Investors consider Chinese green technology companies attractive, as they generally offer a lower entry valuation than Internet enterprises and some consumer firms, and justifiably high growth predictions, according to a speaker at the recent “3rd Renewable Energy Finance Forum China 2008” convened in Beijing. A notable array of speakers laid out opportunities, risks and strategies facing investors chasing green gold in China, presenting an up-to-date snapshot of a fast-changing industry.
Excitement over the scale of the investment opportunities was balanced by awareness of the challenges – including barriers to competition; regulatory change; and the difficulty of connecting the renewable energy sources to China’s vested power infrastructure.
China’s green technology sector has come a long way in a few years. Most discussion at the first REFF China conference in 2005 centered on planning and developing renewable energy projects, says K.K. Chan, managing director for Greater China of for London-based Climate Change Capital. Now, many projects are up and running, and some investors are already receiving dividends, said Chan – double quick time for investment in infrastructure. He described the attraction of Chinese renewables investments: Besides being quick to execute, Chinese projects come cheap. A biomass power plant, for example, can be built in a third the time, and at a third the cost, as in the UK.
Much of the foreign investment in China’s green technologies is routed through the Clean Development Mechanism (CDM) established under the Kyoto Protocol, Chan said. The CDM allows industrial countries to offset their greenhouse gas emissions by purchasing Certified Emissions Reductions credits (CERs) from the developing world; China is now the world’s biggest base for CDM. Climate Change Capital, which is involved in private equity investments and project finance, anticipates that at least half of its new CDM-related investments will be in China.
Moreover, China’s green investment sector is receiving significant attention from venture capital (VC) and private equity (PE) investors. China surpassed the UK last year as the world’s second largest venture capital market. And, as the conference heard, venture capitalists’ interests are aroused by sectors growing many times faster than GDP, and renewable energy fits that bill. “PE and VC [financing] is very hot and growing,” said Chan.
Linda Cai, Head of China for Partners Group, said her firm has invested $1.5 billion in Asia, much of it in China, both directly and via investments in funds. Cai said that most of the funds the company has invested in have either already put money into what she describes as the “clean tech, environment, natural resource arena,” or are working out how to do so. Partners Group is looking to invest more in such companies, which Cai said generally offer a lower entry valuation than Internet enterprises and some consumer firms, and justifiably high growth predictions.
No Garden of Eden
Cai acknowledged that VC and PE’s encounters with renewables and clean tech in China have not been entirely smooth. “Probably, it is fair to say that clean tech and environment-type of investments are the hardest areas for the funds we have invested in and for ourselves as well,” said Cai.
This is, in part, a global phenomenon. “There’s a little bit of an identity crisis within venture capital right now,” explained Qiming’s Curtis. “VC is not really designed for financing projects: it’s more for building companies. So a lot of the sorts of investment risks that we’re willing to take on are more technology risks, or company formation risks.” In the energy sphere, however, investments progress quickly from early stage financing to project finance, as investors need to cough up more cash to maintain their stake. “As a venture capitalist, we’re trying to learn how to ride that curve,” said Curtis.
“I’m maximum bullish on Chinese renewables,” said Climate Change Capital’s Chan. “But at the same time, we also realize that there are a lot of potential difficulties.”
For instance, Chan said the lack of availability of Long-term Power Purchase Agreements (PPAs) – multi-year contracts in which the electricity buyers who own electrical distribution systems agree to buy power from an electricity generator – hinders the renewable generators’ financing ability..
Cathy Tang, senior legal advisor at Eversheds LLP in Shanghai, told China Knowledge at Wharton that there are a limited number of long-term (for example, four-year) PPAs available. “In most cases, the term is one year only, no matter whether it is a renewable energy project or coal fired energy project,” said Tang. The ability of project owners to negotiate longer PPAs will depend on their bargaining power with the grid company in question, she said, noting that one-year contracts have been the established norm within the industry, and state-owned grid companies are reluctant to overturn tradition.
“Without a long-term power purchase agreement in place at the early stage of their investment, foreign investors who have limited access to the grid company and the local authorities would be concerned as to whether they can ensure the sales revenue – and therefore investment return – of their power plant,” she said. In practice, however, whether and when a new plant can be connected to the grid may be a greater concern, she adds.
Despite regulations requiring grid companies to purchase all power generated from renewable sources, Climate Change Capital’s Chan described the problems China has experienced linking turbines to the grid: Many wind farms in Inner Mongolia, for instance, have been put on hold pending a study of the grid system in the province. Indeed, Shi Pengfei, the vice-president of China’s wind energy association, said in January that although China installed almost double its target for new wind power facilities in 2007, more than a quarter of its total capacity remained unconnected to the grid. Shi blamed bad planning and the grid’s resistance to wind power, according to news reports.
Chan outlined another cause for concern: Some wind farms are not being paid for their electricity. This is a problem, Chan pointed out, which has been known to drive foreign investors away from even the traditional coal-fired sector. Nevertheless, Eversheds’ Tang said that once both a grid connection and power purchase agreement (even if only short-term) are in place, the chances that the grid company will refuse to renew the agreement are low. This said, there is no guarantee that the grid company will not try to add new conditions when the agreement comes up for renewal, Tang said.
Regulations are another complication, pointed out Azure’s Terry. “One thing I would say is unique to China is they [regulations] change all the time,” said Terry. “And that provides many challenges to project investors or venture capital-like investors.” He added that China’s appetite for foreign investment tends to be cyclical, with enthusiasm giving way to increased protectionism. While in the past few years, China’s government and companies have been very hungry for foreign investment, Terry warned that “we’re starting to see that that’s shifting.”
Terry also noted that foreign investors face competition in China’s domestic market from vested interests. “Traditionally, the people who are selling products into the Chinese market are arms of subsidiaries of state owned companies, or very large Chinese companies,” he explained. “They have a lot of advantages in terms of access to companies, access to money vis-à-vis any entrepreneurs.” This means that foreign investors face a “very difficult fight” if they choose to compete with local companies in selling to the Chinese market, even if they have very good management teams. In other markets, superior technologies might trump this, but Terry noted that “we haven’t seen a lot of new technologies yet being developed in China.” Because they are flush with cash, he added, China’s established enterprises are better placed than foreign investors to introduce technologies that have been tried and tested in other countries.
Furthermore, Terry warned that the low cost of capital for state owned enterprises, together with a tradition of “copycatting,” tends to lead to rapid over-investment in profitable areas. Price competition ensues, with industries going from zero to over-capacity within a year or two.
Localization Is the Key
“Whether you can make money is a question of whether you are smart enough,” stated Climate Change Capital’s Chan, advising that localization is the key. “Localization can mean a lot of things. Localization of your staffing, your construction or procurement strategy or your financing.”
If the conference was anything to go by, new possibilities for localizing funds’ finances are generating much interest among green investors. Peter Corne, a partner and managing director at Eversheds in Shanghai, outlined the rise in popularity of investment funds denominated in Chinese Yuan. “There has been a little bit of a hiccup in how to structure venture capital,” he said. “And that’s because of the prohibition on ‘round tripping’ in 2006.” Round tripping refers to the practice of establishing a Chinese entity to take a share in an offshore vehicle, allowing it to be listed in China’s market. The system was “very successful,” Corne said, but central government approvals have all but dried up. This means that foreign funds have faced difficulties in bringing foreign capital to China and finding ways to attract local partners with the prospect of a fruitful exit.
However, things appear to be looking up. “One thing that escaped attention for a long time, and it’s just coming on-stream,” Corne told the conference, “is the concept of a [yuan] fund.” To date, only a small number of funds have been set up, but approvals have been forthcoming, and more such funds are in the pipeline. Corne pointed out that one of the advantages of this structure is that money can be raised from Chinese investors, offering the potential to tap into China’s $2.5 trillion savings.
Eversheds’ Cathy Tang explained that, thanks to regulatory reforms in recent years, foreign investment entities are now able to list on Chinese stock exchanges. While overseas IPOs are still possible, Tang said that most foreign VC funds currently considering setting up yuan-based funds plan to exit via an offering of their portfolio companies’ shares in either Shanghai or Shenzhen. “It should be noted, however, that the listing prices of Chinese companies (which are based on price-earnings ratios) have been very volatile in recent months,” Tang cautioned. Tang also warned investors to bear in mind regulatory risks, such as stringent domestic listing conditions.
Climate Change Capital is currently looking at setting up a private equity style fund denominated in yuan, Chan said. Financial localization could make the fund as local as any of its domestic competitors, he said, because it would offer advantages such as streamlined approval processing. Furthermore – and of particular relevance to foreign investors in Chinese renewable energy firms – Chan pointed out that such a vehicle could offer a way around another element considered by some as a barrier to foreign investment in renewables — the requirement that 51% of joint ventures’ operations under a CDM should be Chinese owned.
Looking to the future, speakers noted that there have been many rumors that China would establish its own carbon exchange, in Tianjin or elsewhere. This would increase the liquidity of carbon assets in China, pointed out Christopher Tung, a partner in the Hong Kong office of law firm Mallesons Stephen Jaques. However, Tung, who specializes in climate change and clean energy issues, noted that none of these rumored initiatives has yet borne fruit on the mainland. In contrast, Hong Kong appears to be moving towards establishing its own carbon futures exchange, Tung said. This bourse may begin operation this year.
Not everyone is convinced, however, that there is a need for a Chinese exchange, or that it could succeed. “It’s a market absolutely averse to risk,” said Enel’s Varrucciu of China’s carbon industry. In India, he noted, project owners commonly bear the risk of the project, and sell resulting credits once they are delivered. By contrast, forward sales of CERs (i.e., CER futures), are the norm in China: Carbon credit buyers must bear all risks, in areas such as approvals or technology, before the project gets underway. Unless this situation changes, Varrucciu believes China will face difficulties developing its own exchange.
As observers speculate on how things might look under a post-Kyoto regime, some in the industry are pinning their hopes on the future of voluntary credits as an alternative to CERs generated in the so-called compliance market. Speakers agreed that voluntary credits remain bedeviled by a confusing array of competing standards. Nevertheless, they could offer foreign investors in China an alternative to CDM, with its prescription of majority domestic control. “To grow the carbon market and to grow China’s share of the global market,” Tung noted, “you really need to look beyond the compliance market.”