Mainland energy companies are stepping up their investment in projects to turn coal into liquid fuel, chemicals and natural gas, as tumbling coal prices caused by oversupply make such processes more lucrative. They had already been experimenting with such projects as a way to meeting rising demand for energy and chemicals, since the mainland is rich in coal but poor in oil and gas. Now, with prices of imported oil and gas staying high, replacing them with cheap domestic coal - particularly coal from remote regions - to produce downstream fuel and industrial chemicals makes economic sense. However, analysts warn, concerns about the depletion of scarce water resources in most of the mainland's coal-rich regions and carbon dioxide emissions from such water-intensive and emission-heavy projects mean they face big environmental challenges and uncertain returns. China Coal Energy, the listed unit of the mainland's second-largest coal producer China National Coal, said late last month that its budget for coal-to-chemical projects this year - 17.4 billion yuan (HK$21.9 billion) - had for the first time surpassed the 3.2 billion yuan set aside for developing coal mines. Its enthusiasm for such projects, to add value to coal and reduce the impact of volatile coal prices on its bottom line, is shared by bigger rival China Shenhua Energy, which plans to buy parent Shenhua Group's coal-to-liquid fuel and chemicals businesses. The liquid fuel includes petrol and diesel, while the chemicals include polypropylene and naphtha, raw materials for making plastics and fabrics. These are traditionally derived from crude oil. The [gas] plan effectively shifts carbon dioxide emissions to [China’s] west UBS ANALYSTS The prospect of using technology to exploit ample domestic coal resources has also caught the attention of non-coal energy firms. China Petroleum & Chemical (Sinopec), the nation's second-largest oil and gas producer, said late last month that a coal-to-gas conversion project that would pipe gas from the coal-rich Xinjiang Uygur autonomous region to Guangdong and Zhejiang provinces had been approved by Beijing. Sinopec's partners in the project, which it is leading, include seven other state-owned power and coal producers. Coal gasification is the process of "manufacturing" natural gas, or methane, from coal. Coal is exposed to steam and air under high temperature and pressure, which produces gases consisting mostly of carbon monoxide and hydrogen. Such "synthetic gases" are further processed to make methane. Liquid fuel and chemicals can also be made from the synthetic gases, in an indirect coal conversion method. Alternatively, they can be directly derived from coal by applying catalysts in a high-pressure, high-temperature environment. The ramping up of coal-to-liquid-fuel and coal-to-gas output could help boost the mainland's bargaining power in negotiations with overseas oil and gas suppliers at a time when imports are rising. The mainland relied on imports for about a quarter of the gas it consumed last year, up from just 5 per cent in 2009. After becoming a net oil importer in 1993, the mainland is expected to import almost 60 per cent of its oil needs this year. Coal conversion technologies were first used commercially by South Africa's Sasol, which used them to produce liquid fuel when faced with a foreign oil embargo during the apartheid years. A proposed joint venture plant with Shenhua Group in the Ningxia Hui autonomous region using indirect conversion technology received approval from the Ministry of Environmental Protection in March 2011, but Sasol withdrew from the project after prolonged delays in the granting of approval by the National Development and Reform Commission. That means mainland firms have relied on domestic technology to complete their projects. Sinopec's massive, 200 billion yuan coal-to-gas project will have an annual output capacity of 30 billion cubic metres (bcm) when it is completed in June 2017, according to state media. That is a significant amount given that Beijing forecasts that mainland gas demand will hit 230bcm in 2015, a forecast that implies annual growth of 16.4 per cent from last year. Beijing's approval of the project came as listed Datang International Power Generation's demonstration project in the Inner Mongolia autonomous region, capable of sending 4bcm of gas to Beijing a year, began trial production. Datang also has a 16 billion yuan coal-to-chemical project in Inner Mongolia, commissioned about two years ago, but attempts to ramp up production have been disappointing due to technical difficulties. Technical issues aside, the developers of coal-conversion projects also face big challenges in terms of environmental protection. For example, 10 tonnes of water are required to produce one tonne of liquid fuel from coal. Activists from environmental group Greenpeace surprised China Shenhua management in Hong Kong late last month when they protested at a press conference on the firm's interim results, demanding that management to respond to claims that Shenhua Group's coal-to-liquid-fuel project in Inner Mongolia had damaged the environment by drawing too much underground water and by illegally disposing of waste water. Management countered that the allegations were exaggerated and the firm's projects and emission standards had been approved by the Ministry of Environmental Protection. Still, mainland energy firms will likely face more questions from both investors and environmentalists about the long-term viability and sustainability of their coal-conversion projects, given their rapid expansion. In a research report, UBS analysts projected that mainland coal-to-gas production would rise to 55bcm in 2020 from just 0.3bcm this year. They estimated that planned projects would require investment of more than 400 billion yuan over the next five years. "China is on the cusp of a five- to seven-year boom in coal-gasification capital expenditure and capacity," they said, adding that carbon emissions were a bigger challenge for the industry than water scarcity because it was less water-intensive than coal-to-liquid-fuel projects. They estimated that rising mainland gas prices, falling coal prices and relatively low steel prices would see coal-to-gas conversion projects achieve internal rates of return of 10 to 13 per cent, depending on project location and coal quality. That is assuming zero cost for carbon emissions. For every 20 yuan per tonne rise in carbon emission costs, the return rate would fall by one percentage point, they said. Beijing has indicated that it plans to introduce a price on carbon emissions. Trial carbon trading started in Shenzhen in June. UBS analysts estimated that the amount of carbon dioxide emitted by converting coal to gas and then burning the gas in power plants was about 40 per cent higher than the amount emitted from directly burning the coal in a power plant. This means coal conversion projects would increase the mainland's carbon footprint. "Coal is gasified in western provinces and sent to eastern provinces as a substitute fuel for coal," they said. "The plan effectively shifts carbon dioxide emissions to the west, while raising emissions across the country."