HCP Q&A: Part 1 with Mun S. Ho on “The Politics and Economics of Electricity Reform and Environmental Protection in China"

October 6, 2020

HCP Q&A with Researchers: The Harvard-China Project on Energy, Economy and Environment, based at the Harvard John A. Paulson School of Engineering and Applied Sciences, is initiating a new Q&A series with our research contributors. This is the third.

Harvard-China Project Q&A: Mun S. Ho

 “The Politics and Economics of Electricity Reform and Environmental Protection in China: PART 1"

Mun S. Ho, Visiting Scholar with the Harvard-China Project and Visiting Scholar with the Resources for the Future, is an economist working on productivity measurement and environmental policy analysis. His two main research interests include using a multi-sector model of the Chinese economy to analyze energy and environmental policies, and studying energy demand – particularly electricity demand – using survey data of households and enterprises. The Harvard-China Project caught up with him to discuss his research, in what will be a two-part series on electricity reform in China. The first part of the interview is as follows, and the second part can be read here:

Harvard-China Project: Mun, can you give our community a brief history of Chinese economic growth as it relates to its environmental and climate change goals? Where has it advanced from, and where does it expect to go in the future?

Mun S. Ho: China’s economic growth was very fast between 1978 to 2011, averaging 10% per year. Then it slowed down to about 6.5% (not counting the period of Covid-19). A 6.5% growth rate is very good, but also a dramatic change from the preceding boom period and one that poses a critical, unfamiliar challenge to the current leaders, who were installed in 2012. At the simplest level, this slowdown makes it difficult to reach their goal to double GDP between 2010 and 2020 and to eradicate extreme poverty by 2020 (well-publicized goals of Xi Jinping at the start of his presidency). At the same time, the government also wants to reduce severe pollution problems, which are caused by the rapid growth of industrial output, fossil fuel use and a late start in implementation of emission controls. And in the middle of this growth slowdown and China’s transformation into an increasingly urbanized country, the government is continuing with reforms of the economy and governance structures.

Harvard-China Project: We understand that the institutions in China are very different from other countries, and thus the policies needed to protect the climate and environment must be different as well. Can you speak about some of the electricity industry differences between the US and China?

Mun S. Ho: The Ministry of Electric Power owned and managed every aspect of the sector until the 1980s, when they began to allow some private generators. The Ministry was abolished only in 1996, and the assets – generators and the transmission grid – were put into the State Power Company, with a separate government office setting rules for the electricity system. A big additional reform in 2002 then broke up that company into two grid companies that own the wires and five large state-owned companies that own the generation assets. And a State Electricity Regulatory Commission was set up to issue rules.

That is to say, China is still a country run by the Communist Party, despite the massive changes of the past 40 years. The State owns almost everything in the power sector, and the Party appoints all the leaders of the various enterprises, and of course, appoints the government officials in charge of regulating the enterprises. Furthermore, the largest purchasers of electricity are state-owned enterprises. Institutionally, this is a different world from, say, the US, where the generators and wires are mostly privately owned, and a set of regulatory agencies at the federal and state levels issue rules for the complex system.

Let me take a step back and remind people that most countries, not just China, have a complex regulatory system for this industry compared to other industries. The power industry is a natural monopoly because we just need one set of wires going to each home or enterprise, and it is not efficient to have multiple companies competing with each other, each owning a very expensive set of wires. Furthermore, in many areas, just one generator is sufficient to supply all the power needs, so we cannot have a competitive market with many generators, or generators from far away incurring electricity losses from long-distance transmission. So the US evolved a system with very tight regulation before the 1980s and gradually introduced market elements. The US now has independent generators bidding in a market (a spot market) run by “Independent System Operators” (ISOs). The ISO chooses the lowest bids for each time interval (say 15 minutes) to supply the expected demand for electricity. Simplifying, this spot market results in a logical system where we have generators that run all the time (the baseload generators that have low marginal costs such nuclear and coal plants) and gas generators that can be started on short notice to supply the peak hours (so-called peaking plants, with a high marginal fuel cost).

Just to clarify for anyone not familiar with the jargon: by “marginal cost” we mean the cost of producing one more kWh given the existing set of generators and transmission system; this will essentially be the cost of the extra fuel that needs to be burnt. The “total cost” of a kWh would include the cost of building and maintaining these capital structures.

Through the spot market, the utilities pay a low price to the generators during the night-time, low-load hours and a high price during the peak hours since gas is expensive. The regulatory authorities determine the prices that households pay, prices that are fixed for all hours of the day for the vast majority of consumers in the US (and China). Another, more flexible system is available for major consumers, such as factories. Through some clever management, we found a system of prices that gave all generators (base or peak) an acceptable rate of return when averaged over the course of the year.

Harvard-China Project: When renewable energy was introduced, how did that shift energy needs and expectations, and subsequently pricing models? How are China’s expectations different from other countries, and what challenges does it face?

Mun S. Ho: These wind and solar power “intermittent renewables” have two special features: one is that the marginal cost is essentially zero since they don’t need any fuel, and the second is that we can only use them when the wind is blowing or the sun is shining. This introduced a big problem for the spot market system, particularly in places like Texas, where at night there is so much wind and so little demand that the bid price drops to zero (or even below zero). This no longer results in average prices that can give all generators a normal rate of return. So the ISOs had to invent some new institutions, one of which is the “capacity market,” where we pay companies to maintain generators that are not used all the time and whose revenue from the spot market is not sufficient to cover the capital cost. The US and many countries are still struggling to make such a privately-owned system like this work well, at the same time we hope to develop much more renewable power for environmental reasons.

Now, to go back to China, its power system managers also have this modern problem: how can they devise a system that has lots of renewables whose intermittency has to be balanced by more readily “dispatchable” plants, often coal- or gas-fired ones with higher marginal costs that leave them idled for many hours of the year? They would need to find a system of prices and payments that would be sufficient to cover the capital costs of all plants (base and peak-load). In the “fair allocation” system prior to the 2015 reforms, the government planning agencies would allocate the generation hours to each plant and set their prices, which would be the same at whatever hour they generate. This system could raise enough revenue to cover costs, but it ignored relative costs and the different pollution intensities of the different plants. There was no simple mechanism to favor renewables or cleaner coal plants. There is some use of a mechanism called “generation rights trading,” where a dirtier plant may choose to not generate and sell its right to generate to another, cleaner, low-marginal-cost plant. This trading is limited, however, and not on the time scale of spot markets.

Incidentally, such a direct government-controlled system means that pollution control is also through direct commands. That is, China cannot easily use market instruments like the SO2 cap-and-trade system in the U.S. The system of “fair allocation of hours” does not allow a simple system of incentivizing pollution control and choosing the cleanest source for each time interval. Various ad-hoc measures were introduced, such as mandating the long-distance transmission of renewable power from the windy, sunny northwest or from the hydropower-rich southwest to the densely populated east. Various experiments (prior to 2015) to prioritize renewables and cleaner coal plants did not really succeed in reducing coal consumption and pollution.

Harvard-China Project: If the state owns everything then why can’t the government agency just order the cleanest plant to produce first and the dirtiest to go last?

Mun S. Ho: This is where we run into the China governance system, which has been called “regionally decentralized authoritarianism.” The central government sets broad goals and delegates economic governance to the provincial and local authorities. In this system, the provincial governments control the construction of new plants, transmission systems, and the allocation of hours subject to limited control by the central authority (the National Development and Reform Commission). Each local government wants to have its own generators to provide employment and tax revenue, and each is thus resistant to a central directive to import power that may be produced more cleanly or more cheaply in another province. A provincial grid authority balances the load using mostly generators within the province; that is, with limited inter-province power flows. It is more efficient to balance loads over a larger region: the wind and sun are more likely to be available somewhere in the system, the peak hours are more varied over distance, and accidents and shutdowns for maintenance are more easily handled.

The reforms that started in 2015 aim to introduce some market logic into this system. One major feature is the use of spot markets, which today have been set up in several provinces where generators bid to supply power. We are eagerly waiting to see how these pilots will perform. These pilot systems still need to address the problem noted above; in a spot market system the peak-time generators may not get enough revenue to cover capital costs and thus have no incentive to continue operations. Intermittent renewables may be able to bid a low price and capture sales, but may not end up with enough revenue to cover capital costs and thus still require a public subsidy or other intervention by the government. In the places still using the “fair allocation of hours” system, there is the problem of not having the right market incentives to reduce pollution or CO2 emissions.

A second aspect of the 2015 reforms is a push for more inter-regional trading of power, having more coordination between provincial authorities. This could allow load balancing over larger regions, making it more efficient as noted above. This is a challenge given the existing governance structures based on provincial autonomy.

Harvard-China Project: We hear about the CO2 emission trading system, how is this affecting the electricity system?

Mun S. Ho: Yes, the desire to introduce a national CO2 emission permit trading system (ETS) is adding another complication to the already complex electricity system. The ETS is where generators have to acquire a permit for each ton of CO2 emitted. The idea is that putting a price on CO2 will provide an incentive to reduce emissions. However, such cap-and-trade systems in other countries are implemented in a system with spot markets – that is, where the CO2 price affects the price bids by generators. In China, where there is not yet a spot market in most places, such an ETS would not provide the right incentives. If hours of operation are allocated by the government, then the CO2 price would not change the distribution of hours across the different plants with different emission rates (CO2 per kWh).

Let me note other complications introduced by new technology, an example being “distributed” generation by households themselves (e.g., rooftop solar). When households buy less from the grid, the average price for what they do buy must rise since the capital cost of the wires for transmission and distribution must still be paid for by electricity tariffs. We will have to leave these challenging, but interesting, topics to another time.

Please read part 2 of this interview with Mun, where he discusses research of economic and environmental dimensions of these power system features.

RESEARCH CITED: Mun Ho, Zhongmin Wang and Zichao Yu. 2017. China’s Power Generation Dispatch, Resources for the Future Report, April.

Have a question for Mun S. Ho? Email us at harvardchinaproject@harvard.edu.