Business was top of the agenda when German Chancellor Angela Merkel conducted a four-day visit to China in June, flanked by executives from German corporate titans such as BASF (BFA.LSE, BAS.FWB), Siemens (SI.NYSE, SIE.FWB) and Volkswagen (VOW3.FWB). The delegation had good reason to be happy: Sino-German trade amounted to US$105.73 billion in 2009, more than Chinese trade with Britain, France and Italy combined. German exports to China rose by 7% in 2009, even while overall exports declined 18%.
But German executives were not in a chirpy mood. Behind closed doors, Jürgen Hambrecht, chairman of BASF, and Peter Löscher, CEO of Siemens, expressed serious misgivings about China’s "indigenous innovation" policies to Premier Wen Jiabao.
Specifically, they argued that multinational firms were being required to make onerous sensitive technology transfers to their Chinese joint venture partners in exchange for increasingly restricted market access. "That does not exactly correspond to our views of a partnership," said Hambrecht. It is an opinion shared by many European and German renewable energy firms operating in China.
In recent years, China’s domestic firms have gained market share in solar and wind energy markets with uncanny speed. Chinese solar panel manufacturing firms hardly existed internationally a decade ago; today they supply between 43-50% of the global market. In China’s wind energy industry, the market share of local manufacturing firms lurched from 25% in 2004 to around 70-75% today.
When pressed to explain these astonishing gains, some multinationals hint darkly at the comments made by Hambrecht and Löscher. But while this is undoubtedly true in some cases, Chinese success has less to do with forced technology transfer than with a more prosaic combination of lower overhead costs, government subsidies and renewable energy mandates. German companies that hope to succeed have been pushed to find new ways to compete. It won’t be easy: In the solar industry, Chinese manufacturers are out-maneuvering their German rivals in the global marketplace by offering similar-quality panels priced at a 20-30% discount.
The cost breakdown
The most common explanation for this price gap is China’s lower labor costs. "But focusing on labor costs is misleading," said China-based independent energy consultant Frank Haugwitz. "Labor costs account for just 5-7% of overall solar production costs. So other factors must be at play."
These other, smaller factors add up to a cumulatively significant price advantage. Utility rates, especially electricity, are some four times lower in China than in Germany. Local governments often offer hefty tax breaks to entice businesses to set up shop.
Even these, says Shyam Mehta, senior solar analyst at GTM Research, pale in comparison to the most significant advantage of Chinese firms: free money. Chinese solar companies enjoy what analysts dub "implicit subsidies." This means that top-tier manufacturers receive loans from state-owned banks at very low interest rates, and can negotiate generous term structures and receive debt extensions year after year.
The immediate impact of implicit subsidies is that Chinese solar manufacturing companies need not bother themselves with capital costs, which for their German rivals can be quite steep – especially as European banks fret over the prospect of sovereign defaults and an anemic economic recovery.
When this reduced cost of capital allows Chinese firms to invest in greater capacity than their German rivals, it produces several knock-on effects. First, Chinese firms can achieve greater economies of scale, allowing them to negotiate volume purchasing discounts in production equipment, raw materials and commodities.
Second, Chinese firms can also afford better vertical integration of their solar panel manufacturing processes. Every step of the process – silicon wafer manufacturing, cell production, and module assembly – can be manufactured in-house, reducing the cost of sourcing materials externally. The end result is that Chinese firms are simply larger than their German competitors, in a field where size matters.
"The average Chinese manufacturer makes wafer cells and modules and at 500 megawatt scale. The average German manufacturer probably only makes modules and at 150 MW scale," said Mehta. "Both factors are in China’s favor. How are you going to compete with that?"
It is a question many German solar manufacturers are asking themselves, because difficult times lie ahead. Germany is by far the world’s largest solar market, comprising about half of the global demand. Its pre-eminence is due in large part to the country’s generous feed-in tariff (FiT) that subsidizes the extra costs of solar energy, which is normally four to five times more expensive than coal power.
But earlier this year, German lawmakers agreed to substantially reduce the FiT, saying it had become too financially burdensome. It is being dropped in a series of successive three-month stages, ending in a cumulative 15-16% reduction by early 2011. Officials hope that this stair-step approach will mirror market price reductions in solar panels, thus softening the blow to manufacturers.
Paradoxically, many analysts forecast that this reduction will make 2010 a good one for solar. German firms are scrambling to accelerate pipeline projects and install new capacity before the FiT falls further. Ivan Lee, a Hong Kong-based energy analyst with Nomura Securities, forecasts a 30% growth in installed capacity in 2010 (about 44% of total added installation worldwide.) GTM’s Mehta says that Germany’s total installed solar capacity may double between 2009 and 2011. Current demand for solar installation is so great that Chinese panel suppliers cannot keep pace, giving German firms spillover demand.
If 2010 promises to be a banner year, the combination of a reduced FiT and expanded Chinese production capacity will make 2011 tough for German firms. Lee predicts a 2% decline in 2011 for German solar installation. "We’re starting to hear solar firms talk about the post-2011 market," said Mehta.
Some German companies are moving manufacturing facilities to Asia to cut costs. Magali Menant of the Delegation of German Commerce and Industry in Shanghai says that most of the solar industry enquiries she receives are related to German firms sourcing production to China.
Other firms are trying to leverage their brand names to sell to retail consumers. This strategy may work well in the brand-conscious residential solar markets, but industrial consumers are hesitant to pay a premium for a German brand name when the top Chinese producers have comparable quality.
More specialized areas of the solar industry, where Chinese firms have not yet gained a foothold, still hold promise for German manufacturers. "Some of them have essentially said, ‘We’re not going to compete with the Chinese’," said Mehta. German firms are particularly interested in building-integrated photovoltaic (BIPV) construction, where many have sensed a demand in China. Yet Menant cautions that these projects are still in the feasibility stage, and are not supported by market fundamentals.
The broadest trend is German solar firms capitalizing on their remaining competitive advantage: innovation. This strategy is working well, because Chinese manufacturers lack in-house research and development capacity, and have decided to effectively outsource innovation to German universities, labs and firms. In the past six months, Mehta says that he has witnessed China’s top-tier solar firms express interest in producing high-efficiency solar panels.
Yet analysts also fret over the implications of these trends. Because Germany dominates the solar industry, its domestic regulations can have a profound global impact. Some analysts foresee Germany going the way of Canada, India and the US in implementing protectionist domestic content policies for the industry.
Specifically, they wonder whether German taxpayers will continue to offer subsidies that are ultimately funneled into the hands of Chinese solar firms, which themselves are already indirectly subsidized by the Chinese government. "How long can it last?" wondered Mehta.
Government protectionism is of course present in China as well, and isn’t limited to solar power. Until recently, all new wind energy installation projects in China came with a 70% domestic content stipulation.
This policy gave an enormous boost to the nascent wind turbine manufacturing industry thanks to vertiginous growth in wind energy deployment in China. In 2004, the country counted four domestic wind turbine manufacturers, and had a total installed capacity of 760 MW.
Today, there are around 80 Chinese wind turbine manufacturers, and according to the Global Wind Energy Council, China’s total installed capacity at the end of 2009 was 25.8 gigawatts. This year, the country plans to add a further 18 GW of capacity, equivalent to about 18 nuclear power plants.
Predictably, protectionism enabled China’s domestic wind turbine manufacturers to trounce their private European competitors in the domestic market, rocketing from 25% of market share in 2004 to around 70-75% today.
A new era
But the era of overt protectionism for China’s wind industry may be over. "I don’t think protectionism is a big factor anymore," said Ying Jun, head of the China department at Bloomberg New Energy Finance. The impact of dropping the 70% rule has been limited, he says, because Chinese firms are already market competitive. Much like their solar counterparts, top Chinese wind turbine manufacturing firms can churn out products of similar quality to European firms at a 25-30% price discount.
To explain this price gap, the usual suspects of cheap labor and utilities come into play. Generous funding by state banks and parent conglomerates is also a factor, though to a lesser extent than in the solar industry. High transportation costs for large, heavy equipment, such as windmill blades, also offer domestic manufacturers an advantage. Ying also points to a "second-mover advantage," as later Chinese solar market entrants invest in newer, higher-efficiency equipment than earlier European entrants.
And while there are no longer any explicitly protectionist policies in China, the regulatory process itself is open to a degree of manipulation. "For some projects the process of allocating development rights and how the manufacturers are selected are not that clear, so domestic players do have an advantage," said Qiao Liming, policy director of the Global Wind Energy Council.
All these factors add up, but still do not fully account for the huge price gap. Many analysts admit that they don’t know how Chinese wind turbine manufacturers can maintain profit margins at such a low cost.
Too much of a good thing
The simple answer may be that they can’t. Fueled by a seemingly endless supply of new local government projects, China’s wind industry is probably overheating. Profit margins at the largest domestic wind turbine manufacturers were 25- 30% in 2004; today the figure is said to be less than 10%.
"We are not losing money, but not making much profit, either," conceded Liang Xiaobing, deputy-general manager of Dongfang Electric Wind Power Technology in an interview with state media in February.
Strains from overcapacity are beginning to show. Speaking earlier this year, the vice president of Shanghai Electric Group (601727.SH, 2727.HK) said that roughly 40% of China’s wind turbine manufacturing facilities are idle because there are too many plants in operation.
Yet if China’s domestic firms can offer prices at margins that would be unacceptably low to multinational firms, why do European and German firms stick around? "The wind energy market is growing so rapidly — it’s doubling every year — that these foreign companies are still making money," said GWEC’s Qiao — even if they lose market share.
Foreign firms are also shifting tack. Liu Jinming, senior vice president of Ardour Capital Investments, says that several multinationals are partnering with domestic firms to gain a local edge in the fierce bidding process to win turbine supply contracts. They have also shifted from competing on price to parlaying superior quality into a selling point.
But some analysts are skeptical of this marketing. "It is impossible to fully evaluate quality because turbines have a 20-25 year warranty," said independent analyst Haugwitz. "It appears that on quality, Chinese companies are about equal with German producers. The performance gap is very small."
There is also growing interest from Chinese manufacturers in exporting turbines abroad. Some firms have lofty ambitions: Xinjiang Goldwind Science & Technology (002202.SZ) expects overseas revenue to constitute 20-30% of total business in the next three to five years. However, while most analysts expect exports to increase, some perspective is needed. In 2009 Chinese firms exported just 19 wind turbines to three countries: India, the US and Thailand.
As with solar, government regulation is a crucial variable for the wind industry’s future. Speculation is ripe that the government will begin to forcibly consolidate the domestic wind industry in the near future. And while there have been no concrete regulations thus far, analysts point to several pieces of draft regulation that would raise the barrier to entry so high that only China’s top 10-15 firms could compete.
Ardour’s Liu also points to other regulations that could require new wind installations to have energy storage facilities in an attempt to handle the undulating nature of wind power that has bedeviled grid operators
These regulations are unlikely to directly impact German firms, which are often unwilling to compete for low-margin Chinese wind projects. Instead, they are increasingly focusing on other areas, particularly production equipment. Most wind turbine production equipment is imported fron abroad because Chinese suppliers lack expertise. The same is true for solar: Haugwitz estimates Chinese manufacturers import 80% of their equipment. DGCI’s Menant confirms that she has noticed a recent uptick in German manufacturing firms supplying equipment to Chinese producers that are seeking to maximize efficiency gains as the cost of labor rises.
It is a trend that will almost certainly continue, and not just in wind energy. Analysts note that Chinese manufacturers from nearly every renewable energy sector have begun to effectively outsource their research and development to Europe. As the relentless government-fueled expansion of Chinese renewable energy manufacturers continues unabated, expect many more German firms to bank on their technological and research strengths to succeed.
"German firms certainly have an upper hand in innovation," said Menant.