MRG

MRG or minimum revenue guarantee (최소운영수익보장/最少運營收益保障) means the assurance of the central or local government's provision of the minimum revenue to the project company or sponsors of privately financed infrastructure projects (민자유치사업/民資誘致事業). In 1988, when the government encouraged private contractors and financiers to get involved in large-scale infrastructure projects like express highways, tunnels, bridges, harbors, etc., the MRG was introduced into the SOC regime in Korea.

Consequently, a number of unsolicited infrastructure projects (민간제안사업/民間提案事業) have been proposed and implemented by the private sector.

After completion, however, the turnover from such MRG-based projects proved more often than not far less than expected. So the government, central or local, is required to pay the difference between the forecast revenue and the real cash flows.

Facing the mounting criticism that MRG was aggravating the financial burden of tax payers and supportive to moral hazards of project sponsors, the controversial MRG was repealed for good in 2006.

Key words
minimum revenue guarantee, privately financed project, SOC, infrastructure

History
Since 1990s, the Korean government with budget constraints has expanded its social overhead capital (SOC, 사회간접자본/社會間接資本) facilities such as express highways, railways, harbors, school buildings, environment facilities, etc., which used to be built with government budget, by inducing private capital. Upon completion of such facilities, the project company transfers its ownership but is awarded the privilege to operate and manage the facilities for a period of 20 - 30 years so as to collect the initial investments and a certain profit. In many cases, the project company is established as a special purpose company (SPC) for non- or limited recourse financing (비소구금융/非遡求金融).

While the government, central or local, is in charge of planning, assessment, approval and financial suppot of the project, the private sector is responsible for the design, financing, construction and maintenance of the facilities.

Privately financed infrastructure projects were put into high gear by legislation:
 * In late 1994, the Act to Promote Private Capital toward SOC Facilities (사회간접자본시설에 대한 민간자본유치촉진법) was established as Act No. 4773 and came into force in November 1994.
 * In 1998, the Act on Private Investment in SOC Facilities (사회간접자본시설에 대한 민간투자법) was renamed since the private sector was reluctant to invest in infrastructure in the aftermath of the IMF Crisis, and, for the first time, introduced the MRG provision in December 1998. Also unsolicited infrastructure projects by the private sector were also encouraged since April 1999. In this connection, PICKO (Private Infrastructure Investment Center of Korea, 민간투자지원센터) was established under the Korea Research Institute for Human Settlements (KRIHS, 국토연구원) in March 1999.
 * In 2005, the Act was again amended into the Private Investment Act on Social Infrastructure Facilities (사회기반시설에 대한 민간투자법). Subject to the amendment to the Act in January 2005, PICKO was merged into PIMAC (Public & Private Infrastructure Investment Management Center, 공공투자관리센터) as a subsidiary of the Korea Development Institute (KDI, 한국개발연구원).

Concept of MRG
At the initial stage of privately financed infrastructure projects, the private sector contractors or financiers were seldom interested in such projects because of various project risks including insufficient cash flows below the construction cost.

If such project was deemed necessary to the public sector but the government could not implement the project with its budget, the government was willing to conduct the project with a kind of subsidy which was calculated as follows:
 * MRG amount = Expected revenue based on the minimum throughput forecasting - Realized revenue from the project


 * In case of MRG-based expressway where the average toll was forecast at 100 million vehicles a year, the MRG has been set at 90 million vehicles a year. When the real throughput turned out to be 70 million after completion contrary to forcasting, the local government has to pay the difference up to 20 million toll a year to the private project company.

See the exemplary SWOT analysis of the controversial Yong-In LRT case.

Previous MRG cases at issue
At first, the MRG was regarded inevitable to induce the private sector to large-scale SOC projects. But the more not-so-frequently-used SOC facilities increase, the more MRG difference should be paid by the government, regardless of central or local. So lawmakers as well as citizens found fault with the MRG regime.

The following MRG-based SOC projects are often at issue. And private financiers like Macquarie Korea Infrastructure Fund (MKIF or "Macquarie Infra Fund", 맥쿼리한국인프라투융자회사) are to blame by the press.

Gwangju 2nd Beltway
Gwangju Metropolitan City (the “Gwangju City”) filed lawsuit against Gwangju Beltway Investment Co., Ltd. (“Gwangju Beltway Investment”, 광주순환도로투자주식회사) over the issue of MRG of the Gwangju Second Beltway (광주제2순환도로). Initially Daewoo E&C and other contractors equity participated in the project company, which was later taken over and has been operated by Macquarie Infra Fund.

Gwangju Beltway Investment under the management of Macquarie Infra Fund intentionally lowered the equity capital ratio to 6.93 percent from 25 percent set forth in the initial project implementation agreement (사업실시협약) between Gwangju City and the project sponsors, and aggravated its financial status by borrowing high interest rate subordinated loans of 10.0 - 20.0 percent p.a. thus giving a great yield to its largest shareholder, i.e., Macquarie Infra Fund. As a result, Gwangju City had to pay additional interest up to 488 billion won until the maturity in 2028. Gwangju City demanded restitution of the financial structure of the project company asserting its structural change has been in breach of the project implementation agreement, but Macquarie Infra Fund refused it. Macquarie Infra Fund would not come to the negotiation over the MRG issue though Gwangju City had asked several times.

In February 2013, the court rendered a decision in favor of Gwangju City, and the prospects of other MRG-based SOC facilities, with which a number of local governments are troubled, remain to be seen.

The administrative panel of Gwangju District Court held:
 * "In case where the private project company has paid high rate of interest to major equity holders, changed the capital structure of the project company without the consent of the municipality for the benefit of major equity holders, and resultantly aggravated its financial condition, the competent administrative body is entitled legally to make a supervisory order to raise the capital adequacy ratio to 29.91 percent at the time of the initial project implement agreement. Gwangju City arranged to fix more than 25 percent of the total investments as the capital in the basic plan for privately financed projects, which was reflected as one of the major assessment factors of project applicants. The capital structure of the project company is included in the project implementation agreement. Therefore, Gwangju Beltway Investment which changed the capital structure of the company for the worse without the consent of Gwangju City is in breach of the implementation agreement. In view of the process of such supervisory order and the facts that Gwangju Beltway Investment has eroded its capital base by borrowing long-term loans with the interest rate of up to 20 percent p.a., thus increasing the cumulative deficits to 102.4 billion won by the year 2010, the supervisory order by Gwangju City was deemed legal after a number of offerings of corrective measures and consultations, but unanswered response or rejection by Gwangju Beltway Investment."

Upon the confirmation of the court judgment in appeal, Gwangju City is going to demand the restitution of financial structure from Gwangju Beltway Investment. Otherwise, Gwangju City will purchase the ownership of the part of the 2nd Beltway for itself.

Busan Sujeongsan Tunnel
Busan Metropolitan City, plagued by MRG-driven financial burden has demanded Macquarie Infra Fund to lower the MRG rate of Sujeongsan Tunnel, but failed. If Macquarie Infra Fund would not come to the negotiation table, Busan City seems to take hard-line alternatives - to stop providing fiscal subsidy to the tunnel, or to order the mandatory restitution of equity capital ratio.

The real traffic of Sujeongsan Tunnel, whose MRG has been set at 91.5 percent, was counted 44,311 vehicles a day in 2012. It is far below the estimation of 70 thousand vehicles a day, and accordingly Busan City has to pay 49.3 billion won to private contractors and financiers for the past 12 years.

Gimhae Light Rail Transit
Busan-Gimhae Light Rail Transit has been less popular to citizens than expected, and gives rise to MRG-related financial trouble at both local governments. The traffic estimation has been downgraded from the initial 340 thousand people a day to 210 thousand in 2001, and to 170 thousand at present. However, the real users of the transit turned out to be mere 29 thousand, 16.7 percent of the projected commuters.

The two amendments to the initial project implementation agreement, which triggers MRG at the point of real traffic below 90 percent of the original estimation, include the cancellation of additional light rail cars and the revised MRG formula - 76 percent for the first 10-year period, 74 percent for the next 11-15 years, then 71 percent for the final 16-20 years. Notwithstanding the above-mentioned efforts by local governments, both Busan City and Gimhae City are required to pay 108.1 billion won a year for 20 years to come.

Seoul Umyeonsan Tunnel
Umyeonsan Tunnel, 3.0 km four-lane tunnel which connects the southern Gyeonggi with Gangnam of Seoul, was constructed from August 1998 to January 2004. Its completion was somewhat delayed to employ special technological innovation to prevent any vibrations from influencing the Opera House just above the tunnel. Although the tunnel is regarded as useful to avoid the notorious traffic jams at nearby Sadang and Yanjae intersections, ordinary drivers usually turn away from this SOC facility because of relatively high toll, which would be raised out of a vicious cycle subject to the MRG provision.

Umyeonsan Tunnel is owned by Umyeonsan InfraWay (우면산인프라웨이), 36 percent of which capital has been invested by Macquarie Infra Fund. Macquarie Infra Fund extended subordinated loans with interest rate of 20 percent p.a. up to 9.6 billion won to Umyeonsan InfraWay. Macquarie Infra Fund is ensured sufficient revenues by means of MRG provisions as well as handsome interest on the subordinated loans.

Solutions
So far, NGOs have criticized the overall privately financed infrastructure projects.

It's because the financial burdens of the local governments as well as the central government are ever increasing since 1998 on account of MRG compensation related to privately financed infrastructure projects as a result of overinflated throughput estimates. Such vicious cycle resulted in the tariff increase to users.

With the amendment to the Private Investment Act on Social Infrastructure Facilities in January 2005, the government introduced build-transfer-lease (BTL) projects and repealed the controversial MRG provisions. Instead, investment risk sharing (투자위험분담제도) was introduced to invigorate the private investors' mind.

From the beginning, the privately financed projects contained various problems. Article 1 of the Private Investment Act provides that the purpose of the Act is to promote the private investment toward the social infrastructure and to expansively operate social infrastructure facilities in a creative and efficient manner, thereby contributing to the growth of the nation's economy. In reality, however, creativity and efficiency have been hardly found, rather easy-going project proposals and profit-making efforts have been rampant. The government was not eager to save the fiscal burden and to reduce the administrative organization.

First and foremost is the problem concerning throughput estimates conducted by specialists who are not responsible for the result. Some forecasts were contrary to the common sense for the advantage of E&C contractors that proposed the unsolicited projects. So exaggerated estimates and unwilling government check-up led to swallowing fiscal burdens and inefficient distribution of resources, and ultimately to increased logistics cost and cost push inflation in the private sector.

As a matter of fact, the infrastructure investors, who collected more earnings than expected, are eager to find alternative source of profits, i.e., by issuing subordinated bonds (후순위채) with coupon rate of over 15 percent p.a. as witnessed in the Gwangju Second Beltway case. While financial investors gain profit from high yield fixed income, the O&M company is in difficulty to remain profitable because ever increasing toll revenues are insufficient to pay the high yield coupon to financial investors. Almost every the O&M company is exempt from the corporate tax not because it is SOC-related company but because it gains little income each year. It's quite strange to increase toll rate every year while the throughput traffic is on the increase.

Then what's the solution? Bashing financial investors is not wise, because few SOC projects are viable without their support and involvement. In the middle of July 2013, it was reported that Macquarie Infra Fund engaged in Seoul Metro No. 9 would be replaced by Korean insurers. When such a big hand as Macquarie steps out of the Korean infrastructure market, it could function as a red signal to other foreign investors. There may be some alternatives among others:
 * 1) The government may take over all or part of private investor's shares.
 * 2) Public entities or local enterprises may take over the operation and management of the SOC facilities.
 * 3) Recapitalization or refinancing may be performed subject to the amendment to the existing project implementation agreement.
 * 4) Ultimately the controversial MRG should be shifted to the Standard Cost Support (SCS, 운영수입보장제).

At the same time, it's important to stimulate and promote demands for SOC facilities by means of tariff cut, massive development of adjacent areas into tourism resort or industrial complex, and other creative ideas. Also it is necessary to work out programs to consolidate SOC facilities with other public facilities from the perspective of not only the central or local government but also the common citizens, who prefer a variety of cultural, educative and entertaining participatory programs.