China is currently experiencing power shortages which this summer may prove to be the worst since 2004 and possibly since 1949. These shortages arise from continuing policy incoherence in the power sector and will effect industrial output in the short-term. Each year a degree of tightness in supply arises during the summer as air-conditioners are turned on. But this year the shortages have started at least two months earlier than usual, in March and April, triggering a slight decline in the rate of growth of industrial production.

Looking ahead, officials anticipate a nationwide shortage equivalent to a generating capacity of 40GW shortage, or 4% of the total national capacity. Shortages are already occurring across the country, not only in the coastal provinces of eastern China, but also in central, northern and north-western areas, such as Guizhou, Qinghai, Gansu and Shanxi. Some provinces face shortfalls of 10-15% of demand. At the same time other regions, like Inner Mongolia, have an excess of electricity which cannot be exported.

The causes for the shortages are multiple:

• The first quarter of 2011 saw a surge in demand for electricity of at least 12.7% on a year-on-year basis, as a consequence of heavy industry ramping up production after the constraints of the last five-year plan which ended in December 2010. Local governments appear to have allowed plants which had been previously closed to reopen in response to rising prices of such commodities as steel, chemicals, non-ferrous metals, and cement.
• Rising demand for electricity also has its origins in a boom in the purchase of household electrical appliances over the last two years. This was stimulated by government subsidies on these appliances with the objective of boosting domestic consumption after the financial crisis.
• The continued construction of new buildings with poor thermal characteristics adds to the demand for energy. Some 80% of new building space is considered thermally inefficient by the Chinese authority responsible for monitoring new buildings.
• Central and south-western regions of China are experiencing their worst drought for many years. This is not only affecting agricultural output but has also greatly diminished the flow of water through many of the country’s large hydro-electric plants, such as the Three Gorges and Gezhouba dams.
• The sustained growth in demand for energy continues to stretch the capacity of the energy transport networks, in this case the railways which carry coal from mines to power stations and the electricity grids which transmit power.
• The power generating companies appear to have been cutting back on investment in new capacity and reducing output from their power plants by putting them on maintenance. This is in reaction to the rising price of coal which has not been offset by an equivalent increase in the price paid by the grid to the generators. As a result the five main generating companies have incurred losses of about US $9 billion over the last 3 years and continue to lose money. The main national grid company, meanwhile, is making profits.

The government has reacted to the growing shortages with two types of measure, economic and administrative. The economic measures include:

• Raising wholesale electricity price paid by the grid to power generators in more than 15 provinces in April and May by about 7%;
• Raising end-user prices for electricity by 3% from 1^st June for industrial, commercial and agricultural users, first time since November 2009;
• Renewing talk of raising tariffs for residential users, using a new tiered system in which greater use incurs higher tariffs.

It has yet to be seen whether these price rises are sufficient to persuade the generating companies to raise their output let alone the level of investment in new capacity.

The administrative measures imposed by the government, usually at local level, include:

• Rationing electricity supply to industrial users, especially to energy intensive enterprises;
• Imposing monetary fines on enterprises which use too much electricity;
• Trying to ensure that power supplies to households, government buildings, schools, hospitals and the military remain uninterrupted;
• Halting diesel exports so as to maximise the availability of diesel for local power generation.

The small and medium-sized enterprise are reported to be suffering the most from these administrative measures, for these restrictions come on top of rising raw material prices and labour costs. In response, these firms are likely to reduce output and delay investment, and some may even go bankrupt. Some of the larger companies can survive by running down inventory, but even they are likely to have to constrain sales in the near future.

Despite the growing domestic requirement for diesel, the oil refiners may not be willing to produce at full capacity because they too are losing money as domestic prices for refined products have not kept pace with the price of crude oil which tracks international markets.

In many respects, this year’s power shortages are a re-run of those in previous years, but are just worse. The ultimate causes remain unchanged, namely the continued rapid growth of demand and an irrational pricing system. With a capacity of more than 1,000 GW China now has the largest power system in the world after the USA, and yet demand is still growing at more than 10% per year. Managing such rapid growth in such a large system is fraught with difficulty, for it requires managing investment in expanding a supply chain which runs from the coal mine to the power plants and then on to the end-user.

The pricing systems for oil and for electricity both suffer from the same deficiencies: the price of the raw materials (crude oil and coal) roughly follow international trends, whilst the wholesale and retail prices for electricity and oil products are controlled by government, usually at relatively low levels.

China’s energy sector is stranded between the plan and the market. Plans to progressively liberalise the energy markets were suspended after the initial restructuring and commercialisation of the energy companies. As a consequence, these commercialised and partially privatised companies are operating in an environment in which some prices are set by the market and others by the government. The resulting economic signals for energy supply and for investment in new capacity are therefore incoherent, as are incentives for energy saving.

The summer rains and recent tariff increases should see the power shortages disappear after the summer. As has happened before, continuing construction of new capacity in coal mining and transportation and in power generation and transmission may allow supply to match demand in one or two years time. But fundamental challenges face the government in how it manages the power sector and how it seeks to constrain energy demand.