The Sound Group is China's largest private-sector environment protection company. Wen Yibo, the founder and president, can look back at almost 20 years of growth since Sound was set up in 1993. It's not been easy operating successfully in an arena dominated by public sector giants, with built-in advantages such as the lower cost of financing. But Sound has taken the technology route to expansion. Along with its subsidiary, Sound Environment Resources Company, which is listed in Shenzhen, and affiliate Sound Global, listed in Hong Kong, it has handled nearly 70 water treatment, sewage treatment, urban domestic waste treatment and industrial waste treatment plants in China. The group has undertaken more than 600 environmental protection projects.

Sewage treatment and water treatment havebeen open to the private sector in China for a few years now. That has challenges as the country moves toward more stringent norms. Wen sees challenges in both sectors, but notes that they come hand-in-hand with opportunity. Sound is on the frontlines hoping to grab an even bigger piece of the action. There is great potential for treatment plants, Wen notes in this interview with China Knowledge at Wharton.

An edited version of the transcript appears below:

China Knowledge at Wharton: The Chinese government has imposed various regulations on the water treatment industry in recent years. How will the industry benefit from the regulatory changes? 

Wen Yibo: There is great potential for sewage treatment in the next five-to-ten years. Growth will come from two avenues: First, the current sewage treatment rate in the cities is only 70%. This is 15% less than the 85% rate required in China’s 12th Five Year Plan (2011-2015). 

Secondly, and more importantly, it is very likely that the treatment standard will be raised from Grade 1B to Grade 1A. The current facilities will require significant upgrading and improvement and the investments will be huge. The investment in one sewage treatment plant to upgrade it from 1B to 1A is to 50%-70% of the initial investment. The operational cost will increase by another 30%. If we add the financing cost, the total operational cost will increase 40%-50%. The standard will be even more stringent in major cities like Beijing. This requires even higher investment. 

China Knowledge at Wharton: What change will this bring to the competitive landscape in the industry? 

Wen: In past years, all companies have been aggressively staking out their turf in China. They were looking for business volumes, not quality. But in the future, with the raised standards, there will be more focus on quality. This will make companies with higher technical capabilities stand out.

Most of the water treatment facilities can reach Grade 1B standard right now. State-owned companies with cheaper financing and more connections with the government enjoy advantages in this capital-intensive industry. However, when the standard increases to Grade 1A, there will be more stringent requirements. Otherwise, the quality of discharge will be unstable. These big companies will find it hard to meet the new standards. 

China Knowledge at Wharton: What are the other growth areas for sewage treatment? 

Wen: My view is that the government will extend its focus from urban areas to rural areas. In the next decade, rural China will offer more opportunities than urban. [At the end of] 2011, there were around 3,000 municipal sewage treatment plants covering most of urban China. However, China has more than 30,000 [smaller] townships. If we build one sewage treatment plant for every township, we will need 30,000 plants. This is a daunting task because there aren't enough professionals to run small-scale sewage treatment plants. Secondly, and more importantly, the widely distributed towns with [relatively] low populations mean that investment cost per capita will be much higher. Rural sewage treatment cannot be accomplished without innovative operating models. 

The Sound Group has made some progress here. We have initiated some innovative experiments on business models, technology and management for rural projects, and have started an integrated wastewater treatment program in rural areas in Changsha, Hunan Province. Some details need to be worked out. 

China Knowledge at Wharton: Going on to a different issue, China’s market for domestic water plants is dominated by state-owned companies. Do you see the market opening more to private capital in the future? 

Wen: I am personally very confident about the gradual opening up of the water market. It might take a long time because of strong resistance from current stakeholders. But there are already water plants looking for private capital.

Why am I so confident that private sector entry is inevitable? There are two reasons: First, people need better water quality; the government monopoly is not good enough. Second, private companies have accumulated rich experience. For example, the Sound Group has four fully-owned water plants with the oldest running for almost 10 years. 

I have insisted that we have 100% ownership of water plants. There are always voices in the government saying that private companies are not capable of running water plants. I want to demonstrate to these people that we can offer better service, improved quality and lower prices. If five years are not enough, we will take 10 years, 15 years or even 20 years to prove ourselves.

It is not a problem to make losses in the short term. If you operate efficiently, you will be able to turn profitable in the longer term. Three of our four plants have started making profits. 

China Knowledge at Wharton: Many people are concerned that if the water market is dominated by private companies, the price of water could rise rapidly. 

Wen: This argument is entirely groundless. The price of water is still controlled by the government, not by the private companies. The regulator can always set a ceiling on price. 

Even without the regulator’s involvement, water prices will be limited by competition. China is a vast country; one company won’t monopolize the entire region. The Sound Group has always priced water lower than competitors. 

China Knowledge at Wharton: There is news that the water price will be raised? 

Wen: In the past few years, regulators have controlled the water price because of the high consumer price index in many regions. However, based on operating cost, there is the need to raise the price. If the new water treatment standards are implemented, plants will need to invest more and there will be a greater need for increasing prices. 

China’s water price is relatively low compared to global markets. I expect China’s water market will experience value return and price increases. The reasons are cost increases and quality improvement.

Some of the state-owned enterprises have poor operating efficiencies and investment constrains. We need structural reform in the water industry. 

China Knowledge at Wharton: Are there any policy barriers for private capital entering the water business?

Wen: In terms of laws, there is no barrier. However, there are glass ceilings. Many stakeholders are obstructing the opening up of the market. Some government officials think that the water business is not suitable for private ownership because of concerns on water quality and service quality. These concerns are unnecessary. 

China Knowledge at Wharton: At one time, foreign companies like Veolia Water from France had purchased water assets in China at a hefty price. Has the market returned to normal now? 

Wen: Foreign companies were aggressive five years ago. After the global financial crisis, state-owned Chinese companies have been aggressive in acquisitions. They irrationally drive up the price of assets and people. They don't bother over whether they have enough technology and management bandwidth. They don't have long-term plans. They have a mindset of invest now, IPO [initial public offering] next. Although the water business is a capital intensive industry, money is definitely not its core competitiveness. 

China Knowledge at Wharton: Water assets are seen as hardly distinguishable from one company to the other. So capital is important, isn’t it?

Wen: This is a misreading of our industry. Normal investors ask a simple question: The state-owned companies have heavyweight shareholders. So what do you have while bidding for projects? They have cheaper financing cost, too. How do you compete with them?

But your assets have to compare with your cash flows. When they don't, [because of inefficient operations], your financial statements will look bad. You will have difficulties raising financing the next time. No matter how much money you have now; there will be an end to the game. It’s useless even if you are a good storyteller. 

China Knowledge at Wharton: But with lower capital, how do you compete with others? 

Wen: We acknowledge our disadvantages on financing. However, we know how to set the rhythm and intensity of investment. We won’t acquire assets at inflated prices. To survive is the first priority. After that, we look for growth. Many companies have come and gone in the past decades. We are still in the market. The Sound Group will have its 20th anniversary in 2013. 

In the water market, private sector companies are relatively weaker. We have to face the reality and know who we are. We have to know our capabilities and weaknesses, and gradually accumulate technology, assets and project reputation. 

China Knowledge at Wharton: Why are you diversifying into lithium batteries? 

Wen: I am a big fan of great technology and great products. Apple is my favorite company. In the water market, nobody will appreciate you if you have good technology and good products. Lithium batteries have extensive uses. There will be great products as well. The investment is a few million yuan, which we can afford; a single sewage power project needs 1 billion yuan. Our lithium battery project gives us a business that is purely market driven, contrary to the water business, which is policy sensitive. 

China Knowledge at Wharton: You need to deal with the government on many issues. How do you handle government relationships? 

Wen: I know many government officials, but I am never too close to them. If they want to cooperate with us, that’s good. But in any cooperation, both parties are equal. If they don’t want to cooperate with us, I would rather go. We make our lives on technology and capability. The nature of running a business is to make good products. 

China Knowledge at Wharton: What’s the most important principle of running a business? 

Wen: The most important thing is to know how to conduct yourself, and to have compassion toward others. I have my employees in my heart. They work for me, and I have to be responsible for them. I never sell my shares in the company. I always think of developing the company and making it better for everyone. 

Our compensation level is mid-market. But we have launched stock option plans. The cost of living is so high now, I am thinking of offering more. For example, we have reserved land in Hunan to build houses for staff members. 

We are honest to clients and investors. In bidding for a project, if our competitor quotes a low price, I will tell the client, "We apologize. We can’t do it at this price. But if you give the project to others who can do it at a lower price, we are happy for you.” 

China Knowledge at Wharton: Can you describe your management style?

Wen: I have no management style. I tend to delegate and allow people to make mistakes. People can learn to grow up after making mistakes.