The central government has approved a proposal to link coal and power prices next year, in a move to allow profit-squeezed electricity generating companies to pass fuel cost rises onto end users.

The mechanism, once it takes effect, could lead to a total electricity tariff rise of as much as 16 billion yuan (US$1.8 billion) next year which will reflect coal price increases.

The government hopes such a pricing linkage mechanism will enable the once-tightly-controlled electricity tariff to fluctuate in line with the coal price changes, easing the long-standing spat between the two industries over coal prices.

Analysts, however, doubt whether the so-called "coal-cost-pass-through" mechanism will be effective.

They said the government is still to cap electricity rate surges which will lead to inflation and hurt the economy.

And the limitation on electricity rates, in turn, leads to controls over coal prices, analysts said.

Late last month, the State Council approved the long-discussed pricing linkage proposal. Details of the proposal are still to be finalized.

Under the proposed framework, when average coal prices fluctuate by more than 5 percent within half a year, government-set electricity rates will change accordingly.

About 70 percent of the coal price increase will be finally transferred to end users. Generating firms will take in the remaining 30 percent of the fuel cost rises.

Should the coal price change by less than 5 percent within the half-a-year period, the electricity tariff would remain unchanged, leaving excessive cost increases to be adjusted in the next half-a-year period.

Electricity tariffs for agriculture and medium and small-sized fertilizer enterprises, which have a meagre, if any, profit margin, are free from the price change.

Sources said the initial coal price for next year will be calculated based on the average prices between the end of May and the end of this year.

Based on that calculation, the electricity rate will increase by 0.0076 yuan (0.09 US cent) per kilowatthour to cover the coal cost hike of 20 yuan (US$2.4) a ton.

Based on last year's electricity power generation, it will increase the total electricity bill by as much as 15 billion yuan (US$1.8 billion).

The power industry consumes half of the 1.9 billion tons of China's total coal output.

Power generating firms purchase part of their thermal coal supplies from coal suppliers at a government-supported price as much as 50 percent below that of the spot market.

As coal prices on the spot market kept rising since late 2002, coal companies have been calling for a price increase for coal supplied to power generating firms.

Power companies, however, refuse to accept an increase. They argued that they cannot afford the fuel cost increase since electricity rates are strictly frozen by the government.

The stand-off has caused many coal suppliers to refuse to observe coal supply contracts, and they sold more coal on the spot market to cash in on the price hike. Generating companies, as a result, ran out of coal supplies and stopped operation, adding to the woes of an already tight power supply.

To offset the coal price hike, the Chinese Government raised the electricity tariff twice in January and June.

But the electricity tariff rises were far from enough to cover the cost increases that are eroding power companies' profit margins.

Analysts see the two electricity tariff rate hikes as a "soft launching" of the coal-power pricing linkage mechanism.

"Seldom has the Chinese central government implemented a policy without first trying it out," said one Hong Kong-based industry analyst.

Analysts said the move may partly help alleviate pressure on domestic power producers, which counts coal as half of their operating costs.

"The coal-power pricing collaboration is the way out to resolve disputes between the two sectors," said Zhu Wenzhang, a veteran power industry expert.

Similar mechanisms work well in many countries and regions including Hong Kong, said Zhu.

Zhu further suggested to set up a special fund as a cushion between coal and electricity prices.

Without changes in power tariffs, the fund collects excessive profits of power companies when coal prices drop, and subsidizes the power firms when coal prices rise.

The fund can avoid too much fluctuation in electricity prices, Zhu said.

Analysts say the coal industry is the major beneficiary of such a collaborative pricing system. The coal price hikes help miners to improve their profitability, increase investment in exploration and production, and improve safety in the work place.

The profit margin of the generating companies, however, will continue to be squeezed in the first half of next year, according to a report of a domestic investment bank obtained by China Daily.

According to the proposal, the on-grid price, at which generating firms sell electricity to grids, would rise by 7 yuan (84.6 US cents) per megawatthour to reflect the 70 percent coal price increase.

But the increase of coal price is expected to exceed 20 yuan (US$2.41) a ton during the first half of next year, the report said.

However, their profit in the second half could be improved with the coal price cutting the necessity for further increase.

Uncertainties remain

Still, the implementation of the principle would be quite difficult. And the mechanism may not completely resolve the disputes between the coal and power sectors, said analysts.

For one thing, the government would not like to see a price surge in end user prices. A fast increase in electricity rates may lead to inflation, jeopardizing the stability of the economy.

"In the end, it is likely to become a means for the government to cap coal price increases in order to keep the electricity rate stable," said Wang Xiaohui, an industry analyst with CITIC Securities.

The Hong Kong-based analyst said: "A risk exists that higher coal prices reflected in power on-grid tariffs could incite the thermal coal suppliers to further hike coal prices, thus creating a vicious circle."

In addition, the proposal does not specify a benchmark coal price, nor set up a timetable for implementation. It leaves room for the government to manoeuvre over electricity prices, analysts said.

"When and how the proposal will be initiated is still under the control of the National Development Reform Commission (NDRC)," according to the report of the domestic investment bank.

"The planning characteristics of the power industry have not been changed... Overall, the conflicts between the coal and power industries have not been resolved," the report said.

CITIC's Wang said it is also difficult to set up a benchmark coal price because the coal industry is highly fragmented and prices and quality varies.

Meanwhile, transportation charges and other freight in the circulation of power also vary. That means the electricity tariff rise may not effectively cover the fuel cost increases of some power generators, Wang said.

Analysts said tough negotiations over coal supply prices are expected at the coming annual coal ordering conference. Power companies settle most of their coal consumption for the next year at the conference.

According to the domestic investment bank's report, Shanxi Province has demanded the supply price rise by at least 30 yuan (US$3.60) a ton next year.

But the NDRC would cap the increase at 20-25 yuan (US$2.40-3.00) a ton, or 8 percent up from the last year.

Analysts said the proposal is an important move towards liberalization of an electricity pricing system.

An official with State Grid Corp, said: "It is the best solution among the feasible ones."

"It is better than nothing," he said.

(China Daily December 23, 2004)