Anyone with any knowledge of the energy constraints facing the modern industrial world understands that alternative energy is essential for the future of any modern society. Two critical raw materials for the key alternative energy technologies are rare earths and polycrystalline silicon (“polysilicon”). China is already virtually the sole supplier of rare earths to the world and it is heading towards doing the same for polysilicon. The reasons have little to do with supply of material, but are related almost exclusively to the peculiar way primary industry operates in China. What is occurring is an exchange with few benefits to either side.

Much has been written recently about the export of rare earth minerals from China. There are two areas of dispute. The first is quotas imposed on exports. China justifies these quotas on resource conservation and environmental grounds. The U.S. disagrees and has threatened to challenge these quotas at the WTO. The second in the accusation in October that China cut off shipments of rare earths to Japan in retaliation over the Diaoyu Islands dispute. China denies that such a ban occurred, but there is much evidence on the other side.

All of this has raised alarm bells in the West. This is because rare earths are an essential component in many high-tech products. For example, the rare earth neodymium is required for the batteries used in the engines of most current electric vehicles and in the generators of most wind power generators. China accounts for about 95% of world rare earth exports. It therefore appears that the West has placed its technological future in China’s hands. The thought of China wielding this monopoly in rare earths on the lines of OPEC is not a pretty picture for Western businesses and governments.

There is, however, a much deeper story.

China’s peculiar situation with respect to rare earths is not a sign of strength. It is actually a sign a fundamental weakness within the Chinese system. This weakness, however, has a highly destabilizing effect on the world economy. The effect is being felt now with rare earths. A similar phenomenon will occur soon with polysilicon.

I will discuss both below.

Here is the basic story for rare earths. Despite the name, rare earth deposits are well distributed around the world and are not particularly rare. Processing of rare earths results in a high level of environmental pollution, arising from both the initial mining and also from the subsequent primary processing of the ores. Any mining operation that properly deals with these pollution issues results in a high priced product.

China has been able to dominate rare earths production by producing product at a remarkably low price. The China price is about one quarter of the price that had previously prevailed in the rare earths market. China achieved this low price in three ways. First, the Chinese producers make only minimal efforts to deal with the environmental impacts of the mining process. As a result, the rare earths mining regions in Inner Mongolia are classified as some of the most polluted regions in the world. Second, rare earth mines pay low wages and provide little or no health or safety protection to miners. The resulting poverty and health problems for the workers are well known. Third, rare earths mining has traditionally been conducted by numerous small operations. These operations ruthlessly bid against each other on price terms. This “ruinous competition” results in a price that barely covers the cost of production. Though China has recently pushed to consolidate the mining in fewer and larger companies, there are still a sufficient number of players so that the intense price completion continues.

What is the result for China?

China takes the pollution, low wages and health risks and keeps that in China. China then exports the resulting product at a fantastically low price to foreign high tech companies who reap the benefit. The real value of rare earths lies in the downstream use of rare earth minerals in the high tech production process. This technology remains almost entirely in the hands of foreign companies. Very little has been transferred to China. It is the usual story: China does the dirty work, takes the environmental and labor consequences and reaps no reward either in terms of profit or in terms of technological advancement.

This is hardly a sign of strength. It is an indicator of incredible weakness.

It appears that the West is the absolute winner in this exchange. However, there is a hidden problem. Economists I have talked with estimate that the “Chinese price” for rare earths is about ¼ of the price that would result from an environmentally sound, worker friendly, profitable operation. This means that the “real” price of rare earths is about four times higher than the current China price. An entire set of “green” industries have grown up over the past ten years in reliance on that China price. The danger is that as the China price is phased out, many of these green industries will prove to be unprofitable. A primary example of this risk is the electric car. Since the China price for rare earths is virtually certain to be phased out very quickly, this risk is quite real.

A similar process is occurring right now in the market for polycrystalline silicon (“polysilicon”). Polysilicon is the fundamental raw material for the current generation of solar cells and related silicon based electronic products. As the use of solar energy boomed in Europe in the past decade, the price of polysilicon spiked. The price rose from about $35 per kilo in 2005 to over $450 per kilo in 2008. This increase in price attracted a substantial amount of Chinese investment in polysilicon production.

In 2001, China had only two manufacturers of polysilicon, with a total production capacity of 80 metric tons. By 2008, this number had increased to 19 makers with a capacity of 30,000 metric tons. With domestic demand at 17,000 metric tons, this produced substantial overcapacity in the Chinese market.

By 2011, capacity is expected to increase to 100,000 metric tons. This amount is about double the entire projected world demand for 2011. The result will be predictable: the Chinese manufacturers will engage in ruinous price competition. The price will fall dramatically. Worldwide, competitors to the Chinese will be driven out of business. Within China, none of the Chinese manufacturers will make any money. However, the process will continue even though no money is made, because the manufacturers are not private enterprises. They are owned and controlled by provincial and local governments, each of which jealously guards these precious investments and none are permitted to go bankrupt. Thus, the normal market correction resulting from falling prices does not occur in China. Instead, overcapacity is maintained, prices are reduced, and pollution, waste and worker conditions are simply ignored.

This is the “price” of the China price.

The resulting story for polysilicon will therefore be the same as it has been for rare earths. The production of polysilicon is energy intensive and highly polluting. Since China must import about 90% of the silica sand raw material, the opportunity for profit is even more constrained. Thus, China will export the clean end product to the west at ruinously low prices. Little or no technology transfer will occur. China will be left with the pollution and waste and little else to show for its efforts. The risk to the West will be that it will have lost most or all of its capacity to produce a critical source material. We will then be hearing the same concerns that China has a lock on the product and is using that monopoly for political purposes.

When this occurs, please spare me the expressions of surprise.