Asia Research & Engagement’s (ARE) briefing analyses the investment risks associated with financing coal power in China. ARE examines where the seven leading listed Chinese power companies are constructing high risk new capacity. This report aims to reveal the financial implications that increasing spending in coal power has for company investors, and provide guidance for company engagement

The report first outlines the major strategic challenges the power sector in China faces including:

• lower demand
• shifts in market structure,
• environmental concerns that now take a far stronger role in policy formation.

At the same time, increasing global efforts are coming together to climate change. This mix of factors has weighed on returns, primarily as it has led to reduced utilisation hours for existing coal plants. This highlights the commercial risks and makes it more important for companies, and investors, to carefully consider the prospects for new plants. Despite the risks, the companies analysed have not provided guidance on their strategy given the rising risks. They all have plans to build in regions exposed to high regulatory risk including stronger air and water standards. A lack of disclosure does not allow investors to assess prospects for any of the companies.

The report sets out each company’s investment projects, together with plant-level analysis of air and water risks. In order to clearly identify where companies are taking on risk, the report used a two-step process to understand the level of air and water risk in the capacity addition plans of the companies. The first step was to quantify province risk as many critical success factors for coal plants play out at the provincial level. Considering the environmental factors that shape the provincial risk profile may not apply uniformly across a province, a second step considered plant level factors. With this approach, the analysis allows for a more nuanced assessment of the risks associated with each company’s proposed capital expenditure.

Overall, the companies’ interim results statements do not provide much clarity on each companies’ response to the emerging risks that would potentially affect future returns. The report, therefore, provides investors with four guidance questions to support company engagement:

• What are your detailed capex plans by plant and by province?
• What are your hurdle rates of return for new coal plants?
• How do the financial models for the new plants change in light of new regulations, particularly on air, water, and carbon, and other market dynamics?
• How have you changed your investment plans to reflect changing market conditions?

While the report is from 2016, it provides a strong example of how to blend sustainable indicators and financial returns to better understand risks to investments and arrive at a set of questions for company management.

1. The power sector in China faces strategic challenges that will affect coal power prospects.
   
   
2. Electricity generation in China grew at a compound annual rate of nearly 11% in any one year from 1994 to 2014, until 2015.
3. Air pollution moved to centre stage in energy policy following the record air pollution in Beijing in January 2013. Water stress has also moved up the agenda.
4. Seven listed Chinese power companies’ 2016 interim results led to downgrades across the sector as analysts digested bad news on sector fundamentals.
5. China has introduced carbon markets as one of its policy pillars. This creates a clear policy signal for the power sector in the run up to the launch of the market in 2017.
   
   
6. Considering new capacity construction involves more than just considering likely generation but the risks to that capacity from increasing regulations on water and air quality.