China Carbon Trading not all Bad News

China's planned national cap-and-trade carbon emissions system may at first appear to be yet another bearish factor for commodity demand in the world's largest consumer of natural resources.

In theory, limiting the amount of carbon emissions by setting a price per tonne and then making polluters pay for permits above their allocated limits will serve to raise costs for carbon-intensive industries, such as steel, aluminium, power generation, copper smelting and oil refining.

A cap-and-trade system is only effective when it raises the cost of polluting to the point where the polluter limits output or invests in new technology or takes other steps to reduce emissions.

Of course, a polluter can try to raise prices for the goods they produce, but this assumes that they enjoy market power, and this is certainly not the current case in many commodity industries.

Much will depend on how China, the world's largest polluter, structures its cap-and-trade system, and details have yet to emerge on the likely cost per tonne, and what industries will be included and how many carbon permits they will be issued.

China already has seven pilot carbon markets that have been established in recent years, and they have been relatively successful in attracting trades, even if the price per tonne is generally lower than in equivalent programmes in Europe.

It's also probably too early for conclusive data on whether these initial schemes have been successful in reducing emissions or driving efficiencies, although the authorities in the southern province of Guangdong last week announced steps to increase the number of industries covered by their programme.

The lack of detail makes drawing definitive conclusions impossible, but it's feasible to look at likely trends and how they may play out.

OVERBUILT INDUSTRIES MAY RATIONALISE
If China's scheme is structured in such a way that it incentivises meaningful reductions in carbon emissions, this will create both winners and losers, and opportunities for commodities producers in other countries.

Take the steel sector. If a carbon trading system raises the cost of production it's likely to do two things.

Firstly it will encourage rationalisation of an already over-supplied sector, meaning older, less efficient blast furnaces are likely to come under pressure to close.

This may lower domestic steel output while raising prices, which in turn could lower China's steel exports, both on the basis that there is less material being produced and what is being manufactured has a higher cost base.

In turn, carbon trading is likely to encourage better quality inputs into the steel-making process, meaning producers of higher quality iron ore may actually benefit even if the total amount of iron ore being consumed in China declines.

The same goes for producers of coking coal, as steel-makers are likely to try and lower the amount of energy they use per tonne of product manufactured.

It's also possible that China will shift more to recycling steel through electric arc furnaces, especially if they can use electricity generated from cleaner sources such as natural gas or renewables.

A similar dynamic may play out in aluminium, which like steel, is a sector where China has overbuilt capacity.

If the cost of producing aluminium rises, again it may encourage rationalisation, with higher-cost, lower efficiency producers leaving the market.

Similar to steel, this may serve to reduce the amount of aluminium available for export, and also reduce the global smelting overcapacity.

COAL REMAINS A LOSER

One major commodity that is likely to struggle is coal, despite it still being China's primary energy source, accounting for more than 60 percent of the total.

While China can't and won't end its reliance on coal, burning less of the polluting fuel would have to be a primary aim of any carbon trading system.

This should be especially bad news for exporters of low-rank coal, such as Indonesia, but it's also hard to construct a bullish scenario for producers of better quality coal, such as Australia, as any serious limiting of China's coal use will mean imports are unlikely to be required at all, with domestic output more than sufficient.

Coal's woes may end up being gains for liquefied natural gas (LNGLF) (LNG), especially if China makes a concerted effort to roll out more gas-fired power plants and increase the building rate of receiving terminals.

It's possible that the low price of spot LNG in Asia <LNG-AS>, which ended last week close to its record low at $6.80 per million British thermal units, will convince China's energy companies to invest more in LNG, given the outlook for prices remains subdued as more new liquefaction plants are commissioned.

Oil refining is another industry that may be affected by carbon trading, and here there is more limited scope for efficiency improvements, given many of China's refineries are already using the latest available technology.

Some older, smaller plants known as teapots may struggle if they are included in a carbon trading system, but the main impact is likely to be an increase in the cost of fuel produced, which will most likely be borne by Chinese consumers.

At the margin, Chinese refiners may lose some competitiveness in export markers for refined products such as diesel, but much will depend on the cost per tonne on carbon emissions that is imposed under the proposed scheme.

Overall, an effective Chinese cap-and-trade carbon trading system is definitely negative for coal producers, both local and foreign, but may actually help steel and aluminium makers outside of China by lowering global capacity and eroding the competitiveness of China's exports.

By Clyde Russell