Background: On October 31, 2012, China's National Development and Reform Commission (NDRC) announced the new Natural Gas Utilization Policy (2012 Gas Policy), which came into effect on December 1, 2012.

The 2012 Gas Policy is a legal document that is meant to address changes in the economics of natural gas in China, including with respect to gas pricing and utilization, and guide the development of the natural gas industry in the near term. The first Natural Gas Utilization Policy was issued by the NDRC on July 30, 2007 (2007 Gas Policy), a time when gas supply was inadequate; therefore, one of the objectives of the 2007 Gas Policy was, in part, to reduce demand for natural gas.

Since then, China's natural gas supply has grown significantly, both from domestic production and increased imports, while demand continued to rise. According to the NDRC's website, the metered gas consumption during January to October 2012 was 118.7 billion cubic meters (M3), representing an increase of 14.1 percent from the same period in 2011; 87.8 billion M3 natural gas was produced domestically, representing a 6.4 percent increase, and 34.4 billion M3 was imported, representing an increase of 37.6 percent.

On the other hand, domestic gas suppliers and importers have been facing increasing pressure under China's "cost-plus" natural gas pricing system and have been calling for pricing reform to better reflect the true costs of gas production and import.

The 2012 Gas Policy has addressed some of these market changes and aims to shift government's focus from restricting gas use to identifying the means by which gas may be properly used and priced, as described in more detail below.

Pricing Reform
Natural gas pricing reform has been an important issue in recent years in China and was partially addressed in the 2007 Gas Policy. Compared with the 2007 Gas Policy, however, the 2012 Gas Policy provides more specifics and direction in terms of how gas pricing mechanisms can be improved. For reference, included below is a comparison of the language included in both policies to address gas pricing:

2007 Gas Policy: "deepen the pricing reform of natural gas and improve the pricing mechanism; gradually rationalize the ratio between natural gas prices and alternative fuel prices; and fully utilize the role of natural gas price in adjusting supply and the demand.

2012 Gas Policy: "further1 deepen the pricing reform of natural gas and improve the pricing mechanism; expedite the establishment of price linkage between natural gas price and the prices of alternative fuels; establish and improve the price linkage from upstream to downstream; encourage the study and implementation of differential pricing policies including seasonal price and interruptible price in regions with large fluctuation in gas demand; provide guidance on the reasonable consumption of natural gas, increase the utilization of natural gas and support an innovative trading system in connection with natural gas.

The 2012 Gas Policy provides greater specificity in terms of how natural gas pricing should be reformed: (a) establishing price linkage to reflect upstream and midstream costs; (b) exploring and implementing a differential pricing mechanism such as seasonal pricing and interruptible pricing.

Price Linkage with Alternative Fuels
Currently, natural gas prices in China are formulated by the government based on a "cost-plus" mechanism. Specifically, prices are constructed by the government by assigning a "reasonable" cost of natural gas production and transportation plus certain "reasonable" level of profit. While this price mechanism has the advantage of keeping the price of gas in check, it may damage the profitability of suppliers. On one hand, it is difficult, if at all possible, to find a "reasonable" cost and profit that are suitable for all gas suppliers in China. In particular, the costs of imported gas are much higher than gas sourced domestically. Gas importers generally suffer losses under the current pricing mechanism. On the other hand, such pricing mechanism gives gas suppliers the incentive to inflate their costs. Ultimately, such pricing mechanism will have a negative impact on supply.

The 2012 Gas Policy encourages further exploration and, ultimately, linking natural gas price and the prices of alternative fuels. Under such policy, the "cost-plus" pricing mechanism may gradually be replaced with net-back pricing, where the ex-factory price would be determined by deducting the transmission tariff from the city-gas price, which would be linked to the prices of alternative fuels such as fuel oil, LPG, etc.

It is thought that a net-back pricing mechanism would better reflect the market price of natural gas and rationalize the various cost points from upstream to downstream, including the ex-factory price, transmission tariff, city-gate price, and end-user price. Having been suppressed for years by the current "cost-plus" pricing method, the profit margins of gas suppliers and importers are expected to significantly increase under the new pricing mechanism, which would in turn be beneficial for a more sustainable development of the sector.

In fact, the net-back pricing mechanism is already under trial implementation in Guangdong and Guangxi provinces. The city-gate prices in these two provinces are RMB2.57/M3 in Guangxi Province and RMB2.74/M3 in Guangdong Province, whereas the city-gate prices in other regions in China are between RMB1.8-2.3 M3. Despite being the highest gas price in China, such prices are still competitive compared to those of other energy resources, such as oil, diesel, gasoline, and LPG. A common belief in the industry is that the end-user affordability in industries consuming oil is strong enough to absorb higher gas prices, although city gas companies might not be able to fully pass on the increase in time.

Differential Pricing
The 2012 Gas Policy also encourages the implementation of seasonal pricing and interruptible pricing.

Seasonal pricing is an effective way to mitigate the cost pressure on gas suppliers in peak-use periods. Under seasonal pricing, when gas demand is low, the gas price remains the same or decreases to stimulate consumption. When gas demand increases as seasons change, the suppliers may increase the gas prices to cover their costs in relation to the construction of gas storage facilities and storage of unutilized gas from the low season.

Interruptible gas pricing is the lower price enjoyed by gas users who are willing to suspend their gas use during the times agreed to between such gas users and the gas suppliers in the relevant gas supply contract. Under an interruptible gas supply contract, the gas user would switch to an alternative fuel during times when gas supply is suspended. By suspending the gas supply to the interruptible gas user, the saved gas can be supplied to residential users and uninterruptible gas users. To compensate interruptible users' costs in maintaining alternative fuel systems, gas companies may offer a discounted gas price, or the interruptible gas price.

The above pricing policies indicate that the Chinese government is placing greater emphasis on the roles of market supply and demand with respect to natural gas economics.

Expansion of "Preferred" and "Permitted" Users
The 2007 Gas Policy classified gas users in China into four categories — "Preferred," "Permitted," "Restricted," and "Prohibited." Users within the "Preferred" and "Permitted" categories could enjoy certain priority or preferential treatment in project approvals and gas pricing, as well as preferential assurance of gas supply, while users in the "Restricted" category and "Prohibited" category could encounter restrictions in those aspects.

The "Preferred" users under the 2007 Gas Policy were quite limited, which only include four types of utilization, i.e. urban residential life, public service facilities, natural gas vehicles, and distributed combined heat and power generation. It is evident that the central government strived to ensure gas availability for the urban communities at a time when gas supply was limited.

The 2012 Gas Policy has increased the types of users included under the "Preferred" category to 12 sub-categories. This change is in keeping with the increase in gas supply. Set forth below are some of the major new sub-categories added to the "Preferred" category":

First, the industrial users whose use of natural gas is interruptible are promoted from the "Permitted" category. Such change is in line with the encouragement of interruptible pricing as discussed above.

Second, gas storage facilities capable of meeting emergency and peak time needs have been added to the "Preferred" category. The inclusion of such facilities in the "Preferred" category indicates the policy-makers' encouragement of mechanisms to enable the increased use of gas during peak times. This change similarly follows from the 2012 Gas Policy's emphasis on pricing reform, in particular, the implementation of seasonal pricing.

Although originally included in the "Preferred" category, natural gas vehicles have seen their definition expanded and detailed in the 2012 Gas Policy, which includes gas-fueled buses, taxis, logistics distribution vehicles, passenger vehicles, sanitation vehicles, and trucks. Natural gas vessels are also newly added to this category. These changes demonstrate the policy support for developing the natural gas vehicle/vessel industry. As natural gas is seen by Chinese policy makers as a cleaner energy compared to oil and other traditional energy resources, the Chinese government aims to support a more environmentally-friendly means of transportation and logistics. With the cost advantage of natural gas discussed above, vehicles and vessels that use natural gas are expected to take up a larger share in the natural gas downstream market. Currently, the gas consumption in vehicle-use gas market only makes up 25 percent of the total LNG consumption volume. That percentage is expected to reach 65 percent in 2015.

With respect to the "Permitted" category, changes include the addition of natural gas-fired power projects. Specifically, the 2012 Gas Policy has removed the prior prohibition on gas-fired power projects. Instead, gas-fired power projects are now permitted to be built anywhere in China except that the construction of base load gas-fired power projects is still prohibited in thirteen large coal-producing areas, e.g. Shaanxi, Mongolia, Jiangxi, and Anhui provinces. Compared with the more traditional means of power generation, power generation by natural gas has the advantages of high conversion efficiency, lowered environmental and investment costs, and shorter construction periods.

The expansion in the "Preferred" and "Permitted" category users is believed to be a result of the growth in gas supply as well as an effort of the government to support the pricing reform and development of clean energy. Such categorization provides useful guidance to develop cleaner and more cost-efficient industries.

Summary
China still lags behind developed countries in terms of the development and consumption of natural gas. In the area of natural gas power generation, for example, in Japan such power generation makes up 28 percent of the country's total domestic power generation. That percentage in the U.S. and Europe is more than 20 percent and 30 percent, respectively, while in China, it is just under 3 percent.

Nevertheless, the Chinese government's efforts to implement the 2012 Gas Policy should play an important role in further developing China's natural gas industry. Natural gas pricing reforms that will be rolled out over the next two to three years will make up a key part of this latest policy initiative. These and other measures by the Chinese government show China's increasing support for pricing reform and expanding the efficient use and reliance on natural gas as an environmentally cleaner energy source and pillar of the sustainable development of China's economy in the years to come.