Death or taxes

A thick cloud of smog blanketed China for thousands of miles in mid-January, prompting local governments to cancel sporting events and ground flights, and forcing residents to take cover indoors. The pollution reached unprecedented levels in Beijing. On the night of January 12, the air quality index ranking in the nation’s capital reached 755 on a scale of 500, and levels of particulate matter in the air were more than 36 times the level deemed safe by the World Health Organization.  

The incident was a sharp reminder of a pollution problem that China has battled for decades. Coal-fired power plants and motor vehicles are responsible for most of Beijing’s thick smog, but the country’s massive manufacturing base has also contaminated its water and soil. China is home to 16 of the world’s 20 most polluted cities, according to World Bank figures.

The Chinese government spends a lot of time quantifying the benefits that years of fast growth have given to its people: GDP growth of over 10% for a decade, 600 million people lifted out of poverty in the last 30 years. However, there’s far less discussion of what economic development has destroyed. This environmental damage should rightly be seen as offsetting some of the benefit China’s economic growth has created in the past few decades.

He Ping, chairman of the International Fund for China’s Environment, estimates that China would need to spend at least 2% of GDP per year to clean up its 30 years of industrial waste, while Mun Sing Ho, a senior economist at Dale W. Jorgenson Associates, put the figure at 2-4% of GDP, according to a report by Bloomberg.

These estimates suggest that a significant portion of Chinese growth came with destruction that should have been deducted from that growth, wrote Michael Pettis of Tsinghua University in a note. “[T]he result is that we overestimate China’s GDP growth today and will underestimate GDP growth tomorrow.”

Besides the outlays for clean-up, pollution has other social and economic costs. The World Bank estimated that Chinese air pollution caused damages to human health totaling around 4-5% of GDP between 1995 and 2003, while an MIT study estimated the cost to health at 6-9% of GDP. And a 2007 report by the World Bank and the Chinese government estimated that air pollution causes more than 400,000 premature deaths in China each year.

The price of pollution

For economists, pollution is the classic textbook example of a negative externality, in which a third party suffers the costs of an economic transaction but does not receive the benefits. As in Microeconomics 101, the best way for China to lessen or eliminate this externality is to reduce the incentive for this behavior by making sure the producer pays for some or all of the negative costs.

One commonly discussed way to do this is by imposing a tax on carbon dioxide emissions. This measure seems a ways off in China: Government sources have said the biggest energy consuming companies may be subject to a carbon tax by 2015.   

But other effective steps are closer on the horizon. China’s first step towards reducing the harmful haze that blanketed its capital in mid-January should be to stop subsidizing coal. In a widely overlooked announcement in late December, the State Council moved to do this, saying it would eliminate the dual pricing system for coal under which some buyers pay government-regulated contract prices and others pay higher, open-market prices. The annual, contract-based pricing system has long required miners to sell much of their coal to power producers at below market prices.

The State Council also said it would move to end some key contracts between major power producers and coal companies, allowing them to negotiate prices with no government intervention. Finally, the National Development and Reform Commission (NDRC) pledged to end its direct involvement in the allocation of transprovincial and transregional rail transport capacities for coal and end the interprovincial railway transport allocation quota as of January 1.

These measures will help to eliminate some of the subsidies that make burning coal artificially cheap and encourage the proliferation of energy intensive manufacturing, harming air quality. The reforms are an important step towards “letting the market play a fundamental role in allocating resources,” one of the 18^th Party Congress’ objectives for upcoming reforms, according to a report issued January 9 by UBS economists.

The market currently plays too little of a role in determining the price of coal-fired energy in China. China consumes 3.5 billion tons of coal a year, more than 70% of its energy consumption. Almost a quarter of this coal was sold at artificially cheap prices in 2012 due to price controlled contracts between coal companies and power producers, the UBS report said, citing information from the NDRC. The NDRC has acknowledged in the past that contract coal prices have been consistently and significantly below market prices.

While the new measures will initially have a negative effect on energy-intensive sectors as the cost of coal rises, UBS argues that the reforms will be positive for the power sector and large coal companies in the long run, presumably by allowing them to charge higher prices. In the longer term, the measures should also help to reduce the country’s energy appetite and improve the allocation of energy resources.

According to UBS, the true test will come when coal prices rise significantly or when power is in short supply. Currently, spot market prices and annual prices are relatively similar, making it far easier for the State Council to negotiate an end to the dual-pricing system. It remains to be seen whether the government will allow its producers to absorb the true cost of energy in the event of either scenario.

Chinese officials first proposed eliminating the contract pricing system 19 years ago, and top leaders have made repeated commitments to reforming resource prices since then. However, they have doubtless faced intense opposition from politically connected state-owned enterprises, many of which are in resource-intensive manufacturing industries. Whether China will make significant progress in these reforms may be one of the most important and underreported questions of 2013.