Back to the drawing board
The first three pilot build-operate-transfer (BOT) projects in
China ? the Laibin B and Changsha Power Projects and the Chengdu
Water Project ? having reached, or are about to reach, financial
close provides an opportune time to take stock of the BOT scheme.
Having put some of China's infrastructure and foreign capital requirements in context, we will identify some distinguishing features of the BOT scheme, discuss some of its practical advantages and challenges and assess what those experiences can tell us about the future development of project financing in China. Furthermore, while the BOT model may require refinement, many of its underlying principles provide a sound framework for, and are likely to dictate, the future development of project finance in China.
The track record ? the 9th Five Year Plan ? 1996 ? 2000
Chinese officials predicted that, of the overall $500 billion required for infrastructure spending between 1996 to 2000, foreign funds would account for 20% or $100 billion. To put this into perspective, $100 billion is equal to roughly 166 Laibin B, 83 Zhuhai and 39 Shandong transactions. Even with a wide margin of error that such statistics inevitably require ? especially when overtaken by a regional downturn ? the demand remains staggering. In the water sector alone, the central government has classified 300 cities as short of water, 108 as having serious water problems and 60 as being critically short of water. The daily water capacity is projected to increase by 30% before 2010.
In contrast, the size and number of foreign financed infrastructure projects to date, and the amount of associated foreign capital, has barely scratched the surface of this demand. Under the BOT scheme, Laibin B, Changsha and Chengdu account for only approximately $1.5 billion of foreign capital and 1500MW and 460,000m3 of installed power generating and water supply capacity.
Two traditional Chinese project finance models emerged as precursors to the BOT scheme: the multi-role and various innovative structures.
The multi-role structure
The multi-role project traditionally comprises a joint venture between foreign and local parties whereby the local party, normally the local water or power bureau, assumes most construction, operation, supply and offtake responsibilities and risks. The project seeks to achieve a minimum return to its investors by a minimum offtake at a tariff which reflects the actual cost of construction, operation and maintenance, taxes and reserves, debt service and minimum equity return ? the so-called cost-plus tariff.
Innovative structures
The recent period has also witnessed a number of innovative structures for normally smaller scale projects which have tested traditional norms of project finance and Chinese regulatory requirements. Such techniques have included various forms of equity or shareholder loans, and limited recourse financing at the foreign shareholder level, shortfall payments by the local party to achieve guaranteed returns to the foreign investor and the splitting of projects into a number of related joint ventures.
Each of these structures involves a greater or lesser degrees of risk on the Chinese participants and necessarily impose higher capital costs. These factors have led to relatively higher infrastructure commodity costs. In all, these are two risks that the policy makers and regulators are keen to avoid.
The classic Chinese BOT model
The BOT structure was designed to contain these risks. The classic model involves a foreign consortium bidding for a concession from a provincial or municipal government to build, own and operate an infrastructure project throughout a concession period. The bid documents would include a draft concession agreement, an offtake agreement with the local power or water company and the related technical specifications and financial information.
Simplistically speaking, the consortium would bear most risks relating to the construction ? such as cost overruns and delays ? and operation ? such as operating costs and performance standards ? of the plant. The Chinese parties would assume most fuel or raw water supply, offtake demand, political, force majeure and currency risks. The concession authority would also guarantee the performance of the local power or water company. The consortium would bid assumptions for the capital and operating costs of the plant which would form the basis of the project tariff. The tariff is normally only varied to reflect exchange rates fluctuations and to insulate the consortium from other risks borne by the Chinese parties. The tariff may therefore not reflect the consortium's actual cost of construction and operation.
The BOT experience
The BOT scheme has a number of advantages for the host government, local parties, foreign investors and creditors.
Clearer risk allocation ? In part by clearly drafted documents but also by the apparent adoption of a benchmark, the BOT scheme has brought a clearer risk allocation. In particular, the concession authority generally accepts responsibility for many of the China risks, which have traditionally pre-occupied foreign investors and their lenders. The contractual recourse to the concession authority has also reduced the concentration of performance and credit risk on the local Chinese party which prevails under the multi-role structure. As a consequence, foreign parties require less support and comfort letters from Chinese government agencies.
Competitive bidding ? The adoption of international competitive tendering has led to many significant advantages: transparency, fairness and more efficient allocation of resource and expertise. This has allowed bidders to focus on cost and technical factors rather than time consuming negotiation and political matters. This has added a welcome degree of certainty to the process and, as a consequence, lower tariffs.
Tariff risk ? The scheme has purported to reduce the tariff approval risk in comparison to multi-role and innovative schemes. First, the move away from cost-plus tariffs and guaranteed returns towards predominantly fixed tariffs have promoted a more objective application of the agreed tariff formula. Second, the specific pre-approval of the tariff formula in the offtake agreement seeks to ensure that the scope of the tariff approval authorities' further scrutiny is restricted to verification that the tariff formula is being applied.
Pre-Packaging of approvals ? Since the basic feasibility study approval is obtained before the bid and the bid documents identify the package of remaining approvals, the successful party has a clearer regulatory road map to financial close before it experiences costly time delays and incurs significant development costs. The packaging of approvals is also intended to reduce ongoing regulatory risks such as the continuance of approvals, tariff adjustment and foreign exchange issues.
So the BOT scheme has achieved three important and fundamental policy goals: a more equitable risk allocation, mitigation of government support and more reasonable pricing of infrastructure commodities.
However, from the perspectives of all participants, the BOT scheme requires further scrutiny and, perhaps, refinement in a number of areas. The following are some practical examples.
Role of the concession authority ? The pivotal role of the concession authority may have negative implications for foreign parties and Peoples Republic of China policy makers. First, there may be some undesirable concentration of risk on the concession authority by virtue of its underwriting of the local offtaker and widespread political and regulatory risks. This risk allocation demands extensive due diligence into the notoriously opaque world of local government finance. Furthermore, certain aspects of the risk allocation are the subject of ongoing debate. For example, is the concession authority really the most appropriate guarantor of foreign exchange for the project? Also, can the assumption by the concession authority of widespread political and force majeure risks stand the test of future legal and policy shifts in China? From the perspective of the Chinese policy makers, the BOT scheme may not yet represent the optimum equitable allocation of risk. Finally, this pivotal role may actually ignore the potentially more important relationship between the project company and the local power or water company.
Regulatory issues ? Despite the advantages described above, the regulatory challenges remain formidable. First, we still notice a tendency of government agencies to issue approvals in sequence (for example State Development and Planning Commission, Ministry of Foreign Economic and Trade Co-operation then State Administration of Foreign Exchange) rather than in parallel, with obvious implications on project timetables. In this sense, the BOT scheme is similar to other models. Second, there remain differing views between, and sometimes within, the various governmental agencies. Third, the promulgation of the 1997 Project Finance Regulations caused a degree of uncertainty on the BOT scheme. We take the view that the regulations do apply to BOT projects and that SDPC and SAFE must therefore issue a specific Project Financing Approval ? a view confirmed by SAFE recently. This causes additional time and cost pressures and may give the governmental agencies the ability to revisit regulatory and risk issues after the initial approvals, or worse, financial close. Such challenges can be mitigated by appropriate planning of the approval process and by shrewd use of any inter-governmental links between participating export credit agencies and multilaterals and the Chinese government.
Local equipment and financing ? With the increasing trend towards utilisation of local equipment and financing in China, one can legitimately challenge the almost exclusive use of foreign currency financing by the current BOT projects. For example, the Chengdu Water Project will source almost all its equipment in the Peoples Republic of China, yet there is no renminbi financing. Such currency mismatches potentially increase the costs of infrastructure development. Furthermore, the potentially significant role of Chinese banks has largely been ignored by the BOT scheme.
BOT Mark II?
The stark comparison between the traditional BOT and other models probably hides a gradual shift away from the extremes of these models.
For example, there is a discernable trend away from the traditional multi-role structure in favour of adopting many BOT features: competitive tendering, avoidance of real or perceived conflicts of interest, a clearer regulatory framework and only partial indexing of tariffs to capital and operating costs. Recent non-BOT projects evidence some of these trends, in particular, the involvement of foreign construction and O&M contractors and the attempts to involve the tariff approving authorities in a clearer framework for tariff adjustment. One may also foresee changes in how future projects address issues of fuel supply, offtake demand and political risks as the pace of liberalisation in China continues.
Furthermore, there is uncertainty on the future status of the pilot, SDPC sponsored, BOT scheme and an apparent impasse on the passing of the draft BOT Regulations . This impasse probably reflects some high level debates on the core issues of macro economic development and foreign investment. Past experience suggests that such debates take months, if not years, to conclude. In the meantime, the draft BOT Regulations remain subordinated legislation and one cannot predict their outcome with any certainty.
In the absence of any clear framework, BOT is likely to develop in an ad hoc way. The Beijing No 10 Water Plant, which is currently open for pre-qualification for the competitive tender, is one example of that trend. Whilst still not totally defined, the project is likely to follow a basic BOT structure. However, it appears to differ from the traditional BOT model in a number of respects.
The project is promoted by the Beijing Municipal Government and does not benefit from direct sponsorship by the SDPC. By itself, this should not have adverse implications.
The Beijing Municipal Government is likely to grant the concession by legislation, rather than a concession agreement, leaving the contractual risk allocation to be defined in an agreement between the winning consortium and the local water company. It is difficult to assess whether this will cause a radical alteration of the risk allocation (especially for those borne by the concession authority under the traditional BOT scheme). The obvious open question is what credit support for the local water company is contemplated or required.
There is likely to be significant renminbi financing, reflecting the high ? compared to Chengdu ? capital cost and the likely sourcing of equipment in the PRC.
Despite the small number of BOT projects to date, the scheme has helped define the framework for future infrastructure development in China. As a pilot scheme, it has been tempered by reality and requires refinement to keep pace with political, social and economic changes in China. Ultimately, the demand for further infrastructure resource and foreign capital is likely to be the most telling factor in ensuring its continuation in one form or another.
Having put some of China's infrastructure and foreign capital requirements in context, we will identify some distinguishing features of the BOT scheme, discuss some of its practical advantages and challenges and assess what those experiences can tell us about the future development of project financing in China. Furthermore, while the BOT model may require refinement, many of its underlying principles provide a sound framework for, and are likely to dictate, the future development of project finance in China.
The track record ? the 9th Five Year Plan ? 1996 ? 2000
Chinese officials predicted that, of the overall $500 billion required for infrastructure spending between 1996 to 2000, foreign funds would account for 20% or $100 billion. To put this into perspective, $100 billion is equal to roughly 166 Laibin B, 83 Zhuhai and 39 Shandong transactions. Even with a wide margin of error that such statistics inevitably require ? especially when overtaken by a regional downturn ? the demand remains staggering. In the water sector alone, the central government has classified 300 cities as short of water, 108 as having serious water problems and 60 as being critically short of water. The daily water capacity is projected to increase by 30% before 2010.
In contrast, the size and number of foreign financed infrastructure projects to date, and the amount of associated foreign capital, has barely scratched the surface of this demand. Under the BOT scheme, Laibin B, Changsha and Chengdu account for only approximately $1.5 billion of foreign capital and 1500MW and 460,000m3 of installed power generating and water supply capacity.
Two traditional Chinese project finance models emerged as precursors to the BOT scheme: the multi-role and various innovative structures.
The multi-role structure
The multi-role project traditionally comprises a joint venture between foreign and local parties whereby the local party, normally the local water or power bureau, assumes most construction, operation, supply and offtake responsibilities and risks. The project seeks to achieve a minimum return to its investors by a minimum offtake at a tariff which reflects the actual cost of construction, operation and maintenance, taxes and reserves, debt service and minimum equity return ? the so-called cost-plus tariff.
Innovative structures
The recent period has also witnessed a number of innovative structures for normally smaller scale projects which have tested traditional norms of project finance and Chinese regulatory requirements. Such techniques have included various forms of equity or shareholder loans, and limited recourse financing at the foreign shareholder level, shortfall payments by the local party to achieve guaranteed returns to the foreign investor and the splitting of projects into a number of related joint ventures.
Each of these structures involves a greater or lesser degrees of risk on the Chinese participants and necessarily impose higher capital costs. These factors have led to relatively higher infrastructure commodity costs. In all, these are two risks that the policy makers and regulators are keen to avoid.
The classic Chinese BOT model
The BOT structure was designed to contain these risks. The classic model involves a foreign consortium bidding for a concession from a provincial or municipal government to build, own and operate an infrastructure project throughout a concession period. The bid documents would include a draft concession agreement, an offtake agreement with the local power or water company and the related technical specifications and financial information.
Simplistically speaking, the consortium would bear most risks relating to the construction ? such as cost overruns and delays ? and operation ? such as operating costs and performance standards ? of the plant. The Chinese parties would assume most fuel or raw water supply, offtake demand, political, force majeure and currency risks. The concession authority would also guarantee the performance of the local power or water company. The consortium would bid assumptions for the capital and operating costs of the plant which would form the basis of the project tariff. The tariff is normally only varied to reflect exchange rates fluctuations and to insulate the consortium from other risks borne by the Chinese parties. The tariff may therefore not reflect the consortium's actual cost of construction and operation.
The BOT experience
The BOT scheme has a number of advantages for the host government, local parties, foreign investors and creditors.
Clearer risk allocation ? In part by clearly drafted documents but also by the apparent adoption of a benchmark, the BOT scheme has brought a clearer risk allocation. In particular, the concession authority generally accepts responsibility for many of the China risks, which have traditionally pre-occupied foreign investors and their lenders. The contractual recourse to the concession authority has also reduced the concentration of performance and credit risk on the local Chinese party which prevails under the multi-role structure. As a consequence, foreign parties require less support and comfort letters from Chinese government agencies.
Competitive bidding ? The adoption of international competitive tendering has led to many significant advantages: transparency, fairness and more efficient allocation of resource and expertise. This has allowed bidders to focus on cost and technical factors rather than time consuming negotiation and political matters. This has added a welcome degree of certainty to the process and, as a consequence, lower tariffs.
Tariff risk ? The scheme has purported to reduce the tariff approval risk in comparison to multi-role and innovative schemes. First, the move away from cost-plus tariffs and guaranteed returns towards predominantly fixed tariffs have promoted a more objective application of the agreed tariff formula. Second, the specific pre-approval of the tariff formula in the offtake agreement seeks to ensure that the scope of the tariff approval authorities' further scrutiny is restricted to verification that the tariff formula is being applied.
Pre-Packaging of approvals ? Since the basic feasibility study approval is obtained before the bid and the bid documents identify the package of remaining approvals, the successful party has a clearer regulatory road map to financial close before it experiences costly time delays and incurs significant development costs. The packaging of approvals is also intended to reduce ongoing regulatory risks such as the continuance of approvals, tariff adjustment and foreign exchange issues.
So the BOT scheme has achieved three important and fundamental policy goals: a more equitable risk allocation, mitigation of government support and more reasonable pricing of infrastructure commodities.
However, from the perspectives of all participants, the BOT scheme requires further scrutiny and, perhaps, refinement in a number of areas. The following are some practical examples.
Role of the concession authority ? The pivotal role of the concession authority may have negative implications for foreign parties and Peoples Republic of China policy makers. First, there may be some undesirable concentration of risk on the concession authority by virtue of its underwriting of the local offtaker and widespread political and regulatory risks. This risk allocation demands extensive due diligence into the notoriously opaque world of local government finance. Furthermore, certain aspects of the risk allocation are the subject of ongoing debate. For example, is the concession authority really the most appropriate guarantor of foreign exchange for the project? Also, can the assumption by the concession authority of widespread political and force majeure risks stand the test of future legal and policy shifts in China? From the perspective of the Chinese policy makers, the BOT scheme may not yet represent the optimum equitable allocation of risk. Finally, this pivotal role may actually ignore the potentially more important relationship between the project company and the local power or water company.
Regulatory issues ? Despite the advantages described above, the regulatory challenges remain formidable. First, we still notice a tendency of government agencies to issue approvals in sequence (for example State Development and Planning Commission, Ministry of Foreign Economic and Trade Co-operation then State Administration of Foreign Exchange) rather than in parallel, with obvious implications on project timetables. In this sense, the BOT scheme is similar to other models. Second, there remain differing views between, and sometimes within, the various governmental agencies. Third, the promulgation of the 1997 Project Finance Regulations caused a degree of uncertainty on the BOT scheme. We take the view that the regulations do apply to BOT projects and that SDPC and SAFE must therefore issue a specific Project Financing Approval ? a view confirmed by SAFE recently. This causes additional time and cost pressures and may give the governmental agencies the ability to revisit regulatory and risk issues after the initial approvals, or worse, financial close. Such challenges can be mitigated by appropriate planning of the approval process and by shrewd use of any inter-governmental links between participating export credit agencies and multilaterals and the Chinese government.
Local equipment and financing ? With the increasing trend towards utilisation of local equipment and financing in China, one can legitimately challenge the almost exclusive use of foreign currency financing by the current BOT projects. For example, the Chengdu Water Project will source almost all its equipment in the Peoples Republic of China, yet there is no renminbi financing. Such currency mismatches potentially increase the costs of infrastructure development. Furthermore, the potentially significant role of Chinese banks has largely been ignored by the BOT scheme.
BOT Mark II?
The stark comparison between the traditional BOT and other models probably hides a gradual shift away from the extremes of these models.
For example, there is a discernable trend away from the traditional multi-role structure in favour of adopting many BOT features: competitive tendering, avoidance of real or perceived conflicts of interest, a clearer regulatory framework and only partial indexing of tariffs to capital and operating costs. Recent non-BOT projects evidence some of these trends, in particular, the involvement of foreign construction and O&M contractors and the attempts to involve the tariff approving authorities in a clearer framework for tariff adjustment. One may also foresee changes in how future projects address issues of fuel supply, offtake demand and political risks as the pace of liberalisation in China continues.
Furthermore, there is uncertainty on the future status of the pilot, SDPC sponsored, BOT scheme and an apparent impasse on the passing of the draft BOT Regulations . This impasse probably reflects some high level debates on the core issues of macro economic development and foreign investment. Past experience suggests that such debates take months, if not years, to conclude. In the meantime, the draft BOT Regulations remain subordinated legislation and one cannot predict their outcome with any certainty.
In the absence of any clear framework, BOT is likely to develop in an ad hoc way. The Beijing No 10 Water Plant, which is currently open for pre-qualification for the competitive tender, is one example of that trend. Whilst still not totally defined, the project is likely to follow a basic BOT structure. However, it appears to differ from the traditional BOT model in a number of respects.
The project is promoted by the Beijing Municipal Government and does not benefit from direct sponsorship by the SDPC. By itself, this should not have adverse implications.
The Beijing Municipal Government is likely to grant the concession by legislation, rather than a concession agreement, leaving the contractual risk allocation to be defined in an agreement between the winning consortium and the local water company. It is difficult to assess whether this will cause a radical alteration of the risk allocation (especially for those borne by the concession authority under the traditional BOT scheme). The obvious open question is what credit support for the local water company is contemplated or required.
There is likely to be significant renminbi financing, reflecting the high ? compared to Chengdu ? capital cost and the likely sourcing of equipment in the PRC.
Despite the small number of BOT projects to date, the scheme has helped define the framework for future infrastructure development in China. As a pilot scheme, it has been tempered by reality and requires refinement to keep pace with political, social and economic changes in China. Ultimately, the demand for further infrastructure resource and foreign capital is likely to be the most telling factor in ensuring its continuation in one form or another.
Request a Demo
Interested in IJGlobal? Request a demo to discuss a trial with a member of our team. Talk to the team to explore the value of our asset and transaction databases, our market-leading news, league tables and much more.