Building on its commitment to peak carbon emissions before 2030 and reach carbon neutrality by 2060, China’s government recently pledged to “strictly control” coal power capacity over the next five years, before beginning to phase it out in subsequent years. Yet, despite these targets and the weakeningunderlying economics of coal-fired power plants relative to renewable generation resources, large state-owned firms in China continue to finance and construct coal-fired generation capacity.

One major factor for this continued investment in coal generation is the central government’s history of responding to economic downturns by directing lending to heavy industrial sectors and the construction industry. It is increasingly clear that the rebound from the COVID-19 crisis has taken this form, resulting in surging output in heavy industry and other energy-intensive sectors. This is contributing to strong demand for electricity, which the coal industry uses to bolster arguments for continued investment in coal-fired generation capacity.

A second major factor is the distorted incentives within the power sector that warp investment decisions in favor of coal. Although the firms that dominate China’s power sector are largely state owned, they do respond to opportunities for profit — so the “rules of the game” that determine how money can be made in the power sector are important for understanding their investment choices.

There are substantial inefficiencies in these rules of the game, stemming from policies established in previous decades that prioritized rapid growth in fossil resources and rewarded firms with annual allocations of guaranteed operating hours at generous administrative prices. Although these policies supported impressive growth and helped meet the energy needs of the rapidly developing country, they are unsuitable for the urgent task of supporting a very flexible grid with high penetrations of variable wind and solar energy.

A power sector reform effort that the central government launched in 2015 has made some significant improvements to the status quo, including rolling back the practice of guaranteed operating hours for coal plants. Progress is very uneven, however, and even leading provinces are struggling with the details of reform.

RAP recently analyzed the details of these reform efforts as they are evolving in differentparts of the country, offering recommendations for practical next steps to change incentives for coal finance and better align financial decision-making in the power sector with the 2030/2060 decarbonization goals. We have drawn on the experience of other countries that are also grappling with decarbonization and power sector transformation. Our analysis included the following themes.

Establishing workable electricity market mechanisms that reward flexibility, support efficient regional coordination, and encourage retirement of unneeded coal generation.

Development of new electricity markets has been a major focus of the power sector reform effort. Several provinces have established spot markets, medium- and long-term contract markets, and other market mechanisms. Overall, these mechanisms have helped put downward pressure on hours of operation and revenue of coal-fired generators and reduced curtailment (waste) of renewable energy. But there is much work to be done to ensure these mechanisms work together well and send reasonably efficient signals to help guide day-to-day operation of the system as well as improve longer-term decisions about resource investment and retirement. In this way, the new markets can increasingly help reveal the underlying economic difficulties of coal-fired generation and spur retirements, starting with the oldest, dirtiest and least-efficient units.

One key issue is establishing market mechanisms that have regional scope. To cost-effectively integrate large amounts of solar and wind generation, it will be essential to move away from a province-by-province approach to operating the power system. A regional (that is, multiprovince) approach to operations would allow wind and solar generation to be balanced across a larger geographic footprint, thus reducing the overall variability and uncertainty associated with these resources. Market regionalization has been an official talking point in the power sector reform effort, and the Southern Grid region is slated to become China’s first regional market. However, the central government has been slow to confirm implementation details.

Our recommendations also include addressing subtle inflexibilities in the workings of China’s medium- and long-term contracting market. In addition, it will be important to carefully design oversight for the new wholesale spot electricity markets, given that large incumbent generation companies dominate the markets in various parts of the country and will likely otherwise have ability to manipulate outcomes in favor of existing coal assets.

Meanwhile, China’s new carbon trading mechanism will need to be closely coordinated with power sector reform efforts in order to function effectively. The new carbon trading mechanism, which covers the power sector but lacks an absolute cap on emissions, is expected to expand and develop in coming years. As it evolves, it will need to be carefully integrated with the new electricity market mechanisms so they can work together to promote coal retirement and decarbonization in a least-cost fashion. To date, power sector reform and carbon trading efforts have been somewhat siloed and are overseen by different government agencies.

Implementing transparent planning mechanisms to help guide power sector investment decisions and improve market functioning.

Better planning processes are essential for smoothing and optimizing the power sector transition. Without this, it will be difficult to maintain the ambitious transition path implied by the new national goals for emissions. China’s five-year plan process has had the central role in establishing national industrial and environmental policy and providing high-level guidance for the amount and type of investment and retirement. It would be very useful to upgrade the five-year plan process with shorter planning cycles based on state-of-the-art models for load forecasting, reliability evaluation and least-cost capacity expansion.

For example, transparent seasonal resource adequacy planning can help counter arguments that reducing coal capacity will threaten reliability. There is a recurring debate in China about reliability concerns, especially in times when system resources appear to be getting tight. This is happening at the moment, as coal generation companies point to growing electricity demand and constrained areas of the grid as an argument for new coal generation — an argument that is all too convincing to policymakers who lack reliable tools to assess the outlook. More broadly, transparent and detailed planning processes can help resolve these debates, uncover cost-effective and clean options, and counter unreasonable arguments for more coal.

Summing up: A practical approach to power sector reform in China

Reform has already begun to change incentives for companies in China’s power sector, and the business model for coal-fired generation has come under pressure in recent years. Major distortions and inefficiencies remain, however, and will need to be addressed to unwind coal finance and support cost-effective clean energy alternatives. As in other countries, there is no simple “on/off” switch for comprehensive power sector reform. Instead, the task is to develop a detailed agenda to support least-cost achievement of decarbonization goals, including practical market mechanisms and improved planning processes.