When it launches in 2017, China's CO₂ emissions trading system (ETS) will cover the largest CO₂ emissions volume of any system to date and be among the very first to launch in a developing country. We evaluate the potential of an ETS to alter the emitting behavior of covered firms and to support the achievement of national CO₂ intensity reduction targets at least cost. Specifically, we focus on two questions: (1) What factors have limited firms' past compliance with environmental policy in China, and (2) what can be done to strengthen compliance with China's national ETS? We argue that altering firm behavior will require a simultaneous effort to strengthen firms' compliance incentives through changes to national institutions - in particular, a strong legal foundation for the system, a nationally unified set of measurement, reporting, and verification requirements subject to independent scrutiny, and ongoing broader economic reforms to support system operation. It will also require signaling a sustained commitment to experimentation, evaluation, and modification of the system based on performance, given that system effectiveness will depend on expectations about its longevity and credibility, but will inevitably require adjustments. We illustrate the importance of these recommendations for firm compliance behavior by drawing on the experience of the Beijing pilot ETS (2013-2015). Given vast heterogeneity across provinces, special attention should be given to strengthening institutional foundations where they are least developed alongside the construction of a national ETS.

Keywords: Climate change, emissions trading system, firm compliance, China