China is dropping its focus on “dirty” industrial growth, while making a massive shift toward renewable energy and a less resource-intensive path to economic success. This reorientation could open up substantial opportunities for equity investors.

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When it comes to the environment, China has a dubious record. Over the past three decades, the world’s second-largest economy has been criticized for pursuing its economic growth agenda without paying much attention to how this enormous industrialization process has hurt the environment.

But things are changing. In 2016, China signed the Paris climate accord, and the country has since renewed its commitment to the treaty despite America´s dropping out. The Asian giant has changed tack and is increasingly setting its economy onto a more sustainable growth path. This has significant implications for the global climate and environment, as well as for investors in Chinese equities.

Pollution Solutions

We believe that this shift is not temporary, but here to stay. Why? Because the Chinese government isn´t going green to improve its image in the West. Rather, it has come to realize that there is a pressing need for better air and water quality. As pollution levels have risen to dangerous levels in many industrialized and heavily populated areas of the country, it’s clear that China’s growing middle class simply won´t tolerate these conditions for much longer.

So what is the government actually doing? And how will these decisions impact various segments of the stock market?

Cleaning Up Their Act

The government’s top priority is to shrink the dirty segments of the economy. First, it must reduce the amount of particulates in the air and assure the supply of clean water. Second, the government aims to adhere to greenhouse gas reduction goals. So, the government is combining its environmental policy objectives with its efforts at tackling overcapacity in resources industries by closing the worst offenders in the steel, paper and chemical industries.

Reduced supply and less competition improves the pricing power of the bigger players in the polluting industries. And higher profitability enables these companies to invest in more emissions reduction, which ensures that they don´t fall foul of the stricter regulatory demands.

Not Just Idle Talk

In the past, reform initiatives have had limited success. Attempts by the leadership in Beijing to force through change at the provincial and local levels have been stymied by lax implementation, corruption and sheer refusal to comply. Today, though, local party leaders who seek promotion must score high in several reviews, with environmental improvement at the top of the list. One example: roving, nonlocal (and thus less corruptible) enforcement teams are conducting unannounced visits to plants.

What’s more, China’s public and private sectors are raising huge sums of money to finance environmental initiatives. Indeed, China’s issuance of green bonds jumped from less than US$1 billion in 2015 to US$23 billion in 2016, outpacing all of Europe, the runner up, according to the Climate Bonds Initiative.

Moving Up the Value Chain

Government efforts come as China is rapidly advancing in environmental technology. China is the world´s biggest producer of solar panels. Investment in the electrical vehicle supply chain and clean energy equipment is surging. It’s clear that China is no longer just the world´s workbench; it is increasingly developing its own technologies to support sustainable energy development. Solar and wind power are still a relatively small piece of China’s energy market (Display, left), but growth is rapidly accelerating (Display, right).

China

Two Buckets of Opportunity

Shifting government policy and technological development are creating two sets of opportunities for equity investors in China. The first is a set of companies that have emerged to fulfill the country’s new appetite for clean-tech and alternative energy. Often, these companies are growing fast, well run and amply funded by both government and private investors. Many are trading at a discount to their developed-market peers.

The second bucket includes companies that are the least-polluting players in sectors traditionally considered “dirty.” These might not typically be seen as green investments. Yet many of these companies are well run and have strong growth prospects, and are often overlooked by foreign investors. Moreover, they generally comply with environmental standards that are on par with—or even better than—global peers.

China´s shift toward more sustainable development is a secular and irreversible trend, in our view. A lot of work remains to improve environmental conditions and the country´s quality of living. And there will doubtless be hiccups along the way. But the Chinese government has recognized that its survival depends on succeeding in this quest. As these efforts unfold—alongside the opening of China’s equity markets—we think global equity investors will find exciting environmental opportunities in surprising places.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

Article by John Lin, Alliance Bernstein

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