Much like the United States, China has an “all of the above” energy strategy: it plans to continue to rely on traditional sources of energy even as it makes the transition to cleaner fuels. And this is only natural. Both countries are continent-sized economies with diverse energy needs and geographically dispersed resources.

But China’s energy situation differs from that of the United States in several notable ways. For starters, the Chinese state’s role in energy looms large, and its hand is seen and deeply felt when it comes to prices. Even more important, China’s per capita resource availability is below the world average -- and even below that of some other developing countries -- yet its total energy consumption could potentially be the largest in history. It is little wonder that China’s energy strategy has been guided by the need to supply enough fuel to power an economy that grew from under $1 trillion in 1997 to more than $8 trillion in 2012.

Over that same 15-year span, China has become staggeringly dependent on imported energy: today, nearly 60 percent of its oil and almost 30 percent of its natural gas is imported. These developments have all but supplanted Beijing’s traditional concept of equating energy security with energy self-sufficiency. But China has little alternative, as just about the only resource it possesses in abundance is coal. (China now devours about four billion tons per year, or nearly half the world’s annual coal output. The bulk of those needs are met by domestic production.)

China’s rampant consumption of coal and fossil fuels has imposed an exorbitant cost on the country’s economic development, including severe environmental despoliation and thousands of deaths in coal mines. These environmental and pollution hazards have been regularly chronicled, and they are eroding the already limited resource base on which future growth depends. Resource scarcity, unfortunately, is a daily reality that China cannot evade.

Such constraints on future economic development are reflections of the growth model according to which the Chinese economy was built. While this model has come in for criticism from many angles, few have appreciated one of its most important features: cheap and highly regulated energy prices. But it is these suppressed prices that drive China’s uncontrolled energy consumption and its negative side effects.

MUCH ADO ABOUT INDUSTRIALIZATION

Ever since the late 1990s, China has been in a phase of development that requires affordable and abundant energy, which feeds the country’s hyper-industrialization. Its development strategy has focused on heavy industry such as steel, aluminum, and cement -- the inputs needed to accommodate an astronomical expansion of infrastructure and housing. This sprawling network of low-efficiency heavy industry has been by far the largest consumer of energy, making up about three-quarters of total consumption. (In comparison, industry in the United States is responsible for about one-third of total energy consumption.) Today, China churns out about half the world’s steel. Its steel sector is so big, in fact, that Chinese demand has largely determined world iron ore prices over the last decade.

Supporting the vast expansion of industry in a relatively poor country, however, meant that the government needed to keep inflation in check, a difficult task given that China’s huge appetite for foreign commodities risked importing inflation along with them. China has to buy iron ore at global market prices from Australia and Brazil, for example, because it does not have adequate domestic reserves. So, to keep Chinese industry humming -- often with razor-thin margins -- the Chinese government decided on a policy that both managed inflation and offered an important industry-wide subsidy: artificially suppressing energy prices.

Although the prices of many commodities and consumer goods were liberalized during China’s economic reforms of the 1980s and 1990s, energy prices have been a holdout because the state has had to ensure that industry could continue to support urbanization and export growth. In other words, China’s economic model has determined its energy strategy.

Much like a devalued currency can function as a market-wide subsidy for exports, the energy price subsidy worked spectacularly well for China’s production-oriented economy. Up until 2011, energy demand from industry and the hundreds of millions of new urban dwellers seemed so great that the government’s main preoccupation was to ensure that supplies were abundant enough to keep prices low. And if that was not enough, the state regularly intervened to prevent prices from rising.

Consequently, over the past decade, the energy required to generate one unit of Chinese GDP, or energy intensity, rose rather than declined as it did in the 1990s, suggesting that overall efficiency was probably decreasing as well. The government’s emphasis on industrialization encouraged local governments to approve hundreds of thousands of energy-intensive infrastructure projects that boosted local growth and supported employment. In turn, industry received all sorts of subsidies, and efficiency and environmental considerations became an afterthoughts. What is more, in the absence of clear market prices set by energy supply and demand, industry and consumers had to depend on the government to raise or cut prices.

INFLATION BITES

The government’s control of prices has hurt Chinese energy security, broadly defined. Throughout the last decade, China experienced major power shortages virtually every year, often forcing the state to raise energy prices on industry to manage demand. Some have blamed coal shortages for the blackouts, but a more compelling explanation is that they have been brought on by government policy and represent a symptom of China’s illiberal pricing system.

Although the market determines domestic coal prices, the government continues to set the price at which power generators sell electricity to the state’s transmission and distribution monopoly. But markets usually move much faster than the government does, so even when coal prices are rising, the state often refuses to raise power prices, causing power utilities to bleed profits. In response, the power companies often take the only action they know to be effective in getting a price hike: idling or fully cutting power generation. Over the past decade, rolling blackouts have become a regular occurrence in China, with one of the most severe episodes in 2004.

The government’s continued grip on energy prices is rooted in its fear of spiraling inflation. Reform of energy prices makes the government nervous, because once the market takes over, prices could get out of control, undermining the economic stability that Beijing has diligently maintained. Even a marginal rise could seriously pinch the still relatively poor Chinese people, whose meager incomes are disproportionately spent on necessities such as food and electricity.

Those concerns have made energy price reforms a torturously slow affair. And even when attempted, efforts have been botched. Take, for example, recent actions to make Chinese gasoline prices more aligned with global crude-oil prices. In 2009, the government announced what was supposed to be an important step toward liberalizing energy prices. It decided on a fairly complex formula that would allow Beijing to change retail gasoline prices according to whether global crude prices moved up or down by four percent over a 22-day period.

The policy turned out to be both exceedingly confusing and highly unpopular with major interest groups. Chinese car owners felt that the government used the mechanism as a ploy to make gasoline more expensive and serve the interests of the big oil companies. The oil companies, meanwhile, remained dissatisfied over the long lag between market movements and the time when the government would raise prices.

The policy eventually devolved into a charade when, immediately before the 22-day period expired, there were reports of runs on diesel and gasoline products at gas stations across China in anticipation of a price hike. As a result, the government essentially abandoned the policy de facto, deciding to change prices when the public was least expecting it. But rumors of imminent price hikes inevitably got around, and it became a game of cat and mouse.

WHERE THE ECONOMY GOES, ENERGY FOLLOWS

Energy price reforms were lackluster and disappointing because Beijing never made them a priority. The economic logic that underpinned the Chinese growth model was simply not conducive to energy price liberalization. But left in the wake of the reforms’ failure are serious problems of unchecked energy consumption, poor energy efficiency, and an industry beset by severe overcapacity. The steel industry, for instance, has about 35 percent more capacity than necessary to meet domestic needs, even as global demand has shrunk after the financial crisis and China itself has imposed austerity measures on the property sector.

But these dynamics appear poised to change, as the country undertakes the transition to a more sustainable economic model. Central to this effort is beginning the process of reaching a better equilibrium between production and consumption, what many observers call “rebalancing.”

To its credit, the Chinese government has, over the last several years, clamped down on heavy industry and forced the most environmentally harmful producers to shut down. But liberalizing energy prices will send a significant nationwide signal that the era of energy subsidies is coming to an end, forcing companies to either improve production efficiency quickly or exit the market because they can no longer survive in an unsubsidized environment. Its effect would be similar to moving to a more flexible exchange rate system, which would signal to exporters that their days are numbered if they conduct business as usual.

Pricing energy right will also play an important role in shifting to cleaner sources of energy. This is particularly true in the near term as China intends to boost natural gas consumption. The official goal is to double gas’ share in total primary energy consumption from roughly four percent today to around eight percent in 2015, but various estimates suggest the increase could be even higher. In recent years, domestic consumption of gas has been growing at a rate roughly double that of domestic production, again forcing China to tap the international market to make up the difference.

But unlike China’s oil reserves, which are limited, the country’s natural gas reserves are potentially immense. Preliminary estimates put China’s shale gas reserve on par with that of the United States. Consequently, China is intent on developing its domestic energy resources such as coal-bed methane and shale. But doing so will require deregulating domestic gas prices, which continue to be below global prices, to incentivize domestic production.

GETTING THE PRICE RIGHT

As China begins to transition from an investment- and export-driven economy to a consumption-driven one, its energy policy must shift from a focus on supply-side security to demand-side management. Although the perennial concern about inflation is unlikely to abate anytime soon, market-based energy prices offer a powerful tool to help shape consumer behavior on energy consumption. And with a rising cohort of relatively prosperous urban dwellers, the Chinese government should reassess its long-held belief that the Chinese public has a low tolerance for inflation.

Perhaps in recognition of these changing dynamics and China’s future demands, Beijing has already begun testing the ground for a more liberalized energy price regime. In Guangdong and Guangxi provinces, pilot programs on reforming natural gas prices have been under way for more than a year. Even the gasoline mechanism that turned out to be a farce has been revived under a purportedly more flexible formula. In the current low-inflation environment, conditions appear conducive for the government to engage in bolder pricing experiments that could put China on a path to more rational energy pricing.

Most important, instead of paying lip service, the new government appears to have seriously prioritized pricing reform as an important component of China’s economic transition. If recent reports are any indication, the government intends to make resource prices a key part in a comprehensive reform package expected to be unveiled at the Third Plenum this fall. Beijing is unlikely to liberalize all prices at once and will likely proceed in stages. It is possible that one of the changes will allow utilities and industry to negotiate power prices without government involvement.

Of course, energy price reforms alone would not be a panacea for China’s diverse economic challenges. De-industrialization will take time and require a strong commitment to shifting economic growth toward domestic consumption and expanding less energy-intensive sectors such as services. But liberalizing prices would, at the very least, send a strong signal that Beijing is committed to putting China on a path toward more sustainable economic development. And just as important, it would send an unambiguous message that one of the most stubborn legacies of the planned economy is finally being written off.