The CEQ on FT.com: Power to the people

By Arthur Kroeber

After a recurrence of power shortages this summer, China is once again facing a power glut. Electricity production fell 4 percent in October compared with last year’s figure as demand from heavy industry collapsed.

For Beijing, the swing from shortage to surplus is a familiar tale: managing the power supply in China’s turbo-charged but volatile economy is a near impossible task.

But it is a task made all the harder by an industrial structure that places more emphasis on boosting generation capacity than on improving electricity transmission. Until the government creates incentives to improve power distribution, the inevitable cycle of shortage and glut will continue.

As of mid-summer, power demand outstripped supply by at least 5 percent in much of the country, and by a far wider margin in one or two industrial provinces such as Shandong. But electricity demand is now dropping fast as domestic construction slows and energy efficiency rises.

Roughly 75 percent of China’s power demand comes from industry, led by heavy industrial producers of steel, other metals, cement and petrochemicals. The fall in electricity demand is largely the result of the recent collapse in industrial production.

China’s power balance and plant hours of operation data also show a clear pattern of swings from shortage to surplus in cycles of 5-7 years from peak to trough. These cycles clearly correlate with swings in GDP growth: as economic growth slowed in 1989-91, and again in 1997-99, the power balance swung from deficit to surplus.

With GDP growth and industrial production slowing sharply, we are likely to see overcapacity in the power sector through 2011. Yet, thanks to recent electricity shortages, new installed generating capacity has exploded in the past few years and plenty more is being built.

Before this shortage turned to glut, conventional wisdom agreed that the basic problem in the electricity sector was that coal prices had gone up while consumer tariffs had remained fixed, which destroyed power generators’ margins. The solution to power shortages, therefore, was to free up electricity prices.

This simple interpretation missed the point. During six years of rapidly rising coal prices, generator margins actually stayed pretty constant – and far from tightening their belts, generators added three Germanys worth of new capacity.

The real problem was not a shortage of capacity but an inefficient transmission and distribution system, combined with a highly fragmented ownership structure which gave local governments far too much ability to cut special off-market pricing deals with favoured customers.

At the end of 2002, the former State Power Corporation was broken into five power generation companies (the “Big Five”), which operate to some extent across regional lines, and two grid companies which operate as regional monopolies.

One effect of the restructuring was that the Big Five generating companies began a frenzy of capacity building. In part this was a response to a severe capacity shortage, but it also reflected the generators’ commercial interest, which was to grab market share as fast as possible.

Another effect was that it gave scant incentive to the monopoly transmission companies to invest in new transmission lines, both because they were monopolies and because they were relatively starved of funds. Initially, most electricity profits went to the generators not the grids.

The two major grid companies actually comprise six autonomous and disconnected regional grids: less than 2 percent of China’s electricity output can be shifted from one region to another.

Inadequate investment in transmission means the system has virtually no ability to shift load from power-rich to power-poor areas – so power-poor regions have an incentive to increase local power capacity even if total national capacity is theoretically sufficient.

The simple and prevalent view of China’s electricity predicament is the classic “partial-deregulation” squeeze, where producer costs (coal) are deregulated but consumer prices (electricity) remain capped. Coal prices have approximately tripled since 2002, while end-user electricity prices have risen by less than 30 percent.

But simply raising end-user electricity prices to a level which restores generator margins to what they were two or three years ago would not be a useful reform. All that would do is spur the construction of more generating capacity, exacerbating today’s power glut.

Rather, Beijing needs to create incentives for greater investment in transmission capacity.

It is unlikely that price reform can accomplish this on its own: the explosion in generating capacity occurred because competing generating companies and localities were in a desperate race for market share.

And the transmission monopolies, which do not operate in a competitive environment, have far weaker incentives to invest even if they are larded with cash through pricing reforms.

One option would be to recombine regional grids with generating companies, creating regional integrated utilities – though this would risk entrenching local baronies whose power Beijing wants to limit.

Another would be to create more competition between regional grids by improving interconnections, thereby enabling power-rich grids to profit by selling excess power to grids in shortage. This would be an intricate task.

The final big job is to erode the power of local governments to control coal mining, power generation and distribution. So long as local governments can give away cheap power to whoever they want, central-level efforts to regulate the industry will be impotent.

For now, Beijing does not appear to have a plan. As the economy slows and constraints on coal supply ease, power generators and suppliers are now cursing overcapacity rather than brownouts. But in 4-5 years the pendulum will likely swing back again.

A thorough restructuring of industry assets will be required if China is ever to escape the twin evils of shortage and excess capacity.

Arthur Kroeber is the managing director of Dragonomics Research & Advisory.

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