Document of The World Bank Report No. 14298-IN STAFF APPRAISAL REPORT INDIA ORISSA POWER SECTOR RESTRUCTURING PROJECT APRIL 19, 1996 Energy and Infrastructure Operations Division Country Department II South Asia Region CURRENCY EQUIVALENTS (As of April 1996) Currency Unit = rupee (Rs) Rs 1.00 = US$0.03 US$1.00 = Rs34.5 FISCAL YEAR April I - March 31 MEASURES AND EQUIVALENTS I kilovolt (kV) = 1,000 volts I kilovolt-ampere (kVA) = 1,000 volts-amperes I megawatt (MW) = 1,000 kilowatts = I million watts I kilowatt-hour (kWh) = 1,000 watt-hours I megawatt-hour (MWh) = 1,000 kilowatts-hours I gigawatt-hour (GWh) 1,000,000 kilowatt-hours ABBREVIATIONS AND ACRONYMS ADB Asian Development Bank AES AES Transpower Inc. ERR Economic Rate of Return GDP Gross Domestic Product GRIDCO Grid Corporation of Orissa ICB International Competitive Bidding IDBI Industrial Development Bank of India IFC International Finance Corporation MOP Ministr, of Power NCB National Competitive Bidding NTPC National Thermal Power Corporation ODA Overseas Development Administration OHPC Orissa Hv dro Power Corporation OSEB Orissa State Electricity Board PMU Project Management Unit PPA Power Purchase Agreement PFC Power Finance Corporation POWERGRID Power Grid Corporation of India SEB State Electricity Board The Regulatory Commission Orissa Electricity Regulatory Commission INDIA ORISSA POWER SECTOR RESTRUCTURING PROJECT Table of Contents LOAN AND PROJECT SUMMARY 1. INDIA'S POWER SECTOR.1 Organization and Regulation .............................................1 Central Sector .............................................2 State Sector .............................................2 Private Utilities .............................................3 Grid Operations .............................................3 Power Sector Reform .............................................4 Central Sector Agencies as Agents of Reform ............... .............................4 Private Power .............................................5 State Power Sector Reform ...........................................6 Past Bank Group Operations in the Power Sector ............................................. 9 Bank Strategy in Supporting Power Sector Reform .............................................9 Lending for State Power Sector Reform ............................................ 10 Future Lending to NTPC and POWERGRID ............................................ 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ORISSA'S POWER SECTOR REFORM PROGRAM ............................................ 11 Orissa Power Sector . 11 Bank Involvement in Orissa .12 Upper Indravati Project .................................................................. 12 Power Sector Reform Dialogue .................................................................. 13 Immediate Bank Support .................................................................. 13 Orissa's Power Sector Reform Program .................................................................. 14 The Orissa Electricity Reform Act 1995 (Reform Legislation) ............................ 14 The Orissa Electricity Regulatory Commission .................................................. 14 The Orissa Hydro Power Corporation (OHPC) .................................................. 15 The Grid Corporation of Orissa (GRIDCO) ........................................................ 15 Corporatization and Commercialization .............................................................. 16 Reform Consultation .................................................................. 16 3. THE PROJECT .17 Project Objectives .................................................................. 17 Project Description .................................................................. 17 Part A: Transmission and Distribution ............................................................... 17 Part B: Demand-Side Managemeit .................................................................. 18 Part C: Training and Technical Assistance ......................................................... 19 Environment and Resettlement and Rehabilitation (R&R) ...................................... 19 Cost Estimates ............................ 20 Project Financing .21 Terms and Conditions .22 Procurement and Consulting Services .23 Disbursements .25 Retroactive Financing .25 4. PROJECT IMPLEMENTATION AND OPERATION ........................................... 26 Executing and Operating Agencies ........................................... 26 Implementation of Project Components ........................................... 27 Project Monitoring and Implementation Review ........................................... 29 Project Accounts and Audit ........................................... 29 - 111 - 5. PROJECT JUSTIFICATION ...................................................... 30 Benefits of Power Sector Reform ...................................................... 30 Benefits to Consumers and Orissa Economy ...................................................... 30 Environment ...................................................... 30 Orissa Finances ...................................................... 31 Impact on the Poor ...................................................... 32 The Specter of a Future with No Power Sector .................................................. 32 Economic Viability ...................................................... 33 Risks and Safeguards ............... ; 34 6. AGREEMENTS AND RECOMMENDATION ...................................................... 37 Agreements ...................................................... 37 Specific Financial Objectives to be Achieved by GRIDCO and OHPC ................. 38 Disbursement Conditions ...................................................... 39 Selected Reform Milestones ...................................................... 39 Recommendation ...................................................... 39 - iv - Part 1I - ANNEXES 1.1 Overview of the Indian Power Sector 1.2 Bank Experience in the Indian Power Sector 1.3 Power Sector Reform and Commitment Lending 2.1 Finances of the Orissa State Electricity Board (OSEB) Attachment 1 - Financial Performance Attachment 2 - Transfer of Assets and Liabilities 2.2 Power Sector Development Policy of the Government of Orissa 2.3 Orissa's Power Sector Reform Program Attachment 1 - Investment Program and Financing Plan 2.4 Orissa Hydro Power Corporation (OHPC) Attachment 1 - Organization Chart Attachment 2 - Financial Projections (FY97-2003) Attachment 3 - Assumptions for Financial Projections Attachment 4 - Asset Revaluation Impact 2.5 Grid Corporation of Orissa (GRIDCO) Attachment 1 - Organization Chart Attachment 2 - Financial Projections (FY97-2003) Attachment 3 - Assumptions for Financial Projections Attachment 4 - Asset Revaluation Impact 3.1 Transmission and Distribution Rehabilitation Program 3.2 Load Management/Electricity Conservation Program 3.3 Environmental Assessment 3.4 Schedule of Disbursements 4.1 Institution Building Technical Assistance - Scope of Work 4.2 Management of the Institution Building Program 4.3 Transmission and Distribution Rehabilitation Program - PMU Consultant TOR 4.4 Project Appraisal Criteria 4.5 Project Implementation Monitoring Plan 5.1 Economic Analysis 5.2 Orissa Government - Power Sector Funds Flow 5.3 Risks and Safeguards 6.1 Documents in the Project File MAP IBRD No.26751 - Orissa Transmission System INDIA ORISSA POWER SECTOR RESTRUCTURING PROJECT LOAN AND PROJECT SUMMARY Borrower: India, acting by its President Beneficiaries: Government of Orissa, the Grid Corporation of Orissa (GRIDCO), the Orissa Hydro Power Corporation (OHPC), private distribution companies and electricity end-users. Poverty: Not applicable. Amount: US$350 million equivalent. Terms: Standard variable interest rate for currency pool loans, repayable over twenty years, including a five year grace period. Commitment Fee: 0.75 percent on undisbursed loan balances, beginning 60 days after signing, less any waiver. Onlending Terms: Government of India to Government of Orissa: standard terms and conditions applicable to central assistance to the states at the time, fully additional to Orissa's plan assistance. Government of Orissa to GRIDCO, OHPC, private distribution companies, and electricity end-users: Not less than 13 percent a year rate of interest, repayable over fifteen years with five years of grace period. Government of India would bear the foreign exchange and interest rate risks. Financing Plan: See para. 3.14. Net Present Value: US$345 million (at 12 percent discount rate). Staff Appraisal Report: 14298-IN. Map: IBRD 26751. 1s INDIA ORISSA POWER SECTOR RESTRUCTURING PROJECT STAFF APPRAISAL REPORT 1. INDIA'S POWER SECTOR 1.1 All across India the quality of the electricity supply is poor. Power shortages are estimated at about 10 percent of total electrical energy and 20 percent of peak capacity requirements. Plant availability and efficiency are generally low and there are high system losses throughout India's transmission and distribution networks. The financial performance of the sector as a whole is also unsatisfactory, with low returns and no contribution to investment from internal resources. Commercial losses of the State Electricity Boards (SEBs) furthermore, are rising. They reached the equivalent of about US$2.2 billion in fiscal 1996, or about 0.8 percent of India's GDP. 1.2 Inefficiencies in India's power sector are largely due to the SEBs' lack of managerial and commercial autonomy. Although the Electricity (Supply) Act of 1948 nominally grants the boards considerable freedom of operation, in practice the states have regarded them as extensions of government and have exerted influence over their tariff, operational, and investment decisions to further political objectives. As a consequence, SEBs generally have an inadequate capital structure, low tariffs and poor bill collection, yet are required to undertake unremunerative activities on behalf of the state governments without proper compensation. The Government of India has now recognized that increased emphasis needs to be placed on improving the efficiency of supply, consumption, and pricing of electricity and that this can only be achieved by reforming power sector management and financing at the state level. The organization and regulation of the power sector is discussed below. An overview of the power sector, including electricity consumption, tariffs and supply, is given in Annex 1. I Organization and Regulation 1.3 Responsibility for the electricity supply in India is shared constitutionally between the central government and the states. The Electricity Act of 1910 provided the initial legal framework that still today governs the operations of licensees, that is, the existing private utilities. As amended, the Electricity (Supply) Act of 1948 provides the overall regulatory framework for the sector, charging the Central Electricity Authority (CEA) with developing a national power policy and with planning, coordinating, and regulating sector development. The 1948 Act also empowers the central government (currently the Ministry of Power) to make rules for carrying out CEA's objectives by means of notification in the Official Gazette. The 1948 Act created the SEBs and entrusted them with primary responsibility for public power supply as well as for related state-level regulation. The boards were envisioned as largely self-governing entities empowered to set tariffs and monitor licensees. But after the Industrial Policy Resolution of 1956 defined the aspects of generation and distribution that were the exclusive responsibility of the states, the once-significant role of private utilities gradually diminished. Today, following the 1991 amendments, it is recognized that various sections of the 1948 and 1910 Acts could be modernized, but there are no fundamental legal obstacles preventing private investment from entering into the sector. Central Sector 1.4 Since the 1970s, the Government of India has been actively involved in power development in India to complement the efforts of the states. The Government owns several generating companies (including the National Thermal Power Corporation, NTPC, and the National Hydroelectric Power Corporation). NTPC's growth has been remarkable and it now accounts for about 30 percent of India's thermal generation (Annex 1.1). The Government also owns India's new national transmission company and grid operator, the Power Grid Corporation of India (POWERGRID). These utilities were incorporated under the Companies Act. 1.5 The Ministry of Power (MOP) approves tariff-setting principles for the centrally-owned entities. Tariff proposals are reviewed by the Central Electricity Authority which then sends them to the MOP for notification. Tariffs are determined on a cost-of-service basis and are subject to basic performance standards. The utilities' financial viability is ensured to the extent that their tariff revenues cover operational costs, including debt service. The Government of India also owns two power sector financial intermediaries, the Power Finance Corporation and the Rural Electrification Corporation. 1.6 The Ministry of Non-Conventional Energy Sources administers the Government's renewable energy program, which seeks to meet the decentralized energy needs of rural areas to supplement conventional power supply with such alternative energy sources as mini-hydro, biomass, wind and solar-power systems. The Government provides budgetary resources for demonstration projects and promotes private investment through various fiscal incentives, while the Indian Renewable Energy Development Agency provides institutional financing. State Sector 1.7 The states own the SEBs and State Generating Companies, which together generate almost 70 percent of India's electricity supply and provide most of the distribution to consumers. The 1948 Act explicitly requires the SEBs to operate "in the most efficient and economical manner" and mandates that they adjust their tariffs to achieve a minimum return, after interest, of 3 percent on net fixed assets in operation. The Act, however, allows a state to specify a higher return target for its SEB than the statutory minimum return. Further, it specifies that interest on loans from the state governments is to be paid by the SEBs only after meeting the minimum return. States are, in fact, required to provide subsidies to help the SEBs meet the minimum return requirement, by compensating the SEBs inter alia for low tariffs to residential consumers and for using the SEBs as administratively convenient vehicles for agricultural input subsidies. - 3 - 1.8 For most SEBs, meeting the statutory 3 percent after-interest return would cover operating costs and debt service provided state government subsidies were fully paid on time and bill collection were reasonable. Because of their poor operational performance, low tariffs, and inadequate subsidies, however, most SEBs do not reach the Act's statutory minimum returns. Their aggregate operating losses are in fact rising and have reached alarming levels (Annex 1.1). Operating deficits and capital expenditures are presently financed by borrowing or from state budgetary resources, greatly burdening state govemment finances across India. Private Utilities 1.9 At independence private utilities and licensed local authorities together provided about 80 percent of India's public electricity supply. But when their licenses expired, most licensees were taken over by the SEBs, in line with the 1956 Industrial Policy Resolution. Today, only five of the private utilities originally licensed under the 1910 Electricity Act remain: Bombay Suburban Electric Supply (BSES) and Tata Electric Companies (TEC) in Bombay, Ahmedabad Electricity Company (AEC), Surat Electric Company, and Calcutta Electric Supply Corporation (CESC) in Calcutta. 1.10 Then in 1991 India reversed its long-standing policy on private investment in the sector. Power was removed from the list of activities reserved for the public sector in the Industrial Policy Resolution, and the 1948 Act was amended to lift many of the regulatory disincentives to private investment in the power sector. These changes were fully consistent with the Government of India's objective to tap the financial, technical, and managerial capabilities of the private sector in areas previously restricted to the public sector. 1.11 India now allows full local or foreign private ownership of power companies and offers a thirty-year license with the prospect of twenty year renewals and increased financial returns. Provision is also made in the 1948 Act for private generating companies and captive plants to sell power to the SEBs. Additional incentives were introduced in the Government of India budget for fiscal 1994 included reducing the import duty on power projects to 20 percent and offering new private power projects a five-year tax holiday. These changes have resulted in remarkable business development activity by private developers (para. 1.16). Grid Operations 1.12 Indian utilities are grouped into five regional interconnected power systems in the Eastern, Northern, North-Eastern, Southern, and Western regions of India. In 1964 the Government of India created Regional Electricity Boards to bring the state boards together with the central and joint sector utilities to coordinate system operations in their respective regional grids. It also entrusted the Central Electricity Authority with the development and operation of Regional Load Dispatch Centers to support the regional boards. In 1991, an amendment of the 1948 Act strengthened the authority of the Regional Electricity Boards by requiring generating companies and licensees to follow their instructions. - 4 - 1.13 In 1993, under the POWERGRID System Development Project (Ln. 3577-IN), the central government agreed to transfer the Regional Load Dispatch Centers and their operational responsibilities from the Central Electricity Authority to POWERGRID. The transfer program was implemented on schedule and completed in January 1996. POWERGRID, in cooperation with the SEBs and with Bank support, is implementing projects to develop modem coordination and control systems for the Northern and Southern regions. It has also prepared similar projects for the Eastern, Western, and North-Eastern regions, all expected to go into implementation in the course of 1996. A recently-completed study confirmed the need for further improvements in the structure of bulk power tariffs, and work on the recommended modifications has began under an action plan approved by the central government as agreed under Ln. 3577-IN. Power Sector Reform 1.14 The Government of India recognizes that its economic growth targets will be threatened as long as the country's power supply constrains industrial development and the financial losses of the power sector remain a burden on the public sector finances. Under the constitutionally mandated sharing of responsibilities in the sector, the central government is pursuing a three- pronged approach to remedy the root cause of many of the power sector's problems with efficiency and resource mobilization. The Government of India imposes financial discipline on the SEBs through its central agencies. It also presses the states to adjust their power tariffs and has opened the sector to private investment. In addition, the Government of India has undertaken to support states willing to reform their power sectors. Central Sector Agencies as Agents of Reform 1.15 In India the states' budgetary allocations are set by an automatic allocation formula, making it difficult for the Government of India to condition central assistance to the states. Within this overall budgetary and central assistance framework, the Government uses its own agencies and the private sector to promote operational and financial improvements in the SEBs: * Power Finance Corporation. Supported by the Bank, ADB, ODA and USAID, the Power Finance Corporation (PFC) provides resources only to those utilities that have committed themselves to improve their performance under time-bound Operational and Financial Action Plans endorsed by their state governments and aimed at improving the utilities' resource mobilization, operational efficiency, and commercialization. While the requirements of these action plans are generally modest, several SEBs and states have found them difficult to comply with. As a result, the PFC has had to restrict in its operations, and its impact on the state power sector has fallen much below original expectations. The PFC is nevertheless promoting minimum improvements (para. 1.20) that are immediately required and thereby contributes to India's overall sector reform. * New collection and sanction policies. NTPC's and POWERGRID's new investment and commercial policies allow NTPC, India's main generating utility, and POWERGRID to shut off or restrict power and defer future investment if their clients are in default of their bulk supply agreements. These strictures are designed to promote better commercial - 5 - discipline in the SEBs, and also to improve NTPC's and POWERGRID's revenue collection and overall operational and financial performance. Since 1994, NTPC and POWERGRID have - with considerable determination and success - applied these new investment and commercial policies agreed with the Bank under two major 1993 lending operations. Providing additional central sector power to performing states and withholding it from defaulters is a powerful instrument to promote financial discipline and an absolutely necessary (though not by itself a sufficient) incentive for the states to undertake sector reform. (For NTPC's and POWERGRID's recent performance, see Annex 1.2). * POWERGRID. India's power transmission and system operations are going through an extensive restructuring program with active Bank support. POWERGRID is being developed to improve the efficiency of the transmission sector, encourage private generation, and facilitate competition in power generation among both generators and their clients. After initial difficulties, POWERGRID's institutional growth has been remarkable and its role in India's power sector is now widely accepted and supported. POWERGRID has also been able to attract funding to support its ambitious investment program to reinforce the power system and develop modem coordination and control systems, breaking past patterns of chronic under-investment in transmission and system operations. The next set of development challenges are being addressed as a part of the preparation of the proposed follow-up Bank operation, POWERGRID II. Private Power 1. 16 In 1991, faced with a growing power gap and diminishing public resources available for the sector, the Government of India opened the power sector to private sector participation in generation, transmission, and distribution (paras. 1.10-11). These policy changes and high-level promotional efforts were successful in encouraging power projects. So far, about 250 proposals for adding almost 100,000 MW of capacity have been received. But despite substantial interest, exploratory activity, and numerous Memoranda of Understanding (MOU) with private developers, only a few agreements have been finalized. 1.17 Most of the MOUs have to be regarded merely as expressions of interest. Some, however, give specific sponsors exclusive rights to pursue investors and developers to their projects and sites. Eight projects are at an advanced stage, with power purchase agreements signed and the extension of counter-guarantees approved by the Government. Only two counter- guarantee agreements have so far been finalized. ENRON's Dabhol power project in Maharashtra proceeded to financial closure but then became the focus of controversy and continues to receive international attention. Project implementation is expected to resume shortly. The lb power project of the AES Transpower in Orissa (para. 2.2) was also expected to reach financial closure in 1995, but its power purchase agreement was opened for renegotiations in mid-1995 between the developer and the state government that took office in Orissa in March 1995. Negotiations are expected to be concluded during 1996. - 6 - 1.18 Progress in the finalization of various private power projects has been slow, partly because of such policy and regulatory issues as the setting up of collection and exchange rate safeguard mechanisms and import tax and duty concessions, the cumbersome administrative processes involved in securing project clearances, and often insufficient preparatory work to make project proposals bankable. Recent changes in state governments have highlighted the political dimension of private power development. The fundamental reason for the slow progress is, however, the poor financial position of most SEBs. 1.19 The Government of India has so far resisted pressures to provide all-encompassing guarantees and has so far limited its support to pioneer projects in states that meet its basic performance criteria, that is, are essentially in compliance with the PFC's Operational and Financial Operation Plan conditions. While progress is expected to remain slow, increased reliance on the private sector should help to improve financial discipline and promote reform, since private investment, in the absence of further central government guarantees, will only go to states with an attractive policy environment and a financially sound power sector with creditworthy utilities. State Power Sector Reform 1.20 The states' severe power sector problems are attributable to the SEBs poor operational efficiency which is largely caused by the state governments' political interference. Immediate minimum actions to restore a measure of financial viability would include: * Financial restructuring to establish a reasonable debt equity structure and satisfactory financial objectives (including an increase in internal cash generation to make a reasonable contribution to future investment) for the SEBs. * Tariff adjustments to meet these revised financial objectives. # Improvements in metering, billing and collection - and in payments to and enforcement by the central utilities. * Shifting investment away from supply expansion (new generation) to focus on efficiency (plant and power system rehabilitation and reinforcement). * Contracting private companies or NTPC to rehabilitate and operate poorly performing stations and other facilities and services. 1.21 While the PFC's Operational and Financial Action Plans typically include some of these items, the Bank's experience in India's power sector suggests that minimum actions by themselves will not be sufficient. To be sustainable, the solution to the management and performance problems in the state power sector will have to go beyond the revitalization of SEBs and - 7 - encouragement of private sector participation in power generation. State power strategy will also have to include: * Privatization of power distribution, either by sale or long-term lease-management contracts. While theoretically possible, it is very difficult to introduce, in the public sector at the state level, the required management and operational autonomy and performance incentives, that are essential to successfully address the fundamental issues in power distribution in India. Private sector participation in generation is required, but by itself is unlikely to solve India's power problems. * Corporatization of the remaining SEB utility operations, if any, under the Companies Act and substantial private sector participation in utilities with government ownership interests. Sufficient operational autonomy is unlikely with 100 percent government ownership and may in practice in many states require majority private ownership. Corporate unbundling, i.e. separation of generation, transmission and distribution into separate companies (even if initially publicly-owned) should also be considered while the sector is still fully under government ownership. Once the ownership is diversified, further power sector restructuring becomes even more complicated. Experience from other countries demonstrates that reliance of functional unbundling places additional requirements on sector regulation, complicates market structures and may result in difficulties in ensuring sufficient future investment particularly in transmission. * Electricity tariff reform that both raises tariff revenues and introduces a tariff structure that will reduce cross subsidies (with significant increases in agricultural and residential tariffs) and promote efficiency in electricity use. Given the inability of most state governments to provide large amounts of subsidies, electricity consumers will have to bear the cost of power supply. * Establishment of a regulatory commission, separate from the state government. Given the track record of state governments in controlling their SEBs, a new and more transparent approach to regulate the power industry is required, to ensure the sustainability of tariff reform and viability of utilities meeting the regulatory commission's performance standards, inter alia to attract sufficient private investment and protect the interests of consumers. 1.22 The Government of India has concluded that drastic measures along these lines are required to redress these management and performance problems in the state power sector, and its power sector strategy is designed to encourage states to adopt such measures. But it is the states that will need to take these decisions and implement the reforms. 1.23 Seeking to support states willing to reform their power sectors, the Central Government has sought Bank assistance. A collaborative Government of India-Bank initiative was therefore formally launched by the MOP in 1993, during the Conference on Power Sector Reforms held in Jaipur in October 1993. Two follow-up seminars have since been organized, one on competitive bidding for private generation in Hyderabad in June 1994 and another on privatization of power - 8 - distribution in June 1995 in Bangalore. MOP intends to organize a follow-up seminar on restructuring and related institutional and legal matters during 1996, focusing inter alia on Orissa's pioneering reform effort, and another seminar on competitive bidding is under discussion. 1.24 In 1993, the Government of India had requested that Cr. 1356-IN be extended to provide immediate financing for Orissa's reform program. The Government also sought assistance for other states from the Project Preparation Facility (PPF). In response to that request, PPF advances have been approved and utilized to help prepare power sector restructuring projects in Bihar, Haryana, Rajasthan, and Uttar Pradesh. A restructuring study has been completed in Haryana in 1995 and an initial tariff adjustment of about 20 percent has been implemented. In January 1996 the Government of Haryana adopted a power sector policy which incorporates the key reform elements outlined in para. 1.21 and is in the process of building up its reform implementation organization. A similar restructuring study was recently completed in Uttar Pradesh. Implementation decisions are expected in mid-1996. Two more studies - one underway in Rajasthan and another about to start in Bihar - are due to be completed in 1996. 1.25 The proposed Orissa Power Sector Restructuring Project is the first in a planned series of Government of India-sponsored and Bank-financed state power sector restructuring projects supporting states willing to undertake fundamental reforms, inter alia involving significant private distribution, corporatization, tariff reforms and independent regulatory commissions (para. 1.21) in addition to encouraging significant private sector participation in power generation. The Orissa power sector reform program goes even further by: (a) splitting the SEB into separate generation, transmission, and distribution companies to effect complete corporate unbundling; and (b) transferring Orissa's distribution system to private distribution companies by the year 2000. 1.26 India's state governments have clearly acknowledged the problems with state-run utilities in such national forums as Power Ministers' Conferences and in the pro-reform draft reports produced by the power committee of the National Development Council. But so far action towards actual reform has been limited. The committee report remains to be finalized, as consensus about its reform-related recommendations is reportedly lacking. 1.27 Not surprisingly, states that have the weakest SEBs are the most willing to consider the radical reform of their power sectors. They can be logically expected to be among the first to conclude that an incremental approach of attempting to revitalize their SEBs is unlikely to bring about sustainable improvement, brought about by the realization of the magnitude of the power challenge and the inability of the public sector-SEB monolith structure to raise financing and deliver in the long term. States with better-performing SEBs feel less immnediate need to reform while several others are simply unable to take action. Indications of Andhra Pradesh and Gujarat reviewing their reform options are encouraging signs of states with better-performing SEBs starting to look ahead. 1.28 Only time will tell whether or not the Government of India's efforts to develop and maintain nation-wide momentum for radical power sector reform will be successful. But, since it is unrealistic to expect all states to reach political consensus at the same pace, progress in sector restructuring and tariff and regulatory reform is likely to be uneven. This will lead to widening - 9 - differences in power demand and supply among states and regions during the next decade, and could create severe problems with regional grids with adverse consequences not only for non- reforming states but also for all interconnecting state and central utilities. Past Bank Group Operations in the Power Sector 1.29 Over the 1980s and up to the early 1990s, IBRD followed a three-pronged strategy in its lending to the power sector in India. It supported Government-owned agencies - NTPC in particular - as a means of effecting sector-wide improvements. It financed a selected number of SEBs whose management and state governments appeared to be committed to revitalization, improving their performance in a gradual fashion. In cooperation with IFC, it financed existing private power utilities and encouraged the Government to lower entry barriers for new investors. 1.30 The success of this strategy has been uneven, reflecting fundamental sectoral weaknesses. Operations with central and private utilities have been generally successful; state-oriented activities have not (Annex 1.2). IBRD tried vainly to improve the performance of SEBs by developing close lending relationships directly with the SEBs. The revitalization of institutionally and financially weak SEBs did not turn out to be feasible. Projects in such states failed to meet expectations beyond the physical construction of facilities and the Bank was forced to take such strong measures as suspending disbursement and subsequently canceling loans. SEBs generally failed to respond to Government generated initiatives and there was no effective mechanism to enforce compliance or elicit their cooperation, even when they failed to pay for central sector electricity. It has become painfully clear that a sustainable solution to the sector's problems will have to focus on SEBs and cannot resolve the power crisis through central and private sector generation capacity additions alone. Bank Strategy in Supporting Power Sector Reform 1.31 The country assistance strategy discussed by the Board on June 20, 1995 emphasizes continued Bank support for the stabilization and economic reform program started by the Govemment in 1991. It recognizes the need to encourage broad-based private sector-led growth and the increasing importance of private market-financing as a means of fueling this growth. Now, following the achievement of many central Government objectives of macro reform, Bank's country assistance strategy has shifted its emphasis to implementing state-level reforms and improving state finances. The Bank accordingly supports India's attempts to reform the state power sector, especially since the pace of state power sector reform affects the sustainability of the country's overall economic stabilization program. Power sector lending would therefore focus on promoting domestic and foreign private investment; supporting the reform efforts of the PFC, NTPC and POWERGRID; and assisting states to implement credible plans to improve the performance and finances of their power sector. 1.32 On June 29, 1993, the Board of Directors reviewed the Bank's power sector lending strategy while discussing the NTPC Power Generation Project (Loan 3632-IN). A update memorandum was issued in March 1994 outlining recent developments regarding progress toward reform at the state level (including preparatory work on state power sector restructuring - 10- programs); implementation of the Government of India's new private power policy; and NTPC's and POWERGRID's performance in the implementation of Bank-supported projects approved during the first half of 1993. Chapter 1 of the present report provides an update through mid- 1996 of the implementation of the strategy in these same key areas. 1.33 The Government's actions through NTPC, POWERGRID and PFC, the opening of the power sector to private investment and its new state power sector restructuring program demonstrate a clear commitment to reform. As detailed in Annex 1.2, NTPC and POWERGRID are generally implementing their Bank-supported projects in a satisfactory manner though bill realization from a few SEB clients needs improvement. The private sector is also responding to Government of India's private power policy, and eight pioneer projects are progressing towards implementation. The Government supports policies for effective institutional, regulatory and financial restructuring that conform to guidelines for Bank lending to the power sector set forth in the policy paper "The World Bank's Role in the Electric Power Sector" (1992). Annex 1.3 measures India's reforms against Bank guidelines and discusses possible further Bank support for both center and state reform in the context of these recommendations. Lending for State Power Sector Reform 1.34 Notwithstanding the progress made, the reform process in the power sector has only just begun, and much remains to be done - particularly at the state level - to reverse the old unproductive trends. India today needs to take actions to improve the quality of its fiscal adjustment. There has been, for instance, virtually no adjustment in the states' fiscal deficits, which presently constrain the flexibility in central Government's ability to make grants and loans to the states. The Government's fiscal deficit could be reduced more rapidly if the states were able to mobilize resources and cut expenditures more rapidly. By cutting subsidies and reducing public spending in the power sector - an area where the private sector can readily take over - state power sector reform would promote fiscal adjustment at the state. The proposed project demonstrates how significant and rapid this adjustment could be (paras. 5.4-7). 1.35 The proposed project is the first in a planned series of Bank state power sector restructuring projects to support state power reforms following the series of relatively unsuccessful SEB operations of the 1980s. The project is the first concrete breakthrough in the protracted dialogue of recent years and was processed in coordination with the IFC, which supports the reform program by helping finance Orissa's first private power generation project under an operation approved in July 1994. Preparatory work on similar projects under Government's state power sector restructuring program is under way in several other states with Bank support (para. 1.24). The timing and number of follow-up operations will depend on the states' willingness to undertake restructuring of their power sectors and to develop a transparent regulatory regime. But it is not likely that many states will be able to reach political consensus and will therefore face continuing deterioration in power supply. The Bank will not finance or guarantee power sector investments in such states. 1.36 The Bank's lending program would provide a forum to continue the dialogue on state power sector reform as well as some of the incentives needed to help states make tough decisions. - 11 - The guarantee authority will be used with the same underlying objectives, and will be limited to reforming states. Although the Bank will continue to use the existing portfolio to support these reforms, this route has been taken to its limits at the state level. After the loan closings and related actions in recent years, significant exposure is now limited to the state of Maharashtra. Future Lending to NTPC and POWERGRID 1.37 NTPC and POWERGRID are contributing to India's overall reform effort directly by providing additional generation capacity and improving transmission and system operations and indirectly by investment and commercial policies that promote SEB improvement. Further Bank support to both is therefore envisaged: * To NTPC to help it increase the supply of electric power and to improve the environmental performance of its power stations. NTPC has demonstrated its capabilities in project implementation and has shown increasing willingness to address environmental and resettlement and rehabilitation issues. * To POWERGRID to help it develop system coordination and control facilities and create a national power grid, to pursue the further reform of bulk power and transmission tariffs and to facilitate financially, commercially, environmentally and operationally sound private power development in large, multi-state mega power projects. 1.38 Bank assistance to NTPC and POWERGRID is premised on their applying their investment and commercial policies. Possibilities for using the Bank's guarantee authority will also be explored in connection with future operations. The Bank could, for instance, assist NTPC in establishing joint ventures with private domestic and foreign investors and could assist POWERGRID in facilitating private sector mega power projects and providing related transmission. 2. ORISSA'S POWER SECTOR REFORM PROGRAM Orissa Power Sector 2.1 At the end of 1995, the installed power generation capacity in the Orissa power system was about 3,000 MW, consisting of about 1,700 MW divided among five plants owned and operated by the Orissa State Electricity Board (OSEB) and the Department of Energy of the Government of Orissa, a 420 MW coal-fired plant just commissioned in lb Valley by the state- owned Orissa Power Generation Corporation (OPGC), 725 MW in two large industrial captive power plants (of which about 100 MW output is being sold to OSEB), and 115 MW in a joint Andhra Pradesh/Orissa hydroelectric power plant (of which Orissa's share is 34 MW). 2.2 OSEB's operational performance has been among the poorest among all state electricity boards (SEBs) in India. In early 1990s, thermal plant efficiency and availability were low and - 12 - technical and commercial system losses exceeded 40 percent. Until very recently, moreover, the chronic lack of funds has prevented OSEB from undertaking rehabilitation projects to reverse this situation. While still less than satisfactory (details are given in Annex 2. 1), OSEB's financial performance in recent years compares more favorably with that of most SEBs, reflecting substantial tariff adjustments, Government subsidies and improvements in billing and collection. OSEB has also been able to secure funds from the Power Finance Corporation (partly originating from ADB and ODA) and the Bank to initiate measures to improve Orissa's power system and has contracted AES Transpower, a private United States power developer, to build two additional 250 MW units at Orissa's lb power station. 2.3 Orissa has about 1.3 million customers. Industries account for about 54 percent of the total electricity consumption and their share would be even higher without supply limitations OSEB has imposed on them in past years. Residential consumers account for about 26 percent and agriculture 6 percent, of the state's total electricity consumption. Power shortages in Orissa have in the past exceeded the all-India averages (para. 1. 1). The situation has improved considerably with new capacity and currently the inadequate transmission and distribution system rather than generation capacity prevents the potential demand to be supplied. Additions at Ib, the 600 MW Upper Indravati hydroelectric station (para. 2.5) and the increasing supply to Orissa from NTPC's projects in the Eastern region (including two 500 MW Talcher units supported under Ln. 2845-IN and the rehabilitated ex-OSEB Talcher) would double the generation capacity available for Orissa by 2000 from fiscal 1995. 2.4 But both the Government of Orissa and OSEB recognized that these generation capacity additions, though a major achievement, will not in themselves be sufficient. They have therefore initiated a comprehensive program of reforms to address the fundamental problems with sector management and financing and to correct power system weaknesses. Successful completion of the reform program would eliminate power cuts and supply restrictions by 2000, and Orissa could achieve sustained power development for its own needs and export, supported by its vast coal and significant hydroelectric resources. Bank Involvement in Orissa Upper Indravati Project 2.5 Bank involvement in the Orissa power sector goes back to the early 1980s, to the preparation and approval in June 1983 of Cr. 1356-IN and Ln. 2278-IN for the 600 MW power component of the Upper Indravati multipurpose hydroelectric project. The project, however, experienced severe difficulties in part due to poor management and in part due to a natural disaster in July 1991. In 1991 the Orissa government agreed to drastically reorganize the Upper Indravati Project's management and implementation strategies, including those related to resettlement and rehabilitation of persons to be displaced by the project, in return for continued Bank support for the project. Since substantial disbursements could be justified only after the project reorganization and reactivation, the Bank canceled the still completely unused US$156 million Ln. 2278-IN in December 1991. - 13 - 2.6 Reorganization of the Upper Indravati Project turned out to be a painstaking endeavor, taking substantially longer than expected. But while the reorganization process was finally substantially completed, a procurement technicality first prevented Bank financing of a balance-of- works contract replacing terminated non-performing contractors and then various primarily environmental concerns (inter alia sedimentation control and mitigation at the power station and reservoir, penstock construction, and the mitigation of potential environmental impacts caused by an irrigation emergency bypass) led to further requirements to be met prior to Bank funding for the remaining items. Bank funding had to be deferred and delinked from the proposed Orissa Power Sector Restructuring Project. In the meantime, Cr. 1356-IN was depleted in March 1995. The forthcoming Implementation Completion Review for Cr. 1356-IN will document the Upper Indravati experience in detail. The completion of the Upper Indravati project was threatened by the lack of funds up to March 1996, when Orissa secured Rs 3,200 million completion financing from PFC. In conclusion, it must be noted that in spite of the extra-ordinary problems and delays, the project is still projected to provide power at a highly attractive rate (at less than 50 per cent of the cost of electricity from new base-load thermal stations) and remains a priority component in the Orissa/Eastern region power system. OHPC's challenge is to realize this potential by completing the Upper Indravati project, for which it now has the necessary funding. Power Sector Reform Dialogue 2.7 Since 1992 the Government of Orissa, OSEB and the Bank have discussed the issues and a variety of possible solutions to Orissa's fundamental power problems. In 1993, the Government of Orissa and OSEB agreed upon a power sector reform program - which involves substantial privatization and complete separation of the power sector from direct government control - as the logical conclusion to these deliberations. The Orissa government's commitment to power sector reform was formally conveyed to the Bank by Orissa's chief minister in a letter in November 1993. The reform program was formally approved by Orissa's Council of Ministers in April 1994 and has since been endorsed by the new state government, which took office in Orissa in March 1995. On April 20, 1995, the Orissa government issued a formal statement of its power sector policy (an updated April 4, 1996 version is attached as Annex 2.2). Events triggering the use of remedies of the Bank under the proposed project include those which shall make it improbable that the provisions of the policy statement, or a significant part thereof will be carried out. Immediate Bank Support 2.8 Well before the proposed new Bank loan, implementation of the reform program had already started. The Orissa government and OSEB have taken measures to improve OSEB's operational and financial performance and creditworthiness. As requested by the governments of India and Orissa, the closing date of Cr. 1356-IN was extended at the end of 1993 by one year and again at the end of 1994, to June 30, 1995 for immediate support for this program in fiscal 1994 and 1995, including the establishment of a reform implementation organization and financing of consultants to help the Orissa government launch the program. The Bank has also assisted the Orissa government efforts to raise financial and technical assistance from ADB, ODA and PFC. - 14 - Orissa's Power Sector Reform Program 2.9 Orissa, as a pioneer among the states in India, has decided to restructure and substantially privatize its power sector. The Orissa government's ultimate objective is to withdraw from the power sector as an operator of utilities and to have competing, privately managed utilities operating in an appropriately-regulated power market. The power sector industry and market structures established under this reform program have been defined to reach this objective with no further institutional restructuring, and significant private sector participation will be required. 2.10 Orissa's power sector reform program (Annex 2.3) involves: (a) the unbundling and structural separation of generation, transmission, and distribution into separate services to be provided by separate companies; (b) private sector participation in the new hydroelectric generation and transmission utilities, the Grid Corporation of Orissa (GRIDCO) and the Orissa Hydro Power Corporation (OHPC); (c) privatization of thermal generation and distribution; (d) competitive bidding for new generation; (e) the development of an autonomous power sector regulatory agency, the Orissa Electricity Regulatory Commssion; and (f) reforming of electricity tariffs at the bulk power, transmission, and retail levels. The Orissa Electricity Reform Act, 1995 (the Reform Legislation) 2.11 New legislation, the Orissa Electricity Reform Act, 1995 (Orissa Act 2 of 1996), had to be enacted to: (a) establish in law a state-level regulatory commission independent of the state government and power utilities; (b) effect the asset, liability and staff transfers from the Orissa government and OSEB to GRIDCO and OHPC; and (c) transfer the statutory duties allocated to OSEB under the 1948 Electricity (Supply) Act (including the basic obligation to serve) to the Regulatory Commission, GRIDCO, and the distributors. 2.12 The Act was passed by the State Assembly in November 1995, notified in the Official Gazette in January 1996 and became effective on April 1, 1996. The Act establishes the Regulatory Commission and defines its functions, provides for the licensing of transmission and supply of electricity, and provides for the Government of Orissa to restructure Orissa's power sector and vest in companies licensed by the Commission certain assets, rights, and liabilities of OSEB. Events triggering the use of remedies of the Bank under the proposed project include those which make it improbable that the provisions of the Government's power sector policy statement or the Act, or a significant part thereof will be carried out. The Orissa Electricity Regulatory Commission 2.13 The Orissa Electricity Regulatory Commission is an autonomous authority responsible for the regulation of the power sector. The structure selected for the Regulatory Commission is a three-member commission with necessary support staff. Its objective is to help ensure the operational, managerial, and financial autonomy of the new utilities in Orissa's power sector, to promote transparency, efficiency, and economy; and to help Orissa attract private capital for power sector development while safeguarding the interests of consumers. Under the new Act, both GRIDCO and the distributors function as licensees and will be regulated by the Commission - 15- in the performance of their statutory and license obligations. At negotiations, agreement was reached that disbursements under Part A of the proposed project will commence only after the Regulatory Commission has been formally established in a manner satisfactory to the Bank, requiring inter alia that the three commissioners and the Commission's initial staff are in place and the first set of regulations have been adopted and notified by the Commission. The Orissa Hydro Power Corporation (OHPC) 2.14 The hydroelectric stations earlier owned and run by the Orissa government and OSEB are owned and operated by OHPC from April 1, 1996 as per the Orissa government's transfer order under the new Act. OHPC's operations and organization; institutional development, staffing and training; private sector participation; investments; and finances are detailed in Annex 2.4. 2.15 OHPC is initially owned by Government of Orissa. During negotiations, agreement was reached that OHPC will list its shares and the Government of Orissa and OHPC will offer them for sale to the public in accordance with a program and timetable satisfactory to the Bank. 2.16 New thermal generation capacity will also be developed by the private sector. The first private power project is expected to reach financial closure during 1996 and a competitive bidding process for the second project is underway. The sale of Talcher, OSEB's only existing thermal station, to NTPC was approved in June 1995. OPGC's Ib units 1-2 are to be privatized, most likely through the sale of the majority of OPGC's shares to private investors. The first disinvestment, about 20-30 percent of the Government's stake in OPGC, is expected during fiscal 1997. Just like OPGC, also OHPC and individual private generating companies will function as generating companies under the 1948 Electricity (Supply) Act. The Grid Corporation of Orissa (GRIDCO) 2.17 GRIDCO is responsible for transmission, coordination of system planning and operations and initially, distribution and bulk power procurement, from April 1, 1996 as per the Orissa government's transfer order under the new Act. GRIDCO is also the main executing agency of investments supported under the proposed project. Its operations and organization; institutional development, staffing and training; private sector participation; distribution privatization program; investments; and finances are detailed in Annex 2.5. 2.18 Distribution privatization is a key feature of the reform program. At negotiations, agreement was reached that GRIDCO will gradually transfer its distribution system to private distribution companies in accordance with a program and timetable satisfactory to the Bank. A distribution operations agreement covering three of Orissa's ten distribution circles is about to be signed with a private distribution company, an agreed disbursement condition. It leaves seven more circles to be transferred in stages during project implementation. GRIDCO has a mandate to privatize its distribution operations by the end of 2000. 2.19 GRIDCO purchases power from OHPC and other generating companies under Power Purchase Agreements and sells in bulk to its own distribution divisions and to the emerging four - 16 - new private distribution companies, which are also allowed (and in future are expected to be able) to buy directly from the generators. 2.20 GRIDCO is initially owned by the Government of Orissa, which will attempt to attract private sector participation. At negotiations, agreement was reached that GRIDCO will list its shares and the Government of Orissa and GRIDCO will offer them for sale to the public in accordance with a program and timetable satisfactory to the Bank. Corporatization and Commercialization 2.21 GRIDCO and OHPC were incorporated under the Companies Act, 1956, on April 20 and 21, 1995, respectively and became full-fledged utilities with the transfer of assets on April 1, 1996 under the new Act. Their boards of directors and management were appointed in the course of 1995, including significant non-government representation on the boards and externally-recruited functional directors in the areas of finance, commercial and human resources development. Corporatization agreements were signed in March 1996, to further spell out the respective responsibilities of the Orissa government and its two new utilities. In essence, the Government reiterated and fleshed out its earlier policy decisions to stay out of their day-to-day management and give GRIDCO and OHPC management and operational autonomy as commercial organizations. Events triggering the use of remedies of the Bank under the proposed project include amendments to their memoranda and articles of association and corporatization agreements which would materially and adversely affect the operations or financial condition GRIDCO or OHPC or their ability to carry out the project. 2.22 GRIDCO's and OHPC's tariffs are set so as to enable them to earn returns comparable to those allowed to private investors in the power sector and make reasonable contributions to the financing of their investments from internal cash generation. Upon transfer, assets were revalued at their estimated depreciated replacement cost, raising the historic value of GRIDCO's transmission and distribution assets by over 200 percent and OHPC's hydro assets by over 300 percent. These are path-breaking decisions - SEBs have never been permitted to revalue their fixed assets and earn commercial returns - to put GRIDCO's and OHPC's tariffs and finances on a sound basis and will subsequently, at the time of privatization, enable the Orissa government to realize a more realistic value for its past investments. They also help eliminate GRIDCO's and OHPC's dependence on budgetary support from the state government. Reform Consultation 2.23 Orissa's power sector reform program has been prepared in consultation with the management, staff and labor unions of OSEB. Consultations with the public at large have taken place through the forum of the Orissa State Power Consultative Council, which brings together the state government, OSEB, and its main consumer groups. A comprehensive public information campaign is also underway. Following the enactment of the reform legislation and the establishment of the Regulatory Commission, public consultation will be continued, inter alia by the Regulatory Commission through its new Commission Advisory Committee and direct hearings. - 17- 3. THE PROJECT Project Objectives 3.1 The proposed Orissa Power Sector Restructuring Project would assist Orissa in: (a) implementing a program of regulatory, institutional and tariff reforms in its power sector; (b) supporting the institutional development of GRIDCO, OHPC and the new Regulatory Commission established under the reform program; (c) reinforcing and rehabilitating Orissa's power system and its demand-side management to make power supply and consumption more efficient; and (d) upgrading the power sector's environmental performance and strengthening the environmental management capabilities of the new utilities. Project Description 3.2 Part A: Reinforcing and Rehabilitating the Transmission and Distribution Systems and Developing Private Power Distribution. The proposed project would support GRIDCO and private distribution companies in carrying out programs to rehabilitate Orissa's transmission and distribution system and reduce system losses in fiscal 1997-2003. 3.3 Part B: Demand-Side Management (DSM). The project would support GRIDCO's and the electricity end-users' programs to carry out a state-wide metering and other DSM investments. (For the purposes of this project, demand-side management is defined as identifying and implementing initiatives that improve the use of power supply capacity by changing patterns for demand). 3.4 Part C: Institutional Development, Training and Technical Assistance. The project would assist Orissa in implement its power sector reform program and support the institutional development of GRIDCO, OHPC and the Regulatory Commission. Part A: Rehabilitating Orissa's Transmission and Distribution Systems and Developing Private Power Distribution (US$599 million of the project's US$740-million base cost). 3.5 Investments under Part A of the proposed project would be used to rehabilitate Orissa's transmission and distribution system and to reduce the current high level of system losses, objectives in line with the reform program to develop commercially viable, efficient utilities. 3.6 OSEB/GRIDCO staff, the Planning Working Group of the Reform Implementation Organization, and Orissa's consultants have prepared a ten-year investment plan for the Orissa power sector (Annex 3. 1). The project would support the implementation of the plan by funding the transmission and distribution projects included in the fiscal 1997-2003 time-slice of the plan. These projects cover 400, 220, and 132 kV transmission lines and substations; 33 kV, I I kV, and 0.4 kV subtransmission and distribution lines; and substations, capacitor banks, and implementation of a program for the reduction of non-technical losses. By funding the rehabilitation of the transformer workshops, laboratory equipment, vehicles, and a portion of its initial working capital - 18 - requirements, (such items as spares and stocks), Part A of the Project also supports the establishment of GRIDCO. Part B: Demand-Side Management (US$97 million base cost). 3.7 Demand-side management initiatives to be implemented under the Project would involve a mix of pricing reform, metering, and other load management and conservation strategies designed to increase the incentives to use electricity more efficiently: * The level of electricity tariffs has already been raised significantly, for the fifth time in three years in November 1995. The Regulatory Commission is being established and financial covenants on OHPC and GRIDCO would be incorporated in the loan agreement to help maintain proper tariff levels in the future. * The structure of electricity tariffs has already been improved and future adjustments would continue Orissa's the program of structural improvements to contain cross-subsidies and give consumers more accurate signals about the cost of supply at peak and off-peak. Once the required time-of-day meters (already purchased) are installed under the proposed project, time-of-day tariffs would be introduced for large industrial consumers. * The reform legislation and licenses require GRIDCO and the new distribution utilities to promote more efficient use of electricity by their consumers (Annex 2.3). The Regulatory Commission will enforce this new regulatory obligation. * Under the part B of the Project, a program of metering and other investments would be implemented. Considerable potential exists to improve the efficiency of power supply and consumption in Orissa through better load management and electricity conservation. The majority of OSEB's consumer meters inherited by GRIDCO are defective and would be replaced as the first step of the investment program under Part B. The Metering Working Group has prepared a US$50 million metering program, which would cover about 13,600 meters for grid substations and other system requirements and for the largest consumers, about 27,500 three-phase meters for other large consumers, and about 600,000 single- phase meters for small consumers. Advance procurement started in 1994, first contracts were awarded in mid-1995. * Promising specific load management and conservation investments have also been identified and are being prepared. These include: load management and power factor compensation in industries; industrial cogeneration in sugar, chemicals, and metallurgical units; vapor absorption refrigeration in hotels and commercial offices; rewinding of motors; and municipal water pumping. Part B of the project would support the implementation of the first batch of these investments and similar projects by GRIDCO and electricity end-users (Annex 3.2). - 19 - Part C: Institutional Development, Training and Technical Assistance (US$44 million base cost). 3.8 Part C of the Project involves several interrelated components to support the implementation of the reform program as well as the development of GRIDCO, OHPC and the Regulatory Commission and the training of their staff. The main components (and consultant contract values) are listed below. (The status of consultant recruitment is discussed in Chapter 4). * The Reform Consultant (under a US$13.3 million contract) is helping (since 1994) the Govemment of Orissa to implement its power sector reform program. Phase I of the consultant's services has already been completed. The focus of phase 2 work is on the Regulatory Commission, distribution privatization, competitive bidding for new generation, and the operationalization of the new decentralized industry and market structures (Annex 2.3). * Institution building consultants (under a US$6.8 million contract) are supporting (since 1995) the development of GRIDCO and OPGC (para. 4.2 and Annex 4.1). * Project management and engineering and environmental services would be provided for the implementation of Parts A and B (under a contract estimated at about US$8.0 million). * Two additional technical assistance activities have been prepared and would be implemented under Part C. They are designed to help OHPC develop its environmental management capabilities and to help GRIDCO implement the DSM component of the reform program. These assignments (under contracts estimated at about US$2.0-2.5 million each) would complement the overall development efforts of GRIDCO and OHPC, respond to specific priority areas under the reform program, and inter alia help implement the demand-side management and environmental management components specified in Parts A and B of the project. * Staff rationalization and training of power sector staff and the provision of related materials and facilities would also be covered under Part C in accordance with the plans prepared by GRIDCO, OHPC, and their institutional development consultants. Environment and Resettlement and Rehabilitation (R&R) 3.9 The project has a B-rating for the purpose of the Bank's Operational Directive 4.01, and no major environmental or resettlement issues are envisaged. Investments would entail mainly transmission and distribution rehabilitation under Part A and the purchase of meters and other demand-side management equipment under Part B. The project's environmental assessment is attached in Annex 3.3, its environmental benefits are summarized in para. 5.3. 3.10 Under the 1980 Conservation of Forest Act, approval for new transmission lines must be obtained from the regional office of the Ministry of Environment and Forest (MOEF). Power line routing in India undergoes extensive review in the project planning stage. OSEB (and under the - 20 - project, its successor GRIDCO), must include alternative route surveys to demonstrate that the power line routing involves a minimum of forest land. The alternative routes are surveyed jointly by GRIDCO and the Government of Orissa's Department of Forestry (DOF) personnel. MOEF clearance is not required if the joint line survey concludes that no forest land is involved, in which case DOF would grant a waiver. 3.11 Under the Indian Telegraph Act, transmission towers can be erected on private land; compensation must be paid. Ownership of the land is therefore not acquired by the transmission company. 3.12 The appraisal criteria (para. 4.10) for investments to be financed under the project require GRIDCO to address these and other potential environmental issues and to design such appropriate mitigation strategies as resettlement and rehabilitation (where needed); studies to determine transmission line rights of way and the impact on land use (agricultural, forest areas, wetlands, wildlands) of various substation sites; access roads to remote areas; the clearing and control of vegetation in rights of ways; control of erosion during construction and along access roads, substations and transmission tower sites; measures to deal with potential electromagnetic frequency (EMF) radiation effects; (central government regulations call for minimum transmission line clearance distances to address EMF effects); radio noise, television interference, and audible noise along transmission line routes; ways to regulate public access to substations and towers to minimize electrocution hazards (GRIDCO will effect restriction of public access by fencing and security of substations and towers). The project management consultants will help GRIDCO appraise investments and implement Part A of the project, including the preparation and execution of environmental mitigation. Cost Estimates 3.13 The project cost is estimated at US$948 million equivalent, with a foreign exchange component of US$609 million equivalent (64 percent) and taxes and duties estimated at about US$195 million equivalent. The total financing required, including interest during construction (IDC), is US$997 million (Table 3.1 and Annexes 3.1-3.2). - 21 - Table 3.1: Project Cost Estimates (US$ million) :~~~~~. : - : , : : : - . - : . . .:. . :. - -.:. .: sF maedP#1ec Cot LOOtI~ FotI ~Tt Base Cost Transmission and distribution 200.8 398.4 599.2 Demand-side management 30.0 66.8 96.8 Institutional Development, Technical 13.2 30.8 44.0 Assistance and Training Total Base Cost 244.0 496.0 740.0 Contingencies Physical b 16.1 44.2 60.2 Price ' 78.5 69.2 147.7 Total Project Cost 338.6 609.4 948.0 Interest during construction 18.9 30.3 49.2 Total Financing Required 15275 3.7 972 * Due to rounding, numbers may not add up. Estimates include taxes and duties equivalent to US$195 million. a. Adjusted to end-1995 price levels. b. 10 percent of base costs except where firm estimates based on identical projects (under Part A) were available or bids or contracts were already in place (under Parts A through D). c. Bank guidelines for India as of January 11, 1996, based on projected domestic and international rates. Foreign exchange costs are escalated at 3.3 percent for 1996, 2.3 percent for 1997, 2.5 percent for 1998-2001, 2.4 percent for 2002 and 2.1 percent for subsequent years (calendar year basis). These estimates for international inflation are consistent with the Bank's latest G-5 MUV index, which is updated periodically. Local costs are escalated at 8.5 percent for 1996, 8.0 percent for 1997, 7.5 percent for 1998, 7.0 percent for 1999 and 6.0 percent for subsequent years on a calendar year basis. Project Financing 3.14 Total financing required for the proposed project, including IDC, is US$997 million, of which the proposed Bank loan would finance US$350 million equivalent or 57 percent of the foreign exchange costs excluding IDC. ADB financing, channeled through PFC, is in place. Also approved and under implementation is ODA's technical assistance grant of about US$19 million equivalent (pound 12 million). A trust fund, administered by the Bank on behalf of ODA, was set up in August 1995 to finance the phase 2 services of the Reform Consultant and related items amounting to about US$11 million equivalent (pound 6.8 million). The balance of ODA's grant is being administered directly by ODA (para. 4.6). - 22 - 3.15 The approval of the proposed Bank loan is expected to trigger additional ODA cofinancing of about US$110 million (pound 75 million) by mid-1996. The Government of Orissa would provide about US$26 million. Local financiers including PFC, the Industrial Development Bank of India (IDBI), the General Insurance Corporation and the Life Insurance Corporation are expected to provide another US$233 million. It is projected that GRIDCO would finance about US$222 million equivalent from internally generated resources (Table 3.2). Table 3.2: Project Financing Plan (US$ million) Government of Orissa 25.6 0.0 25.6 ADB 0.0 56.8 56.8 ODA 65.1 45.0 110.0 Other Financiers 233.0 0.0 233.0 Internal cash generation 33.8 188.1 221.8 IBRD 0.0 350.0 350.0 All 357.5 639.7 997.2 Due to rounding, the numbers may not add up. Terms and Conditions 3.16 The Borrower would be India, acting by its President. Loan terms would include standard variable interest rate, five years of grace period and a final maturity of twenty years. The closing date of the loan would be December 31, 2002. At negotiations, agreement was reached that: * The Government of India will onlend the proceeds of the loan to the Government of Orissa, under its standard arrangements for developmental assistance to the states, and that this loan would be fully additional to Orissa's plan assistance. * The Government of Orissa will onlend the proceeds to GRIDCO (under Parts A-C of the project), and, if necessary, to OBPC (under Part C), private distribution companies (under Part A) and electricity end-users (under Part B) on terms and conditions acceptable to the Bank and will, without setting off any amounts that may be due to it from GRIDCO and OHPC, release funds simultaneous to releases by the Government of India. 3.17 The expected onlending terms are a 13 percent rate of interest, five years of grace, and a final maturity of fifteen years for GRIDCO and OHPC. Comparable terms for onlending would be offered to private distribution companies and electricity end-users. Onlending by Government of Orissa to private distribution companies under Part A would be subject to these companies having been selected through procedures acceptable to the Bank and having submitted satisfactory project reports and financing plans; the latter requirement would also apply to onlending by the Government of Orissa or GRIDCO to electricity end-users (under Part B). GRIDCO would also be allowed to lease items purchased under the loan to private distribution companies and electricity end-users. - 23 - Procurement and Consulting Services 3.18 All Bank-financed procurement would be done in accordance with the Bank's Guidelines on Procurement (Table 3.3). Table 3.3: Summary of Proposed Procurement Arrangements (US$ million, amounts to be financed by proposed Bank loan in parentheses) -~'dect Element ICR NCB Otber ::.. . Civil Works 143.3 9.6 0.0 31.2 184.0 (75.0) (5.0) (0.0) (0.0) (80.0) Equipment, materials, and miscellaneous 492.9 36.0 9.5 174.6 712.9 (235.0) (20.0) (5.0) (0.0) (260.0) Consultancies and training Implementation Support 5.9 13.0 18.8 (4.5) (0.0) (4.5) Policy Support 5.9 6.3 12.1 (4.5) (0.0) (4.5) Capacity-Building 1.3 18.9 20.2 (1.0) (0.0) (1.0) Total Project Procurement 636.1 45.5 22.5 243.9 948.0 (310.0) (25.0) (15.0) (0.0) (350.0) a. Not Bank financed. b: Due to rounding, numbers may not add up. Part A 3.19 US$260 million of the proposed Bank loan is allocated to transmission and distribution projects under Part A of the project. The bulk of procurement (in terms of value), including all B^ank-financed contracts, under Part A (which accounts for about 80 percent of the project's total cost) would be awarded through international competitive bidding (ICB) using ICB tender documents approved by the Bank and extensively used under two large POWERGRID loans, Ln. 3577-IN and Ln. 3237-IN. Most would be supply and erection contracts. In view of long lead times and to obtain most favorable prices through competition, GRIDCO would procure selected main items (transformers, conductors, switchgear) in bulk on the basis of estimated total requirements, then make these items available to the supply and erection contractors. 3.20 To provide for better project control and expeditious completion, three large transmission line supply and erection contracts would be awarded. Each contract would include surveying and clearing of the line routes; line design; procurement of equipment, materials, and structures (though some would be made available by GRIDCO); transporting to site; and the construction and commissioning of the lines. These contracts would range in value from about US$30 million to US$50 million. One smaller contract, of about US$8 million, will also be awarded. Substation supply and erection contracts would include design and specification of equipment ensuring compatibility with existing equipment where necessary; procurement of all equipment, relays, and cables (though some would be provided by GRIDCO); civil works; and erection, testing, and commissioning. These four substation contracts would range in value from about US$5 million to - 24 - US$ 15 million. The subtransmission and distribution system upgrading contracts would be awarded as four geographically defined packages, values ranging from about US$35 million to US$50 million. The bulk supply contracts, about 25 in number, range in value from about US$5 up to US$15 million. A large number of contracts of small value are in implementation or procurement stage, under financing arrangements not including the Bank. 3.21 Separate civil works contracts are not envisaged under Part A. The erection portion, including limited civil works under supply and erection contracts, is estimated at about US$130 million, of which about US$70 million equivalent under the proposed loan. Part B 3.22 US$80 million of the proposed Bank loan is allocated to demand-side management. Contracts for the supply and installation of meters, for which US$50 million is allocated under the proposed loan, would be awarded through ICB. Tender documents accounting for about 8 percent of the total project cost have already been finalized by OSEB/GRIDCO and approved by the Bank. Advanced procurement has started (para 4.11) and three contracts ranging from about US$1 million to about US$4 million have been awarded. 3.23 The balance of Part B, for which US$30 million is allocated under the proposed loan, would primarily consist of a large number of small contracts averaging about US$50,000. Most are expected to fall below the US$250,000 ICB threshold - ICB procurement would account for about US$5 million. Supply, as well as supply and erection, contracts amounting to about US$20 million would be awarded through national competitive bidding (NCB). National shopping would amount to about US$5 million, under contracts up to US$25,000 in value, averaging about US$10,000. Separate civil works contracts are not envisaged. (The erection portion, including limited civil works under the supply and erection contracts, is estimated at US$5 million equivalent under the proposed loan). Part C 3.24 US$10 million ofthe proposed Bank loan is allocated for consultancies and training. The main Bank-financed consultant contract (the Reform Consultant) has already been awarded (in accordance with Bank Guidelines on the Use of Consulting Services) under Cr. 1356-IN. Payments under existing contracts would be financed (reimbursed) by the Bank under the proposed new loan. 3.25 Under the Part C, ODA would recruit and finance the balance of consultants. The balance of the ongoing phase 2 of the Reform Consultant's services would be financed under the Bank- administered ODA trust fund. ODA is also expected to finance further services (phase 3 or its equivalent) and provide consultants to help implement Parts A and B of the project (paras. 4.3 and 4.5). The Bank has not required a cross-conditionality with ODA financing. In case ODA funding does not materialize or is terminated, such services would be financed under the proposed Bank loan, in which case Bank guidelines on the use of consultants would apply. Funds would be reallocated to Part C from Part A. - 25 - Bank Reviews 3.26 Prior Bank review of bid documents and approval of all contracts expected to cost the equivalent of US$500,000 or more would be mandatory. All procurement under Part A, consultant contracts under Part C, and the metering component of Part B is expected to fall under this category. Smaller contracts would be subject to selective post-award review. The aggregate value of such contracts, all to be awarded under Part B, is not expected to exceed US$30 million (about 9 percent of the total loan amount). Disbursements 3.27 Disbursements from the proposed Bank loan would be made against: * 100 percent of foreign currency expenditures (CIF). * 100 percent of the local ex-factory cost. * 80 percent of other local expenditures for equipment. * 70 percent of expenditures for civil works and erection services. * 100 percent of services rendered by consultants. 3.28 Disbursements for equipment contracts valued at less than US$500,000 equivalent; for civil works and erection contracts valued at less than US$500,000; and for consulting services contracts to firms valued less than US$100,000 or to individual consultants valued at less than US$50,000 would be made against statements of expenditures (SOEs), the documentation of which would not be sent to the Bank but would be retained by GRIDCO and OHPC for inspection by supervision missions. Total Bank funding for such contracts is estimated at about US$30 million under Parts B and D. All other disbursements would be fully documented. 3.29 To facilitate disbursements, a special account would be established for the Bank loan with an authorized allocation of US$12.0 million, equivalent to four months of average disbursements through the Special Account. At negotiations, agreement was reached that the Government of India will advance funds to the Government of Orissa and that the Government of Orissa will advance funds to GRIDCO and OHPC simultaneous with releases by the Bank. Annex 3.4 shows the estimated disbursement schedule as derived from the construction programs of the project components assuming normal terms for commercial payments, including retention payments. Retroactive Financing 3.30 Responding to request from the governments of India and Orissa, the Bank extended the closing date of Cr. 1356-IN to June 30, 1995 to minimize the gap between the closing of Cr. 1356-IN and the effectiveness of the proposed new loan. The credit was exhausted, however, in March 1995. Expenditures under eligible contracts originally awarded but not reimbursed under the credit would be reimbursed by the Bank retroactively at effectiveness of the new loan. At negotiations, agreement was reached to use up to US$7 million (or 2% of the total loan) for advance procurement and retroactive financing of logistical inputs for Orissa's Reform Implementation - 26 - Organization, essential consulting services and electricity meters, from November 1, 1994. This would extend the standard 12 month retroactive financing period up to 20 months. Such advance procurement was necessary to enable Orissa to effectively initiate the implementation of its power sector reform program. Retroactive financing is subject to submission of standard documentation and withdrawal applications to the Bank. 4. PROJECT IMPLEMENTATION AND OPERATION Executing and Operating Agencies 4.1 Under Orissa's power sector reform program, the state government's and OSEB's power sector operations were transferred on April 1, 1996 to the two utilities, GRIDCO and OHPC, effective from April 1, 1996, the start of India's fiscal 1997. They are described in Chapter 2 and are discussed in more detail in Annex 2.4 (OHPC) and Annex 2.5 (GRIDCO). 4.2 GRIDCO is responsible for transmission and distribution and would be the executing agency of Parts A and B of the proposed project. Orissa's transmission facilities including those to be developed under the project would be operated by GRIDCO. Distribution facilities including those to be developed under the project would be gradually transferred to private distribution companies. 4.3 OHPC is responsible for the operations and maintenance of the existing hydroelectric plants taken over from the state government and OSEB and for the Upper Indravati project. 4.4 Part C of the project provides implementation support to GRIDCO and OHPC, and policy support for the reform program and capacity building of GRIDCO, OHPC, and the Regulatory Commission (Annexes 2.3-5). Under Part C of the proposed project, technical assistance would help GRIDCO and OHPC refine their organizational structure; develop and introduce financial, personnel, and management systems; and develop staff capacity needed to make the power companies viable corporate entities (Annex 4.1-2). 4.5 Staff transfer orders were issued on April 1, 1996 on as-is-where-is basis, under existing personnel policies. They will be refined and discussed with staff in the course of 1996 for the finalization of GRIDCO' s and OHPC's staff cadres by March 31, 1997. In the past, most of the OSEB engineers were state government employees seconded to OSEB. GRIDCO and OHPC officers and other staff will be employees of the companies. A five-year transition plan for staff rationalization through retraining, redeployment and voluntary retirement is also under preparation, with the assistance of Orissa's institutional consultants. Staff rationalization and related support facilities and equipment would be financed under the proposed project mostly by ODA. - 27 - 4.6 At negotiations, agreement was reached that GRIDCO and OHPC will: * adopt their (1) employee classification, control, and appeal regulations and recruitment and promotion regulations and (2) five-year staff transition plans by December 31, 1996; and * complete the transfer of staff to their respective cadres by March 31, 1997. Implementation of Project Components PartA 4.7 GRIDCO, which would be responsible for the implementation of Part A of the proposed project, has established a Project Management Unit (PMU) to coordinate day-to-day implementation. As the distribution privatization program (Annex 2.3) proceeds, selected sub- transmission and distribution activities and related project implementation responsibilities may also be transferred to the new private distribution companies. 4.8 Given the significant increase in transmission and distribution investment in Orissa, the Orissa government and GRIDCO have agreed to engage consultants and POWERGRID to help implement Part A of the project as GRIDCO's Engineer. PMU will use staff drawn from both GRIDCO and its consultants for the preparation of project reports, tender documents (including technical specifications), bid evaluation and the supervision of project implementation. (Terms of reference are given at Annex 4.3). 4.9 In 1994, OSEB engaged POWERGRID to help implement the transmission lines associated with the Upper Indravati project. POWERGRID was subsequently invited to join the PMU to assist with procurement and with the supervision of project implementation. Construction will be done by contractors under large supply and installation contracts. Procurement has already started under advance procurement action. 4. 10 The implementation of Part A would start with GRIDCO's proposed 220 kV and 400 kV double-circuit transmission lines (including optical fibre ground wire and related substations) from Duburi to Paradeep, Brajarajanagar to Bolangir, and Meramandali to Bidanasi to Chandaka at an estimated cost of US$65 million. The Bank has reviewed and approved these transmission line projects. Additional transmission and distribution projects would be proposed to the Bank during project implementation. The Bank would approve funding on the basis of project reports prepared by GRIDCO with the assistance of its consultants during project implementation. Distribution projects submitted for funding could be either GRIDCO's or those of the new private power distribution companies to be established under the reform program. Criteria for eligibility (Annex 4.4) include technical feasibility and project justification, environmental assessment (including rehabilitation and resettlement if any, though none is currently expected), statement about clearances, and financing plan. Part B - 28 - 4.11 The implementation of the metering program has started under advance procurement and the first proposed contract awards have already been cleared by the Bank. Installation will be the responsibility of the suppliers. GRIDCO's consultants will assist in further bid evaluation and implementation supervision. 4.12 Other demand-side management investments would be implemented by GRIDCO with the assistance of consultants being engaged under Part C. In addition, a power utility would be engaged under Part C to help GRIDCO implement and operationalize the load research program. 4.13 Investments would be undertaken either by GRIDCO (charged through monthly electricity bills or leased separately) or by the electricity end-users (to provide the necessary flexibility for GRIDCO to respond to its clients' requirements). Funding would be provided under the loan and channeled through GRIDCO, or in the case of larger individual projects, possibly directly by the Orissa government. In case of onlending of Bank funds by GRIDCO, a project implementation agreement acceptable to the Bank would be a condition of Bank support. Demand-side management projects below a threshold value of US$200,000 would not require prior approval by the Bank, but would have to meet specified eligibility criteria, to be reviewed by the Bank during project supervision. GRIDCO has established a demand-side management steering committee chaired by its chairman and managing director to oversee the implementation of the demand-side management program. The Orissa chapters of the National Productivity Council, Confederation of Indian Industries, and the Chamber of Commerce are represented on the steering committee. The Bhubaneswar Branch of the Industrial Development Bank of India (IDBI) is also represented and is expected to participate in the program as a cofinancier and appraiser of lessees and borrowers, that is, end-users. Its participation would also facilitate the promotion of the demand- side management funding facility. Part C 4.14 The two main consulting services assignments under the reform program began in 1994. The Reform Consultant - a UK/US/Canadian/Indian consortium of management, financial, economic, legal, regulatory, power and environment consultants - was engaged in September 1994 under Cr. 1356-IN. The consortium is led by KPMG Management Consulting and McKenna from United Kingdom. NERA (UK and United States), Monenco-Agra (Canada), and DCL (India) are members, along with several individual consultants from other firms from all four countries. Monenco was also engaged in late 1994 under an ADB technical assistance grant for long-term investment planning for the Orissa power system. 4.15 A British consortium of management, financial, and technical consultants - led by Price Waterhouse and including Merz MacLellan and Northern Electric - was engaged by ODA in late 1994 to supply institution-building support to GRIDCO and later to OHPC. Their work is being closely coordinated with the overall reform program and arrangements for close interaction with the Reform Consultant have been put in place (Annex 4.2). ODA is in the process of recruiting consultants for OHPC for the environmental management and for GRIDCO for project management, environmental management and the demand-side management assignments. The - 29 - training program for GRIDCO and OlPC will be managed by Price Waterhouse, for the Regulatory Commission by the Reform Consultant. Project Monitoring and Implementation Review 4.16 GRIDCO and OHPC, with the help of their consultants, would implement the project Implementation would be monitored by the Orissa government and closely reviewed by the Bank (Annex 4.5). Implementation review missions would monitor Orissa's progress in the implementation of its power sector reform program and compliance with its own policy statement (para. 2.7). 4.17 In view of the nature of the reform program it supports, the project would require much more time than is standard at the Bank for supervision. It is estimated to require about forty staff weeks a year in the first two years, reducing gradually thereafter. In the first three years, the project would be reviewed in depth annually, the third review being designated a mid-term review of the proposed project. Part of this intensive supervision effort would be carried out by the consultants first engaged by the Bank to review the original reform program in early 1994, who have continued to assist with sector reform implementation and project preparation. 4.18 GRIDCO would submit to the Bank quarterly progress reports covering the work of the PMU, procurement, physical progress of project components, disbursements, technical assistance and various administrative and financial aspects of the project. GRIDCO and OHPC would also subrmit quarterly information to the Bank, on receivables against supply of power, age-analysis of receivables, commercial payables, and cash-flow statement. Every six months (at the end of June and December), the Bank would receive information on key financial indicators. The formats for these reports have already been submitted to the Government of Orissa. GRIDCO and OHPC would also furnish to the Bank annual financial and audit reports (paras. 4.19-20 and Annex 2.5). Project Accounts and Audit 4.19 GRIDCO and OHPC would establish separate accounts for the project to be maintained in accordance with the commercial accounting system defined in the Companies Act. The Special Account would be maintained by the Government of India in accordance with appropriate accounting practices. 4.20 At negotiations, agreement was reached that the Government of India will: * Have the records and accounts for the project and those for the Special Account for each fiscal year audited in accordance with appropriate auditing principles consistently applied, by independent auditors acceptable to the Bank. * Furnish to the Bank as soon as available - but in any case not later than six months after the end of each year - the report of such audit by said auditors, of such scope and detail the Bank may reasonably request, including a separate opinion by said auditors as to whether the statements of expenditure submitted during such fiscal year, together with the - 30 - procedures and internal controls involved in their preparation, can be relied upon to support the related withdrawals. 5. PROJECT JUSTIFICATION Benefits of Power Sector Reform 5.1 By implementing power sector reform, Orissa can make its utilities commercially viable and attractive to capital financiers, private sector as well as official donors. Investments in the reform program are designed to go well beyond closing today's power gap. They would create the basis for sustainable future growth of the system. The Reform Implementation Organization has projected the Orissa power system to be able to reduce the current shortages rapidly and be able to meet projected electrical energy requirements as soon as the distribution weaknesses are addressed under the program. Benefits to Consumers and Orissa Economy 5.2 Closing the chronic gap between power demand and supply will benefit all electricity consumers. Industrial consumers in particular will benefit from the improved quantity, quality and reliability of their power supply, since they account for the majority of consumption and bear the brunt of load shedding and other failures of supply. The Orissa government expects the state's improved power supply outlook to attract additional industrial investment and encourage existing industries to expand their production facilities. This expectation is fully in line with national surveys where industrialists consistently rate power supply as one of their most critical constraints. The benefits of projected additional supply have been conservatively quantified in the economic analysis and demonstrated to exceed the costs of the program by a comfortable margin (paras. 5.14-18 and Annex 5.1). Environment 5.3 The overall environmental impact of the reform program is expected to be significantly positive. Higher electricity tariffs and improved metering and collection will encourage electricity conservation. Orissa's existing thermal generation will be renovated and new capacity will be constructed and operated by private utilities in accordance with modern practices and national environmental standards (which are in line with Bank standards). Both major ongoing thermal projects in Orissa are being developed in accordance with Bank Group environmental standards: NTPC's Talcher is supported by the Bank; Ib units 3-4 by IFC. Further support for Upper Indravati's environmental and resettlement and rehabilitation aspects is proposed to be provided under the proposed project. The proposed transmission and distribution rehabilitation, demand-side management and technical assistance would significantly reduce power system losses and help improve the efficiency of electricity consumption in Orissa, thereby also helping to containing environmental emissions. - 31 - Orissa Finances 5.4 By cutting subsidies and reducing public spending in an area where the private sector can efficiently replace public investment, the power sector reform program will promote fiscal adjustment and help reduce Orissa's deficit. Given the past large share of the power sector both in investments and subsidy requirements, sectoral adjustment will have a significant positive impact on the Orissa govemment finances by eliminating state subsidies to OSEB from fiscal 1997 (para. 5.6), progressively reducing (and ultimately eliminating) the need for state investment in the power sector, and converting Orissa's financially unrewarding investments in OSEB into profitable investments (in terms of dividends and debt service) in GRIDCO and OHPC. The overall impact of these measures would be to reverse the net flow of funds as of fiscal 1998 (para. 5.8). Power sector reform would therefore help reduce the Orissa government's fiscal deficit (a problem not adequately addressed in India's macroeconomic reform program). 5.5 Power accounted for about 20 percent of Orissa's Seventh plan fiscal 1985-89 investments and about 26 percent of its Eighth plan (fiscal 1992-97) investments. This puts it second only to irrigation. But after the implementation of the reform program, power sector investments in Orissa would be made from internal cash generation by the new corporations and using funds raised from private investors, other commercial sources, co-financiers, and funds onlend by the Government of Orissa (including the proposed Bank loan). In the Ninth Plan (fiscal 1998-2002) power sector investments are expected to be well below 10 percent of Orissa's total and to be eliminated altogether once the new corporations are fully privatized. 5.6 State subsidies provided to OSEB to enable it to meet its financial targets (including covenants under Cr. 1356-IN) have grown steadily to take up an increasing share of the Government of Orissa's resources. Fiscal 1993's power subsidies (about Rs 0.8 billion) accounted for almost 40 percent of Orissa's total budgeted subsidies. In fiscal 1994, the power subsidy (including the balance of fiscal 1993 requirement) was about Rs 2.0 billion, due to the need to clear the state subsidy backlog and make up for the write-off of uncollectable accounts receivable, which had accumulated over the years. By contrast, estimates for fiscal 1995 indicate that OSEB covered its costs, although it still required a subsidy of some Rs 0.3 billion to meet its financial objectives. The five tariff adjustments implemented in 1992-95 will eliminate the need for these subsidies from fiscal 1997. 5.7 The impact of the reform program on Orissa's state finances goes well beyond the elimination of subsidies and reduction in state funding for the sector. Although the Govemment of Orissa will have to provide equity financing to GRIDCO up to fiscal 1999, such outflows will be smaller than debt service, dividends, and electricity duty inflows from the utilities (Annex 5.2). The power sector will therefore become a net source of funding to the state, from fiscal 1997. Annual net inflows to the state would approach US$70 million equivalent in the fiscal 2001-03, excluding the privatization proceeds which are expected to be substantial over the years. The impact of onlending Bank funds would initially be revenue neutral (outflows to utilities are reimbursed by the Bank through the central Govemment) and would become another source of revenue after project completion, since Orissa's borrowing terms from the Govemment of India are more favorable than its lending terms to the utilities. - 32 - Impact on the Poor 5.8 The proposed project is not directly targeted to the poor, and its main direct poverty consideration is related to electricity pricing. While Orissa's electricity pricing policy emphasizes cost recovery, the utilities would continue to provide low-cost (life-line) rates for poor electricity consumers to ensure that service for basic household uses of electricity remains affordable. It must also be recognized that while a more commercial approach to sector development may result in investment plans with more modest system expansion targets than what is commonly evident in SEBs' plan across India, what actually gets implemented on the ground by GRIDCO and its distribution successor organizations is likely to far exceed what OSEB would have been able to actually execute in the coming years. The reform program would indirectly help the poor by freeing up state funding (as elaborated above) for higher priority use in the social sectors. Most importantly, by improving the power supply, the program will eliminate one of the most serious constraints to higher economic growth. Orissa is a poor state even in the Indian context and poverty is wide-spread. In the long term, its eradication is fundamentally dependent on growth and employment, the state's direct poverty alleviation interventions notwithstanding. These indirect impacts are regarded to be more important in Orissa, where connection rates are still low, in rural areas well below 20 percent of households, and the poor typically do not have a power connection. The key contribution of power reform to the poor is to lift the burden the power sector has placed on the state government finances (which mostly these poor indirectly have to bear) and simultaneously remove the power supply bottleneck to economic activity and growth. The Specter of a Future with No Power Sector Reform 5.9 Project justification has so far focused on the benefits of the proposed reform program and on comparisons to the program's total estimated cost. This is a conservative measure of the project's real overall impact. For without power sector reform, any expansion of generation capacity in Orissa - beyond the possible eventual completion of the Upper Indravati Project - would be highly unlikely. In the absence of the reform program, even the Government of India counter-guarantees and IFC support for the Ib unit 3-4 would have been unlikely. While NTPC might possibly have taken over OSEB's Talcher in exchange for the electricity OSEB could not pay for, additional NTPC generation would be diverted to paying clients and away from Orissa. 5.10 Transmission and distribution rehabilitation would also not be possible in the absence of the proposed Bank loan to finance it. OSEB might have been able to retain the on-going support through the PFC, but continued compliance with the OFAP and therefore continued access to PFC funding in the absence of reform would have been doubtful at best. 5.11 Tariff reform - including bulk of the adjustments already implemented since 1993 - would not have materialized without the prospect of sector reform. OSEB would therefore not have covered its cost of operations, nor been able to raise funds from intemal cash generation to devote to future investment. Without improved billing and collection discipline, OSEB would have continued to accumulate arrears, and at best, system losses would remain at the 45 percent level of the early 1990s. - 33 - 5.12 In summary, without a complete power sector overhaul, electricity consumers in Orissa would face a scenario of deteriorating power supply, increasing average unit costs and higher costs to the state government - a scenario not unlike that facing several other Indian states in the coming years. The increasing burden of the power sector on the Orissa government finances, moreover, would further constrain state funding available for other priority investments, adversely affecting the development of the state far beyond any direct economic effect caused by the deteriorating power supply and resultant loss of investment and production. 5.13 Comparing the benefits of the proposed reform project to this admittedly speculative prospect of no power sector reform, its justification is far stronger and its estimated economic returns far higher than those derived against the estimated costs of the program alone. This does not mean that there would be no losers under the program. Consumers presently enjoying free if unreliable electricity they steal from the system will more often have to pay for electricity, at increasing rates. Some utility staff will see a corresponding decline in their total earnings, and some may opt for voluntary separation. Except where workers are affected or terminated because of theft of electricity, these people would be compensated under the program. OSEB staff and their labor unions have generally acknowledged that the current system cannot continue and - so long as a large-scale retrenchment can be avoided - cautiously support the program. The political burden of OSEB's poor performance and a genuine desire for Orissa's development explain the wide political support enjoyed by the program once the initial visionary go-ahead signal was given by Orissa's chief minister in 1993. It is appropriate to conclude by reiterating that the poor and the environment are beneficiaries, not among the losers, under Orissa's power sector reform program. Economic Viability 5.14 The economic rate of return (ERR) was calculated on the basis of the incremental cost and benefit streams associated with the fiscal 1997-2003 time-slice of Orissa's investment program. Tariff revenue is regarded as the minimum measure of actual benefits, since tariff revenue reflects only a portion of the total benefits of electricity supply. Yet even with this conservative, revenue- based benefit valuation, the ERR for the program is about 14 percent. 5.15 A more accurate valuation of the economic benefits of electricity supply was also carried out. Shares of replaced use were established for alternative sources of energy (diesel generation, diesel pumping, and kerosene lighting) and energy consumption induced by the availability of electricity were established for major consumer categories. Induced consumption was then valued by estimating the consumer surplus - the difference between what the consumers would be willing to pay for electricity and what they actually pay - and adding that to the tariff revenue. The replaced use of alternative sources was valued in terms of economic resource cost savings. Using this analysis, the project's base-case ERR was established at about 17 percent. 5.16 Finally, an analysis was carried out in which the economic value of electricity supply was based on more conservative estimates of the consumers' surplus. This analysis is yielded an ERR of about 14 percent. Excluding the consumer surplus entirely, on the other hand, yielded an ERR of about 13 percent (Annex 5. 1). These results incidentally confirm that electricity is projected to - 34 - be priced appropriately under the reform program. Sensitivity analysis confirms the robustness, as the summary of results in Table 5.1 readily indicates. Table 5.1. Economic Rate of Return and Sensitivity Analyses (percentage) 1. Base case 16.8 14.5 2. Transmission and distribution 16.4 14.2 investment up by 10 percent 3. System loss reduction decelerated 15.8 13.7 (losses up by 10 percent) 4. Generation down by 10 percent 15.4 13.2 5. Average tariff revenue down by 20 percent 15.1 8.6 6. Scenarios two through four combined 14.1 12.0 7. Scenarios two through five combined 12.5 6.3 a. Benefits valued at economic replacement cost and willingness to pay. b. Benefits valued at tariff revenue. 5.17 Changes in the costs of the investment program and in the implementation schedules of its individual components would not significantly affect the economic viability of the present time slice. The impact on the program of lower than projected generation due to lower-than-projected demand or somewhat slower than projected loss reduction performance is similarly not threatening. A reduction in demand growth would affect the timing of new projects but not that of generation projects within the present time slice (Upper Indravati and Ib units 3-4). For despite problems with implementation, these projects would be needed in the system even before their current commissioning dates. The transmission and distribution rehabilitation program is also urgently required, and only the timing of transmission lines directly associated with new generating stations would need to the adjusted. 5.18 The critical role of proper electricity pricing is confirmed in this sensitivity analysis. Cases where tariff revenue - rather than willingness to pay - is used as a measure of benefit, show how the returns drop sharply if tariffs are not properly adjusted. Tariff reform is one of the key elements of the reform program and the Regulatory Commission is expected to authorize adjustments and enable utilities meeting its performance standards to earn reasonable returns. It is evident, as the results summarized in Table 5.1 readily demonstrate, that the investment program is viable, economically attractive and robust to changes; as long as the underlying reform program continues to be implemented. These results are linked to qualitative risks and safeguards below. Risks and Safeguards 5.19 The major project risk is its direct dependence on Orissa's political willingness and capability to implement the reform program. The government and OSEB have so far - 35 - demonstrated strong commitment to the program by implementing difficult and typically unpopular measures by raising tariffs, improving collection and lowering subsidies, and are now actively pursuing privatization. These are concrete signs that Orissa has embarked towards a primarily commercial behavior in power sector management and operations. As long as the key elements of the reform program proceed as planned, the project and Orissa's overall power sector investment program remain viable under a wide range of implementation difficulties (Table 5.1). Should the reform program collapse, inter alia resulting in minimal tariff adjustments, stagnation of distribution rehabilitation, loss reduction and revenue collection, and further slowdown of investments, the economic viability of the investment program would also be threatened - and its financial viability would disappear. 5.20 The implementation of the reform program has continued after a change of state government in March 1995, demonstrating its political support in Orissa, and the wide recognition of the need for a fundamental change in the state's power sector. The new state government quickly reviewed and adopted the program, as evidenced by the submission of a formal statement of its power policy in April 1995 (para. 2.7). The commitment was demonstrated in a most concrete fashion by the November 1995 tariff adjustment, Central government clearance and State Assembly approval of Orissa Electricity Reform Act, and the transfer orders under the new Act on April 1, 1996. Therefore, given the outlook for reasonable electricity tariffs and the interest already expressed by various reputable private investors to take over existing assets and invest in new developments, successful reform is feasible though by no means guaranteed. 5.21 Orissa's capability to develop and manage the two new utilities and the regulatory commission is a major project risk. Appropriate management arrangements and safeguards against future government interference are key features of project design (Annex 5.3). Orissa has acknowledged that while technical skills are readily available, the required management expertise is in short supply. Therefore, the boards of directors of GRIDCO and OHPC include several non- government part-time directors and outside functional directors as well, for financial, commercial and human resource areas. The government invited to GRIDCO's board two individuals who were instrumental in the initial institution building of POWERGRID, for ready access to that highly relevant experience. A comprehensive range of external support has also been engaged. While a variety of problems will continue to be faced in the reform process, the new entities with their outside directors and external support are expected to be able to meet the challenges and maintain reform momentum. 5.22 The Bank intends to continue its current close involvement in the implementation of the power sector reform program through intensive supervision and its active dialogue with cofinanciers to help Orissa secure their continued support for the program. Continued Bank support would inter alia depend on the state allowing persons it has appointed to manage GRIDCO and OHPC and to lead the Regulatory Commission independently in accordance with the state's power sector policy statement. The Bank would have remedies under the loan agreement to deal with noncompliance with this policy statement or failure to meet other commitments; moreover, the Bank has an established track record in Orissa of using such remedies, including the cancellation of Ln. 2278-IN in 1991 and the suspensions of Cr. 1356-IN - 36 - on three different occasions. The emphasis will, however, be on helping Orissa face both the expected and unforeseen challenges in reform implementation in particular at times of trouble. 5.23 Given the fundamental structural changes involved, the reform program's implementation necessarily entails a number of financial, commercial and institutional risks. These have been analyzed and appropriate safeguards have been built in to the project design (Annex 5.3). The project's main financial and commercial risk relates to tariff reform and the utilities' ability to recover charges from their clients. Special attention has been paid to ensure that power distribution, the foundation of the sector, will be developed commercially, with arrangements in place to ensure satisfactory attention to loss reduction and revenue recovery. This will be accomplished essentially by transferring responsibility for distribution to specialized private companies whose survival depends on their success in addressing Orissa's current problems in distribution. To minimize the initial operational complexities during the transition from a state controlled monolith to decentralized market structures, GRIDCO, in addition to being the grid company (a transmission company and coordinator of system operations) will initially also be responsible for central power procurement. 5.24 Proven technologies will be used throughout the project, which does not therefore pose any particular technical risks in implementation or operation. Sensitivity analysis has established that the impact on the ERR brought about by a combination of substantial adverse changes would be acceptable (Table 5.1) with appropriate pricing of electricity by the Regulatory Commission. 5.25 Legislative risks at central and state levels have been mitigated by securing the Government of India clearance for Orissa's reform legislation and by Orissa enacting the legislation. Through its broader policy dialogue with India, moreover, the Bank continues to emphasize the role of the Central Govemment in state power restructuring. The Govemment of India is expected to provide political leadership and support to reforming states, undertake the reforms required at the central level to pave the way for state power reform, and encourage parallel reform initiatives in other states besides Orissa. - 37 - 6. AGREEMENTS AND RECOMMENDATION Agreements 6.1 Agreements were reached at negotiations that: (a) The Govemment of India will onlend the proceeds of the Bank loan to the Government of Orissa, under the Government of India's standard arrangements of developmental assistance to the states, and fully additional to Orissa's regular central assistance (para. 3.16). (b) The Govemment of Orissa will onlend the proceeds to GRIDCO (under Parts A-C of the project), and, if necessary, to OHPC (Part C), private distribution companies (under Part A) and electricity end-users (under Part B) at terms and conditions acceptable to the Bank and will, without setting off any amounts that may be due to it from GRIDCO and OHPC, release funds simultaneous with releases by the Govemment of India (paras. 3.16 and 3.29). (c) The Govemment of India would: (1) have the records and accounts for the project and those for the Special Account for each fiscal year audited in accordance with appropriate auditing principles consistently applied by independent auditors acceptable to the Bank; and (2) furnish to the Bank as soon as available, but in any case not later than six months after the end of each such year, the report of such audit by said auditors of such scope and detail as the Bank may reasonably request, including a separate opinion by said auditors as to whether the statements of expenditure submitted during such fiscal year together with the procedures and intemal controls involved in their preparation can be relied upon to support the related withdrawals (para. 4.20). 6.2 Agreements were reached at negotiations that: (a) the Government of Orissa will fumish to the Bank (1) by December 31 each year, a statement of the Regulatory Commission's estimated expenditure for the ensuing financial year as prepared by the Commission; and (2) by March 31 each year, the Regulatory Commission's approved budget for the ensuing financial year (Annex 2.3, para. 8). (b) the Government of Orissa will indemnify GRIDCO for all liabilities that may be incurred by GRIDCO as a result of commitments made by the Govermment or OSEB under power purchase agreements, Memoranda of Understanding or other similar arrangements with independent power producers (Annex 2.3, para. 15). - 38 - Specific Financial Objectves to be Achieved by GRIDCO and OHPC 6.3 Agreements were reached at negotiations that: (a) OHPC will take all such measures (including adjustments of the level and structure of its tariffs) and conduct its operations and affairs in such manner as to achieve: (1) in fiscal 1997, revenues from all sources related to operations and non- operating income sufficient to cover all expenses related to operations (including administration, adequate maintenance, taxes, payments in lieu of taxes, adequate depreciation and other non-cash operating charges and interest and other charges on debt, and (2) in each subsequent fiscal year such rate as may be permissible under applicable Government of India notifications (Annex 2.4, para. 14). (b) GRIDCO will take all such measures (including adjustments of the level and structure of its tariffs) and conduct its operations and affairs in such manner as to achieve: (1) in fiscal 1997, revenues from all sources related to operations and net non-operations' income sufficient to cover all cash expenses related to operations (including administration, adequate maintenance, taxes, payments in lieu of taxes, and interest and other charges on debt); and (2) in fiscal 1998 a rate of return on its capital base of not less than 10 percent and in each subsequent fiscal year such rate as may be permissible under the Electricity Act or prescribed by the Regulatory Commission, whichever is higher (Annex 2.5, para. 16). (c) OBPC and GRIDCO will from fiscal 1998 not incur any debt unless a reasonable forecast of their revenues and expenditures show that their estimated net revenues for each financial year during the term of the debt to be incurred would be at least 1.5 times their estimated debt service requirements in such year on all their debt, including the debt to be incurred (Annex 2.4, para. 15 and Annex 2.5, para. 18). (d) OHPC and GRIDCO will from fiscal 1997 maintain accounts receivable at a level not exceeding two months average billing, and accounts payable not exceeding two months equivalent of purchases (Annex 2.4, para. 15 and Annex 2.5, para. 21). (e) OHPC and GRIDCO will from fiscal 1997 furnish annually by December 31 their five-year financial projections, including their investment programs and financing plans, for Bank review and comments (Annex 2.4, para. 16 and Annex 2.5, para. 22). (f) OHPC and GRIDCO will from fiscal 1997 (1) have their records, accounts, and financial statements (balance sheets, statements of income and expenses, and related statements) audited for each fiscal year, in accordance with appropriate auditing principles consistently applied by independent auditors acceptable to the Bank; and (2) furnish to the Bank as soon as available, but in any case not later - 39 - than six months after the end of each such year, (i) certified copies of their financial statements for such year as so audited; and (ii) the report of such audit by said auditors of such scope and in such detail as the Bank may reasonably request (Annex 2.4, para. 17 and Annex 2.5, para. 24). Disbursement Conditions 6.4 Agreement was reached at negotiations that disbursements for Part A of the Project will commence after: (a) One distribution area has been placed under a lease/management contract satisfactory to the Bank (para. 2.18