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

The vice minister of ecology and environment, Li Gao, anticipates the presence of a first group of financial institutions actively trading on China's national carbon market by the end of the year. Currently, financial institutions chiefly provide associated financial services to traders required to surrender carbon allowances to offset their emissions. The introduction of direct buying and selling by financial institutions could have significant effects on the market.

Financial institutions are being introduced to the carbon market to boost liquidity, assist companies in managing carbon assets, and enhance the precision of carbon pricing signals. China's carbon market comprises major emitters who are obligated to cancel carbon allowances equivalent to their emissions, typically once a year. These trades tend to cluster around compliance deadlines or aligned with internal accounting periods, resulting in unequal trading schedules between buyers and sellers.

He Qing, carbon finance director for Guotai Haitong, emphasizes the role of financial institutions in providing liquidity through buffering supply and demand. This liquidity improvement is expected to result in decreased price fluctuations and more accurate price discovery mechanisms. The carbon price is not solely influenced by compliance costs, but also informs companies' decisions regarding investments in emissions reduction technologies.

Financial institutions can facilitate market access and agency services for companies, particularly smaller businesses that may lack necessary expertise. They can split trades to accommodate specific needs, such as a company requiring 1,522 tonnes of carbon allowances when the market trades in units of 1,000 tonnes. Furthermore, financial institutions can act as "market-makers," providing supply and demand when required, thereby reducing irrational market behavior.

Experts anticipate financial institutions to independently invest in the carbon market and provide services on behalf of clients. Initially, banks and securities traders are expected to engage in profit-driven trading, while also potentially trading on behalf of clients. Companies anticipating future carbon allowance needs can buy and hold allowances with the trade completed when required, avoiding the need to pay higher prices during concentrated trading periods.

In the European market, financial institutions provide risk-management tools like futures contracts, enabling companies to spread carbon costs over time instead of purchasing large quantities at once. Financial institutions can also design structured products combining spot and futures purchases to help companies manage risk. In addition, long-term contracts in sectors like steel and shipping could include carbon prices, allowing companies to better manage carbon spending through inclusion in the cost of end products.