Coal pricing reforms only get half the job done

Recent news that the National Development and Reform Commission (NDRC) was considering scraping the long-standing annual contract pricing system for thermal coal has been making huge waves with both thermal coal suppliers and power plants.

Currently in China, thermal coal can be purchased both on the spot market at prices that reflect real supply and demand pressures or via contracts negotiated between coal producers and buyers and coordinated under the auspices of the NDRC. With regard to the latter sales channel, the NDRC requires domestic coal suppliers to sign agreements to sell a certain amount of coal below market value in order to ease cost pressures for power producers.

While government-intervened contracts have benefited electricity producers and end-market users, they have also bedeviled the nation's coal suppliers and created friction within the energy supply chain for some two decades. But now that market prices of thermal coal are near contractual prices, many now believe that the impact of axing the annual contract pricing scheme would be limited.

Unfortunately, we should not fool ourselves into thinking that things will go smoothly if annual contracts suddenly disappear and thermal coal is priced solely by conditions within the market. As the government still dictates the price of energy in the market, many power producers would be unable to cope with large or prolonged upswings in thermal coal costs, which account for around 70 percent of their operating overhead. In fact, power producers could decide to cut their output if high thermal coal prices made electricity production unprofitable. Such a turn of events could potentially deal a huge blow to the country's economy and lower living conditions for people nationwide.

If government planners want to liberalize coal prices, they need to also liberalize energy prices at the same time. Of course, this does not mean that the government should completely bow out of the electricity and coal industries altogether, but it should slowly minimize its presence as it also works to create a healthier market.

In the short term, the government could tie thermal coal prices to electricity prices and offer subsidies to citizens in the event of massive spikes in energy rates. Looking long term though, authorities should encourage more companies to join the electricity production industry in order to stir up competition. Once the industry is no longer monopolized by a handful of giant firms, prices will normalize and electricity supplies moving to the market will remain stable.