Changing how coal power plants get paid: What’s next for policy in China

In late 2023, China’s National Development and Reform Commission (NDRC), established a new capacity payment mechanism for coal power generators. A capacity payment is an annual payment per megawatt of available capacity that is paid regardless of how many hours a generation unit operates. NDRC’s explanation of the new policy rests, in part, on a reasonable principle: that fossil-fuelled power plants should be incentivised to operate only when needed in support of a renewable energy dominated system – that is, when generation from wind, solar and other clean energy resources are low. However, the policy has several major shortcomings and problematic design elements. As we pointed out at the time, because of these problems, the policy risks exacerbating the build out of excess coal power, slowing the development of clean energy, raising costs, and increasing emissions. Fortunately, over the past year, policymakers have signalled publicly that they recognise and are moving to rectify these issues. The question is now how quickly the policy can be reformed and how key details will be handled.

Shortcomings of the November 2023 policy

A primary problem with the policy is that it offers payments to coal-fired generation units and only to coal-fired generation units, without requiring any direct comparison with alternative resources – such as demand response, energy storage and energy efficiency – that can potentially provide support for a renewable dominant system in a more effective, cleaner and lower cost manner. The policy allows even new coal power to be eligible for payments. This could stimulate continued overinvestment in coal generation that misaligns with the power sector decarbonisation target.

Second, the policy lacks clear guidelines for determining what is needed. While it vaguely stipulates that only coal plants conforming to ‘national plans’ are eligible for capacity payment, this abstract requirement has not been clarified even as provinces have implemented the policy. The policy establishes very weak qualifying criteria, allowing payments to most coal plants connected to the grid. While the policy states that coal units that do not satisfy emission, environmental, and energy efficiency standards are not to receive the payment, these criteria are vague and, in practice, only exclude some smaller units that are already scheduled to retire.

Third, the policy lacks a dynamic mechanism to adjust payments in response to changes in needs. For example, the policy does not set out a structured way to decrease payments when projections of needed resources decrease. The mechanism, instead, pays each coal generation unit a fixed payment, set at 30% of the annual fixed costs of a coal unit (as set in the policy by NDRC). The policy says that the percentage will increase to 50% in 2026. The policy does leave provinces some room for discretion.

In early 2024, provinces issued implementation policies, and the payment mechanism is now in operation across the country. The provincial approaches are very closely aligned with the November 2023 statement, with little policy innovation.

Reform signals

In April, NDRC issued a broader policy directive, Foundational Rules for Electricity Market Operation, laying out a vision for various elements of electricity market development, including spot markets, medium and long term contract markets, and capacity payment mechanisms. NDRC called for marketisation of capacity payment mechanisms, with competition between coal, storage and ‘other resources.’ Although NDRC framed the marketisation as ‘gradual,’ this represents a remarkably rapid shift in policy direction.

Additional indications of reform to the capacity payment have followed. China Electricity Council (CEC), acting as leader of a group of state companies and state research institutions empowered by NEA, issued a ‘blueprint’ position paper on power sector reform. The blueprint includes significant language on capacity payment reform, including calls for marketisation and establishment of a complementary forward-looking resource assessment process. However, CEC did not push the boundaries of NDRC’s ‘gradual’ timeframe, instead suggesting a glacial pace with an ‘exploration’ marketisation complete by 2029.

Meanwhile, some provinces are providing separate capacity payments for clean energy resources. For example, in January, Hebei Province announced a temporary new capacity payment for all energy storage projects scheduled to come online during 2024. In June, Jiangsu Province offered capacity payment to some demand-response resources that can be directly controlled by grid companies. Although these new developments show some promise, these additional incentives are still inadequate to foster adequate portfolios of clean energy resources.

Next steps

Additional policy clarification is needed for the future of the capacity payment mechanism. Our recommendations include the following:

Assess what resources are really needed: Despite the country’s famous proclivity for five-year planning, the power system lacks an official framework for transparent, routine and forward-looking resource assessments. These are needed to assess resource gaps to meet system needs and can be used to calibrate market mechanisms, including any new competitive capacity market. These assessments will be critical to ensure just the right level of investment is made in the right resources to cost-effectively maintain the reliability of power supply in the context of growing amounts of renewable energy.
Reward capability, not just capacity: A power system dominated by renewable energy will need resources that can provide the right mix of capabilities, including flexibility and availability at different timescales. A mechanism that focuses on a simple definition of capacity will raise costs and undermine system reliability.
Ensure demand-side resources compete directly: Around the world, demand-side resources, including aggregations in the form of virtual power plants (VPPs), are showing great potential to beat traditional power plants in terms of cost, performance and emissions. This potential is also there in China, particularly in comparison to traditional coal power plants. Policymakers in China have been encouraging VPPs, but so far have held back from fostering head-to-head competition with coal power.
Develop market rules that recognise characteristics of various clean resources: Special care should be given to design market rules for alternative resources – including energy efficiency and demand response. For example, it will be important to establish rules that recognise the value and capabilities of seasonal resources such as aggregations of smart thermostats or investments in more efficient building cooling equipment.

In terms of timing, we are suggesting policymakers move beyond a gradual approach.Rapid reform is feasible and will be part of the puzzle in following through with the monumental task of reducing the role of coal power in the power system and fostering a reliable grid dominated by renewable energy. While this year’s policy statements broadly point the capacity payment mechanism in a positive direction, they fall short of a definitive commitment that aims to swiftly transition away from a coal-only capacity payment. We suggest the NDRC and NEA should develop a road map on implementation details to drive capacity mechanism reform.