Focus: Energy

Power Politics

China must push through reforms in its energy sector—especially price reform

by Julie Walton

Unimaginable though it may be, factories in some of the world's most vibrant manufacturing hubs are turning off the lights once a week. In coastal cities from Beijing to Shenzhen, and even as far inland as Chongqing, companies received notices as early as April of this year warning them of rolling blackouts for the summer months and often demanding to know which day of the week the factory would prefer to be without power. In the Yangzi River Delta, companies that made investment decisions based on promises of preferential access to the West-East Natural Gas Pipeline are quietly being told to lower their expectations because demand is so strong.

China's current electricity shortages and skyrocketing demand for fuel—whether oil, natural gas, or coal—point to a larger problem within the system: China's management of its energy resources, both domestic and imported. The fragmented regulatory structure that governs the sector inhibits strategic decisionmaking and genuine reform. In particular, the lack of transparency in pricing and regulation throughout the energy supply chain encourages waste and prevents the development of new or efficient technologies. The PRC government has undertaken several rounds of reform, but even its latest effort is unlikely to make much progress as long as the leadership remains unable to resolve the conflict between the need for market forces to play a greater role in resource allocation and the government's desire to protect state-owned enterprises (SOEs) and other vulnerable employers from the consequences of these forces—primarily rising energy prices.

Pricing problems

The National Development and Reform Commission (NDRC) sets enduser prices for natural gas, electricity, and gasoline; rarely do these prices reflect the actual market prices of these commodities. According to the World Bank, energy prices in China are one-quarter of those in the United States as a result of controls on pricing throughout the system. For example, in early 2005, NDRC issued a notice setting a ceiling for this year of 8 percent above the 2004 price of coal supplied to power plants. But coal producers, looking for a price that more accurately reflected market conditions, were hoping for at least a 20 percent increase over the 2004 price. In 2004, the average PRC market price for coal was ¥206.43 ($24.93) per ton, 27 percent higher than the average price of coal supplied to state-owned power plants, which was ¥162.05 ($19.57) per ton. This type of distortion occurs throughout the supply chain: The government caps the price power generation companies charge the grid companies, which in turn have limitations on how much they can charge endusers.

NDRC also sets the price for refined petroleum, with only occasional adjustments to reflect global price fluctuations. For instance, at the end of May 2005, the price for various refined petroleum products in China was roughly $120 per ton below international prices, according to NDRC. This amounts to a subsidization of sectors that rely on refined petroleum, such as the auto sector, and impedes the development of new products and changes in customer behavior. For example, although NDRC raised the retail price of gasoline in March, it was unwilling to adjust the price of diesel fuel lest such a move adversely affect farmers (who rely on diesel fuel for their equipment, particularly during the spring planting season). Refineries produced more gasoline because they could get a better return; the result was a nationwide shortage of diesel. It was only at the end of May that NDRC allowed refined diesel prices to rise.

According to the director of NDRC's Energy Research Institute, the central government must monitor the price of refined petroleum because allowing domestic prices to fluctuate with the international market would have negative consequences for economic development. The Chinese leadership is fundamentally committed to pursuing a course of expansive economic growth to maintain social stability. The director's remark goes to the heart of the fact that central planning authorities are seriously worried that allowing more market-determined prices for energy could trigger inflation, which would hurt important constituencies and threaten social stability. Inefficient SOEs, many of which rely upon regular cash injections, and disgruntled urban residents (often those laid off from crumbling SOEs) are vulnerable to any increase in energy or electricity prices. In May, NDRC prohibited local governments from raising electricity rates if local inflation rises more than 4 percent year on year for three consecutive months.

At the same time, the government is acutely aware of the need to reflect supply and demand signals in energy prices. To this end, just before it imposed the inflation limits, NDRC allowed power producers to pass along 70 percent of coal cost increases to distributors and consumers if coal prices jump more than 5 percent in six months.

Such conflicting directives neither protect consumers nor aid the development of genuine market-based solutions. Allowing generators to pass on input price increases in full would benefit the whole industry, ensure a steadier power supply, and, one hopes, improve safety throughout the electricity supply chain because companies would have more money to spend on maintenance and upgrades. China could then provide direct subsidies to its poorest endusers, as is done in other countries.

The tight rein on pricing, together with a general inability to enforce contracts, deters foreign companies from participating in various segments of China's energy market. Most foreign independent power producers have left the market because local governments have refused to pay the electricity price to which they originally agreed. And foreign companies pulled out of the West-East Natural Gas Pipeline project in part because of PetroChina's refusal to recognize internationally accepted pricing practices.

The coal question

Though coal prices have been rising, coal is still the cheapest type of fuel in China. China's substantial coal reserves fuel the thermal power plants that supply almost 70 percent of the country's energy. In comparison, electric power from all other energy sources—including natural gas shipped through the West-East Pipeline—is more expensive. Consequently, central planners offer tax breaks and price caps to make electricity from other sources competitive with coal. Domestic price caps that limit returns on investment, combined with the large supply of inexpensive (but sometimes low-quality) coal, discourage diversification into other areas of energy production.

Nevertheless, China's vast coal reserves—114,500 million metric tons at the end of 2004, according to BP Statistical Review of World Energy—could provide valuable alternative energy options, if they were priced according to market principles. Because the country has so much coal, national energy policy in recent years has focused on adopting new technologies and management practices to use domestic coal resources more efficiently, rather than on reducing the overall reliance on coal.

One such effort is a coal liquefaction project in Inner Mongolia (coal liquefaction turns coal into oil). Although debate exists about the true cost competitiveness of coal liquefaction, industry analysts believe that it is cost competitive for China if crude oil remains above $30 a barrel. Others caution that the technology is immature, expensive, and requires coal of a certain quality. Nevertheless, NDRC is working with a South African company to pursue coal liquefaction technology. Development of such alternative coal technologies will only succeed if regulators are willing to pass on the true cost of energy to the enduser.

Recent electricity price reforms

China's regulators are, however, trying to address the mismatch between the price that endusers pay for their energy and the cost to the producer. In addition to raising gasoline prices, in March 2005 NDRC took an important step forward in electricity price reform when it published three regulations that set out specific electricity pricing measures for three stages of electricity generation and transmission: sales from generators to grid companies; electricity transmission and distribution; and sales from grid companies to endusers (see Electricity Woes).

Significantly, the rules link prices at each stage and allow some electricity generators to raise prices when fuel costs rise. For the sale of electricity from generators to grid operators, the government sets a base price, which reflects the generators' average fixed cost and market demand and applies to every generator in the same region. The generators are free to charge as much or as little as they like over that price. The regulations for pricing of electricity distribution and transmission take the reforms one step further by permitting distribution and transmission companies to incorporate more of the electricity cost into their pricing. The final set of regulations—governing enduser price—may not be as progressive as the other two. NDRC still sets electricity prices but promises to establish a mechanism to ensure that the electricity price for endusers floats with the price the grid companies pay to generators. The mechanism has not yet been made public.

Price reforms since these regulations took effect on May 1 have varied across regions and sectors. NDRC increased electricity prices by an average of ¥0.022 ($0.0027) per kilowatt-hour in mid-June, but the rate hike did not apply to the country's northwestern or northeastern regions and excluded all agriculture and fertilizer-related industries. Many localities have introduced peak and off-peak pricing for commercial and industrial applications; Beijing, Hebei, and Shanghai will introduce seasonal differential pricing for the third quarter of 2005, during which peak pricing is likely to be 11 percent higher than during peak times throughout the rest of the year. Residential rates remain in the hands of local governments throughout the country, but raising them is always contentious.

Foreign investors' concerns

As more sectors open to foreign investment, China's regulation of its energy markets—either through price controls or government edicts— is a growing concern for foreign companies. The Catalogue Guiding Foreign Investment in Industry encourages investment in coal-gas integrated gasification combined cycle plant technology and equipment, as well as in the construction and management of a variety of power stations. In addition, China's World Trade Organization (WTO) entry agreement includes phased liberalizations for wholesale and retail sales of crude and refined petroleum (upstream oil and gas exploration and production was not covered in the WTO agreement).

China's commitments to open wholesale and retail distribution of crude and processed oil are of particular interest to foreign companies. On December 11, 2006, foreign companies will be allowed to distribute wholesale imported crude and processed oil. This could be a significant market opening because, in theory, it means that foreign oil companies can sell their product directly to a customer of their choosing. Yet many foreign companies remain skeptical about the willingness of PRC authorities to implement this commitment according to the letter and the spirit of the WTO. The bulk of China's imported refined and processed oil currently flows through four designated state-trading companies: China National Chemical Import and Export Co., China International United Petroleum and Chemicals Co., China National United Oil Co., and Zhuhai Zhenrong Co., with a limited quota volume allocated to nonstate-trading entities.

As a sign of a potential opening at the end of 2004, 16 PRC companies received licenses to import crude and processed petroleum. All of the licensed companies were endusers rather than distributors, however, thus preserving the China Petrochemical Corp. (Sinopec) and PetroChina Co. Ltd. distribution duopoly. Moreover, as the two Chinese companies control the vast majority of China's refineries, the newly licensed nonstate crude importers can only sell crude to the duopoly for refining. Finally, the licenses restrict imported processed petroleum to fuel oil, such as kerosene, and do not cover the highly regulated market of refined petroleum products such as gasoline and diesel, which stay under the four state trading entities. (In a positive development, China recently broke the jet fuel monopoly, though foreign investment is still not permitted.)

Although it is unclear how China will regulate the wholesale market, there are signs that authorities will not make entry easy for foreign companies.

Foreign companies see these restrictions as examples of measures that regulators might use to limit future foreign investment. Although it is unclear how China will regulate the wholesale market, there are signs that authorities will not make entry easy. For example, the idea of setting up an importer registration system with strict qualifications such as minimum earnings, domestic storage capacity, and port infrastructure is under serious consideration, according to industry insiders. This last point is particularly contentious because Sinopec and PetroChina currently control most of the coastal tanks and storage facilities. It is unlikely that either company would be willing to surrender space to foreign entrants.

Foreign companies want to import, refine, and sell their own branded products, but many industry analysts believe that the central government is willing to allow only limited foreign participation, to ensure the clear market leadership of state-owned giants Sinopec and PetroChina (see China's National Oil Companies). As evidence, they point to the manner in which China has implemented its WTO commitments for foreign investment in retail gas stations. China agreed to allow wholly foreign-owned retail distribution enterprises by December 11, 2004, but companies with more than 30 outlets are restricted to minority shares in joint ventures, according to China's WTO commitments. Foreign companies believe that if this is interpreted as 30 stores nationwide, they will be effectively shut out of the retail market because it is terribly expensive to supply only 30 stores with imported gasoline.

Several foreign companies have chosen to go the joint-venture route to access more than 30 outlets and must co-brand their products. For example, at gas stations run by Sinopec and Shell (Jiangsu) Petroleum Marketing Co., a joint venture between Royal Dutch Shell plc and Sinopec, Sinopec appears at the top of the sign and Shell at the bottom. Other companies with retail joint ventures include BP plc with two joint ventures, BP PetroChina Petroleum Co. Ltd. and BP Sinopec Zhejiang Petroleum Co. Ltd., and Chevron Corp., parent company of Caltex South China Investments Ltd., which has several retail joint ventures. As for refining, foreign companies cannot own and operate their own refineries, but may and do refine through JV partners. The ultimate goal for all foreign retailers, not just oil companies, is to operate wholly foreign-owned retail outlets in China with the same access that Chinese companies have in the United States. The trick will be to get China to agree to an interpretation of "30 retail outlets" that would allow foreign companies to establish enough outlets to achieve economies of scale, though prospects of this being ironed out in the near future are dim.

In addition to market access, pricing, again, is a concern. Currently, NDRC adjusts the benchmark price for retail gasoline and diesel when the average crude prices in Singapore, Rotterdam, and New York change by a classified margin. Such poor transparency makes it extremely difficult for foreign companies to formulate effective pricing models or business plans. Many companies argue that market access means little unless pricing mechanisms, along with licensing and import procedures, are transparent and liberalized. Transparency is important in the granting of oil import licenses, which ideally would allow a full range of product services. Companies should be able to obtain import privileges without high capitalization or other requirements, such as having to own storage capacity.

Though PRC regulators are unlikely to move quickly to reform pricing, different reform proposals have circulated among the state oil companies and relevant ministries. In one scenario, regulators would regulate factory and cost, insurance, and freight prices, while freeing wholesale and retail prices. In another proposal, regulators would free wholesale prices but continue to regulate retail prices, which is similar to what the three electricity pricing regulations do. Of course, foreign companies would prefer the third option, which would be the complete liberalization of retail and wholesale prices.

Avoiding a candlelit future

China's energy situation is highly complex and exacerbated by understandable fears that true market reform would harm the economy. But the longer energy reform is postponed, the more painful economic dislocations and severe energy shortages will be. China needs more transparency, better law enforcement, and fewer restrictive regulations in the energy sector. Transparency is needed particularly in bidding; in determining pricing for the generation and transmission of electricity to commercial, industrial, and residential users; and in setting the cost of oil and natural gas for importation, transmission, and distribution. (Some companies acknowledge that they can operate with limited price controls as long as they know how and why the prices are set.) Improving the general business environment—by allowing companies to access reserve history data and choose their own suppliers and partners and by enforcing contracts—would go a long way to improving China's energy sector.

China needs a comprehensive energy policy, rather than ad hoc reactions to periodic crises. Otherwise, the blackouts will keep rolling across the country for summers to come.

A New Energy Leading Group

China's power sector is plagued by insufficient coordination among multiple regulatory agencies. Currently, the State Asset Supervision and Administration Commission oversees the management of state-owned power plants and energy companies, while the State Electricity Regulatory Commission supervises the power sector from the plant to the consumer. The National Development and Reform Commission's (NDRC) Energy Bureau monitors the energy sector and approves projects, while NDRC's price bureau sets electricity and gasoline prices. Over the years, various ministries have attempted to craft and implement a nationwide energy policy, but none has had enough clout to push one through.

The government announced in May 2005 the formation of a new interagency task force to improve regulation and guidance of the country's fragmented energy industry. Premier Wen Jiabao now heads up the State Council Energy Leading Group, with Vice Premiers Huang Ju and Zeng Peiyan serving as vice chairs. To promote interagency coordination, the group also includes leaders from 13 top government agencies, including NDRC Minister Ma Kai, Minister of Commerce Bo Xilai, Minister of Foreign Affairs Li Zhaoxing, Minister of the State Commission on Science, Technology, and Industry for National Defense Zhang Yunchuan, and Minister of Finance Jin Renqing. The leading group is responsible for formulating the country's energy strategy and for providing policy suggestions to the State Council regarding energy exploitation, conservation, security, and international cooperation within the energy sector.

NDRC Minister Ma Kai heads the 24-person, vice-ministry-level State Energy Office, which is charged with overseeing day-to-day affairs for the leading group. Ma Fucai, former president of China National Petroleum Corp., and Xu Dingming, director of NDRC's Energy Bureau, are vice directors. The office reports directly to the leading group, monitors energy security, organizes energy-related research, and aids the group's decisionmaking.

Company responses to the formation of the leading group have been mixed. Some believe that the leading group's high-level leadership will finally be able to force policy coordination and change. Others, however, look at the heads of the implementation office—NDRC personnel—and argue that policy implementation will be a problem because NDRC is still where most of the bottlenecks lie. Nearly everyone agrees on one point, however: Unless the leading group is willing to tackle the fundamental question of energy pricing, no amount of agency reform and policy coordination will improve China's energy prospects.

—Julie Walton

China's National Oil Companies

China's oil and gas sector has experienced significant institutional and structural change in the past half century. After 1949, the central government nationalized the industry under the Ministry of Petroleum Industry (MOPI). In addition to being responsible for administrative and commercial aspects of upstream and downstream operations, MOPI assumed the role of industry regulator and responsibility for the welfare of all sector employees. By the early 1980s, lack of technology and capital led to declining exploration and production. As part of a set of broader reforms taking place in China, the government in 1981 began a two-tiered reorganization program to rejuvenate the industry.

First, the government contracted with MOPI for an annual production target and allowed oil produced in excess of this target to be sold in domestic markets. This worked as an incentive for further exploration and production and provided funds for investment in much-needed technology. Second, to separate the regulatory and social functions from commercial functions, the government established national oil companies focused exclusively on oil exploration, production, and marketing. By 1988, China had established three national oil companies: China National Offshore Oil Corp. (CNOOC), China Petrochemical (Group) Corp. (Sinopec Group), and China National Petroleum Corp. (CNPC). As a result, the ministry was shut down. The government further restructured the industry in 1998 to encourage overseas exploration, investment, acquisition, and stock market listings.

CNOOC
In February 1982, MOPI created CNOOC as the first of the new national oil companies. The company assumed complete responsibility for exploration, development, and production of oil and gas in China's territorial waters. In an attempt to boost investment in China's oil and gas industry, the government encouraged CNOOC to engage with foreign parties in production sharing contracts and joint ventures.
A main goal of the government-led restructuring was to create globally competitive oil and gas companies. Accordingly, in 1999 CNOOC created and transferred all of its valuable commercial assets to a subsidiary, CNOOC Ltd., which listed on global markets in 2001. Nearly 70 percent of CNOOC Ltd.'s share capital belongs to its parent company. Its largest production area is Bohai Bay. Today, the company engages independently and with foreign partners in upstream offshore operations. Major partners include Chevron Corp., ConocoPhillips, and Devon Energy Corp. Under US-educated CEO Fu Chengyu, the company has gained a reputation as a fairly nimble, internationally savvy oil company.

CNOOC Ltd.'s parent company was the first of the national oil companies to pursue liquefied natural gas (LNG) operations and is developing China's LNG infrastructure in Guangdong, Fujian, Shanghai, and Zhejiang. CNOOC Ltd. has interests in Indonesian and Australian LNG production and development and is on track to supply its parent company's terminals with LNG from these endeavors.
Sinopec
MOPI created the second national oil company, Sinopec Group, in 1983, which assumed a dominant position in petroleum refining and petrochemical production. By the late 1990s, Sinopec Group owned more than 90 percent of China's refining capacity. Shortly before the 1998 industry restructuring, the government decided that China's oil and gas companies needed to develop integrated upstream and downstream operations to be globally competitive. To this end, in 1998 Sinopec Group was instructed to swap assets with CNPC along regional lines. After the swap, Sinopec Group held both upstream and downstream assets in the mainland's southern and eastern regions. In February 2000, Sinopec Group created and transferred most performing assets to its subsidiary Sinopec Corp. Sinopec Corp. was listed on global markets in 2000, and its parent company retains about 68 percent of the company's share capital. Sinopec Group's background in downstream operations has allowed Sinopec Corp. to become the mainland's largest producer and distributor of oil products. The company's preeminence in downstream operations is aided by its more recent upstream efforts, with the company producing the second-largest amount of crude oil in China.
Sinopec's LNG operations have only just begun. Under Chair Chen Tonghai, the company recently secured rights to build an LNG terminal in Shandong, and the company has created a new unit, China Petroleum and Chemical Corp. Gas Co., to assume all gas-related operations of both the company and its parent. Sinopec Corp. has set up a number of joint venture operations with multinational oil companies including BP plc, Royal Dutch Shell plc and, most recently, Exxon Mobil Corp.
CNPC
In 1988, MOPI's remaining commercial operations were transformed into CNPC, and the ministry was abolished. This national oil company assumed all assets and some regulatory and social responsibilities previously belonging to MOPI. It was tasked with upstream development of onshore oil and gas, both domestically and internationally. In 1998, Sinopec Group transferred all assets held in the northern and western part of China to CNPC. To turn itself into a company that could compete globally, CNPC created a subsidiary, PetroChina Co. Ltd. focused entirely on commercial interests. As with the other subsidiaries, parent company CNPC handed over most of its performing assets in March 2000. One month later, PetroChina listed on global markets. CNPC holds roughly 90 percent of PetroChina's issued stock.
Today, PetroChina is responsible for the largest and most lucrative oil and gas field in China, Daqing. In terms of production, PetroChina is the largest oil and gas company in China. The company is also the sponsor of the 2,500 mile West-East Pipeline from Xinjiang to Shanghai. Though PetroChina is an integrated company, its strengths lie in upstream operations. The chair of the subsidiary and the parent company is Chen Geng. Last month, PetroChina established a 50-50 joint venture with its parent company for control of CNPC's non-contentious global oil reserves. (The venture excludes reserves in contentious areas, such as Sudan.) This includes stakes in oil and gas field ventures in Algeria, Azerbaijan, Canada, Ecuador, Kazakhstan, Oman, Peru, and Venezuela. Before the joint venture was announced, PetroChina's offshore assets were confined to Indonesia. The company has formed retail joint ventures with Shell and BP and has a cooperation agreement with Shell for development of the Changbei gas field, which straddles the Inner Mongolia-Shaanxi border.

—Teresa Finn

Teresa Finn is a Business Advisory Services assistant at the US-China Business Council in Washington, DC.

Julie Walton is director, Business Advisory Services, at the US-China Business Council in Washington, DC.

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	Focus: Energy Power Politics China must push through reforms in its energy sector—especially price reform by Julie Walton Unimaginable though it may be, factories in some of the world's most vibrant manufacturing hubs are turning off the lights once a week. In coastal cities from Beijing to Shenzhen, and even as far inland as Chongqing, companies received notices as early as April of this year warning them of rolling blackouts for the summer months and often demanding to know which day of the week the factory would prefer to be without power. In the Yangzi River Delta, companies that made investment decisions based on promises of preferential access to the West-East Natural Gas Pipeline are quietly being told to lower their expectations because demand is so strong. China's current electricity shortages and skyrocketing demand for fuel—whether oil, natural gas, or coal—point to a larger problem within the system: China's management of its energy resources, both domestic and imported. The fragmented regulatory structure that governs the sector inhibits strategic decisionmaking and genuine reform. In particular, the lack of transparency in pricing and regulation throughout the energy supply chain encourages waste and prevents the development of new or efficient technologies. The PRC government has undertaken several rounds of reform, but even its latest effort is unlikely to make much progress as long as the leadership remains unable to resolve the conflict between the need for market forces to play a greater role in resource allocation and the government's desire to protect state-owned enterprises (SOEs) and other vulnerable employers from the consequences of these forces—primarily rising energy prices. Pricing problems The National Development and Reform Commission (NDRC) sets enduser prices for natural gas, electricity, and gasoline; rarely do these prices reflect the actual market prices of these commodities. According to the World Bank, energy prices in China are one-quarter of those in the United States as a result of controls on pricing throughout the system. For example, in early 2005, NDRC issued a notice setting a ceiling for this year of 8 percent above the 2004 price of coal supplied to power plants. But coal producers, looking for a price that more accurately reflected market conditions, were hoping for at least a 20 percent increase over the 2004 price. In 2004, the average PRC market price for coal was ¥206.43 ($24.93) per ton, 27 percent higher than the average price of coal supplied to state-owned power plants, which was ¥162.05 ($19.57) per ton. This type of distortion occurs throughout the supply chain: The government caps the price power generation companies charge the grid companies, which in turn have limitations on how much they can charge endusers. NDRC also sets the price for refined petroleum, with only occasional adjustments to reflect global price fluctuations. For instance, at the end of May 2005, the price for various refined petroleum products in China was roughly $120 per ton below international prices, according to NDRC. This amounts to a subsidization of sectors that rely on refined petroleum, such as the auto sector, and impedes the development of new products and changes in customer behavior. For example, although NDRC raised the retail price of gasoline in March, it was unwilling to adjust the price of diesel fuel lest such a move adversely affect farmers (who rely on diesel fuel for their equipment, particularly during the spring planting season). Refineries produced more gasoline because they could get a better return; the result was a nationwide shortage of diesel. It was only at the end of May that NDRC allowed refined diesel prices to rise. According to the director of NDRC's Energy Research Institute, the central government must monitor the price of refined petroleum because allowing domestic prices to fluctuate with the international market would have negative consequences for economic development. The Chinese leadership is fundamentally committed to pursuing a course of expansive economic growth to maintain social stability. The director's remark goes to the heart of the fact that central planning authorities are seriously worried that allowing more market-determined prices for energy could trigger inflation, which would hurt important constituencies and threaten social stability. Inefficient SOEs, many of which rely upon regular cash injections, and disgruntled urban residents (often those laid off from crumbling SOEs) are vulnerable to any increase in energy or electricity prices. In May, NDRC prohibited local governments from raising electricity rates if local inflation rises more than 4 percent year on year for three consecutive months. At the same time, the government is acutely aware of the need to reflect supply and demand signals in energy prices. To this end, just before it imposed the inflation limits, NDRC allowed power producers to pass along 70 percent of coal cost increases to distributors and consumers if coal prices jump more than 5 percent in six months. Such conflicting directives neither protect consumers nor aid the development of genuine market-based solutions. Allowing generators to pass on input price increases in full would benefit the whole industry, ensure a steadier power supply, and, one hopes, improve safety throughout the electricity supply chain because companies would have more money to spend on maintenance and upgrades. China could then provide direct subsidies to its poorest endusers, as is done in other countries. The tight rein on pricing, together with a general inability to enforce contracts, deters foreign companies from participating in various segments of China's energy market. Most foreign independent power producers have left the market because local governments have refused to pay the electricity price to which they originally agreed. And foreign companies pulled out of the West-East Natural Gas Pipeline project in part because of PetroChina's refusal to recognize internationally accepted pricing practices. The coal question Though coal prices have been rising, coal is still the cheapest type of fuel in China. China's substantial coal reserves fuel the thermal power plants that supply almost 70 percent of the country's energy. In comparison, electric power from all other energy sources—including natural gas shipped through the West-East Pipeline—is more expensive. Consequently, central planners offer tax breaks and price caps to make electricity from other sources competitive with coal. Domestic price caps that limit returns on investment, combined with the large supply of inexpensive (but sometimes low-quality) coal, discourage diversification into other areas of energy production. Nevertheless, China's vast coal reserves—114,500 million metric tons at the end of 2004, according to BP Statistical Review of World Energy—could provide valuable alternative energy options, if they were priced according to market principles. Because the country has so much coal, national energy policy in recent years has focused on adopting new technologies and management practices to use domestic coal resources more efficiently, rather than on reducing the overall reliance on coal. One such effort is a coal liquefaction project in Inner Mongolia (coal liquefaction turns coal into oil). Although debate exists about the true cost competitiveness of coal liquefaction, industry analysts believe that it is cost competitive for China if crude oil remains above $30 a barrel. Others caution that the technology is immature, expensive, and requires coal of a certain quality. Nevertheless, NDRC is working with a South African company to pursue coal liquefaction technology. Development of such alternative coal technologies will only succeed if regulators are willing to pass on the true cost of energy to the enduser. Recent electricity price reforms China's regulators are, however, trying to address the mismatch between the price that endusers pay for their energy and the cost to the producer. In addition to raising gasoline prices, in March 2005 NDRC took an important step forward in electricity price reform when it published three regulations that set out specific electricity pricing measures for three stages of electricity generation and transmission: sales from generators to grid companies; electricity transmission and distribution; and sales from grid companies to endusers (see Electricity Woes). Significantly, the rules link prices at each stage and allow some electricity generators to raise prices when fuel costs rise. For the sale of electricity from generators to grid operators, the government sets a base price, which reflects the generators' average fixed cost and market demand and applies to every generator in the same region. The generators are free to charge as much or as little as they like over that price. The regulations for pricing of electricity distribution and transmission take the reforms one step further by permitting distribution and transmission companies to incorporate more of the electricity cost into their pricing. The final set of regulations—governing enduser price—may not be as progressive as the other two. NDRC still sets electricity prices but promises to establish a mechanism to ensure that the electricity price for endusers floats with the price the grid companies pay to generators. The mechanism has not yet been made public. Price reforms since these regulations took effect on May 1 have varied across regions and sectors. NDRC increased electricity prices by an average of ¥0.022 ($0.0027) per kilowatt-hour in mid-June, but the rate hike did not apply to the country's northwestern or northeastern regions and excluded all agriculture and fertilizer-related industries. Many localities have introduced peak and off-peak pricing for commercial and industrial applications; Beijing, Hebei, and Shanghai will introduce seasonal differential pricing for the third quarter of 2005, during which peak pricing is likely to be 11 percent higher than during peak times throughout the rest of the year. Residential rates remain in the hands of local governments throughout the country, but raising them is always contentious. Foreign investors' concerns As more sectors open to foreign investment, China's regulation of its energy markets—either through price controls or government edicts— is a growing concern for foreign companies. The Catalogue Guiding Foreign Investment in Industry encourages investment in coal-gas integrated gasification combined cycle plant technology and equipment, as well as in the construction and management of a variety of power stations. In addition, China's World Trade Organization (WTO) entry agreement includes phased liberalizations for wholesale and retail sales of crude and refined petroleum (upstream oil and gas exploration and production was not covered in the WTO agreement). China's commitments to open wholesale and retail distribution of crude and processed oil are of particular interest to foreign companies. On December 11, 2006, foreign companies will be allowed to distribute wholesale imported crude and processed oil. This could be a significant market opening because, in theory, it means that foreign oil companies can sell their product directly to a customer of their choosing. Yet many foreign companies remain skeptical about the willingness of PRC authorities to implement this commitment according to the letter and the spirit of the WTO. The bulk of China's imported refined and processed oil currently flows through four designated state-trading companies: China National Chemical Import and Export Co., China International United Petroleum and Chemicals Co., China National United Oil Co., and Zhuhai Zhenrong Co., with a limited quota volume allocated to nonstate-trading entities. As a sign of a potential opening at the end of 2004, 16 PRC companies received licenses to import crude and processed petroleum. All of the licensed companies were endusers rather than distributors, however, thus preserving the China Petrochemical Corp. (Sinopec) and PetroChina Co. Ltd. distribution duopoly. Moreover, as the two Chinese companies control the vast majority of China's refineries, the newly licensed nonstate crude importers can only sell crude to the duopoly for refining. Finally, the licenses restrict imported processed petroleum to fuel oil, such as kerosene, and do not cover the highly regulated market of refined petroleum products such as gasoline and diesel, which stay under the four state trading entities. (In a positive development, China recently broke the jet fuel monopoly, though foreign investment is still not permitted.) Although it is unclear how China will regulate the wholesale market, there are signs that authorities will not make entry easy for foreign companies. Foreign companies see these restrictions as examples of measures that regulators might use to limit future foreign investment. Although it is unclear how China will regulate the wholesale market, there are signs that authorities will not make entry easy. For example, the idea of setting up an importer registration system with strict qualifications such as minimum earnings, domestic storage capacity, and port infrastructure is under serious consideration, according to industry insiders. This last point is particularly contentious because Sinopec and PetroChina currently control most of the coastal tanks and storage facilities. It is unlikely that either company would be willing to surrender space to foreign entrants. Foreign companies want to import, refine, and sell their own branded products, but many industry analysts believe that the central government is willing to allow only limited foreign participation, to ensure the clear market leadership of state-owned giants Sinopec and PetroChina (see China's National Oil Companies). As evidence, they point to the manner in which China has implemented its WTO commitments for foreign investment in retail gas stations. China agreed to allow wholly foreign-owned retail distribution enterprises by December 11, 2004, but companies with more than 30 outlets are restricted to minority shares in joint ventures, according to China's WTO commitments. Foreign companies believe that if this is interpreted as 30 stores nationwide, they will be effectively shut out of the retail market because it is terribly expensive to supply only 30 stores with imported gasoline. Several foreign companies have chosen to go the joint-venture route to access more than 30 outlets and must co-brand their products. For example, at gas stations run by Sinopec and Shell (Jiangsu) Petroleum Marketing Co., a joint venture between Royal Dutch Shell plc and Sinopec, Sinopec appears at the top of the sign and Shell at the bottom. Other companies with retail joint ventures include BP plc with two joint ventures, BP PetroChina Petroleum Co. Ltd. and BP Sinopec Zhejiang Petroleum Co. Ltd., and Chevron Corp., parent company of Caltex South China Investments Ltd., which has several retail joint ventures. As for refining, foreign companies cannot own and operate their own refineries, but may and do refine through JV partners. The ultimate goal for all foreign retailers, not just oil companies, is to operate wholly foreign-owned retail outlets in China with the same access that Chinese companies have in the United States. The trick will be to get China to agree to an interpretation of "30 retail outlets" that would allow foreign companies to establish enough outlets to achieve economies of scale, though prospects of this being ironed out in the near future are dim. In addition to market access, pricing, again, is a concern. Currently, NDRC adjusts the benchmark price for retail gasoline and diesel when the average crude prices in Singapore, Rotterdam, and New York change by a classified margin. Such poor transparency makes it extremely difficult for foreign companies to formulate effective pricing models or business plans. Many companies argue that market access means little unless pricing mechanisms, along with licensing and import procedures, are transparent and liberalized. Transparency is important in the granting of oil import licenses, which ideally would allow a full range of product services. Companies should be able to obtain import privileges without high capitalization or other requirements, such as having to own storage capacity. Though PRC regulators are unlikely to move quickly to reform pricing, different reform proposals have circulated among the state oil companies and relevant ministries. In one scenario, regulators would regulate factory and cost, insurance, and freight prices, while freeing wholesale and retail prices. In another proposal, regulators would free wholesale prices but continue to regulate retail prices, which is similar to what the three electricity pricing regulations do. Of course, foreign companies would prefer the third option, which would be the complete liberalization of retail and wholesale prices. Avoiding a candlelit future China's energy situation is highly complex and exacerbated by understandable fears that true market reform would harm the economy. But the longer energy reform is postponed, the more painful economic dislocations and severe energy shortages will be. China needs more transparency, better law enforcement, and fewer restrictive regulations in the energy sector. Transparency is needed particularly in bidding; in determining pricing for the generation and transmission of electricity to commercial, industrial, and residential users; and in setting the cost of oil and natural gas for importation, transmission, and distribution. (Some companies acknowledge that they can operate with limited price controls as long as they know how and why the prices are set.) Improving the general business environment—by allowing companies to access reserve history data and choose their own suppliers and partners and by enforcing contracts—would go a long way to improving China's energy sector. China needs a comprehensive energy policy, rather than ad hoc reactions to periodic crises. Otherwise, the blackouts will keep rolling across the country for summers to come. A New Energy Leading Group China's power sector is plagued by insufficient coordination among multiple regulatory agencies. Currently, the State Asset Supervision and Administration Commission oversees the management of state-owned power plants and energy companies, while the State Electricity Regulatory Commission supervises the power sector from the plant to the consumer. The National Development and Reform Commission's (NDRC) Energy Bureau monitors the energy sector and approves projects, while NDRC's price bureau sets electricity and gasoline prices. Over the years, various ministries have attempted to craft and implement a nationwide energy policy, but none has had enough clout to push one through. The government announced in May 2005 the formation of a new interagency task force to improve regulation and guidance of the country's fragmented energy industry. Premier Wen Jiabao now heads up the State Council Energy Leading Group, with Vice Premiers Huang Ju and Zeng Peiyan serving as vice chairs. To promote interagency coordination, the group also includes leaders from 13 top government agencies, including NDRC Minister Ma Kai, Minister of Commerce Bo Xilai, Minister of Foreign Affairs Li Zhaoxing, Minister of the State Commission on Science, Technology, and Industry for National Defense Zhang Yunchuan, and Minister of Finance Jin Renqing. The leading group is responsible for formulating the country's energy strategy and for providing policy suggestions to the State Council regarding energy exploitation, conservation, security, and international cooperation within the energy sector. NDRC Minister Ma Kai heads the 24-person, vice-ministry-level State Energy Office, which is charged with overseeing day-to-day affairs for the leading group. Ma Fucai, former president of China National Petroleum Corp., and Xu Dingming, director of NDRC's Energy Bureau, are vice directors. The office reports directly to the leading group, monitors energy security, organizes energy-related research, and aids the group's decisionmaking. Company responses to the formation of the leading group have been mixed. Some believe that the leading group's high-level leadership will finally be able to force policy coordination and change. Others, however, look at the heads of the implementation office—NDRC personnel—and argue that policy implementation will be a problem because NDRC is still where most of the bottlenecks lie. Nearly everyone agrees on one point, however: Unless the leading group is willing to tackle the fundamental question of energy pricing, no amount of agency reform and policy coordination will improve China's energy prospects. —Julie Walton China's National Oil Companies China's oil and gas sector has experienced significant institutional and structural change in the past half century. After 1949, the central government nationalized the industry under the Ministry of Petroleum Industry (MOPI). In addition to being responsible for administrative and commercial aspects of upstream and downstream operations, MOPI assumed the role of industry regulator and responsibility for the welfare of all sector employees. By the early 1980s, lack of technology and capital led to declining exploration and production. As part of a set of broader reforms taking place in China, the government in 1981 began a two-tiered reorganization program to rejuvenate the industry. First, the government contracted with MOPI for an annual production target and allowed oil produced in excess of this target to be sold in domestic markets. This worked as an incentive for further exploration and production and provided funds for investment in much-needed technology. Second, to separate the regulatory and social functions from commercial functions, the government established national oil companies focused exclusively on oil exploration, production, and marketing. By 1988, China had established three national oil companies: China National Offshore Oil Corp. (CNOOC), China Petrochemical (Group) Corp. (Sinopec Group), and China National Petroleum Corp. (CNPC). As a result, the ministry was shut down. The government further restructured the industry in 1998 to encourage overseas exploration, investment, acquisition, and stock market listings. CNOOC In February 1982, MOPI created CNOOC as the first of the new national oil companies. The company assumed complete responsibility for exploration, development, and production of oil and gas in China's territorial waters. In an attempt to boost investment in China's oil and gas industry, the government encouraged CNOOC to engage with foreign parties in production sharing contracts and joint ventures. A main goal of the government-led restructuring was to create globally competitive oil and gas companies. Accordingly, in 1999 CNOOC created and transferred all of its valuable commercial assets to a subsidiary, CNOOC Ltd., which listed on global markets in 2001. Nearly 70 percent of CNOOC Ltd.'s share capital belongs to its parent company. Its largest production area is Bohai Bay. Today, the company engages independently and with foreign partners in upstream offshore operations. Major partners include Chevron Corp., ConocoPhillips, and Devon Energy Corp. Under US-educated CEO Fu Chengyu, the company has gained a reputation as a fairly nimble, internationally savvy oil company. CNOOC Ltd.'s parent company was the first of the national oil companies to pursue liquefied natural gas (LNG) operations and is developing China's LNG infrastructure in Guangdong, Fujian, Shanghai, and Zhejiang. CNOOC Ltd. has interests in Indonesian and Australian LNG production and development and is on track to supply its parent company's terminals with LNG from these endeavors. Sinopec MOPI created the second national oil company, Sinopec Group, in 1983, which assumed a dominant position in petroleum refining and petrochemical production. By the late 1990s, Sinopec Group owned more than 90 percent of China's refining capacity. Shortly before the 1998 industry restructuring, the government decided that China's oil and gas companies needed to develop integrated upstream and downstream operations to be globally competitive. To this end, in 1998 Sinopec Group was instructed to swap assets with CNPC along regional lines. After the swap, Sinopec Group held both upstream and downstream assets in the mainland's southern and eastern regions. In February 2000, Sinopec Group created and transferred most performing assets to its subsidiary Sinopec Corp. Sinopec Corp. was listed on global markets in 2000, and its parent company retains about 68 percent of the company's share capital. Sinopec Group's background in downstream operations has allowed Sinopec Corp. to become the mainland's largest producer and distributor of oil products. The company's preeminence in downstream operations is aided by its more recent upstream efforts, with the company producing the second-largest amount of crude oil in China. Sinopec's LNG operations have only just begun. Under Chair Chen Tonghai, the company recently secured rights to build an LNG terminal in Shandong, and the company has created a new unit, China Petroleum and Chemical Corp. Gas Co., to assume all gas-related operations of both the company and its parent. Sinopec Corp. has set up a number of joint venture operations with multinational oil companies including BP plc, Royal Dutch Shell plc and, most recently, Exxon Mobil Corp. CNPC In 1988, MOPI's remaining commercial operations were transformed into CNPC, and the ministry was abolished. This national oil company assumed all assets and some regulatory and social responsibilities previously belonging to MOPI. It was tasked with upstream development of onshore oil and gas, both domestically and internationally. In 1998, Sinopec Group transferred all assets held in the northern and western part of China to CNPC. To turn itself into a company that could compete globally, CNPC created a subsidiary, PetroChina Co. Ltd. focused entirely on commercial interests. As with the other subsidiaries, parent company CNPC handed over most of its performing assets in March 2000. One month later, PetroChina listed on global markets. CNPC holds roughly 90 percent of PetroChina's issued stock. Today, PetroChina is responsible for the largest and most lucrative oil and gas field in China, Daqing. In terms of production, PetroChina is the largest oil and gas company in China. The company is also the sponsor of the 2,500 mile West-East Pipeline from Xinjiang to Shanghai. Though PetroChina is an integrated company, its strengths lie in upstream operations. The chair of the subsidiary and the parent company is Chen Geng. Last month, PetroChina established a 50-50 joint venture with its parent company for control of CNPC's non-contentious global oil reserves. (The venture excludes reserves in contentious areas, such as Sudan.) This includes stakes in oil and gas field ventures in Algeria, Azerbaijan, Canada, Ecuador, Kazakhstan, Oman, Peru, and Venezuela. Before the joint venture was announced, PetroChina's offshore assets were confined to Indonesia. The company has formed retail joint ventures with Shell and BP and has a cooperation agreement with Shell for development of the Changbei gas field, which straddles the Inner Mongolia-Shaanxi border. —Teresa Finn Teresa Finn is a Business Advisory Services assistant at the US-China Business Council in Washington, DC. Julie Walton is director, Business Advisory Services, at the US-China Business Council in Washington, DC. Further Reading China Powers Up Upstream-Downstream Generating Profits from Waste in Wenzhou Natural Gas: Fuel for the New Economy An Update of China's Oil Sector Overhaul Power Struggle Top of Page Table of Contents
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