Report and Recommendation of the President to the Board of Directors

Project Number: 40634-01 July 2010

Proposed Loan People's Republic of : Autonomous Region Environment Improvement Project (Phase II)

CURRENCY EQUIVALENTS (as of 21 June 2010)

Currency Unit – yuan (CNY) CNY1.00 = $0.1464 $1.00 = CNY6.826

ABBREVIATIONS

ADB – Asian Development Bank CHP – combined heat and power CNG – compressed natural gas CO2 – carbon dioxide EIRR – economic internal rate of return FIRR – financial internal rate of return GDP – gross domestic product GIMAR – Government of the Inner Mongolia Autonomous Region IMAR – Inner Mongolia Autonomous Region km – kilometer LIBOR – London interbank offered rate m2 – square meter MW – megawatt NOx – nitrogen oxides PAM – project administration manual PMO – project management office PRC – People’s Republic of China SCADA – supervisory control and data acquisition SO2 – sulfur dioxide TSP – total suspended particulates

NOTE

In this report, "$" refers to US dollars

Vice-President C. Lawrence Greenwood, Jr., Operations 2 Director General K. Gerhaeusser, East Asia Department (EARD) Director A. Bhargava, Energy Division, EARD

Team leader S. Yamamura, Energy Specialist, EARD Team members I. Ahsan, Counsel, Office of General Counsel X. Liu, Project Officer (Energy), PRC Resident Mission, EARD T. Oi, Energy Specialist, EARD K. M. Ozoa, Administrative Assistant, EARD M. Pajarillo, Sr. Financial Analysis Specialist, EARD R. Sabur, Environment Specialist, EARD

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.

CONTENTS

Page I. THE PROPOSAL 1 II. THE PROJECT 1 A. Rationale 1 B. Impact and Outcome 4 C. Outputs 4 D. Investment and Financing Plans 5 E. Implementation Arrangements 6 III. DUE DILIGENCE 7 A. Economic and Financial 7 B. Governance 8 C. Poverty and Social 8 D. Safeguards 9 E. Risks and Mitigating Measures 9 IV. ASSURANCES AND CONDITIONS 10 V. RECOMMENDATION 10

APPENDIXES 1. Design and Monitoring Framework 11 2. List of Linked Documents 13

I. THE PROPOSAL

1. I submit for your approval the following report and recommendation on a proposed loan to the People's Republic of China (PRC) for the Inner Mongolia Autonomous Region Environment Improvement Project (Phase II).

II. THE PROJECT

A. Rationale

2. The PRC depends heavily on coal, which made up 68.7% of the primary energy supply in 2008. This has brought substantial environmental damage caused by harmful emissions such as sulfur dioxide (SO2), nitrogen oxides (NOx), and total suspended particulates (TSP). SO2 and NOx are the main causes of acid rain, a pressing environmental problem in the PRC, and TSP causes serious respiratory diseases. Carbon dioxide, the main greenhouse gas, is a major emission from coal burning and a cause of global warming. Air pollution is estimated to cost the PRC economy 3.8% of gross domestic product (GDP) annually. 1 The Inner Mongolia Autonomous Region (IMAR) depended on coal to meet more than 90% of its energy demand in 2008. Reliance on coal has a high environmental cost for urban areas in IMAR, as only 6 out of 15 cities monitored for air quality reach class II air quality standards.2 IMAR has proven coal reserves of more than 47 billion tons, or about 25% of the total coal reserves in the PRC, but it has less than 2% of the PRC's population. 3 IMAR generates electricity for export to other provinces and major load centers like Beijing. This causes disproportionately high SO2 and other coal emissions in IMAR. In 2008, its SO2 emissions were 1.43 million tons, which is 5% of national emissions. Coal burning for heating contributes 10% of IMAR SO2 emissions. The Government of the PRC targets in its Eleventh Five-Year Plan, 2006–2010 a 10% reduction 4 in SO2 emissions and a 20% reduction in energy intensity by 2010 compared with 2005. The IMAR economy is relatively inefficient, using 2.61 tons of standard coal equivalent per CNY10,000 of GDP, or double the national average of 1.10 tons in 2008. The IMAR target is to improve energy intensity by 25% by 2010.

3. District heating in IMAR depends primarily on coal, which provides 95% of heating requirements. Moreover, most of the existing district heating infrastructure is old and inefficient. The IMAR government recognizes the importance of improving energy efficiency in district heating as a priority toward achieving IMAR's target for improving energy intensity. Large energy efficiency gains are attainable from the district heating subsector through replacing and upgrading heat generators and improving insulation on distribution systems. Small heating boilers typically have efficiencies of 40%–50%, while new, larger boilers have efficiencies exceeding 80%. Additional opportunities for improving energy efficiency and reducing the environmental impact of district heating are offered by alternative renewable or recycled energy, such as geothermal energy and using waste heat from industrial processes.

4. Due to its remoteness and low population density, IMAR includes some of the poorest areas in the PRC. The population of IMAR was 24.14 million in 2008, which is 1.82% of the national total, though IMAR occupies 12.3% of the land area. IMAR has 31 national poverty counties and 29 provincial poverty counties with 800,665 people living below the poverty line.

1 World Bank and State Environmental Protection Administration. 2007. Cost of Pollution in China: Economic Estimates of Physical Damage. Washington, DC (conference edition, February). 2 All energy sector data in this document were taken from the National Bureau of Statistics of China and IMAR Statistics Bureau unless noted otherwise. 3 International Energy Agency. 2009. Cleaner Coal in China. Paris. 4 Energy intensity is measured as primary energy consumption in standard coal equivalent per CNY10,000 of GDP. 2

The provision of reliable, affordable household heating is a basic necessity in IMAR as temperatures can fall to –40°C and the heating season can last for 7 months. Environmental impacts from current heating methods have a disproportionately high impact on the poor. Inadequate coverage of district heating in low-income urban areas drives residents to use indoor coal stoves for heating, which is a major cause of respiratory disease. Urban pollution from small, local boilers also worsens outdoor air pollution and causes significant cumulative harm to public health. The cost of heating for the poor is relatively high. A typical family living on the poverty line in a remote area of IMAR can expect to pay 20%–30% of its annual income on heating. Poor-quality district heating has a disproportionate impact on women as women take more responsibility for collecting fuel and operating household heating systems and spend more time at home exposed to high indoor pollution.

5. Demand for district heating is growing rapidly with strong economic growth, higher incomes, and the privatization of housing, which has increased sharply in recent years. Single- story residences that are expensive to supply with district heating are rapidly being replaced with high-rise residential buildings that are more suitable for district heating. Relocation policies for rural herders, intended to reduce environmental pressure on fragile pastures, are causing urbanization and increased demand for district heating. The urban share of IMAR’s population increased from 42.2% in 2000 to 51.7% in 2008.5 As a consequence, the district heating area has expanded rapidly, increasing by more than 50% during 2006–2008. This rapid increase has resulted in demand–supply imbalance.

6. Municipal and county governments are responsible for urban planning, establishing heating tariffs, providing financial support to the urban poor to pay heating bills, encouraging private sector participation in the heating sector, and establishing supply contracts with district heating companies. Heating reforms are works in progress with significant adjustments in tariffs that are now based on cost recovery plus a margin, and mechanisms are in place to allow tariff adjustments based on increases in operating costs. However, private sector engagement in IMAR’s heating sector has been relatively slow because (i) financial returns are low; (ii) initial infrastructure costs are high; (iii) perceived high risks make local financial institutions reluctant to provide financing, particularly in remote urban areas with small markets; and (iv) the number of private companies with the required technical and managerial capacity to operate such utilities is small. The district heating sector is not yet mature enough to survive the withdrawal of support from the public sector that is required for capacity building and easier access to capital.

7. Existing district heating infrastructure consists largely of inefficient neighborhood coal- fired boilers with low capacity and efficiency and an aging and poorly insulated pipe network that suffers high distribution losses. The existing coal-fired boilers are highly polluting and lack emission-control devices. In many urban areas, district heating systems were installed in the 1970s and have exceeded their design lives, resulting in unreliable service. The inadequacy of heating in remote areas disproportionately affects the poor.

8. IMAR is a major producer of natural gas, which is widely considered to be the cleanest fossil fuel.6 But the consumption of natural gas as a proportion of total energy consumption is less than 2.5%, lower than the national average. This is primarily because natural gas transmission and distribution infrastructure is underdeveloped. Analysis of natural gas consumption patterns in IMAR shows that natural gas is used mainly in industry, while household use accounts for only 16.1% of the total. The project will extend the natural gas

5 National Bureau of Statistics of China. 2009. Statistical Communiqué of the Inner Mongolia Autonomous Region on the 2008 National Economic and Social Development. Beijing. 6 The carbon intensity of natural gas is only half that of coal.

3 distribution system in one of the main banners in Xing-an Prefecture, providing cleaner fuel to 108,000 urban residents.

9. The project will upgrade infrastructure for district heating that will make it more energy efficient and allow increased heat supply for expanding areas. Assistance will construct more efficient boilers, as well as transmission and distribution pipelines. The government has classified natural gas for residential use as a priority area for development. Keyouqian Banner has incorporated the supply of natural gas into the design of newly urbanized areas. The project will enable the provision of clean energy to the city and boost economic development in Keyouqian, which is one of the poorest banners in IMAR.7

10. The project will avoid coal consumption by 1.04 million tons annually, thereby reducing annual emissions of 14,070 tons of SO2, 15,420 tons of TSP, 6,500 tons of NOx, and 1.59 million tons of carbon dioxide (CO2). Combined, the Inner Mongolia Autonomous Region Environment Improvement Project8 and the proposed project will construct or rehabilitate a district heating area of 71.49 million square meters (m2) in IMAR, which is 38.7% of the total district heating area of 184.5 million m2 in 2008.9 Together, these projects will improve energy efficiency in the district heating sector of IMAR by more than 15%, thereby annually avoiding 1.75 million tons of coal consumption and annual emissions of 31,640 tons of SO2, 36,967 tons 10 of TSP, 9,218 tons of NOx, and 2.66 million tons of CO2.

11. The project is consistent with the PRC country partnership strategy, 2008–2010 11 strategic pillar of resource efficiency and environmental sustainability and the Energy Policy12 priority of energy efficiency and environmental protection. It supports the Asian Development Bank (ADB) energy efficiency initiative to expand ADB’s investments in clean energy projects. The project will build on continuing engagement with the Government of IMAR (GIMAR) in the energy sector. In 2006, ADB approved the Inner Mongolia Autonomous Region Environment Improvement Project for $120 million (footnote 8), which targeted district heating and natural gas distribution in the and municipalities of IMAR. In June 2010, ADB approved a major change in project scope for the expansion of Linhe district heating subcomponent, utilizing $48.96 million in unused balance of Loan 2260.13 The project will help GIMAR provide improved and diversified district heating to a significant proportion of the remaining municipalities in IMAR, including remoter and poorer areas.

12. Some start-up delay was experienced in implementing the Inner Mongolia Autonomous Region Environment Improvement Project due to (i) slow mobilization of domestic loan funds, (ii) county governments’ poor understanding of requirements for counter guarantees, and (iii) deferment of detailed project design until the loan agreement is signed. The project has addressed these issues by (i) rigorously reviewing the key factors in project readiness that may

7 A banner is an administrative unit essentially equivalent to a county. 8 ADB. 2006. Report and Recommendation of the President to the Board of Directors: Proposed Loan to the People’s Republic of China for the Inner Mongolia Autonomous Region Environment Improvement Project. Manila (Loan 2260-PRC, approved on 29 September, $120 million). 9 The IMAR heating area increased from 52.2 million m2 in 2000 to 184.5 million m2 in 2008 and was projected to increase to 245 million m2 by 2010 and 492 million m2 by 2015. 10 The detailed environmental benefit is in the Summary Sector Assessment (Appendix 2). 11 ADB. 2008. Country Partnership Strategy: People’s Republic of China, 2008–2010. Manila. 12 ADB. 2009. Energy Policy. Manila. 13 The major variation was necessary due to accelerated implementation of six district heating components ahead of time without utilizing the ADB loan amount. Similarly, one of the wastewater treatment facilities became obsolete as the source of the wastewater was forced to shut down because it failed to meet environmental performance requirements. The expanded Linhe district heating will enlarge coverage to additional 10 million m2 than what was originally envisaged.

4 delay start-up; (ii) ensuring that county governments are fully aware of counter-guarantee requirements; (iii) providing training on ADB procurement and disbursement procedures; (iv) commencing detailed project design even while the loan is being processed; and (v) encouraging utilization of advanced contracting and retroactive financing features. In addition, the project management office is getting involved early in the project design stage to ensure better coordination between the design institutes and implementing agencies. To further ensure smooth implementation, especially in the first year, separate capacity-building technical assistance (TA) for Energy Efficiency Improvements in Inner Mongolia Autonomous Region is provided.14 This TA provides support in (i) capacity building and knowledge dissemination for improved energy conservation in the district heating sector and (ii) institutional capacity building in project management.

13. GIMAR will implement key heating reforms in the project areas by requiring the implementing agencies to (i) install radiator control valves in apartments to encourage heat conservation, and (ii) use heat-measuring devices and consumption-based billing systems so that charges will be based on actual heat consumption. These reforms will enable consumers to regulate the amount of heat they consume, which is essential if tariff-based incentives for heat conservation, insulation installation, and heat-loss reduction are to work.

14. Although the heating sector’s high growth rate provides significant opportunity for private sector participation, a number of barriers exist (para. 6). Considering the importance of affordable and reliable heating during winter, GIMAR plans initially to support interested private companies, thus allowing them to strengthen their technical, financial, and managerial capacity and reach economies of scale. The project will provide financial assistance to two 100% privately owned district heating companies and two partly privatized companies to expand operations in remote urban areas, thereby contributing to economies of scale and improved commercial performance.

B. Impact and Outcome

15. The impact of the project will be improved energy efficiency in IMAR. The outcome of the project will be improved air quality in six urban areas in IMAR.

C. Outputs

16. The project will have two outputs: (i) district heating supply and (ii) natural gas transmission and distribution, as summarized below.

17. Output A: District heating supply. Output A will rehabilitate or construct infrastructure for 34.49 million m2 of district heating area.15 It comprises six subprojects and will involve the installation of 21 efficient coal-fired boilers, 591 heat-exchange substations, 535 kilometers (km) of heating pipelines, and 10 supervisory control and data acquisition (SCADA) systems, allowing the closure of 383 small, coal-fired boilers. Eighty percent of the heat will be from combined heat and power plants, 16 19% from coal-fired boilers, and 1% from waste heat recovery.

14 ADB. 2009. Technical Assistance to the People's Republic of China for Energy Efficiency Improvements in Inner Mongolia Autonomous Region. Manila (TA 7443-PRC, $500,000, approved on 14 December). It was brought ahead of loan processing to facilitate capacity strengthening. 15 For comparison, installed district heating area in IMAR was 184.5 million m2 in 2008. 16 Four heating subprojects of , , , and Kalaqin will utilize heat from combined heat and power. The project will not finance the construction or rehabilitation of such plants in Baotou, and Chifeng. A new steam boiler in the existing combined heat and power plant for Kalaqin District Heating Supply will also be installed.

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Table 1: Output A Subprojects Heat Heating Small Exchange SCADA Pipelines Boiler Heating Area Subproject New Boilers Stations (no.) Systems (km) Closures (million m2) Hohhot DHS one 3×58 MW, 94 5 344.10 144 5.89 two 3×29 MW, one 4×29 MW Chifeng DHS 194 1 91.35 37 13.04 Baotou DHS 239 1 50.41 164 9.76 Keyouqian DHS 3×70 MW 28 1 25.00 11 3.00 Kalaqin DHS 1×45 MW 16 1 5.30 0 0.80 Zhalaite DHS 4×29 MW 20 1 18.50 27 2.00 Total 835 MW 591 10 534.66 383 34.49 DHS = district heating supply, km = kilometer, MW = megawatt, no. = number, SCADA = supervisory control and data acquisition. Sources: Subproject feasibility studies.

18. Output B: Natural gas transmission and distribution. Output B consists of the installation of natural gas distribution infrastructure in Keyouqian Banner, including 37.23 km of natural gas pipelines and associated auxiliary and control plant and equipment.

D. Investment and Financing Plans

19. The project is estimated to cost $333.02 million. The investment plan is summarized in Table 2.

Table 2: Project Investment Plan ($ million) Item Amount A. Base Costa 1. Output A: District Heating Systems (DHS) a. Hohhot DHS 98.68 b. Chifeng DHS 80.50 c. Baotou DHS 34.20 d. Keyouqian DHS 29.37 e. Kalaqin DHS 11.77 f. Zhalaite DHS 18.40 2. Output B: Natural Gas Transmission and Distribution a. Keyouqian natural gas supply system 16.23 Subtotal (A) 289.14 B. Project Management 1.75 C. Contingencies 1. Physicalb 23.27 2. Pricec 8.85 Subtotal (C) 32.12 D. Financing Charges during Constructiond 10.01 Total (A+B+C+D)e 333.02 a In June 2010 prices. b Physical contingencies are computed at 8% of base cost. c Price contingencies are based on estimated domestic and international inflation rates during construction. d Includes interest during construction and commitment charges. e Includes taxes and duties estimated at $9.93 million for components financed by Asian Development Bank. Sources: Asian Development Bank and project implementing agencies estimates.

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20. The government has requested a loan of $150 million from ADB’s ordinary capital resources to help finance the project. The loan will have a 24-year term, including a grace period of 4 years, an annual interest rate determined in accordance with ADB’s London interbank offered rate (LIBOR)-based lending facility, a commitment charge of 0.15% per year (the interest and other charges during construction to be capitalized in the loan), and such other terms and conditions set forth in the draft loan and project agreements. The government has provided ADB with (i) the reasons for its decision to borrow under ADB’s LIBOR-based lending facility based on these terms and conditions, and (ii) an undertaking that these choices were its own independent decision and not made in reliance on any communication or advice from ADB.

21. The ADB loan will finance 45% of total project costs. The remaining $183.02 million (55%) will be financed by implementing agency equity (35.5%) and domestic bank loans (19.5%). Implementing agency equity includes internally generated funds from parent company or local government contributions. The ADB loan will be used for civil works, equipment and supplies, consulting services, interest, and commitment charges during construction on the ADB loan, and including taxes and duties estimated to be $9.93 million on the ADB financed portion of the project costs. ADB's decision to finance the taxes and duties was based on the analysis that the amount of taxes and duties does not constitute an excessive share of the project cost and it is material to the success of the project. The government will finance contingencies and land acquisition and resettlement costs. Table 3 shows the financing plan by implementing agency.

Table 3: Financing Plan ($ million) Source Equity Domestic Loan ADB Loan Total Implementing Agencies Hohhot Futai Heating Supply Co. Ltd. 36.75 28.54 50.00 115.29 Chifeng Fulong Heating Supply Co. Ltd. 27.42 25.96 39.00 92.38 Baotou Municipal Heating Supply Company 10.99 10.36 18.00 39.35 Durui Heating and Power Supply Co. Ltd. 16.97 0.00 16.00 32.97 Chifeng Jinfeng Heating Supply Co. Ltd. 6.26 0.00 7.50 13.76 Zhalaite Xingda Heating Supply Co. Ltd. 9.91 0.00 11.00 20.91 Keerqin Kangze Pipeline Gas Co. Ltd. 9.86 0.00 8.50 18.36 Total 118.16 64.86 150.00 333.02 % 35.48 19.48 45.04 100.00 ADB = Asian Development Bank. Sources: Asian Development Bank and project implementing agencies estimates.

E. Implementation Arrangements

22. The borrower is the Government of the PRC, which will make the proceeds of the ADB loan available to GIMAR through a subsidiary loan and to the municipality and county governments and implementing agencies through onlending. The implementing agencies will assume the risks for foreign exchange and interest rate variation.

23. The implementation arrangements are summarized in Table 4 and described in detail in the project administration manual (PAM).17

17 Project Administration Manual (Appendix 2).

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Table 4: Implementation Arrangements Aspects Arrangements Implementation period March 2010–June 2014 Estimated project completion date December 2014 Project management (i) Oversight body Project leading group Chair: Vice-Governor of Government of IMAR Members: Representatives of IMAR Development and Reform Commission, IMAR Finance Bureau, IMAR Construction Bureau, and IMAR Environment Protection Bureau. (ii) Executing agency Government of IMAR

(iii) Key implementing agencies Baotou Municipal Heating Supply Company Chifeng Fulong Heating Supply Co. Ltd. Chifeng Jinfeng Heating Supply Co. Ltd. Durui Heating and Power Supply Co. Ltd. Hohhot Futai Heating Supply Co. Ltd. Keerqin Kangze Pipeline Gas Co. Ltd. Zhalaite Xingda Heating Supply Co. Ltd. (iv) Project implementation unit Project Management Office, Hohhot, IMAR, 9 staff Procurement International 26 contractsa $119.6 milliona competitive bidding National competitive 8 contractsa $22.6 milliona bidding Consulting services QCBS 55 person-months $1.0 million Individual Variable $0.75 million Retroactive financing and advance The executing agency has requested advance contracting and contracting retroactive financing. This will include the recruitment of consulting services and the procurement of goods and civil works. The amount to be retroactively financed will not exceed $30 million (equivalent to 20% of the Asian Development Bank loan) and may finance costs incurred prior to loan effectiveness but not earlier than 12 months before the signing date of the loan agreement. Disbursementa Type Minimum Ceiling Direct payment none none none none Reimbursement Imprest account 6 months' estimated 10% of loan amount expenditure

Statement of none $200,000 per individual Expenditure payment procedure Commitment none none procedure IMAR = Inner Mongolia Autonomous Region, QCBS = quality- and cost-based selection. For guidance, refer to the Asian Development Bank’s Loan Disbursement Handbook (2007, as amended from time to time) and Technical Assistance Disbursement Handbook (2010, as amended from time to time). a These are based on current estimate in the procurement plan, which may need modifications in the future. Sources: Government of Inner Mongolia Autonomous Region and Asian Development Bank.

III. DUE DILIGENCE

A. Economic and Financial

24. Financial internal rate of return (FIRR) is calculated for each subproject. Financial analyses of the subprojects indicate FIRRs of between 7.0% and 9.2%, which for each case is higher than the specific weighted average cost of capital. The FIRR for the whole project is 7.6%, more than double the weighted average cost of capital of 3.6%. Sensitivity analysis

8 shows that the FIRR of the whole project would decrease to (i) 6.4% if there were a cost overrun of 10%; (ii) 4.5% if revenue decreased by 10%; (iii) 5.5% if major operating costs increased by 10%; (iv) 7.4% if there were a 1-year delay in construction; and (v) 3.9% if (i), (iii), and (iv) were all to occur. The project is considered financially viable and sustainable. Sensitivity analysis shows that the project is likely to be sustainable under various adverse scenarios.

25. The economic benefits of district heating supply include improvements in heating efficiency and to the environment. The economic benefits of natural gas supply derive from improvements to the environment. The calculations reflect all project-related costs, benefits from cost savings from alternative fuels and efficiency improvements, and local and global environmental benefits. Analyses for each subproject indicate economic internal rates of return (EIRRs) ranging from 14.1% to 34.8%. The EIRR of the whole project is 27.6%, which is more than double the 12% economic cost of capital. Therefore, the project is economically feasible. Sensitivity analysis for each subproject indicated that a 10% benefit decrease would lower EIRRs for the subprojects to between 12.7% and 32.3%, still exceeding the economic cost of capital. The analysis indicated that a 10% cost increase would reduce EIRRs for the subprojects to between 10.1% and 28.2%, with three subprojects having EIRRs marginally lower than the economic cost of capital. This is considered acceptable and would not affect the project’s viability. Should the project encounter a 1-year delay in commissioning, the EIRR for the subprojects would fall to between 12.4% and 29.7%, which would not affect project viability.

B. Governance

26. Procurement of goods and works shall be carried out in accordance with ADB’s Procurement Guidelines (2010, as amended from time to time). International and national consultants financed under the loan will be recruited in accordance with ADB’s Guidelines on the Use of Consultants (2010, as amended from time to time) using the quality- and cost-based selection method with simplified technical proposal (quality–cost ratio of 80:20).

27. ADB’s Anticorruption Policy (1998, as amended to date) was explained to and discussed with the government and GIMAR. The specific policy requirements and supplementary measures are described in the PAM.

C. Poverty and Social

28. The project will improve public health by reducing urban air pollution with the closure of small, inner-city boilers, installation of more efficient heating boilers, reduced use of household stoves, and reduced coal truck traffic through urban areas. Improvements in air quality will indirectly benefit the entire urban population of about 2.28 million residing in the six subproject areas, and particularly the 78,100 poor residents, or 3.4% of the total. Access to reliable district heating and natural gas will improve the standard of living. By 2015, it is expected that 786,200 urban residents will benefit directly from improved district heating and natural gas supply as a result of the project, and a further 680,500 urban residents will benefit from the improved infrastructure. The increased use of natural gas and improved district heating will reduce the use of such fuels as raw coal, wood, and coal briquettes for indoor heating and cooking, which will benefit public health, particularly for the poor and women who spend most of their time indoors, as well as reduce the labor needed to acquire and burn fuel. The project will eliminate 1,229 jobs with the closure of small boilers. The survey of affected workers indicated that 30% of them were former employees of the heating companies and the remainder were migrant workers with contracts for a single heating season. A labor-restructuring plan has been

9 prepared to cover the affected workers.18 The implementing agencies have agreed to ensure that all permanent employees affected by the closure of the small boilers under the project are reemployed in a timely manner and in accordance with the project labor-restructuring plan.

D. Safeguards

29. The project has been classified as environmental category B, involuntary resettlement category B, and indigenous peoples category C. The project has substantial environmental benefits resulting from energy efficiency improvements and reductions in emissions from coal burning. The project will (i) close small, inner-city coal-fired boilers; (ii) replace household coal- fired stoves; (iii) stop the transportation of coal through urban areas; (iv) substantially improve local air quality through reduced emissions of SO2, TSP, and NOx; (v) provide a global public good by reducing emissions of CO2; and (vi) support the utilization of industrial waste heat. The potential adverse environmental impacts from the project include (i) soil erosion during construction, (ii) increased noise and dust affecting local residents during construction, (iii) inappropriate storage of hazardous materials and wastes during operation, and (iv) increased gas emissions during operation. The summary initial environmental examination concluded that the potential adverse environmental impacts can be adequately mitigated by funding appropriate mitigation measures.19

30. The project is classified as involuntary resettlement category B and indigenous peoples category C. One of the seven subprojects, Zhalaite District Heating Supply (DHS), will affect people through land acquisition. The remaining subprojects have no resettlement, as they will be implemented on government-reserved land or existing premises. For Zhalaite DHS, the expansion of the existing facilities will require (i) 1.1 hectares of government-owned land currently used by two private entities, a driving school and a closed factory, and (ii) 1,740 m2 of office and factory buildings of these entities. A short resettlement plan has been prepared for the Zhalaite DHS subproject.20

31. The resettlement objective is to achieve equal or better income and living standards in line with ADB’s Involuntary Resettlement Policy (1995). Consultations with the two entities affected by Zhalaite DHS revealed that they prefer cash compensation for losing land-use rights and structures. The estimated cost of land acquisition and leasing is CNY3.54 million for Zhalaite DHS, including compensation for land-use rights, nonresidential buildings, other assets, moving allowances, administration and internal monitoring, and contingencies.

E. Risks and Mitigating Measures

32. Major risks and mitigating measures are summarized in Table 5.

Table 5: Summary of Risks and Mitigating Measures Risks Mitigating Measures Future heating tariff increases may be The heating sector tariff reforms are in progress with the current insufficient to ensure the financial mechanisms ensuring full cost recovery with adequate returns. The sustainability of the heating sector. government is committed to the market-based heating sector without recourse to subsidies. Project implementation delays. (i) Efforts have been made (para. 12) to avoid delays by incorporating lessons learned from the implementation of a similar loan in IMAR. (ii) The rigorous examination of individual subprojects readiness

18 Labor Restructuring Plan (Appendix 2). 19 Environmental Assessment and Measures (Appendix 2). 20 Involuntary Resettlement Assessment and Measures (Appendix 2).

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Risks Mitigating Measures (feasibility reports and EIAs already approved) should avoid potential delays (iii) The project management office has gained some experience through the implementation of the Inner Mongolia Autonomous Region Environment Improvement Project of the Asian Development Bank (ADB).a Separate capacity-building technical assistance for Energy Efficiency Improvements in Inner Mongolia Autonomous Region is provided to strengthen the capacity of the implementing agencies.b a ADB. 2006. Report and Recommendation of the President to the Board of Directors: Proposed Loan to the People’s Republic of China for the Inner Mongolia Autonomous Region Environment Improvement Project. Manila (Loan 2260-PRC, approved on 29 September, $120 million). b ADB. 2009. Technical Assistance to the People's Republic of China for Energy Efficiency Improvements in Inner Mongolia Autonomous Region. Manila (TA 7443-PRC, $500,000, approved on 14 December). Source: Asian Development Bank.

33. Overall, risks associated with the project have been adequately addressed. The integrated benefits and impacts are expected to outweigh the costs.

IV. ASSURANCES AND CONDITIONS

34. The Government of the PRC and GIMAR have assured ADB that the implementation of the project shall conform to all applicable ADB policies including those concerning anticorruption measures, safeguards, gender, procurement, consulting services, and disbursement as described in detail in the PAM and loan documents.

35. The Government of the PRC and GIMAR have agreed with ADB on certain covenants for the project, which are set forth in the loan and project agreements.

36. Disbursement of the loan proceeds for each subproject will be conditional on the government’s certification, in form and substance satisfactory to ADB, that the applicable municipal government or county government, and the implementing agency concerned, have executed and delivered the relevant onlending agreement, which will include the terms and conditions as required in the loan agreement, and which has become effective and binding upon the parties thereto in accordance with its terms.

V. RECOMMENDATION

37. I am satisfied that the proposed loan would comply with the Articles of Agreement of the Asian Development Bank (ADB) and recommend that the Board approve the loan of $150,000,000 to the People's Republic of China for the Inner Mongolia Autonomous Region Environment Improvement Project (Phase II) from ADB’s ordinary capital resources, with interest to be determined in accordance with ADB’s London interbank offered rate (LIBOR)- based lending facility; for a term of 24 years, including a grace period of 4 years; and such other terms and conditions as are substantially in accordance with those set forth in the draft loan and project agreements presented to the Board.

Haruhiko Kuroda President

9 July 2010

Appendix 1 11

DESIGN AND MONITORING FRAMEWORK

Performance Targets and Data Sources and Design Summary Indicators with Baselines Reporting Mechanisms Assumptions and Risks Impact Assumptions Improved energy Compared to 2010, at least IMAR statistical year book Heating sector reforms are efficiency and 15% improvement in energy with annual data on different implemented. environment in IMAR efficiency of district heating sectors of the economy sector by 2020 The energy efficiency improvements in district heating Compared to 2010, all cities remains a priority for the and urban areas of IMAR government meet improved air quality standards of at least class II The required investments are by 2020 made by the government and enterprises in other urban areas of IMAR.

Risk

Air emission improvements are negated by the establishment of new polluting industries.

Outcome Assumptions Improved air quality in By 2015, energy-efficient Annual environmental report Both ADB loan projects in IMAR urban areas in IMAR district heating and natural in project areas by the IMAR for environment improvements gas supplies in urban areas environment protection are implemented as scheduleda avoid coal consumption by bureau at least 1.75 million tons, CNG vehicles are purchased for thereby avoiding annual IMAR statistical yearbooks public transport in areas where emissions of CO2 by more natural gas is provided. than 2.66 million tons, SO2 Project environmental by more than 31,640 tons, monitoring reports No new high-polluting industries TSP by more than 36,967 are set up in project areas tons of TSP, and NOx by causing the air quality to more than 9,218 tons. deteriorate further.

The air quality in project Risk areas improve to at least grade II by 2015. Delays in the projects’ implementation and thereby in environmental benefits

Outputs Assumptions 1. Improved district Upgrading or extension of Quarterly project progress Timely project implementation heating in project district heating services to reports cities and towns 1.47 million urban residents, PMO is adequately staffed and of Huhhot, with a coverage of about Project environmental counterpart funds are provided Chifeng, Baotou, 34.49 million m2 by 2014 monitoring reports on time. Keyouqian, Kalaqin, and Energy-efficient district Loan review missions and Risks Zhalaite heating results in closure of project performance reports 383 small, inefficient, and The project implementation is polluting coal-fired boilers delayed due to weak

by 2014 performance by contractors, PIAs, and PMO. Energy efficient district heating avoids 1.04 million

tons of coal usage annually

12 Appendix 1

Performance Targets and Data Sources and Design Summary Indicators with Baselines Reporting Mechanisms Assumptions and Risks in these urban areas reducing the associated emissions of CO2 by 1.59 million tons, SO2 by 14,070 tons, NOx by 6,500 tons, and TSP by 15,420 tons.

2. Provision of gas Provision of reliable natural transmission and gas supplies of 20 million distribution cubic meter annually in systems in Keyouqian banner from Keyouqian 2014 to 108,000 urban residents and public transport system

Activities with Milestones Inputs

Activity 1: District heating ADB: $150.0 million 1.1 Construction of 21 heating boilers, 535 km of heating pipeline, and 591 heat- Implementing agencies: $118.0 exchange substations, and installation of 10 SCADA systems in 6 urban areas million - Hohhot, Chifeng, Baotou, Keyouqian, Kalaqin, and Zhalaite by December Local banks: $65.0 million 2014

Total project cost: $333.0 million Activity 2: Natural gas distribution

2.1 Construction of 37.23 km of gas transmission and distribution pipeline, 3 CNG vehicle supply stations, 1 pressure-reduction station, and 34 pressure- regulating stations, plus the acquisition of CNG tankers and SCADA system in Keyouqian by December 2014

ADB = Asian Development Bank, CNG = compressed natural gas, CO2 = carbon dioxide, IMAR = Inner Mongolia 2 Autonomous Region, km = kilometer, m = square meter, NOx = nitrogen oxides, PMO = project management office, SCADA = supervisory control and data acquisition, SO2 = sulphur dioxide, TSP = total suspended particulates. a ADB. 2006. Report and Recommendation of the President to the Board of Directors: Proposed Loan to the People’s Republic of China for the Inner Mongolia Autonomous Region Environment Improvement Project. Manila (Loan 2260- PRC, approved on 29 September, $120 million). Sources: Asian Development Bank, Government of Inner Mongolia Autonomous Region, and project implementing agencies.

Appendix 2 13

LIST OF LINKED DOCUMENTS http://www.adb.org/Documents/RRPs/?id=40634-01-3

1. Agreements Loan Agreement Project Agreement 2. Summary Sector Assessment 3. Project Administration Manual 4. Project Classification Summary 5. Contribution to the ADB Results Framework 6. Development Coordination 7. Financial Analysis 8. Economic Analysis 9. Country Economic Indicators 10. Summary Poverty Reduction and Social Strategy 11. Environmental Assessment and Measures 12. Involuntary Resettlement Assessment and Measures 13. Risk Assessment and Risk Management Plan 14. Labor Restructuring Plan