Coal contract negotiations are a yearly affair. But with no easy fix to the misalignment of coal and power pricing, top planning officials at the National Development and Reform Commission have turned to their bosses at the State Council for resolution of the issue. This year's difficulty was exacerbated by a drastic economic downturn and the widest price expectations between coal and power companies since 2002; the former is burdened by increased taxes, while power firms suffered unprecedented losses last year. As officials, companies and investors await Beijing's decision, analysts believe restoring investor confidence in the grim business climate is top priority. They say Beijing should fix the misalignment of mainland coal and power pricing, and put plans to let power generators compete on prices on the back burner until there is sustainable industry profitability. The problem is highlighted by a two-month stalemate in negotiations between power and coal producers on this year's annual supply contracts, due to huge price expectation differences. The root cause is the mismatch in regulation of coal prices, which have been liberalised since 2002, and that of power prices which are under Beijing's control. Under the system, in times of steep rises in coal prices, such as in 2004 and last year, Beijing imposes price caps. But given the vast number of coal mines and producers, this has been difficult to implement at the local level. Last year, the unprecedented surge in global energy prices put the system on a severe stress test. Tight control on power prices amid a 50 per cent jump in coal prices saw the coal-fired power generation industry make a combined loss of 39.2 billion yuan (HK$44.5 billion). By contrast, coal-sector profit shot up 80.1 per cent to 130.4 billion yuan. Although power prices were raised twice in last year's third quarter, power producers say these are not enough for them to return to the profitability levels prior to the coal price spiral, if contract coal prices do not recede this year. Zhang Guobao, head of the NDRC's National Energy Commission, says a 50 yuan per tonne - just under 10 per cent - increase in contract price this year is reasonable, given expected increase in resource tax and value-added-tax burden on coal producers. He notes that while it makes sense for the additional costs to be passed on to power producers, it is up to the State Council to find a solution to the price dilemma. If Beijing decides that raising power prices would be too politically sensitive amid the economic downturn, it may need to cancel the tax rises for coal producers, compensate power producers for their losses or force coal producers to accept lower prices. Analysts say whatever the State Council decides will only be palliative, and a more fundamental overhaul of the pricing system is needed to prevent power supply shortages due to a decline in power generators' interest and capacity to invest in new plants. 'The immediate step is for [power] rates and [coal] costs to align, and hopefully this can be done in three to five years,' said Woo Chi-keung, a senior partner at United States-based consultancy Energy and Environmental Economics. 'There needs to be some certainty in investment return.' In 2005, the NDRC came up with a so-called 'coal cost pass-through' mechanism, under which it would raise power prices if coal costs rose by more than 5 per cent in a six-month period, so that 70 per cent of the increased costs could be passed on to power distributors and consumers. But the mechanism has not been properly implemented, as coal costs escalated soon after it was unveiled, which saw policymakers hold back on raising power prices for fear of stoking inflation and social unrest. 'The collapse in [this year's] contract negotiations reflects a chronic coal-power pricing bottleneck and the associated profit distribution [problem],' wrote Nomura Securities analyst Donovan Huang in a research report. 'We believe that only electricity tariff reforms can address the root cause.' One way to reform is to link coal and power prices closely. To help shield consumers from short-term coal price surges, Mr Woo proposes a mechanism for power generators to set aside funds when fuel prices are low and use the money to absorb losses when coal prices are high. This will give power generators the confidence to invest in capacity to meet future demand growth even at times of low profitability, hence ensuring supply reliability, he says. Beijing had also considered another cure for the price conflict - to use market forces to set power prices - which theoretically will also lower prices and boost efficiency. In 2002, it split the industry into generation and distribution companies so that generators could compete with each other for new plant construction. The restructuring also paved way for them to compete on power prices through bidding. Trials had been run in northeast and eastern China on a small percentage of power sales for a few years, but widespread power shortages - due to a lack of generation capacity between 2003 and 2006 and due to tight coal supply last year - hampered success, as shortages resulted in extreme price volatility. With the global financial crisis cutting mainland power demand sharply and substantial new capacity addition stemming from a plant construction binge in the past few years, surplus capacity is expected to continue to rise this year. Substantial surplus capacity is a prerequisite for the introduction of power price competition, as shortages lead to unwanted price rises. Yet analysts caution that Beijing should not hasten expansion of its trials on price competition, as overseas experiences pointed to more failures than successes. 'In my 15 years working on power market reform research, I have not seen many successful cases,' Mr Woo said. 'Governments tend to overestimate gains of market reform and underestimate the cost.' Xiamen University Centre for China Energy Economics Research director Lin Boqiang also said: 'I think [the government] should start [implementing] the coal cost pass-through mechanism ... Pricing [liberalisation] is more difficult.' Mr Woo says industry deregulation, which sometimes comes with privatisation, is often driven by government seeking to raise funds or cut budget deficits, citing Britain, Ontario in Canada and Australia as examples. In most cases, liberalised power prices were not lower than those before reform. In Ontario, dominance of an incumbent and a delay in market opening had led to insufficient investment and capacity shortages, while in California, a complicated market design saw traders gain at the expense of consumers, Mr Woo notes. In some cases, governments ended up having to intervene to ease the sharp rise in liberalised prices by subsidising consumers, or forcing cash-starved power distributors to issue bonds to pay for surging electricity prices, he adds. In Hong Kong, the government also toyed with the idea of opening up the market to new players in the past two years, but ended up bargaining down the incumbents' allowable rate of returns. The Macau government late last year proposed to open up the power generation sector to newcomers and freeze the generation capacity of monopoly Companhia de Electricidade de Macau (CEM) despite surging power demand, as it sought to lower power prices. Like their counterparts in Hong Kong, CEM is also regulated by rate of return limits. Mr Woo says governments often use market opening proposals as a bargaining chip to lower incumbents' returns and power prices. 'If the single most important thing in reform is price, then negotiate on the price,' he said. 'The so-called consultation is just posturing.' For the mainland, it remains to be seen when and how the government will come up with its own regime to provide some transparency and certainty on industry investment return. This is particularly important now that the fast growth of the power generation sector in the past six years has given way to much slower growth, and profit clarity is at its lowest.