Hubei Enshi Qing River Upstream Environment Rehabilitation Project (RRP PRC 47048) FINANCIAL ANALYSIS A. Introduction 1. The financial analysis of the project was carried out in accordance with the Asian Development Bank (ADB) guidelines for the financial analysis of projects. 1 The analysis included assessments of the current financial performance and the future viability of costrecovery objectives, and the fiscal impact of non-revenue-generating projects. Enshi and Lichuan city governments will service the ADB loan and are responsible for counterpart funding and ongoing recurrent operation and maintenance (O&M) costs. Project outputs are described in Table 1. Table 1: Project Outputs Output Subcomponents Type of Analysis Enshi Wastewater Enshi Hongmiao WWTP Enshi Dashaba WWTP Cost-recovery objectives, FIRR Enshi sewage network Lichuan Wastewater Lichuan WWTP Cost-recovery objectives, Enshi River Improvement Lichuan River Improvement Nonstructural measures Lichuan sewage network Enshi flood management Enshi river greening Lichuan flood management Lichuan river greening Agriculture NPS pollution reduction pilot scheme Other nonstructural measures, e.g., flood warning system to complement the structural components to improve their effectiveness and sustainability FIRR Non-revenue-generating, financial sustainability analysis Non-revenue-generating, financial sustainability analysis No financial analysis, these are capacity building, public engagement, and pilot projects FIRR = financial internal rate of return, NPS = nonpoint source, WWTP = wastewater treatment plant. B. Non-Revenue-Generating Outputs 2. Financial sustainability analyses were completed for the Enshi and Lichuan flood management and river rehabilitation outputs to assess the fiscal sustainability and debt repayment capacity of the Enshi city government (ECG) and Lichuan city government (LCG). The growth of total revenues and expenditures were analyzed. Assessment of the past financial performance of the cities was completed. The ECG and LCG will provide counterpart funding during implementation and pay debt service and O&M costs for non-revenue-generating outputs following project completion. The objectives of this assessment are (i) to review the historical revenue-generating capacity and the share of revenue from higher government sources during 2007 2011, and determine how much expenditure this supports; (ii) based on historical revenue-generating capacity, to assess the financial capacity of the cities to finance counterpart funding during project implementation; and 1 ADB. 2005. Financial Management and Analysis of Projects. Manila; and ADB. 2009. Financial Due Diligence: A Methodology Note. Manila.
2 (iii) based on projections of financial income, to assess the capacity of the cities to finance O&M and debt service costs, in addition to their other obligations, over the loan payback period. 3. A review of statements of revenue and expenditure for 2009 2013 was completed for these jurisdictions to evaluate financial performance and their capacity to support current operations and finance the new costs. Revenues and expenditures were forecasted forward at a conservative rate of 5% per year to evaluate upcoming fiscal burdens. Counterpart funding and incremental O&M costs were compared to forecast expenditures and revenues. Average annual counterpart funding accounts for 0.55% of ECG projected revenues and 0.67% of the LCG projected revenues during implementation and all incremental costs are less than 0.1% of revenues after 2020. The financial sustainability assessment indicates that the ECG and LCG have sufficient funds to finance the counterpart contributions, as well as to finance debt service and O&M costs during operation. C. Financial Analysis of the Revenue-Generating Component 4. Cost-recovery objectives include the wastewater treatment plants (WWTPs). The financial analysis for these was conducted at an enterprise level based on pro forma financial statements. This analysis considered cost recovery, profitability, and liquidity of the enterprise based on existing tariffs. Financial internal rates of return (FIRRs) were estimated for the project investment based on financial cash flows. The analysis was completed with existing tariffs and full cost-recovery tariffs. 5. The following assumptions are used in the analysis: (i) Separate projections were made of with-project and without-project demands, revenues, and costs. (ii) Project construction costs were estimated by the project design institute. (iii) All costs are estimated at 2014 prices. These are forecasted forward based on growth in demand and inflation. (iv) FIRRs were evaluated at constant 2014 prices, while financial performance assessments were based on inflating values. (v) Physical contingencies were estimated as 8% of base costs. Price contingencies account for cost inflation and potential exchange rate movements over the construction period. (vi) An exchange rate of CNY6.13 = $1 was assumed. (vii) Capital costs include base cost and physical contingencies, but exclude price contingencies and financial charges during implementation. (viii) O&M costs include personnel salaries and welfare, and repair, maintenance, and other costs. Expenses also include depreciation of fixed assets. (ix) Revenues are derived from transfers from the city governments and from wastewater tariffs. (x) Outputs are financed using the ADB loan and counterpart funds from local governments. The ADB loan is a variable rate loan with straight line amortization. The loan period is 25 years including a 5-year grace period. Financing charges during implementation are not capitalized. 6. The financial cost benefit analysis compares the costs and benefits of the project from the viewpoint of the enterprise. The project costs use market prices including applicable taxes and duties.
3 7. Investment cost. The wastewater components are estimated to cost CNY440.51 million in Enshi and CNY191.49 million in Lichuan. Capital costs include civil works, equipment, land acquisition and resettlement, environmental and social monitoring costs, capacity building, taxes and duties, and physical contingencies. Price contingencies and financing charges during construction are not included. 8. Weighted average cost of capital. Estimated FIRR values are compared to the weighted average cost of capital (WACC). Financing sources consist of the equity contributions from the ECG and LCG and ADB foreign currency loan. The 10-year US Dollar fixed swap rate (2.46%) is assumed for debt servicing. 2 An ADB spread of 0.5% and a maturity premium of 0.1% are added to this rate. 3 The cost of equity was assumed to be 5.71% based on a risk-free rate of return of 3.64% and an assumed risk premium of 2.00%. 4 The corporate tax rate is 25%. The real after-tax costs of ADB funds were estimated to be 1.09% and of equity 2.63%. Domestic inflation is set at 3.0% and an international inflation at 1.58%. The computed values for WACC are shown in Table 2. Table 2: Weighted Average Cost of Capital Weighting Nominal Inflation Real Term Funding Source ECG LCG Rate Tax Rate ECG LCG ADB 52 59 3.06 25 1.58 0.57 0.86 ECG 48 5.71 0 3.00 1.27 LCG 41 5.71 0 3.00 1.07 Real WACC 1.84 1.72 ADB = Asian Development Bank, ECG = Enshi city government, LCG = Lichuan city government, WACC = weighted average cost of capital. 9. Wastewater tariffs. Revenues are estimated based on current tariff revenues and existing subsidies. Tariff revenues are based on assumed tariff levels and the customers billable water volumes. Both Enshi and Lichuan currently use a wastewater tariff that is a simple or uniform volumetric charge of CNY0.8 per cubic meter (m 3 ) that all customers with a water supply connection pay, even if they do not have a wastewater service connection. With this tariff level, cost recovery is estimated to be 90% in Enshi and 49% in Lichuan in 2015. Implementation of this tariff followed construction of the first WWTPs in Enshi in 2006 and in Lichuan in 2009. Under the policy, the intended purpose of this tariff is to cover the cost of wastewater treatment but not collection or sludge treatment. Billable water is the customer s average metered water supply. All water supply customers are billed for wastewater services based on metered water use. 10. A recent notice of the National Development and Reform Commission requires that the tariff is increased to CNY0.95/m 3 before 2016. Both the ECG and LCG have committed to a progressive increase of wastewater tariffs to achieve full cost recovery in accordance with national wastewater tariff policies and regulations. Adjustments to a full cost-recovery tariff level are gradual and are assumed to occur every 5 years. Measured at 2014 price levels, the full cost-recovery tariff profile for Enshi had tariffs increasing from CNY0.80/m 3 in 2015 to CNY1.79/m 3 by 2041 (average CNY1.25 per m 3 ) and from CNY0.80/m 3 to CNY 2.25/m 3 in 2 http://www.federalreserve.gov/releases/h15/update/ accessed on 19 November 2104. 3 The average loan maturity is 15.25 years. 4 A return of 3.64% was reported for 10-year government bonds in the PRC (http://asianbondsonline.adb.org, accessed 19 Nov 2014).
4 Lichuan (average CNY1.42 per m 3 ). With these increases, full cost recovery is achieved by 2026 in Enshi with a tariff of CNY1.27/m 3 and by 2021 in Lichuan with a tariff of CNY1.22/m 3. Both Enshi and Lichuan have committed to providing subsidies to fully cover funding shortfalls in wastewater operations caused by tariffs that fail to achieve full cost recovery. With ongoing increases, cost recovery continues to improve, so average recovery of capital and O&M costs over the life of the project is 132% in Enshi and 193% in Lichuan. 11. Tariff affordability analysis. Tariffs are considered affordable when they do not exceed 5% of average monthly incomes of CNY4,220 in Enshi and CNY3,960 in Lichuan based on monthly water consumption of 17.6 m 3. The tariff affordability analysis shows that the share of income spent on water and wastewater at full cost-recovery levels is well below the benchmark of 5.0%, less than 1.9% for average-income households, and less than 2.6% for low-income households. Nonetheless, the ECG and LCG have committed to (i) undertake periodic review of tariffs and fees following specified tariff setting mechanisms, (ii) assess the impact of wastewater collection fees and tariffs on the poor and provide necessary subsidies to ensure wastewater collection services to the poor, and (iii) hold public tariff consultation hearings to consult with the affected people when setting or adjusting tariffs for wastewater. 12. Financial internal rate of return. Results of the analysis of revenue-generating outputs are summarized in Table 3. The financial analysis for output 1 in Enshi and Lichuan confirms that it is financially feasible, with an FIRR above the weighted average cost of capital given commitments of the ECG and LCG to (i) a progressive increase of wastewater tariffs to achieve full cost recovery in accordance with national wastewater tariff policies and regulations, and (ii) provide subsidies to fully cover funding shortfalls in wastewater operations caused by tariffs that fail to achieve full cost recovery. Table 3: Revenue-Generating Output Analysis Tariff increase (every 5 Item WACC FIRR years) Enshi wastewater 1.83 4.6 35.0 Lichuan wastewater 1.72 5.0 35.0 FIRR = financial internal rate of return, WACC = weighted average cost of capital. 13. Sensitivity analysis. Sensitivity analysis was completed for the scenario that assumes a full cost-recovery tariff adjustment (Table 4). The large reduction in growth has little impact. None of the tests depress the FIRR to below the WACC. Table 4: Sensitivity Analysis Financial Internal Rate of Return Item Enshi Lichuan I. Base case 4.6 5.0 II. Capital cost increased 10% 4.1 4.4 III. Operating cost increased 10% 4.2 4.6 IV. Revenue down 10% 3.8 3.9 V. Combination of II, III, and IV 3.0 3.0 VI. Demand growth reduced 50% a 4.3 3.3 FIRR = financial internal rate of return a Adjusts high initial growth rates that reflect current growth patterns. Source: Asian Development Bank estimates
5 D. Financial Management Assessment 14. The Enshi prefecture government (EPG), the project executing agency, has extensive experience in preparing and implementing projects funded by the World Bank and foreign governments. A new prefecture project management office has been established within the Enshi Prefecture Development and Reform Commission. It is responsible, on behalf of the EPG, for daily coordination and management of project preparation and implementation. The Enshi Prefecture Finance Bureau (EPFB) will be responsible, on behalf of the EPG, for the financial management of the project. The Enshi Urban Construction Investment Company (EUCIC) and Lichuan Liangli Urban Construction and Development Company (LLUCDC) are the implementing agencies of the project responsible for implementation of subcomponents in respective cities. They are stated-owned companies. 15. The financial management assessment looked into the financial management capacity of the EPFB, EUCIC, and LLUCDC. The assessment included review of fund-flow arrangements, staffing, accounting policies and procedures, internal and external auditing arrangements, reporting and monitoring, and financial information systems. 16. The EPFB has adequate financial staff, accounting policies and procedures, internal and external controls, audit arrangements, and reporting systems. It has experience with World Bank and foreign government projects, but no experience with ADB projects. The LLUCDC and EUCIC have sound financial management systems which can meet the minimum financial management requirements for their current activities. They have no experience with the financial management of foreign-funded projects. External financial management assistance is proposed to help the EUCIC implement improvements in its budget management system. 17. The executing and implementing agencies have agreed to strengthen their financial management capability to manage the project, including (i) undertaking training, particularly on ADB policy and procedural requirements including procurement, disbursement, and project management; and (ii) seeking external financial management assistance as needed. 18. The overall financial management risk rating of the project, after considering mitigating measures, is moderate. The identified financial management risks will be closely monitored during project implementation.