Ken Silverstein EnergyBiz Insider Editor-in-Chief

China relies largely on coal to power its economy. But, domestic and global environmental pressures are forcing it to look at other options that include nuclear energy and hydropower. To get there, it needs a heck of a lot more foreign participation. The Cambridge Energy Research Institute says that it must have a total of $1.4 trillion to modernize its whole energy infrastructure in the next 15 years.

According to the U.S. Energy Information Administration, China burns nearly 2 trillion kilowatts an hour of electricity today. But, that will grow to 4.5 trillion kilowatts per hour by 2020. Coal powers about 65 percent of the total consumption today. Government reforms are easing restrictions to foreign investment in newer generation technologies and particularly those associated with renewable power and nuclear energy. In fact, nuclear energy is expected to rise from 2 percent of all such generation fuel today to about 4 percent in 2020 -- necessitating $50 billion in investment by 2020.

"With China's entry into the World Trade Organization in November 2001, the Chinese government made a number of specific commitments to trade and investment liberalization which, if fully implemented, will substantially open the Chinese economy to foreign firms," says the Energy Information Administration. "In the energy sector, this will mean the lifting or sharp reduction of tariffs associated with imports of some classes of capital goods, and the eventual opening to foreign competition of some areas such as retail sales of petroleum products."

Despite moves toward privatization, much of China's economy is controlled by inefficient government enterprises. That's affected foreign direct investment, which now accounts for about 10 percent of all capital in the country's power sector -- not enough to meet the expected future demand. So, the Chinese government is working to make its utility industry more attractive to private investors.

The government has approved dozens of power projects in the last couple years. More than 120 gigawatts of generation capacity is now under construction in China. But, the Energy Information Administration says that it will take until 2007 before the country can produce enough energy to catch up with the growing demand at 15 percent a year.

Three Gorges Dam is the biggest project there that is expected to be completed in 2009. It involves 26 separate 700-MW generators, for a total of 18.2 GW. The Yellow River Hydroelectric Development Corporation, meantime, is planning for the construction of 25 generating stations with a combined installed capacity of 15.8 GW. Hydropower accounts for 25 percent of all power generated in China.

Fine Line

China's energy appetite has forced the majority of its provinces to undertake efforts to conserve energy. That includes having shopping malls turn their power off during peak periods as well as having smaller fertilizer and steel mills close down altogether or drastically curtail their operations.

China is walking a fine line as it tries to ease into a market-oriented power sector. If it moves too quickly, havoc may result. But, deregulating too slowly could hamper economic growth. Electricity prices are now contingent on government approval, although coal prices that went up 30-40 percent during 2004 vary with market demand. Power generators can pass that cost on to consumers.

The trend is definitely toward reform -- something that policymakers there say will permit the optimal distribution of power. Reform actually began in 1998. Recently, leaders have disbanded the State Power Corporation that controlled half the generation plants and nearly all of the transmission lines. Instead, they have formed 11 smaller generation and distribution units, now run by the State Electricity Regulatory Commission.

The goal is to fuel its economy and to end the blackouts. The immediate remedy, say analysts, is to get the grids interconnected so that those areas with surpluses can feed power to those regions that suffer shortages. At the same time, government needs to tie electricity usage to time-of-use rates. In other words, manufacturers might be charged more during peak periods when electricity usage can spike 100 percent.

Beyond that, China generally must create a legal structure in which foreign investors know that the contracts they are entering into are enforceable. At the same time, long-term electricity pricing contracts don't exist there while government-owned generators are given preferences over any foreign-controlled enterprise.

While some of the issues are getting addressed, the problems have hurt U.S. and European power companies. Many came to China in 1995 but have not seen returns on their investment. Enron, Mirant and Sithe used to participate in the Chinese market while Electricité de France, Peak Pacific and CLP Holdings are the main foreign companies involved with the market there now. But, given that 24 of 31 provinces report electric power shortages and blackouts are common in industrial centers, a greater level of investment is needed. That's why more and more players are excited by the possibilities that China may offer.

"Although there are few, if any, major international power developers who would undertake a large-scale Greenfield project in China these days, recent reforms appear to have made the power sector more palatable to many investors," writes Jeffrey Blount, partner in Fulbright & Jaworski's Hong Kong office, in a column he authored for the Houston Business Journal.

China is trying to build a stable generation base comprised of nuclear, coal and hydro facilities. That, of course, takes money. To achieve that objective, policymakers know they must restructure their electricity sector to make it more attractive to outside investors that require adequate returns. The trick is to limit price volatility while at the same time let consumers there know that prices can and will fluctuate. If done right, China can help fuel its sizzling economy with foreign direct investment.