China - Power sector reform : toward competition and improved performance

Report No. 12929-CHA China Power Sector Reform: Toward Competition and Improved Performance September 15, 1994 Industry and Energy Operations Division China and Mongolia DeDartnient East Asia and Pacific Regional Office Document of the World Bank MILCC)G RAPHICS Report No: 12929 CHA Type: SEC  CURRW-NCY EQUIVALENTS Currency Name - Renminbi (RMB) Currency Unit = Yuan (Y) Y1.00 = $0.11 $1.00 Y 8.50 FISCAL YEAR January 1 to December 31 WEIGHTS AND MEASURES km Kilometer (= 0.62 miles) kWh Kilowatt hour (= 860.42 kcals) GWh Gigawatt hour (1,000,000 kilowatt hours) TWh Terawatt hour (1,000,000,000 kilowatt hours) kW Kilowatt (1,000 watts) MW Megawatt (1,000 kilowatts) GW Gigawatt (1 million kilowatts) kV Kilovolt-ampere (1,000 volt-amperes) kVA Kilovolt-ampere (1,000 kilovolt-amperes) MVA Megavolt-ampere (1,000 kilovolt-amperes) mg Milligram m3 Cubic meter tce tons of standaid coal equivalent  ABBREVIATIONS AND ACRONYM ADB Asian Development Bank CDC Capital Development Corporation CITIC China International Trust and Investment Corporation CRISPP China Reform Institutional Support and Preinvestment Project ECO Expanded Cofinancing Operation EDF Electricit6 de France ESMAP Energy Sector Management Assistance Program GDP Gross Domestic Product GNP Gross National Product HIPDC Huaneng International Power Development Corporation ICB International Competitive Bidding IDF Institutional Development Fund IPP Independent Power Producer LRMC Long-Run Marginal Cost MOEP Ministry of Electric Power MOF Ministry of Finance PCBC People Construction Bank of China PPDF Private Power Development Fund PPP Public-Private Partnership SDB State Development Bank SEIC State Energy Investment Corporation SIC State Investment Corporation SOE State-Owned Enterprise SPC State Planning Commission TVE Township and Village Enterprise  CONTENTS m*Ie .au.. . **......................... . .. ..... . vii 1ut iuctou . 1 Oveview of China's Power Sector 1 Power Sector Reform in the 1980s. 7 The Need for Future Reform. 8 2 Conm erlation and Corporatization .10 The Current Status of Power Enterprise Reform .10 Separation of Government and Enterprises Functions .13 Increased Autonomy and Accountability .14 Clarification and Specification of the Rights of Owners .16 Conclusions and Recommendations .17 3 Structure of the Industry .19 Characteristics of the Current Structure: A Mixed Model .19 Toward Competition in Generation .20 Priority Actions. 25 Conclusions and Recommendations .27 4 LqAWand Rgltory Reform .28 The Context of Legal and Regulatory Reform .28 Legal Basis for Power Enterprise Corporatization .29 Contractual Arrangements .30 Reguatory Framework ..... 30 The Proposed New 'Electricity Law" ..... 33 Conclusions and Recommendations .37  -ii F ectkrStyF cizg ................................... 39 How teCutomeraoffs AreSt a S.. 39 TM Cat2louePrice ........ 42 Joint-Invesment and "New Plant/Now Price" Prica. 44 Addidoal Above-Quota Prie. 45 IivestUrt Suchae Pas and Taxes ... . .. . 45 Fimal ConsumerPre and Coo ofSupply 45 Direcom hforFurth Refom . . .47 Cocluaonsc and Rcomnudations ................ ... ... 50 6 FnctbeExpuskn S.52 Past Developments .52 Issues in Project Financing .53 Increased Financing by Power Utilities .55 Financial Sector Reform and Novel Financing Schemes .55 Encouragement of Foreign Financing .57 Conclusions and Recommendatios .58 7 Energy Efficiency and Environmental Protection ............... 60 Improving the Efficiency of Electricity Delivery and Use .... ..... 60 Improving the Efficiency of Coal Use in Power Plants .... ....... 62 Reducing Air Pollution from Thermal Power Plants .... ........ 64 Hydropower Plants and Resettlement ..................... 69 Conclusions and Recommendations ...................... 70 ANNEXES 1 InstitutionalDevelopment Fund Study ..................... 73 2 Proposed Bank Assistance for Implementation of Power Sector Reform in China ......................... 76 3 An International Experience of Power Sector Reform .... ........ 86 4 Highlights of the Draft Electricity Law ..................... 95 5 Current Regulatory Framework for the China Power Sector .... ..... 98 6 Consolidated Add-ons on Top of Catalog Price in Hangzhou City ..... 104  H iii - FIGURES 1.1 Organizaon Chart of Power Sector ....................... 2 1.2 A Comparison of GNP and Electricity Generation Annal Growth 4 1.3 Installd Capacity in MW ............................. 5 2.1 Powe Group Structure and Related Supervisoy Govemment Ofranizaons .....12 3.1 EvolutkoaofPoweSoctor Structure in China .24 5.1 Quotas and Tariffs .................................. 40 6.1 Capacity Additions to the System (GW) ..................... 54 TABLEs IN TEXT 1.1 Power Generaiion in China, 1980-93 ................. . 5 1.2 Electricity Forecast (1995-2000) ................. . 7 3.1 Policies Needed Under Structural Alternatives ..... ............ 22 5.1 The 1976 Catalogue Tariff ..................... 42 5.2 Zhejiang Province-The New Catalog Prices for 1994 ...... ...... 43 6.1 Financing for he Power Sector .......................... 54 7.1 Coal Consumption and Economies of Scale in Thermal Power Production in China in 1990 ................................. 63 BOXES 4.1 Power Sector Regulation ............... ............... 32 4.2 Potential Regulatory Tasks .............. ............... 33 4.3 Options for Tariff Regulation ............. .............. 36 5.1 Apples and Oranges ............ ..................... 46 7.1 Applying Market-Based Incentive Instruments for Environmental Protection ............................ 65  fiv - PREFACE In early 1993, the Chinese Govement requesd Bank asince t s its power sector reform progress and provide guidance on the direction and implen -tion of frti reforms. This assisnce was provided in two phases. In phase one, dte Bank funded, through its Institutional Development Fund (IDF), technical assistance to improve common understanding on key restructuring concepts, review successful international experiences, discuss strategic options for power sector reform in China and build a consenlsus among agencies involved in the restructuring process on a strategic vision of what might be the most appropriate ownership/organization/legal and regulatory structure of the industry over the medium term. The assistance focused on building local capacities to sustain the gradual and difficult sector restructuring process. A summary of the activity is provided in Annex 1. In the second phase, two missions were fielded by the Bank in November 1993: the first to review recent development in power sector reform, identify key remaining issues and discuss with the Chinese counterparts future priorities of the reform; the secoiid to discuss present and planned institutional arrangements in China for the power sector financing and recommend new institutional measures to improve resource mobilization both domestic and foreign. Building upon the lessons leamed from past projects and the work carried out this report focuses on two major sets of issues that, if not adequateiy addressed, could jeopardize the future of China's very fast growing power sector. The first set of issues is related to the structural organization of the sector: ownership, structure of the industry and legal and regulatory framework. The second set of issues is related to performance of the sector pricing, diversification of the financing of the sector, and the environmental impacts of the development of the sector essentially based on coal and big hydro-projects. The report makes suggestions on ways the Chinese Government could accelerate implementation of power sector reform. Annex 2 of the report outlines a future Bank assistance program to provide support for implementation of power sector reforms. The task was completed by N. Berrah (task manager and Principal author of the report) and R. Taylor (energy economics). This paper and its annexes are based on the finding of a mission to China in October/November 1993. The mission team comprised S. Hunt (pricing and sector structure), R. Fitzgibbons (legal and regulatory framework), R. Lamech (corpo.atization and sector structi're); Z. Khan, P. Cordukes (financial issues), Y. S. Wang (research assistance). A. Hussain also contributed substantially to the corporatization section. A key foundation of t' is report was the work of four Chinese working grups coordinated by Shao Shiwei ar.d chaired by Zhou Fengqi (oanization and structure of the sector), Zhou Zhongnan (legal and regulatory framework), Ye Rongsi  (separation of govemmient and power utilities), and Zhu Chengzhang (finann sources). The members of the study team would especially like to acknowledge the support of the inistry of Finanoe and the Mniry of Electric Pwe, Jns Provincdal Meetr w Company, Zhejiag oincal Electic Power Company, and the wide variety of agencia and institutes, without which this study would not have been possible. he r ort wa reviewed by D. Andro (MINDR), D. Craig (ECEIV) and W. Hay (IENPD). Me Division Chief is Richrd S. Newfarrer, and Department Diretor is Nicholas C. Hope.  -vi - EEUTIVE SUMMARY A. AN Ouvuvw i. China's power system grew at a high pace of more than 8 percent per annum from 1980 to 1993 to become the fourth largest generating system in the world. Installed capacity increased from 66 GW to 183 GW and power generation increased from 300 TWh to 836 TWh. However, in spite of this dramatic growth, tIe sector is still plagued by acute shortages and still fails to provide adequate supply to the economy. ii. To cope with the surging demand, the indusiry has cone through a series of incremental cr,anges to decentralize decision-making and give further autonomy to power enterprises, to increase and rationalize power tariffs and finally to diversify ownership and attract enough funds to sustain the expansion. The power industry is in a state of rapid transition. The Reforms of the 1980s iii. At the beginning of the 1980s, China's power industry was one large government department with provincial bureaus operating as local representatives of central and regional administrations. Managers needed to refer virtually all decisions to the top. Prices were low and totally controlled. Tne industry was fully vertically integrated and run as an administration rather than a commercial business. iv. Faced with tightening budget constraintL, in the early 1980s, the central government changed the funding of large power generation and transmission projects from state budget allocations to lov. erest loans through government policy banks or specialized financial institutions. it also provided provincial power entities increased autonomy and more important roles in the operation and day-to-day management of the systems and mobilization of investm^nt funds. These limited changes fell short of meeting the increasing investment needs and the sector was, by the mid-1980s, facing a major capital crisis, which triggered a second wave of reforms. v. To increase the volume of the investment, the Govemment took two major steps in reforming the sector. In 1985, the "Provisional Regulations on Encouraging Fund- Raising for Power Construction and Introducing Multi-Rate Power Tariff" put an end to the monopoly of the central government as the sole supplier of investment funds in the industry and stared the process of diversification of ownership with far-reaching effects on the struure of the industry and the pricing system. It allowed entrants at the generation level to charge prices based on debt repayment and the power companies to pass  - viii- on the higher costs of 'new electricity' to final con. ners through a multi-tier pricing system. In 1988, the iniadon of the 'Responsibility Contract System' gave the provindal power companies a greater rsponsibility for administration of labor and wages and allowed them to rtain part of their operating surplus. This measure increased the business orientato of the industry, and provincial power bureaus were renamed power companies in many povinces. vi. lb results have been imssive. Annual added capity to the syv increased from 4-6 GW in the early 1980s to 10-12 OW by the end of th decad. Various levs of government (e.g., provincial, prefecture and county) dramatically incre their participation in financing new power investments through so-called 'joint-investment projects,' which accounted in 1993 for about half the installed capacity in several provinces. The Government created two independent public power sector producers to attract more foreigr. funds to the sector and improve the technology transfer. Finally, the Hopewell Group (Hong Kong) built one of the first BOTs in a developing country, opening the sector to private investors. The Need for Further Reform vii. The reforms of the 1980s went a long way to loosen the centralized management of the power sector, mobilize and diversify financial sources and improve cost recovery through higher tariffs. However, they yielded mixed results: power supply has dramatically increased but still fails to cope with the surging demand and the ad hoc approach to reform has not yet established a conerent and transparent framework for sustained development of the sector. The sustained rapid economic growth will put even more pressure on China's Pl,wer industry. Yearly capacity additions will average about 15 to 16 GW from 1994 to 1997 and about 17 to 20 GW from 1992 to 2000, compared to the average yearly increase of 12 GW from 1987 to 1993. This annual increment is equivalent to the total installed capacity in Indonesia or Belgium. viii. Many of the leading officials recognize that coping with this tremendous growth requires an urgent and wholesale reform agenda to improve efficiency at all levels of the industry (investment, production and consumption) through introduction of market- based policies, further opening of the sector to domestic and foreign investors, and sound environmental policy to minimize adverse impacts of large coal-fired and hydro power plants. ix. To achieve these objectives, the Chinese Govemment initiated in the early 1990s a comprehensive and coordinated reform agenda. The efforts will focus on promoting an industry structure that ensures that enterprises are run as efficient businesses and reduces (and ultimately removes) barriers to entry to spur competition at the generation level; and a legal and regulatoryframework that supports further progress towards market economy and ensures proper regulation of the monopolistic segments of the industry. The Government intends also to put in place performance incentives to improve the economic efficiency of the system through adequate pricing at all the industry levels to guarantee tht investors earn an appropriate retirn and customers pay enough tn cover the costs of the  -*l new investmts; atuct pwvate (domestic and foegn) invetont funds; and inrease th enviromental awaren of power enterprises. D. Poucy uoN To bwiovi E MARxEr OtVrAIrAON oF R Suwca X. Seval new policies and reforms, summarized below, could achiv th above obecdves d pvde do plicy envirnment I* alloviate pow duotg d hbr the t_ud owatds m open and mrsutdnmv pow ucm. TIU rS t of pole relae to the ownip, sruct organzat of the indusy and th lba Sd reglary fmework. Te seoond set of pdicies rabte to mare adeqate pridg , further diversification of the financing of fte sector, and finaly imprved mitgaio of the environmental impwcts of the fast expending generating system. This report suggats an acceleration of the reform program to address structural weaknesses of the industry and its performance shortcomings. Corporati at'on xi. Because of China's 40-year history ot central planning, power companie are still not run as businesses that respond to market signals (commercialization), and still do not have clear ownership, governance and internationally accepted accounting principles and standards (corporatization). They are combined with a network of supervisory government organizations and carry social and other activities not related to their core business. Finally, management is still not fully responsible for enterprise performance and do not focus on their corporate objectives. xii. The policy initiatives over the last two years clearly indicate the Government's resolve to achieve full corporatization of China's power industry. An adequate policy and legislative framework has been put in place through the enactment of three major regulations and laws: the "Regulations on Transforming the Management Mechanism of State-Owned Enterprises" (July 1992), the "Regulations on rdoption of New Accounting System' (July 1993), and more importantly, the "Company Law" (December 1993). However, implementation is slow. xiii. 7he Bank therefore recommends that Government put in place incentives/penalties that encourage the transformaion of -he sec.or companies to enterprises that are run as efficient commercially oriented businesses, sheltered fJom government interference in micro-management, and therefore fully accowuntabk for their profits and losses, through a two pronged approach. First, all new entrants, in all segments of the industry, should be established as corporations, with clear status under the new Company Law, autonomous management and clear procedures ) ensure proper accountability. Second, existing power enterprises should be required to prepare time- bound plans to implement the existing laws and regulations relating to enterprise commercialion and criporatization, in cooperation with the various organizations involved in the sector. These implementation plans should focus on the following priority actions: (a) Separaion of Govrnment and Enterprise Functions. Detailed arrangement should be prepared and agreed upon by relevant authorities to separate power bureaus from  x power companies. (b) Managemne Autonoy and AccouNtablity. Th trasito reguladons issued by MOEP on the implementation of the -0 14 rightso are very resticv and should be reviewed to provide the sector enterprises more autonomy. Rights that are incompatible with the monopolistic powers of the companies ould be reviewed and adt to the sector specfic characteristics. Proper procedumes should be dend and impementd to encs pxope accountabiOity of the entrpdr. (c) Ades_v hu1em de. qCPw NW Repop ini SYaeR. Power mcor "dupnm shuld focus on adequate imlemntation of the MOP new fin reuldons baed on in Ita acuntig pi and ndards, tgether with the desin of imprved intnal management and financial reporting systems, based on resonsibility concepts. (d) Revised Charters. Power enteprises should be required to prepare new chartes that clarify their objectives, authorities, responsibilities, legal powers, governance and corporate structure. The new charters should be based on the new Company Law and reflect other laws related to the management of SOEs (see also Chapter 5). Industry Structure xiv. The ad hoc structural changes did not provide a c!ar direction on stable environment conducive to efficiency. The roles of the different entities are still not clearly defined, and suitable policies and trading relationships are still not in place. However, the current structure emerging trends and size of market have the potential for competition in generation. China should now focus on capturing the higher efficiency which competition can provide, throvgh easier entry at the generation level and further development of a framework and incentives, especially competitive prices, to attract independent power producers. xv. Involvement of a wide variety of producers should be encouraged, including domestic joint-investment projects, foreign/domestic joint ventures, and wholly foreign- owned companies. The Government should promote the Purchasing Agency Model as the basic structure for provincial systems, so as to foster increased competition at the generation level and ease entry of new producers. Under different variations of this mox -, the provincial power company acts as the sole bulk purchase and sales agent of power within a franchised retail service industry. Furthes progress, depending on the specific conditions of each system, will require expansion of the role of IPPs, including the reformulation of joint-investment plants into true IPPs, and the development and implementation of improved contractual arrangements for power exchanges based on principles of greater transparency and equal treatment of all operators. xvi. In most cases, it is expected that the purchasing agency will continue also to be a power producer and/or distributor. It is therefore critical that sector regulation be fully separate from tde provincial power company, to avoid potential conflicts of interest and abuse of market power. In the more advanced provinces, a number of more sophisticated variations of this model could be tried. Generation could be fully separated from the provincial power companies, and place with one or more state generation companies, competing against IPPs and separate joint-investment plants. Greater independence among distribution entities also can be promoted, through further creation  -xXi - of autonomos distribution companies, or at least proper definition of distribution sub- entities as profit centers. Lepl and Regubtory Famework xvii. China's legal taditon is short. The power sector is still governed by a compe aray of laws, provisions, administrative rules, regulations and policy circula. Moe of hem laws ad regulaons, enacted under the command and control economy, fail to upport stuctWl changes and, sometimes, hinder the smooth funcdoning of the emerging market economy and further involvement of private investors in the sector. xviii. The Government has initiated a major overhaul of the legal and regulatory framework to support the power sector reform, to reconcile the current contradictory requirements on the power sector and define the rights and responsibilities oi power enterprises and supervisory government organizations. xix. To complement these efforts, the Government should put more focus on the design and imnlementation of a legal and regulatory framework that ensures the above objectives, reduces barriers to the introduction of market forces and encourages private investment in power sector. China's legal and regulatory reform will obviously take time, however, priority actions include (a) FYnalization of the Electricity Law. The final law, and associated regulations, should clearly define the rules of entry at the generation level, including private investors rights, to encourage private investment in new power projects. (b) Promotion of Contractual Arrangements. The Government, especially Ministry of Electric Power (MOEP) should encourage the expanded use of proper contractual arrangements to define and clarify commercial relationships for power exchanges at all levels. Technical assistance might be sought to help identify contractual arrangements likely to be required by the power sector, to develop model contracts, to provide education as to the content of such contracts, and finally to support the power enterprises in negotiations with potential power developers. Electricity Pricing xx. China has made considerable progress in increasing power tariffs to reflect costs and rationalizing tariff structure to reduce cross-subsidies and improve electricity consumption. However, the pricing system remains cumbersome and problematic. Some of the issues which need to be addressed include (a) the time structure of current debt repayment pricing at the generation level; (b) the structure of prices in power purchase contcs; (c) unification of multiple-track consumer tariffs; (d) the structure of consumer prices; and, (e) the quota allocation process. xxi. lhe Government should consolidate and accelerate the reform process developed in 1985 to continue evlving towards economic pricing and to ensure that customers pay enough to cover the costs of new investment. At this juncture, it is important to undertake an objective assessment of the existing options for the future, foowed by the definition of a pricing system (or pricing systems) most appopria forthe  -xli- country's long-trm needs and a medium-tem strategy for putdng this in place. Cam thought needs to be given to how to balance different needs in the development of picing for ew gain fcilies, and how to prvide adequately for transmission and distribution investment as the stucture of the power industry changes. Past expimce has own that adopi