Why China’s power sector restructuring is a game of mergers and demergers

PUBLISHED : Friday, 08 September, 2017, 3:11pm
UPDATED : Friday, 08 September, 2017, 9:55pm

Restructuring of China’s electricity generation industry looks set to come full circle with a reconsolidation of state-owned majors, some of which were established only 15 years ago through the break-up of former behemoth State Power Corporation into five big generation firms.

However, the latest revamp is not a straightforward regrouping of broken up power companies, as it involves the merger of Shenhua Group, a coal mining giant that also has a big fleet of power plants, with China Guodian Group, one of the big five power generators.

“The curtain for the central government’s power generation firms has just been raised. We expect a second and third case to come soon,” Pingan Securities analyst Zhu Dong said in a note.

“Two possible routes are mergers between power generators and the combination of coal and power firms.”

The merger is part of Beijing’s long term plan to reduce 99 firms directly administered by the central government – nine of which are power generators focusing on segments other than nuclear power – to 40 to enhance competitiveness.

It comes at a time when the power generation industry is suffering from its second major profit downturn in a decade due to volatile coal prices and an inability to pass higher fuel costs on to customers, since power prices are still largely state stipulated.

This is despite gradual but slow market liberalisation to introduce competition via direct selling prices and volume negotiations between power producers and some large customers.

Wang Binghua, chairman of State Power Investment Corporation, one of the big five generators, recently hinted that more consolidation was on the way. In July mainland media quoted him saying that nine central government owned power generation firms competing in the same market “was clearly unsuitable”.

Without commenting on whether his firm would merge with bigger rival China Huaneng Group, Wang said a key principle for mergers among state enterprises was that it must be “on a voluntary basis”.

State Power Investment went through its own restructuring just two years ago, having been created from the absorption of nuclear technology importer State National Power Technology Corp into China Power Investment Corp, another of the big five.

Beijing approves Shenhua-Guodian marriage to become the world’s biggest energy juggernaut

While the break-up of State Power Corp in 2002 had promoted industry competition, a lack of progress in power price liberalisation until two years ago, and increased state dominance in the industry meant the majors had focused their competition on grabbing market share by building new projects, instead of improving efficiency and profitability.

“The power majors have succeeded in becoming big, but they fell short on becoming strong,” Lin Boqiang, director of the China Centre for Energy Economics Research at Xiamen University, told the South China Morning Post.

The result was an unprecedented capacity glut, as capacity expanded at an average rate of 9.2 per cent in the five years to 2016, almost double the 4.8 per cent growth rate for power demand.

Coal fired power plants’ average utilisation was 4,165 hours last year, or around 48 per cent, the lowest in 53 years.

Lower plant utilisation means more fixed costs such as depreciation and maintenance need to be offset against revenue generated from the same amount of output, resulting in lower profit margins.

Profits have also been crimped by higher debt servicing costs, as the building boom was mostly debt financed.

Datang urges Beijing to further lift power prices to relieve coal cost squeeze

Industry leader China Huaneng Group, which posted a net loss attributable to shareholders of 570 million yuan (US$87.6 million)last year, incurred interest expense of 24.4 billion yuan, around double its operating profit.

Coupled with volatile coal prices, which doubled to around 740 yuan a tonne late last year from the trough early last year, Hong Kong listed Chinese coal fired power producers saw major year on year profit declines – as much as 96 per cent in the case of Huaneng Power International – in the first half.

The profit rout came after Beijing intervened in the oversupplied coal market by ordering all mines to operate no more than 276 days a year to cut capacity by roughly 10 per cent, to prevent mass bankruptcies of coal mines.

Before that, prices of the fossil fuel had sunk as much as 55 per cent during the bear market as a result of a mining capacity construction binge amid slowing demand growth, which lasted more than four years and mired many coal mines in losses.

Last year’s production days cap lasted seven months, during which time power prices were not raised by the government despite surging coal prices resulting from the state intervention.

As far back as 2004 Beijing launched a mechanism to link changes in power generators’ selling prices to coal prices, but fears of stoking inflation and social unrest during the commodities price boom meant it was rarely implemented properly.

As a result, power producers had to absorb higher fuel costs for consumers and hoped that regulators would cut power prices at a slower rate when coal prices ease.

Lin said the decision to merge coal and power firms is directly linked to the failure to implement the so-called coal cost pass-through mechanism.

“By merging coal and power companies, they can cancel out the impact from fuel price volatility on upstream operations against that on downstream operations,” Lin said.

“This way, the integrated energy companies can have greater stability in financial performance regardless the commodities industry cycle, and have greater incentive to improve efficiency”.

As Beijing remained cautious on liberalising power prices so power generators could focus on profits instead of scale, it once again had to resort to administrative means – as it did in other sectors like coal, steel and aluminium – to cut excess capacity.

The new company will be even bigger, less nimble and with more social burdens
Jenny Yang, IHS Markit

By merging industry players, Beijing hopes that redundant plants of two industry players in the same region can be closed, although some analysts are sceptical.

UBS head of Asian utilities research Simon Powell said that “in a perfect world” market forces and free competition determine which plants need to be closed based on their cost competitiveness.

“But this would result in a bloodbath where industry players will sustain prolonged periods of losses until the excess capacity is eliminated,” he said. “Beijing would prefer the adjustment to be done in a more controlled manner.”

Although a bloodbath can be avoided by merging companies, it would also result in less competition and slower cost efficiency gains, which may keep power prices at levels higher than desired, he added.

Jenny Yang, who covers China gas, power, coal and renewables at industry research provider IHS Markit, shared the concern.

She said mergers would result in the emergence of oligopolies, with state control of the energy industry tightened.

“Even before the merger, Shenhua and Guodian were already among the largest state-owned enterprises in China, rife with inefficiencies... the new company will be even bigger, less nimble and with more social burdens,” she said.

“By reducing the number of players and creating larger integrated companies, the current state enterprise reform trend contrasts with the plan to inject more market elements into the energy sector, as previously stipulated at the third plenum of the eighteenth [communist] party congress in 2013.”

In Beijing’s strongest signal yet of its seriousness in restoring demand-supply balance in the power industry, 16 ministry-level authorities late July issued a joint edict. It ordered the suspension or delay in construction of new coal-fired power plants with total capacity of 150 giga-watt (GW) and elimination of 20GW of capacity in the five years to 2020, by which time total capacity must not exceed 1,100GW.

Total capacity stood at 1,060GW at the end of June this year, with 14.2GW added in the first half of the year, compared to 47.5GW of net addition last year.

Hu Xinmin, principal at Hong Kong-based electricity industry consultancy Lantau Group, warned that even if capacity is successfully capped at the targeted level, oversupply will likely persist for several more years given the outlook of slower demand growth and that several large plants are still being built.

He cited the example in Jiangxi province, where 10GW of coal-fired capacity was under construction last year – compared to installed capacity of 25.3GW at the end of 2015 – despite infrastructure existing for it to import power from other provinces.

“China needs to coordinate planning at the national level to optimise generation capacity additions. Lack of coordinated cross province planning and misaligned local versus national incentives continues to frustrate more rational power system development,” he wrote in a report.