China’s Climate Challenge
Financing the transition to net zero
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This article was first published by the World Economic Forum.

Since 2006, China has been the world’s largest CO2 emitter. The 11 billion metric tons of carbon dioxide it released in 2020 accounted for about 30% of global emissions that year. There have been urgent demands in China for measures and initiatives to tackle climate change. The latest five-year plan covering 2021-2025 puts decarbonization and the “construction of a green development engine” at the center of policymaking. China has committed to reach peak CO2 emissions in 2030 and have net-zero carbon emissions by 2060.

China’s circumstances are unique. With manufacturing and construction being the major contributors of its GDP, the country’s path to net zero will require huge investment and financial innovation to support substantial technological advances. The uniqueness of the Chinese circumstances stems further from China’s economic governance model in which the central government and state-owned enterprises can be expected to play a far more prominent role in handling the country’s transition to net zero than in most other economies.

A substantial gap in net-zero financing in China exits:

Public funding, in turn, will also play a more significant role in China than elsewhere. The overall funding requirements will exceed supply, leading to a finance gap. Mismatches in funding, including between the types of instruments, deal structures and tenors available are another issue. Bank lending is the backbone of corporate finance in China. Banks, however, being risk adverse, target large state-owned and private enterprises, leading to inadequate financial support for SMEs, which account for 65% of total CO2 emissions in China.

Key sectors core to achieving net zero: construction and real estate, steel and mobility, respectively responsible for 15%, 13% and 11% of CO2 emissions in China, according to the International Energy Agency (IEA). Energy, although accounting for the largest share of emissions today (45%), has a relatively clear decarbonization pathway (such as renewables, nuclear and biomass, alongside with carbon capture, utilization and storage adoptions). The other three, however, will require substantial technology breakthroughs for their transitions to be realized.

For China to achieve net zero, the following issues will also need to be addressed:

Data granularity and quality
Tracking and reporting emissions is fundamental to China’s net-zero transition. China has established national-level Carbon Emission Accounts and Datasets (CEADs). However, further efforts are required to be able to collect and make available all the granular, standardized data that will be needed. More than 70% of those interviewed for the report raised concerns about China’s still underdeveloped emission information infrastructure. For example, regarding emission measurements, further clarity is needed if China’s data is to match the requirements of international standard such as the Partnership for Carbon Accounting Financials (PCAF) and the Paris Agreement Capital Transition Assessment (PCATA).

Funding mismatches
Funding support for net-zero transition efforts has been mainly offered through bank loans, characterized by shorter tenors, rigid collateral requirements and pricing mechanisms, and more bland structures. To support net-zero targets, the market needs to respond with longer-dated, blended equity and debt structures. Providing adequate financial support for the net-zero transition of small and medium-sized enterprises (SMEs) will also be critical, given the size of CO2 emission by the SMEs considering their Scope 1, 2 and 3 emissions.

Lack of clear policy support
China’s net-zero policy framework needs to be enhanced. First, standards need to be aligned for all regions, business types and sizes. At present, production limits for blast furnace steels vary widely, with large-scale state-owned enterprises in East China tending to have more flexibility than SMEs in north-east China. Second, long-term production and investment plans require consistent policies to be put in place and maintained. Currently, many steelmakers are reluctant to invest in minimills because of concerns about possible future caps on production.

Lack of cross supply chain collaboration
The indirect emissions in a company’s value chain – usually known as Scope 3 emissions – can be significant for industries with long value chains. (automakers’ Scope 3 emissions, for example, typically account for more than one-third of their total emissions). Reducing these emissions calls for collaboration along a company’s value chain. Scopes 2 emissions arising from the purchase of electricity, heat and steam will also need to be addressed through partnerships with power generators. Most companies surveyed, however, are focusing mainly on cutting their Scope 1 emissions, directly generated in the production process, such as through their own vehicles, or the use of boilers on their facilities.

How can these challenges be overcome?

Due to the scale of change needed, China’s green transition will call for continuous efforts from its major carbon-emitting sectors combined with support from government policy, finance and value chain collaboration. Innovation will be required in all these areas.

Policy support
Top-down support led by the Chinese government is crucial given the important role played in the Chinese economic governance model. The support can be both financially and non-financially. Comprehensive government support, including tax, land, approvals and financing, are effective in promoting green transition, given the strong influence of the central government. Tax incentives are in particular powerful tools for accelerating the transition similar to carbon taxes in Europe.

State-owned enterprises should also lead from the front given their prominent role in the economy. However, their efforts need to be broader than Scope 1, with the right incentives to drive standards across their supply chains targeting Scope 2 and 3 emissions, where SMEs are key participants. It is also important to ensure the right market intermediaries are in place.

Underpinning these efforts should be an ongoing effort to develop and enforce consistent and unified rules and regulations across regions and sizes of companies, as mentioned in its recent “unified national market” strategy as well.

Financing innovation
Financial institutions need to introduce innovative new products and services tailored to the needs of China’s net-zero transition. These could be pioneered by state-owned enterprises in addition to a dedicated “green bank”. Innovation will require a new term structure, collateral requirements, instrument archetypes and portfolio strategies to ease the shortage of equity green financing and long-term green loans in China.

To enable the industry to transition, it will be critical to develop one-stop solutions that bring together supply chain support for Scope 3 with new deal structure that integrate different instruments and tenors for Scopes 1 and 2. These efforts need to be in lockstep with private equity and venture capital, ensuring effective risk reward tradeoffs for equity financing and asset managers covering longer-term loans and banks covering the short terms.

Ecosystem collaboration
Industry players need to connect with their value chain partners to establish holistic emissions goals, especially when it comes to reducing their Scope 3 emissions. This will require anchors setting the standard and driving it through their supply chains and ecosystem participants. This collaboration will extend beyond standard setting and into the commercial structure to ensure incentives and verification motivates the right outcomes.

While the road ahead is steep, if China gets this right, it could position itself to drive the next green revolution globally given the country’s scale and its position in the global economy and supply chains. However, this will require greater innovation in financing, policy support and industry collaboration.