China's new government will face tough challenges reforming the energy sector

The new leadership of China’s Communist Party is now installed and by April the new government will be in place. Pronouncements of the new party leaders suggest that one of the top priorities of the new government will be economic reform. Indeed, the frequent repetition of the term “reform” in speeches is reminiscent of Bill Clinton’s “It’s the economy, stupid” and Tony Blair’s “Education, education, education”.

If the new government follows through on this rhetoric, the energy sector has to be one of its targets, for a number of reasons. First, energy is a vital input into most economic activity in China and, despite progress in recent years, much remains to be done to improve the way in which energy is produced and used. Second, reform of the energy sector has stalled over the past decade. Whilst this has allowed the government to push forward policies on energy efficiency and renewable energy in the short-term, it has let the large state-owned energy companies to increase their market power. Finally, the administrative policy instruments favoured by the government will soon reach the limit of their effectiveness in the energy sector. In order to move forward and use more market-based policy tools such as emissions trading, it will be necessary to press ahead with reform of the energy sector.

The fundamental challenge that the government has to address is that China’s energy sector is currently stranded between the plan and the market. A number of major inconsistencies or discontinuities exist in the policy framework for energy and, as a consequence, many administrative policy instruments which would have been effective in the past now have limited success. Likewise, economic instruments cannot be expected to yield the desired results in the absence of an energy market.

Whilst it is understandable and possibly commendable that the government held back on further reform of the energy sector during a period in which the economy and the demand for energy were growing very rapidly, the recent economic slowdown provides an opportunity to restart the reform process. The main policy questions that need to be addressed fall under three headings: industry structure and ownership, pricing and markets, and sector governance.

Despite the restructuring carried in 1998 the oil industry is still dominated by two giant corporations (CNPC/PetroChina and Sinopec). The reform of the power sector in 2002 led to the creation of the State Power Corporation which controls transmission and distribution over most of the country. In electricity generation, the five large companies created at that time have seen their market share grow from 40% to 50%. The majority ownership of all of these companies lies in state hands, and all have access to generous loans from state-owned banks, face soft budgetary constraints and have only modest requirements to pay dividends to their major shareholder, the government.

Whilst these privileges have allowed the companies to invest in new capacity at a prodigious rate in order to meet China’s rising energy demand, they have also let them squeeze out smaller companies, both state- and privately-owned. Such market power not only results in reduced pressure for economic and technical efficiency, but also allows these companies to obstruct or distort the design and implementation of government policies. The government has to decide whether it wishes to retain this dominance of the energy sector by a few state-owned companies, or whether it wants to encourage new players. If it does want a greater diversity of players, bold steps will have to be taken to reduce the economic power of the incumbents, by breaking them up, by forcing them to relinquish assets, through ownership reform or through a combination of these measures.

Prices provide a key signal to both energy producers and energy users. Twenty years of price reform from 1980 to 2000 radically changed the economic incentives faced by the producers of primary energy. The prices of crude oil and coal produced in China are closely linked to international prices, with the exception of the price for coal sold to power generators. As a result, coal production rose dramatically in the first decade of this century to meet soaring demand, and China’s oil companies have worked hard to maintain annual output of crude oil from domestic fields. However, energy prices further down the supply chain are controlled by the government: the price at which electricity generators and oil refiners sell their output, and the end-user prices for electricity and oil products. In the gas industry, all prices along the supply chain are set by the government.

This mix of market and controlled prices may allow the government to address various macro-economic, social and industrial policy objectives, but it sends confused signals to the energy companies which incur massive financial losses in some of their activities. Most notable among these loss-making functions are oil refining and the import of natural gas from Turkmenistan. The financial performance of power generating companies is highly sensitive to the balance between the price of coal and the price which the grid company pays for their output. Many energy users are also not receiving clear incentives to save energy. Whilst the introduction of fully competitive electricity markets may be a long-term aspiration, much can be done in the meantime to reduce these inconsistencies in the pricing of energy.

The final issue concerns the governance of the energy sector, in particular the nature and authority of the relevant government agencies. Today, as in 2003 and 2008, there is much speculation about whether the new government will re-establish a Ministry of Energy, last abolished in 1993. The Energy Bureau was created in 2003 as a small department within the National Development and Reform Commission. This was upgraded to a National Energy Administration in 2008, but even then it lacked authority over pricing and over the all-important energy efficiency programme. Its position in the hierarchy also constrained its ability to regulate the large energy companies. The State Electricity Regulatory Commission remains more a policy adviser than a regulator. The Ministry of Land and Resources appears to be unable or unwilling to force the oil companies to relinquish any of their vast holdings of land which may be prospective for shale gas. If the new government wants to improve the governance of the energy sector, it will need to take yet another step in elevating the status and authority of the responsible agencies.

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