Just over two years ago, China’s top leaders launched a major round of power sector reform. From a clean energy perspective, the reform efforts to date show clear progress, but deeper reform efforts will be a challenge.

Development of Competitive Wholesale Market Mechanisms

Efforts to implement new wholesale market mechanisms have been a high-profile item on the power sector reform agenda in China. ­­In recent months, public attention focused on the prospect of price decreases for industrial end-users. However, with less fanfare, the wholesale reforms have also helped facilitate promising initial steps away from long-standing and highly inefficient generator dispatch practices, by reducing the scope of traditional planned allocation of annual operating hours to coal-fired generators.

So far, the government has only required certain generators to participate in these markets, forcing them to compete against one another for operating hours in the form of annual, or sometimes monthly, contracts with end-users or retailers. In 2016, this subset of generators accounted for nearly 20 percent of total consumption, and was mostly composed of coal generators that previously enjoyed allocated hours of operation—operational hours traditionally more or less guaranteed by government policy. In the context of significant coal generation overcapacity, these new markets induce less efficient coal units effectively give up hours of operation to more efficient units.

Although the current situation, even for this market subset of generators, falls well short of an optimal approach to dispatch, a rough estimate suggests significant emission reductions may be associated with redispatch of this part of the coal generation fleet. Assuming that the redispatch improves the overall efficiency of the coal fleet by five percent, this policy may have shaved off nearly one percent of power sector CO2 emissions in 2016 alone, and resulted in improvements in air quality and reduced costs for consumers. Looking forward, the scope for emissions reduction is much larger. The government plans to gradually subject most or all coal-fired generators to market forces; any new thermal capacity will also be placed in this competitive category.

More Renewable Energy on the Grid

In 2016, wind generators fed 29 percent more energy into the grid than in 2015, continuing an upward trend. This success has been partly obscured by even faster growth in installed wind capacity in 2015 and 2016, nudging up the national wind curtailment rate from 15 to 17 percent in 2016. Nevertheless, the strong growth in utilized kWh from wind is a substantial achievement. This has been possible due to a passel of initiatives bearing some fruit, including investments in transmission capacity and efforts to implement—albeit in an imperfect way—“priority status” for renewable energy.

Increased End-Use Energy Efficiency

Electricity production per unit of GDP declined at a 3.8 percent annual rate in 2015 and 2016. An existing framework of policies, including industrial restructuring (related, in part, from efforts to meet provincial-level air quality targets), ongoing industrial energy efficiency programs, and demand-side management, facilitated this progress. Data from the first quarter of 2017 clouds the picture somewhat: the reduction in electricity consumption per unit of GDP appears to have slowed, as output from heavy industry experienced strong growth. Nevertheless, these policies, together with the power sector reform effort, are likely to support continued improvements in energy efficiency.

In addition, the average efficiency of coal-fired generators continues to improve and new flexible gas-fired capacity continues to be added to the system.

What’s Next for Clean Energy Transformation in China?

Despite these encouraging developments, China’s power sector still faces substantial challenges in terms of clean energy.

Coal Generation Overcapacity

China has been struggling with excess coal-fired generation capacity. Most regions have between 10 and 40 percent more generation capacity than needed to meet peak electricity demand, including a reasonable reliability margin. Meanwhile, the 13th Five Year Plan for the electricity sector, issued late last year, countenances the possibility that coal capacity may continue to grow to as much as 1100 GW in 2020, up from 900 GW in 2015, further exacerbating the overcapacity problem.

Several policy initiatives may help alleviate this problem, including coal consumption “caps” and pressure from new market mechanisms. For example, if competitive wholesale markets continue to expand, as called for by the government’s power sector reform policy, excess coal capacity will likely face significant losses and incentive to retire capacity. However, it is far from clear which might give way first, the coal generators or the government’s commitment to markets. The state-owned enterprises responsible for investing in this overcapacity may find ways to slow down reform and lobby for new protections to keep unnecessary coal capacity in operation.

System Inflexibility and Renewable Energy Curtailment

In order to support government targets for strong continued growth in wind and solar capacity and to bring curtailment rates down, China’s power sector will need to make more progress toward addressing long-standing problems with system flexibility. This diverse set of issues includes dispatch reform, coordination of the electricity and heating sectors, greater coordination between balancing areas, more electricity transfers between regions, implementation of market mechanisms and other incentives to support resource flexibility, incorporation of wind and solar into system dispatch, and better use of wind and solar forecasts. The existing wholesale market mechanisms do little to support hour-by-hour flexibility, as they are based on competition for annual or monthly allocation of operating hours. However, late last year, the central government called for an ambitious effort to develop short-term “spot markets,” with a regional pilot due by 2018 and national implementation by 2020. Much of the government’s hopes of meeting overarching emissions and clean energy goals will likely become tied up with this complex initiative over the next few years.

Deeper Changes to Business Models for Giant Grid Companies

The roles of China’s main grid companies—Southern Grid and State Grid, whose territories cover nearly of the entire country—have been at the center of power sector reform discussions. However, that discussion has dwelled on a narrow set of issues, namely reining in the monopolistic behavior of the grid companies and opening up room for increased competition in the power sector. The main initiative affecting the grid companies—transmission and distribution price reform—has been framed by the government as an effort to increase oversight of grid company finances and reduce costs for consumers. These are certainly laudable goals, but the grid companies’ part in supporting a clean energy transformation has received much less emphasis. The key is to broaden the discussion of grid company regulation, in order to envision a “utility of the future” with Chinese characteristics.

In conclusion, it’s worth noting that many countries have struggled—and continue to struggle—with power sector reform. The road to a clean energy future is rocky and the complexity of the task in China is compounded by a unique set of institutional challenges. Although China’s power sector reforms have, so far, produced clear results for clean energy and emissions reductions, many challenges remain.