According to Standard Life Investments, China has been afforded numerous accolades in recent years, yet a dubious honour it has received is that it is one of the world’s most polluted nations.
The World Bank estimates that China is home to 16 out of the top 20 most polluted cities in the world, while the World Health Organisation estimates that pollution levels in many highly populated areas of China are 40 times higher than its recommended limit. For many people, this has been regarded as a necessary, if high, cost to pay for the phenomenal pace of growth which the country has sustained in recent decades. However, a developing public health crisis and an increasing recognition of the economic implications of a failure to address its air quality problem suggest the world’s second largest economy is finally set to confront this issue.
Of course, getting to grips with the problem is no easy task and any serious policy to stabilise or reduce overall air pollution will need to tackle three core contributors: coal, transport and industry (See Chart). Fortunately, the authorities have fully recognised the importance of these pollutants and the National Air Pollution Action Plan announced in 2013 has set out some key policy initiatives targeting these sectors:
- Coal: Reduction in coal’s contribution to energy mix from 68% to 65% by 2017. Elimination of all coal-fired power stations in Beijing by 2017. Coal consumption caps imposed in several major cities by 2017.
- Transport: Cap in car volumes in key provinces. New, cleaner ‘Stage V’ vehicles introduced nationwide by 2017.
- Industry: Cut in cement and steel capacity in key production provinces. Tightened emission limits for high polluting industries. Expansion of environmental protection market.
Of course, in China there is frequently a disconnect between top-down directives and what is actually implemented at local level. Worthy initiatives count for little if they are not enforced. Encouragingly, the Chinese government has committed a further US $7bn to enhance the ability of supervisory bodies to monitor and enforce these centrally mandated directives. Actions are already apparent. During 2013, the government moved to close down small-scale cement and steel factories with inefficient production facilities while it also implemented a specific capacity reduction target within Hebei, the largest steel producing region in China, with 10% of this having already been achieved. Major companies have also been targeted with both PetroChina and Sinopec having their expansion plans frozen by authorities in 2013 due to their failure to meet environmental impact assessment targets.
For investors, the key question is which sectors and which companies are likely to be beneficiaries of greater efforts to curb Chinese air pollution and for whom do these actions represent a threat? As fund managers, a fundamental question always asked in the investment process at Standard Life Investments is “what is already priced in?”.
Some of the key winners in the energy space are likely to be gas exploration and service companies. If coal is to become a smaller part of the energy mix with regard to electricity generation, other sources must take up the slack. While gas only represents 5% of current energy consumption in China, this is forecast to rise to 12% by 2020 and 18% in 2030. While China is only a minor global gas producer, an increased focus on gas will lead to substantial investment in infrastructure to secure supplies from neighbours, such as Russia. Additional pipeline capacity and accompanying capital expenditure, such as liquefied natural gas terminal construction, present clear opportunities for companies operating in this field.
Other possible beneficiaries of a more proactive approach to the pollution problem are railways and subways. As the government attempts to tackle air pollution from cars and city congestion by limiting car consumption growth, investment in rail infrastructure is required. To increase railway length by 60%, government investment in railways will need to increase by 40%. These changes present growth opportunities for constructors, rolling stock manufacturers and operators.
Finally, environmental solutions firms capable of cleansing energy consumption in China are also likely to be clear winners. In both the coal and industrial sectors, demand will increase for equipment involved in desulphurisation, de-nitration and dust control processes. Demand will further rise for air, water and land quality treatment services. Investment in the enforcement regime in the country will fuel demand for a wide variety of monitoring and measurement equipment.
Of course, there are likely to be losers due to the shifting environmental policy position, with coal producers the most obvious sector negatively impacted. While absolute coal consumption may continue to grow, the growth rate of demand will certainly fall. This has negative implications for internal rate of return assumptions factored into future investment proposals and may lead to new coal projects being cancelled as they are assessed as unviable or insufficiently profitable. The expectation that demand growth for coal is set to fall is already negatively impacting company valuations. Investment analysts are revising downwards their demand assumptions for Chinese thermal coal companies and pricing in air pollution mitigation costs.
For heavy industry too, certain producers are likely to be hit by reductions in national cement and steel production. However, in industry overall, those companies operating in highly polluting sectors face increasing environmental compliance costs. Considerable investment will likely be required particularly the installation of abatement technologies and processes to mitigate toxic emissions.
In conclusion, we believe that there has been a decisive change in environmental policy in China. The nation is going to be transitioned away from dirty fuel (coal) towards cleaner energy sources. Industry is going to have to start taking its environmental responsibilities seriously, and make equally serious investments in environmental protection. This may have painful consequences for some sectors of China’s old economy. However, opportunities will undoubtedly exist for companies ready and able to offer appropriate solutions, providing fertile investment ideas for our investment managers to exploit.
Andrew Milligan, Head of Global Strategy, Standard Life Investments