UK: China Publishes Guidance on Wastewater Treatment Concessions

The new Model Agreement covers with characteristic brevity many of the usual and essential aspects of a project financed WWT concession, including a number of provisions not found in the MOC's Sample Concession Agreement on Urban Water Supply, such as a minimum capital investment requirement of thirty per cent applicable to sponsor interests throughout the course of the concession period. Perhaps most helpful are the provisions dealing with the extremely important issue of WWT fees. This update focuses on those particular measures in view of their critical importance to prospective investments.

Sub-Clause 3.2 of the Model Agreement provides that at any given time during the concession period, the Concessionaire shall ensure that its equity investment in the project shall not be less than thirty per cent of the ‘total investment’ in the project. The term of ‘total investment’ refers to the amount of total funds required for the development of the project, including debt funding elements. Whilst this debt to equity ratio will not be out of line with international norms, such guidance could limit scope for innovative financial engineering.

For some time there has been significant uncertainty as to the principles set out in the Water Law of the PRC and in its subordinate regulations governing the setting and revision of water treatment fees. This uncertainty has been heightened by the view of some at sub-national government levels that the Water Law's key principles of cost compensation and reasonable profit do not override the requirement of the Price Law of the People's Republic of China for periodic price reviews by the price department of the State Council or de novo public hearing processes. Whilst the Model Agreement does not rule out the possibility of diminution in the actual or implied unit price paid during the concession period by such means, there is some suggestion that the Concessionaire should have a great deal more control over pricing levels. Clauses 9.1 and 9.2 provide for both:

• the parties to stipulate the unit price in the Agreement
• a right of the Concessionaire each year to request an adjustment to the unit price based on costs of production in the preceding year, without any reciprocal right on the part of the host government.

Evidently it has not escaped the attention of the Ministry of Construction that some local governments have expressed an unwillingness to accept the risk of adverse changes in the quality or quantity of raw water due to the impact of, and/or changes in, upstream industrial activity. The Model Agreement addresses ‘raw water risk’ by:

• providing that the host government shall ensure the collection and transportation of the raw water to the point of intake in accordance with the basic quantity and quality requirements set forth in the Agreement (Sub-Clause 8.3)
• basing the WWT fee on the higher of the quantity of raw water treated and a pre-agreed ‘basic quantity’ (Sub-Clauses 9.1(a) and (b))
• providing for the Concessionaire to be compensated by the host government for any additional treatment costs arising due to the quality of the raw water falling below a pre-agreed standard, and releasing the Concessionaire from liability for substandard treatment quality where the raw water is rendered untreatable (Sub-Clauses 9.1(c), 9.4(a) and (b)).

Moreover, Sub-Clause 8.10 grants investors some further comfort in connection with the more general risk of pre-existing environmental hazards by exempting the Concessionaire from responsibility for any pollution and hidden safety problems existing prior to the effective date of the Contract, whether caused by a third party of the host government.

Many of the obligations of the parties under the Model Agreement are supported by a termination remedy in the event of default. More generally there exists the usual reciprocal right of termination for default of the counterparty (Sub-Clauses 16.1(h) and 16.2(c)). The consequences that a default termination entail are however unorthodox.

For instance, in the event of termination by the host government for Concessionaire default, Sub-Clause 16.5.1 gives the host government an option to ‘buy’, by way of a payment of ‘compensation’, the Concessionaire's rights and interests in respect of the project. The amount of the compensation is to be determined taking into account various factors, including:

• the concession period
• how much of the concession period has expired
• the total investment of the Concessionaire in the project
• the ‘extent of Concessionaire's fault’.

Although the drafting could be clearer, it would seem that the right to ‘buy’ is being equated with the usual right to bring the concession to an end by means of an election by the host government to terminate. Thus if the government does not exercise the option to ‘buy’ then the concession will remain on foot.

On the other hand, relevant host government default will provide the Concessionaire only with the right to request the host government to buy, by way of a payment of ‘compensation’, the Concessionaire's rights and interests in respect of the project. It would thus appear that the Model Agreement does not provide the Concessionaire with a right to elect to terminate the concession for host government default.

Where the host government agrees to terminate in such a circumstance then it would seem that the criteria for valuing the ‘compensation’ are identical to those provided for in Sub-Clause 16.5.1 as mentioned above in the context of Concessionaire default termination Sub-Clause 16.1. Sub-Clauses 16.5.1 and 16.5.2 envisage that Schedule 12 to the Model Agreement will supply more detail as to the method of compensation, however this schedule has not been published along with the Model Agreement. Presumably Schedule 12 will draw the logical distinction between which party is in default for the purposes of calculating the Concessionaire's buy-out price.

Given the specific nature of the Model Agreement, one could only expect it to address issues specific to the WWT water sector, and not to go into the wider legal and financial issues concerning project financings in the PRC water market. On balance, the Model Agreement promises much needed certainty in the area of WWT fees, however the minimum investment requirement and termination provisions would benefit from further clarification.

The Model Agreement has been posted in simplified Chinese, without its schedules, at the MOC's website at www.cin.gov.cn.

The Masons Water Sector Group's involvement in the China water sector includes legal work relating to water and WWT projects and advice on regulatory issues, environmental issues, institutional reform, desalination projects and industrial water outsourcing.