Infrastructure like highways, railroads, harbors, and water supply and treatment facilities has a spillover effect to the nation's economy as a whole, and is open to the public use. Moreover, building infrastructure requires a huge amount of capital over a long period of time. Therefore, the infrastructure development has historically been the preserve of the government.

Infrastructure status quo

However, infrastructure projects exclusively financed by the public sector would create large fiscal deficits, or result in inefficient operation. Take an example of Korea, scant provision of social overhead capital (SOC) during the last decade has growingly become a bottleneck in the sustained economic growth. Accordingly, total logistic costs in the gross domestic product (GDP) increased to account for 14.3 percent in 1990 to 15.7 percent in 1994, and further to 16.5 percent in 1995. The trend is expected to continue until 2000 when the investment results and returns of large-scale SOC investments since the mid-1990s become visible.

In retrospect, a genuine effort to build infrastructure began in the early 1960s, when the nation first instituted the economic development plan. The entire effort was aimed at the single goal of carrying out the export-oriented industrialization policy. Two instances from the 1960s are the expansion of Pusan Port and the completion of Seoul-Pusan Expressway.

Into the 1970s, the Korean government launched various projects to stimulate exports and to foster heavy and chemical industries. During that period, demand for roads, ports and electricity rose sharply so that more and more industrial complexes, highways, ports and multi-purpose dams had to be built. Despite these efforts, Pusan Port alone bore the burden of processing more than 80 percent of the import and export cargos. It was obvious that, because most industrial complexes had been built alongside Seoul-Pusan Expressway, balanced regional development had not been successfully accomplished.

In the early 1980s, the government realized that unbalanced regional development was a destabilizing factor in the further growth of the Korean economy. Thus, more attention was devoted to balancing the regional development of the East and the West. Industrial estates were constructed in those regions that had been neglected in the earlier era of economic development.

In the mid-1980s, the external conditions - low interest rates, cheap oil prices and favorable dollar rates - brought about fast prosperity into the nation's economy. Furthermore, successful hosting of the 1986 Asian Games and 1988 Seoul Olympiad added a momentum to infrastructure investments in both the public and the private sector.

Moving into the late 1980s, the economy had suddenly overheated, and the laborers demanded to take a bigger share of the pie in unprecedented labor strifes. The government had to allot more budget for the improvement of social welfare including housing, education and metro-subways, and there appeared a wide gap between the supply and demand of SOC facilities. Inadequate infrastructure resulted in an upsurge in distribution costs for producers as explained above.

According to a recent publication of the 1997 World Competitiveness Report issued by the International Institute for Management Development (IMD), the level of Korea's SOC investments stood very low compared with other nations, i.e., ranking 34th among 46 IMD-surveyed countries. For instance, the competitiveness of the Korean road system ranked 18th, railroads 17th, while coming in at the 43rd for distribution system.

As a result, increasing number of Korean companies are rushing to expand and relocate their manufacturing bases overseas to reduce production costs to the extent of worrying about "apprehensive industrial vacuum" in Korea.

Current Legal Framework

To ease fiscal constraints and enhance the efficiency of infrastructure operations, the private sector is obliged to shoulder a large share of the burden. In the East Asian countries, for example, the governments cover about two-thirds of SOC spendings. On the contrary, in Korea, of the total U$127 billion that is required for infrastructure investment during the 1992-2001 period, 63 percent is expected to come from the public sector.

Therefore, the government established the Act for the Promotion of Private Capital Inducement into SOC Facilities (hereinafter referred to as the "Private Capital Inducement Act" or the "Act") in 1994 to encourage private investment in SOC and to attract the private expertise and management skills to the construction and operation of SOC facilities. In general, the Act provides the following procedures and means to induce private capital to infrastructure investment.

  SOC Facilities
To begin with, the Act divides the SOC facilities into two categories( 2ев). Each of the SOC facilities has been defined by relevant laws. Category I consists of roads, railroads, metro-subways, ports, airports, multi-purpose dams, water supply and treatment systems, river structures, fishery harbors, garbage disposal facilities, telecommunication systems; while Category II includes power generators, gas supply facilities, combined energy facilities, computer networks, distribution centers, logistic terminals and warehouses, bus terminals, integrated land-and-sea passenger terminals, tourism promotion areas, on-street parking lots, city parks, livestock sewerage and sanitation facilities, recycling centers, sports complex, physical training facilities for youth, libraries, and museums.

Facilities in the first category should be owned by the state or local governments( 22), while those in the second category are open to private ownership. Recently the Act was amended to include night-soil processing facilities and international convention centers both in Category II, effective from November 29, 1997.

  Government Plan for Private SOC Projects
Each year, the government should comprehensively formulate a basic plan for private capital inducement for SOC facilities (hereinafter referred to as the "Basic Private Capital Inducement Plan") in order to promote balanced development of the nation, to enhance the competitiveness of industries and to improve the convenience and quality of life(Sec.4ич). The government need to exploit private expertise and management skills, while maintaining the public nature of the facilities, in conformity with the national economic plans and investment priorities(Sec.4иш). The Basic Private Capital Inducement Plan spells out the government policy statement, the desirable projects, investment terms and conditions, the operation and maintenance (O&M) of project facilities, the government incentives and supporting measures, and other necessary policy matters(Sec.5).

To review and screen the government policy, the Basic Private Capital Inducement Plan, major SOC project proposals and other necessary SOC matters, the Ministry of Finance and Economy is establishing and operating a deliberation committee on private capital inducement projects (hereinafter referred to as the "Private Capital Inducement Committee") chaired by the Minister of Finance and Economy, and assisted by professional advisers(Sec.6&7).

The recent amendment to the Act provides for initiatives of the private sector to propose an appropriate project which will be suitably implemented with private capital and under the private management, but excluded from the Basic Private Capital Inducement Plan(Sec.5-2).

[Figure] Work Flow of SOC Project Implementation See the KDB Focus, September 1997, p.20.

  Project Implementation Plan
In line with the Basic Private Capital Inducement Plan, the state or local government body (hereinafter referred to as the "Authority") should make out and publish the basic plan to implement SOC facility projects (hereinafter referred to as the "Basic Project Plan") when the Authority deems it necessary to induce private capital(Sec.8). The Basic Project Plan sets forth in the proposed project along with its site, total costs, construction period, incidental income-generating activities, the incentives and supporting measures, O&M conditions of the project facility, qualifications of the project company, and other necessary matters(Sec.9ич).

The Authority should provide a level of consideration to small and medium-sized enterprises in working out the Basic Project Plan(Sec.9иш). As in the case of the Basic Private Capital Inducement Plan, the private sector may propose an adequate project that can be implemented under the private initiatives, but not contained in the Basic Project Plan(Sec.8иш).

When private companies tender proposals for project implementations, the Authority should review and screen each of the proposals, and select a qualified and suitable project company, subject to the deliberation of the competent committee (hereinafter referred to as the "Deliberation Committee") as the case may be(Sec.12).

The Authority may divide the whole project into several parts, one of which would be implemented by a private company or companies, based on its functions, facilities or blocks(Sec.13).

When the Authority awards concession, the project company should prepare a project implementation plan to get the Authority's authorization(Sec.14ич), or enter into a project implementation agreement or a "concession agreement" with the Authority. The same procedure is applied to the project company when changing the project implementation plan. When the Authority makes public the authorized project implementation plan(Sec.14иш), the pertinent authorization, approval or permission is deemed to have been acquired and noticed in accordance with relevant laws(Sec.15ич).

  Legal Nature of the Project Company
Like an ordinary project financing, the Act is most concerned about the project company, not sponsors who actually push ahead the project. To clarify the nature and obligations of the prime mover of a project, the Act demands that the project company should form a legal entity, i.e., a stock company or a limited company(Sec.2).

It means that, in Korea, an individual, a consortium or an unincorporated joint venture are not permitted to implement SOC projects. However, the project-company-applicant may be a joint venture or a consortium of companies, until it is awarded a license to implement the project. When a group of companies form a consortium to pursue an SOC project, the Authority usually demands that one sponsor should take the lead, i.e., holding more than 25 percent of equity, and big three control more than half of the total shares.

In case of Category II facilities, the public sector such as the state or local governments may join a project company holding less than 50 percent of equity(Sec.44). It is usually called a "third-sector" financing. In reality, some municipalities are planning to establish telecommunications and multimedia R&D centers with private partners.

  Privileges of the Project Company
The project company may enter or temporarily use private premises, and change or remove the structures thereof as permitted by relevant laws( 16). The project company is entitled to use the state or local government-owned land free of charge until the facility is completed(Sec.17), and also to expropriate the private-owned property in accordance with the Land Expropriation Law(Sec.18). If necessary, the company may entrust the Authority or the local government with the job to purchase land, to compensate for losses, if any, and to help the inhabitants move out of the project site(Sec.19).

The Authority may allow the project company to pursue sources of ancillary revenues along with the core activity of the concession(Sec.20ич). In case of a project to build a toll road, for example, the project company may be given permission to develop adjacent land for rest areas and to run restaurants, gas stations and motels. The project company may engage in housing development undertakings to build houses and commercial buildings. Such ancillary activities could diversify the sources of income and contribute to the overall profitability of the project. Anyhow, the ancillary activity of the project company should be stipulated in the Project Implementation Plan subject to the approval of the Authority(Sec.20иш), which is deemed to replace the approval or permission of the authorities concerned under relevant laws(Sec.20ищ).

Financially, the project company may apply for government subsidies or long-term loans(Sec.45) offsetting the losses caused by the lower price or revenue from Category I facilities than initially expected. The company is eligible for commercial loans from overseas financiers(Sec.46). Also it enjoys some exemptions from limitation of the aggregate equity participation amounts under the Anti-Monopoly and Fair Trade Law(Sec.47), mandatory dividend for the public sector shareholder of the "third sector" company under the Commercial Code(Sec.48), or any pecuniary encumbrance on the landlord in accordance with relevant land development laws(Sec.49).

In particular, the state or local government may afford tax exemptions to the project company if permitted by the tax law(Sec.50). As the newly amended Act notes, if the company has been formed to exclusively implement the project specified by the Authority(Sec.12-2), it would be eligible for the preferential corporation tax rate. The company is strictly prevented to conduct any other business than the Authority has licensed.

  Transfer and O&M of the Project Facilities
When the construction is completed, the project company should submit the completion report to the Authority, and let the Authority check and test the completed facility in accordance with the concession standard and quality(Sec.21).

Upon the completion of Category I facility, its ownership including related assets and premises is automatically transferred to the state or local government, while the project company is allowed to maintain the ownership of Category II facility(Sec.22).

As for Category I facility, the project company is allowed to use and benefit from the facility to the extent of possible recovery of the total investments including, but not limited to, construction costs, design and engineering fees, compensations to landlords, facility operation costs, taxes and duties, and reasonable profits, as specified by the enforcement decree(Sec.23ич).

The concession period should be set by the Authority in advance(Sec.23иш). When the cost overrun or force majeure takes place, the Authority may extend the period after discussion with the Deliberation Committee(Sec.23иш). During that period, the project company may lease the facilities within the purview of its rights(Sec.23ищ).

As the project company is entitled to operate and manage the state or local government-owned facilities free of charge, and collects toll or tariff from users during the concession period, a build-transfer-operate (BTO) scheme, rather than an ordinary BOT method, is required by law in Korea as far as Category I facilities are concerned(Sec.24). On the other hand, a build- own-operate (BOO) scheme applies to Category II facilities.

The right to operate and maintain SOC facilities (hereinafter referred to as the "O&M right") should be filed in the registration book of the Authority. The Act provides for the O&M rights that shall be treated as the right in rem or the right on land(Sec.25). Therefore, the creation, change or termination of a mortgage against the O&M right should be registered at the Authority(Sec.26). In other words, the O&M right could be offered to financiers as a collateral.

  Price Setting of the Project Facilities
The project company may charge users a price or tariff, and its formulae and collection method must be reported to the Authority in advance(Sec.28ич).

If the price setting or collection method causes a great deal of trouble and inconvenience to the users, the Authority may change such encumbrances after consultation with the company(Sec.28иш).

Price setting and price increases are usually stipulated in the Authority's concession or the project implementation agreement. However, the prices in nature must not exceed the amounts needed to recover the total costs and leave a reasonable profit. On the contrary, if the Authority determines a price below the break-even point owing to social concerns, such being the case with toll roads around the big city, the state or local government is required to pay the difference(Sec.45). Generally, the Authority may set a reasonable price reflecting the circumstantial changes including cost overrun and interest rate hikes, which were hardly expected at the time of concession award.

  Infrastructure Credit Guarantee Fund
The Private Capital Inducement Act has established the Infrastructure Credit Guarantee Fund (hereinafter referred to as the "Fund"), which is managed by three financial institutions, i.e., the Korea Development Bank, the Credit Guarantee Fund and the Technology Credit Guarantee Fund(Sec.29). The Fund operation is controlled and supervised by the Private Capital Inducement Committee(Sec.6ее) as a whole.

The Fund was designed to prompt financiers to extend credit to project companies which have difficulties in securing funds because of their lack of credit and collateral.

Its main function is to guarantee the repayment of loans for project company borrowers with weak credit standing(Sec.31). Sources of the Fund are contributions from the state or local governments, borrowings from financial institutions and other public funds, and earnings from its operations(Sec.30).

  Supervision of Project Implementation
The Authority is responsible for adequate control and monitoring of project implementation( 40). In doing so, the Authority may obtain periodic reports from the project company, examine on-site project facility, and have access to all documents and records of the company(Sec.43).

When the project company violates the Act or the Authority's order under the Act, or delays or ceases to implement the project intentionally without any reasonable cause, the Authority may withdraw the concession, change or stop the project or demand to restore to the initial state(Sec.41).

Furthermore, the Authority may demand that the project company should change or stop the construction if the situation surrounding the project facilities or the public interest so requires(Sec.42ич). The Authority should make a reasonable and proper compensation to the project company that suffers loss as a result of the above Authority's decision(Sec.42ищ).

How to Finance SOC Investment

In a traditional infrastructure development, the state or local governments take the responsibilities of implementing the project and obtaining funds out of the public budget. However, in a BOT scheme, it is the project company that assumes such responsibilities. Commercial loans are made against the project's anticipated cash flows.

In a BOT project, as explained before, the project company undertakes to complete a construction and to operate the facility for a certain period of time with an aim to recoup its costs and make reasonable profits.

Thus, the project company has a clear interest in the feasibility of the project. The company also has an interest in securing that the legal and commercial conditions for construction and profitable operation of the facility are set in place and will remain basically unchanged throughout the period of the concession.

It is usually difficult to acquire funds for SOC projects because lenders are not readily attracted to such projects of huge capital requirements with substantial risks. To make an infrastructure project feasible, it is essential that the project risks shall be allocated and distributed reasonably among major participants.

At this point, banking institutions step in as a coordinator between private investors and the host government on infrastructure projects. If the project risk is too high, then the bank suggests the host government to guarantee a minimum level of revenue, prevent alternative competing facilities, or extend the concession period in case of force majeure.

A bank acts as a third-party intermediary to accommodate the interests of all parties involved. A syndicate of banks can exploit vast resources by utilizing a variety of financial techniques that can be tailored to the needs of individual investors.

The Private Capital Inducement Act has a list of banking institutions that provide funds to SOC projects such as commercial banks, development banks and trust companies. The newly amended Act added insurance companies and merchant banks to the above list(Sec.2xv).

Recently the government has allowed the project company engaged in the construction of Category I facilities to obtain foreign capital for the project payment up to 20 percent of total construction costs, and the importation of equipment within a certain amount per year under the Act for Foreign Direct Investment and Foreign Capital Inducement.

To mobilize funding sources to the maximum, the project company or participating financiers may issue SOC-purpose-only bonds(Sec.50-2) effective from November 29, 1997, which are eligible for the separate taxation for big financial assets holders, and much lower income tax rate.

Conclusion

In 1996, the United Nations Commission on International Trade Law discussed the BOT concept and BOT legislation of its member countries. In view of the Commission report dated of April 19, 1996 (A/CN. 9/424 which is easily found at http://www.un.or/law), the Private Capital Inducement Act of Korea is well-equipped with clarified procedures, competent government bodies, various attractive means and measures, and so on.

But there are few provisions concerning the concessions that a host government undertakes to make the infrastructure project feasible and bankable. Thus, the project company or a financial institution is not able to claim support from the host government because of lack of legal grounds. Unless the government positively commits itself in an individual SOC project, the project company or financiers will assume the risk of uncertainty and unprofitability of the project, which might lead to a failure.

At the same time, it should be noted that the government holds the position as a "visible hand" to prevent private investors from concentrating on a few highly profitable SOC facilities. Banking institutions, for their part, ought to help private companies to invest more in infrastructure by devising innovative and favorable financial instruments and services.

The important factor in BOT financing is the potential for mobilizing private sector resources for infrastructure developments without the need of raising public debt. This element of the BOT concept is particularly attractive in view of worldwide trend in privatization of various utilities and services previously supplied by the government, and decreasing availability of public SOC investments.

In an increasingly globalized world, another advantage is higher potential for foreign direct investments, and access to technologies and management skills not available locally. The expertise accumulated in the course of pursuing large-scale SOC projects must be invaluable in preparing for the unification of Korea in the near future.
(Source: KDB Economic & Industrial Focus, September 1997; This article was also in the PFI Yearbook 1998, Project Finance International, pp.60-62.)