China’s energy prices: internal policy contradictions persist

The unintended or undesirable consequences of China’s approach to energy pricing have been the subject of analysis by many commentators, including in this column. In the past my main observations have been

  1. that the discontinuity between the market-based pricing for crude oil and coal and the regulated pricing for oil products and electricity create distorted incentives for energy enterprises, and
  2. that the relatively low end-user prices for energy fail to provide sufficient incentives to save energy.

Whilst progress has been made in the oil industry since January 2009 with higher taxes and higher prices for oil products, wider policy coherence for energy prices continues to be absent, at least for the outside observer such as myself.

Through its energy pricing policies China’s government, like all governments, has to balance a range of priorities: the desire to constrain prices in order to control inflation and to protect poor people; the need to allow prices to rise in order to encourage investment in energy production and in order to encourage efficiency of end use; and, finally, to secure revenues for government from the production and use of energy. Behind all of these considerations lies the question as to whether energy prices should be set by government or whether they should be determined by market forces.

Announcements by China’s government between June and early August 2010 appear to show that policy incoherence in energy pricing remains as pronounced as it has been for many years. These announcements include a cut in retail prices for oil products, a new royalty on oil and gas production, an increase in producer prices for natural gas, a cap on coal prices, and a draft regulation to allow the capping of prices in monopoly industries.

During 2009 and 2010 the government has kept to its policy that the prices of oil products should broadly follow international trends and it adjusts domestic retail gasoline and diesel prices every 22 days if international prices fluctuate by more than 4%. Thus we saw a rise in prices in November 2009 and in April 2010. This was followed, in June 2010, by a reduction of these prices to levels above those before the adjustment in April, in line with falling international prices.

Also in June 2010, after much internal debate, the government introduced a pilot scheme in Xinjiang as part of a long-overdue reform of its taxation of resource extraction. In the past, enterprises paid what was called a ‘mineral resource compensation fee’ which was a set amount of money for every tonne of mineral extracted. In the case of oil this amounted to about 30 Yuan per tonne or, at present exchange rates, about  US $ 0.60 per barrel.

This approach to resource taxation suffered from two weaknesses. Firstly, the tax was based on volume and not on value. Today, very few countries tax the extraction of mineral resources on the basis of volume, and usually such an approach is limited to low value construction materials such as gravel. In the case of oil and natural gas, there can hardly be a country in the world which still applies taxation in the basis of volume or weight, for the simple reason that such taxes do not react to changing prices and governments lose potential revenues when prices rise.

Secondly, the level of the resource compensation fee was far too low, even in times of low oil prices. With crude oil prices at US $ 80 per barrel, the fee is equivalent to a royalty of 0.75 %. Even with prices of US $20 per barrel, this tax amounted to just 3% of the value of the crude oil. This compares with crude oil royalties around the world which commonly fall in the range 5-12%. Indeed, even China’s own production sharing contracts for foreign investors include a royalty for oil of up to 12.5%.

Under the new scheme to be tested in Xinjiang, the extraction of oil, natural gas and coal will attract a resource tax of up to 5% of sales value, and all the revenues will go to the government of Xinjiang, or in the future, to the government of the respective Province, Municipality or Autonomous Region. In this allocation of the revenues the government is also following international trends in allowing a progressively greater share of resource revenues to flow to the locations where the resources are extracted. In addition to raising revenues, such royalties also act to constrain uncontrolled resource exploitation on the part of the oil and mining companies and to constrain their profits.

In June 2010 China’s government announced a 25% increase in well-head prices for natural gas. This was another long-overdue move to address two growing anomalies in China’s domestic energy prices: the relatively low price paid for natural gas as compared to coal, and the low price of domestically-produced gas compared to imported gas. Whilst this price rise is probably only a first step in reforming the system for gas pricing, it gives a much-needed boost to investors in new natural gas production capacity.

Set against these progressive moves, are a number of actions or failures of action, particularly relating to coal and electricity. 

Coal prices in China have fluctuated in line with international prices. In June 2008, before the financial crisis hit, prices for Shanxi premium blend coal were up at Yuan 900 per tonne (spot, free-on-board prices at Qinghuangdao port). By June 2009 prices were down to Yuan 580 per tonne, but by June 2010 they had risen to Yuan 760 per tonne. Fearful of rising inflation the government announced a cap on coal prices at the end of June 2010. The move was also driven by a concern for the profitability of the electrical power generating companies, squeezed as they are between high coal prices and low on-grid tariffs.

The government has not touched electricity prices for two years. In July 2008, wholesale electricity tariffs were allowed to rise by 5%. The burden of these tariff increases was borne mainly by the industrial and commercial sectors, as rural and urban households were protected. Indeed household electricity consumers have not seen a price rise since 2006, despite the supposed importance of the national energy efficiency policies.

This facet of prioritisation in energy policy was further illustrated by the announcement in early August 2010 that the government was deliberating a draft regulation which would allow it to cap the prices of goods and services provided by monopoly suppliers. Whilst such a move should not affect prices paid to the producers of primary energy such as coal, natural gas and crude oil, it would clearly be applicable to the utility suppliers of electricity and gas. In some ways, such a regulation would not cause any change in pricing behaviour, for the government has always kept firm control of these end-user energy prices. But it would mark a reversal of earlier moves to progressively introduce market forces to the energy sector, and a preference for maintaining the utilities as monopolies in order to use them as instruments of economic policy. The draft regulation also calls into question the government’s determination to use pricing as an instrument of energy efficiency policy.

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