THE WALL STREET JOURNAL: The Leapfrog Strategy: Monday 25 July 2005

In a lab on the outskirts of Shanghai, professor Wan Gang and his students are leading an effort to secure China's energy independence. Last year, the team from Tongji University created the Start II, a prototype fuel-cell car that runs on hydrogen and spurts nothing but water from its tailpipe.

Now they are trying to make it cheaper and more efficient -- but, as Mr. Wan sees it, they are running out of time.

An explosion in car sales in the past three years has choked major Chinese cities with smog and sent the country's oil consumption soaring. Last year, China became the world's second-biggest oil consumer, after the U.S., and it now imports 40% of its oil.

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That's potentially unhealthy, especially with prices hitting record highs and the oil-rich Middle East in turmoil. China's aggressive efforts to secure oil and gas are also starting to cause friction with its neighbors Russia and Japan, and U.S. politicians are on high alert as China's Cnooc Ltd. tries to acquire U.S. oil company Unocal Corp.

"If China imports more and more crude oil, then other countries will have problems, and prices will be higher," Mr. Wan says. "It isn't just a China problem, but a problem for the whole industrial world."

Looking to Hydrogen

Fuel cells, advocates argue, are China's best bet for limiting its dependence on petroleum and cleaning up its air. Moreover, they say, China is uniquely positioned to take advantage of fuel cells, thanks to a seeming disadvantage: the nation's underdeveloped automotive and energy industries.

In developed countries, gasoline and diesel distribution networks are so extensive that converting them to supply hydrogen will be costly for energy companies. But China's car culture is new, so it doesn't have a big fueling infrastructure in place. Fuel-cell advocates argue that this gives the country a golden opportunity to leapfrog ahead of petroleum and create a network of fuel-cell stations instead. If fuel cells are the future, they say, why build a full-blown support system for gasoline?

In developed countries, "the infrastructure investment is so huge, and inertia so great, that it's very difficult to do things differently," says Dan Sperling, professor of engineering and environmental policy at U.C. Davis. "There's probably only one developing country in the world that could even conceive of [leapfrogging ahead]. And that's China."

He adds, "The real question is, in the long term, would a leapfrog strategy cost more than a gasoline-diesel strategy? And that's unclear." Mr. Sperling will soon be studying the issue as head of the China Center on Energy and Transportation, a cooperative effort between U.C. Davis, Tongji University and Tsinghua University that will be launched this fall.

Even though the Chinese government has made few official overtures toward fuel cells, it has recently shown a general interest in alternative fuels. Last year, the government updated its auto policy for the first time in a decade, calling for companies to use more environmentally friendly technology and encouraging foreign companies to transfer such technology to their Chinese operations.

This year the government has also launched a top-level energy task force headed by Premier Wen Jiabao to deal with all energy-related issues, including shortages, conservation and China's deteriorating energy trade balance.

In addition, Mr. Wan says the government plans to introduce tax incentives for fuel-saving cars, as well as fuel taxes to dissuade consumers from buying gas guzzlers.

Outside Influence

China's fuel-cell efforts could get a boost if international auto giants undertook fuel-cell research there. So far most foreign manufacturers are treading carefully, for fear that bringing such research and technology to China could mean giving it away free. China doesn't have a great record of protecting intellectual-property rights, and companies fear that their products will be stolen and refined by local firms -- and possibly end up gobbling market share.

Mr. Wan says that to further encourage foreign car makers, the government could allow them to set up wholly owned companies. Today, global auto makers are forced to take on a local partner, which increases the odds of technology being drained.

Already, some foreign companies are considering taking the plunge. Ballard Power Systems Inc., the world's leading fuel-cell research firm, with investors including Ford Motor Co. and DaimlerChrysler AG, is eyeing China for its future. Ballard, of Burnaby, British Columbia, claims that it will begin making commercially viable automotive fuel cells by 2010.

But the company has been fighting increasing pessimism that the fuel-cell future may be at least another generation away. Now its leaders believe China could help Ballard accelerate the commercialization of fuel-cell cars.

"China has the strongest argument in the world to...leapfrog from the old 19th-century oil and gas technology to the 21st-century fuel-cell technology, and skip all that hydrocarbon infrastructure investment that would be required to support the tremendous demand for automobiles," says Denis Campbell, chief executive. "By teaming up with a company like Ballard, the Chinese government or the Chinese companies can shoot to the head of the pack."

Stephen Kukucha, Ballard's director of external affairs and government business, notes that China has a strong base of automotive suppliers that could also help cut costs in building fuel cells. As for intellectual-property concerns, he says, "China's a market that you avoid at your peril."

Global energy companies also are taking a strong interest in China's fuel-cell future. "Shell Hydrogen sees China as a wild card," says Gabriel de Scheemaker, vice president, Asia Pacific of Shell Hydrogen, a unit of Royal Dutch/Shell Group. The country's expected boom in vehicle sales and potential demand for hydrogen could make it a world leader in the new market. "Even as a follower[], it will very quickly overtake whoever is in the lead."

Shell says it wants to set up experimental fuel-cell cars and stations in China with the government and car makers, to match similar projects in the U.S. and Japan. Shell says it expects a network of hydrogen refilling stations to be built by energy companies in close cooperation with the local government in Shanghai within two to four years, and that it is discussing internally how to eventually integrate the manufacturing, supply and distribution of hydrogen with its existing operations and offerings.

But even without outside help, Mr. Wan says, China will bring the technology to fruition. "I think it's better for [the global auto makers] to push this technology in China rather than in developed countries," he says. "But anyway, if global auto makers wait for China to develop [fuel-cell technology] before investing, we will already be exporting."

Write to Jane Lanhee Lee at jane.lee@dowjones.com