China Energy Sector Survey Part III: Foreign Inbound Investment

FOREIGN INVESTMENT IN ENERGY GENERALLY

Foreign investment in the energy sector, like investment in other industries, is subject to PRC government oversight. There are two principal governing documents: Guiding the Direction of Foreign Investment Provisions (指导外商投资方向规定)(the Guidelines, effective April 1 2002) and the Foreign Investment Industrial Guidance Catalogue (外商投资产业指导目录)(the Catalogue, also effective April 1 2002). The Guidelines describe the characteristics of activities that are subject to four categories (encouraged, restricted, prohibited, permitted), and that determine the acceptability of a foreign-invested enterprise or activities in China, while the Catalogue describes the specific industries or activities that are included in the encouraged, restricted and prohibited categories.⁷

Foreign investment in the energy sector is addressed by the Catalogue and includes industries and activities in all categories. Some activities are prohibited outright; others require a Chinese partner; and still others are encouraged and attract beneficial tax rates or exemptions. The assignment of the various categories is a reflection of China's commitment to certain WTO accession principles as well as its commitment to the growth of its own economy. For the latter, China seeks to both enhance its development, and at the same time strengthen the ability of its national energy companies to compete when its energy markets are fully opened.

FOREIGN INVESTMENT IN OIL AND GAS

The tenth five-year plan seeks to stabilize production in the east, develop the northwest basins and continue to pursue offshore opportunities. Natural gas is a developmental priority, and natural gas pipelines and LNG import terminals are the underpinnings of the increasing role of gas. To achieve these goals, the tenth five-year plan encourages greater participation in the oil and gas sector by foreign investors.

To date, foreign investment in various areas of the oil and gas sector has lagged behind expectations. The main reasons for this are policy-based or economic. However, from a legal perspective, the basic framework for foreign investment in the oil and gas sector is firmly in place and is generally better defined than the structures created for foreign investment in other energy sector industries.

Upstream

The 2002 Catalogue identifies oil and gas exploration and development as encouraged.⁸ This encouragement is accompanied by a plethora of laws, regulations and guidelines that serve to structure foreign investment in this area.

Foreign investment in the upstream oil and gas sector has been more significant in China's offshore areas than onshore. As of December 31 2002, CNOOC had over 30 production sharing contracts (PSCs, the documents that govern the operational and financial life cycle of a project) with foreign investors, while PetroChina is party to 14 PSCs. Sinopec is involved in only a handful of foreign-invested development projects in China.⁹ One reason for this difference may relate to the length of time foreign investment in China's offshore has been allowed. Offshore projects were opened to foreign investment in 1982, concurrent with the formation of the China National Offshore Oil Corporation (CNOOC). At that time, the State Council promulgated the PRC Exploitation of Offshore Oil Resources in Cooperation with Foreign Parties Regulations (Offshore Regulations). The regulations established the legal and operational framework under which CNOOC was to work with foreign investors in connection with the exploitation of offshore oil and gas resources.

China's onshore areas have been open to foreign investment only since 1993, when the State Council promulgated the PRC Exploitation of Onshore Oil Resources in Cooperation with Foreign Parties Regulations (Onshore Regulations). The Onshore Regulations identify China National Petroleum Corporation and (since 2001) Sinopec as the two national oil companies responsible for participation in any agreements associated with foreign cooperation.

The foreign investment regime for upstream oil and gas activities is clearly the most complex, or at least the subject of the most legal oversight and scrutiny, of the foreign investment schemes in the oil and gas sector. Foreign investment here is governed by a matrix of laws, regulations, circulars and opinions, and is overseen both by national oil companies, with whom foreign investors are required to partner and execute PSCs, and a number of state and provincial institutions, depending on the level of investment.

The Onshore and Offshore Regulations

The Onshore and Offshore Regulations are nearly identical. Under these Regulations, CNPC and Sinopec are responsible for conducting onshore exploitation, and CNOOC for offshore exploitation, as well as the exclusive responsibility for negotiating and performing contracts with foreign entities for exploitation in areas approved by the State Council. Exploitation contracts (generally in the form of a PSC) must be approved by the Ministry of Commerce (MOFCOM). Onshore PSCs may be entered either by way of public tender or negotiation. Where the block is located offshore, the award must be preceded by a public tender.

By virtue of the limitations imposed by the Catalogue, the parties to a project under either the Onshore or Offshore Regulations are expected to enter into a cooperative joint venture (CJV) pursuant to theSino-foreign Cooperative Joint Venture Law(中华人民共和国中外合作经营企业法). The foreign party in a cooperative joint venture is required to establish a presence in the PRC by way of a branch, subsidiary or representative office, and in a location to be agreed with the Chinese partner.

The CJV must appoint an operator, which can be either the foreign partner or the Chinese partner; however, the Chinese partner is responsible for obtaining the requisite approvals before development operations may be conducted where the foreign party is the operator. The foreign partner is responsible for undertaking all financial risks associated with the exploration phase of the project. Hence, all costs and expenses of exploration are borne by the foreign partner until a commercial discovery is made. Thereafter, the foreign partner is entitled to recover its exploration costs, plus a return on investment, under the cost recovery methodology negotiated in the PSC. The foreign partner is entitled to export its share of production or to sell it to its Chinese partner (with the corresponding right to repatriate its income abroad in accordance with the foreign exchange rules). Once the foreign partner has recovered its investment, all equipment installed by the foreign partner becomes the property of the Chinese partner. Furthermore, the Chinese partner owns all data and information acquired pursuant to development operations from the time of their creation.

Additional Legal Requirements

The Onshore and Offshore Regulations are only the starting point for foreign investment in the upstream area. Both Regulations explicitly provide that exploitation of offshore and onshore areas in cooperation with foreign parties must be conducted in compliance with “relevant laws, regulations and rules of the PRC and must be subject to the supervision of the relevant authorities of the PRC government”.

The principal laws and regulations are identified in the endnote.¹⁰ They govern the life cycle of an upstream project, from the identification of blocks for exploration through production to the disposition of the block.

The PRC Mineral Resources Law (MRL, adopted in 1986, and amended in 1996) sets the backdrop and tone for all mineral exploration and exploitation in the PRC, including oil and gas development through foreign investment. Under the law, mineral resources are owned and managed by the state, and any party seeking to exploit them must register to do so. The Ministry of Land Resources (MOLAR) is the principal agency in charge of the oversight of mineral development activities. The MRL sets broad standards for the conduct of mineral activities, including conformity with labour and environmental requirements set by PRC law. It also requires that resource developers be subject to tax and the payment of other mineral compensation to the state.

The MRL is heavily policy-oriented and also provides for a broad range of internal requirements that serve to maximize the value of the mineral resources for the state. These provisions range from the requirement of mineral surveys through restrictions on the construction of incompatible structures in mineral areas to the establishment of legal liability standards for mineral developers.

The PRC Mineral Resources Law Implementing Rules came into effect in 1996 and generally provide more detailed guidance on the rights and obligations of mineral developers. The Rules require exploration and development licences prior to undertaking activities and set out the corresponding rights and obligations of licence holders.

The Rules also require the preparation of medium and long term plans for state wide mineral exploration, which serve to assist MOLAR in setting the term of a production licence and evaluating requests for its extension.

The Administration of Registration of Mineral Resource Exploration Blocks Procedures (the Exploration Procedures) govern the registration system and are applicable to foreign investment in mineral resources generally. Under the Exploration Procedures, each area open to exploration is divided into units, with the largest units being allocated to oil and gas exploration. However, only those blocks approved in advance by the State Council may be made available to foreign investment. An exploration licence must be obtained from both the state and the provincial or local government before operations can commence. The applicant for an exploration licence, in the case of foreign-invested oil and gas activities, is the Chinese partner, who must provide plans for the exploration and development of the block and documents evidencing the qualifications of the party responsible for the operation. In the course of reviewing an application for an exploration licence, the approval authorities have the right to impose restrictions on the parties' agreement as well.

An exploration licence for oil and gas is valid for up to seven years, and may be extended for up to two years at a time. During the licence period, licensees must undertake minimum annual work commitments each year of the licence; excess expenditures are creditable to the next year. Work commitments in the oil and gas sector are generally divided in the PSCs in three areas: acquisition of seismic data and information; drilling of exploration wells; and commitment of other exploration expenditures. The specific nature and amounts of these work commitments are negotiated into the PSC.

Once a commercial discovery is made, the Administration of Registration for Exploitation of Mineral Resources Procedures (the Exploitation Procedures) come into play. These regulations require foreign investment enterprises to obtain a development or production licence before the commencement of production. MOLAR has principal responsibility for issuing production licences at the national level, though some projects will still be subject to scrutiny by the provincial and local governments based on their size.

Like the application for an exploration licence, a production licence application must be made by the Chinese partner and accompanied by evidence of the foreign contractors' qualifications, its development or production plans and an environmental report.

The term of a production licence varies, based on the scale of the project: large projects attract up to a 30-year term; medium scope projects up to 20 years and small projects up to 10 years. Term extensions are available. Issuance of the production licence is to be preceded by the preparation of a reserve report, which identifies the anticipated productive life of the field, which in turn determines the initial term of the licence. However, in the case of oil and gas PSCs, the production period is normally fixed at 15 years, subject to extension.

Production Sharing Contracts (PSCs)

The PSC will have the most impact on the life of the project from exploration through development to production. The PSC embodies as contractual terms and conditions a number of the basic provisions of the Onshore and Offshore Regulations, the requirements of the relevant mineral development laws and regulations, and the provisions of the exploration and production licences. Ultimately, as the name implies, the PSC determines the sharing of production from a successful exploration endeavour, including the formula by which the foreign investor recovers its risk investment made during the exploration phase.

The foreign investor and the relevant Chinese national oil company are the parties to the PSC. In the case of the Chinese partner, only the state company may negotiate and execute a PSC, whereupon it may assign it to its publicly listed entity. The undertakings between the national oil companies and their publicly listed affiliates generally allow representatives of the publicly listed company to participate in the negotiation of the PSC.

Under the PSC, one party is designated as the operator. A joint management committee comprised of representatives of the parties supervises the activities of the operator. The operator manages the day-to-day activities of the joint venture and has responsibility for the preparation and execution of work programmes and budgets, equipment procurement, the funding of operations via cash calls, hiring crew to conduct operations, maintaining records and the oversight of all other operations associated with the work programme agreed by the parties. Where the foreign investor (referred to as the Contractor) is the operator, the Chinese partner has the right to take over operations once the Contractor has recovered its share of exploration and development costs.

Under the PSCs, the Contractor is required to bear all costs and expenses in the exploration phase. The Contractor is required to relinquish acreage following each phase of exploration until a Development or Production Area is delineated. Once a discovery is made, the Chinese partner has the right to take up to a 51% participating interest in the block. At this point, after the payment of production taxes to the PRC government, the Contractor is entitled to recover its current share of development costs and its exploration investment plus interest out of production through a cost-recovery formula provided in the PSC. The remaining value of the production stream is allocated to the government royalty obligation and then divided between cost recovery oil and remainder oil. Royalty is paid to the PRC government on a sliding scale that ranges from 0% up to 12.5% for oil based on production volume and 0% to 3% for gas, also based on production. Recovery “oil” (including non-associated natural gas) is earmarked to reimburse the parties for their current development costs and, once monthly costs are recovered on a current basis, the excess recovery oil is applied to pay down the Contractor's exploration investment. The remainder oil is then divided between the PRC government and the parties on the basis of each partners' respective participating interest. The Contractor has the right to sell it in the international market or it may sell it to its Chinese partner.

Midstream (including Transportation) and Downstream

Foreign investment in the midstream and downstream phases of the oil and gas sector is less structured and regulated than in the upstream area, although areas of commercial uncertainty, e.g., fiscal stability, market-based pricing, regulatory transparency, etc., may be correspondingly greater. The midstream and downstream areas that tend to attract foreign investment occur in four general areas: pipeline transportation, LNG receiving and regasification terminals, refining (including petrochemicals) and marketing (wholesale and retail).

Transportation

The “construction and operation of oil (gas) pipelines” is encouraged in the 2002 Guidelines. The 2002 Guidelines eliminated the requirement that the Chinese party hold a majority stake, although no foreign investor appears to have taken advantage of this change to date. In addition, gas distribution is now merely restricted and requires majority ownership by the Chinese party. Moving gas distribution from the prohibited category to the restricted category is a recognition of the condition of this segment of the industry and the need for improvement if natural gas utilization is to be increased.

Liquefied Natural Gas (LNG)

LNG activities, which from China's point of view principally mean receiving terminals and regasification facilities, are not mentioned in the 2002 Guidelines per se (though gas depots are encouraged), despite the facilities under construction, and the proliferation of planned terminals, along the east coast of China. Thus, in the absence of any mention in the Guidelines, these activities are considered areas in which foreign investment is permitted.

Oil Refining and Manufacture of Petrochemicals

The construction and operation of oil refineries is restricted and requires “overall state balancing”. In contrast, a wide range of petrochemical manufacturing, from the manufacture of ethylene through synthetic rubber to biological agrochemicals, is encouraged under the 2002 Catalogue. However, investment in facilities that manufacture ethylene with an annual production capacity greater than 600,000 tons requires Chinese majority ownership.

Marketing

Foreign participation in the wholesale and retail markets is technically restricted. Although characterized as restricted, foreign investment in the wholesale side of the downstream business is effectively prohibited until December 11 2006, at which time foreign investment is “permitted to deal” in both crude oil and refined products (called “processed oil”). In the absence of this permission, only state-controlled companies have licences to import or export crude oil and refined products.¹¹

On the retail side, foreign investors will be permitted to establish wholly owned enterprises and “permitted to deal” in processed oil by December 11 2004. However, there is still a restriction, under which foreign investors may not be permitted to hold a controlling interest in “chain stores” that have more than 30 outlets.

Investment in Midstream and Downstream

Unlike the upstream end of the oil and gas sector, there are no substantive laws and regulations governing foreign investment in the midstream and downstream portions of the business. Thus, subject to the approval and ownership/participation restrictions placed on foreign participation by the 2002 Catalogue, activities in these areas are principally governed by standard joint venture laws and related company laws and regulations. And unlike the Onshore and Offshore Regulations, which prescribe adherence to the CJV structure, no particular form of business entity is prescribed for midstream or downstream activities involving foreign enterprises.

Foreign investment in the downstream area has varied by project type. For instance, foreign investment in oil refining has been very limited, principally due to the high cost of entry and the historic duopoly held by Sinopec and CNPC. Still, a number of major foreign oil companies have interests in refineries in China, as well as lubricant plants, bitumen manufacturing plants and storage facilities. Foreign participation in oil refining is increasingly tied to the manufacture of petrochemicals; a number of integrated petrochemical projects are underway that include the installation or enhancement of oil refining capacity to provide feedstock for the petrochemical complex (an encouraged activity).

Foreign investment in the gas processing and petrochemicals end of the downstream business has a long history in China. Several world-scale petrochemical complexes are today located in China, and they are foreign-invested. The highest profile projects have been joint ventures by the local arms of foreign investors such as BASF,¹² BP,¹³ Dow,¹⁴ ExxonMobil¹⁵ and Shell¹⁶. Their projects include petrochemical complexes, storage facilities and terminals.

The retail side of the downstream business has seen limited foreign investment over the years, but currently is the subject of significant foreign investment attention. Three major foreign investors are positioning themselves for a key role in China51s downstream market. BP and Sinopec have recently announced formation of a joint venture to build 150 gas stations in Zhejiang province and to expand to 500 stations within three years. BP also has announced a similar joint venture with PetroChina for 500 service stations in Guangdong province. Shell and Sinopec have reportedly entered into a joint venture under which they would jointly operate 500 retail stations in Jiangsu province. And ExxonMobil is reported to be in a joint venture with Sinopec to open 500 stations in Fujian province.

The transportation side of the energy sector probably has seen the least foreign investment. The best known transportation project in China currently is the West-East Pipeline (WEP), running from Lunnan in westernmost Xinjiang province to Shanghai, which is expected to carry 12 billion cubic metres of natural gas annually. A Joint Venture Framework Agreement was signed in July 2002 between PetroChina and affiliates of ExxonMobil, Shell, Gazprom (each holding a 15% interest) and Sinopec (holding a 5% interest), though discussions to advance the foreign investment in the WEP are reported to be on hold. Recently, the first segment of the WEP from Jianbian in Shaanxi province to Shanghai was completed and gas is being delivered into Shanghai. Other foreign-invested pipelines are under discussion, primarily those originating in bordering Russia (Angarsk and Kovytka) and Kazakhstan, but the ownership mix has not been agreed. It is possible that national oil companies or other governmental entities within their respective territories will exclusively own each of these pipelines.

Impact of World Trade Organization (WTO) Accession Commitments

Many of the current laws and regulations in place are the result of the PRC's efforts to comply with its WTO accession commitments. The 2001 amendments to the Onshore Regulations and Offshore Regulations are the product of concerns that the old regulations might violate the PRC51s accession obligations. The 2001 revisions lifted the restriction on foreign parties to sell their share of production to their Chinese partner and eliminated the preference for Chinese personnel and goods and supplies. Likewise, changes between the 1997 and 2002 Catalogue, particularly those provisions in the restricted category eliminating majority ownership in certain enterprises by Chinese partners, are linked to the PRC's desire to meet its WTO accession promises.

In addition to the areas opened up to foreign investment under the 2002 Catalogue, the Annex to the Catalogue identifies areas that will be the subject of future relaxation to meet the requirements of WTO compliance. The most significant changes ahead in the oil and gas sector due to WTO will be in the wholesale/retail markets. WTO accession obligations require China to allow foreign ownership in its retail markets by December 11 2004, and wholesale markets by December 11 2006. Other areas in which restrictions were recently relaxed include tariffs and import quotas. Tariffs on imported crude oil have been eliminated and tariffs on gasoline and lube oil have been reduced. Likewise, import quotas and licence requirements for refined or processed oil (described as gasoline, kerosene, diesel, lubricants and the like) were recently relaxed, thus allowing foreign investors to apply for a direct import licence. Remaining quotas and licence requirements are to be eliminated by January 1 2006.

The upstream area is expected to see no further changes in anticipation of WTO than those imparted in the 2001 Onshore and Offshore Regulations. The 2002 Catalogue maintains the requirement that oil and gas risk exploration and production must be conducted in cooperation with Chinese partners.

FOREIGN INVESTMENT IN ELECTRIC POWER

Tenth Five-Year Plan

The tenth five-year plan emphasizes the continuing reduction of small plants and the corresponding increase in generation capacity in larger, clean plants. Gas-fired generation plants are encouraged, as is the installation of clean technology to improve the efficiency of generated power. While transmission improvements and interconnections are also stressed, as will be seen below, this area is off-limits to foreign investment.

Catalogue Characterization

Under the 2002 Catalogue, foreign investment in the power sector is generally encouraged. The only area that is closed to foreign investment is in the construction and operation of power grids. The construction and operation of conventional coal burning power stations with a single generator capacity of 300,000 kW or less (except small power grids) is restricted, and it may be difficult to secure approval.

The 2002 Catalogue limits the permissible form of investment vehicles for certain kinds of power projects. In the areas of power generation (including thermal, hydroelectric and nuclear), and distribution and transformation equipment that exceeds certain specification requirements set out in the Catalogue, foreign investment must be made through either an EJV or CJV.

The construction and operation of power stations employing clean coal technology, co-generation facilities, natural gas power stations, hydroelectric power stations primarily intended for power generation, and power stations employing new alternative sources of energy are all in the encouraged category. Fossil fuel power stations with a single generator capacity of 300,000 kW or more also are encouraged. The Catalogue does not limit foreign investment in these projects to EJVs or CJVs.

Although nuclear power stations are also encouraged, the Chinese party must hold a majority interest, which requires a joint venture arrangement.

Procedures for Entry

Application of the Bidding Law

The PRC Invitation and Submission of Bids Law (the Bidding Law), as a practical matter, applies to most power projects. Article 3 of the Bidding Law requires that bids must be tendered to undertake engineering and construction projects (including survey, design, construction, supervision and procurement) of the following types:

• large-scale infrastructure, public utilities and other projects involving the public interest or public security;

• projects wholly or partially financed by the state or in which state-owned funds are invested; or

• projects using loans or aid funds from international organizations or foreign governments (except that the respective lender or fund provider may determine the bid invitation process as long as the public interest of the PRC is not thereby violated).

There are few circumstances under which the engineering and construction of a power project would not be subject to the Bidding Law; most power projects fall into one of the three categories requiring its application.

Approval Process and Requirements

The approval process for foreign investment in power projects corresponds to the approval process for foreign investment enterprises generally, but has requirements that are specific to the power sector. Two documents are particularly relevant here: the Foreign Investment in Power Projects Several Provisions, issued March 20 1997, which made reference to the Reporting and Approval Procedures for Direct Foreign Investment in Power Projects Tentative Provisions, promulgated on December 9 1996 (Dianji [1996] No. 723).¹⁷ The over-arching import of these documents is that foreign-invested power projects must be consistent with state industrial policies, and be included in a five- or ten-year plan unless the project receives special permission from the state.¹⁸

Foreign investors may invest in China's power sector by way of EJV, CJV or WFOE vehicles. Foreign investment also may occur through the purchase of shares in domestic companies. Build-Operate-Transfer arrangements are another option.¹⁹ Nuclear power projects and hydroelectric power projects over 250MW are not open to WFOE investments; instead, these projects may only proceed in the form of an EJV or CJV, with PRC state-owned assets accounting for a majority (51%) interest.²⁰ Although the CJV laws and regulations permit CJVs with non-legal person status, a CJV power project will probably have to opt for legal person status. For instance, legal person status is required for all newly built, expanded or renovated large or medium-sized thermal power generation projects.²¹ In addition, a power project must have legal person status in order to enter into a power purchase agreement with grid operators.²²

Joint ventures may be formed with the Chinese party using “inventoried assets”, in which there are two possibilities. The first is a simple change of capital structure, involving the transfer of some of the assets of the Chinese party's existing power station to the foreign party in order to form a joint venture and to jointly run the existing power station. The second possibility is an expansion of and change in capital structure, involving the investment of assets of an existing power station by the Chinese party and of cash or equipment by the foreign party in order to form a joint venture. This option permits parties to jointly run an existing power station, or to renovate an existing power station or to build a new one.²³ Special rules apply to the review and approval of joint ventures using inventoried assets.²⁴

The commercial operating terms for power projects involving foreign investment may generally not exceed 20 years for thermal power stations, 30 years for hydroelectric power stations and 25 years for nuclear power stations (or plants). Where “inventoried assets” are used, the actual term may be based on the results of asset valuation, but must not exceed the limits stated above.²⁵

Approval Authorities

Unlike the general foreign-invested enterprise approval practice, which centres on the size of the total amount of investment, approval for power projects is different because energy production is a sector still heavily subject to state planning practices. Most power projects are capital intensive and involve state funds. In addition, power projects are actually classified as requiring “State Overall Balancing”, and generally call for central approval. This authority rests with the NDRC in most cases. For significant projects, which would include projects involving large investment amounts (over US$100 million) or those identified by the central government as key projects, State Council approval is required upon referral from the NDRC.

Document Requirements

For an EJV or CJV to obtain approval to establish the project (lixiang), a project proposal, together with an approved letter of intent signed by the parties and evidence of the foreign party's credit worthiness, will be submitted to the local planning authorities for preliminary review. The local planning authorities will then refer the project proposal to the NDRC for approval.

Once lixiang approval is obtained, the project investors/partners may prepare a Feasibility Study Report (FSR). The FSR will be submitted to the local planning authorities for preliminary review, and then be referred to the NDRC for approval.²⁶ The FSR must be accompanied by approval documents from (and where applicable contracts with) central and provincial level administrations regarding environmental protection, land use, water use, fuel supply, transport and grid price, etc. In addition, contracts or other documents pertaining to preliminary design, equipment procurement and overseas financing will be necessary. Finally, the package must include the joint venture agreement signed by the parties and charter documents for the project company.²⁷

A number of agencies other than the NDRC also will be involved in the FSR approval stage. Each of these will review the FSR, and issue approval in support of the FSR. For example, MOFCOM has now assumed the role of the former MOFTEC in making sure that the joint venture agreement and charter documents for the project company conform to foreign investment laws. The State Administration of Foreign Exchange (SAFE) will review issues relating to foreign exchange and foreign credit.

The State Environmental Protection Administration will scrutinize the project51s environmental compliance, especially if coal is used as the fuel source. Foreign investors must ensure that the project will be in compliance with environmental obligations at every stage of the approval process.

Upon approval of the FSR by the NDRC and MOFCOM's approval of the joint venture agreement and charter documents, MOFCOM will issue a Foreign Investment Enterprises certificate, whereupon the project company may apply to the State Administration for Industry & Commerce (SAIC) to obtain a business licence.²⁸

For a WFOE, the process and document requirements are generally similar. A preliminary application report and a project report are required in the place of a project proposal and FSR.²⁹

Impact of Restructuring

China's power sector recently has undergone major structural and regulatory reorganization. Five power generation group companies have been established to take over the generation assets of the former State Power Corporation (SPC). Likewise, two grid companies now operate the grid assets of the SPC. Meanwhile, a new State Electricity Regulatory Commission (SERC) has been created to oversee the power sector. And it is expected that the PRC Electric Power Law, the principal law governing the power sector, will be amended to suit the change in circumstances that have taken place since its original promulgation in 1995. The various regulations that govern or otherwise affect foreign investment in the power sector may be changed accordingly afterwards. But for now, it is not clear whether there are more opportunities for foreign investment as a result of the reform of the power sector.

Operating Issues

Grid Connection and Dispatch Agreement. Power producers need to be connected to a power grid to supply power to the market. The Administration of Power Grids Dispatch Regulations, effective November 1 1993 and the Administration of Power Grids Dispatch Implementing Rules effective October 11 1994, set out the conditions that must be met in order for a power plant to be connected to the grid.³⁰ A power project will need to enter into a grid connection and dispatch agreement with a grid operator.

Basic terms of a grid connection and dispatch agreement are set out in Article 31 of the Administration of Power Grids Dispatch Implementing Rules. Recently, the SERC published a model contract. The basic terms cover areas such as the technical conditions for interconnection; peak load, frequency and voltage modulation, backup/reserve capacity, dispatch plans, safety measures and accident handling procedures.

Power Purchase Agreements (PPA). A power project sells electricity by entering into a PPA with a grid operator.³¹ A PPA may be short term (less than one year) or long term (up to 20 years). For power projects with foreign investment, whether EJV, CJV or WFOE, the duration of a long term PPA may not exceed the term of the project described in the approved FSR.³²

The Power Supply Business Regulations, October 8 1996 (Article 90) and the Standardizing Administration of Power Purchase Contracts Tentative Procedures (Articles 7 and 8) require certain basic terms to be included in a PPA, such as the interconnection mode, quantity and quality of the electricity generated, time of electricity generation, measurement of quantity transmitted, grid price, and methods to resolve discrepancies between the actual and the planned quantity of power purchase.

Recently, the SERC issued a model short term (one year) PPA. Instructions to the sample contract, however, provide that parties may utilize the model contract, negotiate a long-term master PPA, and then execute annual PPAs with reference to it.

Electricity Pricing

A nationwide competitive power market is on the horizon. Market pricing structures are being tested in specifically approved regions, e.g., in northeastern China. Meanwhile, electricity prices are still under state control. Although power projects may negotiate prices with grid operators, the electricity price is subject to ratification by the State Price Bureau. The Standardizing Administration of Power Purchase Contracts Tentative Procedures require all PPAs to contain the initial electricity price and its calculation method. The electricity price must be determined in accordance with principles set out in the PRC Electric Power Law. These include: the recovery of reasonable costs; the determination of gains in a reasonable manner; and the inclusion of taxes.³³ For grid price, the basic principle is “same grid, same quality, same price”.³⁴

The PRC Electric Power Law and the Standardizing Administration of Power Purchase Contracts Tentative Procedures prohibit the supplier from changing price without approval.³⁵ Electricity prices may be adjusted, but probably no more frequently than on an annual basis. For example, the model PPA issued by the SERC is designed to set electricity prices annually. Usually, the project and the grid operator can determine the grid price for the coming year by negotiation. Adjustments are subject to ratification by price control authorities.

The SERC has conducted a thorough review of electricity prices across the country, and reaffirmed certain restrictions aimed at curbing violations in electricity pricing.³⁶

FOREIGN INVESTMENT IN COAL

Role in the Tenth Five-Year Plan

While aiming to reduce coal's share in China51s total energy supply, the PRC government acknowledges that coal will continue to be a dominant energy source. The current five-year plan expresses a strong desire to invest in clean coal technology and to better exploit coalbed methane resources. China also appears to welcome foreign investment that includes technology to improve the efficiency and productivity of China's coal mines.

Characterization in Catalogue

Under the 2002 Catalogue, exploration for and development of coal resources is encouraged. The Catalogue itself does not limit the form of foreign investment in coal mining. The 2002 Catalogue also addresses foreign investment in construction and operation of coal pipeline transportation facilities, which is categorized as encouraged. The Catalogue does not limit the form of investment in this respect.

The coal sector is not expected to attract sizeable foreign investment. However, opportunities for foreign investors may be found in the application of new technologies such as coal liquefaction and gasification. For instance, Shenhua Group, one of the major coal companies in China, has been working with foreign investors to develop a coal liquefaction facility.

Coalbed Methane (CBM)

Under the 2002 Catalogue, exploration for and development of CBM is encouraged. Foreign investment in CBM will be conducted along the lines set out in the Onshore Regulations referred to above. The Onshore Regulations also give the China United Coalbed Methane Company (CUCBM) the exclusive right to partner with foreign investors in CBM activities. As with oil and gas, only those blocks approved in advance by the State Council may be made available to foreign investment. Operations are conducted pursuant to a PSC that is similar in form to those used in onshore oil development. A PSC for CBM is usually 30 years in duration, which encompasses the exploration, development and production phases.

CBM is subject to the legal regime imposed by the Mineral Resources Law and its implementation regulations described above. The Exploration Regulations and the Production Regulations apply to CBM in much the same way as they apply to oil and gas upstream activities. Only the Chinese party may hold an exploration licence for CBM, and therefore CUCBM will make such an application. The exploration licence shall be valid for up to seven years, and may be renewed for no more than two years at a time. The minimum work commitments apply for CBM as they do for upstream oil and gas activities: for the first year of exploration, Rmb2,000 per square kilometre; Rmb5,000 per square kilometre in the second year; and Rmb10,000 per square kilometre from the third year onward.

Exploration licence fees are also payable and calculated on the basis of the size of the exploration block. For the first three years the fee is Rmb100 per square kilometre, which is then increased by Rmb100 per square kilometre starting in year four to a maximum of Rmb500 per square kilometre.

Prior to production, a mining licence must also be obtained from MOLAR pursuant to the Mining Registration Regulations. A mining licence user fee is also payable on an annual basis at a rate of Rmb1,000 per square kilometre.

Conclusion

The foreign investment regime for energy varies in China, from the detailed matrix of laws and regulations that govern oil and gas exploration and production to the generic provisions that address only the formation of joint ventures to manufacture petrochemical products. There appears to be little correlation between the detail of the regime and the level of foreign investment. In the end, the level of foreign investment in the energy sector in China may have more to do with the policies and economics of the individual industry and activity than with the comprehensiveness of the foreign investment regime or ease of entry.

Still, there are a number of observations that emerge from an analysis of the legal structures that support foreign investment in the energy sector. Clearly, the upstream oil and gas area is comprehensive and in need only of fine-tuning. However, the transportation area, while now encouraged, appears to been in need of broad substantive measures to better define the role of foreign investors in that sector generally. Likewise, in the area of natural gas distribution a comprehensive framework of regulation for investment will be necessary before the benefits of the natural gas supply chain are fully realized. Finally, to the extent that the great majority of infrastructure investment over the next 25 years is expected in the electric power area, predictability will be important. The impact of the recent restructuring on foreign investment is uncertain and will need to be clarified if meaningful investment in this area can be expected from abroad.

Readers are referred to the first two instalments in this series, which appeared in the November 2003 and December 2003/January 2004 editions, respectively.

Endnotes

1 International Energy Agency, World Energy Investment Outlook: China Energy Investment Outlook 2003 Insights, pp. 43-44.

2 Ibid, p. 47.

3 Ibid, p. 50.

4 Ibid, p. 63.

5 Ibid, p. 64.

6 Ibid, p. 59.

7 Only three categories are included in the Catalogue because if an industry or activity is not specifically listed as encouraged, restricted or prohibited, it is considered permitted.

8 Also encouraged in the upstream area are: “development of oil/gas pools (fields) in low permeability formations”; “development and application of new technologies for increasing the crude oil recovery factor”; “development and application of new technologies for petroleum exploration and development such as geophysical prospecting, drilling, logging, downhole operation, etc.”.

9 Nevertheless, Sinopec had 294 exploration licences and 193 production licences at the end of 2002.

10 PRC Invitation and Submission of Bids Law; Administration of Invitation and Submission of Bids, Auction and Listing of Exploration Rights and Mining Rights Procedures (Trial Implementation); PRC Mineral Resources Law; PRC Mineral Resources Law Implementing Rules; Administration of Registration of Mineral Resource Exploration Blocks Procedures; Administration of Registration for Exploitation of Mineral Resources Procedures; Transferring Exploration Rights and Mining Rights Procedures; Administration of Granting and Assigning Mining Industry Rights Tentative Provisions.

11 Foreign investors also have the right under their PSCs to export crude oil allocable to their participating interest.

12 BASF/Sinopec Yangtze Petrochemical JV in Nanjing.

13 BP/Sinopec/Shanghai Petrochemical JV in Shanghai (SECCO).

14 Dow UCC Tianjing Ethylene JV.

15 ExxonMobil/Saudi Aramco/Fujian Petrochemical JV (proposed).

16 Shell/CNOOC/Guangdong Province JV at Daya Bay.

17 These provisions were promulgated based on the general principles under the laws and implementing rules governing the formation of EJVs, CJVs and WFOEs, to specifically detail the document requirements and procedural steps for foreign investment in power projects. It should be noted, however, that these provisions do not apply to projects involving the use of inventoried assets, nor to BOT projects. These are governed by separate regulations respectively. Investment in the nuclear power industry must also comply with additional industry specific regulations.

18 Dianji [1996] No. 723, Article 2.

19 Ministry of Power Industry, Foreign Investment in Power Projects Several Provisions, March 20 1997.

20 Ibid, Article 11.

21 Implementation of Legal Person Responsibility System for Electric Power Construction Projects Provisions, Dianjian [1997] No. 79, February 5 1997, Article 2.

22 Standardizing Administration of Power Purchase Contracts Tentative Procedures, September 29 1996, Article 4.

23 Power Industry Use of Inventoried Assets for Joint Ventures with Foreign Companies Economic Appraisal Implementing Rules (Trial Implementation), September 22 1996, Article 2.

24 Examination and Approval Procedures for Power Industry Use of Inventoried Assets to Attract Foreign Investment Provisions, July 19 1996.

25 Foreign Investment in Power Projects Several Provisions, Article 12.

26 Dianji [1996] No. 723, Article 10.

27 Ibid, Article 11.

28 See the EJV Implementing Rules and CJV Implementing Rules.

29 Dianji [1996] No. 723, Articles 13 to 18.

30 See, e.g., Administration of Power Grids Dispatch Implementing Rules, October 11 1994, Article 30.

31 See Standardizing Administration of Power Purchase Contracts Tentative Procedures, Article 4.

32 Ibid, Article 8.

33 Electric Power Law, Article 36.

34 Ibid, Article 37.

35 Ibid, Article 43; Standardizing Administration of Power Purchase Contracts Tentative Provisions, Article 16.

36 Fagaijiajian [2003] No. 1152, issued on September 11 2003.