Overview
Rapid economic development combined with lax enforcement of regulations has saddled China with severely polluted air and water. This pollution impacts both the health of the population and GDP growth prospects. Studies estimate premature deaths from air pollution at 1 to 2 million per year and the World Bank puts the overall cost of China’s water crisis at 2.3% of GDP. Policymakers are aware of these threats: more than 10% of the Third Plenum reform plan focused on the ecological crisis and the responsibility of the state to reverse it. Aided by structural transition away from polluting heavy industries, initial reform efforts are making some difference. Yet much more is required to put a sustainable future within reach, let alone clean up China’s air and water enough to approach international standards.
To gauge environmental progress, we track measures of air and water pollution. Lower levels indicate improved conditions. We seasonally adjust these indicators to account for annual weather patterns and energy consumption changes. Improvements may reflect factors other than environmental reform implementation, such as a macroeconomic growth slowdown or industry consolidation. That said, short of a growth collapse, China’s environmental goals demand extraordinary policy reforms. To supplement our analysis, we also look at wind curtailment in clean energy generation, sales of new energy vehicles, and non-fossil-fuel electricity generation.
Quarterly Assessment and Outlook
Our primary indicator of air and water environmental reform outcomes shows progress in this quarter, but at a slowing rate, as low-cost interventions are completed and a more challenging phase of reform lies ahead. Our supplemental indicators show movement in the right direction in terms of alternative power and alternative vehicles – both of which trends are borne of China’s investment in technological upgrading.
Overall, the power sector is still more affected by general macroeconomic cycles, short-term stimulus programs, and factors (like rain patterns) outside of Beijing’s control than by environmental policy per se. For instance weather-related flooding reduced hydropower and pushed up coal use in 2Q2017, with consequences for air quality.
3Q2017 and 4Q2017 are make-or-break times for air pollution targets.
3Q2017 and 4Q2017 are make-or-break times for air pollution targets. Key smog-prone areas in the north, including Beijing, may have trouble meeting 2017 air quality targets, and the Ministry of Environmental Protection (MEP) announced a plan in August that focuses on remedial action for 28 cities. According to the plan, thousands of coal boilers will be forced to close and government will further curb heavy-polluting industries including iron and steel and cement. For water, new policy revisions are promising, especially data transparency requirements, but success will depend on liberating local authorities from parallel GDP growth targets. Aggressive local action by central environmental inspection teams suggests that this de-linkage from GDP may be happening. With weather problems receding, GDP growth pressures potentially moderating, and new pollution authorities in place, we generally expect the pollution index to improve in the quarters ahead.
This Quarter’s Numbers
In 2Q2017, the average airborne particulate pollution (PM2.5) concentration index fell from 73.6 to 70.3 (i.e., from 55 to 53 micrograms per cubic meter). This continues a generally downward trend over the past several years. However, the rate of improvement is slowing in 2017. Improvement from 2Q2014 to 2Q2015 was 22% compared to a more modest 9% improvement from 2Q2016 to 2Q2017. Authorities have struggled to shut down heavy industries including iron and steel and aluminum surrounding urban areas such as Beijing, but fiscal stimulus tends to boost production of the energy-intensive goods that drive demand for coal. While this has not been a reversal, and marginal improvements in air quality continue, our indicator suggests that the low-hanging fruit like shutting down small inefficient coal boilers has already been picked. Continued improvement will require going after larger, politically well-connected industries. Cleaning up the power sector will improve air quality, but in 2017 large-scale flooding shut down some hydroelectric production, necessitating more coal power.
In 2Q2017, average water pollution changed little from the previous quarter. However, more granular monthly data reveal a shift in the trend direction – overall water quality decreased by 11% from start to finish of the current quarter. This decline in quality can largely be attributed to the Hai and Liao river basins, both of which include areas of heavy industry. As our indicator tracks major river systems that in turn rely on thousands of tributaries, it is hard to attribute any one industry or source to a decrease in water quality. However, flooding resulted in more water storage than usual in the second quarter, which inevitably means less pollution dilution and helps explain the shift in water quality improvement. Conversely, this means outcomes should improve in the subsequent period. Finally, much like air pollution, an increase in industrial production driven by local government fiscal expenditures to sustain GDP growth is exacerbating pollution absent additional mitigation measures.
Continued improvement will require going after larger, politically well-connected industries.
Our supplemental indicators tell a more positive story this quarter, one that suggests that efforts to mitigate environmental impacts are achieving some success. First, the amount of wind electricity capacity unused due to political and technological factors – the “wind curtailment rate” – was at the lowest point since 2015 (see Wind Energy Curtailment). Curtailment rates declined by 5% nationally from 16% to 11%. This indicator reflects China’s ability to integrate new low-pollution energy. Regulatory and market mechanisms are making headway toward the environmental goal of power sector reform. New energy vehicle sales increased 24% year-on-year in the quarter, even though subsidies for these vehicles are being phased out: this is positive. Given the low base, we are only looking at 2.2% of all vehicle sales (see Sales of New Energy Vehicles). Finally, non-fossil electricity generation (see Non-Fossil Generation and Overall Electricity Generation) declined slightly as a proportion of the overall electricity supply. Even though China installed record amounts of wind and solar in 2017, large-scale flooding depressed hydropower production, and this deficit was filled by coal power. Flooding issues continued into the first part of 3Q2017.
Policy Analysis: 2Q2017
As they prepared for the 19th Party Congress, officials were under pressure to ensure stable GDP growth, which necessitates keeping production levels high, including in overcapacity polluting industries. The improvement in pollution levels over the past five years has resulted from dissemination of standards including fuel quality rules, technological advancements such as affordable emission scrubbers for power plants, and fuel switching from coal to hydropower. Going forward, additional improvements from these strategies grow costlier, and more fundamental environmental gains require a structural shift from heavy industry to cleaner economic activities, such as services. Local governments, where regulation to drive this adjustment must be implemented and enforced, are confronted with the difficult task of mitigating pollution while maintaining headline GDP growth. Encouragingly, through the second quarter we continue to observe high-powered, central environmental policy inspection teams deploying to all provinces for extended periods of time. These teams, composed of Party leaders, discipline officials, and MEP technical staff, appear to be fundamentally more serious about altering local business as usual than past groups were, and we are watching this campaign closely to see if it marks a policy watershed.
In June, China updated its Water Pollution Control Law for the first time since 1984. The revision shifts the focus from emissions to end results: provinces now must meet water quality targets, not just show how they tried. This is complemented by new requirements to release real-time data on water quality outcomes. This makes the main target laid out in the Water Pollution Prevention and Control Action Plan by the State Council in 2015 – to bring 70% of key watersheds to acceptable standards (grades I, II, and III in China’s system) by 2020 – measurable, and thus much more meaningful. The mechanisms for implementation are fines, increased enforcement of existing laws, and incentives for water reuse and investment in control technologies. Local governments will largely be responsible for implementation, with increased transparency from real-time data. Governments will face more public scrutiny as a result, as has been the case with air pollution. In a sign of urgency, the government launched 8,000 water cleanup projects backed by RMB 100 billion in funding this quarter.
On the air pollution side, in 2Q2017 Beijing stepped up pressure to meet 2017 emission targets. The National Action Plan on Air Pollution Control has set regional emissions targets for PM10 and PM2.5 (key air pollutants). These targets are derived from a 2012 baseline with goals set for 2017 and range from 5% to 25% reductions. Analysts from the Clean Air Alliance of China suggest that these targets are on track. However, with progress on these targets, marginal gains become more difficult. For example, Beijing has successfully switched local power plants from coal to gas, improving air quality, but remaining sources of PM2.5 including vehicles and industry are harder to abate.
Finally, policy movement on electric vehicles was evident in draft regulations shared with industry leaders at the Shanghai Auto Show in April. A significant share of output for large-scale car manufactures will be required to be battery powered (BEVs), plug-in hybrids (PHEVs), or fuel-cell vehicles. If manufacturers fail to comply, they will have to buy credits from manufacturers that exceed their targets. Credits will be apportioned according to the number of these new energy vehicles sold, with more technically advanced and all-electric drivetrains receiving more credits. Program targets are potentially as high as 8% of sales by 2018, 10% by 2019, and 12% by 2020. Going from 1.8% of total sales in 2016 to 8% in 2018 is aggressive and a 12% target for 2020 would translate into roughly 4 million BEVs and PHEVs sold that year – eight times current levels. That would mean roughly 12 million new energy vehicles on the road by 2020 – more than double the government’s current target. Unsurprisingly, automakers have pushed back hard and these draft targets may be lowered in final regulations, but these regulatory debates are pushing the level of ambition in policy forward.