China has established ambitious goals to achieve peak carbon emissions by 2030 and carbon neutrality by 2060. The country is currently the world’s largest carbon emitter, contributing nearly 30% of the global total in 2019^Footnote[i], although its per capita CO₂ emissions are only half those of the U.S. China’s intent to double GDP by 2035 and further increase urbanization only add to the challenge. The country will need to aggressively lower its carbon intensity, measured as emissions per unit of GDP, to meet its 2030 peak emissions target.

That will be difficult because energy-intensive and highly polluting manufacturing has driven China’s rapid growth since Beijing joined the World Trade Organization in December 2001. The country relies heavily on coal, which is more carbon-intensive than most energy sources.

To achieve carbon neutrality, China will need to rebalance its economy, tighten industrial pollution standards, improve energy efficiency, and increase renewable energy capacity. Many commodities (including fossil fuels), will remain central to China’s growth in the short to medium term. However, in the medium to long term, we expect fossil fuels to be replaced by cleaner energy sources. Demand for certain base metals used in the installation and manufacturing of renewable energy will likely be supported by China’s decarbonization goal.

Decarbonization: modest impact on growth and inflation this year

The Chinese government has started to use production controls and power tariffs to meet short-term emission targets. But the impact on growth will likely be small. Measures include capping crude steel production at 2020 levels and limiting increases in electrolytic aluminium capacity. We estimate production cuts in these sectors could reduce overall GDP growth for 2021 by 0.1–0.2 percentage points, a minor decrease relative to our baseline calendar year growth forecast of 8.6%.

The effect on inflation should also be modest. The fall in pork prices to a more normal level has offset the impact of rising energy prices on CPI this year. Overall, consumption growth remains below trend due to lingering public health concerns and core inflation has remained soft. In addition, China’s consumer goods manufacturing sector is extremely competitive and producers are reluctant to raise prices, fearing the loss of market share. While they have been unable to pass higher prices on to consumers, the impact on profits has been cushioned by strong export demand so far.

Production controls have led to higher commodity prices

China is a major producer and consumer of commodities such as coal, steel, aluminium, and copper. Production controls have exacerbated a supply-demand imbalance aggravated by rebounding demand in developed markets, a delayed recovery in supply in many emerging markets, and logistical bottlenecks (although we expect these pressures to ease by the end of the year). As a result, prices of major commodities surged in the first half of 2021 and China’s domestic producer price index (PPI) jumped to 9% year-on-year in May (Figure 1).

While the Chinese government has expressed concern about the commodity price surge, we do not expect any significant tightening of monetary and foreign exchange policies. Indeed, the government just cut the reserve requirement ratio (RRR) for banks to avoid over-tightening risks and ensure adequate support for the recovery. The government has taken measures to reign in speculative commodity trading and fine-tune the pace of carbon-related production curbs on steel, aluminium and coal. In response to speculation China may allow more currency appreciation to offset imported inflation, the People’s Bank of China (PBOC) has reiterated its goal to maintain the Chinese yuan exchange rate around an "appropriate and equilibrium level”. We have observed that the PBOC has taken measures to slow the pace of CNY appreciation in recent weeks.

Investment implications

We expect a broadly stable macro environment in China, but decarbonization initiatives should create varied investment opportunities. In the near term, leading players in upstream sectors such as coal, steel or other base metals could benefit from surging output prices, while profit margins could be squeezed downstream. In the next five to 10 years, demand for coal and other fossil fuels will likely remain supported by China’s growth and associated energy demand.

In the medium term, decarbonization is expected to boost demand for specific commodities. Base metals such as aluminium and copper are widely used in renewable energy installation, electrical power grids, electricity storage and manufacturing of hybrid and fully electric automobiles – all areas where China will need to significantly increase capacity. This should provide some pricing support, offsetting the impact of slowing infrastructure and housing investment.

However, longer-term, China’s demand for fossil fuel commodities should diminish as the country switches to clean energy. This will be negative for owners of coal and oil assets, with risks relating to the viability of what would typically be considered long-term assets.  More broadly, sectors related to renewable power generation and transmission and distribution of electricity could benefit from government support and the rebalancing of the economy, providing attractive opportunities for investors.

For insights into our outlook for the global economy in the year ahead and the investment implications, please read our latest Cyclical Outlook, “Inflation Inflection.”