Dalian Water Supply Project February 26, 2004 Alyona Dubrovina Jim Horiuchi Henning Hummervoll

Context China, 1994 Asian Development Bank considers $160 M investment in a water supply project Background Project Description Analysis Conclusion

17% Infant mortality rate Cambodia

Aids spreading in Africa

75 million living below poverty line in China

Problem definition Which project should be financed?

Agenda Background Project description Analysis Conclusion

China 1.17 billion people (1994) Steady reforms since 1978 –GDP growth of 9% per annum –Infrastructure bottlenecks Tight political controls Pressures for reforms –Increased trade –WTO Background Project Description Analysis Conclusion

Dalian Municipality Important seaport Technology Development Area Growing population –4.7 million in 1997 growing at 3% pa Water supply shortage –Lowest average supply –Static water tariff level DalianChinaAsia Water Supply (lpcd) Background Project Description Analysis Conclusion

Project description Background Project Description Analysis Conclusion

Scope of Project Increase water supply –220 lpcd per person –2.2 million residents, farming and industry Project goals –Alleviate water shortage –Improve public health –Support regional growth –Increase water treatment capacity Background Project Description Analysis Conclusion

Project Mechanism Transport water –Biliuhe Reservoir  Dalian (160 km or 100 miles) Total project cost: $379.7 million Project components: Water conveyor (68 km) Two pipelines (94 km and 79 km) Two new pumping stations Water treatment plant near Dalian Distribution lines + storage tanks Project completion by September of 1998 Background Project Description Analysis Conclusion

Project Location Biliuhe Reservoir Dalian City Part A: Northern Conveyor (68 km) Transporting raw water to Wazidian Reservoir Part B: Southern Conveyor (2 pipelines of 68 km and 79 km) Conveying raw water to pumping stations and water treatment plant Transport treated water through water distribution lines Wazidian Pumping Station: Sales of raw water to DWSC takes place Background Project Description Analysis Conclusion

Stakeholders Executing Agencies –Dalian Water Supply Company –Northern Water Supply Company Debt holders –Dalian Municipality Government –Asian Development Bank –China Construction Bank and other commercial banks Other stakeholders –Dalian population, farming community and industries Background Project Description Analysis Conclusion

Financial Structure: Use of Cash Total project cost: $379.9 million Background Project Description Analysis Conclusionv

Financial Structure Sources of Cash –Loans: ADB Local commercial banks (China Construction Bank) PRC government –Ministry of Water Resources –State Planning Commission –Gant from PRC government –Dalian municipality’s own resources Background Project Description Analysis Conclusion

Financial Structure (continued) Effectively “all-PRC” funding other than ADB Loan –Enhancement of credibility Execution Agents Dalian Water Supply Company Northern Water Supply Company ADB Loan relent under separate loan agreements Debt Service Disbursement Debt Service Local Commercial Banks Ministry of Water Resources State Planning Commission Dalian Municipal Government Debt Service Disbursement Grant Project Execution & Management Central Government Background Project Description Analysis Conclusion

ADB Loan: Terms & Conditions Currency & Loan Amount US$160 million PurposeTo finance the foreign-currency component of the Dalian Water Supply Project BorrowerThe People’s Republic of China Interest TypeFloater based on ADB’s pool-based rate lending system (similar to cost of funding) Grace Period5 years Repayment20 years commencing 6 months from the end of grace period Total Term25 years Commitment Fee0.75% p.a. on undisbursed balance Covenants- DSCR to be maintained at minimum of 1.2x - No additional debt without prior consent of ADB Summary of terms and conditions Background Project Description Analysis Conclusion

Analysis

Investment Criteria GoalCriteria Project sustainabilityReturns exceed project cost of capital ADB’s sustainabilityReturns exceed ADB’s cost of capital Achieve economic growth Maximize economic benefits Background Project Description Analysis Conclusion

Project cost of capital Background Project Description Analysis Conclusion Cost of debt 8.51% –US 30-year treasury 7.37% –1994 Chinese government bonds spread 1.14% –Risk mitigation factors (discussed later) Cost of equity 15.82% –Market risk premium 3.5% –Sovereign risk premium 8.51% –Equity beta 0.3 –Risk mitigation factors (discussed later) WACC 10.5% –Capital structure: 53% equity, 47% debt

Project risk analysis -Dependence on completion of environmental protection and wastewater programs -Agency risks associated with large project and no direct foreign involvement -Availability of inputs -Size and sustainability of reservoir -Stability and cost of power supply -Dependence on tariff increases for profitability -Currency risk -Possible floating of Yuan could result in devaluation and difficulties in repayment of loans in USD as income is in Yuan Background Project Description Analysis Conclusion

Results of financial analysis Background Project Description Analysis Conclusion –Negative NPV $(474.9)M –IRR 8.9% –Growth rate and discount rate sensitivity: Base case: Growth rate 9%, discount rate 10.5% Project most likely not attractive to private investors

Sensitivity Analysis: Key Variables Background Project Description Analysis Conclusion Key variables: − Water Sales − Water Tariff − Raw water expense − Power expense

Sensitivity analysis: NPV Background Project Description Analysis Conclusion Expected NPV $(723) Less than 2% probability of positive NPV

Sensitivity analysis: IRR Background Project Description Analysis Conclusion Expected IRR 7.93%

ADB’s perspective Returns to ADB equal interest rate Variable interest rate exceeding cost of capital High probability of default on debt payments 83% ADB’s debt is expected to be honored at the expense of other debt holders

Alternative sources of financing Corporate finance –Municipality owned operating agencies: inefficiencies and agency problems –Illiquid assets Private sources: Highly unlikely Limited recourse project finance –Elimination of agency problem –Local and state government resistance –Not a Greenfield development –More expensive Private sources: Highly unlikely Background Project Description Analysis Conclusion

Economic analysis Benefits: High –Increase GDP, productivity, foreign investment –Improve public health –Eliminate inefficiencies in water sector Costs: Low –Wastewater treatment –Additional subsidy –Opportunity costs Risks: Low –In case of operational success economic benefits will be achieved Background Project Description Analysis Conclusion

Financial analysis should be enhanced by economic analysis –Unconvincing financial projections –Strong economic benefits and low risks We recommend to invest in the project Background Project Description Analysis Conclusion

What happened Loan approved for $160 million Reappraisal in 1997 extended scope –2 subprojects implemented to utilize northern conveyor Economic internal rate of return estimated at 13.4% Projected completed on time Knowledge and project skill transfer deemed successful Opened up for 8 more water supply and wastewater management projects including BOT and international investments Background Project Description Analysis Conclusion

Questions?