Philippines - Rural electrification sector study : an integrated program to revitalize the sector

_. po fht so Report No. 6Ol16-PH Philippines Rural Electrification Sector Study: An Integrated Program to Revitalize the Sector Noven*er 9, 1989 Coy Deparmnt 11 Asia Region FOR OFFICIAL USE ONLY i~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ DocuUmen of the Worl Bark This document has a restricted distribution aridnmay be used by recipients only,p if*th performance of their officdal duties. Its content may not otherwise be disclosed without Worl Bank authorization. W. " ,%~~~~~~~1  CURRENCY EQUWALENTS Currency Unit - Philippine Peso (P) US$1.00 - P 21.4 P 1,000 - US$46.73 P 1 = 100 Centavos (Ctvs.) WEIGHTS AND MEASURES Kw _ Kilowatt (1,000 watts) MW = Megawatt (1,000 kilowatts) GW Gigawatt (1 million kilowatts) kWh - Kilowatt-hours (1,000 watt-hours) NWh - Megawatt-hours (1,000 kilowatt-hours) GWh - Gigawatt-hours (1 million kilowatt-hours) kV = Kilovolt (1,000 volts) m - Meter (3.2808 feet) km = Kilometer (0.6214 miles) ABBREVIATIONS AND ACRONYMS ADB - Asian Development Bank APT - Asset Privatization Trust BAPA - Barangay Power Association BOT - Build-Operate-Transfer Program COA - Commission on Audits DBP - Development Bank of the Philippines DENR - Department of Environment and Natural Resources DOF Department of Finance ECC = Energy Coordinating Council ERB - Energy Regulatory Board ERR - Economic Rate of Ret-urn FECOPHIL - Feder. of Electric Cooperatives of the Philippines IRR - Internal Rate of Return LRMC = Long Run Marginal Cost MERALCO Manila Electric Company MIS = Management Information System NEA - National Electrification Administration NEDA - National Economic Development Authority NPC - National Power Corporation NPV - Net Present Value NRECA - National Rural Electric Cooperative Assn. (U.S.A.) OEA Office of Energy Affairs OECF = Overseas Economic Development Fund (Japan) PNOC = Philippine National Oil Company REA = Rural Electrification Administration (U.S.A.) REC - Rural Electric Cooperative REMP - Rural Electrification Master Plan SMCC - Synthesized Ma:ginal Cost of Capacity TOD - Time of Day USAID = United States Agency for International Development  FOR OFFICIAL USE ONLI PHLIPPINES RURAL ELECTRICATION SECTOR STUDY: AN INTEGRATED PROGRAM TO REVITALIZE THE SECTOR Table of Contents EXECUTIVE SHMARY . . . . .......1. . . . . . . . . . . . . . . . . . . 1. RURAL ELECTRIFICATION SECTOR OVERVIEW . . . . . . . . . . . . . . .1 A. Introduction .1.................... . . . B. Energy Sector Institutions. 2 C. The Rural Eleci.rification Program . . . . . . . . . . . . . . 3 The Program's Origins . . . . . . . . . . . . . . . . . . . 3 Current State of the Sector. 4 D. Issues Facing the Sector ........ .. ... .. .. . 6 Operations, Investment and Priciag .... . . . . . . . . 6 The Rural Electric Cooperatives . . . . . . . . . . . . . . 8 The National Electrification Administration . . . . . . . . 9 E. A Revitalization Program ........ .. ... .. .. . 10 2. OPERATIONAL EFFICIENCY .... . . . . . . . ...... . . . . . 11 A. Introduction .... . . . . . . . . . . . . . . . . . . . . 11 B. The Rural Electric System .... . . . . . . . . . . . . . . 12 C. Operation and Maintenance . . . . . . . . . . . . . . . . . 15 D. Commercial Practices . . . . . . . . . . . . . . . . . . . . 17 E. Non-Technical Losses .20 F. Core Systems . . . . . . . . . . . . . . . . . . . . . . . . 22 G. Rural Electrification Master Plan . . . . . . . . . . . . . . 23 3. INVESTMENT STRATEGY .... . . . . . . . . ....... . . . . . 26 A. Current Planning Strategy .... . . . . . . . . . . . . . 26 B. Investment Priorities .... . . . . . . . . . . . . . . . . 27 C. Investment Scenarios .... . . . . . . . . . . . . . . . . 30 D. Coverage Targets . 33 E. Investment Criteria and Planning. 34 F. Planning Constraints .... . . . . . . . . . . . . . . . . 37 G. Summary of Recommendations .... . . . . . . . . . . . . . 39 This document has a restred distibution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  4. PRICING POLICY . . . . . . . . . . . . . . . . . . . . . . . . . . 40 A. Introduction ....................... . 40 B. NPC Costs . . . . . . . . . . . . . . . . . . . . . . . . . . 41 C. LRMC-Based Wholesale Pricing ..... . . . . . . . . . . . 42 D. REC Cost of Supply . . . . . . . . . . . . I . . . . . . . . 43 E. A Possible Rate Formula .................. . 45 F. Operating and Customer-Related Costs . . . . . . . . . . . . 48 G. Other Pricing Issues .50 Affordability and Price Elasticity . . . . . . . . . . . . 50 Pilferage ........................ . 51 Regulation . . . . . . . . . . . . . . . . . . . . . . . . 51 H. Summary of Pricing Principles ... . . . . . . . . . . . . . 52 5. THE RURAL ELECTRIC COOPERATIVES . . ....... . 55 A. Introduction . . . . . . . . . . . . . . . . . . . . . . . . 55 B. Financial Condition .... . . . ...... . . . . . . . . 56 Aggregate Financial Results .... . ..... . . . . . . 56 Comparison of REP Performance by Area and Region . . . . . 58 Comparison of RECs with Investor-Owned Utilities . . . 59 C. Institutional Structure and Management .. ..... . . . . 60 Role of NEA .... . . . . . ....... . . . . . . . . 60 Role of REC Boards of Directors ... . ..... . . . . . 62 Role of REC Managers .... . . ...... . . . . . . . 63 D. Guidelines for Restructuring the RECs . . . . . . . . . . . . 63 Increase the RECs' Equity ................ . 64 Relief from Non-Performing Assets and Delinquent Loans . . 65 Improve the Manageability of the RECs .. ..... . . . . 66 Reorient the RECs' Investment Practices .. ..... . . . 67 6. THE NATIONAL ELECTRIFICATION ADMINISTRATION . . . . . . . . . . . . 69 A. Introduction ..69 B. NEA's Role . . . . . . . . . . . . . . . . . . . . . . . . . 69 C. Institutional and Financial Context . . . . . . . . . . . . . 71 D. Current Financial Performance ..74 E. Proposal for a Financial Restructuring of NU . . . . . . . . 78 F. Financing Strategy ..84 G. NEA's Financial Prospects ..87 H. Organizational Issues ..89 I. Summary of Recommendations ...... .......... 91  Annexes Armex 1.01 - Consumers Served by the RECs Annex 1.02 - Annual Formation of RECs Annex 1.03 - Current Status of Mini-Hydro and Dendro-Thermal Programs Annex 2.01 - Kilometers of Line per Region by Design Parameter Annex 2.02 - Consumers per km. of Line per Region Annex 2.03 - Distribution System Design Aspects of Technical Losses Annex 2.04 - Current Condition of the Rural Distribution System Annex 2.05 - Reeommendations for Improved Tree Clearing & Pole Treatment Annex 2.06 - Zonal Repair Facilities to Service the RECs Annex 2.07 - Transformer Circuit Metering - The'BAPA Model Annex 2.08 - Annual Energy Sold and Losses (By Geographic Region) Annex 2.09 - Program to Reduce Non Technical Losses Annex 2.10 - Pilot Program for Rehabilitating Substations and Feeders Annex 3.01 - NEA Investment Requirements Survey 1988 Annex 3.02 - Sample Feasibility Studies Annex 3.03 - Sample Feasibility Studies - Results Annex 3.04 - Potential Savings from Construction Efficiency Improvements Annex 3.05 - Rural Distribution Investment 1989-95 Annex 4.01 - Comparative Rate Levels for NPV's Luzon Grid Annex 4.02 - Marginal Cost Analysis Annex 4.03 - L.A - Based Wholesale Pricing Annex 4.04 - REC Cost of Supply: Four Case Studies 4nnex 4.05 - Hypothetical Cases: Marginal Cost Rates for REC Customers Annex 4.06 - Sample Cooperatives: Price and Cost Data Annex 4.07 - REC Performance Indicators Annex 4.08 - Price Elasticity of Demand Annex 5.01 - REC Energy Usage Annex 5.02 - 25 Largest/Smallest Rural Electric Cooperatives Annex 5.03 - REC - Summary Statement of Operations Amnnex 5.04 - REC - Net Operating Income (Losses) Annex 5.05 - REC - Summary Balance Sheet Annex 5.06 - Comparison of Loan Records - NEA vs RECs Annex 5.07 - Distribution of RECs Among Performance Categories Annex 5.08 - Cost Profile Summary Annex 5.09 - REC General Managers - Board vs NEA Appointments Annex 5.10 - Loan Releases to RECs (Per NEA Records)/ Annual Lending to the RECS Annex 6.01 - Foreign Lending to NEA - By Source Annex 6.02 - Foreign Lending to NEA - By Year Annex 6.03 - Summary of Overdrawn Loans to RECs Annex 6.04 - Status of NEA's Mini-Hydro Loans - By Region Status of NEA's Dendro-Thermal Loans - By Region Annex 6.05 - Summary of NEAL's Relending Terms Annex 6.06 - NEA's Fi.nancial Projections for 1989-93 Annex 6.07 - NEA Staff - By Department Annex 6.08 - Comparison of NEA & NPC Salary Structure Annex 6.09 - Relending Program - Status of Loan Repayments Appendix A - List of RECs and Their Acronyms Maps IBRD 216C8 - The Rural Electric System - Luzon Area IBRD 21763 - The Rural Electric System - Visayas Area IBRD 21762 - The Rural Electric System - Mindanao Area  Acknowledgements This report was prepared by a rural electrification sector mis- sion that visited the Philippines during February 20-March 10, 1989. The mission included: (a) Jamil Sopher, Senior Financial Analyst/Mission Leader (b) Karl G. Jechoutek, Senior Economist (c) William H. Lawrence, Institutional Specialist (d) Gerald G. Dunnion, Rural Electrification Specialist (e) Ashley Lyman, Electricity Pricing Specialist (f) Myrna B. Villaralbo, Financial Analyst In addition, the mission wishes to express its sincere thanks to Raymond Schoff (Rural Electrification Specialist) and Eleanor Alcanites (Financial Analyst/Auditor) for the substantial assistance they provided, both during the mission and thereafter. We also wish to extend our thanks to Patricia Brereton-Miller, Merle Mendis, Lillian Samson and Anjali Villagran for the substantial help they priovided at headquarters. The mission wishes to express its gratitude for the excellent cooperation and gracious hospitality afforded by the host agency, the National Electrification Administration (NEA); the National Power Corpora- tion (NPC); the Department of Environment and Natural Resources (DENR); the Office of Energy Affairs (OEA); the National Economic Development Authority (NEDA); the Department of Finance (DOF); the Energy Regulatory Board (ERB); and the Development Bank of the Philippines (DBP). The mission also grate- fully acknowledges the management and staffs of the Cebu I, II and III Electric Cooperatives (CEBECO); Tarlac I Electric Cooperative (TARELCO I), Camarines Sur III Electric Cooperative (CASURECO III), Benguet Electric Cooperative (BENECO), La Union Electric Cooperative (LUELCO), and Tablas Island Electric Cooperative (TIELCO), who consulted with the team during field visits in the course of the main field mission and an earlier prepa- ratory mission (November 29-Docember 9, 1988). Finally, the mission wishes to offer sincere thanks to the staff of the Office of Capital Development of the United States Agency for International Development (USAID) mission in the Philippines, wb-, were ex- tremely generous about sharing their extensive knowledge of and experience in the rural electrification sector.  EXECUTIVE SUMMARY A. Introduction 1. In early 1988, tbe Bank undertook a study of the Philippine energy sector; that study (Report No. 7269-PH; September 15, 1988) recom- mended a broad strategy for resource allocation and utilization. Since then, the Government indicated concern that some of the important benefits of that strategy might not be realized because of inefficiencies in the electricity distribution system, through which about 15% of total available energy is consumed. The Government was particularly concerned about the impact of rapidly increasing distribution losses, which reached 25% by the end of 1987, on the US$7 billion investment program that was launched for electricity generation and transmission in 1989-96. In June 1989, the Bank approved a US$65.5 million loan to finance distribution system improvements in Metro Manila and the surrounding area. In addition, it conducted a study of the rural electrification sector in February 1989. This report details the findings of that study. 2. The study confirmed that the rural electrification sector has major problems. Until about 1983, substantial investments were made for system expansion without due regard for cost or quality of service. Since 1983, with funding for further expansion becoming increasingly constrained, repayment of earlier loans coming due, and the physical deterioration of core systems scaadily increasing, the financial distress of the sector's institutions has become acute. The problems are so pervasive that they cannot be addressed by simple solutions; rather, the Government will need to implement an integrated program to revitalize the sector. That program should have three essential components: (i) a comprehensive restructuring of the sector's core institution, the National Electrification Administra- tion; (ii) a broad program of institutional reform, featuring some finan- cial restructuring, of the 117 Rural Electric Cooperatives that are respon- sible for distributing electricity to smaller urban centers, towns, vil- lages and rural areas nationwide; and (iii) a thorough refocussing cf oper- ational practices and investment priorities. B. Background The Economic Settng 3. The Philippine economy has undergone a dramatic turnaround since the mid-1980s. The economic reorientation since 1986 has stressed the primacy of efficiency, prudent macroeconomic management, a transition to market mechanisms, a reform of public enterprises, and a streamlining of public sector investment. The next steps in the transition to efficiency- oriented management will include (i) tailoring a public sector investment program to provide the prerequisites for sustained economic growth; (ii) upgrading the implementation capacity of public sector agencies; (iii) accelerating rural development investments; and (iv) removing infra-  - ii - structure bottlenecks. In this context, a revitalization of the rural electrification sector is critically needed if issues of investment effi- ciency, rural development, and infrastructure improvement are to be ad- dressed vigorously. Energy Sector Instftutions 4. The main energy sector Government institutions include: (i) the National Power Corporation (NPC), which is responsible for power generation and transmission; (ii) the Philippine National Oil Company (PNOC), which is responsible for maintaining adequate oil supplies and developing indigenous energy resources; and (iii) the National Electrification Administration (NEA), which is responsible for formulating and implementing rural electri- fication policies. Following the change in Government in 1986, the Office of Energy Affairs (OEA) was given responsibility for planning and coordi- nating energy sector policies and programs. OEA, NPC and PNOC are under the formal control of the Office of the President while NEA reports to the Department of Environment and Natural Resources (DENR). Recently, to de- velop formal linkages between the energy sector participants, the Govern- ment formed an Energy Coordinating Council (ECC). 5. Within the power sector, NPC is responsible for all but very modest generation facilities nationwide and most transmission systems. The Manila Electric Company (MERALCO), an investor-owned company, is responsi- ble for electricity distribution in Metro Manila and surrounding areas. Six investor-owned power utilities provide distribution to urban centers outside Manila. Distribution for the smaller urban centers and the rural areas is provided by 117 Rural Electric Cooperatives (REC). NEA is respon- sible for coordinating the activities of the RECs. Historical Context 6. The rural electrification program began formally in June 1969, when Republic Act 5038 (i) declared total electrification of the country- side on an area coverage basis to be a national policy; (ii) provided for the creation of NEA as the primary agency responsible for executing the rural electrification policy; and (iii) provided for the organization of RECs to implement the electrification targets and operate the resultant networks. At that time, only 18X of the country's population was enjoying electric service. NEA was supposed to fulfill its statutory responsibility by (i) providing technical support to the RECs; and (ii) financing their expansion programs rith grants and long-term loans. Later, it acquired tne additional responsibilities of (i) supervising the RECs' technical and man- agerial activities; (ii) regulating their electricity rates; and (iii) pro- moting the development of alternative generating schemes and certain other special projects, which were concerned with integrated rural development programs but not per se with rural electrification. 7. In the program's early years, official and Government funding for rural electrification was so plentiful that the cooperative system ex- panded extremely rapidly. This expansion was realized through both the  - iii - construction of new networks and the assumption of responsibility for existing systems following the failure of locally-based, investor-owned power companies. During this early period, RECs were formed following a thorough feasibility study, with service areas that afforded reasonable chances for technical and financial viability. But, as the pace of expan- sion accelerated, the feasibility studies became more superficial; and RECs were formed to meet political objectives, REC managements suffered from the same politicization, and the quality of operations suffered as a result. C State of the Sector 8. Currently, 117 RECs have franchises covering the entire country outside of the areas served by MERALCO and six smaller investor-owned dis- tribution companies. From an initial base of about 170,000 connections in 1971, they now provide electricity to about 2.8 million consumer members. A large proportion of RECs face serious operational and financial problems. Only 22 RECs are considered to be well managed and financially viable; for another 24, financial viability is within reach if they make some opera- tional and commercial adjustments. The remaining 71 either have a pro- nounced need for substantial remedial action or are considered beyond res- cue. REC distribution losses average 25%, but are in some cases as high as 45-50. Theft of electricity is common, and maintenance is inadequate throughout the REC system. Annual loan releases, which had averaged more that US$28 million in 1971-83, have dropped precipitously, reaching only US$3.3 million in 1988. With the decline in funding, the annual growth rate of new connections has slowed from 30% or more before 1980 to under 4% since 1983, and even declined in 1988. 9. The sector's operational and financial weaknesses are critical. The RECs' poor standards of maintenance have led to a widespread physical deterioration of their networks; as a result, with technical losses averag- ing 17% (non-technical losses are averaging 8%), most REC distribution sys- tems are operated at well below their design standards, leading to low re- liability of service. The Government's past emphasis on growth of coverage without sufficient regard for cost, combined with its use of the RECs to implement costly and economically unlustifiable alternative generation and rural development programs, has saddled most of the RECs with debts they cannot pay, despite the heavy concessional element built into the instru ments that were used to finance the sector's expansion. Generally, the RECs lack the skilled staff and equipment needed to improve their opcra- tional performance, and the burdens of past mistakes have weakened their prospects for improving their financial health. In many instances, the RECs' financial problems are directly related to managerial weaknesses that have resulted from the interference in their internal affairs by highly politicized Boards or individual Directors. Even if the RECs as a group would be provided with financial relief, some 25-30 among them face limited future prospects on account of franchise areas that are inherently too costly to serve. 10. NEA has performed poorly as both a lender and a provider of technical support to the RECs. Although it collects monthly data to docu-  - iv - ment the RECs' performance. it has been unable to implement programs foi operational and financial improvement, largely because its already scanty technical staff is spread too thin to perform its functions well. NEA's financial condition is poor; and in 1987 and 1988, it realized a collection efficiency of only 36Z. This, in part, reflected the weakened financial condition of the RECs as a result of the recession of 1983-86, and, in oth- er part, the inherent inability of the RECs to repay loans for uneconomic investments that were promoted by the Government and NEA. Too often, the Government has used NEA to promote costly alternative generation schemes or rural development programs of dubious economic value; and, as a result, NEA has on its books some P 2.6 billion in loans for alternative generation and an undetermined amount of loans for social programs for which it has negli- gible prospects for repayment. Overall, NEA has questionable prospects for meeting some P 7 billion of loans raised from foreign lenders and from the Government. 11. NEA's weaknesses result largely from a lack of clarity regard- ing its role in the sector, and its consequent lack of direction. While its revenues accrue entirely from its lending operations, it has viewed itself primarily as an electrification company. In that regard, it has acted as the sector's policy maker, investment planner, regulator, and uti- lity manager of last resort; however, it has not developed the primary functions of a financial intermediary, namely loan programming and credit evaluation. Its lack of a clear focus has inhibited it from acting as an effective core agency for the sector. 12. Perhaps the sector's biggest problem is the participating in- stitutions' chronic lack of technical accountability. NEA has neither had (i) a mechanism to coordinate its activities with the rest of the energy sector, even though the RECs taken together form a substantial block of energy consumers, nor (ii) the outlook and accountability of a financial institution, even though lending and credit are essential elements of its own financial health. Instead, NEA h-as either been accountable to politi- cal agencies, as it was during 1979-86 to the former Ministry of Human Set- tlements, or to rural development agencies, as it is currently to DENR. In that context, its staff has dispensed substantial capital without regard for the technical or financial requirements for cost recovery. 13. The politicization of NEA created an environment that enabled the RECs to become politicized. Although NEA has sound rules governing the conduct and remuneratlon of REC Boards and individual directors, those rules are flaunted more often than not. Availabla data suggest a high cor- relation between interference by Poard members in the day-to-day activities of the RECs and poor management of those institutions. While the RECs are in principle accountable to their consumer members, most RECs whose weak performance may be attributed to poor management show little effort to de- velop member involvement. In effect, these Boards (and in turn their RECs) are accountable primarily to the political interests that sponsored their elections.  . v . D. A Revitzation Pogram 14. Major reforms in the sector are urgently needed. To address problems that are so pervasive, an integrated nrogram should be developed that will simultaneously (i) introduce proper operational practices. Apgro- priate investment strategies. and sound pricing princigles and (ii) streng- then the sector's weak institutions. The first focus of the program should be on operations and investment, so as to determine the requirements for restoring the networks to their original design standards and the parame ters of an affordable investment program. Concurrently, appropriate pric- ing principles should be introduced to optimize the RECs' recovery of their costs from revenues. Programs to restructure and strengthen the RECs and NEA should follow after the requirements of operational and investment re- form have been established. Because neither the RECs nor NEA can concen- trate effectively on their future responsibilities as long as they are bur- dened with unmeetable obligations accruing from past uneconomic policies, the institutional strengthening components of the program should include measures for the financial restructuring of these organizations. To ensure that the benefits of restructuring remain effective in the long term, NEA will need to develop and implement a financing strategy that (i) encourages the RECs to invest in high-return projects and adopt proper operational practices and pricing principles, and (ii) discourages them from failing to meet obligations to their creditors and their consumers. Finally, any re- form of the RECs and NEA should include provisions for developing funcrion- al accountability within each of the organizations while also taking ac- count of the realistic constraints they face. 15. This report makes many recommendations for improved opera- tions, investment planning, and pricing for the rural electrification sec- tor. While the study addresses these issues in the aggregate, to ensure that these diverse activities are properly coordinated and to translate this extensive program into a management plan for each REC, an comprehen- sive Rural Electrification Master Plan (REMP) is needed to provide a de- tailed framework within whick (i) specific improvement measures can be for- mulated, taking into account realistic constraints on available financing, and (ii) operational performance can be measured against realistic techni- cal and financial targets. The REMP should be prepared by NEA in consulta- tion with the RECs, with the assistance of consultants. It should plan the integrated long-term development of rural electrification, with special emphasis on the next ten years. It should include as its main elements: (i) establishment of a methodology for investment planning and evaluation; (ii) preparation of indicative investment and lending programs; (iii) de- velopment of an appropriate pricing system; (iv) establishment of opera- tional performance criteria; and (v) formulation of a manpower development plan.  - vi - E Operations, Investment and Pricing 16. The condition of the rural electric distribution system has gradually deteriorated so that supply standards and the quality of service have diminished markedly. Now, NEA and the RECs are facing the need for substantial investment in rehabilitation, system improveme.ts, and major maintenance as well as investments that may be justified ir system expan- sion. To ensure that capital is not wasted, proper operation and mainte- nance should take precedence over any investment in new systems. Funds that are allocated for new investmer.t should be used to support projects that are economically justifiable. Currently, because of the general.ly poor condition of many core systems, the relative priority of rehabilUta- tion within the context of all possible investments needs to be estab- lished. To the degree that investments in rehabilitation and system im- provements can be justified on economic grounds, NEA and the RECs should refocus away from extending area coverage and toward improving the quality of existing service. Finally, pricing of electricity should be reformu- lated so as to encourage efficien. operation and maintenaino2 bY the utili- ties as well as efficient utilization of electricity by the consumer, and not merely the recovery of average costs. Operational Effidency 17. Basic_Svstem Design. The basic design of the distribution net- works is sound and appropriate. Until the early 1980s, electricity service and supply continuity standards were generally good, and continue to be satisfactory in a majority of RECs. The system's main flaws result from (i) beginning construction prior to obtaining propsr rights-of-way; (ii) improper maintenance; and (iii) use of ad-hoc approaches for construction, operations and maintenance in the face of financial constraints. 18. Imiroved Operation and Maintenance. Network maintenance is currently performed by the RECs on an ad hoc basis, with poorly-trained staff using inadequate materials, tools and transport. Field inspections of more than half of the RECs, conducted by consultants in 1986-89, found that about 10 of the networks were well maintained, 25X satisfactorily maintained, 35X unsatisfactorily maintained, and the remainder showing no sign of maintenance. NEA should therefore develop a national program for planned and operational maintenance. Based on that program, NEA would help the RECs prepare their own budgets and work programs for major maintenance, and ensure through conditionality con future loans that each REC had formu- lated and would implement its own maintenance program. Programs for plan- ned maintenance should only cover core systems operating at or near design standards; otherwise, rehabilitation must be done first. At a minimum, maintenance activities should include the following three components: (i) clearance of trees; (ii) treatment of poles to prevent rotting; and (iii) repair of damaged equipment and tools that are now lying idle. 19. Rehabilitation of Core Systems. The rural distribution core system consists of about 250 69-kV substations and about 600 13.2-kV feed- ers that supply the distribution transformers, low-voltage networks and  - vii - consumer service drops. About 20X of the rural network requires extensive rehabilitation or replacement to restore the system to the original design standards. A pilot program for rehabilitating core systems is included under the proposed Bank-Zinanced Energy Sector Loan; if successful, that program could form the basis for the design and implementation of future rehabilitationw projects. 20. Reduction of Nontechnical Losses. Nontechnical losses are un- acceptably high and should be reduced through a program that includes the following measures: (i) continuous surveillance of lines; (ii) replacement of all "Al base type meters; (iii) sealing of all socket-type meters; (iv) on-site meter testing, replacement and recalibration; (v) rewiring of all substandard major industrial and commercial meters, with regular checks of these meters; (vi) installation of check meters on distribution transform- ers; and (vii) replacement of low-grade service connections with concentric cable. These technical improvements should be complemented by (i) stronger laws to enable utilities and RECs to pursue pilferers and to impose stiffer penalties on those pilferers who are convicted (several proposed bills are currently pending before Congress); and (ii) increased consumer involvement through the promotion of group accounts, known as Barangay Power Associa- tions (BAPA), that would shift responsibility for losses in the secondary system to the BAPA and reduce billing costs. 21. Commercial Practices. Over the years, the RECs have become slack in implementing proper commercial procedures; now, only about 10 of the RECs run their commercial activities effectively. The causes of this deterioration include: (i) management's failure to accord priority to bill- ing, collection and related activities; (ii) insufficient funds to provide and maintain the equipment needed for commercial efficiency; (iii) short- ages of functioning mete.:s; ane (iv) local political and social pressures to forgive delinquent consumers. To restore the RECs to a sound commercial footing, NEA should update its commercial guidelines and encourage the RECs to implement them. Each REC should be provided with a mini-computer to manage its billings and collections, and training in the procedures as well as the hardware and software supplied. These improvements should be com- pl.'qmented with investments to rehabilitate service loops, metering instal- lations and meters. The experience in those RECs that have been performing well indicates a high correlation between effective collections and height- ened member involvement; therefore, the formation of BAPAs and implementa- tion of member outreach programs should be encouraged. Finally, NEA and NPC should develop technically-based policy guidelines concerning supplies to large industrial and commercial consumers; those guidelines would speci- fy conditions under which the RECs could enjoy exclusive franchises within their service areas. 22. Manpower Development. The most critical manpower development requirement facing the sector is to increase the effectiveness of managers, particularly the RECs' General Managers and NEA's senior functional manag- ers. The REMP could provide the framework for a management development program consisting of: (i) annual seminars for small groups of managers to discuss action planning, prioritization of operational and investment ac- tivities, and constraints on implementat.Ion of operational and investment plans; and (ii) training courses, including situational management, human resources management, investment planning and financial management, and  - viii - distribution planning, to upgrade managerial skills. NE& will need to pro- vide the facilities and absorb the cost of managing this program; the en- sure that the related costs are recovered, NEA will need to charge appro- priate fees to participating RECs. Investment Strategy 23. In its early years, the rural electrification program was ori- ented towards expanding the distribution network outside the urban centers. The dominant issues in investment planning were the appropriate geographi- cal spread of network expansion and the pace for connectir.g villages and households. This approach, which was driven by (i) technical consider- ations, (ii) availability of finance, and (iii) implementation capacity, lent itself to quantitative planning methods primarily aimed at ensuring that the financial performance of the newly established RECs kept pace with investment. Over time, this planning approach gradually overlooked such increasingly important system requirements as maintenance and upgrading, intensification of connection density along existing lines, and service to non-residential consumers. 24. NEA changed its investment priorities in 1988 and embarked on a crash program of identifying the previously neglected rehabilitation and upgrading needs. However, this salutary effort can be sustained only if an investment evaluation and programming method based on economic criteria is put into place. Using such an approach confirms the intuitive view that rehabilitation is the highest investment priority, as indicated by rigorous analysis of alternative investment options which compete for scarce re- sources. As only marginal savings could be realized from changing design standards, the investment options are determined by the relative weight given to system improvement and expansion in the investment program. The results of sample feasibility studies conducted by NEU indicate that the highest priority should be accorded to rehabilitation/upgrading with simul- taneous addition of new connections in the rehabilitated parts of the net- work. Expansion is economically justified only when a large part of demand is provided by non-residential consumers such as medium and small industry. 25. These indicative priorities need to be translated into a con- sistent rural electrification investment plan and NEA lending program. Since establishing such a comprehensive planning and programming process in NEA and the RECs will take some time, indicative investment scenarios were developed to get this process started. Based on the priority for system improvement derived in the sample studies, two scenarios involving varia- tions in the pace of investment were examined: (i) a scenario based on a gradual increase in rehabilitation expenditure, and (ii) a second scenario based on a massive early rehabilitation effort. The first scenario even- tually rises to a higher level of annual expenditure as delayed rehabili- tation overlaps with increasing investment for expansion. Under both sce- narios, (i) system upgrading will take up most of the sector's funding and implementing capacity for the medium term, and (ii) considerable investment in expansion will have to be postponed to allow the distribution system to regain efficiency. In the early 1990s, when annual investment levels reach about P 1 billion, substantial new funds will have to be mobilized. In any  - ix - case, the most important constraint affecting the level of future invest- ment appears to be the absorption capacity of NEA and the RECs. The most likely scenario, which involves aggregate investments of about 1 3.8 bil- lion during 1989-93, represents a best guess of NEAs absorption capacity. 26. During the early 1990s, assuming a redirection of NEA's invest- ment strategy, the proportion of rural population receiving electricity supply could rise from the present level of about 50X to about 651 by 1993/94. About half of the newly connected 700,000 to 800,000 consumers would be within easy reach of the existing grid, and would receive their connections through add-on investments; the remainder would receive elec- tricity as a result of judicious expansion into economically justifiable areas. From the mid-1990s onward, connecting the remaining 250,000 to 300,000 consumers that could be supplied economically through add-on in- vestments would increase coverage to about 701 of the rural population. However, given that the share of unconnected productive consumers must nec- essarily decline and the areas remaining to be electrified would become increasingly remote, the expansion investments that might increase penetra- tion significantly are likely to become more difficult to justify in eco- nomic terms. Even in the long term, penetration beyond about 75X of the rural population would appear difficult to justify economically, and would have to rely instead on social priorities (in which case, the economic cost would have to be absorbod). 27. The past preliferation of rural electrification in the Philip- pi.es occurred because of the emphasis that had been given to the social aspects of expanding the service. However, during the next five to ten years, the sector will be undergoing substantial restructuring (paras. 36 and 41-44). During this period, emphasis needs to be placed on addressing issues surrounding the needed restructuring while supporting investments that have prospects for an imminent favorable financial outcome and direct economic potential. Investments that are justified primarily on social grounds can be considered only sparingly before the late 1990s or early 2000s, and should be postponed until the current institutional problems have been remedied and the RECs have regained financial strength. Pricing Polic 28. NEA guides and monitors the RECs' rate setting activities. Rates are established according to a simple formula that includes the cost of power purchases (or own generation), REC operating costs, and debt ser- vice requirements. Current NPC bulk rates for REC purchases from the major grids are about P 0.5-1.0/kWh, resulting in an average retail rate for REC customers of about P 1-2/kWh. In isolated island RECs, where local genera- tion costs P 2.0-2.5/kWh, retail rates have averaged about P 4-5/kWh. Re- cently, NPC has agreed to take control of the generating facilities serv- ing those islands and charge those RECs a subsidized rate of P 1.30/kWh; in turn, the RECs would observe a retail rate ceiling of P 2.5/kWh. 29. In general, the existing formula does not encourage efficiency in consumption patterns, and does not provide for future investment. A move towards rates based on long-run marginal cost (LRMC) principles would  - x - address both deficiencies. In 1987, the Government instructed NPC to de- velop LRMC-based bulk rates, and NPC is in the process of designing an ap- propriate pricing structuro. As the power purchase price forms a large element of the final REC retail price, the outcome of the NPC pricing anal- ysis will be an essential input into REC rate setting. The key issue in the structure of NPC rates is the differential in marginal cost between peak and off-peak periods of daily demand. To give clear signals to whole- sale consumers, NPC should introduce time-of-day pricing gradually, thus encouraging the shifting of price-elastic demand to off-peak periods. 30. The application of marginal-cosc principles to REC pricing is a logical extensicn of the improved NPC rate structure. During the evening hours, when NPC and REC peak periods overlap, the supply cost imposed by retail consumers is highest, amounting to about P 3/kWh in Luzon RECs with acceptable system loss levels; however, the corresponding off-peak costs would only be P 0.60-1.80/kWh. Large REC consumers such as industries could be billed on a time-of-day basis, according to this cost structure. Residential consumers, for whom average pricing is more suitable, would face a single rate, which would reflect the weighted costs imposed on the system by their pattern of consumption. On average, the RECs' revenue per kWh is likely to remaiui below the current ceiling of P 2.50 (assuming that they can keep their system losses at or below 20X), while the demand pat- tern would adjust to optimize the cost of supply. The report develops a rate formula which follows these principles. While the rate formula indi- cates substantial changes in the structure of rates to encourage more effi- cient utilization of electricity, efficient RECs would be realizing average revenues near their current rates. In many cases, industrial consumers would be paying less than or the same as current rates, while residential consumers might be paying as much as 10-15X more than they are currently. While the concept of time-of-day pr-cing is beneficial in the long run, it should be intreduced cautiously, observing consumer reactions at each grad- ual implementation step. If the concept yields efficiency benefits and is easy to administer, it should be implemented in full. 31. Electricity appears affordable to typical rural residential consumers. A simple cross-sectional analysis of price elasticity (ignoring income effects), as well as the responses to an NEA-conducted survey, indi- cate that consumer resistance to price increases only becomes strong at about P 2.50/kWh. The current share of expenditure for electricity amounts to about 10 of household income, while that for kerosene lighting is clos- er to 15X. Survey responses indicated that households would use electrici- ty to expand their lighting hours provided it cost no more than kerosene. In the minority of RECs that depend on high-cost isolated diesel genera- tion, any subsidization should be granted to the REC in a highly transpar- ent manner, showing the cost differential between retail rate ceilings and true supply costs.  - xi - G. The Rural Electric Cooperatives 32. The RECs' problems do not result from their structure as coop- eratives. This conclusion is supported by (i) the mass failure in the ear- ly 1970s of investor owned utilities that served provincial cities and towns; (ii) the disinterest of investor-owned utilities or utility manage- ment companies in taking control of failing REC franchises; and (iii) the concentration of these failing REC franchises in areas where core systems are in severe disrepair and institutional problems are pervasive (as in central and southern Luzon), or where high self-generation and administra- tive costs undermine financial viability (as in the small, remote islar s of the Visayas). The RECs' operational and financial performance is more likely to be improved by launching programs to address the problems crip- pling the system rather than by creating a new organizational arrangement. 33. The major institutional problem shared by the most of the poor- ly performing RECs is the high degree of politicization of their Boards. Too often, tnose Boards and their members have become excessively involved in the REC's day-to-day affairs. This has resulted in abuse of perquisites and indications of corruption. While an elected Board representing the interests of consumer members is the fundamental characteristic of a coop- erative, the politicization of REC Boards and the resulting abuses indicate that, in those instances, the Board members are not accountable to their consumer members but rather to the political interests that supported their elections. To restore some accountability, existing legislation should be amended to provide that (i) a majority of REC Boards be composed of non- elected members, chosen either on an ex-officio basis or by appointment of ths NEA Administrator, and (ii) elected Board members serve a fixed term of two to four years, and thereafter be ineligible to serve the REC as a top officer. NEA's currently sound guidelines governing the conduct of REC Boards and their members need to be enforced through the use of condition- ality on future NEA loans to the RECs. 34. The subdivision of RECs, usually for reasons of political pa- tronage, has created clusters of RECs with franchise areas that cannot be served economically. Currently, some 25-30 RECs appear to have severely limited chances of ever becoming financially viable. Geography appears to be the most important constraint limiting their prospects for attaining viability. Virtually all of these RECs serve either remote, small islands, or sparsely populated mountainous areas with insurgency problems in Luzon, Mindanao, or Samar. The Government needs to consider adopting special pol- icies for supporting those R!SCs. Such policies could include excusing past loans that these RECs have virtually no chance of repaying, and using grants to finance economically-viable investments. 35. In conjunction with a program to restructure NPC, NEA received P 500 million in equity in August 1988; in turn, the funds were used to enable 21 RECs to refinance their significant arrearages to NPC. Under this Relending Program, 10 of the RECs retained their existing General Man- agers and Boards; for the other 11 RECs, NEA appointed new General Managers after the Boards agreed to be reduced to advisory bodies. Operations have improved significantly in the first group, but have continued to deterio-  - xii - rate in the latter group. If NEA must exercise its authority to supplant a General Manager and/or disembody a Board, it should take that action as a receiver and not as a utility manager. In that capacity, NEA should ac- tively solicit proposals from all potentially interested parties - includ- ing adjacent RECs, investor owned utility management companies, and new groups from within the bankrupt REC's franchise area - for the future via- ble operation of that franchise. 36. While solutions to the RECs financial constraints can best be developed on a case-by-case basis, the following system-wide measures, which would have the effect of restructuring the RECs, would be generally beneficial and should be implemented as soon as practicable: (a) Even the most financially viable RECs are unable to generate sufficient revenues from operations to finance needed invest- ments. The RECs as a group are seriously undercapitalized and their scope for recapitalization is extremely limited. New consumers are required by law to pay only P 5 to join a REC, far below the cost to the REC of providing each consumer with service. As a result, membership-contributed capital in 198' represented just 0.2X of total REC assets. The Government needs to amend existing legislation to increase the membership fee to at least P 200 for all consumers. While this could in- crease the RECs' paid-in capital by an aggregate of about a 320 million by 1995, still other approaches to increasing the RECs' capital should be considered. Specifically, the Govern- ment should provide the RECs with relief from (i) loans for ex- tensions of service to uneconomic areas, alternative generation schemes, or social programs; and (ii) damage caused by natural disasters such as typhoons. (b) NEA should contain the proliferation of RECs by (i) curtailing the establishment of new RECs, (ii) reviewing the feasibility of consolidating adjacent RECs now participating in NEA's Re- lending Program, and (iii) developing incentives for well- functioning RECs to absorb adjacent REC franchises in receiver- ship. Such incentives could take the form of providing (i) special working capital loans, or (ii) grants to support needed economically justifiable investments aimed at revitaliz- ing the failing franchise. A broader consolidation program was considered and dropped for the time being out of concern that NEA could not enforce the dissolution of a REC that was not in receivership. A further factor now deterring consolidation is that the main criterion tor an effective consolidation is geo- graphical contiguity of service areas, and very few poor per- formers are contiguous to-good ones. (c) NEA should encourage needed institutional reforms through the use of conditionality in connection with future NEA loans to poorly performing RECs. NEA should consider supporting addi- tional investments for RECs that meet their targets for opera- tional and finarcial improvement, and might consider lending cash to RECs with a record of several years of good perform- ance. Alternatively, NEA should deny funding to poor perform-  - xiii - ers that maIe insufficient effort to improve their operations, regardless of the priority of those RECs' planned investments. 37. An attempt by NEA to quantify the degree of managerial depth available to the cooperative system indicated that managerial ranks are thin, largely because of the low pay scales in effect at most RECs. These pay scales should be adjusted to enable the cooperatives to attract and retain sufficient numbers of qualified managers. HI The National Electriflcation Administration 38. Following the change of Government in 1986, many government agencies received special arsistance to restructure their operations, but no such assistance was extended to NEA. Despite this lack of Government support, in 1987-88, NEA's Board recruited an energetic new leadership team that appears capable and interested in providing the agency with an appro- priate focus. That team has already taken bold steps to streamline the staff and introduce efficiency measures. However, these measures by them- selves are not enough to make NEA function effectively as the sector's core agency. The organization needs a reorientation of its role and its vperat- ing perspectives, accompanied by a financial restructuring to put it on a "clean books' basis. NEA's Role 39. Given its weak performance during the last ten years, NEA's continued existence carmot be justified on the basis of its electrification activities alone. NPC can provide many, though not all, of the same ser- vices. However, NEA's lending activities are so specialized as to make compelling Jits continued functioning in that capacity. Its borrowers, the RECs, provide a service that is critical to the economic development of the areas within which they operate, yet few of them are financially viable and even fewer are credit worthy. Highly specialized technical support is needed to ensure that the formulated loans support feasible and appropriate projects, and the RECs develop into institutions that operate well enough to repay their loans. 'rhus, a core agency coordinating rural electrifica- tion through lending and technical support activities is essential to any institutional structure serving this sector. 40. NEA's difficulties have stemmed mainly from a lack of focus in its activities, and the previous Government's bent for asking NEA to exceed its institutional capabilities. Previously, however, when its direction was clear and its available resources were adequate, NEA performed effec- tively. Now, its Board and top management should reorient NEA to act pri- marily as an interested lender that provides support services aimed at as- sisting its borrowers on the path to credit worthiness. NEA currently has a staff of about 900 people who are providing many of those support ser- vices. These activities need to be supplemented with more focussed loan programming, credit analysis, and loan administration functions. Because NEA needs only to reorient its focus and supplement its existing staff, the  e xiv - most effective approach to developing the needed core agency activities is to address NEA's weaknesses. 41. Over the years, NEA has acquired a number of side activities that were only peripherally related to rural electrification, or aimed at developing for the RECs supply alternatives to connection to the NPC grid. In its 1988 reorganization, NEA discontinued some of the more arcane of these activities; however, it continues to be involved in alternative gen- eration investments. NEA needs to restrict its business to providing fi- nance and technical support for the distribution utilities serving rural areas, and should divest itself of its other activities. 42. Despite its involvement in the energy sector, NEA is currently formally accountable to DENR, which cannot provide the technical support that NEA needs. To coordinate NEA's activities and investments with the rest of the energy sector, NEA has a seat on the ECC. Even so, a stronger interaction with the energy sector is needed. NEA should have the same reporting relationships as NPC, PNOC and OEA, the energy sector's main par- ticipants; this would mean bringing NEA directly under the Office of the President, and having it report to the Executive Secretary. 43. NEA also urgently needs to develop functional accountability over its activities. Although operating in both the electrification and the lending businesses with constrained resources, NEA has not previously had either formal ties to NPC or the outlook and accountability of a finan- cial institution. NPC can provide technical support for many of NEA's electrification planning and implementation functions. NEA should formal- ize its relationship with NPC by having the NPC president serve ex-officio as the NEA chairman, with the NEA Administrator assuming an ex-officio seat on NPC's Board. To ensure that NEA follows the policies of a financial intermediary, one seat on NEA's Board should be reserved for a senior bank- er, and a second for a senior official of the Department of Finance. Be- cause NEA currently lacks the staff needed to discharge its lending opera- tions and has only limited prospects for acquiring such expertise given its current pay scales, it should acqrire the expertise through a consulting arrangement with a major bank or financial institution. Financial Restructuring 44. NEA can hardly address the problems of the RECs while it is burdened with problems of its own that threaten to overwhelm the organiza- tion. Viewed as a commercial enterprise, NEA is insolvent. Accrued inter- est income, which is essentially NEA's only source of revenue, grew at an annual rate of about 151 during 1984-88; but interest expenses, which gen- erally account for about 75% of operating expenses, grew at an annual rate of 17% during the same period. Overall, NEA collects only about half of the amortization due from the RECs, and the default rate for its alterna- tive energy loans is nearly 100%. Since 1986, current liabilities (mainly advances from the Government) have exceeded current assets, and the gap is growing. A relevant restructuring program, which would put NEA on a "clean-books' basis, would include the major measures enumerated below. The progran to implement these measures will need to be framed in the con-  - xv - text of when the Government, with its limited resources, can feasibly take responsibility for the liabilities from which NEA should be relieved. (a) Advances from the Gcvernment, aggregating P 3.3 billion, should be converted to equity. These obligations were accrued as the Government made debt service payments to foreign lenders that NEA could not otherwise have met during the past few years. (b) The Government should assume the impact of foreign exchange losses, aggregating about P 1.9 billion, on NEA's existing for- eign loan obligations. (c) Construction loans receivable due NRA from about 25 remote and/or self-generating RECs, amounting to about P 1.1 billion, should be written off; a corresponding amount of Government loans to NRA should be converted to equity. (d) NEA should divest itself of all assets and liabilities associ- ated with dendro thermal and mini-hydro generation. This in- cludes divestiture of substantial uninstalled inventory and removal of about P 791 million of dendro thermal loans and P 1.8 billion of mini-hydro loans from NEA's books. (e) NEA should divest itself of assets and liabilities associated with all social programs and other activities unrelated to electricity distribution (value to be determined). (f) NEA should reschedule all delinquent REC debts (principal and interest aggregating P 1 billion), based on feasible repayment terms. NEA should arrange a major loan monitoring and collec- tion effort. (g) P 150 million in deferred development costs, Government project costs and salaries and allowances of NEA staff posted to manage RECs should be expensed against current operations and the ac- counts used for their deferral should be closed. (h) NEA should turn its non-performing assets over to the Asset Privatization Trust, which should try to return to the Govern- ment whatever value can be realized from those assets. NEA's stronger balance sheet as a result of the proposed restructuring would enable it to be a magnet for increased official financial assistance; without restructuring, official sources of funds could only be attracted by the social appeal of rural electrification. Because many the loans from which NEA would be relieved under this restructuring program were raised in support of either (i) Government promoted system extensions into uneconomic areas, or (ii) Government sponsored social programs that were only margin- ally related to rural electrification, they should rightly be transferred to the Government for disposition. 45. This restructuring program involves a substantial outlay of public funds; in order that this be a one-time event that succeeds in revi- talizing the sector, the Government needs assurances that the RECs will  - xvi - discontinue the practices that gave rise to their serious financial prob- lems. The effectiveness of the recommended meaaures presumes that the RECs will (i) curb their technical losses; (ii) take actions to identify and punish pilferers, and thereby reduce non-technical losses; (iii) imKrove their collection efficiency; (iv) revise their Drices to cover the full cost of providing service; and (v) gal on time for their power purchases and debt service. 46. The primary beneficiaries of the program will be the 25 poorly performing RECs with inherently poor financial prospects, which will bene- fit greatly by having past construction loans cancelled. The other major beneficiaries will be the 46 poorly performing RECs whose current distress results largely from mismanagement. Most of these latter RECs are cluster- ed in central and southern Luzon, and have franchise areas that provide favorable financial and economic prospects. To enable these prospects to be realized in the future, many of their delinquent loans will need to be rescheduled. All the poorly performing RECs should be required to earn their relief by formulating and agreeing to implement operational and fi- nancial improvement programs. Their progress in realizing agreed perform- ance targets should be monitored closely, and these RECs' eligibility for future loans from NEA should depend on their showing clear evidence of sus- tainable improvements in performance. Financing Strategy 47. The proposed restructuring is essentially a one-time measure with an immediate impact. To prevent a recurrence of its past problems, NEA will need to develop a financing strategy that, at once (i) provides finance on appropriate terms for economically justifiable projects, (ii) penalizes RECs that make insufficient effort to improve performance, and (iii) considers the special needs of RECs with structural constraints that limit their prospects for financial viability. 48. To keep its lending activities manageable, NEA should simplify its categories for lending and standardize its lending terms. In the fu- ture, it should limit its lending to support rehabilitation of rural net- works, add-on connections, economically justified system extensions, and working capital. While the bulk of its loans should be for the cash value of materials and equipment it provides to the RECs, it might consider lend- ing cash under special circumstances. 49. NEA should develop a basic interest rate pegged to its average cost of money plus a sufficient premium to cover its normal operations and the foreign exchange risk it expects to bear on future loans. A premium of about 2-3X should cover NEA's normal operations, while a premium of about 6-7% should cover the expected foreign exchange risk. The basic rate would guide NEA's pricing of all its loans. Also, the provisioning against the anticipated foreign exchange losses should be based on all NEA loans made under this financing strategy, not simply those with related foreign expo- sure, at least until an ample fund has been accumulated. Recently, in con- nection with a rural electrification project that it is financing, the United States Agency for International Development asked NEA to onlend at I  - xvii - 12Z. In the current environment, that rate satisfies the criteria for the basic interest rate while being positive with respect to inflation and con- -s_tent with the opportunity cost of capital in the Philippines; therefore, it could serve as NEA's initial basic rate. The basic rate should be re- viewed annually, and the new rate fixed for all loans generated after com- pletion of the review. 50. NEA can provide incentives to the RECs through variations in the maturity and grace periods applied to individual loans. NEA's standard loans should carry grace periods of two years and maturities of ten years (these terms correspond to the construction period and depreciable lives of most distribution investments). However, maturities of more than ten years (perhaps as much as 20-25 years) could be applied to loans that suppc.t, directly or otherwise, (i) investments with higher than normal rates of return, (ii) agreed institutional improvement programs adopted by poor per- formers, or (iii) the sustained good perfonmance by the better RECs. 51. To accommodate the justifiable investment requirements of RECs without reasonable prospects for financial viability due to geographic con- straints, the Government should create a pool of grant funds that can be on-lent for 25-30 years at no interest but with a service charge of 1-2X (to cover NEA's costs). NEA could provide interest rate relief by blending loan and grant financings. Funding from this facility should be treated similarly to NEA's other loans. To qualify for financing from this pool, an REC would have to undertake a program to improve its operational and financial performance. To receive funds from this facility, the REC would need to agree to conditionality to (i) implement the performance enhance- ment program, and (ii) realize agreed periodic performance targets. 52. NEA should use its leverage as a lender to discourage chronic unsatisfactory performance in certain RECs. Performance targets could be included in loan conditionality. In the extreme, NEA could decide not to finance a particular poor performer, regardless of the priority of that REC's investment program. 53. Based on this financing strategy and financial projections de- veloped for NEA based on the alternative investment scenarios, NEA will need to finance some P 3.8 billion of investments between 1989-93. Of that amount, about P 1.6 billion will come from official financing that is ei- ther committed or at advanced stages of negotiations. Another P 1.7 bil- lion is expected to be provided through as yet unidentified official fin- ance. In addition, about P 0.5 billion will need to be provided by the Government as equity. This corresponds to the amount expected to be re- quired for (i) justifiable investments by RECs with limited prospects for commercial viability, and (ii) repair of networks damaged by typhoons. I  - xviii - Organizational Improvements 54. Some of NEA's spotty performance can be attributed to organiza- tional weaknesses, including: (i) a lack of central coordination; (ii) in- adequate managerial compensation, making the retention of well-qualified managers very difficult; and (iii) a propensity to become involved in the day-to-day management of the RECs, thereby spreading thin its managerial and technical cadre. NEA should make three major organizational changes: (a) To coordinate the activities of its disparate units more effec- tively, it should establish a multi-disciplinary unit reporting directly to the Administrator that would be charged wtith apply- ing sound banking principles in the formulation and implementa- tion of a consistent medium-term lending program. While NEA has staff with some of the skills required by this unit, it lacks the requisite banking expertise; therefore, NEA will need to obtain this loan programming function on a consulting basis from a large bank or major financial institution. (b) Since NEA's pay scales follow directly from its classification as an infrastructure agency by the Department of Budget and Management, NEA should establish and fulfill the requirements for reclassification as a Government Financial Institution, a category with higher pay scales. (c) NEA should seek to minimize the time during which it must sec- ond its own staff to manage RECs by starting immediately after a takeover the process of identifying and transferring control of a REC to the group with the best long term plan for operat- ing it viably.  1. RURAL ELECTRIFICATION SECTOR OVERVIEW A. Introduction 1.1 In early 1988, the Bank undertook a study of the Philippine energy sector; that study (Report No. 7269-PH; September 15, 1988) recom- mended a broad strategy for resource allocation and utilization. Since then, the Government has indicated concern that some of the important bene- fits of that strategy might not be realized because of inefficiencies in the electricity distribution system, through which about 15X of total do- mestic available energy is consumed. The Government was particularly con- cerned about the impact of rapidly increasing distribution losses, which reached 251 by the end of 1987, on the US$7 billion investment program that was then being launched in electricity generation and transmission for 1989-96. The Bank has responded to the Government's concern by making a loan to finance a project to improve power distribution in and around Metro Manila (Loan 3084-PH, 1989). It also studied the condition of the rural electrification sector in February 1989. This report details the findings of that study. 1.2 In brief, the study confirmed that the rural electrification sector has major problems, including (i) poor operational performance, (ii) physical deterioration of core systems, and (iii) acute financial dis- tress among all the sector's institutions. The problems are so pervasive that they cannot be addressed by simple solutions. Rather, the Government will need to implement an integrated program to revitalize the sector, with the aim of (i) restructuring of the sector's core institution, the National Electrification Administration (NEA); (ii) considerably reorienting the organization, operations, and financial structure of the 117 Rural Electric Cooperatives (REC) that are responsible for distributing electricity to smaller urban centers, towns, villages and rural areas nationwide; and (iv) thoroughly refocussing the sector institutions' operational practices, investment priorities and pricing policy. 1.3 The recommended program for strengthening the rural electrifi- cation sector would provide an important stimulus for the continued econom- ic revitalization of the Philippines economy, which has undergone a dramat- ic turnaround since the mid-1980s. Following an economic decline during the early years of this decade, the reorientation since 1986 has stressed the primacy of efficiency, prudent macroeconomic management, a transition to market mechanisms, a reform of public enterprises, and a streamlining of public sector investment. While much already has been done to move forward in these areas, a large part of the reform agenda remains to be addressed. The next steps in the transition to efficiency-oriented management will in- clude (i) improving the level and composition of the public sector invest- ment program, focusing on appropriate priorities to sustain economic growth; (ii) upgrading the implementation capacity of public sector agen- cies; (iii) accelerating investment in rural development to encourage in- come growth outside of urban areas; and (iv) removing infrastructure bot-  tlenecks to encourage productive investment and improve the delivery of services such as power supply. Such a reorientation is critically needed in the rural electrification sector, w'here strengthening the sector's weak institutions will enable issues of investment efficiency, rural develop- ment, and infrastructure improvement t.o be addressed vigorously. B. E^r- Swector Institutions 1.4 Before the change in Government in 1986, the Ministry of Energy coordinated all policies, plans and programs for the energy sector. The ministry served as the parent organization for two of the largest Govern- ment owned corporations: (i) the National Power Corporation (NPC), which had responsibility for power generation and transmission; and (ii) the Philippine National Oil Company (PNOC), which was responsible for assuring the adequacy of oil supplies and for development of indigenous energy re- sources. The National Electrification Administration (NE6), the organiza- tion responsible for formulating and implementing the Government's rural electrification policies, was under the control of the Ministry of Human Settlements, and not under the Ministry of Energy. 1.5 Following the change in Government in 1986, both the Ministry of Energy and the Ministry of Human Settlements were dissolved; all energy agencies as well as NEA were brought temporarily under the Office of the President. In mid-1987, the Office of Energy Affairs (OEA), which was giv- en responsibility for planning and coordinating policies and programs for the energy sector, was formally pla^ed under the Office of the President. At the same time, EPC and PNOC were brought under the formal control of the Office of the President while NEA was placed under the jurisdiction of the Department of Environ- e-nt and Natural Resources (DENR). Recently, to dev- elop formal linkages between the energy sector participants, the Government formed an Energy Coordinating Council (ECC) that would (i) be chaired by the Executive Secretary; (ii) have as members NPC, PNOC, and NEA; and (iii) have OEA acting as its Secretariat. 1.6 In its early stages, NPC was responsible only for hydropower development. The Manila Electric Company (MERALCO) generated most of the power for the Manila metropolitan area; power was supplied to provincial towns and rural areas by other privately-owned power companies and small municipal utilities. In 1971, NPC was given total responsibility for all power generation facilities nationwide as well as for the establishment of island power grids. This restructuring led to NPC's acquisition in 1979 of most of MERALCO's generating facilities. Electricity distribution in rural areas is handled by Rural Electric Cooperatives (REC). 1.7 Currently, NPC is responsible for all but very modest genera- tion facilities and most transmission systems nationwide. MERALCO is re- sponsible for distribution in Metro Manila and surrounding suburbs and ru- ral areas. Six privately-owned power companies provide distribution to the larger urban centers outside Manila. Distribution for the smaller urban centers and the rural areas is provided by 117 RECs. NUA is responsible for coordinating the activities of the RECs.  -3- C. The Rural Electrfi0cation Program The Program's Origis 1.8 In June 1960, the Electrification Administration was created (Republic Act (RA] 2717) to carry out the Government's policy of providing cheap and dependable electric power for the country's agro-ir.dustrial de- velopment. Rural electrification of previously unenergized areas proceeded at a slow pace for the next seven years. In February 1967, using funds provided by the United States Agency for International Development (USAID) feasibility studies were conducted for two pilot rural electrification pro- grams: (i) to electrify eight towns in Misamis Oriental, and (ii) to elec- trify three towns in Negros Occidental. In June 1969 total electrification of the countryside on an area coverage basis was declared i national policy (RA 6038). At that time, only about 18X of the country's population was enjoying electric service. This Act also provided for the organization of Rural Electric Cooperatives to implement the electrification targets and operate the resultant networks, and converted the Electrification Adminis- tration into the National Electrification Administration. 1.9 NEA's charter gives it the twofold responsibilities of (i) co- ordinating implementation of the Government's total electrification policy, and (ii) supporting the RECs' efforts to achieve that total electrification objective. NEA is supposed to fulfill this latter responsibility by (i) providing technical support to the RECs; and (ii) financing their expansion programs with grants and long term loans. later Presidential Directives gave NEA the additional responsibilities of (i) supervising the RECs' tech- nical and managerial activities; (ii) regulating their electricity rates; and (iii) promoting implementation by the RECs of mini-hydro and dendro- thermal generating schemes. The Government also created within NEA various Special Project Offices that are responsible for integrated rural develop- ment programs unrelated to rural electrification. These programs included housing, water supply and livelihood projects. 1.10 In September 1971, the first REC, Misamis Oriental Electric Co- operative, Inc. (MORESCO) was energized. In August 1973, NEA became a cor- poration (Presidential Directive [PD] 269) and was provided initial capital stock of P 1 billion. Subsequent capital increases in 1978 (PD 1370) and 1979 (PD 1645) raised the authorized equity capital to P 5 billion. NEA orchestrated the growth of the system by functioning as a financial inter- mediary channeling the Government contributions or funds provided by donors to the RECs. Almost all the loan^ provided by NEA to any particular REC were for the peso value of materials procured by NEA on behalf of that REC. As such, the REC received goods and was credited with a loan liability; cash seldom flowed from NEA to an REC. Few, if any, sources of private sector finance were willing to lend to the RECs; as a result, they were re- quired to self generate the working capital needed for operations. As do- nor and Government funding for rural electrification appeared to be plenti- ful, the cooperative system expanded rapidly both through the construction of new distribution networks and the assumption of responsibility for  - 4 existing facilities. The RECs acquired these existing core systems (mostly small, aging networks with 2400 volt primary distribution lines) from lo- cally-based, investor-owned power companies. 1.11 The cooperative system was cLosely modeled on the U.S. experi- ence. NEA itself was modeled, both in form and operation, on the Rural Electrification Administration. The RECs were organized and were supposed to be administered in much the same fashion as those in the United States. Also consistent with the U.S. model, the Philippine RECs established (in July 1979) the Federation of Electric Cooperatives of the Philippines (FECOPHIL) to serve as the umbrella organization representing their inter- ests. FECOPHIL's charter was closely based on that of the National Rural Electric Cooperative Association (NRECA), which had functioned as the lead consultant providing technical assistance under USAID financed projects. 1.12 The movement to use cooperarives to supply electricity to small urban centers and rural communities developed momentum in the early 1970s. During this early period, the RECs' service areas were defined to afford reasonable chances for technical and financial viability, and the decision to form an REC was generally prece' d by a thorough feasibility study. However, as the pace of expansion accelerated, the feasibility studies be- came more superficial. NEA did not focus significant attention on the day- to-day concerns of managing a rapidly expanding commercial organization; and, because of the long grace periods included in the terms of most NEA loans to the RECs, the financial implications of what was too ambitious an expansion program and the poor financial performance of the RECs were masked until the early 1980s. Annex 1.01 shows the number of consumers served by the RECs each year since 1974, and Annex 1.02 shows the year-by year formation of RECs. Current State of the Sector 1.13 Currently, 117 RECs are providing electricity throughout the entire country, except for franchise areas served by the investor-owned companies. About 22 of these RECs are considered to be well managed as well as financially viable; for another 24, financial viability is consid- ered within reach if they make some operational and commercial adjustments. The remaining 71 either have a pronounced need for substantial remedial action, or are considered beyond rescue. 1.14 The RECs' problems are both operational and financial. Chronic operational problems include excessive distribution losses, theft of elec- tricity, and inadequate maintenance. The RECs' poor standards of mainte- nance have led to a widespread physical deterioration of their networks; as a result, with technical losses averaging 17Z, most REC distribution sys- tems are operated at well be-low their design standards. The Government's past emphasis on growth of coverage without sufficient regard for cost, combined with its use of the RECs to implement costly and economically un- justifiable alternative generation and rural development programs, has sad- dled most of the RECs with debts they cannot pay, despite the heavy conces- sional element built into the instruments that were used to finance the sector's expansion. Generally, the RECs lack the skilled staff and equip-  ment needed to improve their operational performance, and the burdens of past mistakes have weakened their prospects for improving their financial health. In many instances, the RECs' financial problems are directly re- lated to managerial weaknesses that have resulted from the interference in their internal affairs by highly politicized Boards of Directors. Even if the RECs as a group would be provided with financial relief, some 25-30 among them face limited future prospects owing to franchise areas that are inherently too costly to serve. 1.15 NEA has performed poorly as both a lender and a provider of rechnical support to the RECs. Although it has documented the RECs' opera- tional weaknesses, NEA has been unable to implement programs for improving their performance, partly because its already scanty technical staff has been spread too thin to perform its functions well. 1.16 The RECs are rural institutions that reflect the economic con- dition and financial health of their members; the economic constraints ex- perienced during last several years by the rural population has had an ad- verse impact on them. Given that its primary business is to act as finan- cier for the sector, NEA's financial condition must necessarily reflect the state of the RECs. The recession of 1983-86 weakened the RECs financially; in turn, that weakness resulted in NEA's realizing a collection efficiency of only 36X in both 1987 and 1988. In many instances, NEA promoted the measures that led to the RECs' uneconomic growth; therefore, not surpris- ingly, when the RECs are unable to meet their obligations on loans from NEA, NEA cannot meet its related obligations on the originating loans. In all, NEA has questionable prospects for meeting some P 7 billion of loans raised from foreign lenders and from the Government. Too often, NEA has lacked clear direction regarding the nature of its business. While its revenues accrue entirely from its lend'ng operations, it has viewed itself primarily as an electrification company. It has iulfilled a wide variety of roles, but it has not developed the primary functions of a financial intermediary, namely loati programming and credit evaluation. The or.-*.niza- tion's lack of a clear focus has inhibited it from acting as an effect.ve core agency for the sector. 1.17 Perhaps the sector's biggest problem is the participating in- stitutions' chronic lack of functional accountability. In the past, NEA has neither had (i) a mechanism to coordinate its activities with the rest of the energy sector, even though the RECs taken together form a substan- tial block of energy consumers, nor (ii) the outlook and accountability of a financial institution, even though lending and credit are essential ele- ments of its own financial health. Instead, NEA has either been account- able to political agencies, such as it was during 1979-86 to the former Ministry of Human Settlements, or to rural development agencies, such as it is currently to DENR. In that context, its staff has dispensed substantial capital without regard for the technical or financial requirements for cost recovery. The politicization of NEA created an environment that enabled the RECs to become politicized. Although NEA has sound rules governing the conduct and remuneration of REC Boards and individual directors, those rules are flaunted with equanimity. Available data suggest a high corre- lation between interference by Board members in the day-to-day activities of the RECs and poor management of those institutions. While the RECs are  - 6 - in principle accountable to their consumer members, most RECs whose weak performance may be attributed to poor management show (i) little effort to develop member involvement and (ii) weak consumer relations. In effect, those Boards (and in turn their RECs) are accountable primarily to the po- litical interests that sponsored their elections. D. Issues Facing the Sector 1.18 To resolve the sector's problems, the issues enumerated In the following paragraphs must be addressed. The issues have been grouped ac- cording to whether their primary impact is on (i) sector operations, (ii) the RECs as irstitutions, or (iii) NEA's capacity to fulfill its responsibilities as the sector's core agency. Operations, Investment and Pricing 1.19 Poor ODerational Performance. As a result of the low priority accorded to operational matters, most RECs provide inefficient and unreli- able service; furthermore, they frequently provide electricity to rural consumers at excessive cost. Even the financially viable RECs have high rates of forced outages; however, operational problems are much more acute in the poorly performing RECs, where constrained cash flow for the proper maintenance of physical and human resources has resulted in the severe phy- sical deterioration of their networks. 1.20 Of the poorly performing RECs, some 25-30 have only marginal chances of ever attaining the financial viability needed to ensure imple- mentation of proper operational practices. Most of these RECs serve small remote islands in the Visayas; the remainder serve rugged mountainous areas with insurgency problems in Luzon, Mindanao, or Samar. Their inimical ge- ography and population sparsity, combined with their high cost of supply, limits their prospects. Another 41-46 RECs could become viable by taking substantial remedial action. Most of them are located in central and southern Luzon, and are characterized by (i) franchise areas with poten- tially favorable financial prospects, (ii) rapidly deteriorating core sys- tems, and (iii) politicized Boards and managements. 1.21 System Losses. With system losses averaging 25X nationwide, substantial amounts of expensive electricity are being wasted. System los- ses represent the second greatest 'use' of available energy. Specific Re- gions show different patterns of efficient operations and loss control. For example, the twelve RECs in Region 3 (Central Luzon) have system losses that averaged about 36X in 1987, making losses the predominant "use" of available electricity in those service areas. 1.22 Area Coverage Targets. The objective of the rural electrifica- tion program was to achieve total area coverage as rapidly as possible. Often, the RECs expanded their systems at the expense of major maintenance or the renewal of obsolescent core networks. Currently, the RECs serve somewhat more than 2.8 million consumers. Although the number of consumer  - 7 - connections grew by more than 30X per year until 1980, this was not enough to meet the Government's original target of 901 area coverage by 1987. With the growth rate dropping since 1981, the target for achieving 901 electrification has had to be extended on several occasions. Currently. the Government's policy is to electrify 901 of rural areas by 1995. 1.23 This emphasis on area coverage has led NEA to support substan- tial investments in system expansion that were not economically justifi- able. The RECs met the cost of these investments either with cross-subsi- dies from productive loads in the same franchise areas, or by ignoring their related debt service payments to NUA. Despite the wide spread evi- dence of uneconomic investment and the resulting sector wide financial con- straints, NEA has still not developed appropriate criteria for investment decision-making. 1.24 Prioritization of Investments. NEA does not have a systematic strategy for programming investments by the REGs. Although a determined effort was made in 1988 to identify and prepare high-priority investments, this exercise was conducted in response to a perceived need to formulate a short-term investment strategy quickly. NEA still lacks a consistent stra- tegy and a sound methodology to establish national investment priorities. 1.25 Alternative Generation Programs. One striking example of the impact of inadequate investment screening is the substantial losses being incurred on account of uneconomic investments in alternative generation facilities. In October 1979, PD 1645 authorized NEA to develop indigenous and renewable energy sources, including specifically (i) mini-hydro gener- ating facilities of under 5 MW, and (ii) dendro thermal generation plants. Overall, 19 mini-hydro sites and 9 dendro thermal plants were either com- pleted or are still under construction. None of the completed dendro ther- mal plants are in operation todayV. Moreover, a large number of mini-hy- dro units, with an aggregate value of almost 0 1 billion, and nine dendro thermal units have not been installed and are in storage. Although, in 1988, NPC assumed responsibility for these facilities, the RECs are still obligated for the loans that financed these investments. At present, they are virtually in complete default to NEA in regard to these loan. In turn, NEA has been unable to service its debt related to these programs (para. 6.13). Annex 1.03 provides a brief summary of the operational aspects of the mini-hydro and dendro thermal programs. ' aie mini-hydro program's major problems included (i) inadequate technical planning, (ii) insufficient site investigation and (iii) unsatisfactory hy- drology. In addition, many of the sites chosen were aimed at serving areas already receiving electricity from the NPC grid. The dendro-thermal program envisaged growing trees on 1,000 acre sites over a five-year cycle. The ma- ture trees, when felled, were to be crushed into wood chips for burning in the boiler of a nearby power plant. The planting program did not produce the ex- pected number and quality of trees; the poor results were due to inadequate site preparation, lack of fertilizer, and generally careless farming. In ad- dition, the wood processing equipment was poorly operated and maintained, and the boilers were unable to burn the resultant output of chips.  - 8 - 1.26 Pricing of Electricitv. Rural electric tariffs neither reflect the cost of supply nor influence consumers to optimize their utilization of electricity. NEA has developed and distributed a rate setting guideline that is based upon a simple average costing methodology. The resultant retail rates do not provide the RECs with sufficient cash for even routine maintenance and equipment overhauls, much less for the self financing of even minor amounts of system expansion. 1.27 Subsidies for Financially Weak RECs. RECs in remote areas, that must rely for their supplies on expensive self-generation, charge high rates (often in excess of P 4.00/kWh) that exceed the threshold of consumer affordability. Recently, the Government has decided to limit retail elec- tric tariffs to a maximum of P 2.50/kWh. To implement this policy, NPC is taking control of all generating facilities and lines energized at 69 kV and above, and will sell electricity to those RECs at a subsidized rate of P 1.30/kWh. In addition, a number of RECs will require direct subsidies to maintain their operations. NEA has computed the cost of this direct subsi- dy, which will be shared by NPC and NEA, at about P 50 million over the next five years. Fourteen self generating RECs are the beneficiaries of the direct subsidy program. The Rural Electric Cooperatives 1.28 Appropriateness of the Cooperative System. In 1988, as the outgrowth of a program to restructure NPC, NEA took control of the manage- ment of eleven RECs whose arrearages to NPC had reached intolerable levels so that the cutoff of electric service was imminent. In connection with the takeovers, the RECs' Boards of Directors were disembodied and the Gen- eral Managers were replaced. The failure of these cooperatives, the major- ity of which are located in some of the most prosperous rural areas of Cen- tral Luzon, raises questions about whether using cooperatives for providing electricity to rural areas of the Philippines is appropriate. If so, a major reorientation of the RECs appears urgently needed. 1.29 The RECs' Weak Financial Prospects. The RECs typically serve residential and small commercial consumers, most of whom take small amounts of electricity (often less than the amount covered by the minimum monthly charge) at low voltage. These consumers are expensive to serve and account for low revenues. Yet, even this modest revenue base has proven difficult to collect. At the same time, the RECs taken together account only for about 15X of NPC's sales. Thus, whether jointly or severally, the RECs have only limited leverage in their dealings with NPC, their principal sup- plier. In effect, the RECs are inherently weak institutions engaged in a business with weak financial prospects; and realizing even those weak pros- pects depends on the RECs (i) managing their operational, commercial, and financial affairs efficiently, and (ii) avoiding costly or non-optimal in- vestments that have only limited potential for acceptable economic returns. 1.30 The RECs Poor Financial Performance. The RECs financial per- formance has been extremely poor. In 1987, the cooperative system as a whole recorded a negative net margin of P 22 million. Certain REC account- ing policies are not consistent with generally accepted commercial prac-  - 9 - tices; therefore, this figure most likely understates the RECs' financial losses. This poor performance has been recorded even though the RECs as a group are realizing very high mark-ups. In 1987, the average revenue for all the RECs was P 1.66/kWh, compared with an average cost of P 0.87/kWh for power purchases from NPC. 1.31 Proliferation and Politiclzation of the RECs. Following the first oil price shock in 1973, a spate of new RECs were formed to replace small private companies that had become non-viable because of their inabil- ity to recover the burgeoning cost of fuel. By 1976, the RECs became view- ed as organizations that provided political outreach to their leaders; and, the regime used REC directorships and management positions as patronage for political support. Until recently, RECs were repeatedly subdivided, there- by ballooning the number of these patronage opportunities. As the RECs became more politicized, financial viability and qtLality of service became less important. The National Electrification Administration 1.32 NEA's Role. NEA has a spotty record as the sector's core agen- cy. Since its nception, NEA has lacked clear direction regarding its role. The relevant statutes cast NEA in the diverse and occasionally mutu- ally exclusive roles of (i) policy maker, (ii) borrower of hard loans, (iii) lender to a marginal clientele, (iv) implementor of network expansion programs, (v) executor of alternative generation programs, (vi) promoter of rural development social programs, (vii) investment planner, (viii) pro- curement agency, (ix) electrification consultant, capable of providing ex- pertise regarding investment, construction, operations, maintenance, pric- ing, and finance, (x) regulator of a fragmented industry, and (xi) utility manager. Moreover, while NEA has always been accountable to political agencies, it has never been functionally accountable. 1.33 NSA's Financial Weakness. Although NEA is charged with earning a profit, the organization currently has an cumulative deficit and is proj- ecting to continue operating at a loss or at break even through 1991. NEA has experienced or is forecasting that its loan collection efficiency of only 36% for 1987 and 1988 will improve only to 52X in 1989. As a result, NEA's cash flow is not adequate to meet its operating requirements; unless NEA is restructured, it will need continuing Government financial commit- ments to enable repayment of outstanding foreign loans. 1.34 Financing Strategv for the Sector. During the period 1989-92, NEA plans to channel up to about US$200 million to the RECs for investment. Currently, the Government and NEA lack a clear financing strategy for the sector. That strategy needs to resolve the following existing gaps: (i) measures for restructuring the sector's institutions; (ii) criteria and instruments for lending; (iii) lending terms; (iv) use of conditionality; (v) measures for addressing foreign exchange risk; and (vi) special poli- cies to accommodate the investment needs of inherently weak RECs. 1.35 Loan Programming. NEA currently lacks an effective loan pro- gramming function; and, as a result, its management lacks the tools for  - 10 - coordinating NEA's diverse activities. NEA's approach to loan programming has involved (i) using money that could be obtained from the Government to make sizeable purchases of materials and equipment, and then (ii) appor- tioning those purchases to the RECs, either to meet an agreed new connec- tion target or to reward Boards and managers for political support. Only rudimentary credit analyses were performed. NEA has neither placed empha- sis on developing and implementing a medium-term lending program, nor on applying sound banking principles in formulating loans. Even if NEA would wish to upgrade its loan programming activity, its staff lacks the needed banking and credit expertise; and it cannot attract the requisite number of suitably qualified people given its current pay scales. E. A Revitalization Program 1.36 Najor reforms in the sector are urgently needed. Addressing problems that are so pervasive requires an integrated program that will at once (i) introduce proper operational practices and appropriate investment strategies, and (ii) develop strong sector institutions. The development of such a program is the focus of the remainder of this report. 1.37 The first focus of the program must be on operations and in- vestment, so as to determine (i) the requiremer.ts for restoring the net- works to their original design standards and (ii) the parameters of an af- fordable investment program. These parts of the program must be comple- mented by the development and adoption of sound gricing principles, so that the RECs may optimize recovery of their costs from revenues. Programs to restructure and strenzthen the kECs and NEA must necessarily follow after the requirements of operational and investment reform have been estab- lished. Because neither the RECs nor NEA can concentrate effectively on their future responsibilities as long as they are burdened with unmeetable obligations accruing from past uneconomic policies, the institutional strengthening components of the program must necessarily include measures for the financial restructuring of these organizations. To ensure that the benefits of restructuring remain effective in the long term, NEA will need to develop and implement a financing strategy that (i) encourages the RECs to invest in high-return projects and adopt proper operational practices and pricing principles, and (ii) discourages them from failing to meet ob- ligations to their creditors and their consumers. Finally, any reform of the RECs and NEA must necessarily include provisions for developing functional accountability within each of the organizations while also tak- ing account of the realistic constraints they face. 1.38 The ensuing chapters of this report follow this sequence in developing the logical underpinnings for recommendations that, when taken together, provide the needed integrated program. The program is necessari- ly comprehensive, and the Government may have difficulties implementing its features simultaneously. For that reason, allovance was made in developing the recommendations for their gradual implementation. Even if implemented gradually, this program should provide substantial economic benefits and financial savings in the process of revitalizing a highly troubled sector.  - 11 . 2. OPERATIONAL EFICIENCY A. Introduction 2.1 Originally, the Government intended that RECs would be formed to provide service in previously non-electrified areas; in those cases, which were mostly in the Visayas and Mindanao, core supply networks were usually technically sound and the operating systems were usually well de- signed and implemented. After the first oil price shock in the mid-1970s, however, a number of RECs were created to take over the franchises of nu- merous operators (mostly serving small urban centers in central and south- ern Luzon) that had failed, and extend their service to oatlying areas. These inherited networks were often old, with substandard core systems. NEA was responsible for financing the return of those core systems to de- sign standards and ensuring that these RECs had adequate qualified staff to operate and maintain properly the assets being absorbed. This mandate to rehabilitate decaying core systems was inconsistent with NEA's primary ob- jective of mobilizing all available resources to extend area coverage, and thus was largely ignored. As a result, many core systems, especially older ones that had belonged to failed franchisees, fell deeper into disrepair. 2.2 Beginning iu the early 1980s and becoming more pronounced after 1983, as funds for expansion became more scarce and the political pressure to add new connections remained strong, the rechnical standards were in- creasingly compromised in the construction of additions to networks. Con- temporaneously, as political pressure mounted to hold down tariffs in the face of mounting constituent costs for electricity, maintenance standards were also increasingly compromised. Major repairs, such as are often need- ed following typhoons, were usually flimsy patchworks that made best use of available materials and equipment; as newly received materials had to be channeled to expansion projects, the patchworks were seldom replaced by permanent installations. 2.3 Since 1983, the quality of rural electric service has declined sharply. Technical losses have iuscreased, as have instances of downed or obstructed lines and outages related to overloading of substations. With a few notable exceptions, the performance of the individual RECs has also declined sharply. This decline has affected all aspects of their opera- tions, including, inter alia, construction standards, supply continuity, network main_enance, control of operating costs, revenue collection, techn- ical losses, and pilferage of electricity. However, because the basic sys- tems and the extensions that were built in the 1970s were well designed and structurally sound, NEA and the RECs can still arrest this decline if as- sistance is made available and the problem is addressed urgently.  - 12 - 2.4 This report makes many recommendations. This chapter develops recommendations aimed at improving operational performanceV; the next two chapters focus on resolving issues concerned with investment planning and pricing. Taken together, these recommendations provide the operational component of a revitalization program for the sector. While this study ad- dresses these issues in the aggregate, to ensure that these diverse activ- ities are properly coordinated and to translate this extensive program into a management plan for each REC, a comprehensive Rural Electrification Mas- ter Plan (REMP) is needed to provide a detailed framework within which (i) specific improvement measures can be formulated, taking into account realistic constraints on available financing, and (ii) operational perform- ance can be measured against realistic technical and financial targets. B. The Rural Electric System Technical Characteristics of the System 2.5 The rural distribution network follows a 60 cycle, 4-wire, mul- ti-grounded WYE design that is almost identical to the standard developed for the rural electrification system in the United States by the Rural Electrification Administration (REA); the major differences are that the Philippines uses 7,620/13,200-volt primary voltage levels (compared to 7,200/12,470 volts in the U.S.) and 240 volt/2-wire secondary systems (com- pared to the 120-240 volt/3-wire system in the U.S.). The basic design of the networks is sound and appropriate, with the major systemic flaw being an underestimation of the need for lightning arresters and voltage regula- tors. U.S. consultants provided good construction and operations manuals and supervised the correct implementation of the recommended techniques in the early years. Until the early 1980s, electricity service and supply continuity standards were generally good, and continue to be satisfactory in a majority of RECs. 2.6 Except for RECs in remote locations, the rural network is sup- plied by NPC at about 250 69-kV grid substations. NPC constructed the sub- stations, which are owned and operated by the RECs. Meters at the substa- tions are placed on the primary side of the transformers. The distribution I/ The measures being recommended fall into categories identified as (i) major maintenance, (ii) system improvement, and (iii) rehabilitation. Major mainte- nance involves activities to keep systems that are operating at design stan- dard in good repair. Expenditures for major maintenance should be budgeted and financed from on-going revenues. System improvement is performed on sys- tems currently operating at or near design standard, to enable them to meet expected increases in demand from existing consumers, or growth in the number of connections. Expenditures for system improvement require capital alloca- tions, but the cost should be quickly recoverable from the resultant incremen- tal revenues. Rehabilitation is needed to restore a system to design stand- ard. Those expenditures will need capital allocations and external financing, and the costs can only be recovered from the total consumer base over five to ten years.  - 13 - networks consist of about 65,000 km of lines, including about 46,000 km of primary lines and about 19,000 km of secondary lines. The RECs also own and operate about 900 km of 69-kV lines (the standard NPC subtransmission voltage). A summary of line lengths is given in Table 2.1 and an analysis of line lengths by Region is provided in Annex 2.01. The RECs in central and southern Luzon that assumed control over the operations of failed pre- decessors acquired extensive non-standard networks. While some rewiring has taken place, the system still includes some 1,900 km of non-standard line. This remnant can and should be replaced. Table 2.1: LENGTH OF LINE BY DESIGN PARAMETER (000 km) 3 Phase 3 Phase 1 Phase 4-Wire 3-Wire 2-Wire Secondary Total Standard RE lines 19.1 5.9 19.8 18.4 63.2 Non-standard RE lines .6 .2 .4 .6 1.8 (2.4, 4.16 and 4.8 kV) TOTAL 19.7 6.1 20.2 19.0 65.0 2.7 Each of the RECs supplies an average of 24,000 consumer mem- bers, with an average of 40 consumers for each distribution transformer. Annex 2.02 summarizes Regional differences in consumer density. Each sub- station serves an average of two to three feeder lines. The design parame- ters for system protection are basic and inexpensive, and consist of re- closers on feeders and fuses on all branches. This low cost approach re- sults in some problems of coordination of rural network protection with protection measures used in the NPC transmission system. The design stan- dard provides for the use of self-protected, single-phase distribution transformers that range in size from 5 to 100 kVa. Wooden poles are used throughout the system and the standard for conductor is steel-reinforced aluminum. As the Philippines does not have any indigenous manufacturing or repair capacity, virtually all this material is imported. Technical Losses 2.8 The original rural electrification system in the Philippines was designed for a 12-13X range of technical losses based on a 5-year load forecast (Annex 2.03); this closely followed the REA design. The level of technical losses should decrease as the load increases, assuming implemen- tation of effective maintenance and planned system improvements. In the U.S., where the system is generally operated and maintained as designed, technical losses declined from 12X to 8X; however, in the Philippines they increased to an average of 171 - and, in some RECs, technical losses exceed 201. These high technical losses result from overloaded lines and. trans- formers, poor line connections, cracked insulators, poorly maintained elec-  - 14 - trical and mechanical equipment and poor service connections. In addition, because necessary rights-of-way were not obtained during construction of lines, -che RECs cannot cut and prune trees to the degree required; as a result, inadequate clearance of trees is a major cause of technical losses. Recommendation 2.9 Considerable gains can be realized from a program to reduce technical losses, principally because much of the system was well con- ceived, designed, and constructed; years of neglect can therefore still be reversed. Reduction of technical losses will require a combination of mea- sures including, among other things, (i) system improvements, including upgrading power supply or increasing the capacity of line transformers where technical losses are high due to overloaded networks; (ii) improved maintenance that focusses on clearing trees (para. 2.16) from lines (alter- natively, poles might be reconfigured where existing rights of way do not permit adequate clearance of trees)V; and (iii) rehabilitation of non- standard core systems or poorly maintained networks (paras. 2.33-2.35). Technical losses due to design factors are discussed further in Annex 2.03. 2.10 With such measures, technical losses could be reduced by 4.5X. This would imply an annual cost saving of about P 1.4 million per REC, or about P 0.62 million per substation and feeder network. Reducing technical losses would also result in derivative benefits for the RECs, including: Mi) increased local system capacity, and (ii) improved supply continuity; both of these benefits would lead to improved quality of service. The fi- nancial impact of these derivative benefits cannot be computed directly; however, if the average REC manages to sell the increments of energy that are saved, it could realize additional revenues of about P 1 million per year (based on current rates), or about P 0.4 million per year per substa- tion and feeder network. Alternatively, it would save the cost of purchas- ing from NPC unsold amount of the energy that was saved. The cost of the system improvement measures (para. 2.9) is not likely to exceed about P 3 million per substation and feeder network (in most cases, the cost would be notably less). The cost of improved maintenance measures should not be incremental, but rather should be borne through improved efficiency. Where rehabilitation is required, the cost should be related to added reve- nues from incremental demand, and not to savings from reduced losses. Therefore the incremental cost of reducing technical losses should be cov- ered by savings in recurrent costs or enhanced revenues from existing de- mand within two years. & As necessary, tree clearing programs should take account of environmental considerations.  - 15 - C. Operation and Maintenance 2.11 As with construction, operation and maintenance standards for rural networks were based on REA practices, and training courses were pro- vided during the 1970s to demonstrate correct procedures to REC staff. Over the years, these procedures gradually fell into disuse in the majority of RECs. Currently, network ^peration and maintenance is performed by the RECs on an ad hoc basis, with inadequately trained staff using inadequate materials, tools and transport. Less than 50X of the original staff who attended the early training courses on operation and maintenance till re- main with the RECs. The original supply of operation and maintenance tools has also been depleted. Test equipment was left unrepaired, safety equip- ment became unworkable, and when the original vehicles finally stopped working, they were never replaced. The RECs must now rely on public trans- port to move crews and materiais, which is expensive and inefficient. 2.12 The years of neglect and poor maintenance have left the network in poor working order. Field inspections conducted at over 50% of the RECs during a 1986-89 survey by USAID-financed consultants found that about 10l of the distribution system was well maintained, 25X was satisfactorily maintained, 35X was unsatisfactorily maintained, and the remaining 30% showed no sign of having received maintenance (Annex 2.04). The causes cited for poor maintenance included (i) lack of finance, (ii) shortages of materials, and (iii) managerial inattention to maintenance. The most com- mon problems ate rotting poles, broken crossarms, conductor sagging, bad connections, broken insulators, missing hardware, broken reclosers, fuses, lightning arresters, and other safety equipment, cut or missing ground wires, unsafe service drops, and defective meters. 2.13 In general, distribution systems require a combination of oper- ational and planned maintenance. Operational maintenance includes such ongoing activities as semi-annual line patrols and monthly inspection of all meter installations in the course of routine meter-reading and check- reading. Planned maintenance programs are normally developed from: (i) operation and maintenance reports, (ii) guidelines for priority plant maintenance, and for equipment such as reclosers, transformers, lightning arresters, and (iii) the physical condition of the network. 2.14 Table 2.2 compares the maintenance requirements of U.S. RECsV, which are generally well-managed and operate systems similar to those in the Philippines, with those of their Philippine counterparts. The perform- ance of the U.S. REGs indicates that the expected trend in well-managed distribution systems is for planned maintenance to increase gradually rela- tive to forced maintenance and the total cost of operations per unit sold to decrease gradually. In the Philippines, the trend is in the opposite ai As the U.S. RECs are generally efficient, well operated and profitable, this comparison may appear unfair to the Philippine RECs; however, since the Philippine rural electrification systems were designed according to the U.S. model, the comparison essentially relates the performance of the Philippine systems to their design standards.  - 16 - direction and will contintue to worsen unless improved operation and mainte- nance procedures are adopted. Table 2.2: COMPARISON OF MAINTENANCE REQUIREMENTS (U.S. and Philippine RECs) U.S. RECs U.S. RECs Phil. RECs Phil. RECs After After After After 5 Years 10 Years 5 Years 10 Years (Percent of Operation and Maintenance Expenses) Operations 70% 50% - 30% Planned Maintenance 20% 35X - 20% Forced Maintenance 10% 15X - 50X O&M Cost as X of Kevenue 5.8X 4.41 5.2X 6.2% Recomeneldation 2.15 Three critical maintenance needs have been identified for the Philippines: (i) clearance of trees, (ii) treatment of poles, and (iii) re- pair of damaged equipment and tools. Remedies for these problems, which are common to many rural electrification systems, could account for about 501 to 701 of the cost of a planned maintenance program. 2.16 Tree clearing and pole treatment programs (Annex 2.05) are cen- tral to a sound annual maintenance plan. These programs are likely to cost. about US$7.5 million annually for the system as a whole (although only about US$5 million are incremental costs for the RECs), and should include specific work plans and budgets for each REC. A failure to implement these programs will lead to further serious deterioration of the network and con- tinuing unacceptably low supply continuity and service standards. 2.17 A recent survey indicates that equipment and tools with a re- placement value of over US$5 million are lying idle in REC stores, and that inoperable network equipment of even greater value is awaiting repair. NEA is acutely aware of this problem and is arranging to establish seven stra- tegically located zonal repair centers to serve the repair, major mainte- nance, and spare parts needs of the RECs (Annex 2.06). 2.18 As the sector's core agency, NEA urgently needs to develop and implement national policies, standards and planning systems for planned and operational maintenance. In that context, NEA will need to help the RECs prepare budgets and work programs for major maintenance. NEA would then need to ensure, possibly as a condition of lending to an REC, that it (i) has developed a sound program of major maintenance, (ii) has arranged to make available from revenues funds sufficient to implement the program (in the near term, when substantial major maintenance is needed to reverse years of neglect, NEA may wish to make some loans for this purpose to RECs  - 17 - that cannot raise sufficient tariff revenues to cover these requirements), and (iii) is implementing properly and consistently the agreed major main- tenance program. Programs for planned maintenance should cover only core systems that are operating at or close to design standards; otherwise, re- habilitation must be done first. Since NEA may not have sufficient numbers of qualified staff to plan and supervise the RECs' implementation of such a comprehensive maintenance program, NPC, which has a direct interest in min- imizing the REC8' inefficiency, should assist NEA by seconding staff to supplement NEA's capabilities, and taking responsibility for the field mon- itoring of the RECs' maintenance efforts. D. Commercial Practices 2.19 In the early 1970s, with assistance from U.S. consultants, NEA provided all RECs with operational and training manuals outlining the com- mercial policies, guidelines and piocedures that were to be followed. Spe- cific guidelines were provided for meter reading and billing, collection, disconnection, penalties for reconnection, membership in a REC, and rights- of-way. The policy also specified the basis for pricing. Over the years, the RECs have become slack about implementing the commercial procedures so that, currently, only about 10 of the RECs run their commercial activities effectively. The causes of this deterioration in commercial performance include: 'i) weak REC management which failed to accord necessary priority to billing, collection and related activities; (ii) insufficient funds to provide and maintain the equipment needed for commercial efficiency; (iii) shortages of functioning meters, resulting in substandard metering, looping of services and unmetered supplies; (iv) local political and social pressures to forgive the delinquency of consumers capable of mustering ex- ternal support: and (v) seasonality of incomes, particularly among farmers, who fall into arrears during the lean months on the promise that they will repay after they sell their wares. At present, financial losses from inef- ficient commercial practices could be as high in value as 8X of energy sold. Arrearage Levels 2.20 The total annual revenue from rural consumers is P 4.0 billion, which averages about P 34 million per REC. The average percentage alloca- tion of revenues among consumer categories is shown in Table 2.3; these percentages vary significantly among RECs, especially for those in remote islands and in central and southern Luzon.  - 18 Table 2.3, ALLOCATION OF REC REVENUES AMONG CONSUMER CATEGORIES (X) Consumer Niseellaneous Categories Residential Industrial Commercial Public Lighting, etc Contribution to Aggregate REC 40 30 18 12 Revenues (X) 2.21 The average level of accounts receivable is about 27X of total revenue (averaging about 3.2 months, or 100 days sales). While residential consumers are responsible for nearly 70% of outstanding bills, the monetary value of residential arrears is only about 35X of the total. Por the bal- ance: (i) local and national government bodies account for about 28X of the monetary value of arrears; (ii) large commercial ard industrial consumers account for about 301, and (iii) other consumers for the remaining 71. While this mix varies among the RECs, a relatively small number of govern- ment and business establishments account for the bulk of arrearages. Industrial Consumption 2.22 Currently, a number of large industrial consumers that take power at high voltage are supplied directly by NPC. These consumers prefer this arrangement because of (i) a desire to pay for electricity at the low- er rates charged by NPC, (ii) a concern that NPC's service is more reliable than that offered by the RECs; and (iii) a reluctance of some among them to face bills that they still have outstanding with the local REC, going back to the period prior to their direct connection with NPC. As indicated in Table 2.4, NPC now directly provides about 401 of the total energy supplied to industrial consumers. Tablg 24; SUPPLIERS OF ENERGY TO INDUSTRIAL CONSUMERS (MWh by Area) Private Area RECs Utilities NPC Luzon 80,312 15,703 78,023 Visayas 29,040 26,600 30,244 Mindanao 62.955 48.000 127.651 TOTALS 172,307 100,303 235,918  - 19 - 2.23 In most other countries, the usual practice is that all consum- ers are supplied by the distribution authorities except those requiring supplies at voltage levels higher than the highest distribution voltage. Some technical factors that would influence this choice are: (i) size of load; (ii) nature of load (e.g., continuous process manufacture); (iii) quality of supply requirements (e.g., the need for supplies to be free of harmonics); (iv) security considerations; and (v) the capital cost requirements of alternative arrangements. Recommendations 2.24 For large consumers, NEA and NPC should develop technically- based policy guidelines concerning the supply of large consumersV. Such guidelines would need to balance the critical importance of protecting the integrity of the RECs' franchise areas against the capability of the RECs to provide industrial consumers with reliable supply at reasonable cost. Where industrial consumers who are directly connected to NPG have arrears outstanding to their local RECs, NPC should arrange to collect a surcharge that would be used to settle those consumers' accounts with the RECs. 2.25 More generally, since the basic commercial systems that the RECs originally implemented are sound, NEA should now arrange to update these guidelines, particularly their coverage of procedures for revenue collection, including meter reading, billing, disconnection, penalties for reconnection, and electricity theft. Each REC should be provided with a mini-computer to process the data developed through the new systems, and with training in the procedures, hardware and software provided1. At the same time, the biases that undermine the ability and desire of REC managers to strengthen their commercia operations will also need to be addressed, presumably through conditionality to be attached to future NEA loans to the RECs. The experience of those RECs that have been performing well has in- dicated a close correlation between effective collections and heightened member involvement. In effect, the members police themselves and bring peer pressure to bear on the larger consumers. Therefore, special arrange- ments might be made to foster the growth of group accounts such as Barangay Power Associations (BAPA) (Annex 2.07). Moreover, mamber outreach programs are also needed to demonstrate the interrelationship between effective rev- enue collection and service standards, operating costs, electricity prices and employment conditions. In this regard, programs such as pre-paid stamps g The Government approved Policy Reforms in the Power Sector already provides that direct connections for industry shall continue until such time as "the appropriate regulatory board determines that the direct connection of industry to NPC is no longer necessary in the franchise area of the specific utility or cooperative." Therefore, the Government's inter-agency committee on technical and financial indicators and standards of performance, where both NEA and NPC are represented, can develop the needed policy guidelines. I/ In cases where an REC has a very small market, the benefits of computeriz- ing billing and collections should be weighed against the likely cost of the equipment, software and training.  - 20 - and raffles with prizes could be used as part of a national communication effort to raise the level of public awareness of these issues. L Non-Technical Losses Levels of Non-Technical Losses 2.26 The average level of losses per REC is 25% (Annex 2.08), or about 700 GWh/year in the aggregate. For the average REC, technical losses are estimated at about 17% with non-technical losses accounting for the balance of 8%; however, non-technical losses of as much as 20% have been recorded in the worst cases, most of which are located in Luzon. 2.27 A detailed analysis of the causes of non-technical losses is provided in Annex 2.09, and can be summarized as: (i) utility staff collu- sion with consumers, (ii) consumer interference with meters, (iii) direct tapping of lines, (iv) faulty metering, and (v) unmetered supplies. Be- cause consumer meters are in short supply, a large number of consumers have unmetered supplies and others have been permitted to provide their own me- ters. Furthermore, the standard follo-ad for metering of large industrial and commercial consumers (those who use current-transformers) is not of sufficiently high. These practices all result in unrecorded consumption; although the resultant non-technical losses caused by these practices are difficult to estimate accurately, the magnitude is significant. Recommendation 2.28 Experience in other countries shows that the most effective strategy for reducing non-technical losses is a combination of management action, customer awareness and technical changes. The major elements of a non-technical loss-reduction program would include: (i) effective national legislation providing for the prosecution of pilferers based on circumstan- tial evidence and prescribing stiff penalties, judicial and financial, for offenders; (ii) continuous surveillance of lines by special monitoring units composed of full-time staff with their own transport; (iii) replace- ment of all "A" base type meters; (iv) sealing of all socket-type meters; (v) programs for on-site meter testing, replacement and recalibration to be implemented on an ongoing basis, (vi) rewiring of all sub-standard major industrial and commercial meters, with regular semi-annual and spot checks of all such installations, (vii) installing of check meters on distribution transformers, and (viii) replacing of low-grade service connections rith concentric cable. 2.29 Existing laws concerning pilferage of electricity are extremely weak. They place an excessive burden of proof on the utility or REC seek- ing redress; and, even when applied successfully, face the miscreant with only minor penalties. Currently, the Congrcss is considering several pro- posed bills to enhance the capability of utilities and RECs to pursue pil- ferers and to increase the penalties for those who are convicted. NEA should support strongly the rapid adoption of the strongest of these bills.  - 21 - 2.30 Generally, the cooperative approach has been found to be the most effective institutional arrangement for reducing electricity theft; in some RECs in the Philippines, consumer involvement, resulting in a combina- tion of a group climate and peer pressure, has been effective in supporting afforts to minimize pilferage. The RECs should place a much higher priori- ty on consumer involvement to encourage their consumer-members to police themselves. Consumer awareness of the problem could be improved by greater REC outreach through the use of newsletters, newspaper articles and adver- tisements, radio programs, and local television appearances and advertise- ments. These measures cost very little and have the capacity to provide substantial savings. They also provide the basis for deeper accountability of the RECs to their corsumer-members. 2.31 Some RECs have made effective use of group accounts, with me- ters installed on individual transformers. Drives to form these group ac- counts, known as Barangay Power Associations (BAPA) (Annex 2.07), have been well received especially in the farming areas. Where the BAPA movement has been successful, non-technical losses have been more effectively con- trolled. The approach has a number of important advantages, including (i) providing single-point connections for many consumers, thereby reducing billing costs; (ii) shifting responsibility for all losses in the secondary system to the BAPA; (iii) monitoring the transformer load; (iv) providing a social grouping in the BAPA; and (v) providing the BAPA with a small income for use on community projects. The estimated cost of a more widesoread program of transformer metering is estimated at about US$100,000 per REC or US$40,000 per substation and feeder network; potential savings per fee<der per year could exceed US$40,000 from the recovery of non-technical losses (Annex 2.06) and US$20,000-30,000 from recovery 2.03). This high potential for savings could induce the RECs to provide internal funding for this program as well as accelerated formation of BAPAs in areas where the concept has taken root. 2.32 In general, NEA should place a much higher priority on the re- duction of non-technical losses. The system improvement measures to be employed cost much less and could potentially produce a far greater immedi- ate financial impact than even the program to reduce technical losses. NEA should therefore arrange for the RECs to prepare a statistical analysis of the level of losses within their franchises; based on these analyses, some pilot loss reduction projects could be developed around the implementation of a number of the measures discussed above. In addition, annual targets for losses could be developed for each REC, and NEA could support efforts to achieve these targets through conditionality attached to future loans to the RECs.  - 22 - F. Core Systems Current Conditon 2.33 Due to poor core systems of some networks taken over from the private sector, increasingly poor planning of the new systems developed, and the allocation of resources for system expansion at the expense of planned maintenance, system improvement and rehabilitation, about 20% of the rural distribution network now requires extensive rehabilitation or replacement. The remaining 80X of the system can readily be restored to the original design standards through system improvement type measures. Recommendaffon 2.34 Recent studies suggest that restoration of the system to the original design standards would, among other things, involve: (i) about 50 new 69 kV substations; (ii) additional transformer capacity in as many as 40 existing substations; (iii) additional voltage regulation and protec- tion equipment, including reclosers and lightning arresters; and (iv) reha- bilitation of the 13.2 kV feeder systems. Implementation of such a program would require (i) strengthening of NEA's distribution planning process and the capabilities of its staff to carry out the related planning, (ii) bet- ter coordination of project formulation between NEAL and the RECs, (iii) better supervision by NEA of the RECs' project implementation activi- ties, and (iv) closer coordination of NEA and the RECs with NPC, particu- larly in relation to the development of the 69-kV network and possible in- troduction of an intermediate 34.5 kV voltage. As NPC has a direct inter- est in optimizing the efficiency of rural networks, it should provide NEA with assistance in project design and implementation. 2.35 Under the proposed Bank-financed Energy Sector Loan, the Bank plans to support a pilot program (Annex 2.10) for rehabilitating core sys- tems. The program includes (i) clearly defined projects to rehabilitate one substation and all the feeders, branches, secondaries, and service drops emanating therefrom in nine carefully selected RECs; (ii) the provi- sion to 32 RECs of one new 69-kV substation each; and (iii) upgrades to one existing 69-kV substation in nine RECs. This rehabilitation program is expected to cost about US$17 million. In particular, the feeder rehabil- itation component emphasizes preparation of detailed project designs by NEA, close coordination between NEA and the selected RECs concerning the focus of the projects, and strict project supervision procedures for NEA. If successfully implemented, the pilot project would form the basis of a future program to restore the rural distribution system to its original design standards.  - 23 - G. Rural Electrification Mastr Plan Improvements on Operations and Planning 2.36 As indicated hereabove, a large number of remedial activities need to be conducted to relieve the operational problems now constraining delivery of electricity service in the rural areas. Some are inexpensive, high-impact measures that the RECs should be able to implement with their existing staffs and revenues, or with limited external assistance. Some will require NEA's financial and technical assistance. To ensure that these diverse activities are properly coordinated and to translate the gen- eral aggregate program into a management plan for each REC, a comprehensive Rural Electrification Master Plan (REMP) is needed; the REKP should provide the details of an overall national program, within which (i) specific im- provement measures for each REC can be formulated, taking into account re- alistic constraints on available financing, and (ii) the performance of each REC can be measured against realistic technical and financial targets. 2.37 Although the REMP is meant to translate a general program for the country into an action plan for each REC, it should be formulated on a top down basis, with the objective of planning the integrated long-term development of rural electrification in the Philippines, with special em- phasis on the next ten years. It should take the form of a management plan with particular emphasis on the technical requirements for running the bus- iness. The REMP would include as its main elements: (a) Establishment and implementation of a methodology for invest- ment planning and evaluation; (b) Preparation of an indicative nationwide investment and lending program, on the basis of which a draft investment program could be developed for each REC; (c) Development of a sound pricing system, together with suggested tariffs for each REC; (d) Establishment of operational performance criteria, together with performance targets for each REC; and (e) Formulation of a broad-based manpower development plan, on the basis of which a draft training program could be prepared for each REC. On a nationwide basis, the plan would identify gaps in all major functions and develop strategies to close them; priority measures for resolving oper- ational and investment issues would be defined, allowing the development of detailed, integrated remedies for the system's major problems. In conjunc- tion with the REMP, an REC Planning Manual would be prepared, which the RECs would use in developing initial integrated five-year rolling technical and financial plans to cover their operations, maintenance, special service improvement programs, and investments. In turn, the indicative investment plans, the suggested tariffs, and the performance criteria that will  - 24 - already have been developed for each REC can be adjusted to take account of the information being provided by the RECs. 2.38 The REMP should also include the development of procedures for compiling management information and performance reviews so that the per- formance of each REC would be measured against (i) its work plans and bud- gets, and (ii) national indices for key parameters (paras. 4.25-4.29 and Annex 4.08). Thus, the REMP would provide a clear framework within which NEA could perform its planning, supervisory and controlling functions and the RECs' Boards and management could assess their own performance. Formulation of the Plan 2.39 The rural electrification institut- arrently lack the know- how, experience and capacity to develop the REMP by themselves. They will consequently need assistance from consultants to design and implement the necessary planning processes and procedures, the pricing system, and the information and review systems. Consulting assistance will also be needed for specification of suitable hardware and software to computerize (i) dis- tribution planning and design, 'ii) consumer records, (iii) billing and collection, (iv) stores manageme-t, and (v) payroll systems. Once the REMP is developed, consulting assist. ace would be needed for dissemination among NEA and the RECs of the Plan's -ey findings and the programs, systems and procedures that comprise the I art of the REMP. 2.40 NPC will also need to become involved in the formulation of those parts of the REMP that concern investment planning and pricing. The effectiveness of NPC's planning of its generation and transmission require- ments depends on the preparation of a coordinated distribution plan. More- over, NPC's financial health rests in part on the RECs' making timely pay- ment for their power purchases. In short, NPC needs a stronger involvement in the planning, implementation and operations of rural electrification. Manpower Development 2.41 Implementation of the REMP should be supported by an enlarged manpower development program for both management and staff at NEA and the RECs. At the staff level, the main training requirements include: (i) skills upgrading for electricians, linesmen, and other operating staff; (ii) skills upgrading for supervisors; (iii) administrative and management techniques; and (iv) effective management practices. The first three sub- ject areas were adequately covered by training courses developed in the early days of the rural electrification program. Since the system includes an ample cadre of adequately skilled or trained staff, particularly since some who had left for lucrative assignments in the Middle East have now re- turned, NEA should provide refresher courses in these areas. NEA has two regional training centets, which are currently used for training personnel from abroad. These centers would better be used for training NEA and REC staff.  - 25 - 2.42 The most critical manpower development requirement facing the rural electrification institutions is to increase the effectiveness of man- agers. In particular, a special effort must be focused on improving the performance of the teneral managers in the RECs and the senior functional managers in NEA. The REMP could provide the framework for a management development program consisting of two major elements; (a) Annual seminars for groups of up to 20 NEA and REC top manag- ers, to discuss (i) planning; (ii) prioritization of opera- tional and investment activities; and (iii) constraints on the implementation of operational and investment plans. The semi- nars would be based on the REMP and the REC Planning Manual. (b) Training courses that fLcus on upgrading the core skills of managers, where mixed groups of managers would come together for about one week every six months for a period of about four years to consider (i) the role of the REC Board and its manage- ment, (ii) situational management, (iii) human resources man- agemer,t, (iv) investment planning and financial management, (v) distribution planning, and (vi) improved performance through staff training and manpower development. 2.43 NEA does not currently have staff with the necessary know-how to design and implement effective training programs for senior managers; it would need assistance to develop this latter category of required training. The performance review component of the REMP should serve as the logical starting point for the management development program, so that the consul- tants assisting with preparation of the REMP should also assist with prepa- ration of the training programs. One of the regional training centers should be fully dedicated to the senior management development programs, which would occupy the facility virtually year round. The other regional training center would be used for the courses to upgrade skills and to train REC supervisors. Hands-on training programs would rainly be imple- mented on-site at the RECs, and would use the updated technical and finan- cial procedure manuals. NEA will need to co'wer the substantial cost (in terms of both money and staff time) of manag..ng such a training program. To ensure that these costs are recovered, NEs will need to charge appropri- ate fees to the participating RECs. 2.44 The following chapters provide the framework for two strategic issues that the REMP would translate into detailed action plans for each REC. These include (i) the development of an investment strategy and lend- ing program for rural electric distribution, and (ii) the establishment of clear and sound pricing principles for the sector.  - 27 - 3. INVESTMENT STRATEGY A. Curent Plantnig Strategy 3.1 Since the early days of rural electrification in the Philip- pines, the philosophy applied to the sector was one of extending electrici- ty supply to the maximum number of rural households, in order to provide basic infrastructure to rural areas. This concept of "total area coverage" required only a relatively simple planning process: subject to the avail- ability of funds, lines were extended from the existing electricity supply grid to villages and areas within relatively easy reach, and with a reason- able prospect of consumption growth. A socio-economic screening test se- lected areas that appeared desirable, and an intensive promotion campaign created the momentum for the establishment of a local REC. Once an REC was established, its aim was to maximize the number of consumers within the franchise area so as to attain the critical consumption level needed for the REC to aclhieve commercial viability. 3.2 This approach to investment planning was optimal for a time of pioneering expansion. The program's early successes confirmed the validity of the approach, and during 1974-81, the number of consumers served by RECs increased by about 38% per year, from 178,000 to 1.7 million (Annex 1.01). 3.3 However, following the phase of rapid expansion driven by so- cial targets, the rate of expansion slowed considerably. During the 1980s, household connections have grown by an annual average of only about 7%; in the last few years, the rate of growth fell to about 3%. At the same time, the dominant issues in planning for the rural electric sector have changed: (i) the requirements of non-residential consumers, who now account for al- most 60% of total REC sales, must be met; (ii) increasingly, investments are needed for upgrading, reinforcement, and rehabilitation of the distri- bution systems as a result of consumption growth, aging core systems and damage caused by natural disasters; and (iii) in view of prevailing econom- ic constraints, NEA needs to guide the RECs toward efficiency-oriented op- erations and investments. 3.4 Despite the changing sectoral needs, the current Public Invest- ment Program (PIP), updated in 1988, still focuses primarily on the in- creased coverage of rural areas and households, with the aim of serving 4 million households by 1992. Investments in rehabilitation, although in- cluded, are dwarfed by expansion investment. Later in 1988, NEA's new leadership (para. 6.1) decided to refocus the investment program to address the pervasive declines in quality of service. After a crash program to develop data from the RECs, NEA formulated a new, highly ambitious invest- ment program for 1988/89 that places greater emphasis on the need for reha- bilitation. This program was later superseded by a proposal covering 1989 alone, that maintained the same priorities but that was reduced in scope to only about 30% of the original request. Both the original and revised pro- grams are summarized in Annex 3.01. In any case, the experience of the last year indicates that, while NEA is changing its investment priorities,  - 2u - it still lacks a consistent investment strategy and a coherent methodology for prioritizing and selecting investments. 3.5 This chapter derives an indicative investment strategy through the conduct of an economic analysis of the various investment options. Based on the findings of the analysis, which indicates the justification of concentrating on (i) system rehabilitation together with the provision of additional consumer connections within the vicinity of upgraded lines and (ii) system extensions designed to capture productive loads, sample in- vestment scenarios are developed to test the pace at which the new in- vestment objectives could be realized. Since the suggested change in in- vestment strategy will require a new methodology for screening investments, the chapter continues by outlining an approach for evaluating and ranking proposed projects. The chapter concludes by noting the various non-econom- ic factors that should be addressed or considered in conjunction with the adoption of the new planning methodology. B. Investment Priorities 3.6 NEA's current methods of evaluating investment proposals are not suitable for the ranking of different types of projects, when those projects are competing for limited resources. The existing methodology reflects the earlier emphasis on expansion, where the main concern was to maintain financial viability of the REC while the construction program was oriented to meeting quantitative targets. The existing feasibility study format employed by NEA is heavily descriptive in technical and costing terms, and evaluates the impact of the proposed investment on the REC's total financial Rerformance. This ensures that any particular investment will not damage the REC's financial health; but it does not yield informa- tion on the underlying feasibility of the project itself, or on the compar- ative merits of different investment options. While the analysis of finan- cial performance should continue to be included as part of any investment evaluation, the missing element of economic feasibility analysis needs to be introduced and become the main criterion for investment decisions. The analysis of investment priorities that follows was conducted by NEA accord- ing to a methodology that relies heavily on these economic principles. 3.7 The electricity distribution system in rural areas is currently characterized by evident medium-term needs for rehabilitation, and estab- lished long-term goals of further expansion. This conflict is typical of rural distribution systems in a transition phase. To determine the most cost-effective investment strategy for the RECs, the following representa- tive alternative investment options were chosen for economic cost/benefit analysis:1' / This analysis does not assume any major adjustments to the system's design standards; the current standards are already relatively low-cost.  - 29 - (a) System rehabilitationV with concurrent addition of new connec- tions along existing lines (add-ons', tali.ng advantage of sup- ply capacity released by the upgrading; (b) System rehabilitation only, without any new consumption in the rehabilitated area; (c) System expansion primarily to satisfy incremental residential demand; (d) System expansion based mainly on incremental industrial demand; and (e) Combined system rehabilitation and expansion. 3.8 Each option was defined as a specific project within the fran- chise area of an appropriate REC, using actual investment proposals as the basis. Capital and operating costs of each option were adjusted to approx- imate economic costs, and the cost of power purchased by the REC was valued both in financial (NPC sales price) and economic terms (LRMC of NPC sup- ply). The benefits were defined as incremental sales, unless the savings from loss reduction investment exceed the additional consumption (relevant for the "rehabilitation only" option). Incremental sales benefits were valued according to a demand function ranging between the cost of alterna- tive energy (kerosene for lighting) and the tariff level, thus capturing the consumer's surplus. Where rehabilitation/upgrading investment was likely to yield system loss reductions in the distribution network, losses were assumed to decline at a realistic rate. The cost of mounting a cam- paign for the reduction of non-technical losses was included in the calcu- lations. The five representative options were tested for the Pampanga I, Capiz, Tarlac II, and Leyte V cooperatives (Annex 3.02). 3.9 The results of the sample feasibility studies (Annex 3.03) in- dicate that the highest priority in forthcoming investments should be placed on rehabilitation combined with an intensification of cons mer den- sity along the rehabilitated lines. This type of investment combination, yielding an internal rate of return of about 40-50 in economic terms, has the advantage of achieving at low cost both system loss reduction and the freeing of additional capacity for incremental consumption. The superiori- ty of this option as compared to rehabilitation without significant growth in consumption is evident from the poor rate of return (about 21 in econom- ic terms) yielded by concentrating on loss reduction and upgrading alone; ' "Rehabilitation" covers reconductoring, transformer replacement, other re- inforcement investments, and replacement of failed or dilapidated equipment. "Add-on" investments cover both the connection of additional consumers along existing feeder and branch lines, and the construction of short new branch lines to reach groups of consumers in the vicinity of the feeder who do not yet have access to electric power. Such consumers had not previously been connected because of (i) lack of materials, and (ii) the emphasis on extending the backbone system. "Expansion" refers to (i) construction of new feeders and substations, or (ii) extension, by some considerable distance, of existing feeders, to connect new consumers.  - 30 - the benefits of reduced bulk purchases to meet an almost unchanged consump- tion level would not justify the massive investment in system improvement. Although rehabilitation is the essential first step toward increa.ing con- sumption in already electrified areas, it needs the follow up of infill connections and growth in demand from existing connections to become eco- nomically justifiable. In many RECs, the deterioration of networks and lack of funds for materials has given rise to substantial suppressed demand within a small distance from existing linesV. This suppressed demand should be tapped by increasing the connection density after rehabilitation, and thus triggering the realization of incremental economic benefits. 3.10 The typical pattern of expansion, namely that based on scat- tered residential connections, shows a low rate of return of about 3-4X; the substantial investment in extending the grid cannot be recovered easily from low-volume consumers. The only clearly feasible expansion option is the extension of feeders to areas dominated by new industrial consumers, where the volume is sufficient to carry the cost of investment. Predict- ably, a combination of rehabilitation and expansion investment as a package yields a modest internal rate of return between the two extremes. Table 3.1 summarizes the results. Table 3.1: REPRESENTATIVE FEASIBILITY STUDY RESULTS Economic Type of Investment Rate of Return Rehabilitation with Add-ons 48X Rehabilitation only 2X Expansion (residential) 4X Expansion (industrial) 35X Rehabilitation and expansion 8X 3.11 The general tr- d of these results is confirmed by a less so- phisticated ranking analys.s conducted by NEA within the framework of sam- ple REC consolidation studies. A financial cost/benefit analysis was car- ried out for alternative investment options (rehabilitation, add-ons, and expansion) in the RECs of Albay I, II, and III, Camarines Sur II and IV, and Pampanga I, II, and III (Annex 3.03). While the rehabilitation invest- ments (albeit with a somewhat optimistic loss reduction assumption) show reasonable internal rates of return, none of the expansion investments meets the criterion of a positive IRR. 3.12 The clear message of the sample exercises is that, in the medi- um term, the primacy for the allocation of investment funds must lie with system improvement combined with the increase of consumer density per km of line. The extension of feeders to unserved areas should be at the bottom of the priority list, unless clear evidence indicates that productive uses vI NEA's own projections indicate that as many as 700,000 potential new con- sumers are within easy reach of existing feeders.  - 31 - of power would enable speedy cost recovery. Equity considerations may dic- tate that some expansion continue, even during the years of heavy emphasis on rehabilitation: the terms for granting a franchise currently mandate that the chosen operator expand the distribution system to low-density ar- eas, based on the principle of cross subsidization witnin the service area (the pace of that expansion is conditioned on maintaining the financial health of the REC). This could be accommodated optimally at the regional level, where even with the implementation of high-priority upgrading works, the allocation of some remaining available funds for economically justified expansion might still be considered. Areas with relatively adequate dis- tribution networks would be in a position to continue expansion. However, on a national level, the investment program of the next few years should reflect the priority of system improvement. 3.13 The investment strategy adopted should also consider how to realize possible cost savings in implementing rehabilitation and expanslon investments. As major savings from design standard adjustments are unlike- ly to materialize, the benefits will have to come from improving efficiency through such measures as reducing conductor size, increasing pole span, reducing transformer protection, and saving meters through other payment systems (Annex 3.04). Such improvements will not likely have a major sys- tem-wide impact but may be significant at the local level. In some in- stances, the simultaneous application of these measures could save as much as 10% from the total cost per km of line, albeit with some reduction in service rel:sbility. A thorough cost/benefit analysis would determine where the benefits of the potential savings outweigh the loss in quality of service. C Investment Scenarios 3.14 As the development of a full-fledged investment program will take some time, NEA and Bank staff constructed a preliminary five-year in- vestment needs projectionY that illustrated the possible options and in- vestment patterns (Table 3.2). The initial years of the projection were based on the detailed survey of requirements conducted by NMA ir. 1988. However, since the survey captures only a portion of rehabilitation re- quirements, as NEA asked the RECs to limit their requests to fit within the constraint of available funds, appropriate multipliers were applied to re- habilitation investment, derived from sample analysis and NEA experience. The total investment requirements were phased over 5-7 years, giving prior- ity to system improvement, and bringing in expansion only gradually in lat- er years. The high returns of a "rehabilitation plus add-on' program make a compelling argument on behalf of this component of investment in rural systems receiving the very highest priority. Although the optimal approach would include a complete package that includes efficiency improvements, the system improvement investments are so essential that they need to proceed g The investment projections include investments in rural distribution net- works only, and do not include any alternative generation programs.  - 32 - as soon as funding can be secured, and thereby lay the foundation for later expansion accompanied by efficiency gains. 3.15 While the system improvement element is determined primarily by (i) the current level of demand, (ii) technical needs, and (iii) the imme- diate potential to connect new consumers along existing lines, the future expansion of the system depends on the pace of penetration into unserved areas. The overall potential is, of course, very large, given that the Government's aggreg.te electrification target still is beyond easy reach. A demand forecast for rural electrificatio.z-, thsrefore, must be guided by the economic justification of individual projects, and by the implementa- tion capacity of the sector. Based on (i) the known short-term potential available through system upgrading and add-ons, and (ii) a gradual progres- sion toward expansion ii-.vestment in later years, NEA developed a tentative projection of electriA4ty consumption for the early 1990s. This forecast, driven by system needs and capabilities, assumes a demand growth of about 8Z per year through 1995 (Annex 3.05). 3.16 Within the core program of investments in rural distribution networks, the scenarios considered were tailored to reflect three important parameters: (i) the primacy of a combination of rehabilitation and add-on investments in the early years, (ii) the projected availability of funds in the short term, and (iii) the likely implementation capacity of NEA and the RECs. Judgments for weighing these parameters are based on the findings of sample feasibility studies and on the institutional and financial con- straints that limit the capabilities of the sector's institutions. The analysis yielded two scenarios that are possible, depending on whether NEA and the RECs can accelerate the current sluggish pace of investment: (a) Scenario 1 assumes that the modest rehabilitation investment needs already formulated for 1989 are representative of the implementation capacity at this point, and that the remaining rehabilitation and add-on investment will be phased over the next four years. (b) Scenario 2 places the bulk of rehabilitation and add-on invest- ment ii. the first two years of the program, assuming that the institutions will gear up rapidly for a massive system upgrad- ing drive. 3.17 In both scenarios, expansion investment does not start to be phased in until 1991. Annex 3.05 provides details of the investment pro- gram of Scenario 1 by Region and by type of investment, then compares the results of both Scenarios to existing plans. Table 3.2 summarizes these findings. Both scenarios are illustrative of the general pattern and mix of expected investments in rural electrification; neither is a carefully developed accurate projection of annual investment in the sector. In appo- sition, NEA's latest draft plan calls for a steep increase in investment to about P 1.3 billion in 1990 (with about 67X apportioned for rehabilitation and 33X for expansion), declining gradually to about P 600-700 million per year by 1994 (with a mix of about 55X for expansion and about 451 for reha- bilitation.  - 33 - Table 3.2: INVESTMENT SCENARIOS (P million) 1989 1990 1991 1992 1993 Scenario 1 Rehabilitation plus Add-on 315 538 538 538 538 Expansion 0 0 154 530 509 Total 315 538 692 1,068 1,047 Scenario 2 Rehabilitation plus Add-on 600 850 700 300 0 Expansion _ 0 150 550 500 Total 600 850 850 850 500 Since actual new investment loans for RECs approved by NEA in 1988 amounted to only about P 200 million, Scenario 1 starts with 1989 investment of P 315 million, and increases to an annual figure of about P 1 billion in 1992 and 1993. Having completed the bulk of system improvement investments by 1993, total investments thereafter would drop and would then include routine rehabilitation and modest expansion. Under Scenario 2, system im- provement is concentrated heavily in 1989-90, driving the total annual in- vestment level quickly up to P 850 million in 1990; thereafter investment levels stay constant as rehabilitation gradually gives way to expansion over time. After the first five years, the total benefits from consumption growth and loss reduction are likely to be similar for both scenarios. Finally, the most important consrraint affecting the level of future in- vestments seems to be the absorption capacity of NEA and the RECs. Scenar- io 1, which indicates aggregate investments of about P 3.8 billion during the period, represents a best guess at "EA's absorption capacity, and not a level that was conside,ed optimal on other grounds. 3.18 Given the prevalence of rehabilitation and add-on investment in the program's first five years, the total investment sequence yields an IRR similar to that of the highest-priority sample investment. Scenario 1, for which detailed incremental consumption data are available, shows a return of 40-50%. In effect, considerable scope exists for economically sound investments in rural electric networks. The first push of investments for rehabilitation plus add-ons, involving expenditures of about P 2,500 mil- lion between 1989 and 1993, would yield high benefits. Investments in sys- tem expansion, which are projected to run at about P 500 million per year from 1992/93 onward, would have to be selected carefully to ensure that productive demand becomes the driving criterion. Since the RECs currently sell about 60X of their aggregate volume to industrial and commercial con- sumers, a good proportion of the expansion program, if selected judicious- ly, can be designed to yield positive net present values at realistic dis- count rates.  - 34 - 3.19 The above Scenarios represent a first estimate of the scope of a realistic investment and lending program. NEA should begin by refining these estimates and match them to the detailed requirements and implementa- tion capacity of the RECs. As the plans endorsed in 1988 and early 1989 (Annex 3.05) do not reflect adequately the change in investment strategy away from expansion to rehabilitation and add-ons, NEA will need te. present formally to NEDA a revised program that reflects its changed priorities. By serving as a rational and realistic action plan, the formulation of a revised investment program will itself facilitate the discussions with cen- tral agencies regarding project approval and fund allocation. Under either Scenario, substantial new injections of finance by 1991/92 appear needed merely to maintain the pace of system improvement, regardless of whether investment for expansion returns to the program in strength at that time or later. The total additional requirement for 1991-93, which is not re- flected in the financial projections for NEA (Annex 6.06) would amount to about P 2,200-2,800 million, including a foreign exchange component of about US$80 million. D. Coverage Targets 3.20 If. during the early 1990s, NEA pursues a system improvement oriented strategy developed according to the indicative investment Scenar- ios, the proportion of rural population receiving electricity supply could rise from the present level of about 50X to about 65% by 1993/94. About half of the newly connected 700,000 to 800,000 consumers would be within easy reach of the existing grid, and would receive their connections through add-on investments; the remainder would receive electricity as a result of judicious expansion into economically justifiable areas. From the mid-1990s onward, connecting the remaining 250,000 to 300,000 consumers that could be supplied economically through add-on investments would in- crease coverage to about 70% of the rural population. However, since the share of unconnected productive consumers must necessarily decline and the areas remaining to be electrified would become increasingly remote, the ex- pansion investments that might increase penetration significantly are like- ly to become more difficult to justify in economic terms. Investment pro- posals would then have to be evaluated carefully and the Government's broadly encompassing area coverage target would need to be adjusted to re- flect the economic, financial, social and political realities derived from several years of investment analysis. Even in the long term, penetration beyond about 751 of the rural population would appear difficult to justify economically. 3.21 In many countries, rural electrification is considered to have a substantial social value, so that investments may well exceed the level to be justified solely on the basis of commercial criteria. The prolifer- ation of rural electrification in the Philippines occurred precisely be- cause the Government and NEA had put great emphasis on those social consid- erations. Currently, many RECs are struggling with serious operational and financial problems that resulted in large part from uncontrolled grownt. Therefore, during the next five to ten years, NEA as well as a larg's number of RECs will need to be restructured (paras. 5.26 and 6.26). During this  - 35 - period, the Government's emphasis should be to address the issues surround- ing the needed restructurings while supporting investments with prospects of an imminent favorable financial outcome and direct economic potential. Although investments that are justified primarily on social grounds can be considered on a case-by-case basis even before the late 1990s or early 2000s, the bulk of such investments should be postponed until the RECs' current institutional and financial problems have been remedied. EL Investment Criteria and Planning 3.22 The recommended priorities and investment scenarios indicate a general direction for a future NEA investment strategy. Translation of the priorities into a consistent, detailed investment plan and an NEA lending program will require the introduction of an appraisal and planning method- ology that can rank projects by using economic criteria. Establishing the analytical framework includes the following steps: (a) An initial screening of investment proposals on the basis of simple infrastructure, demographic, and priority parameters; (b) A rigorous cost/benefit analysis of the pre-screened proposals, utilizing economic methodology; (c) On a regional or sub-regional level, a ranking of proposals ac- cording to economic internal rate of return; (d) On a national and regional level, the development of an inte- grated investment program, based on macro parameters and over- all targets for efficiency; (e) Consolidation of steps (c) and (d) to arrive at a realistic list of priority investments; (f) Application of constraints, including, inter alia, the avail- ability of funds and the capacity to implement projects; (g) Development and implementation of a consistent NEA lending pro- gram based on the adjusted investment plan; and (h) Annual revision of the plan and lending program, and continuous appraisal of investment proposals. 3.23 The screenina process can employ several different methodolo- gies. Traditionally, the NRECA approach of weighting expected benefits and costs has been used, which results in a rough benefit/cost ratio of scores for a specific project. This approach requires a large amount of judgement by experienced practitioners, and detailed survey data. An improvement over the judgmental method would be the detailed ex-post analysis of past projects, from which certain characteristics of successful projects could be derived. A regression analysis of a large sample of completed projects can yield statistically significant correlations between the features of  - 36 - the area and the project, and the rate of return. All new projects with similar characteristics (population, incomes, price of electricity and oth- er energy, agricultural output, access to credit, terrain difficulty, cur- rent levels of electricity use, etc.) can be expected to-yield certain rates of return, prequalifying them for more rigorous analysis. Alterna- tively, the regression method can be replaced by discriminate analysis where the characteristics derived from ex-post analysis divide investment candidates into feasible and non-feasible groups. A thorough study of past REC investments, aimed at developing such screening parameters, would be highly beneficial at this point. 3.24 The methodology for economic cost/benefit aaalysis needs to be straightforward enough so that it can be applied by REC staffs in preparing their investment proposals for NEA scrutiny. As a minimum, it needs to include (i) adjustment formulae for cost data that transform financial costs into border-price-equivalent economic costs, using appropriate con- version factors; (ii) realistic rules for the estimation of consumption growth and the reduction of systems losses, to avoid overly optimistic pro- jections; (iii) the valuation of benefits at the true value of energy to consumers, as demonstrated by the willingness to pay for both electricity and alternative energy sources (Annex 3.02); (iv) the valuation of power purchases at estimated levels of long-run marginal cost of supply at the substation; and (v) the use of discounted cash flow methodology to derive internal rates of return and net present values, which in turn can be used as decision-making criteria. 3.25 The use of economic cost/benefit analysis as the main invest- ment decision criterion would involve testing the calculated economic rate of return against the benchmark of the opportunity cost of capital, which in the Philippines ranges from about lOX to 15%. On purely economic grounds, investment proposals with a lower rate of return should be re- jected as unjustifiable. The analysis of the revised investment strategy, based on rehabilitation plus add-on investments, implies that the bulk of projects included in the early years would be economically sound. As the emphasis in later years shifts to prudent expansion, projects with signifi- cant productive loads (small industry, large commercial ventures, etc.) would be economically attractive while those aimed at serving low-volume residential demand would not. All investment proposals, regardless of the commercial viability of the franchise area or the financial health of the REC, should be measured against this same economic yardstick; however, in- vestment decisions per se could well be determined on the basis of other considerations such as (i) social or regional equity, or (ii) strategic or political constraints. When financing such projects, a case would have to be made as to why other considerations should override the economic judg- ment. The burden of demonstrating that an investment falling short of eco- nomic criteria and benchmarks should be financed and implemented would be- long to NEA as the financing agency. Rigorous standards of scrutiny would need to be applied to the justification of deviations from economic priori- ties. Finally, when NEA decides to finance a marginally justifiable proj- ect, it w!l1 need to safeguard the financial health of the implementing REC through the use of appropriate pricing agreements, financing instruments, and (as needed) transparent subsidies, which are clearly separated from the RECs' commercial operations.  - 37 - 3.26 The development of a national rural electrification investment glan and NEA lending program in parallel with the appraisal of individual investment proposals should proceed according to the following steps: (a) Conduct an inventory of the status of the distribution systems; (b) Adjust the overall priorities of the program to reflect the new requirements for system upgrading; (c) Project national and regional demand development for rural electricity supply, taking into account macroeconomic and demo- graphic variables; (d) Apply standard physical and cost guidelines for rehabilita- tion/add-on and expansion investment, to determine broad con- struction and funding scenarios; (e) Evaluate possible cost-saving and loss-reducing measures such as the increase of distribution voltage, and more economical service standards, where applicable; (f) Integrate the results of the ranking of local investment pro- posals into the indicative plan by adjusting priorities and focusing on investments that provide high rates of return to the economy; (g) Test the impact of the investment expenditure on marginal cost and tariffs, and determine whether a more modest investment scenario should be contemplated to ensure cost recovery; (h) Project the outlook for foreign exchange and domestic funding limits, based on the broadly identified program over 5-10 years, and make repeated adjustments to the program to ensure its consistency with available resources; (i) Design a year-by-year lending program for NEA based on the fi- nal adjusted indicative plan, and provide the appropriate man- power resources, analytical skills, procurement procedures and timing, processing procedures, cash flow projections, etc. 3.27 The principal aim of such an exercise will be to gain a longer planning horizon than in the recent past, and to provide a framework within which changes in investment priorities can be accommodated. The indicative national plan should cover 5-10 years, and is likely to be dominated by system improvement investment in the early years. In the outer years, the emphasis is likely to change to a lower level of overall investment, with a balance between steady expansion and the maintenance of the existing sys- tem. The NEA lending program would cover about 5 years, indicating the numbers and types of loans to RECs anticipated each year, with tentative loan amounts identified.  - 38 - F. Planning Constraints 3.28 Even with a more appropriate investment strategy and methodolo- gy, a number of constraints and considerations exist which will complicate the planning process, including (i) a scarcity of funds, both foreign and local, (ii) a shortage of staff with the required skills, both at NEA and at the RECs, (iii) strong local and political pressure for expansion of the distribution system and new household connections, (iv) an explicit socio- political mandate to integrate many rural development activities in the electrification program, and (v) the poor operational and financial record of many RECs. 3.29 Funding remains one of the major binding constraints on the investment program. After the deterioration of many RECs' operating per- formance, little new resources were mobilized. In 1988, only limited funds were available. Of the total of P 700 million, the bulk (P 500 million) was devoted to covering the recipient RECs' arrears to NPC (para. 5.16). Of the remaining P 200 million, about P 150 million was used to provide loans for expansion, and only P 50 million for rehabilitation. Although additional finance has been indicated by USAID and the Bank to support in- vestments during 1989-92, these resources are unlikely to accommoeste both the rehabilitation and the expansion programs simultaneously. Careful hus- banding of the funds is needed, and priorities have to be defined clearly and rigorously. Current financial projections indicate that NEA will need to borrow an additional US$80 million during 1991-93. 3.30 The skills mix of staff in NEA and the RECs is not appropriate for rigorous investment prioritization. Sound engineering, accounting, and administrative professional skills are available in house, and are being put to good use in the evaluation of investment proposals. The crucial economic analytical skill, hiwever, is in short supply. The small NEA pro- ject appraisal unit, which until recently was charged with reviewing and evaluating the RECs' investment proposals, consisted of engineers and fi- nancial analysts. The new corporate planning division is only slowly add- ing and thereby giving voice to economists. Finally, in their staffing, the RECs have emphasized operational competence rather than analytical skills. The logical next step in improving the sector's skills mix would be for NEA to accelerate its recruitment of economists and planners, while also developing its own core function of formulating and implementing a consistent lending program. In parallel, the RECs (or regional groups of RECs) should establish suitable counterpart units that can conduct an ongo- ing dialogue on investment programming with NEA's corporate planning staff. Until NEA and the RECs acquire the necessary expertise, simpler prioritiza- tion guidelines will be needed to enable the sector to implement high-pri- ority investments quickly. 3.31 The legitimate socio-golitical goal of assimilating larger pop- ulation groups into the basic infrastructure network needs to be implemen- ted circumspectly, avoiding the sub-optimal use ci scarce resources. The 1970s and 1980s were characterized by expansion-oriented investment; the coming decade will require a careful balance between competing investment components. The strong demand for new connections, voiced by potential  - 39 - consumers, will not be satisfied if the existing core of the distribution system deteriorates. In fact, the most economical way to release capacity for additional consumption is the upgrading and reinforcement of overloaded or aging equipment. If system improvement investments are neglected, the benefits accruing to new consumers along extended lines will be nullified by incremental costs imposed on existing consumers by the deterioration of service. A neutral ranking methodology based on economic costs and bene- fits will facilitate the delicate balancing of needs. 3.32 Rural electrification cannot easily be separated from rural development as a whole. This has been the underlying rationale for NEA's direct involvement with other rural programs including, inter alia, liveli- hood projects, rural telephone systems, alternative energy, and rural cred- it. This approach, however, can be appropriate only for a more mature sys- tem with a strong central electrification agency, which could expand its planning horizon beyond network investment to encompass ancillary invest- ments. Indeed, at this time, the Government should emphasize the efficient coordination of related rural development activities rather than asking NEA to assume single resRonsibility for the process. NEA's concern should be limited to ensuring that rural electric investments can have a productive impact. At this stage of rural electrification, NEA's role in that coor- dinative process could include: (a) In the course of appraisal, providing a mandate for NEA's proj- ect evaluation staff to assess the adequacy of other rural de- velopment facilities, the,absence of which would obstruct the full impact of electrification on the area. These assessments would focus on the availability of credit for productive equip- ment and for housewiring; the ease of obtaining and maintaining electric motors, pumps and appliances; the availability of ad- ditional fertilizer and other inputs for pump-irrigated agri- culture; the existence of a working rural extension service; and an adequate transport infrastructure. A standard checklist for NEA and REC staffs would be a useful tool for this assess- ment; (b) A permanent consultation procedure between NEA, the RECs, and other local and national agencies engaged in rural development. Using its regular project proposal evaluations, NEA could make known requirements for supporting investments and policies in a forum that could take action in time for achieving synergy. The Regional Development Councils could become the significant medium for this development coordination process. However, only a consultation medium closer to the locale of the invest- ment project can determine effectively how to coordinate vari- ous activities; developing such a medium at the barangay level or one local administration level above could be considered. 3.33 Finally, the distressed financial and institutional situation facing many RECs detracts from the development of a sound planning capabil- ity. Short-term considerations dominate the RECs' day-to-day business, as scarce resources must be devoted to anti-pilferage campaigns, the search for line materials, administrative problems, and solutions to financial crises. The introduction of a clear methodology to set investment priori-  - 40 - ties will enable the RECs to follow a straightforward procedure in making proposals to NEA, while minimizing the time and staff resources that need to be allocated to this exercise. G. Summay of Recommendations 3.34 The development of an investment strategy and a lending program for rural electric distribution systems will require the following: (a) In the medium term, investment priority should be shifted pri- marily to system improvement, consisting of (i) rehabilitation, (ii) upgrading, and (iii) additions of new connections to ex- isting lines. Expansion of the network to unserved areas should be delayed, unless productive use of electricity would ensure a high return. On the basis of available information, increasing coverage from the current level of 50X of potential consumers to about 651 by 1993/94 appears economically justifi- able and financially feasible; however, even in the long run, penetration beyond about 75X of the rural population would ap- pear difficult to justify economically. (b) NEA needs to be relieved of direct responsibilities for invest- ments and programs that are only marginally related to the core function of financing electric distribution systems; and, in- stead, it needs to focus on its investment and loan programming activities to increase the efficiency of electricity distribu- tion in rural areas. To the extent that the availability of electricity is central to economic activity in the rural areas, NEA should continue to coordinate plans for electrification with other rural development activities. (c) NEA needs to develop and introduce an improved method for screening, evaluating, and reiking proposed investment projects according to economic criteria. (d) NEA should develop an indicative investment plan and translate it into a consistent and feasible lending program. This lending program should (i) be based on macroeconomic parameters and constraints, (ii) reflect the relative priorities of individual projects, and (iii) to the extent feasible, be within the framework of the Public Investment Program. (e) From about 1991 onwards, additional funds needed to finance the ongoing rehabilitation program and to enable economically jus- tified further expansion will need to be mobilized. (f) NEA and the RECs should start an intensive staff development program that encompasses (i) training of existing staff and (ii) recruitment of economists and planners.  - 41 - 4. PRICING POLICY A. Introduction 4.1 Each REC determines its tariff levels and structure based on the cost of purchasing power from NPC and its own internal cost structure. The NPC wholesale rate accounts for about half the total cost included in the retail rate for REC consumers, thus exerting a significant influence on REC rate-setting. 4.2 Each REC sets its rates under the supervision of NEA, accord- ing to a simple formula that allows for recovery of (i) power supply costs, (ii) an allowance for system losses up to 251, (iii) other cash operating expenses, and (iv) debt service. This cost-plus formula is computed on the basis of P/kWh, and yields the average retail rate to be realized by the REC. By reviewing and approving the calculations that underlie rate ad- justment requests received from the RECs, NEA is fulfilling a regulatory function. The current formula has the advantage of being simple to admin- ister, but fails to provide (i) incentives to control internal operating costs, (ii) internal funding of future investment requirements, and (iii) incentives for efficient patterns of consumption. While a crude av- erage cost recovery approach was appropriate for the early period of expan- sion, the increasingly varied consumer mix requires a more sophisticated method of demand management and cost control. 4.3 The pricing system includes one major element of subsidization, namely, the relief granted to small, remote island RECs that must rely for their supplies on high cost, local, small-scale diesel generators. An ap- plication of the current NEA-approved pricing formula for these 14 RECs yields average retail rates of P 4-9/kWh, compared to P 1-2/kWh in most others. The overall subsidy consists of (i) a below-cost power purchase price from NPC (the current owner of the small generating sets) limited to P 1.30/kWh, and (ii) a direct subsidy shared between NPC and NEA in the ratio 84/16. The total subsidy requirement is defined as the difference between the theoretical formula-based average retail rate and the recently imposed rate ceiling of P 2.50/kWh. 4.4 The following paragraphs provide comprehensive suggestions for a thorough reform of the pricing system. In view of the importance of the NPC selling price for the level and structure of REC retail rates, recom- mendations for the ongoing transition of NPC to marginal-cost-based bulk rates are developed. Subsequently, a pricing philosophy for RECs is sug- gested, based on the forthcoming change in NPC rates. While the recommen- dations form a consistent system, some elements of reform are more urgent than others; therefore, the components of the proposed policies can be im- plemented gradually. However, the ultimate target remains a rational pric- ing structure that promotes efficiency of both supply and use.  - 42 - B NMC Costs 4.5 During recent years, a consensus developed within the Govern- ment that NPC should redesign its tariff to reflect long-run marginal cost (LRMC). Currently, NPC's rates are not sufficiently differentiated to ac- commodate the large differences in costs that consumers with substantially differing demand patterns (such as HERALCO, the RECs, and directly con- nected industries) impose on its supply system. Clearer cost-based differ- entiation is needed. 4.6 In 1985, Electricite De France International completed a mar- ginal cost study of electric tariffs. In performing the study, the consul- tants used a computer model that assumed the least-cost composition and sequencing of generating capacity to meet projected peak demand. Recently, NPC developed calculations using the "peaker" methodology, in which peak marginal cost is based on the costs of capacity specifically designated for meeting the peak. Off-peak marginal cost is based only on ttz> costs of base-load equipment, which would meet off-peak demand. Using this method- ology, the calculations for Luzon indicate that a pure LRMC-based tariff would yield a range of rates between P 0.97-1.86/kWh (Annex 4.01), compared with a current average price range of P 0.96-1.08/kWh. The greater breadth of the range reflects the differences in cost of serving the varied con- sumption patterns of NPC's consumers. According to these calculations, the Luzon RECs would be subject to rates ranging from P 1.02/kwh to P 1.46 kWh. 4.7 An analysis of NPC's LRMC, taking into account peak and off- peak costs of supply, is presented in Annex 4.02. Based on using gas tur- bines to provide peaking capacity for the Luzon grid, this analysis results in the costs shown in Table 4.1: Table .1:. NPC's CALCULATION OF LRMC FOR THE LUZON GRID CaRacitX Cost Energy Cost (P/KW/year) (P/kWh) Peak Off-peak Average At generation 1,285 1.00 0.53 0.60 At extra-high voltage 1,570 1.00 0.53 0.60 At very high voltage 1,960 1.02 0.54 0.61 At high voltage 2,190 1.07 0.57 0.61 At medium voltage 2,440 1.14 0.60 0.68 4.8 Electricity demand in the Philippines does not appear to be subject to significant seasonal fluctuations, except for Luzon. In the Luzon Grid, seasonal peaking does occur during the hot season, and probably reflects the growing air-conditioning load. This seasonal peaking in Luzon would likely lead, with the calculation and use of loss-of-load probabil- ities, to a higher marginal cost for summer day peaks (7:00 to 23:00 hours)  - 43 - than for the winter daily peak periods (same time range). However, for simplicity, this refinement was not considered and all peak periods are assessed as having the same marginal cost of supply. C. LRMC-Based Wholesae Pricing 4.9 Based on the LRMC structure derived for the Luzon grid, the theoretical bulk electricity price to the RECs is calculated in detail in Annex 4.03 and summarized in Table 4.2: Table 4.2. THEORETICAL ELECTRICITY COST TO THE RECs Peak Period Off-Peak Average (A/k1Wh) (0VkWh) (1/kWh) At 81 discount rate 1.56 0.52 1.05 At 12X discount rate 1.72 0.52 1.12 These estimates lie within the range of the cost-based rate previously cal- culated by NPC. The main difference results from the proposed introduction of differentiation by time of day. 4.10 NPC should move cautiously to introduce time-of-day (TOD) rates as soon as possible. In terms of hardware, such a move requires only that NPC introduce TOD metering for its major customers. However, since the principle of TOD pricing has not yet been accepted by Philippine consumers, NPC should move in this direction by introducing much smaller peak/off-peak price differentials than what would be justified purely on the basis of marginal cost considerations. After one to two years experience with this smaller differential, assessments and further adjustments could be made. 4.11 In addition to TOD differentials, electric rates should clearly reflect differential supply costs. This means that cost differences for supplying different voltage levels should be reflected in NPC's rate struc- ture. In the case of the RECs, their bulk rate would need to reflect the additional costs of (i) the downward steps from 230 kV (NPC's transmission voltage) to 69 kV (the level at which the RECs take their supplies); and (ii) transmission at 115 kV and 69 kV to the substations where the RECs take their power. 4.12 TOD rates that are based on daily peaking in demand and the cost of supplying the peak should encourage customers - especially indus- trial and commercial customers - to shift electricity usage to off-peak times where feasible. As a result, a firm peak that cannot be shifted through inducements will be established. Of equal importance, TOD rates could provide incentive for developing technology to enable consumers to shift their electricity usage for certain productive activities to off-peak periods.  - 44 - 4.13 The application of marginal cost principles for rate setting in the grids outside Luzon is possible by using similar calculations. The sources of additional capacity needed to meet marginal requirements in the other grids are similar to those contemplated for the Luzon grid. At the margin, therefore, supply costs are likely to be similar nationwide, al- though average costs may differ. D. REC Cost of Supply 4.14 The average price paid in 1987 for REC-supplied electricity varied from as little as D 0.87/kWh to as much as P 5.31/kWh. Some of this variation was due to differences in the cost of electric generation. Most RECs purchased power from NPC at rates that varied from a low of about P 0.57/kWh in the Mindanao grid to somewhat over P 1.00 kWh in most other grids. Some RECs generated their own power at reported costs as high as P 2.30 to P 2.40/kWh. While some questions regarding whether the RECs op- erated their generating facilities efficiently have arisen, the issue be- came moot when NPC agreed to take responsibility for power generation na- tionwide. Under the new arrangement, if the inefficiencies in power supply cannot be reduced, they should at least be standardized. Once the average price paid for electricity by each REC has been rationalized through the application of LRMC-based NPC tariffs, the remaining spread to cover other costs still exhibits very large variations among different RECs. For some RECs, the current mark-up to cover distribution and customer costs is as low as P 0.49-P 0.51/kWh. For others, the current spread is as high as P 2.66-P 2.91/kWh. Admittedly, some RECs face costs that others do not; however, the breadth of the variations in these spreads is not justifiable within a system of efficiently operating RECs. 4.15 Case studies were conducted for the Tarlac II, Pelco I, Leyte V and Capiz I RECs to test inter alia the economic viability of their reha- bilitation and expansion investment programs. In all of these cases, load forecasts projected increased peak loads. Rehabilitation by itself does not stimulate increased peak demand, and so its costs are removed from in- vestment expenditures in computing an REC's cost of supply. Investments for expansion include some cost for actually connecting additional custom- ers and therefore these costs should also be excluded from investment ex- penditure when computing an REC's cost of supply. For each of the case studies, appropriate adjustments were made. 4.16 Table 4.3, which is based on the more detailed calculations shown in Annex 4.04, summarizes the marginal cost calculations applicable to the four case studies. Column 3 gives the off-peak marginal cost of electricity, which is basically the NPC rate adjusted for system losses in the range of 15X. Column 4 shows the synthesized marginal cost of new REC distribution capacity (SMCC) for the peak period and column 5 gives the total peak period marginal cost (derived by adding the energy cost from column 3 to the SMCC in column 4). Column 6 shows the average cost of ca- pacity per kWh sold. Finally in column 7, total average cost is the sum of the average capacity cost and the off-peak marginal cost (column 3).  - 45 - Table 4.3: MARGINAL AND AVERAGE COSTS FOR CASE STUDY RECs (Based on NPC Using Average Cost Pricing) (1) (2) (3) (4) (5) (6) (7) NO. UTILITY CAPACITY ENEE;Y 8 TOTAL CAPACITY TOTAL (#/KW) COST (/RWNW) PEMK WV AVG. COSTA' AVG. COSTV (FA/) (U.KMh) (U/Wh) (0/Kh) 1. TARLAC II 2148.7 1.29 1.68 2.97 .8795 2.17 Excluding Rehabilitation .84 2.13 .4397 1.73 2. PELCO I 708.27 1.32 .55 1.87 .187 1.51 3. LEYTE VI 2503.6 1.29 1.96 3.25 .813 2.10 Excluding Rehabilitation .98 2.27 .406 1.70 4. CAPIZ I 496.07 1.25 .39 1.64 .161 1.42 11 SCC - Synthesized Marginal Capacity Cost 2/ Mc - Marginmal Cost 3/ AVG. COST - Average Cost Al For Tarlac II and Leyte V, the second line of figures represents the capacity costs after re- moval of costs unrelated to marginal capacity increases. 4.17 If NPC adopts full marginal cost pricing, the cost of energy to the REC will differ markedly from present rates. To illustrate the impli- cations for a REC, complete marginal costs were calculated for Tarlac II. Table 4.4 shows the results of this exercise. The actual rates charged by Tarlac II in March 1988 were in the range P 1.74-P 1.81/kWh. These actual rates are within the range of the average cost rates calculated in Table 4.3; however, they are well below marginal cost when the peak period for NPC and the REC coincide, and well above marginal cost when the off-peak periods of the two entities coincide. Table 4.4: MARGINAL COST PRICES FOR TARIAC II (P/kWh) (Based on NPC Charging Marginal Cost) Time Period Etirgy Price Adj. for SMCCI1 Total from NPC 15X Losses Tarlac II MC2G NPC Peak Period 7:00-17:00 Daily 1.56 1.83 0.0 1.83 NPC & REC Peak Period 17:00-23:00 Daily 1.56 1.83 1.68 3.51 to .84 to 2.67 Off-Peak 23:00-7:00 Daily .52 .61 0 .61 / SMCC - Synthesized Marginal Capacity Cost ~/ MNC - Marginal Cost NOTE: As of March 1988, tk-. electric rates charged by Tarlac II were: (i) Residential, P 1.78/kWh; (ii) Commercial, P 1.81/kWh; and In- dustrial, P 1.74/kWh  - 46 - EL A Possible Rate Fonrula 4.18 The major weaknesses of the current pricing guidelines being followed by the RECs include: (a) The guidelines do not contain an explicit provision to enable the RECs to generate revenues sufficient to recover their in- vestment in distribution system assets. (b) Prices, particularly for large consumers, do not reflect the variations in marginal cost of supplying electricity at differ- ing voltage levels, times-of-day, and (in Luzon) seasons. (c) The guidelines do not address the administrative efficiency issues that have led to substantial differences in internal costs per kWh among the RECs. (d) The guidelines do not address problems of pilferage, politici- zation, and poor management that have fostered system losses in excess of 20X in about 70 RECs. 4.19 Efficient guidelines require that the following data be collec- ted and calculated for each REC: (a) All system investments need to be segregated into two categor- ies: (i) those that are sensitive to peak demand, and (ii) those that are unrelated to peak demand. The latter cate- gory clearly includes inter alia such distribution system com- ponents as (i) meters, (iij drop lines to consumer premises, and (iii) the smallest sized power lines and transformers. The remaining investment should be categorized as investments that are sensitive to peak demand. (b) System investments that are sensitive to peak demand should be valued on a replacement or current value basis. (c) A real cost of capital [r] needs to be identified for the REC.  - 47 - (d) A carrying charge rate [CCR] must then be calculated based on the cost of capital and the life expectancy of the investments that are sensitive to peak demand. This carrying charge rate is then used to convert the investment [I1 to an annualized amount, which is then divided by the increased paak capacity made possible by the investment [MCm,J. Next, a coincident load factor [LFJ1 for the customer category under consideration needs to be determined, and the number of peak hours during the year [Hp.) is calculated. A synthesized marginal cost of ca- pacity [SMCC] can then be calculated. 1 CCR (r.-infl) (----------------------1 1 - ( (l+infl)/(l+r8) )T (rr) (-------------------) (approximation) 1 _ l/(l+r,)T MC,>,- CCR * I 8,760 hours - HPK + HpK SMCC - MCI/ (LFC * HPK) where infl - the rate of inflation r,- the nominal rate of interest or cost of capital rr the real cost of capital T - life of the investment (e) Then, the marginal prices for energy PE1] from NPC can be ad- justed to reflect REC system losses [L1 and a set of margir