China and the EU could lead the low-carbon economy

The EU and China’s combined economic power could provide an unprecedented opportunity for leadership in a global low-carbon transformation, says a report from Chatham House. Bernice Lee presents a summary of their findings.

We are on the cusp of a new industrial revolution, one driven by energy and climate security concerns. Policy-makers and business leaders are beginning to calibrate decisions on trade, financing and production planning against this new reality. Central to making this vision work is enlightened thinking around the potential economic and political benefits – rather than the costs – of the transition to a low-carbon future.

China and the European Union (EU) together account for around 30% of global energy consumption and 30% of global emissions. Their common interests provide a foundation for deepening collaborative efforts on energy and climate security over the next quarter-century. The combined economic might of the EU, the world’s largest single market, and China, the fastest- growing economy, can provide unprecedented opportunities to generate benefits of scale that will lower the costs of climate-friendly goods and services globally. By working together, China and Europe could become the de facto engine of global low-carbon transformation.

Business as Usual (BAU) is not an option. The International Energy Agency (IEA) forecasts a global increase in energy consumption of more than 55% by 2030. There is no sign that energy demand and consumption will abate in the near future. Oil prices increased fivefold over the last eight years, in real terms hitting the 1979 high in October 2007. The era of cheap hydrocarbons may now be over. Waiting for world oil production to reach its maximum capacity could leave the world with a significant liquid fuel deficit for at least two decades. Supply concerns are driving investments towards unconventional fossil fuel sources, with large associated energy costs and significant carbon dioxide (CO2) emissions.

The alarming projected impacts of climate change also point to the range of risks, vulnerabilities and choices confronting policy-makers and citizens. The Stern Review estimated the avoidable costs of inaction would be between 5% and 20% of GDP per year.  BAU scenarios project extreme temperature rises of 4 to 7 degrees Celsius by the end of the century. A responsible risk management strategy for policy-makers would be to keep to the low probability range of 2 degree Celsius rise, as climate sensitivities appear higher than previously estimated. Put another way, global CO2 emissions will need to peak in the next two decades and reduce by over 50% by 2050. For developed countries, such as the member states of the EU, this implies moving to an essentially zero-carbon economy by around mid-century, with major developing countries such as China following well before the end of the century.

Choices made in China matter. China’s immediate decisions about its infrastructure needs and patterns of consumption will have a decisive impact on global efforts to stabilise greenhouse-gas emissions, and the feasible rate of reduction to sustainable levels. China currently emits about 19% of global CO2 emissions and is expected to contribute about 27% by 2030. In preliminary estimates for 2006, China topped the list of CO2-emitting countries, surpassing the US by an estimated 8%. However, China’s per capita carbon emissions level is over three times less than the EU average and six times less than the US average.

China’s strategic aspiration towards an innovation-based economy with science-based development – as enunciated at the seventeenth Party Congress in October 2007 – is in line with the vision for a low-carbon transition. A focus on developing and deploying advanced climate technologies is also consistent with China’s aspiration to move up the global value chain. A recent study suggested that for every US$1,000 of Chinese exports to the United States in 2002, only US$386 was accrued in China. Ensuring that China gains a sizeable share of the low-carbon economy is critical to managing its domestic emission growth, and would provide incentives for China to play a larger role in the post-2012 global deal on climate change.

Why China and the EU?

China and the EU are economically entwined. China is the EU’s largest trading partner. The EU is China’s second largest. The EU is also China’s largest supplier of technologies, foreign direct investment (FDI) and services. China is increasingly the main source of EU trade deficits. Bilateral trade deficits make news headlines, but obscure the fact that a significant part of the value addition of products ‘made in China’ accrues to European companies. Shoes imported from China return 50% to 80% of their value to the European companies that design and market them. As manufacturing supply chains integrate across borders, components are often made in one country and then shipped to others for final assembly. It means that it has never been harder to know who reaps the economic benefits from a product, and who should bear responsibility for the emissions produced in its manufacture.

Investments in China have helped EU firms stay competitive through access to lower-cost inputs. Cheap Chinese imports have meant lower prices for European consumers. The rate of return from FDI in China is increasing: in 2003 it was 8%, while the average return on EU capital from investments in other countries was 6%. In the longer term, as the European workforce shrinks, the economic relationship with China will become increasingly critical for the European economy. Estimates show that European wages in 30 years could be 16% to 40% lower if China fails to sustain its rapid economic growth.

China and the EU face common challenges in energy and climate security. Both are expected to be importing 80% of their oil supply by 2030. Resource needs have driven investments into politically unstable and fragile regions, changing the geopolitical landscapes in Central Asia, the Middle East and Africa. Ensuring security of supply – and stability in resource-rich regions – is thus a vital interest for both regions. They also need to manage the impacts of climate change, which will increasingly undermine food, water and human security, with implications far beyond national borders including in areas of high shared strategic interest such as Central Asia and East Africa. The two powers will both need to radically improve their adaptive capacity and work with other countries to reduce the risk of resource conflict over access to vital resources and distress migration. China and the EU also have remarkably similar and ambitious energy policies to enhance energy security through greater energy efficiency and use of renewable energy. It is estimated that the EU could be purchasing 77% of carbon credits generated in China by 2012 to help meet its compliance with the Kyoto Protocol.

It is imperative for China and the EU to take advantage of the opportunities offered by their interdependence to achieve win-win solutions that not only bring national economic benefits but also generate shared public goods of energy and climate security. This cooperation should be driven by mutual opportunities and recognition of the shared carbon responsibilities associated with bilateral trade. Estimates suggest that over 40% of China’s CO2 emissions are produced during the manufacture of goods made for export. For Europe to strengthen its relationship with China, it needs to avoid political rhetoric that feeds anxieties based on exaggerated fears of Chinese competition. Such populism will undermine support among European citizens for the cooperation needed to preserve their energy and climate security in the long term.

The scale of China’s market – and its corresponding clean energy needs – offers one of the quickest routes to bringing new, clean energy technologies to maturity and widespread use. The combined strength of the Chinese and EU economies could help substantially bring down the cost of low-carbon technologies and adaptation tools and make them available to less industrialized countries. The maturity of the EU’s aspirations to global leadership will perhaps be measured in part by its willingness to strengthen engagement with China on energy and climate security.

Avoid locking in carbon-intensive investments

In the next quarter-century, US$22 trillion will be needed for investment in energy supply infrastructure worldwide. China alone requires about US$3.7 trillion. The shape of this investment will help determine the energy use patterns and CO2 emissions for a generation. In the power sector China’s reliance on coal is well known, as is the rate of expansion. Estimates suggest that 1,260 gigawatts (GW) of new power stations will be built by 2030, 70% of which will be coal-fired. What is less well known is that over the same period Europe will build over 850 GW of new power stations needed to replace old ones and meet growing demand. Both regions share a responsibility in ensuring this planned capacity does not lock the world into a high-carbon future.

Constructing these facilities with conventional technology would both increase emissions immediately and reduce opportunities for switching to less polluting sources in the future. As an alternative, existing technologies, such as energy efficiency and renewables, can be introduced and implemented rapidly. Rapid expansion of renewable energy use is pushing up prices, but Europe and China could work to remove supply chain bottlenecks and create integrated supply chains that support aggressive supply expansion and cost reduction. Even with these programmes, China will still increase its coal use. EU–China cooperation could be strengthened to reduce the sustainability impacts of the whole coal fuel cycle, from mining to efficiency of use for power and heat. Europe should also enhance its collaboration with China on carbon capture and storage technology, building a truly shared partnership to accelerate commercialization in both China and Europe.

The building sector in China is in the midst of a massive boom. New housing stock being built between now and 2020 will equal the total housing stock in the EU-15 countries today. China’s existing building codes, if effectively enforced, would deliver significant energy efficiency gains. Far more could be saved through introducing EU best practice. Similarly in the EU, an immediate move towards implementing best practice will bring measurable improvements, with estimates of well over 20% savings already possible at low or negative costs. More ambitiously, Europe and China could work to mainstream and massively expand the use of existing close-to-zero-energy housing technology, and cooperate to develop better and cheap technologies in this sector.

The growth in fuel use for transport in both China and the EU is accelerating and in the medium term will outstrip emissions growth from all other sources. Increased demand coupled with declining domestic resources adds to the climate incentive for reduced oil use. With 80% of Chinese vehicles manufactured by joint venture companies, many with EU partners, there are opportunities for collaboration on joint roll-out of higher emissions standards across a huge combined market. Similarly, the search for low-carbon and sustainable liquid transport fuels presents opportunities for joint development and deployment – for example, around new-generation biofuels.

Leading the technology race

Both China and the EU have prioritized the development of new efficient and low-carbon technologies, ranging from incremental improvements to buildings and vehicles to potentially disruptive innovations harnessing biotechnology, nanotechnology and advanced materials. However, achieving these advances remains costly, difficult and uncertain. Embracing both aggressive technological innovation and diffusion as policy goals requires creatively balancing the incentives for the innovators or investors, while urgently maximizing access to climate technologies at affordable prices to avoid technology lock-in.

To create the necessary enabling framework, energy and climate policies need to contain incentives for innovation and diffusion. Existing subsidies that favour inefficient technologies to the detriment of low-carbon alternatives need to be reformed. R&D investments need to be complemented by other policies to create or expand markets and to drive large-scale deployment of low-carbon technologies. Market pull from regulation, prices, and public procurement strategies will all be critical. There will be no ‘one size fits all’ solution. Different technologies have varying needs. They will be accelerated down the innovation chain in different ways, often helped by some concrete mechanisms.

There has been only slow progress on developing the practical and effective innovation incentives needed to drive a global low-carbon transition. Despite ongoing initiatives in China and the EU, the question of how best to utilize existing efforts to promote transformative impacts at scale remains. Too often the desire to support national champions or protect local markets stands in the way of productive initiatives to share risks, pool research efforts and combine market incentives for innovation. Many allocated resources for collaborative innovation by both regions remain under-utilized. Today, there are genuine opportunities to embrace new models of technological cooperation to lower costs and accelerate progress for China and Europe. This will require addressing the linkages between technical standards, intellectual property rights and legal enforcement capacity in a clear and balanced manner as part of the incentive framework for low- carbon innovation and diffusion. Europe could potentially implement stronger measures to share publicly supported low-carbon technologies with China, for example, especially if market reforms enabled rapid market expansion for its firms in the energy efficiency and services sectors.

Capturing gains through trade and investment

The Stern Review points to the need for a transformative increase in the scale of international finance flows for a low carbon economy. China and the EU can explore win-win options to capture both carbon and economic gains through creating new market incentives for scaling up low-carbon trade and investment. The sheer size of the two markets means that an EU–China trade agenda will influence the global marketplace and further stimulating trading opportunities, both with each other and elsewhere. This could also help offset competitiveness concerns of EU and Chinese entrepreneurs about moving quickly towards low-carbon alternatives.

This vision, however, requires removing barriers to trade and investment in low-carbon trade in goods and services. Easier to implement and potentially more significant than tariff cuts, enhanced cooperation on defining common and improving performance and technical standards for low- carbon products could influence trade and investment patterns. Increasing trade in services relating to climate change adaptation as well as emissions reduction (e.g. building design, energy efficiency management) could provide real benefits for EU companies and for increasing know-how and management skills in China. As with previous economic reform processes, many of these policy innovations could be tested in designated ‘low-carbon economic zones’ (LCEZs) in China, which would benefit from focused European support.

Mapping the pathways

The report outlines a number of options to assist policymakers and stakeholders in China and Europe in mapping the pathways in the transition to a low carbon future.

1. Building ‘low-carbon economic zones’ in China – one in the more prosperous east and the other less developed west – could be a bold initiative for policy-makers to consider. These LCEZs would be the testing grounds for policies promoting the economic transformation necessary for a low-carbon future. Their focus on attracting investment in research and high-end manufacturing will be consistent with the Chinese leadership’s desire to shift away from simple processing and assembly. The LCEZs could be to China’s next industrial revolution what Shenzhen was to the current one – and a powerful demonstration of the viability of the low-carbon economy. The EU could focus its energy and climate cooperation with China around these zones to demonstrate the real possibility of large-scale transformations to other regions and countries.

2. Setting world-class standards for energy efficiency goods could bring benefits to major producers such as China and the EU; for example under the Eco-Design Directive the EU will soon be setting increasingly tight energy efficiency standards on major energy-using goods. China and the EU could set up a consultative committee to define aggressive standards for energy efficiency and low-carbon goods which could drive progress in both markets.

3. Making coal more sustainable is central as future dependence on coal is expected to increase in China and the EU. Both could enhance existing cooperation to deliver an agreed set of benchmarks and practices for improving efficiency and reducing the sustainability impacts across the coal fuel chain; including enhancing cooperation on development of carbon capture and storage as a potential future energy option.

4. An EU–China Ultra-Efficiency Building Research platform could be developed to capture the joint technical and development opportunities with China in this very fast-growing sector and to avoid energy consumption lock-in.

5. Exploring an EU–China low-carbon free trade agreement. A joint China–EU working group could be established to develop a framework to facilitate trade in high efficiency and low-carbon products. This could be the first step towards defining the scope of a potential China–EU low-carbon free trade agreement. Such an initiative could establish a global precedent for the treatment of climate-friendly technologies which could be extended to other markets.

6. Pioneering sectoral approaches to climate change Competitiveness concerns about climate change policies have generated significant interests in global sectoral standards agreements for energy-intensive sectors. China and Europe could develop a model sectoral agreement, commencing with the cement sector, which would help to drive efficiency and reduce emissions.

7. Tackling global supply constraints on renewable energy could help meet China’s and the EU’s shared targets on renewables and the corresponding cost concerns. The two powers could establish a high-level joint commission to tackle production bottlenecks and facilitate advanced investment.

8. Reducing dependency on imported oil from unstable regions to meet growing transport needs is central for China and the EU in the coming decades. With more than 80% of vehicles manufactured in China through joint venture companies, many with European partners, a unique opportunity exists for China and EU to work together to reduce import dependency through harmonizing energy efficiency and pollution standards.

9. Developing a low-carbon investment regime could help address the twin objectives of rapid diffusion of key technologies and ensuring competitiveness of domestic businesses for China and the EU. This could include relaxing Chinese restrictions on inward investment in return for access to carbon finance and enhanced technology cooperation.

10. Increasing energy efficient and low-carbon technology cooperation for China and EU could start with an agreement on practical steps to address structural issues in low-carbon technology cooperation around intellectual property rights. This could focus on practical mechanisms such as conditional or compulsory licensing, fair use rights, and guidelines for standardization, to enhance technological diffusion. Other joint initiatives could include combining EU and Chinese public R&D budgets in strategic areas; using existing supply chain links to drive the creation and spread of technology; and setting up a China–EU climate technologies prize fund to encourage innovation in the field of energy-efficient and environmental products.