The three reasons that are leading China to suffer an unprecedented energy crisis

China Energy Crisis

China has been gaining relevance on the world economic and media board for years. However, in recent weeks it seems to have become the major focus of attention in the markets due to a series of events (Evergrande and the energy crisis) that could mark the future of the global economy in the short and medium-term. Asia’s largest economy is suffering the first consequences of an energy crisis, which is partly self-inflicted, and which could have global repercussions, given the role of China as the great factory of the world, a role that has also been reinforced during the covid crisis.

“China is facing an unprecedented energy crisis, said Alicia García Herrero, chief Asia-Pacific economist for Natixis and one of the leading experts on the Chinese economy. The authorities have begun to impose energy rationing that threatens to further strain global supply chains and create shortages of “everything,” according to economists at the Japanese bank Nomura.

The intensification of electricity supply problems is forcing factories in several key production centers to reduce or completely stop their activity. “These restrictions produce big challenges from the supply side, coming right in the middle of a pandemic-induced boom in global demand for goods, many of which depend on Chinese production and therefore require a higher electricity consumption”, explain in a note the economists of BCA Research.

What is really happening in the Chinese energy market to get there?

García Herrero highlights in a note just published this Wednesday that there are three key factors that are generating this energy crisis that is keeping the whole world in suspense: (I) the rush of local governments to meet their emissions targets, (II) ) the gap between the supply and demand of coal and (III) the caps imposed on the cost of electricity.

These caps that limit the price of electricity prevent the occurrence of what is known in economic jargon as ‘destruction of demand’, which is the reduction of electricity consumption (or anything else) at prices so high that it causes it is unfeasible to continue consuming at least as much energy as before. In China, in the end it is the authorities who have to decide who can continue to consume energy and who cannot.

“This triple blow will surely raise producer prices in China, and possibly headline inflation, and affect growth,” says García Herrero. Breaking down a bit more each factor that is dominating the energy market in China, it should be noted that local governments are struggling to meet their emissions targets, which has forced them to slow down, or even temporarily halt, production in industries that are more energy-intensive.

An anecdote that perfectly sums up this movement by China in pursuit of a more sustainable and ‘green’ economy appeared a few days ago in the financial agency Bloomberg: it seems that China has a clear objective in the very short term, that the sky is totally blue at the Beijing Winter Olympics next February.

Coal shortage in China

The second reason is the global coal supply shortage, which affects China even more given its heavy dependence on coal-based electricity (72% of total electricity generation from January to August according to national sources), he says. the Natixis economist. This is coinciding with restrictions on the importation of coal from Australia in the face of growing political tension between the two countries, add the experts from BCA Research.

On the other hand, the strong demand for industrial production (Chinese industry has been strengthened by the covid), which has increased by 13.1% so far this year, thanks to the global economic recovery, has enormously raised the prices of thermal coal. The rising cost of coal is coupled with skyrocketing gas prices and the very energy crisis that much of the world is experiencing.

Ceilings to the price of electricity

“The third and final reason is crucial, which makes China’s energy crisis very different from Europe’s since electricity prices are limited by local governments,” says García Herrero.

This has a positive part, and that is that the transfer of costs to electricity users is not occurring in the beginning. That is, in Europe and Spain, if the electricity goes up, consumers pay a higher price and that, in turn, can lead to lower energy consumption (to save costs) that ultimately moderates prices (supply and demand ). In China the rules are different and they also have negative consequences. 

By not being able to pass the higher costs on to consumers, “electricity generators suffer a fall in their profit margins. This is reducing the incentives to generate electricity. The widening gap between energy supply and demand is forcing governments locals to use rationing to restrict the use of electricity, which will surely affect China’s growth prospects, “warns García Herrero.

The expert points out in the document published by Natixis that as half of the provinces have not reached their energy goals so far, “the pressure will surely increase even more… Energy restrictions to control demand will particularly affect the manufacturing sector, which so far it has offered the most support to the Chinese economy in the context of a rapid deceleration led by services.”

Although electricity prices do not rise for consumers, the reduction in industrial activity can generate shortages of certain final and intermediate goods. When shortages make their appearance, prices tend to respond with sharp increases. The result is fewer goods produced for a demand that seems to be on the rise, which will lead to a rise in prices. 

The impact of restricted energy supply can be very different for each sector. According to Natixis data, in August 2021, secondary industry accounted for 67% of electricity consumption in China. And the main losers will be sectors with high consumption and energy density, such as metals, chemicals and other materials such as cement, whose market is already in a tense situation, which is weighing on the construction of housing in Europe or the US.

“For other sectors, the impact will depend on how long the power restriction lasts. We see preferential treatment for semiconductors with hardly any restrictions on the use of electricity, which means that the impact on chip production should be limited. However, the spillover effect can still occur in other products. The winning sectors will be the coal miners in the short term given the increase in prices, “says García Herrero. Although in the long term, China’s intention to continue reducing emissions and investing in renewable energies should be stronger.

Power shortages could delay economic recovery. In addition, “if production cuts are prolonged, one of the main consequences for the world economy would be higher Chinese export prices, which would threaten to become another source of upward pressure on inflation worldwide,” they warn from BCA Research.