It's a bit like trying to sell flood insurance in a dustbowl: In the depths of the worst power shortage to hit China since the mid-1980s, a growing number of energy industry analysts are worried, ironically, about a coming power glut.
Not surprisingly, their voices have been drowned out by all the dire news about the present energy crunch. Every week this summer has seen the announcement of some new and more drastic power-saving measure: factories shifting production to nights and weekends to alleviate peak time load on the overtaxed grid; mandatory paid holidays for some Beijing workers; five-star hotels, office towers and shopping centers told to keep air conditioners set to 26?C; the scenic lights on Shanghai's fabled Bund gone dark.
Estimated shortfalls for the summer months range as high as 40 gigawatts, over 10% the 385 gigawatts in total national capacity at the end of last year. Sizzling under a three-week-long, nearly nationwide heat wave, China broke its all-time record for one-day power consumption, using 6.406 billion kilowatt hours on July 21. That same day, Beijing, ordinarily protected from such measures, imposed its first brownout, a planned outage affecting some suburbs for 47 minutes. Brownouts and even unplanned blackouts have already been reported in 24 provinces and municipalities this year.
Even as they prophesy the coming floods, analysts agree that the present drought will continue for some time to come. The State Grid Corporation, the larger of China's two integrated grid operators, recently revised its earlier forecast which saw shortages, easing after the summer, with the situation improving next year and coming essentially back into balance in 2006. It now sees current constraints continuing and likely worsening into next year. Meanwhile, power demand growth has been phenomenal, increasing by 15% year-on-year in 2003, and by close to 16% in the first half of 2004.
Why, then, would anyone worry that supply (i.e. generating capacity) is in danger of outstripping demand?
On the supply side, that's easy: unprecedented new capacity is now under construction. All five major producers are plunging ahead with large-scale power projects that will bring another 37 gigawatts on stream, about one-half the total capacity of the UK, this year alone. Manop Sangiambut, China power analyst for CLSA Asia-Pacific, estimates the capacity of plants currently under construction or already green-lighted at 160 gigawatts, a 40% increase that will hit the market at a rate of 30 to 40 gigawatts per year. About 75% of that capacity is in coal-fired thermal plants, and most of the balance in hydro. But while this squeeze lasts, anything that can generate a kilowatt hour is back on the agenda, including nuclear power: two new nuclear facilities were approved in July, for hard-hit Zhejiang and Guangdong provinces, and more approvals are expected this year.
By any measure, 160 gigawatts is a lot of new capacity, but the roughly 10% annual capacity bump that this total represents is still shy of what's needed if China's energy demand continues on its current growth trajectory, right? Trouble is, say analysts, demand growth over the last two to three years has been an anomaly resulting from disproportionately heavy fixed-asset investment in a few key industries. "Over the last year, about 40% of the growth in power demand came from four sectors: steel, aluminum, cement, and chemicals, mainly plastics," said Scott Roberts, director of China energy for Cambridge Energy Research Associates. "All of these are much more power-intensive than other parts of the energy economy." The increasingly power-hungry character of economic activity in China is borne out in the numbers for 2003, when for every 1% increase in GDP was there was a 1.8% increase in power consumption.
That's clear enough in hindsight, but power demand growth is notoriously hard to predict. Investment in those sectors caught China's central planners completely off guard: they had assumed only a 3 to 4% annual increase in power demand for the current Five Year Plan (2002 – 2006). In the first year of the plan alone, demand grew by 10.8% on the previous year before shooting up faster still in the following 18 months. To bet on demand continuing at these levels, then, is to bet that investments and credit will continue to flow into steel plants and cement factories. Given that these are precisely the sectors that China's planners have singled out for a quick cooling, it's puzzling that China's major power producers are lining up to make that bet. If Beijing's macroeconomic policies have their intended effect, power demand growth should, after all, fall to only 8-9%.
No denying an oversupply
None of this comes as a surprise to Chinese independent power producers (IPPs). "There's no denying that an oversupply situation is on the horizon, but we do not plan to stop projects that have already been approved," said a Beijing-based manager at IPP Guodian, who would only give his surname as Yang. Perhaps they're right not to. Given the long lead times required to build a power plant and the difficulty in forecasting demand, regulators can easily oversteer, as they did following an electricity glut in the late 1990s. Following that shortage, the Ministry of Electric Power imposed a three-year moratorium on approvals for construction of new plants which, though imperfectly enforced, led directly to the current shortfall.
To power plant operators, a few years of oversupply isn't generally too worrisome. Power producers have relatively easy access to credit on favorable terms for new projects. "You can't run away with them, they throw off a lot of cash, and they're considered a strategic state asset," Roberts noted. Power producers can afford to take a longer view: the glut passes, generation picks up, and a few good years down the road will allow a plant to repay its loan, and then some.
Beijing-based independent energy consultant Jim Brock sees supply-demand volatility in the electricity sector as cyclical, describing a 10-year repeating pattern of alternating tight supply (the present crunch and earlier shortages in 1993-94 and 1983-84) and oversupply (1997-98 and 1987-1988). The shortages, he says, are typically the result of exuberant building in the first years of a Five Year Plan period, while the gluts are simply supply catching up. "Demand is local. If you want to build a factory in Shenzhen, you go to the local mayor, you put up a few million dollars, and in six months you have a factory," Brock explained. "But to build a power plant takes a billion dollars, three to five years, and needs to be approved in Beijing. Demand is a one-year lead; supply is a five-year lead. They'll always be out of sync."
No one denies better market-signaling in prices would go far toward flattening out some of the inherent volatility in the power market. "You want to get rid of this shortage? Let the economics work," suggested Brock. "Raise the price of electricity by 15 or 20% and the demand will go away really quickly. The same in three years: lower the price by 20 percent and all that supply will get sucked up."
It's not, of course, that simple. Power price reform in China involved a bona fide power struggle, pitting then-Premier Zhu Rongji against Li Peng, who as former Minister of Electric Power had an extensive patronage network in the ministry, the grids and power plants that it oversaw. As both a major state-run sector badly in need of reform and the personal fiefdom of Zhu's main political rival, power emerged as a primary battleground.
Zhu took substantial strides toward liberalizing its energy sector: he pushed through the separation of power generation from distribution, broke up the old generation monopoly into five competing providers, and even experimented, in some five provinces, with power pooling, a transparent, competitive system popularized in the US and some parts of Europe by which power generators bid prices into the grid to supply electricity for particular blocks of time.
Zhu's political triumphs were, however, only half the fight. Reformers trying to bring Chinese power pricing in line with world practices quickly ran into two problems. Unlike most developed markets, power prices charged to industry are higher than to residential users in China. Any meaningful increase in power prices to the average Zhou risks social unrest, and for little real gain; residential power use only amounts to about 12% of the nation's total. On the other hand, lowering prices for industrial users who account for well over 50% of demand simply takes cash out of the system and discourages investment in new capacity.
Pricing becomes an issue
Meanwhile, the entire system of pricing both the schedule of prices charged to end users by the grid operator and prices paid by the grid to power generators remains hopelessly complex and inconsistent, bearing little relation to the rest of the market, let alone supply and demand. Prices paid by grid operators, for example, are determined in negotiation with regulators and based largely on providers' costs. "You've got a dog's breakfast of pricing determinants out there," said Roberts. "Different plants, different equipment, different cost structures, different vintages, different loan structures and they all make for their own power prices."
Beijing's initial enthusiasm for power pooling, the first experiments in which began during a period of relatively balanced supply and demand in China, has cooled considerably in the wake of the California blackouts, which served as a grim warning that markets can fail. "The system has to be set up just right, otherwise one of two things happens," noted Roberts. "Either you destroy your returns by competing them away, and it's a race to the bottom, or people don't invest, and prices go up."
The State Energy Regulatory Commission has begun experimenting in some markets with tiered pricing, charging different rates for peak- and off-peak power use, mainly for residential and commercial customers, to reflect the higher value of kilowatts consumed by people going home from work and turning on their air conditioners. But for the most part, reforms have been back-burnered in light of the recent crunch: a shortage environment, after all, is not an ideal time to try to marketize prices. The current administration of Hu Jintao and Wen Jiabao, with its particular concern for consumer prices, has unsurprisingly shown little eagerness to take up price reforms under current conditions. Is the coming glut, then, a window of opportunity for reform-minded regulators to push through power pooling and other market- oriented reforms? Yes, according to Brock. "This time, when we come out of this shortfall situation, I suspect they will apply pooling with a vengeance. And they will say to the people crying glut, 'Easy: lower your price.'"
Sangiambut also expects that reforms will coincide with the supply surge. "We hear that they will wait until 2007 or 2008. If they were to do it now, prices would skyrocket." But reforms may not get any easier when the market is oversupplied. Looking again to the California example, regulators will be anxious lest price cuts kill any incentive for investment. Investors and developers, meanwhile, will fear for the safety of their returns.
What's the worst that could come of a glut, then? While Roberts notes China's "great capacity to muddle through," he fears nonetheless that falling power demand will compel producers to cut costs however possible and that the first victim will be the environment. "In places where there is a lot of dirty coal burned in dirty ways, environmental standards are likely to fall because the state no longer has the ability to enforce emissions fees." With no investment in desulphurization capacity, that means increased SO2 emissions and acid rain. "The follow-on from that is a few years down the road, where you've got industrial distress these companies don't have the revenue that they thought they did and they don't invest in the market, so when there's a new cycle of demand they're caught short again."
And so the cycle of famine-and-feast continues, with power supply and demand never quite in balance. That, says Jim Brock, is the nature of the beast. "The volatility is an attribute of the growth rate just like Beijing's traffic. People complain that the traffic is horrible. But the economy is booming. What do you expect? You want no traffic? Shut down the economy. Sit in the traffic and enjoy it. This is what success feels like."
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