Foreign Investment Opportunities in China's Water Distribution Sector

The recent changes to the legal framework with respect to foreign investment in water distribution networks indicate that the Chinese authorities recognize the scale of this problem. They also show an acceptance of the need for foreign capital, technology and expertise to overhaul and expand China's water distribution infrastructure.

At the same time, due to the politically sensitive nature of water distribution as a basic government service, the opening of this area is still quite limited. The resulting compromise is that whereas the two previous versions of the Investment Catalogue (in 1995 and 1997) prohibited foreign investment in the construction and operation of urban water distribution networks, the present Investment Catalogue now lists "construction and operation of pipe networks for . . . water supply . . . in large and medium-size cities" in the "restricted" category.

The Investment Catalogue further specifies that the Chinese party must hold the controlling interest in such a project. Consequently, only joint ventures and not wholly foreign-owned enterprises (WFOEs) will be approved at this time. It is not stated whether projects in the form of BOT structures, which have been adopted in several water treatment facilities projects, will be permitted in water distribution projects (it should be noted that the construction and operation of urban water treatment facilities is listed in the new Investment Catalogue in the "encouraged" category).

In spite of the narrowness of the opening, the underlying market potential together with the new regulatory changes are likely to prove attractive to foreign investors. In the past several months, in fact, several deals have been publicly announced, including Vivendi Water Systems' agreement to establish a joint venture with Shanghai Pudong Waterworks Company to help operate and manage the water distribution services of the Pudong section of Shanghai. Ondeo, the water arm of French services group Suez, is also reported to have entered into two agreements to supply water services in Shandong province. Other investors are also known to be actively considering similar projects.

Obstacles to investment still remain however. The approval process for water projects is long and slow, like those for other sensitive areas closely related to the government's mandate to provide essential public services. For larger projects, numerous ministries, agencies and bodies at the central, provincial and local level, each with its own interests and agenda, are involved in the approval process, frequently resulting in protracted negotiations with the authorities and the project partners.

Perhaps the most critical item for investors to consider when embarking on water projects is price. The government has traditionally subsidized water prices in order to provide water to industrial and individual users at below cost. The sudden removal of such subsidies and consequent increase in water charges would be politically difficult to carry out and could well result in social unrest, a result the government is keenly aware of and anxious to avoid. As such, while government subsidies cut into profitability and discourage investment from foreign companies, it is difficult to obtain the higher tariffs needed to run a viable project.

The significance of the liberalization consequently lies in the fact that foreign companies will now have an opportunity to improve the economic viability of water projects by improving the delivery to and collections from the ultimate consumer. Reduced leakage will result in greater quantities deliverable, and an ability to control collection procedures and systems will no doubt increase revenues received. In these areas, sophisticated international water companies should be able to both add value locally and benefit from increased revenues and project viability.

The many challenges notwithstanding, the scale and potential of China's gradually opening water market is too large for foreign companies to ignore. While it will be necessary for foreign investors to exhibit creativity and flexibility in composing a project, the gradual liberalization of investment in urban distribution networks should make China more attractive for foreign water companies who will now have the ability to be involved in the full process of water services from production to distribution.

By Tarrant M. Mahony and Leland Fong

Freshfields Bruckhaus Deringer