Paulson takes on China and climate change

WASHINGTON (Fortune) -- Treasury Secretary Hank Paulson has careened from crisis to crisis lately, backing the Bear Stearns rescue, engineering the government takeover of Fannie Mae, refusing to commit taxpayer money to save Lehman Brothers, and Friday announcing a massive program to help banks offload mortgage-related assets.

When he hasn't been fighting fires, Paulson, the former chief executive of Goldman Sachs (GS, Fortune 500), and his team at Treasury have been working on two big, long-term issues that matter to him, and should matter to all Americans - U.S. relations with China and climate change.

They are intertwined, of course. Without the support of huge, rapidly-developing nations like China (and India), there's no way that Europe, Japan and the U.S. can drive a global consensus to curb global warming.

Paulson and key aides spent hours talking with Fortune recently and we, of course, focused on the headlines. But it turns out that the Treasury chief has made progress on both China and climate.

In September 2006, just a few months after Paulson took office, President Bush and President Hu Jintao of China launched an initiative called the Strategic Economic Dialogue between the U.S. and China. The idea, and it was Paulson's, is to promote better understanding, with formal meetings of Cabinet-level officials scheduled twice a year to talk about a range of issues including trade, the environment, innovation, open markets and product safety.

"It was amazing," Paulson says. "When I got down here, I saw there were a good number of people who looked at China's emergence as a global power as something that needed to be constrained, contained, countered. I clearly saw the path to success as engagement."

"U.S-China relations are more productive today than ever before."

Not surprisingly, given his Wall Street pedigree, Paulson believes strongly that the key to improving U.S.-China relations is to expand free trade, persuade the Chinese to open their capital markets and to let their currency float. (Keeping the value of the yuan artificially low makes Chinese exports to the U.S. cheaper.) All those steps, he says, would benefit both countries.

"The thing that you need to understand when you view China is that robust and sustained economic growth is imperative," Paulson says. "It is through that lens that they look at so much of their international activity."

The SED has not produced much in the way of tangible results. The countries struck an aviation deal last year, which will mean that U.S. passenger flights to and from China will more than double by 2012, and restrictions on air-cargo flights will be lifted by 2011. China has also agreed to develop an emissions-trading program to reduce sulfur dioxide from its coal plants; this could help pave the way for a future agreement on greenhouse gases.

As for the pesky, high-profile currency issue, Paulson notes that the value of the yuan has appreciated by about 23% since July 2005, when China first unpegged the currency from the U.S. dollar. Some say that's not enough, but it's progress.

Says Paulson:"The Chinese like stability and they say the greatest risk is moving too fast. I've been trying to convince them that the greatest risk is not in moving too fast, it's in moving too slow because they are an economy in transition."

Perhaps more important, Paulson has worked hard to head off anti-China legislation on Capitol Hill. "We have avoided counterproductive currency legislation," he says.

In a long article in the current issue of Foreign Affairs magazine, Paulson writes: "U.S-China relations are more productive today than ever before." You can read his arguments here.

One thing Paulson makes clear is that it's in everyone's interest to promote clean technology and energy efficiency in China, to curb global warming. According to Paulson, if China today was as efficient in its use of energy as the U.S. was in 1970, it would save the equivalent of 16 million barrels of oil a day, or almost 10% of the world's daily oil consumption.

All of the world must learn to make do with less, he argues. "There simply are not enough energy resources to allow the world's entire population, or even the third of it represented by the Chinese, to lead the resource-intensive lifestyle that Americans currently enjoy," Paulson says.

Paulson's an environmentalist - he is the former chair of the Nature Conservancy and the reason why Goldman Sachs, under his watch, became the first investment bank to call for federal regulation of greenhouse gases. But his influence on Bush administration climate policies has been limited, judging by the fact that the president still opposes mandatory regulation of greenhouse gases.

But Paulson has used his influence to persuade the World Bank to create a $5 billion to $10 billion clean technology fund, supported by France, Germany, the United Kingdom, Japan and the U.S. The idea is to help poor countries - like China - afford cleaner but more expensive technology.

Paulson has asked Congress to pledge $2 billion to the fund over the next three years. "I'm really excited about that," he says. In August, Treasury hired William "Billy" Pizer, a Harvard-trained economist and climate change specialist, as a treasury official to coordinate energy and environment policy.

Paulson told Fortune: "With climate change, my view is that there the science, which is clear. There is the politics. And there is the economics. And the three have not come together."