With its combination of low costs, high capacity and growing tariffs, China is uniquely situated for explosive growth in the development of small hydro projects. China Hydroelectric Corporation shares its experiences with owning and operating 27 small projects in four provinces.
By John D. Kuhns
I believe the People’s Republic of China enjoys the finest climate for hydroelectric power investment in the world, particularly with respect to small hydro assets. In China, small hydro is defined as any project with less than 50 MW of capacity.
Based on my 20 years of experience with developing and owning hydro projects in this country, I believe that returns for small hydro projects in China surpass those for similar assets in other parts of the world. They also easily surpass returns earned by other types of power generation in China. The cheapest way to make a kWh of electricity in China is with a hydroelectric project. All other sources of electric generation in the country — including coal-fired projects — do not recover all their costs and are subsidized in some form.
My partners and I have organized our company, China Hydroelectric Corporation (listed on the New York Stock Exchange under the trading symbol “CHC”), to take advantage of this situation. CHC is one of the largest owners of small hydro in China, with 564 MW of capacity at 27 projects in 4 provinces — Zhejiang and Fujian on China’s eastern seaboard and Sichuan and Yunnan in southwestern China. CHC’s largest project is 45 MW, and its smallest is less than 2 MW.
To test this thesis that the returns on CHC’s small hydro assets are superior to the returns that would be generated on comparable portfolios in other parts of the world, we used accessible public information. This included CHC’s public filings with the Securities and Exchange Commission of the USA and the public filings of comparable publicly-traded hydroelectric companies from around the world.
Many are aware that China is home to the 18,200 MW Three Gorges facility, the largest hydroelectric project in the world in terms of generating capacity (Brazil’s 14,000 MW Itaipu is second). And some also know that China has the largest aggregate installed hydroelectric capacity of any country — about 200,000 MW — compared to about 100,000 MW in Brazil, the world’s second largest country in terms of total hydro capacity.
But most are surprised to learn about the huge portfolio of existing hydroelectric projects generating electricity in China. According to the Chinese Bureau of Statistics, there are more than 48,000 operating hydro projects (about 45,000 are larger than 1 MW) in the country, which is the most operating projects of any country in the world. By comparison, the USA, which has about the same land mass as China (3.7 million square miles), has roughly 4,000 operating hydro projects, according to data from the Federal Energy Regulatory Commission.
Lastly, experts estimate that only 25% to 33% of China’s total hydroelectric potential has been developed. Recently, in its newly minted Twelfth Five Year Plan, the government of China emphasized that it intends to favor hydroelectric power development in the future, trying to maintain its current level of China’s total electric generating capacity at 23%. How? By offering increasing tariffs and other incentives to developers and owners of hydroelectric projects.
CHC believes investment discussions with respect to hydroelectric projects are best conducted using an analysis of a project’s internal rate of return (IRR) on unlevered equity. Why use the IRR criterion? One of the beauties of investing in hydroelectric projects is their financial and operational simplicity. These include: no fuel costs, low variable costs, no inventory or finished goods, single customer, low annual capital expenditure, slow rotating equipment and long life time.
In fact, to many, an investment in a hydro project is akin to investing in a security — such as a variable rate bond. And comparing one bond to another usually involves using the bond’s total return, including an analysis of the interest rate and premium or discount to par. Accordingly, when evaluating an investment in a hydroelectric project, IRR on unlevered equity represents essentially the same thing.
The four factors that most influence the IRR on hydroelectric assets are capital cost per megawatt, capacity factor or utilization, operating costs and tariff characteristics. And, in the case of each of these factors, their measurements with respect to an average portfolio of small hydroelectric assets in China generally are superior to those of an average portfolio of small hydroelectric investments in other countries.
Low capital costs per megawatt
With respect to this variable, CHC uses comparable small hydro assets. (Due to economies of scale, construction costs vary based on the hydro project’s generating capacity.) Also, CHC’s capital cost per megawatt reflects the fact that the company built four of its small hydro projects and acquired the rest from independent third-party sellers.
CHC’s average capital cost per megawatt is about $1.3 million. I know of no place in the world where capital costs for small hydroelectric capacity are so low. Why is this the case? The capital cost of a small hydro project consists of about 75% civil work — in other words, concrete and labor — and there are few places in the world where concrete and labor are cheaper than China.
This is true even though nearly two-thirds of CHC’s installed capacity is in China’s eastern provinces of Zhejiang and Fujian, while another third is in the western province of Yunnan and one small project is in adjacent Sichuan. In China, things are more expensive in the industrialized eastern provinces and cheaper in the rural west. If the company’s portfolio was limited to Yunnan Province, the average historical capital costs per megawatt would be lower — about $1.1 million.
And finally, because CHC purchased the majority of its projects from others, its capital costs include a “developer’s premium,” which is a profit paid by CHC to the project developers in excess of their actual construction costs. In many parts of the world, hydroelectric sites are in short supply and developers can demand a healthy premium. But there is no shortage in China, so a typical developer’s profit is low — about 10% to 20%, CHC believes.
|The 41 MW Bing Lang Jiang in Yunnan Province is one of China Hydroelectric Corporation’s most attractive projects. The company bought the project in 2007 when it had a capacity of 21 MW and expanded it by adding 20 MW of capacity in 2009 for less than $1 million per MW.|
Therefore, if the company was to focus only on Yunnan and build all its hydro projects as opposed to buying them, CHC could own such assets even cheaper than the current average — or as little as about $1 million per megawatt. (The above data are based on historical costs. Like all costs in China, CHC expects capital costs for small hydroelectric equipment to increase in the future.)
High capacity factor
The capacity factor of CHC’s hydro portfolio is about 39%. For the portfolio of assets in Yunnan, the capacity factor would be greater than 50%. In other words, in Yunnan CHC is making electricity 50% of the hours in the year — an unusually high rate and an indicator of a key advantage of small hydroelectric resources in China.
Of course, capacity factors vary by project, and there are many hydro projects around the world with higher capacity factors. The Hoover Dam in the USA comes to mind. But there are only so many Hoover Dams in the world. Looking at the capacity factors of incremental projects to be built around the world — that is, at prospective sites — a more realistic level of capacity factor comes into focus. CHC believes that, in most countries, particularly developed ones, it is difficult to locate incremental hydro sites with capacity factors above 25% — about the same utilization level as an energetic wind farm.
|China Hydroelectric Corporation acquired the 40 MW Wangkeng Dam project, in Fujian Province, in 2009.|
What contributes most to a project’s capacity factor? Hydrology, topography and the resultant elements of the project’s design: head and whether the plant operates with a reservoir (and its size) or is run of river. These contributors are partially a function of the virgin nature of the site. In the early days of any country’s hydroelectric development, before its sites are picked over, developers will construct facilities at those sites that have the best designs or where the design engineer can optimize capital cost relative to electric energy production. As the good sites get taken, optimal ratios diminish.
Across China, the best sites are surely taken — Three Gorges comes to mind. But because of the nature of the country’s hydrology and topography, there are many attractive sites still to be developed. Yunnan Province, for example, enjoys a long rainy season, receiving monsoon rainfalls coming north from the Indian Ocean, and is mountainous as well. Many good sites are yet to be developed in Yunnan.
Low operating costs
The typical cash flow ratio of CHC’s projects is greater than 80%. And about half of its operating costs are taxes and fees: CHC pays a 6% value-added tax and another 1%-2% in water fees, depending on the province. The remaining elements of a typical project’s operating costs are labor and annual maintenance capital expenditures.
It is probably equally useful to point out what costs are not predominant in CHC’s portfolio. CHC pays low levels of property taxes and property and casualty insurance. While CHC’s projects all are subject to local taxes and fees, the relative level of such taxes in China is much less than in many other countries. In addition, CHC pays the costs of various insurances, but these costs also are low in China.
Increasing tariffs for hydro
China employs a tiered tariff structure. Uniquely, hydroelectric tariffs are lower than tariffs paid to coal-fired power producers. And the coal-fired sector is under duress because of the rapidly increasing cost of coal, inefficiency of the delivery system from mine to power project (typically by truck, not rail) and pressure to add modern pollution control equipment at these plants.
|The 32 MW Ruiyang Dam project in Zhejiang Province was acquired by China Hydroelectric Corporation in 2009. It was the last project the company acquired before its initial public offering.|
The result is that coal-fired power producers in China lack profitability, even though tariffs paid to them are high by world standards, meaning tariffs must continue to rise, especially because China must develop thousands of megawatts of incremental electric generating capacity. This dilemma has provoked debate as China’s leaders ask how they can subsidize a sector responsible for environmental stress when another generating sector — hydroelectricity — is not only cheaper and more financially viable, but clean.
This debate has led China’s electric power leaders to propose the “one grid, one tariff” plan. While so far this is only in the talking stage, the day is coming when, similar to other nations, the grid in China will be generation-technology agnostic. A kilowatt of capacity will fetch a certain tariff depending on many factors, but not the type of technology that produces it. That day will represent a windfall for China’s hydroelectric power producers.
Hydroelectric tariffs have been steadily rising across China over the past decade. Tariffs vary from province to province because they are established by the pricing bureaus at the country’s provincial governments.
As with most things in China, tariffs are higher in the wealthier eastern provinces and lower in the rural west. In the eastern, more industrialized provinces, hydro tariffs have increased substantially over the past decade and now are approaching the levels of coal-fired tariffs, or about $0.07 per kWh. However, in the rural western provinces like Yunnan, hydro tariffs average about $0.025. Moreover, coal-fired tariffs in Yunnan are as much as two times higher, or about $0.05.
In general, CHC expects that hydroelectric tariffs across China will experience a slow and stable rise, with more upside in the western provinces. In any event, even a slight increase in hydro tariffs would have a significant impact on the IRR of CHC’s small hydroelectric portfolio.
Experiences in China
China Fortunes: A Tale of Doing Business in the New World, by John D. Kuhns, is a novel loosely based on the author’s personal experience of conducting business in China. Kuhns is a financier and industrialist who has been doing business in China for more than 25 years. He founded USA-based Catalyst Energy Corporation in 1984 and was the first American to acquire commercial hydro generating equipment from China. In January 2010, Kuhns closed an initial public offering for his new company, China Hydroelectric Corporation, China’s largest owner of small hydro projects. For more on this book, visit www.johndkuhns.com.
As a result of the factors discussed above, the IRR on unlevered equity for an average CHC project ranges from 11% to 14%, with an average of slightly less than 13%. Compare this with what CHC believes from the comps to be a worldwide average for all hydro — not just small hydro — of about 7%-8%.
Beyond IRR: the future is bright
Many additional elements point to a bright future for the small hydro investment climate in China.
First, the market is beyond dispute. China will need huge incremental amounts of electric generating capacity for decades. Even if hydro merely stays at about 23% of total capacity, the additional opportunity for new hydro investment is enormous.
Second, China’s capital markets are robust and pro-hydro. CHC conducted an initial public offering and listed its stock on the New York Stock Exchange in 2010 and is regularly considering other available means of capital funding, such as bond offerings.
And third, China has a mature, highly developed hydroelectric vendor industry. Dozens of vendors can professionally supply everything from turbine-generators to tunneling excavation services.
Most importantly, hydroelectric power is a big part of the central government’s energy plans. The government has pushed for hydroelectric tariff increases and encouraged banks to lend to hydroelectric producers. China’s leaders know the overwhelming portion (about 85%) of their country’s electricity is produced by coal-fired projects with inadequate emission control equipment wherein the coal is generally low Btu, dirty fuel. Because this coal-fired electricity costs much more to produce than do the kilowatt-hours coming from the nation’s hydroelectric projects, the coal-fired industry’s kilowatts are causing rate stress and political pressure.
So what are China’s leaders doing about it? They are raising tariffs to coal-fired producers (the industry has not been truly profitable for years) and discussing the aforementioned one grid, one tariff experiment to provide incentive for more clean, low-cost power.
The overall business environment in China
The important changes in China’s business environment, especially with respect to the electric power industry, have already taken place. Liberalizing the structural ownership and investment rules was one of the most important forces behind the river of foreign money flowing into the country that has been essential for China’s industrialization.
For example, in the 1980s, foreigners were not allowed to own any part of a power project in China. But the country needed huge amounts of new electric generating capacity, so in the early 1990s the rules were changed so foreigners could participate — on a minority ownership basis — in Sino/foreign joint ventures to own power projects. In turn, foreigners learned that the joint venture structure could be unsatisfactory, as it prevents each side from seeing what the other is doing.
And because China needed more power, in 2002 the authorities further deregulated the electric sector. Since that time, investors have been able to own a power project through a structure called a WOFE (wholly-owned-foreign-enterprise), which is a much more transparent vehicle.
Other positive factors contributing to a healthy investment climate in China include the emergence of an extremely vibrant and viable banking market; development of a large, well-educated, English-speaking workforce; and development of world-class infrastructure elements, such as roads, power lines, airports and trains.
Of course, there are risks in China
Investing in China is not for everyone. Many things can change at any time. The key is dollars and cents, the basis of most of China’s politics and decision-making. As the low-cost producer of electricity in China, the hydroelectric industry is, generally speaking, in a relatively low risk position. Surprisingly, environmental rules are fairly mature in China. True, these rules are not always obeyed, but that will change, and capital and operating costs will increase as a result of this change.
And when the government concludes that hydroelectric producers are making too much money and it does not need these producers to keep building capacity, the government may create a higher water tax and start taking its share. But such things have already happened in many other countries.
John Kuhns is chairman and chief executive officer of China Hydroelectric Corporation (www.chinahydroelectric.com) and author of China Fortunes: A Tale of Doing Business in the New World.