China's economic reforms promise big changes for energy sector
A shift to market pricing and a new focus on environmental protection will produce new winners and losers
China's leadership is pushing major changes to the country's energy sector as part of wide-ranging economic reforms that could re-shape the landscape for players across the industry over the coming years.
As part of the measures, the industry is expected to see more competition, a shift to market-driven pricing for fuel and natural gas and a greater emphasis on environmental protection, according to reforms outlined in November following the Communist Party's Third Plenum meeting.
Some of the most significant changes to come will be driven by Beijing's efforts to strike a new balance between environmental protection and economic growth. Environmental protection has always received plenty of lip service from China's leaders, and the country has, on paper at least, stringent environmental and emissions regulations. But in practice local officials have mostly ignored the rules. The tacit understanding being that worsening air and water pollution and rapidly rising carbon dioxide (CO2) emissions were seen as a regrettable but inevitable cost of the country's economic rise.
The Third Plenum offered the most concrete evidence yet that mindset is changing. Perhaps most crucially, Beijing has pledged to change the way it evaluates the performance of local officials. In the past, local officials were judged almost solely on their ability to promote economic growth. Local cadres looking to move up the ranks knew that above all else they had to deliver strong economic growth. That singular focus on top-line GDP figures, though, produced both distortions in the economy and wrought environmental degradation that will take decades to clean up.
Beijing, though, says it will now take a more balanced approach to balance economic growth with environmental performance, local worker conditions and other social and environmental factors. "We believe the two overarching trends that will drive China's transition to a more environmentally sustainable economy will be the rise of the middle class, and China's economic rebalancing," say Laban Yu and Joseph Fong, analysts at Jeffries, an investment bank. "We believe China is committed to facing its water and air pollution, climate change, habitat and other environmental challenges head on."
President Xi Jinping has pledged to move the economy away from the investment-driven growth model that has characterised its three decades of explosive economic expansion to a more sustainable model focused on services and consumption.
The Party also needs to make the changes to maintain legitimacy with China's growing middle class, a segment of society that is growing increasingly wealthy and environmentally conscientious. Earlier this year the southwestern city of Kunming saw a successful high-profile protest, largely led by middle-class Chinese, against a proposed oil refinery.
The smog that hangs heavy over much of China's more prosperous eastern provinces is also a source of growing outrage. One study found that air pollution in northeast China had cut life expectancy in the region by five years. The case of an eight-year-old Beijing girl diagnosed with lung cancer drew widespread calls for action. Pollution, more than corruption, a growing wealth divide and labour disputes, is increasingly driving social unrest.
The shift is expected to result in wide-ranging policy changes at the local and national level that will largely be beneficial to renewable energy and natural gas while hurting coal and heavy industry.
Some of the changes have already started. Beijing, for instance, has announced a raft of ambitious measures aimed at reducing air pollution that could have wide-ranging effects. The city plans to limit the number of cars on the road, eventually bringing annual growth in new cars down to nearly 0% later this decade when the total number of cars in the city reaches 6 million, up from around 5.35 million now. The city has also clamped down on the construction of new coal-fired power generation plants and has said it hopes to get more of its energy and heat from the use of natural gas. Other cities have made similar pledges to reduce air pollution.
At national level, Beijing increasingly sees the introduction of market forces into the energy sector as an important part of addressing some of the country's most pressing environmental problems.
The country, for instance, has rolled out its first carbon emission trading scheme earlier this year and is expanding the programme to regions around the country, including Beijing and Shanghai. "While there are still challenges ahead for China, the regional carbon markets could set the foundations for a strong national carbon trading market that would be the biggest in the world - and that would help transform China's economic development towards strong, sustainable, green growth," Changhua Wu, China director at the Climate Group, said.
Beijing is also expected to move towards market-driven energy prices, replacing the long-held central planning system. That would almost certainly see prices for refined fuel products such as gasoline and diesel rise as well as natural gas.
That would be good news for China's big three state oil companies, PetroChina, Sinopec and China National Offshore Oil Corporation (Cnooc), which are expected to see their bottom lines boosted by fuel-price liberalisation. "The energy sector will benefit from the market-oriented reforms," Gordon Kwan, an oil and gas analyst at Nomura, an investment bank, said in a research note.
Beijing's energy price controls have long made the state oil companies' refining and natural gas businesses loss making, though recent changes to lift prices have helped return those businesses to profitability in recent months.
Sinopec and PetroChina, for instance, have benefited from changes to domestic fuel pricing this year that raised prices at the pump and allow the government's economic planning body to change prices every 10 days to more accurately reflect changes in international crude prices. Both Sinopec and PetroChina's refining businesses returned to profit this year following the changes. Similarly, a 15% rise in natural gas prices to around $8.90 per million British thermal units earlier this year helped lift PetroChina's natural gas business into profitability.
Beijing appears determined to go further towards full price liberalisation. "We expect the government will enable PetroChina and Sinopec to set their own retail fuel prices. This will improve domestic pricing transparency and increase refining margins," said Kwan. Similar changes are seen for natural gas prices, with many analysts expecting another significant increase in natural gas prices in the first half of 2014.
Sinopec and PetroChina are also expected to benefit from a move towards the implementation of cleaner burning gasoline and diesel standards, known as Phase IV. The move has been long delayed, but is finally expected to take effect in early 2014.
Allowing prices at the pump to rise, it is hoped, will encourage refiners to invest in the infrastructure upgrades and technology needed to produce cleaner-burning gasoline and diesel. Beijing has pushed for more stringent environmental standards in recent years, passing a number of new regulations that aim to bring fuel standards up to European levels. But refiners have resisted making the investment needed to meet those standards, arguing they didn't have the cash to do so.
Higher natural gas prices, meanwhile, are seen as necessary to spur new investment to supplying the domestic market. Natural gas makes up only around 5% of China's energy mix, and the government wants that to rise to around 12% by 2020. But low natural gas prices have historically made the business unattractive to investors. As a result investment has gone elsewhere and China is faced with recurring natural gas shortages. Policy makers are keen to see that change.
Higher prices, it is hoped, will spur new investment in developing China's domestic resources, particularly shale gas, coal-bed methane and offshore reserves.
Domestic gas prices have been set below international prices, so the more gas Chinese companies import the more money they lose. As a result, there remains a large gap between the volumes of long-term supplies contracted by Chinese compared to expected demand if gas is going to play a significant role in meeting future energy demand. A significant rise in domestic natural gas prices could spur a new wave of long-term liquefied natural gas and pipeline deals. It could also provide the push needed to complete a long delayed supply deal with Russia's Gazprom, where a disagreement over price has been the major stumbling block.
Gas is expected to play a role in crowding coal out of the energy mix, but it could also make significant inroads into the transport sector. Analysts at Deutsche Bank reckon investment in natural gas vehicle and fuelling equipment and infrastructure will total 150bn yuan ($24.6bn) between 2013 and 2017, over which time more than 500,000 new natural LNG-fuelled trucks and buses and 2.7m compressed natural gas vehicles will hit the road. Even with a rise in natural gas prices, the economics of natural gas in the transport sector will remain attractive, Deutsche Bank says.
Not that the task of liberalising energy prices will be easy. It will require significant political courage from Beijing. Although a rise in energy prices is expected to provide a host of environmental benefits by, for instance, encouraging more efficient use, and will boost the bottom line at state oil companies, it will also be a difficult pill to swallow for many.
Artificially low energy prices have been a crucial ingredient in China's economic success over the past three decades. China's vaunted export machine has been fueled by cheap energy and low-cost labour, which has given manufacturers a major advantage over their US and European competitors. Now manufacturers face higher energy prices at the same time their US competitors are seeing lower prices because of the steep fall in energy prices brought on by a surge in new shale gas supplies. Consumers, weaned on very cheap coal for heating and electricity and suppressed prices at the pump, may also have to adjust to higher prices.
One area of potential reform that the Third Plenum meeting left unclear is the future role of state-owned companies in the energy sector. The Party reiterated state-owned enterprises' (SOE) central role in the economy, but also promised to put profit over politics at the companies and introduce more competition into sectors, such as energy, where monopolies existed.
Prior to the meeting, many saw a high-level corruption crackdown at PetroChina as potentially setting the stage for a major re-organisation of the company. The initial Third Plenum document did not outline specific plans for structural reform of PetroChina or any other state-owned companies, but some still see that as part of the plan.
"We believe PetroChina will be the poster boy of SOE reform. The unprecedented corruption purge of senior management is not just an investigation into PetroChina, in our view, but a manoeuvre against entrenched SOE interests," said Jeffries analysts Yu and Fong. "We believe PetroChina may become a 'pilot project' for SOE reform with experiments in "mixed ownership" structures and SOE-private sector partnerships - all geared towards optimising efficiency, improving management, reducing corruption and maximizing value."
The task of following through on the reforms outlined will fall to a high-level committee being set up for the task. Beijing has balked on making reforms widely seen as necessary in the past, and implementation, as ever will be crucial. But there are signs that this time is different. Xi appears determined to push through reforms on a scale not seen since Deng Xiaoping set China on a course of historic economic expansion 30 years ago.