How to profit from China's battle against pollution

In January, Beijing was blanketed in a thick, grey smog of rancid pollutants. The city's 20 million inhabitants were warned to stay indoors or wear masks if they ventured out. Meanwhile, drivers had to deal with visibility as low as 100 metres in places. Sales of masks and purifiers rocketed as people tried to do whatever they could to keep out the filthy air.

It wasn't the first time Beijingers have had to battle smog. Living in a dense metropolis, situated in the industrial heartland of the world's biggest polluter, means most residents are pretty accustomed to bad air quality. But this time was different.

For starters, it was much worse than usual. Thanks to unhelpful climatic conditions, the smog built up to unprecedented levels. And, while less easy to measure, there were also signs that public attitudes have changed. The January smog sparked a furious outpouring on social media.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

"I love my city but I refuse to be a human vacuum", was one of many striking comments. Even more significant was the tone of the normally docile media. Official mouthpiece the People's Daily said the smog was a "suffocating siege" that had to be addressed urgently. Meanwhile, the state-run China Daily said the country had to learn to balance development with quality of life.

This just might prove to be Beijing's 'Great Smog of 52' moment. That particularly bad London smog led to the passage of the Clean Air Act in 1956 and the eventual improvement of the capital's skies. In the aftermath of the Beijing smog, incoming vice-premier Li Keqiang admitted that "we must act" and announced a range of measures to combat pollution.

But this is about far more than just clean air. Until now, China's rapid economic progress has been based on using cheap labour and a lax attitude towards environmental regulation to enable it to make cheap exports. But now (unlike their Western counterparts) Chinese citizens are far richer than they were a generation ago. That means they're less willing to put up with the horrible living standards created by environmental destruction.

China's attempts to rebalance its economy and address the population's growing concerns about its environment will create a raft of investment opportunities.

Breathing in Beijing: a 20-a-day habit

The first step in fixing Beijing's terrible air quality is having a reliable way to measure it. People on the street, who find themselves coughing up black phlegm on particularly bad days, can easily tell when the air feels dirty. But that's not particularly scientific. The government's preferred measure used to be the blue-sky days' indicator.

Somehow this index recorded a steady improvement from 100 blue-sky days in 1998 to 286 in 2011. But the spread of social media increasingly rendered this crude PR trick ineffective, as web-savvy Chinese citizens began to mock the discrepancy between the blue skies reported in the papers and the filthy reality outside their windows.

That pressure was made worse by the insistence of the US embassy in Beijing on publishing more accurate data that measures the presence of small particles, known as PM2.5, in the air. These particles, so-called because they're 2.5 micrometres or smaller, are deemed the most dangerous because they are fine enough to enter lungs and the bloodstream.

Eventually, the Chinese government relented and published its own PM2.5 data. Initially, the data was published only in Beijing, but as of last month, it includes 70 other cities too.

All of this matters because it gives citizens a reliable, scientific indicator with which to judge the government's clean-up efforts. So far, it doesn't make happy reading. At one particularly bad point in January, Beijing recorded 886 micrograms of PM2.5s per cubic metre. The daily average for the month was 196.

To put that into perspective, a smoking lounge at an airport typically has 170 PM2.5s per cubic metre. The World Health Organisation's recommended daily limit is just 25.

Of course, you don't have to be a dyed-in-the-wool cynic to question whether this new pollution data will make any difference. But while China may not be a democracy, that doesn't mean its leaders don't care about public opinion.

In recent years environmental concerns have been by far the biggest cause of protests on the Chinese mainland, and that's made the authorities keen to assuage such anxieties. As The Economist points out: "China's government has long staked its legitimacy on being able to generate improved standards of living, and people have grown used to complaining about things they do not like. Adding chronically poisoned air to the mix could prove volatile."

Aside from political factors, there are also strong health and economic drivers for an improvement in air quality. It's estimated that bad air contributes to around 8,500 deaths in the cities of Beijing, Shanghai, Guangzhou and Xi'an each year. Millions more are affected by way of respiratory problems.

On a countrywide basis, the World Bank reckons that air pollution costs the equivalent of 3.3% of China's national income a year via various problems such as rising rates of lung and heart diseases, not to mention road accidents and flight cancellations.

Cleaning up cars

So what are the causes of all this pollution? And how will China fix it? One major factor is dirty diesel and petrol. Chinese fuel prices are capped. That makes the refining operations of the country's two major fuel suppliers, state-controlled PetroChina and Sinopec Group, unprofitable.

That's a burden for those companies, but the government returns the favour with lax regulations that allow them to produce cheaper, poorer-quality fuel. For example, says The Economist, "in much of China, regulations allow the sulphur content in petrol to be as high as 150 parts per million, whereas European standards cap it at 10 ppm".

The recent furore over air quality could change this cosy understanding. In February, the ruling State Council announced that it is working on new standards that will cap the sulphur content of diesel and petrol toten ppm by 2017. So, "refiners must upgrade facilities or else", says The Economist. That won't come cheap.

It's estimated that Sinopec will have to spend up to $6.5bn on extra equipment to meet the new standards. In return, however, the state will allow prices to rise. Changes announced last month mean diesel and gasoline now sell for around $1.20 per litre.

Next up are the vehicles that burn the fuel. One problem is quantity. China is now the world's largest car market, selling 20 million new cars per year. Sales are expected to hit 30 million a year by the end of the decade. The other difficulty is quality.

Owing to lax regulations and the older technology used by some local car producers, many of those vehicles emit far more pollution than their Western peers. Trucks in particular stand out, contributing 80% of vehicle particulate matter, despite accounting for just 25% of traffic.

Countrywide, other factors such as coal-fired stations and steel furnaces cause more pollution. But "in dense urban areas, [traffic] is almost certainly the highest contributor to human exposure of PM2.5", says Vance Wagner from the International Council on Clean Transportation, a think tank, in The Wall Street Journal.

In January, Beijing's acting mayor, Wang Anshun, promised to enforce existing regulations more strictly and take 180,000 old vehicles from the road. Then, in February, the city implemented European-style tighter emissions standards for new cars.

These regulations are likely to be rolled out to the rest of the country in the months ahead, says David Green on WardsAuto.com, a news website. That means some cars will have to be upgraded with catalytic converters (to clean emissions) or turbochargers (to make engines more efficient) before they can be sold. That will benefit foreign component suppliers, says Steve Man of Nomura Securities few Chinese providers have a strong position in these technologies.

The move could also boost China's long-suffering electric car industry. According to Bloomberg New Energy Finance, the Chinese government "has supported both public and private purchases of electric vehicles with some of the most generous levels of support in the world".

So far this hasn't worked: electric vehicles sales are well short of the government's target of 500,000 cumulative sales by 2015, and five million by 2020. Yet the continued problems with air quality are a good incentive to renew efforts.

For example, the government is expected to order electric vehicles for its own fleet. Again, this is good news for foreign companies: Michael Liebreich, chief executive of Bloomberg New Energy Finance, notes that China "will need to bring in expertise and technology from foreign players to create competitive vehicles, and to deploy the full muscle of its auto industry in order to produce vehicles the public trusts".

Cleaning up coal

Another major cause of air pollution is China's huge and growing fleet of coal-fired power plants. In the last ten years, China's coal consumption has doubled. It now uses almost as much as the rest of the world combined. Unsurprisingly, this reliance on the dirtiest form of power generation is terrible for air quality.

China is loathe to ditch coal completely a cheap, secure energy source but it is looking for ways to mitigate its impact. So, it is investing heavily in clean coal' technologies that can cut the amount of pollutants emitted by coal-fired stations.

China is now the world's biggest investor in renewable energy technology. In 2012, Chinese spending on clean energy rose 20% to $67.7bn, a 20% increase on 2011. America is way behind in second place with $44.2bn.

Even more noticeably, China is continuing to increase investment in renewable energy at a time when subsidy cuts in much of the cash-strapped West led to an 11% fall in overall spending. This spending is only set to increase as the clean-up push continues.

China's solar-power installation target for 2015 has now been raised by 67% to 35 gigawatts (GW). That's a huge increase: Britain's entire power generating capacity stands at about 90 GW. Nuclear also looks likely to benefit. Following a brief hiatus in the wake of the Fukushima disaster in 2011, the State Council has given approval for 130 GW of new nuclear capacity. That may be less than before, but it is still more than any other country.

China won't solve its problems overnight. Despite its best efforts, London still suffered terrible smogs after the great one of 1952. The rapid, unprecedented scale of China's development means its problems are even more deep seated and complex. But what is clear is that the Chinese government will make increasingly concerted efforts to solve the problem. We look at the best way to play this trend below.

The four best plays on a greener China

China's impact on the world's car industry is huge. Not only is it currently the biggest car market in the world, it is also the one with the most potential for growth. Indeed, some equity analysts, covering European carmakers for European clients, have moved to China because that's where they believe the future of these firms lies. So China's decision to push through stricter emission controls will have a huge impact on the industry.

One way to play this is through component makers. Borg Warner (NYSE: BWA) manufactures a range of engine and drivetrain components that increase fuel efficiency and reduce emissions.

For example, the company makes turbochargers that squeeze air through an engine to make its fuel use more efficient. Its drivetrain business also has exposure to the hybrid and electric vehicle industry, as it is developing components for electric vehicles.

For now, Asia only accounts for 15% of sales overall, but it is expected to account for 50% of Borg Warner's net new business between now and 2015. The firm has partnerships with every major Chinese car manufacturer as well as firms that export into China. It trades on a forward price-to-earnings (p/e) ratio of 13, well below its historic average of 18.

If you don't fancy taking the plunge on a particular component supplier or vehicle maker you can play the general trend by investing in platinum or palladium. The two related metals are used to make catalytic converters and should benefit as Chinese fuel standards improve.

Cars account for around 40% of platinum use and 80% of palladium use. As a rule, a combination of the two metals is used, with platinum more commonly used in diesel engines and palladium for petrol. That said, manufacturers are constantly developing the technology so it's probably best to give yourself exposure to both.

One cheap way to invest in platinum is through the ETFS Physical Platinum (LSE: PHPT). It's backed by physical stores of the metal and has an annual management charge of 0.49%. The ETFS Physical Palladium (LSE: PHPD) offers a similar way to invest in palladium.

Production for both metals is quite tight. Less than 200 metric tonnes of each is produced annually, compared to around 2,500 tonnes of gold. Disruptions in South Africa, its major producer, have also weighed on output. That means that miners will take a long time to react even if prices for either get back to pre-crisis levels, giving investors plenty of time to make a profit.

There's no doubt that the lion's share of China's increased environmental spending will go to Chinese companies. Over the past decade the country has made sure that local producers have been able to build up dominant positions in most domestic markets. The trouble is, it's not easy for an outsider successfully to pick those winners, and many of these technologies are at fairly early stages of development, which makes it all the harder.

So this is one theme that we'd suggest playing through a fund. The Impax Asian Environmental Markets Investment Trust (LSE: IAEM) invests in companies that make products to aid the cleaner or more efficient delivery of energy, water and waste in the Asia Pacific region.

It is mainly China-focused and stands to benefit as politicians introduce a wide range of measures to curb pollution in the country. Its biggest holding is ENN Energy, a Chinese pollution controls company. Another top ten holding is Xinyi Glass, a Chinese solar energy firm.

Investment manager David Li believes the trust will benefit from the incoming government's aim to turn "the country's economy from a manufacturing to an innovation-led economy".