Uruguay - Power Sector Rehabilitation Project

Document of The World Bank FOR OFFICIAL USE ONLY /xA &42.>- 0/C Report No. P-4140-UR REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INrERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN IN AN AMOUNT EQUIVALENT TO US$45.2 MILLION TO ADMINISTRACION NACIONAL DE USINAS Y TRASMISIONES ELECTRICAS TO BE GUARANTEED BY THE REPUBLICA ORIENTAL DEL URUGUAY FOR A POWER SECTOR REHABILITATION PROJECT September 6, 1985 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCf'EQUIVALENT Currency Unic = New Uruguayan Peso (NUr$) NUr$100.0 (6/30/85) US$1 WEIGHTS AND MEASURES 1 mecer (m) = 3.281 feet (ft) 1 cubic meter (m3) = 35.315 cubic ft (ft3) = 264.2 gallons (gal) = 6.290 barrels (bbl) 1 kilogram (kg) = 2.206 pounds (lb) 1 ton (r; metric; 1,000 kg) = 1.100 short tons (sh. tons) 1 kilowatc (kW) = 1,000 Watts (103 W) 1 Megawatt (MW) = 1,000 kW {(10 kW; 106 W) 1 kilowatt hour (kWh) = 1,000 Wact hours (103 Wh) = 830.3 kilocalories (kcal) I Gigawact hour (GWh) = 1,000,000 kWh (106 kWh) 1 kilovolt (kV) = 1,000 Volts (103 V) I Megavolt ampere (MVA) = 1,000 kVA (106 VA) 1 kilocalorie (kcal) = 3.968 Bricish chermal units (Btu) = 4,186.8 Joule (J) 1 Hertz = I cycle/second =. .per... .- = ... ...per second; ... per hour h= ...Is; ..Jh ...per day; ... per year /a= .../d; ./a GLOSSARY OF ABBREVIATIONS ANCAP = Adminiscracion Nacional de Cementos, Alcoholes y Portland (National Petroleum Company) ANTEL = Administracion Nacional de Telecomunicaciones (National Telecommunications Company) COMIPAL = CDmision Mixta de Palmar (Mixed Commission of Palmar) CTM = Comision Tecnica Mixta de Salto Grande (Mixed Technical Commission of Salto Grande) EdeF = Electriciee de France IDB = Inter American Development Bank MIE = Ministerio de Industria y Energia (Ministry of Induscry and Energy) UTE = Administracion Nacional de Usinas y Trasmisiones Electricas (National Power and Transmission Company)  FOR OFFICIAL USE ONLY URUGUAY UTE - POWER REWABILITATION PROJECT Project Su"mary Borrower: Administracion Nacional de Usinas y Trasmisiones Electricas (UTE) Guarantor. Government of Uruguay Amount: US$45.2 million equivalent Terms: Repayment in 15 years, including 3 years of grace, with interest at the Bank standard variable rate. Project Description: The project consists of the following components: (a) rehabilitation of the 128 NW Gabriel Terra hydro plant; (b) extension of the 500 kV transmission system to the eastern part of the country; (c) extension of the 500 kV and 150 kV transmission systems in Montevideo; (d) remodeling and upgrading the 30 kV underground network in - Montevideo; (e) and consulting services for project management and supervision. Benefits and Risks: The proposed project would help meet Uruguay's power needs with lower fuel consumption, improved system reliability and a higher degree of operational efficiency of the instaLled capacity. Should cofinancing be delayed, or not materialize, the ensuing delays in transmission and distribution investments would reduce the proposed gains in system reliability. A delay in the execution of these components, however, would not affect the benefits from more efficient hydropower generation which would be supported by the proposed A-Loan. The project does not present major technical risks. . This docunent has a restried distribution and may be used by recipients only in the perfonmance of tleir official duocs. Its contents may not otherwise be disclosed without World Dank authorization.  - ii - Estimated US$ Million Project Costs: Local Foreign Total 1. Rehabilitation of the 128 MW Gabriel Terra hydro plant 2.6 21.8 24.4 2. Expansion of the 500 kV Transmission System to the East 9.8 7.9 17.7 3. Expansion of the 500 kV and 150 kV Transmission System in Montevideo 11.2 15.7 26.9 4. 30 kV Distribution in Montevideo 2.8 6.2 9.0 5. Project Management and Supervision 1.6 3.2 4.8 Total Base Costl/ 28.0 54.8 82.8 Physical Contingencies 1.8 4.3 6.1 Subtotal 29.8 59.1 88.9 Price Escalation 10.6 21.0 31.6 Total Project Cost 40.4 80.1 120.5 Interst during Construction - 17.6 17.6 Total Financing Requirements 40.4 97.7 138.1 Financing Plan: Millions of Current US$ Component A-Loan B-Loan UTE Total Gabriel Terra Rehabilitation 37.1 - 4.4 41.5 Transmission and Distribution - 43.0 36.0 79.0 Interest During Construction 8.1 9.5 - 17.6 45.2 52.5 40.4 138.1 Estimated Bank FY Disbursements: 1986 1987 1988 1989 1990 1991 1992 1993 Annual 1.60 4.85 8.10 10.00 9.40 7.00 3.50 0.75 Cumulative 1.60 6.45 14.55 24.55 33.95 40.95 44.45 45.20 Rate of Return: 11.9X on UTE's investment program. Appraisal Report: Report No. 5833-UR - September 4, 1985 Map8: IBRD Nos. 19257 and 19258 1/ At June 1985 prices. Includes taxes (16Z) and import duties (10%).  INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN OF USS45.2 MILLION TO ADMINISTRACION NACIONAL DE USINAS Y TRASMISIONES ELECTRICAS TO BE GUARANTEED BY THE REPUBLICA ORIENTAL DEL URUGUAY POWER SECTOR REHABILITATION PROJECT . 1. *I submit the following report and recommendatfon on a proposed loan to the Administracion Nacional de Usinas y Trasuisiones Electricas (UTE) with the guarantee of the Uruguayan Republic for the equivalent of US$45.2 million to help finance a Power Rehabilitation Project. The loan would have a term of 15 years, including 3 years of grace, at the Bank standard variable interest rate. PART I - THE ECONOMY 2. An Economic Memorandum (No. 3652-UR) was distributed to the Executive Directors in March 1982. An economic mission visited Uruguay in April/May 1985, and its report is in preparation. The following paragraphs summarize recent developments. A summary of Country Basic Data is attached as Annex 1. Background 3. Uruguay was one of the most prosperous countries in Latin America in the first half of the twentieth-century. This achievement initially was the result of an outward-oriented trade policy based on beef and wool exports and, later, of import-substitution stimulated by the shortage of consumer goods during the Second World War and the immediate post-war period. However, the small domestic market offered only limited opportunities for import-substitution, which were exhausted by the early 1950s. The industrial sector that developed was not competitive; it was composed of small and medium-sized, inefficient plants producing under tariff protection and depending on imported inputs. On the other hand, a predominantly urban and highly literate population demanded higher wages and increasing social benefits and expanded public services. Comprehensive welfare legislation was enacted providing a broad range of benefits. This required a sustained transfer of income from the livestock sector to the rest of the economy, which was achieved through fiscal, exchange rate, price, and trade policies, at a time when the external demand and prices for wool were declining. The economic and social environment discouraged  growth, and particularly stifled export-oriented production, leading to a sharp deterioration in the country's external accounts. Exports in 1960 vere roughly at the 1945 level while iuports had increased sharply. Consequently, Uruguay's economy deteriorated steadily in the sixties and early seventies. Political and social unrest were compounded by the adverse economic effects of the oil price shock in 1973. The ensuing crisis forced the country into a fundamental reappraisal of its basic economic strategy. 4. The inward-looking policies of the preceding half century, and the loss of fiscal and monetary discipline, were seen by the economic leadership that took office in 1974 as major contributing factors to the prolonged economic stagnation and periodic balance-of-payments crises. During 1974-78, efforts were made to reverse the historic import-substitution bias of macro-economic policy in favor of greater integration with world markets. Export growth accelerated under the impetus of new incentives, including subsidies and state-supported credits to non-traditional exports, frequent devaluations, liberalized drawback facilities, and a streamlining of administrative processes. Import licensing restrictions were discontinued, and tariff rates were somewhat reduced, with the maximum tariff rate declining from 346% in 1974 to 180% in 1977. Investment was stimulated by phased reductions in price controls, expanded fiscal incentives, liberalization of the foreign investment regime, and decontrol of financial and foreign exchange markets. In spite of the rise in oil prices and the fall in the dollar prices of beef, economic performance changed dramatically. Between 1974 and 1980, real fixed investment and exports of goods grew by 18% and 19% a year, respectively. Exports to other Latin American countries, particularly Argentina and Brazil, played a major role in this expansion. Overall .output increased by nearly 5% annually, the highest average rate in a quarter of a century. Unemployment fell from over 12% in the mid-1970s to 5.8% in the first half of 1981. The budget deficit was progressively reduced. Tnflation came down from a historical peak of 107% in 1974 to 46% in 1978. Nevertheless, the authorities were not satisfied with the progress made in reducing inflation and raising the technical and managerial efficiency of domestic industry. 5. In late 1978, a comprehensive policy package was instituted. Most price controls were eliminated, including those on live cattle and beef, to promote expanded production. Financial market deregulation was accelerated. Interest rate ceilings were eliminated, and restrictions on financial intermediaries were dismantled. Believing that monetary policy was ineffective in regulating a small, open economy, the Central Bank also withdrew from active management of the domestic money supply: open market operations were halted, and banking reserve requirements eliminated. In the absence of controls on capital movements, the Government expected that domestic interest rates would converge quickly with foreign rates adjusted for depreciation of the peso, assuring a continuous source of credit on reasonable terms. In addition, labor mobility was increased by the creation of a unified social security fund, and payroll taxes were reduced in favor of Government transfers out of general revenues. To improve the  competitiveness of industry, the maximum global import tariff was lowered to 116% in 1979, and it was announced that this level would be reduced, in annual stages, to 35Z by January 1, 1985. To curb inflationary expectations, the US dollar/peso exchange rate, officially-mandated salaries and public utility tariffs were announced several months in advance at rates of adjustment well below the prevailing rate of inflation. The advance announcement of salary and utility rate increases was discontinued in 1979, but was maintained for the exchange rate until November 1982. The pre-announced exchange rate schedule continued to be set at less than the difference between domestic and world inflation. 6. Although the policy package's initial impact was contrary to expectations (prices nearly doubled in 1979), inflation subsequently fellt rapidly. However, the inconsistencies of the policy reform pulled the economy in opposite directions and led to a major crisis, the consequences of which are still being felt by Uruguay. The reforms were expected to raise the profitability of export production vis-a-vis import substitutes and non-tradeables. Although inflation eventually fell, however, it remained substantially above the pre-announced rate of devaluation, generating a severe cost-price squeeze that eroded the competitiveness of export production. Financial liberalization, combined with the legalization of foreign currency deposits, attracted large foreign capital inflows, which financed high levels of imports and permitted domestic expenditures to far exceed production. These inflows also contributed to the appreciation of the real exchange rate and exacerbated the adjustment difficulties of domestic producers struggling to export and to compete with imports. The exchange and interest rate policies, together with the legalization of dollar deposits, also made excessive borrowing and investing in financial assets and speculative activities attractive, while discouraging productive investments. 7. GDP growth fell steadily from 6.01 in 1980 to 1.9% in 1981 and -8.4% in 1982. Unemployment in Montevideo doubled from the first half of 1981 to the second half of 1982. Nominal dollar merchandise exports slowed from 34% in 1980 to 15% in 1981, and turned into a decline of 161 in 1982. The non-financial public sector fiscal balance shifted from a surplus of 0.3% of GDP in 1980 to deficits of 2.3% in 1981 and 10.2% in 1982. The Central Bank also incurred major quasi-fiscal losses associated with a variety of subsidized credit operations, equivalent in 1982 to about 8% of GDP. The current account balance of payments showed large deficits totalling over US$1.6 billion for 1980-82, which were financed with the large inflows of foreign funds. Finally, Uruguay's external accounts registered an overall deficit of US$800 million during 1982, in spite of large commercial borrowings abroad. Stabilization Programs and Recent Economic Developments 8. It became obvious that these economic policies could not be sustained, as confidence in the pre-announced devaluation schedule had eroded and capital flight accelerated. In late November 1982, the Government abandoned, therefore, its exchange rate strategy, announcing  that the rate would be freely determined by market forces. The 1983 average rate of around UR$34/US$1 implied a nominal peso depreciation on the order of 60% relative to the US dollar parity quoted just prior to the float. The Government also introduced sweeping changes in salary, fiscal, monetary, trade and external debt management policies designed to reduce rapidly the size of the public sector deficit, to correct distortions in relative prices, and to halt the dangerously high losses of foreign exchange. The Government program called for a sharp reduction in the deficits of the non-financial public sector, a scaling down of official external borrowing, a deceleration of central bank credit growth, and improved resource allocation through a freely floating exchange rate, changes in the trade system, and realistic pricing of public sector goods and services. The IMF supported the Government's stabilization program with a stand-by arrangement. Shortly after approval of the stand-by, Uruguay and its commercial banks creditors agreed to reschedule US$575 in million principal obligations falling due in 1983 and 1984, and to provide fresh financing of US$230 million. 9. During 1983-84, the economic recession continued; real GDP declined an additional 7%. Nominal dollar exports decreased 10%, and fixed investment dropped 46Z. Real wages deteriorated sharply, and unemployment remained high at 13Z. Nevertheless, the deficit of the non-financial public sector was reduced by more than a half (from 10.2% of GDP in 1982 to 4.6% in 1984), resource allocation was improved via a 442 real depreciation of the exchange rate (with respect to that of November 1982), the deficit of the current account balance of payments was reduced (from 8.1% of GDP in 1982 to 2.3% in 1984), and the loss of foreign exchange reserves were substantially diminished (from US$800 million in 1982 to US$50 million in 1984. Public enterprise tariffs were raised, public sector wages and social security benefits were scaled-down in real terms, and a new tax package was adopted in June 1984. In addition, to reduce the Central Bank losses, which originated mostly from the assistance to the National Housing Bank and on the service of the external debts associated with purchases of the non-performing portfolios of commercial banks, the authorities stopped remunerating legal reserve deposits. Nevertheless, the 1983 program did not achieve its major stabilization aims. Weaknesses in 'inancial policy management, uncertainties related to the presidential elections, lower-than-anticipated levels of economic activity and imports, and flagging confidence caused by difficult conditions in the region generally, combined to slow the rate of adjustment. Inflation exceeded the levels projected in the program. Substantial private capital flight also took place, which exacerbated the shortage of liquidity. 10. The combined deficit of the Central Bank and the non-financial public sector (16% of GDP in 1983 and about 10% in 1984 compared with 18% in 1982) remained incompatible with reducing inflation, decreasing reliance on external savings, and promoting economic recovery. Uruguay's inability to comply with the stand-by program's fiscal targets led to an interruption of drawings at the end of 1983. Although the outgoing Administration made serious efforts towards the restoration of external and internal equilibria during 1984, it did not meet the targets the Fund had set for a new stand-by. A request for IMF support was postponed until the new Administration took office on March 1, 1985.  - 5 - 11. The new Administration took steps to arrest the economic deterioration in public finances that had taken place duing the transition period from military to democratic rule. Public enterpr:se tariffs/prices were hiked 30% in April to recover the ground lost in the first months of 1985, and fuel and taxes were increased sharply. It requested the IMF support in April for a comprehensive policy package to reduce inflation, control public finances, and bring about an economic recovery, and it began work on a program for structural changes designed to provide a stable policy framework for sustained export and GDP growth over the next five years. 12. The Government and the Fund have reached agreement in principle on a stand-by arrangement. The program, which is expected to be approved by the IMF Board in September 1985, aims at reducing the rate of inflation to 60Z during the period July 1985 to June 1986, and at diminishing the current account balance of payments deficit. The agreement calls for a reduction of the public sector deficit (including the Central Bank losses) from an estimated 10.6Z of GDP during July 1984-June 1985 to 5.8% of GDP dt::ing the July 1985-June 1986 period. This will require tax measures equivalent to about 2.5 percentage points of GDP - which already have been enacted -, public enterprisest tariff increases of about I percentage point of GDP, and a 10% reduction of public expenditures in real terms. External financing is expected to cover about two-thirds of the fiscal deficit. On the basis of the stand-by arrangement, the Government is negotiating with the commercial banks a multi-year rescheduling of principal payments falling due in the 1985-89 period, together with the fresh financing for about US$150 million, including a mediur-term money facility of USM5O million. 13. The Government is also working on the main structural changes needed by the Uruguayan economy. The expected components of a reform program are: industrial sector reform (including rationalization of the trade regime and financial restructuring of manufacturing firms), which is a major challenge to the success of the Administation's policies; improvements in tariff/price policies of public enterprises as well as in public investment programming and budgeting; and rationalization of both the social security and the tax systems. Medium-Term Prospects 14. The Uruguayan Government is attempting to establish a basis for renewed growth in an environment of price stability. The stabilization program should set the stage for a 2% projected GDP growth in 1986. Furthermore, the Government fully recognizes that prospects for sustained economic recovery are closely linked to the effectiveness of policies to promote export growth and to rationalize the trade regime. In addition to the measures undertaken to restore internal and external equilibria, the authorities have indicated their intention to institute a policy and incentive framework geared to expand exports. This framework includes a freely-floating exchange rate, strengthened export incentives, and a renewed commitment to reduce effective protection. It is notable that, notwithstanding increases in restrictive practices elsewhere and in the  - 6 - region and a difficult short-term situation, Uruguay has maintained freedom of exchange transactions on both balance of payments and capital accounts. The Government is also planning to support a financial restructuring of firms, which have suffered from past exchange and credit policies, to reactivate their productive capacity, particularly those that produce for export. Financial assistance will be provided for equipment modernization, working capital, and improved product quality. Given the experience with previous stabilization efforts, further actions to strengthen public finances and reduce inflationary pressures, including improvements in tariff/price policies of public enterprises and public investment budgeting practices, are under consideration. Assuming a moderate sustained growth in the developed countries, no major increases in international interest rates, and continued Uruguayan progress toward improved demand management policies, the country has the potential to grow during 1987-90, at average rates similar to those of the mid-1970s. 15. Exports of goods are expected to grow at about 51 a year during 1985-90, with the current account deficit of the balance of payments declining to less than 1X of GDP in 1990. While export-oriented growth is not new to Uruguay, the effort to expand exports that is now required must be considerably more intensive than in the past to ease the severe constraint on growth imposed by the high external debt service. Servicing the debt will require a large share of domestic savings. As noted earlier (para. 12), a stand-by arrangement, a multi-year commercial banks'debt rescheduling, and the provision of fresh funds are expected to be in place soon. The anticipated debt rescheduling would reduce the projected 1986 debt service ratio from 551 of exports of goods and services to 37Z. The ratio is projected to fall further to 29Z by 1989. Given Uruguay's demonstrated readiness to adopt the policies needed to enable it to service its external debt, the country is considered creditworthy for the amounts of external financing proposed. PART II - BAlK OPERATIONS IN URUGUAY 16. As of March 31, 1985, the Bank had made 23 loans to Uruguay, amounting to US$496.0 million, of which 10 are not yet fully disbursed. The undisbursed amount as of March 31, 1985 was US$193.6 million. Annex II contains a summary statement of Bank loans. At the end of 1984, the Bank held 5.2% of Uruguay's external public debt outstanding; its share -z the service on this debt in 1984 was 6.6Z. As of March 31, 1985, IFC had committed in Uruguay a total of US$27.8 million for five projects, of which US$22.6 was in loans and US$5.2 million in equity. The total undis~9e portion (all under the loan category) was US$8.0 million. 17. Performance of Bank supported projects in Uruguay is generally satisfactory for repeaters, such as in the highway sector. Despite delays, it is expected that the Second Highway Project will be fully disbursed  - 7 - within six years compared to the Bank LAC average of seven years. Operations in new sectors have experienced initial delays, mostly because it has taken the Government longer than expected to comply with institutional covenants and because executing agencies have needed more time than anticipated to become familiar with Bank procedures. These factors have adversely affected the execution of operations in the education, ports, and telecommnications sectors. By and large, these problems havre been solved with increased supervision, and disbursements should proceed satisfactorily. Disbursements of the agricultural and the industrial credit operations have been adversely affected because of the economic recession in Uruguay. Meanwhile, in the absence of alternative lines of medium and long term credit, there has been considerable recent improvement in commitment levels under the industrial credit. 18. The new Uruguayan Government has embarked upon a comprehensive stabilization program to reduce inflation, strengthen the balance of payments, improve public sector finances, and reactivate the economy, which is supported by a stand-by arrangement for SDR 122.85 million. Apart from continuing strengthening public finances and controlling inflationary pressures, Uruguay's highest development priority is to increase exports and to improve resource allocation. Progress in this area will require improvements in export incentives and continuing the tariff liberalization process, followed by reductions of non-tariff barriers, and speeding up of the restructuring and modernization of production facilities. Bank lending, through two industrial credit operations, has provided critical support to the Government's program to lower import barriers and reduce price controls. The Government has requested Bank assistance to strengthen Uruguay's export capacity, restructure the finances and modernize industrial enterprises, improve public investment and budgeting processes, and rationalize the social security system. The Bank is prepared to support the Government reform programs in these areas. 19. Second, Uruguay has not yet achieved the degree of institutional development required to assure self-sustaining growth. In addition, its upper and middle management, in both the public and the private sector, need also to be adapted to the more pragmatic needs of a more open economy. Some significant progress in these areas has been made, however, with the help of the Bank. Power, telecommunications, and ports projects supported by Bar loans are gradually improving operations of three of Uruguay's oldest and most poorly managed agencies. Longstanding assistance to the livestock sector has been instrumental in establishing a high-quality extension service. Two recent industrial credit projects have led to the establishment of an independent appraisal unit. Bank lending for highways has enhanced transport planning capability. An ongoing Bank supported vocational training and technological development project is also helping to address the country's needs for trained manpower. Nevertheless, institutional capacity and management training need further strengthening. Future operations in the energy, water supply, and, possibly, railways sectors would emphasize strengthening management capabilities and planning processes, and reducing operating costs.  -8- 20. Finally, agriculture is and will continue to be the mainstay of Uruguay's economy. The sector's contribution to GDP and employment is relatively modest, but it is of crucial importance as a foreign exchange earner and a supplier of raw materials to domestic industry. The Bank has hitherto concentrated on the livestock sector, particularly on strengthening producer incentives, credit availability and ranch management. The Bank has also been instrumental in setting up a solid extension/appraisal institution, and, through the recently approved Agricultural Sector Loan, in supporting increased exports of livestock and livestock products, reducing price distortions, and improving regulatory agencies. Future Bank involvement in agriculture will shift towards the crop subsector, with particular attention to intensified livestock/crop rotation techniques, more effective export promotion mechanisms, better crop-oriented research services, and a more comprehensive crop extension network. Projects under consideration would be geared to helping stabilize producer incomes, enhancing productivity, and reducing soil erosion. PART III - THE ENERGY SECTOR Energy Resources 21. Uruguay has been one of the Latin American countries hardest hit by the energy crisis. In 1984, oil imports amounted to about US$260 million or 28Z of export earnings. Pricing and taxation policies for oil derivatives have aimed at reducing consumption. Domestic prices exceed international levels. The price of gasoline is equivalent to about US$2.8/gallon while the price of diesel oil is equivalent to US$1.7/gallon. Lower taxes have been levied on diesel oil to avoid a negative impact on the competitiveness of domestic industry and agriculture. Because of these policies, additional conservation efforts and a slowdown in economic activity, demand for oil products has fallen significantly since 1979, while the use of electricity has risen by nearly 4Z per year. 22. The countryts energy resources are limited: it does not have known oil or gas reserves and only small reserves of coal (with a high ash content and low calorific value). There are some oil shale and peat deposits, and there is an insignificant amount of fuelwood. Hydropower resources are few and, by and large, either already utilized or not economical to develop at present fuel prices. Within the past six years two large hydroprojects have come into operation: Salto Grande and Palmar. Salto Grande (1,890 MW) is a binational project shared with Argentina. It is located on the Uruguay River and started commercial operations in 1979. At present Uruguay is entitled to 315 MW of Salto Grande's output but it may exercise options to gradually increase its share to 945 MW by 1995, Palmar (330 MW), located on the Rio Negro, started operations in late 1982, and has been in full operation since early 1983. The total present installed capacity in Uruguay is 1,282 MW, of which 881 MW (68Z) are provided by hydro resources and 401 MW (32%) by thermal  - 9 - resources. Because of very favorable hydrological conditions during 1984, UTE was able to meet most of the demand for electricity with hydro generation, keeping its thermal installations as reserve. Energy Sector Organization 23. Most of Uruguay's energy sector is state controlled, and electric power policy is determined by the Government, through the Ministry of Industry and Energy (MIE). The most important operating entities are the national petroleum company, Administracion Nacional de Cementos, Alcoholes y Portland (ANCAP) and the power company, Administracion Nacional de Usinas Y Trasmisiones Electricas (UTE). Electricity rates are approved by Presidential decree; the Ministry of Economy and Finance and the Planning and Budgeting office help determine their levels, with primary decision-making powers vested in the latter. 24. UTE (paras. 45-50) is organized as an autonomous public entity (its Board of Directors is appointed by the Government) but its operations are subject to legal and administrative constraints. UTE's budget has to be approved by the Planning and Budgeting Office, which places legal ceilings on the company's investments and expenditures. The Government auditing agency (Tribunal de Cuentas) is responsible for ensuring that UTE complies with budget and procurement legislation. 25. The only other entity that now operates in the power sector is the Ccmision Tecnica Mixta de Salto Grande (CTM). CTM was created in 1946, and is an international organization governed by a Board composed of four Argentine and four Uruguayan members, all appointed by their respective Governments. CTM4 has built the Salto Grande hydroplant (para. 22), and is responsible for its operation. CTM's bulk rates for the sale of electricity are expected to decrease starting from 1992. Another entity, Comision Mixta de Palmar (COMIPAL) was created in 1973 to build the El Palmar hydroplant; after its completion, El Palmar was transferred to UTE and COMIPAL was dissolved by Law 15.700 of January 10, 1985. Energy Planning 26. Formally, the Ministry of Industry and Energy (MIE) is responsible for long-range planning. After the 1973 oil price increase, the Direccion Nacional de Energia was formed within the MIE to deal with sector policies, but has not yet been able to play a significant role. So far no systematic energy planning has been carried out, and the Government has not defined a comprehensive energy policy. 27. A recently completed Energy Sector Study (supported by the Bank, para. 35) identified the technical and administrative assistance needs of the MIE, proposed changes to its organizational structure, and made recommendations to complete the data base required for the preparation of a National Energy Plan. The Government has agreed (Loan 2484-UR) that it would furnish to the Bank an action plan to implement the Study's  - 10 - recommendations, including the timetable for the preparation of a National Energy Plan, and that it would start carrying out the action plan by December 31, 1985, after taking into account the Bank's comments. The Power Market 28. Over the last five years, power demand has grown at a faster rate (8.9% p.a.) than energy demand (5.3% p.a.) reflecting a decrease in the load factor and inefficient use of installed capacity. Implementation of a revised tariff structure based on marginal costing, the first phase of which is being financed by the Bank, is expected to reverse this trend and improve the load factor. During the same period, industry's share in the market fell from 39% to 33% while supply to residential users increased from 43Z in 1979 to 48% in 1984. The growth pattern of generation by different sources (hydro, thermal and purchase) has changed significantly. The share of hydrogeneration increased from 46% in 1979 to a peak of 97.6% in 1984, which was a year of unusually favorable hydrological conditions. This trend is the result of the commissioning of the Salto Grande and Palmar hydro plants in late 1979 and 1982 respectively, and of new construction of transmission lines to the interior, where isolated areas of the country were incorporated to the interconnected system. 29. UTE delivers electricity to its consumers through a transmission system of 2,809 kms operating at 500 kV, 150 kV, 110 kV, and 60 kV, a primary distribution system of 14,800 kms operating at 30 kV, 15 kV, and 6 kV, and a secondary 220 kV distribution system comprising 10,900 kmi. The system includes 32 substations (transmission level) with a total installed capacity of 1,890 flVA and 158 substations (primary distribution level) with a total installed capacity of 1,206 MVA. UTE has operated and maintained its facilities efficiently. However, the distribution system, particularly in the area of Montevideo, is old and its reliability is not as great as that of the transmission and subtransmission system. UTE's investment plan therefore provides for expansion and improvement of the primary and secondary distribution system. Furthermore, with Bank assistance, UTE will carry out a comprehensive distribution system study including an analysis of opportunities for loss reduction at medium and low voltage levels. Energy Capacity Balance 30. Forecasts based on regression analyses of demand for the principal consumer categories during 1965-1984, indicate that aggregate sales would grow from 3,019 GWh in 1984 to 4,283 GWh in 1993. The average annual increase of slightly below 4% is close to the trend over the last five years. Montevideo's demand is expected to grow slightly faster than that of the country as a whole. The results of simulation studies, based on hydrological conditions over a 70-year period (1908-1978) and very conservative reliability criteria, indicate that additional thermal generating capacity would be needed by 1989 in order to meet projected demand. The present investment program does not provide for additional generating capacity, however, pending completion of an Operation Planning Study (para. 36).  - 11 - 31. Under this Study, a comprehensive review of UTE's present interconnected system model and practices will be carried out to ensure effective utilization of existing facilities at a satisfactory level of reliability under dry year conditions. Should the review establish that demand would exceed reliable generating capacity during the planning period, it might be more economical to exercise the option for increasing Uruguay's share of Salto Grande's output (para. 22) Power Sector Objectives and Strategy 32. Since the oil price increases in the early 1970s, the Government's key objective has been to reduce Uruguay's dependence on imported fuel. In the power sector, its strategy has been aimed at substituting hydro for thermal generation. The potential for this substitution has now been substantially achieved with the construction of the Salto Grande and El Palmar hydroplants. A generation development study through the year 2000 made by independent consultants has shown that none of the small hydro projects that have been identified can compete with conventional thermal plants. Thus, future fuel savings will have to be achieved through more efficient operation of UTE's generating plants and distribution systems, loss reductions, and improved system planning and demand manaement through pricing policies which take marginal costs into account. Bank Participation in the Sector 33. The Bank has made six loans to Uruguay's power sector for a total of US$110 million (1950, Loan 30-UR; 1955, Loan 132-UR; 1956, Loan 152-URB 1970, Loan 712-UR; 1979, Loan 1779-UR; and 1984, Loan 2484-UR). The first four loans have been fully disbursed. Achievements under the earlier projects could not be sustained during the 70s, a period of severe social conflict and dislocation, when the operation and finances of the power sector deteriorated badly. The Project Performance Audit Report (SecM78-867 of November 29, 1978) notes that progress towards meeting institutional objectives under the Fourth Power Project was slow and generally disappointing and that UTE did not comply with sooe of the loan covenants. 34. The Government and the Dank made a fresh start to rehabilitate the sector with the Fifth Power Project in 1979. In preparation of a new project, the Bank Loan carried out a comprehensive review and recommended various measures to strengthen the sector and improve UTE's performance. Agreement in substance with the Government on all major issues led to the Fifth Power Project Loan 1779-UR). The Government passed a new Electricity Law and its corresponding regulations, approved new by-laws and institutional arrangements for UTE, and set up a mechanism to allow automatic tariff increases when input costs increase. Furthermore, under the project, UTE set up a planning department and engaged consultants to improve internal operations, to develop a long-range generation expansion plan, and to provide training for its staff.  - 12 - 35. Under Loan 1779-3UR the Bank financed consultant services for the following studies: (a) an Energy Sector Study, which reviewed institutional arrangements of the sector and developed a framework for energy planning (para. 27); (b) a planning study, which resulted in a least cost development plan to the year 2000 for electricity generation (para. 32), and provided training to UTE's staff in planning techniques; this plan will be reviewed under the operation planning study financed under Loan 2484-UR; (c) a management study, which reviewed UTE's organization and operations and provided recommendations on means to improve its efficiency; this study has been successfully completed and its recommendations are being implemented; and (d) a tariff study which resulted in recolmendations to rationalize the tariff structure based on long-run marginal costs. These recommendations would be implemented through Loan 2484-UR. Overall, UTE's operations have measurably improved over the past few years. Project completion of Loan 1779-UR is expected for December 1985, including 3.5 years delay. 36. The recent Power Engineering Loan (2484-UR) is designed to enhance the Bank's policy dialogue with the authorities on further reforms in the power sector. It includes financing of the feasibility study for the rehabilitation of the Gabriel Terra hydroplant (which has been already completed), an Operation PlannIng Study, a distribution system study (designed to reduce losses and to promote more economic operation and expansion of generating facilities), and a training component to promote management development. The proposed project would serve as a basis for extending the Bank's cooperation and continued involvement in the action program that will evolve from the studies the Bank has helped to finance. PART IV - THE PROJECT Background 37. The proposed project was identified by Bank staff in Hay/June 1984. It was prepared in March 1985 and appraised in May/June 1985. Negotiations were held in Washington on August 29, 1985. The Uruguayan delegation was led by Mr. Rodolfo D'Amado, President of UTE. Special conditions of the project are included in Annex III. Development Program 38. The proposed project is designed to support UTE's 1985-1993 development program for reliably meeting future power demand. The program is expected to cost US$805 million (in current dollars). Of this total, 27Z would be for generation, 18% for transmission, 51% for distribution and 4% for miscellaneous investments. The generation program would consist mainly of the respective item in the proposed project. The transmission program mainly involves the components of the project, projects under execution and other future extensions to meet demand growth in various areas of the country. The distribution program would essentially involve new connections, rehabilitation and expansion of networks in Montevideo and  - 13 - extension of the 60 kV and 30 kV lines to various productive areas in the interior of the country. The transmission and distribution components of the proposed project have been selected for Bank financing on the basis of their priority and status of preparation. Project Objectives 39. The project's main objectives are: Ca) to reduce Uruguay's fuel consumption by strengthening the operating efficiency of installed hydroelectric generation capaci-ty; (b) to improve the reliability of service in the country and to connect areas with growing economic activity to the system grid; (c) to strengthen UTE's financial position and managerial practices; and (d) more generally, to reinforce the Bank's policy dialogue on power sector issues, following up on the recommendations of the studies under execution (para. 35). Project Description 40. The project would include the following components: (a) Rehabilitation of the Gabriel Terra hydroplant. This component consists of: replacement of electromechanical equipment in the power plant (generators, turbines, voltage and speed regulators, 150 kV circuit breakers, transformers, power and control cables, protective equipment and station service and auxiliaries); replacement of mechanical equipment at the dam (gates, grillages and related accessories); and minor civil works both in the power house and dam; Cb) Extension of the 500kV transmission system to the East. This component consists of: 123 km of 500 kV lines from Montevideo to San Carlos; 17 km of 150 kV line to connect the San Carlos substation; and expansion of the 150 kV Montevideo and San Carlos substations; (c) Extension of the 500 kV system in Montevideo and upgrading the 150 kV circuit ring. This component consists of: 20 km of 500 kV transmission lines; 11 km of 150 kV lines, 25 km of 150 kV underground lines, and related 500/150 kV and 150/30 kV substations; (d) Remodelling and upgrading of the 30 kV distribution network in Montevideo. This component consists of: 70 km of underground 30 kV distribution lines; 160 MVA 30/6 kV substations; and 23 MVA 30/15 kV substations; and  - 14 - (e) Consultant Services for project management and supervision. Project Cost and Financing 41. Total project cost including physical and price contingencies has been estimated at about US$120.5 million, of which about US$80.1 million would be foreign exchange. Total financing requirements, including US$17.6 million interest during construction, would be US$138.1 million. 42. The cost data for the rehabilitation of the Gabriel Terra hydroplant component are based on a feasibility study prepared by UTE's consultants, Electricite de France, using prices at levels as of June 1985. Cost data for the transmission and distribution component of the project estimates are based on a feasibility study prepared by UTE's planning and construction staff using price levels prevailing in June 1985. Prices of equipment and materials for the transmission and distribution component reflect UTE's recent experience with respect to similar works. Costs include import duties (10) and taxes (16%). Physical contingencies were calculated on the basis of 10% and 5% of the base costs for the generation and transmission and distribution components respectively. Price contingencies were applied using the following annual expected international price increases: 5% for 1985; 7.5% for 1986; 8% for 1987-1990 and 5% for 1991-1992. It was assumed that exchange rate adjustments would reflect the difference between internal and external inflation. 43. The financing scheme for the proposed project would include this proposed loan of $45.2 million (the A-Loan) to finance the foreign exchange component of the rehabilitation of the Gabriel Terra hydroplant and cofinancing by means of a B-Loan of $52.5 million, to finance the transmission and distribution components. Commercial banks have expressed interest in participating in a cofinancing operation. UTE would finance the remaining US$40.4 million from cash generation. The A-Loan would finance the foreign exchange requirements of the Gabriel Terra rehabilitation, equivalent to 33% of total project cost. The B-Loan, possibly including a Bank a guarantee of principal payments maturing in the outer years, would cover the foreign exchange requirements of the transmission and distribution component, or 38% of total project costs. Interest during construction on both loans would be financed in view of the heavy financial burden imposed on UTE by the implementation of its ongoing investment program and servicing of its external debt. 44. UTE would be the Borrower of the proposed A-Loan. The Uruguayan Government is expected to be the Borrower of the proposed B-Loan. The proceeds of this loan would be onlent to UTE, as required, on the same terms and conditions; UTE would bear the exchange and interest rate risks. The Government intends to deposit the B-Loan proceeds into an account in the Central Bank and make them available as and when needed for the purposes of the project. Thus, the Bank would retain the right to  - 15 - withhold funds from the A-Loan if there were any difficulties with the use or replenishment of funds for the project components financed under the B-Loan (Section 6.01 (b) of draft Loan Agreement). The Borrower 45. The Borrower of the proposed A-Loan would be the Adminiscracion Nacional de Usinas y Trasmisiones Electricas (UTE), a separate legal entity owned by the Uruguayan Government which is responsible for public power supply in the country. UTE's organization is satisfactory; it is governed by a full-time, five-member Board of Directors with its President acting as Chief Executive Officer. The present President is a former UTE Planning Manager, with more than twenty years' experience with the company. The General Manager and other senior staff are also career executives. 46. To improve UTE's efficiency and flexibility, management consultants carried out a comprehensive organization and administration study whose recommendations have been, or are in the process of being, implemented (para. 35). One of the main consequences has been the recognition by UTE's management of training needs in order to provide continuity to institution-building efforts. 47. UTE presently employs about 10,600 people (representing about 84 consumers per employee), which include 225 professional staff, i.e. about 2Z of the workforce employees. Though this represents an improvement over the situation a few years ago, there is still an imbalance between professional and non-professional staff. Many senior managers are close to retirement age, so there is also a need to develop middle and junior management. Further steps are needed to attract qualified professionals. Under the Power Engineering Project, agreement was reached on a training program for management. Under Loan 1779-UR, UTE engaged Price Waterhouse to conduct a salary survey. The survey showed that, in 1982, the salaries of professional and managerial staff would have had to be increased significantly to be competitive with the private sector. At that time, some modest corrections were implemented. At present, economic conditions in the country have reduced professional turnover and external employment opportunities are limited; UTE has consequently been able to maintain and increase its professional staff. During project supervision, however, special attention should be paid to ensuring that appropriate compensation policies are followed. 48. UTE's commercial systems have been improving in recent years. Staff are still in the process of developing expertise in financial planning; significant improvements have been achieved in the past few years. Accounting, budgeting and billing systems are adequate, as are insurance policies and practices. Under previous loans, UTE agreed to engage independent external auditors to audit its accounts and assist in developing internal auditing capabilities; the results were satisfactory. The loan documents for the proposed project would repeat the covenant of earlier loan agreements that UTE should have its accounts audited by independent auditors (Section 5.01 (b) of draft Loan Agreement).  - 16 - 49. UTE's inventory management is poor and a program for improvement is underway. The absence of a well-structured inventory policy and the need to strengthen inventory management are acknowledged by UTE's Board and staff, and are emphasized at every opportunity by both internal and external auditors. Also, there has been significant overstocking in the last two fiscal years, which is reflected in the projection of working capital requirements for 1985-93. To tackle the problem, an internal group was created to deal with procurement and internal control matters, but UTE agrees that further improvements are necessary. Under Loan 2484-UR, UTE agreed to submit to the Bank an action plan for improving inventory management, and to implement it, after taking into account the Bank's comments, by October 31, 1985. 50. By the end of 1984, UTE had reduced its overall average collection period to 60 billing days, compared with a covenanted 75 days under Loan 1779-UR; the collection period for private consumers was 45 days. Public sector accounts receivable were further reduced in later 1984, following discussions with the Bank and a plan was submitted to reduce the billing period to the covenanted 75 days under the loan. As of December 31, 1984, the collection period for public sector accounts was about 135 days; this represented a significant improvement compared to the 355 days in 1982, although still short of the 75 days. UTE agreed to maintain the 75 days target agreed upon in Loans 1779-UR and 2484-UR and the Government agreed on an action plan to settle its accounts payable to UTE within the following terms: by December 31, 1985, not more than 120 days; by June 30, 1986, not more than 90 days and by December 31, 1986 and thereafter, not more than 75 days (Section 3.02 of the draft Guarantee Agreement). Finances 51. Since 1977, UTE's financial results have fluctuated in response to changes in Government economic and tariff policies, but on balance its financial performance has been adequate. The rate of return exceeded the level covenanted under loan 1779-UR until 1979; after deteriorating in 1980-82 performance, began to improve again in 1983. In this year COMIPAL's assets (US$600 million: US$546 million in respect of El Palmar hydroplant and transmission lines, and US$54 million of current assets) were transferred to UTE and US$ 594 million of debts (most of which mature in the next 5 years) were added to UTE's liabilities; the remaining US$6 million was a Government equity contribution. Despite this increase in it:. debt, UTE's debt equity ratio is still at a satisfactory 50:50 level. 52. During 1983 and 1984, UTE's financial performance improved substantially. Although the rates of return achieved in these years, 2.8B and 3.8% respectively, were lower than the rates covenanted under Loan 1779-UR, UTE's financial performance was respectable, given the economic  - 17 - difficulties the country was facing. The recent record also represents significant progress from the negative returns of 1981 and 1982, especially since asset revaluation and the transfer of the El Palmar assets resulted in a significantly higher rate base than expected during the appraisal of Loan 1779-UR (para. 57(b)). 53. UTE's operational financial needs are linked to exchange rate changes (energy purchases from CTN, fuel costs, maintenance supplies and debt service) and to domestic price changes. Timely adjustments of tariffs to compensate for exchange rate variations and domestic cost increases are essential for maintaining in real terms the financial balance which requires an average tariff level of about 6 US cents/kWh in mid-1985 prices. Periodic adjustments that are allowed by current legislation were incorporated in agreements with the Bank under Loans 1779-UR and 2484-UR, and would be repeated in the proposed loan (Section 5.02 of draft Loan Agreement). The new Government's w.llingness to comply with both the legislation and agreements with the Bank was demonstrated in two tariff increases of 301 and 181 carried out in last April and July respectively, which took the average tariff level slightly over 6 US cents/kWh. 54. The restructuring of El Palmar debt service is a matter of priority. The Government and UTE agreed that if the El Palmar debt were not satisfactorily restructured with commercial banks in line with UTE's cash generating capacity, then it would be restructured through an agreement satisfactory to the Bank between the Government and UTE. The end result of such restructuring would be to provide financial relief to UTE. The agreement would be in place 30 days after loan signing (Section 6.01(c) of the draft Loan Agreement). As a consequence, the obligation under Loan 2484-UR on the ratio of funds from internal sources to capital expenditures is no longer necessary because it has been superseded by the above agreement (Section 5.06 (ii) of the draft Loan Agreement). 55. UTE's investment program and financing plan for 1985-1993 period is summarized below: US$ Current Requirements for Funds Millions % Construction Program Ongoing Works 94.9 10.4 Proposed Project 120.5 13.2 Future Works 589.4 64.7 Sub-total 804.7 88.3 I.D.C. 34.9 3.8 Total 839.6 92.2 Net Change in Working Capital 71.5 7.8 Total Requirements 911.1 100.0  - 18 - Source of Funds Gross Internal Cash Generation 1,641.7 180.2 Less: Debt Service 1,235.6 135.6 Net Internal Cash Generation 406.1 44.6 Borrowings 505.0 55.4 Existing Loans 22.0 2.4 IBRD 1779-UR 5.2 0.6 IBRD 2484-UR 4.0 0.4 Other 12.8 1.4 Proposed Loans 97.7 10.8 IBRD "A" 45.2 5.0 IBRD 'B 52.5 5.8 Future Loans 385.2 42.3 Total Sources 911.1 100.0 56. During the preparation of the Fifth Power Project, UTE and the Bank agreed on the regulations to the Electricity Law which state that: (a) UTE's tariffs will be set on the basis of a target rate of return (not lower than 6Z) on a rate base consisting of average revalued net fixed assets in operation and a provision for working capital; and (b) UTE may request tariff adjustments to take into account changes in operating costs. The target rate of return under Loans 1779-UR and 2484-UR is 7.5% provided that if in any one year the rate of return is below 7.5Z, but above 6Z, the difference may be made up in the following year. Connection fees are not to be considered as operating income, since provisions of the Electricity Law stipulated that they would be refundable. 57. The Bank, the Government and UTE agreed to amend the rate of return covenants in the following manner: Ca) connection fees would be treated as operating income as long as they are not refundable. Under current legislation, this will be the case until December 1986 (Section 5.02 (a) of the draft Loan Agreement and para. 2 of Schedule 5 thereto); (b) the rate base would now be defined as average net fixed assets in operation revalued in a mnnner satisfactory to the Bank and excluding provisions for working capital (Section 5.02(a) of the draft Loan Agreeuent and para. 3 of Schedule 5 thereto). (c) the rate of return would be not less than 6Z, and any shortfall would be made up the following year. UTE would review annually, before October 31, whether it would meet the rate of return requirement in the current year and in the next year and would prepare an appropriate action plan. UTE would also submit to the Bank quarterly financial reports on rate of return and tariffs (Section 5.02 (b) and (c) of draft Loan Agreement).  - 19 - The 6% rate is lower than that covenanted under Loan 1779-UR; it is justified since: (i) average revenues for kWh resulting from the 6% rate of return are in the range of the incremental cost for the 1985-93 investment program; and (ii) the company will contribute a very satisfactory 45% from self-generation of funds to the financing of its 1985-93 investment program. 5