Turkey - National Transmission Grid Project

Document of The World Bank Report No: 17603-TU PROJECT APPRAISAL DOCUMENT ONA PROPOSED LOAN IN THE AMOUNT OF US$ 270 MILLION TO THE TURKISH ELECTRICITY GENERATION AND TRANSMISSION CORPORATION WITH THE GUARANTEE OF THE REPUBLIC OF TURKEY FOR A NATIONAL TRANSMISSION GRID PROJECT MAY 15, 1998 Energy and Telecommunications Europe and Central Asia Regional Office  CURRENCY EQUIVALENTS (Exchange Rate Effective March 1998) Currency Unit Turkish Lira 1 TL = US$0.000,004 US$1 = TL235,000 FISCAL YEAR January 1 - December 31 ABBREVIATIONS AND ACRONYMS AGM - Assistant General Manager AWOCS - Automated Work Order Control System BEST - Bulk Electricity Supply Tariff BO - Build-Own BOO - Build-Own-Operate BOT - Build-Own-Transfer BOTAS - Petroleurn Pipelines Corporation CAPEX - Capital Expenditures CPP - Corporate Performance Plan DSI - State Hydraulics Authority (DSI) EBIT - Earnings Before Interest and Taxes EIE - Electricity Survey Administration EIRR - Economic Internal Rate of Return FMIP - Financial Management Improvement Program CGPN - General Procurement Notice GOT - Government of Turkey GWh - Giga Watt hour (I million kilo Watt hours) IDC - Interest During Construction IPP - Independent Power Producer kV - kilo Volts (1,000 Volts) kWh - kilo Watt hour (1,000 Watt hours) TKI - Lignite Enterprise LNG - Liquefied Natural Gas MENR - Ministry of Energy and Natural Resources MTA - Mineral Research Institute MTR - Mid-Term Review MW - Megawatt NGS - National Grid System NLDC - National Load Dispatch Center NPV - Net Present Value OECD - Organization for Economic Cooperation and Development OMIP - Operational Management Improvement Program POAS - Petrol Ofisi A.S. RLDC - Regional Load Dispatch Center SEEs - State Economic Enterprises SPO - State Planning Organization TEAS - Turkish Electricity Generation and Transmission Corporation TEDAS - Turkish Electricity Distribution Corporation TOOR - Transfer of Operating Rights TPAO - Turkish Petroleum Corporation TRICEM - Tariff Revenue and Incremental Cost Evaluation Model rSO - Transmission System Operations TTK - Turkish Hard Coal Enterprises TUPRAS - Turkish Petroleum Refineries Corporation Vice President: Johannes Linn Country Manager/Director: Ajay Chhibber Sector Manager/Director: Hossein Razavi Task Team Leader/Task Manager: Raghuveer Sharma  TURKEY NATIONAL TRANSMISSION GRID PROJECT CONTENTS Page No. A. Project Development Objectives ...................................................................2 Project development Objective and Key Performance Indicators ................... ........................ 2 B. Strategic Context ...................................................................3 Sector-related CAS Goal Supported by the Project ................................................................. 3 Main Sector Issues and Government Strategy ...................................................................3 C. Project Description Summary ...................................................................8 Project Components ...................................................................8 Key Policy and Institutional Reforms Supported by the Project ..................... ........................ 8 Benefits .................................................................. 9 Institutional and Implementation Arrangements ................................................................... 9 Procurement ...................................................................9 Disbursements ..................................................................................9 Project Monitoring and Bank Supervision ....................................... ........................... 10 D. Project Rationale .................................................................. 11 Project Alternatives Considered .................................................................. 11 Lessons Learned and Reflected in Project Design .................................................................. 11 Indications of Borrower Commitment and Ownership ............................................................ 11 Value Added of Bank Support in this Project ................................................................ .. 11 E. Project Analysis .................................................................. 12 Institutional Analysis .................................................................. 12 Financial Analysis .................................................................. 18 Economic Analysis .................................................................. 23 F. Sustainability and Risks .................................................................. 26 Sustainability .................................................................. 26 Risks .................................................................. 26 G. Main Loan Conditions .................................................................. 27 H. Readiness for Implementation .................................................................. 29 I. Compliance with Bank Policies .................................................................. 29  - ii - Page No. Annexes Annex 1 Project Design Summary ........................................ 30 Annex 2 Project Description ........................................ 31 Annex 3 Estimated Project Costs ........................................ 41 Annex 4 Procurement Aspects ........................................ 42 Annex 5 Disbursements Arrangements ........................................ 47 Annex 6 TEAS Organizational Chart ........................................ 50 Annex 7 Actual and Forecast Financial Statements ...................... .................. 51 Annex 8 Cost Benefit Analysis ........................................ 56 Annex 9 Project Processing Budget and Schedule ........................................ 58 Annex lOA Statement of Loans and Credits ........................................ 59 Annex I OB Statement of IFC's Committed and Disbursed Portfolio ............................... 60 Annex 11 Country at a Glance ........................................ 61 Annex 12 Documents in Project File ........................................ 63 Map IBRD 29488  TURKEY NATIONAL TRANSMISSION GRID PROJECT Project Appraisal Document Europe and Central Asia Regional Office Energy Date: May 15, 1998 Task Team Leader/Task Manager: Raghuveer Sharma/James Moose Country Manager/Director: Ajay Chhibber Sector Manager/Director: Hossein Razavi Project ID: TR-PE-48852 I Sector: Energy Program Objective Category: Private Sector Development Lending Instrument: Specific Investment Loan Program of Targeted Intervention: | [X] Yes I [ ] I No Project Financing Data [X] Loan [] Credit [] Guarantee [] Other [Specify] For Loans/Credits/Others: Amount (US$M/SDRM): US$ 270 Million Proposed terms: [] Multicurrency [X Single currency, specify I_ Grace period (years): 4 [] Standard [] Fixed [x] LIBOR-based ___ _ _ Variable Years to maturity: 17 Commitment fee: 3/4% Service charge: _ _ _ _ _ _ _ _ _ _ _ _ Financing plan (US$M): _ Source Local Foreign Total TEAS (Borrower) 142 90 232 IBRD__ 270 270 Total 142 360 502 Borrower: Turkish Electricity Generation and Transmission Company (TEAS) Guarantor: Government of Turkey Responsible Agency(ies): TEAS Estimated disbursements (Bank FY/US$M): 1999 2000 2001 2002 2003 2004 Annual 28 65 89 64 22 2 Cumulative 28 93 182 246 268 270 For Guarantees. [H] Partial credit [ ] Partial risk Proposed coverage: Project sponsor: Nature of underlying financing: Terms of financing:| Principal amount (US$) Final maturity Amortization profile, I I I I Financing available without guarantee?: H ] I Yes I[] |No If yes, estimated cost or maturity: Estimated financing cost or maturity with guarantee: Project Implementation Period: 6 years Expected Effectiveness Date: September 1998 Expected Closing Date: December 31, 2003  Page 2 A: Project Development Objectives Project Development Objectives 1.01 The objectives of the proposed project are to assist the Republic of Turkey and TEAS to: (a) develop adequate transmission grid capacity in a timely and environmentally sustainable manner; (b) continue the reform of the power sector by establishing the independent operation of the transmission grid system; and (c) maintain the financial viability of the state institution responsible for the grid development and operation. Project Monitoring and Performance Indicators Project Objectives Progress Monitoring Benchmarks Measure of Success (a) Development of (a)Procurement monitoring (a)50% of Bid Packages awarded (a)Grid Capacity increased to adequate transmission according to agreed plan by September 2000 carry 25,000 MW of power capability in a timely (b)Construction/installation (b) 100% of Bid Packages (b)Load Dispatch System manner monitoring according to awarded by June 2002 fully modernized agreed plan (c) 25% of contracts completed by September 2000 (d)60% of contracts completed by June 2002 (b)Establishment of the (a)Governmental decrees (a) By December 31, 1998, (i) (a)A well functioning Grid independent operation of and decisions regarding adoption of Decree providing Company the transmission grid grid separation, transmnis- for the legal establishment of (b)A transparent Transmis- system sion operations policy, the Grid Company and (ii) sion Systems Operations transmission pricing satisfactory progress towards Framework implemented (b)Corporate decisions re- making the Grid Company (c)A fair and equitable trans- garding organizational functional. mission pricing levied on changes (b) Transmission Systems Grid users (c) Consultant work to assist Operational Framework the above decisions adopted by September 30, 2000 (c) Bulk Electricity Supply Tariff Regime implemented by December 31, 1999 (d) Business Plan for Grid Com- pany deployed by January 1, 2000 (c)Maintaining the financial (a)Governmental and (a)Retail electricity tariffs (a)A balanced financial viability of the state corporate decisions maintained at no less than structure for Grid institution responsible for regarding investment US$0.06/kWh on an annual Company grid development and program, pricing average basis (b)Creditworthiness operation (b)Corporate Performance (b)Bulk electricity tariffs maintained Plan prepared and maintained at no less than (c)Ready to access inter- deployed annually US$0.032/kWh on an annual national financial markets (c) Annual Audit Reports average basis (c) TEAS Annually achieving the following financial perfor- mance targets: (i) Self financing Ratio - 35% (ii)Debt Service Cover Ratio - 1.5 times (iii)Current Ratio - 1.0 Account Receivables - 45 days  Page 3 B: Strategic Context Sector-Related Country Assistance Strategy (CAS) Goal Supported by the Project 2.01 The proposed Project is consistent with CAS which aims to "catalyze private investments and reform the public sector for the efficient development of energy resources to adequately support economic growth". The current CAS document number is 16992-TR and the date of latest CAS discussion at the Board is September 4, 1997. Main Sector Issues and Government Strategy 2.02 Institutional Setting. The Ministry of Energy and Natural Resources (MENR) is responsible for policy making, sector regulation and planning the development of energy. At the operating level, the energy sector is dominated by State Economic Enterprises (SEEs). The Turkish Hard Coal Enterprise (ITK), the Lignite Enterprise (TKI), the Turkish Petroleum Corporation (TPAO) and the Mineral Research Institute (MTA) have responsibility for the extraction of fossil fuels and radioactive materials. Design and construction of hydroelectric schemes is entrusted to State Hydraulics Authority (DSI). The Turkish Electricity Generation and Transmission Corporation (TEAS) is responsible for the public sector generation and transmission of electricity all over the country. Turkish Electricity Distribution Corporation (TEDAS) is responsible for distribution of electricity throughout most of the country. The production, transport and marketing of petroleum products are undertaken by the Turkish Petroleum Refineries Corporation (TUPRAS), Petroleum Pipelines Corporation (BOTAS) and Petrol Ofisi A.S. (POAS- marketing and distribution). The Electricity Survey Administration (EIE) is responsible for renewable energy, hydropower surveys and for the formulation and implementation of the national energy conservation programs. Private sector operation in the sector is limited to two small electricity utilities (CEAS and KEPEZ) whose total installed generating capacity is about 750 MW and who are also responsible for distribution in their respective franchise areas; and two distribution companies, AKTAS and KAYSERI, who are responsible for electricity distribution, on an operations rights transfer basis, in the Asian side of Istanbul and Kayseri province respectively. There are also several industrial autoproducers, small coal mines, one independent refiner, joint ventures with TPAO for petroleum exploration, and petroleum product marketing. 2.03 Energy Resources. Turkey's most important domestic source of energy is hydroelectricity, which accounts for 40% of total electric power generation. The exploitable hydropower potential is estimated at 31,000 MW, of which 10,500 MW has been developed and another 3,200 MW is under construction or planned to be developed by 2000. Deposits of low quality lignite also exist -- estimated at 6.4 billion tons (most of which are of low calorific value and high sulfur content)-- accounting for 36% of power generation and 16% of primary energy. There are also limited quantities of low-quality high-sulfur hard coal and of oil and gas; proven hydrocarbons reserves consist of 250 million barrels of oil and 309 billion cubic feet of natural gas. Domestic production of hydrocarbon accounted for 10% of their domestic demand in 1995. This proportion is not expected to increase substantially because of the limited prospectivity of Turkey's geology. A greater utilization of domestic lignite and coal is severely constrained by environmental considerations. The balance of domestic energy demand is met, and is likely to be met in the future, by fuel imports, especially crude oil and petroleum products (35 million tons in 1995 which together constitutes 33% of primary energy supply) as well as natural gas (8 billion cubic meters [bcm] in 1996). Energy imports cost approximately 2% of GDP in 1996. About 5.5 bcm of natural gas is currently imported from the Russian Federation on the basis of a long-term take-or-pay contract; and about 2.4 bcm from Algeria through the Liquefied Natural Gas (LNG) terminal at Thrace.  Page 4 2.04 The Power Subsector. Turkey presently has an installed power generation capacity of about 21,000 MW (40% hydro, 60% thermal, mainly based on local coal/lignite) and an extensive transmission and distribution network which provides access to electricity to almost 100% of the population. Electricity consumption has been growing at an annual average of 10% over the last decade and the power system is capable of meeting its peak power demand of about 17,000 MW. The demand for electricity is forecast to grow at an annual average of 8% over the next 15 years, as a consequence of economic growth and the low levels of per capita electricity consumption (1700 kWh in Turkey compared to, for e.g., l1,000 kWh in the U.S.). This will require annual investments of about US$2.5 billion, comprising on average, US$1.8 billion for generation, US$200 million for transmission system extension and reinforcement, and about US$500 million for distribution system strengthening. 2.05 These levels of investments cannot be mobilized by the public sector, given Turkey's present situation. The traditional approach to financing power sector investments in Turkey has been through: sovereign and sovereign-guaranteed debt; and the utility's internal sources of funds, mainly through tariffs. This traditional approach is no longer tenable: Mobilizing Sovereign and Sovereign-Guaranteed Debt Financing: Turkey has to recover its reputation in the capital markets to levels before the financial crisis of 1994. Given its present credit ratings (Standard & Poor's B; Moody's B 1), spreads remain at or above 300 basis points over LIBOR; and the average life of the loans have been extremely short - 2 to 5 years. Under the traditional financing approach, the debt financing sought for the power sector investments would be of the order of US$1.8 billion per year. Such amounts are not available perennially. Moreover, under the prevailing short maturities and high interest rates situation, such financing will render the sector non-viable financially. Electricity Tariffs and Internal Sources of Financing: After dismal performance in terms of tariff adjustment in late 1980s, Turkish authorities have shown exemplary commitment to electricity pricing adjustment. Since February 1990, tariffs have been adjusted on a monthly basis to account for the high inflation.' A satisfactory electricity pricing policy was put in place in 1995, in pursuance of which a monthly increase of 5% was implemented in 1996, and a 3.8% increase was implemented for 1997. As a result of such sustained actions, the retail electricity tariffs, including taxes, presently average US cents 7.1/kWh 2, compared with an OECD average of US cents 7.76/kWh. Therefore, any additional upward pressure on electricity tariffs to finance power investments would erode the competitiveness of Turkey and create social problems. 2.06 Considerable problems have adversely affected operations of the existing power infrastructure. In generation, the plant availability factor has remained low (40-60%), attributable to poor quality fuel supply and more recently, to erratic gas supplies from Russia. While transmission losses are at satisfactory levels of 2.7%, the losses in the distribution network continue to be high, at 16% of total generation. In some distribution areas, the losses are as high as 35%. Except for 3 months in early 1994 during the economic crisis, and again for two months in late 1995 during the political vacuum. However, the ensuing increases have made up for the lack of adjustments during these two crises. 2 The agreement with the Bank is that average tariffs, net of all taxes, will be maintained at US cents 6/kWh on average at the retail level.  Page 5 2.07 The Government's Strategy for the Development of the Power Sector. Recognizing these problems, the Government of Turkey (GOT) is taking a two-pronged approach to sector development, one aimed at revamping the policy and concomitant legal/regulatory framework to attract a much larger level of private sector investments to finance the expansion of the sector; and the other aimed at privatizing existing power infrastructure. The Government's strategy for the development of the power sector is as follows: * a large portion of the existing public sector generation plants, both thermal and hydro, will be privatized on a Transfer-Of-Operating-Rights (TOOR) basis; * the national transmission grid and load dispatching facilities, which will continue to be owned and operated by the State, will be separated from state-owned generation; and the transmission system will be strengthened and expanded; * distribution facilities will be transferred to the private sector on a TOOR basis in order to: improve the efficiency distribution operations; mobilize the necessary resources; and strengthen and expand the distribution networks; * new investments for the sector, particularly for generation capacity expansion, will mainly be mobilized from the private sector, through Build-Operate-Transfer (BOT); Build-Own- Operate (BOO) and other independent power producer (IPP) mechanisms; * an independent regulatory authority will be set up to regulate the various entities; and * competition will be introduced wherever possible (e.g. generation). 2.08 Implementation Progress of Power Sector Strategy. The Turkish authorities have already begun the implementation of the sector development strategy. The progress achieved to date, is summarized below. 2.09 Revision of Institutional. Legal and Regulatory Framework. MENR has started the necessary work to revamp the institutional, legal and regulatory framework. The consulting firm, Coopers & Lybrand, is assisting MENR in this regard. The ongoing work will result in: * restructuring of sector institutions to develop a sector structure that is conducive to introduction of competition in the medium term; * the institutional design of a regulatory authority for the power sector; and * recommendations on the changes needed to the legal framework to implement the above policy and regulatory frameworks. 2.10 Private Participation in Turkish Power Sector. The Government has established several schemes and mechanisms to enlarge private participation in the sector for new investments as well as for existing infrastructure. As results of such efforts: * Five power projects, three thermal and two hydroelectric, with a total capacity of about 1900 MW, are under construction by private sector consortia under the Build-Own-Transfer (BOT) scheme;  Page 6 * Five thermal power projects under the Build Own (BO) scheme, with a total capacity of 5300 MW, have been awarded to private investors in a competitive process and negotiations are underway with each of these private investors to finalize the contractual framework. The expected commissioning dates for these projects range from end-2000 to 2002; * Eight existing thermal plants, with a total capacity of 4253 MW, will be privatized under the Transfer of Operating Rights (TOOR) scheme. Negotiations with private sector investors (who have won the operating concessions in a competitive process) are underway with these investors and the transfers are expected to be done by late 1998; * Two additional existing thermal power plants, Ambarli and Hamitabat (both outside Istanbul), with a total capacity of 2550 MW are expected to be tendered imminently to be privatized under the TOOR scheme. * More than 1000 MW of autoproducer capacity (i.e. captive power capacity of industries which have surplus power to sell to the grid) has been contracted, and offers from private sector for an additional 2000 MW of such capacity are under review. The Government's future plans include privatizing, also on a TOOR basis, the hydroelectric power plants that are currently owned and/or operated by TEAS. 2.11 In addition, Turkey is expanding its electricity imports. Presently, about 2500 GWh from Bulgaria, 800 GWh from Georgia and 120 GWh from Iran have been contracted. There are plans for more electricity imports and all of these are expected to be under long-term contracts. 2.12 On the distribution side, the distribution network has been divided into 29 distribution areas, and all of it has been subjectecl to privatization under the TOOR scheme. Four of these areas are under private operation for sometime (para 2.02). The operating concessions for the remaining 25 areas were bid out in 1996/97 and awards have been announced for 20 of these 25, for which negotiations are underway to culminate these awards before the end of 1998. Once finalized, 87% of the distribution network could be privately operated. Bank's Involvement in the Turkish Power Sector 2.13 Experience with Onioin2 Proiects. The Bank has long been involved in the power sector in Turkey. The current portfolio in Turkey includes a loan of US$300 million to finance a TEK Restructuring Project (Ln. 3345-TU) whose objective is to rationalize economic and institutional incentives to increase efficiency; and reduce the financial burden imposed on the Government by the sector's investment requirements. 2.14 These development objectives have been achieved. In terms of rationalization, electricity prices have been restructured and the levels are being adjusted each month since February 1990 to counter inflation and generate a third of the resources required for investments from internal sources. Furthermore, the sectoral institutions are being restructured (in fact, the erstwhile TEK was split up in 1994 into TEAS and TEDAS to facilitate privatization of thermal power plants and distribution assets). Technical assistance was also provided to implement a reform of their management practices including the adoption of annually renewed Corporate Performance Plans. As regards reduction of the financial burden on the government, the foreign portion of the public sector debt attributable to power sector, which was US$5 billion when the project was approved, is down to US$2.3 billion as a result of appropriate prices, improvement in financial management and better control of investmnent.  Page 7 2.15 The Bank is also providing considerable advice and technical assistance, through a Japanese Grant Fund for the Power Sector Reform Program. This assistance includes, among other things, the work by Coopers & Lybrand (para 2.09). 2.16 The Bank's Power Sector Development Assistance Strategy. The objective of Bank's medium term Power Sector Development Assistance Strategy should be to support the Turkish authorities to catalyze private investment and reform the public sector for the efficient development of energy resources to adequately support economic growth. To achieve this objective, the Bank's strategy calls for: (a) technical and financial assistance for sector and corporate reform and initial privatization under the ongoing TEK Restructuring Project; (b) support for power generation projects which have private sector involvement, particularly through guarantees, with concomitant technical assistance being provided to governmental authorities to successfully negotiate and finalize the deals; (c) as regards transmission, the Bank's support would be to strengthen the network and facilitate private sector investments in generation; (d) in the area of power distribution, the Bank would support investments for network development and institution building to complement private sector equity investments; and (e) in order to slow down the rate of growth of energy demand, the Bank would help in the design and implementation of programs and projects to improve energy efficiency and conservation at the consumption end. 2.17 The Bank's assistance would be provided through the use of the range of instruments at the Bank's disposal including: formal and informal economic and sector work; lending; guarantees; technical assistance; project preparatory financing on its own account (Project Preparation Facility, Institutional Development Fund) and/or mobilizing such financing from bilateral (e.g., Japan PHRD, USTDA) sources. The proposed Project is part of such assistance Strategy and would support the strengthening of the transmission network, and support institutional reform of the public sector institutions to facilitate private investments in the sector.  Page 8 C: Project Description Summary Project Components 3.01 The Project will comprise: (a) development of a three-year time-slice of TEAS's grid investments (transmission lines, substations and load dispatch facilities) for the period 1999 through 2002; and (b) technical assistance for: (i) establishment of the independent operation of the transmission grid system; (ii) institutional development including environmental analysis of grid investments; and (iii) helping TEAS borrow from the international markets. Cost Incl. Contingencies % of Bank-financing % of Bank- Component Category (US$M) Total (US$M) financing Grid Investment Physical 493 98 261 53 Technical Assistance Institutional 9 2 9 100 Total 502 100 270 54 Annex 2 provides a detailed Project description. Key Policy and Institutional Reforms Supported by the Project 3.02 As per the chosen strategic and policy framework for the sector, the transmission and load dispatch functions will remain with the state. Given that the power demand is expected to grow by an average of 8% per year (the growth rates for the immediate past and future are about 10% per annum) the generation capacity needs to increase by 1800 to 2000 MW each year. It is also important to note that, over the next five years, rnuch of this incremental capacity will be from the private sector (para 2.10). Therefore, the key policy aspect supported by the project is to ensure that the state will fulfill its designated role properly i.e. provide adequate transmission capacity in a timely and environmentally sustainable manner. 3.03 Second, the private sector will provide incremental capacity under BOO and BOT arrangements which include take-or-pay clauses and any delay in providing the required transmission capacity will be a financial burden on the state and an economic loss for Turkey. Therefore, an important institutional reform objective supported by the project is to ensure that the transmission capacity will be provided without eroding the financial viability of the state entity, TEAS, that would be responsible for the grid. 3.04 Third, TEAS will undergo changes in its corporate structure and functions during the project's tenure, to become the grid company responsible for transmission, load dispatch and system planning. Many business practices (technical, financial and institutional) will need to be revised to make this transition. Therefore, the other major institutional reform objective supported by the project is to help TEAS undergo these changes from a generation-cum-transmission company into grid company.  Page 9 Benefits 3.05 The planned development of the power sector supported by the proposed Project, will enable achievement of economic growth in Turkey, thus benefiting the entire population of the country, as well as the productive sectors. The proposed Project will facilitate private sector development with the planned institutional reforms, such as the establishment of the independent operation of the transmission grid system. In addition, implementation of the proposed Project will enable the Government to accrue significant fiscal revenues through taxes and levies on electricity sales. The estimated incremental fiscal revenues cumulatively over the 1998-2002 period would amount to just over US$6.0 billion. Details are provided in Annex 8. Institutional and Implementation Arrangements 3.06 TEAS is responsible for the implementation of the proposed Project. The project will be implemented over a five-year period, FY99-FY03. TEAS agreed to continue to maintain in a manner satisfactory to the Bank, an adequately staffed steering committee under its General Manager or an Assistant General Manager and a member of the Board of Directors to oversee the implementation of the project and to be responsible for the technical and administrative functions under the Project, including the procurement of goods. In addition, TEAS would continue to maintain the World Bank Project Group reporting to an Assistant General Manager and a member of the Board of Directors of TEAS to coordinate the implementation aspects of the Project. Furthermore, the Steering Committee would ensure that all the relevant data needed to carry out the frequent updates of the CPP, which comes from across the company, will be provided in a timely manner (para. 7.03(a)). Procurement 3.07 The procurement of goods and services of the Bank-financed components would be done in accordance with the Bank procurement guidelines. The project components not financed by the Bank would be procured in accordance with the national regulations or the cofinancing institutions procurement regulations. The project elements, their estimated cost and procurement methods are presented in Annex 4. A procurement plan detailing the packing and estimated schedule of the major procurement actions is also presented in Annex 4. All other procurement information, including capability of the implementing agency, the date of publication of the General Procurement Notice (GPN) estimated dates for bid invitations and the Bank's review process is presented in Annex 4. Disbursements 3.08 The proceeds of the Loan would be disbursed over six years (FY99-FY04) on the following basis: (a) for the grid investment component, 85% of the contract amount for the supply and installation contracts; and 100% of foreign expenditures and 100% of local expenditures (ex-factory cost) with respect to contracts for goods only; and (b) for the technical assistance component, 100% of the foreign expenditures for the consultancy services.  Page 10 Project Monitoring and Bank Supervision 3.09 The project will need to be monitored in concert with TEAS, its Management and Board, MENR, Treasury as well as SPO. The following documents will be prepared by TEAS to facilitate project monitoring: * A Quarterly Progress Report, which will contain the update of the entire Project Implementation Plan, but in particular the updated project costs and cost phasing; procurement and disbursement schedules; key milestones reached in implementing the technical assistance components; and project financial statements. * A draft Corporate Performance Plan (CPP) prepared by October 31 of each year; and final CPP by December 31 of each year. * An audit report, prepared by external auditors by June 30 of each year. There will also be consultants' reports on specific topics, governmental decisions, policy pronouncements, etc., which will also facilitate project monitoring. Accordingly, during negotiations TEAS agreed to: (i) maintain policies and procedures adequate to enable it to monitor and evaluate on an ongoing basis, in accordance with the indicators agreed upon with the Bank, the implementation of the Project and the achievement of its objectives; (ii) prepare, under terms of reference satisfactory to the Bank, and furnish to the Bank, by October 31 of each year, a report integrating the results of the monitoring and evaluation activities performed, on the progress achieved in carrying out the project during the period preceding the date of the report and setting out the measures recommended to ensure the efficient implementation of the Project and the achievement of its objectives during the period following such date; and (iii) review with the Bank, by December 31 of each year, the report on the progress of the Project and, thereafter, take all measures required to ensure the efficient completion of the Project and the achievement of its objectives, based on the conclusions and recommendations of the report and Bank views (para. 7.03(b)). 3.10 In addition, the Bank's monitoring of the Government's proposed project will involve closely following the implementation of the Power Sector Development Strategy (para 2.07), including frequent exchanging of views, having joint seminars and providing necessary advice. Moreover, the Bank will carry out supervision in the field, at least twice a year, with a time lag between two sequential supervisions no more than six months. 3.11 The project monitoring plan would involve a detailed Mid-term Review (MTR) of the project by the Bank. This MTR is proposed during FY200 1 and should coincide with the targeted completion of the establishment of the independent operation of the transmission grid system.  Page 11 D: Project Rationale Project Alternatives Considered 4.01 There is no alternative to the transmission grid system to dispatch and transmit electricity generated or imported to the distribution end of the power sector. In terms of technical design of the grid system, TEAS periodically reviews the need for introducing high voltage transmission into the system. However, owing to the fairly even growth of the system across the country (both from a load growth, as well as generation plant location perspective), the present 154 kV and 380 kV level is adequate at least for the next 10 years. Major Related Projects Financed by the Bank * Rationalization of economic and institutional incentives to increase sector efficiency * Reduction of the financial burden imposed on the Government by the sector's investment requirements Project TEK Restructuring Project Latest Supervision (Form 590) Ratings Implementation Progress (IP) Satisfactory Development Objectives (DO) Satisfactory (see para 2.14) Lessons Learned and Reflected in the Project Design 4.02 The most important lessons learned and reflected in the project design are (a) to resolve necessary policy issues affecting the project before loan/project approval; and (b) to ensure the simplest possible project description. Indications of Borrower Commitment and Ownership 4.03 Government and the Bank concur fully on the power sector development strategy (as part of the CAS discussions). In addition, four successive governments have, with remarkable consistency, followed the same sector development strategy. The Government is already implementing a sector reform program, key areas of which the project aims to support. Finally, performance under the ongoing project is fully satisfactory. Value Added of Bank Support in this Project 4.04 The Bank is fully involved in the design of sector reformn and is helping in the realization of the reform deploying various Bank instruments. The proposed separation and independent operation of transmission grid involves many technical, economic and institutional challenges which the Bank can help overcome. Moreover, the Bank can help ensure the overall consistency between policy, legal and regulatory regimes that would govern the proposed project and other parts of the unbundled sector.  Page 12 E. Project Analysis Institutional Analysis 5.01 Introduction. Turkish Electricity Generation and Transmission Corporation (TEAS), the proposed borrower, is a wholly GOT-owned enterprise attached to MENR. TEAS was created in 1994 by splitting the erstwhile TEK under decree 93/4789 which establishes TEAS as a limited liability corporation. TEAS's mandate is to generate and transmit electricity. The principal statute of the Turkish Electricity Authority (enacted in 1984) which applies to TEAS, classifies TEAS as State Economic Enterprise (SEE) under Decree Law no. 233 (1984). Although Decree Law 233 provides significant autonomy for TEAS, MENR under Law No. 3154 (1985), sets policies for energy planning, pricing and reviews annual investment programs. Furthermore, Laws 657 and 399, which are applicable to all SEEs, govern TEAS's personnel policies for its administrative and contractual employees. Within the context of the above legal framework, the organizational, managerial, and operational aspects of TEAS are presented below. 5.02 Organization and Management. TEAS's main business activities are generation and transmission of electricity. In addition, TEAS also has manufacturing interests ranging from 93% holding in Turkish Electro-mechanical Industries to 0.5% in Turkish Electronics Industry and Trading Incorporated. TEAS is responsible for consolidating the energy available from TEAS various power plants as well as from non-TEAS generation sources and transmitting it to several large industries directly and to TEDAS (including TEDAS's seven incorporated distribution subsidiaries), large industrial consumers, and other private power utilities (para 2.02). 5.03 TEAS has a Board of Directors comprising the Chairman, who is also the General Manager of TEAS, and five Directors. Two of the Members of the Board are Assistant General Managers (AGM) of TEAS while the other three are GOT representatives, two from MENR and one from the Undersecretariat of Treasury. The Board is the overall corporate policy making as well as the policy implementing body. Management of the utility is the responsibility of the General Manager and the four AGMs, each for Power Plant Operation and Maintenance; Planning, Research & Coordination; Transmission Operation and Maintenance; and Administration. The four AGMs are supported by 23 Directors and their staff in carrying out the mandate set for the utility. 5.04 Personnel and Staffing. Personnel management is the responsibility of Personnel Director who reports to the AGM for operations. Personnel Planning is carried out for one year at a time although the personnel requirements for new generation plants are forecast for longer periods. TEAS's labor force is unionized and the relationship between management and the union is satisfactory. As with all SEEs, TEAS's employees are governed by three laws: Law 657 for employees on Civil Service status; Law 399 for contractual employees; and general Labor Law 1475 for labor which applies equally to both public and private enterprises. Under this law, all labor contracts are subject to collective bargaining without any Government intervention. Layoffs are permitted, provided that the employer pays severance (one month salary for every year of service, subject to a maximum amount adjusted annually by Parliament). 5.05 In an effort to reduce overstaffing in SEEs, the Government has restricted new hiring in SEEs to 70% of their vacancies. In addition, TEAS's own strategy presently is to reduce its staff over time through attrition (about 270 to 300 employees per year), and limit new hiring to a few essential technical staff.  Page 13 Table 5.1: TEAS Staff Profile Head Office Outside Head Office Total Staff Number | Number _ Number l Officers Civil Servants 189 9 305 2 494 3 Contract Staff 1,099 54 4,420 25 5,519 27 Workers 763 37 13,372 73 14,135 70 Subtotal 2,051 100 18,097 100 20,148 100 TEAS's staff profile is given in Table 5.1. Staff complement at TEAS is 20,148. They are dispersed around the country and are grouped functionally rather than regionally. About 10% of the staff are based in headquarters. 5.06 TEAS's Power Infrastructure - Generation. TEAS installed generation capacity at the end of 1996 was about 18,903 MW, comprising about 9,240 MW ( 49%) of hydro capacity and the remaining 9,663 MW (51%) of thermal. The breakdown of TEAS's generation capacities and energy generation from such capacities is given in Table 5.2. Table 5.2: TEAS Installed Capacities and Energy Generated - 1996 Gross Capacity Generation Capacity Type (MW) % (GWh) % Hydro 9,240 49 26,976 39 Thermal Lignite 5,913 30 38,445 30 Hard Coal 300 2 1,950 3 Fuel Oil 680 4 4,300 7 Diesel 204 1 90 0 Natural Gas 2,551 13 16,580 21 Geothermal 15 - 90 - Total Thermal 9663 61,455 _ Total 18,903 100 88,433 100 TEAS's installed capacity accounts for 89% of total capacity in the country; while TEAS's generation accounts for 90% of total electricity generated in Turkey. Natural gas based generation has grown faster than other forms of generation, and this trend is expected to continue. 5.07 Transmission. TEAS transmission grid, which covers the whole of Turkey, mainly comprises 380 kV and 154 kV systems as follows:  Page 14 Table 5.3: TEAS's Transmission Grid Voltage Transmission Substations Level Lines (km) No. Capacity (MVA) 380 kV 12,395 88 14,290 154 kV 24,475 674 26,280 220 kV 85 66 kV 986 1,057 5.08 International Interconnections. There are currently six cross-border interconnections as follows: * Azerbaijan - a 34.5 kV and 154 kV interconnection, with a 100 MW power transfer capability which is presently used for export * Georgia - a 220 kV interconnection with a 300 MW power transfer capability, which is presently used for import. * Bulgaria - a 380 kV interconnection, with a 500 MW power transfer capability, which is currently used for import. * Iran - a 154 kV interconnection, with a 100 MW power transfer capability, which is currently used for import. * Syria - a 66 kV interconnection, with about 40 MW capability - this link is currently inactive. * Armenia - a 220 kV interconnection, with a 300 MW capability - this link is currently inactive. * Iraq - a 380 kV interconnection with a 500 MW capability - this link is currently inactive 5.09 Load Dispatch System: The system comprises a National Control Center in Ankara and five regional dispatch centers spread around the country. The equipment is 15 to 18 years old, and given the information technology basis of these systems, coupled with the phenomenal growth of the power system itself, the Load Dispatch system is in urgent need of modernization. Long Term Planning 5.10 Investment Planning. Investment planning is the responsibility of a Director for Planning under the AGM for Planning, Research and Coordination. Under the Director, there are separate divisions each for Generation Planning and Transmission Planning. A load forecast is prepared by MENR, based on which the generation planning division prepares generation expansion plans for the entire country using the planning tool, MAED (Module I of this software). In preparing the load forecast, MENR gets inputs and feedback from key players in the energy sector (e.g. SPO, BOTAS, DSI, TEAS and TEDAS) and representatives of the industrial sector. Module II and III of MAED are used by  Page 15 TEAS using the output from Module I to arrive at the annual generation and peak MW demand which will translate into a generation expansion plan. 5.11 The Transmission Planning and Coordination Division prepares the Transmission System Master Plan to correspond to the generation expansion plans prepared by the Generation Planning Division. This Master Plan is revised whenever major changes occur in generation investments or in the estimated growth of demand in the major load centers. The Master plan is prepared using State-of-the-Art software (industry standard) and is based on studies of load flows, system stability (both transient and steady state), short circuit analyses, etc. These studies are carried out using computer systems within TEAS. 5.12 Corporate Planning. Corporate planning was non-existent in TEAS until recently. However, under the ongoing TEK Restructuring Project, TEAS was able to develop, with the help of consultants financed by the Bank, a Corporate Planning System, which is used to integrate the investment plans and the financial plans into the company's Corporate Performance Plan (CPP). CPP is prepared annually for a rolling five-year horizon. TEAS is presently taking the necessary steps to deepen, within TEAS, this process of integrated corporate planning and to make it the main planning tool. These efforts will include: more frequent updating of the CPP to reflect changes in the business environment and to assess the impact of these changes on TEAS's corporate performance; and establishing a dedicated team of professionals for corporate planning under the coordination of the Finance Department. 5.13 TEAS also prepares an annual budget, which is a combination of its operating and capital budgets. The first year of the CPP does reflect this annual budget. The Public Finance Department of the Treasury (which coordinates the funding requirements of all SEEs) stipulates the assumptions that TEAS uses in preparing its budgets. These assumptions include a forecast of domestic inflation, exchange rates, and the amount of foreign financing available. TEAS, using these assumptions, prepares its annual budget in a prescribed format (which is common to all SEEs) and submits it to the Treasury for review and approval. In conjunction with SPO and the Ministry of Finance, Treasury approves the budget of TEAS. 5.14 Environmental Management. TEAS has a well staffed Environmental Department. The staff of the environmental department, who have received technical assistance and training under the ongoing Bank project, are capable of carrying out environmental assessment of generation (hydro, thermal, etc.) as well as transmission lines and substations projects. In parallel with the Bank's requirements, Turkish law also requires environmental assessments to be carried out before any environmentally sensitive investments are undertaken. 5.15 Project Implementation Capacity. TEAS is responsible for design and construction of hydroelectric plants smaller than 50 MW;3 and thermal generation plants. Organizationally, it is the responsibility of TEAS's AGM for Civil and Thermal Construction. TEAS has its own project departments for generation and transmission, which prepare the design as well as the bidding documents for procuring equipment and services. Almost all construction is carried out by contractors under the supervision of the respective design and construction departments. 3 DSI is responsible for implementation of hydropower projects larger than 50 MW capacity.  Page 16 5.16 TEAS has established a World Bank Projects Group, reporting to the General Management to oversee the implementation of Bank-financed projects. The staff to this Group are drawn from various TEAS departments to reflect the Bank Projects' components. The main functions of this group are: the staff coordination role within TEAS; management of the consultancy assignments included as part of the Bank's projects; and providing interface with the Bank. The Group receives management guidance from a Steering Committee of senior management of TEAS, which is headed by the General Manager. 5.17 The staff of the Group are trained in the Bank's operational procedures that TEAS needs to observe, such as procurement, disbursement, quarterly reporting, auditing, etc. The Group's performance has been good in the ongoing TEK Restructuring Project. Recently, the Group has assumed a significant role in project preparation, including the preparation of the proposed project. This Group will continue to function as the project implementation unit for the proposed project. 5.18 Operation and Maintenance. The operation of hydro plants is under the joint responsibility of DSI and TEAS, DSI being responsible for operation of the dams while the operation of the power houses is under TEAS. This calls for a high level of coordination between TEAS and DSI, particularly in multipurpose hydro projects such as Keban. 5.19 TEAS continues to make efforts to improve its operational efficiency. Under the ongoing TEK Restructuring Project, TEAS has, with Consultants' help, successfully completed an Operational Management Improvement Program (OMIP). Under OMIP: (a) an automated generation plant maintenance management tool called Automated Work Order Control System (AWOCS) has been developed and deployed; (b) a Cost Analysis System that can identify the cost of service for each business unit (each generation plant, transmission system, and headquarters costs) has been developed and deployed; (c) A Tariff Revenue and Incremental Cost Evaluation Model (TRICEM) which enables revenue requirement assessment; and (d) several studies identifying the technical/operational principles to be followed in various areas (automatic regulation of cascading hydro plants, fuel quality assessment and quality control in lignite generation plants) have been completed. Commercial and Financial Management 5.20 TEAS's Customer Profile. TEAS is only a bulk electricity seller and its customers are: TEDAS, the four private ultilities and selected heavy industries. Table 5.4 provides the Structure of TEAS's Sales in 1997. Table 5.4 TEAS's Structure of Electricity Sales in 1997 Electricity Sales Revenue Revenue Revenue/kWh Customer (GWh) (US$ Mil.) (%) (US Cents) TEDAS 72,402 2,034 76 2.82 AKTAS 5,335 205 7 3.85 KAYSERI 1,343 47 2 3.49 CEAS 5,531 222 8 4.02 KEPEZ 1,144 46 2 4.02 Direct Customers 2,195 126 5 5.73 TOTAL 87,950 2,679 100 3.10 As mentioned earlier, TEDAS's network has been divided into 25 distribution areas which are to be privatized under the TOOR scheme (para 2.12). When the privatization transactions are concluded, those private distribution operations will become TEAS's direct customers.  Page 17 5.21 Tariff Structure. TEAS tariff structure is based on the broad classification of its customers into categories: TEDAS; Industrial direct customers; Distribution Companies; and Private Utilities. Industrial customers are further classified as those in: (a) priority provinces designated by GOT for industrial development; and (b) others. Industrial tariffs in the priority provinces are about 89% of the tariff level for other provinces. TEAS applies a single term tariff to most customers, except for industrial customers whose demand is above 0.7 MW. For these customers, two-part tariffs are applied which consist of peak (17:00 - 22:00 hrs), off-peak (22:00-6:00 hrs) and normal (6:00 - 17:00 hrs) tariffs. In addition to two-part energy charges, industries pay demand charges, and punitive demand charges are applied for consumption of power above the contracted limit. 5.22 Billing and Collections. TEAS bills its customers once a month and the bills are delivered immediately. TEAS's electricity bills do not include the taxes and levies4 to its customers (since they are not final consumers), except for Direct Customers. However, for Direct Customers the Labor Fund tax is not levied. 5.23 Financial Organization. The financial management function in TEAS is headed by the AGM for Finance who is supported by the Director of Finance for day-to-day financial management. There are seven managers reporting to the Director, Finance, one each for Central Accounting, Budget and Consolidation, Domestic Finance, Foreign Finance, Investment, Balance Sheet and for Affiliations. Each manager is assisted by a specialist, at the level of assistant manager with staff responsibilities. Other assistant managers with line responsibilities carry out the tasks specific to the unit. Many of the finance and accounting staff in TEAS headquarters have university degrees in Commerce and Business Management. A comprehensive Financial Management Improvement Program (FMIP) was designed and implemented under the ongoing TEK Restructuring Project (Loan 3345-TU). Under FMIP: (a) a new power utility accounting system complying with both Turkish accounting laws and international accounting standards was developed, adopted and staff of TEAS were trained; (b) modern working capital management tools as well as foreign debt monitoring systems have been developed, implemented and staff trained; and (c) automated corporate planning tools have been developed and are being utilized to prepare annual CPPs. 5.24 Accounting Systems and Practices. In accordance with Turkish Law, TEAS as an SEE is required to maintain its statutory accounts according to a statutory Chart of Accounts. Since the statutory Chart of Accounts does not fully meet the utility's accounting needs, TEAS with the help of consultants, financed by the Bank, has developed and deployed a modern accounting system which is computerized and largely corresponds to international accounting standards. TEAS's key accounting policies are: accrual basis method of accounting; revaluation of assets and liabilities; no capitalization of interest during construction; accounting for work in progress and fixed assets; expensing the foreign exchange losses on transactions, but capitalizing the foreign exchange losses due to translation (to match the current value of the foreign debt); depreciation policies according to industry normns; inventory accounting policies; provision for doubtful receivables; accounting for subsidiaries and associated companies. 4 Energy Fund (1%) and a Value Added Tax (15%) are separate items while a Labor Fund (10%), and Television and Radio tax (3.5%) are included in the base tariffs.  Page 18 5.25 TEAS has been maintaining its accounts in accordance with this modernized system since 1995 and the flow accounts, such as profit/loss, are much more transparent. However the stock accounts, i.e., the balance sheet accounts continue to elicit comments from external auditors, mainly because the values from before the deployment of the new accounting system in these stock accounts have not been cleaned up. The proposed project will include efforts to clean up the TEAS' s accounts (see next section). 5.26 Auditing. TEAS's internal audit department (called Board of Inspectors) is headed by a director reporting directly to the GM. The internal audit in TEAS is focused mainly towards the use of funds and checking for payment irregularities with only routine checking for compliance with accounting principles and policies. Also, the internal audit does not cover financial performance aspects. The report by the audit department and the recommendations therein are discussed by the Board at the option of the GM who is the chairman of the Board. In addition, the Audit Wings of the Treasury and MENR perform audit of TEAS's accounts pertaining, respectively, to transactions with the Treasury and large projects/investments. 5.27 The statutory external audit of TEAS's financial statements is carried out by the Supreme Board of Control attached to the office of the Prime Minister. The Supreme Board examines whether all relevant laws are complied with, but does not check for compliance with internationally accepted accounting principles, or performance criteria agreed with external agencies such as the Bank. Since 1988, TEAS has been audited by Price Waterhouse as external auditors. TEAS has initiated a process to recruit the external auditor for the period 1997-2000. This auditor is expected to be on board in the next two months. 5.28 Price Waterhouse in their audit reports have identified several areas which are deficient and have declined to give an opinion on the utility's accounts. It is essential for TEAS to receive unqualified certification of its accounts from an intemationally recognized audit firm, in view of the need to raise capital on the foreign capital markets on the strength of its balance sheet and trading profile. The comments of the auditors are within the control of TEAS's management to address. Accordingly, TEAS agreed during negotiations to take all actions required on its part to receive an unqualified audit opinion from the independent auditors for its financial statements for the calendar year 1998 (para. 7.03(c)). Financial Analysis 5.29 Introduction. The financial affairs of TEAS are governed by the 1984 TEK Statute which stipulates that TEAS is an SEE with the autonomy to manage its financial affairs and to set its own prices. In return for such autonomy, since 1985, GOT is no longer expected to make contributions towards TEAS's investments. GOT, however, does guarantee TEAS's debt. In reality, the Government, through MENR, SPO, Treasury and Ministry of Finance, regulates TEAS's pricing, investments and budgetary allocations. 5.30 Past Performance. TEAS's past performance is analyzed for the 1995-1997 period, 1995 being the first full year of TEAS's existence. Table 5.5 shows the summary of TEAS's financial performance in the 1995-1997 period.  Page 19 Table 5.5: TEAS's Financial Performance Summay, 1995-1997 Electricity Sales (GWh) 72,572 79,728 87,950 Electricity Tariffs (US cents/kWh 3.2 3.2 3.1 Net Revenues (US$ Million) 2,287 2,526 2,673 Total Operating Costs (US$ Million) 1,740 1,967 2,234 Earnings before Interest & Taxes (US$Million) 547 559 439 Performance Indicators Current Ratio 2.7 2.8 2.1 Internal Cash Generation Ratio (%) 76 11 Debt-service Coverage Ratio (times) 0.8 0.8 0.8 Debt:Equity Ratio (%) 48:52 41:59 43:57 5.31 TEAS's operating environment was characterized by high growth in electricity sales (8% on average) but also by high inflation and devaluation of the Turkish Lira. To compensate, TEAS's tariffs were adjusted monthly. TEAS, since April 1994, has been responsible for bulk electricity pricing at or above the 66 kV level, while TEDAS is responsible for retail pricing of electricity. Presently, TEAS, with the approval of MENR, sets its tariffs to meet 35% of its average annual capital expenditures (CAPEX), after meeting cash operating costs, debt service and statutory obligations. Prices are adjusted monthly to mitigate the effect of high inflation. TEAS electricity tariffs have been at a minimum of US$0.03 1/kWh over the three years 1995-1997. 5.32 Improved financial management and control systems were instituted which helped control cash and receivable levels. Moreover, the investment levels declined substantially, as a result of austerity measures instituted by the government, and the increased efforts to attract private capital. Such reduced investment levels also resulted in reduction in the stock of foreign debt from a level of US$5 billion in 1992 to US$2.3 billion in 1997. All of these actions resulted in satisfactory financial performance and considerable cash surpluses for TEAS particularly in 1995 and 1996 as indicated by the high self- financing ratios. In 1997, earnings before interest and taxes (EBIT) declined by 21%, as a result of higher than forecast inflation which resulted in a slightly lower tariff realized, and an increase in power purchase cost from autoproducers and from imports. 5.33 Present Financial Position. TEAS's Balance Sheet, at the end of 1997, is summarized in Table 5.6 Table 5.6: TEAS Balance Sheet (US$ Million at December 31, 1997) Equity 3711 Fixed Assets (Net) 5965 Long-Term Liabilities 2646 Current Assets 758 Current Liabilities 366 Total Assets 6723 Total Equity & Liabilities 6723  Page 20 TEAS, in accordance with its accounting policies, revalues its fixed assets (and accumulated depreciation) and carries the long-term foreign debt at current values. Accordingly, the utility's equity includes the resulting Revaluation Surplus. TEAS's present financial position is satisfactory, as indicated by the (long-term) debt:equity ratio of 43.57. In addition, the utility's short-term capital is adequate, as indicated by the current ratio of 2.1. 5.34 Future Financial Performance. From a perspective of future financial performance, the following will be characteristics of TEAS's business environment: * TEAS's electricity sales will comprise, increasingly, electricity that it has purchased from other generators and these purchases will be under contracts with take-or-pay provisions. Therefore, TEAS's power purchase costs will eventually be the largest cost item; * TEAS's major costs will be denominated in foreign currency. Fuel costs will increasingly be denominated in US$ terms - presently natural gas prices are set in US$ terms by BOTAS; and there are efforts to set petroleum product prices according to international prices and set the taxation on these products in US$ terms. Power purchase costs from BOTs, BO and TOOR plants, as well as from autoproducers and imports are already set in US$ terms. * Until the generation business is separated, TEAS will (continue to) own the power plants that would be transferred to the private sector on a TOOR basis, and TEAS will (continue to) be responsible for servicing the debt on the transferred power plants; and since the utility's debt is primarily foreign debt, debt servicing will also be a foreign exchange obligation. In such a business environment, to remain financially viable, GOT and TEAS should focus on three issues: (i) implementation of a maximum affordable CAPEX program; (ii) set for itself and achieve key financial performance criteria; and (iii) have adequate electricity pricing. These three issues are discussed below. 5.35 TEAS's Capital Expenditures. TEAS's capital expenditures (CAPEX) are approved annually by the Government and then by the Parliament as part of the National Budget. In the past three years, TEAS's actual capital expenditures have been rather low, particularly compared to its planned levels. Firstly, the investment approved has been much lower than what TEAS had requested, due to Govemment's public expenditure control measures; and due to the decision and efforts to attract private investments to the sector, particularly for generation. Such control of investments has helped TEAS to, among other things, improve its financial performance (para 5.32). Table 5.7: TEAS's CAPEX - Actual and Projected h_ _ _ _ _ _ _ _ _ _ 19 6 l ~ 9 _ _ _ Z 0 I " T Generation 97 235 364 564 797 428 415 330 Transmission 65 111 106 150 169 166 159 193 Other 23 17 44 64 66 69 72 76 Total 185 363 514 778 1032 663 646 __599  Page 21 Similar CAPEX trends are expected to continue. TEAS's investments in generation are expected to be limited to ongoing projects, emergency-type generation projects, and those projects where private sector does not show keen interest. TEAS will continue to be responsible for CAPEX in transmission, and these expenditures will increase as a proportion of TEAS investments from the present 19% in 1997 to about 32% in 2002. 5.36 Financial Performance Criteria. TEAS needs to achieve four key financial performance criteria, in order for the utility to remain financially viable. * Contribution to the Financing of Investment. This is a key criterion, which measures the financial viability of a utility which has a sizable CAPEX program. According to agreement with the Bank under the ongoing project, TEAS would seek to finance from its internal sources, 35% of its average CAPEX (averaged over the preceding current and succeeding years to smooth out any lumps in TEAS's annual investments). The 35% self-financing level reflects the proportion of local costs within TEAS's CAPEX and achieving this level would help TEAS maintain a satisfactory financial structure. During negotiations, TEAS agreed to produce funds from internal sources equivalent to not less than 35% (for the fiscal year 1998 and in each succeeding fiscal year) of the three-year average of its capital expenditures (para. 7.03(d)). : Debt Service Coverage. Also a key criterion, which measures the creditworthiness of the utility. Under agreement with the Bank, TEAS would seek to cover from its internal sources at least 1.5 times the debt service obligations of the particular year. There is a need to continue to monitor the creditworthiness of TEAS as it undertakes a sizable CAPEX program, 65% of which (see above) is to be borrowed on average. Therefore, during negotiations TEAS agreed to ensure that the estimated net revenues will be at least 1.5 times in 1998 and each succeeding fiscal year, the estimated maximum debt service requirements for such year on all its debts (para. 7.03(d)). * Short-Term Liquidity. While contributions to investments and debt service coverage address long-term capital adequacy, there is a need to monitor the working capital (also known as short-term capital) needs of TEAS, to understand the liquidity situation of the utility to meet its day-to-day obligations. The standard measure is the current ratio (the ratio of current assets to current liabilities). This current ratio should be at least 1.0, which implies that TEAS will have enough liquidity to meet all current obligations (which include current portion of long-term debt) from current assets (which include cash and accounts receivable). During negotiations, TEAS agreed to maintain, beginning with the fiscal year 1998, a ratio of current assets to current liabilities of not less than 1.0 (para. 7.03(d)). * Accounts Receivable. Management of accounts receivable is a key element of short-term liquidity management, and many a time the utility could be facing a cash flow constraints due to a high receivable level which is not captured by the monitoring of the current ratio. Therefore, TEAS will need to manage its accounts receivable level diligently to ensure that there are no cash flow constraints. TEAS's customers are all bulk customers who are billed monthly and are required to settle their bills upon presentation. Accordingly, during negotiations, TEAS agreed to maintain its accounts receivable level at no more than 45 days of average daily electricity sales during a calendar year. If any projection shows that TEAS would not meet these requirements for the fiscal year covered by the review, TEAS should  Page 22 promptly take all necessary measures (including, without limitation, adjustments of the structure or levels of its tariffs) in order to meet these requirements (para. 7.03(d)). Electricity Pricing 5.37 A new Bulk Electricity Supply Tariff (BEST) regime will be designed and implemented under the proposed project, to correspond to the proposed transformation of TEAS into a grid company (para 1.01). Until BEST regime is implemented, TEAS needs to have an adequate electricity pricing regime for it to remain financially viable. The present electricity pricing regime has served the company reasonably (para 2.05), and it is expected to continue until the new pricing regime is implemented. Therefore, GOT agreed to, in conjunction with TEAS, take all actions required on its part to: (i) enable TEAS to maintain electricity prices at least at US$0.032/kWh, net of all taxes and levies, on an annual average basis; and (ii) enable TEAS to monitor and evaluate the progress of the Project in accordance with the agreed criteria (para. 7.01(a)). 5.38 In accordance with the government's strategy, distribution networks will be privatized under the TOOR scheme (para 2.12). However, until the TOOR transmissions are culminated, TEDAS will remain as the single largest buyer accounting for 76% of TEAS's sales in 1997. Therefore, TEDAS's timely settlement of TEAS's bill is crucial for TEAS's continued viability. Furthermore, the viability of the entire power sector is dependent upon the final electricity tariffs being maintained at adequate levels. Under the ongoing TEK Restructuring Project, Government has agreed to maintain the TEDAS's tariffs (i.e., retail tariffs) at least US$0.06/kWh net of all taxes. These tariffs have been maintained through monthly adjustments, thus ensuring the viability of the entire power sector. Therefore, GOT agreed to, in conjunction with TEDAS, take all actions required on its part to ensure that TEDAS: (i) maintains, at all times, its retail electricity prices at the level of at least US$0.06/kWh, net of all taxes and levies, on an annual average basis; and (ii) settles TEAS's electricity bills within 30 days of billing (para. 7.01(b)). 5.39 Monitoring of Corporate Financial Performance. The Government of Turkey, as well as the Bank, should be able to monitor the achievement of the above financial targets. To enable such monitoring, TEAS will prepare annually a Corporate Performance Plan (CPP), which will be agreed annually between TEAS and the Government. TEAS and the Government would jointly be responsible for implementing the agreed measures. The CPP would set out, inter-alia, TEAS's performance targets for the year (both physical and financial) consistent with the agreed financial performance criteria and electricity pricing agreements; TEAS's planned CAPEX, including those components to be financed by the proposed Bank loan, borrowing, financing plan, tariff structure and levels; etc. The CPP would be backed by medium-term financial projections and would include qualitative targets and strategies for achieving the targeted results. During negotiations, TEAS agreed to prepare, following an exchange of views with the Bank, and furnish to the Bank, no later than October 31 of each year, a draft Corporate Performance Plan (CPP) for the ensuing year which will include: (i) the generation and transmission system expansion targets, including the components of the capital expenditures program to be carried out during the next fiscal year and the investments under such components financed from the proceeds of the loan; (ii) the financial targets for TEAS, including a financial projection showing whether TEAS would meet the financial performance criteria; and (iii) TEAS's levels of services, borrowing needs, financing plan and tariff levels and structures (para. 7.03(e)). In addition, TEAS agreed to obtain GOT's approval of the CPP and of the actions required, and furnish to the Bank the final version of the CPP prior to the start of the fiscal year covered by it. TEAS will exchange views regularly with the Bank with respect to progress in carrying out the CPP (para. 7.03(f)).  Page 23 5.40 Financial Forecasts. Financial forecasts have been prepared based on the CAPEX program discussed in para 5.35; the existing electricity pricing regime for TEAS (para 2.05); and are designed to achieve the financial performance targets discussed above (para 5.36). These forecasts are presented in Table 5.8. Table 5.8: TEAS's Financial Performance Summary, 1998-2002 1998 1999 2 2000. 2001 2002 Electricity Sales (GWh) 88,038 103,395 110,541 121,742 134,215 Electricity Tariffs (Bulk) (USCents/kWh) 3.2 3.20 3.20 3.42 3.65 Net Revenues (US$Million) 2,817 3,296 3,524 4,148 4880 Total Operating Costs (US$ Million) 2,395 2,794 3,226 3,898 4,635 Eamings before Interest & Taxes (US$Million) 411 502 298 249 245 Net Income (US$ Million) 265 366 161 118 114 Performance Indicators Current Ratio 1.4 1.5 1.5 2.3 3.0 Average 3-year Investment (US$ million) 771 825 780 636 622 Internal Cash Generation Ratio (