In last month’s column I ended with the following words: “China’s energy sector is truly stranded between the plan and the market, and the government retains few levers of management”. There may indeed be few levers left, but the government has not lost faith in these levers. The last few weeks have seen announcements on another annual subsidy to Sinopec and on a substantial tax rebate to companies which import crude oil. These actions illustrate two fundamental contradictions in government energy policy in recent years and these relate respectively to the role of prices and the commercialisation of the national oil companies.

The oil industry in China suffers from the same type of pricing discontinuity as I described for the electricity industry in last month’s column. Refining companies purchase crude oil from either the domestic or the international markets. Crude oil on the domestic markets is priced at levels close to those of the international markets. Companies importing crude oil pay an international price plus a 17.5% VAT. The refineries then convert the crude oil into a number of individual oil products. The prices for most, but not all, of these oil products are set by the government. Prices for those products most in demand, such as diesel and gasoline, are kept at levels well below the costs of the refining companies. As a result the refiners are losing money on every litre of gasoline or diesel they produce.

This is not a new problem. The current pricing policy for crude oil and oil products was introduced in 1998 and it was intended to allow the prices of both crude oil and oil products to track international prices, though with the requirement that all prices be sanctioned by government. This innovation was part of a much wider set of reforms to the energy sector and to industry as a whole. The aim was to progressively remove the government from the pricing process, to integrate China’s oil markets with international markets, to provide clear commercial incentives for oil companies and to send clear signals to the consumers of oil.

This new pricing policy came into effect at a time when international oil prices were at their lowest levels for twenty years. This relatively free market approach was able to withstand the gradual rise of prices from about US$ 15 per barrel in 1998 to US$25 per barrel in 2002, but started to fall apart as they rose beyond US$40 per barrel in 2004. In order to maintain the incentive for exploration and production of oil within China, domestic crude oil prices were allowed to follow international levels. But the government tightly constrained consumer prices in order to protect society from the negative impacts of these rising prices. It is likely that the Chinese government, like others around the world, were hoping that the rise in oil prices was a temporary aberration and that markets would soon fall back to their earlier levels. This would then allow the government to make upward adjustments to domestic retail prices but to a lower level than would have been required at ‘the peak’ of the international prices. Sadly, international prices are still on the rise.

The need to protect society from high energy prices is a long standing policy imperative in China and in many other developing countries. This need has been accentuated over the last year by rising inflation. This has obliged the Chinese government to draw on whatever instruments it has in order to constrain inflation. With bank interest rates still at low real levels, all it can do is constrain the few prices that they still control. As mentioned in last month’s column, these are energy, water and food prices. This approach stands in direct contradiction to the stated policy intention to use energy prices in order to constrain energy demand, as part of wider energy conservation policy.

It is understandable that the government places a higher priority on short term social equity and stability than on longer term energy conservation, and this requires some kind of subsidy. But the issue is how this subsidy should be administered. Ideally the subsidies would be targeted at specific oil consumers: individuals, organisations or businesses which were deemed to be in need of the subsidy.  All others should pay the prevailing market price, possibly with a substantial tax as well. But this approach requires a very effective administrative system which few countries have. As a result, most developing countries provide cheap oil products to all consumers, whether they be rich or poor, and the rich benefit more than the poor. But somebody has to pay for this subsidy. The question is, who?

Despite the occasional modest increases in consumer prices, China’s oil companies have been losing money on their refining activities for more than three years. As the country’s major oil refiner, Sinopec has been in a powerful position to negotiate compensation from the government for its financial losses: RMB 10 billion at the end of 2005, RMB 5 billion at the end of 2006 and RMB 12 billion in March 2008. Despite operating losses relating to refining of more than RMB 20 billion, PetroChina has not received any subsidy.

Paying a single annual subsidy to Sinopec is clearly easier and cheaper than designing and implementing a complex subsidy system that actually reflects the needs of individual consumers. But it brings with it another problem. It distorts the incentives for the oil companies concerned. The reforms of 1998 included a restructuring of the country’s oil industry and the start of a concerted process of commercialisation. CNPC, Sinopec and CNOOC were each restructured into a holding company and a commercialised subsidiary which held most of the productive assets and which was partially floated on the international stock markets. The aims of this reform, along with the price reform, were to provide effective and transparent incentives for managers to improve the commercial performance of these companies, to remove the need for government subsidies, and to radically reduce the role of government in the management of these companies.

However, these companies were privatised only partially. As a result the government retains the right and the power to use the companies as instruments of government policy, whether for security of supply or for social equity purposes. Thus the government has ordered the oil companies to import more crude oil and more oil product and to run their refineries at full capacity despite the commercial losses.

Where are the transparent and effective incentives for improving performance now? Sinopec succeeds in negotiating a subsidy, PetroChina does not. Then the government reduces the VAT payable on oil imports in order constrain the losses felt by all oil companies. We appear to be back in the bad old days of the 1990s. Profits and losses and now even share prices depend not on corporate performance but on government policy and on the ability of company managers to negotiate concessions from the government. Further, the last few years have seen the domestic market power of Sinopec and PetroChina grow markedly as they have been permitted to squeeze out smaller players.

China can no longer run its energy policy on the assumption that international oil prices may fall at any time soon. The government needs to rethink its priorities and redesign its set of policy instruments so that they are effective in a world of high energy prices. Continuing to muddle through threatens to undermine the great economic achievements of the last three decades.