July 2011, Tom Luckock
Chinese water continues to attract a growing class of investors. No longer is it the preserve of a few dedicated niche water developers. In recent years, we have seen increased levels of activity from infrastructure investors, Japanese trading houses and insurers as well as the traditional developers. This trend will continue as the Chinese Central Government places even greater pressure on municipal authorities to increase water treatment levels and as China grapples with increasing supply shortages.
Norton Rose Group has advised foreign investors on more than 20 PRC water treatment, water supply, desalinated water (desal) and waste water treatment projects over the last 18 months. There is no standard road map for closing these deals and water continues to be a highly fragmented, localized investment with different regimes, documentation and structures applying in each city. However, similar risks tend to emerge.
In this article we explore the current market, the delivery models and documentation and highlight some of the challenges for foreign investors in the sector.
Water infrastructure investment in China
China has made significant inroads into developing and modernising its urban water infrastructure. However, continued investment remains a priority of the PRC Central Government. Between 2006 and 2010, there was an estimated 700 billion RMB in investment (both public and private funding) in the water sector across China. It is expected that this figure will increase to 2 trillion RMB by 2015 in line with the objectives of the recently adopted Twelfth Five Year Plan. Foreign investment will be an important source of funding, but the role for foreign players will continue to be secondary to the role played by dominant local players like Beijing Capital, Beijing Enterprises, Chongqing water.
Three asset classes, three risk profiles
There are three key classes of water infrastructure open to foreign investors: wastewater treatment; water treatment; and desal, and each offers a slightly different risk profile. Water distribution and supply is also open to foreign investors, but generally, investors will only consider supply assets where necessary to secure water supply for a water treatment plant and we have not covered supply assets in this article.
Wastewater treatment projects continue to be the mainstay for most PRC water portfolios. These projects involve the treatment of waste water produced by Chinese industrials which is then discharged into the river or the municipal water system. Investment in wastewater treatment offers a 25 to 30 year long term income stream under take and pay conditions at a return on investment of around 9 per cent to 15 per cent. The tariff and regulatory regime for these projects is established and there is a well trodden path for foreign investors into the sector.
Desal opportunities are occasional and recent years have only seen key project developments in Qingdao, Caofeidian and Tianjin. China is cautious around the energy efficiency and cost of desal (desal product water tends to be about 4 to 8 times more expensive to produce than other treated water) and as a result, Chinese authorities have not developed a strong regulatory framework to support the sector. On the one hand the regulatory vacuum means there is less certainty around aspects of a desal project, such as the need for a concession agreement and the regulation of tariffs, on the other hand it means there is less scrutiny over the cap on investment returns that is applied by the authorities to projects. Yet despite the uncertainty, desal projects still offer the same long term 25 to 30 year offtake as a waste water treatment, although on occasions the offtaker may be an industrial consumer, rather than a municipal water utility.
Water treatment projects are not structured under take and pay arrangements and the offtake of water is structured through short term supply agreements with individual consumers. To date, the sector has attracted limited foreign capital. Many foreign investors remain concerned about the will of the local government in second tier cities to set uniform tariffs that pass the full cost of water onto consumers and many infrastructure investors’ internal investment criteria also require a long term offtake to be in place. Yet for investors satisfied with the local tariffs and who can get comfortable with the market risk around demand for water within a project’s catchment area, water treatment offers potential for greater upside than waste water treatment and desal projects. This is because unlike waste water treatment and desal, returns on investment are not capped and so increased profit from efficient operation and construction and any increase in the numbers of consumers in the catchment area, passes directly through to the investor.
Project structure and documentation
PRC water projects are usually delivered using Build Operate Transfer (BOT) or Transfer Operate Transfer (TOT) delivery models with projects awarded through a tender process. Typically, the concession agreement will be entered into with the municipal authority, or a local finance or construction bureau of the municipal authority. Under PRC law, the term of the concession cannot extend beyond 30 years. As a result, a concession term will normally be for 25 to 30 years with an obligation to return the project to the local water utility or joint venture partner at the end of that term. The municipal authority will provide broad policy support for the project during the concession term, however its commitment will fall short of standing behind the obligations of the local water utility, as PRC government authorities are not permitted to guarantee an investor’s return.
For desal and waste water treatment the project company will have a long term offtake in place with the local water municipality. Generally, the minimum guaranteed offtake volume that the local water utility will assume, is set at around 80 per cent of the capacity of the plant. However, for many projects the minimum guarantee may fall away part way through the concession term, by which time the project company should have repaid its debt and have a reasonable picture of the supply of influent water. For water treatment there is no guaranteed offtake and the investor will need to enter into short term purchase agreements on terms approved by the authorities with local consumers. Under these short term arrangements investors take market risk on demand from consumers and they will also in practice, assume a degree of risk on supply of water from the local reservoir. Supply risk cannot be passed through to the end consumer as the project company must guarantee 24 hour supply of treated water. However, the local municipality will normally accept an obligation in the concession agreement to step in to guarantee supply in the event of local shortages.
Plants are constructed on a multi contractor basis, generally with different contractors responsible for the plant, equipment, effluent and influent pumps and pipes. Chinese financiers and investors do not demand a single contractor to wrap construction risk for the entire project and so projects can be delivered more cheaply on this basis, with up to 10 contractors contracting directly with the project company. The project company needs to manage contractor interface risk, particularly in respect to delays, because the municipal authority and sometimes the land resources bureau can (but will not always) impose liquidated damages for delays in construction. Liability for liquidated damages can be passed through to contractors, but because the contractors will generally not have strong balance sheets, liability ultimately rests with the project company. However, apart from risks around delay liquidated damages, investors generally take limited construction risk on the projects, because under the tariff calculation formula most construction cost overruns can be passed through to the water utility offtaker as an increase in the tariff.
The vast majority of water projects are financed by local banks with light documentation, low security and low interest rate arrangements. Typically finance will be provided on a non recourse basis, for an 8 to 12 year tenor secured by a limited security package which may only be a pledge over project receivables combined with bank account controls. Gearing levels tend to be around 20/80 for RMB debt reducing to 33/66 if funding is in forex and the borrower is foreign invested. There are some signs, however, that Chinese bank lending is being reined-in and at the same time, some PRC banks are becoming cautious around projects with certain local water utilities. Foreign bank exposure to the sector remains limited. However, there are signs that some foreign banks are considering the sector.
In most countries, water tariffs for desal and waste water treatment projects will be determined through a competitive bidding process with oversight from an industry regulator. In China, the determination of tariffs is not transparent and this has led to a wide variance in tariffs across cities and provinces (we have seen tariff variances of up to 200 per cent for similar projects in different locations).
For wastewater and desal the tariffs are calculated on a project by project basis, based upon the costs of the project plus a reasonable rate of return for the investor. At the same time, the tariff should be benchmarked against other plants in the local area and against the tariffs submitted by other bidders for the project. Ultimately, the authorities aim to ensure that the tariff is set so that the investors return on investment is within a range of 9 to 13 per cent.
The initial tariff will be determined based upon the cost of the project set out in a feasibility study report that is submitted by the project company as part of its bid for the project. This tariff is applied to water treated during the initial commissioning period which normally lasts for around 6 months while the project is inspected and tested by the authorities. At the end of the commissioning period, the tariff will be adjusted based upon the actual construction cost for the project.
It is important that investors understand the tariff calculation process, as projects can be structured to minimise the impact of the investment return caps. Some investors put in place service agreements with the project company to extract service fees from the project (which are not calculated within the investment return cap). Many local developers will also extract additional revenues through their affiliated construction contractors who build the project.
For water treatment plants, the local municipalities apply a uniform tariff for water that applies to all water treatment projects in the city. The tariff varies depending upon the class of consumer, with industrial consumers paying significantly more for their water than residential consumers. The tariff is broadly determined based upon the production costs for the most inefficient plant in the city (which plant will generally be an older, state-owned water treatment plant). As a result, unlike for waste water treatment and desal, a water treatment investor is incentivised to operate efficiently, as cost savings pass through to the investor’s bottom line.
Probably the key risk facing investors in the water sector is around receivables. In the PRC, local governments and in turn local water utilities, receive limited direct funding from the Central Government. They are reliant upon profits from the sale of land, the issuance of municipal bonds and a to a more limited extent local tax revenues to fund new projects. At the same time, the wastewater treatment charges that form part of the water utility bill for end consumers, rarely covers the full cost of treatment.
Given this, investors need to understand the local water utility’s source of funding, the amount of the local water treatment fee, collection rates and levels of non-revenue water as all of these factors will feed into the likelihood of facing receivables issues. Importantly, if the full cost of waste water treatment is not passed through to end consumers, then investors need to understand whether there is provision for payment of the balance of the tariff from the local government’s budget.
Chinese water projects involve a unique set of risks and opportunities and each class of project involves a slightly different risk profile. Investors need to take the same precautions that they take for water in other parts of the world, but Chinese projects also involve a degree of local risk which means it is important to understand and adapt to the local regulatory framework (or lack of it).