Beijing's Brownout

A year ago, China looked like the El Dorado of the global power-supply industry. Goldman Sachs, American Insurance Group, and GE Capital were raising billions to finance its demand for electricity. Meanwhile, developers scrambled from one power-starved province to another signing huge deals. Hong Kong billionaire Gordon Y.S. Wu alone snared agreements for a dozen major projects.

That euphoria has faded. In early August, Wall Street greeted a public listing by Shandong Huaneng Power Development, a collection of existing power plants, with a shrug. Back in China, a squabble over how much foreigners should earn has left dozens of critical projects in limbo. Even Wu is threatening to walk away from a $2.2 billion deal because officials won't allow him to make at least an 18% return on equity. "They still look at foreign investment as exploitation," fumes Wu.

It's not just foreigners who are viewed with suspicion. Central planners also distrust the provincial officials who have signed many of the deals with foreigners. Beijing wants to maintain stable electricity prices and control inflation, but local governments need power fast--and are willing to pay high prices to get it.

Planners have picked a bad time to clog the electricity pipeline. Even as ministries hold up approval of more than 30 projects to build and operate major power plants, China believes it must add up to 15,000 megawatts of capacity annually for the next decade. That's about equal to two new conventional nuclear plants a month.

But foreigners may not stick around. While most investors seek at least an 18% return on investments in Chinese power plants, Beijing considers 12% to 15% to be adequate. Those rates have many balking. "Who is going to put [his] money into a plant with all of China's risks for a 15% return?" asks one Western banker. U.S. power-plant financing, considered very low-risk compared with China, fetches an average 10% return.

Making things worse is the political tug-of-war between provincial officials and Beijing over who controls the levers of the economy. Many of the deals on hold were arranged by local governments--sometimes against the wishes of planners in Beijing. "The freewheeling provinces can be thorns in the side to them," says James M. Polachek, senior East Asia analyst at Baring Securities Inc.

Moreover, Premier Li Peng, an engineer who formerly ran the Power Ministry, takes a strong personal interest in

the industry. Last December, he helped pull the plug on a project set up by Goldman, Sachs & Co., which had arranged to buy with other investors a 30% stake in a new company of an existing power plant. Concerned that Goldman would make a windfall return of at least 25%, an angry Li intervened to stop the deal, say rival investment bankers in Hong Kong and New York.

What's more, investing in China is looking riskier than ever. Fears of instability after the death of Deng Xiaoping, who recently turned 90, aren't the worst of it. As part of the country's financial

reforms, Vice-Premier Zhu Rongji recently ordered the Bank of China to stop providing funds or guarantees to power projects in rich coastal provinces, on grounds that ample private capital was available.

More worrisome are changes in China's foreign currency system. In the past, cities used foreign exchange holdings to service loans and pay for imported equipment. They even billed local factories in U.S. dollars. In April, China's central bank regained control of foreign exchange. Trouble is, local companies have long had problems getting foreign exchange when they need it from Beijing-controlled banks. So Western investors are insisting the government provide long-term guarantees that utilities will be allotted enough foreign exchange to repay their debts. So far, Beijing has refused.

COASTAL CRUNCH. But the most frustrating problem is the bureaucratic gridlock as planners debate how to deal with foreign investment. For now, they aren't focusing on the price of power and what types of fuel the plants will burn. Instead, "the Chinese are obsessed with the rate of return," says one investment banker in New York.

The brunt of Beijing's obstructionism will be felt in the booming coastal cities. A joint venture between General Electric Co. and Shanghai's municipal power bureau to build a 400-Mw oil-fired plant has been waiting 10 months for Beijing's go-ahead. "They needed the power this summer," says Delbert L. Williamson, president of GE's Industrial & Power Systems unit for Asia. "We could still get it commissioned in six months if the paperwork came through now."

Not that coastal cities will soon be left in the dark. As the big projects remain paralyzed in Beijing, small plants, typically with a capacity of 25 or 50 Mw and fired by imported diesel generators, are being built at a furious pace. That's because Beijing's approval usually isn't required for foreign investments under $30 million. Many earn returns of 20% to 25%. "We must be financing one of these a month," says Michael G. Thresh, Hong Kong-based director of project finance for Standard Chartered Bank, one of a club of about 40 European and Asian banks that dominate financing of small plants.

LACKLUSTER. Some foreign developers advise concentrating on those tiny deals that escape Beijing's scrutiny. "The bigger the project, the bigger the target for various people within China who can kill a deal," says Shawn Cumberland, a former partner of Denver-based Wing Group. He recently formed a Hong Kong-based company, ABC Development, to line up U.S. partners to focus exclusively on small plants. Meanwhile, Wing has been waiting about 18 months for Beijing's go-ahead on a $2 billion project in Henan province that would be 70% owned by a consortium of U.S. utilities and developers.

While small plants may meet immediate local needs, they're regarded as expensive and wasteful alternatives to big projects. Despite the Street's lackluster reception of the Shandong Huaneng listing, a handful of other power companies with existing plants are likely to go ahead with offerings. That won't be enough to pay for China's huge energy needs, though. As pressure mounts, some developers are betting Beijing will accept the foreigners' terms.

There are signs the Chinese are getting the message. The Coal Ministry is negotiating with a U.S. consortium to build a $900 million coal-slurry pipeline that would grant foreign majority control--and 20% rates of return. Ultimately, investors believe China will have to grant sweeter rates of return and better operating climates. Beijing is moving "toward returns people feel they need," says Thomas W. Widener, director of investment banking at Merrill Lynch.

Until then, Gordon Wu is looking elsewhere. He says he's focusing on such power-starved countries as Indonesia, where he recently signed a $1.8 billion power project. Wu is pursuing an even bigger deal in Pakistan. Unless the ideological battles end soon in Beijing, money once earmarked for China may go to places less suspicious of foreign devils.

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