South Korea’s Emission Trading System: Challenges, Prospects and Lessons for Canada

Author: Kyae Lim Kwon

With a vision to “redesign and build a strong carbon-neutral economy,” Ontario is joining British Columbia and Quebec in taking province-wide action on climate change. And it is doing this by putting a price on carbon. With the release of Ontario’s Climate Change Discussion Paper on February 12, 2015, the province has engaged stakeholders through discussion, town hall meetings and forums for public input to shape its long-term climate strategy and come to the decision to introduce a cap-and-trade system that would be linked with Quebec’s and California’s carbon markets. [1] Details on the design of Ontario's cap and trade is expected to be developed by October, according to Ontario's Environment Minister Glen Murray.

As Ontario works out the details of its cap-and-trade, the province should look at South Korea’s recent experience. The worlds’ 12th-largest economy recently launched a nationwide emissions trading system (ETS) that began trading on January 12, 2015 on the Korea Exchange (KRX), and it is now the world’s second-largest carbon market after the EU’s ETS. [2] South Korea’s ETS is worth watching for two reasons: first, it could positively influence other countries’ ambitions and commitments at the Paris Climate Change Conference (COP21) later this year; and second, it could provide valuable lessons for Ontario (and perhaps for Canada as a whole) as it charts its own course to a lower-carbon future.

Background on Carbon Pricing

Pricing carbon is a way to encourage investment and innovation in clean energy and technology by making polluters pay for the environmental costs of production. According to the World Bank, about 40 countries and over 20 sub-national jurisdictions have already begun doing this, covering almost six gigatons of carbon dioxide, or about 12 per cent of the annual global greenhouse gas (GHG) emissions (see map).

 

 

The two most popular policy tools to price carbon are a carbon tax and an ETS (or carbon market). A carbon tax imposes a fee on carbon emissions by setting a price per tonne of CO2 equivalent (or using a metric directly based on carbon), then translating it onto a tax on burning fuels. [3] In contrast, an ETS sets a price on carbon by establishing a market for tradable permits. The government sets a cap on carbon emissions, which is lower than the projected amount of emissions to be emitted under a ‘business as usual’ scenario. The government then distributes tradable carbon ‘units’ to companies that emit below their allocated quota, and those companies can sell those units to other companies that emit beyond their quota.

ETS gives firms flexibility to decide how to meet their emissions obligationsOne reason many economists have championed the ETS system over the carbon tax is because it creates the ‘right to pollute’ whereby the market, instead of the government, determines the price of such rights. Put differently, ETS gives firms flexibility to decide how to meet their emissions obligations: either they reduce emissions internally and sell their emissions reduction on the carbon market, or they purchase carbon credits from the market.

 

The ETS Story in South Korea

Since the 1990s, the Korean government has tried to ‘harmonize’ its energy systems with the environment in response to intensifying international environmental regulations. The 2008 global recession accelerated the push towards energy self-sufficiency (i.e. through investment in renewables and diversifying its energy portfolio), especially because the country has no indigenous sources of carbon-based energy. This is evidenced by former President Lee Myung-bak’s enthusiastic embrace of the ‘Green Growth’ agenda, which was framed as a “stone that kills three birds”: in other words, it helps achieve energy sufficiency, economic growth and environmental protection. The agenda subsequently led to the ‘Green New Deal’ stimulus package, as well as the passage of the ‘Framework Act on Low Carbon Green Growth’ and the release of the Five-Year Plan for Green Growth.

With this background, South Korea’s road to ETS began at the 2009 UN Climate Change Conference (UNFCCC) in Copenhagen where it pledged to reduce its emissions by 30 per cent relative to 2005 levels by the year 2020. [4] This commitment was one of the brighter spot of the conference, which was seen by many as a disappointment because it failed to produce a legally-binding agreement. Indeed, South Korea’s announcement was surprising in light of some studies that had suggested that such an ambitious emissions target would end up reducing the country’s GDP growth rate by 1.5 per cent per year until 2020.

What explains South Korea’s proactive embrace of ETS?

First, this was an anticipatory move on the government’s part. South Korea is now the seventh-largest GHG emitter in the world with the highest growth rate in GHG emissions (3.9 per cent from 1990 to 2020) among OECD members. Under the new climate regime that is expected to replace the Kyoto Protocol later this year, the country expects that it likely will have to adopt binding emissions targets anyway.

Second, South Korea has a direct interest in spurring international action on climate change because of its own vulnerability to the impacts. For example, the average temperature in the country has increased by 1.5 C over the last century, more than double the global average of 0.6 C during the same period.  As a result, the past 20 years have been marked by natural disasters in South Korea that are rising in frequency and intensity.

Third, reducing reliance on GHG-producing fossil fuels, which currently account for 97 per cent of the country’s energy use, is a way to meet important energy security objectives, especially by increasing nuclear and renewable energy in the country’s primary energy mix.

Seoul sees ETS as an important mechanism for catalyzing the country’s green industriesFinally, and significantly, Seoul sees ETS as an important mechanism for catalyzing the country’s green industries and securing a share of the global green market. It is banking on using this as a way to develop a competitive edge in clean tech, renewable energy and energy demand management services.

Overcoming Domestic Resistance

South Korea’s ETS currently covers 525 businesses and public institutions, accounting for nearly two thirds of the country’s annual GHG emissions. [5] Implementation is divided into three phases (Phase 1: 2015-17; Phase II: 2018-20; Phase III: 2021-25), during which it will continue to lower the threshold for emissions and gradually bring more companies from more sectors of the economy under its umbrella.

Although the ETS Act, led by the Presidential Committee on Green Growth, passed in May 2012 with near-unanimous support from the Korean National Assembly (148-0 vote, with three abstentions), implementation has encountered resistance from industry. For example:

  • The Korea Chamber of Commerce and Industry and the Federation of Korean Industries strongly argued for a delay in implementation from 2013 to 2015.
  • The Ministry of Environment’s original plan was to ‘auction’ a significant portion of the emissions allowances, as recommended by policy experts. But industry commissioned a report that found that auctioning the allowances would substantially increase average production costs, thereby making the Ministry’s plan much less attractive than a ‘free allocation’ system. [6] (With free allocation, the government hands out emissions allowances to each firm at no cost, whereas in an auction system, firms bid against each other to acquire emissions allowances at their own cost).
  • Following publication of the National Emission Allocation Plan in May 2014, an association of industries produced a Joint Statement requesting that the government: 1) recalculate the business as usual scenario, as they deemed it was too severe; 2) exclude indirect emissions (i.e. electricity and steam) as they fall under dual regulation; and, 3) increase consultation with industry.

In response to some of these concerns, the government compromised. For example, it agreed to move the start date from 2013 to 2015, increased the percentage of free allocation and allowed ‘sensitive’ sectors (largely defined as those that face steep international competition) to receive free allocation for the entire three phases (i.e. for the next ten years).

However, the government did not yield to every demand. For example, although the power and manufacturing sectors argued that actual emissions could be a third higher than what was indicated in the business-as-usual scenario, the government declined to revise it. Additionally, the Ministry of Environment remained firm on the inclusion of indirect emissions associated with the power sector. [7] The government’s resolve in the face of resistance from various industries demonstrates its determination to meet the international commitment to lower GHG emissions, while also spurring technological innovation, improving energy intensity and driving consumer demand for cleaner sources of energy.

Stumbling Out of the Gate

After the ETS was finally launched on January 12, 2015, the system faced immediate challenges. In fact, after the first four days, emissions trading stopped altogether before picking up again recently. The reason for the market inactivity was the lack of tradable carbon credits. [8]

 

In December 2014, just one month before the scheduled ETS rollout, a coalition of 525 companies was still requesting a total cap of 2.2 billion tonnes of emissions allowances; however, the government granted only 80 per cent of that amount. As a result, there are currently many buyers but no sellers. This has caused wide concern across industry, as it is likely to face stiff penalties – three times the market price for carbon – if the trend persists. Industry groups argue that such penalties will cost their stakeholders 27.5 trillion won (approximately $C30 billion) by 2017. [9] The steel, petrochemical and semiconductor sectors, concerned about their international competitiveness, are leading an industry coalition against the current ETS. [10] In the first month of the system almost half of the companies under the system filed formal objections with the Ministry of Environment against the seemingly ‘unfair’ system. In addition, a number of critics of ETS have argued that the credit shortage should have been foreseen.Beyond such criticism, another real concern is the dearth of specialized training in carbon trading.

ETS: Here to Stay

Despite these initial setbacks and industry dissatisfaction, there are reasons to believe that the South Korean carbon market not only has staying power, but also will grow. Why the optimism?

First, it is useful to bear in mind that the ultimate objective of the system is to reduce emissions by putting a price on carbon. Even with a lack of trading of carbon credits, the system will still push firms to reduce their emissions, with the penalty system ensuring that the polluting firms ‘internalize’ the cost of carbon. Also, the volume of trading may improve in the coming months as offset credits begin to be traded. Offset credits are derived from project-based carbon abatement outside the company, such as funding renewable energy, energy efficiency or forestation projects, rather than an actual reduction in a company’s emissions. This is an important mechanism through which companies without the capacity to generate credits internally can meet their obligations.

In January, the Ministry of Environment reviewed four South Korean companies operating overseas that have projects approved by the UN’s Clean Development Mechanism – an international mechanism under the UNFCCC to finance low-carbon projects, - to turn their emissions reductions into tradable credits on the domestic carbon market. [11] On April 6, KRX and the Ministry of Environment approved the 19.1 million tonnes to be converted into offset credits and traded on the domestic carbon market, which immediately increased market transactions.

Second, while opponents have criticized the government’s ‘learning by doing’ approach to ETS, it allows the system to retain a degree of flexibility and to better respond to stakeholders. For example, the government is reviewing international law to integrate Certified Emissions Credits (CER) from the Clean Development Mechanism projects in North Korea, which may facilitate closer co-operation across the peninsula on environmental issues. Some have suggested that it may be necessary to increase the percentage of offset credits (currently at 10 per cent) that companies can use to meet their emissions reduction targets in the future. An industry representative has also suggested that the carbon penalty be channeled into R&D fund to assist energy-intensive industries to develop low-carbon technologies.

While traditional energy-intensive sectors may feel they are losing out under ETS, it will be a big win for the clean tech sectorFinally, while traditional energy-intensive sectors may feel they are losing out under ETS, it will be a big win for the clean tech sector. Specifically, those companies with a track record of developing clean technologies have been identified by the South Korean government as a major priority. In addition, a number of companies with approved technologies under the UN’s Clean Development Mechanism are well positioned to benefit from ETS. For instance, Hu-Chems, a fine chemical corporation manufacturer, has established a low-carbon manufacturing system that will generate an estimated 300 million won (approximately C$340,000) in revenue from the sale of nearly two million tonnes of carbon credits in the current trading period. Notably, other companies benefitting from the ETS include LG Electronics, which has been generating about 7,000 tonnes of carbon credits under the UN’s Clean Development Mechanism for developing and manufacturing energy-efficient refrigerators in India since 2013.

There are also signs that energy-intensive industries are restructuring their business strategies to accommodate the new carbon-pricing system. POSCO, the world’s fourth largest steel-maker, recently announced that its future restructuring will divide its ‘environment and energy group’ into two new entities — the ‘environmental resource group’ and the ‘climate change and energy group’ — to strategically respond to its emissions reductions obligations.  

ETS as a Source of International Competitiveness

Choi Kyung-Soo, chairman of the Korea Exchange (KRX) takes a long-term approach to the development of ETS, noting that assessing the system based on short-term market performance takes away from achieving GHG emissions reductions. Further, he has testified that South Korea has a long-term ambition to make KRX internationally competitive, and is preparing to link it globally with other carbon markets. Many consultants and academics also support ETS, and consider it as an important stepping-stone for achieving green growth.

Perhaps most importantly, ETS supports the government’s goal of making South Korea a hub for green growth industries and institutions. It already hosts the Global Green Growth Institute (GGGI) and Green Climate Fund (GCF), two international institutions that provide climate change solutions and finance climate change mitigation and adaptation. The government also envisions developing ETS to promote its green influence in the region, including promoting co-operation in Northeast Asia over GHG reductions as South Korea starts to feel more of the effects of air pollution and climate-related issues from neighbouring China and Japan. As linking up carbon markets can improve cost efficiency and effectiveness, enhance market liquidity and promote bilateral or multilateral co-operation, there are considerations in the longer term to link up with the EU’s ETS as well as China’s carbon market (China currently has seven pilot schemes and may implement a nationwide ETS between 2016 and 2020).

Implications for Ontario and Canada

There are two sets of implications for Canada from South Korea’s ETS story: one is the lessons that could be drawn from the South Korean experience, especially for Ontario’s future carbon pricing policy, and the other concerns future Canada-South Korea trade relations at the national level.

For Ontario, South Korea’s experience clearly shows that it can take a long time to design an ETS and get it right. Even after launching an ETS, a government needs to remain flexible to respond to challenges that may arise. While a group of Ontario’s business leaders have vocalized their support for ETS over a carbon tax, the South Korean experience shows that an ambitious cap on emissions can be a source of discontent for industry, and therefore a source of resistance. The Korean experience illustrates how the transition to a low-carbon future may be eased by government assistance to the targeted industry, and this could take the form of increased R&D spending for innovation to meet their carbon obligations and the establishment of mechanisms prior to launching the system to incorporate sufficient level of offset credits. Lastly, it is noteworthy that while South Korea’s ETS has been challenged from domestic industry, the government maintains a positive outlook for the system and hopes to link up with other regional and more distant carbon markets that may provide South Korea with more economic opportunities.

For Canada as a whole, South Korea’s ETS signals clear policy direction towards low-carbon economic development, with an emphasis on the clean technology sector. This should trigger corresponding trade policy responses from Canada.  The Canada-Korea Free Trade Agreement, which contains a chapter on the environment, is a good vehicle to advance green co-operation. Ontario and British Columbia are particularly well positioned to co-operate with South Korea as they are two provinces with proven potential in clean technology. Canadian policy-makers and industry should see the paradigm shift in South Korea as a reflection of a wider trend in Northeast Asia to take action on climate change. There are seven pilot ETSs in China and two ETSs at the city-wide level in Japan. Once China establishes a nationwide carbon market, it is likely that South Korea and China will seek to link their systems, as hinted at when their respective economic ministers agreed in January 2015 to co-operate on emissions trading, GHG emissions data verification and low-carbon technology. Canada must make sure that its trade and international co-operation activities with Asian countries reflect these green growth priorities.

Kyae Lim Kwon is a Post-Graduate Research Fellow at the Asia Pacific Foundation of Canada. She holds an M.Phil in Environmental Policy from the University of Cambridge. The author wishes to express her sincere gratitude to Matt Horne of the Pembina Institute for his helpful comments and suggestions on an earlier draft of this article.

 

[1] There are two main types of ETS: ‘cap and trade’ and ‘baseline and credit.’ South Korea’s ETS is a cap and trade system. In a baseline and credit system, tradable emissions credits are generated by going under an emissions threshold (or a production standard). A third variant of ETS is based on intensity target (emissions per unit of GDP), which has been implemented in China.

[2] KRX is South Korea’s only platform for listing and trading stocks, bonds and derivatives.

[3] CO2e, or carbon dioxide equivalent, expresses the impact of each GHG in terms of the amount of carbon that would create the same amount of warming.

[4] Under the 1992 Kyoto Protocol, Annex I or industrialized countries were obligated to commit to returning to their 1990 levels of GHG emissions. Under the Protocol, which forms the basis for the current international climate governance, South Korea is classified as a developing country and is under no obligation to adopt a target to reduce its GHG emissions in absolute terms.

[5] The system covers firms that emit more than 125,000 tonnes of CO2 equivalents annually based on the average of GHG emissions for the preceding 3 years, or a facility that produces 25,000 tonnes of CO2 equivalents annually for the same period.

[6] It found that average production cost increases by 1.27% under the assumption of 20% emissions reduction relative to the BAU scenario and even a reduction goal of 10% would result in a 1.03% production cost increase.

[7] The reason for inclusion of indirect emissions, which is unique for South Korea’s ETS, is that the proportion of indirect emissions in South Korea is particularly high (above 20%) relative to other countries as the price of electricity is considered inexpensive. Inclusion of indirect emissions from the power sector partly allows the regulators to incentivize the consumers to reduce their electricity consumption. Meanwhile, still facing opposition to the ‘Allocation Plan’ just four months before the launch date, the government adjusted the cap level slightly upwards by reducing the rate for indirect emissions in September 2014.   

[8] The government handed out 14 million tonnes worth of carbon credits, which falls 423 million tonnes short of what the industry had requested. By the second week of trading, only 380 tonnes worth of credit had been traded out of 1.6 billion tonnes. The price, or Korean Allowance Unit (KAU) (the unit price of one tonne of CO2 equivalent), increased from 8,640 won (approx. $C9.93) to 9,930 won (approx. $C11.41), reflecting the scarcity of the emissions allowances.

[9] The Ministry of Environment argues that the industry has over emphasized the cost burden; the Ministry estimates that the penalty will be around 1 trillion won ($C1.15 billion).

[10] Interestingly, the petroleum-refining sector is complying without complaints, as it was early to plan for emissions reduction measures.

[11] For CDM credits, called Certified Emissions Reductions, to become tradable, it must first be approved to be converted as KOC (Korean Offset Credit), which then needs to be converted to KCU (Korean Credit Units) to be traded on the KRX.

The views expressed here are those of the author, and do not necessarily represent the views of the Asia Pacific Foundation of Canada.

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