Asia Society Policy Institute

Emissions trading systems (ETSs) are inherently cost-effective. A key attraction of ETSs is their cost-effectiveness in achieving GHG emission reduction targets. This is because emissions reductions are incentivized where they are cheapest. An entity that can reduce emissions at a relatively low cost will be encouraged to do so for the opportunity to sell surplus allowances or credits. An entity with more expensive abatement options can reduce compliance costs by buying allowances or credits instead of having to rely only on in-house abatement.

Each entity has a wide range of emission reduction opportunities available, including energy efficiency, fuel switching, and GHG emissions abatement such as carbon capture, utilization. and storage (CCUS). The cost-effective potential of an ETS is maximized when an ETS covers a large number of entities with a wide range of abatement costs. Depending on the ETS, there may be opportunities to purchase offset credits. Entities can also benefit from the flexibility of ‘banking’ allowances or credits to be used in future compliance periods.

ETSs are proven in practice. An ETS provides a carbon price signal that drives GHG emissions reductions towards less carbon-intensive production through investments and operational decisions. In the EU, for example, installations covered by the EU ETS have reduced their emissions by 47% from 2005 to 2023. Importantly, an ETS can provide governments with assurance in achieving GHG emissions reduction targets through effective sanctions for non-compliance, with almost 100% compliance in the leading ETSs globally. Furthermore, concerns about potential impacts of an ETS on international competitiveness can be effectively addressed through suitable policy design, such as free allocation of allowances to energy intensive and trade exposed (EITE) entities at risk of carbon leakage.

ETSs are increasingly adopted globally. The ability of an ETS to cover a large proportion of national emissions and achieve cost-effective reductions is why the mechanism is widely adopted to achieve Nationally Determined Contributions (NDCs) under the Paris Agreement. As NDC targets, on the path to Net-Zero, gradually become more stringent and more expensive to achieve, the cost-effective advantage of an ETS will become more important. Another significant driver for the uptake of ETSs is the emergence of carbon border adjustment mechanisms (CBAMs), where a notable example is the EU CBAM. This will impose a carbon price on selected imported goods starting from 2026, equivalent to the EU ETS carbon price, with the aim to prevent carbon leakage from the EU by ensuring that imported goods are subject to the same carbon costs as goods produced within the EU. If importers can prove that a carbon price has already been paid during the production of the imported goods, the corresponding amount can be deducted. As a result, countries outside the EU, particularly those in Asia, are increasingly motivated to adopt similar carbon pricing mechanisms to mitigate the impact of CBAMs on their trade competitiveness.

Source: Asia Society Policy Institute

The chart above shows the significant development of national ETSs in Asia over the past decade, including the recent acceleration in ETS uptake driven by the above factors. Kazakhstan established the first national ETS in Asia in 2013, followed by South Korea in 2015. In China, eight sub-national ETSs have been implemented since 2013, leading to the launch of China’s National ETS in 2021, the world’s largest national ETS by emissions coverage. In 2023, Indonesia and Japan both launched national ETSs, with Japan’s ETS informed by the experiences of two sub-national systems that have been in operation since 2010. By 2023, ETSs in Asia are estimated to cover approximately 6,500 million tons of CO2e emissions, around 13% of total global GHG emissions. By 2025, new systems are expected to be launched in Türkiye, India, and Vietnam; and there is a clear trend towards gradual sectoral expansion for several systems. As such, by 2026, a key milestone due to the implementation of the EU CBAM, national ETSs in Asia are projected to cover approximately 22% of global GHG emissions.

There are different types of ETSs to suit the specific needs and circumstances of any country. There is also a well-established global trend for the evolution of ETS design based on learning by doing and the achievement of increasingly ambitious reduction targets. Asia's landscape of national ETSs is diverse, reflecting various start dates, covered sectors, targeted greenhouse gases, cap types, and regulatory approaches, as illustrated in the table below.

Source: Asia Society Policy Institute

Some key features of national ETSs in Asia are summarized below.

Sectors

For Asian ETSs, there is a clear focus on the power and industrial sectors given they are the region’s significant contributors to national emissions. The power sector is one of the most important to cover in any ETS due to the scale and abatement potential of GHG emissions, as well as the ability to introduce auctioning and to generate climate finance, as covered in the following ‘Revenue’ section. A wide coverage of sectors and entities provides a diversity of abatement costs and thus increases the cost-effectiveness of an ETS. It is also important for an effective carbon market. However, consideration should be given to exclude smaller emitters for which the transactional costs of an ETS—particularly in terms of monitoring, reporting and verification (MRV)—may be excessive. An expected future trend in Asia is the expansion in scope to include buildings and transportation sectors, regulating upstream energy suppliers, given the challenges of other types of policies to adequately control emissions from these sectors.

Type of Cap

The type of emissions cap could be a top-down absolute emissions cap or a bottom-up emissions intensity-based cap. Absolute caps—as currently employed in Kazakhstan, South Korea, and planned for Türkiye—set a fixed limit on the total GHG emissions that entities can emit over a specific period. This approach provides greater environmental certainty, economic efficiency, and market functionality. However, it also requires effective policy tools to address possible serious and unexpected surpluses or shortages of allowance supply. In contrast, China and Indonesia use intensity-based caps, which limit emissions per unit of output. As such, the total allowable emissions will vary depending on the level of production. This approach can be suitable in countries where economic growth rates are high and less predictable and where determining a reasonable absolute emission target can be challenging. In the longer term, an absolute cap will be a key consideration.

Mandatory or Voluntary Systems

Most existing and upcoming ETSs in the region are mandatory, requiring compliance from covered entities. Japan's GX-ETS currently operates on a voluntary basis but is expected to become mandatory by Phase 2 in 2026. Similarly, Vietnam’s ETS is planned to start on a voluntary basis and is expected to become mandatory by 2028. A voluntary system can be used to help with the gradual introduction of an ETS, although it is not expected to achieve significant additional emissions reductions until a system becomes mandatory.

Allowance or Credit Approaches

In an ETS, the regulator can either provide emissions allowances at the beginning of the compliance period, or they can provide carbon credits at the end of the compliance period. In the first case, which is the more commonly applied approach globally and in Asia, the complying entity must surrender to the regulator the allowances that correspond with its emissions. In a credit-based system, the regulator provides carbon credits to an entity if it has overachieved its emissions target. This latter system is applied in Japan’s GX-ETS and is planned for India’s CCTS. It is expected that the current Japanese system will transition to an allowance-based system to facilitate the auctioning that is planned for a later phase. Allowance-based systems should provide better liquidity

Auctioning

Under an allowance-based system, allowances are given for free or by auction. Auctioning is the most transparent method of allocation,--it puts into practice the principle that the polluter should pay, and it creates a stronger carbon price signal to drive emissions reductions. It also reduces the risk that some entities may gain an unfair (‘windfall’) profit in which they can charge a higher price for their product without paying for the allowances. Furthermore, auctioning facilitates the generation of revenue, as described in the following ‘Revenue’ section.

Currently the ETSs in Asia mainly use free allocation. South Korea currently auctions 10% of allowances, with plans to increase this share in Phase 4 (2026 to 2030). Japan has plans to start auctioning for the power sector by 2033. The timeline and extent of auctioning for other countries is not yet determined.

Long-term Planning

It is good practice to have a long-term plan for the development of an ETS, recognizing that not all the elements of an effective design may be in place in the first phase and may, in fact, take some time to develop. Such a plan would provide considerable benefits, including providing greater long-term certainty and predictability for obligated entities to help them make effective investment decisions for reducing GHG emissions.

ETSs can provide a powerful mechanism for reducing GHG emissions by generating revenue for the government that can then be used to support both investment in decarbonization technologies and vulnerable stakeholders during the clean energy and net-zero transition. This is typically achieved by auctioning a portion, or even all, of the emission allowances, rather than allocating them for free. The revenue generated from ETS auctions could be substantial. The figure below highlights the revenue raised up to 2023 from key ETSs worldwide.

Source: chart by Asia Society Policy Institute; data from International Carbon Action Partnership Status report 2024

A key factor in determining the feasibility for auctioning allowances is the extent to which a sector can pass through carbon costs to product prices. In ETSs around the world, the power sector is where this is most feasible, and where auctioning of allowances is most widely applied. An effective interaction between an ETS and the power market will be necessary for enabling carbon costs to be reflected in power station dispatch decisions (driving fuel switching to lower-carbon fuels and renewables) and passed-through to retail electricity prices (facilitating auctioning of emissions allowances for the power sector and demand side management of electricity consumption). In conjunction, measures may be needed to mitigate the impacts of potentially higher electricity costs on vulnerable stakeholder groups, which can be financed by auction revenue.

The EU has generated the most significant amount of ETS revenue so far due to relatively high carbon prices and full auctioning for its power sector. Revenue is partly distributed among member states for climate and energy purposes, as well as related social purposes; and it is also partly used to finance centralized funds, including the Innovation Fund (for demonstration of innovative low-carbon technologies in ETS sectors), Modernization Fund (for the upgrading of energy systems in lower-income Member States), and Social Climate Fund (financial support for vulnerable households, transport users, and micro-enterprises). Other notable examples of how ETS revenue can be distributed include the California Cap-and-Trade Program, Regional Greenhouse Gas Initiative (RGGI), and Washington State Cap-and-Invest Program.

In Asia, a notable example of how ETS revenue can be used is Japan’s GX-ETS. While it began as a credit-based system, the ETS is expected to transition to an allocation-based system to enable the auctioning of allowances for the power sector by 2033. The auction revenue, in addition to revenue from a fossil fuel levy, will be used to repay a Climate Transition Bond. Beginning in 2024, Japan has started to issue this bond worth approximately USD 120 billion over the next ten years. The finance will be used to support upfront investment in green transition in power and industry sectors and to catalyze private investment in low carbon technologies such as green hydrogen. This will leverage over USD 900 billion of public and private sector investments in green transformation. Japan’s Climate Transition Bond is a solution for generating funds in the present, even though ETS auctioning is yet to be introduced. The framework for this bond is shown below.

Source: Japan Climate Transition Bond Framework and Asia Society Policy Institute’s analysis

As more experience is gained in implementing ETSs in Asia and worldwide, there is a better understanding of best practices in ETS design and solutions to common challenges. Asia Society Policy Institute’s Dialogue Facility on ETS Development in Asia supports the development of effective and successful systems through a series of private dialogues that bring together policymakers and experts from major Asian economies. Some key elements of effective ETS design are summarized in the figure below.

Source: Asia Society Policy Institute

A brief overview of key challenges and solutions for ETS design follows below.

Cap-setting

The cap in an ETS sets the limit on total GHG emissions or emission intensities, typically established annually or for multiple years within a phase. Cap-setting is a fundamental aspect of ETS design, determining the system's overall emissions reduction ambition and carbon price. Currently, the caps in Asian ETSs have relatively modest levels of emissions reduction ambition, leading to surplus-free allowances and low carbon prices. These results are also impacted, as in the case of the Korean ETS (K-ETS), by an absolute cap but without yet effective flexibility measures to respond to economic shocks such as the one caused by COVID-19, although this will be addressed in the next phase. Additionally, certain systems publish caps only for a few years ahead, creating uncertainty, and hindering effective investment decision-making and market functionality.

Best practice involves developing a long-term absolute cap trajectory that is aligned with national emission targets including NDCs, using detailed economic and energy system modeling, and considering sectoral mitigation opportunities and costs. Such modelling needs to carefully consider economic growth projections and the impact on GHG emissions of complementary ‘business as usual’ policies, including those targeting the scale up of renewable energy. The ETS cap should represent a cost-effective and optimized sharing of the GHG emissions reduction burden across the economy as a whole, considering both ETS and non-ETS sectors. The different prospects for emissions reduction across sectors covered by an ETS can be reflected by developing sectoral GHG emissions targets and ensuring that final allocations are adjusted to align with these targets. There should also be space within the cap to allow for allocations to new factories and expansions in the production of existing entities. For example, the cap-setting approach of the K-ETS embodies many of these aspects of best practice.

Some systems in Asia utilize intensity-based caps, such as in China and Indonesia, which set emissions intensity targets for each entity (e.g., tCO2e/t product). Actual emissions will depend on production levels. While intensity-based caps can suit regions with less predictable economic growth, they provide less control over total emissions than systems with absolute caps and potentially reduced market functionality due to greater uncertainty in emissions allocations. For such systems, planning a transition to an absolute cap would be recommended, such as for China’s national ETS. This could start with setting a relatively loose absolute cap and gradually tightening it, with a transitional phase comprising of both intensity-based and absolute caps. The risk of unexpected surpluses or shortages of allowances associated with absolute caps can be addressed by market stability operations, allowance banking, and long-term predictability in system design. Other measures include auctioning allowances with a price floor, sales of allowances at fixed prices, and reserves for new entrants.

For more details, refer to the report from the ASPI Dialogue Meeting on ETS Cap-Setting and Allocation, an issue paper on The Transition from an Intensity to an Absolute Emissions Cap in China’s National Emissions Trading System and a report on Economic and Environmental Impacts of China’s New Nationwide CO2 Emissions Trading System.

Allocation

The allocation method establishes the approach for distributing allowances under the cap, has direct financial implications for covered entities, and, in the case of free allocation, enables governments to mitigate risks of carbon leakage in energy-intensive and trade-exposed sectors. For free allocation, both grandfathering and benchmarking approaches are applied in Asia. There is a trend towards benchmarking as it rewards entities with low GHG emissions intensity, and it can reduce competitiveness distortions within a sector. In contrast, the grandfathering method, whilst potentially easier to implement, allocates allowances in line with historic emissions. Driven by the need to achieve greater emissions reductions, reduce oversupply of free allowances, and reduce exposure to costs under the EU’s CBAM, it is expected that benchmark levels in Asian ETSs will become more ambitious. For example, these benchmarks can be based on the emissions intensity of the top 10% of facilities or 10% below the average, as applied in the EU and California. Best practice is one benchmark per product, with no differentiation for fuel type, technology, or size. This incentivizes low carbon production.

Practical lessons include the need to introduce legally binding data submission requirements, have clear data collection guidelines and ensure close involvement with stakeholders during the process. Specifying key allocation details in legislation is also important for a timely development process. For more details on ETS allocation, refer to the report from the ASPI Dialogue Meeting on ETS Cap-Setting and Allocation, and a paper outlining South Korea’s experience in establishing benchmarks for the industrial sector.

Auctioning is the alternative to free allocation, creating a stronger carbon price signal for emissions reductions and facilitating generation of revenue that can be used for investment in GHG emissions reduction projects. So far, auctioning of allowances in Asian ETSs is limited to the K-ETS and at a relatively low level, although this is due to be increased, and other jurisdictions are also planning auctioning. To introduce and scale up auctioning, it is necessary to assess the potential of sectors to pass-through carbon costs to product prices and further facilitate this where possible. See the section below on ‘Power Market Interaction’ for further details.

Power Market Interaction

The ETS carbon price can help power sector decarbonization by first, impacting power station dispatch decisions in the wholesale market, leading to a switch from coal to lower carbon fuels and renewable energy; and second, reducing electricity end-user demand through pass-through of costs to electricity prices in the retail market. In many Asian countries, power markets may require modifications to fully reflect carbon costs and allow an ETS to realize its full mitigation potential. For example, where an economic merit order system is in place where the order of dispatch of power stations is based the order of increasing operating costs, this can be adapted to an environmental merit order system to include carbon costs as additional variable operating costs.

Where full cost pass-through to retail electricity prices is not yet feasible, an interim solution to facilitate demand side management of electricity consumption is the use of indirect emissions allocation, where emissions related to electricity consumption are controlled. K-ETS is an example of where this is successfully applied.

For more details, refer to the report from the ASPI Dialogue Meeting on ETS and power sector, as well as our papers addressing the specific issues and solutions for ETS’s in China and Korea.

Monitoring, Reporting and Verification

Any ETS will need to have a monitoring, reporting and verification (MRV) system that is robust, transparent, consistent and accurate. A key challenge to MRV is achieving accurate data cost-effectively. An increasing body of global best practices, building on the EU ETS experience, can help address this. Key elements include:

• A tiered approach to monitoring with higher tiers for larger emitters with stricter rules for accuracy, and allowing improvement over time.
• Robust quality assurance and control (QA/QC) with a requirement to set-up specific procedures for calibration, document management, review of data, etc.
• A requirement for a monitoring plan, approved by the regulator, which specifies how monitoring should be conducted, promotes equal treatment, and facilitates compliance checks.
• Verification and accreditation based on ISO 14065.
• Peer evaluation of accreditation body.
• Training and procedures to ensure competence and impartiality of third-party verifiers.
• IT systems to enhance efficiency, effectiveness, and accuracy of MRV processes; facilitate workflow; and enable recording and tracking of all relevant information.

Stringent sanctions will be needed for non-compliance and data fraud of covered entities, as well as relevant sanctions for verifiers such as the withdrawal or suspension of accreditation.

For more details, refer to the report from the ASPI Dialogue Meeting on MRVA systems.

Carbon Market

Carbon markets in Asia currently have low levels of liquidity, with transactions concentrated around the compliance deadline and a relatively low number of transactions throughout the rest of the year. Additionally, entities tend to hold and bank large amounts of free allowances. These effects can make price discovery more challenging, create difficulties for entities in securing allowances to meet compliance obligations, and reduce overall economic efficiency. Fundamental causes can include policy uncertainty, a lack of market transparency and predictability, a relatively loose cap, and generous levels of free allocation.

A key approach to improving liquidity is to allow participation in the carbon market of third parties such as financial institutions. In contrast to compliance entities, third parties will be incentivized to buy and sell frequently, and thus improve the supply and demand of allowances. This role can also be implemented in a more formal way through a market maker, with daily trading obligations, such as those adopted in the K-ETS. Appropriate controls against market abuse and manipulation can be applied, drawing on the practices from the European Union and the United States. Banking restrictions, like those adopted in South Korea and China, can help reduce the hoarding of allowances. Furthermore, it can be beneficial to prevent the banking of allowances from the initial learning phase, when free allocations are typically more generous, to later phases in order to prevent surplus allowances in circulation and persistent low carbon prices.

For control of the amount of allowances in circulation and price levels, volume-based or price-based market stability measures can be considered, similar to measures from the EU’s Market Stability Reserve and the California Cap-and-Trade Program’s Allowance Price Containment Reserve, respectively. Such control becomes more important with an absolute cap in order to deal with economic shocks, as described in the cap-setting section.