Electricity cross-subsidies in China: Social equity, reverse Ramsey pricing, and welfare analysis

The so-called “cross-subsidies” in China’s electricity market have existed for decades, i.e., residential electricity prices are much lower than industrial electricity prices. The claimed rationale of social equity for such a pricing scheme (i.e., to ensure low-income households with basic living standards) was left unsubstantiated. Many argued that China’s government should adopt Ramsey pricing in the electricity industry to achieve efficiency, increasing the residential electricity price beyond the industrial electricity price based on their relative price elasticities. This paper first proposes a theoretical model to explain the reverse Ramsey pricing in the Chinese power sector for social equity reasons. We then calibrate the model with observed industrial data. We find that the reverse Ramsey pricing could be optimal if the residential sector were given a higher weight than the industrial sector; the greater the weight of the residential sector, the lower the residential electricity prices. Based on the calibrated model, we use the actual electricity prices to find the most likely weighting scheme used by the regulator. Using these most likely weights, we further conduct social welfare analyses under different scenarios, providing helpful guidance for policymakers in future electricity market reforms.