Sri Lanka - Private Sector Infrastructure Development Project

Document of The World Bank Report No. 15391-CE STAFF APPRAISAL REPORT SRI LANKA PRIVATE SECTOR INFRASTRUCTURE DEVELOPMENT PROJECT Nay 15, 1996 Energy and Project Finance Division Country Department I South Asia Region  CUlRRENCY [ (lIlVAL ENT (May 1996) CurrencN Unit-Sri Lankan Rupee (SL R) US$ 1-SI,R 54.73 Sl R I million-USS18.272 F:IS('AI YEAR l'or l'SIDC Januarv I - I)ecemher 31 PRINCIPAL ABBREVIATIONS ANI) ACRONYMS USkD ADB - Asian Development Bank BID - lureau for Infralstrlcturc D)evelopmernt B01 - Board of Investments BOO - 13uild Ow%n Operate BOT - Iuild On Transfer CLA - Central Environmental Authorit, CEB - Ceylon Electricity Board ('AS - Countr% Assistance Strategy C) C'ommllonvwealth Development Corporation (Canadian) I'A - Environienital Assessments 1I1C'( I ngineering Plrocurement and Construction (contract) FDI - Foreign D)irect Inmestment (iDP - (iross D)omestic Product (iOS - (iovernment of Sri Lanka IA - Implementation Agreement IBRI) - International Bank for Reconstruction and Development IDA - International D)evelopment Association ILC - International Financc Corporation JFXIM - [he Export-lmport Bank ol'Japan KtW - Kreditanstait liir Wiederaulbau LO[ - Ietter of Intenit MIGA - Multilateral Insurrance Guaranltee Agency M(O - Ministrv of' F:inance NE A - National L:n\ ironilienit Act N\SI)DB - National Water Supply and D)rainage Board O & Op - Operations and Maintenance O()C, - Oerseas E conomic Cooperation Fund of'Japan l'AA - 'roject Approv ing Agenc\ I'Al - IPreliminarv Acceptance letter PERC - Public E1nterprise Reforimi Comimiliission I'SA - Private Sector Assessment 'SIDC - P'rivate Sector Iiifrastructure D)ekelopnient Company PSED)F - Private Sector Lnergy Development Fund (IPakistan) PSHI)I' - Private Sector Infrastructure De\,elopment Proqject RDA - Road Development Authority Sll)l - Secretariat for Intrastructure Development and Investment SDR - Special l)ra%king Rights SLIPA - Sri Lanka Ports Authioritv Sll' - Sri Lanka 'l'eecom SLIA - Sri Lanka 1'elecommilunications Authority LJSAID - I nited States Agencv Ibr International Development  SRI LANKA PRIVATE SECTOR INFRASTRUCTURE DEVELOPMENT PROJECT Credit and Project Summary Borrowsr: The Democratic Socialist Republic of Sri Lanka Implementing Private Sector Infrastructure Development Agency: Company Ltd. (PSIDC) Beneficiaries: Special purpose entities established for the construction, operation and ownership of commercial infrastructure projects; public sector agencies. Poverty Category: Not Applicable Amount: SDR 52.9 million (US$77.0 million equivalent) Terms: Standard IDA terms, with 40 years maturity Commitment Fee: 0.50 percent oni undisbursed credit balances beginning 60 days after signing, less any waiver. On Lending Terms: From the Government of Sri Lanka (GOSL) to PSIDC on the same terms as the IDA credit. From PSIDC to the various private sector sponsors of infrastructure projects, up to 22 years maturity, including up to 8 years of grace, in US dollars with the private sponsor carrying the foreign exchange risk. The two options for interest rates are initially: (a) Variable. based on 6 month US$ LIBOR, plus a premium of 3 percent (LIBOR + 3 percent); or (b) F[xed based on the term of the loan and the US dollar swap rate, plus a premium of 3 percent. Financing Plan: See Paragraph 3.23 Task Identification Number: LK-PA-10517   SRI LANKA PRIVATE SECTOR INFRASTRUCTURE DEVELOPMENT PROJECT Table of Contents Page No. Credit and Project Summary 1. INTRODUCTION ...........................................................I 11. POLICY ENVIRONMENT FOR PRIVATE SECTOR FINANCED INFRASTRUCTURE ...........................................................2 A. The State of Sri Lanka's Infrastructure ...................2.......................................2 B. Infrastructure and Competitiveness ...........................................................3 C. Constraints to Efficient Public Sector Infrastructure Provision .................... .....................4 D. GOSL Policies for Attracting Private Infrastructure Investments ......................................4 E. IDA's Operational Lessons and Strategies for Supporting Private Sector Infrastructure Development ...........................................................7 111. THE PROJECT ..10 A. Project Origin .10 B. Project Objectives .10 C. Project Description and Technical Assistance .II D. Project Design .12 E. The Long-term Debt Facility .14 F. Financial Arrangements .16 G. Project Costs and Financing .20 H. Project Implementation and Supervision Strategy .21 IV. THE SUBPROJECTS .22 A. GOSL Subproject Pipeline .22 B. Environmental and Social Impact Requirements and Economic Analysis for Subprojects .25 C. Procurement and Disbursements .26 V. BENEFITS AND RISKS ..30 A. Benefits .30 B. Risks ..... 30 VI. SUMMARY OF AGREEMENTS AND RECOMMENDATION .32 This report was based on findings of an appraisal mission which visited Sri Lanka in March/April 1995. Follow- up missions with respect to legal, environmental and resettlement issues were undertaken during August/September 1995. The report was prepared by Mrs. Jane Walker (Private Sector Development Specialist, Task Manager), Messrs. P. Kyle (Senior Counsel), S.V. Iyer (Financial Consultant), J. Sachs (Financial Consultant), D. Knott (Engineering Consultant), M. Stanfield (Private Sector Transport Consultant), A. Salaam (Resettlement Consultant) and S. Pilapitiya (Environmental Engineer - Resident Mission). B. White assisted in the production of the report. Peer reviewers were: Messrs./Mmes. P. Guislain (Principal Private Sector Specialist, PSD), K. Siraj (Advisor, FSD), A. Mody (Principal Financial Economist, CFS), and F. Mazhar (Senior Financial Officer, CFS ). Mr. Per Ljung is Chief, Energy and Project Finance Division, SAI and Ms. Mieko Nishimizu is the Director, Country Department 1, South Asia Region.  Page No. Annexes: 1. Private Sector Infrastructure Development Company Ltd . .................................................... 36 2. The Security Package ........................................................ 42 3. The Project Pipeline ....................................................... 46 4. Financial Projections of PSIDC ....................................................... 57 5. Environmental and Social Assessment Framework: Environmental Aspects ............ ............. 68 6. Environmental and Social Assessment Framework: Resettlement Aspects ............... .............. 74 7. Legal Aspects ....................................................... 85 8. Technical Assistance to PSIDC: TORs for General Manager .................................................. 86 9. Technical Assistance to PSIDC: TORs for Technical Advisor ................................................ 89 10. Technical Assistance through PSIDC: TOR for Feasibility Studies .97 II Implementation and Supervision Schedule .100 12. Performance Indicators .104 13. Disbursement Arrangements .106  SRI LANKA PRIVATE SECTOR INFRASTRUCTURE DEVELOPMENT PROJECT STAFF APPRAISAL REPORT 1. INTRODUCTION 1.1 Sri Lanka's US$10 billion economy is built on a richly endowed and varied agricultural resource base with a low population growth rate and exceptional social indicators. Its per capita income, at US$550, is the highest among countries in South Asia. Although the country's recent history has been marked by political upheavals, including assassinations of key public figures and shifting prospects for peace in the ongoing armed conflict in the North, there have been two periods of high economic growth (1977-84 and 1989-1994). Both periods have followed significant reform initiatives, deregulation and a shift towards market orientation. The focus of the reform effort has nlow shifted to addressing fundamental growth-limiting factors, such as the overextended and poorly performing public sector and infrastructure constraints. 1.2 The present Government of Sri Lanka (GOSL)i has largely maintained the progressive economic reform and private sector investment policies of the previous government. However, the Government's ability to maintain the pace of economic growth at a level of six percent per annum is strongly predicated both on sustained macroeconomic confidence and the speed and efficiency with which critical infrastructure services can be upgraded and delivered. For several years, public investment in and execution of infrastructure projects has been below expectations. New construction and the rehabilitation of the existing infrastructure stock have been supported almost exclusively by donor funding. The effectiveness of this lending has been diminished by chronic operational weaknesses of line agencies which have led to procurement and implementation delays. As a result, serious bottlenecks are evident in the delivery of power, transport and water/sanitation services. 1.3 Government policy since 19922 has been oriented towards enhancing the efficiency of infrastructure provision, improving managerial expertise and securing more modern technology through private sector participation. GOSL's initiatives to seek private sector investments, both in the form of privatization and greenfield projects, have been heightened by the increased pressure on budget resources imposed by the civil conflict. The progress in actually closing deals with private sector investors has been slow. However, the successful privatization of the Colombo Gas Company, followed by the finalization of the Build-Own-Transfer (BOT) project The present Government came to power through elections in the latter half of 1994. Led by the People's Alliance, it replaced a government led by the United National Party since 1977. 2 This policy initiative for private sector participation in infrastructure was strongly supported by a USS10 million United States Agency for International Development (USAID) technical assistance project (ongoing) which includes institutional building, training, market outreach and a comprehensive public education program. Similar USAID initiatives have contributed to successful private sector infrastructure investment programs in Pakistan. the Philippines, and Indonesia.  -2- agreement for a 51 MW diesel-fired power generation plant with a private consortium in December 1995 has set the stage for further private sector initiatives. 1.4 The proposed project seeks to develop a modern and efficient infrastructure system in Sri Lanka by promoting significant participation of the private sector in the investment, operation, ownership, and maintenance of infrastructure facilities. The project will enable potential investors to access long-term financing (the lack of which presently hinders infrastructure project development) through a single purpose government owned company, the Private Sector Infrastructure Development Company (PSIDC). PSIDC will provide long-term subordinated debt at rates based on prevailing market conditions for infrastructure projects in tandem with additional private sector debt and equity. The leveraginig of private sector financing will also induce operational efficiency and techniology transfer inhierent in private sector operations. In collaboration with USAID, techniical assistance provided under the proposed credit will help strengthen GOSL's ability to evaluate and negotiate private infrastructure projects. 1.5 The proposed project will supplement rather than replace traditional sources of funding. Thus, sub-borrowers will be encouraged to maximize the use of export credits and seek the assistance of institutions with a mandate to support private investments in infrastructure facilities such as International Finance Corporation (IFC), Multilateral Investment Guarantee Agency (MIGA), Asian Development Bank's (ADB) private sector wing, and Canadian Commonwealth Development Corporation (CDC). PSIDC is expected to work very closely with these agencies and with commercial lenders in reviewing and finanlcing subprojects to provide complementary financing. II. POLICY ENVIRONMENT FOR PRIVATE SECTOR FINANCED INFRASTRUCTURE A. The State of Sri Lanka's Infrastructure 2.1 Sri Lanka has registered impressive achievements in non-traditional exports and maintained a consistent growth path. Value-added in manufacturing has grown by 8.8 percent per annum on average during 1990-94, contributing a third to gross domestic product (GDP) growth. However, sustaining this growth requires immediate attention to infrastructure deficiencies. In the power sector, the absence of new generation capacity is causing shortages. In the road subsector, rapid expansion in traffic volume, fueled by rising industrial and commercial activity, has led to serious transport bottlenecks, especially in the Greater Colombo area. The capacity expansion of key traffic corridors, such as Colombo-Katunayake, Colombo- Galle and Colombo-Kandy, has become critical to sustaining the competitiveness of Sri Lanka's agricultural and manufactured exports. The unsatisfied demand for telecommunication services is estimated to exceed the number of currently connected subscribers. 2.2 Per capita availability of power, measured by households with access to electricity, shows that Sri Lanka lags behind India. It fares much worse when compared to East Asian countries (see Table 1). System losses are comparable to India's, but quite high when compared with Thailand's or Malaysia's. Despite Sri Lanka's smaller size and plentiful water resources, access to safe drinking water is marginally worse than in India. In the telecommunications sector, Sri Lanka has 12 phone lines per thousand people compared to 31 in Thailand and 111 in Malaysia. Although call completion rates in Sri Lanka are better than in its South Asian neighbors, there is need for improvement as compared with the more progressive  -3- East Asian countries. In the road subsector, although Sri Lanka has a good network, years of neglect and under-investment have eroded the infrastructure stock, resulting in poor rankings in terms of paved roads in good condition. Over the last decade, Colombo Port, which is acknowledged as the best run port in the region, has emerged as a major transshipment center for containers. However, it lags far behind its main competitor, Singapore, in terms of efficiency. B. Infrastructure and Competitiveness 2.3 Several studies conducted in Sri Lanka in the recent past have underscored the importance that industries and business establishments attach to adequate and reliable provision of infrastructure services. The Bank's Private Sector Assessment (PSA) conducted in 1994 and the Industrial Infrastructure Assessments carried out in 1992 and 1994 reveal that industries and businesses face high economic costs due to infrastructure deficiencies, such as rescheduling production and providing stand-by generation and timely movements of inventory and products. With the increasing trend towards the outsourcing of intermediate production to areas of skilled and inexpensive labor, a new dimension has been added to cost competitiveness: businesses are seeking facilities where comparative logistical costs of manufacturing and marketing are lower. In this regard, studies reveal that logistical costs as a percentage of sales value for garment industries, for example, are seven to ten percentage points higher in Sri Lanka than in the Philippines, implying that Sri Lanka's export competitiveness is critically dependent on infrastructure improvements.3 Table 1: Infrastructure: How does Sri Lanka Compare? Indicator Sri Lanka India Pakistan Philippines Thailand Malaysia % Households with Electricity 33 54 3 1 46 43 64 System Losses (% of output) 1 8 1 9 24 1 9 1 I 16 Average tariff US cents 5.8 4.8 6.2 7.6 7.1 na Population with safe access to drinking water (%) 60 73 55 81 77 78 Telephone Density (Lines/1000) 12 8 16 10 31 III % Calls completed (Local calls) 60 40 na 68 93 na Paved Road Density (km\million persons) 536 893 229 242 513 na Percent Paved Roads in good condition (%) 10 20 18 31 50 na Notes: (I) Data generally pertains to the years 1990-94. (2) Sources for data - The World Development Report 1994, A Survey of Asia 's Energy Prices, and International Telecommunications Union (ITU) reports. 3(i) "Private Sector Assessment - Sri Lanka," SAICO, the World Bank, March 1994. (ii) "Greater Colombo Infrastructure Assessment," SAIEF paper, September 1994.  -4- C. Constraints to Efficient Public Sector Infrastructure Provision 2.4 The operation and ownership of the vast majority of Sri Lanka's infrastructure is in the public sector. The private sector participates in the provision of bus and ancillary telecommunication services. Over the last three decades, both the creation of new infrastructure and maintenance of existing assets has been under-funded, leading to serious supply constraints.4 Countries developing at the pace of Sri Lanka require annual investments of five to six percent of GDP to maintain and renew infrastructure stocks. The ratio of investment in economic infrastructure to GDP has never exceeded five percent, even during periods of high GDP growth. This has led to insufficient investments in new capacity, as well as poor attention to maintenance of existing assets. The situation has been compounded by poor management, over-staffing and inefficient operations in most utilities. Although estimates vary, conservative projections of required investments in energy and infrastructure indicate a need for US$2 billion in new investments over the next seven to ten years. Securing financing for and timely implementation of projects of this magnitude is clearly beyond the scope of the public sector. Hence, there is a significant need to involve the private sector in the financing, operation and management of infrastructure assets. Besides leveraging more resources and mitigating under-funding of new investments, the country would also realize significanit efficiency gains from the injection of new technology and managerial expertise. D. GOSL Policies for Attracting Private Infrastructure Investments 2.5 Responding to this situation, GOSL adopted a policy in 1992 to promote private sector participation in infrastructure provision. The policy had three main objectives: (a) to complement public investment; (b) to provide additional capacity in critical areas through privately-led investments; and (c) to mobilize private sector management resources to improve efficiency. Despite the shift in government policy in favor of private participation, translation into real transactions has been a difficult and contentious process. 2.6 One of the foremost reasons for slow progress in policy implementation stems from the entrenched interests of different players in the public sector monopolies. The absence of capacity to deal professionally with private sector investors and to facilitate and promote transactions also has hindered progress. Furthermore, the lack of a comprehensive legal and regulatory framework that sets out the full policy and incentive package for private sector investors has slowed the investment process. The lack of professional capacity to efficiently manage project transactions involving private sector investments and the scarcity of appropriate financing that matches the investment requirements of large infrastructure projects have also contributed to slow progress. Table 2 revisits the constraints to the private sector provision of infrastructure investment and sets out the current set of coordinated GOSL and donor activities that are in train to mitigate these constraints. 2.7 In 1992, the Government established the Secretariat for Infrastructure Development and Investment (SIDI), now the Bureau for Infrastructure Development (BID), as the institutional instrument to interface with the private sector and promote their participation in line with the policy objectives. BID, with technical assistance from USAID, has carried out a series of initiatives aimed towards awareness-building, education and training and capacity-creation in 4For purposes of this paper, irrigation investments have been excluded.  -5- government agencies for identifying, developing and evaluating private sector projects. The policy has been successful in raising awareness among line ministries and public utilities to the possibilities of private sector financing. The Ceylon Electricity Board (CEB), the National Water Supply and Drainage Board (NWSDB) and the Sri Lanka Ports Authority (SLPA) are exploring project processing through Build-Own-Transfer (BOT)/Build-Own-Operate (BOO) mechanisms directly; in so doing, they are building up their own capabilities. Currently all the major government agencies with responsibilities for infrastructure development have explicit private sector development programs that involve at least one project that is suitable for private sector financing. Table 2: Constraints and Mitigation Policies and Actions for Private Sector Infrastructure Investment Constraints Mitigation Policy and Actions Lack of capacity to facilitate, promote * Creation of SIDI (BID) as the central GOSL coordinating and and negotiate infrastructure project promoting agency (USAID) transactions * Technical assistance to build capacity in the line ministries/agencies to solicit, negotiate, and evaluate private infrastructure projects (the proposed International Development Association (IDA) credit) Public sector ownership and entrenched * Outreach and extensive education and training to line ministries interest groups seeking to maintain the provided by BID (USAID) status quo * Workshop(s) on project finance with line ministries and agencies (IDA) Lack of enabling legal, regulatory and * Preparation of draft Private Sector Infrastructure Regulations to institutional framework Board of Investments (BOI) Act (USAID) * Preparation of regulatory framework for private sector participation in the power sector (IDA) * Identification of potential private sector participation possibilities and preparation of a framework for private participation in the transport sector (IDA) * Liberation and strengthening of the regulatory framework for the telecommunication sector (Telecommunications Sector Regulatory Support Project financed by IDA) * Solicitation and evaluation of proposals for private sector waste water treatment plants and creation of a framework for implementation and operation of such facilities (The Colombo Environment Improvement Project financed by IDA) Lack of institutional capacity to manage * Establishment of the Private Sector Infrastructure Development and perform infrastructure project Company with ability to build an appropriate skill base in transactions project finance transactions (proposed IDA credit) Lack of appropriate term financing * Establishment of the Private Sector Infrastructure Development Company with the ability to provide appropriate term financing (proposed IDA credit with co-financing from Kreditanstalt for Wiederaufbau) * Debt and equity financing through IFC  -6- 2.8 Recent examples of private sector infrastructure development include the solicitation of proposals for power generation through barge-mounted power plants and a 150 MW combined cycle generation plant near Colombo. In the port sector, proposals have been invited through open solicitation for refurbishment of the Queen Elizabeth Quay in the Colombo Port. Requests for proposals for two wastewater treatment plants on a BOT basis are also to be issued soon. Bidding for two wireless. basic telephone licenses that will compete with Sri Lanka Telecom's (SLT) basic services is in its final stages. Table 3 summarizes progress in private sector involvement over the last four years. Table 3: Chronology of Development of Private Sector Infrastructure Date Activity Mid 1992 a Cabinet Decision to promote private sector participation in infrastructure through BOO/BOT mechanisms and approval to set up SIDI under the Ministry of Policy and Planning Late 1992 . Establishment and staffing of SIDI as "one-stop shop" for liaison with private sector investors 1993-1994 * SIDI's education and outreach to line ministries in the development of private sector infrastructure projects; building up of potential project pipeline . Training and capacity-building for GOSL through SIDI for project identification, negotiations with project sponsors, and financial and technical review of potential projects 1995 . Public Enterprise Reform Commission (PERC) created . SIDI moved to the more commercially oriented BOI and a new management structure was created as BID. . Finalization of the first BOO power project (51 MWs) * Solicitation for BOT for Colombo Port * Solicitation for BOO for 150 MW combined power station . Invitation for the two (wireless) basic telephone licenses that will compete with SLT 2.9 Notwithstanding the progress on private sector involvement with infrastructure, as illustrated in Table 3, both private investors and the Government realize that the lack of long- term financing constitutes a significant barrier to closing these transactions. Box I highlights these financial constraints. Furthermore, in line with experience from other high-risk country environments, project sponsors seek the comfort of a multilateral presence to bolster risk mitigation mechanisms. These factors have led GOSL to request IDA support, both for project facilitation and financing. IDA is coordinating with USAID to firm up the institutional side of project facilitation, and with IFC and KfW to establish appropriate financing arrangements for maturing projects.  -7- B2xLJ: Sri Lanka - Infrastructure Financing Constraints It has become increasingly apparent that the inability to mobilize debt for infrastructure projects has become a key impediment to their financing. Accounting for nearly 75 percent of a typical financing package, the availability of debt, in terms of volume and maturities necessary for large scale infrastructure projects, is an area of growing concern. Commercial banks have exposure limits to countries and sectors, and find it difficult to lend at maturity terms suitable for infrastructure projects (12-15 years or more). Other potential sources of debt, such as provident funds or insurance companies, are typically averse to undertaking equity-like risks often associated with long-term infrastructure debt financing in developing countries. Furthermore, if commercial lenders include the necessary risk premium to compensate fully for the perceived riskiness of the transaction, sponsors and/or governments will often deem the price prohibitive. In the case of Sri Lanka, these constraints to long-term debt mobilization are compounded by the international financial community's relatively low regard for the nation's credit-worthiness. A developing country like Sri Lanka with balance of payments constraints cannot rely exclusively on foreign capital to finance its infrastructure. However, with an under-developed financial sector, Sri Lanka is likely to face severe constraints in securing long-term domestic funding for private sector infrastructure projects. The volume of funding sourced from the local market (debt and equity) for private investment expenditure in Sri Lanka has been quite small, only 20 percent of total new private sector investment in 1992. Currently IDA is supporting reforms in the financial sector through the ongoing Private Sector Development Project (PSDP) which includes the privatization of state-owned banks and insurance companies. IFC has also been active in supporting the commercialization of pension funds and in the development of a secondary market for government bonds. The debt market, however, remains ill- equipped to accommodate the volume of financing necessary to support domestically financed infrastructure projects. Private sector access to long-term domestic funds has been limited by a very strong market for funds with short maturity terms (dominated by government paper) and a corresponding absence of market instruments to attract funds with longer maturity terms. The situation is exacerbated by the high retums on treasury bills, relatively risk-free instruments, that keep funds out of other instruments. The lack of a secondary market in debt instruments further compounds the problem. There are no long-term government bonds; and, as a result, there is no market-determined reference point to establish a yield curve. Furthermore, savings institutions, such as the Provident Fund and National Savings Bank, contribute to the diversion of term savings away from the private sector since there are mandatory placements in government securities. E. IDA's Operational Lessons and Strategies for Supporting Private Sector Infrastructure Development 2.10 In the past, IDA has supported infrastructure development in Sri Lanka through lending to public sector agencies. The effectiveness of this lending has been diminished by the chronic operational weaknesses of these agencies. Significant funding amounts under several IDA credits for infrastructure operations in the road and power subsectors have been cancelled due to the inability of public sector agencies to implement these credits in a timely manner, often as a result of procurement delays. The diminished fiscal position of the public sector as a whole has also exacerbated these operational weaknesses.  -8- 2.1 1 GOSL has articulated its intention to follow the rest of Asia in supporting the increasing demands for rapid infrastructure development through the use of the private sector. If acted upon, sorely needed operational efficiencies, technology transfer and increased financial resources will result. Though it must be recognized that the private sector can only develop projects selectively and public investment will remain extremely important, a major objective of the World Bank Group is to influence and accelerate the transitional process from public- dominated infrastructure to private operation and ownership. The Bank Group's proactive role in Sri Lanka is seen as an innovative one for the promotion of private sector opportunities, given the main emphasis on public sector lending for infrastructure by the other major donors - Overseas Economic Cooperation Fund (OECF) and ADB. Furthermore, in countries eligible for International Bank for Reconstruction and Development (IBRD) lending partial risk guarantees are suitable instruments for Bank support of private infrastructure projects. However, in "IDA only" countries other types of operations must be used. The limited credit-worthiness of these countries means that a greater degree of direct donor support is needed to encourage private infrastructure investments. 2.12 Over the years, the Bank has provided some financial support for private infrastructure investments (especially in power). However, this support has generally been in the form of loans to existing utilities and not for greenfield BOO/BOT projects financed on a limited recource basis. The Private Sector Energy Development Fund (PSEDF) in Pakistan that was created with the assistance of the Bank (Loan 2982-PAK) provides the most relevant experience for the design of the proposed operations. PSEDF (see Box 2) clearly demonstrates the effectiveness of a public-private approach at the beginning of the transitional period from public sector monopoly to widespread private sector participation in infrastructure provisions. PSEDF gave the Bank and other donors the ability to influence the process of private investment in infrastructure early on. The background work and technical assistance provided under PSEDF provided the foundation for Pakistan's policies supporting private power and infrastructure investments. The main lessons learned from PSEDF can be summarized as follows: (a) there is a need for a central focal point in the Government for promotion of private infrastructure projects; (b) the concerned line ministries and agencies need to be actively involved in the solicitation and negotiation process; (c) the financing agency needs to be independent and apply sound commercial criteria; (d) the fund management should not provide senior loans and/or equity in order to avoid possible conflict of interest situations; (e) it is essential to employ high caliber international legal, financial and technical consultants for the evaluation and negotiation of the subprojects; (f) the mere existence of the Fund can provide a strong incentive for private sponsors to make the necessary investments in project development; (g) the initial projects should not be too large in order to facilitate the mobilization of external financing; and (h) in low income countries with limited credit-worthiness, the commercial lenders require the additional protection provided by the subordination of the donor financing.  -9- BoxL2: The Privale Sector Enera Development Fund (MED]0_ Pakintan PSEDF was designed to address a fundamental constraint to greater private sector involvement in the energy sector in Pakistan. Specifically, PSEDF was then, and continues to be today, a means to successfully address the issue of a lack of long-term finance for power and energy-related infrastructure projects with relatively long periods of gestation and economic life. PSEDF provides a source of long-term subordinated debt from which private sector sponsors can borrow. Terms for PSEDF for subordinated loans include: (a) maturities of up to 23 years; (b) grace periods of up to 8 years; and (c) a minimum equity of 20% in the proposed project. PSEDF was established with Bank assistance in 1988 (Loan 2982-PAK) and was replenished in 1994 (Loan 3812-PAK). Under the former loan, an institutional framework was created for the promotion, negotiation and financing of private energy projects. Private Power Cell was established in the Ministry of Water and Power as the focal point for negotiation with project sponsors, and Private Energy Department was created in the National Development Finance Corporation (NDFC) to appraise subprojects and manage PSEDF. Additional technical assistance to the Government of Pakistan (GOP) was provided by USAID. The first subproject financed through PSEDF, the Hub Power Project, took over 5 years after the initiation of the start of construction, largely due to factors beyond the control of GOP and project sponsors. When construction started in early 1993, the 1,292 MW Hub Project was the largest private power plant being built in a developing country. The construction is on schedule and start of commercial operations are expected to occur before the end of June 1996. The negotiations for the Hub Power Project gave GOP valuable experience that led to a fine-tuning of the institutional arrangements and the announcement of a Private Power Policy in early 1994. Under this policy, that many developers have described as the most transparent and best prepared in any developing country, five more power projects--with a total capacity of about 1,100 MW-- have reached financial closure. Another five projects are expected to reach financial closure before the end of June 1996. PSEDF has also been successful in augmenting its resources from donors, for example, in additional to the World Bank, who have contributed US$390 million, JEXIM has contributed US$400 million. 2.13 The project incorporates these lessons and is tailored to support a selected program of private sector investment that will: (a) leverage IDA's reduced lending involvement with private sector resources; (b) improve operating efficiency in infrastructure; and (c) act as a catalyst for further project development. Initiated at the beginning of the transition period when private sector operations will be introduced into traditionally public sector managed and controlled activities, the project will be able to influence the process of private investment, much as in PSEDF. To date, several potential BOO/BOT-type transactions have been seriously delayed in the very early stages which in part underlines the inexperience of GOSL in dealing with these types of transactions. Furthermore, Sri Lanka's poor record of attracting overseas non- guaranteed debt will make it difficult for private sector sponsors to mobilize the required financing for larger infrastructure projects that are urgently required. Lessons from countries in the region indicate that for long-gestation, private sector energy and infrastructure projects, the necessary financing can probably be mobilized only with significant support provided by the  -10- Bank Group, other multilateral development banks and bilateral agencies. The subordination of the long-term debt proposed under the project will give added comfort to prospective lenders, most specifically at the initiation of the program of private sector transactions in infrastructure. 2.14 The innovative nature of the proposed operation is consistent with the World Bank Group's country assistance strategy (CAS) as it is in support of GOSL's various efforts to ease infrastructure constraints through significant involvement of the private sector. The project is specifically directed at supporting large infrastructure projects, the lack of which hinders the country's growth. Sri Lanka's current uncertainties and the lack of confidence of the international financial community in the country make it necessary to bring to bear the full range of the Bank Groups' complementary financial products in order to attract private sector investment. III. THE PROJECT A. Project Origin 3.1 The project originated with a growing acceptance that the private sector has a significant role to play in infrastructure development which led to GOSL's adoption in 1992 of a policy of encouraging private BOO/BOT operations and the creation of SIDI (now BID). Technical assistance provided by USAID to BID has helped create awareness of private sector options in the ministries and agencies responsible for infrastructure development and helped develop a pipeline of potential projects. Recognizing the difficulty of mobilizing sufficient commercial funds for private infrastructure projects once such projects are identified, GOSL requested IDA's support in establishing a long-term subordinated debt facility. The debt facility will complement GOSL efforts by identifying and capturing private sector resources, efficiencies, and technology transfer in typically large-scale infrastructure projects. The project was prepared with the assistance of a Policy and Human Resources Development (PHRD) grant provided by the Government of Japan. B. PiQ-jct Objectives 3.2 The overall objective of the project is to develop a modern and efficient infrastructure system in Sri Lanka by promoting significant private sector participation. More detailed objectives of the project are to: (a) establish a GOSL facility for the placement of long-term debt that will work in tandem with private sources of capital to facilitate potential private sector investment; (b) encourage significant participation of the private sector in the investment, implementation, operation and maintenance of new infrastructure facilities; and The most recent CAS for Sri Lanka is dated June 13, 1996.  -1 1- (c) strengthen GOSL's ability to attract, negotiate and close private sector sponsored infrastructure projects by increasing capabilities to evaluate and negotiate projects with private sponsors. C. Proiect Description and Technical Assistance 3.3 The Private Sector Infrastructure Development Project (PSIDP) would support the establishment of a long-term debt facility and associated technical assistance consisting of: (a) The Long-Term Debt Facility: The proposed IDA credit would provide long-term subordinated debt for private sector infrastructure projects.6 The recently created Private Sector Infrastructure Development Company, Ltd. (PSIDC), a public sector company, would act as the executing agency for the project. It would administer project funds received from official development sources, on behalf of GOSL, and place these funds in selected private sector subprojects up to a maximum of 40% of the total subproject cost. Subproject sponsors, who would prepare individual subprojects, would provide the equity and arrange for the remainder of the debt financing from commercial sources. Planned as a transitional mechanism, the facility would have available US dollars for long maturities that match new infrastructure investment needs. The facility has been planned to accommodate additional multilateral and bilateral financing to increase the total availability of funds. In addition to the US$70 million provided by IDA, KfW will also provide DM 20 million or about US$14 million. ADB and OECF have also expressed interest in supporting the project. A Project Preparation Facility (PPF) of US$700,000 has been secured to assist with start-up costs of the project; and (b) Technical Assistance: (US$7 million) Technical assistance (TA) is provided under the project to assist in the organization, operation, management and consultancy services for PSIDC, training and funds to support project preparation for solicited projects in association with the line ministries and agencies. The TA funds will be passed on as a grant from GOSL to PSIDC. Full details of the project's TA components are set out in Annexes 4, 8, 9 and 10 and are summarized below: TA to support PSIDC (US$3.5 million). In order to meet project objectives, it is necessary to ensure that requisite technical, financial and managerial competencies are provided within PSIDC to attract serious private sector interest and to be able to process and negotiate projects with private sector sponsors. Besides meeting the expenses of setting up the Company office, the TA would provide management expenses for the Company, including salaries and other operating expenses for an initial period. The Company brochure and the operational manuals of PSIDC would be prepared under this TA. This also includes the provision of a long-term consultant as advisor to the General Manager. The TA would also be used to retain the services of a consortium of consulting firms to provide the technical, financial, legal and environmental 6At the mid term review for the project, consideration will be given to expanding the financial products offered by the project to include takeout finance, senior debt, etc.  -12- expertise on an "as required" basis to appraise, evaluate and negotiate project proposals. The TA would also provide training and professional development for PSIDC staff. The TA would be operative for a period of four years from the start of operations of the Company. TA in support of Line Ministries (US$3.5 million). The credit would also provide funds to support project preparation of individual subprojects that have been (or will be) identified by the line agencies as suitable for private sector investment and participation. This TA will be used in cooperation with the line agencies to support evaluation and negotiation of subprojects. The TA will also support the further development of existing pre-feasibility studies or the commissioning of entirely new studies. The objective of the studies will be to provide complete documentation to enable the solicitation of high caliber BOT/BOO bids for infrastructure projects. The TA would also support limited work on sectoral policy and regulation, if these are necessary to advance private sector transactions in specific sectors, especially in areas where other multilateral or bilateral assistance is not available. D. Proiect Design 3.4 D.asi& Rational. The rationale for PSIDC stems from the need to address constraints experienced by project sponsors in raising long-term debt for projects in Sri Lanka. Typically sponsors will choose non-domestic private sector financing of infrastructure projects on a non- or limited-recourse basis, with the projects being formulated under BOO/BOT arrangements. This means that the lenders' ability to seek payments from the sponsors and other equity holders is limited. Since the liquidation of infrastructure assets is extremely difficult, lenders have to rely primarily on the revenue stream of the enterprise to ensure the repayment of the loans. Since equity participants take a higher risk, they typically demand higher returns than debt holders to invest in developing country projects. In the infrastructure sectors, projects with a large share of equity in the capital structure are usually not viable since the higher returns demanded by equity holders raise the price of the output beyond the local market's paying capacity. Therefore, infrastructure projects tend to be highly leveraged with debt-equity ratios in the range of 70:30 to 80:20. This means that they have a limited ability to adapt to changing market conditions. In view of this risk and the large proportion of debt in the capital structure of such projects, it is typically the willingness of commercial lenders to place debt for the project that determines its viability. IDA's participation, in the form of long-term subordinated debt, will lessen the transaction risks perceived by sponsors and lenders and facilitate the mobilization of senior commercial debt. 3.5 Subordination and Limits to PSIDC Funding. Private sector infrastructure projects in developed countries are financed with long-term debt that reasonably matches the long economic life of the assets. For power plants, maturities typically are in the range of 15 to 20 years while the financing for toll roads in some cases has extended as far as 40 years. In the case of Sri Lanka, commercial debt sources typically operate on terms of three to four years, extending to seven years in very special cases and often require government guarantees. These maturity terms do not match the typical financing profile of infrastructure projects, where capital costs are high, construction times are long and the projects do not generate sufficient cash flow in earlier years to service large amounts of short-term debt. In order to provide longer maturities (up to 12  -13- years), commercial lenders insist on export credit insurance coverage for sovereign risks. Other alternatives sources for long-term debt are IFC, ADB's private sector window, and CDC. The maturities of these loans tend to be in the range of 10-12 years. 3.6 For infrastructure projects, it is essential to structure at least a portion of the debt as loans of long maturity with a grace period in the earlier years of the project. Recovery of principal for the long-maturity loans commences after the bulk of commercial, shorter term debt is retired. Thus in order to provide maturities of 15 to 17 years, PSIDC would provide loans with maturities of up to 22 years and with grace periods of up to eight years. Maturities would be linked to the cash flow and construction periods of the subprojects, expected economic life of the assets and the maturities of senior loans. The inclusion of senior commercial debt in the financing package is important, since it lowers the overall financing cost of the project and brings to the project a high degree of commercial diligence, both to financing decisions and in structuring the security agreements. 3.7 The design of the project is significantly influenced by the experience gathered from a wide range of international project financing transactions. The main sources of financing for private infrastructure projects in Sri Lanka are likely to be export credit agency (ECA) guaranteed debt, A and B loans from IFC and, to a minor extent, loans from ADB and CDC. The extent of ECA coverage depends on the sourcing of the equipment and the country and project ceilings that various ECAs apply for risk management purposes.7 Direct loans from IFC, ADB, and CDC are subject to similar limitations. IFC's B loans are further subject to market limitations. For some smaller projects it might be possible to mobilize commercial debt with minimal PSIDC participation. However, for high-risk "first" projects in each sector, or those of a larger magnitude, the support of PSIDC financing is likely to be required. The project design envisages flexible participation by PSIDC with PSIDC playing the role of the "lender of last resort." PSIDC financing in any subproject would be limited to a maximum of 40 percent of total project cost. Thus, the overriding objective would be to maximize leverage of private capital sources and minimize PSIDC involvement. 3.8 Location and Governance. The design of the facility has been guided by two principles. Firstly, the facility would complement existing market sources of financing, i.e., equity and short- term commercial debt. Secondly, while respecting GOSL's important policy oversight role, the facility would be organized and operated in a relatively autonomous fashion. PSIDC would be professionally managed, equipped and empowered to make decisions on clearly established commercial principles at arms length from GOSL. The project preparation process extensively examined the viability of channeling IDA's funds through an existing financial institution, but the size of its potential loans were seen as incompatible with the current operation strategies of the existing institutions. The requisite size of the facility would have meant that the repository financial institution would violate its single borrowing and capital adequacy requirements. Furthermore, the option of having one of the two existing private sector development banks manage the fund was examined. However, a major objective of the proposed project is to involve these development banks in the mobilization of the senior local debt for subprojects. There is clear conflict of interest between the senior debt position and the subordinated debt position if either of the domestic development banks were to act as a A review of six recent private power projects in Pakistan showed that ECA financing ranged from 20% to 47% with an average of 34%. The situation for Sri Lanka is expected to be similar.  -14- contractor or agency for the Government in the placement of the subordinated debt. The option of having a commercial bank manage on a fee basis or contract base was explored. Possible conflict of interest with existing large customers and the involvement with public sector funds were cited as reasons why this type of arrangement was not appealing to the private banking sector. E. The Long-Term Debt Facility 3.9 Organizational Structure. PSIDC was incorporated as a public company in August 1995. It will be the executing agency for the project on behalf of GOSL. PSDIC will have available IDA and other donor funds, received from GOSL, to place in financially and economically viable infrastructure subprojects. PSIDC has the responsibility to identify. evaluate, approve and supervise suitable subprojects as set out in its Articles of Incorporation. PSIDC has been incorporated with a nominal share capital basis of 2,000 SLRs. All shares of PSIDC are held in trust for GOSL; the Secretary of Finance is the majority shareholder with 70 percent of the shares. Decisions on the allocation of PSIDC loans will be vested in the Board of Directors, who are appointed by GOSL, and would be taken in accordance with criteria agreed by IDA. Following approval by PSIDC and subsequently by IDA, PSIDC will enter into a subproject loan agreement with, and make loan funds available to, the sub-borrower. Funds designated for use as long-term subordinated debt and their repayment will be maintained in an account at the Central Bank of Sri Lanka (the Fund account). This account will be independent from PSIDC's operating account (OP a/c) which will be established only for meeting its day-to- day operating requirements. In accordance with normal practice, Government entities have the right to operate accounts with the Central Bank. PSIDC is expected to follow this practice and the Fund account is recommended to be housed in the Central Bank. The Central Bank has no special oversight functions with respect to the account. 3.10 The Board of Directors of PSIDC currently has a majority of non-civil servant directors. The GOSL confirmed that it will maintain this policy of a majority of non-civil directors over the life of the company. This will help insure the autonomy and creditability of the PSIDC in dealing with the international and local private sector. PSIDC's General Manager will serve as the Secretary of the Board of Company. The duties, legal authority and obligations of the Company have been set out in the draft of the subsidiary loan agreement (SLA) between GOSL and PSIDC. As a condition of effectiveness of the Credit, GOSL will enter into a legally binding SLA with the PSIDC that is satisfactory to IDA. Further, GOSL agreed that the operating procedures of the PSIDC will be set out in the SLA in such a way as to assure PSIDC's autonomy and give it the ability to function on a commercial basis. The procedures for staffing and for staff benefits are therefore expected to be comparable to existing private sector financial institutions currently operating in Sri Lanka. It was agreed at negotiations that this would be accomplished by September 15, 1996. 3.11 The financial resources managed under PSIDC will be supplemental to those existing resources available to Sri Lanka. PSIDC will work closely with sub-borrowers to make the most of traditional sources of project finance. Sub-borrowers will be encouraged to maximize the use of export credits and seek the assistance of IFC, the MIGA, ADB's private sector wing, the CDC and other similar purpose institutions when putting together the funding package for proposed projects.  -15- 3.12 PSIDC's operations will be directed by the General Manager with a small staff which initially will include a financial analyst, an accountant and an infrastructure project specialist. These professionals will be supported by consultants hired on a retainer basis to assist in legal, technical, financial and environmental aspects of subproject evaluation and financial risk assessment. Normally, reputable international firms with extensive experience from private sector infrastructure projects would be employed. The Manager will be supported by a long- term resident advisor who will help coordinate all activities and identify the need for the short- term subject specialists. Loan disbursements and collections will be handled by accounting experts within PSIDC. The Government agreed that the evaluation of the proposals for the shortlisted consultants would be completed by September 1, 1996, and the award of this contract would be accomplished by October 1, 1996. The long-term advisor is expected to be in place by January 1997. 3.13 Subproject Eligibiity Criteria. Subproject processing will be carried out by PSIDC's General Manager and his staff under the overall direction and control of the Board of Directors. PSIDC will approve subprojects for financing only after ensuring that the proposals are consistent with Sri Lanka's national priorities. In particular, PSIDC would ensure that policy and regulatory frameworks for private sector participation that would take account of end user benefits would be in place.8 The subprojects will meet technical, economic, financial and environmental viability criteria and national or IDA environmental standards (including criteria for involuntary resettlement, should it arise) in case of IDA-supported subprojects.9 Ordinarily the question of a subproject being compatible with national planning priorities will be examined by the line ministries and BID before being recommended for financing. In fact the Letter of Intent (LOI) issued by GOSL, which forms the basis of the project financing, implies that the subproject has met all national criteria. However, it is still incumbent on PSIDC to examine the proposed private sector subproject in this regard. The subproject eligibility criteria that have been agreed to by Government for projects to be financed by PSIDC are set out in Box 3. 3.14 Subproject Approval Procedures. PSIDC has two points for project approval. Early on in the process, the subproject sponsor submits a loan application to PSIDC. At this time the GM will carry out a preliminary assessment to ascertain if the subproject is likely to meet the eligibility criteria for PSIDC funding. This early vetting will be done is association with IDA. As the subproject develops, PSIDC's staff will prepare an appraisal report. To assist with these due diligence processes, PSIDC will employ reputable international legal, financial, environmental and technical consultants. At this time, the PSIDC will be involved with the detailed discussions of the Security Package (SP). During negotiations, the Government agreed to the generic conceptual framework as described in the SP for the undertaking of privately supported subprojects in the infrastructure sector. The appraisal report, along with a recommendation to make a loan, will be forwarded by the General Manager to the Board of Directors, who will be responsible for sub-loan approvals. In order to ensure that the subprojects meet IDA's requirements regarding quality and viability, the appraisal report prepared by PSIDC will be reviewed and approved by IDA. IDA's approval is a condition of disbursement of the sub-loans. Once the recommendation of a sub-loan is accepted, the General Manager and staff, including consultants, will be responsible for loan documentation and negotiation, as well as Table 2 sets out a list of regulatory and policy frameworks at various stages of preparation for different subsectors. See Annexes 5 and 6 on the Environment and Social Assessment Framework for the project.  -16- supervision, monitoring and fulfilling reporting and auditing requirements. The sub-loan approval process is set out in Box 4. Box 3: Subproject Eligibility Criteria *: GOSL 's Priority Plan: Public and private sector investments should form an integral part of the priority plan for the relevant subsector. This would also ensure that public and private investments are complementary. * Regulatory and Policy Framework: Policy and regulatory frameworks for private sector participation that adequately protect benefits to end users should be in place: before subproject approval. * Uset of Proven Technologies: The technology proposed for a project should have a track record of demonstrated success in countries at a similar level of technological development and infrastructure support, as in Sri Lanka. * Viability: Sponsors should possess a proven capability to develop, finance and operate the infrastructure projects in countries at a similar level of development as Sri Lanka. To ensure commitment, sponsors equity would need to represent at least 20 percent of the project cost with the main project sponsors holding a minimum of 35 percent of the equity for at least five years after start up of commercial operations. * Limited Recourse Financing: Private investors and lenders should not require direct. sovereign guarantees. Lenders should rely on the security package (see Annex 2), future cash flows from the project and the value of the assets for comfort. The debt; financing must include some portion of non-recourse commercial senior debt. PSIDC will not cover more than 40 percent of the project's total costs. * Economic Rate of Return: The economic rate of return will exceed 12 percent and, where applicable, the subprojects will form part of the least-cost development plan. * Environment and Social Assessment Criteria: All projects will necessarily meet GOSL's environmental and social assessment criteria as set: out in the National Environmental Action Plan as well as IDA's environmental and social assessment;; guidelines. Source: Annex 1, 5 and 6 F. Financial Arrangements 3.15 Lenuding Tern,. GOSL will pass through all credits from donors to PSIDC on the same terms as the original credit. Thus, IDA funds placed in PSIDC would carry an interest rate of 0.75 percent per annum and a maturity rate of 40 years, including a grace period of 10 years. However, the loans to PSIDC would be denominated in US dollars and, in the case of the IDA credit, GOSL would take the SDR - US dollar exchange rate risk (see para. 3.22-3.23). PSIDC will provide debt to sub-borrowers in US dollars and will arrange for loan maturity periods not  -17- exceeding 22 years, including a grace period of up to 8 years. Maturities and grace periods will be determined on a case-by-case basis taking into account the nature of the subproject. Interest during construction would be capitalized and form part of the financing provided by PSIDC to subprojects. In order to protect PSIDC's cash position during the start-up period, the loan from GOSL to PSIDC would have a five-year moratorium on the payment of interest. Box 4: Sub-Loan Approval Process Summary * GOSL issues a Letter of Intent (LOI) to the selected Private Project Company. . The Private Project Company submits a Loan Application to PSIDC together with the Loan Application Fee. * The General Manager (GM), in collaboration with IDA, will carry out a preliminary assessment based on the information received in order to ascertain the eligibility of the subproject by PSIDC. . The GM will submit a recommendation to the Board of Directors to accept the loan applications and for the authorization to commence negotiations. . If the Board of Directors clears the operation, the GM will issue a Preliminary Acceptance Letter (PAL) to the Private Project Company including a draft-term sheet and sub-loan agreement. . The Private Project Company will convey their acceptance of the PAL and deposit the Sub-loan Appraisal Fee . If the proposal was unsolicited, the Private Project Company will complete the project's Feasibility Study in accordance with the LOI and the PAL. * The GM, supported by consultants, will participate in the negotiations of the Security Package (SP) with the Private Project Company. * At the same time, preliminary negotiations of the Sub-loan Agreement will take place and be evaluated by the GM, supported by consultants. . Once the SP is initiated, the GM will undertake the subproject appraisal and prepare an Appraisal Report including Due Diligence. . The GM will seek approval of the loan by the Board of Directors.