Financing Alternatives for Energy Cooperation in Northeast Asia

Jang-Yung Lee

Senior Counselor to the Minister

Ministry of Finance and EconomySeoul, Korea

October 2002

1. Need to Support North Korea’s Economic Development

• North Korea’s transition to a market economy and opening to the outside need to be supported

• Northeast Asia’s investment climate be improved

• Political stability on the Korean peninsula depends on a progress in economic development

• Hopes for the Korean reunification can be raised

2.Jump-start of Investment is necessary

• Need for infrastructure investment

=> Return on other investment will be high

=> Repair and rebuild the transport, communication, power and utilities urgent

• Investment in key productive sectors

• Assist with food security

3. Prospects of Private/Official Financing

• Flows of private investments likely to be small will take years to create minimum necessary confidence

in the North Korean economy * East European countries took 7-8 years of reforms** TRDP failed because of the uncertainty in policies (esp. trade,

movement of people, foreigner’s right to establish)

• Need to rely on official capital flows, for the time being => Multilateral development banks (e.g. IBRD)

=> Bilateral donor countries (e.g. Japan and South Korea)

4. North Korean membership in IFIs

• Lengthy period of entry negotiation

• Obstacles in NK’s membership negotiation => lack of political consensus on substantial reforms

(e.g., private ownership, decentralized decision-making) => compliance with IFIs’ surveillance unacceptable (e.g., disclosure of key economic data and information) => normalization of economic/financial relationship (e.g., the defaulted bank debt of 1970’s owed mostly to the J

apanese banks should be resolved first)

5. Is special assistance program for non-members available to NK?

• Is North Korea eligible for Special Trust Fund ? • Reconstruction support designed for the post-conflict

countries => IBRD’s definition: Countries with widespread violence,

armed warfare, or where the state has failed

*Examples of post-conflict infrastructure program

=> IBRD’s Special Trust Fund for Gaza and West Bank (1993), Bosnia and Herzegovina (1996)

=> ADB’s Post-conflict program for Tajikistan (1998)

6. Cost of Infrastructure Investment

• General state of NK’s infrastructure in 1998

: comparable to South Korea’s 1975

• Estimate of the infra improvement (CERI)

=> Target ‘80: 19 tril. Won (Power: 2.9 tril.Won)

=> Target ‘85: 44 tril. Won (Power: 7.3 tril Won)

=> Target ‘90: 72 tril. Won (Power: 10 tril.Won)

7. Long-term Cost of Korean Reunification

• Dfn: Extra fiscal need due to unification => repayment of external debt in arrear + public sec

tor maintenance cost + income subsidies + cost of economic development

• KDI’s estimate: 400 trillion (US$363 billion) • Choi, Joonook (1997): US$78 - 354 billion under 3 different scenarios regarding government i

nvestment for economic development

8. Financing Alternatives

• Use of the two S.K’s government funds => South-Korea Cooperation Fund (SNCF) : 500 billion won => EDCF, pending diplomatic normalization • Assistance from Japanese government => Post-war indemnification ($5 – $12 billion?) => ODA fund flow to N.K• Assistance from multilateral organizations => membership is required

9. Project Financing As an Alternative

• Valuable tool for infrastructure investment

(1) finance large high-risk projects without extra sponsor guarantee (limited-recourse financing)

(2) project’s own cash flows are important

(3) alleviates investment risk thru risk-sharing

=> facilitates public-private partnership

(4) make possible low-cost financing

(5) allow 3rd-party scrutiny of the project’s merits

(economic/technical feasibility analysis)

10. Sample Structure of Project Finance

• Risk Allocation Scheme

(1) Cost-overrun risk with the contractor (2) Operation risk with the operator (3) Market risk with the long-term off-taker (4) Financing risk with investors and lenders (5) Supply risk with feedstock supplier (6) Political risk with various insurance agencies

11. Sample Structure of Project Finance (1)

Contractor

Financial Advisor

EquityParticipants

Operator

Feedstock Supplier

Off-TakeAgreement

Investors

Lenders

PoliticalRisk Cover

ProjectCompany

CostructionContract

AdvisoryContract

PartnershipAgreement

FinanceAgreementOff-Take

Contract

FeedstockContract

O&MContract

12. Sample Structure of Project Finance (2)

NK central gov’t(sponsor)

SK central gov’t(sponsor)

N.K.Power Co.(project company)

NK Authority(regulator)

MitsubishiEngineering(constructor)

G.E(operator)

Western bank(syndicate)

KEPCO(off-taker)

Citi Bank(escrow account)

Shell Oil Co.(supplier)

equity participation

license

approve

construction

lendRaw materialOff-take agreement

Workingcapital

revenuesRepay debt svcs

repay

13. Special Relevance of PF for North Korea (1)

• Make long-term financing available to large-scale infrastructure projects in a country where

perceptions of project risk remain high : those projects without any prior track record

Govt’s debt repayment capacity is limited :can protect the sponsor’s capital base

14. Special Relevance of PF for North Korea (2)

• The project company’s right to build and operate the plant can be assured

Through Build-Transfer-Operate (BTO) contract

• If the power off-taker is a NK entity, its default risk gets higher

=> Possibility that electricity price will be politically set below the market prices

=> Lenders may ask the NK government’s guarantee against the default risk

15. Major obstacles for PF in N.K.

• Legal and judicial framework do not exist in N.K => contract may not be legally enforceable• Unstable macroeconomic environment • Inconsistent policy environment => high political risk of change in laws and taxes

How to mitigate project risks ? => support from host government - guarantee against the political risk - assurance against the FX control - a grant of land free of charge, tax holidays, etc.

SectorCountry risk grade

80-60 60-40 40-20 20-0

Water and Sewerage 0 29 89 100

Road and rail 11 11 78 0

Agriculture 0 0 60 100

Oil and gas/upstream 0 25 40 60

Mining 0 26 30 71

Property 0 3 56 50

Power 22 27 51 38

Oil and gas/downstream 6 22 35 20

Telecommunications 0 21 29 25

Manufacturing 6 10 17 29

Transport/shipping 0 0 30 21

Total 45 174 515 514

Involvement of Multilateral Financial Institutions in Developing Countries’ Project Finance, 1994-97

Note : Percentage of transactions in which a multilateral of bilateral agency or an expert credit agency Participated. Country risk ratings are Institutional Investor ratings.Source : Oliver Wyman and Company, based in Capital DATA Project Finance Ware

(percent)

16. How to mitigate project risks in North Korea

• Mitigate project risks (esp. political risk) => use risk cover from OECD countries

(e.g. U.S EXIM Bank’s political risk cover) => transfer to multilateral organizations (e.g. IFC’s partial risk guarantee) (e.g. MIGA’s political risk cover program) => transfer to private insurers (e.g. Lloyd’s of London’s underwriting)• Financial advisor’s role is important

=> arrange the contractually defined structure

17. Rationales of Northeast Asian Development Bank (NEADB)

• A supplementary source of development financing => IBRD, ADB, EBRD are limited in loans and guar

antees they can have outstanding

• Facilitate funding from other private investors => catalytic funtion (confidence signaling)

• Provide political risk cover & Coordination role => Orchestrate the diverse activities of the P.F.