Even the casual observer of China during the last thirty years can’t help but be awestruck by the country’s transformation—across all sectors, but especially the power sector, the central infrastructural industry on which economic development depends. What had been a system characterized by too frequent shortages and under-investment became the world’s largest and one of its most technologically advanced. This achievement is unmatched around the world and is a critical reason behind China’s leap to the forefront of the global economy.

Of particular note is that this effort has helped China confront and make progress with its crippling air quality problem. Although there is still more work to be done, China has made much progress, including the shuttering of its most inefficient and polluting power plants and investing heavily in emissions control equipment on new, high-efficiency coal facilities. China has implemented progressively more stringent air quality rules and, more recently, enacted a revised air law that together call for investment in industrial and end-use efficiency improvements and the deployment of renewable energy technologies as a means of improving air quality. China is now putting into effect a national carbon cap-and-trade regime that will help it transition to a low-emissions, low-cost energy future.

These efforts are all part of a theme, succinctly expressed in Beijing’s pronouncement of March 2015—Document #9—which set out a comprehensive vision for power sector reform to achieve multiple goals: improved system reliability; increased use of market mechanisms; consumer protection; energy savings, emissions reductions, and increased use of renewable and distributed generation; and improved governance and regulation, including better planning and strengthened institutional capacity. These are laudable goals and, if achieved, should reduce both the long-term costs of the power system and its environmental impacts.

But “getting reform right” is by no means easy, for China or for Europe and the United States either. Reform is an ongoing endeavor, endlessly shaped by changing circumstances, evolving technologies, and more urgent policy requirements, especially those that operate at the intersection of environmental and energy decision-making. Choices made today will have effects—some desired, some unforeseen—for years to come. The challenge that China faces today, and will continue to face, is to keep reform on a track that will ensure a high probability of success—success as measured by the achievement of those goals.

We would like to emphasize a few recommendations from our work. Chief among these recommendations: the need for significant investment in the efficiency with which Chinese homes and businesses use energy. Using energy more efficiently is the least costly way to meet demand for energy services. China’s policymakers understand this and, for more than two decades, have operated one of the world’s most extensive national industrial energy conservation programs. Expansion of this effort across all sectors—industry, commercial buildings, heating and cooling, consumer end-uses, etc.—will produce cost savings (especially by avoiding investment in expensive power plants) for years to come.

Second is the need for significant improvement in the economic efficiency of electric system operations. This has to do with the way in which decisions are made to operate generating facilities as demand for power varies in real time. It is called “dispatch” and China has made important strides in this area in recent years, but further reform is still needed before one can say that system operations are “optimized.” The critical reform will be to base dispatch decisions on the variable operating costs of power plants—lowest cost first, highest cost last. Economic or “merit order” dispatch will go a long way to fully integrating renewable resources into the system, since they cost almost nothing to operate, and to minimizing the use of the least efficient and often most polluting power plants. Both costs and emissions will be reduced by implementing this straightforward approach to system operations.

Economic dispatch will also reveal the value to the system of other cost-saving actions, such as demand response. Enabling customers (typically industrial and commercial users but also aggregated residential customers) to vary their usage in response to changes in prices saves money, creates flexibility in the system that makes integrating renewables easier, and again reduces reliance on dirtier, less efficient generation.

Economic dispatch can be achieved through the creation of short-term “spot” markets for electricity, which, if well designed, will cause generators to base their price bids on their operating costs. The system operator will then dispatch the system according to those costs. China plans to have spot electricity markets operating throughout the country by the end of 2020. It is an ambitious goal, but economic dispatch need not wait for spot markets. Simply requiring generators to disclose their operating costs to the system operator will provide it with the information necessary to optimize system dispatch. Taking this first step would give both generators and system operators experience with economic dispatch, while avoiding the thornier challenges associated with preventing abuses of market power.

Third, making better use of long-term planning methods—for example, integrated resource planning as it is practiced in the U.S.—will help China reduce the risk of significant mismatches between supply and demand, that is, between investment and capital utilization. Such an approach to planning is not at odds with China’s desire to make use of market mechanisms in the power sector. Planning will identify the system’s needs. Competitive procurement will minimize the costs of those investments.

Fourth, evolution in technology is rapidly making it possible to electrify much of what we use fossil fuels for, in particular transportation and heating. Electrification creates new opportunities for grid companies and generators, but also new challenges. If the promise of electrification—lower cost, increased efficiency, and greater environmental protection—is to be achieved, it should be expressly linked through policy and investment to clean, non-emitting generation resources.

And fifth, China should continue its effort to reform transmission and distribution pricing. On this topic, we suggest that there is useful experience to be drawn from the efforts to reform grid company business models—that is, to reform the way grid companies make money—in several other countries, including the U.S. and much of Europe. The reforms there are focused on how to better align the grid companies’ behavior with public policy goals. Performance-based regulatory methods of the types used in Europe and the U.S. can be an important part of transmission and distribution price reform in China and can help drive grid company behavior so as to increase the likelihood that desired outcomes—such as increased integration of renewable generation, increased investment in demand-side resources, and reduced emissions—are achieved. In short, the grid companies should be able to make money doing the right things.

These are not all of the steps that China can take to keep its power sector reform efforts heading in the direction described in Document #9, but together they will go a long way to making that vision of a low-carbon, low-cost, highly efficient energy sector a reality.

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