In the Mood for Investment: New Opportunities in China's Infrastructure Projects?

In the past, foreign parties dealt with this commercial dilemma by entering into cooperative joint ventures and securing a fixed return, which was sometimes guaranteed by local governments to make up for revenue shortcomings. Fixed returns for foreign investments in China came to an end during the Asian financial crisis, however, when the PRC central government banned them. The government took the position that fixed returns are a type of foreign debt and that they violate the principle of mutual profit and loss sharing between Chinese and foreign partners. The legacy of this ban lives on today in the ambiguous legal status of local incentives and subsidies.

This combination of fixed price policies, a prohibition on fixed returns, and legal uncertainty regarding government guarantees and subsidies may render public infrastructure projects commercially untenable and impossible to finance. However, there are also increasing opportunities in the modernization of China's basic infrastructure. Several factors, including greater willingness by local governments to give concessions and thus for foreign investors to use a Public Private Partnership (PPP) structure, suggest that now may be the time for foreign investors to make China's infrastructure projects pay.

Concession Agreements

One positive factor may be the greater likelihood of use of the PPP structure. So far few infrastructure projects have been implemented using a PPP structure, i.e., using a concession-based structure. The majority have been set up as regular foreign direct investment projects instead. An advantage of a concession agreement (compared to a regular foreign investment structure) is that it can be used to address many of the issues that are likely to be of concern to foreign investors in Chinese infrastructure projects, such as allocation of risk, tariff structures and control, public sector support, etc.

On the whole, the legal framework for PPP structures in China is not well defined, but vagaries in the law can for the most part be remedied in the concession agreement.

In PRC law, there is no clear cut statutory definition of the concept of a concession agreement. Nor are there meaningful implementing rules for typical PPP structures, such as build operate transfer (BOT) and transfer operate transfer (TOT) projects, at the national level and/or of universal application. In this respect, the Several Issues Concerning the Examination, Approval and Administration of Experimental Foreign-invested Concession Projects Circular² - the BOT regulations - contains only nine articles and is a pilot regulation, while the State Development and Planning Commission, Strengthening the Administration of the Transfer of Assets and Interests of State-owned Infrastructure Circular³ - which addresses TOT - reflects a lack of coordination between the authorities as it was issued by the predecessor of the National Development and Reform Commission without the involvement of other departments-in-charge of the infrastructure industries. In an effort to better regulate the market, the Ministry of Construction issued the Administration of Concessions for Urban Utilities Procedures on March 19 2004, but they are only applicable to urban public utilities such as water, gas, heat, sewage treatment, refuse treatment and public transportation, and not to non-urban public utilities such as power plants, ports or highways. There have also been local attempts at defining these conceptual terms.⁴

The concession agreement can, however, operate as a regulatory mechanism and fill the gaps left by the statutory framework by setting out both the main parameters and project specific details, although the rights and obligations of the conceding authority will be contractual and civil instead of legislative in nature. The positive effect is that host governments are willing to treat the granting of concessions as a commercial act and are open to the idea of waiving sovereign immunity. However, in dispute resolution for possible breach of the concession agreement by the government, an outstanding issue is whether the government is willing to accept international arbitration, or, if litigation is the only option acceptable to the host government, whether the Chinese court will act in a truly neutral manner.

Controlling Tariffs

One major issue of interest to foreign investors that can be addressed in the concession agreement is tariff or charge control. If the tariffs are fixed or regulated under the concession agreement, then the agreement should cover both the initial charges as well as the right to increase the tariffs over the life of the concession. The need to address tariff increases in the concession agreement would arise if the concessionaire is unable to absorb certain risks and, due to fixed or regulated tariffs, is unable to transfer their economic impact to third parties. Conversely, where the concessionaire has full and discretionary control over its tariffs, the need for such a provision diminishes.

There is, of course, the need to factor in the PRC pricing system. In addition to fixed or regulated tariffs under the concession agreement, fees charged may be subject to China's mandatory pricing system. As readers might be aware, under this system there are three types of pricing regimes:

(i) "government-fixed pricing", meaning that only the government is authorized to determine the price;

(ii) "government-guided pricing", meaning that operators of the related business may determine prices with government guidance regarding the base price and its range of fluctuation; and

(iii) "pricing subject to market adjustment", meaning that the operators are authorized to fix prices by themselves.

Among these three, infrastructure projects are most often subject to government-fixed pricing - where the initial charges as well as any increase in tariffs are subject to government approval - and this presents the greatest problem. Until recently, national and local level pricing bureaux were in charge of such price administration, but lately the PRC National Development and Reform Commission and its local counterparts appear to have taken over this role in several major locations. As tariff changes may be subject to further approvals, and because the government department that is a party to the concession agreement will likely not be the pricing approval authority, no particular tariff increase formula will automatically be enforceable based on the strength of the concession agreement. However, compared with non-concession based investment scenarios, the PPP structure is far more attractive because, if the concession agreement is properly structured, the host government may be held accountable if the contractually prescribed tariff increase is not honoured by the pricing authority.

Public Sector Support

As part of risk allocation for the project, local governments may be willing to take certain steps in regard to promoting the project, such as tax incentives, facilitation of authorizations and consents, investment protection rights, and even government subsidies and guarantees. The legal status of government subsidies is a grey area in China, however.

In a culmination of the bans that first appeared in 1998, a State Council circular in 2002 - the State Council General Office, Issues Relevant to the Proper Handling of Current Projects with Guaranteed Fixed Returns for Foreign Investors Circular - reiterated that all domestic Chinese entities, including local governments, are prohibited from guaranteeing fixed returns to foreign investors.

Strikingly, the government prohibited fixed returns without defining the term, leaving the matter open and casting uncertainty over any arrangements of this kind. For example, the abovementioned State Council circular primarily aims at fixed returns in joint ventures, with or without government guarantees supplementing them. The most worrisome arrangements were joint ventures where the foreign shareholder was paid a fixed return regardless of whether any profits were available for distribution. These situations resulted in the undesirable "foreign debt" scenarios that were targeted by the government.

Subsidies, however, may serve as a tool of the host government to share part of the risk associated with government fixed pricing structures that would lead to unviable commercial situations. They have, therefore, a more far-reaching political significance than only attracting foreign investors to certain infrastructure projects. However, even though subsidies are paid out to the project company instead of the foreign investor directly, they will operate to some extent as a fixed return to the foreign investor (and to the Chinese partner as well), and thus may fall within the ban on fixed returns. In particular, subsidies can be exposed to different kinds of dangers. The central government may invalidate subsidies (on the basis that they are a form of fixed returns) during approval procedures for projects warranting central government approval, and may do the same to locally approved projects by issuing a ruling. Because of the legal tenuousness of subsidies, local governments could also subsequently cancel subsidies to reallocate funds.

Current Opportunities

Although the history of ensuring the profitability of returns for foreign investors in Chinese infrastructure projects has been an unfortunate one, investing in China has always involved a combination of ingenuity and fortuitous timing. Certain current market factors, along with a sound PPP structure, may offer investors a chance to pursue commercially tenable investment in China's infrastructure industry.

The confluence of WTO commitments and domestic need has led to a shift in attitude that has pushed the sector to become much more of a profit-oriented concern. In terms of the WTO commitments, foreign investment in water supply and distribution in China has been permitted since 2002, and many restrictions in the rail industry have been phased out since accession to the WTO.

In addition, national and local governments realize that the price to be paid to expand infrastructure, both in terms of funds and technology, is far too high for them to bear by themselves. They have responded by opening up certain sectors to greater private sector investment, including foreign investment. Much of this has not even stemmed from the WTO. For example, foreign investment in the construction and operation of urban water supply plants is listed under the "encouraged" category of the Foreign Investment Industry Guidance Catalogue with no restrictions on maximum foreign shareholding. China's WTO commitments make no stipulation for this.

The desire to draw more private investment to infrastructure projects has also caused changes in price controls, where tariffs can be set to match costs and make a profit. Water prices have been rising. To give an example, in the port sector, it is expected that some of the pricing items will be taken out of the traditional "government-fixed pricing" category and shifted to the liberal regime of "pricing subject to market adjustment".

As for deals, there has also been more willingness by local governments to give concessions and take measures to make subsidies or guarantees more legally sound. This is being done via provisions in the concession agreement and even the promulgation of local legislation to recognize guaranteed benefits. One way to secure basic security for foreign investors is a "take or pay" arrangement.

This trend has been helped along by the emergence of private utilities that serve an increasing number of industrial end-users. Apart from its own industrial giants, China has attracted some of the largest multinational companies to China. These multinationals have either been drawn to use China as an export base or to serve the domestic market, and this has created many attendant companies to provide for these large enterprises. Together, these companies have tremendous resource and infrastructure needs, and because they are businesses, the social element restraining price increases is removed from the equation. In addition, because of Chinese zoning policies, more and more of these big users (both foreign invested and domestic) are located in dedicated investment zones. The supply to these big user zones has the potential to be the commercially viable projects foreign investors have been waiting for.

Endnotes

1 China Hand, December 2004.

2 Issued by the former State Planning Commission, the former Ministry of Electric Power and the Ministry of Communications on August 21 1995.

3 Issued by the former State Development and Planning Commission (now the National Development and Reform Commission) on October 19 1999 and effective as of the same date.

4 For example, the Beijing Municipality, Concessions for Urban Infrastructure Procedures were issued on August 28 2003.