The Boao Forum for Asia 2016: Pre-Conference Reflections

Energy reform impact: Fuel for growth reflections

The biggest challenge facing the energy industry during the 13^th Five-Year Plan period (2016-2020) might be the “new normal” of lower energy demand.

China’s energy consumption is geared toward heavy industries, and though the country is still in the developmental stages of urbanization and industrialization, when the “peak” of infrastructure construction passes, energy and electricity demand will grow at a slower pace. Closely related to demand growth rate is the rate of “capacity reduction”. Huge energy capacity will curb energy prices. Thus, in situations where lower demand puts downward pressure on pricing, energy industry needs to raise efficiency and to reduce costs in order to ensure survival and future development. This calls for the reform of energy prices and the entire energy system.

What will drive price reform?

Energy system reform and energy pricing reform are closely intertwined. However, these reforms are inherently gradual due to their complexity and susceptibility to economic cycles. “Liberalizing production and retail” and “controlling transmission and distribution” will provide the foundation for energy system reform, which will lead to pricing reform. From an energy system perspective, breaking monopoly is a precondition for price liberalization. “Controlling transmission and distribution” focuses on natural monopoly elements of energy while “Liberalizing production and retail” entails the need of providing investment opportunities for private funding in departments with lower technology and capital requirements. The fundamental driver to ensure market-based energy pricing is promoting adequate competition amongst industry players. Hence, system reform is needed to support price reform.

What will drive energy reform?

Regarding pricing mechanism, energy price adjustments must take into account the interests and responsibilities of multiple levels of governments and certain parties. Currently, state-owned energy enterprises have not only set economic goals but also are responsible for certain social responsibilities. Their close relationship with governments coupled with less transparent energy price setting and subsidies has led private enterprises to distrust SOEs, and consequently their reluctance in embracing mixed ownership. Meanwhile, administrative interventions in price setting might lead to uncertainties of future profits. Indeed, “mixed” private capital could be subject to uncertain profits; and uncertain profits would further influence the motivation of private capital. Thus, energy price reform is an integral part of energy system reform.

At this stage, over supply and low energy price will spur energy reform. There are two premises for energy reform (of which energy price is the more sensitive reform):

• First, energy supply and demand should be balanced. It is politically difficult for the government to implement reforms during energy shortages. While under shortages, satisfying energy demand takes priority over efficiency. Reform is about increasing efficiency, so reform will become more urgent after basic demand is met.
• Second, energy prices must be stable or even declining. The biggest barrier for energy price reform lies in price increases, which further influences economic growth and social stability. Reform against the backdrop of low energy prices would not lead to price increases but would change the pricing mechanism. Reform under such circumstances will definitely be facing fewer resistances, as customers often care more about whether reform would result in price increases, rather than the changed pricing mechanism. Thus, to push for reform when energy prices are low could minimize negative impacts on economic growth and social stability.

Energy demand and industry development during the 13^th Five-Year Plan period

Demand growth in 2015 was quite slow, and there have been no indications of rising demand in 2016. China is undergoing profound transformation, so whether the current demand remains low in the coming Five-Years depends on the length of the transformation period and whether the transformation is successful. Of course, in the medium to long term, as China continues to urbanize, the gap between energy growth and GDP growth could narrow. Therefore, if GDP growth maintains 6.5% in next five years, energy demand growth is likely to be 2% with electricity consumption growth at about 5%. Lower energy demand growth will benefit changes of energy structure. When energy demand grows rapidly, due to resource allocation and the urgency of meeting energy demand, China has to use more coal. Lower energy demand enables China to choose clean energy. Moreover, lower energy demand growth will force the energy industry to increase its efficiency, ultimately changing the development model. In the next few years, China’s oil consumption will see continued rapid growth. However, given low oil prices caused by weak demand, Chinese oil companies should increase their efficiency while at the same time making strategic plans as China’s dependence on oil imports will continue to grow.

Energy system reform during 13^th Five-Year Plan period

The basic tenets of the proposed energy system reform include progressively building a system framework of “liberalizing production and retail markets” and “controlling transmission and distribution” to form a competitive market on the basis of further separation of governments and business in energy industry, the separation of grid and transportation in the oil and gas industries, as well as reform of the electricity retail market. Energy reform emphasizes the role of private investment. By liberalizing prices of competitive sectors, the government can progressively liberalize energy plans other than plans for public interest and regulations.

Through energy system reform, the government’s energy management function needs to transform accordingly. The government needs to study and propose an energy industry system which suits China’s conditions, and promotes reform by avoiding detours. While strengthening energy regulations, if interventions were required, the government should use market-oriented tools. While gradually loosening restrictions on its energy plan, the government needs to strengthen strategic planning for the energy industry. Any energy reform must consider safe and efficient operations as well as reliable supply as major conditions, which is the government’s key responsibility.

In light of progress and expectations, what should be expected for energy price reform during the 13^th Five-Year Plan period?

For natural gas price reform, the goal is to establish a market-oriented link between the price at gate stations (wholesale price) and the price for customers (retail price), in essence by promoting a transmission mechanism of terminal prices, with visions of loosening price controls for non-residential gas at a measured pace. In 2015, the government changed gate station price management for non-residential gas from a maximum-price-based approach to a baseline-price-based approach, enabling suppliers and consumers to negotiate a specific gate station price with an upper limit of 20%. For domestic gas price reform, the primary goal is to reduce random subsidies and cross subsidies. Reform might not be able to eliminate cross subsidies, but may minimize them by lowering non-residential gas prices. Tiered pricing, differentiated prices based on usage, is a key measure to promote market-oriented reform of residential gas prices. By improving gas use efficiency, tiered pricing allows for certain socially-equitable subsidies for targeted groups, and raises the price for wasteful consumption. Despite the fact that the government was trying to establish tiered pricing mechanisms in all gas-connected cities by 2015, this goal may be achieved in 2016.

Recently, the government proposed to relax controls on the price of refined oil by the end of the 13^th Five-Year period. However, it will be a long process before these controls are lifted completely. The government announced a reform plan for the price mechanism of refined oil, where the government issues price adjustment information instead of adjustment orders.

The plan also sets adjustment limits for the price mechanism of refined oil, which allows the domestic price of refined oil to be adjusted according to the mechanism when the oil price per barrel ranging US$40 to US$130. Historically, the price mechanism linked the domestic refined oil price with the international crude oil price, but it relied on the government’s announced adjustments, so uncertainty arises as the government might not make adjustments, or make fewer adjustments, even when crude prices are volatile. The key point for an improved refined oil price mechanism is the elimination of such uncertainty, which is a key step toward market-oriented reform. Further reform would allow the refined oil price, within a certain range, to be determined by domestic market forces.

The government recently also proposed to improve the coal-electricity linkage mechanism. The current refined oil pricing mechanism has pitfalls, but for the market the refined oil price adjustment mechanism is transparent and predictable. Specifically, before price adjustment, the range for adjustment predicted by market institutions according to the changes of international oil price should be more or less the same with that announced by the government. The basic approach to improve the linkage mechanism for coal and electricity mainly depends on the government adjusting feed-in tariffs strictly in accordance with the timeframe and range set out by the mechanism, and considering how to link the retail electricity price.

The biggest highlight for this round of electric power reform is the vertical separation of electricity selling from the power grid, allowing multiple owners to enter the power retail market. The biggest challenge is how to provide the private sector with ample opportunities, as SOEs may continue to dominate the retail market if the government does not set limits.

Energy reform will have profound impacts on the energy industry. Given China’s energy consumption and vast market, changes in energy structure, energy production, and consumption propelled by reforms will greatly affect global energy markets. A clean and sustainable Chinese energy industry will be positive for the world.

Impacts on global energy markets and Asian countries in particular

As the largest energy consumer globally, China’s energy structure reform will also drive the optimization of energy structures in Asia and around the globe. Given that China accounts for 50% of global consumption of coal, a meaningful reduction of China’s coal consumption would change global energy mix. Indeed, according to the International Energy Agency (IEA), global coal demand is likely to come down from 29% to 26%, from 2012 to 2030.

Asian countries may experience even more direct impacts. The Middle East and Central Asia (former Soviet Union) are the main sources for China’s crude oil, accounting for two thirds of its total crude oil imports. China’s increasing demand for oil in the future will benefit Central Asia’s economic growth. Before 2014, China mainly imported pipeline natural gas (PNG) from Central Asia, and liquefied natural gas (LNG) from Australia, Indonesia, and Malaysia. In the future, however, the China-Russia gas pipelines may impact these countries’ exports of natural gas to China. These regions will also benefit from the changes in China’s energy structure as China significantly raises its proportion of gas consumption in the future. However, massive overcapacity within China’s coal industry has resulted in significant shock to Mongolia and Indonesia who have exported coal to China. These two countries may struggle due to weak coal exports to China in future.

As for energy cooperation, China is bound to strengthen its influence in Asia’s energy sector as the Belt and Road Initiative unfolds. Central Asia will be the main beneficiary, largely due to its relatively stable political situation, abundant and complementary energy resources, and close geographic proximity to China.

Lin Boqiang
Director
China Center for Energy
Economic Research at Xiamen University