India - Andhra Pradesh Power Sector Restructuring Project

Document of The World Bank Report No. 18849 IN PROJECT APPRAISAL DOCUMENT ON A PROPOSED LOAN IN THE AMOUNT OF US$210 MILLION EQUIVALENT TO INDIA FOR A ANDHRA PRADESH POWER SECTOR RESTRUCTURING PROJECT IN SUPPORT OF THE FIRST PHASE OF THE ANDHRA PRADESH POWER SECTOR RESTRUCTURING PROGRAM January 25, 1999 Energy Sector Unit South Asia Region  CURRENCY EQUIVALENTS AND METRIC EQUIVALENTS Currency Unit = Indian Rupee US$ 1.00 = Rupee 42.30 Rupee Crore Rupee 10,000,000 1 Megawatt (MW) = 1,000 Kilowatts (kW) 1 Megawatt-hour 1000 Kilowatt-hours 1 Gigawatt-hour(GWh) = 1,000,000 Kilowatt-hours FISCAL YEAR April 1 - March 31 ABBREVIATIONS AND ACRONYMS APGENCO = Andhra Pradesh Power Generation Corporation APL = Adaptable Program Loan APTRANSCO = Transmission Corporation of Andhra Pradesh APSEB = Andhra Pradesh State Electricity Board BSES Bombay Suburban Electric Supply CAS Country Assistance Strategy CEM Country Economic Memorandum CIDA = Canadian International Development Agency DFID Department For International Development (UK) DISCOM Distribution Company ERR = Economic Rate of Return FRR Financial Rate of Return GOAP Government of Andhra Pradesh GOI Government of India GRIDCO Grid Corporation of Orissa IBRD International Bank for Reconstruction and Development iFC International Finance Corporation IPP Independent Power Producer JEXIM = Export and Import Bank of Japan NPV Net Present Value NTPC National Thermal Power Corporation OECF Overseas Economic Cooperation Fund of Japan PFC Power Finance Corporation PPIP = Program and Project Implementation Plan SAR Staff Appraisal Report SEB State Electricity Board SOE = Statement of Expenses USAID = United States Agency for International Development Vice President: Mieko Nishimizu Country Director: Edwin R. Lim Sector Manager: Alastair J. McKechnie Task Team Leader: Mohinder Gulati  INDIA ANDHRA PRADESH POWER SECTOR RESTRUCTURING PROGRAM FIRST ANDHRA PRADESH POWER SECTOR RESTRUCTURING PROJECT TABLE OF CONTENTS Page No. A. Program and Project Development Objective ................................................................. 3 Program development objective and key performance indicators .......................................................... 3 Project development objective and key performance indicators ............................................................. 4 B. Strategic Context ................................................................ 5 Sector-related CAS goal supported by the program ................................................................. 5 Main Sector issues and Government's strategy . ................................................................ 5 Sector issues to be addressed by the program and strategic choices ................................................... 8 Andhra Pradesh power sector restructuring program ................................................................. 9 Investment program ................................................................ 10 Key conditions for the loans ................................................................ 11 Key conditions for each of the subsequent APLs ................................................................ 11 C. Project Description Summary ................................................................ 13 Project components ................................................................. 13 Key policy and institutional reforms supported by the project ............................................................... 13 Benefits and target population ................................................................ 14 Institutional and implementation arrangements ................................................................ 14 D. Program and Project Rationale ................................................................ 16 Alternatives considered and reasons for rejection ................................................................ 16 Major related projects financed by the Bank and/or other development agencies ............................... 18 Lessons learned and reflected in proposed project design ................................................................ 18 Indications of borrower commitment and ownership ................................................................. 19 Value added of the Bank support in this project ................................................................ 20 E. Summary Program and Project Analyses ................................................................ 21 Economic assessment ................................................................ 21 Financial assessment ................................................................ 21 Transfer scheme ................................................................. 22 Financial projections ................................................................ 23 Impact on state finances ................................................................ 24 Risk factors ................................................................. 25 Technical assessment ................................................................ 25 Institutional assessment ................................................................ 26 Social assessment ................... 26 Environmental assessment.. 28 Participatory approach .28  F. Sustainability and Risks ............................... 29 Sustainability ............................... 29 Critical risks ............................... 30 Possible controversial aspects ............................... 32 G. Main Loan Conditions ............................... 32 Effectiveness conditions ............................... 32 Covenants .................................32 H. Long Term Support for the Program .............................. 34 I. Readiness for Implementation .............................. 34 J. Compliance with Bank Policies .............................. 34 ANNEXES Annex 1. Project Design Summary Annex 2. Detailed Project Description Annex 3. Estimated Project Costs Annex 4. Cost-Benefit Analysis Summary Annex 5. Summary of Financial Appraisal Annex 5.1 Summary of Historic and Projected Financial Performance of APSEB and its Successor Entities Annex 5.2 Net Cash Impact of Power Sector on State's Budget Annex 6. Procurement and Disbursement Arrangements Table A.1 Project Costs by Procurement Arrangements Table A.2 Consultant Selection Arrangements Table B.1 Thresholds for Procurement Methods and Prior Review Table B.2 SOE Limits Table C. Allocation of Loan Proceeds Annex 7. Project Processing Budget and Schedule Annex 8. Documents in Project File Annex 9. Statement of Loans and Credits Annex 10. Country at a Glance Annex 11. Supervision Plans Annex 12. Detailed Power Sector Policy Statement from the Government of Andhra Pradesh Annex 13. Executive Summary - Program and Project Implementation Plan Annex 14. Summary of the Proposed Subsequent Adaptable Program Loans Annex 15. Current status of private power projects in the State Annex 16. Terms of Reference of Institutional Strengthening Program Annex 17. Social Impact Assessment Study: Scope of Work Annex 18. Project Eligibility Criteria Annex 19. Major Related Projects Financed by the Bank and/or Other Development Agencies Annex 20. Fiscal Impact of Power Sector Reform Program Map: IBRD No. 30055 TASK TEAM: Bank staff who worked on the program and project include: M. Gulati (Task Leader); A. Ceyhan; S. Khosla; R. Sinha; B. Bhatia; S. Ahmed; N. Raman; K. Nyman; J. Plummer, S. Vani; P. Kochar; V. Scott; William B. Marke; S. Padmanabhan; I.U.B. Reddy and S. Kapoor. Consultants who worked on the project include: J. Barker; P. Meier; M.G. Ramachandran; and H. Salgo Peer Reviewers: R. Bates; P.Cordukes  Project Appraisal Document Page I INDIA Andhra Pradesh Power Sector Restructuring INDIA ANDHIRA PRADESH POWER SECTOR RESTRUCTURING PROGRAM FIRST ANDHRA POWER SECTOR RESTRUCTURING PROJECT Project Appraisal Document South Asia Region Date: January 25,1999 Task Team Leader: Mohinder Gulati Country Director: Edwin R. Lim Sector Manager: Alastair J. McKechnie Project ID: IN-PE-49537 Sector: Power Program Objective Category: PSDI Lending Instrument: Adaptable Program Loan Program of Targeted Intervention: []Yes [x] No Program Financing Data FY 1999 - 2009__________________ Indicative Financing Plan Estimated Implementation APL (Sector Investment Program) Period Borrower _ _ _ _ _ _ _ _ _ _ _ ____ ______ _____ _____ ______ _ _ _ _ _ _ _ _ _ _(B an k FY ) _ _ _ _ _ IBRD Others Total Commitment Closing Date ___________ ____________ ~~ ~~~Date _ _ _ _ _ _ _ _ _ _ _ _ US$ million Av. % US$ Million US$ Million APL 1 L'oan 21 3 66 576 February 1999 February 2003 Govern- ment of India APL 2 L'oa'n 10O0 3'5 188 288 March 2000 2003-04 TBD APL 3 Loan 250 26 697 94 2000-01 2005-06 TBD APL 4 Loan 250 21 961 1,211 2002-03 2007-08 TBD APL I Loa6n" 190 '1,3 1,248 1,438 '2004-05 2008--09 TBD"-" Total I 1,000 22 -3,4601 4,460 _ _ _ _ _ _ _ __ _ _ _ _ _ _ _ _ _ Notes: 1. Ongoing investments amounting to US$933 million over the period FY99 to FY04 (US$693 million for FY99 to FY02) have not been included in the program. 2. Partial risk guarantee operations may also be considered as separate operations outside the APL framework. 3. Loan amounts for APL 2 to APL 5 are indicative only, and will be determined during project implementation.  Project Appraisal Document Page 2 INDIA Andhra Pradesh Power Sector Restructuring Project Financing Data IX] Loan [ Credit [I Guarantee ] Other Amount (US$ million): 210 Proposed Terms: [] Multi currency [ [X] Single currency Grace period (years): 5 [ Standard Variable [ Fixed [X] LIBOR-based Years to maturity: 20 Commitment fee: 0.75% less any waiver Up front fee: 1% of loan amount less any waiver Service charge: Nil Financing plan (USS million: Local Foreign Total (current $) Bank Project Government of Andhra Pradesh 67 0 67 IBRD 63 147 210 DFID 4 19 23 CIDA 1 2 3 TOTAL 135 168 303 OTHER NEW SCHEMES Government of Andhra Pradesh 61 0 61 PFC 20 8 28 REC 50 20 70 DFID) 19 28 47 Others 67 0 67 TOTAL 217 56 273 GRAND TOTAL 352 224 576 Memo Item Ongoing Investments Generation 85 127 212 Transmission 72 72 144 Distribution 65 73 138 Add: IDC 199 0 199 TOTAL 272 693 FINANCING Government of Andhra Pradesh 253 53 306 OECF 67 157 224 DFID 4 9 13 IBRD (Cyclone Reconstruction) 7 15 22 Others 90 38 128 TOTAL 421 272 693 Borrower: Government of India Guarantor: N/A Responsible agency(ies): APTRANSCO, APGENCO, distribution companies when created Estimated disbursements (Bank FY/US$ million): 1999 2000 2001 2002 Annual 22 75 80 33 Cumulative 22 97 177 210 Project Implementation Period: 48 months Expected effectiveness date: March 1, 1999 Expected closing date: February 28, 2003  Project Appraisal Document Page 3 INDIA Andhra Pradesh Power Sector Restructurng A. Program and Project Development Objetive 1. Program development objective and key performanc- idi cators (see Annex 1) Development expenditure in Andhra Pradesh has been crowded out in the last 15 years by costly and poorly targeted subsidies, by a rapidly expanding civil service and by interest payments. As a result, critical public spending on social development and on the maintenance of the essential irrigation and road networks has fallen far short of the state's needs. Power sector development has not kept up with demand and constrains economic activity and burdens the state finances. These are some of the major reasons for the low level of social development in the state, the high incidence of poverty and the relatively slow rate of economic growth. Most social development indicators in Andhra Pradesh are below the national average. Infant mortality rate is 73 per thousand of births. Population below the poverty line is alrnost 30 percent. Malnutrition among children aged 0-6 years is estimated at about 30 percent. The literacy rate is only 44 percent, significantly lower than the national average. At 33 percent, the female literacy rate is one of the country's lowest. The poor health and educational status of the population is largely explained by declining budgetary allocations for these services. From FYI 987 to FY1 998, total combined public expenditure on health and education declined from 4.7 percent of state's gross domestic product to 3.6 percent. Power subsidies have increased steadily and reached 1.6 percent of GSDP and 46 percent of the fiscal deficit of the state. The Government of Andhra Pradesh is aware of these issues and has launched a comprehensive program of economic and structural reforms to address them, to accelerate economic growth in the state and to increase the capacity to finance much-needed human development in the longer term. Power sector reform is the focus of the proposed Andhra Pradesh Power Sector Restructuring Program. A parallel operation, the Andhra Pradesh Economic Restructuring Project (APERP, for which Ln. 4360 and Cr. 3103-IN were approved on June 25, 1998) provides resources to meet immediate priority needs in human development (nutrition, primary health and primary education) and in the maintenance of economic assets affecting the rural poor (irrigation, rural roads and core access roads). These investments are linked to a program of fiscal reforms aimed at bringing about a permanent shift in public expenditure and debt. The proposed Andhra Pradesh Power Sector Restructuring Program has two directly inter-linked development objectives: * The reform of the power sector is the single most important element of structural and fiscal reform in Andhra Pradesh. The underlying broader development objective of the Andhra Pradesh Power Sector Restructuring Program is to bring about a permanent shift in public expenditure in the power sector, from a major drain on the budget to a contributor of funds for social sectors and other priority areas for public investment. This fiscal dimension links the Program to the broader APERP. Taken together, APERP and the proposed Andhra Pradesh Power Sector Restructuring Program would make a major contribution to modernizing the state's infrastructure and social sectors, and they would be fundamental to the restructuring of the state's finances and for the acceleration of economic growth and longer term human development. * Andhra Pradesh's power sector has deteriorated in the past several years and is now in a critical physical and financial situation, which constrains the economic growth of the state and affects the welfare of its population. The power sector-specific development objective of the Andhra Pradesh Power Sector Restructuring Program is to ensure that, by FY2007 the energy requirements of the state are met, and that consumers are provided with reliable, high-quality and cost-effective electricity supply by creditworthy and commercially-operated power utilities, functioning in a competitive and appropriately regulated power market, with significant private ownership and participation.  Project Appraisal Document Page 4 INDIA Andhra F'radesh Power Sector Restructurng Key Program Performance Indicators FY 1999 FY 2002 FY 2007 Energy (deficit)! surplus (percent) (8) (1 1) 4 Per capita consumption (kWh) 410 640 l 890 Access rate (percent population connected) 50 55 >62 ___ _ .. __ . . . . ........... ....... _ . ...... ... ... . . .... . . . . ... .. . . . , ..... ................~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~.... ........ Transmission and distribution losses (percent) - Technical 18.2 16.9 14.7 ~~~~~~~~~~~~~- ......................................... .. ... . ..... ............. . .... .... ..... = Non-Technical 14.5 9.5 3.0 Private sector participation (percent) in - Generation a/ 6 12 35 - Distribution b. 0 >30 90-100 Return on Equity (percent) ....... ..... .-- .10 -....................... ... . .. - APGENCO (64) 16 16 - APTRANSCO (64) 16 16 Contribution to Capital Investments (percent) - APGENCO 9 20 32 ..... .. .................... .I .. . ..... . .. . - APTRANSCO 9 20 32 ...... . ....... ........... ... ......P... Subsidies as percent of revenue from sale of electricity 35 1 1 0 (percent) . Contribution of the power sector to the state's budget (400) (192) 204 (US$ Million) - cash plus adjustments _______ _____________ a! This percentage represents the share of private sector in total installed power generation capacity available to Andhra Pradesh. b/ This percentage represents the share of private sector in the total distribution business. The private sector is defined as private investors holding majority equity stake, management control, and obligation to bring risk capital and financing for investments. c/ This figure pertains to FY 2000 and not to FY 1999 since in FY 99 all losses are set off in balance sheet restructuring against GOAP loans. d/ In the last three years the government had to contribute, on average, about US$ 500 million every year to APSEB through cash subsidy and write-offs of government loans. This development objective will be achieved with steady progress over an agreed 10-year program including the following phases: Phase I Establishment of a new legal, regulatory and institutional framework, functional unbundling of the system, corporatization of sector entities, and removal of some of the most critical bottlenecks of the power system (1999-2001). Phase I Regulatory Commission and the corporate entities fully functional, privatization of part of the distribution business, partial restoration of creditworthiness of the sector, and improvements in system efficiency (2001-2003). Phase l/l Completion of privatization of distribution business, consolidation of the functioning and financial performance of the new power utilities (2003-2005). Phase IV Achievement of higher customer satisfaction through reduction of power deficit, attainment of higher quality and efficiency in electricity services, and deepening of power sector reforms to increase competition and private participation (2005-2007).  Project Appraisal Document Page 5 INDIA Andhra Pradesh Power Sector Restructuring 2. Project development objective and key performance indicators (see Annex 1) The development objective of the First Andhra Pradesh Power Sector Restructuring Project is to initiate the reform process by establishing the new legal, regulatory, institutional framework, and industry structure, (including the establishment of an independent Regulatory Commission, creation of the new power corporations, and initiation of preparatory work for privatization of the distribution business), and removing some of the critical bottlenecks of the power system. The reform of the power sector is the single most important element of structural and fiscal reform in Andhra Pradesh. This fiscal dimension links the Project to the broader parallel APERP. Key Performance Milestones Completion Date Reform legislation made effective January 1999 Regulatory Commission established at April 1999 Restructuring measures effected, and new power and utilities established Transmission and Generation companies January 1999 Distribution companies September 2000 Licenses, where appropriate, issued. September 2000 Financial Restructuring Plan APSEB's assets and liabilities restructured and transferred to APSEB's January 1999 successors. Financial support to APSEB's successors provided by the Government as per During FY1999-2003 the Plan Financial restructuring plan negotiated and agreed between Andhra Pradesh September 1999 and APSEB's creditors Tariff adjusted, at a minimum, to meet the financial targets. Every year before March a/ The Regulatory Commission will be considered as established when the Government of Andhra Pradesh has issued a Notification of establishment as per the Andhra Pradesh Electricity Reform Act, and the Commission Members have been appointed and have taken their oath. B. Strategic Context 1. Sector-related CAS goal supported by the program (see Annex 1) The proposed Program, together with the ongoing APERP, would support a key objective of the CAS, which is to focus Bank resources on states that have embarked on a comprehensive program of economic and structural reforms. Andhra Pradesh is the first of these programs, supporting a state which is not only among the poorest in India but which has emerged as one of the leading reforming states in the past three years. Its efforts are attracting increasing international attention and support. The sector-related strategic objective stated in the CAS is to reduce power infrastructure bottlenecks by inter-alia promoting and implementing comprehensive state power sector reforms. The promotion of sector reforms at the state level will contribute to improvement in state finances, build institutional capability of power utilities and increase resource mobilization for public and private infrastructure investment, and by reducing pressures on the state's public finances and removing sectoral constraints to the state's economic growth, facilitate sustainable poverty reduction - India: Country Assistance Strategy, Report 17241-IN, dated December 19, 1997 presented to the Board of Executive Directors on January 15, 1998. 2. Main sector issues and Government's strategy India's Power Industry. India's power industry is characterized by inadequate and inefficient power supply. Peak capacity and energy supply shortages are estimated to be over 20 percent and 10 percent respectively and are expected to grow in the years ahead due to insufficient investments in the first half of  Project Appraisal Document Page 6 INDIA Andhra Pradesh Power Sector Restructuring the 1990s and the sector's continuing inability to implement investment plans that would be required to close the power gap. Plant availability and efficiency are generally low, and system losses are high throughout India's power transmission and distribution networks. Low tariffs, heavy cross-subsidies, poor collection performance and outright theft, combined with increasingly tight state budgetary resources, have constrained supply expansion and investment in upgradation of transmission and distribution system. The financial performance of the sector as a whole is unsatisfactory, with low or no returns and no contribution to investment from internal resources. Commercial losses o1 the State Electricity Boards (SEBs) have reached the equivalent of about US$3 billion or about 1 percent of India's GDP. In 1991, in an effort to mobilize resources for generation capacity expansion, the Government of India (GOI) opened power generation to private sector investments. However, private investments have not been readily forthcoming without assurances of guarantees from the Government of India. It has since become evident that in the absence of major structural and regulatory reforms in the power sector at the state level, which would enhance the financial viability of the sector, it would be difficult to mobilize the resources to support investment needs of the sector. Accordingly, the Government of India, with the assistance of the Bank, has been encouraging states to undertake comprehensive power sector reforms. India's state governments have clearly acknowledged the problems with state-run utilities in such national forums as the Power Ministers' Conferences and a few states, including Andhra Pradesh, have initiated comprehensive reform program. Recognizing that actual investments remain constrained by the lack of creditworthiness of the client SEBs, the Government of India encourages the states to adjust their power tariffs and improve the performance of state utilities and advocates sectoral reforms through national initiatives. (Documented in the recent Country Economic Memorandum, the Economic Sector Work report on "India: Energy Sector Issues and Options", Bank's appraisal documents for Orissa Power Sector Restructuring Project, Haryana Power Sector Restructuring Project, and Second POWERGRID System Development Project). Other government initiatives include the promotion of private sector mega-power projects. Increasing attention is also being paid to exploring possibilities to import power from neighboring countries, from export-oriented hydro projects and temporary power surpluses. Recently the Government of India has also announced a new hydropower development policy to attract private financing and has delegated clearance authority, up to defined thresholds, to the states. The Government of India enacted an Electricity Regulatory Commission Act in July 1998. This Act provides for establishment of Central Electricity Regulatory Commission (CERC) and State Electricity Regulatory Commission(s) (SERC) at the national and state levels, in an attempt inter alia to depoliticize the tariff-setting process. The CERC has been established and the commissioners appointed. It is responsible for approval of tariff for central sector utilities, and tariff review/setting of multi-state Independent Power Producers (IPPs). India's power transmission and system operations are going through an extensive national restructuring program in parallel with state-level reforms. To encourage private investment in the transmission business, the Central Government enacted the Electricity Laws (Amendment) Act 1998, in August 1998. This Act provides for the establishment of a central transmission utility, state transmission utilities and transmission licensees and thereby facilitates private investment in power transmission. POWERGRID, India's national transmission utility (designated as the central transmission utility under the new Act), is developing modern system coordination and control facilities (including load dispatch systems for state utilities) and regional power pools. These facilities and the emerging regional electricity markets with availability-based bulk power tariffs and frequency-linked power pool rates will enable generators and utilities to improve the efficiency of system operations and trade power under scheduled and unscheduled interchange arrangements, supplementing power supplied under long-term Power Purchase Agreements (PPAs). Over time, POWERGRID plans to interconnect these regional systems towards a national power grid. POWERGRID is also involved in facilitating power imports from neighboring countries. Main Sector Issues in Andhra Pradesh. Andhra Pradesh's power sector has deteriorated in the past several years and is now in a critical physical and financial situation, which is threatening the economic growth of the state and the welfare of its population. The public power supply is met entirely by Andhra  Project Appraisal Document Page 7 INDIA Andhra Pradesh Power Sector Restructuring Pradesh State Electricity Board (APSEB) which is a vertically integrated, state-owned utility. Over the last ten years (FY1988 to FY1 998), Andhra Pradesh has added about 3,362 MW of capacity to its system, which currently consists of 2980 MW of thermal capacity and 2657 MW of hydro capacity. However, this has not been adequate and energy shortage in the state has grown from about 5 percent in 1988 to about 13 percent in 1998. From a "no shortage" situation in 1985, its peaking shortage has grown to reach a level in excess of 23 percent. Technical and non-technical losses are estimated at a minimum of 33 percent of available energy. APSEB's financial losses, without subsidy from the state, increased rapidly and are in excess of Rs. 10 billion in FY 1998. The accumulated commercial losses (excluding state's subsidies) as on March 31, 1998 are Rs. 39 billion (US$900 million) as compared to the state government's cumulative investment in equity and subordinate loans of Rs. 36 billion. In 1996 and 1997 power subsidies amounted to 1.3 percent and 1.6 percent of GSDP and over 39 percent and 46 percent respectively of the fiscal deficit of the state in these two years. Given the deterioration of its fiscal situation and determination to shift public expenditure towards social sectors, it is no longer possible for the Government to fund APSEB's losses and support the development of the power sector. Substantial expansion of supply through private power producers is also not possible without restoring sufficiently the creditworthiness of energy off-takers. This deterioration in APSEB's financial situation, among other reasons, is largely due to high distribution losses and non-remunerative tariffs charged to agricultural customers. The tariff for supply to agriculture was converted to a flat rate and brought down to Rs. 50/hp/annum in 1983. In the same year, the consumption of electricity by agriculture was reported to have increased by about 50 percent. APSEB's present stated sales of 38 percent to agriculture, in the absence of consumer metering, are at best only an estimate. Its revenue of about Rs. 0.19/kWh' from agriculture, charged on the basis of flat rate for connected load, is therefore not a realistic indicator of the price paid by the farmer. Not only the actual average tariff paid by the farmers is higher than Rs. 0.1 9/kWh due to over-estimation of quantity sold to farmers they also have to bear additional cost of repairing the motors which burn frequently due to low voltages, cost of alternative sources of irrigation, and loss of crop productivity due to inadequate power 2 supply . This difference between APSEB's estimated average agricultural tariff and the cost actually borne by the farmer creates a perception gap between the farmers and the utility, accentuating the political difficulty in adjusting the agricultural tariffs. If agricultural supply was metered and quality of supply improved, it may provide incentives to the farmers to use electricity more efficiently and reduce the cost of power in agricultural production in the state. However, Andhra Pradesh cannot afford to continue to supply power to agriculture at such heavily subsidized rates. It has to start adjusting agricultural tariffs, installing meters and charging metered tariff to provide farmers an incentive for efficient use of electricity as well as improve efficiency in use of groundwater pumped through electric pumps for irrigation. Causes. The root cause of this crisis - now largely recognized and accepted by Andhra Pradesh's policymakers - is the pervasive politicization of most decisions affecting APSEB's operations and expansion, and the resulting lack of a commercial orientation in its functioning. This has led to evolution of an organizational culture that does not promote accountability or provide incentives to the managers and staff for performance. The state has exerted influence over APSEB's tariff, operational, personnel, and investment decisions to further its political objectives. As a consequence, APSEB has been directed to charge low tariffs to agriculture and residential consumers, and to undertake or continue unremunerative activities under the instructions of the state government without proper compensation. APSEB has not been able to enforce effective remedies to collect bills and to take bold measures to eliminate the large system non-technical losses. While theoretically possible, it is very difficult to introduce, in the public sector at the state level in India, the required management and operational autonomy and performance incentives, that are essential to successfully address the fundamental issues in power distribution in India. i ' The average revenue of Rs. 0.19 /kWh is calculated by dividing the revenue from the agricultural sector by the estimated quantity of sales. Since the quantity of energy sold is overestimated to account for losses, the actual sales to the agricultural sector are lower, and therefore actual average tariff paid by the agriculture would be higher than Rs. 0.19 /kWh. 2 A Bank funded study for estimating the use of electricity by agriculture in Andhra is currently underway and would lend additional insights into actual cost borne by the farmers.  Project Appraisal Document Page 8 INDIA Andhra Pradesh Power Sector Restructuring Challenge and Government Strategy. The demand for power in the next ten years is expected to grow at a compounded annual growth rate of 7.5 percent. Preliminary and rough estimates indicate that Andhra Pradesh's economy has lost more than Rs. 110 billion in the five years ending FY98 on account of "unserved energy" (assuming the cost of unserved energy at a conservative rate of US12 cents/kWh used by CEA). The major brunt of power shortages are borne by industry. Eliminating the power deficit and meeting this potential demand - through supply and end-use efficiency improvements - require additional capacity of about 7,500 MW in the next five years. This translates into an investment of about US$7 billion in generation and about US$5 billion to rehabilitate and augment APSEB's transmission and distribution system. This level of investment is clearly not financible in the public sector. Andhra Pradesh already has two IPPs, approximately 425 MW, in its system. The security structure for these projects includes Letter of Credit payments, escrow accounts, and state guarantees. One of the two projects also has a Government of India counter-guarantee. A third project (1,040 MW), also with a Government of India counter-guarantee, is approaching financial closure. APSEB has under consideration a number of other IPPs (Annex 15) at various stages of negotiation and development. One of these, Kondapalli (355 MW) has recently reached financial closure with the assistance of the Commonwealth Development Corporation (CDC). However, counter-guarantees from the Government of India are no longer available. Further investment from IPPs, of the scale required, will not materialize in the absence of creditworthy energy off-takers. Payments to existing IPPs will lead to further deterioration of APTRANSCO's finances if the financial viability of the sector is not restored. This is the challenge that Andhra Pradesh's political leaders have decided to address. Andhra Pradesh's long-term vision is a financially healthy sector procuring enough power from NTPC, IPPs and state sector companies; power utilities focusing on their clients' needs and providing high quality services to their customers and having an incentive system in place that rewards efficiency and performance; and the Government no longer needing to provide subsidies, loans and guarantees and actually deriving a net income from the power sector. The Government of Andhra Pradesh has concluded that the state's power requirements cannot be met without a massive mobilization of private financing, restoration of the creditworthiness of the power utilities, and the establishment of a regulatory framework, which would insulate the power sector from external influences, balance interest of various stake holders and provide appropriate incentives for efficiency. The ultimate objective of the reforms initiated by Andhra Pradesh is for the Government to withdraw from the power sector as an operator and regulator of utilities and to have commercially operated, largely privately owned utilities functioning in a competitive and appropriately regulated power market. To realize this objective, the Government of Andhra Pradesh has launched an ambitious program for restructuring and reforming its power sector, complex and challenging by itself but made even more ambitious by the inter-linked objective to use power sector reform as a critical most important element of structural and fiscal reform in Andhra Pradesh. 3. Sector issues to be addressed by the program and strategic choices The Andhra Power Sector Restructuring Program is designed to address the above issues. In shaping the strategy that underpins this program, Andhra Pradesh has made a number of strategic choices relating to the structure, regulation, and ownership of the power industry, and the implementation approach. a. Structure. Andhra Pradesh has decided to unbundle its power utility (APSEB) into separate generation, transmission and distribution functions. The new structure of the industry is expected to facilitate: (i) functional separation; (ii) private participation and ownership in various activities of the sector; (iii) efficient regulation of the sector; (iv) transparency, autonomy and accountability in the governance of the sector; and (v) in the long term, increasing competition in all segments of the power industry. b. Independent regulation. Andhra Pradesh has decided to provide for independent and autonomous regulation of the sector to reduce the interference of the state government; minimize  Project Appraisal Document Page 9 INDIA Andhra Pradesh Power Sector Restructuring the politicization of key sector decisions (for example on tariffs), bring transparency into the regulatory process, and balance the interest of various stakeholders such as customers, government, investors, financiers and lenders, suppliers, employees, and people of Andhra Pradesh. The Commission's rules, regulations, tariff methodologies will be made public and well defined. Its processes shall be transparent and participative and shall encourage private risk capital in the distribution and generation business. This will ensure balancing of interests of different stakeholders. c. Privatization and private sector investment. Given the massive financing requirements, most of the new generation facilities would be possible only through private sector investments. Investments by central or regional utilities or leveraging of Andhra Pradesh's existing generation assets for capacity addition (for example through joint ventures, accessing market finance without state government budgetary or guarantee support) would also help bridge the gap. Andhra Pradesh has decided to privatize its distribution business since this appears to be the best, if not the only, solution to reduce the high non-technical losses which plague the sector and to improve the quality and reliability of power supply and customer service. In addition, Andhra Pradesh expects that in the longer term, private distributors would be able to finance the large required investments from commercial sources. d. Demand side management and energy efficiency. Andhra Pradesh is implementing a DSM program in two distribution districts, one with grant assistance by DFID and another with the assistance of OECF. An agricultural DSM project catalyzed by the Bank has been recently approved for grant funding by the Government of Norway under "Activities Implemented Jointly" (AIJ) program. Recent Bank studies indicate cost-effective opportunities to advance DSM and energy efficiency exist in Andhra Pradesh's urban and industrial sectors, in addition to agriculture. e. Phased and participatory approach in implementation. Andhra Pradesh's reform program is complex and ambitious and it is neither feasible nor desirable to have a precise implementation plan. The appropriate approach would be to allow it to evolve and retain flexibility in implementation strategy - hence a phased program of implementation. Andhra Pradesh has adopted the approach of building up consensus through a sustained communication program and consultation at different levels - political, consumer interest groups, civic society, industries and industry associations, employees and others. 4. Andhra Pradesh power sector restructuring program 4.1 Reform Program. Industry and Market Structure. Initially Andhra Pradesh State Electricity Board (APSEB) will be split into two companies: Andhra Pradesh Power Generation Corporation (APGENCO) for generation, and Transmission Corporation of Andhra Pradesh (APTRANSCO) for transmission, system operation, and distribution. Andhra Pradesh has announced that these companies will be established by the end of January 1999.Both the companies will be initially state-owned and at a later stage the state would list their shares in the stock market. APTRANSCO will subsequently transfer the distribution functions to a number of distribution companies expected to be established by early-year 2000. The distribution companies will initially be state-owned, but they will be privatized in the course of implementation of the reform program. APTRANSCO would enter into long-term power purchase agreements (PPAs) with APGENCO and IPPs. For new contracts with APTRANSCO (other than for the existing plants), APGENCO shall have to compete with IPPs for the market - and APTRANSCO will have to demonstrate to the Regulatory Commission that its purchases are economic and efficient. Following the establishment of separate distribution companies, APTRANSCO would become their bulk supplier. Over time, the distribution companies may also enter into direct power purchase agreements with generators and other bulk suppliers, and APTRANSCO increasingly focusing on transmission and system operations. The pace of movement from the "single-buyer" model (APTRANSCO contracting all power purchases) to "multi-buyer"  Project Appraisal Document Page 10 INDIA Andhra Pradesh Power Sector Restructuring model would be determined inter-alia by the Andhra Pradesh Electricity Regulatory Commission based on the experience and knowledge gained on the functioning of the restructured industry, efficiency and economy of power purchases, the potential for wholesale competition, and by the market, based on the creditworthiness of the contracting distributors. Under its transmission license, APTRANSCO will be expected to maintain separate accounts for its bulk supply and transmission services, which will provide a basis for future functional separation of power purchase and transmission system operation and move away from single buyer model. Well ahead of possible state-level multi-buyer markets, India is pursuing national bulk power tariff reforms and regional and inter-regional electricity trading, initiated under the ongoing POWERGRID System Development Project and to be supported under the proposed Second POWERGRID System Development Project. APTRANSCO will operate in the Southern region power pool and the emerging national power market and will represent Andhra Pradesh in the Southern Region Electricity Board (the governing body of the Southern region power pool). Legal and Regulatory Framework. A comprehensive reform legislation (the Andhra Pradesh Electricity Reform Bill) approved by the State Legislative Assembly on April 28, 1998, for the restructuring of the electricity industry and the establishment of the Andhra Pradesh Electricity Regulatory Commission received the President of India's assent on October 21, 1998. The Act was notified on October 29, 1998. Andhra Pradesh has announced that it will make the Act effective by January 1999, and establish APGENCO and APTRANSCO at the same time. By April 1999, Andhra Pradesh expects to establish the Regulatory Commission. The Commission shall issue appropriate regulation, licenses for transmission and distribution companies and set their tariffs through transparent and formal proceedings. Appeal against regulatory orders shall be to the Superior Courts and not to the Government. Privatization of Distribution. The distribution companies will be progressively privatized either through the sale of equity shares to strategic private investors or through other appropriate modes. Andhra Pradesh expects that the privatization of at least one/twc distribution companies (representing at least one-third of the total distribution business) will be accomplished by the end of FY2001 (an agreed milestone for APL 3) and distribution privatization is expected to be completed (an agreed milestone for APL 5) by FY2004 at the latest. However, it would not be surprising if the Government of Andhra Pradesh decided (as Orissa did in 1997) to advance these actions with growing confidence and support for power sector reform. 4.2. Investment program (see Annex 2 and 3 for more detailed description) Andhra Pradesh proposes to invest US$5.4 billion in generation (ongoing projects), transmission and distribution during the period FY1999 to FY2007, of which US$0.9 billion is on ongoing schemes. IPPs, central and regional power utilities, would carry out investment in generation. The proposed APLs would support, to the extent of US$1 billion, the investment program of US$4.5 billion that Andhra Pradesh's utilities would implement and focus on (during the Program Implementation period): a. The rehabilitation and expansion of the transmission system (indicative cost: US$1.4 billion). The objective of this component would be to: (i) expand the system to meet the growing load demand; (ii) ensure that the transmission losses and voltage regulation are within permissible limits; (iii) evacuate power from the proposed power plants and bulk supply points to the load centers; and (iv) ensure a high level of reliability of the transmission system. b. The rehabilitation and expansion of the sub-transmission and distribution system (indicative cost: US$3.0 billion). The objective would be to: (i) rehabilitate the system and achieve significant reduction in technical and non-technical losses; (ii) improve the voltage profile, system reliability and efficiency; (iii) reinforce the system to meet the growing demand; and (iv) improve customer service. IBRD financing would be available essentially during a transition period, until private distribution companies are in a position to finance, on their own, the expansion of the distribution network. If needed, IBRD financing from the APLs could be made available to the private distribution companies during the initial years of their operations.  Project Appraisal Document Page 11 INDIA Andhra Pradesh Power Sector Restructuring c. The implementation of demand-side management measures (indicative cost: US$50 million, included in the distribution investments in the Annex 3). The objective of this component would be to: (i) improve the end-use efficiency; (ii) minimize the consequences of the power deficit through rational load management and power curtailment and demand side management; and (iii) mitigate the impact of increasing retail tariffs. This component would include: (i) the procurement and installation of load research equipment; (ii) the implementation of specific load management and energy efficiency investments by the utilities and end-users (such as efficient motors and lighting equipment in industries, reactive power compensation improvement in industries, co-generation projects, or efficiency improvements in pumpsets); and (iii) fostering private sector provision of energy efficiency services. d. Technical assistance and engineering services to assist Andhra Pradesh power sector entities in implementing the reform measures and the investment program (indicative cost: US$32 million); and in addition, voluntary separation costs of employees, if needed, would be determined during project implementation and possibly financed through subsequent loans. In addition to APLs, the World Bank Group's support could also include the provision of guarantees to IPPs and the participation of IFC and/or MIGA in private power generation and/or distribution. Any such financing would be processed as separate operations. 4.3. Key conditions for the loans Andhra Pradesh's reform program is expected to be accomplished over a period of next eight to ten years. Some measures such as approval of the Reform Bill by the state legislature in April 1998, issuing of detailed policv statement in October 1998, and agreement and commitment on financial restructuring plan (issued on January 4, 1999), have already been accomplished and ensure that the reform process already enjoys a considerable degree of irreversibility. The pace and phasing of introducing the new industry and market structure, establishment of independent legal regulatory framework, distribution privatization, tariff reforms, and implementation of financial restructuring are defined in the Program and Project Implementation Plan (PPIP) submitted by Andhra Pradesh (summary presented in Annex 13). This operation is proposed as an APL, and therefore, most of the agreements on policy and institutional changes, beyond what is achieved upfront, would not be set as dated covenants but as milestones for future Bank support through a series of APLs. At present, agricultural tariff in Andhra Pradesh is below Rs. 0.50/kWh - a minimum set under the Common Minimum National Action Plan for power. It is unlikely that in the short-term, under the current political situation the agricultural tariffs can be increased significantly when the supply situation is far from satisfactory. Once the Regulatory Commission comes into existence, the tariff setting would be depoliticized, and if the Government wishes to subsidize agricultural consumers beyond the tariffs set by the Regulatory Commission, it would have to be done through a transparent process of submissions during the tariff setting process and paid for through the budget. The Government of Andhra Pradesh will also list APGENCO and APTRANSCO on the stock exchange to enable them to tap international and domestic capital markets on competitive terms. Key conditions for each of the subsequent APLs are as follows (Annex 14.1 to 14.4) The Second APL (indicative amount of US$100 million) would be considered when: * Andhra Pradesh Electricity Reform Act has been notified and made effective ( partially fulfilled by notification of the Act); * Regulatory Commission is functional i.e., the Commission Members have been appointed; staff have been engaged under its own employment terms; adequate budgetary allocations have been made; its Regulations and Rules, including tariff procedures and methodology, have been notified and made effective; and an institutional development plan has been approved by the Commission members;  Project Appraisal Document Page 12 INDIA Andhra Pradesh Power Sector Restructuring * APGENCO and APTRANSCO have become operational i.e., assets and liabilities transferred, staff have been transferred and engaged under the companies' own terms and conditions of employment, licenses wherever appropriate have been issued by the Commission; * Distribution system has been reconfigured; distribution companies have been established and are operating under their own licenses obtained from the Regulatory Commission; DSM cells are established in APTRANSCO/Distribution Companies, as appropriate, to plan and execute load research, and energy efficiency programs; * New companies have made tariff submissions, to an extent not less than that indicated in the financial restructuring plan and satisfactory to the Bank, and the Regulatory Commission has issued the tariff orders; * The Government of Andhra Pradesh has entered into corporatization agreements, satisfactory to the Bank, with the new companies; * Updated PPIP has been endorsed and submitted by the Government; and * The Government of Andhra Pradesh has implemented measures and its commitments included in the financial restructuring plan. The Third APL (indicative amount US$250 million) would be considered when, in addition to the continued and satisfactory compliance with the agreements under APL 1 and APL 2: * At least one/two of the distribution companies3 (representing at least one third of the distribution system) have been converted into joint ventures with majority equity and management control transferred to the private sector. The Fourth APL (indicative amount US$250 million) would be considered, when in addition to the continued and satisfactory compliance with the agreements under APL 1, APL 2, and APL 3: * At least one/two additional distribution companies (representing a cumulative total of at least two thirds of the system) have been converted into joint ventures with majority equity and management control transferred to the private sector; and * APGENCO has listed its shares on the stock market. The Fifth APL (indicative amount US$190 million) would be considered when, in addition to the continued and satisfactory compliance with the agreements under APL 1, APL 2, APL 3, and APL 4: * Entire distribution business has been privatized. * APTRANSCO has listed its shares on the stock market. In addition to the above project-specific milestones, it is expected that before considering any loan (APL 2 to APL 5): * Andhra Pradesh's power sector functions along the principles underlying the Reform Program as stated in Andhra Pradesh's Power Sector Policy Statement. 3 Andhra Pradesh's Distribution system may be configured into several companies, say three to five, for which analytical work is underway.  Project Appraisal Document Page 13 INDIA Andhra Pradesh Power Sector Restructuring * The Regulatory Commission operates in accordance with the Andhra Pradesh Electricity Reform Act. * Financial restructuring plan is under satisfactory implementation. * Companies have made tariff submissions, to an extent not less than that indicated in the financial restructuring plan and satisfactory to the Bank and the Regulatory Commission has issued the tariff orders. * Satisfactory updating of the PPIP and companies' business plans. * For any loan under execution: covenants are complied with, the Bank is not applying remedies, project implementation is satisfactory to the Bank, and procurement and disbursements are satisfactory to the Bank. Standard Bank conditions relating to investments shall apply to all the loans as follows: * The beneficiary entities have defined their priority investment and financing plans, prepared bidding documents and invited bids in accordance with Bank's guidelines for an amount considered satisfactory by the Bank, and - Environmental and social requirements are met as per Bank guidelines and policies. C. Project Description Summary 1. Project components (see Annex 2 for a detailed description and Annex 3 for a detailed cost breakdown) Component Category Cost Incl. Bank- Percent Bank- Contingenc financed financed ies (US$ M) (US$ M) (%/-) Transmission System Physical 70 25 57 81 Augmentation Sub-transmission & Physical 103 37 84 81 Distribution System Strengthening Metering System Physical 65 23 53 82 Improvement Unallocated Physical, 11 4 10 9-1 .... capacity building Technical Assistance Capacity Building 32 11 6 17 Totbl ________ 281 100 .21 . 7 Note: The cost includes physical and price contingencies but does not include interest during construction. 2. Key Policy and Institutional Reforms Supported by the Project Refer to section B. 4.1  Project Appraisal Document Page 14 INDIA Andhra Pradesh Power Sector Restructuring 3. Benefits and Target Population Benefits Target population . Improved quality of power in selected areas; . Customers where the quality of the power supplied improved service to the customers. is particularly poor (overloaded transmission or distribution systems). Improvement in quality of power and services to customers will therefore be more visible. . Increased availability of power through . Existing and new customers. reduction in transmission and distribution losses and upgradation of system. . Improved metering and billing. . APTRANSCO and Distribution companies; customers receive better service. . Demonstration of the beneficial impact of . Andhra Pradesh's population at large (impact reform leading to increased acceptance of, increasing over time). and support to the reform program.