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Release of medium-to-long term outlook on respective agenda based
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Urban, Rural and Regional Economics

Policy Study

Valuation of the Minimum Revenue Guarantee in the Urban Railway PPP Project

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  • Author Kang-Soo Kim
  • Date 2013/12/31
  • Series No. Policy Study 2013-06
  • Language Korean
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SUMMARY In the revised Act on Public-Private Partnerships in Infrastructure on Dec. 31, 2000, Korea introduced a system that is designed to reduce traffic forecasting risk by guaranteeing the minimum revenue. Accordingly, large-scale PPP projects for road, railway, airport, environment and logistics infrastructure have been initiated including the option of the Minimum Revenue Guarantee (MRG). The MRG system has been indeed a significant contributor to the promotion of the large-scale Build-Transfer-Operate (BTO) projects, but the system has its own structural problem that the private concessionaire might try to intentionally overestimate the traffic flow.

This study is to calculate the economic value of the minimum revenue guarantee in the concession agreement of the ongoing OOO PPP urban railway project. According to the agreement, when the actual revenue exceeds 50% of the agreed revenue in the given year, the government shall guarantee 80% of the agreed revenue from the date of commencement of operation until the end date of the five-year period and 70% from the day following the end date of the five-year period until the end date of the ten-year period. When the actual revenue exceeds more than 120% of the agreed revenue from the date of commencement of operation until the end date of the five-year period and 130% from the day following the end date of the five-year period until the end date of the ten-year period, the government shall collect the overage.

The analysis found that provided the risk-free rate of return is 5.5%, the value of (put) option of the MRG right, the private concessionaire holds on the OOO PPP urban railway, is 209.8 trillion won, which is merely 3.45% of the private concessionaire’s total investment (607.8 billion won as of 2002). Meanwhile, the value of (call) option of the collection right the government holds is 5.2 trillion won, which is merely 0.09% of the government’s construction subsidy (561.1 billion won), implying that it is highly unlikely that the actual traffic flow of the OOO railway will exceed the agreed(forecasted) traffic flow. These low probabilities are due to the fact the MRG option is applied only to a limited period, early ten years (a third) of the total 30-year duration and that, in particular, the actual revenue is unlikely to exceed 50% of the agreed revenue of the given year.

Meanwhile, the yearly changes in the government subsidy for MRG following the year of commencement of operation shows a propensity that the (expected) government subsidy for MRG payment decreases over time, which is due to the declining probability that the actual revenue will exceed 50% of the agreed (forecasted) traffic revenue.
The analysis also found that a rise in traffic flows does not cause a significant increase in the value of the MRG right, which is because the revenue from the increased traffic flows will not most likely to reach the level of feasible exercise condition (when the actual revenue exceeds 50% of the agreed revenue) for the MRG option. On the other hand, when the traffic flow increases, the value of (put) option of the MRG right the private concessionaire holds and that of (call) option of the collection right the government holds tend to increase, though marginally, which is because the increase in the traffic flow will provide the private concessionaire with a better chance to satisfy feasible exercise conditions for the MRG option and also the government the same to collect the excess amount of revenue.

This study re-analyzed the values of the MRG and the collection option, and obtained the result that the two values turned out to be symmetric at a level of around 55% of the MRG rate after maintaining the current ten-year duration for MRG and excess revenue collection but changing the feasible exercise condition for MRG and excess revenue collection.

The feasible exercise condition for the MRG which guarantees the operating revenue only when the actual revenue exceeds 50% of the agreed revenue was adopted for the purpose of preventing the concessionaire intensionally trying to overestimate traffic flows. It was concluded if no feasible exercise conditions are attached (meaning 0%), the value of the MRG option for ten years would be 232.98 billion won, which is larger by 11 times compared to this project with the feasible exercise condition attached (20.98 billion won) and is also estimated to be approximately 38.33% of the total private investment expenses (607.8 billion won as of 2002). To put it another way, the feasible exercise condition for the MRG has acted to greatly reduce the (expected) government subsidy, which as a result has significantly discouraged the private concessionaire’s expectation of a huge profit. It means that the feasible exercise condition for the MRG can be seen as having playing a significant role in improving the eligibility of private investment projects and rectifying the asymmetric option conditions between government and private concessionaire. This result implies the importance of what terms and conditions and in what way they should be included in the concession agreement between government and private operator to deal with systemic propensity or problems of overestimating traffic flows.
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