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China’s energy transition hits a bump in the road amid slow power market reforms

07 October 2021 Max Tingyao Lin

China's slow progress on electricity market reforms has contributed to the country's worst power crunch in a decade this summer. Now, energy experts say Beijing needs to up its game if the world's largest GHG emitter is to meet future decarbonization targets.

Despite promising to liberalize electricity pricing in 2015, the Chinese government has in general retained a tight grip on power tariffs, tamping down energy costs for retail and industrial users.

While mitigating energy poverty and keeping the economic engine humming during the COVID-19 pandemic, the policy is widely blamed for the past few months of widespread power outages in nearly two-thirds of the country. Coal-fired power generators—which account for around half of China's electricity mix—have choked back supplies to end-users in the past month, as a result of coal prices soaring due to domestic shortages and reduced imports.

Data from IHS Markit and Xinhua Infolink show China imported 50.7 million metric tons (mt) of steam coal between January and the end of August, down 25% from the same period of 2020. Coal prices rose by over 40% in north China last month.

"The power crunch is related to China's regulated power market, in which surging coal prices cannot be passed through to electricity prices," said Refinitiv Lead Carbon Analyst Yan Qin, adding that plants are squeezed between "market coal prices" and "regulated electricity prices."

In its latest China Coal Monthly report, IHS Markit estimated that coal plants were losing roughly RMB0.1 ($0.02) per kWh of generated power as of late September. "I wouldn't call it a failure of the electricity market, but rather say that China has not yet been able to set up a functional power market," said Lara Dong, IHS Markit senior director for Greater China power and renewables businesses.

Coal-fired power producers' reticence to operate at a loss is coming at the same time as weather-related issues undercut hydropower output and raised electricity use in southern China—thus creating a power shortage.

Overall, nationwide electricity demand has shot up in recent quarters as economic activity recovers. China's power usage totaled 5.47 trillion kWh in the first eight months of 2021, representing a 13.8% jump compared with the year-ago level, according to the China Electricity Council.

Michael Davidson, an energy researcher at the University of California San Diego, told Net-Zero Business Daily that China's power shortages are "weather induced but institutionally exacerbated." He added: "Since the power market is not fully liberalized, generators cannot pass through the increased costs of fuel and they may choose to hold less inventory or even fake outages."

Some Chinese observers shared a similar view.

"China is not short of coal and power. To ease the tight supply of electricity, essentially we need a pricing mechanism," Boqiang Lin, dean at the China Institute for Energy Policy Studies at Xiamen University, told the state-owned People's Daily newspaper. "Perhaps, if power tariffs are hiked, utilities will be more motivated when it comes to supplies."

Others in China have echoed this stance, saying that the government should allow tariffs to reflect generators' costs and supply-demand fundamentals.

Tight control

So far, the liberalization of power prices has been severely limited.

In October 2019, China's National Development and Reform Commission (NDRC) introduced a floating tariff mechanism that allows a 10% upward and 15% downward adjustment from its benchmark rate. But the central planning body said in the directive that "no upward adjustment would be allowed in 2020 because we want to be sure industrial users don't need to pay more."

Davidson said the mechanism was designed to reflect coal price changes in power tariffs. Instead, "this was ineffectively and inconsistently used, leading to massive swings in profits for generators," he added.

Among other reforms targeting utilities in recent years, Beijing has launched spot pilot power markets in eight provinces that cover 30% of the country's population and introduced medium- to long-term energy contracts across the country, except for in Tibet.

Figures from the China Electricity Council showed the share of electricity traded in markets reached 33% in 2020. In general, 80% of the trades take place under medium- and long-term contracts.

Qin believes the reforms have been slow after observing only "discrete spot trading" in the pilot markets. "This needs to speed up to establish a well-functioning spot power market nationwide," she said.

In a press briefing 29 September, the NDRC signaled that utilities can raise tariffs by up to 10% to reflect fuel costs. Some provinces—including the most populous, Guangdong—have taken advantage of the stop-gap measure to try to ease their power shortages.

China plans to allow more freedom in the power market over time. However, most analysts do not expect a liberated tariff system like the ones introduced in Europe or the US.

"China has no interest in having 'wild west' power markets like what's seen in the West," said Norman Waite, an energy finance analyst at the Institute for Energy Economics and Financial Analysis. "Chinese free market electricity prices will still have the same Chinese characteristics as other markets, perhaps more."

"My view is that China's energy pricing markets will remain highly regulated and therefore moderated by government intervention. Prices will eventually be market determined, but the government's guiding hand will limit volatility," he added.

Energy targets

China's "dual-control" policy of capping energy intensity and overall energy consumption in each province is partly to blame for the power crunch, according to analysts.

The NDRC in August said in an alert that more than two-thirds of the country missed at least one target during the first half of 2021. Many provinces have therefore been rationing electricity since last month to stay within their full-year quotas.

With China establishing its climate goals of peak CO2 emissions by 2030 and reaching carbon neutrality by 2060, few expect Beijing to scrap the caps. But recently there has been ongoing fine-tuning of this policy as well.

On 16 September, the NDRC released new rules to enforce the policy scheme. Regional governments are now allowed to prioritize their energy intensity targets over energy consumption. Moreover, the areas with high renewable energy output are given some leeway in their consumption goals.

"[This] could effectively promote the development of renewables in the long term," said Chunping Xie, a climate policy fellow at the London School of Economics.

China has limited power supplies for energy-intensive industries during the recent shortages, and analysts expect at least some of the constraints to remain during the energy transition. Steelmakers, aluminum smelters, and cement makers could become less competitive, according to some.

Waite said companies in all industries should take note of the policy. "If the energy efficiency targets aren't waived, I would think this approach would apply to every commercial or industrial operation," he said. "The most efficient, no matter the sector, may have little to worry about."

Separately, the NDRC has stated Chinese households are paying less for electricity by international standards while Chinese industrial users are paying more. In many other countries, households are paying higher electricity prices than non-residential consumer, reflecting higher transmission costs for them.

"In China there are huge amounts of cross-subsidies given to households each year, coming from non-residential consumers, to keep household electricity prices at a very low level," Xie said. "I think eventually household users will have to pay more, and to reflect to real costs of electricity supply."

But raising household tariffs is seen as a difficult task politically, given that China's per-capita income remains low. Data from the World Bank showed China's GDP per capita reached $10,500 in 2020, below the global average of $10,926. Some experts expect any reform to be gradual.

"In absolute terms…power tariff per kWh for [residential customers] in China is less than in many other countries," Qin said. "However, I think [one] must take into account the average income level in China."

Dong said China is applying a tiered pricing scheme for household consumers where bigger users pay higher rates. "In the future, high rates may become higher, while low rates may be maintained to avoid energy poverty issues," she added.

More reforms needed

To achieve the country's future decarbonization targets, many observers believe China will need to carry out more market reforms to reduce costs during the energy transition and provide stronger financial incentives for renewable power generators and consumers.

The International Energy Agency (IEA) said China could achieve its carbon neutrality target well before 2060 by aggressively reducing coal use and accelerating the adoption of renewables. But the Paris-based energy watchdog added that more transparent market structures and regulations would be required in the process.

"Retail market and grid tariff reforms await full implementation. In many provinces, new retail companies can be formed, but the services they can offer are still limited," the IEA said in a recent report. "Clearer rules on grid tariffs, including for distributed energy resources to participate in wholesale or distribution system trading, are needed to encourage the deployment of distributed solar, batteries, and demand response."

China aims to boost its installed wind and solar power capacity to more than 1,200 GW in 2030 from 540 GW currently. As the country's future renewable energy supply is expected to mainly come from western provinces and demand from coastal ones, there have been calls for the government to enhance a nationwide grid system and cross-province power trading.

"Regulatory reforms for grid operators that rationalize grid use tariffs, which are still under consideration, will have a major impact on the competitiveness of new renewables," said the IEA, suggesting that future regulations should incentivize traditional asset owners to invest in low-emission alternatives.

If China can meet all its stated pledges, the IEA said full economic benefits through spot trading could reduce operational costs by 24% and CO2 emissions by 31% before 2035. The expansion of inter-provincial connections and trade can cut costs by another 37% and emissions by 45%, it added.

Refinitiv's Qin sees some of the same potential. "The power price needs to fully reflect supply and demand fundamentals and fuel costs need to pass through. In addition, enhancing cross-provincial transmission capacity will also contribute to fully utilizing the current power fleet," she said.

Others suggest China should design future market rules based on the nature of wind and solar power generators, which are weather-dependent, but enjoy near-zero marginal costs.

"It takes effective market mechanisms to ensure that each power generating and related technology, in particular clean technologies, is compensated sufficiently to operate and invest in a sustainable manner," Dong said.

Posted 07 October 2021 by Max Tingyao Lin, Principal Journalist, Climate & Sustainability, IHS Markit

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