China introduced a new system in which the oil price would fluctuate between the lower and upper limits of $40 and $130 per barrel. Within this range, oil producers can raise or cut prices in line with the actual situation. It hopes to basically remove price restrictions on refined oil products by the end of the 13th Five-Year Plan Period.

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In the past year, China has steadily advanced its energy reform to promote the development of the energy industry. Nevertheless, low energy demand has become the biggest problem facing the energy industry.

At present, demand for energy and power is growing at a low rate. Moreover, energy enterprises face pressure to cut capacity, and excessive capacity has restrained energy prices. In this context, energy enterprises should improve efficiency and reduce costs to survive and develop, which also highlights the importance of energy system and price reform.

 

Mutual promotion
The readjustment of the energy system and the market-oriented reform of energy prices are closely related and a mutually reinforcing process. Unavoidable resistance to reform from vested interest groups and the influence of the macroeconomic situation have complicated the process, which should be conducted gradually.

On the one hand, systemic reform is needed to support price reform. The strategy of “regulating energy supply and lowering the threshold in technology and capital” will also have a bearing on energy pricing reform.

Breaking up monopolies in the integrated industrial chain is the basic requirement for the market-oriented reform of energy pricing. Relaxing requirements on technology and capital will provide investment opportunities for private capital. This could foster diversified competition, laying a foundation for energy prices to be determined by the market.

On the other hand, price reform is needed to support systemic reform. Government decisions to fix and adjust energy prices are a result of weighing policy objectives and balancing the interests of all parties. At present, state-owned enterprises often stress the importance of social responsibilities in addition to economic purposes.

However, due to their close ties to the government, these state-owned enterprises lack transparency in the operation of energy pricing and subsidy. As a consequence, private enterprises tend to distrust them and are less inclined to establish joint ventures with them. Moreover, administrative intervention in pricing may add uncertainties to future earnings, diminishing the enthusiasm of private enterprises to join mixed ventures.

The surplus of energy and low prices at the present stage provide a good foundation for reform in this area. Energy reform—pricing reform in particular—is possible with two preconditions.

One is sufficient supply and demand of energy. In the case of energy shortage, the government has to prioritize meeting energy demand over conducting reform to improve efficiency.

The other is steady or descending energy prices. The largest obstacle to reform lies in the concern that energy prices may go up after reform, which will affect economic growth and social stability. Thus, reform will be easier to support and more successful if it focuses on correcting the previous wrong method of pricing while maintaining or even reducing energy prices.

Consumers are more concerned about whether reform will lead to rising prices than they are about the kind of pricing mode the government will adopt. Therefore, carrying forward reform at a time when energy prices are low can minimize the negative influence on economic growth and social stability.

 

Government functions
In 2016, energy system reform in China focused on separating government functions from corporate management while separating oil and gas pipe network construction from production and sales to replace the integrated management of central enterprises. Also, China strengthened reform on management of departments in charge of selling power.

These measures have contributed to breaking up monopolies in the energy industry and relaxing control in technology and capital, giving rise to a competitive mechanism. In the process, the government emphasizes increasing the role of social capital while gradually opening up energy projects, except projects aimed at public welfare and resource regulation, by lifting the control over energy prices in competition.

Meanwhile, the government’s energy management functions have been transformed. It needs to probe into an industrial system in line with China’s actual conditions in order to avoid detours when carrying forward reform.

Since the beginning of 2016, the coal price has started to rise, with its growth rate exceeding 60 percent in the market. The rally can be attributed to multiple factors. But the main reason is that in April 2016, the government introduced a 276-workday regulation for coal enterprises to restrict production. The new rule was a bad omen in the context of market-oriented reform.

Theoretically, in the event of excessive capacity in any industry, the government can raise prices through production restriction, which, however, will bring uncertainties to the market. Therefore, in addition to strengthening energy regulation, the government should resort to market-oriented means as much as possible when it is really necessary to intervene in the energy market. Moreover, the government should strengthen strategic planning when opening up energy projects. It should play a key role in steering energy reform in the right direction of pursuing energy security and efficiency, and ensuring sufficient supply.

Pricing mechanism for oil, gas
China will deepen energy-pricing reform during the 13th Five-Year Plan (2016-2020) Period. For natural gas, the objective of reform is to establish a market-oriented linkage between city gate gas price and terminal-user price while relaxing control over price for non-residential users. The city gate is a gas distribution station in a city.

In 2015, the government requires the standards for setting gas prices for non-residential users to be based on the benchmark city gate price instead of the highest city gate price. Suppliers and buyers can determine the final price through negotiations within the scope, with an upper limit of 20 percent and no lower limit.

Reform for residential gas price is mainly intended to reduce subsidy with no specific target and cross subsidy. Though cross subsidy cannot be prohibited through reform, lowering non-residential gas price would reduce cross subsidy as much as possible.

The government called for the establishment of a ladder pricing system for residential gas use: Prices are charged based on different levels of gas consumption. The new system will help reduce waste and improve resource utilization while retaining subsidies for target groups to achieve social equity. All cities with gas supply systems were required to establish the ladder pricing system by the end of 2016.

In 2016, China announced that it would basically remove price restrictions on refined oil products by the end of the next five-year period. However, it will take much longer to truly achieve the goal nationwide. Instead of issuing a uniform order for price adjustment, China introduced a new system in which the oil price would fluctuate between the lower and upper limits of $40 and $130 per barrel. Within this range, oil producers can raise or cut prices in line with the actual situation.
 

 

The previous mechanism linked the price of national refined oil products with that of international crude oil. However, uncertainties arise when the government determines price adjustment because the government may choose not to make adjustment or make insufficient adjustment. Decentralizing the right of the government has marked a crucial step in the market-oriented reform. Further reform should allow the price of refined oil products to be determined by domestic market supply and demand within a certain range.

 

Power system reform
In 2016, China also proposed to improve the mechanism linking coal and power prices. Under the linkage, the electricity price will move in line with coal price increases. Though it has yet to be improved, the current pricing mechanism for refined oil products is transparent and predictable. There is little difference between price adjustments calculated by oil producers according to the changes of international oil price and those conducted by the government. Therefore, the government only needs to adjust the on-grid price as well as the electricity price for terminal users in light of the linkage mechanism between coal and power prices.

The current period of power surplus provides a favorable environment for the market-oriented reform of electricity. However, it is unknown how long this period will last. After all, the electricity consumption per capita in China is at a lower level, and it is difficult to maintain a growth rate of 2 to 3 percent in power generation.

Experience at home and abroad shows the periodicity of power demand and economic development. Therefore, the current power surplus may be periodic and may not last for long. In developed countries, the growth of power demand in a country tends to hit a turning point when its GDP per capita reaches $20,000 to $30,000. At present, GDP per capita in China is about $8,000. This indicates that the slow growth in domestic power demand is likely to be transitory.
 

 

Once there is a rebound in demand, market pressure will be intensified, posing challenges to reform, which is an important lesson we should learn from the previous round of power reform. Now, it is necessary to seize the opportunity to carry forward systemic reform of electric power.

 

Lin Boqiang is director of the China Center for Energy Economics Research at Xiamen University.