Georgia - Power Privatization

Report No. 17152-GE Georgia Power Privatization December 16, 1997 Energy Sector Unit Georgia Country Unit Europe and Central Asia Region Document of the World Bank  Currency Equivalents (as of end of November, 1997) Currency Unit - Lari US$1 = 1.31 Laris Abbreviations and Acronyms EU TACIS - European Union Technical Assistance for the Commonwealth of Independent States LAS - International Accounting Standards IPS - Interconnected Power System kV - Kilowatt kwh - Kilowatt hour MFE - Ministry of Fuel and Energy MW - Megawatt MWh - Megawatt hour NDC - National Dispatch Center NERC - National Electricity Regulatory Commission PPA - Power Purchase Agreement TA - Technical Assistance USAID - United States Agency for International Development VAT - Value-added tax This report was prepared by Jonathan Walters (task team leader, ECSEG), Arpad Bajkay (Consultant), Manuel Dussan (IENPD) and James Schmidt (LEGLR). The managing country director was Judy O'Connor. The managing sector director was Hossein Razavi (ECSEG) and the sector leader was David Craig (ECSEG).  GEORGIA - PO WER PRIVA TIZA TION TABLE OF CONTENTS Summary of Principal Findings and Recommendations ...........................................;i1-11 Chapter 1: Introduction - The Investment Climate for Power Privatization . 1 Chapter 2: The Regulatory Framework and the Wholesale Power Market . 3 I. The Legislative and Regulatory Framework .3 II. Electricity Tariffs .5 III. The Wholesale Power Market .7 Chapter 3: Privatization Options and Issues ..10 I. Introduction .10 II. Objectives .10 III. Selecting the Companies to be Privatized .10 [V. Timing and Sequencing . 1 V. Methods of Privatization .12 VI. Bidding and Award Process .14 VII. License Design ............. 16 VJIII.Institutional Arrangements and Advisory Services . .17 X. Preparatory Activities .18 BoxEs 1.: Profile of the Georgia Power Sector and its Investment Needs .2 2.: Potential for Electricity Exports from Georgia .13 TABLES 1.: Georgia: Electricity Tariffs .6  * Given the complexity of power privatization to strategic investors, and the need for transparency, an investment bank should be engaged to promote the sales and assist in the transactions. * It is important to start power privatization with a successful sale in order to increase the interest of potential investors in the process as a whole. In addition, distribution companies should be sold first, since this should improve collections and thus enhance the sales prospects of generation companies. In view of these two considerations, Telasi should be offered for sale to strategic investors at the beginning of the process.  1. Introduction: The Investment Climate For Power Privatization 1.1 The shock of the break-up of the Soviet Union was compounded in Georgia by conflicts in the Caucasus region: the economy went into free fall. Since 1994 the economy has been recovering rapidly: growth has been strong, inflation has been brought under control, a broadly stable and convertible currency has been introduced, and the fiscal and balance of payments deficits are falling. In addition to macroeconomic adjustment, the prospect of exploiting Georgia's geographical position for the transit of oil, gas, and general freight has contributed to positive investor expectations. 1.2 However, growth is taking place primarily in sectors where payback periods are very short. Investment remains very low. The attainment of macroeconomic stability has required large amounts of temporary donor financing, which has been supplemented by accumulation of arrears. The regional conflicts have been pacified but not resolved. 1.3 The Government of Georgia has taken a pro-private sector policy stance; privatization has been quite rapid and the legal framework for private sector development is being established. However, enterprise restructuring is only just beginning and overall financial discipline is quite weak. The economy is supporting non-productive employment in declining sectors at the expense of potential growth areas. This is compounded by the constrained fiscal situation which makes it difficult for the Government to provide an adequate social safety net to cushion the effects of economic restructuring. 1.4 Against this background, the Government has used the power sector as a tool of social and industrial policy. Toleration of payments indiscipline combined with low tariffs have effectively channeled quasi-fiscal subsidies to the population and to large parts of industry and agriculture. The intention was to stave off economic collapse and social distress, but the adjustment of the economy has been retarded in consequence. The power sector has been required to finance much of this subsidy flow from its own resources; the result has been extreme capital consumption. In consequence, the power supply in Georgia is highly unreliable and the sector's infrastructure is severely dilapidated. 1.5 This policy has been tuming around since 1995. Tariffs have sharply increased, tariff discounts have been largely removed, and collections have been permitted to improve substantially. The power sector has been restructured to facilitate competition and transparency through unbundling generation, transmission/dispatch, and distribution. The regulatory framework for the power sector, and institutions to implement that framework, are now being put in place. 1.6 The Government is thus beginning to use the sector to harden the budget constraint of the enterprise sector and induce widespread restructuring. In consequence, the prospects for financial viability of the power sector should improve. The Government recognizes the 1  necessity of this improvement if reliable electricity supply is to be restored and if the large investment needs of the sector are to be financed (see Box 1). 1.7 The process of unbundling and regulatory reform have contributed to this depoliticization of the power sector. However, this process is unlikely to be consolidated and sustained while the sector remains under the close control of political leaders. Privatization of the sector would therefore do much for its recovery. 1.8 This privatization will be challenging, given the high level of risk attached to investment in the sector and in Georgia. The authorities must deepen structural reform in the economy at large and enhance macroeconomic stability to improve the overall investment climate. In the power sector itself, regulatory institutions must be strengthened, and the method of privatization must give operational control to investors with capital and expertise. These are the main themes of this report. WX ....The t.ota n.a. epla geeato .cc...ty .i e....... s .. b. 5. , i 5=~~~~~.:.::.:.:..:::: . "' ........ .. .u...u.... .-.. .... .. W....... ' RR : 9 '.. ... R . '.. -. ,' " .,,.-' fRtRtR; ' l 'x'- - ~.... '.'RR R R- R-R - 0,RR R R'.. ..... ...........R thi& plants (ThlsiT.var heb. andthe.. T .h.ilisti ont -ne r beat...d pat)....... 284. MW.....n..... X,0-f'-difficult to giv a'0-;- precis esitto the,", cation.t!y avi"l genera.t''n caciy gvnth taeo curn disrpi u ':it4,59R9 is ,'.',?f, much smaller than thei, naepat ca.cy Ale h eaiitto fot o 380 0.'05,R0 ...................... ........ R*. ....... Rl.9'R" 'W ''"9R,.,,R .. . -. -9---. . R.....- ......... 9RR 99 R 26R 00 M .Ti s uhhger tha the peakodemand in f ^ n to e~}ai colRe b ;'2~~~~~~~~~.oni wi.Rl anio.il doe not exceed1500 MW (base demand is 600 MW)..~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~........ 800' milio.R Transm ission and Dist:R 9bu 'tion. 't''5"'|0Ry'' "R2R ... an disptch0; funtins Th 9eX t ransmi;ssinetwork. wRith'in Georgi RR nsistst of 57 no lV ie,2 mo and- highe|}'}}"r, ofwih 8sbtatQion have tepiar voltage'"''-' 9equlo or ecding20k.Psr5t consistsof 33 ..... t lns, 25 km of 0 lne.s., kR o' tV ls a 764 km of 9 ..... lines........ Tr ete a ds cc s .. ri e r in Thilisi, now dysthnctional (see Box 2); a national dpcct ND lc dliTisaddp hcti. net10yar r etmedin exes of US22 mi I ..... Th oa nesmnsi hepwa yte.eddfr3eiaiiato.mlndeuamnodteeitn facilities an constructio of ne.nsoe.h.et510yasaetu siadt oeta S13blin 2ix  2. The Regulatory Framework And The Wholesale Power Market I. The Legislative and Regulatory Framework 2.1 The Electricity Law approved by the Parliament and signed by the President on June 27, 1997, provides a good legal framework to establish an unbundled electricity sector in Georgia that will be acceptable to private investors. The law establishes an independent Electricity Commission (Commission) of three members appointed by the President for six year terms, with autonomy to establish its own organization and salaries, and authority to approve energy tariffs, to issue, enforce, and revoke licenses for activities in the electricity sector, and, for monopoly services, to consider and approve applications for tariffs that are designed to recover the Licensee's cost of service for each customer class. The law does not prescribe a specific industry structure, but is based on a broad consensus that following restructuring and unbundling, the industry will have multiple sector participants within four classes of licensees, as follows: . A single entity will hold the Transmission License for operation of the Transmission Grid. Transmission assets that are not connected to the national grid (i.e., facilities that are used solely for import and export) are not included in the Transmission Grid under the law, and are not subject to Commission regulation. The Ministry of Fuel and Energy will be responsible for licensing any transit transmission facilities proposed in the future (none now exist). * A single entity will hold the Dispatch License for coordinating supplies and demands on the Transmission Grid, and performing dispatch services. The Dispatch Licensee may also function as a purchaser and seller of electric capacity and energy for other Licensees and Direct Consumers (who receive power directly from the Transmission Grid, but are not Distribution Licensees). The Commission is authorized to grant the Transmission and Dispatch Licenses to the same entity, but may also impose terms in the Licenses that require further unbundling in the future. * Distribution Licensees will be authorized to distribute electricity within their service territories, pursuant to tariffs approved by the Commission. Distribution Licensees may purchase electric capacity and/or energy from Generation Licensees, the Dispatch Licensee, foreign generators, or through brokers. * Generation companies will receive Licenses from the Commission to attach specific facilities to the Transmission Grid. Generation companies will also obtain from the Ministry of Fuel and Energy or any other applicable Ministry other licenses required by law to locate their facilities, obtain fuel, or block rivers for hydro projects. Generation companies may enter into contracts to sell their 3  capacity and/or energy to the Dispatch Licensee, to Distribution Licensees, to Direct Consumers, and to foreign customers, or to brokers. These commercial provisions of these contracts will not be subject to Commission review if the electricity is intended solely for export or the Commission determines that the commercial provisions were established by a competitive process. In addition, to facilitate the restructuring of the sector and bring it under the new system in an organized manner, all entities active in the electricity sector on the date the law came into effect were granted Interim Licenses with a duration of two years. 2.2 The Electricity Law establishes a good framework to foster economic efficiency and promote private participation in the sector. However, the law would be ineffective in achieving these goals if the principles established in it are not developed by clear, consistent and stable regulations and if these regulations are not enforced in a transparent and non- discriminatory way by independent and competent institutions. Of particular interest to private investors are the independence, transparency and fairness of the regulator, the price regulations, the licensing conditions and procedures and the rules for electricity trade. The National Electricity Regulatory Commission (NERC) has the responsibility of developing and enforcing these regulations under very difficult initial conditions in the power sector, featuring wide-spread rationing of electricity, high electricity losses, low collections, tariff distortions, poor financial condition of power utilities and lack of reliable information on sector operations. 2.3 The legal framework provides the basic elements for establishing an independent and competent regulation. The new electricity law creates NERC as an independent, semi- judiciary legal entity, funded by license-fees and with administrative autonomy. NERC is, however, a new and weak institution which is facing difficulties to set up offices and hire staff. NERC is starting to charge license fees based on interim licenses, but NERC is competing for scarce financial resources in the sector, and income from license fees may not be forthcoming in 1997. It is important that the Government shows its commitment to the implementation of the Electricity Law by providing the support that is required to ensure that NERC will have the resources during this initial critical period to establish and consolidate a competent technical staff capable of managing the process of developing and enforcing the new regulatory regime. 2.4 Substantial technical assistance (TA) is required to implement a work program to set up NERC and develop the electricity law. It is important to note that this TA is just one element of the power sector reform program in Georgia. Substantial financing and TA is being provided for the rehabilitation of power facilities, improving collection of payments, restructuring Sakenergo and preparing state-owned enterprises for privatization. The main areas of the work program are: * Establish NERC. Includes the organization, staffing, budgeting, funding, training and putting in operation of NERC. * Establish rules and procedures for NERC. Includes the preparation of rules of practice to conduct public hearings, take decisions, consider appeals, levy fines; 4  the design and development of information system needed for sector regulation; and the establishment of an uniform system of accounts for power utilities. * License electricity services. Includes preparation of conditions, requirements and procedures to grant, revise and revoke licenses for generation, transmission, distribution and dispatch; preparation of conditions under which ownership of shares in more than one licensee will be allowed at any given time; and issue interim licenses and final licenses according to the Law. * Price Regulation. Includes the preparation of principles, methodologies, formulas and procedures to regulate generation, transmission, distribution, wholesale and retail prices; and the preparation of a tariff adjustment program to reach cost- reflective tariffs. * Wholesale Market. Includes the preparation of a strategy to develop a competitive wholesale market; the definition of the institutional arrangements for the operation of the power market; the preparation of the market rules (criteria, rules and procedures to coordinate, contract, meter, settle, bill and pay for wholesale energy trade) ; the preparation of technical codes for planning, operation and maintenance of transmission and distribution grids and for the operation of the electric power system. 3 Support to Sakenergo. Includes restructuring the dispatch function, improving expansion planning methodologies, upgrade system control and communications facilities, and improve software for system operation and economic dispatch. * Support to Ministry of Fuel and Energy (MFE). Includes revision of existing legal framework for the power sector and harmonization with the new electricity law, and strengthening WFE capabilities in the definition of energy policy. 2.5 There are two activities in the work program which are critical for the privatization of the power sector: electricity tariffs and the wholesale power market. The following paragraphs discuss the main issues and options on these matters. II. Electricity Tariffs 2.6 The Government has taken steps to resolve current problems of arrears in the payment of electricity bills, low collections and low tariffs. Collections, although still low, have steadily improved during 1996 and 1997, reaching the average level of about 62 percent at retail level, compared with less than 20 percent in 1995. The Government approved in August 1997 an increase of 36 percent in residential tariffs to reach the same tariff level charged to other retail consumers (36 US$/MWh). Average wholesale prices for generation and for sales from Sakenergo to distribution companies were increased by NERC in September 1997 by about 20 percent to 15 US$/MWh and 26 US$/MWh, respectively. The following table shows current tariffs and full-cost recovery tariffs. The estimated full-cost recovery tariff is based on international experience as well as on analysis of potential efficiency gains in Georgia (but it is a highly approximate estimate). 5  US cents/kwh rJ Item current average full cost- tariff recovery (Sep/97) tariff Generation 1.5 a/ 2.3 HighVoltage (large industries) 2.5 Medium Voltage (distrib.companies) 2.6 Retail Consumers 3.6 b/ Average Retail 3.4 b/ 4.5 Transmission margin 0.9 c/ Distribution margin 0.6 d/ a/ Generation tariffs are not uniform: while the average tariff for Tbilsresi thermal plant is about 3.4 UScents/kwh, the tariff for Inguri hydro plant is 0.7 UScents/kwh. b/ Weighted average of HV (12%) and retail consumers (82%). Does not take into account inpact of privileged tariffs c/ Net margin for Sakenergo, based on 14% losses reported by Sakenergo. d/ Average margin for distribution companies based on 10.5% losses e/' Includes 20% VAT 2.7 In spite of above mentioned actions, substantial increases in electricity tariffs and improvements in collections and losses are still necessary to have financially viable power utilities. Current retail tariffs would nominally cover operating costs, but with high losses and low collections, actual revenues are not sufficient to cover these costs, let alone needed investments in rehabilitation. This generates a chain reaction of non-payments and poor service. Distribution companies cannot and do not pay on time for wholesale power purchases to Sakenergo (60 percent collections during first semester of 1997), Sakenergo cannot pay to generators and fuel suppliers, needed repairs and fuel supply for generation cannot be funded, and supply cannot meet demand (by some accounts, about 40 percent of demand is rationed). 2.8 The Electricity Law establish as a general principle that tariffs should be cost- reflective. It is not clear precisely what tariff increases would be necessary to meet the cost of providing reliable electricity service in Georgia (although an estimate is given in the table above.) Even though demand fell 66 percent from 1989 to 1996, substantial investment is needed to rehabilitate power facilities in poor condition to meet current demand. Except for part of generation stations and the transmission network, where rehabilitation is underway, there are still major uncertainties about the investment needs and the financial situation of power utilities. NERC is preparing a tariff study with the assistance of consultants, which will define a strategy and a program to implement cost-reflective tariffs, and the rules and procedures to regulate electricity prices. As discussed below, these regulations are important for private participation in generation and distribution. 2.9 A gradual tariff adjustment program should be prepared to implement cost-reflective tariffs. During this transition period to full-cost recovery, retail electricity tariffs will not be sufficient to cover economic costs of generation, transmission, and distribution, let alone financial costs under inefficient conditions of high losses and low collections. The tariff 6  adjustment program can allocate total revenues for sales to final consumers among generation, transmission and distribution companies, in such a way that during a transition period priority investments can be financed and a few power utilities can be financially viable if operated efficiently. 2.10 The distribution business in Georgia may be attractive to a private investor as there is a substantial margin to improve collections and quality of service and reduce electricity losses, pari-passu with tariff increases. However, a private investor would like to see that: (i) regulated electricity tariffs are sufficient to recover the cost of wholesale power purchases, reasonable cost of losses, and distribution costs, including needed investment for rehabilitation, and (ii) there are legal instruments and political support to enforce collections and control losses. A private investor may perceive substantial commercial risks if at the time of privatization there are not in place a credible tariff adjustment program, clear pricing rules which allow for cost-recovery, and a clear demonstration that delinquent consumers are cut- off. 2.11 The regulation of wholesale prices is also important for private participation. NERC currently sets individual generation prices to cover operating and fuel costs of each generation plant, resulting in substantially higher prices for Tbilsresi thermal station than for hydro. Sakenergo currently incurs in financial losses for incremental power purchases from Tbilsresi, because, as single-buyer, it has to sell power to distribution companies at a regulated price which is lower than the average unit cost of power purchases from Tbilsresi. Sakenergo has, therefore, disincentives to increase power purchases from Tbilsresi, a essential source of supply to reduce present energy rationing. 2.12 NERC would need to define new rules for regulating (or deregulating) wholesale prices which ensure pass-through of the cost of economic power purchases from generators to distribution companies and consumers, but that at the same are consistent with the retail tariff program. On the one hand, a private generator will be concerned for the credit-worthiness of a single-buyer squeezed between high generation costs and low wholesale prices. On the other hand, deregulation of wholesale prices to reflect generation costs will be a source of concern for private distributors if there are doubts on whether the increased cost of power purchases can be passed-through to retail consumers. III. The Wholesale Power Market 2.13 The Electricity Law is a general framework which provides flexibility for developing over time a competitive wholesale power market. The Law allows the market to operate primarily as a single-buyer scheme where the dispatch company has the right to purchase and resell wholesale power and to contract transmission services to satisfy the demand of distribution companies and direct consumers. However, it also allows distributors and large users to purchase power directly from local or foreign suppliers under competitive conditions. 2.14 There are still many options and issues, related with the initial operation of the wholesale power market and the transition to a competitive market, which should be addressed before privatization, as they may have a major impact on the finances and commercial risks of power utilities. The basic questions are whether a pure single-buyer model should be established from the beginning and when and how it is feasible or convenient 7  to deregulate wholesale prices and allow direct contracts between generators, distributors and large users. 2.15 Usually, under a pure single-buyer model Sakenergo would purchase power from all generators based on power purchase agreements (PPAs), and sell power to the distribution companies at prices that cover the cost of PPAs, transmission and dispatch charges, and a fee for single-buyer services. Distribution companies pass through these costs to their consumers. The single-buyer is usually responsible for dispatching available generation based on merit order to meet demand at least-cost and ensure a reliable and safe operation of the interconnected power system. 2.16 This model has some attractive features for Georgia: * the single buyer and the distributors do not assume market risks for wholesale purchases, as these costs are passed-through to consumers. The credit-worthiness of the single buyer would not be an issue for a private generator, and distribution companies do not have to worry on how to recover costs that are not under their direct control. * The PPAs can guarantee a long-term and stable income stream for a private generator, sufficient to recover investment in rehabilitation and other operating costs. * Individual generation prices can be regulated to support priority investments in generation rehabilitation. * Wholesale prices for distribution companies can be regulated to facilitate the transition to cost-reflective tariffs, including the introduction of regional differences in retail tariffs to reflect costs. 2.17 It is important to clarify that PPAs and cost pass-through are not features that are exclusive to a single-buyer model. In fact, PPAs are found in competitive markets around the world and cost pass-through is a standard feature of unbundled power markets. The main feature of the single-buyer model is that all bulk energy is traded through a single institution. Precisely this feature create some concerns about the implementation of this model in Georgia: * During the transition period it is essential to improve collections for the payment of electricity and establish financial discipline. A major concern is that the centralization of bulk power trade in a single-buyer will dilute the responsibility for prompt payments for electricity supply and will facilitate Government intervention to control the flow of cash in the market, weakening incentives for financial discipline. * The centralization of power purchases can be used to maintain a centralized expansion planning at the expense of individual initiatives by private investors to provide other supply options not included in the plan. * A single-buyer with cost pass-through has weak incentives to achieve economic power purchases and does not provide a good benchmark to regulate wholesale prices, specially in Georgia where most of new investments in generation are related to rehabilitation of existing stations. An external body, like NERC, would have to determine the general terms and conditions for purchasing and dispatching power, regulate wholesale prices and supervise these processes to ensure least-cost supply. This scheme burdens the regulatory 8  function as the regulator may become, de facto, responsible for generation expansion, operation planning and investment decisions. The single-buyer can enter into long-term PPAs to meet most of future demand, imposing severe constraints for introducing competition in the future. A partial solution to the above concerns is to separate the dispatch and single-buyer functions from the transmission operation. These functions could then be assigned to a private company. 2.18 A competitive market with direct contracts between generators, distributors and large users can also address the concerns about lack of efficiency and benchmarks. One option is to introduce a hybrid single-buyer model with a parallel power market where distributors and large consumers can purchase energy directly from generators (as provided for in the Electricity Law). The operation of a competitive parallel market is complex and may discourage private participation in generation. On the one hand, generators selling to the single-buyer would be afraid that generators in the parallel market will be able to take away the best distribution and industrial customers from the single-buyer, and weaken its credit- worthiness. On the other hand, generators in the parallel market may be concerned that they will be discriminated by the single-buyer in the economic dispatch and in the conditions to access transmission grids. As a result, investments in generation would be more risky. 2.19 Another option to introduce direct contracts is a competitive market based on a power pool arrangement, similar to the one used in Chile, where generators, distributors and large users can negotiate freely bilateral power supply contracts (i.e. PPAs); wholesale prices for large users are deregulated; generators settle hourly the imbalances between real energy flows resulting from the economic dispatch and the contracted energy quantities; and wholesale prices for distribution are regulated based on short-run marginal costs. In this case, the single- buyer is eliminated and replaced by a market administrator. Generation costs are automatically passed through to distribution companies. 2.20 In the short term, there are many constraints for the implementation of this option. Sakenergo has major deficiencies in metering, telecommunications and dispatch facilities, essential to manage a competitive power pool. During the transition period retail tariffs do not cover costs and most likely, generation prices in a competitive market cannot be passed- through to consumers. The interconnected power system would operate with major generation and transmission constraints, supply would not be sufficient to meet demand, and competition in generation would not be possible. Private generators will perceive, in this case, higher market risks associated with volatile energy prices and untested market rules. 2.21 It may be viable to overcome these difficulties in about two years. It would be necessary to modemize the dispatch and communication facilities, to improve the financial position of power utilities and achieve cost-reflective tariffs to ensure that energy transactions in the pool are paid on time, and to develop the rules and procedures for the operation of the wholesale power market. A track record of clear and stable rules and the possibility of bilateral contracts with distributors and consumers wili help to mitigate market risks faced by generators. These are options that should be considered in the definition of a strategy for the transition to a competitive power market. 9  3. Privatization Options And Issues I. Introduction 3.1 The Georgian Government is developing its strategy for privatization of the power sector. The strategy will update and revise the Presidential Decree No. 828 of December 19, 1996 on this subject. This chapter describes some issues that will need to be addressed in developing and implementing the strategy. The chapter addresses: (a) privatization objectives; (b) selecting the companies to be privatized; (c) timing and sequencing; (d) methods of privatization; (e) the bidding and award process; (f) license design; (g) institutional arrangements and advisory services for privatization; and (h) preparatory activities. II. Objectives 3.2 Many Georgian Government officials have indicated that their primary objective for privatizing the power sector is to finance investment (particularly rehabilitation) in the sector, rather than to maximize revenue for the Government budget. In addition, the Government hopes to improve financial discipline in the sector (including improving collections) and efficiency of operation through privatization. 3.3 However, in a broader sense, the principal objective should be maximizing economic efficiency, namely the provision of reliable service at least cost to consumers. While in many cases, this will require significant new investment, the focus of privatization should not simply be on attracting new financing, but more broadly on improving management and operating efficiency in all power sector companies and ensuring that new investments are implemented in an economically efficient manner. Hence, the privatization strategy should be aimed at: (i) improving productivity and operating efficiency; (ii) enhancing management; and (iii) attracting investment financing. It is critical for the success of privatization that public information be provided emphasizing these objectives in order to mobilize support for this strategy. III. Selecting the Companies to be Privatized 3.4 Most power sector enterprises are being considered for privatization; transmission and dispatch (Sakenergo), sector enterprises in Abkhazia, and leased enterprises are currently excluded from the process. 3.5 Additional analytical work should be undertaken on defining the market rules and the responsibility of the transmission company in expanding the transmission system (see Chapter 2) prior to reviewing whether Sakenergo should be privatized. However, the privatization of 10  transmission could not only yield significant efficiency gains, it could also enhance the overall credibility of the sector restructuring and privatization process. IV. Timing and Sequencing 3.6 Careful preparatory work needs to be undertaken to ensure that a sound legal and regulatory framework, tariff regime, and licensing/risk-sharing arrangements are in place before finalizing the transactions. A poorly-designed privatization can have significant negative long-term effects on consumers and can be difficult to correct once private shareholders are in place. 3.7 Privatization should be sequenced in the order of those companies where privatization is expected to produce the greatest efficiency gains for consumers (not necessarily those companies needing the most investment). As well as contributing new investment capital and technology, private investors may also bring improved organizational and information systems. 3.8 Sequencing should also depend upon the likelihood of a successful transaction; companies needing substantial immediate investment may be harder to sell in the early stages of the privatization process (especially to strategic investors). It is critical to start with a successful privatization in the sector in order to increase the interest of potential investors in the process as a whole. 3.9 Preliminary analysis suggests that the Government should start with privatizing the distribution companies, as these would likely produce the greatest immediate benefits for consumers, and face fewer risks and unresolved issues than generation. In particular, an improvement in collections, which can only begin at the distribution level, would enhance the privatization prospects of the whole sector. 3.10 Telasi (Tbilisi Distribution Company) is an obvious candidate for the first privatization as the largest and most prominent distribution company (provided outstanding tariff and regulatory issues are addressed). 3.11 There also are strong concerns about the configuration of the 65 distribution companies outside Tbilisi. The small size of each of these companies will hamper its financial viability. These companies should be consolidated into a much smaller number before being offered for sale; the Government's current proposal is for eight consolidated companies. The privatization process should be allowed to induce further consolidation if necessary. This requires that NERC adopts (before companies are offered for sale) appropriate criteria for approving ownership of shares in more than one licensee at any given time (see para. 2.4). 3.12 While the generation plants are suitable candidates for privatization, there are many issues that need to be addressed prior to privatization and many more risks facing potential investors. These include, inter alia: (a) the existence of excess generation capacity (unless export markets are developed) and dispatch constraints (either technical or contractual), which limit the medium-term market potential for privatized hydro and thermal plants; (b) lack of clarity on the regulation and availability of water for privatized hydro plants; (c) uncertainty about future market rules and the future role and status of Sakenergo as a buyer and seller of power; (d) risks of non-payment by Sakenergo for the purchase of power from generation 11  plants. These issues will need further analysis and resolution (where possible) before the Government can credibly try to privatize the generation plants. Similarly in the case of transmission, more work is required on defining the industry structure, market rules and transition path before privatization can be considered. Analytical work is currently underway in all these areas except (b) - this should commence as soon as possible. V. Methods of Privatization 3.13 In discussions, many officials indicate that: privatization of the power sector is fundamentally different from prior privatization in Georgia; strategic investors/operators with effective control would be desirable in most cases; and privatization should be via international tender. 3.14 There are many options for private sector participation, with varying degrees of private sector risk, ownership and control. The range of options, with an increasing degree of private sector risk and control, include: (a) management contract, where a private firm assumes responsibility for operating the company for a fee (possibly related to profitability), but assumes no operating or investment risk; (b) an operating lease, where the private firm assumes responsibility for operating the company, pays a fee to the government, and assumes operating but not investment risk (investments generally remain the responsibility of the government); (c) a full concession, where the private firm assumes responsibility and risk for operations and capital investment, but the assets remain owned by the Government (the operator may pay a concession fee); and (d) divestiture, where the private firm buys the assets, and assumes full operating and investment responsibility and risk. 3.15 As a general principle, the greater the degree of transfer of risk and control to the private sector, the greater the efficiency gains, provided a sound legal and regulatory framework and tariff regime are in place. Hence, the Government should not retain any ownership or direct control over the privatized companies. The public interest (in terms of preventing abuse of monopoly power and ensuring appropriate tariffs) should be protected by the National Electricity Regulatory Commission on behalf of the Government, not by the Government as residual shareholder. 3.16 If one-hundred percent sale is not deemed desirable in the near term, a partial sale could be considered. Given the risks any investor would face (see Chapter 1 for more details), it is very likely that investors will want full control of the enterprise; in view of the weak protection of minority shareholder rights in Georgia and the rest of the former Soviet Union, this may require sale of more than 50 percent of the equity'. In Hungary, power sector privatization only succeeded through offering options to purchase majority shareholdings. Decree No. 828 of December 19, 1996 provided for majority private ownership for distribution but not for generation companies. 12  'i' ..'."..--o 2 Potntia fi Ele'ricity Exports and Regional Electricity Trade , ......... ... .has,been experiencing electricity shortages for the. last several years due to difficulties in ng li1 iports. .and prop'er- mainteace of power plants, its existing electricity production capabilities -- after p-eti1n of rehlitatin woirk. curen,tly under way -- are sufficient to satisfy domestic demand. In the medium to long tenn1 t3eorgia h potential not onlytocontin, ue cove i'g its domestic electricity consumption, but to develop significant expmtcapahrhties _ndIfa.eitateire-io,al. electicity trade,: provided that such projects attract the necessary fmancing. This potential is based on the abundance of hydropower resources, he geographic position of the country as a transit corridor, nd thei indispathd banssion network infastructure. Reonal d a fo,.r.hydropower should be signifiant :Turkey has a major deficit in electricity and could iheref-xe be a 'ajor net'electricity imporer. .Russia and Azerbaijan could. subsfitute their fossil fuel generation with potentially less-expens hydropower b fimports.fom. Georgia to free mnore of their fossil fuels for export. The flexibility of hydropower, with ite peaking a.d Interme iate capab ies, also presents an opportunity for daily and seasonal electricity trade wih Armenia, Azerbaijan, and usiia: tocompleienttheir prdonminantly base:andintermediate generatingplants. If (3eergia becomes abami~eounky foirgas from Russia, Azerbaiyan or Central Asia,: there would be a possibility of natural _pa etriitXy neaiO-. fo export, patc,al to - , --e- , _=Rf- f~~~~~~~~~~~~.-:. .::.-:. .... -. .:. The Georgian _ower system tghe W _ with the power system of Armenia and Azerbaijan - constituted the _ Jntenonnected _wer Syste.P.(Po), one of thI, 11IPSs in' the former Soviet Union -(FSU, wWhich was eobollmdrilpatche fromthe Tanscauasianregionl disatch enter in Thilisi. The: center still e xists, although it is _~~~~~~~~~~~~ad o_ On ;cen_rll m. '-- te<the -telect y trade :fr politic;l and economic resos Once --:eg,ional; electricity trade rae,e teclcoiupvigtsri,th _ _e_ _ 1 iW i b y_ 3 h. eceed 3000 MW in capacity, conipend with bout SG MW ofpeak doestic emand a this ime Tis -proides: Signifiant ptnalfreotsas ~Thenajr wth ln lconistoone500 lne wth pertionl cpacty f about.1000 MW, aid ne 2211-ky lbf with q~crationa1 capacity ofabont JOG M_. lire design capacities of both lines are_ igher, but the erniugomtintkes limts cold inreas~ l4efher ine s curentlyoperaing nd thir coditin nisenclea.TTh 13  3.17 Only once such strategic investors are in place, might financial investors (i.e. equity investors without control) be attracted to buy shares in the enterprise. In addition, the involvement of strategic investors would greatly facilitate mobilizing the substantial levels of debt financing needed for investment. 3.18 It may be beneficial to reserve a minority portion of the shares for the Georgian public via a domestic share issue. This would give citizens/consumers a stake in the future success of the privatized company; it would also contribute to capital market development in Georgia. 3.19 It may also be politically and even economically desirable to reserve shares for employee ownership. If the employees are part of the privatization process, they may be more supportive. Employees may have the motivation through share ownership to work harder and prevent asset stripping; the level of corruption may also decrease. Since power sector shares have positive value, employees should pay for shares (though this could be on an installment basis). It may be desirable to limit the employee portion to say 10 percent (although employees would also be able to participate in a public offering). A higher element of employee ownership may be detrimental to restructuring and to privatization of the remaining shares. VI. Bidding and Award Process 3.20 The bidding process will depend on the method of privatization selected. If the Government wishes to attract a strategic investor/operator, the process should be designed to stimulate competition among well-qualified bidders (thereby allowing the market to yield the best result) and to ensure transparency (which enhances credibility with investors and the 2 public). A number of procedural issues need to be addressed, including: the process, criteria and timing of prequalification; how proposals will be structured and evaluated; and whether the Govermnent will establish a "base" (or "reserve") price. 3.21 Many countries use a prequalification process for privatizing regulated utilities to ensure that all bidders have the requisite technical and financial capability to operate the company. Some governments have used quantitative technical and financial criteria3, thereby eliminating subjectivity once potenfial investors submit their qualifications. However, if the Government does publish quantitative criteria, it should have already had extensive discussions with potential investors so that it can be assured that there will be enough bidders for meaningful competition. Given the level of risk, it may be difficult to attract several well-qualified investors for each power sector privatization; this should be considered when establishing the prequalification criteria. 2 In view of the rudimentary nature of the Georgian stock market, and the very limited capital markets regulatory framework, it is unlikely that a strategic investor could be attracted through an initial public offering rather than a direct sale by tender. 3 For example, Peru used six quantitative fnancial and technical indicators in privatizing the Lima electricity distribution company. 14  3.22 While prequalification helps ensure that bidders have sound technical and financial capabilities, it does not ensure good future performance. A well-designed license is essential to ensure that there are appropriate incentives to reward efficient service provision, as well as penalties for poor performance. Moreover, an effective regulatory agency is also necessary to ensure that the penalties set out in the license are actually enforced. Additional details on license design are set out in Section VII below. 3.23 In the bidding process, the Government must decide whether to have a two-stage process, with separate technical and financial proposals, and how the proposals should be structured. Some countries have required bidders to submit technical proposals (generally business plans) which have then been assessed prior to proceeding to the financial proposal stage. This provides the Government with greater insight on how bidders plan to operate the company and greater flexibility in selecting the winner. 3.24 However, there are two drawbacks to including technical proposals in the evaluation process: (a) it is difficult to compare proposals objectively, which reduces transparency and hence credibility with investors and the public; and (b) the commitments made in business plans (particularly investment commitments) are frequently not kept, sometimes for justifiable reasons.4 This reduces the meaningfulness of using business plans in the bid evaluation process. 3.25 An alternative is for the Government to specify the service requirements and other future obligations in the draft license (included in the bidding documents) and have all interested parties bid on the same requirements.5 If all parties bid on the same terms and conditions, then the winner can be selected solely on the basis of the best financial proposal. This is the most transparent method, as it leaves no room for subjective judgment. 3.26 The issue of how the financial proposals should be structured will also be important, if privatization is to be aimed primarily at attracting new capital into the power sector companies, not maximizing revenue for the Government. It may not be desirable therefore to base the bidding on the highest amount offered for the Government's existing shares. The issue of how to structure the financial proposal will need careful analysis (with the assistance of advisers) to ensure that the Government achieves its objectives (investment of new funds into the companies) in a manner that is efficient and enforceable.6 3.27 The Government may consider establishing a base price for the power sector privatization. Govermnents sometimes set a base price for tender privatization, largely to avoid the potential embarrassment of a very low winning bid, although it is preferable not to restrict the 4 It is difficult for bidders to evaluate investment needs in advance of actually operating the enterprise; even if they evaluate accurately ex ante, commercial circumstances can change substantially ex post. 5 These service requirements may include, for example, permitted frequency and duration of interruptions (at the distribution level), maximum outage rates (at the transmission level), and availability and efficiency levels (at the generation level). 6 In Bolivia's capitalization program, investors bid for new shares, with the funds to be deposited in the company. This is one way to ensure that privatization actually yields investment in the assets of the company. 15  sale process in this way. If it is considered essential to set a base price then it should be set reasonably low, in order to stimulate as many bids as possible. Setting too high a base price will discourage bidders and yield a worse result for Government. To ensure transparency with the public and investors, any base price should be announced prior to the bidding. VII. License Design 3.28 The license will be the key contractual document governing the privatized power companies, and careful attention is required in its preparation, particularly for those services with natural monopoly characteristics (i.e. distribution and transmission). The license will set out, inter alia: the geographic boundaries of the service to be provided (in the case of distribution); the duration of the license and provisions for its renewal or rebidding; service obligations; the pricing regime (to the extent this is not specified in the Electricity Law and secondary regulations); penalties; risk-sharing arrangements between the operator and Government; dispute-resolution procedures; and procedures for amending the license. 3.29 Some important lessons in license design have emerged recently based on international experience with utility privatization. Licenses have tended to be overly-rigid and detailed, with obligations for the operator specified not only in terms of service requirements, but also in terms of inputs (e.g. mandating specific rehabilitation investments, types of equipment, etc.). The objective was to ensure that the operator carried out the original commitments or requirements and to limit the discretion of the operator and regulatory agency in implementation. 3.30 This has proven unrealistic and counterproductive for several reasons. First, the information on the state of the network and consumer demand may be incomplete and unreliable prior to privatization; as a result, the actual financial performance and investment requirements may differ substantially from the original forecast prior to privatization. Second, if competition is also introduced, this may significantly alter market circumstances and consumer demands. Hence, periodic revisions in the license will inevitably be required, and may in fact benefit consumers as well as the operator.7 3.31 For these reasons, licenses should include a limited number of service targets and avoid detailed requirements concerning types of investments, etc. This will provide the operator with greater flexibility to adapt the business to changing circumstances, within the framework of the overall service objectives. In the Georgian power sector privatization, it will be important to establish a limited number of realistic service targets in the license, which can be periodically revised as part of the regulatory process. The National Electricity Regulatory Commission will need to monitor the quality-of-service targets. Hence, the operator should be required to put in place adequate information and monitoring systems that will enable an independent audit by the regulator of actual performance vis-a-vis the license requirements. 7 Licenses will need to include clear principles and procedures for revision. These are essential to guide the regulatory agency and to enhance credibility with the public and the operators. 16  3.32 The timing of the preparation of licenses is an important issue. It is probably unrealistic to expect that the licenses issued to state-owned companies can be transferred to the privatized operators without any modifications (because, for example, one of the main objectives of privatization is to raise the quality of service). Indeed, the Government will wish to analyze carefully the service targets, risk-sharing arrangements and penalties before privatization. Similarly, the Govermnent will likely wish to give potential investors an opportunity to review and comment on a draft license before it is finalized for bidding. VIII. Institutional Arrangements and Advisory Services 3.33 The institutional arrangements for power sector privatization are currently complex and somewhat unclear. Several ministries play a role. The Ministry of Fuel and Energy has responsibility for the power sector and the Ministry of State Property Management is responsible for implementation of privatization. The Ministries of Finance and Economy have an overview role. 3.34 There are two separate tasks at hand for the Government: the development of the privatization strategy for the power sector and the implementation of that strategy. The Ministry of Fuel and Energy appears to have responsibility for the development of the strategy (with inputs from the other ministries and institutions involved). However, for the implementation of that strategy the other ministries will have a larger role. 3.35 Specific individuals should be designated to follow and facilitate power sector privatization. In particular, a "Power Privatization Coordinator" should be appointed in the Ministry of State Property Management to oversee the process. The Coordinator would report to an interministerial working group. 3.36 In addition to the advisory services for power sector reform and the privatization framework currently being provided by USAID and EU TACIS, an investment bank and legal advisors would be required to assist in preparing and implementing the strategic privatization transactions. 3.37 Generally, investment banks are paid a retainer plus a success fee, expressed as a percentage of the transaction(s) amount. Therefore, investment bankers try to maximize their own fees by maximizing the size of the transaction. They typically have little interest in the structure of the market or the interests of the consumers. There is a potential incentive problem if the market structure and tariff regime have not already been defined by the time the investment bank is recruited. It is essential therefore that the work on the tariff methodology and on the structure of the wholesale power market proceed on a timely basis. 3.38 The investment bank will assist the Government in managing the process of privatization and represent the interests of the Government in the sale of any power sector companies. This investment bank will add credibility and transparency to the process, especially as any interested reputable operator will have its own investment banking and legal team. Such advisory services have became standard in power sector privatization (and other major infrastructure sales) 17  throughout the world, and many investment banks have developed expertise in the sector and the region. 3.39 Legal advisors are also critical to representing and protecting the interests of the Government. The legal advisors provide legal assistance throughout the preparation and tendering process including all negotiations, contracting and financial closing. There is an option of either a single contract (with the investment bank subcontracting the legal firn), or separate contracts for the investment bank and legal advisors. 3.40 Under either contracting scenario, the legal advisors typically charge per hour worked on the transaction. Legal fees are usually very high and there is typically little room for negotiation of their hourly rate. A legal firm may prefer to be subcontracted under an investment bank with whom they have an existing working relationship, as this would provide little risk to them that their fees would not be paid. If the Government contracted the legal firm separately, the legal fimn may perceive some additional risk and may compensate for that additional risk by charging a higher retainer. As long as the legal firm understands that it represents the interests of the Government and works on behalf of the Government (rather than the investment bank), either option is acceptable. IX. Preparatory Activities 3.41 A number of preparatory activities will need to be undertaken by the Government and by its advisors to prepare the companies for privatization. These include: * preparing audited financial statements (according to IAS) for each company being privatized; * reviewing the debt situation of each company and determining whether any debts need to be written off or assumed by the Government; * reviewing labor levels and assessing whether workforce reductions would be desirable prior to privatization; * assessing whether any legislative changes are required to implement the selected privatization strategy; . preparation of a preliminary sales brochure for potential investors, undertaking international sales promotion, and identifying investor interest; * undertaking a valuation of each company; * issuing prequalification and bidding procedures; 18  * preparing and issuing a draft license, for bidders' comments, setting out the proposed terms and conditions (risk-sharing arrangements, service obligations, penalties, dispute resolution procedures); and * finalizing the license and other sales documents (e.g. sales and purchase agreement). 19