Urban–Rural Infrastructure Development Demonstration II Project (RRP PRC 45509)

FINANCIAL ANALYSIS

1. The financial analysis includes (i) an assessment of the financial viability of the revenue-generating Wanzhou Yangliu water supply subproject, and (ii) financial sustainability analysis of six non-revenue-generating subprojects of urban–rural roads and flood risk management. The financial analyses and preparation of the financial management assessment are in accordance with the Asian Development Bank (ADB) documents: Financial Management and Analysis of Projects 1 and Financial Due Diligence: A Methodology Note.2

A. Financial Analysis of the Wanzhou Yangliu Water Supply Subproject

1. Methodology

2. The financial internal rate of return (FIRR) was estimated for the revenue-generating Wanzhou Yangliu water supply subproject. The weighted average cost of capital (WACC) based on financial assumptions was compared with the FIRR to ascertain the financial viability of the component. Sensitivity tests were undertaken to test the robustness of the FIRR to changes in underlying parameters, namely increases in capital and operating costs, low demand associated with reduction in revenue, or delays in the timing of tariff review and project implementation. Project cash flow projections are based on the realistic estimation of water tariffs, and assess whether cumulative cash flow will meet cash operating costs, debt service, and capital replacement, particularly of mechanical and electrical equipment.

2. Financial Assumptions

3. Financial projections of 25 years from project commencement and 20 years after project completion (cash flows) were prepared to determine the annual required revenue to ensure that the cumulative cash flow would meet cash operating costs, depreciation, and debt service. All costs are expressed in November 2012 prices. Cost streams used for calculating the FIRR are capital investment and operation and maintenance (O&M) costs. Capital costs include the (i) base cost, including the investment cost for the associated water intake facilities, water transfer pipelines, and water distribution pipelines; and (ii) physical contingencies; but exclude price contingencies. O&M costs include personnel salaries, cost of chemicals and agents, utility cost (e.g., electricity), plant maintenance cost, administration, taxes, and other expenses. Project revenue will be derived from water sales. The water demand projection considered (i) water supply population of 578,000 in 2017, and (ii) daily water consumption per capita of 137 liters throughout the projection period. 3 Other assumptions include that (i) the ADB loan repayment period is 25 years including a 6-year grace period, and (ii) the baseline tariffs used to estimate the revenues are tariffs in Wanzhou in 2011 and assumed to increase gradually every 5 years. The future tariff was projected carefully by making a conservative and realistic projection based on historical tariff revisions in Wanzhou. The analysis identified the financial viability of the Yangliu water supply plant to meet cash operating costs, to build up funds to cover capital replacement, and to pay debt service. The Wanzhou government will pay the debt service if tariffs are not able to cover it. Net cash flows were determined after income taxes were calculated at 25%. No residual value was assumed. The foreign exchange rate of CNY6.3 = $1.0 was used for the analysis.

1 ADB. 2005. Financial Management and Analysis of Projects. Manila. 2 ADB. 2009. Financial Due Diligence: A Methodology Note. Manila. 3 These figures are considered to be conservative because (i) the projected water supply population is based on the actual service population, which is about 70% of the projected water supply population under the Chongqing Municipality Wanzhou Urban Master Plan Revision (2010–2020) and Chongqing Municipality Wanzhou District Water Supply Strategic Plan (2010–2020); and (ii) per capita consumption remained stable at 137 liters per day per capita, the daily average tap water consumption per capita in Chongqing in 2011. 2

3. Weighted Average Cost of Capital

4. To compute the WACC, the financing sources are assumed to comprise the Wanzhou district government equity contributions and an ADB foreign currency loan. The Ministry of Finance of the People’s Republic of China (PRC) will relend the funds from ADB with the same terms and conditions to the Chongqing municipal government and the Wanzhou district government. The loan rate will be 10-year US dollar fixed swap rate plus the ADB margin (of 0.4%) and a maturity premium of 0.1%, a total of 2.3% per annum.4 The cost of equity is calculated at 8.0%, assuming a risk-free rate of return of 6.0% plus a 2.0% margin. Income tax is assumed at 25.0%, with the WACC calculated on an after-tax basis. The other assumptions are domestic inflation rate of 3.5% and international inflation rate of 1.9%. The computed real WACC for the component is 3.7% (Table 1).

Table 1: Calculation of the Weighted Average Cost of Capital Nominal Amounta Weighting Nominal Tax Rate after Inflation Real Term WACC Source ($ million) (%) Rate (%) (%) Tax (%) Rate (%) (%) (%) ADB loan 20.78 15.00 2.33 25.00 1.70 1.90 (0.15) (0.02) Counterpart 114.06 85.00 8.00 0.00 8.00 3.50 4.35 3.68 Total 134.85 100.00 3.65 Real WACC 3.65 ( ) = negative value, ADB= Asian Development Bank, WACC = weighted average cost of capital. a The project cost includes expected future domestically funded projects for water distribution pipeline network expansion planned during the duration of the financial projection. Source: Asian Development Bank estimates.

4. Financial Internal Rate of Return

5. A summary of the estimated FIRR and results of the sensitivity analysis is in Table 2. The FIRR at 6.1% is higher than the WACC of 3.7%. The Wanzhou Yangliu water supply plant is therefore considered financially viable (Table 2). Sensitivity analysis shows that the FIRR is most sensitive to a 10% decrease in revenue, which will decrease the FIRR to 4.4%; and to a simultaneous 10% increase in capital costs and operating costs and a 10% decrease in revenue, which will decrease the FIRR to 3.1%.

6. Water tariff and affordability. Wanzhou district’s water tariffs are typical of those in the PRC; they are differentiated by customer class. Domestic customers are charged the lowest tariffs, while nondomestic industrial and commercial customers are charged higher tariffs. The current tariffs, revised in 2010, are CNY2.17/cubic meter (m3) for domestic customers and CNY3.23/m3 for nondomestic customers. The analysis assumes that the water tariff during the first year of operation in 2017 is CNY2.39/m3 considering a tariff increase of 10% every 5 years from 2010.5 The proposed tariff structure is sufficient to recover the operating and capital costs of the project, but the risk is that it could be revised downward since proposed tariffs have to be approved through public hearings by the Wanzhou district government. A lesson from past projects indicates that the water tariff should be carefully reviewed and simulated during project preparation. Another assumption of a tariff increase every 10 years was also tested. The analysis confirmed that the tariff increase of 10% every 10 years resulted in an FIRR of 3.6%, marginally lower than the WACC. A tariff increase of 10.5% is required to keep the FIRR higher than the WACC. Given the historical water tariff revisions, this increase is considered feasible. In the event that revenues are not adequate to finance O&M and to repay the loan, the Wanzhou district government will provide subsidies.

4 As of 12 December 2012. 5 The assumptions are considered conservative because based on the past water tariff revisions in 2001, 2004, and 2010, the tariff increase rates in Wanzhou were 33% over 5 years and 103% over 10 years. 3

7. The tariff analysis includes assessments of affordability for project beneficiaries and of the agreed degree of cost recovery during operation. The primary social objective of water and wastewater tariff structures should be to ensure that all members of the community have access to these services without placing an undue burden on their household expenditures. Considering Wanzhou district’s average household size of 3.7 persons and daily water consumption of 100 liters per capita for poor household, 6 the projected water tariff increase would result in an estimated water and wastewater bill in 2017 of about CNY30.4 per month, equivalent to 1.2% of the average household monthly income and 2.6% of a poor household’s monthly income. The share of income expended is therefore considered affordable.

Table 2: Financial Internal Rate of Return and Sensitivity Analysis FIRR NPV SI Sensitivity Analysis (%) (CNY million) (%) Base Case 6.1 270.1 (i) Capital costs: +10% 5.3 189.5 1.4 (ii) Operating costs: +10% 5.6 216.5 0.8 (iii) Reduction in revenue: –10% 4.4 75.9 2.8 (iv) Combination of (i), (ii), and (iii) 3.1 (58.4)

(v) 1-year delay in implementation 6.0 236.5 (vi) Tariff review delay (10% in every 10 years) 3.6 (7.7) Weighted Average Cost of Capital 3.7 ( ) = negative value, CNY = yuan, FIRR = financial internal rate of return, NPV = net present value, SI = sensitivity indicator. Source: Asian Development Bank estimates.

5. Project Financial Projections

8. Wanzhou Water Supply Company, which operates as the Yangliu water treatment plant, is a state-owned enterprise established under the Wanzhou district government. Financial projections for 10 years after project completion show that cumulative cash flow can meet O&M costs, service debt, provide for periodic equipment replacement, and build up cash reserves to meet emergency repairs (Table 3). The financial condition will improve after the project mainly due to (i) increased water supply capacity and coverage areas, (ii) closure of inefficient plants, and (iii) increased water tariff. The working ratio shows the company’s ability to recover operating costs from annual revenue. The company can also achieve the minimum debt service coverage ratio of 1.2 over the forecast period with a ratio of 1.7 in 2017 before starting the loan repayment in 2019. It suggests that the operation of the company will be sustained without subsidies within the proposed tariff structure.

Table 3: Key Indicators of Financial Projection for Wanzhou Water Supply Company Year Construction Operation Actual (Projection) (Projection) Item 2011 2014 2017 2020 2023 2026 Residential water tariff (CNY/m3) 2.17 2.17 2.39 2.39 2.63 2.89 Operating revenue (CNY million) 71.8 83.3 152.0 156.0 173.1 192.5 Operating cost (CNY million) 70.9 82.0 94.8 103.7 111.2 119.2 Net Income after tax (CNY million) (5.0) (6.3) 16.3 7.8 15.2 23.8 Working ratio 0.9 0.9 0.4 0.4 0.4 0.4 Debt–equity ratio 0.3 0.2 0.2 0.2 0.1 0.1 Debt service coverage ratio 0.03 0.04 1.7 1.2 1.4 1.6 ( ) = negative value, CNY = yuan. Source: Asian Development Bank estimates.

6 In general, daily water consumption per capita of poor people is lower than the average. The affordability analysis assumed that a person in a poor household use about 75% of the average daily water consumption per capita in Chongqing. 4

B. Financial Sustainability Analysis

1. Counterpart Fund, Operation and Maintenance Cost, and Debt Service Coverage

9. Financial sustainability of the project components during implementation and operation was determined. Based on a detailed review of the revenue and expenditure statements of all seven project district and county governments during 2007–2011, a performance assessment was carried out to analyze the fiscal impact on each government by comparing annual revenues from the identified financing sources with the annual counterpart funds required for (i) capital expenditures during project implementation, and (ii) recurrent costs for O&M (for non-revenue-generating components) and debt service of the project components during operation. Revenue, excluding income from land sales, is projected to increase by 7.5% per annum.7

10. As a percentage of annual revenues in 2015, the maximum annual capital expenditure, which comprised counterpart funds and interest during construction, is projected to be about 1.3% for Chengkou, 0.4% for Fuling, 0.3% for Rongchang, 0.9% for Shizhu, 0.4% for Wanzhou, 2.0% for Wulong, and 1.4% for Youyang. This indicates acceptable fiscal risk since fiscal revenues of the municipal governments are expected to grow in line with economic development, providing more resource mobility for the municipal governments to finance the project components. Similarly, as a percentage of annual revenues in 2019, the funds for O&M and debt service during operation is projected to be about 0.4% for Chengkou, 0.2% for Fuling, 0.1% for Rongchang, 0.3% for Shizhu, 0.1% for Wanzhou, 0.7% for Wulong, and 0.5% for Youyang. The analysis concludes that, based on the identified funding sources during project preparation (including new budgets, subsidies, and allocated financing), all subprojects have sufficient funds available for counterpart funds during implementation and for O&M and debt service during operation.

2. Necessity for Strengthening Public Financial Management

11. The assessment also indicates that the fiscal revenue of some project county and district governments relies largely on transfers from the Chongqing municipal government. In some cases, the contribution from the Chongqing municipal government is more than 50% of the average of total annual revenue. Financial performance of the district and county governments in 2007–2011 is characterized by a gradual increase in loan portfolio concentration, increasing dependence on external financing, and slow generation of surplus from their own operations to build up reserves. In 2011, the total outstanding loan balances from various sources in the seven project districts and counties represent 8%–69% of total revenue. The projected fiscal impact of total annual debt service—interest and principal—to each project district and county government ranged from 1.7% (Rongchang) to 7.6% (Wulong) of total projected revenues in 2013, although the figure will be lowered from 1.1% (Rongchang) to 5.3% (Wulong) when principal repayment of the ADB loan starts in 2019. The financial sustainability analysis concludes that this will not pose an immediate financial risk for affordability of counterpart funds, O&M costs, and loan payments. However, the capacity of each project district and county government will need to be strengthened to manage public finance and alternative financing options and the creditworthiness of local governments will need to be enhanced. District and county training on public financial management is included in the project design. The training may include (i) strengthening

7 Gross domestic product (GDP) growth targets for the PRC under the Twelfth Five-Year Plan (2011–2015) include 12.5% for Chongqing and 7.5% for the PRC. Much higher GDP growth was projected for each project district and county government. In the analysis, the PRC average was used to give a conservative estimate of future GDP growth. 5

county and district creditworthiness, (ii) identifying alternative financing options, (iii) enhancing revenue, (iv) controlling expenditure, (v) managing debt, (vi) implementing domestic and international good practice, (vii) using performance indicators, and (viii) performing internal audit and financial evaluation.

Table 4: Total Annual Debt Service of Project Districts and Counties Total Annual Debt Service 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 (CNY million) 50.4 50.8 51.2 51.5 51.5 51.5 58.2 58.0 57.9 57.7 % of total projected revenues 2.3 2.2 2.0 1.9 1.8 1.6 1.7 1.6 1.5 1.4

Fuling district (CNY million) 569.8 570.3 570.9 571.3 571.5 571.5 581.6 581.4 581.1 580.9 % of total projected revenues 6.3 5.9 5.5 5.1 4.8 4.4 4.2 3.9 3.6 3.4 Rongchang county (CNY million) 142.2 142.5 142.8 142.9 143.0 143.0 148.1 148.0 147.9 147.8 % of total projected revenues 1.7 1.5 1.4 1.3 1.3 1.2 1.1 1.0 1.0 0.9 Shizhu county (CNY million) 178.4 178.8 179.3 179.5 179.6 179.6 186.6 186.5 186.3 186.1 % of total projected revenues 5.0 4.6 4.3 4.0 3.8 3.5 3.4 3.1 2.9 2.7

Wanzhou district (CNY million) 675.5 676.1 676.6 676.8 677.0 677.0 686.4 686.2 685.9 685.7 % of total projected revenues 5.0 4.7 4.4 4.1 3.8 3.5 3.3 3.1 2.9 2.7 Wulong county (CNY million) 289.4 290.3 291.6 292.4 292.6 292.6 310.6 310.2 309.7 309.3 % of total projected revenues 7.6 7.1 6.6 6.2 5.7 5.3 5.3 4.9 4.5 4.2 Youyang county (CNY million) 42.0 42.6 43.2 43.6 43.7 43.7 53.4 53.2 53.0 52.8 % of total projected revenues 1.4 1.3 1.2 1.2 1.1 1.0 1.1 1.1 1.0 0.9 Note: County and district total loan includes outstanding loan from various sources plus proposed ADB loan. Source: Asian Development Bank estimates.