The creation of the wholesale electricity market will go through three phases, according to the China-based State Electricity Regulatory Commission (SERC). 'Authorities plan to launch two regional wholesale electricity markets, one in northeast China and the other in eastern China,' says Joseph Jacobelli, vice-president of utilities research at Merrill Lynch. Thermal generators (excluding those selling heat) with a capacity in excess of 100 megawatts are expected to participate in the new market. In phase one, tariffs are expected to remain at existing approved prices for most of the output in the region. Only a limited amount of power, which Merrill Lynch puts at 20 per cent, will be available for on-grid competitive bidding. 'This bidding would include both day-ahead bids and spot market bids once the technical infrastructure is ready; before then, bids would be on a month-ahead basis,' Mr Jacobelli says in a report released this month. In phase two, two-tier tariffs per kilowatt hours will be introduced. 'One tier will be for capacity payment covering fixed costs and the other for energy or volume payment covering variable costs,' Mr Jacobelli says. He expects all the output will be subject to this new formula once the market is more 'mature' and the technical infrastructure is 'fully operational'. In the final phase, the entire output will be subject to on-grid competitive bidding. SERC also adds that an electricity futures market and an options market will be introduced at this stage. The only difference between the northeast and eastern markets will be the percentage of annual generation that will be up for competitive on-grid power bidding. 'We understand that, while the percentage of the eastern market should be in a similar range, it could possibly be lower,' Mr Jacobelli says. He expects the first phase to last three to five years. The Merrill Lynch report notes some SERC officials as saying that phase two should be two to three years. But other observers, including some listed independent power providers, believe the second phase is at the very least five to 19 years away. Foreign investors in mainland power plants will be forced to re-negotiate guaranteed-price purchase agreements with buyers as part of the industry reform, leading to a probable reduction in tariffs and returns. The requirement will add to the uncertainties over mainland power investments by foreign firms, which have been hit in the past few years by the outlawing of guaranteed returns on foreign-invested infrastructure projects. But Mr Jacobelli says the exposure of the industry to foreign investment in infrastructure has been 'relatively small'. 'Even then, these investors also have other options,' he says. The phasing out of guaranteed-price arrangements is necessary for Beijing to implement power pooling and price bidding, part of wider reforms to move the industry's planned pricing system to a market-based one. Mainland power investors such as CLP Holdings, Cheung Kong Infrastructure and United States-based Mirant are among those expected to be affected. Mr Jacobelli says the new requirement raises concerns. Many foreign investors were hurt when the Philippines government forced them to renegotiate the terms of power projects with guaranteed returns it said were too high. For these reasons, Merrill Lynch remains long-term (12 months) bearish on this sector. 'There needs to be a clear path to reforms,' says Mr Jacobelli. If the introduction of regional wholesale electricity markets become a messy process, the 'yet another uncertainty' factor for the sector should appear. 'Of particular concern to us is the fact that if on-grid power competition does not include pass throughs of higher costs on to end-users or does not allow for direct contracts between the generation companies and large lot users, then further margin squeeze is likely,' he adds. Mr Jacobelli also believes the reforms will nevertheless go through since there is 'too much political momentum behind the reforms'. He believes the northeast regional wholesale market 'should go ahead'. 'The province has a reserve margin of about 30 per cent, thus preventing a potential grid squeeze; all of the bidded power would be sold to the grid, which will then sell it to users,' he adds. 'Should grid prices go up too much, then the grid would earn less money unless end user prices are adjusted.' Hong Kong will likely see some direct repercussions, albeit not in the short term, says Mr Jacobelli. 'This is because currently the government is contemplating what direction the sector should take after the current contractual agreements with Hong Kong's two integrated electric power companies expires in 2008,' he says. Chinese authorities have not shown plans to take the regional wholesale electricity market experiments to Guangdong. Mr Jacobelli believes Hong Kong authorities would 'rather err on the side of caution' and as such, Hong Kong becoming part of a southern China regional wholesale electricity market is unlikely. Nevertheless, such a result still remains an option and analysts feel this will add uncertainty for the two Hong Kong power companies.