Draft Paper for Region Waters Dialogue, Hydropower Session 230606

China’s New Builders and the Emerging Regulatory Framework for Competitive Power Markets

Ms. Grainne Ryder Policy Director, Probe International, Energy Probe Research Foundation, Toronto, Canada [email protected]

Mekong Region Waters Dialogue Co-convened by IUCN, TEI, IWMI, M-POWER Vientiane, Lao PDR 6-7 July 2006

1 Draft Paper for Mekong Region Waters Dialogue, Hydropower Session 230606

Recommendation: 's new electricity industry regulator (SERC) should initiate an open and impartial review of proposed large-scale hydro investments in province, in cooperation with its environmental counterpart, SEPA. This would bring much-needed financial transparency and economic scrutiny to investment proposals that affect electricity service and river management in jurisdictions within and beyond national borders. SERC’s review should preempt any new multilateral development bank support for large hydro projects and export-oriented grid expansion in China.

China’s Emerging Electricity Regulatory Framework

Since China approved construction of the world’s largest hydro dam nearly two decades ago, the country’s power industry has changed beyond all recognition and is expected to change even more profoundly in the next five years. How China’s new dam builders are operated and regulated as commercial power generating companies may be the single most important factor (apart from rainfall) affecting how rivers will be regulated in the six-country Mekong region for years to come.

Earlier this year, Chang Jianping, director of State Electricity Regulatory Commission (SERC), advised foreign investors that the transition to regulated and competitive power markets in China would be completed within five years. SERC ran a trial market in southern China last year, in which power producers bid against one another to supply the grid. Last December, SERC announced a new certificate system for power producers which, if implemented, would oblige power companies to submit their business plans, financial reports and environmental performance records for assessment by SERC in order to be certified for operation.

Precisely how China’s dam building companies will be regulated and licensed is not yet clear. There are indications that hydro will not be required to compete against other power suppliers although the dam owners may be obliged to disclose more financial and environmental information to regulators and the securities commission.

Currently, the price of hydro exported from Yunnan is set by the central planning agency, National Development and Reform Commission, at about 3.8 US cents per kilowatt-hour, which is less than the average cost of coal-fired power and well below the full cost of production and transmission. As electricity rates move closer to actual costs of production, and assign economic value to reliability, availability, water consumption, use of transmission grids and so on, the viability and desirability of large hydro projects compared to alternative investments will become increasingly questionable and questioned by China’s power consumers and potential competitors.

2 Draft Paper for Mekong Region Waters Dialogue, Hydropower Session 230606

Centrally Mandated Hydro Exports

A key policy driving large dam construction in Yunnan province, and one that predates the government’s 2002 industry reform plan, is the central government decree that hydropower from Yunnan will be sold to coastal areas and neighbouring Vietnam and Thailand. This was laid out in Beijing's 10th Five Year Plan (2001-05): Guangdong would import about one-quarter of its power supply from the southwest by 2005. Additional targets were set for hydro exports to Vietnam and Thailand. To meet export targets under Beijing's 11th Five Year Plan (2006-10), China Southern Power Grid Company, which is responsible for transmission in the five southern provinces, plans to spend US$29 billion on transmission infrastructure to increase Yunnan-Guangdong hydro transfers and exports to Vietnam and Thailand. Southern Power began exporting power to Vietnam in 2004. Its recorded earnings in that year were more than half a billion dollars and by 2010, the grid company plans to boost its annual profit to US$1.2 billion.

Guangdong Province Finds Reliance on Hydro Imports “Worrisome”

For Guangdong province, one of the designated purchasers of Yunnan hydropower, increased reliance on hydro imports is “worrisome.” The province’s concerns have been documented by a team of senior power sector planners and economists at the Guangdong Techno-Economic Research Development Centre in affiliation with US-based Stanford University. Their 2004 report explains:

"While the central government has been turning down [approval of] new power plants in Guangdong and mandates the Province to import southwestern hydropower instead, Guangdong fears that the imports are insufficient to either meet the level of market demand or match the load curve." Between 2001 and 2005, the central government banned construction of power plants in Guangdong in order to make room for western hydro imports - a directive that contributed to severe power shortages and discouraged private investment in new generating capacity just when Guangdong needed it most, the report notes.

There are "uncertainty and reliability issues associated with southwestern electricity imports such as seasonality of southwestern hydropower, compatibility with planned dispatch and Guangdong load curve, and increase in power demand within western areas." In particular, water shortages have "not been considered by central government planners when they decide how much Guangdong's demand will be set aside for southwestern hydro imports." In other words, Guangdong fears there won’t be enough hydro available when power is needed, in which case the province has to plan for backup power investments. Or, there will be too much hydro available when consumers don’t need the power, which would then force Guangdong dispatchers to reject power from local producers in order to accommodate politically mandated imports. This policy has already created havoc for the province and discouraged investors.

• End “political dispatch” of hydro

3 Draft Paper for Mekong Region Waters Dialogue, Hydropower Session 230606

Instead of increasing hydro imports under Beijing's directive, and thereby increasing the risk of future power disruptions and shortages in Guangdong, the Guangdong experts argue for abolishing what they call "political dispatch" of power from outside the province. They recommend a new system of economic dispatch and market rules be adopted to promote investment in power plants within Guangdong, without political interference.

The Guangdong team points out that hydro dams are constrained by other functions, which makes them inherently unreliable as power providers. “Hydropower stations integrate the functions of flood control, irrigation, shipping, water supply as well as electricity generation. These functions other than power generation are all closely linked with the social and economic development of the Southwestern regions. It is hard to think that hydropower stations will be allowed to pursue maximum profit at the expense of all alternative uses of water.”

• Make reservoir operations and dispatch procedures clear

For hydro projects already in operation and exporting power to Guangdong, the report recommends that:

• various services and prices of hydro projects be clarified including water charges for power generation; • flood control, irrigation, water supply and shipping be designated primary functions with power generation secondary; and • a specific department be designated in charge of hydro dispatch.

State Electricity Regulatory Commission Should Step In

China’s new electricity regulator, SERC, is the right agency to investigate Guangdong's concerns about the reliability of hydro imports, prices, reservoir operations, and dispatch procedures. Given SERC’s mandate to regulate power companies and introduce competition, the agency should also review the economic implications of centrally mandated hydro development and export-oriented grid expansion on the development of competitive power markets in Guangdong province and elsewhere.

Note SERC’s mandate:

1. Enforcing environmental laws, regulations and standards in co-ordination with relevant environmental protection agencies; 2. Issuing licenses to power producers; 3. Ensuring orderly and fair competition in the market; 4. Regulating the non-competitive parts of the generation business; 5. Reviewing electricity tariffs; 6. Proposing changes to government pricing authorities; 7. Investigating possible violation of laws and regulations by market participants, and resolving disputes among them; and

4 Draft Paper for Mekong Region Waters Dialogue, Hydropower Session 230606

8. Organizing implementation of reforms and proposing options for further reform.

Clearly, SERC has the mandate to assist the State Environmental Protection Administration (SEPA) with a review of the dam builders' costs of compliance with environmental regulations and standards. Note that SEPA (created in 2002) established its credentials as the country’s environmental regulator in 2004 when it fined several dam builders, including the Three Gorges Corporation, for failing to comply with the country’s new laws on environmental impact assessment. Compliance with the EIA law is not enough, however. China is directing billions of dollars worth of state and private capital to projects that have not had the benefit of economic scrutiny or market discipline. As the State Council’s industrial economics department warned last year, the power sector suffers from a “vast regulatory vacuum;” the current semi-planned/semi-market- driven state of the power industry is “the most adverse state.”

• Financial transparency

SERC’s review would bring much-needed financial transparency to the dam builders' plans for Yunnan which until now have been shrouded in secrecy. Here, the regulator should seek input from Guangdong's power industry experts, as well as would-be competitors, and power consumers in affected jurisdictions.

The regulator should call for disclosure on risk allocation: which parties will be held financially responsible if the proposed hydro dams cannot recover costs from ratepayers (for example, due to inadequate demand for their output, drought, or other natural disasters that either cripple production or render the dams inoperable).

• Check hydro plans/profits/costs

A SERC review would check that big hydro profits have not been inflated at public expense by underestimating costs or externalizing costs onto riparian communities or neglecting its social and environmental obligations.

• Check transmission expansion plans/profits/costs

West-east transmission profits and costs also require regulatory scrutiny. SERC has already complained to State Council last year that China Southern Power Grid and its larger rival, the State Power Grid Corporation, are entrenching their monopoly buyer and distributor positions by building super high-voltage power lines (1000-kV AC), which are designed to accommodate huge volumes of power over long distances. SERC warned that stalled market reform is impeding investment and economic growth. The separation of state-owned generation from state-owned transmission assets, which began in 2002 as a prerequisite for competition, is far from complete. The State Power Grid Corporation, the country's largest transmission operator, still controls more than 36,000 MW of generating capacity and routinely dispatches its own generators before rival power producers, which has created conflict with private power producers.

5 Draft Paper for Mekong Region Waters Dialogue, Hydropower Session 230606

China’s Dam Builders: Then and Now

When China approved the 18,200 MW Three Gorges dam for construction nearly two decades ago there was no such thing as profitability or market risk for China’s dam builders, and certainly no regulatory agencies charged with reviewing costs and proposed rate increases. Bigger was better in power generation, and electricity prices were whatever the central government said they were, bearing no relation to actual costs. If dam builders could not find enough customers for their power or repay their loans for whatever reason, the central banks bailed them out. Projects like the Three Gorges dam were not allowed to fail, even if not failing meant ordering power industries to consume more electricity, or undercutting competitors by selling power below-cost, or even banning power plant construction to ensure that Three Gorges would have no difficulty selling its output when its first turbines started generating power in 2003.

Whether the tactics employed to protect the Three Gorges dam from market and other financial risks will apply to rival dam builders operating in the post-2002 power sector is open to speculation.

In 2002, the State Council broke the State Power Commission, which owned about half the country’s generating capacity and all state transmission assets, into two large transmission companies and five power generation companies. Each generating company is a stock company in which the government retains a majority stake.

Known as the “Big Five,” they are: China Guodian Corporation, China Huadian Corporation, China Huaneng Group, China Power Investment Corporation, and China Datang Corporation.

Huadian and Huaneng were given exclusive development rights to the Salween/Nu and Mekong/Lancang rivers, respectively. A sixth company is the China Three Gorges Project Corporation, which exists parallel to these five and operates directly under the State Council, holds development rights to the Jinsha River in Yunnan.

Both Huaneng and Huadian have subsidiaries listed on the Hong Kong, Shanghai, and New York stock exchanges. The Three Gorges Corporation has one subsidiary, Yangtze Power Company, listed on the Shanghai stock market.

At present, decision making on large-scale hydropower projects and electricity prices ultimately rests with the country’s top planning body, the National Development and Reform Commission and the State Council, with input from provincial units. Technical and financial issues affecting feasibility and profitability of dams in Yunnan province have typically been reviewed at the provincial level while social and environmental impacts are considered the responsibility of central government.

China’s New Dam Building Companies

6 Draft Paper for Mekong Region Waters Dialogue, Hydropower Session 230606

• Yunnan Huaneng Lancang Jiang Shuidian Youxian Gongsi (Yunnan Huaneng Lancang River Hydropower Company)

Hydrolancang, officially the Yunnan Huaneng Lancang River Hydropower Company, is owned: 56 percent by Huaneng Group; 31.4 per cent by Yunnan Province; Development Investment Company; and 12.6 percent by Yunnan Hongta Investment Company. Hydrolancang has two large hydro dams operating on the Lancang (also known as the Mekong where it flows through Lao PDR, Thailand, Cambodia, and Vietnam), and three under construction. When completed in 2012, Xiaowan will be the world's tallest arch dam, with a height (292 metres) equivalent to the 71-storey SEG Plaza in the coastal city of Shenzhen. Next under way is the 254-metre (or 52- storey-high) Nuozhadu dam, which is expected to start generating power in 2017. Each project is expected to cost several billion dollars to build, excluding the cost of long distance transmission lines to deliver the dams’ massive output to distant markets.

Six of the eight Lancang/Mekong dams are "seasonal reservoirs," with output dependent on seasonal flows rather than storage capacity behind the dams. The two other dams - Xiaowan and Nuozhadu - will function as giant cisterns or storage reservoirs operated to maintain baseload power production throughout the year and downstream flow through the seasonal reservoirs. If completed, Xiaowan will be the world's tallest arch dam, with 38 times as much design storage capacity as the , and a reservoir that will stretch 169 km upstream. The Nuozhadu reservoir will stretch 226 km upstream.

• Yunnan Huadian Nu River Hydropower Development Company

A subsidiary of China Huadian, one of China’s “big five” power generating companies, has plans for 13 high dams along the Nu River, one of only two major rivers in China that remain free-flowing. The tallest of the planned dams, located in Tibet, would stand 307 metres high and have an installed capacity of 4200 MW.4 Construction on the Nu is currently suspended following an order from Premier Wen Jiabao in March 2004. The plans are under review by the National Development and Reform Commission, and are likely to be scaled back or postponed due to environmental concerns.

• China Three Gorges Corporation/Yangtze Power Company

Further east along the border with Sichuan province, the Three Gorges Corporation is pushing ahead with the 278-metre-high Xiluodu dam, China’s second largest hydropower project after Three Gorges. With an installed capacity of 12,600 MW, Xiluodu is part of a nine-dam cascade on the upper Yangtze (Jinsha), which, if completed, would produce three times as much power as the Three Gorges dam, the world's largest hydro generation project. Most recently, a third dam in the cascade, the 12,000 MW Baihetan dam was approved and planned for completion by 2015.

7 Draft Paper for Mekong Region Waters Dialogue, Hydropower Session 230606

Profitability Matters

Prior to 2002, profitability was not an issue for hydro developers (or transmission companies). The price of their output was set by the central government and bore no relation to actual costs. Today's dam-building companies, however, have a modern corporate and financing structure and are required to maximize profits for shareholders/stockholders. They promise high returns to attract commercial investors but, for now at least, the central government still sets their selling price. The dam builders are hoping to raise at least a portion of the capital required for expansion from the Chinese stock market or by issuing corporate bonds. Most of the capital, however, is still expected to come from the central banks.

Yangtze Power Company (YPC), the first listed hydro subsidiary, is likely to serve as a model for Hydrolancang and Huadian Nu River Company.

Yangtze Power Company – Fundraising Vehicle for Jinsha Hydro Development

YPC was setup in 2002 to raise funds for the project’s final phase of construction and other dams on the Jinsha. As a fundraising vehicle for the Three Gorges Corporation, it is listed on the Shanghai stock market and it competes for equity capital with other state owned and publicly traded companies. YPC is still two-thirds owned by the Three Gorges Corporation, an estimated 20 percent of its shares are now held by domestic Chinese investors. The company bought its first four generating units from its parent company in 2003, followed by another two in March 2005.

Yangtze Hydro Profits

Since 2003, the company has been steadily increasing its revenue from newly acquired generating units thanks to strong water flow in the Yangtze River. The company sells its output for 3 US cents per kilowatt-hour which is slightly less than the cost of the average coal-fired producer’s output. According to the Shanghai Stock Exchange, Yangtze Power’s annual net profit doubled in 2004, from US$170 million in 2003 to US$370 million. But these profits are a fabrication crafted by government policy, ignoring the project’s real costs and public subsidies. Yangtze Power pays only for the generators it acquires – each 700 MW is priced by the government at about US$600 million. And the Three gorges corporation gave Yangtze Power the Gezhouba generating units, valued at US$918 million, at no charge in return for a majority stake in the company. Other costs – for resettlement and environmental management of the 600-kilometre reservoir are left with the parent company and central government.

Hydrological Risk

Yangtze Power Company appears profitable because it is separated from the real costs of the Three Gorges project. But even with this protection, Yangtze Power Company has developed a business-like aversion to hydrological risk. The company knows it is still vulnerable to financial losses due to its dependence on river flow and competing demands

8 Draft Paper for Mekong Region Waters Dialogue, Hydropower Session 230606 on the reservoir. Drought and competing demands have crippled hydro production in recent years. The problem is particulary acute in the dry season: hydro reservoirs are at their lowest just when rural and urban power demand is highest. That’s why Bi Yaxiong, general manager of Yangtze Power company, announced in 2005 the decision to diversify into coal-fired production. Quoted in the Beijing-based Economic Observer, Yaxiong said the diversification was due to concerns about relying on highly variable and seasonal river flows.

No doubt the Yangtze Power Company, which has yet to complete any dams in Yunnan, will be watching its rivals’ financial performance this year: Hydrolancang's Manwan and Dachaoshan dams were barely operational this March due to low flows in the Lancang River. Power production was 350 MW below average for March, when river flows are usually at their lowest. Water levels behind the two dams were almost at the "dead level," below which the turbines cannot operate, according to Yunnan Daily (20 March 2005). Kunming Daily reported that the Yunnan grid company (a subsidiary of China Southern Power Grid) had to cut back hydro exports to Guangdong province by 200 MW while importing 300 MW of coal-fired power from neighbouring Guizhou province to meet demand within the province (China Power News Network, 31 March 2006).

Yangtze Power manager, Bi Yaxiong, also said reliance on long distance transmission lines to deliver power from inland hydro dams to the coastal provinces posed additional safety and economic risk for the company.

9