China's LED industry is facing a drastic shake-up caused by failing firms and price drops, said a report released on Thursday.

The average price of Chinese LED chips declined 32 percent year on year in 2012, according to a report issued by the Gaogong LED Industry Research Center.

The government has encouraged the use of LED lighting in order to reduce emissions, triggering intense competition among small LED manufacturers.

From 2009 to 2011, the number of new LED chip companies hit a record high of more than 80. But 20 of them went out of business in 2012, the report showed.

"Tempted by tax breaks and government subsidies, LED companies have boosted their production capacity to a level that far outstrips demand," said Qi Faxin, a senior analyst at SEMI (Semiconductor Equipment and Materials International) China.

Industry observers warned that the industry will face the same problems as the solar panel industry if excessive investment is not curbed.