ON July 30, China's Ministry of Housing and Urban-Rural Development released the country's 12th five-year plan (for 2011-2015) for the national development of urban gas.

The plan calls for setting up a more transparent tariff mechanism to pass through upstream costs to downstream users and more than doubling the country's natural-gas supply to 120 billion cubic meters by the end of 2015 from 53 billion cubic meters in 2010.

If implemented, these changes would be credit positive for our rated city-gas distributors as they would remove the uncertainty hanging over China's evolving regulatory framework.

Despite robust growth and the government's support in promoting more use of natural gas, city distributors face the risk of delayed cost pass-throughs, which impair profitability.

China's central government controls upstream, wellhead prices and transmission tariffs for piped natural gas, but leaves end-user price adjustments to local governments. This dichotomy in regulation results in time lags between adjustments for upstream and downstream costs, particularly residential tariffs.

Regulators' concerns about inflation and lengthy approval processes have resulted in distributors often waiting six to 12 months before being able to pass cost increases on to residential users.

In 2011, China's total consumption of natural gas rose 16 percent, while the volume of imported gas jumped 45 percent as a ramp-up in domestic productive capacity was not sufficient to cover total demand.

China National Petroleum Corporation, which supplies most of the country's natural gas and imports via pipelines from central Asia, must sell its imported natural gas at a low fixed price to domestic Chinese distributors, and in doing so, incurs losses. So far, CNPC's much larger domestic-gas production operation has more than compensated for those import losses, although as imports outpace domestic output, losses are likely to grow.

We expect the central government to raise upstream tariffs to provide CNPC with enough economic incentive to continue importing adequate amounts of natural gas to cover rising demand.

However, without a timely and efficient cost-pass-through mechanism, an upstream tariff increase will squeeze downstream gas distributors.

Such a scenario occurred in 2010 when local governments delayed approving tariff increases to end users' after upstream gas prices rose.

Ameliorating threat

The central government's implementation of the 12th five-year plan would ameliorate that threat.

China's central government uses five-year plans to guide the development of key industries.

Although not officially a regulation, these plans direct different government agencies to pass detailed rules and regulations. We expect that a more transparent and efficient tariff-setting mechanism could be in place in the next one to two years, thus minimizing the adverse impact of potential increases in upstream prices.

Compared with most industrialized countries, the passing through of costs to users in China's regulatory framework is more uncertain, owing to it being less developed, less transparent and subject to excessive governmental intervention.

However, if the plan for the city gas distributors comes to fruition, it would change our current assessment of China's regulatory framework and bolster the financial and credit profiles of the affected distrib10utors.

Kai Hu is a vice president and senior analyst at Corporate Finance Group with Moody's Investors Service (Beijing) Ltd. Ivy Poon is an associate Analyst at Corporate Finance Group with Moody's Investors Service Hong Kong Ltd. The opinions are their own.