Most of the data collected for this article are from this excellent website, http://chinawaterrisk.org/, and its published research articles.
China’s water sector has long been an attractive target for investors. Natural scarcity of rainfall, coupled with industrial pollution from decades of unbridled industrial growth, have made most of China’s waterways, reservoirs and groundwater unsuited for drinking and even agricultural and industrial use. Water conditions within China, especially its 9 dry provinces, remain stressed. Climate change is expected to cause retreating Himalayan glaciers and further exacerbate water scarcity. One significant catalyst for the sector has been the government’s recent anti-pollution and pro-water policies, and local governments tendering more water treatment contracts to meet targets. Increasingly stringent water quality regulations are affecting small water players and inefficient SOEs, while foreign players are being hindered by their relative lack of political connections to local authorities and lax IP enforcement.
Water supply value chain is divided into three components:
1. Upstream Raw Water distribution
2. Tap water supply
3. Wastewater treatment
Raw Water Distribution
Transportation of raw water from natural water sources to downstream water treatment plants. Raw water distributors invest in raw water projects such as water dams, reservoirs, and long-distance transfer pipelines
Example of China companies: Guangdong Investment, Shanghai Municipal Raw Water
Water supply distributors purify raw water for drinking or industrial use. Afterwards, they supply the purified water to end users through a pipeline network. Water supplier is also responsible for installing water meters and billing end-users.
Water supply infrastructure is developed (compared to wastewater treatment) and has grown steadily at 3%, in line with urbanization and population growth. Tap water supply revenue is collected directly from end-users, hence there are fewer regulatory risks as compared to collecting from the local government. However, as the end-users are from the private sector, water supply distributors face higher credit risks than either raw water or wastewater. Tap water supply companies can also control pipeline expansion and meter installation, hence they have more control over their revenue streams.
Officially, there are no restrictions for foreign companies to participate in water supply. In reality, foreign investors in large cities can only do so by taking up a minority position in a Joint Venture with distribution networks. For small cities, they are allowed to build and operate water supply and drainage networks.
Example of China companies: China Water Affairs, NWS Holdings
Wastewater treatment involves purification of municipal or industrial wastewater. Wastewater is collected through a sewage network and treated before being released into the river/sea. Usually operate under BOT or TOT arrangements. Wastewater treatments are usually standalone operations that receive fixed and heavily subsidized tariffs from the government as its single debtor. Concessionary contracts are usually heavily subsidized by government. Foreigners can invest in wholly-owned companies or partner with a local Chinese partner in a Joint Venture.
Example of China companies: China Everbright, CITIC Envirotech
Project-based Business Model
Contract risk in the water sector is defined by how low a company is willing to bid a contract in terms of negotiated bulk water sale price, as well as the number of total years required to recoup the capital investment. Contracts with low water sale price may pose a constant long-term hindrance to the company’s O&M profitability. Aside from bidding wars, contracts are also determined by political connections, which are disadvantageous for foreign players.
Public-Private Partnership (PPP) arrangement
The most widely-used business model in the China water market is based on public-private partnerships (PPP), a cooperative long-term agreement between a private and public organisation. Among PPPs, private companies generally prefer Build-Operate-Transfer (BOT) arrangements over riskier full concession contracts such as Build-Own-Operate (BOO).
Build-Own-Operate-Transfer (BOT) arrangement
Under a BOT arrangement, the company invests the full cost required in the construction of the reservoir or treatment plant and is contracted to operate the facility for a defined period (usually 15-30 years), after which it is transferred to the public sector. The local water authorities pay the company a set price per cubic metre of water for the duration of the contract.
In ensuring that the company can recoup the costs of this investment, set price must provide sufficient revenue for the company to cover its capital costs and operations. Moreover, government should be able to afford the rate. In 2004, Thames Water abandoned a plant in Shanghai when the municipal govt. renegotiated the rates downwards.
BOT is a type of project financing and, as such, its key elements are:
• The lenders to the project look primarily at the earnings of the project as the source from which loan repayments will be made. Their credit assessment is based on the project, not on the credit worthiness of the borrowing entity; and
• The security taken by the lenders is largely confined to the project assets. As such, project financing is often referred to as a “limited recourse” financing. This is because lenders are given only a limited recourse against the borrower.
• Most project finance structures such as BOT are complex. The risks inherent the project are spread between the various parties; each risk is usually assumed by the party, which can most efficiently and cost-effectively control or handle it.
Once the project’s risks are identified, the likelihood of their occurrence are assessed and their impact on the project determined, the sponsor must then allocate such risks to the relevant parties. More specifically, its options are either to absorb the risk itself, lay off the risk with third parties such as insurers, or to allocate the risk among contractors and lenders.