Global Industry Chains Amid Green Transformation: Opportunities and Challenges

Abstract

Environmental movements in the 1960s marked the beginning of green transformation, and expedited the shaping of today’s global industry chains. The international transfer of low-value added and high-pollution industries to developing countries created economic boosts as well as significant environmental pressure for these countries. What kind of changes would a new cycle of carbon neutrality-centered green transformation bring to the global industry chains? What challenges and opportunities would such changes bring to China?

We think the new round of green transformation may affect global industry chains in the following ways:

• 1) Rising energy consumption costs amid carbon neutrality. Over the short term, China’s energy-intensive industries will benefit from the regulation of energy prices and low carbon costs (Carbon costs refer to the overall cost to emitters brought by carbon pricing and non-pricing policies. Carbon costs include abatement costs and the costs of remaining emissions), but we believe that the limited increase in energy consumption costs will be unfavorable for energy conservation and low-carbon upgrades. The traditional energy industry should see a short-term boost from energy price rallies but experience long-term pressure from a decline in demand. Meanwhile, the alternative energy industry will continue to thrive on stable expectations, while competition between countries may increasingly intensify.

• 2) International policies on preventing carbon leakage, such as the introduction of carbon tariffs, may narrow the carbon cost difference between countries. Such policies may add to restrictions on energy-intensive industries transferred to China from countries with stringent environmental regulations.

• 3) A meaningful green transformation cannot be achieved overnight. The global industry chains may continue to face rising climate costs and more frequent occurrences of extreme climate events over the long term. Industries with high exposure to climate risks, such as transport and logistics, agriculture, and energy, would be affected over the long term, and the impact would extend upstream and downstream via industry chains.

China has switched focus from “prioritizing economic growth over the environment” to “putting equal emphasis on the economy and sustainable development”. Meanwhile, developed countries have started to protect their own green industries. This trend has led to fiercer international competition in global industry chains. Hence, we think that China’s role in this new cycle of green transformation is to balance the development of green and traditional energy intensive industries as it adapts to or even leads the change in global industry chains.

Specifically, we believe China’s goals of achieving peak carbon emissions and carbon neutrality should be in line with efforts to maintain energy security. While industrial competitiveness should be protected, energy price regulations should be gradually relaxed, and carbon restrictions tightened. Faced with an increasingly rigorous international environment, China could deepen international cooperation, and encourage the innovative development of green industries via sustainable financing and investment, in our view. Moreover, we believe China could fully leverage its economies of scale to strengthen the resilience and steadiness of industry chains when coping with climate risks. We think enhancing the competitiveness of emerging green industries will help improve industry chain efficiency as well as strengthen China’s overall industrial security.

Authors of this chapter: CHEN Ji, WANG Shuai, LI Yating, ZHAO Yang. Translator: ZHANG Xinyue. Editors: Kenneth HO, Prashani RAMBUKWELLA, WANG Shuai, LIU Xinran.

6.1 How Green Transformation Will Impact Global Industry Chains: Internalization of Environmental Costs

The switch in focus from minimizing environmental pollution locally to reducing carbon emissions worldwide has been expediting industrial transformation across the globe. The publication of Rachel Carson’s Silent Spring in 1962 may have been one of the catalysts for the modern environmental movement in the US in the 1960s. Along with the United Nations Conference on the Human Environment in Stockholm in 1972, and the adoption of United Nations Framework Convention on Climate Change in 1992, the essence of green development has evolved and reshaped global industry chains.

Countries used to focus on the control of local pollutants such as chemical contaminants, air pollutants, sewage, and heavy metals when seeking sustainable development. In the 1960s, developed countries’ adoption of stricter environmental policies and regulations forced the relocation of low-added-value and high-pollution industries to developing countries.¹ As the goal of green development gradually shifted toward slowing climate change, countries began to propose carbon reduction or even net zero emissions, and introduced additional policies. At the macro level, green transformation should help restore efficiency loss caused by the negative externality of climate change, and the resolution of long-term climate risks produced by carbon-emitting activities should strengthen the security of industry chains.

Global industry chains seem to be undergoing a policy cycle similar to that of the control of local pollutants. As countries became more concerned about sustainable development, governments introduced environmental policies which internalized the negative externality of industrial production, resulting in environmental costs being transferred from the public to the polluters.² With environmental policies around the world reflecting varying levels of severity, producers in different countries faced varying internalized environmental costs, which in turn affected global industry chains. Whether the goal was to control localized pollution (as in the past) or global carbon emissions (as is currently the case and will continue to be so in the future), the fundamental premise that internalization of external costs will increase production cost remains unchanged.

Fig. 6.1

Source CICC Global Institute

Internalization of external environmental costs: Differences and similarities between controlling local pollutants and controlling global carbon emissions.

However, we believe the control of carbon emissions will impact global industry chains more extensively and more deeply compared with the control of local pollutants (Fig. 6.1). The consequences of global climate change, such as frequent occurrences of extreme weather conditions and rising sea levels, may impact industry chains across countries. The ecological balance, once broken, is hard to be restored over the long term. It may cause more severe and extensive market failures, and result in higher external environmental costs. While local contaminants would only affect some activities in some regions during a certain period of time,³ more parties are held responsible for global climate change, including both the direct polluters (mostly producers using fossil energy) and broad-sense polluters (energy consumers).

The internalization of external costs is achieved through policy instruments. Although the ultimate goal of reducing carbon emissions is mutually inclusive, not all policies at present are carbon policies directly aimed at achieving this goal. Other energy policies are also effective, such as control of both total energy consumption and energy consumption density, and renewable energy subsidies.⁴ In the future, the energy consumption costs for companies will comprise energy prices (both fossil energy and renewable energy) and carbon pricing. Section 6.2 discusses the impact of energy consumption costs on global industry chains. Against the backdrop of worldwide carbon emission reductions, we believe that the different levels of severity of carbon policies adopted by various countries will lead to varying carbon costs, the impact of which on industry chains is discussed in Sect. 6.3. Since the internalization of external climate change costs cannot be achieved overnight, climate change costs are very likely to continue be borne over a long period of time. Section 6.4 analyzes its potential impact on global industry chains.

6.2 Rising Energy Consumption Costs: Gains and Losses in Energy Supply and Consumption Industries

6.2.1 Why Will Energy Consumption Costs Rise?

The green transformation trend is heralding increases in energy consumption costs. We discuss the cost of using fossil energy and renewable energy separately in this chapter. The cost of using fossil energy may increase due to two major reasons.

First, tightening of control over carbon emissions will drive up carbon costs. More and more countries have set net zero-emission targets in recent years.⁵ While command-and-control policies such as a cap on total carbon emissions and carbon emission intensity created implicit carbon costs or shadow prices in the industry chains,⁶ incentive policies such as carbon tax and carbon markets created explicit carbon costs, i.e., carbon pricing. The number of carbon pricing tools worldwide increased from nine in 2005 to 68 in 2022, and the coverage rate of carbon emissions rose from 5 to 23%.⁷ Meanwhile, the carbon pricing policies have become increasingly stringent. The carbon quota prices in the EU continued to increase as EU countries adopted stricter climate goals and tightened carbon quotas. Moreover, carbon prices in other countries such as South Korea, New Zealand, and the US also increased, and may still have room for further upside, in our opinion.

Second, the decline in supply elasticity has led to more frequent and sharper increases in the prices of fossil fuels, raising energy consumption costs over the past two years. As policies such as carbon pricing and dual control over total energy consumption and energy consumption density were adopted, the market expected fossil energy demand to peak earlier and the stranded asset risks to increase. However, investments in fossil energy usually take a long period of time to recover. This has led to low levels of global capex on oil and gas exploitation. Moreover, we believe that the accelerated investments in clean energy may cause a crowding-out effect on fossil energy investments, and the geopolitical risks may rise further. Consequently, the elasticity of fossil energy supply may decline, which means energy producers will be more cautious about increasing output when energy prices go up.

An International Energy Agency (IEA) survey shows that oil and gas companies worldwide generally invested less in traditional oil and gas activities in 2022 compared with 2019 despite higher oil and gas prices.⁸ In this case, supply cannot change simultaneously along with prices. Hence, any disruptions on the supply or demand side would not only drive fossil energy prices to surge, but also increase the medium-term price volatility.⁹ For example, the Russia-Ukraine conflict disrupted natural gas supply, and led to a surge in global energy prices.

A major uncertainty over the supply of renewable energy is extreme weather. Against the backdrop of an accelerated shift in climate conditions and a higher proportion of renewable energy in total energy consumption in recent years, energy systems have been disrupted more frequently and more profoundly. In the UK where wind power is developing rapidly, the proportion of wind power in total electricity generation plummeted to 7% in September 2021¹⁰ from 25% (the average level in 2020) due to a lack of wind in the North Sea, causing power supply shortages and a 100% increase in electricity prices.

The intermittency and volatility of renewable energy will continue to disrupt the stable operation of the power system. Power system costs will rise more rapidly as the penetration rate of renewable energy increases,¹¹ and efforts to reduce volatility will also drive up the cost of using renewable energy. Although advancements in renewable energy technology over the long term will drive down the cost of power generation and energy storage, it will require intensive R&D input, and the switch in industrial production models needed for green transformation would incur costs centering on electrification and intelligentization.

Overall, one of the intrinsic requirements for green transformation is to increase the fossil energy consumption cost. When it costs more to use fossil energy than to use renewable energy (i.e., when the green premium drops to below zero), the switch towards clean energy should accelerate, and fossil energy consumption should trend down, driving carbon emissions to decline. As the technology for renewable energy advances, the cost of using it will initially increase, then decrease.¹² We believe as the proportion of renewable energy in total energy consumption goes up, the overall energy consumption costs will also show an inverted U-shaped pattern, and the volatility of energy prices will eventually decline. However, for a considerable period of time in the future, the energy consumption costs will increase and remain volatile. What does the increase in energy consumption costs mean for global industry chains? We will discuss the impact on energy-intensive industries, the traditional energy industry, and new energy industry separately in this chapter.

6.2.2 Impact on Energy-Intensive Industries

Energy-intensive industries are the most directly affected by rising energy consumption costs due to high energy consumption density and carbon emission density. In China, over 10% of production costs are spent on energy use in industries, including nonmetallic minerals, metal smelting, chemicals, and transportation (Fig. 6.2). Assuming other factors remain unchanged, we estimate that every 10% increase in energy costs will drive up the total production cost of these industries by 1%.

In the previously published book Guidebook to Carbon Neutrality in China,¹³ we estimated domestic green premium at 138% for building materials, 53% for chemicals, 15% for steelmaking, 11% for papermaking, 7% for petrochemicals, and 4% for non-ferrous metals in 2021. This also indicates the negative impact of rising energy consumption costs caused by internalization of external costs on energy-intensive industries. We believe that rising energy consumption costs will eventually lead to higher product prices and reduced output in energy-intensive industries. Moreover, increases in energy consumption costs during the early stages of the green transformation may result in economic stagnation.

Fig. 6.2

Source China national input–output (I-O) table [2020], CEADs, CICC Global Institute

Proportion of energy cost in total production cost and carbon emission density (2020).

We think efficient policies to control energy prices and low carbon costs may help reduce the actual energy consumption costs for domestic companies in energy-intensive industries in China. The price control policy hindered the pass-through of rising energy costs and delayed the impact of international energy price increases on domestic energy-intensive industries.¹⁴ A computable general equilibrium (CGE) model-based research study shows that the price control policy may reduce the impact of a 50% increase in international oil prices on the output and price rallies of domestic chemicals and transport industries from over 3% to less than 1%.¹⁵ The relatively low energy prices in China helped enhance the international competitiveness of domestic energy-intensive industries.

While global energy prices surged after the Russia-Ukraine conflict, energy-intensive industries in China enjoyed low energy consumption costs owing to the price control policy. For example, unlike international coal prices, coal prices in China did not rise significantly, leading to a wide price gap between China and other countries. Moreover, energy prices increased much less in China than in Europe.¹⁶ This created low-cost advantages for some energy-intensive industries in China, such as papermaking, aluminum, and chlor-alkali, and caused a surge in the exports of these products to Europe. Meanwhile, affected by the energy price increases in Europe, large numbers of companies in energy-intensive industries such as metallurgy cut or halted production, leading to sharp declines in output of aluminum and zinc.¹⁷ The supply shortages in Europe also drove up China’s exports of goods such as vehicles, machinery, and electronics.

The Russia-Ukraine conflict has sounded an alarm bell for energy and industrial security during the green transformation, highlighting the “impossible triangle” of energy security, economic growth, and clean energy. While Europe has made rapid progress in its green transformation, it relies heavily on the import of natural gas and other forms of renewable energy whose output is highly volatile. Meanwhile, other forms of energy such as coal and nuclear power were abandoned to some extent, increasing the fragility of Europe's energy supply.

When risk events such as the Russia-Ukraine conflict occur, Europe cannot respond quickly to guarantee energy supply, leading to the risk of energy shortage for industrial use and even the relocation of related factories to other regions. According to a 2022 survey by the Federation of German Industries (BDI), 58% of German companies faced serious pressure from rising energy prices, and 34% worried about bankruptcy.¹⁸ Europe's largest automaker, Volkswagen, is considering moving its production base outside of Germany.¹⁹ In the long run, increasing renewable energy supply will remain an effective way for European countries to reduce their dependence on energy imports and ensure stable energy supply for industrial use. However, as energy prices will increasingly fluctuate in the future, the stability of energy supply and price will also become increasingly important.

In terms of carbon costs, China's carbon reduction policies are not as severe as those in developed countries such as the US and those in Europe, and companies therefore are faced with less pressure from rising carbon costs. In theory, due to China's higher carbon emission intensity, its economy would be affected much more than those of such developed countries if it had to bear the same level of carbon costs.²⁰ However, in reality, the coverage of carbon pricing policies and carbon costs varies a great deal among different countries.

We calculate the explicit carbon cost by multiplying carbon price by the carbon emissions covered by carbon pricing. The explicit carbon cost accounts for 0.23% of GDP in China, lower than the 0.83% in the EU and 0.58% in South Korea²¹ in 2021. Even taking the implicit carbon cost into consideration, we think the carbon costs in China will very likely be lower than in developed countries such as the US and those in Europe before China reaches carbon emission peak in 2030.²²

Rising energy consumption costs have increased cost pressure on energy-intensive industries, but have simultaneously encouraged innovation in energy-saving and emissions reduction technologies, moving the development of industrial systems towards electrification and automation.²³ The theory of induced technological change suggests that changes in the relative prices of production factors themselves may stimulate innovation, guiding technological change towards the more efficient use of relatively expensive production factors.²⁴

The Porter hypothesis also suggests that strict environmental regulations may promote technological innovation, and even enhance industrial competitiveness.²⁵ For example, Japanese auto brands rapidly built market share in the US during the oil crisis in the early 1970s as their vehicles were better at conserving energy. It was during this time that the R&D around fuel cells also entered a fast track. The US expedited technological upgrades in the steelmaking industry through adoption of environmental regulation costs, which had at one point accounted for as high as 13–15% of the industry’s total capex.²⁶ This policy contributed to the rapid boom in electric arc furnaces (EAF). The proportion of EAF in steel output and coal prices are positively correlated in Europe, and the former hit a high of 40% when the latter peaked in 2008.²⁷

6.2.3 Impact on Traditional Energy Industry

The rising energy consumption costs will have both short- and long-term impacts on the traditional energy industry, in our opinion. Over the short term, we think the energy price hikes may benefit the traditional energy industry,²⁸ mainly considering relatively lower elasticity in energy demand and less stringent carbon regulations during the early stages of green transformation. Surges in oil and gas prices have led global oil and gas industry revenue to more than double compared with its five-year average,²⁹ and the market expects that US shale oil companies may generate free cash flow of US$180bn.³⁰ Over the long term, however, we expect traditional energy industry revenue to trend down. Energy consumers may gradually reduce their reliance on fossil-fuel energy as the cost to use such energy rises. In addition, we believe that higher carbon costs and unfavorable policies for the traditional energy industry will eventually weaken demand for fossil-fuel energy.

6.2.4 Impact on Alternative Energy Industry

We expect the alternative energy industry to benefit from the energy replacement effect in the coming period. As carbon regulations are tightened, the cost of consuming fossil-fuel energy will gradually exceed that of alternative energy, expediting the switch from fossil-fuel to alternative energy. Hence, we think alternative energy demand will remain strong over the long term. The rallies in fossil-fuel energy prices amid the Russia-Ukraine conflict are accelerating the global energy transformation and boosting growth in both volume and price for the alternative energy industry. The EU raised the target proportion of renewable energy sources in the overall energy mix from 40% to at least 42.5% for 2030.³¹ Buoyant energy prices also increased demand for PV installations in Europe, boosting China’s exports of PV products to Europe. In 2H22, China’s total export value of PV products jumped 113% YoY to around US$25.9bn.³² As strong PV demand will help sustain the growth momentum in major sectors along the PV industry chain, we expect domestic polysilicon producers to continue to expand capacity.³³ Moreover, other alternative-energy related industries such as energy storage and virtual power plants may also rapidly begin to thrive.

The increase in energy consumption costs would also help alternative energy companies strengthen profitability and reduce their reliance on government subsidies, which used to be the case for countries around the world as alternative energy costs more to use than fossil-fuel energy.³⁴ As the cost of generating power from alternative energy drops, we think the alternative energy market will gradually mature and enter a new stage of development after the subsidies are cut. We think the high energy prices should help strengthen the profitability of the alternative energy industry, and the switch from subsidies to carbon pricing will continue to boost industry development.³⁵

The alternative energy industry is also attracting sustainable financing and investment. While the short-term energy price rallies may boost the traditional energy industry, the alternative energy industry is set to benefit more and offer more stable investment returns³⁶ during the energy transformation. Hence, financial instruments such as green finance and ESG investment tend to favor alternative energy. By end-2021, China had the largest amount of outstanding green loans around the world, and the second largest amount of outstanding green bonds.³⁷ Moreover, capital market-led ESG investment also brings numerous funds to the alternative energy industry.³⁸

Aside from the growth opportunities, alternative energy companies in China may also face fiercer competition from overseas peers in terms of technological innovation. The alternative energy industry chain includes raw materials such as lithium, cobalt, and nickel, which rely more on natural resources, and manufacturing. The increase in demand would benefit the entire industry chain. However, it may give a stronger boost to the profits of raw material suppliers who enjoy a solid monopoly and higher bargaining power.³⁹

Manufacturers, on the other hand, will require technological innovation to enhance their profits, in our opinion. China has limited battery metals. While domestic companies have developed many world-leading alternative energy technologies, there remains ample room for further innovation. For example, next-generation technologies such as solid-state battery and perovskite battery have become the latest development trend. We think technological competition among countries may intensify. China’s alternative energy firms will need to resort to self-driven innovation to achieve high-quality growth.

6.3 Narrowing Difference in Carbon Costs: Changes in and Transformation of High-Carbon Industries

Countries around the globe are at different stages of decarbonization, and their carbon costs differ notably. It is difficult to quantify the difference in carbon costs caused by the adoption of different carbon policies, and we therefore use the carbon prices reflected in the carbon market or carbon tax policy. Among the countries currently implementing carbon pricing policies, South Korea and Japan both have over 70% of carbon emissions covered by the trading system, and the coverage rate is around 30–40% in the EU and China. The carbon prices are markedly higher in the EU and the UK compared to China, Japan, and South Korea. Most developing countries have yet to introduce a carbon pricing system, but many have already begun exploring this avenue. India’s Energy Conservation (Amendment) Bill 2022 offers legal ground for the launch of a voluntary carbon market.⁴⁰ Vietnam issued its carbon market development plan in January 2022,⁴¹ and Malaysia’s Bursa Malaysia launched a voluntary market in December 2022.⁴²

Theoretically, the “pollution shelter” hypothesis⁴³ suggests that high-pollution industries in countries with strict environmental regulations may be transferred to countries with less severe environmental regulations, causing an increase in greenhouse gas emissions (referred to as carbon leakage), with the difference in carbon costs possibly encouraging the industrial relocation.

In reality, countries worldwide had been seeking to reduce carbon emissions before the adoption of carbon neutrality policies, and the carbon cost difference already existed as far back as the late 1990s. Some sources attribute carbon leakage to the 1997 Kyoto Protocol: While countries that committed to carbon reduction saw carbon emissions decline, the carbon emissions implied in their exports from countries not bound by the agreement increased, resulting in the limitations of the Kyoto Protocol amid the transfer of high-carbon industries.⁴⁴ The carbon cost difference between regions within one country may also cause industrial transfer.⁴⁵ For example, high-carbon industries were transferred from eastern China to central and western China, where the carbon reduction policies are less severe. As a result, provinces in central and western China delivered above-average growth in carbon emissions.⁴⁶

However, there are other sources that suggest that the transfer of high-pollution industries to developing countries was not simply an attempt to lessen their environmental costs. We think possible reasons for this could be that⁴⁷: (1) The increased environmental costs resulting from the tightening of environmental regulations only accounts for a small proportion of the overall operating costs of companies; (2) the difference in environmental costs is not a major factor affecting the decisions being made by transnational corporations for foreign direct investment; factor endowments, infrastructure, and business environment all play important roles; and (3) pollution-intensive industries are mostly capital-intensive as well, and transferring these industries would require ground support for technological equipment which would involve additional expenses. This means the high-pollution industries would only be relocated when the carbon cost difference between countries is high enough to exceed the opportunity cost of international transfer.⁴⁸

However, the aforementioned cost structure indicates that the carbon cost is lower than the energy cost, and the marginal impact of the carbon cost would be less when considering other costs. We therefore think the carbon cost is actually unlikely to cause industrial transfer. More importantly, the increase in external costs amid climate change would propel countries to adopt stricter policies to prevent carbon leakage, lowering the possibility of carbon price arbitrage. We summarize two major types of policies:

Border carbon adjustments policies are typically introduced for the prevention of carbon leakage. Many developed countries already take into consideration possible carbon leakage when designing their carbon reduction policy. The EU Emissions Trading System (EU ETS) grants free allocations of emission permits to leakage-prone industries,⁴⁹ and the EU Carbon Border Adjustment Mechanism (CBAM) continues to play its role after the free quotas are gradually canceled. CBAM charges carbon tariffs on exported goods for excess carbon emissions, which helps fill the carbon cost gap between EU and other regions and reduces the possibility of industrial transfer caused by the carbon cost difference.⁵⁰ Carbon tariffs would also reduce China’s exports to Europe, especially machinery equipment, metal products, and petrochemicals.⁵¹ In addition to the tightening of carbon regulations, many developed countries also introduce supportive policies to protect the competitiveness of their own industries. For instance, EU ETS revisions in 2022 proposed expanding innovative funds (to support the development of low-carbon technology, carbon capture, renewable energy, and energy storage in energy-intensive industries) and modernization funds (to support the modernization of the power sector and energy system in 10 lower-income EU member states).⁵²

International organizations’ restrictions on international economic activities. For example, airlines and shipping companies run their businesses across countries, and identifying which countries are relevant for their carbon emissions is complicated and becomes another major source of carbon leakage. The International Maritime Organization (IMO) and International Civil Aviation Organization (ICAO) have tightened control over these carbon emissions in recent years.⁵³ Such international policies have led countries around the globe to face greater pressure to reduce carbon emissions from the aviation and shipping industries. We believe that the resulting changes in transport costs will significantly impact global industry chains.

These international policies aimed at preventing carbon leakage may reduce the possibility of carbon price arbitrages in high-carbon industries. Looking back, we think global regulation of ozone layer depleting substances (ODS) went through a similar process. Like carbon emissions, ODS are also a worldwide negative externality as they damage the ozone layer and increase instances of diseases such as skin cancer. The Montreal Protocol on Substances that Deplete the Ozone Layer, signed in 1987, requires that countries gradually phase out ODS, with different timetables for developed and developing countries. However, developed countries’ restrictions on imports of CFC refrigerators hindered the transfer of the CFC refrigerator industry to developing countries, and forced developing countries to start industrial upgrades earlier than planned.⁵⁴ Hence, we believe international policies designed to narrow the carbon cost difference will very likely reduce the possibility of international transfers of high-carbon industries, which may offset the carbon cost increase with energy conservation and low-carbon upgrades over the long term.

6.4 Climate Cost Increases: Challenges and Impact From Extreme Climate Events

Global warming is an issue caused by carbon emissions accumulated over centuries of industrialization. The global carbon cost cannot be internalized even over a long period of time. Moreover, historical data suggests that costs associated with climate change have continued to rise. According to data from NASA, the global temperature deviation from the historical average over 1951–1980 increased from −0.5° C in 1900s to around 0.8° C in 2021,⁵⁵ while the number of climate disasters rose from a few per year to 300–400 per year. Research by the Intergovernmental Panel on Climate Change (IPCC) indicates that global warming will significantly raise the frequency and intensity of extreme heat. The extreme high temperatures that occurred once a decade before industrialization may happen around 5.6 times every decade if the average temperature rises 2° C.⁵⁶

Climate change may lead to increases in the Earth’s surface and ocean temperatures as well as rising sea levels over the medium to long term, and more frequent and intense occurrences of extreme climate disasters over the short term. Such extreme climate events may impact all industries and economic structures over the medium to long term, and disrupt industry chains over the short term.

Industries related to physical assets and natural resources are more vulnerable to extreme climate events, such as transport and logistics, agriculture, and energy. A global multi-sector CGE study⁵⁷ suggests that rising temperatures will negatively impact the agriculture, fisheries, forestry, energy exploitation, energy-intensive industries, and transportation in most countries. It would also affect other economic sectors via labor productivity and factor prices.

In addition to direct physical impact, climate risk events would also have an indirect impact on production factors. High temperatures also increase morbidity and mortality rates in many regions. According to the International Labor Organization, labor productivity would rapidly drop when wet bulb globe temperature (WBGT)⁵⁸ exceeds 24–26° C, and workers with moderate workloads would lose 50% of their working capacity when the temperature hits 33–34° C.⁵⁹ Tropical regions may see declines in labor supply and productivity as climate change intensifies, especially in sub-Saharan Africa, as well as some regions in South Asia and Southeast Asia.⁶⁰ Meanwhile, land, fixed assets, and infrastructure will more likely be affected by climate issues such as floods, hurricanes, and cold waves, which may damage or destroy physical assets such as real estate, and lead to insurance loss.⁶¹

The deep integration of global industry chains and the adoption of a lean production model allows the negative impact of climate risk events to extend along the industry chains, and to affect countries or regions where the downstream factories are located, creating a domino effect. For example, a flood in Thailand in 2011 was the most severe flood since 1970 led to suspension of production of over 10,000 factories in the auto, electronic and electric appliance manufacturing, and textile industries. As a result, Thailand’s exports to Japan, Europe, and the US dipped 14%, 35%, and 21%, in November 2011. Due to the global production networks and low inventories under the lean production model, Japanese companies had to shut down the auto assembly lines in Thailand, leading to a 24.1% decline in Japan’s auto parts exports in December 2011.⁶² Some auto parts manufacturers suspended production for as long as 174 days, and their net profit tumbled 50%.⁶³ A London insurance company paid a settlement of US$2.2bn for the event.⁶⁴

The “bullwhip effect” in supply chain management normally involves random uncertainties and risks that can be rapidly resolved, and its impact on industry chain structure and output is limited.⁶⁵ However, climate risks are caused by complex meteorological factors which require rapid resource recombination or the search for alternative solutions to resume or sustain production and production networks amid a high level of uncertainties. The degree to which climate risk events impact global industry chains depends on multiple factors such as the characteristics of the industry chain. We think climate risks may lead to the short-term divergence of output in different regions, and the transfer or transformation of production over the long term.

6.5 Thoughts and Implications: China is Adapting and Leading

While global industry chains were reforming during the last cycle of green transformation, China was expediting industrialization and attracting international industrial transfers due to low-cost labor and resources. However, this created significant challenges, including pressure to protect the environment. In the beginning, the “pollute first and clean up later” model was necessary, and we think can be justified from the perspective of internal demand versus the external environment. Internally, rapid economic growth remained the national strategic priority since China’s reform and opening-up in 1978 and until 2012. Environmental protection was sacrificed to boost economic growth during this period.⁶⁶ Externally, the environmental movements that emerged in the 1960s in developed countries propelled the international transfer of high-pollution and resource-intensive industries, creating opportunities for developing countries such as China.⁶⁷

When analyzing China’s role in global industry chains during the latest round of green transformation, we noticed changes in both internal demand and the external environment. The Chinese economy entered a phase of new normal after 2012, and economic growth became increasingly in sync with sustainable development. The phase-out of outdated capacity and industrial structure adjustments were all related to green upgrades. Externally, due to the worldwide negative externality of carbon emissions as described before, developed countries are morally going to prevent carbon leakage caused by industry transfer. Doing so also serves their own interest to create new economic growth drivers and enhance industrial competitiveness.⁶⁸ Meanwhile, some developing countries were early to recognize the importance of sustainable development. Hence, we believe China’s major goal during the latest round of green transformation is not simply to protect high-carbon and energy-intensive industries but, more importantly, to balance the development of green and traditional industries in order to adapt to or even lead the change in global industry chains.

Over the short term, we think rising energy consumption costs amid green transformation will add cost pressure on manufacturing industries, and the instability of energy supply and the fluctuations of energy prices are detrimental to the security of the industry chain. Over the long term, however, we believe the higher energy consumption costs will stimulate energy conservation and advances in renewable energy technology, while encouraging countries that lack fossil-fuel energy resources to increase their supply of renewable energy and reduce reliance on energy imports. This should enhance both efficiency and security of the industry chains.

China provided a favorable environment for the development of domestic energy-intensive industries by effectively controlling energy prices and ensuring low carbon prices, but these industries, faced with less pressure to transition to sustainable energy sources, were less motivated to upgrade and innovate technologies. As a result, China’s path towards reaching carbon emissions peak and carbon neutrality was hindered. Against a backdrop of more frequent increases in energy consumption costs and energy prices, China needs to strike a balance between achieving the goal of carbon emissions peak and carbon neutrality, and maintaining stable energy supply and prices. While industrial competitiveness should be properly protected, energy price regulations should be gradually eased and optimized, and carbon restrictions tightened. Furthermore, we think the clean low-carbon transformation should be advanced in fields such as industrial production and energy conservation. We also believe that carbon-reduction technologies should be developed and promoted to boost the greening of industrialization.

EU carbon tariffs aimed at preventing carbon leakage and international organizations’ restrictions on carbon emissions for international airlines and shipping gradually weakened China’s carbon cost advantage. International policies are becoming increasingly stringent. We think China could encourage its energy-intensive industries to adapt to the changes in international carbon-restriction standards⁶⁹ to reduce its negative impact on China's exports.

Strengthening international cooperation in coping with climate change and international coordination of green transformation may slow the backlash against globalization. Nevertheless, in light of China’s advantages in alternative energy, developed countries have enhanced policy intervention, with an emphasis on localization and the security of the renewable energy industry chain. In our view, China could introduce favorable polices to boost innovation in green industries and encourage the development of sustainable financing. Industrial security is associated with competition between countries, and enhancing the competitiveness of emerging green industries may help improve industry chain efficiency and strengthen China’s overall industrial security.

While the impact of climate change is negative overall, we think China may fully leverage its advantages to enhance its capability to adapt to these changes. China boasts a complete industry chain, which helps it to rapidly switch production capacity and resume production when faced with climate-related challenges. Awareness of adapting to climate change remains weak among all sectors of Chinese society, in our opinion, and the related management system needs to be improved.⁷⁰ Furthermore, coping with climate risks also requires more resilient and robust industry chains. At the macro level, China can fully leverage its economies of scale, and reduce regional risks via diversification of supply and demand. At the micro level, industries should assess climate risks before selecting new business sites to be able to shift from “just in time” (prioritizing costs by keeping inventory to a minimum, and being agglomerative and close to suppliers and customers) to “just in case” (diversifying to mitigate risks). Region-specific emergency plans for supply chain management should be made in advance to ensure the stability of the supply chain.