China's Quest for Energy


Cooperation and coordination will help the United States avoid an energy-policy confrontation.

Fortnightly Magazine - February 2006

Deep underground, at a coal mine near China’s border with Siberia, coal-dust levels were building up to critical levels. The pit’s ventilation systems, stressed even in the best of conditions, fell behind as miners dug faster and deeper to meet the country’s soaring demands for coal.

Then, in late November 2005, the inevitable happened; a spark ignited the coal dust, and an explosion ripped through the mine. More than 170 lives were lost in the blast and the collapse that followed.

The Dongfeng mine disaster, unfortunately, was just one of a stream of deadly mining accidents in China’s coal industry. Indeed, even as the Dongfeng rescue operation was proceeding, a mine in Henan province flooded, trapping more than 40 workers. And a few days later, an explosion in Hebei province killed 74 miners.

Deadly coal-mining accidents happen almost every day in China. The central government in Beijing estimates that 6,000 workers were killed in mining accidents in 2004; independent organizations put the number much higher, at more than 20,000. Either way, these numbers indicate a crisis in China’s coal-mining industry, a crisis that the central government is seeking to address by tightening safety standards and closing thousands of unsafe mines, mostly small ones that operate with little government oversight.

“The most fundamental reason for these kinds of mining disasters is that supervision and administration are not very strong, and the laws are not strictly enforced,” said Li Yizhong, minister of the State Administration of Work Safety, speaking at a news conference.

China’s safety and environmental laws are relatively stringent, but until modern, large-scale mines open up, enforcing those laws will be difficult and economically risky—especially in areas that are enduring regular power curtailments caused by fuel shortages.

Coal is just one aspect of an increasingly complicated and hazardous energy supply picture. To secure fuel for its growing economy, China is seeking to acquire resources and infrastructure from all over the world, from the oil fields of Venezuela to new shipyards for building liquefied natural gas (LNG) tankers in Shanghai. And the acquisition patterns of China and its state-owned industries has put the country on a collision course with the United States and the rest of the world.

“China doesn’t want to be a prisoner of other countries for fuel supply, especially transportation fuel,” says James Woolsey, former director of the Central Intelligence Agency and now a vice president with Booz Allen & Hamilton and policy advisor to the U.S. Secretary of Defense. “They are likely to be ruthless in getting that fuel, more so than we are. They will support Iran as it develops its nuclear program, for example, and will help the Sudan avoid international sanctions for the genocide it has committed.”

The tension is building as China’s thirst for petroleum grows. For example, China’s burgeoning middle class is buying automobiles. More than 3 million new cars went on the road in China during 2005, making it the third-largest auto-sales market, and adding to its distinction as the second-largest petroleum consumer in the world, behind the United States.

To a lesser degree, China’s growth affects global markets for all energy commodities, including coal and LNG. But more broadly, the potential for conflict between China and the United States over energy security issues poses geopolitical risks that jeopardize economic stability and defy easy solutions.

At the same time, however, the need for energy security creates significant opportunities, as China and the United States work toward solutions that serve the long-term interests of both countries. Whether and how these opportunities might evolve depends on the ability of leaders in both countries to engage in cooperation and coordination as a strategy for avoiding confrontation and conflict.

King Coal Reigns

Like coal mines, China’s power industry has seen many small, freelance power projects crop up all over the country—many of them outside the normal permitting process, and using minimal emissions controls if any. “A lot of local developers have set up projects without even partially going through approval procedures,” says Zhu Songbin, president of Songlin Group, a consulting and research firm in Beijing. “The central government realized this is no way to do business, so they shut down about 120 GW of power plants.”

Many of the plants have restarted several months after they ostensibly were closed, however, as power-supply margins grew dangerously slim and the need for power outweighed other concerns. “We’ve had a power-supply shortage for almost three years,” Zhu says. “A lot of people are saying it’s time for us to reconsider our energy and power policies, and focus on using something other than coal.”

China has the world’s third-largest reserves of coal, and is the largest producer and consumer of coal in the world. In theory, its reserves are more than adequate. But in recent years, coal producers have been unable to keep up with demand, forcing some power plants to burn oil when they run out of coal. Others have been forced to shut down completely, causing brownouts and blackouts in many areas of the country.

To improve China’s energy security, the central government has begun restructuring its electric-power sector to encourage more rational and competitive investment. Furthermore, its policies are emphasizing fuel diversity—namely by expanding hydropower, nuclear, and natural-gas fired capacity.

Natural gas has been expected to serve a growing share of China’s fuel demand, particularly in coastal urban areas that can be served by LNG imports with minimal new pipeline construction. But price increases in recent years and months are forcing decision makers to re-think the role of natural gas in China’s energy strategy.

“Price control in China has left gas prices in a former state, closer to coal prices than reflective of the world market,” says George Hopley, an associate director with Barclays Capital in New York. “Even before the Hurricanes in North America, prices were trending toward $7 or $8[/bcf], and that is double what they want to pay. It will be tough for them to look at the LNG market now, in the post-Katrina era, with Henry Hub prices around $14.”

At the same time, several large hydropower facilities are in the process of starting up, making hydro electric China’s second-largest electricity generation resource. Several new nuclear reactors also have begun operation in the past few years. China aims to have 27 GW of nuclear capacity operating by 2020. But even with this aggressive development schedule, nuclear power will account for less than 5 percent of China’s total installed capacity.

Thus, even with plans to increase power generation from other sources, coal likely will remain king in China, meeting two-thirds of the country’s power demands for the foreseeable future.

In this context, China is trying to channel investment toward large power plants rather than small ones, which have mushroomed in an environment of power shortages and limited regulatory enforcement. “China first will focus on development of large-scale power plants, because they are more efficient and environmentally friendly than smaller ones,” Zhu says. “Second, from now on, desulfurization is a must for any coal-fired project, and the Environmental Protection Bureau will enforce new standards for air emissions.”

Kyoto Comes to China

Environmental factors are becoming a key driver of policy and investment in China, as government leaders respond to public discontent over the country’s severe environmental degradation. China’s environmental regulation efforts focus on pollution affecting local communities. “Climate change is talked about, but it is still not a major issue here,” Zhu says. “Instead, the government has focused on reducing sulfur and nitrogen oxides.”

Global market pressures and political trends, however, might be changing that.

At a chlor-alkali facility in Jiangsu province, equipment is being installed that will capture nearly 9 million tons of CO2 equivalent per year. More precisely, the project will capture trifluoromethane (HFC-23), a fluorocarbon compound that is 11,700 times more potent than CO2 in contributing to greenhouse warming.

The project, at Jiangsu Meilan Chemical Co. Ltd. in Taizhou City, is one of 18 in China that have been approved under the Clean Development Mechanism (CDM), an international arrangement under the Kyoto Protocol on climate change. The CDM approach allows companies from industrialized nations to invest in greenhouse gas-reduction projects in developing countries, including China, to help meet their Kyoto-compliance obligations.

China represents one of the world’s most fertile markets for developing CDM projects, because its 200 million tons of CO2 emissions over the next five years represents almost half of the potential global market for tradable carbon credits. Furthermore, a large share of China’s emissions come from antiquated and inefficient systems. As such, they represent low-hanging fruit in terms of greenhouse-gas (GHG) reductions and productivity benefits as well.

“With the CDM, China has become the most promising supplier in the global emission market for greenhouse gas,” stated Marc Stuart, a director with EcoSecurities Ltd. in Dublin, Ireland, an investment firm specializing in emissions-trading deals. “It will also harvest great profit from the CDM projects.”

The Asian Development Bank estimates the potential market for Chinese emissions-reduction credits exceeds $13 billion a year. As a result, investments are beginning to flow into CDM projects at a healthy pace—an estimated $240 million in 2005.

In the Jiangsu Meilan Chemical plant example, the World Bank will finance the project, paying facility owners to install and operate the equipment and then selling carbon credits to various buyers. Not all such projects, however, are being financed by multilateral agencies. Six industrial facilities, producing steel, coal, gas, and electric power in the city of Chongqing in Southwestern China, signed an agreement with EcoSecurities in November to invest in capital improvements that will reduce their GHG emissions by more than 1.5 million tons of CO2e/yr. EcoSecurities will pay the companies about $53 million between now and 2012, and will sell their carbon credits in the world market.

Because the United States has not ratified the Kyoto Protocol, U.S. companies cannot invest directly in CDM projects. They can, however, invest through foreign subsidiaries, or in unilateral deals where carbon credits are assigned to the host country. As U.S. carbon policies evolve toward greater harmony with the rest of the industrialized world, investment opportunities will become more attractive to American companies.

Looking Beyond Oil

Environmental considerations and rising fossil-fuel costs are driving both China and the United States toward long-term energy strategies that rely more on domestic resources. A third factor is adding momentum in the same direction: geopolitics.

Since the end of the Cold War, the United States has stood virtually unchallenged as the solitary world superpower. But China’s star is rising, casting a different light on America’s military and economic position. In particular, China’s approach to securing fossil-fuel supplies raises alarm bells in security-policy circles.

“China is not a market economy. They are seeking to own energy assets at the wellhead or the mine, to capture those resources and take them off the market,” says Mike Wessel, a commissioner with the U.S. China Economic & Security Review Commission. “As everyone’s energy demand increases, this puts us in competition for fewer reserves and creates enormous problems for end users.”

It also raises the stakes in an international gambit involving foreign policy, global trade, and political ideology.

“China’s strategic reach for energy is a huge issue for potential conflict with the United States,” says former CIA Director Woolsey. He cites China’s recent efforts to secure oil reserves in Venezuela, Iran and the Sudan—all countries that are at odds with U.S. foreign policy. Another example is the attempted acquisition of U.S.-based Unocal by state-owned China National Offshore Oil Co. (CNOOC), which prompted a political firestorm and Congressional hearings. CNOOC eventually withdrew its bid, but the episode exemplifies the tension between the United States and China over energy resources.

“It’s too early to tell what kind of threat China poses in the geostrategic equation,” Wessel says. “China has done a lot of things that are adverse to our interests. As China projects its power and pursues its energy acquisition strategies, the potential for conflict arises. We’re not there yet, and our goal now is to find a way to cooperate with China and manage these issues before they do become part of the geostrategic equation.”

Opportunities for cooperation abound, because China and the United States face very similar dilemmas over energy security, and solutions that help one will help both.

For example, coal-liquefaction technology offers both countries a promising alternative to imported petroleum. Toward that end, Chinese coal-mining giant Shenhua Group is building a large coal-liquefaction facility in Inner Mongolia, scheduled to begin startup in 2006. U.S. companies and government agencies—including the Department of Defense—are working on similar efforts in the United States.

“Unless we move—as we should—toward substituting other things for oil, there will be pressure in the world market over oil supplies,” Woolsey says. In addition to developing alternatives to petroleum—including coal and various biofuels—both the United States and China are expected to move toward electric vehicles, especially plug-in hybrids. Markets for such vehicles are small in both countries today, but in the coming years and decades sales are expected to rise along with increasing petroleum prices.

“We have proven the concept and we are looking at how to get it into the mainstream,” says Brian Wynne, president of the Electric Drive Technology Association (EDTA) in Washington, D.C. “The main challenge we are facing is the need to get to scale and compete with the installed base of internal-combustion engines. All the drivers are moving in that direction, and it’s safe to say that in the next 20 years we’ll see a material transformation of the vehicle fleet.”

The more readily that transformation occurs in both the United States and China, the more transportation-fuel loads will move from imported petroleum to electricity generated with domestic resources. To the degree electricity is generated with cleaner technologies, this movement also will serve environmental goals in addition to energy security goals.

“We should want to work with China on things like clean fuels and battery technologies for plug-in hybrids,” Woolsey says. “Moving decisively away from oil means we won’t have to scrap over Venezuelan oil and Indonesian oil, and it does a lot to reduce global-warming conditions. That is in everyone’s best interests.”

Applying Pressure

China’s energy-demand growth poses interesting challenges and opportunities for the United States in general, and American companies in particular. In the long term, market and policy pressures are driving both the United States and China toward the same set of solutions. Some of the greatest opportunities depend on policy shifts that might take years to occur. In the meantime European and Asian companies enjoy certain advantages over American companies in terms of new technology development and investment opportunities.

However, U.S. policy winds seem to be shifting. Security hawks are forming political coalitions with environmental advocates and religious groups concerned about stewardship issues. Moreover, corporate American leaders are pressing lawmakers for greater certainty about environmental and energy-policy issues, and increasingly are pursuing business strategies that recognize the challenges and opportunities of a carbon-constrained, petroleum-poor future.

In the midst of these trends, opportunities for greater cooperation between the United States and China promise to reduce risks and yield benefits for both countries. As a strategic framework for such cooperation, the U.S.-China Commission is recommending the two countries form a working group similar to the one the United States has with Japan, to establish an ongoing dialogue that will focus on energy-security approaches and solutions that will help both countries.

“Some of this is long-term planning, as well as investment strategies to bring new products to market and determine what is economic and what is not,” Wessel says. “This is a cutting-edge issue, but it is rising to the top of the policy agenda. The public is demanding that policymakers confront the China challenge.”