Hidden Costs Of China’s Coal-to-Chemical Sector

By Kaboo Leung 17 October, 2017

Trucost's Leung on a new framework to stress test environmental risks & embed them into financial analysis

Unit price costs in China’s coal-to-chemical sector could increase by 35 - 64% due to environmental risk
Production loss from regulatory compliance accounts for >90% of costs; ~45% of environ risks relate to water use
Growth targets in 13FYP will increase exposure

Report Cover
Both Chinese and international policy makers are emphasizing the importance of stress testing environmental risks for investment, including the use of scenario analysis. Yet, it is unclear to investors how these potential environmental impacts may translate into financial costs, and more importantly, how these risks could be incorporated into existing financial analysis to potentially improve risk management.
Trucost’s new report “The Hidden Cost of China’s Coal-to-Chemical Sector” presents a possible assessment framework to measure the hidden costs from various regulatory and physical risks under key scenarios, and illustrates how investors might integrate this into existing risk and financial analysis using the coal-to-chemical sector as an example.

How do environmental risks translate into financial risks?

Environmental risks build upon the physical impacts businesses have on the environment, which then translate into financial risks for business and investors via risk factors. The risk factors included in the analysis are compliance with energy and water standards, environmental tax, water resource tax, the national carbon emissions trading scheme (ETS), the pollutant emission trading system, and water stress.

Environ risks build upon the physical impacts businesses have
Potential costs have been estimated for 7 key coal-to-chem products
(click on image to enlarge)

Based on China-specific life cycle assessment (LCA) data (Wernet, G. et al., 2016), policy research and stakeholder consultation, Trucost estimates the potential costs for each risk factor under various plausible pathways for seven key coal-to-chemical products. These pathways are then analysed using likelihood scoring matrices and categorized into three key scenarios – most likely, likely, and less likely.

Environmental compliance and water-related risks are the most prominent

Trucost’s findings show that environmental risks could lead to a financial cost of about 35 – 64% of the unit price of these products on average in the three scenarios. For most of the coal-to-chemical products, potential costs from environmental risks increase significantly towards the less likely scenarios. This illustrates that while the costs for some products may be limited at present, they could be subject to disruptive rises in future, bringing greater uncertainty for investors.

 Environ risks could lead to a financial cost of 35 – 64% of the unit price…
…but potential loss of production due to regulatory compliance accounts for the largest share of environ risks
(click to enlarge image)

Exhibit 3
  Potential loss of production from regulatory compliance accounts for the largest share of environmental risks for most products – over 90% of total cost on average (see the blue portion of the bars shown in the graph above). With the dominance of risks from environmental compliance, stringent and ongoing due diligence may help investors to mitigate a significant share of these potential costs.

The overlaps of risks and industry growth

Water appears to be the most prominent environmental impact driving these risks, as about 45% of total environmental risks is related to water use. It is also a key factor for regional variations in risks. As shown in the map below, the higher risk intensity is in the north-eastern provinces, overlapping with regions where the greatest coal-to-chemical production capacity is located.

~45% of total environ risks are related to water use…
…the overlap between risks & production may further expand with targets set in the 13FYP
(click image to enlarge)

The overlap between risks and production may further expand with the industry growth target set out in the 13th Five-Year Plan (FYP) by China for coal to oil and coal to gas. Using coal to oil as an example, the map indicates the potential growth in capacity would likely concentrate mostly in higher risk regions and thereby increase the exposure of environmental risks for this sector as well as investors.
If the capacity growth is realized for both products, the environmental risks could account for 2 -6% of the projects’ investment, potentially increasing to 8% in future.


Case studies show significant impacts on profitability

To illustrate how these environmental risks could have financial implications for projects, Trucost selected two projects as case studies  – one was coal to oil and the other was coal to gas. Taking environmental risks into account, the internal rate of return (IRR) of both projects is estimated to be positive (3-5%) while still far from reaching their weighted average cost of capital (WACC) (the two companies have their reported long-term WACC at 8-9%).
Trucost’s sensitivity analysis also shows that the breakeven threshold for both projects becomes significantly more stringent as environmental risks increase. They require much higher diesel and gas prices while relying on a low coal price in order to break even (see the graph below for results under the “most likely scenario”).

The internal rate of return of both projects is estimated to be positive (3-5%)…
… and the breakeven threshold for both projects becomes significantly more stringent as environ risks increase

(click on image to enlarge)

This analysis demonstrates the importance of integrating environmental risks in investment analysis and how this could help investors better understand the risk-adjusted profitability of their investment. Factoring in the potential costs of environmental risks could enhance risk management to avoid projects that could become stranded in the future when environmental risks become much more significant.

Integrating environmental risks into investment

The results demonstrate that environmental risks could have profound impacts on project profitability. The potential scale and uncertainty of future environmental changes emphasize the importance of incorporating environmental risks into financial analysis for investment decision making.

The results demonstrate that environ risks could have profound impacts on project profitability

Trucost posits that policy makers could address these financial risks through robust and consistent regulation and enforcement to encourage sustainable business decision making. This could provide a clear and effective incentive for businesses to consider environmental impacts in the management of their operations.
Investors could consider integrating in-depth assessment of environmental risks into their current financial analysis. Investors should also recognize that conducting due diligence before and after investment is also vital to increase the resilience of portfolios to environmental risks.

1 Total environmental risks are estimated based on production data and assumed production at current average utilization rate (45% for coal to oil and 61% for coal to gas) for pilot and backup projects as proposed in 13FYP.

Further Reading

  • Water Stewardship In Industrial Parks: The Kunshan Case – Kunshan City ranked as China’s most developed county-level city but faces increasingly serious water challenges. Alliance for Water Stewardship’s Zhenzhen Xu, WWF’s Aihui Yang & Qiandeng Environmental Protection Bureau’s Dadi Feng share experiences from their water stewardship project
  • China’s River Chiefs: Who Are They? – River chiefs were first implemented in 2007 following a pollution incident. Now, by 2018 all of China’s rivers/lakes will have river chiefs. How will this work & what do they do? China Water Risk’s Yuanchao Xu expands
  • 5 Facts About The Tarim River – Compared to the Yangtze or the Yellow, the Tarim River Basin is relatively unknown despite its strategic importance as China’s ‘Water Tower’ with 41% of its ice. China Water Risk’s Feng Hu shares 5 water facts we need to know about the Tarim
  • Rivers Flow In Me: Reflections From Zhejiang – China Water Risk’s Feng Hu shares his childhood experiences with rivers in Zhejiang and laments the pollution that has occurred since; but as government and business marry economic decisions with water, things are looking up
  • Why Do Hydro-Hegemons Cooperate? – Cooperation and conflict exist on a spectrum in transboundary river basins. Dr Selina Ho from Lee Kuan Yew School of Public Policy explores the policies of China & India, Asia’s two hydro-hegemons. How and why they work with other states on the Mekong & the Ganges?
  • At A Glance: Water Risk Dashboard – Need to gauge water risks across your operations, suppliers or investees at a glance? China Water Risk’s Hubert Thieriot expands on a new dashboard for exactly that – check it out!
  • Water Risk Valuation – What Investors Say – See what 70+ investors have to say on different valuation approaches we applied to 10 energy stocks listed across 4 exchanges. Is there consensus? What are they most worried about?
  • Banking in the Age of Water Risk – Are water risks and their potential impacts factored in by banks? Or is ‘water exposure’ just the water used in their office buildings & branches? Tan says prudence dictates we must start to waterproof portfolios
  • Quantifying Water Risk: What’s My Number? – Industries are exposed to water risks but financial valuation of such risks remain elusive. China Water Risk’s Thieriot reviews existing quantification tools & methods and highlights gaps that need to be filled to put a number on water risks
  • Corporate Bonds Water Credit Risk Tool –  China Water Risk sat down with GCP’s Liesel Van Ast & GIZ’s Simone Dettling, two developers of the Corporate Bonds Water Credit Risk Tool to find out how it helps investors & banks mitigate exposure and impact on the bottom line
  • Valuing The True Cost Of Water – Water-related risks can be numerous for any given operational site. Nina Cambadelis & Johann Clere walk us through how Veolia’s tool, “The True Cost of Water” can mitigate risks and show potential economic gains
Kaboo Leung
Author: Kaboo Leung
Kaboo Leung is a Senior Analyst at Trucost, part of S&P Dow Jones Indices. Her work focuses on assessing environmental risks through scenario analysis, natural capital valuation, and supply chain assessment. She involved in developing various climate risks initiatives such as the environmental stress testing on aluminum sector with ICBC, carbon pricing tool, ESG assessment framework, etc. Kaboo has years of experience in environmental research and consultancy in U.S., Europe, and Hong Kong. She also holds a BA (Hons) from University of Washington in Economics and a MSc in Environmental Economics and Climate Change from London School of Economics and Political Science.
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