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China's aluminum industry is heading for a massive transition. China makes most of the world's aluminum, largely using coal-fired electricity. The sector singlehandedly creates about 5% of China's carbon emissions. To meet the country's climate goals, producers will need to rebuild plants close to renewable energy sources. S&P Global Ratings expects the transformation to be increasingly disruptive, and that only the biggest players will manage the radical changes ahead.

This is a highly carbon-intensive industry. About 13 metric tons of greenhouse gases are emitted for every metric ton of aluminum that is produced using coal-fired electricity. If aluminum is made using clean energy, the process creates 85% less emission.

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China cannot plausibly meet its target of being carbon neutral by 2060 if it doesn't clean up the sector. Its ability to reform this industry speaks to the credibility of its ambitious carbon targets.

We believe China's trends toward consolidation, integration, and energy transition will bolster the standing of big producers such as China Hongqiao Group Ltd., and the Aluminum Corp. of China Ltd. (Chalco).

Helpfully for such producers this transition is playing out while the industry is going through a sharp cyclical upturn. The London Metal Exchange (LME) aluminum price reached a decade high of US$2,600 in August 2021. The three-month aluminum price on the Shanghai Futures Exchange has jumped 60% over the past 12 months, with buyers scrambling to secure supply amid depleting inventories in China.

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Local and central governments are supporting entities that move to clean energy sources with cheap electricity and other inducements. The biggest players are also vertically integrating--essentially, they are buying bauxite mining and making alumina. The upshot is that large players will be less exposed to the industry's notorious boom and bust cycles, letting them focus on the shift to more carbon neutral production.

Industrial firms are also embracing aluminum as the "metal of the future." It is highly recyclable. This is a positive for packaging firms looking to bolster their green credentials. Solar and wind power plants, which are in aggressive expansion phase, also favor the metal. Electric-carmakers appreciate that the material's light weight. This gives vehicles more range, and range is a key criterion on which these cars are sold. Building constructors also like that aluminum is strong and light, with many viewing it as a substitute for steel.

Such demand dynamics should increase consumption of primary aluminum by 3%-5% in China in 2021 from 38 million metric tons in 2020.

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Energy Transition Will Be Difficult

Aluminum producers will eventually benefit from the move to renewable energy. Over the next five years, however, the transition will be costly and disruptive.

The aluminum industry will find it difficult to move away from cheap, reliable coal-fired electricity. Electricity comprises around 30%-40% of the costs of aluminum production. In 2020, coal-fired electricity powered around 86% of aluminum production in China.

Nevertheless, the industry needs to end its reliance on coal if China is to meet its carbon-cutting targets. Government policies are stacking up to push aluminum producers away from coal-fired power. These involve carrots and sticks.

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For example, since February 2021, the Inner Mongolia government removed the grid electricity price discount for aluminum producers based in the western part of the region. It also charged extra fees on electricity generated from captive power plants--almost all these plans are coal-fired.

The new policy raised local aluminum producers' cost of production by Chinese renminbi (RMB) 100 to RMB300 per ton. Greater scrutiny on emissions has also forced some companies to close their captive power plants over the past three years.

A migration to China's hydro-heavy southwest

Aluminum producers that previously enjoyed cheap coal-fired electricity in northwest China, or relied heavily on captive power supply, will see their costs rise. In August 2021, China's National Development and Reform Commission banned any preferential coal-fired electricity price offered to primary aluminum makers. Companies will also have to pay for carbon credits when this market expands to China's aluminum sector.

Such dynamics will prompt Chinese producers to move aluminum plants to the southwest part of the country, where there is abundant hydropower. More than 4.5 million metric tons per year (mtpa) of combined aluminum capacity will come to Yunnan, Guangxi, and Sichuan through 2020-2021. This would be about 12% of China's total aluminum production in 2020.

There are also inducements. The Yunnan government offers hydropower at an average price of RMB0.25 per kilowatt-hour (kWh) to certain newly built aluminum plants in Yunnan. In other provinces, the cost of coal-fired power is typically above RMB0.30 per kWh.

Hongqiao is relocating 2.03 mtpa of its aluminum capacity to Yunnan. Aluminum Corp. of China, the parent of Chalco, will likely increase its presence in Yunnan to 4.2 mtpa of aluminum capacity over the next two to three years, from 1.7 mtpa at the end of 2018.

When these moves are finalized, these companies will have 60 billion kWh–70 billion kWh of electricity switched to hydropower from coal-fired power. That's 11%-15% of total electricity used to produce aluminum in 2020.

This will be a difficult transition. Hydropower is highly seasonal and this can disrupt production. In May 2021, water shortages hit electricity supply. This forced about one-quarter of the aluminum plants in Yunnan to temporarily shut.

Such closures hit aluminum producers hard. Production halts require plant operators to shut down the electrolyzer (electrolysis is a key step in making aluminum). Restarting an electrolyzer would cost a typical midsize Chinese producer about RMB150 million, assuming one-quarter of its production capacity were halted. And, of course, the company must also deal with lost output during the suspension period.

We nevertheless believe Beijing's policy stance, and a persistent ramping-up of cost incentives, will compel Chinese producers to use clean energy. Other renewable energy sources developed by local governments and energy suppliers will compensate for seasonal hydropower shortages.

Governments may also tackle hydropower supply fluctuations by applying advanced technologies, such as storing excess power produced in peak periods.

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Supply-Side Reforms Are Boosting Efficiency

The aluminum sector's move to clean energy will be complicated and costly, and we believe that only the biggest and best managed firms will pull it off. China's aluminum sector is consolidating and its large producers are becoming much more efficient and profitable.

China has set a capacity ceiling of 45 mtpa for aluminum. This has constrained capacity and upheld prices. The country put stringent controls on aluminum supply from 2015 by setting a capacity replacement rule: any new capacity has to be matched by the closure of existing capacity at a ratio of at least one-to-one.

Supply-side reforms that have been rolled out in the aluminum industry since 2013 have also improved production utilization, increased energy efficiency, and upgraded emission standards. The government is phasing out small producers unable to meet these evolving standards.

This is aggregating production at the biggest firms, making the country's aluminum sector more efficient, productive, and green. The top 10 aluminum makers accounted for around 70% of China's capacity in 2020.

China's aluminum capacity utilization rate increased to 85%-90% in 2019 and 2020, from less than 75% before 2012.

The gross margin of Chalco's primary aluminum business will likely exceed 20% in 2021 and 2022. This is about double the margin seen in 2019, just before the pandemic hit. The gross margin will be around 25% in 2021 and 2022 for Hongqiao, which has a lower cost of production.

Solid industry profit levels should support the credit quality of rated aluminum producers over the next 24 months. Chalco's and Hongqiao's annual operating cash flows for the next two years will likely be 60% higher than their pre-pandemic levels.

More Integration, More Resilience

The larger firms are embracing an integrated model that makes their businesses less exposed to the boom and bust cycles of aluminum markets. This will give the companies more resilience and more ability to focus on their energy transition.

Integration typically means getting involved in bauxite mining and alumina production. This can boost producers' margins. It also gives the aluminum a natural hedge. When bauxite and alumina prices rise, their upstream businesses profit, offsetting the losses of the downstream producers. Alumina, which is refined from bauxite, accounts for almost half the cost of primary aluminum.

Chalco and Hongqiao have invested in bauxite mines in Guinea. Hongqiao's joint venture in Guinea started operation in 2015. The site provides up to 50 mtpa of bauxite. This covers most of Hongqiao's needs for alumina production. The company, along with several business partners, has also entered into a contract with the Guinean government to develop another bauxite mining project in December 2018.

Chalco's Boffa bauxite mine in Guinea started production in 2020. The company is expanding the mine's annual capacity to 18 mtpa. When the Boffa mine operates at full capacity, Chalco will likely be able to self-supply 70% of its bauxite needs.

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Chinese producers are building alumina production facilities, typically where they have abundant access to bauxite and cheap electricity.

Chalco's new alumina plant in Guangxi reached its full production capacity of 2 mtpa in 2021. The plant is close to bauxite import ports, enabling it to process Chalco's own bauxite supply, shipped from Guinea.

Hongqiao will likely complete its alumina capacity expansion in Indonesia in 2021, to 2 mtpa from 1 mtpa. The alumina production site benefits from ample local bauxite supply and captive power. We expect Chalco and Hongqiao to self-supply around 90% of alumina in their aluminum production starting from 2021. The self-sufficiency rate was 86% for Chalco and 88.4% for Hongqiao in 2020.

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The industry is transforming. As it gets cleaner, its two main entities are getting leaner. It is somehow consistent that the decarbonization of China's aluminum sector tracks improving operational performance of dominant players.

Related Research

• Steely Resolve: Why Green Mandates May Finally Stop China's Steel Expansion, Aug. 11, 2021
• Metal Price Assumptions: Prices Stay Hot, But No Signs Of A Melting Point, June 29, 2021
• China's Chemical Sector: Bonding Growth To Environmental Goals, May 17, 2021

Writing: Jasper Moiseiwitsch

Digital Design: Evy Cheung