China's ambitious climate goals should propel its steel industry to, finally, stop expanding. The country produced more than half of the world's total crude steel output in 2020. S&P Global Ratings believes this tremendous capacity is a chronic industry risk, especially given China is shifting from an investment-driven model. Steel production is also a major source of pollution, with costs for the whole of society.

Last September, Chinese leader Xi Jinping committed the country to reaching peak carbon emissions by 2030 and neutrality by 2060. That is a huge task. In our view, the country cannot keep its carbon-neutral promises without requiring a clean-up in the steel industry. Steel is the largest carbon emitter among the manufacturing sectors, and contributes about 15% of total carbon emissions in China.

Going green will force out steel producers that cannot afford to meet standards including "ultra-low" emissions and cleaner furnaces. As players consolidate or exit the market, overall crude steel output will gradually decline. For rated steel producers, this means more market share and less irrational competition. However, it's unclear if these benefits will compensate for their hefty costs of green upgrades. We estimate the industry-wide price tag at Chinese renminbi (RMB) 500 billion-RMB850 billion (US$77 billion-US$131 billion) over the next five years.

Haven't We Heard This Story Before?

China has long planned to cut steel capacity, originally because excess supply was draining earnings potential for the sector. Continually rising headline production figures would suggest the goal was missed. In fact, the story is more nuanced. Expansion rates did slow, and the sector is now more profitable and less fragmented. Moreover, in recent years, the industry has begun to clean up. A lot of inefficient and overly polluting equipment has been decommissioned or upgraded.

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In our view, sustainable development is a priority for the central government, and will increasingly matter more than short-term GDP gains. The cost of green upgrades for the steel industry will weed out weaker players, and limit budgets for general expansions.

Decarbonization Will Test Steelmakers' Financial Strength

The green agenda puts steel mills in a bind. Large capital expenditures for cleaner furnaces and other equipment could bankrupt steel mills with high leverage and weak profitability. However, if they don't invest in decarbonization, producers could be shut down for not meeting national standards on environmental protection.

Besides indirect costs facing the industry, we expect the main source of direct costs will cover the following:

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The ultra-low emission retrofit will expand to 80%

Chinese steel mills have been retrofitting their facilities to achieve "ultra-low emissions," based on definitions on pollutant emission covering particulates, sulfur dioxide, and nitrogen oxides. From 2018 to 2020, about 60% of crude steel capacity was completed or began the process of meeting ultra-low emission.

Producers that have invested in retrofits are being rewarded. For example, in March, the local government in Tangshan, Hebei province, ordered steel-production cuts as part of an effort to reduce pollution. Two locally based subsidiaries of Shougang Group were exempted, however, because they were the only two "ultra-low emission" plants in the area. This meant these producers stayed open in a year when steel margins are solid.

We expect more than 80% of crude steel capacity to reach ultra-low emission by 2025. This equates to 200-300 million tons per annum (mtpa) more in capacity. The China Iron and Steel Association estimates that total investment on ultra-low emission retrofit will be about RMB2.6 billion for crude steel capacity of 10 mtpa. That means further investment of RMB50 billion-RMB80 billion will be needed by the industry in the next five years. In addition to the initial outlay, variable cost per year to maintain ultra-low emissions will be RMB50 per ton. To put that into context: an additional RMB500 million a year for steelmakers with annual output of 10 mtpa.

Blast furnaces: The flame is flickering

China is likely to invest in closing the gap with the developed world on furnace technology. This means replacing oxygen blast furnaces with electric arc furnaces (EAF), which would significantly reduce carbon emissions. For each ton of crude steel produced from an integrated mill with a blast furnace, about 2,100 kilograms (kg) of carbon is emitted. That's more than 3x the 600 kg from EAF mills (see chart 3).

Chart 3

In 2020, China's crude steel output from EAF accounted for only 9% of total output, compared with 25% in Japan, 31% in South Korea, and 71% in the U.S. In 2019, the Ministry of Industry and Information Technology (MIIT) guided for the proportion of EAF crude steel to reach 20% by end of 2025 (see chart 4).

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By our estimates, achieving the MIIT target requires new EAF capacity of about 140-150 mtpa over the next five years. That is almost double the current capacity of about 160 mtpa, with investments costs of RMB420 billion-RMB700 billion.

Steelmakers are unlikely to exceed the MIIT's 20% target for EAF mills by 2025. This is because of the high costs of the replacement, as well as higher production cost compared with blast furnaces in China. EAF utilization rates in China tend to be lower and more volatile than for blast furnaces, in part due to lack of domestic scrap resources for input into EAF steel production (see chart 5).

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Carbon allowance purchases could get expensive over time

China's nascent market for carbon emissions, launched in July 2021, currently focuses on power plants but will probably expand to other large emitters soon including steel, petrochemicals and cement. Costs for purchasing carbon quota will likely be low on global standards at first, but steel producers that go this route--rather than cutting emissions--will face volatility and uncertainty.

Based on the industry's current steel production costs, we estimate that purchasing allowances would be RMB110 per ton of steel produced. That price tag is derived from the first bulk transaction: China Petrochemical Corp. purchased carbon emission quota from China Resources Group at a cost of RMB52.92 per ton. This is much cheaper compared with about €50-€55 per ton from the European Union's emissions trading scheme. If the price of China's carbon emission allowances goes higher in the future, the cost to steel mills will be even higher.

A note on hydrogen-based steelmaking technology

China will likely experiment with alternative production technologies; however, fossil-fuel combustion will continue to dominate for some time. Replacing metallurgical coke with hydrogen in the steel-making process can reduce carbon emissions by 70%-80%. But given the relatively small capacity, high production cost as well as other challenges in transportation and storage of hydrogen, hydrogen-based metallurgy technique is still at a pilot stage limited to a couple of steel mills.

HBIS Group started construction of a hydrogen project of 1.2 mtpa in 2020. This Chinese steelmaker projects the facility will reduce carbon dioxide emissions to 125 kg per ton of crude steel, only 6% of traditional blast furnaces. China Baowu Steel Group and Jiuquan Iron and Steel Group are also among the pioneers in this field's research and development. In our view, it will take years for this technology to become economically feasible for large-scale steel production.

Industry Consolidation Can Support Decarbonization

We believe decarbonization is one of the key motives behind official targets for industry consolidation. The government has guided for the top 10 steelmakers to account for over 60% of capacity by 2022, up from only 39% at end-2020. This blueprint also calls for three to four large steel groups having capacity of over 80 mtpa by 2025.

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Fewer larger steelmaking groups will make it easier for the government to implement policies, control capacity increases, and carbon emissions. As an example, China's largest producer, China Baowu Steel Group (see table 1) is the first steel mill that announced peak carbon emissions by 2023 and carbon neutrality by 2050. Given the size of Baowu after a series of mergers, that means over 12%-15% of China's crude steel capacity will achieve carbon peak by 2023.

Another major producer, Ansteel, has announced a roadmap to hit peak emissions by 2025 and be carbon-neutral by 2060. This target will apply to its acquisition targets as well. We expect more mills will be announcing decarbonization roadmaps over the next 12 months.

Table 1

In our view, the consolidation will be led by steel mills with stronger balance sheet and profitability. Dirtier steel mills are less likely to be targets of consolidation, or they will be acquired at discounts because of costs to meet environmental standards. Therefore the latter are more likely to be phased out and hence reduce emissions.

Finally, we note that China cancelled export tax rebates on many types of low-value added steel, after total steel exports surged by 30% during the first half of 2021. In our view, this is a sign that decarbonization is becoming a priority, given that China's overseas competitiveness in low-end products comes at the expense of higher domestic pollution.

Cutting tax rebates on low-end exports should also curb further increase of capacity that focus on this niches. We note the export rebates remain on high-value added products such as silicon steel, auto plates, and home appliances, encouraging steelmakers to upgrade their product mix.

Production May Peak In 2022 Then Plateau

Steel is currently in profit upcycle, which will encourage high production despite policymaker targets of "flat" output in 2021. Guidance from domestically listed steel companies shows net profits during the first half of 2021 exceeded the combined actual earnings for the same group in the previous industry peak, in 2018 (see chart 9).

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Price conditions are not conducive to decommissioning capacity--nor following rules on pollution-related production cuts. For example, Tangshan's local government announced 30%-50% suspension of steelmaking operations would commence in March this year and last until the end of the year to cope with severe pollution. Based on this announcement, we estimated a production loss of 30 mt-40 mt, or 3%-4% of annual national crude steel output. However, statistics show crude steel output in Hebei province fell by only 1 mt during the first half, indicating production cuts were not strictly implemented.

Policymakers have vowed to crack down on steel production in the second half of 2021, after output rose 11.8% in the first half of 2021, or 60 mt more than the same period of last year. Provinces that increased output during the first half will have higher pressure on controlling production until year-end and will likely carry out stricter measures. Output increased the most in Jiangsu, Shandong and Guangxi during the first half of 2021. We expect central state-owned steelmakers to be more disciplined in adhering to guidelines on "flat output" for 2021.

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Given how COVID-19 has ravaged fiscal positions, we believe the tax revenue from the steel boom is just too tempting at the moment. In our view, discipline will reassert itself as the pandemic recedes. A likely scenario will be for steel output to peak in 2022 then plateau for several years before it gradually trends down.

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Going green is a financial burden for the sector. Our rated steel players have been first movers in environmental protection and invested over 20%-25% of annual capex on upgrading facilities to meet the standards during the past few years. We anticipate additional capex on maintenance, but this should be less than 10% of annual capex over the next few years. The solid steel-price environment will help them absorb these costs. However, the sector has limited flexibility to peel back spending even if margins or dynamics turn tough.

Bigger Steel Players Will Better Deal With The Strains

Larger steelmakers will be better able to afford green upgrades. This in turn will give them first rights in times of production cuts or other curtailments. Moreover, mills with stronger balance sheets and profitability will benefit as smaller players leave the market due to the cost burdens of going green. In our view, the structural changes coming for the steel sector will rein in output, supporting margins and steel prices. We believe our rated entities have strong enough balance sheets to endure the cost of decarbonization.

Table 2

Editing: Cathy Holcombe

Digital design: Evy Cheung