The real reasons behind China’s energy crisis

More than half of China's provinces have been rationing electricity over the past couple weeks, disrupting the daily lives of tens of millions of people. Elevators have been turned off, stores' opening hours have shortened, and factories have had to reduce operating days and power consumption. Some provinces have experienced outright blackouts. Meanwhile, September saw industrial output decline for the first time since China started recovering from the Covid-19 lockdowns.

It's the worst electricity crisis China has faced in a decade. The immediate cause is that China is still highly dependent on coal, which provides 70 percent of the country's power generation. The electricity prices paid to generators are regulated by the central government, while coal prices are set on the market. When coal prices rise, unless regulators increase electricity prices, it doesn't make economic sense for coal power plants to keep supplying electricity. Plants can then avoid generating at a loss by claiming they have a technical malfunction or by failing to purchase the coal they need to run, both of which happened in the run-up to the current crisis.

But the reasons for the crisis can also be traced back to a string of policy missteps and poorly thought-out market interventions after the beginning of the pandemic. The crisis has put China's continued dependence on coal in stark relief, even as its market shares of renewable and nuclear energy have continued to increase.

Regulated power prices are intended to shield electricity users from price risks—a subsidy that comes at the expense of those who generate the power. Beijing is usually slow to raise prices because the public feels it when it does.

China's recovery from the initial economic shock of the pandemic relied excessively on construction and heavy industry, which caused demand for coal to increase 11 percent in the first half of 2021. This short-term trend was in sharp contrast with Beijing's calls for a "green recovery" and its strengthened pledges to reduce emissions.

The increase in coal demand meant that the market was always going to be tight. But the government's attention was on combating producer price inflation, and hiking power prices didn't fit that agenda. Instead, as fuel prices started to rise on the back of the global recovery and blistering demand in China, the regulators took actions that amounted to an implicit ban on raising coal prices, and they were even considering a formal price cap. This meant that Chinese coal miners couldn't charge the high rates that others on the market were getting abroad.

Failing to raise power prices and pushing back on coal price increases meant that coal plants cut back on coal purchases and ran down the stockpiles instead. It also meant that coal mines didn't ramp up output in time, as the regular price and demand signals were dampened.

Now, power plants have been running down their stocks for months. Reported coal inventories at major power plants started falling below historical averages a year ago and at the end of August fell 37 percent from the same time last year, according to industry data from Wind Financial Terminal.

Beijing's attempt in late 2019 to introduce flexibility to pricing appears to have made things worse. Power plants were given the ability to negotiate long-term contracts with grid operators within a certain price band. This could have allowed plants to negotiate higher margins, but as some warned already in January 2020, it had the opposite effect: Because China has overcapacity in coal-fired power, it was the grid operator that had the pricing power, and generators bid low, further lowering prices. It's textbook economics: Oversupply led to low prices and low or negative profits to suppliers. It didn't help that the government's clear priority was to reduce power prices: In 2020, the first year of the new system, prices were only allowed to be lowered.

The effect of the negotiations between the grid operators and power plants, and government pressure to keep prices low, can be seen in what little pricing data is available: The average rates paid to every listed company that is reporting data fell in the first and second quarter of 2021, even as coal prices were rising. Government measures to cut power bills in 2020 likely put further pressure on grid operators to negotiate down prices. Paradoxically, having too many coal-fired power plants contributed to the power crunch.

Effectively, the regulators allowed plants to run down stockpiles in a gamble to avoid electricity price hikes, and the gamble failed spectacularly.

A long list of alternative—and false—explanations have emerged within China. Grid operators have sought to attribute the issues to rising demand, even though the real estate slowdown and milder temperatures mean that demand has already come down from its summer peak. Opponents of climate action have blamed the power rationing on local government attempts to meet energy consumption targets or broader climate goals. The international media has hinted at attempts to shift from coal to renewables as a factor in the blackouts and devoted disproportionate attention to whether China's ban on importing Australian coal is contributing to the situation.

In all fairness, many of these factors have led to power rationing before. Zhejiang province was rationing power at the end of 2020 to meet energy consumption targets after surging demand, and Hunan and Jiangxi experienced power shortages at the same time due to lack of generating capacity and outdated grid operation.

But none of these reasons come close to explaining why power shortages are occurring now, throughout the country, even as the central government is doing its best to restore full supply. Certainly no bureaucrat thinks that power cuts will win Beijing's favor at this moment.

State media has also blamed the variability of wind power for the outages, citing low production in a single province. However, wind, solar, and nuclear power all delivered record output in the period from July to August, increasing 16 percent, 10 percent, and 12 percent, respectively, from that time last year, easing the pressure on coal supply.

In the short term, to get the lights back on and make it through the winter, increasing coal supply and power prices is necessary, and Beijing's central planners are already taking steps in this direction. At the same time, the crisis should be seen as alarming proof of the economy's vulnerability to fossil fuel prices, and the transition to zero-carbon energy should be accelerated. The best thing that could have happened in this situation would have been more zero-carbon generating capacity in place that was not affected by fuel prices.

The crisis has been brewing for months, and it cannot be resolved overnight. Coal purchases have lagged behind demand and stockpiles have been falling since early 2021, so now when everyone is trying to restock at the same time, bottlenecks abound, and coal prices are through the roof. Power demand will be especially high in the winter, so Beijing's regulators face an uphill battle to restore full power supply in the next months.

As a part of the regulators' efforts, China's electricity pricing reforms, which have progressed at a snail's pace for the past decade, are going to happen very fast and ad hoc now. Guangdong and Hunan provinces have already announced changes to rates paid to generators that are aimed at allowing them to increase rates when fuel prices increase. This is a part of the short-term solution, but it passes the price risk to consumers and retailers, which will undermine the industrial policy predicated on stable power prices—but will also increase the attractiveness of zero-carbon energy that isn't affected by fuel prices.

What matters the most is not external noise but how Beijing interprets the events internally.

Meanwhile, the current power cuts are hitting the entire economy, including retail, services, and high-tech manufacturing, which the government is counting on to support economic growth as real estate has slowed down after the Beijing's moves to pull back from its construction stimulus and instate targeted restrictions on credit to the real estate sector. (This is what precipitated the implosion of Evergrande and has seen demand for steel and cement plummet in recent months.)

As always, the risk is that once the acute crisis is resolved, the government will resort to the old playbook of more wasteful construction projects to prop up the economy, which would lead to another surge in emissions and further delay the economic transition away from construction-driven growth. There are strong fossil fuel lobbies within China's power industry and government that are also using the crisis to attack climate-related policies under false pretenses, in a bid to make the government more reluctant to introduce new climate-related targets and measures.

What matters the most, though, is not external noise but how Beijing interprets the events internally. The central planners are expected to soon release a key document that will lay out the targets and measures to peak carbon dioxide emissions before 2030. This will give the rest of the world a sense of China's ambitions before the upcoming climate summit in Glasgow, Scotland. Only then will we know how the energy crisis will affect China's determination to tackle climate change and finally move away from coal.

Lauri Myllyvirta is the lead analyst at the Centre for Research on Energy and Clean Air.

Disclaimer: This article first appeared on ForeignPolicy, and is published by special syndication arrangement