China has a growing problem. It wants cleaner air; it needs to upgrade the quality of its fuels to get that; but it traditionally has regulated retail prices to ensure they don't get to levels that might cause unrest. In this week's Oilgram News column Petrodollars, Yen Ling Song discusses the conundrum.

China's heightened pollution problems this year have put state refiners in the spotlight and again highlighted the need for energy pricing reforms.

Following serious problems in January, when both national and other privately-tracked data showed air pollution at record levels in much of the northeast, the government faced severe public criticism and is now pushing for cleaner fuels to be adopted with renewed urgency.

The State Council, or Cabinet, said early this month it wanted to speed up the implementation of cleaner fuel specifications for transport diesel and gasoline, setting a transition deadline for National Phase V fuels for 2017.

This would cap sulfur levels to 10 parts per million, tightening from Phase IV standards of 50 ppm currently being introduced. The deadline for transition to Phase IV gasoline is early next year, while that for Phase IV diesel is the end of 2014.

China had previously set deadlines for the introduction of Phase IV specifications by 2011, and then 2012, but these were not mandatory and were delayed due to various problems, including fears of insufficient supply of low-sulfur fuel and protests by refiners about additional costs.

"The government has not brought forward the Phase IV deadlines but wants the refiners to stick to the existing timetable," said Kang Wu, an expert on China's energy sector at FACTS Global Energy.

With the latest pollution problems, the pressure now is on everyone to improve the situation—state refiners and various government divisions, including the environment ministry and the National Development and Reform Commission responsible for energy pricing reforms, Kang said.

Analysts say Sinopec and PetroChina had already been upgrading their refineries in the last few years to cope with the new demands, and the additional investment is not likely to be significant compared with their overall capital budgets. JP Morgan expects 770,000 b/d of new crude distillation capacity this year, 6.5% more incremental capacity added compared with last year.

But the new cleaner fuel requirements raise further concerns about refining profitability and the country's existing system of cost controls on retail oil product prices, which has caused refiners billions in lost refining margins.

"The main issue here would be the cost. Who will bear the additional cost of [the cleaner] fuels?" said Liu Gu,analyst at Guotai Junan Securities in Shenzhen.

Price controls at the pump would prevent Sinopec from passing on the costs fully to end-users, Moody's said, and suggested that the government could subsidize some of the cost.

"Sinopec's financial burden reflects its social responsibility role, which is one of the most important considerations supporting its strategic importance to the Chinese government. As air pollution becomes a severe social problem for the government, it may receive fiscal support from the state."

But while Beijing has not explicitly stated if the consumer or producer will shoulder the financial burden, Premier Wen Jiabao said in a recent work report that some environmental costs have to be borne by society.

"This suggests that the government's thinking is to increase prices and make energy sources valuable and more expensive for consumers," said Liu.

Plans have been afoot to reform the current pricing mechanism but were stymied by inflation concerns in 2011 and the ongoing leadership transition last year.

Reforms are widely believed to be announced this year but more details will only likely be revealed following the annual meeting of the National People's Congress next month, when wide-ranging policy issues are debated by the legislature.

"While previously the concern was with [the impact of higher fuel prices on] economic growth and stability, the pollution situation will likely spur the NDRC to accelerate pricing reforms," said Kang.

He added that refiners likely want to see price differentials being set for various fuel standards to reflect the production costs.

The immediate concern for refiners is to remain profitable. The last retail price adjustment—a roughly 3.5% cut—to gasoline and gasoil prices was in November last year and since then global crude prices have risen by more than 4%, which is the threshold that would technically trigger a price review by the National Development and Reform Commission.

Under the current mechanism, the NDRC can adjust prices of gasoline, gasoil and kerosene if the 22-day rolling average of a basket of Cinta, Dubai and Brent benchmark crude prices rise or fall by more than 4% from the previous price adjustment.

More timely price changes, along with less volatile crude prices last year, improved both PetroChina and Sinopec's refining bottom lines.—Yen Ling Song in Singapore