Belt and Road insiders: What we think about “greening” the initiative

Interviews with banks and SOE executives shed light on what motivates Chinese players to (not) go green in BRI projects.

By Huang Wei and Tom Baxter

When it comes to issues arising from the Belt and Road Initiative (BRI), be they debt burdens, local community engagement or environmental sustainability, external stakeholders are often more confident with prescribing what China “should” do than offering convincing arguments about “how” Chinese actors can be made doing the right thing. One of the key barriers of translating visions into actions is the lack of access to the actual thinking of Chinese actors involved in the BRI, thanks to the opaqueness of the Chinese political, business and financial institutions.

With the aim of overcoming that very barrier, my team and I recently conducted a round of intensive interviews with practitioners who are at the forefront of China’s overseas endeavors, with a focus mainly on energy investment. The interviewees include large state-owned construction firms; financiers and insurers; and third party consultancy firms that provide accounting and legal services to the Chinese companies. We would like to use this rare window to understand more about the driving forces and roadblocks for greener investment along the Belt and Road.

The Chinese government appears to be increasingly willing to engage in discussion on the environmental sustainability of BRI, with numerous high level officials, including President Xi himself, calling for the Belt and Road to be a “green” initiative. In May last year a government document containing “green belt and road” guidelines was issued to promote such a vision. The document, however, consists of non-binding “guidance”, rather than legally enforceable regulations. In addition, being issued by multiple government departments, it left confusion more than guidance in its wake.

In the twenty months since that document was issued, advocacy groups, think tanks and even industrial associations have worked to flesh out and clarify the government’s intention, producing a proliferation of “voluntary compliance standards” and initiatives targeting everything from banking practices to corporate social responsibility.

But to what extent are such policies actually “greening” the BRI? Are “voluntary standards” and “initiatives” shaping the behavior of Chinese actors participating in the initiative? What is the real impetus for green investment along BRI? These are crucial questions that need to be addressed.

The interviewees were asked a set of questions that focus on their decision making process with regard to environmental standards, the motivations behind those decisions and their perceptions of “Green BRI” in general.

This article will not list out their answers in full. Rather, it attempts to pull out some of the main insights and common themes in order to shine a light on the thinking of key Chinese players when it comes to introducing higher standards for sustainability in BRI projects.

GreenBRI
The Chinese government appears to be increasingly willing to engage in discussion on the environmental sustainability of BRI, Image: cbcgdf.org

The Profit Equation

The most evident conclusion from the interviews was that banks and companies generally don’t have motivation to go beyond recipient countries’ local standards and regulations as they still operate within the simplest market logic of profit maximization.

When we posed the question: How do you decide on your choice of environmental standards for a project? The majority of interviewees would understand the question as, what do higher environmental standards mean for profit.

During the initial process of bidding and negotiation for an overseas power plant, for example, companies need to come up with a project design plan that is both most economically desirable and that ticks the boxes of local environmental requirements and electricity demand. It is an extremely practical process, similar to solving a maximization problem under constraint that economics students are often faced with at school — choices are computed based on input of numbers into a standard formula. Inputting a higher standard will automatically shrink the profit margin and absorb capital that would have been earning money elsewhere. This serves to weaken a company’s competitiveness in a highly competitive field.

It is often argued that environmental risk need to be factored into this calculation for its potential negative impact on profit. But, as was evident from our interviews, when companies and banks talk about “environmental risks”, they are in fact referring to costs and penalties arising from non-compliance, which are real monetized indicators. “Risk” would only influence choice if it is considerable and tangible enough to be input into the profit formula, such as the risks of fines and penalties many heavy industries in northern China face since the introduction of strict emissions standards.

Shielding against market risks

A commonly used argument by critics of fossil fuel-based BRI energy projects is the potential risk of “stranded assets.” Expensive projects may end up as facilities inutilizable as environmental standards and climate change mitigation measures become more restrictive over time. Companies and banks are therefore urged to look beyond short term profit calculus. To many of our interviewees, however, this argument did not ring any alarm bells.

Companies tend to already see themselves as shielded from such long-term risks through the means of contracts at the project planning stage. One example of such a contract is the Power Purchase Agreement (PPA) signed during the initial stages of investment in power plant projects. The PPA provides certainty in future price, volume and time period for electricity sold, meaning that any further cost of retrofitting would be borne by the recipient country government, not by companies. Whether or not local governments are aware of the risks that are left on their shoulders in signing such agreements is another question, and one that certainly deserves digging into.

In addition, the most common form of Chinese investors’ participation in overseas project is a short term, “turn-key” EPC (Engineering, Procurement and Construction) contract, which ends immediately upon construction completion. Under an EPC arrangement, long term risks are not a consideration. Longer term contracts, such as Built, Operate, Transfer (BOT), do exist and entail a different set of considerations where longer term risk is a more important factor. The BOT model tends to be more common in investments in overseas hydropower projects.

As for the banks, lending is prioritized in capital structure and potential risks are usually covered by insurance companies such as Sinosure, meaning that banks are sheltered from revenue shock, significantly eroding the effect of the stranded assets argument.

Reputational risks

Advocates for a greener Belt and Road have also argued that companies’ potential reputational gains or losses, and political recognition that could confer, are a key factor in project decision making. Given the state-owned nature of the vast majority of Chinese companies and banks involved in Belt and Road projects, China’s domestic politics, including image and reputation, no doubt do play a role. Our interviews showed, however, that such factors have yet to be seen as tangible indicators for companies to enter into their profit formulas. In fact, contrary to conventional belief, going beyond market norms would put a company under greater scrutiny, which may or may not lead to greater recognition, but certainly adds extra risk to company operations.

Who holds the keys to change?

What and who can motivate for greener investment then? Well, it’s a billion-dollar, and potentially billion tons of carbon, question. But the interviews did uncover some of the key players and factors that are most influential over Chinese companies’ behavior. In my experience, the below “keys to change” are generally not well understood in the communities working to green the BRI.

SASAC:

The State-owned Assets Supervision and Administration Commission (SASAC) is an institution under direct management of China’s State Council. It is authorized to act as a shareholder of SOEs with responsibility over their performance evaluation. The SASAC performance evaluation is, then, the closest thing to a tangible measure of SOE reputation. It also gives SASAC distinct power over the career progression of heads of SOEs.

According to interviewees, the performance evaluation (which is not publicly available) still relies heavily, if not entirely, on profit indicators, leaving SOEs with zero incentive to jump out of the profit maximization mindset. Indicating SASAC’s influence over SOE investment behaviour, one interviewee said: “If SASAC could incorporate ‘green’ as quantitatively assessable criteria into the performance evaluation, it would be implemented in no time among SOEs.”

Sinosure:

Sinosure is the single Chinese state-owned insurance corporation that provides export credit insurance. The fact that many advocacy groups categorize Sinosure insurance as financing is somewhat misleading, as insurance is actually more like the pre-requisite of financing during real investment cycle.

More often than not, Sinosure’s involvement in a project is what gives it the green light. Banks would rarely say yes to an overseas project without the nod from Sinosure to assure that political and market risks associated with projects far away from home are covered. With few alternatives on the market, Sinosure holds a near monopoly over “life or death” insurance for Chinese companies’ overseas investments and, by end of 2017, had enabled over 2.9 trillion RMB of overseas financing.

Given their vital role as risk-covering agent, there is huge potential to lobby Sinosure to be more attentive to environmental risks.

MSCI:

Morgan Stanley Capital International Index (MSCI) is the most commonly used equity market index for investment portfolio managers around the world. Since 2017, MSCI has been going through a long process of integrating China A-shares (Shanghai and Shenzhen stock exchange traded RMB shares) into its Index. It is a milestone for China as the integration would enable publicly listed Chinese companies to gain access to international capital.

Significantly for our purposes, after being included in MSCI a company would be required to undergo Environment, Social and Governance (ESG) assessment and classification. Good performance would allow that company to be included in an ESG index called “the Green Leaders Index”. Any underperforming companies would be removed from that index. This would help portfolio managers who are wary of the risks behind bad ESG performance in emerging market to come to informed decisions. Given MSCI’s large client base, the impact of this indicator on a company could be significant.

Currently, many listed companies that underperform on ESG are seeking solutions from consultancy firms who provide advice on how to improve. This dynamic is not only an engagement chance for those who work on greening BRI, it also has broad implications for environmental advocacy within China.

Signs of Change

Despite the seemingly unbreakable profit calculus of Chinese SOEs, there have been some cases of projects adopting standards higher than the bare minimum required. Three special circumstances stand out:

  1. When there is willingness of a recipient country to go beyond average standards, such as for a flagship project. An example would be the ultra-supercritical Hamrawein coal power plant soon to enter construction in Egypt. For this mega-scale project, the Egyptian government has required higher standards and promised to pay for a higher electricity price. In return, the Chinese financier will give a discount on loan terms.
  2. When a project is backed by a syndicate loan that involves international banks, the project will have to reach the highest standard within the syndicate group (normally that of multilateral development banks such as the World Bank or European Bank for Reconstruction and Development). This effectively forces Chinese financiers to adopt higher standards than they would normally be required to.
  3. Some projects with extremely handsome rates of return will consider raising standards for a win-win outcome on both profit and reputation, according to one interviewee.

Where next for Green BRI?

No systematic change will come from special circumstances, however. To effectively leverage for a genuinely green BRI, stakeholders will have to consider closely how they engage with the dynamics of Belt and Road investments as well as carefully consider what exactly they are advocating for. As one interviewee bluntly put it, his company would only act differently if green requirements are translated into “departmental rules from the government, SASAC performance evaluation criteria, and clear reward-penalty mechanisms.”

The takeaways from the interviews are clear:

Firstly, stakeholders must always be mindful of the communication gap. In order to influence investors, advocates for a greener BRI must be able to speak to them in their language. This requires us to question our assumptions and make sure to study the nitty-gritty of the investment process.

Secondly, “profit” is clearly front and center in investors’ decision-making process. We should not put “green” on balance, hoping that it would outweigh “profit”. Instead, we need to put “profit” on balance, and think about how “profit” can be outweighed by environmental and other factors.

Lastly, outside of profit calculus, there are two strangleholds for investors: one is an assessable “green” benchmark and a clear reward-penalty mechanism from supervisory bodies; the other is a requirement for higher standards from capital providers. This has put the keys to unlocking “green Belt and Road” in a selected few players’ hands. Advocates would do well to focus their efforts on those who hold the keys.

This blog is co-authored by Huang Wei and Tom Baxter. Huang Wei was a Climate & Energy campaigner with Greenpeace East Asia. Her expertise is in China’s overseas energy investment, coal and air pollution in China.

** This article was updated on 27 December to clarify that ESG assessment for a company would occur after inclusion in MSCI, rather than as a prerequisite for inclusion. **

Unpacking Chinese financing of Pakistan’s “dream” power plant

Chinese companies are not just pouring concrete along the Belt and Road. Financing is a big part of China’s overseas involvement.

By Liu Shuang

There has been much discussion about China’s involvement in coal projects overseas. Critics point to the tremendous carbon footprint it may create, and call for a change in the practice. Analyses have highlighted the complicated dynamics that enable the continued build-up of coal fired power capacities around the developing world, against the stern warning of climate scientists.

Within that complex dynamics, financing is one central piece of the puzzle that is often poorly understood. Due to intrinsic difficulties in gaining access to information about how financial actors (especially Chinese ones) operate, presenting an accurate picture of key financial components at project level proves to be challenging.

This blog tries to shed some light on Chinese financed coal-fired power plant, by using a “strawman case” built out of publicly available information.

The case in point is the Engro Thar Block II (ETBII) project in Pakistan’s Sindh province, one of the key coal power projects listed under the China Pakistan Economic Corridor (CPEC). As a major destination of Chinese coal investments globally, Pakistan provides a good observatory point to understand why coal projects along the Belt and Road continue to get funded by Chinese lenders.

engrothatblockII
Engro Thar Block II 2×330MW Coal fired Power Plant TEL 1×330MW Mine Mouth Lignite Fired Power Project at Thar Block-II, Sindh, Pakistan. Source: CPEC Website

“The Thar dream”

Ever since the discovery of the massive coal reserve in Thar in 1991, a desert area 500 kilometers to the east of Karachi, the anticipation of developing Pakistan’s indigenous source of energy has captured the imagination of the nation. The reserve is estimated to comprise 175 billion tons of lignite coal. Unlocking a fraction of it would be sufficient to power the entire country, which, to this date, still heavily relies on imported fuel oil for its electricity demand. But technological barriers had thwarted attempts to tap the resource in the past. And due to concern with climate change impacts, the World Bank withdrew its support for the endeavor in 2009, leaving the project in financial uncertainties for a few years.

The entry of Engro, one of Pakistan’s largest private energy conglomerates, breathed life into the project. But the prospect of developing the Thar minefield really improved after China got on board. In 2014, Engro Thar Coal-fired Power Plant (660 MW) was listed under the China Pakistan Economic Corridor (CPEC). And the year after, a consortium of Chinese finance institutions committed to fund the project, enabling the project to achieve financial closure in April, 2016. According to CPEC’s official project registry, the Engro Thar Block II project is a combination of coal mining and mine-mouth power generation, with the first phase of the coal-fired power plant consisting of two 330MW units.

Engro’s official website celebrated the project as a “significant feat”, marking “a new era for energy security in Pakistan and brings with it the realization of the Thar dream.”

Chinese actors

The project illustrates a typical financing structure that is increasingly common along the Belt and Road.

ETBII Finance

At least four categories of Chinese actors are involved in this case:

Lender : China Development Bank (CDB), Industrial and Commercial Bank of China (ICBC), Construction Bank of China (CBC)

Credit insurance: Sinosure

Construction company (EPC contractor): China Machinery Engineering (CMEC)

Project developer: Sindh Engro Coal Mining Company (SECMC, with China Power International Holding and CMEC as shareholders)

As in many other similar China-financed projects, the structure features one Chinese policy bank (either CDB or the Export-Import Bank of China), two Chinese commercial banks and Sinosure. The arrangement helps spread financial risks across multiple Chinese players. While players such as CDB has attracted wide attention as one of China’s financial engines powering the Belt and Road Initiative, other key players have managed to stay out of the spotlight. One of them is China Export & Credit Insurance Corporation (Sinosure), whose involvement in such deals can often tip the balance between go and no-go.

Sinosure engages in a business known as “policy insurance”, non-profit oriented insurance bankrolled by China’s treasury, with the aim of promoting the country’s export and overseas investments. In a project like ETBII, Sinosure provides an Export Buyer’s Credit Insurance to the Chinese financial consortium against the risk of repayment delay or failure due to political or commercial reasons. For a range of risks from war to contract breach, the company offers a maximal 95% insured percentage. The safety net is critical in markets with high uncertainty and gives Chinese companies a considerable edge. Despite the seemingly bottomless “pockets” of Chinese policy banks and state-owned commercial banks, whether Sinosure is on board usually accounts for “50-60% of the weight” in their decision making, according to those familiar with the matter. And Chinese actors don’t even have much choice. Alternatives to Sinosure, commercial insurance companies or foreign insurers, are much less desirable for their high charges. Sinosure’s influence in deciding China’s overseas energy footprint cannot be underappreciated.

Even though on paper Sinosure may maintain an “agnostic” approach to the types of energy projects it insures, be they coal-fired or renewable, other project features can tilt it more toward coal. Guarantee from a project’s host country government matters to an insurer. Large fossil fuel projects, in this regard, usually have better access to state support than renewable energy projects much smaller in scale. Smaller project size also means a lower “financial threshold” of entry, attracting developers that, to insurers, are intrinsically riskier. Large fossil fuel projects may also leave behind more valuable fixed assets than renewable projects in occasion of a default, an important consideration for insurers. All those non-climate related factors may make Sinosure more inclined toward projects like ETBII.

A bankable PPA

In any major power project that involves financing from international lenders, the Power Purchase Agreement (PPA) often ranks as the most important contractual component of the deal. On the surface, a PPA is merely an instrument that facilitates the sale and purchase of electricity. But more importantly, for most power projects, payment from the buyer under the PPA constitutes the only revenue stream for the project company to repay its loans. The negotiation and set-up of a PPA would often decide if a project is considered “bankable” to potential lenders.

The Pakistani authority has more or less standardized the PPAs of coal power projects, making them acceptable for international financiers. In a 2016 presentation by Pakistan’s Private Power and Infrastructure Board (PPIB), a government body that facilitates investments into the country’s power sector, it boasts government guarantee of power purchaser obligations, attractive Return on Equity (ROE), tariff indexation against inflation and government assurance of foreign currency conversion as terms that would sweeten a power deal for foreign investors. Most, if not all, of those elements will end up in a project PPA.

Based on the information published by Pakistan’s National Electric Power Regulatory Authority (NEPRA), we could get a glimpse of the key components of the PPA for ETBII.  The following chart lists those components and juxtaposes them with equivalent PPAs of wind power projects in Pakistan for reference.

PPA
* A selection of multiple wind energy PPAs from the NEPRA website is used here for reference purpose

Beyond the fact that a coal power PPA usually features a relatively low electricity tariff, which is highly valued by Pakistan’s policy makers and regulators that put “affordability” of electricity at the center, the PPA also caters to the needs of other key stakeholders in the deal. From a lender’s point of view, the PPA’s tariff formula incorporates debt service considerations of the project, based on a standard interest rate (London Inter Bank Offer Rate plus 450 basis points) for foreign currency loans. In addition, it also promises an over 30% Return on Equity for the project’s sponsors (i.e. shareholders), which is higher than what’s typically factored in in PPAs of other similar projects (15%-20%).

The PPA represents a different kind of product that is being promoted along the Belt and Road: the knowhow of setting up financial frameworks of projects fundable by Chinese financial institutions. As Chinese banks and companies take leading roles in overseas power projects, they share their expertise with host countries, showing them how to make projects work. This is something much less tangible than the infrastructure projects ended up being built, but no less important.

The enabling environment

Chinese financing can only be materialized into projects with the help of enabling investment and regulatory frameworks in Pakistan, co-created by a host of government agencies. The bonding of the two elements releases “energy” that propels Belt and Road power projects forward.

In the ETBII case, beyond PPIB support of the project, endorsement statements were provided by the Ministry of Petroleum and Natural Resources and the Government of Sindh in support of the project, quoting energy security and the use of “indigenous resources” as main reasons; the province’s Environmental Protection Agency issued a No Objection Certificate, with no climate considerations included.

For those with a view to contain and even reverse the “chemical reaction”, understanding both the financing element and the enabling element will better prepare them for engagement and intervention. The strawman case is not meant to depict a complete picture. Yet the snapshot it creates should contribute to the mapping of key players and their interactions that illuminate the way ahead.

Liu Shuang is the Director of Energy Foundation China’s Low-Carbon Economic Growth Program. At Energy Foundation China, she develops and implements program strategies, manages grants on carbon emission scenarios, market-based instruments, economic analysis of environmental and climate policies, and mainstreaming climate research into economic growth. She holds an MSc in Environmental Economics from University College London and a BA in Economics from Peking University.