Evolution of Korea's emissions trading system
By Kim Sung-woo
Myron Scholes, a professor at Stanford University and a 1997 Nobel Laureate in Economic Sciences, remarked during his visit to Korea last June that the carbon credit market would grow enormously in the future. As a founder of the Black-Scholes Model for pricing option contracts, he is known to have built a theoretical framework for pricing financial derivatives. Through carbon credits, companies can trade their carbon reduction performance. Companies short of their reduction targets may purchase carbon credits to fill the gap and achieve their target.
While acknowledging the huge potential in the market for carbon credits, Professor Scholes also flagged the underlying risks in the market that may arise from the ambiguous nature of what counts as a carbon credit. Professor Scholes advocated the need to introduce legal and accounting frameworks to address these risks. In other words, the Nobel Laureate seemed to believe that carbon credits are a promising means to reduce carbon emissions but also a potentially controversial tool that requires further discussion and improvement.
Carbon credits are key to the emissions trading system, which is rising as an effective tool to reduce carbon emissions. The emissions trading system is a market for trading carbon credits. Companies that emit a certain amount of carbon are allocated a certain quantity of carbon emissions they are allowed to emit. Those companies under the permissible emissions threshold can sell their carbon credits to other companies that exceeded their permissible threshold.
Since 2015, Korea has been operating an emissions trading system to achieve its national carbon reduction target. It was the second country in the world after the EU to initiate the emissions trading system nationwide. The total volume of transactions in Korea was 54.72 million tons in 2021. The covered entities emit 73 percent of the country's total emissions, which is the largest ratio around the world.
The Korean government adopted the emissions trading system as a primary tool for achieving the national reduction target, established for the first time in 2009. In 2020 and 2021, the national reduction target was heightened due to the Paris Agreement taking effect. In addition, the emissions trading system has become increasingly more important as Korea needs to navigate various hurdles in international trade that arise from environmental concerns such as the EU Carbon Border Adjustment Mechanism.
Meanwhile, companies have been raising concerns due to the difficulty in implementing the emissions trading system into their business and calling for improving the system to make it more reasonable and practical. Against this backdrop, the Korean government has faced a huge need to upgrade the emission trading system to address the lack of motivation for companies to reduce carbon emissions and the increased volatility in the market environment.
Accordingly, the government and the private sector jointly formed the Partnership for Advancing Emissions Trading System, consisting of experts from relevant ministries, companies and associations, and announced plans to improve the emissions trading system last November. As key strategies, the partnership proposed increasing incentives for carbon reduction, enhancing market mechanisms for proper pricing of carbon and supporting companies to implement reductions.
The partnership proposed to increase the incentives for companies' carbon reduction investments by recognizing their reduction performance if they replace existing facilities with high-efficiency facilities that are the top 10 percent of the industry on average, produce products with low-carbon raw materials such as bio-naphtha, or use electricity produced with renewable energy. In addition, the partnership also suggested that the government would gradually increase the participation of financial institutions as market makers and introduce a trading system based on a third-party delegation and a futures trading system to mitigate volatility in carbon credit prices and facilitate transactions.
The government is also planning to ease the procedure for converting overseas carbon reduction projects into carbon credits that can be traded in Korea, if the reduction projects have been certified by the UN. The government support for carbon-neutral facilities using funds generated from the paid allocation (auction) of carbon credits will continue to increase.
For successful implementation of the plan, a few conditions must be met. First of all, the electricity market should take into account prices of carbon credits such that the carbon prices can incentivize companies to reduce carbon emissions in the power generation sector, a key industry in Korea's transition to the next generation of energy. In addition, since future emission allocation is determined based on past emissions, the government must take action to prevent moral hazard for those companies that used to have large emission amounts in the past. Lastly, the government must make it more predictable regarding how they exercise discretion over carbon credits for price stability.
There is no one-size-fits-all type of emissions trading system for roughly the 700 companies covered in the system. It is even more difficult for companies that grow by increasing the number of factories they operate. Nevertheless, for the past eight years, Korea has operated the emissions trading system for industries with high energy-consuming structures, and Korea should tap into such experience as an asset.
Korea's emissions trading system, which is evolving, is a good example for developing countries that need to introduce carbon reduction policies. Korea's failures and successes can be both a learning resource for developing countries so that they do not repeat the same failures and a way of not reinventing the wheel. Korea is well-positioned to share its trials and errors with the international community in its journey to perfecting the emissions trading system.
Kim Sung-woo is head of Environment & Energy Research Institute at Kim & Chang.