Efficient Market vs Regulatory Capture: the Political Economy of China's Power Market Reform

China's power sector reform has been a topic of significant interest as the sector accounts for 45% of its carbon emissions. We delve into the efficiency changes spurred by market reforms and explores the influences of both market-driven and politically driven mechanisms in the reform process.

Background: China is the largest emitter of greenhouse gases globally, and its power generation sector is heavily reliant on coal, contributing to about 45% of China’s total carbon emissions. This dependence has also resulted in significant air pollution, and other public health impacts. To address these issues and improve generation efficiency, China initiated a new round of power sector reforms in 2015, aiming to introduce market mechanisms into power generation operations through economic dispatch.

The Role of Economic Dispatch: Economic dispatch is a market-based approach where generators are dispatched based on their generation costs. This approach incentivizes more efficient generators with lower fuel costs to produce more electricity. Previous studies (Abhyankar et al, Wei et al, Lin et al) have demonstrated the potential of economic dispatch in reducing operational costs and emissions in the power sector in China.

Political Challenges in Reform: However, the implementation of market-based reforms in China's power sector faces political challenges. Historically, power supply and demand have been balanced at the provincial level, with local governments responsible for formulating annual generation plans. Given the significant contribution of locally owned power generation companies to the local economy (such as taxes), this arrangement can lead to local protectionism and regulatory capture, where local enterprises are favored over central state-owned enterprises (SOEs) in the allocation of generation quotas.

Key Findings: The study evaluated the reform's efficiency changes using data from the southern grid region of China. We identified an overall improvement in coal-fired power generation efficiency after the reform. Before the reform, large capacity generators have fewer allocated generation hours (Tabel 1). After the reform, however, large-capacity and high-efficiency generators gained more operating hours, on average, 62 hours per 100 MW increase in capacity, indicating a positive impact on generation efficiency.

Table 1. Regression on operating hours, capacity and ownership structure of coal-fired generators

Robust standard errors in parentheses. aP < 0.01,, bP < 0.05, cP < 0.1. P values are for a two-sided test based on normal distribution.Yesdenotes that the fixed effect is controlled in the model. (1) Although we see that 600-1,000 MW generators obtained fewer operating hours after the reform compared with 300-600 MW generators, the coefficient difference between them is not significant statistically (P = 0.759). (2) Table 1 takes central SOE as the benchmark and generates three dummy variables: ownership-local SOE, ownership-private enterprise and ownership-other. The coefficients of the three variables indicate the difference in operating hours between these three types of enterprise and central SOE, with other conditions remaining the same.

However, the study revealed that regulatory capture in provincial markets limited the reform's full potential. Local governments, motivated by economic and political considerations, protected small coal-fired and natural gas generators owned by local SOEs by allocating them more generation quotas (Figure 1b). This preference for local enterprises hindered their motivation to improve generation efficiency, resulting in unrealized carbon dioxide emission reductions and social welfare gains. If the economic dispatch is fully implemented, 3.1 million tons of CO2 and 7.3 billion RMB would be saved due to efficiency gain, however, under the hybrid economic dispatch with allocated generation, only about 1.5 million tons of CO2 and 4.1 billion RMB would be saved in Guangdong in 2018.

Figure 1. Allocated generation and hours of different generators in Guangdong after the reform. a, The allocated generation, average allocated hours (right y-axis) and total generation of gas-fired generators in Guangdong. b, The average allocated hours of coal-fired generators with different capacity levels (< 300 MW, 300–600 MW, 600–1,000 MW, and ≥1,000 MW) in Guangdong.

The findings highlight the importance of addressing political challenges alongside market mechanisms in power sector reform. The study underscores the need to ensure equal treatment of all market entities, irrespective of ownership structure, to foster competition and efficiency. Overcoming regulatory capture and local protectionism is crucial for realizing the full benefits of market-based reforms in China's power sector.

Conclusion: China’s power market reform holds great promise in terms of emission reduction and energy cost savings. However, the study highlights the challenges and missed opportunities that hindered the reform’s full potential. With stronger implementation of market mechanisms and addressing regulatory interference, China can unlock the full potential of emission reductions, achieve social welfare gains, and improve energy efficiency in its power sector. These findings underscore the importance of continued efforts to refine and optimize power market reforms to promote a fast transition to a new and clean power system in China.

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