The financial closing of China's third build-operate-transfer (BOT) project, the Chengdu No. 6 Water Treatment Plant, was due by the end of last month. Only a couple of weeks after the original deadline of March 12, project sponsors Companie Generale Des Eaux (CGE) of France and Marubeni of Japan were expected to announce the signing of financial documentation for loans representing about 50 percent of the total project cost of just over US$100m.
The Chengdu- project is the latest to be tendered under the supervision of the State Development Planning Commission (SDPC) as part of a BOT ‘pilot projects' programme under a notice known as the BOT Circular.
The SDPC had originally planned for an initial batch of five BOT pilot projects which would cover a variety of basic infrastructure sectors: power, water and transportation. These model projects could then serve as blueprints for local governments to independently develop projects in these sectors in the context of an expanded programme.
In the wake of Asia's financial woes, plans to expand the programme have been shelved temporarily. The government has understandably been reluctant to take on substantial tariff obligations and foreign currency debt under present economic circumstances. Nevertheless, the success of the Chengdu project will again demonstrate the effectiveness of BOT as a tool for directing foreign investment into high-priority infra-structure, particularly in less-developed areas of the country.
What is BOT?
The BOT Circular in 1995 was a turning point for foreign investment in and financing of key infrastructure projects in China. Other foreign-invested infrastructure projects became bogged down in the many obstacles to bankability which remain deeply entrenched in China's administrative and legal systems. These obstacles include a complex and opaque approval process, conflicts of interest in the project contracts and an untested security law. China's BOT model bypassed these obstacles with remarkable efficiency to deliver financing at reasonable cost and in record times.
BOT involves the government turning over temporarily to private investors a project of a kind which normally would be considered to be a public sector responsibility. The private company finances and builds the project, operates it for a fixed period during which it makes its return, then returns the project to the government. In the Chengdu project, CGE and Marubeni will design and construct the water treatment plant, own and operate it during a concession period of 18 years, then transfer it back free of charge to the city government.
High political risk
The critical document in a BOT project is the concession agreement, in which the government sets out its required specifications for the project, grants to the private company the right to carry out the project, and promises to provide all necessary government support for the project. Because projects in areas such as water cut into traditional government functions, they involve a high degree of political risk, and a high level of support may be required to reassure investors or lenders that their rights will be protected throughout the concession period.
In cases where the only possible buyer for the product is a government-owned utility, the utility will generally agree to buy all or part of the project's output under an offtake agreement. Since a steady and predictable revenue stream is essential to attract lenders, the project company will of course prefer a greater minimum take, a more fixed price and a longer term. Such offtake agreements are also common in non-BOT projects with monopoly buyers. However, BOT offers the great advantage that in cases where the utility's credit is not strong enough to satisfy lenders, the concession-granting government can guarantee these payments and so make the deal financeable. For example, municipal tap water companies in China have tradition-ally operated on the basis of government subsidies and therefore do not have strong credit histories. In the case of Chengdu, the city government has in the concession agreement guaranteed all of the tap water company's offtake payments.
Other features of the BOT pilot project that have proven attractive to foreign investors and lenders include:
-a fair and transparent bidding process under SDPC supervision
-100 percent foreign ownership, eliminating pressure from local utilities to retain control
-fairly generous compensation payments for many early termination events which are government guaranteed
-a ‘fast-track' contract negotiation and approval process which has proven efficient guaranteed convertibility for debt service and equity returns, which eliminates foreign exchange risk for lenders and investors alike.
In the first three BOT projects, the SDPC has set and maintained a high standard of documentation, which has been a major factor in the programme's credibility and has reduced negotiation time and costs for both government and sponsors.
The Chengdu project is the first BOT water treatment project – the previous two BOT projects were both power plants. While water projects are generally less technically complex and less costly than power generation, the water sector presents its own set of obstacles and risks. The successful closing of Chengdu is expected to demonstrate that the BOT model for water projects offers a satisfactory resolution of these problems.
Because water is even more of a basic necessity than power, water prices have been kept lower relative to real costs than electricity charges. Water supply companies have in the past been more heavily subsidised and therefore are now less creditworthy on a stand-alone basis than power grid operators. The credit support provided by the government guarantee of offtake payments is therefore even more important than in a power deal.
However, while power projects are usually managed at the provincial level and BOT power concessions have been granted by provincial governments, tap water companies are city owned and regulated. Thus the concession-granting authority and credit support provider for Chengdu is the city government. One of the issues in Chengdu has been whether the BOT format would be less attractive if supported by the city government, which is even further removed than its provincial counterpart from the central government's ‘sovereign guarantee,' and presumably more limited in its resources. In fact, the successful financing of Chengdu as a city concession will show that this has not been perceived as a major difficulty.
Efficient transportation of water is also an issue for many water projects. Sources of clean water are often located far from the large urban centres these plants are built to service. Often the single largest expense in a water project will be the construction of many kilometres of transmission pipeline to transport raw water to, and treated water from, the water treatment plant itself. Since the tap water company does not have the money to build this pipeline itself, the pipeline must be included in the project. But while the project company and its lenders may be prepared to take the risk of building the pipeline, its ongoing maintenance and repair over the entire concession period is quite a different matter.
The problem is partly one of ownership to have the project company acquire land-use rights to the entire length of the pipeline would be very costly, but without that it is difficult to legally guarantee it the access rights it will need to carry out repair work. Also, if there are parallel pipelines nearby which are already operated by the tap water company, the project pipelines will have to be linked to them at intervals. This may have the effect of incorporating the pipeline into the tap water company's ‘water distribution network,' investment in which is off-limits to foreigners.
The Chengdu solution is to put ‘BT' into the BOT arrangement. That is, CGE will build the 27km pipeline from the plant to the city of Chengdu and immediately transfer ownership and operation of it to the municipal government. Compensation for the BT pipeline will be included in the guaranteed payments for the overall project, and if the concession is terminated the city will repay the full cost of the pipeline even if no compensation at all is payable in respect of the treatment.
A third category of risk particularly important to water projects is future change to the availability and quality of the raw water at source. The plant will not be able to produce the required quantity of treated water if drought has dried up the water source, or if for natural or manmade reasons the flow of water into the source changes its course. Over the term of the concession, there may be a real risk that upstream flooding or increased pollution result in deterioration of the quality of raw water available to the plant, which may make the treatment process significantly more expensive. Since the government is likely to be in the best position to assess and deal with these risks, the allocation of these risks to the government makes the project much more appealing to potential lenders and investors. This is the usual practice in other countries and has also been adopted in Chengdu.
The successful completion of the financing of the Chengdu project is expected to demonstrate that, despite the effects of the Asian crisis, it is still possible to finance a solid infrastructure project in China with the right amount of firm government sup-port. Meanwhile, another major water project, the Beijing No. 10 Water Treatment Plant, is also on the horizon, and we understand that bid documents are now being prepared.
While this project will not fall under the umbrella of the official BOT programme, and so may not be able to fully utilise the advantages of the ‘Chengdu model' potential, investors and lenders hope that a way will be found to retain the benefits of BOT, albeit even in a somewhat different format.
Freshfields 1999. Freshfields is an international law firm. Most of its offices in Asia, Europe and North America include China specialists. For further details, contact Melissa Thomas in Beijing (tel: +86 10 6410 email@example.com) or Lucille Barale in Hong Kong (tel: +852 2846 firstname.lastname@example.org) or Matthew Cosans in London (tel: +44 171 936 email@example.com)
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