Transition from plan to market: Imperfect regulations in the electricity sector of China

Introduction

In a planned economy, resources are subjected to government controls and certain regulations are designed to reach policy goals such as equity or minimum consumption guarantees. However, government regulations, even well-intended, can result in substantial inefficiencies and distortions when compared with market-based allocation (Joskow, 2010). Previous research indicates that international lessons in regulatory policies which did not function as intended (Bhattacharyya et al., 1996; Le Grand, 1991; Martimort, 1996; Yavlinsky and Braguinsky, 1994). However, the reasons and mechanisms underlying the regulatory failure remain poorly understood, particularly in the context of public sectors within economies transitioning toward a market-based system.

The Chinese economy was dominated by central planning until 1978 when major reforms began, and the government started to use markets to allocate resources for some goods. While most industries in China have now undergone market reforms, a notable exception is the power generation sector. The electricity sector is traditionally viewed as a natural monopoly because of economies of scale in generation and distribution networks (Borenstein and Bushnell, 2000; Joskow, 1997). Nevertheless, the average scale of power plants, especially since the surge in renewable power, has drastically declined over time. Many developed and some developing countries have begun marketization or have restructured their electricity sectors in the recent decades (Borenstein and Bushnell, 2015; Erdogdu, 2007; Hogan, 2002). However, China has instead adopted an incremental approach to reforming the electricity sector, previously administered by the Ministry of Electric Power (MEP) (Ngan, 2010; Pollitt et al., 2017). Did the incremental reforms improve the efficiency of the electricity sector or introduce inefficiencies with skewed prices and market segmentation (Young, 2000)? If there were inefficiencies, what aspects of the system, the institution or the reform process created them? What insights can we derive from the gains and losses of previous reforms that are useful for designing and implementing current reforms including electricity market liberalization? Power dispatch reform in the complex multi-layered electricity system in China provides an attractive setting in which to explore these questions.

Power dispatch in China differs from the commonly used economic dispatch.¹ Inherited from the planned economy era, electricity dispatch follows a “Transparent, Fair and Impartial” principle, which is widely known as the san gong, or “three fairness” principle.² Provincial agencies set an annual quota for each power plant based on an equal-share principle in which generators of the same class are allocated the same annual hours of operation. This approach was established in part to attract private investment in generation during periods of shortages. Consequently, all coal-fired power plants of a given class were allocated similar annual utilization hours, irrespective of their differences in energy efficiency and technology. This system of allocation failed to discourage investment in small inefficient thermal power plants (Kahrl et al., 2013).

To improve the energy use efficiency realized in this equal-share system, and reduce pollutant emissions, the government initiated a pilot of Energy-Saving Generation Dispatch (ESGD) system in 2007. In the pilot areas, the provincial government determines the power dispatch order according to fuel efficiency and pollutant emission levels. This reform of power generation dispatch changes the administrative allocation from an equal-share dispatch to an energy-saving dispatch.

The dispatch reform is a step toward market allocation. The new merit order is based on energy efficiency which rewards reductions in fuel use and lower marginal cost. Nevertheless, the dispatch allocation remains an administrative decision and is subject to centralized regulation due to political and economic challenges (Kahrl et al., 2013; Wei et al., 2018). In the context of this unique reform setting, this paper revisits the issues of government regulation and market transition with comprehensive power plant level data. The following questions are addressed: Did the reform achieve the desired outcome? What was the energy saved by the reform compared with the equal-share dispatch rule inherited from the planned economy system? How, and why did the realized dispatch differ from the market dispatch? What lessons can be learned for current power system reforms?

We adopt a difference-in-differences (DD) framework to compare output changes in thermal power plants regulated under the policy with those plants that were unregulated. The between-province analysis of power plants shows that, on average, the dispatch reform had insignificant effects on power generation and hours in pilot provinces compared with plants in non-pilot regions.

Despite the overall null effect, we find that the reform caused large compositional changes in power generation within the power plants of a given capacity level in the pilot provinces. According to the ESGD policy, the power plants should be dispatched in an ascending order based on real-time fuel efficiency. However, the triple-difference results indicate that, instead of considering real-time coal consumption rates, the pilot provinces dispatched electricity based on nameplate coal rates, which were determined solely by generator capacity. Furthermore, although power plants with larger capacities were indeed allocated more hours, our findings reveal deviations from a strict capacity-based order. These deviations illustrate the operation of imperfect regulation under an administrative system in comparison with market allocation.

We further uncover the underlying drivers of the imperfect regulation. First, we demonstrate that the lack of compensation for power plants allocated fewer hours is most likely the critical reason behind the policy's imperfect implementation. Our empirical analysis reveals that provinces without a specific compensation mechanism for ESGD deviated more significantly from the merit order than those with a mechanism. The lack of compensation failed to adequately address the interests of all stakeholders, resulting in opposition from smaller power plants that were allocated lower generation quotas. Second, we find that regions with fewer fluctuations in net electricity load were more capable of adhering closely to the merit dispatch order. This highlights the technical constraints of maintaining system stability and reliability in changing power dispatch. Additionally, multiple other factors, such as favoritism towards local stakeholders, stringent regulations on air pollution, and incomplete information on real-time coal consumption, could also contribute to intentional or unintentional deviations from the efficiency goal.

This paper contributes to previous work in the following ways. First, our study fits into a large body of literature that discusses the inefficiency in government regulations pertaining to energy and environmental policy. For example, Fowlie (2009) demonstrates how incomplete pollution regulation induces leakages in the imperfectly competitive power industry, and Cicala (2015) highlights how asymmetric information, capital bias and regulatory capture result in regulatory distortion. The inefficiency is also attributed to the heterogeneity in compliance costs across firms under regulation, as discussed by Lade and Rudik (2020). In China, regulations in an administrative style are very common (Greenstone and Schwarz, 2018). Here we provide evidence on the regulations that sometimes may not attain the original target when mixing market with planning characteristics, traits that are also common in other transition economies.

Owing to the regulatory imperfections, the transition from command-and-control to market allocation in the electricity sector has been a primary focus of extensive research. Chan et al. (2017) find that electricity restructuring has a positive effect on plant efficiency. Discussions of reforms by Borenstein and Bushnell (2015), Jamasb and Pollitt (2005), Fabrizio et al. (2007) and Ibarra-Yunez (2015) also confirm that liberalization leads to allocative efficiency gains. This paper is closely related to that of Cicala (2022) who shows that market dispatch in the US electricity sector significantly reduces total production costs because of gains from trade compared with “economic dispatch” in which dispatchers try to prioritize efficient sources without price signals. Here we find that the ESGD reform, with an intended order akin to economic dispatch, failed to achieve the optimal dispatch in terms of cost saving.

Our second contribution is to revisit economic reforms in China (e.g., survey by (Xu, 2011)). China takes an incremental approach to reforming its economy, whereby a part of production is allocated by markets and a part is allocated by various administrative plans (Byrd, 1987; Wong, 1987). However, the partial reforms encounter obstacles, such as a breakdown in production coordination, opposition to privatization (Murphy et al., 1992), and rent-seeking behavior from local governments (Young, 2000). Nevertheless, Sicular (1988) concludes that planning and markets are not at odds, and that the mixed system was well justified by the situation at that time. Lau et al. (2000) also argue that economic reforms in China achieve efficiency without creating losers. We attempt to understand the features of economic reform by examining power sector reform in China (Chen et al., 2022; Ho et al., 2017; Williams and Kahrl, 2008; Xie et al., 2020b; Zhao and Ma, 2013). Most ex-post analyses evaluate the effects of the 2002 unbundling of generation and transmission, and the 2015 general reform (Du et al., 2013; Ma and Zhao, 2015; Xie et al., 2020a; Zheng et al., 2021). The dispatch system is a crucial element in the power sector, but its reforms lag behind other changes to the power system. China has introduced markets for long-term contracts and is currently pushing to include diverse sources of power in the electricity markets to establish a market dispatch system (Pollitt, 2021). The efficiency gains and emission reduction benefits of market-based reforms in the electricity sector have been compared with egalitarian distribution (Chen et al., 2020a; Ding et al., 2023; Luo et al., 2023; Yu et al., 2023).

Studies have also focused specifically on the ESGD. Studies by Ding and Yang (2013), Gao and Li (2010), Kahrl et al. (2013), Dong et al. (2015) and Ho et al. (2017) provide comprehensive insights into the implementation of the ESGD policy, illuminating the short-term results obtained, while also dissecting potential challenges and implications for various stakeholders. Notably, these studies do not provide a quantitative analysis of actual effects. Ex-ante modeling analyses are predominant in quantitative research, which involve three distinct phases. During the ESGD pilot phase, potential benefits are estimated based on the literature in terms of energy efficiency, emission reductions and economic costs. The benefits are obtained via either optimization and unit commitment models (e.g., Gao and Li, 2010), or straightforward re-ordering of dispatches (e.g., Kahrl et al., 2013). Research conducted in the latter stages of the policy, particularly after the failure of the pilot rollout, primarily proposed schemes to improve energy-efficient generation dispatch. Various elements are considered, such as generation and demand-side uncertainties (Liu and Li, 2018), renewable energy curtailment (Zhao et al., 2017), obtaining the support of all stakeholders (Zhong et al., 2015; Ding and Yang, 2013), and the transition toward a market mechanism (Wei et al., 2018). Recent papers focus more on evaluating the potential benefits of a successfully implemented economic dispatch compared with the equal-share scheme (Luo et al., 2023; Xiang et al., 2023b; Yu et al., 2023). Our work discusses the effects of the dispatch rule change empirically in detail and investigates the reasons why the implementation of the pilot reforms deviated from a strict interpretation of the regulations. The ex-post exploration of regulatory distortions in the implementation of the ESGD provides a nuanced perspective on the challenges of market-oriented reforms in China. Additionally, it highlights the advances made through incremental policy changes. We find that the dispatch reform was not as effective as sometimes claimed. The incremental reform significantly improved total generation efficiency compared to that achieved with the equal-share dispatch; however, it still falls short of achieving optimal dispatch.

The third notable contribution of this paper is an in-depth discussion on compensation mechanisms in reforms, thereby enriching the literature on redistribution resulting from policy changes. As governments begin policy reforms, it is almost inevitable that even policies with net social benefits will produce losers. How those conflicts of interest are addressed will shape the trajectory of future policies, whether offering satisfactory compensation or staging or postponing the reform initiative (Trebilcock, 2014). A long strand of papers emphasize the significance of compensation in the reform process (Angell and Graham, 1995; Commander, 2012; Jain and Mukand, 2003; Rodrik, 1996). For electricity systems, a shift toward a more liberalized market should take into account the diverse interests of key stakeholders, as evidenced by Arocena et al. (1999) on Spanish reforms and Tankha et al. (2010) on India.

We provide empirical evidence emphasizing how insufficient compensation structures led to less effective implementation of dispatch reform. We find that compensation strategies differed across regions, and remarkably, market-driven compensation methods often underperformed when accompanied by imperfect market-supporting elements. By contrast, administratively directed compensation was effective but unsustainable. The feasibility of enforcing compensation, especially amidst fluctuations in market-driven coal prices, remains uncertain. We also examine the role of local governments in balancing diverse interests and achieving multiple objectives. When the government is intertwined with a losing sector, local protectionism can be a coping strategy during a redistributive process (Jain and Mukand, 2003). A transition to market-based economic dispatch would make inefficient local state-owned enterprises (SOE) lose market share (Ding et al., 2023). This study highlights the preferential treatment extended by local governments to non-central SOEs in dispatch reform. Such preferential treatment illustrates the selective enforcement of reforms in response to local interest lobbying by myriad groups.

The remainder of this paper is organized as follows. Section 2 provides the policy background, whereas Section 3 describes the empirical framework, including data description and econometric models. Section 4 presents the main results, and Section 5 explores underlying mechanisms. Section 6 analyzes the welfare effects, Section 7 discusses dispatch change after ESGD, and Section 8 provides conclusions.