By Mark Schaub and Atticus Zhao   King & Wood Mallesons’ Corporate group.

China is embarking on bold moves to re-shaping its auto industry policy. This follows recent announcements in relaxation of key restrictions on foreign investment in the auto sector.

The National Development and Reform Commission (NDRC) is the body tasked in China with laying the direction for industrial policy. On May 17, 2018 the NDRC circulated the draft Administrative Rules on Auto Industry Investment (“Draft Rules”) to local governments and industry stakeholders for comment. The Draft Rules when passed will replace the current car industry development policy that has been in place since 2004.

In short the Draft Rules reform the China approval system for auto investment projects by delegating more authority to local governments, expressly prohibit any new production capacity for fossil-fuelled vehicles and raise the threshold for establishing electric vehicle manufacturing companies.

The Draft Rules set 25 May 2018 as the deadline for feedback from local governments and industry participants.   Accordingly a tight timeline and sorry if you missed it! This does, however, hint that feedback will be limited and that NDRC has clear ideas as to the direction it intends to take. Generally, longer feedback periods are granted.

The key points of the Draft Rules are as follows:

Policy Goal and Approval System Reform

The goal of the Draft Rules is to improve entry standards for auto industry investment projects, guide reasonable investment direction of social funds, tightly control any increase in new production capacity for traditional fossil-fuel burning autos, promote the healthy development of new energy vehicles (NEVs), and establish an innovation system for intelligent vehicles.

A major reform under the Draft Rules is that the authority for all vehicle and components investment projects will be delegated to local governments and the approval system will be changed to a filing system. Currently, projects for Sino-foreign passenger manufacturing joint ventures require approval from the State Council; projects relating to electric vehicle manufacturing company require NDRC approval and other projects require provincial government approval. Accordingly this will be a very meaningful relaxation for some key foreign investments. The change also mirrors China’s decade long move away from approvals towards filing.

Key Development Areas

The Draft Rules encourages social funds and companies with strong technology capability to invest in innovative sectors such as NEVs, intelligent vehicles, energy-saving vehicles and key components and parts R&D.

In the area of intelligent vehicles, the priority is to develop key common technology such as complex environmental sensing, new smart terminals, in-car intelligent computer platforms etc. In particular, the Draft Rules stress the development of chips, CPU and operation systems as being priority projects. This may relate to US’s sanctions on China’s telecoms equipment maker ZTE which re-emphasized China’s vulnerability if it does not own core technologies. However, it also does align with the fact that many Chinese companies have been on the hunt for semi-conductor companies in recent years.

Under the Draft Rules, intelligent vehicles are defined as being new generation vehicles equipped with advanced in-car sensors, controllers, actuators and other devices, adopting new technology such as information and communication, internet, big data and artificial intelligence, with partial or full autonomous driving capability. Intelligent vehicles are also generally referred to as intelligent and connected vehicles, self-driving vehicles or driverless vehicles.

Encouraging More Restructuring and M&A

Companies are encouraged to, by way of equity investment, conduct more M&A, strategic cooperation, joint products development and improve industrial concentration.

More notably, the Draft Rules support state-owned automakers and private car manufacturers to engage in a “mixed-ownership reform” in order to create industrial champions to compete with global peers. China is clearly intent in winning the race to become the leading country for autonomous cars and NEV.

Given the technology demands and capital intensive nature of the auto industry this emphasis on creating scale is no doubt necessary for China to create world leading “champions”.

This initiative again follows existing Chinese policy. Since 2004, China’s car industry policy has encouraged domestic car companies for restructuring and M&A so as to improve industrial concentration. Currently, the top 10 car makers in China account for 90% of the production capacity. However, in contrast with the highly concentrated Western countries, China still has more than 200 car manufacturers.[1]  As such, it is very sensible for the Chinese government to continue to encourage restructuring and M&A of Chinese carmakers in order to form industry giants which can compete toe to toe with international players.

Restrictions on Fossil-fuelled Cars

Under the Draft Rules, the production capacity for fossil-fuelled cars has been strictly controlled.

The Draft Rules clearly prohibit the following investment projects on fossil-fuelled cars:

  • Establishing any new separate fossil-fuelled carmaker;
  • Existing carmakers to build fossil-fuelled car production capacity across the categories of passenger car and commercial cars;
  • Existing fossil-fuelled car makers that have not been included into regional development plan, to re-locate outside the province where it is located; and
  • any equity change in “zombie” fossil-fuelled car makers (i.e. in order to prevent companies taking approved but unused capacity to build more fossil fueled cars).

In addition, if an existing fossil-fuelled car maker intends to increase its production capacity then it must meet six key requirements. These include having car production capacity utilization in both the last two years that is higher than the national average level and the output of NEVs in the last two years being higher than the national average level.

The policy is clear.  It is not considered enough to issues policies to encourage NEVs (i.e. carrot) but there will also be policies curtailing fossil-fueled cars (i.e. stick). It seems fossil-fuelled car makers will have to gradually adjust their production away from fossil-fuelled cars as NEVs ascend.

Electric Vehicles Encouraged but the Bar Raised

Under the Draft Rules, electric vehicles remain strongly encouraged by the PRC government. However, the threshold for investing in electric vehicles has been raised. The detailed requirements include:

  • Project area

To establish a new electric vehicle manufacturing company, the province where such proposed manufacturer is located has to meet the following conditions:

  • The percentage of owned NEVs is higher that of the national average level;
  • With sound electric charging facilities and ratio of charging pole and electric vehicles are higher than the national average level;
  • The cleaning out of “zombie” NEV companies has been completed; and
  • The investment project of the current electric vehicle company has been established and the output has reached the construction scale.
  • The new electric vehicle manufacturing company

For establishing a new electric vehicle manufacturing project, the new electric vehicle manufacturing company is required to meet the following conditions:

  • All the shareholders shall not withdraw or transfer its equity in the new electric vehicle manufacturing company before the completion of the establishment of the project and the output reaching the construction scale;
  • The shareholders shall have the intellectual property rights and production capability on key components such as vehicle control system, driving motor and vehicle power battery;
  • The existing new electric vehicle manufacturing project has been established and the output has reached the construction scale, no illegal construction projects;
  • If the shareholding of the major shareholder is higher than 1/3, such shareholder shall have sufficient self-owned funds for the construction and operation of the project and shall meet other specified requirements (including specific requirements for overseas companies on IP and number of vehicles sold);
  • Having an established R&D center that meets specific requirements;
  • R&D investment for last two years is not less than RMB200 million;
  • Having sound after-sale services.

In addition to the above, there are specific requirements on manufacturing projects, for example, in terms of construction scale, not less than 100,000 electric passenger vehicles or 5,000 electric commercial vehicles. These requirements could be challenging to newcomers. The two largest local electric vehicle makers, BYD Co. and BAIC Motor Corp., respectively sold 113,000 and 103,000 new-energy cars in 2017.[2]

Since July 2015, 15 electric vehicle manufactures have obtained manufacturing approvals from NDRC. However, there are more than 200 companies queuing for these approvals. Based on our research it appears that from June 2017 NDRC has not issued any additional approvals for electric vehicle manufacturer. [3]

It is likely that the pause in issuing new production licenses for electric vehicles is due to the work on the Draft Rules. However, although the production license issue is likely to be resolved the raised bar for electric vehicle manufacturing companies will likely be a barrier for many newcomers.

Clearly, the Chinese government may already feel that the investment in electric vehicles in China is a bit overheated considering the growing number of new start-up car makers. The higher thresholds may squeeze out a growing bubble.

NDRC revealed a 5-year transition period on 17 April 2018 to fully end China’s foreign ownership limits on automakers and foreign ownership restrictions on NEVs will be removed in 2018. As such, the requirements on electric vehicles investment project in the Draft Rules will apply to international newcomers like Tesla.

Auto Components and Parts Investment Project

The Draft Rules have also set out detailed requirements on investment project in auto components and cars, which primarily cover engine and power batteries.

For fossil-fuelled vehicles, engine directly relating to environmental protection and resources consumption. The Draft Rules clearly set out the KW/L indicator and the China’s latest emission standard (i.e. China VI Emission Standard).

For key components and parts of NEVs and power battery, the Draft Rules set out the requirements on production capability, core technology capability, level of intelligence and recycling capability.

These requirements are forward-looking and will upgrade China’s auto industry.

Summary

The Draft Rules continue and extend existing policies in place.

On the one hand China has announced relaxation of restrictions on foreign investment in auto sector with a 5-year transition plan and also reducing import tariffs on autos to 15% from 25% and on auto parts to 6%.

On the other hand China is clearly putting in place policies to allow it to have a strong domestic auto market in which it will compete head to head with international competitors. This future competition will be in respect of NEVs and autonomous cars.

The Draft Rules are expected to be officially issued within 2018 but their impact on the China’s auto industry will reach into the next decade.

[1] http://www.jiemian.com/article/2184219.html

[2] https://www.caixinglobal.com/2018-05-26/china-plans-overhaul-of-auto-industry-development-policy-101256905.html

[3] http://auto.gasgoo.com/News/2018/05/26051621162170042858C501.shtml