Cheap Coal: Enabling Power Pricing Reform in China

Beset by chronic inefficiencies and shortages in the country's power sector, the Chinese government has long seen the need to let the market set end-user electricity prices.

Its plans for reform have been hindered, however, by fears of economic disruption and social unrest that would result from higher electricity prices in an economy that had grown accustomed to cheap power. Rising coal prices in the 2000s strained power suppliers and promised a large gap between the likely market rate of electricity and the rates fixed by the government, making reform unacceptably risky for the Chinese government. But low coal prices over the past year have expanded the profit margins of power suppliers and shrunk the gap between currently fixed power prices and a market rate of electricity pegged to coal. In essence, a window has opened for the government to attempt market reforms in the power sector.

Because the price of electricity has historically been fixed below market rates, costs to electricity consumers are likely to go up over the long run. Liberalization will provoke resistance from state-owned enterprises and entrenched interests that do not want to lose what had been a longstanding power subsidy. To deal with resistance and minimize economic shock, the Chinese government probably will proceed with reform slowly. Since neither domestic nor international prices of coal appear likely to return to pre-2012 levels anytime soon, the Chinese government can afford a gradual approach to power pricing reform.

Liberalizing electricity prices — essentially, letting them climb to market rates — means the removal of an implicit industrial subsidy as old as the People's Republic of China itself. The higher costs of power will generate resistance, so the Chinese government is starting small with test reforms in select cities, such as the coastal city of Shenzhen.

In Shenzhen, the government's highest planning and regulatory body, the National Development and Reform Commission (NDRC), has initiated a price cut of 6 percent on power transmission fees levied by the China Southern Power Grid on end-users of electric power. The commission has also begun harvesting data on the cost of power transmission. The price cut is part of a three-year pilot plan to decrease the cost of electricity in Shenzhen, where the price of power is higher than anywhere else served by the company.

Although the price cut is not the same as power price liberalization, it is an attempt to identify and reduce unnecessary intermediary costs in the power market. The move to rationalize power costs may lay the groundwork for market reform in the power sector, a key element of the 18th Party Congress' Third Plenum reforms. China's reluctance to implement pricing reform cannot be understood without examining the relationship between the price of power and the price of coal, which dominates Chinese electrical power generation (accounting for 73.8 percent of total Chinese power generation in 2013, according to figures from the China Electricity Council).

How High Coal Costs Squeezed Power Suppliers
A difficulty in reforming China's power sector lies in the structure of the sector, a relic of China's planned economy. After 1949, Chinese authorities pursued rapid economic development through investment in a massive heavy industry sector. The government fed state-owned enterprises with inputs at below-market rates, including electricity. To ensure a supply of cheap electricity, the government employed price controls at every stage of the power supply chain: the price of coal sold to power providers, the price of power sold into the grids and the price that grids charge end-users.

Today, China's system of price controls in the power supply chain continues to resemble how it looked during the planned economy. The key difference is that input costs were gradually liberalized, while end-user costs remain fixed below market rates. The result was that rising coal prices between 2000 and 2012 placed stress on the power supply chain.

In the opening and reform period, which started in 1978, China began to transition away from a planned economy. In its place was a temporary hybrid structure: the dual-track pricing system, in which a certain quantity of goods were sold to the state at planned rates to continue supplying state-owned firms with cheap raw materials, while the excess could be sold at market prices. Reflecting the government's continued desire to keep power cheap, coal remained on the dual-track pricing system long after the prices for most key industrial inputs had been liberalized.

Although the dual-track prices did not amount to full marketization, dual-track coal rates increasingly exposed the power supply to the market and led to higher input prices. Starting in the 1990s, the price and quantity of "planned coal" became subject to contract negotiations between coal producers and power producers at annual conferences hosted by the NDRC. The commission capped contract prices below market rates, but the negotiations gave producers more of a say in the price. Between the 1990s and the mid-2000s, the NDRC gradually reduced its role in determining rates.

Planned coal quantities could never cover the full quantity demanded by power producers, who were forced to buy a growing proportion of their coal at much higher costs on the spot market. As coal prices shot up between the 2000s and 2012, power producers and power grids found themselves squeezed between increasing upstream costs and end-user prices fixed below market level.

The squeeze on producers exacerbated chronic inefficiencies in the Chinese power market. Frequently forced to operate at a loss, power suppliers were disincentivized from investing in the newer infrastructure or technology needed to service growing demand, and they resisted the implementation of environmental conservation measures. The result was frequent power shortages and setbacks to environmental policy. Without a market pricing mechanism to set end-user prices, power suppliers were forced to lobby the NDRC to increase the fees they could levy on end-users. These fees could not be accurately pegged to demand, leading to accusations from end-users that transmission rates were set arbitrarily.

The power sector's loss of profits limited the government's options in pursuing price reform. Doing too little to address seemingly arbitrary fees could result in end-user dissatisfaction. At the same time, trying to cut fees too aggressively could eliminate the already-thin profits available along the power supply chain, leading to power shortages. Moving away from price controls and allowing the market to determine the price of electricity was not an option that the Chinese government was prepared to take. The high price of coal ensured that the market price of electricity would far exceed the prices fixed by the government, guaranteeing undesirable social and economic consequences.

Slow Moves Toward Reform
In 2012, falling demand and oversupply brought both Chinese and international coal prices down, a trend that has continued to this day (with the exception of a brief rally at the end of 2013). The price drop has reduced a major obstacle on Chinese government action both upstream and downstream along the power supply chain. The sharp fall in coal prices diminished the gap between the prices of market coal and planned coal and led the State Council to finally abolish the dual-track pricing system for the commodity and fully liberalize its market.

The low price of coal reversed the longtime trend of high input prices that had strained the power supply chain and stymied reform attempts. Even as end-user prices remained fixed in 2013, China's five state-owned power generation companies collectively reported profits of $12 billion, primarily as a result of falling coal prices. In Shenzhen, the cushion provided by expanded profit margins has given the NDRC the leeway to experiment with the transmission tariffs charged by China Southern Power Grid without worrying about sending the company into the red. This pilot initiative will take pressure off Shenzhen power consumers in the short term and harvest usage data that will be valuable in planning further reform.

While power price liberalization is an important goal of the Chinese Communist Party, the size and scope of the Shenzhen power pilot fall far short of the sweeping declarations of support for market reform included in the Third Plenum communique in 2013. It appears the Party recognizes that despite low coal prices, considerable hurdles remain for the liberalization of the end-user power market.

The most significant hurdle is that price liberalization implies higher costs across the economy. Low coal prices can minimize the pain of electricity price liberalization by narrowing the gap between the current fixed electric prices and market rates, but they cannot completely eliminate this disparity. Although statistics about the market value of electricity in China are not readily available, the difference between the two prices can be inferred to be substantial.

For this reason, the greatest challenge to power liberalization is likely to come not from producers of power, but from consumers, especially industry (which made up 87.25 percent of total power consumption in 2013). The removal of the indirect electricity subsidy will most likely prompt pushback from powerful state-owned enterprises and result in adjustment pains from households. To minimize economic shock and deal with opposition, the Chinese government will want to "cross the river by feeling for stones," proceeding carefully and slowly. It has already begun doing so in Shenzhen with the power pilot, a relatively small project in a single city serviced by the smaller of China's two power grids.

There is no question that power reform is risky for the Chinese government. It would provoke powerful opposition and expose power prices to volatility in both coal prices and electrical demand, removing an element of control that the Chinese government has been long accustomed to holding. However, the long-term payoff will be a power sector that responds flexibly to changing market conditions, allocates capital effectively and invests in cleaner fuel sources, such as both unconventional and conventional natural gas. Since it does not appear that the price of coal is likely to rise anywhere near its 2012 levels in the near term, the Chinese government will most likely be able to take its preferred gradual approach toward this end goal.

Courtesy : Stratfor