Philippines - Power Transmission and Rehabilitation Project

Document of The World Bank FOR OFFICIAL USE ONLY Report No. 17709 IMPLEMENTATION COMPLETION REPORT PHILIPPINES POWER TRANSMISSION AND REHABILITATION PROJECT (LOAN NO. 3626-PH) APRIL 17, 1998 Energy and Mining Sector Unit East Asia and Pacific Region This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS (As of December 31, 1997) Currency Unit = Philippine Peso (P) P1.00 = US$0.025 US$1.00 = P40.00 P1.00 = 100 Centavos FISCAL YEAR OF BORROWER January 1 to December 31 ABBREVIATIONS AND ACRONYMS ADB Asian Development Bank BOT Build-Operate-Transfer BPS Bureau of Product Standards BTO Build-Transfer-Operate COP Committee on Privatization DA Department of Agriculture DAR Department of Agrarian Reform DBM Department of Budget and Management DENR Department of Environment and Natural Resources DOE Department of Energy DOF Department of Finance DOST Energy Coordinating Committee DSR Debt Service Ratio DTI Department of Trade and Industry ECC Energy Coordinating Council EHV Extra High Voltage EOIS Efficiency and Operational Improvement Study (NPC) ERB Energy Regulatory Board ESP Energy Sector Plan GDP Gross Domestic Product ICC Investment Coordinating Committee IDP International Development Planners IPP Independent Power Producer MW Megawatt (1,000,000 Watts) NEA National Electrification Administration NEDA National Economic and Development Authority NPC National Power Corporation OEA Office of Energy Affairs OP Office of the President OPSF Oil Price Stabilization Fund PCIERD Philippine Council for Industry and Energy Research PD Presidential Decree PDP Power Development Program (NPC) PHRD Policy and Human Resources Development PNOC Philippine National Oil Corporation PNOC-EDC PNOC Energy Development Corporation PU Public Utility RA Republic Act REC Rural Electric Cooperative ROM Rehabilitate-Operate-Maintain RORB Return on Rate Base SAR Staff Appraisal Report Regional Vice President Jean-Michel Severino, EAP Country Director Vinay Bhargava, EACPF Sector Manager Yoshihiko Sumi, EASEG Task Manager Mohammad Farhandi, EASEG  FOR OFFICIAL USE ONLY IMPLEMENTATION COMPLETION REPORT PHILIPPINES POWER TRANSMISSION AND REHABILITATION PROJECT (Loan No. 3626-PH) Table Of Contents Preface.1 Evaluation Summary ................................................. iii PART I Implementation Assessment .................................................1I A. Statement[Evaluation of Objectives ..................................................I B. Achievement of Objectives ..................................................3 C. Major Factors Affecting the Project ..................................................6 D. Project Sustainability ..................................................8 E. Bank Performance ..................................................8 F. Borrower Performance ................................................. 10 G. Assessment of Outcome ..................................................11 H. Future Operation ..................................................11 I. Key Lessons Learned ................................................. 12 PART II Statistical Annexes .................................................. . 13 Table 1: Summary of Assessment .13 Table 2: Related Bank Loans .14 Table 3: Project Timetable .15 Table 4: Loan Disbursements .15 Table 5: Key Indicators for Project Implementation .16 Table 6: Key Performance Indicators for Project Operation .18 Table 7: Studies Included in Project .27 Table 8: Project Costs and Financing .29 Table 9: Economic Costs and Benefits .30 Table 10: Status of Legal Covenants .31 Table 11: Compliance with Operation Manual Statements ........................................... 32 Table 12: Bank Resources - Staff Inputs ........................................... 32 Table 13: Bank Resources - Missions ........................................... 33 Appendices .................................................. 34 A. ICR Mission Aide-Memoire ................................................. 35 B. Borrower's Contribution to the ICR ................................................. 40 C. Borrower's Comments on the ICR .................................................. 47 Map (IBRD 24234) This document has a restricted distribution and may be used by the recipients only in the performance of their official duties. Its contents may not be disclosed without World Bank authorization.  IMPLEMENTATION COMPLETION REPORT PHILIPPINES POWER TRANSMISSION AND REHABILITATION PROJECT Preface This is the Implementation Completion Report (ICR) for the Power Transmission and Rehabilitation Project in the Republic of the Philippines, for which Loan 3626-PH in the amount of US$110 million equivalent was approved on August 13, 1993, and made effective on December 6, 1993. Loan 3626-PH was closed on December 31, 1997, compared with the original closing date of December 30, 1996. Final disbursement is expected to take place by April 30, 1998. Some US$55.45 million was canceled on August 25, 1995, and an additional US$2.95 million was canceled on January 14, 1997. The ICR was prepared by Calum Gunn, Consultant, EASEG, and Leo Rodaje, Operations Officer, EACPF, under the supervision of Mohammad Farhandi, Principal Energy Specialist, Energy and Mining Sector Unit of the East Asia and Pacific Region. The ICR was cleared by Yoshihiko Sumi, Sector Manager, EASEG. Preparation of this ICR was begun in October 1997 followed by an ICR mission in November 1997. It is based on material in the project file as well as data provided by the Borrower. The Borrower contributed to the preparation of the ICR by stating their views as reflected in the mission's Aide Memoire (Appendix A), by preparing their own evaluation of the Project's execution (Appendix B), and by commenting on the draft ICR (Appendix C).   - 111 - IMPLEMENTATION COMPLETION REPORT PHILIPPINES POWER TRANSMISSION AND REHABILITATION PROJECT (Loan No. 3626-PH) Evaluation Summary Introduction i. This Project is one in a recent series of loans outlining a major reform program for the Philippine energy sector, and for the power sector in particular. Each project, to some extent, involves the same Borrower, the National Power Corporation (NPC); the key player in the power sector.' Central aspects of this reform program include ensuring NPC's financial viabifity and strengthening its institutional capacity, and vertically and horizontally unbundling the Corporation in preparation for privatization. This ICR provides an opportunity to review the progress of reform, and additionally sets a precedent for evaluating the outcomes of the subsequent projects in the series. Project Objectives and Results ii. Physical Objective and Project Economic Rate of Return. The Project's main objective, as stated in the Staff Appraisal Report (SAR), was to alleviate the power shortages in Luzon, caused by a power crisis that had begun in 1991. Brownouts caused by the crisis were responsible for causing economic losses to the Philippines of around US$600-$800 million per year. This objective was to be achieved by financing many of the transmission lines that would connect a series of "fast track" generation plants into the Philippine power grid. From the Bank's perspective, the Project was consistent with the regional objective to encourage private sector participation in power generation, since the "fast track" projects were primarily to be developed under BOT (Build-Operate-Transfer) and BTO (Build- Transfer-Operate) contracts with IPPs (paras 1-4). iii. The Project substantially achieved the objective of contributing to theresolution of the power crisis, in spite of the fact that a significant portion of the Loan was canceled (paras 16-17). However, this achievement came at a high cost, and a recalculation of the Project's net present value (NPV) results in a negative amount. Project approval was given on the basis of ignoring the avoided cost of the economic damage caused by power outages. Nevertheless, even taking this economic damage into account in the recalculation, based on the assessment of avoided costs in the SAR, does not produce a positive NPV, due to the expensive nature of the "fast track" IPPs (para. 19). On the other hand, the magnitude of the power crisis may have been such that the avoided cost of outages was underestimated in the SAR, and hence the Project may have resulted in a significant net benefit in macroeconomic terms (para. 20). These projects are: the already closed Energy Sector project (although its JEXIM-financed component is still active, and is being supervised by the Bank), for which PNOC and the Government were also Borrowers (NPC's component being Loan 3163-PH); the Leyte-Cebu and Leyte-Luzon Geothermal projects, due to close in June 1998 and June 1999 respectively, and for which PNOC is also a Borrower (NPC's components being Loans 3700-PH and 3746-PH); and the Transmission Grid Reinforcement project, due to close in December 2000 (Loans 3996-PH and 3997-PH).  - iv - iv. Although it was recognized at the time that responding rapidly to the crisis would result in a tradeoff between the shorter lead times of the "fast track" plants and their associated higher costs, the economic evaluation in the SAR overestimated the future plant factors of these IPP units. It did not explicitly consider the impact of sector reforn and the associated introduction of competition in generation on the dispatch of the IPPs. Moreover, the Project's internal rate of return (IRR) in the SAR was overstated, as the calculation excluded the impact of transmission losses, even though it was stated that losses had been taken into account. Had the IRR been determined on the basis of the assumptions actually specified in the SAR, for the case where the avoided cost of outages was ignored, it would have been 6.5 percent instead of I I percent, and the Project would have exhibited a negative NPV (para. 18). v. Sectoral Policy Objective. Apart from contributing to the alleviation of the power crisis, the Project provided an opportunity for the Bank to support a series of reforms in the energy sector by maintaining a dialogue with the Government regarding an Energy Sector Plan (ESP) which covered policies, institutions and implementing mechanisms. Although many of the actions in the ESP have been implemented, a major issue of concern is the protracted debate over the details of an Omnibus Electricity Bill which provides the mandate to privatize NPC and empowers the Department of Energy (DOE) to effect the restructuring of the entire power industry (paras 11-12). vi. Financial and Institutional Development Objectives. Two related objectives of the Project, and of the ESP as well, were ensuring NPC's financial viability to make required investments, and also strengthening the Corporation's institutional capacity, since the healthy performance of NPC is critical to the effective and efficient operation of the power sector as a whole. Achievement of the Project's institutional objective has been reasonably impressive, although progress in this respect is continuing. NPC has implemented many of the recommendations of the 1994 Efficiency and Operational Improvement Study (EOIS), which was funded by the Japan Grant Facility and managed by the Bank within the scope of the Project (para. 15). vii. The importance of the Project's financial objective is evidenced by the associated stringent conditions required to be met before Board presentation (para. 9), and consequently the relatively long period between the appraisal mission and Board presentation in the face of the power crisis. Thus, although a substantial provision for retroactive financing allowed many of the Project's physical components to be completed prior to Board presentation, NPC completed some of the more urgent transmission works using alternative sources of funding. NPC's financial viability vvas seen as critical, since the Corporation's financial problems were considered to have been one the key contributing factors leading to the crisis in the first place. In many of the previous years NPC had been unable to generate sufficient cash internally to finance its substantial investment requirements (para. 2). viii. The Bank spent considerable effort prior to Board presentation in helping NPC to increase its base electricity tariff and to provide tariff indexing for the costs to NPC of fuel, purchased power and foreign exchange fluctuations, all in an attempt to improve the Corporation's revenue stream (para. 13). With the conditions of Board presentation met, the Bank felt that NPC's problems had been resolved and that the Corporation was on track to meet its financial covenanits while satisfactorily financing its investment program. Yet in hindsight, although necessary, these tariff changes were not sufficient measures to ensure NPC's financial viability, and so the financial objective has not been achieved. NPC still does not have enough internally generated funds to cover debt servicing requirements (para. 14), and the quality of the Corporation's equity, which consists largely of appraisal surplus, is poor (para. 32). ix. Major Factors Affecting the Project. The main factors which have maintained NPC's financial difficulties (Section C) are: (i) the consequences of historical decisions made by the Government and  v - NPC prior to the Project's inception, which constrained NPC's possible response to the crisis; (ii) the slow pace of sector reform, which has delayed privatization and hence the infusion of fresh equity; (iii) Government emphasis on developing indigenous energy resources for strategic and environmental reasons at a high contractual cost, the burden of which is not being equally shared by all electricity consumers; (iv) competition from new IPPs, which NPC finds difficult to meet given the high cost of some of its existing IPP contracts; (v) delays in tariff approval and problems with tariff design, which have had temporarily negative impacts on NPC's revenue stream; (vi) NPC's high reserve margin, which raises its average costs; and (vii) weak integration of financial and non-financial planning within NPC, which has resulted in non-optimal investment programs and non-optimal asset utilization. Overall Outcome and Bank/Borrower Performance x. Bank Performance. Bank performance in project identification and preparation was satisfactory. Considerable flexibility was built into the project description to facilitate changes in the project design in response to inconstant crisis conditions. However, although the Bank's commitment to assist NPC in restructuring its tariffs and strengthening its institutional capacity was laudable, overall, the performance of the Bank in appraising the Project is rated deficient, specifically with respect to the sensitivity analysis of the Project's IRR and the assessment of NPC's financial situation (Section E). The Project focused mainly on improving NPC's income statement (by securing revenue through automatically-adjusting tariffs), whereas greater effort was also needed to improve NPC's balance sheet (by augmenting its level of equity). Further, the short term benefits of mitigating the economic damage caused by the power crisis were estimated at the time as offsetting the longer term costs due to the expensive IPP contracts. Given that the process of sector reform made NPC's market share and overall level of sales very difficult to forecast, the sensitivity of the IRR to such highly uncertain factors should have been investigated in the SAR. Nevertheless, Bank performance during supervision was generally satisfactory, and NPC's financial problems were diagnosed more accurately during the appraisal for the later Transmission Grid Reinforcement project. xi. Borrower Performance. NPC's performance during preparation and implementation of the Project was satisfactory, and the Corporation was highly committed to the Project (Section F). NPC acted to meet all the Bank's conditions of Board presentation and loan effectiveness, and physical implementation was marked by many contracts being completed early and under the cost estimates. NPC took action with regard to the majority of recommendations in the EOIS, although some were put on hold pending the outcome of NPC's ongoing restructuring process. On the other hand, compliance with financial covenants was not attained in every year, and the financial objective of the Project was not achieved. However, a number of the factors contributing to this result were outside of NPC's direct control during the project period (para. ix). xii. Project Sustainability. Overall, the prospects for project sustainability are uncertain (Section D). In terms of responding to the power crisis, the Project has contributed to making it unlikely that such a level of brownouts will happen again in the foreseeable future. Nevertheless, meeting the Project's physical objective came at a high cost, and has contributed to the perpetuation of NPC's poor financial position. Since the financial viability of NPC is critical to ensuring an effective and efficient power sector, this means that the project sustainability as a whole must also be rated as uncertain. This conclusion is reinforced by: (i) general sectoral uncertainty caused by the delay in passing the Omnibus Electricity Bill; (ii) the recent depreciation of the peso; and (iii) implementation delays in NPC's other Bank-financed projects.  - vi - xiii. Assessment of Outcome. The overall outcome of the Project is rated unsatisfactory (Section G). The reason for the unsatisfactory rating is twofold: (i) NPC has maintained its precarious financial situation over the Project period, and hence the objective of ensuring NPC's financial viability has not been achieved (para. viii); and (ii) the high cost of meeting the Project's physical objective was a contributing factor to this situation, and consequently a recalculation of the Project's NPV results in a negative value (para. iii). The importance of the Project's financial objective is evidenced by the stringent conditions relating to NPC's finances which were required to be met prior to Board presentation (para. vii). NPC's financial viability was seen as critical, since the Corporation's financial problems were considered to have been one the key contributing factors leading to the power crisis. Hence, ensuring the sustainability of the Project's short term physical objective, to resolve the immediate needs of the power crisis, was dependent on also achieving the longer term financial objective. xiv. Nevertheless, this outcome must be qualified by noting that: (i) the physical objective to alleviate the power crisis was substantially achieved; (ii) the magnitude of the power crisis may have been such that the avoided cost of outages was substantially higher than the assessment in the SAR, hence the Project may have resulted in a significant net benefit in macroeconomic terms; and (iii) in meeting the Project's physical objective, the implementation performance of NPC was satisfactory. Many of the factors leading to both the Project's poor economic return and the perpetuation of NPC's precarious financial situation were as a consequence of decisions made by the Government and NPC prior to the Project's inception. To a large extent these factors constrained NPC's possible response to the power crisis. Future Operation and Key Lessons Learned xv. Future Operation. The Bank's recent sector reports have built on the ESP by providing the strategic framework for restructuring and privatizing the power sector, and NPC in particular. More specifically, the covenants of the Transmission Grid Reinforcement project include the requirement for the separation of NPC's transmission activities as a separate corporate entity. Yet NPC's precarious financial situation, the slow pace of sector reform and the fragmented nature of the distribution sector, are still of concern. The Bank will continue to monitor NPC's finances through its ongoing supervision of the subsequent projects. However, a resolution of these outstanding issues still requires a concerted effort by DOF, DOE, NPC, PNOC-EDC and NEA, with coordinated assistance from both the Bank and ADB (Section H). xvi. Key Lessons Learned. The stringent conditions of Board presentation relating to the Project's financial objective, which resulted in presentation delays in the face of a crisis, suggest that the resolution of short term problems was not to be at the expense of the long term financial viability of the Philippine power sector's key player. However, because the IPP arrangements associated with the Project were developed under crisis conditions, they came at a high cost. This has been a contributing factor to the failure of this Project to meet its financial objective and has detrimentally affected the Project's economic rate of return. Such an outcome indicates the need to clearly identify potential interactions between project objectives, and highlights the pitfalls in not conducting sufficient sensitivity analyses of a project's economic rate of return, particularly in a sector undergoing major structural reform. Further, return on rate base (RORB) and debt service ratio (DSR) financial covenants are not in themselves sufficient indicators of a public utility's financial resiliency. Had NPC actually met the covenants in every year of the Project, this would have masked the actual precariousness of the Corporation's financial position (Section I).  IMPLEMENTATION COMPLETION REPORT PHILIPPINES POWER TRANSMISSION AND REHABILITATION PROJECT (Loan No. 3626-PH) PART I: IMPLEMENTATION ASSESSMENT A. STATEMENT/EVALUATION OF OBJECTIVES 1. Background. Beginning in 1991, the Philippines experienced a very serious power crisis which posed a grave threat to its economic development and stability. The crisis resulted in substantial outages of up to 10 hours per day in Luzon and Mindanao, hurting industrial production and the development of new industrial and commercial activities. In addition, there were serious disruptions of key services that depended on electricity, ranging from traffic management to water supply and sewerage. The cost of consequent unemployment and economic losses was estimated by the Bank to be around US$600-$800 million per year.2 2. The crisis was partially due to natural causes, a serious persistent drought which caused several key hydro dams to be below minimum operating levels. However, equally important were institutional problems which had resulted in minimal investments being made in power generation during the period from 1986 to 1992. These problems included: (i) inadequate financial performance of the National Power Corporation (NPC), the state-owned entity responsible for power generation and transmission, due to insufficient tariff levels resulting in negative cash generation and reduced amounts available for power investments; (ii) inadequate maintenance and rehabilitation of NPC's thermal plants (having an average age of 22 years), resulting in frequent unplanned outages; (iii) long delays in obtaining environmental approval for power projects, in part due to the very negative public perception of NPC; (iv) slow procurement, project implementation and disbursement procedures by NPC; and (v) the mothballing of the Philippine Nuclear Power Plant (600 MW). 3. In response to the crisis, the Government of the Philippines enacted the "Electric Power Crisis Act of 1993" (RA 7648) to give the President special powers to facilitate tariff increases and to expedite project approvals. A "fast track" generation program of BOT (Build-Operate-Transfer) and BTO (Build- Transfer-Operate) contracts with the private sector was initiated comprising 700 MW of capacity for Luzon and 200 MW for Mindanao. These contracts involved internal combustion turbines operating on relatively expensive fuel/bunker oil or diesel that could be commissioned rapidly. Other conventional power supply projects (coal, geothermal and hydro), which have lower operating expenses, require much longer construction lead times and hence would not have been able to provide the necessary relief in the short term. NPC intended that as soon as adequate conventional power generation was installed to serve base load requirements, that these operationally expensive plants be reserved for peak power generation or standby capacity, as is dictated by the principles of economic dispatch. However, it was recognized that these plants would continue to be expensive, since the high take-or-pay charges under the BOT contracts persist irrespective of operational conditions. 2 This estimate, which was presented in the Project's Staff Appraisal Report (SAR), corresponded to around 1.5 percent of GDP, and was calculated on the basis of using US$0.50/kWh as the cost of unserved energy. (This was the value used by the National Power Corporation (NPC) in its planning process).  - 2 - 4. Project Objectives. As stated in the Project's Staff Appraisal Report (SAR) of June 1993, the main objective of the Project was to alleviate power shortages in Luzon, through: (a) a transmission system expansion and reinforcement program needed to bring power to Manila from the "fast track" generation plants; and (b) the rehabilitation of the Bataan thermal generating plant (225 MW). The Project was also intended to improve the performance of the energy sector through the approval by the Government, in consultation with the Bank, of an Energy Sector Plan (ESP) covering policies, institutions and implementing mechanisms. In addition, it was to ensure the financial viability of NPC to undertake a massive and long-overdue investment program and improve its institutional setup. 5. Project Components. The Project was originally designed to have the following major components: (a) expansion of the transmission system in the Bataan and Batangas areas near Metro Manila; (b) provision of goods and materials (conductors, insulators and supports) to reinforce the transmission system; (c) rehabilitation of the two units (Unit #1, 75 MW and Unit #2, 150 MW) of the Bataan oil-fired thermal power plant; (d) consulting assistance to prepare a master plan to develop the 500 kV extra high voltage (EHV) system and rehabilitate the Bataan thermal plant; and (e) an "Efficiency and Operational Improvement Study" (EOIS) funded by the Japan Grant Facility and managed by the Bank. 6. After the Loan was declared effective, conditions in the power sector changed from those prevailing at the time of appraisal. Among other changes, one of the proposed BOT developments (600 MW) never eventuated, necessitating the indefinite postponement of the proposed transmission reinforcement measures in the Batangas area. Furthermore, NPC opted to seek a private sector developer to rehabilitate the Bataan thermal plant on an ROM (Rehabilitate-Operate-Maintain) basis in line with new policies to divest generation to the private sector, and not to use funds from the Loan for this purpose. On August 24, 1995, NPC requested the cancellation of these components. 7. Evaluation of Objectives. In responding to the emergency conditions brought on by the power crisis, the Project objectives relating to the physical components were directed at ensuring the successful implementation of the Government's "fast track" generation program. They also complemented the Bank's wider country objectives of promoting private sector involvement in infrastructural development. The description of the transmission system expansion and reinforcement components of the Project in the Loan Agreement was sufficiently broad to allow a flexible change of project scope in response to the risk of non-implementation of specific generation projects. Moreover, the risk of delays in the implementation of the transmission components was minimized by an advanced and effective procurement program monitored monthly by the Bank, and by the provision for retroactive financing of up to 20 percent of the loan amount prior to signing. Implementation of the physical components of the Project was neither demanding nor complex from NPC's perspective, and there were no major environmental or resettlement issues. 8. The Loan Agreement required an exchange of views between the Bank and the Government on the ongoing process of sector reform outlined in the ESP. The Government approved the ESP prior to Board presentation and this plan provided a roadmap for an extremely ambitious and complex program of reform for the wider energy sector, not just the power sector (para. I 1). 9. The objective of ensuring NPC's financial viability to undertake its investment program did not have a related project component. However, stringent conditions for Board presentation required an increase in NPC's base tariff and a provision for an automatic tariff adjustment to reflect fluctuations in the cost to NPC of purchasing petroleum products, in order to improve NPC's revenue stream. In addition, loan effectiveness conditions included further tariff indexing for the costs to NPC of coal,  -3 - geothermal steam and purchased power, and to account for foreign exchange rate fluctuations. NPC's financial viability was also an area of action in the ESP. The ESP proposed enacting legislation to authorize equity infusions to NPC from the Oil Price Stabilization Fund (OPSF). At the time of Board presentation, the Bank felt that NPC's financial problems had been resolved and that the Corporation was on track to meet the covenanted return on rate base (RORB) of 8 percent and debt service ratio (DSR) of 1.3. Yet, although necessary, these tariff changes and limited equity infusions were not sufficient measures to ensure NPC's financial viability (para. 32). 10. The objective of improving NPC's institutional setup was to be achieved by the implementation of the recommendations of the EOIS (para. 15) and a transmission system development study, for which extensive terms of reference were included in the SAR. B. ACHIEVEMENT OF PROJECT OBJECTIVES 11. Sectoral Policy Objective. Achievement of the Project's sectoral policy objective has been partial. Nevertheless, although significant additional restructuring of the power sector is still required, the gains made during the project period through the ESP were reasonably impressive. Many of the required actions in the plan have been implemented (Table 6C). These included passing legislation to: (i) create the Department of Energy (DOE); (ii) deregulate the oil industry; (iii) rationalize the tariff and tax component of petroleum products; (iv) empower a single body, the Energy Regulatory Board (ERB), to have control over the regulation of electric utility pricing; (v) prohibit and prosecute power pilferage; and (vi) institutionalize the Committee on Power Conservation and Demand Management. 12. On the other hand, the main issue still outstanding is the protracted debate in the Philippine Senate and Congress over the details of an Omnibus Electricity Bill (first drafted in early 1995) that provides the mandate to privatize NPC and empowers the DOE to effect the restructuring of the entire power industry. Unfortunately, in November 1997, the Supreme Court of the Philippines declared the Oil Industry Deregulation Act of 1996 (RA 8180) unconstitutional.3 This redirected the focus of both Senate and Congress, and ensured that the Omnibus Bill would not be passed under the current administration. Furthermore, legislation both to remove the current disincentives to private sector participation in geothermal development, and to change the proscriptive policy regarding geothermal royalties that has driven up steam prices, is still pending after more than four years. 13. Financial Objective. Despite notable efforts on both the part of the Bank and of NPC, achievement of the Project's financial objective has been negligible. NPC complied with its RORB covenant in 1994 and 1996 (8.3 and 8.2 percent respectively), but not in 1993 and 1995 (5.9 and 7.3 percent). The DSR was 0.9, 1.3, 0.9 and 1.4 in the years from 1993 to 1996. As a result of the Project, NPC's bulk tariffs were restructured to improve NPC's income (para. 9). This process included: a base rate tariff increase; the application of automatic adjustments for the cost to NPC of fuel (i.e., petroleum products, coal and geothermal steam), purchased power and foreign exchange rate fluctuations; and the introduction of demand charges to all customers. A later development was the approval by ERB of an open access transmission tariff (OATT) applied to IPPs wanting to wheel power through NPC's transmission network to distributors. (This has set an important precedent, as the wheeling tariff level is based on receiving a 12 percent RORB on NPC's transmission assets). 14. However, irrespective of covenant compliance or non-compliance, and in spite of the measures taken to restructure tariffs, NPC still faces financial difficulties in terms of not having enough internally 3 Congress approved a new and more competitive deregulation law in February 1998.  - 4 - generated funds to even cover debt-service requirements. Hence, NPC has not been able to satisfactorily finance its investment program as planned. NPC had intended to put P37.1 billion and P38.7 billion into new projects in 1995 and 1996. Actual capital expenditure was only P20.6 billion and P23.3 billion during these years. (The major factors impacting on NPC's financial situation are outlined in Section C). 15. Institutional Development Objective. Achievement of the Project's institutional objective has been partial. Although reasonably impressive gains have been made, further progress in this respect is still required (para. 27). NPC has implemented many of the 1994 EOIS recommendations to strengthen the management of its assets and to function more in accordance with commercial principles. On the basis of these recommendations and the lessons learned from the Bank's involvement with NPC through the Energy Sector project (Loan 3163-PH) and the ongoing Leyte Geothermal projects (Loans 3700-PH and 3746-PH), specific corrective measures were taken during the course of the Project period. These included: (i) appointment of project directors under a new vice presidency; (ii) establishment of a Project Management Office to manage the responsible design groups in the Engineering Department, as well as outside consultants; (iii) strengthening NPC's procedures to deal with environmental and resettlement issues; (iv) training in the implementation of Bank procurement procedures; (v) standardization of bid documents to ensure a uniform approach in evaluating and awarding contracts (as was covenanted under the Loan Agreement); and (vi) the development of other programs such as Reliability Central Maintenance (RCM) and Total Quality Management (TQM) intended to achieve continuous performance improvement. In addition, the Transmission Master Plan funded under the Loan provided the basis for planning much of NPC's future transmission expansion program (Table 7). However, actions on some recommendations in the EOIS have been put on hold, pending the outcome of the current restructuring of NPC. 16. Physical Objective. The overall physical objective was substantially achieved, even taking into account the cancellation of the component for rehabilitating the Bataan thermal plant. In terms of alleviating the power crisis, the Project eventually facilitated the transmission of up to 1200 MW of additional power within Luzon, and to the Metro Manila region in particular (Appendix A). The construction of the Hermosa-Bocaue-Balintawak line, and the associated expansion of the Balintawak and Manila substations, were both necessary to evacuate power generated from the Subic and Bataan regions to Manila. The temporary Limay-Hermosa dual circuits, financed retroactively and completed prior to loan signing, transmitted up to 600 MW of power from the Bataan (ABB) combined-cycle plant to the Hermosa substation. In addition, the Subic-Olongapo line and the expansion of the Olongapo substation, allowed the transmission of up to 100 MW from the Enron-Subic II plant through to Hermosa. In Northern Luzon, the Payocpoc-Bauang line allowed the export of around 200 MW from First Private Power's (FPP) Bauang plant. The construction of the Pinamucan-Batangas line, completed prior to loan signing, and the expansion of the Batangas and Binan substations and of the Calaca and Makban switchyards, connected up to 100 MW into the grid from the Enron-Pinamucan plant. Finally, the rehabilitation of the Kalayaan-Tayabas line and the expansion of the Dolores substation eventually contributed to bringing north up to an additional 200 MW from the geothermal plants in Southern Luzon. 17. Prior to the Project's inception, the Bataan thermal plant had been operating at less than half its capacity and experiencing frequent outages. Its rehabilitation under the project scope was intended to restore the plant to full capacity. This component of the Loan in its entirety, including the remaining portion of the associated consultancy contract, was canceled in August 1995, the justification being that the rehabilitation would still be performed through divesting the plant to the private sector on an ROM basis (para. 6). As yet, this has not ensued. Nevertheless, the failure of this component to be completed within, or outside, the extent of the Loan did not hinder achievement of the project objective to provide relief for the power crisis. Moreover, the portion of the related consultancy contract that was utilized did  -5 - enable NPC to revise its maintenance procedures to achieve an increase in firm capacity and a reduction in forced outages (Table 7).4 18. Economic Rate of Return. The internal rate of return (IRR) for the transmission expansion and reinforcement program was estimated in the SAR as 11 percent, assuming that NPC's average bulk tariff could be increased from P1.66/kWh to P1.84/kWh. Although it was stated in the SAR that the IRR was calculated accounting for transmission losses, this was not the case. Correcting for this, the IRR in the SAR would have been only 6.5 percent with an associated negative net present value (NPV) of P1.9 billion.5 When avoided losses to the economy due to frequent power outages were taken into account, the IRR was considerably higher, indicated in the SAR as being 136 percent. (The avoided cost of outages, associated with the incremental sales due to the Project, was presented in the SAR as being P7.2 billion over a two year period). Correcting again for the omission of transmission losses, the IRR in the SAR would have been 92 percent, with a positive NPV of P3.1 billion. 19. The Project NPV has been recalculated on the basis of NPC's current forecasts for plant costs, power tariffs, sales and revenues (Table 9). Both the Enron-Subic II and Enron-Pinamucan plants have been included in the revised economic analysis, since the Project facilitated the transmission of power from both of these plants in order to alleviate the power crisis (para. 16). The ESI plant was built by a different developer and is included in the analysis as the FPP-Bauang plant. The recalculated NPV is negative P14.6 billion, ignoring avoided outage costs, or negative P9 billion, including the level of avoided outage costs used in the SAR. The main reason for the substantially lower recalculated NPV is NPC's reduced forecasts for plant factors, in particular, that for the ABB combined-cycle units. Given that NPC's average tariff for Luzon is optimistically projected to almost double over the next nine years, these plant factors could be also be optimistic (para. 24). 20. On the other hand, it is possible that an insufficient level of avoided outage costs was used in the SAR's economic analysis; such costs are problematic to estimate, evenexpost. These costs have been reassessed, based on assumptions provided in the Bank's 1994 Philippines Power Sector Study (13313-PH), to give an indication of the possible order of magnitude for the economic damage mitigated 4 A quantitative analysis of the benefits of the Bataan thermal plant rehabilitation was not attempted in the SAR. However, it was considered that the rehabilitation cost of around US$31 million was justified in comparison to the replacement cost of the plant. Given the significant improvement in perfornance that has been achieved at the Bataan thermal plant, primarily due to the associated consultancy study, it can be concluded that this component of the Project achieved a higher economic return than was expected. 5 (All NPVs discussed in this Section are for a discount rate of 10 percent). The SAR calculation also assumed that transmission expenditure for 1992 was sunk (i.e., around 8 percent of the Project's transmission costs were ignored). In addition, station losses (typically around 3 percent) appear to have been ignored. These have been included in the revised calculation. Finally, the plant factor for the ESI plant was listed in the SAR's Annex 15 (containing the IRR calculation) as being 79 percent after 1995; sales figures in the SAR were actually calculated on the basis of a more realistic plant factor of 30 percent. 6 Another issue relating to the plant factors is that the economic viability of this Project, the components of which were acknowledged by the SAR as not normally being part of a least cost expansion program, may have been detrimentally affected by investment decisions made subsequent to the Project's inception. Without performing a detailed optimization analysis, it cannot be ruled out that later investments, particularly in base-load geothermal and coal-fired plants (both currently operating as well as under construction), may have suboptimally displaced, and continue to further displace, the sunk ABB units in the dispatch merit order (para. 27). Even if justifiably displaced, all the plants relating to the Project may have some additional economic value associated with their use as reserve capacity which is not accounted for in the recalculated IRR.  -6 - by the Project.7 Applying these assumptions results in an overall avoided cost of outages of P26.8 billion over the three year period 1993-1995 (compared to P7.2 billion used in the SAR over a two year period). Using this substantially higher level of avoided costs in the recalculated economic analysis results in a positive NPV of P7.0 billion.8 C. MAJOR FACTORS AFFECTING THE PROJECT 21. Factors Not Subject to Government or NPC Control. (a) Historical factors: NPC's need to respond to the power crisis by relying on plants that would not normally have been part of a least cost generation expansion program stemmed from historical factors (para. 2), and hence were not subject to the control of either NPC or the Government subsequent to the inception of the Project. At the onset of the crisis in 1991, insufficient generation investments were in the pipeline, and due to existing undercapacity NPC had little choice but to keep its aging plants online rather than risk outages. Without periodic overhauls, the condition of its generation facilities deteriorated sharply, further exacerbating the crisis. In addition to problems related to securing environmental and social clearances, the lack of generation investment was due to insufficient internal cash generation. With encouragement from the Government, NPC had stopped implementing the existing fuel cost and exchange rate adjustments in its tariff in 1989. Also, the Corporation had had to delay tariff increases required to respond to the large hike in oil prices caused by the Gulf War, and was unable to arrange needed equity financing due to constraints on Government cash investments. This had forced NPC to borrow in foreign currency to meet its local currency investment requirements; a situation which has continued. Conditions were further complicated by the politicizing of NPC tariff increases in anticipation of the May 1992 presidential and congressional elections. 22. (b) Tariff design: The formula initially approved by ERB for the purchased power adjustment would have had a negative impact on NPC's revenue had it been applied, and it was not until 1996 that NPC was able to have a more favorable methodology approved. When finally applied for Luzon customers, it contributed to a major improvement in NPC's average rate for 1996. Another tariff change, intended at least initially to be revenue neutral, was introduced as a covenant under the Loan. This was the application of a higher demand charge component in the bulk tariff. Because the split of demand and energy charge components was approved by ERB based on historical data, and NPC's customers have in most cases subsequently improved their load factors, this change resulted in a negative impact to NPC. 7 This 1994 study assumed the economic cost of outages to be US$0.43/kWh for 1993, and US$0.28/kWh subsequently. The reduction over time is because, after a long period of unreliable service, consumers tend to be better prepared for outages, thus reducing the impact of the crisis. A large number of consumers purchased gensets as back-up units during the power crisis, generating at a cost of around US$0.17/kWh. The avoided cost in each year is thus the weighted average of NPC's own estimate of US$0.50/kWh (Footnote 2) and the self- generation cost, as the production from gensets increases. Applying these avoided costs to the incremental sales due to the Project over the period 1993-1995, for the peak 8 hours of each day, results in an overall value of P26.8 billion. This calculation is not intended to be definitive, but only to provide a possible order of magnitude. For instance, attributing avoided costs to the entire year of 1995, during which other NPC and IPP plants came on-line, might overstate the benefits. The IRR associated with this higher level of avoided costs is only 3.5 percent. This seemingly anomalous result is because the cost-benefit stream is the reverse of that for typical investment projects. Net benefits occur in the initial years of the Project (due to the avoided outages), whereas net costs occur in all subsequent years (since revenue from incremental sales is insufficient to cover the capacity costs of the "fast track" plants).  23. Factors Subject to Government Control. (a) Pace of sector reform: A key factor influencing NPC's finances is the slow pace of sector reform, particularly the delay in the passage of the Omnibus Bill by more than two years (para. 12). The privatization of NPC's generation assets is not a realistic option until after this Bill is passed. In early 1996, the SAR for the Transmission Grid Reinforcement project (Loans 3996-PH and 3997-PH), noted that rapid progress with commercialization and privatization was of great importance to NPC, as its financial planning depended on adequate amounts of fresh equity capital through the sale of shares in its planned subsidiaries by 1997. Although noting that the Government has a policy of not acquiring any more equity in NPC, this SAR warned that, if the privatization program failed to provide adequate amounts of equity by this time, the Govemment would need to provide relief, either through new equity investments or advances given on highly concessional terms. The infusion of equity from the OPSF (para. 9) and from revenues of the Philippine Amusement and Gaming Corporation has had little impact. 24. (b) Competition from new IPPs: Ironically, the process of sector reform has itself contributed to NPC's financial difficulties. One of the main impacts of reform has been to expose NPC to competition in generation. In principle, this is desirable aspect of the reform process, but the playing field is tilted in favor of the IPP entrants that want to wheel power through NPC's transmission network and sell directly to distributors. NPC finds it difficult to compete with these relatively efficient and lower cost new generators, because its average generation cost is weighted upward by the expensive contracts it already has with some of its own IPPs.9 NPC maintains that the solution to its problems lies in increasing market share through aggressive pricing and contracts. Consequently, NPC recently applied to ERB for a reduction in its base tariff, and approached the Bank to request a relaxation of all RORB loan covenants. The motivation for these requests is that, if NPC's generation market share is eroded, its already high reserve margin and average costs will increase further, launching a vicious cycle of reduced sales and even higher costs. However, the solution to this problem does not lie in NPC establishing a monopoly in generation through a relaxation of its financial covenants with the Bank, but rather in leveling the playing field through recouping the higher costs of past decisions from all consumers, not just NPC's. 25. (c) Emphasis on indigenous resources: Apart from being a response to the immediate needs of the power crisis, a number of NPC's power purchase arrangements were entered into in order to comply with the Government's promotion of the use of indigenous energy resources, especially geothermal. Contracts entered into for strategic reasons, or to internalize externalities, can be considered as beneficial to all electricity consumers (or even to the economy at large), and the burden should be shared accordingly. As a partial rejoinder, NPC has filed an unbundled tariff with ERB which contains a component explicitly quantifying the additional cost to NPC due to the "development of indigenous resources". Correspondingly, NPC recently proposed to the Department of Finance (DOF) the imposition of a geothernal levy, borne by all electricity consumers, to recover the cost of geothermal contracts over and above the competitive market price.10 26. Factors Subject to NPC Control. (a) High reserve margin: At the time, the Government was aware that, as a result of the "fast track" projects, once the longer term and more economical power supply alternatives had materialized, peak power capacity might be somewhat in excess of what would be 9 For 1996, the average cost of NPC's plants was reported as 1.3658 P/kWh, whereas the average for NPC's IPPs was 1.9853 P/kWh, of which the geothermal plants cost 1.6826 P/kWh (as presented in the Bank's 1997 Energy Strategy and Pricing Study; para. 39). The price that PNOC-EDC can offer NPC for steam is inflated by the Government's policy on geothermal royalties. Although a bill to reform this policy has been pending in Congress since 1993, it has not yet been passed (para. 12).  - 8 - planned under normal circumstances. This was justified on the basis that such a high reserve margin was necessary to ensure that further damage to the economy was avoided, and to hedge against the risks relating to the unreliability of existing thermal plants, the possibility of implementation delays, and uncertainty regarding the financing of some of the "fast track" projects. The SARs for both this Project and the subsequent Leyte projects concurred with this view, suggesting that a margin of at least 30 percent would be required. However, NPC has continued to bring more projects onstream, and around 1900 MW of new generation is programmed over the next four years. I To ensure that NPC's financial situation is not further eroded due to a poor average plant factor, markets need to be found for this capacity, but NPC's market share is becoming increasingly constrained by competition from new IPPs (para. 24). 27. (b) Weak integration of financial and non-financial planning: The EOIS (para. 15) noted a need for closer integration between financial and non-financial planning within NPC. Accordingly, NPC still needs a clear strategy to ensure: the financial viability of projects; the affordability of marketing, investment and borrowing decisions; optimum asset utilization; and the minimization of foreign exchange risks. The tendency of NPC's marketing and planning groups to marginalize advice from its financial departments is a contributing factor to NPC's current situation. D. PROJECT SUSTAINABILITY 28. Overall, the prospects for project sustainability are uncertain. In terms of responding to the power crisis, the Project has contributed to making it unlikely that such a level of brownouts will happen again in the foreseeable future. In fact, rather than suffering from undercapacity, NPC now experiences a high reserve margin (para. 26). Moreover, the related Leyte projects and Transmission Grid Reinforcement project, which follow the course outlined by the Transmission Master Plan funded under the scope of the Project, continue to improve the robustness of NPC's transmission network. Although some transmission bottlenecks are still being experienced with respect to the existing generation capacity, these should be eliminated during 1998. 29. Nevertheless, meeting the Project's physical objectives came at a high cost, and has contributed to the perpetuation of NPC's poor financial position (para. 24). Since the financial viability of NPC is critical to ensuring an effective and efficient power sector, this means that the Project's sustainability as a whole must also be rated as uncertain. This conclusion is reinforced by: (i) general sectoral uncertainty caused by the delay in passing the Omnibus Bill (para. 23); (ii) the recent depreciation of the peso; and (iii) implementation delays in NPC's other Bank-financed projects. E. BANK PERFORMANCE 30. Identification and Preparation. Bank performance in project identification and preparation was satisfactory. The Loan provided an opportunity for a positive demonstration of the Bank's support for a Borrower experiencing financial and institutional difficulties, and needing to respond rapidly to a crisis situation. Specifically, it was designed to ensure that NPC had the capability to respond to the "fast track" initiatives by private sector BOT and BTO proponents to restore power as quickly as possible, since commercial loans are typically not available for transmission or rehabilitation work. Considerable Without performing a detailed optimization analysis, it cannot be ruled out that investments which contribute to the high reserve margin, both presently and in the future, may detrimentally impact the specific economic viability of this Project (Footnote 6), in addition to affecting the Corporation's finances.  -9 - flexibility was built into the project description to facilitate changes in the project design in response to inconstant crisis conditions. The project scope was also directed at ensuring NPC's financial viability, strengthening its institutional capacity, and initiating a wide range of reforms in the energy sector through agreement with the Government on the ESP, not just in meeting the immediate needs caused by the power crisis. 31. Appraisal. Bank performance in appraising the Project is rated deficient. However, the provision for retroactive financing enabled NPC to complete urgent transmission works prior to loan signing, although some of the originally planned sub-projects were financed by other sources because of the delay in signing. Furthermore, the Bank's commitment to assist NPC in restructuring its tariffs and strengthening its institutional capacity was laudable. Nevertheless, the assessment of NPC's financial situation and the sensitivity analysis of the Project's IRR had limitations. In the period between the appraisal mission and presentation of the Project to the Board, which lasted around 9 months due to the stringent conditions attached to Board presentation, the Bank placed a clear emphasis on NPC's financial difficulties (para. 37) and pointed out the expensive nature of the "fast track" generation plants. For instance, the appraisal mission had noted that, while appreciating the Government's concern about the deteriorating power situation and anxiety to safeguard the country's economy, it would have been prudent to perform a critical review of some of the less economical power plants being procured, as these plants could cause a serious drain on NPC's already stretched financial resources. The SAR also noted that, in the future, a proliferation of BOT contracts under take-or-pay conditions might result in complex dispatch problems and difficulties in allocating the reserve and spinning costs of capacity. Yet, by the time of Board presentation, the improvements to NPC's income stream through tariff increases and adjustments (para. 13), were considered sufficient to relieve NPC's situation. 32. The only risk identified in the SAR with respect to NPC's finances was that base tariffs might not be increased sufficiently further in the future. However, this risk was considered to be mitigated by ERB's prior endorsement of the principles behind NPC's revised tariff structure, and because the new administration in the Philippines was seen as having targeted energy problems as a top priority. The potential impact of a more competitive generation environment on NPC's market share and financial position was not considered, neither was it contemplated that, as a consequence, NPC would ever willingly file for a rate reduction as opposed to a rate increase (para. 24). Furthermore, it was not until the SAR for the Transmission Grid Reinforcement project that the Bank placed appropriate emphasis on the poor quality of NPC's equity (which consists largely of appraisal surplus), highlighting that the Corporation's financial constraints derive from its balance sheet rather than from its income statement. In other words, the Project focused mainly on securing NPC's revenue through automatically-adjusting tariffs, whereas greater effort was also needed to augment its level of equity. 33. At Board presentation the concern was raised that the IRR presented in the SAR was relatively low, suggesting problems with productivity in the power sector. In addition, a question was posed regarding the IRR's sensitivity to assumptions regarding tariff rates, and whether other sensitivity factors had been examined. For instance, although implementation delays had been identified in the SAR as a risk, the sensitivity of the IRR to this factor was not examined. The response was that the IRR was 12 The SAR's Annex 15 did present a calculation of the IRR based on the existing tariff of P1.66/kWh (para. 18). This resulted in a reduction of the IRR from 11 percent to I percent when ignoring avoided costs, and from 136 percent to 7 percent when including avoided costs, or correcting for the omission of transmission losses (para. 18), from 6.5 percent to negative 2 percent, and from 92 percent to positive 2 percent, respectively. However, this analysis was not discussed in the main body of the SAR, and the highly sensitive aspect of the IRR was not highlighted.  - 10- acceptable given the emergency circumstances under which the Project was to be executed, and that when losses to the economy due to frequent power outages were taken into account, the IRR was considerably higher (para. 18). Yet, even accounting for the benefits of negating the outages, based on the assumptions presented in the SAR, the SAR's NPV is only positive because of sales subsequent to 2008 (i.e., after the end of the BOT contract cooperation periods, once the requirement to pay annual capacity fees has expired). Given the ongoing process of sector reform, by such a time, power sales wil.l be governed by a totally different market mechanism, making individual plant factors, NPC's market share and overall level of sales, very difficult to forecast.'3 In hindsight, the sensitivity of the IRR to highly uncertain factors, in particular future plant factors, should have been investigated in the SAR. 34. Supervision. Bank performance during supervision was generally satisfactory, although it might be argued otherwise since there were only two formal implementation review missions. However, supervision of the Project needs to be assessed in the context of the related missions for supervision of the Leyte projects, and for project preparation and appraisal of the Transmission Grid Reinforcement project. Issues raised in this context led to the funding under the Project of studies on economic dispatch and open access transmission tariffs (Table 7). Moreover, NPC's financial problems were diagnosed more accurately as part of the appraisal for the Transmission Grid Reinforcement project. Finally, the presence of a local procurement specialist at the resident mission in the early stages of the Project was beneficial. F. BORROWER PERFORMANCE 35. Preparation. NPC's performance during preparation of the Project was satisfactory. NPC was highly committed to the Project and acted to meet all the Bank's conditions of Board presentation and loan effectiveness. The delays in this respect were in part due to a Supreme Court injunction against the rate increase approved by NPC's Board, and the subsequent time taken by ERB to reapprove this increase and other automatic tariff adjustments. 36. Implementation. NPC's performance during implementation of the Project was satisfactory. Physical implementation was marked by many contracts being completed early (Table 5) and under the cost estimates. However, in one case NPC failed to comply with the Bank's procurement guidelines, which resulted in the denial of contract funding. The loan closure date was extended to accommodate the completion of contracts to supply communications equipment and to develop model transmission service contracts. However, this extension was mainly required because these components were more closely related to the scope and timetable of the later Transmission Grid Reinforcement project. NPC took action with regard to the majority of recommendations contained in the institution-building consultancy studies, although some of the recommendations in the EOIS were put on hold pending the outcome of NPC's ongoing restructuring process (para. 15). NPC also worked closely with the Bank to restructure its tariffs. Compliance with financial covenants was not attained in every year and the financial objective of the Project was not achieved (para. 13). However, as is discussed in Section C, a number of the factors contributing to this result were outside of NPC's direct control during the project period. 13 Although it cannot be ruled out that the later investments which displace the "fast track" plants in the merit order were suboptimal, and hence unfairly affect the re-evaluation of the economic viability of the Project (Footnote 6), it was recognized in the SAR that significant additions of base-load geothermal and coal-fired plant were already programmed by NPC.  - 11 - G. ASSESSMENT OF OUTCOME 37. The overall outcome of the Project is rated unsatisfactory. The reason for the unsatisfactory rating is twofold: (i) NPC has maintained its precarious financial situation over the Project period, and hence the objective of ensuring NPC's financial viability has not been achieved; and (ii) the high cost of meeting the Project's physical objective was a contributing factor to this situation, and consequently a recalculation of the Project's NPV results in a negative value (para. 19). The importance of the Project's financial objective is evidenced by the stringent conditions relating NPC's finances which had to be met prior to Board presentation (para. 9). NPC's financial viability was seen as critical, since the Corporation's financial problems were considered to be one the key contributing factors leading to the power crisis in the first place (para. 2). Hence, ensuring the sustainability of the Project's short term physical objective, to resolve the immediate needs of the power crisis, was dependent on also achieving the longer term financial objective.'4 38. Nevertheless, this outcome must be qualified by noting that: (i) the physical objective to alleviate the power crisis was substantially achieved; (ii) the magnitude of the power crisis may have been such that the avoided cost of outages was substantially higher than the assessment in the SAR, hence the Project may have resulted in a significant net benefit in macroeconomic terms; and (iii) in meeting the Project's physical objective, the implementation performance of NPC was satisfactory. Many of the factors leading to both the Project's poor economic return and the perpetuation of NPC's precarious financial situation were as a consequence of decisions made by the Government and NPC prior to the Project's inception. To a large extent these factors constrained NPC's possible response to the power crisis. H. FUTURE OPERATION 39. The Bank's 1994 Power Sector Study (Report 13313-PH) and 1997 Energy Strategy and Pricing Study (Report 16605-PH) have built on the ESP by providing the strategic framework for restructuring and privatizing the power sector, and NPC in particular. More specifically, the covenants of the Transmission Grid Reinforcement loan include the requirement for the separation of NPC's transmission activities as a separate corporate entity, and provide a framework of procedures, under a Transmission Grid Code, for implementing optimal generation dispatch. This loan also includes a large technical assistance component (co-financed by ADB) for NPC to build on the institutional support provided by the Project, and a PHRD grant to ERB to strengthen its capacity to evaluate transmission charges and related dispatch issues. Nevertheless, NPC's precarious financial situation, the slow pace of sector reform and the fragmented nature of the distribution sector, continue to be major areas of concern. The Bank will continue to monitor NPC's finances through ongoing supervision of the Leyte projects and the Transmission Grid Reinforcement project. However, a resolution of these outstanding issues still requires a concerted effort by DOF, DOE, NPC, PNOC-EDC and the National Electrification Administration (NEA), with coordinated assistance from both the Bank and ADB. 14 At the time, the Region indicated that, if the changes to NPC's tariffs specified as conditions for Board presentation were not approved, then further processing of this Loan and subsequent loans to the power sector would be stopped.  - 12 - I. KEY LESSONS LEARNED 40. The stringent conditions of Board presentation relating to the Project's financial objective, which resulted in presentation delays in the face of a crisis, suggest that the resolution of short term problems was not to be at the expense of the long term financial viability of the Philippine power sector's key player. However, because the IPP arrangements associated with the Project were developed under crisis conditions, they came at a high cost. This has been a contributing factor to the failure of this Project to meet its financial objective and has detrimentally affected the Project's economic rate of return. Such an outcome indicates the need to clearly identify potential interactions between project objectives, and highlights the pitfalls in not conducting sufficient sensitivity analyses of a project's economic rate of return, particularly in a sector undergoing major structural reform. Further, return on rate base (RORB) and debt service ratio (DSR) financial covenants are not in themselves sufficient indicators of a public utility's financial resiliency. Had NPC actually met the covenants in every year of the Project, this would have masked the actual precariousness of the Corporation's financial position.  - 13 - IMPLEMENTATION COMPLETION REPORT PHILIPPINES POWER TRANSMISSION AND REHABILITATION PROJECT (Loan 3626-PH) PART II: STATISTICAL ANNEXES Table 1: Summary of Assessment A. Achievement of objectives Substantial Partial Negligible Not applicable (0 (' (' (' Macroeconomic policies Q O 0 E Sector policies 0 0 0 Financial objectives Q O 0 Institutional development QE 0 0 Physical objectives 3 0 0 0 Poverty reduction E 0 0 CD Gender concerns - o O O Other social objectives Q O 0 Q Environmental objectives Q O 0 E Public sector management Q O 0 O Private sector development o O O Economic benefits O