Philippines - Infrastructure Assessment Study

FILE COPY Report No. 11944-P lC P FILE COPY CONFIDENTIAL: Report No.:11944-PH Type: (SEC) Title: INFRASTRUCTURE ASSESSMENT STUD Author: GUINARD, ARNAUD Ext.:80646 Room:D 8111 Dept.:EAlIN THE PHILIPPINES INFRASTRUCTURE ASSESSMENT STUDY June 30, 1993 East Asia and Pacific Region Country Department I Infrastructure Operations Division CURRENCY EQUIVALENTS (as of February 28, 1993) Currency Unit = Peso (R) US$1.00 = P25.3 ABBREVIATIONS AND ACRONYMS BOO = Build - Operate - Own BOT = Build - Operate - Transfer BTO = Build - Transfer - Operate BWSA = Barangay Water and Sanitation Associations COP = Committee on Privatization CPA = Cebu Port Authority CISO = Conference of Inter-Island Shipping Operators DILC = Department of the Interior and Local Government DOE = Department of Energy DOTC = Department of Transport and Communication DPWH = Department of Public Works and Highways EO = Executive Order ERB = Energy Regulatory Board ESP = Energy Sector Plan LTFRB = Land Transportation Franchising and Regulatory Board LWUA = Local Water Utilities Administration MARINA = Maritime Industry Authority MICT = Manila international Container Terminal MTDP = Manila Terminal Development Program MWSS = Metropolitan Waterworks and Sewerage System NEA = National Electrification Administration NPC = National Power Corporation NTC = National Telecommunication Commission PAL = Philippine Airlines PCCI = Philippine Chamber of Commerce and Industry PLDT = Philippine Long Distance Telephone Company PPA = Philippine Port Authority REC = Rural Electric Cooperative WD = Water District GOVERNMENT FISCAL YEAR January 1 to December 31 THE PHILIPPINES INFRASTRUCTURE ASSESSMENT STUDY Table of Contents EXECUTIVE SUMMARY INTRODUCTION 1 INFRASTRUCTURE DEFICIENCIES IN THE PHILIPPINES 4 Introduction . . . . . . . . . . . . . . . . . . . . . . .. . . .. . . . . . . . . . . . . . . . . . . . . 4 The Power Sector ............................................ 4 Sectoral Organization ....................................... 4 Adequacy of Services ....................................... 5 Sectoral Issues ............................. ..... .... ... .. 7 The Telecommunications Sector ................................... 8 Sector Organization ........................................ 8 Adequacy of Service Provision ................................. 9 Sectoral Issues ............................. ...... ... ... . 11I The W ater Supply Sector ...................................... 12 Sectoral Organization ...................................... 12 Adequacy of Service Provision ................................ 14 Sectoral Issues .......................................... 16 The Road Transport Sector ..................................... 17 Transport SectorOverview ................................... 17 Road Sector Organization .................................... 17 Adequacy of Service Provision ................................. 18 Sectoral Issues .......................................... 20 The Road Transport Industy ................................. 22 The M aritime TransportSector................................... 22 M aritime Sector Organization ................................. 23 Adequacy of PortSerices ................................... 23 Sectoral Issues .......................................... 24 The Domestic Shipping Industry ............................... 25 Overview and Conclusions ..................................... 26 II. CONSTRAINTS TO INFRASTRUCTURE DEVELOPMENT 28 Introduction . . . . . . . . .. .. .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28 M acroeconomicConstraints ..................................... 29 Institutional and Financial Constraints .............................. 34 Inadequate Organization and Management of Government Businesses ......... 35 Inappropriate Pricing of Infrastructure Services ...................... 38 Regulatory Constraints ........................................ 40 Restrictions on Entry ....................................... 40 Bundling of Contestable and Monopoly Businesses .................... 41 Inadequate Regulatory Framework .............................. 42 C onclusion . . . . . . . . . . . . . . . . .. . . . . . . . . . . .. . . . . . . . . . . . . . . . . . 43 III. INFRASTRUCTURE: A FRAMEWORK FOR GROWTH 44 Introduction . .................................. ....... .. ... 44 Rationale for a New Approach to Infrastructure Development ................ 45 A New Approach to Infrastructure Development ........................ 46 A Roadmap for Infrastructure Development ........................... 48 Pursuing and Extending the ReformAgenda ........................ 48 Ensuring Greater Competition in the Provision of Infrastructure ......... 48 Removing Restrictions on Entry and Exit ..................... 49 Opening Up ContestableMarkets .......................... 50 Strengthening the Role of the Private Sector ................... 51 Establishing an Effective and Transparent Regulatory Framework ...... 52 Improving the Management of Infrastructure Systems ................ 54 Improving Operational Efficiency and Maintenance/Rehabilitation of Existing Assets ................................... 54 Clarifying Institutional Roles and Responsibilities ................ 55 Establishing Independent Management Structures ................ 56 Pricing of Infrastructure ................................ 58 Increasing Selectively Public Investment and Mobilizing Private Sector Financing . 59 C onclusion . . . . . . . . . . . . . . .. . . . . . . . .. . . .. . . . . . . . . . . . . . . . . . . 62 TABLES Table 1.1: Number of Households With Electricity, 1988 ..................... 5 Table 1.2: Outages in the LuzonGrid.................................. 6 Table 1.3: Availability of Telephones and Waiting Lists ..................... 10 Table 1.4: Telephone Density by Area, 1988 ............................ 10 Table 1.5: Households by Main Source of Water Supply ..................... 15 Table 1.6: Distribution of Road by Type ............................... 18 Table 1.7: Road Sector Indicators for Selected East Asian Countries .............. 19 Table 1.8: Transportation Cost of Corn to Manila from Major Source Points, 1989 . . .. 20 Table 1.9: National Government Road Transport Revenues and Expenditures ........ 21 Table 1.10: Shipping and PortUtilization ............................... 24 Table 2.1: Actual Public Investment in Infrastructure by Sector, 1978 to 1990 ....... 31 Table 3.1: Public Investment for Key Economic Infrastructure Sectors ............ 61 FIGURES Figure 2.1: Public Investment by National Government and GOCCs .............. 30 Figure 2.2: International Comparison of Debt (% GDP), 1990 ................. 32 Figure 2.3: Public External and Domestic Debt (Proportion of GDP) ............. 33 Figure 2.4: LWUA Billing and Collection .............................. 37 Figure 2.5: Comparative Costs of Infrastructure Services (current US$) ........... 38 BOXES Box 1: The Impact of Power Deficiencies on Selected Export Industries ............ 7 Box 2: Telecommunications Deficiencies and Private Sector Operations ............ 11 Box 3: A Day in the Life: Family Copes With Power, Water Crisis .............. 16 Box 4: Infrastructure and Debt in the Philippines .......................... 32 EXECUTIVE SUMMARY 1. Infrastructure in the Philippines has deteriorated sharply over the last decade, and now threatens to constrain future economic growth. Persistent and lengthy brownouts, lack of telecommunication services, deteriorating road systems, increased port congestion and limited (albeit improving) availability of water supply services are all symptomatic of a growing crisis. Despite recent improvements in the macroeconomic outlook of the Philippines, the government fears that the general deterioration of economic infrastructure is compromising the Philippines' ability to produce internationally competitive goods. There is increasing evidence from the private sector that these fears are validated. Yet, because of tight fiscal constraints and prior investment decisions-many of which involved infrastructure investment--the government is limited in its capacity to make new investments in economic infrastructure. Moreover, the government also faces mounting resistance from consumers, who are increasingly reluctant to pay higher charges and tariffs while still experiencing severe degradation in services. Sustained electricity brownouts, exasperation over inadequate telephone lines and quality of service, poor access to ports and paved roads are lapses demanding action if the government is to achieve sustainable growth. 2. Because of the prominence of the power crisis in the Philippines, public attention and energies now tend to be focussed mainly on solving this problem. However, adequate transportation systems, communication networks and sources of electricity and water supply are together all crucial if the physical and human capital of the country are to function effectively and productively. Although the power crisis deserves immediate action because of its severity and high visibility, bottlenecks and shortfalls in other key infrastructure sectors should also receive attention before they, too, reach a crisis situation. This is all the more important, given the long gestation period of infrastructure projects and the need to ensure complementarity of infrastructure inputs. Interviews conducted during the course of this study with private sector firms also underscore the fact that combined infrastructure deficiencies can exert negative impacts. They increase the cost of doing business and reduce the ability of the private sector to compete in international markets. Therefore, infrastructure problems and solutions both need to be looked at in a less segmented manner and with more of a consumer orientation than has been the case until now. This report represents an attempt in this direction. 3. This reports deals with economic infrastructure. It attempts a comprehensive look at infrastructure deficiencies, constraints and solutions with a cross-sectoral perspective. The report coverage is selective, however, both in terms of sectors and topics. It focusses only on four key sectors- power, telecommunication, transport and water supply-whose proper functioning and performance are essential for economic growth. 4. The report has three main objectives. The first is to assess the magnitude of economic infrastructure deficiencies in the Philippines. The second is to identify the key constraints on infrastructure development. The third is to develop a policy framework for the formulation of an infrastructure development strategy to help achieve the government's economic goals. 5. The report first reviews the current state of economic infrastructure in the Philippines and takes stock of the infrastructure deficiencies (both in terms of access and quality) in these four critical areas. It also looks briefly at the impact of infrastructure deficiencies on the private sector from the point of view of the cost of doing business and the country's competitiveness vis a vis other market economies in the region. The report analyzes the various institutional, financial and regulatory constraints that hamper development. It argues that as bad as shortfalls in infrastructure services are now, these will only worsen if the underlying causes are not remedied. It then advocates a new vision on infrastructure development together with a reassessment of the respective roles of the public and private sectors. Finally, the report outlines a possible road map to transform this vision into reality. The State of Economic Infrastructure in the Philippines The Power Sector 6. Lack of a reliable supply of electricity is one of the most pressing problems facing the Philippine economy. Essential to the function of a modem economy, electricity is not only necessary for manufacturing equipment and industry, but also traffic signals, water pumping stations and other activities that impact on the productivity of manufacturing industries and commercial businesses. Frequent daily 4-10 hour power outages and brownouts are common in Luzon and Mindanao. In Luzon, the situation has deteriorated dramatically, with the frequency of outages increasing from fewer than 20 days per year in the mid-1980's to over 100 days in 1990. These outages lead to reduced productivity, additional expenditure for on-site generators, missed deadlines and lost orders. It has been estimated, for example, that it cost the country P45 million for every hour of power outages in Luzon. The Government has responded by instituting load curtailment programs and has established an Energy Sector Action Plan. The Department of Energy was created in late 1992 to address long-term issues. To expedite actions to deal with the energy crisis, the Congress granted emergency powers to the President in early 1993. The Teleconununication Sector 7. The Philippines is suffering from a lack of telephone services. Between 1983 and 1990, telephone availability remained constant, at around 8 working telephone lines per 1000 population. However, waiting lists have more than doubled over the same time period rising to 8.5 applicants per 1000 population in 1990 from 3.7 in 1983. The distribution of existing service is uneven with services concentrated in the lucrative urban markets and non-existent in some rural areas; over 80% of the smaller towns in the Philippines did not have access to telephone services in 1988. Businesses are responding to this shortage by setting up alternative radio communications systems or establishing offices in Metro Manila. The Water Supply Sector 8. The Philippines has made progress in protecting the population from water pollution; the number of households obtaining water from contaminated sources decreased from 50% to 35% between 1980 and 1990. However, water utilities have been hard pressed to keep up with the increase in demand brought on by rapid urbanization. Deficiencies exist, especially in and around Metro Manila and in Cebu where water production has not kept pace with the increase in service connection. Available water per customer has decreased. The situation was made worse by the droughts experienced in recent years in Central Luzon. The Road Transportation Sector 9. While the overall length of the Philippine road network is considered to be adequate, the quality of the existing road infrastructure is poor. Only 14% of the network is paved. The pavement ii level is higher for national roads, 49%, but many suffer from a lack of maintenance. Only 34% of the national roads are considered to be in good condition. Poor roads are a major factor in increasing cost of agricultural products in the main urban markets as confirmed in detailed costing studies for major commodities. 10. The road transport industry has been highly regulated with government-set tariffs and a cumbersome franchising system that has restricted the number of operators. In practice, regulations have not been fully enforced and the industry has been defacto deregulated, with costs to shippers reflecting market conditions. The government has recently taken steps to deregulate the trucking and passenger transport industries. The Maritime Sector 11. With close to 90 national ports, another 90 municipal ports and over 200 privately-owned ports, the Philippines is not faced with a shortage of harbors. The main problem in public ports operated by the Philippine Ports Authority (PPA), is inefficiency and high costs. Restrictive practices, the lack of facilities--forklifts and cranes, inadequate storage--and the mixing of passenger and cargo operations in most domestic ports, hinder the efficient loading and unloading of vessels. PPA's practice of negotiating annual contracts for stevedoring (on board cargo hauling) and arrastre (land handling) operations with a single operator leads to monopolistic behavior and high prices. 12. Inter-island shipping has also been highly regulated. Liner shipping companies have operated under franchise privileges, with fixed sailing schedules, routes, and government-determined fare/freight rates. These rules and regulations combined with the oligopolistic structure of the liner operators has led to price and service distortions, protecting the least efficient operators. The government has also started deregulating the shipping industry. Impact of Infrastructure Deficiencies on Private Sector Growth and Competitiveness 13. The combined effect of all infrastructure deficiencies is an increase in the cost of doing business relative to what costs could be if efficient infrastructure systems were in place. First, poor infrastructure and low quality of service provision increase the direct operating costs of manufacturing and commercial firms. Second, firms incur additional expenses in privately substituting for inadequate public infrastructure. Third, another important, but less obvious cost incurred, is the failure to meet deadlines and the eventual loss of revenue due to contract cancellations. Fourth, it hampers foreign direct investment. Smaller firms suffer more from infrastructure deficiencies because they rely heavily on the utilities for supply. 14. Philippine firms are paying considerably more than they need to in order to obtain reliable infrastructure services. On-site diesel generators for power generation and radio equipment for communications are widely accepted prerequisites for business operations. The private provision of infrastructure indicates a willingness to pay more for reliable services. 15. Finally, poor quality of infrastructure services constrains Philippine firms in effectively competing in international markets. Superior communications, reliable power supplies, and efficient iii transportation systems are essential to keep abreast of changes in demand, meet tight deadlines and survive in today's competitive global economy. If infrastructure continues to decline, there is a real prospect that the Philippines could lose any further competitive advantage in modem communications- intensive sectors, and have to fall back on "cheap labor" commodities. However, it is not clear whether the Philippines would be able to compete with other emerging low-wage countries such as China and Vietnam without having to suffer a significant decrease in the standards of living. Constraints to Infrastructure Development 16. The dimensions of the infrastructure crisis in the Philippines are complex and highly intertwined. Despite varying conditions across sectors, there is a commonality of causes in explaining the current infrastructure situation. Constraints to infrastructure development in the Philippines can be grouped into three broad categories: macroeconomic constraints, institutional and financial constraints, and regulatory constraints. Other risk factors have also exacerbated problems in infrastructure development. The absence of a stable political and economic environment, or uncertain contractual and legal arrangements, will therefore attach high risk premia to infrastructure private investments. 17. Fiscal constraints have and will continue to limit the government's capacity to make new economic infrastructure investments. The need to reduce high levels of budget deficit because of high levels of debt since the mid-1980s has necessitated curtailing public investments. In this process, public infrastructure investments were slashed and declined from an average 4.7% of GDP from 1978 to 1983 to an average of 2.6% of GDP from 1987 to 1990. However and quite ironically, a substantial portion of the debt was directly associated with infrastructure projects. Therefore, past public infrastructure investments, which were mainly financed through debt, contributed to the original debt problem. 18. It is often widely perceived that recent declines in public infrastructure investments are the major reason for the present infrastructure service inadequacies in the Philippines. While it is undeniable that low levels of investment will eventually contribute to the poor state of economic infrastructure (and have already begun to do so in power), they are only part of the explanation and tend to focus mainly on the quantitative aspect of deficiencies. 19. The key issue is not only the quantity but also the quality of infrastructure investments. Given the present fiscal constraints, the quantity of infrastructure investment will continue to be limited in the absence of more self-sustaining mechanisms for infrastructure development. Continued heavy reliance on debt financing for economic infrastructure cannot be sustained in the present economic context. As far as the quality of investment is concerned, it depends largely on the performance of the institutions that implement, supervise and maintain infrastructure projects. Incentives, adequate industry structures, financial and legal arrangements are the key to improve performance. Unfortunately, structural constraints across sectors have hampered the ability of Philippine infrastructure institutions to provide sufficient quantity and improve quality of infrastructure. 20. As in many countries, the provision of infrastructure in the Philippines has been largely dominated by single sector institutions. Because of economies of scale and high initial investment costs, economic infrastructure services have been considered natural monopolies, making it more cost effective to limit the number of suppliers. The Government has sought to protect the interest of consumers by regulating prices to guard against monopoly pricing. Also, because of the need to maximize scarce iv qualified personnel, responsibilities (in some cases, regulatory, financing and supply) have been consolidated into a single agency. As a result, single institutions play a dominant role in the various sectors: NPC in power, PLDT in telecommunications, LWUA in water supply outside of Metro Manilla, and PPA in ports. 21. Experience in the Philippines shows that the concentration of responsibilities into single institutions has not necessarily had the desired effect. Instead, it has often resulted in poor operational performance in most of these agencies. It has also led these institutions to exploit their monopolistic positions by engaging in rent-seeking behavior, i.e. maximizing the benefits to the owners, managers and employees to the detriment of the public as a whole. 22. During the last decade, many infrastructure institutions have performed poorly. This has limited their capacity to maintain and invest in infrastructure systems. For example, LWUA's collection ratio is very low (40 percent); NPC's self-financing ratio was negative from 1987-89, 1 percent for 1990, minus 54 percent for 1991 and only 7 percent for 1992. This has also resulted in high operational losses. For instance, MWSS's unaccounted for water remains at about 57 percent of water produced; MERALCO's physical losses are still high at 14 percent. Poor operational and financial performance, in turn, and the consequent difficulties in keeping pace with customer demands for infrastructure services, can be linked to a number of factors, which variously include: * conflicting regulatory, commercial and social objectives (e.g. PPA and LWUA); * limited commercial focus of government enterprises, coupled with political intervention in management activities (e.g. NPC); * low prices (NPC) and/or inappropriate pricing structures (NPC, PLDT and PPA) together with inadequate revenue collection (LWUA); * high levels of debt and debt servicing requirements because of excessive operating costs relative to revenue collection; and * insufficient implementation capacity. 23. As a result, many government enterprises have failed to both expand access and improve quality of services to a growing population. They have also had to rely increasingly on the government's financial support to sustain their activities. This support is inconsistent with the need to reduce budget deficits. 24. Industry structures and regulatory arrangements have also deterred new firms from entering these markets. Although the government is now actively promoting private sector participation in infrastructure, there is little competition in the supply of infrastructure services in most sectors. The main reasons are: (a) restrictions on entry (especially telecommunication), (b) the bundling of contestable and monopoly businesses (power and telecommunication), and (c) the absence of a proper regulatory framework that promotes competition and enforces anti-trust legislation (all sectors). V Infrastructure: A Framework for Growth 25. Reflecting the widely held perception that insufficient investment in infrastructure has been the major cause of deficiency, the Philippine government is now emphasizing an increase in both public and private sector investment as a mean of solving infrastructure problems and promoting economic growth. At the same time, recognizing the crisis situation in the power sector and major bottlenecks in the telecommunication and transport sectors, the government has also started addressing some of the key institutional and regulatory issues that constrain infrastructure development. The report argues that these initiatives ought to be pursued and extended across sectors within a more balanced framework, promoting sustained and self-financed growth in infrastructure development through structural reform. This would allow an increase in reliable, cost-effective infrastructure services to be made available without disrupting an improving, but still fragile, macroeconomic environment. 26. Immediately, the government is faced with a major dilemma: it needs to increase infrastructure spending without resorting to excessive budget deficit expansion. However, it faces mounting resistance to reform, especially since "reform" is mainly associated with raising charges and tariffs on customers who are already experiencing severe degradation in services. The report suggests that to break this vicious cycle, the government ought to develop a new view of infrastructure development. This new perspective focusses on a shift from a traditional centralized supply-driven intervention to one with a more customer oriented approach aimed at meeting the effective demand for infrastructure. The report argues that the objective of achieving a more sustainable infrastructure development in the Philippines would best be served by: * pursuing the reform process started in the power and transport sectors, and beginning necessary reforms in the water supply and telecommunications sectors; * encouraging and developing efficient ownership and management of infrastructure systems which are fully accountable and independent of the political process; * establishing competitive industry structures to attract new firms to supply infrastructure needs; * fostering an effective and transparent regulatory framework; and * maintaining stable macroeconomic, legal and political environments to generate confidence in the Philippine economy. Rationale For a New Approach to Infrastructure Development 27. Until now, infrastructure development programs in the Philippines have mainly assumed a "top down" approach, aimed at alleviating immediate bottlenecks. This approach has not acknowledged three critical elements to sustainable infrastructure development in the Philippines. First, the provision of domestic and external resources to infrastructure agencies is only part of the solution to the infrastructure funding problem. Private and self-financing of local services are also a big part of the equation. The potential for self-financed infrastructure development exists in the Philippines. Consumers are willing to pay for increased and better quality infrastructure services. They vi must be confident, however, that their funds are being put to good use. One key to generating this confidence is to entrust the responsibility of managing infrastructure services to fully accountable legal entities which have both the incentive to provide services that suit their consumers' needs and demands, and the ability and will to provide them at a reasonable co9t. 28. Second, basic changes in the institutional and regulatory structures are necessary if infrastructure development is to be sustained. Unless the present institutional and regulatory framework that allows monopolistic (rent-seeking) behavior by incumbent organizations is modified, private investment in infrastructure is likely to remain modest. Policy solutions and action programs must address infrastructure constraints at the core level and do not just deal with the symptoms. Therefore, infrastructure programs which rely solely on providing additional funding, or focus on "plugging the leaks" as in the past will either fail or only generate limited returns. Also, despite some initial success in implementing BOT/BTO schemes to help relieve some of the immediate bottlenecks, the magnitude of the infrastructure requirements in the Philippines is such that this type of financing is neither a panacea to meet the demand nor a substitute for pursuing the necessary domestic resource mobilization effort. These arrangements may be more appropriate and easier to develop in the power and telecommunication sectors than in the transport sector (e.g., roads) where all levels of government will continue to play a crucial role in financing investments. 29. Third, international experience and technological change has shown that the assumptions which initially justified government regulation and monopolistic supply of infrastructure were not always well founded and can increasingly be challenged. There is now growing recognition of the need to separate contestable markets' from naturally monopolistic activities, and of the potential role of the private sector in financing and delivering infrastructure services, However, this requires a fundamental reassessment of the institutional and regulatory framework within which the public and private sectors can and should play their respective roles more efficiently. A New Approach to Infrastructure Development 30. Because of the existing tight fiscal constraints, the limited returns of past infrastructure investment programs and the need for action to solve the underlying causes of the present infrastructure crisis, the focus of infrastructure development needs to be reassessed with regard to the respective roles of the government and the private sector. In particular, the core of the government's intervention needs to be redirected toward ensuring higher standards of performance and returns in all sectors. The government needs to improve the capacity for self-financed infrastructure investment and to encourage private sector participation and competition among firms. To achieve this goal, the report advocates a more balanced approach between: * quantity and quality of infrastructure through lower cost and improved reliability. * physical expansion and improvements in efficiency of supply and maintenance. Maintenance and repair of existing infrastructure assets should receive top priority to Contestable markets can be defined as areas where potential for competition exists and in which the mere threat of entry can enforce good conduct by incumbent suppliers. vii ensure adequate returns on existing and future investments and avoid further deepening of infrastructure breakdowns. centralized infrastructure systems focussing on supply and decentralized systems focussing on demand (the customer). The case should be made for greater involvement of private enterprise and for local communities in infrastructure provision through the establishment of competitive industry structures with clear rules of access. The key purpose is to improve the quality and adequacy of services to those paying for services. Better quality services and associated patterns of taxes, user charges and ownership at the local level should be capable of harnessing greater support than centralized structures. * systematic regulation and well targeted and carefully supervised regulatory reform. There is a clear need to establish an effective and transparent regulatory framework where the obligations and rights of the various parties are clearly outlined. It will also be necessary to deal with the potential distortions arising from the activities of natural monopolies and deregulation. A Roadmap for Infrastructure Development 31. Transforming this approach into reality will require not only selective increases in investment, but also decisiveness in managing a difficult transition process. It will be necessary to maintain steadfast political commitment to reform despite mounting pressure to adopt quick-fix, stop-gap measures. Presently, the most pressing challenge is for the private sector and government agencies to jointly design and finance structures and facilities that can both resolve the short-term crisis and sustain infrastructure in the long-term. The priority task remains designing and implementing infrastructure programs that match any funding increases with structural reforms as integral steps in removing the infrastructure gap. To achieve this result, the report proposes a roadmap whose main elements include phased implementation of the following set of interrelated and complementary actions: (a) pursuit and extension of the reform agenda, and (b) selective increases in infrastructure investments. Pursuing and Extending the Reform Agenda 32. Aware of the limits of the traditional approach to infrastructure development and hard pressed to solve the current crisis, the government has already started addressing key sectoral issues and implementing some structural reforms. In the transport sector, deregulation has proceeded to encourage entry and competition on major routes and to liberalize price setting. In response to the continuing power crisis, the government has adopted a comprehensive Energy Sector Plan (ESP) and established a Department of Energy with responsibility for the sector's policy, planning, and oversight. It has also realized some progress in depoliticizing energy price setting. The government has also taken steps to encourage greater participation by the private sector in infrastructure through privatization (civil aviation), commercialization (ports and national road network maintenance) and direct financing through BOT/BTO schemes (especially power). 33. These initiatives constitute important steps in the right direction. They now need to be pursued within a more balanced framework that promotes sustained and self-financed growth in infrastructure development and be extended across other sectors. The essence of the reform process in viii economic infrastructure is for the government to provide the necessary incentives to the suppliers to improve efficiency of services. This would help lower prices (to reduce business costs and make services more affordable to the poorer segments of the population) and raise service levels (in line with consumers' demands). The report suggests this can be achieved by: (a) ensuring greater competition in areas where markets are contestable, and (b) improving the management of infrastructure systems in areas where government is expected to continue to play a key role (natural monopolies). 34. Ensuring Greater Competition in the Provision of Infrastructure. A common feature of the power, telecommunication, transportation and water supply sectors is that they all contain some elements of natural monopoly. There is, however, considerable scope for competition in the supply of services in most of these sectors. For example, while electricity transmission and distribution lines, and trunk telephone networks are natural monopolies, generating and distributing power and providing telephone services are fully contestable businesses. The context in the Philippines is no different from that in other countries. 35. Competition in providing infrastructure services can keep suppliers from charging artificially high prices for some market segments which are traditionally subject to high tariffs (e.g. industrial and commercial businesses). It can also introduce incentives for existing suppliers to provide more reliable and higher quality services in line with customers' demands. Finally, it allows more channels for investments to flow into the sectors. Greater competition can be achieved by (a) removing entry and exit restrictions, (b) opening up contestable markets whenever feasible, and (c) enhancing further private sector participation. However, merely removing entry and exit restrictions, opening up contestable markets and promoting BOT/BOO projects will not be sufficient to induce private sector participation in infrastructure on a sustainable basis. Private sector firms will also have to be encouraged and protected by a legal and regulatory framework that allows them to assess and undertake reasonable market risks (through transparent pricing principles), and to enter into long-term contractual arrangements with grid operators (through clear rules of access to grids, especially in power and telecommunications). This regulatory framework should also protect them against uncompetitive practices which may arise under deregulation. Reinforcing competition legislation and enforcing antitrust legislation is, therefore, crucial. It is also essential that in establishing the regulatory framework, the functions and obligations of the regulator are clearly defined, and the regulator has adequate resources and the effective power to implement its regulatory authority. 36. Improving the Management of Infrastructure Systems. There is clearly a priority for improvement in efficiency of those infrastructure systems that are likely to remain under the effective control or management of the government either permanently or until they can be privatized. This will entail: (a) improving operational efficiency and maintenance/rehabilitation of existing assets, (b) clarifying institutional roles and responsibilities, (c) establishing clear ownership and management structures that are fully accountable for performance and independent of political control, and (d) structuring prices to meet infrastrucure costs. For each sector, the report provides detailed recommendations. Increasing Selectively Public Investment and Mobilizing Private Sector Financing 37. Implementing the above reform agenda, many parts of which are now being developed by the relevant authorities, will have to be accompanied by increased investment. The needs for ix infrastructure in the Philippines are enormous, partly because of low investment in the past decade. For example, the cost of restoring the Philippines road network is estimated at $5.2 billion in 1992 prices. In order to meet electricity demand over the next five years, the Philippines will need about 3,500 megawatts of generation capacity estimated to cost about $4.5 billion. Expanding investment together with the implementation of the reform agenda appears necessary in order to break the current vicious cycle and to sustain growth. 38. Recent improvements in the Philippine macroeconomic outlook may have provided the opportunity for an increase in government spending on infrastructure. Nevertheless, government's capacity to provide funding for the development of infrastructure systems remains highly constrained. In view of the current debt, further fiscal adjustment is still required to lower public debt and interest rates. Therefore, the prospect is limited for financing all the immediate infrastructure needs at the same pace. The authorities are still reluctant to raise taxes and other public revenues. Although some savings may be realized through reduction or reallocation of public expenditures, under the present circumstances, the prospect of immediate savings is not very favorable. Eventually, the consolidated public sector deficit may require a moderate and only temporary increase provided that expenditures are properly targeted, phased and prioritized. In particular, it will be essential to ensure that: (a) funds are being used efficiently for high return investments, especially for rehabilitating and maintaining existing assets; (b) projects are targeted in areas where economic potential exists (e.g., growth pole centers such as the Calabarzon); (c) the moderate deficit is financed by long-term loans; and (d) a credible plan to improve the institutional and financial capacity of public agencies and corporations has been established as a prerequisite to undertaking improvements in infrastucture and mobilizing foreign funds. 39. The power and the transport sectors should be high on the list of activities that will benefit from increased investments. These sectors have not only started to show promising signs of structural reforms but will also consume a large portion of the increase in public infrastructure investments. The report estimates that public investment for economic infrastructure will need to increase from 2.4 percent of GDP in 1992 to 3.4 percent in 1993, and 3.7 percent thereafter. 40. In addition to increased public investment, private sector financing will have to be mobilized on a larger scale and possibly under different forms than at present. The government's initiative to establish a Private Sector Infrastructure Development Fund (PSIDF) for large infrastructure projects (mainly in power and telecommunication) needs to be pursued. The government also needs to systematically promote the development of BOO schemes rather than BOT/BTO arrangements. Major constraints, however, must be removed before these schemes can be implemented on a scale commensurate with need. Ultimately, the rate at which the private sector will be willing and able to undertake infrastructure investment will largely depend upon the pace at which the reform process proceeds, and the government's ability to maintain a stable political and economic environment. Conclusion 41. As the Philippines continues to witness the deterioration of its infrastructure base, the Government faces a difficult challenge but also an opportunity since communities are now demanding real changes. Failure to act quickly and redress the present situation will compromise recent efforts made to put the country back on the path of sustainable economic growth. It will also further curtail its ability to compete with other economies in the region. Although the severity of problems may differ across x sectors, bottlenecks and shortfalls in all infrastructure sectors deserve immediate attention before the situation reaches crisis proportions as in the power sector. 42. A major thrust of this report is that both public and private firms must be given an adequate institutional, financial and regulatory framework within which they can provide competitive and efficient levels of infrastructure. The Government has already taken several sectoral initiatives in this direction. The report argues that the reform process needs to be pursued and extended across sectors with steadfast political commitment. This process also needs to be complemented by selective and well targeted increases in investment in order to trigger a positive supply response. 43. Given the time required to implement changes and existing fiscal constraints, the effects of reforms and additional investments will, however, not be felt immediately. Bottlenecks and shortages will be eliminated only gradually For example, some improvements in the power situation would be achieved starting in 1994 providing the new generation capacity under fast track projects and associated transmission systems come on stream as expected. Moreover, meeting the large backlog of unmet infrastructure demands remains a formidable proposition. 44. Throughout the reform process, it will be essential to assess the impact of reforms and policy changes on the performance in the various sectors. To this end, the authorities need to put in place a proper monitoring system to follow more closely the overall performance in each sector. The existing monitoring system for some 14 GOCCS needs to be improved and complemented by a set of performance indicators which assess and capture the overall progress in each sector. Such indicators should cover inter alia adequacy of services (quantity and reliability), financial performance and operational efficiency. 45. Similarly, any substantial increase in infrastructure spending will have to be carefully controlled and monitored, and accompanied by commensurate efforts to raise revenues. Despite some macroeconomic improvements, there is still a real danger that increased (non tax-financed) infrastructure spending will destabilize the economy. A return to high levels of budget deficits together with jumps in inflation and interest rates, or surges in wage demands, would negate recent economic gains, and further curtail the capacity yo either afford infrastructure or to maintain existing assets. 46. In summary, the Government needs to continue to both address fundamental structural issues (at the macro and sectoral levels) and facilitate greater private sector participation in infrastructure provision. As these elements start falling into place, the infrastructure base of the Philippines can again be an engine of growth, rather than a handicap to the many and varied talents of the Philippine community. xi INTRODUCTION Background 1. Despite positive signs of economic recovery in 1987-1989, the Philippines entered the 1990's with substantial economic problems. These included a large external and internal public debt, high levels of poverty and unemployment, growing public sector and current account deficits, and low levels of savings and investments. These problems were compounded by a series of exogenous shocks which further weakened the fragile economic recovery that had begun in 1987. A prolonged drought stretching through the first half of 1990 reduced agricultural production and led to serious power shortages. In July 1990, a devastating earthquake resulted in severe physical and human loss, and the loss of assets was valued at about 1 % of GDP. Soon after, the Gulf crisis placed severe pressures on the balance of payments. In November, a devastating typhoon hit the southern Philippines, causing more damage. Finally, on June 12, 1991, the Philippines experienced one of the worst volcanic disasters of the century when Mount Pinatubo erupted. All these factors considerably undermined confidence that the economic recovery could be sustained. After strong growth in 1986-89, peaking in 1988 with growth above 6%, GDP fell by 1 % in 1991 and stagnated in 1992. Per capita income in 1991 remained 11 % below its 1980 level. 2. The Government's objective of restoring and sustaining economic growth will depend largely on its ability to maintain a stable macroeconomic framework and implement structural reforms, provide necessary public investment where complementary to private sector growth, stimulate the growth of exports, increase public and private savings, and use investment resources more efficiently. The role of economic infrastructure will be critical in attaining these goals. The lack of an adequate infrastructure- -one of the reasons for industry's poor performance-is among the major factors impeding the resumption of economic growth. 3. Policy reforms together with the restoration of a sound macroeconomic framework have now set the stage for sustained growth. In particular, the tight monetary and fiscal stance sustained by the authorities through 1991 and 1992 has reduced the consolidated public sector deficit to 2.3% of GDP. Inflation has been reduced from 17% in 1991 to 8% in 1992, and foreign exchange reserves built up to 3.3 months of imports. However, much of the progress made in reducing fiscal imbalances has been accomplished by compressing growth-oriented expenditures, especially in infrastructure investment and operations and maintenance expenditures. Public sector investment has been low since the 1983 crisis, averaging 2% of GDP through 1990 and returning to 3.6% of GDP in 1992. Undoubtedly, this low level of investment over a prolonged period has contributed to the present breakdown in infrastructure and further exacerbated existing structural infrastructure deficiencies, especially in the power sector. 4. Despite improvements in the present macroeconomic environment and because of tight external constraints in the future, the task of ensuring an adequate and efficient infrastructure supply--let alone the ability to meet the backlog of unmet demands-will present a major development challenge for the Government. Besides the need to maintain and use the existing infrastructure efficiently, there is also a need for infrastructure expansion. This must be based on priorities between and among sectors and sub-sectors and fall within the limitations of available resources. This calls for the formulation of an efficient infrastructure development strategy that sustains economic development objectives. The Role of Economic Infrastructure in the Philippines Development 5. The fundamental interdependence between economic performance and infrastructure is largely documented in the economic literature. The essence of infrastructure in a sensible model of economic growth is that infrastructure assets can enhance the productivity of other factors of production and reduce the transaction costs of purchasing goods and services. This will ultimately lower overall costs, increase competitiveness, and lay the foundation for employment and income growth. As in other growing market economies of the region, an efficient and adequate economic infrastructure is essential for private sector growth in the Philippines. Transport and communications are critical to the commercialization of the economy and to enhance the mobility of goods and services, especially given the archipelagic structure of the country. Power and water supply are essential inputs in the production process. Without complementary development of these facilities, severe bottlenecks could emerge thereby affecting private sector growth and reducing competitiveness in international markets. It is now widely perceived that such a scenario has already occurred in the Philippines and the persistent power crisis with 10 to 12 hour daily brownouts has obviously reinforced this perception. 6. Because of the prominence of the power crisis in the Philippines, public attention and energies now tend to be focussed mainly on solving this problem. However, adequate roads, transportation systems, communication networks and sources of electricity and water supply are together all crucial if the physical and human capital of the country are to function effectively and productively. Although the power crisis deserves immediate action because of its severity, bottlenecks and shortfalls in other key infrastructure sectors should also receive attention before they,too, reach a crisis situation. This is all the more important, given the long gestation period of infrastructure projects and the need to ensure complementarity of infrastructure inputs. Interviews conducted during the course of this study with private sector firms also underscore the fact that combined infrastructure deficiencies can exert negative impacts. They increase the cost of doing business and reduce the ability of the private sector to compete in international markets. Therefore, infrastructure problems and solutions together need to be looked at in a less segmented manner and with more of a consumer orientation than has been the case until now. This report represents an attempt in this direction. Objectives and Scope of the Report 7. This report deals with economic infrastructure in the Philippines. It attempts to provide a comprehensive look at infrastructure deficiencies, constraints and solutions, with a cross-sectoral perspective. The report coverage is selective, however, both in terms of sectors and topics. The report focusses only on four key sectors--power, telecommunication, transport and water supply-whose proper functioning and performance are essential for economic growth. 8. There are three main objectives of the report. The first is to assess the magnitude of economic infrastructure deficiencies in the Philippines. The second is to identify the key constraints on infrastructure development and assess the impact of infrastructure deficiencies on private sector growth and competitiveness. The third is to develop a policy framework for the formulation of an infrastructure development strategy to help achieve the government's economic goals. 9. The report is organized as follows: Chapter I provides a snapshot of the current infrastructure deficiencies in the various sectors. For each sector, it gives first an overview of the sectoral 2 organization. It then analyses the adequacy (or lack thereof) of service provision both in terms of current availability (overall coverage) and quality of service (reliability and sustainability). Finally, it summarizes the key sectoral issues. After setting the stage of the current situation in each sector and providing a basis against which future sectoral performances could be assessed, Chapter II identifies the major constraints to infrastructure development in the Philippines and stresses the commonality of issues across sectors. Based on the analysis developed in the previous chapters, Chapter III defines a framework for growth and underscores the need for a new vision of infrastructure focussed on a shift from a traditional centralized (and segmented) supply-driven intervention towards a more customer-oriented approach aimed at meeting the effective demand for infrastructure. Finally, the chapter outlines a proposed roadmap to translate this vision into action. 10. The report is based on the findings of two Bank missions to the Philippines. In November 1991, a preparatory mission comprised of Messrs. A. Guinard (Task Manager), Y. Uchimura (EAllN), E. Rice (YP) and M. Hoskote (consultant) discussed the objectives and scope of the study with public officials and private sector representatives, and collected background information and relevant data for the exercise. The main mission took place in March 1992 and included Messrs. A. Guinard, J. Bajpai, D. Havlicek (EAllN) and M. Hoskote (consultant). In addition, the report draws heavily on the findings of two separate papers commissioned as a part of this study. The first, entitled "Cost and Reliability of Trade and Transport Logistics in the Philippines," was prepared by Messrs. B. De Saint Laurent and C. De Castro (consultants) following a mission in April 1992. The second, entitled "Infrastructure in the Philippines" was prepared by Messrs. M. Porter and A. Quinn (consultants) in December 1992 following another mission. The report also benefitted from input provided by various members of the EAlIN Philippines Country Team. 3 I. INFRASTRUCTURE DEFICIENCIES IN THE PHILIPPINES Introduction 1.1 Economic infrastructure in the Philippines was generally deemed to be adequate in 1980 but has emerged in recent years as one of the economy's primary bottlenecks. Since the mid 1980s, Philippine consumers and producers have labored under the handicap of both insufficient infrastructure services provision across every sector of economic infrastructure, as well as increasingly common and burdensome service failures, especially in power and telecommunications. This deterioration and the failure in the past decade of complementary development of infrastructure inputs has caused bottlenecks to appear in the Philippine economy, particularly with respect to electricity. Regional disparities in economic infrastructure have broadened and service deficiencies are increasingly widespread. 1.2 This chapter analyzes the evolution of economic infrastructure in the Philippines over the last decade and attempts to provide a picture of the state of infrastructure in the following key sectors: power, telecommunications, waste supply, road transport and maritime transport. For each sector, the chapter first reviews the prevailing institutional arrangements. It assesses the evolution and adequacy of service provision, and the impact of deficiency on the private sector. It then summarizes the key issues affecting the functioning of the sector. The main causes of infrastructure deficiencies are analyzed in Chapter II. The Power Sector 1.3 Unlike some other ASEAN countries, the Philippines is not well endowed with indigenous energy sources. Apart from coal and hydropower, the Philippines has substantial geothermal energy, and there has been a recent discovery of natural gas. However, the coal is of low quality, and the hydro sites that have not been developed are far from the demand centers in Luzon. Thus, power generation is still heavily dependent on imported oil. During the last decade, the power sector in the Philippines has gradually deteriorated. It is now suffering from a serious crisis that affects both electricity consumers and the rest of the economy. There are major difficulties in meeting the present load. Power cuts represent a major threat to industrial growth, apart from disrupting commercial and service activities. Sectoral Organization 1.4 The electric power market in the Philippines is divided along functional lines into two major power delivery systems: (a) a generation and transmission system dominated by the National Power Corporation (NPC); and (b) a distribution system consisting of the Manila Electric Company (MERALCO), the largest private distribution utility, 32 private and municipal utilities and 119 rural electric cooperatives (RECs). The new Department of Energy (DOE), established in December 1992, is responsible for policy formulation, planning and supervision of the energy sector. The Energy Regulatory Board (ERB) under the DOE is responsible for regulatory functions including the approval of power tariffs. 1.5 NPC is a Government Owned and Controlled Corporation with the Secretary of the Department of Energy as the Chairman. It accounts for the bulk of power generation in the Philippines, operates three independent grids, one in Luzon, one in Visayas and one in Mindanao, and sells bulk power to distribution utilities, large industries and the RECs. As a government corporation, NPC is subject to standardized salaries for government employees and finds it difficult to keep technical and managerial staff, especially with the recent increase in private sector investment in power. Since 1972, when the power sector was reorganized, NPC has been the dominant institution in power generation, being given a monopoly over power generation and transmission. However, NPC lost its monopoly in 1987 when the Government allowed private sector entry into power generation under Executive Order 215. 1.6 NPC's financial situation has been poor in recent years. NPC's working ratio (operating expenses excluding depreciation/operating revenues) rose from about 53% in 1989 to approximately 75% in 1991, before falling to 63% in 1992. Consequently, NPC has only a limited surplus available for capital expenditures. Similarly, the self-financing ratio (cash available from operations for investment/3- year average capital expenditure) was negative for 1987-89, 1% for 1990, -54% for 1991, and only 7% for 1992. These values of self-financing ratio are significantly below the norm of 20-30% that is appropriate for utilities that need to undertake major capital expenditures. Besides external factors (such as the drought in 1992 and the revaluation of NPC's fixed assets in 1991 and 1992), NPC's poor financial condition is mainly due to insufficient tariff increases and the accumulation of debt service after 1991 because of previous debt rescheduling. 1.7 MERALCO, the largest distribution utility in the Philippines, is privately owned and services Metro Manila and the surrounding municipalities in Luzon, encompassing over 2 million customers. MERALCO is NPC's largest customer accounting for 78% of NPC's sales in Luzon in 1990. 1.8 Power in the rural areas is provided by RECs which are non-profit, member owned utilities with regional franchises. There are currently about 120 RECs servicing around 1,300 smaller towns. The RECs come under the jurisdiction of the NEA which administers the financial and technical requirements of the RECs. Adequacy of Services 1.9 In 1988, around 60% of the households in the Philippines had electricity (Table 1.1). Access to electricity per se is less of an issue in the urban areas where 86% of the families had access. In Metro Manila, close to all of the families (98%) were served with electricity. In the rural areas where households are much more dispersed, the electrification rate is significantly lower with only 44% of the households being served by electricity. Table 1.1: NUMBER OF HOUSEHOLDS WITH ELECTRICITY, 1988 Households with Electricity Total No. of Households Number Percent Philippines 10,533,926 6,308,510 60% Urban 3,985,144 3,432,396 86% Metro Manila 1,435,496 1,400,393 98% Rural 6,548,782 2,876,114 44% Source: 1988, Family Income and Expenditure Survey 5 1.10 While access may not be a problem in the urban areas, unreliable electricity, however, is a major issue. In fact, lack of reliable electricity supply is now one of the most pressing problems facing the Philippine economy. Power outages are frequent and brown outs of 4-10 hours a day are becoming increasingly common in Luzon and Mindanao. While Luzon was faced with brownouts all throughout the 1980's (Table 1.2), the frequency has increased from an average of 19 days between 1986- 88 to 103 days in 1990 and loss of sales in electricity from an average of 17 GWh in 1986-88 to 251 GWh in 1990. Table 1.2: OUTAGES IN THE LUZON GRID Brown Outs Energy Sales Lost (Days) (GWh) 1980 145 125 1981 90 66 1982 148 156 1983 70 130 1984 16 42 1985 8 11 1986 16 18 1987 28 27 1988 12 6 1989 41 91 1990 103 251 Source: NPC (reproduced from World Bank "The Philippines: An Opening For Sustained Growth") 1.11 Load curtailment programs have been established for the Luzon and Mindanao grids to deal with the crisis. For the Luzon grid, NPC publishes weekly power outlook bulletins announcing available generating capacity for each week, forecast peak demands, and reserve capacity. Residential and commercial customers experience daily brownouts, while industrial customers are expected to curtail their energy use for certain periods of time. In Mindanao, NPC has allocated monthly energy quotas to customers (RECs, private utilities, and industrial companies), based on their previous year's energy use. The load curtailment package calls for a 15 percent reduction in power consumption. Nevertheless, power cuts amounting to 20 percent of demand were experienced in 1990, peaking at 50 percent of demand in 1991. 1.12 Electricity is essential to the functioning of modem industrial and commercial firms. Loss of electrical power causes shutdown of heavy machinery, loss of use of computers and other office equipment, or deterioration in the work environment following breakdowns in climate control. Power outages result in lower productivity and potential loss of business. The importance of power is reflected 6 in the willingness of consumers to invest in their own facilities, duplicating the functions of the utility companies. For example, a survey of firms in Luzon and Cebu conducted by the Office of Energy Affairs in 1989 found that 75% of these firm had on-site generation facilities. While installed mainly as back-up facilities, many were being required to operate on a continous basis. Entrepreneurs expressed their dissatisfaction with power and other infrastructure deficiencies in interviews carried out as part of this study (see Box 1). Box 1: THE IMPACT OF POWER DEFICIENCIES ON SELECTED EXPORT INDUSTRIES Garment Industry The inadequacy and unreliability of power was a major concern for garment companies in Luzon. The garment industry's peak production months (January to August) coincides with the utility's peak demand season (March to June). To combat brownouts, the companies have resorted either to smoothing out production processes by accelerating production during lean market demand to compensate for production decline or to investing in diesel generator sets. The costs incurred during brownouts (i.e. value of goods not produced, wages, machinery repairs and in process material losses) are estimated to average 3% to 5% of production costs per annum. Smaller firms are more vulnerable to power outages. Subcontracting to home-based cottage industries for sewing and embroidery using electric machines is a common practice in this industry. Most subcontractors do not have the financial capacity to invest in back-up generators. Consequently, whenever there are brownouts, the subcontractors' operations virtually grind to a halt. The whole production chain suffers because the subcontractors are unable to deliver their share of the production to complete the production cycle. Microelectronics Industry The semiconductor industry is energy and water intensive: energy for automatic manufacturing systems and water for the production of de-ionized water for plating printed circuit boards. Power outages lead to productivity losses when machines have to be recaliberated. The industry also shoulders a higher inventory carrying cost because production is accelerated during months when power outages are less. Metallurgical Industry Steel and ferroalloy production facilities are highly energy intensive. These industries are located in Mindanao, a region experiencing a 35% to 50% power curtailment. The National Steel Corporation has drastically reduced operations and six ferroalloy companies have closed until such time that there are assurances of uninterrupted power delivery. A foundry in Cagayan De Oro, which makes ferrous alloy valves for the export market, reported a 50% decline in orders because it was unable to make timely deliveries on existing orders. The Association of Mindanao Industries estimates that power dependent ferroalloy producers in Cagayan De Oro, Davao and General Santos are standing to lose over US$100 million in annual export earnings. Sectoral Issues 1.13 Several factors combined to bring about the present crisis. First and foremost, there was no major addition of capacity during the last few years. Several factors contributed to the lack of capacity. The Aquino Government delayed commissioning of the 620 MW Bataan nuclear plant as part of its review of decisions taken during the Marcos Administration, disrupting NPC's plans to increase supply in Luzon. Implementation of ongoing projects was slowed down because of delays in procurement. Start of construction of new plants was delayed due to difficulties in obtaining environmental clearances, not necessarily caused by the investment proposals per se but by inadequate environmental guidelines and lack of capacity in the reviewing agency. 7 1.14 Second, existing capacity was not effectively utilized. For example, the installed rated capacity in Central Luzon in 1991 (4,321 MW) should have been sufficient to meet the peek demand of about 3,000 MW. Part of the problem was beyond NPC's control. Poor rains reduced the generation capacity of NPC's hydro-electric plants.' The existing thermal power plants, whose primary function were to meet peak demand, were operated over their capacity for longer periods of time because additional capacity was not brought on line. Scheduling periodic maintenance became a problematic while lack of funds, spare parts and, increasingly, the lack of qualified technical staff exacerbated the maintenance problem. This resulted in breakdowns in the thermal power plants, aggravating the shortages. 1.15 The use of the more costly thermal plants combined with higher oil prices during the Gulf War increased NPC's costs at a time when NPC was facing popular resistance to a raise in tariffs. This worsened NPC's financial situation which in turn hampered NPC's efforts to raise additional resources for investments. 1.16 In November 1992, the government approved an Energy Sector Action Plan (ESAP) which addresses the issues in the sector and outlines a set of reforms to improve sectoral performance. Some of the salient recommendations of the ESAP are the creation of the Department of Energy (DOE) to improve planning and coordination in the sector, privatization, oil industry deregulation, the establishment of a single price regulatory body for all utilities, streamlined approval system for power projects and increased equity and higher tariffs to improve NPC's financial viability. Some of the recommendations have already been implemented. For example, the DOE was formally established in December 1992. The government is also actively promoting private participation in power generation through BOT, and BTO projects. Other reforms such as the privatization of NPC are understudy. The Telecommunication Sector 1.17 Telecommunication is essential to the development of modern manufacturing and service industries. The ability to communicate swiftly with suppliers and buyers, both domestic and foreign, is essential for business success. Inadequate communications reduces efficiency throughout the economy, erodes the competitive advantage in exports and trade, and inhibits foreign investments in the country. Economies of scale and high initial investment costs had made telecommunications a natural monopoly, limiting the entry of competitors. However, satellite communications, improved cables, cellular phones and other technological improvements have made it possible to introduce an element of competition into the industry. Sector Organization 1.18 Telecommunication services in the Philippines are provided mainly by the private sector within a regulatory framework established by the Government. The Department of Transportation and Communications (DOTC) formulates the sectoral policies and direction. An attached agency, the National Telecommunications Commission (NTC) is responsible for regulating the activities of the operators by Mindanao was hit harder by the water shortages since 86% of the region's installed capacity is hydro-electric. 8 awarding and renewing operating licenses to franchised companies; (a) approving expansion plans and tariffs of carriers; (b) monitoring the performance of network operators; and (c) managing frequency spectrum. Historically, one group of private companies has been licensed to provide record services (telegraph, telex, data and facsimile) and another licensed to provide telephone services. DOTC's Telecommunication Office (TELEOF) also acts as a carrier of telephone and telegraph services to remote areas. 1.19 The Philippines Long Distance Telephone Company (PLDT) dominates the sector. PLDT, one the nation's largest privately owned companies, provides telephone service to about 90% of the country's 800,000 working lines and about 94% of 1.3 million installed telephones.' PLDT owns most of the long distance networks that connect with local interchanges. It carries virtually all domestic long distance and international traffic. Until recently, PLDT was the only carrier to provide international telephone services; however, in 1989, NTC opened this service to competition by awarding licenses to operate gateways to Eastern Telecommunications Philippines Inc. (ETPI) and Philippines Global Communications (PHILCOM). Small operators that are not interconnected to PLDT's long distance networks are limited to providing local service in marginal markets and thus have a weak revenue base. Operators that are interconnected only share modestly in revenues from long distance and international service. 1.20 PLDT is one of the financially healthiest companies in the Philippines. During 1988-91, PLDT's current ratio ranged between 1.4 to 1.7, its quick ratio from 1.2 to 1.4, its interest coverage from 2.7 to 4.9, and debt service coverage from 1.8 to 2.4. These financial ratios are comfortably high and point to adequate liquidity for a company that provides a capital intensive service. Adequacy of Service Provision 1.21 The Philippines is suffering from a severe lack of telephone services. Between 1983 and 1990, telephone availability has remained constant, at around 8 working telephone lines per 1000 population. However, waiting lists have more than doubled over the same period of time from 3.7 applicants per 1000 population in 1983 to 8.5 in 1990. The ratio of waiting listed persons to working lines deteriorated from just over 45% in the mid-1980's to 98% by 1990. In 1990, there were as many people on formal waiting lists as there were people with working lines. 1.22 Investments in the telecommunication sector have not kept pace with demand during the 1980's. Investment in the sector dropped from an average of 0.9% of GDP between 1980-84 to 0.3% between 1985-88, a period of economic and political instability in the Philippines, before recovering to 0.7% of GDP in 1989-90. While there is no correct level of investment,' the increase in the ratio of wait listed applicants to working lines indicates a gross underinvestment in telephone services. 2 About 50 private and local government owned operators provide 8% of the connections and TELEOF provides the remaining 2%. Generally, these operators are small, financially weak and thinly capitalized and provide poor quality of service. Developed countries invest about 0.7% of GDP in telecommunications, whereas developing countries invest as an average 0.6% of GDP. 9 Table 1.3: AVAILABILITY OF TELEPHONES AND WAITING LISTS (Per 1000 Population) Working Telephone Lines Phone Line Waiting List Ratio of Waiting to Working Lines 1981 5.4 3.3 62.3% 1982 5.5 3.8 68.9% 1983 7.9 3.7 46.9% 1984 7.5 3.4 45.5% 1985 7.7 3.6 46.1% 1986 7.8 3.9 46.9% 1987 7.8 5.2 67.4% 1988 8.2 5.8 71.2% 1989 8.4 7.1 84.2% 1990 8.8 8.5 97.2% Source: World Bank, "The Philippines: An Opening for Sustained Growth" 1.23 At present, telecommunications in the Philippines fair poorly compared to other Asian countries. In 1988, the Philippines averaged 1.0 main stations per 100 inhabitants. While this is better than Indonesia with 0.4 main stations per 100 population, it is worse than Thailand, 1.7, Malaysia, 6.5, and Korea, 20.5. In 1985, there were approximately 0.37 applications wait-listed for every 100 main stations in the Philippines compared to 0.19 in Malaysia and 0.09 in Korea. The subscriber complaint rate in 1988 was 17 per 100 lines per month in the Philippines compared to an average of 6 per 100 lines per month for Thailand and 9 for Indonesia. Table 1.4: TELEPHONE DENSITY BY AREA, 1988 Towns Population Main Stations per (No.) ('000) 100 Residents (No.) Philippines 1,565 57,928 1.03 Major Cities 58 13,598 4.03 Smaller Towns With Telephones 225 13,380 0.37 Without Telephones 1,282 30,950 0.00 Metro Manila 17 7,494 5.51 Luzon 744 24,076 0.36 Visayas 402 12,989 0.46 Mindanao 402 13,369 0.27 Source: Philippines National Development Plan 1991-2010 1.24 The distribution of service is uneven with services concentrated in the lucrative urban market and non-existent in some rural areas. In 1988, the telephone density was 5.5 main stations per 100 inhabitants in Metro Manila and around 2.0 in Cebu and Davao, the second and third largest cities in the Philippines. On the other hand, 82 percent of towns did not have access to telephone services. At a regional level, 74 percent of towns in Luzon, 90 percent in Visayas, and 93 percent in Mindanao did not have access to telephone services. Regional disparities in telephone services reflect differences in economic opportunities; the lower population densities and incomes (ability to pay) in the less developed regions has made expansion of services into these areas not cost effective. 10 1.25 Given the importance of communications, for international transactions, many businesses firms are now increasingly forced to invest in alternative communication facilities, including even a separate office in Manila, to make up for inadequate telephone services. (See Box 2.) Box 2: TELECOMMUNICATIONS DEFICIENCIES AND PRIVATE SECTOR OPERATIONS Although the larger garment companies have access to telephones, waiting time for new additional lines averages three to five years. In order to communicate with their subcontractors, the larger garment companies have resorted to alternative modes of communication, such as investing in radio equipment, motor cycles, and courier services. The smaller garment companies typically have their production facilities outside of Metro Manila and need to maintain a separate office in the capital (at an average cost of P35,000 a month) to have access to communications services for importlexport transactions. Companies in Mindanao do not maintain a separate office in Manila because the quality of telecommunications services between Manila and Mindanao is unreliable. 1.26 To address the regional deficiencies, the Government initiated the National Telephone Program with a target of installing 87,000 new lines by 1994 in localities unserved by PLDT in Regions III-XII. Progress has been slower than expected so that completion is likely to be delayed until about 1996. The Government has secured bilateral financing for different segments of the Program. The Government also passed the Municipal Telephone Act in 1989 which aimed at implementing a program to provide basic telephone service to the 1,200 or so unserved municipalities by 1993. It directed DOTC to administer the program and authorized the Government to use its own funds as well as official loans to finance private sector efforts to implement this program. Sectoral Issues 1.27 The inadequacies in the telecommunication sector are the result of several factors. First, the macroeconomic and political instability during the mid-1980s made it difficult to raise the relatively large amounts of capital needed, especially from foreign sources. In addition, PLDT's expansion program was also affected by a combination of denial of access to foreign exchange and Government's intervention in curbing PLDT's expansion plans. The smaller operators hid behind the modesty of their profits and the high cost of capital to curtail their own investment programs. 1.28 A second factor is the lack of effective competition within the sector because of entry authorization process and the monopolistic behavior of PLDT. The franchising process for providing telecommunications services is cumbersome, lengthy and subject to Congress approval. As a result new operators find it difficult to enter the market. PLDT has also attempted to maintain its dominant position by resisting entry by other firms in the sector. For instance, PLDT has structured its tariff in such a way as to discourage new entrants. Monthly access fees have been set to barely recover long run investment costs and tolls for domestic long distance call are below cost. These are balanced by excessively high charges for international toll services which allowed PLDT to remain profitable. PLDT has also challenged the award of competing franchises in court, even obtaining a Supreme Court ruling invalidating the Government's authorization to ETPI to operate additional international gateways. 11 The Water Supply Sector 1.29 The Philippines has generally abundant raw water resources for domestic water supply, irrigation and industrial use. Average annual rainfall is about 2,300 mm, and there are 18 major and over 400 principal rivers, about 60 lakes, and significant quantities of groundwater. Most of the rain is concentrated in the four months of the monsoon season. Regional differences exist in the availability of water with Central Luzon (Region Ill), Western Visayas (Region VI) and Cebu Province in Region VII facing possible shortage over the long term. In addition, many rivers, lakes and groundwater sources are increasing being polluted and excessive withdrawal of groundwater is raising concern over saline intrusion in the coastal areas. Sectoral Organization 1.30 As in the power sector, the national government plays a prominent role in the water sector in the Philippines. Two key sector institutions, the Metropolitan Waterworks and Sewerage System (MWSS) and the Local Water Utilities Administration (LWUA), are agencies attached to the Department of Public Works and Highways (DPWH). MWSS is responsible for development, operation and maintenance of water supply and sewerage disposal systems in Metro Manila and its contiguous areas. LWUA is responsible for development of water systems outside of Metro Manila through the promotion of Water Districts (WDs) and Barangay Water and Sanitation Associations (BWSA), although it does not plan to be active in the latter. DPWH is also involved in point source development in rural areas (i.e. a protected well with a hand pump, or protected spring and outlet, without a distribution system) and oversees the National Water Resources Board which is responsible for coordinating and integrating all activities related to water resources development and management.' The Department of the Interior and Local Government (DILG) is actively promoting the involvement of local governments in water supply through the formulation of BWSAs. The Department of Health monitors drinking water quality and implements sanitation programs. Metropolitan Waterworks and Sewerage System (MWSS) 1.31 MWSS plans, designs, constructs, operates and maintains water supply and sewerage disposal systems in Metro Manila, Rizal Province and parts of Cavite Province. It is a semi-autonomous public utility with its own Board which formulates policy and determines tariff rates. As a Government Owned and Controlled Corporation, MWSS is subject to government pay scales and the agency's budget is subject to approved by the Office of the President upon recommendation of the Department of Budget and Management. Day to day management is carried out by an Administrator appointed by the President. In 1991, MWSS served about 7.2 million or around 75% of the people in its service area. MWSS's tariffs are progressive with prices rising as water use increase' and were increased in 1990 to reflect higher costs due to inflation. Commercial and industrial users are charged a higher tariff than domestic 4 Until recently, DPWH also oversaw the National Irrigation Administration (NIA). Supervision of NIA has been transferred to the Department of Agriculture. s In addition, all customers with water connections pay 10% on their water bill as an environmental charge; in addition, those with sewerage connections pay a sewerage charge equal to 50% of the water bill. 12 users. MWSS financial performance has been reasonable, maintaining a return on net fixed assets of around 10% between 1986-91, surpassing the minimum 8% required by the Bank. 1.32 MWSS faces several operational deficiencies that are being addressed with the support of Bank projects. First, Non-Revenue Water (NRW), water produced but not billed, is a major problem for MWSS. When the La Mesa treatment plant entered into operation and normal pressures restored in 1986, NRW reached 66% of the water produced. It is estimated that about 80% of the NRW is due to leakage and the remaining 20% due to metering errors and unregistered or illegal connections. While the situation has improved somewhat, NRW remains around 57% of the water produced. Second, billing and collection is poor. Gross accounts receivable have remained around six months' sales which is excessive. Non-payment of water bills by government agencies, including local governments, have contributed to this problem. Water Districts (WDs) 1.33 WDs and some local governments supply water to residents in urban areas outside of Metro Manila. Traditional municipal systems have largely been replaced by WDs to introduce more commercial practices in their operations and management. Of the more than 1,500 cities and municipalities in the Philippines, about 1,000 had piped water systems in 1980; by 1990, there were 539 WDs covering 560 cities and municipalities including most of the larger cities and municipalities. WDs are formed through a local government resolution turning over municipal water/sewerage systems to WDs. A WD is governed by a Board of Directors consisting of five members from various community groups (civic, professional, business, educational and women's organizations) who are appointed by the mayor. 1.34 A survey of 48 WDs, which consisted the bulk of LWUA lending in 1989, indicated that, as with MWSS, NRW was a problem in the WDs. NRW averaged around 35% of water produced. Second, accounts receivable averaged about 50 days of annual total revenues which is significantly better than that of MWSS. Third, WDs averaged a return on assets (net income before interest to net assets) of around 10%. However, smaller WDs tend to have lower returns: e.g. 39% of the WDs with less than 2,000 connections in the survey had returns of less than 2%. Political intervention and difficulties in adjusting water tariff rates in line with increases in cost are considered to be the prime causes of poor profitability. Barangay Water and Sanitation Associations (BWSA) 1.35 Outside of the urban areas, BWSAs are organized to operate smaller localized systems typically consisting of a well, pump, in some cases a storage tank, and distribution network serving around 100 households. A BWSA is formed from one or more barangays and is a non-stock, non-profit cooperative association which is registered with LWUA or the local government. Organization and management of BWSAs tend to be informal and their performances are mixed. BWSAs receive assistance from DPWH and DILG in the construction, operation and maintenance of their systems. 13 Local Water Utilities Administration (LWUA) 1.36 LWUA was established in 1973 as a specialized lending institution for the promotion, development and financing of WDs. Its functions include: (a) regulation of the water supply sector outside Metro Manila; (b) formation of WDs, provision of engineering assistance and training to the WDs, and construction of facilities; and (c) provision of loans for WD investments. LWUA develops, finances and constructs water supply systems which are handed over on completion to the WDs which then assume responsibility for operation, maintenance and repayment of the capital cost of system development (including feasibility studies, design and construction supervision) to LWUA. 1.37 LWUA raises funds from the central government and external agencies to finance its development program. Interest payments on its loans are the principal source of LWUA's revenues and the timely payments by the WDs of their debt service obligations is critical for LWUA's viability as a financially autonomous agency. Total loans granted to WDs amount to P5.4 billion of which P3.2 billion has been utilized. About 60% of LWUA's investments are placed with the 20 largest WDs, many of which are not meeting their debt service obligations. LWUA was collecting only 43% of all collectable funds in 1989 and its collection efficiency has varied from around 70% in the early 1980's, to around 50% in the mid-1980's, and to about 60% at present. These low collections efficiencies makes it extremely difficult for LWUA to meet it debt service obligations to the Government and the external financing agencies. Adequacy of Service Provision 1.38 In 1990, about 42% of the households in the Philippines obtained water from faucets and another 23% from deepwells (Table 1.5). The remaining 36% obtained their water from doubtful sources such as shallow wells, dugwells, springs, lakes, rivers and water vendors. There are significant differences in service levels between urban and rural areas: e.g. the share of households which get their water from faucets is 82% in Metro Manila, 53% in other urban areas, and only 23% in rural areas. The share of households with faucets, i.e. receiving water from (formal, piped) systems, increases with the level of urbanization, reflecting the fact that the higher densities in urban areas make it more difficult for households to rely on their own sources for water supply. 1.39 During the 1980's, the Philippines was successful in increasing the share of households with access to safe sources of water. The number of households with access to faucets increased from 2.5 million in 1980 to 4.8 million in 1990, an increase of 90%, and the share of households with faucets increased from 29% to 42%. The number of households which obtain their water from shallow wells, dugwells, springs, lakes, rivers and other doubtful sources decreased by 6% from 4.3 million in 1980 to 4.0 million in 1990 and their relative share in total households dropped from 50% to 35%. 1.40 The expansion of water systems may have just kept pace with the high rate of urbanization, especially in areas outside of Metro Manila. Between 1980 and 1990, the urban population increased by an average of 3% per annum, with areas outside of Manila growing at 6% per annum. While progress has been made in improving water supply in the urban areas outside Metro Manila, the achievements have been overwhelmed by the increase in the number of households. Outside of Manila, the number of urban households with faucets more than doubled from 0.9 million to 2.1 million during the 1980s but their overall share improved only from 44% to 53%. The share of urban households with 14 doubtful sources dropped from 27% to 19% but the absolute number of households actually increased from 0.6 million in 1980 to 0.8 million in 1990. Table 1.5: HOUSEHOLDS BY MAIN SOURCE OF WATER SUPPLY 1980 al 1990 Number Share Number Share Metro Manila Faucet 794,908 72.0% 1,289,868 82.2% Deepwell 169,805 15.4% 185,929 11.8% Others 138,850 12.6% 93,791 6.0% 1,103,563 100.0% 1,569,588 100.0% Urban (excluding Metro Manila) Faucet 921,699 43.6% 2,138,129 53.3% Deepwell 618,744 29.2% 1,101,942 27.5% Others 575,101 27.2% 772,821 19.3% 2,115,544 100.0% 4,012,892 100.0% Rural Faucet 776,462 14.4% 1,314,106 22.6% Deepwell 1,067,918 19.8% 1,375,671 23.6% Others 3,543,700 65.8% 3,135,005 53.8% 5,388,080 100.0% 5,824,782 100.0% Total Faucet 2,493,068 29.0% 4,742,103 41.6% Deepwell 1,856,467 21.6% 2,663,542 23.3% Others 4,257,652 49.5% 4,001,617 35.1% 8,607,187 100.0% 11,407,262 100.0% A/ Adjusted for peddlers: assumed share of households obtaining water from peddlers in 1980 similar to that in 1985. Source: NSO, Population Census, 1980 and 1990 1.41 While coverage by communal systems has improved, this does not necessarily imply that there has been a commensurate improvement in the quality of service. In the case of Metro Manila and its immediate surrounding areas covered by MWSS, the production of water did not keep pace with the increase in numbers of connections. The levels of water production have remained constant around 2.4 million cu. m. a day since 1986 while the number of domestic, commercial and industrial customers has increased by 40% from 0.5 million 1986 to 0.7 million in 1991. As a result, the amount of water produced has decreased from around 490 liters per capita a day in 1986 to 350 liters per capita a day in 1991. In addition, the droughts experienced in recent years in Central Luzon and shut downs in treatment plants due to power shortages have resulted in further decreases in water availability and are worsening the situation. Inadequate water is exacting a toll on the residents of Metro Manila. (See Box 3.) 15 Box 3: A DAY IN THE LIFE: FAMILY COPES WITH POWER, WATER CRISIS Mrs. Gonzales stays awake past midnight waiting for water from her faucet so she can store enough for the next day. She is one of millions of Metro Manila residents suffering through a water shortage aggravated by an electricity crisis that includes daily power outages lasting up to 10 hours. Mrs. Gonzales and her four children live in a district of Quezon City which receives water only 10 hours a day - five hours in the morning and another five hours in the evening. Some districts receive water only one hour a day. Wealthy residents may pay private companies to deliver water daily by truck. "Sometimes it doesn't come at all", Gonzales said. "And I just lose sleep from waiting." Gonzales' district is on high ground, requiring water to be pumped, officials say. And power outages disrupt operations at the city's 16 pumping stations. The power shortage has cost Metro Manila companies P20 billion in lost business since Jan. 1. Since 1987, the Philippines has suffered from a drought due to the El ]Rino factor, which altered weather patterns in the Pacific. Forecasters expect sufficient rain this year when the rainy season begins in May. But the city's water system, much of which was built in 1896, is in such disrepair that officials estimate more than half the supply is lost through leaks and illegal taps. Coping with the water shortage requires cooperation and ingenuity. Mrs. Gonzales' neighbors have bought large plastic and steel drums, each holding at least 100 liters of water, just enough for a day's need. They fill the drums whenever they have the opportunity. Because of the low water pressure, it takes Mrs. Gonzales about two hours to fill all her household containers - pails, kitchen pots and pans and used plastic ice cream cans. To conserve and recycle, she washes dishes in a pan, saving the soapy water to flush the toilet. Family members bathe standing in front of a large basin that catches the water xised to rinse. The water is then used to clean the bathroom. "Without water, it is hard to keep the house and kitchen clean and tidy," she said. "We can stand not having electricity, but not having no water too, is really too much." Source: The Manila Standard, April 5, 1993 1.42 Within MWSS's area, many commercial and industrial users rely mainly on groundwater for their water needs. MWSS is estimated to be providing only about a third of total commercial and industrial water consumed in Metro Manila. Many industrial users do not need treated water and find MWSS water too costly. MWSS's tariff for industrial users is estimated to be about four times the cost of pumping water. In addition, commercial and industrial users have been concerned about the quality of MWSS's service, namely low water distribution pressures and unreliability, especially for those enterprises in the industrial zone which is at the end of MWSS's distribution area. Some entrepreneurs have been forced to make additional expenditures to obtain water needed for their operations in times of low water pressure. Although groundwater exploitation has undoubtedly depleted resources in some areas, particularly adjacent to Manila Bay, the overall water resources in other areas are still considered to be substantial. Sectoral Issues 1.43 Unlike power and telecommunications, the Philippines is not presently faced with major deficiencies in water that could become a constraint to economic growth in the immediate future in most areas. The availability of groundwater provides a relatively cheap alternative to formal piped systems for industrial users who may not require treated water. However, availability of water may become an issue over the long term as excessive extraction depletes groundwater and industrial and domestic waste discharges pollute the existing ground and surface water sources. 16 1.44 While the report has focussed on the impact of infrastructure on firms and economic performance, water is also a basic need (unlike telecommunications and to a lesser extent power) and the impact of water deficiencies on households would need to given full consideration. Continued rapid urban growth would increase the demand for piped water systems in the cities. The cost of water in the major urban areas is expected to increase as the most accessible and least costly water sources would be fully exploited and water utilities would need to invest in source development in more distant areas and transmission facilities. This would require more effective use of existing financial and water resources. The Road Transport Sector Transport Sector Overview 1.45 The Philippines transport system is composed of over 700 km of railways, over 160,000 km of roads; about 85 public ports, some 90 municipal ports and over 200 private ports; and 6 international and more than 80 other public airports. The system is basically bimodal: road transport and inter-island shipping together account for almost 100% of national freight and over 95% of passenger movements. Domestic air transport is very limited and almost entirely passenger traffic, while railway traffic, both passenger and freight, is negligible. Most transport services are provided by the private sector, the exception being rail services.6 The discussion of the transport sector focusses on its two main subsectors, road and maritime transport. Road Sector Organization 1.46 The public road network in Philippines is administered by the Department of Public Works and Highways (DPWH) and the local governments. DPWH is responsible for the national highways. The provinces, cities and municipalities are responsible for administering local roads within their jurisdiction. As part of the Government's Decentralization Program, administrative responsibility for barangay (local community) roads, just over half of the road network, were devolved from DPWH to the local governments and national government funding for local road maintenance and barangay road construction were discontinued in 1992. 1.47 The Department of Transportation and Communication (DOTC) is responsible for overall transport policy and for administration and regulation of the sector. Various special regulatory boards were set up to oversee compliance with the law. Within the road sector, the Land Transport Franchising and Regulatory Board (LTFRB) administers operator franchising and the Land Transportation Office (LTO) vehicle registration, driver licensing, and enforcement of vehicle and road safety regulations. Both the LTFRB and LTO are attached to DOTC. 6 Philippines Airlines was recently privatized by the Government. 17 Adequacy of Service Provision 1.48 The Philippines has a total road network of approximately 160,000 km, including 26,272 km of national roads, 29,156 km of provincial roads, 16,758 km of city and municipal roads, and 88,363 km of barangay roads in 1990 (see Table 1.6). Overall road kilometer increased by 4.6% between 1981 and 1990. The main road network coverage comprising of national and provincial roads, is about 18 km. per 100 sq km. This level is comparable to that in other Southeast Asian countries (Table 2.7) and, except in isolated locations, the lack of roads per se is not considered to be a major problem in the Philippines. Table 1.6: DISTRIBUTION OF ROAD BY TYPE 1981 1985 1990 Road Length (Kms) 153,529 161,867 160,559 National Roads 23,489 26,191 26,272 Provincial 29,953 28,193 29,156 City and Municipal 15,638 16,812 16,768 Barangay 84,449 90,671 88,363 Coverage of National and Provincial Roads: Road Kms. per 100 Sq. Km. 17.81 18.13 18.48 Source: World Bank, "Philippines Infrastructure Assessment Study: Performance Review of the Road Subsector" 1.49 However, the quality of the existing road infrastructure is poor. Only 14% of the network is paved with either cement concrete or bituminous surfacing. The level of pavement is higher in national roads, 49% of which were surfaced with asphalt or concrete compared to 8% for the local roads. Significant regional disparities exist in the quality of roads; 89% of the roads in Metro Manila are paved compared to only 3% to 4% in the regions. The quality of the main network is significantly inferior to several East Asian countries; in 1984, the latest year for which comparable data is available, a very low proportion of main roads in the Philippines were paved (29% in Philippines compared with 60-70% as observed in other Asian countries) and were considered to be in good condition (with the exception of Indonesia). 1.50 Many of the existing roads suffer from a lack of maintenance and only 34 % of the national roads were considered to be in good condition according to a recent DPWH survey. It is estimated that over 40% of the provincial roads and over 50% of the barangay roads are in such poor condition that they cannot be maintained and have to be rehabilitated or abandoned. 18 Table 1.7: ROAD SECTOR INDICATORS FOR SELECTED EAST ASIAN COUNTRIES Main Road Network (1984) Road Expenditure GNP Per Density Paved Rd Condition Vehicles (excl. 2-wheelers) Country Capita Kms / Weighted % Vehicles/ Vehicles/ % Exp / % Maint./ ($) 100 Sq.Km. a/ Paved Km 1000 pop. GDP GDP Philippines 710 18.41 142 00 29.00 17 65 16 25 0.84 0.19 Thailand b/ 1220 8 67 135.00 76.00 48.98 39.34 1.05 0.20 Malaysia c/ 2160 10.90 130.00 78.00 51.31 106 10 1 08 0.11 Korea d/ 4400 24.63 117 00 65.00 83.48 48.01 1.25 0 09 Indonesia e/ 500 2.92 155.00 62.00 39 45 12.31 0.57 0.11 a/ Weights for road condition; Good = 1.0, Fair = 1.5, Bad = 2.0 b/ Revenue and expenditure statistics for 1990 taken from the Fourth Highway Sector Project SAR c/ Estimated average annual road expenditure during 4th Plan (1981-85); maintenance expenditure for federal roads only. !/ Estimated annual average expenditure during the Fifth Year Plan (1982-86) Source: World Development Report, 1991 World Road Statistics 1985-89, IRF, Washington, D C Road Deterioration in Developing Countries, World Bank, 1988 1.51 Inadequate roads are preventing the rural areas from fully exploiting their natural comparative advantages and hindering regional development. Poor road conditions (together with the inefficiencies of the ports and price distortions in the maritime sector discussed in the next section) make agricultural products more expensive in their markets. A study of rice and corn marketing in the Philippines has found that poor farm to market roads have led to the emergence of middlemen to transport grain to all weather roads. Such intermediate activity has resulted in delays of up to one week in the rainy season, and post-harvest losses of between 15 and 25 percent. The cost of agricultural products in major markets is also high due to transportation difficulties. For example, the cost of corn transported from the Cagayan Valley (Region II) to Metro Manila by land is estimated to be US$15.00 per mt. in Manila, of which freight is estimated to be US$12.36 or 82% of cost (Table 1.8). Corn from Cagayan De Oro City in Northern Mindanao (Region X) is estimated to be US$22.26 per mt. in Manila or equivalent to the cost of corn shipped from Bangkok. Local procurement costs in Cagayan de Oro City are already high reflecting the cost of transporting corn from the farms to the port. Table 1.8: TRANSPORTATION COST OF CORN TO MANILA FROM MAJOR SOURCE POINTS, 1989 (US $ PER METRIC TON) Source Local Procurement Freight Cost Total Cost Cagayan De Oro 13.80 4.91 22.26 Cagayan Valley 2.64 12.36 15.00 US Ports - 80.25 81.85 Bangkok - 21.62 23.27 Source: IFPRI/USAID Report on the Corn Industry, 1991 (reproduced from the World Bank "Philippines, Cost and Reliability of Trade and Transport Logistics", October 1992) Sectoral Issues 1.52 Deterioration of the network is the most serious problem facing the road sector in the Philippines. Roads are a valuable national asset. The replacement value of the Philippine road network is estimated to be about US$8.0 billion. Unfortunately, much of this capital has been allowed to waste away from lack of maintenance. The total cost of restoring the Philippine road network has been estimated at US$5.2 billion in 1992 prices. This implies that 66% of the value of road assets has been lost, and that the current net value of the road network stands at only US$2.4 billion, or 5% of GNP. This value is extremely low in comparison to other countries in the East Asia and Pacific region, which average around 15% of GNP. 1.53 The decline in road expenditures, especially for maintenance, in real terms during the 1980s contributed to the poor condition of road infrastructure. National government expenditures for both road construction and maintenance in constant 1985 prices is estimated to have dropped from P9.6 billion in 1981 to R4.8 billion in 1990 (see Table 1.9). Maintenance expenditures for the main arterial network (national and provincial roads) is estimated to have fallen from around P25,000 per km. in 1985 prices in 1981 to about R 16,000 per km. in 1990. 20 Table 1.9: NATIONAL GOVERNMENT ROAD TRANSPORT REVENUES AND EXPENDITURES (in P millions, constant 1985 prices) 1981 1985 1990 a/ Road User Charge Revenues b/ 11,442 8,311 8,907 Fuel Taxes 9,998 7,195 7,943 Motor Vehicle Registration 1,122 876 735 License and Plate Fees 104 79 48 Other 218 161 181 Expenditures 9,636 4,697 4,807 Road Construction 6,551 3,182 3,239 Road Maintenance 2,531 1,346 1,419 Other 553 169 149 Selected Indicators: Road Expenditure/GDP 1.5% 0.8% 0.7% Construction/GDP 1.0% 0.6% 0.5% Maintenance/GDP 0.4% 0.2% 0.2% Expenditure/User Charges 84.2% 56.5% 54.0% Maintenance/Km. c/ (pesos) 25,390 13,058 15,896 a/ 1990 revenues based on estimates for 1989; 1990 expenditures based on consultant estimates. b/ Excludes import duties. i/ DPWH expenditures for national and provincial road maintenance. Source: World Bank, "Philippines Infrastructure Assessment Study: Performance Review of Road Subsector" 1.54 Underfunding compounds the maintenance problem as available resources are used to carry out the most urgent repairs. Regular and preventive maintenance on relatively good roads are deferred until they too deteriorate to the point that they become urgent or more likely need major rehabilitation. The relative share of road construction in GDP fell from 1.0% in 1981 to 0.5% in 1990 and the share of maintenance from 0.4% to 0.2%. Compared to other east Asian countries such as Thailand, Malaysia and Korea that devote above 1% of their GDP to highways construction and maintenance, the current level of highway expenditures in Philippines appears low (see Table 1.7). 1.55 Budgetary constraints are given as the cause of the decline in road expenditures. The increase in debt service payments by the national government lead to less resources being allocated to capital expenditures and operations and maintenance in general during the 1980's. However, revenues raised from road user charges are estimated to have more than offset road expenditures during this period. In 1981, national expenditures for road construction and maintenance were 84% of fuel taxes, motor 21 registration and other road user charges collected by the national government. In 1990, the share of road expenditures is estimated to have dropped 45%. In fact, the road sector has consistently made significant net contributions to the general budget. 1.56 While overall resources have been constrained during the last decade, limited available funds may not have been effectively utilized due to poor management practices. In particular, the quality of the construction has often been poor and supervision of works has not always been adequate, resulting in inefficient use of equipment and insufficient monitoring of use of funds and physical accomplishments. The Road Transport Industry 1.57 The transport industry is predominantly privately owned.' The majority of the trucking and bus companies are small. Companies with less than five vehicles and owner-operators with only one vehicle are estimated to comprise around 75% of the trucking industry and large companies with more than 50 trucks about one percent. In addition, commercial trucking accounts for only about 10% of the total fleet, the remaining 90% being registered for private, own use. Similarly, small companies with less than 10 buses account for about 85% of the bus industry. 1.58 On paper, the road transportation sector has been highly regulated, being governed by laws, regulations and practices dating back to the 1930's. Official authorization or franchise from the LTFRB is needed to provide freight and passenger services. In practice, however, the regulations have not been fully enforced and the industry has been de facto deregulated with costs to shippers reflecting market conditions. Nevertheless, potential restrictions to entry, government-set tariffs and uneven enforcement of the regulations have constrained the development of the road transport industry over the long term. The Government has recently taken steps to address some of these regulatory issues. A detailed discussion of these issues is given in paras 2.40 - 2.47. The Maritime Transport Sector 1.59 The Philippines is an island nation consisting of eleven large islands divided into three major island groups, Luzon, Mindanao and Visayas, with an extensive coastline of over 34,000 km. The shipping industry plays an important role in the economic integration of the country. The maritime and road transport sectors complement each other, the former responsible primarily for inter-island transport and the latter for intra-island transport. 7 One exception is the Metro Manila Transit Corporation under DOTC which provides bus services in Metro Manila. 22 Maritime Sector Organization 1.60 There are two government agencies under DOTC responsible for the Philippines maritime industry, the Philippines Port Authority (PPA) and the Maritime Industry Authority (MARINA). PPA is responsible for developing, maintaining, operating, supervising and regulating services and facilities of the public ports. PPA conducts dredging and provides berthing space, open and covered storage areas, backup space, and other port facilities. Private companies are responsible for cargo handling operations, stevedoring (on board cargo hauling) and arrastre (on land handling), under contract from PPA. In addition PPA establishes and enforces port regulations, sets port tariffs (e.g., pilotage, wharfage, berthing, cargo handling), oversees and monitors port operations. PPA's main sources of income are cargo dues (wharfage, storage, and arrastre fees) and ship dues (dockage, port usage fee, port dues, lay up fees). In addition, PPA has the authority to levy fees on cargo handled in private ports. 1.61 MARINA is responsible for developing shipping, shipbuilding and repair facilities; setting policies and regulations governing passenger fares, freight rates and route franchises; and coordinating maritime training. Domestic shipping is provided by the private sector operating within the regulatory framework established by MARINA. Scheduled liners account for about half the domestic freight and almost all of the passenger service. The remaining cargo is carried by unscheduled contract carriers (trampers) and by own account vessels. As with the trucking and passenger transport, shipping was highly regulated. Adequacy of Port Services 1.62 In 1990,8 the public port system comprised of 29 ports of entry, which include the principal ports of the Philippines, 57 sub-ports, and 92 other municipal ports. The private sector owns and operates around 220 ports, most of which (about 85%) are dedicated cargo handling facilities owned by large enterprises such as oil, mining and food processing companies. Private ports are estimated to accommodate more than half (almost 56%) of total cargo of the Philippines, while the public ports service a higher share of domestic cargo (about 54%). 1.63 During the 1980s, total cargo throughput through Philippines ports followed the overall economic trends of the country. Reflecting economic recession, traffic fell from 67.8 million tons in 1981 to 61.8 million tons in 1985 (Table 1.10). As the economy began to recover after 1985, port traffic gradually increased, reaching 93.3 million tons in 1990 and averaging an annual growth rate of 8.6% which was almost double the growth in national GDP during this period. Domestic traffic experienced higher growth compared to foreign traffic leading to a decline in the share of foreign traffic from 50% of the total in 1985 to 43% in 1990. The rapid growth in import trade produced almost 69% increase in import traffic and raised the share of import to total foreign traffic from 64% in 1985 to 72% in 1990. Growth in export traffic has been modest, about 16% during the same period. 8 Due to continuing reclassification, the number of ports by category fluctuates significantly each year. For example, PPA statistics show that ports in the Philippines totalled 392 in 1988, 411 in 1989 and 399 in 1990. 23 Table 1.10: SHIPPING AND PORT UTILIZATION 1981 1985 1990 Total Cargo Throughput ('000 mt) 67,807 61,796 93,349 Domestic 34,035 34,371 52,405 Foreign 33,772 27,425 40,944 Import 19,998 17,580 29,565 Export 13,774 9,845 11,379 Operational Indicators: PPA Ports Only Cargo Ton per Ship Hour Domestic 5.71 7.33 8.38 Foreign 53.40 63.20 53.27 Hours at Berth per Vessel 48.28 44.19 44.08 Domestic 46.54 42.64 41.66 Foreign 83.76 75.64 91.50 Waiting Hours per Vessel 2.05 1.27 1.48 Domestic 1.66 1.01 0.98 Foreign 9.93 6.64 11.40 Source: World Bank, "Philippines Infrastructure Assessment Study: Performance Review of the Port Subsector" 1.64 The productivity or the speed with which goods move through port facilities directly influence its capacity to attract cargoes, influence costs and provide customer satisfaction. The overall berth productivity, measured in terms of tonnage handled per ship hour at government ports, showed modest improvement for domestic traffic whereas for foreign traffic, it has declined from 63.2 tons per ship hour in 1985 to 53.3 tons per hour in 1990 (Table 1.10). Similarly, the time spent by ships at berth has remained around 42 hours for domestic cargo between 1985-90 despite the increase in traffic while that of foreign cargo has deteriorated from 75.6 hours to 91.5 hours. The waiting hours per foreign vessel has increased from 6.5 hours in 1985 to 11.4 hours in 1990. Sectoral Issues 1.65 Various studies have identified several factors that have contributed to inefficiency in government port operations. First, the lack of facilities such as forklifts and cranes, inadequate storage (especially for containers) within the port area, and the mixing of passenger and cargo operations in most domestic ports hindered the efficient loading and unloading of vessels. Second, PPA's method of awarding contracts for stevedoring (on board cargo hauling) and arrastre (on land handling) operations resulted in high costs and inefficiencies. PPA's contracts to private operators were for one year which did not provide an incentive for the operator to invest in equipment or training to upgrade operations. In addition, the contracts were negotiated with a single contractor for each port. The number of contractors was subsequently expanded to two in principal ports to introduce some competition. However, this attempt to allow two operators to compete only on service quality (but not on price which remains set by PPA) has not resulted in service improvements because of formation of duopolies, union resistance against the two operator policy, and lack of full commitment on the part of PPA to enforce competition. These monopolies have lead to stevedoring and arrastre charges being levied even if these 24 services are not performed, e.g. because ships own cranes are used due to lack of the necessary equipment in the port. Third, various rules and regulations required ships to get different approvals from several government agencies before they could set sail, delaying departures. 1.66 The PPA has taken several measures to improve the efficiency of port operations. First, it has upgraded the facilities in the Port of Manila, Cebu and other major ports with financial assistance from bilateral and multi-lateral financial institutions. Second, PPA has established "one stops shops" (Port Integrated Clearing Offices) in its ports to facilitate processing of paper work. Third, PPA awarded the operation and management of the Manila International Container Terminal (MICT) through competitive bidding to a private operator. In addition, the contract was for a 25 year period. This has provided an incentive for the operator to invest in equipment to improve operations and has resulted in a turn around in MICT's operational efficiency. The average service time per vessel increased from 22.8 hours in 1985 to 46 hours in 1989 but declined to 16.6 hours in 1990. Recent improvements in the performance of MICT (Manila) following the selection of a new contractor, have triggered PPA's interest in privatizing other ports including the North Harbor, Batangas, Davao and Cebu. 1.67 While improvements are being made in port operations, PPA's role as both regulator and operator of ports is considered to be a key constraint to the development of effective port operations over the long term. At present PPA collects various fees from private ports for which it does not provide services. This does not only distort competition to the advantage of the ports operated by PPA but it also tends to relieve PPA of the pressure to strive for more operational and cost efficiency in its ports. A further problem is the extensive cross subsidization between ports. This tends to distort incentives structures between PPA ports, reduces pressures for cost control in loss making ports, prevents a rationalization of the ports structure and of shipping operations, and may influence investment decisions adversely. The Domestic Shipping Industry 1.68 The inter-island shipping industry consists of liner operators, trampers, tankers, barges (long-distance and lighterage), and industrial or specialized operators. The domestic shipping fleet consists of over 740 vessels of more than 50 gross tons (GT) (100 passenger cargo ships, 200 ferries, 400 cargo ships and 40 tankers) and a large number of smaller vessels and barges. The liner-shipping industry provides virtually all inter-island shipping passenger services, and it accommodates most non- bulk cargoes. Inter-island shipping is dominated by the Conference of Inter-island Shipowners and Operators (CISO) which comprises of 17 members owning about 80-85% of the country's shipping tonnage and which carries about the same percentage of inter-island cargo and passenger traffic. 1.69 Tramper operators do not have assigned routes or fixed rates, and they normally are on a time charter basis. Liner shipping companies, on the other hand, operate under franchise privileges, with fixed sailing schedules, routes, and fare/freight rates approved by MARINA. These regulations combined with the oligopolistic structure of the liner operators are thought to have contributed to a distorted price structure, protecting the least efficient operators and allowing the more efficient ones to earn a rent. While liner operators have offered discounts below regulatory rates, CISO has now established an effective control mechanism which ensures that the prescribed rates and fares and other conditions of carriage are adhered to. As with road transport, the Government has taken steps to deregulate inter-island shipping. 25 1.70 However, there is a need to reinforce competition in shipping. Without strict enforcement of competition rules, which do not yet exist, price deregulation may actually lead to monopolistic pricing practices in markets where entry is relative costly and/or can be restricted to a small number of participants. The possibility of cartelization and price fixing in liner shipping is strong because of the substantial sunk cost at stake. Therefore, there is a danger that without effective enforcement of competition rules price liberalization might result in monopolistic pricing. Overview and Conclusions 1.71 Several conclusions can be drawn form this overview of the power, telecommunications, water, land transport and maritime sectors. First, the traditional approach of concentrating responsibility for infrastructure provision into sector institutions has not necessarily had the desired effect. Instead, it has resulted in poor operational performance in most of these agencies. 1.72 Second, the traditional emphasis on supply has worked to the detriment of the consumers who are faced with a combination of constraints. As with this chapter, the power, telecommunications, water, land transport and maritime sectors are typically discussed separately reflecting the fact that different sets of institutions are responsible for overseeing development in their respective sectors. This has resulted in an emphasis on the constraints of the suppliers (the agencies) and less on the problems facing the consumers (the manufacturing firms, commercial establishments, and households). From a consumer's perspective, minor problems, when combined together, can become significant impediments for development. A study of transportation logistics in the electronic, furniture and textile industries concluded that transit costs in the Philippines were high,9 not necessarily due to a few major constraints, but because of the combined effect, among others, of poor roads and high domestic trucking costs (outside of Manila), multiple handling and inefficient transportation logistics, monopolies in port operations, poor port equipment (especially for containers), and cartelization of inter-island shipping. 1.73 Third, infrastructure deficiencies are exacting a toll on Philippine businesses by increasing costs relative to what they could be if efficient infrastructure systems were in place. Poor infrastructure and unreliable supply add to the direct operating costs of manufacturing and commercial firms e.g. through higher transportation costs, low capacity utilization, wastage and higher inventory costs. In addition, low productivity and delays result in cancellation of contracts because of inability to meet deadlines and make timely deliveries. 1.74 Firms are paying more than they need to in order to obtain reliable infrastructure services by spending on alternative sources of supply, such as private generators for electricity and two-way radios for communications.'o Self-provision has even become institutionalized to the extent that local financial institutions require industrial borrowers to include the cost of generators in their loan applications. Private provision of infrastructure reflects the importance these firms attach to these services and indicate a willingness to pay more for reliable services. The shadow price for reliable infrastructure services, e.g. 9 World Bank, "Philippines Cost Reliability of Trade and Transport Logistics", October 1992. The study estimated that a 10% saving on transit cost for these commodities would represent about US$200 million a year. 10 The impact of the deficiencies is greater for those services where cheaper options do not exist and for smaller firms which do not have the resources nor the sufficient scale of operation to invest in their own facilities. 26 in power and telecommunications, is significantly higher than the current nominal prices being charged for unreliable services. 1.75 The need for consumers to invest in their own generators and communications systems undermines the traditional economies of scale argument for maintaining monopolistic structures. Not only is the economy not benefiting from the economies of scale in infrastructure provision but resources that could have been used for capacity expansion and improving productivity are instead spent on in-house power and telecommunications facilities. Where high infrastructure costs retard the growth of existing firms and hamper the emergence of new ones, employment and incomes that could have been generated in the Philippines with low cost and reliable infrastructure services, are lost. 1.76 The Philippines is now caught in a downward spiral of poor infrastructure services, poor economic performance, low resource mobilization, and cutbacks in maintenance and investments resulting in further deterioration of infrastructure. The costs of starting and running a business in the Philippines have increased over recent years as electricity brown-outs and other disruptions have increased. Requiring back-up power generation, or waiting months, or years, for telephone connections, being unable to place calls, or having to install a dish for communications, makes doing business unnecessarily costly. Time delays and congestion, and frequent interruptions in production activities, add further to the costs of doing business. The wide range of deficiencies and the declining level of services have triggered consumers' resistance to price increases. But without increasing prices and revenues, the utilities are constrained from improving services and investing in additional capacity. 1.77 If infrastructure in the Philippines continues to decline, there is the real prospect of the Philippines losing further competitive advantage in the modem communications-intensive sectors, and hence having to fall back on "cheap labor" commodities. However, it is not clear whether the Philippines will be able to compete with other emerging low wage countries such as China and Vietnam without having to suffer a significant decrease in the standard of living of the average worker. 1.78 Financing of infrastructure investment, however, presents major current difficulties for the Philippines Government, which is facing a serious revenue shortfall and whose potential private investors face large risk premiums on foreign capital markets. This places the Government in a difficult position. Poor infrastructure with increased deficit spending runs the risk of destabilizing the economy and reversing the macroeconomic gains that have been achieved through disciplined fiscal and monetary management. On the other hand, failure to develop economic infrastructure could see the Philippines lose further ground to other economies in the region. 1.79 The traditional approach to infrastructure services with its reliance of single sector institutions and emphasis on supply side issues in each of the sectors is now being brought into question. The Government has already taken steps to make changes in the institutional and regulatory structure by introducing more competition into the provision of infrastructure services. These changes would have to be designed and implemented on the basis of a good understanding of the core constraints to infrastructure development. The next chapter examines this issue in detail. 27 H. CONSTRAINTS TO INFRASTRUCTURE DEVELOPMENT Introduction 2.1 As described in Chapter I, it is clear that in the mid-1980s, the Philippines experienced both a slowdown in expanding access of infrastructure services to underserved segments of the economy and a dramatic deterioration in the quality of its economic infrastructure. In large part, the chronology of this breakdown in infrastructure coincides with the timing of broader domestic events: the political and economic crisis of 1983-1986, the ensuing political consolidation and tentative economic recovery, and the economic stagnation that followed the subsequent abortive coups. The purpose of this chapter is to provide an analysis of the main causes that have led to the present infrastructure failures. 2.2 The dimensions of the infrastructure crisis in the Philippines are complex and highly intertwined. Despite the varying conditions across sectors, it can be argued that there is a commonality of causes in explaining the current infrastructure situation. Constraints to infrastructure development in the Philippines include not only macroeconomic constraints brought about by the need to stabilize the economy, but also, and more importantly, systemic institutional, financial and regulatory problems. The latter have now become more prominent at a time of fiscal stringency. 2.3 The need to reduce high levels of budget deficit since the mid-1980s because of high levels of debt has necessitated curtailing public investments. Public infrastructure investments were slashed and declined from an average 4.7% of GDP during 1978-1983 to an average of 2.6% of GDP during 1987-1990. However, and quite ironically, a substantial portion of the debt was directly associated with infrastructure projects. Therefore, past public infrastructure investments, which were mainly financed through deficit expansion, exacerbated the debt problem. 2.4 It is often widely perceived that recent declines in public infrastructure investments are the major reason for the present infrastructure service inadequacies in the Philippines, together with the associated negative impact on foreign and domestic private investment. While it is undeniable that low levels of investment will eventually contribute to the poor state of economic infrastructure (and have already done so in power), they are only part of the explanation and tend to focus mainly on the quantitative aspect of deficiency. 2.5 A more fundamental issue lies with the lack of self-sustained mechanisms for developing infrastructure systems as well as, inadequate industry structures, dominated primarily by public enterprises and private monopolies. During the last decade, the poor economic performance and weak financial outcome of many Government enterprises have seriously limited their capacity to maintain and invest in infrastructure systems through internally generated funding. This poor performance can, in turn, be traced to structural factors. These include non-commercial management structures, unclear and often conflicting commercial and social objectives, low capitalization and limited accountability for performance. Further constraints to generating revenue internally have been imposed by price controls, inadequate pricing levels and/or tariff structures, as well as, difficulties in enforcing revenue collections. As a result, many government enterprises have failed both to expand access and to improve quality of services to a growing population. They have also had to rely increasingly on the government's financial support to sustain their activities. This support, combined with the need to reduce budget deficits, has further diverted already limited resources and prevented the government from making necessary 28 infrastructure investments. 2.6 In addition, existing and new firms face further disincentives to provide infrastructure and improve the quality of services. These stem from existing industry structures and regulatory frameworks which encourage incumbent firms to focus on lucrative market segments, while presenting significant barriers to entry by new firms. Such barriers have arisen, for example, through a bundling of commercial and regulatory functions into a single organization (e.g PPA), thereby creating considerable impediment to competition in the provision of infrastructure related services. In other instances (e.g. power and telecommunication), natural monopoly elements within the various sectors have been bundled together with contestable businesses, thereby frustrating effective competition in supply and reducing incentive to improve quality. 2.7 Finally, other risk factors exacerbated infrastructure development. The threat of political or environmental upheavals have, in the past, considerably increased the risk of investing in the Philippines. Such concerns may continue to weigh heavily on the minds of potential investors. Investment in infrastructure is particularly susceptible to country risk factors because returns are typically recovered over long time periods, due to initial high capital costs and long range planning. The absence of a stable political and economic environment, or uncertain contractual and legal arrangements, will therefore attach high risk premia to private investment in infrastructure. Macroeconomic Constraints 2.8 Fiscal constraints have and will continue to limit the government's capacity to make new economic infrastructure investments. Prior to the onset of the Philippines' political crisis in the mid- 1980s, the government initiated a substantial expansion of the public investment program. Between 1978 and 1983, public expenditure on economic infrastructure averaged 4.7% of GDP. The payment crisis that began in 1983 forced the government to reduce its budget deficit, mainly by slashing public investment, including infrastructure investment. Despite a resurgence in economic growth from 1986 to 1989, economic infrastructure investment continued to stagnate at little more than half its high pre-1984 levels. From 1987 to 1990, the government pared down the public investment for economic infrastructure to an average of only 2.6% of GDP. In real terms, public investment in economic infrastructure declined by 54% (1980-83 versus 1984-90). (See Figure 2.1 and Table 2.1.) 2.9 This reduction of infrastructure investment has occurred during the implementation of the Philippine stabilization plan, which calls for strict limits on the consolidated public sector deficit. This was required partly in response to growing levels of external and domestic debt throughout the 1980s, which has imposed considerable financial obligations through large debt servicing requirements on the present government. However, and quite strikingly, a large share of the current debt can be directly attributed to past infrastructure investments (see Box 4). Because of heavy reliance on debt financing, past infrastructure investments have contributed to exacerbate the debt problem. 2.10 The level of public debt in the Philippines has remained at extraordinarily high levels throughout the 1980s, peaking at 93 percent of GDP in 1986. Since then, the government has been able to reduce the level of debt to an average of around 79 percent. Nevertheless, the level of debt remains high by international standards (see Figure 2.2). 29 igure 2.1: Public Investment by National Government and GOCCs (as % of GDP) 6 Intrastructure ONon4ntrastructure 0 1979 1980 1981 1982 1983 1964 1985 1986 1987 1988 1989 1990 Sources' National income Accounts, NSCB, Governmen Corporations Monitoring and Coordinating Committee, Lamberte (1991) 30 Table 2.1: Actual Public Investment in Infrastructure by Sector, 1978 to 1990 (Constant 1985 Prices) TOTAL Of which: WATER POWER AND ECONOMIC: TRANSPORTATION COMMUNICATIONS RELATED ELECTRIFICATION NON-ECONOMIC TOTAL Year (mil P) (as %) (mil P) (as %) (mil P) (as %) (mil R) (as %) (mil P) (as %) (mil R) (as %) (mil V) (as % 1978 21,638 90.0% 5,646 23.5% 69 0.3% 4,810 20.0% 11,111 46.2% 2,413 10.0% 24,049 100 1979 29,313 94.5% 6,483 20.9% 57 0.2% 6,480 20.9% 16,291 52.5% 1,703 5.5% 31,014 100 1980 27,724 94.2% 5,580 19.0% 28 0.1% 6,285 21.4% 15,830 53.8% 1,698 5.8% 29,422 100 1981 30,115 95.7% 7,022 22.3% 58 0.2% 7,125 22.6% 15,908 50.5% 1,360 4.3% 31,476 100 1982 32,700 96.4% 9,221 27.2% 216 0.6% 7,021 20.7% 16,241 47.9% 1,219 3.6% 33,920 100 1983 32,761 96.6% 5,733 16.9% 287 0.8% 5,177 15.3% 21,563 63.6% 1,146 3.4% 33,908 100 1984 18,388 96.8% 3,938 20.7% 35 0.2% 3,526 18.6% 10,888 57.3% 606 3.2% 18,994 100 1985 12,930 96.5% 2,137 16.0% 44 0.3% 2,938 21.9% 7,811 58.3% 462 3.4% 13,393 100 1986 11,203 94.6% 3,683 31.1% 16 0.1% 2,527 21.3% 4,977 42.0% 639 5.4% 11,843 100 1987 10,225 81.5% 3,174 25.3% 63 0.5% 3,084 24.6% 3,903 31.1% 2,314 18.5% 12,539 100 1988 7,152 87.0% 1,460 17.8% 16 0.2% 3,371 41.0% 2,305 28.0% 1,065 13.0% 8,217 100 1989 15,905 89.9% 5,179 29.3% 478 2.7% 4,155 23.5% 6,094 34.4% 1,795 10.1% 17,700 100 1990 16,367 93.1% 5,203 29.6% 387 2.2% 4,590 26.1% 6,186 35.2% 1,211 6.9% 17,577 100 Sources: Nl>A, Piilippne Development Ieports. 31 Box 4: INFRASTRUCTURE AND DEBT IN THE PHILIPPINES Much of the debt incurred for infrastructure cannot be identified as such, since it consists of general obligation government debt, particularly for operational deficits and other subsidies. Nevertheless, the share that can be clearly identified is impressive. As of year-end 1991, the entire stock of long-term, government- guaranteed foreign debt equalled US$25.9 billion. Another US$15.1 billion represented domestic debts. About US$7.1 billion-the overwhelming part of its foreign debt--can be directly attributed to economic infrastructure projects, programs and subventions to those government corporations that provide economic infrastructure services. This is equivalent to 27 percent of the total foreign debt (or 17 percent of the combined foreign and domestic total). In addition, as government deficits were financed by foreign debt, a fraction of these deficits were incurred in support of explicit (and implicit) subventions to the government corporations that provide economic infrastructure. Explicit subventions consist of direct subsidies, equity contributions, and loans all from the national government. The only available data is the report of the Government Corporations Monitoring and Coordinating Committee, and covers 1985 to 1991. These data show that a total of approximately 27 billion (current) pesos of aggregate subsidies, equity contributions, and government loans were made to the 10 economic infrastructure-related government corporations. These direct subsidies therefore added another US$1.0 billion to the country's debt burden. There have also been many types of implicit subventions, such as tax exemptions and those reflected in government pricing policies. It is difficult to quantify most of these subventions. Nevertheless, notable components include the cost to the Treasury of (a) income tax exemptions for the 10 corporations that provide economic infrastructure services (estimated at almost P 3 billion in 1990), and (b) fuel tax exemptions for NPC (estimated at more than P2 billion annually). Figure 2.2: International Comparison of Debt (% GDP), 1990 a l0 0 10 pm CIk COluM Mo Vmanf Phppm OPubIcBfat etadPt idyG8Wmbed OPbloimes Source: World Bank, "The Philippines: An Opening for Sustained Growth" 32 2.11 Reductions in the debt level have been achieved largely by decreasing growth-oriented spending, such as public infrastructure investment, operation and maintenance expenditures. The stabilization of debt has also been facilitated by relatively high inflation and by a significant appreciation of the real exchange rate. While these factors may appear to be advantageous through their effect in reducing the real cost of debt, they are likely to be deleterious to growth over longer periods of time. 2.12 The reduction in the level of debt has also been accompanied by a change in the composition of debt, with greater reliance on domestic debt through the latter part of the 1980s. External public debt has fallen from around 70 percent of GDP in 1986 to around 54 percent of GDP at the end of 1991. Public domestic debt, on the other hand, increased from 24 percent to around 28 percent of GDP over the same period of time (see Figure 2.3). Figure 2.3: Public External and Domestic Debt (Proportion of GDP) 0.9 0.71 180 IM 1982 183 1984 198 1088 1987 ItSU 18 19M 19 Pul EA*mWa Debt !Pubic Duwesic Debt ATMta Publile D.Mt Source: World Bank, "The Philippines: An Opening for Sustained Growth" 2.13 The effect of this shift from external to domestically-financed debt has been to exert upward pressure on domestic interest rates. Between 1987 and 1989, real ex-post Treasury bill rates averaged 7 percent, and increased to around 9 percent between 1989 and 1990. In the first half of 1990, real rates declined to some extent, but were on the rise again in the latter half of the year. High interest rates, in turn, make fiscal discipline more difficult to sustain, due to added interest costs, the dampening effect on domestic growth, and the consequent erosion of the tax base. In this context, private borrowing rates matter most since they determine the cost of capital to existing and new firms. These rates could well rise sharply as brownouts and government's failure to address infrastructure bottlenecks become the major concern. 2.14 Recent declines in public infrastructure investment have often been cited as the main reason for the present infrastructure service inadequacies together with the associated negative impact on private investment, both foreign and domestic. This perception offers only a partial explanation of the present state of infrastructure. Investments in economic infrastructure involve long-term projects which 33 affect the economy with a substantial time lag. In the Philippines, the completion time for World Bank- financed infrastructure projects has averaged 8.0 years (ranging from 6.6 years for ports to 9.3 years for water supply). Consequently, it is unlikely that the recent infrastructure deficiencies (and the decline in private investment) can be primarily ascribed to the infrastructure investment cutbacks of the last seven years. Moreover, even when public infrastructure investments were relatively high, it remains doubtful that they generated the expected return, given the mounting economic infrastructure deficiencies. It should also be noted that, to some degree, the allocation of available resources during the last decade has been biased away from infrastructure investment and maintenance, as evidenced by the lack of counterpart funds for foreign-assisted projects, most of them in infrastructure. Finally, tight budget constraints cannot be seen as the overwhelming obstacle providing infrastructure services; In many cases, it costs more to be without and consumers have increasingly demonstrated a willingness to pay in order to ensure reliable services. 2.15 As bad as shortfalls in infrastructure services are now, these will only worsen if the underlying causes are not remedied. While one can argue that increased investments are required to finance the necessary expansion of infrastructure systems, the key issue is not only the quantity but also the quality of these investments. Given the present fiscal constraints, the quantity of infrastructure investment will continue to be limited in the absence of more self-sustaining mechanisms for infrastructure development. Continued heavy reliance on debt financing for economic infrastructure cannot be sustained in the present economic context and, to a large extent, reflects inadequate industry structures. As far as the quality of investment is concerned, it depends largely on the performance of the institutions that implement, supervise and maintain infrastructure projects. Incentives, adequate industry structures, financial and legal arrangements are the key to improving performance. Unfortunately, structural constraints across sectors have hampered the ability of Philippine infrastructure institutions to provide sufficient quantity and improve quality of infrastructure. The next sections examine these issues in more detail. Institutional and Financial Constraints 2.16 As in many countries, the provision of infrastructure in the Philippines has been largely dominated by single institutions. Because of economies of scale and high initial investment costs, economic infrastructure services have been considered natural monopolies, making it more cost effective to limit the number of suppliers. The Government has sought to protect the interest of consumers by regulating prices to guard against monopoly pricing. Also, because of the need to maximize scarce qualified personnel, responsibilities (in some cases, regulatory, financing and supply) have been consolidated into a single agency. As a result, single institutions play a dominant role in the various sectors: NPC in power, PLDT in telecommunications, LWUA in water supply outside of Metro Manilla, and PPA in ports. 2.17 Experience in the Philippines shows that the concentration of responsibilities into single institutions has not necessarily had the desired effect. Instead, it has often resulted in poor operational performance in most of these agencies. It has also led these institutions to exploit their monopolistic positions by engaging in rent-seeking behavior, i.e. maximizing the benefits to the owners, managers and employees to the detriment of the public as a whole. The causes can be traced to the existing institutional, financial and regulatory arrangements that govern industry structures across sectors. 34 2.18 During the last decade, many infrastructure institutions have performed poorly, limiting their capacity to maintain and invest in infrastructure systems. Poor operational and financial performance, in turn, and the consequent difficulties in keeping pace with customer demands for infrastructure services, can be linked to a number of factors, which variously include: (a) conflicting regulatory, commercial and social objectives; (b) limited commercial focus of government enterprises, coupled with political intervention in management activities; (c) low prices and/or inappropriate pricing structures together with inadequate enforcement of revenue collection; (d) high levels of debt and debt servicing requirements because of excessive operating costs relative to revenue collection; and (e) insufficient implementation capacity. 2.19 Some examples of the difficulties which are encountered as a result of existing institutional and financial arrangements are provided below. Inadequate Organization and Management of Government Businesses 2.20 In the power sector, NPC owns and operates most of the generation facilities at present. As a government-owned corporation, it is subject to a number of constraints and the potential of micro- management by the government. The salaries and benefits of NPC staff are subject to regulations that apply to all government employees. This has resulted in the departure of many key technical and managerial staff, and this problem may intensify in the future as private sector projects are likely to attract NPC staff. 2.21 Because of the insufficient qualified staff and shortage of spare parts (due to lack of funds and lengthy procurement methods), NPC has paid inadequate attention to operations and maintenance of its existing facilities. At present, proper and planned maintenance becomes more difficult because the system cannot afford to shut down operating (aging) plants, which would lead to further outages. There are no incentives to management of power utilities to hold down cost since technical and non-technical (pilferage)losses can be passed on to customers. Moreover, existing laws make it difficult for the utilities to prosecute violators because an unauthorized connection or a tampered meter are not considered acceptable evidence; instead, the utilities are required to catch a miscreant in the act of tampering and provide two witnesses who attest that the miscreant intended to defraud the utility. 2.22 Finally, although NPC has the legal authority to set its own rates, in practice, it has had difficulty in changing its tariffs. For example, the recent increase in tariffs of P 0.18/kwh proposed by NPC was opposed through a petition filed with the Supreme Court, which subsequently granted a restraining order against the rate increase. In April 1993, NPC Board approved (and DOE's Secretary confirmed) that if the Supreme Court has not approved the R 0.18/kwh by end 1993, NPC will withdraw this increase, and present a request for the same (or higher) tariff increase to ERB. This could now be 35 approved quickly under the emergancy powers recently given to the President by Congress. 2.23 In the water supply sector, while MWSS has managed to be a self-funding entity and, thus, effectively "off-budget" (being financed internally, but with ODA support), LWUA and the water districts, in contrast, have faced major difficulties in adequately fulfilling their functions. 2.24 LWUA assumes a number of responsibilities in the water sector outside Metropolitan Manila, including the establishment of Water Districts at the request of local communities, and provision of financial and technical support. Its role is primarily that of a financial institution. The capacity of LWUA to fulfil these various responsibilities effectively, however, is constrained by: (a) overlapping financial, technical and regulatory functions, poor accountability for managerial performance, and non-commercial Board structures; (b) high turnover of administrators in the period of political instability; (c) an extremely poor collection ratio - 40% in 1990; and (d) obligations to supply "non-commercial" water supply systems. 2.25 At the district level, many of the deficiencies in water supply do, in fact, emanate from existing institutional arrangements. Water Districts (WDs) have a limited commercial focus and, in many cases, poor accountability for performance. A principal contributing factor is a recent Supreme Court decision recognizing the WDs as Government entities. This ruling has consequently subjected Water Districts to public sector operating and employment guidelines. Moreover, the power of Mayors to appoint the Boards of Directors in the WDs further increases the scope for political intervention in their activities. 2.26 The poor performance of LWUA and some of the Water Districts, and the consequent inability to fund and provide other assistance in developing new water systems, is strikingly apparent from a comparison of billing and collection performance between 1985 and 1990 (see Figure 2.4). LWUA has been unable to generate a surplus for many years. This has resulted in LWUA defaulting on its payments to the Bureau of Treasury, resulting in a 2 percent additional surcharge per month on outstanding loans. 2.27 The implications for infrastructure development are clear. Poor collection efficiency and management performance affects LWUA's capital investment program. Unless surplus funds from collections are realized, investment funds available for the WDs are limited. 2.28 In the maritime sector, PPA plays the combined role of owner, operator and regulator. By virtue of its regulatory control over all ports, it can restrict or eliminate competition between private and public ports . PPA has the authority to set tariffs for pilotage, wharfage, berthing, and cargo handling. It also regulates the establishment of new private ports and lease extensions for existing private ports. PPA also negotiates the payment of fees from private operators even when no services are provided. These fees have therefore the character of a special tax. In 1990, they amounted to a substantial 28% of PPA's operating income. This not only distorts competition to the advantage of the government ports operated by PPA but it also tends to relieve PPA of the pressure to strive for more 36 operational and cost efficiency. Ultimately, it increases import and export costs. Figure 2.4: LWUA Billing and Collection $0 -* Ide C MW 2W0 100 0 1I8$ I" 1W I" 18 19 0 Source: National Census data. 2.29 On the surface, PPA appears to have performed well, having maintained a positive operating surplus since its inception. But this is hardly surprising, in view of its effective monopoly in the provision of port services, and the powers to set tariffs and to charge private operators. In 1990, PPA-operated ports were in deficit to the tune of 420 million pesos, but this was more than offset by the 596 million pesos received from private ports and leasing of the Manila International Container Terminal (MICT). 2.30 With no effective competition, and a secure source of income, the PPA has limited incentives to invest in new port facilities or to maintain and upgrade existing facilities. This helps to explain the increasing levels of congestion that have been experienced in Government ports since 1985. Incentives for private development of ports are similarly blunted under existing institutional arrangements. Private investors will, understandably, hold considerable reservations when contemplating the provision of new port facilities. 2.31 In the road sector, (limited) available funds have often not been effectively utilized due to poor management practices, lack of accountability and transparent arrangements. First, the quality of road construction is often poor. National and provincial roads are generally constructed by contract but construction supervision is seldom adequate. DWPH has started to tackle this problem by establishing Quality Assurance Units, reporting directly to the Secretary. These units are expected to carry out spot checks for discrepancies between specifications and actual construction results. Second and until recently, maintenance operations on national highways have been carried out by DPWH through force account. Management has been poor, resulting in inefficient use of equipment, overstaffing, and insufficient monitoring of use of funds and physical accomplishments. For example, less than 30% of the available equipment is being used and labor accounts for about 50% of maintenance funds rather than the 28% 37 considered appropriate by DPWH. To improve efficiency, DPWH is now increasingly contracting out maintenance to the private sector. Inappropriate Pricing of Infrastructure Services 2.32 At the present time, prices for infrastructure services in the Philippines are "reasonable" in comparison to other counties in Asia, including Korea, Malaysia, Hong Kong and Thailand (see Figure 2.5). The electricity rate per kwh was considerably lower than in Korea in 1991, and only slightly higher than in Malaysia and Thailand. Water rates were similarly moderate, while telecommunication costs per minute were relatively high. Figure 2.5: Comparative Costs of Infrastructure Services (current $U.S.) 0.7 OA U 01 O4 4~A U IS I I38 38 Source: World Bank, "The Philippines: An Opening for Sustained Growth", 1992. 2.33 Low prices, however, are not necessarily desirable when the supply of infrastructure is inadequate. Prices which are not sufficient to enable efficient businesses to cover costs, including the cost of new infrastructure, will place added pressure on the Government budget for funding infrastructure development, or alternatively, will contribute to continued infrastructure shortages. Moreover, even when price levels are deemed adequate, distortions in tariff structure do not reflect economic costs (e.g power) or limit the incentive for private firms to invest in facilities (e.g ports and telecommunication). The following paragraphs provide a snapshot of the impact of the existing pricing inadequacies in the various sectors 2.34 In the power sector, the lack of adequate funds for maintenance of electricity generation plants, for example, has resulted in reduced plant availability, premature plant aging, and a higher incidence of power outages. Insufficient levels and inadequate structuring of tariffs, as well as the process of setting electricity tariffs have been major contributing factors. 2.35 Besides external factors (the drought in 1992 and the revaluation of NPC's fixed assets between 1991 and 1992), NPC's poor financial condition is mainly due to insufficient tariff increases and the accumulation of debt service after 1991 because of previous debt rescheduling. NPC's tariff structure is also inadequate and does not reflect economic costs. For MERALCO (NPC's largest customer, accounting for 78% of NPC's sales in 1990), NPC does not differentiate between demand charges and energy charges while for NPC's industrial customers and RECs, NPC's tariff includes a small demand charge that does not reflect the capital cost of generating and grid facilities. As part of the Energy Sector Action Plan (ESAP), NPC has designed a new set of tariffs based on long-run marginal costs, with a demand charge that reflects economic costs (see para. 3.70). 2.36 In the telecommunication sector, although the overall level of tariffs and resulting revenues are adequate to provide a reasonable rate of return for the largest operator, PLDT, there are, nevertheless, serious distortions in the tariff structure which limit the incentive to invest in local network facilities. First, there is a pronounced dependence on international voice revenue, which provides about 50% of total telephone revenues. Second, monthly telephone line subscription charges barely cover their long-run incremental cost and third, local calls are presently free, even during periods when local network congestion occurs. As a result, local independent operators have little incentive to invest in local network expansion. 2.37 In the maritime sector, charges are uniform across all ports. The current tariff structure, therefore, does not reflect regional differences in operating costs of individual ports, the demands for port services relative to available capacity, or variations in maintenance and investment requirements. PPA charges levied on private ports have also enabled it to maintain an operating surplus, despite substantial losses in Government ports see para. 2.24). Because of the extensive cross-subsidization between ports and the uniform port charges, cost control is difficult if not impossible. Government ports are operated as one system and not on the basis of individual port profit centers. As a result, incentive structures between PPA ports are distorted, pressures to control cost in loss making ports are limited, rationalization of the ports structure and of shipping operations is difficult and investment decisions may be adversely influenced. 39 Regulatory Constraints 2.38 Industry structures and regulatory arrangements have also deterred existing and new firms from providing infrastructure and improving the quality of services. Although the government is now actively promoting private sector participation in infrastructure, there is little competition in the supply of infrastructure services in most sectors. The main reasons are (a) restrictions on entry, (b) the bundling of contestable and monopoly businesses, and (c) the absence of a proper regulatory framework that promotes competition and enforced anti-trust legislation. Restrictions on Entry 2.39 In all sectors, central regulatory agencies/boards have been created to oversee compliance with the law and control prices in order to protect the public interest. Difficulties in obtaining official authorizations, franchises or licenses, and price controls have often caused significant barriers to entry by new operators and resulted in rent-seeking behavior by single suppliers. The intended objective of protecting the public interest has often been lost. 2.40 The negative impact of regulations differs from sector to sector. In transport, restrictions are being lifted. In power, despite efforts to promote BOT, there are legal restrictions to private investment in rehabilitation of existing facilities as well as in provision of new generating capacity. In telecommunications, entry remains very difficult and is further constrained by the monopolistic structure of the sector. 2.41 On paper, the road transportation sector has been highly regulated, being governed by laws, regulations and practices dating back to the 1930's. Official authorization or franchise from the LTFRB is needed to provide freight and passenger services. Until recently, to obtain a franchise, the applicant had to show proof of Philippine citizenship (majority Philippine ownership for companies), satisfactory financial status, and the fact that the proposed operation would promote the public interest. Current operators could challenge a prospective applicant on the last point and prevent or delay entry since it was incumbent upon the applicant to demonstrate public need. Passenger operations were limited by the standard criteria used for determining the number of vehicles allowed to operate on any route. The Government set transport fares, requiring uniform rates per ton-km for general cargo, despite differences in operating costs throughout the country. 2.42 In practice, regulations have not been fully enforced and the industry has been de facto deregulated with costs to shippers reflecting market conditions. Trucks registered for "own-account" operations actually operate on a "for-hire" basis. It is estimated that possibly only 25% of the trucking services are carried out by registered, commercial operators and as much as 75% performed by "own- account" or other illegal operators. Official tariffs are disregarded and actual fares negotiated between the trucker and the client. Similarly, only bus services are regulated and minibus, jeepney and tricycle services are de facto deregulated. In most areas there are a variety of services offered, which are competitive in cost and quality, and except where roads are in poor condition, passenger services are considered adequate. 2.43 In the maritime sector, as with road transport, an applicant for a franchise needs to be a Philippine citizen (or majority Philippine-owned company) and be financially sound. Shipping rates and passage fares have been set by the Government to maintain liner profits at reasonable levels (12% return 40 on investment) and to keep user costs as low as possible. This has resulted in numerous distortions and inconsistencies in rates and within categories of cargo and passengers. Actual fares do not correspond to the cost of shipping. The fare for rice, corn, vegetables and other cargo classified as basic commodities is set below cost which acts as a disincentive to liners to handle these commodities. Similarly low fares for Third Class passengers result in poor service and overcrowding as liners attempted to hold down costs and maximize revenues. 2.44 Government regulations combined with the oligopolistic structure of the liner operators are thought to have resulted in price and service distortions, protecting the least efficient operators and allowing the more efficient ones to earn a rent. While liner operators have offered discounts below regulatory rates, CISO has now established an effective control mechanism which ensures that the prescribed rates and fares and other conditions of carriage are adhered to. The is also a cabotage law which prohibits non-national shipping companies from competing for national traffic. 2.45 The Government has now taken steps to address some of the regulatory issues in the transport sector and has recently started to deregulate land transport and inter-island shipping (para. 3.21). 2.46 In the power sector, the Executive Order (EO 215), which authorizes private participation in the power sector, includes only generation and distribution but excludes rehabilitation activities. For generation and distribution, the order restricts power generation by private firms to only 10% of the existing demand on the NPC grids, and does not permit private firms to set up electricity distribution operations without an interconnection agreement with NPC. 2.47 In the telecommunication sector, entry is by way of legislative franchises. The entry authorization process is difficult and uncertain. A telecommunication firm must obtain a national franchise from the government authorizing the carrier to provide service typically over a 50 year term. A member of Congress is required to sponsor a bill requesting authorization to grant a franchise to a company and the bill has to be approved by the legislature and signed by the President.' Entry into the sector is also further constrained by the strategic behavior of the dominant carrier (PLDT), which controls the long-distance network as well as about 90% of telephone lines. As a result, PLDT has effectively been able to deter entry into the sector by refusing to provide timely, adequate, non-discriminatory interconnection, and, in some cases, initiating legal actions.2 Bundling of Contestable and Monopoly Businesses 2.48 A common feature of the power, water, telecommunication and transportation sectors is that they all have some elements of natural monopoly. There is, however, considerable scope for competition in the supply of services in all four sectors - for example, while electricity transmission and distribution wires and trunk telephone networks are natural monopolies, generation and distribution of For example, one company's attempts over a three-year period to obtain from Congress a national franchise, have failed. 2 Pursuant to a case brought by PLDT, a Supreme Court ruling in August 1992 held that the authorization for EPTI's international voice gateway was not valid. PLDT also resisted interconnection with an independent cellular operator up to the Supreme Court (where interconnection was finally mandated). 41 electricity, and provision of telephone services, are fully contestable businesses. 2.49 Competition in the provision of services in contestable markets can constrain suppliers from charging artificially high prices for some market segments which are traditionally subject to high tariffs (for example, industrial and commercial businesses), and thereby reduce the capacity to cross- subsidize other customers. It can also introduce pressures onto existing suppliers to provide higher standards of service, and improved reliability. 2.50 However, the bundling of grid networks together with other aspects of service provision present a powerful barrier to entry by new suppliers in the Philippines. When the companies that own the grid networks are also responsible for supply to the consumer, then the risks for potential new entrants are substantially raised. This risk could arise due to the potential for refusing access to new suppliers to the grid network. 2.51 Even with clear rules of access to the grids, however, the scope for cross-subsidization between transmission and other activities within the one enterprise can undermine effective competition in supply. The ability to implement strategic cross-subsidies enables monopolistic enterprises to attract business away from competitors, and to disguise excessive network charges. 2.52 An example of the difficulties which can arise when networks are bundled with service delivery is provided by PLDT in the delivery of telecommunication services. Following the award of international gateways to two new companies, PLDT lowered rates for international traffic by 20 percent almost immediately, and offered interconnected local operators a more favorable split of international revenues. The ability to offer attractive international rates, and lure business away from its competitors, was considerably enhanced by its monopoly over domestic telecommunication. 2.53 The upshot of these practices is that new suppliers are likely to encounter considerable difficulty in establishing market shares, when incumbent firms control the grid networks. Expansion of services is, therefore, likely to be curtailed, as existing suppliers protect their market share, particularly in the more lucrative customer segments. As a consequence, the injection of new sources of capital into the development of infrastructure systems is likely to suffer. 2.54 Similarly, under NPC's present charter, private sector generation under BOT schemes requires prior approval by NPC. Presidential Decree No. 40, issued in 1972, provides that the setting up of transmission line grids and the construction of generating facilities is the responsibility of NPC, being the authorized implementing agency of the state. This means that NPC approves power projects which could potentially compete for business. The Philippine Chamber of Commerce and Industry (PCCI) has proposed that the government revoke Presidential Decree No. 40 in order to facilitate private generation projects. Inadequate Regulatory Framework 2.55 In many cases, the absence of effective competition rules and an independent institution to enforce them is a major impediment to investment by new firms. The Government has essentially relied on the existing regulatory boards/agencies to perform this function. Not only have these institutions failed to perform this task because of their weak institutional capacity (e.g NTC in 42 telecommunication) but, the effect of their intervention has too often been to frustrate the intended outcome, for example in transport (para 2.44). 2.56 An example of the poor performance of regulatory agencies can be found in the telecommunication sector with NTC. NTC has had limited success in important areas such as network interconnection, revenue settlement, tariff review and monitoring carrier transactions with affiliated companies. To a large extent, this weak performance reflects the lack of priority the government has given to ensuring that a fully adequate and effective regulatory agency is operating. Thus, NTC is underfunded and suffers from a shortage of qualified staff. Moreover, the independence of the single Commissioner can be jeopardized by not having tenure. All these issues will have to be addressed if NTC is to exercise leadership in tackling difficult issues involving major carriers. 2.57 Apart from the institutional weaknesses of many regulatory agencies, there is a risk that without effective competition rules and their enforcement by and independent institution, deregulation and price liberalization might not achieve the intended objectives. On the contrary, they may result in continued monopolistic behavior (telecommunication) and inappropriate pricing practices (interisland shipping). Conclusion 2.58 A central lesson can be drawn from the analysis presented in this chapter. Recent declines in infrastructure investment offer only a partial explanation of the present deterioration of economic infrastructure in the Philippines. Rather, the root causes of the present crisis are mainly to be found in the existing institutional, financial and regulatory arrangements that govern industry structures across sectors. These arrangements have often not proven adequate to ensure sufficient provision of infrastructure and adequate quality of services. 2.59 Continued low levels of infrastructure investment will eventually further exacerbate the current poor state of services. However, as bad as infrastructure shortages are now, they will only worsen if the underlying causes are not remedied. Also, given the present fiscal constraints, the government's capacity to finance infrastructure through deficit expansion still remains limited. The government has become increasingly aware that it needs to address these issues simultaneously from both macroeconomic and sectoral perspectives. The next chapter proposes a framework to help the government meet this difficult challenge. 43 Ell. INFRASTRUCTURE: A FRAMEWORK FOR GROWTH Introduction 3.1 Reflecting the widely held perception that insufficient investment in infrastructure has been the major cause of deficiency, the Philippine government is now emphasizing an increase in both public and private sector investment as a mean of solving infrastructure problems and promoting economic growth. At the same time, recognizing the crisis situation in the power sector and major bottlenecks in the transport sector, the government has also started addressing some of the key institutional and regulatory issues that constrain infrastructure development. This chapter argues that these initiatives ought to be pursued and extended to other infrastructure sectors within a more balanced framework, promoting sustained and self-financed growth in infrastructure development through structural reform. This would allow an increase in reliable, cost-effective infrastructure services to be made available without disrupting an improving, but still fragile, macroeconomic environment. 3.2 At present, the government is envisaging a large increase in infrastructure spending in its Medium Term Development Plan (MTDP). By itself, such a course may have limited benefits when ownership and management structures, and the institutional, financial and regulatory arrangements that govern them, are inadequate. As experience in other countries has clearly demonstrated, massive public sector programs of investment in transport, electricity, water and other infrastructure facilities are not sufficient to ensure economic progress. Aside from sufficient implementation capacity, ownership structure, adequate pricing mechanisms, transparent regulatory arrangements, incentives and managerial expertise are all crucial to infrastructure development. 3.3 More importantly, even if infrastructure strategies were approximately correct in the Philippines, the Government's decision to pump-prime the economy through a significant increase in infrastructure spending could well rekindle inflation if this process is not carefully controlled, monitored, and accompanied by revenue raising efforts. A return to high levels of budget deficit, together with jumps in inflation and interest rates, or surges in wage demands, could all reduce recent economic gains. This would further curtail the capacity to either afford new infrastructure or to maintain existing assets. There is therefore, a serious risk that financing infrastructure primarily through major budget deficit expansion could have negative impacts in the medium and long runs. It could, in fact, negate many of the economic gains achieved during the period of stabilization. Maintaining a stable macroeconomic setting is therefore essential to sustainable infrastructure development in the Philippines. 3.4 It is well known that political instability played a role in disturbing economic performance. It resulted in a decline in business confidence and a reduced capacity to fund investment in and maintenance of key infrastructure. Post-election signs of political stability and prospects of renewed fiscal discipline are encouraging and provide a basis for attracting new investments. However, a mood of caution still prevails because of the persistence of certain endemic problems ( e.g. delays in the approval of electricity tariff increase, concerns about crime and lawlessness). Unless the Administration can act quickly and decisively in addressing these issues, the business climate could be impaired. 3.5 Immediately, the government is faced with a critical dilemma: it needs to increase infrastructure spending without resorting to budget deficit expansion. However, it faces mounting 44 resistance to reform, especially since "reform" is mainly associated with raising charges and tariffs on customers who are already experiencing severe degradation in services. This chapter suggests that to break this vicious cycle, the government ought to develop a new view of infrastructure development. This new perspective focusses on a shift from a traditional centralized supply-driven intervention to one with a more customer oriented approach aimed at meeting the effective demand for infrastructure. It argues that the objective of achieving a more sustainable infrastructure development in the Philippines would best be served by: (a) pursuing the reform process started in the power and transport sectors, and beginning necessary reforms in the water supply and telecommunications sectors; (b) encouraging and developing efficient ownership and management of infrastructure systems which are fully accountable and independent of the political process; (c) establishing competitive industry structures to attract new firms to supply infrastructure needs; (d) fostering an effective and transparent regulatory framework; and (e) maintaining stable macroeconomic, legal and political environments to generate confidence in the Philippine economy 3.6 Transforming this vision into reality will require not only selective increases in investment but also decisiveness in managing a difficult transition process. It will be necessary to maintain steadfast political commitment to reform despite mounting pressure to adopt quick-fix, stop-gap measures. After providing the rationale for a new vision on infrastructure and outlining a new approach to infrastructure development, the chapter lays out a proposed "roadmap" for infrastructure development. In particular, it attempts to list and prioritize key elements of the reform agenda to be pursued across sectors. It considers the status of ongoing reform initiatives in each sector, areas for further reform and attempts to establish a timeframe for the implementation of these reforms. Rationale for a New Approach to Infrastructure Development 3.7 Until now, infrastructure development programs in the Philippines have mainly assumed a "top down" approach, aimed at alleviating immediate bottlenecks. This approach has been founded on a traditional supply-driven centralized intervention where infrastructure systems are typically run by central government agencies, government corporations and private monopolies. Central regulatory boards have also been established to regulate natural monopolies and control prices, and to protect the public interest. In practice, government agencies and corporations have remained far removed from the needs and demands of their customers and have often not efficiently use their considerable resources. Private monopolies have restricted their activities to the most lucrative market segments and have influenced tariff structures to prevent entry by potential new firms. Regulatory boards have not adequately performed their functions because of institutional weaknesses (NTC) or political interference (ERB). In some cases, as with various transport boards, their intervention has had the overall effect of frustrating their intended objective--protecting the public interest. 45 3.8 This traditional approach has also not acknowledged three critical elements to sustainable infrastructure development in the Philippines. First, the provision of domestic and external resources to infrastructure agencies is only part of the solution to the infrastructure funding problem. Private and self-financing of local services are also a big part of the equation. The potential for self-financed infrastructure development exists in the Philippines. Consumers are willing to pay for increased and better quality infrastructure services. Businesses in particular, are already spending large amounts on alternatives such as private generators, on site wells, two-way radios, etc. to compensate for infrastructure deficiencies. Customers must be confident, however, that their funds are being put to good use. One key to generating this confidence is to entrust the responsibility of managing infrastructure services to fully accountable legal entities which have both the incentive to provide services that suit their consumers' needs and demands, and the ability and will to provide them at a reasonable cost. 3.9 Second, basic changes in the institutional and regulatory structures are necessary if infrastructure development is to be sustained. Unless the present institutional and regulatory framework that allows monopolistic (rent-seeking) behavior by incumbent organizations is modified, investors will not find it attractive to finance infrastructure. It is now clear that without institutional, financial and regulatory reforms, bottlenecks and deficiencies in infrastructure will persist and large private investments will not be sustained. This calls for the development of policy solutions and the implementation of action programs that address infrastructure constraints at the core level and do not just deal with the symptoms. Therefore, infrastructure programs which rely solely on providing additional funding, or focus on "plugging the leaks" as in the past will either fail or only generate limited returns. The structures in which these investments are made must be properly managed and financially sustainable. Also, despite some initial success in implementing BOT/BTO schemes to help relieve some of the immediate bottlenecks, these arrangements by themselves may not be part of a long-term solution if they do not fit into self-sustaining structural reform plans for each respective sector. The magnitude of the infrastructure requirements in the Philippines is such that this type of financing is neither a panacea to meet the demand nor a substitute for pursuing the necessary domestic resource mobilization effort. 3.10 Third, international experience and technological change has shown that the assumptions which initially justified government regulation and monopolistic supply of infrastructure were not always well founded and can increasingly be challenged. There is now growing recognition of the need to separate contestable markets from naturally monopolistic activities, and of the potential role of the private sector in financing and delivering infrastructure services. However, this requires a fundamental reassessment of the institutional and regulatory framework within which the public and private sectors can and should play their respective roles more efficiently. A New Approach to Infrastructure Development 3.11 Because of the existing tight fiscal constraints, the limited returns of past infrastructure investment programs and the need for action to solve the underlying causes of the present infrastructure crisis, the focus of infrastructure development needs to be reassessed with regard to the respective roles of the government and the private sector. In particular, the core of the government's intervention needs to be redirected toward ensuring higher standards of performance and returns in all sectors. The government needs to improve the capacity for self-financed infrastructure investment and to encourage private sector participation and competition among firms. To achieve this goal, there should be a more balanced approach between: 46 (a) quantity and quality of infrastructure through lower cost and improved reliability. While quantity of infrastructure is still an issue in less developed areas, and in certain sectors, this can be addressed by increasing competition in order to reduce the cost (price) of services and make marginal markets more attractive to investors. Targeted subsidies can be provided where clearly needed; (b) physical expansion and improvements in efficiency of supply and maintenance. Maintenance and repair of existing infrastructure assets should receive top priority to ensure adequate returns on existing and future investments and avoid further deepening of infrastructure breakdowns. (c) centralized infrastructure systems focussing on supply and decentralized systems focussing on demand (the customer). The case should be made for greater involvement of private enterprise (and for local communities) in infrastructure provision through the establishment of competitive industry structures with clear rules of access. The key purpose is to mobilize savings and investment to improve the quality and adequacy of services to those funding the process. Better quality services and associated patterns of taxes, user charges and ownership should be capable of harnessing greater support than more remote external structures. (d) systematic regulation and well targeted and carefully supervised regulatory reform. There is a clear need to establish an effective and transparent regulatory framework where the obligations and rights of the various parties are clearly outlined. It will also be necessary to deal with the potential distortions arising from the activities of natural monopolies and deregulation. 3.12 In support of this approach, the government needs to create and maintain the right "environment" which would encourage long-term investments by existing entities and new firms and assure them of reasonable returns. With this end in mind, the government should concentrate on laying down fair, efficient and pro-competitive rules for the conduct of business and for the funding and provision of public goods. Government should also develop funding arrangements, including tax systems that promote private and public savings and investments, which are the key to maintaining high economic growth rates. A clear role for government in expanding infrastructure is to facilitate access to value- adding service companies seeking to connect to telephone wires and power lines. 3.13 Government should continue to play an important role in other areas of infrastructure. It should, for example, establish and monitor pricing abstraction rights from water tables. It should define and regulate laws governing issues of maintenance, congestion, intersection and coordination of transportation systems, which cannot be efficiently resolved by private parties. Government should also play a major role in defining the processes for selling monopoly rights, and in creating the environment for regulating monopoly prices. Finally, there is a need for the government to take notice of "best international practice" cost structures and the deadweight costs of regulation. 47 A Roadmap for Infrastructure Development 3.14 Presently, the most pressing challenge is for the private sector and government agencies to jointly design and finance structures and facilities that can resolve the short-term crisis and sustain infrastructure in the long-term. The priority task remains designating and implementing infrastructure programs that match any funding increases with structural reforms as integral steps in removing the infrastructure gap. To achieve this result, a roadmap is proposed below. Its main elements include phased implementation of the following set of interrelated and complementary actions: (a) pursuit and extension of the reform agenda, (b) selective increases in infrastructure investments, and (c) maintenance of a stable macro-economic framework. Pursuing and Extending the Reform Agenda 3.15 Aware of the limits of the traditional approach to infrastructure development and hard pressed to solve the current crisis, the government has already started addressing key sectoral issues and implementing some structural reforms. In the transport sector, deregulation has proceeded to encourage entry and competition on major routes and to liberalize price setting. In response to the continuing power crisis, the government has adopted a comprehensive Energy Sector Action Plan (ESAP) and established a Department of Energy with responsibility for the sector's policy, planning, and oversight. It has also realized some progress in depoliticizing energy price setting. The government has also taken steps to encourage greater participation by the private sector in infrastructure through privatization (civil aviation), commercialization (ports and national road network maintenance), direct financing through BOT/BTO schemes (especially power), and encouraging new entry (telecommunication). 3.16 These initiatives constitute important steps in the right direction. They now need to be pursued within a more balanced framework that promotes sustained and self-financed growth in infrastructure development and be extended across other sectors. Although resolving the power crisis deserves immediate action because of the current severe situation, bottlenecks and shortfalls in other key infrastructure sectors should also receive sufficient attention before the situation reaches crisis proportions. This is all the more important because of the long gestation period of infrastructure projects and the need to ensure complementarity of infrastructure inputs to sustain growth. 3.17 The essence of the reform process in economic infrastructure is for the government to provide the necessary incentives to the suppliers to improve efficiency of services. This would help keep prices low (reduce business costs and make services more affordable to the poorer segments of the population) and service levels high (in line with consumers' demands). The report suggests this can be achieved by: (a) ensuring greater competition in areas where markets are contestable, and (b) improving the management of infrastructure systems in areas where government is expected to continue to play a key role (natural monopolies). Ensuring Greater Competition in the Provision of Infrastructure 3.18 A common feature of the power, telecommunication, transportation and water supply sectors is that they all contain some elements of natural monopoly. There is, however, considerable scope for competition in the supply of services in most of these sectors. For example, while electricity 48 transmission and distribution lines, and trunk telephone networks are natural monopolies, generating and distributing power and providing telephone services are fully contestable businesses. The context in the Philippines is no different from that in other countries. 3.19 Competition in providing infrastructure services can keep suppliers from charging artificially high prices for some market segments which are traditionally subject to high tariffs (e.g. industrial and commercial businesses). It can also introduce incentives for existing suppliers to provide more reliable and higher quality services in line with customers' demands. Finally, it allows more channels for investments to flow into the sectors. Greater competition can be achieved by (a) removing entry and exit restrictions, (b) opening up contestable markets whenever feasible, and (c) enhancing further private sector participation. However, these actions will likely be unsuccessful unless an effective and transparent regulatory framework is established. 3.20 Removing Restrictions on Entry and Exit. Increased entry would not only provide incentives to incumbent firms to improve their performance and meet customers' demands but would also enhance overall sector performance through investments and the operation of new firms. While some progress has been made in lifting restrictions on entry and exit in the transport sector, the process remains uncertain in the power sector and difficult in the telecommunication sector. 3.21 In the transport sector, the government has already taken steps to deregulate land transport and inter-island shipping. It has issued a Department Order' which significantly reduces the barriers to entry/exit in the transport industry by eliminating several cumbersome administrative practices enacted by the Public Service Act of 1936. The government has allowed for market determined fares and flexibility in rates determined from guiding rates, with the exception of mandatory rates imposed on routes monopolized by a single operator. Some issues, however, still need to be resolved. 3.22 First, new entrants are still required to obtain a Certificate of Public Convenience proving Philippine citizenship, financial capability, and sufficient insurance coverage to protect consumers. The requirement for citizenship may be at variance with the government's aim of attracting foreign investors. Although there are exemptions from this constitutional rule, the transport industry is not among them. Also, foreigners are presently not allowed to own more than a 40% of a transport enterprise. This restriction limits considerably the attraction of investors in shipping and ports operations where resource- starved Philippine enterprises are allowed majority ownership. Finally, although some "tests" to determine the merit of new Philippine applicants have been abolished (i.e. prior operator and priority of filing rules), regulatory agencies could resort to other criteria to measure public need and still have considerable discretion in refusing entry. 3.23 Second, where markets are contestable and serviced by a single operator, the government will now allow at least one additional franchise holder to operate. It is doubtful whether this rule will be sufficient to promote competition. Experience in other countries has shown that restrictive practices such as rate fixing and service reduction under the guise of rationalization are the more likely outcome. 3.24 Third, in road transport, there is still a distinction between public utility licenses (TH- license), whose holders are officially allowed to operate for hire services, and own account licenses (T- Department Order No. 92-587 of March 1992, titled "Department Order No. 92-587 Defining the Policy Framework on the Regulation of Transport Services". 49 license), whose owners are not. In practice, T-license operators offer services for hire relatively unencumbered by the authorities. Non-compliance with licensing requirements gives them a market advantage since they do not pay the 3% Common Carriers Tax. Efforts to abolish the distinction between TH and T licenses have not yet succeeded, but ar6 being pursued. 3.25 Although rehabilitation of existing capacity in the power sector is perhaps the most cost- effective way in the short-run of adding capacity, Executive Order 215 (authorizing private sector participation in the power sector) refers only to new capacity and does not include the possibility of private involvement in rehabilitation. It is necessary therefore, to first remove legal constraints to private sector participation in rehabilitation projects (via ROT or ROL schemes). EO 215 restricts power generation by private firms to only 10% of the existing demand on the NPC grids. It does not permit private firms to set up electricity distribution operations without an interconnection agreement with NPC. 3.26 For the short-term, legal requirements for franchises (generation) should be eliminated, and private participation should be encouraged through long-term contractual arrangements. At the same time, the transmission company (at present NPC) should be obliged to provide access to any generating company that wants to transmit power. Wheeling facilities2 should also be introduced to encourage competition. In the medium-term, NPC would retain responsibility for transmission, control and dispatch, while providing access to the transmission network. Over the long-term, transmission and generation functions within NPC should be separated. The possibility of privatizing transmission functions (either by sale of shares or by management contracts) should also be considered (see para. 3.61). 3.27 In the telecommunication sector, weak performance is more likely to be sustained in the present monopolistic environment. Therefore, entry or threat of entry is necessary to (a) provide a strong incentive to PLDT and local operators to improve technical efficiency and expand output, and (b) increase investment in this key sector. Unfortunately, under the current institutional configuration, new entry into telecommunication remains very difficult. 3.28 DOTC is well aware of this situation and has adopted a pro-competitive position regarding interconnection, privatization of US$600 million ODA-financed network facilities and licensing new (digital) cellular telephone operations. The privatization of the government's RTDP and NTP1-1 networks (about 70,000 lines) to a second major operator and the upcoming licensing of digital cellular telephone systems will provide a good opportunity for the government to influence the sector structure. If successfully implemented, these two initiatives will be a first step towards an increased level of supply diversity and competition in the sector. Further consideration should also be given to diversify supply by encouraging the development of a second major operator to provide local, long-distance and international telephone services. 3.29 Opening up contestable markets. Another approach to facilitating effective competition in service provision, particularly in the power and telecommunication sectors, is to free up contestable businesses by establishing independent grid networks. The separation of the grids, which are natural monopolies, from core and usually contestable businesses (i.e. telephone services and electricity generation) will provide more opportunities for new firms. The rules of access to the grid must be 2 The sale of power from a generation facility located in one region to a customer located in another region via access to the transmission network. 50 explicit and grid charges fully transparent. Because of the natural monopoly characteristics of the grid networks, however, effective regulation of grid charges will be required. 3.30 In addition, new interim network companies could be established using existing owners and managers (e.g. PLDT and NPC) to facilitate smooth adjustment to the new structure. There should be, at the same time, new and explicit pricing strategies for interconnection. For instance, separate "wires" and telephone access charges would be listed allowing new generation distribution and service companies to interconnect on a reliable and cost effective basis. These network companies could be private or corporatized government entities, and would earn regulated incomes based on price indices delivering a commercial return relative to independent estimates of "best practice" or efficient cost levels. The effect of price regulation relative to independent cost estimates is that it retains the incentive to be cost efficient. 3.31 In the long-term, the government's objective of increasing investment in infrastructure systems and improving the quality of services would be encouraged by: (a) establishing independent electricity and telecommunication grid management companies, subject to external regulation of grid charges and access rules; (b) promoting active competition between independent electricity generators, and electricity distributors, across existing grid networks; and (c) promoting competition in domestic and international telecommunication services. 3.32 Strengthening the role of the private sector. As mentioned earlier, the government has taken steps to encourage greater private sector participation in infrastructure through privatization (civil aviation), commercialization (ports and national road maintenance) and direct financing through BOT, BOO projects (especially in power). In the power sector, where the private sector is expected to play an increasing role in easing present shortages, BOT, BTO schemes have been given particular prominence. Apart from the first BOT project (the Hopewell project at Navotas which is operational), there are several other BOT BTO projects under implementation or designated as "fast-track" projects. As of September 1992, NPC had signed eleven BOT and BTO private generation projects with an aggregate capacity of about 2,000 MW. These will require a private sector investment of about US$2 billion. 3.33 BOT, BOO and BTO schemes have great potential for facilitating infrastructure expansion when government resources are limited. They can relieve immediate bottlenecks by providing a source of capital otherwise unavailable to the government. Also, if properly tendered, they are awarded to those companies that can produce the desired outcome at the lowest possible cost. However, the potential benefits of these schemes should not conceal two important factors. First, because of the complexities, uncertainties, risks of failure and the need to develop business confidence, the pace at which the private sector will get involved may initially remain modest. Second, these arrangements may be more appropriate and easier to develop in the power and telecommunication sectors than in the transport sector (e.g roads) where all levels of government will continue to play a crucial role in financing investments. 3.34 In addition to careful selection of projects, several essential conditions must be met if these arrangements are to produce the desired outcome. First and foremost, the strong commitment to 51 private sector participation needs to be matched by accompanying changes in legislation, regulation and practice. Although the BOT Law (RA 6957) is a step in the right direction, some of the BOO/BOT regulations that govern private sector operation in the Philippines need to be amended. In particular, BOO arrangements should be strongly encouraged.' Congressional approval should no longer be required in order to eliminate unnecessary delays. The type of 20% government-financed share should be clearly specified (e.g. equity, loans or contribution in kind). 3.35 Second, aside from legal changes, the success of such schemes is dependent upon the Philippines having a stable and predictable political and economic environment. Otherwise, the risk premium attached to this type of contract may well undermine any gain. Also, without predictable pricing mechanisms, transparent regulatory arrangements, and well-defined approval procedures for obtaining environmental clearances, the private sector will likely be reluctant to engage in such ventures. 3.36 Perhaps more fundamentally, while systems and catalysts for accommodating private expansion of infrastructure in the Philippines need development, the issue of where and under what form and conditions private investment should be undertaken remains unanswered. The private sector will always be willing, at a price, to enter into BOT agreements in areas such as electricity generation, port development, toll roads and telephone exchanges. Such schemes, however, should be considered for their implication for longer-term infrastructure development. 3.37 Whether or not BOT schemes will add to or subtract from the long-term infrastructure problem will depend, in part, on the overall structure of the industry. An important concern is that they are piecemeal changes and that they do not address important systems issues. How much capacity is required; what form of capacity augmentation should be undertaken; and where should new capacity be situated? Bolstering a poorly structured power or telephone industry with a new BOT (or an incremental loan) may well lock in or take pressure off a bad structure. If the new BOT investment does not really enhance the private sector capacity to invest in infrastructure (e.g. if it is, in fact, a new and rather deceptive or expensive form of borrowing) there may be little short-term gain and substantial long-term risks. However, if the scheme is part of opening up a grid structure which invites competitive inputs, then it may increase both the quantity and quality of infrastructure, and consequently reduce the government's funding requirement. 3.38 Establishing an Effective and Transparent Regulatory Framework. Merely removing entry and exit restrictions, opening up contestable markets and promoting BOT/BOO projects will not be sufficient to induce private sector participation in infrastructure. Private sector firms will also have to be encouraged and protected by a legal and regulatory framework that allows them to assess and undertake reasonable market risks (through transparent pricing principles), permit them to enter into long- term contractual arrangements with grid operators (through clear rules of access to grids, especially in power and telecommunications) and protect them against uncompetitive practices which may arise under deregulation. Reinforcing competition legislation and enforcing antitrust legislation is, therefore, crucial. It is also essential that in establishing the regulatory framework, the functions and obligations of the ' The law considers mainly BOT/BTO arrangements. BOO projects represent, however, a more definite type of privatization because the facility remains under private sector ownership. Under BOT arrangements, the transfer of the facilities to the government still leaves open the question of maintenance responsibility before and after the transfer. 52 regulator are clearly defined, and the regulator has adequate resources and the effective power to implement its regulatory authority. 3.39 There is a risk that without strict enforcement of competition rules, which do not yet exist, price deregulation may actually lead to monopolistic pricing practices in markets where entry is expensive and/or can be restricted to a small number of participants. This is potentially the case in interisland shipping and telecommunication. 3.40 Interisland shipping is dominated by the Conference of Interisland Shipowners and Operators (CISO) which comprises 17 members. Rates and fares are regulated by MARINA on the basis of a complex cost plus maximum ROI formula which has not changed since 1928. As a result, there are numerous distortions and inconsistencies between rates, within categories of cargo and passengers and between cargo and passengers. Neither shipowners nor shippers are satisfied with the present system because both groups are forced to cross-subsidize certain market segments. Nevertheless, CISO has established an effective control mechanism which ensures that the prescribed rates and fares and other conditions of carriage are adhered to. Although this points to the potential instability of the Conference, the tendency to cartelization and price fixing remains strong because of the large sunk cost at stake. At present, the Philippines have neither an efficient competition legislation nor an institutional framework capable of enforcing it. 3.41 In the case of telecommunication, the strategic behavior of the dominant carrier has reinforced monopoly (see para. 2.52). This, combined with ineffective regulation and weak anti-trust legislation, has severely constrained competitive development in the sector. 3.42 Attention should be given to strengthen antitrust legislation and to establish an independent agency that promotes competition and enforces antitrust legislation. This institution should deal with the whole economy and include an Infrastructure Department. This department would follow developments in the respective sector, represent and defend the legitimate views of users, participate selectively in proceedings of regulatory agencies such as ERB, NTC and MARINA and support pro-competitive initiatives. 3.43 Better definition of the functions and obligations, and strengthening the effectiveness of sectoral regulatory structures would also be necessary to ensure the existence of a level playing field among suppliers and between suppliers and users. This is particularly important in the power and telecommunication sectors. 3.44 In the power sector, regulatory policy formulation and implementation should be consistent for all utilities in the Philippines. A first step in this direction has already occured with DOE becoming effective. The Energy Regulatory Board (ERB) is expected to play the role of a single (price) regulatory body. ERB will be placed administratively under DOE and will have authority to regulate the tariffs of all utilities - NPC, MERALCO and RECs. While this arrangement will ensure consistency in pricing policy and allow NPC to adjust its tariffs to appropriate levels, it will not address a key element of the power sector reform--establishing a single central autonomous regulatory body to oversee all generation, transmission and distribution facilities. In particular, as the number of firms engaged in power generation increases, there will be a growing need for effective regulation from both price and non-price perspectives to maintain competition. ERB could potentially fulfill this role provided it is restructured and strengthened so it can undertake both price and non-price regulation. Safety and 53 environmental aspects should remain the responsibility of the agencies concerned with these matters across sectors. 3.45 In the telecommunication sector, underfunding, shortage of qualified staff and lack of independence of the single commissioner have contributed to the absence of institutional "confidence" in NTC. It has also hampered the Commission's ability to exercise leadership in addressing difficult issues involving major carriers. Essential measures to upgrade the effectiveness of the NTC should be urgently considered. They include (a) enlarging the Commission from one to three-five tenured Commissioners having staggered terms, and (b) authorizing NTC to retain sufficient user fees to become self-financing and, therefore, able to attract and retain qualified professional staff. NTC has already attempted to strengthen its operations. It has recently published the "NTC Practices and Procedures Manual" and has received technical assistance. 3.46 However, unless NTC also receives strong political backing, it will not be able to take and enforce necessary decisions to prevent actual or potential monopoly practices, particularly about interconnection, revenue settlement, pricing and cross-subsidy, and ownership. The first test of government's commitment to support NTC would take place during NTC proceedings on the new telephone rate structure to be developed by January 1, 1994, and during implementation thereafter. Improving the Management of Infrastructure Systems 3.47 There is clearly a priority for improvement in efficiency of those infrastructure systems that are likely to remain under the effective control or management of the government until they can be privatized. This will entail (a) improving operational efficiency and maintenance/rehabilitation of existing assets, (b) clarifying institutional roles and responsibilities, and (c) establishing clear ownership and management structures that are fully accountable for performance and independent of political control. 3.48 Improving Operational Efficiency and Maintenance/Rehabilitation of Existing Assets. On-going efforts aimed at improving operational efficiency in the various sectors must be continued and strengthened. New initiatives are also urgently required to increase the productivity of investment by introducing best operating practices. 3.49 In the power sector, NPC's own efforts to streamline its operations and reduce losses are to be supplemented by an operational efficiency improvement study expected to be completed by December 1993. NPC is also expected to develop annual year-end projections of rate changes, investment and overall requirements. These changes, if implemented, will undoubtedly contribute to improve NPC's operational efficiency in the short-term. They will not, however, change the fundamental way in which NPC operates (see para. 3.60). 3.50 At the distribution level, operational improvements are urgently needed due to high non- technical losses. Although MERALCO's losses have been reduced to 14 percent from 21 percent, they are still more than twice that of other utilities. The average losses for the RECs are 22%. Power pilferage and theft of transmission and distribution equipment remain major problems and existing laws make it difficult to prosecute violators. The government has yet to enact a new law (originally expected by March 1993) to address these problems. Moreover, adequate enforcement power will need to be clearly spelled out in this legislation. 54 3.51 In the telecommunications sector, PLDT's future performance will continue to have a large, if not the largest impact on sector performance. In this context, recent initiatives by the government to encourage new entry into the sector need to be complemented by measures aimed at (a) increasing capacity by encouraging the development of other major telephone carriers, (b) ensuring competition in cellular telephone services, (c) improving the regulation of telecommunications generation (para. 3.45), and (d) improving the tariff structure and the revenue settlement/network interconnection regime (para. 3.72). 3.52 In the water supply sector, MWSS and the WDs need to continue to reduce (presently high) Non-Revenue Water levels through leak detection, rehabilitating distribution systems and improving water meters. Despite some recent improvements, poor billing and collection efficiency need to be addressed, especially for MWSS who has a high level of customers in arrears. Consideration should be given to contracting out some of these functions to the private sector. 3.53 In the transport sector, the management, maintenance and operation of transport infrastructure is increasingly being transferred to the private sector. For example, the management and operation of the Manila International Container Terminal (MICT) has been awarded to a private sector firm. The Philippines Airlines (PAL) was privatized in January 1992. By 1994, over 70% of national road maintenance is expected to be carried out by private contractors according to the new system put in place by DPWH. 3.54 Building on the experience of the MICT, PPA has now prepared a timetable for private operation of port facilities in Manila North Harbour. Under the privatization proposal, North Harbour will be divided into three sections, containing various piers and slipways. Operators of each terminal may be single private companies, joint ventures, or consortia, which would run port facilities under twenty-year contracts. The Committee on Privatization (COP) is also considering the creation of a planning body to "fast track" the transfer of government port facilities to the private sector. Under this proposal, PPA would no longer handle the privatization scheme for Philippines ports, but would retain its regulatory functions. This initiative should be carefully considered in the context of the redefinition of PPA's roles and responsibilities (see para. 3.57). 3.55 In the case of roads, the present organization and management of road maintenance, although improving on the national road network, does not yet meet international criteria for efficiency. This problem is further exacerbated by the government's recent decentralization effort where responsibility for barangay roads has been transferred from DPWH to the local authorities. A comprehensive road network stabilization program is urgently needed. This would entail (a) clarifying institutional responsibilities, (b) establishing appropriate funding and transfer mechanisms between central and local governments, (c) upgrading technical competency at all administrative levels (national, provincial and barangay), (d) establishing clear physical and financial goals and quality control mechanisms, (e) improving financial management, and (f) strengthening accountability. A start has been made in creating such a system for the national road network. This endeavor will have to be extended to the provincial and barangay road networks as well. 3.56 Clarifying Institutional Roles and Respronsibilities. Throughout the public sector and particularly in infrastructure, government agencies have played a combination of roles as owner, operator, regulator and financier. These institutions have attempted to perform all these functions in spite of conflicts of interest. This has been significant in the maritime sector (PPA and CPA) and the water sector 55 (LWUA). While problems have clearly been identified, remedies need to be carefully designed given the complexity and peculiarity of the issues involved in both cases. This is especially true because of the government's move toward decentralization. 3.57 In the maritime sector, in line with the government's strategy of reducing its micro- management in transport, there is growing recognition that PPA and CPA need to develop and implement a phased program to (a) reduce and ultimately transfer their economic regulatory powers to Government, (b) further contract out port management and operation to the private sector (commercialization), and (c) gradually devolve the tertiary ports to local governments. A proposed maritime sector project, has been initiated by the Bank to assist PPA and CPA in this endeavor. The project will sponsor the implementation of a systematic survey of PPA's and CPA's ports to (a) determine their potential for private sector involvement, (b) develop a strategy and action plan for the ports with potential for commercialization, and (c) define the residual role of the port authorities in the new environment. At present, PPA's and CPA's planned devolution of some 50 tertiary ports is mainly driven by the government's goal of decentralizing and the desire of two Port Authorities to redirect their focus on those ports which are vital for interisland and international trade. However, because of a lack of adequate resources and a shortage of qualified staff at the local level, the devolution of tertiary ports to local government entities should be phased. After the enactment of an enabling law by Congress, a gradual transfer of operation and management of these ports to local governments would be followed by the transfer of ownership. 3.58 In the case of water supply, LUWA's broad mandate and the inherent conflict between the different functions it is expected to perform, have resulted in a lack of clear operational objectives. This has a negative impact on its effectiveness (see para. ). To date, LWUA has placed emphasis on physical expansion, conducting feasibility studies, designing, financing and constructing water systems before handing them over to the WDs. This has made it difficult for LWUA to carry out strict financial evaluations of its own investment proposals or to impose financial discipline on the WDs, many of whom felt left out during the initial planning and construction phases of the investments. Moreover, with the increase in the number of WDs, establishment of smaller WDs in outlying areas and the take over of the RWSAs, LWUA lacks the necessary outreach capability to serve adequately such a geographically dispersed clientele. LWUA's operational objectives together with a review of the WDs and their operational strengthening are being reexamined under a Water Supply Sector Reform Study. This study is scheduled to be completed by September 1993. 3.59 Establishing Independent Management Structures. A key requirement for the management and development of infrastructure systems is to establish clear ownership and management structures, within which suppliers are fully accountable for performance and independent of political control. Under existing institutional arrangements, many suppliers have performed poorly, due to political intervention and a lack of commercial focus. This is particularly true in the case of power (NPC) and water supply (WDs). 3.60 As a government-owned corporation, NPC remains subject to several constraints and the potential of micro-management by the government. For example, salaries of NPC staff are constrained by regulations that apply to all government employees. This has already resulted in difficulties in retaining qualified staff. Also, as established by the Act that created the new Department of Energy (DOE), from 1993 forward, NPC's budget will be submitted to Congress for approval and the Secretary of the DOE will also be the Chairman of NPC. There are still no incentives for management to increase 56 productivity or reduce costs. In short, the management of NPC does not have operational autonomy and NPC is still not operating along commercial lines. 3.61 The government has decided to privatize NPC in the long-run. The exact mode and timing of NPC's privatization has not yet been decided but the authorities are now considering the recommendations of a report prepared by Price Waterhouse. DOE is expected to submit NPC's privatization plan by September 1993, and the Cabinet is expected to approve it within six months after submission. There is still considerable debate about whether the two scenarios developed by Price Waterhouse form an adequate basis for privatizing NPC. The first (recommended) scenario envisages NPC's generation assets would be transferred to a holding company that will be privatized, with other NPC functions (transmission, dispatch, control and planning) going to a transmission corporation that will be sold to distribution companies (such as MERALCO). The second scenario proposes that NPC be broken into three units corresponding to its three grids, and the generation and transmission assets of each group would be sold individually. The net result would be the formation of three generation and transmission regional utilities. This approach would be consistent with the desire to bring services closer to end users. 3.62 One fact remains certain. Changing NPC into a truly commercially-oriented entity will require time4 and should be done in phases. Immediate changes in the nature of NPC could be detrimental to the short-term goal of adding generation capacity which is critical to bringing about an end to the present power outages. A possible third alternative would be to allow NPC to continue managing the process of adding generation capacity under BOT arrangements in the short-run. At the same time, a law should be prepared endowing NPC with a corporate structure. Most importantly, its management should be given a charter with clear operational mandates and sufficient autonomy (including authority to fix market-based salaries for staff and to contract out selected functions to the private sector through performance contracts ) to function along commercial lines. In the long-run, consideration should be given to privatizing NPC through the sale of shares once its financial situation has improved. 3.63 Water Districts have limited commercial focus and are not fully accountable for their performance. One of the principal contributing factors is a recent Supreme Court decision recognizing WDs as government entities, thus subjecting them to public sector operating and employment guidelines. Moreover, the power of Mayors to appoint the Boards of Directors in the WDs further increases the scope of political intervention in their activities. 3.64 One approach to improving this situation would be to establish local Water Districts as commercial entities with independent Boards of Directors. To do this, would required new legislation entrusting the boards with full legal responsibility for the new companies and ensuring that board members are elected by shareholders and fully accountable to customers and shareholders. This process would recognize the potential advantages of broader community participation in managing existing systems and guiding the development process. The basis for reforming the structure and size of WDs is being reviewed under the Water Supply Sector Reform study. 4 Privatization programs in countries such as U.K., Chile, Thailand, Malaysia have been generally slow and complex. 57 3.65 PricinL of Infrastructure. Accomodating growing and changing infrastructure demands over time will require not only greater efficiency in infrastructure management, but also pricing structures which attempt to maximize internally generated cash while providing appropriate cost signals to consumers. Infrastructure pricing policy, however, is complicated by governments' attempts to serve a variety of social, economic and financial objectives which may not be complementary. Philippines is no exception to this phenomenon and the need to clarify which objectives should prevail in establishing pricing structures for the various infrastructure sectors. 3.66 The severe public sector budgetary constraints in Philippines and the difficulty in raising general revenues make it necessary for the various infrastructure agencies and enterprises to internally generate as much revenue as possible through user charges. Reviews in each of the sectors indicate that there is substantial scope for increasing revenues, often by simply collecting what is owed, and that the willingness to pay for reliable service is quite high. There is potential for meeting some of the capital needs through internally generated cash or at least by providing a sufficient cash flow to attract equity or debt financing. 3.67 A second objective is to establish prices that reflect the costs of providing desired services, including cost variations across time and location. This will provide an instrument for rationalizing demand. In sectors where there are natural monopolies or restricted entry together with substantial inefficiencies distorting cost structures, however, cost-based pricing would reduce the pressure to improve managerial and operational efficiency. In such cases, regulatory policy will be required. 3.68 Lastly, there are valid social objectives in infrastructure pricing such as ensuring the provision of basic services to remote areas of the country or to low-income populations. In Philippines, this has been mainly financed through cross-subsidies from other services rather than through direct payments to operators or consumers with resultant distortions in the pricing of remunerative services. 3.69 The following discusses the types of pricing initiatives which should be considered for the various sectors. 3.70 In the power sector, given NPC's present financial situation, expeditious resolution of the power tariff increase is a key priority and progress is being made. On April 2, 1993, ERB decided in favor of NPC two tariff cases which had been pending for almost two years. At the same time, the new NPC's tariff structure proposed under ESAP would require immediate implementation. It will be based on long-run marginal costs with demand charges that reflects economic costs. This new structure, together with the proposed automatic indexing mechanism that links NPC's tariff to fuel price and exchange rate variation (still to be confirmed by ERB) would lead to economic efficiency in electricity consumption and improved financial viability for NPC. 3.71 ESP's proposal to introduce time-differentiated power usage rates would also encourage use during off-peak hours. Nevertheless, these proposals are still lacking management incentives to keep costs down since they can be passed on to customers. MERALCO's high 14 percent distribution losses, for example, continue to be passed on to users. There is a need for anti-pilferage laws with strict enforcement provisions. Further, MERALCO should only be allowed to pass on to customers minimal accepted losses, with any other excesses being absorbed by the utility. This solution has been recommended under the proposed new tariff policy for RECs. The maximum recoverable amount of 58 system losses allowed for RECs will be reduced from the current 25 percent to about 15 percent in 1997, with very few exceptions. 3.72 In the telecommunication sector, the Government has agreed to develop by January 1, 1994 a policy framework to review the structure of telephone tariffs. This review would need to ensure that (a) monthly rental charges cover their long-run incremental costs, (b) local call charges (presently free) are introduced, at least during periods when local network congestion occurs, (c) national long- distance charges (presently below cost) are increased, (d) PLDT is less dependent on excessively high international charges and (e) PLDT's tariff structure (presently too complex with 15 local service location classes, each with their own staff, and 59 toll distance bands) is simplified. 3.73 Pricing in the road sector is complicated by the indirect nature of the charging mechanisms, i.e. registration fees and fuel taxes, and the fact that the main revenue source, fuel taxes, are considered as a general revenue tax. Tolls as a direct form of charging will always remain a relatively minor source except for certain high volume road segments. Thus, while the total revenues generated by the sector are sufficient to cover more than the present level of expenditures, one cannot expect to divert more resources to the sector to cover additional maintenance and rehabilitation expenditures without also providing a source for more government revenue. Fuel prices in Philippines are generally in line or even above those of its neighbors in Thailand, Indonesia and Malaysia but still are well below those countries which have taken a more aggressive stance in charging road users such as Japan, Hong Kong and Korea. It is estimated that a one peso increase in gasoline and diesel taxes would cover the additional road maintenance expenditures required. 3.74 As in other countries, however, the structure of road taxes generally results in an undercharging of trucks and other heavy commercial vehicles. If a diesel tax is considered controversial because of diesel consumption by other sectors, then a more substantial registration tax should be considered which is related to the relative damage to roads by various types of vehicles. 3.75 User charge reform in the road sector, however, should be associated with a careful screening of expenditures which will ensure noticeable improvements in the quality of the network. Thus, while user charges may rise, road costs generally should decline with better road quality. 3.76 In the maritime sector the introduction of greater competition in cargo handling, more flexibility in port charges, a reduction in excessive port charges and overall inter-port competition should result in a reduction in prices. 3.77 In the water sector the reduction in unaccounted for water and improved collection efficiency should reduce the need for future increases but no absolute reduction in water charges could be expected as the cost of meeting increasing urban demands, especially in Metro Manila will continue to rise. MWSS will have to tap more expensive sources to meet demand which will place pressure on the average cost of providing water. Increasing Selectively Public Investment and Mobilizing Private Sector Financing 3.78 Implementing the above reform agenda, many parts of which are now being developed by the relevant authorities, will have to be accompanied by increased investment. The needs for infrastructure in the Philippines are enormous, partly because of low investment in the past decade. 59 Expanding investment together with the implementation of the reform agenda appears necessary in order to break the current vicious cycle and to sustain growth. 3.79 Recent improvements in the Philippine macroeconomic outlook may have provided the opportunity for an increase in government spending on infrastructure. Through a broad reform package, which includes trade policy liberalization, tax reform, improved fiscal discipline and debt management, and liberalized exchange rate management, inflation has been brought under control and is currently at about 9 percent. Foreign exchange reserves (the equivalent of 3 months imports) are at record levels, and there has been a considerable return of capital from overseas. 3.80 Nevertheless, government's capacity to provide funding for the development of infrastructure systems remains highly constrained. In view of the current debt, further fiscal adjustment is still required to lower public debt and interest rates. Therefore, the prospect is limited for financing all the immediate infrastructure needs at the same pace. Despite some recent improvements, the authorities are still reluctant to raise taxes and other public revenues'. Although some savings may be realized through reduction or reallocation of public expenditures, under the present circumstances, the prospect of immediate savings is not very favorable. Eventually, the consolidated public sector deficit may require a moderate and only temporary increase providing that expenditures are properly phased and prioritized. In particular, it will be essential to ensure that: (a) funds are being used efficiently for high return investments, especially for rehabilitating and maintaining existing assets; (b) projects are targeted in areas where economic potential exists (e.g., growth pole centers such as the Calabarzon); (c) the moderate deficit is financed by long-term loans; and (d) a credible plan to improve the institutional and financial capacity of public agencies and corporations has been established as a prerequisite to undertaking infrastuctural improvements and mobilizing foreign funds. 3.81 The power and the transport sectors should be high on the list of activities that will benefit from increased investments. These sectors have not only started to show promising signs of structural reforms but will also consume a large portion of the increase in public infrastructure investments. Table 3.1 shows preliminary estimates of the main public investment requirements for infrastructure over the next three years. These estimates are based on an assessment of funds needed to complete on-going projects and to meet part of the future demand. They also take into account the implementation capacity of the various agencies in each sector. 3.82 In the power sector, substantial public investment is urgently needed to complement on- going "fast track" BOT power schemes, in particular, to rehabilitate and maintain existing generating plants, and to extend transmission networks in anticipation of the expanded generating capacity. The proposed increase from P17.9 billion in 1992 to P48.2 billion in 1995 will correspond to an increase from 1.1 percent of GDP to 2.5 percent of GDP during the same period. * In 1980, tax revenues received by the government amounted to 12.5 percent of GDP. Tax revenues remained at or below this level until 1989, when revenues increased to 13.2 percent of GDP. In 1991, tax revenues climbed to 14.7 percent of GDP. 60 Table 3.1: Public Investment for Key Economic Infrastructure Sectors (in Pesos billion) Actual Preliminary Estimates 1991 1992 1993 1994 1995 1996 Power NPC 9.7 17.2 30.0 41.2 48.2 50.6 NEA 1.4 1.1 0.8 1.0 1.0 1.2 Transport Roads Maintenance 1.0 a 1.4 a 6.7 7.5 8.3 9.2 Const/Rehab 5.8 7.3 7.7 8.2 8.7 9.3 PPA Capital 1.1 0.6 0.8 0.7 0.5 0.3 Maintenance 0.04 0.1 0.2 0.2 0.2 0.2 Water Supply MWSS 2.1 4.8 4.4 4.4 4.0 3.0 LUWA 0.6 0.5 0.5 0.8 0.8 0.8 Total 21.74 33.0 51.1 64.0 71.7 74.6 Total as % ofGDP 1.8% 2.4% 3.4% 3.7% 3.7% 3.4% a National roads and bridges only. Sources: Financial Statements of GOCC and Bank staff estimates. 3.83 In the transport sector, road rehabilitation and maintenance should receive priority to arrest the dramatic deterioration of the network. Road investments would increase from P8.7 billion in 1992 to P17 billion in 1995, thus averaging about 0.9 percent of GDP per year compared to about 0.6 percent of GDP at present. These estimates are based on the following assumptions. Good and fair roads of all classes would receive routine and periodic maintenance to prevent further degradation. All national roads rated "bad" would be rehabilitated. About 60 percent of provincial roads rated "bad" would be rehabilitated and the balance would be abandoned as unmaintainable. Fifty percent of barangay roads (at 1975 level) would be rehabilitated and the balance would be abandoned. About one sixth of the roads rated "bad" would be rehabilitated each year (5,550 kum) and receive routine maintenance over the period of the MTDP (1994-1998). In the maritime sub-sector, the issues are essentially institutional in nature. They need to be dealt within the context of the proposed restructuring of PPA. Funds will be needed to complete existing port projects and implement the proposed maritime sector project. More importantly, maintenance of existing port facilities should be doubled from the present P100 million per year. 3.84 In the telecommunication sector, the key to attracting more investment lies mainly in fostering private sector financing through greater competition. However, the government should continue to support the Municipal Telephone Development Program. Finally, in water supply, MWSS' own funding projections of about P4 billion a year appear reasonable to meet expected demands. The 61 expansion of LUWA's program remains largely dependent on the outcome of the present water supply reform study, which is reviewing the future of LUWA and investigating the possible restructuring of Water Districts. 3.85 In addition to increased public investment, private sector financing will have to be mobilized on a larger scale and possibly under different forms than at present. The government's initiative to establish a Private Sector Infrastructure Development Fund (PSIDF) for large infrastructure projects (mainly in power and telecommunication) needs to be pursued. This fund would administer a pool of funds derived from seed capital and loans from international lending agencies. Efforts to develop the PSIDF have so far been stymied by the need for legislation in order to establish an appropriate legal entity for the fund. Operating procedures have yet to be established but a proposal has been made that the Development Bank of the Philippines (DBP) act as the promoter/catalyst for project financing which would be structured along the lines of a BOT, BOO, or BTO. Investment requirements in infrastructure are very large, however, especially in power (at least $3 billion is required over the next three years). It is unlikely that the market can supply all the required funding on a voluntary basis at commercial rates. Support from external sources will, therefore, be necessary to finance suitable projects. 3.86 The government also needs to systematically promote the development of BOO schemes rather than BOT/BTO arrangements. The government needs to play an active role in developing, implementing and coordinating this process. Major constraints, however, must be removed before private schemes can be implemented on a scale commensurate with need. For instance, the combination of the Foreign Borrowings Act and the Monetary Single Borrower Limit effectively preclude the government from encouraging private infrastructure ventures through direct official support. Moreover, major official lenders, including the Bank, cannot provide credit enhancement such as the ECO for justifiable private initiatives because the government claims it is not authorized to provide the requisite counter guarantee because of a legal vacuum. Ultimately, the rate at which the private sector will be willing and able to undertake infrastructure investment will largely depend upon the pace at which the reform process proceeds, and the government's ability to maintain a stable political and economic environment. Conclusion 3.87 As the Philippines continues to witness the deterioration of its infrastructure base, the Government faces a difficult challenge but also an opportunity since communities are now demanding real changes. Failure to act quickly and redress the present situation will compromise recent efforts made to put the country back on the path of sustainable economic growth. It will also further curtail its ability to compete with other economies in the region. Although the severity of problems may differ across sectors, bottlenecks and shortfalls in all infrastructure sectors deserve immediate attention before the situation reaches crisis proportions as in the power sector. 3.88 A major thrust of this report is that both public and private firms must be given an adequate institutional, financial and regulatory framework within which they can provide competitive and efficient levels of infrastructure. The Government has already taken several sectoral initiatives in this direction. The report argues that the reform process needs to be pursued and extended across sectors with steadfast political commitment. This process also needs to be complemented by selective and well targeted increases in investment in order to trigger a positive supply response. 62 3.89 Given the time required to implement changes and existing fiscal constraints, the effects of reforms and additional investments will, however, not be felt immediately. Bottlenecks and shortages will be eliminated only gradually For example, some improvements in the power situation would be achieved starting in 1994 providing the new generation capacity under fast track projects and associated transmission systems come on stream as expected. Moreover, meeting the large backlog of unmet infrastructure demands remains a formidable proposition. 3.90 Throughout the reform process, it will be essential to assess the impact of reforms and policy changes on the performance in the various sectors. To this end, the authorities need to put in place a proper monitoring system to follow more closely the overall performance in each sector. The existing monitoring system for some 14 GOCCS needs to be improved and complemented by a set of performance indicators which assess and capture the overall progress in each sector. Such indicators should cover inter alia adequacy of services (quantity and reliability), financial performance and operational efficiency. 3.91 Similarly, any substantial increase in infrastructure spending will have to be carefully controlled and monitored, and accompanied by commensurate efforts to raise revenues. Despite some macroeconomic improvements, there is still a real danger that increased (non tax-financed) infrastructure spending will destabilize the economy. A return to high levels of budget deficits together with jumps in inflation and interest rates, or surges in wage demands, would negate recent economic gains, and further curtail the capacity yo either afford infrastructure or to maintain existing assets. 3.92 In summary, the Government needs to continue to both address fundamental structural issues (at the macro and sectoral levels) and facilitate greater private sector participation in infrastructure provision. As these elements start falling into place, the infrastructure base of the Philippines can again be an engine of growth, rather than a handicap to the many and varied talents of the Philippine community. 63