It is a truism amongst fund managers that very few of China's 1200 and more listed companies have the earnings to reflect China's dazzling GDP growth over the last 20 years. The energy sector is a good example. With demand rocketing on the back of 10% GDP growth a year for the past decade and more, the sector would seem to be a sure winner.
But for many foreign and domestic investors the uneven liberalization of the energy sector is having painful consequences. The main problem is that despite large-scale price liberalization, key commodities such as coal, the most important source of fuel for China's power companies, are still under government control.
That is not unusual, with the stable supply of power to homes and businesses a key consideration for most developed economies also. What irritates smaller investors in China is that the market is tilted in favour of a handful of companies with close connections to the central government. .
The large scale power producers, such as Huaneng Power and Datang Power, obtain their coal at prices fixed at the annual coal conference. Coal companies, usually state-owned, are then tied in to supplying the power producers for one year contracts at a fixed price.
Edward Lee, an energy analyst at JP Morgan, estimates the contract price is up to 40% less than the spot price.
Not surprisingly, these cosy arrangements and widely reported power shortages helped the share prices of the listed IPPs to surge, especially in the first half of the year.
Datang's Power's share price has improved from HK$2.25 at the beginning of last year to a high of HK$7.45 in early April. Huaneng Power's share price performance has been even more impressive, from over HK$16 at the beginning of last year to a high of over HK$43 in April this year.
Some observers believe China's listed power producers manage to smooth their earnings by buying coal from affiliated companies.
"In some cases, the largest power producers have affiliated companies from whom they buy the coal, such as the parent company, that absorb the volatility," says a second analyst. "That smoothes out spikes and enables the listed companies to give a much rosier picture of what's going one."
Others complain that the state-owned nature of the companies and their close relationship to state banks means they have superior financing channels to their less favoured competitors.
"But the smaller power producers in the provinces have to negotiate directly with their coal producers and pay the spot price," says one foreign power operator in precisely the same situation.
Even this would not be so serious if power companies at the mercy of the coal mines could pass on their costs to the end-users in the form of higher tariffs.
"There is no way we can do that," he adds. "The government will not pay higher prices for the coal we provide. As a result we're finding our margins slashed from between 9% and 13% in past years to under 5% to 6% so far this year."
He estimates the price he pays for coal has doubled in the last 12 months, with only a fraction of these higher costs passed on to the end user.
"Roughly 90% of the rise in coal prices stays with us. Where's the pass through mechanism," he asks.
"And if power companies continue to sell at low or negative margins what's going to happen in the winter?" he continues, adding that if they continued to be squeezed, some of the smaller producers might simply close down or cut off supply. China's smaller plants are often established right in the centre of the cities they heat.
The rise in coal prices is even having repercussions for companies heavily favoured by the government. According to research by ABN AMRO costs have risen 20% year-on-year at Huaneng, 14% at Huadian and 5% at Datang International.
The reason for this is that the cosy arrangement between the power producers and the coal suppliers has recently broken down.
"The coal producers were furious about the fixing of coal prices one year in advance," says one Beijing-based executive of a mainland mining company. "They feel they're subsidizing the IPPs."
One foreign investor also adds that transport bottlenecks are adding to the coal supply problem.
"The railway network is already operating at peak capacity. How are they going to ensure the power producers get the coal they need? As usual, it will be the best-connected ones which get the coal first," he estimates.
One stop-gap measure for power operators was to generate more power in order to maintain absolute returns, but "margins are sinking too rapidly," says one.
Other problems concern environmental protection measures, which add to the cost of plants and the fact that coal mines have been under pressure to place more focus on security after decades of terrible accidents. Under the current system, some observers say they do not see the growth and investment in the power industry as sustainable.
"The country is adding the equivalent of twice the capacity of the power generation in the UK every year, but you won't find many investors coming to China if they can't make a fair return on their investment," warns one observer, adding that a typical coal-fired power plant costs $500 million.
Caught in the middle between the IPPs and the end-users are the grid companies. In a nod to Western systems, the grids are meant to buy power from competing IPPs.
In effect, the price is fixed through negotiation between the central and local governments as well as the IPPs.
This situation is a disaster for the grid companies, which are earmarked to spent Rmb 120 billion in capital expenditure over the next several years as China puts on a mighty push to improve its energy infrastructure.
"Unless the grids can push up the tariffs to improve their cashflows and pass on some of the benefits to the IPPs, the modernization effort is just not sustainable," says JP Morgan's Hui.