Energy Policy (Néngyuán zhèngcè 能源政策)|Néngyuán zhèngcè 能源政策 (Energy Policy)

Trevor HOUSER and Daniel H. ROSEN

Vast amounts of energy are needed to fuel China’s industrial plants, such as the Jia Yu Guan Steel Company. As China’s share of global energy swells, the country is forced to rely on international markets for more of the oil, gas, and coal it consumes. PHOTO BY JOAN LEBOLD COHEN.

Economic growth, especially as a result of investment in heavy industry, has rapidly increased China’s share of global energy use. Weak enforcement from Beijing and local authorities who appear to opt for profit over environmental efforts emphasize the need for a stronger energy policy in twenty-first-century China.

Between 1978 and 2000, the Chinese economy grew approximately 9 percent annually while energy demand increased 4 percent. At the turn of the twenty-first century, China accounted for 10 percent of global energy demand but met 96 percent of this demand with domestic energy supplies. After 2001, however, economic growth continued apace, but changes in the structure of the economy pushed energy demand up. By 2006, China’s share of global energy use swelled to over 16 percent, forcing the country to rely on international markets for more of the oil, gas, and coal it consumes.

This fundamental shift in China’s energy profile has created both shortages at home and market volatility abroad and raised questions about the sustainability of China’s growth curve. According to the International Energy Agency, China is now the world’s second-largest energy consumer and has likely become the leading source of greenhouse gas emissions.

Evolution of Energy Demand in China

Decades of state planning and ideological aspiration prior to reform in the late 1970s had distorted China’s energy demand profile. Rather than embracing a development strategy compatible with its natural endowments as Japan, Hong Kong, Taiwan, and others had done, Chinese leaders ignored a comparative advantage (that China is rich in labor but poor in capital, arable land, and technology) and dragged China—kicking, screaming, and sometimes starving—toward Soviet-style industrialization. For thirty years, resources sporadically were shifted out of agriculture and into energy-intensive industries like steel and cement. Data from within China claims that between 1949 and 1978, industry’s share of economic output grew from 18 to 44 percent, and the amount of energy required to produce each unit of output tripled.

This command-and-control fiasco resulted in severe inefficiency. In 1978 leaders began to unleash China’s potential. Beijing reformed agricultural production targets and let prices rise, with dramatic results. Farm output increased, and the early 1980s saw rural residents with more time on their hands, cash in their pockets, and freedom to use it as they chose. Much of this new wealth was invested into township and village enterprises (TVEs) set up to exploit what China was best suited for: labor-intensive light manufacturing.

Reform also brought changes within heavy industry, which reduced the energy intensity of Chinese growth.Economic incentives—such as the right to keep profits—were introduced, and awareness of bottom-line profits made enterprises focus more on top-line expenses, including energy. As enterprises were becoming more aware of the impact of energy costs on profitability, their energy bills were growing as a result of the partial relaxation of oil, gas, and coal prices. The introduction of limited competition for both customers and capital, not just from other state-owned enterprises (SOEs) but also from a growing private sector, made energy cost management all the more important. Domestic competition was accompanied by a gradual integration with world markets; lower trade barriers not only exerted pressure on SOEs from energy-efficient foreign companies but also allowed them to acquire the more energy-efficient technology their competitors enjoyed. China’s small existing base of modern plants and equipment enabled it to absorb new technology quickly, significantly improving the efficiency of the country’s capital stock.

By 2000, Chinese economic activity required two-thirds less energy per unit of output than in 1978. Energy intensity improvement on this scale was unprecedented for a large developing country, and it meant that in 2001, China accounted for 10 percent of global energy demand rather than the 25 percent that had been projected based on its 1978 energy performance.

Investment-Led Energy Surprise

At the start of the new millennium in 2001, China’s leaders expected the energy intensity improvements that had been taking place since 1978 to continue. Most energy forecasters at home and abroad assumed that the structural shift away from energy-intensive heavy industry would persist; at least, no one expected the evolution to reverse quickly.

In 2001 both the Chinese government and the International Energy Agency (IEA) predicted 3 to 4 percent energy demand growth between 2000 and 2010.

In actuality, both wildly missed the mark. The economy grew much quicker than anticipated from 2001 to 2006, but the real surprise was a change in the energy intensity of economic growth: Energy demand elasticity (the ratio of energy demand growth to gross domestic product, or GDP, growth) increased from 0.4 (during 1978–2001) to 1.1 (2001–2006). In 2006, energy consumption in China grew to 16 percent of global demand, four times faster than predicted. And yet on a per capita basis, China’s energy demand remains one-sixth that of the United States, triggering anxiety about how much more growth is yet to come.

This discovery not only shocked domestic and international energy markets but also prompted a fundamental reassessment of China’s energy future—and hence the world’s. In its 2007 World Energy Outlook, the IEA raised its 2030 forecast for China’s energy demand to 3.8 billion tons of oil equivalent, up from the 2.1 billion tons it had predicted in its 2002 outlook—a 79 percent upward revision. Under this scenario, China will account for 22 percent of global energy demand, more than Europe, Russia, and Japan combined, easily surpassing the United States as the world’s largest energy consumer.

What caused China’s two-decade history of energy intensity improvements to change course? Many authorities assume that the recent evolution of China’s energy profile reflects growth in consumption and transportation—for instance, air conditioning and personal cars—but this is not correct. Consumption-led energy demand will be a major force in the future, and it is already significant in absolute terms, but the main source of current growth is energy-intensive heavy industry. Industrial energy efficiency has continued to improve over the past six years; every new steel mill is more efficient than the last one. But the late-twentieth-century structural shift away from heavy industry toward light industry has reversed, and a new steel plant—no matter how much more efficient than its predecessor—uses substantially more energy than a garment factory. The IEA asserts that industry accountsfor two-thirds of final energy consumption in China today, while the residential, commercial, and transportation sectors account for 12, 5, and 13 percent, respectively.

TABLE 1 Energy demand by sector, 2005 (percent)

This industrial energy consumption is high by either developed or developing country standards.. (See Table 1.) But when pundits express shock at how much more energy intensive China is than Japan, for example, they usually ignore the important factor of what the country makes. High energy-intensity partly reflects the role of industry in the Chinese development model, as opposed to India, which has taken a more services-heavy approach, or Japan, which has lowered its energy intensity in part by relocating its energy-intensive sectors to China. According to Chinese statistics, industry accounts for 48 percent of all economic activity in China, compared with India at 29 percent and Japan at 26 percent. So the fact that one unit of economic output requires five times as much energy in China as in Japan says more about the type of economic activity taking place in China than the efficiency with which it occurs.

Increasingly, economic activity in China is slanted toward capital investment, and from an energy standpoint, the current investment cycle is different than in the past. Rather than importing, China is now producing domestically more of the energy-intensive basic products (such as steel and aluminum) used to construct the roads and buildings for which investment pays. China now accounts for 49 percent of global flat glass production, 48 percent of global cement production, 35 percent of global steel production, and 28 percent of global aluminum production. Some of this production also reflects the migration of industry from other parts of the world not only to meet domestic demand in China but also for export. Whereas China used to be a net importer, it has now become a major global exporter of steel, aluminum, and cement.

The changing composition of China’s industrial structure is also a result of competition among provinces and localities to grow GDP, tax revenue, and corporate profits. Not just Beijing but also local interests (including industrial enterprises) set the rules of competition. And regardless of who sets the rules, implementation is a local matter. Within this context of competition, short-term economic incentives—specifically low operating costs and profits—explain much of the increase in heavy industrial activity.

After-tax earnings in energy-hungry industries have been good, rising from near zero in the late 1990s to a level comparable to that of their light-industry counterparts—ranging from 4 to 7 percent in steel, glass, chemicals, and cement in recent years. With China modernizing over 170 cities of more than 1 million people, certainly there is a large domestic market for basic materials; supply was squeezed by breakneck growth after 2001. But with overcapacity arising almost as soon as the first profits come in, the ability of firms to sell surplus production in international markets has been critical to remaining profitable.

China’s energy-intensive industry enjoys low operating costs, which has allowed for rising profit margins and a dramatic growth in capacity that is at the center of China’s overinvestment in heavy industry. Localgovernments often provide deeply discounted land, and they often do not enforce regulations to protect air and water. Construction time is short, and labor costs are low. These benefits apply to all industries, however, they are particularly valuable in the energy-intensive sector, where capital costs are large.

Energy Prices and Environmental Costs

Energy prices in China, once highly subsidized, have gradually converged with world prices over the past thirty years. Yet, it can be difficult to accurately assess the price a specific firm pays for coal, gas, oil, or electricity. Chinese prices for raw energy commodities (including coal and natural gas), particularly in interior provinces close to resource deposits, can be significantly cheaper than elsewhere in the world. For coal, low prices result not from subsidization but rather from low extraction costs in areas isolated from international markets; as obstacles to transportation ease, coal prices will rise toward world prices. Beijing also directly controls natural gas prices, attempting to keep them competitive with the Middle East. But this approach has failed to encourage development and delivery of sufficient quantities of natural gas to meet demand, and authorities are allowing domestic prices to increase.

China’s industry increasingly receives its energy in electrical form, and reported prices of electricity are high compared with those in developing and some developed countries; only in Germany, the United Kingdom, and Japan are costs greater. However, based on conversations with Chinese business leaders and industry analysts, it is likely that many industrial enterprises do not bear the full cost provided by national average figures from the Statistical Bureau. China’s National Development and Reform Commission (NDRC) sets electricity tariffs province-by-province based on the recommendations of local pricing bureaus, which answer to local officials. While the NDRC would like to see energy pricing rationalized to reduce overall energy consumption, it is sensitive to local social and economic development concerns.

Energy prices in China have not reflected environmental costs historically. Over 80 percent of the country’s electricity is generated from coal. But at the end of 2006, less than 15 percent of coal power plants had flue gas desulphurization (FGD) systems (used to remove sulfur dioxide from emissions streams) installed and even fewer had them running. Operating an FGD system reduces production efficiency by 4 to 8 percent and therefore contributes to higher electricity prices. If all the power plants in China installed and operated FGD systems, average electricity tariffs could rise by 10 to 20 percent. Industries that burn coal directly (such as steel and cement) are subject to sulfur taxes, but these are generally too low to reduce pollution. Other air pollutants, such as nitrogen dioxide and mercury, are largely unregulated. Regulated or not, enforcement generally falls to the provincial and local governments, which must balance environmental concerns against economic growth priorities. In the absence of a strong environmental regulator, like the U.S. Environmental Protection Agency, that balance is skewed toward near-term economic growth, as industry threatens to cut jobs and tax revenue if enforcement of environmental regulations is increased.

While it is a daunting and subjective challenge to compute the external impacts of China’s penchant for heavy industry, it is important to recognize that they exist: China does not necessarily do the world a favor by overproducing. Moreover, there are other effects to be considered. A rebalanced China, better aligned with its natural endowment of labor, could be a bigger economy, grow faster, and be less prone to collapse; hence it would be a better engine of world growth. Also, heavy industry in China is less likely to attract innovation and technological change due to weaknesses in intellectual property protection and the difficulty of recovering research-and-development investments. Similarly, institutional weaknesses in regulation and enforcement of pollution controls undermine the process of finding innovative ways to remedy environmental damage.

Further Reading

International Energy Agency (IEA) (2007). World Energy Outlook 2007. Paris: Organization for Economic Cooperation and Development. Retrieved February 16, 2009, from http://www.worldenergyoutlook.org/

Lardy, N. R. (2006). China: Towards a consumption driven growth path. Policy Briefs in International Economics 06-6. Washington, DC: Peterson Institute for International Economics.

Lieberthal, K & Oksenberg, M. (1988). Policy making in China: Leaders, structures, and processes. Princeton, NJ: Princeton University Press.

Naughton, B. (1995). Growing out of the plan: Chinese economic reform, 1978–1993. New York: Cambridge University Press.

Rosen, D. & Houser, T. (Forthcoming). China’s energy evolution: The consequences of powering growth at home and abroad. Washington, DC: Peterson Institute for International Economics.

Source: Houser, Trevor, & Rosen, Daniel H. (2009). Energy Policy. In Linsun Cheng, et al. (Eds.), Berkshire Encyclopedia of China, pp. 710–715. Great Barrington, MA: Berkshire Publishing.

Technicians in an observation booth at a heavy machinery plant in Beijing. PHOTO BY JOAN LEBOLD COHEN.

Energy Policy (Néngyuán zhèngcè 能源政策)|Néngyuán zhèngcè 能源政策 (Energy Policy)

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