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China unplugged: Investing in the world’s largest decarbonization effort

Santiago Millan, CFA, Macro Strategist
June 2021

The views expressed are those of the author at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed.

China has pledged to target peak emissions by 2030 and net-zero carbon emissions by 2060. This massive environmental initiative could affect almost every production, consumption, and investment decision for the next several decades. Achieving carbon neutrality while continuing to grow will require an overhaul of the Chinese economy and a fundamental shift in the type of incentives in place since its reform and opening over 40 years ago. Details and consequences of this effort will take time to emerge, but we believe investors can and should position themselves on the right side of China’s low-carbon transition today. Even incremental progress toward these goals will create widespread risks and opportunities, with ripple effects across global markets.

The Chinese government plans to tackle its decarbonization challenge by:

  • Overhauling the national energy structure and increasing energy efficiency
  • Establishing a carbon price and developing the Green Financial System
  • Adopting a framework for environmentally sustainable economic activities
  • Investing in mitigation, adaptation, and innovation solutions

Here we provide a high-level look at these approaches and how we believe investors can take advantage of them.

Overhauling the national energy structure and increasing energy efficiency

To reach net-zero carbon emissions, China’s entire energy structure must change. Renewable energy production would need to quintuple to decarbonize current electricity demand — and that’s just part of the challenge. More than half of China’s electricity is generated from coal and other fossil fuels today. All major sectors, including manufacturing, transportation, construction, and agriculture will either need to be electrified or generate power from alternate energy sources like hydrogen, wind, and solar.

There is also the growth challenge. China’s per capita GDP remains a fraction of the developed world. As China grows (Wellington’s macro forecasts for its GDP are 6% annually for the next five years), it will continue to use more energy. According to the China National Petroleum Corporation, China’s total primary energy consumption is not expected to crest until 2035.If carbon emissions are to peak in 2030, China needs to make massive efficiency improvements to decelerate energy demand growth. Recognizing this dichotomy, the recently released Fourteenth Five-Year Plan (14FYP) requires a 13.5% reduction in energy intensity (energy use per unit of GDP) through 2025 and an 18% reduction in carbon intensity (CO2 emissions per unit of GDP) with a stated focus on high-quality growth and development.2

Establishing a carbon price and developing the Green Financial System

The Chinese economy will not decarbonize by itself. To mobilize the massive amounts of capital required, a government-led incentive structure — unlike any in the country’s history — is starting to appear. By putting a price on carbon, China aims to penalize high-emitters and reward low-carbon production and consumption. Eventually, all players in the economy will be forced to respond to carbon as a price signal. Companies that impede or detract from China’s energy transition will face higher costs, including cost of capital, regulatory-related costs such as taxes, and reputational risk, as consumers choose green options over brown ones. In contrast, companies that assist or accelerate the transition will likely enjoy economic advantages, attract investment dollars, and be able to monetize their contribution.

Green Financial System: In 2016, the People’s Bank of China (PBOC) issued its Guidelines for Establishing the Green Financial System, encompassing green bonds, loans, and insurance; development funds for environmentally sustainable projects; a market for emissions-generation rights, local government initiatives; and calls for international cooperation. Today, more than 10% of financing in China is for investments classified as green, including clean energy, green transportation, and green building construction.We expect green finance to increase to around 33% by the end of this decade and gradually cover more of the economy thereafter. As Dr. Ma Jun, chair of the Hong Kong Green Finance Association put it, “eventually, no finance will be labeled ‘green,’ because all of finance in the economy will be green finance.”3

As with most aspects of China’s economy, green finance will have international implications. According to the Climate Policy Initiative, “A solid foundation for green banking [in China] is now established. Although the impact of green banking has been relatively small to date, there is significant potential to scale, which would have major impacts on the availability of financing for sustainable infrastructure around the world.”5

Carbon market: China’s national emissions-trading scheme (ETS), related to the Green Financial System, took effect in early 2021. The first wave of ETS requires more than 2,200 coal- and gas-fired power plants to retroactively report their carbon emissions for the last two years, and retrospectively extends emissions allowances for the same time frame. Rather than cap absolute emissions levels, China’s market will impose limits on carbon intensity. While still relatively narrow in scope, the carbon market will eventually include financialization of environmental rights, including for environmental credits, emissions allowances, and carbon assets.

Traditional regulation

Finally, traditional forms of regulation will remain in place, including efficiency standards for fuels, regulation of factory emissions, and building codes for green insulation and energy efficiency, among others.

Adopting a framework for environmentally sustainable economic activities

In a further offshoot of the Green Financial System, China is taking steps to establish definitional frameworks that help policymakers, companies, and investors identify and assess companies’ contribution, positive and negative, to environmental sustainability and the energy transition. Like other emerging frameworks, China’s will be modeled on the EU Sustainable Finance Taxonomy, and the People’s Bank of China is working with EU representatives to determine common standards. To date, China has established a Green Bond Endorsed Project Catalogue and Green Industry Guiding Catalogue to govern green bonds and industrial activity nationally. With the ability to size up a company’s carbon footprint and intensity, investors will gain an input that could be a key determinant of value and alpha potential.

Investing in climate mitigation, adaptation, and innovation solutions

Investing in decarbonization is more complex than simply grading companies and activities along green dimensions. In China, as in many countries around the world, we believe capital will not only flow to companies and industries already green (renewable energy, for example) but also to businesses in any sector taking steps to become more sustainable, lower their carbon footprint, and support the low-carbon transition. The companies, too, may be the beneficiaries of massive spending and investment.

We suggest three categories that may become more commonplace in climate-aware investing as markets increasingly view carbon as a material factor in companies’ long-term success:

  • Climate mitigation: Solutions that reduce the physical and financial risk of climate change, often by directly reducing carbon emissions
  • Climate adaptation: Solutions that protect against the physical effects of climate change
  • Climate innovation: Solutions that help economies both mitigate and adapt to the effects of climate change

Figure 1

Closing

The scope and scale of China’s energy transition are difficult to overstate. China is the world’s second-largest economy, with over US$12 trillion in GDP. It ranks number one in electricity consumption and accounts for 28% of global carbon emissions. Its transformation into a low-carbon economy will take decades and require investment and spending on a massive, unprecedented scale. Investors should consider the effects of China’s decarbonization efforts on virtually any global asset and look for ways to position themselves on the right side of the transition.

Key topics and themes
Sustainable investing
China
Emerging markets
Macro and market
Climate change
Written by
Millan_Santiago_2674_w316
Santiago Millan, CFA
Macro Strategist
Hong Kong

1Reuters, 17 December 2020, citing CNPC research. | 2“Q&A: What does China’s 14th five-year plan mean for climate change?,” CarbonBrief, March 2021. | 3“Green Banking in China: Emerging Trends,” Climate Policy Initiative, August 2020. | 4Comments made at the Euromoney conferences Sustainable Financing in China’s Market webinar, 21 October 2020. | 5“Green Banking in China: Emerging Trends,” Climate Policy Initiative, August 2020.

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