China is often viewed, perhaps justifiably, as an environmentally degraded smog-filled country.
Four of the five biggest freshwater lakes are classified as category five, the worst rating on the scale, meaning ‘no biological function.’ Beijing remains pollution-bound. Almost all the major State-Owned Enterprise (SOE) power companies have been named for breaching environmental rules. Many low-end, polluting manufacturing activities have also moved to China.
However, in recent years, China has made significant environmental progress, moving from sustainability laggard to leader. The country is already the world’s largest manufacturer of solar panels. In 2007 it set an internal target to generate 2GW of solar energy by 2020. This figure has recently been increased tenfold to 20GW as the government launched a comprehensive package of financial and technical support. The government has also set targets for wind power to increase from 12GW to 100-150GW by 2020.
Co-operation
International co-operation is also growing. Foreign companies such as Suzlon are joining the race to develop clean energy projects in China. Domestic companies like ENN group have hired overseas experts to lead their R&D efforts. The Ministry of Environmental Protection and the National Development and Reform Commission have cooperated with international agencies in the environmental area.
Revenue models for clean energy operation in China now appear reasonable. For example, in the solar sector, the government rejected a very low bid by a solar company for a power project, instead accepting a much higher tariff from another company. This was to provide a higher level of profitability for the industry as a whole and discourage players from competing on cost alone.
The waste-to-energy business also offers a well-defined revenue model. Local governments pay operators rubbish-collection fees and reasonable on-grid tariffs. China has made considerable progress in producing municipal solid waste with almost 200 million tonnes a year. It has a massive programme to introduce large-scale waste-to-energy plants across the country. The first steps are low-tech, relying heavily on additional fuels to ensure adequate combustion. Emission standards are as yet low and the carbon benefits are questionable, but the country appears committed to improvement.
Future returns
The government has recently raised wind power tariffs by 20%. Wind turbine costs are also coming down and operators should enjoy better returns in the future. Nuclear power plants offer tariffs similar to thermal plants, but better potential returns due to high utilisation. However, for safety reasons only four state-owned companies are currently allowed to operate and take controlling stakes in nuclear power plants.
Policies are being introduced to change consumer behaviour. It is now illegal to give away free plastic bags in supermarkets. Beijing residents are only allowed to drive their car on four out of five days. All electronic products are now graded on a scale of one to five for energy efficiency. China has a list of resource-intensive industries it is actively seeking to discourage. Shanghai controls the number of new cars by using a licensing scheme similar to the Car Ownership Entitlement in Singapore with a current price of RMB30,000.
There is likely to be growing calls for the Chinese government to use other economic tools to promote better environmental protection in the future. For example, the pricing of environmental and carbon costs in the coal-fired power sector may need to be re-assessed and new pricing implemented. Current electricity prices are too low to capture these costs and may increase substantially in the future to take account of them. However, timing and affordability issues will be key concerns for the government.
Technology development
At the corporate level, the technologies used by many Chinese companies in the sustainable space still lag those in Germany, Japan and the US. Some key equipment and components still need to be imported. Nevertheless, several domestic companies stand out in terms of technological development: ENN Group in clean coal and algae-to-bio fuel, Suntech Power in Pluto technology for solar power and Tianwei Baobian for high-voltage transformers.
In conclusion, China is making substantial progress towards a more sustainable economy driven by a government committed to a greener agenda, although the country still faces huge problems associated with a very large population, significant disparities of wealth and bounding levels of economic growth. We believe the journey will provide interesting opportunities for long-term equity investors. When analysing companies in the environmental sector, it is important to maintain a disciplined investment approach. We remain focused on quality in terms of business franchise, management and financial structure.
Note: this article originally appeared in FT China Confidential, September 2009
Quanqiang Xian, senior portfolio manager, Greater China Equities, First State
