Restructuring China's Power Sector

Four power construction and service firms have also been created: China Power Engineering Consulting Group; China Hydropower Engineering Consulting Group; China Water Conservancy & Hydropower Construction Group; and China Gezhouba Group.

Market Deregulation

One of the goals of power sector reform is the creation of greater market efficiency by having generation companies compete against one another to sell power through a power pooling arrangement. Success in this area requires, among other things, an effective electricity distribution system. The creation of a unified national grid therefore is a key element of the overall plan. The formation of the State Power Grid Company and the Southern Power Grid Company is a step in this direction.

A related area of critical concern is tariff policy. As the power industry attempts to make a transition from a state-planned to a market-based pricing system, a rational mechanism for setting on-grid and end user electricity prices is of primary importance. However, after many years of discussion and various attempts to introduce power pooling, the central authorities still have not been able to reach a consensus on how this aspect of the reform plan is to be implemented.

The current pricing regime allows for differential pricing throughout the market, from producers to end-users. At present, on-grid tariffs are negotiated and set on a plant-by-plant basis, resulting in dramatic fluctuations in tariff rates. On the consumer side, industrial and rural users have traditionally paid significantly higher prices than subsidized urban users. As a step towards resolution of this issue, the government has committed to unify end user electricity tariffs in urban and rural areas. In January, the SDPC announced that roughly 70% of all counties are now charging uniform tariffs. Significantly more work, however, will be required as this process moves forward.

A New Regulatory Body

Another objective of the reform process is to create greater accountability in the power sector. The SERC, as the new regulatory body, is intended to improve oversight of the power industry. The SERC's role will be to supervise market competition, ensure transparency and efficiency, propose tariff adjustments and issue and administer power service licences for power operators. However, authority over determining electricity prices and approving the construction and expansion of power plants will remain with the SDPC. This factor may limit the SERC's effectiveness in implementing reforms.

Impact on Foreign Investors

Foreign investment in power projects is subject to the Foreign Investment Industrial Guidance Catalogue (外商投资产业指导目录) (the Investment Catalogue, updated in April 2002). According to the Investment Catalogue, foreign entities may invest in power generation projects that are categorized as either "encouraged" or "restricted". Investment in the construction and operation of power distribution, however, remains in the "prohibited" category.

One area of increased interest for foreign investors is the acquisition of existing assets previously owned by the SPC. Since October 17 2000, when the State Council issued the Circular on Relevant Issues Regarding Reforms of the Power Industry (Guo Ban Fa [2000] No. 69), the sale of state power assets has been restricted in order to prevent disruption of power reform plans. With the completion of the reform plan and the break-up of the SPC, the purchase of former SPC assets is likely to become an area of heightened activity.

Despite such potential opportunities in the M&A area, the level of risk and uncertainty associated with power projects in China still argues for caution. An example of this continuing uncertainty is the recent statement from sources at the SERC that investors will soon have to renegotiate existing offtake contracts that guarantee minimum fixed investment returns. Such questions over the enforceability of existing contracts will no doubt cause foreign investors to think twice before making new investments.

Overall, the December 29 power sector reform plan represents a significant achievement by the central authorities in their attempts to rationalize China's power supply market. The present changes augur well both for consumers and producers.

Still, many issues remain and it will require years of implementation and further refinement before the entire process can be judged a success.

By Tarrant M. Mahony and Leland Fong Freshfields Bruckhaus Deringer

Beijing