E N E R G Y & M I N I N G S E C T O R B O A R D D I S C U S S I O N P A P E R S E R I E S P A P E R N O . 5 N O V E M B E R 2 0 0 2 Mitigating Regulatory Risk for Distribution Privatization ­ The World Bank Partial Risk Guarantee Pankaj Gupta, Ranjit Lamech, Farida Mazhar, Joseph Wright THE WORLD BANK GROUP The Energy and Mining Sector Board AUTHORS ACKNOWLEDGMENTS We would like to thank John Besant-Jones for his guidance in developing the paper. We would also like to thank Ananda Covindassamy, Mansoor Dailami, Thomas Duvall, Mohinder Gulati, Bernard Tenenbaum and Michel Wormser for their helpful comments. DISCLAIMER The findings, interpretations, and conclusions expressed in this study are entirely those of the authors and should not be attributed in any manner to the World Bank, to its affiliated organizations, or to members of its Board of Executive Directors or the countries they represent. CONTACT INFORMATION To order additional copies please call the Energy Help Desk. 202-473-0652 energyhelpdesk@worldbank.org This paper is available online www.worldbank.org/energy/ For more information on World Bank guarantee instruments contact Farida Mazhar fmazhar@worldbank.org or Pankaj Gupta pgupta2@worldbank.org or visit www.worldbank.org/guarantees The material in this work is copyrighted. No part of this work may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording, or inclusion in any information storage and retrieval system, without the prior written permission of the World Bank. The World Bank encourages dissemination of its work and will normally grant permission promptly. For permission to photocopy or reprint, please send a request with complete information to the Copyright Clearance Center, Inc, 222 Rosewood Drive, Danvers, MA 01923, USA, fax 978-750-4470. All other queries on rights and licenses, including subsidiary rights, should be addressed to the Office of the Publisher, World Bank, 1818 H Street N.W., Washington DC, 20433, fax 202-522- 2422, e-mail: pubrights@worldbank.org. E N E R G Y & M I N I N G S E C T O R B O A R D D I S C U S S I O N P A P E R S E R I E S P A P E R N O . 5 N O V E M B E R 2 0 0 2 Mitigating Regulatory Risk for Distribution Privatization ­ The World Bank Partial Risk Guarantee Pankaj Gupta, Ranjit Lamech, Farida Mazhar, Joseph Wright The World Bank, Washington, DC THE WORLD BANK GROUP The Energy and Mining Sector Board Copyright © 2001 The International Bank for Reconstruction and Development/The World Bank. All rights reserved FOREWORD Privatization of electricity distribution utilities, a key World Bank privatization guarantees have been specifically component of reforming energy markets, is a priority for designed to help governments attract back investors by the governments of many developing countries as they addressing their concerns through mitigation of perceived seek to improve efficiency and reliability and attract private government performance risks associated with privatizations. investment in network expansion. Not only is access to The guarantees can also help catalyze private capital flows 1 reliable electricity a key driver of economic growth, but it is for much needed investments in the sector, thereby reducing also a direct means of reducing poverty by improving the the fiscal burden on governments. productivity of households and enhancing the delivery of social services. Because privatizations are such an important part of the Bank's development effort in emerging market countries, The mixed post-privatization experience of investors in the Partial Risk Guarantee (PRG) can be made available utility distribution entities in developing countries, however, to clients to back regulatory and other political risks in has heightened investors' sensitivity to regulatory risk. support of distribution privatizations. This discussion paper Moreover, events of 2001/2, including the poor financial provides general guidance on how emerging market performance of several international power companies and governments could use the Bank's PRG for this purpose, the Argentinian finacial crises, have increased investors' thereby enhancing private investor interest in power risk aversion toward developing countries in general. Many distribution in these countries. investors have consequently withdrawn from these markets, leading to a substantial reduction in private capital support for privatizations. For developing country governments to Jamal Saghir realize the desired private investment in distribution utilities, Director, Energy & Water Department it is essential that they take appropriate action to address Chair, Energy and Mining Sector Board investor concerns regarding regulatory and other associated Private Sector Development and Infrastructure Vice-Presidency political risks. Recognizing the failure of the public sector to deliver Michel Wormser sustainable energy and other services, the World Bank Director, Project Finance and Guarantees Department Group has oriented its activities toward liberalizing and Private Sector Development and Infrastructure Vice-Presidency privatizing infrastructure markets under a sound regulatory framework, shifting support away from the traditional integrated state-owned monopolies and toward greater use of private investment in the energy markets of developing and transition economies in the context of sector reform. 2 INTRODUCTION & OBJECTIVE This paper outlines how a World Bank Partial Risk Guarantee As proposed in this paper, the World Bank PRG can help (PRG) may be used to promote private sector investment in to reinforce confidence in new regulatory frameworks, electricity distribution utilities. The paper explains how a thereby enabling investors to be more responsive to PRG could backstop a government commitment to a privatization opportunities. This is particularly important in pre-defined regulatory framework and a process of dispute the context of recent attempts by several countries to privatize resolution, thereby helping to mitigate regulatory risk. As their distribution business in a deteriorating investment a risk mitigation instrument, the World Bank PRG can also climate. Although PRGs are being actively considered in be applied to the privatization of generation, transmission, support of distribution privatizations in several countries, or integrated power sector businesses, as well as to other no transactions have been concluded to date. 3 infrastructure privatizations. However, this paper focuses on identifying issues and proposing strategies to cover Elements of political risks other than regulatory risk may regulatory risk in distribution privatizations, because recent also need to be mitigated to ensure a successful privatization. experience in power sector reform in developing countries Investors will typically seek coverage for other political has shown that distribution privatization can present new risks, such as expropriation, change of law, restrictions on risk allocation and risk mitigation challenges for both currency convertibility and transfer, and frustration of investors and governments. arbitration. These risks can also be covered under the PRG ­ and there are many successful examples of how this Although between 1990 and 1998 more than 70 distribution has been done.3 businesses were privatized in developing and transition countries,1 the post-privatization experience of investors in The paper presents a two step approach to mitigating these businesses has been mixed. Furthermore, in recent regulatory risk. Firstly, it reviews the nature of regulatory years private investors have shown reduced, and in many risk facing investors in electricity distribution businesses cases no, interest in power distribution utilities in developing and explains how such a risk may be mitigated through countries. In some instances of distribution privatizations, pre-privatization design of the regulatory framework and not a single bid was received. dispute resolution process. Secondly, the paper discusses the need for risk mitigation instruments such as a PRG to In a recent World Bank survey of private power investors2, backstop a government's commitment to the regulatory 45 percent of respondents considered "fair adjudication of framework and the outcome of dispute resolution. Two tariff adjustments and disputes" to be a critical factor in possible structures for applying a PRG to this end -- a determining the success or failure of an investment, making Limited Recourse Structure and a Letter of Credit Structure it the second most important factor after "cash-flow sustain- -- are described. Last, the paper outlines a process for ability" (which is also affected by tariffs). In the same survey, implementing a privatization using a PRG. when asked to describe their worst power sector investment experience, 50 percent of respondents cited a failure to respect contractual regulatory commitments as a contribut- Most of these privatizations took place in Latin American countries, notably 1 ing factor. Clearly, regulatory risk in developing countries is Argentina (18), Brazil (17), Peru (9), El Salvador (3), Colombia (3), Bolivia (2), considered by investors to be a political risk that must be Dominican Republic (2), Guatemala (2), and Panama (2). The results of which are to appear in a forthcoming Energy and Mining 2 adequately mitigated if they are to invest in the privatization Sector Board Discussion Paper by R. Lamech and K. Saeed, "Survey of of distribution businesses. Power Sector Investors in Developing Countries." See PFG Notes on guarantee operations at www.worldbank.org/guarantees. 3 THE NEED TO MITIGATE REGULATORY RISK It is also important to note that, from the perspective of private investors, these features of distribution businesses Distribution privatization is considered a priority because of constitute risks. Firstly, the fact that it is difficult to liquidate low levels of access to electricity in developing countries, or re-deploy distribution assets exposes the investor to the the deterioration in supply quality in many power systems risk of strategic behavior by the government, for example, during the 1990s, and the limited availability of public effective expropriation of the assets by setting tariffs below capital to fund rapid network expansion. Privatization is costs. Secondly, concern about abuse of monopoly power also expected to address high distribution system losses, means public scrutiny of profitability (even if these profits which undermine the benefits of efficiency improvements in are legitimate according to regulated prices). Thirdly, there upstream sectors of the industry. In addition, improved cash is the risk that the government will seek to impose below collection at the distribution level supports the privatization cost tariffs or unviable investments on the utility in order to of upstream generation businesses by reducing the credit seek political advantage. risk of power purchasers. Therefore, the privatization of distribution companies, through long-term concessions or The challenge for governments is therefore to design asset sales, is a key element of power sector reforms in regulatory frameworks that are impartial (that is independent most developing countries. from capture by the various producer, consumer and political interests) and at the same time accountable for providing 4 An important element of power sector reforms is the fair and effective regulation. A government that seeks to establishment of new economic regulatory regimes and implement an effective new regulatory framework must also institutions to make impartial decisions on tariffs, set per- be able to make a credible commitment that it will maintain formance standards, and monitor efficiency improvements. the regulatory framework in this way. However, because Power distribution networks have several special features privatizations often follow the creation of a regulatory that necessitate regulation4: framework, sometimes even occurring commensurately, governments often lack the record of good performance. · They are capital intensive, and most network assets may Without adequate assurances of an effective regulatory not be redeployed once they have been installed. framework, private investors will be reluctant to commit Therefore, if distribution tariffs are not maintained at a their capital (even though they may be willing to assume the level that permits the recovery of reasonable costs operational and investment risks of a distribution business). (including a fair rate of return), the owners may find themselves trapped in a loss making business, unable to In addition to an effective regulatory framework, the content liquidate their assets. of regulation, that is the rules about pricing, quality and technical standards under which a utility operates, are also · They are characterized by economies of scale to the of concern to investors. Specifically, an investor's perception extent that the market is most economically served by of regulatory risk will be mitigated to the extent that the one distribution network in a given geographical area. In content of regulation adheres to the following principles: the absence of regulation, consumers may therefore be exposed to the abuse of monopoly power by the network · A tariff regime that provides a predictable and stable provider. trajectory of revenues, and allows for the reasonable recovery of costs. · They supply a service considered valuable to the welfare of households, and therefore access to electricity, its · An impartial and timely process for re-setting retail tariff price and quality can be a political issue. parameters, for example, performance targets (allowable losses, expansion requirements); reasonably incurred These characteristics both make economic regulation a energy purchase costs; foreign exchange; and inflation necessity for utilities and make it difficult5. rates. · An automatic pass-through of distribution costs beyond the control of the operator. This section draws on the following two papers: Stern & Holder, 1999, and 4 Levy & Spiller 1994 (full details of these references are given at the back of the paper). Stern and Holder (1999, p35) 5 · Regulatory commitment to provide timely approvals, for MITIGATING REGULATORY RISK THROUGH example, approval of the investment programs required PRE-PRIVATIZATION DESIGN by the operator to achieve performance and expansion targets. Private investors will not invest in a business opportunity if they perceive regulatory risk to threaten the long-term · Predictable quality of service and technical standards. viability of their investments. To attract investors with the financial and technical ability to improve and expand The principal regulatory risk that a distribution utility faces distribution businesses, governments need to mitigate is that it will not be permitted to earn sufficient revenues to regulatory risk effectively in advance of the distribution cover its legitimate costs, including a reasonable rate of privatization. The best way is through sound project return. Therefore, if the regulatory rules do not enable the structuring and regulatory design, supported by political investor to project cash flow with reasonable certainty, or if risk mitigation mechanisms. they grant the regulator broad discretionary powers, then they are likely to be perceived as unacceptably risky. Two key elements of pre-privatization design are central to moderating the perception of regulatory risk. The first From the perspective of the government and consumers, involves carefully defining the regulatory framework in a minimizing regulatory risk -- both ensuring an effective manner that provides both the regulator and the investor regulatory framework and good regulatory content -- is with an acceptable level of predictability about tariff setting, 5 important for several reasons. First, regulatory risk mitigation coupled with the flexibility required to deal with changing will enhance the value of offers, and commitment to invest business conditions. The second concerns the design of a in the business, that bidders are willing to make. Secondly, dispute resolution mechanism that provides assurance that it may increase the number of firms willing to bid for a regulatory decisions can be legitimately questioned and privatization opportunity, thereby increasing the fairly resolved. competitiveness of the sale tender. Thirdly, mitigation of regulatory risk offers the prospect of lower tariffs than Defining the Regulatory Framework would otherwise be the case, as the investor may expect a lower risk-adjusted rate of return from its investment6. A carefully constructed regulatory framework built on sound fundamentals should address each of the conditions In later sections this paper discusses how a PRG could be discussed previously. While accommodating the need to be utilized to reinforce the credibility of a government's flexible, the regulatory regime should not allow crucial commitment to a regulatory framework while it establishes adjustments that affect the investor's revenues to be a record of good performance. It may be questioned delayed by a regulator's inaction. Hence, it is important to whether a government back-stop supported by a PRG is define a period within which the regulator is required to necessary if a government has already signaled its respond to a tariff request from the investor. commitment by establishing an independent regulator with what may be considered a good regulatory framework. The general principles of this type of regulatory framework Experience has shown that in the difficult transition to credible are best established in primary legislation such as an regulatory and government conduct: (a) governments have electricity reform law, while the detailed implementation of been known to undermine a good regulatory framework by these principles may be defined in secondary legislation, causing regulatory rules to be broken through indirect licenses, concession agreements, or regulatory orders. The pressure on a regulator, denying the regulator adequate benefit for all parties is that the tariff methodology and resources to do a effective job, and frustrating the dispute parameters, and the procedure to effect changes, to the resolution process; and (b) regulators have been known to extent possible, are defined in advance.7 For example, this take decisions that may be technically correct but practically methodology could encompass a multiyear tariff path unsound -- for example, denying a revision of agreed (typically lasting five years or longer) calculated according baseline loss levels when facts prove those initial baselines to This point should not be overstated: it may be that investors are unable to 6 have been wrong. In this context, a PRG can help to facilitate effectively price regulatory risk in emerging markets into their expected rate a smooth transition to a credible regulatory framework. of return and that they would rather not invest at all if regulatory risk is a serious concern A forthcoming paper by Bakovic, Tenenbaum, and Woolf provides a detailed 7 analysis of this type of arrangement ­" regulation by contract" - along with examples of its application. to well-defined tariff formulae and base assumptions. The Dispute Resolution Mechanism investor is better able to assess the prospective profitability of the company and associated business risks, while the The existence of clear regulatory rules does not remove the government and consumers benefit from a predictable possibility of a dispute arising as a consequence of an tariff path and assurance that the investor will meet its unforeseen event or an alleged failure by one party to performance obligations, thereby reducing the risk of abide by the regulatory contract or license. Therefore, a disputes for both parties. key component of regulatory risk mitigation is a regulatory framework that commits both parties to adhere to established This type of regulatory predictability does not undermine dispute resolution mechanisms. regulatory authority; rather it requires laying the basis for making major regulatory decisions in advance of the The specific mechanism for achieving this will vary according entry of the private investor, and specifying them in the to country circumstances and the outlook of the investor license, regulatory/concession contract, or other binding and the government. For example, some jurisdictions legal instrument. The regulator is then responsible for permit international arbitration, while others do not. In administering the rules fairly. Necessary regulatory flexibility some instances, a regulatory dispute must be heard by a is not forgone but it is circumscribed for both the investor specialized appellate tribunal, whereas in others it requires and regulator. a court hearing. 6 In practice, a regulatory framework will not be prepared Generally, however, the dispute resolution mechanism under circumstances of perfect foresight. Pre-privatization should include the following features: design of the regulatory framework will never eliminate the need for a credible and competent regulatory authority, as · The form of dispute resolution should be appropriate to it will be necessary to periodically re-set the tariff formula the magnitude of the dispute, in terms of both time and or other elements of the regulatory framework. For example, cost. For example, a dispute with a regulator over it is common for both the regulator's and the investor's enforcement of easement rights for a distribution line understanding of system losses to evolve as better informa- would be more appropriately handled by a local court tion becomes available after privatization. In addition, than by international arbitration. some of a distribution company's costs (for example, taxes, compliance with environmental standards, and sometimes · The adjudicator of a dispute should have the requisite power purchase costs) are beyond its control, and changes technical expertise to make an informed determination. in such costs should be appropriately reflected in a retail For example, a dispute over the correct value of the tariff adjustment. Such adjustments may be unavoidable asset rate base may be better referred to an independent within the multiyear tariff period, but as far as possible engineer rather than a local court. tariff adjustments should be scheduled from the outset8. · The dispute resolution process should have a well-defined Where cost changes are beyond the control of the operator timeframe. For example, specific time limits within which and are objectively verifiable, ideally tariffs would be each party must present evidence to an appellate tribunal, automatically adjusted. Tariff adjustments that involve a and within which the tribunal should issue a ruling. greater element of judgment (for example, to allow for new information on system losses) require both parties to commit · The outcome of dispute resolution should be binding, to an objective process for reaching a determination. Such a and the opportunity for appealing a decision should be process, for example, might involve the use of independent limited. For example, if it is possible to appeal the rulings expert third parties, or a commitment to mediated negotiation. of a specialist appellate tribunal to the local judicial system (and this is done commonly), then the tribunal may effectively serve to delay dispute resolution. Stern & Holder (1999: p39) observe that "Given the enormous difficulties of 8 writing (let alone rewriting) time-consistent, enforceable long run contracts for a long period ahead that can cover all the necessary contingencies, elim- · The parties to dispute resolution should have access to inating any mediating regulatory agency is likely to place too much strain on the concession agreement." The recommended strategy is therefore to have formal international arbitration (International Center for a capable and independent regulator to complement the concession agree- the Settlement of Investment Disputes - ICSID, United ment, and for the concession agreement to clearly define the roles of the regulator and the investor, and the process for re-opening the agreement should it be necessary. Nations Commission on International Trade Law - perceptions of political risk by developing a good track UNCITRAL, and so forth) in the event of a serious dispute. record of implementing sound policies. However, political risk guarantees may be needed during the transitional · There should be incentives for parties to settle disputes period to allow a government the time to build a credible before commencing the formal dispute resolution process. policy and regulatory track record. The problem for One example is the use of procedures for notification of governments is that their contractual commitments may not each party when regulatory rules are thought to have be sufficient to assuage investors' concerns, particularly if been violated, and `cure' periods whereby disputes may they have a poor track record to date in honoring contractual be settled amicably before formal dispute resolution undertakings or supporting private investment in the country. commences. In such instances, a third-party political risk guarantee, such as a World Bank PRG, may be required to backstop government policy and regulatory undertakings USE OF A PRG TO BACKSTOP REGULATORY RISK In the context of regulatory risk, a PRG could backstop a government commitment that the regulatory framework World Bank privatization guarantees can help to catalyze defined in the pre-privatization phase would be adhered to private capital flows to emerging market countries by and not changed unilaterally after privatization. This can mitigating government performance risks associated with be critical for investors because there is a high perceived 7 privatizations. The Bank's guarantee is generally available risk of: (i) unilateral changes in the regulatory framework in any country eligible for borrowing from the International itself and (ii) decisions being made in contravention of the Bank for Reconstruction and Development (IBRD) or defined regulatory framework. Although investors are well International Development Association (IDA). As with loans, equipped to, and should, assume the commercial risks such the Bank would require a counterguarantee from the host as demand, collection, and operational risks, they consider government in the form of an Indemnity Agreement. In regulatory risks to be within the government's purview and addition, compliance with the Bank's policies and due beyond their control. This is especially true in emerging diligence requirements relating to the project and the market countries, where at best the limited track record of sector, including environmental and social safeguards, is regulatory bodies does not enable investors to assess the required. PRGs can support both foreign and domestic extent of their independence from government influence. currency financing. Because governments are responsible for setting up the Given the Bank's unique relationship with its member policy and regulatory framework, and in particular as they countries and their governments, it is better equipped than often have a say in the appointment of the regulator, the private sector to backstop certain political risks, thereby investors believe that governments should be in a position reinforcing the incentives for governments to comply with to commit themselves to not interfere with the regulatory their performance undertakings. A PRG would be particularly mechanism. In addition, they would expect the government relevant in countries where the sector is in the early stages to take the steps necessary to compensate them in the of reform and the perceived risk of policy reversals and event that a regulator refuses to abide by the regulatory changes to the regulatory framework is high. The Bank's framework (once confirmed by the outcome of the dispute objective when structuring a PRG is always to provide its resolution process) because they have no other recourse support only to the extent needed to make a privatization except to the government. In such instances, the government transaction financeable in the commercial markets (see the would be expected to take remedial steps, including section entitled "PRG Structures for Mitigating Regulatory compensation, because the government at its discretion Risk" for details of alternative PRG structures) has alternative means of recovering compensation payments made to the investor (for example, through levying additional Political risk guarantees are necessary to support private taxes or lowering subsidies to the sector). power investment in circumstances where investors lack sufficient assurances that a government will not change A PRG for regulatory risk mitigation would therefore the policy framework unilaterally, and will maintain the address a specific gap in risk coverage that investors seek commitments relating to the regulatory framework that it in countries where the sector is in the early stages of has put in place. A government can best mitigate investors' reform (see also the box entitled "Coordination of the PRG with Other Bank Group Instruments"). By backing the primary or secondary legislation, a license or regulatory principles agreed to up front by all parties, the concession/regulatory agreement -- the GSA commits the PRG would reinforce the incentives for compliance by each government to backstopping this framework, and the PRG party. The PRG would weaken the incentives for existing would guarantee this government commitment. A PRG and future governments to exert pressure on the regulator therefore would not interfere with the definition or adminis- to deviate unilaterally from the framework because it would tration of the regulatory framework. In addition to the bind governments and make them contractually accountable regulatory risk, other associated risks, which would include for their undertakings. At the same time, by backing the frustration of the dispute resolution process, may need to regulatory or licensing agreement, and the dispute resolution be addressed in the licensing agreement or the regulatory process contained therein, the PRG would strengthen the contract as well as in the GSA. Other such risks might be: incentives for the regulator to abide by the agreements, competition policy, the ability for the operator to enforce thereby reducing the likelihood of the regulator behaving disconnections in accordance with prevailing laws, the capriciously and exposing the government to claims for ability to collect payment from government consumers, and damages that could undermine the sustainability of the performance of the electricity generation and transmission privatizations. The investor on its part should be held companies. These risks would be considered as a subset of accountable by the regulator for the investment and the regulatory risks and could be backed by the PRG (see operational efficiency commitments that are under its "Risk Coverage" on page 11). 8 control, which would not be guaranteed by the PRG. PRG's do not provide cover for lenders against debt service A PRG is essentially a transitional instrument to be used shortfalls that result from operational inefficiency and other until a country has developed a regulatory track record commercial risks. and has built up sufficient confidence in its sector policy and political environment. To this end, a PRG may be A PRG to support distribution privatization would generally structured to include financial incentives for the private require a direct contractual agreement between the gov- lenders or the investor to allow the PRG to "fall away" ernment and the investor in the form of a Government once certain pre-agreed conditions have been met. These Support Agreement (GSA) confirming the obligations of the conditions could be contingent upon the achievement of government with respect to the agreed-upon regulatory appropriate credit ratings for the privatized entity or certain framework and mechanism to resolve disputes. In whichever debt service or other financial ratios which would indirectly manner the regulatory framework is defined -- be it in reflect compliance with regulatory rules for setting tariffs. In Coordination of the PRG with Other Bank Group Instruments World Bank guarantees generally complement other Bank Group instruments, which are deployed following a hierarchy that starts with financial market-based instruments, followed by Multilateral Investment Guarantee Agency and International Finance Corporation instruments, then Bank guarantees (with the sovereign counter- guarantee), and finally sovereign-guaranteed loans and credits to state-owned energy suppliers when private investment cannot be catalyzed or for investments that the private sector should not undertake. However, the Bank's Board has agreed that the PRG can be considered for deployment on a "stand-alone" basis when one or several of its features (explicit counterguarantee, booking on Bank's balance sheet and specific remedies attached, influence of the Bank, linkage to the Bank's sector dialogue, sector conditionality, and so forth) are critical from a risk management or market point of view to achieve private financing objectives. Thus, deployment of PRGs can be considered for transactions where one or several of the following conditions are met: · The sector is in the early stages of reform, where the risk of reversal is seen as significant; · The operation is risky and large and booking of the risk on the Bank's balance sheet, with remedies attached to Bank operations, is seen as preferable from a risk management perspective. · The operation is highly dependent on government support or undertakings, and the explicit counterguarantee and the clout of the Bank are seen as critical to mobilizing private financing. cases where the appropriate credit ratings or financial ratios Bank. This helps achieve more sustainable retail tariff are not achieved because of inefficient management, the regimes for consumers by lowering the capital costs that PRG would not fall away, but it could not be called in so far investors need to recover through tariffs. as there are no instances of government non-compliance. · No Incremental Government Liability or Costs: The ADVANTAGES OF THE PRG PRG generally does not give rise to any additional con- tingent liability for the government, as it backstops only The PRG supports two key objectives for providing risk the contractual arrangements that the government mitigation for distribution privatizations, as follows: already makes with the investor. However, mitigation of the critical risk of the regulatory performance could · Enhancing Investor Interest: Risk mitigation through a enhance the willingness of investors to assume additional PRG strengthens investor confidence in a government's risks in other areas. In addition, the government does commitment to the regulatory framework. As a consequence, not incur any cost associated with the PRG, as all more firms may be expected to bid for a privatization, guarantee-related charges are payable by the investor thereby increasing the competitiveness of the tender, (see "Guarantee Related Charges" on page 10). resulting in higher bid prices or stronger upfront commit- ments to invest in network rehabilitation and expansion. · Reinforcing Regulatory Independence and Credibility: The Bank's involvement through a PRG 9 · Leveraging Additional Investment: A PRG improves signals government's commitment to achieving a credible the risk profile of the privatization, enabling investors to regulatory regime as a basis for sustained investment raise funds in commercial debt markets that may not be and financial viability in the sector, thereby boosting available without some form of political risk mitigation. investors' confidence in the sector. Thus, a successful As such, a PRG helps make the privatizations financeable privatization supported by a PRG has a positive demon- by catalyzing acquisition finance as well as by leveraging stration effect by making future privatizations feasible large amounts of capital typically needed for network without the need for political risk guarantees. rehabilitation and expansion. In this way, the pace of new investments for expansion of relevant services can be accelerated by overcoming the general reluctance of PRG STRUCTURES FOR MITIGATING investors to commit large amounts of capital upfront. REGULATORY RISK Catalyzing such investments through the private sector can relieve a government's fiscal resources for other The Bank has developed two guarantee structures to expenditures. mitigate regulatory risk in distribution privatizations: (i) a Limited Recourse structure, and (ii) a Letter of Credit (L/C) A PRG offers the following additional benefits through its structure. Both these structures can be used to support political risk mitigation: privatizations undertaken by means of a Concession or Transfer of Ownership. · Better Risk Sharing: The risks covered by the PRG would be limited to government-related performance Limited Recourse Structure: undertakings. In this way, the PRG provides a transparent mechanism for allocating risks between the government Under the limited recourse structure, the Bank can provide and investors. The government is accountable only for guarantees of commercial debt or shareholder loans to the its own actions and for the proper implementation of privatized company, thereby providing political risk mitiga- the regulatory framework, while the investors are tion as well as catalyzing commercial debt in support of accountable for all the commercial risks, including distribution privatizations. Under this guarantee structure, demand and collection risks as well as investment and the Borrower would be the privatized company and the performance risks. Bank would cover scheduled debt service payments. The Bank guarantee could only be triggered in the event of a · More Competitive Tariff Structures: Using the PRG to debt service default on the covered loans caused by gov- catalyze commercial debt not only helps to achieve ernmental non-compliance to its contractual undertakings much longer tenors for the debt, but also reduces the to the privatized company, typically as set out in the GSA cost of financing because of the AAA credit-rating of the (and other associated agreements) and as guaranteed by the PRG. This structure would be suited to privatizations of governmental non-compliance to its contractual undertakings large distribution companies where there is a need for to the privatized company, typically as set out in the GSA substantial amounts of debt capital for system investments (and other associated agreements) and as guaranteed by as well as for acquisition finance. the PRG. This structure would be more suited to support the privatization of small- and medium-sized distribution Letter of Credit Structure companies where the investor would be financing the purchase largely through equity or when the investor's The L/C structure is designed to provide political risk financing plan for system investments is not known ex-ante. mitigation to the private investor(s) through an L/C Facility This structure could also be utilized to support direct opened in favor of the privatized company by the government payment obligations (for example, subsidy government. Under this structure, the guarantee could payments or government payment arrears to a privatized only be triggered if cash flow shortfall resulted from a company). The two structures are described in detail below. Partial Risk Guarantees for Regulatory Risk Coverage The Limited Recourse Structure The L/C Structure Application Privatizations of large distribution companies Privatizations of small distribution companies where there is need for the investor to raise where the investor would be financing the 10 a substantial amount of debt for system purchase largely through equity or when the investment, and to finance the acquisition cost. investor's financing plan for system investments is not known ex-ante. Also, to support direct government payment obligations (for example, subsidy payments) to a privatized company. Objective · Political risk mitigation · Political risk mitigation · Catalyzing commercial debt PRG Unpaid debt service payments on a Government payments under an L/C to the Coverage commercial or shareholder loan made to privatized distribution company for cash flow the privatized distribution company. shortfalls of up to pre-agreed amounts. Illustrative An investor commits to a total financial outlay of An investor commits a total financial outlay of Structure US$100 million for the distribution company, a portion US$50 million for the distribution company. The of which may be transferred to the government as sale government opens an L/C through a domestic price. The balance is used to fund investments. There is or/ international bank in favor of the privatized an equity contribution of US$50 million together with a company for a specified amount. (For example, shareholder loan of US$25 million and a commercial the L/C could be equivalent to an appropriate loan of US$25 million to the privatized state owned percentage of projected annual revenues.) enterprise. The PRG covers a portion of the commercial Repayment of the L/C by the government is loan and/or the shareholder loan. guaranteed by the PRG. The Limited Recourse Structure The L/C Structure Government Government Indemnity Indemnity Guarantee Guarantee Regulator Regulator Agreement roceedsP roceedsP Agreement License Agreement/ License Agreement/ Repayment of L/C Government Regulatory Contract Government Regulatory Contract Sale Sale Disbursements Support Support covered by WB-PRG Equity (US$50m) Privatized Privatized Private Private Letter of Investor Distribution Commercial Investor Distribution Credit Company Lenders Total Company Letter ofCommercial Shareholder Financing Credit (US$50m) Commercial (US$50m) Bank (US$25m) (US$25m) (US$50m) Partly covered Partly covered by WB-PRG by WB-PRG Partial Risk Guarantees for Regulatory Risk Coverage The Limited Recourse Structure The L/C Structure Mechanism · The PRG can be triggered if a debt service shortfall · The PRG can be triggered if a revenue shortfall occurs as a result of a default of a government occurs as a result of a default of a government contractual obligation only if the claim is not contractual obligation only if the claim is not disputed (if the default does not result in a debt disputed (in this case the L/C Bank would make service shortfall, then the PRG can not be triggered, the payment and seek reimbursement from the and only dividends on the investor's equity would Bank if the government fails to repay the L/C bank be impacted). within the stipulated period). · If the claim is disputed, the Bank will pay only if · If the claim is disputed, the L/C-issuing bank will the dispute is resolved in favor of the investor in pay only if the dispute is resolved in favor of the accordance with the predefined dispute resolution investor in accordance with the predefined dispute mechanism. resolution mechanism. · Payments under the PRG will be limited to the · The host government would then be obligated to principal and interest payments on the covered repay the claim amount plus accrued interest to debt tranche. the L/C-issuing bank at the end of a stipulated · Any payments the Bank makes to the guaranteed period. If the government makes a repayment to commercial lenders under the Guarantee the L/C bank as due, the L/C could be reinstated Agreement give the Bank the right to seek by the amount of the repayment. If the government immediate repayment from the host government does not repay as due, the L/C-issuing bank under the Indemnity Agreement. would have the right to call on the PRG. If the 11 Bank makes any payments under its guarantee, the L/C will not be reinstated for those amounts. · Any payments the Bank makes to the L/C-issuing bank under the Guarantee Agreement give the Bank the right to seek immediate repayment from the host government under the Indemnity Agreement. A repayment by the host government to the Bank will not reinstate the guarantee to the L/C Bank for those amounts. Risk · Regulatory Risk -- tariff principles · Regulatory Risk -- tariff principles Coverage · Associated risks -- the ability of the operator to · Associated risks -- the ability of the operator to enforce disconnections in accordance with enforce disconnections in accordance with prevailing laws, the ability to collect payment from prevailing laws, the ability to collect payment government consumers, performance of state- from government consumers, performance of owned electricity generation and transmission state-owned electricity generation and transmission companies, competitive policy/market structure companies, competitive policy/market structure and frustration of the dispute resolution process and frustration of the dispute resolution process Guarantee- · Guarantee fee of 1% per annum (IBRD countries) · Guarantee fee of 1% per annum (IBRD countries) Related and 0.75% per annum (IDA countries) of and 0.75% per annum (IDA countries) of Charges guaranteed loan amounts. guaranteed loan amounts. · Upfront fee of 1% of guaranteed amount (IBRD · Upfront fee of 1% of guaranteed amount (IBRD countries only). countries only). · Initiation and processing fees of up to 0.65% of · Initiation and processing fees of up to 0.65% of guaranteed amount. guaranteed amount. The Limited Recourse Structure The L/C Structure Tariff request to the Regulator Tariff request to the Regulator Regulator takes Yes Matter Regulator takes Yes Matter appropriate action resolved appropriate action resolved No No Government/regulator Government/regulator Investor submits default notice disputes the claim Investor submits default notice disputes the claim to regulator/government to regulator/government claim 12 Dispute resolution process Dispute resolution process the dispute claim not the Decision against Decision in favor Decision against Decision in favor regulator of regulator does regulator of regulator dispute not does Regulator issues amended tariff order Regulator issues amended tariff order egulator/governmentR No Yes No Yes L/C bank pays egulator/governmentR Government pays Matter resolved claim/arbitral award Matter resolved compensation to investor Govt. repays L/C No Yes bank as due No WB guarantee is triggered Matter resolved WB guarantee is triggered Yes L/C reinstates by WB pays private lender repayment amount WB pays L/C due amounts guaranteed amounts as due WB claims repayment from WB claims repayment host government from host USING A PRG TO SUPPORT PRIVATIZATIONS The schematic below outlines a process for implementation of a distribution privatization using a PRG. Given that a The Bank can consider providing a PRG once a client successful distribution privatization is generally predicated government has embarked on a sound and sustainable on sound pre-privatization design, it is recommended that reform program. Ideally, the Bank's involvement should be the integrity of this step not be compromised. requested early in the pre-privatization design phase, to ensure that the Bank is in a position to issue an indicative This paper has outlined the need for regulatory risk mitigation term sheet for a PRG for incorporation in the Invitation to to promote private investment in the distribution sector and Bid for the privatization. In this way, the government is able has proposed that this is best achieved through the pre- to extract maximum value of the PRG in the form of enhanced privatization design of a regulatory framework and dispute investor interest, higher price offers, and greater upfront resolution mechanism. At issue has been the need for investment commitments. The Bank's provision of the PRG governments to enhance confidence in the level of their would in all cases be subject to due diligence satisfactory commitments to such a policy and regulatory framework. to the Bank, including a review of the sector, industry, and In this context, a PRG can be used to backstop a govern- project structures; compliance with all applicable Bank ment's commitment to the regulatory framework, thereby policies; Board approval; and satisfactory conclusion of an enabling a strategic investor to mobilize private capital for Indemnity Agreement with the host government. investment in electricity distribution in developing countries. · Definition of industry & market structure 13 · Basic design of regulatory framework eformR · Electricity law Strategy Main regulatory elements Sector and enterprise Phase · Regulatory institution restructuring · Regulatory rules · Separation/unbundling · Dispute resolution process · Financial restructuring Design · Licenses · Privatization strategy and · Tariff formula transaction design -Privatization · Performance standards · Request for a PRG Pre Preparation for bidding and privatization documents · World Bank senior management "early approval" · Indicative World Bank PRG term sheet · Prequalification request for proposal · Bid package 9information memorandum & data room · Preparation of privatization documents Phase Bidding and Selection Process · Winning bidder chosen · World Bank formal due diligence · World Bank senior management approval Privatization · Finalization of PRG and privatization agreements · World Bank Board approval · Execution of PRG and transaction documents Financial closure of privatization REFERENCES Berg S.V. (2000) -- Sustainable Regulatory Systems: Laws Resources and Values, Utilities Policy 9, 159-170 Levy B. and Spiller P. (1994) -- The Institutional Foundations of Regulatory Commitment: A Comparative Analysis of Telecommunications Regulation, Journal of Law Economics and Regulation, 10 (2), 201-246 Stern J. and Holder S. (1999) -- Regulatory Governance: criteria for assessing the performance of regulatory sys- tems. An application to infrastructure industries in the developing countries of Asia, Utilities Policy 8, 33-50 14 THE WORLD BANK GROUP The Energy and Mining Sector Board The World Bank 1818 H Street N.W. Washington, D.C. 20433 USA