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Potential Gains From Reforming Price Caps in China’s Power Sector

About the Project 

The KAPSARC Energy Model of China (KEM China) project began in 2014 to study energy and environmental issues in China. KEM China has been developed to understand China’s energy economy and fuel mix, how they are impacted by government intervention, as well as their interaction with global markets. It is a modular integrated mixed-complementarity problem model that optimizes supply decisions, minimizing fuel and technology costs, while taking into account the effect of government regulation on prices and the environment.

Key Points

When energy sectors transition from government-controlled to market-driven systems, the legacy regulatory instruments can create unintended market distortions and lead to higher costs. In China, the most notable regulatory throwback is ceilings on electricity prices that generators can charge utilities, which are specified by plant type and region. We built a mixed complementarity model calibrated to 2012 data to examine the impact of these price caps on the electricity and coal sectors. Our study highlights the following major findings: 

  • Capped on-grid tariffs incentivize market concentration and vertical integration so that generators can cross-subsidize power plants, ensure an uninterrupted supply of fuel and reduce the impact of volatility in fuel prices. 
  • Tight price caps can cause the system to deviate from the least-cost capacity and fuel mix. In 2012, this resulted in an additional annual cost of at least 45 billion RMB, or 4 percent of China’s total power system cost. The government also had to subsidize some of the losses, which indicates that this regulatory design is not responsive to market realities. 
  • Price constraints can impact the outcomes of other policy initiatives causing them to veer from intended goals. In the case of China, according to our modeling, greater installed wind capacity does not have a significant impact on the amount of coal consumed. Also, abolishing restrictive tariff caps on coal-fired generation does not increase coal use because the utilization rate of peak-shaving coal plants drops. 
  • We also estimate, using the model, subsidies required for a range of wind capacity additions to China’s power generation mix and find that the feed-in tariff could have been less generous.

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