The East is green

PORTFOLIO POINT: While the risks for China’s economy look bigger by the day, the country’s dire environmental challenges will provide a wealth of opportunities.

The expression “green on the outside, red in the middle” is being used with increasing frequency, not because watermelon are in season but because the economic debate is becoming increasingly obsessed with what some might regards as socialism masquerading as environmentalism.

But beyond this straw man of an idea, a far more useful paradigm might be “red on the outside, green in the middle”, for this – no matter what happens to economic growth in the next few years – might come to define the People’s Republic of China and a phenomenon of enormous consequence.

China’s environmental credentials are understandably dubious and one needn’t spend much time in one of the country’s 170-plus cities with more than a million people to understand why. The intersection of totalitarianism and environmentalism is likewise pretty dubious too, with a long pedigree extending back to fascist Europe in the 1930s.

What’s not up for debate at least is that China faces mammoth environmental challenges. Already, separate studies by the World Bank and MIT estimate that damage from air pollution costs China between 4.6% and 6% of GDP per annum.

Water pollution and constraints, it is believed, have a similar cost to society, while the effects of living in one of China’s 450 so-called “cancer villages”, located in heavily-polluted areas, are immeasurable.

The Harvard School of Public Health and the World Economic Forum estimate that cancer will lead to 7.8 million deaths, and respiratory diseases 3.5 million, in poor and middle-income countries between 2011 and 2025. Many of those deaths will be in China and most of them will be inadequately treated due to the inability for a poor country to fund the rich-world cost of such diseases.

And as discussed before, China faces even more pressing problems in the form of water and food supply, let alone quality or cleanliness (see Pincer closes on China and The world’s real liquidity crisis). As I wrote in the second of those two articles in August, 90% of China's urban groundwater and 75% of its rivers and lakes are polluted. But what's more, 400 out of 600 cities face water shortages, including 30 of the 32 largest urban areas.

Several days after writing that article I met up with an Australian scientist who has spent years studying northern China’s groundwater and, in particular, the ancient aquifers near Beijing. What he said left me even more concerned. By the time that China builds its massive South-North Water Transfer Project, which aims to divert water from the Yangtze in the south to the Yellow and Hai rivers in the north, Beijing will have otherwise run out of water and the diversion will only meet existing needs, not provide a further buffer of safety. In its long history, China has already had a dozen capital cities. Should Beijing run out of water it is not hard to imagine that its capital will one day need to relocate again.

With this in mind, I asked Australia’s returning ambassador Geoff Raby what he thought of China’s environmental risks when he addressed a seminar last week. China’s problems were real he said, but conversely they provide an opportunity to investors. Dr Raby said that China would be a centre of environmental technology and green businesses if only because the alternative is an existential question of national security. And as with the twin issue of resource supply – which China has increasingly relied on the world for since becoming a net oil importer in the 1990s – this presents a mountain of prospects for Australian business.

With its equally dramatic economic and political challenges (see China at the precipice and Nouveau riche get theirs) I have been far less bullish on China’s mercantilist and investment-driven economic model than most of my colleagues at Eureka Report, especially the parts of China that contribute to Australia’s resources boom. Yet one area I am bullish about is China’s future demand for environmental solutions, no matter how fast or slow overall GDP growth turns out to be.

This segment of demand could also provide a rare entrée to China’s elusive household sector, something Western businesses have been attempting since the days of Marco Polo, the Jesuit Missions and the East India Company. Yet like almost everything with China, it’s a bit more complex than that, as hundreds of failed entrepreneurs have found before. And within the environmental industry itself some of China’s biggest scams in recent years have played out.

Two of the most prominent scandals have been in celebrated green stocks Sino-Forest and Chaoda Modern Agriculture. Sino-Forest, a $US5 billion Toronto-listed company in November of last year, was seen to represent the future in sustainable plantation timber and lumber processing, while Chaoda, listed in Hong Kong and on the US Pink Sheet market, claimed to be China's biggest listed agriculture group and “official vegetable caterer” to the 2008 Beijing Olympics.

Claiming ownership of 757,000 hectares of trees under management, Sino-Forest was the first to fall. In a lesson that can be applied to many other areas of sharemarket investing, it was a previously unknown research analyst, Carson Block, who blew the whistle. Block's firm, Muddy Waters, claimed Sino-Forest was a “multibillion-dollar Ponzi scheme '¦ accompanied by substantial theft.” At first these claims were dismissed, but a subsequent investigation by PricewaterhouseCoopers and a downgrade by ratings agency Standard & Poor's triggered a free-fall. Former US hedge fund guru John Paulson was wiped out, being forced to sell his entire stake for a $US720 million loss, and the Ontario Securities Commission suspended the company's shares. The company's stock price, in the meantime, had fallen by 82%.

Chaoda’s crisis has been more recent. Although it was accused by Hong Kong-based Next magazine in May of having inflated farmland figures (Chaoda’s model is to aggregate, economise and manage small-scale farms), the firm came to wider attention last week when none other than Anonymous, the internet “hacktivist” collective famous for attacks on the Church of Scientology, Stephen Conroy's ISP filter and companies that prevented donations to Wikileaks, issued an extraordinary research note on the company.

Vaguely resembling a sell-side broker report peppered with quotes from Seinfeld and The Simpsons, the nonetheless extraordinary document details the gaping holes in Chaoda’s profit and loss and balance sheet reports. Issued under the byline of “Anonymous Analytics”, no reputations – other than the company’s – were put on the line, but the subsequent decision by Hong Kong’s Market Misconduct Tribunal to launch a hearing is a grave embarrassment to Macquarie and other conventional research firms who had previously upheld the company’s claims that it was not exaggerating figures or operating a scam, notwithstanding a corporate structure like this:

For a larger version of this image, click here.

Unfortunately, this is not the first nor likely the last time a Chinese company in such a crucial industry will be proven a fraud. Already the Bloomberg Chinese Reverse Mergers Index, which tracks Chinese companies that have backlisted onto exchanges like Nasdaq and Toronto, has fallen more than 50% in the past year and traders like former Platinum Asset Management analyst John Hempton, famed hedge fund manager Jim Chanos and industry bête noire Hugh Hendry have made a fortune short-selling Chinese stocks. Indeed, notwithstanding the positive GDP figures on the surface, being short China over the past 12 months has paid extremely well.

Beyond the markets, Chinese environment scams have had a far more insidious impact, adding not only grist to the mill of climate change sceptics, but completely derailing legitimate attempts at greenification. Last year the European Commission claimed that many Chinese companies were manufacturing refrigerant HCFC-22 only in order to make money sequestering the byproduct greenhouse gas HFC-23, which can be worth five times more in EU carbon credits. Elsewhere, fraud has been charged against numerous Chinese solar firms alongside allegations that factories are causing net damage to the environment by dumping highly toxic waste and emitting harmful emissions. Most recently, a mass protest in the eastern province of Zhejiang saw violent attacks on a compound belonging to NYSE-listed Jinko Solar after solid waste laced with fluoride had flooded a nearby river.

And the scams aren’t confined to heavy industry either. A company at Luoyang, one of those dozen ancient capitals, has sparked similar protests after being found to be reselling cooking oil from restaurant gutters and in Guangdong, hundreds blocked a highway and attacked a police station and local Communist Party headquarters after a series of farms were commandeered by officials for factories and luxury housing.

But just as the Chinese word for “crisis” contains elements of both “danger” and “opportunity” if one can find a way to invest in what’s undoubtedly one of China’s biggest needs without getting fleeced then there’s undoubtedly money to be made. The best way in my view for Australian investors is to stick with local stocks however where line of sight and corporate accountability exists. Last week I profiled one such stock, Dyesol Limited, which has had difficulties in the past, but nonetheless has a highly prospective portfolio of environmental technologies that could eventually see commercialisation not just in China, but across the world.

Similarly, I profiled a number of Australian environmental stocks in my list of impact investments and the "discounted dozen". Giles Parkinson also covered another list of environmental stocks in July as did James Frost last year in a profile on ethical funds.

Per my note from September 12 (see Ten years after), the next decade is likely to be remembered for competition for environmental resources and this will likely drive the next credit and investment cycle (see The age of extremes) once issues of market and economic imbalance are slowly restored to equilibrium. Yet at this early stage in the cycle, investment in these themes will likely remain speculative and risky – as shareholders in Sino-Forest and Chaoda will be most aware – though in the long-term the macro dynamics will reward patient and careful investors.

It’s difficult, as such, to pick a stock that will perform the best, although diversified investors in green energy like small caps Wasabi Energy (WAS) and CVC Limited (CVC) ought to do well assuming prudence and caution rule the day. Another small cap, CBD Energy (CBD), which has entered a joint venture with China Datang Corporation, also ought to do well but, like so many other green energy stocks, its share price performance in the past year has been very disappointing.

Overall, the main thing to remember is that these are long-term themes and investors should not rush into what looks like a once-in-a-lifetime opportunity because it’s not. The best of the green energy boom is yet to come and, as with all bull markets, the beginnings are in a bear market.