Paths and policy adjustments for improving carbon-market liquidity in China

Weak liquidity and low spot prices for carbon are critical problems facing China's carbon markets. This study aims to quantify the liquidity of China's carbon markets under different carbon-pricing strategies by analyzing a model which integrates linkages between the government, markets, and firms. It uses the decoupling theory to set the penalty scale, aiming to reduce the effects of carbon emissions on economic growth. The model permits the study of policy adjustments for certified emission reduction, traders' coverage, and free quotas - the benchmarks of quota allocation. The theoretical analysis indicates that the effect of policy on market liquidity is mainly reflected in the penalty scale and quota-allocation rules. Numerical simulations indicate that the issuance of new quotas accounts for 3.3% of total allocated quotas and raises carbon prices by about 45%. Further, the carbon price rises with an increase in free quotas and then rapidly drops after a peak price of 57 yuan/ton. Our findings indicate that adding free quotas in the short term and expanding trading volume in the middle and long term will improve market liquidity and raise carbon prices.