Multinationals should be capitalizing on potential market-based opportunities created by China’s green policy change, write Paul Davies, Kimberly Leefatt and Andrew Westgate

In recent decades, the US and Europe have introduced a variety of market-based incentives as instruments of environmental policy and reduced their reliance on command-and-control-style regulation. Examples include fees on the discharge or emission of pollutants, such as the UK’s climate change levy, tradeable credit programmes such as the acid rain programme in the US, and carbon-trading programmes including the EU emissions trading system (ETS) and the California cap-and-trade programme.

Until recently, China employed a predominantly command-and-control-style approach to environmental regulation, where regulators specified both the standards that must be achieved and the technology and pollution control strategies to be employed by potential polluters. This approach was exemplified by the environmental impact assessment (EIA) system in China.

For many years, the EIA system provided the only method by which pollution control requirements were imposed on companies, by incorporating the requirements into the EIA. EIAs have not, however, proved an effective basis for permitting discharge, from either a regulatory or a business perspective. As China has sought to modernize its environmental governance, the country has also shifted its environmental policy emphasis and increased its use of fiscal and market tools in environmental governance.

EPL ARTICLES 21 AND 22

China is the largest consumer of energy and producer of pollution, which poses great challenges for its much-desired green transition. Driven by the recognition that command and control measures tend to be reactive and do not incentivize industrial firms to protect the environment, China is redirecting its efforts and employing its powers under the Environmental Protection Law (EPL) to change direction.

In particular, article 21 of the EPL calls for direct incentives for environmental industries in the form of “fiscal assistance, taxation, prices and government procurement to encourage and support the environmental industries”. Article 22 focuses on incentives to improve the environment in excess of mandated requirements, and provides that “governments shall adopt policies and measures in finance, taxation, price, and government procurement, among others, to encourage and support further pollutant discharge reduction by enterprises, public institutions, and other businesses after meeting the statutory requirements for the discharge of pollutants”.

Although the EPL is primarily a framework providing for more detailed requirements, this emphasis on market-based measures represents a marked shift in policymakers’ thinking with regard to environmental compliance.

The Measures for the Implementation of Consecutive Daily Penalties by the Responsible Environmental Protection Departments – issued by the former Ministry of Environmental Protection (now the Ministry of Ecology and Environment, or MEE) shortly after release of the EPL – standardize the implementation of daily penalties imposed against polluters. The measures specifically identify five types of environmental crime relating to illegally discharging pollutants and falsifying monitoring data, but also allow local authorities to increase, as necessary, the types of offences that are punishable by consecutive daily penalties. There is no limit to the number of consecutive daily penalties, which incentivize polluters to address compliance violations quickly.

China is now aggressively developing policies to establish economic incentives for industry and the general public to change their culture of growth at all costs, under which China has prospered but which has also led to massive environmental issues as a result of the nation’s rapid industrialization. By setting goals and performance standards without relying solely on reactive penalties, China is embracing market tools in order to develop a more effectual culture of environmental protection.

SOIL POLLUTION PREVENTION AND CONTROL

The recent passage of the Soil Pollution Prevention and Control Law, in August 2018, is a major development in the management of soil and groundwater contamination issues in China. Article 59 of the new law imposes obligations on land-use rights holders – land is leased, not owned, in China – to investigate potential contamination on the occurrence of certain triggers, and provides for private action remedies against responsible parties. These concepts force firms to conduct environmental due diligence on parcels of land, so as to avoid incurring responsibility for potential contamination. Thus, the market will bear much of the burden of identifying and assessing contaminated land.

The Soil Pollution Law implements the “polluter pays” principle, forcing companies to take into account potential liability for pollution in making business decisions, and creating a significant incentive to conduct robust due diligence on new ventures or acquisitions. Article 3 imposes strict liability on the polluter for the cost of addressing soil contamination, as well as the burden of devising a specific plan to restore the polluted land. The polluter is also liable for the investigation and assessment costs incurred by the government. If there are uncertainties about the identity of the polluter, the local branches of MEE and other agencies (depending on the type of land at issue) are directed to jointly investigate responsibility for the contamination.

According to article 96, polluters will be liable to pay damages for the personal or property injuries caused by the contamination. If the identity of the polluter cannot be determined, the land-use rights holder will be liable for the cost of performing pollution risk management and remediation of the polluted soil.

Interestingly, article 73 of the Soil Pollution Law provides that “enterprises engaging in soil pollution risk control and restoration activities shall enjoy tax benefits under the laws and regulations”. Applying tax benefits to environmental restoration is a similar approach to that adopted by the Land Remediation Relief Scheme (or contaminated land tax relief) in the UK, where businesses can claim a deduction in their corporation tax for revenue and capital expenditure incurred through remediation of certain derelict or contaminated pieces of land or buildings. Companies can deduct up to 150% from their corporation tax when calculating taxable profits. Similarly, “brownfields” programmes in many US states provide tax incentives for redevelopment of contaminated land once the land has been remediated to the point that it can be repurposed and reused. Allowing companies in China to realize similar tax benefits will help incentivize them to identify and remediate contamination. Article 71 provides for establishment of a soil pollution prevention and control fund.

Article 72 outlines that the state encourages financial institutions to increase credit availability for soil pollution risk control and restoration projects. Under this article, the state also encourages financial institutions to conduct soil pollution condition investigations when participating in financial transactions involving land rights as security interest, just as Phase I investigations are typically required in connection with such financing in the US. The Soil Pollution Law will come into effect on 1 January 2019.

EPTL PENALTIES SEVERE

The Environmental Protection Tax Law (EPTL) sets outs four types of pollutants subject to environmental taxation: (1) atmosphere pollutants; (2) water pollutants; (3) solid waste; and (4) noise. Notably, this list does not include greenhouse gases (GHGs), and the EPTL does not target businesses that discharge pollutants indirectly.

The law is the first of its kind in China and replaces the discharge fee system that has been in place for more than three decades. Although the pollution fee system also attached a cost to the discharge of pollutants, the key difference implemented by the new EPTL is a significant increase in the severity of penalties for failure to pay the required discharge taxes.

For companies already in compliance with the old fee system, this new scheme should not prove significantly different, as the scope for levying, bases and rates is very similar to the fee system. However, the law is likely to mean there is greater scrutiny of companies making the relevant kind of pollutant emissions. Estimates indicate that more than 260,000 companies had to start paying environmental tax from April this year. As such, the EPTL is a significant step in “levelling the playing field” of environmental compliance in China, which is instrumental in creating a culture of compliance among businesses.

Article 13 of the EPTL provides that if a taxpayer’s emissions of taxable atmospheric pollutants or water pollutants is less than 30% of the pollutant discharge standards set by provincial and local governments, the tax will be levied at 75% of the specified level. If the taxpayer’s emissions are less than 50% of the applicable national and local pollutant discharge standards, the tax will be levied at 50% of the usual rate. This favourable rate will mitigate the impact of the EPTL on smaller businesses, which have less ability to install and operate capital-intensive pollution control equipment.

Article 24 of the EPTL stipulates that the government will, at all levels, encourage taxpayers to increase investment in environmental protection construction and provide financial policy support for taxpayers’ investment in automatic monitoring equipment.

In Europe, taxation has also been used to curb environmental pollution. For example, the fiscal legislation EU Directive 2003/96/EC contains a provision on the taxation of energy products and electricity. Under this legislation, member states receive total or partial exemptions/reductions of their taxation liability in relation to electricity produced from combined heat and power generation.

NEW PROVISIONS ON SOLID WASTE

For decades, China was the world’s largest importer of waste for recycling, importing nearly nine million metric tonnes of plastic a year. But, in a sudden turn of events, China instituted an import ban on 24 types of recycled materials in January 2018, including unsorted paper and low-grade polyethylene terephthalate used in plastic bottles.

While this sudden move is more reminiscent of its command and control history, the ripple effects it has sent across the world have forced countries to reconsider their recycling programmes, and spurred China’s own domestic recycling programme. However, it also reflects a growing awareness of the “importation” of emissions into China that has resulted from so much industrial activity relocating to the country. As a particularly emissions and pollution-intensive industry, recycling is a logical industry of focus for regulators seeking to move China’s economy up the value chain.

The National Development and Reform Commission (NDRC), China’s economic planner, has also released a new regulation addressing household garbage to promote sustainable development. The regulation requires municipalities to assess charges for solid waste treatment – largely based on the amount of trash – and to establish a comprehensive charging system for collecting and processing household waste by 2020.

The goal is to create a pricing mechanism that ensures a reasonable profit for those involved while “fully reflect[ing] market supply-demand and scarcity of resources, as well as ecological value and the cost of environmental damage”. The new pricing mechanism initiatives will let polluters pay the cost while ensuring a reasonable profit. Local governments are also encouraged to introduce measures to attract the participation of enterprises to support sorting, reducing, recycling and disposal.

The Law of the People’s Republic of China on Solid Waste Pollution Prevention and Control, which was implemented in 2013 and most recently amended in 2016, applies to regulation of solid waste in China. The national legislature undertook an evaluation of this law in 2017 and concluded that it should be updated to better meet China’s regulatory needs. In July 2018, the MEE published a Proposal to Amend the Solid Waste Law for public comment.

The proposal sets out in article 3 a goal of adopting to policies to promote “comprehensive utilization” and maximize recycling of solid waste. Note that while recycling of waste is being promoted in article 3, the importation of waste for recycling is not addressed. In fact, the focus on comprehensive utilization likely implies a focus on full utilization of domestic waste and continued restrictions on importation.

Article 4 of the proposal states that the government will prevent and control environmental pollution from solid waste, and will “incorporate it into national economic and social development plans, and take economic and technological policies and measures to achieve environmental protection against solid waste pollution”.

Article 20 of the proposal requires that waste generators pay environmental tax in accordance with the EPTL. Entities that collect, store, move, use or dispose of hazardous waste must take part in a compulsory environmental pollution liability insurance programme (article 73 of the proposal). These changes are consistent with the promotion of the “polluter pays” principle endorsed by the EPL, and will create a market incentive for evaluation and assessment of the risks associated with solid waste.

EMISSIONS TRADING SCHEMES

China’s most anticipated shift toward market-oriented environmental protection has been its embrace of a national emissions trading scheme (ETS) to incentivize reductions in GHG emissions. In December 2017, China announced the roll-out of its official plan, which builds on the experience of the initial seven pilot programmes that were introduced in 2013, and expands on those seven regional programs to cover the entire nation.

Once fully implemented, China’s ETS will be the largest in the world, covering more than three billion tonnes of GHG emissions, almost a quarter of the global total and close to double the size of the EU ETS. However, when the programme was launched in late 2017, the initially planned scope of eight key industries – petrochemicals, chemicals, building materials (including cement), iron and steel, non-ferrous metals (such as aluminum and copper), paper, electricity and civil aviation — was pared back to a launch covering only electric power plants emitting more than 26,000 tonnes of GHG annually and only simulated trading.

As a result, only 1,700 companies are currently covered by the ETS, down from an initial forecast of 6,000. The central government plans to begin auctioning emissions allowances in 2020, and to eventually expand the scope of the programme to cover the eight industries originally envisioned.

Although the delay in implementing a mandatory ETS is unfortunate from a climate perspective, it does demonstrate that regulators are conscious of the importance and challenge of designing an effective system of incentives and preserving “stable and healthy economic development”. Introducing the programme gradually will allow companies not yet included in the programme more time to prepare for a compliance obligation being imposed on their emissions, and allow regulators time to fine-tune regulation of the carbon allowance market.

However, regulators should consider how to incentivize (and not to punish) further early action by companies to reduce emissions before the ETS becomes mandatory for their industry. China has also suggested a preference for the more business-friendly rate-based limit for curbing emissions.

A rate-based limit seeks to reward firms for producing fewer emissions per unit, rather than imposing an overall emissions cap. The approach is in keeping with China’s pledge to hit “peak emissions” at or prior to 2030, rather than committing to a specific target. Finally, progress benchmarks appear to be bifurcated based on the power generation methods employed by each plant, thus avoiding pitting less carbon-intensive facilities like natural gas plants against coal-burning competitors.

Trading is expected to begin in 2020, at the earliest. In the interim, China must determine how to price and allocate credits, develop an effective process for collecting data, and develop guidance for issuing penalties for non-compliance. The NDRC issued tentative Measures for the Administration of Trading of Carbon Emissions Rights in 2016, but a final set of trading rules has not yet been released.

MORE OPPORTUNITIES

As China moves away from the command-and-control approach and adopts market-based instruments that have been popular in the US and Europe for the past quarter of a decade, multinationals will be well placed to capitalize on opportunities that are increasingly available through this shift of policy. These include favourable tax treatment for creating environmental benefits, increased transparency, and the ability to lower costs by improving compliance.

Paul Davies is a partner at Latham & Watkins in London. Kimberly Leefatt and Andrew Westgate are associates at Latham & Watkins in Washington DC and New York, respectively.

This article was prepared also with the assistance of Olivia Featherstone in the London office of Latham & Watkins and Zhuoshi Liu of the Environmental Law Institute in Washington DC