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 economic growth. Studies estimate premature deaths from air pollution at 1 to 2 million per year, while 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.

The 2013 Third Plenum Decisions focused on improving environmental regulations and management systems to strengthen enforcement and advance a longer-standing goal of reducing coal’s share in the nation’s energy mix. That included using tax reform to raise prices for “products that consume too much energy.” Improving environmental realities is a major political mandate for the Chinese government, borne from popular disquiet over rampant pollution and recurrent environmental crises. By spoiling its natural resources including land and water, current environmental degradation levels erode China’s future growth potential.

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

We downgrade our assessment of environmental reform from positive in our previous three editions to neutral, based on backsliding on environmental outcomes as Beijing relaxed regulatory pressure on polluting industries. Both our main water and air indices increased from the previous quarter, indicating worse environmental quality. Crude steel production and thermal power generation, the two main drivers of pollution, increased to 9.1% year-on-year (yoy) and 8%, respectively. These data suggest that Beijing loosened its environmental enforcement after the winter heating season, giving polluting industries room to expand in 2Q2018. Clean energy sources also declined as a seasonal percentage of electricity production, since new non-fossil generation was not able to keep pace with overall electricity demand growth from industrial production. Additionally, subsidies for solar were slashed. This is a conundrum: some global observers welcomed this as a move away from industrial policy intervention in the marketplace; however, in the short term this means slower progress toward replacing heavily polluting generation with renewables.

On the policy side, we expect environmental pressure on heavy industry to turn back up as the winter months approach. Until then, pollution will be driven by swings in demand for polluting goods, which are driven by the credit environment and overall economic structure. Given expectations for marginal monetary easing in the remainder of 2018 (see Financial System), the environmental outlook in the near term is not bright. Overall, Beijing is still a long way from achieving 2013 Third Plenum environmental goals. The second quarter shows the difficulty in maintaining hard-fought gains, let alone making continued progress.

Beijing is still a long way from achieving 2013 Third Plenum environmental goals.

This Quarter’s Numbers

In 2Q2018, the average airborne particulate pollution (PM2.5) concentration index worsened, increasing by 7.9% from 1Q2018. Looking at actual PM2.5 concentrations across the five major cities we monitor, the average concentration increased from 49.2 micrograms per cubic meter to 53.1. Regionally, only Guangzhou and Shanghai improved in air quality, by 41.0% and 10.5%, respectively. Beijing, Shenyang, and Chengdu all declined, by 48.8%, 22.4%, and 29.7%, respectively. Noticeably, air in Beijing, which is more influenced by emissions from heavy industries like steel, suffered the greatest deterioration.

Nationally, water quality also declined by 4.0% according to our main indicator, which tracks surface water quality across several basins. Declines in water quality are also tied to increased industrial production, in addition to weather-related conditions. Regionally, the Huai, Liao, Pearl, Songhua, Yangtze, and Zhejiang-Fujian basins all saw quality decline (between 3.3% and 10.4%). The Hai and the Huang basins improved by 5.9% and 12.2%, respectively.

Non-fossil electricity made up 28% of generation in 2Q2018, an increase of 5 percentage points yoy from the prior quarter, due to increased springtime runoff (see Non-Fossil Generation). Adjusted for seasonality though, our non-fossil generation index declined 6.4%, meaning that 2Q2018 was seasonally low. These data reveal that even with double-digit yoy percentage increases in solar, wind, and nuclear generation, the large increase of overall electricity demand (up 8.3% from 2Q2017) as a result of renewed industrial activity required significant increases in thermal generation, mainly coal. Renewable sources are still insufficient to replace marginal growth in coal demand and are therefore a long way from replacing existing coal. However, there was some good news concerning renewables: “wasted” wind energy (meaning energy produced by wind turbines that is unable to be transferred to the nation’s electricity grid) held roughly constant with 1Q2017 levels at 9% and improved from 11% in 2Q2017 (see Wind Energy Curtailment). These data show that with the world’s largest installed wind fleet, China is getting better at managing the intermittent nature of renewable energy.

Finally, sales of new energy vehicles (NEVs) comprised 3.9% of total sales, a record high for the second quarter (see Sales of New Energy Vehicles). Even though NEVs remain a small share of the overall car market, generous subsidies are pushing the sector toward a self-sufficient critical mass by encouraging increased investments by automakers and supporting consumer purchases. Given that automobiles are another major driver of air pollution in big cities, this is a positive development.

China’s environmental policy toolbox is now familiar: the long-term aim is to switch the entire economic structure away from heavy industry while cleaning up energy sources and placing direct production limits on pollution sources in the short term.

Policy Analysis

In early July, China published its “2018–2020 Three-year Action Plan for Winning the Blue Sky War,” a follow-up to the previous air pollution action plan. The new action plan targets nitrous oxides (PM2.5) and volatile organic chemical reductions based on a 2015 baseline, similar to previous plans. New cities that were left out of the last action plan are included in the updated targets. Previously, heavily polluting steel production factories were merely shifted beyond the Beijing-Tianjin-Hebei metropolitan areas to circumvent pollution measurements. Expanding the reach of pollution mitigation makes such tactics harder and, therefore, should reduce nationwide emissions.

Specific targets are as follows: PM2.5 will be reduced 18% from 2015 levels by 2020, sulfur and nitrous oxides will be reduced by 15%, and days categorized as “severe” air pollution or worse will be reduced by 25% compared to 2015. The methods used to achieve these targets will likely be similar to those employed in winter 2017, including forcing polluting industries to shut down before key targets become due and forcing firms to switch from coal to natural gas for power.

During the review period, Beijing also confirmed that production cuts targeting air pollution would continue to be a key policy tool starting in October, ending in March 2019. The newly created Ministry of Ecological Environment (MEE) says that pollution efforts will be “more nuanced” and with more local control, as Beijing wants to avoid repeating the chaos of 4Q2017 when gas shortages left households and firms literally out in the cold. The MEE says that during the winter season, steel, coke, and other major polluters in the Jing-Jin-Ji will have to cut their production by 50%, while other firms are targeted to cut capacity by 30%. Rather than simply shutting down all polluting factories, however, the MEE states that local environmental and economic conditions will be taken into account. Despite these assurances, we largely still expect a similar policy implementation pattern as that of 2017 and 2018. As targets come due, coupled with the winter heating season, forced production cuts will likely be draconian. In the spring and summer, antipollution efforts are likely to slacken, as they did in this review period.

In June, the State Council also unveiled guidelines for water and soil pollution. The guidelines include goals that 70% of surface water is drinkable (grade II or better by Chinese standards) by 2020 and that 90% of polluted farmland be used safely. These targets are also consistent with previous goals. China’s environmental policy toolbox is now familiar: the long-term aim is to switch the entire economic structure away from heavy industry while cleaning up energy sources and placing direct production limits on pollution sources in the short term. The challenge for water is that water pollution is tougher to address than air pollution in this way because nonpoint sources (e.g., herbicides and pesticides picked up from runoff) play a larger role, reducing the effectiveness of acute policy interventions. According to the State Council, water policy will focus on limiting pollution from industry, livestock and poultry breeding, and domestic sewage treatment facilities, as well as the remediation of sewage outlets in river basins. The tactics include a mix of incentives and penalties, such as fining pollution violators while investing in water treatment facilities.

As we noted in our last edition, in June the National Development and Reform Commission (NDRC) announced new limits for small-scale solar deployment as well as cuts to solar subsidies. This is mainly due to the overwhelming success of previous solar deployment, which resulted in both heavy bills stemming from subsidies and inefficient deployment. Future development is likely to be slowed; however, solar power that is developed will likely be more efficiently utilized. Coupled with the ongoing U.S.-China trade war (see Trade), this is already putting numerous Chinese solar manufacturers in financial difficulties. Much like steel, even in “clean” industries, the Chinese government is pulled between reducing overcapacity and ensuring stable domestic economic conditions.

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