Has China Finally Picked Up the Pace on its Natural Gas Reform?

22 February 2012

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Summary

For some years, there has been talk of natural gas price reform in China. However, to the disappointment of many international players, the Chinese central government has hereto shown little willingness to accelerate the process of natural gas price reform.

In late 2011, certain changes were announced which might herald a serious effort at natural gas price reform.

Recent history of price reform measures

Between 2004 and 2008, policy changes to gas prices in China edged forward by small steps. In December 2004, China entered into its first long-term LNG sale and purchase agreement. This move led the traditionally inward looking Chinese gas market to believe that reform was imminent.

In 2005, the well-head prices in China were allowed to be set by negotiation for the first time; although the negotiated price was subject to a ceiling of 10 per cent over a government guide price. No floor price was set. The wholesale gas prices were also pegged to the weighted prices of a basket of substitute energy resources including crude oil, LPG and coal.

In 2006, the price of pipeline gas was calculated for the first time to include charges for ‘pipeline capacity fees and pipeline utilisation fees’ in addition to the well-head price. To recognise the scarcity of gas resources, the central government issued guidance in 2007 to direct local governments to develop gas consumption by home users and to restrict the expansion of gas consumption by industrial users, power generators and petrochemical projects, which then were the largest natural gas consumer in China.

Two pieces of regulation were introduced in 2007 and 2008: The Energy Law and the Energy Conservative Law of the People's Republic of China. They apply to natural gas and other forms of energy resources and set the establishment of an energy administration, a market-orientated pricing mechanism and strategic energy reserves as long-term targets of the Chinese government. 2009 was a relatively uneventful year for policy changes in gas regulations in China.

In 2010, reforms were resumed. The State Council declared the establishment of the National Energy Commission, whose members include representatives from various government agencies such as finance, central bank, tax, transportation, environment and the National Development and Reform Commission (NDRC). The Commission’s function is to formulate an overall energy policy in China, draft an energy development plan, review energy security and major energy issues and co-ordinate with domestic and international energy development co-operation. It contributed greatly to China’s energy policy for the 12th Five Year Plan.

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Latest price reform measures

In late December 2011, the NDRC issued a notice announcing a natural gas price reform pilot scheme. According to the notice, the pilot scheme will be implemented in Guangdong province and the Guangxi Autonomous Region. This pilot scheme has sent a positive signal to the market that China is finally stepping up its natural gas reforms.

This is a summary of the key features of the scheme:

The scheme lays down the goals and processes of the natural gas price reforms. The ultimate goal of the reforms is to liberalise and let the market decide the well-head prices. The government will only supervise the pipeline transmitted gas prices. The process comprises the following:

  1. The pricing mechanism is to be changed from a 'production cost' base to a 'market net return' base. The new pricing mechanism applies to gas produced at onshore gas fields in China and imported pipeline gas.
  2. The new city gate prices will be linked to the import price of two types of substitute fuels: fuel oil (giving a 60 per cent weight in the final prices) for power generation and LPG (having a 40 per cent weight in the final prices) for cooking in Shanghai, and the prices of these substitute fuels are to be used as a starting point by the government to derive a benchmark price in Shanghai. This benchmark price will in turn be used to calculate the gas prices for Guangdong and Guangxi, which are the two regions initially subject to the scheme.
  3. The city-gate prices are adjusted, initially annually, then semi-annually or quarterly, according to the change in prices for the above mentioned substitute fuels; and
  4. The prices of unconventional gas such as shale gas, coal seam methane and coal to gas will be liberalised and decided by the market.

The pilot scheme is viewed as an incentive to unconventional gas and will likely boost gas imports as well as output of cleaner fuel in China.

However, another important incentive introduced last year has been quoted by some as a less positive message to those hoping to see more drastic gas price policy changes. This is the value added tax (VAT) rebate scheme introduced by the Ministry of Finance in August last year. According to the scheme, the government will grant VAT rebates for LNG and gas imported between 1 January 2011 to 31 December 2020. By way of background, the gas imported by Chinese companies is exempted from customs duty but is subject to 13 per cent VAT. It is widely perceived that the purpose of this scheme is to help alleviate the huge losses assumed by the big state-own entities who, under the central government's direction, paid international prices for large quantities of imported gas and LNG but were unable to pass on the costs to domestic gas off-takers due to the natural gas price ceiling imposed by the central government. Some observers commented immediately after the rebate policy was announced that the rebate extension would likely delay the central government’s progress on natural gas price reform. However, other energy analysts argued that the rebate would only cover a fraction of the imported costs; unless the natural gas prices in China are raised significantly, the big state-owned oil companies in China would not be able to offset losses from their gas imports. Hence, price reform will continue.

Considering that the rebate scheme was announced four months earlier than the pilot gas price reform scheme, it seems more likely the VAT rebate will only serve as a temporary measure to set-off a small portion of the price disparity between the international gas prices and the domestic natural gas prices. If China is to realise its plan to increase gas consumption to account for a significant portion of its total energy consumption, it will have to pick up the pace of price reform.

As the NDRC mentioned in its notice introducing the pilot scheme, the aim of the gas price reform pilot scheme is to assist the government to determine a reasonable pricing mechanism, a suitable basket of indexed fuels and an appropriate price adjustment system. If the pilot scheme proves to be successful, the new pricing system will be rolled out nationally. In time, China may be able to reduce the gap between imported prices and its domestic gas distribution prices.

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