Reducing Overcapacity in China's Coal Industry: A Real Option Approach

Coal accounts for more than 60% of China's primary energy consumption. Due to the demand decline since 2013, the coal industry was facing the dilemmas of falling prices, overcapacity, and high debt ratios. Reduction of overcapacity of the coal industry has become a crucial task in China's supply-side structural reform. This paper attempts to explain several issues related to overcapacity reduction in the coal industry. First, we analyze the characteristics of China's coal market and the causes of over-capacity in the coal industry. It is revealed that the aggregate coal demand of China is price inelastic, and the coal enterprises own market power. In addition, we illustrate that current overcapacity is the result of enterprises' rational expansion in the context of rapid growth in demand in the previous period. Second, different capacity reduction schemes are compared. The results suggest that some of the inefficient production capacity should be temporarily withdrawn from the market, rather than ordering all coal mine to limit production capacity in the same proportion. Third, we conduct a regression model to describe the long-term price trend of coal and establish a mean-reverting model to simulate the motion path of the coal price. According to the Monte Carlo simulation, we estimate the value of the real option of coal capacity and find it is higher than the capacity replacement cost. This demonstrates that the real option is economically feasible in application.