Electricity Restructuring In China: How Competitive Will Generation Markets Be?

ELECTRICITY RESTRUCTURING IN CHINA: HOWCOMPETITIVE WILL GENERATION MARKETS BE?

RUSSELL PITTMAN*

Antitrust DivisionU.S. Department of Justice, LSB 9446

Washington, DC 20530, USA

and

New Economic SchoolNakhimovskii Prospekt 47117418, Moscow, Russia

[email protected]

VANESSA YANHUA ZHANG

LECG, LLC33 W. Monroe Street, Suite 2300

Chicago, IL 60603, [email protected]

The continuation of China’s remarkable economic growth will depend on continued increases inelectricity supply. China has commenced a program of electricity sector restructuring, with theannounced aim of relying on markets and competition to provide incentives for attracting privateinvestment and encouraging efficiency. However, a close examination of the generation marketsbeing created suggests that truly free wholesale prices are likely to be both high and volatile. Thismay be the reason that these prices have not yet been freed — and it may not bode well for truemarket liberalization in the future.

Keywords: Electricity restructuring; competition; China.

JEL Classification: L94, O13, P28, Q48

1. Introduction

The continued success of China’s rapidly growing economy and the accompanyingeconomic reforms will depend in no small measure on continued growth in the electricitysector. In an effort to attract the massive investments required and to insure that they areused most efficiently, the Chinese government has undertaken a major and fundamentalelectricity sector restructuring, including the now standard worldwide reform strategy ofthe separation of the assets and operations of generation from those of transmission anddistribution. The ultimate contemplated outcome includes a generation sector characterizedby independent enterprises competing among each other for access to the transmission grid

*Corresponding author.

The Singapore Economic Review, Vol. 55, No. 2 (2010) 377–400© World Scientific Publishing CompanyDOI: 10.1142/S021759081000378X

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and for customers, with free wholesale prices both insuring that the most efficient gener-ation assets are called into production and providing a return to the owners of those assets.

However, it is not clear how realistic or likely this contemplated outcome is, eitherpolitically or economically. Politically, the Chinese government has so far been unwillingto allow either wholesale or retail electricity prices to increase in line with increases incosts, most notably increases in the price of coal. As in Russia, for example, the gov-ernment has continued to regard the prices of electricity and other public services more as aweapon for fighting inflation than as a mechanism of resource allocation. Economically,certain aspects of the electricity sector that are not likely to change quickly — especiallythe heavy dependence on coal generation and the limited interregional transmissioncapacity — may render generation competition difficult to achieve, volatile, and ineffectualat supporting the goals of broader restructuring.

In this paper, we outline the basic inherited structure of the Chinese electricity sector aswell as the overall reform plans and the progress achieved to date. We then examine closelythe six primary regional markets that are considered by the government as likely to be theloci of wholesale competition when it appears. We discuss why competition may beineffective in these markets and consider policies with the potential to make beneficialreform outcomes more likely.

2. The Chinese Electricity Sector

2.1. Background

The Chinese electric power industry has grown into the second largest in the world, withinstalled capacity rising from 1.85GW in 1949 to 713.29GW in 2007, an average annualgrowth rate of 10.8%.1 The vast majority of generation plants are either coal-powered —

almost 78% of the total capacity in 2007 — or hydro powered — over 20%. Nuclear plantsaccount for only about 1% of the capacity. Although the Chinese electricity industry hasbeen expanding dramatically, installed capacity per capita in 2006 is still at a low level of0.5KW, compared to 1.6 KW in the EU-25 and 3.6KW in the United States,2 and percapita annual electricity consumption in 2006 was only around 2,149KWh.3 In the longrun, a massive expansion of power infrastructure will still be needed if average con-sumption is to approach developed world levels.

When China began its transformation from a centrally planned to a market-orientedeconomy in 1978, the already rapidly growing demand for electricity suggested the crucialnature of reforms in the electricity sector. However, electricity has been one of the lastsectors in which the government introduced, and relied on market mechanisms. Theshortage of public funds and the desire for a separation of government administration from

1See the websites of the China Electricity Council, www.cec.org.cn, and State Power Information Network, www.sp.com.cn/zgdl/dltj/default.htm.2See the website of the China Electricity Council, www.cec.org.cn; European Union Energy in Figures 2009 Part 2, EuropeanCommission, Directorate-General for Energy and Transport (DG TREN) http://ec.europa.eu/energy/publications/doc/statistics/part_2_energy_pocket_book_2009.pdf; the website of the Energy Information Administration, www.eia.doe.gov.3Office of the National Energy Leading Group (2007) at http://www.chinaenergy.gov.cn/news_20866.html.

378 The Singapore Economic Review

business were the main political reasons to launch the reforms in the electricity sector. Inparticular, the central government wanted to encourage rapid infrastructure expansion andimprovement of power generation efficiency in the reforms undertaken after 1986. But asthe reforms are still ongoing, it is impossible to draw a simple conclusion regarding theirsuccess; there are still many challenges confronting Chinese electricity policymakers.4

One important issue going forward will be the strengthening of the rule of law ingeneral and of regulation and competition law in particular. On August 31, 2007, Chinapassed its first comprehensive Anti-Monopoly Law (hereinafter the AML), which becameeffective on August 1, 2008. How to get regulatory regimes aligned with the currentframework of the AML is a serious challenge for policymakers. An independent compe-tition commission is to be set up under the State Council to assume the main responsibilityfor investigating possible anti-competitive conduct. However, the AML does not stateclearly how it will be applied in regulated industries. In addition, as the Chinese electricityindustry was originally operated by the provincial governments, they have been reluctant torelease their residual controls. Even though the market mechanism has been nominallyintroduced into reforms and its use is one of the stated main objectives of the pol-icymakers, the central government continues to exercise extensive investment planningand social policy intervention, as well as price controls, in electricity and the otherstrategic energy sectors. The AML does not state how an enforcement agency is to dealwith such an “administrative monopoly,” and this raises critical questions regarding itsimplementation.5

2.2. The structure of the Chinese electricity sector

We begin with the introduction of the players in the Chinese electricity market, followed bya discussion of the fuel structure, and of the transmission and distribution of the electricityindustry.

2.2.1. The players

The incumbent monopoly generator, transmitter, and distributor of electricity, the StatePower Corporation (SPC), was broken up in late 2002. The generation assets of the SPCwere divided into five generation companies: Huaneng Group, Huadian Power, GuodianPower, Datang Power Group, and China Power Investment Company. Each of thegeneration companies was designed to control no more than 20% of China’s nationalgeneration capacity.6 The transmission grid was separated from generation operations andthen further separated into two power grid operators, the State Power Grid Company andthe South China Power Grid Company. Transmission and distribution continue to beregulated monopolies, with power supplied from a competitive generation sector.

4Detailed discussions of the history and current status of Chinese electricity reforms include Berrah et al. (2001),Development Research Center (2002), Sun et al. (2003), Xu (2004), Yeoh and Rajaraman (2004), Zhang and Heller (2004),Ni (2005), IEA (2006), Xu and Chen (2006), Yang (2006), Que (2003), Wu et al. (2004), and State Council (2007).5See Zhang and Zhang (2007), Deng and Leonard (2008), and Wen (2008).6See more discussion of the State Power Corporation in Woo (2005).

Electricity Restructuring in China 379

The State Electric Regulatory Commission (SERC) was established in March 2003 tooversee the power industry and to issue licenses to environmentally qualified operators.7

The SERC is the equivalent of the U.S. Federal Regulatory Energy Commission (FERC),though it is currently limited to regulating only the electricity industry (while FERC coversa wider range of energy industries). It is expected that, over time, other energy sectors willbe overseen by SERC. The SERC is also in charge of proposing amendments to the electricpower law and drafting regulations on competition in the electricity market. It is the firstregulatory commission in the public utilities sector, and it is also in the process of helpingthe seven state-run operators (five generation companies and two power grid operators) toadopt modern corporate governance practices.

The powerful National Development and Reform Commission (NDRC) is the gov-ernment’s primary economic policymaking and planning agency.8 It is the institutioncharged with formulating strategic and long-term plans for the development of the elec-tricity sector, planning the spatial distribution of major electricity investment projects, andarranging state investment funds for infrastructure. It also examines electricity prices andformulates, monitors, and enforces the government’s pricing policy. Allocating tariffregulation to a broad government policy body like NDRC rather than a sectoral regulatorlike SERC is unique to China. This transitional arrangement may be intended to last onlyuntil the SERC has demonstrated the capacity to successfully establish and put intooperation electricity markets, in addition to administering its other functions. Thisarrangement also allows the NDRC to maintain ultimate control over tariffs instead ofceding that power to an independent body before the transitional issues are addressed (e.g.,stranded costs and cross subsidies).

Other institutions and organizations also participate in the regulatory framework of theelectricity industry. The Ministry of Finance (MOF) takes the responsibility of establishinga financial management system, monitoring costs, and carrying out financial inspectionsfor the state-owned enterprises in the electricity sector; it also establishes a taxation policyfor the sector.9 The Ministry of Environmental Protection is the institution that enforcesenvironmental laws, regulations, and standards.10 The State Bureau of Quality and Tech-nical Supervision stipulates and enforces technical and safety standards and regulations.11

The State-owned Assets Supervision and Administration Commission (SASAC) isresponsible for supervising and administrating state-owned assets.

Electricity demand is dominated by the industrial sector, which accounted for over 75%of power consumption in 2007. Residential and commercial consumption account for justunder 11% and 9%, respectively. Unlike some other developing countries, agriculturalconsumption of electricity in China is relatively quite small, accounting for only 4%.12

7See the website of the State Electric Regulatory Commission, http://www.serc.gov.cn/8See the website of the National Development and Reform Commission, http://www.ndrc.gov.cn/9See the website of the MOF, http://www.mof.gov.cn/mof/10See the website of the Ministry of Environmental Protection, http://www.mep.gov.cn/11The State Bureau of Quality and Technical Supervision is now under the General Administration of Quality Supervision,Inspection and Quarantine of the People’s Republic of China, http://www.aqsiq.gov.cn/12See Yaping Xu, China’s electricity industry 2007–2008, China Network, January 31, 2008, available at http://www.china.com.cn/economic/zhuanti/08jjbg/2008-01/31/content_9624958.htm.


Some large industrial customers have their own captive power suppliers for historicalreasons. In addition, the NDRC is gradually increasing the freedom of industrial customersto choose particular generation sources in their regions. Especially in Guangdong province,some industry consumers are allowed to organize and build up their own thermal gen-erators. The largest power consumers have more and more power to influence generationdecisions.

2.2.2. Fuel structure

The Chinese electricity generation market has been experiencing rapid demand growthsince the mid-1980s due to both high-speed economic growth and increasing livingstandards. By 2007, the total generation capacity reached 713GW, with system capacityincreasing roughly by 60GW each year between 2003 and 2007.13 According to the StatePower Grid Corporation, a total generation capacity of 852GW is projected by the end ofthe 11th Five-Year Plan (2006–2010) and 1,330GW by 2020.14

China is a coal- and hydro rich country. In fact, it has the world’s largest exploitable coaland hydro power capacities. As a result, coal and hydro are the two largest components inthe country’s electricity generation fuel structure (Figure 1). As of 2007, 77.7% of the totalgeneration capacity was powered by coal and another 20.4% by hydro.15 In 1992, Chinaintroduced nuclear power as part of its fuel structure. Today, nuclear power contributesonly about 1% of the nation’s total generation capacity. Plans to expand nuclear powerhave not been very successful due to high costs and lack of funding. An official of theElectricity Designing Institute of the SPC predicts that the country’s nuclear power gen-eration capacity will grow to 36–37GW by 2020, accounting for roughly 4% of China’stotal generation capacity; however, a report by the Development Research Center of theState Council questions the economic viability of increased reliance on nuclear power(Li, 2003).

Resource development and utilization are major challenges for the Chinese government,since the country’s fuel resources are located predominantly in the northern and westernparts of the country while major load centers are located in the eastern coastal areas.Although coal-based generation will remain dominant in the near future, hydro power willplay an increasingly important role in the generation of fuel structure. This is largely due tothe Chinese government’s commitment to develop the relatively underdeveloped hydro richwestern region and the adverse impact that coal generation has on the environment. Chinaalso plans to include natural gas in its electricity fuel structure. The capacity of natural gasgeneration is planned to reach 36GW by 2010.16

13See China Energy Industry, China Knowledge, available at http://www.chinaknowledge.com/Business/CBGdetails.aspx?subchap=1&content=7.14See Ting Zhou, Renewable energy focus: The future of hydro power, China New Energy Network, September 27, 2007,available at http://www.newenergy.org.cn/html/0079/2007927_14461.html.15Supra note 13.16See operation status of China’s power industry 2007,Market Avenue, March 14, 2008 available at http://www.marketavenue.cn/upload/articles/ARTICLES_1274.htm


2.2.3. Transmission and distribution

As of the end of 2007, China had 1,106,300 km of transmission lines of 35KV and abovepreviously in operation.17 Formally there have been seven regional networks (Northeast,Northwest, North, East, Central, South, and Guangdong) and five provincial networks(Shandong, Fujian, Xinjiang, Hainan, and Tibet). Currently, the State Power Grid controlstransmission and distribution networks in the Northeast, Northwest, North, East, andCentral regions. The South China Power Grid controls the power grids in the southernregions (Southwest plus Guangdong).18

Independent distribution companies, which might have their own generation plants orpurchase electricity directly from the national grid, also exist in rural regions where smallhydro power plants dominate. Those independent distribution companies might also havetheir own transmission network in the regions where the national grid does not serve.

The fragmented heritage of the national transmission grid has made and will continue tomake the integration of regional wholesale markets a challenge for the government.Another challenge, in the light of the different locations of resources and electricity

Capacity

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Coal generation

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Capacity by fuel type in 2000

Hydro generation24.85%

Others0.11%

Coal generation69.26%

Nuclear generation

0.66%

Natural Gas generation

0.30%

Oil generation4.82%

Figure 1. Fuel Structure of Electricity Generation (2002)Source: Wu et al. (2004).

17See the website of the State Electricity Regulatory Commission, http://njb.serc.gov.cn/news/2008-12/20081222140113.htm18See the website of the State Grid Corporation,http://www.sgcc.com.cn/dwxx/default.shtml.


demand, is the transmission of resources and power broadly from West to East. This is alsoconnected with a broader government policy of increasing development in the West toaddress the widespread poverty there, a policy termed “Open Up the West”.19

To integrate the power grid network, the Chinese government initiated the West–EastElectricity Transmission Project in its 10th five-year plan (2001–2005). This projectincludes the construction of three major West–East transmission corridors: North, Central,and South. The West–East Electricity Transmission project aims to transmit electricity fromcoal- and hydro- rich regions in the west to high-electricity-demand regions in the east.

The North corridor covers three regional power networks (Northwest, North, andNortheast) and the Shandong provincial power network. This corridor can transmit powerup to 620 miles with its AC transmission lines. The construction and expansion of theNorth corridor is expected to boost the development of the coal-rich regions such asShanxi, West Inner Mongolia, and Ningxia.

The Central corridor integrates two regional power networks (Central and East) and twoprovincial power networks (Sichuan–Chongqing and Fujian). It is built mainly on DCtransmission lines and transmits electricity between 620 and 1,370 miles. The construction,of the Three Gorges, the Jinshajiang, and the Sichuan hydro power stations benefit fromthe development of the Central corridor.

The South corridor mainly connects the southern power network and the Hainan pro-vincial power network. This corridor uses both AC and DC transmission and transmitspower between 620 and 930 miles. The construction of the South corridor efficiently easesthe tight power supply in Guangdong province, which is one of the major load centers.

2.2.4. Price regulation

To encourage investment in the late 1990s and early 2000s, the central governmentestablished a tariff scheme for old and new generation plants: special cost-plus tariffs paidto all new generation plants and to older plants. For those plants built before 1985 andfunded by state grants, NDRC set the price in a way that covers only the operating cost ofpower plants and transmission and distribution. The price does not reflect equipment andconstruction cost of the plants. For those newer generation plants, there is a special tariffformula that includes an accelerated capital repayment schedule that allows capital costs tobe recovered quickly.20

It has been highlighted in the tariff scheme that electricity generated by new capacitywould be more costly than that by the older state-financed plants given that the older plantshave received subsidized capital and fuel supplies from the central government. In effect,the electricity-pricing policy allowed wholesale prices to be set individually on the basis ofthe approved cost of a power plant. In some extreme cases, prices were set differentlyamong individual generating units. Table 1 illustrates the cost-plus tariff of one repre-sentative power plant in Guangdong Province.

19A dissenting view suggests that a continued role for the Western provinces as raw materials supplier to the industrial Eastwill only entrench and exacerbate the subsidiary role of the former. See Oakes (2004).20See Xinrui Chao, China to accelerate electricity-pricing reform, Energy, May 12, 2009, available at http://energy.people.com.cn/GB/9283409.html.


Since the past few years, the government has set up a number of regional simulations ofwholesale electricity markets. These include provinces in Northeast China and East Chinain 1999 and again in early 2004, in East China again in mid-2004, and then in South Chinain 2005. One of the results of the simulations was further demonstration of the inadequacyof interprovincial and interregional transmission capacities, as the simulated markets fre-quently suffered from grid congestion. The trials were finally abandoned as the growingoverall shortage of electricity capacity lessened interest in mechanisms for wholesalecompetition regarding price or grid access.21

In 2002 and 2003, the State Council issued several policy statements concerning elec-tricity price regulation, which summarized the results of the first of these experiments andprovided a preliminary framework for future wholesale competition.22 In March 2005, theNDRC issued three interim provisions for the regulation of wholesale, retail, and powertransmission and distribution prices, which are the milestones for the new pricing regime inthe Chinese electricity industry.23 In this new price scheme, the NDRC decided to implement

Table 1. Cost-Plus Tariff of a Representative PowerProducer in Guangdong Province (1999) Yuan (US$)

Capital CostCapital Cost by Capacity Yuan/KW 6000Interest Rate Percent 10Payback Period Year 12Annual Capital Cost Yuan/KW 880Operating Hours Hour 5000

Unit Capital Cost Yuan/KWh 0.176

Fuel CostCoal Yuan/ton 300Coal Consumption Gram/KWh 475

Unit Coal Cost Yuan/KWh 0.143

O and M Cost Yuan/KWh 0.002

Total Cost Yuan(US$)/KWh 0.321 (0.039)

Miscellaneous Yuan/KWh 0.018Tax and Profit Yuan/KWh 0.10Tariff Yuan(US$)/KWh 0.439 (0.053)

Source: GETRC (1999).

21The simulation experiments are discussed in Zhang and Heller (2004), IEA (2006), and OECD (2008).22See State Council Reform Plan for The Regulation of Electricity Industry (2002), available at http://cogenchina.com/laws/index2.htm?id=200608080001; State Council Reform Plan for the Price Regulation of Electricity Industry (2003), availableat http://hzj.serc.gov.cn/news?id=1043.23See NDRC Interim Provision on The Regulation of Whole Electricity Price (2005), available at http://www.sepc.com.cn/outer/main/viewArticle.jsp?id=6b62e762a99513fe1aa3; NDRC Interim Provision on The Regulation of Retail ElectricityPrice (2005), available at http://www.sepc.com.cn/outer/main/viewArticle.jsp?id=04c14ecac2b39de981f2; NDRC InterimProvision on The Regulation of Power Transmission and Distribution Price (2005), available at http://www.sepc.com.cn/outer/main/viewArticle.jsp?id=cc44132da3c2cb8f0fcc.


a structure of two-part electricity prices after generation competition was applied in thewholesale market. This two-part electricity price consists of a capacity price and a systemmarginal price. The capacity price is determined by NDRC Department of Price, while thesystem marginal price is set through market competition. The government will use a cost-plus formula in the calculation of the capacity power price. The wholesale price will thus belinked directly to fuel cost. As for the retail price, the government will control it during theearly stages of this new price scheme but has stated its intention to allow retail prices to bedetermined by market forces after distribution activities are separated from retailingactivities. Under such a new price scheme, competition would be encouraged and expandedin the wholesale market and be gradually introduced into the retail market.

3. Competition in Generation

It is clear that an important component of the Chinese electricity restructuring plan asstated and publicized is the creation of competition among generation companies. The“Plan for the Reform of the Electric Power System” issued by the State Council in April2002 calls for unbundling generation from transmission and distribution to create a systemof “accessing the power grid through competition.” More recently, a report from the StateCouncil titled “China’s Energy Conditions and Policies”, issued in December 2007, notesthat “the price mechanism is the core of the market mechanism”, and that “the Chinesegovernment … has propelled electricity tariff reform to ensure that electricity generationand selling prices are eventually formed by market competition.” This goal is consistentwith the broad strategy of vertical separation and the creation of “upstream” competitionthat has become a standard, even a “default”, strategy for the restructuring of naturalmonopolies around the world (Newbery, 1999; Pittman, 2003, 2007b; Xu, 2004).

But how realistic is this plan for China? To begin with, what form would such gener-ation competition take? In China, as in Russia (Pittman, 2007a), ex ante discussions andanalyses of generation market competition have taken existing regional designations asprovisional geographic markets. In China, these designations divide the country into sixregions (excluding Tibet): North, Northeast, Northwest, East, Central, and South, as shownin Figure 2. In fact, also as in Russia, actual geographic generation markets will probablyturn out to be smaller than these regions once real market operation begins, especiallyduring times of peak demand when transmission congestion becomes likely.

This is likely for two reasons. First, historically China’s transmission system was highlyfragmented. It is only recently that investments in the grid have begun to address thissituation in a serious way, and despite these investments, interconnection remains weak,not only among these six regions but also within them (IEA, 2006). Second, even thesmallest of these regions, the East, is much larger than geographic generation markets thathave been typical of countries that have already created such markets. A recent example isthe geographic markets found by the U.S. Department of Justice and FERC in theirinvestigations of a proposed merger of electricity companies in the PJM region of thenortheastern United States; the geographic market delineated by these agencies was


considerably smaller than East China during periods of low demand, and during periods ofpeak demand, network congestion caused it to become smaller still.24

For this reason, the government’s generation sector unbundling and restructuring planthat limited the share of any single firm in any single region to 20% may not be effective inlimiting firm shares in the actual geographic markets that come into being with theintroduction of competition. For the same reason, our analysis of the competitive structureof these regions may err on the side of optimism.

However, there are other reasons to be seriously concerned about the likely outcomes ifprices and competition are freed in these markets, as is called for by the government’sreform strategies. We may divide these reasons into particular aspects of electricity marketsand Chinese electricity markets.

As has been noted elsewhere (Borenstein and Bushnell, 1999; Borenstein et al., 1999),a number of characteristics of electricity and electricity markets make it more difficult tocreate workably competitive markets in this sector than in many others. In other words,electricity markets that appear to be competitive using the normal tools of industrialeconomics may in fact not operate competitively.

The demand for electricity is very inelastic in the short run. This has to do with itsessential nature as a household product, its small cost share but crucial role in commercialand industrial applications, and the exceeding rarity of real-time pricing, even for the largest

Figure 2. Geographic Generation Markets in China

24See Competitive Impact Statement, U.S. v. Exelon and Public Service Enterprise Group, August 10, 2006, available athttp://www.usdoj.gov/atr/cases/f217700/217717.htm. For broader discussions of the case, see Armington et al. (2006) andWolak and McRae (2009).


industrial users. At the same time, supply is very inelastic with capacity utilization nears100%: the product itself is not storable (though hydro ponds and pumped storage mayperform this function indirectly), and unit costs tend to increase dramatically as one movesfrom baseload nuclear and coal plants, through mid-merit combined cycle natural gas plants,to peaking natural gas and oil plants. The combination of inelastic demand and inelasticsupplymeans that the returns to the anti-competitivewithholding of output may be quite high.

Two additional factors exacerbate the incentives of generation firms to withhold outputand their ability to do so. First, wholesale electricity markets typically take the form ofauctions or quasi-auctions, operating on hourly offering bids from generation firms. Thismeans that these firms play the competitive “game” in these markets many times: 24 timesa day, 168 times a week, and 8,760 times a year. It seems not unlikely that profit-seekinggeneration firms in such an environment will study each other’s behavior and learn tobehave (tacitly) cooperatively rather than competitively.

Second, the typically steep slope of the market cost curve as market capacity isapproached and as higher cost generation units are called into production may createperverse incentives for firms that own one or more of the high-cost peaking plants alongwith one or more of the much lower cost baseload plants. If a particular gas- or oil-firedplant would be just barely profitable at a particular wholesale price level, it follows thatshutting down that plant would sacrifice very little profit; yet if that plant operates at a verysteep point on the industry supply curve, shutting it down could have a significant impacton price and thus yield large inframarginal rents to the firm’s baseload plants.

Problems like these may be especially acute in the special circumstances of China. Firstof all, China’s dramatic economic growth has placed a large burden on the electric powersystem; the situation is generally and broadly one of new supply trying to catch up torapidly growing demand. Thus, as in many other developing countries, the most importanttask of electricity reforms in China is to encourage and support investment into the system,rather than, as in developed countries, increasing the operational efficiency of an existingsystem (Gnansounou and Dong, 2004; Zhang and Heller, 2004). For the same reason,freed electricity prices are likely to increase.

Second, despite its strong desire for markets rather than bureaucrats to determine out-comes, the Chinese government has thus far been unwilling to allow electricity prices(wholesale or retail) to increase proportionately in response to cost increases, fearing thepolitical results of increased inflation (Oakes, 2004; IEA, 2006). The best known recentexample has been the increase in coal prices in response to high levels of demand alongwith transport bottlenecks. Rather than allow the price of coal-generated electricity toincrease proportionately as a result of high demand, the government tackled the problem byseeking to re-regulate coal prices, as well as allowing generation companies to suffer amargin squeeze (Yeoh and Rajaraman, 2004; IEA, 2006).25 More generally, observers

25See, for example, Amy Lam, Coal prices hold down power profit,China Daily, March 27, 2008, andMufson S and BHarden(2008), Coal can’t fill world’s burning appetite.Washington Post, March 20, 2008. As the latter reports, “China has done little tocontain demand. Indeed, the government has limited electricity rate increases for years, encouraging greater use. Concernedabout climbing inflation, Beijing on January 10 turned once again to Communist-style measures, freezing electricity prices evenas coal and oil prices soared.”


note that “missing from plans for further reform is the removal of electricity price-settingauthority from state control” (Yeh and Lewis, 2004).

The third problem for China is a structural one. As noted above, cost curves inwholesale electricity markets tend to become fairly inelastic as market capacity levels areneared. Still these curves tend to exhibit a classically curved shape as generation plants ofdifferent technologies and efficiencies are called into service. Figure 3 shows a stylizedexample from the PJM-East region of the northeastern US discussed earlier. The curvebegins with a low and flat “baseload” component of nuclear and hydro plants, moves up abit to baseload “coal” plants and then to natural-gas-fired “combined cycle plants”, finallyincreasing its slope to a virtually vertical range as gas- and oil-fired “efficient peakers” and“super peakers” are called into production. Cost curves in many generation markets aroundthe world would take a similar form.

China’s cost curve is different. As of 2007, 77.7% of China’s generation capacity iscoal-fired, and 20.4% is hydro.26 Nuclear makes up most of the rest, with very small sharesfor oil and gas.27 As we discuss below, the system is even more dependent on coal in thecoal-rich North and Northeast regions.28 In other regions, hydro generation may provide

PJM East Cost Curve Pre-Merger

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PJM East Cost Curve Pre-Merger

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Figure 3. PJM East Cost Curve Pre-Merger

26Supra note 13.27 Ibid.28See McKibbin (2006).


some flexibility — we discuss the important issues involving the incentives of hydroproducers momentarily. But for now, note that a system with nothing but coal plants wouldexhibit a cost curve with an appearance less like the cost curve in Table 1 and more like thebottom and right-hand-side axes of Figure 3: a large region of low and fairly flat costs — itssmall rise accounted for by different efficiency levels of the different coal plants — followedby a vertical line as market capacity is reached.29

Note further how a system with such cost curves — and with very inelastic demand —

operates as demand increases and supply tries to keep up. If and when demand is belowcapacity, market prices will tend to equal the very low marginal costs of the marginal coalplant. The resulting low prices are good for customers, of course, but they provide littlemargin to encourage existing or new firms to invest in the business. (A common policyresponse is to institute a regime of capacity payments — which the Chinese governmenthas proposed, as noted above — but at this point the system starts to become highlyregulated, apparently raising the question of the degree to which one is still relying onmarkets to determine outcomes.30) When demand is at capacity, prices may increase a greatdeal and in a highly volatile way: there is little demand response to these price increases,and the short-run supply response is small as well. As noted above, the Chinese govern-ment is not willing to allow electricity prices to rise proportionately with coal prices. Itseems quite unlikely that the government would tolerate high and volatile prices inresponse to movements in demand above and below capacity levels. And yet, those areexactly what would be expected in markets with cost curves like these.31

The Australian experience is instructive here. Australia has a similar generation mixto China, mostly coal with some hydro and gas, and it has several regional markets withsome interconnection between them. Restructuring and the introduction of competition ingeneration have yielded gradually falling prices. In contrast to China, however, Australiabegan restructuring with excess generation capacity — and yet, in periods of peak demand,the pattern of prices resembles a “reverse L-shape” (Newbery, 1999, pp. 255–258).

Finally, let us consider the issue of hydro generation more closely. In the Central,South, and East regions, coal-generation capacity is supplemented by a good deal of hydrocapacity — most famously from the Three Gorges Dam project, but from a large andincreasing number of other dam projects as well (McCormack, 2001). Hydrogenerationmay provide supply-side responsiveness to wholesale electricity price signals where watermay either be stored directly in holding ponds or pumped back into ponds for later release.Thus, it is possible for hydro generators to perform a “peak shaving” function that

29See Michaelowa et al. (2003) and Liu et al. (1997).30Cf. IEA (2006): “China proposes to implement a two-part generation price. This would comprise a capacity price thatreflects the plant’s capacity (or capital) cost, and an energy price that reflects the plant’s energy (variable or marginal) cost…When fully competitive markets are established, the capacity component should be reviewed. Capacity pricing in fullycompetitive markets is controversial, as it masks pricing signals for efficient investment.” (p. 96)31Note, for example, Newbery’s qualification regarding the appropriate setting for a reform model including competition ingeneration: “The English model of vertical separation is rapidly becoming the reference model for reform in developedcountries where the [electricity supply industry] is mature provided that the system is large enough to support a number ofcompeting generation companies (or has gas, which greatly reduces the minimum viable size of generation companies.”(Newbery, 1999, p. 199)


significantly increases the efficiency of the system overall: they may store water whenwholesale prices are low to release it when prices are high, thus obviating the need to callexpensive “super peakers” into operation.

However, there are situations and conditions under which hydro generators cannot or donot perform such a function. They cannot do so when river flows are so high as tooverwhelm the capacity of the storage ponds — a frequent occurrence during flood sea-sons in many countries. In such a circumstance, hydro plants with storage ponds becomeindistinguishable from “run-of-river” plants: they generate power as the river flows. Theydo not or may not perform a peak shaving function when they are not provided with theincentives to do so. This may occur under a variety of circumstances:

. When government-owned hydro plant managers are not rewarded for profit-maximizingbehavior (which seems to occur most often when governments decide to allocate low-cost hydro to particular end users for political reasons);

. When, on the contrary, hydro plant managers are maximizing profits, but they enjoymarket power and so have incentives to allow prices to increase;32 and

. When, and to the degree that, releases of water for hydro generation are constrained byirrigation requirements and/or restrictions regarding reservoir levels and changes.33

One indicator of the likely lack of hydro flexibility in the flood season in China is thatpolicymakers have already determined that almost one-third of the electricity output fromthe Three Gorges project during flood season will be exported from the Central region tothe South and East regions.

With this background, let us examine the structure of the six regional generation“markets” as they are currently configured. To conserve space, we present only the floodseason capacities; this biases the summary discussions in the direction of reducing theapparent dominance of coal. (Dry season capacities are available upon request.)

4. The Regional Generation “Markets”

4.1. The North and Northeast regions

Figures 4 and 5 show the generation market structures in the North and Northeastregions.34 Each bar aggregates the generation plants in the region by parent company andthen by generation technology.

The main factor that stands out from Figures 4 and 5 is the overwhelming dominance ofcoal generation in these two regions. Of 66 generation plants in the North, 60 are coal-fired, accounting for 93.3% of the flood season capacity. Five plants (5.7% of the capacity)

32The interesting literature on this issue includes Kelman et al. (2001), Arellano (2003, 2004), Førsund and Hoel (2004),and Hoel (2004).33See, for example, Crampes and Moreaux (2001), Edwards (2003), and Atkinson and Halabí (2005).34Tables listing the individual generation plants in each region, along with their parent company, technology, and capacity,are included in the working paper version of this article, available on request from the authors or at http://www.usdoj.gov/atr/public/eag/232668.htm.


are hydro, and one (1%) is oil-fired. Of the 21 generation plants in the Northeast, 18 arecoal-fired, accounting for 86.5% of flood season capacity, while three hydro plants accountfor the remainder.

The North and Northeast are coal-dependent regions that will exhibit reverse L-shapedwholesale electricity cost curves, except to whatever extent the small amount of hydrocapacity is used in a peak-shaving manner. Free, uncontrolled wholesale markets seem

Figure 4.

Figure 5.


likely to exhibit large price fluctuations, from slack period low prices that return no marginto generation companies (again, abstracting from government-imposed capacity payments)to peak period high and volatile prices that transfer large sums from electricity consumers togeneration companies without having much output increasing effect in the short run.

4.2. The Northwest and Central regions

Figures 6 and 7 show the generation plant level structures in the Northwest and Centralregional markets.

The Northwest and Central regions are made up entirely of coal- and hydro generationplants. In the Northwest, coal accounts for 65.5% of the generation capacity in the floodseason and 88.5% in the dry season; in the Central region, home of the Three Gorges dam,coal’s shares are 48.5% in the flood season (after the promised exports of Three Gorgespower are accounted for) and 72.5% in the dry season.

It is clear — especially in the Central region, and especially in the flood season — thatthe incentives and freedom of maneuver faced by hydro generation companies will becrucial determinants of the performance of wholesale electricity markets. If hydro producersare willing and able to shave wholesale price peaks, prices will behave with a good dealmore stability and predictability than if they are not.

Note, however, two possible sources of additional concerns regarding competitiveconditions in these markets. First, despite stated government reform policies to the con-trary, a single firm, the China Power Investment Corporation, holds (slightly over) 30% ofthe Northwest regional generation capacity in the flood season. Similarly, even afteraccounting for mandatory exports, the China Three Gorges Project Corporation holdsabout one-quarter of the Central regional generation capacity in the flood season. To the

Figure 6.


extent that these two firms have the ability to affect the timing of their releases of water,they may have the incentive to allow prices to increase during periods of peak demand andenjoy the resulting high profits.

Second, in the Central region, three generation companies hold capacity portfolios witha mix of coal-fired and hydro plants: China Guodian Corporation, China Datang Cor-poration, and China Power Investment Corporation. If and when these hydro plants haveno flexibility, this mix will not create anti-competitive incentives. However, if and whenthey are flexible, their owners may enjoy the incentives discussed earlier to reduce hydroproduction at the margin to raise market price and create inframarginal rents for thebaseload coal plants. Again, this is in addition to similar incentives that may accrue toCPIC in the Northwest and Three Gorges in the Central region as a result of their relativelyhigh single-firm market shares.

4.3. The South and East regions

Figures 8 and 9 show the generation plant level market structures in the South and Eastregions. These two regions have the most diverse generation portfolios, including in bothcases some nuclear capacity and some oil and/or gas-fired capacity. Still, coal accounts for81% of the flood season generation capacity in the East, and (baseload) nuclear another5%; it is only in the South that hydro’s large share combines with a bit of oil and gas toreduce the share of coal to 55% (with nuclear at 6%). In neither region do peaking plantspowered by oil or gas seem likely to have sufficient capacity to give much gradual rise tothe market-wide generation cost curve; as in the Northwest and (especially) Centralregions, most flexibility, if it exists, will come from hydro.

Figure 7.


Furthermore, in the South there are multiple generation companies that hold mixedtechnology portfolios that may create incentives to reduce output at peaking plants togenerate inframarginal profits at baseload plants; these include China Huaneng, ChinaDatang, China Huadan, and the State Development and Investment Company, with theirmixes of coal and hydro, and the Guangdong Yudean and Shenzhen Energy Groups, withtheir mixes of coal and gas.

Figure 8.

Figure 9.


5. Discussion

The analysis presented here suggests that, as currently designed, and for reasons of bothtechnology and producer incentives, uncontrolled Chinese generation markets are likely toexhibit both high and volatile prices — an outcome that the Chinese government has thusfar been unwilling to permit.

A number of ameliorative measures could be considered. The most promising measuresundoubtedly are those that also address the primary concern of Chinese electricity sectorrestructuring in the first place: the “shortage economy” that has resulted from rapid,economy-wide increases in electricity demand far outpacing increases in supply.

As a purely structural supply side matter, markets where a single firm now has a largeshare of generation capacity may be more likely to operate competitively if that firm isdivested of one of its existing plants; this type of gradual deconcentration strategy hadsome success in the United Kingdom, where the initial restructuring of the electricity sectorcreated generation companies with market power (Newbery, 1999). Similarly, the poten-tially anti-competitive incentives created by mixing baseload and peaking plants under theownership of a single firm could be removed by dividing such firms into single-technologyenterprises. On the other hand, of course, there may be economies of scale deriving fromone firm’s ownership of multiple plants, and the ownership of plants with varying tech-nologies should diversify some risk borne by the firm.

One powerful tool for reducing the incidence of local market power that also has thedistinct advantage of addressing the shortage problem is the increased investment in long-distance transmission capacity that makes power generated from other sources more oftenand more widely available to a particular regional market. This tool is especially effectiveat addressing supply shortages when it can integrate regions with differing demand peaks,as in the case of northeast China, where a broader and better integrated wholesale elec-tricity market could serve the summer demand peaks of South Korea and Japan and thewinter demand peaks of China and the Russian Far East (Yun and Zhang, 2005). As notedabove, investments like this are already taking place — particularly in the form of themassive West-East Transmission Project promoted by the central government — but thereis still a long way to go if significant geographic barriers to interregional power flows are tobe reduced.35

Similarly, to the degree that coal price increases are the result of bottlenecks in railtransport, the ongoing investments in rail infrastructure improvement may help to addresssuch problems. However, as with the electricity sector, investments in the Chinese railwaysector must work hard just to keep up with economic growth, much less to ease bottlenecks(Pittman, 2004). On the other hand, environmentalists may be expected (somewhatcounterintuitively) to support such policies, as it is clearly the case in today’s China thatcoal-fired electricity generation by large, efficient plants using washed coal is considerably

35Peyrouse (2007) reports hopes and plans for future imports into China of power generated in Central Asia, especiallyhydro generated power, but this remains only a long-term prospect. Evans et al. (2008) and Valeri (2008) discuss the welfarebenefits of increasing transmission capacity across existing geographic markets in, respectively, New Zealand and GreatBritain/Ireland.


easier on the environment than generation from smaller, localized generation plantsburning local, unwashed coal.36

Increases in nuclear generation capacity would both increase the range of wholesaleelectricity available at low marginal cost and help to address concerns about greenhousegas emissions and other air pollutants, but since nuclear plants are baseload capacity andextremely inflexible, this would not address the problem of wholesale price volatility oncecapacities are reached.37 Based on the western experience, some environmentalists wouldsupport increased reliance on nuclear power generation as a carbon emission reductionstrategy, despite their misgivings concerning nuclear waste.

Further development of natural gas generation could insert more flexibility into thesemarkets. China’s extensive but remote natural gas supplies are expected to be shipped bypipeline from Xinjiang to Shanghai. Coastal gas generation plants will be powered by LPGshipped from Australia and elsewhere to a huge terminal in Guangdong and plannedterminals in many other coastal provinces. There are proposals to import gas by pipelinefrom Russia by 2015 and from Kazakhstan and Turkmenistan by 2020.38 On the otherhand, however, recent policy statements of the government suggest a prioritization of theuse of scarce gas supplies in domestic and commercial applications rather than electricitygeneration.39

On the demand side, increases in real-time metering for large customers seem especiallypromising because of their triple-edged benefits: they not only (i) reduce the returns to anti-competitive output reduction strategies by increasing the elasticity of demand in wholesalemarkets, but they also (ii) reduce the extent and cost of shortages by saving peaks, and (iii)use the price mechanism without relying on an overall price increase to ration demand(hence without exacerbating macro-economic inflation). The latter function may also beperformed by the introduction of a “lifeline” system of low prices for basic quantities ofelectricity for households, balanced by higher, market-level prices for quantities above thelifeline levels.40

Finally, long-term contracts between generation companies and large industrial users orlocal distributors generally have the effect of reducing the incentives for the generationcompanies to manipulate output and prices in spot markets.41 (On the other hand, long-term contracts may under some circumstances facilitate collusion among generationcompanies.)42

More broadly, the analysis presented herewould seem to suggest that it may be a long timebefore the Chinese government allows completely free wholesale electricity prices — and,

36See, for example, Ni (2007) and Steinfeld et al. (2008).37Also, as noted above, concerns have been raised at high levels about the economic viability of significant increases innuclear power generation — see Li (2003).38Gnansounou and Dong (2004); Zhang and Heller (2004); Chu et al. (2006); Von Hippel and Hayes (2008).39OECD (2008), {291, at p. 62, citing SERC and NDRC documents.40See, for example, OECD (2008): “The desire to protect individuals from high energy prices was and continues to be aconstant consideration in government policy. A further social dimension to its strategy for the power industry was the need toextend access to electricity to as many rural households as possible and to protect these users from unfairly high levels oftariffs….” ({237, at p. 53).41See, for example, Kelman et al. (2001), Bushnell et al. (2007), and Anderson and Hu (2008).42See, for example, Harvey and Hogan (2000) and Green and Le Coq (2007).


more broadly still, that such hesitation would reflect not only political but also economicrealities: it is not at all clear that, for a commodity as basic and important as electricity,uncontrolled prices that fluctuate wildly without having much short-term impact on eitherdemand or supply enhance anyone’s welfare. Whether the ameliorative policies suggestedhere will be sufficient to address these problems, or whether a reconsideration of the entireelectricity restructuring strategy is called for, would seem appropriate topics for furtherdebate.

Acknowledgments

The authors are grateful for extremely helpful comments and suggestions from Jade Eaton,Peter Egger, John Holt, Harry Koller, Anne Layne-Farrar, David Smith, participants atNDRC and OECD meetings in Beijing and Paris, and an anonymous referee, and forexcellent research assistance from Justine Jiménez, Sarolta Lee, and Robert Morris. Theviews expressed are not those of the U.S. Department of Justice or LECG.

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Electricity Restructuring In China: How Competitive Will Generation Markets Be?

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