Republicof Uganda Privatization and Utility Sector ReformProject (Credit 3411-UG) Proposed Amendmentto the LegalAgreements 1. The proposed amendments to the legal agreements for the Privatizationand Utility Sector ReformProject (Credit 3411-UG)aim to support the concessioning o f the distribution assets of the publiclyowned Uganda Electricity Distribution Company Limited(UEDCL), to a Ugandancompany (UMEMELimited) formed by a private consortium o f investors selected by UEDCL and the Government of the Republic ofUganda (GOU). The concession will entail enteringinto additional contractual arrangements among the parties including several with IDA (para. 6 and Sections IV and V). I. BACKGROUND 2. A Credit inthe amount o f SDR 36.2 million (US$48.5 millionequivalent') for the Privatization and Utility Sector ReformProject was approved on August 24,2000 and signed on December 18,2000. The Project was declared effective on January 3 1, 2001. As o f November 16, 2004, about SDR14.9 milliono fthe Credit has been disbursed. There has been one amendment to the Development Credit Agreement datedNovember 19,2002, which was to add a second Special Account specifically for severance payments and a new category o f expenditures for audits, to reallocate funds to fully cover Project Preparation Facility expenditures, and to revise aggregate procurement amounts for National Competitive Bidding and National Shopping. A mid-termreview o f the project i s scheduled for January 2005, and the original Closing Date o f the Project i s January 31,2006. All legal, financial, and audit covenants under the project are beingmet. 3. The four main project components cover: (a) privatization o f remaining industrial and commercial public entities; (b) institutional support for a Parastatal MonitoringUnit to oversee the financial performance of parastatals inthe Ministryo fFinance, Planning and Economic Development (MFPED); (c) implementation o f sector reforms inthe telecommunications, electricity, railways and water and sewage sectors; and (d) the effective functioning o f a Project Coordinating Unit inthe MFPED. The overall project implementation ratingi s satisfactory (see SectionI1on project implementation performance). 4. InOctober 2002, the GOUrequestedIDA support inrelationto securingprivate sector participation inthe power distribution business o f UEDCL. Earlier, inMarch 2001, with IDA support under this project, the former Uganda ElectricityBoard (UEB)was unbundledinto three successor entities, for generation, transmission and distribution. While the generation entity, the Uganda Electricity Generation Company Limited(UEGCL), was already successfully concessioned on April 1,2003, there were delays inreaching agreement with the proposed distribution concessionaire due to the needto adequately mitigate certain perceivedregulatory and GOU-related payment risks which were beyond the control o f the private investor. A critical component o f the security package negotiatedbetweenUMEME, UEDCLand GOU, is recourse to a LiquidityFacilityduringthe first seven years following the privatization. This LiquidityFacility canbe accessedon the occurrence o f certain 'As ofNovember 16, 2004, the value of the original Credit of SDR36.2 million was aboutUS$52.3 million due to the appreciation of the SDR againstthe U S DoIlar. 2 UEDCL/GOU-relateddefault events defined inthe Privatization Agreements (these Agreements and the IDA-backedEventsare described inSection IVbelow). The Liquidity Facility would be established by means o f a Standby Letter o f Credit (L/C) issuedfor the benefit o f UMEMEby Citibank Uganda Limited (the L/C issuingbank). Ifthe L/C i s drawn, UEDCL would be obligated to repay the L/C issuingbank within one year (including interest), pursuant to the Reimbursement and Credit Agreement betweenUEDCL and the L/C issuingbank. It i s proposedthat US$5.5 million' equivalent o f the proceeds o f Credit 3411- UGbe utilizedas a contingent Credit to: (a) backstop UEDCL'sobligation to repay principal plusaccruedinterestto the L/C issuingbank underthe Reimbursement andCreditAgreement inthe event theL/C is drawn; and(b)disburse thebalance ofthe amount oftheL/C intothe EscrowAccount (as defined inparagraph 6 (k) below), in the event the L/C i s not renewed for the full seven year periodinaccordance with its terms. 5. The proposed amendments are inline with the original objectives o f the project as stated inthe Development Credit Agreement (DCA), which are to: "Support the Borrower inthe carrying out o f its policy to improve the quality, coverage and economic efficiency o f commercial and utility services through: (a) the divestiture and restructuring o f the remainingPublic Enterprises still operating inthe Borrower's economy; (b) increased private sector participation inthe provision of infrastructure in sectors such as telecommunications, energy, water and rail transport; and (c) the strengtheningo f the regulatory framework and institutions required to carry out the said policy." 6. The proposedamendments to the DCA would include the following: (a) adding a new component (Part E) to the project description: IDA backstop o f UEDCL's repayment obligations under the Reimbursement and Credit Agreement in respect o f amounts drawn under the L/C established insupport o f the concessioning o f UEDCL's distribution assets and the provisionfor disbursement of the Credit proceeds directly into the Escrow Account inthe event that the L/C ceases to be ineffect for the full seven year period; (b) introducingnew definitions as well as new covenants and a condition ofeffectiveness o f the component pertaining to the GOU's obligations, such as the need for a supplementary legal opinion on the proposednew component (Part E o f the project); (c) a corresponding modification to the allocation o f the proceeds of the Credit by introducing a separate category inSchedule 1o f the DCA. The amount that would be allocated to this category would be the full amount o f the Credit that i s currently unallocated (SDR5,475,165), which i s the equivalent o f US$8,270,072 at the prevailingexchange rate. It i s expected that this amount o f SDRs would be more than adequate to fundthe USS5.5 millionthat couldbe required to be disbursed under the new component (Part E) o fthe project. There i s a potentialriskthat inthe future, the US$ could appreciate significantly against the SDR, such that the Credit proceeds allocated to this new component would be inadequate to fundthe entire US$ amount o f the L/C facility. To mitigate against this risk, a provisionwould be added to the DCAwhich wouldprovide for the amount ofthe Credit to be increased bythe additional amounts required to fundthe US$ amount; This includes US$5.0 million for LIC coverage andUS$500,000 to cover any accrued interest payments. 3 (d) extension of the Closing Date to January 31,2013, to allow for disbursements from the Credit to the L/C issuingbank inthe event of arepayment default by UEDCL under the Reimbursement and Credit Agreement. This would be handledby means o f a Side Letter which would provide for an extension o f the new ClosingDate for this component, prior to the expiry o f the existing Closing Date; (e) a waiver of the GOU's right to cancel and IDA's rightto suspend disbursements for thisnewproject component (Part Eofthe project) untilthe ClosingDate ofJanuary 3 1,20 13 (as discussed in (d) above), so as to provide the L/C issuingbank and UMEMEthe assuranceof an irrevocable commitment from IDA; and (0 the cancellation ofany undisbursedCredit for thisnew componentafter the new Closing Date. In addition to the above amendments to the DCA, the followingAgreements will be concluded: (h) aProject Agreement betweenIDA andUMEME,which would outline UMEME's undertakings to IDA inrelation to the proposedIDA commitment to repay amounts owed by UEDCL under the Reimbursement and Credit Agreement with the L/C issuingbank; (i)anIDACommitmentAgreementbetweenIDAandtheL/Cissuingbank,providing the terms of IDA's support o fUEDCL'sobligationto repay the L/C issuingbank for amounts drawn under the L/C and owedby UEDCL under the Reimbursement and Credit Agreement by means o f the contingent Credit; (`j)aReimbursementandCreditAgreementbetweentheL/CissuingbankandUEDCL providing for UEDCL's repayment to the L/C issuingbank o f amounts drawn under the L/C within an agreed loan term o f 12months plus accrued interest; and (k) an Escrow Agreement betweenUMEME,UEDCL, andthe Escrow Agent (Citibank N.A., London). This Agreement will provide for the payment byUMEMEofrentdue to UEDCL under the PrivatizationAgreements into an escrow account (the Escrow Account) with the Escrow Agent. The foregoing agreements have been substantially negotiated and will be finalized following approval by the Executive Directors o f the recommendation contained inthis Memorandum. Intheunlikelyeventthere isany significant changeinthose agreements,Managementwill revert to the Executive Directors. 7. Since the power sector and GOUhave set aside adequate finance for staff retrenchment, funds originally intended for power sector staffretrenchment under Credit 3411-UGwould be reallocated to support the L/C (see para. 9). Also, because the amount o f the credit enhancement i s small, it was determined that it would be more expedient and cost- effective to process this operation through an ongoing project. A stand-alone guarantee operation could considerably delay the concessioningbeyond the currently scheduled contractual Transfer Date for the assets inDecember 2004, therebyjeopardizing the power sector reformprogram and the Government's overall privatization efforts. A project supervision budget would be provided for the new component through the extended Closing Date for supervision by the Africa Energy Group. An Implementation Completion Report on 4 the mainproject would bepreparedwithinsix months after the Closing Date. Followingthe extendedClosing Date for the proposednew component, a supplementalImplementation Completion Report would be prepared. 11. PROJECTIMPLEMENTATIONPERFORMANCE 8. The Project is moving satisfactorily towards meeting all ofits development objectives. The main development objective i s to improve the quality, coverage and economic efficiency o f commercial and utility services, through privatization, private participation ininfrastructure and an improved overall regulatory framework. Important outcomes o f a higher level o f private investmentand divestiture o f the remainingpublic enterprises would be improvedquality and access o f services inthe telecommunications, water, electricity and transport sectors, a reduction o f the fiscal burden o f utilities inUganda, increased competition, and lower costs for consumers andbusinesses. 9. Privatization and Divestitureo f Industrial and Commercial Public Entities (US$25.5 million), includingtechnical assistance, environmental audits and severance payments for retrenchedworkers. As mentioned earlier, the Uganda Electricity Board was unbundledinto three successor companies inMarch2001: the Uganda Electricity Generation Company Limited (UEGCL), the Uganda Electricity Transmission Company Limited(UETCL), and the Uganda ElectricityDistribution Company Limited(UEDCL). The UEGCL was concessioned to Eskom(South Africa) inMarch 2003 and the Privatization Agreements were concluded with UMEMEonMay 17,2004 for the concessioning ofUEDCL (see paras. 24-30). Implementation o f the privatization programs for the railways and water sectors i s ongoing. To buildconsensus on the overall privatizationprogram and accelerate its implementation, the project i s supporting an active communication campaign. Several workshops were successfully conducted, includingsome targetingparliamentarians and other politicians. About US$5 million o f the estimated US$14 millioninfunds under the Credit targeted for employee retrenchment has been disbursed. The Government has about USh60 billion (US$34 millionequivalent) inits privatization account which can be utilized for retrenchment payments for the Postal Office, Uganda Railways Corporation and the National Water and Sewerage Corporation. Since the Uganda Electricity Boardand its successor companies set aside adequate funds for power sector staff retrenchment, additional funds under the Credit for this purpose will not be required. Hence, US$5.5 million originally envisaged for power sector staff retrenchment under the project i s proposedto be reallocated to support the L/C Facility in the form o f a contingent Credit. Most o f the allocation for environmental audits (US$6 million) under the Credit has not yet been committed. 10. Strengthening o f Financial Oversight o f Parastatals (US$l.9 million). The Parastatal MonitoringUnit supportedunder the project i s monitoringprogress made on Public Enterprise restructuring and the reduction of Government subsidies. One o f the key issues continues to be the level o fpublic enterprise debt. The Project Monitoring Unit's2003 report and summary o f performance indicators show that the net performance o f the public enterprise sector has improved: subsidies have declinedby 76 percent during 1994-2001, and there are no new Government agency accumulatedarrears with utility service providers in 2004. Inaddition, there has been an improvement inpublic enterprise statutory compliance includingthe divulgingo f information on such areas as audited accounts and operating plans. 5 UtilitvSector Reform(US$9.0 million). The TelecommunicationsSector. Substantial improvements have beenrecordedin the telecommunications sector. The market size has grown to 600,000 subscribers in 2003, o f which 550,000 are mobile subscribers. The capacity for fixed lines has also doubled to 120,000 lines, comparedto 60,000 lines in 1999. There are 3,300 public phones inthe country. The penetration rate has increased from 0.28 telephones per 1,000 people inUganda in 1998, to 2.5 per 1,000 people in2003, The future strategy for the sector i s to increase the penetration rate andreduce the cost o f services. 0 TheElectricity Sector, The concessioning o f UEGCL and UEDCL experienced initial delays due to changes inthe intemational market andperceived global risk which were outside of Uganda's control (see Section 111). The Water and SewerageSector. The Cabinet approveda sector reform strategy paper in October 2003, and a Sector ReformImplementation Committee was established inNovember 2003. A new Performance Contract betweenthe GOU and the National Water and Sewerage Corporation (NWSC) was signed inDecember 2003. The Performance Contract regimehas continued to provide a basis for the implementation o fbold performance improvement programs withinNWSC. The latest o f these programs i s the Internally DelegatedArea Management Contracts, an initiativeto create autonomous business units or "water partnerships" inthe NWSC towns akin to mini-utilitiesoperating under contracts. This initiative i s consistent with the overall agreed reform direction, and i s a step towards a separation of the operations functions from the asset holding function. The various programs initiated by NWSC underthe PerformanceContract regime have inculcatedaperformance-oriented attitude and culture. As aresult, significant performance improvements have been recordedsince 1999 when the first Performance Contract was signed, includinghigher billing and collectionratios, almost a doubling o f water connections to about 100,000 in2004, anda one-thirdreduction instaff. 0 TheRailways Sector. Substantial progress has beenmade under the Government's railways sector reformprogram. A joint Memorandum o f Understanding, signed in July 2004 by the Ministers o fFinance and o fTransport inKenya andUganda, sets out the objectives, structure, approachand methodology for achieving the joint concessioningo f the Kenya Railways Corporation and the Uganda Railways Corporation, and i s based on market consultations heldwith interestedparties inthe United States and Canada, the UnitedKingdom, South Africa and inKenya. In addition, stakeholder workshops were held inUganda and Kenya. Advertisement for pre-qualification was sent out on September 1, 2004. Fifteen firms registered for pre- qualification, o f which nine firms submittedbidsby the submission due date, and the applications are under evaluation. The pre-qualified biddersshouldbe announced before the end o f 2004. The estimatedtimetable for pre-qualified firms to submit their bids i s April 2005. The award and signing o f a concession agreement i s envisaged inJune 2005, with the transfer o f operations by December 2005. 0 Regulatory Reform. The Project i s supporting the Uganda Communication Commission and the Electricity Regulatory Agency (ERA) through acquisition o f essential equipment, technical assistance and capacity buildingactivities. 11. Proiect Management (US$8.9 million). The financial management capacity o f the Project Coordination Uniti s satisfactory. Adequate counterpart funds are available and 6 internal controls are also sufficient. Project implementationhas been delayed due to slow procurement processes. To rectify this shortcoming, a procurement monitoring system has been established which permits rapid follow-up on outstanding requests. 111. POWERSECTORREFORMAND PERFORMANCE 13. Over the past five years, substantial progress has beenmade towards implementing the Government's power sector reformprogram. InJune 1999,the GOUapproved a comprehensive power sector reform strategy. InNovember 1999, a new Electricity Act was promulgated. The Government established the ERA inApril 2000; the UEB was unbundled into three successorcompanies, one each for generation, transmission and distribution in March 2001; the ERA substantially increased tariffs inJune 2001, and with assistance from the donor community, a debt restructuring proposal for the power sector was implementedat the endof2001. The concessioningofUEGCLwas completedinMarch 2003 andthe Government i s now inthe process o f successfully concluding the concessioning o f UEDCL. The objective is to transfer key UEDCL operational and investment responsibilities to the private sector inDecember 2004. i. i. i +" DISTRIBL'TIOS SECTOR 8.. C u S 'p M SystemOperator R S ......: .......... ...................... ................................ ......................................... ; I.. j 14. The expected impact o f these changes will be to transform the commercial operation o f the system, improve the quality o f supply, and facilitate the development o f commercially fundednew supplies to serve the market. Economic growth andpoverty alleviation are built into the Government's power sector reform program inthe following ways: 0 The private distribution concessionaire will commit to a multi-year investment program which will ensure the availability o f new capital for system improvements and expansion; 0 Tariff adjustments will be linkedto the quality and recovery o f investments for expansion o f service to new consumers; the distribution concessionaire will have strong incentives to 7 reduce losses, eliminate theft, and ensure full collection. The concessionaire will also be penalized if agreed performance targets are not met; The autonomous ERA established in2000 to regulate the sector will protect consumers and investors, and ensure that distribution and generation concessionaires comply with the terms o f their operating licenses, including quality of service standards (see paras. 24, 25, 44 and45); and A RuralElectrification Fund,designed to partially subsidize initial capital costs, was established under the Electricity Act to help foster electricity service expansion into unservedareas bynew private rural electrification companies, and is part of the Government's Rural Electrification Strategy for 2001-2010. 15, A successhl concessioning ofUEDCL's distribution assets is a fundamental necessity to underpin the commercial viability o f the sector and to support future new generation investments. Increased electrification and improvement o f the commercial operations o f the sector are the primary objectives o f the distribution privatization. Itwill help to improve service delivery, expand access for households and social infrastructure such as schools, clinics, hospitals, and water systems. The collective impact o f the Government's power sector reformprogramwill be to contribute to poverty alleviation through income and employment generation, thereby improvingthe quality o f life inUganda. Inaddition to eliminating budgetary subsidiesby placing the power sector on a commercial basis, the provisiono f adequate and least-cost power will foster economic activity and generate fiscal revenues, thereby increasing budgetary resources which the Government can direct to health, education and other activities benefiting the poor. Power Sector Financialand Operational Performance 16. The financial performance o f the power sector has improved since the implementation o f significant retail tariff increases inJune 2001 and the power sector debt restructuring program at end 2001, UEB's successor companies are now ina position to service their debts to Government to a large extent, and were able to finance U S 3 7 million o f investments from internal resources during2002/03. UEDCL made encouraging progress inits billing collection performance untilNovember 2003; thereafter, the performance steadily declined untilApril 2004, to reachthe lowest monthly collection ofUSh8.9 billionsince 2002. Collections returnedto their normal levelinJune 2004. Following an intensive collection drive, UEDCLcollected an exceptionally highsum o f UShl8 billioninJuly 2004. The monthly collection duringthe three months to October 2004 i s expectedto average around UShl2 billion. 17. The overall financial performance o f the sector has improvedover the past two years inspite ofthe dip inUEDCL's billingcollection duringDecember 2003 to April 2004. The principalfactors contributing to the improvement are: 0 Growth inenergy generation o f 8.8% and 3.5% in2002 and 2003, respectively. Hydropower output increased by 4.5% duringthe first seven months o f this year over the corresponding period in2003. An increase inmonthly average billing collection, from USh7.8 billion in2001 to USh12.4 billionin2004. 8 0 The appreciation o fthe Shillingvis-a-vis the USdollar since December 2003 helped reduce the burdeno f foreign exchange dependent revenue requirements, amounting to about 35% o f total requirements (net o f export revenues). 18. UEGCL and UETCL are both financially viable. UETCL's liquidity i s very strong. Apart from funds set aside for the bulk supply tariff stabilization fund, UETCL has built up approximately USh48 billion inliquidresources. The principal reasons for this accumulation o f cash are the appreciation o f the Shillingand UETCL's slow uptake inimplementing its investment program. However, UEDCL's collected revenues in2003 and 2004 are almost equal to its recurrent operational expenditures and debt service requirements. 19. Electricitv Tariffs. The present weighted average retail electricity revenue3i s about 139.7 UShkWh, equivalent to O.O8US$/kWh at the current exchange rate. The last tariff review inJanuary 2004 led to a decrease inthe weighted average retail revenueby about 34% due to a rebalancing oftariffs. Energytariffs for large andmediumindustries and commercial businesses were reduced and domestic use tariffs were increased. Power sector revenue requirements will increase significantly after the take-over o f the distribution concession by UMEMEwhich is scheduled for December 2004 andbecauseofthe addition ofnew debt service burdens associated with the UrbanPower and Power IV on-lent loans (the African Development Bank (ADB),IDA, the Nordic Development Fund(NDF) and the Norwegian Agency for Development (NORAD)) between 2005 and 2008. Inorder to avoid the extent o f tariff increases inthe initial years o f UMEME's operations when the full benefitso f the concessioningwould not have materialized, the Govemment has proposedvarious tariff relief measures including fundingfrom the BST stabilization provision which would reduce the overall revenuerequirementso f the power sector. On the assumption that tariffs are adjusted at six monthly intervals on May 1 andNovember 1, 2005, the indicative tariff increases would be approximately 10%and 14% respectively. The anticipatedcommissioning o f units 14 and 15 (8OMW capacity) at the Kiira Power Plant inMay and July 2005, respectively, will increase energy supply and help to generate additional sales revenues, which will moderate the required increases intariffs. The US$16million o f urgent distribution investments inthe first 18 months of the distribution concession, o f which US$5 millionwill be provided by UMEMEandUS$11million isproposedby IDA under Credit 3545-UG, will also helpto increase UMEME's revenue eaming capacity over the next two years, and hence mitigate the pressure on electricity tariffs. The financial analysis indicates that as efficiency improvements take effect, tariffs would come down each year inrealterms beyond the first two years. The weightedaverage revenue would decline from 0.099US$/kWh in2005/06 to about O.O91US$/kWh by 2009. Because significant investments ingenerationare likely to be required in2010 andbeyond, the Govemment i s reviewingthe structure and buildupo f a stabilization fund, which would permit electricity tariffs to be smoothed out over the medium- to long-term so as to avoid radical changes intariff levels from year to year. Attachment 2 provides more detailed information on the financial situation and prospects o f the power sector. The Bujagali Hydropower Project and Future Power Generation Prospects 20. An IDA PartialRiskGuarantee o fUS$115 million andIFC support of: (a) an "A" loan o f up to US$60 million; (b) a "B" loan o f up to US$40 million; and (c) a risk management instrument o f up to US$10 millionfor the Bujagali Hydropower Project were approvedby the IFC and IDA Executive Directors on December 18,2001. The A E S Average retail electricity revenue i s the amount accruing to UMEMEAJEDCLand excludes 17% VAT which is added to end-use customer bills. 9 Corporation (the private sponsor) and the project encountered several difficulties which eventually ledto a pull-out o f AES and termination of the project with the Government in September 2003. The main issues confronting the project were threefold. The first was the wavering support o f export credit agencies for the project due to the highlevel o f perceived country and business risk. This created a financing gap of about US$234 million for which a promisingoption was pursued with the Multilateral Investment Guarantee Agency. Secondly, inparallel, there were ongoing investigations inthe US, Norway, theUKandUganda concerning allegations o f corruption involving one o fthe engineering/procurement/ construction contractors, and links to another private power generationproject under preparation inUganda. Third, the private sponsors' financial situation continued to deteriorate following a severe downturn inthe global economy, a worldwide change inmarket conditions and the shrinking o f investor interest inemerging markets. Following intensive discussions between AES and the Government, on August 13,2003, AES announced its intention to withdraw from the project. Subsequently in September 2003, the Government and AES terminated the Implementation Agreement which gave the Government the right to take ownership o f the intellectual property and land, and IDA cancelled the Partial Risk Guarantee (PRG). InAugust and September 2003, the World Bank Group fielded several missions to discuss with the Government its options, the transition arrangements including the needto ensure the integrity o f the project site and handover o f intellectual property, and the maintenance o f a unit to monitor the project, including the environmental and social aspects. The Government has taken appropriate action on all of these matters. 21. Inassessingthe Government's optionsandpowersectorneeds, the Government decided to continue to pursue the BujagaliHydropower Project since it believes this project remains boththe best option and least-cost generation alternative for Uganda. Its preference would be for private sector participation over a public sector project. Inthis regard, in January 2004, the Government initiated a transparent process to solicit the interest o f prospective private sponsors. The Government understands that a re-assessment o f the scope, design, and economic, technical, financial, institutional andenvironmental and social aspects o f any new power generationproject, would be required inthe context o f Uganda's power demand requirements. The Government has already initiated the selectionprocess for a developer o f the new project. The short-listing has been completed and the selection process i s expected to be concluded inMarch 2005. 22. As part of IDA'Snormal supervision activities inconnection withthe ongoing Power IVProject (Credit 3545-UG), sector work on anassessmentofelectricity demand since 2001 has beenundertaken. Also, legal advisory and technical consultancy assistance has been provided to the Government under Credit 3545-UG to support the Government's efforts to revivethe Bujagali HydropowerProject. IDA'Simmediate focus inthe power sector has been to support the concessioning o f distribution which is key to the operational and financial turnaround o f the sector, and to attracting private investment for the future needs o f the power sector. IDA i s also working with the Government on its plan to address the current power supply shortage. 23. The due diligence for any newpower generationproject inUganda, includingthe possible resurrection o f the Bujagali Hydropower project ina different form or structure, will take note o f the various issues raisedby the InspectionPanel inits report o f May 23,2002 and Management's Response dated June 7,2002, and will address them inthe context of the feasibility studies, design and social and environmental assessment o f any new private power generationproject involving the World Bank Group. The main lessons learned from the collapse o f the BujagaliHydropower Project are the importance of: (a) confirming the financing plan (the export credit agencies unexpectedly pulled out o f the project one month 10 after the IFC/IDAjoint Boardpresentation); (b) a transparent and competitive process for the selection o f the civil works and electro-mechanical equipment contractors; and (c) ensuring the efficient operations ofthe power sector's distribution businessincluding improved quality o f supply and access. A financially viable distribution business will help to mitigate the perceived risks o f potential private investors since this i s the primary source o f the power sector's cash flow and i s a crucial aspect uponwhich investors will assess the power sector's capability to repay new investments. IV. PROPOSEDNEW COMPONENT: SUPPORTFORTHE POWER DISTRIBUTION CONCESSION 24. UEDCLis the first unbundleddistributionnetwork inSub-Saharan Africa to be concessioned to the private sector. In2003, UEDCL supplied 1036GWhto 235,000 customers and generated revenues o f USh155 billion (about US$SO million). UMEMEwill have the right to collect revenues from all connected customers based on tariffs approved by the ERA. With technical assistancefrom NORAD, the ERAhas achieved independence in economic regulatory matters although it i s still requiredto consider Policy Guidance o f the MinistryofEnergy andMineralDevelopment. InJune2001, the ERAimplementeda new tariff structure whichreflected full cost recovery and the removal o f cross subsidiesbetween consumer classes, though a lifeline electricity tariff still exists. This brought average electricity revenues to about US$0.084per kWh,which was the first adjustment inabout a decade duringwhich time tariff revenue denominated inUShhad deteriorated to about US$0.052 per kWh. The June 2001 increase helpedto set the stage for the sector's financial recovery. The average electricity tariff revenue had dropped to US$0.072 per kWhduring 2003; however, it has since recovered to about US$O.OS per kWhdue to the recent appreciation o f the Shilling. A tariff review undertakenin2004 substantially confirmed the justification for earlier increases, and also demonstrates that the ERAhas been successful in asserting its autonomy. 25, The ERAcapacity buildingcomponent financed by Credit 3411-UGhas helpedthe ERAto develop a tariffmethodology that hasbeenencapsulated inthePrivatization Agreements, to undertake "twinning" arrangements with other utilities, and has enabled ERA to participate inthe African Forum for Utility Regulators. Also since its inception, the ERA has received technical assistance from the NorwegianRegulatory Agency inthe form of: (a) resident technical advisors; (b) the technical support o f a management consulting firm in developing a comprehensive tariff model; (c) international field visits to other regulatory agencies; and (d) specific training inelectricity regulation. Inaddition, under the Power IV Project (Credit 3545-UG), technical assistanceto the ERA i s being providedto buildits regulatory capacity and help manage a stabilization fund whose purpose i s to smooth out the tariff trajectory when significant new investmentsmaterialize inthe future. The Utility Reform Unito f this project is coordinating a TrainingNeeds Assessment Study, one o f its objectives beingto identifythe capacity buildingrequirementso f the existingand proposed regulatory and asset holding institutions. 26. A consortium consisting of Globeleq Limited,a wholly-owned subsidiary of the Commonwealth Development Corporation o fthe UK,and Eskom, the state-owned utility o f South Africa, was selected to undertake the concession following a transparent and competitive biddingprocess undertakenby the GOUwith transaction advisor support under Credit 3411-UG. The Consortium has since formed UMEMELimited, a company established inUgandaandjointly ownedbyGlobeleq Ltd.ofBermuda (56%), awholly-ownedsubsidiary of Globeleq Ltd., and EskomEnterprises (44%), a wholly-owned subsidiary o f Eskom. Globeleq will bringcommercial and financial expertise to the company; and Eskom, with its 11 experience indistribution, will provide the technical expertise requiredto turn around the underlyingbusiness. UMEMEwill be operated as ajoint venture company with an independent culture, but with strong support from both o f its shareholders. Under the Shareholders Agreement, Globeleq nominates the General Manager and Chief Financial Officer, Eskomnominates the Head o f Technical Services and Head o f Customer Services, and the Board appoints the nominees. The intention of the joint venture partners was to combine Globeleq's commercial expertise in structuring,negotiating and managing independentpower projects with Eskom's wealth ofknowledge andresources inthe electricity distribution business. Inorder for the project to succeed, both shareholders agreed to builda strong culture within UMEMEcombining the best aspects from Globeleq, Eskom and the current UEDCL business. Shareholders adopted the approach o f a limitedexpatriate top-management team, with the intention o f including as much local managerial talent into the structure as possible. Also, both shareholders would make available their specialist services intheir respective domainsofexpertise: financial/commercial(Globeleq) andtechnical/ business processes(Eskom), as and when required. 27. Globeleq i s the fastest growing emerging markets power company with a particular focus on Africa and South Asia. Inthe past three years, Globeleq has acquired six IndependentPower Producer projects (a total o f almost 2000MW) infive countries on three continents, all o f whom it i s currently managing. All o f Globeleq's projects thus far are in generation, which i s why it sought to form ajoint venture with Eskomwhich has substantial distribution expertise. Globeleq's commercial approach, its strategic commitment to emerging markets and strong, recognizable financial support from the CDC Group, make it an energy developer of choice inmany developing countries. 28. Eskomi s a vertically integrated utility that generates, transmits and distributes electricity in SouthAfrica, rankingninthinthe world interms o f energy sales. Its ability to mobilize appropriate technical and managerialresources, together with strong financial backing, make it a player that ranks highabove all others on the continent. Eskomhas demonstrated its capability to supply and distributeelectricity inAfrica by usingfirst-class standards, and has been a key factor in South Africa's economic growth. Inaddition to successfully serving its existingindustrial, commercial and residential customers, inthe past decade, Eskomhas delivered a very ambitious electrification plan. Hence, a relevant body o f knowledge has beendeveloped on how to build, maintain and manage electricity distribution businesses inan African context, from which UMEMEwill benefit. 29. UMEMEis the signatory to a Lease andAssignment Agreement withUEDCL, a Power Sales Agreement with UETCL (for the bulk supply o f electricity) and a GOU Support Agreement (GSA) with GOU (collectively, the Privatization Agreements). The Privatization Agreements were signed onMay 17,2004. UEDCL andUETCL are wholly-owned GOU entities that own Uganda's distribution and transmission assets, respectively. Underthe Lease and Assignment Agreement, UMEMEwill lease the operating assets o f UEDCL,for which it will payrent to UEDCL on a monthly basis. UETCL transmits the energy generatedby EskomUganda Ltd., a wholly-owned subsidiary of EskomEnterprises which i s operating the two adjacent hydro-electric facilities -- Nalubaale andKiira, under a 20-year concession agreement. The GSA details GOUundertakings to support UMEME(e.g. to ensure USh convertibility and to issue Consents when applied for properly), and the principal terms and . conditions o f Buy Out Amounts to be paidby the GOUto UMEMEinthe event of termination o f the Concessionfor GOUand UMEMEevents o f defaults, for Force Majeure events, as well as for the retransfer o f the Distribution Systemto UEDCL. 12 30. The 20-year distribution concession will require a minimuminvestment from UMEMEover the first five years ofUS$65 million, ofwhich US$45 millionwill be funded in the form of equity and shareholder loans, andthebalance through the company's internalcash generation. There would also be a working capital facility of US$5 million. A transmission and distribution needs study was carried out as part o f the Government's due diligence process. It indicates the type o f investments requiredto strengthen the distribution system and reduce technical losses, to absorb the additional power to come on line in2005 at the Kiira power plant, and to expand access to new consumers. UMEMEi s required to discuss and agree with the ERAthe specific details of the investmentplan to ensure the efficiency o f investments and the resultant tariff implications. The GOU and UMEMEhave agreed to an eighteenmonthpreliminaryoperating and investingperiod inwhich UMEME's investment obligation will be limitedto US$5 millionof the total o f US$65 million. UMEMEwould have the right to withdraw from the Concession duringthis preliminary periodunder the terms and conditions agreed inthe GSA. Other key obligations o f UMEMEover the first five years o f the Concession will be to provide for up to 60,000 new connections, reduce technical and non-technical distribution system losses and improve collection rates. Should UMEME fail to invest an amount o f US$65 million by the end o f the fifthyear o f the Concession or to carry out its other obligations outlined above, the GOU would have the right to call on all or part o f the US$15 million PerformanceGuarantee postedby UMEME, and to terminate the Concession. 31. Inaddition to theproposedcredit enhancement mechanism, the Government has requested support for UMEMEunder the Power IV Project (Credit 3545-UG). This would be inthe formo fthe proposedfundingofUS$11millionofurgent distribution investments to helpenhancerevenue generationandmaximize the chances that early operational and financial improvements would be realized. This would also help to smooth out the tariff trajectory during the initial UMEMEtakeover period. V. PROPOSED AMENDMENTS Rationale 32. A major objective o fUganda's Country Assistance Strategy is to reduce poverty through rapid economic growth which depends upon increased foreign and domestic private investment. The Bank's strategy inthe power sector consists o f a three-pronged approachto support this objective by: (a) promoting efficient operations of the power sector through implementation o f a comprehensive sector reformprogram and increasingthe role o f the private sector inits operation and fiture development; Cp) providing adequate, reliable and least-cost power generation capacity to meet local demand; and (c) increasingthe percentage o frural households with direct access to electricity andrevitalizingrural development. 33, IDA support for the proposedConcession is criticalto ensuringthe successful concessioningo f UEDCL's power distribution system assets to UMEME. IDA'Srole in providing revenue support for the Concession, inthe event o f regulatory or GOUnon- compliance o f its contractual undertakingwhich could affect the operations o f the company, will helpprovide assurances to UMEMEconcerning the viability o f the Concession. IDA'S ongoing involvement inthe sector andregular supervision should help to ensure the sustainability o f the distribution business, particularly in the earlier years o f the Concession when it couldbe most susceptible to political intervention or other related project issues. 13 Escrow Account andIDABackedL/C Security Structurein Supportof UMEME 34. Underthe Privatization Agreements, the GOUhas undertaken to provide a Security Package consisting o f the Escrow Account and the L/C Facility to be inplace for seven years following the privatization. The Escrow Account i s to be funded initially by UEDCL inthe amount o f US$2.5 millionand then with UMEME's rent while the L/C Facility would be backstoppedby the proposed IDA contingent Credit component o f Credit 3411-UG. The Security Package has been designed to provide compensationto UMEMEfor any loss o f revenues resulting from non-compliance o f certain UEDCL/GOUundertakings specified in the PrivatizationAgreements. Any loss ofrevenues wouldberecoveredbyUMEMEinthe following order: (a) a rent offset; (b) a draw-down from the Escrow Account; and (c) a draw- down from the L/C Facility. Inaddition to providing funds for UMEME's loss o frevenue, the Escrow Account will also be available to pay any BuyOutAmounts due to UMEME which are not paidby the GOU. However, the L/C Facility could only be accessedfor a Buy Out Amount ofUS$2.5 million, inthe event of early termination ofthe Concession duringthe initial eighteen monthperiodwhich resulted from a breach of the Privatization Agreements by the GOUand its entities. 35. Escrow Account: UEDCL will deposit an initial amount of US$2.5 millioninthe Escrow Account at the Transfer Date which will be supplemented by monthly deposits o f rent payable by UMEME,estimated at the equivalent o f US$1.35 million. If,at any time, the amounts indeposit inthe Escrow Account plus the balance inthe L/C Facility exceed the "Required Amount" (an amount equal to US$5 millionor its equivalent at the Transfer Date, increasing to US$8 million 12 months after the Transfer Date andrising to a cap o f US$20 million or its equivalent), then any surplus amounts will become payable to UEDCL each monthby the Escrow Agent. The Escrow Account would be inoperation for the duration o f the Concession. 36. IDA BackedL/C Facility: To supplement the cash deposit inthe Escrow Account, UEDCLis requiredto establish a Standby Letter ofCreditfor aninitial amount ofUS$2.5 millionat the Transfer Date, increasing to US$5 million at the first anniversary thereof, and then remaining at that amount (unless reducedby a drawing which i s not replenished). The L/C i s requiredto be ineffect for seven years following the privatization. Because o f certain Ugandan regulatory requirements, the initial term o f the L/C will be three years to be renewed twice for two year periods for the balance of the seven year term. Inthe event the L/C i s not renewed or replaced beyond its initial term, such that the L/C ceases to be ineffect for the full seven year period, the GOUhas agreed that UMEMEcould draw from the Credit, for deposit into the Escrow Account, an amount equal to the amount that would have been available for draw under the L/C prior to its expiration. 37. UMEMEwould be entitledto draw any revenue shortfall amounts from the L/Cupon the occurrence o f the "IDA-Backed Events" covering loss o f revenues (see paras. 41-47), if there were insufficient funds inthe Escrow Account to satisfy the amounts claimed after rent offset. As part of the L/C arrangements, the L/C issuingbank will enter into a L/C Reimbursement and Credit Agreement with UEDCL. Underthis agreement, UEDCL would undertake to repay the L/C issuingbank the amounts drawn, plus accrued interest, within a period o f up to 12months (the L/C Repayment Period). First,however, the L/C would be replenished duringthe LK Repayment Periodthrough a claw-back from rent payments depositedinthe Escrow Account by UMEME. Alternatively, the GOU or UEDCL could choose to replenishthe L/C from its own resources. Ifby the end of the L/C Repayment Period, however, the amount o f the drawing was still outstanding, then UEDCL would be 14 obligated to make the necessary repayment to the L/C issuingbank, inUS dollars, to the designated account stipulated inthe Reimbursement and Credit Agreement. Repayment would normally be required to be made to the L/C issuingbank's account inUganda. If because o f Ugandanrestrictions, UEDCLwere unable to make payments inUS dollars to such account, or UEDCL were unable to transfer payments made to such account outside Uganda, UEDCL will be requiredto make payment to the designated account of the L/C issuingbank outside o f Uganda. Following a repayment from any of the above sources, the L/C would be reinstatedby the amount o f the repayments. 38. Inthe eventUEDCL fails to make the requiredrepayment bythe endofthe L/C Repayment Period, the L/C issuingbank would be entitled to claim from IDA the repayment payment, IDA would repay the L/C issuingbank through a disbursement from Credit 3411- o f the due amounts plus accruedinterest. Followinga submission o f a valid claim to IDA for UGup to an amount not exceedingUS$5.5 million. Followinga repaymentby IDA to the L/C issuingbank, on behalfo f UEDCL,neither the L/C nor the amount o f IDA'S support would be reinstatedfor such amounts. The proposedIDA support would be available for a total term o f 8 years and 25 days to allow for a sevenyear L/C availability period, a 12 month UEDCL Repayment Period, plus the 25 day IDA claim and disbursement period. The principal terms o f the L/C and IDA support are outlined inAttachment I. UMEMEEscrowandIDA-Backed L/CSecurity Structure I I I r E i LC repayment ...... UC Issuing Bank ........................ LC replenishmentv within 12 months I In case EscrowAccount balance is higher than required. RisksUnderpinnedby the Security Package 39. There are seven events listedbelow related to UEDCL/GOUcontractual undertakings under the Privatization Agreements which would give UMEMEthe right to offset rent payments and draw from the Escrow Account, for the purpose o f ongoing revenue payments, as well as to satisfy GOU's obligation for the BuyOut Amount inthe event of termination of the Concession. O fthese events, only the first three ((a ), (b)and (c) below) are "IDA-backed Events" that would entitle UMEMEto access the IDA-backedL/C Facility following a rent offset and a draw from the Escrow Account (see paras. 41-48 below). a) Failure by the ERA to approve tariff adjustments according to the pre-agreed Tariff Methodology set forth inthe Distributionand Supply License. 15 Non-payment by GOU entities of their Electricity Bills. Early Termination o f the Concession by UMEMEresultingfrom abreach o f the Privatization Agreements by GOUand its entities during the initial 18 monthperiod. Inthis case, UMEMEwould be entitledto receive compensationofUS$2.5 million (the "Early Termination Amount") ifother funds available to UMEME(cash and unutilized investmentfunds inthe Company Escrow Account) were insufficient to recover the full Early Termination Amount. Early Termination o fthe Concession by UMEME for reasons relating to the company, within the initial eighteen monthperiod, which would entitle UMEMEto a compensation o f US2.5 millionfor the initial investment o f US$5 million. Refundsmade byUMEMEo f Connection Fee and Security Depositsprovidedby customers o f UEDCL prior to the Transfer Date. Indemnification obligations to third parties and property damage resulting from the condition o f the Distribution System, within the first eighteenmonths o f the Transfer Date. Termination o f the Concession due to UEDCL or GOU Events o f Default, and Politicalor Other Force Majeure Events. As noted above, the Security Package i s essentially designed to protect UMEME against UEDCL/GOUrisks, and cannot be accessedfor UMEMEEvents o f Default except in the case of Termination which would entitle UMEMEto compensation for areducedamount (80%) o f any approved butun-depreciated investments that UMEMEhas made, and which have not beenrecoveredthrough the tariff. Descriptionof the "IDA-backed" Risks 41. As outlined inpara. 39, the IDA-backed L/CFacility can only be accessedinthe event o f a revenue shortfall causedby the occurrence o f the two IDA-backedRevenue Events and for the Buy Out Amount inthe event of Early Termination by UMEMEfor UEDCL and GOUrelated events. These "IDA-backed Events" are described inmore detail below. 42. Non-Compliance by ERA o f the Regulatorv Framework: This covers the failure of the ERA to adjust retail tariffs in accordance with the Distributionand Supply Licenses within 45 days o f a legitimate claim from UMEME,inaccordance with the pre-agreed Tariff Methodology (contained inAnnex A o f the Supply License), which results ina corresponding loss o f revenue to UMEME,includinginterest on any overdue amounts. Under the Licenses, UMEMEwould berequiredto make an annual tariff submissionto the ERAat least 30 days prior to the effectiveness o f the tariff. Tariffs may, however, be adjusted quarterly on an automatic basis to reflect changes inbulktariff supply costs, inflation and exchange rate movements. 43. The retailtariff, as calculatedinaccordance with the agreed TariffMethodology consists o f two elements: (a) the Power Supply Price determined on a quarterly basis for each twelve monthperiodbeginning on the Transfer Date; and (b) the DistributionPrice determined annually for each Tariff Year. The DistributionPrice consists o f the following components: (a) operation and maintenance costs which will be fixed at the bidcost plus 16 indexation for inflation; (b) the Retum on Investment fixed inaccordance with the bid proposal; and (c) Lease Rentpayable to UEDCL. The US dollar components of the DistributionPrice are identified inthe DistributionLicense and are to be provided inthe tariff at prevailing USh/US$ exchange rates. Since the components inthe tariff are generally pre- determined interms o f either being fixed or outlined ina contract such as the Lease and AssignmentandPower SalesAgreements, the probability ofriskof disputes on interpretation appears fairly limited. Inthe event that there are disputes on interpretation between UMEME and the ERA, the License and Privatization Agreements provide for a dispute resolution mechanism through recourse to an expert's determination on an expeditedbasis. Ifeither party were to disagree with the expert's determination, it could resort to bindingarbitration. The GOUandUEDCLrecognize that ifUMEMEdraws on the L/C Facility for an IDA- backed Event,pendinga dispute, UEDCL will not be relieved o f its obligation under the L/C Reimbursement and Credit Agreement to repay the L/C issuingbank after the 12-month Repayment Period. Ifan arbitration i s ongoing at the end o f that periodand an L/C draw should result ina claim to IDA, any disbursements under the Credit will remain a GOU obligation even should a later arbitral award be issued infavor of UEDCL/GOU. Inthis case, UEDCL/GOU's recourse would be to seek reimbursementfrom UMEMEunder its contractual obligations ifthe Concession is continuing, through refunds into the Escrow Account; and under the award and at law ifthe PrivatizationAgreements have been terminated and an improper Buy Out Amount (or early Termination Amount) has beenpaid prior to the award having been rendered. 44. The other potential riskto IDArelating to the tariff framework is that either the ERA or GOUrenege on the contractually pre-agreed Tariff Methodology. The ERA has been involved inthe formulation o f the pre-agreed regulatory framework contained inthe Supply License (also incorporated as Annex E o f the Lease and Assignment Agreement). Since its inception, ERAhas developedas an institution which has proven to be capable and transparent indealing with the earlier phases o fprivatization o f generation. To date, it has preserved its independence and the integrity o f its processes, includingconsultations with the public. The ERA i s currently working ina coordinated manner with the MOF, MEMD, UMEME,and IDA, supportedbyits Advisers,to lay the groundwork for the formal tariff submission from UMEME. The ERAhas been involved throughout the privatization process and has intimate understandingo f the PrivatizationAgreements, especially the tariff framework and methodology. This experience should help inproviding stability to the regulatory framework as the Concession becomes operational. 45, Despite the significant power sector efficiency improvements envisaged, Uganda will require additional investments in generation, transmission and distribution, and hence electricity tariffs are likely to gradually increase inreal terms over the mediumterm. The bulksupply tariff stabilization fund, described inpara. 19, will helpto mitigate against potential sudden hikes inthe retailtariff. As with most regulatory agencies indeveloping countries with limitedtrack records, the future politicizationo f tariffs i s a risk that cannot be ruledout. However, giventhe GOU's commitment to its power sector reformprogramand the positive track record o f the ERA over the past four years, the risk o f a GOUbreach o f the Privatization Agreements i s consideredmoderate, particularly as such a breach could lead to a termination o f the Concession and a payout to UMEMEo f the agreed Buy Out Amounts. Because o f the critical needto improve the operational and financial performance o f the sector and the expansion o f electricity service as a basis to sustain future significant generation investments, there shouldbe sufficient incentives for the GOUto stay the course, thereby makingthe probability o f a policy reversal unlikely. 17 46. Non-Payment bv GOUEntitiesof Electricitv Bills: This deals with the failure o f Government entities (listed inAnnex B o f the GSA) to pay their electricity bills within 60 days from the due date, which results ina loss of revenue for UMEMEincludinginterest on the overdue amounts. Inthe event that the relevant GOUentity makes apayment ofthe due amounts following a drawing o f the amounts by UMEMEfrom the Escrow Account or L/C Facility, UMEMEshall repay all such amounts into the Escrow Account plus interest equivalent to the prevailing LIBOR rate plus 3 percent. The amounts deposited inthe Escrow Account will thenbe applied first to replenishthe L/C Facility to the extent it has been drawn. 47. The largest single UMEMEcustomer today i s the Govemment and its entities, whose monthly electricity bills o f around US$800,000 account for about 10%o f sector revenues. Assuming that no paymentswere received from the Govemment and its entities, such monthly electricity bills would be offset by the monthly rental payments o f around US$1.35 million (increasing to about US1.5 millionfrom 2007), as well as the Bulk Supply Tariff payments, before any recourse to the security package could be made. Furthermore, UMEME would have the rightto disconnect the nonpaying entities. Finally, the risk o f non-payment occurring i s considered low because the GOUi s now makingmore realistic provisions inthe departmental budgets o f GOU entities to enable them to meet their electricity bills. A call on IDA support would occur only inthe event that unpaidGOUbills exceeded the amount ofthe monthly rent and only once the Escrow Account has been depleted. 48. Payment o f Early Termination Amount Resulting;from a Breach o f the Privatization Agreements by GOU and its Entities: UMEMEwould be entitled to access the L/C Facility inthe event of atermination within the initialeighteen months ofthe Concessionfor abreach of the undertakingsprovided by the GOU, UEDCL, or UETCL, under the Privatization Agreements. For this event, the Early Termination Amount i s capped at US$2.5 million. This amount would be recovered from other sources such as the Company Escrow Account (established by UMEMEto fundrequired investments) and the initial cash amount o f US$2.5 milliondeposited by UEDCL inthe Escrow Account on the Transfer Date, prior to recourse to the L/C Facility. Therefore, the risk of a drawing from the L/C to fundthis modest Buy Out Amount, within the limitedperiodo f eighteen months, is consideredlow. 49. Failure o f L/C Facility to Remain inEffect for Seven Years after Privatization because o fNon-Renewal or Inability to Replace: As noted above, one o f the requirements of the Security Package i s that the L/C Facility be inplace for seven years following the privatization. UnderUganda regulations, the maximum initial term of the L/C Facility cannot exceed three years. Hence, there i s a risk (although quite low) that the L/C Facility may not berenewedor becapable ofbeingreplaced through a substitute bank upto the full sevenyear period. There would be a clear incentive for the L/C issuingbank to renewthe L/C inorder to preserve its interest and fee income. Ifthis risk were to materialize, UMEMEwould be able to draw directly under the IDA Credit inan amount equal to the amount available under the L/C Facility, immediately prior to its expiration, for the purpose o f placing such amounts in the EscrowAccount. IDA SupportFees 50. Inorder to provide alignment with thepricingpolicies ofIDA guarantees, the following pricing i s proposed. Underthe current Credit agreement, the GOUpays the applicable commitment fee currently set at 0.35% per annum on the undisbursed Credit amount and a service charge o f 0.75% on the disbursed amounts o f the credit. This arrangement would continue for this component. Inaddition, it i s proposed that UMEME would pay a guarantee fee o f 0.75% per annum on the available amount o f the contingent 18 Credit (which has not beendisbursed), payable six months in advance duringthe term o f the IDA support. Ofthis, an amount equivalent to the then-prevailing commitment fee (0.35% per annum for FY05) would bepaidto the GOU, andthe balance amount (0.40% for FY05) would be paid to IDA, to take into account that IDA would be irrevocably committed to honor payments due from UEDCL to the L/C issuingbank under the Reimbursementand Credit Agreement. The amounts payable to GOUand IDA out o f the total guarantee fee o f 0.75% would be annually adjusted based on the IDA commitment charges which will be communicatedby IDA to UMEME. Inaddition, UMEMEwould pay an InitiationFee o f US$lOO,OO.OO and a Processing Fee o f upto 0.50% of the contingent Credit amount o f US$5 millionavailable to UMEMEunder the L/C, to cover IDA'Sreimbursable expenses. MIGA Coverage 51. UMEMEintendsto seekMIGA insurance insupport ofits equityand shareholder loans for an amount o f US$45 millioninsupport o fthe Government's Buy Out obligations to UMEME,inthe event oftermination ofthe Concession. WorldBank Group support hasbeen closely coordinated to achieve a complementary risk mitigationpackage whereby IDA, because o f its close involvement with the sector and its monitoringability through regular supervision, would backstop the policy and ongoing revenue-relatedevents critical to project sustainability, while MIGA would mitigate the political risk for the equity investmentsby guaranteeing the termination payments o f the Government. MIGA i s expected to provide Breach o f Contract, Transferability and Expropriation cover to UMEMEand will be seeking Boardapproval inDecember 2004. Procurementand Disbursements 52. The proposednew component does not entail IDA financing any investments. Hence, there will be no procurement for this component. Selection o f the commercial bank that will be issuingthe L/C was carried out on a competitive basis and ina transparent manner. 53. Except as described inpara. 49, the disbursement o f IDA funds would only take place following the occurrence o f an "IDA-backed Event" as described inparas. 41-48, and only in the event o f a failure by UEDCL to repay the amount of a valid drawing under the L/C Facility made infavor of UMEME, within a periodo f 12months as provided for inthe Reimbursement and Credit Agreement. At the Closing Date o f this component of the project, any remaining funds that would not have beendisbursed would be cancelled. 54. There i s a possibility that as a result o f movements in SDR/US$, the obligations under the contingent portion o f the Credit inUS$ could exceed the amount o f SDR allocated for this project component. To address this risk, SDR5,475,165 will be allocated to this component. This amount is equivalent to US$8,270,072 at current exchange rates and shouldprovide a sufficient cushion to ensure that there will be enough SDRs available under the Credit to meet the U S dollar amounts of up to US$5.5 million that may be required to be disbursed to the L/C issuingbank or UMEME. Inthe unlikelyevent that the available SDR amounts would be less than the U S dollar amounts required,the Credit amount would be increased by the additional amount o f SDRsrequired to meet the fullUS dollar disbursement amount. Auditing 55. UMEMEwill have its financial statements for each fiscal year audited inaccordance with internationally acceptable auditing standards, by an independent auditor andwould have 19 the obligation to provide these to IDA under the Project Agreement between UMEMEand IDA. SafeguardPoliciesand Impacts 56. The backstopping of the L/C facility would not invoke any World Bank safeguard policies since there are no physical investments relatedto the proposednew component. Nonetheless, thorough environmental and social due diligence i s beingundertaken by UMEMEthrough its compliance with Uganda's environmental policies, laws, regulatory and administrative frameworks for the duration o f the lease agreement. An understanding has been reachedbetweenUEDCL, UMEMEand the Utility ReformUnitthat UMEMEwould develop and implementan environmental management plan for the distribution network that would be consistent with UgandanLaw. Inthis regard, fundingwould be obtained through the tariff. Benefits and Risks 57. The principal benefits o f the proposednew component are that it will: (a) help to secure a private investor for the concessioning o f the country's power distribution facilities; (b) leadto more efficient delivery ofelectricity service through agreed operational performance milestones; and (c) catalyze US$65 million o f investments inthe first five years o f the concession for the expansion o f services. 58. The two principal risks ofthe operation are that: (a) UMEMEis unable to improve the performance of thepower sector and decides to exit at the endof 18months; and (b) there i s a drawdown on the IDA-backed L/C Facility which i s not repaid by UEDCL by the due date. The first o f these risks will be mitigated by the Government's continued support and commitment to the power sector reform agenda and the importance accordedto improving the efficiency o f the power sector as a basis to support large private hydropower generation transactions. Concerning the second risk, the likelihoodo f a drawdown on the IDA-backed L/CFacility has been mitigated through the design o f a comprehensive security package, with minimal IDA support. The amounts o f the IDA component are modest as noted above, compared to the estimated amounts o f annual rent buildup o f over US$12 million. Furthermore, except inthe circumstance describedinpara. 49, there are only three risks (see para. 39) which would be backstoppedby IDA and only for a limitedperiod o f seven years. Most importantly, IDA would be at risk only when the rentpayment and the moneys inthe Escrow Account have been exhausted and only inthe event o f a failure o f UEDCLto reimburse the L/C issuer, within a periodof twelve months. This would provide IDA twelve months to work with UEDCLand the GOUto resolve issues and to ensure that UEDCL i s in a position to make the required payment on the due date, therebypreventing a claim on the proposed IDA contingent Credit. An important feature o f the security package i s that the L/C would bereplenishedby means of any accumulatedrental payments, following a drawing. This would serve as additional protection for UEDCL and a further riskmitigant for IDA. Furthermore, there is minimal reputational risk to IDA that the Concession would not be realized since UMEMEhas already adequately demonstrated its commitment to this transaction: the company i s established inUganda andhas expended substantial resources prior to the Transfer Date. Inaddition, the FinancingDocuments have been substantially negotiated which reflects the parties' commitment to the transaction. 20 Attachment 1 PROPOSEDTERMS OF THE IDA-BACKED L/CFACILITY PrincipalTerms of the Letter of CreditFacilityandIDA Support L/C Applicant: UEDCL IDA-BackedL/C: A Standby Letter o f Credit (LE)issuedby the L/C Issuing Bank and backstopped by IDA by means o f a contingent Credit. L/C IssuingBank: Citibank Uganda Limited (Citibank N.A. London Branch will act as Escrow Agent). L/C IssuingDate: Scheduled Transfer Date (December 2004). L/C Beneficiary: UMEME. L/C Currency: U S Dollars. L/C Amounts: Upto aprincipal amount ofUS$5 million, with an initial amount ofUS$2.5 million at the Transfer Date and increasing to US$5 million on the anniversary thereof (plus interest o f up to US$500,000). L/C Validity Period: Initially 3 years renewable for up to 7 years. Available for drawing by the L/C Beneficiary upon filing o f a claimbythe L/C Beneficiary on the basis o fvalidated documentation. L/C Reimbursement Period: Repayment by UEDCL to Citibank within twelve months from each L/C drawing. ValidityPeriodof IDA Support: Upto 8 years and 25 days. IDA BackstopFees: 0.75 % per annum on the available amount o f the IDA contingent Credit, payable by UMEME.4 Front-endFees: 0 An InitiationFee o f 0.15 % ofthe L/C amount (but not less than US$lOO,OOO) for Project preparation and development costs payable by UMEME. 0 A ProcessingFee o fupto 0.50 % o fthe L/C amount to cover IDA-designatedreimbursable expenses payable by UMEMEuponreceipt o f invoices. IDA-BackedEvents: To provide a guarantee for recovery o f a loss o f revenuessubsequent to: (a) a failure by the ERA to approve tariff increases inaccordance withthe pre-agreed Tariff Methodology set forth inthe Supply License; (b) a failure by GOUentities to pay their electricity bills; and (c) payment o f the balance o f any Early Termination Amount not recovered from other specified sources (including the EscrowAccount) upona terminationo fthe Concessionwithinthe initial 18months for breach o f the PrivatizationAgreements by GOU and its entities. Conditions Precedent Usual and customary conditions for financings o f this type, including the following: to the Effectivenessof 0 Execution, delivery and effectiveness o f allprivatization and financing agreements each in the IDA Support: form and substance satisfactory to IDA; 0 All host country environmental approvals and other Consents requiredfor the operation of the Concession and compliance with all applicable IDA safeguard requirements; 0 Provision o frelevant satisfactory legal opinions which may be requiredunder the transaction documents; 0 Payment infill o f the Initiation Fee and Processing Fee, and the first installment o f the Guarantee Fee; 0 Conclusion o f an L/C Reimbursement and Credit Agreement between UEDCL and Citibank Uganda Limited, o f an IDA Commitment Agreement between IDA and Citibank Uganda Limited, o f a Project Agreement between UMEMEand IDA, and of an amended IDA Development Credit Agreement with the GOU. UMEMEwould be requiredto remit to the GOUaportiono fthis fee equivalent to the IDA commitment fee, and the balance to IDA. 21 Attachment 2 Power Sector Financialand OperationalPerformance 1. Since implementation o f significant increases inretail tariffs inJune 2001 and o f the power sector debt restructuring program at end 2001, the financial performance o f the power sector has been transformed. UEB's successor companies (UEGCL, UETCL and UEDCL) are now largely ina position to service their debts to Government, and were able to finance US$37 milliono f investments from internal resources during2002103. 2. The overall financial performance o f the sector has improved over the past two years. The principal factors contributing to the improvement are the growth inenergy generation, increases inmonthly collections and the appreciation o f the Ugandan Shilling vis-&vis the U S dollar since December 2003, which helpedto reduce the burdeno f foreign exchange dependent revenuerequirements, amounting to about 35% o f total requirements, net o f export revenues. 3. UEGCL and UETCL are both financially viable. UETCL's liquidity position i s very strong. Apart from funds set aside for the bulk supply tariff stabilization fund, UETCL has built-upapproximately USh48 billioninliquidresources. The principal reasons for this accumulation o f cash are the appreciation o f the Ugandan Shillingand UETCL's slow uptake inimplementingits investmentprogram. UEDCL's collectedrevenues in2003 and2004 are almost equal to its recurrent operational expenditures and debt service requirements. 4. Electricitv Tariffs. The present weighted average retail electricity revenue' i s about 139.7 USh/kWh, equivalent to O.O8US$/kWh at the current exchange rate. The last tariff review inJanuary 2004 led to a decrease inthe weighted average retail revenue by about 4% due to a rebalancing o ftariffs. Energy tariffs for large andmediumindustries and commercial businesses were reduced and domestic use tariffs were increased. The sector revenue requirementswill increase significantly after the take-over o f the distribution concession by UMEMEinDecember 2004 andthe addition ofnew debt service burdens associated withthe UrbanPower and Power IV on-lent loans (ADB, IDA,NDF andNORAD) between2005 and 2008. The impact on retail tariffs will be considerable inthe early years o f UMEME's operations. Inorder to avoid tariff increases inthe first six months o f Umeme's operations when the fullbenefits o fthe concessioninghave not yet materialized, the Government has proposedvarious tariff relief measures includingfunding fi-om the BST stabilization provision which would reduce the overall revenue requirementso f the power sector.6 On the assumption that tariffs would be adjusted semi-annually on May 1and November 1, 2005, the indicative tariff increases would be approximately 10% and 14% respectively. The commissioning o f Kiira units 14 and 15 (8OMW capacity) inMay and July 2005, respectively, will increase energy supply andhelp to generate additional sales revenues, which will moderate the required increases in tariffs. The proposed US$16 million o furgent distribution investments inthe first 18 months o f the distribution concession, o f which US$5 millionwill be provided by UMEME and US$11 million i s proposedby IDA under Credit 3545-UG, will also help to increase UMEME'srevenue earning capacity over the next two years, and hence mitigate the pressure on electricity tariffs. The financial analysis indicates that as efficiency improvements take effect, tariffs would come down each year inrealterms beyond the first two years. The weightedaverage revenue would decline from O.O99US$/kWh in2005106 to about 0.091US$/kWh by 2009. Because significant investments ingeneration are likely to be Average retail electricity revenue i s the amount accruing to UMEMEAJEDCL and it excludes 17% VAT which is added to end-use customer bills. Without such measures, electricity tariffs would needto be increased by around 19% o n UMEME takeover. 22 required in 2010and beyond, the Government i s reviewingthe structure and buildup o f a stabilization fund. This would permitelectncity tariffs to be smoothed out over the medium- to long-term so as to avoidradical changes intariff levels from year to year. 5. Under the existing regulations, the ERA can adjust electricity tariffs automatically for the effects o f inflation and exchange rate movements. Although this provision hasnot been invokedto date, the ERA will infuture be obliged to put into effect this mechanism as the tariff methodology under the UMEMElicense agreement provides for the quarterly indexation o f tariffs for inflation and exchange rate movements. Since 1998, the Ugandan Shilling has depreciated by about 25% against the U S dollar. However, the Uganda Shilling has appreciated by about 15% over the past twelve months, from USh1,997 in September 2003 to USh1,743 inAugust 2004. The Uganda Shilling i s forecast to depreciate against the USdollar by2.4% inthis financial analysis. Onthe other hand, ifthe recentpast appreciation o f 250 Shillings o f the Uganda Shillingwere to be reversed over the next few months, the impact on the sector revenue requirementsand thus tariffs will be significant. Approximately 55% to 65% o f the sector revenue requirements are foreign exchange dependent, and for every movement o f 100 Shillings inthe exchange rate, the impact on tariffs i s approximately 2.1% in 2004/05 and between 3.5% and 4.0% in subsequent years. Inthe future, it is proposed that electricity tariffs be adjusted on a regular basis for the effects of exchange rate movements. 6. The ERA is of the view that customers will be more willing to accept regular and needed adjustments intariffs as a result o f exchange rate movements, once consumers start noticing improvements inthe quality and availability o f supply and customer service. For these reasons, the ERA believes that it can introduce the automatic tariff adjustment mechanism six months after UMEMEtakeover. However, UMEMEhas the right under its license agreement to request quarterly changes inretail tariffs to account for inflation and exchange rate movements. The table below provides estimates o f projected average electricity revenuethrough 2009. Table 1: Uganda: Projected Average Electricity Revenue 7. The ERAhas recognizedthe needto set up abulk supply tariff stabilization fund (referred to as the BST stabilization fund) which i s beingfunded through the bulk supply tariff each year. The purpose o f the BST stabilization fundi s to mitigate against a spike inthe retail tariff due to significant hydropower investments in generation which could be realized around 2010. The accumulated fundwill be usedto provide the necessary security deposits (escrow finds) and to absorb the tariff shock by smoothening the tariff pathinthe early years after the commissioning o f any new plant. Revenue collected so far by UETCL on account o f the BST stabilization fundis heldina separatebank account andthe balance accumulatedto date amounts to Shs32 billion(US$17 million). The ERA i s inthe process o f appointing an independent consultant to advise on the appropriate mechanisms and make an assessmento f the likely level o f annual provisionrequired for the BST stabilization fund. 23 8. FutureProspects ofthe Power Sector. Table 2 on the followingpageprovides a selection of operational and financial performance indicators for 2003 to 2009. Performance i s basedon the assumption that the end customer tariffs over the forecast period are maintained at the levels indicated inthe preceding paragraphs, including the requirement for annual provisionfor the BST stabilization fund. 9. ERA'stariff methodologyprovides for concessionaires' leaserentalpaymentsto UEGCLandUEDCL. Rentincludes depreciation on assets fundedbythe companies from internal resources, debt service and a fee to cover the administration costs of UEGCL and UEDCL. The Government doesnot envisage earning any returns onleasedassets for the next seven years. On this basis, UEGCL andUEDCL will be ina position to meet their cash flow requirements andremain solvent. As for UETCL's own revenue requirements, the ERA's current tariff methodology makes provisionfor operating expenses, depreciation on assets acquired since vesting, interest on loans, investmentreturns andprovision for the BST stabilization fund. This approach does not always match UETCL's cash flow requirements, whichhave so far provedto be far less than ERA's approvedrevenues for UETCL, principally because investment returns allowed for inthe tariff have exceeded repayments o f loan principal and investments funded from internal resources. Consequently, UETCLhas accumulated cash surpluses over the past three years. The ERAhas agreed to review whether UETCL's cash flow needs would serve as a better basis for determiningthe company's revenue requirements inthe future (inother words, depreciation and returns would be replacedby investments funded from internalresources andrepayments o f loan principal). 10. UMEME'sFutureProspects. Aside from politicalrisks,UMEMEhasnegotiateda good commercial deal and stands to earn adequate profits and returns for its shareholders in the medium to long term. UMEMEhas sufficient safeguards built into the lease agreement, the assignment agreement and the associated transaction documents and agreements with UEDCL and the Government, as well as limited security guaranteesbackstoppedby IDA to sufficiently protect itself from tariff regulatory risks and non-performance by the Government and its agencies over the mediumterm. The tariff methodology definedinthe lease and assignment agreement betweenUEDCL and UMEMEwill enable the company to recover the bulksupplycosts ofUETCL, its own operational andmaintenance costs (as bidand subject to cost efficiency factors and indexation for inflation and exchange rate movements), bad debts, lease payments due to UEDCL, interest on loans, capital recovery charges and a return on investment. All foreign exchange dependent costs are to be protected from exchange risks by provisiono f quarterly tariff adjustments for the Shilling/US$ exchange rate movements. In view o f all of the above, the future financial prospects for UMEMEare deemed to be healthy. 11. The lease and assignment agreement provides for annual efficiency improvements over the next seven years interms o f revenue collection, distribution losses, numbero f new consumer connections and a distribution cost efficiency factor. Distributionloss targets are subject to review within the first two years o f the transfer date since the underlying distribution losses at the present time are not truly known due to inadequate monitoring/ meteringequipmentand the inadequacy o f UEDCL's billingsystem. Also, adequate funds have been set aside by UEB (for benefits accruing up to March2001) and UEDCL (for benefits accruing from April 2001) for the payment o f all terminal benefits inthe event o f any staff retrenchment. 24 Table 2: Power Sector Operational& FinancialIndicators(2003-2009) Foi :ast - -. 2006 1870 1662 131 4.0 25.0 1247 10.5 89 304 - UEB ---- UMEME 45 UEGCL 11 11 11 11 11 3 3 UETCL 285 295 295 295 295 295 295 UEDCL 1420 15 15 15 15 3 3 nla 1248 813 839 Customersiemployee-UEDCLAJMEME 172 209 343 356 --- UETCL Ave. Ugandarevenue (USh/kWh) UEGCL/Eskom(based on energy sent out) 17.0 11.3 13.7 17.8 18.1 18.4 19.1 (basedon bulk supply) 40.8 30.0 24.0' 44.8 45.5 47.2 50.5 UEDCLAJMEME(basedon retail sales) 150.4 139.7 146.4 175.5 173.6 175.5 181.7 Ave. Ugandarevenue (US$kWh) - UEGCL/Eskom(basedon energy sent out) -- UETCL(basedon 0.087 0.061 0.075 0.096 0.095 0.094 0.095 bulk supply) 0.021 0.016 0.013 0.024 0.024 0.024 0.025 UEDCLRJMEME(basedon retail sales) 0.077 0.075 0.080 0.094 0.091 0.090 0.091 -- In Change inave. Ugandaretailrevenue (%) Uganda Shillingterms - 7.1 4.8 19.9 - 1.0 1.1 3.5 InUS$terms - -6.1 14.7 -2.4 7.4 17.0 -3.4 - 1.3 1.0 Revenue collected(excl VAT) per kWh ofbulk 115.6 130.0 138.9 146.2 --- UEGCL - 1.2 - - 0.6 - 0.6 - 0.5 - 0.5 1 . I -2.0 1.5 UETCL 10.3 5.4 1.0 6.3 5.6 5.5 6.1 UEDCL 16.5 -- Sector 1.8 5.9 6.2 8.1 12.4 14.2 UMEME nla 37.6 39.6 36.0 24.4 19.8 16.2 6.3 0.2 1.6 6.0 6.5 7.0 7.1 Current ratio --- UEDCL - UEGCL 1.5 1.2 1.1 1.1 1.1 1.1 1.0 UETCL 2.3 2.6 2.3 2.2 2.2 2.1 2.1 1.6 1.0 1.0 1.o 0.9 0.9 0.9 UMEME nla 1.7 1.4 1.7 2.1 2.2 2.3 - Sector 2.4 2.6 2.1 2.1 2.2 2.2 2.1 -Debvequityratio (%) --- UEDCL UEGCL 12 17 16 17 17 16 15 UETCL 35 37 33 32 34 37 39 109 140 146 151 159 168 178 Sector 38 43 42 41 40 40 39 Debt service ratio -- UETCL UEGCL 2.8 1.1 1.1 1.o 1.0 1.0 1.0 -- UEDCL 9.3 4.7 2.2 2.8 2.1 2.0 2.0 2.2 0.4 1.1 1.1 1.1 1.1 1.1 Sector 2.6 1.3 2.0 2.3 2.1 1.9 1.9 'The drop inbulk supply tariff was due to temporary tariff reliefmeasures.