Carbon Offsetting in China: Shanghai Emission Allowance Forward
We discuss the functionality of the SHEAF and its role in hedging the Chinese carbon market.
Although China’s carbon market is still small relative to its economic output, it is growing rapidly, both for economic and environmental purposes. Policymakers in China are encouraging financial derivatives within green development to assist participants along the way. This paved the way for the Shanghai Emission Allowance Forward (SHEAF), an innovative financial product. This is the first forward product in China’s seven pilot carbon markets and serves a similar purpose to carbon financial derivatives. Officially launched on January 12, 2017, the SHEAF helps carbon market participants to manage market risks.
The Lead Up
China’s pilot carbon market consists of three financial innovations — carbon loans, carbon margin trading, and carbon forward.
The China Certified Emission Reduction (CCER) Pledge Loans are loans that enterprises can access when they own CCERs. Parties sign tripartite agreements with the Shanghai Environment and Energy Exchange and the Shanghai Clearing House, to officially apply for a loan. The SEEE will then freeze the CCERs in the system to guarantee the applicant its pledge credits until the contract’s expiry date. The Carbon Margin Trading is for institutions to trade margins for allowances from eligible enterprises or institutional investors. When this expires, the borrower returns the allowances to the lender and pays the agreed proceeds. The SHEAF is a hedging tool that helps manage the market risks caused by both of these entities as well as institutional investors.
Functionality
A SHEAF contract is between two parties to buy or sell allowances at a specified price on a future date. The SEEE provides the trading platform for SHEAF while the Shanghai Clearing House (SCH), a securities depository by the central government, provides counterparty clearing services and daily market prices. The pricing and settlement of SHEAF is in Chinese Yuan (CNY) and the trading is based on inquiry. The newly acquired trades are reviewed once a year (the specific date of review varies for firms). According to an analyst SCH, there are five forward contracts and an estimated 17,500 forward agreements signed, representing over 1.8 million tons of underlying allowances, although the final market price has not been revealed.
Long-term Benefits
SHEAF services are expected to benefit the market in the long run and build recognition for China’s role in the international carbon market. According to an investment analyst at SEEE, China plans for the national carbon trading market to reach a transaction volume of over 600 billion CNY or approximately $93 billion; “to reach this, we need a trustful system to ensure contract transactions are secured and transparent.” SHEAF also gives incentives to investors to join the market because it helps to secure interest, expose products to global investors, and locks in revenues for future years. It gives emitters the chance to see signals of future carbon costs and allows projects to pre-sell credits.
Lastly, the SHEAF provides market participants and interested parties with critical pre- and post-trade data. This includes information on the provenance of offsets, ownership distribution throughout the market, and the supply of offsets and allowances in circulation. The access to such data helps prevent the rapidly growing market from factors of financial, performance, registration, reversal, and issuance risk.
