China is heavily reliant on coal for power generation. The power sector accounts for 43% of all energy-related CO2 emissions, as well as causing air pollution and other public health impacts. To address those issues and make power generation more efficient, the country launched a round of power market reforms in 2015. These focused on tougher oversight and price-setting for transmission and distribution networks, which were monopolies, while opening up the non-monopolistic generation and retail ends to competition.
The reforms aimed to introduce “economic dispatch” at the generation side. This would prioritise the use of more efficient capacity, which either uses less expensive fuel or consumes less of it, thereby reducing emissions. As a result, less efficient sources that rely on costlier fuel or consume it in greater amounts would only be tapped when essential. This approach would not only reduce costs but also curtail emissions.
But the switch to economic dispatch was incomplete and a hybrid “quota + economic dispatch” system formed: some generation was determined in advance, some left up to the market. At the end of every year, provincial governments would produce guidance for power generation over the coming 12 months, with every generating unit in the province given a generation quota. Only power demand outside of those quotas was met competitively, via the economic dispatch system.
So why do those quotas remain when efficiency improvements and transition are so urgent? And what impact does this have on the electricity markets? A paper recently published in Nature Energy, which I co-authored with fellow researchers at Renmin University of China, and Lawrence Berkeley National Laboratory, has examined these issues.
Do quotas increase efficiency?
One of the aims of the reforms was to increase efficiency. Prior to the changes, there were cases of inefficient generators, which burned lots of coal, running more than efficient ones, which burned less. The reforms helped improve that situation, mostly due to economic dispatch, with more efficient coal power plants competing on the market and generating more power.
Quotas, meanwhile, are in part a product of local protectionism. Generation by enterprises owned by local government (which we will call local state-owned enterprises, or local SOEs) is significantly less efficient than that by SOEs owned by central government (central SOEs). This holds true both before and after the reforms. In five southern provinces (Guangdong, Guangxi, Yunnan, Guizhou and Hainan), central SOE coal power plants produced a kilowatt of power for the equivalent of 308.7g of standard coal before the reforms, and 305.6g after. For local SOEs, those figures were 317.4g and 311.8g. But an analysis of the quotas found that the smaller and less efficient plants owned by local government were allocated more hours of operation than the larger and more efficient central SOEs (see chart). Between 2016 and 2019, central SOEs in Guangdong were allocated an average of 200 hours of generation less per year, on average. That undercut the potential efficiency gains a freer market could have provided.
In China, each province works as a separate power market, with provincial governments allocating quotas. This makes local protectionism a risk. Income from local enterprises, especially local SOEs, goes directly to local government accounts, while that earned by central SOEs goes to central government, via the State-owned Assets Supervision and Administration Commission. Provincial governments are therefore motivated to prefer local firms, and local SOEs in particular, both to aid local economic development and improve the showing of local government leaders. Local firms, in turn, are motivated to influence local regulators and win better treatment, such as lower procurement costs of fuel or more relaxed oversight. This creates a situation of mutual benefit to local companies and regulators. Central SOEs are squeezed out and local firms have no incentive to become more efficient.
Losses arising from protectionism
We quantified the losses due to protectionism. Calculations for Guangdong’s electricity market in 2018 show that full economic dispatch would have resulted in more power coming from efficient coal power plants, cutting carbon emissions by 3.1 million tonnes and saving 7.3 billion yuan (US$1.1 billion). But the use of quotas meant some inefficient coal power plants and expensive gas power plants generated electricity that would have been sourced elsewhere under economic dispatch, squeezing out the more efficient alternatives. This meant actual emissions reductions were only 1.5 million tonnes and savings only 4.1 billion yuan. In other words, about half of the potential benefits were wasted.
Ending protectionism
Currently, renewable energy in China is not competing on price, but being given priority generation rights. In other words, renewable generation must be used first, and only then do other sources of power come into play, competing on price. The author holds that this does not encourage renewables operators to make efficiency improvements.
The 2015 reforms prioritised renewables such as wind, solar and bioenergy, ordering local governments to ensure this capacity was accounted for in annual generation plans, with a ratio for use of renewable energy in regional and provincial power transfers. That helped speed up the roll out of renewable energy, but it did not encourage efficiency or cost improvements in the renewables sector.
Provincial favouritism of inefficient local firms over more efficient alternatives must be ended. Our research found that creating larger regional electricity markets, or even a single national market, would achieve this. A national dispatch market would seek to minimise costs and maximise profits at the national level, allocating resources nationwide, with interconnectors between provinces. A national market would also even out imbalances in natural endowments across provinces and make cross-province deals easier, allowing for more use of the most efficient sources of power.
For example, in southern China, Guangdong lacks renewable energy (particularly hydropower) but has huge demand for power. The barriers associated with the existing provincial markets make it hard for Guangdong to use the cheap and clean power available from places like Yunnan and Guizhou. A national market would remove those restrictions, encouraging Guangdong to buy power in from outside the province if it was cheaper and cleaner, and cut back on local but inefficient generation.
Given China’s particular circumstances, we also recommend a compensation scheme to help certain key stakeholders, such as local firms, make the transition smoothly. While local protectionism reduces power sector efficiency, local firms do have strengths in terms of ensuring security and stability of local supplies, particularly during peaks and troughs in demand. Those companies must not suffer a hard landing. Rather, a smooth transition must be realised by gradually phasing out the quota arrangements while offering support and incentives for efficiency improvements.
