Avoiding Pitfalls in China's Electricity Sector Reforms.

AuthorDavidson, Michael R.

    In March 2015, China's highest-level policy-making body, the State Council, inaugurated a new round of electricity reforms with the goals of enhancing market-based competition, establishing trading mechanisms for a variety of products, reducing retail electricity prices, and improving regulation of grid monopolies (State Council, 2015). This renewal of central-level changes to electricity sector management--the first major overhaul since unbundling of the former vertically-integrated State Power Corporation in 2002--was precipitated by political directives to increase the role of market-based pricing and reduce direct government planning throughout the Chinese economy (CP-CCC, 2013). It also follows failed attempts in the Northeast and East China grids in the early 2000s to create wholesale electricity markets along international designs (Andrews-Speed, 2013).

    In the absence of competitive markets, the majority of electricity production has been assigned annually by local governments with tariffs determined by the central planning agency. While central pressure for reforms waned, some provincial governments gradually created various forward physical contract markets (annual and monthly) between large suppliers and consumers, an approach that forms the basis for the current round of reforms. With renewed high-level support for market-based initiatives, building on over a decade of post-unbundling regulatory experience and these medium-term markets, moods are high.

    However, as is well-documented, building efficient electricity markets entails a vast number of institutional changes, which can be particularly challenging in industrializing countries without sufficient market and independent regulatory experience (Joskow, 2008; Jamasb, 2006; Jamasb, Nepal, and Timilsina, 2017). Fully restructuring can require years of detailed planning, and the best-laid plans can be modified and delayed as a result of market experiences and changing political preferences. In non-OECD Asia, countries have generally fallen short of reform ideals, pointing to the need to examine how individual reform steps generate outcomes (Sen, Nepal, and Jamasb, 2018).

    China's reforms, relying upon broad central guidelines without a detailed roadmap of timetables and new institutional structures, leave many details and initiatives up to the provinces (Zhang, Andrews-Speed, and Li, 2018; Pollitt, Yang, and Chen, 2017). (1) Furthermore, China's market approaches are often uniquely crafted for national or local contexts, differing in fundamental ways from standard international designs (Li, Zhang, and Andrews-Speed, 2019). This complicates analysis of the reform's progress toward efficient markets, requiring thorough examination of de jure and de facto market processes. Existing literature has examined political obstacles to reform and is beginning to make recommendations aimed at ameliorating deficiencies in specific implementations (Dupuy et al., 2018).

    In this paper, we examine government plans and numerous market implementations at the provincial level, building on interviews conducted with grid and market operators, regulators and generation firms, conducted in 2015, 2016, and 2018. We find several warning signs that the current round may fail to achieve its broader aims, which have been highlighted in various forms in the literature. Our organization of these into "pitfalls" grounded in basic regulatory economics results and supporting international lessons provides a concise and comprehensive treatment that we believe can help focus future academic discussion on the reforms, and which has direct relevance to policymakers. It extends existing work summarizing progress or prescribing fixes for specific provincial contexts by creating a general framework of ultimately measurable metrics applicable to various reform efforts. We conclude that effective restructuring in China will most likely require enhanced centralization of institutional design and substantially strengthened independent regulatory powers.


    Similar to many other countries, for much of its history China's electricity system was owned and operated by a single vertically-integrated utility (VIU) within a government ministry. The scope of this ministry varied over the years, encompassing at times all energy sectors, but its responsibility for electricity included all aspects of planning, investment and operation. By the 1980s, central government budget constraints led to massive energy shortages just as China's economic liberalization reforms gained steam. This prompted investment to be opened up to local governments and enterprises, in some cases backed by foreign loans, with pricing roughly based on rate-of-return regulation determined plant by plant (Zhang and Heller, 2007).

    Expanding investment essentially eliminated electricity scarcity by the mid-1990s, but restructuring continued as a result of pressure from international institutions for complete marketization based on early reforms elsewhere; political leadership that embraced corporatization and privatization of state-led production; and complaints of discriminatory access and dispatch for new non-VIU generators (Yeh and Lewis, 2004; Ma and He, 2008; Xu, 2016). Over 1998-2003, China put in place much of the international model, including separating business from government functions through new state-owned grid companies, unbundling generation from the network, and establishing a new independent regulator. It also called for an "open, competitive and orderly electricity market" to be created, and began to experiment with various wholesale markets (State Council, 1998; Andrews-Speed, 2013).

    Over the 2000s, progress in these reforms slowed, including the failure of several market pilots, and a partial liberalization of the generation sector persisted. In particular, province-wide benchmark tariffs for generators--intended as an interim measure--became a key lever of macro-economic planning, and in the absence of market signals of production costs, dispatch followed general principles of maintaining "equal shares" across generators and ensuring revenue sufficiency (Ma, 2011; SERC, 2003). Throughout this period, the system followed a quasi-"single buyer" model where the integrated transmission-distribution grid companies had a monopoly of supply to customers and energy purchases from generators, which has been pursued as an interim setup toward liberalization in other countries (Besant-Jones, 2006). Measures such as "energy-efficient dispatch" and priority dispatch for renewable energy attempted to integrate cost principles into production decisions, with varying degrees of success (NDRC et al., 2007; SERC, 2007; Zhong et al., 2015). The independent regulator was abolished in 2013 and its authorities subsumed by larger government planning bodies, indicative of the broader hurdles of implementing standard market designs (Lin and Purra, 2018).

    Failures to meet central objectives such as efficient operation and renewable energy integration led to the current round of reforms, which broadly focuses on fostering price competition in generation and retail, enhancing regulation of grid costs and services, expanding inter-regional transmission, and strengthening overall government planning in the sector (State Council, 2015; Zeng et al., 2016).

    The new round, the focus of this paper, will need to address many of the entrenched institutions that have developed over three decades of reforms, ranging from eliminating the quota to reforming pricing and grid dispatch procedures (Zeng et al., 2016; Kahrl and Wang, 2014). In terms of key elements of "textbook" reforms, China faces numerous obstacles, in many cases owing to large provincial government influence (Pollitt, Yang, and Chen, 2017). Furthermore, market institutions crafted at the provincial level for local contexts exhibit a striking amount of diversity (Li, Zhang, and Andrews-Speed, 2019; Cheng et al., 2018). These raise questions about the effectiveness of these market-based approaches, which has led to some tailored recommendations designed to ameliorate deficiencies for specific provinces and designs (Dupuy et al., 2018).

    In the following section, we elaborate on issues of the de facto system of regulation, operation and markets, and identify key "pitfalls" where the reforms as currently designed and/or initially implemented diverge from well-established regulatory principles.


    Five pitfalls were identified through a careful review of the available literature on China's market reforms and reform experiences globally; market design and market outcome documents of Chinese experiments (where available); and a large number of interviews mostly in Mandarin Chinese with stakeholders in government agencies, regulators, grids, generation companies, and research organizations. Interviews (77, in total) were conducted in 2015, 2016 and 2018 in 9 Chinese provinces (2) as part of studies into dispatch practices, wind integration issues, and the market design process at central and provincial government levels.

    Space does not permit treatment of all markets--virtually every province has established some competitive elements in its electricity sector. Examples of cases were thus selected as illustrations of various pitfalls. It is indicated where these are commonplace--and thus more representative--as well as where these cases are somewhat unique, but possibly growing in importance.

    3.1 Physical Contracts Rather Than More Flexible Financial Contracts

    3.1.1 Basic Rationale

    Due to the instantaneous matching of electricity supply and demand, physical constraints on electricity production, and non-linear interactions of network flows, the marginal cost of delivering an additional unit of electricity can vary substantially over short-time periods and distances. Production and consumption decisions based on the intersection of marginal supply and...

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