The country is recovering from one of the most widespread energy supply crises it has suffered in recent memory. The immediate cause was clear: the worst winter weather over central and southern China for more than fifty years. The force of nature can render useless even the most of robust of man’s constructions and systems, but in this case China’s energy systems were already fully stretched and were highly vulnerable to any external shock. This lack of resilience can be attributed primarily to the nature of the energy policy and mix of policies currently being pursued by the national government.

During last year, 2007, there was good reason for a growing confidence in the ability of the power sector to deliver the required supply of electricity to end-users. Five years of heavy investment had resulted in a doubling of the national generating capacity from 350 GW to nearly 700 GW and in the rapid construction of additional capacity in the electricity transmission and distribution networks. Investment in the capacity of largest coal mines had also been large, as had investment in the railways to carry the coal from the mines to the power stations, for 90% of the new generating plants were fuelled by coal.

But hidden beneath these favourable trends lay disturbing long-term and short-term developments. The supply of thermal electricity comprises a complex chain of players including the coal mining companies, the transport companies (rail, road and water), the power stations, the grid companies and the end-users. This chain is only as robust as its weakest links. A shortage of capacity or an unwillingness to operate at full capacity in any one of the links in the chain undermines the ability of the system to deliver the electricity required. This is so in any supply chain, but is particularly applicable to the power industry because electricity cannot be stored in large quantities.

For several years the balance between China’s coal production and it consumption was getting tighter. During the late 1990s domestic production of coal raced ahead of consumption and the nation’s net exports of coal rose from 27 million tonnes per year in 1995 to nearly 90 million tonnes in 2001. China had become a major exporter of coal and this flood of coal onto international markets was depressing world prices. Since 2003, when energy demand started to rise sharply in China, this trend has been reversed and net coal exports in 2007 amounted to just two million tonnes. Indeed in some months China was a net importer of coal. This sudden decline of surplus supply can be attributed to a combination of the surging demand for coal in the new power stations and the unavoidable time lag in developing new coal mine capacity. This squeeze was exacerbated by the enforced closure of large numbers of small-scale coal mines which had long been able to address short-term supply shortfalls; though government officials deny that these closures have contributed to the shortage of coal supply.

This long-term decline of surplus coal supply has been matched in the short-term by a shortage of hydro-electricity availability on account of a dry summer and a lack of water in reservoirs. Thus it was already clear in the autumn of 2007 that China was likely to face a difficult winter for power supply.

This already potentially difficult situation was further exacerbated by a distortion of economic signals to producers and users of energy. Across the world prices for primary energy supplies (coal, oil, gas) continued to rise during 2007. Within China, the prices for coal, crude oil and, to a lesser extent, natural gas, followed these trends. This in turn contributed to the rise of inflation in China and in the rest of the world. In order to control this inflation, China’s government reached for the only levers it trusted, which were price controls. And which prices can they control? Energy, food and water. End user prices for energy in China had long been held at relatively low levels. Yet the new policy for energy conservation and efficiency should have resulted in these prices rising in order to provide incentives to save energy. Instead, the government felt obliged to restrain rising prices in order to control inflation.

At the other end of the supply chain, coal prices were continuing to rise and power stations were only allowed to pass a proportion of this increase through to the grid company purchasing the power. As a result the power stations had little economic incentive to operate at full capacity. Further, they and the government were putting pressure on the coal industry to sell coal to power stations at prices below market levels, thus undermining the incentive of the coal mines to operate at full capacity.

The same problem of incentives also affects the oil industry. Oil refineries pay high prices for crude oil and then sell the refined products at lower prices to end-users. The economic incentive for the refiners is either to reduce output or to export the products to markets which yield a higher prices. In order to encourage Sinopec to continue refining at full capacity despite financial losses, the government gave large financial compensation to the company at the end of 2005 and 2006.

The government is thus caught in a difficult dilemma. It does not wish to raise energy prices substantially as this will fuel inflation and also be an added burden for the poor. Yet, at a time of rising energy prices, the longer it delays passing on these prices to energy users, the worse this distortion of economic signals becomes. At the same time, the government has commercialised all the state-owned energy companies, though most shares still remain in the ownership of organs of the state, either central or local. Thus the companies are expected to seek profits, and the ability of the government to command and control their behaviour has been radically reduced. Television viewers in China and around the world were treated to the sight of the President and Prime Minister travelling around the country asking energy companies and their workers to increase their output. Ten or fifteen years ago this would have been unnecessary. A few phone calls would have sorted the matter. But these days, it appears that neither ‘command’ nor economic incentives work effectively, and the government is left with the solitary tool of ‘persuasion’.

China’s energy sector is truly stranded between the plan and the market, and the government retains few levers of management.

Philip Andrews-Speed is Director of the Centre for Energy, Petroleum and Mineral Law and Policy at the University of Dundee, UK