A Primer for Hong Kong Power Reforms

UNCLAS SECTION 01 OF 04 HONG KONG 001082

SIPDIS

STATE for OES, OES/EGC, OES/PCI, EB/ESC/IEC and EAP/CM
USDOE for SKelly, International/Pumphrey/Price
USDOE for Fossil Energy/Swift/McKee
USDOC for NOAA/Office of Global Programs
HQEPA for International/Thompson

SENSITIVE

SIPDIS

E.O. 12958: N/A
TAGS: ENRG SENV KSCA ECON BTIO TRGY CH HK
SUBJECT: A Primer for Hong Kong Power Reforms

Ref: Hong Kong 1976

HONG KONG 00001082 001.2 OF 004



1. (SBU) Summary: In late December 2005, the Hong Kong
Government (HKG) proposed to reform the Scheme of Control
Agreements (SCAs) governing Hong Kong's electricity market
to lower the rates of return to both of Hong Kong's power
companies, Hong Kong Electric (HKE) and China Light and
Power (CLP). (CLP is a joint venture with ExxonMobil and
represents the largest U.S. investment in Hong Kong.) The
reforms also aim to open the door to new investors,
strengthen compliance with Hong Kong's environmental
regulations, and minimize the development of excess
generation capacity. This cable follows up on reftel with an
analysis of the potential benefits and risks of the key new
proposals. Given public perceptions that the power companies
are responsible for much of Hong Kong's air pollution and
that electricity prices in Hong Kong are excessively high,
we assess that the HKG is in a strong negotiating position
to achieve its goals. However, we caution that the HKG's
proposals, if fully adopted, have the potential to lower the
reliability of Hong Kong's electricity service and may not
achieve the lower tariffs and environmental benefits the HKG
is seeking. There are four clear benefit/risk scenarios
that can be drawn from the HKG proposals: (a) reduced rates
of return after 2008 and more frequent tariff reviews could
lead to lower electricity rates but also to a commensurate
(and offsetting) increase in the financial risks faced by
the power companies; (b) linking the power companies' rates
of return to their achievement of emission reduction targets
could strengthen compliance with environmental controls but
could skew investment decisions; (c) tightly controlling
"excessive investment" on generation facilities could
prevent the power companies from unnecessary spending for
the sake of greater returns but could also deter necessary
new investments; (d) opening Hong Kong's electricity sector
to new investors and power supply from Mainland China over
the long term could introduce competition and flexibility
into the power generation market but risk damaging the
reliability of Hong Kong's power supply. End Summary.

Overview
--------------


2. (SBU) On December 30, 2005, the Hong Kong Economic
Development and Labour Bureau (EDLB) issued a Stage II
Consultation Paper that laid out the HKG's proposed reforms
to the electricity sector (see reftel). Those proposals
come in advance of the expiration in 2008 of the 15-year
bilateral Scheme of Control Agreements (SCAs) between the
HKG and the two power companies, HKE and CLP. ExxonMobil is
a joint-venture partner with CLP through the Castle Peak
Power Company. The HKG expects to issue its final proposal
for electricity reforms by the end of 2006, which will
become the basis for its negotiations with HKE and CLP. If
negotiations do not lead to a mutually agreeable solution by
the end of 2008, the HKG is likely to extend the existing
SCAs in the interim. Overall, the HKG proposes to continue
the current regulatory system of bilateral contracts, which
has historically allowed Hong Kong to enjoy a 99.99%
reliable supply of electricity - meaning that Hong Kong
enjoys one of the most reliable supplies of electricity in
the world. However, the HKG has also responded to
criticisms that the SCAs' inflexible terms have led to
excess returns over-investment by proposing lower permitted
rates of returns, tighter regulatory controls and the
possibility of increased competition.

Lower Proposed Returns to the Power Companies
-------------- -


3. (SBU) The HKG has proposed lowering the permitted rate of
return on fixed assets to 7-11% from 13.5% (15% for assets
financed by shareholder funds). Instead of a flat rate
return on all assets, as is currently the case, the HKG
proposes an integrated approach that sets the rate of return
based on the risk-adjusted costs of raising capital, to be
re-evaluated every 5 years to reflect prevailing economic
conditions. Furthermore, the HKG has proposed varying the
rate of return for different types of assets (generation,
transmission, distribution, renewable energy, etc). Miranda
Chiu, advisor to the EDLB on energy policy and the HKG on
the proposed electricity reforms, said: "In Hong Kong,

HONG KONG 00001082 002.2 OF 004


people strongly believe that returns [to the power
companies] are exorbitantly high. Interest rates have
fallen since the agreements were signed 15 years ago."
According to Chiu, the companies are able to finance their
investments for significantly less than they receive from
the fixed rate of return, allowing them to earn excess
returns. (When the last SCAs were signed in 1993, the
prevailing interest rate was 6.5%; since then, it has fallen
as low as 5.0% and has moved as high as 10.0%. As of January
2006, it was 7.75% and rates were trending upwards.)


4. (SBU) EDLB Secretary Stephen Ip commented after the
proposals were released that the actual level of permitted
rate of return would likely be about 9-10%, leading to a 10-
20% reduction in power tariffs. The Hong Kong Legislative
Council added its voice to the debate on February 15, 2006,
by voting 44-3 to cap HKE and CLP's rate of return on fixed
assets at 7%. Since the SCAs are bilateral contracts not
governed by legislation, the vote was non-binding on the HKG
but indicated the public's disapproval of high electricity
rates.


5. (SBU) The HKG's proposed rate reduction took the power
companies and securities analysts by surprise. CLP
expressed "grave concerns" that the HKG's proposed return
levels were too low to support reliable and safe power and
environmental responsibility, while HKE called the proposed
reductions "drastic." According to Betty Yuen, managing
director for CLP: "The proposed return level fails to
recognize the fundamental nature of the industry and the
mount of risk undertaken by the power companies. If returns
are not set at appropriate levels, the public will end up
bearing the risks of insufficient investment." In its
defense, CLP noted that it had not raised electricity
tariffs for the past 8 years. HKE recently raised its
average net tariff by 7.2%, effective January 1, 2006, but
stressed that it had voluntarily foregone over HK$2 billion
(about USD 258 million) in permitted profits between 2003
and 2005 through various rebates.


6. (SBU) ExxonMobil Energy Limited Chairman Brad Corson said
that the proposed rate of return was not consistent with the
investment risks faced by the power companies. He pointed
out that the proposals could result in as much as a 50%
reduction in potential returns while asking investors to
face increased uncertainty with market opening proposals,
greater scrutiny on capital investments, and unspecified
penalties for failing to meet new environmental provisions.


7. (SBU) Democratic Party (DP) Legislator Fred Li told
Econoff that a 9% or 10% rate of return was a "realistic and
fair" number, pointing out that even pro-business Legco
members like the Liberal Party's James Tien had strongly
supported a 7% rate of return. Li opined that pressure from
the public and from Legco will keep the HKG from
compromising on the proposed rate of return, thus forcing
the power companies to grudgingly accept a 9% or 10% overall
rate of return. Hong Kong Environmental Protection
Department (EPD) Deputy Director Roy Tang said that the
power companies had "overplayed their hand," particularly
regarding public opinion, and were thus in a very weak
bargaining position vis-a-vis the HKG in the upcoming
negotiations.


8. (SBU) JP Morgan's Edmond Lee said in a report that the
lower rates of return would provide little incentive for the
power companies to invest in new facilities. While he
expected that the HKG would need to achieve some tariff cuts
in order to "save face" with the public, he expected that
the negotiated effective rate of return would be closer to
the top end of the proposed range. However, Alice Hui of
UBS Securities believes that the HKG will have the upper
hand in future negotiations: "We think the two Hong Kong
power companies will be fighting an uphill battle to
convince both the government and the public that they need
to have a return of at least 10% to continue their
substantial investment in Hong Kong."

Returns Tied to Achievement of Emission Targets
-------------- ---


9. (SBU) According to EPD figures, power generation

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facilities emit 92% of the sulphur dioxide and half of the
nitrogen oxides in Hong Kong. Between 1997 and 2004, the
emission of sulphur dioxide by power generation increased as
much as 60%. In 2002, the Hong Kong and Guangdong
provincial governments agreed to reduce, on a best efforts
basis, the emissions of sulphur dioxide, nitrogen oxide,
respirable suspended particulates and volatile organic
compounds by 40%, 20%, 55% and 55%, respectively, by 2010,
as compared to 1997 levels. To ensure that the power
companies fully comply with the 2010 emission caps, the HKG
has proposed linking the permitted rate of return on all
fixed assets to the ability of the power companies to meet
the emission targets. CLP has complained that the HKG
cannot include such a provision in the next SCAs without
first laying out a long-term energy policy that gives the
power companies an idea of what they will be required to do
post-2010. Alice Hui of UBS commented in a recent report
that "unless the two Hong Kong power companies are able to
close down all their existing coal-fired power plants and
switch to natural gas-fired generation, we think it would be
difficult for them to reduce respirable-suspended
particulates [to the target level]. As a result, we believe
that there will be no other alternatives for the two power
companies to avoid the emission trading costs and penalty
charges for not meeting the emission caps."


10. (SBU) Environmental organization Friends of the Earth
(FOE) stated that the SCA consultation papers could not
serve as a substitute for a proper energy policy, a policy
which should at least include: solid plans for renewables
application, management of energy consumption,
diversification of energy sources and the consideration of
environmental performance when deciding the rate of return.


11. (SBU) ExxonMobil Chairman Brad Corson thought it was
inconsistent of the HKG to require the power companies to
meet strict emissions targets and then set the lowest
proposed rate of return (7%) for emissions control
investments. Why, he asked, is the HKG creating such a
strong disincentive for the power companies to invest more
heavily in emissions control measures? Corson flatly
rejected the HKG's proposal to link the overall rate of
return to performance in meeting emissions caps. He
concluded that it is "unacceptable" for CLP's returns to be
affected by emissions targets that the HKG can arbitrarily
set without any regard for scientific, technical, or
practical considerations.


12. (SBU) DP Legislator Fred Li, on the other hand, felt
that the power companies were "lucky" to gain any return on
emissions investments at all. Hong Kong should operate on a
"polluters pay" principle, he continued, so the power
companies should pay for their pollution by shouldering the
full cost of meeting the HKG set emissions caps. However,
Li said that the link between emissions performance and the
overall rate of return was the single issue on which he
believed the HKG was willing to compromise. He concluded
that the power companies would never agree to annual reviews
of their overall rates of return based upon their emissions
performance and that the HKG would probably find another way
to financially penalize power companies for failure to meet
emissions targets.


13. (SBU) EPD Deputy Director Roy Tang was more confident
about the HKG's ability to prevail in all of its negotiating
positions. Tang discussed the February 14, 2006 death of a
Hong Kong citizen who had participated in the Hong Kong
Marathon on a particularly polluted day. Tang admitted that
it was impossible to directly link the death of the man, who
had a history of respiratory illnesses, to the air
pollution. However, he continued, the Hong Kong public will
long remember the images of marathon participants wearing
oxygen masks against a grey backdrop of pollution-induced
haze and "draw their own conclusions" about the pollution in
Hong Kong. Tang felt that with the public's support the
HKG's negotiating position is sufficiently strong that, if
the power companies are not careful, they could walk away
from the SCA talks with "completely empty hands."

Controlling "Excessive Expenditures"
--------------


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14. (SBU) Responding to concerns that the power companies
have historically taken advantage of the fixed rate of
return to over-invest in capacity, the HKG has proposed
deducting 100% of any capital expenditures on generation
facility machinery and equipment found to be "excessive"
from the rate base. Currently, the HKG has the ability to
deduct a portion of the "excess" capital expenditures (40%
for CLP and 50% for HEC). However, even the HKG recognized
in its proposal that such a high exclusion rate could damage
Hong Kong's supply reliability by further weakening the
power companies' incentive to invest based on anticipated
changes in demand.


15. (SBU) DP Legislator Fred Li admitted to Econoff that the
HKG proposal to monitor the capital expenditures of the
power companies was "difficult at best." He pointed out
that the HKG did not have enough technically proficient
officials who could make the admittedly subjective
determination as to what construed an "excessive"
investment. Instead, continued Li, the HKG should set up a
semi-independent regulatory body for the energy market along
the lines of the Office of the Telecommunications Authority
(OFTA) and contract out positions to experts in the energy
field to deal with difficult technical issues.

Proposal to Open the Hong Kong Power Network
--------------


16. (SBU) Although HKE and CLP have defacto service areas in
Hong Kong, neither has a franchise and the power sector has
technically always been open for competition. However, the
fact that the two power companies are vertically integrated,
combined with Hong Kong's small size and the limited
availability of new sites for generation facilities, has
thus far prevented any serious new suppliers from emerging.
With its latest proposal, the HKG confirmed its intention to
pave the way for new sources of supply by developing
regulatory arrangements that allow third-party access to the
power network and increased interconnection. While the HKG
is not advocating introducing greater competition in the
near term, it hopes its proposals will encourage more
suppliers of renewable energy to build in Hong Kong, and
will allow Hong Kong to benefit from any future surplus
electricity from mainland China. However, given China's own
electricity shortages in recent years, the HKG is cautious
about relying on the mainland for electricity. One key
question will be whether Hong Kong power companies are
willing to open up their transmission and distribution
networks.


17. (SBU) ExxonMobil Chairman Brad Corson opined that the
HKG needs to establish principles for opening Hong Kong's
power market. All players should have access to a level
playing field and be subject to equivalent environmental
standards and enforcement, uniform rights and
responsibilities, and reciprocal market access. Corson
warned that the current unclear policy toward market
entrants may lead to disorder in the Hong Kong power market
and possibly subject "clean power generators" in Hong Kong
to unfair competition from cheap coal-burning power
generators in mainland China.


18. (SBU) DP Legislator Fred Li said that although it is not
realistic to expect real competition in the Hong Kong power
market "any time soon," the establishment of an independent
energy regulatory body could speed up this process
significantly. The regulatory body could ensure that
companies applying for access into the Hong Kong power
market adhere to Hong Kong environmental standards and also
provide for access to the Hong Kong power grid at
established and regulated fees. Li admitted that the
creation of a complete new bureaucracy would create many
extra costs for the HKG but felt strongly that it would lead
to a freer, more robust, and responsible power generating
system in Hong Kong.

CUNNINGHAM