Is Power Sector Reform Essential to China’s Greener Future?

The Three-Gorges Dam in China (Picture Credit: Marshall Segal)

This article by Chris P. Nielsen, China Project Executive Director, and Mun S. Ho, China Project Senior Economist, originally appeared in China US Focus on October 12, 2018.

The scale of air pollution problems in China, particularly in winter, is well known. The term “airpocalypse” was popularized by the severe haze episodes in Beijing in January 2013. However, more recent measurements indicate improved conditions in 2017, with lower pollution readings in targeted regions and fewer red-alert days. It will take time for scientists to disentangle how much of the improvement is due to reduced emissions and how much to favorable meteorological conditions, but there is no doubt that stepped-up efforts by the government have reduced pollution.

Further improvement in air quality, however, will be more challenging. More extensive progress will be slowed by institutional, economic, and political constraints. These obstacles rise in importance as remediation shifts from narrow technical solutions to long-term strategies for transforming the energy sector and restructuring the economy, strategies that could have major effects on governance, business, and policy. In fact, the overwhelming focus of recent air quality plans on China’s three leading urban regions yielded progress in those areas partly by relocating heavy industry to other parts of China. Unsurprisingly, air quality outside of the target regions has not made similar progress and the success of the plans is less complete when viewed nationally.

On top of these air quality challenges, the government is also committed to greenhouse gas reduction, introducing a national CO2 emission trading system (ETS) in the power sector, now scheduled to begin in 2020. Decarbonizing electricity generation means a shift from coal to renewables, nuclear, or natural gas. These shifts also reduce emissions of sulfur dioxide, nitrogen oxides, and particles that contribute to poor air quality.

An aerial view of a power station at night in Shaoxing, China. © Adobe

In addressing formidable policy tasks such as the ETS, there is a further undertaking that could help progress, or hinder it, if done poorly: reform of the electric power sector. In an industry long regulated tightly by planning authorities, reforms initiated by the so-called “Decree №9” of 2015 could, in principle, make market-oriented pollution reduction more effective. Reforming the huge power system, which currently accounts for 45% of total coal use in China, is one of the most complex tasks for the government. While the controls on pollutant emissions in the electric sector are much tighter compared to other coal-burning industries, the sector is still a major contributor to air pollution given its sheer size.

The Ministry of Electric Power ran the power system until it was transformed into the State Power Company in 1996. Privately-owned generators were permitted to help ease electricity shortages that were then common. In 2002, the generation assets were separated into five large state-owned companies, and the State Grid and Southern Grid formed to manage transmission of energy. Over this period, the shortages gave way to excess capacity, and a system of planned allocation of generation hours was devised to ensure a “fair” allocation of total demand to the generators. Thus a dispatch system was created that did not prioritize efficiency or cost; in a more rational, market-oriented system, the most inefficient (often also the dirtiest) plant would be dispatched last. Various efforts since 2007 at introducing a more environmentally friendly system, such as “Energy Conservation Dispatch,” have had limited success and the “fair allocation” system remains largely in place.

Wind farm in Xinjiang, China. © Wikipedia

China has expended great efforts on renewable power and now leads the world in wind, solar, and hydro power capacities. Renewables, however, must operate largely within the “fair dispatch” system where incumbent coal plants retain their centrally planned share of generation hours despite higher marginal costs. Also, state-owned coal generators are important sources of employment and revenue for local governments, pushing provincial authorities to protect their market share and resist renewable power from other provinces. These factors, along with others, result in very high wastage of clean and cheap electricity; wind power, for example, was curtailed by 21 percent in the first half of 2016. Even hydropower is curtailed due to its geographic concentration in the southwest, far from load centers.

These obvious inefficiencies are one of the targets of the Decree №9 reforms. The reform proposals include the establishment of spot markets and power trading centers, and allowing retail competition. A spot market for electricity is a market for narrow time intervals (e.g., an hour) where generators offer bids specifying price and quantity and the trading center manager finds the lowest price that would cover enough bids to satisfy demand for that time interval. The demand comes from enterprises and households who face prices that are mostly regulated. Such a spot market requires an advanced trading system and sophisticated market participants, and has thus taken a long time to develop in an industry with central planning origins like China’s.

In a typical spot market, demand would be close to capacity during peak hours and the highest marginal-cost generator would be able to sell its power. In the U.S., the highest marginal cost generators would normally be gas turbines, which can shut down and start up quickly. In China, there are currently very few gas-fired generators and the highest marginal cost plant would likely be the most inefficient coal plant. During off-peak hours, a market system would reduce output of such plants. Wind and solar have essentially zero marginal costs and would be used when feasible, peak or off-peak. Such a system is very different from the current setup where the majority of generation hours are allocated according to a centralized plan. If such a market system succeeds, with coal plants generating less and renewables selling more, the contribution to reduction of air pollution and carbon could be substantial.

On top of this, if the CO2 permit system (ETS) is effectively implemented, it would require that the cost of burning coal includes the CO2 price, raising the spot price bids from coal generators. This would further advantage low-carbon sources.

These two “ifs” are big uncertainties given the complexity of the systems, resistance of politically powerful incumbent coal generators and other economic challenges facing the government in 2018.

Finally, relaxation of investment controls in the mid-2010s sparked a huge over-building of coal-fired power plants. This overcapacity has led to a sharp fall in utilization rates of coal generators, leaving them idle more than half the time in 2017. Estimates of “stranded” coal power assets exceeded $500 billion in 2015. Yet recent satellite evidence indicates even more coal plants are being added, despite suspension of their construction permits, exacerbating the problems posed by overcapacity.

There is a strong possibility that dealing with stranded assets and grappling with power sector reforms that challenge entrenched interests will preoccupy those in charge of energy policy, and distract from efforts to implement the CO2 ETS and reduce emissions from the electricity sector. But for a major transition to clean power in China to gain real traction — and for the carbon pricing of the ETS to function as intended — the first priority must be getting power sector reform right.

Chris P. Nielsen

Chris P. Nielsen is the executive director of the Harvard-China Project on Energy, Economy and Environment. Working with faculty at collaborating Chinese universities and across the schools of Harvard, he has managed and developed the interdisciplinary China Project from its inception. See the main Harvard-China Project website for a summary of this work, starting with research and editing of the book that launched the Project, Energizing China: Reconciling Environmental Protection and Economic Growth (1998, HUCE and Harvard U. Press, with McElroy and Peter Lydon). Nielsen has a B.A. in Geology from Colorado College, where he was a Boettcher Scholar, and an S.M. in technology and policy from the Massachusetts Institute of Technology. He earlier lived in Taipei, Taiwan, working for the Colorado state trade and investment office.

Mun S. Ho

Mun S. Ho, who received his Ph.D. in Economics from Harvard University, has been serving as Senior Economist at the Harvard-China Project on Energy, Economy and Environment since the inception of the Project in 1993, and is currently a Visiting Scholar at Resources for the Future, Washington DC. Dr. Ho centers his research on economic growth, productivity, taxation, and environmental economics, with a specific focus on China.