Infrastructure is key to China’s economic and social progress, but building a sound legal framework may be more urgent than beginning construction.
Richard Li reports
The promotion of the public-private partnership (PPP) model was one of the topics at the executive meeting of the State Council held on 7 July 2016, and there was a problem. News reports said the National Development and Reform Commission (NDRC) and the Ministry of Finance (MOF) gave their opinions on “concession legislation” and “PPP legislation”, respectively, but their suggestions contained considerable duplication and conflicting content.
Premier Li Keqiang requested at the meeting that the Legislative Affairs Office of the State Council should take the lead in the PPP legislative process and quicken its pace. “As we are creating a government grounded in the rule of law, the Legislative Affairs Office must look beyond the interests of different ministries,” he said.
The promotion of PPPs across the country accompanies a wave of infrastructure development, and the premier’s firm stance regarding PPP legislation reflects the emphasis that the central government places on infrastructure development. Apart from the demands of overall economic development, environment protection, an aging population, urbanization and other issues that have become increasingly important in recent years have also beefed up China’s demand for infrastructure development.
Monica Sun, a partner at Herbert Smith Freehills (HSF) in Beijing, has recently seen significant interest from private investors in two major areas – municipal works and energy infrastructure. “In the energy sector, LNG [liquefied natural gas] and gas projects in particular have garnered a lot of attention,” she says.
HSF advised a leading Japanese trading house on its investment into regional LNG regasification plants in China. Monica Sun has also seen new domestic entrants in the LNG regasification market, such as China Huadian Corporation and ENN Group. In the municipal sector, HSF acted for the Beijing MTR Corporation on some aspects of its metro-line project in Beijing.
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“In the future, we see a clear trend towards infrastructure projects emphasizing municipal works, transport and environmental protection,” says Monica Sun. “Waste water treatment and waste-to-energy plants, utilities for water, gas and heating supply, urban rail and metro projects are clear ‘hot’ sectors to look out for.”
Sun Hui, a partner at Zhong Lun Law Firm in Beijing, has noticed that “integrated” infrastructure projects have increasingly become favoured investment targets. “The objective of these types of projects is not the construction of a single facility, but rather, the provision of a one-stop solution to address social demands,” she says. “Such a project may include the construction and operation of a series of related facilities and the provision of related services.” Such projects include, for example, new towns, industrial parks, and treatment facilities for polluted water.
The healthcare and senior care sectors are other sought-after investment areas, as China needs to cope with its aging population. “In consideration of the weak hospital infrastructure and limited healthcare resources in China, the potential market of Chinese healthcare and aged care sectors is quite enticing for private investors,” says Rebecca Silli, a partner of Minter Ellison in Hong Kong. “It is forecast that healthcare spending by the private sector, state-owned enterprises [SOEs] and consumers will reach RMB8 trillion (US$1.18 trillion) over the next five years.”
In an effort to ensure the funds required for infrastructure construction, the government has been actively seeking to attract social capital into infrastructure projects in recent years by promoting the PPP model. Huang Rui, former general counsel with China General Consulting & Investment, says that commercial practice in mainland China under the PPP model has been around for more than 20 years, since the 1990s, with the relevant legislative history broadly divisible into three stages.
The first stage mainly involved the regulation of pilot foreign-invested concession projects; the second stage, starting at the beginning of the millennium, mainly focused on the regulation of public utilities and related infrastructure; and the third stage, starting in 2013, focuses on the new orientation of government procurement of services, and has been widely implemented for infrastructure and other public services, as well as for investment and financing innovation, SOE reform, etc. “The state has demonstrated an unprecedented dynamism in carrying out economic development, risk control and even the transformation of government functions using PPPs,” says Huang Rui.
Jiang Wei, a partner at the Beijing office of Guantao Law Firm, says that in the past few years the government has been pushing the PPP model for public infrastructure. The past two years have seen the emergence of investment in infrastructure in such sectors as smart cities, urban pipe gallery projects, urban flood prevention and drainage facilities.
“These types of projects hold great significance for resolving urban development difficulties and realizing sustainable urban development,” he says. Such infrastructure projects apparently require the input of massive amounts of funds, but Jiang believes that, in the initial stages of public infrastructure construction, the funds mainly come from the public purse, while government efforts to open and stimulate diversified investment and financing remain insufficient.
Zhou Xing, another partner at Guantao Law Firm in Beijing, says that for the public good, many of the above-mentioned urban construction projects require enterprises’ operations to have a public welfare aspect. Accordingly, the returns on project operations are relatively low, with a rate generally between 6% and 8%, or even no return at all, running counter to the objective of maximizing profits. “As there are limits to government fiscal outlays, particularly in urban pipe gallery construction and urban flood prevention and drainage facilities, many private partners have taken a wait-and-see attitude, resulting in a significant slowdown in project investment and construction,” he says.
Of even greater urgency than project returns is the unification and improvement of current legal systems. Huang Rui points out the issue in the current legal framework for the PPP model: “The relevant laws and administrative regulations have fallen behind the times, and there is a large number of overlapping ministerial-level rules, regulations and regulatory documents. These fail to offer clear assistance for urgent projects.” For example, the NDRC and MOF, separately leading other government authorities, have issued a large number of ministerial-level rules, regulations and administrative regulatory documents relating to the implementation of PPP projects, but some of the provisions intersect, or are inconsistent.
Sun Hui, from Zhong Lun, says there is a lack of co-ordination among some of the PPP regulations issued by various authorities, “resulting in complications in the implementation of PPP projects and also causing problems for regulators in the course of the operation and oversight of PPP projects”.
PPP CONFUSION
Huang Zaizai, a partner at the Beijing office of Tian Yuan Law Firm, says: “To ensure the success of the PPP model, relevant laws and regulations need to be improved as soon as possible, so as to provide legal support. Additionally, a sound PPP-related fiscal expenditure restraint mechanism needs to be established.”
Huang Zaizai points out that the PPP model currently faces three typical questions: (1) Concerning the transaction structure, can government procurement be applied to projects in which the main subject is project construction?; (2) How are the government budget and expenditure systems to be harmonized with PPP? If the government fails to perform the fiscal expenditure matters to which it committed in a PPP project, how is its liability for breach of contract to be pursued?; and (3) In a PPP project, can allocated land be placed in the name of the project company and used for project construction?
Regarding the first question, Cao Shan, deputy director of the Shanghai head office of City Development Law Firm, says two regimes exist in China: the government procurement procedure, mainly governed by the Government Procurement Law; and the project bid invitation procedure, mainly governed by the Law on the Invitation and Submission of Bids. She says there is a debate in practice as to which procedure is applicable to the selection of the private partner for a PPP project.
“Presently, in the PPP models led by the MOF, incorporating the selection of private partners into the government procurement regime is advocated,” says Cao. “However, government procurement requires the use of fiscal funds, making it currently impossible for the government procurement regime to fully cover the PPP models’ scope of applicability.” She adds that the procurement procedure involves a relatively large number of regulations, some of which are in conflict. The conflicts in the application of the law in practice can potentially affect the validity and operational efficiency of private partner procurement in PPP projects.
Huang Rui adds: “There are marked differences between the government procurement regime and the bid invitation/submission regime in terms of the selection procedure and compliance requirements, and it’s almost impossible to take both regimes into account simultaneously.” The specific requirements on bid invitation announcement, preparation of bid invitation documents, bid evaluation method and criteria, disclosure of the outcome, handling of objections and complaints, and other procedural issues, all differ between a bid invitation conducted under the Law on the Invitation and Submission of Bids and an invitation carried out under the government procurement regime. “In the implementation of specific projects, all of these constitute institutional costs,” she says.
In addition to various rules, the implementation of PPP projects is also complex. It may involve different government authorities, says Silli, from Minter Ellison. They may include the NDRC or its local counterparts, the MOF or its local counterparts, construction and planning authorities, the China Banking Regulatory Commission or its local counterparts, the State Administration of Foreign Exchange, and government authorities in charge of specific industrial sectors. “The government formalities to implement PPP projects are very time consuming and inefficient,” she says.
Although the central government has been encouraging local governments to set up a joint review and approval mechanism to streamline the approval procedure, Silli says so far they have not seen such joint authorities in local governments set up to facilitate implementation of PPP projects.
The dispute resolution mechanism applicable to the PPP model is another uncertainty. “The essence of the issue of the dispute resolution mechanism for PPP models is how to determine the legal nature of the model,” says Cao. According to her, pursuant to the government procurement procedure, the relationship between public and private partners in the PPP model is an equal civil relationship and, as such, dispute resolution should be subject to civil law provisions, with both litigation and arbitration available for dispute resolution.
However, pursuant to the newly revised Administrative Procedural Law, implemented since 1 May 2015, and relevant judicial interpretations from the Supreme People’s Court, disputes involving concession agreements – under which the government authorizes a private partner to participate in a PPP project – fall into the category of administrative disputes, and so are subject to administrative procedure provisions, excluding arbitration, as an option for dispute resolution.
Furthermore, “in judicial practice there is a tendency towards recognizing the PPP model as a combination of a civil relationship and an administrative relationship, with the specific dispute resolution method to be determined by examining the legal nature of the matter under dispute”, says Cao.
Zhai Songjun, an associate at the Beijing office of East & Concord Partners, says the core reason for the uncertainty over the PPP dispute resolution method is the unclear legal relationship between the public and private partner. “This issue has a bearing on the issue of whether a civil contract or administrative one applies to a PPP contract, and on the issue of the dispute resolution method under PPP,” he says.
Zhai says that, from a practical perspective, clarifying that the relationship between the public and private partners under a concession/PPP agreement is an equal relationship between civil entities would help to ensure the rights and interests of private partners and attract private capital. However, he says from the legislators’ perspective, a concession/PPP agreement can be seen as an overlapping legal relationship that is both administrative and civil.
Zhou, from Guantao, has noticed that in order to rapidly develop infrastructure, certain local governments, constrained by limited fiscal funds, have adopted such models as build-transfer (BT), potentially putting them in violation of the PPP project regulations of the MOF, and other such authorities. “This has given rise to an awkward situation: there is an extremely large number of possible PPP projects, but the number that satisfies regulations and can genuinely achieve the standards as a model project is small,” he says.
“Accordingly, I believe that further exploration of the feasibility of the BT model will have to be carried out at the regulatory level in future, as this is required in reality for the infrastructure construction in China. The law should give judicious guidance according to circumstances instead of saying ‘no’ across the board.”
FINANCING ISSUES
Wang Weidong, executive partner at Grandall Law Firm in Beijing, says some issues at the financing stage of PPP projects also require attention. First, the life of a PPP project is generally quite long, whereas the term of current financial products is relatively short, resulting in a time mismatch.
As for financing methods, “at present, PPP projects mainly rely on bank loans for financing; banks’ requirements in respect of the capital ratio of projects are relatively stringent and they require the provision of security,” says Wang. “As the realization of no-recourse, or limited recourse financing, is difficult, financing costs are relatively high.”
In the China context, private partners in the PPP model also include state-owned entities. Wang says that private capital, in comparison to SOEs, has even fewer advantages in terms of financing costs. Future returns and assets of a project are usually provided as security, but he says this type of financing method is not yet mature and banks universally deem the risks to be quite high.
Furthermore, “the interest rate for debt financing is generally relatively high, making it unsuitable for the majority of PPP projects whose returns are relatively low”, says Wang. “To develop the PPP model, financial institutions need to be innovative in the creation of financial products. Furthermore, the establishment of a no-recourse or limited recourse project financing system is
very important.”
Internationally, financing of PPP projects is generally carried out by a special purpose vehicle (SPV)/project company, says Wang. “The core of project financing is no recourse or limited recourse. If a risk arises in the project, making repayment of the bank loan impossible, the bank can seek recourse only at the level of the SPV/project company, and cannot make claims against the shareholders of the project company, or the government.”
Compared with domestic Chinese players, foreign investors seem to have an advantage in project financing. “Compared to the domestic private investors, foreign investors may have more flexible and stronger ability to obtain financing from overseas markets to fund the infrastructure projects,” says Liang Yaohai, a registered foreign lawyer at Minter Ellison in Hong Kong.
Liang says that the current yield rate of a Chinese PPP project is generally between 6% and 8%, and the financing cost for Chinese private investors was around 6.7% in the first quarter of 2016; such cost is estimated to continue to increase. “Since the domestic private investors in China are restricted from directly financing from abroad – unless they are listed overseas – they are not as competitive as foreign investors with respect to financing,” he says.
STATUS OF PRIVATE PARTNERS
Qin Yu, a partner in the Beijing office of JunHe, has noticed that some local governments have a pressing need to reduce debt, and as a result, “they place emphasis on construction but take operation lightly, failing to genuinely implement the philosophy of long-term co-operation and performance management in PPP projects”.
“For example, the commencement of work, construction period and managing contractor are usually the focal point of the parties during the invitation of bids and the negotiations for a project,” says Qin. “But the setting of the project operation and management targets, performance assessment arrangements and other such details are relatively cursory or even blank.” He argues that the grip on performance-related issues should be tightened.
Qin has also noticed that some private partners are overly reliant on the payment undertakings given by local governments for the seeking of returns, but overlook the exploitation of the profit potential of the project itself. “For example, in a lot of PPP projects, government fee payment still takes the form of ‘the payment of costs plus interest’, which, in essence, is drawn-out BT,” he says. To exploit the profit potential of the projects themselves, Qin says it is necessary to encourage project innovation, and the development of complex projects.
Chambers Yang, a senior partner at Dentons in Shanghai, points out that the PPP model faces the issue of how to ensure “no competition” for the project. “As a result of the construction or alteration of another project by the government or another investor, an [existing] project may face substantive commercial competition,” he says. “Once the issue of project uniqueness arises, a suite of subsequent risks, such as a change in market demand, market return risk and trustworthiness risk, follows on its heels, potentially leading to the failure of the project.”
Yang recommends that private partners set out express provisions on non-compete in the relevant contract. “Of course this is built on the assumption that the parties to the contract respect the provisions of the contract,” he says. “Due to the inequality between the positions of the private and public partners, there is a necessity … to expressly provide in policies and regulations for the protection of the rights and interests of the private partner, and the remedies available, in the event of a breach of contract by the public partner.” But he has also seen that the issue of the trustworthiness of the public partner has been improving year by year.
In addition to the issue of trustworthiness, the government’s actual control over decision-making can also weaken the function of the private partner. “Although the government is not a major shareholder in a PPP project, in many circumstances the actual decision-making power in a project lies in the hands of the government,” says Dai Guanchun, a partner at Jingtian & Gongcheng in Beijing. “This makes it impossible for the [private] investor to get a grip on the project risks or even turns it into a mere payer of the bills.” He says that the most important thing is improving the protection of investors’ legal rights.
FOREIGN INVESTMENT PROSPECTS
Calvin Ho, a senior associate at Herbert Smith Freehills in Hong Kong, believes China’s infrastructure development is attractive to foreign investors because of its massive size, scope and clear policy support for foreign investors. “For example, even as the energy sector suffered a downturn in the past two or three years, the huge market for LNG regasification in China, coupled with official government policy to open up this area to private investors, means that it is impossible to ignore for foreign investors,” he says.
Yang also says there is great demand in China’s infrastructure industry itself, and that, together with the stable and even relatively high anticipated returns, makes it quite attractive to foreign investors. He notes that in recent years the central government has taken an increasingly more permissive attitude to foreign investment – for example, the legal system under which recordal is the prime means for foreign investment administration took effect on 1 October 2016.
“With respect to the PPP model – except certain industries that fall in the restricted and prohibited categories of the Catalogue of Industries for Guiding Foreign Investment – there is little difference in the accessibility of the PPP model to domestic private capital and foreign investment,” he says.
However, Helena Chen, a partner in the Beijing office of Pinsent Masons, has seen that in certain industries, the foreign investment in PPP projects has been decreasing. For example, “foreign investment once took a lion’s share in China’s waste water treatment PPP market, but that has now decreased significantly”, she says.
One concern for foreign investors, according to Chen, is that sometimes the bidding process is not transparent to “outsiders”. “There might be special requirements in the invitation to bid (ITB), say, the requirement of certain experiences/credentials of local projects, the requirements of company capital, etc., which are obstacles to foreign investors, or even to local private investors,” she says. “The foreign investors might not have as good connections with local authorities as what the local state-owned enterprises would have.”
Also, foreign investment in infrastructure projects may be subject to national security review, says Liang, from Minter Ellison. “Under the PRC legal regime, acquisition of important energy, resources and infrastructure projects by foreign investors shall be subject to the national security review by the joint committee of the governmental departments at the central level – headed by NDRC and Ministry of Commerce,” he says.
“However, the Chinese laws and regulations do not give a clear definition of ‘important infrastructure’ and there are no clear and specific guidelines indicating what kind of infrastructure projects with foreign investment shall be subject to the security review.”
Dai, from Jingtian & Gongcheng, says that although the PPP model itself is highly open to foreign investors, the competitiveness of foreign investors is insufficient and their desire to take part is also somewhat lacking. “The main reason is that foreign investors are not so adept at dealing with the government, and they put more emphasis on performance risks and assurance of project cash flow,” he says. “In contrast, domestic enterprises have more experience in these areas.” Dai adds that foreign investors can leverage their strengths in supplying certain technologies and equipment to a project.
However, there is no guarantee that advanced technology will always be translated into an advantage for foreign investors. Qin, from JunHe, says some local governments do not have a strong demand for technology, and accordingly, are not very reactive to such strengths.
Qin has also noticed that foreign-invested companies may not be as active as wholly Chinese-owned companies in terms of contact in the early stages of a project. In comparison, “the tracking of PPP projects by wholly Chinese-owned companies begins at the earliest stages, and in some cases close contact has already been established with the local government even before the implementing plan has been formulated”, he says.
Xing Fei, an associate at East & Concord Partners in Beijing, has noticed that in actually implemented PPP projects, the private partner will usually be an SOE under the central government or a local SOE with proprietary technology, and if a foreign investor is involved, it will typically be a red-chip enterprise. “Although in terms of laws, regulations and policies, such projects are essentially completely open to foreign investment, the extra impediment lies in local governments looking askance at co-operation with foreign investors when operating projects, because they involve works that have a bearing on people’s livelihoods,” he says.
Like Chinese enterprises, foreign-invested ones also face the problem of government trustworthiness. “In the construction model for the domestic infrastructure industry, because the issue of government trustworthiness is quite frequently encountered, foreign investors are not adept at carrying out assessments of this, and making investments on this basis,” says Huang Zaizai, from Tian Yuan.
Given the difficulties in accessing infrastructure projects in China, “foreign investors tend to want to partner with reliable domestic partners to help them navigate through the myriad local regulations and customs when doing projects in China”, says Ho, from HSF. “This is a sensible approach, but we would caution that choosing the right local partner remains very important in being able to pull off a successful project.”
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