Chinese Co-Chair: Zhang Kun

International Co-Chair: Hidefumi Imura

1. Introduction

1.1 Background

Insufficient environmental investment has long been a bottleneck hindering environmental protection in China. Although significant efforts have been made and have led to a number of achievements, the country’s environmental situation continues to deteriorate. In order to achieve the environmental objectives set down in the Tenth Five-Year Plan, a significant amount of investment is required in the field of environmental protection and pollution control. In many ways, China is on the road to establish a well-off society, but without introducing effective environmental measures, this may also bring about further negative impacts on the environment. In order to achieve a balance between economic growth and social development, ongoing efforts must be made for environmental protection. Also, ensuring a stable and safe living environment for the country’s population has been recognized as a growing need in Chinese society. Therefore, China has set high goals and is expected to initiate further actions for environmental protection. To this end, the Government of China has identified insufficient environmental investment as a serious issue and has prioritized it in its planning agenda. In addition, positive actions to explore financial channels may provide a breakthrough for environmental protection in the country.

The conditions necessary for researching and innovating financial mechanisms for environmental protection have begun to take shape. Over the past two decades of reforms, China’s economy has experienced rapid, continuous growth, and the state of citizens’ incomes and governmental finances have improved remarkably. With regard to the transformation from the planned economy to a market economy, China has achieved marked success in setting up a socialist market economy primarily. In terms of environmental protection, environmental management has undergone reform and innovation, with a focus on the market economy, and in the process has accumulated valuable experience and methods in researching financial mechanisms. Accession to the World Trade Organization (WTO) has also provided China with new opportunities to utilize international capital for environmental protection.

In this context, the China Council for International Cooperation on Environment and Development (CCICED) approved the establishment of the Task Force of Financial Mechanisms for Environmental Protection in China in the first year (2002) of its third-phase activities, and the Task Force has received financial support from the Government of Japan.

1.2 Objectives and subjects of study

The objectives of the Task Force are to identify key problems faced in the field of environmental investment and financing in China, in order to create innovative approaches to solve these problems, address environmental protection priorities, and make holistic and strategic policy recommendations to the Government of China.

The results of the analysis on the current status of environmental investment and financing illustrate that insufficient investment and low investment efficiency are the two key problems faced in this area, as discussed in detail in Chapter two. These problems are obvious in the field of urban environmental infrastructure (UEI) and pollution control in small- and medium-sized enterprises (SMEs) . Although the problem of low investment efficiency is not directly associated with the mechanisms of investment and financing, it directly affects the effectiveness of investment.

Therefore, the Task Force chose urban environmental infrastructure (UEI) and pollution control for SMEs as its areas of research. It is hoped that the study will contribute to finding the solution to these problems, especially in the context of insufficient investment and low investment efficiency.

In the field of UEI, research was undertaken on how to establish a mechanism to utilize non-governmental investment entities and commercial financing approaches. It is apparent that foreign funds should also be fully mobilized for environmental protection. Regarding the pollution control in SMEs, the study focuses on establishing specialized financing mechanisms and institutional arrangements under governmental support. In addressing the improvement of funding efficiency, the study focuses on the two areas, in view of achieving market-based approaches to the construction and operation of pollution treatment facilities. It is also expected that introducing market-based approaches will increase the efficiency of the investment itself.

2. Current situation and key issues in environmental investment and financing in China

Insufficient investment and low investment efficiency are the main obstacles blocking effective environmental protection investment and financing in China. In particular, these problems are prominent in the two fields of UEI and SMEs’ pollution control. Although many other factors contribute to the problem of insufficient investment, from the perspective of investment and financing mechanisms, the absence and insufficient functioning of social investment entities other than government and polluters and the lack of commercial financing methods could be other important contributing factors. These are closely related to the China’s under-developed financial market and credit system as well as the absence of a mechanism to absorb and mobilize the capital that has accumulated in society in the process of rapid economic growth. Meanwhile, the lack of competition in the construction and operation of pollution control facilities is another important reason for the low efficiency of environmental investment in China. The above-mentioned characteristics and present situation constitute the key issues in environmental investment and financing in China.

2.1 The issue of insufficient investment

A. Investment in environmental protection in China has been increasing rapidly, but total investment is still insufficient to meet needs.

Since the 1990s, the Government of China has placed greater importance on environmental protection, and, as a result, investment in environmental protection has increased rapidly. The sum of investment in environmental protection was 360 billion RMB during the period of the Ninth Five-Year Plan (1996-2000), which is 2.6 times that of the Eighth Five-Year Plan period (1990-1995), and in 2002, it reached 1.12% of the country’s gross domestic product (GDP). Investment in environmental protection increased substantially after the Government adopted a pro-active financial policy. Environmental investment (including funds for ecological construction) between 1998 and 2002 was 580 billion RMB—1.7 times as large as between 1950 and 1997—and accounted for 1.3% of GDP. The current environmental investment in China is equivalent to that of middle developed OECD countries in the early 1990s. Urban environmental infrastructure is one area in which investment is growing rapidly; its share of overall environmental investment rose from 33% in 1991 to 55% in 2002.

The current investment in environmental protection, however, is far from adequate to meet actual demand. In the Ninth Five-Year Plan period, despite the adoption of a positive financial policy, actual environmental investment did not quite reach 450 billion RMB, and in fact there was a shortfall of 90 billion RMB compared to the amount initially planned. In the Tenth Five-Year Plan period, the investment required for environmental protection is 700 billion RMB. According to a preliminary estimate, the investment demand for environmental protection in the Eleventh Five-Year Plan (2006-2010) period is expected to be about 900 billion RMB, or 1.1% to 1.3% of GDP in the same period. If the current investment and financing mechanisms are not reformed, investment shortfalls will worsen, which may hinder the implementation of China’s environmental protection plan.

B. Insufficient investment is especially prominent in the fields of urban environmental infrastructure and SME pollution prevention and control.

Insufficient investment is a problem common to many aspects of environmental protection in China, and it is especially prominent in the fields of UEI and SMEs’ pollution prevention and control—the two weakest areas of environmental pollution control in China. From the mid-1990s, the focus of environmental protection was on the treatment of industrial pollution, while urban domestic pollution, such as household wastewater and solid waste, was considered a minor issue. Due to rapid urbanization, the growing problem of urban domestic pollution has become increasingly prominent, while construction of related treatment facilities has lagged far behind. This has resulted in a huge demand for funds for the construction, operation, and maintenance of treatment facilities. In industrial pollution prevention and control, attention has always been placed on the large- or medium-sized polluting enterprises (including some SMEs). No special policies exist to support SMEs in investment and financing, which has left them to face certain difficulties alone in investing and financing pollution prevention and control.

B-1 Urban environmental infrastructure is underdeveloped and faces serious funding deficiencies.

Since the introduction of its reform policies, China has undergone rapid urbanization, with the urbanization rate of the population currently at 37%. By 2010 and 2020, this rate is expected to increase to 46% and 55%, respectively. Growth in the number of cities and an expansion of existing cities will result in a corresponding increase in the volume of urban domestic wastewater and solid waste. Over the past decade, discharges of urban domestic wastewater have increased by 5% annually. In 1999, the amount of urban domestic wastewater discharged exceeded that produced by industry for the first time. In 2002, the amount of urban domestic wastewater discharged reached to 23.22 billion tons, accounting for 52.9% of China’s total emissions of wastewater, and urban domestic solid waste increased by between 5% and 8%. In 2002, the amount of urban domestic solid waste generated reached 1,360 million tons. It is predicted that by the year 2020, the production of urban domestic wastewater and solid waste will increase by between 1.3 and 2 times the volumes discharged in 2000.

Existing facilities for treating urban domestic wastewater and solid waste, however, are seriously deficient, and new construction is lagging behind. By the end of 2001, the rate of primary treatment of urban domestic wastewater was merely 36.4% of the total amount produced, of which only 18% received secondary treatment. The municipal solid waste disposal rate was 58.2%, of which only 10% received sanitary treatment and disposal.

According to China’s environmental protection plan for the Tenth Five-Year Plan period (2001-2005), the treatment rate of centralized urban domestic wastewater is targeted at 45% by 2005, and the rate in cities with populations larger than 500,000 is targeted at 60%. Under the plan, the increased capacity of sanitary treatment and disposal of urban solid waste is supposed to be 150,000 tons per day. In order to realize the above objectives, China will need hundreds of billions of RMB to construct treatment facilities for urban domestic wastewater, and 45 billion RMB to invest in the construction of domestic solid waste treatment facilities. The Task Force predicts that during the Eleventh Five-Year period, the investment required in these two fields will be around 170 billion RMB. Under the current investment mechanisms and capabilities, it will be very difficult to satisfy these demands. For some local areas, the problem of insufficient funding for construction of urban environmental infrastructure will be very serious.

B-2 Specific difficulties faced by SMEs

SMEs play a significant role in China’s national economic development plan, evident in the fact that 99% of all enterprises in China are small- and medium-sized organizations. They contribute 50.5% of the nation’s GDP and 76.6% of total value-added by industry and 43.2% of revenue, as well as 57.1% of commodity sales value. Most job opportunities are found in SMEs, which is over 75% the corporate employment rate. Among the annual export value of 200 billion dollars in recent years, SMEs accounted for about 60%. Owing to their flexibility and innovative characteristics, SMEs are the core driving force in the nation’s industrial development and economic restructuring, and they play a crucial role in the optimization of resource allocation.

At the same time, SMEs are the major source of industrial pollution in China. According to preliminary estimates by the Task Force, SMEs contribute about 50% of total industrial pollution discharges, and this proportion is increasing. In contrast to large point sources of pollution, the fact that SMEs are large in number and spread out over large areas has also caused difficulties in pollution management.

SMEs are predominant in sectors such as paper-making, the leather industry, electroplating, printing and dyeing, cement manufacturing, brick making, and mining for coal, ferrous and non-ferrous metals, and non-metal minerals, etc., all of which employ unsophisticated technologies but present difficulties in pollution treatment.

Industry has generally been regarded as a target area for improving environmental management, but SMEs have not been specifically identified for improvements in management and service and for implementation of the polluter-pays principle. Taking advantage of the recent industrial restructuring, a large number of SMEs identified as serious polluters have been given administrative orders to close down. In general, either actively or passively, most SMEs are taking positive steps towards pollution control; however, they face the critical problem of insufficient funds for taking such actions. First, their poor economic capacity limits their ability to fund pollution control by themselves. Second, it is difficult for them to obtain financial resources for pollution treatment due to its high cost and the risky nature of financing and credit. Third, SMEs are at a disadvantage because they cannot apply for government funds for environmental protection, nor can they benefit from subsidies provided by local governments.

B-3 Lack of sound investment and financing mechanisms is an important cause of insufficient investment in environmental protection in China.

Insufficient investment in environmental protection in China is mainly caused by the excess demand for investment and the undeveloped state of current investment and financing mechanisms. Since these mechanisms are controllable and changeable over time, they were chosen as the focal point of this Task Force.

The large demand for funding is determined by the severity of China’s environmental situation and quality as well as the Government’s environmental protection objectives. Now experiencing rapid economic development, China must face not only the problems emerging from industrialization (e.g., industrial pollution, urban domestic pollution, destruction of ecological systems), but at the same time it also faces newly-emergent problems, including global environmental issues. In this context, China faces environmental challenges that are more severe than those experienced in any developed country. In order to solve such complex environmental problems, a large amount of investment is needed. On the other hand, economic growth continues where rapid urbanization is shaping the creation of an affluent society. In addition, in order to satisfy the needs of social development in China, environmental objectives must be set high.

The shortcomings of existing investment and financing mechanisms are the most significant causes of insufficient investment in environmental protection today. As the country develops a clearer picture of its needs for environmental protection, and as China makes progress with reforms of its economic system (including overall national investment and financing systems), the future structure for environmental investment and financing is taking shape in China, with the involvement of multiple investment entities, financing channels, and instruments. The multiple entities include governments, environmentally-liable social entities (e.g., polluting enterprises), and non-environmentally-liable social entities (e.g., enterprises and other profit-oriented and non-profit organizations). The multiple channels and instruments include public budgets, environmental levies (from enterprises and non-profit organizations for pollution discharge and from urban residents for wastewater treatment and waste disposal), treasury bonds, government loans, funds from enterprises, enterprise loans, and private funds, etc.

In terms of the roles played and contributions made by the entities and various instruments, however, the current mechanisms reflect the following characteristics: (1) they mainly rely on measures and channels under governmental plans, e.g., public budgets, environmental levies, and treasury bonds, etc.; (2) measures related to non-environmentally-liable social entities and public fund-raising approaches are either insufficient or non-existent; and (3) levy systems for urban domestic wastewater treatment and waste disposal are still at an initial stage and they have not been fully utilized. According to initial estimates, about 60% of urban solid waste is subject to a levy to pay for treatment, with the price ranging between 0.2 to 1.2 RMB per ton, while only about 16% of waste is subject to a levy for solid waste treatment and disposal.

The above-mentioned problems in investment and financial mechanisms are the main causes for the insufficient investment in environmental protection, particularly in urban environmental infrastructure. According to a study, governmental and public funds account for more than 70% of the expenditures for environmental protection in China. Conversely, in countries under a market-based economy, such as the United States and the United Kingdom, the private sector accounts for 60% of pollution abatement expenditures. Although financing has been increasing significantly in recent years, mainly through governmental channels, the huge need for investment in urban infrastructure construction in China has barely been satisfied. Investment in urban environmental infrastructure mainly relies on tax revenues, local financing, and treasury bonds. Over the past decade, investment in urban environmental infrastructure increased rapidly. In terms of SME pollution control, the shortage of funding is mainly caused by the unfavorable position of SMEs, under the current financing and investment system and mechanisms for industrial pollution control. Low environmental awareness and weak enforcement of environmental laws also contribute to the lack of incentives for corporate investment in pollution control.

2.2 The problem of low investment efficiency

Due to the growing demand for financing, and despite inefficiencies nationwide, China has started to introduce market-based approaches for pollution prevention and control. The low efficiency of environmental investment in China is mainly reflected by inefficiencies and problems in the construction, operation, and management of urban wastewater treatment and solid waste disposal facilities as well as in industrial pollution treatment facilities.

For years, in the field of urban environmental infrastructure, the government has been the main source of funding for construction of these facilities, with non-profit organizations responsible for their operation and management. This type of government monopoly excludes institutional competition, which in turn contributes to the problem of low investment efficiency. In this regard, similar situations have occurred in the past in developed countries—and in some cases still exist. But the problems formed under the planned economy are especially complicated and severe. In industrial pollution control, China implemented a single basic policy that states that the polluter is the one responsible for treatment, and, subsequently, all polluting enterprises built and operated their own treatment facilities. Little consideration was given to leaving pollution treatment to specialized enterprises through a levy mechanism, which could bring about efficiencies in the division of labor and economies-of-scale into full play. Because of this, implementation of the “polluter treats pollution” policy caused investment inefficiencies for SMEs. The emergence of this situation in China was clearly associated with the development process of the environment-related service sector.

With the advancing reforms of the market economy system and the ongoing development of the environmental service industry, a pattern of so-called "marketization" emerged in China for pollution treatment at the end of the 1990s, based on international trends favoring practices such as PPP and PFI . In the field of urban environmental infrastructure, marketization is contributing to a break-up of the government’s monopoly structure. This was carried out at three levels: (1) levying urban residents for household wastewater treatment and waste disposal and opening up the development of urban environmental infrastructure through public bidding; (2) demolishing the system of government-dominated construction and operation by introducing competitive mechanisms (i.e., enterprises take over commercialized management of existing facilities); (3) encouraging the participation of other economic entities , apart from government agencies, in the construction and operation of the facilities, attracting capital that has accumulated in the society; and (4) establishing a management system, under which various entities participate in facility construction. The corporate operation of those facilities is also based on market mechanisms.

In the field of industrial pollution treatment, the essence of marketization is that either specialized enterprises can be chosen to treat pollution through a levy system, with division of labor and economies of scale, or enterprises can handle their own pollution treatment if it is cost-effective. The market-based approach may not only improve investment efficiency but also contribute to increasing the chances of securing financing.

Since market-based patterns could increase investment efficiency and secure financing, active reforms have been undertaken in recent years in China. Ground-breaking progress has been made in both shifting policy and practices for the marketization of pollution treatment, although these are still at their initial stages in the context of China’s overall situation.

3. Guiding principles and overall strategies for designing financial mechanisms for environmental protection

3.1 Environmental financing as a tool for environmental management

Environmental financing is a tool used to implement environmental policy, but without a proper mix of funding and technology, it cannot be effectively enforced. The scale and range of financing should be properly designed and determined according to the environmental policy goals of the state or region.

The primary objective of environmental financing is to raise the funds necessary for special environmental protection purposes, but the choice of financial instrument may have far-reaching implications, including various economic and social impacts. Therefore, financial mechanisms should be properly designed so that they can meet multiple economic and social objectives, such as the improvement of investment efficiency, correction of market and government failures, and the achievement of equity goals (i.e., income redistribution, re-adjustment of regional gaps). Among others, improving the efficiency of environmental projects is a key issue to consider in designing functional environmental financing mechanisms in China. Moreover, in the reform of its economic system, the development of environmental financing mechanisms focused on marketization is especially vital in order for China to achieve both its economic and environmental objectives. In this regard, the following strategies should be considered in order to address the problems of insufficient investment and low efficiency:

(1) Environmental protection requirements should be met by designing financial mechanisms that incorporate the polluter-pays principle and the user-pays principle. Efficient financing and social equity (equity between well-off and impoverished population/regional distribution) and financial risk mitigation, should also be taken into account

(2) The roles of the various actors in investment should be clearly defined. Among them, the Government should play a lead role by (i) implementing and enforcing environmental laws and regulations, (ii) increasing the amount of investment in its fiscal budget, and (iii) promoting financial procurement from the market.

(3) Investors other than the Government and polluters should be encouraged in environmental investment. To this end, the establishment and improvement of market-based financial mechanisms should be given high priority.

(4) UEI construction and SME pollution control should be designated as priorities in the efforts to establish effective environmental financing mechanisms.

Among the multiple channels available for financing and investing in environmental protection, the main ones are governmental and commercial. After two decades of stable and rapid economic development, China has witnessed a dramatic increase in the level of government financing, and the Government, at all levels, has strengthened inputs in environmental protection. It is recommended that it should further strengthen the facilitation of the less-developed western region in environmental protection. Capacity building for environmental management and urban environmental infrastructure construction should be prioritized.

The development of commercial financing instruments should be included in development planning, and existing financial resources in the country should be mobilized for environmental protection, in particular, for the construction of urban environmental infrastructure.

In addition, in light of international experience and practices, the design of China’s investment and financing mechanisms should include utilizing governmental budgets, specialized funds, or other economic measures such as policy-oriented investments, project financing, long-term financing, and foreign direct investment (see Table 1).

Table 1. Main options for environmental investment in China.