Turkey - Turkish Electricity Authority (TEK) Restructuring Loan Project

Document of The World Bank FOR OFFICIAL USE ONLY A-/& 3 S' Jf-7-u Report No. 9385-TU STAFF APPRAISAL REPORT TURKEY TURKISH ELECTRICITY AUTHORITY (TEK) TEK RESTRUCTURING PROJECT MAY 21, 1991 Energy Operations Division Country Department I Europe, Middle East, and North Africa 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 Currency Unit = Turkish Lira (TL) US$1.00 TL 3704 (March 1991) TL 1.00 = US$0.000270 TL 1,000,000,000 = US$270,000 MEASURES AND EQUIVALENTS 1 Kilometer (km) = 1,000 meters (m) - 0.6214 mi]es (mi) 1 Meter (m) e 39.37 inches (in) 1 Kilocalorie (kcal) = 3.97 British Thermal Units (BTU) 1 Kilovolt (kV) = 1,000 Volts (V) 1 Kilovolt Ampere (kVA) = 1,000 Volt - Amperes (VA) 1 Megawatt (MW) = 1,000 kilowatts (KW)=l million Watts 1 Gigawatt-hour (GWh) = 1,000,000 Kilowatt-hours (kWh) ABBREVIATIONS AND ACRONYMS BOT - Build Operate Transfer CEAS - Cukurova Elektrik A.S. (Cukurova Power Company) CHF - Collective Housing Fund DM - Deutsche Mark DSI - Devlet Su Isleri (State Hydraulic Works) EC - European Community EIE - Electric Power Resources Survey Administration ESAL - Energy Sector Adjustment Loan FMIP - Financial Management Improvement Program GATT - General Agreements on Tariffs and Trade GOT - Government of Turkey ICB - International Competitive Bidding ICG - Internal Cash Generation KEPEZ - Kepez Electric Company LCB - Local Competitive Bidding LIB - Limited International Bidding LRMC - Long-Run Marginal Cost MENR - Ministry of Energy and Natural Resources MIS - Management Information System MUV - Unit Value Index nf Manufactured Exports Expressed in US$ Terms OMIP - Operational Management Improvement Program PEE - Public Economic Enterprise PPA - Public Participation Administration PSBR - Public Sector Borrowing Requirements SEE - State Economic Enterptise SEI - Southern Electric International SOE - Statement of Expenditure SPO - State Planning Organization TEK - Turkiye Electrik Kurumu (Turkish Electricity Authority) TRT - Television and Radio Tax VAT - Value Added Tax  FOR OFFICIAL USE ONLY TEK RESTRUCTURING PROJECT Table of Contents Page No. LOAN SUMMARY ................................................. (i) I. THE ENERGY SECTOR ............................................ 1 A. Background . 1 B. Response to the Oil Shocks ...................................... 2 C. Energy Sector Adjustment under ESAL ...................... 2 D. High Inflation and Recent Trends in Energy Sector Investments and Their Financing ........................ 5 E. Environment and the Increased Use of Natural Gas ......... 6 F. Impact of Long-Term Energy Policies ...................... 7 G. SEEs, TEK and the Economy ................................ 8 H. Bank Involvement in the Power Subsector .................. 10 I. Rationale for Bank Involvement ........................... 11 J. Experience with Bank Lending ............................. 11 K. The Bank's Medium-term Strategy for the Power Subsectir .............................................. 12 II. THE LEAST-COST POWER SUBSECTOR INVESTMENT PROGRAM AND ITS FINANCING ........................................... 12 A. Turkey's Electricity Balance ............................. 12 B. Least-Cost Investment Program in Power ................... 13 C. The Financing of the Least-Cost Investment Program (1990-94) ...................................... 16 III. TEK'S MEDIUM TERM CORPORATE RESTRUCTURING PROGRAM . ........... 17 A. Corporate Background and Recent Performance .... .......... 17 B. Reform of Electricity Pricing Policy ..................... 22 C. Reform of TEK's Management Practices ..................... 23 D. Restructuring of TEK's Capital and Debt .... .............. 26 E. Preparation of Long-Term Corporate Restructuring Options ................................................ 29 F. Strengthening Environmental Assessment Capacity .... ...... 31 G. Monitoring of the Corporate Restructuring Program .... .... 32 H. Results of the Restructuring Program ..... ....... ........ 35 This report was prepared by Messrs. A. Eguren (Task Manager), R. Sharma (Corporate Restructuring), V. Atur (Financial Analyst), and A. I'ocic (Power Engineer). Also contributed to this report J. Balkind (Economist), R. Taylor (Public Enterprise Reform), F. Batzella (Division Chief), David Baughman (Economist), and Mr. C. Denizer and Ms. D. Velasco (Research Assistantship). I 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.  IV. THE LOAN ................................... 36 A. Objectives of the Loan .36 B. Description of the Loan .................................. 36 C. Lending Arrangements .37 D. TEK's Investment Program and Financing Plan .37 E. Procurement .37 F. Disbursements .38 G. Audit of Annual Accounts and Special Account .38 V. ECONOMIC IMPACT OF THE RESTRUCTURING PROGRAM . .39 A. Impact of TEK's Corporate Reform Program .39 B. Economic Feasibility of the Investments .40 VI. AGREEMENTS REACHED AND RECOMMENDATION .41 ANNEXES 1. Implementation Time Table for Restructuring Program 2. Least-Cost Investment Program in the Power Sector 1990-99: Summary 3. TEK Actual and Forecast Income Statements, Balance Sheets, Forecast Cash Flow Statement and Financing Plan 4. Procurement and Disbursement Schedules 1991-95 5. Economic Rate of Return 6. List of Documents in Project File Map: IBRD 23018  (i) TURKEY TEK RESTRUCTURING PROJECT LQOAN SUMM Borrower: Turkish Electricity Authority (TEK) Guarantor: Republic of Turkey Amount: US$300 million equivalent. Terms: Repayment over 17 years including 5 years grace at the Bank's standard variable interest rate. TEK would bear the foreign exchange risk. Obiectives: The main objectives of the proposed Loan are to support: (a) corporate restructuring of TEK in the context of the Government's SEE reform program; and (b) the implementation of an agreed least-cost investment program for the power subsector in both the public and privato sectors during the period 1990-1994, and the strengthening of local capacity to assess their environmental impact. Description: The proposed Loan of US$300 million would: (a) support the implementation of a Corporate Restructuring ProgralT for TEK which includes: (i) a reform of electricity pricing policy; (ii) a reform of TEK's management practices, including the adoption of an annual Corporate Performance Plan to be agreed between TEK and the Government as a means to enhance TEK's managerial autonomy and accountability; and (iii) restructuring of TEK's debt including conversion of part of it into equity; (b) partially finance the foreign exchange cost of a time-slice (1991-94) of TEK's least-cost investment program in power; and (c) finance technical assistance to build up TEK's capability to carry out environmental impact assessments and for (a) and (b) above.  (it) Benefits and Risks: The main benefit of the proposed operation 's the rationalization, increased efficiency, autonomy and accountability of TEK, and the gradual reduction of the burden on the Government and on the economy that originates from TEK's financial imbalance, with beneficial effects on the PSBR. The time slice (1991- 94) of l1K' s investment program to be financed under the proposed Loan is part of the long term least cost program for the power subsector. It would constitute ar. addition to the power system; its incrementai benefits are closely interlinked with those accruing from all subsector investments, undertaken by TEK, DSI and the private sector, including BOTs. The estimated economic rate of return of all investments in the subsector, which is taken as a proxy for the return on the proposed investment component, is calculated to be 16% based on measurable costs and benefits, which compares favorably with the opportunity cost of capital of 12%. Sensitivity analysis shows such rettrn ranging from 13% to 17%. With the inception of the investments, Turkey will be able to capture the benefits of its very large hydropower investments, in particular those made in the Atatuirk Dam in the South East (2400 MW), by constructing a major high voltage transmission line to evacuate power from AtatOrk to the main load centers in the central and western parts of the country. Risks. The main risk associated with the operation is the possibility that the restructuring of TEK will not be implemented successfully and that the enterprise will continue to experience a deteriorating financial position, with adverse effects on the fiscal position of the Government. Despite TEK's poor track record in earlier attempts to reform, particularly the company's accounting and financial functions, the Government's and TEK management's commitment to the proposed program of reforms render this risk commensurate with the Project's expected benefits. The Corporate Performance Plan to be agreed every year between TEK and the Government, which will set out, inter alia, the respective obligations of TEK (performance targets, investment/financing program, etc.) and the Government (tariff approvals, level of Government financial support), is expected to be an effective mechanism to monitor implementation of key decisions and actions, including TEK's progress in adopting a greater commercial orientation in its operations. This rolling agreement should also reduce the other major risk of the operation stemming from Turkey's uncertain short term economic prospects.  (iii) Total Investments and Financing Plan in the Power Subsector (CYs 1991-94): Investment Program (USS Million) Local Foreign Total Public Sector - TEK 3,942 1,446 5,388 - DSI 1,598 267 1,865 Private Sector - CEAS & KEPEZ 185 262 447 - Others 529 1,306 1,835 Total 6,254 3,281 9,535 Financing Plan Public Sector - TEK-Net ICC 890 890 GOT Equity 1,373 1,373 Customer Deposits 40 - 40 Bank Loan - 300 300 Other Borrowing 1.639 1.146 2.785 Subtotal - TEK 3.942 1.446 5.388 - DSI-PPA 1,598 - 1,598 GOT - 267 267 Subtotal - DSI 1.598 267 1-865 :ivate Sector - CEAS & KEPEZ 185 262 447 Others 529 1,306 1,835 Total 6,254 3,281 9,535 Estimated Disbursement: (USS Million) Bank FY FY92 EF93 FY94 FY95 Annual 45 80 100 75 Cumulative 45 125 225 300  TURKEY TEK RESTRUCTURING PROJECT STAFF APPRAISAL REPORT I. THE ENERGY SECTOR A. Background 1.01 The Ministry of Energy and Natural Resources (MENR) is responsible for planning the development of energy. At the operating level, the energy sector is dominated by State Economic Enterprises (SEEs). The Turkish Hard Coal Enterprise (TTK), the Turkish Lignite Enterprise (TKI), the Turkish Petroleum Corporation (TPAO) and the Mineral Research Institute (MTA) have responsibility for the extraction of fossil fuels and radioactive materials. Design and construction of hydroelectric schemes is entrusted to the State Hydraulics Authority (DSI). The Turkish Electricity Authority (TEK) is responsible for the generation, transmission and distribution of almost all the electricity sold in Turkey. TEK is also responsible for the implementation of the Government's rural electrification program and the construction of all publicly owned thermal power plants and transmission and distribution facilities. The production, transport and marketing of petroleum products are undertaken by Turkish Petroleum Refineries Corporation (TUPRAS), Petroleum Pipelines Corporation (BOTAS) and Petrol Of is]. (marketing and distribution). The Electricity Survey Administration (EIE) is responsible for renewable energy, hydropower surveys and for the formulation and implementation of the national energy conservation program. Private sector participation in the sector is limited to two small electricity utilities (CEAS and KEPEZ) whose total installed generating capacity is about 350 MW, a few industrial autoproducers, small coal mines, one refinery, joint ventures with TPAO for petroleum exploration, and petroleum product marketing. However, the role of the private sector is expected to increase in the near future, given the Government's emphasis on attracting venture capital to supplement public investments which are constrained by the shortage of financial resources. The Public Participation Administration (PPA), an extra-budgetary national fund for investments in infrastructure, although not formally a part of the energy sector, plays a significant role in the financing of the power subsector. In particular, hydropower facilities constructed by DSI are financed by the PPA, in addition to funds from the national budget and foreign credits and loans. PPA's sources of funds comprise market-instruments such as revenue sharing bonds, and since 1985, a levy on TEK's generation from certain large hydropower plants whose construction was financed by PPA. 1.02 Turkey's most important domestic source of energy is hydroelectricity, which accounts for 34% of total electric power generation and 8% of primary energy supply. The exploitable hydropower potential is estimated at 31,000 MW, of which 7,500 MW has been developed and another 3,200 MW is under construction or planned to be developed by 1994. Installed power generation capacity is 17,000 MW, of which 44% is hydro and 56X thermal (9,500 MW). Abundant deposits of low-quality lignite also exist--estimated at 8.2 billion tons, half of which are of low calorific value and high sulphur content-- accounting for 36% of power generation and 18% of primary energy. There are also limited quantities of low-quality, high-sulphur hard coal ana of oil and gas; proven hydrocarbons reserves consist of 250 million barrels of oil and 0.5 billion cubic feet of natural gas. Domestic production of hydrocarbons accounted for 12% of their domestic demand in 1989. This proportion is not expected to increase substantially because of the limited prospectivity of Turkey's geology. A greater utilization of domestic lignite and coal is severely constrained by envirormental considerations. The balance of domestic energy demand is met, and  -2- is likely to continue to be met in the futu; , by fuel imports, especially crude oil and petroleum products (21 million tons in 1989), which together constitute 42% of primary energy supply, as well as natural gas (3 billion cubic meters in 1989). Energy imports cost approximately 4% of GDP in 1989. Natural gas is currently imported from the Soviet Union on the basis of a long-term take-or- pay contract which allows payments to be partly made with counter-trade. A new LNG terminal is being built in Thrace to allow diversification of imported sources, especially from Algeria. B. Resoonse to the Oil Shocks 1.03 The international oil price increases of the mid-1970s precipitated a dramatic change in energy policy in Turkey. While domestic oil production was falling significantly during the 1970s, oil imports, which were only US$200 million ir 1970, jumped to US$3.5 billion in each of the years from 1979 to 1984. The response by Turkish policy makers was to curtail, through substitution, the level of energy imports by embarking on a massive program of indigenous resource development, especially lignite and hydropower, and also oil, gas and geothermal resources. Nevertheless, by the time of the second oil shock, Turkey's dependence on imported oil was still growing. Of the country's net primary consumption of about 32 mi'llion toe in 1980, petroleum accounted for as much as 60%, compared to only 20% in 1960. Electric power accounted in 1980 for 23% of all commercial energy used 5% of which was imported from Eastern Europe; the industrial sector consumed then 61% of all electricity produced. Lignite accounted in 1980 for only 15% of commercial energy consumed, almost a third of which went for power generation. Non-commercial energy (primarily fuelwood, but also other biomass) represented in 1980 only one fifth of the energy used in the economy as a whole, but was the primary energy source for the household sector, accounting for about 57% of its total final consumption, which helped to cushion the population from the oil shocks. 1.04 Energy investment showed a dramatic increase in the post 1975 period and by 1984 had peaked at about 40% of total public fixed investment and 3.0% of GDP. By the mid-1980s, however, Turkey's energy strategy was seen as having failed to meet its ambitious targets. Various Bank reports in the early 1980s had concluded that "... resources, human and financial, have been spread too thinly over too many projects in the investment program", and this resulted in "... major supply interruptions, project delays, frequent and protracted plant breakdowns and unacceptably high losses". Furthermore the policy of import substitution by indigenous resources entaile(. high risks since shortfalls in electricity supply could not be fully met, for technical reasons related to system stability, by electricity imports. This lack of flexibilicy had caused, by the early 1980s, a substantial energy deficit. The sector's problems had reached crisis proportions - problems that were deep rooted, and almost all linked to inefficient practices of the public sector energy agencies in planning, project implementation, financing and operations. The public sector had, since the end of the 1970s, an almost total monopoly in energy supply. The lignite sector had been nationalized in the early 1970s and statutory barriers to private electricity investment assured TEK's monopoly. C. Energy Sector Adiustment under ESAL 1.05 In response to the above problems, the Government adopted a set of policy initiatives aimed at adjustment in the sector over the medium term. The Government assigned highest priority to the energy sector and to investments that would reduce the energy deficit and costs of supply. The strategy for the development of the sector was developed during the preparation of the Fifth Five  Year Plan (1984-88). In line with the priorities of the structural adjustment program (import liberalization, investment rationalization and an enhanced role for the private sector) the Development Plan identified the key areas to be addressed in the energy sector, as part of a sector policy framuework supported by the Bank under ESAL (June 1987) which is still of considerable relevance: (a) continued priority would be given to domeatic sources of energy, especially hydro and lignite, when economically justified; (b) the economic justification of projects based on imported energy, especially gas and coal, would be subject to close sc--utiny; (c) private sector financing, both local and foreign, would be sought for participation in energy development; (d) conservation through indirect (pricing) as well as direct (non- pricing) measures would be supported; (e) energy SEEs would be given greater financial autonomy especially in setting output prices; and (f) the public investment program for energy would be rationalized by rocusing on priority projects and priority subsectors. 1.06 By 1986, the initial achievements of the new energy policy were already apparent. The rapid expansion of installed power generation capacity and lignite production, in conjunction with a successful economic stabilization and structural adjustment, and a significant fall in the world market price of oil, had beneficial impact on the economy. Turkey's import substitution program and aggressive energy demand management allowed it to overcome the energy shortage which had plagued the economy in the early 1980s. Moreover, sector planning, particularly medium and long-term energy demand and supply forecasting, improved substantially with the adoption of sophisticated computer models. Most critically, economic deregulation was initiated which facilitates private sector investment in power generation under the Build-Operate-Transfer (BOT) arrangement. 1.07 The aggressive energy pricing policies of the first half of the 1980s were relaxed in the second half, reflecting a loosening of Turkey's demand management policies at the macro level, but also the softening of energy prtces worldwide. Table 1 below shows the evolution of relative prices of key energy products during the 1980s. Salients aspects of Turkey's pricing policies illustrated in this Table are that: (a) There were very wide fluctuations in energy prices during the 1980s. Most important, except for a relatively minor fall in lignite prices, all energy prices increased significantly in real terms during the first half of the 1980s, electricity tariffs having increased the most. Conversely, all energy prices decl'ned significantly in real terms during the second half of the 1980s, rhis time with electricity tariffs falling the most. (b) Whereas during the first half of the 1980s the relative price of electricity improved with respect to its major production inputs (heavy fuel oil, lignite, and more recently gas), the converse was true during the second half of the 1980s, especially with respect to lignite, the most important of such inputs.  -4- (c) The substitution of fuel oil by lignite was particularly encouraged during 1980-85 when the real price of lignite vis a vis fuel oil declined significantly; that -ivantage was subsequently eroded and finally lost by 1989, as a result of the significant decline in fuel oil prices in real terms during the second half of the 1980s. (d) Although very competitive with fuel oil for power generation ..nd household consumption, natural gas is less competitive than lignite for power generation as, on an equivalent heat basis, lignite prices in 1990 were only 31% of the purchase price of gas by the power subsector. (e) The significant fall in domestic lignite prices in real terms for power generation which took place during the 1980s was of greater magnitude than that in the world market price of coal. Lignite prices for domestic households, on the other han&, remained at roughly the same level in real terms during most of the decade. Partly as a result, gas can at present compete with lignite as far as domestic household use is concerned, at least on an heat equivalent basis. (f) Domestic prices of petroleum products increased considerably in real terms during 1980-85. These fell significantly during the remainder of the decade, ranging from a 38% fall in the case of gasoline to a 50% fall in the case of diesel oil/kerosene, and LPG; part of this fall also paralleled trends in the world market of crude oil, the price of which declined by about 55% in real terms during the second half of the 1980s. Table 1.1: Relative Prices of Key Enerxv Products a/ Prices as X of that of Price Indices Natural Gas A. Electricity 1980 1985 1989 (1990) c/ Average Tariff k/ 100.0 198.1 96.4 Inputs: Heavy fuel oil 100.0 122.6 60.8 159.6X Lignite 100.0 88.3 56.1 30.72 Natural Gas N.A. N.A. N.A. 100.0X B. Households Light fuel oil 100.0 123.7 96.6 250.9X Electricity 100.0 103.6 51.9 248.8X Lignite 100.0 114.8 98.8 100.22 Natural gas 100.02 C. Petroleum Products Gasoline 100.0 121.0 75.0 Diesel Oil/Kerosene 100.0 134.2 91.0 LPG 100.0 146.2 73.0 Memo items: Real effective exchange rate: 100.0 89.1 90.7 Consumer Price Index (Ist.) 100.0 496.5 3132,5 US$ International Price Index (MUV) 100.0 95.4 132.5 Oil World Market Price (US$ real terms) 100.0 91.4 40.7 Coal World Market Price (USS real terms) 100.0 114.6 70.7 a/ Yearly averages, based on real domestic prices per toe; including taxes. h/ Computed as TEK's net average revenue. S/ Third quarter. Source: MENR, TEK, mission estimates  D. High Inflation and Recent Trends in Energy Sector Investments and Their Financing 1.08 High and variable inflation had a particularly deleterious impact on the energy sector during 1987-89, which was compounded by the Government's efforts to reduce public sector expenditure to fight inflation. The turnaround in performance took place in 1987, although this became increasingly apparent only in 1988. Both annual investment budgeting and the setting of energy prices were put unde; serious stress as a result of accelerating domestic inflation and the continuous devaluations of the exchange rate, which also made more difficult the 'inancial situation of some key SEEs. Moreover, the significant, although short lived, increase of the world market price for oil in 1987 highligk'ted once again the vulnerability of the economy to potential external shocks. The Government's attempts at stabilization also have restrained energy sector investments--only ongoing power projects were included in the 1988 and 1989 budgets. In the end, investments in the energy sector fell substantially in real terms each year during 1987-89, with power investments falling by 16% and mining investments (which include lignite, oil and gas) by over 60%. 1.09 Most of the fall in real energy prices illustrated in Table 1.1 in fact took place during 1987-89, when inflation accelerated. Domestic fuel prices decreased by about one third in real terms in 1987 alone. With the increase of domestic demand, imports of crude oil and other petroleum products shot up by an almost unprecedented 45% in nominal teims (over 18% in real terms) to about US$3 billion in 1987, representing 31% of the increase in the country's commodity imports. The Government was eventually forced to draw down the oil stabilization fund in order to cover the cash shortfall of TUPRAS in the wake of rising crude oil prices, domestic operating costs and fixed (nominal) retail prices for fuel products. The setting of electricity tariffs suffered from analogous problems. From February 1986, tariffs were allowed to be eroded by inflation, and eventually fell by about 24% in real terms between December 1986 and October 1987; by December 1987, however, significant increases authorized by the Government in the nominal level of tariffs had fully reversed that situation. But the rapid pace of inflation in 1988 eroded those gains, and tariffs in real terms again fell rapidly. As in the case of petroleum, the fall in the real tariff, in conjunction with the rapid growth in domestic demand throughout the economy led to a rapid increase in electricity demand (13% in 1987), althouih not sufficiently to prevent a deterioration of TEK's financial situation. 1.10 As power subsector investments (TEK and DSI) accounted for about one fourth of all public sector investment during the Fifth Plan (1984-88) their financing has had significant impacts on the public sector debt. In spite of their considerable fall in recent years (para. 1.08), the share of power subsector investment in public sector investment has increased from 26% in 1984 to 28% in 1989, although its share in total investment in the economy has fallen from about 16% to 13% over these years (and is estimated to have fallen even further in 1990). In macroeconomic terms, power subsector investments have been financed during the second half of the 1980s to a large extent by private domestic savings transferred to TEK through various mechanisms (Government transfers and subsidies, domestic borrowings) combined with sectoral external savings while, except for 1986 ahd to a much lower extent 1987, sectoral savings played a minor role. In fact, the share of sectoral external savings in the financing of power subsector investments, in the form of net external borrowing by TEK, has shown an upward trend, increasing from only 7% in 1985 to 34% in 1988, and an estimated 31% in 1989. The structure of financing has in fact deteriorated beginning in 1987, as it has moved toward an increased reliance on external savings and private domestic savings, away from sectoral savings.  - 6 - Therefore, since 1986 the macroeconomic investment-savings gap in the power subsector has widened considerably, reaching 3% of GNP in 1989. 1.11 In contrast to the power subsector, the financial situation of the three SEEs operating in the oil and gas subsector TPAO, TUPRAS and BOTAS, is now relatively satisfactory, mainly because their pricing arrangements are essentially on a cost-plus basis. In 1989, the Government boldly deregulated the procurement of crude oil as well as the pricing of refined products at the ex-refinery and retail levels. This has in particular increased TUPRAS' autonomy, which is now fully responsible for pricing its own product slate, whereas formerly it was the role of the Government's Directorate of Petroleum Products. Reacting swiftly to world market developments in the wake of the Gulf crisis, domestic retail petroleum prices were raised in three separate occasions in August and September 1990, for a cumulative 63% for gasoline, 38% for motor oil and 24% for fuel oil. The refinery company, which is to be privatized this year, is still in the process of adapting to this new policy environment, which, over the medium-term, will entail a gradual reduction of the effective protection from foreign competition together with environmentally more stringent specifications to reduce air pollution regarding the lead and sulphur content of petroleum products. E. Environment and the Increased Use of Natural Gas 1.12 The Government has launched in recent years major initiatives in regard to the environment, aimed at further replacing high sulphur fuel oil and lignite with cleaner imported coal and natural gas. The Government decided to undertake these environmental initiatives for fuel substitution after recognizing the serious environmental and health risks, especially in Ankara, created by air pollution from the use of low quality lignite. This will require, however, a proper relative pricing framework for substitute products, and the expansion and rehabilitation of the gas transmission and distribution network, particularly in the main urban areas along the Black Sea. Natural gas demand is expected to increase to about 14 billion cubic meters per year (bcm/y) by the late 1990s compared to 3 bcm/y in 1989. Turkey's domestic production of natural gas is, however, small (about 12 million cubic meters per year (mcm/y) from the Hamitabat field in Thrace), but imports of gas are increasing very rapidly. Since 1987 a gas supply contract with the USSR has been in place, whereby imports via Bulgaria are to reach 5.6 bcm/y by 1992. Under this fifteen year contract at least 7P% of the cost of the imported gas is covered by counter trade, thus helping Turkey trn expand its exports to the USSR. In addition, liquified natural gas (LNG) to be imported from Algeria to the terminal facility now under construction in Thrace, is expected to reach, after a four year buildup, 2 bcm/y by 1997. More recently, the Government has reportedly signed a protocol with Libya to import 1.5 bcm/y of LNG, and negotiations on price are underway. A substantial share of imported gas is currently allocated to bulk users, i.e., the power and industrial sectors. This up-front use of gas by large-scale users is in line with the strategy of other gas importing countries in Western Europe; market development among private users, on the other hand, will have to be gradual. Under ESAL, the Government agreed to undertake a Gas Utilization Study (GUS) to optimize gas development and address the complex issues raised by it. Progress in regard to the GUS has been slow, but is now recognized as a priority by BOTAS, the main public sector agency involved, which has recently awarded a contract to a Canadian firm for carrying out the study, expected to be finished by the end of CY 1991.  -7- F. Impact of Long-Term Energy Policies 1.13 In summing up the present situation in Turkey's energy sector, including progress under the ESAL framework, it is clear that sector planning deficiencies are still apparent: (a) forecasting methods remain mechanistic in their approach; (b) the economic implications of greater private sector involvement in future power generation, as well as of increased reliance on imported energy products (coal and/or gas) are not being fully examined; (c) annual investment decision-making authority remains diffused in spite of the central role played in principle by the core planning agencies; and (d) the capacity to prepare a medium-term rolling investment program is lacking. In spite of such institutional weaknesses, however, and of the deleterious impact of the macroeconomic environment in recent years (paras. 1.08-1.10), the policies and investments launched in response to the two major oil shocks were largely successful not only in overcoming the serious energy shortages of the early 1980s (para. 1.05), but also in changing significantly the structure of the energy sector toward less dependence on imported oil. The policy of passing on to consur.iers increases in the international price of petroleum products also contributed. The evolution of the country's overall energy balance during the past decade illustrates such progress. By 1989 Turkey's overall energy intensity had increased considerably, as net primary energy consumption grew by about 72% during the 1980s, as compared to a 49% increase of real GDP. But with the supply of electricity having grown faster (gross supply more than doubling in 1980- 89), the country's dependence on petroleum products had fallen by as much as 5 percentage points to 55% of total commercial consumption. Consequently, in 1989 electricity (of which less than 1% of net supply was imported), accounted for a somewhat larger proportion (27.5%) of all commercial energy used than in 1980 (23%), with industry's share having declined over the past decade to the benefit of residential consumption (para. 1.03). In parallel, the use of domestic lignite expanded significantly during the 1980s, by as much as 6 percentage points, representing in 1989 about 21% of commercial energy consumed. The policy of reducing oil dependence was successful in the power subsector through a greater use of domestic lignite, of which 47% was used for power generation in 1989. The role of non-commercial energy sources continued to decline to 14% of total energy consumption, although still representing about one half of household energy consumption in 1989. 1.14 Because of the increased role of natural gas in energy consumption (para. 1.12), however, and in spite of the reduced role of oil in the overall energy balance (para. 1.13), Turkey's dependence on imported energy was exacerbated over the last decade, as the share of energy imports in the country's overall net supply of primary energy increased from 44% in 1980 to 48% in 1989, largely as a result of greater reliance on cleaner imported coal and particularly gas, an implicit cost of the country's increased concern with improved environmental quality and environmental health conditions. 1.15 Turkey remains vulnerable to a sustained third external oil shock, particularly when compared to other oil importing countries, mainly because: (a) The net external oil trade balance at 3.8% of GDP in 1989 is still very high, indeed much more so than in a wide range of oil importing countries, such as the U.S., Argentina (both less than 1%); France, West Germany, and Poland (all with 1.1% of GDP)- Brazil, Italy and Spain (ranging from 1.3% to 1.6%); and even Kenya and South Korea (both with 3.2%). Turkey's crude oil import bill reached US$3.5 billion in 1990, amounting to a net increment of US$l billion or 41% over 1989, largely due to higher international prices.  (b) Although efficiency in overall energy consumption has increased since the first oil shock in 1973 (in contrast to several other developing countries: Brazil, Argentina, Mexico, Poland and Venezuela), it has done so only marginally and considerably less than in OECD countries (except Spain), where enormous savings in the use of energy (particularly in Britain, Japan and Italy) have taken place since the first oil shock. (c) Oil as a percentage of total energy consumption, although declining, is still high at 42%; higher than Czechoslovakia (25%) and the US (40%), but lower than Japan (56%), Argentina (54%), Spain (54%) and Italy (61%). 1.16 This vulnerability highlights the relevance of the import substitution strategy supported under ESAL for the energy sector, which would be further pursued with the implementation of the least-cost investment program for the power subsector agreed under the proposed Project (Chapter II). C. SEEs. TEK and the Economv 1.17 SEEs are dominant in many sectors of the Turkish economy. Overall, the 30 largest SEEs produce a total value added of 10% of GDP at factor cost, while the share of investments by SEEs out of total investment was about 19% in 1989, after falling from 30% in 1984. The prime cause of this fall has been the Government's policy to reduce the public sector borrowing requirement (PSBR) and the role of SEEs in the economy. Total employment in the 31 largest SEEs has remained at about 3.9% of the total civilian labor force during the last 5 years and has been increasing in absolute number since 1985. Only in manufacturing has there been a noticeable decline in SEE employment since 1984. During the first half of the 1980s the performance of the SEEs improved somewhat, largely as a result of the freeing of prices in 1984 in a context of falling inflation and of lower operating costs in real terms. Their performance, however, has again deteriorated due to rising wage and salary bills and interest payments together with a stagnation of productivity and falling output prices in real terms. During 1981-85, the SEE share of the PSBR remained around 2- 3% of GNP; it peaked at more than 4% of CNP in 1987, which was as large as the Consolidated Budget deficit of the Central Government. The borrowing requirements of SEEs fell subsequently mainly due to a significant decline of SEE investment in real terms, to 2.6% of GNP in 1989. Mainly reflecting increased Government support to domestic agricultural prices, these requirements jumped to 4.4% of GNP in 1990, close to one-half of the total PSBR. 1.18 All of the Bank's five structural adjustment loans (SALs), placed reform of SEEs at the top of the agenda. SALs IV and V, in particular, included conditionality to the effect that the SEE sector would be reformed, starting with improvements to the overall environment governing SEE performance and efficiency. Legislation passed in 1984 and 1985 represented important steps in promoting SEE accountability. Manufacturing SEEs and public utilities (PEEs) were differentiated, and a duty loss provision was introduced to assure a satisfactory rate of return for those SEEs which are prevented from raising prices to economic levels. TEK, the railways (TCDD), and the Post, Telephone and Telegraphs Entity (PTT), were able to apply for duty loss rebates. The Bank's structural adjustment loans had all included agreements for the Gove.nment to reduce the level of budgetary transfers to the SEEs. SAL IV limited them to TL 350 billion in a given year, a target which was met in 1984 but not in 1985 and 1986.  -9- 1.19 Among SEEs, TEK, one of the two largest SEEs in the economy in terms of volume of investment (accounting in the second half of the 1980s for about 20-25% of all public investment), asset base, sales, and number of employees (about 9% of all SEE employees), has a significant impact on the Government budget and on the borrowing requirements of the public sector. Table 1.2 below shows selected indicators of TEK's role in public finance and the economy; it also illustrates some of the benefits expected during the first phase of the proposed restructuring Project (1990-91; further analysis in Chapter V). (a) TEK's share of total public sector fixed investment is falling significantly, in line with the rationalization of power subsector investments pursued. TEK's share of SEEs fixed investments is expected to reach about 39% in 1991, down from 54% in 1989. (b) TEK's internally generated funds are increasing rapidly relative to all such SEE funds, from 17% in 1989 to about 32% in 1991, largely due to the electricity tariff policy carried out since early 1990 under the Project. (c) Because of the fall in TEK's investments, and the significant increase in the utility's self-financing capabilities, TEK's net borrowings have also been falling since 1990. This is true both for net foreign borrowing as well as borrowing from the domestic commercial banks; in fact, TEK has paid off all short term debt to such banks in 1990 as part of the capital/debt restructuring under the Project. TEK's medium and long term external debt stood high as of end 1989 (about US$3 billion) at 73% of all such SEE debt, but only at 8% of all such public sector debt. (d) TEK will require about 14% of all Government transfers to SEEs in 1991 as part of the capital restructuring. The company would still represent almost one third of all SEE borrowing planned for this year, although down from between one half and two thirds of all SEE borrowing during the second half of the 1980s. (e) TEK's financing requirements from outside sources are falling significantly, from 1.8% of GNP in 1989 to 1.2% in 1990, and 1% of GNP in 1991. TEK's PSBR, defined as the latter but net of Government's budgetary transfers and support funds, would be halved from 1.4% of GNP in 1989 to 0.7% of GNP in 1991, contributing thus significantly to fiscal and macroeconomic adjustment.  - 10 - Table 1.2: TEK - Selected Economic and Finanoial Indicators (in Peroentages) i980 1990(E) 1391(P) A. TEK's X of Public Sector's: - Fixed investment 21.7 14.9 11.6 - Medium and long term external debt 8.6 N.A. N.A. B. TEK's X of Non-financial SEEs: - Fixed investments 53.8 39.8 39.1 - Internally generated funds 17.1 27.5 31.7 - Net foreign borrowings 73.8 45.8 -33.0 a/ - Net domestic bank lending 7.6 -11.8 b/ - - Government's budgetary transfers 24.5 2.1 13.8 - Borrowing requirements 52.1 22.2 31.6 - Medium and long term external debt 73.0 N.A. N.A. C. X of GNP: - TEK's net financing requirements from outside sources 1.8 1.2 1.0 - TEK's PSBR c/ 1.4 1.0 0.7 (E) Estimated, (P) Projected. a/ The negative sign means that the SEEs, but not TEK, will effect net repayments in 1991. b/ The negative sign means TEK effected net repayments in 1990. c/ Net of Government's budgetary transfers and support funds. Source: SPO, Treasury, TEK and Mission Estimates. H. Bank Involvement in the Power Subsector 1.20 The Bank has long been involved in the power subsector in Turkey. To promote the development of indigenous energy resources in order to lessen Turkey's dependence on imported energy sources, the Bank has helped finance investments to expand hydroelectric capacity through the Sir Hydropower Project (Ln. 2750-TU) and the Kayraktepe Hydropower Project (Ln. 2655-TU), and critical transmission lines. Currently, the Bank has three operations involving TEK under supervision: TEK Transmission IV (Ln. 2586-TU); Power System Operations Assistance Project (Ln. 2602-TU); and the Energy Sector Adjustment Loan (ESAL) (Ln. 2856-TU), under which TEK is a major beneficiary. 1.21 The Sir Hydropower Project, being implemented by the private company CEAS, is progressing well and is on schedule with original plans. Implementation of TEK Transmission IV is about to be completed. After a three year start-up delay, execution of the Power System Operations Assistance Project is making progress, following a reallocation of part of the loan to high priority high voltage transmission lines and the issuing of bidding documents for significant amounts; this may call for a review in the near future towards an extension of the loan's current closing date of December 31, 1991. Performance under ESAL has improved recently in regard to disbursements for the investment component under the loan which had been lagging considerably since 1987. This was due to the large number of agencies involved within Turkey and their relatively cumbersome procurement procedures. ESAL has contributed to overhaul the policy framework in the energy sector (paras. 1.05-1.13) leading, as noted, to less dependence on imported oil, significant deregulation of the domestic market for petroleum products, freedom of entry for the private sector in power generation, transmission and distribution, substantial expansion of power generation capacity based on domestic resources, and increased use of natural gas for broader health and environmental considerations; it has also paved the way for further reforms, such as those proposed under this operation. ESAL has contributed to initiate reforms of TEK's organization and management. TEK's Board of Directors was reconstituted to include representatives from outside of TEK (SPO, MENR and the Treasury) and TEK's management was streamlined through a reorganization. In addition, TEK's accounts were audited for the first time by private auditors (Price Waterhouse) of international repute, whose report highlighted the  . 11 - deficiencies in tie utility's financial management and practices. Partlv due to this, and within the framework of a possible divestiture and/or privatization of TEK's distribution enterprises and other assets, the accounting and MIS improvements recommended by TEK's consultants under the recently completed TEK Transmission III Project (Ln. 2322-TU) would be implemented under the proposed operation. I. Rationale for Bank Involvement 1.22 The deteriorating economic environment since late 1987, coupled with a concomitant serious erosion of TEK's electricity tariffs in real terms, resulted in TEK not complying with important financial covenants agreed with the Bank since 1988, particularly in regard to internal cash generation and short term liquidity. Financial pressures forced TEK to borrow, especially from foreign commercial banks at shorter maturities, to complete major generation projects as well as to meet other financial obligations. The sharp increase in TEK's debt-service on foreign loans caused by the accelerated devaluation of the nominal exchange rate of the Turkish Lira through 1989, and the continued debt- financing of a relatively high level of investments, plunged the utility into financial distress. The absence of an agreement with the Bank on the rationalization of investments, by TEK in particular, and of those in the power subsector by GOT in general, brought the Bank's new lending to the subsector to a halt since 1988. TEK emerged as a major contributor to the PSBR. The Government's request in 1989 for Bank's help in restructuring TEK enabled a renewed dialogue with GOT and TEK. The proposed reform program for the power subsector, to be implemented during the Sixth Plan, would deepen the reforms supported under ESAL, focussing on a medium-term corporate restructuring program for TEK, which would rehabilitate the utility's finances and, in the process, allow compliance with the above covenants. 1.23 The Government has formulated this program with the assistance of the Bank. After a three-year period of policy drift in the subsector, a consensus has emerged on the major policy issues, leading to initiation of reforms toward rationalizing tariffs, subsector investments, instituting environmental safeguards, and increasing autonomy and accountability of TEK. Bank lending for the highest priority components of the 1991-94 time slice of TEK's medium-term investment program would be a vehicle for offering support to the program for restructuring TEK and the power subsector, as well as for strengthening local capacity t assess the environmental impacts of subsector investments. In the absence of the Bank's assistance, the restructuring of TEK and its restoration to financial solvency would be exposed to considerable uncertainty. J. Experience with Bank Lending 1.24 Three PCRs have been recently prepared for Bank loans involving TEK. These are for the third TEK Transmission Project, the Karakaya Hydropower Project (Ln. 1844-TU), and the Elbistan Project (Loans 1023-TU and 2650-TU). The PCRs note major problems in regard to TEK's performance, in particular inadequate decentralization and quality of project management; lack of internal coordination, sustained commitment and accountability; cumbersome bureaucratic procedures, including on procurement; failure to make efficient use of consultants and studies; lack of autonomy in financial and personnel policies; absence of strategic approaches; insufficient local fui,ding with inappropriate tariff policy; and finally, inadequate power system expansion planning in the country. The PCRs most far-reaching recommendation to address these issues is to establish commercially-oriented corporations independent from the Government  - 12 . in the power subsector, or to privatize TEK altogether. To address these issues, as well as to adopt to an ever changing external environment, an overall corporate approach has been taken focusing on key strategic goals and options, and mechanisms. The preparation of this Project has stressed from the start the building of consensus and commitment among the major parties involved within TEK and the Government. This involved upfront analysis and dialogue, particularly on the critical need to rehabilitate TEK's finances and its financial and accounting practices. The Government sees the opportunity to reduce what was becoming an unmanageable financial burden. The Project would implement measures to enhance TEK's autonomy and accountability, introduce greater transparency in decision making, and provide a more effective program implementation and monitoring mechanism. Enhancing TEK's commercial orientation would also improve decision making and pave the way for privatization, particularly through the establishment of independent cost centers within the company with appropriate transfer pricing mechanisms. Privatization could begin with the creation and commercialization of a few TEK subsidiaries, which would enjoy a greater degree of autonomy under the Turkish Commercial Code, and be more subject to performance based on normal commercial criteria. The scope and timing of privatization, however, depend on the interplay of major political and economic forces which have not yet fully crystallized and are thus difficult to predict. The proposed Project would be the object of intensive supervision under the above corporate approach. K. The Bank's Medium-term Strategy for the Power Subsector 1.25 The agreed subsector strategy calls among other things, for TEK to concentrate its investments on the optimization and rehabilitation of its transmission and subtransmission system, on abating pollution from lignite fired thermal plants, while the starting of new generation projects would be left to the initiative of private investors, mainly under BOT schemes. Involvement of new private investors in the power subsector has not been progressing at the pace envisaged by the Government. Delays have been due to: (a) the lack of an adequate institutional framework for attracting and securing private sector investments in new power projects; (b) absence of an appropriate methodology to prepare a technically and financially viable privatization package of TEK's assets; and (c) strong local opposition on environmental grounds in some areas. The proposed operation aimed at restructuring TEK is intended as but the first stage of a medium term strategy to support the process of reforming and developing the power subsector. It would be complemented by a follow-up operation (FY93), aimed at abating pollution from TEK's lignite-fired thermal plants with appropriate environmental policies and investments. The Bank would also be financing the Berke Hydroelectric Project (FY92) for the private utility CEAS. This project would enhance the role of the private sector in the power subsector, ensure that CEAS becomes a model regional private utility with responsibilities for generation, transmission and distribution, as well as rationalize the power exchange relationship with TEK, which would continue to be a major supplier of CEAS. The Government has requested the Bank to undertake another operation, which would, inter alia, establish an Energy Fund with an adequate institutional framework to attract new foreign and domestic private investors in the power subsector. II. THE LEAST COST POWER SUBSECTOR INVESTMENT PROGRAM AND ITS FINANCING A. Turkey's Electricity Balance 2.01 The evolution of Turkey's electricity balance during the past decade (1980-89) illustrates major achievements of this country's long term energy  13 - policies since the second oil shock (further analysis in item 4 of Project File; ref. Annex 6): (a) A more than doubling to 13 million TOEs of total gross electricity generation (73%) between 1980 and 1989 due to a massive expansion of thermal generation (173%), and hydro generation (58%). (b) A greater role for domestic resources (hydro and lignite) whose share increased from 67% to 70% of total gross generation during the past decade; this was mainly due to a remarkable increase in the use of lignite (271%) in thermal generation in conjunction with a significant decline in the use of petroleum products, which now account for only 6% of total generation compared to 25% in 1980. (c) A virtual disappearance of imported electricity, which constituted less than 1% of consumption in 1989. (d) An increasing use of environmentally benign fuels, such as natural gas, which accounted for about 19% of total gross generation in 1989. Gas and hydro-based generation, together, accounted for about 53% of total gross generation in 1989, and even more in a good hydro year (1988), compared to 46.5% in 1980. 2.02 Despite such progress, certain weaknesses have become apparent, however. The overall efficiency of the power system seems to have declined somewhat over the last decade, as technical losses arising from the energy transformation processes, and also transmission and distribution, increased to almost 72% of total energy inputs in the power subsector in 1989 compared to 68% in 1980.1/ Greater losses were incurred in the energy transformation process given the increased role of thermal plants in the power system and their specific thermodynamic characteristics. Moreover, substantial excess generation capacity exists at present, partly due to the unexpected slowdown of economic growth and demand in the late 1980s, as well as to an imbalance between generation and transmission infrastructure (para. 2.03). More broadly, in spite of the achievements in the power subsector, Turkey's dependence on imported energy was exacerbated over the last decade, as the shars of energy imports in the country's overall net supply of primary energy increased (para. 1.14). B. Least-Cost Investment Program in Power The Investment Program 2.03 Turkey's dependence on imported energy is expected to remain high beyond the turn of this century. The Government has confronted increasing difficulties in implementing its strategy for the power subsector. The exploitation of lignite is being slowed down because of environmental concerns. 1/ This indicator is not very precise, however, as it is influenced by possible variations in hydroplant generation due to different hydrological conditions in any given year, as well as by the specific assumptions needed for the conversion of hydroelectric energy to equivalent thermal generation. A better indicator of the overall technical efficiency of the power system is the ratio between energy sold and gross generation. Overall losses thus measured were 24% of gross generation in 1984 (the first year where data are available) and much less so at 16% in 1989, which suggests that technical efficiency may have actually improved.  - 14 - The development of hydropower potential experienced significant cost overruns in the wake of accelerating domestic inflation and devaluations of the nominal exchange rate in the second half of the 1980s. Public sector investment was reduced significantly, including in Lne power subsector (para. 1.08) and, given the need to complete the ongoing hydropower development program, resources originally envisaged for transmission and distribution were reallocated to generation. Consequently, the major hydropower schemes currently under implementation in eastern Turkey, which are expected to come on stream between 1991 and 1994 to provide about 2400 MW of generating capacity, may not be utilized fully tinless the high voltage (380 kV) transmission facilities are promptly upgraded to evacuate power to the main load centers located in the western part of the country. Delays in strengthening the transmission infrastructure would also hinder the optimal use of other existing and planned generation capacity. As said earlier, the attempts to attract major private sector investments for generation under the BOT arrangement have so far not fully materialized (para. 1.25). 2.04 In order to address the difficulties in developing the power subsector along the least cost path, the Government is launching a medium-term investment program for the power subsector, which is an integral part of a long- term least cost investment program (Annex 2). The Bank has reviewed extensively and vetted the least cost program of public and private sector investment in the subsector, which is consistent with the energy policy framework mentioned earlier (para. 1.05). The least-cost investment program aims, inter alia, at reducing the impact of a potential third oil shock both in the short and medium-term as a result of the large hydro generation capacity to be commissioned in the early 1990s under such program. Over the long term, no new oil-fired thermal plants are included in the least-cost expansion program through the year 2000, as this would increase the system's overall costs. A few large gas-fired plants are to be commissioned during the 1990s, while existing fuel oil plants are being shut down altogether, or converted to gas use. 2.05 Natural gas is favored also for environmental reasons, although there is the additional foreign exchange cost of importing natural gas compared to using domestic lignite. The price of imported gas is linked with a few months lag to the world market price for petroleum products. The price of lignite for power generation is only about 30% of that of imported gas; moreover, it has fallen significantly in real terms in 1985-89 (Table 1.1), despite increasing development costs at the mines. Lignite prices should reflect true economic costs, not only for encouraging the use of gas and imported coal with less sulphur content, but also, to reflect environmental costs. BOT plants based on imported coal are included in the least cost development program to be commissioned in the second half of the 1990s. To encourage the economic pricing of lignite and the adoption of commercial criteria, autonomous cost centers and related transfer pricing mechanisms would be developed under the proposed Project (Chapter III) for TEK's lignite mines which feed its thermal plants. The costs of the pollution abating investments, and the pollution costs themselves, would be assessed and incorporated in the structure of lignite prices under a follow- up project (para. 1.25). 2.06 TEK has expanded generation capacity substantially by adding 4284 MW of thermal capacity to the system during 1985-90, about twice the level added during the first half of the 1980s. Together with the 3613 MW of hydro capacity added by DSI, Turkey's total installed capacity increased by 7897 MW between 1985 and 1990. While such increase has eliminated electricity shortages, it has also resulted in a relatively high reserve margin, a measure of the system's excess capacity; such margin reached 82% in 1990, when the overall system's installed  -15 - capacity reached 17,016 MW while the peak load was only 9,342 MW.11 Such overbuilding of capacity typifies the segmented decision making process that exists in the planning agencies (MENR, SPO and TEK) and implementing agencies (TEK, DSI, CEAS, KEPEZ) in the power subsector. The least-cost investment program in power, which has been agreed among all such agencies, addresses this problem and provides for a better balance between generation, transmission and distribution (para. 2.06) and, most significantly, for a progressive reduction of the reserve margin to 55% in 1995 and to 35% in the year 2000, a level considered adequate for a power system of Turkey's characteristics, with between 45% to 50% hydro capacity, large variations in the country's hydrology, and poor interconnections with neighboring countries. Given such characteristics, excess generation capacity in 1990 was much less at 47% (with the above 82% reserve margin of that year). 2.07 The proposed Project would support TEK's least-cost medium-term investment program (1990-94) in the power subsector. To this effect, a detailed review of power subsector investments with regard to the volume, composition and phasing of such investment program, and on the respective roles of TEK, DSI and the private sector has been carried out. Power subsector investments, both actual during the Fifth Plan (1984-88) and those projected for the Sixth Plan (1990-94), for both the public and private sectors, are given in Table 2.1 (Annex 2; further detail is given in Item 5 of Project File; ref. Annex 6). During the Fifth Plan, power subsector investments were concentrated in generation (66% of total), while transmission and distribution (16%) received considerably less emphasis. The Sixth Plan addresses this imbalance. The volume of power subsector investment during the Sixth Plan has been reduced by about 13% compared to that under the Fifth Plan (1984-88) as a result of rationalizing investments. Investments in generation by the public sector are to fall by about 62% in real terms--affecting both TEK and DSI--whereas those in transmission and distribution are to increase by 63% in real terms over the same period, from about US$1.9 billion to US$3.1 billion in 1989 prices. Hence the share of total investments accounted for by transmission and distribution would rise significantly from 16% to 42%. The share envisaged for the private sector has also been considerably expanded. Several BOT projects are expected to begin during 1991-93, and the private sector is to become involved in the distribution system. Private investment in power generation projects alone is expected to total US$2.2 billion in the Sixth Plan (compared to less than US$100 million in the Fifth Plan) representing 43% of total investment in generation. International experience suggests that large projects under BOT arrangements are, however, subject to a greater degree of uncertainty given their complexity and innovative character. For the time being, existing surplus generating capacity (para. 2.06) enables Turkey to absorb such risks comfortably. High priority projects in the power subsector over the 1990-94 Plan period would require investment estimated at US$10.1 billion in 1989 prices, of which US$7.4 billion in the public sector and the remaining US$2.7 billion in the private sector. 1/ Installed capacity reserve margin in 1990 - 17.016 MW - 9.342 M-W - 82% 9,342 MW  - 16 - Table 2.1: Planned Power Sub-sector Investment (1984-94) (US$ Million in 1989 prices) Fifth Plan(1984-88) Sixth Plan(1990-94) _____ - ___---------- X-- Amount X of Total Amount X Of Total Chanac Public Sector 11.437.0 100.0 7.401.0 100.0 -35.3X Generation 7,494,0 65.5 2,875.0 38.8 -61.6X Transmission 712.0 6.3 1,468.0 19.8 106.22 Distribution 1,161.0 10.1 1,625.0 22.0 40.02 Other 2,070.0 18.1 1,433.0 19.4 -30.8S Private Sector 98.0 10, a.695.0 100.0 2650.0X Generation 98.0 100.0 2,167.0 80.4 2111.2X Transmission 0.0 0.0 0.0 0.0 0.0X Distribution 0.0 0.0 528.0 19.6 N/A Other 0.0 0.0 0.0 0.0 0.0X Total 11.535.0 100.0 10.096.0 100.0 -12S Generation 7,595.0 65.8 5,042.0 50.0 -33.6X Transmission 712.0 6.2 1,468.0 14.5 106.2X Distribution 1,161.0 10.1 2.153.0 21.3 85.4X Other 2,070.0 17.9 1,433.0 14.2 -30.8X Total 11.535.0 100.0 10.096.0 100.0 -12.5X Public Sector 11,437.0 99.1 7,401.0 73.4 -35.32 Private Sector 98.C 0.9 2,695.0 26.6 2650.0X N/A - not applicable C. The Financing of the Least-Cost Investment Program (1990-94) 2.08 Public sector investments in the power subsector together with the financing plans, actuals for the Fifth Plan (1984-88), the transition year 1989, and the first year of the Sixth Plan (1990), as well as projected for the remaining period of the latter (1991-94), are given, as yearly averages, in Table 2.2 (in current US Dollars). Table 2.2: Public Sector Investments in Power and its Financing. 1984-94 (Yearly Averages) (In current US$ Million) a/ ---Fifth Plan--- ------------Sixth Plan----------- 1984-88 (actual) 1989 (actual) 1990 (prov.) 1991-94 (proj.) Amount X Amount X Amount X Amount X Investments TEK 1483.2 71.5 1551.0 73.8 1760.0 70.4 1347.0 74.3 DSI 592.2 28.5 552.0 26,2 741.0 29.6 466.3 25.7 Total 2075.4 100.0 2103.0 100.0 2501.0 100.0 1813.3 100.0 Financinz Net ICG 145.6 7.0 -830.2 -39.5 -644.4 -25.8 222.5 12.3 GOT Equity 98.6 4.8 490.3 23.3 60.2 2.4 555.0 30.6 Borrowings 1239,0 59.7 1890.9 8L9. 2344.2 93.7 569.5 31.4 TEX Total 1483.2 71.5 1551.0 73.8 1760.0 70.4 1347.0 74.3 DS5 PPA Adm. 198.6 9.6 289.0 13.7 226.0 9.0 399.6 22.0 GOT Budget 393.6 19.0 263.0 12. 51.0 20.6 66.7 3.7 DSI Total 592.2 28.5 552.0 26.2 741.0 29.6 466.3 25.7 Public Sector Total 2075.4 100.0 2103.0 100.0 2501.0 100.0 1813.3 100.0 a/ Average exchange rates were used; Source: IFS and IBRD.  - 17 - 2.09 The sources of financing power subsector development in Turkey comprise GOT's budget, PPA, TEK and the private sector. CEAS and KEPEZ, the two private sector utilities, would finance about 23% of the expected private sector investment in generation during the Sixth Plan, while the remaining 77% would be through BOT schemes. The Government budget and the PPA finance DSI's hydropower investments, while TEK is expected to be able to mobilize the resources to finance its investments. The PPA was established in 1984 by Law 2983 as part of the Government's innovative resource mobilization policy to finance infrastructure investments. The PPA issues revenue sharing bonds to the public against specific revenue earning infrastructure investments. Also, the agencies responsible for managing these investments pay a certain fee to the PPA, not necessarily related to the interest yield on the bonds. In the power subsector, the PPA has been involved in the financing of hydro-schemes. TEK, which is responsible for operating and maintaining these hydropower plants constructed by DSI, pays to the PPA about 53.5% of net average revenue per kWh (net of all taxes and levies) on the generation from those power plants financed in part by the PPA. Accordingly, the levy constitutes a variable cost for TEK as it is directly proportional to the output from existing hydro plants. 2.10 The 1991-94 time-slice of the public sector's least-cost investment program in power would be financed to a larger degree than in the past from subsector revenues rather than through borrowings, as indicated by the subsector's self-financing ratio, measured as the sum of TEK's net internal cash generation (ICG) and the levy which TEK pays to the PPA (para. 2.08). This sum would increase from 17% of total public sector investments during the Fifth Plan, and from negative levels in 1989/90, to 34% during 1991-94 (Table 2.2). TEK's net ICG would increase from 7% of total public sector investment (including the hydro plants of DSI) in the Fifth Plan to 12% during 1991-94, as a result of the reform of tariff policy and other reforms to be carried out under the Project. In addition, with the progressive commissioning of several large generating units of the Ataturk hydropower plant during 1991-93, the entire local cost requirements of DSI's medium term investment program could be financed from the levy collected by the PPA. Under existing arrangements (para. 2.09), the PPA's share of total power subsector investment financing would increase from 10% in the Fifth Plan to 22% during 1991-94, thereby reducing the need for Government budgetary appropriations from 19% to only about 4% of total investment. To ensure expansion of the country's power system at least cost, the Government agreed to a medium-term least-cost investment program for the power subsector, composed of ongoing and new projects for each of the entities in the public sector, as well as for the private sector, for the period 1990-94, including a financing plan for each entity. Furthermore, TEK agreed to, beginning 1991, review with the Bank no later than October 31 of each year, progress achieved in carrying out its investments, and update, in agreement with the Government and in a manner satisfactory to the Bank, TEK's investment program as an integral part of the overall power subsector least-cost investment program, and the mea-ures necessary for its implementation. III. TEK'S MEDIUM TERM CORPORATE RESTRUCTURING PROGRAM A. CorRorate Background and Recent Performance Corporate Background 3.01 TEK is a wholly GOT-owned public economic enterprise attached to the Ministry of Energy and Natural Resources (MENR). TEK was originally established in 1970 with responsibility only for generation and transmission of electricity.  - 18 - In 1982, the responsibility for distribution of electricity was transferred to TEK from the municii.-lities. In 1984, Decree KHK 233, which has the force of Law, contains measures aimed at improving productivity and efficiency of both SEEs (i.e., those in manufacturing and commerce) and of Public Economic Enterprises (PEEs, i.e., public utilities and services like TEK) and giving greater autonomy to the SEE/PEEs. Subsequently in 1985, the Principal Statute of TEK was enacted which classifies TEK as a PEE under Decree 233. The overall responsibility to set policies for energy planning and to review annual investment programs, continues to be vested in the Government, despite TEK's new Statute. However, Decree 233 grants TEK the authority to set its prices, with a proviso that, whenever necessary, the Council of Ministers can require an adjustment of these prices, with the payment of an appropriate subsidy to TEK. The personnel policies for administrative and contractual employees of SEEs and PEEs, including TEK, continue to be subject to the provisions of old legislation, which assimilated their staff to the civil service. As a result, the Government continues to influence TEK's management and corporate policies. Detailed institutional analyses of the impact of such institutional framework on TEK's organizational, managerial, and operational aspects is provided in the Project File (Item 7, ref. Annex 6), and suumarized below. 3.02 TEK comprises a General Management Organization (GMO), a Generation and Transmission Enterprise (GTE), and 72 Distribution Enterprises (DE). The GMO is the overall policy making as well as the policy implementing body. The GTE is responsible for consolidating the energy available from TEK's various power plants as well as from non-TEK generation sources and transmitting it to several large industries directly and to the 72 DEs. The DEs are responsible for supplying electricity locally in their designated areas. The GTE and DEs are formally distinct from TEK, with their own capital, but in practice they do not enjoy the required level of autonomy from the GMO. 3.03 TEK also holds equity in one Affiliated Partnership and 12 Participations in Turkey. The detailed list of TEK's investment interests, showing the value and percentage of TEK's shareholdings, is included in the Project File (Item 7, ref. Annex 6). TEK's Affiliated Partnership is the TEMSAN (Turkish Electromechanical Industry Inc.), in which TEK holds 93% of the shareholding. Government policy, as reflected in TEK's statute, has been to make the utility also responsible for promoting the development of the electromechanical industry within Turkey. Among the 12 Participations, four generate electricity from small hydro schemes; two others are involved exclusively in electricity distribution; five manufacture electrical equipment; and the remaining one primarily provides consulting services to the private and public industrial sector which install and maintain captive power plants. Government policy to involve TEK in the generation and distribution partnerships is aimed at facilitating adherence to national standards in planning, construction and maintenance of electrical plant and equipment. Under this framework, TEK's holdings in the manufacturing entities are to enable TEK to have access to equipment supplies in times of emergency, as well as to promote competition in the electrical equipment manufacturing industry. TEK's provision of consulting services for setting up captive power plants aims at reducing the public and private sectors' dependence on relatively expensive foreign consultants. All of these Participations and the Partnership are independently managed by their own Board of Directors elected by their respective shareholders with no direct interfere!z:e from TEK's management. TEK's investments in these Participations and the Partnership, which account for about TL 34 billion (US$11 million), are very small as these represent less than one-tenth of 1% of TEK's employed assets.  - 19 - Recent QOerational Performance 3.04 TEK's Existing Power Infrastructure. TEK's installed generation capacity at the end of 1990 was about 15,039 MW, comprising about 6,431 MW (43%) of hydro capacity and the remaining 8,608 MW (57%) of thermal. Roughly 55% of the thermal capacity is based on indigenous lignite, while the remaining 45% is based on fuel oil (8%), diesel (4%), natural gas (30%), and hard coal (3%). As regards transmission, TEK's National Grid System is based on 8,330 km of 380- kV trunk lines, while 20,200 km of 154-kV lines connect shorter distances. In addition, there are 87 km of 220-kV lines and abouit 1,650 km of 66-kV lines. At the 380-kV level, TEK's transformer capacity amounts to 10,290 MVA, comprising 71 transformers in 28 substations. At the 154-kV level, transformer capacity amounts to about 18,328 MVA, comprising 500 transformers spread over 292 substations. As regards distribution, TEK's consumers are served by about 483,000 km of distribution lines which are fed via 96,158 transformers with a total capacity of about 24,000 MVA. 3.05 TEK' s operational performance has not been fully satisfactory, judged from a perspective of plant availability, thermal efficiency, and system losses. In the generation area for instance, compared to the installed capacity of over 15,000 MW in November 1990, the effective available capacity then was only 10,500 MW. Only a small portion (370 MW) of such a large difference can be explained by the hydro capacity based on run-of-the-river schemes (which are available only during rainy season), while another 1,000 MW was under planned maintenance. The remaining unavailable capacity was due to: (i) forced outages, as a consequence of improper maintenance planning and scheduling; (ii) derating of thermal capacity, primarily because of differences in specifications of input fuels; and (iii) inappropriate operating practices. In addition, since 1985, the introduction of the PPA levies on certain major hydro plants (Keban, Karakaya, Kokluce, Oymapinar and Altinkaya, which account for 71% of hydro capacity or 31% of total capacity), has acted as a disincentive for TEK to optimize hydro generation, as a consequence of the way the PPA levy is administered (para. 2.09). Furthermore, TEK's generation expansion has been at the expense of the transmission and distribution systems and as a result, system losses are about 14%, with losses in some distribution enterprises reaching 35%. 3.06 If the availability of TEK's plant had not been well above the system's peak demand of 8,900 MW (in November 1990), TEK's consumers would have experienced power shortages. Therefore, TEK needs to improve the system's operating efficiency. At this juncture, TEK does not know the real costs of its operations in many areas. Operational costs are not systematically planned, nor recorded due to the lack of adequate information on unit commitment, maintenance scheduling, and unit efficiency. Moreover, TEK does not maintain accounts of costs at PPA-financed hydro plants although it operates them, because, irrespective of the costs incurred to generate electricity at these plants, TEK has to pay PPA levies proportional to their output. TEK's records of fuel costs are also unreliable, as illustrated by the fact that the records kept by the plant and accounts departments are not reconciled. Furthermore, transmission and distribution costs are not identified separately. Lacking a proper costing basis, TEK is unable to establish a proper tariff setting mechanism that would help achieve TEK's short- and long-term development objectives. Attempts have been made in the past with the help of reputable consultants, to determine the economic costs of supply as a basis for tariff formulation. However, with the excessive system expansion of the 1980s, which was .!inanced mostly with debt, tariffs based on economic costs of supply were inadequate even to meet operating costs and debt service. Furthermore, the fact that TEK's plant and equipment originates from various sources, both OECD and Eastern European, has given rise  - 20 - to differing levels of technology and to varying cost efficiencies in TEK's system, particularly in generation. As a result, TEK has not been able to identify the operating costs, nor to formulate a comprehensive efficiency enhancement program. Recent Financial Performance 3.07 Detailed analysis of TEK's past performance for the period 1985- 90, and a discussion of the reasons for TEK's financial deterioration are presented in the Project File (Item 8, ref. Annex 6) and summarized here. The financial affairs of TEK are governed by the 1985 TEK Statute which stipulates that TEK is a PEE with the autonomy to manage its financial affairs, and to set its own prices. In return for such autonomy, since 1985 GOT is ostensibly no longer expected to make contributions towards TEK's investments. GOT, however, does guarantee TEK's debt. The financial performance criteria for TEK agreed with the Bank primarily comprise an internal cash generation (ICG) covenant. This covenant replaced in 1980 a rate of return target which was impractical to monitor in the absence of regular fixed asset revaluations. The ICG covenant required TEK to generate each year from internal sources, 35% of the investments undertaken by TEK and DSI. In addition, TEK has agreed to maintain the ratio of current assets to current liabilities at least at 1.0 and to improve its billing and collection system to bring down its receivable levels to 90 days of electricity sales. TEK has not been able to comply with the accounts receivable agreement since its inception in 1985. The current ratio covenant also remains in non-compliance since 1987 and the ICG covenant, waived for 1987, remained unmet since. 3.08 Table 3.1 below shows the evolution of key indicators of TEK's financial performance in the 1985-90 period. Table 3.1: TEK's Key Financial Indicators. 1985-90 'rov. 1985 1986 1987 1988 1989 19S0 Operating Ratio (2) 60.6 73.2 84.6 97.4 106.5 9s.0 Current Ratio 0.9 1.0 0.8 0.6 0.6 G.' Return on Assets (M)a/ 26.5 23.0 10.6 1.4 -3.6 3.0 Internal Cash Gen (X) 32.2 34.2 7.4 -14.4 -50.5 -47.9 Debt Service Coverage(times) 1.6 2.6 1.0 0.7 0.4 .6 Net worth - TL Billion b/ 917 940 748 780 1372 - $ million c/ 1582 1237 731 419 593 , a/ On revalued net fixed assets in use. b/ Total revalued assets less revaluation reserve less liabilities. c/ At end-of-year exchange rates; source : IFS. TEK's ability to generate a financial surplus from operations to meet debt service and other fixed costs was severely eroded, largely as a result of tariffs adjustments not having kept pace with inflation. This is reflected in the ratio of operating costs to operating revenues which deteriorated from 60.6% in 1985 to 106.5% in 1989. Technically TEK is illiquid, as its short-term obligations are larger than the short-term assets: their ratio deteriorated from 1.0 in 1986 to 0.6 in 1989. The utility's return on net tevalued fixed assets in use, which was 26.5% in 1985 deteriorated to a negative 3.6% in 1989. The large returns in 1985-87 are attributable to the absence of regular and appropriate fixed asset revaluations in the early part of the 1980s and are therefore overstated. During 1988-90, TEK's asset base (in nominal TL terms) increased dramatically (by an average annual compounded rate of 81% from 1987 levels) because of cost overruns (e.g., Elbistan Thermal Power Project), sizeable nominal devaluation of the  - 21 - Turkish Lira, and overinvestment in generation projects without matching investments in ,"v^.0 transmission and distribution, resulting in * cl capitalization levels far in excess of their respective revenue earning capabilities. Despite insufficient surpluses from operations, TEK ~w .-fa continued to undertake new investments relying primarily on borrowings, mostly in foreign exchange, to finance them, allowing the ICG ratio to deteriorate from 34% in 1986 to a negative 51% o in 1989 and a negative 48% in 1990. In other words, in 1988 to 1990 TEK had to borrow substantially also to finance its operating Figure