The private sector and power generation in China

WO RLD BANK DISCUSSION PAPER NO. 406 Work in progress WDP406 for pubHiC discussion February 2000 The Private Sector and Power Generation in China Energy and Aining Sector Unit East Asia and Pacific Region The World Bank  Recent World Bank Discussion Papers No. 340 Developing the Nonfarm Sector in Bangladesh: Lessonsfrom Other Asian Countries. Shahid Yusuf and Praveen Kumar No. 341 Beyond Privatization: The Second Wave of Telecommunications Reforms in Mexico. Bj6rn Wellenius and Gregory Staple No. 342 Economic Integration and Trade Liberalization in Southern Africa: Is There a Rolefor South Africa? Merle Holden No. 343 Financing Private Infrastructure in Developing Countries. David Ferreira and Karman Khatami No. 344 Transport and the Village: Findingsfrom African Village-Level Travel and Transport Surveys and Related Studies. Ian Barwell No. 345 On the Road to EU Accession: Financial Sector Development in Central Europe. Michael S. 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Nicholas Prescott and Menno Pradhan (Continued on the inside back cover)  WORLD BANK DISCUSSION PAPER NO. 406 The Private Sector and Power Generation in China Energy and Mininlg Sector Unit East Asia and Pacific Region The World Bank Washington, D.C.  Copyright C) 2000 The International Bank for Reconstruction and Development/THE WORLD BANK 1818 H Street, N.W. Washington, D.C. 20433, U.S.A. All rights reserved Manufactured in the United States of America First printing February 2000 Discussion Papers present results of country analysis or research that are circulated to encourage discussion and comment within the development community. The typescript of this paper therefore has not been prepared in accordance with the procedures appropriate to formal printed texts, and the World Bank accepts no responsibility for errors. Some sources cited in this paper may be informal documents that are not readily available. 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Electric utilities-China-Congresses. 2. Electric utilities Government policy-China-Congresses. 3. Privatization-China-Congresses. I. World Bank. II. World Bank discussion papers; no. 406. HD9685.C62 P75 2000 333.793'2'0951-dc2l 99-462067  - iii - CONTENTS Foreword ............................................................v Abstract ............................................................ vi Abbreviations and Acronyms ........................................................... vii PART ONE: PRIVATE POWER AND INVESTMENT OPPORTUNITIES IN CHINA ............................................................1 Conference Summary ............................................................3 Conference Agenda ........................................................... 19 Conference Participants ........................................................... 22 PART TWO: PRIVATE POWER DEVELOPMENT IN CHINA: THE 1,000-MILE JOURNEY ........................................................... 27 Acknowledgments ........................................................... 29 Introduction ........................................................... 31 Chapter 1. The Scope for Private Investment in the World's Second-Largest Power Sector ........................................................... 33 Highlights ........................................................... 33 High Economic Growth ........................................................... 33 Power System Growth and Development Potential ............................................... 34 Modernization of Generating Facilities ........................................................... 34 Decentralization and Power Sector Financing ....................................................... 36 Chapter 2. Involving the Private Sector in Power Generation .................................... 38 Highlights ........................................................... 38 Key Steps and the General Approach ........................................................... 38 Profile of Private Sector Developments ........................................................... 40 Chapter 3. The Evolving Power Sector Framework ..................................................... 50 Highlights ........................................................... 50 Rationale for Reform ........................................................... 50 Key Steps to Restructuring ........................................................... 51 Laws and Regulations ........................................................... 51 Proposed Build-Operate-Transfer (BOT) Regulations .......................................... 54 Changes in the Power Sector Structure ........................................................... 54 The Approval Process ........................................................... 56  - iv- Chapter 4. Evaluation of Private Investor Concerns ............................................... 59 Highlights ............................................... 59 Impact of the Asian Economic Crisis ................................................ 59 Potential Foreign Exchange Risks ................................................ 61 Rate of Return and Tariff Issues .......................................... 61 The Project Approval Process .......................................... 62 Guarantees .......................................... 63 Conclusion .......................................... 64 Annex 1: Projects Involving Direct Foreign Investment ............................................... 65 Annex 2: Major Private Projects Closed and Under Development ................................... 66 Annex 3: Sample Conditions Precedent to Loan Disbursement by Commercial Banks ............................................... 69 Annex 4: Selected Small and Medium Power Plants Involving Direct Foreign Investment ................................................ 71 Annex 5: Power Companies Listed in Stock Exchanges ............................................... 72  FOREWORD Since the early 1980s, the Chinese Government has been gradually easing entry in power generation and ensuring private participation in power sector development. It first proceeded with several pilot projects and gradually expanded opportunities for private sector investment, mainly through establishment of joint ventures for developing greenfield projects or securitizing existing assets, BOT arrangements and listing of power companies in local and foreign stock markets. The progress achieved has been impressive and widely recognized. However, in the afternath of the Asian economic and financial crisis, concerns are being voiced about Renminbi devaluation and the impact of the slowdown of electricity growth on the implementation of past contracts and new investment opportunities. To assess these emerging concerns, China's Ministry of Finance and the World Bank sponsored a two-day conference, held in Beijing June 22-23, 1999. The conference aimed mainly at improving understanding and narrowing the gap in perceptions of risks related to project development between government officials, representatives of provincial power companies and financial institutions, and private investors. The first part of this publication is dedicated to the narrative summary of the conference. The second part presents a background paper prepared for the conference to take stock of the progress achieved and identify issues and problems that still need to be addressed to create an environment conducive to further private involvement in power sector development. In publishing this volume, we very much hope it proves to be useful to the international community that is interested in past and future development of private sector involvement in China's power sector. Yukon Huang Country Director China Country Unit East Asia and Pacific Region  - vi - ABSTRACT This paper discusses issues and problems related to private sector involvement in China's power sector in two parts. The first part, a summary of the conference held in Beijing June 22-23, 1999, stresses that despite the problems encountered and the impact of the Asian economic and financial crisis, China's power sector remains attractive to investors because of its size, growth potential, and the improving business and regulatory environments. The discussion at the conference highlighted the need for more transparency in the implementation of the reformns and regulatory framework, streamlining of the project approval process, and improving creditworthiness of power offtakers. The second part, a paper prepared by Jianping Zhao on private power development in China, assesses the current status and future prospects of private sector involvement in China's power sector. It outlines the key characteristics and indicates some future developments for the different forms of private sector participation that have emerged and developed since the early 1980s. It, finally, provides a review of some concerns voiced by investors and provides a preliminary assessment of their impacts on future investments.  - vii - ABBREVIATIONS AND ACRONYMS BOO Build-Operate-Own BOT Build-Operate-Transfer ECA Export Credit Agency FDI Foreign Direct Investment GDP Gross Domestic Product GOC Government of China GW Gigawatt fHIPDC Huaneng International Power Development Company IPO Initial Public Offering IPP Independent Power Producer ITIC Provincial Investment Company JV Joint Venture kW Kilowatt kWh Kilowatt-hour MvIOC Ministry of Communications MOEP Ministry of Electric Power MOFTEC Ministry of Foreign Trade and Economic Cooperation MOU Memorandum of Understanding MW Megawatt F'PA Purchase Power Agreement ROR Rate of Return SAAB State Assets Administration Bureau SAFE State Agency for Foreign Exchange SAIC State Administration of Industry and Commerce SDPC State Development and Planning Commission (formerly SPC) SEPA National Environmental Protection Agency SETC State Economic and Trade Commission SOEs State-Owned Enterprises SP State Power Corporation SPC State Planning Commission   PART ONE: PRIVATE POWER AND INVESTMENT OPPORTUNITIES IN CHINA (Beijing, June 22-23, 1999)   Conference Summary 3 CONFERENCE SUMMARY A Private Power Conference, sponsored by China's Ministry of Finance and the World Bank, was held in Beijing June 22-23, 1999.1 The conference agenda and list of participants follow this summary. Conference Background and Organization The conference took place in response to growing concerns about the future of China's power sector and the role of and support for private sector participation. Principal concerns include the following: (a) the Asian economic and financial crisis is affecting the economy, even though to a lesser extent than in other East Asian countries, and fueling speculations about devaluation of the Renminbi; (b) electricity demand is growing at a slower pace in most provinces and even declining in some; and, more importantly, (c) Chinese operators, foreign developers and the international financial community are increasingly worried about the implementation of past contracts. On the Chinese side, the government seems reluctant to continue providing letters of support beyond pilot projects; and are concerned that high rates of return required by developers may result in high electricity prices. The State Power Corporation (SP) and its affiliated power companies are dissatisfied with the "take or pay" obligations and the requirement for minimum guaranteed dispatch associated with current power purchase agreements (there is an increased perception of inequitable allocation of market risks), especially in provinces where there is excess generating capacity. From the perspective of foreign developers and international financiers, project development and implementation remain very difficult in China despite acknowledged successes during the last decade. The project approval process is cumbersome and less than fully transparent; the underdevelopment of the legal and regulatory framework greatly increases the uncertainty and risks relating to the projects; the requirement of increased domestic content limits the ability of project developers to involve Export The conference was jointly organized by N. Berrah and D. Girdis in the World Bank Headquarters in Washington D.C. and E. Sun, J. Zhao and R. Ma in the World Bank Country Office in China with the active support of the staff of the International Department of the Ministry of Finance. This summnary note was prepared by N. Berrah, R. Fitzgibbons, D. Girdis and R. Tomkins. It was reviewed by Y. Albouy, M. Farhandi, B. Trembath, D. Lilaoonwala, E. Sun and J. Zhao of the World Bank Group; Yang Qing, Deputy Director General, Department of Planning, Finance and Investment, State Power Corporation; Zhao Hubin, Deputy General Manager, Zhejiang Provincial Power Company; K. Wall, Barclays Bank; and I. Parker, National Power.  4 Conference Summary Credit Agencies and to introduce technological innovation; the potential breaches of support agreements (especially dispatch of the units to ensure adequate revenues) and payment defaults caused by insolvency of large state-owned enterprises are undermining financiers' confidence in the "sanctity" of power purchase agreements. As noted by Yukon Huang, Country Director and Chief of the Country Office of the World Bank in his introductory remarks, the conference was organized by the Ministry of Finance and the World Bank to provide an opportunity to discuss the foregoing concerns among senior executives and representatives of the Chinese Government, SP and its affiliated power companies, project development companies, financing institutions and the World Bank Group. Three sessions, consisting of 15 presentations, and 3 roundtable discussions provided a forum for open dialog among over 100 participants about the following key issues: * Macroeconomic background, particularly the economic growth outlook in the aftermath of the Asian economic crisis and the stability of the Renminbi; * Financing options experienced in China, mainly limited-recourse financing associated with joint ventures (for development of greenfield projects and securitization of assets) and build-operate-transfer (BOT) arrangements for generation projects, and equity financing through listing of power generation companies on international and local stock markets; * Future of the Chinese power sector given the recent slowdown in growth of electricity demand and the stagnation of direct foreign investment in the country; * Changes in risk profile and increased apprehension and concerns expressed by power project developers in light of the impact of the Asian economic crisis on private power investments in other Asian countries (especially Indonesia and Thailand) and the increasing reluctance of provincial power companies to solely bear market risks; and * Reform initiatives, especially the announced gradual transition from the single buyer model to provincial competitive markets, and their impact on private investment in the sector. Stability of the Macroeconomic Situation Despite the Regional Turbulence Zhu Guangyao, Director General of the International Department of the Ministry of Finance, and Li Ruogu, Director General of the International Department of the People's Bank of China, stressed the continued strength and stability of China's  Conference Summary 5 economy, and attractiveness to foreign investors. The country has been far less affected by the Asian economic and financial crisis compared to other countries in the region. Gross domestic product (GDP) growth, which has fallen from annual rates exceeding 10 percent in the early 1990s to rates slightly above 7 percent in 1997 and 1998, remains among the highest experienced worldwide. Following a reduction of about 5 percent in 1997, foreign direct investments increased by 2 percent in 1998 and are expected to grow at about the same level in 1999. The underlying economic fundamentals remain strong despite the visible effect of the Asian economic crisis. Foreign trade growth dropped to 0.2 percent in 1998 after a sustained growth at about 15 percent up to 1997 but rebounded to 8 percent during the first half of 1999. Exports to North America and Europe grew substantially to offset the reduction of exports to traditional markets in Asia, mainly Japan. Foreign exchange reserves increased to nearly US$150 billion and China's debt level and debt service ratio remain very low as a percentage of GDP, while its debt structure is sound with short-term debt accounting for around 15 percent of the total. However, the Chinese government remains aware of the potential threats to the economy (foreign capital flight, loss of competitiveness, drop in consumers' confidence, etc.) and is striving to continue to provide a stable environment for domestic investment and household consumption to maintain growth. A key component to macroeconomic growth and attracting investment to China has been the stability of the Renminbi despite the extensive currency devaluation experienced in emerging markets, particularly in East Asia. Li Ruogu noted that while China has committed itself to avoiding devaluation of the Renminbi and potential exacerbation of the regional crisis, it is a little known fact that more than 80 percent of trade in China's currency is at market-determined rates and not the government- determined rate. In conclusion, Li noted that the Renminbi could, as for all currencies, be subject to fluctuations determined by the market. However, the Chinese government is committed to maintaining the Renminbi's stability through monetary and economic policies aimed at sustaining the strength of the fundamentals of the economy. This assessment is consistent with recent market trends but investors continue to carefully monitor threats and uncertainties that could endanger economic growth and China's sovereign rating. These include mainly China's competitiveness and related stability of the Renminbi, social and economic impacts of the reform of the state-owned enterprises (SOEs), emerging difficulties faced by financial institutions at the provincial level (ITICs), and government policies and regulations, especially those related to infrastructure investments, that would reduce China's attractiveness compared with other countries.  6 Conference Summary A Fast-Growing Power Sector and Increased Private Involvement To support this sustained and strong economic growth, China's power sector grew at more than 8 percent from 1980 to 1998 to become the second largest system in the world with 277 GW of installed capacity. However, in 1997 and 1998, demand growth fell to 4.5 percent and 2.6 percent, respectively, raising concerns about overcapacity and future development of the sector. As reported by Wang Xingmao, Director of the Economic Research Center of SP, these fears began lessening in the first half of 1999 with clear signs of rebounding electricity growth in many provinces. The slowdown of the two past years was beneficial in tempering the overly optimistic expectations about the future of the sector. However, China still has considerable potential for growth considering its expected strong economic development and still very low per capita consumption (about 6 percent of the per capita electricity consumption of United States and 22 percent of Korea's and 42 percent of Mexico's, respectively). Despite the recent slowdown, the investment climate for private power in China has continued to be relatively strong. The government allowed the first experiments involving private investors in developing power projects in the early 1980s to help meet the growing investment and financial requirements. Following the early successes, it gradually moved to develop and implement a framework for private participation in the Chinese power sector. Jianping Zhao reviewed the past two decades' experience of private power investment. As he noted, by mid-1998: (a) 34 large2 projects involving private developers, with an installed capacity of over 26 gigawatts (GW), were operational or under construction; and (b) 25 power companies, with an installed capacity exceeding 12 GW, were listed on domestic and foreign markets. By any accounts, this is a great achievement in a country where private investment has been legal for less than five years, noted Yukon Huang in his introductory remarks. Private investors have been involved in developing power projects through three main methods: * Joint ventures (JVs), * Initial public offerings (IPOs) on stock exchanges, and * BOT agreements. This diversified approach has helped the whole investment program to be successful since it allowed investors to adapt their corporate strategies to the particular problems and 2 The number of small (less than 100 megawatts, MW) projects is estimated at about 200 projects with an installed capacity of about 6,000 MW.  Conference Summary 7 difficulties encountered in different parts of China and to choose the most appropriate risk mitigation methods, noted Yoshihiko Sumi, Sector Director, East Asia Energy and Mining Development Sector of the World Bank. By far, the vast majority of private power investments (amounting to about US$15 billion) in China have been JV agreements to develop greenfield projects with limited- recourse financing.3 One of the most successful investments was the Zhuhai (2x700 MW) coal-fired plant that is nearing commercial operation. Experience with Zhuhai and other JV limited-recourse projects indicates that the key factors for a success include proper allocation and sharing of risks among parties, strong commitment of local partners, and identification of development and financing conditions (Box 1). All these help to overcome difficulties due to complicated and lengthy requirements in the approval process and gaps in the legal and regulatory framework. Box 1: ZHUHAI JOINT VENTURE AND LIMITED-RECOURSE FINANCING The Zhuhai 2x700 MW coal-fired plant, sponsored by Cheung Kong of Hong Kong, was the first JV project utilizing limited-recourse financing in China to be financed without a multilateral or government guarantee. The initial JV was signed in 1993, reaching financial closure in 1996, with commissioning of the second unit by rmid-2000. The total JV period is 20 years, with a total of six units (total capacity of 4,200 MW) planned. For the first phase (2x700 MW), the total project cost is about US$1.23 billion, of which 30 percent is shareholders' equity. The remaining financing includes US$670 million in export credit from the Bank of Tokyo Mitsubishi, US$126 million in conmmercial loans, and Y 500 million in local financing. Key factors in closing the project included not only JEXIM participation but also letters of support from the government and equitable risk allocation. The success of the project is also attributable to proper documentation for tariff adjustnents, clearly stated roles and well-defined tasks, and clear comrnmunication among all players. Source: Study team. Eric Kwan, Chief Executive Officer of China Infrastructure of Cheung Kong Infrastructure Holdings Limited, noted and most of the participants (especially the foreign investors) agreed that JVs will continue to be a successful and preferred approach for power project development and financing. He stressed the importance of the Chinese JV partner in building consensus of the Chinese authorities around the project and in managing the many steps required for implementing it. The success of this approach was confirmed when the closure of the Shandong loan syndication for US$2.2 billion in late 1998 raised capital for over 3,000 MW of power plants (Box 2). 3 Unlike some BOTs, where the most commnon approach for selection of the investor is international competitive bidding, JV agreements have often been concluded through negotiation, although competitive tendering is also possible and increasingly employed.  8 Conference Summary Box 2: SHANDONG ASSET SECURITIZATION A large loan syndication of Shandong Zhongua Power Company, a joint venture sponsored by Shandong Electric Power Group, CLP Holdings, and EdF, was completed for the US$2.2 billion project, with US$1.5 billion worth of financing for 3,000 MW of generating capacity: 2,400 MW at Shiheng II, Heze II, and Liaocheng coal-fired power plants, and the acquisition of 600 MW Shineng I. The deal involved an uncovered commercial loan for US$350 million, a US$312 million term loan facility with 100 percent political and commercial risk coverage by the Export Credit Agency (ECA) ECGD, and an equivalent US$822 million loan denonminated in Renminbi from the China Construction Bank and Shandong CITIC. The issue was oversubscribed by 130 percent. Source: Study team. Second, IPO listings have raised almost US$2 billion in equity investment in the Chinese power sector through international and domestic listings. Despite the Asian crisis and subsequent stock market volatility, most have performed well. According to Yang Hongming, Executive Director of the Beijing Datang Power Generation Company, this can be attributed to the listing of only strong, well-managed companies, the selection of the best-performing assets, the strong interaction with market players, and the focus on the international business concept of building shareholder value (Box 3). The ongoing success of IPO is demonstrated by the pending listing of Shandong International Power Development, which will make a bid to list at about US$300 million in Hong Kong. Box 3: BEIJING DATANG IPO Five major investment firms, Warburg Dillion Read, ING-Barings, ABN-AMRO, and Donaldson, Lufkin & Jenrette, have all made recommendations in 1999 supporting investment in the three publicly traded power companies with access to foreign capital. Beijing Datang, one of these three, is a joint stock company that first traded H shares on the Hong Kong stock exchange and London Exchange in March of 1997, raising about Y 3.7 billion (US$440 million). Beijing Datang's output from its four plants in Hebei and Beijing has continued to grow, with expected growth to continue through 1999. Its principal market is the North China power grid where demand has remained strong and utilization rates continued at about 5,500 hours. The company plans to continue development of large coal-fired plants, greater than 300 MW. The capacity is expected to expand by 9.6 percent in 1999 and by 7.5 percent in 2000. Eamings are expected to increase by about 20 percent in 1999 and 35 percent in 2000. Datang has several competitive advantages. It is a low-cost producer with 70 percent of its on-grid tariff price the lowest sold into the Beijng-Tianjin-Tanghan power gird. Another major advantage for the company is its strong balance sheet with low debt, strong cash flow, net cash position of Y 700 million, and a management philosophy that emphasizes increasing shareholder value. Source: Study team. Last, China was one of the first countries to implement the BOT model in the mid-1980s. The successful Shajiao-B plant (2 x 350 MW) in Guangdong was the first large private power project to be put into operation. However, some reservations emerged  Conference Summary 9 about the effectiveness of the negotiated contracting procedures and the government moved to a competitive approach for subsequent BOT projects. China's first competitively tendered BOT in the power sector was Laibin-B. (Box 4). The widely acclaimed success of this project, noted Kevin Wall, Managing Director of Investment Banking of Barclays, can be attributed to a number of factors, most notably a formal letter of support from the State Development and Planning Commission (SDPC), transparency of the development process, tight adherence by the government to the announced implementation schedule and procedures, and a financeable allocation of risk among key partners. Replicating this success may be difficult for later projects given the high visibility and level. of support and attention this first project was given by the government. Future projects may not have the same level of government support, thereby increasing the need to rely on offtaker creditworthiness. Box 4: LAIBIN-B BOT Laibin-B was the first BOT project, selected through competitive bidding, formally approved by SDPC. It is considered a model for future projects in China. The project includes 2x360 MW coal-fired power station in Guangxi Province for a concession period of 18 years, (operation of 15 years), and a total cost of US$616 million. Total equity was US$154 million (25 percent), with commercial debt of US$159 million and a COFACE loan of US$303 million, including a $120 million standby and contingency facility. EDF and GEC Alsthom, the sponsors, won through intemational competitive tendering with financial closure less than two years after the issuance of tender documents. The project fulfilled multiple goals: for the government of using limited public sector capital and promoting transfer of technology; and for investors of mnaximizing returns and using services and experience of the sponsors. Key success factors include establishment of the BOT legal framework, availability of government support via SDPC, ECA participation and favorable terms, allocation of foreign exchange to service the debt, clear tariff approval process, and provincial government credit. Source: Study team. Lessons Learned from the Crisis in Southeast Asia A number of countries in Southeast Asia have embarked on ambitious independent power producer (IPP) programs to respond to the power shortages appearing in the early 1990s and the financing requirements of rapidly growing demand. Discussion at the conference focused on two example countries, Indonesia and Thailand. Both countries developed their programs by providing private developers with traditional long- term power purchase agreements (PPAs) with the national electric utilities, the sole purchasers of power from IPPs. Both national utilities had expectations of recovering the cost of power supply through tariff adjustments. In both countries, the long-term PPAs include take-or-pay capacity payment obligations and foreign exchange indexation that place the market risk (the demand for power and revenue receipts from consumers) and foreign exchange risk (rising domestic currency costs due to devaluation of the currency)  10 Conference Summary on the purchasing utilities, with the cost consequences of such risks expected to be passed through to captive customers. With the onset of the Asian crisis, the IPP programs in both countries ran into severe difficulties. In the Indonesian power sector, the problems were, and continue to be, particularly dramatic and coincided with a period of political and social uncertainty. Yet even before the crisis, there was significant overcapacity. Five main factors were stressed by Ray Tomkins, Managing Director of Economic Consulting Associates Limited, in his presentation. First, the tariffs in the PPAs were not competitively determined. They were established though negotiation between PLN (the national electric utility) and project companies including consortium partner companies owned by, or with close links to, companies associated with high government officials. This resulted in PLN being pressured to enter into PPAs with tariffs in the range 6 to 8 US cents/kilowatt-hour - kWh (the highest is around 10 US cents/kWh), far higher than PLN's current retail tariff rates of about 3 US cents/kWh versus 6-8 US cents/kWh before the collapse of the Rupiah. Prices in most of the PPAs are fully indexed to the US dollar. The second problem has been the collapse of the currency, which fell from around Rp 2,500 per US$1 to over Rp 16,000 at the height of the crisis, before recovering to its current level of around Rp 7,500 per US$ 1. PLN's current tariff in dollar terms is under 3 US cents/kWh. Third, economic dispatch is restricted since over 55 percent of the installed capacity of the Indonesian power sector is now subject to long-term inflexible contracts (geothermal plants are must-run, PPAs have take-or-pay capacity obligations, and take-or-pay gas contracts). Fourth, the projects appeared to foreign investors to have the character of a JV due to the involvement of companies sponsored by government officials but the weak letters of support issued by the Government of Indonesia may not be enforceable. Finally, following the economic turmoil, the need for power dropped significantly, such that none of the new IPPs under development are needed soon-yet PLN will remain obligated to make the capacity payments. It is not politically or socially possible to increase power tariffs to cover these additional costs in the short term. As a result, PLN's ability to remain financially viable depends heavily on continuing large subsidies from the government. The government has instructed PLN to reach renegotiated settlements to these contracts but has also attempted to address this by suspending certain contracts notwithstanding their terms.4 This response is unlikely to prevail as the Indonesian government recently lost a US$500 million arbitration award in which the arbitrator concluded that the Indonesian government was not entitled to take such unilateral action. As a result, the most likely 4 PLN has also announced that it will not operate IPP plants that are due to come into operation in the next two years, and has also delayed or suspended payments due under the PPAs or is paying at a notional pre-crisis exchange rate of Rp 2,450 per US$1. International credit rating agencies have recently severely downgraded the debt rating of the Paiton 1 project, which is a large coal-fired plant and the next IPP due to be completed in 1999.  Conference Summary 11 consequence will be a financially insolvent utility and protracted renegotiation (for at least two years) of all of the PPAs. The Asian crisis has had a similar, but less dramatic, effect on the Thai power sector. Unlike Indonesia, the tariffs for IPPs were established through a very competitive power solicitation. Even with the indices for foreign exchange adjustment eventually included in the PPAs, the tariffs for gas and coal projects were approximately 3.3 US cents/kWh and 4.3 US cents/kWh, respectively. In addition, the foreign exchange risk was not a 100 percent pass-through to the Thai purchasing utility (Electricity Generation Authority of Thailand, EGAT). Instead, the exchange indices adjusted a percentage of the capacity payment based upon the amount of costs that could be legitimately expected to be procured from foreign sources. The initial success of this program, indicated Rob Fitzgibbons, Advisor to EGAT, in his presentation, can be attributed to a well-defined legal system and project approval process, the broad-based support for the IPP program generally, the attractive tariffs that resulted from the competitive tender process, the long period of sustained economic growth that predated the competitive solicitation, the financial community's confidence in the financial viability of EGAT as the power purchaser, and EGAT's willingness to enter into long-term PPAs that allocated project and market risk in a manner that met what at the time were the international standards for limited-recourse financing. Nonetheless, as in Indonesia, the Asian crisis and the allocation of market risk to EGAT through long-term PPAs is creating significant problems for the power sector in Thailand. If all seven IPPs that have executed PPAs with EGAT obtain financing, the power sector will have excessive reserve margins throughout much of the next decade. This overcapacity and the cost of the take-or-pay obligation will be politically difficult to pass on to consumers notwithstanding the broad-based support for the IPP program that existed prior to the advent of the Asian crisis. Although such costs may not have as severe a consequence on EGAT as with PLN, it will still create a severe financial strain on the operation of the Thai power sector. To address this situation, EGAT has already conducted one round of renegotiation of the PPAs to delay the five IPPs that have not yet achieved financial closure and an additional round of renegotiation is expected in the future. Finally, the governments of both Indonesia and Thailand have initiated efforts to reform their power sectors to introduce a single buyer model and some competition between generators. If such reforms are implemented, it is unlikely that PLN or EGAT will execute any further long-term contracts with IPPs. In both cases, new trading mechanisms will need to be found to accommodate the existing PPAs within the operation of the competitive generation markets. In summary, although different in many ways, both Indonesia and Thailand demonstrate the weaknesses of the traditional long-term PPAs premised upon the single  12 Conference Summary purchasing agent model and inappropriate allocation of risk. First, the success of this model is dependent on the financial strength of the purchasing utility and the sensitivity of that strength to market risk. Second, the success of this model depends upon effective regulation to discipline the purchasing decision of the purchasing utility. Since the single buyer is expected to be permitted to pass all its costs onto consumers, it has poor in-built incentives to minimize the cost of new generation investment. Finally, the inflexibility of long-term take-or-pay contracts (often with take-or-pay fuel supply obligations) restricts the ability of the utility to dispatch the generating plant in the most efficient way. As a result, perhaps the most important lesson to be learned from Indonesia and Thailand is that the long-term viability of IPP projects cannot be determined solely by the quality of its preparation and the strength of the PPA. Investors must look through the PPA to the fundamentals of the macroeconomic situation and the viability of the whole power sector and seek an equitable agreement with respect to allocation of risks as stressed by Jean-Paul Pinard, Associate Director, International Finance Corporation (IFC). Impact of the Asian Crisis on the Chinese Power Sector China is obviously in a very different situation to the rest of Asia. The Renminbi is stable, tariffs are more reflective of costs and China has been more careful in its reliance on foreign-funded IPPs. Nonetheless, the Asian crisis is having an indirect effect on foreign-financed IPPs. First, there is obviously less enthusiasm for investing and funding power projects in Asia generally. This reduced liquidity will constrain financing available for projects in China and increase its cost. In addition, the Asian crisis has affected China by increasing project developers' and foreign financial institutions' sensitivity to certain project risks, including unilateral reforms of the power sector and abrogation of contracts. As a result, power developers and international financiers are more closely analyzing power project risks. Private investors and financiers indicated at many occasions during the conference that the Chinese could mitigate some of the effects of the Asian crisis and enhance the attractiveness of the power sector to potential foreign investors through a number of measures. These included clear articulation of a policy in support of the sanctity of contracts, the accelerated development of a national transmission grid, improved transparency and a simplified approval process, creation of a more independent framework for regulation, greater assurance in the adjustment of tariffs to reflect costs, and increased transparency in the accounts of the power supply bureaus.  Conference Summary 13 Competitive Market Reforms and Private Sector Involvement Following the enactment of the Electricity Law, the Chinese government has shown strong commitment to reforms aiming at easing new entry at the generation level, separating ownership and commercial functions from government policy and regulatory functions, gradually developing a legal and regulatory framework, and promoting private sector investments. The success of the initial reforms is demonstrated by the alleviation of the acute power shortages of the late 1980s/early 1990s, the encouraging development of private power and the increased commercial orientation of the sector. However, as strongly stated by Xu Songda, Deputy General Manager of Jiangsu Provincial Electric Power Company, the slowdown of demand growth in 1997/98 revealed the limits of the single buyer model and the "new plant, new price" policy that stipulates that tariffs should permit recovery of operation costs, repayment of debt and taxes with reasonable profits. The short-term maturities of loans, especially domestic ones, require recovery of capital costs over a period of 8 to 12 years, resulting in front- loading of power tariffs, particularly when exacerbated by the slowdown of demand growth. The mismatch between loan maturity and the economic life of the assets led to very high prices in the early years of operation of the projects and the one-part tariff structure used in some contracts led to nonoptimal dispatch and important efficiency losses. Faced with the slowdown of power demand and "take-or-pay" clauses of the PPAs, provincial power companies voiced concerns about solely bearing the full market risk. To address these issues, the Chinese authorities are considering how to further develop the reform process by gradually moving toward wholesale and possibly, in the longer term, retail competition. Regulations have already been issued by the State Council for full separation of generation from transmission and distribution in all provinces. Plants will initially be given a two-part contract (capacity and energy components), thus replacing the minimum dispatch obligation with an available capacity payment and allowing economic dispatch to be fully implemented. At the next step, these contracts will be replaced by flexible "contracts for differences" to allow the plants to bid for dispatch to establish a common clearing price ("pool price") for generation although all the power will continue to be sold to the provincial power companies (single buyers) and the majority of generators' revenue will still be assured through the contracts for differences. The market risk will initially remain with the single buyer with a small portion being borne by the power plants. In the second stage, the contracts for differences will be assigned to distribution companies and the proportion of power purchased covered by them reduced, so that the market risk will be shared between the distributors and the power plants, with the grid company (formerly the single buyer) no longer bearing any market risk. Wholesale competition, in which generators may contract directly with large consumers is the next stage. Retail competition, the last stage in which all consumers will  14 Conference Summary have a choice of suppliers, could take another 10 years and will be dependent upon prevailing economic conditions and management skills at the provincial level. Several developers expressed concerns that a premature move toward competitive markets without establishment of a credible and predictable regulatory framework and clarification and streamlining of administrative procedures could increase the risks related to project development. This could jeopardize the progress achieved to date, mainly based on long-term contracts. Responding to these concerns, both Shi Yubo, Director of Electric Power Development at the State Economic and Trade Commission (SETC), and Xie Songlin, Chief Accountant of SP, indicated that the implementation of the new wave of reforms will be kept under review in the light of the experiences gained from the pilot provinces now developing competitive markets. They stressed that past contractual arrangements will be honored, and noted the expressed requirement of developers to have contracts (possibly of a different type) to help secure financing of new projects. In order to judge the pace and scope of potential reform measures for China, six pilot provinces were selected to proceed with increased competition at the generation level. Zhao Hubin, Deputy General Manager of Zhejiang Provincial Electric Power Company presented Zhejiang's reform program, which will be the first test case. Zhejiang is seeking to unbundle power markets to increase competition and reduce supply costs. Differential tariffs are seen as a way of minimizing risk for generators during the transition period. Initial trials of the new market are expected in 2000. A future step will be to gradually allow the distribution companies and large consumers to contract for purchase directly from generators. This will shift the market risk on to the distributors. As pointed out by Diana Gan of ABN-AMRO, both investors and lenders would expect considerable improvement in the transparency of the distributors' accounts in order to be able to assess the risks of these new contracts. Developers were not so much concerned with the direction of reform, but with having a transparent process and schedule for implementing reforms so that the consequences of such reforms can be assessed during the development and structuring of projects. In addition, power project developers emphasized the need for clear rules to be able to assess the impact of reforms on existing projects and their PPAs, including those that might be signed between now and when the reforms are introduced. The developers' concerns about the impact of future reforms lessened following the emphasis put by Chinese decisionmakers on the lengthy transition period that will be required for such reforms based upon international experience (e.g., the United Kingdom has already taken 10 years and its market is still evolving). Lastly, it was consistently stressed that the sanctity of existing contracts (which does not preclude freely negotiated changes to those contracts) should be preserved during the transition to a competitive market.  Conference Summary 15 In a discussion on the impact of the reform and the aim to shift more market risk onto IPP developers, both Ian Parker of National Power and George Grant of InterGen (who were the first to develop a merchant power plant project in the United Kingdom)5 stressed that merchant power plants are still a long way off for China. But there was optimism that China would succeed with its reform process and ultimately reach a competitive market through its gradual approach. Actions to Promote Private Sector Investment Throughout the conference there was general agreement that, despite the heightened risk awareness, JVs with limited-recourse financing will remain a dominant option for power projects in China. BOTs (fully foreign-owned in China) will be further developed, but many developers expressed their continuing preference for the JV approach. The main concerns expressed by project developers and international financial institutions included the following. Project Approval Process. All developers agreed that the project approval process must be clear, unambiguous, transparent and, if possible, more streamlined. In response to this concern, a number of the Chinese officials stressed that the approval process is fair because it is identical for domestic and foreign projects. While they recognize that the process is lengthy and involves many institutions, it is transparent (as indicated in several presentations) and contributed to minimize the problems faced by the sector compared to other countries. It will certainly be streamlined with the progress of the country toward a socialist market economy. Tariff Approval and Adjustment Process. Concerns were raised about the tariff approval and adjustment process. First, there was a concern that it takes too long to obtain initial tariff approval and subsequent annual adjustments. Second, certain developers and financial institutions expressed concern about the cost-plus approach to reviewing tariffs and the requirement to have such tariffs approved on an annual basis. Project developers and international financiers also echoed concerns regarding the transparency of the review process given some recent problems, highlighting an urgent need for detailed implementation regulations to provide more assurances to financiers and developers and assist provincial regulators. Developers generally agreed that there is an urgent need for a transparent and well-defined regulatory regime for determnining tariffs. Chinese officials emphasized the need for developers to follow Chinese regulations regarding tariffs. They stressed that emerging problems stem from the developers' reliance on approvals and 5 A merchant power plant is one in which the investment is committed without having long-term contracts in place. InterGen's project was implemented after nearly 10 years' experience of the operation of a competitive pool in England and Wales. However, it should be noted that even though no power offtake contracts were in place when construction commenced, the plant will aim to sign a number of contracts with consumers before it comes into operation.  16 Conference Summary assurances given by local authorities, who sometimes went beyond their decision-making power. Creditworthiness of the Offtaker. Many conference participants agreed that the Asian crisis, coupled with the Chinese government's expressed intent not to issue any more letters of support, had increased investor concerns about project fundamentals and stressed that the financial strength of the offiaker becomes fundamental to project financing. The assessment of offtakers' financial conditions in China is hampered by the difficult access to their accounts and their noncompliance with international accounting standards. There is an urgent need to address these issues, particularly as the reform process moves forward. In addition, several participants, especially World Bank representatives, noted that market risks of power projects could be better allocated only if project developers would be given direct access to customers. Two elements of the power sector reform reported by the Chinese speakers respond to this concern. First, commercialization of the provincial power companies should result in better financial information about offtakers. Second, separation of generation, transmission and distribution should eventually result in open markets that will allow generation companies to directly sell to industrial customers and distribution companies. Contractual Compliance and Enforceability. A small number of the developers attending the conference stated that their PPAs were not being fully honored and expressed concern that they do not have an effective mechanism for enforcing their rights under existing contracts. In particular, power project developers are worried that provincial power companies will not honor their minimum dispatch obligations. The Chinese representatives recognized the investors' and lenders' concerns, although they ideally would like contracts to be shorter and provide for more balanced sharing of market risks. Some participants noted that extending the length of the BOT franchise period and even moving toward Build-Operate-Own (BOO) arrangements could give more assurance to achieving acceptable returns while spreading the capital recovery over a longer period. Foreign Exchange Risk and Renminbi Financing. Several developers highlighted the importance of developing mechanisms for hedging against foreign exchange risk. In this regard, both developers and Chinese speakers emphasized the value of developing mechanisms for raising Renminbi financing for power projects. It was pointed out that Renminbi financing not only provides a means to reduce foreign exchange exposure for power projects, but also provided an opportunity to attract more domestic private funds to the sector through foreign/domestic private JVs. However, the Remninbi capital markets are currently too thin and will need time to expand. Clear and Transparent Regulation. Many speakers commented that clear, transparent and predictable regulation of the power sector is imperative for lowering project development risks and will become increasingly important as the availability of  Conference Summary 17 "iron clad" long-term contracts diminishes. As more competition is introduced into the power sector and developers are being asked to assume more risk, they will need to rely on well-defined rules for the approval process (of projects and tariffs, as noted earlier), access to transmission, and access to customers. Developers will need confidence that the regulatory process has sufficient independence to protect their competitive position and commercial interests. Conclusions and Priorities for Future Reforms In his concluding remarks, James Bond, Director of the Energy, Mining and Telecommunications Department of the World Bank, summarized the outcome of the conference in seven points. First, the consensus of all participants at the conference is that, notwithstanding the Asian crisis and diminished liquidity in financing, private capital can still make an important contribution to financing power sector infrastructure in China. However, to access such financing, it is important to continue strengthening China's investment climate for competing with other borrowers in the international financing markets and keeping the risk-to-return ratio for power projects in China comparable to similar investmnents elsewhere in the world. Second, all participants agreed that risks associated with power projects in China can be reduced by ensuring transparency, predictability and clarity in the regulatory process for project development, including the process for project and tariff approvals. China should continue to push forward with its efforts to develop a strong and independent regulatory structure. Third, the Asian crisis has demonstrated that although PPAs are important, project developers and financiers must look beyond PPAs and focus on the economic fundamentals of the individual power projects, the offtaker's creditworthiness and the viability of the entire power market. Fourth, the Asian crisis and reforms underway will demand changes to the way projects are financed. Additional measures must be developed to hedge against project, currency and market risk and ensure that risks must be allocated as equitably as possible. Currency risk can be reduced by broadening the Renminbi markets and making more Renminbi available for investment. Ultimately, equitable sharing of market risk will require power generators to obtain direct access to consumers. This indicates that reform of the distribution sector should not be allowed to lag too far behind reform of generation. Fifth, China remains a tremendously exciting market for investments in power projects due to its size, growO