Electric Blues: Reforming China's Electricity Pricing System

With separate entities controlling generation and transmission assets, it is now possible that the Chinese power sector can effectively operate as a horizontally integrated market. This has opened the way to introduce separate pricing mechanisms for each step in the supply chain (i.e., generation, transmission/distribution and retail sale of electricity).¹ China is currently looking at a number of different pricing mechanisms for each of these three functions and has implemented pricing experiments in different parts of the country under which different mechanisms are being implemented on a trial basis.

In this article we look at China's plans to reform the generation, transmission/distribution and retail prices for electricity, and consider some of the consequences of introducing competition into China's electricity market.

Generation: The On-grid Price

The on-grid price is the price at which plants sell power to the grid. In accordance with the PRC Electric Power Law(中华人民共和国电力法), electricity is purchased from power plants under annual contracts based on a costs plus reasonable profit pricing formula. The National Development Reform Commission (NDRC) must approve the final price negotiated between the power plants and the grid. Dispatch to the grid is then determined by sharing the required electricity output between the available power plants, irrespective of the price of the electricity they produce.

As on-grid prices are determined on a plant by plant basis, there are large fluctuations in pricing. With different plants using different fuel, different equipment and different financing techniques, the costs plus profit system means there is little uniformity in on-grid pricing across the country. In addition, with costs built into the pricing formula there is little incentive for plants to become more efficient producers, as any cost savings do not flow through to the plant's bottom line. To overcome these and other shortcomings the NDRC and the State Electricity Regulatory Commission (SERC) are currently trialling a competitive price pooling system in north-eastern China.

The North-eastern On-grid Pricing Trials

The north-eastern pricing trials were introduced in Liaoning, Jilin, Heilongjiang and Inner Mongolia through a package of regulations issued by the NDRC and SERC earlier this year (collectively the On-Grid Trial Measures).² The north-eastern region of China was chosen because of its comparatively stable supply of electricity and its previous experience with pricing trials in 1999.

The On-Grid Trial Measures introduce a dual pricing system under which around 80% of the required electricity output will continue to be sold under annual contracts using the traditional costs plus profit formula, and the remaining 20% will be sold under a competitive power pooling system. Under this system, plants will compete with each other for dispatch by making offers to sell to the grid. The plants' offer prices are supervised by a central trading centre that organizes dispatch based on considerations of the offer price as well as an assessment of the security of the grid if the plant is dispatched. In general, the plant with the cheapest offer will be dispatched first and the plant with the most expensive offer dispatched last.

During the initial stage of the trials, plants will only be able to participate in the market through monthly trades. However, the On-Grid Trial Measures envisage that as the market matures plants will be permitted to participate in real time spot price trading and daily trading of electricity.

The Impact of the On-grid Trial Measures

Clearly, the competitive price pool model will have far reaching consequences if it is adopted on any scale. One issue that will need to be addressed is how to incorporate more expensive energy such as renewable energy into the system, as a purely price-based market would discriminate against renewable energy plants. At this stage the authorities have avoided this issue by limiting the participants in the On-Grid Trial Measures to large coal-fired plants.

In addition, the status of long-term fixed-price power purchase agreements has not been specifically addressed. At this stage it is unclear how these contracts will be incorporated into a competitive market-based model. At least for the short term, authorities have taken some steps to reassure foreign investors as to the validity of their fixed-price contracts. Plants selling power under long-term fixed-price contracts have been specifically excluded from the competitive price pool scheme in the On-Grid Trial Measures for around three to five years. In addition power purchase contracts were specifically excluded from the categories of fixed-price contracts declared "illegal" by the State Council in regulations introduced in May 2002.³ However, based on comments made by SERC officials⁴ it appears that over the longer term, if the competitive price pool is implemented on a larger scale there will be increasing pressure on foreign-invested power plants to renegotiate their power purchase agreements.

The Transmission/Distribution Price

As a result of phase one of the Plan, both transmission and distribution facilities are now controlled and operated by two state-owned enterprises, the Southern Power Grid Company and the State Power Grid Company. The transmission price is the price for these companies to transmit electricity through the grid. While the Electric Power Law(电力法), in principle provides that the transmission price should be based on a costs plus profit formula, in practice it has not been systematically determined and is generally just the balance left over after the NDRC has determined the on-grid and retail prices. This meant grid companies were squeezed between the NDRC's desire to increase the on-grid price to attract investment and political pressure to decrease retail prices to consumers. The result has been to leave grid companies debt ridden and starved of sufficient funds to upgrade their grid networks.

Under the Plan, the government will continue to control the transmission price, but authorities intend to enforce the reasonable costs plus reasonable profits formula to ensure the grid companies are profitable. The aim is that grid companies should generate profits sufficient to at least fund the maintenance and upgrading of their grid networks.

Over the longer term the government is also considering separating the transmission price into a low voltage distribution price and a high voltage transmission price. Regulations introduced for the eastern power market⁵ (the Eastern Region Trial Measures) have requested input from market participants on this issue in preparation for the implementation of transmission and retail pricing trials scheduled for next year.

The Retail Market

The retail price is the price charged by state-owned retailers to end consumers. Currently, the retail price is tightly controlled by the NDRC and there are significant retail price differences throughout the country. In addition, the price is tiered depending upon the category of consumer, so that urban and rural households pay significantly less for their electricity than industrial and commercial consumers.

At this stage details of the reform of retail pricing remain scant. However, it is understood that the Chinese authorities are considering various strategies to link the on-grid and retail price so that the two operate in tandem. In the Eastern Region Trial Measures, the government has requested input from market participants as to developing means to achieve this. The aim of linking the on-grid and retail prices is to ensure price signals flow through to consumers, so that when supply is tight both on-grid and retail prices increase, thus encouraging consumers to consume less and thereby balancing supply and demand. While the transmission and retail pricing trial measures are scheduled for next year, it is not yet clear what mechanisms authorities are considering to link the on-grid and retail prices.

There have also been some reports that the authorities are considering introducing some degree of competition into retail pricing, which would possibly allow consumers to choose their supplier. However, this possibility was not raised in the Eastern Region Trial Measures and is probably still some time away.

Conclusion

More than two years have now elapsed since the Plan for Structural Reform of the Power Industry was first introduced. With generation, transmission and retail functions operating with increasing independence the foundations for a competitive market-based pricing system are in place. While recent power shortages have caused a slight hesitation in the pace of reform, there is no denying that Chinese power markets are marching toward deregulation. On-grid price experiments have already been introduced in the north-east, transmission and retail price experiments are scheduled for next year in eastern China and end-user price experiments have been introduced throughout the country.

However, the secrecy surrounding details of the Plan and the variety of the pricing experiments in place mean that there is considerable uncertainty as to the shape a deregulated market will take. In addition, concerns as to fixed-price power purchase agreements, questions as to the incorporation of clean energy and a lack of guidance on the general direction of reform of retail markets and transmission prices leave little certainty for market players. In theory the current environment of power shortages, restraints imposed on lending by local banks and China's increasing concern with its environmental record should create ideal conditions for investment in cleaner, foreign-invested and financed power plants. However, the reality may be that given uncertainties surrounding the current pricing reform combined with lenders' traditional concerns about the Chinese power sector, financing power projects in China will continue to be a considerable challenge.

Endnotes

1 The separation of the generation and transmission prices was achieved through the introduction of the Power Generation and Transmission Price Separation Implementing Procedures, issued by the NDRC on May 23 2003.

2 Regulation of the Power Market of the North-east Region Implementing Opinion (Tentative), Entry into the Power Market of the North-east Region Implementing Opinion (Tentative), the Initial Operation of the North-east Regional Power Market Procedures (Tentative) and Implementation of Supervision and Administration of the North-east Regional Power Market Implementing Opinion (Tentative).

3 Issues Relevant to the Proper Handling of Current Projects with Guaranteed Fixed Returns for Foreign Investors Circular, issued in September 2002 by the State Council.

4 "Deepening China's Electricity Pricing Reform," International Finance Daily, January 17 2003.

5 Trial Reforms for Developing the Distribution and Transmission and Retail Electricity Price in Eastern China and Guangdong Province issued in April 2004.