Document of The World Bank FOR OFFICIAL USE ONLY 4A // ;?i f / -P/ Report No. 7754-PH STAFF APPRAISAL REPORT PHILIPPINES MANILA POWER DISTRIBUTION PROJECT IMAV 4, 1989 Industry and Energy Operations Division Country Department II Asia Regional Office This document has a restricted distribution and may be used by recipients only In the perfonmance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. CURRENCY EQUIVALENTS (As of December. 1988) Currency Unit - Philippine Pesos (P) US$1.00 = P 21.4 P 1,000 - US$46.73 P 1 = 100 Centavos (Ctvs.) WEIGHTS AND MEASURES kW = Kilowatt (1,000 watts) MW = Megawatt (1,000 kilowatts) kWh = Kilowatt-hours (1,000 watts) MWh = Megawatt hour (1,000 kilowatt-hours) MkWh Million kilowatt-hours GWh Gigawatt-hours (million kilowatt-hours) TWh = Terrawatt-hours (billion kilowatt-hours) kV Kilovolt (1,000 volts) m e meter (3.2808 foot) km = Kilometer (0.6214 mile) ABBREVIATIONS AND ACRONYMS APT Asset Privatization Trust APEX = Apex Development Finance Program BOT = Build-Operate-Transfer Program DBP = Development Bank of the Philippines ECC e Energy Coordination Council ERB = Energy Regulatory Board ERL = Economic Recovery Loan (Loan 2787-PH) ERR = Economic Rate of Return ICB = International Competitive Bidding IGLF = Industrial Guarantee and Loan Fund IRR = Internal Rate of Return UfW = Kreditanstalt fur Wiederaufbau LRMC = Long Run Marginal Cost MERALCO = Manila Electric Company MIS = Management Information System NEA = National Electrification Administration NPC = National Power Corporation NPV = Net Present Value OEA = Office of Energy Affairs OECF = Overseas Economic Cooperation Fund PCIB = Philippine Commercial and Industrial Bank PNOC = Philippine National Oil Company REC = Rural Electric Cooperative SCADA = Supervisory Control and Data Acquisition SOEs = Statements of Expenditures FISCAL YEAR January 1 to December 31 FOR OMCIAL USE ONLY i I- PHILIPPINES itANILA POWER DISTRIBUTION PROJECT Loan and Project Summary Borrower: Development Bank of the Philippines (DBP) Guarantor: Republic of the Philippines Beneficiary: Manila Electric Company (MERALCO) Amount: US$65.5 million Lending Terms: Repayable over 20 years, including five years of grace, at the standard variable interest rate. Relending Terms: DBP would relend the funds to MERALCO under terms thut include a twenty year maturity and a five year grace period, and a fixed spread not to exceed 3.65Z over the Bank's interest rate. ProJect Obiectives: The proposed project aims to improve MERALCO's subtransmission and distribution systems, facilitate better communication between substations, and revitalize the organization's maintenance capabilities. Proiect Description: Under the proposed project, HERALCO would undertake the following activities: (a) construction mnd upgrading of subtransmission lines, and addition of substation capacity; (b) upgrading of existing distribution networks; (c) improvement and expansion of the radio- multiplex facilities for system monitoring and control; and (d) provision of equipment and vehicles to improve maintenance. 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. - ii - Benefits: The benefits of the proposed project are primarily (i) the enhancement of the reliability of supply to existing consumers; (ii) the decrease of system losses to achieve greater efficiency in transmission and distribution; and (iii) the provision of additional distribution capacity to satisfy strongly growing demand. Risk: No technical risks are foreseen. As a result of the occasional liquidity constraints that are normal to a public utility, MERALCO could have difficulty realizing counterpart funds and thereby keeping to the project implementation schedule. EstimatelI Costs: Local Foreign Total --------USS Million------- Subtransmission Lines and Substations 34.3 33.4 67.7 Upgrading of Distribution System 15.1 9.7 24.8 Radio-Multiplex Facilities 0.9 2.0 2.9 Mairtenance Equipment and Vehicles 1.4 4.7 6.1 Base Cost 51.7 49.8 101.5 Physical Contingencies 5.2 5.0 10.2 Price Contingencies 4.1 4.2 8.3 iotal Project Cost /a 61.0 59.0 120.0 Interest During Construction 3.5 6.5 10.0 Total Financing Requirements 64.5 65.5 130.0 Financing Plan: IBRD 6.5 59.0 65.5 MERALCO 58.0 6.5 64.5 Total , 64.5 65.5 130.0 Estimated Disbursements: IBRD Fiscal Year 1990 1991 1992 1993 1994 1995 - _______________ (USS million) ------------ Annual 0.5 5.9 12.8 17.0 14.0 15.3 Cumulative 0.5 6.4 19.2 36.2 50.2 65.5 Economic Rate of Return: 32Z /a The project cost includes an estimated US$9 million equivalent of taxes nt" g,t 4 - - iii - PHILIPPINES MANILA POWER DISTRIBUTION PROJECT STAFF APPRAISAL REPORT Table of Contents Page No. I. THE ENERGY SECTOR ............................................. 1 A. Overview .................................................. 1 B. Energy Sector Institutions ................................ 1 C. The Power Sector ....... ................. 2 D. Bank Lending for the Sector ............................... 4 E. Sectoral Issues ......................... S F. Rationale for Bank Involvement ..... ............. 8 II. THE PROJECT.8 A. Project Origin and Formulation .. B. Project Objectives .. C. Project Description.. 9 D. Project Costs ..10 E. Financing Plan ..11 F. Project Implementation and Schedule ..12 G. Procurement ........................................... 13 H. Disbursements.. 15 I. Monitoring and Reporting. ............................ 15 J. Environment ....................... ........................ 16 III. THE BORROWER ................................................... 16 A. Background 1958-1986 ...................................... 16 B. DBP's New Role and Strategic Orientation .................. 17 C. Organization and Management ............................... 19 This project was appraised originally in August 1987 by a mission consisting of Messrs. Jamil Sopher, Darayes B. Mehta, and Anil K. Malhotra (World Bank). It was reappraised in November 1988 by a mission consisting of Messrs. Jamil Sopher, Vinod Busjeet, Karl Jechoutek, Mihir Mitra, and Joachim Iske (World Bank). This report is based on the findings of these two missions. - iv - Page No. D. Personnel Policy and Training .. 19 E. Accounting and Management Information System . . 20 F. Loan Activity and Asset Management . . 20 G. Liability Management .. 21 H. Firancial Position and Performance . . 22 I. Audit ..................................................... 24 J. The Proposed Loan .................... ...................... 24 IV. THE BENEFICIARY ................................................ 25 A. Introduction ............................................... 25 B. Ownership ........................ ......................... 25 C. Organization, Management and Staff .......... .. ............ 26 D. Training .. 27 E. Operations, Maintenance and Losses .......... .. ............ 27 F. Accounting System ....... ............. ..................... 28 G. Financial Planning and Budgeting ........... .. ............. 28 H. Commercial Systems ....... ............. .................... 28 I. Audit .......................... ........................... 39 J. Taxes .......................... ........................... 39 K. Insurance ........................ ......................... 39 L. Dividends ........................ ......................... 30 V. FINANCIAL ANALYSIS OF MERALCO ................................. 30 A. Introduction .. 30 B. Past and Present Financi-- Performance ........ .. .......... 30 C. Tariff .......................... .......................... 33 D. Revaluation of Assets .. 34 E. Financing Plan ........ .............. ...................... 35 F. Future Financial Performance .............I................ . 36 VI. PROJECT JUSTIFICATION AND RISKS ............................... 38 A. Design Optimization ....... ................. ............... 38 B. Economic Rate of Return ............... .. .................. 39 C. Benefits and Risks . .............................. 40 VII. AGREEMENTS AND RECOMMENDATION ................................. 41 v ANNEXES 1.01 Load Forecast for the Luzon Grid 1.02 Load Forecast for the MERALCO Franchise Area 1988-97 2.01 Detailed Description of the Project 2.02 Detailed Project Cost 2.03 Project Implementation Schedule 2.04 Major Project Procurement Contracts 2.05 Disbursement Schedule 3.01 DBP's Annual Financial Statements 1984-87 3.02 DBP's Projected Annual Financial Statements 1988-94 3.03 Organization Chart for DBP 3.04 DBP's Policy Statement 4.01 Organization Chart for MERALCO 4.02 MERALCO - Staffing Profile 5.01 HERALCO's Annual Financial Statements and Projections 1984-95 5.02 MERALCO's Program to Reduce System Losses, Receivabl.es and Payables. 6.01 Economic Rate of Return 6.02 List of Documents in Project File MAP IBRD 21390 - Expansion of the MERALCO System - 1 - I. THE ENERGY SECTOR A. Overview 1.1 The energy sector's preeminence in the Philippine economy grew as a result of the oil crisis of the 1970s. At the time of the first major oil price increase in 1973. imported oil accounted for 95Z of total energy consumption. The Government responded to that price increase by implementing an iergy diversification/management policy, which was based on: (a) replacing imported oil with indigenous primary energy; and (b) using pricing as the major means of encouraging the efficient utilization of energy. Since then, the ratio of imported oil to total energy usage declined to 562 in 1986 and is expected to drop further to about 482 by 1992; and the price paid by users of petroleum and derivative products, including electricity, increased substantially. With the recent economic recovery, energy usage has begun increasing rapidly; in particular, electrical energy consumption reached 19,337 GWh in 1987, representing a growth rate of 13.4X over 1986. Power consumption in 1988 and beyond is expected to continue to grow at a rate of about 72 per annum. 1.2 The shares of energy consumption by sector have remained stable over the years. The residential and commercial sectors account for about 162 of usage, with the industrial sector consuming 442, and the transport sector, 352. The share of electricity as a proportion of energy consumption has increased considerably; electrical energy accounted for about 472 of primary energy consumption in 1986, compared to only 222 in 1973. B. Energy Sector Institutions 1.3 Before the change in government in 1986, the Ministry of Energy coordinated all policies, plans and programs for the energy sector. The ministry served as the parent organization for two of the largest Government owned corporationss (i) the National Pcwer Corporation (NPC), which had responsibility for power generation ani transmission; and (ii) the Philippine National Oil Company (PNOC), which was responsible for assuring the adequacy of oil supplies and for development of indigenous energy resources. The National Electrification Administration (NEA), which has been the organization responsible for formulating and implementing the Government's rural electrification policies, wap sIot within the control of the Ministry of Energy, but ratner under the Ministry of Human Settlements. 1.4 Foilowing the change in Government in 1986, both the Ministry of Energy and the Ministry of Human Settlements were dissolved; all energy agencies as well as NEA were brought temporarily under the Office of the President. In mid 1987, the Office of Energy Affairs (OEA), which was given responsibility for planning and coordinating policies and programs for the energy sector, was formally placed under the Office of the President. At the same time, NPC and PNOC were brought under the formal control of the Office of the Pr sident while NEA was placed under the jurisdiction of the Department of Environment and Natural Resources. The Energy Regulatory Board (ERB) was formed, and was given inter alia price setting authority over private sector suppliers of electricity. Recently, to develop formal linkages between the -2- energy sector participants, the Government formed an Energy Coordinating Council (ECC) that would (i) be chaired by the Executive Secretary; (ii) have as members NPC, PNOC, and NEA; and (iii) have OEA acting as its Secretariat. C. The Power Sector 1.5 Overview. The electric power industry in the Philippines is divided into two segments: (a) generation and transmission; and (b) distribution. The sector has a number of participating organizations, some of which are publicly, and others privately, owned. By far, the largest organization is NPC, which is responsible for the generation of bulk power and its transmis- sion through a number of grids that serve virtually the entire country except for remote rural areas and small outlying islands. Power is distributed within major urban areas by a number of investor-owned utilities. Of these, the largest is the Manila Electric Company (MERALCO), which serves Metro Manila and surrounding tural areas, and accounts for about 70? of NPC's sales in Luzon (about 502 of NPC's sales nationwide). The rural areas are served by 117 Rural Electric Cooperatives (REC), a few of which generated all or patt cf their power. Recently, NPC agreed to take control over these RECs' generating facilities; and the RECs are becoming electricity distribution outfits exclusively. NEA was established to service the cooperatives by (i) mobilizing funds; (ii) providing technical assistance; and (iii) arranging procurement of common materials. 1.6 At the end of 1987, the total installed capacity of the Philippine power subsector was abo ' 6,600 MW, of which 5,788 MW (88Z) belonged to NPC. Total generation from be,; facilities was about 21.0 TWh in 1987, accounting for about 90Z of the Philippinec' total generation. The residential sector accounted for 23Z of aggregate electricity sales; the commercial sector, 22Z; the industrial sector, 50Z; and the Government, street lighting and water supply, 5X. Losses exceeded 212 of gross generation. 1.7 As a result of absorbing the franchises of failing rural electrifica- tion cooperatives along its fringes, MERALCO's service area expanded from 3,244 sq km in 1982 to 8,813 sq km in 1986, and its number of customers rose by 45?, from 1.1 million to 1.6 million during the same n-riod. While its franchise area remained essentially the same in 1987, its number of consumers increased by nearly 62 to about 1.7 million during that year. MERALCO's energy sales rose from a 1982 level of 8.5 TWh to a high of 9.2 TWh in 1983, and then fluctuated with the performance of the economy; sales declined to about 8 TWh during both 1985 and 1986 before rising again to about 8.8 TWh in 1987. Annual financial performance has been averaging a healthy 8? return on revalued assets; however, because of liquidity constraints (para. 5.3), MERALCO's capital expenditures have been less than 70Z of the company's own estimate of requirements for sustaining its standards of service, especially during the economic recession of 1982-86. During that period system losses increased from 11? to 21Z. While MERALCO stabilized its losses at essentially the same level in 1987, it succeeded in reducing them considerably to an average of 17Z during 1988. 1.8 Load Forecasts for Luzon and the MERALCO Franchise Area. The strong growth in demalnd recorded in 1987 has continued into 1988. As a result of the economic recovery and expectations that the deeper economic problems of the mid-1980s have been overcome, growth in electricity demand is expected to remain strong well into the 19909. The latest system load forecast for the Luzon grid through the year 2002 (Annex 1.01) assumes a growth rate of 7.01 for energy sold for the period 1988-90; this growth rate increases to 7.52 for the period 1991-2002. An even more robust growth is forecast for the MERALCO franchise area (Annex 1.02). Total sales are forecast to grow by slightly more than 10? per year during the period 1988-92; this rate would then be expected to drop to about 7.82 for the period 1993-97. The projected growth in demand is expected to be led by industry (whose demand for electricity is expected to grow by nearly 12X per year during 1988-92 and about 8.4? per year during 1993-97) and commerce (whose demand for electricity is expected to grow by nearly 112 per year during 1988-92 and about 8? per year during 1993-97); during the same period, the number of MERALCO's consumers is only expected to increase by about 4.22 per year (4.72 per year during 1988-92 and 3.7? during 1993-97). These growth rates will require that (a) NPC make substantial investments in generation and transmission equipment between 1989-98; (b) MERALCO expand and upgrade its distribution system substantially during the same period; and (c) MERALCO improve substantially its system reliability, inter alia by reducing losses, during 1989-92. 1.9 Power Sector Investment Program. The existing generating capacity in Luzon is 4,100 MW. NPC's oil-based power plants (about 1,925 MW), many of which had originally been built and owned by MERALCO, have not been maintained adequately during the recent past and have deteriorated to conditions of poor reliability and low thermal efficiency. Currently, those plants are operating at substantially less than their rated capacity, and NPC has begun implementing a program to rehabilitate them. In addition, about 220 MW at the Tiwi Geothermal plant will be retired by 1990 due to technical problems with the steam supply. Therefore, the total available capacity, after rehabilitation of the oil-fired plants, will be about 3,000 MW. In contrast, the Luzon grid's current peak demand of 2,600 MW is expected to reach 3,700 MW by 1992. New generation due to be commissioned before 1992 includes some 500 MW of gas turbines and the 110 MW Bacon Manito 'eothermal Power Plant (financed in part by Loan 2969-1-PH). As a result, system reliability is expected to fall somewhat; the loss of load probability is expected to increase from its present level of about four days/year to about seven days/year by 1991. 1.10 Meeting increased load demand and improving NPC's system reliability will require some heavy investment, estimated at about US$7 billion equivalent between 1989 and 1995, a time when both NPC and the Government will face serious resource mobilization constraints. Short-term increases in capacity can only be provided through projects involving short lead time for which substantial financing will have to be obtained on attractive terms. Longer- term investment decisions need to be optimized in order that available resources can be stretched as far as possible. NPC is exploring ways of relieving the Government and itself of a part of this investment burden by creating a climate conducive to private sector participation in generation through Build-Operate-Transfer (BOT) or Build-Operate-Own (BOO) programs; alternatively, mechanisms are being developed to char..el private sector financing into the power sector. The Development Bank of the Philippines (DBP), which has been designated by the Government to become the nation's principal wholesale bank (para. 3.6), is considering a number of initiatives for encouraging private sector investment in the power sector. In the context - 4 - of its role as a wholesale bank, DBP ir participating in the proposed project as the prospective Borrower of the RanK loan and will onlend the proceeds to MERALCO (paras. 2.12 and 3.27). 1.11 The plannez: investments in generation ard transmission need to be supplemented with investments by the private distribution companies and the RECs in improvement and augmentation of distribution systems. Investments in reducing distribution losses are particularly urgent, as these can delay the need for additions to generating capacity. However, throughout the 19809, investments in distribution system upgrades were well below what was needed and focussed primarily on adding new connections. MERALCO alone is facing investments of about US$460 million during 1989-93, merely to restore its system to its 1982 operating standards. These investments would expand the capacity of its transmission and subtransmission networks as well as its system of substations, ard extend primary and secondary distribution lines to meet the load. To the extent that MERALCO can obtain financing for this program from commercial sources, the investment burden facing NPC and the Government would be reduced still further. To ensure not only that MERALCO develops an investment program that addresses adequately the need for system expansion and improvement, but also actually implements those investments in a timely fashion, at negotiations MERALCO agreed (i) to conduct not later than December 1 of each year jointly with DBP and the Bank, a review of its investment program for the next five years as well as its investment accomplishments for the past two years, and (ii) to adopt the reviews' mutually acceptable recommendations. 1.12 While MERALCO's medium term investments will have the biggest and most immediate impact on upgrading the quality and reliability of distribution services, the Government also needs to address the issue of inadequate distribution systems in the rural electrification sector. To this end, the Bank is considering including in some future operation to finance power investments a rural electrification component targeting urgently needed rehabilitatior. and major maintenance. In addition, a Rural Electrification Sector Study will help prioritize investments in system expansion and improvement. The Bank could then consider a program of investment lending for that sector. D. Bank Lending for the Sector 1.13 Over a period of 30 years, the Bank Group has made seven Bank Loans and one IDA Credit, aggregating US$267.2 million, to NPC. These eight operations financed seven projects, including one to develop geothermal power, three to finance hydroelectric facilities, two to support thermal power plants, and one to improve NPC's transmission system. However, between the Seventh Power Project (Loan 1460-PH) and the Bacon Manito Geothermal Power Project (Loan 2969-1-PH), the Bank did not have an active policy dialogue with NPC for about ten years (1978-88). All of the early projects successfully met their objectives and were completed without major problems; however, most encountered project implementation delays caused in part by design changes and in other part by cumbersome procedures for contract award. Some of those delays led to cost overruns and delayed loans closings. This was particularly true of the Fifth and Sixth Power Projects during the mid 19709 and, to a -5- lesser extent, of the Seventh Power Project (the last project to be financed before the ten year hiatus). The Bank Group also made one loan for US$60 million to NEA. PPARs were prepared for (i) the Fourth Power Project (PPAR No. P-0980, january 1976), and (ii) the Rural Electrification Project (PPAR No. 5372, June 1985). Both audit reports confirmed that the projects encountered implementation delays and some cost overruns resulting from design changes and cumbersome contract award procedures. These problems should be minimized under the proposed project because (i) detailed designs were comprehensive and thorough, and were either completed or well advanced by project appraisal in November 1988, and (ii) the appraisal mission concentrated on procurement packaging with the expectation that bidding procedures would be completed ahead of schedule, thereby accommodating some delays in contract award. 1.14 Another member of the Bank Group, the International Finance Corporation (IFC) has made two loans to MERALCO: (i) one for US$12 million equivalent in 1967, and (ii) a second for US$32 million equivalent in 1588. The recent lTan is intended to finance a time slice of MERALCO's investment program between 1989-91. In addition, IFC has indicated an interest in taking a lead role in placing with other investors future MERALCO issues of common stock or equivalent permanent equity instruments. With IFC as the anchor for its foreign financing efforts, MERALCO is seeking investment financing from (i) the Bank for the proposed project; (ii) the Kreditanstalt fur Wiederaufbau (KfW) for a project to strengthen its system of substations, and (iii) the Overseas Economic Cooperation Fund (OECF) for projects that will improve and augment distribution facilities serving depressed areas in Metro Manila and rural areas within MERALCO's franchise. IFC is taking an active role throughout the Philippine power sect-or. In addition to its activities with i MERALCO, IFC is participating in the first BOT venture to construct and operate generating facilities and sell the output in bulk to NPC. E. Sectoral Issues 1.15 In conjunction with the recently completed Energy Sector Study (Report 7269-PH; September 15, 1988), the Government has developed a strategy for exploiting alternative fuels in future power sector developments. As a derivative of that strategy, NPC developed a least cost investment program that was eviewed in detail with the Bank. In conjunction with the Bacon Manito Geothermal Power Project (Loan 2969-1-PH), NPC has agreed to annual reviews by the Bank of its investment program. The other issues, which need to be addressed in the context of the proposed project and future operations in the Philippine power sector, are operational in nature and concern the need to (i) mobilize long-term funds, especially from private sector sources, to finance power sector investments; (ii) reduce distribution system losses; (ili) rationalize tariffs in line #ith long run marginal cost; and (iv) restructure the finances of the power utilities and RECs. 1.16 Financing of Power Sector Investments. As mentioned previously (para. 1.10), the power sector's investment requirements exceed the financing capabilities of the Government. Steps to engage private sector participation in investments in electric power are needed urgently. NPC is proceeding on one track to interest private parties in the construction and operation of - 6 - generating facilities. In those cases, NPC would purchase the output from these facilities at a price based on its own cost of supply; the operator could realize a substantial return on investment, depending on the efficiency with which the facility was built and operated. If successful, these programs would reduce the extent of power sector investments that the C' vernment would need to address. 1.17 In addition, the Government needs to develop a strategy for financing power sector investments. For the short and medium terms, that strategy needs to emphasize borrowing from foreign lenders, with an immediate focus on official sources. NPC is already authorized to borrow from abroad and has developed direct access to a wide varietv of foreign lenders and development institu'tions. However, the Government must also arrange for the private distribution utilities and the RECs to obtain financing from similar sources for their critically needed investments. In the longer term, resources need to be mobilized from the private sector and channeled into instruments with maturities appropriate to the longer term needs of the power sector. 1.18 Following its successful restructuring and institutional strengthening during the last two years, DBP has been designated as the financial institution responsible for tapping long-term funds currently available in the Philippines (such as, funds from the Social Security System, insurance companies, pension funds, etc.) for channeling into capital intensive sectors. It would perform this resource mobilization function by acting as a (i) wholesale bank, providing funds raised locally as well as from official foreign borrowings to retail financial institutions for onlending to eventual borrowers; and (ii) syrndicator of local currency loans. This strategic reorientation of DBP from a traditional development finance institution into a wholesale bank will lead to it playing an important role in financing power sector investments in the future. By acting as the prospective Borrower and onlender ot the proposed loan, DBP is undertaking its first significant initiatives toward fulfilling its wholesale banking responsibilities in this sector. 1.19 Reducing Distribution Losses. Nationwide, distribution losses exceeded 21? in 1987. System losses within Luzon increased from 14Z in 1978 to 24? in 1987. During the same period, MERALCO's system losses increased from about 9? to about 21Z. The Government, however, has lacked a strategy for investment in distribution. Whatever investment was made during this period, be it within the franchise areas of the private distribution utilities or the RECs, focussed on adding new connections, frequently at the expense of quality of service for existing consumers. 1.20 In 1987, when MERALCO r.ecognizci the urgency of addressing this problem, it developed programs for reducing technical and non-technical losses. An investment program was developed to improve and augment its facilities so that they would be adequate to meet growing demand throughout its franchise area. Specific investments were selected inter alia based on the benefits they would provide in reducing system losses (para. 6.2). The proposed project includes many components that address the issue of technical losses, either by strengthening or replacing system weak points. In addition, MERALCO has developed and begun implementing successfully a program to reduce non-technical losses (para. 5.8 and Annex 5.02). In conjunction with the proposed project, MERALCO agreed to continue implementing that program. - 7 - 1.21 In part to assist in developing an approach for reducing rural distribution losses, the Government invited the Bank to conduct a Rural Electrification Sector Study. The main field mission for that study was undertaken in March 1989, and the results of the study are expected to be discussed with the Government during the summer of 1989. That study will seek to help NEA develop a strategy for investment, and identify measures that NEA and the RECs can take to improve their operational effectiveness. 1.22 Tariff Rationalization. Although NPC's revenues per kWh are similar to what would be expected from a marginal cost based tariff, and revenues per kWh of the distribution utilities and the RECs often exceed marginal cost based levels, the structure of tariffs is inconsistent with marginal cost considerations. Demand charges are low and do not reflect the cost of adding capacity; in contrast, high voltage consumers pay energy charges that exceed considerably the cost of supply. Moreover, virtually all distribution tariffs include (i) extremely generous blocks of electricity being provided to low voltage consumers at highly subsidized rates, and (ii) provisions to enable the distribution utilities and the RECs to recover from the consumer the cost of purchasing electricity that has either been subsidized or dissipated as losses. Thus, some consumers are paying negligible amounts for much more than their minimal power requirements, while others are paying much more than the cost of supply for their electricity. 1.23 In early 1987, the Government adopted a policy that electricity tariffs should be based on marginal cost. In that context, NPC is restructuring its tariffs to reflect marginal cost considerations. The distribution utilities and the RECs would then redesign their own tariffs based on the new NPC tariff that applies to them. The Bank has an active dialogue with the Government and NPC regarding this issue. The proposed project does not address this issue specifically because the initiative in resolving this issue rests with NPC and not MERALCO. 1.24 Financial Restructuring of the Power Utilities and the REC8. Because of the absence of long-term financial instruments bearing maturities that are appropriate to the long-term needs of the power sector, the power utilities and the RECs must necessarily be more conservative than their counterparts in developed countries in their use of leverage. However, the power utilities (including, in this instance, NFC) have built their equity foundation on revaluation reserves (which are non-cash book entries) rather than on paid-in capital or retained earnings (which represent actual cash inflows). In turn, the RECs have only minimal paid-in capital and generally lack the revenues needed to build a solid base of retained earnings. 1.25 Until an appropriate long-term debt instrument is developed, the power utilities need to be encouraged to raise more permanent capital. Since they will need to pay dividends to attract that capital, rates will need to be kept high enough to enable the retention of satisfactory amounts of earnings. The proposed project addresses this issue through the raising of new equity capital and the substantial retained earnings that are vital constituents of MERALCO's financing plan for 1989-93 (para. 5.13 et seq. and Annex 5.01). The Rural Electrification Sector Study is examining prospects for the RECs to use electricity pricing to improve their retained earnings. -8- F. Rationale for Bank Involvement 1.26 The Government is facing major investments in the power sector over the next several years. These investments are intended to provide major gene- ration and transmisqion facilities needed to meet existing demand as well qs rapidly increasing new demand resulting from recent and projected economic growth. However, the benefits of new investment in generation and transmis- sion cannot be optimized unless balanced by appropriate investments in distri- bution. The Government has developed a strategy far least-cost power development and for strengthening the policy and institutional framework in the sector. It would like the Bank to help in implementing that strategy by supporting a series of projects. 1.27 Through the Bacon Manito Geothermal Power Project (Loan 2969-1-PH; June 23, 1988), this proposed project, and an Energy Sector Loan that is currently under preparation, the Bank has developed close working relationships with the principal sector entities and is thus in a position to assist the Government in achieving much needed sector coordination. While the other operations address issues related to generetion and transmission, this project addresses issues facing the entity responsible for distributing about half of the country's commercially available electricity. In particular, the project will support overdue system extensions and improvements, and will ensure that MERALCO maintains investments at appropriate levels in the future. Also, the project would enable the Bank to support specific measures for strengthening MERALCO's operational and commercial capabilities. 1.28 The proposed loan would also support DBP in its new wholesale banking role. More specifically, the Bank's participation in the project will help develop DBP's capacity to appraise and supervise large loans to the power sector. II. THE PROJECT A. Project Origin and Formulation 2.1 The Bank was originally asked to consider financing much of the proposed project as a component of the Bacon Manito Geothermal Power Project (Loans 2969-0-PH and 2969-1-PH). Therefore, the proposed project was appraised for the first time in August 1987, in conjunction with the appraisal of the Bacon Manito Project. However, the MERALCO component was dropped from the Bacon Manito Project when an arrangement for channeling the proceeds of a Bank loan to MERALCO, acceptable to the Government, MERALCO and the Bank, could not be established. Since then, DBP has been successfully restructured and designaW.ed as the nation's principal wholesale Bank (para. 3.6); in that capacity, it can serve as conduit for official foreign loans to private sector companies. The Bank reappraised the proposed project in that context in November 1988. - 9 - B. Project Obiectives 2.2 The proposed project is designed to improve MERALCO's subtransmission and distribuition systems, facilitate better communication between substations, and revitalize the organization's maintenance capabilities. In so doing, it will er-able MERALCO to meet increasing load demands in the coming years, reduce losses and ensure more effective distribution of electricity within its franchise area. The proposed project will also support improvement of MERALCO's technical and commercial operations. C. Project Description 2.3 The main components of the project are: (a) Construction and upgrading of subtransmission lines, and addition of substation capacity; (b) Construction and upgrading of distribution systems; (c) Improvement and expansion of the radio-multiplex facilities for system monitoring and control; and (d) Provision of equipment and vehicles to improve maintenance. 2.4 Subtransmission Lines and Substations. This component entails construction of about 78 km of 115 kV, 31 km of 34.5 kV and 6 km of 13.8 kV subtransmission lines, in addition to some small sections of 230 kV and 69 kV lines; reconductoring of about 14 km of 34.5 kV and 4 km of 13.8 kV lines; installation of about 1,355 MVA of substation capacity; and addition of approximately 104 MVAR of reactive compensation devices. It will enable MERALCO to strengthen its transmission and distribution network to cope with projected increases in demand for power, reduce system losses, improve quality of service, and enhance the reliability of its distribution system. While the subtransmission lines will also relieve overloading of existing lines and provide additional outlets for power, the substations will assure efficient distribution of energy. 2.5 Upgrading of Distribution Systems. Due primarily to resource constraints, MERALCO's distribution network had not been maintained adequately in the recent past (paras. 4.9 and 5.4), resulting in increased system interruptions, loss of reliability and higher system losses. Since mid-1987, however, MERALCO has embarked upon a distribution system improvement program. Not only are the constituents of this component intended to reverse the deteriorating trend, but they also aim to reduce technical losses through optimum design of extensions and improvements in existing distribution facilities. Activities included under this program are rehabilitation of lines, conversion to higher voltages, reconductoring of overloaded lines, and improvement of power factor, metering and monitoring facilities. This latter activity involves inter alia installation of voltage regulators, line capacitors, kWh-meters, load break - 10 - switches, transformer cooling fans, conductors and power cables. This combination of activities has been formulated as an on-going program for which MERALCO has developed annual implementation plans. This project component envisages financing a time slice of HERALCO's annual distribution system improvement plans for the years 1990 to 1993. 2.6 Radio-Multiplex Facilities. Effective system operation and control includes ensuring adequate communication facilities between the electric system control center and the substations. A SCADA (Supervisory Control and Data Acquisition) system is being installed with the financial and technical support of the suppliers/manufacturers of the equipment; however, the effective use of the SCADA system as well as other equipment for system operation and control requires that the existing communication facilities linking MERALCO's substations be rehabilitated and expanded to accommodate increased communication traffic brought about by increases in the number of customers and the expansion of the franchise area. A radio multiplex system currently serves as MERALCO's primary communication link for supervisory control, pilot-wire relaying, telemetering, and voice and data communication. Rehabilitation and improvement of this radio multiplex system will require purchase and installation of 30 sets of radio multiplex equipment to link the master control station with 18 remote stations. Other communication and control activities included under this component are: (i) installation of a system to monitor remote substations; (ii) replacement of old communication equipment and cables; and (iii) installation of a voice frequency telegraph system. 2.7 Maintenance Equipment and Vehicles. To operate and maintain its vast array of transmission and distribution networks effectively, MERALCO needs special maintenance equipment and mechanized construction and maintenance vehicles as well es spares of important line equipment. Included in this component are the purchase of cranes, basket and derrick trucks and a wrecker to facilitate both construction and maintenance, and spare transformers, capacitors, switchgear, and circuit breakers to facilitate repairs. 2.8 A detailed description of the proposed project is presented in Annex 2.01. D. Project Costs 2.9 The total project cost is estimated at US$120 million (excluding interest during construction), of which about US$59 million is the foreign cost including the indirect foreign cost of local components. Detailed cost estimates for the project are presented in Annex 2.02 and summarized below in Table 2.1: - 11 - Table 2.1: PROJECT COST ESTIMATE Foreign Coat Po oUMillion USIJ million as X of Local Foreign Total Local Forelgn Total Total Subtran"miaain Lines and Substations 784.0 714.0 1,443.6 84.8 18.4 67.7 49.8 Upgradin of Distribution System 828.1 207.6 580.7 15.1 9.7 24.8 89.1 Rodlo-Multiplox Fel'lltl" n19.8 42.6 62.1 0.9 2.0 i.9 69.0 Meintenance Equipment and Vehicles 80.0 100.6 180.6 1.4 4.7 6.1 77.1 Total B*se Coat 1,106.4 1,065.6 2,172.2 61.7 49.6 101.6 49.1 Phyulcl Contingencies 111.8 107.0 216.8 6.2 6.0 10.2 -- Price Contingencies 67.7 86.5 174.2 4.1 4.2 6.8 -- Total Project Cost / 1,806.4 1,269.8 2,6e4.7 61.0 59.0 120.0 49.2 INTEREST OURINQ CONSTRUCTION 74.9 189.1 214.0 8.5 6.6 10.0 -- TOTAL FINANCING REQUIRED 1,860.3 1,896.4 2,776.7 64.5 65.5 180.0 50.4 /a The project cost Includes an estimated USS9 million equivalent of taxes and duties. 2.10 All costs are in December 1988 prices and are based on recent price quotations from equipment suppliers. Physical contingencies are computed at 102. The price escalation for all costs expressed in US dollars is calculated according to anticipated international price movements of 5.32 for 1988-90. and 4.12 for 1991 and thereafter. The price escalation for all costs expressed in local currency is calculated according to projected local inflation rates of 7.5Z for 1988. 9Z for 1989-90 and 8.02 for 1991 and thereafter. Interest during construction on the Bank loan is calculated by applying the Bank's current interest rate of 7.652 to the average amount expected to be drawn down in each year of construction. Interest during construction on other loans is calculated similarly, using the aggregate interest rate to HERALCO of 11.3Z. and adding applicable costs including the commitment fee for the undrawn portion of the Bank loan before substracting the amount payable to the Bank. E. Financing Plan 2.11 The financing plan for the project is presented in Table 2.2 below: Table 2.2: FINANCING PLAN FOR THE PROJECT (USS Million) Local Foreign Total Percent IBRD 6.5 59.0 65.5 50.4 MERALCO 58.0 6.5 64.5 49.6 Total 64.5 65.5 130.0 100 - 12 - The Bank would finance the entire foreign component of the Total Project Cost (which excludes interest during construction). In addition, the project entails a substantial amount of civil works for the subtransmission and distribution components. The Bank would finance about 652 (about US$6.5 million) of civil works that would be undertaken by contractors. 2.12 The proposed Bank loan of US$65.5 million would be lent to DBP for 20 years, including five years of grace on repayment of principal, at the standard variable interest rate. DBP would relend the proceeds of the Bank loan to MERALCO on terms that include a maturity of twenty years and grace period of five years, and a fixed interest rate spread of not more than 3.65Z over the Bank loan. MERALCO would finance from internal cash generation the interest during construction associated with the onlent Bank loan and also would bear the full foreign exchange risk. Execution of a Subsidiary Loan Agreement between DBP and MERALCO, that shall have been reviewed and found satisfactory by the Bank, is a condition of loan effectiveness. 2.13 The Government would guarantee the proposed Bank loan to DBP. In turn, DBP would rely on collateral provided by MERALCO to secure the onlending of the Bank loan proceeds (para. 3.30). F. Project Implementation and Schedule 2.14 The transmission and distribution components are well within MERALCO's technical and managerial capabilities for design, engineering and implementation. By June 15, 1989, MERALCO will appoint a project manager for coordinating its activities in connection with the proposed project. The stringing of subtransmission lines will be undertaken by MERALCO's own work force. Construction under the project will be managed by MERALCO. In cases where the civil works involved are relatively small and well within the purview of its normal activities, that construction would also be handled by MERALCO's own work force. Otherwise, the civil works would be undertaken by contractors. Erection of equipment for the substations will be undertaken by the equipment suppliers under the overall coordination of the MERALCO Project Manager. Assembly of the communications system will, be implemented by MERALCO, with supervisory assistance from the equipment suppliers. 2.15 The implementation schedule for the subtransmission and distribution components has been determined according to the order of priority derived for each individual constituent of MERALCO's least-cost development plan. Those two components are scheduled to be implemented entirely during the period 1989-93. For most individual constituents of the subtransmission component, engineering and design as well as procurement will need to be completed in 1989, primarily because of the long lead time involved in the procurement of transformers. In contrast, the design for substations can only be finalized after the equipment is purchased; therefore the implementation schedule for the substations indicate that they will be designed in parallel with implementation of the rest of the project components. 2.16 Implementation of the distribution system upgrade component is scheduled according to annual plans, within which MERALCO has identified constituent activities needed to address: ' , system loss reduction; - 13 - (b) enhancement of system reliability and quality of service; and (c) requirements to meet load growth. In effect, the year-by-year work schedules have been prioritized based on current levels of technical losses, service interruptions, and projected load growth. 2.17 The engineering and design for the radio multiplex facilities has already been completed, and tender documents for this component are under preparation. 2.18 MERALCO plans to procure the maintenance equipment and vehicles in a phased manner during the period 1990-92. 2.19 Annex 2.03 gives the implementation schedule with key dates for the completion of important milestone activities for each component of the proposed project. The project is scheduled for completion by end 1994. G. Procurement 2.20 The procurement arrangements for the project are summarized in Table 2.3 below. Table 2.3: SUMMARY OF PROCUREMENT ARRANCEMENTS (US$ million) Procurement Method Project Component ICB LCB Other/a N/Alb Total Cost Subtransmission Lines and Substations 43.6 8.3 1.0 27.2 80.1 (41.1) (2.0) (1.0) (0.0) (44.1) Distribution System Upgrade 11.5 4.1 1.0 12.7 29.3 (10.5) (2.0) (1.0) (0.0) (13.5) Radio-Multiplex Facilities 2.3 0.5 0.0 0.6 3.4 (2.3) (0.0) (0.0) (0-0) (2.3) Maintenance Equipment and Vehicles 5.6 0.0 0.0 1.6 7.2 (5.6) (0.0) (0.0) (0.0) (5.6) Total 63.0 12.9 2.0 42.1 120.0 (59.5) (4.0) (2.0) (O.O) (65.5) NOTE: Figures in parentheses indicate financing from the Bank loan. /a Limited international bidding, and international and local shopping. Lb Refsrs to expenditures on engineering and administrative overheads and also duties and taxes of the order of approximately US$9.0 million. - 14 _ 2.21 For this project, MERALCO will prepare separate procurement packager for all items to be procured through International Competitive Bidding (ICB). These packages, which were finalized at negotiations, include: (i) power transformer; (ii) mobile power transformer; (iii) metal clad switchgear; (iv) gas-insulated switchgear; (v) power circuit breaker; (vi) disconnect switch; (vii) station type capacitor base; (viii) transformer cooling fan; (ix) underground power cable; (x) wire; (xi) storage battery and battery charAer; (xii) fuse cutout; (xiii) distribution transformer; (xiv) potential transformer and current transformer; (xv) radio multiplex equipment; (xvi) oill/vacuum circuit recloser; (xvii) voltage regulator; (xviii) regulator bypass disconnect switch; xix) line capacitor and accessories; (xx) load breaker switch and line disconnect switch; (xxi) transmission and distribution on-line pole; (xxii) lighting arrestor; (xxiii) insulator; (xxiv) time-of-day meter; (xxv) mechanized vehicle; (xxvi) switchboard material; (xxvii) hardware and accessories; and (xxviii) civil works for transmission and distribution systems. Many of these procurement packages will be bid concurrently so that potential bidders are able to obtain bidding documents for as many packages as they like and bid on any number of packages. The procedures to be followed will be ICB as specified in the Bank's Procurement Guidelines, except in those instances noted in para. 2.22, in which Local Competitive Bidding (LCB), Limited International Bidding (LIB), and/or international and local shopping (according to procedures that 'have been reviewed and found satisfactory by the Bank) might be used. Annex 2.04 identifies the mode of procurement to be used for each of the proposed packages together with a list of the equipment included in each package and the expected delivery schedule for each category of equipment. All civil works to be financed by the Bank will be bid according to ICB. For all ICB procurement, local suppliers and contractors will be permitted to participate and, at MERALCO's option, will be eligible in the evaluation of bids for the lower of: (a) a preference of 15? on the CIF cost of the imported goods; or (b) the prevailing customs duties and other import taxes. All essential procurement documentation for goods being financed by the Bank and having an estimated cost of over US$1 million equivalent will be subject to the Bank's prior review. Procurement packages valued at approximately 80X of the loan amount are likely to be reviewed. 2.22 While MERALCO intends that most of the major packages of materials and equipment will be procured through ICB, some exceptions are possible for contracts for (i) small lots of low value items where a large number of foreign manufacturers are well represented in the Philippines; (ii) equipment and materials that are proprietary; or (iii) purchases that are needed to ensure standardization and compatibility with existing equipment. In particular, for the distribution system upgrade component, many small items, such as voltage regulators, line capacitors, kWh-meters, and load break switches, need to be purchased on an annual basis. Also items in constant demand, such as hardware and accessories needed for construction and installation of equipment, are usually available off the shelf and MERALCO should be capable of procuring them at short notice. The administrative burden involved in procuring these items according to ICB may negate the benefits of using that procedure. Contracts for these goods, not exceeding US$200,000 up to an aggregate of US$4 million may be procured through LCB procedures that have been reviewed and found acceptable by the Bank. Equipment standardization may also call for LIB procedures that have been reviewed and found acceptable by the Bank, to be followed in some exceptional - 15 - cases. Contracts for these goods, not exceeding US$200,000 up to an aggregate of US$1 million, may be procured through LIB. Finally, contracts for goods not exceeding US$50,000 up to an aggregate of US$1 million, may be procured through international or local shopping, based on price quotations obtained from several foreign and Local suppliers (usually at least three) to ensure competitive prices. H. Disbursements 2.23 The Bank loan would be disbursed against (a) 100X of the foreign expenditures of directly imported equipment and materials; (b) 100? of local expenditures (ex-factory cost) of locally manufactured items procured through ICB; and (c) 802 of local expenditures for other items procured locally; and (d) 652 of the cost of civil works to be performed by contractors whose services would be procured through ICB. 2.24 Disbursements for small contracts, with a value of USS 200,000 or less, would made on the basis of statements of expenditures (SOEs). Documentation supporting the SOEs would not be submitted to the Bank but would be retained by DBP and made available for review by the Bank supervision missions. To facilitate project disbursements, a Special Account in a fully convertible currency will be established by DBP on terms and conditions satisfactory to the Bank. The authorized allocation to the Special Account will be US$4 million, representing four months' average project expenditure. Replenishments to the Special Account would be made quarterly or whenever the account is drawn down by about 50Z of the initial deposit. The otandard procedure for auditing SOEs will apply. 2.25 Annex 2.05 gives the disbursement schedule for the proposed Bank loan. Since no specific disbursement profile has been compiled for power projects in the Philippines, the Asia regional profile for power projects was used to derive the disbursement schedule for this project. However, given that the project consists of discreet components that are characterized by standard materials and equipment and relatively short construction periods, this project is not likely to span the seven years implied by the Asia Regional profile. Therefore, that profile has been followed for the first five and a half years and the remainder of the loan is assumed to be disbursed in the last semester of the sixth year. The project completion date for the proposed loan will be December 31, 1994 and the closing date of the loan will be June 30, 1995. During appraisal, MERALCO indicated eloquently the urgency of these investments and its commitment to implementing them even ahead of schedule. This commitment combined with the approach used in packaging procurement suggests that flie loan could be disbursed faster than projected and that the project could be completed as early as December 1993. I. Monitoring and Reporting 2.26 Satisfactory procedures for monitoring (i) the physical execution of the project; (ii) project expenditures; and (iii) MERALCO's technical, commercial, and financial performance were developed at appraisal. HERALCO will furnish proaress reports to the Bank every six months. - 16 - J. Environment 2.27 In and around Metro Manila, the subtransmission lines will traverse existing routes of N.PC-owned 230 kV lines or MERALCO-owned 115 kV and 34.5 kV lines. None of the new lines will traverse virgin territory. They constitute either second circuits of existing systems, or new lines supplementing existing distribution networks. New substations are mostly additions to existing NPC or MERAEf-O facilities. As such, no significantt environmental impacts are associated with these projects. The transmission lines will be designed according to international standards. Within urban areas, high voltage lines will be run on poles meeting necessary safety codes. 2.28 Noise pollution from distribution substations is the one possible environmental hazard that could exceed prescribed limits. After receiving detailed design information on the trah.sformers from the potential suppliers, MERALCO will conduct environmental impact studies for each of the substation project components under this project. These studies will determine if, with the installation of the new transformers, the noise level at the boundary of any substation would exceed allowable limits. The results of these studies will be available for discussion with the Bank. In the event the studies find noise pollution that exceeds prescribed limits, MERALCO will take measures to enclose transformers with adequate sound barriers so as to ensure compliance with environmental regulations concerning electrical substations. These arrangements are expected to ensure that the installations to be built will meet the Bank's environmental guidelines and that the proposed project will not have an adverse impact on the environment. 2.29 Although MERALCO owns most of the land it needs for the project, it will need to purchase some additional small parcels in connection with a number of the substations. In those cases, it has already identified the parcels and is negotiating their purchase with the present owners. MERALCO has confirmed that each of these parcels is vacant. However, in the event that these parcels should become occupied by squatters, MERALCO will ensure that they are adequately compensated. This is satisfactory to the Bank. III. THE BORROWER A. Background: 1958-1986 3.1 Established in 1958 as a Government-owned development bank, DBP's financing operations until 1986 encompassed almost all segments of the economy, and both large and small-scale enterprises. In addition to its industrial, agricultural, real estate and transportation lending, DBP engaged heavily in lending to social sectors such as education and health care. Starting in the seventies, under the guise of its developmental mission, DBP financed high risk and low return Government development programs ('directed' or 'behest" lending), and the takeover of financially distressed firms at Government's direction. - 17 - 3.2 This lack of financial discipline in its lending, compounded by serious weaknesses in internal organization and procedures (notably credit appraisal and supervision), led to serious financial problems. In the early 1970s, the total debt to equity ratio rose to over 10:1; the current ratio fell to 0.2:1; and arrears in the 1. a portfolio and defaults in the guarantee portfolio were high. With its resource mobilization capacity undermined, DBP had to rely mainly on Government deposits for funding its activities. 3.3 Several capital increasee between 1972 and l180, substantial government deposits to support its liquidity position, and strengthening of its organization and procedures all failed to stop DBP's deterioration in the eighties. Considerable problems of portfolio arrears and poor collection rates persisted, as did the more intractable issue of high-risk and low-rate behest loans. As part of the Bank financed Industrial Finance Project (Loan 1984-PH; 1981), the Government and DBP were asked to implement an "Action Program", which included further organizational changes, measures to reduce DBP's dependence on Government deposits, and actions to improve the collection performance. The financial effects of behest lending were to be made transparent, and Government was to provide financial assistance if DBP's financial viability would be impaired as a result of behest lending. However, continuation of DBP's problems, exacerbated by the economic and political crises of the period, led to DBP losing its accreditation as a participating financial institution in the project. DBP's financial situation in 1985 remained poor, with a net loss of P 6.9 billion (US$370 million equivalent), representing a negative return on average net worth of -182.3Z. Annex 3.01 presents the details of DBP's financial performance for the period 1984-87. 3.4 Following the change in Government in 1986, the severity of DBP's problems and its technical bankruptcy were addressed by a comprehensive rehabilitation and financial restructuring program developed in conjunction with the Bank financed Economic Recovery Loan (Loan 2787-PH) (ERL). Major components included: (i) a new charter and policy statement, (ii) installation of a new management team and Board of Directors, (iii) transfer of P 74 billion of nonperforming accounts to the Asset Privatization Trust (APT), created by the Government to sell those assets; (iv) implementation of a drastic cost reduction program through staff reduction and sale of branches; (v) an internal reorganization and strengthening program focussing on credit policies, legal procedures, financial controls, accounting and internal cor.trols. and personnel management; and (vi) phasing out of subsidized Government deposits. B. DBP's New Role and Strategic Orientation 3.5 DBP's financial restructuring and the major elements of its internal strengthening program under the ERL have essentially been completed, with DBP being solvent during the last two years. Despite its profitability, however, DBP has been seeking to define its role in the financial system. Not endowed with the financial, organizational and personnel resources necessary to undertake commercial banking, DBP was also not sure that traditional development banking activities (with the higher risks attendant on term lending) would be adequate to sustain its profitability. - 18 - 3.6 A recent Bank study of the financial sector (IBRD Report No. 7177-PH, August 23, 1988) identified the lack of institutional arrangements for mobilizing and channeling long-term funds as a major constraint to investment. The study recommended that a revamped DBP could be developed to fill this institutional gap. This would involve mandating DBP to act primarily as a wholesale financial institution, catering to financial intermediaries rather than directly to business enterprises. Agreement with Government has been reached on this new orientation. 3.7 The wholesale DBP would mobilize and channel term funds to the private s,ztor through retail financial institutions. Given the availability of domestic long-term funds from the Social Security System, insurance companies and pension funds, DBP is expected to play a major role in domestic resource nobilization. However, DBP's increased reliance on domestic resource mobilization can only be gradual; in the near future, the lack of a developed capital market and the Government's continuing needs to tap domestic savings through high-yield Treasury bills would impede DBP's raising significant long term peso funds. In such an environment, DBP will have to fund itself to a significant degree through foreign sources in the coming years. In this context, DBP has been designated as a conduit for official foreign borrowings, the proceeds of which are to be channeled through retail financial institutions for use in financing private enterprises. In line with this, the Government has agreed to the transfer from the Central Bank to DBP of the existing credit programs with foreign funding -- the Apex Development Finance Program (APEX) and the Industrial Guarantee and Loan Fund (I6LF). As part of the Financial Sector Adjustment Program, IBRD has helped DBP formulate an Institutional Development Plan that would define and make operational DBP's wholesale banking strategy, including an action plan for mobilizing domestic term funds. 3.8 DBP's transformation to a primarily wholesale bank will be accomplished through a gradual reduction of its tetail loan approvals and outstanding retail loans to enterprises relative to the wholesale loan appro-als and outstanding wholesale loans to financial institutions. By the end of 1993, DBP's portfolio is to be predominently wholesale. Subject to the availability of expected ODA funds, DBP projects that 692 of its outstanding loan portfolio will consist of wholesale loans by 1994. Annex 3.02 provides details of the gradual reduction, in relative terms, of retail lending and the concomitant growth of wholesale loans. 3.9 The transition will also entail the gradual disinvestment from DBP's br&nch network. With the exception of 15 regional and metropolitan branches, all branches will be pooled into five regional development banks, which are to be privatized according to a schedule agreed under the ERL. By 1993, DBP's equity stake in these regional development banks would have been reduced to 302. - 19 - C. Organization and Management 3.10 Before 1987, the Board of Directors held day-to-day operational responsibilities. Under the revised charter, the Board is a policy making body distinct from management; only the Chairman and the Vice Chairman of the Board are also bank managers. Composed of nine members appointed by the President of the Republic of the Philippines, the Board now includes five members from the private sector. 3.11 DBP has developed a revised organizational structure (Annex 3.03) that is appropriate for implementing its wholesale banking strategy. The guiding principles behind the new organization structure are: (a) clear separation of funding and lending operations; and (b) upgrading of the resource mobilization function by creating a Capital Markets Department. Given the increased importance of resource mobilization, which has to be carried out in the financial markets by an individual of high standing, the Capital Markets Department will be headed by an officer holding the rank of at least Vice President, reporting to the Executive Vice-President in charge of the Treasury Gioup. On the lending side, an Executive Vice President for Marketing will oversee the Financial Institutions Department that will manage wholesale loans; the Entrepreneurial Banking Department will be in charge of i the Metro Manila Branch, and the Corporate Banking Department will be in charge of project management. The Industrial Restructuring Unit, which will form part of the Strategic Planning Center, will report directly to the Chairman. The two Executive Vice Presidents and the Senior Vice President in charge of Accounting and Administrative Services will also report to the Vice Chairman, who in turn reports to the Chairman. An Internal Audit Department reports directly to the Board of Directors. D. Personnel Policy and Training 3.12 Under the ERL, DBP has reduced its staff from about 3500 to 2000, mainly through an early retirement scheme. The new wholesale orientation of DBP is expected to lead to a further net staff decrease of about 250: selective recruitment of a small number of qualified individuals to handle the new wholesale banking functions will be offset by reductions in staff resulting from DBP's disinvestment from the branch network and reassignment of existing staff from retail banking to wholesale banking. 3.13 A job and performance evaluation system as well as a merit oriented financial reward system are in place, with the integration of the two systems planned for 1989. The Chairman and senior management are aware that the reorganized DBP must be able to offer compensation competitive with the private financial sector, if it is to attract and retain the high caliber staff necessary for it to perform its functions effectively. 3.14 DBP has engaged in extensive training of its staff in corporate finance, loan packaging, financial analysis and legal issues. Aware that the training efforts will have to be reoriented towards DBP's new activities in wholesale banking, DBP's management is reviewing its training needs for the period 1989-92, in the context of the Institutional Development Plan currently under preparatior.. This assessment will take into accounts (a) the - 20 - incorporation of the APEX and IGLF units currently in the Central Bank; (b) the increased importance of resource mobilization efforts; and (c) DBP's role in conducting industrial restructuring studies and acting as a wholesale channel for loans to support industrial restructuring programs. E. Accounting and Management Information System 3.15 The flow of accounting data has improved substantially over the last two years. Revised Branch and Head Office Accounting and Procedures Manuals have been completed. Liquidity and reserve summaries are generated daily; financial statements of branches and head office are consolidated monthly. The general ledger is computerized and closed daily. Subsidiary ledgers for loans, which had been booked separately by lending groups and industries before the reorganization, have been centralized in the Transactions Processing Department. A central mainframe computerized information system, acquired from Citibank, is expected to be operational by 1990. This state-of- the-art system will provide an integrated Management Information System that allows immediate access to all transactions iJrrmation that is stored in a centralized data base. The system will also .......egrate (i) on-line authorization and printing of customer advices, and (ii) contract administration for loans, placeinents, bonds, deposits, commitments, receivables and sundries until final maturity, thereby eliminating the need to keep track manually of interest accruals, principal payments, liquidations and billings. The system will also incorporate an automated accounting service. Internal communications within the head office and between branches and head office are expected to be computerized by the end of 1989. In the meantime, the branches operate with stand-alone microcomputer systems for the general ledger, loans and liabilities and the savings and current accounts. The ongoing computerization and a system of account profitability analysis are expected to improve the management information system considerably. F. Loan Activities and Asset Management 3.16 The DBP loan window was reopened in mid-1986 after a hiatus of four years during which no new loans were released. Since then, DBP's investment policy has been conservative, with lending being primarily short term and excess liquidity being invested in securities, primarily Government issues. In 1987, DBP realized no positive new net lending, while its securities portfolio grew by P 2.8 billion. In 1988, outstanding loans grew by P 1.2 billion, while investments in bonds and securities were reduced by P 880 million. 3.17 DBP uses resources from its "Regional Development Fund" to extend loans that do not completely satisfy commercial banking risk or collateral criteria. Considered essential from a developmental point of view, these loans involve concessions in one or moie of the following parameters -- interest rates, repayment terms, or collateral requirements. The Regional Development Fund comprises 30? of each year's net income after taxes and repayments of loans sourced from the Fund. In the first three quarters of 1988, P 517 million or 18.5 Z of new loans were approved under this "Window III" facility. However, as of December 1988, only P 74 million of Window III loans were - 21 - actually outstanding. DBP has agreed that (i) the risk exposure of these loans and compliance with the 30% net income ceiling will be monitored closely; and (ii) appropriate provisions will be made to take into account the potentially higher risk. These provisions will amount to not less than a level of 10-202 above the average provisioning on conventional performing loans. 3.18 Loan recovery of non performing loans, entrusted to branch loan workout taskforces and the Remedial Management Group at head office, has met with some success. Out of 6000 non-performing accounts, representing P 4 billion, that remained on DBP's books after the transfer of the bigger accounts to APT, collections representing P 1.2 billion were made on 3,800 accounts. In addition to standard loan collection and foreclosure activities, an 8incentive scheme for pretermination" has been devised. By offering the debtors a roll-back of interest to 1984 ( retroactive computing of interest due on the basis of 1984 rates) and condonation of penalties in exchange for a 202 downpayment and an agreed schedule of repayment of the recomputed past due, DBP has succeeded in collecting on about 300 formerly doubtful accounts. Loan loss reserves cover 112 of the performing portfolio and 982 of the non performing portfolio. Given DBP's past history, the conservative provisioning policy is appropriate. G. Liability Management 3.19 The current average maturity of funding liabilities is about 1.8 years, against an average loan maturity of 3.8 years. DBP's balance sheet is now exceptionally liquid, with cash and due from banks representing 552 of deposits and investments in bonds accounting for 372 of total assets. Liquidity will decrease somewhat as (i) countryside bonds issued by DBP mature and the interest-free Government deposits are repaid, and (ii) wholesale lending activities grow. Investments of over P 5.1 billion in bonds and securities at 1987-end have fallen to P 4.3 billion at 1988 end and are projected to fall further. Wholesale lending is projected at P 3.8 billion in 1989, P 13.2 billion in 1990, P 18.0 billion in 1991, and P 23.9 billion in 1992. To fund its projected lending, DBP intends to supplement its foreign currency sources by actively tapping the domestic capital market. 3.20 As a wholesale institution, DBP aims at playing a major role in domestic resource mobilization. In addition to promoting an active secondary market and lobbying for appropriate regulatory changes designed to open up the primary market, DBP will enter the market for its own account by issuing a variety of instruments, specially designed to tap different categories of institutional investors. Through recruitment of a few experts in its Treasury Group, DBP would acquire the required capabilities for designing, packaging, timing, pricing and placing its debt instruments. Given investors' current preference for short-term paper, DBP envisages that it would initially launch a P 300 million, 3 year, listed bond issue to re-establish its presence in the market. Favorable reception in the market would then be followed up by further issues with longer maturities and lower coupons, to the extent allowed by market conditions and crowding-out effects resulting from Government funding requirements. - 22 - H. Financial Position and Performance 3.21 DBP's financial statements for the perlod 1984 to 1987 are given in Annex 3.01. Unaudited results for 1988 are given in Annex 3.02. Its recent financial performance is summarized in Table 3.1. Table 3.1: SUMMARY OF DBP'S FINANCIAL PERFORMANCE--1986-88 (P billion; Ratios in Percent ) Year 1986 1987 3988 Total Loans Outstanding 5.27 4.39 6.15 Total Debt 6.82 7.07 6.63 Total Equity 2.68 3.46 5.2 Ratios: Debt/Equity 2.5 2.0 1.3 Cash and Due from Banks/Deposits and Short Term Borrowings (Z) 35.5 26.8 45.3 Provisions for Doubtful Accounts /Total Loans (2) 47.3 53.6 48.9 Net Interest Margin/Total Assets (Z) (29.5) 9.7 8.3 Return on Average Net Worth (2) (157.7) 25.5 20.1 Operating Expenses/Total Assets (Z) 81.8 9.2 7.3 3.22 With the significant relief resulting from transfer and workout of old non-performing accounts and its conservative investment policy of the last two years, DBP's debt to equity ratio is now a very conservative 1.3:1, compared to the ceiling of 5:1 set under the ERL. 3.23 In 1988, DBP generated net pretax income of P 898 million, compared to P 800 mil'.ion in 1987. Earnings indicators look impressive: return on assets is 14.02; return on net worth, 32.32. However, if the sale of DBP's holdings in Philippine Commercial and Industrial Bank (PCIB), one of its subsidiaries, is excluded from the calculations, DBP's return on assets drops to 7.22 and return on net worth to 20 12. 3.24 Nonetheless, this performance is not fully indicative of DBP's long term earning capability on a going concern basis. Of the total operating income of 2.6 billion, only 282 is interest from loans, whereas 362 comes from gains in asset sales and 182 from investment in securities, primarily Government issues. On the revenue side, this reflects the cautious investment approach taken in the first year after the financial restructuring, as well as exceptional gains of P 93' million realized through sales of shares in PCIB. Moreover, P 42 million of penalty interest on overdues contributed to 1988 earnings; this source of income will decline as more accounts are brought current in future years. As for expenses, about P 2 billion of interest free Government deposits, or 192 of total funds, were on DBP's books in early 1987; - 23 - as these free deposits are gradually being repaid (the schedule calls for full repayment by the end of 1989), these funds will have to be replaced with higher cost funds, which would decrease the spread DBP is realizing. This combination of factors which reduce revenues and increase expenses will lead to lower, though still positive, net returns in the future. Detailed projections of DBP's future financial performance are presented in Annex 3.02 and summarized in Table 3.2. These projections are of an indicative nature, as the assumptions underlying them are dependent on general macroeconomic conditions, the development of the local capital market, and the availability of ODA funds. Table 3.2: SUMMARY OF DBP'S PROJECTED FINANCIAL PERFORMANCE (P Billion; Ratios in Percent) Year 1989 1990 1991 1992 Wholesale Loans Outstanding 3.85 13.23 18.03 23.90 Retail Loans Outstanding 7.51 8.75 11.40 13.72 Total Debt 9.45 18.50 24.86 31.93 Total Equity 5.94 6.82 7.58 8.63 Ratios: Debt/Equity 1.6 2.7 3.3 3.7 Cash and Due from Banks/Deposits and Short Term Borrowings (X) 20.7 27.5 31.5 37.3 Provisions for Doubtful Accounts/ Total Loans (X) 8.1 3.9 4.0 3.7 Net Interest Margin/Total Assets(Z) 6.6 6.7 6.6 6.4 Return on Average Net Worth (2) 15.1 15.0 12.2 14.6 Operating Expenses/Total Assets (2) 8.3 7.8 10.3 10.2 3.25 Though DBP's performance still has room for improvement, its results for the last two years show that DBP is now endowed with features that enable real optimism regarding its future prospects. It has a new management that has demonstrated a willingness and an ability to make hard decisions; it has developed a focused strategy and has restructured its organization to implement that strategy; and it has developed and is implementing improved controls and procedures. Of equal importance, its operations are to be governed by a set of policies designed to ensure that it avoids the mistakes of the past. On April 5, 1989, DBP's Board approved a new Policy Statement (Annex 3.04) which reflects its wholesale lending orientation and which deals with inter alia DBP's investment policies, financial prudence limits and capital structure. Salient features of the Policy Statement provide for: (a) private sector orientation with autonomy in decision-making; (b) an interest rate and fees policy that is consistent with prevalent market rates and that ensures full recovery of all its direct and indirect costs, including provisions as required, plus an adequate profit margin; (c) prudent interest rate and maturity match between its assets and liabilities; and (d) a debt-equity ratio not exceeding 5:1. Barring a deterioration in the macroeconomic environment, DBP is now poised for growth. - 24 - I. Audit 3.26 In addition to the audit performed by the Government Commission on Audit, a private independent firm audits DBP's annual financial statements. The independent auditor for 1987, Joaquin Cunanan and Company, a member of the Price Waterhouse group, qualified its opinion by remarking that the volume of loans from the National Government, mainly in the context of the transfer of non-performing assets to the APT, could not be established and audited. DBP expects that this qualification will be dropped from the 1988 audit. At negotiations, DBP agreed to furnish to the Bank by June 30 of each year, its annual financial statements certified by an auditor acceptable to the Bank. J. The Proposed Loan 3.27 DBP would be the Borrower of the proposed Bank loan and would onlend the proceeds to MERALCO. As lender to MERALCO, DBP would bear the MERALCO credit risk. MERALCO would bear the full foreign exchange risk and pay the commitment fee on the Bank loan as well as other costs related to the proposed Bank loan. The terms and conditions of onlending are given in para. 2.12. 3.28 The Subsidiary Loan Agreement between DBP and MERALCO would cover, inter alia, (i) the procedures to be followed in executing the project; (ii) adequate arrangements for securing the Loan (para. 3.30); and (iii) the conditionality to which MERALCO agreed at negotiations (paras. 1.11, 4.16, 5.8, 5.17 and 5.18). The Bank would conduct its project supervision jointly with DBP. 3.29 As the proposed transaction would lead to DBP exceeding its single borrower limit, the Bank explored various alternatives for channelling the Bank funds to MERALCO. The only feasible option which met the requirements of all parties concerned was for DBP to act as the Borrower with the Government guaranteeing the loan. Given that the investmnents to be financed by the loan are needed urgently and that MERALCO is one of the nation's better credit risks, DBP has sought, on an exceptional basis, a waiver of the single borrower's limit for purposes of this project. The Monetary Board has approved the waiver. 3.30 DBP would secure the onlending of the proposed Bank loan with first mortgage bonds that MERALCO would issue against its Trust Indenture. Taken together with the first mortgage bonds DBP will receive in connection with a US$35 million equivalent KfW loan to MERALCO that is being channelled through DBP, the exercise of rights from the bonds issued in connection with the proposed loan offers DBP a sound and potent security that mitigates substantially the MERALCO credit risk. - 25 - IV. THE BENEFICIARY A. Introduction 4.1 The beneficiary of the proposed Bank loan will be the Manila Electric Company ("MERALCO" or "the Company"). MERALCO is a large corporation owned by the private shareholders. The Company was founded as the Manila Electric Rail and Lighting Company by U.S. interests in the early 19009. It was awarded, inter alia, a franchise to provide electric service within Metro Manila; this franchise entitled the Company to own and operate generating stations as well as distribution facilities within a defined area. In the late 19609, prompted by Government action for economic reform, ownership of the Company was sold to local interests; by then, MERALCO had become a full service electric utility that was well regarded throughout the region. In the late 1970s, in connection with the Government's reorganization of the power subsector, NPC purchased most of MERALCO's generation facilities; MERALCO was then recast as a distribution utility. In 1982-86, the Company nearly tripled its franchise area when, at Government's behest, it absorbed the activities of several failing electric cooperatives along its fringes (para. 5.5); even so, with about 30% more customers, peak demand and energy sales did not increase (para. 1.8). As a result of (a) an aging rate base; (b) inordinately high system losses; and (c) poor credit, MERALCO's performance has ;uffered in recent years. B. Ownership 4.2 About 98.5% of the company's 43 million shares (following a 702 stock dividend paid in late 1988) are owned by one institution, the MERALCO Foundation (the Foundation). The Foundation purchased this stock from the First Philippine Holdings Corporation (Holdings) using loans that were secured by the shares themselves and were to be repaid using the company's dividends. As of August 1987, four financial institutions had about 61Z of the Foundation's stock pledged to them; the remaining 392, representing shares that were purchased by the Foundation but for which payment had not been remitted, continued to be retained by Holdings as collateral to be released when the payments are eventually made. In turn, Holdings has used the 39? of shares it holds as collateral to secure borrowings of its own from DBP. In all, on a post-split basis, DFP retained about 28 million shares or 65.1? of the outstanding 43 million MERALCO shares as collateral for loans advanced to both the Foundation and Holdings. 4.3 In January 1987, in accordance with government policy concerning non- performing assets, DBP transferred these loan accounts, together with the stock being retained as collateral for these loans, to the Asset Privatization Trust (APT) for disposition. In mid-1987, Holdings and the Foundation arranged with a syndicate of banks led by the Bank of the Philippine Islands and the Morgan Guaranty Trust Company (the BPI-Morgan Group) to purchase from APT these loans together with the stock being held as collateral, and liquidate the loans by selling about 20 million MERALCO shares to the public over a period of three to four years. Under this arrangement, the BPI-Morgan Group would provide Holdings and the Foundation the bridge financing of P 690 million needed to liquidate the loans held by APT. In return, the MERALCO shares being held as collateral by APT would be transferred to the BPI-Morgan - 26 - Group. The BPI-Morgan Group would then sell the MERALCO shares into the market; after its financing has been liquidated and it realizes a stipulated fee based on predetermined thresholds, the BPI-Morgan Group would share with Holdings and the Foundation, the proceeds from the sale of the remaining shares. In the process, MERALCO's ownership would become widely dispersed in a manner consistent with the Government's stated objective. 4.4 This scheme was finally approved by the Government in December 1988 after delays of nearly fifteen months. During that time, the scheme was reviewed by several statutory and ad hoc committees. Those committees recommended several adjustments to the scheme, including: (i) Government receiving, after liquidation of the P690 million principle amount, a 30Z share in the proceeds from the further sale to the public of the MERALCO stock; and (ii) shortening of the period during which MERALCO shares would be retained by the BP:-Morgan Group. After these changes were agreed by the Foundation, Holdings and the BPI-Morgan Group, the Government authorized APT to proceed with the transaction. Currently the shares are being registered for listing on the various local Stock Exchanges; they are expected to be approved for listing by mid 1989. At that time, the purchase of the loans together with the shares from APT will be completed; and the Foundation, Holdings and the BPI-Morgan Group can begin selling the shares to the public. 4.5 In the course of the various committees' reviews of the aforementioned scheme, the Government clarified the issues surrounding (i) the potentially conflicting liens on MERALCO's stock; and (ii) the Company's ownership. Albeit that the Foundation had collateralized a number of large obligations with MERALCO's stock, the Foundation retained its rights and privileges as owner of the shares because neither DBP, Holdings, nor any of the three other local banks retaining MERALCO shares as collateral for the Foundation's delinquent obligations ever formally declared the Foundation in default. Therefore, the Foundation could Pnd did properly exercise its right to appoint MERALCO's Board and oversee the Company's affairs. Although the Foundation had been constituted as a non-profit organization acting for the benefit of MERALCO's consumers, the Government declared that it was better qualified than any alternative party to act in the best interest of the Foundation's beneficiaries; therefore, the Government assumed the responsibility for nominating the Foundation's Board and overseeing the Foundation's activities. During implementation of the aforementioned scheme, the Foundation will retain ownership of the shares being offered for sale until the shares are actually sold. Upon completion of the privatization scheme, the Foundation will continue to own about 54Z of MERALCO's stock, and the Government will continue to control the affairs of the Foundation on behalf of the beneficiaries. These clarifications have satisfactorily resolved the apprehensions of DBP and the Bank regarding MERALCO's ownership. C. Organization, Management and Staff 4.6 MERALCO's corporate powers are exercised by its eleven-member Board of Directors. Although the Foundation, Holdings and DBP have all had claims on major blocks of MERALCO shares, the Foundation has given considerable representation to Holdings, DBP and the Government when constituting the Company's Board in recent years. As a result, the Company has not suffered a - 27 - legal challenge to (i) the composition of, (ii) any decision made by, or (iii) any agreement entered into by, its Board. The present MERALCO Board, which consists of bankers and businessmen, was endorsed by the shareholders at the company's 1989 Annual Meeting. Each Board member is elected to serve until the next Annual Meeting and may be re-elected without limitation. MERALCO's management is vested in its President, who is himself a Director and serves as the company's Chief Executive. He is reappointed each year at the first meeting of the reconstituted Board of Directors following the Annual Meeting. 4.7 MERALCO's organization chart is presented in Annex 4.01. The structure presented therein is appropriate. A profile of staff, allocated according to organizational group, is presented in Annex 4.02. As of September 30, 1988, MERALCO had a total staff of 7,034; its 248 customers for each employee, as of that date, represents steady improvement in that ratio since 1982. D. Training 4.8 MERALCO has an ample in-house training program. The program focuses on (a) orientation of new staff; (b) skills development for working level and clerical staff; (c) technical development for engineers and other professional staff; (d) managerial skills development for (i) existing managers, and (ii) staff identified as having potential for promotion to managements and (e) organizational behavior and communications courses and workshops for staff of specially targeted units. In addition, MERALCO arranges for on-the-job or external training for deserving staff to cover topics that are not available in the in-house program. These arrangements are appropriate. E. Operations, Maintenance and Losses 4.9 While MERALCO has registered some recent declJnes in its forced interruption frequency rate and its forced cumulative interruption time, it continues to have considerable scope for improving the quality of its service. MERALCO's service has suffered as a result of its failure to (a) renew aging facilities, and (b) extend its system to keep pace with the development of demand (para. 5.4), and not because of factors relating to operation and maintenance. In fact, HERALCO has operated and maintained its system satisfactorily, especially considering its resource constraints in recent years. 4.10 MERALCO's system losses, which in 1982 averaged about 112 of system output, reache about 212 in 1986, and then dropped to about 20.8Z in 1987. This improvemenL strengthened during 1988, so that the company recorded losses averaging 172 for the year. MERALCO believes that technical losses, which were about 82 in 1982, increased to the range of about 122; the remaining losses are believed to result from pilferage and other non-technical causes. The company has been seeking to reduce technical losses through (a) the proposed project, which is expected to strengthen inadequate lines and upgrade some of its substations; and (b) a second project, being financed by KfW, which is expected to upgrade its remaining substations. In addition, the - 28 - Company is seeking to improve its quality of service by implementing two projects being financed by OECF: (a) the first project will strengthen existing distribution networks and build new lines to serve depressed areas in Metro Manila; and (b) the second project will improve existing networks and provide new lines in rural areas served by MERALCO. At the same time, MERALCO is in the midst of implementing an action program, begun in August 1987, aimed at reducing non-technical losses (para. 5.8 and Annex 5.02). Through various measures included in this action program and the investments being undertaken to reduce technical losses, MERALCO aims to reduce its aggregate system losses to about 122 by 1992. F. Accounting System 4.11 MERALCO's accounting system is based on accepted power utility principles and procedures. It was modeled after the Uniform System of Accounts prescribed for public utilities by the Federal Energy Regulatory Commission of the United States of America, and adapted to suit local conditions and requirements. G. Financial Planning and Budgeting 4.12 MERALCO has well staffed units for financial planning and budgeting. The financial planning unit has developed an integrated computerized financial model, which it uses primarily to test the impact of investment and financial decisions and to provide information to external financiers. MERALCO prepares budgets annually. The budget is revised periodically during the year and comparisons of actual performance against budget is a regular managerial exercise. H. Commercial Systems 4.13 As of September 30, 1988, MERALCO had about 1.7 million customers. More than 902 of these customers subscribe to residential service; most of the remaining customers are national or local Government units. MERALCO has about 7,000 customers (0.5Z of its total) with loads of 40 kW or more. These 7,000 consumers, including large Government and commercial as well as industrial establishments, account for more than 65? of revenues. 4.14 As of appraisal, after deducting receivables deemed uncollectible but still on the books (about 17? of all private sector receivables), about 90? of private sector accounts were current. MERALCO follows a policy of disconnect- ing delinquent private sector customers, with action being taken more quickly against those with large arrears. In contrast, only about 172 of receivables from Government sector customers were current. Past efforts to disconnect delinquent public sector establishments had resulted in adverse consequences; therefore, the Government has decided to use a clearing-house approach to settle agreed obligations from public agencies against MERALCO's obligations to NPC. Agencies of the national Government have so far cooperated with this approach; however, local Government units, which account for about 60? of MERALCO's sales to the public sector, have not been as forthcoming in provid- - 29 - ing the agreements needed to settle their bills in this manner. The program for strengthening MERALCO's commercial operations (para. 5.8 and Annex 5.02), includes measures to address this problem; however, progress in regularizing these accounts is expected to continue to be slow. 4.15 Through 1986, MERALCO financed the shortfall created, inter alia, from the slow payment of public sector obligations by stretching its own obligations to NPC. By September 1987, its arrears to NPC reached P 1.7 billion; and, as a result of Government intercession, the two parties concluded a rescheduling of those arrears. The terms of that rescheduling included MERALCO's making cash payments of about P 0.9 billion and issuing a six-year 17? note for the remainder. The rescheduling agreement carries penalties to dissuade MERALCO from failing to meet current obligations. MERALCO is current with its other obligations and has been meeting its current obligations to NPC on time since execution of tte rescheduling agreement. I. Audit 4.16 HERALCO has its annual financial statements audited for inclusion in its Annual Report and presentation to its Annual Meeting. The audit is normally performed by a well reputed independent accounting firm, not necessarily the same one every year. The 1987 statements were audited by Sycip, Gorres, Velayo and Company, an accounting firm enjoying a strong professional reputation region-wide. The audit included a review of account- ing policies and practices, as well as transactions. At negotiations, MERALCO agreed that, by June 30 of each year, it will furnish to the Bank audited financial statements for the previous year, together with the certification and related report prepared by an acceptable auditor. 4.17 MERALCO has an internal audit department. This unit has broad responsibilities; yet, its primary activities involve reviewing blocks of transactions. On a special assignment basis, it will review policies and practices, systems and procedures, and the operations of specified organiza- tional offices or units. Inputs to the computerized accounting system are verified by the internal audit department and reviewed by the external auditor. J. Taxes 4.18 Since February 1987, MERALCO has become liable for income tax, assessed at 352 of net income. In addition, the company must pay a franchise tax, assessable at 22 of gross revenues, and real estate taxes. Customs duties in the range of about 15-302 are assessable on all imports. K. Insurance 4.19 MERALCO insures its assets through a combination of self-insurance and commercially purchased policies. Risk management studies are performed regularly by divisions responsible for the assets being insured. At appraisal, these practices were reviewed and found satisfactory. - 30 - L. Dividends 4.20 In the 1980s, the Company suspended payment of dividends, first on common stock and later on preferred stock. During 1987, the Company met its arrears for preferred stock dividends and has been meeting these obligations in timely fashion thereafter. Different issues of preferred stock carry different dividend rates, ranging between 10% and 182. To enhance the marketability of its shares, MERALCO would like to resume paying dividends on common stock; and it expects to resume these payments after the conclusion of 1989 if that year is as successful financially as 1987 and 1988 have been. Under the indenture that it uses to collateralize borrowings, dividends on common stock cannot exceed the previous year's earnings. V. FINANCIAL ANALYSIS OF MERALCO A. Introduction 5.1 MERALCO maintains its own accounts and manages its own financial affairs. As such, it has authority to set prices, formulate its investment program, enter into contract with suppliers of goods and services, and borrow from foreign, as well as domestic, lenders. However, its financial autonomy is limited. As a utility, its pricing policy is subject to ERB's approval. Because of its difficult financial situation, MERALCO has recently been relying on Government guarantees to raise foreign loans from official and commercial sources; this dependence gives the Government considerable influence over MERALCO's investment decisions. Finally, the rescheduling of its arrears to NPC has resulted in more constraints on MERALCO's financial freedom. B. Past and Present Financial Performance 5.2 MERALCO's financial performance for 1984-87 is presented in Annex 5.01 and summarized in Table 5.1. - 31 - Table 5.1: MERALCO'S KEY FINANCIAL INDICATORS - 1984-88 Financial Year Ended December 31 1984 1985 1986 1987 1988 ----------(Actual)---------- (Proj) Energy Sales (GWh) 8,428 7,880 7,938 8,967 10,313 Average Revenue (Ctvs./kWh) 131 180 169 166 160 Capital Expen. (P Million) 562 420 636 702 747 operating Revenue (P Million) 11,029 14,165 13,455 14,843 16,459 Operating Income (P Million) 351 814 950 1,180 985 Net Income (P Million) (231) (70) 244 500 694 Rate Base (P Million) 7,377 9,230 10,504 11,420 12,209 Rate of Return - Revalued Assets 4.762 8.82% 9.041 10.332 9.83? Debt Service Coverage 0.06 4.06 11.82 0.98 2.31 Self-Financing Ratio -1982 832 2812 -99? 1572 Debt/Debt Plus Equity: Including Revaluation Reserve 42Z 242 37% 40? 30? Excluding Revaluation Reserve 632 542 66? 622 46? Operating Ratio 972 94? 932 90? 922 Current Ratio 52? 47? 63? 77? 96? Accounts Receivable - Months 2.19 2.07 2.08 1.87 1.64 Accounts Payable - Months 1.00 1.52 2.59 0.92 0.80 5.3 Although the key indicators might suggest that the Company was a strong performer throughout the period, a more detailed analysis indicates that MERALCO experienced a dramatic turn around toward financial viability in 1987 that continued even more vigorously in 1988, after some years of weak financial performance characterized by severe liquidity constraints. The rapid acceleration of technical losses during 1983-86 combined with declines in the quality of service in those years attests to serious underinvestment before and during that period. The high Self-financing Ratio realized during 1985-86 resulted from a combination of (i) a constrained investment program; (ii) a roll-over of short term loans and current maturities of long-term debt, instead of meeting those obligations when scheduled! and (iii) stretching of accounts payable to NPC. During 1987 and 1988, the Company began planning and implementing an investment program while also (i) restructuring its arrears to NPC; (ii) making timely payments to NPC for its current electricity purchases; and (iii) meeting its amortization obligations on time. Thus, the low Self-Financing and Debt Service Coverage Ratios recorded in 1987 are actually indicators of improving financial viability, given the need to channel internal cash generation into the front end payments associated with a return to financial discipline. In fact, the high ratios expected to be recorded for 1988 indicate remarkable performance in view of the acceleration of amortization payments due in that year. Given that long term debt instruments bearing maturities of appropriate length for electric utilities are not readily available, MERALCO's Debt/Paid in Equity (Equity net of Revaluation Reserves) should be in the range of 402-50?. The improving trend in MERALCO's financial performance is confirmed by the drop in that important ratio from 66? to 46? during 1986-88, indicating that the Company has realized impressive increases in retained earnings during these two years. - 32 - 5.4 MERALCO's financial difficulties began in the mid-1970s, when the Foundation purchased some sizable blocks of stock from other shareholders (para. 4.2) and financed these purchases with borrowings, the repayment of which was to be met from dividends. While these transactions did not infuse any new equity capital into the Company, they did result in increasing the pressures on the Company to pay dividends. At the same time, margins declined because growth in demand was lower than expected; thus, dividends were paid, on occasion in lieu of making necessary investments. This began a pattern of undercapitalization that prevented MERALCO's system from expanding in parallel with demand growth and caused the quality of its service to decline. 5.5 In 1983-84, the Government pressed MERALCO into absorbing the businesses of several failing cooperatives along the fringes of its franchise area. As a result, W'RALC0 needed to raise substantial investment finance just when it was unable to raise loans with appropriate longer maturities, either on its own credit or with Government guarantees, or raise sufficient amounts of equity capital in depressed domestic capital markets. To solve this problem, the Company chose to borrow extensively for short and medium terms from local and foreign commercial banks. 5.6 In the meantime, MERALCO's quality of service continued to decline. Technical losses rose sharply (para. 4.10), and outages remained high. At the same time, collections slowed. In effect, the business was increasingly inefficient at producing cash. Although a return to financial discipline should have begun with the rescheduling of the Company's outstanding loans, neither the former Government nor MERALCO's top management were prepared to support the initiatives needed to bring pilferage and consumer delinquency under control. As a result, faced with heavy cash requirements and restricted in its access to short term borrowings, the Company generated cash by delaying its payments to NPC for power purchases. By the end of 1986, MERALCO was obligated for a restructured loan of US$148 million owed to a group of banks headed by the Bank of Montreal, with the first of 17 unequal quarterly payments due in December 1987. At the same time, arrears to NPC reached about P 1.7 billion, or two months billings over and above current charges. 5.7 In 1987, after changes in both the Government and MERALCO's top management, the Company faced the inevitable need for financial discipline. Programs were developed and implemented to address the problems of increasing non-technical losses and accounts receivable; by the end of 1987, those two problems had stabilized. In 1988, substantial improvement was re.orded in both of these areas. Amortization payments were met, reducing the balance outstanding on the restructured loan to US$141 million at the end of 1987 and US$112 million at the end of 1988. MERALCO rescheduled its arrears to NPC, making various front end payments aggregating P 915 million by September 30, 1987, and issuing six year first-mortgage bonds for the .emaining P 800 million. As importantly, the Company has since then been paying its current bills for power purchases on time. 5.8 Recognizing the special importance of MERALCO's service, the Govern- ment has evolved a policy of enabling MERALCO to reverse the harm of under- investment by providing it with ausrantees for borrowings from official lenders; however, the Government wants the Company to continue its positive - 33 - actions towards financial discipline. The Bank supports this approach. MERALCO expects to continue strengthening its commercial and operational practices. In August 1987, the Company began to implement an action program, acceptable to the Government and to the Bank, tot (a) reduce losses: (b) maintain accounts receivables at existing or improved levels; and (c) remain current in meeting its accounts and debt service payable. That action program is given in Annex 5.02. At negotiations, MERALCO agreed to continue implementing that actiGn program throughout the per'!od of project implementation. MERALCO will also be expected to increase its capital by selling substantial new equity, and thereby develop for itself the capacity to borrow as much as it would need for financing satisfactory levels of investment. To support this objective, MERALCO has furnished to the Bank an action program for increasing its proportion of permanent capital (through the sale of new common and preferred stock) during the period 1989-93 (Annex 5.01 and Table 5.2). C. Tariff 5.9 MERALCO's tariff includes: (a) two lifeline blocks to enable domestic and small commercial consumers to purchase initial amounts of energy at subsidized rates; (b) a generation charge, related to its cost of purchasing power from NPC; (c) an adjustment to the generation charge to allow MERALCO to recover from the consumer the cost of purchasing from NPC increments of energy that were subsidized or lost; (d) a distribution charge, related to its own system operation and administrative costs: and (e) an exchange rate adjustment. MERALCO's charter allows the company to set rates at levels that cover operating costs (including depreciation) and provide a maximum rate of return of 122 on revalued net fixed assets. HERALCO's average revenue of about US
Группа Всемирного банка · Staff Appraisal Report
Philippines - Power Distribution Project - Manila
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