China's Changing Environmental Landscape: Lessons Learned From a $45B Compliance Crisis

The recent shutdown of an auto parts supplier in Shanghai for violating environmental laws demonstrates a new era in China – one in which environmental concerns are being prioritized and laws enforced. Companies should rise to the challenge by taking steps toward compliance.

The Shaeffler Supply Chain Crisis

On September 18, 2017, an urgent pleading letter issued by the CEO of Schaeffler China on September 14 to several government agencies in Shanghai was leaked and rapidly spread throughout Chinese social media, igniting a public outcry. In the letter, Schaeffler, a leading global auto supplier, petitioned the Shanghai government to suspend enforcement of local government’s penalty of shutting down Shanghai Jielong Metal Wiredrawing Co., Ltd. (Jielong), Schaeffler’s sole supplier of its needle bearings, for violating Chinese environmental laws. The letter claimed that Jielong notified Schaeffler on September 11 that the local government had cut off Jielong’s power supply and ordered it to demolish its production equipment on September 10 for violating environmental laws. It further claimed that it would take at least three months for Schaeffler to switch to a new supplier, and that without suspending the government penalty during such replacement period, 49 automakers in China, including SAIC (one of the largest Chinese State Owned Enterprises backed by the Shanghai government), would suffer from the Schaeffler supply shortage, leading to a reduction of 3 million vehicles produced in China with losses estimated to be around RMB 300 billion.

Schaeffler China, through its official account on social media, quickly responded to the leak on the night of September 18, acknowledging the authenticity of the letter but claiming that Schaeffler “has mobilized its global resources” to deal with the Jielong shutdown and that the impact on automakers would be “manageable.” Despite Schaeffler’s efforts to cool down its social media crisis, the public outcry has extended to mainstream media and drawn strong reactions from several Chinese government agencies, including the Ministry of Environment Protection (MEP) at central government. The mainstream media accused Schaeffler of trying to hijack the Chinese government by blaming the loss of RMB 300 billion to the government’s environmental law enforcement efforts, and asserted that local government had already issued two warnings to Jielong in December 2016 and March 2017 respectively to demand plant shutdown, but Jielong and Schaeffler simply ignored such warnings and failed to take action, which led to the plant shutdown on September 10, 2017.

China’s Increasing Environmental Consciousness

This episode is not an isolated report of the Chinese government’s recent efforts to shut down the operation of companies that have violated environmental laws and regulations. Starting in 2016, Chinese authorities have been shutting down mills, smelters and chemical plants to cut excessive industrial capacity and help curb pollution, in turn straining the production and supply of various raw materials. Many multinational companies have already observed significant price hikes from Chinese suppliers this year, and the Schaeffler crisis is a clear warning sign that multinational corporations need to be prepared to avoid the same drama hitting their Chinese affiliates and suppliers and causing a nightmare for their operations.

Unlike in the past, when GDP and local tax revenue were prioritized over environmental concerns and local authorities tended to be lax when pursuing companies discharging pollutants, the Chinese leadership and government in recent years have been forced to adopt more stringent rules and enforcement efforts to react to public outcry over the heavy losses and costs associated with the seemingly inescapable pollutions in China, from heavy smog to undrinkable water. During 2015-17, a wave of new of laws, regulations and rules has been promulgated by China, followed by local rules, changing the environmental law enforcement landscape significantly.

Major Environmental Developments

1. The focus of administrative supervision on environmental protection is tilting from the ex-ante Environmental Impact Assessment (EIA) formality toward ongoing monitoring and ex-post supervision. Previously, the EIA formality would require an entity to commission an EIA report or complete an EIA filing form, submit the same for review and approval by the local Environmental Protection Administration (EPA), build the facilities (including environmental protection devices and systems) strictly in accordance with the design reported in the EIA report/form, go through a trial run, and then have the facilities inspected by the local EPA to obtain approval for engaging in full-scale operation (EIA Completion Review).
   
   The new rules have eliminated the test-run requirement and delegated the responsibility of EIA Completion Review from EPA to the project operator, while requiring the operator to publicly disclose the EIA Completion Review documents and imposing higher penalties on the operator should it fail to conduct such a compliance review. In certain industries, such as mining, metals and chemicals, a project may need to undergo a post-effect EIA process three to five years after it starts full operation.
    
2. In 2017, China started implementing a nationwide pollutant discharge permitting system.The pollutant discharge permitting rules used to exist only in some provinces and cities and varied among localities in terms of the conditions for obtaining a permit, with limited information regarding the pollutants being discharged. The ongoing operations of the relevant project were not strictly monitored.
   
   Under the new rules, a unified permitting system will be implemented where each entity discharging pollutants will need to obtain a discharge permit, which will specify the limits on the various types of pollutants it’s permitted to discharge into the environment. The permit holder will also be subject to an ongoing obligation to periodically monitor its own emissions, maintain records of certain metrics in its operation activities, and compile self-assessment reports from time to time. All such information will be disclosed to the public. A phased-out plan has already been formulated so that all existing companies will need to apply for the new pollutant discharge permit by certain deadlines applicable to their respective industry sectors, with the latest being the end of 2020.
    
3. The enforcement authorities, namely MEP and local EPAs, are further empowered to impose meaningful sanctions on violations, including impounding production facilities and equipment, imposing accumulative daily penalties with no monetary limit during the period when the violation persists, ordering temporary suspension or reduction of operation and rectification within a designated period, and ordering permanent closure of violating enterprises. Some local regulations also give the authorities power to cut off power, water and other utilities to the violating enterprises. Principals and responsible individuals of the violating enterprises may be detained and subject to criminal penalties (including monetary penalties and imprisonment up to seven years) if the violation meets the threshold for criminal prosecution.
    
4. Starting from January 1, 2018, a uniformed environmental protection tax will be levied on entities discharging pollutants that are listed in the catalogue attached to the Environmental Protection Tax Law.
    
5. Entities are required to disclose more detailed information regarding their operations and emissions. Public engagement on supervising environmental compliance and whistleblower reports is encouraged, with complaint hotlines at both the national and local government levels. Some local jurisdictions even offer monetary awards to whistleblowers.
    
6. Grass-roots environmental nongovernmental organizations with five or more years of operating history are given a legal standing as a plaintiff to bring class actions against entities discharging pollutants.
    
7. Chemical companies, especially those involving the use, trading or production of “hazardous chemicals” as identified in an official catalogue, are subject to more stringent regulatory oversight, including being required to operate within designated chemical industry parks. Various local regulations have also been adopted to force chemical and other manufacturing companies to move away from their original locations in ecologically sensitive areas or adjacent to densely populated residential areas.
    
8. In order to overcome the resistance of the self-interested local authorities, the MEP has been launching inspections, where officials from state-level government agencies including MEP and the Communist Party’s disciplinary arm are sent to designated provinces to work on site and supervise the local environmental law enforcement. Local officials are obligated to handle the violations identified by state inspectors within a designated timeframe and report back to the state regarding the progress and outcome of each case. Local officials who have failed to enforce the environmental laws have been subject to various political disciplines and demotions.

Next Steps for Companies

As demonstrated by Schaeffler’s recent supply chain crisis, companies can no longer ignore the tremendous risks associated with environmental noncompliance issues in China. What worked in the past may no longer work today or in the future.

Companies should consider taking the following steps:

• Seek legal advice to ensure compliance under the evolving regulatory requirements and to deal with government agencies and media
• Immediately conduct environmental compliance reviews of China affiliates and existing suppliers to identify risks and issues under the new environmental law regulatory regime
• Put strong EHS compliance programs in place
• Consider adjusting China business plans to build in the costs and risks factors
• Prepare a crisis management plan to deal with potential social media outbreak, with advice from legal counsel

Companies seeking new vendors in China should conduct rigorous due diligence on each vendor’s EHS compliance records as an essential step in the vendor onboarding process. Draft agreements with a vendor to give the sourcing party adequate oversight over the vendor’s EHS regulatory affairs, including auditing rights and rights to be immediately notified of any inquiry, investigation and other proceedings pending or threatened by any EHS regulatory body against the vendor. Such contractual rights shall be actively exercised to make it living and breathing. Last but not least, companies should probably have more than one vendor for a certain key component or material to prepare for the contingency where the exclusive supplier might not supply continuously due to EHS enforcement actions.