Regulation and Pricing: A Case in Power Sector Reform

In March 2015, the Chinese government issued “Opinions on Further Deepening Power System Reform”[1] (Hereinafter “Opinions”), representing an in-depth study of power market reform after the 2002 power plant-grid separation and governmententerprise detachment reform. The focus of the 2015 reform is to separate power transmission and distribution from the retail end and rationalize the price formation mechanism. At the same time, the reform will carry out the implementation of opening market access to the power retail end, bringing in main competitors and promoting the increase of investment. It requires time to judge whether this reform can indeed improve industry efficiency and service level, stimulate innovation in technology and management, and promote social welfare.

The primary task of the current reform is to validate transmission and distribution pricing separately; by establishing power trading mechanism, the electricity price in the supply side and demand side is to be determined by the market, which means the operating mode of the power grid needs to be regulated and reformed. Grid enterprises will no longer benefit from price differentiation between on-grid power tariffs and retail tariffs, but to charge wheeling costs according to the government validated transmission and distribution pricing. This can ensure the stable revenue and return rate of grid companies and regulate their investment and assets management. If there is no effective regulatory strategy, it is difficult to succeed in electricity reform in terms of power generation and retail end separation from transmission and distribution, competition between supply side and demand side, as well as the adjustment in price formation mechanism and the establishment of power trading mechanism.

Considering the validation of transmission and distribution pricing, “Opinions” uses the “cost and reasonable return” principle. Such pricing principle is totally different from what Tirole suggested in his regulatory policy studies[2], namely incentive menu-type contract. To a large extent, the regulators still have interventions into grid enterprises in electricity reform in China, while it also seems that regulators are unwilling to admit the fact of unequal information sharing with business managers on electricity pricing. Under such system, grid enterprises will probably lack the motivation to enhance operational efficiency, increase investments and improve the reliability of power system operation. Although the new pricing mechanism has achieved some progress in the pilots of Inner Mongolia and Shenzhen, where the  selling price of price has declined somewhat, it still faces some challenges. This includes how to moderately regulate and how to incentivize enterprises to improve their efficiency. Certainly, the reason why China has chosen such a pricing model might be due to the restrictions on ownership, and the contractual agent relationship has not been established between the regulator and enterprises.

Power market reform is an arduous and complicated task. China needs to draw on the experiences from other countries and refer to research on electricity regulatory reform in order to reach the goal of the reform, which is to promote competition, stimulate technological innovation, enhance market efficiency and improve social welfare. We believe that the core of the power market reform launched in 2015 is to determine the price formation mechanism. In terms of the pricing model of transmission and distribution, we consider that the current pricing mechanism still can not solve the problem of how to regulate within a proper scale and leave enough room to incentivize enterprises to improve their efficiency.

Regulatory Reform Framework of Power Sector[3]

1)Privatization of state-owned electricity monopolies to create hard budget constraints and high-powered incentives for performance improvements and to make it more diffi cult for the state to use these enterprises to pursue costly political agendas.

2)Vertical separation of potentially competitive segments (e.g. generation, marketing and retail supply) from segments that will continue to be regulated (distribution, transmission, system operations) either structurally (through divestiture) or functionally (with internal “Chinese” walls or “ring fencing” separating affi liates within the same corporation). These changes are thought to be necessary to guard against cross-subsidization of competitive businesses from regulated businesses and discriminatory policies affecting access to distribution and transmission networks upon which all competitive suppliers depend.

3)Horizontal restructuring of the generation segment, to create an adequate number of competing generators to mitigate market power and to ensure that wholesale markets are reasonably competitive.

4)Horizontal integration of transmission facilities and network operations to encompass the geographic expanse of “natural” wholesale markets and the designation of a single independent system operator to manage the operation of the network, to schedule generation to meet demand and to maintain the physical parameters of the network (frequency, voltage, stability), and to guide investments in transmission infrastructure to meet reliability and economic standards.

5)The creation of voluntary public wholesale spot energy and operating reserve market institutions to support requirements for real time balancing of supply and demand for electric energy, to allocate scarce network transmission capacity, to respond quickly and effectively to unplanned outages of transmission or generating facilities consistent with the need to maintain network voltage, frequency and stability parameters within narrow limits, and to facilitate economical trading opportunities among suppliers and between buyers and sellers.

6)The development of active “demand-side” institutions that allow consumers to react to variations in wholesale market prices and fully integrate demand side responses to energy prices and reliability criteria into wholesale and retail markets.

7)The application of regulatory rules and supporting network  institutions to promote effi cient access to the transmission network by wholesale buyers and sellers in order to facilitate effi cient competitive production and exchange. This includes mechanisms effi ciently to allocate scarce transmission capacity among competing network users, and to provide for effi cient siting and interconnection of new generating facilities.

8)The unbundling of retail tariffs to separate prices for retail power supplies and associated customer services to be supplied competitively from the regulated “delivery” charges for using distribution and transmission networks that would continue (primarily) to be provided by regulated monopolies.

9)Where policymakers have determined that retail competition will not be available (e.g. for domestic and small commercial customers), distribution companies or alternative designated suppliers would have the responsibility to supply these customers by purchasing power in competitive wholesale markets or, if they choose, to build their own generating facilities to provide power supplies. However, in the latter case the associated charges for power would be subject to wholesale market-based regulatory benchmarks, primarily competitive procurement processes.

10)The creation of independent regulatory agencies with good information about the costs, service quality and comparative performance of the fi rms supplying regulated network services, the authority to enforce regulatory requirements, and an expert staff to use this information and authority to regulate effectively the prices charged by distribution and transmission companies and the terms and conditions of access to these networks by wholesale and retail suppliers of power, are also an important but underappreciated component of successful reforms.

11)Transition mechanisms must be put in place to move from the old system to the new system. These mechanisms should be compatible with the development of well functioning competitive markets.


Author:Zhao Ang  and Lin Jiaqiao



[1]Link: Access: 2015.12.04.
[2]Jean Tirole: imperfect competition and regulation of the electric power industry. Claude Crampes, Thomas-Olivier Léautier. Link: jean-tirole-imperfect-competition-and-regulation-electric-power-industry?language=en Access: 2015.12.01.
[3] Lessons Learned From Electricity Market Liberalization. Paul L. Joskow. The Energy Journal, Special Issue. The Future of Electricity: Papers in Honor of David Newbery. 2008

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