A delicate balance - China's economic growth versus its deteriorating environment

After a nearly two decades of fast economic growth, China has achieved huge success in growing its economy and generating wealth for its citizens. However, this success comes at a large cost - a deteriorating environment. Air pollution and water pollution are particularly serious in the economically developed North and East regions. The government has been addressing pollution issues for some time, but when economic growth and environmental protection cannot be achieved simultaneously, the former has superseded the latter.

In his opening speech, at the 19th National Congress of the Communist Party on October 18th, 2017, Chinese president, Xi Jingping, laid out his view to maintain economic growth while tackling pollution over the next five years. The use of both an economic lever and executive regulations to squeeze out environmentally unfriendly and small-scale capacity will continue to be the government's long-term approach. In the short-term however, this tactic may cause disruption in several sectors. Nonetheless, it benefits the industry as a whole by reinforcing consistent environmental policy, phasing out outdated capacity, creating a fair market, and in the end having long-term sustainable growth. This represents a major shift in the central government policy, evident from the start of 2017.

Critically, the enforcement of the series of policies and regulations on environmental protection that the central government has issued, is now more stringent than it has ever been. This round of enforcements applies nation-wide with a focus on the regions most affected by pollution. North China, particularly the region around Beijing and Tianji - China's most heavily polluted area - is the main target.

Policies

Since January 2017, various government agencies, including the State Council, Ministry of Environment Protection, Ministry of Industry and Information Technology, and NDRC, have issued 11 policies and memorandums addressed to local government and industry sectors, mandating the reduction of energy consumption, carbon emissions and more strict pollution controls. The central government has launched three rounds of comprehensive environment inspection to enforce implementation.

Among these policies, the "2017 environment protection act in Beijing, Tianjin, Hebei and surrounding area" has the strongest impact on the energy and manufacturing sectors. The policy - called '2+26 Act' for short-- targets Beijing, Tianjin, eight cities in Hebei province, four cities in Shanxi province, seven cities in Shandong province and seven cities in Henan province, and was jointly issued by the Ministry of

Environment Protection and NDRC in March. The key element for this Act includes:

• Reducing energy consumption
• Enforcing stricter waste discharge permit
• Implementing tougher control on volatile organic compounds (VOC) emissions
• Eliminating redundant capacity (supply-side correction)
• Tightly scrutinizing environmental impact, and energy-saving evaluations for any new project prior to project approval
• Pollution control targeting aluminum, coal coking, steel, construction materials, carbide, and ammonia sectors

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Impact

First of all, this round of policy enforcements have a profound impact on energy sector. Coal has been the dominant fuel for power and heating. As a means to combat air pollution, the central government requestsconsumption of coal. They are ordered to replace coal with natural gas and/or electricity in densely populated cities. As such, this policy immediately affects the energy sector. With this mandate, the demand for natural gas surges. As North China enters its winter season, natural gas demand is expected to increase further. Major energy companies are looking into increasing gas supply through all possible sources, including domestic gas production, gas import via pipeline, LNG imports, and coal-bed methane.

A second effect of these policies, is the removal of surplus capacity from the supply chain. Although the primary intention is to control pollution, the side effect is to eliminate large amount of capacity, and tighten the supply and demand relationship and therefore improve industry profitability. The result is to ease off cut-throat price competition in the oversupplied sectors, such coal mining, steel, glass, construction materials and some chemicals. These chemical products include ammonia, caustic, soda ash, carbide and polyvinyl chloride.

There are clear winners and losers following the implementation of these policies over the past nine months. In general, large and well-established companies are mostly winners, while small and medium sized companies are generally losers. Those companies not (or less) affected, have been enjoying improved margins for the year so far.

Most large companies, especially large state-owned enterprises, are equipped with modern plants and implement tighter waste and emissions control. Rather than being affected by capacity shutdowns or cutbacks, these companies have benefited from tighter supply, higher product prices, and thus enjoyed higher margins.

Some of small and medium-sized companies, which are generally privately owned and have less systematic control on waste discharge and emissions, were forced to shut down. Even those lucky enough to survive the crackdown, have had to cut back production, by 30% on average.

While the manufacturing sectors have benefited overall, it has not been without sacrifice. In the coal mining, coking steel and cement sectors, all producers faced production cuts, even when they met the environmental standards.

Policy implementation also varies in consistency from one region to another. In some cities, companies failing to meet the standards were given a grace period for upgrading. In other instances, some local governments took a "single knife-cut" approach, and force shutdown all producers in certain product chains, or all plants in entire industry parks. In these instances, the policies have also hurt local economies and employment.

This has caused disruption through entire supply chains, the level of disruption varying depending on the supply chains in question. The crackdown for the chains with large surplus capacity, has been tougher than for these with little to no surplus capacity.

The tougher stance on environment control by the government is largely welcome, and come bit too late. However, the unpredictability of government policy along with its way of implementing is a cause of concern. It is for sure that the central government's tightening grip on environmental regulation will be long lasting and likely to remain in place in the near future.

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Paul Pang, Vice President, Chemical at IHS Markit
Posted on 23 November 2017