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China’s Potential Green Future

China’s rapid growth over the last three decades has changed the face of the country’s economy and made it an economic superpower; it has become a middle-income country and the 2nd largest economy in the world.  However, this has come at a significant cost to the environment as China’s growth model has remained focused on manufacturing and other heavy industries.  As the country transitions to the next generation of Communist Party leaders, public awareness and angst at the environmental consequences of industrial expansion are being heard.  The challenge for the new leadership is to manage the environmental consequences (and public reaction) in a credible manner in the near term, while putting in place policy initiatives which can create a sustainable growth model over the long term.  This will require adjustments to the current trajectory and structure of almost every major industry in China.  While this will create significant direct costs and dislocation in the near term, over the long-term, this shift will create a net long term benefit for China – with the growth “dividend” from investing in green energy and the cities of tomorrow far outweighing the immediate costs which need to be incurred.  We will make the case that, economic growth and preserving the environment are not a mutually-exclusive trade-off, but rather an opportunity for China to transition its economy onto a more stable, sustainable and evolved growth path and at the same time become a world leader in one of the most important emerging industries in the world.

An Introduction to the Environmental Impact of Growth

China has industrialised rapidly over the last three decades – and has firmly put in place a growth model which relies on fixed asset investment in infrastructure and heavy manufacturing industries.  This model has served China well – with overall nominal GDP increasing from $189 billion in 1980 to $8 trillion in 2012 – making China the 2nd largest economy in the world and the largest exporter.   However, the price China has paid for this approach has been substantial: pollution today causes 760,000 premature deaths annually, 16 of the world’s 20 most polluted cities are in China, 500 million Chinese people lack access to clean drinking water, and lung cancer is 2-3x more prevalent in cities than in the countryside despite similar rates of tobacco smoking.1  These facts cannot be explained away as merely coincidental or anecdotal –they are rooted in the fundamental model of growth that China has and is following.  The key underlying factors contributing to China’s on-going environmental degradation are:

  1. Rapid Urbanisation. In only the last 22 years in China, over 400 million people have moved from the countryside to the cities; China’s urban population has increased from c.300 million people (26% of the population) in 1990 to 712 million (53%) in 2012.  The Chinese government estimates that another 300 million people will move from the countryside to the city in the next 15 years2.  This will put an increased burden on cities which are already suffering from record levels of smog, even as the total number of cars in China will increase from 62 million in 2009 to 200 million by 2020 (almost 13-14 million new cars each year)3.  Unlike the mature cities of the world where large metros serve as hubs for the service and innovative sectors, China’s mega-cities are primarily industrial zones which concentrate and compound already significant pollution.
  2.  World’s Factory. China’s manufacturing sector today is the world’s largest4 and generates 47%5 of GDP (vs. 29%6 in Germany, the biggest manufacturer in the Western world) – with a focus on heavy industries such as metals and machinery.  Its relentless focus on expanding industrial output has succeeded in generating high employment, but has also created one of the world’s largest consumers of resources and energy.   China today consumes more coal than the rest of the world combined, and coal accounts for an estimated 70-75% of China’s total energy consumption, producing 8.7 billion tons of emissions each year.   This energy intensive approach to manufacturing has made China coal-dependent and the world’s largest emitter of CO2, producing nearly 30% of global annual output.7
  3. Agriculture and Desertification. China has only 7% of the world’s arable land, but produces enough to feed c. 20% of the world’s population due to its high agricultural yields.  This success has been achieved by using modern industrial scale agricultural methods which include the intensive use of chemical fertilisers and pesticides8 which causes significant soil, water, and air pollution.  Nitrogen fertiliser gets washed away and pollutes groundwater with surveys indicating 90% of urban groundwater is contaminated while soil quality deteriorates due to the accumulation of heavy metals9.  In addition to this, China is also coping with the impact of desertification (the natural expansion of the Gobi desert reduces China’s arable grassland by c. 3,600 square kilometres each year10) which is putting a huge burden on the need for yield on China’s agricultural land.

The Immediate Challenge

The cumulative environmental impact of these factors is easy to see, whether one is looking out of the window in Beijing on any given day or reading a newspaper (see the inset for some of the headlines from the previous month).  The increased public awareness due to the coverage in both traditional and social media seems to have made the environment one of the critical issues on which China’s people will measure the performance of the new leadership.  The new leadership recognises that as China progresses to a middle-income nation, the old formula of economic growth as a way to maintain social stability will need to incorporate an element of environmental sustainability as well.  Some of examples of recent measures the Party has taken to encourage more sustainable growth include impressive progress on the “Green Wall of China” re-forestation initiative launched in 1978 which has seen China restore 40,000-70,00011square kilometres of desertified land every year, as well as a more recent attempt to incentivise provincial officials based on ‘Green Gross Domestic Product’ rather than just GDP growth.

Recent News Headlines on Environmental Issues in China 

16,000 Pig carcasses found in Shanghai river 

Chinese Government admits pollution causing “cancer villages” 

Soil quality is classified as a “state secret” by environment ministry

70% of China’s lakes and 90% of groundwater are contaminated 

Beijing air pollution literally goes off the charts

However, given the size of problem and the vested interests involved,  China requires concentrated and coordinated efforts in order to develop a comprehensive plan which cleans up the country’s environment (at a significant short-term cost in terms of lost productivity) alongside significant new investments in the new economy.  While the specific elements of any feasible long term solution are well understood and the Chinese government has begun to focus on these, efforts need to be redoubled across the board.  If the environment is seen as an issue rather than one of the great strategic opportunities, the policies will be defensive.  China’s policies regarding renewable energies are a case in point.  China’s current five year plan is targeting 15% of energy from renewable sources by 2020 through increased investments in solar, wind, biomass, etc, up from 10% today12. By comparison, however, some other large emerging markets have more ambitious targets – for example Thailand is looking to increase its share of renewables from 7% to 20% by 2022 and Mexico is on track to achieve its target of increasing the share of renewables from 7% to 40% in 201413.   Even with the 2020 targets met, China will still be one of the most carbon intensive economies.  In order to materially reduce its carbon footprint and reduce its coal dependency, China needs to set its sights much higher not only on energy alternatives but also on energy intensity and efficiency.  It also clearly needs to empower the newly created Ministry of Environmental Protection (“MEP”) along the lines of the EPA in the US with powers to strictly enforce both existing environmental standards and introduce new restrictions which are in line with developed country standards.  For example, when the State Environmental Protection Agency, the predecessor of the MEP had tried to order some well-placed state-owned enterprises to stop construction on projects which were violating environmental codes, the order was largely ignored14.

Achieving Sustainable Growth in the Long Term

In order to not only make economic growth more stable and sustainable over the long-term but also to become a world leader in the emerging environmental industry, China needs to develop a vision of the industry that is greater in scale, ambition, policy, innovation, technology, engineering and financing than the world has seen so far.  Such a vision will fundamentally transform China over the medium to long term and its impact on the world.  The key elements of this blueprint are:

  • Smart Cities: Create the Green Cities of Tomorrow.With an additional 300 million people expected to move from the countryside to the cities, China has an opportunity to create the global blueprint for and build sustainable cities of the future.  This will require ambitious plans to redevelop urban infrastructure in an environmentally sustainable manner, and investments in and incentives for public transport systems, upgrading buildings to developed country environmental standards, creating more open spaces combined with innovative urban governance initiatives to reduce pollution (such as congestion charges or taxes on car registrations).  China needs to embrace elements of the eco-city model of Curitiba, Brazil and Stockholm, Sweden in order to build cities which are self-sufficient on energy with renewables.   Given the environmental state of China’s metros, such towns could act as a powerful model for the major metros to adapt their sustainability models.  These cities could act as innovation hubs which spur the creation of new industries and private sector jobs – and if done on a wide enough scale in China – can help create the kind of structural change to China’s economic structure that China’s leaders want.
Energy Intensity Vs. Structure of Economy16
  •  Smart Industries.  While China clearly needs to shift to its economic model to strengthen its service industries, it cannot simply dismantle its existing industrial structures in order to reduce their impact on the environment.  The key for China will be not only to move to less resource intensive industries within manufacturing but also to reduce the resource intensity and the efficiency of its existing scaled industries. By way of comparison, the South Korean economy today has almost as high a percentage of industry in GDP (40% vs. 47% in China) but consumes c. 60% less energy resources per unit of GDP than China (see table).  This is due to an organised effort since 1990 to increase productivity in its core industries within the manufacturing sector while driving a longer term shift toward high-technology industries.  According to the US Library of Congress’ country study15: “In 1990 South Korean manufacturers planned a significant shift in future production plans towards…the production of such goods as new materials, mechatronics, industrial robotics, bioengineering, microelectronics, fine chemistry, aerospace, etc. This shift in emphasis, however, did not mean an immediate decline in heavy industries such as automobile and ship production, which had dominated the economy in the 1980s.”  Similarly, China will need to replicate such efforts on a far larger scale in order to drive resource efficiency in its industrial base – this will make Chinese products more competitive and also help drive the country towards a more sustainable industrial structure.
  •  Smart Integrated Technologies. In parallel, China will need to develop next generation green technologies, both to provide the tools required to implement the required environmental protection and clean-up as well as to provide new sustainable growth industries for the future.  China has already identified seven “strategic sectors” for development that are highly relevant to China’s green future in this regard.  These include (i) energy saving and environmental protection, (ii) next generation IT, (iii) biotechnology, (iv) advanced equipment manufacturing, (v) new energy, (vi) new materials and (vii) new energy vehicles.  The government has announced targets for these sectors, which accounted for 3% of China’s GDP in 2010, to contribute 8% in 2015 and 15% by 2020.  Equally if not more important than the development of new industries and technologies is the integration of these components into solutions that lead to large scale environmental breakthroughs.  This is something for which China has the capital and needs to become the global leader.  It will require the development and implementation of visionary large scale projects. The Dongtan eco-city project was one such project that highlights the execution challenges involved.  The vision was to build an eco-city housing 500,000 people on the island of Chongming near Shanghai, with zero-greenhouse-emission transit and complete self-sufficiency in water and energy, together with the use of zero energy building principles.  Dongtan was planned as the first of up to four such cities to be designed and built in China by international design and engineering firms to be the most advance in terms of energy use, emission and ecological factors.  The plan has fallen far behind schedule and no construction has taken place, awaiting further investment and initiative.
  • Smart Agriculture.  China has made impressive progress on its reforestation initiatives across the country and it has significantly slowed the impact of desertification, setting a target of 22% forest coverage by 2015, (up from 20% in 2009).  China now needs similarly ambitious initiatives to develop the overall agricultural sector in an environmentally sustainable manner.  These could include investing in R&D on biotechnology and organic techniques to help reduce the consumption of fertilisers and pesticides while preserving China’s high agricultural yields.  This is critical because heavy use of fertilisers and pesticides erodes soil quality and pollutes the water supply – which over time will lead to lower yields, and moreover, other adverse impacts on public health.  China will also need to establish incentives for organic farming and sustainable animal husbandry (China has the largest animal husbandry market in the world) in order to encourage their growth, and experiment with innovative ideas like ‘vertical farming’ (where production of food is shifted from factory farms to urban facilities with technical facilities).   The key advantages of vertical farming are year-round production, isolation from pests, controllable resource recycling, and reduced transportation costs due to the proximity to end-markets.17 China needs to find such innovative ways to produce more with less resource inputs including land and fertiliser – the experience of other countries such as the US which have highly-productive agricultural sector with relatively fewer inputs indicates that such a transition is indeed possible with focused and co-ordinated efforts by the government, private sector, and farmers.
  • Smart Finance and Incentives.  Clearly, all of these initiatives will need substantial investment and finance.  China has already invested significant amounts of capital into its “strategic sectors” and has set even more ambitious targets, committing $1.5 trillion in investments across the seven industries mentioned above by 2015.  Transforming China on the scale we have laid out will clearly require even more.  With fixed capital investment currently contributing nearly 50% of total GDP, the absolute sum of money required will not likely be the issue.  What China will need to get right however is the value maximising allocation of capital to innovative and high growth opportunities.  China’s state owned enterprises, which generate nearly half of total industrial output, have traditionally been the preferred recipients of capital in China.  The government will either need to direct these firms towards more innovation and higher quality products while reducing their environmental footprint, or develop mechanisms to allocate a greater of total investment to smaller, nimbler and more innovative private companies.  Both options will clearly require a realignment of incentives for provincial and local officials who are responsible for promoting growth and executing the central government’s targets.  China requires a framework that assesses its officials not only on growth, but also a variety of other factors such as creation of private service sector jobs, investments which lower the environmental impact, etc.  Given the decentralised nature of execution of Chinese economic policy, such a framework will be urgently required.

Economic Growth and Environmental Protection Are Not a Trade-off, they Provide a Great Opportunity

Clearly, some level of pollution is an entirely normal outcome of rapid growth and many now developed countries faced similar challenges in the early to middle part of the 20th century as they rapidly grew their industrial bases before moving to a more sustainable growth path driven by innovation and services rather than resources and manufacturing.  Their success in transitioning their economies to this model (to differing degrees) proves that with coordinated efforts, such transitions are indeed possible to achieve and in the best interests of all stakeholders. 

Environmental Dividend of 1.5 to 2% p.a.  Clearly, today pollution and environmental degradation impose a direct cost on the Chinese economy, totalling 3.5% of GDP annually,18 in the form of lost productivity, increased public health costs and premature deaths.  But cleaning up the environment, and just as importantly, keeping it clean, has costs associated with it as well.  Studies estimate that the cost of environmental protection can range from anywhere between 1-2% of GDP19 annually.  For China, incurring this cost is an obvious choice given that the cost of inaction far exceeds it.  The difference between these two figures – effectively 1.5-2.0% of GDP is the “environmental dividend” that China could potentially reap annually.

Transformational Impact.  Moreover, if China’s leadership succeeds in implementing a comprehensive strategy like the one outlined above, we estimate that the economy could benefit from an additional 0.5% of annual growth through improved industrial efficiency20 and an additional 0.5% of annual growth through smart agriculture from improved agricultural yields21.  The total impact of China’s potential green future therefore could be as high as 1.0% annually.  The investment intensity and the focus on industry and agriculture makes this blueprint an attractive hedge against the rebalancing of China’s economy towards domestic consumption underway, which many fear will be accompanied by significant reductions in economic growth.  China’s green future would allow the country to continue effectively utilising high rates of investment while shifting the emphasis to high value added exports.

Reputational Impact.  China has been seen as a block to world progress on Climate Change.  An initiative of this magnitude would change China from an obstacle to the leader in the field.  In addition, although the model outlined above is specific to China and its current situation, variants of the same could be employed by other industrialising countries.  India, in particular has a much less reported but equally serious air pollution problem22 that will only worsen as the country steps up the rate of industrialisation and its urbanisation and agricultural challenges are even greater than China’s, given the poor quality of its infrastructure and the need for land reform.  Implementing a plan like the above one would involve leapfrogging many of the problems China created during its own industrialisation, although the execution challenges involved would of course be significant.  If both countries take the approach that growth and clean environments matter, they will approach industrial policy, financing, international negotiations and innovation differently.  They will receive more support from the world, and become exporters as well as importers of innovation, taking a leadership position in building the smartest cities of tomorrow.

Turning a liability into an opportunity is never easy, particularly when the liability, like China’s pollution, has been building up virtually unchecked for nearly 30 years.  The case for change however is urgent and the size of the prize is significant.  China today has the pieces of the puzzle required to not only address perhaps the single largest threat to its sustained development but to also change the trajectory of this development, developing and becoming a global leader in new growth industries.  President Xi Jinping’s government has the opportunity to shape and execute a decade long transformation plan that would create a lasting legacy for both China and the world.  China has already demonstrated that it can mobilize resources to literally move mountains on much shorter timeframe than anybody could imagine.  It now has the opportunity to impress the world yet again.

[1] Cost of Pollution in China: Economic Estimate of Physical Damages, Joint Report of the World Bank and the State Environmental Protection Agency of China (SEPA), February 2007

[2] Government Estimates, World Bank Population Database

[3] Source: McKinsey

[4] Source: IHS Global Insight Study, March 2011

[5] Source: China National Accounts

[6] Source: OECD

[7] Source: 2011 estimate by European Commission and Netherlands Environmental Assessment Agency

[8] On average, China uses c. 400kg of fertilisers per hectare vs. a typical “safe” limit of 225kg per hectare in developed countries (Source: Xinhua News Agency)

[9] Source: Xinhua News Agency July 5, 2006

[10] Source: The Guardian, January 2011, available at http://www.guardian.co.uk/world/2011/jan/04/china-desertification

[11] Source: Al-Jazeera, Dec 2012, available at: http://www.aljazeera.com/indepth/features/2012/12/2012126123056457256.html

[12] Source: China’s Five Year Plan, KPMG China

[13] Source: Renewable Energy World, Feb 2013, available at: goo.gl/QLYYA

[14] Source: China’s Environmental Super Ministry Reform: Background, Challenges, and the Future, Xin Qiu and Honglin Li, Environmental Law Institute

[15] Source: South Korea – A Country Study, Andrea Matles Savada and William Shaw, editors, GPO for Library of Congress, available at: http://countrystudies.us/south-korea/

[16] Source: Energy Information Administration

[17] Source: Crops Review, available at: http://www.cropsreview.com/vertical-farms.html

[18] Source: Cost of Pollution in China, World Bank

[19] Source: Bloomberg, Sept 2010, available at: http://goo.gl/IFzNA

[20] GPC Estimate: Assumes 12.5% reduction in total coal usage, estimated based on current coal prices and 2012 GDP

[21] GPC Estimate: Assumes 5% increase in agricultural yields and impact of desertification offset by re-forestation initiative (no change in arable land)

[22] 2012 Environmental Performance Index

 

©2013 Greater Pacific Capital