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Credit FAQ: China's Power Outages--Get Used To It

As fuel shortages hit Europe and India, and global crude prices jump, China is dealing with its own energy crunch. Coal shortages have forced parts of the country to curtail output to industrial producers, saving power for residences. Swaths of rated entities are affected, most particularly China's independent power producers (IPPs), and the steel, aluminum, and cement makers.

S&P Global Ratings believes events are connected, that shortfalls and bottlenecks are becoming common as the world economy pulls out of COVID. This will create disruptions and hit ratings, often in unpredictable ways.

We also expect that the global push to green energy makes economies more vulnerable to swings in the supply of renewable power, which is typically weather dependent. China's hydropower recorded historically low water intake this year. It was unable to compensate for shortfalls in coal-fired power.

Europe's natural gas shortages are linked to the fact that solar and wind energy are still insufficient to cover energy demand. Both China and Europe find themselves with less spare capacity during spikes in demand, particularly when renewable sources falter.

India's robust power demand (15% above the pre-COVID level) led to coal supply shortages even after record domestic coal production in April-September 2021. Coal shortages and the high price of imported coal together are triggering electricity outages in the country.

China's local governments are limiting the electricity available to high carbon sectors such as steel, cement, and aluminum. Many such producers are lagging behind energy conservation targets set by the central government at the beginning of the year, under the so-called "dual control" plan. The plan sets goals for energy intensity, or the amount of energy expended for a given unit of GDP.

China's power outages shows how coal-dependent its economy continues to be, notwithstanding its aim to be carbon neutral by 2060. As China's economic recovery accelerates, its infrastructure buildout continues, and its exports rise, demand is increasing for steel, aluminum, and cement, boosting demand for the energy (largely coal) to make these commodities.

The sectors consume about half of China's electricity. We draw a direct line between their increased output in the first half and the country's recent power strains. Events show how carefully China needs to balance its energy security, and economic and environmental goals.

The sectors are playing a large part in China's recovery, but they wreak havoc on the country's targets for energy-intensity and carbon emissions. Steel, aluminum, power, and cement making contributed about 16% of the country's GDP by value added in 2017, according to the Asian Development Bank. The sectors also accounted for about 80% of carbon emissions among all industrial sectors.

Chart 1

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Investors are keen to understand the effect of the China's power outages on rated electricity firms and the companies that rely on them. We offer our views here:

Frequently Asked Questions

Why is China facing a coal shortage?

A lot more demand, and a little less supply. The government has been shutting coal mines that fail to meet environmental and safety requirements. Indicatively, China's coal production dropped 5% in June 2021, year on year, and 3.3% in July.

The country has also been curbing coal imports, partly to meet emission targets, and partly for political reasons (in the case of its ban on Australian coal). Total coal imports into China dropped about 10% year on year, from the start of 2021 through to August.

Meanwhile, surging demand has driven up power consumption. Thermal-coal-fired electricity production was up 12.6% in the year through to August, largely due to strong industrial demand. Chinese exports of manufactured goods have been strong. Its factories are fully open even as producers elsewhere continue to deal with COVID-related setbacks.

The Qinhuangdao spot price for thermal coal was up 94% at end-September compared with the average price in 2020.

Chart 2

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Chart 3

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What is the credit impact on rated independent power companies?

Shortages have sent the sector broadly into loss. The average unit fuel cost at coal-fired power plants increased by more than 50% in June. Over 70% of coal power plants were losing money, according to the China Energy Council, an industry body. Among the IPPs we rate, those that are reliant on thermal-coal power have been hit the hardest, such as Huaneng Power International Inc. and China Huadian Corp. Ltd.

Those that have renewable power sources are less sensitive to the cost of coal. This includes China Power International Development Ltd.

Given that entities are now making heavy losses on the power they provide, the IPPs are curtailing their coal-fired output. While the government has asked for more coal production, it will take time for the new supply to come online. We expect commercial and industrial users (C&I) will continue to ration power into the winter. The government has prioritized the supply of residential power, which should be secure.

Several provincial governments are allowing on-grid tariff hikes based on the "basic-tariff-plus-floating" mechanism set by the National Development and Reform Commission (NDRC, an economic planning body) in 2019. IPPs are allowed to increase on-grid tariffs by no more than 20% above the local benchmark tariff.

The State Council, China's main governing authority, recently widened the floating band from 10%. In addition, the electricity sold to energy-intensive sector is not restricted by the 20% cap. The government also requires all coal-fired power to be sold under the market-based trading mechanism and encourages 100% of C&I users to participate in the market.

IPPs' losses should narrow slightly in the fourth quarter as fuel costs ease and power consumption decelerates.

The major IPPs in China have committed to targets that line up with the government's 14th five-year plan, with a particular focus on expanding use of renewable energy. For example, Huadian Group aims at a 36% compound annual growth rate in renewable use over the next five years. This almost double the growth it registered in the past five years. State Power Investment Corp. Ltd. has already achieved a portfolio mix dominated by renewables.

The switch to clean energy involves a high level of debt-funded capital expenditure. The gradual ramp-up of the renewable energy projects that do not rely on subsidies will weigh on IPPs' cash leverage ratio. The state-owned producers will continue to benefit from strong refinancing capability. Their ratio of funds from operations to interest costs should remain intact.

Chart 4

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How will outages affect rated grid companies?

Moderately, given that the grid firms have more capacity to pass on costs to users than do the IPPs. Entities have shut grids in northeast China to ensure the stability of their networks. Coal shortfalls, and the undersupply of coal-fired power, drove the outages. Wind speeds have also been slower than usual, reducing the contribution from wind power.

The incidents have revealed that part of China's grid facilities are not yet flexible enough to handle such events. They lack "smart" power distribution technology, which would let them adapt to fluctuating input from renewables. Both of China's grid companies (China Southern Power Grid Co. Ltd. and State Grid Corp. of China) have been investing in power storage and smart distribution facilities to align better with renewable power. Recent events will push them to adapt more quickly.

The grid firms can pass on most of the cost of the tariff hikes to users. In a recent notice issued by the NDRC, retail tariffs for C&I customers will reflect the market rate, instead of being set by the local NDRC. This is a milestone for China's power reforms, in our view, and follows a decision in August to allow a higher peak retail tariff. The central government seems more inclined to pass extraordinary energy costs to end users, instead of burdening grid firms, as was typical in the past. However, lower power consumption growth in the second half may hit revenues.

Longer term, the gridcos are moving toward a more transparent and stable regime in which they earn a regulated return. Their profitability should therefore become more predictable and stable.

The key credit risks with gridcos, especially for China Southern Grid, lie with their capital expenditure and acquisitions in overseas markets. China Southern Grid is eying transmission and distribution assets in a few developing countries. If those deals go through, the debt-funded financing could push its cash-leverage ratio below our downgrade threshold. For this reason, our rating outlook on the entity is negative.

State Grid's ratio of funds from operations to debt still has headroom. This is even after its recent acquisition of assets in Oman and Chile. Capital expenditure remains at about its historical average, and the entity is deleveraging, in line with directions from the central government.

How are the power outages affecting the natural gas distributors?

The national natural gas consumption was up by 16% year on year in the first nine months of 2021. This was driven by buoyant industrial demand and continued growth in coal-to-gas extraction in city gas projects. This growth decelerated sharply in August and September for the industrial segment due to soaring gas prices.

We estimate 2021 national gas demand growth to be 12%-13%. This is a meaningful gain even after accounting for the low base set in pandemic-impaired 2020. Power curbs and production cuts will weigh on gas volumes in the last quarter.

The credit effect should be limited for our rated gas distributors. Soaring gas prices are compressing the dollar margins, but volume growth in the first nine months of the year offsets the strains. Distributors will likely pass on increased costs in most parts of China, though they may experience delays in raising rates for residential customers.

Most distributors are entering an unfavorable pricing cycle with a strong balance sheet. They can also pull back their capital expenditure to support their credit quality, if needed (see "China's Gas Distributors Won't Get Burned By Higher Costs," Oct. 7, 2021).

What do the coal shortages say about China's climate goals?

We see some wavering, at least this year. The energy disruptions in China, Europe, and elsewhere show how economically challenging decarbonization will be. While we do not have the data yet to understand how the outages have hurt the Chinese economy, the effect likely will be sharply negative.

This is creating debate within China about the need to balance growth with climate goals. For example, the government's decision to increase coal production in response to shortages reveal a degree of reticence about its carbon targets when they impede the economy and threaten social stability.

On Aug. 12, 2021, the NDRC specified that provinces must meet its dual control targets. The release also listed provinces' progress toward these goals, which mandate less energy consumption and a less energy-intensive economy.

However, recent data show China is missing its targets on energy intensity. The country's electricity consumption grew 14.8% in the year to August (year on year). Seasonally adjusted and disaggregated GDP grew about 11.2% over the same period. This means electricity consumption efficiency has declined 3.2%. The overall energy efficiency target, which includes other sources of energy such as fuels in addition to electricity, is for an efficiency gain of 3%.

China contends with the same dynamics as the rest of the world. A hard reboot of the global economy which is climbing quickly out of COVID has sparked a surge in demand for many durable goods. Failures to meet this demand are creating supply-chain gaps. This impairs the recovery at a critical moment.

The elasticity of supply, or the ease with which manufacturers can produce more goods, has been low due to tight inventories and shortages and delays of some key inputs. This exacerbates shortages and triggers price surges.

Economic planners in all countries are facing great temptation to push back their carbon goals. China is sorting through the same policy ambivalence, at least temporarily (see "China's Energy Transition Stalls Post-COVID," Sept. 22, 2020).

How is the steel sector managing amid power cuts?

Many competing trends should largely wash out. Power outages have hit production, and feedstock prices are volatile. Iron ore cost about US$90 per metric ton in mid-2020, climbed to about US$230 per metric ton in May 2021, and fell back to US$120-US$130 per metric ton recently. Steel prices are also rising, climbing 40%-50% in the year to date.

On the policy side, the government rolled out infrastructure projects to support the economy during COVID, and this has bolstered demand. Steel production rose about 12% year on year in the first half of the year as a result.

With an eye on its energy-intensity targets, the government has curtailed steel output in the second half. This output fell 13.2% in August, year on year. Elsewhere, government measures to rein in property prices and developer debt is weighing heavily on home construction, hitting steel demand.

The net effect will be neutral--this year's steel output should be flat to last year's. Steel prices will be higher but this will largely track the increased cost of iron ore, coking coal, and power.

How do power cuts affect the credit standing of aluminum producers?

The aluminum makers are going through a difficult time. The sector is highly dependent on coal power. In 2020, coal-fired electricity powered around 86% of aluminum production in China (see "The Future Of China Aluminum Production: Leaner, Cleaner, Greener," Sept. 5, 2021.)

So a more expensive coal price is meaningful, with electricity comprising 30%-40% of the cost of aluminum production. The government is also targeting aluminum firms in curtailing electricity supply, to meet its carbon targets and to preserve power for homes. Some provinces have suspended approvals for particularly energy-intensive projects that would likely consume a lot of aluminum.

Shortages are supporting already high prices for aluminum, supporting producers' profitability.

As always, the bigger players with more diversified operations are best placed to ride out the energy crunch. But even the large entities--such as Aluminum Corp. of China and China Hongqiao Group Ltd.--are exposed.

Both firms are moving production to Yunnan, to take advantage of the province's typically ample hydropower. Hongqiao had been relocating 2.03 mtpa (million metric tons per year) of its aluminum capacity to Yunnan. Aluminum Corp. of China (Chinalco) was looking at increasing its presence in Yunnan to 4.2 mtpa of aluminum capacity over the next two to three years, from 1.7 mtpa at the end of 2018. The firms may delay this relocation in light of Yunnan's recent hydropower shortages.

Since May 2021, Henan Shenhuo Coal & Power Co. Ltd. has suspended 200,000 tons of annual aluminum capacity in Yunnan, more than one-quarter of its total capacity in the province. Power shortages have also stopped the company from activating 150,000 tons of new capacity added this year. Yunnan Aluminum Co. Ltd. (a subsidiary of Chinalco) said in an announcement on Sept. 17, 2021, that it suspended 770,000 metric tons of annual capacity. The firm says its 2021 aluminum output will be 2.36 million metric tons, significantly below the 2.87 million metric tons it targeted at the start of the year.

Yunnan province had offered aluminum firms preferential power prices, but these cost incentives may be revoked. The province wants to curtail incentives to high-energy-intensive producers, in line with the government's green goals. About one-quarter of Yunnan's aluminum plants have been shut. The firms are losing production in a strong market for their products. It is also expensive to restart these plants, which is pushing up the cost of production.

Writer: Jasper Moiseiwitsch

Related Research

This report does not constitute a rating action.

Primary Credit Analysts:Apple Li, CPA, Hong Kong + 852 2533 3512;
apple.li@spglobal.com
Danny Huang, Hong Kong + 852 2532 8078;
danny.huang@spglobal.com
Allen Lin, CFA, Hong Kong + 852 2532 8004;
allen.lin@spglobal.com
Christine Li, Hong Kong + 852 2532 8005;
Christine.Li@spglobal.com
Yuehao Wu, CFA, Singapore + 65 6239 6373;
yuehao.wu@spglobal.com
Asia-Pacific Economist:Vishrut Rana, Singapore + 65 6216 1008;
vishrut.rana@spglobal.com
Greater China Country Lead:Charles Chang, Hong Kong (852) 2533-3543;
charles.chang@spglobal.com

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