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