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China Reaches A Milestone For Power Reform With Higher Peak Retail Tariffs

SINGAPORE (S&P Global Ratings) Aug. 4, 2021--S&P Global Ratings said today that China has reached another milestone for its market-oriented reforms. The National Development and Reform Commission (NDRC) has set higher peak retail tariffs, allowing more effective cost passthrough for the electricity sector.

"The higher tariffs should alleviate the burden on power generators struggling with high fuel costs at a time of high investment needs," said S&P Global Ratings credit analyst Yuehao Wu.

Indirectly, the higher tariffs will support the industry at a time of increasing leverage. The industry will incur aggressive capital expenditure to meet the country's "dual-carbon" targets under its 14th five-year plan (2021-2025).

On July 29, 2021, NDRC announced approval for retail electricity tariffs to rise by at least 20% during hours of peak demand.

The implementation of the higher peak retail tariff should help smooth out power demand during the peak seasons of summer and winter. It also shaves unnecessary peak load, indirectly lowering carbon emissions because additional demand is likely to be met by a thermal source.

"The NDRC's stance is consistent with the policy tone so far for a more effective cost pass-through to end customers. Higher retail peak tariffs allow for additional room for higher on-grid tariffs," said Ms. Wu.

According to the NDRC's notice, the peak tariffs should be no less than 3x of valley tariffs; and no less than 4x if the peak-valley demand gap exceeds 40%. Peak-valley tariffs should reflect local peak-valley demand patterns, share of renewables, and peak-shaving capability.

Strong recovery in power demand and high fuel costs tend to dampen the bottom line of independent power producers (IPPs). Such is the case this year, in our view. In July 2021, China Electricity Council (CEC) revised up its forecast for power demand to grow 10%-11% this year; its second revision since February. National power demand has grown at a robust 16.2% year on year during the first half of 2021, driven by the commercial and industrial sectors. But non-fossil power generation hasn't caught up as fast, rising just 12.4%% (and only +1.2% for hydro).

Fossil power inevitably takes up the supply slack when fuel costs are unfavorably high due to supply constraints. Average of coal prices (CCI5500) soared 49.5% year on year during the first half of 2021 to RMB807 per ton, 34% more than the red line set by NDRC, and this was a blow to the profitability of power generators. Huaneng Power International's net profit declined 27.3% whereas unit fuel costs rose 21.2%. Volume increased 20.8%, which didn't help with the bottom line. According to the CEC, 70% of the country's coal-power plants were loss-making in June 2021.

We expect provincial on-grid tariffs to be adjusted upward to reflect the prevailing high fuel costs. Inner Mongolia was the first province to announce such a step with effect from this month. The policy highlights that market-traded volumes (35%-40% of generation) are reflective of high fuel cost hikes, helping to preserve power generators' profitability. This challenges the ingrained false assumption that on-grid tariffs tend always to be at a discount.

We believe other provinces may follow suit to arrest the widening damage to the balance sheets of IPP groups. But a 10% cap, as in the case of Mongolia's tariff increase, isn't sufficient to arrest the profit decline this year. For our selected rated IPP groups--China Huaneng Group Co.Ltd., China Huadian Corp. Ltd., State Power Investment Corp. Ltd., and China Resources Power Holdings Co. Ltd.--the profit from the coal-power segment will likely decline by 20%-25% this year. EBITDA should remain flattish or moderately increase due to clean-power capacity additions this year.

"The new retail peak tariff policy appears a logical step, following efficiency reforms that have benefitted the wider economy. It recognizes that higher electricity costs can't be absorbed entirely by the industry alone," said Ms. Wu.

Over the past three years, the government has implemented retail tariff cuts for the Commercial and Industrial segment of 10% annually in 2018-2019 and by 5% in 2020. The cuts ate into the profitability of the two grid companies: State Grid Corp. of China and China Southern Grid Power Grid Co. Ltd. However, given an increasing share of renewable energy is dispatched by the grid, we expect higher transmission and distribution costs to be reasonably passed on to end users (renewables' all-in costs including peaking and energy storage are generally higher than fossil fuel-based power even though on-grid tariffs could be at parity or even lower for renewables).

The policy indirectly helps to some extent with the upcoming all-time high decarbonization-related capex over the 14th five-year period (2021-2025), in our view.

Given the credit-positive policy, we are optimistic that the government is willing to tone down profit declines to support climbing leverage. The big five central power generation groups have announced 75-80 gigawatt of total renewables capacity addition during the period, at more than twice the pace in preceding period. The two grid companies also have massive investment plans to cater for higher renewables.

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This report does not constitute a rating action.

S&P Global Ratings, part of S&P Global Inc. (NYSE: SPGI), is the world's leading provider of independent credit risk research. We publish more than a million credit ratings on debt issued by sovereign, municipal, corporate and financial sector entities. With over 1,400 credit analysts in 26 countries, and more than 150 years' experience of assessing credit risk, we offer a unique combination of global coverage and local insight. Our research and opinions about relative credit risk provide market participants with information that helps to support the growth of transparent, liquid debt markets worldwide.

Primary Credit Analyst:Yuehao Wu, CFA, Singapore + 65 6239 6373;
yuehao.wu@spglobal.com
Secondary Contact:Apple Li, CPA, Hong Kong + 852 2533 3512;
apple.li@spglobal.com
Research Assistant:Rick Yoon, Hong Kong

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