How Provincial Favoritism Hinders China’s Energy Transition, Driving Up Costs and Carbon Emissions?

Provincial favoritism in China’s energy sector, driven by local protectionism, impedes efficient power generation, inflates costs, and contributes to higher carbon emissions, hampering the country’s transition to cleaner energy sources.

Image depicting China's energy transition on a provincial level.

China’s Energy Challenge: From Coal Reliance to Greener Solutions

China’s heavy reliance on coal has led to a significant environmental burden. With the power sector accounting for 43 percent of CO2 emissions linked to energy use and contributing to air pollution and public health issues, a shift towards more sustainable practices is imperative.

In 2015, China embarked on a journey of power market reforms to address these pressing concerns and enhance power generation efficiency. These reforms targeted the monopolistic transmission and distribution networks, introducing stricter oversight and price regulations. Simultaneously, the competitive landscape was expanded to include the non-monopolistic segments of generation and retail. The overarching goal was to establish ‘economic dispatch’ within the generation sector – a practice that prioritizes efficient capacity utilization. This involves favoring power sources that use less expensive or lower quantities of fuel, thereby reducing both costs and emissions. Less efficient sources, relying on costly fuels or consuming higher amounts, would only be tapped when necessary. This approach promised cost savings and a significant reduction in emissions.

However, the complete transition to economic dispatch was only partially successful, giving rise to a hybrid system known as ‘quota + economic dispatch.’ Under this system, some generations were pre-determined, while others were left to market dynamics. At the close of each year, provincial governments provided guidelines for power generation in the upcoming year, assigning generation quotas to each unit within the province. Power demand exceeding these quotas was then met through competitive means using the economic dispatch system.

This evolving landscape reflects China’s ongoing efforts to strike a balance between centralized planning and market forces, aiming to create a cleaner and more efficient energy future.

Why Do Quotas Persist Despite Urgent Efficiency Needs?

The pressing need for efficiency improvements and transition in China’s energy sector begs the question: Why do outdated quotas still hold sway? Moreover, how does this intricate issue impact the electricity markets? A recent study, co-authored by experts from Renmin University of China and Lawrence Berkeley National Laboratory and published in Nature Energy, delves into these difficulties.

Boosting Efficiency

One pivotal objective of China’s energy sector reforms was to enhance efficiency. Before these reforms, an alarming pattern emerged—inefficient power generators, guzzling substantial coal amounts, outperformed their more efficient counterparts. The reformative measures triggered a positive change, primarily propelled by economic dispatch mechanisms. This led to more efficient coal power plants flexing their muscles in the market, yielding increased power generation.

Quotas and Their Efficiency Impact 

However, quotas remain an enigma, partially due to the influence of local protectionism. Enterprises under local government jurisdiction (local state-owned enterprises or local SOEs) consistently exhibit lower efficiency than their central government-owned counterparts (central SOEs). This disparity persists even after the reforms. For instance, in five southern provinces—Guangdong, Guangxi, Yunnan, Guizhou, and Hainan—central SOE coal power plants produced a kilowatt of power at 308.7g of standard coal before reforms and 305.6g after.

Conversely, local SOEs reported 317.4g and 311.8g, respectively. Intriguingly, a closer analysis of quotas unraveled a startling trend: smaller, less efficient plants under the local government’s purview received more operational hours than their larger, more efficient central SOE counterparts (illustrated in the chart). Between 2016 and 2019, central SOEs in Guangdong received an average of 200 hours less of generation allocation each year, effectively undermining the potential efficiency gains that an open market could foster.

The Local Quandary

Protectionism and its Motivations China’s provincial structure translates into distinct power markets, each governed by its own set of quotas allocated by provincial authorities. This scenario lays the groundwork for local protectionism. Revenue generated by local enterprises, particularly local SOEs, directly fills local government coffers. In contrast, earnings from central SOEs are channeled to the central government via the State-owned Assets Supervision and Administration Commission.

This fiscal arrangement predisposes provincial governments to favor local enterprises, especially local SOEs, to stimulate regional economic growth and enhance the performance records of local government leaders. Consequently, local enterprises strive to influence local regulators, aiming for preferential treatment such as reduced fuel procurement costs and relaxed oversight. This symbiotic relationship between local firms and regulators becomes entrenched. Meanwhile, central SOEs face constraints, and local enterprises lack incentives to prioritize efficiency enhancements.

Image depicting China's energy transition on a provincial level.

Counting the Costs of Protectionism: How Local Bias is Holding Back China’s Energy Progress

Have you ever wondered about the unseen losses that protectionism can cause? Let’s take a look at Guangdong’s electricity market in 2018. If the focus had been on economic efficiency, we could have witnessed a significant boost in power coming from highly efficient coal plants. This shift would have slashed carbon emissions by a whopping 3.1 million tonnes and saved a staggering 7.3 billion yuan (equivalent to around US$1.1 billion).

However, due to the use of quotas, the story took a different turn. Less efficient coal and pricey gas power plants generated electricity that otherwise would have been sourced from more efficient alternatives under an economically optimized system. The result? Actual emission reductions were only 1.5 million tonnes, and cost savings amounted to just 4.1 billion yuan. In simple terms, almost half of the potential benefits were lost in the process.

So, how can we turn this around? The key lies in putting an end to protectionist practices. Right now, renewable energy in China doesn’t compete primarily on price; instead, it’s granted priority when generating power. This approach means renewables are used first, and only after that do other power sources, based on their pricing, come into play. However, this strategy doesn’t motivate renewable energy operators to improve efficiency.

In 2015, reforms were introduced to prioritize renewables like wind, solar, and bioenergy. Local governments were mandated to include these capacities in their annual generation plans, with specific regional and provincial power transfer ratios. While this helped speed up the adoption of renewables, it didn’t necessarily encourage efficiency or cost reduction improvements within the renewable energy sector.

To drive progress, it’s time to eliminate the preference for inefficient local companies over their more efficient counterparts. Research by China Dialogue suggests a potential solution: creating larger regional or national electricity markets. Picture this – a national dispatch market that minimizes costs and maximizes profits nationwide. This approach would allocate resources efficiently across the country, facilitated by interconnections between provinces. Such a market would level out the disparities in available resources among regions, making it easier for them to strike deals and utilize the most efficient power sources.

Take the example of Guangdong in southern China. This region needs more renewable energy sources, mainly hydropower, despite having substantial power demand. However, the current provincial market structure makes it difficult for Guangdong to tap into the clean and affordable power available from regions like Yunnan and Guizhou. A national market would break down these barriers, encouraging Guangdong to import power from other provinces if it’s more cost-effective and environmentally friendly. It would also reduce local but inefficient power generation.

Given China’s unique circumstances, China Dialogue suggests a compensation scheme to assist key stakeholders, including local companies, in transition. While protecting local interests sometimes leads to inefficiency, these firms are vital in stabilizing local power supply, particularly during peak demand periods. It’s crucial to avoid a sudden shock and ensure a gradual shift by phasing out quota arrangements while offering support and incentives for improvements.

In essence, it’s time to rethink the protectionist approach and pave the way for a more efficient and sustainable energy landscape in China.