Stable energy prices can help China achieve considerable progress on market-driven approach

Though China has signaled its intention to let the market play a decisive role in allocation of resources, it would need to make considerable progress on energy pricing to achieve tangible results in the long term.

Decisive steps on energy pricing will also help reiterate the government's strong commitment to reforms, and indicate the way forward for energy producers and consumers.

Since 1984, China has dabbled with energy reforms in one form or another. While the focus of these reforms has been to move away from a centrally monitored pricing mechanism to a more market-driven approach, the pace and scale of reforms have differed for various types of energy.

Among these reforms it is the coal-pricing mechanism that has drawn much attention, especially in terms of pace and scope. The first major reform in this sector was the dual pricing system, which was introduced in 1984, wherein enterprises were required to sell a quota of coal at prices that were set by the central government and the rest at prevailing market rates. In 1993, the central government decided to adopt a pricing mechanism based on usage patterns.

Under the dual-pricing system, coal prices for non-utility use, the so-called market coal, were determined by the market. But the price of coal for utilities, the so-called power coal, was based on the guidance price set by the National Development and Reform Commission, often at rates lower than prevailing market rates.

In 2004, the commission decided to use price bands for fixing coal prices. Though the mechanism involved extensive discussions with coal producers and electricity generators, it was scrapped in 2006.

The commission also proposed, in May 2005, that it would consider a coal-electricity price "co-movement" mechanism that would allow power tariffs to be raised if coal prices rose by 5 percent or more over a six-month period. The scheme also allowed power generators to pass up to 70 percent of the increased fuel costs to grid companies.

However, in December 2012, the State Council announced the abolition of the dual pricing system for coal, and shifting to market-based pricing.

At the same time, it tweaked the coal-electricity price co-movement mechanism and allowed adjustment in power tariffs if coal prices fluctuated by 5 percent or more in a 12 month-period and permitted electricity generators to pass up to 90 percent of increased fuel costs to grid companies, instead of the existing 70 percent threshold.

Like coal, a dual pricing system for crude oil was introduced in 1984, and was virtually eliminated in 1993. Since 1998, domestic crude oil prices have tracked international prices, but refined oil product prices have not. To address this disconnect, the government has, since May 2009, implemented a pricing mechanism by which it can adjust domestic petroleum product prices if the moving average of a basket of international crude oil prices, on a composite basis, rise by more than 4 percent within 22 consecutive working days.

To better reflect refiners' costs and adapt to fluctuations in global crude oil prices, in March last year the commission launched an automatic petroleum product pricing mechanism, shortening the 22-working-day adjustment period to 10-working-days and removing the 4 percent threshold. The government also decided to adjust the composition of the basket of crude to which oil prices are linked.

Reforms have also been undertaken for natural gas prices. A breakthrough in the reform area has been changing the existing cost-plus pricing to the "netback market value pricing" in Guangdong province and the Guangxi Zhuang autonomous region. Under the new pricing mechanism, pricing benchmarks are selected and pegged to prices of alternative fuels to establish a price linkage between natural gas and its alternative fuels. Gas prices at various stages will then be adjusted accordingly.

Before introducing the Guangdong and Guangxi pilot reform program to the entire country, the commission plans to implement three-tier-tariffs for household use of natural gas across China by the end of next year. These price reforms and the pilot scheme in Guangdong and Guangxi help to establish a market-oriented natural gas pricing mechanism that fully reflects demand and supply conditions.

The government still retains control over electricity tariffs. But to encourage coal-fired power plants to install and operate flue gas desulphurization and denitrification facilities the government has since 2004 accorded a price premium for electricity generated by coal-fired power plants with flue gas desulphurization facilities installed and since November 2011 a price premium for electricity generated by power plants with flue gas denitrification facilities. The level and scope of the price premium have been amended since their initial implementation in order to achieve the mandated emission reductions.

The government has also charged differentiated power tariffs for companies classified as "eliminated types" or "restrained types" in eight energy-guzzling industries from October 2006 onwards. Since July 2012, the commission has used three-tier-tariffs for household electricity use, and in January this year expanded the three-tiered electrify pricing approach to the aluminum sector to phase out outdated production capacity and promote industrial restructuring more quickly.

Similar tiered power pricing policies are likely to be implemented in industries like cement to force industrial upgrades and promote sustained, healthy development.

Clearly, China has made great efforts to reform energy prices. However, such reforms are far from complete. While the new pricing mechanism for petroleum products is one step towards a more market-oriented pricing mechanism, it is still not enough.

Petroleum product prices fluctuate with global crude oil prices, and are hence decoupled from the domestic market. Reforms should also take domestic factors into account, so that petroleum product prices can better reflect the relationship between domestic supply and demand.

The pilot scheme in Guangdong and Guangxi provides the right direction to establish a market-oriented natural gas pricing mechanism.

China also needs to draw on the lessons learned from the two pilot schemes and examine what kinds of adjustments and improvements are needed regarding the choice of alternative fuels, the selection of the pricing reference point and the creation of netback market value pricing formula in order to implement the reforms on a nationwide basis.

While China has been reforming the electricity industry structure since 2002, transmission, distribution and sale of electricity is undertaken by two main grid companies, State Grid and China Southern Power Grid, and several local grid companies, such as Inner Mongolia Grid and Shaanxi Grid. As the designated sole buyers of electricity from generators and distributors and sellers of electricity, they hold monopolies in their respective areas. Their monopoly power and the lack of competition in the electricity market has often drawn criticism.

However, separation of transmission and distribution is not a viable option. The feasible approach should be to set up a power trading market. In this regard, direct purchase of power for major electricity users, as per the pilot program in Yunnan province, should be promoted. That will help to infer the actual cost of electricity transmission and its effective distribution and help the government to set the appropriate level of the grid's transmission and distribution charges in future electricity power structure reform.

While splitting the grid is not a necessary option, separating electricity sales from the grid's transmission and distribution is a must to establish a competitive power market. It would also lead to the creation of an electricity market that is not reliant on the grid. These are the more realistic options for pushing forward power reforms.

The government could also consider raising the current level of price premium for de-nitrification in order to encourage more power plants to install and run denitrification facilities.

In the case of coal, though the dual-pricing system has been abolished, it is still difficult to establish a nationwide market, as railway freight mechanisms have not been liberalized. Given the uneven geographical distribution of coal production and output, and the need for coal to be transported over long distances, it is imperative that the freight mechanisms are also liberalized quickly. Reforms need to be targeted in such a manner that they can lead to the formation of a complete coal value chain.

However, even if such reform is undertaken coal prices do not fully reflect the cost of production because of the government's controlled costs and distorted prices. They also do not include negative externalities.

The resource tax levied on crude oil and natural gas on a revenue basis, rather than by existing extracted volume, which has been applied nationwide since November 1, 2011, is a step in the right direction.

China should broaden that reform to coal, by overhauling the current practice and fix the levy on coal by revenues. This will also help to increase local government's revenues and alleviate their financial burden and encourage them not to focus on economic growth alone.

The author is a distinguished professor and chairman at the School of Economics, Fudan University, Shanghai. He is a fellow of the Asia and the Pacific Policy Society. The views do not necessarily reflect those of China Daily.

(China Daily European Weekly 05/23/2014 page12)