At first glance the decline in China's headline inflation rate announced yesterday is excellent news for mainland consumers. Unfortunately, in the longer run it may prove less positive for the earnings of some prominent Chinese companies. On the face of it, last month's drop in consumer price inflation looks like just what the doctor ordered. Prices rose only 4.9 per cent over the year to August, down from July's 6.3 per cent rate and well below the 12-year high of 8.7 per cent recorded in February. The latest figure puts consumer price inflation within a whisker of Beijing's target rate for the full year of 4.8 per cent. With food price inflation abating fast, non-food price rises moderate, and producer price rises - although still high - now appearing to level off (see the first chart below), hopes are growing that the inflation demon has been successfully contained. If so, that will give Beijing more room to focus on boosting economic activity in the face of an international slowdown and a shaky domestic property market. Many analysts expect a raft of pro-growth policy initiatives in the near future, including tax rebates for exporters, easier credit conditions for cash-starved smaller businesses, and a possible slowing of the yuan's trade-weighted rate of appreciation. All are possible, but following damaging fuel and electricity shortages, policymakers may first decide to seize the opportunity presented by falling inflation to push through energy price reform. Change is badly needed. Beijing's price controls on petrol and diesel mean that retail prices have failed to keep pace with the rising price of crude oil over the last year, pushing refiners into the red and causing widespread fuel shortages. Meanwhile, with coal prices having risen faster than electricity tariffs, by some estimates power producers are now losing as much as 50 yuan (HK$57) on every megawatt they generate. However, with the crude price now down almost a third from its July high, oil refiners are once again close to breaking even, meaning this would be a good time to lift the controls without bumping up inflation too heavily. Analysts at Morgan Stanley reckon that a 10 per cent increase in the price of refined fuels would directly add only 0.35 percentage points to inflation; a price well worth paying to avoid shortages in the future should the oil price rebound. Similarly, Morgan Stanley estimates a 10 per cent increase in electricity tariffs would add just 0.52 percentage points to the inflation rate; considerably less than last month's fall. But although reform would clearly be positive for the stock prices of big refiners like PetroChina and Sinopec and for power producers like Datang International Power, scrapping price controls would hammer the earnings of heavy energy users. The same Morgan Stanley analysis estimates that if competition were to prevent companies passing on the energy price increase to their customers, then a 10 per cent rise in the cost of refined fuels could cut the profits of coking coal producers by as much as 67 per cent. Gas suppliers would see their earnings shrink 31 per cent, while the profits of computer manufacturers would slump 22 per cent. Even those figures pale in comparison with the impact of a 10 per cent increase in electricity tariffs, however. Factoring in both the direct and indirect effects of a power price rise, Coke producers would see their profits wiped out entirely, while a swathe of key sectors would see earnings reduced by between 15 and 30 per cent (see the second chart below). In reality, it is likely at least some of the increase would be passed on to customers. Inflation would remain a touch higher than it would have been otherwise, and companies would see some compression in their profit margins. In the long run, this would be positive, penalising waste and providing an incentive for users to become more energy efficient. In the shorter term, however, it looks like there would be some casualties in the stock market.