Ecuador - Power Sector Improvement Project

Documentl of The World Bank FOR OFFICILL USE ONLY XA ;5>'3- SC Report No. P-4228-EC REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN IN AN AMOUNT EQUIVALENT TO US$8.5 MILLION TO THE ECUADORIAN ELECTRIFICATION INSTITUTE (INECEL) WITH THE GUARANTEE OF THE REPUBLIC OF ECUADOR FOR A POWER SECTOR IMPROVEMENT PROJECT May 12, 1986 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS Currency Unit: Sucre (SI.) February 1986 (Unified Rate) US$1 = S/.110.0 S/. 1 = US$.009 S/. 1,000 = US$9.09 FISCAL YEAR January 1 to December 31 WEIGHTS AND HEASURES Whenever possible, the SI (International System) was used in this report. Exceptions are: kgoe = kilogram of oil equivalent = 42.2.106 J toe = tons of oil equivalent = 42.2.109 J I barrel = 0.159 cubic meter (petroleum) bd = barrels per day Wh = Watt-hour =3.6.103 j AEBREVIATIONS k (kilo) = 103 (thousand) M (Mega) = 106 (million) G (Giga) = 109 (billion) CEPE = Corporacion Estatal Petrolera Ecuatoriana (State Petroleum Company) CONADE = Consejo Nacional de Desarrollo (National Development Council) IDB = Inter-American Development Bank INE = Instituto Nacional de Energia (National Institute of Energy) INECEL = Instituto Ecuatoriano de Electrificacion (Ecuadorian Electrification Institute) MEM = Ministerio de Energia y Minas (Ministry of Energy and Mines) PRONAF = Programa Nacional Forestal (National Forestry Program)  FOR OMCIAL USE ONLY ECUADOR POER SECTOR IMPROVENENT PROJECr LOAN AND PROJECT SJNAY Borrower: Instituto Ecuatoriano de Electrificacion (INECEL). Guarantor: Republic of Ecuador. Amount: US$8.5 million equivalent. Terms: Repayable over 17 years, including 4 years of grace, at the Bank's standard variable interest rate and charges. Projec Description: The project would help improve INECEL's overall performance in the country's power sector. This would be achieved through: (i) an institutional development program, con- sisting of studies and implementation of institutional reforms in INECEL; (ii) studies to undertake a comprehensive evaluation of the present power tariff structure and formu- late a plan for implementating necessary adjustments; (iii) studies on ways to optimize power system operations; (iv) training for INECEL's staff; and (v) provision of equipment and vehicles in support of the above activities. Benefits: The proposed loan would help improve operational efficiency and financial performance in the power sector by: (i) identifying and addressing key organizational and functional problems, including implementation of modern management systems within INECEL; (ii) developing a tariff framework to form the basis for implementing electricity pricing reform; (iii) improving the economics of power system operation and the quality and reliability of power supply; and (iv) increasing the competence of managers and technical and administrative staff through a comprehensive per- sonnel training program in INECEL. This document has a restricted distribution and may be used by recipients only in the performance oftheirofficial duties. 16 contents may not otherwise be disclosed without World Bank authorization.  - ii - Risks: Successful implementation of the proposed project depends on INECEL's continued commitment to (i) improve its overall efficiency; and (ii) make timely arrangements to contract necessary consultant services. The risk that the necessary commitment to improve efficiency will not materialize is judged to be minimal, since both INECEL's high-level manage- ment and Government officials are committed to the proposed technical assistance and institutional reforms. Con- sultations with key personnel during project preparation have helped to obtain commitment to reforms from INECEL's middle-level staff as well. The risk of delays in contracting of consultants will be minimized because the process will have been begun under the Public Sector Management Project (Loan 2516-EC), and the staff and performance of the four organizational units set up by INECEL to implement this project will be closely monitored by the Bank, and will receive Bank assistance during project implementation. The project does not pose environmental risks.  - iii - Estimated Costs Local Foreig Total (US$000) Estlmted Costs: Studies - Institutional Development Program Part A 430 1,320 1,750 Part B 790 790 - Tariffs 450 475 925 - System Operation Management 670 1,140 1,810 - Training Planning 70 120 190 - Computing Equipment - 460 460 - Metering Equipment 515 515 - Power System Simulators - 1,200 1,200 - Training Equipment 90 720 810 - Vehicles - 95 95 TrainiLg - On-the-job and courses abroad 130 390 520 - Experts - 285 285 Total Base Cost 1,840 7,510 9,350 Physical Contiugencies 184 751 935 Price Contingencies 306 1,239 1,545 Total Project Costs 1/ 2,330 9,500 11,830 n 4 Plan INECEL 2,330 - 2,330 Loan 2516-EC - 1,000 1,000 Proposed Loan - 8,500 8,500 2,330 9,500 11'830 Estimated Disbursemts 1987 1988 1989 1990 -(US$ millions by Bank FY)-- Annual 2.8 3.5 1.7 0.5 Cumulative 2.8 6.3 8.0 8.5 Rate of Return: Not applicable Staff Appraisal Report: None 1/ The tax content of this project would be negligible.  INlTUNTIONAL BANK FOM AND DEEJlOPUhT REPORT AND * 10 OF THE PRESIDENT OF THE lEDN TO TUB EXECJTrIE DIRECrORS OR A PROPOSED LOM TO INEE FOI A POI SEC IR PROJE 1. I submit the following report and recommendation on a proposed loan to the Ecuadorian EJectrificatioc Inutitute (IECEL), with the Guarantee of the Republic of Ecuador, for the equivalent of US$8.5 million, to help finance studies to improve its organization and operations, and prepare the ground for possible future Bank projects in the power sector. The loan would be repayable over 17 years, including 4 years of grace, at the Bank's standard variable interest rate and charges. PART I - THE ECONOMY 2. The most recent economic report on Ecuador, Report No. 5676-EC entitled "Ecuador: Public Investment Review.' was distributed to the Executive Directors on December 16, 1985. An earlier general economic memorandum, Report No. 5094-EC entitled "Ecuador: An Andmfa for Recovery and Sustained Growth," was distributed on October 5, 1984. The subsequent paragraphs reflect those reports as well as the findings of a March 1986 economic mission to Ecuador. Annex I provides the main social and economic indicators. 3. While Ecuador began the 1970s as one of the least developed Latin American countries, the discovery, exploitation and subsequent world price hikes of oil placed it firmly among the middle-income countries of the hemisphere by the end of the decade. Oil changed Ecuador's economy dramatically. Two-thirds of 1970 export revenues were from agriculture; by 1980, nearly two-thirds were from petroleum and only a quarter was from traditional agricultural crops. Real GDP grew an average 9 percent a year in the 1970s. With this rapid income growth, much social progress was made in spite of rapid population growth (2.8 percent). Significant increases in education enrollment were achieved, infant mortality was halved, and life expectancy increased by 15 years. 4. Resources generated from oil exploitation were, in general, used to improve priority physical infrastructure needed for development: trunk roads, pipelines, airports, seaports, power generation. In addition to financing much of public sector investment, these oil revenues were channeled through Central Bank credit to the private sector. However, the Government's role grew: total public expenditures rose from 24 percent of GDP in 1973 to 34 percent in 1982. Government subsidies-to urban consumers, fuel and  - 2 - electricity users, import-substituting industries, exporters--grew in importance. The public sector's use of external borrowing also grew; medium- and long-term debt outstanding rose from around US$600 million in 1977 to US$7.1 billion in 1985. Nevertheless, the country's institutions remained weak. Moreover, the benefits of growth not only created severe structural problems, they were also unevenly distributed: a sizeable middle class emerged but about 40 percent of the urban and 65 percent of the rural population still live in poverty. 5. By 1984 over half of fiscal revenues came from petroleum. Since much of the oil revenues were earmarked, only 60 percent of General Government current revenues were channeled through the budget. Furthermore, the non-oil revenue effort was seriously weakened: income taxes represented less than 2 percent of GDP, while income and import taxes collected represented less than a quarter of their theoretical yield. Low internal energy prices created distortions in consumption and investment patterns. 6. Further structural problems developed as a result of the trade and exchange rate policies followed since the 1960s, which gave high protection to the industrial sector and permitted a steady real appreciation of the exchange rate. These policies allowed real manufacturing output to rise 150 percent during 1972-1982, virtually all based on import-substitution. But with one or two exceptions, Ecuador's non-oil exports stagnated, and by 1982 two-thirds of foreign exchange came from oil exports. These underlying problems made Ecuador's economy very vulnerable to world petroleum prices and to the availability of foreign credit lines, and helped bring the period of prosperity to an end by 1982-1983. Economic Performance in Recent Years 7. A recession developed when oil prices ended their real rise in 1981, foreign credit lines were reduced drastically in 1982, and natural disasters occurred in 1983. GDP dropped by 3 percent in the Latter year. The Authorities initially borrowed heavily abroad to counteract the fall in oil prices, but as Ecuador's access to external funds dwindled, an IMF-supported stabilization program became necessary. This program adjusted the exchange rate, introduced mini-devaluations, and placed temporary restrictions on imports. Ecuador also undertook a debt rescheduling and initiated a fiscal austerity program. Inflation, however, surged to 50 percent in 1983 owing to flood-related output disruptions and the short-term effects of the adjustment measures. By 1984, economic growth resumed (4.1 percent of GDP), the public sector deficit was virtually eliminated, and inflation was halved. With new petroleum fields coming on stream, the volume of oil produced rose 18 percent between 1983 and 1985. Non-oil exports, responding to improved exchange rates and better weather, also rebounded. 8. Following a close election, a new Administration took office in August 1984. Its economic philosophy is very much market-oriented. The new Government took a number of significant measures aimed at consolidating economic recovery and initiating structural reforms: further devaluations;  -3- increases in domestic fuel prices, electricity tariffs, and interest rates; removal of those emergency import controls introduced in 1982; promotion of direct foreign investment; and elimination of most administered prices in agriculture. It also negotiated a new IMF Stand-by, which focussed on achieving balance of payments equilibrium and a reduction in inflation. Supported by the Stand-by, Ecuador unified two official exchange rates 1/, introduced a new financial savings instrument-certificates of deposit--with market-determined interest rates, generated a public sector surplus, eliminated some prior import deposits, and tightened monetary control. The results of all the above measures, together with continued recovery from the 1983 disasters, allowed 1985 GDP to grow by 3 percent, inflation to decline to a 22 percent annual rate, export volume to grow by 8 percent, net reserves to improve to nearly US$200 million (equivalent to one month of imports), and private savings mobilization to increase significantly, mostly through the new certificate of deposit. 9. A prime target of the Government's program was its external debt, servicing of which would have consumed three-fourths of export earnings had further reschedulings not been arranged. The Government's multi-year debt rescheduling was finalized in December 1985. All principal falling due to commercial banks between 1985-1989 (about US$4.2 billion) was rescheduled, but virtually no fresh money was provided. Similarly, a multi-year arrangement was worked out with the Paris Club in April 1985, dealing with 1984 arrears and principal falling due in 1985-87 (about US$400 million). Assuming world petroleum prices had remained about constant in real terms, the Authorities-and Bank staff-believed Ecuador could have achieved GDP growth of 5-6 percent p.a. with a modest level of additional external financing restricted to official sources. 10. The precipitous fall in oil prices in early 1986, however, has significantly changed Ecuador's prospects. Petroleum revenues stand to decline by over US$850 million in 1986 alone (29 percent of 1985 merchandise exports), while fiscal revenues from oil could fall by US$460 million (5 percent of GDP). Partly offsetting the oil export losses, agricultural exports are expected to bring in an additional US$250 million because of higher coffee prices and Ecuador's good policies during 1984-1985. Nevertheless, these net losses now mean that over a quarter of Ecuador's 1986 domestic savings and 28 percent of its exports will be needed for foreign interest payments. Outlook 11. Given the recent enormous loss of oil income, Ecuador is likely to suffer a recession in 1986. While the economic performance of Ecuador is highly sensitive to world petroleum prices, its prospects also depend on its ability to accelerate the implementation of structural reforms. 12. The country is, especially in its new petroleum fields, a rather low-cost producer, so low that six private oil firms have signed exploration 1/ There still remains a legal floating rate used for certain invisible transactions.  - 4.- contracts since 1985; one has found new oil and is testing its commercial feasibility. Staff projections indicate that if the oil price were to increase to a level of US$15/bbl for 1987 and beyond (at 1987 prices) GDP growth could be above population growth after 1987, even if the current account deficit were restricted to about 3 percent of GDP. The debt-service ratio would be about 30 percent of exports of goods and services, assuming that the new borrowings were provided by official and commercial sources at attractive terms. At this relatively low oil pzice the Ecuadorian economy could begin only a slow recovery if the Government desired to improve its creditworthiness and maintain private consumption per capita at about the 1985 level. If oil prices reach a level around US$17/bbl in 1987 and thereafter (at 1987 prices), the economy could achieve higher GDP growth rates-4 to 5 percent-even if the current account deficit were restricted to 2 percent of GDP. 13. After oil prices, the greatest effect on Ecuador's recovery and creditworthiness will stem from the Administration's ability to aggressively implement adjustment policies already begun. These include a steady liberalization of many factor and product prices, reduction of industrial protection, divestiture of inefficient state enterprises, maintenance of an attractive exchange rate for exporters, increased utility tariffs and domestic petroleum prices, increased exploration for oil by both public and foreign private companies, and enhancing and diversifying sources of fiscal revenue. A new challenge, which partly stems from the new oil price prospects, will require greater efforts to restrict the growth of public expenditures, both current and capital. 14. As of end-April 1986, the Government of Ecuador was negotiating with the IMF for a new Stand-by arrangement. The Bank is also assisting the Authorities in developing a medium-term growth strategy as a possible vehicle to mobilize additional resources for Ecuador's development. Because of Ecuador's past determined efforts to adjust its economy, the likelihood that petroleum prices will rise from present (end-April 1986) levels, and the Government's positive policy responses, we believe the country remains creditworthy for Bank lending. PART II - BDAK GOUP OPERhIIONS IN ECADCR 15. Bank Group operations in Ecuador date back to 1954 when a loan was made for a first highway project. The Bank and IDA have extended 36 loans and 6 credits to Ecuador totalling US$872.6 million net of cancellations. As of March 31, 1986, US$498.7 million of this amount had been disbursed. The IFC has invested in five firms in Ecuador, including a large textile company, a sugar mill, a cement company, a mining enterprise and a development ftnance company. As of March 31, 1986, commitments for these operations amounted to US$28 million, of which IFC held US$5.2 million. Annex II contains a suamary statement of Bank loane, IDA credits and IFC operations as of March 31, 1986. 16. Execution of Bank Group financed projects has often been hampered by weaknesses in Ecuador's implementation capacity, reflecting the insuffi- ciency of the country's public sector managerial and technical resources-a constraint that is still a serious obstacle to Ecuador's economic and social development. In recent years, the Goverrment and Bank staff have worked  together to step up disbursement of Bank loans. Among other initiatives, a Special Action Program for the country provided for revolving funds in five projects. As a result of these general efforts, disbursements rose from US$26 million in FY83 to US$42 million in FY85. The country has set up a monitoring committee for all externally financed projects which should rein- force efforts to accelerate disbursements. The Bank plans annual portfolio implementation reviews to detect and resolve specific obstacles to execution of Bank-financed projects; the first took place in November 1985. 17. Bank and IDA lending in Ecuador was originally concentrated in transport and power, where there were substantial bottlenecks to be over- come. To date, approximately 22 percent of Bank Group lending has been for infrastructure. Seven of the nine loans and credits extended for transport were to improve the country's road network and two were to help finance the expansion of the port of Guayaquil. Three power operations aimed at improving generation and distribution facilities in Quito. The first live- stock development loan, approved in FY67, marked the beginning of a diversi- fication in the Bank Group's lending program away from infrastructure. Since then, the Bank Group has made ten other loans and credits for agriculture and fisheries, nine loans to support industrial development, and two for pre-investment studies. These productive sector loans comprise 65 percent of total Bank lending to Ecuador. Bank Group support for social sectors-education, water supply and urban development-now accounts for about 13 percent of total Bank lending. 18. Turning to the future, the Bank strategy is to support Government initiatives in macroeconomic and sector reforms over the medium term. This will be achieved through a series of sector and project loans aimed princi- pally at supporting policy improvements in energy, agriculture, and industry, and developing social and economic infrastructure. In addition to the design and adoption of adequate sector policies, Bank lending will emphasize the generation of exports and employment. Besides the Power Sector Improvement Project recommended in this report, for the near term the Bank is preparing agricultural credit and water supply operations. In addition to Bank lending, the IFC is analyzing several possible operations in agribusiness, fisheries, petroleum refining, hotels and merchant banking. 19. Substantial development financing has also been provided to Ecuador by the Inter-American Development Bank (IDB), the US Agency for International Development (USAID) and, to a lesser extent, by other bilateral sources. IDB haa been the single largest lender to Ecuador. Loans outstanding (including undisbursed) from IDB to the country as of December 31, 1985, totalled about US$1.2 billion equivalent. Past IDB lending has been concentrated in the power, agriculture, industry and transport fields. Most of IDB's loans to the country have come from the Fund for Special Operations and normally carry concessional terms. It is likely that IDB will remain Ecuador's major development lender in the immediate future with power, agriculture and socially-oriented projects continuing to account for a large share of its lending program. By December 1985, USAID had about US$158 million in outstanding loans to Ecuador (including undisbursed). Its program concentrates on irban development, agriculture, health and the private sector. In addition to maintaining close contact with USAID, IDB and other aid agencies to assure compatibility of programs, Bank staff have undertaken a full public sector investment review which could serve as the basis for a Consultative Group Meeting of Ecuador's creditors, possibly by end-1986.  -6- 20. As of December 31, 1985, the public and publicly-guaranteed medium- and long-term external debt of Ecuador totaled about US$7.1 billion. Of the former sum, the Bank group was owed 4.4 percent and the IDB 8 percent. Through 1990, the IBRD share of Ecuador's outstanding and disbursed public foreign debt is expected to remain below 10 percent, and the IBRD share of total public foreign debt service is projected to remain about 11 percent. PART III - TE ETNOM,Y SECTOE 21. In 1984/85 the Bank undertook a thorough assessment of Ecuador's energy sector. The results of this assessment were published in December 1985 as Report No. 5865-EC entitled 'Ecuador: Issues and Options Ln the Energy Sector." The findings of this report have served as the basis for dialogue between the Bank and the Government on sector issues, including those to be treated by the proposed project. Energy Sources and Balance 22. Ecuador has diverse and abundant energy resources, largely untapped, consisting of hydroelectric power, oil, natural gas and renewable resources, such as firewood and bagasse. Hydroelectric potential, of which less than 4 percent (725 MW) is presently exploited, is estimated at about 21,000 MW. Oil reserves are estimated at about 1.5 billion barrels, and natural gas at about 550 billion cubic feet. Although hot water springs exist in the country, the Government has not yet started to study these potential geothermal sources. The country has abundant forests, most of them located in the sparsely populated Amazonian region, but fuelwood is scarcer in the densely populated areas. 23. In 1984 Ecuador consumed about 4.5 million tons oil equivalent (toe) of energy, rerFilting in a low per caput consumption of about 500 kg of oil equivalent (kgoe), compared with a world average of about 1,500 kgoe and ' Latin America average of 1,000 kgoe. Petroleum products accounted for a very high share (72 percent) of energy consumption, with firewood (22 percent) and hydroelectricity (6 percent) completing the picture. 24. The transportation sector is the largest energy coeisumer (39 percent), followed by households (33 percent), industry (17 percent), agriculture (3 percent), and others (8 percent). Petroleum products are the main energy source for industry, agriculture and transportation, accounting for 69 percent, 100 percent and 100 percent respectively of consumption in these sectors. 25. Petroleum is of crucial importance for the colintry. Crude oil accounts for over half of total exports, and whatever happens to the volume of oil production or oil prices overshadows developments elsewhere in the economy. The country started producing 3,700 barrels of oil per day (bd) in 1971 and attained 209,000 bd in 1973. After that, production remained relatively static at about 267,000 bd. Oil production between 1986-88 is predicted to average about 300,000 bd. However, since past exploration  -7- efforts were insufficient, petroleum reserves declined by almost 30 percent between 1973 and 1984. As a result, projections indicate that after 1988, production from existing fields will be unable to maintain crude oil exports at the 1984 levels and serve continually increasing internal demand. Since this would severely aggravate the country's economic situation, especially given oil price declines, the Government has acted to incre