Financing Alternatives for Energy Cooperation in Northeast Asia

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Financing Alternatives for Energy Cooperation in
Northeast Asia
October 2002

• Jang-Yung Lee
• Senior Counselor to the Minister
• Ministry of Finance and EconomySeoul, Korea

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1. Need to Support North Koreas Economic
Development

• North Koreas transition to a market economy and
  opening to the outside need to be supported
• Northeast Asias 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

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2.Jump-start of Investment is necessary

• Need for infrastructure investment
• gt Return on other investment will be high
• gt Repair and rebuild the transport,
  communication, power and utilities urgent
• Investment in key productive sectors
• Assist with food security

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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,
  foreigners right to establish)
• Need to rely on official capital flows, for the
  time being
• gt Multilateral development banks (e.g. IBRD)
• gt Bilateral donor countries (e.g. Japan and
  South Korea)

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4. North Korean membership in IFIs

• Lengthy period of entry negotiation
• Obstacles in NKs membership negotiation
• gt lack of political consensus on substantial
  reforms
• (e.g., private ownership, decentralized
  decision-making)
• gt compliance with IFIs surveillance
  unacceptable
• (e.g., disclosure of key economic data and
  information)
• gt normalization of economic/financial
  relationship
• (e.g., the defaulted bank debt of 1970s
  owed mostly to the Japanese banks should be
  resolved first)

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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
• gt IBRDs definition Countries with
  widespread violence, armed warfare, or where the
  state has failed
• Examples of post-conflict infrastructure program
  
• gt IBRDs Special Trust Fund for Gaza and West
  Bank (1993), Bosnia and Herzegovina (1996)
• gt ADBs Post-conflict program for Tajikistan
  (1998)

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6. Cost of Infrastructure Investment

• General state of NKs infrastructure in 1998
• comparable to South Koreas 1975
• Estimate of the infra improvement (CERI)
• gt Target 80 19 tril. Won (Power 2.9
  tril.Won)
• gt Target 85 44 tril. Won (Power 7.3 tril
  Won)
• gt Target 90 72 tril. Won (Power 10
  tril.Won)

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7. Long-term Cost of Korean Reunification

• Dfn Extra fiscal need due to unification
• gt repayment of external debt in arrear public
  sector maintenance cost income subsidies cost
  of economic development
• KDIs estimate 400 trillion (US363 billion)
• Choi, Joonook (1997) US78 - 354 billion
• under 3 different scenarios regarding
  government investment for economic development

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8. Financing Alternatives

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

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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) projects own cash flows are important
• (3) alleviates investment risk thru risk-sharing
• gt facilitates public-private partnership
• (4) make possible low-cost financing
• (5) allow 3rd-party scrutiny of the projects
  merits
• (economic/technical feasibility analysis)

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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

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11. Sample Structure of Project Finance (1)
Advisory Contract
Costruction Contract
Partnership Agreement
OM Contract
Feedstock Contract
Finance Agreement
Off-Take Contract
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12. Sample Structure of Project Finance (2)
NK central govt (sponsor)
SK central govt (sponsor)
equity participation
Mitsubishi Engineering (constructor)
N.K.Power Co. (project company)
NK Authority (regulator)
construction
license
approve
lend
repay
Raw material
Off-take agreement
G.E (operator)
Western bank (syndicate)
Working capital
Shell Oil Co. (supplier)
KEPCO (off-taker)
Citi Bank (escrow account)
revenues
Repay debt svcs
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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
• Govts debt repayment capacity is limited
• can protect the sponsors capital base

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

• The project companys 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
• gt Possibility that electricity price will be
  politically set below the market prices
• gt Lenders may ask the NK governments guarantee
  against the default risk

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15. Major obstacles for PF in N.K.

• Legal and judicial framework do not exist in N.K
• gt contract may not be legally enforceable
• Unstable macroeconomic environment
• Inconsistent policy environment
• gt high political risk of change in laws and
  taxes
• How to mitigate project risks ?
• gt support from host government
• - guarantee against the political risk
• - assurance against the FX control
• - a grant of land free of charge, tax
  holidays, etc.

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Involvement of Multilateral Financial
Institutions in Developing Countries Project
Finance, 1994-97
(percent)
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
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16. How to mitigate project risks in North Korea

• Mitigate project risks (esp. political risk)
• gt use risk cover from OECD countries
• (e.g. U.S EXIM Banks political risk cover)
• gt transfer to multilateral organizations
• (e.g. IFCs partial risk guarantee)
• (e.g. MIGAs political risk cover program)
• gt transfer to private insurers
• (e.g. Lloyds of Londons underwriting)
• Financial advisors role is important
• gt arrange the contractually defined structure

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17. Rationales of Northeast Asian Development
Bank (NEADB)

• A supplementary source of development financing
• gt IBRD, ADB, EBRD are limited in loans and
  guarantees they can have outstanding
• Facilitate funding from other private investors
• gt catalytic funtion (confidence signaling)
• Provide political risk cover Coordination role
• gt Orchestrate the diverse activities of the
  P.F.