China is under strain this summer. Prolonged and intense heatwaves and droughts across its southwest have crippled hydropower generators, forcing energy curbs in some cities. With production halted, the stress on supply chains could have knock-on effects globally. All this at a time when China's economic growth has substantially slowed. Policymakers were already pushing for more sustainable energy sources to power industries. The urgency is clear.

Business activity has taken a hit, with more than half of China's landmass reeling under scorching temperatures and limited rainfall. The lengthy heatwave is draining the Yangtze River, the world's most heavily used waterway for transport, and many shipping routes have partially closed.

Reservoirs in the Sichuan basin are drying up, curtailing the hydropower generation on which its industries heavily rely. Sichuan contributes 4%-5% to national GDP and is home to major producers of lithium and technology hardware, as well as auto makers.

Authorities are rationing the limited power supplies by curbing commercial-industrial activities, reducing usage by public facilities, and shortening mall operating hours. There are signs of resumption, but earlier power shutdowns in key industrial centers, such as Sichuan and Chongqing, are likely to have impeded production and exacerbated supply-chain problems.

The heatwave is also spreading across China's major agricultural belt, and crop yields may falter. In particular, water-intensive crops could wither, such as rice and soybeans. Existing irrigation infrastructure can't cope with low water supplies. The annual grain harvest accounted for more than 70% of China's annual grain supply in autumn 2021, according to the National Bureau of Statistics. If food inflation remains a lingering concern, domestic consumption will be subdued.

Rainstorms are now happening, of course. But while offering relief from the heat, they also risk flash floods, and that could further batter business activities and increase insurance claims.

It'll Be A Long Way From Brownouts To Green Action

Growing demand and the likelihood of weather extremes mean China faces greater urgency to improve the efficiency and adequacy of its gigantic power system. It still has a long way to go. Initiatives include an ambitious renewable energy buildout, west-to-east power transmission pipelines, enhancements to cross-regional power grids, and better power storage.

More frequent weather-related catastrophes are likely to result in more disruptions to cross-regional power dispatches and renewable power generation. On a long-term basis, developing a more flexible and intelligent power system will require continuous and substantive investments. The energy transition will need to factor in climatic scenarios and accommodate higher proportions of renewable power.

As this major energy transition will take years to materialize, coal-fired power will remain the backbone of the nation's energy supply. Policymakers are prioritizing energy security and reining in coal prices, following lessons from late 2021 when demand and costs rose sharply during a harsh winter due to insufficient coal supply. Coal prices still remain high, however.

Since then, coal production capacity has been increasing to ensure sufficient supply. China maintains high self-sufficiency in thermal coal, and is also enforcing long-term contracts and price regulation. All these efforts signify a reduced likelihood of a severe and extended energy crunch in winter.

China has committed to ensuring non-fossil fuels support about a fifth of total energy consumption by 2025. But it may temporarily take its foot off the pedal for the phasing-down of coal. In the first seven months of 2022, coal production grew 11.5% compared with the same period last year. Coal-fired power generation declined slightly since hydropower generation had been buoyant before the drought.

The power utilities that we rate can absorb the stresses from the current weather extremes. While growth in power consumption could moderate this year, it will probably be close to mid-single digits.

Coal-fired independent power producers continued to report losses in the first half of 2022 because of their limited ability to significantly improve cost pass-through. But progress in this area with greater flexibility for lifting tariffs have at least narrowed the losses compared with 2021's.

Further support comes from the authorities' controls on coal prices after the spikes in late 2021, and their enforcement of the regulations and long-term contracts to stabilize supply. Financial support from the government, including subsidies for renewables, provides an additional cushion.

The temporary plunge in hydropower generation over the past month or so should be manageable. That's because this energy source represents less than 20% of overall generation in China, even though the country is the largest producer globally.

In the severe winter of 2021, more than 20 provinces introduced power curbs to combat national coal shortages. This time, the curbs are weather related. The policy reaction is therefore more localized, with regions setting measures to ration energy supply for industries and residents. But while power supply is constrained, soaring temperatures have led to record demand, particularly for air-conditioning.

Slower Industrial Activity, Higher Food Inflation

The recent power shortages are additional pain points for industries to COVID and the property downturn. While the overall credit impact should be manageable for sectors, the pressure is uneven. Downstream manufacturers and energy-intensive sectors could see an uptick in drought-related costs, given their higher input costs and longer production downtime.

Electricity curbs will slow industrial production in August in Sichuan, Jiangsu, Anhui, and Zhejiang. These four provinces together accounted for nearly 25% of GDP in 2021 and are important to China's industrial supply chains. Historically, these provinces have sent their excess electricity to eastern China, including Shanghai and Hangzhou. This will be hard to resume anytime soon. Growth in industrial activity growth was already slowing to reach 3.5% for the first seven months of 2022, compared with 5.7% for full-year 2019.

Agricultural activity is also likely to be hit hard by the heatwaves. Food inflation that started in recent months is likely to persist this year, driven mostly by high agricultural input costs and feed prices. The risk to agriculture from the drought is a key issue for policymakers. The threat to the autumn harvest has prompted the government to step up efforts to combat the drought, such as the use of water sprinklers, cloud seeding, diversion of water resources, and early harvesting.

Harvesting will require more expensive irrigation options, which combined with crop damage, could spur food inflation. If weak harvests lead to more imports, the risk could spill over onto global markets.

The central government recently announced a Chinese renminbi (RMB) 10 billion emergency budget to tackle the drought in the downstream areas of Sichuan and the Yangtze River and protect the autumn harvests.

Supply Chains Could Be Stretched Too Far

Our base case for corporates assumes that power-related business disruptions will be localized and temporary, affecting only a small amount of annual production. Many companies will be able to compensate for production shortfalls by using inventory and increasing capacity at their facilities in other regions.

So far, most business disruption has centered on Chongqing and Sichuan, areas with the highest hydropower dependence in China. Last year, in contrast, production was suspended across the country as coal shortages curtailed power output to industrial producers.

That said, if the situation in Chongqing and Sichuan is more prolonged than we expect, it could lead to supply-chain challenges for corporate sectors. Lithium supply could be particularly hit. Sichuan contributes almost 20%-30% of lithium compound production, and a prolonged suspension there could drive up lithium prices. That would squeeze the margin of downstream manufacturers, such as lithium battery and electric vehicle makers. However, lithium production could increase in places such as Jiangxi and Qinghai to alleviate the pressure.

Prolonged disruption to production in the region could also undermine component supply across industries. Collectively, Chongqing and Sichuan account for about 10% of China's auto production and they are home to many auto suppliers. These areas are also important manufacturing hubs for technology hardware products. By some estimates, they represent around 70% of the global supply for Wintel laptops (i.e., those that use Microsoft Windows operating systems and Intel processors). If the power shortages and longer outages persist, the strain will increase for the broader technology supply chain.

We expect climate change to play a more important role in the business strategy of Chinese corporates. Firms need to be better prepared for production disruption by sourcing diversified power, restructuring supply chains, and increasing inventory buffer. All these may add additional costs and debt for corporates if extreme climate events happen more frequently.

Rural Banks Will Be Hardest Hit

The drought won't be a sizable setback for China's banking sector. The sector has a well-diversified loan book, with just 5% direct exposure to corporates in agriculture, fishery, and forestry. Yet the drought is another chip in its armor, following blows from COVID and the weak property sector.

The Chinese commercial banks with the biggest exposure to the agriculture sector and rural communities are Agricultural Bank of China, Postal Savings Bank of China, rural commercial banks, rural cooperate banks, and rural credit cooperatives. Exposure to rural communities is likely to take the form of retail loans to proprietors and rural households.

The hardest hit will be local rural financial institutions with high concentration of exposure to the drought-stricken areas. National banks are better protected because of their wide geographic and sector diversification.

As with any other country, a prolonged drought and heatwave in China could see broader ramifications across various corporate sectors. And that would inevitably undermine loan quality. The biggest risk will be for bank lenders with concentrated exposures to water-intensive and energy-intensive sectors.

In that extreme scenario, some financial institutions may need support from shareholders or the government. Should that eventuate, even large state-owned commercial banks would find the going tough.

Agriculture Insurance Will Grow

Property and casualty (P/C) insurers with large agriculture exposure in drought-stricken provinces could face swings in underwriting results. Claims may grow if the drought persists or has more prolonged effects. The six key affected provinces of Sichuan, Chongqing, Hubei, Hunan, Anhui, and Jiangsu accounted for over 20% of agricultural insurance premiums and 1.5% of total P/C premiums in 2021. These provinces also generated 168 million tons of food production in 2021, accounting for 24.6% of the country's total production.

Reinsurance demand will rise as natural catastrophes increase in frequency and intensity. Sichuan, in particular, is also in an earthquake zone, compounding its vulnerability. A further reinsurance driver is the rapid growth in agriculture insurance, which climbed 30% year on year in the first half of 2022.

We anticipate that domestic reinsurers will shoulder some of the insured losses as primary insurers undertake risk-mitigation initiatives. State-backed China Agriculture Reinsurance Corp. (CARC) manages 20% of agriculture insurance exposure for the domestic market. Primary insurers will likely increase demand for agriculture reinsurance protection in addition to the cover provided by CARC.

Agriculture insurance will continue to grow rapidly, likely at 30%-50% over the next two years, particularly given the central government's increase in premium subsidies for this segment. The recent drought will also be a wake-up call for farmers to buy insurance, in our view. And there's also likely to be more demand for insurance against business interruptions, such as the power curbs during the heatwave.

Critical Steps

China wasn't alone in dealing with droughts this year--they spread across the northern hemisphere. And whether such events will become a frequent occurrence isn't definite. But it is certain that China, like many countries, is increasingly exposed to the physical impact of climate change and is counting the rising costs. China's carbon neutral targets by 2060 involve broadening its clean energy diversity. Faster progress is key to sustainably powering its industries and growth.

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Editor: Alison Dunn