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Special Report 4: China’s EnergySystem Revolution

Shi Yaodong and Angus Gillespie

Innovation plays a crucial role in China’s energysystem transition and revolution. At the 6thmeeting of the Central Leading Group for Finan-cial and Economic Affairs in June 2014, GeneralSecretary Xi announced that China would:(i) carry out an energy system revolution to putChina’s energy development on the fast track;(ii) reform the energy industry into an effective andcompetitive market systemwith a market-orientedpricing mechanism; and (iii) transform the gov-ernment’s regulation of the energy industry andimprove the energy legislation system.

There have beenmany system constraints on thesustainable development ofChina’s energy industry

for a long time. For example, state monopoly in theoil, gas and power sectors has restricted marketcompetition andkeptprivate capital investment low.Government price control of those three sectors hasprevented the market from allocating resourcesefficiently and distorted the prices of some products.To address these constraints, the government hasintroduced a series of guidelines and reform road-maps over the past few years. These include theOpinions of the CPC Central Committee and theState Council on Further Deepening the Reform ofthe Electric Power System (March 2015), theOpinions of the CPC Central Committee and theState Council on Advancing the Reform of thePricing Mechanism (October 2015), the OpinionsonDeepening theReformof theOil andGasSystem(May 2017), and theAction Plan for Energy SystemRevolution (July 2017). These guidelines androadmaps clearly identify the objectives, pathwaysand mechanisms for deep energy system reform.

With the introduction of these guidelines,action plans and related support measures,1 the

DRC Team Lead of Special Report 4: Shi Yaodongfrom the Research Department of Industrial Economy,DRC of the State Council of China.

Shell Team Lead of Special Report 4: Angus Gillespie,Former Vice President Group CO2, Shell GlobalSolutions.

Contributors: Philip Gradwell and Cameron Hepburnfrom Vivid Economics; Li Weiming, Chen Jianpeng andZhou Jianqi from DRC of the State Council of China;Liu Xiaoli from the Energy Research Institute, NDRC;and Fan Jingli and Wu Lin from the China University ofMining and Technology.

S. Yaodong (&)Research Department of Industrial Economy, DRCof the State Council of China, Beijing, China

A. GillespieFormer Vice President Group CO2, Shell GlobalSolutions, The Hague, the Netherlands

1For example, the supporting documents for power systemreform include the Implementation Opinions on PromotingtheReform of Power Transmission andDistribution PricingMechanisms, the Implementation Opinions on Promotingthe Development of the Power Market, the ImplementationOpinions on Building and Consistent Operation of PowerTrading Institutions, the Implementation Opinions on theOrderly Deregulation of Power Generation and Consump-tion Planning, the Implementation Opinions on PromotingPower Retail Reform, and the Guidelines on Strengtheningand Regulating the Supervision and Management ofBackup Coal-Fired Power Plants.

© The Author(s) 2020Shell International B.V. and the Development Research Center (DRC) of the State Council of the People’sRepublic of China (eds.), China’s Energy Revolution in the Context of the Global Energy Transition,Advances in Oil and Gas Exploration & Production, https://doi.org/10.1007/978-3-030-40154-2_5

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https://doi.org/10.1007/978-3-030-40154-2_5

reform of China’s energy institutions and systemhas made positive progress.

Reforming China’s energy system is a for-midable task and cannot be achieved overnight.Li Wei, Director of the DRC of China’s StateCouncil and Chinese lead of this DRC-Shellcollaborative research project, said in a recentspeech that in the context of the global energyrevolution, there are still some deeply rootedcontradictions and problems for China to addressbefore it can deliver a clean, low-carbon, secureand efficient modern energy system.2 In Specialreport 4, we discuss how China can develop anddeepen its energy system revolution and institu-tional innovations, and we put forward a series ofconstructive policy proposals.

1 Factors and Trends in EnergySystem Reform

1.1 Energy Supply and Demand:Global Energy Oversupplyand Strong Energy DemandGrowth in Asia’s EmergingEconomies

Historical experience suggests that it is difficultto implement energy system reform at a time ofrapidly growing energy demand, as the priority isto ensure energy supply security and meetdemand. In recent years, affected by such factorsas slowing world economic growth and industrialrestructuring, global energy demand has shownlittle movement. On the other hand, the shale gasrevolution and large-scale investment anddevelopment in response to high energy priceshave resulted in global energy oversupply andlower energy prices. As China’s economy entersthe new normal of slower growth, demand forenergy will decline and lead to overcapacity inthe country’s energy sectors, including coal,electricity and oil. Thus, it is unlikely that therewill be sharp fluctuations in energy demand and

large-scale energy supply shortages. To driveenergy system reform forward, improvements inenergy use efficiency can help strengthen rela-tively stable internal and external environments.

The annual growth rate in China’s energydemand is forecast to fall below 2% by 2035, from8% in 2000. This is attributed to China’s slowingeconomic growth, improved energy efficiency andchanging patterns of consumption. China’s energydemand is increasingly less dependent onenergy-intensive industries like steel and cement.Instead, future energy demand will be closelylinked to economic restructuring—more structuraladjustments mean less energy demand, and viceversa. For example, if China’s economic structureshifts closer to that of the USA, energy demandwill decrease. As the global economy grows,energy demand will also grow. Almost all newenergy supply in 2014–35 will be consumed byrapidly developing economies. According to BPEnergy Outlook 2035 (2016), the average annualgrowth rate in world primary energy demand in2014–35 will be 1.4% and world total energydemand will increase by 34% in the same period.In the new normal economy, China’s energydemand will grow slowly but sustainably. In2025–35, China will account for less than 30% ofthe increase in global energy demand, compared to60% in the past decade (BP 2016).

The share of oil, natural gas and coal in globalenergy demand has been stable over the pastdecade (Fig. 1). In 2016, the share of oil, naturalgas and coal production was 38.95%, 28.55%and 32.5% respectively.

Oil and natural gas production shows slightbut steady growth over the past decade, com-pared to coal, which has declined. Ascoal-dominated energy producers begin to seekalternative energy sources, the energy systemgradually evolves (Fig. 2).

Global primary energy demand did notchange significantly in 2006–16 (Fig. 3). Oil hadthe largest share of global primary energydemand, reaching 33% in 2016. Although manycountries are now reducing their consumption offossil fuels to lower their CO2 emissions, this didnot have much impact on energy demand.Renewable energy is expanding and its

2Speech made by Director Li Wei at the China GrandEnergy Transition Forum 2017, August 19, 2017.

394 S. Yaodong and A. Gillespie

production landscape is changing. In 2016,demand for renewable energy grew by 12%(including wind, geothermal, solar, biomass,waste-to-energy and biofuels, excluding hydro-power). Although this is lower than the averagegrowth rate of 15.7% in 2006–16, it still repre-sents the biggest annual increase ever (a rise of55 Mtoe, which is more than the decline in coaldemand). In the same year, China became theworld’s largest renewable energy producer aheadof the USA. Although renewable energy onlyaccounts for 4% of global primary energydemand and the average growth rate of somerenewable energy sources, including nuclear andhydro, is only 2.64%, new energy is expected toremain the major driver of the energy revolutionand will play a major role in driving economicgrowth in the future.

Figure 4 shows that growth in energy demandto 2035 comes entirely from emerging econo-mies, with China and India accounting for morethan half of the increase. In contrast, oil demandin OECD countries will continue to fall steadily.In terms of oil supply, non-OPEC countries arethe main source of increased supply, producing

11 million barrels per day (MMbbl/d) comparedto 7 MMbbl/d in OPEC countries. The increasein non-OPEC oil supply comes entirely from theAmericas: shale oil from the USA, deep-sea oilfrom Brazil, and the oil sands of Canada (BP2016) (Fig. 5).

BP estimates (BP 2016) that the averageannual growth rate of global natural gas demandwill reach 1.8% in 2014–35, making natural gasthe fastest growing fossil energy source. Thisrobust growth is the result of focused supply andenvironmental policy support. The increase innatural gas demand comes mainly from emergingeconomies, with about 30% from China andIndia and more than 20% from the Middle East.Industry and power generation are behind theincrease, whereas in OECD countries theincrease is primarily from power generation.World shale gas production is rising. In 2014–35,the average annual growth rate of shale gasproduction is expected to reach 5.6%, and itsshare of total natural gas production will bealmost 25%. In 2014–25, nearly all the increasein shale gas output will be contributed by theUSA. By 2035, China is expected to become the

Fig. 1 Share of oil, naturalgas and coal in global energyproduction. Source BPStatistical Review of WorldEnergy 2017

Fig. 2 Global primaryenergy production. Source BPStatistical Review of WorldEnergy 2017

Special Report 4: China’s Energy System Revolution 395

largest contributor to increased shale gas pro-duction. Global coal demand is forecast to dropsharply to an average annual growth rate of only

0.5% in 2014–35. This is largely due to slowinggrowth in coal demand and rebalancing of theeconomy. Even so, China will remain the world’s

Fig. 3 Share of global primary energy demand. Source BP Statistical Review of World Energy 2017

Fig. 4 Global primary energy demand. Note Ktoe = thousand tonnes of oil equivalent. Source BP Statistical Review ofWorld Energy 2017

Fig. 5 Global oil demand and supply in 2035. Source BP Energy Outlook 2035 (2016)


largest coal market, consuming almost half ofglobal output in 2035. In the same period, Indiawill register the highest growth in coal demand(435 Mtoe) and become the world’s second lar-gest coal consumer ahead of the USA. Althoughstrong growth in coal demand in India and SouthEast Asia can offset lower demand in the USAand the EU, it is unlikely that India and SouthEast Asia will drive the global coal market asChina did previously.

Global demand for hydropower and nuclearpower will grow steadily at an average rate of1.8% and 1.9% respectively, due mainly togrowing demand for energy in Asia. China’sunprecedented development of hydropower willcome to an end, settling at an average annualgrowth rate of 1.7% in 2014–25. Brazil will havethe second highest growth rate (after China) andwill replace Canada as the world’s largesthydropower producer. China’s nuclear powerdemand will grow rapidly, climbing to an aver-age annual growth rate of 11.2%, which is higherthan China’s growth rate in hydropower over thepast two decades. China’s demand for nuclearpower is forecast to double by 2020 and increaseninefold over the current level by 2035.

According to the U.S. Energy InformationAdministration’s (EIA) World Energy Outlook2017, global energy consumption will increase

by 28% between 2015 and 2040, with more thanhalf of the increase coming from non-OECDcountries in Asia, including China and India(Fig. 6). Growth in energy demand from Asia’semerging economies is the result of their strongeconomic performance. Rising economic growthand growing energy demand will intensifycompetition for energy supply. It is thereforeimportant that these countries seize the strategicopportunities of the Belt and Road Initiative todrive international energy cooperation and dee-pen energy system reform.

1.2 Major Adjustments to the WorldEnergy Landscape:Diversified Energy Supplyand Increased RegionalEnergy Collaboration

After 2005, the share of shale gas in total USnatural gas production increased rapidly—from5.4% (1 trillion cubic feet) in 2006 to 56% (15.2trillion cubic feet) in 2015.3 In 2009, US naturalgas production exceeded that of Russia, makingit the world’s largest natural gas producer. US

Fig. 6 Energy consumption in OECD and non-OECD countries. Note Btu = British thermal units. Source EIA WorldEnergy Outlook (2017)

3https://www.eia.gov/dnav/ng/ng_prod_shalegas_s1_a.htm.


https://www.eia.gov/dnav/ng/ng_prod_shalegas_s1_a.htm

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shale gas production is forecast to exceed 20trillion cubic feet by 2040, accounting for morethan half of its total natural gas production.4 Newproven natural gas reserves in the USA continueto increase and are currently estimated to be2,300 trillion cubic feet. At the present level ofconsumption, the reserves are sufficient to last fornearly 100 years (Fig. 7).

With its substantially increased oil and gasproduction, the USA is likely to turn itslong-advocated slogan of energy independenceinto reality. The USA has reduced its dependenceon oil imports from 60% in 2005 to 25% in2016.5 The National Intelligence Council pre-dicts that the USA will achieve energy indepen-dence by 2030 and become an oil self-sufficientcountry and a major natural gas exporter. Canada—with proven oil reserves of 172.19 billionbarrels in 2015—has 10.1% of the world’s totalproven oil reserves, the largest after Venezuelaand Saudi Arabia. It also has about 95% of theworld’s proven oil sand resources. With abun-dant conventional and unconventional oil andgas resources, Canada has become a new energy

superpower. According to the InternationalEnergy Agency (IEA 2017), Canada’s oil pro-duction will reach 30–60 MMbbl/d by 2030. Therise of North American energy intensifies thediversification of energy supply.

The US shale gas revolution sparked a shalegas investment boom across the world. In 2011,the USA calculated its domestic shale gasresources and those of 32 other countries. In2013, it expanded its assessment to include 137shale formations in 41 countries, including shaleoil resources in addition to shale gas. Theassessment found that there are highly abundantshale oil and gas resources in the world, corre-sponding to 10% of the world’s recoverablecrude oil reserves and 32% of the world’srecoverable natural gas reserves. Russia has themost abundant shale oil reserves, followed by theUSA, China, Argentina and Libya. China has thehighest shale gas reserves, with Argentina,Algeria, the USA, Canada, Mexico and Australiaalso richly endowed.6 Currently, Europe andAustralia have increased their efforts to exploreand exploit shale gas resources, and China is

Fig. 7 Natural gas production in the USA (trillion cubic feet). Source IEA (2017)

4EIA, Short-Term Energy Outlook 2017.5https://www.eia.gov/tools/faqs/faq.php?id=32&t=6.

6https://www.eia.gov/analysis/studies/worldshalegas/pdf/fullreport.pdf.


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starting large-scale commercial development ofits shale gas resources. The IEA forecasts thatunconventional natural gas will account for abouthalf of world total natural gas production in2035, with most produced in China, the USA andAustralia. In 2035, China’s shale gas productionwill stand at 13 billion cubic feet per day (Fig. 8and Tables 1 and 2).

The shale gas revolution in the USA hascaused a ripple effect in energy and related fields

across the world. The impacts of this revolutionwere first reflected in natural gas prices, which inthe USA fell from $10 per million British thermalunits (MMBtu) in 2005 to around $3/MMBtutoday. In time, as costs rise, the price is expectedto increase by about 2.4% per year, reaching$7.8/MMBtu in 2040. Compared with prices inAsia and Europe, the USA will have a clearadvantage in prices over the longer term.The IEA estimates that the cost of liquefied

Fig. 8 Distribution of basins with shale oil and gas resources across the world. Source https://www.eia.gov/analysis/studies/worldshalegas/

Table 1 Top 10 countriesin terms of shale oilreserves in 2015a

Ranking Country Reserves billion (bbl)

1 USA 78

2 Russia 75

3 China 32

4 Argentina 27

5 Libya 26

6 UAE 23

7 Chad 16

8 Australia 16

9 Venezuela 13

10 Mexico 13

Countries’ total 419ahttps://www.eia.gov/analysis/studies/worldshalegas/


https://www.eia.gov/analysis/studies/worldshalegas/



natural gas (LNG) exports from the USA (in-cluding the cost of liquefaction, transport andgasification) can be held below $10/MMBtu,which is still competitive when compared withthe current level of $16/MMBtu and $12/MMBtuin Asia and Europe respectively. As the USAgradually deregulates natural gas exports, itsimpact on the world’s natural gas market will beincreasingly prominent (IEA 2017) (Fig. 9).

As a result of lower natural gas prices, manycoal-fired power plants in the USA have swit-ched their fuel from coal to natural gas, resultingin falling coal and electricity prices. This brings agreat opportunity to regenerate the manufactur-ing and chemical industries. Chemical companiesthat shut down plants in the USA several yearsago, due to high natural gas prices, are planningto reopen production facilities and are againusing low-price natural gas as a raw material toproduce ethylene, synthetic ammonia, chemicalfertilisers and diesel fuels.

In short, the large-scale extraction and use ofunconventional oil and gas resources make theAmericas one of the most important resourceexporters after the Middle East, Russia and NorthAfrica. US oil and gas exports will impact energytrade between Europe and Russia for severaldecades—reducing Europe’s dependence on itsneighbour and diversifying its energy importstructure. To safeguard energy exports, Russia

will strengthen energy cooperation with countriesin East and South Asia. The reduction in Eur-ope’s energy dependence on Russia will furtherconsolidate the political, economic and militaryalliance between Europe and the USA andCanada. Russia’s political and economic coop-eration with China, and with emerging econo-mies in Asia, will also grow. China willstrengthen its energy cooperation with othercountries through the Belt and Road Initiative(BRI). BRI covers two high-quality energy-richregions: Russia-Central Asia; and the GulfRegion-Western Europe, the former endowedwith oil and gas, the latter with advanced energytechnologies and widely deployed renewables.Stronger international energy cooperationthrough BRI will connect Central Asia,North-east Asia, South East Asia, Europe and theAmericas, creating regional energy communitiesto deliver win-win cooperation.

1.3 Protecting the Environmentand Combating ClimateChange Are GlobalConcerns

The large-scale development and use of fossilenergy severely impacts the air, water and envi-ronment. Fossil fuel use emits a large amount of

Table 2 Top 10 countriesin terms of shale gasreserves in 2015a

Ranking Country Reserves (trillion cubic feet)

1 China 1115

2 Argentina 802

3 Algeria 707

4 USA 623

5 Canada 573

6 Mexico 545

7 Australia 429

8 South Africa 390

9 Russia 285

10 Brazil 245

Total 7,577ahttps://www.eia.gov/analysis/studies/worldshalegas/



pollutants into the air, including carbon dioxide(CO2), sulphur dioxide (SO2), nitrogen oxides(NOx) and soot. Global SO2 emissions are about90 million tonnes per year (IEA 2017). Theyacidify soil and rivers and erode buildings andhistorical sites. Around 30% of China’s soilsurface contains sulphur deposits above the crit-ical level. NOx emissions from fossil energy useimpact land, rivers, marine ecosystems and theozone layer. NOx emissions from urban trafficand thermal power plants are the main source ofPM2.5 atmospheric particulate matter. Increasingamounts of particulate matter from thermalpower plants, transport and other industrial sec-tors cause widespread and severe haze, threat-ening human health. In addition, fossil energyextraction and use consume water resources andcause severe pollution.

According to the International Energy Agen-cy’s World Energy Outlook 2017, 20% of theworld’s population live in areas with watershortage. Global water consumption in energyproduction was 600 billion tonnes, about 15% oftotal global water consumption. Its impactsinclude wastewater discharge from coal

production and marine and groundwater pollu-tion from oil and gas exploitation. Large-scaledevelopment of conventional energy resourcescan damage vegetation and landforms. Renew-ables and other types of new energy also impactthe environment, such as visual pollution fromwind turbines and the disposal of nuclear waste.

Most CO2 emissions from human activitiesare from burning fossil fuels. As energy con-sumption grows, CO2 emissions also increase.According to the Fifth Assessment Report (AR5)of the Intergovernmental Panel on ClimateChange (IPCC), the concentration of CO2 in theatmosphere reached 392 parts per million(ppm) in 2012, and the global average tempera-ture rise over the last century was 0.74°C. Thereport suggests that global climate warming hasbecome an indisputable fact, which can be evi-denced by the rise in atmospheric and sea tem-perature, large areas of melting snow and ice, andrising sea levels. According to the data monitoredby the US National Oceanic and AtmosphericAdministration (Fig. 10), global average CO2

concentration exceeded 400 ppm in July 2017,which is about 40% higher than 100 years ago.

Fig. 9 Price of imported natural gas ($/MMBtu). Source BP (2017)


Some climate experts believe that the CO2 con-centration of 400 ppm represents a critical valuethat cannot be reversed. When the critical valueis exceeded, the global temperature rise willreach 2°C.

Global warming has negative impacts on theecosystem. The combined average temperatureover global land and ocean surfaces for April2016 was 1.10 °C above the 20th century aver-age of 13.7°C—the highest temperature depar-ture for April since global records began in 1880.Sixteen of the 17 warmest years on record haveoccurred since 2000. Global warming does notjust make winters warmer and summers hotter, italso causes major environmental crises, such asglacial retreat in the Qinghai-Tibet Plateau andmelting ice and snow in the Antarctic and Arctic.Research indicates that if the global averagetemperature rise exceeds 2°C compared topre-industrial levels, many species with pooradaptability will die out; if the global averagetemperature rise exceeds 4°C, grain yields willfall sharply and fishing productivity will be sig-nificantly reduced, exposing global food supplyto high risk.7 Global warming increases the fre-quency and intensity of extreme weather condi-tions, and accelerates the melting and shrinkingof glaciers, the largest freshwater reserves onEarth, causing sea levels to rise. Millions ofpeople will be threatened by environmental dis-asters like floods, droughts, typhoons, waterscarcity and the submergence of coastal areas,islands and low-lying littoral cities. According tothe World Bank, the losses inflicted by extremeweather conditions are increasing—the averageannual loss in the 1980s was valued at $5 mil-lion. This has risen to $200 billion in the pastdecade.8 Some scientists predict that the averageglobal temperature will rise by at least 3°C by theend of this century, which will result in theextinction of a large number of species (Fig. 11).

From the United Nations Framework Con-vention on Climate Change (UNFCCC) in 1992to the Kyoto Protocol in 1997 and the Paris

Agreement in 2015, the international communityhas been increasingly concerned about climatechange and made vigorous efforts to reducegreenhouse gas emissions. The Paris Agreementsets ambitious goals for reducing greenhouse gasemissions. It established an approach based on thenationally determined contributions (NDCs) ofeach signatory country to reduce national emis-sions and adapt to the effects of climate change;and it reiterates the UNFCCC’s principle of thecommon but differentiated responsibilities ofindividual countries. The Paris Agreement rep-resents the first consensus reached by the inter-national community to combat climate changetogether, and the first proportionate response bythe world’s political system to environmentalthreats. It also brought politicians and academicstogether, in agreement and on the same side.However, the process is full of twists and turns—the Trump administration announced withdrawalfrom the Paris Agreement in June 2017 andcancelled the Clean Power Plan introduced by theObama administration in October 2017, both ofwhich obstruct efforts to combat climate change.The Trump administration is also widely criti-cised by the international community for itsregression and non-action about global climatechange. To deliver the goal of emissions reduc-tion, all countries must gradually reduce their useof fossil energy. It is, however, extremely difficultto arrange international negotiations on climatechange and align developed and developingcountries on climate protection goals, emissionsreduction responsibilities and financial invest-ments. As the country with the most advancedindustry and the highest cumulative carbonemissions per capita, the USA should accept itsresponsibilities. Its decision to withdraw from theParis Agreement is disappointing. Despite theintricate political and economic games behind thenegotiations on climate change, the trend ofinternational collaboration on combating climatechange cannot be reversed (Fig. 12).

The sense of urgency felt by much of theworld about controlling environmental pollutionand combating climate change provides opera-tional space for energy system change. Pollutionlike haze and environmental pollution constraints

7http://www.ccchina.gov.cn/Detail.aspx?newsId=68179.8http://news.china.com.cn/world/2013-11/20/content_30647909.html.


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have made the public aware of the effects ofenergy consumption on the environment. As aresult, the public generally supports energy sys-tem reform to control haze and alleviate energyconstraints. People are willing to choose cleanerenergy consumption and share the cost of envi-ronmental protection. As past international

experience shows, the public’s recognition ofclean development can force the government andbusiness to focus on clean development—theMontreal Protocol on substances that deplete theozone layer is a case in point (Fig. 13).

The green energy era began at the start of the21st century. The principal trend in the global

Fig. 10 Global monthly mean CO2 concentration. Source US National Oceanic and Atmospheric Administration,NOAA (2017) (https://www.esrl.noaa.gov/gmd/ccgg/trends/global.html)

Fig. 11 Global CO2 emissions from fossil fuels. Source IEA (2016)


https://www.esrl.noaa.gov/gmd/ccgg/trends/global.html

energy transition is the shift from fossil fuels to asustainable, clean and low-carbon energy system.In developed economies, the share of low-carbonenergy in the supply system is increasing. In1974, Japan issued a new energy developmentplan to raise investment in developing and usingsolar, geothermal and hydrogen energy andsynthetic natural gas, and identified the devel-opment of solar energy as a national strategy. In2004, Japan introduced its strategic vision ofdeveloping new energy technologies, includingsolar and wind, into a pillar industry valued atJPY 3 trillion. This would include reducing oiluse from 50% to 40% of its total energy con-sumption and increasing the share of new energyto 20%. In recent years, European and Americancountries have adopted a goal-oriented and sys-tematic approach to achieving an energy transi-tion by 2050. For example, as mentioned in theEU Energy Roadmap 2050, the share of renew-ables in total energy consumption will be morethan 55% in 2050. A study by the U.S. Depart-ment of Energy said that renewables can meet80% of power demand by 2050.

Clean energy is becoming a megatrend inglobal energy development. As the world’s lar-gest energy consumer, China is already targetingan energy revolution. In energy technology, theAction Plan for Innovation in the Energy Tech-nology Revolution (2016–30) and the 13th

Five-Year Plan (2016–20) for Energy Technol-ogy Innovation have defined 15 innovationpathways for China’s energy technologies in themedium-to-long term. According to the Strategyof Energy Production and Consumption Revo-lution (2016–30), by 2020, the year before the100th anniversary of the Chinese CommunistParty, China will fundamentally change its modelof extensive growth in energy consumption.Total energy consumption will be held within a 5Btce limit and the share of coal consumption willbe decreased. The share of non-fossil energy willbe 15%, and energy consumption per unit ofGDP will be 15% lower than in 2015. By 2030,the share of non-fossil energy and natural gas intotal energy consumption will be around 20%and 15% respectively. Increases in energydemand will be met mainly by clean energy.

1.4 A Sound Legal System Will Securethe Energy Marketand Guide the EnergyRevolution

Energy in developed economies is based on arelatively mature market system. A sound legalsystem across the entire energy value chain givesdeveloped economies a head start in energydevelopment. For instance, Japan introduced a

Fig. 12 GDP, energyconsumption and CO2

emissions.


series of laws to implement emissions reductionmeasures and control energy demand growth inall sectors. To lower energy consumption, theUSA issued a national energy efficiency policyand regulations and the National ApplianceEnergy Conservation Act. To reduce emissions,the USA passed the Clean Water Act, the CleanAir Act and the Solid Waste Disposal Act, andothers.

Developed economies are at the forefront ofnew energy legislation. The UK government

passed the Climate Change Act 2008 and theEnergy Act 2011, which cover green energyoptions, energy efficiency and low-carbon tech-nologies. The House of Representatives passedthe American Clean Energy and Security Act of2009 (ACES) to drive development of cleanenergy and energy security in the USA. In Japanin 2011, the House of Councillors and the Houseof Representatives passed the Act on SpecialMeasures for Renewable Energy to promote newenergy technology innovation and reduce

Fig. 13 Change in global average temperature, sea level and snow-cover in the northern hemisphere. SourceIntergovernmental Panel on Climate Change (IPCC), Fourth Assessment Report (2007)


dependence on nuclear power. Germany intro-duced the Renewable Energy Sources Act in2014, which requires the share of new energyconsumption to eventually exceed 50%. Earlier,in March 2009, Germany passed the RenewableEnergies Heat Act to increase the share ofrenewable energy in heat production.

Renewable energy is an irreversible trend.According to the International RenewableEnergy Agency, by the beginning of 2016 173countries had set renewable energy developmentgoals and 146 countries had introduced relatedsupport policies. For instance, by 2050 Denmarkwill be free from fossil fuels and in Germanyrenewable energy will account for 60% of energyconsumption.

China has yet to introduce an energy law tosupport energy development. In May 2016, theNational Energy Administration of China issuedthe Energy Legislation Plan 2016–20, identifying“five laws and four regulations” as priority pro-jects. These include the Energy Law of thePeople’s Republic of China and laws on electricpower, the coal industry, oil and gas, oil and gaspipelines, nuclear power administration, offshoreoil and gas pipelines, national petroleumreserves, and energy supervision and adminis-tration. As the energy industry develops, the gapbetween safeguarding energy security and regu-lating and managing energy is increasinglyapparent. To reform the supervision and admin-istrative system of the energy industry in China,it is important to implement the Energy Law ofthe PRC.

In recent years, China’s new energy devel-opment has accelerated. Installed wind and solarpower capacity is at a world-class level. How-ever, there are still some challenges for China toaddress, including wind and solar curtailment,destructive exploitation of geothermal energyresources, and management and operationalmechanisms for new energy development. Solv-ing these problems will largely depend onadjusting relevant policies and laws and regula-tions, and by drawing on those of other countries.

1.5 The Energy TechnologyRevolution: IT, SmartTechnologiesand the Energy Internet

The energy landscape is undergoing majorchange. This is an age where technologicalbreakthroughs are continually made in energytechnologies and the energy system undergoesgame-changing evolution. It is the age of sys-temic change, where the electricity market isincreasingly deregulated and existing businessand profitability models in the energy industryare shaken. This is the age of the Energy Internet(Internet+), where the Internet and energy areintegrated and disruptors spring up to acceleratethe game-changing process.

According to Jeremy Rifkin, a renownedAmerican trend expert, the revolutionary com-bination of communications technologies andenergy is breeding the third industrial revolution.Advanced information and communicationstechnologies like the Internet of things (IoT), bigdata and cloud computing create the EnergyInternet by reshaping energy production, trans-mission, marketing and use. The Energy Internet,with the smart grid as a carrier, is the inevitableresult of the extension of Internet developmentinto the energy and other industries. New tech-nologies like cloud computing, IoT, big data andE-commerce connect people with things andenable dispersed components like informationand the grid to be consistently managed. In thisway, grid production and management cangradually emerge from their decentralised silosinto a culture of centralised collaboration, thusimproving business, management and innova-tion. As the integrator of energy and information,the Energy Internet will drive technological andindustrial revolution and have a broad and pro-found impact.

Many governments and businesses areexploring Energy Internet projects. The USFREEDM project is building the Internet ofenergy: a network of distributed energy resources


that intelligently manages power using securecommunications and advanced power electron-ics. The German eTelligence project used Inter-net technologies to build a real-time electricitybalancing and trading system, which managesintermittent, fluctuating levels of energy outputusing load adjustment to integrate new energysources with the grid. It also provides a real-lifeexample of how energy allocation can be adjus-ted using a real-time electricity trading system.And in China, the State Grid Corporation hasinitiated the concept of the “global energyInternet”, a globally connected smart grid that isdesigned to allow clean power transmissionthrough ultra-high voltage transmission systems.

There are many other pilot projects that arefocused on achieving optimal integration of dis-tributed energy and microgrids. For instance,GCL’s distributed micro-energy grid and ENN’sUbiquitous Energy Network (UEN) are bothexamples of a complementary regionalmulti-energy Internet that works across anextended industry chain. GCL has mainlyfocused on solar photovoltaic and combined heatand power, although it also operates in naturalgas and smart energy; while ENN is mainlyfocused on fuel gas and the processing of fuel gasfor power generation and cooling and heatingservices.

For traditional power grid businesses, theEnergy Internet brings significant challenges. Inparticular, the deregulation of the distributionnetwork and the openness and sharing that areinherent in the Energy Internet will significantlyweaken these companies’ control of the grid. Theavailability of more competitive products andservices will result in high-value customersleaving traditional power grid companies; thiscan already be seen in the continual customerloss that major grid companies in other countrieshave suffered after electricity market reform.Traditional power grid enterprises therefore needto: (i) change their mindset to one of activecompetition, maintain their strength on thedemand side of the distribution network, andproactively develop integrated energy serviceslike combined cooling, heat and power; (ii) de-velop clean energy on the supply side and in

alignment with the relevant national policies; and(iii) focus on and incubate promising and com-petitive industries to rapidly connect the valuechain. In short, traditional power grid companiesneed to transform themselves and become morecompetitive in the market.

For traditional power generators and othertypes of energy company, the era of the EnergyInternet provides both opportunities and chal-lenges. Power generation companies can gradu-ally move from being behind the scenes to takecentre stage and interact directly with customers.They need, however, to diversify their businessportfolio. As demand growth for power slowsdown, power generation companies will need toadjust their business rapidly, because they are nolonger competing solely with other power gen-eration businesses, but with companies along theentire power value chain. To stay ahead in theEnergy Internet, traditional power generationcompanies will need to focus on clean and dis-tributed energy, and proactively develop inte-grated energy services that provide decisionsupport for the demand-response system. Inbrief, they should be customer-oriented and tar-get the end-user market.

For new energy companies, the EnergyInternet will bring substantial financial benefits;many of these companies have already achievedfame and wealth from it. The conservativeapproach of the traditional energy companies,which often translates into a wait and see strat-egy, means that they have yet to show up fully ascompetitors. New energy companies should,therefore, take advantage of this opportunity andcapitalise on their strengths by developingbenchmark projects and industry standards, inreadiness for a future counter-attack by theenergy majors. In short, new energy companiesshould develop a flexible approach in order toproactively guide industry trends.

For power equipment companies, the EnergyInternet undoubtedly poses higher demands onthose implementing the Made in China 2025strategy. For these companies, their top prioritiesare to address the weak integration of energy andthe Internet, and to support and drive improve-ment in power equipment manufacturing. They


should also consider collaborating with othercompanies to jointly develop solutions in theInternet of things and artificial intelligence. Inbrief, power equipment companies need tomodernise and exercise their strengths in intelli-gent manufacturing.

For Internet and IT companies, big data is animportant cornerstone of the Energy Internet. InApril 2016, the National Development andReform Commission (NDRC) issued its Guide-lines on Promoting the Development of Internet+Smart Energy. In these guidelines, the NRDCproposed developing energy big data serviceapplications and outlined the requirements for ITcompanies and for the integration and securesharing of big data, business service systems, andindustry management and supervision systems.However, Internet and IT companies need toexplore how to capture energy big data effec-tively and integrate it with other big data tomaximise data value. In short, Internet and ITcompanies need to unlock the value of energydata.

1.6 New Energy Developmentand Storage Technologies:Cheaper and BetterRenewable EnergyAccelerates the Growthof a Low-Carbon PowerSystem

According to Bloomberg New Energy Finance’sNew Energy Outlook 2017, the cost of solarpower and onshore wind power will drop by 66%and 47% respectively by 2040, and the operatingcost of renewable energy will be lower than thatof most fossil fuel power plants by 2030. As thereport indicates, the transition of global powersystems towards low-carbon energy will be fasterthan in previous predictions—the total globalcarbon emissions from power systems will peakin 2026, and by 2040 will be 4% lower than in2016. One of the report’s authors says: “Thanksto rapidly decreasing solar and wind power costsand the increasingly important role of variousbattery technologies, including electric vehicle

batteries, in balancing power supply and demand,the green power system represents an irreversibletrend across the world”. The report also pointsout that solar and wind power will dominate thefuture power system. It estimates that by 2040,72% of total global new investment in powergeneration will be in renewable energy ($7.4trillion of the $10.2 trillion total). Solar powerinvestment will be $2.8 trillion and its installedcapacity will increase by a factor of 14, and windpower investment will be $3.3 trillion and itsinstalled capacity will rise by a factor of 4. By2040, wind and solar power will account for 48%of global installed capacity and 34% of globalpower output, significantly higher than the cur-rent levels of 12% and 5% respectively.

Solar energy will pose more challenges forcoal-fired power generation. Currently, the leve-lised cost of energy of solar photovoltaic poweris only a quarter of the 2009 level and is expectedto fall by a further 66% by 2040, i.e. the solarpower that can be purchased with $1 will be 2.3times that of the current level. In Germany,Australia, the USA, Spain and Italy, the price ofsolar power is at the same level as coal power.

The cost of offshore wind power is expected todecrease faster than onshore wind power. Thanksto greater experience, intense competition, lessrisk and the substantial effects of economies ofscale in large wind farms, the cost of offshorewind power will fall sharply by 71% by 2040.The cost of onshore wind power will drop by47%, from a level that has declined by 30% overthe past eight years. This is due to lower windturbine costs, improved efficiency and morestreamlined operations and maintenance.

New and flexible energy capacity, such asbattery storage, will also facilitate the develop-ment of renewable energy. The market forlithium-ion batteries for energy storage systemsis projected to grow to at least $239 billion by2040. As a result, there will be increasinglyintense competition between utility-scale batterystorage and natural gas-fired power generation.As a report from the International RenewableEnergy Agency shows, the cost of battery storagefor some applications may fall by up to 66% by2030. Declining battery prices could also


increase the installed capacity of battery storageby a factor of 17, creating new businessopportunities.

The increasing use of electric vehicles(EVs) will raise demand for electricity as well ashelp balance the power grid. By 2040, EVs willconsume 13 and 12% of the power output inEurope and the USA respectively. Since EVs canbe charged at peak times of renewable energygeneration or when the wholesale electricityprice is low, the power system will be able toaccommodate intermittent energy sources such assolar and wind power better. The development ofEVs will drive a reduction of 73% in the cost oflithium-ion batteries by 2030. At the same time,the use of fixed power storage technologies likeEV batteries helps decarbonise energy end-useapplications.

Household photovoltaic (PV) systems willbecome increasingly popular. By 2040, the out-put from rooftop PV systems will account for 24,20, 15, 12, 5 and 5% of the total power output inAustralia, Brazil, Germany, Japan, the USA andIndia respectively. The development of largerenewable energy systems will squeeze thedemand for power generated by coal- and naturalgas-fired power plants. Even with the increasedpower demand from EVs, large fossil fuel-firedpower plants will be under pressure to maintaintheir profitability.

1.7 Accelerating Change in GlobalEnergy Governance:From OPEC and the IEAto Win-Win Cooperation

Global energy governance in the second half ofthe 20th century was epitomised by the ongoingstruggle between the Organization of PetroleumExporting Countries (OPEC), representing theinterests of oil producers, and the InternationalEnergy Agency (IEA) under the Organization forEconomic Co-operation and Development(OECD), which represents the interests of Wes-tern oil consumers.

In the 21st century, countries are increasinglyconcerned about energy security, as a result of

which global energy governance has graduallyimproved. As the most important internationalenergy organisation, the IEA has shifted from itsinitial goal of “preventing oil supply disruption”to “maintaining and improving system responseto oil supply disruptions, promoting reasonableenergy policies, strengthening cooperation withnon-IEA countries, and industrial and interna-tional organisations across the world, operating apermanent international oil market informationsystem, improving the global energy supply anddemand structure, driving forward internationalcollaborations on energy technologies throughdevelopment of alternative energy and improve-ment of energy utilisation efficiency, and helpingintegrate environmental and energy policies”. Tothis end, it has taken a series of measures:strengthening exchange and negotiations withOPEC to promote stability in the international oilmarket; developing cooperation with Russia andemerging economies such as China and Indiathrough the G7 platform; and improving energyefficiency and promoting clean energy to addressthe huge challenges of global energy develop-ment and climate change. In 2012, the IEA putforward six basic principles to build an “efficientenergy world”. These include making the eco-nomic benefits of energy efficiency more visible,so that regulation can encourage the promotionof energy-efficient technologies.

Global energy governance has developed asthe energy industry has evolved. Over 150 years,the energy industry has become a major driver ofprogress in the world and a core industry in mostmajor countries. However, as the number ofparticipants in the world energy market graduallyincreases, global energy governance has becomeever-more complicated. Despite the currentmainstream message of win-win cooperation, thediverse economic and political features of energymake global governance a difficult task in thelong term. It will take several decades for theworld’s energy consumption to shift from fossilfuels to new energy alternatives, and the globalgame that currently surrounds fossil energy pro-duction, transport and consumption will remainand even intensify while the transition takesplace. This can significantly affect international


energy cooperation. In particular, the inherentstructural conflict between energy producers andconsumers makes dialogue and collaborationbetween them difficult. However, sovereigncountries will continue to play a dominant andirreplaceable role in global energy governance,and their input and influence will be essentialwhen it comes to building a new global energygovernance system and navigating the energytechnology revolution.

1.8 Global Energy Majors AccelerateTheir Transformationinto Integrated EnergyCompanies

In recent years, as environmental problems havebecome increasingly severe, a global consensushas formed around the shift to low-carbon andclean energy. In response to the need for achange in the overall structure of energy con-sumption, all countries are increasing their policysupport for large-scale development of the newenergy sector. As a result, the installed capacityof new energy is continuously increasing, thetechnical costs are rapidly decreasing and thereturn on investment is steadily improving.

International oil majors, including BP, Shelland Total, began investing in new energy in the1990s. However, the profits that were availablefrom continuously rising international oil pricesafter 2009 meant that they reduced their newenergy investments or dropped parts of their newenergy businesses altogether. After June 2014,the international oil price plunged and then set-tled at a sustained low price. At the same time,the oil majors recognised the existential role ofclimate change and the need for oil and gascompanies to respond to societal concerns onclimate change and play their part in the transi-tion to a lower carbon world.

BP is the international oil giant with thedeepest and widest footprint in new energy. thecompany has identified biofuels as a priority inits new energy business. According to BP, by2035, the number of vehicles worldwide willgrow to 1.8 billion units, double the current level.

By then, despite the relatively sufficient avail-ability of oil, the pressure from climate changeand carbon emissions will increase, which BPsuggests can be mitigated by biofuels. With morethan 40 years of experience in hydrogen pro-duction and more than 10 years of experience inoperating hydrogen refuelling stations, BP hasbeen named the energy partner of the world’stwo largest hydrogen demonstration projects inEurope and the USA. BP and the Ministry ofScience and Technology of the People’sRepublic of China have cooperated successfullyon hydrogen energy projects, including China’sfirst hydrogen refuelling station. Wind power isone of the largest components in BP’s renewableenergy business. BP currently operates 14 windfarms in seven states of the USA, with2,200 MW of capacity.

Turning to Shell, new energy technology nowaccounts for a fifth of Shell’s annual R&D budgetand is expected to become an important growthbusiness. Raízen, a biofuels joint venture betweenShell and Cosan, has evolved into the third largestbiofuels company in Brazil, producing more than2 billion litres of bioethanol and more than 20billion litres of other industrial and transport fuelsannually. In hydrogen, Shell plans to build 390hydrogen retail sites by 2023, including 230 sitesusing Shell products. Shell has several windfarms in the USA and the Netherlands, withannual wind power output exceeding 500 MW.In 2017, Shell acquired NewMotion, whichoperates more than 30,000 eV charging stationsin western Europe. The acquisition highlightshow Shell has strong expectations that this rep-resents the future trend in vehicle energy.

In the context of lower oil prices, Total plansto invest $500 million annually in new energyand expects to increase its share of the newenergy market to 15–20% by 2035. Total’s solarenergy has been listed among the world’s topthree in terms of business size. A leading biofuelsproducer in Europe, Total began its developmentof biofuels in 1992, including the first generationof ethyl tert-butyl ether from ethanol and veg-etable oil methyl ester. Currently, Total isdeveloping the second generation of biofuels. In2011, Total paid $1.4 billion for a 66%


shareholding in SunPower, the world’s secondlargest solar panel manufacturer. SunPower madenet profits of $246 million in 2014 and became akey pillar of Total’s business performance. In2016, Total acquired Saft Groupe, a France-based battery manufacturer, for €950 million.This company ranks 15th in the world in fieldslike nickel-cadmium batteries, high-performancedisposable lithium batteries and lithium-ionsatellite batteries.

It is clear that these traditional energy titanshave had a profound influence on technologicalprogress, especially in new energy, while carry-ing out their own strategic readjustments.

2 Current Developments in China’sEnergy Industry

In 2016, China’s energy supply and demandsituation was generally improving. Structuralreform of the supply side was under rapidimplementation, and there was steady progress inrealigning the energy system. However, the tra-ditional sectors—coal, coal-fired power genera-tion, refining and chemicals—were still runningat overcapacity, and the development of cleanenergy was facing major challenges.

2.1 Slight Growth in Energy Demandand Significant Progressin Changing the EnergySystem

In 2016, China’s total energy demand was 4,360million tonnes of coal equivalent (Mtce), up1.4% (60 Mtce) on 2015. This was 2.2% lowerthan the average annual growth rate during the12th Five-Year Plan (2011–15) and 5.3% lowerthan that for the 13th Five-Year Plan (2016–20).

The first reason for this change was a sharpdecrease in China’s coal consumption, especiallyscattered coal. In 2016, China’s total coal con-sumption was 3,780 Mt, down 4.7% (185 Mt)from 2015. This was the third consecutivedecrease since 2014, and it slowed down growthin total energy consumption. Between 2011 and

2015, China’s total energy consumptionincreased by 7.4%, an annual growth rate of lessthan 1.5%. This was in sharp contrast to theaverage annual growth rate of 7.9% between2000 and 2011. China’s energy consumption perunit of GDP fell by 18.2% between 2011 and2015, exceeding the goal of the 12th Five-YearPlan (2011–15); it then declined by a further 5%in 2016. This shows that China is supportingeconomic and social development, while reduc-ing energy consumption and using less resources.Individual sectors tell a similar story: betweenJanuary and November 2016, coal consumptionin the power and steel industries decreased by0.4% and 0.6% respectively, compared to thesame period in 2015; coal consumption inbuilding materials remained at the same level as2015; coal consumption in chemicals increasedby 7.2%; and coal use in other sectors decreasedby 10.7%. Coal consumption in power, steel,building materials and chemicals represented47.9%, 16.3%, 13.8% and 7.2% respectively oftotal coal use during the same period, up 0.6, 0.1,0.3 and 0.6% from 2015, while coal consumptionin other sectors accounted for 14.9% of the total,down 1.5% from 2015. The reduction in coalconsumption in other sectors, especially of scat-tered coal, was driven mainly by the policies onair pollution control introduced in the previoustwo years. From 2016, major projects designed toreduce coal consumption, such as modernisingcoal-fired boilers and substituting waste heat andshallow geothermal energy for coal in householdheating, were developed in the Beijing-Tianjin-Hebei region to reduce coal consumption. Thescope of this pilot coal reduction and substitutionprogramme was gradually expanded to includethe Yangtze River and Pearl River deltas, as wellas Liaoning, Shandong and Henan. The scopewas also extended from power projects tonon-power projects.

The second influential factor was that China’spower consumption grew steadily and thedemand for power from service industries andhouseholds increased significantly. The NationalEnergy Administration’s data show that China’stotal power consumption was 5,920,000gigawatt-hours (GWh) in 2016, up 5% from


2015 (an increase of 282,500 GWh). Specifi-cally, the growth rate of power consumption bythe service industries and urban and ruralhouseholds was 11.2% and 10.8% respectively,far higher than the growth rate of 2.9% in man-ufacturing. The service industries and urban andrural households accounted for 56% of thecountry’s total power consumption.

The third factor was that consumption of oilproducts kept growing, though there was a cleardifference between petrol and diesel. In 2016, asChina restructured its economy and modernisedconsumption patterns, use of oil products con-tinued to rise. According to the Bureau of Eco-nomic Operations Adjustment of the NationalDevelopment Reform Commission (NDRC),China’s total consumption of oil products was289 Mt in 2016, up 5% on 2015. Specifically,petrol consumption grew by 12.3%, due to therising number of vehicles on the road. At thesame time, macroeconomic trends and industrialrestructuring led to a decline in diesel con-sumption, down 1.2% from 2015, although therewas a gradual increase in demand for industrialdiesel. Aviation fuel continued its high growthtrend, up 10.4% on the preceding year but 7%points lower than previously due to the popu-larity of high-speed rail. High consumptionlevels of oil products and significant imports ofcrude oil meant China’s apparent oil consump-tion reached 556 Mt in 2016, up 5.5% on theprevious year.

The fourth factor was that China’s natural gasconsumption picked up, though its share of totalenergy use remained low. Data from the NationalBureau of Statistics (NBS) show that China’stotal apparent natural gas consumption reached208.6 billion cubic metres in 2016, up 8 or 4.6%points on 2015 (an increase of 15.5 billion cubicmetres). However, natural gas’s share of primaryenergy consumption remained at a low 6.3, only4% higher than in the early 21st century. Drivenby a market-oriented natural gas pricing systemand new controls on air pollution, natural gas hasbegun to replace coal projects in many provinces.And on the residential side, a tiered gas pricingmechanism has been launched to encourage theshift to gas. In addition, natural gas consumption

in several major sectors has significantlyincreased. According to the NBS data, the powersector used the most natural gas in 2015; gasconsumption in the coal, gas and water produc-tion and supply sectors reached 35.27 billioncubic metres, up 30.87% on 2014 (an increase of8.106 billion cubic metres).

The fifth factor is a significant increase in theuse and share of non-fossil energy. In 2016, useof commercial non-fossil energy was around 541Mtce, accounting for 12.4% of China’s totalenergy consumption. Adding non-commercialnew energy brings the share to 13.3%, a rise of1.3% on 2015. Initial estimates show that con-sumption of primary electricity reached about1,701,000 GWh, up 11.2% (171,000 GWh) on2015. Non-fossil energy use rose by about 60Mtce, making it the largest contributor to theincrease in consumption.9

So, by taking a broad range of measures,China continued to optimise its energy system in2016. Coal’s share of energy consumptiondecreased for the third consecutive year, andnon-fossil energy was the main source of newenergy use. Coal’s share of primary energyconsumption was 62%, down 1.7% points on2015, whereas oil’s share was 18.3%, similar to2015. The share of natural gas and fossil fuels inprimary energy consumption was 6.4% and13.3% respectively, up 0.5% and 1.25% on 2015.Changes in China’s patterns of energy produc-tion and consumption over the past decade haveimpacted the relationship between supply anddemand, driving reform (Fig. 14).

2.2 Sharp Decrease in EnergyProduction and SignificantRise in Clean Energy Supply

In 2016, China’s total primary energy productionwas about 3.46 Btce, down 4.2% from 2015.Coal and crude oil production sharply decreased,

9Xiao Jianxin et al., Analysis of China’s Energy Devel-opment in 2016 and the 2017 Energy Outlook for China,in Energy of China, Issue 3, 2017.


and natural gas and primary electricity slightlyincreased.

Coal production declined sharply in 2016,with raw coal production at 3.41 Bt, down 340 Mt(9%) on the previous year. This was consistentwith the trend of declining coal consumption overthe previous three years. There was a slightincrease in the second half of the year, as somehigh-quality, safe and efficient capacity wasreleased in August and September. The StateCouncil of China announced in its Opinions onAlleviating Overcapacity in the Coal Sector toSecure Sound Development that the approval ofnew coal mines and mine modernisations to cre-ate additional capacity would be stopped fromMarch 2016. For any new coal mines that weregenuinely essential, the policy was to reduceoutdated capacity and replace it with high-qualitycapacity. Thanks to the efforts to eliminate over-capacity, excess coal capacity was reduced by290 Mt, which also helped stabilise the coal price.

There was also a clear drop in crude oil pro-duction, though refined crude oil output main-tained its growth rate. In 2016, spurred by lower

international oil prices, China’s crude oil pro-ducers further reduced inefficient production.Data from China’s NBS show that crude oilproduction was 199 Mt in 2016, down 6.9% onthe previous year. This was also the first yearsince 2010 that crude oil production was lessthan 300 Mt, with the annual decrease exceeding10 Mt for the first time. At the same time, reg-ulations around the import and use of crude oilwere relaxed. As a result, driven by high demandfrom the vehicle and aviation sectors, China’scrude oil processing capacity grew rapidly,reaching 541 Mt (up 3.6% on the previous year).In particular, crude oil processing capacity inShandong, a province with several local oilrefining companies, was 101 Mt, which madeShandong the first province to exceed 100 Mt incrude oil processing capacity. In 2016, China’sproduction of oil products stood at 345 Mt, anincrease of 2.4%.

Natural gas production, on the other hand, roseslightly, and shale gas output grew rapidly.Coalbed methane (CBM) production alsoincreased. In 2016, due to slower growth in

Fig. 14 Total energy consumption and share of various energy sources. Source National Bureau of Statistics of China(2017)


domestic natural gas demand and a significantincrease in natural gas imports, China’s produc-tion of conventional natural gas was 136.9 billioncubic metres, up slightly (1.7%) on 2015. Shalegas production maintained strong momentum,with production in 2016 reaching 7 billion cubicmetres, up 52.2% on 2015. CBM developedslowly—CBM ground extraction reached 4.5billion cubic metres, a slight increase of 1.7%, andCBM use was 4.2 billion cubic metres. Productionof coal gas was 1.6 billion cubic metres, up 14.3%on the previous year. In 2016, the production anduse of coalmine gas were 17.9 billion cubic metresand 8.8 billion cubic metres respectively, anincrease of 96 and 148% compared to 2010.

Installed power capacity continued to grow,and non-fossil energy’s share of the power mixincreased. According to data from the ChinaElectricity Council, by the end of 2016, China’sinstalled power capacity reached 1,650 gigawatts(GW). Specifically, installed capacity and outputof hydropower were 330 GW (up 3.92% on2015) and 1,174,800 gigawatt-hours (GWh) (up5.58% from 2015). The installed capacity andoutput of nuclear power were 33.64 GW (up23.83%) and 213,100 GWh (up 24.39%). Theinstalled capacity and output of grid-connectedwind power were 147.47 GW (up 12.79%) and240,900 GWh (up 29.78%). The installedcapacity and output of grid-connected solarpower were 76.31 GW (up 80.91%) and 66,500GWh (up 68.51%). The installed capacity ofnon-fossil energy, including hydro, nuclear, windand solar power accounted for 36.6% of China’stotal installed power generation, while outputfrom non-fossil energy generating units amoun-ted to 29.14% of the total. New installed capacityin 2016 reached 120 GW, including 48.36 GW ofthermal power, 19.3 GW of wind power, 34.54GW of solar power, 11.7 GW of hydropower and7.2 GW of nuclear power. Non-fossil energyaccounted for 60% of China’s total new installedpower capacity, the fourth consecutive year itexceeded 50%. This is clear evidence that Chinais continuing to optimise its power system. In2016, China’s total power output was 5,990,000GWh and the share of non-fossil energy was28.4%, up 1.5% points on 2015. The new power

output is equivalent to the 2016 output of twoThree Gorges hydropower stations.10

The breakdown of China’s primary energyproduction in 2006–15 is shown in Fig. 15. Rawcoal production gradually declined, but is still themain component in energy production. In 2015,raw coal’s share of total primary energy pro-duction reached 78.2%, while the share of otherenergy sources exceeded 10%. Natural gas pro-duction increased at an average annual growthrate of 5.27%, reaching 5.3% of total primaryenergy production in 2015. The average annualgrowth rate of primary electricity and otherenergy sources was 6.94%. The share of otherenergy sources also increased, the result of Chi-na’s changing energy system. In the future, themarket share of natural gas and renewable energysources will increase, and their production sharecould also continue to increase.

China should: (i) develop an energy supplysystem based on solar, wind, hydro, nuclear andbiomass as well as other clean energy sources,complemented by fossil energy such as coal andoil; (ii) encourage energy producers to investmore in clean energy technologies and produc-tion, give clean energy priority access to themarket, and increase the share of clean energy inthe energy supply system; and (iii) implementappropriate taxes and financial policies on fossilfuel energy production and supply, and reducethe development of existing conventional fossilenergy resources.

2.3 Energy Efficiency PoliciesGradually Take Effectand Controls on EnergyConsumption and EnergyIntensity Produce Results

Energy efficiency is a key component in buildinga greener civilisation. Energy efficiency is notjust about reducing energy use, but also aboutimproving energy productivity, sharpening

10Xiao Jianxin et al., Analysis of China’s EnergyDevelopment in 2016 and the 2017 Energy Outlook forChina, in Energy of China, Issue 3, 2017.


industrial competitiveness and creating an effi-cient and modern energy system. The measures toachieve this include reshaping patterns of pro-duction and living, restructuring the economy,optimising the industrial system, increasing theshare of clean energy, and making energy usemore efficient. Energy efficiency can pave the wayfor a green and low-carbon society and help rea-lise the centenary goals to mark the founding ofthe Communist Party of China in 2021 and thePeople’s Republic of China in 2049. Those twogoals are building a moderately prosperous soci-ety in all respects by 2021 and transforming Chinainto a modern socialist country that is prosperous,strong, democratic, culturally advanced and har-monious by 2049.

In 2016 the State Council of China issued theOverall Work Plan for Energy Conservation andEmissions Reduction for the 13th Five-Year Plan(2016–20), outlining targets for energy effi-ciency: by 2020, the energy consumption per unitof GDP should be RMB 10,000, 15% lower thanin 2015, and total energy consumption shouldremain less than 5 Btce. Moreover, the goal ofcontrolling total energy consumption and energyintensity would be delegated to the provinces. As

part of the 2016 plan, the National Developmentand Reform Commission (NDRC) and otherauthorities were entrusted by the State Council toevaluate provincial government success indelivering the energy efficiency goals of the 12thFive-Year Plan (2011–15). The provinces alsohad to define their 2016 and 2017 targets forcontrolling total energy consumption and energyintensity. In 2017, NDRC and its partnerauthorities assessed the provincial governments’progress in fulfilling those targets. Twelve min-istries and commissions, including the NDRC,the Ministry of Science and Technology, theMinistry of Industry and Information Technol-ogy and the Ministry of Finance, jointly issuedthe Action Plan for National Energy Savingduring the 13th Five-Year Plan (2016–20). Theplan defined the top 10 energy-saving measuresto achieve the targets, including deployingenergy-efficient products and promoting energysaving. The introduction of regulations on energysaving—including the Measures for EnergyConservation Supervision, the Measures for theEnergy Conservation Review of Fixed-AssetInvestment Projects, the Plan for Developingthe Energy Saving Standard System and the

Fig. 15 China’s primary energy production and share of various energy sources. Source National Bureau of Statisticsof China (2017)


Measures for the Administration of Energy Effi-ciency Labels—helped drive energy saving.

With policy support, China began to promoteenergy efficiency in key sectors. In 2016, theEnergy Efficiency Forerunner Programme,designed to make China a leader rather than afollower in energy efficiency, was extended. Inthe same year, the NDRC and the GeneralAdministration of Quality Supervision, Inspec-tion and Quarantine of the People’s Republic ofChina published the Energy Efficiency Forerun-ner Product Catalogue for household refrigera-tors, flat-panel TVs and adjustable-speed airconditioners. The NDRC provided investmentsupport to improve energy efficiency inenergy-intensive sectors, promote energy con-servation, and improve energy use in urban streetlighting, airports, stations and ports. China issuedthe Measures for the Administration of EnergyConservation in Major Energy-ConsumingEnterprises, launched the “100-1,000-10,000”energy conservation programme,11 and drove thedevelopment of an online energy consumptionmonitoring system of major energy-consumingenterprises. The Ministry of Housing andUrban-Rural Development made great progressin implementing the green building initiative.The Ministry of Transport promoted the devel-opment of a modern, integrated transport systemand established a green transport network.

Thanks to the efforts made by these stake-holders, China’s total energy consumption waseffectively controlled in 2016, and the energyconsumption per unit of GDP reduced by 5%compared to the previous year, thus exceedingthe targets for 2016. Overall, China reducedenergy consumption by 230 Mtce, equivalent toabout 500 Mt of CO2 emissions.

2.4 Fossil Fuel Energy PricesRebound and the ElectricityPrice Continues to Decline

In 2016, oversupply in the international marketslackened and China’s energy supply reformswere strengthened. As a result, the price of majorenergy sources rebounded after levelling out,though there was much variation among them.

The price of coal increased slightly in the firsthalf of 2016, rose significantly in the third quarter(Q3), then stabilised at the end of 2016. The pricerise in those six months could be seen in theBohai-Rim Steam-Coal Price Index (BSPI) for5,500 kilocalories per kg (kcal/kg) thermal coal,which reached RMB 401 per tonne at the end ofJune, RMB 30/t higher than earlier in the year.Between July and October the price rose quickly,and by the end of October exceeded RMB 600/t,RMB 236/t higher than at the start of the year. Atthe beginning of Q3, several advanced capacityprojects came into operation and dealers releasedtheir stockpiles, substantially increasing theamount of coal on the market. Between Novem-ber and December, the coal price slowly declined,RMB 14/t lower at the end of 2016 than its highpoint for the year. The coal market then stabilised.

The international oil price rose irregularlyafter hitting the bottom, and prices of oil productsin China increased correspondingly. At thebeginning of 2016, Brent and West Texas Inter-mediate (WTI) prices had plunged to $27.88 perbarrel (bbl) and $26.21/bb respectively, thelowest point of the year, after which they grad-ually picked up. By the end of 2016, Brent andWTI prices had doubled—both exceeding$50/bbl. However, due to an easing in bothsupply and demand, rebalancing was slower thanexpected. In addition, the lowering costs andimproving efficiency of US shale oil alsorestricted a rise in oil price. In 2016, of the 25adjustment cycles for oil products in China, therewere five downward adjustments, 10 upwardadjustments and 10 non-adjustments. The annualcumulative price rises of petrol and diesel wereRMB 1,015/t and RMB 975/t.

The international natural gas price remained ata low level, while that of imported natural gas

11The “i00, 1,000, 10,000” energy conservation initiativeplaces the top 100 energy-consuming enterprises in Chinaunder national regulation, the top 1,000energy-consuming enterprises under the regulation oftheir respective provincial governments, and other highenergy consuming enterprises under the regulation oflower-level governments.


significantly declined. In 2016, the gas price ininternational markets dropped—the averageannual Port Henry price, UK National BalancingPrice (NBP) and Japan Liquefied Natural GasImport price were 2.49/$ per million Britishthermal units (Mbtu), $4.64/Mbtu and $6.8/Mbturespectively, down 5%, 30% and 36% respec-tively on the previous year, and the price differ-ences between the three indexes narrowed.According to statistics from the General Admin-istration of Customs, China’s average natural gasimport price was $305/t in 2016, down 27% on2015. In particular, the average price of importedpipeline gas and imported LNG were $270/t and$343/t, 31 and 24% lower than in 2015.

The electricity price continued to decline,which helped lower the cost to the real econ-omy. In January 2016, China introduced thecoal-electricity price linkage mechanism, andlowered the feed-in tariff for coal-fired generatingunits and the retail price for general industrialand commercial use by RMB 0.03/kWh, helpingbusinesses to reduce their electricity expenditureby about RMB 22.5 billion. The feed-in tariff forrenewable energy decreased: the benchmarkfeed-in tariff for onshore wind power in Class 1,2 and 3 resource-rich areas was decreased byRMB 0.03/kWh, and in Class 4 resource-richareas by RMB 0.01/kWh. The benchmark feed-intariff for solar photovoltaic power in Class 1 and2 resource-rich areas was decreased by RMB0.1/kWh, and in Class 3 resource-rich areas byRMB 0.02/kWh. The pilot reform of powertransmission and distribution pricing passed thestrict cost supervision and review test, reducingpower transmission and distribution prices by16.3%.

2.5 Imports of Major Energy SourcesGrow Rapidly and Oiland Gas Imports Hita Record High

In the context of lower international energy pri-ces, China’s imports of coal, crude oil and nat-ural gas grew rapidly in 2016, with growth rates

exceeding 10%. As a result, China’s dependenceon oil and gas imports rapidly increased. Exportsof oil products also grew significantly.

The strong rebound in China’s coal pricestimulated a significant increase in coal imports.International coal prices, affected by trends inbulk energy commodities like oil, rose onlyslightly. Meanwhile, lower shipping prices madeimported coal more price-competitive in China’ssouth-east coastal areas. All these factors led tocoal imports increasing from May 2016 onwards,with total coal imports in 2016 reaching 256 Mt,up 25.2% from 2015, while coal exports were8.78 Mt. Net coal imports were 247 Mt, 48 Mt(24.2%) higher than in 2015.

Due to a build-up in oil reserves and changesin the regulations regarding the right to importcrude oil, China’s crude oil imports grew sharplyto 381 Mt in 2016, equal to that of the USA. Thisfigure was 45 Mt higher than in 2015, reflectingan annual growth rate of 13.6%. Driven by thissignificant growth, China’s dependence on oilimports hit a record high of 64.4, 3.9% pointshigher than in 2015.

Despite the limited growth in domesticdemand, China’s annual net exports of oil prod-ucts reached 32.55 Mt, a substantial increase of11.2 Mt compared to 2015. Exports of oil prod-ucts accounted for 10.7% of China’s total crudeoil processing capacity, and 17.9% of the totalnet oil product exports of the Asia-Pacific regionin 2016, 5.2% points higher than in 2015. Chinabecame the third largest exporter of oil productsin Asia-Pacific, after Japan and South Korea.

In 2016, due to lower international natural gasprices, rising natural gas demand in China andmany new long-term contracts, China’s naturalgas imports resumed their high growth, thoughthis came at the cost of lower production atdomestic gas fields. Data issued by the NationalBureau of Statistics of China show that naturalgas imports were about 74.5 billion cubic metresin 2016, an increase of 21.9% on the previousyear. LNG imports increased particularly shar-ply, by 11 billion cubic metres. In addition,China’s dependence on natural gas importsreached 34.2%, up 3.1% points.


2.6 Variations in Energy CompanyProfitability and Demandsthat the Petrochemicaland Power Sectors DevelopSustainably

In 2016, the diverging price trends of majorenergy sources caused business performance tovary in the different energy sectors. In particular,coal companies significantly improved theiroperating performance, while upstream oil andgas companies made losses and midstream oil andgas companies enjoyed steady profits. The prof-itability of coal-fired power plants declined andnon-fossil energy companies registered losses.

In the first half of 2016, a slight rise in thecoal price helped to improve the performance ofcoal companies. Between January and April, thecoal mining and coal washing and preparationsector reported total profits of RMB 960 million,down 92% on the same period in 2015. FromMay onwards, however, coal company profitsincreased month by month. In 2016, the cumu-lative profits of the coal mining and coal washingand preparation sector reached RMB 109.09billion, up 223.6% on 2015. In contrast, the totalprofits of the mining industry decreased by27.5% against 2015. Total profits of the coalmining and preparation sector were 60% those ofthe mining industry, significantly improving theperformance of coal companies.

The performance of oil and gas companiesvaried greatly—oil and gas exploration anddevelopment suffered losses but refining andchemicals made huge profits. According to theCNPC Economics & Technology ResearchInstitute, due to lower international oil prices, theprofits of China National Petroleum Corporation(CNPC), which has a large share of the upstreamoil and gas exploration and production business,decreased sharply by 94.34% in 2016, whileChina National Offshore Oil Corporation(CNOOC), which is also in the upstream busi-ness, suffered a huge loss of RMB 7.735 billionin the first half of 2016. Benefiting from nationallegislation on oil products, China Petroleum &Chemical Corporation (or Sinopec), which has ahigher share of the refining and chemical

businesses, reported profit growth of 11.2%. Inthe context of lower oil prices, the performanceof international and Chinese oil companies wasweaker. As a result, reducing investments andcosts and improving operational efficiency was acommon remedy for most oil companies.

In 2016, the profit margins of coal powercompanies were squeezed significantly due tolower feed-in tariffs, rising coal prices, a sharplydecreasing electricity price and lower output.According to statistics from the China ElectricityCouncil, between January and November 2016,the total profits made by the top five Chinesepower generation groups amounted to RMB 54.2billion, down 45% on the same period in 2015. Inparticular, the profits of coal power businessesdropped by 67.4%. Preliminary estimates showthat the reduction in profits in China’s coal powersector resulting from lower feed-in tariffs, risingcoal prices and lower output were RMB 110billion, RMB 7 billion and RMB 7.4 billionrespectively.

Due to difficulties connecting renewableenergy to the grid, non-fossil energy companiessuffered large losses. In 2016, the restrictions onconnecting non-fossil energy to the grid becamea severe problem—about 150,000 GWh of cleanpower was not used effectively, equivalent to areduction in turnover of RMB 60–80 billion.This undoubtedly affected the profitability ofnon-fossil energy companies. In addition, lowerrenewable energy subsidies also resulted inhigher financial losses for these businesses. Ini-tial estimates show that the gap that renewableenergy subsidies failed to cover in 2016 excee-ded RMB 60 billion.12

2.7 Coalbed Methane Is DevelopingWell, but Challenges Needto Be Addressed Urgently

On November 24, 2016, the National EnergyAdministration of China released the 13th

12Xiao Jianxin et al., Analysis of China’s EnergyDevelopment in 2016 and the 2017 Energy Outlook forChina, in Energy of China, Issue 3, 2017.


Five-Year Plan (2016–20) for Coalbed Methane(CBM) Development and Use. The 3rdFive-Year Plan (1966–70) for the CBM sector isthe guideline for China’s exploration and use ofCBM during the 13th Five-Year Plan. The 13thFive-Year Plan is the decisive stage in building amoderately prosperous society in all respects anda critical period for adjusting the energy systemtowards diversified energy supply and cleanenergy. The CBM sector faces both opportunitiesand challenges, but the opportunities tend tooutweigh the challenges.

On the one hand, the external environment isgenerally favourable. China has implemented thenecessary energy supply structural reforms to:(i) increase the share of non-fossil energy andnatural gas in total energy production anddemand; (ii) raise the share of natural gas in totalprimary energy demand to 10%; and (iii) en-courage the development of CBM. China hasalso implemented an innovation strategy andaccelerated the local development of criticaltechnologies and equipment. As a result, thetechnological bottlenecks constraining CBMdevelopment are expected to disappear. As Chinaintroduces increasingly strict requirements forsafety in coal mines, the safe extraction of coal-mine gas is a fundamental means to prevent gasexplosions. China has made a solemn commit-ment to the international community to decreaseCO2 emissions per unit of GDP by 40–45% by2020, and that CO2 emissions will peak around2030. These factors bring a hard-won opportu-nity for the rapid development of the CBMsector.

On the other hand, the sector still has somechallenges that need to be addressed urgently.CBM is still in its infancy. The size of the marketis small and competition is weak. In recent years,the price of CBM has dropped significantly dueto the adjustment of natural gas prices, whichoffsets the positive effects of subsidies. More-over, gradually rising production costs andslowing investment in CBM exploration anddevelopment have created a large gap betweenthe production and use of CBM. In some regions,CBM does not have open and fair access tonatural gas pipelines, and the transmission and

distribution facilities of some CBM projects areinadequate. The large number of potentiallydangerous mines in China increases the difficultyof extracting gas. In addition, the gas extractedfrom coal mines is of low concentration and verydifficult to use. China therefore needs to makevigorous efforts to address these challenges dur-ing the 13th Five-Year Plan (2016–20).

2.8 Steadily Promote EnergyDevelopment in the Beltand Road Initiative

In September and October 2013, during his visitsto Kazakhstan and Indonesia, President Xi Jin-ping proposed building the Silk Road EconomicBelt and the 21st Century Maritime Silk Road,which together form the Belt and Road Initiative(BRI).

Energy cooperation is an important part of theBRI, which connects energy consumption mar-kets in Europe and Asia with major energyexporters in the Middle East, Central Asia andRussia. The BRI covers two high-quality fossilenergy-rich regions—Russia-Central Asia andthe Persian or Arabian Gulf—as well as WesternEurope, which has advanced energy technologiesand widely deployed green energy. Building theBRI with other countries can promote stability inthe energy market in Eurasia and drive the tran-sition to green energy.

In March 2016, the Outline of the 13thFive-Year Plan (2016–20) for the National Eco-nomic and Social Development of the People’sRepublic of China was published. The BRI wasincluded in the Five-Year Plan because it is animportant means to coordinate regional devel-opment in China and it opens up and activelyinvolves China in global governance.

The 13th Five-Year Plan (2016–20) for theDevelopment of the Energy Industry states thatChina will: (i) take the domestic and the inter-national markets into consideration and use allavailable resources to implement its energycooperation strategy; (ii) seize the major oppor-tunities of the BRI to interconnect energyinfrastructure, expand international cooperation


on capacity sharing and actively participate inglobal energy governance; (iii) speed up thedevelopment of energy cooperation projects tointerconnect energy infrastructure in BRI coun-tries and regions; and (iv) conduct research oncross-border transmission systems and collabo-rate on power grid modernisation.

The 13th Five-Year Plan (2016–20) for theDevelopment of the Power Sector states thatChina will: (i) use all available domestic andinternational resources to promote internationalcooperation on power system equipment, tech-nologies, standards and engineering services; and(ii) drive the building of interconnected powergrids and encourage Chinese power companies toparticipate in the construction and operation ofoverseas power projects.

The 13th Five-Year Plan (2016–20) for theDevelopment of the Coal Sector states that Chinawill: (i) strengthen international cooperation oncoal to sharpen the competitiveness of China’scoal sector; (ii) steadily develop internationalcoal trading to promote the development and useof overseas coal resources and expand overseasengineering, procurement and construction pro-jects and technical services; and (iii) promoteinternational win-win cooperation on coalcapacity to develop overseas coal resources,build support infrastructure and invest inupstream and downstream coal businesses.

The 13th Five-Year Plan (2016–20) for theDevelopment of the Oil Sector states that Chinawill: (i) improve the quality and benefits ofinternational cooperation on oil; (ii) optimise thepace of investment and asset portfolio; diversifyoverseas investments, investors and modes ofcooperation; and integrate energy and finance—thus boosting the Going Global strategy of Chi-nese oil enterprises; (iii) optimise and promoteoil and gas cooperation with Russia, the MiddleEast, Africa, the Americas and Asia-Pacific; and(iv) collaborate on building interconnectedinfrastructure in BRI countries.

The 13th Five-Year Plan (2016–20) for theDevelopment of the Natural Gas Sector statesthat China will: (i) implement the BRI andstrengthen cooperation with natural gas produc-ers to develop a diversified supply system and

safeguard natural gas supply security; (ii) estab-lish a multi-level coordination regime to ensuresupply security and safety with countries withcross-border natural gas pipelines; and (iii) co-operate with natural gas consumers in North-eastAsia to create a regional natural gas market andimprove China’s right to speak on natural gaspricing.

The 13th Five-Year Plan (2016–20) for theDevelopment of the Renewable Energy Sectorstates that China will: (i) develop the renewableenergy value chain to sharpen the internationalcompetitiveness of China’s renewable energysector and play an active role in driving theglobal energy transition; and (ii) combine thedevelopment plans and construction demands ofBRI countries to deliver signature collaborativeprojects in a timely fashion, thus encouraging ajoint Going Global strategy for renewable energyconsulting, design, contracting, equipment sup-ply and operating companies.

2.9 Strongly Promote Energy Reform

2.9.1 Supply-Side Structural Reformof the Coal Sector Will CutOvercapacity

China has introduced policies to identify themeasures necessary to cut overcapacity in thecoal sector. In early February 2016, the StateCouncil of China issued Document No. 7, whichset the goal of shutting down surplus coal pro-duction facilities. Between March and July theauthorities introduced eight policies to identifythe support measures needed to reposition sur-plus workers, administer funds for bonuses andsubsidies, manage land and mines for newcapacity, and set environmental constraints.Despite the sharp slowdown in demand for coal,China’s coal sector still has strong marketpotential in the medium and long terms,according to the Research Report on Overca-pacity Cutting and Development Strategies inChina’s Coal Sector, 2017–21. The coal sectorshould, therefore, grasp the opportunities toimplement structural reform of coal supply, seekpolicy support, shut down outdated capacity and


cut overcapacity, thereby transforming andmodernising the industry.

China has made major progress in shuttingdown coal production facilities. With the help ofsupport policies, China has placed strict controlson unsafe production, overcapacity and the ille-gal construction of mines, and has introducedreward and subsidy measures. As a result, 290Mt of cumulative coal capacity was cut in 2016,which is almost 60% of the overcapacity sched-uled for removal during the 13th Five-Year Plan(2016–20). As stated in the Report on the Workof the Government published in March 2017,China will also shut down at least 150 Mt of coalproduction facilities and reduce steel productioncapacity by around 50 Mt. At the same time,China will suspend or cancel 50 GW of coal-firedpower generation capacity.

China made limited progress in 2016 inrestructuring the coal industry and reducingproduction capacity. The main reasons for thisare: (i) the companies to be merged had greatdifficulty guaranteeing re-employment for work-ers; and (ii) companies to be restructured lackedfunds in the first half of 2016; when those fundswere made available in the second half of theyear they were considerably lower than expected,which slowed down the restructuring process.

Reducing overproduction is an important partof the goal of “cutting overcapacity, reducingexcess inventory, deleveraging, lowering costsand strengthening areas of weakness” in order tostructurally reform the coal industry. In accor-dance with the decisions of the Central Com-mittee of the Communist Party of China and theState Council, China’s coal sector made furtherefforts to reform the industry and cut overca-pacity. Various measures were taken, includingrestricting new capacity, shutting down outdatedproduction facilities and excess capacity in anorderly manner, controlling illegal mine con-struction and expansion, and reducing produc-tion. As a result, coal production declined,reducing oversupply to some extent.

From July 2016, as the excess coal inventorylessened and coal demand grew, the coal pricerose rapidly and some regions faced shortages.

The reasons for the shortages were several. Theyinclude rising thermal power output, increasedstorage of coal for winter, better control ofover-the-limit road transport and adjustments tothe railway network, reduced overcapacity, pro-duction controls and curtailing illegal production.However, it should be noted that coal demanddid not increase sharply: coal consumption in thefirst 11 months of the year declined by 1.6%against the previous year. There are still manycoal mines that are a safety risk or close toresource depletion, use outdated technologiesand equipment, do not conform with safe pro-duction conditions and coal industry policies, orhave a production capacity of less than 300,000tonnes per year, all of which make cutting coalovercapacity a challenge.

2.9.2 Electricity System ReformMeasures Are in Placeand Making SignificantProgress

A multi-level pilot project was rolled out acrossChina in 2016 (excluding Xizang). Twenty-oneprovinces implemented a pilot scheme for com-prehensive electricity system reform, nine pro-vinces and the Xinjiang Production andConstruction Corps launched a pilot system toreform power retailing, and three provincespiloted grid connections for renewable energy.

The power transmission and distribution pricereforms covered provincial power grids. In 2016,China introduced the Measures on Supervisionand Review of Power Transmission and Distri-bution Prices with the aim of identifying andreducing unneeded assets and unreasonable costsin grid companies and establishing an incentiveand restraint mechanism. In addition, China dis-closed the power transmission and distributionprices of 12 provincial grids; the average his-torical grid cost reduction ratio stood at 16.3%.Power generation and power consumptionunderwent orderly deregulation. The formationof electricity trading institutions was basicallycompleted in 2016. It involved creating amedium-to-long-term electricity trading mecha-nism in 28 provinces to pilot cross-provincial


trading, along with arrangements for direct trad-ing between power users and power generationcompanies. In 2016, the amount of electricitytraded exceeded 1 million GWh, accounting forabout 19% of China’s total power consumption.

In addition, China established an access andexiting mechanism for market participants and anew regulatory system, developed a pilot reformscheme for power distribution services, andincluded coal-fired backup power plants withinthe scope of the regulations.

2.9.3 Oil Sector Reform Features“ComprehensivePromotion, MajorBreakthroughs and PriorityTrials”

First, a pilot programme was launched to reformthe management of oil and gas mining rights. In2015, Xinjiang piloted open bidding for theexploration of conventional oil and gas blocks.And in October 2016, Xinjiang was identified asthe pilot province for comprehensive energyreform, with the focus on deregulating marketaccess to the oil and gas sector.

Second, the reforms deregulating the right touse imported crude oil and the right to importcrude oil took effect. In 2016, an increasingnumber of non-state enterprises were awarded thenecessary permits to import and use crude oil, andthe quota for imported crude oil was increasedsignificantly. To address issues like quota resel-ling, China implemented new allocation princi-ples, along with various other adjustments and astrict assessment regime. This effectively guar-anteed the fair allocation of imported crude oiland maintained sound market development.

Third, overcapacity cutting policies wereextended to the refining and chemical sectors toimprove oil product quality. In 2016, Chinaintroduced several policies—including theGuidelines on Adjusting the Structure, Promot-ing the Transformation and Increasing the Profitsof the Petrochemical Industry; and the Develop-ment Plan for the Petrochemical and Chemical

Industries, 2016–20—to solve the problem ofproduction overcapacity in refining and chemi-cals. Tax incentives were also introduced toincrease oil product exports and reduce domesticoutput of oil products. In addition, oil productquality was further improved—in 2016, 11 pro-vinces in east China supplied China V petrol anddiesel; this was extended across China in 2017.

Fourth, the oil product pricing system wasimproved to reflect market developments. In2016, in the context of sharply falling interna-tional crude oil prices and various difficultiesaffecting domestic oil and gas production, Chinaadjusted the oil product pricing system andlowered the limit for oil product price regulation.This will mitigate risks that may arise from anyfuture increase in oil product prices.

Fifth, China accelerated the reform ofstate-owned oil enterprises and encouraged theparticipation of private capital. In 2016, CNPCrestructured its engineering and constructionbusinesses, Sinopec restructured its regional oilengineering services, and CNOOC integrated itsrefining and chemical companies. In addition,state-owned oil enterprises allowed private cap-ital to become stakeholders, thereby creatingmixed ownership businesses. A case in point isSinopec, which sold a 50% stake in Sichuan-to-East China Gas Pipeline Co., Ltd.

2.9.4 The Natural Gas Sector IsReformed and AchievesRemarkable Success

First, there was progress in reforming natural gaspricing into a market-oriented system. In 2015,China delivered the goals of the three-step tran-sition in natural gas pricing reform. In 2016,China took natural gas pricing reform even fur-ther by identifying pricing policies for gas stor-age facilities, promoting market-oriented naturalgas pricing for chemical fertilisers, and bypiloting reform of the city-gate gas price inFujian. The price of non-residential gas, whichaccounts for more than 80% of China’s totalnatural gas consumption, was almost all


negotiated between the supply and demand par-ties, apart from a small amount of residential gasnecessary to maintain people’s living standards.The market-oriented pricing system drove downthe price of natural gas, reducing the cost of gasuse for companies.

Second, regulation of the natural gas trans-mission tariff and distribution fee has been stea-dily strengthened. Following the principle of“deregulating gas sources and retailing, andcontrolling gas transmission and distribution”,China introduced several policies to regulatenatural gas transmission and distribution. Theseincluded measures for administering the gaspipeline transmission tariff and for supervisingand reviewing pricing costs, which required thecross-provincial gas pipeline operating compa-nies to establish independent accounting pro-cesses before June 1, 2017. China also effectedmeasures for the supervision and administrationof local gas transmission tariffs and distributionfees, requiring all provinces to introduce thenecessary support policies to reduce end-use gasprices.

2.9.5 Policies to Promotethe Developmentof Renewable Energy AreIntroducedand an Assessment SystemIs Developed

First, in 2016, a guiding framework for renew-able energy development and use was intro-duced. China quantified the share of non-fossilenergy for the first time and clearly defined therequirements to develop, connect and measurerenewable energy in all provinces.

Second, a system was developed to guaranteethe purchase of wind and solar power. In 2016,China issued the Measures to Guarantee thePurchase of Electricity Generated by RenewableEnergy and made public the volume of wind andsolar power purchased in all provinces. This wasan important institutional change to help reformthe legal and power systems, and a significantstarting point to guarantee grid connection of

renewable energy and ensure market access fornew energy in the future.

Third, the green certificate and trading systemfor renewable energy was formed. The greencertificate is an evidence-based means for eval-uating how well power supply companies aredelivering their planned share of non-hydrorenewable energy. As electricity system reformcontinues and a carbon trading system is devel-oped, market conditions for the green certificateand trading system will gradually improve, andthe green certificate will become a channel tosecure new funding for renewable energyprojects.

2.9.6 Reform of State-Owned EnergyEnterprises Accelerates

First, China has developed the “1+N” policy. “1”refers to the Guidelines on Deepening Reform ofState-owned Enterprises (2016). Specifically, 10pilot reform projects were implemented inaccordance with the Guidelines and led by theState-owned Enterprise Reform Steering Groupunder the State Council. “N” stands for thesupport pillars, which include the development ofa mixed ownership economy, improvement ofthe state-owned asset management system,supervision of state-owned assets to prevent theirerosion, development of a robust legal system,introduction of equity and dividend incentives,separation of social responsibilities previouslyundertaken by state-owned enterprises (SOE),supervision and management of state-ownedasset transactions, SOE restructuring, illegaloperations, investment accountability, employeestock ownership pilot projects, and so on.

Second, China is improving corporate gover-nance by forming pilot boards of directors. Thescope of the pilot includes China Baowu SteelGroup, State Development & Investment Cor-poration (SDIC) and China General NuclearPower Corporation (CGN). A system forrecruiting managers and professional executiveswill be piloted at centrally run enterprises andtheir subsidiaries, including SDIC and ChinaRailway Signal & Communication (CRSC).


These pilots will be extended to include eightother SOEs—China Shenhua, Baowu, ChinaMinmetals Corporation (CMC), China Mer-chants Group (CMG), China CommunicationsConstruction Company Limited (CCCC), ChinaPoly Group, China Cheng Tong and ChinaReform Holdings Corporation Limited.

Third, China is using mergers and acquisitionsto integrate enterprises. In May 2015, withapproval from the State Council, China PowerInvestment Corporation (CPIC) and StateNuclear Power Technology Corporation mergedto form State Power Investment Corporation(SPIC), with assets of more than RMB 700 bil-lion and annual operating revenues of aroundRMB 200 billion. SPIC broke the monopoly innuclear power of China National Nuclear Cor-poration (CNNC) and China General NuclearPower Group (CGN) and made SPIC one of thecountry’s top-three nuclear power groups, inte-grating upstream and downstream businesses. Inthe future, SPIC plans an initial public offering,with the ambition to become China’s largestnuclear power group.

3 The Current Energy Systemand Existing Problems

3.1 Energy Legislation System

3.1.1 Current DevelopmentsChina’s legal framework for the energy systemhas started to take shape, providing the legalbasis and guarantees for energy development andgovernment administration. Energy lawenforcement is an important part of China’senergy administration. However, legal supervi-sion and compliance remain in their early stages.

(1) The energy law framework is taking shape

China’s energy legislation is complex in structureand scattered in content. It is a mixture of old andnew laws and regulations.

The elements of China’s energy legislationsystem comprise laws, administrative regula-tions, departmental regulations, mandatory

standards and specifications, local laws and reg-ulations, and international conventions. Thelegislative hierarchy consists of national institu-tions and the State Council, below which aredepartments, local institutions with legislativepowers, and local government.

The participants involved in the energy sys-tem include producers, traders, consumers, gov-ernment at all levels and other energy marketentities. The provisions regarding the rights andresponsibilities of energy market participants arescattered across different energy laws andregulations.

China’s energy legislation system coversexploration and production, processing andconversion, distribution, transport and use. Thesystem is an integral part of the much largerambition to build an ecological civilisation androbust legal system. Provisions relating todownstream energy are linked to environmentalprotection and combating climate change.

(2) Energy law enforcement has become animportant part of energy administration

Energy law enforcement is an important part ofChina’s energy administration.

The main energy law enforcement entitiesinclude national and local authorities for devel-opment and reform (pricing), land and resources,environmental protection and safety. Depart-ments and administrative bodies relating tocommerce, customs and quality supervision alsoplay a role.

Enforcement mainly takes the form of tradi-tional law enforcement and administrativemethods like supervision. Central government isgenerally better than local government atenforcement. The number of enforcement agentsnecessary to cover a sector as large as energymakes it difficult to find good-quality personnelwho satisfy professional requirements.

Results are typically related to capability.Because the basis for enforcement is sometimesunclear, it can be difficult to enforce legislationeffectively over national energy infrastructure.Enforcement by local government often meetsintervention from other parties.


(3) Legal supervision and compliance in theenergy sector is still at an early stage

The development of a judicial system for energylaw is just beginning. Due to the long-standingpattern of administrative enforcement, energycases resolved by the judicial system are rare,and the final decision tends to be one of admin-istrative action.

Energy law compliance currently relies moreon self-discipline. The development of a systemrequiring compliance with energy law is still atan early stage and the existing self-governingindustry organisations continue to play animportant role.

Legal supervision is still in its infancy. Theactivities of non-governmental organisations playa role, but the development of a consistent legalsupervisory system still has a long way to go.

3.1.2 Analysis of Existing ProblemsIn general, the inconsistency and lack of coor-dination in China’s energy law and regulatorysystem need to be addressed. Problems such asdependency on administrative enforcement, alack of judicial practices, inadequate punishmentand slack law enforcement exist. In addition,poor coordination between the energy legislationsystem and energy reform is set to become amajor barrier to China’s energy revolution.

(1) Current problems in China’s energy lawand regulatory system

The fact that a fundamental energy law andspecific laws for key energy sectors have beenlacking for a long time has impeded the sus-tainable development of China’s energy industry.The Energy Law of the People’s Republic ofChina (PRC) should be the foundation of theenergy industry and the bedrock of the entireenergy legislative system. Currently, however,the Energy Law of the PRC is in draft form only.

At the same time, the long absence of laws inkey energy sectors has resulted in ineffectivenon-law-based regulation of construction, man-agement and operations. Currently, there are nospecific laws for the oil and gas sectors, or for

energy utilities and energy product marketingand services.

Some regulations still bear the hallmarks of aplanned economy, and others are poorly adaptedto the needs of a market economy. For example,the Electric Power Law of the PRC lacks rulesfor electricity trading, power generation mecha-nisms and power system development. The CoalIndustry Law of the PRC has many provisionsthat are ill-adapted to the current state of the coalsector, and which need to be amended andimproved as soon as possible. In addition, Chi-na’s energy laws and regulations are excessivelybased on principles and can be impractical. Manyenergy laws and regulations do not have thenecessary support regulations for implementa-tion. Their impracticality is due mainly to lack ofclarity on rights and responsibilities. It is, there-fore, necessary to define the rights and respon-sibilities of government and market participantsin each part of the energy value chain. In addi-tion, there are departmental regulations that areclearly intended to suit the interests of thedepartment or authority concerned.

The provisions regarding specific services inChina’s energy industry are scattered amongdifferent laws and administrative, local anddepartmental regulations. As such, their effec-tiveness varies. In the absence of consistentguidelines, differences between the laws andregulations of different jurisdictions createinconsistencies in regulating the same energyservices.

(2) Energy law enforcement is decentralisedand relies on administrative processes

Constrained by the energy legislation andadministrative system, China’s energy lawenforcement relies strongly on administrativeprocesses. Even in those areas of energy lawinstituted since China’s reform and opening-up,only rarely are energy issues resolved throughjudicial channels. Energy issues with a clear lawenforcement basis and defined rights andresponsibilities are mainly resolved throughenergy regulation (see below). Some policy goalsare realised through administrative enforcement,


for example by shutting down overcapacity, andthese actions tend to be taken by local govern-ment. Technically speaking, these measures donot have a legal basis; their main purpose is toimplement government policy.

China’s energy law enforcement is decen-tralised and spread among different levels ofgovernment and departments. Enforcement ismainly the responsibility of the authority forenergy policymaking, regulation and adminis-tration. The right to enforce energy law relatingto the economy is decentralised to the NationalDevelopment and Reform Commission and theNational Energy Administration; and the right toenforce energy law with regard to society is withthe Ministry of Environmental Protection, as wellas those authorities responsible for quality andsafe production. The enforcement of energy lawalso involves the relevant agencies of localgovernment. China’s energy and environmentallaw enforcement are separate, especially in theupstream and midstream energy sectors.

China lacks personnel and expertise in itsenergy law enforcement force, especially atgrassroots-level energy administration, whereenforcement teams are often too small and lackprofessionalism and independence. This resultsin incomplete or slack enforcement, no deter-rence for severe violations or only minor penal-ties for infringements, rules and regulations thatare ignored, and an absence of regulation ofenforcement institutions.

Energy law enforcement is not carried out ona regular basis, and there is a severe lack ofenforcement while activities are taking place.Instead, China’s energy law enforcement is lim-ited to unannounced or scheduled inspectionsand the post hoc results of energy activities.

At the same time, punishments for activitiesthat break the energy laws are inadequate. Chi-na’s energy law enforcement focuses more oncorrecting behaviour, and the punishments forviolations tend to be light. In the economicenforcement field, the penalty for violating faircompetition is far less than the illegal profits that

may have been made. In the social enforcementfield, the excessively light punishments fornon-compliant emissions are far lower than thecost of controlling those emissions.

(3) Poor coordination between the energylegislation system and energy reform

The slow development of energy legislation hashindered energy system reform. Some of China’skey energy laws were developed in the earlyyears and not amended for a long time, so theyare poorly adapted to the requirements of modernenergy development. Held back by the con-straints of these energy laws, reform at differentlevels of the energy industry has achieved onlylimited improvement of the energy system.Despite local successes, the ideal situation, inwhich energy legislation is aligned with energyreform, has not been realised, and so the reformshave had no effective legal basis.

The values underlying some energy laws arenot aligned with the direction of energy systemreform. From the market’s perspective, some ofChina’s existing energy laws were based on aguiding principle of “meeting demand with suf-ficient supply”, and this clear supply-orientedbias makes the laws increasingly ill-suited formarket-oriented energy supply and demand.From the government’s perspective, the existingenergy laws and regulations are unclear regard-ing the roles, rights and responsibilities of thegovernment, and contain only very limiteddescriptions of the relationship between thegovernment’s functions (including planning,supervision and regulation) and the market.

The lack of clear definitions of rights andresponsibilities in the energy laws results inenergy system reforms lacking a legal basis.Specifically, government bodies in the energysector do not have clear powers that they can useto act, and energy market participants do not haveclear descriptions of their rights and responsibil-ities. These gaps stifle effective planning, opera-tion and regulation in these natural monopolies.


3.2 The Energy AdministrationSystem

3.2.1 Current DevelopmentsIn general, China’s energy administration systemhas become relatively centralised in the upstreamand midstream sectors, with coordinated admin-istration now a regular practice. Energy regula-tion and policies are becoming increasinglyimportant, although it is still difficult to distin-guish between regulation and intervention.Energy planning is gradually transitioning to amarket-oriented system from a planned economyapproach. Energy strategies are increasinglyvalued and the energy reserve system is under-going improvement.

(1) Centralisation of upstream and midstreamenergy administration

Gradually, China’s energy administration hasshifted from a decentralised to a relatively cen-tralised format.

The National Energy Administration (NEA) isChina’s most important energy administrationbody. As a national vice-ministerial organisationunder the National Development and ReformCommission (NDRC), the NEA oversees suchkey energy sectors as power, coal, oil, naturalgas, nuclear power and renewable energy. Itsmain responsibilities include: (i) preparing draftsof energy-related laws and regulations, formu-lating and implementing energy developmentstrategies, plans and policies, promoting anddrafting energy system reform, and coordinatingmajor issues in energy development and reform;(ii) engaging the relevant personnel to developenergy industry policies and related standards,and approving fixed-asset investment projects inthe energy industry; (iii) guiding and promotingtechnological progress in the energy sector;(iv) managing nuclear power development,including the development and implementationof plans and standards, carrying out nuclearpower-related R&D and organising emergencymanagement of nuclear power plants; (v) takingcharge of energy conservation and ensuring

comprehensive resource use in the energyindustry; (vi) conducting energy forecasting,releasing information and participating in oper-ational coordination and emergency preparations;(vii) supervising and regulating the power mar-ket; (viii) licencing, supervising and managingpower production safety, reliability and emer-gency response; (ix) taking the lead in promotinginternational energy cooperation, and reviewingor approving major overseas energy investmentprojects; and (x) participating in energy policy-making in areas such as resources, finance andtaxation, environmental protection, climatechange, and making recommendations on energypricing and imports and exports.

The NEA has 12 departments and employs240 executive staff, including 42 leaders.The NEA departments and their main responsi-bilities are listed in Table 3. The NEA’s internalorganisational integration involves two majorchanges.

First, Market Supervision and Electric PowerSafety have become two new departments.Electric Power Safety covers the responsibilitiesof the former State Electricity Regulatory Com-mission (SERC), and Market Supervisionexpands the responsibilities of Electric PowerSafety to include new energy, coal and oil andgas, as well as promoting market-oriented energydevelopment. Thanks to the responsibilitiesadded by the new Market Supervision depart-ment, the NEA will gradually play a dominantrole in energy system reform and the formationof an energy market.

Second, the former Policies and Regulationsfunctions of the NEA and SERC have beencombined to form Legal and InstitutionalReform, which is mainly responsible for researchon major issues in energy law, regulations,supervision and institutional reform.

China’s local energy administration systemcomprises two levels—six regional energybureaus and 12 local energy offices. However, asthe local energy administration system wasformed by merging the electricity regulatoryagencies under the former SERC into the NEA,the main responsibility of China’s regional


Table 3 NEA internal organisation

Name Main responsibilities

General Office Administrative affairs; disclosure of government affairs; security and confidentiality;petitions; energy statistics; forecasts and early warning; coordination of the NationalEnergy Commission Office

Legal and InstitutionalReform

Research on major energy issues; drafting laws and regulations on the development,supervision and management of energy system reform; reviewing the legality ofdocuments; supervising enforcement, reviews and litigation; work related to energysystem reform

Development Planning Carrying out research and making proposals on energy development strategy;creating energy development plans, annual plans and industry policies; participatingin research on controlling China’s total energy consumption; guiding andsupervising work related to controlling China’s total energy consumption; andcomprehensive energy services

Conservation and ScientificEquipment

Providing guidance on energy conservation and the use of resources by the energyindustry; work related to technological progress and equipment; developing energyindustry standards (excluding coal)

Electric Power Developing and implementing plans and policies on thermal generation and powergrids; electricity system reform; coordinating and balancing power supply anddemand.

Nuclear Power Preparing and implementing nuclear power development plans and policies;emergency management of nuclear power plants

Coal Developing and implementing plans and policies on coal development, coalbedmethane (CBM) and the conversion of coal into clean energy products; work relatedto the reform of the coal sector; managing stakeholders in CBM development;shutting down outdated coal production facilities; the management and use of CBM

Oil and Gas Developing and implementing plans and policies on oil and gas development andrefining; work related to the reform of the oil and gas sector; management of nationaloil and gas reserves; supervision and management of commercial oil and gasreserves

New and RenewableEnergy

Providing guidance for and coordination of new, renewable and rural energydevelopment; developing and implementing plans and policies for new energy,hydropower, biomass energy and other renewable energy sources

Market Supervision Preparing plans for power market development and regional power markets;regulating the power market and power distribution, supply and non-competitivepower generation services; handling disputes in the power market; conductingresearch and providing proposals on electricity tariffs; supervising and reviewing theelectricity tariff criteria for ancillary services; recommending policies on universalpower services and supervising their implementation; and regulating fair access tooil and gas pipeline facilities

Electric Power Safety Developing policies on the safety of non-nuclear power plants, the construction ofpower system projects and supervising project quality and safety; supervising andmanaging power safety and production, reliability and emergency response;supervising and managing the safety of hydropower dams; investigating andhandling accidents in power production and engaging the participation of relevantstakeholders

International Cooperation Promoting international energy exchange and cooperation; conducting negotiationsand signing agreements with foreign energy authorities and the International EnergyAgency; developing energy opening-up strategies, plans and policies; coordinatingoverseas energy development and use

Party Committee (HR) Personnel and organisational management, team building, discipline and supervisorywork in the NEA and regional energy administrations directly under it; party work inthe NEA and the Beijing-based organisation directly under it


energy bureaus and local energy offices is stillregulating the power sector.

The NDRC and the State Council are respon-sible for the approval of major energy projects(including infrastructure); and the NDRC, underthe control of the central government, is respon-sible for energy pricing (mainly in the upstreamand midstream sectors) and its supervision andmanagement. The development and reformdepartment under local government is responsiblefor the approval of local energy projects, and thelocal development and reform (pricing) depart-ment is responsible for local energy pricing(mainly with regard to downstream use).

Some government administration functionsrelated to energy have been assigned to otherdepartments. For example, the Ministry of Landand Resources administers the mining rights foroil, natural gas and natural uranium; the centraland local land and resources authorities admin-ister the coal mining rights under their

jurisdiction; the State Administration of CoalMine Safety is responsible for safety in coalexploration and development, and the StateAdministration of Work Safety is responsible forsafety in conventional energy production; andcustoms authorities administer energy importsand exports. In addition, the State-owned AssetsSupervision and Administration Commission(SASAC) invests in large state-owned energyenterprises.

Coordinated administration has become nor-mal practice. Some major energy policies arejointly released by the NDRC and NEA. Basi-cally, the NEA can coordinate the administrationof all energy sources, except nuclear power andcoal, which have special requirements for safety.To undertake overall administration of China’senergy system, the NEA must coordinate withthe NDRC and local government, and effectivelyperform its governmental functions of planning,regulation and supervision (Table 4).

Table 4 China’s energy administration institutions and their responsibilities (2014)

Institution Responsibilities

National Energy Commission (NEC) National energy development strategies and major issues and activities

National Development and ReformCommission (NDRC)

Overall plans, addressing climate change, and statistics; energy conservation, cleanenergy development mechanism, development and use of new and renewableenergy, and demonstration and promotion of energy conservation and emissionsreduction

National Energy Administration(NEA)

Information, strategies, plans, strategic reserves, emergency management of nuclearaccidents, institutional reform and international cooperation; energy equipment andtechnology, energy industry events

The Ministry of Land and Resources Resource management (mining rights)

The Ministry of Water Resources Rural hydropower strategy, plans, institutional reform, international cooperationand information; small hydropower projects, rural power grids and technologies

The Ministry of Industry andInformation Technology

Emergency management of nuclear accidents, nuclear industrial planning andinternational cooperation; nuclear research, major technologies and equipment,energy conservation and emissions reduction; fuel efficiency of motor vehicles anddevelopment of new energy vehicles

The Ministry of Science andTechnology

Technical research, research on basic science; development and implementation ofscience and technology plans, and promotion of oil and gas pipeline technologyadvances

The Ministry of Finance Fuel tax, and financial and tax policies related to renewable energy development,gas use and energy-efficient products

The Ministry of Construction Energy-efficient buildings and urban sewage and biogas

The Ministry of Agriculture Promotion of biogas, biomass energy and solar energy

The Ministry of Transport Planning and implementation of green transport

The Ministry of EnvironmentalProtection

Control of emissions from energy-consuming machines and tools, and pollution


(2) Energy regulation and policies play anincreasingly important role

Government regulation and policies are playingan increasingly important role. The governmenthas promoted a shift in energy production by:(i) introducing an assessment system for energyconservation and emissions reduction; (ii) re-straining total energy consumption by shuttingdown outdated production facilities and cuttingovercapacity; and (iii) stimulating the develop-ment of new and clean energy with tax incen-tives. Although these are all government-ledmandatory policies, they have delivered gen-uinely strong results to date. The ability of gov-ernment regulations and policies to incentivise ordisincentivise the energy industry is critical to theefforts to create an ecological civilisation andpromote sustainable energy development.

However, government is still intervening inmarket access. The government has imposedselective control of the energy sector and setmany access thresholds in terms of investmentscale, site choice, equipment level and productsourcing for energy development projects. Com-pared with large enterprises and foreign-ownedcompanies, small and medium-sized enterprisesand domestic companies are faced with highrestrictions on access.

(3) Energy planning promotes balance andadapts to economic and socialdevelopment

Planning is an important government function inthe energy system and is increasingly adapted toeconomic and social development.

Energy planning has been shifting from“meeting demand with sufficient supply” to bal-ancing supply and demand. China’s energymarket has entered an era of diversified compe-tition, where energy substitution occurs at mul-tiple levels and supply and demand are changingrapidly. The previous energy market, driven bysupply, has changed, with the demand side nowplaying an increasingly important role.

Energy planning functions have also changed,from mandatory to directive. Previously, energy

planning started from the supply side andfocused on state-owned energy enterprises in keysectors. With the reform of the energy marketand enterprises, the mandatory planning functionis gradually weakening and energy plans arerapidly assuming a more directive role.

Energy planning has gradually become sci-entific, consistent and democratic. The practicesin the 12th and 13th Five-Year Plans (2011–15and 2016–20 respectively) prove that the gov-ernment values research during the early stagesof energy planning and seeks opinions from allwalks of life, striving to ensure that energy plansare in the common interests of all stakeholders.

(4) Energy strategies are valued factors indecision-making

China values energy strategies and considersthem an important basis for decision-making.Both central and local government developstrategies for each energy source and each part ofthe energy value chain, as well as medium- andlong-term strategies for some key sectors. Chi-na’s Strategic Action Plan on Energy Develop-ment (2014–20) of the General Office of the StateCouncil describes the major actions and safe-guards required to implement energy strategies.

(5) Energy reserves are valued and emer-gency response stocks have improved

Energy reserves are the responsibility of theenergy administration under the central govern-ment. Reserves of fossil fuels are mainly physical(energy products) and cannot respond quickly toongoing events. In terms of energy source, Chi-na’s reserves are mainly oil and coal. The oilreserve is of strategic significance. Due to Chi-na’s high self-sufficiency in coal, coal reservesare not kept at strategic levels. In addition, nat-ural gas reserves are mainly used for balancinggas supply with demand, so natural gas storagefacilities are small and used for peak shaving.

National strategic oil reserves are the respon-sibility of the National Energy Administration(NEA). China has built a national oil reservecentre. The NEA is responsible for building and


managing national oil reserve bases, collectionand storage, rotation and use of strategic oilreserves, and monitoring supply and demand ininternational and domestic markets.

Natural gas reserves are used mainly to adjustgas supply. China’s gas reserves have difficultymeeting normal demand. Due to the small scaleof gas reserve storage facilities and absence of apeak-shaving gas pricing mechanism, thepeak-shaving capability of gas reserves is belowinternational levels. At the end of 2014, theincreased production of residential gas and weakdownstream gas demand resulted in higherinventories at several liquefied natural gas ter-minals, but there is still not enough space to storemore spot gas.

Coal reserves are not as crucial as oil reserves.China has begun building an emergency coalreserve system. Many provinces are buildingemergency coal reserves, and large coal enter-prises, utilities and ports already have emergencycoal reserves. Currently, China’s thermal powerplants consider a coal stock of 15 days to benormal and of seven days to be a warning. Thethermal coal stock of a power generation com-pany should not be less than 20 days. In terms ofadministration, China’s emergency coal reservesystem is mainly the responsibility of theNational Development and Reform Commission(NDRC), the Ministry of Finance and govern-ment departments for transport, railway andenergy. Organisations like the China NationalCoal Association (CNCA) and State Grid pro-vide coal market monitoring, early warning ser-vices and information support. The enterprisesresponsible for emergency coal reserves builddedicated storage facilities. Overall planning andregulation of emergency coal reserves are carriedout by national government and specific taskfulfilment is the responsibility of enterprises andports.

In the event of a severe natural disaster oremergency, the NDRC and the Ministry ofFinance make decisions on using reserves basedon applications from provincial governments orsuggestions from organisations like the CNCA orState Grid. NDRC and the Ministry of Financethen give the order to use the emergency reserves

to the relevant enterprises that hold the reserves.Since normal production and operation areongoing, reserves are rotated so that used stocksare replaced with new, and at least one rotationper quarter takes place.

Enterprises that undertake coal emergencyreserve tasks can apply for bank loans, and thenational government can grant subsidies fornewly built reserve facilities and reconstructionor expansion projects. For enterprises that havefulfilled their emergency reserve tasks, the cen-tral finance department will pay interest on theirloans or on the capital they have invested in theemergency reserves, as well as subsidise othercosts such as site occupancy and storage charges.

China’s energy emergency reserve system isdesigned to respond to energy emergencies,ensure secure and stable energy supply, andmake short-term decisions on energy security. Atthe centre of emergency management is the“inter-ministerial coordination mechanism forensuring coal, electricity, oil and transport secu-rity”. China’s energy emergency reserve systemis decentralised and short term, with the relevantcentral enterprises performing the emergencymanagement function. First, the NDRC has thelargest say in energy emergency managementand also has administrative responsibility forenergy regulations. Second, the responsibilitiesof the NEA include ensuring energy emergencysupply, managing oil reserves, guiding imple-mentation of administrative measures by nationaloil companies, and emergency management ofthe power sector, which was previously the mainresponsibility of the former SERC. Third, theState Administration of Work Safety is respon-sible for leading production safety and emer-gency rescue work in key energy sectors, such ascoal and petrochemicals. In addition, the StateAdministration of Science, Technology andIndustry for National Defence is responsible foremergencies in nuclear power. The generaladministration office and the energy authority oflocal governments cooperate with the centralgovernment in carrying out energy emergencymanagement. China’s energy emergency man-agement has played an important role inaddressing energy emergencies, such as the 2008


snow disaster in south China, conflicts betweenthe coal and power sectors, and regional oil andgas shortages.

3.2.2 Analysis of Existing ProblemsChina’s existing administrative system lacksconsistency and the level is low. Problems suchas decentralised administration, unclear rightsand liabilities, and overlapping functions remain.Administrative coordination between variousdepartments regarding strategy, planning andpolicy is poor. The culture of putting approvalahead of public service has not fundamentallychanged. In addition, the management ofenergy reserves and emergencies lacks publicengagement.

(1) Inconsistent administrative oversight andno independent high-level institution

There are many agencies that have someresponsibility for energy administration, but theylack a centralised organisation. In many placesthey suffer from overlapping remits, where dif-ferent departments have joint administrativeresponsibility for specific areas, which can behighly problematic. The National Energy Com-mission was established to improve energystrategy and overall coordination, but its role hasbeen restricted by the way its organisationalstructure was set up, and it does not coordinate theadministrative activities of the various depart-ments effectively. The National Energy Admin-istration (NEA) is responsible for overall energyplanning and development, as well as for super-vising the energy industry as a whole, but theadministrative functions for specific energy sec-tors are decentralised to the Ministry of Industryand Information Technology, the Ministry ofWater Resources, the Ministry of Agriculture, theState Administration of Work Safety, the Min-istry of Environmental Protection and the Min-istry of Commerce. This administrative approachof “divided policies from various sources” notonly increases the cost of coordination, but alsoresults in unclear responsibilities, conflictingauthorities and inefficient administration.

Definitions of rights and liabilities in theenergy sector are unclear, both horizontally (be-tween departments of the central government)and vertically (between central and local gov-ernment). The first problem is that China’senergy-related administrative institutions per-form their functions in accordance with the Planon Defining Functions, Internal Organisation andStaffing, and therefore the power granted to themis not based on law. The absence of a funda-mental energy law means that the rights andliabilities of energy administrative institutionsalso lack a legal basis. The next difficulty is thatthe body framing energy regulation is a sub-sidiary of the institution that administers thosesame regulations, and this non-independentapproach, which bundles administration andregulation together, hinders effective energy lawenforcement. Another problem is that localenergy regulation is vulnerable to pressure fromlocal government. Finally, the administrativesystems in various energy sectors have their ownspecific features (except for oil and gas). In thoseenergy sectors that adopt a hierarchical admin-istrative approach, there is a clear lack of coor-dination between central and local administrativeinstitutions.

The NEA is a vice-ministerial department. Ittherefore ranks below other resource adminis-tration departments that are ministries, such asthe Ministry of Water Resources and the Min-istry of Land and Resources. For some majorenergy decisions, the NEA still needs to seekapproval from the National Development andReform Commission (NDRC). All this makes itdifficult for the NEA to play its coordinating roleeffectively. A typical example where overalloversight is needed is regulating energy volumeand energy prices. The NEA is mainly respon-sible for energy volume and the NDRC controlsthe administration of energy pricing, and thisseparation does not sit well with the strong linkbetween the two areas. Inevitably, conflicts arisebetween the measures for adjusting volume andthose for adjusting price, and as a result thepolicies introduced by both departments tend notto deliver good results.


(2) Outdated approach to administration andovercomplicated approval processes

Due to the typically large scale of investmentrequired in the upstream and midstream sectorsof the energy industry, and the need for pro-ductivity allocation and cross-provincial coordi-nation, the requirement that the administrativefunction be vertically hierarchical and horizon-tally decentralised creates an overcomplicatedapproval process. Moreover, there are somespecific requirements that make it difficult toaccess non-state-owned capital. Central enter-prises entering this field also need to handle theirrelationship with local government, for whom theconflict between administration and interests isdifficult to manage.

There is also a lack of public services in theenergy sector, which can be clearly seen in theprovisions for information disclosure. First, thereis insufficient disclosure of government infor-mation, including missing or inadequate updatesregarding administrative licencing and laws andregulations, as well as too little disclosure ofdocuments and notices that have a direct impacton the development of the energy industry.Second, the mandatory information disclosuresystem for natural monopolies like oil and gaspipelines has not been established, and informa-tion disclosure platforms are absent. Third, thereis no administrative system for making datapublic, especially in basic research. As a case inpoint, the system for collecting and submittingdata on oil and gas resources was introduced inChina several years ago, but due to slackenforcement the relevant administration has haddifficulty obtaining and managing these data. Thedelay in building databases and disclosinginformation has severely affected the integrationof mining rights administration processes.

(3) Poor and uncoordinated energy plansmake it difficult to balance supply anddemand

The coordination between energy plans at dif-ferent levels and in different sectors is poor.Some energy plans are conditional on each other.

Other energy plans (especially local plans) do nottake energy supply and demand sufficiently intoaccount. The energy plans for some sectors havenot been effectively implemented or even com-pleted for some time. Coordination betweencentral and local energy plans is poor. Typically,energy plans are more often completed on thesupply side and poorly implemented on thedemand side. The evaluation of energy plans andtheir implementation is far behind schedule.

Planning for supply and demand balancingtends to consider volume ahead of how priceaffects energy demand. Although changes in thescale and structure of energy demand are assessedwithin the context of socioeconomic develop-ment, the current (government-led) pricingmechanisms for oil, gas and electricity make ithard for price changes to reflect market supply anddemand. When energy plans are implemented,price tends to severely restrict the market’s role.Moreover, the administration of energy volumeand price are separate responsibilities of the NEAand NDRC respectively, which also contributes tothe tension between volume and price whenenergy supply and demand are considered.

The lack of coordination between plans forpower consumption and generation has becomeincreasingly acute, which can be clearly seen ingenerating equipment availability. In 2014, theaverage availability of several types of generatingequipment in China hit a record low. In additionto weak power demand due to the sluggisheconomy, the distribution of power generatingunits also caused problems. For example, thestart-up of Unit 2 of the Hongyan River nuclearpower plant was postponed even though it wasready, because the power supply capacity of thenorth-eastern power grid had not been properlyconsidered at the planning stage. The lead timefor nuclear power plant construction increases thelikelihood of mismatches between installedpower capacity and power demand.

(4) Energy strategies lack national supportand an implementation mechanism

China lacks national medium- and long-termenergy strategies. Despite the introduction of the


Strategic Action Plan on Energy Development(2014–20), national energy strategies are unclear.Local and national energy strategies are notcoordinated, and the guidance provided byenergy strategies lacks relevance for energyplans. In addition, there is no strategy imple-mentation mechanism or policy support.

The energy revolution needs clear goals and aroadmap, coordinated safety measures and rela-tively stable policies. The energy revolution andmedium- and long-term energy strategies arecarried out by means of dynamic economic andsocial development and synchronised reforms,including those of government, finance, scienceand technology. Some of these dynamicallydeveloping reforms are interdependent.

(5) The energy reserve and emergencyresponse systems need to be updated

China’s energy reserves commonly suffer fromseveral problems, exemplified by oil and coalreserves. These problems are: (i) a powerfullegislative guarantee for strategic reserves islacking—there is no clear legal definition of theboundary between government and market, or ofthe rights and liabilities of the various energyindustry participants, regarding levels of reservesof different energy sources; (ii) an incompleteadministration system—the storage and releaseconditions for energy reserves need to beimproved: price is the key, but the necessarysupervisory system is absent; (iii) the method forholding reserves needs to be improved—staticenergy reserves result in excessively high costsand relatively limited reserve size; (iv) poorlevels of IT functionality in energy reserveadministration, leading to insufficient disclosureof information, especially on reserve capacityand volume; (v) inefficient reserve storage facil-ities—the logistics of energy reserves still needto be improved; and (vi) physical reserves areconcentrated in large central energy enterprises,while commercial oil and gas reserves aregrowing slowly.

China’s energy emergency management isdesigned mainly for domestic, local andshort-lived, unexpected energy incidents; it

would have great difficulty responding effec-tively to global energy events that had wider ordeeper implications. First, China’s energy emer-gency management is limited to guaranteeingsupply in the case of an emergency. Second,China’s energy emergency management isdecentralised and lacks consistent national man-agement and coordination. It is very much set upfor emergencies involving a specific energysource or a particular part of the energy valuechain and is inadequate for responding to globalenergy events that involve several energy sour-ces. Moreover, the geographical scope of energyemergency response is limited to China, and nointernational energy emergency management hasbeen set up. Third, the development of an energyemergency material guarantee system is inade-quate. China’s oil reserves still have some way togo to meet the International Energy Agency’s90-day oil stock security criteria, and the size andcapacity of the power grids and the natural gaspipeline network do not meet emergency demandlevels. Fourth, energy reserve and emergency-related legislation is still lacking, and relatedsystems need to be improved, including the useand storage of energy reserves, supervision,evaluation, IT-based administration and fundingsystems.

China’s energy reserve and emergency man-agement suffer from poor information disclosureand public engagement. As there is no informa-tion disclosure system, participants in the energysector have difficulty obtaining information in atimely fashion. Since commercial energyreserves are not mandatory and a reasonablepricing mechanism for energy reserves has yet tobe established, private capital is not motivated toenter the field.

3.3 Energy Market and CirculationSystem

3.3.1 Current DevelopmentsChina’s energy market and circulation system arestill very much a monopoly. This is rooted in theenergy system and institutions and is reflected innetwork facilities. China’s energy market system


is still in its early stages. The level of marketi-sation varies for different energy sources—thecoal sector has completed its market-orientedreform; the downstream oil and gas sector ishighly deregulated, but upstream still suffersfrom severe monopoly problems; and themarket-oriented reform of power transmission,distribution and retail is urgently needed. Inaddition, the institutional barrier in naturalmonopolies has become a major hurdle in thereform of the energy circulation system.

(1) Slightly more competition in the oil andgas market, but resource monopolyremains

As a result of the 1998 reform and restructuringof the oil and gas sector, and the related reformand policy measures that followed, an energyproduction and circulation system has takenshape, covering upstream and downstream,domestic and overseas trading, and production,transmission and sales. The market consists ofthe top four oil groups—China National Petro-leum Corporation (CNPC), China Petroleum &Chemical Corporation (Sinopec), China NationalOffshore Oil Corporation (CNOOC) and Yan-chang Petroleum—alongside various other oiland gas enterprises of different ownership typesand sizes, with the top four dominating andforming in effect an oligopolistic or monopolisticcompetition landscape.

Competition in refining and chemicals,wholesale and retail, has increased. In recentyears, state-owned oil enterprises such asCNOOC and Sinochem, which have crude oilresources, have rapidly enlarged their refiningpresence, intensifying the competition.Because CNOOC and Sinochem have limiteddownstream distribution resources, the con-struction and operation of refineries backed byCNOOC and Sinochem investment will increasecompetition in the energy wholesale and retailsectors.

At the same time, easier entry terms intowholesale oil products have helped diversifymarket participants. CNOOC, Sinochem andsome private oil and gas companies have all been

awarded an oil product wholesale licence.Compared with the early 21st century, the com-petition landscape of the wholesale oil productmarket has evolved, and competition has gradu-ally intensified.

CNPC, Sinopec and CNOOC have retainedtheir resource monopoly, restricting the devel-opment of other market players. In terms ofmarket structure, domestic crude oil and gasresources are concentrated in state-owned oilenterprises, especially CNPC and CNOOC.Wholesale is dominated by CNPC, Sinopec andCNOOC, but in recent years competition inrefining, oil production and natural gas wholesalemarkets has intensified somewhat. There arenumerous players in the energy retail market, butbecause the resource market is dominated byCNPC, Sinopec and CNOOC, private companiesdealing in oil products and natural gas other thanthe top four oil groups do not have a completevertical presence throughout the market, and theyrely on the top four oil groups for resources andeven marketing.

(2) Electricity market reform has started andneeds to be deepened

China’s electricity market has more than a dec-ade of experience, during which time smallreforms in different parts of the electricity valuechain have been continuously carried out andhave delivered good results. In 2002, Chinaseparated generation from the power grid, andgradually developed pricing mechanisms inpower generation, transmission, distribution andsales. In 2004, China introduced the benchmarkfeed-in tariff policy and began to set andannounce regularly the feed-in tariff for newgenerating units in each province.

The main problems in China’s electricity sec-tor are reflected in its market structure. In powergeneration a pattern of diversified competitionhas taken shape. The vast majority of powergeneration enterprises are state-owned andstate-controlled, including the top five largepower generation corporations (China Huaneng,China Datang, China Huadian, China Guodianand State Power Investment Corporation, SPIC)


and the top four small power generation groups(State Development & Investment Corporation,SDIC; Guohua Electric Power; CR Power; andChina General Nuclear Power Group, CGN). Theinstalled capacity of these companies accounts for60% of the country’s total. There are also somepower generation enterprises that are whollyowned or controlled by local government. At thesame time, power transmission, distribution andsales have not yet been deregulated, and powersupplies in all provinces come mainly from localmonopoly power grid enterprises. Electricitysales from central grid enterprises account formore than 80% of the country’s total electricitydemand. Independent market-oriented trading hasnot yet been established in China’s electricitymarket—competition has been introduced inpower generation, but monopolies remain intransmission, distribution and sales. Grid com-panies with power transmission and distributionnetworks have a monopoly in both wholesale andretail. Finally, power generation plans are devel-oped in coordination with government at alllevels and with power plants and grids. This hascreated an administrative system influenced bymultiple factors, such as regulation policies,energy conservation and emissions reduction, andthe requirements of administrators.

The new electricity market reform plan hasbeen released in the Opinions on Further Deep-ening the Reform of the Electric Power System.The goal of “establishing and improving themarket mechanism in the power sector that fea-tures ‘legal basis, separation of government andenterprises, compliant market participants, fairtrading, reasonable prices and effective supervi-sion” stated in the Opinions echoes actualrequirements. The priorities and pathway ofelectricity market reform can be summarised as“deregulating a new power distribution and salesmarket, deregulating electricity prices other thantransmission and distribution tariffs, and dereg-ulating power generation other than that for safeand efficient power operation and supply relia-bility, and others. The reform framework isdefined as “deregulating power generation, salesand end use, and control of power transmissionand distribution”, which is basically what would

be expected. Generally, this round of electricitymarket reform has been carried out with acommon-sense approach and has taken both therequirements of reform and the principle ofpracticality into consideration. Compared with“Document No. 5”, released in 2002, the Opin-ions is of more practical significance.

(3) Coal sector market reforms are complete,though the long-term contract price forthermal coal needs to be tested in themarket

The coal sector has ended its dual-track pricesystem and completed its market-orientedreform. Apart from thermal coal, China’s coalmarket was already market-based. In 2013, thecancellation of priority contracts and the endingof the dual-track price system for thermal coalcompleted the market reform of the coal sector.Although the contradiction between market-oriented coal and planned electricity appears tohave been resolved, the long-term contract pricefor thermal coal, reached through difficult nego-tiations and compromise between all partiesinvolved, has yet to be tested in the market.

3.3.2 Analysis of Existing ProblemsChina’s energy circulation system is largelymonopolistic. Administrative monopoly isprominent in investment access and resourceacquisition in upstream primary energy. The factthat there is only a limited number of marketparticipants in the oil and gas sector (especiallyin upstream and midstream) affects the overallefficiency of the sector.

(1) The upstream and downstream oil and gasmonopoly affects the overall efficiency ofthe value chain

The monopoly in upstream oil and gas persists.Despite mutual penetration of each other’sdominant market areas by CNPC, Sinopec andCNOOC, the “separation of upstream anddownstream, separate administration of domesticand overseas trading, and separation of offshoreand onshore oil and gas” in the oil and gas sector,


which was formed at the end of the 20th century,has remained relatively stable, and China’s cur-rent regulations and administration reinforce thissituation.

First, the unequal status of different marketparticipants makes access difficult fornon-state-owned investors, so it is hard to createa fair market environment. This is not conduciveto improving the overall efficiency of the oil andgas sector or sharpening the competitiveness ofoil and gas enterprises, nor does it help increasethe exploration and development of domestic oiland gas resources.

Second, local monopoly markets formbetween upstream, midstream and downstream,and within each part of the oil and gas valuechain, which leads to market separation andmakes it difficult to establish a consistent andopen market system.

Third, various market structures—a nationaloil and gas exploration and mining rights tradingmarket, a pipeline capacity trading market, areserves market and a futures trading market—are all yet to be established. As a result, themarket has very little scope to play a role inallocating resources; resource use efficiencycould therefore be improved. As a large oil andgas consumer, China does not have enough sayin international oil and gas pricing.

(2) Many interrelated problems hinder thedevelopment of the electricity market

The Opinions is just a guideline. If the require-ments stated in the Opinions are truly to beimplemented and the reform goals achieved, thensupport policies and regulations, along withimplementation documentation, are needed.Problems to be solved in the power sectorinclude: (i) the relationship between power gridenterprises and relatively independent electricitytrading institutions urgently needs to be defined;(ii) power transmission and distribution tariffsneed to be set independently; (iii) mar-ket-oriented power generation and sales prices,other than those for public goods, need to bephased in; (iv) cross-subsidies for electricityprices need to be gradually decreased; (v) the

bilateral trading market needs to be kick-startedby increased market participation and across-provincial market mechanism; (vi) powersales reform needs to be steadily promoted andpower distribution and sale services need to bederegulated to admit private capital in an orderlymanner; and (vii) the results of reform need to besafeguarded by legislation.

(3) Barriers in the coal market and severedecentralised administration remain

Of all the energy sectors, coal has the mostrelaxed administration. However, despite thesubstantially reduced level of government inter-vention in the coal market, there are still manyproblems in the sector. First, the involvement ofmultiple departments in its administration and thecomplexity of coal circulation results in highcosts. Second, there are acute transport bottle-necks, such as poor allocation of transportcapacity. Third, coal logistics management isinadequate, and there are still no emerging coalcirculation companies and logistics centres.Fourth, supervision of the coal circulation pro-cess is poor and there is a serious problem withpollution. In addition, poor quality control isholding back the sustainable development of thecoal market.

There are still many obstacles in coal circu-lation. First, coal logistics generally divides intowest-to-east and north-to-east coal transport, andany imbalance in economic transformation mayreinforce such supply and demand differences.Second, rail transport plays a more important rolein the coal logistics system, which is of greatersignificance for coal transport in Xinjiang andeastern Inner Mongolia. Third, water transport isan important method of north-to-south coaltransport. The coal volume transported by waterincreases year by year, and the establisheddirections of coal flow are undergoing change.

The coal sector features the loosest adminis-tration of all primary energy sources. Centralgovernment, local government and coal associa-tions all play a role in the administration of coal.Although administrative streamlining hasallowed some tasks to be erased or delegated to


local government, there has been no obviousimprovement in decentralised administration.

3.4 Energy Pricing System

3.4.1 Current DevelopmentsThe government continues to intervene in energypricing. In each part of the energy value chain thepricing guidance reflects market dynamicspoorly. Overall, there are many problems inChina’s energy pricing system: in price forma-tion, composition and regulation, and in thecoordinated administration of production andpricing. Pricing in upstream primary energy hasgradually been deregulated, but governmentintervention remains influential in the pricing ofenergy products for major end users. The groundhas been prepared for market-oriented pricingreform in the oil and coal sectors, but gas pricingreform still needs more work. The energy tax andfinance systems and policies play an importantrole at some stages of reform and have a positiveimpact on end-user energy prices.

(1) Problems with China’s energy pricingsystems severely constrain energy systemreform

China has been steadily promoting energy pric-ing reform for years, but deeply rooted contra-dictions have not been resolved. Distortions inpricing cause resources to be miscalculated,structural imbalances and extensive overdevel-opment. Although the policy of “replacing pric-ing reform with adjustment” has had partialsuccess, prices and price adjustments that workin the short term have not developed into along-term pricing mechanism and a workablepricing settlement for the entire energy system.

Energy pricing reflects the various drawbacksin China’s energy system and is a core compo-nent of energy system reform. Unreasonableenergy product prices and slow-moving pricingreform severely constrain the smooth transitionto a new development process and a change inoverall economic structure. Administratively,energy planning and balancing supply and

demand are mainly the responsibilities of theNEA, while energy pricing and administrationare the responsibilities of the NDRC. Thisadministrative separation of production volumesand pricing is the major cause of China’s energypricing problems, many of which are outlined inthe following paragraphs.

First, due to the unfair pricing mechanism andthe government’s forceful intervention in pricing,prices do not reflect the true value of energyproducts. Market-oriented pricing in competitiveenergy fields and related areas is not commonpractice. For historical reasons and due to thespecific characteristics of energy resources, theprices of China’s energy products have been setor strictly controlled by the government for along time. As a result, energy prices cannoteffectively reflect supply and demand and thescarcity of energy resources, which restricts therole of price in resource allocation.

Second, pricing calculations and taxation areunreasonable and full-cost accounting is not wellimplemented. In the current price calculation ofenergy resource products, cost items are enteredat a low level that does not provide reasonablecompensation for the energy resource productionprocess. Neither do they reflect the cost of con-trolling environmental pollution in the resourcedevelopment process nor the cost of safe pro-duction. Moreover, external costs are not inter-nalised. Inconsistent taxation and energy costs donot reflect the price relationships of energyproducts, resulting in users lacking any costconstraints for some energy products. This isdetrimental to the correct alignment of the energysystem.

Third, the incomplete price regulation system,poor regulatory expertise and inadequate infor-mation disclosure hinder effective price regula-tion. When the price regulatory body regulatesprices in natural monopolies it tends to lackreal-time cost information and feedback; its priceand cost accounting and supervisory capabilityare, therefore, weak. Moreover, there are insuf-ficient levels of personnel, finance, materials andIT in the price regulatory body, and inadequatetransparency of price regulation and publicengagement. At the same time, lack of


transparency and cross-subsidies due to monop-olistic pricing are the main reasons why effectivesupervision is difficult to deliver. Some energysources and links in the energy value chaincompletely lack cost and price regulation,resulting in a hardened price monopoly in naturalmonopolies like power grids and oil and gaspipeline networks.

Fourth, the disconnect in energy pricingresults in intermittent price transmission andobvious contradictions between pricing in dif-ferent links of the energy value chain, whichaffects the ability of the market to allocate energyresources effectively. This phenomenon is espe-cially evident in the power sector, for example inthe disconnect between the sales price and cost ofgeneration, and between the power transmissionand distribution tariffs and the feed-in tariff. Inaddition, the links with international anddomestic market pricing are weak. Governmentpricing does not respond promptly to marketdynamics, and China also lacks a voice ininternational energy pricing.

Fifth, separating production volumes andprice amplifies the shortcomings in China’senergy pricing system. Energy planning andbalancing supply and demand are mainly theresponsibility of the NEA, and energy pricingand administration are the responsibility of theNDRC. This administrative system, which sep-arates production volume and price, is the majorcause of China’s energy pricing problems. Whensupply is tight, the effects of the separation arenot obvious, but in the context of diversifiedenergy supply and demand, especially during thetransition to market-oriented energy pricing, theadministrative separation is increasinglyill-adapted to the requirements of energydevelopment.

(2) Deregulation of upstream pricing isgradual, but government interventioncontinues

Pricing in China’s upstream energy sector hasgradually been deregulated. The deregulation ofpricing in the coal and oil industries has beenimplemented in phases: upstream coal pricing

has been deregulated for years, and the crude oilprice is independently determined and based onthe international oil price. The implementation ofnetback pricing has made the upstream naturalgas wellhead price redundant. Power generationpricing has evolved from a price based on eachgenerating unit to a benchmark price, and gov-ernment interventions are gradually decreasing.

Government intervention still occurs indownstream energy, especially in the pricing ofmajor end-use energy products. Natural gas andelectricity end-user prices in particular are stillcontrolled by local government, due to the reli-ance of these two energy sources on naturalmonopoly networks and facilities and the publicservice attribute associated with them.

(3) Pricing reform in the oil and coal sectors iscompleted, but hurdles remain in elec-tricity and gas

Oil pricing has become market oriented. China’scrude oil prices are now negotiated or indepen-dently determined by oil-producing enterprises,based on the international oil price. The price ofcrude oil supplied by national oil companies isnegotiated by the buyer and seller on the prin-ciple that the cost of delivering domestic onshorecrude oil to refineries should be equivalent to thecost of delivering imported crude oil frominternational markets to refineries. The price ofcrude oil supplied to local refineries fromnational oil companies is set by referring to theprice of mutually supplied crude oil between twooil groups. The price of crude oil produced byCNOOC and other companies is independentlydetermined by the corresponding producer withreference to the international oil price.

The pricing of oil products is linked to inter-national oil prices, but a degree of governmentintervention remains. Having connected thegovernment-guided moving-average price withthe international oil price, the government caninfluence end-user oil prices more through taxpolicies. In March 2013, the governmentannounced an improved oil product pricingmechanism, whereby the price adjustment cycleof oil products would be shortened from 22 to 10


working days, and the price adjustment restric-tion of ±4% of the energy source’s average pricein the international market would be cancelled. Ingeneral, China’s current oil product pricingmechanism follows the basic principle of fol-lowing the international oil price, but to ensure arelatively stable domestic oil price it implementsthe government-guided pricing approach. Theexisting oil product pricing mechanism coversthe following five aspects: (i) differentiated oilproduct prices—either government-guided priceor government-controlled price; (ii) adjustmentof petrol and diesel prices based on changes inthe international crude oil market price every 10working days; (iii) adjustment of oil processingprofit margins and thus oil product prices, basedon changes in the international crude oil price;(iv) the NDRC sets the ceiling retail price ofpetrol and diesel for all provinces and majorcities; and (v) defines the difference betweenwholesale and retail prices.

A dynamic price adjustment mechanism thatreflects market supply and demand and the scar-city of resources has been preliminarily estab-lished in the natural gas sector. China hasgradually implemented the netback pricingapproach for pipeline gas since 2011, but theprice of pipeline gas has been restricted by gassource price and limits on pipeline transmissionand distribution. The implementation of the net-back pricing approach represents a major step inrationalising the relationship between the naturalgas price and the alternative energy price. China’snatural gas market is still supplier-dominated andnon-competitive, and the gas end-user price isdetermined by such factors as gas source prices,government-controlled long-distance gas trans-mission tariffs and local government-controlledgas distribution fees and sale prices. Hence,compared to alternative energy sources, thecompetitiveness of the natural gas price isuncertain. Liquefied natural gas (LNG) pricinghas been reformed and is market-oriented, but theprice of LNG entering the pipeline network aspeak-shaving gas remains unclear.

Due to the complicated network of interestsassociated with the price of electricity, themarket-oriented reform of electricity pricing hasbeen much discussed, but without reaching aconclusion. China’s electricity price is currentlyconsidered both from the power generation sideand from the demand side. China’s currentelectricity price system covers mainly feed-intariffs, transmission and distribution tariffs andthe power sale price. On the generation side,different power generation companies set differ-ent feed-in tariffs in light of local conditions, andthe NDRC sets the benchmark feed-in tariff. Onthe supply side, local government sets differentprices according to the type of end user—a dualpricing system (including basic price and meterprice) is generally applied to large industrialusers, and a tiered electricity pricing system isapplied to residential users.

Coal pricing has been market-oriented for awhile. The double-track price system used forthermal coal pricing was ended along with pri-ority contracts in 2013. The publication of theGuideline of the General Office of the StateCouncil on Deepening the Market-OrientedReform of Thermal Coal marked the officialending of the dual-track price system, which hadbeen in place for more than 20 years. The NDRCno longer sets the annual framework for allo-cating rail transport capacity for cross-provincialcoal to local governments.

3.4.2 Analysis of ProblemsIn general, the government still intervenesheavily in energy pricing in China, and there isinsufficient guidance on end-user energy pricing.Energy prices reflect poorly market supply anddemand and the attributes of each energy com-modity. The current energy pricing systemstruggles to reflect the interactive relationshipbetween production volume and price, and thereis insufficient transparency in pricing. In addi-tion, the energy tax and subsidy systems fail toprovide useful guidance on energy productionand consumption.


(1) Transparency and timeliness in the oilproduct pricing system

Despite the quasi-market-oriented nature of oilproduct pricing, the contradiction between oper-ating a transparent pricing system and allowingfor delayed price adjustments has not beensolved. The risk-free arbitrage behaviour that thisgap allows clearly generates instability in marketsupply, which in turn has an impact on the sta-bility of the oil product market, especially whenoil prices fluctuate wildly. A market-based oilproduct pricing mechanism will address theseproblems and allow the government to stillintervene through tax and other means.

(2) There is no market-oriented gas pricingmechanism; the price of gas does notreflect its actual value

There is no market-oriented gas pricing mecha-nism, and the difference in gas price betweenregions is unjustified. In general, the price of gasdoes not properly reflect the attributes of naturalgas as a commodity. Gas pricing reform can becompleted independently, but it should be coor-dinated with pipeline network reform.

The price determined by netback pricing isunreasonable—it is obviously too high, and theceiling city-gate gas price defined by currentpolicies has become the de facto gas source pricein each province. As research indicates, this pricelevel is about 30% higher than the total cost ofgas, so there is a great amount of profit built in.However, the high price squeezes the profitmargin of downstream industries and discouragesany significant increase in gas’s share of totalenergy consumption.

Gas price adjustment policies are incompleteand the residential gas price is low. The gas priceadjustment policies introduced in Beijing, Hebeiand Shanghai in 2011 do not affect the residentialgas price, allowing it to stay at a low level. Thisresults in an underlying expectation among resi-dents that low-cost gas will be available. Incontrast, the price of industrial gas is higher thanthat of residential gas.

The gas pricing system is incomplete anddistorted. There is no clear pricing mechanismand no administrative system that differentiatesbetween peak and off-peak consumption, gasprices that allow supply cut-off at any time andtiered gas prices. There are no specific require-ments on how to calculate cost and price or todetermine who is responsible for supervision,which makes it difficult to set prices.

(3) Electricity pricing is a major problem inenergy pricing reform

Electricity pricing reform is dependent on elec-tricity system reform. Two main problems needto be addressed.

The first problem is the arbitrary pricingmechanism. On the grid connection side, thefeed-in tariff is decided by the government.Without market competition, it is difficult tomotivate power enterprises. On the powertransmission and distribution side, power gridoperators do not decide transmission and distri-bution tariffs; their revenue is generated by thedifference between the power wholesale priceand the feed-in tariff. On the sales side, wholesaleprices do not reflect user demands and result inlimited options for consumers. Cross-provincialpower supply lacks a mechanism that can moti-vate both the supplier and the buyer. In general,electricity prices in China are decided byadministrative bodies and do not reflect the realsupply and demand relationship and productioncosts. A scientifically based pricing mechanismhas yet to be established.

The second problem is the largecross-subsidies. On the grid connection side, thehydropower feed-in tariff is significantly higherthan that for other types of power generation. Onthe wholesale side, the subsidies for differenttypes of use overlap. For instance, urban areassubsidise rural areas, industrial and commercialusers subsidise residential and agricultural users,users of high voltage subsidise users of lowvoltage, and consumers of large loads subsidisethose of low loads. As a result, the electricityretail price does not reflect the true cost of power


supply and fails to guide consumers to useelectricity efficiently. The existence ofcross-subsidies also hinders market-orientedreform in power generation and sales.

In addition, although coal pricing has becomemarket-oriented, the price does not includeexternalities, so it needs to be adjusted throughinstitutional reforms such as an environmentaltax and resource tax.

3.5 Energy Regulation System

3.5.1 Current DevelopmentsChina’s energy regulation system is not inde-pendent or sufficiently professional, and itssupervision capabilities are inadequate to safe-guard fair market operation. The organisationalstructure of China’s energy regulation system ismostly situated at lower administrative levels,and the rights and liabilities it sets out areunclearly defined and decentralised. The systemprioritises economic regulation. It bundlesadministration and regulation together, resultingin weak supervision and enforcement that requireimprovement.

(1) Regulatory functions are decentralisedand multi-level

Generally, China’s energy regulation system is:(i) decentralised across several authorities, withboth a horizontal division of labour (regulatingmarket access, investment, cost and price, etc.)and a vertical division of labour (regulating thevalue chain of the different energy sources);(ii) multi-level (including the State Council,central ministries and commissions, and localgovernment); and (iii) features separate economicregulation and societal supervision.

Economic regulation of the energy sector is ata high administrative level, being mainly theresponsibility of the central government. China’seconomic and social supervisory functions for oiland gas, coal, electricity and nuclear power aredecentralised across various departments andauthorities, whereas the economic regulatoryfunctions for the energy value chain are mainly

concentrated in central government. For exam-ple, the regulatory functions for market access,cost and pricing in the power sector are in thehands of different departments, including theNDRC, the Ministry of Finance and the NEA.A single economic regulatory function mayinvolve different departments. For example, thesupervision of electricity investment involves theNDRC, the NEA and local government bodies.

Significant regulatory functions are mainlyundertaken by the NDRC and the NEA. As amacroeconomic management agency, the NDRCalso coordinates China’s economic and socialdevelopment and the regulatory means to enactit. The establishment of the NEA in 2013 high-lights how energy regulation has been strength-ened. Its supervisory activities focus on“improving the energy regulation and adminis-trative system, strengthening energy regulationand administration, controlling total energyconsumption, developing the energy market andmaintaining energy market order” (see Table 5).

(2) Economic regulation has been prioritisedand social supervision is gradually beingimproved

The energy sector is a priority for governmentregulation, but China’s energy regulation is stillin the early stages of transition away fromplanned supervision and administration. Energyregulation prioritises economic regulation, whilethe social supervision of energy use remainsrelatively weak. Currently, economic and socialsupervision are separate.

In general, energy regulation in China meanseconomic regulation. Economic regulation con-sists mainly of supervising market access, pric-ing, investment, costs and market tradingconduct. These functions are mainly decen-tralised to departments like the NDRC and NEA.China has strict supervision of market access andinvestment, but the supervision of trading con-duct is not very effective. Economic regulationtakes place at a higher level, and (with theexception of coal) is typically implemented bycentral government.


China is attaching increasing importance tosocial supervision in the energy sector. Thesupervisory functions for the environment, safetyand health involve externalities and publicgoods, and tend to be centralised in departmentsor administrative institutions such as those forenvironmental protection and safety at work.Social supervision, however, tends to follow theguiding principles of local administration.

(3) Administration and regulation have beenbundled together, but regulation is weak

China’s institutional organisation of energy reg-ulation generally bundles administration andregulation together. This reflects the relationshipbetween energy regulation and other energyadministrative functions. For example, supervi-sion, planning, policy, regulation and publicservices are centralised in one department, likethe NDRC or NEA. These departments areresponsible not only for developing investment,operation and administrative policies in energysectors like power, natural gas and coal, but alsofor supervising the implementation of thesepolicies. Despite the relative independence of

these organisations and the formation of somesupervisory departments and bureaus, regulationis still weaker than other functions, such asplanning and policy.

In the long term, however, especially as theenergy pricing mechanism gradually improves,the separation of administration and regulationwill continue. Regardless of which approach toadministration and regulation is taken, bundledor separated, the following tasks need to beundertaken: increase energy regulation; graduallyraise the access threshold to the energy market;improve technical standards, environmentalrequirements and safety standards; and improvethe management of energy projects and the safetysupervision of energy enterprises. In addition, thescope of energy regulation should be enlargedand the supervision of costs in sectors with anatural monopoly should be increased.

(4) The energy regulation system has takenshape

China’s energy law and regulation system hastaken shape. Energy-related laws, administrativeregulations, departmental regulations, normative

Table 5 China’s energy regulation institutions and their responsibilities (2014)

Institution Responsibilities

NDRC Supervision of pricing and investment (access)

NEA Technical standards, supervision of investment (access),market (order), electricity safety and universal service

The Ministry of Water Resources Technical standards for hydropower in rural areas

The Ministry of Finance Energy-related financial norms and accountingregulations

The State Administration of Work Safety (the StateAdministration of Coal Mine Safety)

Supervision of energy-related (production) safety

The State Administration of Science, Technology andIndustry for National Defence under the Ministry ofIndustry and Information Technology

Review and management of the import and export ofnuclear materials, regulation of nuclear materials(circulation)

The National Nuclear Safety Administration under theMinistry of Environmental Protection

Supervision of environmental and nuclear safety

The General Administration of Quality Supervision,Inspection and Quarantine

Quality standards and product standards

The Ministry of Commerce Criteria for oil product market access and supervision ofthe oil product market

Source Based on the Plan on Defining Functions, Internal Organisation and Staffing, and official websites


documents and mandatory standards and speci-fications form the legal basis for energy regula-tion, and they all play their part in modifying andregulating energy development.

The legal foundation of China’s energy reg-ulation system is spread across various energylaws and regulations, with some parts of theenergy sector subject to several different energylaws and regulations. The laws that can be usedas the basis for energy regulation include theMineral Resources Law of the PRC, the ElectricPower Law of the PRC, the Coal Industry Law ofthe PRC and the Energy Conservation Law of thePRC. There are also some provisions on energyregulation in other related laws, such as theWater Law of the PRC, the Environmental Pro-tection Law of the PRC, the Law of the PRC onPrevention and Control of Radioactive Pollutionand the Production Safety Law of the PRC.Beyond this, the departmental regulations passedby the State Council and by ministries andcommissions serve as the basis for supervision ofvarious energy sectors, for example the Regula-tion on Electric Power Supervision (2005) andthe Regulation on the Emergency Response toand Investigation and Handling of Electric PowerSafety Accidents (2011). The former StateElectricity Regulatory Commission (SERC)introduced more than 60 regulations on super-vision and more than 160 normative documents.Finally, the mandatory standards and specifica-tions set the limits and procedures for key energysectors, so they provide the most direct basis forsupervision.

3.5.2 Analysis of ProblemsIn general, China’s energy regulation lacksindependence, is positioned at a low adminis-trative level, needs higher standards of profes-sionalism, and has difficulty carrying out thesupervision needed of a modern energy market.As a result, there is not enough consistent andeffective supervision in key energy sectors,especially in natural monopolies.

(1) Supervisory agencies are positioned at alower administrative level and they arenot independent

First, there is currently no independent high-levelenergy regulatory agency. An approach thatbundles administration and regulation togetherhas been in use for years. During this time therehas been no independent, dedicated agencyresponsible for energy regulation. This lack ofindependence has severely restricted how energyregulation is carried out.

Second, the existing energy regulation agen-cies are at a lower administrative level. Amongthe major agencies that perform energy regula-tion, the NEA is at the department/bureau leveland the NDRC is at the division level. Only theNational Nuclear Safety Administration is rela-tively independent; it is a national agencyadministered by the Ministry of EnvironmentalProtection on behalf of the central government.However, the special nature of nuclear safetysupervision makes it different to most other typesof energy regulation.

Third, there is no national agency that con-sistently carries out energy regulation. Thedecentralised nature of supervision has preventedthe synergies from the energy regulation systemas a whole being realised, so that often a situationarises where many parties have responsibility forsomething, but none of them delivers anything.When the NEA was formed in 2013 it was giventhe energy regulation function, but there are morethan 10 national government departmentsinvolved in energy sector supervision for oil andgas, power, coal, nuclear power, renewableenergy and others.

Fourth, when it comes to supervisory effi-ciency, the excessively decentralised regulatoryfunction increases the difficulty of coordinatingsupervisory activities, which compromises effi-ciency to some extent. The contradictions andconflicts between various departments, andbetween central and local government, are


unavoidable. To give one example, if the super-vision of pricing, cost and quality was wellcoordinated it would help to deliver optimalresults; but in reality pricing supervision is theresponsibility of the NDRC, cost supervision isthe responsibility of the Ministry of Finance andNEA, and the NEA is also responsible forsupervising service quality and standards. Thisdivision of functions runs counter to a logicalsolution, which is to supervise pricing, cost andservice quality together. The current administra-tive silos and the non-sharing of informationundoubtedly affect the efficiency of supervisionand the effective implementation of China’senergy policies.

(2) Consistent and effective supervision isabsent in key energy sectors, especially inupstream and the midstream

First, consistent and effective supervision isabsent in key energy sectors. Thanks to inde-pendent, professional and consistent supervision,the former State Electricity Regulatory Commis-sion (SERC) achieved good results in the super-vision of electricity. In other key energy sectors,including oil, gas and coal, the decentralised,fragmented and inconsistent supervision avail-able does not deliver a professional service, withknock-on effects in the various energy sectors.

Second, supervision is particularly inadequatein some key links of the energy value chain, suchas in natural monopolies. For example, there isno effective supervision of dominant enterprisesthat might abuse their market rights in the oil, gasand power sectors.

Third, there is a large rift between energyregulation and environmental supervision. In therenewable energy sector, supervision of theresource and environmental problems caused byrenewable energy development has yet to beintroduced. And when it comes to social super-vision of oil and gas exploration and develop-ment, the energy and environment supervisionauthorities do not play a significant role, with theresult that action on these issues depends on theself-discipline of oil and gas companies.

(3) An incomplete basis for supervision makesit difficult to meet the requirements ofmodern energy regulation

There are many reasons for China’s incompleteenergy regulation system. Large gaps in legisla-tion and delays in ratifying laws and regulationsin key energy sectors make it difficult to meetmodern energy regulation requirements.

First, the absence of significant energy lawsand regulations has resulted in an incompleteregulatory system. The most important energylaw is still awaited—the Energy Law of the PRCwas prepared at the end of 2007, but the date of itsrelease is still uncertain. In addition, there are noenergy regulatory laws, so there is no high-levellegal basis for defining energy regulation rightsand liabilities. In addition, laws for some keyenergy sectors are missing. For example, thelong-term absence of the Oil and Gas Law of thePRC and the Atomic Energy Law of the PRC hasleft gaps in energy consumption legislation.

Second, obsolete laws and delayed amend-ments have failed to meet the requirements ofenergy development and supervision. Based onobsolete legislative concepts, some energy laws,such as the Coal Industry Law of the PRC and theElectric Power Law of the PRC, are essentiallytraditional administrative regulations. Legislationin the oil and gas sector is emergencyresponse-oriented, temporary and out of date.Moreover, the amendment of some energy-related legislation is slow. A case in point is theamendment of the Mineral Resources Law of thePRC, which, due to theoretical disagreements andthe involvement of other non-energy sectors, hasstill not been finalised after years of discussions.

Third, the absence of essential implementationand support regulations leads to poor operability.For example, oil and gas legislation, such as theCoal Industry Law of the PRC, suffers fromunclear regulatory boundaries, unclear definitionof rights and liabilities, and uncertainty regardingits scope and conditions. The lack of imple-mentation and support regulations results inlegislation that is ineffective and unsuited topractical implementation.


(4) Inadequate and unprofessional govern-ment supervision

The NEA has built a dedicated supervisorydepartment that aims to extend the successfulexperience gained in electricity supervision toother energy sectors, especially fossil fuels. Theoil, gas and power sectors are strikingly differentin terms of technical and economic characteris-tics and supervisory demands. China’s oil andgas supervision is still in its infancy and the gapbetween it and the advanced supervision foundelsewhere in the world is wider than in electricitysupervision. Coal supervision, however, hasChinese characteristics, which make it hard toapply the experience and practices of electricitysupervision to fossil energy.

In addition to the two dedicated supervisorydepartments of the NEA, the agency under theformer SERC—that was merged into the NEAand positioned as a dedicated supervisorydepartment—has found it difficult to address thesupervisory requirements of multiple energysources. Furthermore, China’s energy regulationorganisations suffer from inadequate funding andlow-level equipment, technology and ITcapability.

Finally, given non-existent social supervision,non-governmental organisations that try to fillthe breach have no legal status within energyregulation, and it is difficult for them to obtainuseful information and access the necessarycommunication channels.

4 China’s Energy SystemTransformation: Progress,Conflict and System Design

4.1 The Urgent Need for EnergySystem Transformation

Energy supply pressure is mounting. Energyconsumption in China has been increasing stea-dily. As a result of its continued economicmomentum and the declining energy consump-tion of the major mature economies, China hasovertaken the USA to become the largest energy

consumer in the world. Energy supply in China,rich in coal but short of oil and gas, is limited,unable to meet growing demand. This has led toan expanding gap between supply and demand,which shows no sign of improvement. Whilestriving to address its energy security, China isbecoming more and more dependent on oil andgas imports. Meanwhile, the sources of theseimports are relatively concentrated geographi-cally and susceptible to global turbulence,increasing the risk to energy security. In thefuture, unsustainable energy supply will give riseto uncertainty in energy development, bringingabout an energy security challenge that cannot beignored.

China’s energy product pricing mechanism isineffective. Market signals do not accuratelyreflect the supply-demand relationship andresource scarcity, as well as externality costssuch as environmental pollution. Energy pricingthat is not market-led, including lower energyprices imposed by regulation, leads to excessiveenergy consumption and impedes the effectiveallocation of scarce resources. For a long time,China’s economy has been dominated byenergy-intensive secondary industries, whichaccount for a large amount of the total energyconsumed by industry. China’s energy intensityis 1.55 times the global average (2016), signifi-cantly impairing the efficiency of the country’seconomic growth.

Massive energy consumption brings severeenvironmental pollution and environmentaldamage. The direct effects can be seen in thegreenhouse gas emissions from unnecessaryenergy use that pollute the environment, damagebiodiversity and impact the climate, as evidencedby the frequent occurrence of extreme weather,such as acid rain and haze. In a time of globaldecarbonisation, high pollutant emissions seri-ously impair China’s image in the world andrestrict its potential for exports, employment,revenues, investment and economic growth.

China’s energy system needs to adapt to a newproductivity trend. China has become the world’slargest energy producer and consumer, with anenergy system comprising coal, electricity, oil,gas, new energy and renewables, as well as


significantly improved technical sophisticationand energy use for living and production. How-ever, a few factors, including inadequate marketcompetition and pricing mechanisms, an outdatedenergy legislation system and inefficient regula-tion, have all restricted the growth of China’senergy industry. It is imperative that the Chineseeconomy shifts from being resource/energy/pollution-intensive to a healthier, innovation-driven mode of growth, and that it moves awayfrom quantity and speed to quality.

Transformation of the energy system, as aninstrumental part of the energy revolution, meanspursuing goals in five different areas: energyavailability guarantees, environmental pollutioncontrols, economic restructuring, price shockabsorption, and energy security.

First, energy system transformation can leadto improved energy availability. Energy under-pins the development and security of a nation.Given an energy portfolio that features anabundance of coal and very little oil and gas, aswell as insufficient use of nuclear, wind and solarpower, a more streamlined energy system is vitalto increase the use of new energy and providelong-term energy supply stability in China.

Second, energy system transformation allevi-ates environmental pressure on the energyindustry. With energy consumption increasing,pollutant emissions from China’s energy sectorare becoming a critical challenge. Especially inrecent years, climate change and the environ-mental impact of the energy sector have drawnmuch attention. In China, extreme weather, suchas acid rain and haze, has become a major threatto people’s health. Energy system transformationwill, therefore, improve efficiency in the sectorand promote clean and green initiatives, whichwill reduce the resource and environmentalpressure on the sector.

Third, energy system transformation facili-tates economic restructuring. China’s extensiveeconomic growth over the past three decades hasresulted in a rigid energy consumption structureas well as waste and the inefficient use of energysources. Given this context, energy transforma-tion provides an effective path to optimise theeconomy: the efficient use of energy sources will

promote economic restructuring and ensure sus-tained efficient operation of the economy.

Fourth, energy system transformation canalleviate the impact of energy prices on busi-nesses and people. An efficient energy pricingsystem accurately reflects the supply-demandrelationship and guides sensible production andconsumption and promotes the efficient use ofresources. If it is to succeed, energy systemtransformation must take into account resourcescarcity, affordability, social fairness andsustainability.

Fifth, energy system transformation helpsimprove energy security. Against the backdrop ofan increasingly complex global political andeconomic landscape, energy security is essentialfor the smooth operation of the Chinese econ-omy, as well as for the sustained progress ofChinese society. Using market mechanisms,energy system transformation leverages pricingto balance energy supply and demand, ultimatelycontributing to national energy security.

4.2 Status Quo and Major Conflictsin China’s Energy System

Since opening up, China has implemented a ser-ies of transformative initiatives in energy devel-opment and exploitation, market access, pricing,investment and financing, international trade, andadministration. The time when only governmentinvested in the energy sector has graduallychanged. The old system of planning andadministration, where demand was dependent onavailability, has also changed, to cover supplyand demand as well. There has been solid pro-gress in transforming the energy pricing mecha-nism, and an energy market has taken initialshape. A few energy sectors are no longer undercentral control, and the institutional climate forenergy development has improved, which playsan instrumental role in guaranteeing supply-demand balance and driving social and eco-nomic development. Specifically, reforms likeprice control removal, administration-enterpriseunbundling and empowering enterprises tobecome market participants have revitalised the


coal market, leading to a golden decade (2002–12) for coal. Initiatives such as restructuring thethree national oil and gas companies in 1998, andloosening market access and price control haveimproved the oil and gas sectors and made Chinaone of the 10 largest oil producers. The initiativesto set up two grid companies, five power gener-ation groups and the China Power RegulatoryCommission in 2002 have essentially broken thehold of the monopolies. As a result, issues thatwere common in the planning era (such asadministration-enterprise bundling and grid-generation conglomerates) have been resolved,allowing competition between multiple partici-pants in the power generation market. All theseinitiatives have effectively released the potentialfor productivity improvements and given impetusto the development of China’s energy industry.

Despite all this, it should be noted that, in thecontext of the global energy industry and in thedrive to deepen reforms, the current energyregime does not satisfy the demands on energyproduction. Neither does it support the con-sumption revolution nor drive the developmentof the socialist market economy. Some deepconflicts and issues still need to be addressedurgently, as summarised below.

4.2.1 A Modern Energy Market SystemHas yet to Take Shape

Since opening up, China has shifted from aplanned market economy to a socialist marketeconomy and has carried out a series of institu-tional reforms in investment, taxation and pric-ing. Despite the reform initiatives in the energyindustry, there are still several challenges to beaddressed, including slow progress in some sec-tors, the unclear boundary between administra-tion and business, government intervention ineconomic activities, unfair competition betweenmarket participants of different legal status, andthe absence of consistent market access criteria.Other concerns include the government’s controlof coal and oil exploration and mining rights,imperfect administration, and poorly regulatedmarket flow. An open, transparent andwell-regulated energy market access system hasyet to take shape. The coal, oil and power

markets are highly fragmented: the system forassessing and approving new entrants is morelike an administrative procedure, with approvalmore likely to be given to large state-ownedenterprises, which poses higher barriers for pri-vately owned and foreign companies. Energyproduction is still under government control, bymeans of power output and oil and gas produc-tion scheduling. Even now, more than threedecades after opening up, it is thought-provokingto realise that sometimes a market participant candecide neither price nor production volumes.There are other administrative and regulatorychallenges that need to be addressed: the imper-fect energy market mechanism and taxationsystem; the financial and taxation policies thatare poorly suited to encouraging the developmentof new and renewable energy; and the restrictedrange of incentives to support development of theenergy industry, including subsidies, financialdiscounts and tax incentives. Also, in the contextof global economic integration, China still needsto integrate itself properly with the global energymarket and use its international influence toshape regional energy markets.

The organisational structure of the energyindustry is still less than optimal, constrainingeffective competition in some critical areas. Ingeneral, there are major differences in industrialorganisation between different types of energy(especially in energy supply), including marketbarriers to private capital, a lack of competitionin some sectors and excessive competition inothers, and even surplus capacity. In the oil andgas sector, the three leading national oil compa-nies maintain obvious first-mover advantages inonshore oil and gas production and pipelineoperation and management (CNPC), petrochem-icals and oil products (Sinopec), and offshore oiland gas exploration and production (CNOOC),while each of them still demonstrates shortcom-ings in value chain integration. Effective com-petition is still required in some major areas toimprove the overall efficiency of the industry.Another major concern is the increasingly obvi-ous overcapacity in the refining segment.

In short, the energy system challenges thatneed to be addressed are: imperfect market


system, monopoly in some segments,pipeline-operation bundling, dispatch-operationbundling and competition restrictions. Mostenergy companies in China are large state-ownedenterprises, with few private investors, giving anunbalanced mix of market participants. Thegovernment still controls the licencing of coal,oil and gas exploration and mining rights, and therules necessary to ensure consistent marketaccess and fair market competition are still not inplace. So, depending on their legal status, com-panies are not competing on the same levelplaying field. Grid operators still have holdingsalong the entire value chain of power transmis-sion, distribution and sales, and a fair andwell-regulated market competition mechanismhas still not been put in place. Integrated opera-tions encompassing exploration, development,refining, transmission, imports and sales havemore or less been realised in the oil and gasindustry, but the industry still does not allowdiverse participants to compete in individualsections of the value chain. A spot and futuresmarket for oil and gas products has not beenestablished, and regional international energymarkets are less and less influential in the widerworld.

4.2.2 The Energy Pricing Mechanism IsStill Imperfect

The deregulation initiative has made slowerprogress and there is still no fair pricing mech-anism—the price of oil products, gas and elec-tricity is still decided by the government. Theprice structure is unjustified. The cost of infras-tructure like pipelines is not systematicallychecked, and externality costs related to theenvironment have not been internalised. Pricedistortion remains: electricity and gas prices forresidential use have been below cost for sometime, and cross-subsidies abound. The energytaxation system is still imperfect, and the struc-ture and levels of resource taxation are unrea-sonable. Other concerns to be addressed include:poorly aligned fiscal and taxation policies forcoal, oil, gas and renewable energy; a restrictedrange of incentives to support development of thenew energy industry, including subsidies,

financial discounts and tax incentives; andincomplete pricing, fiscal and taxation systemsthat fail to reflect the supply-demand relationshipin the energy products market, the scarcity ofenergy products, and their environmental impact.

The government still intervenes in the energymarket and it is still impossible to deploy energyresources by means of price. In a market system,the most efficient information is the price signal—precise and flexible price signals can successfullyadjust supply and demand, provide guidance forinvestment and optimise resource allocation.With the exception of coal, there is still nomarket-based pricing mechanism for other typesof energy—grid and sales tariffs are still decidedby the government, and the price for oil productsis still not decided by market competition, thoughit has been aligned with the international market.Current energy prices in China do not reflectsupply and demand, resource scarcity and envi-ronmental impact, or provide guidance for con-sumption, investment and resource allocation.Over the course of a decade of reform, themonopoly in the coal sector has been broken up toenable competition. However, state-ownedenterprises still maintain their dominance in theoil and gas and power transmission and distri-bution sectors, and a diversified range of marketparticipants has still not materialised. The enter-prises active in these sectors are less motivated toimprove productivity, and their resource alloca-tion is inefficient.

4.2.3 Government Administration StillNeeds to Be Improved

The relationship between government and themarket still needs to be improved and the gov-ernment needs to accelerate its transition to adifferent role. On the one hand, the governmentintervenes too much in the market and itsadministration is too specific, especially when itcomes to project approval. The procedure forproject approval is relatively complex and someof the initiatives to shift approval from upper- tolower-level government have failed to achievethe desired results. On the other hand, there hasnot been enough research on energy strategy,which is not clearly aligned with the goals of the


Two Centenaries.13 Energy planning is less sci-entific, authoritative and actionable than it shouldbe, and the alignment between different plans ispoor. Project approval tends not to be alignedwith implementation.

Even though reforms have been carried out inthe energy industry, progress in some areas isslow. The boundary between administration andbusiness is less clear than it should be, and thegovernment intervenes too much inenergy-related economic activities. Other con-cerns to be addressed include the impossibility ofachieving fair competition between market par-ticipants of different legal status, the absence ofconsistent market access criteria, theover-representation of state-owned capital, andthe lack of efficient market-led pricing mecha-nisms. In 2002 China replaced the examinationand approval system with the verification system,with the aim of clarifying the obligations of thegovernment and business, streamlining the pro-cess, and regulating investment. However, in thereal world, the verification system looks verymuch like administrative approval, which, com-pared with practices in other developed countriesstill has several flaws. In addition, project veri-fication is usually more favourable to largestate-owned enterprises, while setting higherentry barriers for privately run businesses.

4.2.4 Imperfect Regulationby Government

The regulatory system for energy is still notindependent, and the regulatory responsibilitiesfor market entry, pricing, investment, costing andtransaction management are spread across dif-ferent authorities, including the development andreform commissions and the energy administra-tors. The regulatory function is still weak, andthe regulation of oil, gas, coal, new energy andthe Energy Internet is clearly inadequate. There

is no effective rules-based regulation of themarket. Industry regulation of oil and gas pipe-line safety, the transfer and assignment of miningrights, fair third-party access, scientific resourcedevelopment, clean production and reasonableenergy consumption is incomplete. In addition,the competence of professional regulators ispoor. In particular, regulation of technical mat-ters and of compliance with standards and spec-ifications barely meets the needs of conventionaland new energy, nor of the energy transition.

There is a lack of independent and profes-sional regulators. The existing decentralisedregulatory system, characterised by the integra-tion of administration and regulation, fails toachieve the results expected, especially in marketregulation.

The level of coordination and alignmentbetween different regulatory departments is poor—regulatory goals, effectiveness and speedacross different departments and between centraland local government are inconsistent. Decen-tralisation results in some regulatory functionsbeing absent or inadequate. Another concern isthe focus on market access approval withoutattaching sufficient importance to post-accessregulation. In other words, the governmentfocuses its regulatory efforts on project identifi-cation and approval, not on regulating projectexecution and post-project delivery. In addition,the government addresses economic aspects,such as investment approval, product and serviceprice, and production scale, but fails to regulateexternalities like resource conservation, safety,the environment and quality. Other challengesinclude an inadequate legal foundation and a lackof strict and scientific energy regulatorystandards.

Monopolies in midstream transmission are notclearly identified, and their regulation is inade-quate, especially of power grids and gas pipe-lines. Grid operators monopolise power purchaseand sale. The building of a regional power mar-ket has progressed slowly, power tariff reform issluggish, and the separation of transmission anddistribution and the bidding mechanism for gridconnections have yet to be implemented. Gastransmission still awaits effective regulation and

13The Two Centenaries mark the founding of theCommunist Party of China (in 2021) and the People’sRepublic of China (in 2049). The goals are to build amoderately prosperous society in all respects by 2021 andtransform China into a modern socialist country that isprosperous, strong, democratic, culturally advanced andharmonious by 2049.


fair access is difficult. National oil companiesstill monopolise investment and construction ofthe pipeline network, while bundling andintra-company transactions continue in gastransmission, distribution and sales. In someregions there are still pipeline monopolies.

4.2.5 Incomplete Legislative SystemChina’s energy legislation system is incomplete,as evidenced by the lack of a fundamental energylaw, the delayed adoption and revision of otherlaws, and the incomplete scope and poor oper-ability of the system. Provisions are spreadacross laws, administrative regulations, regionalregulations and departmental rules, with varyingdegrees of enforcement. Due to the lack of con-sistent legislative guidelines and fundamentalprinciples, the links between specific regulationsat different administrative levels are absent.Some departments legislate regulations for thebenefit of the department itself. Other notableconcerns include an excessive reliance onadministrative enforcement and inadequate pun-ishment for infringements.

China is now confronted with severe resourceand environmental constraints, pressure to reducegreenhouse gas emissions, and the challenges ofmaintaining energy security and driving theenergy technology revolution. China’s initiativeto combat climate change requires that its carbonemissions peak around 2030. While energyconsumption will still rise in the future, theabundant clean energy resources of hydro, windand solar have not been exploited effectively.This suggests there is huge scope for adjustmentin the energy system. The dependence of oil andgas on imports is 70% and 40% respectively, andChina is the largest importer of oil and gas fromthe Middle East, making energy security a chal-lenge. The development of emerging technolo-gies like the Energy Internet will radicallychange the industry. This will force the govern-ment to change its regulatory and administrativepractices, and drive innovation in industrialorganisation and government administration,

which in turn will set new demands on theenergy revolution.

In brief, to solve the above issues and addressemerging situations and challenges, it is neces-sary to transform China’s energy systemurgently. In this critical window, when interna-tional energy prices are low, China will waste notime in initiating its energy system revolution,based on the consensus of all stakeholders.

4.3 System Design for China’s EnergySystem Revolution (2030)

4.3.1 Guiding IdeasIn the spirit of the 18th and 16th National Con-gress of the Communist Party of China in 2012and 2002 respectively, China should embark onits energy system revolution with the goal ofbuilding an ecological civilisation. This shouldfocus on accelerating energy transition in linewith the development concepts of “Innovation,Coordination, Green, Openness and Sharing”.The market should play a decisive role inresource allocation, while the government shouldcarry out its administrative and regulatory rolesbetter in order to break down the barriers toenergy sustainability and shape a modern, open,complete and competitive energy system. Such asystem will prioritise renewables and gas, ensurethe well-coordinated development of centralisedand distributed energy, soundly balance supplyand demand, and improve energy efficiency, allfor the benefit of the national economy, people’slivelihoods and the environment.

4.3.2 Fundamental Principles

(1) Market orientation

Taking into account industry characteristics andlaws, China will distinguish between areas ofnatural monopoly and areas of competition andgive participants equal access to the market.Efforts will be channelled towards creating an


“effective market + efficient administration”, withthe focus on building the market, enhancingmarket regulation, maintaining market order,ensuring fair competition, mobilising and moti-vating market participants and shaping a modernenergy market system.

(2) Access criteria

While loosening the restrictions on marketaccess, China will introduce substantive stan-dards for safety, the environment and energyefficiency. China will also transform and mod-ernise the energy mix to alleviate the harmfuleffects of energy production and consumption onthe environment and release the benefits ofreform as much as possible.

(3) Energy security

Given the fact that it is a large energy consumerand importer, China will maintain its energysecurity by integrating international and localmarkets, sharing international resources, com-peting globally and playing an active role inglobal energy governance.

(4) Public benefits

China will carry out its transformation of theenergy system with a well-coordinated packageof goals and with the aim of providing cleareconomic and social benefits—including pro-viding the public with clean, affordable andhigh-quality energy and ensuring a reliableenergy supply.

4.3.3 Strategic Goals

(1) Market system perfection

China will create an open and modern energymarket system, underpinned by comprehensivelegislation and orderly competition. A marketcompetition landscape—where huge energycompanies act as the backbone and a diversifiedmix of energy production, transmission and salescompanies of different legal statuses and sizes

coexist—will effectively address concerns aboutinequality among market participants, marketsegmentation and disorderly competition.

(2) Pricing mechanism perfection

Prices in competitive segments will be decidedby the market. Prices in natural monopoly seg-ments will largely be supervised and regulated bythe government. Together, these will create apricing mechanism and fiscal and taxation sys-tem that accurately reflect the supply-demandrelationship, resource scarcity and environmentalimpact, and address concerns about unfair pricepolicies and pricing mechanisms.

(3) Government administration improvement

The boundary between government and marketwill be clarified and an industry strategy, overallplan, regulations and standards, and high-levelenergy administration bodies for energy reservesand emergency response will be created. Fol-lowing the tenet that “Things prohibited by lawscannot be done, things not prohibited by laws canbe done, and duties enforced by laws must beperformed” will address the challenges caused bythe absence of unified and independenthigh-level energy administration bodies.

(4) Effective market regulation

Unified, independent and professional marketregulators will be set up to form a modern energyregulatory system. The new system will have aclearly defined responsibility matrix, and willpursue fairness and equality, transparency andefficiency, and effective regulation, therebyaddressing problems such as the bundling ofadministration and regulation, decentralised ormissing regulatory functions and poorly enforcedregulations.

(5) Complete legislative system

A complete, well-structured, well-aligned andunified system of energy law will be created,with associated regulations, standards and laws


for power, coal, oil and gas. This will supportnational energy security and sustainability, andaddress existing problems, such as the lack ofunified fundamental principles that underpinlegislation, and the lack of coordination, consis-tency and cohesion in the current energy legalsystem.

4.3.4 Strategic Priorities

(1) Creating a modern energy market system

Natural monopoly segments will be separatedfrom competition-based segments, and the mar-ket access mechanism will be improved toencourage diversified participants to invest indifferent segments of the energy industry in anorderly manner. Trading regimes for the energymarket will be introduced or improved, and amodern hierarchical energy market system,including links between the national market andmultiple regional markets, will be formed. Powersystem operators capable of performing dis-patching and transactions independently will beestablished to separate the power transmissionand distribution businesses. Oil and gas and coalexploration and mining rights will be acquirableonly through bidding and market competition.Oil and gas pipeline operators will be encouragedto gain exclusive rights, pipeline transport ser-vices will be completely separated from sales,and fair third-party access to pipelines and otherinfrastructure will be allowed. Deployment of aglobal Energy Internet that connects everythingand comprehensive energy service markets willbe accelerated. An energy system that facilitatesneutral peer-to-peer interconnection betweencentralised and distributed energy sources, aswell as between energy storage and load devices,will be deployed.

(2) Reshaping the energy market pricingmechanism

A scientific pricing mechanism for monopolysegments will be created, combining constraintsand incentives, and based on cost supervisionand audits. By introducing scientific, transparent

and consistent regulation, monopoly segmentswill be encouraged to undertake healthy andsustainable development and to reduce theircosts. Prices in competition-based segments willbe deregulated and shift to a market-led pricingmechanism. Performance-based, complete, inde-pendent and incentive-guided power transmis-sion and distribution pricing systems will becreated. Pricing reform in inter-provincial andlocal power transmission will be introduced.Studies will be conducted to determine the cor-rect tariffs for regional distribution grids, and theformation of a complete power transmission anddistribution regulatory system will be acceler-ated. Studies will be conducted on methods thatcan be used to publish power transmission anddistribution fees and price information, as wellas methods to determine and distribute voltage-based costs. The price of oil products and gaswill be deregulated and determined by marketcompetition. Apart from the gas distributionnetwork, charging for the use of other oil and gaspipeline infrastructure will be decided by themarket. Subsidy and assistance mechanisms willtarget people in need and industries serving thepublic good. Cross-subsidies will be eliminatedand an energy price regulation regime will beperfected to establish a reasonable price ratiobetween different types of energy.

(3) Creating an efficient energy administra-tion regime

A central regulatory body for state-owned naturalresources and the environment will be formed tooversee land use, environmental conservationand recovery, pollutant emissions and enforce-ment. Planning, policy, standards and incentiveswill be used to administer energy industrydevelopment in a holistic manner. The boundarybetween government and market will be clarified,and complete lists defining powers and dutieswill be created. Approved plans will be carriedout effectively, approval criteria clearly defined,approval procedures streamlined and adminis-trative approval powers revoked or delegated, allof which will reduce government intervention onspecific issues. Renewable energy integration


and curtailment will be thoroughly addressed,and inter-provincial transmission will be incor-porated into the national strategy for long-termpower transmission and use. Power generationwill be completely deregulated and new energygeneration in all regions will be guaranteed thesale of a minimum number of hours per year.Peak shaving and standby auxiliary servicemarket mechanisms will be completed, motivat-ing improvements to fossil power flexibility andthe deployment of new peak shaving and energystorage facilities. Spot energy markets will beformed to benefit from the lower marginal cost ofrenewable energy.

(4) Creating an effective energy regulationsystem

China will separate administration from regula-tion, establishing independent and professionalregulators, and building on the dual-level (centraland regional) regulatory system. The responsi-bilities of regulators will be clearly defined,focusing on economic aspects, while regulationof the societal dimension will be enhanced toensure fair competition in natural monopolysegments like pipeline infrastructure. Regulatorycapacity and efficiency will be improved tomaintain fairness in market competition.

(5) Creating a modern energy legislationsystem

China will adopt its Energy Law to provide alegal basis for the creation and revision of otherenergy-related laws and regulations. The ElectricPower Law will be revised, the Oil and Gas Lawwill be researched and drafted, and the Coal Lawwill be improved, all of which will provide alegal basis for the creation, implementation,assessment, supervision and adjustment ofpower, coal, oil and gas strategies. The EnergyConservation Law and Renewable Energy Lawwill be implemented, while consistent regulatory,coordination, holistic decision-making and pub-lic consultation mechanisms will be formed orimproved. Studies will be carried out on

formulating the Energy Regulation Provisions,and energy regulatory rules, methods and pro-cedures will be created.

5 Reforming the Oil and Gas Sector

5.1 Progress in the Reform of China’sOil and Gas Sector

The pace of market-oriented reform of China’soil and gas sector accelerated after the 18thNational Congress of the Communist Party ofChina in 2012. A series of reform policies andmeasures covering upstream access,market-based pricing, pipeline network reform,market regulation, and management of crude oilimports and exports was introduced. The CentralCommittee of the Communist Party of China andthe State Council unveiled the Opinions onDeepening the Reform of the Oiland Gas Industry in May 2017, which definesthe direction, targets, methods and tasks ofreform. The move to reform the oil and gasindustries energised the market, enabling it toallocate oil and gas resources fairly and create afavourable policy environment for the sustain-able and steady development of China’s oil andgas industries.

5.1.1 Pilot Mining Rights Reformof Upstream Resources HasMade Great Progress

Due to the long-term monopoly in oil and gasexploration and production in China, miningrights are highly concentrated in several largestate-owned oil and gas corporations, making itdifficult for private capital to gain access toupstream resources. Because the mining rightstransfer and exit system is defective, the miningrights market cannot operate efficiently, andbarriers to trade are common, leading to low oiland gas exploration, poor exploitation efficiencyand insufficient investment. To resolve theseproblems, the Chinese government has launchedpilot oil and gas mining rights managementreform programmes.


Public tender was applied to shale gas blocks.Following the first round of public tenders toattract private investment to shale gas in 2011,the Ministry of Land and Resources initiated thesecond round in September 2012. The tworounds of public tendering involved 24 shale gasblocks, covering a total area of 20,002 squarekilometres in Chongqing, Guizhou, Hubei,Hunan, Jiangxi, Zhejiang, Anhui and Henan.There were successful bids for 21 blocks. Thebid winners include: large state-owned enter-prises like China Huadian Corporation and ChinaShenhua Energy Company; energy groupsinvested in by local government, such asChongqing Energy Investment Group and Ton-gren Energy Investment Group; and two privateenterprises (Huaying Shanxi Energy InvestmentCompany and Beijing Titan Source Natural GasResources Technology).

There were breakthroughs in mining rightsreform in conventional oil and gas blocks. TheMinistry of Land and Resources initiated publictenders for six conventional oil and gas blocks inXinjiang in 2015. Thirteen enterprises submittedbids, including state-owned oil companies, localenergy corporations and publicly traded petro-chemical companies. At the end of 2017, theMinistry of Land and Resources commissionedthe Xinjiang Land and Resources Trading Centreto list the mining rights for five oil and gasblocks in Xinjiang for public transfer. Thetransfer term was set at five years, two yearslonger than that specified in the 2015 tender.Private companies were also allowed to take partin this pilot reform of upstream oil and gas. Theobjective was to expand investment in oil and gasexploration and exploitation and diversifyupstream investors. Awarding the blocks bypublic tender broke the state-owned oil compa-nies’ monopoly over upstream exploration andexploitation, helping the reform process to makesubstantial progress.

Competitive bidding was also used to transfershale gas and coalbed methane explorationblocks. Guizhou and Shanxi provinces signedagreements with the Ministry of Land and

Resources to develop shale gas and coalbedmethane resources. On the instructions of theMinistry of Land and Resources, the GuizhouProvincial Government auctioned the Zheng’anblock, where Anye Well 1 is located, in August2017 to accelerate the exploration and productionof shale gas. Besides Guizhou, other provincesand regions also selected shale gas explorationblocks for transfer through competitive bidding.The Department of Land and Resources ofShanxi Province transferred the mining rights for10 coalbed methane blocks (covering a total areaof 2,043 square kilometres) through public bid-ding in November 2017 to seven local enter-prises, including Shanxi Blue Flame CoalbedMethane Group. This was the first batch ofcoalbed methane transferred in China after thereform of the mining rights system. It motivatedlocal governments and energised the market.

Many support policies have been introducedto deepen mining rights reform. The ReformScheme of the Transfer System of Mining Rightsand Plan for the Reform of the Mineral ResourceRoyalty System was adopted in December 2016.Its purpose was to promote the transfer of miningrights through competitive bidding, restrict thetransfer of mining rights through private agree-ment and build a new mineral resources royaltysystem with Chinese characteristics. As stated inthe 13th Five-Year Plan (2016–20) for NaturalGas, the transfer of exploration blocks throughcompetitive bidding to eligible market partici-pants in a fair and open manner would helpcreate an exploration and production systemdominated by large state-owned oil and gasenterprises, but which would also include privatecompanies.

5.1.2 Market-Oriented Pricing Reformis Progressing Rapidly

In China, the natural gas price is administered atdifferent levels. The city-gate price is adminis-tered by the price authorities under the NationalDevelopment and Reform Commission (NDRC),and the sales price after the city-gate station isadministered by local government pricing


authorities. Gas price is composed of ex-plantprice, city-gate price14 and end-user price.15

Ex-plant price, trunk pipeline transmission tariffand city-gate benchmark price are set by theNDRC. The local pipeline gas distribution fee isset by the provincial government’s pricingauthorities, as is the urban end-user price.

Gas price deregulation in China has beenmaking steady progress since the 18th NationalCongress of the Communist Party of China in2012. Following the principle of “maintainingthe administration of pipeline transmission tariffsin a natural monopoly and deregulating gassources and prices”, a complete price regulatorysystem covering the natural gas value chain fromtrans-provincial long-distance pipelines andprovincial short-distance pipelines to city/towngas distribution pipelines has been established.

The non-residential gas price was fullyreformed, step by step, through pilot implemen-tation in selected regions. The three steps of gasprice deregulation were completed during the12th Five-Year Plan (2011–15). Pilots for gaspricing mechanism reform were first carried outin 2011 in Guangdong and Guangxi. Measuresincluded shifting gas price management fromfactory to city-gate, capping the maximum price,changing the pricing method from cost-plus tonetback, and building a dynamic adjustmentmechanism linking gas price to the price of fueloil, liquefied petroleum gas and other alternativeenergy sources. The new gas pricing mechanism,based on the knowledge gained from the twopilots in Guangdong and Guangxi, was intro-duced nationwide in 2013. The price of stock gasand incremental gas was adjusted separately. Theprice of incremental gas was first linked to theprice of alternative energy. Then the price ofstock gas was linked to the price of alternativeenergy in three steps. At the beginning of 2015,the price of stock gas and incremental gas wasloosely tied to conditions in domestic and

overseas markets. In this way, the non-residentialgas price was fully reformed.

The residential gas price has been graduallyadjusted. In order to take people’s well-beinginto account, China used a dual pricing systemfor residential and non-residential city-gate gasprices. The residential city-gate price had notbeen adjusted since 2010, which meant that theaverage residential city-gate gas price was about20% lower than the non-residential price. Withchanging domestic and international markets,deepening reform of non-residential gas pricesand inconsistent pricing mechanisms for resi-dential and non-residential gas, the gas pricebecame increasingly difficult to manage and wasa constraint on gas supply security. To addressthe residential and non-residential city-gate gasdual pricing system, the NDRC released theCircular on Adjusting Residential City-Gate GasPrice in May 2018. This changed the ceilingprice administration system into a benchmarkprice administration system. It stated that theresidential gas price should be linked to thenon-residential city-gate gas benchmark price,and that the supplier and buyer should beallowed to negotiate a city-gate price that is nomore than 120% of the base level (with no lowerlimit). Given the difference between residentialand non-residential gas prices in some provinces,the national pricing authority allows them toreform residential gas price stepwise. The priceincrease in residential gas price may not exceedRMB 0.35 per cubic metre in 2018, and theremaining price difference should be adjusteda year later. At this point, residential andnon-residential gas are linked by both the pricingmechanism and price level, and the price of gasin competitive parts of the value chain is decidedby the market.

The price of shale gas, coalbed methane,coal-to-gas and other types of unconventionalgas were deregulated and allowed to fluctuate in2013, as was the price of liquefied natural gas inSeptember 2014 and the price of gas supplieddirectly to users (except fertiliser companies) inApril 2015. The price of gas used for chemicalfertilisers, and the gas storage purchase, sale andservice price were deregulated one by one in

14City-gate price = ex-plant price + pipeline transmissiontariff.15End-user price = city-gate price + local pipeline gasdistribution fee.


2016. A pilot reform of the city-gate price wasalso carried out in Fujian province.

After several years of reform, the marketisa-tion of the residential gas price had clearlyimproved. Before the reform, the residential gasprice was managed by the government. After thereform, the price of non-residential gas (whichaccounts for more than 80% of China’s total gasconsumption) was determined by the market, ofwhich 50% was completely determined by themarket. For the remaining 30%, a flexiblemechanism, whereby the price may be 20%higher than the maximum gate station price, wasapplied.

A price regulation system covering all nodesin the gas transmission and distribution networkswas created by reforming the pipeline transmis-sion pricing mechanism. To resolve thelong-term absence in China of clear and sophis-ticated gas pipeline transmission pricing andsupervisory and review mechanisms, the NDRCissued the Measures for the Administration ofNatural Gas Pipeline Transport Prices (tentative)and the Measures for the Supervision andReview of Natural Gas Pipeline Transport Pric-ing Costs (tentative) in October 2016. Thesemeasures specify the scope and objectives ofprice regulation, the methods and procedures ofprice management, as well as some key indica-tors based on the principle of “allowable cost +reasonable profit”. As a result, a new gas pipelinetransmission pricing method has been estab-lished. The price no longer differs from onepipeline to another. Rather, it is assessed andthen fixed, based on the cost of transmission(made public by the government) and the pricingformula. Pipeline transmission costs that are notpart of the tariff are clear to all parties. Thisstandardises pricing and provides clear and ver-ifiable charging criteria for third parties wantingaccess to the transmission network.

Because the price regulation rules for gasdistribution are not yet complete, the gas distri-bution price varies between regions, with someregions charging a higher price than others.The NDRC issued the Guiding Opinions onStrengthening Regulation of Gas Distribution inJune 2017, which defines the methods for setting

the gas distribution price. It also defines the keyindicators and parameters and the requirementsneeded to improve regulation, build cost con-straints and create motivation mechanisms, aswell as requiring disclosure of business infor-mation. The Guiding Opinions established theprice regulation framework for downstreamurban gas distribution, thereby building a com-plete price regulation system covering all parts ofthe gas system, from transmission to distribution.In addition to alleviating the cost burden on usersby lowering the high distribution price in someregions, the Guiding Opinions lays a solidfoundation for the future separation of distribu-tion and sales and the opening of the gas distri-bution network to third parties.

In the first half of 2017, the NDRC reviewedthe pricing of 13 trans-provincial gas pipelinetransmission companies. The pipeline transmis-sion price had decreased by around 15% onaverage, saving businesses using downstream gasabout RMB 10 billion. Shaanxi, Jiangsu, Zhe-jiang, Hebei, Yunnan and Jiangxi developed theirown transmission and distribution price regula-tions, as required by central government, andreduced their pipeline transmission and gas dis-tribution prices, cutting the cost for businesses bymore than RMB 4 billion. Supervision andreview of transmission and distribution pricesenabled pipeline transmission companies toreduce costs and increase efficiency, benefittinggas users. Most importantly, the process openedthe pipeline network and marketised gas trading.After the long-distance pipeline transmissionprice had been reviewed and fixed, two pipelinetransmission companies immediately openedtheir pipelines to third parties.

5.1.3 Access to Infrastructure WasFurther Deregulated

Systemic shortcomings severely impede theefficient use of infrastructure and fair competitionamong market participants. To resolve theseproblems, the NDRC and the NEA issued theMeasures for the Administration of Natural GasInfrastructure Construction and Operation andthe Measures for the Supervision and Adminis-tration of the Fair Opening of Oil and Gas


Pipeline Network Facilities (tentative) in April2014. The measures state that: “the state shallencourage and support various kinds of capital toparticipate in the investment and construction ofnatural gas infrastructure included in integratedplanning”; “third parties shall be allowed to usegas infrastructure, including liquefied natural gas(LNG) terminals”; “oil and gas pipeline networkoperators shall, in the case of spare networkcapacity, share their pipeline network facilitiesequally with third-party market participants andprovide transport, storage, gasification, liquefac-tion, compression and other services”; and “oiland gas pipeline network facility operators shalluse facility capacity to the full, ensure servicesare maintained for existing users, and provideaccess to the facilities for new users in a fair andnon-discriminatory manner”. After these mea-sures were declared, some oil companies pro-vided third parties with access to their LNGterminals. For example, CNPC provided BeijingGas Group with access to its Dalian andTangshan LNG terminals and the Yongqing-Tangshan-Qinhuangdao pipeline, thereby pro-viding unloading, storage, gasification andtransmission services for imported LNG (450million cubic metres of gas was transmitted in2016). CNPC’s Caofeidian terminal received15,000 tonnes of LNG imported by China Gasfrom Nigeria. Sinopec transmitted 210 millioncubic metres of natural gas for Kunlun Gas,China Gas, China Resources Gas and ShanxiGuohua Energy. CNOOC transmitted 54 millioncubic metres of natural gas in its Guangdong gaspipelines for China Resources Jiangmen andENN Dongguan.

To improve the supervision and regulation offair access to oil and gas pipeline facilities and toprovide information that could form the basis forfair access, the NEA issued the Notice onInformation Disclosure of Access to Oil and GasPipeline Facilities in September 2016. The noticespecifies the parties required to disclose infor-mation, the information to be disclosed, themethods of disclosure and the arrangements forsupervision and regulation. CNOOC, Sinopecand CNPC published on their websites theinformation required on all their infrastructure,

including long-distance pipelines and LNG ter-minals. Some provinces, including Shanxi, alsodisclosed information on their pipelines to thepublic. After three years, gas infrastructureinformation was transparent, providing the basisfor fair access to, and supervision and regulationof, the facilities.

5.1.4 Reform of the Right to ImportCrude Oil and the Rightto Use It

Crude oil is imported to China by state-ownedand non-state-owned trading companies. Permitsfor state-owned trading companies are issued bythe State Council. Those companies with permitsinclude Sinopec, CNPC, CNOOC and Sinochem.Import volumes are not limited. Non-state-ownedtrading companies are managed by quota. Theirimport volumes are capped. Permits and importvolumes are managed by the Ministry of Com-merce. Crude oil imported by non-state-ownedtrading companies can enter approved refineriesonly. There were more than 20 non-state-operated trading companies before 2012,importing around 10% of China’s total importedcrude oil. China began to deregulate crude oilimport rights in 2012, granting them tostate-owned enterprises like China NationalChemical Corporation, and in 2014 to privatecompanies like Xingjiang Guanghui Petroleum.

China began to speed up reform in 2015, byextending the right to import and use crude oil toapproved Chinese refineries. The NDRC issuedthe Notice on Issues Concerning Use Manage-ment of Imported Crude Oil in February 2015.This allows crude oil processing companies thatmeet energy consumption, quality, environmen-tal and safety conditions to use imported crudeoil, on condition that they shut down outdatedcapacity or construct gas storage facilities of acertain size. The notice marks the point whencrude oil import rights were officially opened upand the eradication of oil and gas monopoliesbegan to gain pace. In 2018, 32 local refineries(excluding those operated by Sinochem) weregranted permits to import more than 90 milliontonnes of crude oil. The Ministry of Commerceissued the Circular on the Application by Crude


Oil Processing Enterprises for Non-State-OwnedTrading and Import Qualification in July 2015.The circular allows non-state companiesapproved to import, export and refine oil prod-ucts—and which meet energy consumption,quality, environmental, safety and storage con-ditions—to apply for approval to import crudeoil. Up to August 2016, 16 companies hadobtained the right to import crude oil, importing62.57 million tonnes in total.

Further deregulation adjusted the original oilimport-export management system and laid aninstitutional foundation for the formation of atransparent and open oil refining market featuringorderly competition and diversified market par-ticipants. The move brought new opportunities tosmall and medium-sized oil companies in trade,financing and logistics. The utilisation rate ofprivate refineries was improved significantly.Statistics show that average capacity utilisationof Shandong’s refineries increased from 41.2% inJune 2015 to 60% in the first half of 2017.

5.1.5 Oil and Gas Exchanges WereSteadily Established

The introduction of natural gas exchanges is animportant means to reform the natural gas pricingmechanism and strengthen China’s voice ininternational natural gas pricing. The role ofnatural gas exchanges is repeatedly mentioned ingovernment documents, such as the 13thFive-Year Plan (2016–20) for Natural Gas, theNotice on Clarifying the Price Policies for GasStorage Facilities, the Notice on the PoliciesRegarding City-Gate Station Price in FujianProvince and the Notice on Promoting Deregu-lation of the Price of Gas Used for ChemicalFertiliser Production. Gas suppliers and users areencouraged to participate in oil and gas exchan-ges and other platforms to establish a transparentgas price through trading.

The Chinese government accelerated theintroduction of natural gas markets, successfullybuilding two trading platforms, one in Shanghaiand the other in Chongqing. The Shanghai Pet-roleum & Gas Exchange, founded in December2014, was put into trial operation in July 2015and official operation in November 2016.

Unilateral gas trading volume exceeded 6.5 bil-lion cubic metres in 2015 and 15 billion cubicmetres in 2016, accounting for around 8% oftotal gas consumption in China. The volume wasexpected to exceed 50 billion cubic metres in2017. LNG bidding for 12 coastal provinces andcities is now conducted through the ShanghaiPetroleum & Gas Exchange, and 174,800 tonnesof LNG have been traded in total. The pricereached by bidding fully reflects local LNGsupply and demand. The Shanghai Petroleum &Gas Exchange carried out the first round ofbidding for pipeline gas in September 2017. Theexchange plays an important role in aligningsupply with demand and establishing a reason-able price. With its influence growing, theShanghai Petroleum & Gas Exchange attractswide attention in and outside China.

Chongqing Petroleum and Gas Exchange wasunveiled in January 2017 and put into trialoperation in April 2018. Some provinces andcities, including Xinjiang, Zhongwei, Shenzhenand Hubei, are actively researching the formationof regional natural gas exchanges.

Natural gas exchanges are important out-comes of oil and gas price deregulation. Theyprovide influential support for the deepening ofreform. Though their size is not yet large, theirrole of allocating resources in a market-orientedand optimal fashion and in providing equalcompetition opportunities to downstream users isnow widely recognised.

China has created an oil futures market.Despite China’s position as the world’s largestcrude oil importer, the second largest oil con-sumer and the fourth largest oil producer, Chinahas inadequate influence in the crude oil market,and suffers from the Asian premium of payingmore for crude oil from the Middle East thanEuropean or US refiners. The development of oilfutures provides a method of price discovery anddrives the reform of China’s oil products pricingsystem. It can also help eliminate the Asianpremium, hedge against oil finance risks andpromote RMB internationalisation. Crude oilfutures were officially listed on the ShanghaiInternational Energy Exchange (INE), a unit ofthe Shanghai Futures Exchange, in March 2018.


It is the first futures market on the Chinesemainland open to outside investors.

5.2 Major Problems in the ExistingOil and Gas Systemand Mechanisms

Following the intensive introduction and imple-mentation of reform policies and measures afterthe 18th National Congress of the CommunistParty of China in 2012, China’s oil and gasmarket-oriented reform made great progress.Measures include improving the oil and gaspricing mechanism, marketising the allocation ofoil and gas resources, enhancing oil and gassupply capacity, and improving oil and gasresource use. However, there are still someunderlying institutional problems in the oil andgas sector that urgently need to be addressed.

5.2.1 Unsound Market Systemand Inadequate MarketCompetition

First, the administrative monopoly is strong inexploration and production, restricting the extentto which oil and gas production capacity can beimproved. Oil and gas exploration and produc-tion is a monopoly in China. According to theAdministrative Measures for Registration ofMineral Resources Prospecting Blocks and theAdministrative Measures for Registration ofMineral Resources Exploitation issued by theState Council in 1998, the companies engaged inexploration and exploitation of oil and gasresources are subject to mandatory approval bythe State Council. So far CNPC, Sinopec,CNOOC and Yanchang Petroleum have beenapproved. Oil and gas mining rights need to beregistered, which has been a long-term policy.The mining rights of the four companies cover allfavourable blocks. At present, China’s registeredoil and gas exploration rights cover 4 millionsquare kilometres of land, of which 3.9 millionsquare kilometres belong to CNPC, Sinopec andCNOOC. Registered oil and gas exploitationrights cover about 118,000 square kilometres ofland, of which 117,000 square kilometres (99%

of all registered exploitation rights) are owned byCNPC, Sinopec and CNOOC. In recent years,China began to explore the transfer of miningrights through competitive bidding for shale gasand coalbed methane exploration blocks andcarried out pilot public bidding for conventionaloil and gas blocks in Xinjiang. However, oil andgas mining rights are still highly concentrated ina few large state-owned oil and gas companies,leading to limited market competition, a lowdegree of marketisation and inefficient operation.Since the procedures for transfer and exit fromoil and gas mining rights are not mature, andsince supervision and follow-up measures areabsent, it is difficult for private capital to enterthe market. A diversified upstream market basedon orderly competition has yet to be formed. As aresult, there is insufficient investment in oil andgas resource exploration and exploitation and thepotential for increased output and lower costs isrestricted. Furthermore, enclosed gas blocks arenot exploited. This prevents blocks of potentialresources from being fully exploited.

Second, the lack of diversity in infrastructureinvestors and insufficiently deregulated invest-ment access result in infrastructure constructionlagging behind market development. In China,trunk gas pipelines and branch pipelines aremainly invested in and built by CNPC, Sinopecand CNOOC. Regional branch pipelines aremainly invested in and built by CNPC, Sinopec,CNOOC and local capital. CNPC’s gas pipelinesaccount for more than 70% of total gas pipelineinvestment. Because of this lack of diversity inpipeline investors, China’s gas pipeline con-struction does not match demand. During the12th Five-Year Plan (2011–15), China con-structed about 25,800 kilometres of trunk andfeeder gas pipelines, accounting for only 58.5%of the planned 44,000 km target. Althoughpipeline investment and construction are not sofar behind that they hinder gas supply, it is stilldifficult for private natural gas companies toenter the market, due to constraints like insuffi-ciently deregulated investment access and longproject approval processes. As a result, it is hardto unlock the huge potential in gas pipelineinvestment and construction—the quantity and


speed of pipeline construction does not meetdemand, and the efficiency and economic bene-fits of pipeline investment and construction needto be improved. Some provinces with their ownpipeline companies want gas pipelines to be builtand operated by these companies in a centralisedmanner, excluding other companies frominvesting in and constructing gas pipelines intheir province. In other provinces that do nothave such policies, the monopoly policy isexercised during project approval. Gas storagefacilities also lack diversity. The country’s 12 gasstorage facilities are owned by CNPC andSinopec. Six private gas companies have jointlyconstructed one town gas storage facility, but it isyet to be provided with working gas.

Third, gas infrastructure is highly integrated,which hinders downstream market development.China’s gas sector has not yet separated trans-mission from distribution and sales. As a result,the highly integrated upstream, midstream anddownstream monopoly business model domi-nates. For example, about 98% of upstream gas issupplied by CNPC, Sinopec and CNOOC. Thesethree companies have built about 95% of trunkoil and gas pipelines and account for 90% of thereceiving capacity at China’s 17 liquefied naturalgas (LNG) terminals. They are also the principalactors in gas production, purchase and sales. Aspipeline construction and investment needs tohave gas sources and a market, the upstreammonopoly creates a barrier for pipeline invest-ment that prevents other participants fromentering the field. In addition, the upstreammonopoly restricts direct gas purchase transac-tions with large users and hinders growth inimported gas, which has a negative impact on thedevelopment of the downstream natural gasmarket.

Fourth, most of China’s trunk gas pipelinesare owned by CNPC, Sinopec and CNOOC, butthey are poorly interconnected. And mostprovincial pipelines were built jointly byprovincial state-owned enterprises and the threeoil and gas titans. Typically controlled byprovincial state-owned companies, the provincialpipelines are not interconnected with nationaltrunk pipelines. Access to pipelines and fair

services is difficult for newcomers, even forstate-owned enterprises supervised and managedby central government. Why? Under the verti-cally integrated model of operation, pipelineshelp large oil and gas companies integrateexploration with imports and sales. Large oil andgas companies with upstream resources do notwant to lose the lucrative midstream pipelinetransmission market and be restricted in theirsales activities. There is not enough pressure onthem to open pipeline infrastructure to others.Also, large oil and gas companies view LNGterminals as gas supply points, rather than publicinfrastructure. There is, therefore, a conflict ofinterest between maintaining the price of gashigh over the long term, providing third-partyaccess to infrastructure, and performing the dutyof ensuring supply. The existing oil and gassystem can meet the demands of market-orientedreform, but it has become a bottleneck impedingthe rapid, healthy and sustainable development ofthe natural gas industry.

5.2.2 The Market’s Abilityto Determine Price IsInsufficient

First, market-oriented pricing has not beenimplemented in competition-based sectors. Theprice of most oil products and natural gas iscurrently set by the government, rather than bythe market. Since the conflict between thetransparency of the oil products pricing mecha-nism and the hysteresis of price adjustments hasnot been resolved, the oil product price mecha-nism cannot fully reflect supply and demand inChina, or the scarcity of resources or environ-mental impact. As a result, it cannot effectivelystimulate or restrain the efficient developmentand reasonable consumption of oil and gasresources. As for the natural gas pricing mecha-nism, the current city-gate price is a benchmarkprice set by government, including ex-plant price(imported gas price) and the pipeline transmis-sion tariff. This pricing model, with its two links,impedes third-party access to pipeline facilities.Although the Circular on Adjusting the Resi-dential City-Gate Gas Price of May 2018 statedthat China would gradually unify the residential


and non-residential city-gate gas prices to elim-inate cross-subsidies, the residential gas price isstill lower than the cost of gas supply. Further-more, cross-subsidies have still not been com-pletely eradicated. In some regions, priceadjustment lags behind the city-gate price, sochanges in the upstream market are not reflectedin price in a timely fashion.

Second, the gas price system needs to beimproved. On the supply side, the construction ofgas storage in China has lagged far behindmarket development for some time. This is due tothe high investment cost of underground gasstorage, a shortage of options for recoveringinvestment in cushion gas, the absence of apeak-shaving gas price, and the failure to estab-lish a market-oriented pricing mechanism for gasstorage services and peak-shaving gas capacity.As indicated in the Report on the Oil and GasIndustry in and Outside China 2017, up to theend of 2017, China had constructed 12 gasstorage facilities (clusters), the peak-shavingcapacity of which stood at 10 billion cubicmetres. The working gas capacity of 8 billioncubic metres accounted for 3.4% of China’s gasconsumption that year, much lower than theglobal average of 12%. In developed countries,the working capacity of gas storage accounts for20–30% of their total gas consumption. Thesevere shortage of gas storage peak-shavingcapacity was an important cause of the nationalgas shortage at the end of 2017. On the demandside, the absence of interruptible and peak andoff-peak gas prices dampens the motivation toexpand the interruptible user base.

Third, natural gas exchanges help push marketreform of the gas pricing mechanism and restorethe commodity attributes of gas. Although theShanghai Petroleum & Gas Exchange has startedoperations and the Chongqing Oil and GasExchange will start soon, China’s natural gasexchanges are still in their infancy. Spot tradinghas begun with small quantities, but futurestrading has yet to start. The gas trading volumeof the Shanghai Petroleum & Gas Exchangeexceeded 15 billion cubic metres in 2017, about6.3% of China’s total gas consumption. There isa large gap between China and the USA and

Europe. Only a small volume of gas is traded viacompetitive bidding. At the Shanghai Petroleum& Gas Exchange, pipeline gas is traded mainlyby reference to the provincial city-gate price setby the NDRC. Competitive bidding is limited tolow-volume LNG trading. Deals are mainlyconcluded by negotiation, with trading modelsstill being explored. The services offered by theexchanges need to be diversified and the tradingsystem needs to be improved. The followingchallenges remain: gas pricing policy factors thatrestrict trading, the absence of a competitiveupstream market, and pipeline networks andinfrastructure that do not provide fair access tothird parties. This means that the natural gasexchanges can only trade in volume; they cannotdetermine benchmark prices. As such, it is diffi-cult for them to replace government-set bench-mark prices in the short term.

5.2.3 Poor Government Administrationand Supervision

China has made great progress in reforming oiland gas management, but administration andsupervision still need to be improved.

As regards resource development and use, oiland gas supply security and environmental pro-tection, too much attention is paid to reviewingand managing market access qualifications, andnot enough to overseeing project implementationand effects. Public services for informationmanagement and modernisation technologies arenot in place. Important information is sometimesnot disclosed in advance or on time. The gov-ernment intervenes too much in the market.Government management is too low-level andspecific, such as focusing on investmentapproval, price setting and output control. Thepower, duties and interests of central and localgovernment are not balanced. The central gov-ernment has strong power and limited duties, andlocal government has little power and unlimitedduties, leading to inefficient administration andpoor outcomes.

Oil and gas strategies have been missing for along time. Industry plans and arrangements(major projects), policies, standards and specifi-cations, and laws and regulations are not aligned


and harmonious, so synergies cannot be created.For example, the positioning of natural gasdevelopment strategies is not clear, and thescepticism about the cleanness of natural gasneeds to be addressed. Plans for the oil and gassector, limited to seeking advice, are not har-monious with other plans, such as those for land,the sea and natural reserves. Key content is notwell aligned. In addition, national oil and gaspipeline construction plans do not incorporatelocal government plans for land and urban andrural development, making coordination duringimplementation difficult. And industry associa-tions do not play their roles to the requiredextent.

The regulatory system is incomplete. First, thefunctions and duties of oil and gas authorities aredecentralised. The policy goals of central andlocal government departments are different andtheir work rate is not aligned, making coordina-tion difficult. Second, regulatory activities do nothave a clear interface. Their efficiency is poorand their effects are weak. The absence of rele-vant laws and regulations means that there isinsufficient basis for effective problem solving.For instance, China has not yet developed anenergy law, an oil and gas law or natural gas law,and the policies related to opening pipeline net-works and gas infrastructure to third parties areissued by ministries or commissions in the formof circulars or measures. Third, there is notenough diversification in the regulators and themeans of regulation, making it difficult toimplement reforms that call for “administrativestreamlining, delegation of powers and serviceoptimisation”. Government regulators relymainly on standard administrative methods andpeer-to-peer supervision and review.

5.3 Objectives of Oil and GasIndustry Reform

5.3.1 The Idea Behind the ReformReform of China’s oil and gas industry is guidedby Xi Jinping’s Thoughts on Socialism withChinese Characteristics for a New Era, the 19thNational Congress of the Communist Party of

China in 2017, the 2nd and 3rd Plenary Sessionsof the 19th Central Committee of the CommunistParty of China in 2017, and the developmentconcepts of “Innovation, Coordination, Green,Openness and Sharing”. The reforms should beimplemented across the whole oil and gas valuechain in an orderly manner, with the focus onsupply-side structural reform, including explo-ration and production, pipeline transmission,circulation, refining and chemicals, enterprisereform, government regulation, and the enact-ment, amendment and abolition of oil and gasregulations. The relationship between the marketand government should be clarified to enable themarket to play a decisive role in resource allo-cation and the government to play a more effi-cient role.

5.3.2 Basic PrinciplesThe market’s decisive role in resource allocationshould be given full play. Industry characteristicsand the laws of market development should befollowed. Barriers to entry and monopolies in theoil and gas industry should be eliminated toenable eligible market participants to entercompetition-based sectors. This will improvecompetition and efficiency, energise the marketand raise oil and gas supply capacity. In addition,government should play a more efficient role inmacroeconomic regulation, market supervisionand regulation, and service provision.

Oil and gas is an integral part of the nation’seconomy. Reform of the oil and gas sector has adirect impact on economic development, resourcesecurity and environmental safety, people’slivelihoods and social stability. Its positive andadverse impacts on the social economy should befully considered. Industry characteristics and thelaws of the market economy should be followedto reform upstream, midstream and downstreamin an orderly and problem-oriented manner. Anoverall reform plan that clearly defines thedirection and goals of reform should be devel-oped, targeting breakthroughs at key points of theplan and implementing pilot projects to gainexperience and test solutions.

China is a large oil and gas producer andconsumer. Ensuring national energy security


under open conditions should be the first objec-tive. Domestic and international markets andresources should be planned in a holistic manner.The survey, assessment and exploration ofdomestic oil and gas resources should bestrengthened, and the resources developed in anorderly and cost-effective way to improve Chi-na’s domestic supply capacity. China should alsoactively develop overseas resources to diversifyimported oil and gas supply, thus lowering riskand enhancing supply security.

Different targets and interests should beacknowledged. Economic returns and socialbenefits should be combined organically. Publicinterest should be better protected. Oil and gassupply capacity and quality should be improvedto make high-quality, clean and affordable oiland gas resources widely available to the public.

5.3.3 Objectives of ReformMarket-oriented reform of the oil and gas valuechains should be accelerated, as required by theCentral Committee of the Communist Party ofChina and the State Council in the Opinions onDeepening the Reform of the Oil and Gas Sys-tem. This will be achieved by capitalising on thestrategic opportunity to deepen reform of the oiland gas sector, thanks to the abundant supplyresources available in the international oil andgas market and low oil and gas prices. The goalis to build a modern oil and gas market that hasbeen opened up in an orderly fashion, featuringfair competition, effective regulation and gov-erned by laws. By 2030 the market will play adecisive role in allocating oil and gas resourcesand government will play a more efficient role.Oil and gas supply capacity and efficiency of useshould be improved rapidly, and the substitutionof energy types should be realised as soon aspossible. In this way, economical oil and gasresources will be available to people, and thestrategic objectives of energy production andconsumption will have been achieved.

More effort should be channelled into restor-ing the commodity attributes of oil and gas toallow prices to be determined by supply anddemand. Government focus will shift, fromintervening in operations and setting prices for

oil and gas producers to developing strategies,plans, policies and rules to create a fair market.Government should strengthen its regulations onmarket access, transactions, monopolised seg-ments, pricing and costs. It should also improvethe standards, rules and procedures of the regu-latory process to create a standardised, orderly,open and transparent supervisory and regulatorysystem.

Oil and gas supply capacity and energy effi-ciency will be improved. Reform of the wholevalue chain should be deepened to make thecompetition-based segments of oil and gascompanies more dynamic. Technical innovationshould be pushed to reduce production costs andimprove supply capacity. Other targets include:using domestic as well as overseas resources;mitigating market risk; improving transmissionand service; improving oil and gas use efficiency;ensuring strategic oil and gas security; andoperating safely and cleanly along the wholevalue chain.

The substitution of energy types should beachieved as soon as possible. Petroleum con-sumption should be guided. The proportion ofnatural gas should be increased significantly todevelop natural gas into one of the main energysources as soon as possible, thereby achievingthe strategic objectives of energy production andconsumption.

5.3.4 Pathways to Reform in the Oiland Gas Sector

To achieve the above objectives, oil and gassector reform should be as follows.

(1) Reform the oil and gas mining rightsmanagement system and establish a min-ing rights market

Reform of the oil and gas mining rights man-agement system should “be market-oriented,diversify investors in an orderly manner,strengthen supervision and regulation, andimprove the tax and fee system”.

To ensure orderly, stable, efficient and greenexploration and production and the efficientallocation and use of oil and gas resources,


management of mining rights should be per-formed at a high administrative level. China canuse the lessons learned from the trial imple-mentation of the competitive transfer model forshale gas and coalbed methane (CBM) explo-ration blocks in provinces like Guizhou andShanxi. These were jointly sponsored by theprovincial government concerned and the rele-vant ministry. Provinces should be selected todelegate shale gas and CBM mining rights tolocal government, thus motivating local govern-ment to drive the exploration and development ofshale gas and CBM resources throughout thecountry. To eliminate the uneven distribution oftax revenues between central and local govern-ment, the mechanism by which oil and gasbenefits are shared by government needs to beimproved to ensure that resource developmentbenefits local people.

The Mining Rights Transfer System ReformPlan issued by the State Council in 2017 clearlystates that China’s mining rights (including oiland gas exploration and exploitation) will shiftfrom agreements to public auction. The planrequires that all mining rights transfers are madethrough listing and that agreement-based trans-fers will be restricted. The price of mining rightstransfers will be determined by the market. Thiscompetitive transfer approach will be fullyimplemented in China’s oil and gas explorationblocks. It is suggested that the relevant authori-ties develop support policies for the nationalmineral resources royalty system as soon aspossible, and that differentiated benchmarks beset for onshore and offshore oil and gas explo-ration blocks and unconventional oil and gasresources.

The experience gleaned from the pilot auctionof exploration rights for the first and secondbatches of conventional oil and gas blocks inXinjiang should be extended to other provinces.Companies registered in the People’s Republic ofChina that have a Chinese entity as their con-trolling shareholder, have sufficient financialresources and a sound financial and accountingsystem, and can independently bear legal liabil-ities, are allowed to hold oil and gas miningrights, thus breaking the upstream monopoly.

However, bid winners should be selected on theirfinancial and technical strength, rather than onthe level of investment committed, to ensure thatblocks are transferred to companies that are trulyinterested in oil and gas and to avoid the need forpassive supervision later. The lessons learnedfrom the auction of shale gas and oil and gasexploration rights in Xinjiang, as well as the pilotreform of CBM mining rights in Shanxi, shouldbe studied. Small and medium-sized enterpriseswith different ownership systems should beallowed to exploit the abundant oil and gasreserves owned by CNPC, Sinopec and CNOOCthat have not been used and for which there is nodevelopment plan in the short term. Non-publicenterprises and capital, as well as companies withsuperior technical strength, are encouraged toform joint ventures and bid for oil and gasmining rights. Finally, an exploration andexploitation system involving diverse partici-pants should be created through mining rightsreform, enabling the market to determineresource allocation.

The lowest limit of investment for oil and gasexploration blocks should be set at differentlevels in different regions for different mineralvarieties and for different phases of exploration.Given the low cost of ownership of explorationrights, and to encourage more companies to exitfrom idle blocks and attract other investors intoexploration, the upper limit of explorationinvestment should be raised for the first andsecond years and lifted completely for the thirdyear. However, the upper limit of explorationinvestment and exploration royalties for difficultand high-risk blocks could be reduced. Forexample, exploration and exploitation of uncon-ventional oil and gas resources are far moredifficult than for conventional resources. A lowerexploration investment threshold and explorationroyalty should be applied to unconventional oiland gas blocks based on geological conditionsand/or difficulty and the time required forexploration. The cost of owning oil and gas blockmining rights and the amount to be paid to cen-tral government in the form of royalties shouldbe set at a suitable level. Mining rights should berationalised and the tax and fee system reformed.


Block circulation includes the transfer ofexited and existing blocks and circulationbetween businesses. First, measures to restrictblock exit should be developed to improve theexit mechanism, including: (i) economic meansto raise the charges for holding explorationrights; and (ii) administrative means to forcemandatory exit of a proportion of the same basinwhenever an exploration right is extended. It issuggested that differentiation be applied accord-ing to the difficulty of exploring in differentregions. For example, the lower limit of explo-ration rights investment for the Tarim andSichuan Basins, which have complex geologicalconditions and a long drilling period, should bedifferent from other basins or regions. The yearsin which such blocks are under assessmentshould be extended appropriately. Second, themeasures to administer transfer of existing blocksshould be improved. Such measures existalready, but there are no relevant assessmentagencies or detailed rules of implementation andno precedent for oil and gas block transfer. It issuggested that rules on the paid use of reservesand valuation methods that are fair, reasonableand consistent with international practice shouldbe studied and developed, and that world-classreserve assessment agencies should be cultivatedto create conditions for mining rights circulationand reserves trading. Third, circulation of exist-ing blocks should be accelerated. After analysingsuccessful circulation cases, such as that ofDaqing Oil Field entering the Tadong Block, thefour major oil and gas companies (Sinopec,CNPC, CNOOC and Sinochem) should beallowed to transfer blocks and trade reservesamong themselves using market-orientedapproaches to revitalise mining rights resources.

To encourage businesses to exit idle blocksand make room for other investors, the initialinvestment of those exiting businesses should becompensated. If a licence holder exits and theexploration right is taken by another company,that company should provide compensation forthe previous investment of the licence holder.Compensation criteria could be investment inseismic exploration, research or drilling.

China will cancel the franchise of the threemajor state-owned oil and gas enterprises foronshore cooperation with foreign businesses andallow other Chinese companies to cooperate withforeign businesses under government regula-tions. Companies should be motivated—andcapital, advanced technologies and managementexperience leveraged—to improve China’s abil-ity to supply oil and gas, especially unconven-tional resources. The franchise for offshorecooperation should also be steadily deregulated.Pilot reforms could be carried out, initially withCNPC and Sinopec. After which the criteria forawarding offshore oil and gas mining rightsshould be researched by examining these pilotreforms. Subsequent laws and regulations shouldbe introduced step by step.

While granting access to upstream resources,China should improve management and sharegeological data. It is suggested that the govern-ment should form a national geological dataorganisation, giving it the right to set up an oiland gas geological data submission system andempowering it to require businesses (includingnational oil companies) to submit geologicaldata. Non-confidential geological data should bemade available to all companies to facilitate dataand information sharing.

(2) Accelerate reform of the oil and gaspipeline network and build an indepen-dent and diversified system of oil and gasinfrastructure

The guiding principle behind the reform of theoil and gas pipeline network is: “drive the inde-pendence of trunk pipelines of large state-ownedoil and gas companies step by step to unbundlepipeline transmission and sales; improve themechanism for fair access to the oil and gaspipeline network to make trunk pipelines andintra- and inter-provincial pipeline networksopen to third-party market participants”. Chinawill focus on addressing the main factors con-straining the development of its natural gasindustry: infrastructure construction, undiversi-fied construction companies and operators, low


level of pipeline interconnection, bundled trans-mission and sales, and ineffective implementa-tion of third-party fair access. China is striving toachieve independence for oil and gas pipelinesand create a nationwide pipeline network by2020 to support an oil and gas production, sup-ply, storage and sales system, and deliver theultimate goal of a coordinated oil and gas valuechain by 2030.

Pipelines and other infrastructure linkupstream to downstream in the oil and gas sector.The reform of the pipeline network, and its effecton upstream-downstream reform, has attractedwidespread attention. The experience of coun-tries with a mature natural gas market suggeststhat natural monopolies like pipelines should beseparated from upstream and downstream busi-nesses, and that pipeline companies should divesttheir bundled sales services. Pipeline companiesshould operate independently and only provide atransmission service, thus helping to create acompetitive and efficient oil and gas market. Theindependence of oil and gas pipelines not onlyprovides the strongest guarantee for fair access toinfrastructure, it also eases supervision of pipe-line transmission costs, accelerates the formationof an efficient pipeline service market and helpsmarketise the whole industry.

In recent years, factors such as low oil and gasprices, slower growth in gas consumption, asignificant decline in the operating revenues ofCNPC, Sinopec and CNOOC, and the upcomingpipeline reform have reduced pipeline infras-tructure construction and made investment inupstream exploration and production less attrac-tive. If reform is not accelerated, it will restrictthe construction of gas pipelines and have anadverse effect on gas supply security. On theother hand, as oil and gas system reform deepens,private enterprise will enter the upstream marketto explore and exploit resources, import oil andgas, invest in infrastructure and develop thenatural gas trading market. As a result,third-party demands for fair access to infras-tructure, especially gas pipelines, will increase.Independent operation of pipelines willundoubtedly facilitate fair access and promotesector-wide market-oriented reform. The

DRC-Shell work stream believes that Chinaurgently needs to speed up reform of infrastruc-ture, including the trunk pipelines of largestate-owned oil and gas enterprises, and intro-duce the plan to reform China’s oil and gaspipeline network as early as possible. This willcreate pipeline independence and develop pipe-line services, thereby ensuring rapid develop-ment of the natural gas market.

The reform of local pipeline networks shouldbe vigorously encouraged. Laws and regulationsshould be improved to ensure fair access. Judg-ing from international experience, a third-partyfair access policy can balance the financialinterests of midstream pipeline owners, upstreamproducers and downstream consumers, andattract capital to invest in infrastructure con-struction. To encourage private capital to investin the construction of China’s oil and gasinfrastructure and to improve the use of existinginfrastructure and thus the efficiency of the entiresector, it is suggested that infrastructure operators(including trunk oil and gas pipelines, intra- andinter-provincial pipeline networks, LNG termi-nals and underground gas storage facilities)should provide transmission services to thirdparties on a non-discriminatory basis. To ensurethird-party access, the national energy adminis-tration should improve the Measures for Regu-lation of Fair and Open Access to Oil and GasPipeline Networks and the Measures forAdministration of Natural Gas InfrastructureConstruction and Operation, and develop theRules for Implementation of Fair Access toNatural Gas Infrastructure. In so doing it shoulddefine: how infrastructure operators can provideindependent services like pipeline transmissionto all users in a fair and just manner; how theyshould disclose information; and define the legalliability for breach of fairness and openness, thuslaying an institutional foundation for fair accessto pipelines. An efficient system should be cre-ated in which regulators can review and approvethe qualifications of prospective upstream anddownstream users applying to operate infras-tructure or gain access. Companies failing togrant fair access or discriminating against thirdparties should be penalised and publicised.


Restrictions should be gradually eliminated todiversify investment. According to the Mediumand Long-term Plan for Oil and Gas PipelineNetworks, issued by the NDRC and NEA in2017, by 2025 China’s total length of oil and gaspipelines will be 240,000 kilometres. Thisincludes 77,000 km of crude oil and oil productpipelines, which increases by 29,000 km the27,000 km of crude oil pipelines and 21,000 kmof oil product pipelines at the end of the 12thFive-Year Plan (2011–15), and 163,000 km ofgas pipelines (an annual increase of 10,000 kmon the 64,000 km of gas pipelines at the end ofthe 12th Five-Year Plan). The next 10–15 yearswill see oil and gas pipeline construction peak.Because the construction of oil and gas pipelinesis capital-intensive, and China needs to buildmany pipelines, a policy that restricts investmentto CNPC, Sinopec and CNOOC will restrainChina’s pipeline development and slow thegrowth of its natural gas market. Restrictions onprivate capital funding pipeline constructionshould, therefore, be progressively eliminated,motivating the private sector to invest in pipelineconstruction and operation. To this end, the fol-lowing aspects should be reformed. First, theinfrastructure investment project approval systemshould be reformed by softening the reviewterms and criteria and by streamlining theapproval procedure, thereby attracting privatecapital to invest in and construct gas infrastruc-ture included in the national and provincial plans.Second, new pipeline investment that is open tothird parties should, if reasonable, be prioritisedfor approval. Third, low-interest or interest-freeloans or subsidies should be offered to thosecompanies building key interconnecting pipeli-nes with low return on investment, to increasetheir returns without raising users’ costs. Fourth,investors should be allowed to invest in, con-struct, operate and manage LNG terminals andgas storage facilities as independent legal enti-ties. This will diversify ownership and operationof LNG terminals and gas storage facilities andspeed up their construction.

Government should—based on the pipelineneeds for crude oil, natural gas and refined oilproducts—plan pipeline deployment and create

standards for investment, construction, operationand pricing. In particular, provincial andinter-provincial pipelines should be intercon-nected to support regulations. Unified standardsshould be developed for natural gas from differ-ent sources feeding into the pipeline network toensure stable quality, usability and safety. Thepressure grade of newly built pipelines should becarefully determined by referring to provenexperience from other countries. Unified designand manufacturing parameters for gas usagefacilities and gas volume measurement criteriashould be defined to ensure technicalinterconnectivity.

Supervision and approval of transmission anddistribution tariffs should be improved to reducetransmission and distribution costs. First, inaccordance with the principle of China “main-taining administration over pipeline transmissiontariffs in natural monopolies and deregulating gassource and sale prices”, a pricing system that isbased on “allowable cost + reasonable profit” andwhich combines constraints and incentivesshould be established. Pricing administration,cost supervision and review, and price regulationof gas pipeline transmission and urban gas dis-tribution should be improved This will allowindependent gas transmission tariffs and distri-bution fees to be set accurately, remove unrea-sonable costs and charges at pipeline nodes, andlower the costs of long-distance pipelines, intra-and inter-provincial pipelines and gas distribu-tion pipelines. Second, financial independence inthe gas distribution, gas sales and engineeringservices of urban gas utilities should be pro-moted. Third, large users that meet the conditionsfor direct supply should be allowed to purchasegas from a provincial pipeline network, localbranch pipeline or city gas franchise. Giveninsufficient pipeline capacity, the absence ofthird-party access and the excessive pipelinetransmission tariff, large users that meet theconditions should be allowed to constructpipelines for direct supply, thus forcing provin-cial pipelines to lower costs, be competitive andimprove efficiency. Fourth, under the guidance ofthe national gas market regulator, independentgas market regulations should be established at


the provincial level to implement independentsupervision of fair access to gas pipelines, regu-late prices and quality of products and services,and maintain an orderly gas market.

Local pipeline reform is a key part of China’smarket-oriented reform of the oil and gas pipe-line network. Local reform should be carried outalongside long-distance pipeline reform, or thelatter will be one step short of success. Reformmeasures for local pipeline networks includeestablishing independent gas pipeline companies,unbundling pipeline transmission and gas sales,and allowing fair third-party access to infras-tructure. First, the creation of independentprovincial pipeline companies and the unbund-ling of pipeline transmission and gas sales shouldbe accelerated. Provincial pipeline companiesshould not operate gas sources or purchase or sellgas. They should only provide a gas transmissionservice. Second, provincial pipeline companiesmust allow fair and non-discriminatory access topipelines to third parties, and provide all userswith pipeline transmission, gasification, lique-faction and compression services. Third, localpipeline construction should be deregulated toencourage private capital to construct gasinfrastructure included in the provincial plan.The rate of construction of intra-provincialpipelines should be planned, taking intoaccount oil and gas resources and demand. Theprinciple of “adapting pipelines and storage tanksto local conditions” should be followed to allowstorage to play a dominant role in cities withlower gas demand, thus avoiding unnecessarypipeline construction. Fourth, intra-provincialpipeline interconnection should be promoted bydeveloping consistent technical pipeline stan-dards and by setting a reasonable lowest loadindicator when estimating the transmission tarifffor connecting pipelines, thereby ensuring gassupply security. Fifth, in provinces with exces-sive transmission and distribution, reform shouldreduce the number of nodes to lower gas trans-mission and distribution costs. Users should beencouraged to negotiate prices direct with gassource companies to encourage fair competitionon the supply side.

(3) Promote oil and gas pricing reform andcreate natural gas exchange centres

In accordance with the principle of “maintainingadministration over pipeline transmission tariffsin natural monopolies and deregulating gassource and sale prices”, China’s oil and gaspricing reform should: (i) improve the oil productpricing mechanism and allow the market to playthe decisive role; and (ii) gradually deregulategas source and sale prices, improve the priceprotection mechanism for low-income groupsand establish a market-oriented oil and gaspricing mechanism. The government should onlyregulate those pipeline transmission and distri-bution tariffs under natural monopoly, andrestrict price intervention to abnormal oil and gasprice fluctuations and to emergencies. Thiswould enable the government to transition itsrole from pricing to regulation and ultimately tomarketise oil and gas prices.

The oil product price mechanism should befurther improved. After several rounds of pricemechanism reform, China’s pricing system forrefined oil products has become increasinglymarket-oriented. In the current and future inter-national energy market, with abundant oil supplyand rapid development of alternative energysources, the external conditions for market-oriented oil product pricing are good. China’soil product market is characterised by three fea-tures. First, market participants are diversified.Private refining and chemical companies, oilproduct businesses and service stations havedeveloped rapidly, and their market penetrationmatches that of the three state-owned enterprises:CNPC, Sinopec and CNOOC. As the crude oilimport quota is gradually deregulated, the quotagranted to local refineries, including private ones,has exceeded 100 million tonnes, allowing oilproduct sources to diversify. Second, there isregular market competition. Excess oil refiningcapacity has intensified competition in the oilproduct market. This means that government-guided crude oil and oil product prices havedeclined in significance. Third, there are regularprice adjustments. As the market-oriented pricing


mechanism for crude oil and oil products con-tinuously improves and China’s economy grows,affordability for people and businesses has sig-nificantly improved, and oil product priceadjustments are no longer a sensitive issue. Thecorrect conditions for market-oriented oil productpricing now exist. It is suggested that domestic oilproduct pricing should be fully deregulated by2020, and that supply and demand should play thedecisive role in pricing. In addition, the regulationof price, oil quality and tax revenue should bestrengthened, and the anti-monopoly lawenforcement system improved, thus preventingmonopoly pricing and maintaining a fair andorderly market.

China has adopted the netback pricingapproach to administer city-gate benchmark pri-ces across the country, reformed gas transmissionand distribution pricing, and unified residentialand non-residential gas prices, laying a goodfoundation for a gas pricing mechanism whereprice is determined by market competition. It issuggested that market-oriented reform shouldprogress steadily in stages and that the principlesof “pilot implementation followed by extensivedeployment”, “incremental capacity increases”and “deregulating while rationalising the indus-try” should be followed, in order to deliver thegoal of open, fair, competitive and orderlymarket-oriented gas pricing reform.

In the short term: first, the pricing systemshould be improved. After unifying the residen-tial and non-residential benchmark city-gate pri-ces, all provincial pricing authorities shouldimprove the measures for administering resi-dential tiered gas pricing. This will allow them todefine the consumption volume and price level ofeach tier, and establish an upstream and down-stream linked price mechanism. Second, pricingpolicies like interruptible gas prices, peak andoff-peak prices and peak-shaving prices shouldbe introduced as soon as possible. To ensurestable gas supply, especially in winter in northChina, an interruptible gas price should be set toincrease the number of interruptible users andoffset the lack of gas storage facilities. Chinashould guide construction of gas storage facilitiesby defining peak and off-peak prices for different

gas-consuming areas and times and encourageusers to adopt peak-shaving. The requirementsfor establishing a gas storage peak-shavingancillary service market, as stated in the Opin-ions on Accelerating Gas Storage Facility Con-struction and Improving the Gas StoragePeak-Shaving Ancillary Service Market, whichwere issued in April 2018, should be imple-mented. Purchase and sale prices by gas storagefacilities should be determined by market com-petition, and the cost of constructing gas storagefacilities owned by city gas companies should belowered. Third, modification of metering andbilling methods should be accelerated.Volume-based billing should be replaced bycalorific value. This would help solve the diffi-culty of feeding natural gas of different qualityfrom different sources into pipelines and ofopening infrastructure to third-party access, andit would align with the international gas tradingsystem. Measures to prevent illegal billingbehaviour should be improved in terms of tech-nology and management. Fourth, China shouldexplore how to set up pilot projects to deregulateend-user gas prices. After summarising the les-sons learned from Fujian’s city-gate pricederegulation pilot, additional pilots to deregulateend-user gas prices should be started in provinceslike Sichuan, Chongqing and Jiangsu to facilitatelater national deregulation of end-user gas prices.

In the medium to long term, once upstreamoperators are diversified, third-party access toinfrastructure has been achieved, and prices atgas exchanges reflect supply and demand, Chinashould stop controlling city-gate prices andderegulate gas source and end-user prices,allowing them to be determined by supply anddemand. The pricing authority should only reg-ulate the transmission costs and tariffs ofinter-provincial long-distance pipelines, branchpipelines, intra-provincial pipelines and distri-bution pipelines under natural monopoly, thusachieving the goal of fair, competitive andorderly gas price reform.

The introduction of gas trading marketsshould be accelerated. In the short and mediumterms, the Shanghai Petroleum & Gas Exchange,Chongqing Petroleum & Gas Exchange and


other regional gas exchanges should form Chi-na’s gas spot price index. First, unconventionalgas (coalbed methane and shale gas), whosepricing is completely market-oriented, shouldcompete with one another through platformtrading. Companies should be encouraged totrade surplus capacity in pipelines, LNG termi-nals and gas storage facilities at the exchanges toincrease the economic benefits for infrastructureoperators and reflect the value of peak-shaving.Second, market trading participants—includinggas suppliers, independent traders, large usersand local gas companies—should be fostered todrive trading growth stably. Third, non-residential gas should be traded at the exchan-ges to ensure openness and transparency withintwo to three years. Fourth, regional exchangesshould be established in an orderly manner, whileaccelerating the development of the Shanghai andChongqing petroleum and gas exchanges. Theseregional gas exchanges should be developed inaccordance with the principle of “different focus,mutual support, moderate competition and coor-dinated development”. They should be located inthe main consumption centres and infrastructurehubs, including Xinjiang, Shenzhen, Beijing,Tianjin, Hebei, Zhongwei and Hubei. Fifth, spotand medium- and long-term trading should beencouraged through listing and competitive bid-ding. This will promote competition betweendifferent types of gas and allow price to reflectfully the following: market demand and supply;price fluctuations in alternative energy sources;seasonal, peak and off-peak price differences; andother market factors—enabling China to create agas spot price index as soon as possible. In thelong term, the Shanghai Petroleum & GasExchange should become an international gasexchange open to the Asia-Pacific region andeven the world. Gas futures, gas options and otherfinancial products should be launched once thespot gas market is large enough and market par-ticipants in upstream and downstream oil and gasare diversified and compete, and infrastructure isinterconnected and open. Later, an integratednatural gas exchange—where financial transac-tions and spot trading complement each other and

develop hand in hand—should be built to shapeChinese and even Asia-Pacific gas spot andfutures price indexes and to influence the globalgas market.

(4) Fiscal and taxation policies for the oil andgas sector need to be improved

The aim of fiscal and taxation reform includesclarifying the interests of different stakeholders,supporting and guiding the development ofunconventional and deep-water oil and gasresources, adjusting the distribution of tax rev-enues between central and local government,promoting the development and use of greenresources, and building a fiscal and taxationsystem that balances the interests of differentstakeholders.

Tight gas subsidy policies should be intro-duced as soon as possible. The geological reserveof China’s tight gas resources is 25–30 trillioncubic metres, equivalent to 45–50% of China’sconventional gas reserves. Moreover, 50% ofthese tight gas resources can be exploited, so it isthe most practical available natural gas resourceand has great development potential. However,tight gas development relies on hydraulic frac-turing technology to deliver industrial capacity,and its development costs are two to four timesthat of conventional gas. Moreover, its singlewell production is low and steady production isfor a short time only. The government has sug-gested that it grant a subsidy of RMB 0.2 percubic metre for newly opened tight gas wells.

Shale gas will remain a key contributor toChina’s gas output growth in the future. Giventhis, subsidies for shale gas exploitation areimportant for China’s development of shale gas.It is suggested that differentiated subsidies forshale gas resources should be researched. Forinstance, subsidies for shale gas resources inmarine facies in south China should differ,depending on whether they are efficiently orinefficiently extractable at a depth above orbelow 3,500 m.

To reduce China’s increasing reliance onimported oil and gas and enhance domestic


supply security, the government should introducedifferentiated tax policies for unconventional,deep-water, low and enhanced recovery of oiland gas to encourage companies to invest in thedevelopment of these resources.

The mechanism for sharing oil and gas taxrevenues and royalties between central and localgovernment should be adjusted. Due to decen-tralisation and the unreliability of local taxation,funds for local oil and gas development arelimited. As China’s economy develops, localgovernments are subject to increasingly strongdemands to support local economic growth andraise people’s living standards with the tax rev-enues from oil resource development. It istherefore suggested that the tax mechanism foroil and gas revenues and royalties be reformed toensure that resource development benefits localpeople. Environmental compensation mecha-nisms should be established to levy a carbon orenvironment tax on resource development anduse to increase local revenues.

A risk exploration fund should be establishedto develop strategic oil and gas fields. The gov-ernment could use RMB 3–5 billion from oil taxrevenues to establish a risk fund, which could beused for high-risk exploration led by the gov-ernment. The government can engage oil com-panies to carry out initial exploration and drillingin high-risk fields by commissioning their ser-vices. If recoverable resources are discovered thefield can be transferred through competitivebidding, and the earnings added to the risk fundto create a long-term mechanism.

Fiscal and taxation policies to support theconstruction of gas storage facilities should bedeveloped. The delays in gas storage construc-tion have become one of the major constraints toChina’s gas supply security. It is suggested thatin provinces that lack the capacity to fulfil gasstorage peak-shaving tasks, the government caninvest in gas storage construction in severalways, such as by allocating funds from the cen-tral government budget. The VAT rate for gasstorage should be lower, and a tax refund couldbe given for the first five years to supportearly-stage construction of gas storage facilities.

(5) Standardise government administrationand create an effective oil and gas regu-latory system

For the government to exercise its role in marketsupervision, regulation and services to the fulland achieve the reform objectives for the oil andgas sector, government functions should betransformed and the methods of regulationoverhauled.

First, government administration should bestandardised. Government should intervene lessin the market and in business activities. Admin-istration should focus on the development ofstrategies, plans, policies and market rules andthe creation of a fair and impartial industry.Second, plans for the oil and gas industry shouldbe developed in a scientific way. They should belinked to economic and financial development,land use, infrastructure construction, environ-mental protection, safety, transport and techno-logical innovation. A plan developmentmechanism should be established to make plan-ning more scientific and authoritative. Plansshould have a dynamic adjustment mechanism,and environmental impact assessments should beimproved in accordance with relevant laws.Third, the development of industry standardsshould be accelerated. Macro-management basedon planning, policies and standards should beapplied to the oil and gas sector. Fourth, gov-ernment services should be optimised. Energyinformation and geological data sharing plat-forms should be built. The government’s role ofdriving technological innovation should beemphasised.

An effective oil and gas regulatory systemshould be created. China should: (i) separateadministration and regulation, and form inde-pendent, unified and specialised regulatoryauthorities, and improve the regulatory system atthe national and provincial levels; (ii) considersetting up an independent centralised energyregulatory system within the National People’sCongress to define regulatory responsibilities(mainly economic regulation), improve socialregulation and ensure fair competition in natural


monopolies like pipelines; and (iii) improve theefficiency of government regulation, prioritisingregulations for processes and activities like fairmarket access, trading behaviour, naturalmonopolies, taxes, pricing, safety and environ-mental protection, and combining legal tools,administrative means, specifications and publicengagement to enable collaborative regulation.

To enable the market to play the decisive rolein resource allocation and the government to playa more efficient role, those parts of existing lawsthat are outdated or conflict with the oil and gassector or hinder its reform should be repealed ormodified to facilitate oil and gas mining rightsreform. For example, those parts not suitable fora market system in the Mineral Resources Law ofthe People’s Republic of China, the Rules for theImplementation of the Mineral Resources Lawof the People’s Republic of China, the Regula-tions on Registering Mineral ResourceExploitation, the Administrative Measures for theRegistration of Mineral Resource ExplorationBlocks, the Measures for the RegistrationAdministration of Mineral Resource Exploration,the Environmental Protection Law of the Peo-ple’s Republic of China and other laws andregulations should be amended as soon as pos-sible. In addition, it is suggested that the Oil Lawand Gas Law be studied and used as soon aspossible to: (i) standardise the business activitiesof the companies and public bodies active in theoil and gas sector; (ii) standardise the supervisoryand administrative activities of government andthe actions of other stakeholders; (iii) improvethe development, use and conservation of oil andgas resources; and (iv) enable the healthydevelopment of the oil and gas sector and otherrelated sectors. The development of energy reg-ulations should be completed as soon as possibleto define regulators’ roles, functions andresponsibilities, regulatory procedures and thedecision-making mechanism; standardise infor-mation disclosure and the dispute settlementmechanism; and define the penalties for viola-tions. All these actions will give legal support tosupervisory and regulatory work and help thembecome authoritative.

6 Reforming the Coal Sector

6.1 Progress and Trends in GlobalCoal Industry Reform

6.1.1 More and More Countries HaveAdopted a Coal ExitStrategy

Reducing emissions from coal combustion hasbecome an important aspect of cooperative glo-bal governance. The international community hasmaintained a high degree of unanimity regardingthe global fight against environmental pollutionand climate change. The Paris Agreement wasadopted with the unanimous agreement of 195countries. The USA officially announced itswithdrawal from the Paris Agreement in June2017 and submitted withdrawal documents to theUnited Nations in August 2017, receivingwidespread criticism. Reducing pollutant emis-sions is an irreversible trend and an importantissue in global governance. The USA’s with-drawal has not yet had a material impact onglobal emissions reduction and will not shake theworldwide determination for global climategovernance or change the development course ofclean energy. Coal is a fossil fuel energy with ahigh carbon content. Reducing coal consumptionhas therefore become a focus of globalemissions-reduction cooperation.

Most European countries have begun to phaseout coal-fired power plants. Eurelectric—thesector association for the European electricityindustry, which has around 3,500 member com-panies—and the European power industry willnot “invest in or construct new coal-fired powerplants after 2020”. This plan is supported by 26EU member states. Leaders of EU countriesreached consensus in October 2014 regarding theobjective of “reducing greenhouse gas emissionsby 40% over 1990” and agreed to disinvestgradually in the coal industry and end subsidiesfor fossil energy. For example, France stoppedproviding financial support for overseas-ownedcoal-fired power plants without carbon captureand sequestration in May 2015. Major financialinstitutions no longer invest in coal mining


projects. The Norway Sovereign Fund began todisinvest in coal companies in June 2015. Scot-land shut down its last coal-fired power plant inMarch 2016. England, Finland, Portugal andAustria plan to phase out coal-fired power plantsby 2025, 2029, 2030 and 2025 respectively. Inaddition, EU countries plan to cancel coal-relatedsubsidies by 2018. Austria, England, Belgiumand Finland have all taken power industrydecarbonisation measures.

All OECD member states strictly controlsubsidies for coal-fired power plants. Thirty-fourOECD member states reached agreement inNovember 2015 to restrict export credits forcoal-fired power plants using older technology,granting allowances only to “coal-fired powerplants that meet the strictest environmentalstandards”, and tightening financial support forthe coal industry.

The USA, Canada and other countries havegradually weakened policies supporting the coalindustry. The USA began to restrict the export ofcoal technologies before the OECD. Major banksin the USA have cancelled financial support forcoal projects, as have the Export-Import Bank ofthe United States, the World Bank and theEuropean Investment Bank. Canada backed car-bon capture and sequestration technologies forcoal-fired power plants in August 2011. It ispossible that it will completely phase outcoal-fired power plants by 2050. Many regions inCanada have introduced decarbonisation mea-sures for the power industry.

Many countries levy resource taxes. Denmark,Finland, Sweden and Norway are pioneers inthese taxes. In Canada, the Alberta governmentbegan to levy CAD 20 ($15) on every tonne ofcarbon emitted from January 1, 2017. Francestarted to levy a carbon tax on coal power in2017.

In summary, the policies for exiting coal canbe divided into two categories: (i) restrictivepolicies on the supply side to reduce coal pro-duction; and (ii) policies on the user side that settargets for the transition to new energy as ameans to reduce coal demand.

6.1.2 The Strategic Positioning of CoalDiffers from Countryto Country

Many countries are heavily dependent on coal.For example, in Germany, coal accounts formore than 20% of the energy mix and coal-firedpower for more than 40% of the power mix. InSouth Korea, the figures are around 30% andalmost 40% respectively; and in India, they arehigher—about 50% and 60% respectively. Chinais one of a minority of coal-based countries. Coalaccounts for around 63% of China’s energy mix,and coal-fired power for more than 70% of itspower mix. A few countries may become moredependent on coal, instead of less. Japan is anexample. Coal accounts for about 25% now, inboth its energy mix and power mix. By 2030, theshare of coal in its energy mix and power mix islikely to increase to 30% and 26% respectively.

To ensure energy supply security, somecountries increase their use of coal. For example,Japan made a new energy plan after theFukushima nuclear accident, which involvesbuilding 41 coal-fired power plants over the nextdecade to ensure energy security. To meetincreasing energy demand and improve eco-nomic development, India plans to increase coaloutput year by year, and has introduced supportpolicies on the environment, land approval andon granting exploitation rights to private capital.

The positioning of the coal industry differsfrom country to country. Most countries areactively reducing emissions from coal combus-tion and optimising their energy and power mixin many ways. But their attitudes on whether toexit or continue to use coal are different, mainlyinfluenced by their resource endowment, indus-trial structure and phase of development. Sig-nificantly decreasing coal’s share of the energymix is impossible for many countries in the shortand medium terms. For example, in Germanyand the USA, the coal-exiting policy has beenignored by coal and other traditional industries.Japan has increased its coal power to ensureenergy security. In keeping with its phase ofdevelopment, India’s coal consumption is


increasing rapidly, and its coal policies are aimedat stimulating coal supply.

6.1.3 Clean Energy Is Rapidly ReplacingCoal, Thanks to Incentivesfor Users

Countries aiming to abandon coal, even thoughthey may be highly dependent on it in the shortand medium terms or increasing their use of it,might yet actively take part in global emissionsreduction governance and issue the necessarypolicies to encourage power generation with cleanenergy. North America is expected to increase theshare of clean energy consumption to 50% by2025. Argentina plans to invest $2.1 billion inwind, solar, biomass power and small hydropowerstations. Sweden plans to make 100% of itsenergy green by 2040. Germany encourages dis-tributed energy through a high level of energyefficiency tax refunds and through financial sup-port for energy-efficiency equipment. It is esti-mated that the proportion of renewable power intotal electricity consumption will increase to 40–45% by 2025, and to 55–60% by 2035. Englandsupports distributed power projects through sub-sidies, credit loans and intelligent metering. Italysupports distributed power projects through anenergy tax, credit loans, high prices, consumptionsubsidies and other preferential policies—thefeed-in tariff for distributed power is 50% higherthan the domestic retail price. In Chile, the pro-portion of new energy will reach 50% by 2035 and70% by 2050.

The cost of generating power with cleanenergy decreases gradually as technologiesimprove. Meanwhile, the environmental cost oftraditional fossil energy is increasing. For thatreason, and to promote the development of theclean energy industry, some developed countrieshave begun to end subsidies for power generationwith clean energy. For example, Germany endedits policy for a preferential feed-in tariff forrenewable power in June 2016. The EuropeanUnion began to limit subsidies from memberstates to the renewables industry in 2017. In thefuture, governments will increasingly use market

mechanisms as the clean energy industrymatures. The policies facilitating the replacementof coal by clean energy will gradually changeinto incentives to make power generationefficient.

6.1.4 Government Support for the CoalIndustry Still Exists

Many countries once dominated by coal stillhave a large coal industry, with many coalworkers. Support policies of different types are,therefore, still needed from government.The USA, for instance, launched in 2015 thePartnership for Opportunity and Workforce andEconomic Revitalization (POWER) initiative,which helps coal communities adapt to the newenergy landscape and reposition their economies.The key points in the Federal Government’sAmerica First Energy Plan include ensuringself-sufficiency in energy, revoking the ClimateAction Plan of the previous administration, andsupporting and promoting the clean developmentof coal. These policies will help revitalise thecoal industry. In addition to building morecoal-fired power plants, Japan introduced poli-cies to increase investment in scientific researchon energy saving and emissions reduction forcoal combustion and support the modernisationof coal-fired power plants.

Government support focuses on technicalinnovation, energy saving and emissions reduc-tion. After analysing different countries’ coalsupport policies, we found that governmentssupport innovation in coal combustion tech-nologies, rather than simply supporting expan-sion of coal’s share of the energy mix, toencourage energy saving and emissions reduc-tion. Replacing coal with clean energy will take along time, and coal power is characterised bylow-cost and proven technologies. That is whymany countries strongly support energy-savingand emissions-reduction technologies in the coalsector, while optimising their energy and powermix. They hope to achieve low-carbon use ofhigh-carbon energy by minimising the emissionsfrom coal combustion.


6.1.5 Coal Companies Are Folding,Merging or Being Sold

Coal companies are going bankrupt. Others aremerging or being sold. The rapid replacement ofcoal by clean energy, the global economicrecession after the global financial crisis of 2008,and China’s declining coal demand since 2014have led to oversupply in the international coalmarket. In the USA, Patriot Coal, Walter Energy,Alpha Natural and Arch Coal filed for bank-ruptcy in 2012, 2015, 2015 and 2016 respec-tively. Peabody Energy, the largest coal companyin the world and engaged in coal exploitation for100 years, joined the list of insolvent coal com-panies in April 2015. For coal companies thathad not filed for bankruptcy, the situation isfrustrating: most of them have been brought tothe verge of bankruptcy due to long-term losses.For example, Murray Energy in the USAannounced a mass layoff programme in 2016 toreduce its losses, and the net loss of New WorldResources, the largest private coal company ineastern Europe, was around €233.6 million in2015. In 2015, more than 80% of Chinese coalcompanies made a loss. The Chinese economyimproved in 2017. Output of domestic raw coalpicked up. Output from January to Septemberincreased by 5.7% over the previous year, whichis 16.2% points higher than in 2016. But lowefficiency, debt, state-owned enterprise reformand other structural problems in China’s coalindustries remain. Merging and restructuringlarge coal companies is on the agenda again, anda new trend of vertical integration has emerged.Shenhua Group, the largest coal company inChina, and China Guodian Corporation mergedto form China Energy Investment CorporationLimited in 2017. Some local state-owned coalcompanies are also exploring horizontal andvertical integration, aiming to sharpen theircompetitive edge through resource optimisationand reorganisation.

International consortia have divested theircoal businesses. Total of France, the fifth largestenergy company in the world, ended its coalproduction and sales activities in 2015. The totalvalue of the coal assets divested by theAnglo-Australian coal mining giant Rio Tinto

since 2013 is more than $4.7 billion, and it sold40% of its holding in Australia’s Bengalla coalmine for more than $600 million. In addition todivesting 60% of its assets in 2016, global min-ing company Anglo American sold 51% of itsholding in Dawson coal mine and 70% of itsinterest in Foxleigh coal mine, both in Queens-land, Australia. Vattenfall, wholly owned by theSwedish government and the third largest energysupplier in Germany, announced in 2016 that itwould gradually retreat from the German coalmarket. In the same year, the largest sovereignwealth fund in the world, the Norwegian OilFund, sold its shares in 52 coal-relatedcompanies.

Some coal companies have seized the oppor-tunity to expand their business. Exxaro Resour-ces of South Africa acquired coal assets fromTotal of France for $472 million in 2014, $45million lower than their value the previous year.Indonesia’s state-owned coal company BukitAsam entered Australia’s coal market in 2016 byacquiring one of Rio Tinto’s largest coal mines inAustralia.

Bankruptcy and merger and acquisition arecommercial activities, as well as means of gov-ernment gaining control. Asset restructuring ofinternational coal companies, an unavoidableresult of the industry’s descent, is changing thestructure of the global coal industry.

6.2 Progress, Status and Assessmentof China’s Energy SystemReform

6.2.1 Reform Has Progressed Despitethe Industry’s Downturn

The years 2010–16 were a transitional period forChina’s coal industry, with industrial growthdropping from high to medium and institutionalreform deepening. The golden decade for Chi-na’s coal industry was 2002–12, when annualcoal output increased on average by almost 10%.The growth rate of the Chinese economy sloweddown in 2012, leading to overcapacity in the coalindustry. Shortage was rapidly replaced byoversupply. The growth rate of coal output


dropped substantially to 0.74% in 2013, thendeclined into negative growth for three yearsfrom 2014, before re-entering positive growth in2017. In the context of the downturn, coalindustry reform has made progress in manyaspects.

China has been using dual coal pricing for along time. Coal traded by sellers and buyersusing a market-based pricing mechanism,through which the price fluctuates in line withmarket conditions, is called market coal. Previ-ously, coal producers and thermal power plantson the state’s list of key enterprises traded coal atan annual national coal fair price under a plan-ning mechanism called planned coal. During thegolden decade, the price of planned coal wasRMB 200 lower than that of market coal,resulting in years of coal power combat. Chinaunified the two prices in 2013, which marketisedthe coal market.

An important component of China’s admin-istrative system reform is “administrativestreamlining and decentralisation, the combina-tion of deregulation and regulation, and serviceoptimisation”. Coal authorities ended the CoalProduction Permit and the Approval Needed toFound Coal Businesses in 2013. Many localgovernments also introduced the reform policies,delegating approval and improving administra-tive supervision and management. Administra-tive supervision and management is becomingincreasingly market-oriented and IT-based.Government functions focus more and more onindustrial services.

Overcapacity in China’s coal industryemerged during the 12th Five-Year Plan (2011–15), reaching a peak in 2015. From November2011 to January 2016, the Bohai-Rim Steam-CoalPrice Index (BSPI) dropped by 56.51% fromRMB 853/tonne to RMB 371/tonne. According todata from the National Bureau of Statistics ofChina, the profit margin of the coal mining andwashing sectors decreased from 14.06% in May2011 to 1.76% in December 2015, and to itslowest point of 1.55% in August 2015. In 2015,more than 90% of large and medium-sized coalcompanies made a loss. China’s coal industry,characterised by its long history, large size and

huge number of employees, was an importantpillar of the national economy. A fast and sub-stantial downturn in the industry brings financialand social risks and threatens the overall stabilityof the Chinese economy. The coal industrytherefore became a key sector for China’ssupply-side structural reform under the new nor-mal of slower economic growth. The structuralreform of the coal industry is focused on reducingcapacity, optimising supply and achieving thereform objectives of reducing inefficient supplyand increasing efficient supply. The State Councilissued the Opinions on Reducing Overcapacity inthe Coal Industry to Achieve Development bySolving the Difficulties in February 2016, whichset out the objective of reducing capacity in thecoal industry. China cut coal capacity by 290million tonnes in 2016, exceeding the target of250 million tonnes. China will strive to meet thecapacity reduction target of 150 million tonnes in2017.

Coal mine safety management has alwaysbeen an important area of coal industry reform.Since 2010, reform has focused on shutting downor reorganising small coal mines, reformingsafety management and increasing safetyinvestment. First, small coal mines that did notmeet safety requirements were shut down. Morethan 3,000 small coal mines, each with an annualoutput of less than 300,000 tonnes, were closedby the end of 2015. The second measure was tomerge small coal mines that met safety require-ments with large companies. Shanxi Provinceimplemented the plan between 2009 and 2012,shutting down 1,545 mines. Other major coalproducing provinces also merged large compa-nies with small coal mines. Henan merged andrestructured 466 small coal mines in 2010. Hebeibegan to regulate small coal mines in 2011,shutting down 237 during the 12th Five-YearPlan (2011–15) through merger, restructuringand integration of resources. Shandong launcheda programme to merge and restructure small coalmines in 2012; by 2015 there were 52 fewer coalmines than in 2010. The third measure was toincrease investment in safety. This became partof management procedures and was well pro-moted and well implemented. Reform was based


on management and supervision at each level andon clearly defining responsibilities, includingthose of regulators, government and coal com-panies. In particular, the responsibilities ofcompany management were clarified.

Emissions of air pollutants from coal use arestrictly controlled. The Chinese government hasimproved its air pollution prevention work inrecent years. Coal combustion is one of the mainsources of air pollutants, so coal-fired powerplants and steel companies are two importantareas of government supervision.

The government began to build a nationalmonitoring system of pollution sources in 2010and has been improving it ever since. Once thesystem was completed, the government passedthe Environmental Protection Law (which pro-vides strict and comprehensive regulation) inJanuary 2015, and the Atmospheric PollutionPrevention and Control Law in January 2016,which codifies emissions regulation. Also, in2012 and 2015, the government substantiallyraised emission standards for the steel industry.Hebei province, a major steel producer, imposedlimits and substantially raised emission standardsin 2014 by incentivising coal-fired power plantsto implement super-clean emission standards.Finally, there has been a push to reduce coalconsumption. Air contamination in Beijing,Tianjin and Hebei is a serious problem. Reducingregional coal consumption is an importantmethod of governance. Beijing is implementingthe coal-to-gas programme. Beijing, Tianjin,Langfang and Baoding plan to introducecoal-free zones by October 2017. Shijiazhuang,Tangshan, Handan and Anyang have adoptedtemporary policies to limit steel productioncapacity to 50% in the cold season.

Tax reform of the coal industry since 2010 iscentred on two measures. First, reform of the coalresource tax, which aims to move from a feesystem to a tax system, as well as encouragingmore efficient use of resources. Second, changingbusiness tax into value-added tax. Unlike thereform of the coal resource tax, the business taxto VAT reform is a national reform, not just acoal industry reform. It involves paying VATinstead of business tax on taxable items. The

business tax to VAT programme, launched inMay 2016, has been fully implemented in thecoal industry, just as it has in other sectors. Thetax reform programme, which aims to relieve thetax burden on small and medium-sized compa-nies and eliminate double taxation on large andmedium-sized companies, is another example oftax reform in China following the tax sharingreform of 1994.

The reform of state-owned coal companieshas been accelerated. The extensive losses ofChina’s coal industry were caused by oversup-ply, the heavy debt burden of state-owned coalcompanies and the weak profitability of mostnon-coal businesses. The Chinese governmenttherefore regards speeding up the reform ofstate-owned coal companies as an important wayto help the industry become profitable. In addi-tion, accelerating the reform of state-ownedenterprises is an important aspect of the coalindustry’s supply-side structural reform.

The first stage was to restructure state-ownedcapital investment corporations through pilotprogrammes. Central and local state-owned coalcompanies have become pilot reform targets forstate-owned capital investment corporations. Theplan is now being developed and implemented.The state-owned capital management system andmechanism are being transformed, as is theorganisational structure.

The second stage was to integrate, merge andrestructure resources. Some major coal suppliersin Shanxi, Shaanxi, Heilongjiang and Hebeiformed large local state-owned coal enterprisesbefore 2010 by integrating state-owned coalresources. Henan further integrated its coalresources after 2010. To improve the safety andefficiency of coal mines, state-owned coal com-panies were encouraged to integrate private coalresources. The coal companies owned by centralgovernment began to integrate resources duringthe 13th Five-Year Plan (2016–20). TheState-Owned Assets Supervision and Adminis-tration Commission under the State Councilintroduced new policies in 2016. These requirecompanies owned by central government that aremarginally involved in the coal industry to exitthe industry and transfer their resources to coal


enterprises owned by central government. Forexample, Shenhua Group and China GuodianCorporation merged into China Energy Invest-ment in 2017.

The third stage was to remove state-ownedcoal companies of their social responsibilities,which were a legacy from the previous round ofreform of state-owned enterprises. To relieve theburden on coal companies during the economicdownturn, government at all levels began toremove these responsibilities from coal compa-nies and made great progress in doing so.

The fourth stage was to reduce coal capacity.Local governments and state-owned coal com-panies actively shut down old mines and zombiecapacity.

The final stage was to promote mixed own-ership. As planned by state-owned enterprisereform, state-owned coal companies are explor-ing ways to carry out mixed ownership reformand are expected to make progress during the13th Five-Year Plan (2016–20).

6.2.2 Reforms Are Characterisedby Marketisation and MoreAdministration

Deregulating the coal price, abolishing coalproduction permits and requiring companies toobtain approval to start a coal business are sig-nificant steps towards market-based reform. Thecoal market’s competitive attributes have beenstrengthened. Intermediary coal service organi-sations are more mature. To meet the need formarket competition, the authorities made regu-lations more market-oriented. First, laws, regu-lations, rules, policies and standards werecustomised for the coal market. Second, a marketinformation system was developed to monitorand analyse the coal market in real time. Third,plans, guidance and support policies for coaltrading, logistics and reserves were introduced tomarketise the coal industry.

As circulation becomes more market-oriented,the government is improving its administrativemeans to regulate the coal industry, especiallyregarding capacity reduction and price stabilisa-tion. At first, in 2016, China put more effort intocapacity reduction. The State Council announced

in January 2016 that capacity reduction should“first take place in the steel and coal industries”,and that “coal capacity should be reduced sig-nificantly” through “the rule of law and mar-ketisation”. To implement the capacity reductionplan, the State Council published the Opinionson Reducing Overcapacity in the Coal Industryto Achieve Development by Solving the Diffi-culties in February 2016. After which, supportdocuments from government departments forhuman resources, finance, safety supervision,land, quality inspection, taxes, and environmen-tal protection were issued. The provinces, citiesand autonomous regions that are major coal andsteel producers also set targets, plans and mea-sures for capacity reduction. Strongly driven bypolicies, the coal industry achieved its capacityreduction objectives ahead of schedule in 2016.

Administration played a leading role incapacity reduction during the market recovery in2016. This was enabled by the following fivefactors: (i) the macroeconomy reported slowerbut stable growth; (ii) market-driven capacityclosures and output reduction during the earlierdownturn reduced supply; (iii) legal measuresforced some outdated capacity to be shut down;(iv) the government strictly controlled the addi-tion of new capacity; and (v) some productionrestrictions adopted in 2016, such as limitingmine operations to 276 working days a year,controlled output during the rapid price recovery.Factor (i) was the foundation. Factors (ii) and(iii) were essential, but the policies of tighteningsupply were more crucial and accelerated therecovery of the coal market. China’s output ofraw coal in 2016 was 9.4% lower than in theprevious year. The government paid closeattention to price fluctuations and took the nec-essary measures to stabilise the coal price. Oncecoal capacity reduction had delivered results, thecoal price went up. To stabilise the price, thegovernment actively influenced long-termagreements with key accounts, under whichcoal was traded at a price lower than the marketprice, restraining price rises. Finally, the gov-ernment strengthened the administrative regula-tory regime for safety, making it a priority toregulate the people in charge of coal companies.


State-owned coal companies have started toreform themselves in accordance with China’sstate-owned capital management system. Mea-sures include reforming state-owned capitalinvestment corporations, introducing mixedownership, organisational restructuring anddeveloping market mechanisms. Centrally runstate-owned coal companies have made break-throughs in vertical integration along the valuechain. Local state-owned coal companies areexiting from inefficient mines, transformingstate-owned capital investment corporations andrestructuring.

After the economic downturn, China’s coalcompanies developed expertise in energy indus-try trends and began to transform and optimisetheir business structure in two aspects: (i) exitinginefficient coal, coal-fired power generation, coalchemicals and coal machinery, and reorganisinginternal resources to allow them to exit thosefields; (ii) planning for new emerging business,developing modern services and intelligentmanufacturing, and using R&D and otherresources to make the necessary breakthroughs.

The tax burden on the coal industry is stillheavy. After the business tax to VAT reform wascarried out, the taxes on some business areas ofcoal companies decreased, such as in equipmentmanufacturing. But for other business areas, thetax burden increased because there were fewerallowable deductions. Overall, businesses arepaying more taxes since the business tax to VATreform. After the coal resource tax was reformed,the tax rate on price and resource-related chargesdiffered from region to region. It is not unusual tofind coal companies for whom tax liabilities haveincreased under both reforms.

6.2.3 China’s Coal Industry Reform StillFaces Many Difficulties

Market-oriented reform conflicts with adminis-trative measures, as revealed in the followingfour cases.

First, there is a conflict between the govern-ment’s regulatory function and business gover-nance. Government regulates macro-aspects ofthe economy and should not intervene at the

micro level of business operation and manage-ment. Government and business are on two dif-ferent levels of administrative, social andeconomic governance. They should cooperate.The introduction of market-based reform requiresthe boundary between government and the mar-ket to be defined. Only by keeping governmentwithin bounds and allowing businesses to per-form can the market’s decisive role be unleashed.If the administrative process is not well con-trolled, the boundary between government regu-lation and business governance can becomeblurred, with the government crossing the lineand intervening in business operations. Thiscould be seen during the drive to stabilise thecoal price and improve safety. Governmentauthorities were encouraging large coal compa-nies to trade with key accounts at a contractualprice, which meddles in the coal companies’business and works against the market-orientedcoal pricing mechanism. The process ofimproving coal companies’ safety implicitlyregards them as targets for administrative man-agement, which conflicts with their responsibili-ties as market players and hinders the reform ofthe state-owned capital management system.

Second, there is a conflict between the targetto reduce production capacity in the medium tolong term and the current supply shortage. Coalindustry losses changed into industry-wideprofitability in 2017, making it more difficult tomake further capacity reductions. One cause ofthe supply shortage is that the government’scompulsory measures make it harder for themarket to meet demand. Capacity reductionshould therefore continue. However, improve-ments in the business environment and the uni-versality of the government’s capacity reductionpolicies still allow inefficient and uncompetitiveproduction capacity.

Third, there is a conflict between reducing andexiting inefficient supply and increasing efficientsupply. Staff relocation and debt repayment arethe inevitable challenges of capacity reduction.Local government and financial institutions haveintroduced some protective measures to mitigatesocial and financial risks. Despite being


uncompetitive, some inefficient mines have beenoperating for a long time. In addition, the gov-ernment’s administrative regulatory system hasplayed an important role in capacity reductionsince 2016, though its inflexibility has restrictedthe development of efficient capacity to someextent.

Fourth, there is a conflict betweenmarket-oriented regulations and governmentadministration. The government has emphasisedthe market’s decisive role and deepened reformalong the lines of “administrative streamliningand decentralisation, the combination of dereg-ulation and regulation, and service optimisation”.However, macro-control of the coal market isstill dominated by administrative processes. Toachieve their environmental and safety objec-tives, some local governments were inflexible intheir administrative guidance, which was notbased on law and resulted in unnecessary finan-cial losses for compliant enterprises. There arealso problems with the coal contract priceencouraged by government. The governmentabolished dual coal prices with the aim ofderegulating coal pricing and forming amarket-oriented coal pricing mechanism. Tradingcoal with key accounts at a contractual pricelower than the market price is consistent with thelaws of economics. However, if the contractualprice does not follow the price trend, or differsgreatly from the market price, it could be con-cluded that the contractual price has been affec-ted by the government’s macro-control, ratherthan being determined by supply and demand. Ifthe contractual price is similar to the old plannedprice, then clearly the government has not cre-ated an effective market-oriented mechanism forcoal pricing.

China’s coal circulation regulatory systemunder the new normal of slower economicgrowth faces new challenges. The market is nowthe vector for transactions, which has a profoundinfluence on the coal industry.

First, a modern coal circulation regulatorysystem is not yet in place. The parties engaged incoal circulation are numerous, decentralised andsmall. These factors make government regulationmore difficult. The current regulatory system

cannot cover all parties for the following reasons:(i) policy constraint is not effective for each partyinvolved in circulation. Regulations on tradingand coal quality cannot fully supervise andrestrain complex markets; (ii) coal circulationregulations are not clearly distributed betweencentral and local government, making the regu-latory system messier and more complicated; and(iii) development of the auxiliary coal market haslagged behind. This dates back to the start of thereform regime and is characterised by poorcontractual performance, scattered market infor-mation, an unsound credit rating mechanism andthe absence of financial regulation.

Second, there is no market-based carrieroptimising supply and demand through the coalcirculation regulatory system. Coal circulationregulation needs to allow an existingmarket-oriented coal pricing mechanism to playits role and stabilise market price fluctuations.However, there is currently no effective carrier.The way to stabilise price fluctuations is byimproving supply and demand in a market-basedway, rather than intervening in businesses’ pro-duction and operations, which disturbs the mar-ket pricing mechanism. The current coalcirculation regulatory system enables regulatorsto keep track of coal market dynamics but doesnot allow them to optimise supply and demand.

Third, the regulatory regime transforms coalcirculation. Supply-side optimisation has a pro-found impact on coal circulation. Future coalcirculation will not be limited to coal trading andthe transport of coal from one place to anotherbut will expand into higher levels of circulation.For instance, the value added to raw coal duringcirculation will increase, logistics will be mod-ernised and capital and information flow servicesimproved. A coal circulation regulatory regimeshould not only standardise and manage circu-lation, it should guide the transformation of cir-culation. However, the current coal circulationregime does not cover higher levels of circulationservices. Such a regime has not yet beendesigned.

Fourth, China needs a coal circulation regu-latory system that meets the demand for greenand low-carbon energy. To meet this new


requirement, the coal circulation regulatory sys-tem prioritised three things: the standardisationof coal quality, restricting the use of bulk coal,and the introduction of policies that support theuse of clean coal. Clean coal is a highly benefi-cial way to transform China’s coal productionand consumption and create new industry trends.However, the clean coal regulatory regime is notsystematic enough in its approach and needs tobe aligned with China’s coal circulation system.Restrictions and incentives are needed: (i) theindustrial heating sector needs to be reformedand aligned with the use of clean coal; (ii) re-strictive regulations are not strictly enforced,giving some businesses and consumers opportu-nities to break them; and (iii) the incentives todrive technical innovation in clean coal andmodernise industrial and public sector equipmentare not in place, nor are consumption subsidies.

It is difficult to reform state-owned coalenterprises due to the large number of peopleemployed in the industry and the heavy debtburden that many companies carry, both ofwhich restrict innovation and transformation.The reform of China’s coal industry is stronglyrelated to the reform of state-owned coal com-panies, which play an important role in China’scoal industry. The top 10 coal companies inChina, in terms of coal output, are all owned bythe state. They produced around 1 billion tonnesof coal between January and September 2017,accounting for more than 60% of raw coal outputby large national coal companies. Largestate-owned coal companies—characterised bytheir large size, diverse business activities andlong history—have inefficient production capac-ity that they need to exit. For many companies,inefficient capacity has become a serious prob-lem, leading to surplus workers and a highdebt-to-asset ratio. These companies enter avicious cycle where the heavier the personneland debt burdens, the more difficult it is for themto exit inefficient capacity. The recovery of theChinese economy in 2017 played an unusual roleby acting as a buffer, allowing state-owned coalcompanies the time and space to transform and

innovate. A strong internal organisation is aprecondition for such transformation and inno-vation. Internal weaknesses need to be eliminatedfirst. Only then can business creativity be stim-ulated through institutional and mechanisminnovation within the larger reform of the coalindustry. The reform of state-owned coal com-panies poses many questions, such as: What willhappen to the workers? How can the companyrepay its debts? Where will the money comefrom? There is currently no answer to thesequestions, which is slowing down the process ofindustry-wide reform.

6.2.4 Evaluating China’s Coal IndustryReform

The coal industry is a pioneer in market-orientedreform. Reform started in the 1980s, and hasnever stopped, but has had different characteris-tics during different periods. As the Chineseeconomy moved from a high growth rate to thenew normal of lower growth, and environmentalgovernance became more intense, a supplyshortage of coal was replaced by oversupply. Atpresent, supply is tight because of the initiativeson capacity and emissions reduction. Changes inthe market have accelerated the reform of thecoal industry. However, difficulties in businessoperation and the pressure to prevent air pollu-tion have pushed the government to strengthenits macro-control.

The reform of China’s coal industry hasthe following characteristics: it is an advancedmarket, with better regulations and deepenerreform.

At first, the marketisation of the coal industrymade steady progress. Coal authorities abolishedvarious policies, including dual coal prices, thecoal production permit and the need for approvalto start a coal business. At the same time, coalcompanies actively explored transitioning fromcoal producer to energy supplier. The logistics,information flow and capital services for the coalmarket were improved. Driven by governmentand businesses, the coal market became more andmore sophisticated.


Next, the government strengthened itsmacro-control. The government’s plans to reduceproduction capacity achieved remarkable resultsin a short time. It not only reduced overcapacitybut improved the business environment of thecoal industry as well. The government also, bycombining capacity reduction with emissionsreduction and focusing on restricting newcapacity and even exiting coal, promotedsupply-side reform. To suppress the recovery ofthe coal price, the government took other mea-sures as well, such as encouraging coal compa-nies to agree low-price contracts with keyaccounts.

Finally, the reform of state-owned enterprisesdeepened. To help state-owned enterprisesescape the conflicts and issues that urgentlyneeded to be addressed, the government elimi-nated deep-rooted institutional and mechanismproblems. The papers regarding reform ofstate-owned enterprises were adopted after 2015,gradually forming the 1+N policy. TheState-Owned Enterprise Reform Leading Groupof the State Council carried out the Ten PilotReform Programmes in 2016, which summarisethe present round of state-owned enterprisereform. The reform of state-owned coal compa-nies has focused on state-owned capital invest-ment corporations, introducing mixed ownership,divesting coal operations from centrally admin-istered state-owned enterprises whose core busi-ness is not coal, and on restructuring andmerging companies. The reform of centrallyadministered coal companies is now makingrapid progress, whereas that of local state-ownedcoal companies is slower.

The coal market experienced a significantdownturn after 2010 and was faced withunprecedented environmental pressure. On theone hand, a supply shortage turned into over-supply, which benefitted market-oriented reform.Dual coal prices were abolished. On the otherhand, the downturn resulted in financial lossesfor the industry. Stabilising growth and mitigat-ing risk were especially urgent. Given marketand environmental pressure, administrative reg-ulation became essential. As a result, the reformof China’s coal industry after 2010 progressed in

marketisation and government administration.Administration played a more important roleafter 2016, not only in reducing productioncapacity and improving environmental protec-tion, but also in stabilising the coal price oncesupply and demand had been optimised. Thegovernment achieved remarkable results in theshort term.

The coal industry regained profitability in2016. However, the drawbacks of administrativeregulation reform were becoming increasinglyevident. Coal supply and demand depends onseveral factors. Reducing production capacitytends to lead to a supply shortage in someregions and in certain types of coal, and exitingmines affects people’s livelihoods, even though ithelps reduce emissions. Trading with keyaccounts at a contractual price should beencouraged. Once the price difference betweencontractual price and market price reaches acertain threshold, a dual price system couldreappear. The goal of reform is to build asophisticated coal market, rather than reducecapacity and stabilise prices. The government’sreform measures were indispensable, but anadministrative mechanism cannot replace themarket mechanism or prevent it from fulfilling itsbasic functions of optimising the system anddetermining price. The administrative mecha-nism should be combined organically with themarket mechanism. Therefore, in the long term,China needs to build a coal market system that isaligned with the long-term objectives of mar-ketisation and that manages the relationshipbetween the market and government.

6.3 Guidelines and Pathwaysfor Future Reform

6.3.1 GuidelinesThe revolution in the coal industry needs toresolve the principal contradictions constrainingits further development. Reform is the mostimportant path. The journey begins by gaining aclear understanding of the coal industry’s role inChina’s economic and social development, andof how China is striving to achieve its long-term


objectives of building a market-oriented, efficientand sophisticated coal industry managementsystem by facilitating revolution through reformand being problem-oriented. There are sixaspects to consider: (i) handle the relationshipbetween the long-term target of creating asophisticated management system and the short-and medium-term policies of the coal industry,while protecting the transformation process fromdisturbance by an emergency; (ii) the govern-ment’s basic regulatory functions in the coalindustry are to avoid price fluctuations and mit-igate risk, as the coal sector is of fundamentalimportance for jobs and economic growth;(iii) once a sophisticated coal market system hasbeen created, control the degree of governmentadministrative regulation and ensure it does notcross the boundary between government andmarket; (iv) allow the domino effect of reform totake effect at carefully defined breakthroughpoints of the coal market system; (v) redefine thepowers and responsibilities of coal mine safetymanagement, and improve and standardise coalcompany governance; and (vi) use state-ownedcapital to optimise the coal industry and improvethe industry’s operations.

6.3.2 Handle the Relationship Betweenthe Long-TermManagement System andthe Short- andMedium-Term Policies ofthe Coal Industry

Coal industry reform should have long-termobjectives, but the market deals in short- andmedium-term cycles. This makes it difficult tocombine long-term system reform with short- andmedium-term regulation. Supply shortages willnot persist in China’s coal market in the long run.Moderate oversupply is the target, which is alsoconducive to improving the coal market system.Shifting from supply shortage to moderate over-supply is a long process, during which labourpains are inevitable. China’s coal market entereda downward trend in 2012, reaching the bottom ofthe cycle in 2015. Markets have the ability toself-regulate. From 2012 to 2015, with an

imbalance between supply and demand, manysmall- and medium-sized coal companies thatwere not competitive left the market. In 2015, thecoal industry made large financial losses. If noother measure other than self-regulation had beenused, more coal companies would have shutdown. To reduce coal capacity, the governmentimplemented many policies and measures, whichwere successful after about a year. Then the coalmarket was short of supply. Compared with thehistorical price, the coal price in 2016–17 did notrise sharply, reaching only the historicalmid-range, though this had a great impact on thebulk raw materials market. Stabilising the coalprice was on the government’s agenda again. Thegoal of ensuring safety also involved a conflictbetween long-term objectives and short- andmedium-term performance. In the long term, coalmine safety needs to be managed by law. Onlywith a sophisticated legal system could along-acting safety management mechanism bebuilt. But in the short and medium terms, thegovernment officials in charge could strengthenthe rulebook to improve coal mine safety man-agement and shift more responsibility onto busi-nesses. During the reform of the coal industry, thecentral government set long-term reform objec-tives. However, when the administrative author-ities introduced the policies and measures, theydid so in response to short- and medium-termproblems. It is not unusual for short- andmedium-term policies and measures, even emer-gency policies and measures, to conflict withlong-term reform objectives. Therefore, toachieve the long-term reform of the coal industry,the relationship between the long-term coalmanagement system and short- and medium-termemergency policies should be properly managed.Specifically, institutional reform of the coalindustry needs to achieve long-term objectives.Short and medium-term government regulation isessential, but it should not be used at the expenseof long-term institutional reform. Althoughshort-and medium-term regulation that runscounter to long-term reform can deliver resultsquickly, it will generate new bottlenecks thathinder the long-term reform process.


6.3.3 The Government’s RegulatoryFunction Needs to BeDefined Clearly

Coal will remain China’s main energy source fora long time to come, although its share of energyconsumption will decline. Forecasting of futureconsumption trends suggests that the coalindustry’s role in the Chinese economy willchange. Its function of supporting energy supply,the economy and society will remain, but itsstatus as a pillar industry will weaken. Coal,which is abundant in China, is a low-cost energythat will continue to account for a high propor-tion of the country’s energy consumption. Thecoal industry has many workers and assets andhigh levels of debt. What happens in the coalindustry has a strong chain effect on midstreamand downstream industrial enterprises and theservice sectors. Stability in the coal industry isimportant.

As China’s main energy source, coal stabilisesand supports the economy and society. Thegovernment therefore needs to impose macro-regulation on short- andmedium-term fluctuationsin the coal market to minimise economic, socialand safety risks. The two functions are related. Ifthe coal price is stable, economic and social risksare low. However, even if the price is steady, coalmine closures, unemployment, insolvency andother economic and social risks still exist. Inaddition, safety should be prioritised.

6.3.4 Controlling AdministrativeRegulation by Marketand Legal Means

Administrative regulation focuses on short- andmedium-term problem-solving and tends to pur-sue short-term performance at the cost oflong-term objectives. The root cause of this isthat administrative regulation is not well con-trolled. Government directly intervenes in theproduction and operation of coal companies,crossing the line between government and themarket. But the status of the coal industry haschanged. It has opened up. Government regula-tion of the coal market should also change in

alignment with ongoing coal industry reform,replacing administrative regulation with marketand law-based regulation.

To control administrative regulation success-fully requires a sophisticated coal industry sys-tem to be in place. Only with complete standardsand laws can the government’s use of market andlegal regulation be fully developed. So, to makethe most of market and law-based regulation, thecoal market system must be improvedcontinuously.

6.3.5 The Coal Market System ShouldBe Developed at CarefullyDefined Points

China’s coal market made great progress after2010. Once dual coal prices were abolished, thepricing mechanism became more market-oriented. Some regional and local coal marketsare becoming increasingly mature. Coal trans-port, trading, finance and information servicesare becoming more and more professional. Theshortage of rail capacity has improved radically.But the coal market system still has someshortcomings, such as incomplete inventorystandards, noncompliant inventory management,multiple information systems and inaccuratedelivery of finished products. These are problemsrelated to coal circulation, which clearly indicatethat China’s coal circulation system is unso-phisticated and that the necessary means to reg-ulate circulation are not in place. A sophisticatedcoal market system is the precondition for gov-ernment macro-regulation using market and legalmeans. So, the coal market system needs to befurther improved to lay a foundation for institu-tional reform of the coal industry. The key is toselect accurate breakthrough points. Inventorystandards, inventory management, unified infor-mation systems (the key) and accurate delivery offinished products are four areas to be improved.Coal market information, as an important enablerof government regulation of coal circulation,includes coal trading, inventory, flow anddemand, and could engage the other three areasto improve the current coal market system.


6.3.6 Adjusting the Powersand Responsibilities of CoalMine Safety Management

Minimising safety risks is a key part of thegovernment’s macro-control. Safety managementof coal mines is special. The coal mines of manylarge and medium-sized coal companies andgroups are owned by subsidiaries. Thestate-owned Assets Supervision and Adminis-tration Commission administers the rights ofinvestors in state-owned coal companies. Coalmine safety management responsibilities in theProduction Safety Law conflict with those in theCompany Law. According to the latter, the mainresponsibility of shareholders is not safety man-agement. The direction of coal industry reform istowards marketisation and legalisation. Anotherpriority for coal industry reform is to align theProduction Safety Law with market law. Currentlegislation on the powers and responsibilities ofcoal mine safety management are not consistentwith China’s ongoing state-owned capital man-agement system reform. In the long term, thepowers and responsibilities of coal mine safetymanagement need to be redefined. They could beadjusted moderately to alleviate investors’administrative management burden.

6.3.7 The Role of State-Owned CapitalIs to Optimise the CoalIndustry

Improving the state-owned capital managementsystem is a priority for China’s reform ofstate-owned enterprises. Many state-owned coalcompanies are now defined as state-owned cap-ital investment corporations. This redefines assetmanagement as capital management, and indus-trial asset operation as industrial capital invest-ment. These changes will have a significantimpact on the future structure of the coal indus-try, leading to two major reform tasks: stan-dardisation of corporate governance and theintroduction of mixed ownership. Adjusting thepowers and responsibilities of coal mine safetymanagement is one way to standardise corporategovernance. Mixed ownership reform and the

flow of state-owned capital are complementary.In the future, the state-owned capital ofstate-owned coal companies will optimise andimprove coal industry operations.

6.4 Policy Suggestions for DeepeningCoal Industry Reform

6.4.1 Optimise Macro-RegulatoryInstitutions

China’s reform of the coal industry relies oneffecting change in government functions. Onlythrough administrative streamlining and decen-tralisation, a combination of deregulation andregulation, and service optimisation, can govern-ment authorities achieve the institutional objec-tives of reform. Government functions shouldfocus on guidance and services, which are closelyrelated to the basic functions of the coal market.

Guidance can be used in two ways: to guidegovernment regulators on the strategic frontlineof ensuring economic growth; and to help opti-mise the coal market by constraining and stim-ulating the regulatory system. The market, whichis a bridge between upstream and downstream,should guide the transformation of coal produc-tion and consumption.

Service has several purposes: to help gov-ernment regulators integrate decision-makingand public services into a macro-control plat-form for the coal market; to facilitatemacro-control by the central government; and toensure that production and consumption developharmoniously and that circulated resources areshared.

Related policy suggestions include: (i) har-nessing the promising opportunities unearthed bythe reform of party and state institutions to reor-ganise government’s macro-regulatory authorityand optimise its functions; (ii) enhancing thegovernment’s macro-strategies for the energyindustry (including coal), and the functions ofmonitoring, forecasting, early warning andlaw-related regulation of the coal market; and(iii) reducing administrative micro-management.


6.4.2 Improve the Regulatory SystemThe first challenge for China’s coal industryreform is that the regulatory system is not suffi-ciently sophisticated. Building a coal circulationregulation system in line with China’s nationalcharacteristics is an important area for institu-tional innovation.

Coal circulation regulations should be alignedwith a regulatory system that combines centrali-sation and decentralisation, encourages central-local collaboration, and strengthens self-regula-tion. Multiple authorities, at different levels andcovering different types of participant—includingregulatory and other government authorities,central and local government, administrations andassociations—should take part.

The regulatory regime should cover variousfunctions of the coal market, including coalquality, commercial fields, logistics, capital, andinformation flow. Multi-functional supervision islimited rather than universal. This means that itshould regulate key processes such as qualitystandards, environmental protection, contractualperformance, credit supervision, risk supervision,and coal mine safety supervision.

Coal mine safety regulations need to bealigned with the reform of the state-owned cap-ital management system and should take advan-tage of IT and intelligent technology. Regulatorsshould consider redrawing the boundary of cor-porate governance to relieve shareholders andinvestors of the burden of administrativemanagement.

6.4.3 Build a Modern MarketInformation Network

Institutional reform of the coal industry isimpossible without the support of IT and com-munications technologies. The purpose ofbuilding a coal market information network isvery clear: it is to create a coal marketmacro-control platform to provide data for gov-ernment regulation. Suggestions are outlinedbelow.

First, a data system that integrates productiondata and capacity regulation information shouldbe built. It should pool production data fromdifferent sectors and form a 3D real-time capacity

data network, providing technical support andscientific references for capacity governance bygovernment. The transition from a data system inwhich designated companies upload their data atintervals, to one in which business and regionaldata is transferred in real time, will enable thedata network to spot companies forging data orinformation in a timely fashion. Moreover, thecommon practice in developed economies ofpenalising companies that forge informationshould be followed. Social groups and individ-uals should be incentivised to engage in capacitysupervision, and safe whistle-blowing channelsshould be provided to supplement governance.

Second, coal circulation should becomeincreasingly intelligent to ensure logistics andprocessing are visible, important coal marketinformation is collected, and key performanceindicators of the regulatory system are measured.

Third, intelligent development should bealigned with the introduction of integrated coallogistics parks, and centralised real-time dataacquisition points should be set up at differentnodes in the coal circulation system.

Fourth, vertical and horizontal barriers inadministration should be eliminated, and the datainterfaces of the regulatory platform shouldenable data to be gathered from differentadministrations and local government authorities.

Fifth, coal industry associations and big datacompanies should collaborate to create an intel-ligent coal market information network that usesbig data to make coal circulation regulation moremarket-oriented.

6.4.4 Accelerate Coal CirculationReform

Reform of China’s coal circulation lasted morethan 30 years, achieving great outcomes. Butcoal circulation reform was not carried out sys-tematically, except in some areas, such as coalpricing mechanism reform, coal market systembuilding and coal regulatory reform.

Under the new normal of slower economicgrowth, the coal market has experienced funda-mental change. Coal circulation reform wasfaced with external and internal pressures. One ofthe objectives of regulatory innovation is to


speed up reform, including the reform of coalcirculation. The regulatory system acts on theexternal part of the industry. The internal impetusfor coal industry reform should be developed.Given the fundamental role of the coal industryin the economy and society, central governmentshould focus on coal circulation reform.Suggestions are outlined below.

First, the optimisation and transformation ofcoal supply in China should be coordinated withair pollution prevention, the energy demandrevolution and the development of traditionalindustries like steel in order to study coal circu-lation reform systematically. Details of thereform should reflect the global nature of coalcirculation, including logistics and the flow ofcapital and information. The objective of coalcirculation regulation reform can only be turnedinto actions through design excellence and sys-tematic implementation.

Second, the parties involved in circulationshould be encouraged to innovate. Reform of thecoal industry needs to stimulate the industry’sdevelopment. This should be in the form oftechnical and methodological innovation,including clean coal processing technologies,logistics, process visualisation, information inte-gration and new circulation methods. The launchof new pilot projects should be considered.

6.4.5 Deepen the Reformof State-Owned CoalCompanies

China should seize the policy opportunities ofsupply-side reform and state-owned capital man-agement reform in order to speed up the optimi-sation of capital stock and eliminate inefficientcapacity. At the same time, efforts should be madeto promote the two-way flow of capital, coordinateexit and entry into themarket, optimise the internalstructure of the coal industry, improve the opera-tions of coal companies, and accelerate innovationand transition through reform.

Staff and debt are the two main barriers toexiting inefficient capital stock in traditionalenterprises. The challenge of repositioning staffcan be addressed, but the debt barrier is more

difficult to surmount. Debt is the priority when itcomes to exiting inefficient capital stock. Thepolicies to reduce debt and make short-term debtrepayments focus on debt-for-equity swaps. Thisshows that exiting inefficient capital stock can becombined with swapping debt for equity.

The current challenges include: (i) Inefficientcapital that needs to be exited cannot rely ondebt-for-equity swaps. In the past, assets under-going a debt-for-equity swap could rapidly entera new round of the profit cycle, but inefficientassets with high debt now have little marketvalue. Financial institutions typically issue adebt-for-equity swap based on profit expectationsfor assets with potential profitability, not forinefficient assets without any prospect of prof-itable development; (ii) the entity that issues thedebt-for-equity swap is the parent company of agroup, not the subsidiary operating the inefficientasset. In the early 21st century, a group wouldhave relatively undiversified businesses, and thegroup would be the principal debtor. The case isdifferent now: a large group typically has adiversified business portfolio, and the debtor ofan inefficient asset is usually the subsidiary thatoperates the asset. If the debt-for-equity swap iscarried out within the group, it does not solve thechallenge of exiting the debts of inefficientassets. Suggestions are outlined below.

First, the purpose of debt-for-equity swapsshould be made clear—it is to spin off inefficientassets and lower the asset to debt ratio of com-panies, and, more importantly, to improve theoperational efficiency of the real economy.

Second, an inefficient asset disposal platformshould be established. Inefficient assets can bepackaged and optimised or reorganised by busi-ness group or region to facilitate consistentimplementation of the debt-for-equity swappolicy.

Third, exit channels in financial institutionsshould be innovated. The financial policies forcutting overcapacity can be leveraged, and theopportunities to reform state-owned capitalinvestment and introduce mixed ownership canbe used to innovate financial capital exit channelsin a market-oriented manner.


7 Market-Oriented Reformof the Power Industry

7.1 Review of InternationalExperience

Vivid Economics, a UK think tank, and a ShellInternational team of experts summarised theglobal market-oriented reform of the powerindustry and made suggestions for the futurereform of China’s power industry.

7.1.1 The Evolution and Effectsof Power MarketDeregulation

China and the World: Economic TransformationthroughStructuralReform, preparedbyDr.MallikaIshwaran, Senior Economist, Shell International,for the 2017 China Development Forum, sum-marises the reform of the global power market. Thepaper points out that power market reform hasevolved over several decades. Liberalised powermarkets, such as those of the USA and UK, wereinitially designed to meet the dual objectives ofenergy affordability and energy security (the energydilemma). Starting with the UK in the 1990s, manycountries have liberalised their power markets,based on standard market design criteria involvingprivatisation, competitive wholesale power gener-ation and retail power supply markets, fairthird-party access to transmission and distributionnetworks, and unbundling the ownership of trans-mission and distribution networks from powergeneration and retail supply. Liberalisation hasbeen premised on encouraging competition—andcompetitive pricing—as a way to reduce electricityprices and develop diversity in supply sources toensure supply security (Fig. 16).16

The first phase of power market liberalisationstarted in 1990 with the UK. This entailedunbundling power generation and retailingactivities from the natural monopoly of

transmission and distribution. In parallel, a pro-cess of privatisation also occurred, particularly inthe competitive segments of the supply chain.This form of liberalisation spread to Norway,Chile, Argentina, New Zealand and Australia in1991, and began to spread across the USA fromCalifornia in 1994. The European Commissionpublished directives in 1996 that encouragedmore countries across Europe to liberalise.

Following the 1990s liberalisation, notions ofa standard market design began to coalescearound maximising the role of competition,rather than around government involvement, inorder to optimise dispatch and investment inpower generation and retail. Whereas the costs ofproduction for power generation and the supplyof electricity to the consumer could be minimisedthrough competition, grid infrastructure, as anatural monopoly, was best delivered through theregulation of a single company.

Phase 2 of power market liberalisation camein the 2000s. This second phase of reform beganwith increasing focus on regional integration,harmonisation and environmental objectives. TheEuropean Commission and US Federal EnergyRegulatory Commission began to promote stan-dard market designs by attempting to prescribebest practice and facilitate trade across borders.The challenge of addressing climate change hasmeant that the energy dilemma facing policy-makers has evolved into an energy trilemma—delivering affordable, secure and decarbonisedelectricity. Current liberalised power markets,which were designed to deliver energy dilemmaobjectives, have struggled to cope. The noveltyand high initial cost of renewables has requiredgenerous government subsidies (underminingaffordability) and their contrasting economicswith fossil fuel generation has reduced the abilityof the wholesale power market to incentiviseinvestment and balance demand and supply(undermining security of supply).

Consequently, power markets across the worldare in a state of flux, as countries have starteddecarbonising their power supply and the levels ofrenewables penetration have increased. Germany,which has led the way in renewables adoption,has nonetheless struggled to decarbonise energy

16Structural Power Market Reform to Support a Decar-bonised Economy, March 2017. Prepared by Dr. MallikaIshwaran, Senior Economist, Shell International, for the2017 China Development Forum on China and the World:Economic Transformation through Structural Reform.


supply, because coal plants remain a low-costsource of secure supply.

The UK implemented phase 1 of its powermarket reform in the mid-2000s but has had torapidly update policy to bring costs under controland maintain sufficient supply. This has createduncertainty for the up to £100 billion of plannedinvestment in power generation from 2015 to2020 (60% of UK infrastructure spending in theperiod).

In recent years, innovation in market reformhas begun to address the challenges of balancingthe energy trilemma. These have focused onauctioning renewable subsidies and capacitypayments to control costs and on incentivisingnew solutions to provide flexibility and improvenetwork management.

Further reform will be needed to deliver a netzero emissions power system. The supply offlexible power is not yet sufficient, and demandfor flexibility will increase as more energyend-uses are electrified, such as transport, whichwill likely increase peak loads. Currently,options such as batteries require multiple revenuestreams to be economically viable, requiringchanges to how value is distributed across theelectricity supply chain. At the same time, themanufacture of renewable power equipment and

the addition of a technology layer on top ofenergy assets, such as with smart meters and theInternet of things, links the transition to a netzero emissions energy system with broaderindustrial strategy aims.

The efficient coordination of an increasinglycomplex net zero emissions power system will bemost efficiently delivered through greater use ofmarkets. However, due to the challenges oflow-carbon power, the appropriate market struc-tures will be different from the historical standardmarket design.17

7.1.2 Overcome the Market Challengesof Renewable Power

Another important task during global energysystem reform is to overcome the market chal-lenges of renewable power. Variable renewables,such as solar and wind, are a crucial part of a netzero emissions power system, but they havecharacteristics that undermine the efficient oper-ation of liberalised power markets as currentlyconfigured.

Fig. 16 The evolution of power market policy focus, measures and outcomes. Source Structural Power Market Reformto Support a Decarbonised Economy, Mallika Ishwaran, Shell International, March 2017

17Structural Power Market Reform to Support A Decar-bonised Economy, March 2017. Prepared by Dr. MallikaIshwaran, Senior Economist, Shell International, for the2017 China Development Forum on China and the World:Economic Transformation through Structural Reform.


Variability. A key feature of many low-carbonpower technologies is that they are variablegenerators. This means that they generate on anas-available basis rather than on demand, i.e.they require the sun to be shining or the wind tobe blowing in order to generate power. Flexiblepower generation and/or storage capacity isrequired to make up for this variability and toaccommodate renewables into the power grid ina way that maintains security of supply. Fur-thermore, variable renewables, such as wind andsolar, may frequently deviate from forecast levelseven when the sun is shining and the wind isblowing, requiring greater short-term balancingbetween electricity demand and supply to correctfor forecast errors. Power systems are alreadydesigned to manage variability. However, withgreater renewables penetration, the demand formore frequent and greater levels of balancing arealso likely to increase.

Low operating costs. Variable renewables,such as wind and solar, have zero or a very lowmarginal cost of operation once they have beenbuilt. This, combined with their variable nature(or intermittency), is already impacting the effi-ciency of existing liberalised wholesale powermarkets and the ability of these markets to deli-ver long-term investment in capacity. Specifi-cally, renewable energy generators, bidding inthe wholesale power market at their operating (ormarginal) costs, have lowered average powerprices. At the lower average price, conventionalplants have found it difficult to recover their

costs, and additional incentives have beenrequired to invest in long-term capacity neces-sary to manage intermittency. This has reducedthe ability of wholesale power markets to deliverenergy security alongside the other two trilemmaobjectives.

Locational constraints. Renewables tend to beless flexible in terms of their location comparedto conventional (fossil-based) power plants,requiring investment in grid expansion toaccommodate and integrate them into the powersystem. They can be located far from demandcentres, with optimal sites for wind and solaronly coincidentally located close to urban areasand with network infrastructure required to con-nect supply with demand. Small-scale renew-ables, such as roof-top solar, may sell power intolocal distribution networks, but network invest-ment is required to allow these new two-wayflows of power without congestion.

Table 6 summarises the evolution of liber-alised power markets and the new market signalsnecessary to accommodate a significant increasein renewables’ share of the power mix.

7.1.3 Build Efficient Net Zero EmissionsPower Markets

Most countries are likely to iterate towards effi-cient power market structures and policies basedon the cost reductions and efficiency gains theyare likely to provide, both in terms of cheaperinvestment and electricity. These benefits areonly likely to increase with greater electrification

Table 6 Additional power market incentives required in a net zero emissions world

Note NZE = net zero emissionsSource Structural Power Market Reform to Support a Decarbonised Economy


of energy use and decarbonisation of electricitysupply.

Progress towards efficient net zero emissionspower markets will depend on a country’s cir-cumstances, such as its level of economicdevelopment and its domestic energy resourceendowments. Looking at a range of sevencountries across this spectrum (Australia, Brazil,China, Germany, India, England and the USA),most are making progress. For example,unbundling along the supply chain to increasecompetition and using market prices (Fig. 17).However, currently these price signals are notvery sophisticated. Only in Australia and theElectric Reliability Council of Texas (ERCOT)in the USA do prices provide strong locationaland temporal signals, and in no market are con-sumers exposed to real-time prices. China andBrazil are the furthest behind, with limitedcompetition between state-owned enterprises.

In terms of progress towards decarbonisation,government action, rather than market competi-tion between fuels, currently drives decarboni-sation (Fig. 18). Governments tend to decide thelevel of renewables by fixing the level of avail-able subsidies, but then look to allocate thesesubsidies competitively. The most efficientpathway for decarbonising the power sector is forthe level of renewables to be determined through

a strong carbon price and ensuing market com-petition. Only the UK gets close, with its con-tracts for difference and carbon price floor.Germany and China, while delivering high levelsof decarbonisation, are doing so through stronggovernment involvement and at a high cost.

Efficient management of the power grid iscurrently delivered according to regulatorydirectives, rather than incentives (Fig. 19).Arrangements for grid management vary con-siderably across countries, with none basinginvestment on economic incentives. Instead, allseven countries regulate grid provision, withvarying degrees of oversight. The UK and Ger-many are closest to being efficient, withperformance-based regulation that rewards effi-ciency. At the other end of the spectrum, Brazil,India, and China reward grid provision on acost-plus basis, which gives little incentive forreducing costs. Australia and PJM and ERCOTin the USA are in the middle of this spectrum,with independent oversight and benchmarking ofcost estimates, which provide indirect pressurefor efficient grid management.

Finally, policy credibility depends on thebroader political, institutional and public envi-ronment. Even with efficient power marketstructures and policies, the ability to attractinvestment depends on policy risk and whether

Fig. 17 Progress towards efficient power market structures. Source Vivid Economics


there is an expectation that particular arrange-ments will persist, or at least change predictably.If policy is seen as credible, this will minimisethe perceived risk of investment. Credibility is aquality of the policy environment, whichdepends on institutional capacity, political pre-dictability, public support and the coordination ofobjectives across power market services.Governments can also take additional measuresto increase credibility and reduce investment

risk, such as passing primary legislation (as theUK did with the 2008 Climate Change Act),writing legal contracts, providing guarantees andreleasing information on the performance offirst-of-a-kind investments.

The pressure on policymakers to ensure thatpower markets function efficiently in deliveringaffordable, reliable and low-carbon electricity isonly going to increase with higher levels ofrenewables penetration and greater reliance on

Fig. 18 Progress towards carbon pricing and market competition between fuel sources. Source Vivid Economics

Fig. 19 Progress towards efficient management of the power grid. Source Vivid Economics


electricity as an energy carrier. From a policy-maker’s perspective, there are two key charac-teristics of well-functioning and efficient powermarkets in a net zero emissions world18:

• market structures that provide efficient pricesignals, both for near-term electricity dispatchand for long-term investment in the sector;and

• energy and environmental policies that cor-rect for market failures and support the effi-cient operation of power markets.

These two factors are necessary for the effi-cient operation of net zero emissions powermarkets, without which meeting the energy tri-lemma objectives becomes significantly morechallenging and expensive. For example, in anenvironment of rapidly declining technologycosts, markets are better placed than policymak-ers to competitively and efficiently procure thenecessary investments. However, policymakershave a fundamental role in providing the neces-sary regulatory and policy frameworks tounderpin the efficient operation of these markets.

7.1.4 Market Structures for ProvidingEfficient Price Signals

The price signal from wholesale and retail powermarkets for conventional generation covers therange of energy provision services: supply ofelectricity, investment in generation capacity,and balance between the demand and supply ofelectricity. Variable renewables only provideenergy and do so intermittently. This increasesthe importance of capacity and balancing, withmarkets potentially being required for these ser-vices as they are no longer provided as part of thebundle that has traditionally been provided by asingle generation asset and paid for throughwholesale and retail electricity prices.

The three requirements for efficient pricesignals are discussed below (see also theleft-hand side of Fig. 20).

Efficient electricity markets. Through contin-ued liberalisation of wholesale and retail powermarkets (including spatially larger and integratedmarkets that maximise the diversity of supply) toincrease competition and security of supply, andthrough greater time-of-use and locational pric-ing with shorter settlement periods to increase thestrength and specificity of the price signal forefficient electricity dispatch.

Investment in capacity. Through atechnology-neutral capacity market (includingboth supply and demand measures and sufficientpenalties to ensure delivery of contractedcapacity), where efficient price signals for newinvestment in capacity are generated throughcompetition among providers of this capacity. Bythemselves, short-term price signals fromwholesale and retail markets are not likely to beenough to incentivise investment in long-termcapacity at high levels of renewable energypenetration, thus requiring capacity markets.

Competitive balancing services. Short-term,grid-specific balancing and flexibility servicesmay also be required to accommodate renew-ables. These would be required to supplement theprice signal from wholesale and retail markets,which may be constrained by political economyconsiderations to protect end users from unex-pected price spikes or due to forecast errors.Procuring these services competitively will pro-vide them at the least possible cost and encour-age the innovative use of new technologies, suchas batteries and technologies that enabledemand-side response. The need for such amarket could decline as the time required todispatch from a power plant decreases, andwholesale and retail power markets become moreinstantaneous.

7.1.5 Energy and EnvironmentalPolicies that Correctfor Market Failures

Efficient policy approaches and frameworks tocorrect for market failures are also needed tosupport the efficient operation of power markets.Three key characteristics of the required policyframework are described below (see also theright-hand side of Fig. 20).

18Structural Power Market Reform to Support A Decar-bonised Economy.


• The optimal way to incentivise low-carbongeneration or encourage energy efficiency isthrough a robust and credible carbon price,preferably through market-based approachessuch as a carbon tax or emissions trading. Inits absence, there is likely to be a proliferationof a patchwork of more expensive and lesseffective policies, such as renewable energysubsidies and mandated performancestandards.

• The natural monopoly of power transmissionand distribution networks is most efficientlydealt with through independent ownership bya single company whose performance is reg-ulated by an independent regulator. Whilethis is a well-developed area of regulatoryeconomics and policy, it will need to evolveto accommodate consumers that both demandand supply electricity; create flexible infras-tructure with natural monopoly characteris-tics, such as large-scale storage andinterconnectors; provide the returns neededfor investment in grid extension and

expansion to integrate renewables; and grantincentives for innovation in smarter grids.

• Maintaining a stable, predictable and crediblepolicy framework across the range of energyand environmental policies that affect powermarkets is essential in order to minimise thecost of capital and incentivise the necessarylong-term investments in the sector. Min-imising policy risk is even more critical on thepath to a net zero emissions world, given thelong-term, large-scale and capital-intensivenature of the required investments. Forexample, the recent cycle of iterative powersector reform and learning has unsettledinvestors, even as the technology has maturedto the point of mass deployment. A balanceshould be struck between the need for poli-cymakers to respond to new circumstancesand the need for stable revenues over longasset lifetimes, for example by making poli-cies predictable, with changes announced wellin advance and conditional on specifiedchanges in circumstance.

Fig. 20 Efficient power market structures and policies for a net zero emissions world


7.2 Use of Central Control or MarketMechanisms in SevenCountries19

Vivid Economics prepared a report summarisinginternational experience in power market reformfor the DRC-Shell Markets Work Stream. Thereport describes the choices made in sevencountries on managing their power systems bycentral control or market mechanisms. Manage-ment of power systems in Australia, Brazil,China, Germany, India, the UK and the USA(PJM, covering 13 states in the north-east, andERCOT in Texas) are compared, based on theframework outlined in Fig. 21 and the majormarket features listed in Fig. 22.

Power market structure. Most countries areslowly moving away from central control tomarket mechanisms, as shown in Fig. 22. Thistrend is expected to accelerate with the increasingpenetration of renewables. While no country hasachieved completely liberalised and integratedmarkets, most countries have been evolving inthis direction over the past three decades. We

observe three main archetypes of marketstructure:

• centrally controlled power markets with lim-ited entry in generation (China, Brazil). Chinacurrently belongs to this group with nocompetitive wholesale market;

• unbundling of generation and supply;wholesale market prices (the UK, PJM in theUSA, Germany and India). Germany is agood example of this: the country has acompetitive wholesale market, but it is notsophisticated enough to reflect adequatelytransmission and other costs in market prices.Therefore, some government intervention isnecessary; and

• increased market liberalisation and strength-ening locational and price signals. In rarecases, for example ERCOT in Texas andNEM in Australia, locational marginal pricinghas been introduced.

Market power. In order to ensure efficientinvestment and operation of grid infrastructure(natural monopolies), most countries currentlyuse direct regulation, rather than incentive-basedinstruments, as shown in Fig. 23. For grids,options for regulation can be plotted along aspectrum, from government-owned and operated

Fig. 21 The power system comprises three markets,which can be managed through central control or marketmechanisms. Source Low Carbon Power Markets:

Lessons from International Experience, prepared by VividEconomics for the DRC-Shell Markets Work Stream,April 2017

19This part is prepared by Vivid Economics. See LowCarbon Power Markets: Lessons from International Expe-rience prepared by Vivid Economics for DRC-ShellMarkets Work Stream, April 2017.


to an unbundled sector with an independentservice operator, where the government regulatesthe cost of service provision. To avoid moralhazard, performance- or incentive-based regula-tion can be introduced. However, as Fig. 23suggests, the most advanced countries on theliberalisation spectrum (Germany and the UK)have opted for performance-based regulation,such as the UK price caps. China is at the otherend of the spectrum—although the Chinese

sector is unbundled, the country still operatescost-plus regulation.

Decarbonisation. The move to lower emis-sions is currently driven by central control, ratherthan by market mechanisms, as shown in Fig. 24.Given political constraints to the roll-out of car-bon pricing, other options that preserve compe-tition while directing investment to cleanergeneration have been introduced. On the moreliberalised part of the spectrum, those options

Fig. 22 Most countries are slowly moving from centralto market mechanisms; this is expected to accelerate withdecarbonisation. Source Low Carbon Power Markets:

Lessons from International Experience, prepared by VividEconomics for the DRC-Shell Markets Work Stream,April 2017

Fig. 23 Market power is mainly managed throughregulation, rather than incentives, especially the powergrid. Source Low Carbon Power Markets: Lessons from

International Experience, prepared by Vivid Economicsfor the DRC-Shell Markets Work Stream, April 2017


include auctions for low-carbon electricity gen-eration contracts, such as those currently inoperation in Brazil and the UK. At the other endof the spectrum, China has adopted the moretraditional way, which involves incentivisingrenewable investment through targeted fixedprice measures, such as subsidies.

Policy credibility depends on the broaderpolitical, institutional and public environment.Even in a liberalised market, policy is importantas it sets the market arrangements. The ability toattract investment depends on policy risk andwhether there is an expectation that particulararrangements will persist, or at least changepredictably. If policy is seen as credible then theperceived risk of investment will be minimised.Credibility does not have a scale from centralcontrol to market mechanisms but is a generalquality of the policy environment. It depends oninstitutional capacity, political predictability,public support and the coordination of objectivesacross electricity market services. Governmentscan also take additional measures to increasecredibility and reduce investment risk, such aspassing primary legislation, writing legal con-tracts, providing guarantees and releasing

information on the performance of first-of-a-kindinvestments.

7.3 Global Trends of Power SystemTransformation

More and more countries have shifted the focusof energy development to clean energy in recentyears, accelerating the global development ofrenewables and further optimising the energyconsumption mix. Green, low-carbon, clean andefficient energy development has become a majortrend and many countries have taken new mea-sures regarding the market system, marketmechanisms and regulation policies.

7.3.1 Adapt to the Energy Transitionand Innovate a New MarketSystem and Mechanisms

Increasing the share of renewables in the energymix and deepening the energy transition imposesnew challenges on the conventional power mar-ket system. In many countries, the power marketsystem is already optimised and the types ofenergy traded is comprehensive. Those systems

Fig. 24 Decarbonisation in most countries is driven bycentral control, rather than by market mechanisms. SourceLow Carbon Power Markets: Lessons from International

Experience, prepared by Vivid Economics for theDRC-Shell Markets Work Stream, April 2017


are better able to achieve the objectives of allo-cating international resources efficiently, makingthe power market competitive, channellinginvestment into new and low-carbon powergeneration, meeting consumer demand, andfacilitating the use of new technologies.

The European Union published the NewEnergy Market Design report in 2015, accordingto which a new power market mechanism tocreate the European Energy Union will be built.It includes developing an international short- andlong-term power market capable of attractinginvestment, perfecting a market mechanismsuitable for renewables, improving the transna-tional capacity mechanism and strengthening thecoordination between wholesale and retail mar-kets. Regional cooperation will be strengthened,an integrated power market will be built and theenergy supply security of the whole EuropeanUnion will be achieved.

To achieve more flexible and efficient powersupply and ensure power security, Germanypassed the Electricity Market Act in 2016 to helpbuild Electricity Market 2.0. The act focuses onrenewables. It strengthens the procedure foradjusting the price signal, expands the balancingmarket, encourages supply-side management,and builds a fair power transmission tariffmechanism and capacity standby mechanism.

Great Britain launched a new round of powermarket-oriented reform focusing on low-carbondevelopment in 2014 by holding the first contractfor difference and capacity market auctions andamending the relevant rules and trading mecha-nism. California improved its real-time market,replacing the hour-ahead market with the 15-minmarket, and launched the energy imbalancemarket to adapt to the output of renewables.

7.3.2 Build Large Resource ApplicationPlatforms by Expandingthe Market

To promote the development of renewables,diversify energy supply and ensure energy secu-rity, transregional and transnational resourceallocation is urgently needed. The scope of thepower market has expanded again and again, aswith the Southwest Power Pool (SPP) in the USA.

Western Area Power Administration, BasinElectric Power Cooperative and Heartland joinedthe SPP in 2015, and power transaction volumesbetween the USA and Canada increased. EUmember states have continued to strengthenregional cooperation on energy. Latvia, Estoniaand Lithuania signed the Baltic Energy MarketInterconnection Plan in 2015. The five majorpower exchanges in Europe signed an agreementto develop a unified European transnationalintra-day trading platform, the purpose of which isto optimise the intra-day transnational and tran-sregional trading plan and promote an integratedEuropean power market. Sixteen grid operators inEurope announced an integrated day-ahead mar-ket for grids in central and western Europe, and incentral and eastern Europe. Six countries in thewestern Balkans signed a memorandum ofunderstanding on regional power market cooper-ation. A power market trading platform has startedto facilitate the integration of the power marketsand grids of countries in the Union for theMediterranean. The European Union and Turkeystrengthened their cooperation on energy marketintegration and renewables development.

7.3.3 Pay Close Attentionto the Constructionof Energy Infrastructurethat Helps Create LargePower Markets

With the expansion of the power market and thelarge-scale development and use of clean energy,many countries are investing in the developmentor modernisation of transnational grids to supportwide power transactions and optimise resourceallocation:

• Grain Belt Express, a cross-state high-voltagetransmission project in the USA, wasapproved by several states. The project,costing $2 billion and 1,255 km in length,aims to integrate and transmit the wind powerresources of Kansas;

• the European Union announced that transna-tional transmission capacity of each memberstate will account for at least 10% of itsinstalled capacity by 2020, and 15% by 2030;


• transmission lines connecting the IberianPeninsula, Baltic Sea region, Ireland and GreatBritain will be built. To this end, the EU set upthe South-west Europe High-level WorkingParty to encourage Spain, France and Portugalto construct energy infrastructure throughtechnical support and regular monitoring, andto strengthen interconnections between thepeninsula and other parts of the EU;

• two new transmission lines connectingLithuania, Poland and Sweden are underconstruction to interconnect the Baltic stateswith Sweden and Poland for the first time;

• the EuroAsia Interconnector, a high-voltagetransmission project that will connect thepower grids of Israel, Greece and Cyprus withcontinental Europe, is under construction;

• to adapt to the rapid development of naturalgas and wind power generation, Australiacontinues to invest heavily in cross-regionalinterconnections. As estimated by the Aus-tralian Energy Market Operator, Australianeeds to invest AUD 24 billion in the trans-mission network by 2030 and AUD 120 bil-lion in the power distribution network; and

• Russia has promoted the construction of anenergy bridge with North Korea, whileaccelerating connection to the grids of sur-rounding countries like Azerbaijan, Belarus,Estonia, Georgia, Kazakhstan, Latvia,Lithuania, Mongolia and Ukraine.

7.3.4 Build a Strong RegulatoryMechanism to EnsureEffective Competitionin the Power Market

As power market reform moved forward, coun-tries gradually realised that strong regulation isan important condition for effective competition.Increasing the powers of the regulators andimproving the content and methods of regulationhas been an important trend in power marketreform in recent years.

• The US Federal Energy Regulatory Com-mission (FERC) issued policies and regula-tions to improve wholesale power, capacity

and auxiliary service market pricing, andregulates the demand-response resourcesentering the market in accordance with thelatest measures for demand-side management.

• As suggested by Germany’s Electricity Mar-ket 2.0, the German Federal Network Agency(Bundesnetzagentur) should issue regulatorymeasures and publish reports on the whole-sale market at least once every two years,making the regulation of market abuse andmonopoly actions more open and transparent.

• An amendment to Japan’s Electricity Busi-ness Act was adopted at the plenary sessionof the House of Councillors. The act definesthe plan for phase 3 of reform and states thatan independent electricity regulatory com-mission will be formed.

• Australia released its national energy marketreform roadmap, according to which regulat-ing investment by grid operators and deter-mining a reasonable rate of return for them isan important part of the reform.

• FERC issued rules on market supervision,regulation and analysis and strengthenedpower market information disclosure. Thisrequires regional power wholesale markets tomake power sales and transmission informa-tion public within a specified time, makepower market prices more transparent andensure users pay a reasonable price.

• To promote the development of low-carbonpower and provide users with affordableelectricity, the UK announced a plan for anew round of reform measures that includesprice support for low-carbon energy throughcontracts for difference and a capacity marketfor procuring flexibility to balance the inter-mittency of variable renewables like wind andsolar. This should improve investment inlow-carbon energy and increase capacity. Thegovernment is also considering adjusting thetransmission tariff mechanism to reflect thetariff for different types of generation,including prosumers supplying distributedrenewable generation to the grid and con-suming electricity from the grid during timesof low or no renewables generation.


7.4 An Evaluation of Progressin China’s Power SystemReform

7.4.1 The Problems Facing ElectricitySystem Reform

As far as policy background is concerned, theDecisions of the Central Committee of theCommunist Party of China on Major IssuesConcerning Comprehensively DeepeningReforms was adopted in November 2013 at thethird plenary session of the 18th Central Com-mittee. The Decisions clearly state that “eco-nomic restructuring is still the focus of deepeningreform comprehensively. Appropriate handlingof the relationship between the government andthe market is still the core issue of economicreform, which will enable the market to play adecisive role in allocating resources and thegovernment to play its role better… In naturalmonopoly industries, in which state-owned cap-ital continues to be the controlling shareholder,we will carry out reform focusing on the sepa-ration of government administration from enter-prise management; the separation of governmentadministration from state assets management,franchise operation and government oversight;the separation of infrastructure networks fromoperations; and relax control of competitivebusinesses based on the characteristics of differ-ent industries; and make resource allocation moremarket-oriented… and improve the mechanismwhereby prices are determined mainly by themarket. Any price that can be determined by themarket must be left to the market, and the gov-ernment should not improperly intervene. Wewill push ahead with pricing reforms of water,oil, natural gas, electricity, transport, telecom-munications and other sectors, while relaxingprice control in competitive areas”.

At the sixth meeting of the Leading Group forFinancial and Economic Affairs held in June2014, the Four Energy Revolutions were men-tioned for the first time, i.e. the revolutions inenergy demand, energy supply, energy tech-nologies and of the energy system. Regarding therevolution of the energy system, it is statedexplicitly that “the commodity attributes of

energy should be restored. A market structureand market system featuring effective competi-tion, and a mechanism whereby energy price isdetermined mainly by the market, should bebuilt”.

Since the electricity system reform of 2002,which separated generation from transmission,the absence of many power market mechanismshas continued to hinder progress. These missingmechanisms include: a trading mechanism, theabsence of which reduces resource use efficiency;a market-oriented pricing mechanism, which ismissing because price relationships are notrational; government functions have not beenfully defined, which prevents the regulatorysystem from regulating the power market effec-tively; nationwide and sector-wide planning andcoordination mechanisms are not in place; thedevelopment and use of new energy and renew-ables is encountering difficulties due to anincomplete market development mechanism;law-making and amendments are lagging behind,restricting power marketisation and its healthydevelopment; and the market credit system isdeveloping slowly.

After observing and comparing China’s powerindustry management system with that of OECDcountries, Vivid Economics pointed out that theinstitutional framework for China’s powerindustry is very complex. No agency has com-plete control over the power industry or theauthority to coordinate other agencies’ actions.Unlike regulators in OECD countries, the powerregulatory function in China is exercised by theNational Energy Administration (NEA), which isadministered in turn by the National Develop-ment and Reform Commission. The NEA is notan independent body. A problem arises fromsuch a management system: planning and pricingdecisions at the central and local levels may beinfluenced by political objectives. This top-downplanning approach for power grids and the lackof coordination with provincial and regional gridcompanies may lead to inefficient investmentdecisions and poor coordination between gener-ation and transmission investments. Theseinvestment patterns create pockets of generationwhere electricity supply is abundant, but other


areas where it is scarce, due to limited trans-mission capacity. As a result, while China hassignificant renewable generation capacity, largevolumes of renewable energy are curtailed,increasing overall electricity costs and carbonemissions.20

According to Vivid Economics, the transitionof China’s energy system to a low-carbon anddecentralised system is likely to exacerbate theseinefficiencies and create new challenges. As theChinese economy and energy sector decar-bonises, it will be increasingly difficult to main-tain a high level of grid reliability at an affordablecost. Moreover, decentralisation of electricityresources requires significant investment in smartcapabilities and creates challenges for efficientplanning and delivery of infrastructure acrossdifferent networks.21

7.4.2 Differences in the New Roundof Electricity SystemReform

When different stakeholders reach a consensuson the problems in the power industry and thenecessity of reform, differences arise regardingthe reform path to be selected, mainly due to thepositioning of grid companies in the powermarket.

One view is that the new round of powersystem reform should follow the same path as thelast round in 2002 to complete unaccomplishedreform tasks. These tasks include separatingtransmission from distribution, making dis-patching organisations and trading institutionsindependent from grid companies, enabling themarket to determine transmission and distribu-tion prices, building regional power markets andcreating a power spot market.

People who hold this view generally believethat integrated grid companies that operatetransmission, distribution and sales hinder com-petition due to their control of the grid and largesize, making effective regulation impossible. In

their opinion, the precondition for a competitivepower market is to restructure these companies.The basic approaches to restructuring in a Chi-nese context are:

• separate grid assets from non-grid assets, andtransmission assets from distribution assets;

• make dispatching an independent, neutralorganisation regulated by governmentbecause dispatching is a public service, not agrid company asset;

• build power exchanges involving variousstakeholders and explore integrating powerdispatching centres with power exchanges;

• create a power market dominated by regionalpower markets to avoid trans-provincial bar-riers and provincial oligopolies; and

• build power spot markets as soon as possible,based on the principle of “no spot, nomarket”.

Another view is that the new round of powersystem reform should develop a practical andeffective solution to the problems facing theChinese power industry. The people holding thisview believe that power reform is a long-termand progressive process, and that radical reformslike separation and restructuring will not solvethe problems but will impact supply safety andgrid stability. They suggest the following reformapproaches:

• maintain control of the power grid butderegulate power generation and sales: grad-ually introduce competition into power gen-eration and sales to develop diversifiedmarket participants and create a fair, com-petitive environment;

• stick to the principle that the power grid is anatural monopoly: maintain integrated man-agement of transmission, distribution, dis-patching and trading; strengthen governmentregulations and provide fair and efficientnetwork services; and

• create a unified, open, competitive andorderly power market in which resourceallocation and macro-control are combinedorganically: forge a sound legal system,

20Vivid Economics, Electricity Grids in Transition, FinalReport. Prepared for the DRC-Shell Markets RevolutionWork Stream, October 2017.21Ibid.


change government functions, improve theregulatory system and build a scientificallybased price mechanism.

The path arrived at in this section of the reportis based largely on the second approach butincorporates some of the principles of the firstapproach.

7.4.3 Targets and Tasks of the NewRound of Power SystemReform

The ZhongFa No. 9 Document of 2015 marks thelaunch of the new round of power system reform.It defines the targets and tasks of reform in thelight of the difficulties faced in building marketmechanisms for China’s power industry.

According to the document, the targets andtasks of the new round of reform are as follows.

The objective of reform is to make power acommodity by building a power industry marketmechanism, developing a rational pricing mech-anism, deregulating competitive segments in anorderly manner, diversifying suppliers, control-ling energy consumption, enhancing energy

efficiency, improving safety and reliability,ensuring fair competition, and protecting theenvironment.

The main tasks of reform are “three deregu-lations, one facilitation and three improvements”.These are: deregulate (in an orderly manner)pricing in competition-based fields, excepttransmission and distribution; open distributionand sales to private capital in an orderly manner;lift control over power generation in an orderlymanner, except peak-shaving; make powerexchanges relatively independent; strengthengovernment regulations; improve power plan-ning; and make power supply safe, efficient andreliable (Fig. 25).

Generally, the three deregulations, one facili-tation and three improvements are all related tobuilding power market mechanisms. The purposeof deregulating price in competition-based fieldsis to build the market price mechanism. Thepurpose of lifting control of sales and powergeneration is to build a market competitionmechanism for generation and sales. The purposeof making power exchanges independent is toequip the market with fair and efficient trading

Fig. 25 Targets and tasks of the new round of power system reform


services and trading platforms. The purpose ofthe three improvements is to change governmentfunctions and build an effective regulatory sys-tem for the power market. The purpose oftransmission and distribution price reform and of

deregulating investment in distribution is toimprove regulation of the power grid—thephysical basis of the power market—and facili-tate the development of distribution networks(Fig. 26 and Table 7).

Fig. 26 Competition in the power market before and after reform

Table 7 Measures, objects and purposes of the new round of power system reform

Measure Object Purpose

Deregulate price in competitive fields Pricemechanism

Build a market price mechanism

Lift control of sales and power generation Competitionmechanism

Build market competition mechanisms ingeneration and sales

Make power exchanges relatively independent Tradingplatforms

Equip the market with fair and efficienttrading services and trading platforms

Strengthen government regulation and powerplanning; make power supply safe, efficient andreliable

Regulation Change government functions and build aneffective regulatory system for the powermarket

Reform transmission and distribution pricing,deregulate investment in power distribution

Physical basisof the powermarket

Strengthen regulation of the power grid—thephysical basis of the power market—andfacilitate the development of distributionnetworks


7.4.4 Progress in the New Roundof Power System Reform

(1) Reform policies

The ZhongFa No. 9 Document defines the targetsand tasks of China’s power system reform. Thesix main support documents published inNovember 2015 provide a specific working planfor the reforms. The National Development andReform Commission and National EnergyAdministration are formulating detailed rules fortheir implementation. The Administrative Mea-sures for Access and Withdrawal of ElectricitySale Companies and Administrative Measuresfor Orderly Deregulation of Power DistributionNetworks were released in October 2016.

The Opinions on Promoting Transmission andDistribution Tariff Reform sets three objectives:(i) build a reasonable, scientific, transparent andindependent transmission and distribution tariffsystem that is well regulated with clear rules;(ii) form a transmission and distribution pricingmechanism based on the principle of “allowablecost + reasonable profit”; and (iii) define gov-ernment funds and cross-subsidies. The maincontent and requirements are shown in Tables 8and 9.

The Opinions on Establishing Power TradingInstitutions and Standardising Their Operationdefines the objectives of “building a competitivemarket structure and market system”, as requiredby the ZhongFa No. 9 Document, and of estab-lishing relatively independent and standardised

Table 8 Opinions on promoting transmission and distribution tariff reform

Main content Main requirements

Gradually expand the scope of pilot transmissionand distribution tariff reform

Include the regions carrying out pilot power system reform inthe scope of pilot transmission and distribution tariff reformAllow regional characteristics to be embodied in transmissionand distribution tariff calculation parameters, the priceadjustment cycle and total income regulation patterns

Carefully calculate the transmission anddistribution tariff

For pilot regions, the National Development and ReformCommission performs centralised cost supervision, calculatestransmission and distribution tariffs for each voltage class,creates balance accounts for pilot regions, and supervises andregulates income and price levelsFor non-pilot regions, research and calculate transmission anddistribution tariffs for each voltage class

Promote cross-subsidy reform by category Gradually reduce cross-subsidies for industrial andcommercial users, and correctly manage cross-subsidies fordomestic and agricultural usersGrid companies report the amount of tariff cross-subsidies fordifferent types of user during a transitional period, which willbe recovered through transmission and distribution tariffsafter being reviewed by price authoritiesAfter transmission and distribution tariff reform, thetransmission and distribution tariff for each voltage class andthe cross-subsidies borne by domestic and agricultural userswill be calculated

Policies on transmission and distribution tariffs forpower trading during the transitional period

In those regions where transmission and distribution tariffshave been set, power is traded at the approved tariffIn those regions where separate transmission and distributiontariffs have not been set, sales-side reform will be promoted


power trading institutions. Its main content andkey requirements are shown in Table 10.

The Opinions on Implementing an OrderlyLiberalisation of Power Generation and Con-sumption Planning lists the following objectives:(i) build a power operation mechanism that fea-tures orderly competition and is strongly sup-ported, and that shifts the power systemgradually from plan-oriented to one in which themarket plays a decisive role; (ii) ensure powersupply to households and other users who do nothave bargaining power by establishing a powergeneration and purchase priority mechanism,granting preferential grid access for public andpeak-shaving purposes. The main content andrequirements of the document are shown inTable 11.

The Opinions on Promoting Power SalesReform has the following objectives: introducecompetition into power sales, open power sales

to private capital, expand user choice, developpower sellers in different ways, and form acompetition-based environment of diversifiedbuyers and sellers. Its main content andrequirements are shown in Table 12.

The main objectives of the Guidance onStrengthening and Standardising the Supervisionand Management of Privately Owned Coal-FiredPower Plants are: gradually make privatelyowned power plants equal with state-ownedpower plants, promote the orderly developmentof privately owned power plants, increase theabsorption of clean energy, improve energy useefficiency, and ensure fair market competition. Itsmain content and requirements are shown inTable 13.

The Administrative Measures for Access andWithdrawal of Electricity Sales Companies pro-vides clear stipulations on access, exit, classifi-cation and scope of business of power sales

Table 9 Opinions on advancing the creation of power markets


Marketcomposition

Composed mainly of medium- and long-term markets and spot marketsMedium- and long-term markets cover power trading on a multi-year, yearly, quarterly, monthly andweekly basis and for interruptible loads, voltage adjustment and other auxiliary servicesThe spot market mainly covers day-ahead, intra-day, real-time power trading and trading of standby,frequency modulation and other auxiliary servicesAfter conditions mature, capacity market, power futures and derivatives trading will be explored

Market mode Includes decentralised and centralised marketsUnder the decentralised mode based on medium- and long-term physical contracts, power users andproducers themselves determine daily output and load curve during the day-ahead period; the deviation isadjusted through day-ahead, real-time balance tradingIn centralised markets, risk is managed through medium-and long-term contracts for difference, andcentralised price competition is applied with the help of spot trading

Market system Divided into regional and provincial (municipal) power markets, which are not gradedNationwide optimal allocation of resources is almost achieved, mainly by the Beijing and Guangzhoupower exchangesSet up spot markets in large and provincial markets that offer optimal allocation of resources

Marketparticipants

Includes power producers, power suppliers (local power grids, bulk sale counties, high-tech industrialparks and economic and technological development zones), power sales companies and power users. Theusers involved in market trading should be those with large capacity and loads whose access voltagereaches the threshold

Marketoperation

Detail provisions by trading organisation or implementation, medium- and long-term trade contracts,day-ahead generation plans, intra-day generation plans, pricing of competitive fields, market settlement,safety assessment, congestion management, emergency response, market supervision and regulation

Credit system Create a market participant credit rating system, annual information disclosure system, loyalty incentivesand dishonesty penalty mechanisms


companies, and plays an important guiding rolein standardising the power sales market. Its maincontent and requirements are shown in Table 14.

The Administrative Measures for Deregulat-ing Power Distribution Networks in an OrderlyManner deregulate investment in incrementalpower distribution network capacity. Its maincontent and requirements are shown in Table 15.

(2) Reform progress

Power system reform. Up to the end of 2016, theNational Development and Reform Commission

had designated: Yunnan, Guizhou, Shanxi,Guangxi, Beijing, Hubei, Sichuan, Liaoning,Shaanxi, Shandong, Anhui, Henan, Xinjiang andNingxia as comprehensive power reform pilotprovinces; Guangdong, Chongqing, XinjiangProduction and Construction Corps, Fujian,Heilongjiang and Hebei as power sales deregu-lation pilot provinces; and Gansu, Hainan andShanghai as electricity system reform pilotprovinces.

Pilot transmission and distribution tariffreform was carried out in six provincial powergrids (western Inner Mongolia, Anhui, Hubei,

Table 10 Opinions on establishing power trading institutions and standardising their operation


Functions andpositioning

Non-profit trading institutions provide market participants with standardised, open andtransparent power trading services under government regulationConstruct, operate and manage market trading platforms, organise market trading,provide settlement and relevant services, gather bilateral contracts between power usersand producers, register and manage market participants, and disclose and release marketinformation

Organisational form Separate the trading business of grid companies, establish trading institutions inaccordance with the articles of association and rules approved by governmentTrading institutions could be companies partly controlled by grid companies, theirsubsidiaries or members of grid companies

Market managementcommittee

Build a market management committee consisting of representatives from gridcompanies, power producers, power sales companies and power users. The committee isresponsible for researching and discussing the articles of association of tradinginstitutions and trading and operational rules, and for coordinating matters related to thepower marketMarket management committees adopt a discussion mechanism, such as voting bycategory of market participantDecisions of market management committees are executed after being reviewed. TheNational Energy Administration and competent authorities should have the power ofveto

System and framework Set up relatively independent regional and provincial (municipal) trading institutions inan orderly manner. These include the Beijing and Guangzhou power exchanges andother trading institutions servicing regional power markets. Encourage tradinginstitutions to expand the scope of trading services and promote market integration

Staffing and sources ofincome

Trading institutions could be staffed with existing grid company employees. Seniormanagers should be recommended by market management committees and appointed inaccordance with applicable laws and procedures. Trading institutions may charge marketplayers reasonably for registration fees, annual fees and service charges for trading

Dispatching Trading institutions are responsible for market trading. Dispatching organisations areresponsible for real-time trading, balancing and system security. For day-ahead trading,functional boundaries should be defined based on circumstances, practical operation andlessons learned


Ningxia, Yunnan and Guizhou) in 2015. Inclu-ded in the pilot transmission and distributiontariff reform of April 2016 were the provincialpower grids of Beijing, Tianjin, southern Hebei,northern Hebei, Shanxi, Shaanxi, Jiangxi,

Hunan, Sichuan, Chongqing, Guangdong andGuangxi; the provincial power grids covered bythe national power system comprehensive reformpilots; and the power grids of north China. InAugust 2016, the National Development and

Table 11 Opinions on implementing an orderly liberalisation of power generation and consumption planning


Build a purchase priority system Priority purchasers: primary industry, domestic users, important utilitiessupplying the service and public service industriesThe measures to protect priority purchase rights: share generating units,improve demand-side management, implement in an orderly manner, andensure power supply to remote and poor regions

Build a priority generation system Priority producers: planned renewables, peak-shaving/frequencymodulation and cogeneration, hydropower, nuclear power, power generatedwith waste heat/pressure/gas; power generated in accordance withtrans-provincial and interregional national plans, local governmentagreements or for historical reasonsMeasures to protect priority generation: (i) leave space for planning;(ii) improve power output and absorption; (iii) forecast output in acentralised manner; and (iv) organise and implement replacement powerand make priority power tradeable

Ensure electricity balancing Manage priority generation: preferentially arrange renewables generation tofill output gaps; arrange peak-shaving and frequency modulation demand asneeded; arrange cogeneration using waste heat, pressure or gas; and managehydropower and nuclear powerOrganise direct trading: ensure load characteristics do not deteriorate, avoidan increase in peak-shaving pressure. Direct trading should not affectdemand for heating. In regions with a high proportion of hydropower, directtrading should distinguish between the wet and dry seasonsCapacity deduction methods: to motivate power producers, the amount ofpower traded may be converted into generation capacity based on the users’maximum load utilisation hours, local industrial users’ average utilisationhours, or the upper limit

Actively promote direct trading Carry out pilot power market projects in regions with the right conditions.Carry out market-oriented trading in non-pilot regions in accordance withthe Opinions on Implementing an Orderly Liberalisation of PowerGeneration and Consumption Planning. Maintain power load characteristicsand avoid irrational competition

Lift control of generation planningin an orderly manner

Gradually increase the amount of power traded: the market for industrialand commercial users of 110 kV and above could be deregulated, followedby that for industrial and commercial users of 35 kV and above. When theconditions have evolved and matured, the market for all users of 10 kV andabove could be deregulatedEstablish a power market system: gradually lower trading accessrequirements for users, power sales companies and power producers toexpand the size of the marketImprove the emergency supply mechanism: encourage enterprises and usersof priority generation to enter the market voluntarily. Renewable powercould take part in market competition with subsidies and be protected by arenewable energy quota system


Table 12 Opinions on promoting power sales reform


Market participants in power sales Power sales companies fall into three categories: (i) power salescompanies that are grid companies; (ii) power sales companieswith the right to operate a power distribution network and useprivate capital to invest in incremental power distributionnetworks; and (iii) independent power sales companies without theright to operate a power distribution network and that do notprovide minimum supply servicesGrid companies, eligible power producers, qualified high-techindustrial parks and economic and technological developmentzones, distributed power and microgrid owners, utilities includingwater, heat and gas suppliers, energy-saving service providers,private capital and private enterprises may invest in or form powersales companies to carry out power sales activities

Access and exit mechanisms for power salesmarket participants

Access and exit of market participants, not subject toadministrative approval, need to be included in an annual list ofprovincial government announcements. Such market participantsneed to make commitments and be registered at tradinginstitutions. Power sales companies need to be independent legalentities registered in accordance with the Company Law of thePeople’s Republic of China

Business and trading activities of marketparticipants

The core business of power sales companies is electricity purchaseand sales, which could include energy performance contracting,energy-saving strategies, electricity use consulting and otherpower-related value-added servicesBefore selling electricity to users in the quantity and at the priceagreed with them, power sales companies may trade with powerproducers freely or through trading platforms. Distributed poweror microgrid users may delegate electricity purchase and sales topower sales companies. The power purchase price for usersinvolved in market trading consists of the market transaction price,the transmission and distribution tariff (including line loss andcross-subsidy) and government fundsGrid companies offering measurement, meter reading, billing,settlement, installation, repair and other power supply services areresponsible for settling electricity bills and ensuring safety of thefunds. Grid companies ensure minimum power supply in theregions they serve

Deregulating investment in incrementaldistribution capacity

Encourage the development of the power distribution businessthrough mixed ownership. Deregulate investment in incrementaldistribution capacity for qualified market playersPrivate capital investing in and wholly controlling incrementalpower distribution networks, i.e. with the right to operate thepower distribution network, also has the same rights as the gridcompanies in the same power supply area and should fulfil thesame responsibilities and obligationsThere could be multiple power sales companies in one powersupply area. But only one of them has the right to operate thepower distribution network and provide minimum supply services

Build credit system and risk preventionmechanisms for the power sales market

Establish a market participant credit rating mechanism andblacklist. Government could intervene in the market in the case ofserious abnormalities


Reform Commission extended the transmissionand distribution tariff reform pilot to all provin-cial power grids except Tibet. Cost supervisionand review were completed in January 2017.

Power sales reform. The first power salescompany—Shenzhen Shendianneng ElectricityCo., Ltd.—was founded in March 2015. Afterthe Administrative Measures for Access andWithdrawal of Electricity Sales Companies wasreleased in October 2016, existing companiescould carry out electricity sales activities afterapplying to expand their business activities andcompleting the access procedures. The number ofpower sales companies increased sharply

3.5-fold in three months. The National EnterpriseCredit Information Publicity System shows thatthere were 5,410 power sales companies in Chinaat the end of 2016.

Reform of trading institutions. Up to the endof 2016, two national power trading institutions,the Beijing Power Exchange and the GuangzhouPower Exchange, had been founded, and 32provincial power exchanges (except Hainan andTibet) established, covering almost the wholecountry.

Reform of incremental power distribution.The National Development and Reform Com-mission (NDRC) and the National Energy

Table 13 Guidance on strengthening and standardising the supervision and management of privately owned coal-firedpower plants


Improve planning guidance andstandardise construction scientifically

The requirements for planning, selection, approval, construction andgrid integration of newly built (or expanded) privately ownedcoal-fired power plants (except backpressure and wasteheat/pressure/gas plant units) should in principle be the same as thosefor state-owned power plants. State-owned power plants are notallowed to change into private ownership

Improve operational management andtake part in auxiliary services

Grid-connected privately owned power plants should followdispatching disciplines, undertake their responsibilities and obligationsto provide safe and stable power supply, and be covered by auxiliaryservice assessment or compensation in accordance with the DetailedRules for the Administration of Grid-Connected Power Plants and theDetailed Rules for the Administration of Ancillary Services ofGrid-Connected Power Plants

Assume social responsibilities by payingcharges and fees

Electricity generated by privately owned power plants and used by theowner is subject to government funds and policy-relatedcross-subsidies. These monies should not be exempted withoutpermission or collected selectively by local government at any level.Enterprises with grid-connected privately owned power plants shouldpay a system standby fee to the grid company based on the agreedstandby capacity at the rate set by each province

Reduce the use of coal combustion Replace privately owned coal-fired power plants with renewableenergy generation

Define the market participants in markettrading

Enterprises with privately owned power plants that are not able tomeet their own power demand could purchase electricity after paying afee set by government. The fee should be in accordance withapplicable laws, regulations and policy-related cross-subsidies

Define accountability and improvesupervision and management

Privately owned power plants should name the parties accountable,improve organisation and coordination, carry out specialisedregulation, improve project management, standardise operation andmodernisation, and strengthen supervision and inspection


Administration (NEA) issued an order in August2016 that requires provinces to start pilot incre-mental power distribution deregulation pro-grammes and carry out 100 incremental powerdistribution pilot projects across the country assoon as possible. The order also requires incre-mental power distribution to be deregulatedthrough mixed ownership. The NDRC and theNEA defined 105 projects, including the Yan-qing Smart Power Distribution Network, as thefirst batch of pilot incremental power distributionreform projects in November 2016.

Market trading. Monthly and annual biddingin Guangdong power markets made great pro-gress. Up to September 2016, 43,960 GWh(RMB 0.033/kWh cheaper on average) had been

traded directly in Guangdong, exceeding theplanned annual target of 4,200 billion kWh.A total of 15,980 GWh (RMB 0.073/kWhcheaper on average) was traded throughmonthly bidding, exceeding the annual target of14 billion kWh.

Up to the end of 2016, Guangdong hadconducted seven monthly centralised biddingrounds, trading 15,980 GWh in total. Thenumber of power sales companies increasedfrom 13 to 154. The electricity sold by powersales companies accounted for 70% of the total.The discount granted by the power producersdropped from a high point of RMB 0.148/kWhin April to RMB 0.037/kWh in September(Table 16).

Table 14 Administrative measures for access and withdrawal of electricity sales companies


Access mechanism Define access conditions for power sales companies. Replace administrative licencingwith confirmation of registration. Process of market entry: sign the letter of commitment,submit registration information online, announce and register at the NationalDevelopment and Reform Commission, National Energy Administration and thethird-party credit information service provided by governmentPower producers, power-related construction companies, high-tech industrial parks,economic and technological development zones, water/gas/heat utilities andenergy-saving service providers in an incorporated capacity, and which meet the accessconditions for power sales companies, could carry out power sales activities afterapplying to industrial and commercial administrations to expand the scope of theirbusiness and complete the procedures aboveExisting qualified high-tech industrial parks, economic and technological developmentzones and companies that build or operate power distribution networks could voluntarilychange into power sales companies after completing the procedures above

Scope of business Power sales companies may provide users with other services, including but not limitedto energy performance contracting, comprehensive energy saving, energy use consulting,electric equipment operation and maintenance, and other value-added services

Market-based trading Power sales companies may purchase or sell electricity through the power market, fromor to power producers, or through trading institutions. Power sales companies couldselect trading institutions for trans-provincial and interregional purchase. There could bemultiple power sales companies in one power distribution area. The same power salescompany could sell electricity in many power distribution areas in its province

Establish a credit ratingsystem

Build a power sales company credit rating system. Establish a penalty mechanism forbreaking power industry law and for immoral behaviour


Table 15 Administrative measures for deregulating power distribution networks in an orderly manner


Planning guidance Include incremental power distribution network projects with the powerdistribution network plans developed by local power authoritiesIncremental power distribution networks need to be finalised in provincialplans to ensure that incremental power distribution networks are consistentwith national power development strategies and industrial policies and meetmarket participant transmission requirements

Competition and openness Encourage private capital to actively take part in incremental powerdistribution. Determine investors through market competition

Rights and responsibilities Private capital investing in an incremental power distribution network isresponsible for its operation and management. Investors should follow nationaltechnical specifications and standards, fulfil their obligations on safe andreliable electricity supply, minimum supply and social services, whileobtaining a reasonable return on investment

Scope of activities in the powerdistribution network

Invest in, construct and operate incremental power distribution networks thatmeet transmission demand and planning requirements, and expand powerdistribution networks through mixed ownershipCompanies that control existing assets in power distribution networks,including high-tech industrial parks, economic and technological developmentzones, local power grids and bulk sale counties, could apply to local powerauthorities for the right to invest in and operate power distribution networks

Operation of power distributionnetworks

Private capital that invests in and controls the incremental power distributionnetwork has the right to operate the network. Those companies that meet theaccess conditions for power sales companies may carry out power salesactivitiesThose grid companies with an incremental power distribution network havethe right to operate the network. Only power distribution activities can becarried out in power distribution areas. The grid company’s competitive powersales business should be gradually shifted to an independent power salescompanyPower producers are not allowed to invest in or build dedicated lines throughwhich power plants supply power directly to users or that connect the plants tothe incremental power distribution network they invest in

Table 16 Power traded through bidding in Guangdong, up to March 9, 2016

Trading volume (GWh) Share of power sold bypower sales companies (%)

Discount granted by power producers(li (one thousandth of a yuan)/kWh)

1st trade 1,050 64.85 125.55

2nd trade 1,450 68.68 147.93

3rd trade 1,400 82.92 133.28

4th trade 1,870 62.07 93.90

5th trade 2,660 75.50 58.87

6th trade 3,550 75.86 43.38

7th trade 4,000 75.00 37.42


7.5 Principles and Roadmapfor Future Reform22

The power market comprises multiple marketsand multiple market failures. The primaryobjective of these markets is to match supplywith demand through optimal dispatch andinvestment. This is delivered through electricity,capacity and balancing markets, which facemarket failures in the form of the carbon pricingexternality, regulation of natural monopolies andthe need for policy credibility to underpinlong-term and long-lived investment decisions.These market structures and failures will exist ina net zero emissions future, but their relativeimportance and sophistication will change withgreater electricity demand and a greater share ofsupply from renewables.

While the six characteristics of market effi-ciency (in terms of price signals) and policyefficiency (in terms of correcting for marketfailures) described above are essential from thedesign perspective, their importance will varybased on regional, national and local circum-stances. For example, countries with largeendowments of non-intermittent, low-carbongeneration23 will have less need to implementall six elements, although they are still likely torequire some evolution of efficient pricingmechanisms and supporting policy frameworks.These countries will have less need for ashort-term balancing and ancillary services mar-ket and are likely to require less sophisticated

capacity markets.24 However, for most countriesrelying on variable renewables to decarbonisepower, there will be significant pressure forreform of the power sector.

For centrally planned economies like China,the challenge will be to achieve the right balancebetween market forces and policy interventions.On the one hand, central planning through theFive-Year Plan process provides policy certainty,security of supply and the ability to distribute theburden of costs away from consumers to otherparts of the system. On the other hand, marketforces, through efficient market design and sup-porting policy frameworks, are likely to be a lessexpensive and more adaptive approach, espe-cially in the context of dynamic and changingpower demand and technologies. The value ofsuch an adaptive approach is even greater, giventhe likely scale and pace of change required toachieve net zero emissions in the second half ofthe century.

Progress towards efficient net zero emissionspower markets will not be smooth. It is likely tohappen at different speeds in different geogra-phies, with countries experimenting with differ-ent approaches; for example, the differentapproaches taken by the UK and Germany, withthe former relying on capacity auctions and thelatter on creating strategic reserves to deliverlong-term capacity and resilience in the system.25

However, the direction of travel is clear, withmany countries already making progress towardsmore efficient power market structures and poli-cies, driven in large part by the efficiency gainsthey provide. This trend is only likely to intensifywith greater electrification of energy use and withthe greater imperative to decarbonise power in away that keeps costs down and delivers a securesupply of electricity.

22Following the publication of the Opinions of the CentralCommittee of the CPC and the State Council on FurtherDeepening the Reform of the Electric Power System(Zhongfa No. 9, 2015), which provides a roadmapfor power system reform in China over the coming years,the National Development and Reform Commission,the National Energy Administration and other ministriesand commissions released specialist action plans. In thissection, we include the opinions and suggestions of foreignexperts, especially Vivid Economics and Shell Interna-tional, which help us to analyse the future directionand actions of power reform from the perspective of in-ternational experts.23For example, hydropower in Norway, bioenergy inBrazil, nuclear power in France and the abundant fossilfuel and huge carbon capture and sequestration potentialof North America and other countries.

24For example, to deal with seasonal intermittency ratherthan the more frequent intermittency associated withvariable renewables like wind and solar.25Strategic reserves provide capacity and flexibility bykeeping mothballed or older (usually thermal) generationplants available, whereas capacity auctions provide afixed revenue for long-term capacity and flexibility in thesystem.


7.5.1 Reform Difficultiesand Approaches to ResolveThem

A reforming power market needs to solve sixproblems urgently.

First, how to allocate power resources opti-mally; how to design an effective market mech-anism to transmit abundant power resources inwest China to the load centres in east China; howto make the market set a reasonable price forclean energy; and how to design an effectiveauxiliary services market mechanism to absorbclean energy across provinces and regions.

Solutions:

• market scope: design a nationwide unifiedelectricity market to allow the free flow ofresources across the country;

• roll-out: starting with provincial markets,promote deep integration of provincial mar-kets step by step to eliminate the trade barri-ers between provinces with a marketmechanism;

• increase the types of trading in provinces andregions: gradually introduce trans-provincialand interregional spot trading (starting withmedium- and long-term trading), and increasethe number of participants by engaging usersand power sales companies intrans-provincial and interregional trading; and

• build a market mechanism that promotes theinter-provincial and interregional grid connec-tion of clean energy, and gradually introduceauxiliary service market mechanisms, such aspeak shaving, to increase trading volumes ofclean power between provinces and regions.

Second, how to launch provincial markets;how to design the power market while taking intoconsideration the differences between provincesin terms of market concept, environment andmaturity; how to coordinate the relationshipbetween planning and the market; how to coor-dinate the relationship between medium- and

long-term trading and spot trading; how tocoordinate the relationship betweenintra-provincial power resources and other pro-vinces’ power resources; and when to make thespot market open.

Solutions:

• choose a suitable power market model basedon local conditions, the market strength ofpower plants, power supply and demand,lessons learned from established markets,technical conditions and new energy; and

• increase the types of trading categories andexpand power trading step by step, takingmedium- and long-term trading first, and thenspot trading.

Third, how to solve the problem of dominantcompanies when establishing a provincial powermarket. Oligopoly is a serious issue in someprovincial markets, such as Zhejiang and Qing-hai. In the process of supply-side reform, cen-trally administered state-owned energyenterprises are very likely to be restructured,intensifying their dominance of provincial powermarkets.

Solutions:

• expand the scope of the power market,through coupling or fusion, to reduce theconcentration of power producers in any onemarket;

• build a strict regulatory system, setting anupper limit for the market share of powergeneration companies, forcing those with alarge share to disclose information; and

• spin off or sell the assets of those powergeneration companies with a high marketshare.

Fourth, how to change a provincial marketinto a national market, in which each provincialmarket chooses its path of evolution and supportmeasures based on actual conditions.


Solutions:

• build the national market by creatingprovincial markets, then integrate severalprovincial markets at their transmission end-points, before finally integrating all provincialmarkets;

• Integrate provincial markets in order ofmutual openness, then relax access conditionsfor inter-provincial market trading, beforeunifying market rules; and

• build inter-provincial markets and thenational market according to the principle of“medium- and long-term markets first, thenthe spot market”.

Fifth, how to eliminate historical priceprovincialisation. The tariff in some provinces thatare traditionally low-price regions could increaseafter integration with the national market, whichcarries the risk of creating social unrest.

Solutions:

• start with provincial markets, expand the scopeof the national market and level the electricitytariff in different markets step by step;

• in the early stages of market creation,low-priced power could be partially reservedfor industrial users to avoid a drastic impacton their costs after the market is built; and

• set tariff buffers and a protection mechanismfor domestic and other public users.

Sixth, how to settle the problem of strandedcosts. In the process of creating power markets,some power producers that were previouslyprotected by the planning system may sufferdamage to their interests or even go bankrupt,leaving them unable to recover their investment.For example, companies that invested in powerplants under the planning system and have out-standing loans might not recover their investmentbecause they are badly positioned for marketcompetition due to their high costs.

Solutions:

• develop a variety of power products, such ascontracts for difference and medium- and

long-term contracts and futures, to avoid tarifffluctuations and ensure stable revenues for allmarket participants;

• use short-term planned power allocation toprioritise power plants that are still recoveringtheir investment, or have recovered theirinvestment but are in difficulty, to give themsome stability; and

• restructure the assets of power plants andpower generation companies separately, inaccordance with the principle of sharingreform costs.

7.5.2 Principles of ReformTo achieve the economic benefits of liberalisedelectricity markets, international best practicesuggests implementing a set of principles forefficient network provision.26

First, proceed towards full liberalisation of thewider power system. Efficient investment in andoperation of the overall power system is a neces-sary precondition for the efficient supply of elec-tricity. This requires liberalisation of sectorssuitable for competition (fuel production, genera-tion, retail), use of markets to procure key services(capacity, balancing), and the pricing of external-ities (such as air pollution and carbon emissions).

Second, align network-provider incentiveswith public policy objectives. Make the incen-tives dependent on the provision of a reliable andaffordable supply of electricity by controllingmonopoly behaviour and ensuring that pricesreflect underlying costs:

• Reform power network institutions. Powernetworks are natural monopolies. It is there-fore critical that their incentives are alignedwith public policy objectives. A monopoly isincentivised to underinvest in new infras-tructure and to charge prices that are higherthan its costs. A state-owned company maybe incentivised to prioritise short-term politi-cal objectives, rather than longer-term public

26This part is provided by Vivid Economics. See VividEconomics, Low Carbon Power Markets: Lessons fromInternational Experience for the DRC-Shell MarketsWork Stream, 2017.


policy objectives. These incentives can bemitigated through institutional reform of thepower network. One option is to reform thenetwork company’s incentives throughperformance-based regulation enforced by anindependent regulator. Another is to separatenetwork operation and ownership through thecreation of an independent system operator(ISO). The UK and most European countriescurrently use performance-based regulation,while the USA uses the ISO model across itstransmission systems, for example in PJM(the transmission system in the north-easternstates), California and New York.

• Consider the use of locational pricing. Effi-cient network investment and operation makeuse of information on network congestion. Ifimplemented, locational (nodal or zonal)pricing can help reveal the cost of networkcongestion. Nodal pricing is used in severalUS states, Argentina, Chile, Ireland, NewZealand, Russia and Singapore, while zonalpricing has been adopted by most Europeancountries and Australia. However, locationalpricing has disadvantages as well as advan-tages. Importantly, locational pricing is mosteffective once time-of-use pricing is fullyimplemented across network users.

Third, take action to meet the challenges of adecarbonised system. Rising electrification andimprovements in the efficiency of electricalappliances will increase the uncertainty over thefuture volume and location of demand fortransmission capacity. Flexible resources such aselectricity storage and demand response cansubstitute for new network investment, so long assufficient investment incentives are present.

• Designate strategic zones for transmission-scale renewable generation to reduce plan-ning and investment uncertainty. Renewableenergy resources may be located far fromdemand centres and thus require large-scaletransmission investment. Uncertainty over the

volume and location of generation can bemitigated through zoning.

• Ensure there is money available to encourageflexible resources to offer a full range ofsystem services. The flexible resources nee-ded for decarbonisation provide several sys-tem services, such as balancing and frequencyresponse, but there may be underinvestment ifthe markets do not exist for these services.Several electricity markets in the West rundemand curtailment markets, allowing flexi-ble resources to generate revenues.

Fourth, prepare for the development of adecentralised power system and its associateddigitalisation by coordinating investment indecentralised resources, their control, balancing,security and data flows.

• Coordinate investment in decentralisedresources. A coordination problem ariseswhen independent developers that lack infor-mation about the plans of other developersmake similar investments, creating overin-vestment or, if the developers are risk-averse,underinvestment. Either way, the result can beinefficient. Solutions include formal processesfor multilateral resource planning and thepublication of current and consented resour-ces, as used by the transmission and distribu-tion system operators of Spain and Ireland.

• Determine how decentralised resources willbe controlled. While distribution networkstoday are largely passive, an active distribu-tion network is capable of accommodatingdistributed resources. As the electricity systembecomes more active and complex, a singlesystem operator may start to rely on interme-diaries, such as virtual power plants andpartners such as distribution system operators,to assist with system balance. New systems ofcontrol, with new computational require-ments, administrative rules and institutionalcharacteristics, may then be employed,reflecting new operational vulnerabilities.


• Balance data transparency with security. Asinformation and communications technologyinfrastructure expands, the amount of datafrom the electricity system grows. The datasystems need their own infrastructure, withpublic access to facilitate competition andoptimise operations. Meanwhile, the distri-bution of data across resources creates newrisks of cyberattack and privacy loss, solvedthrough adequate protocols.

7.5.3 Reform RoadmapVivid Economics and Shell’s internationalexperts proposed a roadmap for the developmentof future network arrangements in China. Theroadmap is based on the following guidingprinciples:

• Strong markets need strong government.Market-based solutions have the potential toidentify and deliver cost-effective investmentand operation of electricity systems. How-ever, both markets and natural monopolynetworks benefit from a strong government totake an active role in ensuring that institu-tional incentives are aligned with public pol-icy objectives. Network incentives can bealigned through separation of roles (un-bundling) or strong regulation.

• The institutional framework can be developedprogressively. Wholesale institutional reformis challenging and disruptive. At the outset,small changes in current practice andsmall-scale pilots may provide proof-of-concept sufficient to build consensus forlarger-scale reforms.

The main points of the proposed roadmap areas follows:

(1) Immediate actions

• Continue the market liberalisation pro-gramme. Phase 1 of the DRC-Shell coopera-tion proposed a programme of power marketliberalisation; consistent with this, China’s13th Five-Year Plan (2016–20) aims to

improve the systems by which markets playthe decisive role in resource allocation. It willbe important to continue with the marketliberalisation programme to deliver a moreadvanced and efficient power system.

• Rationalise investment planning. Clearlydefined metrics for reliability and economicefficiency help network planners to identifyefficient investments. Meanwhile, the appli-cation of the beneficiary pays principleencourages investment that increases pro-ductivity and avoids diverting nationalresources to stimulate regional output. Toge-ther, these approaches, when applied atnational and regional level, facilitate greaterinterconnection and sharing of generationservices.

• Implement a coordinated approach toinvestment. The use of a common investmentframework enables generation and networkinvestment planning to be coordinated, har-nessing strategic decisions and market enter-prise. For example, the framework might setout the role of generation zones forlarge-scale renewables alongside alternativessuch as small-scale distributed generation.

• Implement smart system architecture. Smart,distributed resources are crucial to affordabledecarbonisation. Before building the dis-tributed resources, the system architecture tomanage it should be determined. At a mini-mum, this includes deploying smart meters tointroduce time-of-use pricing to consumerson the distribution network; creatingupstream information and communicationsarchitecture; and carrying out R&D todevelop technical solutions for the smart grid.

(2) Move towards an efficient pricingmechanism

• Deregulate prices. Cost-reflective pricing cansignal efficient investments and operations todecision makers. The deregulation of pricescan proceed sequentially, with further pricereform contingent on the success of previousreforms. Price reform could commence


upstream and progress downstream, begin-ning with input fuels and progressing throughgeneration, network access and ending withretail, with provision to protect retailers ifwholesale prices rise above retail pricesbefore deregulation is complete.

• Create harmonised trading arrangementsbetween transmission systems. Use prices todetermine interconnector flows betweenprovincial and regional transmission systems,signalling which provinces or regions couldbenefit from new investment. The priceswould stimulate lower-cost generators torespond to demand.

• Implement time-of-use pricing. Time-of-usepricing allows consumers and flexibleresources to respond to variation in genera-tion costs and demand. Again, it can proceedsequentially, starting with larger consumers,such as industrial facilities with flexible pro-duction schedules, and ending with smarthousehold appliances.

• Consider locational pricing. Similarly, loca-tional pricing can signal efficient investmentsand operations, but it brings disadvantages aswell as advantages. China may considerlocational pricing, following the implemen-tation of time-of-use pricing. That is, signalgeographical network constraints oncedemand peaks have been shaved. Zonalpricing is a potential intermediate stepbetween uniform and full nodal pricing.

• Protect end users. The deregulation of retailelectricity may result in rent-seeking byretailers, raising consumer prices. This canhappen if consumers do not switch suppliersreadily or if for other reasons competition isnot effective. Policies to protect consumerscould be developed alongside any deregula-tion of retail electricity prices.

(3) Begin market trials

• Create small-scale trials. Create small-scaletrials to procure competitively new transmis-sion investments, non-network alternatives tonew transmission assets, ancillary services

and so on. Use competitive tenders or auc-tions for the trials. These may provideproof-of-concept and experience with inno-vative, cost-effective solutions. To be suc-cessful, procurement must be open-access andtransparent.

• Progressively introduce market procurement.If the competitive procurement trials aresuccessful, they can be scaled up and widermarket procurement progressively intro-duced, where appropriate, across each trans-mission system. Market procurement can helpto reveal information about the relative costsand benefits of a range of generationtechnologies.

(4) Make institutional choices

• Develop transmission network institutions.Options include the status quo, an enhancedrole for market procurement and a regulatedtransmission system operator (TSO) or inde-pendent system operator (ISO). Internationalexperience of the regulated TSO or ISOmodel is yet to reveal the best performer ofthe two, so it matters more to adopt agood-quality institutional model early than tochoose between the options.

• Select a model of control for decentralisedresources. Initially, when the number ofresources is small, the transmission systemoperator may be able to control them directly.However, as the number of resources increa-ses, and as temporal and locational pricingbecome more sophisticated, the computa-tional, commercial and contractual capacityof a single operator model may be exceeded,and new models of control may be needed.

8 Build a Unified and DynamicNational Carbon Market

To control total carbon and carbon intensity,China plans to launch a national unified carbonmarket by 2018, which will cover key industries


such as steel, power, chemicals, constructionmaterials, papermaking and nonferrous metals.After national carbon exchanges are created,China will become an integral part of the inter-national carbon trading market. The pressure onChina to reduce carbon emissions will be largelyalleviated by means of the market. Launch ofChina’s carbon exchanges will drive the trans-formation and modernisation of traditionalindustries and sharpen the international compet-itive edge of China’s low-carbon sectors.27

The Notice on Carrying out Pilot CarbonEmissions Permit Trading issued by the NationalDevelopment and Reform Commission (NDRC)in October 2011 approved the launch of pilotcarbon emissions permit trading in Beijing,Tianjin, Shanghai, Chongqing, Hubei, Guang-dong and Shenzhen. The pilot carbon exchangesin the seven provinces and municipalities wereopened between June 2013 and June 2014.The NDRC released the Notice on Key Points forthe Launch of a National Carbon Trading Marketin January 2016, according to which Phase 1 ofthe national carbon market should cover petro-chemicals, chemicals, construction materials,steel, nonferrous metals, papermaking, power,aviation and other high-emitting industries.However, China’s carbon market uses a baselinemethod to set the carbon quota, which is stricterthan the historical method and more demandingin terms of technologies and data.

Given the progress of current pilot carbonmarkets, when building the carbon market, Chinashould: improve the system of laws and regula-tions; coordinate allowance allocation; establisha unified trading platform and pricing mecha-nism; and optimise the design of the nationalcarbon market to include guidance and bench-marks for its creation and improvement.

8.1 Summary

Carbon markets are a key instrument for deliv-ering cost-effective mitigation. Mitigation ofcarbon emissions is in the best interest of allnations, because the cost is less than that ofunconstrained climate change. The cost of miti-gation can be minimised via carbon markets,especially if carbon markets are the primarydriver of mitigation in an economy, if the carbonprice is robust to shocks, and if the price providesincentives for long-term investment.

However, competing objectives often requiretrade-offs that are reflected in carbon policy.Carbon markets, such as an emissions tradingsystem (ETS), can help deliver benefits that arein line with other policy goals, for exampleimproved air quality or resource efficiency.However, carbon markets can also adverselyaffect some policy goals, like industrial compet-itiveness, or be undermined by shocks, such aswhen a recession leads to an oversupply of per-mits that undermines the ability of the carbonprice to incentivise long-term investment. Thesecompeting objectives are often legitimate, andshocks should be expected. The challenge topolicymakers is, therefore, how to take these intoaccount when designing carbon markets, withoutreducing the cost-effectiveness of mitigation.

We call carbon markets that accommodatecompeting objectives and shocks while main-taining cost-effectiveness robust markets, whilethose that fail to do so are fragile. Unfortunately,most carbon markets in international experienceare fragile, having become stuck in a transitiontrap of managing competing objectives andshocks via countervailing policies that furtherundermine the markets. As China’s ETS willdouble the quantity of emissions covered by acarbon price globally, when it is fully imple-mented, it is imperative that it is robust, or elsecarbon markets may lose support, which wouldseriously undermine decarbonisation efforts.

International experience suggests that carbonmarkets can be robust if certain design featuresare incorporated. Carbon markets have four setsof design options. These are options around:(i) the creation of carbon units, such as targets

27Liu Junyan and Fu Jingyan, Lessons from Guangdong’sCarbon Market Practice for Building a National UnifiedCarbon Market, in Science and Technology ManagementResearch, 2016, 36 (13): pp. 237–242 and 254; Xue Rui,China’s Carbon Market Response in the Context of theParis Agreement, in Ecological Economy, 2017, 33(02):pp. 45–48 and 128; Peng Sizhen, Chang Ying and ZhangJiutian, Reflections on Major Problems in the Develop-ment of China’s Carbon Market, in China Population,Resources and Environment, 2014, 24(09): pp. 1–5.


and cap setting; (ii) the distribution of allowan-ces; (iii) governance of the market, such ascoverage, banking, offsets, price controls andtrading arrangements; and (iv) policy interactionswith other decarbonisation policies. We analysedthe experience of the European Union ETS, theRegional Greenhouse Gas Initiative in the USA,the New Zealand ETS and the California ETS,for lessons on which choices in each of these setsof design options lead to a robust carbon market.

China looks likely to use a slow start toemissions trading. As such it should consideradopting price controls and a clear reform path toreduce the risk of becoming stuck in the transi-tion trap. Design trade-offs in the early stages ofcarbon pricing are common and can result infragility. This means that an active approach toprice management, such as a tight price corridor,can be used to ensure that incentives are main-tained while the market develops. This can besupported by signalling the direction of climatepolicy. For instance, committing to specificchanges through legislation can provide clearguidance on the direction of policy. This can helpmaintain prices and public support for carbonmarkets in the event of a shock.

While the next stage of China’s ETS is beingplanned, policymakers should consider whetherChina should adopt an evolutionary or a

revolutionary approach to carbon markets. Cli-mate change has aspects that suggest a balancebetween evolutionary and revolutionary change.The rate and level of the required emissionsreduction suggests the need for revolutionarychange. However, the difficult politics of such achange, and limitations in institutional capacity,suggest that an evolutionary approach may bemore feasible. The choice of approach is forChinese policymakers to make. We provide adetailed roadmap for both options, across thefour sets of design choices, so that the requiredactions and pace of reform are clear, whether anevolutionary or revolutionary approach is taken.These roadmaps, presented in Sect. 8.4, reflectbest practice from international experience,drawn from the examples provided in Sect. 8.3.

Table 17 illustrates what an evolutionaryversus revolutionary approach may look like inChina. An evolutionary approach would startslow, providing assistance to companies and alow, but stable price; while a revolutionaryapproach would rapidly make the ETS a centralforce in economic decisions through strong pricesupport and low levels of assistance.

Regardless of whether China takes an evolu-tionary or revolutionary approach to carbonmarkets, international experience suggests somegeneral lessons for China:

Table 17 Evolutionary and revolutionary change can differ in all aspects of scheme design

Note MSR = market stability reserveSource Vivid Economics


• developing an ETS requires consideration ofthree key questions: how many units to cre-ate, how to distribute them, and how togovern their trade;

• the supply of emission units should reflect thenature of the climate policy problem in thelonger term. This requires movement to capsand targets that reflect the absolute globalemission reductions required;

• some auctioning is important for price for-mation early on, but movement to full auc-tioning may be gradual;

• allocating free permits may be necessary, butcosts can be reduced through benchmarkingand limiting allocations to cost pass-throughin constrained industries; this requiresaddressing data constraints as a priority;

• the early learning phase of an ETS brings arisk of price shocks, so that price controlsmay be needed;

• broad coverage increases market efficiencyand stability, and should be sought as rapidlyas politically feasible;

• full banking is preferable to support invest-ment from the outset, so long as caps do notcreate hot air;

• designing an ETS that is robust to shocks isessential for success. ETSs to date have suf-fered from fragility, with poor design inter-acting with cyclical, technological and/orsupply shocks to undermine their effective-ness; and

• investing in early data collection can helpimprove policy outcomes and better ETS design.

Overall, China has an important opportunityto learn from international experience and delivera robust carbon market. While the design ofChina’s forthcoming ETS is largely finalised,revisions are expected by 2020. Therefore thenext few years provide an important opportunityto learn from the initial stage of China’s ETS anddetermine which path, evolutionary or revolu-tionary, China should take in the next phase of itsETS, drawing on the best practice of interna-tional experience to ensure a robust design andtaking into account the competing objectives andshocks the ETS is likely to face.

8.2 Introduction

8.2.1 Policy Objectives, Market Failuresand Trade-Offs

Responding to climate change requires a trans-formation of energy systems. The world’sfossil-fuel-dependent energy mix is not consis-tent with the Paris Agreement objective to limitglobal temperature rise to well below 2°C abovepre-industrial levels. If this objective is to beachieved, it means that all countries must takeaction to ensure that their future energy needs areprovided by low-emission energy sources.

This transformation requires significantinvestment in the development and deploymentof low-emission technologies and practices. Theenergy sector is capital-intensive, relying heavilyon long-lived assets with high upfront costs.Further, there are multiple technologies that candeliver low-carbon energy. These include maturetechnologies like nuclear and hydropower, andrapidly developing technologies such as solar,wind and battery storage. This means that poli-cies seeking to drive an energy transformationmust both mobilise finance to fund investmentsand provide a mechanism to choose betweencompeting technologies and providers.

The range of options for low-carbon energycan come with widely varying costs. These costswill be determined by a range of different factors,including, for instance, the development oftechnology, the geographic location of differentenergy technologies, and network and learningeffects associated with the roll-out of thesetechnologies. This means that while there aremany different ways in which an energy trans-formation can be pursued, these options maycome with very different costs.

Achieving climate change mitigationcost-effectively frees resources for alternativeuses and enables society to pursue a broaderrange of opportunities to increase well-being.Climate change mitigation is only one of manyoutcomes that society seeks to achieve; otheroutcomes include greater material well-being,higher rates of employment and an engaged andcontent population. However, these outcomes allhave some degree of cost associated with them.


By reducing the costs of achieving climate mit-igation, more of a society’s resources can bedevoted to achieving other objectives.

As the level of climate change mitigationrequired is likely to increase over time, thecost-effectiveness of a given policy mix becomesincreasingly important. If dangerous climatechange is to be avoided, then over the next30 years action on climate change must acceler-ate to achieve the required balance betweensources and sinks of greenhouse gases. Thisimplies a rapid progression in the level of miti-gation and the movement to higher-cost forms ofmitigation. This means that the differencebetween an expensive policy mix and acost-effective policy mix will become greater inabsolute terms as time progresses. In order tolimit the impact of climate change mitigation onachieving other policy objectives, the focus oncost-effectiveness should increase over time.

The need for a cost-effective mechanism toidentify and allocate competing mitigationoptions has led many jurisdictions to turn tomarkets. In doing so, individual incentives canbe used to identify mitigation options that aresuitable to a specific context. Markets enabledecision-making processes to be aggregatedacross individuals, in turn ensuring that thebroadest possible set of information and

mitigation options is being considered. This canreduce the incremental and overall cost of mov-ing towards a low-carbon energy mix.

Policy objectives do not exist in isolation,and progress in achieving one objective mayhave an impact on society’s ability to achieveothers. This is true for climate change mitiga-tion, where achieving lower emissionscost-effectively can make some policy objec-tives easier, while making others more difficult.For instance, achieving cost-effective climatemitigation may improve local air pollution bysimultaneously reducing emissions of particulatematter. However, it may also make otherobjectives more difficult; for example, main-taining industrial competitiveness may be harderif a carbon price is applied in one jurisdictionbut not another (Fig. 27).

Achieving effective climate policy is mademore difficult by the existence of multiple marketfailures and the interaction of different policies.Carbon pricing is an example of a policy thattargets a market failure by seeking to internalisethe externality of unpriced climate change.However, other externalities are also relevant toclimate policy, such as:

• coordination failures, which may result ininadequate investment in the research,

Fig. 27 The gains from better climate policy will grow over time, as low-cost mitigation is exhausted and moremitigation is required. Source Vivid Economics


development and commercialisation oflow-emission energy technologies;

• network effects, which may create barriers tothe expansion of low-emission transport; and

• asymmetric information, which means thatopportunities to improve energy efficiency areleft untapped.

Different market failures may require differentpolicy interventions, not all of which are com-patible. For instance, encouraging investment inlow-emission technologies through a feed-intariff may result in lower emissions from theenergy sector and a lower carbon price. Thismeans that there are trade-offs made betweenobjectives, and within the policy mixes that areused to achieve them (Fig. 28).

Balancing and achieving competing societalobjectives subject to constraints is a central roleof government. There is a range of legitimateobjectives that government seeks to achieve atthe same time, using imperfect policy

mechanisms. Policy objectives that are com-monly affected by climate policy include:

• economic objectives: for instance, ensuringthat increased energy costs do not reducecompetitiveness in a perverse manner byavoiding carbon leakage;

• social objectives: for instance, ensuring thatthe costs of transition are fairly distributed;

• environmental objectives: for instance, thespecific mitigation options that are taken upwill determine the pollution co-benefits thatoccur at the local level; and

• political objectives: for instance, as differentsegments of society will be affected in differ-ent ways, climate policy choices may have animpact on a government’s political support.

The existence of potentially competingobjectives means that trade-offs may be neces-sary, with social preferences determining therelative valuation of different objectives, and the

Fig. 28 Achievingcost-effective abatementmakes some policy objectiveseasier, but may requiretrade-offs with others. SourceVivid Economics


preferred quantity of these objectives that wouldbe obtained with a given constraint.

The necessary trade-offs between two com-peting objectives can be represented as a frontier.This frontier shows the maximum extent towhich different combinations of two competingobjectives can be achieved. Any point on thisfrontier represents a potentially optimal socialoutcome given a specific set of societal prefer-ences. This in turn will be reflected in differentpolicy designs which may be capable ofachieving these objectives to a greater or lesserextent.

Achieving social objectives requirestrade-offs. However, poor management of thesetrade-offs often leads to suboptimal outcomes.When policy results in an outcome inside thesocial objectives frontier, each objective isachieved to a lesser extent than is possible. Forinstance, the red dot in Fig. 29 shows lowcost-effectiveness and low competitiveness out-comes, where both outcomes can be improved onby moving closer to the frontier.

8.2.2 Fragile Carbon Marketsand the Transition Trap

Carbon markets to date have not delivered on theobjectives for which they were developed.Across several carbon markets, persistently lowprices have undermined incentives to invest innew, low-emission technologies, and have

caused policymakers to turn to overlapping pol-icy instruments.

Poor policymaking has resulted in fragilecarbon markets incapable of recovering fromeconomic shocks. A carbon price should seek todeliver a price signal that is both efficient androbust. An efficient carbon price is one that issufficient to deliver the changed production andconsumption patterns that are required at leastcost. A robust carbon market will also ensure thatthis price signal is stable and predictable in thelong run. This is necessary to reflect the long-runscarcity value of greenhouse gas emissions, andto drive investment in new technologies andcapital so that costs may fall in the future. Incontrast, a fragile carbon market will fail todeliver the incentives needed to drive thelong-term emission reductions required, at thelowest cost possible over time. The fragility of acarbon market may not be obvious until it is hitby a shock. To date, however, almost all carbonmarkets have been hit by some form of shockthat has contributed to their ineffectiveness.

There is a range of shocks that can negativelyimpact a carbon market. These include:

• demand shocks: for instance, the EU reces-sion reduced industrial demand, productionand emissions;

• supply shocks: such as the oversupply ofcredits in the form of certified emission

Fig. 29 The socialobjectives frontier representsall potentially optimaloutcomes based on societies’preferences regarding twoobjectives. Source VividEconomics


reductions and emission reduction units,which depressed prices in the EU ETS; and

• technology shocks: such as the shale gasrevolution that changed the structure of theeast-coast US energy industry and depressedprices in the Regional Greenhouse GasInitiative.

Often policymakers will seek to limit oppo-sition to a new policy through a slow start.A slow start may have different elements in dif-ferent contexts. However, most are characterisedby seeking to limit the reallocation of resourcesbetween groups in the economy. For instance, aslow start may see the grandparenting of freeallocations to existing firms, the limitation ofcoverage to only a small set of emission sources,or significant access to low-cost emissionreductions through the use of international unitsor offsets (Fig. 30).

A slow start occurs when other objectives areprioritised above the cost-effectiveness of thecarbon market in the short term. This may focusparticularly on increasing political support for thecarbon market, given the political challenges thatcan occur in establishing a new tax and changingthe competitiveness of industries. This limits the

impact of carbon pricing on the attainment ofother policy objectives in the short term. How-ever, policymakers may intend to strengthen it inthe future as the carbon markets gain accept-ability and political support. However, thesepolicies may also result in systematic fragility,which means that when a shock occurs it canresult in persistently low prices.

A slow start can make new carbon marketssusceptible to the transition trap. The transitiontrap occurs when policymakers decide to take aslow start to carbon markets, but an economic ortechnology shock interrupts the reform process,shifting the market to a suboptimal equilibriumbefore it can be strengthened. When this occurs,it can reduce the credibility of carbon marketsand create support for the introduction of over-lapping measures, such as feed-in tariffs to sup-port renewable energy investment. Theproliferation of these overlapping measures fur-ther reduces prices in the carbon market, drivinga self-enforcing cycle that keeps carbon priceslow. This is shown in Fig. 31.

The transition trap helps to explain the per-sistently low prices in carbon markets to date.Carbon prices have proved insufficient to driveinvestment in new low-carbon technologies and

Fig. 30 An effective carbon price will be both efficient and robust. Source Vivid Economics


assets, which have instead largely been incen-tivised through overlapping policy, such as min-imum renewable energy generation requirements,energy efficiency standards and feed-in tariffs.

China can draw on the lessons from interna-tional experience to avoid the transition trap anddevelop a robust carbon market. If well designed,

carbon markets can be a cost-effective mecha-nism for achieving emission reductions alongsideattaining other objectives. International experi-ence provides a range of lessons applicable toChina as it considers the role of carbon markets,and how it can improve market design andfunctioning in the future (Fig. 32).

Fig. 31 The transition trap explains how a carbon market may become stuck in an ineffective equilibrium. SourceVivid Economics

Fig. 32 Carbon markets have experienced persistentlylow prices. Note EU ETS Phase 2 and 3 prices refer toDecember settlement futures contracts, the most com-monly used contract type; RGGI prices are taken fromquarterly auction results; and NZ ETS prices weregraphically digitalised and are indicative only. RGGIauction prices have been converted to tonnes. All prices

have been converted to euro using monthly averageexchange rates. CER = certified emission reductions.Source Intercontinental Exchange and Quandl (2016),Intercontinental Exchange (2016), Climate Policy Initia-tive (2016) RGGI (2016) and International Carbon ActionPartnership (2016). Exchange rates from OECD (2016)


8.3 International Experience

Creating a carbon market is a process of settingrules for the creation of carbon units, decidinghow they should be distributed, establishing rulesfor market governance and trade, and managinginteractions between the carbon market and otherpolicies:

• creating carbon units is the process of deter-mining targets and caps;

• distributing carbon units involves deciding onthe level and manner of distribution of freecarbon units, and the use of revenue-raisingdistribution mechanisms, such as auctions;

• governance includes rules regarding coverageand cost pass-through, the banking of units,the use of domestic and international offsets,linking with other emissions trading systems,the use of price controls and the impact ofdesign on the development of the secondarymarket; and

• managing policy interactions involves con-sidering the appropriate role of carbon priceand complementary, overlapping and coun-tervailing policies.

8.3.1 Creating Carbon UnitsTargets and coverage decisions will largelydetermine an ETS’s cap—the number of carbonunits that can be created. Targets determine thelong-term trajectory of emissions in a jurisdic-tion, and therefore the long-term supply of unitsin the carbon markets. Caps give the number ofemission units that are added to a carbon marketin each compliance period. They are generallycalculated as the target level of emissions less theexpected emissions from sectors that are notcovered by the ETS, known as uncovered sec-tors, as illustrated in Fig. 33.

To ensure that emissions do not exceed ajurisdiction’s target, emissions from uncoveredsectors must be considered when establishing acap. This involves estimating the likely trajectoryof these emissions based on an assessment ofeconomic conditions and the impact of mitiga-tion policies on uncovered sectors. In the EU,emissions from uncovered sectors are also sub-ject to a target through the effort-sharing deci-sion, providing further guidance on the likelyemissions trajectory.

Jurisdictions often overestimate the trajectoryof future emissions, as a preference for

Fig. 33 Targets and coverage decisions largely deter-mine ETS caps. Source Emissions from 2005 to 2014sourced from Eurostat (2016); 2014 emissions cap and

linear reduction factor from the European Commission’sDirectorate-General for Climate Action (2016); othercalculations by Vivid Economics


conservative assumptions creates a projectionbias towards the continuation of current trends.This can have real effects on the functioning of acarbon market. For instance, in 2006, EU pro-jections suggested continued growth in energyuse. However, the recession that followed resul-ted in a rapid decline in energy use and emis-sions, as shown in Fig. 34. An assumption ofcontinued energy sector growth would mean thatthe EU’s 2020 emissions target was less ambi-tious (in terms of deviation from business asusual) than was originally intended. The impactof unexpected outcomes (shocks) can be miti-gated by adjusting supply or demand for permitsto maintain a relatively stable price trajectory.

The response to short-term market shocks isbest dealt with by adjusting caps, while structuraloversupply should be rectified by adjusting tar-gets. Cap and target-setting arrangements shouldprovide the market with a clear directionregarding the trajectory of future caps, whilemaintaining the flexibility to respond to changedconditions. Rule-based supply mechanisms likemarket stability reserves and contingencyreserves are considered in the discussion on pricecontrols below.

Cap-setting mechanisms should provide themarket with a clear direction regarding the

trajectory of future caps, while maintainingflexibility to respond when conditions change.Flexible target and cap-setting arrangements caninclude the use of conditional targets, establish-ment of institutional review mechanisms and theuse of active cap management approaches:

• conditional targets enable governments torespond to changed circumstances. A price-contingent target would increase targets whenprices are low;

• institutional mechanisms can be used toreview caps and targets, for instance Aus-tralia’s Climate Change Authority providedthe government with advice on the appropri-ate range of emissions targets; and

• cap management mechanisms could beestablished within an independent body, suchas a carbon central bank, to alter medium-term supply to manage prices.

8.3.2 Distributing Carbon UnitsAllocations determine who gets carbon units andwhat price, if any, they pay for them. Auctionsremain the best way to establish the value ofunits on the primary market. However, in manycases, a jurisdiction will allocate units to busi-nesses with liabilities under the carbon price, free

Fig. 34 Projections of continued growth in energy use may have resulted in the adoption of a weaker target in the EU.Source European Commission (2006) and Eurostat (2016)


of charge, to offset potential impacts on com-petitiveness and avoid carbon leakage. Carbonleakage may occur when domestic companies areunable to pass on their cost increases because ofcompetition from companies overseas that arenot subject to an equivalent carbon price. Thiscan mean that emission reductions that occurdomestically are offset by emission increasesoverseas, as production can transfer to jurisdic-tions with a lower—or no—carbon price.

When allocations are done poorly, they cancontribute to overallocation, which can increasethe fragility of the carbon pricing system. Thereare two main approaches to free allocations:

• grandparenting, where assistance is tied tohistorical emissions; and

• production-based benchmarking, whereassistance is tied to the level of actualproduction.

Grandparenting on its own does not causeoverallocation. However, it is often part of abroader set of arrangements that cause overal-location and drive low prices. Grandparentingdoes not of itself prevent carbon leakage, as theprovision of free units occurs regardless of thelevel of production. Grandparenting can be usedas a transitional measure while benchmarks are

being developed for other allocation methods(Fig. 35).

The design of a benchmark determines themitigation options that are used:

• process benchmarks: allocation is based onthe emissions intensity of a process used toproduce a specific good, which incentivisesprocess efficiency;

• product benchmarks: allocation is based onthe average emissions intensity of the pro-duction of a particular product, which incen-tivises technology substitution; and

• sectoral benchmarks: allocation is based onthe emissions intensity of a particular industryor product category, which encourages sub-stitution between similar products. However,this would be very difficult to implement.

Having no free allocations also incentivisesend-use substitution, the choice to consume dif-ferent products when relative prices change.Overall, this means that the gradual movementaway from free allocations to full auctioning willincentivise a greater array of domestic mitigationoptions.

The auctioning of units also provides rev-enues that can be put to other uses. Revenuesmay be used to reduce other taxes, to increase

Fig. 35 EU ETS grandparenting contributed to overal-location, which lowered prices. Note EU ETS Phase 2 and3 prices refer to December settlement futures contracts.

Source Prices sourced from Intercontinental Exchangeand Quandl (2016); emissions and allocations from theEuropean Environment Agency (2016)


general government revenues, or be directly tiedto other spending programmes. For instance, inthe EU at least half of all auction revenues mustbe used for climate- or energy-related purposes(Fig. 36).

There are several design features that may beused to limit the amount of free allocations andincrease the number of units available for auc-tion. These include:

• limiting allocations to certain industries, inparticular those industries that present a car-bon leakage risk. These are usually industriesthat are trade-exposed, which means that theyare less likely to be able to pass on costs dueto overseas competition, andemissions-intensive, which means that a car-bon price could have a potentially largeimpact on their relative competitiveness;

• differentiated assistance rates seek to reflectdifferent levels of exposure to carbon leakage.A jurisdiction may therefore decide to pro-vide different rates of assistance to jurisdic-tions that are judged to have different rates ofexposure to carbon leakage risk; for instance,Australia’s ETS differentiated allocation ratesare based on the emissions intensity of theindustry;

• envelopes cap free allocations by limitingthem to a certain proportion of total units. For

instance, for Phase 3 of the EU ETS, freeallocations are limited to 43% of the total cap;

• automatic cuts to assistance: for instance,Australia’s ETS included a carbon produc-tivity dividend to account for potential naturalcarbon efficiency improvements over time,and this reduced the rate of assistance by1.3% per year; and

• reviews can independently assess evidence ofan industry’s ability to pass through costs,and therefore their exposure to carbon leak-age. These reviews can be a formal mecha-nism with outcomes that are directly tied torates of assistance, or they can simply providea source of information that enables govern-ment to make informed decisions. Forinstance, Australia’s Productivity Commis-sion was responsible for assessing costpass-through and leakage risks.

Figure 37 shows the rates of assistance formoderately emissions-intensive and highlyemissions-intensive industries in the AustralianETS. Assistance to highly emissions-intensiveindustries started at 94.5% of the benchmarklevel, while assistance for moderately emissions-intensive industries started at 66%. Both assis-tance rates were subject to the carbon produc-tivity dividend, and assistance rates then declinedby 1.3% each year.

Fig. 36 The manner of assistance provided to companies determines the mitigation possibilities available. SourceVivid Economics


8.3.3 Governing Carbon MarketsThe rules for governing a carbon market areessential to its efficient and robust functioning.The governance of a carbon market can include awide variety of different decisions and designoptions. However, several design considerationscommon to all carbon markets are particularlyimportant. These include decisions regarding:

• coverage of emissions;• banking of emissions units;• international linking and the use of offsets;

• the use of price stabilisers; and• provisions for secondary market develop-

ment.

(1) Coverage

Broad coverage and market design that encour-ages cost pass-through and increases the efficiencyof an ETS can improve its robustness. Coveragerules determine which sectors and greenhousegases incur a carbon price liability; cost

Fig. 37 Differentiated and declining assistance in the Australian ETS signalled transition to auctions. Source VividEconomics

Fig. 38 Coverage decisions and the level of cost pass-through determine the mitigation options available. SourceVivid Economics


pass-through is determined by the broader set ofrules that determine which users will face the costsand incentives following from a carbon price.

Broad coverage and cost pass-throughincrease market efficiency by incentivisingmore abatement options. Examples of theabatement options that might be incentivisedthrough different coverage and cost pass-througharrangements are outlined in Fig. 38. Whencoverage is limited or cost pass-through does notoccur, these options are not considered, whichmeans that mitigation becomes more expensive.

The potential emission reductions from anygiven mitigation option increase with the carbonprice. This means that as carbon prices rise moreand more, potential mitigation options will bemissed if a specific source of mitigation is notincentivised. In turn, this means that when cov-erage is limited, or cost pass-through is con-strained, more costly abatement will be requiredand less abatement will be achieved at any givencarbon price. This is illustrated in Fig. 39.

Narrow coverage reduces robustness byincreasing the carbon market’s exposure to

Fig. 39 When coverage or cost pass-through is limited, any given target will require more costly abatement. SourceVivid Economics


sector-specific shocks. Shocks will often affectdifferent parts of the economy in different ways.

Technology shocks will often drive majorchange in the emissions profile of a single sector,while leaving others largely unaffected. Forinstance, the expansion of unconventional gasextraction in the USA had a major impact onpower sector emissions. This in turn was

reflected in demand for units in the RegionalGreenhouse Gas Initiative (RGGI), which onlycovered the electricity sector. In RGGI memberstates, emissions from electricity generationdeclined by more than 30% between 2008 and2013, while emissions from other sectorsdeclined at a far slower rate. This is shown inFig. 40.

Fig. 40 The decision of RGGI member states to limit coverage to the power sector exaggerated the impacts of theunconventional gas technology shock. Source Calculated from U.S. Energy Information Administration (2016) data

Fig. 41 Production shock concentrated in EU ETS sec-tors exaggerated the impact of the EU recession ondemand for emission units. Note Production levels inEU ETS sectors are proxied by the weighted productionvalue of NACE codes 17, 19, 20, 23, 24 and 35 usingconstant 2010 prices disaggregated by industry sector.This includes industries responsible for the vast majority

of EU ETS emissions covered, including the manufactureof paper, coke, refined petroleum, chemicals, base metals,other mineral products and electricity and gas supply.Emissions have been adjusted to account for geographicexpansion and changed coverage arrangements to ensureinter-annual consistency. Source OECD (2016) andEurostat (2016)


Economic shocks can also be concentrated inspecific sectors. For instance, the EU ETS pri-marily covers emissions from the industrial andenergy sectors. These sectors were particularlyaffected by the recession in 2007–08, whereproduction levels in those sectors covered fluc-tuated far more than in the EU as a whole. Thiswas reflected in emission outcomes, and there-fore demand for European emission allowances.This sharp fall in demand was largely responsiblefor the fall in prices that occurred in 2008. This isshown in Fig. 41.

(2) Banking

The banking of carbon units can both increasethe cost-effectiveness of an ETS by enablingsubstitution of abatement across time andimprove the robustness of the market. Bankinglets firms stockpile carbon units for later use.This makes caps across compliance periodsfunction as a budget rather than a target. This inturn means that when emissions in a complianceyear are lower than expected, carbon units of thatvintage retain their value, as they can still be usedto discharge liabilities. Banking increases effi-ciency as it enables emissions to be reduced atthe time when mitigation is at its lowest cost; it

also increases robustness by ensuring that carbonunits retain a positive value even after a shock.However, this also means that when a shock islarge, banking can lead to a persistent oversupplythat can continue to depress prices for manyyears.

The importance of banking is demonstratedby the experience of the EU ETS. Banking ofunits was not allowed from phase 1 to phase 2 ofthe ETS, which led prices to fall towards zero asthe level of oversupply was revealed. Subse-quently, the European recession in phase 2 of theETS, led to large falls in industrial production,which resulted in an oversupply more than 10times larger than in phase 1. The ability to bankunits meant that prices remained low, but greaterthan zero. However, this has also contributed tothe prolonged depression in prices in phase 3 ofthe ETS, as shown in Fig. 42.

(3) Linking and offsets

Linking with other emission trading systems, orwith credible offset mechanisms, will increasethe efficiency of carbon markets, and maystrengthen its robustness. Linking to other ETSsgenerally stabilises demand across markets,because overall emissions become less dependent

Fig. 42 Banking ensured prices remained positivedespite oversupply in the EU ETS. Note Europeanemission allowances (EUA) prices based on Decemberdelivery futures prices. Cumulative oversupply is calcu-lated as total EUAs allocated (both free and auctioned)

plus the number of Kyoto units surrendered, minusverified emissions. Source European EnvironmentAgency (2016), Intercontinental Exchange and Quandl(2016)


on economic circumstances in any one market.For instance, emissions in the EU as a wholeexhibit much more stability than emissions in anaverage EU member state, as is shown in Fig. 43.A link can affect:

• supply only, such as the use of Kyoto offsetsin the EU ETS and New Zealand ETS;

• demand only, such as the proposed one-waylink between the Australian ETS and the EUETS; and

• supply and demand, such as the link betweenRGGI member states and California andQuebec.

A supply-only link can reduce prices withinan ETS but may also be a mechanism for trans-mitting supply shocks through low prices. A de-mand-only link can increase the cost ofmitigation but can also stabilise prices in theevent of a demand or technology shock. Supplyand demand links mean that shocks are trans-mitted between markets, but their effects areusually tempered. When a small market linkswith a larger market, however, economic cir-cumstances in the larger market can dominatecircumstances in the smaller market.

International offsets can provide substantialabatement at low cost and support the expansion

of carbon markets. However, offsets often sufferfrom quality concerns, because determining theactual level of emission reductions from projector sectoral crediting mechanisms remains diffi-cult. As such, offsets are often subject to a set oflimits that seek to constrain their impact on thebroader functioning of markets. These limitscome in two main forms:

• qualitative limits allow only certain types ofunits to be used in an ETS (for instance,restrictions on the source country of Kyotounits in the EU ETS); and

• quantitative limits restrict the number of acertain unit class that can be used. When alimit is binding (or expected to bind), aquantitative limit will force prices to diverge.

The propensity for prices to diverge when aqualitative limit is applied or when a quantitativelimit binds means that there can be a directtrade-off between efficiency and robustness. Forinstance, prices of New Zealand emission unitsclosely tracked the Kyoto unit price from 2010 to2013. However, the prospect of a ban on Kyotounits and its subsequent introduction led prices todiverge after this period. In introducing this ban,New Zealand made a trade-off between efficiencyand robustness, forgoing a low-cost source of

Fig. 43 Volatility in country emissions can be stabilised by linking markets. Note GHG = greenhouse gas emissions.Source Eurostat (2016)


mitigation to achieve a carbon price more con-sistent with the long-term need to reduce emis-sions. This is shown in Fig. 44.

(4) Price stabilisers

Price stabilisers can be a useful tool to maintain arobust carbon price signal, especially in newmarkets. The policy compromises that are madewhen establishing a carbon market mean thatcarbon markets may be particularly fragile toeconomic shocks. There are two main types ofprice stabiliser that can be used: price-contingentstabilisers and quantity-contingent stabilisers.

Price-contingent stabilisers intervene in themarket when one or more price criteria are met.These stabilisers include:

• price floors, auction reserve prices and sur-render charges, which seek to maintain aminimum price or the equivalent priceincentive;

• price ceilings and contingency reserves,which seek to maintain a maximum price; and

• price corridors, which seek to ensure that theprice remains within a given range.

Most stabilisers target a price level byadjusting the level of supply or demand in the

market. In its purest form a price floor will pro-vide unlimited demand, and a price ceiling willprovide unlimited supply, when prices hit certainpredetermined levels. More common is the use ofsoft-price controls like auction reserve prices,which limit supply by setting a minimum price atauction, and contingency reserves, whichincrease unit supply when a specific price level isreached. A price corridor refers to stabilisers thatseek to maintain both a minimum and a maxi-mum carbon price. Price corridors, in the form ofauction reserve prices and contingency reserves,are used in both the Californian ETS and RGGI.The effect of these policies on prices in thesemarkets is shown in Figs. 45 and 46.

Surrender charges do not seek to maintain aspecific price but try to maintain a minimumprice incentive by charging a top-up fee for eachunit that is surrendered for compliance. A sur-render charge is currently used in the UK toencourage greater levels of mitigation than thosedriven by the current low carbon price.

Quantity-contingent stabilisers are less com-mon, the main example being the EU’s marketstability reserve (MSR). The MSR seeks to cor-rect imbalances in the carbon market by adjust-ing supply based on the number of excess unitscurrently in the secondary market. When thequantity of units in the secondary market is

Fig. 44 Compliance rules determine relative prices. Note CER = certified emission reductions. Source IntercontinentalExchange (2016) and International Carbon Action Partnership (2016). Exchange rates from OECD (2016)


above a certain level, units that were to be auc-tioned are instead placed in the MSR. When thequantity of units in the market is below a pre-determined level, it reintroduces some of thepreviously withheld supply. As the MSR with-draws supply gradually, it may be better suited toaddressing temporary imbalances rather thanstructural oversupply. Figure 47 demonstratesthe way in which the MSR would alter supplygiven an illustrative emissions trajectory.

Price controls can be difficult to integrate withother policy mechanisms and may create

difficulties in linking with other markets. Bymaking supply responsive to prices, the use ofprice controls may undermine the environmentalintegrity of a link. It is possible that if a pricefloor is triggered in one jurisdiction, it canincrease supply to such an extent that net emis-sions in that jurisdiction exceed the emissionsthat would have occurred under business asusual. Price controls can also have difficult dis-tributional consequences; if triggered, they mayresult in a net transfer of resources from onejurisdiction to another. Harmonising price

Fig. 46 California’s auction reserve price has limited falls in the carbon price, but also reduced revenues. SourceClimate Policy Initiative (2016)

Fig. 45 Soft price floors and ceilings may result in prices deviating outside their target range. Source RegionalGreenhouse Gas Initiative (2016)


controls may deal with these issues to someextent. However, this entails other complications;for instance, it may require the development ofcommon auctioning platforms or agreeing tomethods to correct for exchange rate fluctuations.

(5) Secondary market development

Policy design can support the development of aliquid and transparent secondary market, whichincreases efficiency and improves price discov-ery. In particular, market design should seek tosupport the development of institutions thatlower transaction costs and reduce the counter-party risks borne by participants engaging in themarket.

The market relies on central counterparties toreduce delivery risks on contracts. Active tradingof emission units requires that market partici-pants are confident that their counterparty willdeliver either units or payment, as agreed. In alarge market with many buyers and sellers,assessing the financial risks associated with eachcounterparty can be arduous. As such, marketsoften rely on trusted central counterparties toreduce these risks and facilitate trade. Thesecentral counterparties ensure that all parties meetminimum standards and will guarantee delivery

in the event of a default from either party. Theyoften support both over-the-counter (OTC) trad-ing and exchange trading platforms.

Cost reductions are sought through movementfrom trading in OTC markets to exchange-basedtrading of standardised contracts. Exchange-based trading generally develops in marketswith large numbers of buyers and sellers, as theaggregation of trades provides greater liquidity.Over the course of phases 1 and 2 of theEU ETS, the market gradually moved from OTCtrading to exchange-based trades. Exchange-based trading has several advantages, includingproviding transparent signals on pricing andreducing costs. The shift to exchange-basedtrading in the EU ETS is illustrated in Fig. 48.

The growth of futures markets reflects thedesire to hedge risks and develop a longer-termprice signal for long-lived assets. Over phases 2and 3 of the EU ETS, futures markets expandedand have since consolidated, with liquid futuresmarkets operating several years in advance—thisis shown in Fig. 49. Nearly all trades in theEU ETS secondary market are now futures con-tracts. The most commonly traded contracts arewithin-year and December delivery futures,while large markets also exist for Decemberdelivery futures contracts running up to 2020.

Fig. 47 The EU’s market stability reserve adjusts thequantity of units in the market in response to over- orundersupply. Note Illustrative emissions trajectory devel-oped for illustrative purposes only. Cumulative

oversupply is calculated as the total EU emissionallowances allocated (free and auctioned) plus the numberof Kyoto units surrendered, minus verified emissions.Source European Environment Agency (2016)


The EU’s changing institutions and regula-tions have supported these market developments.In phases 1 and 2 of the EU ETS, registries weremanaged by member states, creating significantduplication across jurisdictions. However, tradein units was concentrated in just a few of theseregistries, which were linked with activeexchange platforms—in particular, France,which hosted the BlueNext exchange. Tradingwas facilitated through open market access,

which enabled liable entities, financial institu-tions and other individuals and businesses tohold emission units. Instances of fraud in spotmarkets in 2008 and 2009 led to more stringentregulation, with spot markets regulated asfinancial products, whereas they were initiallyregulated as commodities. These problems on thespot market also accelerated the shift towardfutures contracts, which were regulated asfinancial products from the outset.

Fig. 49 The growth of futures markets provides newopportunities for risk management and improves pricediscovery. Note Volumes for December delivery futures

only. ICE EUA = Intercontinental Exchange EU (emis-sion) allowances. Source Intercontinental Exchange andQuandl (2016)

Fig. 48 As markets mature and participation increases, trading tends to move to secondary exchanges. Note As sourcedata were not available, the figure was created by digitalisation; as such it is indicative only


In phase 3 of the EU ETS, national registrysystems were consolidated into a single EU reg-istry, which supported the development of a moreefficient and mature market. The move to a cen-tralised market increased the ease of trade acrossthe EU by requiring a common set of processesand approaches for accessing the registry. Themove to centralised reporting increased thetransparency of market information, whichenabled better decision-making by market partic-ipants. The EU registry also included a new type ofaccount for exchange platforms. This simplifiedthe process of engaging in exchange-based trad-ing, while ensuring that security standards weremaintained. The single registry also facilitateslinking with other carbon markets in the future, byenabling registry links to occur under specifiedcircumstances. These changes in registry designare illustrated in Fig. 50.

8.3.4 Managing Policy InteractionsCarbon pricing operates within a broader policymix. Many of these other policies will influencehow a carbon market functions and its ability toreduce emissions efficiently. Policies that impactthe operation of the carbon market can includethose that directly target climate change mitiga-tion, as well as those that target other policyobjectives. They can be grouped into three broadcategories:

• complementary policies improve the func-tioning of carbon markets and increase effi-ciency; this in turn reduces costs and thelikely carbon price;

• overlapping policies duplicate some of theincentives provided by carbon markets. Thesemay increase or decrease the overall effi-ciency of climate policy depending on policydesign, but all overlapping policies tend toreduce the equilibrium carbon price; and

• countervailing policies provide incentivesthat oppose those provided by the carbonmarket. These will reduce the efficiency ofclimate policy and increase prices.

These policy groupings are outlined inFig. 51.

(1) Complementary policies

Complementary policies are those that improvethe functioning of an ETS by addressing marketor regulatory failures that can impede the effi-cient operation of the carbon market. There is awide variety of complementary policies that canimprove market functioning in several ways.Some examples include:

• mandatory energy efficiency labelling, whichreduces search costs and allows people to

Fig. 50 The design of the EU registry system hasbecome more centralised, and has developed to facilitatethe development of exchange trading platforms. Note

CITL = community independent transaction log; EEX =European Energy Exchange; ICE = IntercontinentalExchange. Source Vivid Economics


make better decisions regarding appliancepurchases. Figure 52 shows how the demandfor new refrigerators shifted towards moreefficient models following the introduction ofenergy use labels and minimum performancestandards; and

• direct measurement of methane in undergroundcoal mines for safety purposes, which allowsthose emissions to be priced more accuratelythan using a standard regional factor.

In many cases, carbon pricing can workalongside complementary policies to support

policy objectives other than emission reductions.This provides the opportunity to implement abroader package of reforms that enhance theperformance of each policy and support sustain-able growth.

(2) Overlapping policies

Overlapping policies can have a positive ornegative impact on the efficiency of climatepolicy. Some will increase efficiency, especiallywhen they are addressing a genuine market fail-ure. For instance, without guidance, consumers

Fig. 52 Labels may have helped improve consumer choice of refrigerators in Australia. Source Energy EfficiencyStrategies (2016)

Fig. 51 The efficiency of climate policy is affected by the interaction of carbon pricing with complementary,overlapping and countervailing policies. Source Vivid Economics


will often purchase appliances that are inefficientand high cost to operate. This can occur for avariety of reasons. For instance, consumers mayseek to reduce the time costs associated withresearching the relative performance of differentappliances and not consider the environmental orenergy impacts of their choices. Alternatively,landlords may purchase cheap but inefficientappliances, which are higher cost because theirtenants pay for high rates of energy use. Becauseof these and other market failures, the introduc-tion of energy efficiency standards has reducedemissions cost-effectively in many countries.These standards improve the quality of the stockof appliances sold, while in many cases havingvery little impact on prices. Figure 53 shows theimpact of the introduction of energy efficiencystandards for washing machines in the USA,which resulted in substantial reductions in energyuse while having no noticeable impact on prices.

In other cases, overlapping policies willreduce the efficiency of a carbon-pricing system,particularly when multiple policy instrumentsseek to address the same market failure. Anexample of this is the use of feed-in tariffs inGermany, where generous subsidies for thegeneration of solar power led to significantgrowth of the industry. However, this mitigation

occurred at a very high cost and placed down-ward pressure on prices in the ETS.

California’s low-carbon fuel standard is anexample of an overlapping policy that probablyreduces the effectiveness of the carbon price. Thefuel standard is enforced through the creation andtrade of certificates, expressed in tonnes per CO2

equivalent. As such, it duplicates the incentivesof the California ETS, which also requires carbonunits to be surrendered for emissions from thecombustion of transport fuels. This reduces theefficiency of climate policy as it means that thetransport sector faces a higher effective carbonprice than other sectors of the economy. Thislarger incentive to reduce emissions in thetransport sector also puts downward pressure onthe carbon price. The disparity between theeffective carbon price faced by transport andother covered sectors is illustrated in Fig. 54.

(3) Countervailing policies

Countervailing policies are those that act inopposition to the incentives created by a carbonmarket. The most obvious example of a coun-tervailing policy is fossil fuel subsidies. Thesesubsidies are often large and remain in place inmany jurisdictions that are also subject to an

Fig. 53 Energy efficiency standards in the USA have reduced energy use at a low cost. Source International EnergyAgency (2015)


ETS, as shown in Fig. 55. Other countervailingpolicies may be less obvious. For instance, urbanmobility policies counteract the impact of thecarbon price, even though this was not theiroriginal intent.

In some cases, a jurisdiction may decide toretain a countervailing policy despite its impact

on the functioning of the carbon market. Thismay occur when the jurisdiction judges that thenegative impact of the policy on the efficiency ofclimate policy is more than outweighed by itsbenefits, and that alternative policies are unableto deliver the desired policy outcomes.

Fig. 54 California’s low-carbon fuel certificates dupli-cate carbon price incentives, with their high pricereducing both demand and price in the carbon market.

Source California Air Resources Board (2016) andClimate Policy Initiative (2016)

Fig. 55 Many countries retain expensive fossil fuel subsidies that counteract the goals of their carbon markets. SourceInternational Monetary Fund (2015)


8.4 Evolutionary and RevolutionaryChange in Carbon Markets

Changes in carbon markets can be evolutionaryor revolutionary. China will shortly establish acarbon market. On December 19, 2017, theNational Development and Reform Commission(NDRC) announced the official launch of Chi-na’s carbon emissions trading system, startingwith the power generation sector. Previously, theNDRC had issued the Plan for Building aNational Carbon Emissions Permit TradingMarket (for the Power Generation Sector), whichoutlined the design of China’s carbon emissionstrading system. However, the design is likely tochange over time in response to shocks andchanging policy priorities. Identifying the chan-ges necessary and what they entail can help guidethe future policy direction for China’s carbonmarket. Our research shows that thecost-effectiveness of climate change mitigationwill become more important over time as greaterlevels of higher-cost mitigation are required. Thismeans that policymakers may wish to move froma carbon-pricing system that is less weightedtowards cost-effectiveness to one where thecost-effectiveness of the policy is a moreimportant consideration. The nature of the policychange required to give this effect depends on thenature of the problem and China’s specificcircumstances.

Evolutionary and revolutionary change differin their speed, level and type of impact. In

general, a change will be more revolutionary if itoccurs rapidly, has a large impact and changesthe nature of the system, rather than just adjust-ing its efficiency or the distribution of costs. Forinstance, policy change that results in net zeroemissions before 2050 through a fundamentalchange in the energy system and in industrialcomposition would be a revolutionary change(Fig. 56).

The decision to pursue evolutionary or revo-lutionary change depends on the rate and level ofchange required, the certainty of impacts, and thepolitical and institutional feasibility of delivery.A more revolutionary approach will be requiredwhen a faster transition or a larger change isrequired. Consideration must also be given to theuncertainty of impacts, with risk-averse decisionmakers likely to prefer evolutionary changewhen the level of uncertainty regarding a pol-icy’s impact is lower. The political feasibility of achange is also important. For example, evolu-tionary change may be more appropriate whenthe trade-offs required by a change are large, orwhere the need for change is contested. The levelof institutional capacity also plays a role: ifinstitutions are more capable, they will be moreable to manage change effectively and respond tochanging circumstances as they occur (Fig. 57).

Climate change has aspects that suggest abalance between evolutionary and revolutionarychange. The rate and level of required emissionreductions suggest the need for revolutionarychange. However, the difficult politics of such a

Fig. 56 Evolutionary and revolutionary change differ in their rate, level and type of impact. Source Vivid Economics


change, and limitations in institutional capacity,suggest that a rapid evolution may be moreappropriate (Fig. 58).

Achieving the desired result requires carefulconsideration of how to sequence change, with ajurisdiction’s choices heavily dependent on itsspecific circumstances. Some elements of climatepolicy may be more conducive to revolutionarychange than others. The interaction of theseelements is therefore a key determinant of thesequencing of policy change.

China looks likely to use a slow start toemissions trading; if it does, it should consideradopting price controls and a clear reform path toreduce the risk of becoming stuck in the transi-tion trap. Design trade-offs in the early stages of

carbon pricing are common and can result infragility. This means that an active approach toprice management, such as a tight price corridor,can be used to ensure incentives are maintainedwhile the market develops. This can be supportedby signalling the direction of climate policy. Forinstance, committing to specific changes throughlegislation can provide clear guidance on thedirection of policy to help maintain prices andpublic support for carbon markets in the event ofa shock.

In the longer term, climate policy shoulddevelop in a manner that delivers:

• increased clarity of price signals, with theETS playing an increasingly large role in

Fig. 58 The choice between evolutionary and revolutionary change is context-dependent. Source Vivid Economics

Fig. 57 The appropriate approach to policy change should be based on the rate and level of change required, thecertainty of impacts, and the political and institutional feasibility of the change. Source Vivid Economics


economic activity and in different sectors andsources of emissions facing equivalent pricesignals; and

• a greater international focus, with domesticcircumstances playing a progressively smallerrole in determining policy relative to thebroader global need to reduce greenhouse gasemissions.

Figure 59 outlines what evolutionary andrevolutionary change could involve for China’sclimate policy. The major difference is the rate ofchange, with the revolutionary approach adopt-ing more cost-effective policy approaches soonerand achieving net zero emissions earlier. In therevolutionary case, carbon pricing becomes themajor driver of new energy investment in theshort term, supported by a robust price corridor,broad coverage and near-term linking withinternational partners.

The following sections provide more detail onthe differences between an evolutionary or rev-olutionary change in the aspects of carbon mar-ket design.

8.4.1 Creation of Carbon UnitsTargets and cap setting are closely related, withchanges in targets often automatically reflected incaps. Figure 60 outlines the interrelationships

and potential sequencing of policies regardingthe creation of carbon units. It demonstrates therelationship between targets, caps and enablingfactors, to demonstrate two potential pathwaysfor reform.

In these scenarios targets shift over time frombeing heavily dependent on national circum-stances to an assessment of the emission reduc-tions required to stabilise the global climatesystem. Over time, emission targets move fromquantified actions or targets based on emissionsintensity, to targets based on absolute emissions.The shift to absolute targets is only likely tooccur after robust projections of emission levelshave been completed, to allow future targets tobe calibrated against expected emission out-comes. Once absolute targets are established,China may choose to move from aspirationaltargets to binding commitments. This couldinclude a commitment to make good any failureto achieve a targeted emissions level in a givenyear. At this time, China may work with inter-national partners to establish principles for set-ting national targets to achieve the requiredglobal emission reductions. These principles canfacilitate a shift in the factors that determine theemissions target, from a focus on national polit-ical and economic circumstances to principles-based global mitigation shares.

Fig. 59 Evolutionary and revolutionary change can differ with regard to all aspects of scheme design. Note MSR =market stability reserve. Source Vivid Economics


ETS caps follow a similar progression, mov-ing from the bottom-up estimation of emissionsfrom covered sectors to a calculation based onthe required emission reductions. In the learningphase of an ETS, a jurisdiction may have insuf-ficient information to establish a credible cap andmay instead allow caps to vary, for instance,based on the level of free allocations in a givenyear. However, over time, the ETS cap shouldtake on a larger role in ensuring that nationaltargets are achieved, which would require a

top-down calculation of the required cap, giventargets and expected emissions in uncoveredsectors. To provide guidance to markets, Chinamay choose to establish gateways that indicatethe range of future caps in the medium term.Eventually China may adopt a set of rulesaligned across jurisdictions that outlines theprocesses for calculating caps.

The number of units released into the sec-ondary market may be altered through the use ofprice flexibility mechanisms. In the early years of

Fig. 60 Sequencing of evolutionary and revolutionary approaches to creating carbon units. Note BAU = business asusual. Source Vivid Economics


operation, this could include price floors, con-tingency reserves or market stability reserves. Inthe longer term, price management may be pro-vided through flexible cap management, eitherindependently or in concert with otherjurisdictions.

A more revolutionary approach to the creationof units would see an immediate move to morestringent target conditions and a more rapid

evolution of caps. China could choose to adoptabsolute targets immediately and to make goodany discrepancy that may be caused throughuncertain uncovered sector emissions and cov-ered sector response. Targets would be morestringent as they transition to reflect requiredglobal mitigation at an earlier stage, whilechanges to cap setting and price controls wouldalso accelerate.

Fig. 61 Sequencing of evolutionary and revolutionary approaches to distribution. Source Vivid Economics


8.4.2 Distribution of Carbon UnitsWith the supply of carbon units determined, thenext step is to decide how, and how many unitsshould be auctioned and freely allocated. In thelearning phase of the ETS, China may choose toallocate most units free of charge, as it seeks tointroduce liable polluters to their obligationsunder the ETS and reduce the risk of carbonleakage. In this case, the method of freely allo-cating permits will determine which mitigationopportunities will be used. Figure 61 outlines inmore detail the potential sequencing of distribu-tion methods.

Data limitations may mean that initially unitsmay be grandfathered or allocated according to acompany’s historical emissions. A quick move-ment away from grandfathered allocations willfree up a greater proportion of units to be auc-tioned and reduce the risk that allocations aresimply sold for profit.

Limiting allocations to those industries thatare constrained by cost pass-through can be aneffective means of avoiding carbon leakage whilereducing costs. Determining whether an industryis constrained by cost pass-through requiresfacility- and process-level data to be collected toenable the assessment of emissions intensity andtrade exposure. These data may also be used forbenchmarking, which facilitates the movementaway from grandfathered allocations. Over time,regular independent evaluations of costpass-through can be used to more closely targetassistance to those industries most at risk ofcarbon leakage.

The level of assistance to industries should bereduced over time to encourage greater efficiencyand product substitution. This can be achieved bydifferentiating assistance rates by emissionsintensity and/or instituting rules-based mecha-nisms to reduce allocations over time. In the longterm, the market should move to 100% auction-ing of units as the expansion and linking ofcarbon markets negates the risk of carbonleakage.

A revolutionary approach to allocations wouldprioritise the collection of data needed to assess

cost pass-through and develop benchmarks. Itwould rapidly move to more cost-effectivebenchmarking methodologies and shift to thefull auctioning of units at an earlier point in time.

8.4.3 Governance of Carbon UnitsThe rules that govern the carbon market willdetermine its cost-effectiveness and its robust-ness. As higher levels of mitigation are required,movement towards more efficient governancedesigns will help limit the costs associated withChina’s energy transition. Figure 62 providesfurther detail on the potential scheduling ofreforms and their relationship with the allocationand distribution of carbon units.

Over time the role of an ETS can change,from first being a learning mechanism, to thenbeing one that plays a major role within a broaderpolicy mix, to eventually becoming the key dri-ver of decarbonisation in an economy. Thischange is facilitated through changed marketrules that act to broaden and deepen the impact ofthe carbon market on decision-making through-out the economy.

There are some design decisions, like bank-ing, where China may choose to move to theoptimal policy setting immediately or after a verybrief period. This is because there are limitednegative consequences of adopting banking earlyon, and banking can significantly improve therobustness of a carbon market.

Other decisions, like coverage, are subject tomore complex trade-offs and capability con-straints. For simplicity, an ETS may first cover asmall number of high-emitting facilities in orderto incentivise those mitigation options that havethe potential to make the biggest impact. Overtime this can be expanded to include all sectorsof the economy with accurate measurement,reporting and verification (MRV) and, as MRVimproves, can extend to all sectors.

Domestic offsets may be used in sectors thathave insufficiently robust MRV to be subject toliabilities under an ETS, but where the mitigationoutcomes of specific projects are well known.With a slow start to emissions trading, it may be


appropriate to apply quantitative limits to the useof domestic offset units to limit their potentialimpact on these potentially fragile markets. Asthe market matures, these limits may be removed,ensuring that domestic offsets trade at the sameprice as other carbon units. As MRV processesimprove and more sectors are covered, thedomestic offset market will gradually disappear.

Similarly, the use of international units maynot be allowed in the early years of the carbonmarket given its fragility, but over time

movement to a fully linked global carbon marketwill reduce costs and increase the robustness ofinterlinked ETSs. Given the current state of theglobal carbon market, full linking may takeseveral years to progress. In the interim, limitedlinking can be used, with quantitative limits usedto quarantine the potential impacts of these unitson markets. The choice to move to full linkingwill have implications across a range of policyareas. For instance, traditional price controls maybe inconsistent with full linking as the

Fig. 62 Sequencing evolutionary and revolutionary approaches to governance. Source Vivid Economics


divergence in prices between markets can lead toperverse effects. Fully linked jurisdictions willalso need to agree to principles and rules fordetermining the minimum ambition of targetsappropriate for each jurisdiction.

Price controls should apply from the outset toensure that credible prices are maintained whilethe market is fragile. As the market develops, theprice should be allowed to vary more freely, asmarket forces will be better able to identify theappropriate price. Direct price controls may needto be removed when jurisdictions fully link theircarbon markets. At this point, linking partnersmay choose to empower an independent institu-tion, like a carbon central bank, to manage capsin a manner that achieves targets while main-taining a credible price trajectory.

The development of the secondary marketshould proceed rapidly to increase cost-effectiveness and enable liable entities to hedgetheir risks. In the learning phase of an ETS, somemarket institutions, like the system of registryunits, may not have the degree of functionalitythey would require as the ETS expands. Pricediscovery in the secondary market may be lessimportant at this stage if a tight price corridor isin place. However, as the market expands andprices float more freely, providing the necessaryinstitutions and market rules to support the sec-ondary market becomes of vital importance.

A revolutionary approach to the governance ofcarbon markets would rapidly move to moreadvanced market designs and target higher pricesthrough price controls and caps. Such an approachwould have no learning phase but would insteadstart with robust design and rules. Banking wouldbe allowed from the outset and coverage would bemaximised. There would be more rapid move-ment to trade in domestic offsets and internationalunits, with full linking occurring in the mediumterm. A rapid transition to a low-carbon economywould be supported initially by a high price flooror similarly robust quantity-based instrument, andby rapidly declining emission caps. The design ofinstitutions and market rules would ensure effi-cient secondary market functioning, supported byexchange-based trading and liquid futuresmarkets.

8.5 Challenges in Establishinga National Carbon Market

Establishing a carbon market is a complex andsystematic task, especially the unification ofChina’s carbon markets. Impeccable systems andinstitutions are needed, including determining thescope of the market, allocating allowances,choosing the allowance allocation method,building sophisticated monitoring, report andsupervisory systems, and establishing a marketcontrol mechanism.28 The design and imple-mentation of each element has an impact on theemissions reduction outcome of the carbonmarket, and will have a wide and profoundinfluence on the regional economy’s develop-ment and the evolution of industry.29

However, due to insufficient time to prepareand gain experience, the creation of China’scarbon markets is faced with some challenges:regulated tariffs, poor regulatory ability, adefective trading mechanism and poor marketfluidity. Most regions are constructing carbonexchanges in accordance with administrativeregulations. Total allowances in pilot regions arehigh, which decrease the allowance price sig-nificantly. The markets are not active enough,leading to limited trading volumes. The marketsupervisory and regulatory system needs furtherimprovement. The awareness and skills of mar-ket participants need to be strengthened.30

Pilot regions face more difficulties thannon-pilot regions as they are integrated into thenational carbon market. The pilot regions havegained a lot of experience, but their existingtrading systems need to be aligned with thenational carbon market. They also face transi-tional obstacles related to the enterprises con-trolled, the allowance allocation methods used

28Zhang Xin, Challenges in Integrating Local CarbonMarkets into the National Carbon Market, in ChinaEconomic & Trade Herald, 2015, (16), pp. 74–76.29Zhang Xin, Sun Zheng, Meng Tianyu and Wang Ying,Reflections on and Suggestions for Regional Disparity inthe Construction of a National Carbon Market, in ChinaEconomic & Trade Herald, 2017, (20), pp. 30–31.30Zou Chunlei, The National Carbon Market is Emerging,in China Electric Power News, 2016.


and the greenhouse gas emission monitoring,report and verification system.31

8.5.1 The Failure to AchieveMarket-Based ElectricityPricing Preventsthe Carbon Marketfrom Working Effectively

China’s power industry has been dominated bycoal-fired power plants for a long time. Thepower industry is not only a major primaryenergy consumer, but also a major carbon diox-ide emitter. Its carbon dioxide emissions accountfor around 40% of the total emissions fromChina’s fossil energy consumption. The powerindustry has inevitably become a major target forcontrol, and it plays an important role in shapingthe national carbon market.32

The Dian Gai No. 9 Order, issued by thecentral government in March 2015, opened anew phase in power system reform. In the pre-vious 18 months, six key policies, includingaccelerating transmission and distribution tariffreform, were introduced. The pilot projects fortransmission and distribution tariff deregulationwere expanded to 20 regions (Shenzhen, westernInner Mongolia and 18 provinces). In addition,there are four pilot regions for comprehensivereform and two pilot regions for power salesreform. A new mechanism where “the electricityprice is determined mainly by the market” willeventually be built and will be extremely bene-ficial to China’s energy saving and emissionreductions.

Overall, the 13th Five-Year Plan (2016–20) isa critical period for power reform and an initialstage for the carbon market. The challenge ofhow to dynamically align carbon market rules topower system reform needs to be overcome

urgently.33 According to Li Jifeng, given thatChina is vigorously promoting tariff deregula-tion, the carbon emitted in power generationshould be attributed to the power producers, andthe rules of the carbon market should be designedon that basis.

Electricity tariff deregulation could improvethe effectiveness of carbon markets and reduceemissions in three ways. It could facilitate tech-nical progress in power producers and optimisethe power mix; and it could encourage electricityusers—both those covered and those not coveredby the carbon market—to save energy. Optimi-sation of the power mix depends largely onenergy authorities planning for power generationwith renewables. The role of the carbon marketshould, therefore, be to reduce emissions byencouraging downstream users to saveelectricity.34

Prices in the carbon market, an importantindicator of the effectiveness of the market’srules, reflect the marginal cost for market par-ticipants to achieve emissions reduction objec-tives. The lower the carbon price, the moreeffective the rules, and vice versa. Take China’scarbon markets launched after 2017: calculationsusing a computable general equilibrium modelshow that the carbon cost for achieving the sameemissions reduction if the power tariff is con-trolled is 18–32% higher than if the power tariffis deregulated. This is because electricity pricecontrol prevents the power sector from tappingthe potential for low-cost emissions reduction,which intensifies the pressure on other sectorsand increases the overall cost of emissionsreduction. In other words, promoting the dereg-ulation of the power tariff may not only reducecarbon emissions by the power industry, butsignificantly reduce emissions reduction pressure

31Li Zhuo, Obstacles to Integrate Pilot Regional Marketsinto National Carbon Market, in Invest Beijing 2016,(04), pp. 39–41.32Zhang Lixing, Comparative Study on and Suggestionsfor Participation by Power Companies in Pilot Regions inCarbon Trading, in Resources Economization & Envi-ronment Protection, 2016, (12), pp. 16–17.

33Li Jifeng, The Design of Carbon Market’s Rules shouldbe Aligned to Price Deregulation, in China Energy News,2016-09-12.34Li Jifeng, The Design of Carbon Market Rules ShouldBe Aligned with Tariff Deregulation, in China EnergyNews, 2016-09-12.


on companies from other sectors in carbonmarkets.35

8.5.2 Carbon Emission RegulationsBarely Support the CarbonMarket

China has not imposed a compulsory carbonemissions permit trading system. Carbon tradingin China is now mainly on a voluntary basis, i.e.businesses or individuals can voluntarily pur-chase carbon emission reductions. Althoughsome provinces and municipalities, includingHubei and Jiangsu, introduced some local regu-lations on carbon emissions permit trading, lawshave not been passed at the state level. There areno uniform settlement standards yet, nor effectivesupervision. In addition, it is difficult to givepurchasers long-term economic incentives withvoluntary emissions reduction trading.36

Once the basic framework of the nationalcarbon market has been built and the market isrunning, each module should be managed byprofessional organisations. For instance, theChina Securities Regulatory Commission couldmanage carbon trading, and the Certification andAccreditation Administration of the People’sRepublic of China could review and approvethird parties. Establishing the carbon market willinvolve many departments, but China still needsone department to coordinate all other depart-ments and mobilise forces across the country tocomplete the work. While China’s carbon marketis being established, the National Developmentand Reform Commission could be responsiblefor overall planning and coordination. The mostscientific approach would be dual-level man-agement, with the central government designingthe main rules for market unification and localgovernment enforcing them.

8.5.3 The Carbon Trading MechanismIs not yet Mature

Compared with international carbon markets,China’s trading mechanism for carbon productsis not sound. Currently, there are many kinds ofcarbon trading market in the world, includingcurb exchanges, markets regulated by govern-ment, and markets that function on a voluntarybasis. They differ in their method of allocatingallowances and in their regulations and emissionsreduction verification mechanisms. Direct tradingbetween different markets is impossible. Theinternational carbon finance market is highlyfragmented. Although China is a developingcountry, any clean development mechanismprojects it participates in can only be traded in asa primary market, through the InternationalCarbon Fund. Trading and circulation betweendomestic sub-accounts are not allowed. Domesticproducts are isolated from the international car-bon trading market, making China’s carbonemission resources uninfluential. China is at theend of capital and resource chains. Due to theseparation between China and the UN’s regis-tration mechanisms, the clean developmentmechanism cannot properly register carbonemission reductions.37

In addition, there is still a dispute over whe-ther China’s future national carbon marketshould choose centralised trading at a singleexchange or decentralised trading at severalexchanges under common rules.

The advantages of centralised trading areunified standards and centralised management,which is conducive to price discovery. It alsomatches China’s “from top to bottom” approachto energy saving and emissions reduction. Thecompetent authorities in central governmentcould make flexible adjustments, creating asynergy between the carbon trading mechanismand other energy and climate policies. Theplanned national carbon market is expected tocover 4 billion tonnes of carbon allowances, thelargest in the world. The huge size imposes very

35Lu Zhengwei and Tang Weiqi, Operation Experiencefrom Domestic Pilot Carbon Markets and the Construc-tion of a National Market, in Fiscal Science, 2016,pp. 81–94.36Wang Chaoying and Gan Aiping, Problems in theUnification of China’s Carbon Markets and Countermea-sures, in Foreign Economic Relations and Trade, 2015,pp. 100–103 and 145.

37Feng Weiwei, China will Launch a Carbon EmissionsPermit Trading Mechanism in 2017, in Energy Conser-vation and Environmental Protection, 2017, pp. 34–35.


strict requirements on the design and improve-ment of trading platforms and rules. If the tradingrules of a single trading platform are not perfectat the moment the market is launched, there willbe a strong impact, and the competition mecha-nism will not be in place and functioning cor-rectly, which runs counter to the goal ofoptimising rule-related services.38

Decentralised trading means that trading isconducted simultaneously on many trading plat-forms under strictly unified calculation criteriaand trading rules. Market systems are improvedthrough free competition and the survival of thefittest. Decentralised trading is common in car-bon exchanges in Europe and North America.First, unified, clear and transparent carbonemission calculation criteria should be set up toensure that the objects traded in different marketsare homogeneous and to avoid cross-marketarbitrage. Second, unified registration systemsshould be set up to ensure the reliability ofcross-market trading information. Once theseconditions are met, exchanges should be allowedto carry out carbon trading at the same time. Thiswill introduce competition among trading plat-forms, forcing them to improve services andmotivating them to innovate, thus driving Chi-na’s carbon market towards maturity andperfection.39

In decentralised trading, local exchangescould attempt to form a trading alliance or useother cooperative mechanisms to facilitatemutual recognition of their members. They couldalso work towards integration by engagingfinancial institutions to open accounts on behalfof clients. This would optimise the process ofopening, registering and managing accounts andfacilitate cross-market trading.

8.5.4 Fluidity Needs to ImproveChina’s pilot carbon markets have a commonproblem of poor liquidity, low volumes and lowturnover. Currently, the daily trading volume ofmost pilot carbon markets is small. Although thephenomenon of zero deals on trading days duringthe non-performance period is becoming less andless frequent, a daily trading volume of onlyhundreds or dozens of tonnes is not uncom-mon.40 Due to such low fluidity, it is difficult toattract financial and investment institutions tocarry out stable and active carbon trading activ-ities, which increases the likelihood that themarket will be controlled by a few oligarchs.

The seven pilot carbon markets are dominatedby trading through performance agreements. It iscommon for trading volume and value to be highwhen a performance period is near at hand, andlow after it has ended. During the three perfor-mance years of 2013–15, the total trading vol-ume of the seven pilot carbon markets wasslightly above RMB 2 billion. This is not enoughfor a country like China with a huge carbonemissions reduction potential. The size of theglobal carbon market in 2011 was $176 billion(the EU Emissions Trading System accounted formore than 90%). Unlike the EU carbon market,which has various carbon financial products(futures, options, spot, forwards), China only hasthe spot carbon product, and no price discoveryor risk hedging tools. China’s carbon exchangesare far from mature.41

Moderate fluidity is the key to achievingreasonable prices and guiding companies toreduce emissions cost-effectively. Without fluid-ity, those companies planning to purchaseallowances would not be able to buy them, andthose planning to sell would not sell them. Norwould companies be able to compare the pricewith their own emission reduction costs andmake cost-minimising emission reduction deci-sions. To improve fluidity, allowances must be38Wang Junchun, A National Carbon Market is a

High-Speed Train for China’s Green Low-Carbon Sys-tem, in Strategic and Emerging Industries of China, 2017,pp. 48–49.39Chen Xiangguo and Ma Aimin, Construction of theNational Carbon Market is Faced with New Challenges,in Energy Conservation and Environmental Protection2016, pp. 24–25.

40Lu Zhengwei and Tang Weiqi, Operation Experiencefrom Domestic Pilot Carbon Markets and Construction ofthe National Market, in Fiscal Science, 2016, pp. 81–94.41Jiang Rui, Carbon Trading and Outlook on China’sCarbon Market, in China Policy Review, 2017, pp. 52–56.


tight. Market players and traded products need tobe diversified into futures, options and otherallowance derivatives. The starting price shouldnot be high. The policies should be progressive,which may strengthen investors’ trust in themarket and emissions reduction policies. Morecarbon asset management training should bemade available for the companies controlled.Violations of regulations should be penalised.42

Carbon allowances should be traded in a fairenvironment with fluidity. To this end, riskcontrol during trading, and supervision andmanagement of market participants and staff,should be improved. Carbon exchanges play aunique role in building the national carbonmarket. Every pilot province and municipalityshould set up its own exchange. We know thatother regions have expressed interest in buildingexchanges. Maintaining more than one exchangein an existing market encourages fair competitionand improves services. But too many exchangeswill reduce average profitability, which mightlead to cut-throat competition and fragmentationof the national carbon market, resulting in localprotectionism. We should pay attention to theseproblems when building the national carbonmarket.43

9 Strategic Transitionand Structural Reform of EnergyCompanies

In the context of the global energy transition,international energy companies and China’sstate-owned companies are undergoing a seriesof significant strategic transitions that affect theirdecision-making, organisational structure, prior-ities, global planning, business models, financeand asset strategies, and digital platforms. Inprevious sections of Special report 4 we said thatinternational oil and gas companies like BP,

Shell and Total have adapted their strategies tochanging market conditions. However, interna-tional energy companies are not the only onesdoing this: global electric utilities, especially gridcompanies, are also changing their strategies.

This section begins with the findings of researchon power grids in transition by Vivid Economics, aUK-based consultancy. The section will then dis-cuss the reform of China’s state-owned energyenterprises (SOEs), since they are a key part ofChina’s energy administration system reform. Inthe context of China’s slowing economic growth,severe overcapacity, mounting environmentalpressures, and adjustment of the energy mix, thereform of China’s SOEs is an important element inthe larger reformof state-owned assets. SOE reformfocuses on optimisation, improving efficiency andunlocking dynamism. Both central energy enter-prises and local state-owned energy companieshave begun their reforms. Given its initial difficul-ties, the reform programme needs to be pushedcontinuously.

9.1 Structural Reform of GlobalEnergy Companies—Electricity Gridsin Transition44

Decarbonisation, decentralisation and intelligenttechnologies pose challenges to the global energytransition. As a result, structural reforms must beaccelerated to ensure energy resources are allo-cated in a more efficient, safer and more sus-tainable way, especially renewables like windand solar power, thus delivering the strategicgoal of low-carbon energy. The structuralreforms and institutional changes designed toaddress the challenges have significant implica-tions for the market-oriented low-carbon reformof China’s power network.

42Fai Li, Clear Our Mind: Make Full Preparation for theNational Carbon Market, in Energy Conservation andEnvironmental Protection, 2014, pp. 32–33.43Zhang Xin, Promoting the National Carbon Marketthrough Effective Policies and Useful Actions, in ZhejiangEconomy, 2016, pp. 24–26.

44The main ideas and content in this section are takenfrom Electricity Grids in Transition, a research reportprepared for the DRC-Shell Markets Revolution WorkStream by UK-based Vivid Economics, October 2017.


9.1.1 Key Principles of EfficientNetwork Provision

In order to realise the economic benefits of lib-eralised electricity markets, international bestpractice suggests a set of principles for efficientnetwork provision:

(1) Proceed towards full liberalisation of thewider electricity system

Effective investment in and operation of thewider electricity system is a necessary conditionfor electricity network efficiency. This requiresliberalising sectors suitable for competition (suchas fuel production, generation and retail), use ofmarkets to procure key services (capacity, bal-ancing) and the pricing of externalities, such asair pollution and carbon emissions.

(2) Align incentives with public policyobjectives

Make incentives for network operators consistentwith their providing a reliable and affordablesupply of electricity by controlling monopolisticbehaviour and ensuring prices reflect underlyingcosts:

• Reform electricity network institutions. Elec-tricity networks are natural monopolies, withlittle scope for competitive markets. It istherefore critical that their incentives arealigned with public policy objectives.A monopoly faces incentives to underinvest innew infrastructure and to charge prices that arehigher than its costs. A state-owned companymay face incentives to prioritise short-termpolitical objectives, rather than longer-termpublic policy objectives. These incentives canbemitigated through institutional reform of theelectricity network. One option is to reform thenetwork company’s incentives throughperformance-based regulation enforced by anindependent regulator. Another is to separate

network operation and ownership through thecreation of an independent system operator(ISO). The UK and most European countriescurrently use performance-based regulation,while the USA uses the ISO model across itstransmission systems, for example inPennsylvania-New Jersey-Maryland (PJM, thetransmission system in north-eastern USA),California and New York.

• Consider the use of locational pricing. Effi-cient network investment and operation makeuse of information on network congestion. Ifimplemented, locational (nodal or zonal)pricing can help reveal the costs of networkcongestion. Nodal pricing is used in severalUS states, Argentina, Chile, Ireland, NewZealand, Russia and Singapore, while zonalpricing has been adopted by most Europeancountries and Australia. However, locationalpricing has disadvantages as well as advan-tages. Importantly, locational pricing is mosteffective once time-of-use pricing is fullyimplemented across network users.

(3) Take further action to meet the challengesof a decarbonised system

The electrification of energy demand andimprovements in the efficiency of electricalappliances will exacerbate the uncertainty overthe future volume and location of demand fortransmission capacity. Flexible resources such aselectricity storage and demand response cansubstitute for new network investment, so long assufficient investment incentives are present:

• Designate strategic zones for transmission-scale renewable generation to reduce plan-ning and investment uncertainty. Renewableenergy resources may be located far fromdemand centres and thus require large-scaletransmission investment. Uncertainty over thevolume and location of generation can bemitigated through zoning.


• Ensure there are revenues available toencourage flexible resources to offer a fullrange of system services. The flexible resour-ces needed for decarbonisation contributeseveral system services, such as balancing andfrequency response, but there may be under-investment if markets do not exist for theseservices. Several electricity markets in theWest run demand curtailment markets, allow-ing flexible resources to generate revenues.

(4) Prepare for the development of a decen-tralised electricity system and its associ-ated digitalisation by investing in thecoordination of decentralised resources—their control, balancing, security and dataflows

• Coordinate investment in decentralisedresources. A coordination problem ariseswhere independent developers that lack infor-mation about the plans of other developersmaymake similar investments, creating overin-vestment or, if the developers are risk-averse,underinvestment. Either way, the result can beinefficient. Solutions include formal processesfor multilateral resource planning and thepublication of current and consented resources,as used by the transmission and distributionsystem operators of Spain and Ireland.

• Determine how decentralised resources willbe controlled. While distribution networkstoday are largely passive, an active network iscapable of accommodating distributedresources. As the electricity system becomesmore active and complex, a single systemoperator may start to rely on intermediaries,such as virtual power plants and partners suchas distribution system operators, to assist withsystem balance. New systems of control, withnew computational requirements, administra-tive rules and institutional characteristics,may then be employed, reflecting new oper-ational vulnerabilities.

• Balance data transparency with security. Asinformation communications technology(ICT) infrastructure expands, the amount of

data from the electricity system grows. Thedata systems need their own infrastructure,with public access to facilitate competitionand optimise operations. Meanwhile, thedistribution of data across resources createsnew risks of cyberattack and privacy loss,solved through adequate protocols.

9.1.2 Roadmap for Efficient NetworkArrangements

This section suggests a roadmap for the devel-opment of network arrangements in China, as thecountry simultaneously carries out large-scaleinvestment, market reforms and decarbonisationof its electricity system. These options are basedon international best practice and leading think-ing on future arrangements.

The roadmap is based on the followingguiding principles:

• Strong markets need strong government.Market-based solutions have the potential toidentify and deliver cost-effective investmentand operation of electricity systems. However,both markets and natural monopoly networksbenefit from a strong government to take anactive role in ensuring institutional incentives arealigned with public policy objectives. Networkincentives can be aligned through separation ofroles (unbundling) or strong regulation.

• The institutional framework can be developedprogressively. Wholesale institutional reformis challenging and disruptive. At the outset,small changes in current practice andsmall-scale pilots may provide proof-of-concept sufficient to build consensus forlarger-scale reforms.

The roadmap suggests the following:

(1) Immediate actions

• Continue the market liberalisation pro-gramme. Phase 1 of the DRC-Shell coopera-tion suggested a programme of electricitymarket liberalisation consistent with this.China’s 13th Five-Year Plan (2016–20) aims


to improve the systems by which markets playthe decisive role in resource allocation. It willbe important to continue with the market lib-eralisation programme to deliver a moreadvanced and efficient electricity system.

• Rationalise investment planning. Clearlydefined metrics for reliability and economicefficiency help network planners to identifyefficient investments. Meanwhile, the appli-cation of the beneficiary pays principleencourages investment that increases pro-ductivity, avoiding diverting national resour-ces to stimulate regional output. Together,these approaches, when applied at nationaland regional level, facilitate greater intercon-nection and sharing of generation services.

• Implement a coordinated approach toinvestment. The use of a common investmentframework enables coordinated planning ofgeneration and network investment, harness-ing both strategic decisions and marketenterprise. For example, the framework mightset out the role of generation zones forlarge-scale renewables alongside alternativessuch as small-scale distributed generation.

Implement smart system architecture. Smart,distributed resources are crucial to affordabledecarbonisation. Before building the distributedresources, the system architecture to manage itcan be laid down. At a minimum, this includes:deployment of smart meters to introducetime-of-use pricing to consumers on the distri-bution network; upstream information and com-munications architecture; and R&D to developtechnical solutions for the smart grid.

(2) Move towards efficient pricing

• Deregulate prices. Cost-reflective pricing cansignal efficient investments and operations todecision-makers. The deregulation of pricescan proceed sequentially, with further pricereform contingent on the success of previousreforms. Price reform could commenceupstream and progress downstream,

beginning with input fuels, followed by gen-eration and network access, and ending withretail, with provision to protect retailers ifwholesale prices rise above retail pricesbefore deregulation is complete.

• Create harmonised trading arrangementsbetween transmission systems. Use prices todetermine interconnector flows betweenprovincial and regional transmission systems,signalling which provinces or regions couldbenefit from new investment. The priceswould stimulate lower-cost generators torespond to demand.

• Implement time-of-use pricing. Time-of-usepricing allows consumers and flexibleresources to respond to variation in genera-tion costs and demand. Again, it can proceedsequentially, starting with larger consumers,such as industrial facilities with flexible pro-duction schedules, and ending with smarthousehold appliances.

• Consider locational pricing. Similarly, loca-tional pricing can signal efficient investmentsand operations, but it brings disadvantages aswell as advantages. China may considerlocational pricing, following the implemen-tation of time-of-use pricing, that is, signalgeographical network constraints oncedemand peaks have been shaved. Zonalpricing is a potential intermediate stepbetween uniform and full nodal pricing.

• Protect end users. The deregulation of retailelectricity may result in rent-seeking byretailers, raising consumer prices. This canhappen if consumers do not switch suppliersreadily or for other reasons competition is noteffective. Policies to protect consumers couldbe developed alongside any deregulation ofretail electricity prices.

(3) Begin market trials

• Create small-scale trials. Create small-scaletrials to competitively procure new transmis-sion investments, non-network alternatives tonew transmission assets, ancillary services


and so on. Use competitive tenders or auc-tions for the trials. These may provideproof-of-concept and experience with inno-vative, cost-effective solutions. To be suc-cessful, procurement has to be open-accessand transparent.

• Progressively introduce market procurement.If the competitive procurement trials aresuccessful, they can be scaled up and widermarket procurement progressively intro-duced, where appropriate, across each trans-mission system. Market procurement can helpto reveal information about the relative costsand benefits of a range of technologies.

(4) Make institutional choices

• Develop the transmission network institu-tions. Options include the status quo, anenhanced role for market procurement and aregulated transmission system operator(TSO) or independent system operator (ISO).International experience of the regulated TSOand ISO models is yet to reveal the bestperformer of the two, so it matters more toadopt a good-quality institutional model earlythan to choose between the options.

• Select a model of control for decentralisedresources. Initially, when the number ofresources is small, the TSO may be able tocontrol them directly. However, as the num-ber of resources increases, and as temporal

and locational pricing become more sophis-ticated, the computational, commercial andcontractual capacity of a single operatormodel may be exceeded, and new models ofcontrol may be needed.

Box 1: Balancing the electricity system

A simple example of balancing an elec-tricity system under network constraints isshown in Fig. 63. In this example, a systemoperator balances a system of two citiesinterconnected with a capacity-constrainedtransmission line. The numbers in green,blue and purple are the inputs for the sys-tem operator’s balancing problem. Thenumbers in red are the outputs.

In City A, generators can produce up to150 MW. Generation costs $10/MWh.Consumers demand 50 MW. In City B,generators have 50 MW capacity. Genera-tion costs $20/MWh. Consumers demand90 MW, exceeding the local generationcapacity. Consumer demand in both citiesis constant and does not change with price.The interconnection between City A andCity B can carry up to 80 MW.

To minimise the total cost of the system,the system operator first uses the cheapgeneration in City A. Generators in City Aserve the local demand (50 MW) and

Fig. 63 Example of system balancing with network constraints. Source Vivid Economics


export 80 MW to City B (in total130 MW). Because the capacity of theinterconnection is fully utilised, expensivegenerators in City B serve the rest of thelocal demand (10 MW). As a result, thesystem price equals the cost of the gener-ators in City B ($20/MWh), and the totalcost is $2,800 (140 MW x $20/MWh).

9.1.3 Challenges in Network ProvisionAs electricity systems decarbonise and decen-tralise, the challenges of planning, delivery,operation and cost recovery are changing fornetwork service providers.

(1) The challenges of network provision

The challenge of efficient provision encompassesplanning, delivery, operation and cost recovery.Challenges in planning and delivery of electricitynetworks arise due to uncertainty over futureelectricity demand and the difficulty of coordi-nating network investment with independentgenerators. Challenges in operation arise fromthe capacity constraints of the network, thecomplexity of the system and the unpredictabilityof flows of electricity. Challenges in cost recov-ery arise due to the natural monopoly character-istics of electricity networks and the difficultiesof mitigating monopoly behaviour with conven-tional regulation:

• Planning and delivery. The planning anddelivery of electricity networks faces uncer-tainty over future electricity demand anddifficulties in coordinating network invest-ment with independent generators. First, thevolume and location of future demand isuncertain and depends on population growth,changes in settlement patterns, changes inindustrial structure, technology and economicgrowth. Network planners judge where net-work assets will be required. Second, whilevertically integrated utilities plan generationand network investment simultaneously, in a

liberalised electricity system, generation andnetwork investment are carried out by sepa-rate organisations. Without coordination,generators face the risk that their revenuesmay be curtailed by network congestion andnetworks face the risk that generators willunderutilise their assets.

• Operation. Balancing the electricity system ischallenging due to system complexity and theunpredictability of electricity flows. Withmany sources of generation and consumption,as well as network constraints, the optimallevel of production and consumption for eachsource is a complex calculation. Furthermore,due to the physical laws governing electricitynetworks, the precise flows of electricitythrough the network depend on the volumesof consumption and production of each gen-erator and user and cannot be predicted inadvance.

• Cost recovery. Electricity networks are natu-ral monopolies. One of the roles of the systemoperator is to levy charges to pay the networkowner. This is achieved through designingtariffs which recoup capital, operation andmaintenance costs for the network owner, andpassing these costs through to network users.In the case where the network operator is alsothe network owner, it operates as a monopoly,and faces incentives to underinvest in net-work infrastructure while charging high pri-ces to consumers.

Innovative arrangements are needed to miti-gate monopoly behaviour effectively. Electricitynetworks are characterised by high capital costsand economies of scale. For these reasons, elec-tricity networks are natural monopolies, with asingle network serving a given area. The con-ventional approach to mitigating monopolisticbehaviour in a natural monopoly is regulation.However, regulators have imperfect informationon current network costs and how these costs canbe reduced over time as productivity improves.Depending on the type of regulation, networkcompanies may face incentives to overstate theircosts or to overinvest.


(2) Future changes: decarbonisation anddecentralisation

Electricity systems are decarbonising anddecentralising, and efficient network provisiontakes these changes into account. Potentialchanges in key characteristics of the electricitysystem are encompassed within two broadertrends: decarbonisation of electricity and thewider energy system; and decentralisation ofsystem resources, as summarised in Fig. 64.These changes, and their implications for thechallenges of efficient network provision, aredescribed in turn.

(1) Decarbonisation

Decarbonising an electricity system and relatedchanges in the wider energy system involvechanges to generation technologies andfar-reaching changes to patterns of electricitydemand. Generation technologies will shift fromfossil generation to low-carbon generation, thatis, a mix of carbon capture and storage, nuclear,biomass and renewables. Electricity demand willbe affected by increases in demand from electri-fication of end-use sectors, particularly heat andtransport, as well as decreases in demand fromgreater efficiency of electrical appliances. Therewill also be a shift in the profile of demand as

low-carbon flexible resources (electricity storageand demand-side response) emerge to balancethe relatively inflexible generation profile ofnuclear and renewables.

These changes are likely to exacerbate thechallenge of planning and delivery of networkinfrastructure. Future volumes of demand will bemore difficult to forecast due to uncertainty overthe level of electrification of end-use sectors andimprovements in the efficiency of electricalappliances. Another element of uncertainty is thedegree to which low-carbon flexible resourceswill reduce peak demand, and therefore theappropriate level of network capacity.

Low-carbon flexible resources can substitutefor new network investments and can reducetotal network costs. However, as these resourcesprovide different system services (balancing,frequency response, network congestion mitiga-tion) there may be underinvestment in flexibleresources if markets do not exist for all the ser-vices that these resources provide.

(2) Decentralisation

Decentralisation involves a shift in electricityresources from the transmission system to thedistribution system. Decentralised electricityresources comprise generation, demand responseand storage. Decentralised generation includes

Fig. 64 Future electricity grids will be shaped by two broad trends: decarbonisation and decentralisation. Source VividEconomics


wind and solar, which are increasingly connectedto the distribution network, including at thehousehold level. Demand response is the flexibleoperation of electrical equipment in response tosystem conditions; electric vehicles are expectedto significantly increase this potential as theymay be able to charge at times of high electricitygeneration and low demand. Decentralised stor-age may also increase, potentially even at thehousehold level.

To unlock decentralised electricity resourcesrequires a shift to a smart grid. A smart grid ischaracterised by dominance of controllableelectricity resources (generators, storage, appli-ances) throughout the electricity system, theability of users to express preferences for use oftheir devices, the development of operatingstandards to allow resources to be operated in acoordinated way, sufficient development ofinformation and communications technology(specifically, communications bandwidth, datastorage and computing power), and adequatedata security and privacy protocols.

Decentralisation exacerbates both the plan-ning and delivery, and operation challenges:

• A coordination problem may arise betweenthe transmission system and the various dis-tribution systems. In current electricity sys-tems, the bulk of new investment occurs in thetransmission system, where adequate infor-mation is available on current and plannedresources to inform new investment decisions.A shift in resources to the distribution net-work, where adequate information is not typ-ically available, will create a coordinationproblem, where investors will not have a clearunderstanding of system needs, nor conse-quently of potential returns on investment.This could result in overinvestment, underin-vestment, a poor technology mix or a poorspatial distribution of resources.

• The computational requirements of balancinga decentralised system will increase signifi-cantly. Optimising the operation of the entiresystem requires determining the optimal vol-ume of output and consumption of everyresource in the system. As the number of

controllable resources increases from thelimited set of large resources in a transmis-sion system to the total set of resources acrossall distribution systems, the computationaldemands of this optimisation calculation alsoincrease. If computing technology is not ableto meet these computational demands, thenintermediate levels of control are required,and only partial optimisation is possible.

Finally, decentralisation will require risks ofdata privacy and cybersecurity to be effectivelymanaged. Decentralisation will be accompaniedby a very significant extension of informationand communications technology across all dis-tributed resources and will create risks of dataprivacy and cybersecurity. Protocols to managedata use and control these risks can be developedand implemented.

9.1.4 Network Arrangementsto Address CurrentChallenges

To address the challenges arising from decar-bonisation and decentralisation, grid companiesneed to take effective measures to ensure efficientnetwork arrangement. The international experi-ence in previous electricity market reform pro-vides some best practice arrangements that Chinacan draw from:

• an institutional model to align incentives withpublic policy objectives: an institutionalmodel is needed that mitigates monopolisticbehaviour and provides networks withincentives to invest in appropriate networkinfrastructure and to operate infrastructureefficiently;

• strategic transmission planning: determiningthe appropriate profile of new transmissioninvestment is a complex process and requiresstrategic planning;

• the appropriate level of locational pricing:investing in and operating networks effi-ciently requires an understanding of currentnetwork congestion; and

• a regime for merchant investments: entry ofmerchant investors has the potential to deliver


greater adequacy of investment than asingle-owner network.

(1) An institutional model to align incentiveswith public policy objectives

An institutional model is needed that mitigatesmonopolistic behaviour and provides networkswith incentives to invest in appropriate networkinfrastructure and to operate infrastructure effi-ciently. Two institutional models that can createan efficient regime are the TSO model, withperformance-based regulation, and the ISOmodel. Figure 65 highlights the key differencebetween these two models: a TSO both owns andoperates the transmission system, requiringstrong regulation, while an ISO is a systemoperator that is fully separated from ownership ofall network resources. A number of intermediatemodels also exist, for example where the systemoperator and transmission owner are legallyseparate companies but owned by the same par-ent company.

As shown in Fig. 64, most electricity systemshave moved from vertically integrated monopolyutilities before liberalisation to one of theseinstitutional models today. In 1985, Chile was

the first country to adopt the ISO model. The UKshifted from vertical integration to a TSO withperformance-based regulation structure in 1990,with Germany following suit in 1998. Followingthe orders of the Federal Energy RegulatoryCommission (FERC) (the US electricity regula-tor), the US regions of Pennsylvania-NewJersey-Maryland (PJM), and California(CAISO) transitioned from a vertically integratedstructure to the ISO model in the late 1990s(Fig. 66).

(1) TSO with performance-based regulation

A transmission system operator (TSO) is anentity that both owns and operates the transmis-sion system; it therefore has incentives formonopoly behaviour. The TSO owns all thenetwork assets and is also responsible for plan-ning, deployment and operation of the system.The TSO model is prevalent in most Europeancountries.

Performance-based regulation is needed toalign a TSO’s incentives with public policyobjectives. A TSO is difficult to regulate as it hasbetter information than the regulator on the costsit faces. This gives rise to one of two problems. If

Fig. 65 The transmission system operator (TSO) andindependent system operator (ISO) are the two mainalternative institutional models for system ownership and

operation. Note PBR = performance-based regulation.Source Vivid Economics


the regulator tries to prevent monopoly beha-viour by imposing a cap on prices, known asprice regulation, it estimates the price levelrequired for the TSO to recover its costs.The TSO then has incentives to exaggerate thecosts it faces, and secure price caps greater thanits actual costs, a problem known as adverseselection. In this case, the TSO can underinvestand continue to set high prices. If instead theregulator tries to prevent monopoly behaviour bypaying the TSO for its costs plus a regulatedreturn (cost-of-service regulation), the TSO doesnot have any incentive to take necessary mea-sures to decrease its costs, a problem known asmoral hazard. In contrast to these approaches,performance-based regulation seeks simultane-ously to address both monopoly profits andunderinvestment. An example of performance-based regulation is the imposition of a price (orrevenue) cap, which is adjusted every year by therate of inflation and target rate of productivitygrowth. The TSO is constrained in exaggeratingits costs by the regulator conducting benchmarkanalysis and detailed studies of the TSO’s his-torical accounts. The TSO has some incentive tolower its costs because it can retain the difference

between the price cap and its actual costs asprofits.

Performance-based regulation is still evolvingand there is no consensus on the optimal mech-anism. Several forms of performance-based reg-ulation have been adopted and these continue toevolve. An example of their evolution is theintroduction in the UK of the retail price inflationminus X (RPI-X) mechanism in 1992, and itseventual replacement by the revenue = incentives+ innovation + outputs (RIIO) mechanism in2013, which is described in Box 2. A key chal-lenge in performance-based regulation is its highinformation burden. The regulator has to reviewthe TSO’s accounts and business plans andundertake benchmark analysis.

Box 2: Performance-based regulationin the UK

The UK introduced performance-basedregulation in electricity networks in 1992with the RPI-X mechanism, eventuallyreplacing this in 2013 with the moresophisticated RIIO mechanism:

Fig. 66 Several countries shifted to the TSO and ISOmodels as they liberalised their electricity markets. NoteVIU = vertically integrated utility; TSO/PBR = transmis-sion system operator with performance-based regulation;

PJM = the regional transmission organisation for thenorth-eastern USA; CAISO = California IndependentSystem Operator


• RPI-X mechanism. Ofgem and its pre-decessors, the electricity market regu-lator in the UK, used the RPI-Xmechanism until 2013. Under thismechanism, Ofgem carried out costforecasts to determine the base revenuerequired by the TSO to recover itscosts. Based on this base revenueOfgem set a price cap and adjusted iteach year for retail price inflation(RPI) and an assumed target rate ofproductivity growth calculated by sta-tistical benchmark analysis. Ofgemreset the price cap at the end of thefive-year price control period to ensurethat the TSO’s cost savings are passedon to end consumers. Under the RPI-Xmechanism, the TSO had incentives toreduce its costs because it was able toretain the margin between the price capand its own actual costs as profit, asshown in Fig. 67. However, the RPI-Xmechanism did not adequately incen-tivise service quality or innovation. Itallowed cost savings to be achievedthrough decline in quality of service,and the five-year price control periodsdid not provide sufficient incentives todevelop new technologies (such assmart meters) with longer investment

cycles and the potential to provide costsavings over the longer term.

• RIIO mechanism. In 2013, Ofgemintroduced the revenue = incentives +innovation + outputs (RIIO) mecha-nism to address the concerns with theRPI-X mechanism. The RIIO mecha-nism takes the elements of the RPI-Xmechanism that work well, such as thedetermination of the base revenue, andadds extensive innovation and outputtargets to them. The RIIO mechanismdetermines the base revenue fromoutput-led business plans with greateruse of option analysis and scenarioplanning. In their business plans, com-panies compare the costs and benefitsof options for delivering long-termoutputs under various scenarios andassess the value of keeping theseoptions open. Moreover, financial andreputational incentives strengthen theincentive structure. Ofgem rewards orpenalises companies when they achieveor miss their output targets respectively.Reputational incentives do not have afinancial element, but they affectOfgem’s evaluation of base revenue inthe next review periods. A longer con-trol period, of eight years, encourages

Fig. 67 Under the RPI-X mechanism, the TSO takes measures to decrease its costs because it retains revenues fromcost savings. Source Vivid Economics


the TSO to focus on longer-terminvestments, such as smart meters.RIIO provides a wider set of perfor-mance incentives than did RPI-X, but ata cost of greater complexity andreduced transparency.

(2) Independent system operator

An independent system operator (ISO) is a sys-tem operator that is fully separated from owner-ship of all network resources. The ISO performsall system operation functions, including allo-cating network capacity among generators andconsumers to respect the physical characteristicsof the network, carrying out residual balancing toensure electricity is delivered to where it is mostvalued, and maintaining the stability of theelectricity system. In an ISO model, the trans-mission network resources are owned by one ormore transmission owners (TOs). The ISO leviescharges from generators and/or consumers foruse of the transmission system and pays thesecharges to the TOs. Typically, an ISO is alsoresponsible for planning new transmissioninvestments, either mandating TOs to carry outthese investments or organising competitivetenders to facilitate delivery of investment.An ISO is usually a non-profit entity.

Separation of operation from ownershipremoves the system operator’s incentives tocharge monopoly prices. An ISO may be anon-profit organisation or may earn profits onrevenues for system operation. As an ISO doesnot earn profits determined by revenues from useof the transmission system or by the costs oftransmission investments, it has no incentive tocharge tariffs that are higher than needed torecover the investment costs of the transmissionnetwork, or underinvest in transmission assets.Unlike a TSO, therefore, an ISO does not needperformance-based regulation.

The ISO’s functions can be specified by itsmandate and its behaviour can be governed by a

set of rules. The mandate could be to minimisethe total cost of meeting a given reliabilitystandard. Rules could govern processes fortransmission planning and investment; providinggrid connections to new system resources;administering competitive tenders for new net-work assets; levying charges for network use;and monitoring market power in the electricitysystem.

Nevertheless, it is desirable to have in place amechanism to incentivise the ISO. It is unlikelyto be possible to specify a set of rules that per-fectly incentivise the management to meet theISO’s mandate. That is, to encourage the ISO tocarry out the planning, investment and operationof the transmission system to strike the bestpossible balance between reliability of electricitysupply and economic efficiency of the network.Imposition of financial penalties on the ISO islikely to be a poor incentive mechanism as ISOrevenues are likely to be small relative to thewelfare losses arising from poor performance inoperating the system. Instead, well-designedmanagement incentives may be needed.

The ISO model is prevalent in North andSouth America. Chile, Argentina and Peru wereearly adopters of the ISO model. There are alarge number of ISOs in the USA, each coveringa transmission network.

(2) Strategic transmission planning

The design of new transmission investment is acomplex process and requires strategic planning.Specific challenges are the uncertainty in volumeand location of future demand; the coordinationproblem facing generation and network inves-tors; and the large number of possible transmis-sion investments. These challenges can bemitigated by strategic planning. Key character-istics of strategic planning include:

• Define the objectives of new transmissioninvestment. Transmission planning is moreeffective when the objectives of new invest-ment are clearly defined. These include reli-ability (security and adequacy of supply) and


economic efficiency (reduction in the totalcost per unit output). Defining these criteriaallows the benefits of new transmissioninfrastructure to be measured.

Estimate and compare the benefits of eachproposed investment. Cost-benefit analysis is akey planning tool to identify proposals that meetinvestment objectives. Reliability and economicefficiency can be assessed with electricity systemmodelling, and modelling of multiple scenarioscan help identify least regrets infrastructureinvestment under uncertainty. If available, loca-tional pricing provides a clear signal of conges-tion costs, and can substantiate the economicbenefits of new network infrastructure.

Consult all relevant stakeholders. As the costsof investments are borne by network users, theyhave incentives to ensure that only the mostvaluable network infrastructure is developed.Stakeholder consultation can elicit views fromgenerators, consumers (municipalities, consumerinterest groups), and connected transmission anddistribution systems to inform the cost-benefitanalysis.

(3) Appropriate level of locational pricing

Investing in networks efficiently requires anunderstanding of current network congestion.New network investments that relieve significantnetwork congestion are particularly valuable.

Many electricity systems operate a system ofuniform transmission pricing, which does notsignal network congestion. Under a system ofuniform pricing, the price of electricity is thesame at every network connection, regardless ofthe degree of congestion. It does not signal theneed to invest in solutions to relieve networkcongestion, such as new network investment,generation, or non-network alternatives to newtransmission assets, such as electricity storageand demand-side response. While, in principle,the system operator can signal the need to investthrough location-specific transmission charges,the rate of these charges is difficult to determineif the electricity price does not signal networkcongestion. Furthermore, uniform pricing results

in re-dispatch costs, where some plant that isscheduled to generate is compensated for cur-tailment if the network is revealed to becongested.

Nodal pricing can help signal network con-gestion. Nodal pricing, or locational marginalpricing, is a price mechanism that reflects thecost of supplying additional electricity at a givennetwork connection (node), given the demand forelectricity, transmission constraints and optionsfor local generation at that node. When there isno network congestion, overall demand is met atleast cost and all nodal prices are the same. Whennetwork congestion occurs, demand is met bycostlier local generation rather than cheap gen-eration from another node, raising prices atcongested nodes. Nodal pricing therefore signalsthe need to invest in solutions to relieve networkcongestion, such as new network investment,new local supply and non-network alternatives tonew transmission assets, such as electricity stor-age and demand-side response. Nodal pricing isbriefly illustrated in Box 3.

Box 3: Nodal pricing

Figure 68 provides a simple example ofbalancing an electricity system under nodalpricing. In this example, a system operatorbalances a system of two cities intercon-nected with a capacity-constrained trans-mission line under nodal pricing. Thenumbers in green, blue and purple are theinputs for the system operator’s balancingproblem. The numbers in red are theoutputs.

In City A, generators can produce up to150 MW. Generation costs $10/MWh.Consumers demand 50 MW. In City B,generators have 50 MW capacity. Genera-tion costs $20/MWh. Consumers demand90 MW, exceeding the local generationcapacity. Consumer demand in both citiesis price-inelastic. In other words, consumerdemand is constant and does not changewith price. The interconnection betweenCity A and City B can carry up to 80 MW.


To minimise the total cost of the system,the system operator first uses the cheapgeneration in City A. Generators in City Aserve the local demand (50 MW). That iswhy the nodal price in City A equals thelocal generation cost ($10/MWh). Genera-tors in City A also export 80 MW toCity B. Since the capacity of the inter-connection is fully utilised, expensivegenerators in City B serve the rest of thelocal demand (10 MW). As a result, thenodal price in City B equals the localgeneration cost ($20/MWh). The total costis $1,500 (= 140 MW * $10/MWh +10 MW * $20/MWh).

However, nodal pricing has disadvantages aswell as advantages. First, vulnerability to marketpower may arise because the segmentation of theelectricity market into smaller locational marketsincreases the concentration of generators at eachnode with a supply deficit. Some authors chal-lenge this view and argue that the networkarchitecture is the main driver of market power,instead of the pricing mechanism. Nodal pricingcan also reduce liquidity in long-term contract-ing, such as financial transmission rights andcontracts for differences. This problem is

addressed in the USA by averaging nodal pricesinto trading hub prices to provide liquidity tomarket participants.

Zonal pricing, another form of locationalpricing, may provide a useful compromisebetween uniform and nodal pricing. Zonal pric-ing addresses the complexity introduced by largenumbers of nodes by aggregating nodes intozones. Similar to dispatch under nodal pricing,the system operator first dispatches generation,given transmission constraints between zones. Iftransmission lines in a given zone are congested,the system operator has to re-dispatch generationin that zone to alleviate congestion. As a result,zonal pricing provides some of the benefits ofnodal pricing in terms of signalling networkcongestion but does not fully eliminate there-dispatch costs associated with uniform pricing.

Locational pricing may be considered oncetime-of-use pricing is fully implemented. Widerchanges to improve the flexibility of the elec-tricity system through electricity storage anddemand response are expected to reduce demandand generation peaks, which would automaticallyreduce network congestion relative to an inflex-ible system. These changes require time-of-usepricing to be fully implemented across all systemresources (including end users) to be fullyeffective.

Fig. 68 Nodal pricing reflects the cost of supplying additional electricity at a given node. Source Vivid Economics


(4) A regime for merchant investments

The entry of merchant investors has the potentialto deliver greater adequacy of investment than asingle-owner network. Merchant transmissioninvestors are third-party developers of transmis-sion projects. If locational pricing is imple-mented, a merchant transmission investor has theincentive to invest in a new transmission linkwhen the revenues from use of that link aregreater than the investment cost. Therefore, inprinciple, merchant competition offers thepotential to increase the adequacy of the trans-mission infrastructure by investing where anincumbent is not willing to do so. This might bethe case if the incumbent is an unregulatedmonopoly, or a poorly regulated TSO.

Other attractive properties of the merchantmodel are the ability to include non-networkalternatives to new transmission assets in plan-ning processes, reduce the risk for consumers andminimise investment costs. In liberalised powermarkets, potential merchant investors couldinvest in new transmission capacity, or enter thegeneration market to supply local generation to anode that is served by a congested transmissionlink. Investment risk is transferred from regulatedtransmission owners and consumers to the mer-chant. As the merchant is the beneficiary of anycost saving, construction costs may also beminimised.

However, merchant investment alone is notsufficient to ensure overall adequacy of the net-work, underscoring the importance of awell-designed institutional model. Transmissioninvestments exhibit economies of scale, wherelarge-capacity investments carry only a smallcost premium relative to small investments. Aslarge-capacity investments offer significantadditional benefits at little additional cost, theyare socially desirable; however, as these addi-tional benefits are reflected in lower locationalprices (due to lower congestion), they are lessdesirable for private investors. In this setting,merchants will tend to underinvest in new net-work capacity. Alternatively, with an ISO insti-tutional model, the ISO can also ensure overallnetwork adequacy by planning new network

capacity and delivering new investment at mini-mal cost by running competitive tenderingprocesses.

Merchant transmission investments have beenimplemented in the USA, Australia and Argen-tina. In the USA, merchant investment is pro-moted by the FERC Order 1,000, and a numberof projects are in progress or have been com-pleted in recent years. Nearly all merchant-ledinvestments have been on interconnectors, thatis, links between distinct networks. Here mer-chants alleviate coordination and cost allocationissues between different system operators.

9.1.5 Network Arrangementsto Address FutureChallenges

This section discusses new arrangements toaddress the future changes of decarbonisationand decentralisation. They comprise:

• Strategic generation zones: Strategic genera-tion zones coordinate investment in trans-mission and generation assets and connectremote renewable energy resources to largepopulation centres.

• Markets for flexibility services: Flexibleresources, such as electricity storage anddemand response, can substitute for new net-work investment, as well as providing a rangeof different system services. A simple set ofmarkets for each system service can rewardflexible resources and avoid underinvestment.

• System for controlling decentralised resour-ces: While distribution networks today arelargely passive, they will need to becomeactive to accommodate distributed resources.Distributed resources increase the complexityof the electricity system. If the system is toocomplex for a single system operator to bal-ance, a hierarchy of resource control will beneeded, with intermediaries such as virtualpower plants and distribution system opera-tors interacting with the transmission systemoperator. The hierarchy of resource controlmay reflect computational requirements,institutional characteristics and operationalvulnerability.


• Coordinated investment in decentralisedresources: Investment in generation andstorage resources should meet the needs ofthe whole electricity system. A decentralisedelectricity system may not provide adequateinformation to investors on system needs,raising the risk of inefficient investment.A coordinated approach to investment canmitigate this risk.

• Open-access, public data on system condi-tions and resources: Market participants needa degree of access to market information tofacilitate a level playing field for competition.A data exchange could be part of an effi-ciently functioning energy system, but wouldneed to be both secure and accessible.

• Accommodating future innovations: Innova-tions in electricity networks include newnetwork structures and peer-to-peer electricitytrading, which may offer significant benefits.These innovations can be facilitated throughpilots and early-stage funding.

(1) Strategic generation zones

The decarbonisation of electricity generation andthe wider energy system heightens the challengeof planning and delivering network infrastruc-ture. The capacity of new transmission invest-ment will be more difficult to determine due togreater uncertainty over the level of total elec-tricity demand (due to electrification of end-usesectors and improvements in the efficiency ofelectrical appliances) and peak demand, as flex-ible resources contribute to smoother generationand consumption profiles. The degree to whichgeneration will be centralised—that is, connectedto the transmission network—will be difficult toforecast.

In many countries, renewable energy resourcesare located in areas that are distant from largepopulation centres, and thus require large-scaletransmission investment. For example, in the UK,the majority of electricity demand is located in the

south of England, while a large proportion ofonshore wind resources are located in Scotlandand offshore wind resources in the North Sea.

In a liberalised electricity system, investors ingeneration and network investment face a coor-dination problem. While vertically integratedutilities are able to plan generation and networkinvestment simultaneously, in a liberalised elec-tricity system, generation and network invest-ment are carried out by different institutions. Thisgives rise to a coordination problem, wheregeneration investors face the risk that their rev-enues may be reduced due to inadequate networkinvestment, and network investors face the riskthat generators will underutilise their newinvestments. This can lead to underinvestment.

This coordination problem can be mitigatedwith strategic generation zones. If a strategicdecision is made to exploit a large renewableresource that is distant from large populationcentres, generation investors may be givenincentives to invest there. This may require anoverarching strategic plan to be developed by aninstitution, such as a government agency, withsufficient authority to determine the location ofboth transmission and generation investment. Itmay also require a credible, long-term regime fornetwork connection to be developed to reducestranded asset risks for generators. For example,in the UK, nine offshore wind farm zones ofvarying size were identified within UK waters todeliver 33 GW of potential offshore windcapacity. The Crown Estate, the statutory ownerof seabed rights, asked renewable energy devel-opers to bid for exclusive rights to develop off-shore wind farms within the zones. TheElectricity Networks Strategy Group, ahigh-level forum bringing together key stake-holders in electricity networks, including theCrown Estate, then identified key transmissioninvestments needed to meet future demand, giventhe expected location of future generation. Theareas identified by this exercise are shown inFig. 69.


(2) Markets for flexibility services

Decarbonisation will require flexible resources,electricity storage and demand response, whichoffer non-network alternatives to new transmis-sion assets. Electricity networks are costly,long-lived assets and investments are made in the

presence of uncertainty over the future spatialand temporal profile of generation and demand. Itwill be increasingly valuable to enable flexibleresources, such as electricity storage and demandresponse, to substitute for new network invest-ments where possible, or defer new networkinvestments until the future profiles of generation

Fig. 69 UK offshore wind farm zones identified for development of renewable energy capacity. Source The CrownEstate (2017)


and demand are better understood. As discussedabove, nodal pricing provides a locational signalfor non-network alternatives.

Flexible resources provide a range of systemservices, which may each be rewarded. As wellas substituting for or deferring new networkinvestments, services provided by flexibleresources include balancing and system stability.To provide balancing services, electricity storagecan hold surplus energy until it is needed, anddemand response can shift demand to whenelectricity is being generated. To provide systemstability, electricity storage and demand responsecan adjust system voltage and frequency. In orderfor flexible resources to deploy at volumes thatbring the greatest benefits, mechanisms exist toreward them for the system services theyprovide.

A simple set of markets for each system ser-vice allocates existing flexible resources andsignals investment need. Storage and demandresponse are already actively engaged in bal-ancing supply and demand in several wholesalemarkets. However, markets for system stabilityare typically not developed enough to allowflexible resources to participate to their fullestextent. Procurement mechanisms for systemservices typically specify these services in termsof the properties of the thermal generators thathistorically provided them, which often closesthese mechanisms to new, low-carbon flexibleresources. Recent attempts to create procurementmechanisms for flexible resources have resultedin a patchwork of complex and mutually incon-sistent set of mechanisms. For example, in GreatBritain, electricity storage facilities providing ashort-term ancillary service called enhanced fre-quency response are not allowed to participate inthe capacity mechanism. A set of simple marketsto reward all system services provided by flexibleresources is needed to ensure adequate invest-ment to provide non-network alternatives.

(3) Model for control of decentralisedresources

While distribution networks today are largelypassive, they will need to become active to

accommodate distributed resources. As demandon the distribution network is typically inflexible,generators on the transmission system operateflexibly to meet demand and maintain systemsecurity. As decentralised electricity resources(distributed generation, storage and demandresponse) are deployed in the distribution net-work, these resources will also need to operateflexibly.

Distributed resources increase the complexityof the electricity system. The optimisation ofelectricity system operation involves finding theoptimal volume of output and consumption ofevery resource in the power system. A conven-tional, centralised electricity system typicallyincludes a limited number of largetransmission-connected generators, suppliers andlarge industrial consumers with flexible demand.However, a decentralised electricity system willinclude a very large number of small decen-tralised resources. The number of resources to beoptimised might increase by a factor of severalmillion.

A similar increase in computational demandwould occur if the temporal resolution at whichresources are controlled increases. For example,shifting from hourly to real-time (second-by-second) settlement of all dispatch and consump-tion actions would increase the computationaldemands of optimal system balancing by a factorof 3,600.

If the system is too complex for a singlesystem operator to balance, a hierarchy ofresource control will be needed. A full optimi-sation of a decentralised electricity system wouldhave very significant computational require-ments. If computing technology is not able tomeet these requirements, then control of thesystem will be distributed.

Virtual power plants (VPPs) and distributionsystem operators have a role to play in a hierar-chy of resource coordination. VPPs, also knownas aggregators, could coordinate (aggregate)decentralised resources and coordinate themindividually to present the system operator at thetransmission level with a level of net generation(or consumption). If the system is complex, morethan two levels of resource coordination might be


needed, with some VPPs coordinating the activ-ity of smaller VPPs further down the hierarchy.Distribution system operators are VPPs thatcoordinate all resources in a given distributionsystem, either directly or via intermediate VPPs.

Hierarchies of resource control provide onlypartial optimisation of the electricity system. Inorder to optimise the whole electricity system, asingle optimising agent must know the demandand supply curves for each system resource.Where no single agent has this information, onlypartial optimisation is possible, as groups ofresources for which information is available mustbe optimised separately. Markets between groupsof resources will be required to coordinate theiroperation to balance the whole system. However,supply and demand curves in electricity systemschange in real time, while the process of pricediscovery in decentralised markets takes placeover time through multiple iterative trades.Therefore, markets between multiple levels ofresource coordination can provide only a partialoptimisation of the electricity system.

A decision has to be made about how dis-tributed resources will be coordinated, withseveral possibilities available. Four possiblemodels for operating distributed system

resources are currently being discussed in theliterature and are illustrated in Fig. 70. Thesemodels are:

• Whole-system operator. This model involvesonly one level of control. The TSO carries outconstrained dispatch of the whole electricitysystem. In other words, it carries outleast-cost dispatch across all system resourcesat the transmission and distribution systemlevels, taking capacity constraints at bothnetwork levels into account. In this model,distribution network operators retain theircurrent, minimal functions of basic planningand operation of the distribution network.

• Whole-system operator with distribution sys-tem operator. This model has two levels ofcontrol. First, the TSO carries out economicdispatch of the whole electricity system,including constrained dispatch of the trans-mission system. In other words, it carries outleast-cost dispatch across all system resourcesat the transmission and distribution systemlevels, but only takes capacity constraints atthe transmission network level into account.Second, distribution system operators (DSOs)modify the operation of distributed resources

Fig. 70 There are several possible models for coordi-nating distributed energy resources. Note TSO = trans-mission system operator; DSO = distribution system

operator; DER = distributed energy resources; VPP =virtual power plant.. Source Vivid Economics


to take into account capacity constraints at thedistribution network level.

• Virtual power plants with distribution systemoperator. This model involves three levels ofcontrol. First, VPPs provide thetransmission-level system operator with offercurves for generation or demand reduction forthe resources they operate. Second, thetransmission-level system operator carries outconstrained dispatch of the transmission sys-tem. Third, DSOs modify the operation ofdistributed resources to take into accountcapacity constraints at the distribution net-work level.

• Distribution system operator. This modelinvolves two levels of control. First, DSOs actas sole distribution-level VPPs, controlling allsystem resources at the distribution level, andcarry out constrained dispatch of the wholedistribution system. DSOs provide thetransmission-level system operator with bidor offer curves for the generation and demandresources they operate. Second, thetransmission-level system operator carries outconstrained dispatch of the transmissionsystem.

Key criteria in this decision are the compu-tational requirements, institutional characteristicsand operational vulnerability of each model. Asexplained above, systems with high computa-tional requirements, or small improvements incomputing technology, will require more levelsof resource coordination, while systems with lowcomputational requirements, or large improve-ments in computing technology, will requirefewer levels of resource coordination, and—withsufficiently developed computing technology—potentially a whole-system operator. Preferencesfor particular institutional characteristics are alsorelevant. For example, the whole-system operatorand distribution system operator models involvecoordination of resources by a single operator.Consumers may or may not have concerns overprice, quality of service and privacy. If they haveconcerns, they might prefer a model involvingcontrol of resources by VPPs, which compete tomeet customer requirements. Finally, the models

may have different degrees of vulnerability tofailures in information and communicationstechnologies (ICT), such as those caused bycyberattacks.

Hierarchies of resource control may be neededuntil ICT capabilities are sufficiently developed.While in the near term a single operator may beable to optimise the electricity system with rela-tively low volumes of distributed resources, oncesufficient volumes of distributed resources aredeployed, the task of optimisation may be toogreat for a single operator. Hierarchies of controlmay be established early to ensure that increasingvolumes of distributed resources can be accom-modated if improvements in computing tech-nology fail to keep pace with increases incomputational requirements. Even if computingtechnology improves to the point where a fullydistributed system can be optimised by a singleoperator, an increase in the temporal resolutionof system control (for example, from half-hourlysettlement towards real time) would result insignificant further increases in computationalrequirements. A shift from hierarchies of controlto a whole-system operator model would only beviable if improvements in computing technologyare sufficient to meet the requirements of opti-mising a fully distributed system in real time.

(4) Coordinated investment in decentralisedresources

Electricity systems with largely centralisedresources provide adequate information toinvestors on system needs. Electricity systemsperiodically require investment in new resources,such as new generation plants. In theory, devel-opers invest in new resources in response to aprice signal in the wholesale market. These newinvestments are typically large. In principle, thisleads to a coordination problem, whereby eitherseveral investors might plan to develop a similarresource (overinvestment) or investors might notinvest in required resources due to the risk thatother investors might do so (underinvestment). Inpractice, these risks are minimised because thetransmission system operator knows whichresources are under development and awaiting


grid connection and is able to make this infor-mation public.

However, a decentralised electricity systemmay not provide adequate information, riskinginefficient investment. As resources shift to thedistribution system level, the same coordinationproblem may arise. This is because, unless ade-quate procedures are introduced, no single mar-ket participant knows which resources are underdevelopment and awaiting grid connection acrossall electricity networks in the system. The con-sequence is, again, inefficient investment: over-investment, underinvestment, a poor technologymix or a poor spatial distribution of resources.

The risk of inefficient investment can bemitigated through a coordinated approach toplanning new assets. As set out in Fig. 71, thiscould be achieved either through formal pro-cesses for resource planning and decision-making, or through provision of information.

Formal processes for resource planning anddecision-making by system operators at thetransmission and distribution system levels havebeen introduced in Spain and Ireland. Processesinclude formal collaboration, with the TSO and

DSOs planning infrastructure and generationinvestment together. For example, in Spain, someregional administrations founded evaluationboards. In these boards the administration, TSO,DSO and developers coordinate investment plansand grid connection requests. The TSO and DSOanalyse and approve investment plans together.Thereby, the TSO and DSO minimise the net-work development and project costs as well asproject risks. In Ireland, under the group pro-cessing approach, investment plans of developersare collected in batches and then submitted to theTSO and DSO for consideration. Then, the TSOor DSO process the plans that are most suited totheir system. This approach coordinates thedevelopment of the transmission and distributionsystems and efficiently allocates scarce capacity.

An alternative approach is to provide adequateinformation. For example, compulsory registra-tion in a publicly available database on applica-tion for planning or grid connection consentwould provide investors with an understandingof the pipeline of future resources, and allowthem to evaluate potential investments againstthe expected system requirements.

Fig. 71 A coordinated approach can ensure efficient investment in electricity system resources. Note TSO =transmission system operator; DSO = distribution system operator. Source Vivid Economics


(5) Open-access, public data on system con-ditions and resources

The development of ICT infrastructure isexpanding the amount of data and informationavailable. Smart meters in buildings track theprofile of energy consumption every second,offering a new source of information on energyconsumption and user behaviour. On the elec-tricity grid, sensors and wide area networksmonitor the reliability of electricity grids, pro-viding real-time information on networkconditions.

Market participants need a degree of access tomarket information to facilitate a level playingfield for competition. The Council of EuropeanEnergy Regulators, for example, has identifiedlimited access to information as a key barrier toentry for new market participants. Access toinformation about distributed resources and net-work conditions may also grow in importance inthe future. This information may also provide afoundation for new opportunities for systembalancing, as new participants could enter themarket and find more efficient balancingsolutions.

A data exchange could be part of an efficientlyfunctioning set of future energy networks butwould need to be managed carefully to mitigaterisks while being accessible. A data exchange is asecure store of data, for example, on customeruse patterns, available distributed resources, localprices and network conditions. The availabilityof this data raises privacy concerns and a balancewould therefore need to be struck betweenaccessibility and protection. Use of dataexchanges will require adequate institutionalarrangements. For example, if DSOs, who par-ticipate in markets for electricity system services,ran data services then gave themselves prefer-ential access. In the long term, ICT developmentsmay make operation of data exchanges by cen-tralised authorities unnecessary, particularly ifthe trading of electricity shifts towards apeer-to-peer level.

(6) Accommodating future innovations

Innovations in electricity networks include newnetwork structures and peer-to-peer electricitytrading, which may offer significant benefits.New network structures, including microgridsand fractal grids, have the potential to makeelectricity systems more resilient to failure, asdiscussed above. Peer-to-peer trading through adistributed data management platform, such asblockchain, offers the potential to lower trans-action costs and reduce the role of intermediariesin electricity markets.

These innovations can be facilitated witharrangements required to deliver efficient net-works, today and in the future. Most fundamen-tally, liberalised electricity markets provide asupportive environment for the development,demonstration and adoption of innovations.More specifically, an institutional model thataligns system operator incentives to public policyobjectives will be needed to mitigate any incen-tive for incumbents to block the spread of inno-vations. A model for control of decentralisedresources will also be needed to allow innova-tions such as new network structures andpeer-to-peer electricity trading the opportunity toparticipate in electricity markets.

It is possible that over time these and otherinnovations will drive or enable larger changesthat have the potential to restructure the elec-tricity system more significantly. It will beworthwhile monitoring new technologies andbusiness models so that policy and regulation canrespond appropriately, to realise value andaddress risks.

(1) New network architectures

Microgrids and fractal grids are innovative net-work architectures. Both of these new networkarchitectures provide greater resilience than theradial links of conventional distribution net-works. Microgrids achieve resilience throughredundancy in generation, while fractal grids


achieve resilience through redundancy in net-work infrastructure.

A microgrid is a small-scale, partiallyself-sufficient network incorporating both gener-ation and demand sources. Microgrids may beconnected to the local distribution network,importing or exporting electricity according tosystem conditions, but may also disconnect fromthe distribution network and operate as an island.As a microgrid can meet a degree of its owndemand, it is more resilient to wider systemfailures, caused by a fault or cyberattack, than aradial network, and is well suited for criticalfunctions such as healthcare, military installa-tions or data centres. As microgrids areself-sufficient, they may require more on-sitegeneration than conventional networks. Thedeployment of on-site generation in microgridsmay result in a larger total volume of generationassets in the wider electricity system, implying adegree of asset redundancy and an increase incosts. In principle, the redundancy can be miti-gated if sufficient generation is deployed to serveonly essential loads when islanded. A microgridcan aggregate its resources like a virtual powerplant to coordinate electricity trading with the

wider power system. This aggregation can beaccomplished by a central controller, or poten-tially by peer-to-peer communication of indi-vidual microgrid resources without a centralcontroller. Figure 72 shows the structure of amicrogrid with some of these features.

A fractal grid is a new network structurecurrently at the concept stage. A fractal gridcombines the economy of radial networks, whereredundancy is minimal, with the resilience ofmeshed networks, where nodes are connected bymultiple links. The fractal grid achieves theseproperties through use of a fractal, or recursivepattern, where multiple sets of links with thesame structure are connected together in aparent-child relationship. Failure of a single linkdoes not prevent power flows between nodes,and the fractal architecture can accommodatemicrogrids that are able to island themselves incase of wider system failure. Proponents offractal grids note that most urban spatial areasalready have a fractal structure, so a fractal gridsystem could be easy to develop in cities. Thereare several fractal grid demonstration projects.For example, CleanSpark’s Fractal Grid has afederated structure that connects microgrids in a

Fig. 72 A microgrid contains generation and flexible resources, as well as sources of electricity demand. Source VividEconomics


parent-child relationship. Microgrids in the frac-tal grid can share their generation and serviceswith other microgrids to shave peak demand andthereby increase the reliability of the wholesystem, or they can island themselves to managegeneration and load independently. The FractalGrid Demonstration at Camp Pendleton militarycamp in California and NRECA’s Agile FractalGrid are other examples of microgrids in aparent-child relationship.

(2) Peer-to-peer electricity trading

Peer-to-peer electricity trading could allow indi-vidual owners of small-scale generation, storageand demand resources to participate in electricitymarkets. Currently, electricity is traded betweengenerators and large electricity suppliers. Asdiscussed above, virtual power plants are alsolikely to enter the electricity market. In addition,developments in peer-to-peer electricity tradingcould facilitate individual owners of small-scalegeneration, storage and demand resources totrade electricity. Peer-to-peer energy trading isbeing trialled at pilot scale in several smallmicrogrid networks. For example, the BrooklynMicrogrid in New York connects generators,distribution lines, batteries and load sources, withtrades and electricity flows tracked though theblockchain distributed ledger.

If peer-to-peer trading is widespread, theremay be a reduced role for intermediaries inoperating the electricity system. Some commen-tators suggest that blockchain could automate theactive participation of large numbers of dis-tributed resources, such that an intermediary, forexample, a virtual power plant, is not required. Infuture, peer-to-peer electricity trading might takeplace not only within a microgrid, but betweenresources at the level of the distribution network,and potentially the transmission network. It istheoretically possible that sufficient automationmight reduce the role of system operators at thedistribution or even transmission system levels,though it is likely that their core roles, managingnetwork constraints and maintaining systemsecurity, will remain.

9.2 Analysis of Policy on the Reformof State-Owned EnergyEnterprises in China

9.2.1 The Reform of State-OwnedEnterprises Since the 12thFive-Year Plan (2011–15)

In November 2013, the Third Plenary Session ofthe 18th CPC Central Committee deliberated andadopted the Decision of the CPC Central Com-mittee on Several Major Issues ConcerningComprehensively Deepening Reform, markingthe start of this round of reform of state-ownedenterprises. General Secretary Xi clearlyexplained the status of state-owned enterprisesand the background of the reform in his state-ment on the Decision: “State-owned enterprisesare an important force that promotes the mod-ernisation of the country and safeguards thecommon interests of the people. After years ofreform, state-owned enterprises have, on thewhole, been integrated with the market economy.Meanwhile, they need to be further reformed dueto the presence of some problems and draw-backs”. The key points for further deepeningreform are identified in the Decision: “China willperfect the state-owned asset management sys-tem, strengthen the supervision of state-ownedassets primarily by means of capital manage-ment, reform the system of authorised operationof state-owned capital, establish severalstate-owned capital operation companies, andsupport the reorganisation of state-owned enter-prises into state-owned capital investment com-panies if conditions permit”.

As for important measures for deepening thereform of state-owned enterprises, the Decisionsets out that, China will, first: “actively develop amixed ownership economy”, “allow morestate-owned sectors, and sectors with other typesof ownership, to develop into a mixed ownershipeconomy”, “allow non-state capital to participatein state-owned capital investment projects” and“encourage non-public ownership enterprises toparticipate in the reform of state-owned enter-prises, and encourage the development of mixedownership enterprises held by non-public


capital”; and second, “impel state-owned enter-prises to perfect the modern enterprise system”,“accurately define the functions of differentstate-owned enterprises”, “increase state-ownedcapital investment in non-profit enterprises”,“separate national railway network infrastructurefrom railway passenger and freight transport, andliberalise competitive businesses in naturalmonopoly industries owned by state-ownedcapital” and “improve the corporate governancestructure to achieve coordinated operation andeffective balance”.

Since then, General Secretary Xi has talkedabout the reform of state-owned enterprises onseveral occasions.

In March 2014, he said in his speech duringthe deliberation of the Anhui delegation at theSecond Session of the 12th National People’sCongress that: “the basic policy for the devel-opment of a mixed ownership economy has beenidentified. Detailed rules and regulations are thekey to, and decisive factor for, success. Theexperience and lessons gained from the pastreform of state-owned enterprises will be drawnon. The reform of state-owned assets will not bean opportunity for profiteering”.

In August 2014, he said at the Fourth Meetingof the Leading Group of the CPC Central Com-mittee for Comprehensively Deepening theReform that: “state-owned enterprises must bewell developed, especially those administered bythe central government that dominate the majorindustries and key sectors and that impactnational security and the national economy. Theyare an important pillar of CPC administration andthe economic foundation of socialist statepower”.

In June 2015, he said at the 13th meeting ofthe Leading Group of the CPC Central Com-mittee for Comprehensively Deepening theReform that: “upholding the leadership of theCPC is a unique advantage of the state-ownedenterprises of our country” and that China will“make state-owned enterprises bigger and stron-ger and able to continuously enhance the dyna-mism, dominance, influence and resilience of thestate-owned economy”, “prevent loss of stateassets” and “accelerate the formation of a

state-owned asset supervision system charac-terised by comprehensive coverage, clear divi-sion of labour, coordination and effectiverestrictions”.

In July 2015, he said in a survey in Jilin that:“state-owned enterprises are an important forcethat promotes the modernisation and safeguardsthe common interests of the people. China willunswervingly uphold the important role ofstate-owned enterprises in the development of thecountry and resolutely develop state-ownedenterprises and make them bigger and stron-ger”. “China will deepen the reform ofstate-owned enterprises, improve the corporategovernance model and operating mechanism,truly establish enterprise status as market playersand enhance their internal dynamism, marketcompetitiveness and leadership.” “The reform ofstate-owned enterprises will preserve and appre-ciate state-owned capital, enhance the competi-tiveness of the state-owned economy and amplifythe functions of state-owned capital.”

In May 2016, he said at the 13th Meeting ofthe Financial Leading Group of the CPC CentralCommittee that: “China will promote the reformof state-owned enterprises”. “It should beemphasised that the disposal of ‘zombiestate-owned enterprises’ means the reform ofstate-owned enterprises and the strategic adjust-ment of the state-owned economy.”

In July 2016, he said in his speech at theNational Forum on the Reform of State-OwnedEnterprises that: “state-owned enterprises, whichare an important force that strengthens thecountry and safeguards the common interests ofthe people, must grow bigger and strongerrationally and emphatically and continuouslyenhance their dynamism, influence and resilienceto preserve and appreciate state-owned assets.China will unswervingly deepen the reform ofstate-owned enterprises, make efforts to innovatesystems and mechanisms, speed up the formationof a modern enterprise system, and activate andenergise the enthusiasm, initiative and creativityof all kinds of talent in state-owned enterprises”.

In October 2016, he said in his speech at theNational Working Conference on Party-Buildingof State-Owned Enterprises that: “state-owned


enterprises should not just be developed but welldeveloped. China will require all relevantdepartments and state-owned enterprises in allregions to adjust to the developments and chan-ges in the economy at home and abroad and inaccordance with the decisions and arrangementsof the CPC Central Committee on the reform anddevelopment of state-owned enterprises. Theyshould follow the policies that preserve andappreciate state-owned assets, enhance the com-petitiveness of the state-owned economy andamplify the functions of state-owned capital,deepen their reform and improve their opera-tional management, strengthen the supervision ofstate-owned assets and unswervingly makestate-owned enterprises bigger and stronger”.

In October 2017, he made a concise andsystematic exposition of issues concerning thereform of state-owned enterprises in his report tothe 19th National Congress of the CommunistParty of China (NCCPC): “China will perfect themanagement of state-owned assets; reform thestate-owned capital authorisation system; speedup the optimisation, structural adjustment andstrategic restructuring of the state-owned econ-omy; preserve and appreciate state-owned assets;impel state-owned capital to grow bigger andstronger and prevent the loss of state-ownedassets; and deepen the reform of state-ownedenterprises, develop a mixed ownership economyand foster world-class enterprises with globalcompetitiveness”.

Premier Li Keqiang has also spoken manytimes about the reform of state-ownedenterprises.

In March 2016, he said in his governmentwork report that: “China will promote develop-ment through reform and tackle firmly the mostdifficult problems affecting the quality and effi-ciency of state-owned enterprises; restructurestate-owned enterprises, especially those that aremanaged by the central government, throughinnovation and mergers; promote equity diversi-fication reform and carry out pilot projects tointroduce boards of directors, a professionalmanagement system, mixed ownership andemployee stock ownership; deepen the reform ofenterprise employment systems and explore and

establish a compensation system for high-leveltalent and managers through market-orientedrecruitment methods; accelerate the restructur-ing and formation of state-owned capital invest-ment and operational companies; transform thefunctions of state-owned asset supervision andadministrative institutions by means of capitalmanagement, and preserve and appreciatestate-owned assets; give greater autonomy tolocal government with regard to the reform ofstate-owned enterprises; and accelerate thedivestment of those state-owned enterprisefunctions unrelated to operations, solve problemsleft over by history, downsize state-ownedenterprises and enhance their corecompetitiveness”.

In May 2016, he said at a State CouncilExecutive Meeting that: “China will promotedevelopment through reform and will tackle thehardest problems to downsize centralgovernment-administered state-owned enter-prises and improve their quality and efficiency,and with the courage and determination to makeprompt and resolute decisions”.

In December 2017, he said at a State CouncilExecutive Meeting that: “China will implementthe arrangements identified at the 19th NCCPC,focus on deepening the reform of state-ownedenterprises and make efforts to preserve andappreciate state-owned assets”.

9.2.2 Use the 1+N Policy Systemto Reform State-OwnedEnterprises

In November 2013, the Decision of the CPCCentral Committee on Several Major IssuesConcerning Comprehensively DeepeningReform was released. On December 30 of thatyear, the Leading Group of the CPC CentralCommittee for Comprehensively Deepening theReform, under the leadership of General Secre-tary Xi, was formed. In August 2015, the CPCCentral Committee and the State Council jointlyissued the Guiding Opinions on DeepeningReform of State-Owned Enterprises. Policies onthe reform of state-owned enterprises wereintroduced within the framework of the GuidingOpinions.


A complete 1+N policy system has beencreated for the new round of state-owned enter-prise reform. “1” refers to the Guidance, which isthe overall idea behind the policy system. “N”refers to policies that cover such key areas asleadership of the CPC, the state-owned assetmanagement system, mixed ownership, classifi-cation of state-owned enterprises, supervisionand solving problems left over by history. “N”includes:

• the Opinions on Rationally Identifying andStrictly Standardising Remuneration and theBusiness Expenses of Heads of CentralGovernment-Administered State-OwnedEnterprises, deliberated and adopted inAugust 2014;

• the Plan of Reform of the CompensationSystem for Heads of Central Government-Administered State-Owned Enterprises,implemented in January 2015;

• the Several Opinions on Further DeepeningElectricity System Reform, introduced inMarch 2015;

• the Opinions on State-Owned Enterprises’Development of the Mixed OwnershipEconomy, introduced in September 2015;

• the Several Opinions on Upholding the Par-ty’s Leadership and Strengthening PartyBuilding in Deepening Reform ofState-Owned Enterprises, introduced inSeptember 2015;

• the Guiding Opinions on Encouraging andStandardising the Introduction ofNon-State-Owned Capital into ProjectsInvested in by State-Owned Enterprises,deliberated and adopted in September 2015;

• the Several Opinions on Reforming and Per-fecting the State-Owned Asset ManagementSystem, introduced in October 2015;

• the Opinions on Strengthening and Improvingthe Supervision of State-Owned Assets ofEnterprises and Preventing the Loss ofState-Owned Assets, introduced in October2015;

• the Circular on Printing and DistributingSupport Documents for Electricity SystemReform, implemented in November 2015

(related support documents are: the Opinionson Promoting the Reform of Power Trans-mission and Distribution Prices, the Opinionson Implementing the formation of ElectricityMarkets, the Opinions on Establishing andOperating Power Trading Institutions, theOpinions on the Orderly Liberalisation ofPower Generation and Consumption Plan-ning, the Opinions on Implementing Elec-tricity Retail Reform, and the GuidingOpinions on Strengthening and Regulatingthe Supervision and Administration of PrivateCoal-Fired Power Plants);

• the Guiding Opinions on the Definition andClassification of Functions of State-OwnedEnterprises, introduced in December 2015;

• the Guiding Opinions on Further Regulatingand Strengthening the Management ofState-Owned Assets of Administrative Insti-tutions, introduced in December 2015;

• the Interim Procedures for the Administrationof Stock Ownership and Dividend Incentivesof State-Owned Scientific and TechnologicalEnterprises, implemented in March 2016;

• the Circular of the State Council on Printingand Distributing the Work Plan for theDivestment of Functions Unrelated to theOperations of State-Owned Enterprises andfor Solving Problems Left Over by History,introduced in March 2016;

• the Regulations on the Supervision andAdministration of Transactions ofState-Owned Assets of Enterprises, imple-mented in July 2016;

• the Guiding Opinions on Restructuring andReorganising CentralGovernment-Administered State-OwnedEnterprises, implemented in July 2016;

• the Opinions on Establishing an Account-ability System for Illegal Operations andInvestments by State-Owned Enterprises,implemented in August 2016;

• the Opinions on the Employee Stock Own-ership Pilot Project of State-Held MixedOwnership Enterprises, introduced in August2016;

• the Implementation Plan for Improving theFunctional Classification Assessment of


Central Government-Administered State-Owned Enterprises, implemented in August2016;

• the Review of Policies and Suggestions onSupporting Reform of State-Owned Enter-prises, introduced in August 2016;

• the Circular on Doing a Good Job of StockOwnership and Dividend Incentives of Cen-tral Government-Administered Scientific andTechnological Enterprises, implemented inOctober 2016;

• the Opinions on the Pilot Implementation ofthe Functions and Powers of Boards of Direc-tors for Central Government-AdministeredState-Owned Enterprises, deliberated andadopted in December 2016;

• the Guiding Opinions on InnovatingGovernment’s Resource Allocation Methods,introduced in January 2017;

• the Regulations on the Supervision andAdministration of Investment by CentralGovernment-Administered State-OwnedEnterprises, introduced in January 2017;

• the Plan of the State-Owned Assets Supervi-sion and Administration Commission of theState Council (SASAC) for TransformingFunctions by Means of Capital Management,introduced in April 2017;

• the Guiding Opinions of the General Office ofthe State Council on Further Improving theCorporate Governance Structure ofState-Owned Enterprises, introduced in April2017;

• the Circular on Doing a Good Job of Declar-ing and Liquidating State-Owned CapitalOperation Budgets for the Divestment of theCentral Government-Administered State-Owned Enterprise Functions of Water,Power and Heat Supply and Property Man-agement for Employee Residential Areas in2017, introduced in April 2017;

• the Several Opinions on Deepening Oil andNatural Gas System Reform, introduced inMay 2017; and

• the Implementation Plan for the Transforma-tion of Central Government-AdministeredState-Owned Enterprises into a CorporateSystem, introduced in July 2017.

9.2.3 Steady Progress in PrioritiesFirst, the Ten Reform Pilots have been imple-mented since 2016. The 10 pilots were carriedout at central government-administered state-owned enterprises to create experience that canbe extended into other companies. The 10 pilotshad the following objectives:

(1) Reform the state-owned asset manage-ment system

State-owned capital investment and operationalcompany reform pilots: China National Cereals,Oils and Foodstuffs Corporation (COFCO), StateDevelopment & Investment Corporation (SDIC),Shenhua Group, Baosteel, Wuhan Iron and SteelCorporation (WISCO), China Minmetals Cor-poration (CMC), China Merchants Group(CMG), China Communications ConstructionCompany (CCCC), China Poly Group(state-owned capital investment company reformpilot) and China Chengtong and China ReformHoldings Corporation (CRHC, state-owned cap-ital operation company reform pilot).

Central government-administered state-ownedenterprise merger pilots: China State Construc-tion Engineering Corporation (CSCEC) andChina National Materials (Sinoma), China OceanShipping Company (COSCO) and China Ship-ping Container Lines (CSCL), and China PowerInvestment Corporation (CPI) and State NuclearPower Technology Corporation (SNPTC).

(2) Develop mixed ownership

Pilot mixed ownership reform in several keysectors: power, oil, natural gas, rail, civil avia-tion, telecommunications and the military.

The first batch comprises nine pilots, thesecond batch consists of 10 pilots and the thirdbatch comprises nine. The 28 pilots includeChina Unicom, China Telecom, China RailwayGroup (CREC), China Railway ConstructionCorporation (CRCC), China Railway Corpora-tion (CRC), China National Aviation HoldingCompany (CNAH), China Eastern Airlines,China Southern Airlines, State Grid Corporationof China (SGCC), China Southern Power Grid


(CSG), POWERCHINA, China Nuclear Engi-neering & Construction Corporation (CNEC),China Energy Engineering Corporation (CEEC),State Power Investment Corporation (SPIC),Harbin Electric Corporation (HE), ChinaNational Petroleum Corporation (CNPC), ChinaNational Offshore Oil Corporation (CNOOC),China Petroleum & Chemical Corporation(Sinopec), China State Shipbuilding Corporation(CSSC), China North Industries Group Corpo-ration (CNGC), China South Industries GroupCorporation (CSGC), China ShipbuildingIndustry Corporation (CSIC), Aero Engine Cor-poration of China (AECC), China AerospaceScience & Industry Corporation (CASIC), ChinaAerospace Science and Technology Corporation(CASC), Aviation Industry Corporation of China(AVIC), and China National Building Material(CNBM).

Pilots of employee stock ownership of mixedownership enterprises comprise third-level sub-sidiaries of Shenhua Group, China NationalMachinery Industry Corporation (Sinomach),China Baowu, COSCO, COFCO, CMG, ChinaEnergy Conservation and Environmental Pro-tection (CECEP), CNBM, China Academy ofBuilding Research (CABR), and CREC.

(3) Improve the modern enterprise system

Pilot to implement the functions and powers ofboards of directors: CECEP, CNBM, Sinopharm,Xinxing Cathay International Group, ChinaBaowu, SDIC and China General Nuclear PowerGroup (CGN).

Pilot for the market-based selection andemployment of managers: Baosteel, XinxingCathay International Group, Sinopharm, CECEP,SDIC and China Railway Signal & Communi-cation Corporation (CRSC).

Pilot to recruit professional managers: ChinaBaowu Group, Xinxing Cathay InternationalGroup and CNBM.

Pilot to reform emolument differentiation inenterprises: Scheduled for launch in 2018 by theMinistry of Human Resources and Social Secu-rity (MOHRSS).

(4) Prevent the loss of state-owned assets

Pilot for state-owned enterprise information dis-closure: COFCO, CSCEC, SPIC and ChinaSouthern Airlines.

(5) Solve the problems left over by history

Pilot the divestment of state-owned enterprisefunctions that are unrelated to operations andsolve the problems left over by history: This willbe carried out in selected provinces and cities.

Second, the merger and reorganisation ofcentral government-administered state-ownedenterprises is an important measure to optimisethe distribution of state-owned capital and adjustthe industrial sector. It is just one of the TenReform Pilots mentioned above. Six pilot enter-prises have completed their merger and reor-ganisation. They include CSCEC-Sinoma (ChinaNational Building Material, CNBM),COSCO-CSCL (China COSCO Shipping Group)and CPI-SNPTC (State Power Investment Cor-poration). In recent years there have been othermergers and reorganisations of state-ownedenterprises, such as CSR-CNR (CRRC),MCC-CMC, Sinotrans and CSC-CMG,HKCTS-CITS (China National Travel ServiceGroup Corporation), Sinolight-CNACGC (PolyGroup), Baosteel-WISCO (China Baowu) andShenhua Group-China Guodian (NationalEnergy Investment Group).

Third, excess capacity in the coal industry isbeing resolved. Capacity cutting by state-ownedcoal enterprises is an important part ofsupply-side structural reform. In July 2016, theState-Owned Assets Supervision and Adminis-tration Commission of the State Council(SASAC) identified the tools for solving excesscoal capacity in central government-administeredstate-owned enterprises. SASAC proposed that:(i) central government-administered state-ownedenterprises should cut capacity by 15% withinfive years and 10% within two years; and(ii) central government-administered state-ownedenterprises involved in the coal industry on anon-core basis should withdraw from the


industry—only professional coal enterprises andcoal power integration enterprises should remain.All the central government-administered coalenterprises achieved their capacity-cutting targetsfor 2016 and 2017. SDIC and Poly Grouphave transferred their coal businesses to ChinaCoal Group. In addition, local government-administered state-owned coal enterprises areactively cutting capacity and have achieved theircapacity-cutting targets for 2016 and 2017.

9.3 The Reform of State-OwnedEnergy Enterprises

9.3.1 The Idea Behind the ReformBased on a review of the speeches and policieson the new round of state-owned enterprisereform, the basic idea behind the reform can besummed up in the following six points:

First, ensuring national energy security wlllcontinue to be an important goal. China is amajor energy producer and consumer, with abalanced structure of supply and demand. Totaldemand is large and has been relatively stablefollowing the economic downturn, with lowgrowth expected in the years to come. There areobjective constraints, such as local resourceendowment and long-distance transport. Sea-sonal and partial shortages are, therefore, difficultto avoid. Ensuring national energy securityremains an important goal of this round of reformof state-owned energy enterprises. In the future,China’s energy supply system will be continu-ously optimised on the basis of local conditionsto ensure that the foundation of national energysecurity will not change.

Second, state-owned enterprises will becomebigger and stronger. General Secretary Xi hascontinually emphasised that China will makestate-owned enterprises and state-owned capitalgrow bigger and stronger. Scale is one of thecharacteristics of state-owned energy enterprisesand will remain so in the future. According to datafrom the National Bureau of Statistics, in 2015state-owned enterprises in the coal, petroleum,

chemical and power sectors accounted for 47.2%of state-owned industrial enterprise assets and40.2% of their employees. The aggregate assets ofstate-owned energy enterprises amounted to18.03% of the total assets of all industrial enter-prises. Central government-administered energyenterprises include China National PetroleumCorporation (CNPC), China Petroleum & Chem-ical Corporation (Sinopec), China National Off-shore Oil Corporation (CNOOC), NationalEnergy Investment Group (renamed after theShenhua Group-China Guodian merger), ChinaCoal Group, SPIC (after the CPI-SNPTCmerger),China Huaneng Group (CHNG), China HuadianCorporation (CHD) and China Datang Corpora-tion (CDT), as well as many localgovernment-administered state-owned energyenterprises that are a pillar of their local economy.These enterprises have good industrial founda-tions and advantages of scale, technology andmarket, reflecting the strategic pattern ofstate-owned capital in the energy industry. In thefuture, the issues of how to make centralgovernment-administered energy enterprisesstronger and bigger will be the focus of theirreform and development. The smooth progress ofthe pilots to improve central government-administered energy enterprises is an examplefor the reform and improvement of localgovernment-administered state-owned energyenterprises.

Third, the roadmap for improving state-ownedcapital in state-owned energy enterprises will becreated. The Guiding Opinions on Restructuringand Reorganising Central Government-Administered State-Owned Enterprises, whichwas implemented in July 2016, stipulates thatthese enterprises “will significantly improve theirsupport capabilities in the sectors that impactnational security, such as national defence,energy, transport, food, information and ecol-ogy”, and that they will “enhance their domi-nance in the key industries that affect the nationalinterest, people’s livelihoods and the nationaleconomy, such as major infrastructure, keyresources and public services”, and that they will


“drive industries like new energy, new materials,aerospace and intelligent manufacturing”.Specifically, the following efforts will be made:

(1) China will implement sole proprietorship orshareholding in fields like: water conserva-tion, hydropower and navigation-hydropowerintegration hubs in important river basins;natural monopolies like oil and natural gastrunk pipeline networks, power grids andnuclear power; and reduce excess capacity inthe coal industry;

(2) China will encourage central government-administered state-owned enterprises inpower, new energy and oil and gas pipelinesto fund specialist joint-stock platforms; and

(3) China will reorganise central government-administered state-owned enterprises in theupstream and downstream coal, power andmetals industries, which will provide a modelfor state-owned capital in the energy sector.

Fourth, state-owned energy enterprises will bereorganised into state-owned capital investmentcompanies. The function of these companies willbe to optimise the distribution of state-ownedcapital through the entry or withdrawal or flow ofstate-owned capital in the energy industry, and topool the advantages of state-owned energyenterprises and enhance their operational effi-ciency and international competitiveness. Thestate-owned capital investment company reformpilot is at SDIC and the Shenhua Group. The goalof the Guiding Opinions on Restructuring andReorganising Central Government-AdministeredState-Owned Enterprises is to “create a mecha-nism for the entry or withdrawal or flow ofstate-owned capital” and to “reorganise centralgovernment-administered energy enterprises intostate-owned capital investment and operationalcompanies”. Some local governments haveidentified the reform pilot of reorganisingprovincial government-administered energyenterprises, such as those engaged in the coalbusiness, into local state-owned capital invest-ment companies.

Fifth, state-owned energy enterprises will beencouraged to develop mixed ownership. The

development of mixed ownership is an importantmeasure to reform the state-owned capital man-agement system and the internal mechanisms ofstate-owned enterprises. The 1+N policy systemincludes special policy arrangements, such as theOpinions on the Development of the MixedOwnership of State-Owned Enterprises, whichwas introduced in September 2015, and theOpinions on the Employee Stock OwnershipPilot of State-Held Mixed Ownership Enter-prises, which was launched in August 2016. Themixed ownership reform of state-owned enter-prises is described in other documents as well.The Guiding Opinions on Restructuring andReorganising Central Government-AdministeredState-Owned Enterprises emphasises that Chinawill maintain state-owned capital’s control of keyindustries and sectors, while supporting the par-ticipation of non-state-owned capital. The Opin-ions on Deepening Electricity System Reform,introduced in March 2015, states that China will“steadily reform, liberalise and open electricityretail to private capital in an orderly manner”,“encourage private capital to invest in powerdistribution” and “gradually open power distri-bution investment to market participants thatmeet requirements, and encourage the develop-ment of distribution businesses based on mixedownership”. The Opinions on Deepening Oil andNatural Gas System Reform, introduced in May2017, states that China will “improve the cor-porate governance structure of state-owned oiland gas enterprises and encourage them todiversify their ownership structure and allowmixed ownership, if conditions permit”. In thecoal sector, Shenhua Group has been identifiedas one of the pilots for mixed ownership reformof central government-administered state-ownedenterprises.

Sixth, the supply-side structural reform ofstate-owned energy enterprises will be deepened.Downsizing state-owned energy enterprises is akey element of supply-side structural reform. Atpresent, it primarily involves three aspects.

(1) Tackling the hardest problems in the reformof state-owned energy enterprises. This pri-marily refers to deepening electricity and oil


and natural gas system reform. Relevantgovernment departments have producedsupport documents like Opinions on FurtherDeepening Electricity System Reform inMarch 2015 and Opinions on the Reform ofPower Transmission and Distribution Prices,Opinions on Creating Electricity Markets,Opinions on Implementing and OperatingPower Trading Institutions, Opinions on theOrderly Liberalisation of Power Generationand Consumption Planning, Opinions onImplementing Electricity Retail Reform,Guiding Opinions on Strengthening andRegulating the Supervision and Administra-tion of Private Coal-Fired Power Plants, andOpinions on Deepening Oil and Natural GasSystem Reform.

(2) Steadily implementing capacity cutting in thecoal and coal-fired power industries. Chinahas intensified capacity cutting in the coalindustry since 2016. Resolving excess coalproduction has become one of the key tasksin the reform of state-owned energy enter-prises. In February 2016, the State Councilissued Opinions on Resolving ExcessCapacity to Stop Losses and Develop theCoal Industry. Since then, support docu-ments on human resources, finance, safetysupervision, land, quality inspection, taxa-tion and environmental protection have beenpublished, and major coal-producing pro-vinces, municipalities and autonomousregions have identified their capacity-cuttingtargets, plans and measures. The GuidingOpinions on Restructuring and ReorganisingCentral Government-AdministeredState-Owned Enterprises of July 2016 stip-ulates that China will “reduce excess capac-ity and speed up the elimination of outdatedcapacity” in industries like coal. In July2017, 16 ministries and commissions jointlyissued Opinions on Promoting Supply-SideStructural Reform to Prevent and Resolve theRisk of Excess Coal-Fired Power Capacity,which started capacity cutting in thecoal-fired power industry. The documentstates that China will ensure power securitywhile “eliminating outdated capacity”,

“shutting down illegal projects” and “strictlycontrolling the scale of new capacity”; andthat China will “encourage large powergeneration groups to reorganise and integrateupstream and downstream enterprises in coaland power to unlock synergies”. Thecoal-fired power industry has identified itscapacity-cutting targets for the 13thFive-Year Plan (2016–20). These includestopping or suspending the construction of150 GW of coal-fired power generation andeliminating outdated capacity of more than20 GW.

(3) Solving problems left over by history anddivesting state-owned enterprises of func-tions unrelated to their operations. In March2016, China introduced the Circular of theState Council on Printing and Distributingthe Work Plan for Accelerating the Divest-ment of State-Owned Enterprise FunctionsUnrelated to Their Operations and SolvingProblems Left Over by History. The circularalso identified these two issues as one of theTen Reform Pilots.

9.3.2 Major ProgressProgress has been made in the reform ofstate-owned energy enterprises that have beenconducted in an orderly manner and in accor-dance with the six aspects of the basic idea, assummarised in Table 18.

9.4 Three Conclusions on the Reformof State-Owned EnergyEnterprises

9.4.1 The Key to the New Roundof Reform of State-OwnedEnergy Enterprises Isto Improve the Efficiencyof State-Owned CapitalInvestment in the EnergyIndustry

This round of reform of state-owned enterprisesfocuses on the state-owned capital managementsystem. Specifically, for state-owned energyenterprises, the goal is to increase the efficiency


Table 18 Summary of progress in the reform of state-owned energy enterprises

Aspect Progress

Ensuring national energy security The responsibility of ensuring energy supply and energy andtechnological reserves has been fulfilled

Making state-owned energy enterprisesgrow bigger and stronger

(1) The state-owned energy enterprises that have reorganised areoperating stably(2) Reorganisation of central and local government-administeredstate-owned energy enterprises will continue(3) Integration across the value chain has taken place, which represents atransformation of the industry(4) State-owned energy enterprises have been downsized throughmeasures like streamlining the business, eliminating outdated andinefficient production capacity and divesting state-owned enterprises ofunrelated operations(5) The modern enterprise system has been improved; the role of theParty has been activated and loss of state-owned assets prevented

Optimising the distribution ofstate-owned capital

(1) The idea of state-owned capital investment in different energy fieldshas been identified(2) Horizontal and vertical integration and the reorganisation ofstate-owned energy enterprises, such as the merger of Shenhua Groupand China Guodian, have started(3) SDIC and Poly Group have transferred their coal operations to ChinaCoal Group—a result of the policy of withdrawing centralgovernment-administered state-owned enterprises from coal if it is nottheir core business

Reorganisingstate-owned energy enterprises intostate-owned capital investmentcompanies

(1) Two central government-administered state-owned enterprises,SDIC and Shenhua Group, are in the state-owned capital investmentcompany reform pilot(2) Some local government-administered state-owned energy enterprisesare also involved in local state-owned capital investment companyreform pilots

Carrying out mixed ownership reform Mixed ownership reform has been carried out to varying degrees atsecond- and third-level subsidiaries of state-owned energy enterprises

Deepening supply-side structural reform (1) The documents on deepening electricity system reform and on oiland natural gas system reform have been introduced and a roadmap formarketisation has been released(2) The annual capacity-cutting plan for state-owned energy enterprisesin the coal industry has been oversubscribed for two years in a row(3) Capacity cutting has been promoted in the coal industry(4) Solving problems left over by history and the divestment ofstate-owned enterprise functions that are unrelated to operations havebeen accelerated. Some state-owned energy enterprises have alreadycompleted this work. For example, the initiative for CNPC and Sinopecto divest unrelated operations affects more than 2 million householdsnear the oil fields. In terms of the workload needed to divest water,power and heat supply and property management for employeeresidential areas, CNPC and Sinopec account for a third of the total ofall the central government-administered state-owned enterprises. Theprovincial government-administered state-owned energy enterpriseshave produced a schedule for this work. Some state-owned energyenterprises in Shandong, Henan, Hebei and Shaanxi have achieved theirtargets


of state-owned capital investment in the energyindustry. Under the new management system, theborder between the government and enterprisesis clearer. As a contributor of state-owned capi-tal, the government is not engaged in managingasset operations, which is the business of theenterprises, but in managing capital and contin-uously optimising the distribution of state-ownedcapital by leveraging liquidity and improving thereturn on state-owned capital. The reformaddresses three levels:

• the responsibility of government departmentsfor state-owned enterprise regulations, andthe relationship between the government andstate-owned enterprises, should be optimised;

• the corresponding internal reform ofstate-owned enterprises should be deepened;and

• government should delegate some manage-ment and investment powers to state-ownedenterprises, which in effect means decentral-ising some power. Specifically, forstate-owned energy enterprises, the govern-ment should optimise the distribution ofstate-owned capital in the energy industrythrough guarantees of state-owned capital forkey and strong sectors and withdrawal frominefficient areas to improve the return oncapital.

As part of the reform of the state-ownedcapital management system, state-owned energyenterprises need to carry out internal reforms,such as reorganising themselves into state-ownedcapital investment companies, establishing amodern enterprise system with internal mecha-nisms and opening up to mixed ownership. Thenecessity of reorganising state-owned energyenterprises into state-owned capital investmentcompanies should proceed on a case-by-casebasis. In the reform pilot of turning centralgovernment-administered state-owned enter-prises into state-owned capital investment com-panies, only two energy enterprises (SDIC andShenhua Group) are involved. For those

state-owned energy enterprises that transitioninto state-owned capital investment companies,their internal systems and mechanisms should bereformed in accordance with the newstate-owned asset management system. The rea-son for this is that the goal of the reform of thestate-owned capital management system is toimprove the return on investment of state-ownedcapital. The mixed ownership system reformpilot involves CNPC, Sinopec and centralgovernment-administered state-owned enter-prises in the power industry.

9.4.2 State-Owned Energy EnterprisesShould Become Biggerand Stronger

Making state-owned energy enterprises biggerand stronger is a realistic requirement fornational energy security and social stability.China is a major energy consumer, working inclose cooperation with the global supply marketin the three major fossil energy areas: oil, naturalgas and coal. It should be emphasised that energysupply is not only an economic issue but also asocial responsibility. First, state-owned energyenterprises shoulder the social responsibility ofensuring energy supply. Second, sincestate-owned energy enterprises have largeworkforces and the areas where they are locatedare often endowed with energy resources, theyshoulder the social responsibility of stabilisingemployment and promoting regional industrialrestructuring. Bearing this dual (economic andsocial) responsibility, state-owned energy enter-prises need to become bigger and stronger.Through years of development, they have laid agood foundation for growing bigger andstronger.

Growing stronger comes before growing big-ger, which suggests that the former is harder.State-owned energy enterprises have alreadybeen big, but this does not mean they are strong.Generally, they are subject to heavy historicalburdens, high interest rates on debt, poor use ofresources and low profit margins. Improvingreturn on investment of state-owned capital in the


energy industry means that the operational effi-ciency of state-owned energy enterprises must beimproved.

Therefore, the key to this round of reform ofstate-owned energy enterprises is to optimisetheir internal structure in business, staffing, assetsand capital, and strengthen their capabilities inmanagement, operation and investment to helpthem become bigger. Through optimisation andstrengthening, state-owned energy enterprisescan use their scale and industry advantages todevelop gradually into internationally competi-tive energy enterprises.

9.4.3 Many Difficulties Remainin the Reformof State-Owned EnergyEnterprises

This round of reform of state-owned enterprises,which focuses on improving the state-ownedcapital management system, is steadily makingprogress. Despite some achievements, consider-able difficulties remain.

First, there are institutional barriers to with-drawing state-owned capital from inefficientenergy assets. Characterised by their large sizeand diversified operations, state-owned energyenterprises have varying degrees of inefficientassets. The losses made by state-owned energyenterprises in these inefficient assets can bestopped by the state withdrawing its capital.Relevant support policies for system reform (bymeans of capital management) and supply-sidestructural reform (through capacity cutting) are inplace. However, withdrawing state-owned capitalfrom inefficient state-owned energy assets isdifficult. The difficulties include resettlingemployees, repaying debt and preserving assets.Once inefficient assets are removed, the reposi-tioning and resettlement of employees and debtrepayment should be handled in a timely manner.Thanks to the central government, local govern-ment and state-owned enterprises, the reposi-tioning and resettlement of employees is beingaddressed through various channels. However,the problem of debt repayment remains a diffi-culty. A debt may be shelved or borne by theparent company. But this also involves the

debt-owning banks, which makes institutionalprogress difficult. Besides, a market-based valu-ation of assets is hard to make. The value ofinefficient assets is low and they often createhuge losses for state-owned energy enterprises.However, the government requirement to pre-serve and appreciate the value of state-ownedassets means that their estimated value rarelyequals their market value, and their estimatedvalue is unacceptable to private capital.

Second, electricity system reform and oil andnatural gas system reform are slow-paced.Although both are industrial management systemreforms, they are closely related to the reform ofstate-owned enterprises because both industriesare dominated by state-owned capital. Bothinvolve the liberalisation of some business areas.The mixed ownership reform pilot involvescentral government-administered state-ownedenterprises in these two industries. The slowpace of the two industry reforms is driven pri-marily by three factors: (i) market liberalisationhas an impact on energy security; (ii) the influ-ence of the existing benefits structure on tradi-tional enterprises has been broken; and (iii) theChinese market system still requires continuousimprovement. These three factors are difficult tochange quickly and the implementation of thereforms will take time and governmentdetermination.

Third, state-owned energy enterprises lack theability to manage investment. State-ownedenergy enterprises were historically industrialgroups focused on production. Under the newstate-owned capital management system, they arerequired to maximise the investment function ofstate-owned capital. However, they lack not onlyhuman resources for and experience in capitalinvestment, but also the requisite internal man-agement system. An organisational structure canbe gradually established and optimised, butreforming investment mechanisms is difficult.

Releasing the dynamism of state-ownedenergy enterprises is an important means toimprove operational efficiency. Internal mecha-nism reform and large system reform comple-ment each other. Since the reform of thestate-owned capital management system has yet


to be fully implemented, the reform ofstate-owned enterprises is difficult to implement.Reform involves defining the responsibility ofstate-owned asset administrative departments, thedivision of labour between government depart-ments, and the government’s authorisation todelegate power to state-owned enterprises.

Fourth, mixed ownership reform is difficult toimplement. The reform pilot for mixed ownershipof state-owned energy enterprises involves sec-ond- and third-tier non-core subsidiaries and isdifficult to roll out at scale. The mixed ownershipreform aims primarily to make state-owned capitalopen to private capital, creating a mix ofstate-owned and private capital. Such a mix is notsimply adding or subtracting capital but integrat-ing different governance mechanisms. Private

enterprise might reject the capital managementsystem and mechanisms of state-owned enter-prises, while state-owned enterprises might notaccept the management system of private enter-prise. As things stand, institutional integration isthe biggest obstacle. Questions such as “Whichbusinesses should be open to private capital?” and“How should state-owned assets be valued andpriced?” are still unanswered. The businessesfavoured by private enterprise are not necessarilyopen to them, while those open to them are notnecessarily attractive to them. The asset prices,which are based on the government policy ofpreserving and appreciating state-owned assets,are likely to be higher than the expectations ofprivate capital. These are the real problemsunderlying mixed ownership reform.

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