Smoke gets in your eyes... and lungs...and heart...
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By Scott Cendrowski
April 10, 2014

We’re not used to hearing this kind of rhetoric from China: The country will “declare war” on air pollution, Premier Li Keqiang, the country’s second-most-powerful leader, told 3,000 Communist Party delegates in early March. He called pollution “nature’s red-light warning” and admitted — in the government’s strongest language yet about the smog, after years of denials — that China has a crisis on its hands: Last year Beijing’s air on average was almost 10 times more polluted than levels considered safe. Sixteen of the world’s 20 most polluted cities are in China, says the World Bank, and a new study from one of China’s best-known researchers shows that some Chinese cities are falling deeper into despair as polluting businesses attract more polluters, dooming areas to a never-ending cloud of smog.

Indeed, the environment has morphed into the world’s biggest country’s most daunting challenge — larger in scope than moving 250 million rural people into cities, fixing corruption, or even closing the wealth gap. But even for a government famous for engineering marvels — from building the Three Gorges Dam to hosting the 2008 Beijing Summer Olympics to orchestrating the urban migration of millions — fixing the air will take more than brute force. Coal burning and heavy industry are responsible for two-thirds of the country’s air pollutants. It will take a willingness to aggressively reengineer the economy from its dependence on cheap coal and shut down polluting enterprises, in many cases the very businesses that have fueled China’s growth and kept its citizens gainfully employed.

Perhaps it is somewhat paradoxical, then, that China desperately needs businesses to help fix its pollution problem — and not simply by reducing emissions or paring back their carbon footprint. China needs to hire private-sector companies to participate in the cleanup effort and develop new solutions for addressing this unprecedented environmental predicament. There’s money to be made: President Xi Jinping and Premier Li have pledged to spend $275 billion over five years to fight smog. Perhaps even a state-owned enterprise could develop an antidote. “In past years business in China grew at any cost and caused the pollution situation today,” says Ma Jun, director of the nonprofit Institute of Public and Environmental Affairs and China’s leading environmentalist. “Now business is realizing they must help fix it.”

Because almost everyone in China now fears the health effects of smog, clean air has become a powerful marketing tool. SOHO China, one of China’s most famous real estate developers, incorporates clean indoor air in its business plans better than almost anyone. Run by Zhang Xin and her husband, Pan Shiyi, SOHO made a name in the U.S. last year after Zhang bought a $700 million stake, with a partner, in Manhattan’s General Motors Building. Pan grew famous in China a few years ago for pressuring the government to release readings of PM2.5, the dangerously small pollutants that create smog and are quickly absorbed into the bloodstream.

One of SOHO China’s newest buildings in Beijing is the futuristic-looking Zaha Hadid-designed Galaxy SOHO, opened in 2012, which includes cutting-edge antipollution technology. SOHO called on Honeywell, based in Morristown, N.J., and Malaysia-based MayAir to install some of the world’s best air-purification systems, which reduce interior pollution, SOHO says, to a 10th of outdoor levels. Galaxy SOHO is able to charge higher rents — 10% to 15% more, analysts estimate — because of the air systems. SOHO says it plans to install similar filters in all new buildings to gain an advantage over competitors. “When the outdoor air quality can’t be improved completely,” Pan told a Chinese newspaper last year, “you can improve the indoor air quality by yourself.” Amid a recent government crackdown on social media criticism, Pan declined Fortune’s requests for comment.

Meanwhile, on the 32nd floor of a Beijing skyrise — “We’re lucky today; you can enjoy the view,” says venture capitalist Lei Yang on a busy Sunday — opportunities to invest in clean tech are quickly multiplying. Yang is a managing director at Northern Light Venture Capital, a China-focused VC firm managing $1 billion. A few years ago Yang was homed in on industrial solutions to pollution, such as wastewater treatment for petrochemical plants and ways to turn garbage dumps into public parks. Today’s air pollution has changed all that. “The country reached a tipping point in 2010,” says Yang, “when the priority shifted to air pollution.”

Green investing as a whole is booming in China, while coal and dirty industries are being left behind. After rising for half a decade, Chinese coal stocks have fallen by 40% over the past three years as investors move their bets elsewhere. Last year shares of BYD, the electric-car maker, and Guodian Technology & Environment, which makes scrubbers for heavy-polluting coal-powered plants, rose more than 20% as China’s homeland stock markets fell by 7%.

Yang’s investments include Pearl Hydrogen, a Shanghai firm that develops hydrogen fuel cells, and SPS, a Chaozhou-based company whose energy-recovery technology is used in high-speed trains to turn heat generated from braking into energy. But Yang thinks the next best thing may be serving pollution-wary consumers. A startup he’s considering syncs a home’s air-filtration system to smartphones. When pollution reaches worrisome levels, a customer can activate his air filters remotely — a tool that Yang thinks has mass-market appeal. He confesses: “Two years ago we mistakenly thought only the very rich would buy air filters.”

Western firms are also circling — and proactively reforming — in China. LP Amina, an American firm that retrofits coal-powered plants, says its China sales doubled in 2013. General Electric is pushing its natural-gas turbines for what it sees as China’s “age of gas,” and Toshiba’s Westinghouse has sold China four of its state-of-the-art nuclear reactors as the country moves to reduce its dependence on coal (see “China goes nuclear“). Apple, meanwhile, has begun monitoring pollution controls for its supplier network after coming under fire from environmentalists for pollution and hazardous waste.

All these companies — from Yang’s portfolio to SOHO China, Honeywell, and hundreds of others — should experience a decades-long boom, because studies increasingly show that air pollution in China, a country still dependent on dirty coal, is a problem that will take decades to fix.

One of those reports comes from Yuyu Chen, who may be China’s most famous pollution researcher. Before the Beijing Olympics in 2008, when outrage over China’s air quality was drawing international headlines, the associate professor of applied economics at Peking University’s Guanghua School of Management switched from writing papers on China’s 1960s famine to determining how many years pollution slashed from lifespans across the country.

Chen discovered that the Huai River in the country’s middle region provided the perfect natural research tool because the river has long been the dividing line between China’s cold, dry north — dotted with coal-powered plants — and its warmer south. Back in the 1950s, Chairman Mao ordered that residents north of the river receive free heating from the coal-powered plants. Chen’s research team compiled government data from 1981 to 2000 showing that air pollution was 55% higher in the northern region. Linking the data to mortality statistics, especially deaths caused by cardiorespiratory illnesses, his research team concluded that pollution shaved 5.5 years off lives in the north.

Chen’s latest research, yet to be published, describes something even bleaker happening across Chinese cities. Chen found that once a city relies on polluting industries for 30% of its GDP, it becomes nearly impossible to attract clean industries. In other words, once a city is polluted, it stays polluted. “Once I found this phenomenon, I felt quite worried,” Chen says, who admits he doesn’t believe the problem can be quickly solved.

Polluted cities cost China hundreds of millions of dollars every year, though estimates can vary because obtaining reliable government data is tough. Even China’s Ministry of Environmental Protection, which quietly released a report in early 2013 showing that costs amounted to 3.5% of GDP in 2010, or $250 billion, admitted it was working off incomplete data. More recently a Beijing official in September estimated the price at $817 billion in the five years through 2017.

Some of the polluted towns, dubbed “cancer villages,” spend millions on health care, while productivity is falling across the country in cities grappling with nearly irreversible smog. When the air is polluted, humans simply can’t do as much work as they can under blue skies.

So what are China’s next steps? In a report released last year and subsequently updated, Jun Ma, a China economist at Deutsche Bank, who according to Chinese media reports caught the attention of China’s leadership and will soon join China’s central bank, offers the most thorough prescriptions for China to improve air quality. The prescriptions are based on China’s goal of reducing particulate matter pollution to an urban average of 35 by 2030, from around 90 today. (The World Health Organization says a level of 10 is healthy, but China is being realistic.)

To reach an index average of 35, Ma says, growth in coal consumption must be halved in the next five years, and growth in ownership of gas-powered cars cut to one-fourth current levels. Subways must expand fourfold. China must reduce coal emissions by 70% over the next 18 years via clean coal technologies.

He says ultimately public and private interests need to join forces to improve the air. China needs aggressive R&D spending increases for coal and oil replacements like solar, natural gas, and electric cars. If coal use isn’t drastically reduced and China doesn’t undertake “big bang” reforms, the outlook is grim.

“The current trend of coal and auto consumption growth implies that China’s air pollution will become a lot worse from the already unbearable level,” Ma concludes.

As bleak as that sounds, many outsiders are optimistic that a combination of political will and opportunistic business interests may conspire to accelerate clean air in China’s cities, much the way similar forces worked to reduce smog in Los Angeles. China’s central government can’t accept polluted air deterring multinational executives from relocating to China’s cities, nor can it allow its elites to flee to cleaner pastures. Markus Rodlauer, the International Monetary Fund’s mission chief for China, says the country has proved it can enact massive reforms since opening up in the late 1970s — from liberalizing the banking industry to becoming a global trading partner. “Given the way China has changed over the past 30 years, it does deserve probably the benefit of the doubt that it will find its way through these challenges,” he says. Put another way, if Rodlauer is right, we probably should get used to more talk and transparency about pollution from Beijing.

This story is from the April 28, 2014 issue of Fortune.

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