The Strategic and Economic Dialogue and Energy and Climate

The State of Play of Chinese Policy and Bilateral Issues

The Obama administration’s fourth major meeting with China, involving multiple Cabinet Secretaries and Chinese Ministers, the Strategic and Economic Dialogue (S&ED), will be held May 3 and 4 in Beijing. As usual, the U.S. delegation will be lead by Secretaries Clinton and Geithner, and their Chinese hosts will be Vice Premier Wang Qishan (who focuses on economic policy) and State Councilor Dai Bingguo (responsible for foreign policy).

This S&ED comes at a time when there are particularly sensitive political and economic issues for the two countries to address, and many of these will obviously be the focus of the meetings. However, if past S&ED’s are any indication, we would expect at least some discussion of climate change, and climate and energy cooperation, despite areas of genuine difference, can be a positive and fruitful area of engagement. Moreover, several of the economic topics likely to be discussed are connected to climate and energy debates. With that in mind we preview some of the climate and energy issues.

Looking at domestic policy there have been a number of important recent developments:

1. Moves Toward Absolute Targets: the Coal Cap and Industrial Capacity Cuts

China’s 12th Five Year Plan set overall national targets, including the 16% energy intensity and 17% carbon intensity (both per unit GDP) reduction targets that have been widely publicized. Implementation depends on sectoral and provincial level Five Year Plans that spell out more of the details. The intensity targets were distributed to the provinces last year, but one of the big open questions was whether China would also start to set some absolute limits. There had been considerable speculation of an overall energy cap, and while that has not emerged, one of the alternatives to a total energy cap was a total coal cap, and that has now appeared.

In the “12th Five-Year Coal Plan”, released in April by the National Development and Reform Commission, coal production capacity is capped at 4.1 billion tons and an annual output target of 3.9 billion tons by 2015, which would limit coal production growth to about two percent per year, considerably lower than the 5-10% growth seen in recent years. While this type of guidance is not as binding as the overall intensity goal, it does give strong policy direction to controlling the share of coal in China’s overall energy mix.

In addition, the Ministry of Industry and Information Technology announced this past week a series of industrial capacity cuts that should also help to reduce energy consumption and carbon intensity. The Ministry plans to shut 7.8 million tons of steelmaking capacity, 700,000 tons of copper smelting capacity this year, 270,000 tons aluminum capacity, 10 million tons iron-making capacity, 320,000 tons zinc capacity and 1.15 million tons of lead capacity by the end of the year. Of these, only the copper target is higher than last year. The lower targets in part reflect the fact that many inefficient plants were closed during the previous Five Year Plan, and also the overall slowing of GDP and industrial growth, suggesting the market is already shifting somewhat from industry to services.

2. Seven Emissions Trading Pilot Programs:

China has continued preparation for the launch of seven carbon-trading pilots by next year and an eventual nationwide carbon-trading program in 2015. The emissions trading programs will be piloted in the cities of Beijing, Tianjin, Shanghai, Chongqing and Shenzhen and the provinces of Hubei and Guangdong. These pilots will provide inputs into the design of the eventual nationwide program, and in large part will shape the future of carbon markets in China.

The specific design and implementation details for the pilots are still being worked out. We can expect that the caps will be closely tied to the energy intensity reduction goals specified in the NDRC’s “Energy Conservation and Emissions Reduction Comprehensive Workplan for the 12th Five-Year Period (2011-2015)” (Chinese only). Each pilot is being designed separately, and as with earlier policy pilots, we’d expect the national government to compare the effectiveness of different approaches before designing a national program. Many of the details are still under discussion, but some cities such as Beijing have begun to discuss possible details. Beijing has announced that more than 600 companies with emissions exceeding 10,000 tons per year – likely industrial plants and utilities – will be included on a mandatory list for emissions limits. It is possible that other cities will choose to focus on specific sectors. While the national government has not formally committed to using absolute caps rather than intensity targets for the trading schemes, our understanding is that there is widespread recognition that for trading to be most effective there will need to be absolute caps for firms included in the trading itself, even if the cities overall do not have absolute caps. These caps can then be distributed by allocation or auction. While most economists see auction as more economically efficient, most countries find it difficult to begin that way – rather than with free allocation. Beijing indicated it might begin with 15% auctioned and the rest allocated.

For the pilot trading schemes to be successful, the select cities and provinces will need to build local capacity to accurately measure and account for greenhouse gas emissions, as well as ensure that the legal infrastructure can spell out clearly defined emission permits, allocation systems, trading rules, monitoring, and enforcement (See this report by the Stockholm Environment Institute for more details of these challenges).

Finally, while there was much discussion amongst Chinese officials about a likely carbon tax during this Five-Year Period, there is still a question as to whether a tax will be instituted and how it will relate to a nationwide emissions trading program. It is likely that the Chinese will begin with the emissions trading pilots first, and decide on how to integrate a carbon tax at a later point in time.

These programs are an effort over the medium term to move from targets and quotas to more market-based mechanisms. In the near-term they will contribute mainly to learning and policy development. The existing infrastructure of quotas and targets under the Five Year Plan will deliver most of China’s emissions control.

3. Higher Prices, But Energy Shortages Remain:

While China is working to curb energy demand, policy analysts still expect shortages this summer. The China Daily reported blackouts are likely, especially in Eastern and Southern China, as China Electricity Council estimates 30-40 million kW shortages during peak demand periods in the summer. These shortage levels are similar to last year and reflect the same mixture of weather (droughts have once again limited hydropower production) and policy choices. Many outside observers argue for market-based pricing, although many fail to note that Chinese electricity prices are not low – they are actually comparable to U.S. prices and in many cases higher. However, they do not vary with peak loads, as they do in the U.S. For example, electricity prices in China in March were 12.4 cents for commercial and industrial consumers and 8.4 cents for residential consumers. This compares to an average price in the U.S. in March of 9.6 cents, with industrial users paying the least – 6.6 cents – and residential consumers the most – 11.6 cents.1 Thus on average Chinese industry pays considerably more for power than does U.S. industry. Since industry is the major user in China, and residential use is more substantial in the U.S., focusing higher charges on the larger group of consumers is more effective at providing a price signal to influence consumption.

While China has higher electricity prices, these prices vary far less than in the U.S., where rates vary not just state by state, but also with daily shifts in demand. This, in part, reflects different opportunities – commercial and residential demand is more variable, while China’s industrial demand is fairly constant. However, the blackouts in the summer are caused by peaking demand from residential and commercial consumers of air conditioning during particularly hot spells during the summer months. Variable pricing would enable the grid to more easily discourage other uses during these peak demand times. Instead, the grid generally deals with these shortfalls by cutting power to industries on a schedule.

Overall, industrial electricity prices having been rising steadily in China, up over 16% in the last 5 years. Coal prices, while fluctuating month to month, have more than doubled over the same period, with high quality coal for power plants now priced at over $120/ton, well above prices in much of the world. Chinese analysts do not expect to see prices fall. The much more rapid change in coal prices, compared to the regulated electricity price, provides an incentive for power producers to look at renewable energy.

Gasoline is also not inexpensive in China. The current price in Beijing is about $5/gallon, over $1 higher than the current U.S. average. Prices are regulated, so there is less fluctuation in China, but that has meant that they tend to hold steady or rise, and not fall, regardless of global market conditions.

In addition, the meeting may be a venue for discussing current multilateral and bilateral disputes:

1. Opposition to European Union’s Aviation Tax:

One area where the U.S. and China have aligned their positions, albeit in opposition to a climate change measure, is with regard to the European Union’s Aviation Tax. In early February, China banned its airlines from complying with the EU’s plan to include airline emissions in its Emissions Trading Scheme (ETS). The move would require airlines with flights originating in and leaving Europe to purchase carbon permits to cover excess emissions. China is not alone in opposing the move and is joined by the United States and India. China’s opposition was intensified when Beijing also suspended the purchase of $14 billion worth of aircraft jets from Airbus, a European manufacturer of long-haul carriers.

While the U.S. and China are essentially on the same page with respect to the E.U.’s plans, there is danger that such a strong stance and economic retaliation could stymie the progress of international climate talks. There are indications that the European Union might be backing down from its initial stance to allow another year for additional negotiation and possible compromise. Thus, there is an opportunity for the U.S. and China to engage in constructive dialogue with the E.U. so as to prevent a global carbon trade dispute and perhaps find a more constructive and climate-friendly approach for both the U.S. and China.

2. Trade Issues:

The most likely issues to appear in the S&ED plenary are issues more directly connected to economic concerns. Secretary Geithner has been quoted in the Chinese press naming key concerns as currency and intellectual property. Intellectual property concerns, while far broader than energy, are of great interest to the clean energy community.

Two other trade disputes might well be discussed. These are the anti-dumping case against Chinese solar panels and a World Trade Organization (WTO) case concerning rare earths. The Commerce Department made a preliminary decision in March to place a modest tariff on Chinese panels, and is reviewing that case until May 17. This gives time for both governments to discuss the issues. There have been growing calls in the U.S. not to impose high tariffs on Chinese goods. Editorials and news articles have argued that much of the U.S. solar industry actually benefits from these imports. Others have argued that fairness is also at stake, and that perhaps there is an opportunity to get Chinese manufacturers to shift some production to the U.S. One potential bright spot is that China’s current solar plan calls not just for increasing production, but also increasing installed capacity in the country and reducing the domestic price of solar power to encourage domestic use. ChinaFAQs has compiled a list of resources concerning the solar trade case here.

The U.S., Japan and the European Union also filed a WTO complaint against Chinese restrictions in the export of rare earths, minerals used in the production of many high-tech products. The rare earths issue is complicated, because China currently produces most of the world’s supply, but there are reserves elsewhere, including in the U.S. Moreover, part of China’s current dominance is fueled by poor environmental standards enabling cheaper production, and there has been an effort by the Chinese government to close down poor facilities, with limited success. The rare earths case is in many ways similar to a case decided against China last year, concerning other Chinese mineral exports. Given the number of disputes, and the risks of economic harm from a trade war, it will be worth watching this meeting to see if any agreements are worked out. In the past, the U.S. and China have often used these bilateral meetings to resolve such issues.

1. All U.S. prices from the Energy Information Agency. Chinese prices from the National Development and Reform Commission, the China Petroleum and Chemical Industry Association and DBCCA analysis, except for the price of gasoline, which is the observed retail price in late April.

Image courtesy of the U.S. Department of State and in the public domain.