By SHAI OSTER
BEIJING -- After years of small-scale experiments in using so-called emissions trading to reduce pollution, China is taking steps to set up a nationwide system.
In recent months, three cities -- Shanghai, Beijing and Tianjin -- have begun creating emissions exchanges modeled after a system pioneered in the U.S. to reduce emissions that caused acid rain.
Known as cap-and-trade, this system sets an overall limit, or cap, on how much an industry can pollute. Individual companies get permits, which can then be traded. A company that invests in cutting its emissions can, for instance, sell its credits to a company that operates less cleanly. Traders can speculate on the future value of the credits. When more production means more pollution, the permits gain value.
A similar approach is being used with the carbon markets in Europe, where national limits on greenhouse gases have been set and companies can trade credits that have been approved through the United Nations's Kyoto Protocol mechanism.
In China, the exchanges are so far little more than offices and ideas. But heavyweight investors are already interested in the fledgling markets. One of China's biggest companies, state-owned China National Petroleum Corp., or CNPC, has joined with the Chicago Climate Exchange -- owned by Climate Exchange PLC, which also owns the world's biggest carbon market, the European Climate Exchange -- to set up the Tianjin Climate Exchange.
By many measures, China is among the most polluted countries in the world, and the profits in cleaning up could be huge. It is already the world's leading source of carbon credits traded in Europe and by some estimates has even surpassed the U.S. as the world's top source of greenhouse gases. China also is the world's biggest source of the pollutant sulfur dioxide, a result of the country's reliance on coal for more than 70% of its energy needs.
So far, the country has relied more on administrative measures than on markets to clean up, with mixed success. But its environmental watchdog doesn't have the manpower or the legal muscle to enforce all of the regulations.
China has been experimenting with small-scale local exchanges since the late 1990s for trading in sulfur dioxide. In the experiments, a handful of power plants would agree to an absolute limit on emissions and trade allowances among themselves.
The experiments haven't been nationalized because of fears that setting absolute pollution limits could limit economic growth and because of technical difficulties in measuring and verifying reductions.
Chinese academics and some government officials hope that linking pollution reduction to profits could prove more effective in increasing compliance.
The founders of the exchanges in China say the government is encouraging them to start developing the infrastructure and technical know-how to reduce pollution. They believe the government is intent on setting absolute national limits on some pollutants, such as sulfur dioxide, and will back the use of the markets to help reach those goals.
Though government officials declined to comment, state media gave the formation of these exchanges extensive coverage.
Executives at the markets say they plan to start out very broadly offering tradable financial instruments designed to help companies meet pollution and energy-efficiency targets. The exchanges could also offer carbon credits for companies such as airlines seeking to offset emissions by investing in greenhouse-gas-reduction projects in China. These would operate outside the Kyoto Protocol.
China is at least a decade away from accepting carbon caps, many observers believe, though there is a chance that sulfur caps could be rolled out much sooner. And while the country has broad targets for reducing major pollutants by 10% under its five-year plan ending 2010, and has an efficiency target, it doesn't yet have any of the legal framework for actual emissions trading.—Sue Feng in Beijing contributed to this article.
Write to Shai Oster at shai.oster@wsj.com
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