China’s electricity sector is key to addressing many of the country’s most pressing public policy challenges, from mitigating climate change and local environmental pollution to providing affordable inputs to economic growth. Over the last three decades, numerous reforms have sought to increase efficiency in the sector, yet full-fledged electricity markets have yet to take hold. Partly as a result of this incomplete transition away from central planning, the sector now faces generation overcapacity across the country, high levels of renewable energy curtailment (i.e., waste), and an uncertain path for innovation in technologies of the future low-carbon grid.

Yunnan province in southern China presents a particular set of challenges. While it has plentiful hydropower resources, it regularly curtails large amounts of this low-carbon energy (exceeding 20% in some months). Coal power plants provide energy needed mostly in the dry winter months, but rely on significant subsidies to do so, at high cost to the system. Growing fractions of intermittent renewable energy (run-of-river hydro, but also wind and solar) further complicate efficiently managing the system using old planning models.

Yunnan has pushed further than most provinces in establishing market-based mechanisms in the electricity sector, with three-fifths of energy in the province sold outside of government-administered plans. Medium-term markets (monthly to annual), in particular, have proliferated with a variety of designs and much differentiation based on fuel types, which can have significant impacts on efficiency and distribution of revenues. Crucially, Yunnan lacks a standard short-run electricity market (“spot market”)—a pricing system that holistically incorporates all supply and network characteristics and provides efficient prices with the associated incentives for operation and investment. In addition, many non-market elements, such as coal power subsidies and priority generation plans, have been implemented to maintain solvency of some electricity sector firms but with negative impacts on efficiency and environmental performance.

In this report, we propose a market reform pathway for Yunnan that is both feasible and applicable to address some of these challenges immediately, while aiming for a standard design based on well-documented international experience. Our proposal includes at its heart a pay-for-performance monthly capacity auction that can help cover revenue deficiencies in the energy market. Building on international experience with capacity markets, this approach provides incentives for availability when generation is needed most and is compatible with the adoption of a single energy market for all electricity resources. Out-of-market payments to cover stranded costs of certain firms can thus be minimized. Finally, engaging consumers in both these energy and capacity markets can create high-powered incentives to shift consumption to low-cost months and hours, benefitting the entire province.

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Recommended citation:

Liu, S., & Davidson, M. R. (2021). China Trading Power: Improving Environmental and Economic Efficiency of Yunnan’s Electricity Market. Harvard Kennedy School Belfer Center for Science and International Affairs. Retrieved from