Third Plenum’s plans for China’s energy sector

Third_plenumThe official resolution from the Third Plenum of the 18th Central Committee of the Chinese Communist Party holds back from announcing wide ranging reforms to the energy sector. Instead it offers hints to the continuation gradual reforms to the state-owned energy companies, to energy prices and to managing the balance between economic growth and the environment. 

Reform of China’s energy sector dates back to the 1980s and has comprised three main elements. The first was the gradual raising and partial liberalisation of some energy prices with the principle aim of stimulating domestic production of energy: first coal, then crude oil and, most recently, natural gas. Today, the domestic prices of coal and crude oil are linked to the international market. The well-head prices for gas remain controlled. In contrast, the government continues to set the end-user prices for electricity, oil products and natural gas below market levels as part of their efforts to constrain inflation and protect vulnerable elements of society and of the economy.


The second element of reform was structural. The old energy ministries were corporatized and restructured over a 20-year period stretching from the late 1980s to the early 2000s. The last radical shake-up occurred in 1998 when the petroleum, power and coal industries all underwent fundamental changes in the structures. This resulted in the ownership of most large-scale coal mines being delegated from central to provincial governments and in a substantial asset swap between CNPC/PetroChina and Sinopec to create two vertically-integrated oil and gas companies. The State Power Corporation, which was created in 1997, was broken up in 2002 to create two transmission companies and five large generating companies.  


The final element, and one which has been pursued with the greatest reluctance, has been the introduction of foreign investors to the domestic energy sector. The only activity where foreign companies have played a sustained and significant role has been offshore oil and gas exploration and production, dating back to 1980. The rationale for allowing this participation was and continues to be the need for foreign technology. Onshore, in coal mining, oil and gas exploration and power generation, large scale foreign investment has been limited in size and scope, through a combination of unfavourable investment conditions, the power of state state-owned incumbents and energy pricing.


The Third Plenum Resolution, like its predecessors, is a long (10,000 words or more) document written in arcane language which appears to want to conceal as much as it reveals. Like many Chinese government documents, it manages to be bold, vague and self-contradictory all at the same time, promising to:


·        “Ensure that the market plays a decisive function in resource allocation”;

·        “Perfect the mechanisms in which prices are mainly determined by markets”;

·        “Support the healthy development of the non-public economy”;

·        “Vigorously develop a mixed ownership economy”;

·        “Give full rein to the guiding function of the state-owned economy”;

·        “Strengthen state-owned asset supervision”.


This rhetorical mix suggests that the government is not planning an imminent and radical attack on the state-owned energy sector, but rather that reform will move ahead at a steady but carefully measured pace, building on past achievements and seeking to address the worst distortions and transgressions. The main targets for reform are likely to be the state-owned energy companies and energy prices.


In all three industries (coal, power and petroleum), the large state-owned energy companies have increased their market power in terms of their share of production and their ability to obstruct new entrants. This has been aided by a combination of low capital costs, soft budgetary constraints and government policies to reduce the role of smaller companies, both private and state-owned.  The large energy companies have also displayed an ability to exert influence over government policy-making and, on occasions, to obstruct the implementation of government policy. As a group they have a reputation for rent-seeking, and senior managers from a few of these companies have been investigated recently for corruption.


The Plenum Resolution is clear about the need to improve the governance of the SOES, including the energy companies. The aims will be:


·        to improve profitability;

·        to  increase the level of dividends paid to the state to 30%, up from 5-15% today;

·        to clamp down on corruption and rent-seeking.


The market power of the energy SOES is greatest in the oil and gas sector, where PetroChina and Sinopec hold the rights to the best resources and own most of the refineries, pipelines and oilfield service companies. The desire of the government to break the market power of the energy SOES was revealed in the second bidding round for shale gas in December 2012 when the government awarded no blocks to the national oil companies and 18 blocks to a mix of power, coal and other enterprises. But the lack of relevant experience of these companies will limit the impact of this move.


Measures which the government could take to reduce the barriers to entry for other players include:


·        requiring the NOCs to relinquish their resource rights in areas where they are not actively exploring or producing;

·        either selling off their oil and gas pipelines or be obliging them to provide third-party access;

·        selling off many of their oil-field service companies.


The government’s reluctance to undertake more radical steps is explained by the policy functions that the NOCs and other energy SOEs fulfil. Of greatest importance is their role in energy pricing, for it is these companies which absorb a large share of the economic losses between the upstream and the downstream ends of the energy supply chain.  They are also perceived as playing an important role in national energy security through their investments at home and overseas, and continue to employ large numbers of people.


Whilst coal and crude oil prices in China follow international markets closely, all other prices are set by government. Whilst this approach has helped the government constrain inflation and address social objectives, it undermines energy efficiency policies and provides inadequate incentives to explore for and produce natural gas.  A further problem is the low price of coal relative to natural gas, which drives the continuing preference for coal rather than cleaner fuels, with the consequence of ever-worsening air pollution.


As a consequence, the government faces the complex challenge of raising energy prices to constrain energy use and introducing schemes to encourage the switch away from coal to cleaner fuels, whilst at the same time trying to avoid undermining economic growth or further disadvantaging the poorer sections of the population. In the last few years the government has launched emissions trading schemes to promote clean energy, tiered pricing for energy users to make those who use more pay more, and time-of-day pricing to spread out the daily load fluctuations. We should expect more efforts in this direction, as well as continuing steps to raise prices for natural gas and for oil products.


In conclusion, whilst the government may take decisive steps to improve the governance of the state-owned energy companies, it is likely to be more cautious in introducing changes to their structure and competitive position. Reforms to energy pricing and measures to promote clean energy will be continued, but in a judicious manner.


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