20 August 2019
How the role of the state affects China’s energy sector
By David Palmer, Co-Fund Manager HC Verbatim Portfolio 5 Income Fund
China’s going to need a lot more electricity. The good news is that this boosts the renewables sector and other potentially fast growing opportunities. The bad news is that Chinese companies remain hard to invest in, chiefly because they fail to achieve levels of governance we would find acceptable.
Over next three decades, demand for electricity in the People’s Republic of China is forecast to grow by 55% 2017 to 2050.
This rapid increase is driven by the nation’s transition towards higher per capita consumption, to match levels in more developed economies. And this trend will be amplified by the requirement to manage climate change.
As a signatory of The Paris Climate Accord of 2015, China is required to reduce greenhouse gas materially over forthcoming decades, before bringing emissions to a net zero position.
One way to achieve these goals is to use electrified solutions. For example, transport systems which currently use fossil fuels could run electricity, or hydrogen. And industrial processes could run on electricity rather than gas. Both of these could help the country to achieve its zero emission targets.
Break with the past
Future high demand comes after decades of increased power use. The nation’s growth in gross domestic product over the past four decades has resulted in a significant increase in electricity demand.
As heavy industry and domestic consumption grew, electricity consumption rose from 1,355 TWh1 in 2000 to 6,495 TWh in 20172. This has made China the world’s largest consumer (25.4%), surpassing the United States (16.8%) and the European Union (15%).
In the future, we anticipate demand for electricity will be decoupled from economic growth. This will primarily be the consequence of a continued shift from industrial to service economies and a marked increase in energy efficiency. This trend is already in evidence in developed nations.
China has long relied on domestic coal resources to meet electricity consumption. It is the dominant fuel in the country’s power system, accounting for 62% of capacity and 71% of generation in 2017.3
In recent years, however, Chinese policies have increasingly focused on the environmental and economic costs of coal. This is due to negative health effects from localised pollution – because burning coal has created 1.16 million tonnes of sulphur dioxide (SO2) and 1.11 of nitrogen oxides (NOx) emissions.
The impact of China’s power generation on global CO2 contributions is immense. The sector is the country’s largest source of emissions, accounting for 40% of total emissions, and for 11.1% of the world’s total CO2 contributions.
To reduce both localised pollution and the nation’s contribution to global greenhouse gas levels, there has been a structural transformation of the power system.
The Chinese government has created incentives to support the development of clean energy sources, and coal’s share of the power mix has fallen from 81% in 2007 to 65.5% in 2017. These enticements have played an important role in the green transition. As the cost of renewable energy generation has fallen, the capacity of solar, wind and hydro capacities have grown.
China has developed the largest installed capacity of renewable energy globally. This is forecast to grow further with green technologies accounting for an ever-increasing share of the power generation.
Thematically positive, but this is China
We have a high degree of confidence that:
In other words, there are strong multi-decade thematic drivers which investors should be able to harness.
But taking a closer look at the structure of the electricity system and it’s less obvious how international investors can benefit from this trend.
That’s because the power system is principally controlled by the State and State Owned Enterprises.
SOEs and their role
China has a dual track corporate sector. The centrally controlled State Owned Enterprises (SOEs) played an important role in the development of modern China and today’s leadership sees them as an essential component of Communist Party control.
SOEs typically earn a lowly 2% return on assets, are highly indebted, frequently loss making, low growth businesses, badly in need of reform. They have not been good investments.
China’s government started the first-round reform of the power industry in 2002, when it dismantled the monopoly Sate Power Corporation. There was a second-round of reforms in 2015, but despite these attempts to shake up the industry, it remains dominated by SOEs.
The continued role of the State and SOEs in the electricity sector is likely to endure as energy generation is viewed as a sovereign industry and closely aligned to the nation’s security.
As the global economy becomes more electrified and networked, transmission and distribution networks “are key elements of a state’s security and defence. They constitute a vital infrastructure for the economy as well as for the communications of a country.”4
Given this strategic import, we do not anticipate any significant loosening of control of the domestic energy sector.
In addition, there are serious limitations on the returns which can be generated from a sector with continued state involvement. That materially reduces our confidence in the returns available from investing in this electrification transition.
Outside China, we continue to invest in electrification themes through holding companies such as Orsted, Enel, NextEra and Schneider. We will continue to monitor China for segments of the market in which we can identify strong thematic drivers and companies well positioned to capitalise on those trends.
1 1 teraWatt - 1,000,000,000,000 Wh (watt per hour of energy)
2 Statistical Review of World Energy, BP
3 Bloomberg New Energy Finance, New Energy Outlook 2018
4 China and European electricity networks: strategy and issues, Note de la FRS No. 17/2018, Mazzucchi
The value of investments and any income from them can go down as well as up and is not guaranteed. Your clients could get back less than they originally invested. Past performance is not a guide to future performance. The portfolios' investments are subject to normal fluctuations and other risks inherent when investing in securities. Verbatim Asset Management has taken due care and attention in preparing this document, which is solely for the use of professional advisers. Verbatim cannot be held responsible for any inaccuracies arising out of information detailed within and will not accept liability for any loss arising out of or in connection with its use. This article is for information only and should not be deemed as advice.