SMOKE AND MIRRORS
China’s central government is serious about cleaning the environment, but local officials can turn compliance into a nightmare.
By Bennett Voyles

For over 15 years, local environmental activist Wu Lihong had complained that the condition of Lake Tai was deteriorating.

The third-largest lake in China, historic Lake Tai is an important local resource – a major scenic destination and the source of drinking water in Wuxi, the industrial town south of Shanghai that is also home to a major fishing industry. Increasingly, it’s also become a receptacle of choice for raw sewage and the industrial waste of hundreds of factories.

When, in May, a huge blue-green algae bloom in the lake west of Shanghai left several million people without drinking water for nearly a week, Wu might seem to have been vindicated. After all, he had warned for years that this very thing might happen, and tap water that smelled like vomit corroborated his view. In the aftermath of the crisis, several local officials were fired or demoted. The premier of China himself, Wen Jiabao, announced that the crisis had “sounded the alarm for us” and launched a formal investigation.

And Wu? In some places, the 40-year-old former salesman would be considered a local hero. But as of July 1, Wu was in jail, where he has been since April 13. Officials allege that he tried to extort about 55,000 renminbi from local industrialists. His wife and friends say the charges are laughable, and are actually revenge for an attempt to persuade the central government that nearby Yixing did not deserve a recently awarded title as a Model Environmental City.

Wu’s trial had been scheduled to begin in June, but his wife (herself under 24-hour house arrest), told reporters that the judge has delayed his trial to an unspecified date to investigate her claims that he has been beaten and tortured.

Hard to see

So what is China’s real environmental policy? Is it the policy of the central government, which vows to make dramatic changes? Or is it the policy of the local governments – a group so pro-business in Jiangsu province, at least, that it could jail and beat a peaceful environmental activist, and keep him in prison even after events proved he was not an alarmist?

The answer, experts say, is both.

On the one hand, the central government is serious about stopping China’s environmental decline. Most experts agree that the intentions of the central government are genuine.

Faced with the prospect of energy shortages and disruptions to the food and water supply, the government now sees improving the environment to be almost an issue of national security. “These people know very well that if people get poisoned by water … they’ve got to do something about it,” says Vaclav Smil, a professor at the University of Manitoba in Canada.

For the central government, two things are now becoming clear, says Boqiang Lin, a professor of economics at Xiamen University, and director of the China Energy Economic Research Center. “One thing is that the growth of energy consumption at this pace is not going to work. The second is that environmental pollution, going at this pace, is also not going to work.”

The government is trying to make changes on a variety of fronts. China’s 11th five-year plan contains new targets to curb the growth rate of its energy consumption. The new rules commit the country to increase energy efficiency by 20% per unit of GDP in the next five years. VAT refund rates are being changed to discourage export of energy-intensive, low-margin goods. Some plants are being closed down – such as the Shougang Group’s landmark steel plant in Beijing – and officials fired. The public naming of non-compliant companies, through the publication of “name and shame” lists, is being encouraged by an increasingly media-savvy State Environmental Protection Administration (SEPA).

On the other hand, the 300 people who work at SEPA can only do so much. Most enforcement is local, and at the local level, inspection standards vary wildly, say CFOs and environmental law experts.

Although SEPA won the right to appoint the heads of the provincial environmental protection agencies a few years ago, most of China’s more than 100,000 environmental inspectors are responsive to local rather than central government pressure, according to Lester Ross, a partner in corporate law in the Beijing office of Wilmer Cutler Pickering Hale and Dorr.

In the past, these local officials tended to worry more about jobs than pollution. “Most would say, essentially, ‘We don’t care what you do – I promise I’ll keep my eyes closed,’” says a China-based environmental consultant, who asked to remain anonymous. When a rare inspection finally did occur, inspectors would typically provide some advance warning, giving the company enough time to shut down any offending process and pass its inspection.

This is still often the case, says the source. However, others find that inspectors are stepping up the pressure to comply. Robert Li, CFO, Asia Pacific, for Hallmark Cards, says that many of his company’s 300 suppliers in China now say they are finding that inspectors are becoming more stringent.

“It’s changing quite a lot,” agrees the CFO of one large Western company’s China unit. Until recently, he says, the local government didn’t raise many regulatory challenges, and those that surfaced could generally be fended off with gifts or through the use of connections. But these days, regulators are looking more often for facts and figures, not dinner. “Some [regulators] you probably need to do some payment,” says the CFO, “but some not. Some are just technical people who really just look at the figures.”

Many say that the strictness of inspection varies by province, with the richest Tier 1 prefectures generally the toughest, and Tiers 2 and 3 much easier to please. To the extent that the environment is an issue at all in many places, the old fundamentals still reportedly apply: a little regulation, a lot of guanxi. And in many places, a lack of technology and proper tools limits the amount of inspecting that can be done.

But Ross of Wilmer Cutler warns that when local officials do decide to step up enforcement, foreign companies are likely to be targeted first. “Foreign companies are more colorful and less politically dangerous to attack than domestic companies,” he says.

Foreign companies that adhere to international standards should have no problem in meeting Chinese standards, according to Ross. “For the most part, those will satisfy or exceed local requirements,” he says.

Companies that aren’t prepared, however, and who have relied on the assurance of local officials that they could safely ignore environmental laws, could have a harder time. “In such cases, they really have very little recourse except to ask for some postponement in the compliance deadline,” says Ross.

For a prepared company, this new level of scrutiny can be turned to an advantage. Eaton Fluid Power, which has three factories in China, has found that its emphasis on pollution control is providing it a whole new set of opportunities. Yan Jin, controller for greater China for Eaton Fluid Power, says that his company’s environmental successes are encouraging the government to be helpful to his company in other ways. Local officials have lowered some of their taxes, he says. Getting the approvals needed to buy new equipment or bring in more capital can also take a lot less time for them than for some of their competitors. “For other companies maybe it will take three months to get one approval. For us, maybe three days,” he says. Government officials even bring a lot of potential customers to Eaton.

2,500 rules to follow

Companies that haven’t managed to acquire this kind of green halo could have their work cut out for them.

Complying with China’s approximately 2,500 health, safety, and environmental regulations isn’t always easy. In fact, even companies that want to follow the regulations have difficulty. “If you have a target or a goal to be 100% compliant, think again,” says the China-based consultant. “It’s almost impossible in China.”

Sometimes the laws are not written clearly, he explains. Or there is no mechanism for enforcement. A regulation might require filing a report, but local officials haven’t designated anyone to accept it.

Technical vagueness can also be a problem. For example, the consultant says, China has 47 categories of hazardous waste. However, unlike environmental rules in developed countries, there are no allowable concentrations, making it nearly impossible to design a system that guarantees compliance.

To add to the complexity, local jurisdictions have their own sets of regulations and enthusiasms. Beijing, for example, is getting extremely tough in its effort to clean itself up in time for the 2008 Olympics, shutting down plants and putting a moratorium on construction during the entire Olympic year. This can be true sometimes even district by district within cities: Pudong and Puxi, both districts within the city of Shanghai, have different rules, according to George Pan, finance and IT director, North Asia for Sidel, a maker of beverage packing equipment.

With so many different rules and so much regional variation in enforcement, companies generally have to decide not whether to be 100% compliant – which is often not possible even to define, let alone achieve – but what degree of environmental risk they are willing to accept, according to Oliver Liu, head of the Shanghai office of Golder Associates, an environmental consultancy. “Basically,” says Liu, “you have to make your own judgments and set your own goal of the bottom line of how much risk you can tolerate.” Costs of that comfort can vary enormously. Sometimes, he says, there can be a tremendous cost difference in a move just from 95% compliance to 99%.

Coming clean

Companies have developed a number of ways to cope with the compliance risk.

Some companies are reportedly shifting their dirty, lower-margin manufacturing to Vietnam, circumventing rising wages and a toughening regulatory regime in China at the same time. For most companies, however, such a shift won’t be an option. The US and western Europe exported some of their environmental problems to China, but China can’t outsource its problems: there’s no place else large enough to absorb all those plants, says Lin, the energy economist.

Others are simply spending more time trying to understand the rules and stay ahead of them. Jin of Eaton Fluid Power says he makes sure his office keeps up with changes in the rules, in part by maintaining a good relationship with local regulators.

Knowing the regulators can have other advantages as well. While rules can’t be changed, says Liu of Golders, the way they are interpreted can often be negotiated. “I don’t think anybody would say, I can change the rules for you. Nobody would do that. But can you negotiate a better deal for yourself? Absolutely,” he says.

Some may look at outsourcing environmental risks to subcontractors, but this may have its own set of problems. As any number of multinationals have learned, conviction in a court of public opinion can be even more dangerous than a regulator’s fine. So far, the attention of non-governmental organizations (NGOs) has focused mostly on multinational labor violations in China. The most prominent case involved Nike, blamed by NGOs for allegedly underpaying workers in China and elsewhere. But environmental issues have emerged more recently as an area of exposure and agitation. One group, the Beijing-based Institute of Public and Environmental Affairs, even posts the names of alleged malefactors on its website (www.ipe.org.cn).

Experts say that NGO and investor pressure is likely to grow. And beyond the publicity risk, companies that use a supplier who hasn’t kept up with legal requirements may be exposing themselves to other potential problems, since a supplier who is not in compliance with environmental and social legal requirements is a supplier at risk of being shut down or fined.

Partly to avoid such risks, Hallmark inspects the plants of every potential new supplier. The card-maker’s engineers go into the supplier’s factories to inspect the production processes not just for production quality but also for environmental compliance, according to Li. “We take everything into consideration,” he says.

Nor do these inspections stop once the supplier is signed up. Hallmark gives each of its over 300 subcontractors an annual environmental audit by a third party inspection firm. Usually, such audits are a day’s work for two to four auditors, depending on the size of the factory, says Li. Such audits cover the issue of whether the company has all its proper certifications from local offices. Beyond collecting all that paper, auditors also make a physical tour of the perimeter of the factory, to make sure industrial water isn’t being dumped.

One opportunity to reduce risks that few companies have looked into is insurance coverage for environmental risks. “People believe that they have pollution cover under their property and general liability policies, but there are, in most cases if not all, huge gaps or restrictions in pollution cover,” says Jim Finnamore, environmental practice leader, Asia, for Marsh, the insurance broker. “Things like first-party clean-up costs aren’t normally covered under a general liability policy, so if you have a spill, the cost of cleaning that up is not covered,” warns the Singapore-based executive.

Corporate social responsibility initiatives, such as sustainability reporting, may also be serving some risk management purposes. Increasingly, many global companies are producing sustainability reports, which detail the company’s social and environmental impact in the past year. Such reports are typically prepared under the auspices of finance and provide qualitative estimates of the company’s environmental impact and are sometimes audited by a major accounting firm. Most top multinational corporations prepare them now, according to Philomena Leung, a professor of accounting at Deakin University in Australia, and she says she expects that they are likely to become more popular in China because of the concern over social and environmental issues.

But is it worth it? Some have dismissed sustainability reports as ‘greenwashing’, a public relations gimmick that helps companies avoid real changes. Although many companies now hire large accounting firms to audit the results, not everyone is convinced. Two skeptical academics, Wayne Norman and Chris MacDonald, have written that such efforts “are best only for facilitating hypocrisy.”

William Valentino, general manager for corporate communications for Bayer in greater China, and director of its corporate social responsibility efforts, argues that there are a number of reasons to undertake sustainability reports and other corporate responsibility initiatives. Although such community-directed projects are good for branding and employee retention, he says, CFOs should look at them as an exercise in risk management as well.

Western investors may emerge as another important audience for these kinds of initiatives. Some private equity funds are reportedly becoming concerned about investing in Asian companies that have a lot of unquantified environmental risk. “As part of their due diligence exercise, they’re looking to manage the environmental risk that they are buying into,” says Finnamore. He points out that many large banks are also now anxious about environmental risk. The global banks that underwrite 85% of the world’s crossborder project finance have signed the Equator Principles, under which they agreed not to lend more than US$10m to any project that doesn’t meet certain environmental standards.

A matter of incentives

Despite the urgency for change, however, it may be some time before environmental compliance is as serious an issue in China as in most developed countries.

Local officials’ incentives are still largely stacked in favor of economic growth, not environmental quality. The last effort to change that equation was undertaken by Pan Yue, the outspoken vice minister of SEPA. Two years ago, Pan tried to initiate a green GDP measure that incorporated the economic impact of environmental degradation, but provinces balked, as did the National Bureau of Statistics, which even refused to release this year’s statistics publicly.

“The failure of the Green GDP experiment is indicative of the continued power of local officials and the overwhelming priority on growth at all costs,” says Elizabeth Economy, a senior fellow at the Council of Foreign Relations in New York and author of The River Runs Black: The Environmental Challenges to China’s Future (Cornell, 2004).

Even if more of the laws were enforced, they may not be strong enough to change much, say some skeptics. In 2005, for example, PetroChina was fined for a benzene spill that shut down the water supply in Harbin for five days in 2005. The fine paid by the US$80 bn company for depriving 3.8m people of their drinking water? US$112,000, according to Liu. “Less than a drop in a bucket,” he says.

Liu believes that until three things change, environmental rules won’t be tightened meaningfully. The first is that legal liability is still low. Second, he says, few people outside the government and the companies involved ever know about environmental problems, because contact about regulatory compliance is strictly between the agency and the enterprise. Third, this lack of public information about local environmental quality makes it difficult for the public to put pressure on the government. “If the public does not know what is happening in my neighborhood, how do you expect them to react?” he asks.

Gradually, then suddenly

Smil, the environmental professor, believes that at some point the government will have to become more vigilant about environmental regulation, if only to protect its food supply. Unlike the US, for example, where most food is grown far away from its most polluted cities, China is so densely populated, he says, that there is no distance between the agricultural centers and the population centers. “The Chinese grow food right where people are. When you start polluting in China, you are polluting agricultural areas,” Smil says.

Nor will importation be an option. Japan might import 75% of its grains, but China can’t. “China can never import most of its food. It’s just too big for it,” adds Smil.

Faced with a crisis, Smil and others predict that the government will eventually act more swiftly. And when the government starts a campaign about something, companies should watch out. “Sometimes the changes can be very dramatic or very aggressive,” says Yan of Eaton Fluid Power.

Yan says the system can be extremely tenacious when it finally chooses a course. Once, he says, his company went through eight tax audits in one year because regulators had decided that something was wrong at his company. Nothing out of place was ever found, he says, and they finally gave up.

“The same thing also applies for the waste water inspection,” he says. “Once you are prepared, once you’ve presented your case well, once you’ve showed them what you have, they never come back.”

Assuming such a shift is on its way, it’s best to make sure you’re prepared in advance, Yan advises. “Either you’re proactive and anticipate the change or you’re going to be late.”

Bennett Voyles is a paris-based business writer