Paving the Way for Energy Evolution: China’s Innovative Approach to Power Sector Transformation

This article unfolds the narrative of China’s energy evolution, spotlighting a groundbreaking development introduced on November 10th—the “coal capacity-payment mechanism.” Departing from traditional payment models, this mechanism strategically positions coal power plants as vital supporters of variable renewable energy sources. As we explore the intricacies of China’s energy landscape, characterized by a rapid surge in electricity demand, regional coal dependence, and inflexible energy markets, we dissect the implications of this innovative policy, questioning its potential impact on fostering a diverse and sustainable energy mix.

Windmills symbolizing China's innovative energy evolution with the coal capacity-payment mechanism, fostering sustainable power sector growth.

China’s Coal Capacity-Payment Mechanism

As the global energy landscape undergoes unprecedented transformations, China emerges as a trailblazer, confronting unique challenges with innovative solutions. Recent developments in the nation’s power sector signify a paradigm shift, strategically positioning coal power plants as essential support for the increasing influence of variable renewable energy sources.

In a bold move on November 10th, China unveiled the “coal capacity-payment mechanism,” diverging significantly from conventional payment models. Unlike the traditional pay-for-electricity structure, this mechanism involves fixed payments to coal power plants based on their capacity, marking a pivotal moment in the trajectory of the energy sector.

The primary objective behind this groundbreaking scheme is to transform the coal sector into a reliable backup for variable renewable energy, facilitating a smooth transition towards a low-carbon energy system. However, this innovative design is not without its challenges and critiques, prompting in-depth inquiries into its potential impact on costs, grid reliability, and the speed of renewable energy assimilation.

While China shares commonalities with other nations in its transition to new energy sources, its situation remains unique. Three key factors set China apart, distinguishing it from European countries further along in the clean energy transition.

Firstly, China grapples with a rapid surge in electricity demand, fueled not only by economic growth but also by the compounding effects of climate change. Instances of heightened electricity demand during heatwaves in 2022, coupled with drought-induced constraints on hydropower output, underscore the complexity of the challenges.

Secondly, the majority of Chinese regions heavily rely on coal power for the majority of their electricity supplies, lacking a low-cost alternative like natural gas to support variable wind and solar generation. Even with retrofits, coal power plants prove less flexible than their gas-fired counterparts, bringing additional costs to operate them flexibly.

Thirdly, the design of China’s energy markets prioritizes mid- to long-term power contracts, inhibiting flexible trading of electricity based on short-term market signals. This inflexibility in power trading between provinces encourages locking in more generation capacity locally, hindering the reliance on regional reserves. 

Experts from Energy Foundation China suggest that unlocking short-term flexibility through spot markets and regional trading could facilitate a more cost-effective transition to clean energy.

NDRC’s Notice: Key Details and Potential Pitfalls

China’s response to these challenges materialized on November 10th through the introduction of the coal capacity-payment mechanism. This scheme, led by the National Development and Reform Commission (NDRC), entails monthly payments to coal plants based on their capacity. Provinces with a higher share of low-carbon energy receive varying rates, reflecting the intricacies of regional energy landscapes.

However, the mechanism’s exclusivity to coal-fired power plants raises questions about its effectiveness in fostering a diverse energy mix. The absence of provisions for technologies such as energy storage, demand response, or renewables paired with storage leaves a void in the policy framework.

The NDRC’s notice outlines key details, including fixed monthly payments, varying rates for provinces with a higher share of low-carbon energy, and penalties for plants failing to meet flexibility, efficiency, or environmental standards. The policy, while innovative, raises concerns about potential financial distress at state-owned power companies and supporting banks due to low coal plant utilization.

Despite its potential drawbacks, coal capacity payments are viewed as a pragmatic solution to the financial challenges faced by coal plants. The urgency to address financial losses aligns with provincial mandates to bolster coal for energy security, necessitating a swift resolution to support major power-sector players.

However, the exclusive focus on coal-fired power plants prompts a critical examination of the broader policy landscape. The absence of discussions on ‘technology-neutral’ capacity markets, which embrace various generation technologies, raises questions about the long-term sustainability and adaptability of the current approach.

Similarly, the lack of capacity mechanisms incorporating payment for performance, prioritizing fast-response technologies like batteries over slower ones like coal plants, diverges from international practices. In Europe and North America, such practices have successfully opened up capacity markets to cleaner technologies, reducing costs and promoting innovation.

The simplicity of a flat, coal-only payment, as opposed to a market-based or technology-neutral approach, has its justifications, as articulated by Yu Hongguang at Guotai Junan Securities. However, this approach deviates from the vision outlined in the NDRC’s 2022 document, calling for a more flexible, market-oriented design by 2025.

Global experiences with capacity markets and payments underscore their significance and challenges. While regions worldwide adopt them to include diverse technologies and prevent overinvestment, they also face criticisms. Concerns about over-investment in capacity at the expense of other reliability solutions highlight the delicate balance needed.

Positive examples from the PJM Interconnection in the US showcase how market-based capacity payments can drive the energy transition forward. Demand response and aggregation of smaller resources, offering reliability services at lower costs, underscore the potential benefits of a diversified energy market.

The focus on technology openness in the US, with national rules encouraging extra compensation for fast-response technologies, echoes the need for adaptability in capacity markets. Energy storage technology’s success in the UK, winning around 10% of annual capacity auctions, demonstrates the potential for integrating cleaner technologies into market designs.

Striking the right balance is crucial, as highlighted by EU regulations requiring temporary adoption of capacity schemes based on identified inadequacies. Germany’s capacity reserve, activated when needed, prevents capacity payments from distorting spot market prices, showcasing a nuanced and adaptable approach.

As China navigates its energy transition, signs of openness to more climate-friendly designs emerge, such as Shandong’s inclusion of energy storage in eligible capacity payments. National policies often reflect best practices at the provincial level, suggesting potential contributions to a more technology-neutral approach.

In the evolving narrative of China’s energy story, the weeks following the new capacity-payment policy release may hold clues to future developments. As spot market pilots gain experience and the country moves towards a national power market design for 2025, introducing market-oriented components into the capacity-payment design remains a possibility.

These measures are crucial to ensure the low-carbon energy transition remains on track, balancing energy security with economic costs for society. China’s journey unfolds as a dynamic canvas, offering lessons and insights for the global community navigating the intricate landscape of energy transition.