Colombia - Power Sector Adjustment Loan Project

Document of The World Bank FOR OFFICIAL USE ONLY LMa/ ;x9mio Report No. P-4676-CO REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A POWER SECTOR ADJUSTMENT LOAN IN AN AMOUNT EQUIVALENT TO US$300 MILLION TO THE REPUBLIC OF COLOMBIA Novenmber 10, 1987 Projects Department Latin America and the Caribbean Regional Office This document has a restrcted distribution and may be used by recpients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS Currency Unit Colombian Peso Col$ Col$ 100 Centavos (ctv) Col$241.39 US$1.00 (June 30, 1987) Col$1,000 US$4.14 (June 30, 1987) AVERAGE EXCHANGE RATES (Col$LUS$) 1982 1983 1984 1985 1986 1987 (June) 64.1 78.9 100.8 142.3 194.3 241.4 WEIGHTS AND MEASURES 1/ meter (m) = 3.281 feet (ft) square kilometer (km2) = 0.386 square mile (mi2) hectare (ha) = 0.01 square kilometer (km2) cubic meter (m3) = 35.315 cubic feet barrel (bbl) 0.159 cubic meter kilogram (kg) = 2.206 pounds (lb) ton (t) = 1,000 kilogram kilowat (kW) = 1,000 watt (W) Joule (J) 1 Watt.second = 1 Newton.meter Joule (J) = 2.3B8x10-4 kcal=9.478xlO4 Btu ton oil equ-ivalent (toe) = 42.2x109 J kilowatt-hour (kWh) = 3.6.106 j kilovolt (kV) = 1,000 Volt (V) kilovolt ampere (kVA) - 1,000 Volt ampere (103 VA) Hertz (Hz) = 1 cycle per second 1/ The SI (Systeme International) and its multiples are used whenevez possible in this report.  FOR OMCIAL USE ONLY ABBREVIATIONS AND ACRONYMS k (kilo) 103 (thousand) M (Mega) 106 (million) G (Giga) 109 (billion) T (Tera) 1012 (trillion) P (Peta) 1015 (quadrillion) E (Exa) 1018 (quintillion) CHB Central Hidroelectrica de Betania CONPES = Consejo Nacional de Politica Economica y Social CORELCA = Corporacion Electrica de la Costa Atlantica CVC = Corporacion Auttonoma Regional del Cauca DNP - Departamento Nacional de Planeacion (National Planning Department) ECOPETROL = Empresa Colombiana de Petroleon EEEB = Empresa de Energia Electrica de Fogota EMCALI = Empresas Municipales de Cali EPM - Empresas Pablicas de Medellin FEN Financiera Electrica Nacional FONADI - Fondo Nacional de Desarrollo ICEL - Instituto Colombiano de Energia Electrica IDB = I rer-American Development Bank ISA = Interconexion Electrica S.A. JNT = Junta Nacional de Tarifas (National Tariff Board) KfW = Kreditanstalt fuer Wiederaufbau MME = Ministerio de Minas y Energia MHCP - Ministerio de Hacienda y Cridito Pablico UNDP United Nations Development Program ESMAP = Energy Sector Management Assistance Program IRR = Internal Rate of Return LRMC Long Run Marginal Cost TAP = Trade and Agricultural Policy Loan FISCAL YEAR = CALENDAR YEAR This document has a restricted distribution and may be used b,' re;:liierionly in the performance of their offAcial duties Its contents may not otherwise be disclosid wft. <,ut World Bank authorization.  t~~~tl  COLOMBIA POWER SECTOR ADJUSTMENT LOAN TABLE OF CONTENTS Page No. PART I - THE ECONOMY . ................... * * * 1 A. Background . ... ............. 9.*#.....* 1 B. Recent Economic Developments ....................... 2 C. The Medium-Term Adjustment Program 1987-90 ............ 4 D. Major Development Issues ................ 5 (a) Public Sector Efficiency ............... 5 (b) External Resource Mobilization ....... ................. ~- 8 E. Relations with the IMF ...... . ........... 9 F. Assessment too ........... . .......... 9 PART II. THE ENERGY SECTOR AND THE POWER SUBSECTOR ............ 9 A. Energy Sector Profile .......................... . ......** 9 Resource Base and Consumption . ... 10 Strategic Issues for the Energy Sector .. 11 B. The Power Subsector .. . ...................... 12 Organization and Institutions. . .. 12 Power Demand ..... ......... .. ..... ...... 14 Power Supply ...................i Electricity Losses ............................. 16 Sector Planning .......*............ 16 Sector Finances ................17 The Finances of the Main Utilities . 18 Electricity Pricing .... ... * ..... ...... ...... 19 Environmental Aspects . ... .. ... ........... *. 20 Social Aspects ................. . 21 C. Bank Support for the Power Sector ....... 21 PART III. THE POWER SECTOR ADJUSTMENT PROGRAM ...... .. 22 A. The Policy Frame and Government Objectives ............ 22 Investment Policies .. ...... to*..... 23 Institutional Framework ....... ........... 23 Improved Efficiency ............. ........... 23 B. The Program . ... . .......... . ............ t 24  TABLE OF CONTENTS (Cont'd) Pate Investment Policies ............................................ 24 The 1987-1990 Investment Program ...... ......................... 25 Investment Program 1991-2000 ....... ............................ 26 Guavio Project ................................................. 26 Inistitutional Framework ........ ................................ 27 Utility Manage,ment ............................................. 27 Electricity Losses . ............................................ 28 Ecological and Social Aspects ....... ........................... 28 Financial Adjustment Program ....... ............................ 29 Pricing Adjustment Program ..........................., 32 PART IV - THE PROPOSED LOAN ........................... 33 Background and Justification for 3ank's Involvement ... 33 Disbursement ................................................... 34 Procurement ............ 34 Monitoring and Reporting ........ .............................. 34 Accounting and Auditing ........ ................. * .............. 34 Program Benefits .............. 0 34 Risks ......................................................... 35 PART V - BANK GROUP OPERATIONS IN COLOMBIA ..................... 36 PART VI - RECOMMENDATION ................... .................... 38 ANNEXES Annex 1 - Economic Indicators.... 39 Annex 2 - Status of Bank Group Operations in Colombia 45 Annex 3A - Letter from the Minister of Finance and Public Credit on Fiscal and Monetary Policy 50 Annex 3B - Letter from the Minister of Mines and Energy on Energy Policy.. .53 Annex 4 - Schedule of Actions ..81 Annex 5 - Description of the Investment Program Components..... . ..... 84 Annex 6 - Actual and Forecast Income Statement (1984-1992) 87 Annex 7 - Electricity Tariff Tables.. .. 91 Annex 8 - Organization of the Power Sector and Sector Statistics........... 93 Annex 9 - Energy and Peak Demand Balances. 95 Annex 10 - Suplementary Loan Data Sheet. 96 Annex 11 - Supporting Documentation and Working Papers 99 Map: IBRD 17690 R  (i) COLOMBIA POWER SECTOR ADJUSTMENT LOAN LOAN AND PROJECT SUMMARY Borrower: Republic of Colombia Amount: US$300 million equivalent Terms: 17 years including 4 years grace, with interest at the standard variable interest rate. Description: The proposed loan would support the continuation of the Government's reform program in the power sector. The principal objectives of the program are to improve the efficiency of power generation, transmission and distribution. Government policies are designed to: rationalize investments, bring electricity pricing in line with l.-ng-run marginal costs, finance a larger share of future investments from sector cash generation and thereby reduce pressure on other public sector investments, and improve the regulatory framework and utility management. The loan would support measures to achieve these objectives and assist in restructuring the finances of the sector. The proposed loan forms part of the package to help financing the total external financing needs of Colombia for 1987-90. Berefits and Risks: Implementation of the Government's power sector adjustment program would result in several significant benefits to the economy. It would reduce both recurrent and capital public expenditures through improved efficiency in management, planning, tariff setting and investment decision making. The main risks relate to the uncertainties regarding the level and timing of securing - .her sources of financing, to the volatility of demand forecasts and their impact on investment, to the Government's ability to maintain the pace of price adjustments necessary for implementing the pricing policies and to possible regional resistance to the concentration of responsibilities on central agencies in the sector. Thn sector adjustment program contains a series of measures designed to reduce these risks to an acceptable level. Estimated Disbursements: Full disbursement of the loan would take place over an estimated fifteen-month period. The loan would be in direct support of the policy reform  (ii) progr# and would be disbursed for general imports (subject to a negative list) in three trenches - $150 million at effectiveness and $75 million each by June-August/88 and by' December/88-Februaryl89. Staff Appraisal Reports Not applicable IBRD 17690 R  INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED POWER SECTOR ADJUSTMEFT LOAN TO THE REPUBLIC OF COLOMBIA 1. I submit the following report and recommendation on a proposed loan to the Republic of Colombia for the equivalent of US$300 million to support the Government's program of reforms in the power sector. The loan would have a term of 17 years, including 4 years of grace, with interest at the Bank's standard variable rate. PART I - THE ECONOMY 2. An economic mission visited Colombia in June 1986 and its report (4444-CO) will be cistributed to the Executive Directors shortly. A mission to review progress made in the implementation of t.ie Trade and Agricultural Policy (TAP) Loan (Loan 2677-CO, approved in March 1986) visited Colombia during March 1987, and its report was distributed to the Executive Directors on July 1, 1987 (Sec M87-780), recommending the second tranche release. A review of macroeconomic developments was provided in the Country Brief circulated in September 1987. Country data sheets are presented in Annex I. A. Background 3. Colombia's development programs are founded on a rich base of human and natural resources. The population, estimated at 28.4 million at mid-1985, occupies an area of just over a million square kilometers, of which nearly one-quarter is considered arable. Population density is relatively low (26 persons per sq km); two-thirds of the population now lives in urban areas. Population growth of 1.9% per year has facilitated substantial improvemer.t in social conditions. Life expectancy at birth now stands at 64 years compared with 50 years in 1970, due partly to declining infant mortality and improved nutrition; primary school enrollment was over 80% in 1985 and the literacy rate about 80%. Nonetheless, poverty remains a critical problem. Some 25% of the population is below minimum nutrient intake levels, more than a third lacks access to safe water, and child mortality remains high. Unemployment is high, especially in the cities. Further, household data, albeit limited, suggests an uneven distribution of incomes, with incomes of the top 20% of households 13-14 times those of the bottom 20%. Disparities in the quality of life among regions are very significant and contribute to strong regional pressures in many spheres of activity. In the disadvantaged areas, guerrilla activity and narcotics related crime have become a threat to security, discouraging investment. 4. Natural resources are plentiful. In addition to relatively abundant land in the mountainous parts ideally suited for coffee, there is  - 2 - abundant water for irrigation. There is vast untapped hydroelectric energy potential and other energy resources include rich coal, oil and natural gas reserves. Mineral resources such as nickel, gold, and emeralds are also substantial. Colombia has a significant locstional advantage because it is close to North America with coasts on both the Pacific and Atlantic Oceans. Mountainous terrain, however, makes internal transportation costly and slowrs down physical and social integration. 5. Rich physical resources, the literate and dependable workforce, a robust private sector, competent national econcmic management, and political stability are major factors explaining %olombia's good record of GDP growth and social improvements over the last 30 years. However, heavy dependence on coffee and its large price variations in international markets have produced problems of short-term fluctuations in the e;onomv and required frequent intervention to stabilize aggregate demand. Longer term economic challenges are therefore to reduce the relative dependence on coffee by developing other exports, to increase the rate of GDP growth and job creation, and to improve income distribution by reducing the incidence of absolute poverty. The Barco administration which came to office in 1986 sees the reduction of poverty, especially in remote areas with only tenuous links to the formal economy, as critical. It gives highest priority to achieving better delivery of social services to marginal areas with a particular focus on the decentralization of planning and program implementation. B. Recent Economic Developments 6. Economic performance over the past 20 years has been influenced above all by world coffee price cycles and by the orientation of production and trade policies. Four main periods can be distinguished: 1967-75, 1975- 80, 1980-83, and after 1983. The 1967-75 period was marked by a shift away from import substitution toward export promotion, backed by a relatively transparent, uniform structure of incentives, modest trade liberalization, a crawling peg exchange rate reg4me, fiscal discipline, and sound public sector investment policies. GDP growth averaged 6.3% p.a. with growth in consumption per capita reaching 4.3% p.a. During 1975-80, GDP growth was only slightly lower, averaging 5.5%. However, when the coffee boom began in the mid 1970s, macroeconomic management faltered. Government consumption accelerated in the mid 1970s in response to sharply increasing revenues; public sector investment surged while private investment activity declined. Money supply was allowed to g-ow more rapidly than before, and the inflation rate rose to almost 25%. Real exchange rate appreciated and the growth of non-traditional exports, particularly manufactured goods, slowed considerably. 7. There was a sharp reversal of economic performance after the coffee boom subsided in the early 1980s. Between 1980 and 1983, average GCP growth slowed to 1.6% p.a. and per capita consumption stalled. Exports, particularly manufactured goods, declined as a result of a loss in competitiveness associated with appreciation in the real exchange rate from 83.5 to 73.6 (base 1975 = 100) and the fall in international demand. The current account turned from a slight surplus to a deficit of 6.5% of GDP. In an effort to maintain aggregate demand, public sector expenditures were  - 3 - increased, and the public sector deficit increMsed from less than 1% to over 7% of GDP. Thus che debt crisis of the early 1980s caught Colombia at a moment when its investment program reached peak levels. Total foreign financing, especially from commercial banks, fell short of needs and capital flight accentuated the problem. International reserves fell by some US$4 billion during 1982/84 to a level of US$1.8 billion at end 198'4 equivalent to less than four months of imports of goods and non-factor services. 8. Responding to the economic crisis, the Government initiated in late 1984 a comprehensive stabilization and adjustment program, which was sustained and elaborated through 1986. Stabilization policies included tax incr ases, public sector price increases, expenditure restraints, and restrictive monetary and credit policies. Growth was to be fostered through deva'uation, removal of restrictions on exports. and reorientation of the publi investment program toward export-oriented activities, notably petroleum and coal, and essential infrastructure. The trade regime was to be liberalized by decreasing the use of import licenses and by phased replacement of quantitative restrictions by tariffs. The 1984 program helped develop a consensus among Colombia's major creditors. Based on the policy understandings betueen the Government, the Bank, and the IMF, external commercial banks agreed to restore trade lines and to commit a US$1 billion jumbo loan; the IMF agreed to a sui generis monitoring arrangement, and the Bank, in the context of two policy-based loans, the Trade Policy and Export Diversification Loan (Loan 2551-C0) and the TAP Loa., (Loan 2677-CO), undertook to assess medium-term performance, particularly in the context of trade reform and the investment and borrowing programs. 9. All the major stabilization objectives of the Colombian rrogram for 1984-86 were achieved. The current account balance improved from a deficit of 5.4% of GDP in 1984 to a surplus of 1.6% of GDP in 1986, aided by a new coffee boom. As a result of revenue and expenditure measures, the overall public sector deficit fell from 7% of GDP to about 4Z in 1985 and was almost elimn:ated in 1986 because of high coffee revenues. The growth in domestic credit to the public sector was within target. Inflation remained at 21% during 1986. The target for the real exchange rate was exceeded, with the December 1986 index at 112 compared with 74 in 1983. Efforts on expenditure restraint were quite successful, notably in the areas of gross domestic investment and government consumption; there were also cutbacks in imports of goods and non-factor services. Gross national savings rose sharply, partly reflecting the successful sterilization of the 1986 coffee windfall. 10. Developments in early 1987 have highlighted the important medium- term challenges that remain and the high sensitivity of the balance of payments and Government income to commodity prices. Coffee prices fell below US$1.10 after the suspension of International Coffee Organization (ICO) quota negotiations. Coal prices also continued to slide, following a decline in 1986. The resulting drop in export earnings was only partially offset by an almost doubling of petroleum export earnings owing to the completion of the Canio Lim6n oil field development. After impressive increases in 1986, foreign exchange reserves have declined by US$221 million in the first quarter but have partially regained their previous level since. The public sector deficit is expected to rise to 3% of GDP in  - 4 - 1987, but would be narrowed down over coming years. C. The Medium-Term Adiustment Frogram 1987-90 11. The Government has, in recent months, defined a medium-term program for 1987-90 aimed to consolidate its adjustment progress and to ensure sustained growth at about 4% p.a. The stabilization program initiated in 1984 will be continued and the loss in international reserves resulting from the 1987 fa3l in coffee prices contained. As in 1984-86, a successful stabilization program will entail application of fiscal and monetary policies within a consistent macroeconomic framework. The public sector deficit is to be reduced to about 2% of GDP by 1990, and public sector gross fixed investment from a projected 7.5% of GDP in 1987 (already below the 1985 level) to 6.7% of GDP in 1990. This will allow an increase in private sector investment during this period. The program envisages growth in the monetary base of about 25% p.a. or just equal to the growth of nominal GDP, and implies no increase in the rate of inflation from the 21% achieved in 1986. Colombia is continuing its exchange rate policy aimed at keeping the real rate competitive and consistent with the objective of restricting the current account deficit of the balance of payments to 2% of GDP for the period 1987-90. Building on the successful real exchange rate adjustment, the program also seeks to achieve: (a) a further opening up of the economy through additional import liberalization and an expanded foreign exchange budget; (b) gradual shift away from quan4itative restrictions and towards tariffs as the major instrument of protection; (c) rationalization of import policies to improve resource allocation and export competitiveness; and (d) more automatic access to import licenses, and a more uniform structure of tariffs and export incentives. 12. Implementation of the program has entailed the enactment in 1986 of two laws, one for tax reform and the other for increased Government decentralization. The tax reform together with tighter control of current expenditures increased the Government revenues by 2 percentage points of GNP and reduced the overall budget deficit while providing greater incentive for private investments. The decentralization program provides for the election of mayors and a gradual transfer of responsibilities and financial resources to the municipalities. Following negotiations with Andean Pact countries the Government has introduced a bill to open up the economy for more foreign direct investment. The Government is also considering important financial sector reforms and is moving towards a more flexible and market-oriented interest rate structure. On trade policy, significant advances are being made, including increases in the foreign exchange budget for reimbursable imports. The share of imports not subject to quantitative restrictions in total imports rose from 55% in 1985 to an estimated 69% in 1986, and is to be increased further in 1987. Further measures to liberalize the trade regime are planned. 13. The macroeconomic and public expenditure program appears to be sustainable. Even if external financing or export earnings were lower than projected, macroeconomic balance could be maintained by making moderate cuts in public investment, for which a margin is left in the program. However, if public investment were significantly higher than projected, excessive amounts of external finance and/or crowding out of the private  - 5 - sector would result. The strengthening of budget mechanisms to implement planning decisions thus merits high priority. The Government's medium-term program represents an effective response to the major development issues facing Colombia; specific priority areas for action are outlined in the following section, with emphasis on issues directly relevant for the power sector. D. Major Development Issues (a) Public Sector Efficiency 14. The Government is focusing sharply on strengthening public sector institutions both to provide better services and to help reduce public expenditures. The public sector accounts for some 47% of Colombia's total investment spendirg, yet public sector management has important weaknesses; causes include frequert change-over of management, weak accountability for producing tangible development results, complicated and slow budget and procurement processes, weak linkages between planning, budgeting, and evaluation, and heavy reliance on legal controls which tends to impair institutions' ability to respond to changing circumstances. The Government has launched several efforts designed to improve management of the core government functions of planning, budgeting, monitoring and evaluation. Central challenges are reorientation of the public sector expenditure program, resource mobilization (domestic and international), including tariff increases for public services, and improvement of efficiency in p.iblic sector institutions (centralized and decentralized). (i) Public Sector Expenditures 15. TMe public expenditure program in Colombia is at a major turning point. The Government's priorities have shifted from a focus on infrastructure development towards social concerns; at the same time, the Government recognizes the need to restrain the level of total public investment. This change in direction takes place in the context of the successful adjustment efforts of the last two years, which have gone far towards correcting the severe fiscal and external imbalances of the early 1980s; nonetheless, important challenges remain. The Bank has worked closely with the Government in helping it to define a public sector investment program which supports the medium-term program. The investment program for 1987-90, averaging US$2.7 billion annually, was approved by the National Economic Policy Council (CONPES) in July 1987. It maintains consistency between macroeconomic and sectoral objectives. The agreed public expenditure program will entail both cuts overall and specific reductions in investment for the energy-related sectors of electric power, petroleum, and coal, while expenditure on social programs will increase. 16. In the power sector, sharp reductions in the investment program through 1990 are envisaged (paras. 88 and 89). From a peak of US$1 billion p.a. in 1982-84, when it made up 35% of the investment program, power sector investment will decline to an average of US$516 million over 1987- 90, reducing its share to 19% of the total program. The program includes completion of ongoing generating plants as well as high-priority transmission and distribution projects, and advances in rural  - 6 - electrification which support social objectives. While overall levels of investment spending have been relatively easy to establish, changes to power sector allocations are difficult to implement, as commitments to spending are made about seven years before project completion. Possible changes in project scope and cost overruns (for example on the Guavio hydro power project) could pose serious problems as they would require cuts elsewhere in the program. 17. Cuts will also be made in the petroleum and coal sectors, wlhere the completion of the initial large investments in mine and field development will make possible a reduction from US$572 million in I ,6 to an average of US$461 million in 1987-90. As a result of reductions of all three energy-related sectors, the energy share of the investment program will fall from 53% in 1985 to 36% in 1990. These shifts should be seen in the context of changing patterns of government spending over the past two decades. While the social sectors had clear priority in the early 1970s, around 1978 the pattern changed; the shares of education and health dropped, while expenditures for energy and highways increased sharply. In the 1979-85 period, the energy sector absorbed half of all public investment resources, and the overall increases in public investment levels were due largely to the energy sector. Even when the Government sought to shift the balance among sectors and to reduce overall investment levels, the difficulty in adjusting energy sector investment because of contractual commitments for projects with long construction periods led to higher proportional cuts in other sectors. 18. The increased resources available for social expenditures will go largely to the transport, water, education and agriculture sectors, as well as multisectoral programs. The road network in remote areas will be strengthened and highway management systems improved. Urban transport projects are being pursued (although the scope and advisability of these projects need careful evaluation). Investments in drinking water, sewage, and drainage facilities, and restructuring services in small- and medium- sized cities are to be increased. Expenditures in education will be oriented towards greater efficiency of existing schools. In agriculture, land reform, technical assistance and research, and improved storage and distribution infrastructure for agricultural products will be the focus. These expenditures and others will be coordinated under the National Rehabilitation Plan, which aims to promote development in poorer regions. Related social expenditures focusing on nutrition and shelter will be executed under the Anti-Poverty Plan. Investment by local governments with resources from the new decentralization initiative are also to be oriented towards social objectives. 19. Strong fiscal management of the energy sector is vital for achieving the macroeconomic goals of employment creation and balance-of- payments stabilization. Since the energy sector is highly capital- intensive, the shift of public investment towards energy may have accentuated unemployment problems. A recent Presidential Employment Mission suggested that a reversal of this shift could be part of an employment creation strategy. Similarly, energy investments have been highly import-intensive, and this has led to massive foreign borrowing, equivalent to 45% of Colombia's public external debt as of December 1986. The planned reduction in energy sector investments should thus support balance-of-payments stabilization and the channelling of imports to high  -7- priority uses. The reduction of energy sector expenditures (power and coal) is an essential part of Colombia's strategy to limit new external borrowings. (ii) Resource Mobilization 20. Improved resource mobilization is central to the Government's medium-term strategy. The Government's current policy aims to improve the financial sector's capacity to mobilize resources by gradually reducing the burden of low-yielding and illiquid assets in the financial system's portfolio. Tax reforms and trade policies are also central elements of the medium term strategy. Issues of economic pricing have immediate importance for the energy sector. Without effective economic pricing policies, inappropriate consumption patterns and infrastructure supply networks are likely, with significant costs to the economy. This means tariff increases in real terms which in turn will help ensure the financial soundness of the utilities and may even provide tax revenues to the Government. 21. Internal generation of funds in the power sector only contributed 20% of total sector investment during 1980-86, even though the sector serves largely the more economically advanced part of the Colombian society. This is partly due to the normal lag in revenues arising from large new investments, but it also reflects inadequate pricing policies. The desire to satisfy social objectives has led to low electricity tariffs for some categories of household consumers, which accounts in part for high residential electricity consumption in Colombia; industry, particularly in Bogota, on the other hand, has faced high tariffs inconsistent with stimulating the utilization of abundant electric energy. More broadly, low admin!stered prices for other energy products, namely gas and petroleum products, have discouraged development of abundant coal supplies, particularly on the coast where natural gas instead of the more economic coal is being consumed in electricity generation. Similarly, petroleum sector savings have been squeezed by the implicit subsidies to domestic consumption through the previous differentials between domestic and international prices, coupled with the long gaps between domestic price adjustments. (iii) Public Sector Management 22. Public sector management presents complex challenges, notably rigidities in systems for allocating public sector expenditures, including earmarking, and the weaknesses in the central planning and budgeting systems. Weak planning systems have resulted in less than optimal sectoral patterns, since the political clout of individual enterprises or regions at times outweighs national priorities. Decisions taken by the Central Economic Council (CONPES) and the Planning Department are inadequately reflected in the budget process, which tends to be a short-term exercise with only partial coverage of the consolidated public sector. Further delays and distortions take place during execution of investment expenditures, notably because of cumbersome disbursement and contracting procedures. The Government has focused on three areas where capacity improvement would help achieve its macroeconomic objectives, namely: (a) policy formulation to link macroeconomic policies with sectoral objectives of the new Administration; (b) implementation at the sectoral level in relation to the resource allocation process; and (c) monitoring and evaluation of public sector enterprises. The key challenge for Colombia at  - 8 - this stage is to strengthen institutional mechanisms to ensure that macroeconomic objectives guide the investment decisions of the decentralized sector. To improve the performance of public sector enterprises, more strategic controls and greater reliance on coordination mechanisms, incentive policies and market forces are needed; gradual reduction in earmarking is important. For the energy sector, as savings rise and investments fall, it is essential that the resource surplus so created be efficiently channeled to the parts of the public sectot where it is most needed. The compartmentalization resulting from earmark4ng and institutional rigidities should not be extended further by inflexible arrangements to distribute energy revenues. A transfer mechanism has now been approved for channeling the "economic rent" from ECOPETROL, the petroleum company, to the Government. Specific measures are being introduced to monitor the 23 largest public sector enterprises that spend 90% of public enterprise investments, as to their compliance with the macroeconomic targets. Pilot programs have been initiated to test different approaches to improving performance of public sector enterprises. (b) External Resource Mobilization 23. Colombia's external resource mobilization strategy is an essential element of the medium term program. It has important implications for the power sector adjustment program because of the high level of power sector debt and heavy financing needs. The basic strategy is to rely on voluntary lending. The Government's objective is to maintain debt to commercial banks at roughly present levels but at the same time to open possibilities for new lending in the future by broadening access to new financial markets and using a wider range of financing instruments. However, diversification of foreign credit should be achieved by expanding borrowing from all sources, including non-preferred creditors. An immediate challenge is to secure appropriate new financing arrangements which will allow Colombia to cope effectively with a heavy bunching of maturities in the 1987-90 period. Even with a scaled-down investment program, the financing needs of the power sector during this period are large and the power sector adjustment program is a response in part to the need for a concerted effort to mobilize the resources the sector requires during this period. 24. Colombia's outstanding medium and long term debt amounted to US$13.7 billion at the end of 1986, of which US$12.1 million was public and publicly guaranteed. The Government's objective is to keep the current account deficits on average around US$850 million, equivalent to 2% of 1990 projected GDP. Given the maturity profile of Colombia's external debt, and the likely path of foreign investment, MLT disbursements would need to total about US$4 billion in 1987-88, rising to US$2.5 billion p.a. in 1990. Under this scenario, total debt as a percent of GDP is expected to decline from 43% in 1987 to 29% in 1995. Because of the bunching of maturities, debt service would rise temporarily from 30% of exports (goods and nfs) in 1986 to 41% in 1989 and then fall cff to 28% in 1995. At the peak in 1989, debt service would be about 8.8% of GDP, and then decline to 5.1% by 1995. 25. Colombia has reached agreement in principle with commercial banks on a financing operation covering 1987-88, totalling US$1,060 million. This is a voluntary operation, reflecting Colombia's strong economic performance. As part of this operation, US$200 million is included as parallel cofinancing for the Power Sector Adjustment Program. Th.e proposed  -9- Bank loan, including its quick disbursing features, is an essential part of the financing package. This package, together with likely new lending from multilateral sources, should provide the funds which Colombia needs to achieve its growth targets during the 1987-88 period. E. Relations with the IMF 26. Colombia entered in 1985 into a monitoring arrangement with the IMF, which was linked to the 1985 "jumbo" loan. Under this program, Colombia met all targets. Since its expiration at the end of 1986, Colombia has maintained close collaboration with the IMF, and intends to continue this relationship without recourse to a formal monitoring arrangement in the future. The Bank and IMF frequently exchange views on issues of Colombia's macro-economic management. F. Assessment 27. In summary, Colombia's medium term program represents an effective basis for policy action in the 1987-90 period, but this period will see important development challenges, and continued strong macro-economic performance will be essential if economic growth is to be sustained at the target level. The Government's success in reducing fiscal deficits and in redirecting expenditures and investment, public and private, to meet production and social objectives, will be critical for the program's success. Major efforts to mobilize domestic resources, including continuing action on tariffs, will also be essential. Finally, the Government has recognized the need for sustained action to improve the efficiency of public sector management, notably by strengthening planning and budgeting systems and enhancing efficiency of institutions like the Important utilities. The task of mobilizing external resources Is difficult, but, given continued strong economic management, access to external financing along the lines outlined above, and increased domestic resource mobilization, and Colombia should be in a position to sustain economic growth and development in the medium term. Thus, the country should also be able to continue its excellent debt service record and maintain its creditworthiness in the future. The Government's major macro- economic objectives for 1987-90, include further narrowing down of the non- coffee public sector deficit, maintenance of Colombia's international economic competitiveness and continued liberalization of the trade regime, including further reductions in quantitative restrictions. This program will be the basis for the continuing exchange of views between the Government and the Bank. PART II. THE ENERGY SECTOR AND THE POWER SUBSECTOR A. Energy Sector Profile 28. Colombia has abundant energy resources and traditionally has enjoyed a positive trade balance in energy, except for the 1976-84 period. During this period, Colombia was a net importer of energy due to a decline in oil production. To redress the negative trade balance that could have  - 10 - compromised balance of payments prospects, the Government moved in the late 1970s to direct public sector investment to the energy field, particularly hydroelectricity and coal. As a result, trade balance in energy is again positive, through oil and coal exports. 29. In the short term, with the exception of the oil subsector, the mr-in problems faced by the energy sector are financial, since internal cash generation will not be sufficient to service the sector's debts and provide for an adequate contribution to its investment needs. In the long run the key concern should be to reap the benefits derived from the country's energy endowments. A comprehensi'-e energy policy is being prepared and will focus on such key matters as private sector participation, sector regulation, pricing, interfuel substitution, and sector funding strategies. Resource Base and Consumption 30. Colombia is self-sufficient in all primary energy resources, and there is substantial scope for future expansion. Traditional primary energy (fuel wood, bagasse, and other agricultural residues) is in abundant supply. Modern energy supplies are even more plentiful. Potential hydro power has been estimated at about 100 GW, with only 4,900 MW (1986) ceveloped. Recoverable proven reserves in petroleum are estimated at 6.4 billion barrels. Recoverable gas reserves are estimated at 7.5 trillion cubic feet. Potential coal reserves are estimated to be on the order of 18 oillion tons, the largest reserve base in all of Latin America. Colombia -s well positioned to export coal, with a sizeable portion of the reserves located in coastal regions. The 1986 energy scenario is shown below: Ratio of Reserves to Reserves Production (1986) Production Mtoe m%) Mtoe (Years) >lydroelectricity 5,475 1/ 29.5 5.27 17.5 Renewable Coal 12,000 64.7 6.20 20.6 1,935 Natural Gas 175 0.9 3.51 11.7 50 Crude Petroleum 900 4.9 15.04 50.2 60 Total 18,550 100.0 30.02 100.0 1/ Theoretical output in 50 years, calculated on the substitution basis. 31. Particularly for hydro-power, substantial preparatory work has been done which confirms the rich potential for future development. An extensive inventory and evaluation of about 300 potential hydroelectric sites is available and a large number of them (20), totalling about 20,000 MW of potential capacity, have been studied at feasibility level. The individual capabilities of the studied sites are between 32 MW and 4,200 IW; eight of the sites are smaller than 300 MW of installed capacity. This spectrum of potential projects is sufficiently broad to allow an economic utilization of the hydro risources of the country. In addition, an inventory of potential sites for steam coal generation is available.  - 11 - 32. Commercial energy consumption in Colombia 's about 14.2 Mtoe/year. Except for the oil requirements of transportation, the demand pattern is fairly diversified. Demand for natural gas has grown the fastest in recent years, with electricity close behind. Demand for non-commercial energy has grown very slowly (about 1.9% per year) reflecting a gradual process of substitution by commercial energy. 33. In 1985, about 70% of electricity was produced from hydro sources. Use of coal for production of electricity was low (10%) compared to the extensive reserves. Production of electricity from gas (15%) was higher due to subsidized gas prices for electricity production. The balance (5%) is produced with petroleum products. 34. Attractive possibilities have been identified for substitution of electricity by other types of energy in the mid-and long-term, especially in the residential sector. The industrial sector, which at present is paying electricity rates above long run marginal costs (LRMC) in some regions, has a proportionally low electricity consumption compared to other sources, mainly coal, bagasse, gas and heavy non-exportable oils. The implementation of the recently approved Government tariff policy (para. 104), under which electricity rates for industry in Bogota are expected to decrease in real terms, progressively converging to LRMC, is expected to result in an increase in electricity's share of industrial energy consumption. 35. Substitution of electricity by gas in the Atlantic coast area and in the Departments of Huila and Santander has started successfully. However, in most other areas, at present there are no viable energy alternatives to substitute for residential electricity consumption. In a few cities, sore bottled LPG is available at highly subsidized prices. However, because of the subsidy, until recently ECOPETROL, the government- owned oil company, distributed only small quantities of LPG. The price of gas used for electricity generation is also highly subsidized. The Government is analyzing the economic justification of the substitution of electricity by LPG for household cooking and water heating purposes and preliminary indications are that it would be advantageous. Feasibility of the construction of a gas pipeline from the Atlantic area to Bogots will also be studied. Strategic Issues for the Energy Sector 36. Colombia has recently undertaken a comprehensive study of the energy sector with assistance from the UNDP/IBRD Energy Sector Management Assistance Program (ESMAP). The review underscored the importance of energy sector issues for macroeconomic performance and shed new light on key sectoral issues, notably energy pricing and substitution. It concluded that a significant shift in the direction of energy sector policies was called for to ensure that they provide effective support to the medium term development program. 37. An important finding was that restricted supply of natural gas and LPG resulted in uneconomic use of subsidized power for cooking and water heating in most of the major urban centers, thereby contributing to the unusually large share of residential consumption of electricity in total energy use in Colombia (50% of total).  - 12 - 38. Another important finding was the lack of coordination between the energy subsectors, both in investment planning and in pricing policies. Such poor coordination was reflected in the coal subsector and the power subsector in establishing price projections for steam coal. The generation program developed in the early 80's was heavily tilted towards hydro projects, as the coal export price (about $55 per ton) was used as the opportunity cost for coal. However, Colombia has huge coal reserves (12,000 Mtoe), distributed over the whole country. Not all of this coal is available for exports due to high transport costs, and therefore, a lower opportunity cost should have been used. 39. To address these issues, the Government plans to establish an Energy Board which would formulate sector policies and regulate the rational use of energy resources (para. 85). B. The Power Subsector Organization and Institutions 40. Six main utilities currently dominate the power subsector: Empresa de Energia Electrica de Bogota (EEEB), Empresas Pu:blicas de Medellin (EPM), and Corporac-on Autonoma Regional del Cauca (CVC); strong independent utilities serving the major markets (Bogota, Medellin, and Cali), Instituto Colombiano de Energia Electrica (ICEL), which is the main shareholder of thirteen smaller utilities, Corporacion Electrica de Costa Atlantica (CORELCA) -- the main shareholder of nine utilities; and Interconexion Electrica, S. A. (ISA), a generation and transmission utility. Five other smaller utilities play a minor role. Basic statistics for each of the main utilities are provided in Annex 8. 41. EPM is fully owned by the municipality of Medellin, Colombia's second largest city. It operates power, water, sewerage and telephone services. It is responsible for serving about 102 of the customers and represents 20% of total national electricity sales in the country. EPM is generally well run and efficient. 42. CORELCA and ICEL are fully owned by the Government and together account for about 50% of the customers and 35% of electricity sales. Their twenty two subsidiaries face serious problems, stemming from poor management, excessive politization and generally poorer, isolated market areas. Control by the two parent companies is poor, particularly in the case of ICEL. An in-depth analysis of these institutions is being carried out and is expected to be completed by September 1988. 43. CVC is a generally well run regional development corporation whose main function in the sector is to sell bulk power to the integrated system, mainly to the distribution company serving Cali (EMCALI). Neither EMCALI nor CVC have major problems. 44. EEEB is a large utility (800,000 customers, 3,800 employees) serving the city of Bogota. Over most of its 20-year relationship with the Bank, EEEB has had a history of good management and satisfactory financial policies. In recent years, however, both the Government and the Bank have  - 13 - become increasingly concerned about the trend in EEEB's performance. The simultaneous construction of the Mesitas and Guavio hydroelectric projects, which the Bank helped to finance through Loans 1628-CO (signed April 9, 1979) and 2008-CO (signed March 8, 1982), strained both EEEB's financial capability and its management. Relatively frequent changes in senior management added to the problem and the zeal of the main shareholder (the municipality of Bogota) in pteserving the autonomy of the company from interference by the Central Government added a political dimension to efforts to redress EEEB's problems. 45. Interconexion Electrica, S.A. (ISA) is a key sector institution, with broad responsibilities for sector planning, interconnection of regional systems, and operation of the integrated system. It uias established in 1967 as a corporation whose shares were owned by the regional and municipal utilities. The Bank played an important role in ISA's establishment, which reflected a concern dating from the early 1960s with the fragmentation of decision-making power among increasingly autonomous utilities. Initially, the Governrent was not represented on ISA's Board. This changed in 1985 when ISA's by-laws were amended to allow Government non-voting representation on the Board. The lack of direct 3overnment representation between 1967 and 1985 was an important impediment which prevented the Government from taking effective action to ensure that power sector policies were fully in line with macro-economic programs. 46. Since the late 1960s, ISA evolved into an important and effective institution. Its role in the critical area of overall sector planning has, however, been seriously constrained by the strong pressures from individual region-based utilities to develop their own generation facilities and their general resistance to intervention. In 1979, at the insistence of the regional utilities which were facing the threat of electricity rationing, the Government agreed to permit the regional utilities to initiate their own generation projects. However, it was agreed by the Government and ISA's shareholders that ISA would operate the trunk transmission lines, act as national dispatch agency and, in the long run, own at least one thire of the total generation capacity in the sector. 47. With the benefit of hindsight, the decision to allow the regional utilities to own and to construct large generation projects was not sound, as it led to competition among them for projects in their respective areas, without due consideration of national interests. This weakened ISA's ability to ensure that the investment program constituted the national least-cost solution and to adjust programs to changing circumstances. Once projects were included in the investment programs of the municipal or regional utilities, ISA lacked the authority to adjust the pace of execution to take into account changes in demand. 48. The Ministry of Mines and Energy (MME) plays an important policy and regulatory function in the power sector and specifically is responsible for issuing regulations on the provision of electricity and on technical standards. The tariff board, JNT (Junta Nacional de Tarifas) which is under the National Planning Department (DNP), -is empowered under Decree 201 of 1974 and Decree 149 of 1976 to set electricity tariffs but does not have full regulatory functions to ensure compliance and to assess the efficiency of individual utilities. While it is adequately staffed to analyze tariff proposals for utilities, it is not organized to play a larger role at  - 14 - present. The present regulatory framework is not fully satisfactory; while some municipalities, namely Medellin, exercise a close control over the activities and performance of the utilities they onm, in others the control is poor. As JNT does not have regulatory and monitoring functions, at present no Government agency is empowered to establish performance indicators, review operating costs and monitor achievement of efficiency targets. Until recen:ly, some utilities interpreted JNT's tariff resolutions as setting onlv an upper limit of the tariffs they could charge to consumers. This contributed to some of the existing tariff distortions, as some utilities chargai lower tariffs than those approved by JNT, especially to low income consumers. Since 1986, the Government has established clearly, in policy directions and by law, that JNT sets the actual tariffs to be charged, and the -*tilities have been complying with the JNT's tariff resolutions. 49. Another sector institution is FEN (Financiera Electrica Nacional) a financial intermediary set up by the Colombian Government in 1982 to help finance the irivestment programs of the power sector, oversee the sector's finances, and coordinate the sector's financing strategies. FEN's shareholders are the National Government (95%) and the sector utilities (5%). FEN was to act as a financial agency for the sector, as well as advisor to the Government on financial issues facing the sector and the funding schemes for large projects. These objectives have not yet been fully attained. FEN's role over the past few years has been to channel to the power sector the funds obtained from the Bank (Loan 2401-CC) and from cofinancing and other foreign sources, and to raise funds in Colombia's financial markets which it has onlent to the sector utilities. FEN iS efficiently run and its organization and staffing are adequate for the functions it is carrying out. Its profitability has been consistently satisfactory, and the return on equity has been 21%-22% a year. Recently it has begun to act as advisor to the Government on financial issues facing the sector. 50. Under a recent loan from IDB for electricity loss reductions, FEN has agreed to evaluate subprojects submitted by the beneficiaries, following criteria which meet the appraisal standards of IDB (which are similar to the Bank's). To do this, FEN has set up a Projects Evaluation Division and has staffed it with qualified personnel. This function will expand FEN's role to one which more closely resembles a development institution for the power sector. Power Demand 51. Electricity use is extensive in Colombia and is increasing at rates higher than those for total energy consumption. About 58% of Colombia's population of 28.4 million has access to electricity. Electrification is higher in urban areas (about 95% in Bogota, Medellin and Cali), but large areas of the country still lack electricity service. Electric power provided 28% of total commercial energy in 1985, which compares with 24% in 1980. The increasing share of electric power in total energy consumption is largely the result of gradual substitution of oil products and non traditional fuels by electricity, mainly in the residential sector.  - 15 - 52. In 1985, nearly 50% of electricity consumption was by residential users, who currently have no sa':e energy alternatives, except on the coast where natural gas is availabl-. In the interior and in some urban areas, poor people use a type of kerosene which is unsafe and highly subsidized. LPG is also subsidized but available only in limited amounts. Industry accounted for about 29% of total electricity consumption. This low share is because some industries have availabIl cheaper energy alternatives, like coal, gas, bagasse and heavy non-exporztble oils. 53. Electricity consumption (25.6 TWh in 1985) increased at a rate of about 10.1% in the 1970s but growth has dropped substantially since 1981. The high consumption growth during the seventies and delays in completing some generation projects caused electricity rationing during 1981 and 1982. This led to excessively optimistic planning for the power sector in the 1980s, on the assumption that demand would continue to grow at about 10% per year. In the period 1980 to 1985, the actual yearly growth rate was only 5.6%. This drop was mostly due to economic recession during this period. 54. The current demand forecast assumes that electricity consumption will continue the trend of the period 1980 to 1985, thus a growth rate of 5.6% per vear is expected during the period 1987-1990. Residential consumption is expected to grow at 5.5% per year, and industrial consumption at 6.1% per year. Electricity billings in monetary terms are expected to increase at a higher pace, 6.8%, mainly due to the expected reduction in theft and increase in tariffs. Power Supply 55. Current electricity generating capacity is well in excess of demand and this situation ia expected to prevail through 1995. Public utilities produced 95% of tocal electricity in 1985 and autoproducers, mainly industrial, thle remaining 5%. Autoproduction is expected to represent the same percentage in the near future. Installed capacity in 1986 was 6,700 MW, of which, 1,800 MW was thermal and 4,900 MW hydro. Three major new plants (San Carlos II, Betania and Termoguajira) will start operating in 1987, and total installed capacity will increase to 8,600 MW. This exceeds the estimated peak demand of 5,000 MW by 72% which is well in excess of a normal reserve margin. However, for Colombia's system which is predominantly hydroelectric, energy generating capability is a more relevant parameter, given its dependence on hydrological variations and oil the size of the reservoirs existing in the system. In this respect, the firm energyl available in the system in 1987 exceeds estimated requirements by 22% which, while much lessi dramatic than the capacity reserve margin, is still excessive as an adequate reserve margin over the firm energy availability. This latter margin will gradually decrease to 14% in 1990, increase again to 18% in 1991 when the Guavio hydroelectric scheme starts operating and would disappear by 1995 whe:, new generation is likely to be necessary. 56. As indicated in para 53, the overcapacity described above results primarily from an overestimation of demand and concern with the consequences of rationing in 1981-82. Another contributing factor may have 11 Firm energy is defined as the energy available 95% of the time.  - 16 - been ISA's lack of power to adjust the pace of execution of projects (para. 47). This led to a large expansion plan approved in 1981 which included the installation of 9,160 MW (of which 8,270 hydroelectric) during the period 1981-1991 and demanded yearly investments of US$1,150 million in 1982, US$1,357 in 1983, US$1,252 million in 1984 and US$928 million in 1985. As the constraints on national resources tor investments and external borrowings and the likelihood of excess capacity became apparent in 1984-85, the Government reviewed the program and decided on drastic reduction in its scope. These decisions were made in consultation with the Bank which was assisting in the financing of some of the projects concerned. As a result, the start of four large hydro projects was postponed (Miel I, Urra, Calima III, and Caniafisto, with an installed capacity of 3,290 MW). The completion target date for the Rio Grande and Guavio projects, totalling 1,360 MW was postponed to 1992. This decision should result in a reduction of 51% in the capacity expected to be $nstalled during the period 1981-1991 in relation to the previous plan. Electricity Losses 57. Electricity losses represent a serious probl.m for the sector. They have increased from 16.8% in 1970 to 20.4% in 1980 and to 23.9% in 1986. This has been due to insufficient investment and inadequate maintenance in distribution facilities which has resulted in their deterioration and overloading, and to a substantial increase in energy theft. The insufficiency of investment in distribution is attributable to deficiencies in distribution planning and management. The increase in energy theft is attributable to industrial theft and to social problems (proliferation of illegal land occupations and corresponding electricity connections). Lack of both an appropriate legal framework to punish energy thefts and of an effective system to detect thefts have contributed to the problem. However, with IDB and Bank assistance, the Government has started to address it. Sector Planning 58. Sector capabilities for generation and bulk transmission planning are relatively strong from a technical standpoint. Present overcapacity problems (para. 56) can be largely attributed to other factors (above all the failure to anticipate slowdown in economic growth). Until the 1960s, power generation expansion plans were prepared independently by each regional utility. When ISA was created, one objective was to centralize in it generation and transmission planning. ISA was initially assisted by Harvard University, and adopted Harvard's models for power expansion planning. ISA subsequently developed a comprehensive methodology for analyzing alternative expansion plans, consisting of several mathematical models, including a stochastic treatment for hydrology, as well as methodologies and models for analyses of the transmission system. In the early 1980s DNP and ISA, with technical assistance from the Federal Republic of Germany, developed an inventory of hydroelectric resources, and optimization and simulation models for long-term strategic planning. Though the planning methodologies used have been sound, some distortions have occurred in the planning and decision making process, for the following reasons: (i) not all generation alternatives were explored to the extent desirable, in particular, not enough attention was given to the possibility of using coal generation more extensively; (ii) the robustness  - 17 - of the selected investment programs was not properly assessed for scenarios which differed significantly from those then considered as most likely; (iii) planning was based on market prices which could be different from opportunity costs; (iv) the decision making process allowed regional interests to exert undue influence; and (v) sector planning has not given due consideration to environmental and social aspects of projects at an early stage. 59. The issues mentioned above are currently being addressed. The next least-cost investment program (for 1991-2000), which would be furnished to the Bank as a condition of release of the second tranche of the loan (para. 94), would be prepared according to terms of reference satisfactory to the Bank (this implies, among other considerations, shadow pricing and inclusion of environmental costs). The demand forecasting methodology still can be improved by a better knowledge of the market of electricity uses and a better assessment of the impact of tariff structure changes. To assist in the preparation of a suitable long-term program, the 1987-1990 investment program includes the following studies: (i) planning methodologies related to cost of electricity rationing, forecasting economic variables required for the power demand models, forecasting of load curves, and the impact of alternative energy prices in the power demand forecasts; and (ii) rehabilitation of power stations. Sector Finances 60. The power sector currently faces serious financial difficulties; notably it has insufficient funds to meet debt service and capital spending requirements in the 1987-90 period. The financial difficulties of the sector can be attributed to: (a) A concentration of debt service commitments in the next few years, arising from amortization and grace periods that were too short given the time required to complete construction of ongoing generation projects (including World Bank loan -- the Guavio loan, for example had a 4-year grace period for a project with a 7 year construction period originally envisaged and which is now estimated to be 10); problems were accentuated by delays in construction schedules; (b) Past and committed capital spending based on higher than realized demand growth rates, causing a large proportion of the generation capacity that is being commissioned between now and 1992 to be unutilized; (c) Periods, such as 1985-86, during which there were significant currency devaluations, causing the debt service burden to increase more rapidly than internal cash generation. In 1986/87, this was further compounded by the devaluation of the US dollar vis-a-vis the Yen, Deutsche Mark and other European currencies; (d) Arrears in amounts due to the utilities for the supply of electricity, especially from the public sector; (e) High level of energy losses (23.9% in 1986), of which about half corresponds to energy thefts;  - 18 - (f) Inefficiencies resulting from lack of a regulatory framework and from inadequate Government supervision of the utilities. 61. The long-term debt of the sector at December 31, 1986 was about US$4.0 billion equivalent of which about 45% corresponds to Bank and IDB loans and the balance to commercial loans and suppliers' credits. Internal cash generation covered only 90Q of debt service, mainly because the average term of the sector debt is short (about 10 years) compared with the average life of power investments, which normally extends beyond 25 years, and because of grace periods much shorter than the construction time required for the projects. Access to financial markets to refinance the sector's obligations has been limited, because of the si2e constraints of the local market and because of conditions prevailing in external markets. The liquidity of the sector has also been very low, reflecti..g the undue use of short-term borrowing to meet financing requirements. The Finances of the Main Utilities 62. On a consolidated basis, the sector rate of return on revalued assets in 1986 was 5.7% and the ratio of debt to total assets was an acceptable 55%; however, the financial situation of the individual utilities differs significantly. 63. EPM (22% of the market) is the utility in best financial shape. Its 1986 rate of return was about 13%, debt only represents about 48% of total assets, internal cash generation is positive and loans already obtained are expected to fund a sizeable part of its investment needs in the coming two years. 64. CVC's finances are also quite satisfactory (CVC has 13% of the market) after a recent agreement with EMCALI, CVC's largest customer, providing for a mechanism for the timely payment of EMCALI's electricity purchases. The rate of return on CVC's assets is above 9% and the ratio of debt to total assets is 52%. The company does face a short-term financial problem arising from inadequate terms on its local borrcwings, but offsetting this are its very modest investment needs. It is expected that the Government and FEN will be able to provide for adequate refinancing arrangements without major difficulties. 65. EEEB (26% of the market) has a very high rate of return on revalued assets, about 16% in 1986, but has been significantly affected by the devaluation of the dollar; its debts currently represent about 53% of total assets. These assets include the very large Guavio project (supported by Loan 2008-CO) on which about US$900 millioi ave already been invested as of June 30, 1987; an additional US$1,100 mill'cX investment is required before the project starts to generate electricity in 1992. EEEB's financial problems are mainly related to the financing of Guavio, but have been exacerbated by a rise in electricity theft and by collection difficulties. 66. The owners of Guavio (EEEB and ISA) have not been able to contribute to the financing plan of Guavio in the agreed amounts. According to the agreements reached when project construction started, the owners agreed to share the cost (and ownership) of the project not financed  - 19 - by loans as follows: EEEB 70.2% and ISA 29.8%. The 29.8% was to be provided by ISA's shareholders other than EEEB as followss EPM 2.6%, CVC 9.3%, ICEL 13% and CORELCA 4.9%. Only EPM is up-to-date with its contributions to the project. An overall s;atisfactory financial situation for the sector would allow the others to contribute their share. Under the proposed loan, measures would be taken to ensure full funding for Guavio and government equity contributions to ICEL and CORELCA (para. 101). 67. The CORELCA group of companies (18% of the market) faces serious financial problems. While the 1986 rate of return for the parent company was relatively high, about 9%, this hides the fact that the group faces major collection problems. Arrears to the subsidiaries from official customers (mainly municipally-owned institutions) were close to two years, reducing in turn the subsidiaries' ability to pay for their block purchases of electricity from the parent company. In addition, net operating income of every subsidiary was negative and six of the subsidiaries had accumulated losses in excess of their capital, thus facing a situation of de facto bankruptcy. 68. The situation of the ICEL group of companies (19% of the market) is, in many aspects, even worse than that of the CORELCA group. This is because ICEL's subsidiaries, by and large, serve relatively poorer markets including rural areas in which population is sparse and average consumption per customer is low. The problems of this group are compounded by the excess capacity the sector now faces, as until 1990 it is expected that the group will have to pay for energy in excess of its requirements, under existing contracts with ISA. The consolidated rate of return of the group is negative, and relatively few of the subsidiaries are in acceptable financial shape. Several of the subsidiaries have a very weak equity base. 69. ISA's finances mirror the situation of the sector as a whole. As a company owned by the other utilities of the sector, ISA is dependent on them both for equity contributions and for the prompt payment of the electricity it sells. ISA's rate of return has been high and its financial structure is sound with debt amoun-ing to about 50% of total assets. Net internal cash generation, on the other hand has been low and is expected to become negative because of heavy debt service commitments arising from inadequate terms on ISA's borrowings. Electricity Pricing 70. Over the past decade, there has been a significant increase in the level of electricity rates. At present, the average level is about 90% higher, in real terms, than in 1976, and the policies in effect call for further real increases in the coming years. While on average tariffs are now quite reasonable (the financial problems of the sector are mainly due to heavy debt service and unused capacity, not to rate levels), and the amount of further adjustment required relatively modest, the tariff structure is quite distorted. 71. With regard to the tariff structure, the following salient aspects might be noted: (a) Residential tariffs are uniformly low relative to LRMC, but those of the lower consumption blocks (especially up to 400 kWh per  - 20 - month) are lower than short-run marginal costs, even in a surpluas generation capacity situation. These tariffs also vary widely across cities, mainly due to historical reasons, but with little economic rationale. (b) The subsidized consumption blocks are too large, extending up to 400 kWh pei month whereas the average consumption per customer is about 230 kWh/month. A preliminary estimate suggests that 100 kWh per month should be more than adequate to satisfy the basic lighting needs of the average poor household. Higher actual consumption levels indicate that electricity is being used for cooking and water heating, which might be done more efficiently using alternative fuels (e.g. natural gas and LPG). (c) The industrial tariffs in Bogota are well above LRMC, but this is not the case elsewhere in the country. Electricity prices paid by commercial and other (non-residential) consumers are also generally on the high side. An estimate of the LRMC structure is shown in Annex 7, which also shows present tariffs in selected cities. Environmental Aspects 72. Colombia has adequate institutional arrangements to deal with environmental matters. By law, all major development projects require an environmental assessment which is submitted to a specialized institute, INDERENA under the jurisdiction of the Ministry of Agriculture, for approval. There is nonetheless room for improvement. The most important change needed is to ensure that environmental considerations are appropriately taken into account in the planning stage, before decisions on project selection are made. At present, environmental costs are not taken sufficiently into account for the choice of a least cost investment program. Furthermore, ISA's Planning Office does not have enough environmental staff. ISA's environmental unit needs to be strengthened by incorporating additional staff, setting up training programs, upgrading the status of the environmental unit, and placing it under ISA's Planning Office. 73. An important concern of the power sector is the adequate protection of the river basins and watersheds where the hydroelectric plants are located. There is room for improvement in river basin management, and in reforestation and protection from sedimentation. In this regard the highest priority should be assigned to the reforestation of the Chivor watershed. The 1000 MW Chivor project was partially financed under Loan 681-CO, signed in 1970. The project is owned and operated by ISA. It was completed in 1977. Of the approximately 340,000 ha which comprise the Chivor watershed, 50,000 ha are considered in need of reforestation. About 3,000 ha have already been reforested and the rest should be done in the next 10 years. 74. One other major type of remedial environmental investment is needed. Ash disposal is the main unsolved environmental problem of Colombia's coal fired thermal plants, and the problem is likely to increase if additional thermal plants are built, as would now seem likely. At  - 21 - present, both fly ash and bottom ash are voluminous, and under the temporary ad hoc systems of ash storage now used, water contamination is a frequent problem. To address it the power sector should invest in environmentally safe ash disposal landfills, or other suitable alternatives. Social Aspects 75. In recent years the power sector has faced on different occasions social problems arising from its heavy hydroelectric construction programs. There have been the typical "boom town" effects caused by the construction activities and also rural protests to request increases in the amounts of compensation for land purchases and to seek more public works (e.g.: roads, schools) in compensation for the disruptive impact of power projects. 76. To take social issues into account adequately, the sector should carry out comprehensive socio-economic studies as part of the planning process. A collaborative process needs to be instituted whereby the power sector, municipal governments and regional and national development agencies work together to resolve the social and economic problems of areas affected by large scale hydroelectric projects. 77. A related matter which deserves specific focus is the development of a disaster planning and prevention capability within the sector. At present projects are examined for seismic risks and dams are monitored. However, since Colombia is located in a geologically active region, the sector should pay special attention to the social and environmental effects of a major accident at a hydroelectric site. Bank Support for the Power Sector 78. The Bank has made 30 loans since 1950 for the Colombian power sector totalling US$1,910 million. Seven projects are presently on-going. Most of the loans have supported the expansion of Colombia's generating and transmission capacity. While Bank-financed power projects included distribution components, the first Bogota Distribution Project (1807-CO, in 1980) was the first Bank loan to Colombia to support exclusively distribution expansion; it was followed in 1985 by a second Bogota Distribution Project (2634-CO). The Bank has made only one loan for rural electrification (Loan 1999-CO in 1981) with limited objectives, which are generally being met. No Bank loan has been made to ICEL, the weakest utility in the country. The loan now proposed would be the first which explicitly addresses issues for the power sector as a whole. 79. Several OED reports have found previous Bank lending to the sector to have been generally successful. One of these reports "Power Interconnection (575-CO) and Chivor Hydroelectric Projects (681-CO)" (Report No. 2720, October 29, 1979) commented upon the Bank's participation in Colombia's efforts to evolve a stronger and more efficient power sector organization. Through the creation of ISA in conjunction with these projects, and the steps taken to overcome financial and institutional difficulties, progress was made toward more coordinated sector development. Despite implementation delays and increased costs both projects were successfully executed.  - 22 - 80. The Project Performance Audit Report (PPAR) on the "Mesitas Hydroelectric Project (Loan 1628-CO)" (Report No. 6638, February 13, 1987), acknowledges the benefits which have accrued to Colombia and its electric power sector from its long association with the Bank and notes that measured by world-wide standards, Colombia has done a most creditable job in the development of electric power. However, the report notes that the Mesitas project was completed four and one-half years late, and that EEEB's financial position deteriorated vis-a-vis the forecast at appraisal. The main reasons for this were the following: (i) financial problems due to currency devaluation; (ii) the initiation of construction of the very large Guavio Project by EEEB at a time when Mesitas still presented important management issues and required substantial counterpart funding; and (iii) increased costs, attributable to the long delays in completion. With the benefit of hindsight, the simultaneous construction of two large hydro projects overwhelmed EEEB and are a probable cause for the deterioration of its performance and quality of management. The Government and the Bank underestimated the effect of these projects on EEEB and failed to take the necessary actions to minimize the risks. PART III. THE POWER SECTOR ADJUSTMENT PROGRAM A. The Policy Framework and Government Oblectives 81. The power sector occupies a central position in the Government's medium term program for the following reasons: (a) the cost and availability of power is of critical importance to the competitiveness of the industrial sector and hence to the Government's overall export drive; (b) power is the largest sectoral consumer of public funds, absorbs a major share of the resources available for public investment and is responsible for the largest share of external debt. Improving the quality and timeliness of investment in the sector is therefore a cornerstone of the Government's policy to rationalize public investment; (c) the power sector has considerable potential for foreign exchange savings through policies directed at improving the efficiency of energy utilization and through rational and economical development of the important indigenous energy resources; and (d) the power sector is an important vehicle for domestic resource mobilization through appropriate pricing policies. 82. While the broad policy framework in the sector has been clearly established, as a result of both policy review and actions initiated by the Government, a number of issues still need to be addressed. Further actions need to be taken to improve the institutional framework, to make the utilities more accountable, and to strengthen the regulatory framework defining the rules for performarce monitoring, which is still embryonic. Actual investment decisions are sometimes contrary to stated policies and investment planning still needs to be improved. Financial restructuring of  - 23 - the sector and of some of the utilities needs to be completed. Furthermore, considerable efforts will be needed by Government to maintain progress made thus far in pricing policy and to achieve the targets set for the reduction of losses. 83, Following extensive discussions with the Bank, the Government presented a satisfactory statement on its power sector policy (Annex 3). This statement addresses all the important investment, inst!tutional, financial and management issues discussed in this report. 84. The Government's policy statement reflects its medium and long- term objectives for the power subsector, which are to: Investment Policies (a) develop a strong planning and coordination capability within the Government and ISA; (b) ensure that future power requirements are fully met without the restrictions of the past or the excesses of the present through investments at least cost to the economy; (c) ensure that indigenous energy resources are exploited according to strict economic principles; Institutional Framework (d) move from the present practice of individual, dispersed and ineffective control of the utilities to a broader regulatory framework in which the rules for investment decision making and operational behvvior are well defined and the utilities operate in a well coordinated environment within the sector, with the rest of the energy sector and with the macro-economy; (e) provide a policy framework whereby the utilities operate efficiently and have a sound financial structure based on the soundness of the sector as a whole. (f) increase awareness of social and environmental concerns and the capability of dealing with them. Improved Efficiency (g) ensure maximum operating efficiency in all utilities through proper utility and project specific management practices, good operating procedures and adequate maintenance; and (h) achieve economic pricing policies while measures will be taken to ensure that the costs of inefficiency will not be passed on to the final consumer.  - 24 - B. The Program Investment Policies 85. One of the major objectives of the power sector adjustment program is to establish institutional arrangements which would overcome past investment planning deficiencies arising from (a) the lack of coordination of such planning across all energy subsectors and (b) the lack of a central authority which could ensure that investment plans took due account of Government policies. With this in mind, the Government submitted to the Congress in November 1986 a draft law which would establish an Energy Board, to be composed of the Minister of Energy, the Chief of the Planning Department (DNP) and representatives of the energy agencies (Carbocol, Ecopetrol, ISA and FEN) and be funded from contributions from the sector companies; it would have its own technical staff. The Energy Board would set policies and regulate the use of energy resources. To achieve this objective, the Energy Board would forecast energy demand and would select the most economical energy source for each use and approve investment plans of all energy sector entities. Thus, the Energy Board, on the basis of alternatives prepared by ISA, would approve generation and transmission expansion projects in the national interconnected system, and all other transmission, subtransmission, distribution and rural electrification programs. This legislation includes provisions designed to achieve greater coherence in the policies followed in the various subsectors, and will make it possible to focus on issues such as the energy sector's linkage to the macroeconomy and interfuel substitution, that were being inadequately taken into account in the past. The Government hopes to obtain passage of the Energy Board legislation during the Fall 1987 session of the legislature. Under the action program, supported by the proposed loan, a condition of release of the second tranche would be either approval without significant change of the draft law by Congress, or adoption of alternative administrative measures which would achieve substantially the same purposes. 86. While the Energy Board will establish standards for and approve power subsector investment programs, the preparation of the major programs will remain the responsibility of ISA. Thus, another measure necessary to ensure the high quality of the investment program will be the strengthening of ISA's role. When major generation and transmission projects are included in the investment programs of the municipal or regional utilities, because of the ownership pattern, ISA does not have the authority to adjust the pace of execution to take into account changes in demand. Furthermore, there is great risk that local or regional pressures may lead to a change in an agreed prograw. To ensure proper execution of the major investment program, the action program provides that ISA will be granted the authority to own, construct, and operate all future major generation and transmission projects prior to release of the third tranche. The Urra project, which has been long ago assigned to CORELCA -the only power company without a share in a hydropower plant-, will be exempted from this new policy. However construction of this project is not expected to start before the early 1990s.  - 25 - The 1987-1990 Investment Program 87. The Government has recognized that it will take some time for the Energy Board to be organized and fully operational and that in the meantime, it is necessary to revise the investment program developed in the early 1980's as it was based on demand projections which did not materialize. In addition, the available spectrum of hydroelectric options has been widened by completing studies on several additional potential hydro sites, and thermal options, mainly coal, seem attractive given the large amount of non-tradeable coal in the country and low production costs. 88. The Government revised in 1986 the sector's investment program through 1990 on the basis of current demand projections, with the objectives of (a) minimizing future excess generation, (b) utilizing presently installed capacity and (c) taking into account the financial restrictions of the sector and of the public investment program. The revised program thus involves: (a) postponing the start of construction of 3200 MW in hydroelectric projects and associated transmission facilities, equivalent to an investment of about US$1300 million in the period 1987-1990; (b) completing generation projects and associated transmission :acilities now under construction, with delayed schedule when feasible; in particular, completion of the large (1000 MW) Guavio nydroelectric project was delayed to 1992; and (c) limiting the scope of the distribution component to those investnments intended to reduce energy losses in existing facilities and required for maintaining electricity service coverage in urban areas and the current pace in rural areas. The revised program envisages direct investments of US$502 million in 1987, US$554 million in 1988, US$550 million in 1989 and US$456 million in 1990, an average of US$515 million per year, which is about 43% of the investment level of the 1982-1985 period. This revised program contains a balanced blend of generation, transmission lines and distribution f_cIlities, and takes into consideration the priority and timing of every program component. 89. The 1987-1990 investment program would total about US$2,062 million at current prices (before interest during construction) of which US$1,056 million would be foreign (both direct and indirect) and US$1,006 million would be local. Local costs include taxes and duties estimated at US$180 million. A summary of the investment program is given in the following table:  - 26 - Power Sector Investment Program, 1987-90 (US Million) FC LC TOTAL % Generation 477 383 860 42 Transmission 249 233 482 23 Subtransmission & Distribution 298 342 640 31 Studies and Other 32 48 80 4 TOTAL (before IDC) 1,056 1,006 2,062 100 IDC 729 202 931 TOTAL 1,785 1,208 2,993 Under the action program: (i) The Government and the Bank agreed during negotiat'&ons on the size, including annLual investment levels, and components of the power subsector investment program for each year 1987-90. (ii) The investment program would be updated annually, and the Government and Bank would conduct joint reviews of the program (and related financing plan -- para. 99 below) and the status of its execution by October 31, 1988 and 1989. A satisfactory updated sector investment program and related financing plan would be a condition for release of the third tranche. Investment Proaram 1991-2000 90. To take care of sector needs beyond 1990, tEe investment program needs to be defined on the basis of a new least cost generation planning study. ISA is already starting to prepare a revised expansion plan, which will take into account all options (mainly hydro and coal), under agreed terms of reference, which include improvements to the planning methodology. The studies of new generation alternatives are expected to be completed in early 1988, in time for a decision for new generation needed in 1995. Under the action program, a draft of the revised least cost investment program through the year 2000, including generation and associated transmission programs, would be completed in a manner satisfactory to the Bank prior to release of the second tranche. The submission of the final least-cost investment program would be a condition of third tranche release. In addition, the Government agreed during negotiations that no new generation investment would be started unless included in the agreed least-cost investment program and that rural electrification programs in excess of those contemplated in the 1987-90 Investment Program should proceed exclusively on the basis of secured additional financing. Guavio Proiect 91. The largest project in the on-going investment program is the 1,000 MW Guavio Hydroelectric project, which is being executed pursuant to a partnership agreement among EEEB and ISA. As mentioned in paras. 44 and  - 27 - 66 above, the construction of this project has placed major strains on the management and finances of EEEB, ohich has the primary mar.agerial and financial responsibilities. It is important to the timely and economic execution of the investment program that implementation of this project be completed in an efficient manner. A new agreement among the partners designed to strengthen the ownership and management scheme, and which takes into account the energy needs of EEEB and the ISA shareholders, has been signed. Agreement was reached at negotiations on a updated financing plan and revised management structure including a schedule for their implementation. Satisfactory progress in their implementation would be a condition for release of the second and third tranches. Institutional Framework 92. Beyond the institutional changes described above which are required to define and implement investment policies and decisions at the sector level, the Government is committed to embark in a broad improve,--t program of the sector's institutional framework to ensure B; efficiency of sector operations. 93. As noted in paragraph 48 above, the existing regulatory framework of the power subsector is inadequate. Important sector entities, most notably CORELCA and ICEL, and more recently EEEB, have experienced serious managerial and financial difficulties, while their managerial and operational autonomy, which would be a very healthly condition in an appropriate regulatory environment, goes virtually unchecked. The JNT has the power to determine tariffs and as discussed in para. 52 above, its authority has been reinforced by recent Government actions. Nevertheless it must accept on faith the data presented by the companies to justify rate adjustments and has no ability to assess whether or not particular adjustments are merely rewarding inefficiency. Establishing appropriate mechanisms for monitoring the efficiency of sector utilities and for enforcing improved performance has proven to be an intractable long-term problem. 94. Under its action program, the Government has approved the establishment of a Monitoring Committee for the power sector, comprised of representatives of the ministries of energy, finance and planning (MME, MHCP and DNP). This Committee, which reports to the Ministry of Energy, with technical support from FEN, will monitor on a continued basis all the power sector utilities in terms of budget execution, financial performance and yearly expenditure allowances. It was agreed during negotiations that by December 31, 1987, the Committee would establish an appropriate system to monitor the performance of the sector. The participation of MHCP will ensure the compliance of the Government's macroeconomic targets for the power sector, while DNP will provide (through JNT) the linkage between the rate-setting function and the assessment of their compliance by the companies. Utility Management 95. Rather than letting the indirect and necessarily slow process of improvement through the regulatory-tariff approval process determine the pace of improvement of the three weakest utilities, EEEB and the ICEL and CORELCA groups, the Government is taking direct, positive steps towards achieving specific improvements in management practices in these utilities.  - 28 - Management studies of the ICEL and CORELCA parent companies ar.d for each of the twenty two subsidiaries of ICEL and CORELCA will be contracted with independent consultants acceptable to the Bank, working under terms of reference satisfactory to the Bank, first to diagnose the management problems of these utilities and then establish detailed plans of action to address the problems Identified by the consultants, and to implement their recommendations. Under the action program, the management improvement action plans for the ICEL and CORELCA group would progress according to a detailed schedule agreed during negotiations. A comprehensive management study of EEEB to be carried out by consultants acceptable to the Bank, working under terms of reference satisfactory to the Bank would identify the reasons for EEEB's decreasing efficiency and quality of management in recent vzaars. A managementgimprovement action plan for EEEB will be submit-ed for Bank approval'by December 31, 1988. Submission of ICEL's and CORELCA's electrificadoras draft management improvement plans would be a condition of release of the second tranche; submission of EEEB's, ICEL's and CORELCA's plans would be a condition of release of the third tranche. Electricity Losses 96. The Government gives high prioiity to reducing electricity losses as a means of improving efficiency and improving sector finances. The sectur is already committed to a substantial effort to reduce physical losses and energy theft. Thus, in the context of the project financed by Loan 2634-CO for EEEB, the reduction of losses in Bogota, which represents 25% of the market, is one of the main objectives of an ambitious recovery program. A special unit in charge of implementing a plan for reducing tnefts in Bogota was created in EEEB in early 1986, and growth of losses was stopped in 1986. To carry out a project oriented to reduce energy losses in the rest of the country, IDB has already approved a US$70 million loan to be administered by FEN, and onlent to the utilities. The total cost of the program which IDB's loan will help to fund is US$200 million. Under this program, studies to reduce physical losses in seven cities have already been completed. In addition, ISA has set up a national committee to follow up the loss reduction program and to recommend measures needed for its implementation. This committee is composed of planning staff of the six major utilities. As a result of these efforts, losses are to be reduced from 23.9% in 1986 to 21.1% in 1990 and further reductions thereafter. Intermediate targets have been agreed during negotiations. It was also agreed that by December 31, 1987 the Government would submit to the Bank, a study of the legal framework and policies against electricity theft and a plan to apply them. Satisfactory progress in achieving the loss reduction targets for 1987 and 1988 would be a condition for release of the second and third tranches. Ecological and Social Aspects 97. It follows from its present and planned responsibilities that ISA should be in charge of overall ecological and social issues that affect the sector. To this end, ISA has begun to develop specific plans to incorporate staff with social sciences background who can assist with the needed planning and monitoring functions. Since Colombia is located in a geologically active region, ISA is developing a disaster planning and prevention capability within the sector to cope with the social and environmental effects of a major accident at a hydroelectric site. ISA is also taking actions to ensure the adequate protection of river basins and  - 29 - watersheds through reforestation of about 50,000 ha. About 3,000 ha have already been reforested at Chivor, a hydro project, partially financed by Loan 681-CO and the rest should be done in the -lext 10 years. Finally, under ISA's guidance, the power sector is investing In environmentally safe ash disposal landfills, and other suitable facilities, ti.A main unsolved environmental problem of Colombia's coal fired tnermal plants. During negotiations it was agreed that ISA would develop by March 31, 1988 an action program to address the ecological and social oroblems affecting the sector, including staffing plan, budget and training programs. Satisfactory progress in implementing the action plan would be a condition for release of the second and third tranches. The action plan also requires ISA to reforest additional areas at the Chivor project. As for social aspects, the Government submitted to the Bank a satisfactory program to address social issues caused by the-Guavio hydroelectric project. Satisfactory progress in complying both with the ISA social and ecological program and with the Guavio program would be conditions of release of the second and third tranches. Financial Ad1ustment Program 98. The long-run objectives of the Government are: (i) to improve the financial structure of the sector by reducing the weight of debt in the total financing mix; (ii) to lengthen the average term of the sector's debt and to progressively increase the self-financing capabilities of the sector through a pricing policy based on economic principles; (iii) to reduce progressively, and eventually eliminate, the need for financial contributions to the sector from the Government; and (iv) to imrrove financial discipline by ensuring prompt payment of accounts due to, from, and within the entities of the sector. In order to achieve these objectives, the constraints posed by the heavy debt-service burden of the sector and limitations in access to external financing sources, as well as economic and social considerations governing the desirable pace of tariff adjustment, must be taken into account. 99. The financing plan for 1987-90 was designed in consultation with the Bank and IDB, after sounding out commercial banks and prospective cofinanciers regarding the feasibility of the amounts that were being considered, and the likely timing of new financing agreements. Even though the investment program has been reduced from the sector's original expectations to take into account macroeconomic priorities and to protect the soundness of the financing program, during 1987 and 1988 equity contributions will be required from the Government, in addition to electricity rate increases, to ensure the full funding of the program. The Government agreed during negotiations on a financing plan for 1987-1990. The sector's investment and financing plans for 1987 through 1990 would be reviewed jointly with the Bank on a yearly basis (para. 89). This would facilitate adjustment of financial targets to changing conditions, while ensuring that the objectives of the program are maintained. The following table shows the consolidated financing plan for 1987-90, and also presents projections for 1991-92. Detailed projections are presented in Annex 6.  - 30 FINANCING PLAN (Millions of Current US$) Total 1987-88 1989-90 1987-90 1991-92 Financing Needs Investment Program 1,459 1,534 2,993 ;,718 Working Capital needs 105 128 _ 233 137 TOTAL 1,564 1,662 3,226 1,855 Financing Plan Gross Internal Cash Generation 1,369 1,759 3,128 2,243 Less: Interest Charged to Pperations (518_ (429) (947) (329) A. Net Cash Flow 851 1,330 2,181 1,914 B. Consumers Contributions 34 29 63 17 C. Government Contributions 1/ 280 110 390 D. Total non-borrowed (A+B+C) 1,165 1,469 2,634 1,931 E. Gross Borrowings 1,383 1,372 2,775 1,047 Existing loans (foreign) 761 359 1,120 195 Future loan-: Loans from Government through FEN 146 57 203 - Cofinancing 300 730 1,030 - Local borrowings (FEN) 176 226 402 296 Other (Future 1991192) 0 0 0 912 F. Less Debt Amortization Requirements (985) (1,178) (2,163) (1,479) G. Net Borrowings (E-F) 398 194 592 ( 333) TOTAL (D+G) 1,563 1,663 3,226 1,855 1/ Includes $300 million from proposed loan. 100. This financing plan which calls for US$3,226 million illustrates the plight of the sector and above all the funding problems during the 1987-1990 period of very heavy debt service requirements. The borrowing program, though sizeable in gross terms, is quite modest in net terms, and would result in a reduction of the debt/equity ratio, from 55:45 at present to 37:63 by 1992. In this situation, unless access to external financing fails to develop as expected, it would not be advisable to seek a greater self-financing effort, as it would require a slower pace of convergence to LRMC levels of those electricity rates now above such levels (an economically undesirable option, particularly at a time of excess generation capacity) or a significantly faster pace of increase to residential consumers, at a time when social concerns arising from high unemployment and unrest in some areas of the country indicate that this would be an undesirable course. 101. The ambitious self financing target in the financing plan requires implementation of several measures: tariff increases, payment of public sector arrears, government contributions, rehabilitation of the utilities of the ICEL and CORELCA groups, and financial assistance to EEEB and ISA. The adjustments proposed in each of these areas are included in the action program and outlined below.  - 31 - (a) Tariffs: Resolution No. 86, which was issued by JNT in November 1986, provides that electricity rates will be adjusted every month, progressively converging to LRMC. In the case of the residential sector, the monthly adjustment will be made on the basis of the annual increase in the minimum wage, and in the case of industrial and commercial tariffs on the basis of the increase in the power sector's costs. In addition, there would be annual step adjustments of up to 4% (residential sector) and 5% (industrial and commercial sector) until LRMC target levels are achieved. JNT has already issued resolutions for the tariff adjustments for 1987. On average, the above results in an increase estimated to be about 3% p.a. in constant terms of the selling price through 1992. To promdte the use of unutilized generating capacity, there is an idea of providing promotional tariffs to industry for incremental loads on a contract basis until capacity becomes fully utilized. To ensure compliance with resolution 86, any adverse material change to it, or failure to implement it, would be a condition of default of the proposed loan. (b) Public Sector Arrears: The total public sector debt to the electric utilities was around Col$10.6 billion in end-1986 (US$52 million). This reflects a situation that has not improved over the years and which affects national, departmental and municipal entities. These arrears pose a financial burden on the utilities, and should be paid. At negotiations, the Government submitted a plan of action to eliminate the arrears of these entities in a gradual way. Satisfactory progress in eliminating the arrears would be a condition for release of second and third tranches. (c) Government Contributions: The Government would make equity contributions to ICEL and CORELCA a total amount of U.;$240 million (1987-90) in local currency. Another US$150 million equivalent would be channelled through FEN as loans to the power sector companies between 1988-1990. Of the total amount, the Government should pay US$150 million equivalent by end 1987 and another US$130 by end 1988, as part of the financing plan. (d) Financial rehabilitation of ICEL and CORELCA's individual utilities: Some of the power companies of the ICEL and CORELCA groups presert a very weak financial performance. Several proposals have been developed over time to address this issue and the Government is now taking the following measures: (a) changing the bulk rates towards LRMC, but differentiating between customers to take into account the characteristics of the markets they serve; (b) an intensified effort to increase the equity participation of municip&lities, departments, and private sector institutions in the poorer utilities; and (c) a study of possible mergers and redistribution of markets. However, the restoration of financial viability can only be achieved through the implementation of financial rehabilitation plans for each company. To successfully implement these plans will require detailed planning as well as the approval and support of all levels of authority necessary for their implementation. Individual companies must be given specific financial targets for which they  - 32 - are to be held accountable, such as rate of return, operating ratios and debt service coverage. Rehabilitation plans for the CORELCA and ICEL group of utilities were agreed during negotiations. The rehabilitation plans should be updated in 1988 to reflect the findings and recommendations of the ongoing management studies. Satisfactoty progress in the implementation of the plans would be closely monitored by the Bank and would be a condition of release of the second and third tranches. (e) Cofinancing. To meet the funding needs of the sector between 1987 and 1990, in addition to the proposed Bank loan of US$300 million, an amount of US$1,030 million is necessary from foreign sources. About US$300 million is expected to be provided by IDB through a loan, mainly for the Guavio Project and transmission system, which is expected to be appraised in the second semester of 1987. The Government has applied to Japanese Eximbank for a loan of up to US$300 million, also mainly for transmission and distribution system investments. About US$200 million is being channelled to the power sector as part of the US$1,060 million external financing package, which the Colombian Government recently agreed in principle with commercial banks. The balance of about US$230 million is expected to be funded by a) future suppliers and export credits, b) additional financing from IDB and the Bank, and c) complementary commercial bank financing, including private placements or bond issues in Japan and floating rate note issues in the Euromarkets. Firm commitment of (1) US$200 mwillion of cofinancing funds (from all sources) would be a condition of effectiveness and (2) and additional US$250 million (a total of US$450 million) of such funds would be a condition of third tranche release. in the event that such actionis and commitments do not materialize, the Government should satisfy the proposed conditions by initiating implementation of an equivalent contingency pF n (e.g. reduction of investment program, increase in Government equity contributions). 103. Future sector borrowings (FEN and the utilities) should be strictly coordinated to be successful and timely, FEN should inform the Bank on the status of the cofinancing arrangements. Pricing Ad1ustment Program 104. The Governmert of Colombia intends to continue with the policy of increasing electricity tariffs in real terms which it has been following for the past ten years. The action program in this area, therefore includes the following: (a) To ensure an efficient allocation of resources while adequately meeting very valid social policy objectives, the consumption block for subsistency needs would be reduced to 100 kWh per month. This may be done immediately in areas where alternate fuels are already available for cooking, but must also be implemented as early as possible in other cities, as other fuels like LPG become more accessible at prices consistent with economic efficiency considerations. During negotiations, it was agreed to gradually reduce the level of the consumption block for subsistency needs to  - 33 - 100 kWh/month, whenever the gas and LPG program the Government is starting to implement in several cities approaches an 85% coverage. Before June 30, 1988, the Government will define a) the timing targets to reach this coverage level in the main cities of the country and b) the criteria for adjusting the consumption block for subsistency needs. (b) Household rates up to 400 kWh (basic consumption level) per month will be raised gradually in real terms. In most consumption centers, the application of this scheme will rapidly bring the 400 kWh/month rate to the level established in Resolution 86. In Bogota, because of the particularities of the residential market, the adaptation to Resolution 86 will take longer than in the rest of the country. At negotiations, it was agreed to adopt an intermediate consumption block (between 200 and 300 kwh/month) for Bogoti and gradually align the Bogoti rates with the rest of thA country. (c) Under JNT's Resolution No. 86, industrial electricity rates throughout the country would be revised, to bring them in line with LRMC, and thus provide efficient price signals for both investments and electricity use. In particular, the Bogota industrial power rates would be reduced, while increases would be implemented in other parts of the country whenever necessary. At negotiations, a scheme was agreed for Bogoti that would allow the company to sell existing energy supplies under special contracts to selected industrial consumers at lower prices. 105. Through implementation of the measures discussed above, it is expected that by 1994, when excess generation capacity is expected to have become fully utilized, all electricity rates will have substantially converged to LRMC-based values, (except for lifeline rates to the poorest sectors of the population). PART IV - THE PROPOSED LOAN Background and Justification for Bank's Involvement 106. The proposed loan is a key element in the Government's plan for external resoure; mobilization in support of its adjustment program. It has also a central role in this program, as it would help achieve the Government's objectives of redirecting public investment away from capital intensive sectors, enhancing domestic resource mobilization through appropriate pricing policies and improving the management of public enterprises. It is the outcome of a Government/Bank power sector dialogue over the past two years. The loan was prepared in the field in June 1986, preappraised in November 1986, and appraised in February 1987. The reports, studies and working papers prepared in support of the proposed loan are listed in Annex 11. Negotiations took place in Washington in SepteAber 1987. The Government was represented by Mr. Guillermo Perry Rubio, Minister of Mining and Energy.  - 34 - Disbursement 107. The proposed loan of US$300 million would be made to the Republic of Colombia. Full disbursement of the loan would take place over a fifteen-month period. Disbursements of the proceeds of the proposed loan to the Government would be made against general imports, subject to a negative list of ineligible items (retroactive to April 1, 1987), in three tranches. -The first tranche of US$150 million would be disbursed upon loan effectiveness; the second and third tranches of US$75 million each are expected to be disbursed about 7 to 9 and 13 to 15 months later, respectively, after fulfilling of the agreed conditions which are indicated in Annex 10. Disbursements wouid be based on satisfactory evidence of: (i) physical entry of the imports into the countsy; and (ii) actual payment in foreign exchange for such imports. Procurement 108. The imports to be financed would be made by public entities and private sector importers, following procurement procedures acceptable to the Bank. Contracts for the procurement of imports exceeding US$5.0 million would be awarded on the basis of international competitive bidding in accordance with procedures consistent with Bank procurement guidelines. Contracts under US$5.0 million would be procured through normal procedures used by importing entities. Monitoring and Reporting 109. Qualified staff within each of the main sector agencies have been designated as responsible for the coordination, monitoring and evaluation of their respective activities under the sectoral adjustment program. Typically the lei.d staff are at the level of either Director of Planning and Coordination or General Manager. FEN would have the responsibility for coordinating the action programs of all sector agencies and would take lead responsibility in preparing major progress reports including the completion report. Accounting and Auditing 110. The Central Bank will maintain separate records and accounts of all transactions under the loan. All such accounts will be audited by independent auditors satisfactory to the Bank, and the auditors' reports will be submitted to the Bank not later than four months after the end of each calendar year. Program Benefits 111. Implementation of the cohesive program of actions to be supported by the proposed loan will result in several significant benefits to the economy. These actions will: (a) rationalize resource allocation in the power sector; (b) significantly increase the stock of trained manpower both in the traditional areas of planning and management and in areas  - 35 - relatively new to Colombia such as regulatory, environmental and social aspects, etc.; and (c) reduce and render more efficient public expenditures in the sector through improved operational efficiencies, cost recovery policies and investment planning. 112. The IRR of the 1987-1990 investment program. is about 13%. The investment program is likely to generate additional social benefits accruing from expanded residential and public use, as well as additional economic benefits accruing to production from a more reliable electricity supply. The estimated rate of return is at the upper end of the opportunity cost of capital in Colombia which suggests that, since electricity rates are used as a proxy to measure the benefits from the sale of electricity, the proposed tariff policies will be consistent with economic pricing. Sensitivity analyses carried out for the investment program are summarized below: Sensitivity Rate of Return Lower demand growth (reduction of 1 percentage point in annual growth rate) 11.0 Energy sales valued at tariffs prevailing in Mtrch 1987 11.7 Investment program costs 10% higher 11.8 113. Power sector policies are mainly designed to improve efficiency and do not have a large d!,ect impact upon poverty except for the Go4eiunent's rural electrification program which is specifically targeted at impoverished areas of Colombia. As a result of a significant increase in investment in 1985 and 1986 the rural electrification program is now well on course to meeting Government's target of completing electrification of main villages by 1990. Risks 114. The main risks in implementing the sector adjustment program arise from: (a) Possible failure to secure cofinancing in the amounts and timing envisaged. However, to ensure the viability of the financing plan, the Government would prepare a contingency plan, in case cofinancing prospects do not materialize as expected, which would detail criteria for delaying investments, define commitments for incremental Government equity contributions and bridge loans, and provide for assumption of sector debtlor provisions for acceleration of the program of rate increases (para. 102). (b) Regional resistance to the concentration of responsibilities on the Energy Bokrd, the Monitoring Committee, ISA ar.d JNT in regulation and monitoring.  - 36 - (c) Volatility in energy demand and supply forecasts as a result of changes in the macro-economy and in external factors such as international energy prices. (d) The pace of tariff increases especially in light of any increases in the inflation rate. Considerable efforts will be needed by Government to ensure that electricity prices reflect changes in inflation in order that planned LRMC targets are maintained. The annual reviews of the investment programs and associated financing plans will give the Bank an opportunity to discuss on a regular basis the details of specific issues and targets. (e) The expected increased independence of the municipalities from the Central Government that might cause differing tariff objectives, in both structure and levels, anticipated under the adjustment program. PART V - BANK GROUP OPERATIONS IN COLOMBIA 115. Colombia has received 120 loans, totalling US$5,731.4 million (net of cancellations), of which US$4,163 million is outstanding as of September 30, 1987. IDA made one credit of US$19.5 million for highways in 1961. Disbursements have been completed on 84 loans and the IDA credit. IFC has made investments and underwriting commitments of US$171.5 million in 32 enterprises and as of September 30, 1987, it held US$57.5 million. Annex 2 contains a summary statement of Bank loans, the IDA Credit, and IFC investments as of September 30, 1987 116. Disbursements have increased significantly in recent years, from an average of US$86 million equivalent per year before 1979, to US$591.0 million in FY85 and US$654.0 million in FY86. In addition to the expanded volume of lending this higher disbursement activity is primarily related to the three fast-disbursing loans (FEN, TPED, TAP) 2 which accounted for 521 of the total disbursed in FY86, and to concentrated efforts to overcome problems in the start-up and implementation of projects. For example, procurement delays have been overcome when Colombian authorities agreed to a more automatic import licensing mechanism for Bank-financed projects. Establishment of Special Accounts and Special Account Program measures alleviated constraints on counterpart funds. Semi-annual country reviews, held with the Government's Project Monitoring Unit established in 1984, have also helped to identify problems to expedite project implementation. 117. The Bank's lending strategy has evolved overtime as the result of an intensive economic policy dialogue with the Government. It has progressively broadened its scope and has recently focused on working improvements in three broad areas: (a) efficiency of resource use and economic diversification; (b) public sector management; and (c) basic needs and employment. Policy discussions over the past several years have highlighted fiscal, interest rate and pricing policies, as well as trade. In trade, the objective has been to enhance the incentives for exports and 2/ Power Development Finance (FEN), Trade Policy and Export Diversification (TPED) and Trade and Agricultural Policy (TAP) loans.  - 37 - to reduce the level of effective protection. The most encouraging results have been achieved in trade policy and public services, including setting more appropriate charges for power, water, irrigation and petroleum prices. 118. The evolving role of the Bank is clearly reflected in the lending commitments. Since the mid-1960s, when 88% of the Bank's loans made were for power of transport, loans have supported projects in agriculture and industry, itrigation and watershed management, education, water supply, telecommunications, urban development, petroleum development, nutrition and health. This diversification process was largely a function of the sustained and broadened socioeconomic progress in Colombia and close Bank association. By the late 1970s, 53% of the loans made to Colombia were for projects other than transport and power. In the mid-1980's, the scope and instruments for lending were extended further via the Trade Policy and Export Diversification and Trade and Agricultural Policy loans. This reflected the Bank's increasing emphasis on stimulating higher productivity in income and employment generating activities in agriculture and industry and on the need to achieve a more outward-oriented economy. Both loans have played an essential role in Colombia in this respect, helping to advance the country's economic program and to attract an associated package of short- and medium-term commercial bank financing. 119. The Bank's lending in FY87 totalled US$180.3 million and consisted of one loan for highways sector. For the future, several projects are under preparation to support the new Government's decision to step up efforts to reduce poverty in Colombia. These will focus in particular on increasing access to water supply and sanitation, education and health services. Work is also underway on operations to facilitate agricultural diversification and generate employment in small scale activities , mining and industry. Other preparations are also being made for operations stressing rehabilitation, modernization and a more intensive use of the existing facilities in the Colombian ports and highways systems, as well as improvement in public sector management. 120. While IBRD, IDB and bilateral sources provided about 77% of total external financing to Colombia in 1970, their shar,a4...e decreased since then to some 60% for 1985 and is expected to decline further to about 33% of external capital requirements by 1990. In addition to its traditional focus on power, IDB has been giving increased emphasis to projects for low- cost housing, urban and rural development, agrarian reform, university education, water supply, rural electrification and land erosion control, which are aimed at improving living standards of the lower-income population. In the future, it proposes to also assist Colombia increasingly to expand productive sector activities to help generate increased employment. USAID has supported programs in education, rural development and small farm development, but is phasing out its assistance to Colombia. The Government of Canada, the Federal Republic of Germany and the Netherlands have also provided concessional financing for basic needs and regional integration projects. IFC has a small, but innovative program in Colombia focusing primarily on private sector investments in nickel, energy and transport, and advisory services to DNP and the Central Bank on foreign investments.  - 38 - PART VI - RECOMMENDATION 121. I am satisfied that the proposed loan would comply with the Articles of Agreement of the Bank and I recommend that the Executive Directors approve the proposed loan. Barber B. Conable President Washington, D.C. November 10, 1987 Attachments 9 .  - 39 - ANNEX I Pag 1 of 6 fa-195 Pptla teaul .42 t3 CP t Sit /USbllII 1.320 A. sas e t FM us_tle PIG wt," L latth Ron IS w _ I" taott Uru cuet pecs, data) lif? t tat fice Saw 1945 113 510 1934 193 196 W19 3 1973-0 19163044 29IS p96 m5 OTIC P3t, It 11 11010.00 10.0.00 100. 10.4 1.* 1M.* L4 4.91 La 2.43 Li5 Not man"t Ta5 .2 10.03 9.3* 10.44 c 59 11.03 543 1o.o 3 _Iyscutut 24.4 24.5 19.33 17.7 17.21 ed 4.31 4.5 1.53 0I 1 st2iy 2.7 .01 3.04 21.42 2.1 4 7.9 2.57 2.La 4.4 l5sfulactort 14.79 I6I? 14.97 t.19 t12 0 LV5 L341 0.3 2.14 sa lmnce 44.44 45.41 4.13 0.217 4. me 1... 2.00 0.74 bes Sle O.9 2.01 0.40 -3.21 1.32 2.70 .. .. tapas of on" ifS 12.01 15.24 17.21 12.14 14.74 19.3 14.94 6.l1 -2.41 6.6 24.1: topto e4 I OI of$ 11.04 14.X 14.31 15.42 L4.0 1.14 14 1.2 3.43 *2.s0 4.2; C tsop 6.? 3o.n 72 8.3 4. 41 63.43 ea 4.42 1.13 3.13 33 .24 Private CUn txse 74.9 71.4 70.43 73.3 n2.t2 as .22 5.07 3.14 ; .90 -0.11 SovMe Coou%Otlo 7?3 96