The purpose of attracting private investment in the construction and operation of social overhead capital (SOC) is to maximize efficiency in the management of and investment in social overhead facilities by replenishing insufficient funds and injecting creativity and innovation from the private sector.

Korea’s Public-Private Partnership (PPP) system―implemented through the Promotion of Private Capital in Social Overhead Capital Investment Act (1994)―initiated the early expansion of social overhead facilities which contributed to economic growth and improving public benefits. Nevertheless, concerns have been raised over the validity of PPP projects due to an unexpected increase in the government’s financial burden resulting from the minimum revenue guarantee (MRG) and termination payments. In particular, the sustainability of PPP projects has been called into question and has even become a social issue because of the relatively high user fees compared to the budgetary projects, among others.

Accordingly, this study attempts to indirectly examine the accomplishments of PPP policies designed to lessen or divide the risks of PPP projects over the past two decades. It analyzed the determinants of the contracted internal rate of return (IRR) to provide implications for enhancing the effectiveness and publicness of government support so that future PPP projects are conducted in a well coordinated manner.

The analysis results revealed that the contracted IRR of build-transfer-operate (BTO) projects do not have a statistically meaningful relationship with the 5-year government bond yield―which shows the conditions in the financing market. This is because large-scale BTO projects have too many hurdles for SMEs to work through, and for that reason, all of the participants are large construction and financial firms. This means that respective participants’ ability to finance a project is more important than general financial market conditions. Moreover, in most cases, a participating financial firm serves as both shareholder and borrower, meaning that there is no incentive for the firm to make an effort to obtain loans with low rates. On the other hand, a statistically meaningful positive correlation between the financing rate and contracted IRR was found for build-transfer-lease (BTL) projects, which has SMEs as investors and separates shareholders and borrowers. In short, the overall changes in financial market conditions or the level of financing rates could greatly affect the level of the contracted IRR of a BTL project while BTO projects are affected more by individual private investors’ financing ability and the composition of investors and borrowers than by financing market conditions.

Second, the government’s risk sharing policies and specific project features such as facility type, investment amount, construction subsidy and MRG conditions were found to little affect the decisions regarding contracted IRRs.

Given that project risks can systemically vary depending on the type of facility, it was initially thought that the contracted IRR could also significantly vary, but the difference was found to be statistically insignificant. Expert opinions and surveys should be taken into account to better identify and understand the characteristics of PPP projects by type, and the government should have a fully established policy direction and support principle with regards to risk management and allocation.

It was also thought that as the size of the total project cost increases, the degree of risk aversion could rise and the ensuing increase in the required return of rate could raise the contracted IRR. However, no meaningful significance was observed. On the contrary, BTL projects―although the effect is minimal―caused a decrease in the ‘alpha (α)’ additional rate (an indicator of the contracted additional rate) as the size of the PPP project cost rises. This appears to be due to the fact that the risks of BTL projects are very small, unlike BTO projects, and thus, large-scale PPP projects are regarded as stable investments from a long-term perspective.

In addition, operational and investment risks can escalate as the period of operation lengthens and growing uncertainties over future risks could entail a high long-term investment premium which would raise the required return of rate. Nevertheless, the results revealed that the operation period did not significantly impact the decisions on the contracted IRR of BTO projects while having a slight impact on the contracted additional rate of BTL projects. Hence, overall, the characteristics of the operation period have not been properly reflected in the contracted IRR.

Meanwhile, construction subsidies, which are directly paid by the government to private concessionaires during the construction period, were found to contribute to lowering the contracted IRR of PPP projects, but the effect was found to be insignificant. The analysis found that in BTO projects, a 1% increase in construction subsidy relative to total project cost causes a reduction of 0.008% in the contractual IRR.

Above all, this study found no contribution from the MRG system to lowering the contracted IRR, and this casts doubt on the effectiveness of the government’s risk allocation policy. Despite the fact that the MRG system―which is designed to make up for the shortage if the actual yearly operating income falls short of the initially estimated income in the concession agreement―can serve as an effective risk-sharing method to sharply reduce the contracted IRR, projects with MRG conditions were found to have concluded with a 0.59% higher contracted IRR at a 99% confidence level. Furthermore, the contracted IRR of MRG-inclusive projects was found to be higher than those without such conditions in an analysis of only road projects. It is assumed that this is because the contracted IRR was set very high during the intial period of the PPP system and subsequent projects were concluded by simply referring to preceding projects without considering the inclusion of the MRG.

Thirdly, the VfM test was also found to slightly contribute to lowering the contracted IRR. The test decides on a PPP project based on a comparison of the total life cycle cost (LCC) of the public sector comparator (PSC) and private finance initiative (PFI). As such, a project will unlikely pass the test if there is an increase in the rate of return as it will weigh on the government’s financial burden. To put it another way, the contracted IRR of a project which has passed the VfM test is more likely to be lowered compared to a project which has failed the test. However, the difference in the contracted IRR between such projects was found to be statistically insignificant, implying that the contents and methods of the VfM test need to be updated. In conducting the VfM test, it is also necessary to quantify project risks and risk-sharing that derive from facility type and the government’s support policy and to reflect them properly.

What should be particularly noted in this study is the effect of the degree of market competition (competition rate) on the contracted IRR. For BTO projects, one additional competitor reduces the contracted IRR by approximately 0.25%, suggesting that the level of the contracted IRR is closely related to the number of competing participants. Considering that encouraging competition could lead to a decrease in the contracted IRR and eventually a reduction in construction subsidies and user fees, the government should aim to enhance the competition rate to strengthen the publicness of future PPP projects.

Under the current PPP system, only large firms can afford the time and expenses required for project proposal, evaluation and negotiation, which poses an obstacle to new market entrants. Simplified processes are needed to save time and money and active participation in PPP projects should be encouraged by enabling easier financing and lower rates to reduce the contracted IRR.

This study has its own limitations. Future studies need to closely examine the impact from private-sector concessionaires and project characteristics on the contracted IRR. Depending on their financing ability, credit rating, PPP experience, and knowledge and know-how about the construction and operation of specific facilities, project concessionaries may present different attitudes and decisions, which could affect the decisions over the contracted IRR.

Further analyses should include accumulating data on project funding and its equity structure; private investors’ experiences and characteristics; construction investors’ average construction margin; operation investors’ operation margin and; loan interest rates for the actual financial arrangement. Additionally, in-depth analyses of the impact of these variables should follow.

Preface
Executive Summary

Chapter 1 Introduction

Chapter 2 Risks and Government Support in Public-Private Partnership (PPP) Projects
　Section 1 Risks in PPP Projects
　Section 2 Government Support Mechanisms

Chapter 3 Calculation and Status of Contracted Internal Rate of Return (IRR) in PPP Projects
　Section 1 Methodology for Calculating IRR in PPP Projects
　Section 2 Current Status of Contracted IRR in PPP Agreements

Chapter 4 Determinants of Contracted IRR in PPP Projects
　Section 1 Data Description
　Section 2 Selection of Explanatory Variables for Contracted IRR
　Section 3 Analysis of Determinants of Contracted IRR

Chapter 5 Conclusion and Policy Recommendations
　Section 1 Key Determinants Affecting Contracted IRR in PPP Projects
　Section 2 Policy Recommendations
　Section 3 Future Research Directions

References
Appendix
ABSTRACT