China. Interesting read.

(Reuters) – Confronting a huge and growing power crisis, China faces a painful choice: either allow a summer of blackouts or swallow a dose of inflation.

The shortage, which has brought electricity cuts for big power consumers and a spate of emergency measures, was avoidable and foreseen by many economists and analysts.

It is not that China lacks the generation capacity to meet demand. Instead, analysts point to a lopsided electricity sector in which government controls starve producers of price rises so that manufacturers can guzzle cheap power.

That has created the worst power shortage in seven years as producers restrict output to make ends meet. The shortage is set to worsen as electricity demand rises during the peak summer months just as hydropower capacity has been hit by drought.

“This is going to be a big one, and it’s compounded by the fact that power companies are losing money for producing,” said Credit Suisse economist Dong Tao. “It is going to be a pretty sticky situation for growth and it will also add to inflationary pressure.”

The only real solution is for the government to raise prices, giving producers an incentive to increase power output, and then to tighten the monetary reins to prevent inflation from seeping into the economy.

The power deficit could exceed 30-40 gigawatts during the summer peak season, the State Grid Corporation of China says.

To put that in perspective, even if all the power plants in Argentina were plugged into China, it would not be quite enough to cover the shortage.

The drought has left water in some of the country’s biggest hydropower producing regions at critical levels just when output should be peaking. During May to October last year, hydropower generated a fifth of China’s electricity generation.

Some economists think the power shortages will be serious enough to slow China’s booming economic growth, which topped 10 percent last year.

Others see no impact, with an expected slowdown in the economy in the second half of the year easing the imbalance between supply and demand.

“The power shortage will cut industrial output (growth) in the second quarter by 0.5 percentage point, and cut GDP growth by 0.2 percentage point,” said Gao Shanwen, chief economist at China Essence Securities in Beijing.

Industrial Securities, a brokerage, said the drag on full-year economic growth could be twice as big at 0.4 percentage point should a 30 GW deficit last from June to August.

THE ROOT OF THE PROBLEM

So far, the government’s response to the crisis has been to restrict power supplies to big industrial users like aluminium smelters and steel mills.

It has banned diesel exports and is importing more gas to provide feedstock for power producers, especially as hydropower levels are suffering because of the drought. The government is also rushing to build new power lines in the worst-hit areas.

The energy-guzzling metropolis of Shanghai is considering cutting off its glitzy, neon-draped department stores in order to conserve power over the summer.

Eventually, the government wants China to have a sparkling example of a smart grid, efficiently managing and pricing its power supplies.

More electricity will come from low-emissions sources and much of the coal-fired power will be sent over long distances by ultra-high-voltage power lines, avoiding the transport bottlenecks that have long dogged the sector.

But none of that addresses the root of the problem, economists say: electricity prices are simply too low.

It is an old problem — power shortages are a perennial menace in China — which is why many analysts are not surprised to see a power crisis just six months after the last one.

Unlike the biggest crisis of the last decade, when supply failed to keep up with demand in 2004, China does not lack the ability to produce enough power — just the will to do so.

“This time, power generators are able to increase their output as long as they are given incentives, such as power price rises,” said Wang Jin, an analyst at Guotai Junan Securities in Shanghai.

Dong Tao at Credit Suisse said prices would have to go up.

“The reality is that power companies do not want to produce power. A power shortage is bad for manufacturers, but it is not so bad for power companies. Some upward adjustment to power tariffs is justified.”

TARIFF HIKES

More than half of China’s power plants are now making losses, giving them a strong hand to bargain for a price hike, according to Gary Chiu at Samsung Securities in Hong Kong.

Some investors agree. The Hong Kong-listed shares of Chinese power producer China Resources Power has risen more than 5 percent since late April and power equipment maker Dongfang Electric has gained more than 13 percent. The wider market has dropped 2.5 percent over the same period.

Media reports have suggested some provinces may be preparing to raise the price at which power producers can sell to the electricity grid, but that may still not be enough.

Although it would boost coal producers, it would also have the unwanted side-effect of resurrecting many of the small mines China has spent years trying to close, while offering only a quick fix, in danger of coming unstuck if coal prices rose too.

The power shortages may give the government an added incentive to push through efforts to weed out metals smelters and steelmaking blast furnaces deemed too small under plans to clean up the country’s most polluting sectors. It could target these smaller companies for power rationing first, prodding them towards closure.

An alternative measure to ease the power crunch, says Citigroup, is for the government to raise the price that grids pay power producers, but without passing that cost on to consumers, thereby avoiding any impact on the consumer price index. The cost of the increase could be shared between the grids and the government, it suggested.

Many analysts contend that for a more durable solution, end-user prices would need to move up too, in line with government plans to one day liberalise the sector so that coal costs are passed through to end-users.

Otherwise demand growth would continue unabated and the grids, which already have vast investment commitments, would be left with a massive extra cost.

But raising end-user prices means inflation, the bugbear of Beijing. Indeed, the government has declared that controlling inflation — running at more than 5 percent — is its top policy priority this year.

The central bank has already carried out a flurry of measures, including interest rate rises, to keep a lid on inflation pressures.

“We believe the government will wait until inflationary pressure has abated in the second half before it raises electricity prices at the end-user level to avoid pushing up inflation further,” said Mizuho chief economist Jianguang Shen in a note to clients.

“However, it may delay inflation from moderating in second half, and monetary tightening will have to last longer than originally expected,” Shen wrote. “We believe there is no easy solution to the situation, and the government may face a dilemma between pushing up inflation and reducing production. A fundamental solution to the problem will be to focus on the root cause.”