The CEQ on FT.com: Taxing times for fuel

By Arthur Kroeber

After years of procrastinating, China has finally imposed a fuel tax. The new levy, slapped on sales of petrol and diesel from January 1, is a strong signal that Beijing will reform energy prices.

Just six months ago, with the crude price at US$150, the question was how long China could sustain subsidies to keep retail fuel prices low. But with the price of crude oil now down around US$40 a barrel, the discussion of Chinese energy pricing policy has reversed course.

Policy makers recognise that the “business as usual” scenario, under which energy intensity grew much faster than GDP, is no longer feasible. Reducing energy intensity is urgent if China wants to sustain high rates of economic growth.

A confluence of bottom-up and top-down market factors has created pressure for reforming China’s rigid pricing system, which could prove an initial step towards genuinely liberalised pricing.

The first is China’s growing dependence on imported crude oil, which means a lessening ability to insulate domestic consumers from movements in the world crude price. Until recently, China’s domestic crude oil production was large and concentrated enough that shielding consumers from global prices was fairly simple.

But in the past five years China has become far more reliant on small, high-cost fields at home and imported crude from abroad. Imports still make up less than half of the country’s total crude demand – but that share is inexorably rising.

Another factor is the increasingly messy economics of China’s oil refining business. Through 2004, when oil prices were still fairly low, China’s net crude oil supplies reliably ran about 500,000 barrels per day ahead of the apparent demand for refined oil products – gasoline, diesel, fuel oil, jet kerosene, etc.

But as crude prices rose from 2005, crude supply fell behind apparent product demand to the tune of about 200,000 barrels per day, mainly because the country’s pricing system created incentives for stockpiling.

The National Development and Reform Commission sets retail petrol and diesel prices, as well as the refinery-gate prices for these products – that is, the price charged by refineries to distributors.

But the wholesale price charged by distributors to gas stations fluctuates freely. So when crude prices rise, distributors have an incentive to buy up stock from the refineries as quickly as possible because the government-set refinery price lags the market crude price.

Distributors then hold on to these stockpiles until petrol stations run down their supplies and need to buy more, at which point the wholesale price will rise. The hoarders can then sell their hoarded fuel at a big profit.

Because the big refiners cannot increase their prices when crude prices rise, there is a lack of incentive for them to supply the market when prices rise. As a result, small independent refiners, which account for 15-20 percent of China’s refining capacity, play a crucial role in providing swing supply.

Concentrated in Guangdong, Shandong and Shanxi, these small refiners sell from the refinery gate, but at unregulated wholesale prices. Even though they lack the economies of scale of the big refiners, they can in most cases make a good profit because they meet marginal demand at market prices.

However, many of these small refiners were forced to shut down in the first half of 2008 as the (unregulated) price of fuel oil reached US$40 a barrel above the already high price of crude oil. This helped contribute to the severe fuel shortages in the first half of the year.

The pressures created by increased import dependence and distorted refinery incentives can only be solved by liberalised pricing.

Greater pass-through of international prices will encourage consumers to be more efficient. And a pricing system which reduces arbitrage opportunities will shift profits from the arbitrageurs back to the refiners, who will then find it worth while to supply the market when prices are high, rather than creating shortages.

“Liberalised pricing” will take some time to implement, and in a Chinese context it will never be synonymous with “free market pricing”. The government will always want to retain some control over pricing to protect consumers from the volatility of international price movements.

Although modest – the new fuel levy adds roughly 16 per cent to the cost of petrol at present pump prices – the fuel tax is an indispensable first step because it puts a buffer between international crude prices and the domestic retail pump.

The more fuel is taxed, the less the retail price will jump around with the crude price because the crude price represents a lower proportion of the retail price. The hope is that, by dampening price volatility, fuel prices will eventually reflect market costs without causing social unrest.

In addition, higher fuel prices should promote resource efficiency and thereby lower China’s energy intensity, which has rocketed in recent years.

Until last summer, when the leadership finally cut fuel subsidies and raised pump prices, policy makers had shown little willingness to use price mechanisms to achieve long-term energy efficiency goals. The imposition of a fuel tax is a further sign that Beijing is seriously committed to getting energy prices right.

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

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