Chinese power sector reforms mean more coal now, less coal later

As China’s electricity shortage woes have continued into October, policymakers have seized the opportunity to push forward key measures targeted at power sector liberalization. While these measures should have the short-term impact of keeping the lights on for power consumers, over the long term, they hold more significant implications for the broad deregulation and decarbonization of the Chinese power sector.

To recap briefly how we arrived here, China has been experiencing moderate-to-severe power cuts across the nation since the last week of September. I previously wrote about those issues here. Since then, coal scarcity has only intensified, driving domestic coal prices to record-setting levels and forcing regulators across the country to relax the tariff cap at which coal generators are allowed to sell their power. While we have not seen a recurrence of the emergency load-shedding that led to loss of residential power in northeastern China last month, power remains scarce and expensive for many commercial and industrial (C&I) power users. In particular, energy-intensive industrial consumers have been targeted for power curbs in many provinces, as they are an easy target for regulators choosing where to trim demand from the grid.

The new regulation

Against this backdrop, on October 12, the National Development and Reform Commission (NDRC) released a sweeping regulatory update that established fundamental reforms for the operation of the sector. The main regulatory points were as follows:

1. Coal-fired generation must now sell 100% of its power in the open markets. There is no guaranteed offtake for coal generation.
2. The rate at which coal-fired generation may trade in the open market is raised to +/- 20% of the baseline rate. Energy-intensive power consumers have no price cap.
3. C&I power consumers must now procure their electricity via open market channels. There are no more government-mandated fixed rates for power consumption for these users (residential and agricultural power users are not affected).

What does it all mean?

First, item 2 obviously speaks to the current woes faced by coal generators in the wholesale markets. By raising the allowed selling price of coal-fired power by 20%, generators are able to afford the more expensive coal, directly passing the higher costs on to the buyers. This doesn’t resolve the fundamental coal supply issues, but it does ease the worst of the power curbs by giving consumers power to buy, even if it is more expensive than before. Jiangsu and Shandong provinces have already started trading power near the 20% cap, with no shortage of willing buyers for the pricey power. Guangxi Province has just announced energy-intensive customers will need to pay 50% (!) more for power for the foreseeable future. Coal is going to remain scarce and expensive as we move into the winter heating season, and if it gets even more expensive before the efforts to increase coal supply can stabilize the price, the tariff cap may have to be raised even further. The fundamental issue here is the coal supply; the tariff cap raise is just a bridging mechanism.

Aside from that, items 1 and 3 mean that coal generators and C&I power consumers can now buy and sell power in an open market forum, one that should exhibit the economic features of a deregulated power market. The implications for the Chinese power sector are numerous. Here’s a moderately geeky review of the relevant electricity economics:

• Power consumers will be able to choose to procure the cheapest power first, then the next cheapest, then the next cheapest, and so on. This is called a “merit order,” the fundamental principle of a freely trading wholesale power market.
• Expanding on the previous point, the most expensive generated power will be consistently ignored by consumers, with most eventually forced to exit the market. In the past, China used a quota system to ensure that all coal-fired generators were paid to operate a certain number of hours each year. With this promise of guaranteed revenue, coal plant overbuilding was rampant, and oversupply was severe. With this reform, China has eliminated its main incentive for constructing superfluous coal-fired power.
• By virtue of the economic merit order, power consumers will create demand for the most affordable (and reliable) power products. Power plant developers will respond by investing in the specific types of power assets that meet the demands of power consumers (and ignoring generation types that are unlikely to lead to attractive returns).

In summary, this regulatory reform is a major step toward power market liberalization, relying less on policy mandates and more on the “invisible hand” of the markets to guide power sector investment and consumption behavior. The state will still enforce outcomes in the market via regulation (e.g., 20% price cap, the decarbonization goals, etc.) but no longer have its hand directly on the steering wheel, instead serving more like highway guardrails.

So…is this good or bad for China’s decarbonization effort?

In the short term, item 2 (the raising and removal of price caps) will be crucial in ensuring the coal-fired generators can keep buying coal and generating power, giving them much-needed relief on cost recovery. Power consumers will have no option except to buy the 20% more expensive power; it’s certainly better than having the lights turned off. This will make coal generators happy, as coal power should be able to recover back to consumption levels seen before the crisis.

But over the medium to long term, it’s clear that these measures expose coal power to market forces that it’s never had to confront before, and probably to its detriment. Over the last few years, the levelized cost of electricity (LCOE) for wind and solar has already come all the way down to competitive levels with new coal. Yes, solar has gotten more expensive this year, due to the silicon shortage, but development costs over the longer run are expected to resume their downward trend. On the other hand, coal is forecast to become more expensive in the coming years (current pricing shock aside, of course), and the LCOE of coal will trend upward due to factors like more stringent emissions standards, carbon markets, etc. There’s good reason to believe that wind and solar will be able to compete extremely effectively on price against coal in China’s open markets, which aligns well with China’s decarbonization plans (and, incidentally, the ESG plans of most multinationals operating in China, many of which have taken on commitments for green energy consumption). This is good news for China and the rest of the world.