Loan and Equity Investment PRC: Municipal Natural Gas Infrastructure Development Project

Transcription

1 Extended Annual Review Report Project Number: Loan Number: 2255/7244 December 2010 Loan and Equity Investment PRC: Municipal Natural Gas Infrastructure Development Project In accordance with ADB's public communication policy (PCP, 2005), this extended annual review report excludes information referred to in paragraph 126 of the PCP.

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3 CURRENCY EQUIVALENTS At Appraisal (as of 1 August 2006) At Project Completion (as of 15 November 2010) Currency Unit yuan (CNY) yuan (CNY) CNY1.00 $ $ $1.00 CNY8.000 CNY6.637 Currency Unit Hong Kong dollar (HK$) Hong Kong dollar (HK$) HK$1.00 $ $ $1.00 HK$ HK$ ABBREVIATIONS ADB Asian Development Bank CAG Central Asia Natural Gas (Shenzhen) Company Limited CGH China Gas Holdings Limited CNG compressed natural gas EIA environmental impact assessment EMP environmental management plan ESMS environmental and social management system GAIL Gas Authority of India Limited LNG liquefied natural gas LPG liquefied petroleum gas PRC People s Republic of China ZIL Zhongran Investment Limited WEIGHTS AND MEASURES m 3 cubic meter mcm (million cubic meter) bcm (billion cubic meter) tcm (trillion cubic meter) NOTES (i) (ii) The fiscal year (FY) of the guarantor ends on 31 March. FY before a calendar year denotes the year in which the fiscal year ends, e.g., FY2009 ends on 31 March The fiscal year of the borrower ends on 31 December and therefore is denoted in calendar years unless otherwise noted. In this report, $ refers to US dollars.

4 Vice President Director General Director Team leader Team members L. Venkatachalam, Private Sector and Cofinancing Operations P. Erquiaga, Private Sector Operations Department (PSOD) C. Thieme, Infrastructure Finance Division 2, PSOD S. Hashizume, Investment Specialist, PSOD B. Garcia, Investment Officer, PSOD M. Manabat, Senior Investment Officer, PSOD V. Medina, Social Development Officer, PSOD J. Munsayac, Social Development Specialist, PSOD M. Pascua, Environment Officer, PSOD In preparing any country program or strategy, financing any project, or by making any designation of or reference to a particular territory or geographic area in this document, the Asian Development Bank does not intend to make any judgments as to the legal or other status of any territory or area.

5 CONTENTS Page BASIC DATA i EXECUTIVE SUMMARY I. THE PROJECT 1 A. Project Background 1 B. Key Project Features 1 C. Progress Highlights 2 II. EVALUATION 2 A. Project Rationale and Objectives 2 B. Development Impact 3 III. ISSUES, LESSONS, AND RECOMMENDED FOLLOW-UP ACTIONS 6 A. Project Issues 6 B. Lessons, Recommendations, and Follow-Up Actions 7 APPENDICES 1. Project Related Data 8 2. Private Sector Development Indicators and Ratings: Infrastructure 9 3. Environmental and Social Due Diligence Report 15 ii

6 BASIC DATA Municipal Natural Gas Infrastructure Development Project (LN2255/E7244 PRC) Key Dates Expected Actual Concept Clearance Approval Board Approval Loan Agreement Loan Effectiveness First Disbursement Commercial Operations Date Loan Closing Months (effectiveness to commercial operations date) 30 August October October April October 2008 Project Administration and Monitoring No. of Missions No. of Persons No. of Days Due Diligence and Loan Negotiations Project Administration XARR Mission a ADB = Asian Development Bank, XARR = Extended Annual Review Report. a XARR mission was not conducted as information necessary to complete the review was gathered during due diligence missions of Phase 2 of the project (approved by the Board on 9 December 2010).

7 EXECUTIVE SUMMARY On 9 August 2006, the Asian Development Bank (ADB) approved (i) an equity investment in China Gas Holdings Limited (CGH) of up to the equivalent of $25,000,000; (ii) a direct loan from ordinary capital resources to Central Asia Natural Gas (Shenzhen) Company Limited (CAG) and Zhongran Investment Limited (ZIL) of up to the equivalent of $50,000,000, of which up to 50% was to be lent in US dollars and the balance in renminbi; and (iii) a B loan to CAG and ZIL for up to $75,000,000. The funds were to be used to support CGH's planned investment in a series of new natural gas distribution infrastructure projects in municipalities in the People s Republic of China (PRC). The ADB loans were extended to CAG and ZIL, which are wholly owned and controlled by CGH and were to channel the funds to subsidiary project companies to develop and operate the natural gas distribution infrastructure. Each new project company enters into a concession agreement with a municipal government with an agreed tariff and a minimum volume forecasted by the municipal government for 30 years. The loans are unconditionally and irrevocably guaranteed by CGH. Using the criteria of the Project Administration Instructions 6.07B on Extended Annual Review Reports for Nonsovereign Operations issued on July 2008, the Municipal Natural Gas Infrastructure Development Project was evaluated for (i) development impact, (ii) ADB work quality, and (iii) ADB additionality. The development impact was evaluated using four criteria: (i) private sector development; (ii) business success; (iii) economic development; and (iv) environmental, social, health, and safety. The contribution to private sector development is rated excellent. The project had a major positive impact on private sector participation in the natural gas distribution industry in the PRC. CGH s strong technical team led by its Design Institute set a new industry standard that was higher than the government s national standards at the time. CGH s innovative centralized electronic procurement system introduced fair competition, improved transparency, and helped control procurement costs while ensuring quality. The scaling up undertaken by the project of downstream gas distribution infrastructure further underpinned large-scale international and domestic trunk pipeline networks. ADB s contributions included an innovative structure by which a series of small- and medium-sized natural gas distribution subprojects were financed on a consolidated basis by extending loans to the intermediate holding companies. This approach allowed the aggregation of subprojects that individually were otherwise difficult to commercially finance due to high transaction costs and the distinctive risks that each subproject might present separately. ADB also mobilized the B loan through a syndication with commercial banks and catalyzed commercial lending by international banks to the natural gas distribution sector, where such lending had previously been very limited. This was ADB's first long-term local currency debt financing in the PRC, linking international institutional investors and the multiple municipal gas projects. Business success is rated excellent. Through the project, CGH has demonstrated successful private sector participation in the natural gas distribution sector in the country and has built significant pipeline networks. It has also established compressed natural gas refilling stations for vehicles to replace gasoline. CGH developed a new business model to franchise and build a customer base through public private partnership arrangements with municipalities.

8 CGH has strong technological capabilities, an innovative procurement system, 24-hour maintenance services, and solid operational capabilities. Economic development is rated excellent. The project is rated satisfactory on environmental, social, health, and safety. It has materially improved CGH s overall environmental performance and that of the project companies, and is in compliance with ADB s Safeguard Policy Statements (2009). The project helped to improve urban air quality and health in the PRC and to reduce overall air pollutants emission, including greenhouse gases. The environmental impacts of subproject pipelines construction were small, short-term, and localized and have been mitigated through sound engineering practices. Gateway stations require less than 0.5 hectare of land each. Except for occasional gas flaring, emissions are expected to be minimal from these facilities and pollution potential is limited. The project is rated satisfactory for investment profitability. The loan margin, fees, and dividends yielded a gross contribution to ADB s income that exceeds (i) the level compatible with direct transaction cost, (ii) the risk profile of the project and (iii) the country risk at the time of investment. CGH and the borrowers have been making interest and principal payments on time for all debt facilities and have complied with their respective financial covenants. Overall, the project is considered highly successful. It is a fine example of ADB private sector operations strategy and of the soundness of government policy in opening up the gas distribution sector for private sector participation. It also demonstrates the efficacy of public private partnerships in municipal infrastructure in the PRC, in building and operating gas distribution infrastructure, and in advocating safety, social, and environmental management. It was one of the first ADB private sector projects to make corporate governance training a specific loan conditionality, an approach now being used as a model. The project has received awards in the PRC for its corporate governance and efficient operations. There were two main variations between actual performance and the assumptions in the report and recommendation of the President. Revenue from natural gas sales was higher than the projection for FY2010, while revenue from connection fees was lower. Secondly, a major non-cash impairment item for FY2009 and a non-cash gain in FY2010 resulted in volatile net profits. These were due to the transitional effects on interest rate swap values. The main lessons and recommendations ADB can draw from the project are that (i) ensuring transparency in corporate governance is essential, and (ii) ADB s value addition can be best achieved through support for private sector participation in the newly opened sector.

9 I. THE PROJECT A. Project Background 1. On 9 August 2006, the Asian Development Bank (ADB) approved (i) an equity investment in China Gas Holdings Limited (CGH) of up to the equivalent of $25,000,000; (ii) a direct loan from ordinary capital resources to Central Asia Natural Gas Shenzhen Company Limited (CAG) and Zhongran Investment Limited (ZIL) of up to the equivalent of $50,000,000, of which up to 50% was to be lent in US dollars and the balance in renminbi; and (iii) a B loan to CAG and ZIL for up to $75,000, The funds were to be used to support CGH s planned investment in a series of new natural gas distribution infrastructure projects in municipalities in the People s Republic of China (PRC). 2. The project aimed to develop natural gas distribution infrastructure and address financial constraints faced by municipalities, two key obstacles to natural gas market development in the country. At the time of project processing in 2005, private sector participation in the natural gas industry was still very limited. Historically, the industry had been vertically integrated under government mandate, with state-owned organizations responsible for exploration, production, transportation, and marketing. It had also been governed by rationing and price floors and ceilings that arguably did not reflect true production capacity and efficiency. In early 2000, the government moved to reform and liberalize the gas market. The key steps were (i) construction of a natural gas trunk pipe network and supporting facilities and (ii) the opening up the downstream gas market to foreign and private investors. Since a government policy decision in 2002 to involve the private sector in natural gas distribution, CGH has targeted natural gas distribution in municipalities situated along such natural gas trunk pipelines as the West East Pipeline (Phase 1) and the Sichuan East Pipeline ADB assistance was intended to support a CGH investment plan to establish, acquire, and operate natural gas distribution services in municipalities through project companies. This was to include joint ventures with municipal governments and state-owned enterprises across the PRC. The project companies were to service residential, industrial and commercial clients. Proceeds from the ADB loan and equity participation were to be channeled to project companies by CAG and ZIL, two wholly owned subsidiaries of CGH in the PRC. On 30 August 2006, ADB entered into a share subscription agreement with CGH for the purchase of shares. The facility agreement for the ADB direct loan was signed on 17 October 2006 and was drawn in April May The participation agreement for the B loan facility was signed on 12 February B. Key Project Features 4. The project has unique features, including the fact that it is ADB s first multiproject financing facility for infrastructure. Financing small- and medium-sized infrastructure projects 1 ADB Report and Recommendation of the President to the Board of Directors on a proposed Equity Investment and Loans to the Municipal Natural Gas Infrastructure Development Project in the People's Republic of China. Manila. 2 The West East Pipeline (Phase 1) starts from the Tarim Basin in Xinjiang Uigur Autonomous Region in the northwest of the PRC and ends in Shanghai. It runs through the provinces Gansu, Shanxi, Henan, Anhui, and Jiangsu, and the Ningxia Hui Autonomous Region. Operation began in December The Sichuan East Pipeline starts from the Sichuan Basin in the west of the country and runs to Wuhan. Operation commenced in December 2004.

10 2 has been challenging and this financing structure allows ADB to bundle and reach small projects that were difficult to finance on a stand-alone basis. 5. In addition, each project company is based on a concession agreement or similar licensing or contractual arrangements with a municipal government that document an agreed tariff or tariff formula and a minimum demand volume forecast by the municipality. Concessions are usually exclusive and for 30 years. Although CGH usually forms joint ventures with local municipalities or state-owned enterprises, CGH generally takes more than 50% direct or indirect ownership of the project companies and controls their boards. This strategy ensures stable operation under exclusive rights and fully leverages CGH s technical expertise and operational know-how. 6. Thirdly, the project risk is well mitigated. The portfolio approach diversifies supply, tariff, political and other risks across several municipalities. ADB selected the onshore holding companies, CAG and ZIL, as the borrowers to control the financial decisions of project companies. ADB also built in a mechanism to avoid a cash trap and to absorb dividends and excess cash of each project company. An unconditional and irrevocable guarantee from CGH further strengthened the project structure. C. Progress Highlights 7. As of 30 June 2010, CGH had built and was operating natural gas pipeline networks with exclusive concession rights in 123 cities, up from 48 cities as of March CGH had completed natural gas connections for 4.8 million domestic households, 792 industrial users, and 32,414 commercial end users. It had put 91 compressed natural gas (CNG) refilling stations for vehicles into operation, with an annual capacity of 0.5 billion cubic meters (bcm). Natural gas sales volume of 3.4 bcm in FY2010 went to domestic households (11.6%), industrial users (71.1%), commercial businesses (10.0%), and for use in vehicles (7.3%). 8. Proceeds from the ADB loan were channeled to project companies in Hohhot, Changmeng, Yubei, Baotou, and Harbin. As at 31 March 2010, the ADB intervention has resulted in 2,323 kilometers of additional gas distribution pipeline network, and estimated greenhouse gas emission reduction of approximately 634,000 carbon dioxide tons per year. II. EVALUATION A. Project Rationale and Objectives 9. CGH has achieved the project objectives by successfully undertaking natural gas distribution projects and increasing its residential customers from approximately 800,000 in FY2006 to almost 4.8 million in FY2010 and its natural gas sales volume from 172 million cubic meters (mcm) to 3.4 bcm over the same period. More specifically, the project has (i) contributed to mitigating environmental degradation by supporting government efforts to encourage the use of cleaner fuels in urban areas and to expand downstream natural gas distribution through private sector participation; (ii) provided flexibility in energy supply for the PRC by taking advantage of the country s abundant natural gas reserves, which were largely underdeveloped and underutilized; (iii) helped lower overall exposure to the volatility of oil prices and contributed to the stability of the economy; (iv) helped build a nascent natural gas distribution market by providing best practices for the downstream distribution market, thus setting standards for other competitors to follow as the market matures; and (v) demonstrated social responsibility in local municipalities through the enforcement of provincial policies that stipulate that initial preference

11 3 in the supply of natural gas go to households before the development of the industrial customer base. B. Development Impact 1. Private Sector Development 10. Private sector development indicators and ratings are in Appendix The project had a positive impact on private sector participation in the natural gas distribution industry in the PRC. It was one of the first major attempts to induce significant commercial lending to the natural gas distribution sector in the country, as well as ADB's first private sector project in the municipal natural gas distribution sector. During project implementation, natural gas consumption in the PRC has risen from 47 bcm in 2005 to 91 bcm in 2009, with much of increase led by private sector players. The scaling up of the downstream gas distribution infrastructure undertaken by the project has further underpinned the large-scale international and domestic trunk pipeline networks. 12. CGH s strong technical team led by its Design Institute set new industry standards that were higher than the national standards existing at the time. CGH s innovative centralized electronic procurement system introduced fair competition, improved transparency, and helped control procurement costs while ensuring quality. CGH ensured that every project company adopted CGH standards in operations, maintenance, marketing, construction, and human resources. Through its technical and managerial strengths, CGH has set high benchmarks for the industry and has thereby contributed to its improved efficiency overall. CGH contributed to building an emerging natural gas distribution market by introducing best practices to downstream distribution. 13. The project has positive impacts on energy end users. Natural gas is critical for many industries because it has several major advantages over fossil fuels such as coal and diesel. Chemical, fertilizer, bio-production, and glass-making industries, in particular, must use natural gas to avoid dust and defects or to achieve precise industrial temperature control. By making natural gas available, the project has enabled these industries to start or expand their activities in municipalities where they could not have operated before. 14. ADB equity participation and loan covenants helped CGH become a leader in corporate governance and demonstrated that good corporate governance can add value in a private sector company s sustainable growth. During due diligence, ADB identified corporate governance at CGH as key risk area where ADB could add value. ADB obtained the right to nominate a nonexecutive director and negotiated an agreement with CGH for it to comply with the international best practices in corporate governance and undertake a corporate governance improvement program. The improvements under the program included (i) an increase in the percentage of nonexecutive directors, (ii) introduction of mandatory rotation and retirement of directors, (iii) creation of four functional committees under the board, (iv) insurance coverage for directors, and (v) significant improvement of transparency and information disclosure. Two rounds of intensive training were also conducted for the directors. As a result of these efforts, CGH has won multiple awards for corporate governance and was ranked in fourth place for the Best Corporate Governance Award in the Asia's Best Companies poll in 2008 conducted by Financeasia.

12 4 15. The project has been successful in other ways as well. It created an innovative structure under which loans were extended to intermediate holding companies and thereby aggregated small subprojects. ADB mobilized the B loan through a syndication with commercial banks that catalyzed commercial lending by international banks to the natural gas distribution sector in the PRC, where such lending had previously been very limited. It was ADB s first long-term local currency debt financing in the PRC, linking international institutional investors and the multiple municipal gas projects. For these reasons, the project s private sector development impact is considered excellent. 2. Business Success 16. CGH has demonstrated successful private sector participation in the natural gas distribution sector under the project and has built up a substantial pipeline network in the PRC. It also established refilling stations for vehicles to replace gasoline with natural gas and developed a new business model to expand its customer base in the municipalities. CGH boasts strong technological capabilities, practices innovative procurement, provides 24-hour maintenance services, and is operationally strong. 17. CGH s financial and operational performance and growth have exceeded the projections, and therefore the project is rated excellent for business success. 3. Economic Development 18. The project is rated excellent for economic development. 4. Environmental, Social, Health, and Safety Performance 19. The project contributed to the improvement of urban air quality and health in the PRC and the reduction in overall emission of air pollutants, including greenhouse gases. The environmental impact of subproject pipeline construction was low, short-term, and localized, and has been mitigated through sound engineering practices. The size of gateway stations is limited (requiring less than 0.5 hectare of land) and potential for pollution is small. Emissions are expected to be minimal from these facilities, except for occasional gas flaring. The project was categorized as FI for environment. 20. Government environmental clearance was secured before construction of project facilities. A safeguard audit report indicated prudent and clean site management. Noise barriers were installed where necessary to minimize the impact on a community near a gas compression facility. Pipeline repair works were undertaken during the non-peak hours or in the night to minimize inconvenience to road users. Truck drivers have gone through strict safety training for CNG transport where pipelines are not connected. 21. With respect to social safeguards, the project was categorized as B/C for involuntary resettlement and C for indigenous peoples. The safeguard audit report indicates that CGH is in full compliance with the applicable national laws and regulations governing involuntary resettlement and indigenous peoples. CGH stakeholder engagement practices are satisfactory and the company complies with core labor standards. Since adoption of the resettlement framework, no new projects have been undertaken by CGH that entailed involuntary resettlement or affected ethnic minorities.

13 5 22. In accordance with ADB s Safeguard Policy Statement (2009), CGH has adopted a corporate-level environmental and social management system (ESMS) as an updated and integrated system from an environmental management system and resettlement framework, and training and awareness building exercises have been ongoing for staff at both corporate and site levels. The ESMS focuses heavily on safety and emergency response to accidental fires or explosions at the gas pipelines or facilities, and an emergency response plan that has become a part of the ESMS is considered adequate. The project has outperformed key standards, practices, and procedures in the PRC as well as the requirements set by ADB at approval. The project has materially improved CGH s overall environmental performance and that of project companies. The project is rated satisfactory for environmental, social, health, and safety performance. 5. ADB Investment Profitability 23. The loan margin, fees, and dividends yielded a gross contribution to ADB income that exceeds (i) the level compatible with direct transaction cost, (ii) the risk profile of the project, and (iii) the country risk at the time of investment. The project is rated satisfactory for ADB investment profitability. 6. ADB Work Quality 24. CGH first approached ADB for assistance to fund the required capital investments in October After concept clearance in February 2005, ADB conducted due diligence, efficiently examining technical, legal, environmental, social, and financial aspects. ADB took the lead in structuring and negotiating the terms of the legal documentation. In August 2006, ADB received Board approval and signed the investment agreement. The A loan agreement was signed in October The quality of ADB s front-end work was further demonstrated by the signing of the B loan in February 2007 through successful syndication with commercial banks. ADB s performance in relation to screening, appraisal, and structuring is rated excellent. 25. Despite the complex multiple drawdowns and the dual currency structure, the disbursements were made smoothly. ADB closely monitored project implementation through regular site visits, reports, financial statements, annual business plans, environmental and social monitoring and reporting, and annual reviews that comprised both field and desk reviews. Both borrowers and the project sponsor have complied with all reporting requirements in a timely manner. ADB has been prompt in giving its consent to waivers and requests for amendments to existing agreements, subject to thorough review. ADB has always kept itself up to date and fully informed about the project and CGH performance in all material areas and has used this knowledge proactively to improve the project development outcome. ADB s performance in relation to monitoring and supervision is rated excellent. 7. ADB Additionality 26. ADB equity participation played an important role not only in satisfying financial requirements and mobilizing additional funds from international banks to finance the project but also in attracting private sector investors by enhancing the institutional capacity at CGH. ADB assistance included corporate governance training for management, resulting in a redesign of the board to incorporate best practices for independence and transparency. ADB maintains supervision through its nonexecutive board seat. External validation of strong CGH efforts in this area has come through several industry awards for corporate governance leadership. ADB

14 6 participation in the project proved to be demonstrational and catalytic, and attracted more strategic investors, such as SK Group of Korea. 27. The ADB A loan was the anchor in mobilizing commercial funds through the B loan for multiple medium-sized public-private partnership projects in the natural gas distribution sector in the PRC. The project has enabled international commercial banks to extend their reach to medium-sized cities that would be difficult to assist directly. The successful implementation of this first multiproject facility generated considerable interest from private sector sponsors in several infrastructure sectors where lack of access to finance has discouraged small- and medium-sized projects. 28. ADB additionality is rated excellent. The leadership provided by ADB was a catalyst and made financing that would not have otherwise been considered feasible. 8. Overall Evaluation 29. Overall, the project is considered highly successful. The ratings are summarized in Table 1. The project is a fine example of ADB private sector operations strategy and of the soundness of the government decision to open up the gas distribution sector for private sector participation. It also demonstrates the effectiveness of PPPs in municipal infrastructure and of the private sector in building and operating gas distribution infrastructure and in advocating safety, social, and environmental management. This was also one of the first ADB private sector projects that made corporate governance training a specific loan conditionality. It is being used as a model. CGH received numerous awards as a front-runner natural gas distribution company in the PRC in relation to its improved corporate governance as well as its efficient operations. Table 1: Evaluation of the Municipal Natural Gas Infrastructure Development Project Indicator/Rating Development Impact Private sector development Business success Economic sustainability Environment, social, health, and safety performance ADB Investment Profitability ADB Work Quality ADB Additionality Unsatisfactory Partly Satisfactory Satisfactory Excellent X X X X X X X Unsuccessful Overall Rating ADB = Asian Development Bank. Source: Asian Development Bank estimates. Partly successful Successful Highly successful X III. ISSUES, LESSONS, AND RECOMMENDED FOLLOW-UP ACTIONS A. Project Issues 30. The key variations between actual performance and the assumptions in the report and recommendations of the President are as follows:

15 7 (i) (ii) Revenue from natural gas sales was higher than the projection for FY2010, while revenue from connection fees was lower than the projection. This has resulted in a lower margin than projected as the margin for connection fees is higher than for natural gas sales. On the other hand, revenue from natural gas sales is a recurring item while connection fee is one-off. As an overall result, CGH is relying more than was projected on recurring revenue and less on one-off revenue, which will ensure its long-term financial stability. A major non-cash impairment item for FY2009 and a non-cash gain in FY2010 resulted in volatile net profits. CGH had entered into interest rate swaps to minimize the risk of rising interest rates and the non-cash impairment was recorded in accordance with Hong Kong accounting standards as a result of the rapid fall in interest rates beginning in October 2008 that resulted from the global financial crisis and the implementation of subsequent quantitative easing policies. The non-cash gain for fair value of the same interest rate swap was recorded in FY2010 due to a rebound in global interest rates after the financial crisis. B. Lessons, Recommendations, and Follow-Up Actions 31. Transparency in corporate governance essential. The project involves a complex ownership and business structure, with many subproject companies. Transparency in corporate governance is an essential factor for the project sponsor s sustainable growth. It is recommended that ADB be scrupulous in taking all possible steps to ensure that the project sponsor adopts sound practices and procedures of corporate governance. 32. Private sector participation a large part of ADB value-added. ADB intervention was timely, coming shortly after the government opened the municipal natural gas sector to private investment and enterprise. ADB leadership in introducing public private partnerships in an important part of the country s economy was a catalyst for financing that would otherwise not have been considered. 33. Replication of project structure in other sectors. As mentioned in para. 27, the successful implementation of the project generated considerable interest from private sector sponsors in other sectors where lack of access to finance has discouraged small- and mediumsized projects, and has resulted in replication and expansion of similar multiproject facilities in those sectors. As such, a carefully planned structure can have a spill-over effect to enable private sector financing in other sectors as well.

16 8 Appendix 1 PROJECT-RELATED DATA A. Investment Identification 1. Country People's Republic of China 2. Loan number LN2255 CFS number CF44 Equity number EI Type of business Gas Transmission/Distribution 4. Project title Municipal Natural Gas Infrastructure Development Project 5. Investee company and/or borrower 6. Amount of approved ADB assistance Direct loan B loan Equity Borrowers: Zhongran Investment Limited (ZIL) and Central Asia Natural Gas (Shenzhen) Company Limited (CAG) Equity: China Gas Holdings Limited (CGH) $50 million $75 million $25 million ADB = Asian Development Bank, CFS = Complementary Financing Scheme. B. Data on ADB Missions Project Administration and Monitoring No. of Missions No. of Persons No. of Days Due diligence and loan negotiations Project administration XARR Mission a CNY = Chinese Yuan, LIBOR = London interbank offered rate, XARR = extended annual review. a XARR mission was not conducted as information necessary to complete the review was gathered during due diligence missions of Phase 2 of the project (approved by the Board on 9 December 2010). 1 Sources: ADB mission authorization requests and back-to-office reports. 1 ADB Report and Recommendation of the President to the Board of Directors on Proposed Loan and Technical Assistant Grant to the People s Republic of China for the Municipal Natural Gas Infrastructure Development Project (Phase 2). Manila.

17 PRIVATE SECTOR DEVELOPMENT INDICATORS AND RATINGS: INFRASTRUCTURE Impact of the Project 1. Beyond Company Impact 1.1. Private sector expansion. Contributes as a pioneering or highprofile project to facilitating or preparing for more private participation in the sector and economy at large Impact to Date Potential Impact (sustainability) and Risk to its Realization Rating b Rating Risk c Ratings Combined Rate a Justification/ Annotations Excellent Satisfactory Low Excellent The project was one of the first major attempts to induce a significant amount of commercial lending to the natural gas distribution sector in the PRC, and ADB's first private sector project to provide assistance for the municipal natural gas distribution sector. Natural gas consumption has since risen from 47 bcm in 2005 to 91 bcm in 2009 and much of this increase has been driven by the private sector players. For instance, the volume of Xinao Gas sales increased from 471 million m 3 in FY2005 to 2.9 bcm in FY2009, and the number of its projects from 44 in FY2005 to 76 in FY2009. Towngas China has also experienced rapid growth, with 84 concessions currently under operation Competition. Contributes new competition pressure on public and/or other sector players to increase efficiency and improve access and service in the industry Excellent Excellent Low Excellent CGH has been an efficient player and has established good relationships with municipal governments. It has established a reliable track record by scaling up its operational base through the project. In the meantime, new entrants such as China Resources Gas Group and PC Kunlun have come into the market. As a result, (i) more municipalities decided to award concessions on a PPP basis, and (ii) competition has grown between the private sector players seeking these opportunities. In this way, the project has resulted in competitive pressure in the industry to increase efficiency and improve access and service. Appendix Appendix

18 Impact of the Project 1.3. Innovation. Demonstrates efficient new products and services, including areas such as marketing, distribution, tariffs, production, and technology; and ways to cover or contain cost, manage demand, etc. Impact to Date Rating b Potential Impact (sustainability) and Risk to its Realization Rating Risk c Ratings Combined Rate a Justification/ Annotations Satisfactory Satisfactory Low Satisfactory The project was innovative in supporting a series of small- and medium-sized natural gas distribution subprojects on a consolidated basis by extending loans to the intermediate holding companies. This approach allowed the aggregation of subprojects that individually were otherwise difficult to commercially finance due to high transaction costs and the distinctive risks that each subproject might present separately. This structure was developed in close consultation with the client and the legal and technical advisors, and has been replicated to channel commercial financing to smaller projects in other sectors such as waste-toenergy, airports, and sanitation. 10 Appendix Linkages. Relative to investments, contributes notable upstream or downstream linkage effects to business clients, consumers, suppliers, key industries, etc. in support of growth Excellent Excellent Low Excellent Natural gas is critical for many industries because it has several major advantages over fossil fuels such as coal and diesel. Chemical, fertilizer, bio-production, and glass-making industries, in particular, must use natural gas to avoid dust and defects or to achieve precise industrial temperature control. By making natural gas available, the project has enabled these industries to start or expand activities in municipalities where they could not have operated before. In addition, while gas producing companies in the PRC have been successfully restructured and the government has implemented a program of large-scale international and domestic trunk pipeline networks, these upstream developments could not be fully leveraged without the scaling up of the downstream gas distribution infrastructure

19 Impact of the Project Impact to Date Rating b Potential Impact (sustainability) and Risk to its Realization Rating Risk c Ratings Combined Rate a Justification/ Annotations that the project has undertaken Catalytic element. Contributes by including pioneering and/or catalytic finance, mobilizing or inducing more local or foreign market financing and/or foreign direct investment in the sector Excellent Satisfactory Low Excellent The project was catalytic in two important ways. It was ADB's first long-term local currency debt financing in the PRC and because long-term CNY commercial lending was limited at the time of processing, the project was a catalyst in linking international institutional investors and multiple municipal gas projects in the PRC. Its catalytic role was also evident in the very successful syndication of the project s B loan component, which attracted the participation of commercial banks and was oversubscribed even though commercial lending by international banks to the natural gas distribution sector in the PRC had been very limited until then Affected laws, frameworks, regulation. Contributes to improved laws and sector regulation for PPP, concessions, joint ventures, and BOT projects; and to liberalizing markets as applicable for improved sector efficiency Partly Satisfactory Satisfactory Low Partly Satisfactory The project s successful implementation and the demonstration of CGH's efficient operations under PPP, in particular, have encouraged more municipalities to consider the PPP model for natural gas distribution rather than operating distribution networks on their own. The number of municipalities now available for PPP has increased as a result. The project has also demonstrated the importance of environmental and social safeguards and municipalities and concessionaires are under pressure to fully comply with higher standards in both these key areas. Because policies on gas distribution networks and marketing still often differ across municipalities, however, uniform industry and municipality standards need to be established Appendix 2 11 Appendix 2 11

20 Impact of the Project Impact to Date Rating b Potential Impact (sustainability) and Risk to its Realization Rating Risk c Ratings Combined Rate a Justification/ Annotations for further market development. 12 Appendix 2 2. Company Impact with Wider Potential 2.1. Skills contribution. Contributes to new strategic, managerial, and operating skills with actual or potential wider replication in the sector and industry 2.2. Demonstration of new standards. Demonstrates new ways to operate the business and compete, and investee performance against relevant best industry benchmarks and standards Satisfactory Satisfactory Low Satisfactory CGH has a strong technical team at its Design Institute in Shenzhen, which undertakes all the technical studies and designs the operating units need. CGH s unique centralized electronic procurement system also helps control procurement costs and ensure quality. These technical strengths have been replicated or have the potential to be replicated throughout the sector. Thus, CGH has helped build a more efficiently managed and technically advanced emerging natural gas distribution market by demonstrating international best practices in downstream distribution. Excellent Excellent Low Excellent In addition to contributing to better skills, the CGH Design Institute has also developed technical standards and operational manuals that are more comprehensive than the government s national standards at the time. CGH ensures that each project company adopts CGH standards in operations, maintenance, marketing, construction, and human resources. By setting high standards based on these technical and managerial advantages, CGH is helping raise efficiency in the overall industry through competition. One quantifiable achievement is CGH's gas leakage rate of 1.7%, which is far lower than the national standard of 5% and those of its peers and has already been benchmarked by the industry.

21 Impact of the Project 2.3. Improved governance. As evident in set standards in corporate governance, stakeholder relations, ESHS fields, and/or in good energy conservation standards Impact to Date Rating b Potential Impact (sustainability) and Risk to its Realization Rating Risk c Ratings Combined Rate a Justification/ Annotations Excellent Excellent Low Excellent The project played an indispensable leading role in dramatically improving CGH's corporate governance. During due diligence, ADB identified CGH s corporate governance as a key risk area where ADB could add value. ADB obtained the right to nominate a nonexecutive director to the CGH board as long as ADB holds its shares. ADB also negotiated a covenant in the loan agreement requiring CGH to comply with the international best practices in corporate governance and undertake the corporate governance improvement program. Since the financial closing, ADB has been closely working with CGH to prepare the program. In December 2006, ADB selected PWC to jointly design and implement the corporate governance improvement program. The concrete improvements under the program included (i) an increase in the percentage of nonexecutive directors from 45% to 62%; (ii) introduction of mandatory rotation and retirement of directors; (iii) creation of executive, audit, nomination, and remuneration committees under the board; (iv) insurance coverage for directors, and (v) significant improvements in transparency and information disclosure. Two rounds of intensive training were conducted for the directors. The first, in March 2007, covered generic corporate governance principals and the second, in December 2008, focused on specific practical issues based on CGH s specific risk areas. As a result of these efforts and improvements, CGH has won multiple awards for corporate governance and was ranked in fourth place for Appendix 2 13 Appendix 2 13

22 Impact of the Project Impact to Date Potential Impact (sustainability) and Risk to its Realization Ratings Combined Rate a Justification/ Annotations Rating b Rating Risk c the Best Corporate Governance Award in the Asia's Best Companies poll in 2008 conducted by Financeasia. 14 Appendix Other 3. Overall PSD Rating. Unsatisfactory, partly satisfactory, satisfactory, and excellent. The rating is not an arithmetic mean of the individual indicator ratings, and does not have fixed weights. Actual positive or negative impacts, future impacts, and risks to its realization need to be considered Excellent Excellent Low Excellent Overall, the Municipal Natural Gas Infrastructure Development Project is considered an excellent project for private sector development in the natural gas distribution sector in the PRC. CGH has become one of the leading players in the market, where the private sector opportunities have grown. Its standards are higher than the government s national ones and it has awardwinning corporate governance employing international best practices. ADB involvement was crucial for achieving and demonstrating these results and has catalyzed an expansion of commercial financing into a new sector through an innovative structure and has encouraged improvements in corporate governance through equity investment. bcm = billion cubic meter, BOT = build-operate-transfer, CGH = China Gas Holdings Limited, ESHS = environmental, social, health and safety, FY = fiscal year, m 3 = cubic meters, PPP = public-private partnership, PRC = People s Republic of China, PSD = private sector development, PWC = Price Waterhouse Coopers, RRP = report and recommendation of the President. a The combined rating should weigh future impact and risk to its sustainable realization. b Unsatisfactory, partly satisfactory, satisfactory, and excellent. The rating is not an arithmetic mean of the individual indicator ratings and these have no fixed weights. Consider already manifest actual impact (positive or negative) and the potential for impact as well as risk to its realization. c Rating scale: high, medium, modest, and low.

23 Appendix 3 15 A. Project Description ENVIRONMENTAL AND SOCIAL DUE DILIGENCE REPORT 1. The Municipal Natural Gas Infrastructure Development Project approved by the Asian Development Bank (ADB) in 2006 aimed to support China Gas Holdings Limited (CGH) investment plan to fund a series of natural gas distribution infrastructure subprojects in the People s Republic of China (PRC). 2. The natural gas users served by this distribution are mainly residences, industrial and commercial businesses, and compressed natural gas (CNG) vehicle refilling stations. As of March 2010, CGH had built and operated natural gas pipeline networks based on exclusive concession rights in 123 cities. 3. CGH was found in compliance with all loan covenants, including corporate governance improvement requirements. The project objectives are in line with the ADB's new Energy Policy 1 that requires energy operations to be aligned with overall ADB strategy emphasizing energy security, transition to low-carbon economies, universal access to energy, and support for achieving ADB s vision of a region free of poverty. This report is based on the environmental and social corporate audit 2 carried out in March 2010 as part of due diligence for an ensuing ADB investment, the Municipal Natural Gas Infrastructure Development Project (Phase 2). B. Environmental Aspect 4. Environmental impacts. Municipal natural gas distribution projects generally entail construction of facilities at a gateway station and laying small gas pipes. These are minor civil works with minor environmental disturbances that can be readily minimized by implementing well-established mitigation measures. Gateway stations and facilities (including stations, tanks, and offices) were well maintained and clean. No public buildings or housing are located within 100 meters. Gateway station operations do not create a significant amount of waste. The small volume of natural gas occasionally vented and flared for a short duration during routine maintenance of valves, filters, and meters is unlikely to have significant impacts on ambient air quality. Temporary environmental impacts during the laying of pipelines are minor in nature. The right of way for construction is about 11 meters wide while trenches are 1.5 meters wide and 2 meters deep. During the site visit, the pipes were stored in an orderly manner on site waiting to be installed when weather permitted. Spoils are disposed of properly. Workers are provided with protective helmets, jackets, and safety shoes. Air pressure is used to test the pipelines rather than water, avoiding waste water issues. Visual observation on site indicated that environmental health and safety (EHS) requirements were complied with satisfactorily and no corrective actions are deemed necessary. 5. Safety performance. CGH and project companies pay considerable attention to safety issues. Natural gas storage facilities and gateway stations adhere strictly to fire department regulations and maintain a safety distance of minimum 100 meters from any buildings in the vicinity. 1 ADB Energy Policy. Manila. 2 A social safeguards specialist consultant, P. K. Agrawal visited Hahhot City, Inner Mongolia during March, 2010 and met with the China Gas Holding officials in Shenzhen on March 18, 2010.

24 16 Appendix 3 6. CGH s safety department with a staff of 14 persons is responsible for supervising and managing occupational safety work, formulating safety management plans, and regular examination and on-site supervision. Project companies have inspection vehicles to check for leaks in installed pipelines operate around the clock. On site, the vehicle was observed to move slowly with hazard lights on. Locally improved German technology can detect leakage up to 80 centimeters below the road surface. Community volunteers at local level are also used in inspection and reporting. Any leak discovered by the inspection vehicle is reported immediately to the office for more a detailed follow-up investigation and necessary repairs. CGH also makes extensive use of public media for public awareness on safety. 7. Training. CGH conducts regular training programs for its staff, focusing on increasing efficiency in management and operational issues. In 2009, CGH organized 37 different types of training programs for its staff at the headquarters and subsidiary levels, covering 1,248 employees. CGH s safety operation system includes 44 specification sets of operational job description and duties, 21 types of operational management systems for city gas operations, 16 types of standard operational management work flow, and 93 types of safety manuals and guides. CGH has an annual safety and operational training program and a review system and operational contest to ensure implementation and execution. To improve its operational system, CGH has started to build and install an operational information management analysis model to improve and enhance operations standards. 8. Corporate environment policy. Corporate policy puts heavy emphasis on safety and environmental protection in company operations. Environmental, health, and safety activities are primarily undertaken by the staff of the project and technology department reporting directly to the project manager. During project planning and construction, the engineering department is mainly responsible for environmental issues. The safety department however, has a staff of 14 personnel. 9. Environmental management procedures and practices. The design and operation of gateway stations and gas distribution systems are required by law to strictly conform with safety standards and practices that are well established by professional institutions in the gas industry. The regulatory authorities periodically monitor safety. CGH has well-established environmental management procedures and practices, which are carried out in compliance with the national and local government environmental and safety requirements. 10. The project is categorized as Environment FI and was required to adopt and implement an environmental management system in accordance with ADB s Environment Policy (2002) to conduct adequate environmental impact assessment (EIA) and appropriate mitigation. Preparation of an EIA and securing environmental clearance has followed the PRC s EIA law and has been generally outsourced to external environment professionals by CGH at the project level. 11. Environmental reporting mechanisms. CGH has an annual reporting procedure in place. Annual reports cover environment and safety issues, among others. Based on available records, all project companies are reported to be in compliance with government environmental standards.