Will the lights go out again in China?

With the Chinese economy expanding rapidly, Alysha Webb asks how the energy infrastructure is coping with the pace of change

If office workers on most floors of furniture maker Ronghshi Industrial Group want to use a computer on Tuesdays or Wednesdays, they're out of luck. Electricity from the local utility is cut on those days; the company uses its own generator to keep its production lines running and lights on in crucial administrative departments like finance.

Ronghshi is used to the routine. Zhejiang Province, where Rongshi is located, faced severe power shortages in the summer too. From July to September, the province had 150,000 cases of power interruptions, and a 5,490MW electricity shortfall, according to the Asian Development Bank.

The situation in Zhejiang is not unique. Last year, 21 provincial power grids faced power shortages, resulting in power cuts during peak hours in many cities. Those cuts will continue in 2004.

China's economy is increasingly market-based, but the power crisis in which the country now finds itself mired is a direct result of planned economy-think. In the late 1990s China had a glut of electricity. The Government halted approvals for new power plant construction for two years. Now this is threatening China's economic growth.

'Inadequate power supply will adversely affect the PRC's economic growth in 2003,' predicted Bo Lin, a senior project economist with the ADB. 'For example, the power shortage could reduce GDP growth in Zhejiang province by 0.7% to 1% in 2003.'

The impact is evident in Shanghai, China's retail and financial leader. The Government has asked manufacturers who are heavy users of electricity to shut down during peak demand times, and to work nights or weekends instead. Despite these measures, the city will still need to buy electricity from other parts of the country - if any surplus is for sale.

City officials are taking an optimistic view. 'If we give companies advanced notice of when there will be power interruptions, they can arrange their production schedules accordingly,' said the head of the electric power department in Shanghai's Economic Commission. 'In this way, their normal production isn't affected.'

Perhaps, but the problem will persist for at least the next two years, according to a report by China's State Electric Power Regulatory Commission.

In 2004, the imbalance between supply and demand 'will be more serious than in 2003', the report concluded. In 2005, 'the imbalance will begin to lessen'; in 2006, 'supply and demand will basically be balanced'.

That may or may not be true. Beijing invested US$24bn in new power projects in 2003 - almost equal to all investment for 2001 and 2002 - and approvals for new power projects have been expedited, but it takes years for new plants to come on line.

And a long-term solution to China's power problems will take more than just building new power plants. 'The present practice of giving too much weight to the short-run fluctuations leads to a hold on approval when there is a surplus, and to approvals for a large capacity when there is a shortfall,' said Bo. 'Under this approach, the large approvals could create a surplus in 2006 or 2007.'

Still, the cost of a power shortage is 'substantially greater' than the cost of a surplus, he concluded.

It didn't have to be this way. China's power shortage problem took root back in the late 1990s, when power consumption growth rates slowed to 4.4% in 1997 and 2.8% in 1998. Since new coal-powered projects equal to nearly 30% of the country's installed capacity were already under construction, the Government stopped approving new projects from 1999 to 2001. Meanwhile, power consumption growth sped up dramatically, rising by 5.9% in 1999, 11.4% in 2000, 9% in 2001, and 11.6% in 2002. The Regulatory Commission believes demand will grow by 15% in 2003, and the shortfall will top 10m kilowatt hours.

Though it hints at poor economic planning as a culprit, the Commission's report cites fast growth in certain sectors, inadequate coal supply, and poor weather conditions as three of the main factors accounting for the shortfall.

Power-intensive heavy industries - traditionally the sector emphasised in planned economies - have grown much faster than the overall economy in recent years. So, while China's GDP grew by a healthy 8.5% in the first nine months of 2003, during the same period the nonferrous metals sector leapt by 119% and the textile industry grew by 87%.

Inadequate coal supplies - from inefficient mines and poor distribution rather than an actual shortage of coal - is preventing many thermal plants from running at full capacity. An exceptionally dry summer dropped the water level so hydroelectric plants cannot run at full capacity. Meanwhile, rising living standards mean Chinese are using their air conditioners and heaters more than before.

The ADB's Bo placed the blame for the shortage squarely with the Government, however. Bad weather, fast economic growth and uneven coal supply are common occurrences, he said. 'Where the situation was different in the PRC was the way approvals for new power projects were withheld for three years, despite the growing power consumption.'

Poor regulatory practices also figure in other factors behind the shortage. The price of coal for power generation was fully deregulated in 2002 (deregulation of coal prices began in 1993), but the Government still controls the price of electricity. When the price of coal spiked in 2003, power stations couldn't raise their rates, so they lowered their output.

The Government did just raise the price of coal-produced electricity for the industrial sector by 0.7 fen (US$0.08) per kilowatt/hour, effective from 1 January, but such a small increase isn't likely to encourage utilities to boost production all that much. 'The increase in tariffs is not in line with increase in coal prices. Power producers are not able to set the tariffs at market price or pass on the cost of coal,' says Slavia Cheong, a fund manager at Singapore-based Aberdeen Asset Management Asia Ltd.

More planned economics is the Government's answer to the coal supply problem. In late December, Beijing announced plans to form eight to 10 large coal mining firms, with three large firms expected to control 60% of the market.

All well and good, but a researcher at the State Council's research centre cited a more serious systemic problem for the power shortage - misallocation of investment. Currently, up to 95% of investment in power projects comes from the Government. 'China needs to change the way it allocates its resources, from having the Government decide to having the market decide,' he told the local media.

Foreign investment

But that call for more private investment in China's power sector is unlikely to be answered with an outpouring of funds. Foreign investors, who once eagerly plunked down large sums to fund power projects here, are largely absent from the sector these days. Instead, bank loans and stock market listings are the major sources of funding.

'If you are a foreign utility looking to come into China, you don't have a great taste in your mouth,' says Christopher Huang, a Hong Kong-based analyst with Morgan Stanley. 'The sector is not very transparent, it is very political, and you need good relations and sponsorship.'

The stability of government-controlled tariff rates used to be an attraction for foreign investors. But a reorganisation of the sector and deregulation of coal prices has made that control more of a risk than a reward. Says Aberdeen's Cheong: 'As attractive as the China power story seems, wherever tariffs are set by the Government, there are always regulatory problems. In China, it's still a careful balance between risk and return.'

Even companies that have good government connections warn of the risks in China's power sector. Pedigrees don't get much better than China Resources Power Holdings, which recently listed on Hong Kong's stock exchange. The company owns and operates five coal-powered plants in China's booming coastal provinces and is building seven more. Its parent company, CRH, is a 'major state-owned PRC conglomerate', says the prospectus. 'We believe that our government relationships give us a competitive edge over foreign companies seeking to invest in power plants in China.'

Nonetheless, 'there is no assurance that our projects will receive all necessary approvals, permits or agreements in a timely manner, or at all', the company notes under the 'Risk Factors'. Another risk: 'Interpretation of PRC laws and regulations involves significant uncertainty.'

In the past, foreign investors in China's power sectors learned first hand that interpretation - or enforcement - of China's laws can have an adverse effect. In the early to mid-1990s, foreign investors flocked to China's power sector, lured by double digit growth in demand and guaranteed off-take agreements or rates of return. 'When China needs your capital, it can be very accommodating,' observed Morgan's Huang.

China can also be very unaccommodating when it wants to hang on to its foreign exchange, however. In the late 1990s, China faced a power surplus at the same time it was dealing with the Asian Financial Crisis. The Government declared such guarantees illegal. Widespread debt ratings downgrades followed.

There is one group of investors who love China's power sector - investors in listed utilities. Aberdeen isn't holding any China utilities right now, but that's mainly because it thinks the stocks are overvalued, said Cheong. 'This sector definitely has promise going forward,' she said.

Domestic investors are also high on utilities. 'Investors in China's 44 listed power companies think the outlook is pretty good for these stocks for the next two years, given China's economic growth and the sector's profitability,' said Li Yuan, a Shanghai-based analyst at Haitong Securities Company.

The last two years haven't been so shabby. In 2002, power sector stocks rose 18.4%, said Guotai Junan Securities analyst, Yao Wei. In 2003, they surged 30.8%.

Investors apparently think 2004 will be bright, too. 'We did a survey,' said Yao, 'and the power sector was the number one choice among fund managers and the number three choice among investment banks. Retail investors also had a good opinion of the power stocks.'

Alysha Webb is a business journalist based in Shanghai.