For discussion
FCR(98-99)12
on 3 April 1998

ITEM FOR FINANCE COMMITTEE

LOAN FUND
NEW HEAD WATER SUPPLY"
New Subhead Loan to the Guangdong Provincial People's Government for water quality improvement project"

Members are invited to approve the creation of a new Head "Water Supply" under the Loan Fund and, under the new Head, a new subhead "Loan to the Guangdong Provincial People's Government for water quality improvement project" with a commitment of $2,364 million to provide an interest-free loan to the Guangdong Provincial People's Government to help finance a works project in Guangdong to improve the quality of water supplied to Hong Kong.

PROBLEM

The quality of raw water supplied from Guangdong to Hong Kong has deteriorated in recent years due to fast industrial and urban development along the water supply system.

PROPOSAL

2. We propose to provide an interest-free loan of HK$2,364 million to the Guangdong Provincial People's Government (the Guangdong authorities) to help finance the construction of a new closed aqueduct for conveying water from the Dongjiang to Hong Kong.

JUSTIFICATION

Water Supply from Guangdong

3. Supply of water to Hong Kong from Guangdong is governed by an agreement signed between the Hong Kong Government and the Guangdong Provincial People's Government in December 1989. Under the Agreement, the Guangdong authorities will carry out extension works to the Dongjiang-Shenzhen Water Supply Scheme in order to increase the maximum designed capacity of the water supply system from the then 660 million cubic metres (mcm) to 1 100 mcm per annum to meet Hong Kong's projected needs beyond the year 2000. The Agreement provides that upon completion of the extension works, that is, from 1995 onwards, Hong Kong is contracted to take an annual supply quantity with an increment of 30 mcm each year. Thus, for the year 1995, the agreed supply would be 690 mcm (30 mcm over the maximum capacity of 660 mcm prior to the completion of the extension works). This will increase annually to 720 mcm for 1996, 750 mcm for 1997, and so on. The Agreement stipulates the annual supply quantities up to the year 2000, that is, at the level of 840 mcm. As regards supply for subsequent years, the Agreement provides that the designed maximum capacity of 1 100 mcm per year is planned to be reached by 2008. The two sides will decide through mutual consultation the annual increments of supply between 2001 and 2008. If the Hong Kong side is unable to provide a definite indication of the annual increments by then, the Guangdong side will continue to supply water at an annual increment of 30 mcm.

4. The Dongjiang-Shenzhen water supply system has been operating satisfactorily for over 30 years. In recent years, due to the rapid urban and industrial development along the existing open channel water conveying system , the risk of pollution to the supply of water to Hong Kong has increased. The Guangdong and Hong Kong authorities have reviewed the situation in their regular business meetings. Although the Guangdong authorities have taken some active measures on pollution control, it would require a more fundamental engineering solution in order to arrest the continuous trend of deterioration in water quality. Separately, owing to the relocation of industries to the Mainland, the water demand growth in Hong Kong has slowed down in recent years. There is thus an increasing concern about water overflow from local reservoirs in the wet years if the contracted annual increase in the quantity of water supply is not appropriately reduced.

The proposed Water Quality Improvement Project

5. In order to achieve significant and permanent improvements to the quality of raw water supplied to Hong Kong, the Guangdong authorities have, at the business meeting held in August 1997, formally put forward an engineering proposal to improve the quality of water supplied to Hong Kong. This involves the building of a closed aqueduct at an estimated project cost of HK$4,096 million in money of the day (MOD) prices. Upon completion, the project will effectively eliminate the risks of pollution along the existing open channel water conveying system. Subject to the availability of funds, the Guangdong authorities plan to start the project in late 1998 for completion by end 2002. To get the project off the ground, they have formally requested the Hong Kong Special Administrative Region (SAR) Government to provide an interest-free loan of HK$2,364 million to help finance the project. The loan amount requested represents Hong Kong's share of the design capacity of the Dongjiang-Shenzhen water supply system which also supplies water to Shenzhen.

6. Although the Guangdong authorities have contractual obligations to ensure that the quality of water supplied to Hong Kong is of acceptable standards as stipulated in the 1989 Agreement, we recognise the need for a long-term practical solution to the pollution problem. At subsequent follow-up meetings, the Guangdong authorities, led by the Director of Guangdong Provincial Bureau of Water Conservancy, assured us that they had carried out comprehensive research and study on the project and were fully confident that it would improve the quality of water supplied to Hong Kong. They further explained that the design and construction of the project would be in accordance with the relevant national standards and agreed to our suggestion to set up a joint design and construction technical liaison group to keep us informed of the progress of construction if the project were to proceed. The Guangdong authorities have also undertaken to ensure that the quality of the supply to Hong Kong after the commissioning of the project will be up to the standards stipulated in the 1989 Agreement or even higher.

7. In addition to the technical aspects of the project, the two sides discussed in detail Hong Kong's concern about overflow in our reservoirs if the contracted supply quantities were not appropriately reduced against a slowing down in demand growth. As a result, the two sides have agreed a package of measures to address both the quality and quantity issues with a view to improving the water quality and reducing potential overflow in our reservoirs.

Reduction in Water Supply

8. The Guangdong authorities have agreed, in return for an interest-free loan of $2,364 million, to reduce the annual increase from a committed 30 mcm to 10 mcm from 1998 to 2004. As a result, there will be a total reduction in supply of 560 mcm over the period, as shown below -

Year

Original quantity
based on the 1989
Agreement
(mcm)

Proposed revised
quantity
(mcm)

Reduction
(mcm)

1998

780

760

20

1999

810

770

40

2000

840

780

60

2001

870

790

80

2002

900

800

100

2003

930

810

120

2004

960

820

140




____



Total

560




____

Apart from addressing the overflow problem, the reduction in water supply will result in very significant savings to the Hong Kong SAR Government. Based on the unit price of water agreed for 1998 and an assumed annual inflation adjustment of 8.65% (which is the rate agreed in the latest round of negotiations on water unit prices), the total savings in recurrent expenditure arising from the above-mentioned reduced supply are $2,240 million in MOD prices.

9.As for annual supply quantities after year 2004, the Guangdong authorities have undertaken to take into account our future demand growth and reservoir storage situation in considering that supply. Both sides have agreed that this issue would be discussed at a later date.

Terms and Conditions of the Loan

10. Taking into account the significant financial benefits from reduced annual supplies, we support the provision of an interest-free loan of $2,364 million to the Guangdong authorities. The proposed terms and conditions of the loan to be specified in the loan agreement to be signed between representatives of the Hong Kong SAR Government and the Guangdong Provincial People's Government are as follows -

  1. the Guangdong authorities will draw down the loan in eight equal instalments in June and December each year, with the first payment to be made in December 1998;

  2. the Guangdong authorities will repay the loan in 20 equal yearly instalments starting from the commissioning of the project or year 2003, whichever is earlier;

  3. a joint design and construction technical liaison group will be set up, through which the Guangdong authorities will report the progress of construction to the Hong Kong authorities;

  4. the agreed annual supply quantities will be reduced as set out in paragraph 8 above;

  5. the Guangdong authorities will ensure that the water quality after the commissioning of the project will be up to the 1989 Agreement standards;

  6. the Hong Kong authorities may request a reduction in the agreed quantity of water supply if the quality fails to reach the required standards and may recoup the undrawn quantity at a later date; and

  7. the Guangdong side undertakes to take into account our future demand growth and reservoir storage situation in considering the supply quantities after 2004, and agrees not to insist on reaching the supply quantity of 1 100 mcm by 2008.

FINANCIAL IMPLICATIONS

11. Based on the proposed schedule for the loan to be drawn down and repaid as described in paragraph 10 above and the current "no gain, no loss" interest rate of 6.262% (calculated on the basis of the overall return on the Exchange Fund on a time-weighted basis), the total interest forgone from the proposed loan to the Guangdong authorities is about HK$2,000 million in MOD prices. This amount will be more than offset by the total recurrent expenditure savings of some HK$2,240 million in MOD prices arising from the reduction in water purchased from Guangdong.

12. Subject to Members' approval, we shall provide the funds for making the first payment of $295.5 million to the Guangdong authorities in December 1998 under delegated authority. We will include the required sums in future Estimates of the Loan Fund.

Implications on Fees and Charges

13. The interest-free loan itself will have no implications on water tariffs. The savings in recurrent expenditure arising from the reduction in the agreed annual quantities of water to be purchased will lead to lower operating costs of the waterworks from 1998 to 2004. We will take this factor into account when considering future tariff revisions.

BACKGROUND INFORMATION

14. In accordance with the 1989 Agreement on water supply from Guangdong, the Hong Kong delegation led by the Secretary for Works and the Guangdong delegation led by Director of Guangdong Provincial Bureau of Water Conservancy hold business meetings annually to discuss all matters in relation to the supply of Dongjiang water from Guangdong to Hong Kong. The annual water supply quantities and the water quality problem have been matters for discussion, amongst other issue, at these meetings.

15. On 4 November 1997, the Executive Council ADVISED and the Chief Executive ORDERED that subject to funding approval by Finance Committee, the Administration should accept in principle the Guangdong authorities' request for an interest-free loan to help finance their water quality improvement project and to negotiate with the Guangdong side the terms of the loan agreement. Negotiation sessions were held during the period 17 to 21 February 1998.


Works Bureau
March 1998