China’s Coal Pricing Mechanism Needs Improvement

China’s coal consumption peak season typically starts before the Chinese New Year. Coupled with the unusual snowstorm in southern provinces this year, coal prices in China shot up furiously within a short period of time at the beginning of 2008.

In the transit hub of Qinhuangdao, major coal prices reached a record high in January 2008, up more than 20% from just a month ago, and such increases are on top of the continued uptrend in coal prices since 2004. Coal is the most important energy source in China, accounting for 70% of the national energy consumption. Why would the coal price keep going up in recent years?

“Tight balance” between supply and demand

The coal price trend in China is closely related to its price forming mechanism. And the reform progress in China’s coal pricing mechanism in recent year has shown a clear tendency towards marketization.

In the era of planned economy, coal prices were uniformly set by the government. In 1993, China started to relax sale prices for coal products other than thermal coal, which accounted for 50% of total coal consumption in China, so thermal coal price was still under a dual pricing mechanism of “planned coal” and “market coal”. In late 2004, the government announced the “Coal-Electricity Price Linking Mechanism”, which allows periodic electricity price increases once thermal coal price increases 5% or more in the past 6 months, and the thermal coal price in turn can be determined by negotiation between coal sellers and buyers in the market. For various reasons, thermal coal price failed to become marketised initially, but the price differentials under the dual pricing mechanism began to converge. In 2007, the 50-year-old system of government organising annual coal order meeting among coal producers, transporters and users was finally removed, and now suppliers and buyers are starting to independently negotiate prices based on market circumstances, under the government’s macro control framework.

Against such a backdrop, the relationship between supply and demand has now become the major factor in determining coal prices. From a consumption mix perspective, the electricity, metallurgical, chemical and construction materials industries, which collectively account for 70% of total coal consumption, are the main users of coal in China. In the first three quarters of 2007, outputs from China’s coal-fired power, coke, raw steel and cement industries had grown 16.7%, 19.4%, 17.6% and 15% respectively over previous comparable period, far exceeding raw coal output growth of 11% from the same period. On one hand, the demand for coal had been increasing significantly. On the other hand, the government were mandating the closure of small and medium coal mines and limiting the capacity expansion of coal mines, thus reducing coal supply growth. And the railway transportation in China has long been a bottleneck for coal. As a result of all these factors, demand and supply of coal in China has been in a “tight balance” situation for years.

Coal prices in China started to decline in 1997 and reached a bottom in 2001. The problem of coal shortage started to surface in 2004. Although coal producers had been expanding their production in the following years, with 8.2% increase in output in 2007 alone, the supply shortage nevertheless failed to alleviate. Therefore, coal producers in China have made a windfall profit in recent years, thanks to the ever-rising coal prices.

Experts predicted that national raw coal output in 2008 would be similar to the level in 2007, with about 2.73 billion tons of production, against an expected demand of 2.728 billion tons. Although there may be tightness in certain regions and coal products, China’s coal market as a whole is expected to reach equilibrium this year, with coal prices maintaining at a high level.

“Full-cost” reflecting resources scarcity

Not only coal prices in China reflects demand and supply interaction, they are also starting to reflect the associated resources scarcity and environmental costs. Therefore, the crystallisation of regulatory costs is another important reason for the ever-rising coal prices in China.

Previously, most coal mining rights in China could be acquired with little compensation, and costs of safety, environment and rehabilitation had not been included in the normal costing of coal. This not only failed to reflect the true value of resources, but also led to uncompensated resources consumption and unrecovered environmental damage. For many state-owned coal companies, they also had to face legacy issues such as rebuilding exhausted coalmines and staff re-employment difficulties.

To solve these problems, China began implementing the system of compensated use of mineral resources in September 2006, and the coal industry took the reform trial. The State Council began a pilot system of compensated use of coal resources in eight major coal producing provinces, and coalminers had to pay for the exploration rights and extraction rights. Further reforms in resource taxes and resources compensation charges are also under contemplation by the regulators in China.

In addition, Shanxi Province, one of the major coal sources in China, is planning to implement a trial scheme for sustainable developments of coal companies this year. One of the important features is to levy and establish three funds, namely coal sustainable development funds, mine environmental recovery fund and coalmine redevelopment fund. And these three funds, along with mining right fees, will be included into total production costs of coal from now on. Therefore, in addition to the production costs, coal producers now have to factor in environmental, resources, ecology and redevelopment costs, hence the “full costs” of coal production.

The risen costs will no doubt put pressure on coal companies. In the first three quarters of 2007, listed coal companies in China reported an average gross margin of 30.31%, down 4.82% from the same period last year, mainly because the rise in regulatory costs had exceeded the growth in coal prices in that period.

Non-coal costs

The increase in production costs is not the sole reason for the rising coal prices. China has a complex coal distribution chain, which had become even more expensive recently, so these non-coal costs are also responsible for the rising coal prices in China. It is understood that sea freight contract prices for coal has increased from 40-50 yuan per ton before 2007 to the current price of 100 yuan per ton.

The “coal-power tension” between coal producers, power generation plants and power distribution networks, which are all acting in their self-interests within the value chain, has long attracted the public attention. While the coal prices continued going up in January this year, the government didn’t accordingly increase electricity prices as per the “Coal-Electricity Price Linking Mechanism”, due to macro control considerations (on inflation). In this circumstance, the thermal coal price became a tenacious point between coal producers and power producers.

Experts suggested that the improvement in coal pricing mechanism in China needs to progress alongside reforms in related industries such as power generation, railway and ports. Furthermore, China is now facing an upward pressure in general prices, so stabilising prices and preventing serious inflation will be the main objective for macro control. An effective coal price setting mechanism should not only observe the principle of market economy, but also take into account the government’s macro control theme and affordability of downstream industries.