China has attracted the attention of most leading international investors in the power business since its electricity generation market was opened to foreign private investment in the early 1990s. By the end of 1999, more than 24,000MW of capacity in Mainland China had been developed on the basis of foreign direct investment- significantly more than in most other emerging markets.
However, foreign involvement in the Chinese power sector has seldom been easy and it became even more difficult after the onset of the Asian financial crisis in the second half of 1997. The crisis exacerbated existing problems for international investors in the country's power sector, leading to a sharp fall in investor enthusiasm and in new investment commitments.
Until late 1997 the growth in Chinese power consumption had appeared inexorable. Electricity use grew at an average rate of 9 percent a year from 1990 to 1997, with supply falling consistently short of potential demand. Most of the power was used by heavy industry. While electricity use expanded rapidly in the residential, commercial and light industrial sectors in the 1990s, more than 60 percent of total output was still consumed, often very inefficiently, by state-owned enterprises (SOEs) in the heavy industrial sector in 1997.
All this changed dramatically from late 1997. Power use by the SOEs slumped as weir revenues collapsed because of domestic deflation and increased competition in export markets. As a result, Chinese electricity demand increased by only 2.5 percent in 1998, and for the first time in the country's history a substantial surplus of generating capacity emerged in many parts of the country. By mid-1999 around 27,000MW of surplus capacity existed, although the lack of interconnection between the country's 15 grids meant that some areas were still under-supplied.
The travails of the SOEs had an immediate impact on those foreign investors in the power sector that had built captive generation plants for SOEs. Since 1998 many of these investors have faced difficulties in securing payment for their power sales to the financially-stricken SOEs, in spite of having ?take-or-pay' contracts for the sales.
The crisis had a similar effect on international investors in independent power producer projects – generating plants built by private investors to sell electricity on a wholesale basis to state-owned power companies. Almost none of the projects secured approval for the tariff increases due under their power purchase agreements (PPAs) in the 1998 and 1999 annual reviews conducted by the commodity pricing authorities. Several – projects also reported that payments owed under their ?take-or-pay' agreements had not been honoured when the grid authorities failed to dispatch their plants.
Investors regarded these payment problems, as a clear breach of contract. However, the limited development of Chinese contract law remains one of the main difficulties facing international investors. The guiding principle underpinning China's electric power law is ?affordability' – payments to generators must be based on the ability of final consumers to pay, and foreign investors must share this market risk with local investors, regardless of what their contracts stipulate.
The payment problems realised some of the main concerns that international investors had always had with China's legal and regulatory framework. In particular, the discretionary annual reviews conducted by the commodity pricing authorities contrasts with the automatic pass through of costs that investors typically require in the PPAs for independent power producer projects elsewhere in the world. In addition, Chinese law does not allow government guarantees for the power payments of state-owned companies. These sovereign guarantees are commonplace elsewhere.
Payment problems were the most immediate cause of concern for international investors. However, the appearance of surplus generating capacity gave the Beijing power authorities unprecedented leverage over power generators. Policies that had previously been downplayed because of the need to secure foreign investment in a capacity-constrained system have been pressed far more forcefully since early 1998.
One key problem has been the insistence that foreign investors should use local rather than imported equipment, and should employ construction groups that include local partners on an equal basis with their international counterparts. In combination, these requirements have severely reduced the likelihood of foreign investors securing project financing from international lenders. Project financing is preferred by most international power companies. It involves limited recourse to the investors' corporate balance sheet, with the revenue stream from the self-standing project thus required to meet all project costs.
International lenders prefer equipment supplied by established and well resourced companies that can offer sufficient recompense (liquidated damages) in the event that equipment problems compromise the project's viability. The lenders similarly prefer plant construction undertaken by deep pocketed contractors capable of backing their commitments with substantial liquidated damages. However, international partners in an engineering, procurement and construction consortium are unlikely to provide liquidated damages cover if they do not have control over the project, while most Chinese construction companies do not possess the balance sheet strength needed to back their obligations. Similarly, although Chinese generating equipment has a long track record of successful operation, most manufacturers have insufficiently strong balance sheets to offer adequate liquidated damages.
The government's reassertion of its long-standing policy of closing small conventional thermal power plants on environmental and efficiency grounds also concerned those foreign investors with stakes in small power plants. Many foreign investors made their first investments in these types of projects that benefited from a shorter approval process than for those requiring central government agreement, and offered entry into the market at relatively low cost.
Moreover, all investors were concerned by government plans, announced in late 1998, to restructure the power generation market and create a pool-based competitive system within the ensuing 10 years. As part of the changes, government officials said that no new power purchase agreements that included take-or-pay terms or fixed power sales tariffs would be approved.
The restructuring plans have been advanced strongly since they were first announced. As a first stage, the state-owned power companies are being stripped of their governmental functions so that they act solely as enterprises. In the second stage, the generation activities of the companies are being separated from the ?natural monopoly' activities of transmission and distribution. In the third stage, pilot projects are being carried out to introduce competition between the generators, initially covering about 15-20 percent of their output. The first lot projects got under way in Zhejiang province and else-where at the beginning of January 2000.
Lack of transparency
While many international investors support these changes in principle, most of those with approved projects have been concerned as to whether their power purchase agreements would be honoured, given the problems that some projects have already experienced with their take-or-pay payments and tariff approval. At the same time, the developers of new projects were concerned that the new market structure would be insufficiently transparent to justify investing in what would now be merchant projects – plants that sell their output into a competitive market without the backing of long-term power sales agreements.
These issues combined with the economic problems afflicting Asia and the specific issues raised by the deflationary spiral in China and the collapse of Gitic to reduce international investor and lender confidence in the Chinese private power market from mid-1998. As a result, even the strongest projects have experienced protracted problems in securing financing and few new deals have been announced since then.
Given the problems, what are the prospects for international investors in the Chinese private power market? First, it would be wrong to regard all the developments since 1998 as negative. For instance, in mid-1999 it was indicated that foreign investors would be allowed to seek yuan from local banks for investment in fixed assets. This had not previously been allowed and could result in renewed progress on many projects – especially for those proposing the use of local equipment and construction. Chinese lenders are more pre-pared than international banks to accept the guarantees offered by the local equipment and construction companies.
The current surplus of capacity is in any case unlikely to last for long, and is not distributed uniformly. New capacity will be needed, and foreign investors will be expected to supply some of it. This will require concessions on the part of the authorities.
Huge new capacity required
The amount of new generating capacity required over the next decade will be substantial, albeit lower than previously expected by international investors and lower than current official projections. The report projects that 6,000-7,000MW of new capacity a year will be needed.
The amount of the additional capacity that will involve foreign direct investment remains uncertain. Much will depend on the approach of the State Power Corporation (SPC), the state company in charge of overall grid operations. The SPC is charged with raising investment for the sector and, through direct or indirect subsidiaries, owns a substantial part of the country's installed capacity.
There have been positive indications in this respect. The SPC has already made clear its commitment to listing the shares of its subsidiaries on overseas markets when the conditions are right. Many of the offerings are likely to include a tranche set aside for strategic international investors. SPC subsidiaries may also enter into joint ventures with foreign investors in developing the large-scale hydro-electric, nuclear and minemouth coal-fired projects that fall within their remit. The SPC has already signed co-operation agreements with several foreign power companies that could pave the way for such investments.
Other opportunities may arise from the policy of privatising existing generation capacity. The pioneering offer of the Laibin `A' coal-fired plant in Guangxi Zhuang autonomous region in late 1998 showed that the privatisation of existing generation assets now has official sanction, although that particular sale appears to have ground to a halt.
A substantial number of Chinese generating assets could come onto the market for sale in the next few years as the power sector is restructured. The success of the sales will depend on some convergence of views on the valuation of existing assets, which private investors and the Chinese government tend to approach very differently. The success will also depend on the availability of PPAs with take-or-pay terms and fixed tariffs that the government has said will no longer be allowed in most circumstances.
SPC officials have nevertheless hinted that PPAs could be offered for some privatisation projects that involve the environmental upgrading and expansion of pollutive coal-fired units. China hosts a substantial amount of ageing and inefficient coal-fired capacity that could be repowered at a relatively low unit cost.
PPAs also seem likely to be offered for some gas-fired projects, involving both green-field sites and conversions from coal. Gas-fired projects are being pursued more positively than before by the central government for environmental reasons. The schemes may involve either piped indigenous gas or imported liquefied natural gas. Incentives for the use of gas in power have been promised. As well as PPAs with take-or-pay terms, these incentives include more flexible gas pricing and project approval priority.
At present, gas-fired capacity accounts for a minuscule share of overall generating capacity, reflecting China's limited gas supply infrastructure and the remoteness of most gas reserves. Coal accounts for 75 percent of capacity and hydroelectric plants for much of the remainder. However, gas-fired generators could account for the use of at least 40 percent of the 80bn cubic metres of gas that it is projected will be available by 2010.
Even so, the dented confidence of foreign investors in the market will only be revived if the key problems and uncertainties are resolved. In particular, it should be observed that the problems with existing PPAs has not been the absence of fixed tariffs and take-or-pay terms, but their enforcement. Progress with Chinese private power schemes will be slow until ways are found of resolving these problems, including the discretionary annual review of tariff costs. There will also need to be greater clarity concerning the future shape and transparency of the generation market, and the place of foreign investors within it, as it moves to full competition.
The article is based on a new report by Martin Daniel on Private Power in China – Risks and Opportunities published in London by FT Energy (telephone +44 171 896 2330, fax +44 171 896 2275).