Electrifying: How China Built an EV Industry in a Decade

Introduction

In December 2019, the Chinese Ministry of Industry and Information Technology (MIIT) announced that new energy vehicles, composed mainly of plug-in electric vehicles (EVs), would represent 25% of overall vehicle sales by 2025. This is a bold target given that less than 5% of total cars sold in 2019 were EVs. Then again, just a decade ago few expected China to develop an EV industry, let alone become the world’s largest market and manufacturer (see Figures 1a & 1b).

Figure 1a. EV Sales in China vs. World, 2011
Note: Only 5,000 EVs were sold in China in 2011.
Source: China Association of Automobile Manufacturers (CAAM); EV-Volumes.

Figure 1b. EV Sales in China vs. World, 2019
Note: China sold over 1 million EVs despite a slump in sales in 2H2019.
Source: CAAM; EV-Volumes.

The EV market grew on the back of Chinese industrial policy 101: a reliance on subsidies and explicit and implicit local government protections. Yet what’s remarkable is that MIIT, the arbiter of industrial policy, announced the 2025 EV target amid a significant shift in the government’s approach to this emerging industry. That is, Beijing seems to be deliberately moving away from a subsidies regime to one that is more market based—a shift that began around 2016.

Consumer subsidies that have fueled domestic EV sales have already been reduced significantly and were scheduled to be fully phased out in 2020. What has replaced subsidies is a credit-based mechanism that operates a bit like a carbon market. Commonly known as the “Dual Credit” policy, its EV credit system is a mandate explicitly modeled after the Zero Emissions Vehicles Program (ZEV) implemented in the US state of California.

This new system essentially allows auto manufacturers, regardless of country of origin, to sell surplus EV credits to other firms to earn additional revenue and has prompted foreign manufacturers like Volkswagen and General Motors to seriously consider manufacturing more EVs in China (more details on the EV credits system below). But that’s not all. Beijing has also brought back the “wholly foreign owned enterprises” (WFOEs) market entry model for foreign EV manufacturers, in contrast to mandating joint ventures for foreign auto manufacturers.

Combined, these changes amount to deliberately introducing more foreign competition in the sector that so far has eluded domestic firms. In fact, that competition is already being felt now that Tesla, the only beneficiary of the WFOE so far, has built its first “Gigafactory” outside of the United States in Shanghai and has already outsold domestic Chinese brands in 2020.

Whether the “Dual Credit” system will be properly implemented remains to be seen, particularly as the government has now extended some consumer subsidies for a couple of years in response to plunging auto sales amid the economic contraction. Tesla’s prospects in the China market are not guaranteed either as domestic players continue to climb the innovation ladder.

Still, this shift from subsidies to more market discipline is largely in response to the dilemma that has long bedeviled Chinese policy mandarins: industrial policy-induced business cycles have generated strong and rapid growth, but they also tend to produce irrational exuberance, policy abuse, and market fragmentation.

That this course correction has come so rapidly is perhaps surprising for a practitioner of industrial policy that has protected legacy industries long past their usefulness. Yet factors including budget constraints, unintended policy consequences, and bureaucratic preferences have influenced the Chinese government’s decision on taking the EV industry down another path after a 10-year run.

This new path will be uneven and challenging, but it also implies that Beijing’s approach to emerging industries is not fixed. Certain forces can compel it to move away from the practice of vintage industrial policy toward one where markets and competition play a larger role.

To shed light on these dynamics and how they catalyzed an EV industry that didn’t even exist a decade ago, this case first examines the incentives and subsidies at the local level that created an embryonic market. It then looks at how Beijing stepped back into the fray as subsidies became very expensive and as local competition and interests did not create leading firms that the government wanted.

How China Grew Its EV Industry Over the Last Decade

During the depths of the global financial crisis in 2009, four Chinese agencies, led by the Ministry of Science and Technology, jointly launched a pilot program to provide subsidies for the purchase of electric buses and public vehicles (including taxi fleets) in a select number of Chinese cities. By the following year, central subsidies were expanded to cover the private passenger EV market in six cities, where local governments could roll out additional subsidies. These efforts effectively kicked off a decade-long pursuit of building an EV industry from scratch.

When it comes to subsidies, China is not alone in this practice. Advanced economies are no strangers to providing grants and loans to automakers, and tax rebates at all levels of the US government and generous consumer subsidies in Europe are also commonly used to stimulate demand. In China, however, imported vehicles were never made eligible for subsidies and were subject to import tariffs.

Moreover, the intellectual property of the core technologies necessary to make one of three EV drivetrains had to be owned by a domestic manufacturer. (Because EVs have different engine systems, they need fundamentally different drivetrains than traditional cars.)

This is a different approach from other countries like Norway with an EV ownership rate of close to 60% in 2019, where all EVs on the market are imported and qualify for subsidies. Another key difference is that the Chinese government has long been in the business of creating markets directly by mobilizing its impressive public procurement machine. 

In short, Beijing wanted to cultivate high quality domestic manufacturers and to establish a domestic supply chain ecosystem. That’s because a reliable and robust supplier ecosystem is indispensable to the auto industry, and it makes China more attractive as a manufacturing destination because EV firms will want to concentrate close to integrated supply chains.

Prior to 2009, EV industry subsidies took the standard form of R&D grants, including through the longstanding high-tech “863 Program.” But with the launch of the city-level pilot programs after 2009, subsidies at the local level played a starring role in creating both public procurement and private passenger markets (see Figure 2).

Figure 2. Aggregate Private vs. Non-Private EV Sales, 2013-2018
Note: Private purchases are defined as purchases by individual households as opposed to corporate purchases, which can include fleets like buses and taxis, public service vehicles (sanitation, police, government), and carsharing services.
Source: Author’s calculations based on the Bluebook of New Energy Vehicles 2016 and Bluebook of New Energy Vehicles 2019.

Having a reliable public sector market was crucial for an EV industry that was just starting to find its footing. And in contrast to the development of the Chinese solar market that was mainly for export, the Chinese government prioritized creating a domestic market for EVs first.

The success of the public market approach can be seen in Shenzhen’s BYD, which until recently was the largest EV manufacturer in the world. This is remarkable for a private firm that began as a battery maker and only got into the business of making cars after it purchased an ailing state-owned automaker in 2003. For example, BYD’s e6, a model specifically developed for the taxi market, was the third best-selling model of 2016 (after the Qin and the Qin Tang models) and the top selling battery EV in the country that year.

As other cities also established public procurement markets, an estimated 18% of China’s total bus fleets were electric as of 2018, of which BYD continues to be a major supplier. City governments also led the way in developing innovative financing solutions to lower the upfront cost of deploying electric taxis and buses, experimented with car-sharing models that leased EVs, and built the necessary charging infrastructure.

The Private Passenger Market: Subsidies Gone Awry

Consumer subsidies played a large role in developing the private passenger market, with city and municipal governments in the driver’s seat. Starting in 2010, numerous cities were selected to dole out consumer subsidies in addition to national ones, with the central government providing general guidance on subsidy levels that were based on different EV ranges (see Figure 3).

Figure 3. Maximum National and Local Consumer Subsidies for Passenger EVs (in yuan)
Notes: Subsidy amounts are based on full battery EV range >250 km through 2017 and EV range >400 km from 2018; starting in 2017, local subsidies were all capped at 50% of the national level. Note that city districts in Shanghai, such as Pudong, also offered additional subsidies for their residents.
Source: City and national-level subsidies schemes and author calculations.

From 2010 to 2016, local governments were given considerable runway to set their own subsidy levels and eligibility requirements. Shenzhen, for example, maintained consumer subsidies that were higher than the central government’s for a few years. This meant that if Shenzhen residents in 2014 wanted to buy BYD’s e6 model, they were essentially getting a one-third discount on the EV’s factory price of 369,800 yuan (~$53,000).

Variations in subsidy levels depended on local conditions such as budgets and local industry interests. For instance, some cities chose to aggressively create both public sector fleet and private passenger markets with generous subsidies (Shenzhen), while others focused on developing low-cost carsharing fleets and eschewing the private passenger market (Hangzhou).

Moreover, support for local firms could also take a more discriminatory bent, as technical standards and other conditions were also used to prevent non-local companies from benefitting from local subsidies and procurement contracts. These local protectionist moves—which made it more difficult to sell across provincial and municipal boundaries–were specifically targeted at domestic companies that might otherwise benefit from local subsidies. As a result, some EV brands were confined to “local champions” rather than “national champions.”

Local protectionism may be good at incubating local firms, but it also leads to negative externalities, chief among them market fragmentation and abuses of the subsidies system. Instances of fraud and collusion were made public by a 2016 government investigation. In several instances, manufacturers received subsidies for vehicles that existed only on paper or that were equipped with batteries that didn’t meet subsidy eligibility requirements. In some cases, vehicles were sold to companies related to the manufacturer so they could pocket the subsidies.

Whether coincidental or deliberate, these cases of abuse began surfacing just as the central government was having a rethink on its overall EV industry strategy. By implicating local governments in mismanaging the subsidies program, the central government was laying the groundwork for more involvement in setting standards and curbing excessive local government spending on subsidies.

In hindsight, it appears that a consensus was reached at the central level that subsidies had served their purpose in creating the new industry. Therefore, they needed to be gradually phased out and replaced with other mechanisms to push the EV industry forward and make it more competitive.

Figure 4. EV Sales in China, 2011-2019
Notes: Sales in 2019 fell after the cancelation of local subsidies in June. Conventional car sales have been declining since 2018 due to the economic slowdown, so the fall in EV demand was expected to eventually converge with the overall industry trend.
Source: CAAM.

One of the main points against subsidies was cost: the spectacular growth in EV sales starting in 2014 made it apparent that the subsidy model was not sustainable (see Figure 4). Of the estimated total government spending of $60 billion to jumpstart the EV industry between 2009 and 2017, almost $37 billion (~60%) went toward consumer subsidies. If this estimate is correct, then consumer subsidies amounted to about a quarter of total EV sales over that time period, a non-trivial sum. The rest of the funds supposedly went toward government procurement, infrastructure subsidies, and R&D.

As a point of comparison, Tesla received a $465 million loan in 2010 from the US government to build its manufacturing plant in Freemont, California. The loan, which was not without controversy at the time, was paid back in full with interest just three years later, while the United States got a leading EV company in the process. This may seem like a bargain, but it is worth noting that China was aiming to build an entire industrial ecosystem from the get-go, a far more ambitious objective.

The cost of subsidies may have been worthwhile if the irrational exuberance that accompanied this “let 100 EV firms bloom” period also led the way in technological superiority. Yet even as registered EV firms mushroomed to more than 400 by 2018, according to some estimates, only about 15% of them are actually manufacturing cars. The vast majority of these firms appears to have either not reached the production stage or have products of questionable quality.

For these reasons, Beijing decided to reassert itself in 2016 first by raising technical requirements and laying out a schedule for subsidy reduction and eventual elimination. For instance, Beijing in 2017 had already lowered passenger EV subsidies significantly by capping local incentives at 50% of the national level. By June 2019, local consumer subsidies for passenger EVs were pulled entirely, while national subsidies only narrowly avoided the chopping block in 2020 due to the pandemic’s impact on auto sales.

Strategic Adjustment

What would take the place of subsidies was certainly subject to considerable internal debate. The result took the form of the “Dual Credit” policy, which is modeled after California’s ZEV program. Led by MIIT, the program is composed of two components: one on credits for EVs and another on credits for achieving fuel efficiency targets.

First announced in 2017, the new program is meant to standardize incentives for auto manufacturers, using a credit trading system as the centerpiece. Automakers can earn credits either by hitting the mandated EV credit target or raise the fuel efficiency of their traditional gas-powered vehicles. The fuel efficiency standards, known as the Corporate Average Fuel Consumption (CAFC), function similarly to the US Corporate Average Fuel Efficiency (CAFE) standards.

The EV credit system is complicated, but here’s how it works in brief. A credit target based on total car production is assigned to an automaker—it’s 12% in 2020 but will be increased to 18% in 2023. Reaching that target depends on the type of EVs produced (full battery EVs get more credits than hybrids). So if a company produces many full battery EVs, it will earn more credits per vehicle and could sell fewer to meet the target. Auto manufacturers that exceed the credit target can sell the surplus credits to firms that can’t meet their EV target or carry them over at a discount.

Of course, manufacturing EVs would meet CAFC standards by default since they use no fuel. So, the credit system is biased toward encouraging automakers to make EVs because that would kill two birds with one stone. This is further reinforced by the fact that earned credits from CAFC cannot be traded to offset EV credits, but EV credits can be used by automakers to offset falling short of CAFC targets. In California’s ZEV program, Tesla has reportedly earned up to $2 billion in revenue from selling credits to the likes of Fiat and GM.

The EV credit system essentially puts the onus on automakers and takes away the power of disbursing subsidies from local governments. In that sense, it is also meant to introduce more competition into the sector because foreign auto manufacturers now have a stronger incentive to enter the EV market. That’s because policy does not focus on the identity of the firm, domestic or foreign, but simply sets a mandated target that all auto manufacturers either need to meet or else rely on credits to make up for missing targets.

After some initial hesitation, foreign firms like Volkswagen have responded by dramatically increasing their investment in the Chinese EV market and are expected to release several new models in the China market over the next year. Some have argued persuasively that China’s EV policies have been a gamechanger for the global EV industry, pushing automakers to rethink their business strategy.

Still, how well this EV credit market will function remains to be seen, as it has exhibited symptoms of credit oversupply that have led to very low prices. Kinks in the implementation of this new system will have to be ironed out over time or it risks faltering. But these challenges are not surprising for a market that is barely two years old, and Beijing has already issued regulations to correct some of these issues by changing how EV credits are calculated and carried over.

Nonetheless, it seems clear that heightened competition and fewer subsidies for the EV industry will be the order of the day. As such, it is inevitable that weaker EV firms will be weeded out—a consolidation that the central government would prefer. But policymakers, and particularly local governments, also need to strike a delicate balance between supporting firms without undermining the industry as a more market-oriented system takes hold.

Conclusion

Industrial policy with Chinese characteristics is often used as the single explanatory variable for why China may or may not succeed in sector x or y. Yet industrial policy in practice is messier, replete with both successes and failures.

As shown in this case study of the EV industry, the Chinese state, particularly local governments, are powerful agents in deploying resources to create markets, support industry, and experiment with various models that can create a complex industry from scratch. They also internalized lessons from the experience of the traditional auto industry: after decades of manufacturing cars, Chinese auto brands still have not achieved the quality and recognition of Japanese or South Korean brands.

Beijing wanted to set a different path for the EV industry from its inception. From the government’s vantage point, Chinese people bought a lot of cars, but Chinese companies weren’t leaders in making cars that Chinese people actually want. That dissonance likely informed the government’s emphasis on not only creating domestic markets for EVs but also establishing a manufacturing ecosystem.

If the intent was to create a leapfrog industry, then the initial playbook relied on what the Chinese government knew best: pilot programs, subsidies, government procurement, and some form of nontariff barriers to market entry. That policy mix produced the world’s largest EV market in a decade, but in its wake sprouted a litany of problems that made Beijing worried that it was replicating the mistakes in the traditional auto industry.

Surprisingly, then, the central government decided to cut off subsidies faster than what was perhaps expected. In its place the government has launched a market-based program focused on raising quality and fuel efficiency and relying more on competition. In other words, the government has proven to be rather adaptive and disciplined when it comes to pivoting to a different approach when the current strategy appears to go off course.

The transition towards a more market-based credit system is far from over and the current economic downturn has seen local governments resorting to bailing out firms and perpetuating subsidies. For example, the Anhui provincial government recently engineered a $1 billion investment to help cash-starved EV startup NIO in exchange for the company to relocate its headquarters to the provincial capital Hefei.

But the writing is on the wall that Beijing neither desires nor is willing to subsidize this industry in perpetuity, preferring to let the market and even foreign competition do more of the work. The long-term objective is for the industry to stand on its own two feet in order to compete effectively in the global market without draining fiscal coffers.

The next few years will not be easy sailing for many EV companies. But the industry could well emerge stronger and more consolidated—which will have knock-on effects on investment decisions and R&D spending globally. Whether the majority of world’s EV production will indeed be “made in China” by 2025 remains a crucial question for governments and auto manufacturers alike. At a minimum, far more Chinese brands will dot the global EV landscape than there ever were in the traditional automotive market.