The Price of Power: the New Chinese Leadership Begins Rebalancing with Resource Prices

July 16, 2013 9:00 AM

Although the prospects of the People's Bank of China (PBoC) initiating further financial reforms – particularly more flexibility on deposit interest rates – has received greater attention this year, there have been more concrete measures in resource price reform.

Over the past half year, the State Council and the National Development and Reform Commission (NDRC) have released measures reforming the pricing of petro, natural gas, coal, and electricity. As these reforms continue to take shape, higher resource prices coupled with anticipated reforms to the pricing of capital could prove to be a major boon for rebalancing.

Any distortions lowering the price of energy favor industry because that sector is by far the largest user of energy in China. In 2012, the industrial sector consumed 70.8 percent of all energy, compared with only 16.5 percent by the service sector and 11 percent by households. More market-based pricing leading to higher energy costs would thus serve to support China's rebalancing by redistributing economic resources away from the industrial sector toward households and services.

Some of the moves made by the NDRC this year to encourage more market-based energy pricing include:

An improved petroleum pricing system

China’s crude oil price already fluctuates freely according to international prices, while the price of refined oil products is protected from volatility in crude oil prices. This has changed in recent years. The NDRC is increasingly reducing controls on refined oil prices and allowing greater exposure to fluctuations in crude oil prices.

In March, the NDRC adjusted China’s retail fuel price system for the first time since 2009. It reduced the number of working days for raising China’s retail prices for refined oil products from 22 working days to 10 working days. NDRC also eliminated some of the controls in the old system. For example, in the 2009 system, no adjustment in refined product prices would be made if the average change in crude oil price was less than 4 percent. This has been eliminated.

Petro Prices

NDRC’s recent changes to the refined product pricing system is overall an improvement but it leaves plenty of room for further reform. The two key changes in this recent policy update were: (1) increased frequency of adjustment and (2) the removal of the minimum fluctuation requirement of at or above 4 percent over the period. However, one of the key restrictions still in place in the latest policy is a cap on refined oil price growth. The NDRC will continue to limit the prices for refined oil products at or below $130 a barrel. As a result, we can expect China's oil refiners - PetroChina - to continue to experience losses if crude prices rise too high.

Natural gas price hike

Natural gas pricing is also improving. At the end of June, NDRC released a comprehensive plan for improving the pricing natural gas products. The NDRC raised the base price paid by non-residential user consumption by 15 percent. NDRC’s last gas price hike was in June 2010 when the base price was raised by 25 percent. Further, the market pricing mechanism introduced in Guangdong and Guangxi in 2012 will be expanded nationwide. This system calls for any incremental gas usage by non-residential users above the volume of 2012 (112 cubic meters) will be priced at 85 percent of the cost of imported substitutes (such as liquid petroleum gas and fuel oil).

LNG prices

Natural gas has traditionally been underpriced in the domestic market, benefiting industrial users and reducing the incentive for large domestic producers like PetroChina to invest in shale gas exploration. The pricing system has been particularly punishing in recent years. PetroChina reported losses of Rmb 2.1 billion on its natural gas segment in 2012. The losses could have been the result of high LNG prices. China is a natural gas importer, half of which comes in the form of LNG. PetroChina has needed to rely more on LNG imports while the imported pipe gas from Central Asia has yet not peaked and the pipeline to Myanmar has not yet opened.  The firm is launching many new coastal LNG terminals in recent years as the price of LNG has soared making it difficult to get a good price on long term LNG contracts.

The better pricing system may help improve the margins on LNG or pipeline imports, particularly the new pricing rule for incremental gas usage but only marginally. Reuters reported the average LNG spot price into China at $13 to $14.5 mmBtu, while the new base price after the most recent hike will still be only $10-12 mmBtu in China’s coastal regions. In other words, the recent rise may only narrow the losses of LNG imports in China.

Coal is free but electricity prices muddle along

The weakest but potentially most important area for further reform is electricity price. Electricity is the dominant form of energy consumed by the economy and the industrial sector. In 2011, electricity consumer represented 61.9 percent of all electricity consumption; of this the industrial sector consumes 72.7 percent of all electricity produced in China.

Despite the importance of electricity pricing to rebalancing, market reforms to electricity pricing have fallen behind crude or natural gas price reforms. Most pricing reforms have focused on the price power producers are compensated by electricity distributors for electricity (the on-grid price) and the price coal miners are paid by power producers, while leaving the more important issue of liberalizing the price industrial end-users pay for electricity untouched.

In December 2012, the NDRC announced it would stop setting the price for coal contracts between power producers and coal mines. Now power producers must directly negotiate purchasing contracts with coal mines.

Liberalizing coal price contracts is a progressive move. In the past, NDRC set the price of long-term purchasing contracts between coal mines and electric power producers. Coal prices were set below the market price in order to protect the margins of electric power producers, reducing the pressure to pass on higher coal prices to electric power prices. However, the system ran in to trouble in 2008, 2010, and 2011, when coal prices spiked coal mines refused to sell to electric power producers at the contract price leading to rolling blackouts when mines refused to deliver at the contract price and forcing power producers to buy on the spot market. The new system will now allow coal producers to make contracts with electric power producers using market rates.

Allowing market rates for coal could leave electric power producers vulnerable. If coal prices rise rapidly, power producers will not be able to pass on higher coal prices to consumers. The NDRC still sets the rate electric power producers are compensated by the grid for their power. When the NDRC is slow to adjust on-grid prices in response to coal price fluctuations, power producers are squeezed. In 2008, thermal power producers lost Rmb 26 billion as a result of coal price hikes.

The new coal contract pricing system does address this to some extent.  It stipulates that if coal prices rise more than 5 percent within a one year period, the electric power price paid by the grid company will rise. The price increase will pass on 90 percent of the coal price rise to grid companies. For power producers, this is a marginal improvement from the previous system. Prior to the change this year, power generating firms were only allowed to pass on 70 percent of the cost of coal price hikes to the grid. Yet the previous system was better in some respects because on-grid prices were to be adjusted every six months instead of only once a year.

Overall it is difficult to assess how the new coal contract pricing system will affect coal power producers less retail electricity prices. Even if on-grid prices are adjusted this is still simply transferring losses from power producers to grid companies rather than energy intensive users. To change this NDRC needs a more flexible retail electricity pricing system.

Electricity prices

Unfortunately, changes to the retail pricing system have been limited. The price grid corporations charge end-users for electricity is still set by the NDRC. There have only been incremental changes to adjust retail electricity pricing.

One of the key initiatives outlined is a simplified classification structure of electricity users. In the past, the NDRC had eight categories of end-users for fixing the sales price of electricity – residential, commercial, non-industrial, basic industrial, large-scale industrial and agricultural users. In June, the NDRC simplified the structure of retail electricity pricing. The categories have been reduced to three – residential, agricultural, and commercial/industrial.

The goal of this policy is to reduce any favoritism to industrial users by placing them in the same category as other business sectors. Yet it is unclear to what degree this will increase prices for heavy industrial users.

A direct electricity contract system for heavy electricity users is another initiative highlighted by this years’ State Council approved NDRC reform plan (推进大用户直购电和售电侧电力体制改革试点). Beginning in 2009, the NDRC began experimenting with a trial program to let large industrial users negotiate power purchases directly with power producers. In theory the system is designed to increase costs for heavy users but this has not worked in practice.

The system is ripe with problems. In 2010, the pilot slowed to a halt when local governments began abusing the system. They co-opted power producers to subsidize energy intensive users in the financial crisis – in other words, the opposite of what the policy was intended to do. Beyond local government tampering, another issue is the lack of transparency surrounding distribution fees. The State Grid Corporation still monopolizes power distribution in most of the country. They have been reluctant to give up their power of end-user pricing to power producers.

Any new policy expanding the direct electricity contract pilot program will need to address this issue. As of March the State Electricity Regulatory Commission (SERC) – the regulator in charge of policing the electric power sector - has been dissolved, meaning electricity price reforms require a direct confrontation between NDRC and State Grid Corporation. Some have even suggested that the State Council and the NDRC are considering breaking up the State Grid Corporation. This would perhaps improve transparency of distribution and transmission prices but if retail prices continued to be fixed, energy-intensive users would still benefit.

More progress has been made in pricing of resources for households. In March 2012, the NDRC received State Council approval for implementing a three-tier electricity pricing system for residential users. A system that would make more heavy users of electricity pay higher rates. In the new pricing system, households consuming relatively more electricity (241 Kwh to 400 Kwh)  pay 50 yuan ($7.9) more for every 1000 Kwh of electricity. Those consuming more than 400 kwh will pay 300 yuan ($47) more for every 1,000 kwh of electricity.   The NDRC working document approved by the State Council this year also called for moving forward with progressive pricing for residential use of water and gas (综合考虑资源节约利用和环境保护等因素,建立健全居民生活用电、用水、用气等阶梯价格制度). A more progressive pricing system for end-users of resources is a critical reform but without a similar approach to heavy industrial users, this is a glass half full approach.

The most recent batch of resource pricing reforms are a concrete indicator of the new leadership’s commitment to rebalancing but it is only a small step in the right direction. It is relatively easy to increase the flexibility of petroleum, natural gas, or coal contract pricing at a time when international prices are low. The real test will come when regulators must commit to allowing international price rises to pass through to heavy users. Meanwhile, the NDRC remains slow to implement greater reforms to the electricity pricing for industry, focusing instead on a more equitable distribution of losses between the grid and power producers. The new leadership has made good use of the lull in international prices to tackle some resource price reforms, but it remains to be seen whether more substantive moves will follow.

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