improved efficiency, thus reducing aggregated welfare. We advise more generous caps to be given to more emissions intensive and less developed regions. If so, as suggest our simulation results, a Pareto-improvement could be attainable.