Report and Recommendation of the President to the Board of Directors ______

Project Number: 40684 March 2011

Proposed Loan and Administration of Grant People's Republic of China: Forestry and Ecological Restoration Project in Three Northwest Provinces

CURRENCY EQUIVALENTS (as of 2 March 2011)

Currency Unit – yuan (CNY) CNY1.00 = $0.152 $1.00 = CNY6.57

ABBREVIATIONS

ADB – Asian Development Bank FIRR – financial internal rate of return GEF – Global Environment Facility IEM – integrated ecosystem management PRC – People’s Republic of China SFF – state forest farm

WEIGHTS AND MEASURES

ha – hectare km2 – square kilometer m3 – cubic meter t – ton

NOTES

(i) The fiscal year (FY) of the government and its agencies ends on 31 December. (ii) In this report, "$" refers to US dollars.

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

Team leader R. Renfro, Officer-in-Charge, Environment, Natural Resources, and Agriculture Division/Lead Natural Resources Economist, EARD Team members L. Medina, Project Officer, EARD R. O'Sullivan, Principal Counsel, Office of the General Counsel F. Radstake, Senior Environment Specialist, EARD A. San Pedro, Associate Project Analyst, EARD M. Vorpahl, Social Development 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 PROJECT AT A GLANCE

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 7 III. DUE DILIGENCE 8 A. Economic and Financial 8 B. Governance 8 C. Poverty and Social 8 D. Safeguards 9 E. Risks and Mitigation Measures 9 IV. ASSURANCES 10 V. RECOMMENDATION 10 APPENDIXES 1. Design and Monitoring Framework 11 2. List of Linked Documents 14

I. THE PROPOSAL

1. I submit for your approval the following report and recommendation on (i) a proposed loan, and (ii) a proposed administration of a grant to be provided by the Global Environment Facility (GEF), both to the People’s Republic of China (PRC) for the Forestry and Ecological Restoration Project in Three Northwest Provinces. The design and monitoring framework is in Appendix 1.

2. To support the national and provincial government development policies and plans, the project will help the State Forestry Administration (SFA); and the Gansu and Shaanxi provinces, and the Xinjiang Uygur Autonomous Region (Xinjiang) improve the productivity of the forestry sector, demonstrate an integrated ecosystem management (IEM) forest-development approach, and introduce forest carbon-sequestration and climate change-mitigation measures. The Asian Development Bank (ADB) provided project preparatory technical assistance ($800,000, approved in December 2007).1 Key outputs of the project will include (i) economic tree crop development on about 38,000 hectares (ha) of barren and low-yielding forest lands that will benefit about 207,000 households; (ii) ecological or natural forestry development on about 300,000 ha, including replanting of about 4,700 ha; and (iii) project management support.

II. THE PROJECT

A. Rationale

3. The rapid development of the PRC through agricultural expansion, industrialization, and urbanization is attributed to the initial impetus from land reforms and the resulting increase in agriculture output and productivity. As the rural economy transitioned from the centrally planned collective and commune systems to market-based management with price and profit incentives and improved property rights, infrastructure and financial services significantly raised income levels and reduced poverty. Rural poverty still persists for a range of reasons, including the small fragmented nature of land plots and the significant influence of the forest sector and the forest lands under its purview. Forest resource management was transferred from the private sector into collectives during 1950–1956, and from 1988 there has been an ongoing movement toward increased integration with market-based decision making through the allocation of forest user certificates to contracted households.

4. The total forest area in the PRC is about 175 million ha and it supports a standing tree stock volume of about 13.6 billion cubic meters (m3). On a per capita basis, the PRC falls far below international standards, with a per capita forest area of about 0.13 ha compared with the international average of about 0.65 ha per capita. The standing stock volume of 10 m3 per capita compares to a global average of 66 m3. The PRC is a net importer of timber products. Land classified as forest land accounts for 285 million ha; however, only 60% or 169 million ha is forested. Forest land is typically of three types in the PRC: (i) ecological or natural forests, (ii) timber plantations, and (iii) economic tree crops comprising fruit and nut orchards. Of the forest land, 115.8 million ha (66%) is natural forest and 53.3 million ha (34%) is plantation forestry (timber and economic tree crops). The extent of forest located on nonforest land is only 6 million ha. The area of degraded and barren forest land totals about 116 million ha and has mostly been left out of the modernization of the rural PRC that focused on agricultural land. Within the western PRC, most of this land still supports traditional low-yielding and low-value cropping systems built around wheat and corn rotations, or is steep gully sidings and desert periphery that are barren or wastelands. The scale of the forest sector has continued to grow, with the

1 ADB. 2007. Technical Assistance to the People’s Republic of China for Preparing the Silk Road Ecosystem Restoration Project. Manila. 2 forest cover increasing from less than 9% in 1949 to about 18% in 2007. This growth in forest cover has averaged about 4 million ha per year since 2000 and is in direct contrast with the global average of progressive forest cover loss, amounting to nearly 7.3 million ha per year over the same period. However, this impressive expansion of forest cover does not reveal the current low quality of forest structure, including the thin forest density and lack of biodiversity in the PRC forests. The sector target for forest cover is expected to reach 20% by 2010 with a further increase to 23% by 2020, requiring an additional 29 million ha to be forested during the project period through 2020. The project will contribute less than 1% of the proposed policy target. Within the rural landscape, the forestry sector has lagged behind in reforms and has been slow to respond to market-oriented policy priorities. Policy analyses demonstrate the need for reform with basically two categories of issues: (i) management of publicly owned forests, and (ii) the role of government in guiding managers of privately operated forest land and forest enterprises to support sector growth.

5. The drylands of the western PRC cover about 40% of the country and contain some of the most severely degraded land in the world. The proposed project area covers about 165,000 square kilometers (km2), incorporating 18 districts and 55 counties selected from some of the worst-affected and poorer parts of Gansu, Shaanxi, and Xinjiang. This area includes three distinct ecological zones: the loess plateau, the central mountain region, and the oases in Xinjiang. The ancient Silk Road ran through this area, starting near Xian and running northwest through Gansu and Xinjiang. The loess plateau in the PRC is characterized by fine, wind-blown soil that is very deep (up to about 200 meters in places) and highly prone to erosion. Much of the area of eastern Gansu and Shaanxi lies on the loess plateau. Agriculture is predominantly rain fed, producing relatively low-value and low-yielding annual crops, such as wheat and corn. The central mountain region includes the Qian mountains in Xinjiang, the Qilian mountains in Gansu, and the Qinling mountains in Shaanxi. It contains several nature and forest reserves that provide important habitats for endangered and protected species. The third zone, the desert oases in Xinjiang, is home to the majority of rural people and agricultural activities, but makes up only 4% of Xinjiang’s territory. The oases require irrigation for agriculture and their desert climate features harsh winters and summers of extreme heat and high winds. To improve economic prospects and living conditions in this region, the establishment of shelter belts to prevent the shifting of the desert sands, and the construction of water management infrastructure (e.g., canals, wells, and high-efficiency irrigation), are vital. Oasis farming of grapes, melons, cotton, and wheat forms the core of local agricultural activities.

6. Between 1980 and 2006, the combined population of Gansu, Shaanxi, and Xinjiang increased from about 60 million to about 84 million, or by about 40%. The population of ethnic minorities therein grew from about 9.2 million to about 15.2 million, or by about 65%, over the same period. Land degradation is a critical environmental problem in all three project areas, seriously affecting about 274,600 km2 of land in Gansu (about 65% of its total area), about 30,000 km2 in Shaanxi (about 14.5% of its province), and about 1.1 million km2 of Xinjiang (about 64% of its total area). The economic cost of land degradation is estimated at about CNY3.1 billion in Gansu (about 15.9% of provincial gross domestic product), and about CNY11.6 billion in Shaanxi (about 3.6% of provincial gross domestic product). About 64% of the population in the three provinces lives in rural areas. In 2006, the average annual urban income in the project area was CNY9,103 ($1,097 equivalent), while the average annual per capita rural income was only CNY2,377 ($286), less than the poverty line defined as $1.25 per day. While there is greater reliance on agriculture in Xinjiang, the rate of growth in agriculture is lower because of the limited access to markets, poorer natural resource endowments (especially water), and a lack of essential infrastructure.

7. The key problems affecting the project area include (i) low forest land productivity and sustainability; (ii) land degradation and diminishing returns from traditional management 3 practices and inputs; (iii) vulnerability of households to price fluctuations and natural disasters; and (iv) lack of adequate working capital and long-term financing for households, enterprises, and state forest farms (SFFs). Farming on degraded and barren land, and steeply sloping land with low-yielding and unsustainable grain crops has become common because of the combined effect of population expansion and poor regulation.

8. The process of reform included widespread consultation, and a period of limited piloting and evaluation prior to the collective forest tenure reform program introduced in June 2008. There are three ongoing reforms for the development and implementation of forest land tenure and institutional restructuring, aimed at creating incentives for investment and development in the forest sector. The first is the reform of collective forest land tenure, seeking to allocate forest rights to households and individuals in order to return the mountains, forests, and profits to the people. For areas under the economic forest land category, land will be contracted to the households for 70 years with the right to renew under the conditions stated in the law at the time of renewal. The current rights include the responsibility to manage the forestry resources as prescribed in the forestry law, as well as the right to make planting, management, operational, and marketing decisions. Households may also subcontract their rights to a third party for operating and managing forest resources. The second reform will be to accelerate the development of SFFs through the definition and classification of their forest resources into economic and ecological resources, and the linking of ecological resources to public-good budgets and secure funding systems. SFFs with natural forests were classified as ecological forests with the objective of providing ecological functions for the wider public good. The purpose of ecological classification is to build a forest management system that delivers against clear objectives. The forest land tenure reforms confirmed rights for 70 years while enabling rights to be rented (subcontracted) to operators, including the requirement to meet the responsibilities of the higher-level contract. For economic forest resources, business units will be reformed to ensure viable operations and financial performance. The third reform seeks to develop the capacity to support the reformed forestry institutions.

9. Lessons. The project design reflects the lessons identified in previous development partner and government programs. The lessons from past land degradation and ecological programs, the World Bank's evaluation of assistance to the PRC forestry sector, and ADB's agriculture and natural resource lending programs are summarized here. The World Bank has assisted the PRC with five forestry projects. Assistance started in 1985 with the Forest Sector Program that built plantation resources. The project was generally considered successful. Subsequent projects, such as the National Afforestation Project for 15 provinces2 (approved in 1990) and the Forest Resource Development and Protection Project for 17 provinces 3 (approved in 1994), were considered highly successful. The Forestry Development Project in Poor Areas for 12 provinces4 (1998–2006) increased forest cover by about 8% in the project area, primarily using economic trees. It was determined that marketing infrastructure support was not required as provision by the private sector already went beyond project capacity. The forest enterprise development component was unsuccessful, with only 14 of the target of 64 established, and of these, 33% failed during project implementation. The ongoing Sustainable Forestry Development Project for 12 provinces5 (approved in 2002) includes components in timber plantations, economic trees, ecological or natural forests, and nature reserves. Key forest sector lessons are that (i) farmer participation in the design and selection of crops (using community forestry assessments) is critical, despite being staff-intensive; (ii) there needs to be

2 Anhui, Fujian, Guangdong, Guangxi, Guizhou, Hebei, Henan, Hubei, Hunan, Jiangxi, Liaoning, Shandong, Sichuan, Yunnan, and Zhejiang. 3 Anhui, Fujian, Guangdong, Guangxi, Guizhou, Hebei, Heilongjiang, Henan, Hubei, Hunan, Jiangxi, Liaoning, Shaanxi, Shanxi, Sichuan, Yunnan, and Zhejiang. 4 Anhui, Guangxi, Guizhou, Hebei, Henan, Hubei, Hunan, Jiangxi, Liaoning, Shanxi, Sichuan, and Yunnan. 5 Anhui, Gansu, Guizhou, Hainan, Henan, Hubei, Hunan, Liaoning, Shandong, Shanxi, Sichuan, and Yunnan.

4 strong links between research and development, and extension systems; (iii) timber plantations have been successful and are largely risk-free; and (iv) the very poor are susceptible to the substantial business risk attached to economic or long-term crops, and emphasis must be placed on good varieties that appeal to the market. The World Bank has prepared two more forestry projects: the Integrated Forestry Development Project, approved on 6 July 2010 in five provinces 6 with timber plantations, ecological forests, and capacity development; and the Shandong Ecological Afforestration Project in saline and rocky areas approved on 6 May 2010. There is a particular need for long-term capital because of the long lead time to reach full production for agro-enterprises. The provision of long-term capital should not be subsidized for this reason. Instead, the terms and conditions of the financing under the project will be assessed for its viability with the selected enterprises. ADB's Dryland Sustainable Agriculture Project7 has adopted these measures and serves as a guide for the involvement of private enterprises in the proposed project. The proposed project has taken into account all of these lessons and has completed due diligence of the orchard crops, enterprises, and farmer interventions selected.

B. Impact and Outcome

10. The impact of the project will be improved incomes and sustainable livelihoods from the use of forest land in Gansu, Shaanxi, and Xinjiang. The outcome of the project will be increased productivity of forest lands and reduced land degradation in Gansu, Shaanxi, and Xinjiang.

C. Outputs

11. The project's strategy is to support the implementation of recent collective forest tenure reforms, and assist with the conversion of land and labor resources into higher-value and more sustainable tree crop production systems using IEM approaches developed by the PRC–GEF Partnership on Land Degradation in Dryland Ecosystems.8 The IEM approach offers the PRC a new way to plan and manage dryland natural resources by providing an integrated planning approach. The project outputs include (i) mainstreamed IEM approaches applied to economic tree crop development on about 38,000 ha; (ii) mainstreamed IEM approaches applied to ecological forestry development on about 300,000 ha; and (iii) project management support strengthened to implement forest sector reforms using IEM approaches in the provinces, counties, towns, and households.

12. Economic tree crop development. Thirteen varieties of fruits, nuts, timber trees, and shelterbelt trees will be planted in the three provinces. In this way, forest land will be converted into more ecologically sustainable land use that generates sufficient profit to create incentives for the long-term management of natural resources. About 207,000 rural households and workers will benefit from the tree crop development. The planted area will require about 12,800 full-time jobs per year by the sixth year, and an estimated 48,500 full-time job equivalents from year 10 onward when harvest reaches the stable yield period. By year 10, the project will

6 Anhui, Hubei, Liaoning, Shanxi, and Zhejiang. 7 ADB. 2008. Report and Recommendation of the President to the Board of Directors: Proposed Loan and Administration of Grant to the People's Republic of China for the Dryland Sustainable Agriculture Project. Manila. 8 The IEM approach provides a planning and implementation approach for natural resources in the dryland areas of northern, central, and western PRC. The approach brings together the legal, policy, design, institutional, technical, economic, environmental, and social systems involved to support the sustainable use and management of natural resources. The IEM approach emphasizes the links between natural ecosystem capacities and socioeconomic activities (including those of poor rural inhabitants), and seeks to holistically rehabilitate damaged ecosystem services and functions by addressing the major root causes of destructive practices. The ongoing ADB-assisted Ningxia Integrated Ecosystem and Agricultural Development Project also adopts the IEM approach. (ADB. 2008. Report and Recommendation of the President to the Board of Directors: Proposed Loan and Grant to the People’s Republic of China for the Ningxia Integrated Ecosystem and Agricultural Development Project. Manila.) 5 generate about 445,900 tons (t) of fruits and nuts. The major outputs will be apples (about 228,240 t), grapes (about 32,390 t), Chinese dates or jujubes (about 31,950 t), walnuts (about 25,000 t), and persimmons (about 18,555 t). For apples, this represents about 2.5% of the current apple output from Gansu and Shaanxi. The proportion of Chinese dates, grapes, walnuts, and persimmons is significantly less than 1% of current provincial production. In addition, the project will finance the expansion of nine profitable private enterprises in Gansu with about 16,000 t of cold-storage facilities, including seven apple storage enterprises, one ginkgo storage enterprise, and one walnut oil processing enterprise; and support 17 other small enterprises (14 private farms and 3 public–private shareholding companies) in Xinjiang that have successfully worked with farmers.

13. Ecological forestry development. This will consist of (i) reforestation of about 3,000 ha of hilly and degraded land in the higher, drier sites of Lintao and Tongwei counties in Gansu with shiny yellow horn trees; and (ii) improvement of forest land and management (including financial sustainability) on seven SFFs in Shaanxi on about 126,000 ha involving public–private partnerships with private ecotourism enterprises. In addition, GEF-financed activities in the three provinces (about $1.7 million available for each province) will include (i) reforestation of about 700 ha of barren and steeply sloping land in four counties of southeast Gansu with pine, larch, and other appropriate species; (ii) restoration of degraded land in Hami and Changji counties of Xinjiang with sand-fixing and replanting technologies on about 435 ha (and about 630 ha using loan funds); and (iii) carbon market readiness and education with ecological forestry and climate change capacity development in Shaanxi's seven SFFs and five SFFs in Gansu. These SFFs will jointly improve their forest management with the aim of becoming eligible to sell the carbon sequestration in their forests through a carbon market. The SFFs will be assisted in the management of ecological forests and initiating carbon trades through a newly established ecological forestry center based in Xian, Shaanxi. The total forest land area managed by these 12 SFFs is about 300,000 ha.

14. Project management support. This will include (i) improvement in project implementation and management in provincial, municipal, and county implementing agencies; and (ii) technical support to participating households and farmers. The executing agency (the State Forestry Administration), the three provincial project management offices, and the 55 county project management offices responsible for project implementation have been extensively involved in the preparation of the project, including applying the selection criteria in the choice of the areas and participating farmers, enterprises, and SFFs. Project financing will be used to provide (i) training in project management, including financial management, procurement, disbursement, and information management; (ii) ecological and environmental training, including pest identification, use of pesticides, integrated pest management, integrated crop management, and good agricultural practices; and (iii) social topics, including gender awareness, creating opportunities for women, and consultation approaches. In the provinces, training will be provided in (i) forestry site planning and project investment planning, (ii) financial management, (iii) procurement and disbursement, (iv) safeguards, and (v) project management and information systems. In the counties, training will be provided in (i) project management, (ii) procurement, (iii) training on statement of expenditures (SOE) procedures, (iv) site selection and planning, (v) monitoring and evaluation, and (vi) financial management. ADB will also provide training on imprest account management, project implementation, and project performance management. The project staff will also provide awareness workshops to mobilize farmers and disseminate project information.

D. Investment and Financing Plans

15. The project is estimated to cost $180.69 million (Table 1).

6

Table 1: Project Investment Plan ($ million) Item Amounta A. Base Costb 1. Economic tree crop development 120.70 2. Ecological forestry development 18.34 3. Project management support 17.11 Subtotal (A) 156.15 B. Contingenciesc 9.65 C. Financing Charges during Implementationd 14.89 Total (A+B+C) 180.69 a Includes taxes and duties of $6.4 million to be financed from the government and Asian Development Bank’s (ADB) ordinary capital resources. b In end 2010 prices. c Physical contingencies were computed at 5% of base costs. Price contingencies were computed based on ADB- prescribed (international and national) price escalation factors, and include provisions for potential foreign exchange rate fluctuations under the assumption of a purchasing power parity exchange rate. d Includes interest and commitment charges during construction. Interest was computed at a US dollar 5-year swap rate plus a spread of 0.3%, and commitment charges were computed at 0.15% per annum on undisbursed funds. Source: ADB estimates.

16. The government has requested a loan of $100 million,9 including taxes and duties10 from ADB’s ordinary capital resources to help finance the project. The loan will have a 25-year term, including a grace period of 5 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, and such other terms and conditions set forth in the draft loan, project, and financing agreements. The government has provided ADB with (i) reasons for its decision to borrow under ADB's LIBOR rate-based lending facility on the basis of 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. The financing plan is in Table 2.

Table 2: Financing Plan ($ million) Source Amount % Asian Development Bank 100.00 55.3 Global Environment Facility 5.10 2.8 Provincial, municipal, and county governments 44.99 24.9 Enterprises 12.74 7.1 Households 17.86 9.9 Total 180.69 100.0 Source: Asian Development Bank estimates.

17. The borrower will be the PRC. On behalf of the government, the Ministry of Finance will enter into subsidiary loan agreements with the 3 participating provinces as subborrowers of the proceeds of the ADB loan: Gansu, $33.34 million; Shaanxi, $33.33 million; and Xinjiang, $33.33 million. The provinces will onlend the proceeds of the loan in local currency or dollars to the municipal and county finance bureaus on the same terms and conditions as the ADB loan for further onlending to households, enterprises, and SFFs, with terms similar to the loan but with an additional interest rate spread of up to 0.2% to cover possible loss and delay in repayment based on up to a 25-year term to households and SFFs, and up to a 15-year term to enterprises, including a grace period of up to 5 years. The 3 provinces will establish revolving fund accounts and allocate recovered subloan principal amounts into the funds. Proceeds from the repayment of the principal from the subloans to enterprises and SFFs will be used to maintain the provincial

9 Transportation and insurance will be eligible under the loan and grant. 10 The calculation of taxes and duties to be financed under the project is based on the following principles: (i) the amount of taxes and duties financed by the ADB loan should not represent an excessive share of the project investment plan, (ii) the taxes and duties should only apply to ADB-financed expenditures, and (iii) the financing of taxes and duties should be material and relevant to the success of the project. 7 revolving funds for onlending for the same purposes and under the same terms and conditions as those for the ADB loan. The beneficiary households, enterprises, and SFFs will repay the loan proceeds and interest charges to the county finance bureaus for onward payment to ADB through the provincial governments and the Ministry of Finance. The foreign exchange risk will be borne by the provincial, municipal, and county governments and subborrowers that borrow in dollars. The provincial, municipal, and county governments will provide counterpart funds of $44.99 million equivalent, while the enterprises will contribute about $12.74 million in the form of equity and the beneficiary households will contribute $17.86 million equivalent in the form of labor. To assist with the ecological forestry output, the GEF will provide grant cofinancing equivalent to $5.1 million, to be administered by ADB. Other grant funds (including the Climate Change Fund, and Gender and Development Cooperation Fund) are also being sought for the project.

E. Implementation Arrangements

18. The implementation arrangements are summarized in Table 3 and described in detail in the project administration manual.11

Table 3: Implementation Arrangements Aspects Arrangements Implementation period October 2011–September 2016 Estimated project completion and 30 September 2016 (project completion) closing dates 31 March 2017 (project closing date) Project management (i) Oversight body Provincial leading groups Chaired by vice-governors (ii) Executing agency State Forestry Administration Through the ADB loan project management office (iii) Key implementing agencies Forestry departments, and municipal and county forestry and finance bureaus of Gansu, Shaanxi, and Xinjiang (iv) Project implementation units National project management office established in the State Forestry Administration. Provincial and county project management offices also established. Procurement National competitive bidding 55 contracts for $34.0 million Force account 1,119 contracts for $105.0 million Shopping 6 contracts for $0.5 million Consulting services Individual consultant selection method Single-source selection 75 contracts for $3.0 million Retroactive financing and/or The executing agency and the advance contracting provinces requested advance contracting and retroactive financing to enable early procurement of goods, works, and services related to spring 2011 planting of economic tree crops and ecological forests. Retroactive financing could only apply to up to 20% of the ADB loan, and accordingly up to 20% of the allocation for each province with respect to expenditures incurred

11 Project Administration Manual (accessible from the list of linked documents in Appendix 2).

8

Aspects Arrangements not earlier than 12 months before signing of the loan agreement. Disbursement The loan and grant proceeds will be disbursed according to ADB’s Loan Disbursement Handbook (2007, as amended from time to time) and detailed arrangements agreed on between the government and ADB. ADB = Asian Development Bank. Source: ADB.

III. DUE DILIGENCE

A. Economic and Financial

19. The economic benefits of the project are calculated from the financial benefits and converting financial prices into economic prices. The economic returns are higher than the financial returns because the shadow wage rate is less than 1 and labor comprises 55%–65% of the total costs. Additional ecological benefits included in the calculations are (i) carbon sequestered over and above the without-project situation, and (ii) the retention of soil and water from the change of forest land use. Sequestered carbon includes the carbon captured by the ecological reforestation program of Gansu, the predicted incremental benefits of secured management of the seven pilot SFFs in Shaanxi, and the soil carbon benefits from moving away from traditional cropping systems to agroforestry or economic forestry. The economic internal rate of return for the overall project is estimated at 19.5%, ranging from 18.7% in Shaanxi to 19.8% in Xinjiang. The distribution and market analysis shows a balanced distribution of economic and financial benefits to farmers and enterprises.

20. A financial analysis was undertaken to assess the viability and sustainability of the proposed project. The major financial benefit arising from the project is the increase in output from economic tree crops, which is estimated to approach 464,000 t per annum by year 10. An estimated 207,000 households will receive financial benefits. An assessment of the financial internal rate of return (FIRR) for the crops indicates that the expected returns range from 12.1% for ginkgo to 45.6% for Chinese dates. About 33% of the planted area will be under apples, followed by about 29% under walnuts. Apples have an estimated FIRR of 16.6% and walnuts have an estimated FIRR of 19.8%. To estimate the financial returns to representative households in the project, three household models were constructed based on different tree crops. Financial due diligence was conducted for all enterprises that are included in the project. The results indicate that the nine private enterprises in Gansu have FIRRs ranging from 12.5% to 18.2%, compared to a weighted average cost of capital of 5.2%.

B. Governance

21. All procurement of goods and works will be carried out in accordance with ADB’s Procurement Guidelines (2010, as amended from time to time) and the agreed procurement plan. ADB’s Anticorruption Policy (1998, as amended to date) was explained to and discussed with the State Forestry Administration; Gansu, Shaanxi, and Xinjiang governments; and the implementing agencies. The specific policy requirements and supplementary measures are described in the project administration manual.

C. Poverty and Social 22. The project will benefit about 207,000 farmer households, 9 private enterprises in Gansu, and 17 farm enterprises in Xinjiang with economic tree crop improvements; 7 SFFs in Shaanxi; and numerous county forest bureaus and forest stations in Gansu and Xinjiang with 9 ecological forest improvements. Except for Xinjiang, where the project areas are among the most productive, poverty rates in the project area are generally higher than the provincial averages. In 2009, poverty rates averaged about 20% in the project counties of Gansu (higher than the provincial average of 19.4%), and range from 14.5% to 28.1% based on survey results. In Shaanxi, poverty rates average about 16.5% in the project counties (higher than the provincial average of 14.8%), and range from 5.6% to 25.8%. In Xinjiang, the average poverty incidence is about 9.6% (lower than the provincial average of 13.9%). In all project areas, poverty rates are much higher than the official national average of around 4.0%. No land acquisition or involuntary resettlement is involved, and incomes will improve as a result of the project.

D. Safeguards

23. The project is classified under environmental category B. During the project preparation, domestic environmental impact assessment reports were prepared for the three provinces in accordance with the PRC regulations. An initial environmental examination report was prepared in accordance with ADB guidelines. Due diligence review of environmental management practices by the participating enterprises has been undertaken. The review shows that the enterprises comply with all national regulations and apply adequate environmental management procedures acceptable to ADB. The initial environmental examinations were approved by the provincial environmental protection bureaus in August 2010. The project is expected to achieve significant environmental benefits, including (i) water savings, (ii) reduced use of agrochemicals (fertilizers and pesticides), (iii) reduced soil erosion, and (iv) increased carbon sequestration both in trees and soils. Carbon sequestration and land improvements are considered significant benefits representative of the overall direct and indirect positive impacts of the project. The project will also enable participating farmers and beneficiaries to better adapt to climate change impacts by introducing sustainable land and management policies.

24. The social assessment revealed that ethnic minority groups live in the five project counties of Xinjiang and that no ethnic groups are involved in the project areas of Gansu and Shaanxi; consequently, the project is classified under indigenous peoples category A. According to the survey data, poverty is higher among ethnic minority groups, although they receive some specifically targeted support programs. In a community that has a small number of ethnic minority people and a large number of Han people, priority will be given to the minority households. To enhance the participation of ethnic minority people, consultation workshops, village project information publicity, and invitation and mobilization of the households will be carried out by implementing agencies, enterprises, and county forest bureaus in ethnic minority languages. The ethnic minority development plan (EMDP) for Xinjiang and the community consultation and participation plans for Gansu and Shaanxi were prepared and endorsed by the executing agencies.

25. The project is classified under involuntary resettlement category C. Due diligence was conducted and the project design has included measures to avoid involuntary resettlement, including (i) avoidance of basic farm land for forest development; (ii) voluntary participation of farmers who will be direct beneficiaries, using a community consultative process; (iii) payment of wages to farmers that participate in the project and provide labor inputs; (iv) no land acquisition will be required for irrigation infrastructure upgrading; and (v) ecological trees will utilize state- owned forest land and hilly and marginal collective land.

E. Risks and Mitigation Measures

26. The financial management assessment indicates that the local governments have accumulated considerable experience from ADB- and World Bank-financed projects, and are familiar with ADB’s requirements. Public–private partnerships for the success of the reforms and

10 commercialization of the Shaanxi SFFs present some risk for the project. Major risks and mitigating measures are summarized in Table 4.

Table 4: Summary of Risks and Mitigating Measures Risks Mitigating Measures Repayment The local governments will guarantee the repayment of disbursed loan funds. In the case of repayment default, the provincial governments will deduct amounts due from the public budgets of the municipal and county governments. Financial The financial management systems of the participating enterprises meet the requirements for Management undertaking their respective activities. Nonetheless, project implementation will involve training and capacity-improvement activities. Mitigation measures are designed to strengthen financial management capacity and mitigate residual control risks, and include (i) recruitment of well-trained project management and accounting staff, (ii) well-designed and focused training by ADB’s resident mission, (iii) establishment of a management information system to monitor the execution of project activities and impacts, and (iv) strengthening of the control and accountability mechanism. Public– The inclusion of private sector management skills, market access, advertising, and equity is Private considered essential for state forest farm reforms and sustainability. There are numerous successful Partnerships companies in the private sector of Shaanxi that can assist with project implementation. ADB = Asian Development Bank. Source: ADB.

IV. ASSURANCES

27. The national government and provincial governments have assured ADB that 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 project administration manual and loan documents. The national government and provincial governments have agreed with ADB on certain covenants for the project, which are set forth in the draft loan, project, and financing agreements.

V. RECOMMENDATION

28. 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 (i) the loan of $100,000,000 to the People's Republic of China for the Forestry and Ecological Restoration Project in Three Northwest Provinces from ADB’s ordinary capital resources, with interest to be determined in accordance with ADB’s London interbank offered rate (LIBOR)-based lending facility; a term of 25 years, including a grace period of 5 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; and (ii) the administration of the grant not exceeding the equivalent to $5,100,000 to the People’s Republic of China for the Forestry and Ecological Restoration Project in Three Northwest Provinces, to be provided by the Global Environment Facility.

Haruhiko Kuroda President

7 March 2011 Appendix 1 11

DESIGN AND MONITORING FRAMEWORK Performance Targets and Data Sources and Design Summary Indicators with Baselines Reporting Mechanisms Assumptions and Risks Impact Assumption Improved incomes and Average net income of 12th Five-Year Plan Effective monitoring sustainable livelihoods beneficiary households reported achievements and ensures that enterprises, from the use of forest increased by 30%, from CNY future directions and county forestry bureaus, land in Gansu, Shaanxi, 1,600 in 2010 to CNY 2,080 priorities SFFs, and forest stations and Xinjiang. by 2020 successfully implement Provincial and county activities and sustain Protection of ecologically yearbooks and reports benefits. sensitive areas increased by 130,000 ha, from about Project benefit monitoring Risk 180,000 ha in 2010 to about reports Rapid economic growth 310,000 ha by 2020 dominates priorities and pollutes landscape. Rural employment increased by 48,000 jobs by 2020

Outcome Assumption Increased productivity of Degraded forest land in the 12th Five-Year Plan Project is implemented as forest lands and three provinces reduced by reported achievements and designed. reduced land 10% in 2010 from about 3.50 future directions and degradation in Gansu, million ha to about 3.15 priorities Risk Shaanxi, and Xinjiang. million ha by 2016 Natural disasters, Provincial and county particularly droughts and Forest cover and tree density yearbooks and reports erosion events, are not (stand volume) increased by effectively mitigated. 3% in Gansu (from 680,000 Forestry department ha to 700,000 ha), 2% in reports Shaanxi (from 735,000 ha to 750,000 ha), and 1% in Xinjiang (from 594,000 ha to 600,000 ha), leading to protection of total carbon stocks of 32 million tons and sequestration of 3.3 tons by 2016 Outputs Assumptions 1. Mainstreamed IEM About 38,000 ha of 13 Provincial and county Demand for fruits and nuts approaches applied varieties of economic tree yearbooks and reports remains high. to economic tree crop crops newly planted and development producing fruit on degraded Forestry department Farmers are able to forest land in the three reports access required support provinces by 2016 services from local Financial statements of government agencies. About 207,000 rural enterprises and commercial households and workers production bases Risks benefiting directly from the Quality control standards production and processing of are inadequate to meet economic tree crops by 2016 domestic and international About 26 enterprises market standards. operating profitably by 2016 Forest land tenure Increased sequestration of contracts and rental about 368,600 tons of carbon agreements are not in orchards by 2016 secured.

Natural disasters seriously disrupt the supply of inputs. 12 Appendix 1

Performance Targets and Data Sources and Design Summary Indicators with Baselines Reporting Mechanisms Assumptions and Risks 2. Mainstreamed IEM About 3,000 ha of degraded Provincial and county Assumptions approaches applied forest land in Gansu restored; yearbooks and reports Forest trees are to ecological forestry protection of carbon stocks of established and survive. development 2.7 tons and sequestration of Forestry department 3.3 tons by 2016 reports Forest tree maintenance is provided by county forest At least seven SFFs in PPMO and CPMO benefit bureaus and financing is Shaanxi improve tree cover monitoring reports made available by county and density on about 126,000 finance bureaus. ha; protection of carbon Reports and audited stocks of 28.8 tons and statements from SFFs Commercial ecotourism sequestration of additional 1 revenue is generated for ton of carbon by 2016 SFFs to operate profitably. Ecological forestry center Risk providing support to SFFs in Public–private forestry management and partnerships fail due to carbon trading unsound management, GEF financing: (i) about illegal corporate practices, 700 ha of degraded steeply and operational neglect or sloping forest land in Gansu natural disaster. restored, (ii) about 1,000 ha of degraded forest land secured in Xinjiang and (iii) carbon forestry improvements made on about 12 SFFs in Shaanxi and Gansu; protection of 6,000 tons of carbon and sequestration of 5,000 tons in Xinjiang by 2016 3. Project management PPMOs and CPMOs Project reports and support strengthened established and operating in monitoring to implement forest each province and county sector reforms using Benefit and impact IEM approaches in Enhanced capacity of monitoring the provinces, households and implementing counties, towns, and agencies in implementing IEM Training records households approaches; about 200,000 Procurement records households received training in IEM

Activities with Milestones Inputs 1. Advance Actions ADB: $100.00 million 1.1 Draft all project management procedures. Amount 1.2 Design and implement PPMS. Item ($ million) 1.3 Update procurement plan for approval by the State Forestry Economic tree crops 86.76 Administration and ADB. 1.4 Prepare household and enterprise loan agreements. Ecological forestry 11.01 1.5 Identify economic planting areas and household planting Project management support 2.23 plans. 1.6 Ratify year 1 tree planting plans. Provincial, municipal, and county 1.7 Prepare project training plan. governments: $44.99 million 1.8 Train project management staff in ADB procedures and Amount systems. Item ($ million) 1.9 Agree and jointly train with county finance officials on Economic tree crops 12.60 procedures and documentations. Ecological forestry 5.49 2. Project Year 1 2.1 Implement procurement plan. Project management support 26.90 Appendix 1 13

Activities with Milestones Inputs 2.2 IEE and EMDP implementation started. Enterprises: $12.74 million 2.3 Initiate beneficiary training. Amount 2.4 Plant about 21,000 ha of economic tree crops. Item ($ million) 2.5 Prepare year 2 planting plans. Economic tree crops 12.74 2.6 Approve ecological forestry center establishment in Shaanxi. 2.7 Monitor survival rates on economic tree planted areas. Households: $17.86 million 2.8 Prepare county ecological planting plans starting year 2. 2.9 Approve enterprise development plans by PPMO and award. Amount 2.10 Contract business planning procedures for each pilot SFF. Item ($ million) 2.11 Design carbon administration system and start training. Economic tree crops 17.38 3. Project Year 2 Ecological forestry 0.48 3.1 Continue beneficiary training. 3.2 IEE and EMDP implemented. GEF: $5.10 million 3.3 Plant about 13,900 ha of economic tree crops. Amount 3.4 Plant about 2,640 ha of ecological forests. Item ($ million) 3.5 Plant replacement economic trees. Ecological forestry 3.06 3.6 Staff and operate ecological forestry center. 3.7 Disburse value chain enterprise loans. Project management support 2.04 3.8 Monitor planting and survival. 3.9 Approve SFF business plans and identify private sector investors. 3.10 Establish carbon database and MIS. 3.11Complete social monitoring. 4. Project Year 3 4.1 Complete beneficiary training. 4.2 IEE and EMDP implementation completed. 4.3 Plant about 3,100 ha of economic tree crops. 4.4 Plant about 1,250 ha of ecological forest trees. 4.5 Monitor and evaluate planting program. 4.6 Design carbon trade. 4.7 Design payment for ecological services schemes. 4.8 Complete PPP design and have it agreed by all parties. 4.9 Complete midterm monitoring report. 5. Project Year 4 5.1 Plant about 810 ha of ecological forest trees. 5.2 Continue tending of trees. 5.3 Implement SFF enterprise investments. 5.4 First carbon trade. 6. Project Year 5 6.1 Monitor project activities. 6.2 Complete training of implementing agency staff. 6.3 Continue tending of trees. 6.4 Evaluate project outputs and evaluation survey 6.5 Project completion report. 6.6 Conclude carbon trades. ADB = Asian Development Bank, CPMO = central project management office, EMDP = ethnic minorities development plan, GEF = Global Environment Facility, ha = hectare, IEE = initial environmental examination, IEM = integrated ecosystem management, MIS = management information system, PPMO = provincial project management office, PPMS = project performance management system, PPP = public–private partnership, SFF = state forest farm. Source: ADB.

14 Appendix 2

LIST OF LINKED DOCUMENTS

http://www.adb.org/Documents/RRPs/?id=40684-01-3

1. Loan Agreement 2. Financing Agreement 3. Project Agreement 4. Sector Assessment (Summary): Forestry 5. Project Administration Manual 6. Contribution to the ADB Results Framework 7. Development Coordination 8. Financial and Economic Analyses 9. Country Economic Indicators 10. Summary Poverty Reduction and Social Strategy 11. Initial Environmental Examination 12. Ethnic Minority Development Plan (and Summary) 13. Risk Assessment and Risk Management Plan