What has Chinese smog got to do with falling commodity prices? This may seem like a silly question but deteriorating air quality is set to become ever more important in determining the price of iron ore -- Australia’s largest export earner in the future.

The relationship between smog and the iron ore price can be best illustrated through what is happening in Hebei province, the world’s second largest producer of steel after China. In 2014, Hebei produced 185 million tonnes of steel. To put that into perspective, that’s 23 times more than Australia’s production, and larger than the combined outputs of Japan and South Korea.

The amount of steel produced in the province dropped 0.6 per cent for the first time in the last 14 years. Despite the small drop in production, the decline signals a more fundamental shift in the government’s industrial policy as well as impact of pollution on policy-making.

Hebei is not only the largest steel maker in China, it is also the most polluted province in the country. Hebei has the dubious honour of claiming seven of the top ten most polluted cities in China. What makes the matter even worse for Hebei is its proximity to Beijing. The Chinese capital is literally surrounded by the province.

As we all know by now, the air quality in Beijing is becoming insufferable. The Chinese government has been forced to take action to clean up its air. Closing down polluting coal-fired steel mills is one of the centrepieces of the government’s strategy. Hebei will bear the lion’s share of the planned production cutback.

The State Council, the Chinese cabinet, wants to reduce the country’s steel production by 80 million tonnes by 2017, or roughly ten per cent of the total output last year. Hebei province alone will have cut 60 million tonnes within the next three years. The planned reduction equals the steel output amount of France and Germany combined.

Beijing’s previous attempts to reduce excess capacity in the steel sector have not met much success due to local protectionism. Local officials often ignore Beijing’s order to close down steel mills and demolish blast furnaces to protect jobs and tax revenue. In fact, some even expanded production when the central government was asking them to shut down excess capacity.

However, they can no longer afford to ignore directives from the central government due to even stronger public pressure. Even an authoritarian government has to respond to people’s concerns about health and safety issues. The ever-worsening pollution is reducing people’s life expectancy by five years.

The tough new emission standards as well as the cost of installing new pollution reduction technology is helping to shut down previously protected mills. One example is Jianyuan Steel and Iron Company which was once the second largest tax contributor to Qianan County. Its production facility was shut down a year ago due to its inability to install new emission reduction technology that would cost 60 to 70 million yuan, according to state-owned news service Xinhua.

These steel mills could have afforded the technology a few years ago when the demand for steel products was high. However, the whole industry is now suffering from excess capacity, low margins and sluggish demand. Its razor thin margins dropped another 15.9 per cent last year despite the falling raw materials price.

Shen Wenrong, the Chairman of Shagang Group, one of the country’s largest steel producers, said the profit on one tonne of steel was not enough to buy a simple stir-fry dish in China now. The average cost of a simple stir-fry dish is about 15 to 20 yuan, or $3 to $4.

This planned shutdown will have a large impact on the unemployment rate. The government estimates the new industrial policy could cost 200,000 direct jobs as well as another 400,000 indirect positions. It has been very difficult for local officials to enforce such job destroying directives in the past. However, the environmental crisis is forcing them to act.

A deputy mayor and a former head of one county have been fired for failure to comply with the new directive.

The impact on Hebei’s economic performance is clear. Its GDP growth slowed to 6.5 per cent, one of the worst performing provinces in the whole country in 2014. The figure is also the worst it’s been for the last three decades. The provincial government is expected to lose 50 billion yuan in tax revenue before 2017.

Beijing’s tough new stance on the environment and the ever-vocal popular demand for cleaner air will have more and more impact on industries like steel and coal. For shareholders in BHP and Rio Tinto, this is an area that you need to pay more and more attention to.�