China is already the world's fourth-largest gas consumer, but it will struggle to reach its goal of doubling gas use to 260 billion cubic metres a year by 2015 unless a range of barriers can be overcome.

Lack of upstream investment is only one of many problems facing China's gas industry. Getting the price right is more important.

The government needs to find a pricing mechanism that will encourage the costly development of domestic gas resources such as shale, as well as an increase in imports, and pay for more transmission and storage infrastructure. At the same time, gas will need to undercut the price of coal as China aims to curb pollution and greenhouse gas emissions.

UPSTREAM INVESTMENT

This week China announced the winners of a new round of shale gas exploration licences, part of a bid to kick-start its stalled domestic shale gas development programme.

The Ministry of Land and Resources (MLR) awarded licences for 19 blocks to a total of 16 Chinese companies following an auction held in October, according to a report published by the official Xinhua news agency.

The auction appears designed to resolve some problems that have slowed the development of the domestic shale industry, which have left it far behind the target of 6.5 billion cubic metres per year by 2015, set out in the government's 12th Five-Year Plan.

Until now, most exploration licences have been allocated to just three domestic companies: China National Petroleum Company (CNPC), China National Offshore Oil Company (CNOOC) and Sinopec.

These three represent the bulk of domestic production and have formed an oligopoly in the upstream sector in terms of licences, according to a report by the International Energy Agency (IEA), with input from the National Energy Administration of China's State Council ("Gas Pricing and Regulation", September 2012).

Threshold exploration activity to keep the licences has been low. Incumbents have been able to hoard licences and prevent entry by competitors despite doing little drilling or surveying. Smaller companies have few chances to acquire licences through compulsory relinquishment, the IEA found.

"The involvement of foreign or smaller Chinese gas companies is ... so far limited and happens mostly through partnerships and joint ventures with the Big Three," which control the pace of exploration, IEA explained.

The IEA report contrasted the situation in China with more competitive and open processes elsewhere: "In the United Kingdom and Norway, companies that are not respecting their work programme as agreed in the plans of development and operation lose their licences, which can then be offered again to the market through tenders."

Expert and rigorous monitoring by officials at the licensing authority "incentivises companies to respect their work commitments to keep their licences, rather than enabling them to avoid competition by buying and holding licences indefinitely."

In China's latest auction in October, the winners included six state-owned enterprises, eight companies backed by provincial governments, and two private firms. Many are non-oil firms, which could provide lucrative opportunities for oilfield service companies such as Schlumberger and Halliburton to become involved in exploration and field development.

MLR promised to supervise exploration efforts and punish firms that fail to carry out the work promised in their licence bids.

By awarding licences to a wider group of participants, including companies with little or no oil or gas production, and extracting promises from them to spend as much as $2 billion over the next three years, MLR is trying to accelerate the rate of drilling.

MARKET REGULATION

The IEA report identified a host of other problems holding back the development of a large and competitive internal gas market, most linked to regulation and pricing.

Responsibility for regulating the sector is split among the National Energy Administration, the National Energy Commission, the National Development and Reform Commission, the Ministry of Land and Resources and a host of other bureaus in Beijing, while provincial governments protect their own enterprises, and the Big Three oil and gas companies have privileged access to the regulatory process.

Unlike the U.S. Natural Gas Act, there is no single law regulating production, imports, pipelines and storage.

Pipeline and transmission capacity remains low for a country of China's size and mostly controlled by the Big Three, with limited or no rights of third parties.

China has more than 50,000 kilometres of large-diameter transmission lines, with more than 30,000 km controlled by CNPC. The network is being rapidly built out. CNPC this week said a gas pipeline from Myanmar will be fully operational by the end of May.

But Germany has more than twice as much transmission capacity for a smaller market (97 bcm) with a land area only 4 percent of China's. The United States, which has a comparable land area, has 500,000 km of transmission pipelines, about ten times as much as China, of which 70 percent are interstate lines.

China has virtually no storage capacity for managing daily and seasonal variations in demand. Working storage is just 1.9 bcm for a market that consumed 130 bcm in 2011. By comparison, most European countries that rely on imports have storage capacity amounting to around 20 percent of annual demand. At the moment all working storage is controlled by CNPC. Local gas distribution companies rely entirely on limited-capacity tanks.

PRICING MECHANISM

Distorted gas prices are the biggest obstacle of all. Prices are not low. For residential customers, tariffs range from $7 per million British thermal units (mmBtu) in Chongqing to $9 in Beijing and $11 in Shanghai. For industrial consumers, prices are higher, varying from $9 in Chongqing to $12.50 in Beijing and $16 in Shanghai in 2011.

This is far above U.S. wholesale prices and comparable to prices paid by many customers in western Europe.

But most are set on a cost-plus basis, and the industry is infested with cross-subsidies. Industrial users subsidise residential customers. High rates of return on pipelines subsidise low well-head prices. There is no mechanism for recovering the cost of storage.

Regulated gas prices are well above the cost of finding and developing conventional domestic gas fields but fall short of the level needed to pay for imported LNG and may not be enough to cover the higher costs of shale gas.

Nor is gas priced competitively with the major alternatives: coal, fuel oil and propane/butane (LPG). In 2012 the government launched a pilot programme linking local gas prices to a 60:40 basket of fuel oil and LPG, but so far it operates only in the southern coastal provinces of Guangdong and Guangxi.

IEA warned that the government must take a view on whether to pursue a market approach based on indexation to alternative fuels or move to a hub-based pricing system, based on experience with the limited hub in Shanghai.

It urged the government to liberalise prices for large industrial users and gradually raise prices for residential customers.

Companies need proper incentives (higher prices, better market access and regulatory certainty) to make investments in the domestic upstream. And the country needs to foster more development of transmission and storage capacity while finding ways to improve third-party access and develop a competitive wholesale market.

None of this will be easy. The IEA appears to prefer a market-based system based on the experience of the United States, the United Kingdom and some other member countries, though it is not clear this would be the right model for China at this stage, and it will be bitterly opposed by the Big Three.

But whatever route the government chooses, there is an urgent need for more stable regulation, clearer pricing and stronger incentives for investment in exploration and storage if the gas market is to live up to the government's ambitious targets.