VZCZCXRO0599
RR RUEHCN
DE RUEHHK #1082/01 0750141
ZNR UUUUU ZZH
R 160141Z MAR 06 ZDK
FM AMCONSUL HONG KONG
TO RUEHC/SECSTATE WASHDC 5507
INFO RUEHOO/CHINA POSTS COLLECTIVE
RUCPDOC/DEPT OF COMMERCE WASHDC
RHMFIUU/DEPT OF ENERGY WASHINGTON DC
RUEAEPA/HQ EPA WASHDC

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 
 
HONG KONG 00001082  003.2 OF 004 
 
 
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" 
------------------------------------- 
 
 
HONG KONG 00001082  004 OF 004 
 
 
¶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