Description of Selected Government Practices and Policies Affecting Decision Making in the Economy

Local grid operators at the regional, provincial and county level divesting hundreds of other equipment manufacturers at the direction of the central

government

“Local grid operators at the regional, provincial and county level have divested hundreds of other equipment manufacturers at the direction of the central government”, Wang explained. 

Contents:

Rationalization of the State Sector – pg. 1

State-Owned Asset Supervision and Administration Commission and Policies - pg. 2

Current Divestments – pg. 5

Analysis of China’s Electricity Market – pg. 9

Analysis of China’s Coal Market – pg. 11

Underlying all of China’s industrial development policies is the restructuring of China’s economy to reduce state ownership of firms and allow the growth of the private sector. China recently clarified its policy regarding SOEs owned by the central government in the December 2006 SASAC policy directive. The directive indicated that China’s policy of divesting SOEs, begun in the 1990s, is largely over and that the existing holdings now are to be maintained by the government and consolidated. This directive has resulted in Rationalization, Privatization, and Corporatization of SOEs.

Rationalization of the State Sector

Rationalization is privatization and closure of uneconomic enterprises. China’s current economic structure reflects both the legacy of central planning and elements of a competitive, modern, and increasingly market-based economy. The central government’s rationalization objectives include closing uneconomic enterprises and “corporatizing” certain SOEs. Corporatization in China refers to a partial form of privatization under which SOE assets are converted into corporate shares and partially sold to the public.

China’s enterprise ownership reform practices and policies aimed at diminishing government’s influence in the economy while relaxing constraints previously imposed on the private sector. Rationalization refers to government policies to reduce the number of unprofitable firms within an industry so that only the most profitable ones remain. Privatization is the transfer of the ownership of firms from the public sector to the private sector. Full privatization in China has been limited to the sale of small, inefficient SOEs. The comprehensive sale of China’s SOE assets is characterized more by the conversion of SOEs into share-issuing firms in which the government retains a majority ownership share in the firm. The goals of rationalization are to generate economy-wide benefits by using China’s available capital and labor more efficiently, creating direct effects on employment but generally indirect effects on investment and trade.

Although rationalization initiatives increased during the 1990s, they were poorly implemented.To address this issue, SASAC was established in 2003 as the main implementing body of SOE rationalization. This section further describes SASAC and its December 2006 directive, as well as China’s main rationalization objectives, which include privatization and the closure of uneconomic enterprises.

State-Owned Asset Supervision and Administration Commission (SASAC)

SASAC was created to coordinate China’s SOE rationalization process through measures such as privatization and bankruptcies, to serve as the central investor in the state sector (by supervising and managing SOE assets), and to consolidate the functions that other government agencies previously provided. SASAC was established under the State Council to “exercise the government’s power of ownership,” and it remains administered by central, provincial, and city-level government authorities.

At its inception in 2003, SASAC was given the responsibility of supervising and managing 196 central government administered SOE nonfinancial conglomerates (which represented approximately 159,000 SOEs) whose assets were valued at approximately $832 billion (RMB 6.9 trillion). The combined profits of these SASAC-managed firms accounted for 70 percent of total SOE profits, which in turn generated an estimated 20 percent of the China’s central government tax revenue.

SASAC’s operating guidelines limit its management of the production and operational activities of state sector firms. However, some of these guidelines also provide SASAC with broader authority to exercise its rights as principal investor. This includes the right to retain SOE dividends (which can hamper managerial investment decisions), impose managerial decisions that may have broader policy implications and select, evaluate, and remove mangers in the state sector. In practice, however, many of these rights are often not exercised below, typically have not yet made required dividend payments to SASAC even as many listed firms have already transferred such payments to their parent companies. To date, SASAC interference in appointing managers reportedly appears to be limited to certain sectors and firms.

As a key component of the rationalization process, SASAC is encouraging its solvent SOEs to list on domestic stock exchanges (through privatization/corporatization), while allowing enterprises with debts exceeding assets to close (through bankruptcy). By August 2005, this

process had reduced the number of central SASAC nonfinancial SOE conglomerates from 196 to 168 (or 127,000 firms).

December 2006 SASAC directive

One of the most influential policies SASAC has proposed to the State Council was the December 5, 2006 announcement on “Guiding Opinion on Promoting the Adjustment of State-Owned Capital and the Reorganization of State-Owned Enterprises.” This directive, for the first time, provided clear insight into the type of industries China’s central government considers strategically important.

The list of industries includes the following: (1) armaments; (2) power generation and distribution; (3) petroleum and petrochemicals; (4) telecommunications; (5) coal; (6) civil aviation; and (7) shipping. Stated criteria for determining which industries were considered strategically important were based on national security and economic independence interests in maintaining absolute control over infrastructure, key mineral resources, public goods and services, and high- and/or new-technology industries. The 44 large SOE conglomerates that remain fully owned by central SASAC are highly concentrated in this narrow group of sectors. SASAC assets and profits in these 44 conglomerates constitute 75 percent and 79 percent of the central SOEs’ total assets and profits.

Further, the directive identifies which industries are “strategic industries,” including the following: armament, power generation, petroleum and telecommunications. The directive also identifies a group of “pillar industries,” including the following: machinery, automobiles, and information technology. The new policy directs SASAC to maintain at least a 50 percent equity stake in each “strategic industry” firm, as well as in principle “pillar industry” firm. The December 2006 directive also called for principle companies in “pillar industries” to remain at least 50 percent government-owned. The list of industries in this group is more comprehensive than that for “strategic industries”, and includes the following: automobiles, construction, and information technology. There are approximately 70 large SOE conglomerates under SASAC supervision in this category, whose assets and profits constitute 17 and 15 percent of the central government-administered SOE total assets and profits, respectively.

SASAC’s December 2006 directive: Industries that are to remain under SASACInfluence

o Strategic and key industries: Armaments, power generation and distribution, oil & petrochemicals, telecommunication, coal, civil aviation, shipping – 44 conglomerates with SASAC maintaining at least 50 percent government equity stake in every firm in industry grouping.

o Basic and pillar industries: Machinery, automobiles, information technology, construction, steel, base metals, chemicals, land surveying, research and development – 70 conglomerates with SASAC maintaining at least 50 percent government equity stake in principle enterprises within industry grouping.

o Other industries: Trading, investment, medicine, construction materials, agriculture, and geological exploration – 50 conglomerates with SASC maintaining necessary influence by controlling stakes in key companies. In non-key companies, state ownership will be clearly reduced

Sources: State Council Opinion released May 12, 2006 (app. 1, doc. 18); exclusive Xinhua interview with SASAC Chair Li Rongrong, Dec. 18, 2006, State Council website; reporting on press conference with Li Rongrong explaining the rationale of the policy paper; and Mattlin, “The Chinese Government’s New Approach to Ownership.”

Privatization

Privatization is the transfer of the ownership of firms within an industry, or entire industries, from the state to the private sector. While China’s broader central government the central government has limited full privatization to the sale of relatively small and inefficient SOEs. As an alternative to the comprehensive sale of SOE assets, China has turned to a partial form of privatization, called corporatization as the preferred medium.

Corporatization

Corporatization is the process through which most of China’s state-owned or collective enterprises have been converted into share-issuing companies. Through this process, China’s government has typically retained dominant equity stakes, as well as a limited management voice, in the privatized enterprises. Recent studies suggest that while corporatization has had a positive influence on SOE innovation, corporate governance, managerial accountability, and hiring practices, corporatized SOEs have dealt less effectively with labor productivity and excessive debt. This is partially explained by the fact that a portion of corporatized companies’ shares (approximately 25 to 33 percent) are still owned and influenced by China’s government, and reflects government concerns about managing unemployment and enterprise debt. China’s government unveiled its formal privatization objectives in 1999 after several years of reforms that helped lay the groundwork. At the Fourth Plenum of the 15 th Central Committee, it formally identified the need to withdraw its influence from certain sectors, diversify the state sector’s ownership structure, and provide a source to finance its national social security system. China also amended its Corporate Law in 2003 to ensure that privatized SOEs and other forms of enterprises were fully represented in the law. This new Corporate Law also provided the basic framework from which firms could be privatized and corporatized.

Under the new law, the split stock system was devised to facilitate the corporatization of firms that still provided social services to its employees. Under this system, the government authorized the division of the company in two parts: the joint - stock company that retained the productive assets and the parent company that assumed the company’s debts, nonproductive assets (e.g., schools, medical clinics), and excess staff. In cases where SOEs no longer performed many social services, the entire company could simply become a joint-stock firm. The amended Corporate Law was subsequently implemented on January 1, 2006.

Closure of Uneconomic Enterprises

The closure of uneconomic enterprises, which has occurred through government mandated bankruptcy filings, represents another instrument that China’s government has used to satisfy its rationalization objectives. In market-based economic systems, bankruptcy laws govern creditor-debtor relationships, provide efficient mechanisms for reorganizing inefficient enterprises, and help transfer resources out of nonviable areas. Sources report that China’s bankruptcy system is inefficient because it is still in the early phases of such reforms and remains encumbered by institutional barriers such as limits on laying off workers. Currently, many resources are lost during bankruptcy procedures, given the lack of a sophisticated secondary market for asset redistribution. China’s most recent Bankruptcy Law entered into effect on June 1, 2007, and sought to remedy problems that persisted from prior legislation and policies by providing a comprehensive approach to bankruptcy that applied to all forms of enterprises.

The Bankruptcy Law places less emphasis on minimizing worker layoffs and adjusts payment priorities to reflect current standard international practices (e.g., first, pay all secured claims; second, pay for all secured employee claims; and third, resolve outstanding tax and unsecured payments). For these efforts, the passage of the new law has been considered a milestone in China’s market-oriented reform measures. The law is likely to increase foreign investor confidence in their ability to recover invested capital and claims in the event of bankruptcy. China’s 2007 Bankruptcy Law authorizes financial regulators to intervene in financial service company bankruptcies (such as those for banks), and places greater responsibility on senior management by prohibiting senior managers who had been involved in a bankrupt company from assuming positions of senior responsibility in other companies for three years after bankruptcy. This law also authorizes voluntary bankruptcy filings by the debtor and involuntary bankruptcy filings from the creditor against the debtor, prevents asset transfers to insiders, and recognizes the rulings of foreign courts. Despite its advancements, the 2007 Bankruptcy Law does not apply to 2,116 of China’s worst performing SOEs (mostly in the military and mining industries) until 2008. This is largely based on government concerns about the social costs of widespread unemployment. Some sources have expressed concerns about the transparency of the law. For example, China’s courts reportedly can decide to accept or reject bankruptcy applications based on undefined criteria. Under “special circumstances” related to the interests of unemployed workers, judicial and government decisions typically favor employee claims. Finally, there is a lack of local, experienced insolvency practitioners and judges to implement such laws, especially in rural China. The number of bankruptcy cases in the state sector has fluctuated throughout 1995-2003 from a low of 1,232 in 1995 to a high of 5,429 in 2001. The vast majority of these cases were bankruptcy filings by small SOEs that typically employed fewer than 1,000 workers. It is estimated that bankruptcies have been responsible for one-third of the decline in the number of SOEs.

Current Divestment

Forced retirement of small inefficient coal-fired plants26 GWe of these was closed in 2009 and 11 GWe in 2010, making 71 GWe closed since 2006, cutting annual coal consumption by about 82 million tonnes and annual carbon dioxide emissions by some 165 million tonnes. China is well advanced in developing and deploying

supercritical and ultra-supercritical coal plants, as well as moving quickly to design and deploy technologies for integrated (coal) gasification combined cycle (IGCC) plants.http://www.world-nuclear.org/info/inf63.html

State Cabinet Announces Break Up of Grid OperatorsThe National Development and Reform Commission (NDRC) announced that the State Cabinet has approved the demerger of grid operating companies. China’s two grid operators are currently vertically integrated, owning distribution assets as well as equipment manufacturers and research and development units. Originally planned for 2008, the measure is a first step along the road toward separation of transmission and distribution networks.Reuters, 30/05/10; Alibabanews.com, 31/05/10

ReneSola Announces Divestment of Henan Polysilicon Joint VentureDecember 8, 2008 – ReneSola Ltd (“ReneSola” or the “Company”)(NYSE: SOL) (AIM: SOLA.L), a leading Chinese manufacturer of solar wafers, today announced that it has sold its 49% equity interest (the “Divestment”) in Linzhou Zhongsheng Semiconductor Silicon Material Co., Ltd. (the “Joint Venture”). In August 2007, ReneSola and Linzhou Zhongsheng Steel Co., Ltd. (“Zhongsheng Steel”) established the Joint Venture to engage in virgin polysilicon production in Linzhou, Henan Province, China. The Company invested approximately RMB103 million for an equity interest of 49% in the Joint Venture. In June 2008, the Company and Zhongsheng Steel amended the commercial arrangement in the joint venture contract to reduce the contracted obligation of the Company to purchase the output of the Joint Venture from 90% to a minimum of 55% at market price with a term of three years, instead of 30 years in the original agreement.

The Company has sold its 49% equity interest in the Joint Venture to Zhongsheng Steel for a total consideration of RMB200 million, represented by cash paid on completion of RMB44 million and either a credit of RMB156 million through a discount of RMB500/kg to the polysilicon spot price for future supplies or cash in the amount of RMB156 million. “As part of our ongoing evaluation of our raw material sourcing strategy for 2009 we have determined it is in the best interests of our shareholders to divest our equity interest in the Henan polysilicon production facility,” said Mr. Xianshou Li, ReneSola’s chief executive officer.http://phx.corporateir.net/External.File?item=UGFyZW50SUQ9MTczNTB8Q2hpbGRJRD0tMXxUeXBlPTM=&t=1

SOEs begin divesting hotel businesses August 5, 2011 - State-owned enterprises (SOEs) are divesting more than US$15.53

billion worth of hotel assets in compliance with a government order to concentrate only on core businesses, state media reported. China Mobile transferred Chongqing-based Li Yuan Hotel on Tuesday "for free" to China National Travel Service (HK) Group Corp. China Railway Group and Sinosteel are also engaged in offloading their assets. Nearly all of the 128 major centrally-owned SOEs have ventured into hotel operations over the years, resulting in a distorted market. Last year the State-owned Assets Supervision and Administration Commission (SASAC) told SOEs that didn't have tourism as their primary business to exit the hotel industry within 3-5 years.http://www.chinaeconomicreview.com/en/content/soes-begin-divesting-hotel-businesses

SOEs Begin Divesting Real Estate StakesMarch 30, 2010 -Four state-owned enterprises (SOEs) have drawn up proposals for the

transfer of property equity in response to an order from the State-owned Assets Supervision and Administration Commission (SASAC) to reduce SOE involvement in the soaring real estate market. On March 18, the SASAC ordered 78 SOEs whose main business is not property to hand in a withdrawal proposal within 15 days. China Merchants Group, the Hong Kong-based conglomerate engaging in transportation, finance and property, put up 8% of its Beijing Hengshi Huarong Real Estate stake for transfer. Another SOE, China National Nuclear Corporation (CNNC) has already disposed of its 8% stake in Beijing Xinrun Real Estate, while China Aerospace Science & Industry Corporation is looking to offload its 80% stake in a Beijing developer. China Petroleum & Chemical Corporation (Sinopec, 600028.SH, 0386.HK) plans to sell its 50% stake in a Zhuhai developer for only RMB 1, and will sell RMB 14.6 million of related debt for RMB 13.14 million.

A developer who was not named told Beijing News that he was interested only in offers covering land reserves or in stakes of 50% or more. The 80% stake offered by China Aerospace has received attention from analysts after it was put on the market March 18. “We expect its market value to reach RMB 1 billion, and a base price of RMB 184 million,” an insider from the China Beijing Equity Exchange (CBEX) said. According to CBEX Chairman Xiong Yan, the SASAC order will serve to encourage move out of the real estate industry, although most are still running their property businesses as usual since the order was given.

http://en.21cbh.com/HTML/2010-3-30/4OMDAwMDE3MDg4OA.html

China Shuts 14GW of Small Coal GeneratorsAccording to the State Electricity Regulatory Commission and the National Development and Reform Commission, China shut small coal-fired power generators with a total capacity of 14.38 GW last year. The figure accounted for 28.76% of the total capacity that the country planned to close during the period 2006-2010. The programme is an attempt to improve the efficiency of power generation in the country. By 2010, China has set a target of reducing energy consumption per unit of GDP by 20%.Xinhua’s China Economic Information Service, 19/08/08; Asia Pulse, 20/08/08

China to Separate Auxiliary Business From Power Grid CompaniesMay 16, 2001 - The State Electricity Regulatory Commission (SERC) said China is planning to separate auxiliary businesses from power grid companies in 2011. At the same time, four auxiliary businesses are to merge into two companies integrating power design and construction. The plan for auxiliary business separation and merger has been approved by the State Councilhttp://www.nera.com/nera-files/NL_GERN_Issue144_Final.pdf

Sinopec Divesting Two SubsidiariesSince 2004, Sinopec Corp. has been buying up more than half of its listed subsidiaries and divesting two subsidiaries to other central enterprises.

China Shenhua Energy Co Ltd acquires Shenhua-Coal & Power China Shenhua Energy Co Ltd, a majority-owned unit of Chinese state-owned Shenhua Group Corp Ltd, planned to acquire the coal and power related assets of Shenhua Group Corp

Ltd, a Beijing-based coal mining company. It also planned interest in Shenhua Baori Xile Energy Co Ltd, a manufacturer and wholesaler of coal, from Shenhua, and agreed to acquire interest in Shenhua Baori Xile Energy Co Ltd, a manufacturer and wholesaler of coal, from Shenhua, in Hulunbuir Shenhua Clean Coal Co Ltd, a manufacturer of coal products. The company earlier agreed to raise its interest by acquiring a further stake in Shenhua Guohua (Beijing) Electricity Institute Co, and to acquire the power and coal assets (PC) of SG, a coal mining company. The assets were Shenhua Shendong Power. The company has also put stake in Tianjin Guoha Panshan Power Generation Co (TG), an electric utility company, from CLP Guoha Power Co, and stake in Suizhong Power Co Ltd (SP), an electric utility company, from Liaoning Power Co Ltd.http://www.alacrastore.com/dealsnapshot/China_Shenhua_Energy_Co_Ltd_acquires_Shaanxi_Guohua_Jinjie_Energy_from_Peoples_Republic_of_China-439138

Yunnan Yuntianhua Co., Ltd. (600096.SH) Yunnan Yuntianhua Co has announced that its subsidiary plans to divest RMB 550 million worth of ammonia and urea production equipment to Industrial Bank Financial Leasing Co., Ltd. and RMB 200 million worth of ammonia and urea production equipment to China National Foreign Trade Financial & Leasing Co., Ltd. After the sales, the subsidiary will rent them back with a term of six years and five years respectively.http://www.researchinchina.com/news/NewsContent.aspx?id=21386

China's Huawei to Reverse Controversial Deal for 3LeafFebruary 12, 2011, IDG News - Chinese network equipment supplier Huawei has reversed its stance and has accepted a U.S. panel's recommendation to voluntarily divest from a business acquisition that had drawn national security concerns. Huawei said in a statement on Saturday that the company has agreed to follow the recommendation of the Committee on Foreign Investment in the United States (CFIUS) by stopping to acquire specific assets from a U.S. startup.

In May, Huawei had paid US$2 million to buy intellectual property from 3Leaf Systems, which specializes in building servers to run together as more powerful mainframe computers. The deal, however, has come under scrutiny from the U.S. government, because it was cleared without the approval from CFIUS. Government officials then asked Huawei to place the deal under the review of CFIUS. Huawei already purchased the intellectual property and hired staff from 3Leaf Systems, so it's unclear how the deal would be reversed.http://www.pcworld.com/businesscenter/article/220183/chinas_huawei_to_reverse_controversial_deal_for_3leaf.html

Poverty Reduction in Coal Mine AreasThe Peoples Republic of China (PRC) is giving priority to the development of large, mechanized mines along with the modernization of existing large and medium coal mines. The PRC is implementing a policy to close small coal mines that have an annual production less than or equal to 90,000 tons, have failed to demonstrate required worker safety practices, are relatively inefficient, or lack proper certification and licensing and deemed illegal.

In Shanxi Province, there are an estimated 84 KSOCMs, 448 SOCMs, and about 4,000 small coal mines, including TVCMs and non-recognized mines that employ an estimated 290,000 persons. Pursuant to the national policy, the Shanxi Provincial Government has decreed that all new and modernized coal mines must have an annual production of more than 300,000 tons. During one of the project stakeholder workshop in Jincheng on December 5/2005 the Jincheng Land Resources Bureau identified approximately 369 mines that will be either closed or merged to produce the required minimum 300,000 tons per year.

The mine closures that have occurred in Shanxi province and throughout the PRC since 1999 have created significant unemployment situations in different areas. Recent closures of approximately 448 small mines producing less than 90,000 tons in Shanxi province has resulted in an estimated total of 47,000 redundant miners. http://www.adb.org/Documents/Reports/Consultant/37616-PRC/37616-PRC-TACR.pdf

Analysis of China’s Electricity Market

With the creation of the five SOEs and the two state grid companies, China’s electricity governance dynamics were reshaped in ways that enforced a two-tier market structure. The five SOEs formed roughly 45 percent of the electricity market at the end of 2008 while remaining 55 percent remained divided between other central government and provincial power generating companies and private companies. While the competition between the five SOEs has been intense, they have also been able to increase their overall national market share over other generating companies in the provinces. It stood at 49 percent at the end of 2009. As the NDRC controls the generation price, also known as the regional benchmark, the other power generating companies are ill equipped to seriously compete with the SOEs that enjoy favorable operating conditions from the NDRC. Furthermore, and even more strikingly, with wider national leverage the SOEs have better access to coal whose price they can control and profit from by selling it other power generating companies. Finally, the NDRC also controls the transmission and distribution prices with almost non-existent transparency as to how the pricing mechanism is set up. This provides the SOEs with a distinct advantage over provincial and private generating companies that are unable to provide long-term cost of production calculations.

The creation of a quasi-competitive market between the SOEs had the benefit of reducing investment costs into the generation side in particular and also of lowering operation costs. Investment cost into coal powered plant was reduced from 6000 yuan per kWh in 2000 to 4000 yuan per kWh today. Whether the increased competition between the SOEs has resulted in overall efficiency gains for electricity is arguable, and in fact the existing mechanism between the generation, transmission and distribution systems and the stronghold of the NDRC. It has the absolute power to approve transmission licenses in each province and to control the benchmark price for transmission across the country.

However, despite the centralized transmission licensing and pricing mechanisms, regional transmission price disparities distort the competitive landscape between power generating companies. In practice, it is the Provincial Development and Reform Commissions (PDRC) that decide on the price of the transmission for pilot projects, thus providing the provincial governments with significant pricing powers. Only the issuance of certificates and licenses for regional small-scale power projects in generation and for transmission to grid companies is left to the SERC.

As the OGCs have a share of 51 percent the total national electricity generation capacity and the two state-owned grid companies buy the electricity from these national and private small- and large-scale power plants before selling it to consumers, any changes to this system likely to have far-reaching consequences to China’s electricity provision. Recent policy changes however have allowed some of OGCs to sell electricity directly to provincial grid companies and to distribute it to end-users without the involvement of the state-owned grid companies.

A few pilot projects of this nature currently exist and a greater number of such projects should eventually provide the SERC with the preconditions of significant scope and reduced transaction costs of the national market it needs to exercise its market oversight authority relation to generation, the transmission sector has been experiencing similar phenomena. Despite being prohibited by law, private investments into the transmission sector have increased at the county level as some governments have not been able to afford the maintenance and further development of their transmission networks. Hence, unloading the financial burden of the local government by privatizing local state companies is not surprising, yet it is possible that these developments echo larger political and economic problems not only in the electricity sector but in other industrial sectors as well.

As the Electricity Law of 1995 allows only one power supply enterprise for each electricity service area, the transmission and distribution sectors have remained natural monopolies In fact, power plants can only cooperate with a single grid company, either the SGC or the CSPG depending on the location, in order to deliver products in a given area In fact, power plants can only cooperate with a single grid company, either the SGC or the CSPG depending on the location, in order to deliver products in a given area preventing the regions from developing their local electricity markets, the central government, namely the NDRC, is also creating unnecessary obstacles for regional economic growth, which may, in time, contribute to social disparities and more wide-spread dissatisfaction over the government’s policies.

Provincial and local governments that have significant information advantage and welfare concerns over infrastructures have been kept out of key decision-making on industrial restructuring and strategic decisions of the new state-controlled firms. Lin (2008) has suggested that the dismal fiscal situations of local states, their profligate investment behaviors, and their local market protectionist tendencies under the previous period of decentralization in the 1980s and 1990s have discredited them in the eyes of the central planners.

http://www.spp.nus.edu.sg/docs/wp/2010/wp1012.pdf

Analysis of China’s Coal Market

Background

China’s coal market – already the largest in the world – is increasingly a driving force in the global trade and pricing of coal. China’s imports accounted for nearly 15% of all globally traded coal in 2009, and that share is poised to increase in 2010. The coal market has entered an era in which even slight shifts on margins of China’s internal market directly impact coal trade and prices globally.

China is now in the midst of a radical restructuring of its coal and power sectors that has the potential to change how coal is produced, traded and consumed both in China and the rest of the world. That restructuring aims to integrate the coal and power sectors at giant ―coal-power bases that combined would churn out more coal annually than all the coal produced in the United States.

One of the most significant reform efforts now under way is an attempt to radically restructure the sector by integrating coal and power businesses at key sites deemed ―coal-power bases.‖ Grounded in the fundamental desire to redistribute risk and profits across the coal and power sectors, consolidate the coal, power, and railway industries, and enhance central government control of China’s energy system, this reform has the potential to fundamentally alter the structure of the Chinese coal and power markets.

Despite a dramatic increase in oil and gas production and the rising share of renewable energy sources, including hydro power and nuclear power, by 2008 coal still provided nearly 70 percent of China’s primary energy supply and generated 80 percent of China’s electricity (NDRC 2008). Moreover, despite large-scale industrial restructuring and government attempts since the 1990s to close down small and inefficient coal mines, coal still provides no less than 4 million jobs directly in the coal sector and millions more in coal-related industries. The sector’s development is significantly constrained by the regulatory structure of the related railway and power sectors. Electricity prices for the power sector are not liberalized and the railway networks are still under monopoly control. This situation creates conflicts between the development goals of the coal, power, and railway industries, and considerably impedes the healthy development of the coal industry. While state-owned (also referred to as State Owned Enterprises, or SOEs) coal for more than a decade been expected to be responsible for their profits or losses, they are not allowed to sell coal to power-generating companies at market prices. The coal sector’s largest customer cannot pass its costs through to electricity consumers, and the result is that revenues from electricity production at times do not compensate for coal input costs. In short, either coal or power must accept losses resulting from electricity revenues not covering coal input costs, and the struggle over who will accept these losses is borne out in China in negotiations over the coal price. This conflict is commonly called the ―coal-power conflict. Additionally, the monopolized rail network is able to take advantage of its dominant position to extract rents from coal producers who rely on the rail networks to transport and sell their product.

Numerous reforms have been attempted or implemented by the Chinese central government in attempts to resolve the conflicts between coal, power, and rail described above. One of the most

significant reform efforts now under way is the radical restructuring of these sectors through integrating coal and power businesses at key sites designated as ―coal-power bases. This reform has the potential to dramatically change.

According to the 11th Five Year Plan of China’s Coal Industry issued by the National Development Reform Commission (NDRC 2007), 13 large coal-power bases have been planned. The policy imagines that each of the 13 mega-bases that would produce over 100 million tonnes (mt) of coal and generate massive amounts of power. These bases involve 14 provinces and prefectures, covering a total area of 287,000 sq. km, comprised more than 98 coalfields. The available coal resources of the bases are to be 690.8 billion tons, representing 70 percent of the total national coal resources. These bases can be developed utilizing three primary ―modes‖ of integration across the existing coal and power value chain: coal firms extending into to the power sector, power firms extending to coal the coal sector, or coal and power (or other firms) acquiring shares of each other

Coal-power base policy and key drivers for creating large coal-power bases

There are severe challenges facing China’s coal industry: incomplete price reform, fragmented production structure and diseconomies of scale, and a poor safety record. All of these factors make China’s coal market inefficient and contribute to higher costs and prices. But above all, the coal, power, and railways conflict stands out as a key challenge.

Chinese policy-makers have put forth policy solutions to these challenges that create large coal-power bases that could end the disputes among the coal, power, and railways, and optimize the structure of the coal industry.

The 11th 5 Year Plan for Coal Industrial Development set forth five principles for building large coal electricity bases. The first is orderly and centralized development (jizhong youxu kaifa). Essentially, one base is developed by one entity (i.e., the company) in order to make a comprehensive plan and to control the pace of development. The second is an emphasis on innovation, focusing on large coal and power group corporations as the best types of firms to drive technology investment and advancement. The third is an optimal coal production structure based on developing a large scale, modern open-cast mines, improving resource recovery rates, and speeding up the closure of small mines (note that this horizontal integration of the coal production structure, which is emphasized in other policies, has been paired with vertical integration in the coal-power base strategy). The fourth is comprehensive development of coal and power, coal and chemical, and coal and railways and the integration of these industries. The fifth is the development of ―the recycling economy‖, in which the close connection between upstream and downstream industries ensures the environment can be better protected (NDRC 2007).

The 13 coal bases will cover 98 coalfields of around 287,000 sq. km, distributed across 14 provinces. Across these 13 bases, the government will allow six to eight coal-power corporate groups, each with a 100 Mt annual output and eight to 10 companies with a 10 Mt annual output. The output of 13 coal-power bases was expected to reach 2.24 Bt by 2010 (NDRC 2007),

indicating that output from these 13 bases will account for about 86 percent of the national total, given the 2.6 Bt of planned national output by 2010 (NDRC 2007).

It should be noted that the 13 coal-power bases in the 11th Five Year Plan have been changed considerably since the initial plan and will be subject to further changes in the future. This is primarily due to the fact that the original coal-power bases were not planned scientifically or are impractical, or new coal resources were discovered. Fang Junshi, head of coal at the National Energy Administration, explained that many of the planned bases were ―not practical and scientific‖ because these bases were found to lack a water resources, a crucial input for extracting coal and washing coal (Shanghai Stock Exchange Report, December 5, 2008). New bases were therefore revised afterwards to replace the previous plan. Xinjiang and its abundant coal resources is a prominent new discovery that could replace previous planned cases. Although 11th Five Year Plan did not include Xinjiang as one of the 13 bases, the reserves and condition of the Xinjiang coalfield deserve close examination. As discussed later in this paper, it holds great promise as a new coal-power base.

The objectives of building up coal-power bases

Reduce price risk and overcome conflict between coal and power firms Creating coal-power bases could reduce transaction costs for coal and power companies associated with selling or purchasing coal, and allow both industries to capture the value in the supply chain previously captured by the MOR. Second, coal-power bases could spread market risk across the whole value chain. Coal profits could supplement power losses when the coal price is high, and vice versa. Power-generating companies will improve their competitiveness because ―if China’s utility companies could supply 30 percent of coal demand with their own source, they would be less vulnerable to coal price fluctuations‖8 (Xie, April 21, 2009). Third, integrated coal-power bases would not require expensive contracts with the MOR and transport costs could be returned to coal producers and consumers as cost savings. Finally, establishing more coal-power bases will help overcome conflict among coal and power companies because coal companies will have more secured customers while power companies have a long term secured coal supply. When more coal companies have their own power businesses and power companies have coal businesses, they both will rely less on the Coal Conference and the railways. In sum, price volatility and transportation dependency are the main risks for both coal and power firms, and as a result risk and profit sharing and transport cost savings are the main drivers of creating coal-power bases.

Optimize industrial structure to nurture large modern coal corporations

Chinese energy policy has made enhancing industrial concentration of the coal sector a top priority. In the current industrial structure, excessive competition among tens of thousands of coal companies results in numerous problems (Rui 2005, chapter 3) — including the coal supply and prices. There are two primary dimensions of optimization at work. The consolidation of the coal production structure is a separate but closely related goal. First, consolidation of coal production aims to achieve horizontal integration of coal production (by consolidating small mines into larger mines). Second, the NDRC had declared that this type of horizontal consolation

of the coal production structure has to be accomplished simultaneously with vertical integration between coal producers and coal consumers.

The government’s desire to build large corporations is an additional key driver for building large coal-power bases. One of the five principles in the 11th Five Year Plan of the Coal Industry is that large corporations will be chosen as the principal enterprises to develop coal-power bases, in order to provide not only a comprehensive plan for the broader industry’s development, but also to secure the best technology and equipment in developing the bases. Coal companies consider technology investment a necessary step to realize economies of scale and to utilize coal resources most efficiently.

Coal-power base policy envisions several key gains from optimizing the industrial structure of coal and power through integration. First, achieving integration will ensure that coal resources can be extracted, processed, and transported in a manner that maximizes the value of coal and reduces inefficient resource use by maximizing economies of scale. Second, this should also be easier for limited large coal corporations to make long term agreements in supply or even cooperate in exploration and R&D. Finally, this will contribute to the reduction of market fluctuation and risk, and transport constraints, as explained above.

Reinforce the central government’s control over energy markets

The Chinese government has a strategic vision to use large coal and power bases to reinforce its control over the energy sector. Zhang Guobao, the head of the National Energy Bureau, published an important article in the People’s Daily (December 29, 2008), titled ―The current situation: opportunities among the danger (dang qian de xingshi: wei zhong zhi ji). Zhang clearly stated in this article that ―large energy enterprise groups are nurtured with the integrative and comprehensive development of coal, power, railways, ports, chemical, and other related industries, so as to toughen the government’s influence and control on energy.‖ Reuters commented that the article ―uncommonly expatiated China’s official view on its energy strategy.

The implications of the government exercising greater control over the energy sector should be strongly emphasized. First, if the coal-power bases are successful, the government could much more easily control national coal production, given that these 13 bases may account for as large as 80 percent of the national output (the exact percentage depends on future national production growth and the rate of development of the bases). Second, in the government’s view, fewer large coal producers would imply a more stable price for coal. Third, if the 13 bases are mainly state-owned, the government will be able to coordinate energy and industrial policy much more easily. Fourth, the government will be able to more easily predict how much coal is available for export and therefore more easily control export volumes (exports are strictly controlled under a quota system). Finally, given the smaller number of producers, the government will be better able to supervise each corporation’s investment in environmental protection, technology and equipment, R&D, and acquisition of new resources both in China and abroad. All of these efforts would be difficult if not impossible in a country with tens of thousands of small coal mines protected by local governments that aimed to maximize short-term profits.

Protect the environment and reduce carbon emissions

One major motive for building coal-power bases is to transform the way energy is moved in China, from the transporting of coal via rail to the transmission of electricity via wire. (also known as coal by wire or gai shumei wei shudian). If a ―coal by wire‖ were successful at scale in tandem with coal-power bases, it could make a significant contribution toward improving the environment and save on carbon control costs. The following example of the energy supply and demand balance between Shandong province and Shanxi province illustrates this point.

As predicted by its provincial government, Shandong province will have coal import demand of 190 Mt, 290 Mt, and 350 Mt from other provinces by 2010, 2015, and 2020, respectively. It will also have a supply shortfall of electricity capacity between 3000 MWh and 6000 MWh in 2009 and 2010. The provincial government is therefore working hard to meet the demand for both coal and power. Meanwhile, neighboring Shanxi province has plenty of coal but needs secure customers as well as roads and ports to transport its coal. After negotiations, the two provinces signed an unprecedented ―agreement framework on strategic cooperation in energy and transportation‖ in early 2009. According to the framework, from 2009 to the end of the 12th Five Year Plan, Shanxi will transmit 10,000 MWh every year to Shandong by building coal-power bases and constructing transmission capacity that enables energy to be exported as electricity via wire rather than coal via rail. As a result, Shandong will obtain electricity from Shanxi at a price 0.10 yuan/kwh lower than the local Shandong grid price. Shanxi will gain access to new markets for its coal after it builds up railways from its central and south region to Shandong’s port of Rizhao. Most experts believe this will be a win-win agreement. Due to the significance of the power grid in this agreement, the State Grid Corporation also joined the partnership. In November 2008 Shandong signed an agreement with the State Grid Corporation in which the latter will build six super high-voltage transmission lines by 2020 in order to transmit electricity from 52,000 MW of dedicated generation capacity to Shandong, a number equivalent to 20 percent of Shandong’s total installed capacity. It should be noted that there is still debate over the cost advantage of constructing a new railway to transport coal versus transmission lines to transport electricity. It is reported that an annual 200 million tons of rail traffic is equivalent to 20 to 34 circles of 1,000 kV UHV AC transmission lines, i.e., they provide an equivalent amount of energy to end-user customers. However, the former's investment is less than 1,000 billion yuan, while the latter's investment is between 2,400 and 4,080 billion yuan, a huge gap between the scales of investment (Chen 2008). However, in the case of Shandong and Shanxi, the cost of transporting electricity will be lower due to the use of existing transmission lines and the network of the State Grid Corporation.

There are additional benefits beyond the secure supply of electricity and the savings on electricity costs. If the goal of ―outside electricity entering Shandong‖ can be realized, Shandong will benefit enormously from protecting the environment. It will save 128 Mt per year on coal consumption, reduce SO2 emissions by 2.06 Mt, and cut CO2 emissions by 256 Mt.11 This could create much more space for Shandong’s industrial development in the future. The framework is regarded as ―unprecedented‖ because it crosses multiple provinces and industries. It will considerably optimize the energy structures of the two provinces and open the closed grid system of Shandong, thereby balancing the power supply shortage in Shandong with the surplus in Shanxi (Xinhua News, January 12, 2009).

Improve technology through R&D at large enterprises

Coal or power companies located in coal-power bases are required to build modern, safe, and high-efficiency coal mines or power plants. This will stimulate the application of advanced technology and high-efficiency equipment and promote R&D.

Table . China’s top 10 coal companies in 2006 and 2008 (Million tons) Rank Coal companies Production

(2006) Coal companies Production

(2008) Million tons % national total Million tons % national total

1 Shenhua Group

149.7 6.3 Shenhua Group

281.3 10.1

2 China National Coal

71.9 3.0 China National Group

114.1 4.1

3 Shanxi Coking Coal

60.8 2.6 Shanxi Coking Coal

80.3 2.9

4 Shanxi Datong Coal Mining Group

56.7 2.4 Shanxi Datong Coal Mining Group

68.9 2.5

5 Heilongjiang Longmei Holdings Co., Ltd.

52.7 2.2 Shaanxi Coal and Chemical Industry

60;4 2.2

6 Yan Mining Group

37.0 1.6 Anhui Huainan Mining

56.7 2.0

7 Shanxi Yanquan Coal (Group)

32.5 1.4 Heilongjiang Longmei Holdings Co., Ltd.

55.0 2.0

8 Anhui Huainan Mining

32.4 1.4 Henan Coal and Chemical Industry

44.7 1.6

9 Henan Pingdingshan Coal (Group)

32.1 1.4 Shanxi Lu’an Mining

42.1 1.5

10 Shaanxi Coal Group

30.8 1.3 Pingmei Shenma

41.2 1.5

Energy Chemical Group

National Total

2,373 100 National Total

2,793 100

http://iisdb.stanford.edu/pubs/23050/WP_98,_Rui,_He,_Morse_China_Coal_Power_Bases_DEC10.pdf