metadata: authors: 0: author: Berrah,Noureddine
1: author: Song,Yanqin
count: China
docna: 0: docna: China: west or east wind -- getting the
            incentives right
docty: Policy Research Working Paper
subtopic: Rural and Renewable Energy,Energy Policies & Economics,Energy Demand,Energy and Environment,Energy and Mining,Renewable Energy,Global Environment
teratopic: Environment,Energy,Science and Technology Development
abstracts: cdata!: With rapid development of wind power in
            China, the following three issues have become barriers for
            further scale-up: 1) concentration of wind farms in the
            Three-North region, which became significantly underutilized
            because of a limited capability of local power grids to
            off-take and consume wind-generated electricity and because
            of a lack of coordinated development of long-distance
            transmission lines to deliver electricity to load centers in
            the South and East regions; 2) increasing subsidies and,
            thus, a burden on final consumers; and 3) resistance of
            local authorities to develop new projects because the new
            value added tax policy reform. How to deal with these issues
            will have significant impact on the future development of
            wind in China. This note proposes a methodology to enhance a
            comprehensive approach by taking both generation and
            transmission into account in crafting the development plan
            and formulating the incentive policies, which may be useful
            in addressing these issues.
geo_reg_key: 517198,119225,517191
repnme: repnme: China: west or east wind -- getting the
            incentives right
display_title: China: west or east wind -- getting
            the incentives right
listing_relative_url: /research/2013/06/17874514/china-west-or-east-wind-getting-incentives-right
topicv3: Renewable Energy m1326170 525,Energy and Extractives m1326595 507,Wind Energy m1326851 529,Power and Electricity Sector m1327094 515,Environment, Natural Resources and Blue
            Economy m1327391 566
publishtoextweb_dt: 2013-06-01T00:00:00Z
historic_topic: Environment,Energy,Science and Technology Development
no_of_pages: 32
author_keys: 0: author_key: 93278
1: author_key: 1007646
model_extractions: WPS6486 Policy Research Working Paper 6486 China: West or East Wind Getting the Incentives Right _Yanqin Song Noureddine Berrah_ The World Bank East Asia and the Pacific Region Sustainable Development Department June 2013
Policy Research Working Paper 6486

# **Abstract**

With rapid development of wind power in China, the following three issues have become barriers for further scale-up: 1) concentration of wind farms in the ThreeNorth region, which became significantly underutilized because of a limited capability of local power grids to off-take and consume wind-generated electricity and because of a lack of coordinated development of longdistance transmission lines to deliver electricity to load centers in the South and East regions; 2) increasing subsidies and, thus, a burden on final consumers; and 3) resistance of local authorities to develop new projects because the new value added tax policy reform. How to deal with these issues will have significant impact on the future development of wind in China. This note proposes a methodology to enhance a comprehensive approach by taking both generation and transmission into account in crafting the development plan and formulating the incentive policies, which may be useful in addressing these issues.

This paper is a product of the Sustainable Development Department, East Asia and the Pacific Region. It is part of a larger effort by the World Bank to provide open access to its research and make a contribution to development policy discussions around the world. Policy Research Working Papers are also posted on the Web at http://econ.worldbank.org. The author may be contacted at ysong3@worldbank.org.

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent._ Produced by the Research Support Team
# **China: West or East Wind**

# **Getting the Incentives Right**<sup>**1**</sup>

Yanqin Song and Noureddine Berrah Key words: wind power concentration, increasing subsidy burden, VAT reform impact, cost and effectiveness JEL Codes: C18 H23 Q48

> 1 This paper was prepared by Mr. Yanqin Song (ysong3@worldbank.org ), World Bank, and Mr. Noureddine Berrah (nberrah1@gmail.com), consultant. It is based on a study carried out by Energy Research Institute which is sponsored by ESMAP. The authors thank the peer reviewers. The findings, interpretations, and conclusions expressed herein do not necessarily reflect the views of the Board of Executive Directors of the World Bank or the governments they represent. World Bank and ESMAP do not guarantee the accuracy of the data included in this publication and accept no responsibility whatsoever for any consequence of their use. The boundaries, colors, denominations, and other information shown on any map in this volume do not imply on the part of the World Bank Group any judgment on the legal status of any territory or the endorsement of acceptance of such boundaries.

1
# ACKNOWLEDGMENT

The financial and technical support by the Energy Sector Management Assistance Program (ESMAP) is gratefully acknowledged. ESMAP—a global knowledge and technical assistance trust fund program administered by the World Bank and assists low‐ and middle‐income countries to increase know‐how and institutional capacity to achieve environmentally sustainable energy solutions for poverty reduction and economic growth. ESMAP is governed and funded by a Consultative Group (CG) comprised of official bilateral donors and multilateral institutions, representing Australia, Austria, Denmark, France, Finland, Germany, Iceland, Lithuania, the Netherlands, Norway, Sweden, the United Kingdom, and the World Bank Group.
# **Table of Contents**

|Introduction ............................................................................................................................... 1|
|---|
|Chapter 1: Wind Power Development: A Quick Look Back .................................................... 2|
|Chapter 2: Financial and Taxation Issues .................................................................................. 7|
|Weak Performance of China’s Wind Farms .......................................................................... 7|
|Lack of Transmission Capacity ........................................................................................... 10|
|Increasing Subsidy Requirements........................................................................................ 11|
|The 2009 VAT Reform Impact on Wind Power Industry ................................................... 13|
|Chapter 3: Exploring Ways to Improve Efficiency and Cost Effectiveness ........................... 16|
|Addressing Concentration Issues ......................................................................................... 16|
|Addressing the Pressure on Subsidies ................................................................................. 21|
|Addressing the Issue of Taxation ........................................................................................ 23|
|Conclusions ............................................................................................................................. 24|
|References ............................................................................................................................... 26|
|**Figures**|
|Figure 1: Wind Resources in Three-North, with Load and Capacity Distribution .................... 1|
|Figure 2: Development of the Wind Power Market in China .................................................... 6|
|Figure 3: Distributions of Wind Power Capacity in the Three-North Provinces and Its Share|
|of the Total Wind Power Installed Capacity in the Province .......................................... 11|
|Figure 4: Growth of Expected Wind Subsidies ....................................................................... 12|
|Figure 5: VAT Flow for a Typical Wind Farm Project ........................................................... 14|
|Figure 6: The Relationship between the Capacity Ratio and the Resource Utilization Rate .. 17|
|Figure 7: Relationship between Capacity Ratio, Resource Utilization Rate, and Costs ......... 19|
|Figure 8: Rates of Return under Resource Conditions and Investment Cost .......................... 20|
|Figure 9: Comparison between Rates of Return for Nongeneration Loss and Different Levels<br>of Generation Loss .......................................................................................................... 21|
|Figure 10: Wind Subsidies per Province by City and Region ................................................. 22|
|**Tables**|
|Table 1: Category of Wind Energy Resources by Area ............................................................ 5|
|Table 2: Environmental Benefit per TCE and the Total Losses from Lost Wind-Based<br>Generation, Three-North Region, 2010 ............................................................................. 9|
|Table 3: National wind power generation loss in selected region, 2009 and 2010 ................... 9|
|Table 4: Estimated Unrealized Environmental Benefits from Wind Generation Losses in<br>Selected Regions, 2009–2010 ......................................................................................... 10|
|Table 5: Relationship between the Capacity Ratio and Generation Losses ............................ 16|
|Table 6: Detailed Calculation of the Generation Costs, Transmission Costs, and Energy Loss<br>Costs ................................................................................................................................ 18|
|Table 7: Relationship between Capacity Ratio, Resource Utilization Rate, Generation Cost,<br>Transmission Cost, and Energy Loss Cost ...................................................................... 18|
|Table 8: IRRs in Four Types of Areas with Different Level of Generation Losses ................ 20|
|Table 9: Comparison of Subsidies in Different Regions ......................................................... 22|
|Table 10: Full Load Operation Hours Needed to Keep IRR at 8% ......................................... 23|
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more economic wind resources in the Southeast region. The paper first takes a quick look back at wind power development in China, then reviews the incentive policy structure, and evaluates some of the main impacts it has had on the wind power sector development. The paper especially focuses on the introduction of wind FIT in 2009 and VAT tax reforms, along with their effects on equipment manufacturers, developers, and local and central governments.

# **Chapter 1: Wind Power Development: A Quick Look Back**

4. Grid-connected wind power development in China started in the early 1980s and lingered for more than two decades before surging forward during the 11<sup>th</sup> Five-Year Plan (FYP 2006–10). Installed capacity increased from almost nothing in 1980 to 4.2 MW in 1990, 344 MW in 2000, and 44 GW in 2010. Broadly, wind power capacity in China developed in four stages:

- Initial demonstration.

- Industrialization.

- Scaling up and turbine manufacturing localization supported by a concession program.

- Development of large-scale wind power bases supported by a FIT.

5. In the initial demonstration stage (1986–93), projects were implemented mostly for demonstration and for scientific research and development—that is, not for commercial purposes. Off-take prices for these projects were mostly aligned with the tariffs of local coalfired plants, approved by the national and local price agencies and documented in PPAs between developers and grid companies. Off-take prices hovered around Y 0.28/kWh, which was a windfall for developers, since the turbines were mostly donated by international aid agencies through international cooperation projects.

6. The industrialization phase started in 1994, with the Chengfeng Plan of the State Planning Commission (SPC) and the Shuangjia Plan and Wind Turbine Localization Promotion Project of the State Economic and Trade Commission (SETC). Both introduced special policies to support domestic equipment manufacturing and to start commercial development. In 1994, the government mandated that grid companies facilitate the connection of wind farms and purchase all the electricity they generate. Off-take prices were calculated based on the “new plant/new price” policy, which ensured that revenues would enable developers to repay debt and secure reasonable profits. Off-take prices were agreed between the developers and grid companies, and approved by concerned price control agencies. This led to a wide range of tariffs—from RMB 0.38/kWh<sup>2</sup> to RMB 1.2/kWh<sup>3</sup> .

7. During this stage, most of the wind farms were small (10 MW or less) and mostly developed by local grid companies or their associates. A general motivation was to improve their image and ensure approval of their conventional projects by local and/or national

> 2 Zhangbei Wind farm by China Energy Conservation Investment Company.

> 3 Kuocangshan Wind Farm in Zhengkiang.

2
agencies. There was no mechanism to pass the incremental cost of wind electricity to end users, but the developers managed to cover incremental costs because they were insignificant compared to their revenues and profits. Because of this ad hoc approach, China failed to reach its 8<sup>th</sup> and 9<sup>th</sup> FYP development targets. The actual installed capacity by 2000 was only 344 MW compared to the central government’s 1,000 MW target.

8. During the 8<sup>th</sup> and 9<sup>th</sup> FYPs, the SPC was responsible for new projects, and the SETC was in charge of retrofit and rehabilitation projects. This created confusion and allowed companies to take advantage of the loose and unclear institutional setup. For example, when seeking approval for a wind farm, developers would name it a new or a rehabilitation project depending on their relationship with the approving agency. This problem was addressed in 2003 when the SETC was merged with the SPC to create the National Development and Reform Commission (NDRC). This streamlined policy development processes, and the situation improved significantly.

9. In the third phase, to promote large scale wind power development, NDRC initiated the wind power concession program to introduce competition and rely on bid-based off-take prices. In 2003, it launched the first concession tender, mandating that turbine local content promote the country’s wind industry. From 2003 to 2008, five concession tenders were organized; at first, there were 50 percent local content mandates, which were later increased to 70 percent. However, this requirement was removed because it was construed as a breach of World Trade Organization (WTO) rules. The electricity off-take price was theoretically determined by the winning bid price up to 30,000 hours of full load operation and at the average network electricity price for generation exceeding that amount. The contract was for 25 years. The lowest bid (later changed to the price closest to the average of the bidding price with the highest proportion of local content) was awarded the concession project.<sup>4</sup> 10. During this period, two major events significantly promoted wind power development in China: (a) China’s commitment to significant wind power targets during the Renewable Energy Conferences in Bonn and Beijing in 2004 and 2005, respectively; and, more importantly, (b) the passage (February 28, 2005) and enactment (January 1, 2006) of the Renewable Energy Law. The law laid a solid foundation and provided unprecedented support to large-scale development of wind power in China. Additionally, higher targets were set by the government in the Renewable Energy Medium and Long Term Development Plan, published in 2007.

11. This legislation and the established policy framework provided incentive mechanisms for scaling up renewable energy—and in particular triggered an unprecedented development of wind power in China. By the end of 2008, the total installed wind power capacity had 4 It must be noted that several developers or manufacturers, especially international ones, complained that the process was biased and bidding prices were influenced by statements made by high-level NDRC officials. These claims seem to be, at least partially, legitimate because many developers who had bid prices lower than the “informal cap prices” set by NDRC officials later received subsidies to improve the return on their projects.

3
reached 12,200 MW (see Figure 2), and developers began facing shortages of wind turbine supply. Many companies started investing in wind turbine manufacturing. By 2010, there were more than 80 manufacturers. The total capacity of turbines manufactured by Chinese companies in 2010 reached 10 GW.

12. Furthermore, another significant contributor to the fast growth of wind power in China was the reliance on the Clean Development Mechanism (CDM) to increase developers’ revenues. Although there are no unambiguous statistics on the percentage of wind farm projects in China that applied for CDM registration, it is clear that a large number of the wind projects developed from 2005 applied for CDM and many of them were successfully registered by the CDM Executive Board of the United Nations Framework Convention on Climate Change (UNFCCC). Unit prices of Certified Emission Reductions (CERs) increased by US cent 1–1.5/kWh and indeed contributed to the wind power surge during this period.

13. In 2008, the CDM Executive Board of the UNFCCC reviewed and rejected 10 wind farm projects from China, stressing inconsistencies in the pricing policy that allowed wind farm developers in different regions to claim “additionality” for their projects. In response, the Climate Change Department of the NDRC and the Chinese Renewable Energy Industry Association (CREIA) argued that the prices were the result of competitive bidding and that differences were justified because pricing mechanisms were periodically adjusted to meet the wind power market’s development needs. In the end, this event contributed to the transition from the wind concession program to the present FIT policy.

14. The fourth stage is characterized by (a) the introduction of the FIT policy in 2009; (b) the decision to develop seven 10 GW wind bases, six of them in the Three-North region; (c) the initiation of offshore demonstration projects; and (d) the increase of the 2020 national wind power development target to 200 GW.<sup>5</sup> 15. The NDRC (and later the National Energy Administration, NEA<sup>6</sup> ) shifted from the wind concession program to the FIT as the main policy to support wind power development. The five rounds of the concession program provided sufficient experience and lessons and contributed to the formulation of the FIT policy. Furthermore, the Renewable Energy Law was amended in 2009 to mandate wind power off-take by grid companies. This new policy theoretically provided a stable and predictable market for potential investors and reduced market risks, since it ensured connection to the grid and off-take of all renewable generated electricity.

16. The established FIT scheme is differentiated into four groups by wind resource classification, based on the energy density at a 70 meter height: type I (higher than 510 W/m<sup>2</sup> ), 5 This is the target was announced by National Energy Administration on July 7, 2012.

6 The NEA consists of nine departments, including a Department of New Energy, which is responsible for formulating and implementing renewable energy development plans and industrial policies, for promoting institutional reform in the renewable energy sector, and for administering renewable energy sector.

4
type II (between 460 and 510 W/m<sup>2</sup> ), type III (between 390 and 460 W/m<sup>2</sup> ), and type IV (lower than 390 W/m<sup>2</sup> ). Each group was offered a fixed tariff: I—RMB 0.51/kWh, II—RMB 0.54/kWh, III—RMB 0.58/kWh, and IV—RMB 0.61/kWh. (See Table 1.)

**Table 1: Category of Wind Energy Resources by Area**

|Category of<br>wind energy<br>resources<br>area|Wind<br>energy<br>density at<br>the height<br>of 70 m<br>(W/m<sup>2</sup>)|Feed-in tariff<br>(yuan/kWh)|Typical areas|
|---|---|---|---|
|Type I|>510|0.51|The areas in Inner Mongolia Autonomous Region,<br>except Chifeng City, Tongliao City, Xing’an League,<br>and Hulunbeier City; Urumuqi City of Xinjiang Uygur<br>Autonomous Region, Yili Kazak Autonomous<br>Prefecture, Changji Hui Ethnic Autonomous Prefecture,<br>Kalamayi City,and Shihezi City.|
|Type II|460~510|0.54|Zhangjiakou City and Chengde City of Hebei Province;<br>Chifeng City, Tongliao City, Xing’an League, and<br>Hulunbeier City of Inner Mongolia Autonomous<br>Region; Zhangye City, Jiayuguan City, and Jiuquan City<br>of Gansu Province.|
|Type III|390~460|0.58|Baicheng City and Songyuan City of Jilin Province; Jixi<br>City, Shuangyashan City, Qitaihe City, Shuihua City,<br>Yichun City, Daxing’anling area of Heleijiang Province;<br>the area of Gansu Province, except Zhangye City,<br>Jiayuguan City and Jiuquan City; the areas in Xinjiang<br>Uygur Autonomous Region, except Urumuqi City of<br>Xinjiang Uygur Autonomous Region, Yili Kazak<br>Autonomous Prefecture, Changji Hui Ethnic<br>Autonomous Prefecture, Kalamayi City, and Shihezi<br>City.;and Ningxia Hui Ethnic Autonomous Region.|
|Type IV|≤390|0.61|Other areas except Category I, Category II, Category III<br>and IV.|

17. To cover the renewable energy (including wind) incremental costs (wind generation cost minus the region’s conventional power network average cost), China’s Renewable Energy Law established a RMB 0.004/kWh<sup>7</sup> electricity surcharge on electricity consumption. Total surcharge revenues that accumulated from 2006 to 2010 amounted to roughly RMB 16 billion (US$2.54 billion), of which 70 percent were used for wind power subsidies.

18. According to the most recent wind power industry development report,<sup>8</sup> gridconnected wind capacity reached 44 GW, and annual wind electricity generation reached 50.1 TWh by the end of 2010. The 12<sup>th</sup> FYP increased the wind capacity target to 100 GW by 2015. The target for 2020 might be increased to 150 GW, 5 times the target announced in 2007 (see Figure 2).

> 7 The surcharge increased to 0.008 RMB/kWh in 2012.

> 8 “Wind Turbine Installed Capacity in 2010,” Chinese Wind Energy Association.

5
<!-- Start of picture text --> VAOK 7 ----n-n-n-nnnnnnnnnnnnnnnnneneneneeneceneneeeeneneeneescenennecenenenssesnensenenentnnenssenenecescsnseseeeeeese 45000<br>41000<br>Average Annual Growth Rate between 1996~2010: 56.3% 40000<br>35000<br>30000<br>60% a {[} ee i 2 80 i<br>10000<br>79 6 2599 A0 5000<br>0% 170 224 268 344 400 468 56% 764q)798p) 913: 0<br>1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010<br>i Cumlative Newly Added Annual Growth Rate<br>Capacity (MW) Capacity (MW)<br><!-- End of picture text -->
# **Chapter 2: Financial and Taxation Issues**

# **_Weak Performance of China’s Wind Farms_**

20. The current regional FIT level is based primarily on considerations of resource endowments and the physical construction conditions. _Availability of local demand, which is important for local consumption, does not seem to have been taken into account adequately_ . The FIT policy is intended to encourage development of good wind resources at a low generation cost. It indeed promoted the construction of wind power bases with a large capacity and strongly supported the local industry’s development.

21. However, the rapid development of wind farms resulted in serious issues, especially with grid integration. The developers’ enthusiasm and the number of wind farms continued to grow, while congestion became a serious problem and threats on grid safety and stability increased. In the 11<sup>th</sup> FYP, the installed capacity in Inner Mongolia increased from about 100 MW in 2005 to 10 GW in 2010, but there was no significant upgrade of the transmission capacity. Nationally by June 2010, the wind capacity not connected to the grid reached 750 MW, and this could increase significantly as capacity under construction amounted to about 16 GW. There are concerns also over suboptimal use of wind resources resulting from wake and micrositing issues. Usually for a large-scale wind farm in China, efficiency losses from wake are at least 2 percent.<sup>10</sup> The overall capacity factor of wind power is less than 15 percent, indicating a low level of efficiency. However, there are no studies that accurately assess these losses. Finally, grid companies refused to off-take wind-generated electricity for stated financial and/or institutional reasons. The worst case is in Inner Mongolia, which is taken as a case below. The discussion in the rest of this chapter focuses primarily on the Three-North region.

22. Wind power generation losses reached 2,760 GWh in 2009 and 2,770 GWh in the first half of 2010 nationwide, accounting for more than 10 percent of the total generation from wind (see Table 2). For the ease of the discussion, the total generation and generation loss in the whole year of 2010 is estimated by doubling the data in the first half of 2010. The losses are detailed as follows:

- Wind electricity generation losses in North China amounted to more than 1,500 GWh, accounting for about 57 percent of the wind power generation losses at the

10 According to the operational experience in California in the United States, the efficiency losses from the wake effect is about 10 percent on average (2 percent to 30 percent). In North China, the torrential characteristics of many wind farms are similar to those in California; therefore, they may have a similar wake effect (”China Electric Power,” November 1998). However, this conclusion might underestimate the wake effect in China, since the size of North China’s wind farms is much greater than California’s and micrositing in China is less than optimal. In addition, wake and micrositing analysis was not part of the scope of the study, but the report refers to similar recommendations and further elaboration in the World Bank/ASTAE publication, “China: Meeting the Challenges of Offshore and Large-Scale Wind Power: Strategic Guidance” (ASTAE/World Bank: 2010).

7
national level, about 14 percent higher than the share of the region’s total generation in the country’s wind power generation (about 43 percent).

- Generation losses in Northwest China were not as significant as in North China. The total losses in 2010 amounted to 305 GWh, accounting for 11 percent of wind power losses at the national level. But because of the fast development of the wind base in Jiuquan, Gansu Province, generation losses are bound to become more and more serious in this region.

- At the provincial level, generation losses in Inner Mongolia amounted to about 2,100 GWh, accounting for 79 percent of the total generation losses at the national level (Inner Mongolia overlaps on both North China and Northeast Grid), about 44 percent higher than the share of the province’s total generation in the country’s wind power generation, which is about 35 percent.

23. The financial and environmental impact of the wind power generation losses were US$433 million in 2010, of which US$254 million were from environmental impacts and US$179 million from unrealized potential coal saving<sup>11</sup> .

24. The estimate of the lost environmental benefits per ton of coal equivalent (TCE) is based on the following formula: Environmental benefit losses = [wind generation loss (kWh)*index of coal consumption (TCE) per unit of electricity generation on average in the network (g/kWh)]/1,000,000 * [index of TSP per TCE (t/TCE) * credit per unit of TSP (US$/t) + index of SO2 per TCE(t/TCE) * credit per unit of SO2 (US$/t) + index of NOx per TCE(t/TCE) * credit per unit of NOx (US$/t) + index of CO2 per TCE(t/TCE) * credit per unit of CO2 (US$/t)] _Total environmental benefit losses were estimated by multiplying the “environmental benefit losses per TCE” by the total coal consumption that could have been avoided if all wind-based electricity could have been used._ The calculation is based on the following assumptions (see Table 2): Indexes of environmental pollution per TCE shown in Table 2 are derived from a SEPA (State Environment Protection Administration) study in collaboration with the World Bank completed in 2008 and the index of coal consumption (TCE) per unit of electricity generation on average in the network (g/kWh) is derived from the 2010 electricity yearbook.

> 11 The actual financial and environmental losses

8
**Table 2: Environmental Benefit per TCE and the Total Losses from Lost Wind-Based Generation, Three-North Region, 2010**

|Pollutants|Units|SEPA<br>study|Pollution index<br>per TCE(t)|Environmental benefit<br>losses per TCE<br>(US$/TCE)|Losses from<br>lost<br>generation<br>(million<br>US$)|
|---|---|---|---|---|---|
|TSP|US$/ton|5,801|0.017|98.617|183|
|SO2|US$/ton|379|0.022|8.338|16|
|NOx|US$/ton|269|0.01|2.69|5|
|CO2|US$/ton|10|2.7|27|50|
|Total|||2.749|137|254|

_Note:_ For coal, the price is US$100/TCE, and the coal consumption for power generation is 334 g/kWh. _Source:_ Beijing Energy Saving and Environment Protection Center and China’s New Renewable Energy Target: The Green Leap Forward (ESMAP and the World Bank Policy Note). _Source:_ The benefit lost resulting from wind generation loss is based on the data in Table 3.

25. The wind generation losses in 2009 and 2010 in selected regions are in Table 3.

**Table 3: National wind power generation loss in selected region, 2009 and 2010**<sup>**12**</sup>

||**On-gri**<br>**(**|**d generation**<br>**GWh)**|**Generat**|**ion loss (GWh)**|**Share**<br>**loss a**<br>**ge**|**of generation**<br>**s % of wind**<br>**neration**|
|---|---|---|---|---|---|---|
||2009|2010|2009|2010|2009|2010|
|**Inner**<br>**Mongolia**|8,470|14,366|1,986|4,202|19.0|22.6|
|**West**|5,971|10,506|1,468|3,054|19.7|22.5|
|**East**|2,499|3,860|518|1,148|17.2|22.9|
|**Jilin**|2,009|2,852|194|520|8.8|15.4|
|**Gansu**|1,153|1,876|181|248|13.6|11.7|
|**Heilongjiang**|1,497|2,816|113|332|7.0|10.5|
|**Liaoning**|2,537|4,568|23|128|0.9|2.7|
|**Hebei**|2,333|4,604|264|122|10.2|2.6|
|**Others**|7,611|13,426|0|0|0.0|0.0|
|**Total**|25,610|44,508|2,761|5,552|||

_Note:_ Data for 2010 are estimated by multiplying the data in the first half of 2010 by 2<sup>13</sup> . _Source: Inspection Report of Wind Power and Photovoltaic Generation_ , State Electricity Regulatory Commission (SERC), January 2011, and team’s calculation.

12 According to SERC’s report, the generation losses are 12.3 TWh and 20 TWh in 2011 and 2012 respectively.

13 According to statistics in SERC’s report, the total wind power generation was 49.4 TWh. The generation losses was about 10 percent of it.

9
The calculated environmental losses are provided in Table 4.

**Table 4: Estimated Unrealized Environmental Benefits from Wind Generation Losses in Selected Regions, 2009–2010**

||**Unrea**<br>**co**<br>**(US**|**lized potential**<br>**al saving**<br>**$ millions)**|**U**<br>**environ**<br>**(US**|**nrealized**<br>**mental benefits**<br>**$ millions)**|**Unrea**<br>**b**<br>**(US**|**lized climate**<br>**enefits**<br>**$ millions)**|
|---|---|---|---|---|---|---|
||2009|2010|2009|2010|2009|2010|
|**Inner**<br>**Mongolia **|64.2|135.8|72.97|154.38|17.91|37.89|
|**West**|47.4|98.7|53.93|112.20|13.24|27.54|
|**East**|16.7|37.1|19.03|42.18|4.67|10.35|
|**Jilin**|6.3|16.8|7.13|19.10|1.75|4.69|
|**Gansu**|5.8|8.0|6.65|9.11|1.63|2.24|
|**Heilongjiang**|3.7|10.7|4.15|12.20|1.02|2.99|
|**Liaoning**|0.7|4.1|0.85|4.70|0.21|1.15|
|**Hebei**|8.5|3.9|9.70|4.48|2.38|1.10|
|**Others**|0|0|0.00|0.00|0.00|0.00|
|**Total**|89.2|179.4|101.40|203.98|24.89|50.07|

# **_Lack of Transmission Capacity_**

26. The regional and provincial grids failed to accommodate the rapid development of renewable energy and wind in particular. Access of renewable energy or wind-based electricity to the grid was constrained for recognized, but not comprehensively addressed, technical, financial, and institutional reasons. In Inner Mongolia by the end of 2010, for example, 60 wind farms were developed with an installed capacity (7,000 MW) that is more than 12 percent of its total power generation capacity (64,600 MW) (see Figure 3). This resulted in serious problems of wind power evacuation and system balancing because Inner Mongolia’s electricity market was incapable of absorbing all generated electricity. Delivering electricity to the nearby North China grid is the only option for accommodating all generation during high wind periods. However, there are currently only two 500 kV lines, built during the 1990s, that are capable of delivering 4,300 MW from Inner Mongolia to the North China grid. During the daytime, the evacuation of wind capacity is not a serious issue. However, during winter nights, electricity generated by CHP (Combined Heat and Power Generation) plants has to be dispatched first to meet the high, space-heating demand. Since wind usually peaks during nighttime winter hours, wind electricity generated during these hours is unlikely to be dispatched because of grid constraints. Evacuation of electricity during high wind hours will, therefore, require building new or strengthening existing transmission lines. Expected wind development in Inner Mongolia requires major strengthening of the transmission system 10
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# **_The 2009 VAT Reform Impact on Wind Power Industry_**

30. The concept of value added tax (VAT) reform and its impacts on the economy and the competitiveness of Chinese enterprises and consumers are well beyond the scope of this paper, since China is gradually reforming its VAT system to align it with international (European) practice defined below: _“Value added tax or VAT is an indirect tax, which is imposed on goods and services at each stage of production, starting from raw materials to final product. VAT is levied on the value additions at different stages of production. VAT is widely applied in the European countries. However, now a number of countries across the globe have adopted this tax system._ _Value added tax, also known as goods and services tax or GST proves to be beneficial for the government. Through implementation of this tax system, government can raise revenues invisibly, where the tax is not shown on the bill paid by the buyer. VAT is different from sales tax in various aspects. While sales tax is to be paid on the total value of the goods and services, VAT is levied on every exchange of the product, so that consumers do not have to carry the total cost of tax. However, VAT is generally not applied on export goods to avoid double taxation on the final product. However, if VAT is charged on export goods, the tax amount is usually refunded to the tax payer._ _The value added tax serves as the solution for different problems related to the sales tax system. Unlike sales tax, in VAT, there is provision for input tax credit or ITC. Because of the simplicity of the VAT system, the entire taxation system on consumer products and services has become easier. (Economy Watch)”_ 31. In 2009, China implemented a VAT reform, which decreased the tax burden on wind farm developers,<sup>18</sup> but reduced the tax revenue to the local government. Some local governments responded by using their administrative authority to either force the wind farm developers to pay additional local fees, purchase equipment produced by local companies, or request that developers build equipment manufacturing facilities in their counties to mitigate their losses in tax resources. These measures could have negatively influenced the quality of the investment made. (See Figure 5.)

> 18 It was noted that the impact of VAT reform on wind farm developers (in Type I area, it is about RMB 0.03/kWh) was taken into consideration when the FIT was determined. But the FIT is still very attractive to the developers, and the developers welcome the VAT reform.

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<!-- Start of picture text --> Subcontractor 1 VAT on part is deducted VAT on wind turbine?<br>Subcontr<br>actor 2 Wind Turbine Wind Farm Grid Final<br>Manufacture Developer Company consumer<br>Subcontr<br>actor 3<br>The 2009 reform,<br>VAT on equipment<br>was not deducted<br>After 2009, allowed<br>deduction on newly<br>purchased equipment such<br>as wind turbine<br>Wind power VAT on<br>equipment deducted from<br>VAT paid on electricity sales<br>75 percent of the 25 percent of the<br>VAT to the Central VAT to the local<br>Government governments<br><!-- End of picture text -->

**Figure 5: VAT Flow for a Typical Wind Farm Project**

32. Given the high initial investment and low operation costs of wind power projects, the revised fiscal policy caused significant changes in government fiscal revenues. Under this new consumption-oriented taxation system, the deduction of the VAT associated with equipment purchased by wind farm developers largely decreased the VAT payments from developers to the local governments during the early years of operation, _but not necessarily over the lifetime of the wind farm_ . Local governments appear to have overconcentrated on lost VAT revenues without taking into account the revenue impacts of large-scale wind power development.

33. Since 2009, wind farm investments averaged US$1.4 million/MW, tax included. Out of the total investment, the equipment cost has been US$1.175 million/MW, tax included. The following estimation of the impact of the VAT reform is based on the following assumptions:

- Investment cost for equipment: US$1.005 million/MW, before VAT (US$1.175 million/1.17).

- VAT per megawatt (eligible for deduction after the reform): US$171,000/MW (US$1.005 million * 17 percent).

- Electricity generation per megawatt: 2,200 MWh (1 MW * 2,200h<sup>19</sup> )

- Tariff: RMB 0.51/kWh.

- Annual revenue per megawatt installed: US$171,600 (2,200 MWh * US$78/MWh).

- Total Annual VAT revenue per megawatt installed: US$14,586 (171,600 * 8.5 percent); 50 percent rebate for VAT of wind power (half of 17 percent);

- Local government share of VAT per megawatt per year: US$3,646 (14,586 * 25 percent); 25 percent of VAT goes to local government according to the regulation.

> 19 Average In type I and II areas with about 10 percent generation losses.

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# **<u>Before January 1, 2009</u>**

Annual VAT revenue for the local government from every megawatt installed is US$3,646/MW (US$14,586 * 25 percent) with payment of 50 percent VAT on electricity sales from the date of commissioning.

# **<u>After January 1, 2009</u>**

Each year the developer can deduct US$29,172/MW from the VAT paid on electricity sale (US$171,600 * 17 percent), since the total eligible deduction is US$171,000/MW. Therefore, the total deduction years are 5.9 (US$171,000/MW ÷ US$29,172/MW).

Since the share of the local government from VAT is US$3,646/MW each year, the total fiscal losses for the local government in 5.9 years amount to US$21,375/MW (US$3,646/MW * 5.9).

For a 100 MW wind farm, which is a common size in Northwest China, each year local VAT losses amount to US$364,600, and the total losses in 5.9 years will reach US$2,137,500.

After the deduction, VAT revenues collected by local governments in the remaining lifetime of the wind farm (14.1 years) amount to US$5,140,860.

After the fiscal policy reform, VAT revenues expected by local governments from wind power projects would at least be equal to or higher than the prereform level if wind power development is increased by 50 percent. The only issue is that in the first 5.9 years of the wind farm operation, there will be no VAT revenue income.<sup>20</sup> Since the effectiveness of the reform, the development of the wind power industry kept a fast pace. At the end of 2008, the total installed capacity was 12,200 MW, while by the end of 2010, the total installed capacity had reached 44,000 MW.

> 20 Local governments invented different kinds of fees to compensate their losses from VAT reform, such as the grassland recovery fee from the developers. Since the equipment price kept decreasing in last a few years, however, the negative and positive impacts generally offset each other. The developers were able to cover these fees while maintaining the same level of investment return. This paper only discusses the relationship between the impact of VAT reform on wind power development scale, which benefited from the VAT reform.

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# **Chapter 3: Exploring Ways to Improve Efficiency and Cost Effectiveness**

34. This chapter will focus on possible measures to address the issues discussed above:

- Concentration

- Subsidy affordability

- Taxation

# **_Addressing Concentration Issues_**

35. In theory, there are three potential approaches to solve the concentration issue. The first is to absorb the power where it is produced. Since local absorption capacity is limited in Northwest and North China<sup>21</sup> (see Figure 1), this option is disregarded. The second option is to deliver the electricity to load centers in Southeast China through high-voltage, direct current (DC) or alternating current (AC) transmission lines. The third option is to build more wind capacity near the load centers in the Southeast region. The two latter issues are discussed further below.

36. To develop wind and deliver power in an effective way, it is necessary to take into account the cost of generation and the cost of transmission. If the transmission line is designed to deliver the full capacity, it could be underutilized because of intermittence issues related to wind generation. For a given capacity of wind, the transmission line needs to be designed to transmit the capacity that minimizes the cost of supply (generation plus delivery). This usually leads to designing the line to transmit only a certain percentage of the installed wind capacity. This percentage is labeled below as the “capacity ratio.” The maximum share of the energy generated and delivered by the line is designated below as the “wind utilization rate.” 37. The China Electric Power Research Institute (CEPRI) carried out a study on the relationship between the wind resource utilization rate and the capacity ratio. The research results show that at the upper end of the wind speed distribution, the utilization rate decreases significantly more slowly than the capacity ratio (see Table 5 and Figure 6).

**Table 5: Relationship between the Capacity Ratio and Generation Losses**

|||||(percent)|||||
|---|---|---|---|---|---|---|---|---|
|Capacity<br>ratio|100|90|80|70|65|60|55|50|
|Resource<br>utilization<br>rate|100|99.86|99.57|86.81|95|82.68|89.80|86.31|

21 There are three routes (South, Middle, and North) of the program Sending Electricity from West to the East. The North route is to send electricity from Gansu and Ningxia, plus North Shanxi and West Inner Mongolia to East China. In 2010, the peak generation capacity in North West Grid was 50600 MW, while the peak load was 44210 MW, the surplus was 6390 MW; Also in 2010, the surplus in North China was 17988 MW; On the other hand it was short of supply in East China, the gap is 24150 MW.

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Energy loss cost: (1-resource utilization rate) * FIT (The resource utilization rate is given in Table 5 above.) Table 6 below provides the results of the calculation of the generation costs, transmission costs, and lost generation costs for different capacity ratios varying from 100 to 50 percent.

**Table 6: Detailed Calculation of the Generation Costs, Transmission Costs, and Energy**

**Loss Costs**

|Capacity<br>ratio(%)|Generat<br>ion loss<br>(%)|Energy lost<br>(RMB/kW<br>h)|Wind<br>farm<br>installed<br>capacity|Wind<br>power off-<br>take<br>(kWh)|Transmis<br>sion cost<br>share|Unit<br>transmissi<br>on cost<br>(RMB/kW<br>h)|Generatio<br>n cost<br>(RMB/k<br>Wh)|
|---|---|---|---|---|---|---|---|
|A|B|C = (B *<br>0.51)|D =<br>(1/A)|E = C *<br>(1-B)|F = (1/E)|G =<br>0.20*F|H = (2/3)<br>* 0.51|
|100|0|0.000|1.00|1.00|1.00|0.20|0.340|
|90|0.14|0.001|1.11|1.11|0.90|0.18|0.340|
|80|0.43|0.002|1.25|1.24|0.80|0.16|0.340|
|70|3.19|0.016|1.43|1.38|0.72|0.14|0.340|
|65|5|0.026|1.54|1.46|0.68|0.14|0.340|
|60|7.32|0.037|1.67|1.54|0.65|0.13|0.340|
|55|10.20|0.052|1.82|1.63|0.61|0.12|0.340|
|50|13.69|0.070|2.00|1.73|0.58|0.12|0.340|

40. The results of the calculation are provided in Table 7 and Figure 7. They show that the lowest delivery cost is reached for a capacity ratio of about 70 percent.

**Table 7: Relationship between Capacity Ratio, Resource Utilization Rate, Generation Cost, Transmission Cost, and Energy Loss Cost**

|Capacity<br>ratio(%)|100|90|80|70|65|60|55|50|
|---|---|---|---|---|---|---|---|---|
|Resource<br>utilization<br>rate(%)|100|99.86|99.57|86.81|95|82.68|89.80|86.31|
|Generation<br>cost(yuan)|0.340|0.340|0.340|0.340|0.340|0.340|0.340|0.340|
|Transmission<br>cost(yuan)|0.200|0.180|0.161|0.145|0.137|0.129|0.122|0.116|
|Energy loss<br>cost(yuan)|0.000|0.001|0.002|0.016|0.026|0.037|0.052|0.070|
|Total cost<br>(yuan)|0.540|0.521|0.503|0.501|0.502|0.507|0.515|0.526|

24 FITs in all the four type areas are determined by the NEA with the following formula: FIT = Power Generation Cost + Tax + Profit (after tax), in which the generation cost is usually two-thirds of the FIT.

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<!-- Start of picture text --> Sum of cost and<br>losses Yuan/kWh<br>0.550<br>0.500<br>0.490<br>0.480<br>0 0.14% | 0.43% | 3.19% 5% 7.32% |10.20%|13.69% Resource Losses<br>1 0.9 0.8 0.7 0.65 0.6 0.55 0.5 and Capacity Ratio<br><!-- End of picture text -->
Type II > Type III > Type IV). It shows that there is less incentive to invest in those areas with comparatively poor wind resources.

<!-- Start of picture text --> 20<br>18<br>16<br>8000Yuan/kW<br>14<br>8500Yuan/kW<br>12<br>10 9000Yuan/kW<br>8<br>9500Yuan/kW<br>6<br>4<br>2<br>Full load<br>0<br>operation<br>( Type IV ) 2200 ( Type III ) 2400 ( Type II ) 2600 ( Type I ) hours<br><!-- End of picture text -->

**Figure 8: Rates of Return under Resource Conditions and Investment Cost** _Note:_ The x axis represents the wind resource— annual full load operation hours.

44. **Projects**<sup>**28**</sup> **in types I, II, and III that usually realize generation losses have similar revenue levels to those in type IV that do not have generation losses.** As discussed previously, the generation losses happen primarily in Northwest. Assuming RMB 8,000/kW investment cost, a 5 percent generation loss in Type II area, and a 3 percent generation loss in Type III, the revenue of the projects in the type II and III areas is still higher than that in the type IV area. With the same investment cost assumption, but with a 10 percent generation loss and 2,600 full load generation hours, the project revenue is lower than in the type IV area. Under the same assumptions, but with 2,800<sup>29</sup> full load generation hours, the project revenue is higher than it is for projects in the type IV area that typically do not have generation losses. Table 8 and Figure 9 compare revenues of projects in Type IV with those in Types I, II, and III, and reveals relative revenue parity when taking into account generation losses.

**Table 8: IRRs in Four Types of Areas with Different Level of Generation Losses**

|Full load operation hours|No generation losses|With generation losses|
|---|---|---|
|2,000 (Type IV)|**13.59**|13.59 (no loss)|
|2,200(Type III)|15.88|14.75(3% loss)|
|2,400 (Type II)|16.73|14.46 (5% loss)|

28 The majority of these projects are located in Inner Mongolia.

29 In the same type of area, there is a range of full load operation hours, but one FIT. For those wind farms built in high full load operation hours sites, the revenue will be higher than wind farms built in lower full load operation hours sites in the same type of areas.

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<!-- Start of picture text --> IRR% 25<br>20<br>oeae<br>10<br>5<br>0<br>2000(TypelV 2200(Typelll) 2400(Typell) 2600(Typel) 2800(Typel><br>)<br>Full load operation Hours<br>—— No generation lost —&- With 0-3-5-10% generation lost<br><!-- End of picture text -->
<!-- Start of picture text --> Yuan/kWh<br>0.40<br>0.35<br>0.30<br>0.25<br>0.20<br>0.15<br>0.10<br>0.05<br>0.00<br><!-- End of picture text -->

**Figure 10: Wind Subsidies per Province by City and Region** (RMB/kWh) _Source:_ Based on the desulfurized coal-fired benchmark price in 2009.

48. According to the subsidy schedule from January to September 2010, the average subsidy in the whole country was RMB 0.224/kWh. The average subsidy for Inner Mongolia and Xinjiang, which are located in resource areas of type I, II, and III, was RMB 0.239/kWh. The average subsidy in other areas was RMB 0.195/kWh. The difference between the two was RMB 0.044/kWh (see Figure 10 and Table 9).

**Table 9: Comparison of Subsidies in Different Regions**

|Wind resource zones|I、II、III|IV|
|---|---|---|
|Price(RMB/kWh)|0.51、0.54、0.58|0.61|
|Areas|Inner Mongolia, Xinjiang,<br>North Hebei, Gansu, western<br>Jilin, part of Heilongjiang,<br>Ningxia|Other areas|
|Installed capacity (MW)|16,090|7,190|
|Generation subsidized(GWh)|21,300|9,700|
|Subsidyline of unitpower(RMB/kWh)|0.239|0.195|
|Overall average subsidy line<br>(RMB/kWh)|0.224||

49. In the Southeast, because the current tariff is RMB 0.61/kWh, developers of wind farms can secure financial internal rates of return (FIRRs) above 8 percent only when they realize equivalent full load operation hours above 1,800 for an investment level at RMB 8,000. The different FIT refers to a different economically exploitable wind resource: For RMB 8,000/kW investment cost: 22
- When FIT RMB 0.61/kWh, 1,780 full load operation hours can secure an IRR of 8 percent;

- When FIT RMB 0.654/kWh, 1,660 full load operation hours can secure an IRR of 8 percent;

- When FIT RMB 0.673/kWh, 1,610 full load operation hours may secure an IRR of 8 percent.

Table 10 provides other estimates based on different investment cost assumptions.

**Table 10: Full Load Operation Hours Needed to Keep IRR at 8%**

|Investment unit kW(RMB/kW)|8,000|8,500|9,000|9,500|
|---|---|---|---|---|
|Equivalent full load operation hours<br>correspondingto 0.61 kWh|1,780|1,890|2,000|2,100|
|Equivalent full load operation hours<br>correspondingto 0.654 kWh|1,660|1,760|1,860|1,970|
|Equivalent full load operation hours<br>correspondingto 0.673 kWh|1,610|1,710|1,810|1,920|

_Note:_ Fixed IRR of 8%.

50. To realize the development target of 100 GW in 2015, there is a need to add 60 GW. It will require, under the current FIT regime, a subsidy of RMB 16.5 billion. Theoretically, if one tenth of the additional capacity, 6 GW, is installed in the Southeast rather than in the Northwest, as originally designed, savings would amount to about RMB 475 million<sup>31</sup> each year.

# _6 GW * 1,800h * RMB 0.044/kWh = RMB 475 million_

This calculated savings assumes that the tariff remains RMB 0.61/kWh in the type IV area on the east coast. If the tariff was raised to RMB 0.654/kWh, with the same amount of subsidy, wind resources with lower full load operation hours (see Table 10) can be exploited. Furthermore, if the tariff was raised to RMB 0.673/kWh, which is equal to the delivery cost from Northwest to the east coast, resources with even lower full load operation hours could be developed, with the same amount of wind power, and extra subsidies would be needed of RMB 0.019/kWh (0.673–0.654).

The analysis above suggests that this approach is worthy for further, in-depth connection studies, for example, taking into account land acquisition costs, and comparing these to the building of long-distance transmission lines mainly for wind in the short term, which will involve transmission cost by RMB 0.14/kWh.

# **_Addressing the Issue of Taxation_**

> 31 Full load operation hours are considered to be 1,800 in the calculation.

23
51. On the one hand, local governments’ fiscal income was negatively influenced by VAT reform. On the other hand, the wind power industry in China experienced rapid development in the last decade, and VAT revenue in most wind resource-rich places increased remarkably. Actions taken by local governments may have brought about local protectionism, which can generally lead to market distortions, installation of substandard equipment as developers try to absorb the costs of administrative measures, and harm the overall quality of projects.

52. The administrative measures adopted by local governments, to require the procurement of locally produced equipment and other fee-charging schemes that are aimed to compensate for VAT losses on equipment, should not be encouraged. Local governments seem to have disregarded the outcome that the new VAT policy will have, along with other government initiatives, of inducing wind development at a larger scale. VAT revenues expected by local governments from large-scale wind power projects would at least be equal to or higher than the prereform level if wind power development were increased by 50 percent. Moreover, some of these practices can threaten good supply chains and increase the overall costs of wind power generation, which are important for the long-term, sustainable development of the industry.

# **Conclusions**

- The government’s large-scale wind power development objectives should be twinned with a clear objective to deliver electricity at a minimum cost. Efficiency is contingent upon ensuring that wind farms are built in places where crucial requirements for success are present: the best resources, adequate project designs, use of proven turbines, regulatory clarity, adequate incentives, transmission capacity to deliver the electricity and, last but not least, appropriate operation and maintenance practices carried out by skilled and trained staff.

- The grid is crucial. International experience has been good in planning wind farm operational integration. However, grid connection and stability issues for gigawattscale wind bases, as envisaged in China, have no precedent anywhere in the world. Comprehensive connection studies with special attention to the optimum connection size and connection circuit layout should be undertaken with the involvement of all stakeholders.

- As large capacity operates at low efficiency in resource-rich Northern China, and because planning and construction of the grid network to off-take the electricity will take time, the government needs to consider readjusting the incentive mechanisms to guide the developers to invest in regions with high efficiency and as close as possible to load centers with an objective of achieving the lowest incremental cost.

53. Shifting part of the focus to the central and eastern regions in China by offering a higher feed-in price _can balance the wind power development pace in China and minimize the_ 24
_incremental cost for wind power development in the country, especially as wind resources in the Three-North region are further developed on a large scale and transmitted in bulk to the load centers._

- Some local governments are using their administrative authority to raise revenues from additional fees, and/or take on measures, such as forcing wind developers to purchase equipment produced by local companies and/or mandate developers to build manufacturing facilities in their counties to compensate tax losses they incurred after the last round of VAT reform. These initiatives should be discouraged because of their harmful impacts on the wind power industry. Local governments seem to disregard the outcome that the new VAT policy will have, along with other government initiatives, of inducing wind development on a larger scale. VAT revenues collected by local governments from wind power projects would at least be equal to or higher than the prereform level if wind power development were to increase by 50 percent.

25