June 19, 2017 9:00 am JST
Lu Jiawei and Sagarika Chatterjee

Chinese investors wake up to risks of air pollution

Impact of smog on productivity and portfolios means 'dirty' assets are out

Investors in China are waking up to the material risk of air pollution on their portfolios, as Beijing ramps up efforts to eliminate smog from the country. The days when China viewed air pollution as a necessary byproduct of economic growth are fading fast.

The economic costs to the country from air pollution are substantial: related health costs and loss of productivity are estimated to strip 3-6% from China's gross domestic product every year.

As slowing economic growth forces a negative ratings dynamic on the country -- in late May, Moody's Investor Service initiated its first credit rating downgrade of the country in 30 years -- the stakes for reducing the impact of pollution on China's growth are rising.

The government's "war on pollution" has a very broad scope, and includes adjusting the mix of energy consumption -- increasing the use of clean energy at the expense of coal. Policy is aimed at promoting energy-saving technologies and managing atmospheric emissions through a reduction in electricity generation by coal plants.

In 2016 the Chinese government announced a five-year plan for the power sector which seeks to limit the capacity of coal-fired power plants to 1,100 gigawatts by 2020, as well as halting or delaying the construction of coal plants in 25 provinces.

Moreover, an environmental protection category has been included in local government officials' performance assessments since 2015, following a change in the law. The central government has sent inspection teams throughout China to oversee the increasingly strict implementation of environmental protection initiatives.

However, Beijing's newly-energized policy towards air pollution presents substantial regulatory risk for companies and asset managers.

Institutional investment groups such as the Asset Management Association of China, a self-regulatory organization established in 2012 to represent China's mutual funds industry, have made clear that they will be stress testing individual companies to understand how their implementation of the 2016 Paris Agreement will affect operational efficiency and decarbonization. The agreement set out an action plan to limit global temperature rises to "well below" 2 C.

From a portfolio management perspective, this creates a dual dynamic of divestment incentives and investment opportunities. For example, companies involved in smog reduction have benefitted from low-cost financing through the country's large green bond market. And the superior secondary valuations afforded to companies involved in air pollution reduction have allowed them to access equity relatively cheaply.

Meanwhile, the concerted government policy initiative increases the risks to investors of holding polluting assets. The result, both in China and globally, is an ongoing divestment program centered on assessing the risk of so-called stranded assets -- those that become unable to earn an economic return because of changes in the market and regulatory environment from the transition to a low-carbon economy.

Large-scale divestment

The risk of stranded assets in air-polluting industries in China is high. Carbon Tracker, a think tank, estimates that China risks wasting $490 billion on new coal plants which will end up being surplus to requirements as coal-fired power generation is slashed by power sector reforms, carbon pricing and rising capacity in renewable energy.

Large-scale divestment away from heavy carbon dioxide-producing -- and polluting -- companies is underway globally. In 2016, Norway's sovereign wealth fund divested stakes in energy companies that derive more than 30% of their revenues from coal. More than 50 companies, including China Coal Energy, were blacklisted by the fund, with the majority based in the U.S. or China.

Meanwhile, French asset manager AXA decided in 2015 to divest its interests in mining companies with more than 50% of turnover derived from coal extraction, and in electricity utilities deriving over 50% of turnover from coal powered generation.

According to a report published in December 2016 by Arabella Advisors, a philanthropic investment group, the value of investment funds committed to selling fossil fuel assets has jumped to $5.2 trillion, double the 2015 total. The report found that 688 institutions and more than 58,000 individuals across 76 countries are now committed to divesting fossil fuel assets.

From a portfolio management point of view, asset managers need to analyze their exposure to polluting sectors and the ability of companies in their portfolios to manage air pollution risk. This includes analyzing the risk of changes in the price of resources, the impact of regulation on business operations, and the cost of capital, including credit ratings and company reputation.

Stranded asset risk in China will grow steadily among the fossil fuel and "brown" industries as the authorities' determination to defeat pollution intensifies. There has been skepticism in the past about the sincerity of the government's anti-pollution stance, with some environmental commentators accusing it of a "stop-go" approach in which the implementation of draconian measures by local government was followed by relaxation to facilitate national output quotas.

But a confluence of dynamics suggests that the quest to defeat pollution in China is developing unstoppable momentum. China's ratification of the Paris agreement is a powerful signal, reflecting the development at breathtaking speed of a renewable energy industry in the country.

Fueled by green financing, which is fast becoming one of the capital markets' most formidable funding vehicles, China's clean energy industry is set to kick its brown counterpart into touch over the next decade or so. Some $36.2 billion of labeled green bonds were issued in China last year, accounting for almost 40% of total green bond issuance globally.

China leads the world in renewable energy investment, which totaled $102.9 billion in 2015. The clean energy industry employs 3.5 million people in China -- more than the oil and gas industry. The country has announced further investment in the renewable energy industry of $360 billion by 2020, which is expected to add another 13 million jobs.

When China's President Xi Jinping stated in an address to the United Nations in Geneva in January that the Paris climate accord must not be derailed and that China would "continue to take steps to tackle climate change and fully honor its obligations," he voiced the determination of his country's authorities to tackle its emissions problem head-on.

There will be no turning back. As divestment from the fossil fuel industry gathers pace across the world, investors in China's energy sector are heeding the call.

Lu Jiawei is senior portfolio manager at China Asset Management Co. Sagarika Chatterjee is associate director of policy and research at the U.N.-backed Principles for Responsible Investment initiative.

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