37476 F E B R U A R Y 2 0 0 4 Operational Guidance for World Bank Group Staff Public and Private Sector Roles in the Supply of Electricity Services THE WORLD BANK GROUP The Energy and Mining Sector Board ACKNOWLEDGEMENTS CONTACT INFORMATION This Note, a joint product of the Energy and Water To order additional copies please call the Energy and Water Department and the Infrastructure Economics and Finance Help Desk 202-473-0652 energyhelpdesk@worldbank.org Department, was prepared by a team consisting of John Besant-Jones, Clive Harris, Gary Stuggins and Alan Townsend. The note has benefited from considerable input from staff in the World Bank Group (IBRD/IDA, IFC and MIGA) and has been cleared by the Energy and Mining Sector Board. F E B R U A R Y 2 0 0 4 Operational Guidance for World Bank Group Staff Public and Private Sector Roles in the Supply of Electricity Services The World Bank, Washington, DC THE WORLD BANK GROUP The Energy and Mining Sector Board CONTENTS FOREWORD......................................................................................................................ii A. CONTEXT AND BACKGROUND ................................................................................2 B. SECTOR REFORM OPTIONS.......................................................................................3 Public and Private Roles in the Provision of Electricity Services...............................4 Enterprise Restructuring and Corporate Governance................................................6 Market Structure..........................................................................................................7 Regulation ...................................................................................................................8 Access and affordability .............................................................................................9 Environmental considerations ..................................................................................10 C. STRATEGIES FOR EFFECTIVE BANK GROUP INTERVENTIONS............................10 MATRIX OF BANK GROUP ELECTRICITY SECTOR INTERVENTIONS ........................13 TABLE 1. MAIN FORMS OF PUBLIC-PRIVATE PARTNERSHIPS ..................................5 TABLE 2. DESIGNING REGULATORY FRAMEWORKS ..................................................9 i FOREWORD It is now recognized that under the poor governance standards found in many developing countries, pure public financing of electricity infrastructure and provision of electricity services has failed to adequately support economic and social development. It is now also recognized that the private sector can deliver efficient investments and improved services provided that the right business incentives and legal and regulatory arrangements are in place to attract investment. However, private investment in the power sector in developing countries peaked in 1997 and has since declined to less than one sixth of peak levels. Difficulties in sustaining reforms to establish the power sector on a commercial footing in some countries, a wider reduction in investment flows to emerging markets, and the withdrawal of investors have ii produced a more difficult climate for attracting private investment in developing country power sectors. This has led to a search for practical solutions for public-private partnerships for financing of electricity infrastructure and provision of electricity services that lie between the purely public and purely private models. This Note provides guidance to World Bank Group staff on assessing the suitability of available options for public-private roles in the financing and provision of electricity, and the main steps which staff should take to analyze these options. It cautions against prescriptive, one-size-fits-all recommendations, recognizing the variations in context across the Bank client countries. The note links the different public-private models with appropriate World Bank Group instruments, including project-specific, sector-wide and broader interventions. As we accelerate the implementation of the Infrastructure Action Plan, the Note provides a framework within which staff can design operations in a way that will enable us to maintain the quality of our interventions. Jamal Saghir Director Energy and Water Chairman, Energy and Mining Sector Board Hossein Razavi Director, Infrastructure Economics and Finance February 2004 EXECUTIVE SUMMARY Context The Bank's Infrastructure Action Plan sets out a series of measures to revitalize the Bank Group's infrastructure business. These measures require the Bank to provide its clients with broad menus of options for public and private sector provision of infrastructure services. Following the recent OED/OEG/OEU review of Bank Group activities to promote private sector development in the electric power sector, the Committee on Development Effectiveness (CODE) requested that guidance be provided to staff on the appropriate roles of the public and private sectors in the provision of electricity services. This will enable Bank staff to assist governments in fashioning strategies to attract the investment required to meet growing demands for electricity. Purpose of the The Note provides guidance to Bank Staff on assessing the suitability of available options for public-private roles in the Guidance Note financing and provision of electricity, and the main steps which staff should take to analyze these options. It cautions against prescriptive, one-size-fits-all recommendations, recognizing the variations in context across the Bank client countries. The note links the different public-private models with appropriate Bank Group instruments, including project-specific, sector-wide and broader interventions. Organization of The report is organized into three sections: (1) a Context and Background section, summarizing the industry and institutional the Note developments which demand a coherent Bank Group response; (2) a discussion of Sector Reform Options, analyzed along the dimensions of public and private roles, sector and corporate governance, market structure, regulation, access and affordability, and environment; and (3) Strategies for Bank Group interventions, presented in a matrix at the back of the note. 1 Key Messages For most Bank client countries, reform of the electricity sector will be at the heart of efforts to improve efficiency, raise service quality, expand access, and power economic growth. Bank staff will need to consider the full range of options from pure public interventions to pure private, but for most countries public-private approaches - in which public interventions are specifically designed to leverage private risk capital and skills - are appropriate. The course that power sector reform takes, and the speed at which reforms can be implemented, will vary from country to country, but reform will be a continuous and evolving process. Generation Private financing, whether from local, regional or international investors, is preferred. Most governments can create a substantial role for private generators within their sector development strategies. Nonetheless, public support, in the form of IDA/IBRD guarantees and other forms of credit enhancement, will be a critical component of many private financings in the generation, along with IFC and MIGA products. A strong public financing role may be vital for countries in transition and for large hydroelectric undertakings, with complex economic, social, and environmental characteristics. Staff should assess carefully the rationale proposed for IBRD/IDA lending for generation projects, and consider whether other Bank instruments or interventions in other subsectors (e.g. distribution) may be more appropriate. Transmission Depending on country policy and sector circumstances, there are substantial lending, guarantee, and insurance opportunities for the Bank, IFC, and MIGA. The Bank could commit lending to state-owned transmission companies, as a key component of an overall sector development program, provided that minimum corporate governance standards are met. Distribution Where public provision is working, or improvements in performance in a public utility are underway, the Bank can consider providing financial support. Where it is not, some form of public private partnership should be considered. Concession and OBA projects that can attract private investment should be considered, focusing on improvements in service quality and service expansion. If private investment still cannot be attracted, then management contracts or leases, accompanied by public investment in part financed by the Bank, can be considered at a minimum as an interim step. Regulation The path to strong, independent regulators with a track record acceptable to investors will often be a long one. Governments should provide for long-term capacity building but should fix, to the extent possible, provisions for prices and technical and customer service standards in the key regulatory instruments, such as licenses or contracts, for a medium-term period. Regulatory frameworks should be designed bearing in mind local capacities and institutional approaches. Next Steps Operational staff should use the framework provided in the note in conducting the dialogue with clients, and identifying and preparing new projects. This note will be supplemented with detailed technical notes that build on current knowledge resources. A. CONTEXT AND BACKGROUND 3. The request from CODE was made following the recent joint OED/OEG/OEU review of Bank Group 1. Infrastructure services are critical to economic activities to promote private sector development in the growth, poverty reduction and the achievement of the electric power sector.4 This review recommended that Millennium Development Goals (MDGs). However, the the Bank continue to promote private participation in investment volumes required to provide the capacity to this sector where countries are committed to reforms. deliver these services are enormous. IEA has estimated However, it highlighted the need for guidance to staff that to keep pace with growing demand, developing in the implementation of reform packages and their countries will have to invest annually around $120bn in sequencing in the diverse country conditions in which the the power sector alone over the period 2001-2010.1 Bank Group is engaged. The report also raised concerns During the 1990s, private capital flows made a substantial at the complexity, cost and time required for major reforms contribution to meeting these needs in some countries. in the sector, as well as concerns about the outcomes of But private flows have fallen substantially in recent years. reform, including the need to integrate poverty and From a peak of $50bn in 1997, investment in power affordability concerns and environmental aspects into projects with private participation in developing countries private sector development activities in the power sector. fell to around $7bn in 2002.2 Difficulties in sustaining reforms to place the power sector on a commercial 4. The Bank's Infrastructure Action Plan sets out a 2 footing in some countries, a wider reduction in investment series of measures to revitalize the Bank Group's flows to emerging markets, and the withdrawal of investors infrastructure business.5 The plan covers three key have produced a more difficult climate for attracting areas: responding to country demand by offering a private investment in developing country power sectors.3 broad menu of options for public and private sector infrastructure service provision; rebuilding infrastructure sector knowledge bases; and applying new and existing BOX 1: Energy and Economic Development Bank Group instruments to effectively maximize the Bank's leverage. This guidance note forms part of the Energy consumption shows a strong correlation with first set of actions, providing a broad menu of options national income. Most economic activity would be for public and private infrastructure service provision. impossible without modern energy including electricity, even the small and medium-scale enterprises that are The plan also stresses that the Bank Group must remain the main source of new jobs for the poor (Energy focused on the delivery of infrastructure services rather Business Renewal Strategy, May 2001). The poor rank than simply building new physical capacity. access to infrastructure as critical for moving out of poverty (Voices of the Poor, 2001). Modern energy also 5. Reform of the power sector will be needed to foster plays a key role in improving social service delivery, also the financial viability of electricity service providers, and critical to the achievement of the MDGs. hence attract on a sustainable basis the public and private financing needed over time to expand services. The substantial investment needs of the power sector 2. In this context, the Committee on Development mean that increased investment from the private sector Effectiveness (CODE) requested that guidance be will be needed. Sector-specific measures to address this provided to staff on the appropriate roles of the public will be important. But actions to attract private investors and private sectors in the provision of electricity services in the power sector have to take into account the so that the funding required to meet these investment overall investment climate in a country.6 These actions needs can be mobilized. must also be realistic given the global and regional context, especially with regard to the current and future In "World Energy Investment Outlook, 2003 Insights", IEA estimates that about $1200 billion of investment is required in the electricity 1 sector of developing countries for the 2001-2010 period, for an average of $120 billion per year. World Bank PPI Database. 2 Harris "Private Participation in Infrastructure in Developing Countries", World Bank Working Paper Number 5, April 2003. 3 "Private Sector Development in the Electric Power Sector: A Joint Review of the World Bank Group's assistance in the 1990s", 4 OED/OEG/OEU, World Bank, July 2003. "Infrastructure Action Plan", presented at an informal Board Meeting, July 8, 2003. 5 "Private Sector Development Strategy: Directions for the World Bank Group", April 2002. 6 levels of investor interest. Investment Climate provision of reliable electric power services in sufficient Assessments and other diagnostic activities will be quantity to meet affordable demand at the lowest cost important for understanding the broader environment in reflecting the resources and impacts involved in their which private participation in power will take place.7 production and transportation. 6. This Note provides guidance to Bank Staff on 8. Competition, unbundling, private participation, and assessing the suitability of available options for public- other reform elements are not ends in themselves, but private roles in the financing and provision rather intended to contribute to the achievement of of electricity, and the main steps which staff should take broad goals for poverty reduction, economic growth to analyze these options. Given the variety and and environmental sustainability. In particular, these complexity of country circumstances, this note cannot reforms should improve the economic efficiency of the provide answers or detailed recommendations to sector and the commercial and operational the individual situations that Bank staff will face. performance of service providers. The note reviews the main choices in the scope and timing of reforms, such as public and private roles 9. Given the differing points at which they find in the sector, unbundling and restructuring, focusing on themselves, countries have to fashion power sector how these reforms might be influenced by country reform strategies that reflect the strategic priorities for conditions. The range of possible Bank Group the sector, and the immediate country conditions that 3 interventions is summarized in the matrix attached influence the suitability of particular approaches. to the back of this note. 12. Governments face critical decisions in reforming B. SECTOR REFORM OPTIONS their power sectors. They must decide the relative roles of public and private sectors in providing power 7. Power sector reform strategies should be designed to services; the governance and reform of public fit an overall framework for delivery of modern energy enterprises operating in the sector; restructuring to services to promote poverty alleviation and economic introduce competition, including unbundling and the growth. Meeting these two objectives requires the development of power markets; and regulatory reforms FIGURE 1. STRATEGIC PRIORITIES ˇ Private Participation ˇ Access ˇ Enterprise Reform ˇ Financial viability ˇ Efficiency More and Better Development PRESENT CONDITIONS ˇ Sector Restructuring Power Services Objectives ˇ Macro-fiscal ­ Competition ˇ Reliable ˇ Poverty environment ­ Unbundling ˇ Efficient Alleviation ˇ Political economy of ˇ Affordable ˇ Economic pricing and reform Growth ˇ Investor interests ˇ Environment ˇ Domestic capital ˇ Regulatory Reform market development ˇ Size of market ˇ Prices relative to cost See also "Implementation Progress Report ­ Private Sector Development Strategy", presented to the Board June 2003 for information on 7 the rollout of ICAs. to improve oversight of the sector, introducing incentives Public and Private Roles in the Provision of for efficiency and encouraging service providers to be Electricity Services responsive to consumer needs. Access, equity, and environment must also be incorporated in the policy 15. At the heart of most power sector reform efforts are framework. Coherent reform strategies have to a set of interrelated challenges: changing the manner in effectively link each area to produce a consistent which new investments are financed, increasing package of measures. Reforms in the main areas the efficiency and development effectiveness of those proceed in most cases in parallel, but judgments about investments, and increasing operational efficiency, while sequencing of measures have to be made in each case. addressing equity concerns as the sector expands. It is "Cookbook" solutions for power sector reform clearly now broadly recognized that pure public financing and have to be avoided.8 provision have failed to adequately support economic and social development under the poor governance 13. Although strategies have to be adapted to standards found in most of the Bank's clients, and that country conditions, they must address fundamental they have imposed high opportunity costs on society. issues. Electricity must be paid for either by consumers The private sector has shown that it can deliver efficient or by taxpayers. Revenue shortfalls are costly: they lead investments and improved services to customers of the to deterioration in the quality of supply, assets and an power sector provided that the right business incentives 4 inability to meet demand, as seen in many countries. are in place to attract investment ­ but that putting this Decisions about investment requirements, prices and framework in place can be challenging in many countries. the level of government support have to be mutually Consequently, practical solutions for these countries consistent to reflect this reality. Robust reform strategies, may be public-private partnerships that lie between regardless of the choices made for the different roles these options. of the public and private sectors, have to confront these issues, often in a situation where prices are well below 16. As outlined in the Bank's Infrastructure Action Plan, full-cost recovery.9 Without credible steps to improve it is important to consider the full range of options for suppliers' commercial and operational performance, public-private partnerships. These range from and to align revenues with costs, reform strategies are management contracts, which transfer only limited risks unlikely to succeed in improving sector performance and and responsibilities to the private sector, through contributing to economic growth and poverty reduction. concessions and asset sales. The likely benefits flowing from these approaches will be different (see Table 1). In 14. Staff should assess the credibility and realism of formulating its approach to public-private partnerships, proposed Government strategies while developing governments should assess what particular issues need interventions. Important steps in such an assessment to be addressed, and thereby the roles that need to be include a thorough understanding of the financial performed by the private sector. It should be position of the entities operating in the sector, and a remembered that the public sector can have a financing plan to improve efficiency and adjust prices to improve and/or a risk bearing role in all of these arrangements. financial viability in a reasonable but credible time For example, under concessions and divestitures, the period. In countries that have had difficulties in government can provide financial support through implementing such reforms in the past, credible targeted subsidies. commitments to these reforms should be established through some actions to improve financial viability, including adjustments to prices and enforcement of payments by consumers, prior to substantial Bank financial support. See "Global Electric Power Reform, Privatization and Liberalization of the Electric Power Industry in Developing Countries" by Robert 8 Bacon and John Besant-Jones. Energy and Mining Sector Board Discussion Paper No.2, The World Bank, June 2002. World Development Report 1994, "Infrastructure for Development", The World Bank. 9 Table 1. Main Forms of Public-Private Partnerships B E N E F I T S M A N A G E M E N T L E A S E S C O N C E S S I O N S / B O T S D I V E S T I T U R E C O N T R A C T S Management Yes Yes Yes Yes expertise Tariff discipline No Yes, but limited to Yes Yes operations and maintenance costs Access to private No Yes, but limited to Yes Yes capital working capital 17. The possibilities for different levels of private gains. While some management contractors have been participation, however, depend on political economy able to improve performance to the point where the utility's factors (including public acceptance, and pricing), the cash flow is sufficient to attract some local commercial country and sector investment climate, and the legal debt, in most cases access to commercial debt cannot 5 framework that may in particular limit choices on the be counted on. mode of private participation (for example, full asset sales may be precluded). All these approaches require 19. Even in situations where revenues will be below competitive bidding for the operating rights, well designed the full cost of supply, including financing costs, it may contractual arrangements, and proper oversight.10 be possible to attract deeper forms of private sector Where revenues are close to or cover costs , and the participation, such as concessions and asset sales, overall investment and regulatory climate is adequate, through well-designed subsidies. The design can be then private funding may be expected to contribute focused on specific interventions such as service expansion significantly to investment needs. Many countries have or covering a temporary shortfall in revenues over costs. had difficulties, however, in moving to and sustaining There are a also number of approaches towards subsidy cost-covering tariffs. In addition, many investors are now delivery, including output-based aid (OBA) approaches reluctant to commit investment capital. This raises as well as more traditional input- based approaches, questions over the viability of reforms that rely on finance that should be examined in developing such approaches and substantial risk-bearing from the private sector, with client governments.11 particularly in countries that have seen reversals in reforms or have been unable to generate sufficient momentum 20. Where subsidies are needed they must be well to embark on the reform path. In these situations, the targeted and based on a clear policy rationale. Whether strategy for achieving achieve the desired development operators are public or private, a subsidy component objectives requires other approaches. being provided either through customers or directly to the company by government should have a secure 18. One response would be public-private partnerships financing source, for example through a dedicated that do not require private investment capital, such as fund. Escrow-type arrangements may be needed to help management contracts and leases. There is some ensure timeliness of payments. A final issue relates to experience that well-structured management contracts phasing out of subsidies. This often does not happen as can soon lead to some improvements in performance. planned, and staff should carefully assess the realism of However, designing these contracts remains difficult, the subsidy phase-out plan. and evidence also suggests that the effectiveness of these contracts diminishes over time after the initial See "Competitive Bidding for Long-Term Electricity Distribution Contract" by S. Littlechild for a discussion of contract design. 10 See the Global Partnership on Output-Based Aid (GPOBA) website, www.gpoba.org, for more information on Output-Based Aid 11 approaches and specific applications in the utilities sectors. 21. Even when prices fully reflect costs, additional Enterprise Restructuring and Corporate measures to attract private investment may be required, Governance for example because of uncertainties related to the legal and regulatory environment, or a lack of 24. In the current environment, even very ambitious confidence that the government will maintain an agreed restructuring programs are likely to include a continuing regulatory framework. These measures may require ownership and operational role for the state. This governments to share certain risks with the private seems to be particularly true in the transmission sub- operators until certain pre-conditions for viability are sector, where a common strategy is to retain public met, and to provide stronger commitments to agreed ownership of transmission assets and continued public contractual and regulatory frameworks. operation of the power system, even if private investors build and maintain new transmission lines. But it is also 22. Responsibilities, risks and rewards need to be the case that certain other assets, for example, carefully allocated in public-private partnerships. hydroelectric and nuclear power plants, might remain Staff should ensure that the client develops a risk and state-owned on public policy grounds. And many reward allocation matrix for public-private partnerships, poorly performing distribution companies are expected and assesses actual and contingent government liabilities to remain in the public sector for some time, usually so that the real costs and benefits of different private because private investors will be deterred by the 6 participation options are clear to the government and likelihood of unattractive returns. its development partners.12 Where a government is faced with providing financial support, whether as a 25. As part of a comprehensive reform strategy, subsidy, a contribution to investment, or a guarantee, institutional strengthening of companies left in the staff should help government assess the rationale, costs public sector will usually be required to improve and delivery means of this subsidy as well as the risks management and corporate governance. Where involved to the government's overall budget situation. unbundling of a utility occurs, capacity building should Such government support will likely be an integral part focus on newly created, successor entities. Caution is of many private participation transactions, particularly advised in the number of new state-owned entities to be in lower income countries for the foreseeable future. created when doing this. Extensive restructuring absent Bank participation can provide both finance and private participation has usually not worked very well. assurance to investors. 26. Staff should assess the credibility of programs 23. The experience from the 1990s has helped to founded on improving corporate governance in weak clarify the risks for governments in focusing primarily on state-owned entities, and in particular assess whether attracting foreign operators and foreign investment. forecast improvements in efficiency and pricing regimes Staff should consider the capabilities of the local and are likely to be realized and sustained. For entities that regional private sector and financial markets during the governments have programmed for privatization, process of discussing public-private strategies with experience has shown that resources for investment and governments. The possibility of using new Bank Group organizational development pre-privatization should be products to support local currency transactions should relatively limited, and that efforts should be focused on be investigated, as IFC has done recently for infrastructure immediate performance improvements and on projects in certain countries. Backstopping government facilitating privatization. Interim management contracts commitments on risk-sharing and regulatory regimes should be considered. For entities that remain in the with guarantees from third parties, can be used to help public sector, the government should place a high mitigate these risks as well.13 priority on establishing satisfactory corporate oversight, for example, by putting an independent and qualified board in place with a clear mandate. Irwin "Public Money for Private Infrastructure", World Bank Working Paper No. 10, July 2003. 12 See "Mitigating Regulatory Risk for Distribution Privatization ­ The World Bank Partial Risk Guarantee" by P. Gupta, R. Lamech, F. Mazhar 13 and J. Wright, Energy and Mining Sector Board Paper No. 5, The World Bank, November 2002. 27. Staff should be especially attentive in assisting Market Structure governments improve the financial viability of electricity service providers as reforms progress. This would include 30. The main issues for power market restructuring are reforms to pricing levels and structures, enforcement of bill the extent and pace of restructuring. The extent of payment, including by government-owned entities, more restructuring concerns vertical and horizontal unbundling targeted and efficient subsidy mechanisms, and improved of the generation, transmission and distribution/supply corporate governance.14 For example, an entity whose segments of the market. This should be assessed on a revenues do not cover its costs ­ including existing debt case by case basis. Full unbundling is generally preferred service ­ should not take on more debt. Financial models in medium to large power markets to facilitate the should be developed or appraised by Bank staff to broaden introduction of competition at least in the market for the understanding of sector financial health, assess wholesale trade in power. Even in some small power projected fiscal and quasi-fiscal impacts of various reform sectors, some level of vertical unbundling is likely to options, and set targets for improving creditworthiness. improve services and lower costs because it helps regulation of power service providers and even 28. Competition and international trade and investment introduction of competitive pressures in the in power generation facilities are facilitated by a strong generation and supply markets. and well-regulated transmission network. Transmission investments should help reduce the cost of supply by 31. For small markets with little or no opportunity for 7 better use of existing generation capacity and facilitating cross-border trading, regulation of a vertically integrated competition. The Bank can consider support to public monopoly may be the most cost-effective choice until sector transmission companies under a sound overall the power market has grown substantially. However, both reform program. Investments should focus on service market growth and regional power markets can be expansion, technical and commercial loss reduction, facilitated by the unbundling of even relatively small systems. and facilitating trade through de-bottlenecking and Unbundling of accounts, staff and management should congestion management. be the first step in this to increase the transparency of price setting and facilitate benchmarking of costs and 29. Governments may seek to introduce new, local service standards,15 but full unbundling will be required to service providers into the rural electrification business to make these changes effective. These actions will also meet demand in areas currently not served by the facilitate regulation by providing better information on costs. incumbent(s). Bank staff should carefully assess the need for capacity building for these entities. They should also 32. The potential benefits of moving to more competitive consider how best to deliver this support, and in trading arrangements are well known and, in addition particular whether it should be provided through existing to governance and regulatory motivations, usually underpin facilities like SME development windows and NGO- the extensive vertical and horizontal unbundling supported micro-finance and business development of monopolistic service providers. The difficulties in entities. Staff should factor in the state of private sector implementing competition in power markets are also by and financial sector development when assessing the now well known.16 There are several reasons for possibilities for SMEs or community-driven models in the approaching full competition cautiously, but four factors power sector. are particularly apparent in developing countries: ˇ Many existing markets are too small to support the number of suppliers and purchasers needed for full competition in the market. See "Private Participation in the Power Sector in Europe and Central Asia: Lessons from the Past Decade", by G. Stuggins and V. Krishnaswamy, 14 World Bank Working Paper No. 8, 2003. Benchmarking can be a useful mechanism to help regulators review prices. However, a number of shortfalls in applying benchmarking are as 15 cited in papers by Graham Shuttleworth's on www.nera.com. In particular, see "Regulatory Benchmarking: A way Forward or a Dead-end?, October 1999. See Besant-Jones and Tenenbaum "California Power Crisis: Lessons for Developing Countries", Energy and Mining Sector Board Discussion 16 Paper No. 1, April 2001. ˇ Even in larger markets, for a number of reasons group of entities abuses its market power. In addition, there are significant risks of market power abuse if the transmission/system operator function should suppliers are allowed to charge market-based prices. remain at arm's length from buyers and sellers in the power market to prevent capture of this monopolistic ˇ The sector may have a number of distributors that function by one or a group of market participants, are not sufficiently creditworthy for trading on and thus it often remains under public ownership.17 commercial terms. Regulation ˇ Policy makers have limited tolerance for the substantial price volatility that occurs with competition in 35. The development of capabilities and institutions to the market regulate power markets is an important part of sector reform. However, it is unrealistic to expect that a new 33. While not losing sight of the long-term potential of regulatory system will be fully functioning and credible moving to fully competitive markets, staff should advise as soon after it is formally created. Experience shows most of the Bank's clients to consider, for the near- to that developing robust regulatory frameworks and strong medium-term, limited competition for the market. institutions to manage them can be hampered by a variety Examples include allowing open access to networks by of constraints, in particular under-funding and a reluctance 8 third parties besides the main generators and distributors, by governments to transfer real independence in decision- and trading on a bilateral basis between generators and making to regulatory authorities even when required to do distributors and other suppliers. so by law. Therefore, it is not surprising that private sector investors contend that a credible regulatory system requires 34. For a number of reasons, in reforming markets power more than a formally independent regulatory entity, capacity and energy tends to be traded under medium- especially in the critical early years right after it is created. and long-term contracts. Broadly speaking, this contract market comes in two models. In one of them only one 36. Since the reality is that many regulators will begin entity (a "single buyer" that is often the state-owned performing their functions with the disadvantage of limited transmission company) contracts to buy all or most of independence and capacity, other transitional arrangements the power produced by generators and sell it to distributors may need to be established to provide stability and and large power users. In the other, generators contract predictability for a new regulatory regime. This could bilaterally with distributors and large users in a multi- include limiting the amount of discretion that regulatory buyer/multi-seller trading structure. The second model bodies have in setting prices and key parameters, particularly requires a mechanism to balance contracted flows of during the initial years of public private partnerships, power with actual flows. While the most efficient balancing particularly where the private sector is investing significant mechanism in theory is a liquid spot market, in practice amounts of capital. This can be achieved by setting out many power markets are too small and institutionally details on key terms, such as initial price controls in the key undeveloped to provide the necessary liquidity. In those regulatory instruments (licenses or contracts), or by having markets, staff should advise clients to consider more clear tariff setting principles in the country's legislation. managed approaches to settling imbalances. Gradual In many situations, governments may have to play a market opening can be facilitated through measures that major role in setting the initial terms and conditions of key enable large users to enter into bilateral contracts with regulatory instruments since these are best established as suppliers, gradually increasing this market by lowering an outcome of the transaction process. Finally, since it the threshold power consumption level for eligibility to will not be possible to anticipate all future events, there enter into these contracts as experience warrants. must also be robust and workable mechanisms for Where competitive markets are created, the government resolving disputes. Alternative (i.e. not going through must ensure that market surveillance is set up so that local courts) dispute resolution mechanisms are often the market operates as intended and that no entity or preferable, including international arbitration.18 See "Transmission System Operators ­ Lessons From the Frontlines" by B. Tenenbaum, World Bank Energy and Mining Sector Board 17 Discussion Paper No. 4, The World Bank, June 2002. See "Regulation by Contract ­ A New Way to Privatize Electricity Distribution?" by Bakovic, Tenenbaum and Woolf World Bank Energy and 18 Mining Sector Board Discussion Paper No. 7, May 2003. 37. Bank staff should judge the appropriate models to state-owned monopolies has successfully improved be adopted and implemented in each case by considering commercial performance. Nonetheless, such regulation ways in which the institutions, regulatory instruments, can make better known the deficiencies in performance and regulatory skills can be developed and established of the public utility, and improve transparency and over time in countries undertaking reform (see Table 2). accountability simply by reporting and benchmarking performance and thereby increase pressures for change. Table 2. Designing Regulatory Frameworks Access and affordability I N S T I T U T I O N S I N S T R U M E N T S S K I L L S What attributes What comprises the What are the tools 40. Comprehensive reforms that place the sector on a are necessary for legal framework that the regulator sound financial footing will generate increased resources regulators to within which the needs to manage for investment in system expansion. However, improvements perform their regulator works? within this mission? framework? in access to electricity services do not automatically follow such reforms. The nature of the problem ­ lack Independence Legislation Monitoring of access to credit, high connection costs, affordability Accountability constraints ­ should first be diagnosed, and the findings Contracts Enforcement should guide policies to address access and equity Transparency Licenses Asset Valuation issues in the sector. In cases where most of the existing 9 consumption subsidies are captured by the better-off Adequate funding Arbitration and Alternative Financial Analysis Dispute Resolution (i.e., the connected, high consumption customers), staff Legitimacy Benchmarking should discuss and agree with clients measures to focus subsidies on lower income consumers. Professional and Industry and company technical expertise financial models 41. Various regulatory and policy approaches have been tried to expand access and affordability.19 They include the use of connection or coverage targets in concession 38. Building professional regulatory capability requires and license agreements, obligation to offer service, political commitment and adequate funding on the part liberalizing entry by other suppliers to unserved or under- of the government. If these prerequisites are in place, served areas; allowing different levels of service for staff can help mobilize a wealth of resources and networks consumers; and the provision of subsidies for system (like IFUR and the regional networks such as SAFIR and expansion and consumption. Governments should also AFUR). In countries with little regulatory capacity, contracting recognize that electricity may be appropriately provided out of many of the technical functions of regulation should by cooperatives or other community organizations operating be considered. Support from established regulatory mini-grids or reselling power purchased from the grid or agencies ­ perhaps linked through regional fora ­ will be by private entrepreneurs offering solar home or battery important in transferring knowledge and best practice. recharging systems. 39. Economic regulation is based on the fundamental 42. In general, targeting subsidies at connections assumption that the regulated entity responds to economic would be preferable to subsidizing consumption. incentives. However, this assumption is false in the case Staff should assess, along with the government, of many public sector firms. Publicly owned service the extent to which proposed subsidy schemes would providers generally do not respond to economic incentives, benefit the poor and whether there is sufficient fiscal such as those which increase profits if efficiency targets space for these subsidies. Schemes that ensure competition are exceeded, unless they have been successfully for subsidies on the part of the service provider should commercialized. For naturally monopolistic segments, reduce the fiscal burden. Cross-subsidies from other there remains the need for effective regulation regardless consumers can also be employed, but staff should of ownership although there is no strong evidence in check that this approach would not unduly distort developing countries that independent regulation of electricity prices or burden those consumers. See Estache et al "Accounting for Poverty in Infrastructure Reform", WBI, 2003 for a discussion of access issues and experience in Latin America 19 on this. Environmental considerations 45. Energy staff should ensure that their activities are consistent with the country's poverty reduction strategy 43. The Bank Group should strive for effective and within the County Assistance Strategy. Staff should environmental oversight of the power sector, regardless also review investment climate issues in attracting of the state of economic reform and the mix of public private capital and the need for broader interventions to and private roles. Reform of the sector provides an achieve required policy and institutional changes. Staff opportunity for examining environmental regulation, and should engage clients in a dialogue about how the for assessing the relationship between the environmental energy strategy fits into the broader poverty, economic, and economic regulators. Measures should also be taken and environmental agenda. to ensure that reforms do not adversely affect the market for electricity generated from renewable energy sources. 46. While staff should consider carefully the electricity Environmental externalities should ideally be directly sector in terms of the dimensions of reform discussed included in project economic analysis. above, Bank Group interventions often focus on one or more specific components of the electricity sector. In C. STRATEGIES FOR EFFECTIVE BANK deciding the appropriate mix of instruments for these GROUP INTERVENTIONS interventions, staff should be aware that where possible, Bank products that do not represent a claim on 10 44. The Bank Group faces many challenges to taxpayer resources should be preferred. Hence the achieve the objectives for its energy sector interventions, selection of instruments depends on the issues to be particularly as regards contributing towards the MDGs. addressed in the sector components covered by the These interventions occur in a dynamic, reform-oriented Bank's interventions, and the public and private roles context in most situations. The range of instruments envisaged for these components (see the matrix available to Bank staff is broad, ranging from technical attached to the back of this note). assistance, adjustment loans/credits, standard investment approaches to utilizing new products, such as OBA and 47. In Generation, private financing, whether from guarantees. More importantly, the potential for combining local, regional or international investors, is preferred. products promises both new opportunities but poses new Most governments can create a substantial role for and complex challenges. It should be recognized that private generators within their sector development significant effort will be required to get various institutions strategies. Nonetheless, public support, in the form and their instruments working effectively together, an of IDA/IBRD guarantees and other forms of credit effort that should start as far upstream as possible ­ enhancement, will be a critical component of many preferably at the level of the PRSP, CAS and Bank Group private financings in the generation, along with IFC strategies for individual country power sectors where possible. and MIGA products. The Results Chain shown below summarizes the recommended approach in a general way. FIGURE 2. RESULTS CHAIN OF BANK GROUP ELECTRICITY INTERVENTION INPUTS OUTPUTS OUTCOMES ˇ Energy staff input into: ˇ More focused client ˇ Increased Service Delivery ­ Poverty Reduction energy strategies ˇ Improved Growth Strategy Papers ˇ More projects with better ˇ Reduced Poverty ­ Country Assistance combinations of ˇ Continuous Monitoring Strategies instruments and Measurement of ­ Recent Economic ˇ Better advisory work Results Developments in ­ Rigorous indicators ˇ Contributions to Achieving Infrastructure (REDI) enabling cross-country the Millennium ­ Investment climate comparison Development Goals Assessments (ICA) ˇ Higher profile in ˇ Focused Bank Client adjustment lending dialogue (PRSCs) 48. Justifying public sector investment in generation on 51. Where staff judge that supporting lending to public the grounds that it reduces financial costs to the sector is thermal generation projects fits with the Bank's strategy not adequate since this simply reflects the subsidies present of assistance for the sector, then the following criteria in public financing. Staff should also critically assess should be met before such support is given: proposals for public financing of generation that rest on the grounds of meeting affordability and equity concerns or ˇ Generation projects under consideration are clearly addressing environmental externalities. Staff should instead consistent with a rigorous and up-to-date least-cost consider approaches where subsidies are more directly system expansion plan in the country or regional context targeted towards specific environmental or access goals, for example as subsidies in a competitive procurement ˇ The government has already taken steps to address for environmentally-friendly generation, or as targeted the main operational and financial problems in the subsidies for electricity distribution services, such as new sector and has in place a credible plan for ensuring connections, or supply to disadvantaged households. the sector remains on a sustainable financing footing 49. In some countries there may be concerns that ˇ There is fiscal space for these investments, and that private financing of thermal generation will not be they represent priority investments given scarce forthcoming, even with substantial support from the public resources; the impact of these investments on Bank Group, and that these projects will therefore have the public sector deficit, and possible impacts arising 11 to be financed and undertaken by the public sector. from the government failing to implement strategies Before supporting such a strategy through IDA/IBRD for placing the sector on a sustainable financial financing, Bank staff should work with the government footing should be evaluated. concerned to undertake a market test to assess whether there is indeed interest from the private sector. This 52. New, large, and complex hydropower projects that market test would incorporate Bank Group instruments have strong economic justification will usually require available to potential private financiers. The test could significant public investment. Compared to thermal involve competitive tendering with Bank Group instruments generation, hydro projects have very different risk and (including IDA/IBRD guarantees, and IFC and MIGA benefit profiles and, accordingly, a much greater public products) built into the tender documents. Bank Group financing role. These include the geological and staff should agree with governments on streamlined hydrological risks, the long-lived nature of the assets, procedures for ensuring that such a market test can be and the fact that many hydropower projects are conducted efficiently by the prospective borrower. multipurpose projects providing public goods such as flood control and drought protection. The Bank should 50. There may be no private interest in these projects, support dams that are economically well justified, and despite the availability of Bank Group instruments. The should ensure that all such projects meet the good lack of a credible reform program in which the sector environmental and social practices which have been generates insufficient revenues to cover costs and pay developed by the industry in recent decades. The for incremental generation is of particular concern. context of the particular country (and in some cases, Here, more public investment may increase the fiscal drain regional) situation should be carefully considered. from the power sector and weaken pressure to improve sector finances. In these situations, staff should consider 53. In Distribution, the focus should be firmly on carefully whether any form of substantial intervention in service delivery. Financial viability of distribution is of the power sector would at this stage be beneficial. In such the highest priority, as the interface with the customer cases, interventions other than supporting public financing determines the level of liquidity for all service providers of generation may be preferable, for example support to in the sector. Experience in distribution privatization has reduce losses and revenue leakages through public-private met with problems in some countries, particularly where partnerships in distribution. government have not lived up to their promises or where private investors misunderstood market risks. Staff should focus on ways in which public sector resources (encompassing equity, loans, output-based grants, and risk management products, including guarantees for the maintenance of contractually-agreed 55. For Rural Electrification and Renewable Energy, regulatory frameworks) can best be packaged with staff should consider possibilities for mobilizing grant sector reforms to leverage private sector investment and resources for clients because of affordability problems. expand access. Possibilities for emerging regional and Cooperatives and dedicated rural electrification agencies, local companies to enter existing or greenfield electricity that have a clear mandate, have shown promise in some supply businesses should be considered. Management countries. For electrification programs, OBA would be contracts or leases will not usually be suitable long-term well suited for IDA grant financing, especially as IDA's solutions, need to be considered selectively. Bank and grant window evolves. Staff are also encouraged to MIGA are well-placed to provide non-commercial risk consider mini-grid, off-grid and grid extension options in guarantees on such management contracts to the extent rural areas. Small power generation requires careful that private financing is mobilized to implement the consideration, taking into account pricing distortions, as contracts. Good performing state-owned distribution they can decrease supply costs and improve grid companies can be considered for new lending. Where stability. For renewable energy, staff should ensure appropriate, Partial Credit Guarantees (in IBRD familiarity with funding possibilities under PCF, CDF, countries) should be considered to facilitate their access CDM, and GEF. to commercial debt markets. 56. Regional integration projects can bring substantial 12 54. Transmission should be seen as an important benefits in terms of reducing generation costs, increasing avenue for public sector investment lending by the Bank reliability and introducing competition. However, staff as transmission systems form the backbone for market should also address the viability of these projects absent operation and facilitate trade. Lending for transmission reforms in the markets being integrated. While many can take place where this function is the responsibility of partially reformed markets would in practice be able to a capable public sector entity, or for combined operations benefit from greater regional integration, in some areas where new lines are developed on a turnkey basis with trade in general, much less realizing the full benefits of private and public participation. Staff should seek trading possibilities, will not be possible without opportunities to assist governments with new investments financially stronger entities. and with establishment and institutional strengthening of new or restructured transmission companies. Bank support for public and public/private transmission investments needs to take into account client commitment to overall reforms, including the attraction of private capital in generation and distribution. Successful experience with BOOT-type transactions, particularly in Latin America, shows that private capital can be beneficially invested the transmission sector, and PSP possibilities in transmission should be presented to clients. Matrix of Bank Group Electricity Sector Interventions SUB- KEY ISSUES PRIVATE SECTOR GOVERNMENT BANK GROUP SECTOR INTEREST APPROACH INSTRUMENTS Generation ˇ Rehabilitation HIGH but. . . . HIGHLY RECEPTIVE IFC ˇ New capacity Policy and regulatory Most governments MIGA20 environment has to assuming substantial ˇ Sector finances be right private sector investment IDA/IBRD Guarantees in generation to attract project debt ˇ Who buys new PSP desirable but not at capacity and any cost: esp. important Public support to cover energy, and how? to limit contingent policy/regulatory risks liability exposure vs. necessary in many of ˇ How to finance direct liability through developing countries required capacity public power needs? development Public investment role might be necessary 13 ˇ What trading Investment Climate opportunities are must be amenable to there for new PSP in energy generation entrants? Transmission ˇ Rehabilitation and MODERATE MODERATELY RECEPTIVE IFC and System Strengthening MIGA Operations With right structure, Most Governments assume IDA/IBRD ˇ Expansion there might be continued state ownership significant interest in (if not monopoly) and ˇ SILs/IBRD PCG for ˇ Regional management contracts operational role but many public sector Interconnections for transmission asset are open to private investment management and investment in new lines ˇ PSP in new lines ? system operations ˇ Guarantees for Transmission business may BOTs and BOOTs ˇ Single Buyer role ? There are opportunities be complicated by Single for private investment in Buyer responsibilities ˇ Financing of ˇ Third-Party Access new lines, but deal flow management (TPA) is relatively slow and contracts? there are only a few significant private players There have been successful BOOTs especially in Latin America MIGA products ­ inconvertibility and transfer risk, expropriation, breach of contract, war: cover on project equity, management contracts, turnkey 20 contracts and debt. Matrix of Bank Group Electricity Sector Interventions SUB- KEY ISSUES PRIVATE SECTOR GOVERNMENT BANK GROUP SECTOR INTEREST APPROACH INSTRUMENTS Distribution ˇ Rehabilitation LOW MODERATELY RECEPTIVE IFC and Access and Strengthening Key challenge is how Many Governments MIGA to package recognize that PSP is ˇ Expansion esp. Government reform highly desirable but OBA support to for new initiatives and Bank many also are reluctant distribution PSP connections Group products to push pricing reform schemes should be to increase private too fast prioritized ˇ Cost-covering sector interest tariffs Important to deal Management contracts Emerging local and up-front with social, and leases might need ˇ Cost regional players can labor issues to be considered for at minimization play an important role least an interim period 14 as operators or ˇ Sustainable minority partners ­ but IDA/IBRD ­ OBA; subsidies often lack adequate guarantee products financing capacity, covering maintenance ˇ Stable tariff how to do due of agreed regulatory evolution diligence on them? frameworks GuarantCo (for covering risks at sub-sovereign level) Regulatory ˇ Electricity market Fair, predictable, and Some reluctance IDA/IBRD TA and Market design transparent regulatory regarding regulatory Matrix condition for Framework framework is independence adjustment lending? ˇ Building eventually critical for professionalism attraction of PSP Political economy of Trust Funds in regulation ­ pricing puts regulatory institutional Sector financial agencies in difficult Bank staff to bring in options ? restructuring, level- position bilateral donors (e.g. playing field with USAID) ˇ Regulatory public utilities tariff discretion ­ path, and subsidy Global and regional independence? approach need to be networks of regulators regulation by fully integrated (IFUR, SAFIR, AFUR) contract? The existence of ˇ Pricing adequate transmission approaches network and credible off-takers with whom ˇ How much to contract capacity are competition essential for new and when? green-field investors. Matrix of Bank Group Electricity Sector Interventions SUB- KEY ISSUES PRIVATE SECTOR GOVERNMENT BANK GROUP SECTOR INTEREST APPROACH INSTRUMENTS Rural ˇ New connections MODERATE to LOW MODERATELY to HIGHLY IFC (incl. Municipal Fund) Electrification RECEPTIVE and Access ˇ Sustainable subsidy Focus is likely to be on MIGA approaches ­ OBA ? smaller national and Many governments regional players recognize the limited IDA Grants for OBA ˇ New operators inc. potential of pure public SMEs, CDD, IMC Potential for SMEs/CDD approaches to the access IDA/IBRD entities to enter an RE problem loan/guarantee support ˇ Social connections market needs to be for OBA ­ health clinics, carefully considered schools, village GEF/PCF lighting GuarantCo ˇ "Rural livelihoods" 15 approaches are Business development difficult in practice from SME facilities Renewable ˇ Carbon mitigation MODERATE to HIGH HIGHLY RECEPTIVE GEF Energy ˇ Transition from Subsidy will almost Governments are amenable PCF traditional energy always be necessary to to PSP in Renewable Energy attract private sector projects ­ grant helps AFRREI, ASTAE ˇ Energy diversity and security Do projects require off- Bank/IFC/MIGA take from grid? guarantees ˇ Multi-purpose, resource management benefits of hydropower with dams Environment ˇ Pollution MODERATE to HIGH MODERATELY RECEPTIVE GEF abatement Many firms thinking Coordination between PCF ˇ Environmental "green" energy and environment mitigation ministries could be an issue IFC Environment emerging ˇ Carbon emission as core competence and How to navigate "develop IDA/IBRD reduction/avoidance competitive advantage now, clean up later" for some energy firms mentality? ˇ Technology/fuel migration ­ from Subsidy may be dirty to clean applicable in some scenarios Matrix of Bank Group Electricity Sector Interventions SUB- KEY ISSUES PRIVATE SECTOR GOVERNMENT BANK GROUP SECTOR INTEREST APPROACH INSTRUMENTS Support to PSPˇ Deal flow Transparent, competitive Despite PSP slowdown, IDA/IBRD TA Transactions bid processes seen as most governments have ˇ Deal quality desirable by private increased PSP in IFC Advisory Mandate sector distribution and ˇ Leveraging public generation at the heart DevCo sector resources ­ Experience shows that of their reform plans OBA? Direct bilaterally negotiated Bank guarantees support to firms? deals have often taken Transparent PSP covering breach of more time to put transaction processes contract; can be offered ˇ Coordination with together, have higher essential for legitimacy at the time of bidding to public sector transaction costs, and enhance competition investments ­ e.g. may result in less stable Avoiding tariff shock is transmission contract structures key political economy MIGA Breach of 16 investments concern Contract cover both for sovereign and sub- ˇ Flexibility in sovereign obligations is lending program especially interesting. to accommodate emerging PSP opportunities Regional ˇ Physical LOW to MODERATE MODERATELY RECEPTIVE Bank Group should be Integration interconnections highly selective Some form of cross- Most governments and ˇ Market integration border guarantee likely parastatals like the idea Projects are unlikely to (SAPP, EU) to be essential of interconnection, but produce expected absence of functioning benefits unless country- ˇ How important is Highly dependent on internal and/or regional level reform is country-level country-level sector markets makes it difficult successful sector reform? financial health Loans and guarantees THE WORLD BANK GROUP The Energy and Mining Sector Board The World Bank 1818 H Street N.W. Washington, D.C. 20433 USA