n hindsight it is no surprise that Project Finance's initial meeting with the Korean Electricity Commission's Competition Planning Unit should have been cancelled. A day after the appointment to discuss the status and schedule for the privatization of five KEPCO generating companies it was announced that none of the four shortlisted bidders had tabled binding bids for the sale of up to 51% of Korea South-East Power Co (KOSEPCO). The first trade sale of a KEPCO generating company is now on hold and all bets regarding the timetable for privatization are off.

Despite this setback, the Korean government says that it remains committed to privatization and the genco trade sales. However, confronted with only muted interest from domestic and foreign strategic investors, Mon-goo Choi, director of the Competition Planning Division at the Korean Electricity Commission (KOREC), confirms that the plan is now to proceed with an initial public offering comprising the sale of between 10% and 20% of KOSEPCO to the general public. ?The IPO will probably happen at the end of this year or early next,? says Choi.

Choi says that KEPCO is scheduled to select an adviser for the IPO by mid-April. He adds, ?according to Korean privatization law, the IPO should be launched no later than nine months after the securities firm has been mandated as adviser.?

But the fall back plan itself is also uncertain. At the moment the government is toying with another idea, the creation of a power company privatization fund, which will be responsible for pooling and on-selling about 10% of the shares of each of the five generating companies to the general public.

Why did the trade sale fail? Market sources say the four short listed bidders, steel maker Posco, advised by Salomon Smith Barney, SK Group, Korea Independent Energy Corporation (KIECO), and JPower each had their own reasons for dropping out of the bidding.

Posco is undergoing a senior management reshuffle, while one of KIECO's two 50% shareholders, El Paso, is said to have reviewed the sale and decided that it did not want the company to bid alone. SK Group retreated partly because of its much publicized accounting problems and JPower, like KIECO, also rejected the idea of a solo bid. ?If JPower is given the chance to bid again, it will attempt to dilute its risks by bidding in consortium with a local Korean company,? a banking source suggests.

As any power sector analyst can verify, appetite for new investments in the industry, be it in Korea, or Asia, or any where else, is in short supply. For the Korean government, being able to cite the internal problems of the bidders for the failure of the trade sale is a convenient way of saving face.

Yet, by the Korean Electricity Commission's own admission, KOSEPCO is the best genco company in the KEPCO fold and, in a market where electricity demand is set to grow at 7% to 8% a year in the near term, KOSPECO should be one of Asia's most attractive electricity investments. Independent observers concur: Je Seong Sohn, equity analyst at Daewoo Securities notes that KOSEPCO has the most stable operations of the five KEPCO generating subsidiaries due for sale, on the back of a 58.2% contribution of base load to operating facilities. Of the five gencos, KOSEPCO also has the lowest debt to equity ratio (90.6%), and the highest profit per unit of power generation capacity. The company's profit stood at Won13 million ($10,453) per MW/h in the first quarter of 2002.

Pricing problems

So what else deterred the four bidders and all the other potential suitors in the international arena? Mark Hutchinson at energy consultancy, Cambridge Energy Research Associates (CERA), which has advised companies on the electricity privatization in Korea, believes that the Korean government's target price was well in excess of what the market was willing to pay.

?It's a general rule with these power privatizations that no government gets what it first thinks it will get,? Hutchinson says. In the Korean case Hutchinson says the target price for the KOSEPCO trade sale was about $3 billion to $3.5 billion, based on a commonly used pricing yardstick of $500 per megawatt hour (KOSEPCO's total generating capacity is about 7,000MgW). ?Since the company is almost 100% geared this market value is immediately cut in half. In addition, uncertainty over the fine detail of the vesting contracts [designed to give greater stability to the market in its early years] and the regulatory system further reduces KOSEPCO's value,? Hutchinson explains. In line with that reasoning, most observers were expecting bid offers to come in at between $1 billion and $1.5 billion.

In the end, KEPCO did not get any firm bids for Korea South East Power. Apart from the high initial asking price, other analysts agree with Hutchinson, arguing that enthusiasm of strategic investors has been dented by the fact that the regulatory environment is still unfinished.

It is not wholly KOREC's fault that the regulatory framework was not finalized before the first trade sale. The Commission has had to adhere to the very ambitious timetable for privatization established by Korea's electricity privatization law.

Indeed, Dong-Sup Shim, director of KOREC's Market Management Division, which is responsible for drawing up the regulatory system, says that, in broad terms, the deregulation framework is already in place. A two-way bidding system, which will introduce competition into the wholesale power market, will come into effect from 1 April 2004. The general terms of the vesting contracts have also been outlined. The volume of electricity covered by the contracts will gradually reduce says Shim, with the contracts terminating altogether at the end of 2008. From then on the market will be characterized by full retail competition.

Admittedly the fine details have not been fleshed out, but according to Choi, neither the unfinished nature of the general regulatory environment nor the fact that the vesting contracts are still a work in progress, caused great concern amongst the strategic investors in the KOSEPCO sale. ?During the final stages of the due diligence process none of the bidders made any complaints about the vesting contracts,? says Choi.

Is the government committed?

The real uncertainty for strategic investors is whether the government will actually see the privatization program through to completion. ?Strategic investors are concerned that the sale of a stake in KOSPECO may not be followed up by sales of the other generating companies still owned by KEPCO,? agrees a banker in Singapore. The four bidders for a stake in KOSEPCO were afraid that they might find themselves in the vulnerable position of being the only private operator, competing in an industry still dominated by KEPCO, and in an industry content with returns well below those acceptable to the private sector. Choi admits, ?potential strategic investors have expressed skepticism about the government's resolve in moving ahead with the full privatization plan?. These concerns have been exacerbated by the fact that the two way bidding pool mechanism has not yet been launched.

Independent market analysts interviewed by Project Finance believe that the government is not necessarily committed to a full and complete realization of the original power privatization plan. ?South Korea has a pretty good record in following through with privatization in the telecoms and banking sectors,? notes Hutchinson at CERA. However, he also notes that the government is facing the conflicting demands of stable pricing while ensuring adequate supply in a rapidly growing market. ?This might delay full privatization?, Hutchinson says. A second source is even more forthright: ?The government may be pulling back from creating a truly competitive market in the power sector to do what they are much more comfortable doing: keeping control.?

The government will therefore continue to have a strong influence on the electricity sector. Scared of giving the private sector free rein in the power industry, the government will use the vesting contracts to mange the market, at least in the initial stages of deregulation. That may mean a more stable market but investors are also worried that it could mean poor returns. Mindful of this, Hutchinson says that the government will very likely set electricity prices high enough to generate acceptable returns to private companies.

But the timetable for privatization is now anyone's guess. Originally, the official plan was to sell all the generating companies by 2005 and to have the KOSEPCO sale quickly followed by a second sale. According to Daewoo's Sohn, it is still likely that the next genco disposal will only happen after the first round sale of shares in KOSEPCO. Which of the four other non-nuclear KEPCO gencos will be the subject of this second auction has not been revealed.

Acquisition Finance

If and when a strategic interest in the companies is sold, financing is likely to be structured on a non-recourse basis says Frank Lee at Hana Bank. ?KOSEPCO and the other gencos are likely to be triple-A rated by local Korean ratings firms and the financings will probably feature corporate bonds as well as syndicated loan and working capital facilities,? the financier notes. As the Korean government has set in motion a program of incentives to make corporate bonds more attractive to investors, debt capital markets funding becomes all the more likely. The banker also suggests that debt equity mix in the financing will be in the range of 1.5:1 and 2:1.

There is, however, considerable disagreement over how involved foreign banks will be in the deregulation process. Foreign banks have been active in advisory work: CSFB and Lehman Brothers were mandated to advise KEPCO on a debt restructuring that proceeded the attempted KOSEPCO sale, and JP Morgan and UBS Warburg (alongside Daewoo Securities) advised the government on the trade sale. But overseas institutions are far more skeptical about participation in the acquisition financing. ?The buyers are naturally going to want to match up local currency revenues with local currency debt and will want Won denominated facilities, particularly as this is a market with a history of recent currency volatility,? says one financier. Other sources are more outspoken, ?Mixing US Dollar and Won debt in these power deals would be a recipe for disaster and would involve some prohibitively expensive hedging,? says another foreign banker.

However, if investors do buy controlling interests in the five gencos earmarked for sale in next few years, it is questionable whether there will be sufficient appetite in the Korean bank market to meet demand. ?Its hard to say if the appetite will be there,? says a second Korean banker, ?right now there is reasonable liquidity in the Korean banking industry as the corporate sector, to whom banks would normally be lending, are not making significant investment at this time.? But in the medium term, the source notes that there are many other infrastructure projects to be financed in the country, including numerous road schemes. And, of course, much will depend on the detail of the vesting contracts.

Frank Lee believes foreign lenders could play a useful role. ?According to the government's plan,? he says, ?the generating companies will become merchant power stations once the vesting contracts terminated. Therefore when it comes to the marketing of any bank debt facility to finance the acquisitions, it will be very useful to have foreign banks involved with experience of merchant power project financings. Generally speaking, Korean banks do not have this experience.?

That will change soon, however. Korea's first merchant power deal, to finance SK Power's 1000MW gas-fired combined-cycle power station project, is expected to come to market this year. According to one banker, the information memorandum for the financing is due to be dispatched within about three months, subsequent to shareholder approval on final project details.

The project cost is approximately $600 million and the financing, says the financier, will be wholly non-recourse. ABN Amro is the financial adviser to SK Power. Contrary to what bankers have suggested regarding the trade sales, foreign currency lending and substantial foreign bank participation is expected in the eventual financing. ?We expect the deal to feature a large US Dollar-denominated tranche. There seem to be plenty of foreign banks interested in this deal,? says a banker in Hong Kong.