Curbing China's coal addiction

John Garnaut, Fairfax's China correspondent, reported yesterday that the Chinese government's State Council, the equivalent of our Cabinet, had agreed to a target that would cap 2015 energy use at levels only marginally above where they are now. It would mean energy demand that has been growing at 6.6 per cent per annum over 2005 to 2010 would need to fall to 3.5 per cent.

Taking into account notable growth expected in power from wind, solar, hydro and nuclear, Professor Pan of the Chinese Academy of Science told Garnaut this would mean an abrupt halt in the growth of coal consumption, which would top out at 4.2 billion tonnes in 2015 (compared to 3.9 billion in 2012).

Such a target, if implemented, would have profound implications for global carbon emissions and the oil, coal and gas industries. The chart below, taken from the International Energy Agency's latest projections, illustrates the significance of China's energy demand and its expected growth to 2035.

IEA projection of non-OECD primary energy demand by region – new policies scenario

Source: IEA World Energy Outlook 2012

In terms of coal, China's consumption growth from 2010 to 2020 is projected by the IEA to be greater than that of the rest of the world combined. This State Council target would involve stabilisation of China's coal consumption five years earlier than forecast and a dramatic decline over past growth.

There are plenty of reasons to be highly sceptical of such Chinese government targets. 

Every few months it seems the Chinese central government issues edicts to curb the growth of energy intensive industries. Yet industries like cement, aluminium and iron and steel just seem to pile on extra capacity as provincial governments thumb their noses at the central government. 

The central government orders small coal mines to be closed but local officials choose to look the other way either because of bribes or a desire to maintain employment.

And a  number of provincial governments, after doing little to improve energy efficiency for several years, in the last few months before the date for the central government's 2010 energy intensity target, instituted a frantic rotation of rolling blackouts for thousands of factories that required them to shut down five days for every nine they operated. Once the target deadline passed it was back to business as usual.

However a deeper look into China's economy and history suggests a massive change in the energy intensity of the economy is not completely out of the question.

Back in 1978 when Deng Xiaoping began to ‘marketise' the economy and reverse much of Mao's ideological lunacy, the economy achieved a remarkable improvement in energy intensity. Resources shifted away from inefficient, sub-economic scale, and archaic state or even community-owned industrial plants (so prized by politicians as a symbol of progress and modernity) towards privately-run labour-intensive industries such as clothing and footwear, where China had a genuine comparative advantage, as well as to industrial firms that were driven more by profit and used energy more efficiently.

Energy intensity of the Chinese Economy (1952-2006)

Source: Peterson Institute for International Economics (2007) – China Energy - A guide for the perplexed

Yet this progress in energy intensity came to an abrupt halt and reversal in the 2000s.  The chart below illustrates how the IEA back in 2002 had a very different forecast of China's future energy use to the one it has now.

Energy Demand – IEA 2002 projection versus actual for China

Source: Peterson Institute for International Economics (2007) – China Energy - A guide for the perplexed

The reason for the sudden reversal was partly due to China's accelerating growth, and urbanisation leading to greater demand for energy-intensive materials like steel, aluminium and cement.

But another element is quite likely to be inefficient communist government interference in the economy reasserting itself, but at a provincial level rather than Beijing.  

As the chart below illustrates, Chinese energy demand is unusually skewed towards industry. While it is typical for countries to allocate more resources towards heavy industry in their initial stages of economic development as they build up infrastructure and construct cities, China's bias towards industry is particularly significant.

And China's energy intensity is noticeably greater than other countries at similar stages of economic development such as Indonesia, Vietnam and Malaysia. Also, China lacks cheap natural resource endowments (unlike say Russia, the Middle-East or Indonesia) that could justify such a bias.

Chinese energy demand by sector versus other countries (2005)

Source: Peterson Institute for International Economics (2007) – China Energy - A guide for the perplexed

China's provincial governments and the state-owned enterprises that tend to dominate energy-intensive industry have had privileged access to cheap finance to fund expansions, often provided without adequate regard to borrower's capacity for it to be repaid.

With such cheap finance readily available, provincial governments have seen investments in new industrial plant capacity as a direct and easy way to generate economic activity versus more indirect and longer-term methods such as stamping out corruption, improving recognition of property rights, and improving education and health. John Lee explains this further in his article, China can't grow out of it's problems. 

Yet given China's natural endowments it seems quite likely that allocation of that finance to activities outside of heavy industry could yield better returns, and also coincidently lower energy consumption and environmental pollution. Instead we can end up with crazy investment patterns not unlike the building out of solar PV production capacity to 60 gigawatts when global demand requires just 30.

On top of this China has very large room for improvement in energy efficiency, not helped by pervasive energy subsidies and counter-productive price controls over electricity.

So while it may be hard to believe China could so quickly arrest its growth in coal consumption, the country has large room to reduce its energy demand without seriously hurting economic growth.