Secure investment strategies (2)

Far from serving China’s interests, protectionism in the water sector is stifling innovation. In the conclusion of a two-part article, Hu Yusha says it’s time to let more foreigners in.

Politically ambitious regulations in China have created wastewater-discharge standards that are comparable to those in developed countries. Accordingly, the level of technology and the operational knowledge and management required to meet these standards is significant. By raising standards and, eventually, requiring compliance, the government is creating demand for advanced wastewater-treatment technologies. This, somewhat paradoxically, creates another challenge for China’s water sector development.

The demand created by high standards will need to be met. However, low water prices and state-owned infrastructure have historically prevented China from being a leader in water technology, creating a vacuum of domestic expertise. Up to the present, China has responded to this problem by intently fostering local companies and actively protecting them from foreign competition. Notably, China has not joined the World Trade Organisation’s Agreement on Government Procurement, leaving them free to bar foreign companies from bidding on government contracts.

While China does not have the capacity to completely replace foreign vendors, especially in the manufacturing of advanced water-treatment technology, there has been a concerted effort to set limits and encourage domestic innovation wherever possible. In 2006, the Ministry of Construction estimated foreign financing in the industry to be less than 10%. In contrast, foreign players constitute 40% of China’s automotive market.

This protectionist approach has its roots in the larger issue of national security. Because water is essential to China’s social stability, economic growth, food security and public health, it is itself a national security issue. The natural implication of this categorisation is that China cannot be dependent on foreign entities for the operation or expansion of its water infrastructure without endangering its national security – and so it is of crucial importance that China fosters and protects its indigenous companies. The steps taken so far to protect and encourage the development of local expertise demonstrate the consequences of this perspective.

Most recently, China has strengthened its policy position with the National Indigenous Innovation Product Accreditation Programme to accredit indigenous products, launched in November of 2009. The scheme gives stated preference to a specific list of accredited enterprises in government purchasing and contracting. Accreditation requires a company to be a legal entity in China and the products it offers must also be sourced from domestically owned intellectual-property rights and not be subject to any foreign restrictions. These requirements make it extremely difficult for foreign companies to reach the preferred list, dramatically reducing the already limited opportunities.

Foreign players in China participate in water-infrastructure development through a complex set of joint venture requirements that are designed to limit foreign control while maximising technology transfer to local firms. They include build-operate-transfer agreements (BOT), public-private-partnerships (PPP), and an array of joint venture (JV) structures that typically require majority ownership to be Chinese. The goal of this system is both to regulate the amount of foreign competition and to force those that are involved to help their domestic competitors.

The emphasis on technology transfer has been largely successful, with a joint venture between Japan’s Toray Industries and China National BlueStar signed in 2009, creating the first water-treatment membrane manufacturer in China. Membrane technology is a key component of water and wastewater treatment and seawater desalination, making this milestone particularly significant. As a result of years of sustained technology transfer and preferential government policy, domestic players are becoming increasingly viable competitors to global companies also seeking to capture a piece of the Chinese market.

A dynamic balance needs to exist between national security concerns and the benefits that foreign expertise and investment can bring. As the water market evolves, the optimal balance between these two competing forces will naturally shift, moving away from tightly controlled protectionism towards a competitive market. China’s discharge standards for wastewater are on par with those of developed countries, challenging China to meet international standards within the next few years. Domestic companies must rise to the level of global players, building an international reputation for high-quality, cost-competitive and advanced technology. They simply cannot be effective international competitors if they continue to enjoy the advantages of an uneven playing field at home.

In the long term, China has no choice but to become a global leader in water infrastructure and water technology. The policy imperative is very much backed up by an environmental ultimatum. Climate change threatens to place further pressure on water-stressed northern China, with changes to monsoon patterns reducing rainfall in the parts of the country that are already under the biggest strain. Water availability in some areas is comparable to that of Israel and Australia – countries that have, out of necessity, become global leaders in water technology. Israel has pioneered emerging technologies such as desalination and highly-efficient drip irrigation, while Australia is a leader in water re-use. The scale and severity of China’s problems mean it will also have to become a leader in water-resource management and technology.

Currently, it is far from that vision. China largely remains a market for conventional water technologies, with limited demand for newer methods. Its 641 small and medium-sized cities struggle to reach 50% wastewater treatment and often have leaky distribution or collection systems. Inadequate price signals and standards have stymied growth in more emergent fields. In such a climate, it would be difficult for the marginal benefit of advanced technologies, such as microfiltration or smart metering, to outweigh the gains from basic fixes that increase the amount of wastewater receiving any level of treatment and address gross inefficiencies. Nonetheless, the level of local innovation needs to increase for China to meet its long-term needs. The speed at which that innovation occurs will be profoundly influenced by the role that foreign expertise plays in the Chinese market.

A constructive role for foreign players allows China to capture and transfer technological, operational and management know-how, lessen the financial burden on the government and achieve policy goals without compromising the development of the local water industry or increasing the financial burden on its citizens. In a Chinese study examining existing instances where foreign firms are allowed to operate and own water infrastructure in China, no significant difference was found between the price that end-users pay for water from foreign utilities and water from domestic utilities, suggesting that the impact of a shift in policy would be felt largely by local competitors and not the local populace.

As the World Bank recommends, foreign-domestic collaboration should be designed not simply to maximise the transfer of technology but also the transfer of operational and managerial know-how. Technology alone is not enough. A 2004 report by the National Auditing Office stated that 60 out of 78 audited wastewater treatment plants were underutilised due to lack of operating funds or delays in construction of ancillary facilities. Sub-standard construction, engineering and procurement often result in facilities that are too large for their market and too poorly connected to receive wastewater from the collection system. Strong incentives that emphasise good operations and management are necessary.

China should also embrace opportunities for the joint design, development and deployment of new technology. Cooperation between local and international firms provides an additional avenue for the development of new technology and invites participation from foreign players who may be wary of existing levels of intellectual-property protection. Furthermore, joint innovation helps China establish a global perspective and develop stronger domestic capacity by encouraging the export of Chinese technology and goods, allowing Chinese firms to work together with foreign firms to enter markets in places such as Africa, where China is already investing in infrastructure.

The degree to which China employs outright limits to foreign participation and engages in explicit prioritisation of domestic firms must decrease if the country is to meet its water-policy goals. Recent movement in the opposite direction, with the announcement of the National Indigenous Innovation Product Accreditation Programme, will make its already ambitious targets even more difficult to achieve. The current situation necessitates a change in the approach China’s government is taking toward the development of water infrastructure. China needs to step away from a protectionist stance and move toward a more global perspective, understanding that increasing foreign involvement will be a necessary part of strengthening China’s national water security.

Hu Yusha recently completed a Fulbright fellowship at the Division of Environmental Policy & Management of Tsinghua University in Beijing.

An earlier version of this article was published in China Security as “Foreign Investment in China’s Water Infrastructure: A New Strategy for National Security”. It is used here with permission.

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