Report and Recommendation of the President to the Board of Directors Project Number: 40634-01 July 2010 Proposed Loan People's Republic of China: Inner Mongolia 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 district 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.