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Global Risk Insights

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Why China’s Energy Deregulation Is More Important Than The Aramco IPO

In recent years, images of China’s rapid industrialization have become all too familiar: from enormous factories, and infrastructure projects, to the ubiquitous smokestacks of the nation’s power plants. While China’s industrial and service sectors have increasingly adopted a free-market attitude, the lifeblood of China’s economy, energy generation, has been under strict control, driven by monopolies and government pricing restrictions – that is until now.

China is in the process of deregulating its energy sector, one of the last commanding heights of the central government. Electricity distribution, transmission, and sale reforms are urgently needed if China wishes to create a modern grid to support, rather than hinder, its changing economy.

Deregulating the dragon

Currently, 35 nations, representing 44 percent of global energy usage, have deregulated energy sectors. China makes 36, representing 25 percent of global energy use. Consequently, China’s reforms will see the majority of worldwide energy become deregulated for the first time.

Specifically, China is in the process of ending the monopoly of state-owned power distributors, by allowing end-users to negotiate directly with generators: “direct trading will bring end-users benefits as low coal prices and power over-supply push down rates.”

(Click to enlarge)

Instead of fixed flat-rate pricing from the government, China will ‘re-commodify’ electricity, by allowing generators to sell via regional power trading platforms. State-owned transmission companies will in turn operate as utilities and only charge a transmission fee. Related: Record Breaking Production Drop In North Dakota

The government is also evaluating the merits of an online payment system to aid consumer adoption and promote e-commerce. These reforms are also slated to create new investment and financial products, as Beijing is investigating the eventual implementation of electric power future and derivatives.

The electricity reforms began with a pilot project in Shenzhen in 2014, which was expanded to five more regions in 2015, with enterprises seeing savings of $854.6 million as result. Similarly, direct energy sales were expanded to seven more cities in 2015. The government is set to expand the program to ten more provincial, and one to two regional power grids in 2016 (including Beijing, Tianjin, Chongqing, and Guangdong), and the entire country by 2017. The government will be monitoring the progress of the pilot project until 2018.

Energy reforms needed to counter excess and wastage

As China’s supercharged economy surged ahead in the 2000’s, the central planning agency prioritised power plant construction, adding 80-100 GW annually from 2005-2010, despite China reducing energy usage by 19 percent over 2005 levels by 2010, as part of its efforts against climate change. This move was driven by fears of insufficient generating capacity holding back economic growth.

The problem China now faces is overcapacity, as the provinces have continued to add generating capacity, despite lower demand. Indeed there has been a 20 percent increase in the number of thermal power projects, despite lower demand, with 200 GW of additional capacity (more than all of Canada) to come online between 2015-2017.

This overcapacity has been compounded by the fact that industry uses 75 percent of China’s energy, and it is this very tier of the economy that is being streamlined as the country moves towards a more consumption-based economic model.

Despite, or indeed because of, this trend, the provinces have continued apace with power plant construction in order to maintain local growth, at the expense of national efficiency. A narrow focus on local jobs, combined with state-set electricity prices that have not been sufficiently adjusted to reflect low coal prices – have until now allowed new power plant projects to remain profitable despite a lack of demand.

(Click to enlarge)

Until now, the government has sought to deal with overcapacity by dictating generating quotas for producers. However, this has led to inefficiencies and under-utilised facilities, as China’s generating portfolio consists of thousands of old and dirty coal plants, alongside newer, cleaner ones, as well as a host of various alternative methods from nuclear to solar. Related: OPEC May Be Forcing Venezuela Into Regime Change

By shifting to a deregulated market, the government wants to use market forces to phase out less efficient and less environmentally friendly producers out of the market. With the market setting prices at various bidding increments, efficient producers will finally be able to fully utilise their assets, under-bidding less competitive producers. As a result, China’s oldest and dirtiest generators will be confined to operating at peak hours, thus reducing pollution, a major domestic security concern for the Chinese government.

Concern about pollution is a major motivation for the reform

Pollution is a central driving factor behind China’s efforts at energy reform, as cheap coal and overcapacity merely encourage wasteful consumption patterns. This frustrates the government’s efforts to improve energy efficiency and reduce pollution. Moreover, China’s large scale investments in wind and solar are being under-utilised under the current system, which is too static to effectively incorporate fluctuating green energy generation rates, resulting in waste and the increased threat of brownouts.

The bottom line of these reforms is that they will open up competition and create new markets for power generation and sales businesses. The private sector is thus being allowed to enter one of the last unexploited sectors of the Chinese economy. As of November 2015, some 300 companies have signed up. In the short to medium term, these reforms, aside from creating a blossoming of Chinese energy companies, will also create opportunities for consultant and IT firms to aid major energy consumers in transitioning to the new system.

By Global Risk Insights

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