ASIAN DEVELOPMENT BANK RRP: PAK 32146

REPORT AND RECOMMENDATION

OF THE

PRESIDENT

TO THE

BOARD OF DIRECTORS

ON

PROPOSED LOANS

TO THE

ISLAMIC REPUBLIC OF PAKISTAN

FOR THE

ENERGY SECTOR RESTRUCTURING PROGRAM

November 2000 CURRENCY EQUIVALENTS (as of 15 November 2000)

Currency Unit − Pakistan Rupee (PRe/PRs) PRe1.00 = $0.0178 $1.00 = PRs56.25

Pakistan maintains a managed floating rate system under which the rupee is fixed on a daily basis in terms of the US dollar.

ABBREVIATIONS

ADB − Asian Development Bank ATM − automated teller machine DISCO − distribution company ESAF − Enhanced Structural Adjustment Facility FAC − fuel adjustment charges FATA − federally administered tribal areas GDP − gross domestic product GENCO − generation company HUBCO − Hub Power Company IMF − International Monetary Fund IPP − independent power producer KAPCO − Kot Addu Power Company KESC − Karachi Electric Supply Corporation LPG − liquefied petroleum gas MOF − Ministry of Finance and Economic Affairs NEPRA − National Electric Power Regulatory Authority NTDC − National Transmission and Dispatch Company PEPCO − Pakistan Electric Power Company PRGF − poverty reduction growth facility SAL − structural adjustment loan SNGPL − Sui Northern Gas Pipeline Company Limited SOE − State-owned enterprise SSGC − Sui Southern Gas Pipeline Company TA − technical assistance T&D − transmission and distribution WAPDA − Water and Power Development Authority

WEIGHTS AND MEASURES

GWh - gigawatt-hour (1,000 megawatt-hours) km - kilometer kV - Kilovolt (1,000 volt) kWh - kilowatt-hour (1,000 watt-hours) mmcfd - million cubic feet per day MW - megawatt (1,000 kilowatts) NOTES

(i) The fiscal year (FY) of the Government ends on 30 June. FY before a calendar year denotes the year in which the FY ends. Thus, FY2003 will start on 1 July 2002 and end on 30 June 2003. (ii) In this report, ‘$’ refers to US dollars. CONTENTS Page LOAN AND PROGRAM SUMMARY ii

I. THE PROPOSAL 1

II. INTRODUCTION 1

III. THE MACROECONOMIC CONTEXT 1

A. Development Objectives, Strategies, and Plans 1 B. Recent Macroeconomic Performance and Prospects 3

IV. THE ENERGY SECTOR 5

A. Background and Recent Performance 5 B. Issues and Constraints 11 C. Government Objectives and Strategy 12 D. External Assistance to the Sector 13 E. ADB’s Operations and Strategy in the Sector 14

V. THE ENERGY SECTOR RESTRUCTURING PROGRAM 15

A. Rationale 15 B. Objectives and Scope 15 C. Policy Framework and Actions 16 D. Social and Environmental Issues 23 E. Cost of Adjustment of the Restructuring Program 24

VI. THE PROPOSED LOANS 26

A. Amount of Loans and Source of Funds 26 B. Interest, Maturity, and Utilization Period 26 C. Implementation Arrangements 27 D. Procurement and Disbursements 27 E. Counterpart Funding 28 F. Monitoring and Tranching 28

VII. THE PROPOSED TECHNICAL ASSISTANCE LOAN 28

VIII. PROGRAM BENEFITS AND RISKS 29

A. Impact on Poverty 29 B. Program Benefits 30 C. Program Risks 31

IX. ASSURANCES 32

X. RECOMMENDATION 32

APPENDIXES 34 LOAN AND PROGRAM SUMMARY

Borrower Islamic Republic of Pakistan

The Proposal The proposed loans to the Islamic Republic of Pakistan include (i) two program loans, one for $300 million and the other for SDR39,083,000, to support policy reforms envisaged under the Energy Sector Restructuring Program (ESRP); and (ii) a technical assistance (TA) loan of SDR3,908,000 for capacity enhancement in the energy sector.

Rationale Pakistan’s energy sector is facing financial crisis, which stems from weak governance, political interference in decision making in the past, rising fuel prices, the adverse impact of power purchases from the independent power producers (IPPs), and endemic corruption (especially in the power sector). Weak governance has resulted in inefficient utility operations, power theft, illegal power supply, reduced billing and collection, and nonpayment of arrears. These problems have had an adverse impact on the financial performance of the utilities and have hindered the effectiveness and sustainability of the power sector. This situation has affected the poor segment of the population more than the affluent and contributed to the build up of the financial crisis in the sector, which has negatively affected the Government’s macroeconomic framework. Appropriate reforms and necessary adjustment measures, including introduction of a market-driven system, are needed to restore financial and operational viability in the sector and to make it self-sustaining. Asian Development Bank (ADB) support of the Government’s initiatives for structural reforms in the energy sector is considered essential given the urgent need to introduce competition as the driving force for improvements and private sector participation as a vehicle for creating a competitive environment. Ensuring a stable supply of electricity is essential for Pakistan’s economic recovery and thus job creation for the poor. The Program provides a sound basis for the Government to reform and restructure the energy sector. The development of a competitive energy market under the reform Program will result in efficiency gains that will have a positive impact on poverty reduction. The ESRP is an integral element of the structural adjustment program of the International Monetary Fund (IMF) in Pakistan.

Objective and Scope The long-term goal of ADB’s intervention is to ensure a self- sustaining, efficient, and competitive energy sector that can provide the required quantity and quality of energy supply at the least cost to consumers. The competitive industry structure must be enhanced and market regulation strengthened to ensure investor confidence and consumer protection. The iii

Program identifies the following areas of reforms necessary to achieve its objectives: (i) enhancement of governance in the sector, (ii) enhancement of the legal and regulatory framework and strengthening of the capacity of the sector regulator, (iii) financial restructuring and privatization of Karachi Electric Supply Corporation (KESC), (iv) restructuring of Water and Power Development Authority (WAPDA) and privatization of corporatized entities, (v) creation of an enabling environment for a competitive electricity market, (vi) resolution of the IPP issue and finalization of the Hub River Power Plant Company (HUBCO) and the Kot Addu Power Plant Company (KAPCO) cases, and (vii) enhancement of reform in the natural gas and petroleum subsector. The reform program will be jointly supported by ADB, the World Bank, and IMF, with the World Bank (WB) providing parallel financing.

Classification Economic growth

Environment Assessment Category C: Environmental implications were reviewed and no significant adverse impacts were identified.

The Loans

Amounts and Terms (i) A program loan of $300 million will be provided, from ADB’s ordinary capital resources (OCR), with interest to be determined in accordance with the pool-based variable lending rate system for US dollar loans and with a term of 15 years, including a grace period of 3 years, and such other terms and conditions as set forth in the draft Loan Agreement.

(ii) A program loan in various currencies equivalent to SDR39,083,000 from ADB’s Special Funds resources, for a term of 24 years, including a grace period of 8 years, and with interest of 1.0 percent per annum during the grace period, and 1.5 percent per annum thereafter.

(iii) A TA loan, in various currencies, equivalent to SDR3,908,000 from the Special Funds resources of the ADB for a term of 32 years, including a grace period of 8 years, and with an interest rate of 1.0 percent per annum during the grace period, and 1.5 percent per annum thereafter.

Program Period and Tranching The Program period will be January 2000 to December 2003. The Government will be able to withdraw funds from the loan account up to 31 December 2003 (a period of three years from loan effectiveness). The loan will be disbursed in three tranches. The first tranche, equivalent to $150 million, will be made available on loan effectiveness, of which, $100 million will iv

be from OCR, and SDR39,083,000 from Special Funds resources. An incentive tranche of $50 million, from OCR, will be made available after three months and upon satisfactory compliance with the stipulated conditions. The second and third tranches, each amounting to $75 million, will be released in December 2001 and December 2002. Specific conditionalities are set for the release of the second and third tranches; however, if all conditions for the second tranche are met, except the privatization of the two WAPDA entities (one distribution company and one generation company), and if the third tranche condition in respect of the privatization of KESC has been met, then the two privatization conditions will be transposed, and all conditions for the release of the second tranche will be considered to be met.

Executing Agency Implementation Arrangements The Ministry of Finance (MOF) will be the Executing Agency. MOF will coordinate and monitor the implementation of the ESRP, and administer the utilization of the loan proceeds. MOF will be supported by (i) the Ministry of Water and Power in the implementation of the sector reforms, (ii) the National Electric Power Regulatory Authority (NEPRA) to ensure proper sector regulation, and (iii) the Privatization Commission to support the privatization of KESC and other corporatized WAPDA entities. A federal steering committee and a KESC privatization cell will ensure the timely implementation of the reform Program.

Procurement The proceeds of the loan will be utilized to finance the full foreign exchange costs (excluding local taxes and duties) of goods and services produced in and procured from ADB member countries (other than items specified in the prohibited list and imports financed by other bilateral and multilateral sources).

Counterpart Funds The counterpart funds to be generated from the proceeds of the program loan will be used to finance the adjustment costs such as financial relief to the utilities and certain programs and activities consistent with the ESRP.

TA Loan The TA loan for capacity enhancement in the energy sector will be used to undertake (i) a poverty impact assessment to monitor and evaluate impacts on residential and commercial consumers, with special attention to the poorest segment of consumers; and (ii) a labor impact assessment and mitigation measures to reduce vulnerability of redundant workers. A portion of the TA funds may be used to prepare a plan to reduce vulnerability of redundant workers in consultation with all stakeholders. v

KESC will be the Executing Agency of the TA loan, and will provide the necessary office space, counterpart staff, local transportation, and other services to the consultants.

All procurement under the TA loan will be in accordance with ADB’s Guidelines for Procurement. The consultants will be selected and engaged in accordance with ADB’s Guidelines on the Use of Consultants and other arrangements satisfactory to the ADB on the engagement of domestic consultants.

Safeguards and Risks The most important safeguard is that the reform Program is comprehensive and was formulated by the Government. The plans for its implementation have been worked out by the Government with due attention to political realities and implementation capacity. A second factor is the sequencing of actions that are already in place, including the establishment of NEPRA, an independent sector regulator; enactment of the privatization law, which protects the rights of the investors and consumers; announcement of the draft labor policy; resolution of the IPP issue and the finalization of the HUBCO case; amendment of the WAPDA Act to split WAPDA for privatization; deregulation of furnace oil prices; adjustment of fuel prices linked to the international price fluctuations; and privatization of liquefied petroleum gas operations. A third mitigating factor is the ADB’s close monitoring of the implementation of the reform Program, with the World Bank and IMF. Finally, adequate provisions have been made to mitigate risks relating to social aspects. Since the reform program challenges existing economic interests, a major risk is weakened political resolve to implement the Program at the required pace and sequencing of macroeconomic and energy sector structural reforms. Political commitment to reforms could waiver in the face of strong opposition from interested groups. Another risk is that of social discontent arising from the difficult economic situation and adjustment measures needed to weed out corruption and theft in the power sector. The economic and the political costs of the “no-reform” scenario in the energy sector are grave and the resulting consequences are unacceptable to the Government. While the risks involved in supporting a strong reform program in the energy sector are significant, they are less than the risks of not supporting such a program. I. THE PROPOSAL

1. I submit for your approval the following Report and Recommendation for the proposed loans to the Islamic Republic of Pakistan for the Energy Sector Restructuring Program (ESRP) comprising (i) two program loans, one for $300 million and the other for SDR39,083,000 to support policy reforms under the ESRP, and (ii) a technical assistance (TA) loan of SDR3,908,000 for capacity enhancement in the energy sector.

II. INTRODUCTION

2. In April 1998, the Government of Pakistan requested the Asian Development Bank (ADB) to provide a quick-disbursing policy-based loan facility to rectify the financial crisis in the power sector and meet part of the sector shortfalls and restructuring costs. In response, an ADB mission visited Pakistan during March-April 1998 to identify key issues, and to discuss with the Government the possible ADB assistance and develop the objective and scope of the ESRP. The mission advised the Government that the further processing of the ESRP would depend on the Government’s implementation of policy reforms; formulation of a realistic, credible, and feasible financial package for the restructuring of Water and Power Development Authority (WAPDA) and Karachi Electric Supply Corporation (KESC); unbundling, restructuring as corporations (corporatization), and commercialization of unbundled WAPDA entities; steps leading to the privatization of KESC and the corporatized WAPDA entities; operational independence of the sector regulator; electricity tariff adjustment mechanism including a reduction in cross-subsidies; and resolution of the issue of the independent power producers (IPPs).

3. A fact-finding mission visited Pakistan from 21 April to 6 May 1998 to firm up understanding of the program loan. However, the processing of the ESRP was suspended following the nuclear testing in May 1998, the subsequent bilateral sanctions, and suspension of assistance from international financial institutions. Nonetheless, ADB effectively made use of this period by fielding a number of follow-up missions to continue policy dialogue with the Government to resolve all pending issues and sought agreement on time-bound implementation of the reform measures. Since the ESRP is an integral element of the structural adjustment program of the International Monetary Fund (IMF), its processing recommenced after the resumption of Enhanced Structural Adjustment Facility (ESAF)/Extended Fund Facility (EFF) program in January 1999. The Appraisal Mission1 visited Pakistan from 26 July to 17 August 2000 to finalize the agreement with the Government. The final agreements reached are reflected in the Government’s development policy letter and the attached Policy Matrix (Appendix 1). The program framework is provided in Appendix 2.

III. THE MACROECONOMIC CONTEXT

A. Development Objectives, Strategies, and Plans

4. Since taking power in October 1999, the new Government has accelerated the pace of economic reforms. A comprehensive structural reform program in line with the economic

1 The Mission comprised Sadiq H. Zaidi, Senior Project Engineer/Mission Leader; Rune Stroem, Senior Financial Specialist; Rita O’Sullivan, Counsel; S.B. Koh, Economist; Tomoyuki Kimura, Energy Sector Specialist; and Carol Litwin, Poverty Specialist. K. Rahman, Manager, and M. Zijsvelt, Resident Representative, Pakistan Resident Mission, provided support to the Mission and attended key meetings with the Government of Pakistan. 2 roadmap was announced by the new Government in December 1999, and a broad-based poverty reduction strategy is being prepared.

5. The Government’s formulation of a poverty reduction strategy takes into account the interrelation of economic, social, and governance dimensions. A four-track approach has been identified by the Government: (i) broadly based economic growth that provides efficient income generating opportunities for the poor and a pattern of growth that is relatively labor intensive; (ii) achievement of the highest possible growth path that is consistent with the available financial and human capital under a governance architecture that is both humane and efficient; (iii) improved access to education, skills training, primary health care, nutrition, and other social services that help the poor become productive employees or capable of starting small-scale business ventures; and (iv) provision of safety nets for the vulnerable groups.

6. The main focus of the Government’s fiscal reforms is to improve revenue performance through broadening the tax base and strengthening tax administration. In the recent past, the Government has introduced a number of tax measures, including (i) an on-the-spot assessment scheme in 13 cities to increase tax compliance, registration, and documentation; (ii) periodic adjustments of petroleum prices in line with international price developments and elimination of the subsidy on furnace oil; (iii) increased registration under the goods and services tax (GST), which will be extended to cover the services sector; and (iv) reorganization and downsizing of the Central Board of Revenue of the Ministry of Finance (MOF). A number of additional fiscal initiatives are also under consideration, including an agricultural income tax, and a more integrated, client-based, and functional tax administration system will be introduced.

7. In the financial sector, detailed privatization plans have been drafted and disposal of the remaining shares of national commercial banks and other state-owned financial institutions is proceeding. New managers from the private sector have been appointed in all but one of the development financial institutes. A program has also been designed to enhance the minimum capital requirements together with necessary amendments in banking laws for this purpose. In addition, the State Bank of Pakistan will be restructured to focus on its core operations such as monetary policy, banking supervision and foreign exchange management. The new insurance law passed in June 2000 will increase financial soundness and help further growth in the sector. Under assistance mainly from ADB,2 the Government has introduced major capital market changes, including establishing a national clearing and settlement system, automating of stock exchange transactions, and setting up credit rating agencies to strengthen information flows and market efficiency.

8. Privatization, which is urgently required to prevent further losses, has been accelerated recently. Initial measures have included (i) a privatization law (to enhance transparency, accountability, and efficiency in the privatization process) has been approved; (ii) two national commercial banks and a partially privatized bank will soon be listed on the stock exchange; (iii) bidding for the liquefied petroleum gas (LPG) business of three companies and the meter manufacturing unit of a gas company is to be held by the end of 2000; and (iv) in the industrial sector, six units are to be liquidated or sold through the stock market before the end of June 2001 and a large number of state-owned enterprise will be privatized in the next two years. The proposed ESRP loan will support privatization of KESC and two corporatized entities of WAPDA. Under ADB’s Loan 1576, the National Investment Trust and Mutual Funds of Investment Corporation of Pakistan are to be privatized by the end of 2000.

2 Loan 1576-PAK: Capital Markets Development Program Loan, for $250 million, approved on 6 November 1997. 3

B. Recent Macroeconomic Performance and Prospects

1. Recent Macroeconomic Performance

9. The past two years have been difficult for Pakistan’s economy. Following the nuclear tests in late May 1998, economic sanctions magnified Pakistan’s long standing socioeconomic difficulties. IMF also suspended its ESAF-EFF package. The economy declined sharply due to the erosion of investor confidence, the virtual cessation of private capital inflows, and the suspension of new official development assistance. Consequently, Pakistan faced a severe foreign exchange crisis as reserves fell to $415 million or the equivalent of less than two weeks of imports in November 1998. To prevent the total collapse of the balance of payments, the Government adopted short-term measures including freezing foreign currency accounts held in domestic banks, adopting a dual exchange rate system, and delaying the servicing of foreign debt.

10. IMF revived the ESAF-EFF in January 1999 after the partial waiving of sanctions in December 1998. Multilateral funding resumed at the same time. In late January 1999, the Government and bilateral creditors negotiated an agreement to reschedule official debt. In early July 1999, Pakistan concluded an agreement for rescheduling commercial loans valued at $877 million. In late September 2000, IMF and the Government reached a preliminary agreement for a standby program, which is expected to be approved by the IMF Board in November 2000. Initially, the program will be for one year. But the agreement could be subsumed into a Poverty Reduction Growth Facility (PRGF) by mid-2001. In addition, Pakistan would be accorded a one- year debt rescheduling, since the present debt rescheduling agreements will expire on 31 December 2000.

11. Pakistan’s economic performance during FY2000 showed some improvement. The new Government introduced a number of measures to stabilize the economy. Positive signs included a modest recovery in economic growth, a fall in inflation rate, increased exports, and a relatively stable foreign exchange level.

12. Real GDP grew by 4.8 percent in FY2000 as against 3.1 percent of the previous year. One of the main reasons for this recovery was a significant improvement in agriculture, which grew by 7.2 percent. A sharp recovery in bumper cotton and wheat crops and a good rice crop supported high agriculture sector growth. The performance of manufacturing in general and large-scale manufacturing in particular appeared weak, as they grew by only 1.1 percent and -0.7 percent, respectively. This weak performance was mainly due to a decline in sugar production. The service sector grew by 4.5 percent during the period. The increase rate of the consumer price index (CPI) declined to 3.6 percent during FY2000 as against 5.7 percent of the previous year.

13. Alongside these positive developments are several areas of concern that require serious Government attention in the short to medium term. First, fiscal deficit emerged as a major source of macroeconomic imbalance. Although Pakistan succeeded in reducing its fiscal deficit from 7.7 percent of GDP in FY1998 to 6.5 percent in FY2000, the current size of the deficit itself is unsustainable. Future fiscal adjustment is essential for restoring macroeconomic stability. Second, continued weaknesses in the tax revenue effort and substantial debt service payments constrain policy choices, particularly by limiting much needed outlays for infrastructure and social sectors. In this context, the main focus of the Government’s fiscal reform is to improve revenue performance through broadening the tax base and strengthening tax administration. According to the federal budget for FY2001 approved in June 2000, the fiscal deficit is projected 4 to decline to 4.5 percent in the current year, but it was subsequently revised to 5.0 percent after discussion with IMF.

14. The fragile balance-of-payments situation remains one of the principal areas of concern. The trade deficit reached $1.7 billion, doubled the Government’s $800 million target for FY2000. Although exports expanded by 8.7 percent during the year, imports increased by 8.0 percent, due largely to higher prices of petroleum and related products. The widened trade gap, coupled with a negative resource transfer from funding agencies, have exerted pressure on the balance of payments. Foreign exchange reserves as of June 2000 totaled $1.39 billion, which is less than two months of imports.

15. Another area that requires immediate attention is arresting the increasing poverty. Declining economic growth, severe macroeconomic imbalances, lack of social safety net, and poor governance in the 1990s have had adverse effects on the country’s poor and most vulnerable. The incidence of calorie-based poverty has increased from 17.3 percent in FY1988 to 22.4 percent in FY1993 and further to 35.2 percent in FY1999.3

16. The short-to-medium-term prospects for the Pakistan economy will depend on political stability and the pace of economic reforms. Above all, improving the quality of governance is essential for the success of reforms and a sustainable development program. Assuming that the Government will implement major structural reforms in a timely manner and maintain macroeconomic stability, GDP is projected to grow by 5.0 percent in FY2001. The inflation rate is expected to be around 4.5 percent on the assumption that monetary expansion will be around 9.0 percent. The trade sector is expected to improve in FY2001, with 11.0 percent growth in exports and 3.6 percent increase in imports owing to sustained increase in agriculture production, revival of manufacturing sector, and stable prices of oil and its products. The trade account is projected to be in deficit by $1.3 billion in FY2001, and thus the current account deficit is expected to decline to 2.0 percent of GDP in FY2001 from 2.4 percent in FY2000.

2. Impact of Energy Sector Restructuring on the Economy

17. The electricity and gas sector accounts for over 4.0 percent of GDP. It is the third largest commodity sector in the economy following agriculture and manufacturing. In FY2000 the energy sector grew by 7.8 percent, substantially higher than the overall GDP growth rate of 4.8 percent. Given the importance of the energy sector, the restructuring program is expected to have a significant impact on economic growth through a reduction of the budget deficit, a reduction of the current account deficit, increased efficiency in the energy sector, and improved overall resource allocation in the economy.

18. The restructuring program is expected to enhance the efficiency of the energy sector through the introduction of competitive market forces and the subsequent reduction in transmission and distribution losses. This will help reduce production costs across all industries, including agriculture and manufacturing, in the medium to long term, which will contribute to a lower inflation rate and higher economic growth. Reduction in transmission and distribution losses will also reduce corruption and waste of public resources.

19. The effect of the restructuring program on the overall resource allocation in the economy is also expected to be significant. Allocation of Government funds to the energy sector diverts public funds away from social sectors and activities which are more conducive for poverty

3 Interim Poverty Reduction Strategy Paper of the Government of Pakistan, September 2000. 5 reduction and fostering economic growth. For instance, the operating loss in FY2000 of KESC alone was PRs12.9 billion, i.e., over 70.0 percent of the total Government expenditure on social services, 144.0 percent of the expenditure on education and 250.0 percent of the expenditure on health. Although these funds are not fully fungible, it is evident that continuous allocation of public resources to the energy sector crowds out public investments to other sectors of the economy. Thus restructuring of the energy sector will lead to a more efficient allocation of public funds, which will contribute to enhancing sustainable economic growth and poverty reduction.

20. The inefficiencies in the energy sector are imposing an increasing burden on the Government budget. Given the unsustainable fiscal deficit of 6.5 percent of GDP in FY2000, the Government does not have the resources to continuously inject funds into the energy sector. In FY2000, KESC had net loss of PRs12.9 billion, and net liabilities PRs20.4 billion. Although WAPDA did not have net loss, in FY2000 the Government was forced to convert PRs36.3 billion of debt into equity and WAPDA had contingent liabilities to HUBCO and KAPCO of PRs31 billion. An idea of the size of these liabilities and losses can be had from the fact that the total tax revenue in FY2000 was PRs346 billion, and the development expenditure was only PRs100.6 billion. The Government is committed to reducing its fiscal deficit to 5.0 percent of GDP in FY2001, and 3.5 percent of the GDP by FY2003. The restructuring program, by reducing losses and facilitating privatization of KESC, will play a critical role in the achievement of these targets.

21. The energy sector is highly import intensive in its input usage, particularly petroleum products. In FY2000, petroleum products and crude oil imports amounted to $2.8 billion, i.e., 27.2 percent of the Pakistan’s total imports. If the transmission and distribution losses of WAPDA and KESC were reduced by 50.0 percent, Pakistan would have needed to import 13.0 percent less of petroleum products at a saving of over $350 million. The energy sector restructuring program, besides helping to reduce the transmission and distribution losses, will also support the replacement of imported petroleum products with domestically produced natural gas. The substitution is projected to generate $3.0 billion in foreign exchange savings for the government over the next 10 years, or $300 million a year. Thus the combined impact of the restructuring program in reducing the current account deficit would be significant.

IV. THE ENERGY SECTOR

A. Background and Recent Performance

1. Power Subsector

22. Pakistan has two public sector power utilities: KESC, a predominantly Government- controlled public limited liability company, and WAPDA, a Government-owned statutory body. The installed generation capacity of Pakistan’s public sector power system is about 11,890 megawatts (MW) of which WAPDA’s capacity is 9,950 MW (84.0 percent), KESC’s at 1,800 MW (15.0 percent), and Karachi Nuclear Power Plant at 140 MW (1.0 percent). Of WAPDA’s total capacity of 9,950 MW, about 4,825 MW is from hydropower and 5,125 MW from thermal power. KESC’s generation capacity is entirely thermal. Thus, of Pakistan’s total generation capacity, about 58.0 percent is thermal, 41.0 percent hydropower, and 1.0 percent nuclear.

23. KESC was established in 1913 as a private corporation under the Indian Companies Act of 1882. The Government, through the Ministry of Water and Power (MWP) now controls its management. Presently, KESC is majority owned by the Government, which holds a 93.0 percent equity stake, controlled directly and indirectly through public sector organizations. The 6 remaining 7.0 percent of shares are privately held. KESC ranks among the top 15 Pakistani companies in terms of market capitalization and is listed on the Islamabad, Karachi, and Lahore stock exchanges. KESC is a vertically integrated electric utility and supplies power to Karachi, Pakistan’s largest city and the country’s commercial and financial capital. KESC’s transmission and distribution lines span over 15,500 kilometers (km). Its extensive and relatively affluent franchise area caters to 1.7 million customers and covers an estimated 6,000 square kilometer (km2), including nearby industrial areas in Sindh and Balochistan provinces. Of KESC’s total installed capacity, its available capacity has recently been as low as 900 MW due to obsolescence of some of the plants and lack of reserve capacity to enable the units to be taken out of service for maintenance. However, since the last unit was installed in 1997, and with KESC now having access to capacity from two recently completed independent power producers (IPPs), the backlog of maintenance has been tackled and the available capacity now amounts to about 1,400 MW. This meets less than 70.0 percent of the energy demand. The balance is met by purchasing electricity from WAPDA and small generation plants of other industrial complexes in Karachi.

24. WAPDA was created by an Act in 1958, as an autonomous body for the development and use of the water and power resources of the then West Pakistan on a unified and multipurpose basis. WAPDA’s responsibility covered the development and use of water resources and included activities related to irrigation, water supply and drainage, flood control, prevention of water logging, and salinity control. WAPDA’s Power Wing functions as an integrated electric power utility for the entire country, except Metropolitan Karachi, which is serviced by KESC. WAPDA has about 110,000 employees, most of whom work in the Power Wing. WAPDA has 11 thermal power generation stations with a total capacity of 5,125 MW. The hydropower projects, such as Ghazi Barotha (under construction), Mangla, and Tarbela are managed by the Water Wing, since they are primarily operated to meet irrigation demands, with electricity as a secondary output. WAPDA’s installed hydropower capacity of 4,825 MW represented 41.0 percent of its current total generation capacity. The power distribution function of WAPDA is carried out by eight area electricity boards, namely: Faisalabad, Gujranwala, Hyderabad, Islamabad, Lahore, Multan, Peshawar, and Quetta. At present, the lines for the transmission of power and the grid system for the entire country are owned, managed, and operated by WAPDA through its transmission and grid department. WAPDA provides electric power utility service to about 11.6 million customers.

25. Additional Generation Capacity. Power consumption in Pakistan grew rapidly during the 1970s and 1980s, at an average annual rate of over 9.0 percent, although it slowed somewhat over the past 3-4 years as Pakistan has encountered economic difficulties. The most significant increase was in the domestic sector, the share of which tripled during that period. While the growth in electricity consumption has been strong, Pakistan’s per capita electricity consumption per year remains low at 320 kilowatt-hours (kWh), less than one quarter of the average for the region as a whole. Also, close to half of the population remains without access to electricity services. An overview of key sector indicators is presented in Supplementary Appendix A. Since the 1980s, power supply lagged behind demand, resulting in major load shedding of up to 30 percent of peak demand. In the early 1990s, it was clear that, with demand growing at about 9.0 percent per year, WAPDA and KESC did not have the resources to increase generation capacity at the rate required to eliminate load shedding and undertake essential routine maintenance on all plants in the system. Faced with the chronic power shortages, the Government in 1994 initiated a study of Pakistan’s future energy needs up to the year 2020. The report highlighted that additional generation capacity of about 9,800 MW was urgently needed by the year 2002. Of this recommended additional capacity, 4,600 MW was already under construction or in the early stage of planning and the balance of 5,200 MW was 7 recommended to be implemented by the private sector. Under a low demand scenario, the 5,200 MW additional capacity was projected to be reduced to 3,200 MW but increased to 7,200 MW under a high demand scenario.

26. Introduction of IPPs and Private Investment. The Government formulated the 1994 power policy and invited, for the first time, the IPPs to invest in the power sector in Pakistan. The World Bank assisted the Government in formulating the framework of IPPs’ involvement in the power sector. The policy allowed full flexibility to the IPPs to bring capacity on line as quickly as possible at predetermined power purchase prices. The Government guaranteed implementation, fuel supply and power purchase. To attract the first private investment of the IPPs into the power sector and to cover the risks perceived by the investors, the Government offered generous tariffs. In 1993, construction started on Hub Power Plant Company (HUBCO), with a capacity of 1,292 MW and a negotiated tariff based essentially on a “cost plus” approach.

27. Power Rates for IPPs. The Government agreed to an average purchase price of electricity from the IPPs for the first 10 years at $0.060/kWh which was subsequently increased to $0.065/kWh. However, high front-end loading of the tariffs to meet the developer’s cash flow requirements resulted in tariffs in the initial years being as high as $0.083/kWh. An additional premium of $0.0025/kWh for the first 10 years was also offered for projects commissioned by 1997. Furthermore, a mechanism was provided for indexation of certain tariff components based on the rupee’s exchange rate against the US dollar, fuel price variation, and inflation. In addition to the generous private power purchase rates of the IPPs, the agreements stipulated that if the Government bought less or no power due to lower demand, the Government (or WAPDA) would still pay the IPPs for 60.0 percent of their plant capacity. With these attractive Government incentives, 19 IPP projects arose and brought over $3.0 billion to install about 3,500 MW capacity. This does not include funds for HUBCO, which included financing from the World Bank and WAPDA’s Kot Addu plant, which later was privatized and became Kot Addu Power Company (KAPCO).

28. Advantages and Disadvantages of the 1994 Power Policy. The advantages of the policy included quick implementation, and access to global capital and technology resources. The drawbacks related to the absence of international competitive bidding procedures, unstaggered timing of the plants’ commissioning, poor planning of the location of power plants, and the inappropriate choice of imported furnace oil fuel for the IPPs power plants. The policy has been successful in rapidly bringing foreign capital for new power generation capacity, it also provided guaranteed high energy prices to IPPs. The IPPs’ new generation power plants were based on imported fuel oil, and were licensed to be located far from the load centers in the central and northern areas of Pakistan, thus putting severe strain on the country’s physical infrastructure, including the electricity transmission system. With the commissioning of some IPP power plants in 1997, WAPDA and KESC purchased electricity from these IPPs. From 1998, Pakistan has had excess capacity with the utilities contracted to purchase expensive IPP electricity while their own plants are underutilized.

29. Government Payments for Private Power Purchase. The Government paid PRs35.6 billion ($0.7 billion) in FY1997 and PRs57.3 billion ($1.10 billion) in FY1998, to purchase power from the IPPs. Most of the payments went to two private sector power operators–HUBCO and KAPCO, which together have a combined capacity of about 2,900 MW. Since then, nine IPPs with a total combined capacity of about 1,940 MW have started operating. The Government claims that it is buying power from HUBCO at $0.118/kWh because of the “cost plus” provision of the tariffs and because HUBCO’s operations are curtailed to about 45.0 percent of its capacity, since WAPDA is not in a position to purchase much of HUBCO’s output. When all the 8

IPPs are commissioned, the Government (or WAPDA) will have to pay them about PRs300 billion ($5.8 billion) over the next three years (up to FY2003) for electricity, all of which may not be used. The payment to the IPPs has adversely affected the Government financing of other public enterprises in the power sector. The Government contends that the $0.065/kWh rate of the IPPs, as per their agreement with the previous Government, is unaffordable for a country like Pakistan. As a result of the large payments to IPPs during FY1996 and FY1997, WAPDA and KESC have faced serious liquidity problems. KESC has defaulted on its fuel payments to the Pakistan State Oil Company (PSOC), Oil and Gas Development Corporation (OGDC), and the oil refineries. WAPDA was the root cause of the National Refinery defaulting on its loan payment to the Islamic Development Bank. The previous Government pressured the IPPs into lowering the tariffs and to coerce a confession of corrupt practices in securing approvals of their projects. A summary of the IPP controversy is presented in Supplementary Appendix B. The funding agencies, including ADB, advised the Government that it should delink the corruption issue from the tariff structure and resolve the IPP issue in an amicable and business-like environment, and within the framework of contractual agreements.

30. Power Subsector Performance. The power sector in Pakistan has a relatively poor operational performance and retail tariffs averaging below the long-run marginal cost, due to subsidization of power to most residential and agricultural consumers. Notwithstanding this, the sector has consistently recorded profits in the past. This is largely due to the low book value of the operating assets resulting in low depreciation expenses, and the Government’s financing of the sector on terms well below market rates. In FY1996, WAPDA’s profits represented 36.0 percent of operating revenues. The situation, however, changed dramatically in FY1997 with the commissioning of IPPs whose power cost almost twice as much as WAPDA’s thermal generation or four times WAPDA’s average hydro-thermal generation. This was compounded by deterioration in operating efficiencies, particularly for KESC, and a two-fold increase in domestic cost of fuel. As a result, the sector recorded losses in FY1997, with WAPDA’s losses representing 2.0 percent of revenues and KESC’s losses at 34.0 percent of revenues. The sector’s total liabilities amounted to PRs233.0 billion ($4.5 billion) as of 30 June 1997. Also, the construction by WAPDA of the Ghazi Barotha and Chashma hydropower projects slowed to a virtual halt due to lack of counterpart funds. The status of the Ghazi Barotha and Chasma hydropower projects is provided in Supplementary Appendix C. The sector’s persistent operational inefficiencies, high cost of operations, and retail tariffs that do not cover the cost of operations, have eroded the operating margins, profitability, and cash flows. These have resulted in the sector’s weak self-financing, debt service, and liquidity capabilities and its corresponding noncompliance with financial health covenants with ADB.

31. KESC’s performance has deteriorated significantly in recent years. Its equity has become negative due to accumulated losses since FY1998. KESC’s long-term debt in FY2000 represented 103.9 percent of total fixed assets and its current ratio is at an alarming level of 0.53 times. KESC has been unable to generate sufficient cash flow to meet its capital expenditure requirement, debt service obligations and a part of operational expenses. KESC’s worsening financial health is threatening its operations, adversely impacting the viability of the energy sector, and causing cash flow problems to its fuel suppliers, which is affecting their privatization. Supplementary Appendix D summarizes KESC’s financial performance.

32. The main factors driving KESC’s net losses and weak cash flows are excessive levels of transmission and distribution losses, the high cost of fuel (which has not been matched by adequate adjustments in tariff levels), the increased purchase and high cost of electricity from IPPs, and poor revenue collection and high levels of uncollected receivables. Transmission and distribution losses have been on the rise and in FY2000 were estimated at about 60.0 percent. 9

This high level of losses, although partly attributed to technical constraints, is primarily due to theft. KESC’s full dependence on thermal generation makes it sensitive to increases in the cost of fuel. Fuel expenses accounted for an increasing share of operating revenues. In addition, the price of furnace oil, which is KESC’s main fuel, has more than doubled since FY1996. This significantly eroded KESC’s operating margins and profitability over time. The current plans of the National Electric Power Regulatory Authority (NEPRA) to introduce automatic adjustments in tariff structure for passthrough items, are expected to help alleviate KESC’s sensitivity to adverse movements in fuel prices and to achieve a better congruence between KESC’s revenue base and cost structure.

33. KESC currently buys power from GUL AHMED, Karachi Nuclear Power Plant, Pakistan Steel Mills Corporation, and TAPAL Energy. While power from Independent Power Producers (IPPs) only accounted for 10.4 percent of operating revenues in FY1996, it was about 46.4 percent of operating revenues in FY2000. Furthermore, KESC’s average IPP costs have increased from PRs128.26/kWh in FY1996 to PRs329.78/kWh in FY2000. This substantial increase in IPP costs, was much higher than the yearly increases in average revenues, also contributed to reductions in KESC’s operating profits and profitability. KESC’s poor revenue collection is reflected in its large receivables in FY2000 of PRs11.7 billion. KESC is required under ADB’s proposed Program loan to improve its liquidity position by reducing receivables to 3.0 months of energy sales by the end of FY2003.

34. WAPDA’s financial performance started to deteriorate in FY1997, and has been unable to meet its financial covenants. Supplementary Appendix E outlines the status of WAPDA and KESC’s performance target compliance. The primary factors driving WAPDA’s declining liquidity, cash flow, and profitability relate to its poor bill collection and high level of receivables from federal and provincial governments due to their inability to pay, increasing purchase from IPPs at price levels much higher than average tariffs, high levels of system losses, large increases in fuel costs, inadequate tariff increases, and decreased growth in power demand. However, in FY1999, WAPDA recovered net income with substantial improvements of key financial ratios.

35. As of 30 June 2000, the cumulative stock of federal and provincial government receivables (including all arrears) grew to PRs29 billion from PRs19 billion on 30 June 1998. To address WAPDA’s liquidity crunch, the Government converted WAPDA’s pending debt service liability of PRs36.3 billion into equity in FY2000. Since then, WAPDA has been current on all its payment obligations. WAPDA’s cost of power from IPPs represented 48.5 percent of revenues in FY1998. In FY1998 for example, the unit cost of IPP-generated power was at least 4.2 times WAPDA’s average unit generation cost (thermal and hydro) and about 2.1 times WAPDA’s unit thermal generation cost (Supplementary Appendix A). Since FY1999, due to a dispute about the power purchase agreements (PPAs) with HUBCO and KAPCO, WAPDA has paid reduced rates to these two power suppliers under court orders. Consequently, WAPDA carries a contingent liability of about PRs26 billion as of 30 June 2000. WAPDA’s fuel costs for its thermal power plants have steadily increased. Its fuel oil cost per unit of thermal power generated doubled from PRs84.1/kWh in FY1996 to PRs161.06/kWh in FY1998, and rose to PRs181.03/kWh in FY2000. Increase in fuel cost also contributed to higher power purchase cost from the IPPs, which were all thermal-fired. Supplementary Appendix D summarizes WAPDA’s financial performance.

36. Because public and private consumers are not paying their bills to WAPDA and KESC, they have been unable to service obligations to fuel suppliers and loan creditors. As of June 2000, the total arrears of the government and private customers owing to WAPDA amounted to 10

$562 million and $483 million, respectively. This forced WAPDA to default on its debt service liability to the Government, and its loan arrears amounting to approximately $700 million were converted into equity in FY2000. Although WAPDA is current on all fuel and debt service obligations, its substantial arrears from the public sector are a formidable obstacle for restoration of financial soundness. Having been strongly urged by the ADB and the WB to resolve this issue, the GOP settled all the public sector arrears developed from January 1999 to June 2000. It was also decided by the GOP that the arrears prior to January 1999 should be written off except for the arrears from the Government of Sindh. To KESC, receivable arrears from private consumers amounting to $299 million have been a major cause for its liquidity problem. KESC has been unable to service its payment obligations to fuel suppliers, the Government, and WAPDA even after a comprehensive debt restructuring in FY1998. As a result, KESC’s payable arrears as of June 2000 amount to $379 million comprising fuel and power purchase arrears of $308 million and loan arrears of $71 million. The major elements of the sector’s debt as of June 2000 are shown in Appendix 3.

2. Natural Gas and Petroleum

37. The natural gas and petroleum in Pakistan have traditionally been controlled by the Government, which acts as owner, regulator, and policy maker. The Ministry of Petroleum and Natural Resources (MOPNR) is the administrative arm of the Government, and is responsible for all aspects relating to natural gas and oil. Pakistan has indigenous reserves of natural gas, oil, and coal, which provide 61.0 percent (24.7 million tons of oil equivalent [toe]) of the total net primary energy supplies of 40.4 million toe. The primary energy supply mix of Pakistan in FY1998 consisted of oil (43.9 percent including petroleum products), natural gas (37.3 percent), hydroelectricity (13.0 percent), coal (5.1 percent), and other sources such as LPG and nuclear electricity (0.7 percent). A number of public and private firms are involved in exploring for and producing oil and gas in Pakistan, and a number of international firms are involved in a large number of joint-venture partnership operations with Government entities. The refining and marketing of oil products are dominated by international and domestic stakeholders with public and private ownership interest. The two state-owned enterprises, Sui Southern Gas Company (SSGC) and Sui Northern Gas Pipeline Company (SNGPL), undertake the purification, transmission, and distribution of natural gas in the country. Pakistan has imported 4.0 million tons of oil and 11 million tons of petroleum products during the FY2000, at a cost of $2.2 billion, to meet its energy needs. The amount of imported fuel oils will increase due to the increased demand for fuel by the power generation plants. This trend can only be prevented if a comprehensive plan is instituted to convert the power plants using the high-cost fuel oil to indigenous sources of energy such as natural gas. The natural gas is being transmitted and distributed by SSGC in the southern part of Pakistan, and by SNGPL for the middle and northern part of the country. The combined transmission network is about 7,600 km of high pressure and about 50,000 km of distribution mains. The total customer bases for SSGC and SNGPL are 1.2 million and 1.5 million, respectively. A number of new natural gas fields have been discovered in Pakistan, and are expected to increase the reserves by 20.0 to 25.0 percent. The gas sales agreements have been signed for the supply of an additional 600 million cubic feet per day (mmcfd) by December 2002, from the new gas fields. In addition, a number of potentially rich areas have yet to be explored for further discoveries of gas fields. The additional gas supply must be effectively and economically used to facilitate the country’s economic recovery. The private sector is negotiating with the Government for capital investment in the transmission networks system of the country.

38. While the natural gas and petroleum subsector has great potential to expand and meet Pakistan’s growing demand, the recent performance of the sector has been less than optimal. 11

The pace of development and private sector investment in the subsector have been lower than anticipated due to the inappropriate policy framework, government interference, and inefficient utility operations. The situation is aggravated by Pakistan’s prevailing political and economic situation. The resulting increased dependency on imported furnace oil and petroleum products has caused the country’s current account deficit to expand to unmanageable proportions. The situation is projected to worsen as the lack of available commercial energy is likely to become a serious constraint on Pakistan’s economic recovery, and the quantity of imported energy will continue to increase unless domestic natural gas and oil resources are discovered and brought into production quickly. Because of large capital requirements in the subsector, the Government has formulated an attractive package of incentives to encourage the private sector to invest in the further development of oil and gas fields, and to undertake exploration, which involves capital risk. These measures are succeeding.

B. Issues and Constraints

39. Governance. Governance has emerged as an increasingly important issue in the power sector in Pakistan. In recent years, worsening problems in this area have had a major impact on macroeconomic performance and have hindered the effectiveness and sustainability of the power sector. Specifically, weak governance has resulted in inefficient utility operations, power theft, illegal power supply, reduced billing and tariff collections, and nonpayment of arrears. These corrupt practices opened the way for massive waste and contributed to the build up of the financial insolvency of the public utilities. While it is difficult to calculate the exact amount of electricity theft, the electricity stolen (used but not paid for) in WAPDA and KESC during 1999 amounted to about $400-600 million and $200-250 million, respectively. A theft of this magnitude could be possible only through corruption and malpractice at all levels of the organizational hierarchy, the government, politicians, labor, and the society in general.

40. Institutional Weaknesses. The Pakistan power sector has been affected by institutional and organizational weaknesses that have led to decisions on investments, electricity tariff determination, and appointment of senior management and staff becoming increasingly politicized. The organizations of WAPDA and KESC have degenerated into unwieldy, overcentralized, and multi-layered bureaucracies, dominated by political expediency, where efficiency and quality of service continue to decline. WAPDA’s scope has become overextended, as it has responsibilities for water and irrigation, developing the private power program, and planning and operating the power system. Even with 110,000 employees in WAPDA and about 12,200 in KESC, responsiveness to customers leaves much to be desired. Over time, lack of financial and commercial skills have become major obstacles to the accountability, quick decision-making, and commercial orientation needed to deal with IPPs. Institutional malaise was most obvious in the recent abrupt decline in financial performance, blackouts, and high levels of losses and stolen electricity (often the result of collusion between WAPDA and KESC staff and consumers). Consequently, WAPDA and KESC lost the confidence of their customers, financiers, and the Government.

41. Tariff Structure and Subsidy. Until 1998, the Government controlled the tariff setting. The successive governments in Pakistan provided electricity at low cost to consumers, particularly the domestic consumers and agriculture.

42. One of the major issues affecting the power sector was the tariff structure, which was not based on a regional and consumer-specific long-run marginal cost (LRMC) but was used as an instrument to achieve political and socioeconomic objectives. This resulted in a uniform tariff structure for WAPDA and KESC, although KESC depended on all thermal generation, which is 12 inherently costlier than WAPDA’s hydro-thermal generation. Thus, increases in fuel costs affect KESC much more than WAPDA. Furthermore, over the last several years, the Government did not adjust the level and structure of tariffs to the new cost structure of the public utilities. Following a decline in real electricity tariffs and a severe financial crisis in the power sector, the Government announced in March 1998 a weighted average tariff increase of 21.0 percent. Then in March 1999, the National Electric Power Regulatory Authority (NEPRA) approved a further tariff increase of 9.4 percent. The lifeline tariff of 50 kWh consumption per month is PRs1.40/kWh ($0.0270/kWh) and the average tariffs for residential, commercial, and public lighting sectors are PRs3.89 ($0.0753)/kWh, PRs7.20 ($0.1393)/kWh, and PRs5.88 ($0.1137)/kWh, respectively. The tariff for the industrial sector is PRs3.55-4.82 ($0.0686- 0.0932)/kWh. For agriculture, there are flat rate tariffs and metered rate tariffs, but the recovery is very low. The large cross-subsidy between agriculture consumers is provided by the sector itself, and not by the Government. The tariff structure after the March 1999 increase is shown in Appendix 4. NEPRA, the sector regulator, is addressing these issues to rectify the situation. Under the directive of NEPRA, the tariff applications submitted to NEPRA by KESC and WAPDA address the issue of cross-subsidy by targeting average domestic and agricultural tariffs to rise more than commercial and industrial tariffs. In addition, WAPDA continues to install meters on the agriculture tubewells and charge tariffs as per the meter reading instead of the flat rate currently in practice.

43. Similarly, the tariff structure in the natural gas and petroleum subsectors are not the true cost of exploration, production, transmission, and distribution. While the gas producers’ prices under the 1994 and 1997 petroleum policy are linked to the international price of crude and fuel oil, the retail gas prices set by the Government for SSGC and SNGPL have been without any adjustments for a few years. As a result, about 40.0 percent of the natural gas is sold by SSGC and SNGPL to consumers below the cost of supply. This shortfall is funded by the Government gas development surcharge. These two companies recover a portion of the losses through a fixed rate of return on equity formula, and the balance of the shortfalls is provided by the Government. To remove these distortions, the Government is in the process of deregulating the prices in the natural gas and petroleum subsectors. The sector regulator is also required to address the issue of sector cross subsidy.

C. Government Objectives and Strategy

44. The Government became aware of the shortcomings of the 1994 policy and with the assistance from ADB4 drafted a new policy that was approved by the cabinet on 1 April 1998. Under this policy, all future power plants will be developed by the private sector on the basis of competitive tendering. The policy will promote the use of indigenous energy sources (initially hydropower and coal) by inviting proposals for projects for development in accordance with a least-cost generation expansion plan. Unsolicited bids for projects, i.e., those not the subject of invitations, will be entertained, but under strict quality control and subject to competition. The new policy also attempts to simplify the bidding, evaluation and licensing process under the Private Power Infrastructure Board (PPIB). The Government, under the new policy, decided to restructure the power sector and approved the strategic plan that envisaged that KESC will be privatized, and WAPDA separated into independent corporate entities responsible for thermal and hydropower generation, transmission, dispatch, and distribution. These corporate entities are to be privatized.

4 SSTA No. 2809-PAK: Private Hydropower Policy Study, Final Report issued in February 1998. 13

45. The Government recognizes that domestic oil and natural gas supply must be expanded to reduce the country’s dependence on imported oil. Priority is being given to the exploration, development, and exploitation of oil and natural gas reserves, and the installation of additional oil refinery, gas treatment, transmission, and distribution facilities. Accordingly, the Government strategy calls for (i) the process of exploration and development of oil and gas fields to be accelerated, and increased foreign investment in this sector to be encouraged; (ii) the development of recently discovered, large reservoirs of gas to be expedited; (iii) regulatory authority to be established for the orderly operations and development of the natural gas and petroleum subsectors; (iv) conversion of power plants from furnace oil to gas to be encouraged; (v) upstream infrastructure including pipelines to be developed for efficient transportation of imports of hydrocarbons and the discovered resources; (vi) the petroleum sector to be deregulated and the privatization process expedited for greater efficiency, for private sector investment, and for retirement of public debt; (vii) margins of oil marketing companies to be rationalized so that they can invest in storage and other infrastructure for oil; and (viii) the price of LPG to be deregulated and the use of compressed natural gas (CNG) to be encouraged. The Government is establishing a Petroleum Regulatory Board (PRB), an independent sector regulator, which is a prerequisite for petroleum sector reforms.

D. External Assistance to the Sector

46. During FY1984 to FY1997, multilateral and bilateral assistance to the power sector in Pakistan amounted to about $7.5 billion. The major sources were ADB, Japan, and World Bank, which together provided more than half of the official external assistance. The assistance from ADB was to both KESC and WAPDA, while the World Bank mainly provided assistance to WAPDA. Supplementary Appendix F presents donor assistance to the sector. A key policy thrust pursued through coordination of aid agencies has been to evolve a strategy for the privatization of the power sector. The policy matrix prepared for the reform program in the sector has been a joint effort of the ADB, World Bank, and Government, with clear delineation of the division of labor between the two multilateral institutions.

1. Funding Agency Coordination

47. ADB has carried out policy dialogue in the sector in close coordination with other agencies, particularly World Bank and IMF, on many common policy covenants. Main areas covered under the policy dialogue include restructuring of the sector and its institutions, enhanced private sector role, integrated operations of WAPDA and KESC systems, rationalization and enhancement of tariffs, energy efficiency and demand-side management, reduction of transmission and distribution (T&D) losses, and reduction of accounts receivables. While ADB can claim significant policy and institution-building assistance to the sector, progress has significantly slowed down in recent years due to political instability, frequent changes in government, and the recent economic crisis. The political and law and order problems in Karachi have also affected the progress on KESC’s restructuring and privatization. The World Bank is currently formulating a structural adjustment loan (SAL) for Pakistan with multisectoral focus, to be approved in the near future, subject to a Government-IMF agreement on the PRGF or similar activity. The energy sector (power and natural gas) will be a major component of the SAL.

2. Cofinancing

48. ADB has vigorously followed the cofinancing opportunities in the energy sector with good results. About $204 million of private cofinancing (by Citibank, and Export-Import Bank) 14 has been mobilized for the public sector program and $45 million in private mobilized in 1996 for cofinancing ADB’s private sector Fauji Kabirwala Power Co. Ltd. Project, one of the IPPs.

E. ADB’s Operations and Strategy in the Sector

1. ADB Operations

49. Since the start of the ADB operations in Pakistan in 1968, total lending to the energy sector in Pakistan amounts to about $2.7 billion, of which $2.1 billion to the power subsector and $0.6 billion to the natural gas and petroleum subsectors. The lending to the energy sector account for about 28.0 percent of total lending to the country. Three-fourths of the assistance to the power subsector ($1,575 million for 13 loans) has been provided to WAPDA and the rest to KESC. The ADB has been the major source of external assistance to the energy sector in Pakistan, having provided about one-third of total external resources to the sector. The ADB is also by far the main source of external assistance to KESC. In power generation, the ADB has significantly contributed to major multi-donor undertakings such as the Tarbela and Ghazi Barotha Hydropower schemes. While lending to the sector has been significant, non-lending activities also has been important with a total of $7.92 million provided for 27 TAs. Main areas covered included tariff rationalization and integration, management information systems, power generation coordination, thermal power plant maintenance, institutional strengthening and restructuring, and privatization.

2. ADB Strategy

50. Due to its significance to Pakistan’s overall economic recovery, the energy sector is recognized in ADB’s country operational strategy as a primary area for policy intervention. ADB’s sector strategy recommend high selectivity in new public sector investments, with priority given to creating a favorable environment for privatization and private sector involvement. Priority areas include (i) increased energy efficiency, on both supply and demand sides; (ii) optimization of the share of hydropower in the generation mix and support to the development of public-private sector partnerships in hydropower generation; (iii) balanced energy generation, transmission, and distribution; and (iv) continued interventions for sector restructuring, rationalization of tariffs, and enhanced private sector participation. The country operational framework places additional emphasis on aspects of weak governance and portfolio performance. Both of these issues are important in the energy sector. The plan for Pakistan’s energy sector up to the year 2003 is presented in Appendix 5. It shows the intermediate measures taken, the achievements up to 2000, and the targets for 2003.

3. Lessons Learned

51. Ten power projects approved up to 1983 have been postevaluated. All of the projects were classified as generally successful. The postevaluation findings show an average implementation delay of 2.4 years (78.0 percent). Five of the projects experienced an average cost overrun of about 82.0 percent, and the other five an underrun of 28.0 percent. The postevaluations draw attention to the need for in-depth analysis of all technical issues before a project is formulated, and the need to comprehensively review cost estimates at appraisal. ADB- financed projects approved after 1983 reflect improved performance. However, KESC and WAPDA have been unable to meet the system loss targets, and the financial covenants due to inadequate tariff adjustments. The tariff adjustments based on social equity and affordability considerations have led to a lack of commercial focus and affected the capacity of these two utilities to produce sufficient funding from internally generated sources to meet all expansion, 15 rehabilitation, and reinforcement requirements. The utilities also lacked focused leadership and management practices as well transparency in operational and financial matters. Most of the ADB-financed projects use the sector-loan approach, which allows considerable flexibility in selection of subprojects, and the use of consultants for formulating the subprojects. As a result, cost overruns have been greatly reduced. However, slow project implementation remains a problem. Other causes for implementation delays are slow appointment of consultants, bureaucratic procedures, organizational and institutional weaknesses, changes in project scope, and shortages of qualified staff.

52. Three main lessons can be learned from ADB’s involvement in the power sector in Pakistan. First, continued weak governance was mainly due to the absence of a sector regulator. The funding agencies, after the initial period of financial assistance to the energy sector, should have insisted upon the creation of independent sector regulators. The prevailing financial and operational crisis in the energy sector could have been averted if the sector was regulated by independent regulators. Second, a collective effort of the funding agencies should have been exerted to enable private sector participation after the initial years of official assistance to the Government for the energy sector. This would have introduced competition and resulted in the efficiency gains. Third, the funding agencies, including ADB, should have involved civil society to make them aware of the overall operation of the energy sector and promote the consumer advocacy groups. These issues are the fundamental components of the Program.

V. THE ENERGY SECTOR RESTRUCTURING PROGRAM

A. Rationale

53. Pakistan’s energy sector is facing a financial crisis which basically stem from weak governance, political interference in decision-making, poor staff morale, and disregard of prudent business practices. The worsening problems in these areas have had a major impact on the financial performance of the utilities and have hindered the effectiveness and sustainability of the energy sector. Weak governance has resulted in inefficient utility operations, power theft, reduced billing and collection, and nonpayment of arrears. These practices have affected the poor segment of the population more than the affluent and contributed to the financial crisis in the sector. The absence of an immediate policy response for the energy sector would have serious economic repercussions. Therefore, radical reforms and tough adjustment measures, including market-driven systems, are needed to restore viability in the sector and to make it self-sustaining. ADB support of the Government’s initiatives for structural reforms in the energy sector is considered essential given the urgent need to introduce competition as the driving force for improvement and private sector participation as a vehicle for creating a competitive environment. Ensuring a stable supply of energy is essential for the country’s economic recovery, which will result in additional job-generating activities for the poor as well. The Program provides a sound basis for the Government to carry out reforms and to restructure the energy sector. The development of a competitive electricity market under the reform program will result in efficiency gains that will have a positive impact on poverty reduction.

B. Objectives and Scope

54. The ADB Program for energy sector restructuring seeks to bring together the measures to reform the energy sector in Pakistan, speed-up the actions needed for its sustainable growth, increase efficiency in the use of resources and improve customer focus in the delivery of services. The ultimate goal is sector economic efficiency and consumer satisfaction. The reform 16 strategy is to restructure the power sector by breaking up the sector’s monolithic vertically integrated power utilities; facilitating implementation of larger number of private power projects, transmission, and distribution facilities; and introducing market-based reforms into the sector. To achieve these objectives, the sector is to be “unbundled,” the state-owned assets in generation, distribution, and transmission to be sold as separate business entities to the private sector to minimize the cost of electricity by matching supply and demand under market-based conditions.

55. The Government’s and ADB’s shared plan is to move the power sector from an inefficient state-controlled monopoly to a competitive, market-driven system in order to produce the highest level of customer satisfaction. The strategy is to include integration of WAPDA and KESC into the restructured power sector. The Program envisions that the Government’s financial support to the energy sector, including guarantees, would be phased out except as a last resort, e.g., for large, risky projects, or to meet social and environmental objectives such as supplying energy to rural communities. Thus, a fully competitive power sector as envisaged under the restructuring program will consist of (i) competitive generation with independent system operator(s) and a bulk power market; (ii) unbundled, open and nondiscriminating access to transmission and distribution services; and (iii) an independent regulatory body for effective market governance, setting sector standards, ensuring competition in the sector, setting tariffs including eliminating cross subsidy, and licensing approvals. This will enable the Government to achieve the longer term perspective of economic efficiency and consumer satisfaction. To achieve these improvements, consumers must be aware of the operations of the power sector, and the consumer advocacy group needs to be strengthened to increase consumer awareness. These activities will result in better dialogue and enhance the role of the regulatory body. The Program includes the engagement of a public relations firm to implement an educational and publicity campaign to explain to the public in general and to WAPDA and KESC employees the Government’s restructuring and privatization program and the resulting benefits from such activities.

56. The long-term goal of the ADB’s intervention is to ensure a self-sustaining, efficient and competitive power sector able to provide required quantities of quality power at least cost to the consumer. In order to achieve this, the Program will focus on the seven key areas of reforms: (i) enhancing governance; (ii) enhancing the legal and regulatory framework and strengthening of the capacity of the power sector regulator; (iii) financial restructuring and privatization of KESC; (iv) restructuring of WAPDA and privatization of corporatized entities; (v) enabling a competitive electricity market; (vi) resolving the IPP issues and HUBCO and KAPCO cases; and (vii) enhancing reform in the natural gas and petroleum subsector. Appendix 1 outlines the Program and its timetable.

C. Policy Framework and Actions

1. Enhancing Governance

57. Because weak governance is one of the major causes of the financial crisis in the power sector, the Government has taken action to strengthen and expedite the accountability process. Key elements of the Government’s action plan, using the military services, include (i) ensuring effective law and order in KESC and WAPDA franchise areas; (ii) dismantling illegal connections and prosecuting offenders in civil courts; and (iii) disconnecting power supplies to all consumers with notices of legal action to those who do not pay their bills, including the elite and the politicians. These Government actions have provided encouraging financial results, especially to WAPDA, and have reduced WAPDA’s peak demand by about 1,000 MW. The actions are expected to reduce the same demand by another 2,000 MW by June 2001. In 17 addition, KESC and WAPDA have instituted measures to reduce theft and improve the overall operational and financial performance (Appendix 6).

58. The results through army intervention may not be sustainable when the army withdraws. The improvement will last only when the public utilities are privatized. Thus, appropriate reforms and necessary adjustment measures, including privatization of the utilities, are expected to help weed out corrupt practices and political interference. The expanded role of the sector regulator under the Program will also ensure good governance and efficient performance. These measures will result in efficiency gains and will minimize the need for frequent excessive tariff adjustment, thereby providing a positive impact on poverty reduction.

2. Enhancing the Legal and Regulatory Framework and Strengthening NEPRA

59. Through the reform Program, NEPRA was established as an independent sector regulator under the Act of the Parliament. A four-member board was appointed and the chairperson is expected to be appointed in January 2001. NEPRA has taken important steps to complete the regulatory framework. It has established a tariff regime, prescribed standards and procedures to determine and revise tariffs, issued application and modification procedure regulations, and issued procedures for the application of service licenses. NEPRA is responsible for issuing licenses, franchising monopoly business, setting and enforcing performance standards and codes of practices, enforcing competitive policies, and setting charges for the monopoly parts of the industry. It will also impose special levies and license fees, in line with the prevailing regulations. NEPRA, under the Act, is mandated to protect the consumers against monopolistic prices, encourage efficiency in licensee operations through financial incentives, encourage economic efficiency by promoting competition, and eliminate cross-subsidies between regions and consumer groups. The Act includes the legal framework for establishing of a competitive electricity market, where generation companies can negotiate the price of electricity with willing customers. The Act also includes the establishment of a system operator and a power exchange with the responsibility to maintain a secure and reliable bulk power supply. ADB provided TA5 to assist NEPRA in strengthening its capabilities.

3. Financial Restructuring and Privatization of KESC

60. Restructuring. In November 1998, the Government approved a financial package of about PRs33.00 billion ($638 million) to cover KESC’s cumulative cash shortfalls for FY1996 to FY1998. This amount was included in the IMF’s ESAF. KESC’s financial restructuring plan aimed to restore its positive net worth, which eroded over time with sustained losses, and improve its liquidity position. The comprehensive restructuring package allowed KESC to wipe out all the cumulative cash shortfalls up to June 1998. However, KESC failed to achieve the targeted level of account receivables and T&D losses, and theft continued to increase at an alarming rate. Coupled with the adverse impact of the fuel price surge, KESC has continued to incur cash shortfalls since June 1999, and its negative net worth is growing. KESC’s financial condition is extremely serious. KESC will continue to incur cash shortfalls during the coming years. The cumulative KESC funding shortfall, under the base scenario, for June 2000 to June 2003 is projected at PRs61.9 billion ($1.2 billion, excluding financing charges). The Government has guaranteed the provision of KESC’s cumulative cash shortfalls of PRs61.9 billion, to keep it afloat, at least until it is privatized, which is expected by December 2002, with financial close in June 2003. Details are in Appendix 7. To keep KESC solvent until it is privatized, additional financial

5 TA 3409-PAK: Capacity Building of the National Electric Power Regulatory Authority, for $1,000,000, approved on 3 June 2000. 18 restructuring, as recommended by the privatization adviser, will be necessary and will have to include conversion of KESC’s debt service liability to the Government into equity and refinancing the term finance certificates by bonds with longer maturity.

61. Privatization. The Government has been involved, since February 1996, in privatizing KESC by selling 51.0 percent of KESC’s share capital and turning management control over to a strategic private investor. To oversee the process, the Government constituted a panel comprising the representatives of the Privatization Commission, ministries of finance, water, and power; and KESC. The Government used the services of two financial advisers for KESC privatization. The work done by the first financial adviser broadly covered privatization and sales strategy; business and operational issues of KESC; and recommendations for the restructuring and related action plans. These activities were taken over by a second financial adviser who was appointed to complete the process of KESC privatization by December 1998. However, the country faced an unprecedented financial and economic crisis, and the privatization was further delayed. Consequently, the agreement with the second financial adviser was terminated in December 1999. As a result, a new privatization adviser is required to privatize KESC.

62. The decision to privatize KESC has been postponed since 1996, due to frequent change of governments and the vested interest of the people in power, and the IPP controversy. The commitment of the present Government to privatize KESC is considered by the funding agencies to be irreversible due to several factors. The most important factor, is that the Government recognizes that it cannot afford to continue to support KESC (para. 60) as such support has destroyed Pakistan’s macroeconomic framework and threatens it’s financial solvency. Thus, the Government decided that KESC must be privatized quickly. Based on this decision, the Privatization Commission provided ADB with the Government’s time frame for steps leading to the privatization of KESC. The ADB Program will support the privatization of KESC, and help ensure that the process of bidding, evaluating, and selecting a strategic investor is transparent and undertaken on a competitive basis. The Government is committed to comply with these ADB requirements.

63. In support of its privatization program in August 2000, the GOP approved the privatization law to give legal cover to the privatization process. The law mandates that 90.0 percent of the sale proceeds are to be used for debt retirement and 10.0 percent for poverty alleviation. The privatization law covers the process of transactions and protects the rights of the buyers and consumers. To secure the interest and confidence of the private investors, the law stipulates that a Government agency may not investigate any transactions one year after the completion of the transaction. Furthermore, the Government has formulated the draft labor policy guidelines in consultation with employees and employers, organizations, and the provincial governments. These guidelines are being used to develop a new labor policy, which will protect the rights of workers and employers. Furthermore, the Government has announced a detailed list of public sector enterprises, including KESC, that must be privatized. The decision to privatize the public assets is also in response to requirements of IMF’s SAL, and the PRGF, which mandates the Government to retire the country’s debt out of the sale proceeds. To create a favorable environment and to rebuild the confidence of the private sector to invest in the power sector, the Government has resolved the IPP issue by signing an orderly framework satisfactory to all concerned, and is finalizing the outstanding cases against HUBCO and KAPCO. To build further confidence among strategic investors, the Government has established NEPRA, an independent sector regulator, to ensure that the interests of the consumers and the investors are protected, and that the sector moves toward a competitive environment. 19

64. At the request of the Government, ADB provided a TA for the privatization of KESC.6 The TA will engage the services of an internationally renowned and experienced privatization adviser to complete the process of KESC privatization. The privatization adviser will be required to engage and mobilize a multidisciplinary team of experts (consortium) from its own organization or from outside sources as necessary, with skills and experience in restructuring and privatizing utilities, financial restructuring, electric utility operations and management, labor issues and human resource planning, legal review and analysis, and technical and financial due diligence. The privatization adviser will formulate a labor restructuring plan in preparation for privatizing KESC and will provide an analysis of options and costs for the labor strategy for discussion and finalization by the Government and ADB’s review. A federal steering committee at Islamabad and a KESC privatization cell at Karachi have been established to coordinate and expedite the process of KESC privatization. To accelerate the process, the Government has provided $1.0 million cash to match ADB’s budget allocation of $1.0 million for the TA costs, and agreed that its share of $1.0 million could be disbursed first for payments of the privatization adviser’s services.

65. ADB is encouraging the Government to consider proposals to sell further equity stakes from its remaining 42.0 percent share in KESC, since sales will help build up the market’s and the strategic investor’s confidence and facilitate the overall privatization process in Pakistan.

4. Restructuring of WAPDA and Privatization of Corporatized Entities

66. Financial Restructuring. To help improve WAPDA’s liquidity, the Program requires (i) the Government, provincial governments, and private consumers to reconcile all billing disputes with WAPDA, and pay in cash the amounts past due to WAPDA; (ii) WAPDA to implement measures to ensure timely payment of bills from government departments and agencies; and (iii) WAPDA to reduce its payables to normal commercial levels. WAPDA’s theft and loss reduction program is outlined in Appendix 6. To restore WAPDA’s financial viability, the Government converted into equity WAPDA’s pending debt service liability, amounting to PRs36.3 billion in FY2000.

67. Unbundling of WAPDA. Under the restructuring program, WAPDA has already been unbundled, i.e., the Power Wing and all its operational departments has been detached from WAPDA. Thus, WAPDA is left with the Water Wing for water resources management, including hydro generation. Supplementary Appendix G shows the organizational structure of the unbundled WAPDA. The WAPDA Act was amended in December 1998, which allowed the establishment of the Pakistan Electric Power Company (PEPCO) for unbundling of WAPDA into (i) 8 distribution companies (DISCOs), formed from existing area electricity boards, and 3 thermal generation companies (GENCOs), of WAPDA’s 11 thermal generation plants; and (ii) the National Transmission and Dispatch Company (NTDC), out of the National Grid Company which will operate the transmission system and control dispatch. Under the amended act, the unbundled entities, including the National Grid Company, have been corporatized; consumer contracts have been transferred from WAPDA to the corporatized distribution companies; staff of the Power Wing have been transferred to the corporatized entities, and WAPDA shares in corporatized entities have been transferred to the President of Pakistan. The restructuring of the Power Wing of WAPDA into separate corporations is essential and advantageous since it will establish distinct asset blocks to be operated autonomously, and enable a shift to business orientation with the introduction of commercial practices. The primary focus of each corporate

6 TA 3502-PAK: Support for Privatization of Karachi Electric Supply Corporation for $1,000,000, approved on 22 September 2000. 20 entity will be customer satisfaction and profit. Under the competitive set-up of the restructured power sector through the Program, there will be no room for the social subsidies that are currently a part of, and are hidden in, the unified accounts of WAPDA. The subsidies being provided by the Government through the revenues of WAPDA will be identified, quantified, and transparent, for the Government to pay for the services rendered by the independent corporatized entities.

68. Thus, the unbundled Power Wing will lead to a structure with several private GENCOs operating under free market conditions, several private regulated DISCOs providing reliable electricity to consumers at a price fixed by NEPRA, and a regulated NTDC.

69. Corporatization and Commercialization Program. As a first step, eight DISCOs, three GENCOs, and the NTDC have been registered. To complete the corporatization process, the following are being completed: (i) transfer of assets and liabilities, (ii) transfer of personnel, (iii) financial restructuring and provision of working capital, and (iv) execution of all legal and contractual agreements. These actions will allow the new companies to begin to function and carry out autonomously the business activities with independent board of directors, financial statements, legal and regulatory legitimization. Thus, the financial modeling and restructuring, asset allocation and evaluation, transfer pricing, and execution of all legal documents and contracts will be effected simultaneously. These activities are under way, and their finalization and consistency with the overall restructuring program will be closely monitored. The new companies are designing and implementing the manpower transition program, management information systems, and change management initiatives. A group of management consultants is assisting them with all activities related to the restructuring of WAPDA’s unbundled entities.

70. Privatization of WAPDA’s Corporatized Entities. PEPCO is also mandated to sell the corporatized units. Under the reform Program, at least one DISCO and one GENCO will be privatized under the ADB program of assistance. To facilitate the timely sale of the two entities, the Government has amended the WAPDA Act to allow the transfer of WAPDA shares in the corporatized entities to the President of Pakistan, and authorized the voting rights in the corporatized entities to the Chairman of PEPCO. The amended Act authorized the transfer of consumer contracts from WAPDA to the distribution companies. In addition, the World Bank also stipulates a number of DISCOs to be taken to the market for sale. After the completion of the sales, PEPCO will be dismantled and will cease to exist.

5. Enabling a Competitive Electricity Market

71. The transformation of the power sector into a privatized electricity market in Pakistan will be an evolutionary process that may take many years. The precise form and timing of the evolution cannot be predicted at this stage because it will depend on many intervening policy decisions and external factors. The power sector will go through a period of transition which will lead to a competitive market. The transition period will involve unbundling, corporatization, and commercialization of 12 entities; privatization of KESC; and the sale of at least one DISCO and one GENCO. The transition period will set the groundwork for future actions; its implementation will be the most critical element of the Program as it will set the foundation for the market-based principles. During this period, appropriate action will be taken to resolve major issues covering tariff subsidies, and a mechanism determined to establish transfer prices from generation to transmission and from transmission to distribution.

72. During the transition period, NEPRA will regulate aspects of the electric power sector that remain a natural monopoly, will foster the competitive structure, and will ensure the 21 reliability and adequate supply of electric power. NEPRA will ensure that the interests of the investor and the customer are balanced through judicious decisions based on transparent commercial principles and prudent investments so that the sector moves toward a competitive environment. NEPRA will minimize the burdens of regulation, in terms of both the scope of regulatory activity and interference with the management of the regulated entities. As the industry becomes fully competitive, the need for regulation will diminish.

73. At present, a nationally uniform tariff structure is applied by WAPDA and KESC with a large degree of cross-subsidization. The cross-subsidies will be phased out during the transition period. The Government will fund socially desired services directly under a transparent system, whereas the lifeline tariff for poor households will be cross-subsidized by the sector itself. With the phased removal of most of the tariff subsidies, rate differentials will emerge across the country reflecting the variable cost in providing the power services. One of the most critical issues during the transitional phase relates to the human resources rationalization plan. While a part of the labor force will be retained in the restructured power sector, a large complement may be retrenched. The retrenchment will be subject to existing rules and regulations and compensation under a transparent system.

74. It is envisaged that the restructured power sector may go through two distinct phases during transition to a competitive electricity market. As the restructured sector matures and producers, distributors, and regulators gain experience, the system should shift to a fully competitive model by removing the bulk supply tariff, and allowing multiple buyer and seller agreements. As the market develops further, retail companies may enter the market to trade and provide services to customers. The two phases leading to a competitive electricity market are outlined below.

75. Phase 1. In Phase 1, the system will be the “single buyer” type, i.e., all energy will be bought by NTDC from GENCOs, WAPDA (Water Wing), and IPPs and sold to the DISCOs. The consumers will have no choice of DISCOs as the DISCOs will be restricted to supply power within their respective franchise areas. During this phase, transfer pricing from the GENCOs to NTDC, from NTDC to the DISCOs and the retail price to consumers, will be set by NEPRA. It is expected that annual transfer prices and tariffs will be adjusted over time, according to a pre- determined formulae, to promote efficiency in each corporation.

76. Until generation and distribution have become fully competitive, the NTDC will stay as a public sector company. The NTDC will not own any generation or distribution assets. The NTDC, being a natural monopoly, will be closely regulated by NEPRA, and will operate as the "single buyer" of power from all GENCOs. It will ensure economic dispatch; the integrated, stable and safe operation of the electric power system’s future load and system planning and forecasting; and the wholesale electricity market. It will be responsible for forecasting generation requirements by utilizing information provided by the distribution companies, the government planners and NEPRA. The NTDC will also ensure that the requisite investments are made in the transmission network to meet the national needs. Although under PEPCO, the NTDC will have full financial, administrative, and operational autonomy to ensure that its decisions do not discriminate between players in the market and are based on purely economic and commercial principles under the regulatory oversight of NEPRA. The Phase 1 model is likely to be in place in 5-7 years.

77. Phase 2. In Phase 2, the system will be of a “multiple buyer and seller” type, i.e., the DISCOs will have a choice to buy electricity from any GENCO and use the services of the NTDC for a fee (wheeling charge) to carry the electricity to their respective franchise areas. The 22

DISCOs could also buy electricity from the wholesale market provided by the NTDC. The new IPPs will have no PPA with the GOP, instead they will enter into contracts either with the DISCOs or the NTDC or both. The larger industrial consumers of over 1 MW will be able to choose from which DISCOs to purchase electricity. They will also be able to contract directly with the GENCOs.

78. During this phase, a new market, known as the pool, will be established for trading electricity between generators and suppliers. The pool will not itself buy or sell electricity, but it will be constituted by agreements between those participating in it. Sales and purchases of electricity in this market will be made between the participating generators and suppliers according to a set of pool rules which will govern the market’s operation and the calculation of payments due to and from each of them. Because pool prices will fluctuate, generators and suppliers may enter into bilateral agreements known as Contracts for Differences (CFDs) to provide a degree of protection against such fluctuations. CFDs will be used to fix the prices that the supplier pays and the generator receives for electricity traded through the pool. The Phase 2 model should be in place for at least 5-7 years. Thereafter, the supply brokers may enter into the electricity market who will buy electricity, package it and sell it to the consumers, using the grid of the NTDC and the distribution network of the DISCOs. The DISCOs will no longer have a monopoly of the supply of electricity to their respective franchise areas. The consumers, including the individual households, will be given a choice of which supplier they will buy from. However, the DISCOs will retain the ownership of their respective distribution networks. It is envisaged that most of the DISCOs’ profits will be from rental of their distribution networks to the suppliers.

79. The role of NEPRA will be drastically reduced as the competitive structure is in place.

6. Resolving the IPP, HUBCO and KAPCO Issues

80. The Government has implemented an orderly framework for resolving the IPP issue. Of the 19 IPPs, memoranda of understanding entailing revision in tariffs have been concluded with 13 IPPs, 3 IPPs are operating under the original power purchase agreements (PPAs), 1 IPP was cancelled, and 2 others have opted out. The settlement processes for HUBCO and KAPCO are in progress, and the Government is committed for adequate implementation of an orderly process to resolve the commercial dispute with HUBCO and address the dispute with KAPCO. The resolution of the IPP issue has built some confidence in the market and generated interest from a few strategic investors for the purchase of KESC and WAPDA’s two corporate entities.

7. Enhancing Reform in Natural Gas and Petroleum

81. The Government policy is to deregulate the subsector and introduce market-based policies and pricing mechanisms. The Government plans to reduce/eliminate its ownership holdings in the petroleum subsector, establish a petroleum regulatory authority, and restructure the natural gas subsector. These reforms are expected to build investor confidence and accelerate private sector capital flow in the subsectors. The Government’s role will be limited to addressing the issues and formulating appropriate policy framework. The Government policy aims at bringing the country’s dependence on energy imports within manageable proportions by mobilizing, to the greatest possible extent, all domestic energy resources; increasing fuel substitutions in the industrial sector; increasing efficiency in energy use; and implementing energy conservation programs. 23

82. The Government has formulated a strategic plan for the restructuring and privatizing the natural gas and petroleum subsectors. Under this policy initiative, SSGC and SNGPL will be unbundled, corporatized, and eventually privatized. In addition, the Government plans to divest its ownership in companies involved in the upstream oil and gas activities, the downstream oil marketing firms such as Pakistan State Oil, and other shareholdings in the petroleum sector. In this regard, the Government extended greater autonomy to the state-owned enterprises (SOEs) in the petroleum sector to prepare the entities for their privatization. The SOEs have been encouraged to seek private sector investment along with management expertise, including nomination of private sector representations on the boards of the entities. These efforts will improve the overall performance of the SOEs and increase their market value prior to the planned privatization. The Government will announce a new policy outlining the activities, including its economic and social objectives in the natural gas and petroleum subsectors.

83. To provide a legal and regulatory framework for the reform program in the natural gas and petroleum subsectors, the Government established the Petroleum Regulatory Board for the oversight of the subsectors. Furthermore, the Government has deregulated the prices of furnace oil and introduced quarterly price adjustments that are linked to the international price fluctuations. In addition, the Government will deregulate the impact of diesel phase-out during the program period. To enhance the reform Program in the subsectors, the Government has rationalized the freight pool arrangements for furnace oil and will establish, during the program period, a phase-out program for the diesel freight pool.

84. The reform Program in the energy sector will be supported jointly by ADB, World Bank, and IMF, but with well-defined and specific program elements for each institution to ensure that sectorwide issues are addressed and the leverage of the institutions is mutually reinforced. Because of the long association with the two utilities, ADB’s assistance under the ESRP covers both KESC and WAPDA, whereas the World Bank will assist only WAPDA. The policy matrix of the reform Program is a joint effort with clear delineation of the division of labor. ADB, World Bank, and IMF will monitor implementation of the reform program.

D. Social and Environmental Issues

1. Social Issues

85. The ESRP will result in a reduction of the burden on the fiscal deficit and in considerable overall efficiency gains for the economy. As a result it will have positive impacts on economic growth and poverty reduction. This will benefit the population in Pakistan as a whole. Anticipated short-term transitional adverse impacts include labor retrenchment and the effects of tariff increases on nonpoor residential and commercial consumers. The direct and indirect impacts on poor households are expected to be positive. In the long run, the competitive electricity market will result in efficiency gains, lower cost of bulk power, and greater reliability of supply, which will be captured by consumers at large. In the short term, tariff increases, reflecting cost recovery, may be considered to restore financial health. However, in the longer term, as a result of efficiency gains from competition, increases will be smaller than would be necessary without the restructuring Program. The expected impacts of the Program are summarized in Appendix 8 table A8.2.

86. Impact on Labor. The program will support the Government’s labor policy “to prevent distress from short-term interruptions in income streams.” The privatization adviser to be engaged under the ADB TA grant, will determine the extent of labor restructuring for KESC based on a financial evaluation. The impact on retrenched labor will be addressed and mitigated 24 by a number of initiatives under the labor impact assessment (LIA). Various options will be considered in consultation with all stakeholders. These may include (i) phasing out excess labor through natural attrition, (ii) retraining for redeployment within KESC transmission and distribution departments, (iii) voluntary lay-offs with compensation, (iii) retraining for small-scale business and other sectors of the labor market, and (iv) early retirement with full benefits. As labor costs represent a small component of the utility’s total costs, and rather than risk a possible conflict with labor representatives, phasing out by natural attrition and retraining are likely options. For each new corporate entity of WAPDA, PEPCO is preparing a human resources transition program. The program is designed to absorb as many staff as possible with training and through redeployment in the expanded transmission and distribution network system. Labor retrenchment will be identified together with appropriate compensation packages for implementation when each corporation is privatized. The Government has agreed that the costs of the human resources transition programs will be estimated and sufficient funds allocated for their implementation.

2. Environmental Issues

87. The ESRP will have no direct environmental impacts, but in the longer term indirect impacts should be beneficial due to lower losses and demand-side measures adopted. The effect of changes in the tariff structure, which will reduce subsidies to agricultural and domestic customers, will send the correct signals about the real cost of energy to consumers and lead to a reduction in wastage of energy. This will restrain load growth with consequent environmental benefits.

E. Cost of Adjustment of the Restructuring Program

88. While it is not possible to precisely determine the cost of the comprehensive ESRP, it can be broadly estimated at $1.705 billion (Table).

Table. Estimated Cost of Adjustment of the ESRP ( $ million ) Items Cost 1. Operational Cost of Restructuring Program 7.0 2. Cost of Formulating Restructuring Plan of WAPDA 4.0 3. Cost of Formulating Restructuring Plan of KESC 2.5 4. Cost of Formulating Restructuring Plan of Natural Gas and 5.0 Petroleum Subsectors 5. Establishment and Operating Cost of NEPRA 6.0 6. Establishment and Operating Cost of Privatization Commission 4.0 7. Establishment and Operating Cost of Consumer Advocacy 1.0 Groups 8. Restructuring Cost of the Energy Sector (Power, Natural Gas, 1,555.0 and Petroleum Subsectors) 9. Cost of Privatization of Energy Sector Utilities 10.0 10. Labor Restructuring Cost 98.0 11. Cost of Skill Development Program for Retrenched Labor 12.5 12. Financing of Pension Liabilities TBD KESC = Karachi Electric Supply Corporation, NEPRA = National Electric Power Regulatory Authority, WAPDA = Water and Power Development Authority. Source: Government of Pakistan. 25

1. Restructuring Cost

89. The restructuring cost of the ESRP (item 8 in the table), prior to privatization, is estimated by the Government at $1.555 billion, of which, about $762 million has been incurred by the Government, and $493 million will be incurred by June 2003, when KESC and two units of WAPDA are privatized, which is expected by December 2002. An important part of the program’s restructuring cost includes the cost to help address the circular debt problem in the power sector, which is threatening to bankrupt the utilities and their fuel suppliers and contractors, and endangering Pakistan’s financial solvency. Appendix 7 shows the restructuring cost and the financing plan.

90. The remaining $300 million of the restructuring cost relates to the adjustment cost of the natural gas and petroleum subsectors, of which the Government has already financed about $100 million. In light of the difficult external environment and social and economic problems the country is facing, the Government, under the ADB reform Program, has already instituted policy reforms in the natural gas and petroleum subsectors, and is committed to implement further measures during the program period. The Government’s reforms in the natural gas and the petroleum subsectors are already creating a favorable climate for the private sector investments, which are expected to increase the availability of natural gas for use in the power plants currently using imported furnace oil. As a result of the reforms, the new private sector investments are expected to make an additional 600 million cubic feet per day of natural gas available in Pakistan during the next 30 months, for use in the power plants. The use of the natural gas as a fuel for thermal power generation by the IPPs and other private sector investors will save Pakistan about $3.0 billion in foreign exchange over the next 10 years, or about $300 million annually ($120 million from KESC’s operations alone), thereby reducing substantially the current account deficit.

2. Operating Costs and Other Related Costs of Reform

91. Associated costs of the ESRP, and of setting up NEPRA, consumer advocacy groups, and the privatization commission that are required under the ESRP; the cost of the restructuring plans for WAPDA, KESC, and the natural gas and petroleum subsectors; and the expected costs of privatization of energy sector utilities are estimated at about $39.5 million. The Government has already financed about $23.7 million (about 60.0 percent) of these costs.

3. Labor Restructuring

92. The power sector currently employs about 122,300 people. While the level of overstaffing is currently being reviewed (by the privatization advisers for KESC and PEPCO for WAPDA), the overstaffing is assumed to be about 50.0 percent. Initially, about 12,000 workers may be retrenched from KESC and WAPDA during the program period. Using the historic average cost of retrenchment compensation paid in Pakistan of $4,650 per worker, plus a standard gratuity of $2,350 representing 0.5 months per year of service, the estimated cost of labor retrenchment, including a 10 .0 contingency, is about $98 million. Such costs will have to be borne by the Government, either as outright payments to retrenched employees or reflected as part of the effective sale price to private buyers.

93. The Government has agreed to make additional funds available for extra cash payments above the statutory minimums for various groups of laid-off workers, to prevent them and their dependents from becoming impoverished. The Government is undertaking an actuarial study to 26 determine its pension liabilities to the employees of WAPDA, who will be retained in the privatized entities, to ensure that the funds are available to meet all its future obligations.

4. Skills Development Program

94. The Government will engage consultants to advise the retrenched workers and their families on how to manage the cash compensation received under the retrenchment plan, including the setting up of small businesses. This may also require provision of financial services and other professional advice on entrepreneur development and training. The Government will also team experienced in developing and implementing redeployment packages, including counseling services, consultation with stakeholders, retraining programs, outplacement, and formulation of special measures to vulnerable groups. The retrenchment plan will include assistance for implementing the program through the provision of trainers and advisers and to monitor the effectiveness of the plan. The cost of the skills development program is estimated at $12.5 million.

VI. THE PROPOSED LOANS

A. Amount of Loans and Source of Funds

95. Loans totaling $350 million, comprising $300 million from ADB’s ordinary capital resources (OCR) and $50 million from ADB’s Special Funds resources will be used to support the Government’s reform program for the ESRP. The Government will use the counterpart funds from the Special Funds resources loan to meet the labor retrenchment costs for KESC and WAPDA, and the skills development program under the ESRP (paras. 92-94) The loan size for the ESRP has been determined on the basis of immediate financing requirements, the costs of implementing the ESRP’s structural reforms, including the social costs, strategic significance of the power sector, and current financial position of the Government. The cost of the ESRP is estimated at $1.705 billion.

96. Parallel financing by the World Bank of $300 million is expected, for banking, energy, and public sector reform programs, under their SAL, which is in line with immediate sector adjustment requirements and the external financing gap of Pakistan. Assistance to the energy sector under SAL covers7 WAPDA’s unbundling into twelve units, corporatization of unbundled units, and privatization of a few of these units. ADB’s ESRP and the World Bank’s SAL are integral elements of the IMF’s current standby adjustment loan and the subsequent Poverty Reduction Growth Facility (PRGF) in Pakistan.

B. Interest, Maturity, and Utilization Period

97. The Borrower will be the Islamic Republic of Pakistan. The OCR loan will carry an interest rate to be determined in accordance with the ADB’s pool-based variable lending rate system for US dollar loans with a maturity of 15 years, including a 3 year grace period, a front- end fee of 1.0 percent, and a commitment charge of 0.75 percent per annum. The Special Funds resources loan will be provided in various currencies for a term of 24 years, including a grace period of 8 years, and with an interest rate of 1.0 percent per annum during the grace period, and 1.5 percent per annum thereafter. The loans will be utilized over a three-year period from the date of loan effectiveness.

7 In addition to SAL, the World Bank is in the process of formulating a Power Sector Adjustment Loan (PSAL). 27

98. The loans will be linked to timely implementation of the actions identified in the policy matrix and will be released in three tranches. The Government has already incurred about $786 million in adjustment costs relating to the reforms in place. The first tranche of $150 million will be made available in December 2000, following compliance with the conditions identified in the policy matrix and upon loan effectiveness. The first tranche represents only about 25.0 percent of the cost already incurred by the Government. The balance of the adjustment cost, amounting to about $919 million, will be spent by the Government during the remaining period of the Program. An incentive tranche of $50 million, from OCR, will be made available after three months and upon satisfactory compliance with the stipulated conditions. The second tranche of $75 million is expected to be released in December 2001, but this will be depend on the privatization of WAPDA’s two units. The third tranche, also $75 million, will be disbursed in December 2002, when the condition relating to the privatization of KESC is met. Specific conditionalities are set for the release of the second and the third tranches; however, if all conditions for the second tranche are met, except the privatization of the two WAPDA entities (one DISCO and one GENCO), and the third tranche condition for the privatization of KESC has been met, then the two privatization conditions will be transposed, and all conditions for the release of the second tranche will be considered to be met.

C. Implementation Arrangements

99. The Ministry of Finance (MOF) will be the Executing Agency. It will coordinate and monitor the overall implementation of the ESRP loan, and administer the use of the loan proceeds. MOF will be supported by (i) the Ministry of Water and Power (MWP) in the implementation of the sector reforms, including operational improvements of the power utilities and the corporatization of WAPDA’s power generation, transmission and distribution activities to be managed by PEPCO, and restructuring of KESC and WAPDA; (ii) NEPRA on regulatory requirements and tariff issues; and (iii) Privatization Commission on privatization of KESC and corporatized WAPDA entities.

100. A federal steering committee has been established to oversee the implementation of the ESRP loan. The committee, chaired by the secretary general (finance) and the chairperson of WAPDA and KESC; federal secretaries of MWP, Ministry of Petroleum and Natural Resources, Privatization Commission, and finance; managing directors of KESC; Privatization Adviser; and the ADB’s Resident Representative, Pakistan Resident Mission, will meet at least quarterly. The committee will ensure that the reforms are undertaken in line with the agreed timetable. Similarly, a KESC privatization cell at Karachi has been established to ensure the completion of KESC privatization at the agreed upon time.

D. Procurement and Disbursements

101. The proceeds of the loan will be used to finance the foreign exchange costs of items produced in and from ADB member countries other than items specified in the prohibited items list (Appendix 9), and imports financed by other bilateral and multilateral sources. The Government will certify that, during each year in which the proceeds of the program loan are expected to be disbursed, the value of imports minus imports from ADB nonmember countries, ineligible items, and disbursements made under other official development assistance, is greater than the amount expected to be disbursed during the year.

102. ADB will have the right to audit the use of the loan proceeds and to verify the accuracy of the Government’s certification. Disbursements under the ESRP loans will incorporate 28 simplified disbursement procedures and audit requirements.8 Withdrawals will be allowed against eligible imports for which expenditures were incurred within 180 days prior to the loan effective date. Retroactive financing is justified to ensure timely release of counterpart funds to the Government, which has already incurred a significant part of structural adjustment cost.

103. All procurement under the ESRP loans will be undertaken through normal commercial practices for the private sector or the Government’s prescribed procurement procedures acceptable to ADB, with due consideration given to economy and efficiency.

E. Counterpart Funding

104. The counterpart funds generated out of the loan proceeds will be used to finance the cost of structural adjustment and programs and activities consistent with the ESRP. ADB will monitor the use of counterpart funds during program implementation.

F. Monitoring and Tranching

105. All 20 items listed in the policy matrix, as conditions for loan negotiations have been completed. Similarly, 5 items listed for the release of the first tranche have also been completed. While the policy matrix also outlines a detailed list of operational monitorable milestones to be completed prior to the release of the second and third tranches, only four conditions stipulated will be for the second tranche release and four for the third. ADB will continue to monitor the completion status through the progress reports of the federal steering committee, and the KESC privatization cell. If all conditions for the second tranche are met, except the privatization of the two WAPDA entities (one DISCO and one GENCO), and the third tranche condition in respect of the privatization of KESC has been met, then the two privatization conditions will be transposed, and all conditions for the release of the second tranche will be considered to be met.

106. The Government and ADB will closely monitor the implementation and impact of the ESRP loan. The Government will provide at least three reports (May 2002, November 2003, and May 2004) to detail compliance with ESRP loan conditions and facilitate a final review of compliance with the third tranche conditions of the ESRP loan. ADB will send review missions to examine compliance with the conditions of the third tranche and advise on corrective action required to keep the ESRP implementation on course. The review missions will also review the proposed TA loan.

VII. THE PROPOSED TECHNICAL ASSISTANCE LOAN

107. To support the energy sector reforms, the Government requested a TA loan for capacity enhancement in the energy sector to support the implementation of ESRP. The TA loan funds will also be used to establish a plan to mitigate the social impact of the ESRP. ADB will assist KESC with a full Poverty Impact Assessment (PIA) during the program implementation to monitor the effects of restructuring of KESC on poor consumers. The PIA will provide KESC with tools for reducing theft and corruption, and enhancing consumer services. The broad terms of reference are outlined in Appendix 10.

108. During the Program period, ADB will assist with a full labor impact assessment (LIA) to determine, in advance of any layoffs, that adequate provisions are in place to safeguard the

8 R5-98: Simplification of Disbursement Procedures and Related Requirements of Program Loans, 23 March 1998. 29 livelihoods of redundant workers and their families. The terms of reference for the consultants, which were formulated in consultation with all stakeholders, are presented in Appendix 10. If involuntary layoffs are required, the Government may use a portion of the TA loan funds of $5.0 million to assist in the preparation of a plan to reduce vulnerability of redundant workers in consultation with all stakeholders. Such a plan will include cash payments above the statutory minimum for laid-off workers, provisions for retraining, and for training on the establishment and management of small businesses. A team will be engaged with experience in developing and implementing redeployment packages in a participatory framework. The mitigation measures will include counseling services, pension/gratuity benefits, and retraining programs, specially designed to meet requirements of the labor market. If required, TA loan funds will be made available to assist in the implementation and monitoring of the effectiveness of the retrenchment plan. ADB has agreed that the Government may use the proceeds of the ESRP loan to meet retrenchment costs for KESC and the privatized entities of WAPDA.

VIII. PROGRAM BENEFITS AND RISKS

A. Impact on Poverty

1. Direct Impacts on the Poor

109. About 75.0 percent of the Karachi population (about 120,000 connections) has electricity through legal connection. The estimated number of illegal connections is 400,000, consisting mainly of poor residential consumers. Appendix 8 table A8.1 presents a dismal picture of underbilling of wealthy consumers as being the main cause of KESC’s poor financial state. The average units billed for KESC consumers is well below the national average, although non-poor residential and commercial consumer amount to nearly 80.0 percent of the KESC consumer base.

110. Given the lack of empirical data for electricity expenditure, the Mission conducted a household survey in low-income areas of Karachi to assess the impacts on the poor. The findings clearly show that corrupt practices and unreliable electricity supply has disproportionally affected poor consumers. Although non-poor residential and commercial consumers are affected by power cuts resulting from deteriorating maintenance, these are more frequent and persist for longer time periods in low-income areas of Karachi. In addition, non-poor consumers often have generators to overcome the inconvenience of power cuts. Due to the high initial capital costs, generators are not available for poor consumers. About 36.0 percent of the households interviewed lose a significant amount of income as a result of power cuts, and suffer adverse impacts on general household welfare, including lack of sleep, mosquito bites, security problems, and loss of studying time.

111. Poor consumers are especially susceptible to corrupt practices in collection, billing, and connection fees. Poor residential consumers spend about 10.0 percent of income on electricity, with large variations between consumers. This is well above international comparisons. For poor households, with a large share of expenditure on food, the corrupt practices have sometimes forced them to sell their assets and decrease expenditure on food. The vulnerability of poor consumers is exacerbated because they (i) face difficulties monitoring their own electricity consumption due to the irregularity of billing, lack of meter readings by KESC officials, and general neglect in consumer services; and (ii) may be illiterate and unable to read their own meter. In addition, connection fees in low-income areas often had a 17.0 percent “unofficial” extra payment. 30

112. Corrupt practices have taken KESC resources away from the provision of legal connections. Although connection fees are a difficult hurdle for poor households to overcome, legal connections are a high priority for poor households in squatter areas because they reduce vulnerability to extortion associated with the illegal connections, and a legal connection is perceived to strengthen property rights. Improvements in the billing system, meter readings, and connection services are important tools for reducing vulnerability of poor consumers. However, to address the inefficiencies in the billing and distribution departments, initial capital costs are required. KESC is trapped in a vicious circle of low revenue collection and not being able to invest in measures that would improve revenue collection. KESC as a public utility has not, despite significant resources and efforts, been able to provide poor consumers with a fair share of benefits of the electricity sector.

113. The key to addressing the vulnerability of poor consumers is to provide restore long-run financial viability of the electricity sector through restructuring and privatization, laying the foundation for a competitive and (thus) cost effective electricity market. Although KESC’s acute financial situation will not primarily be solved by raising tariffs, but rather by reducing theft, tariff increases reflecting cost recovery may be expected in the short run. With the elimination of corrupt practices, strengthening of consumer groups, and lifeline tariffs, the expenditure on electricity will have significant benefits for poor consumers.

2. Indirect and Macroeconomic Impacts on the Poor

114. The macroeconomic effects of the ESRP have wider implications for poverty than the direct effects on the consumers. Although the key to reducing income poverty in Pakistan is economic opportunities for the poor, it is not sufficient to reduce vulnerability and poverty in the long run. Reliable electricity supply is crucial for industrial and commercial development to secure income-generating activities. A stable macroeconomic environment and good governance are key variables for reducing risks and encouraging productive investments. Public investment in KESC nourish corruption and is a significant source of inefficient allocation of resources in the economy. It diverts public funds away from sectors more productive for economic growth and poverty reduction. For instance, the cash required to keep KESC afloat for FY2000 is nearly proportional to Government expenditure on social services and is more than 1.7 times the expenditure on education or 5.0 times the expenditure on health. Although these funds may not be fully fungible, the public allocation of funds to KESC is a costly and inefficient way to provide electricity and has implications for the budget deficit limiting the options available for the Government. The KESC cash short-fall for FY2000 amounts to 5.2 percent of the fiscal deficit and is projected to increase to 7.2 percent for FY2001. Given the overall fiscal deficit for Pakistan (6.5 percent of GDP) the Government has limited resources to keep KESC afloat. The fiscal deficit can primarily be financed through increasing money supply or by domestic and international borrowing. Printing money causes inflation that acts as a tax, and the burden of inflation falls disproportionally on the poor. Borrowing crowds out private (and other public) investment, crucial for economic growth and employment generation. Privatization of KESC and restoring financial health in the energy sector will reduce the burden on the Government deficit and induce a more efficient allocation of resources for the economy as a whole. Privatization of KESC is also strongly a governance issue that will act to reduce political and socioeconomic risks.

B. Program Benefits

115. The ESRP’s benefits are two-tiered. First, the ESRP is designed to reduce the role of the Government in the management, development, and operation of the energy sector. The 31 privatization of KESC, unbundling of WAPDA, and the creation of smaller corporate entities with a view to privatizing them, will create an enabling environment for a competitive bulk electricity market. The electricity price will be based on commercial principles and consumers will benefit through improved service and reduced prices. Regulatory focus will shift from determining tariff levels to ensuring that the competitive environment is maintained, and interventions will gradually be limited to social and environmental areas. The Government will continue providing policy directions for the sector in areas such as the use of domestic fuel, rural electrification, and subsidies for poor consumers. Second, the macroeconomic position of Pakistan will improve as a result of the restored financial viability of the power sector.

116. Socioeconomic growth is also dependent on a swift improvement of the macroeconomic framework. Economic growth is crucial to ensure job opportunities for a rapidly growing population and to generate the financial resources for sustained investment in human and physical capital in the private and public sectors. Once the financial health of the utilities has been restored, less Government subsidies will flow into the sector and a higher portion of capital expenditures for system expansion can be generated by the utilities, also reducing the requirement for Government support. This in turn will allow the Government to increase the allocation of its scarce resources to priority programs for poverty reduction and human development.

C. Program Risks

117. A continuous drainage from the fiscal budget to KESC will be a significant burden for the economy. It will deepen the budget deficit and divert public funds from more productive sectors in the economy with subsequent adverse impacts on poverty. Continuous public investment in KESC nourishes corruption, adversely affecting the most vulnerable groups of consumers. As a result only two options are available for the Government: (i) provide no or limited electricity supply in Karachi, or (ii) restructure and privatize KESC. Given the industrial base in Karachi and the importance of electricity for industrial growth, the former option has severe implications for investments, economic activity, and employment generation with subsequent effects for economic growth and social unrest. The effects of social unrest are publicly severe. It will destabilize an already fragile government, which in turn will delay the return to democracy. A lack of light on the streets of Karachi would have severe effects on security and safety, especially for women, and would disproportionally affect the low-income areas of Karachi, where substitution possibilities are limited. With dwindling investments in all sectors of the economy, the prospects for economic recovery and poverty reduction would be dismal.

118. While the risks involved in supporting a strong reform program in the power sector are significant, they are less than the risks of not supporting such a program. And, several factors mitigate the risks. Perhaps most important, the reform program is both comprehensive and Government formulated, and the plans for its implementation have been worked out by the Government with due attention to political realities and implementation capacity. A second mitigating factor is the sequencing of actions that are already in place, i.e., privatization of KESC; unbundling of WAPDA; and corporatization, commercialization, and completion of the process of the privatization of at least 4 out of 12 corporatized entities. A third mitigating factor is ADB’s intense monitoring of the implementation of the reform program along with World Bank and IMF. Finally, adequate provisions have been made to mitigate risks relating to social aspects.

119. The risks of not supporting the reform Program are greater than the risk of failure. The benefits of the reforms to be implemented and the financial crisis that might eventuate in the 32 absence of support for the bold actions already commenced by the Government strongly justify ADB’s involvement in and support for restructuring of the power sector.

IX. ASSURANCES

120. In addition to the standard assurances, the Government has given the following assurances which are incorporated in the legal documents:

(i) The policies adopted and actions taken prior to the date of the Loan Agreement, as described in the development policy letter and the policy matrix, will continue in effect for the duration of the Program Period.

(ii) Measures are being introduced to decrease the levels of theft and T&D losses at KESC and WAPDA. These will be monitored frequently to ensure that losses are reduced and the financial status of the two utilities improved.

(iii) KESC and WAPDA’s corporatized units will be privatized in a fair, transparent, and competitive manner and in the time frame agreed upon.

(iv) Labor retrenchment, as required, will be carried out in accordance with the laws of Pakistan and the Government will make the necessary funds available, as required, for a voluntary retirement scheme in a timely manner.

(v) Public awareness campaigns will be developed under the TA loan and implemented to gain broad-based public support for the reform program.

(vi) The Government will support consumer advocacy groups through NEPRA and the TA loan, to make civil society aware of the operations of the energy sector.

(vii) The Government will maintain its policy to ensure a nonuniform tariff structure in the country.

X. RECOMMENDATION

121. I am satisfied that the proposed loans would comply with the Articles of Agreement of the ADB and recommend that the Board approve:

(i) a loan of $300,000,000 from ADB’s ordinary capital resources to the Islamic Republic of Pakistan for the Energy Sector Restructuring Program, with a term of 15 years, including a grace period of 3 years, and with interest to be determined in accordance with ADB’s pool-based variable lending rate system for US dollar loans and such other terms and conditions as are substantially in accordance with those set forth in the draft Loan Agreement presented to the Board;

(ii) a loan in various currencies equivalent to Special Drawing Rights 39,083,000 to the Islamic Republic of Pakistan for the Energy Sector Restructuring Program with a term of 24 years, including a grace period of 8 years, and with an interest charge at the rate of 1.0 percent per annum during the grace period, and 1.5 percent per annum thereafter, and such other terms and conditions as are substantially in accordance with those set forth in the draft Loan Agreement presented to the Board; and 33

(iii) a loan in various currencies equivalent to Special Drawing Rights 3,908,000 to the Islamic Republic of Pakistan for Capacity Enhancement in the Energy Sector from the ADB’s Special Funds resources with a term of 32 years, including a grace period of 8 years, and with an interest charge at the rate of 1.0 percent per annum during the grace period, and 1.5 percent per annum thereafter, and such other terms and conditions as are substantially in accordance with those set forth in the draft Technical Assistance Loan Agreement presented to the Board.

TADAO CHINO President 20 November 2000 34

APPENDIXES

CORE

Number Title Page Cited On (page, para.)

1 Development Policy Letter and Policy Matrix 35 1, 3 16, 56

2 Program Framework 52 1, 3

3 The Circular Debt Problem 53 10, 36

4 Tariff Structure After March 1999 56 12, 42

5 Long-Term Strategic Planning 57 14, 50

6 Theft and Loss Reduction Program of KESC and WAPDA 58 17, 57 19, 66

7 Cash Shortfall Financing Plan and Restructuring Cost 61 17, 60 25, 89

8 Poverty Impact Assessment 65 23, 85 29, 109

9 Items Not to be Procured Under the Loans 69 27, 101

10 The Proposed Technical Assistance for Capacity Enhancement in the Energy Sector 70 28, 107 29, 108

SUPPLEMENTARY (Available on request)

A. Key Sector Indicators B. The IPP Controversy C. The Status of Ghazi Barotha and Chasma Hydropower Projects D. Financial Performance of KESC and WAPDA E. Status of Covenant Compliance F. Donor Assistance to the Sector G. WAPDA’s Organization Structures

DRAFT POLICY MATRIX PAKISTAN: ENERGY SECTOR RESTRUCTURING PROGRAM LOAN

OBJECTIVES ACTIONS REQUIRED COMPLETION ESRPL Actions Status/Remarks Loan Negotia First Incentive Second Third tions Tranche Tranche Tranche Tranche

A. STRATEGIC PLAN AND LEGAL FRAMEWORK FOR THE POWER SECTOR REFORM PROGRAM
1. Maintain consistency with A.1 GOP to reach agreement with IMF on Appropriate arrangements with IMF ✓ macroeconomic macroeconomic framework. in place (Letter of Intent signed framework 6 November 2000.)
2. Implement Strategic Plan A.2.1 Constitute Policy Committee on the Completed (April 1998). ✓ for the Restructuring and Restructuring of the Power Sector. Privatization of the Power Sector (the Reform Program)
A.2.2 GOP to issue detailed statement on the Completed (November 1998). ✓ power sector reform.
A.2.3 Privatization Commission (PC) to finalize Completed (Gazetted 28 ✓ 41 and submit draft Privatization Law to the September 2000 ). Cabinet for approval.
A.2.4 GOP to submit draft labor Policy paper Completed (Submitted to ADB on ✓ finalized by Ministry of Labor to ADB. 30 September 2000).
A.2.5 Ministry of Water & Power to issue policy Completed (12 December 1998). ✓ statement on GOP’s economic and social objectives in the restructured power sector.
A.2.6 GOP to provide mitigation measures to GOP to maintain its lifeline tariff ------Ongoing ------ensure that no undue adverse impacts are policy and NEPRA to monitor imposed on poor and low-income compliance. Appendix 1,page7 consumers during and after the privatization of KESC. OBJECTIVES ACTIONS REQUIRED COMPLETION ESRPL Actions Status/Remarks Loan Negotia First Incentive Second Third tions Tranche Tranche Tranche Tranche
3. Provide legal framework to A.3.1 GOP to amend WAPDA Act to allow (a) Completed (May 1999). WAPDA Act ✓ implement the Power unbundling of WAPDA, (b) corporatization amended through the promulgation Sector Reform Program of the National Grid Company, (c) transfer of Presidential Ordinance. of consumer contracts from WAPDA to the DISCOs, and (d) transfer of WAPDA staff to the corporatized entities.
A.3.2 GOP to authorize transfer WAPDA WAPDA action complete. X shares in corporatized entities to the ECC decision pending. Target President of Pakistan. February 2001.
A.3.3 GOP to authorize transfer of voting Completed 15 December 1999. ✓ rights in corporatized entities to Chairman Presidential Authorization granted. PEPCO from the President of Pakistan.
A.3.4 GOP/provincial governments to provide Completed May 1999, May and ✓ exemptions on income tax, wealth and June 2000. ECC approval given. capital value tax and stamp duties related to transfer of WAPDA assets to

corporatized entities. 42
4. Enhance regulatory A.4.1 GOP to appoint the Chairman and three Three members appointed. X framework including remaining members of NEPRA in order to Appointment of one member and operationalizing NEPRA constitute NEPRA’s Board of directors. chairman awaited. and ensuring its Target March 2001. independence to set tariffs
A.4.2 GOP to approve NEPRA’s Rules and Tariff Rule promulgated (31 Dec O Standards for independent tariff setting. 1998); Distribution Licensing Rules NEPRA to prepare licensing rules for promulgated (Feb 1999); DISCOs, GENCOs and NTDC. Generation Licensing Rules promulgated. Transmission Licensing Rules awaited.
A.4.3 NEPRA to issue to KESC: Target 31 May 2001. O Appendix 1,page8 - distribution licenses; - generation licenses; - special purpose transmission Licenses

X = A tranche release condition, O = An operational monitorable milestone towards satisfactorily achieving the tranche release condition. OBJECTIVES ACTIONS REQUIRED COMPLETION ESRPL Actions Status/Remarks Loan Negotia First Incentive Second Third tions Tranche Tranche Tranche Tranche
A.4.4 NEPRA to issue distribution licenses to All DISCOs have filed applications O corporatized DISCOs. for licenses with NEPRA. Public hearings were held for all DISCOs and KESC. Awaiting issuance of final licenses by NEPRA.
A.4.5 NEPRA to issue generation licenses to GENCOs submission of application O GENCOs. in progress. NEPRA to approve and issue licenses.
A.4.6 NEPRA to issue utility performance and Target 31 December 2001. O investment standards, and guidelines for the preparation of grid codes.
A.4.7 NEPRA to issue Transmission Licenses NTDC has sought guidance from O to NTDC. NEPRA regarding actions necessary for securing special purpose Transmission Licenses.

A.4.8 NEPRA to introduce an automatic - KESC and WAPDA have filed X 43 adjustment in tariff structure for pass- applications for automatic through items, e.g. fuel and taxes, etc. adjustments. ADB’s TA will provide Adjustment must be reported to NEPRA technical experts to assist NEPRA. for approval.

B. PRIVATIZATION AND FINANCIAL RESTRUCTURING OF KESC
1. Privatization of KESC B.1.1 GOP to approve the sale of at least 51% Completed -Document provided to ✓ of KESC shares to the strategic private ADB. investor for the privatization of KESC.
B.1.2 PC and ADB to engage the Privatization Target date end 15 January 2001. X

Advisor (PA) to advise on the privatization Actions to be taken by PC and ADB. Appendix 1,page9 of KESC including recommendations on financial, social, environmental, and labor issues.

B.1.3 GOP to ensure that all necessary policy decisions and actions to facilitate the divestment process for the privatization of KESC are undertaken, including:

X = A tranche release condition, O = An operational monitorable milestone towards satisfactorily achieving the tranche release condition. OBJECTIVES ACTIONS REQUIRED COMPLETION ESRPL Actions Status/Remarks Loan Negotia First Incentive Second Third tions Tranche Tranche Tranche Tranche
B.1.3.1 GOP to secure in principle letters of Target 30 June 2001. O no-objection from ADB and other major lenders for the sale of a majority shareholding in KESC to a private investor, subject to the proper treatment of their respective interests in direct and indirect outstanding loans to KESC; and
B.1.3.2 KESC to continue to enhance its KESC submitted to ADB the action ✓ business practices and to optimize its plan to optimize KESC’s operations, operations as a utility. indicating the proposed timeframes, priorities and manpower resources, and including social sector issues, billing arrangements, and customer service operations for review and comments by the ADB.

B.1.4 GOP to determine whether to offer to • GOP advised ADB that offer will be ✓ ADB a seven and six/tenths percent (7.6%) made.

equity stake in the privatized KESC. 44
B.1.5 KESC to submit an application to Target 31 March 2001. X NEPRA for: - a distribution license; - a generation license - a special purpose transmission license.
B.1.6 PC to ensure that a labor restructuring To be incorporated in PIM. O strategy, social considerations, and environmental safeguards are developed by the PA and included in the Preliminary Information Memorandum (PIM) to be

provided to perspective buyers of KESC. Appendix 1,page10
B.1.7 PC to ensure that the requirement for the To be incorporated in PIM. O unbundling of KESC after privatization will be included in the PIM. (The process and time frame for unbundling of KESC will be agreed by GOP/NEPRA with the successful bidder).

X = A tranche release condition, O = An operational monitorable milestone towards satisfactorily achieving the tranche release condition. OBJECTIVES ACTIONS REQUIRED COMPLETION ESRPL Actions Status/Remarks Loan Negotia First Incentive Second Third tions Tranche Tranche Tranche Tranche
B.1.8 GOP to issue the Letter of Target December 2002. X1 Acceptance to the successful bidder for the GOP sale of not less than 51% of the total outstanding shareholding in KESC.

2. Financial Restructuring of KESC
a. Tariff Setting Mechanism B.2a.1 KESC to submit an application to Application submitted on 24 August X NEPRA for a tariff adjustment. 2000 for tariff adjustments by NEPRA. GOP confirmed that there was no uniform tariff policy of the Government.
b. Improve KESC’s liquidity B.2b.1 KESC to reduce levels of net Target 21 November 2000. X position receivables to 4.5 months of electricity sales.

B.2b.2 GOP to ensure that: 45
- a minimum of PRs400 million of public Target 21 November 2000. X sector receivables of KESC as of 30 September 2000, is paid; and

- the balance of PRs700 million of public - Target 31 January 2001. X sector receivables of KESC as of 30 September 2000, is paid.
c. Restore KESC’s positive net B.2c.1 GOP to convert KESC’s unpaid Completed under Phase I of KESC ✓ worth/solvency foreign debt service liabilities of PRs9.575 financial restructuring program in the billion to GOP into a subordinated long- amount of Rs33.0 billion. term interest-bearing loan (15 year tenor,

5 years grace) and convert other GOP Appendix 1,page11 loans of up to PRs3.045 billion into equity.

B.2c.2 GOP to review KESC’s financial O restructuring options given by the PA and implement the one which is considered most appropriate for the privatization of KESC.

1 Where condition B.1.8 is met before condition C.2b.2, they will be transposed to the second and third tranches respectively.

X = A tranche release condition, O = An operational monitorable milestone towards satisfactorily achieving the tranche release condition. OBJECTIVES ACTIONS REQUIRED COMPLETION ESRPL Actions Status/Remarks Loan Negotia First Incentive Second Third tions Tranche Tranche Tranche Tranche
d. Implement measures to B.2d.1 GOP to guarantee provision of a Outline of the financing plan ✓ finance KESC’s funding gap facility for funding KESC’s cumulative submitted to ADB during Loan from FY1999 to FY2003 cash shortfall from 30 June 1999 to 30 Negotiations. (projected privatization date) June 2003, or the date of privatization, whichever is sooner, by:

- Bridge financing including debt-equity swap up to the period 30 June 2001 will be arranged with GOP guarantee. This facility will be adjusted against the amount of ADB’s first tranche release;

- The funds from the First Tranche shall be used to support KESC’s operational expenses for FY2001 only and shall not be applied for capital expenses; and

- Balance of the cumulative cash shortfall 46 for the period 1 July 2001 to 30 June 2003 to be arranged through a combination of financial arrangements to ensure that KESC remains solvent.

B.2d.2 The Governor of the State Bank of Target 21 November 2000. X Pakistan shall have assured ADB in writing, that (i) that all necessary steps have been taken for a syndicate of commercial banks to provide a line of credit of PRs 4.758 billion to KESC and (ii) there are no impediments to prevent such actions.
B.2d.3 The GOP shall provide to ADB a Target 31 January 2001. X Appendix 1,page12 written commitment from the syndicate of commercial banks, to provide a line of credit of PRs 4.758 billion to KESC that can be utilized up to 30 June 2001, or shall make alternative financing arrangements satisfactory to ADB.

X = A tranche release condition. OBJECTIVES ACTIONS REQUIRED COMPLETION ESRPL Actions Status/Remarks Loan Negotia First Incentive Second Third tions Tranche Tranche Tranche Tranche

C. RESTRUCTURING OF WAPDA

1. Financial Restructuring of WAPDA
Implement financial C.1.1 GOP and provincial governments to Completed 10 August 2000. ✓ restructuring of WAPDA. settle arrears from 1 January 1999 to 30 Accelerate collection of June 2000. This includes arrears of AJK, arrears and improve FATA, and Baluchistan tubewells. collection of current bills

C.1.2 GOP/WAPDA to finalize arrangements O for meeting public sector arrears outstanding as of 31 December 1998. Payments, if any, will be made during FY2002.

2. Unbundling/Restructuring

of WAPDA 47
a. Separate WAPDA’s water C.2a.1 Pakistan Electric Power Company Recruit remaining key professionals X and power wings and (PEPCO) to unbundle WAPDA, for corporatized entities. Target restructure WAPDA’s power corporatize unbundled entities for March 2001. wing into twelve commercial operation and prepare these
O independent and entities for privatization. Complete corporatization of DISCOs autonomous companies including: under the Companies - completion of BTA, ODA and Ordinance regulated by ESA; NEPRA. - transfer of assets and liabilities; - issuance of license by NEPRA.
Complete corporatization of O GENCOs and NTDC including: Appendix 1,page13 - completion of BTA, ODA and ESA; - transfer of assets and liabilities; - issuance of license by NEPRA.
C.2a.2 PEPCO/WAPDA to finalize transfer Execute bulk supply contract O pricing for each DISCOs and GENCOs and between WAPDA and NTDC. NTDC and seek NEPRA approval.

X = A tranche release condition, O = An operational monitorable milestone towards satisfactorily achieving the tranche release condition. OBJECTIVES ACTIONS REQUIRED COMPLETION ESRPL Actions Status/Remarks Loan Negotia First Incentive Second Third tions Tranche Tranche Tranche Tranche
C.2a.3 PEPCO to finalize financial modeling PEPCO/WAPDA/GOP to prepare O exercise to analyze financial position of 12 financial performance targets for proposed companies and residual WAPDA each DISCO, GENCO, and NTDC, and propose allocation of assets and and undertake financial restructuring liabilities (including common services) and if required. financial targets for each of the entities.
C.2a.4 Transfer WAPDA staff to respective Phase I involving secondment of O corporatized entities. about 113,000 WAPDA employees to corporate entities completed. Phase II is in progress, including studies on HR Management Systems and Voluntary Separation Schemes to determine manning levels and redundancies.
C.2a.5 PEPCO to appoint a public relations Campaign to start in January 2001. O firm to implement a campaign explaining to the public and WAPDA’s staff the GOP’s restructuring and privatization program. 48
C.2a.6 PEPCO to conduct public awareness Draft PR Campaign Plan under O campaign regarding the restructuring of review for finalization. January 2001 WAPDA. target date for launching campaign.

C.2a.7 WAPDA to approve financing plan for O implementation of Manpower Transition Program, including recommendations for funding of pension liabilities.

- PEPCO to prepare the HR Management Systems and Voluntary Separation Schemes, including the estimation of Appendix 1,page14 post-retirement benefits, for the corporatized entities.

- PEPCO with the assistance of WAPDA to prepare a Manpower Transition Program, including recommendations for funding of pension liabilities.

O = An operational monitorable milestone towards satisfactorily achieving the tranche release condition. OBJECTIVES ACTIONS REQUIRED COMPLETION ESRPL Actions Status/Remarks Loan Negotia First Incentive Second Third tions Tranche Tranche Tranche Tranche

C.2a.8 WAPDA to ensure satisfactory O progress on implementation of agreed recommendation of Manpower Transition Program.
b. Privatization of C.2b.1 Announce framework for privatization Corporatization process in progress. O corporatized entities of corporatized entities.

1 C.2b.2 GOP to divest its shareholdings in Target December 2001. X one DISCO and one GENCO such that the management and operational control of these two WAPDA corporatized entities are transferred to the private sector.

D. RESOLUTION OF IPPs ISSUE AND SETTLEMENT OF HUBCO AND KAPCO CASES
1. Normalize relations with D.1.1 Implement agreed orderly framework for Completed. Of the 19 IPPs, ✓ 49 IPPs resolving IPP issues. Memorandums of Understanding entailing revision in tariff have been concluded with 13 IPPs. Three IPPs are operating under the original PPAs. One IPP was cancelled and two others have opted out.

2. Settlement of HUBCO and D.2.1 Adequate implementation of an orderly Completed – see Letter of Intent. ✓ KAPCO cases process to resolve the commercial dispute Re-nationalization of assets in the with HUBCO and action to address the power sector earlier transferred to dispute with KAPCO. the private sector is not Appendix 1,page15 contemplated by GOP.

1 Where condition B.1.8 is met before condition C.2b.2, they will be transposed to the second and third tranches respectively.

X = A tranche release condition, O = An operational monitorable milestone towards satisfactorily achieving the tranche release condition. OBJECTIVES ACTIONS REQUIRED COMPLETION ESRPL Actions Status/Remarks Loan Negotia First Incentive Second Third tions Tranche Tranche Tranche Tranche

E. STRATEGIC PLAN AND LEGAL FRAMEWORK FOR THE PETROLEUM SECTOR REFORM PROGRAM
1. Implement Strategic Plan E.1.1 Constitute Advisory Committee on the Completed (December 1999). for the Restructuring and Restructuring of the Oil & Gas Sector. Privatization of the Oil and
Gas Sector (Oil and Gas E.1.2 Government to issue detailed statement Completed (December 1999). Reform Program) on the Oil & Gas sector reform.
E.1.3 Ministry of Petroleum and Natural Minister of Petroleum and X Resources (MOPNR) to review, update, Natural Resources has already and issue a new version of the 1997 initiated this work. Petroleum Policy, which will also cover - Target December 2001. economic and social objectives of GOP in the oil and gas subsectors.

E.1.4 GOP to approve, in-principle, - Completed. ✓ restructuring plan for the gas companies; SSGC and SNGPL.

50 2. Provide legal framework to E.2.1 GOP to develop and introduce to the Draft ordinance for establishing the X implement the Oil and Gas Cabinet a Petroleum Regulatory Authority PRA submitted to industry groups Reform Program (PRA) Act, which will amalgamate the and other ministries by MOP for promulgated Natural Gas Regulatory review and comments first week of Authority (NGRA) Act and the planned August 2000. Submission to Petroleum Regulatory Board (PRB) Act. Ministry of Law, Justice and Human Rights by November 2000 and approval of the Cabinet is expected by March 2001. 3. Strengthen regulatory E.3.1 GOP to appoint the members of PRA. O framework and
operationalize PRA and E.3.2 PRA to prepare rules for licensing, Target December 2001. ensure its independence on tariff setting and other operational X operational issues such as matters as required, relating to Appendix 1,page16 tariff setting, issuance of production companies, transmission licenses, etc. companies and distribution companies.
E.3.3 GOP to approve PRA’s Rules and Target December 2002. X Standards for tariff setting, licensing rules and draft license formats for producers, transmission, and distribution companies.

X = A tranche release condition, O = An operational monitorable milestone towards satisfactorily achieving the tranche release condition. OBJECTIVES ACTIONS REQUIRED COMPLETION ESRPL Actions Status/Remarks Loan Negotia First Incentive Second Third tions Tranche Tranche Tranche Tranche
E.3.4 PRA to issue licenses to producers, Target December 2002. X transmission and distribution companies.
4. Introduce operational E.4.1 GOP to rationalize the freight pool GOP has already rationalized the X improvements that will arrangements. freight pool arrangements for increase the efficiency in furnace oil, and it is developing a petroleum sector and have phase-out program for the diesel positive national economic freight pool. Target 31 May 2002. impact
E.4.2 GOP to introduce a petroleum price GOP has deregulated the prices on X setting mechanism to align the furnace oil. On other product, GOP domestic product prices with has introduced quarterly price compatible international based pricing adjustments linked to international policies on oil based products. price fluctuations. GOP to deregulate the import of diesel. Target date 30 June 2001.

51 E.4.3 Gas transmission companies to Completed. Gas sales agreements X execute gas sales agreements with gas have been signed covering all six producers. new gas fields.
E.4.4 GOP to approve gas swapping Completed. X agreement between SSGC and SNGPL.

E.4.5 GOP to formally allocate the following Target 31 March 2001. X minimum natural gas supply to KESC, in - The Board of SSGCL has addition to the existing quota: approved the investment needed a) 40 mmcfd to Bin Qasim Thermal to meet the increased gas Plant by 31 March 2001, allocation. b) 80 mmcfd by 30 June 2001, and c) 176 mmcfd by 1 January 2003. Appendix 1,page17
E.4.6 SSGCL to submit to ADB, its proposal Submitted by SSGCL. ✓ for gas supply arrangements with KESC.

X = A tranche release condition. PROGRAM FRAMEWORK

Design Summary Program Outputs Monitoring Mechanisms Risks

Goal

To establish an efficient and competitive Through restructuring of the energy sector, (i) Reports of PEPCO on the progress of Lack of political will to overcome the industry which will provide a high quality stimulate economic growth, (ii) have a positive restructuring. Published Government accounts. vested interests in the status quo. service to its customers at least cost. impact on the macro-economic situation, (iii) Annual reports and accounts of the Lack of potential investors in the ensure investor’s confidence and consumer’s corporations giving details of sales and receipts industry. protection, and from various categories of consumers and (iv) reduce negative environmental impacts of changes in fuel sources. Six monthly ADB energy generation. review missions.

Objective
Assist the Government to separate the Ensure that the independent regulator Transcripts of public hearings regarding tariff Government uses energy sector existing energy sector SOEs, create (NEPRA) remains free from political applications, issuance of licenses, etc. tariffs as a macro-economic tool. commercially run corporations, and interference so that it can provide equal Provincial governments force the facilitate their privatization. opportunities until a full competitive market Government to interfere in tariffs situation prevails. and licenses.
Promote the commercialization of the 12 Six monthly ADB review missions. Reports PEPCO not able to complete the separated WAPDA corporations, i.e. 8 from PEPCO on progress of legal and commercialization process. DISCOs, 3 GENCOs, and the National commercial activities of the corporations.

Transmission and Dispatch Co. 52
Ensure that by the end of program period, Announcements by the Government, PEPCO, No bidders for the corporations or at least 1 DISCO and 1 GENCO have Privatization Commission, and the sales cannot be closed. been privatized. corporations. Second tranche release conditional on putting 1 GENCO and 1 DISCO for sale to private sector.
Ensure the privatization of KESC, which will First tranche release on loan effectiveness. No bidders for KESC and WAPDA lead to (i) improved customer service, (ii) Second tranche release conditional on entities, or sale cannot be closed. elimination of crisis-subsidy, and (iii) privatization of WAPDA entities. Third tranche financial sustainability of the utility within release will be conditional on the Government the national framework. issuing a letter of intent to the winning bidder for the purchase of KESC.
Assist the Government to develop the Public announcements by NEPRA of new Lack of private sector interest in country’s indigenous energy resources generating licenses. indigenous resources. Lack of

through the private sector via a political will to insist on competitive Appendix2 competitive bidding process. bidding.

Program Components Inputs Loan Loan of $350 million in three tranches, to help Progress reports of review missions. Government fails to meet the defray the cost (restructuring and social costs) agreed conditions of sector reforms. associated with the restructuring process.

TA Loans $5 million to provide assistance for capacity Progress reports of review missions and Failure to agree on use of enhancements in the energy sector. technical assistance consultants. local/foreign consultants.

ADB = Asian Development Bank, DISCO = distribution company, GENCO = generation company, KESC = Karachi Electric Supply Corporation, NEPRA = National Electric Power Regulatory Authority, PEPCO = Pakistan Electric Power Company, SOE = state-owned enterprise, WAPDA = Water and Power Development Authority. 53 Appendix 3, page1

THE CIRCULAR DEBT PROBLEM

A. Sector Debt Situation

1. The major elements of the debt situation as of June 2000 in the sector are shown in Figure A3. Because both Water and Power Development Authority (WAPDA) and Karachi Electric Supply Corporation (KESC) finance their capital investments mostly by a substantial amount of loan credit from the Government, the net total debt of the sector to the governments (provincial and federal) amounts to about $2.425 billion (including $304 million of debt to state- owned fuel suppliers). This exceeds the Government’s proposed national development expenditure budget for FY2000 of $1.940 billion, i.e., the debt of the sector is 1.25 times of the Government’s development budget. The net indebtedness of WAPDA amounts to $1.4 billion including a contingent liability of $501 million owed to Hub Power Company (HUBCO) and Kot Addu Power Company (KAPCO). KESC carries $631 million of net debt. As WAPDA is almost six times KESC in asset size, KESC is financially more burdened than WAPDA. Some debts are disputed, particularly the arrears from the governments to WAPDA and KESC, because the two utilities in the past distributed inflated bills in order to enhance its cash flow. The amount involved, the circular nature of the debt, and the lack of trust between the parties have proved to be formidable obstacles to resolution of the sector’s financial difficulties. The Energy Sector Restructuring Program Loan, together with other lending to the sector, is designed to reconcile and restructure the various debts to provide a foundation for organizational restructuring.

B. Receivable Position of KESC and WAPDA

2. To KESC, the government of Sindh and its local bodies owe almost PRs2 billion of arrears, whereas the Federal Government paid out its arrears during FY2000 and is current on its payment. The Government has committed to have all public sector receivables outstanding as of 30 September 2000 paid before the incentive tranche release of the proposed loan. The Private sector accounts for 83.0 percent of KESC’s arrears, and are a serious problem. Although KESC has recently improved its current bill collection ratio from 64.0 percent in FY1998 to 75.0 percent in FY2000 with assistance from the army, collection from private consumers leaves much to be desired. KESC has committed to reduce net receivable (net of provision for bad debts) from 5.5 months of sales on June 2000 to 4.5 months by November 2000 and 3 months by June 2003 through remedial measures, including additional army assistance, rationalization of the billing process, outsourcing to Citibank the work of reconciling statements, improved metering, and strict enforcement of disconnection policy.

3. By contrast, for WAPDA, public sector arrears have reached a critical level while collection from private customers continues to be good. The major public sector defaulters include AJ&K and the Government of Sindh, which owe 70.0 percent of WAPDA’s public sector arrears. On 29 June 2000, the Government decided that arrears from federal and provincial governments, FATA, and agricultural tubewell consumers of Balochistan developed from 1 January 1999 to 30 June 2000 should be paid immediately while the arrears of Federal Government, FATA, and agricultural tubewell consumers developed prior to 1 January 1999 should be written off. All the payments regarding this decision have been made. However, a settlement plan of arrears from the Government of Sindh developed prior to January 1999 is still being discussed. Table A3.1 shows the outstanding balance of account receivables of KESC and WAPDA. 54 Appendix 3, page2

Table A3.1: Outstanding Balance of Accounts Receivable (as of 30 June, in PRs million) Receivable KESC WAPDA From 1999 2000a 1999 2000a Amount Month Amount Month Amount Month Amount Month Federal Government 2,022 9.4 1,035 4.1 7,881 15.0 10,570 7.1 Provincial Government 1,269 12.6 1,972 9.9 19,714 38.1 18,503 19.5 FATA/Tubewell 0 0 0 0 7,418 77.6 10,302 37.3 Other Private 14,333 9.2 15,467 8.4 13,041 5.8 14,674 1.7 KESC 0 0 0 0 4,125 15.6 10,740 22.0 Total 17,624 9.4 18,474 8.0 52,179 10.8 64,789 5.4 FATA = Federally Administered Tribal Areas, KESC = Karachi Electric Supply Corporation, WAPDA = Water and Power Development Authority. a Provisional Source: KESC, WAPDA.

C. Payable Position of KESC and WAPDA

4. Because of accumulated arrears from consumers, KESC and WAPDA have delayed their payments to fuel suppliers, power suppliers, and lenders. While WAPDA is current on its fuel bills, KESC has not paid about PRs7 billion to its gas and oil suppliers, which are public corporations such as Pakistan State Oil and National Refinery Limited. KESC has not paid its power purchase cost from WAPDA since March 1999. KESC has also defaulted on its debt service obligations to the Government amounting to PRs3.6 billion. Out of WAPDA’s PRs29.4 billion payable to independent power producers, PRs26 billion represents deferred payment to HUBCO and KAPCO under court order. WAPDA’s arrears to the federal Government were reduced substantially in FY2000 because PRs36.3 billion of its debt service liability to the Government was converted into equity.

Table A3.2: Outstanding Balance of Accounts Payable (in PRs million) Payable KESC WAPDA To 1999 2000a 1999 2000a Oil & Gas 6,966 6,910 11,447 8,879 Power Purchase 545 1,147 12,696 29,433 Federal Government 770 3,650 37,015 3,349 WAPDA 2,542 7,960 0 0 Others 0 0 4,124 4,095 Total 10,823 19,667 65,282 45,756 KESC = Karachi Electric Supply Corporation, WAPDA = Water and Power Development Authority. a Provisional Source: KESC, WAPDA. Figure A3: Sector Debt Situation (as of June 2000, in $ million)

2,060 Federal Government 680a

204 20 Provincial Government 357 38

WAPDA 153 KESC 55

171 133 22 567b State-Owned Fuel Suppliers

483 299 Independent and other Power Suppliers

Private Customer Appendix 3,page3

Total Debt Burden: About $5.2 Billion a Include foreign loans through the Government b Includes contingent liability of $501 million to HUBCO and KAPCO 56 Appendix 4

TARIFF STRUCTURE AFTER MARCH 1999

1. The categories and the tariff structure after the adjustments in March 1999, are shown in the table.

Table A4: Tariff Categories and Structure Category Structure PRs/kWh US Cents/kWh

Lifeline (2 percent) Consumption up to 50kWh/month 1.40 2.70 Residential (36 percent) Average Residential 3.89 7.53 Industrial (38 percent) 66/132 kV 3.55 6.86 (in a 400-volt line) 4.79 9.26 11 kV 3.98 7.70 (in a 400-volt line) 4.82 9.32 Bulk Supply (12 percent) 400 volts 4.82 9.32 11 kV 4.57 8.84 Public Lighting (3 percent) Average 5.88 11.37 Commercial (9 percent) Average 7.20 13.93 PRs/HP/Month US Cents/ HP/Month Agricultural a. Punjab and Sindh i. Flat rate 3.73 7.21 ii. Metered 2.34 4.53 b. NWFP and Balochistan i. Flat rate 3.16 6.11 ii. Metered 2.01 3.89 Source: KESC and WAPDA.

2. The lifeline tariff of a 50 kWh consumption per month is PRs1.40/kWh. Higher rates apply to households using more than 50 kWh per month and range from PRs1.718/kWh to PRs6.811/kWh with the average tariff at PRs3.89/kWh. The residential customers consume about 38 percent of the total consumption. In the commercial sector, the average tariff is PRs7.20/kWh. The commercial consumption accounts for about 9.0 percent of the total consumption. Industry tariffs are divided into four categories (Table A4). Industries consume about 38.0 percent of the total. The tariffs for the bulk supply range between PRs4.57/kWh– PRs4.82/kWh and represent 12.0 percent of the total consumption. Electricity used for street lighting (3.0 percent) is charged at PRs5.88/kWh.

3. The electricity tariffs are comprised of four parts: (i) base tariffs, (ii) fuel adjustment charges, (iii) surcharges, and (iv) additional surcharges. The base tariff is calculated on the recovery of the fixed investment costs in generation, transmission, and distribution, in the form of depreciation and interest plus operation and maintenance costs, including a portion of fuel cost and administrative overheads. Base tariffs are applicable to the fixed capacity charge and energy use charge in industrial and bulk supply consumers, whereas only the energy use charge is applicable to residential, commercial, and small industrial consumers. The fuel adjustment charges (FAC) were introduced in 1970 to recover the fuel cost in excess of PRs2.24 per million British thermal unit (BTU). However, after the introduction of a surcharge in January 1992, the fuel subsidy was eliminated and the utilities were allowed to adjust the shortfall in fuel cost against recovery of the same. The surcharge concept in Water and Power Development Authority (WAPDA) was introduced for payment of royalties to the provincial government at the rate of 2.5 percent from 1 January 1992, and gradually increased to the level of 10.4 percent in 1997. The objective of the additional surcharge was to generate sufficient revenues to meet the financial covenants. LONG-TERM STRATEGIC PLANNING (Pakistan Energy Sector Reforms)

Intermediate Measures Achievements (1992-1998) Energy Sector Reform Targets (2003)

ADB $2.1 bn Loans Investments Other Agencies $7.4 bn Private Investment $3.2 bn 1) Mobilization of ADB resources $700 m Mobilization of WB resources $700 m

Demand Side Management Study 2) No load shedding Policies Support for the Government sector Restructuring 3) No application for new connection pending for more than 2 months

4) Collection to be at least 98% of billing Power and Water Institutional Study Technical Management Information System Study Institutions 5) Elimination of tariff cross-subsidy Assistance KESC Organization and Restructuring Study Split of WAPDA Water and Power Wings 6) Work force optimized 57

Human Resources 7) Workers compensation package improved Generation and Coordination Training 8) Network to increase peak load handling from 10,000 MW to 15,000 MW Good Governance Private Hydro Policy Study Enactment of New Private Independent 9) Losses reduced from 25% of input to the grid to Power Policy less than 15% Investment in 6,500 MW of IPPs 10) Average thermal station fuel efficiency to be increased to 35%

Creation of National Sector Regulator 11) Commissioning of Ghazi Barotha and Chasma Private Sector (NEPRA) Hydropower projects Unbundling of WAPDA Power Wing 12) Implementation of new private independent power policy Economic and Regional Facilitation of Pakistan – India Power Trading Sector Work Cooperation 13) Average reliability increased to at least 95% at MV level KESC restructuring and privatization study Transition to Preparation for privatization of KESC Market Economy Establishment of PEPCO Appendix 5

ADB = Asian Development Bank, IPP = Independent Power Producer, KESC = Karachi Electric Supply Corporation, MV = megavolt, MW = megawatt, NEPRA = National Electric Power Regulatory Authority, PEPCO = Pakistan Electric Power Company, WAPDA = Water and Power Development Authority, WB = World Bank. 58 Appendix 6, page 1

THEFT AND LOSS REDUCTION PROGRAM OF KESC AND WAPDA

1. A summary of measures instituted by Karachi Electric Supply Corporation (KESC) and Water and Power Development Authority (WAPDA) to reduce theft and improve the overall operational and financial performance are outlined below.

A. KESC

2. KESC has introduced the following measures:

(i) Installation of ATMs. KESC has entered into an agreement with Citibank to install on 1 October 2000 about 30 automated teller machines (ATMs), near KESC payment stations. The ATMs have been installed and eliminate some cash payments personnel, who often did not credit payments to the customer’s account. The ATM will increase the integrity of transactions, reduce fraud, provide cash to KESC, and decrease customers’ complaints. For its services, Citibank will receive from KESC PRs10 per transaction.

(ii) Citibank as KESC Collection Agency. Citibank entered into an agreement with KESC to become its collection agent. The Citibank will accept payments from KESC customers at its branches. The arrangement will increase the integrity of KESC’s collection system, assist customers in the immediate accreditation of the bills paid, and reduce the customers’ burden of record reconciliation. The arrangement has been in effect since 1 October 2000.

(iii) Citibank Data Management System. Another Citibank agreement with KESC involves managing KESC’s billing and payment system. Citibank will completely reconcile the amount billed by KESC’s billing department and payments received at KESC’s payment stations. The outsourcing of this function is a major step in avoiding problems relating to the collection of cash. The Citibank data management control management system has been operational since 1 October 2000, and will provide credibility to KESC’s billing and collection system. Citibank will receive from KESC PRs2.50 per reconciled payment stub.

(iv) Substation Metering. KESC will install meters at its substations to indicate the exact electricity usage in various areas of its franchise. The meter reading will be a cross check to the actual amount billed to the customers in each area, will provide an accurate monitoring system, and will help ensure that the electricity consumed from a particular substation is accurately billed and the correct amount collected. Initially, the meters will be installed in areas with high electricity consumption.

(v) Average Billing. The current billing system uses an average billing method to assess the monthly amount to be paid by the customers. This practice has been an opportunity source of corruption. Effective 1 October 2000, KESC stopped its current widespread practice of average billing.

(vi) Army Involvement. KESC has recently employed 44 army personnel, mostly for intelligence gathering and for management positions. In addition, 400 soldiers will be deployed for operational activities and to interact with KESC customers. Furthermore, an additional 70 army personnel could be recruited as permanent 59 Appendix 6, page 2

KESC staff at supervisory and management levels, to handle the operational and administrative functions of KESC. The involvement of the army is well planned and coordinated, and indicates the Government’s commitment to restore the operational and financial viability of KESC.

(vii) Extension of 11kV Lines into Interior of Residential and Commercial Areas. This will delay the errant consumers the opportunity to install hooks on to lines directly. Secondly, small capacity transformers and insulated low tension lines will be used to run the system at rated capacity and reduce the possibility of illegal usage.

(viii) Metering Distribution Transformers. KESC has initiated a program to install meters on all distribution transformers.

(ix) Installation of Meters Outside the Premises. Under this program, KESC has started to relocate the meters from inside the premises to outside to ensure proper connection of service cable and meters.

(x) Use of Insulated Cables. Using insulated 4-core bundled cables to avoid illegal connections.

B. WAPDA

3. Since mid-January 1999, WAPDA has been implementing, with the support of the armed forces, an intensive campaign to reduce electricity theft and losses, improve billing and collection, and improve its operational and financial performance. These efforts can be grouped in three broad areas–theft and loss reduction, improvements in operating systems and procedures, and billing and collection (including the collection of arrears).

4. The theft and loss reduction campaign is primarily focused on detection and removal of illegal electricity connections, and checking of consumer meters, and is implemented by the distribution companies (DISCOs). On average 4,000-4,500 armed forces personnel are assigned to each DISCO, to support WAPDA personnel (organized into 15-20 teams of inspectors) in inspecting consumer premises, removing illegal connections, and lodging reports with the judicial authorities in case there is evidence of electricity theft. In addition, a chief executive officer for each DISCO has been appointed from the army, for a period of two years.

5. WAPDA reported that influential people (including ruling party politicians and other key officials) are being caught, and the operation appears to be proceeding without political interference. Since mid-January 1999, peak load has declined by 700-800 MW in the WAPDA system. The normal (daytime) load remained roughly constant, at about 4,400 MW. WAPDA officials view this as an early indicator of the success of the theft reduction campaign, as illegal connections are being removed by WAPDA and by consumers, in anticipation of the inspections.

6. The results of this campaign are being documented and a comprehensive database on consumers and load of each DISCO is being prepared. This will enable WAPDA to more intensively monitor operational performance of each subdivision. Reports on electricity supplied, units billed, and revenues collected for each subdivision are being submitted to WAPDA headquarters, and are reviewed by senior WAPDA management on a weekly basis. Similarly, a situation report is prepared daily on the activities being undertaken and is submitted to the chief executive officer of each DISCO. 60 Appendix 6, page 3

7. The backlog of pending applications is being cleared quickly, and the process for providing new connections has been streamlined. Since one of the main complaints regarding the provision of new connections related to the storage of meters available to the DISCOs, WAPDA has negotiated fixed prices for meters with a number of local suppliers, and the customer can purchase the meter directly from those suppliers.

8. The main focus of the campaign to detect illegal connections and theft is on domestic, industrial, and commercial consumers. Checking the metering installations of these consumers requires more technical knowledge and capital investment. While the detections are being made and consumer arrears calculated, it is not possible to verify whether the billing records (updated meter reading, new meter number, etc.) are simultaneously being permanently updated. DISCOs are required to carefully check on this aspect, and ensure that the billing records are updated simultaneously. 61 Appendix 7, page1

CASH SHORTFALL FINANCING PLAN AND RESTRUCTURING COST

A. KESC Cash Shortfall Projection

1. The financial projections are driven by efficiency improvement measures committed by the Karachi Electric Supply Corporation (KESC)/the Government including: (i) change from furnace oil to gas fuel, (ii) restoration of generation capacity (iii) reduction in transmission and distribution (T&D) losses, and (iv) improvement in bill collection. No tariff increase is assumed in the projection because further tariff increase can not be justified as the present KESC tariff level is considerably higher than the international level. However, if the National Electric Power Regulatory Authority (NEPRA) introduces a tariff setting mechanism to automatically reflect cost items such as fuel increases, KESC’s average tariff is likely to be raised.

2. Change from Furnace Oil to Gas Fuel. To take advantage of the lower cost of domestic gas compared to imported furnace oil, KESC is converting Bin Qasim Thermal Power Station to a gas-fired Plant. The technical conversion of its four units has been completed, and the remaining two units will be converted by January 2001. 176 million cubic feet/day of gas is required to operate all six units. However, due to the limited availability of gas, a full supply of gas is expected to start on January 2003. Until then, one unit will be operated under gas by June 2001 and two units will be operative thereafter.

3. Restoration of Generation Capacity. An integrated phased program is in place to enhance KESC’s generating capacity from 1,204 MW to 1,532 MW by May 2001. As KESC’s own generation will increase, the resulting lower purchase of power, which is normally more expensive than KESC’s own generation, is expected to reduce overall generation cost.

4. Reduction in T&D Losses. Based on the present consumption data, KESC’s T&D losses are documented at 40.8 percent in FY2000. Determination of actual T&D losses is very difficult because the power theft has been hidden by excess billing. However, with additional collection by the army and other measures to reduce power theft, KESC has committed to reduce T&D losses by 6.0 percent in FY2001, 7.0 percent in FY2002 and 6.0 percent in FY2003.

5. Improvement in Bill Collection. KESC’s Accounts receivables as of 30 June 2000 were PRs18.5 billion, which is equivalent to 5.5 months of its energy sales. Currently, major defaulters are the provincial governments and private sector. Arrears from the government of Sindh and its local bodies to KESC were approximately PRs2 billion. As one of the conditions for the first tranche and the incentive tranche release, net receivables have been reduced to 4.5 month of sales by 21 November 2000 and public sector arrears are to be fully recovered 31 January 2001 and. KESC has also committed to further reduce its accounts receivable to 4.0 months of sales by 30 June 2001, 3.5 months by 30 June 2002, and 3.0 months by 30 June 2003.

6. Financial Projections. Based on the above assumptions, the Asian Development Bank (ADB) prepared financial projections up to 30 June 2003, which were agreed to by the Government. A detailed description of KESC’s projected financial performance and the resulting cash shortfall up to privatization is provided in Table A7.3. The summary of the cash shortfall projection is given in Table A7.1. 62 Appendix 7, page2

Table A7.1: Cashflow Projection for KESC (PRs billion) 1998-99 1999-00 2000-01 2001-02 2002-03 Item Actual Provisional Budget Projected Projected Cash Collection 22.2 25.5 32.4 35.7 40.9 Fuel and Power Purchase 20.7 25.9 34.7 32.0 34.5 Other Operating Expense 3.3 2.9 3.5 3.7 4.1 Capital Expenditure 1.2 2.0 3.0 3.3 3.1 Debt Service 5.2 7.8 9.0 10.6 10.2 Gross Cash Shortfall (11.4) (10.1) (17.2) (14.1) (10.7) Mitigation Measures 1.10.4000 Net Cash Shortfall (10.3) (9.6) (17.2) (14.1) (10.7) Cumulative Cash Shortfall (10.3) (19.9) (37.1) (51.2) (61.9) Source: KESC, ADB.

7. Continued efforts to recover arrears and reduce power theft are expected to increase cash revenue by 17.0 percent per annum during FY2000 to FY2003, while energy demand is projected to grow at 5.0 percent annually and no tariff increase is assumed in FY2002 and FY2003. Percentage of fuel and power purchase cost in cash revenue is expected to further increase in FY2001 as a result of the recent hike of international oil prices. However, due to conversion from fuel oil to gas, the fuel and power purchase cost is projected to represent 84.0 percent of cash revenue in FY2003, while it slightly exceeded cash revenue in FY2000.

8. Despite an improvement of the overall cash flow position, KESC’s operational cash flow will not cover its minimum capital investment requirement and debt service obligations. The cumulative cash shortfall up to 30 June 2003 is estimated to be PRs61.9 billion. To keep KESC solvent until privatization, this cash shortfall needs to be fully financed.

9. In ADB’s base case, no tariff increase is assumed after the most recent raise by 13 paisa/kWh on 1 November 2000. However, ADB, through the policy matrix, encourages NEPRA to introduce a mechanism to automatically adjust in the tariff structure the cost for items such as fuel and taxes. If such a tariff setting mechanism is established, the average tariff of KESC will likely be raised by 15.0 percent in FY2001, 8.0 percent in FY2002, and 8.0 percent in FY2003. Such tariff increases would reduce KESC’s cumulative cash shortfall from PRs61.9 billion to PRs40.3 billion by 30 June 2003.

B. Cash Shortfall Financing Plan

10. The cash shortfall of PRs128.2 billion, comprising PRs91.8 billion for KESC and PRs36.4 billion for WAPDA, needs to be financed to make the power sector current on its payment obligations and to keep KESC and WAPDA solvent until privatization. The cash shortfall for WAPDA was fully financed in FY2000 by converting PRs36.4 billion debt-servicing liabilities to the Government into equity. KESC’s cumulative cash shortfall of PRs29.9 billion up to FY1998 was financed by the Government’s financial restructuring package, approved by the Cabinet in November 1998.

11. The Government has fully committed to finance KESC’s cash shortfall up to 30 June 2003. The cumulative cash shortfall of PRs37.1 billion up to 30 June 2001 will be financed by (i) conversion of unpaid principal and interest to the Government outstanding as of 30 June 2000 63 Appendix 7, page3 into equity (PRs8.4 billion); (ii) conversion of overdue liabilities of fuel/power purchase into long- term loan (PRs15.0 billion); (iii) on-lending of the first tranche of the proposed ADB loan (PRs9.0 billion); (iv) bridge financing from commercial banks, guaranteed by the Government (PRs4.7 billion). The Government will finance the cumulative cash shortfall for 1 July 2001 to 30 June 2003, by the combination of budgetary allocation, debt-equity swap, on-lending of the second tranche of the proposed ADB loan, and refinancing of the existing term finance certificate (TFC). The financing plan is detailed in Table A7.2.

Table A7.2: Cash Shortfall Financing Plan (PRs billion) Item FY98 FY99 FY00 FY01 FY02 FY03 Total Cash Shortfall for the Year KESC 29.9 10.3 9.6 17.2 14.1 10.7 91.8 WAPDA 0 0 36.4 0 0 0 36.4 Total 29.9 10.3 46.0 17.2 14.1 10.7 128.2 Cash Shortfall Financing Conversion of Government Loan to Equity 0 0 36.4b 8.4b 3.8b 3.7b 52.3 Conversion of Government Loan to Subdebt 9.6 0 0 0 0 0 9.6 Rollover of Government-Guaranteed Loan 7.4 0 0 0 0 0 7.4 Netting of Circular Debt 1.4 0 0 0 0 0 1.4 New Government-Guaranteed Loan/ ADB Loan 0 0 0 13.7 (0.4)c 0 13.3 TFC, Budgetary Allocation, etc. 11.5 0 0 15.0 10.7 7.0 44.2 Total 29.9 0 36.4 37.1 14.1 10.7 128.2

Net Cumulative Cash Shortfall 0 10.3 19.9 0 0 0 30.2 Other Financial Restructuring of KESCa Conversion of Government loan to Equity 0 3.0b 00003.0 Conversion of Government Subdebt to Equity 0 0 0 9.6b 009.6 ADB = Asian Development Bank, KESC = Karachi Electric Supply Corporation, WAPDA = Water and Power Development Authority. a No impact on cash flow. b Restructuring cost incurred or to be incurred by the Government. c Including repayment of the GOP guaranteed commercial loan. Source: KESC, ADB.

C. Restructuring Cost of the Power Sector

12. As Table A7.2 shows, the Government has converted its loans to KESC and WAPDA amounting to PRs39.4 billion ($762 million) into equity up to FY2000. Unlike other financial assistance by the Government, which is primarily in the form of guarantee, this debt write-off is considered a restructuring cost of the power sector. KESC’s debt obligation of PRs25.5 billion ($493 million), which the Government has committed to convert into equity from FY2001 to FY2003, will be an additional restructuring cost to be incurred by the Government. The restructuring cost may increase if further Government loans or Government-guaranteed loans are written off in the process of privatizing KESC and WAPDA although the cost can be partly recouped by sale proceeds. 64 Appendix 7, page 4

Table A7.3: KESC Financial Projection (ADB Base Case) (PRs million) Item FY99 FY00 FY01 FY02 FY03 Actual Provisional Budget Projected Projected Operational Assumptions Demand Growth 3.0% 7.5% 5.1% 5.0% 5.0% T&D Losses 38.6% 40.0% 33.4% 26.4% 20.4% Tariff Increase 9.7% 4.5% 3.0% 0.0% 0.0% Fuel Oil Price Change -11.5% 51.1% -9.1% 0.0% 0.0%

Income Statement Items Total Sales (GWh) 6,131 6,443 7,534 8,755 9,952 Revenue 23,781 26,145 31,402 36,421 41,345 Operating Income (4,323) (7,141) (11,201) (4,059) (2,236) Net Income (7,483) (12,896) (17,244) (9,461) (6,942)

Cash Flow Statement Items Cash Collection 22,246 25,521 32,441 35,706 40,968 Revenue Expenditure 24,058 28,883 38,308 35,874 38,671 Capital Expenditure 1,209 1,980 2,970 3,296 3,109 Working Capital Change 3,145 (3,400) (824) (179) (507) Debt Servicing (Net) 5,211 7,802 9,045 10,641 10,205 Cash Surplus(Shortfall) (11,377) (10,065) (17,186) (14,080) (10,689)

Balance Sheet Items Account Receivable (Net) 11,899 11,738 10,263 10,435 10,167 Net Fixed Assets 49,751 49,298 50,442 50,553 50,331 Total Assets 69,610 65,837 65,415 65,310 64,950 Long-term Debt 53,188 51,217 47,135 41,672 34,006 Equity (8,605) (21,497) (38,738) (48,194) (55,131)

Financial Ratios Debt Service Ratio -0.74 -0.68 -0.55 -0.01 0.29 Self Financing Ratio -281.6% -257.3% -439.9% -310.2% -242.2% Current Ratio 0.98 0.53 0.29 0.22 0.18 Long-term Debt as Percentage of 119.3% 172.3% 561.3% -638.9% -161.0% Long-term Debt + Equity Net Receivables (month) 6.1 5.5 4.0 3.5 3.0

GWh = gigawatt-hour, T&D = transmission and distribution. Source: KESC, ADB. 65 Appendix 8, page 1

POVERTY IMPACT ASSESSMENT

1. The entire Karachi area is directly affected by the Government’s restructuring program. The current financial situation of the Karachi Electric Supply Corporation (KESC) leaves the Government with only two options: let KESC go bankrupt with no, or limited power supply in the Karachi area; or restructure and privatize KESC. Given the industrial base in Karachi and the importance of the electricity supply for industrial growth and household welfare, the former option is not acceptable. The current corrupt practices, and a possible decision of the Government to let KESC go bankrupt would impact the poor severely. Keeping KESC, as a public utility, afloat with Government resources is not a sustainable solution as it nourishes corruption and limits the Government’s ability to invest in social and more growth enhancing sectors.

2. This appendix is organized into three sections. The overview of the consumer base of KESC, presented in section A, gives a picture of the distributional implications of the current situation. Section B provides an assessment of the direct and indirect impacts on the poor and most vulnerable of the restructuring program. The overall macroeconomic implications for poverty reduction of the program is discussed in section C. A summary table of the expected impacts is provided at the end of this appendix.

A. Overview

3. The official electrification ratio in Karachi is 74.4 percent. The remaining 25.6 percent comprises illegal connections (about 400,000) mainly by poor residential consumers. Table A8.1 presents a dismal picture of significant underbilling of non-poor and commercial consumers, the main cause of the deficit and cash short-fall for KESC.

4. About 24.0 percent of the official consumer base of KESC are poor or low-income households1. These consumers are billed for nearly 21.0 percent of the total billed units with an average consumption of 170 kWh per month. About 60.0 percent consume less than 100 kWh per month. Considering that the average consumption of electricity in Pakistan is 333 kWh per month, the corresponding figures for non-poor residential consumers in Karachi seem low, especially since average consumption is normally higher in urban areas. More than 73.0 percent of commercial consumers are billed for less than 100 kWh per month; although commercial consumers represent 19.5 percent of the consumer base, they only receive 15.0 percent of the total billed units.

Table A8.1: Estimated Distribution of KESC Consumer Base Consumer Category Residential Commercial All Poor Non-poor Total Connections (%) 23.9 56.6 80.5 19.5 100.0 Billed Amounts (%) 20.6 64.2 84.8 15.2 100.0 Average Units Billed (kWh) 170 225 209 154 198 Consumer Share Billed less than 100 kWh (%) 59.7 37.5 45.8 73.4 51.2 Source: KESC.

1 Estimates of the distribution of the residential consumer base are based on geographical location of households. 66 Appendix 8, page 2

B. Poverty Impact Assessment of the Program

5. Given the lack of empirical data for electricity expenditure ADB’s Mission conducted a household survey in low-income areas of Karachi to assess the preliminary direct and indirect impacts on the poor.2 In addition, the Mission conducted in-depth discussions with small-scale businesses to assess consequences for economic activity directly affecting income-earning opportunities for the poor. The interviews focused on assessing the effects on the poor in terms of quality of supply, consumer services, expenditure on electricity, vulnerability to corrupt practices, economic activity, and general welfare of households. Based on the outcome of the survey a technical assistance for a poverty impact assessment was formulated with components for continued monitoring of the effects on the poor during the program implementation period and capacity building to consumer participation in the competitive electricity market. The capacity building was formulated with particular relevance to reducing the vulnerability of poor consumers.

6. The corrupt practices and KESC’s consequent cash short-fall for KESC has affected poor consumers more than other consumer groups. Whereas non-poor residential and commercial consumers area affected by power cuts resulting from deteriorating maintenance, these are more frequent and persist for longer time periods in low-income areas of Karachi. In addition, non-poor consumers have often invested in generators to overcome the inconvenience of power cuts. Due to high initial capital costs this option is not available for poor consumers. The initial assessment shows that 36.0 percent of the households interviewed suffered from loss of income as a result of power cuts. In addition, adverse impacts on general household welfare were significant, including lack of sleep, mosquito bites, security problems, loss of study time, and general inconvenience, especially for children. Poor consumers are especially susceptible to corrupt practices in collection, billing and connection fees. The vulnerability of the poor is reinforced by the fact that these consumers face difficulties in monitoring their own electricity consumption due to the irregularity of billing, lack of meter readings by KESC officials, and neglect in consumer services. The poor’s vulnerability to extortion is exacerbated by illiteracy and inability to read their own meters. Corrupt practices have displaced resources in KESC away from provision of legal connections. Although connection fees are difficult for poor households to pay, they prefer legal connections because they are perceived to strengthen property rights. Improvements in the billing system, meter readings, and connection services are important tools for reducing the vulnerability of poor consumers. However, to address the inefficiencies in the billing and distribution departments, initial capital costs are required. KESC is trapped in a vicious cycle of low revenue collection and not being able to invest in measures that would improve revenue collection. KESC has not, despite significant resources and efforts, been able to provide poor consumers with a fair share of benefits of the electricity sector.

7. The key to addressing the vulnerability of poor consumers is to restore long-run financial viability of the electricity sector through restructuring and privatization, laying the foundation for a competitive and (thus), cost effective electricity market. Although KESC’s acute financial situation will primarily be solved by reducing theft, some tariff increases reflecting cost recovery may be expected in the short run. However, in the longer run increased competition will lead to efficiency gains and ultimately result in lower tariffs. The current average expenditure on electricity among poor residential consumers is about 10.0 percent of cash income, well above

2 In these areas, KESC had recently replaced illegal connections with legal ones. 67 Appendix 8, page 3 international comparisons.3 To eliminate the adverse impact of tariff increases on poor consumers, the lifeline tariff will be maintained.

C. Macroeconomic Impacts of the Program

8. The macroeconomic impact of the program is pro-poor and has significant implications for government spending on social sectors and public allocation of investments and the resulting effect on overall economic growth. KESC’s current financial situation has diverted public funds away from social expenditures and other sectors that enhance economic growth that would benefit the poor. For instance, the cash short-fall in KESC for the fiscal year (FY) 2000 is nearly equal to Government expenditure on social services: more than 1.7 times the expenditure on education or 5.0 times the expenditure on health. Although these funds may not be fully fungible, allocation of funds to KESC has implications for the budget deficit and the options available for the Government. The KESC cash short-fall for FY2000 amounts to 5.2 percent of the fiscal deficit and is projected to increase to 7.2 percent for FY2001. Given Pakistan’s overall fiscal deficit (5.8 percent of gross domestic product) the Government has limited resources to keep KESC afloat. The fiscal deficit can primarily be financed through increasing money supply or by domestic and international borrowing. Printing money causes inflation, the burden of which falls disproportionally on the poor. Borrowing crowds out private (and other public) investment, crucial for economic growth and employment generation. Privatization of KESC and restoring financial health in the energy sector will reduce the burden on the Government deficit and induce a more efficient allocation of resources for the economy as a whole.

3 Electricity expenditure for low-income groups is usually 3.0-6.0 percent of income. The unusually high figures for Karachi is most likely due to over-billing of poor consumers. 68 Appendix 8, page 4

Table A8.2: Summary of Expected Impacts of the Energy Sector Restructuring Program Channel Direct Indirect Macro Non-poor Labor • Increased • Increased • Short-term contraction economic economic activity, of unskilled and semi- opportunities and job opportunities, skilled labor in KESC increased and productivity but increased long run productivity employment generation

Prices • Short run: higher prices • Small indirect • Increased costs • Increased expenditure for all consumer impact of tariff to industry due to due to appropriate categories except the increases on goods appropriate billing billing practices poorest, who will gain and services practices from elimination of over-billing

• Medium-long run: lower • More efficient prices as a result of • Small indirect allocation of efficiency gains impact of lower inputs due to input costs correction of relative prices

Access to • Increased • Maintained electricity

Transfers • Lifeline tariffs • Reduced drain of • Reduced budget Government deficit resources • Reduced inflation pressure of government deficit financing

• Reduced crowding out effects on investments

Net impact Direct pro-poor: better access, reduced expenditure on electricity, reduced vulnerability, and increased income earning opportunities Indirect pro-poor: Reduction of government deficit may allow increased allocations to social sectors

Assumptions Direct impacts: • improved billing and collection practices to eliminate corrupt practices • improved meter readings • financial health to improve maintenance and ability to extend services • elimination of theft is efficiently targeted • lifeline tariffs maintained and well targeted • capacity building of consumer groups to represent poor consumers • competition is introduced for efficiency gains

Indirect and macro impacts: • lifeline tariffs not to be financed through government budget • budget savings from the program are largely fungible, with increased allocations to social and other sectors crucial for growth and poverty reduction and/or reduced deficit

Narrative For low-income households consuming more than 50 kWh, the expected impact of a tariff increase is neutral. During the program implementation period, direct and indirect impacts for poor consumers will be monitored under the technical assistance, one crucial component of which will be to increase consumer participation, especially for the poorest segment, in the competitive electricity market

Source: KESC. 69 Appendix 9

ITEMS NOT TO BE PROCURED UNDER THE LOANS

No withdrawals from the loan account will be made for the following items:

(i) goods included in the following chapters and headings of Pakistan’s Customs Coordination Council Nomenclature, Alphabetical Index to the Nomenclature and the Explanatory Notes (English Text), amending Supplement No. 15 Customs Coordination Council, Brussels, Second Edition, June 1978, as on Table A9.

Table A9: Prohibited Items Chapter Heading Description of Items

22 22.03 – 22.10 Alcoholic beverages

24 24.01 Tobacco, unmanufactured tobacco refuse

24 24.02 Tobacco, manufactured (whether or not containing tobacco substitutes)

28 28.50 – 28.52 Radioactive and associated materials

71 71.01 – 71.04 Pearls, precious and semi-precious stones, unworked or worked

71 71.05 – 71.06 Jewelry of gold, silver, or platinum group metals 71.09 – 71.15 (except watches and watch cases) and goldsmiths’ or silversmiths’ wares (including set gems) 71 71.07 – 71.08 Gold, nonmonetary (excluding gold ores and concentrates)

84 84.59 Nuclear reactors, and parts thereof, fuel elements (cartridges), nonirradiated for nuclear reactors

(ii) goods intended for a military or paramilitary purposes or for luxury consumption; and

(iii) pesticides categorized as extremely hazardous or highly hazardous in Class 1a and 1b of the World Health Organization’s Classification of Pesticide by Hazard and Guidelines to Classification 4. 70 Appendix 10, page 1

THE PROPOSED TECHNICAL ASSISTANCE FOR CAPACITY ENHANCEMENT IN THE ENERGY SECTOR

A. Poverty Impact Assessment Component

1. Objective

1. The technical assistance (TA) loan will undertake a poverty impact assessment to monitor and evaluate the impacts of the Energy Sector Restructuring Program (ESRP) on residential and commercial consumers during the implementation period. The monitoring system will serve as a tool for effectively targeting anti-poor practices. It will assess and monitor the distributional impact of the restructuring program with special emphasis on evaluating the direct and indirect effects on the poor and the most vulnerable groups of consumers. The TA for capacity building will identify channels for consumer advocacy, strengthen consumer participation and capacity of consumer group organizations, in particular for the most vulnerable groups, in the competitive electricity market within a consultative framework involving key stakeholders. The TA will design and conduct a public awareness campaign to build consensus for the ESRP.

2. Scope of Work

a. Monitoring

2. The team to develop and conduct monitoring will comprise two international consultants with expertise in qualitative and quantitative methodologies, econometric analysis, and conducting and leading socioeconomic monitoring. About 14 person-months will be required for the implementation of the three stages. The international consultants will be supported by a team of domestic consultants, consisting of a local research organization, with relevant experience from monitoring and poverty assessments. Thirty person-months is allocated for the domestic team.

3. The monitoring team will design and implement the monitoring in close coordination with the Privatization Cell and key stakeholders. They will also be supported, as appropriate, by the Poverty Cell of the Planning Commission and the Pakistan Institute of Development Economics. The consultants’ work will include the following: (i) a full distribution analysis of the consumer base in Karachi Electric Supply Corporation (KESC) and Water and Power Development Authority (WAPDA); (ii) an assessment of the extent and socioeconomic distribution of illegal connections; (iii) consultation with key consumer groups, nongovernment organizations (NGOs), and individual consumers to identify issues for the impact study; (iv) design of a set of quantitative and qualitative indicators for measuring the impact of interventions in the energy sector on households, with particular emphasis on the poor and enterprises; (v) design of the methodologies and framework for gauging the impact before and during the ESRP, and after the privatization of KESC and WAPDA’s units; (vi) conduct of the monitoring in three stages; (vii) identification and assessment of the socioeconomic impact of disruptions and lack of electricity, and current practices in WAPDA and KESC; (viii) assessment of the impacts on economic activity and household welfare of tariffs, including the effectiveness of targeting and sustainability of lifeline tariffs; (ix) identification of mechanisms for reducing vulnerability to billing practices and strengthening consumer participation; (x) recommendations for financially viable mechanisms to finance connection and capital costs for poor households; (xi) after each stage, preparation and conducting of participatory workshops with key stakeholders from departments in WAPDA, KESC, National Electric Power Regulatory Authority (NEPRA), representatives from 71 Appendix 10, page 2 consumer organizations, and nongovernment organizations (NGOs), to present findings of the analysis and identify strategies to enhance accountability, services and measures to deal with vulnerability of poor consumers; (xii) conduct of two follow-up surveys and a distributional analysis of the consumer base to monitor the program implementation; (xiii) based on the data collected by the consultant, assessment of the direct and indirect impacts of the restructuring program, with special attention to poor and vulnerable households; the analysis will include indicators of effects on food expenditure for poor households; (xiv) assessment of the coverage and reliability indexes to assess changes in the distribution of access to and reliability of electricity supply: (xv) distributional analysis of indexes such as subsidies, economic and financial burden, nonmonetary indicators, affordability, total and average capital cost, average variable cost, and capital intensity across consumer categories and income groups; (xvi) assessment of consumer satisfaction with the quality of services provided under the program implementation period; and (xvii) a final report, which will assess the effects of the measures taken to reduce the vulnerability of poor households.

b. Capacity Building for Consumer Participation in a Competitive Electricity Market

4. The team for capacity and consensus building will comprise two international consultants with expertise in participatory methodologies, consensus building, and public awareness programs, preferable from the energy sector. They will be supported by a team of domestic consultants with relevant local experience in participatory methodologies and capacity building for independent consumer organizations. A total of 20 person-months is allocated for the international and 18 person-months for the domestic consultants.

5. The international consultants, in collaboration with domestic consultants, will identify and implement measures to strengthen and promote demand-oriented consumer services for KESC in the competitive electricity market. The capacity building will focus on strengthening the channels for consumer advocacy for the poor and most vulnerable segment of consumers. The terms of reference will include: (i) identifying consumer organizations and evaluating their capacity to represent consumers, especially the most vulnerable groups, in issues relating to electricity supply; (ii) undertaking strategies for strengthening the public awareness and capacity of these organizations to represent the interests of poor consumers (this will include developing training materials, developing promotional public campaigns, conducting participatory workshops for consumers and representatives of consumer organizations, and conducting media campaigns; (iii) advising consumer groups on mechanisms to increase the bargaining power of consumers and helping to design and implement measures to reduce the vulnerability of poor consumers, including training in meter reading and providing information on the billing system; (iv) in consultation with representatives of consumer organizations, KESC, and NEPRA, identifying and strengthening communication channels for consumer advocacy for the competitive electricity market; (v) assisting KESC in strengthening consumer services and measures to reduce consumer’s vulnerability to corrupt billing practices; and (vi) designing and assisting key stakeholders in implementing campaigns for gaining public acceptance of the energy sector restructuring program.

B. Labor Retrenchment and Redeployment Component

1. Objective

6. To help minimize the negative effects on KESC employees resulting from the organization's restructuring arrangements, the second component of the TA will involve: (i) 72 Appendix 10, page 3 problem identification and analysis; (ii) program formulation; and (iii) program implementation and monitoring. The TA will encompass stakeholder consultation and participation in all three phases, and the identification and strengthening of the key institutions involved in ensuring the attainment of the TA's objectives. The TA will be carried out by two individual consultants experienced in applying international standards and best practices in labor redeployment programs and compensation packages to minimize the negative impact of organizational change and structural adjustment at enterprise level. About 20 person-months will be required for the implementation of this TA component.

2. Scope of Work

a. Phase 1: Problem Identification and Analysis

7. By the end of this phase, a detailed report identifying the nature and scope of KESC's retrenchment and redeployment program will have been completed, resulting from ongoing consultations with stakeholders at all levels.

8. The consultants will (i) consult with the Privatization Adviser (PA) with a view to preparing recommendations to guide KESC's labor retrenchment and redeployment program; (ii) identify the key individuals and institutional stakeholders to participate in and to consult with in all phases of the retrenchment and redeployment program; (iii) formulate the consultative processes to ensure that all stakeholders are consulted to the highest possible degree; (iv) specify the scope of the retrenchment and redeployment program by identifying (a) the total number involved; and (b) the disaggregation of this total by age, gender, functional responsibilities, skill levels, years of employment, geographic location, salary, and other factors; (v) identify alternatives to retrenchment within KESC in consultation with the PA; (vi) advise, in consultation with the PA, on a new organizational structure for KESC for the efficient and effective attainment of its objectives, including staff levels, skill requirements, officer-staff ratios, and geographic distribution; (vii) prepare and discuss transparent and objective criteria for determining individual lay-offs, after consultation with stakeholders; (viii) advise, in consultation with the PA, on the establishment of a task force to assist KESC in program formulation and implementation; and (ix) prepare and discuss job descriptions for positions at all levels.

b. Phase 2: Program Formulation

9. By the completion of this phase, a detailed retrenchment and redeployment program will have been formulated and agreed with stakeholders (prior to actual lay-offs).

10. The consultants will prepare a detailed retrenchment and redeployment program based on the new organizational structure proposed by the PA, and agreed for KESC. The consultants will (i) advise on assessing the skill levels of employees identified for retrenchment; (ii) advise on alternative wage and self-employment opportunities by reference to the providers of both public and private employment services (this will include advice on job matching, guidance and counseling, and special employment programs); (iii) advise on training required to secure alternative employment by reference to training providers in both public and private sectors; (iv) advise on the development of diagnostic tools to assess suitability for self-employment and the availability of support services (advice, training, credit, markets) for persons interested in self- employment opportunities; (v) advise on financial packages for voluntary and involuntary retrenchment supported by advice on employment opportunities, and other inputs required for successful implementation of the retrenchment scheme; (vi) prepare a staff development plan to support the new organization, with reference to target groups, objectives, training content and 73 Appendix 10, page 4 methodology, staff appraisal schemes, and other factors directed to ensuring staff development activities are a fully integrated component of organizational performance.

c. Phase 3: Program Implementation

11. By the completion of this phase of the TA, the retrenchment and redeployment program will have been implemented and systematically evaluated.

12. The consultants will (i) advise KESC and help implement financial packages and retraining of persons involved in the program; (ii) design and implement an evaluation instrument to assess the impact of the program; (iii) advise and assist in the implementation of KESC's staff development program; (iv) advise on consultative arrangements to improve workplace cooperation; (v) identify shortcomings in the program and advise on remedial action; and (vi) prepare a detailed report on the overall program with reference to objectives, program elements, outcomes and results, and related indicators; successes and achievements; problems and shortcomings; and conclusions and recommendations for further action.

C. Cost Estimates

13. Table A10 presents the cost estimates and financing plans for both components.

Table A10: Cost Estimates and Financing Plan ( $ ) Item Foreign Local Total Exchange Currency Cost A. Poverty Impact Assessment Component

1. Asian Development Bank Financing a. Consultants i. Remuneration
and Per Diem
International Consultants 730,000 0 730,000 Domestic Consultants 0 340,000 340,000 ii. International and Local Travel 50,000 30,000 80,000 b. Communications 15,000 0 15,000 c. Equipment and Supplies 30,000 0 30,000 d. Data Collection and Computer Assistance 0 20,000 20,000 e. Workshops, Seminars and Training 0 90,000 40,000 f. Media Campaign and Public Advocacy 0 130,000 130,000 Group g. Contingencies 125,000 90,000 215,000 Subtotal (A1) 950,000 700,000 1,650,000

2. Government Financing a. Remuneration and Per Diem of Counterpart 0 275,000 275,000 Staff b. Office Accommodation, Local Travel, and Logistical Support 0 160,000 160,000 c. Contingency 0 65,000 65,000 Subtotal (A2) 0 500,000 500,000

Subtotal (A) 950,000 1,200,000 2,150,000 74 Appendix 10, page 5

Item Foreign Local Total Exchange Currency Cost B. Labor Retrenchment and Redeployment Component

1. Asian Development Bank Financing a. Consultants i.
Remuneration and Per Diem
International Consultants 475,000 0 475,000 International and Local Travel 85,000 0 85,000 b. Communications 20,000 0 20,000 c. Equipment, Supplies and Training Materials 180,000 0 180,000 d. Training and Workshops 90,000 0 90,000 e. Implementation of Program and 0 2,370,000 2,370,000 Compensation f. Contingencies 130,000 0 130,000 Subtotal (B1) 980,000 2,370,000 3,350,000

2. Government Financing a. Remuneration and Per Diem of Counterpart 0 275,000 275,000 Staff b. Workshop Accommodation and Local Travel 0 160,000 160,000 c. Contingency 0 65,000 65,000 Subtotal (B2) 0 500,000 500,000

Subtotal (B) 980,000 2,870,000 3,850,000

Total ADB Financing (A1+B1) 1,930,000 3,070,000 5,000,000 Total Government Financing (A2+B2) 0 1,000,000 1,000,000 Total 1,930,000 4,070,000 6,000,000 Source: Mission and the Government.