Energy price strategies that will matter(2)

The government still retains control over electricity tariffs. But to encourage coal-fired power plants to install and operate flue gas desulphurization and denitrification facilities the government has since 2004 accorded a price premium for electricity generated by coal-fired power plants with flue gas desulphurization facilities installed and since November 2011 a price premium for electricity generated by power plants with flue gas denitrification facilities.

The level and scope of the price premium have been amended since their initial implementation in order to achieve the mandated emission reductions.

The government has also charged differentiated power tariffs for companies classified as "eliminated types" or "restrained types" in eight energy-guzzling industries from October 2006 onwards.

Since July 2012, the commission has used three-tier-tariffs for household electricity use, and in January this year expanded the three-tiered electrify pricing approach to the aluminum sector to phase out outdated production capacity and promote industrial restructuring more quickly.

Similar tiered power pricing policies are likely to be implemented in industries like cement to force industrial upgrades and promote sustained, healthy development.

Clearly, China has made great efforts to reform energy prices. However, such reforms are far from complete. While the new pricing mechanism for petroleum products is one step towards a more market-oriented pricing mechanism, it is still not enough.

Petroleum product prices fluctuate with global crude oil prices, and are hence decoupled from the domestic market. Reforms should also take domestic factors into account, so that petroleum product prices can better reflect the relationship between domestic supply and demand.

The pilot scheme in Guangdong and Guangxi provides the right direction to establish a market-oriented natural gas pricing mechanism.

China also needs to draw on the lessons learned from the two pilot schemes and examine what kinds of adjustments and improvements are needed regarding the choice of alternative fuels, the selection of the pricing reference point and the creation of netback market value pricing formula in order to implement the reforms on a nationwide basis.

While China has been reforming the electricity industry structure since 2002, transmission, distribution and sale of electricity is undertaken by two main grid companies, State Grid and China Southern Power Grid, and several local grid companies, such as Inner Mongolia Grid and Shaanxi Grid. As the designated sole buyers of electricity from generators and distributors and sellers of electricity, they hold monopolies in their respective areas. Their monopoly power and the lack of competition in the electricity market has often drawn criticism.

However, separation of transmission and distribution is not a viable option. The feasible approach should be to set up a power trading market. In this regard, direct purchase of power for major electricity users, as per the pilot program in Yunnan province, should be promoted. That will help to infer the actual cost of electricity transmission and its effective distribution and help the government to set the appropriate level of the grid's transmission and distribution charges in future electricity power structure reform.

While splitting the grid is not a necessary option, separating electricity sales from the grid's transmission and distribution is a must to establish a competitive power market. It would also lead to the creation of an electricity market that is not reliant on the grid. These are the more realistic options for pushing forward power reforms.

The government could also consider raising the current level of price premium for de-nitrification in order to encourage more power plants to install and run denitrification facilities.

In the case of coal, though the dual-pricing system has been abolished, it is still difficult to establish a nationwide market, as railway freight mechanisms have not been liberalized. Given the uneven geographical distribution of coal production and output, and the need for coal to be transported over long distances, it is imperative that the freight mechanisms are also liberalized quickly. Reforms need to be targeted in such a manner that they can lead to the formation of a complete coal value chain.

However, even if such reform is undertaken coal prices do not fully reflect the cost of production because of the government's controlled costs and distorted prices. They also do not include negative externalities.

The resource tax levied on crude oil and natural gas on a revenue basis, rather than by existing extracted volume, which has been applied nationwide since November 1, 2011, is a step in the right direction.

China should broaden that reform to coal, by overhauling the current practice and fix the levy on coal by revenues. This will also help to increase local governments' revenues and alleviate their financial burden and encourage them not to focus on economic growth alone.

The author Zhongxiang Zhang is a distinguished professor and chairman at the School of Economics, Fudan University, Shanghai.