Peru - Electricity Privatization Adjustment Loan

Dmeiimt of Tbe World Bank FOR OFFICIAL USE ONLY Reprt No. P-6138-PE REPORT AND RECOMKENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED ELECTRICITY PRIVATIZATION ADJUSTMENT LOAN IN AN AMOUNT EQUIVALENT TO US$150 MIlLION TO THE REPUBLIC OF PERU OCTOBER 27, 1994 1IT r C AP 1IotX Ty;:e: P9 This document has a restritd distributon and may be used by recipients only in the perfornmae of their offiecia duts. Its contents may not otherws he dilosed without World Bank autrbiation.  CURRENCY EQUIVALENTS (as of October 27, 1994) Currency Unit = Sol US$1.00 =S./2.25 1 Sol = US$0.4444 FISCAL YEAR January 1 to December 31 PRINCIPAL ABBREVIATIONS AND ACRONYMS GW - Gigawatt (1 million kW) kW - Kilowatt kWh - Kilowatt-hour kVA - Kilovolt-Ampere Mt - Metric ton MW - Megawatt TWh - Terawatt-hour CEPRI - Special Privatization Committee COES - Committee for Economic Operation of the nterconnected System COPRI - Commission for Promotion of Private Investment CTE - Electricity Tariff Commission DGE - General Electricity Directorate Electrolima - Lima Electricity Company Electroperu - Peru Electricity Company EMTAL - Energy and Mining Technical Assistance Loan ETECEN - Enterprise for Electricity Transmission in the Central Northern Interconnected System INDECOPI - National Institute for the Defense of Competition and Protection of Intellectual Property MENI - Ministry of Energy and Mines OTERG - Tecbnical Office of Energy  FM OURCIL USe OMY mu ELECTRICITY PRlVAMIZM ADlUIME LON Table o Contents Loan and Program Summary ............. . . . . .* I 1. Electricity Sector ...................................... . 1 A. Background ................................... 1 B. Goverment Sectoral Objectives and Strategy . .............. 2 C. Reform Program to be Supported by the Loan . . . 3 (a) Macroeconomic Framework ........... 3 (b) Legal, Regulatory, and Institutional Reforms ........... 3 (c) Electricity Pricing ............ S (d) Privatization of Electricity Holdings .... ............. 7 Environmental Aspects ........... 9 Social Impact............. 10 u. The Propose Loan ........... 10 Description ............. 10 Proposed Loan Conditions ........... 10 Technical Assistnce ................ 11 Monitoring and Reporting ............ 11 Procurement, Disbursement, Audit, and Administation ........... 11 Benefits ............ 13 Risks ............ 13 m. Recommendation ............ 14 ANNEXES I Relationship Among Bank Adjustment Operations 2 Projections of Key Economic Indicators 3 Policy Matrix 4 Policy Letter S New Legal/Regulaory Framework for the Electricity Sector 6 Assets of Electrolima and Elect u 7 Energy Sector Strategies and Policies 8 Supplementary Loan Data Sheet 9 Status of Bank Group Operations in Peru This douent has a resicted dist oa and may be used by redpients only In the peormance o I their offlcdl duties. Its contents may not othew be didosed without World Bak authorizton  PERU ELECTRICITY PRIVATIZATION ADJUSTM LOAN Loan and Program Sunmmary Bornower: Republic of Peru Excuting Agencies: Ministry of Energy and Mines; Conmission for Promotion of Private Investment Amount: US$150.0 niillion equivalent Terms: Repayment in 17 years, including five years of grace, at the standard variable interest rate. Loan Objectives: The proposed loan would support the Government's electricity privatization program and related legal/regulatory and institutional reforms. The program is designed to promote adequate and environmentally sustainable electricity sapplies and to enhance economic efficiency through competition and private sector involvement. Loan Descripdon: The reform program to be supported by the proposed loan includes four components: (a) maintenance of a satisfactory macroeconomic program and financing plan; (b) implementation of legal, regulatory, and institutional reforms in the electricity sector to promote ompetition and facilitate privatization; (c) application of electricity pricing based on economic costs; and (d) privatization of the electricity sector. Benefits: Privatization and related regulatory reform are expected to result in: (a) improved service reliability and responsiveness to demand; (b) increased efficiency through pricing reform, improved management, and introduction of coetition, (c) private investment; and (d) fiscal benefits through the elimination of subsidies and increased tax revenue from more profitable sector companies. Risks: There is a risk that the macroeconomic and sectoral adjustment will be weakened, and that the reform process would not be permanent. Election-year pressures might bring about some backsliding in the Government's program. Nevertheless, the Government is expected to achieve its program targets, given its adherence to sound macroeconomic policies and its commitment to sustaining the stabilization and structural reform program, as evidenced by its agreement with the Bank and IMF on a macroeconomic program and financing plan for 1993-95. Maintenance of a macroeconomic policy framework and financing plan consistent with the objectives of the overall stuctural reform program supported by the Bank is a condition for all tranche releases of this loan. With respect to electricity privatizaion, the main risks are that: (a) the Government will face difficulties in attracting private companies; and (b) Government intervention in the tariff-setting process wil resume. The new legal/regulatory regime and the tariff system are designed to enhance incentives, increase competition, and ensure economic and financial viability for the sector, which ought to stimulate private investment. There has thus far been strong investor interest in ongoing privatizations in the electricity sector. To address the risk of political  - ii - intervention in tariff setiag, the 1992 Electricity Law establishes the authority of the Electricity Tariff Commission and the automaticity of tariff adjustnents. Their effective maitenance are conditions of all tranche releases. EanatedDisbursemets: Bank FY 1995 1996 Aual: IOG.O 50.0 Cumulative: 100.0 150.0 Disbursements will be made upon fulfillment of conditions of effectiveness, second tranche release, and third tranche release, respecti ely. E _ WClassi catn: B Povert Category: Not Applicable  REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED ELECTRICITY PRIVATIZATION ADJUSTMENT LOAN TO THE REPUBLIC OF PERU 1. I submit the following report and recommnendation on a proposed losn to the Republic of Peru for the equivalent of US$150 million. The proposed loan would support the privatization of the Government's electricity holdings and implementation of related policy and regulatory reforms in the sector. The loan would be repayable over 17 years on a fixed amortization schedule, including five years of grace, at the Bank's standard variable interest rate. 2. This report is being accompamed by a separate document on the Country Assistance Strategy (CAS) for Peru, which analyzes the current position and proanects of the economy and the Bank's strat-gy to assist in the development process. The previous CAS was presented to the Board on April 20, 1993. The Bank's long-term objectives, as outlined in the CAS, are to assist the Govemment in: (a) infrastructure development; (b) poverty alleviation/income dtribution; (c) institution building; and (d) macroeconomic sustainability. By supporting privatization and regulatory reform in the electricity sector, the proposed Loan contributes to the objective of assisting the Goverunent to improve the performance of infrastructure services. The Government expects that privatization will not only enhance the efficiency of existing assets, but also attract additional private investment to the electricity sector. By supporting the maintenance of a satisfactory macroeconomic framework, the Loan contibutes to the strategy of ensuring economic sustainabiity. The proposed operation is, therefore, consistent with the Bank's assistance strategy for Peru. I. TIE ELECTRICITY SECTOR A. Background 3. Regulatory reform and privatization in the electricity sector are critical components of the Government's structural reform program. Over extended periods, the sector was adversely af1ected by inappropriate policies and institutional weaknesses at the government level, and managerialoperational deficiencies and a critical financial situation at the enterprise level associted with inadequate pricing and high indebtedness. Electricity supplies continue to be hampered by low reliability and high losses. Installed generation capacity has fallen behind demand: only 1,062 MW were added in 1980-93, compared to about 1,400 MW of increased demand over the same period. Transmission and distribution networks are in poor condition. Drought-inflicted shortages of hydropower in 1992 and major maintenance requirements in 1994 made extensive electricity rationing necessary. 4. Since nationalization in the early 1970s, public electricity service has been provided exclusively by goverment-owned utilities. These include: (a) Electropeu, a nation-wide generation and transmission utility, which sells entirely in bulk to other utilities; (b) Electrolima, the second- largest generation company and the largest distribution company, serving the greater Lima region, and  2 (c) nine smaller regional utilities'. As part of institutional reform and in preparation for privatization, Electrolima's and Electroperu's transmission assets were transferred in early 1994 to a separate transmission company for the central-northern grid (Empresa de Transmisi6n El6ctrica Centro Norte; ETECEN S.A.), whereas Electrolima was segmented into one generation and two distribution companies. Installed generating capacity in the public system in 1993 totalled 2,897 MW (hydro accouwts for 75 % in the overall public system, and for 91 % in the interconnected Central- Northern Systemn), and generation, 10.9 TWh. In the same year, self-generatmig capacity largely in mining and manufacturing ainunted to some 1,300 MW and generation, to 3.6 TWh. During 1980 92, public system generation incre:1 by 3.8% annually to 9.6 TWh, while growth of sales averaged only 2.7% annually because of t'ie elec,ricity system's own consumption plus technical and adnunistr.t ive losses, which have increased from 13% to 22%. The composition of sales in 1993 was as follows. 45% were made to industrial customers, 36% to residential customers, 5% to commercial customers, and 14% to others (including Government). 5. The Ministry of Energy and Mines (MEM) is responsible for formulating sector policies and, through its General Electricity Directoate (DOE), for normative regulation, especially supervising the sector enterprises. The autonomous Electricity Tariff Commission (CTE) is charged with economic iegulation, primarily the setting of tariffs. B. Government Sectoral Objectives and Staeg 6. The Government became aware soon after taking office in mid-1990 that, in order to obtain adequate and efficient electricity supplies without draining public resources, far-reaching policy and Institutional reforms in the sector were needed, with competition and privatization as " ,ir centerpiece. These reforms were to be achieved by allowing market forces to exert their allocative function through (a) deregulation of activities where competition is feasible, combined with arm's- length regulation of natural monopolies; and (b) privatizaeon of state-owned enterprises, with future expansion to be undertaken primarily by private investors. As a consequence of this approach, the role of the state in the electricity sector has been redefined, clearly separating its policy and regulatory role from its subsidiary - and transitional - role as owner of public enterprises. For this purpose, the Govermnent under the US$300 million Structural Adjustment Loan (Loan No. 3452-PE; Board Approval on March 26, 1992) outlined a new sector development strategy, including a specific, time-bound agenda for legal/regulatory reforms, as part of its overall privatization strategy. These reforms will be implemented under the proposed Loan. In combination with similar reforms for the hydrocarbons sector being implemented under the US$250 million Privatization Adjustment Loan (Loan No. 3595-PE; Board Approval on April 20, 1993), the energy sector in its entirety is expected to become more competitive and efficient. Annex 1 sets out the linkages among Bank adjustment operations in the area of privatization and reguatory reform. 1. Electro Norte, Electro Nor-Oeste, Electro Norte-Medio (formerly Hidroandina). Electro Centro, Electro Sur-Medio, Electro Sur-Este, Sociad El5ctrica del Sur-Oeste, Electro Oriente, and Electro Sur.  3 C. Reform Program to be Supported by the Loan 7. Deficient electricity supplies have been a major consttaint to the development of Peru's economy. Therefore, reform of the electricity sector is an integral part of the Goverunent's global program of economic adjustment and restructuring. This reform aims at ensuring adequate and envinrmnentally sustainable electricity supplies required by the growing economy, enhancing operational efficiency, and eliminating the fiscal burden caused by electricity operations. These aims are to be achieved through decentralization, competition, and maximum reliance on the private sector. The program to be supported by the Loan has four components: (a) maintaining a satisfactory macroeconomic program and financing plan, consistent with the objectives of sectoral reform; (b) implementing legal/regulatory and institutional reforms in the electricity sector; (c) implementing electricity pricing reform; and (d) privatizing the Government's holdings in the sector. (a) Macroeconomic Framework 8. In order to successfully implement the Government's privatization program, both in the electricity sector and throughout the economy, satisfactory macroeconomic policies and performance need to be sustained and structural reforms need to be nmaintained and deepened. Following the successful completion of the debt workout program in early 1993, agreement was reached on a three- year macroeconomic program and financing plan for 1993-95. This program is being supported by the IMF through a three-year Extended Fund Facility, and by the Bank through its adjustment lending. To ensure continued satisfactory macroeconomic policies and performance, maintenance of a macroeconomic policy framework and financing plan consistent with the objecdves of the overall structural reform program supported by the Bank and satisfactory progress in implemeneting the electicity sector reform progrm set oet in the Policy Letter, are conditions of effectveness and of second and third ranche releases for this operation. During negotiations, agreement has been reached with the Government on specific macroeconomic targets to be monitored during this operation. These targets, which for 1994-95 are consistent with the IMP program, would be as follows: (a) Central Government current revenue approaching 12.5 percent in 1994 and 14.2 percent in 1995; (b) primary fiscal balance of 1.1 percent of GDP in 1994 and 1.4 percent in 1995; and (c) inflation declinmg to 20 percent in 1994 and 12 percent in 1995. 9. Progress in the overall reform program has been good. However, one feature of the macroeconomic program, specifically in the area of financial sector reform supported through the US$400 million Financial Sector Adjustment Loan (Loan No. 3489-PE; Board Approval on June 17, 1992), has lagged. This concerns the reform of the state-owned Banco de la Naci6n and disposal of the assets of the development banks. The Government has made progress in undertaking the necessary restructuring measures, and reiterated its commitment to completing these reforms. (b) Legal, Regulatory, and Institutonal Reforms 10. Following the nationalization of the electricity sector in the early 1970s, inadequacies in the sectoral legal/regulatory framework, organization, and policies have stifled efficiency. Past governments cansidered the sector more as a vehicle to extend subsidies, control inflation, and create employment, ttan as a productive activity. After 1985, CTE lost its authority to set tariffs. Government interference and financial constraints weakened sector management, impeded corporate efficiency, and worsened employment conditions, which militated against attracting and retaining qualified personnel.  4 11. The 1982 General Law for Electricity aimed at establishing a decentralized institutional structure for the sector while maintaining public ownership and management. Nine regional utilities were created, for which Electroperu was to act as a holding company. However, fronm 1985 onward, ownership of these utilities was transferred to the regional governments. Because of ambiguities in ownership caused by contradictory legislation and conflicts between Electroperu and the regional governments over the division of assets and liabilities, the regionalization process created confusion to the point of jeopardizing the efficient operation of the inter-regional systems. In an effort to resolve these issues, MEM in 1992 assumed control of the shares of the regional utilities. 12. Government Action. In order to provide a cohesive framework for electricity sector reform and ensure consistency between the sector structure and the legal/regulatory system, the Govermnent has adopted market-oriented concepts that have been sLccessfully applied in Chile and Argentina. They are based on the principles of decentralization, competition, deregulation where competition is feasible, and arms-length regilation oi natural monopolies. The Government enacted in 1992 the new Law on Electricity Concessions and in early 1993, the corresponding regulations covering the public system, which redefine the role of public institutions in policy making, sector entry and exit, pricing, investments, and quality of service. They establish that (a) generation will be decentralized, deregulated, and made subject to market forces through competition; (b) transmission will provide third-party access to all suppliers with an adequately regulated toll scheme; and (c) distribution will continue as a natural monopoly, with fully regulated rights and duties of suppliers and consumers, including the obligation to provide service of adequate quality. 13. Integrated enterprises have been segmented into independent companies at the generation, transmission, and distribution levels. Equity participation by generation or distribution enterprises in primary transmission is disallowed, and limits in cross-shareholdings are being determined, so as to establish clear accountability and prevent the emergence of monopolistic conditions. The new Electricity Law and regulations also stipulate the formation of supply pools by generation and transmission companies (Committees for Economic Operation of the Interconnected System - COES) to manage load dispatrh. The COES will be responsible for calculating short-run marginal costs and node prices and developing the least-cost dispatch program for system operation, for review by CTE and as basis for tariff setting. The formation of COES has been completed for the Central-Northern System and is pending for the two southern systems, awaiting their interconnection. The new structure of the electricity sector ensures open access to all stages of the grid and free contracting between producers and distributors and major consumers. Large-volume consumers (in excess of 1,000 kW, accounting for about 40 percent of total sales) will be allowed to negotiate contracts directly with generation and distribution companies. Small-volume consumers will be protected through tariff regulation based on marginal cost pricing. Finally, transactions between generating companies will be self-regulated by the COES (see Annex 5 for a description of the new legal/ regulatory framework). 14. The Government, with support from the US$11.8 million Energy and Mining Technical Assistance Loan (EMTAL; Loan No.3610-PE; Board Approval on June 1, 1993), has taken steps to strengthen MEM and other public entities in their policy and regulatory functions. MEM, through DGE, will be responsible for normative regulation, which includes granting concessions and authorizations, approving contracts, setting technical standards, supervising service quality, monitoring compliance by the enterprises with their new obligations, administering the sector information system, and providing access to technical and financial information on utility operations. The Ministry's Technical Office for Energy (OTERG) will be responsible for evaluating options for  5 overall energy deveiopment and for preparing an integrated energy strategy, and is to act as an advisory entity for sector strategies and policies. OTREG will also maintain an indicative expansion plan for electricity generation and transmission which will be available to interested investors and operators to assist them in planning new projects. CTE will continue to be responsible for tariff setting for regulated consumers, as defined by the 1992 Electricity Law. The 1992 Law also specifies revenue sources for CTE, independent of the Government. 15. For the market-based scheme in the sector to be viable, open accee ) the transmission network for generation and distribution co'upanies is essential. This in t. n requires that transmission systems be separated from Electroperu and Electrolima. ETECkN, the transmission company for the Central-Northern network, was legally established in 1993. Electroperu's and Electrolima's transmission assets we 'ransferred to ETECEN in January 1994, based on an agreement between the parties on the value of transmission assets so transferred. 16. Further Refonns to be Supported by the Loan. Sector reforms are well advanced with the enactment of the 1992 Electricity Law and attendant regulations. However, subsequeni to the enactment of the Law, the Government, concerned at the impact of electricity price increases on inflation, created in late 1992 a Technical Commission of COPRI (the Privatization Commission, consisting of representatives of the Economic Cabinet) with authority over public utility pricing including electricity. With the creation of this Commission, CTE's authority in tariff setting, as established in the 1992 Electricity Law, was restricted. The Government has communicated to the Bank its decision to eliminate, by November 1994, the authority of COPRI's Technical Commission over electricity pricing. Maintenance of CTE's full autonomy is a condition of second and third tranche releases. 17. While the 1992 Electricity Law promotes market-based schemes, additional measures are required to buttress competition in the electricity sector post-privatization. This includes antitrust measures, since the existing economy-wide competition legislation does not specifically address issues that could arise from the abuse of market power in the electricity secter, such as through cross- ownership between generation and distribution. Additional measures also comprise fair trade rules in regard to concession contracts, rules on COES supplemented by settlement arrangements to ensure commercial confidentiality, obligations to provide third-party access to the transmission system, and company charters that place limitations on cross-shareholdings. MEM and the National Institute for the Defense of Competition and Protection of Intellectual Property (INDECOPI) have prepared a draft Supreme Decree containg antimonopoly regulations for the electric.y sector. During negotiations, agreement was reached between the Government and the Bank on this draft Supreme Decree. Offciad publication of antitrust rules for electricity sector enterprises, and provision to the Bank of final model concession contracts for electricity trans ion and distribution assuing third- party access and use of, respectively, the htanmsion and distribution systems, are conditions of second tranche release. (c) Electricity Pricing 18. Tariff inadequacies in terms of both levels and structure have persisted over many years. Real tariffs during 1985-89 declined by 60 percent, to 18 percent of their economic cost overall and 2.3 percent for residential consumption. Country-wide uniform tariffs added to distortions, and cross- subsidization of the high-cost utilities undermined efficiency incentives. Taxes and surcharges on electricity consumption increased in number and complexity.  6 19. Government Action. The Government's reform program involved major increases in electricity tariffs, together with changes in the tariff structure and the process of tariff setting. Electricity tariffs were increased s:ibstaiitially from August 1990 onward. They averaged in October 1994 98.6 vercent of economic costs2 overall anJ 94 percent for residential consumption of less than 151 Kwh/uilonth. On a disaggregated basis, cost coverage for residential consumption of less than 151 kWh/month was 96% in the Lima systems and 88% in the remaining systems. Tariffs for all other customer categories cover 100 percent of their economic costs. Because of these advan-.es, the gap between rates and economic costs for consumption below 150 Kwh/month i as been significantly reduced, given that the mear. residential consumption is about 200 Kwh/month and the median roughly 175 Kwh/month. 20. In parallel, a far-reaching tariff reform has been implemented, which cmanged the basis for tariff setting from accounting to economic costs. Country-wide unified tariffs and the associated system of regional cross-suibsidization have been abolished, and distortions amnong and within different tariff categories have been eliminated. CTE devised a system of tar,ff regulation based on short-run marginal costs consisting of (i) tariffs at the generation through high-voltage transmission level, (ii) tansmission charges, and (iii) distribution tariffs to final consumers. Distribution tariffs have been consolidated into three categories according to voltage level (i.e., for low, medium, and high voltage), which reflect the cost of supply more appropriately than the previous distinction based on economic sectors. Residential consumers will be incorporated into the general low-voltage category once their tariffs reach economic costs. Under the new regulatory framework, regulated tariffs are not to deviate by more than 10% from the average of the freely negotiated prices for electricity sales to large consumers. Tariff options offered to end-users reflect fairly accurately the resource cost of meeting these users' demands. While tariff regulation is essentially based on cost of service, it does contain significant efficiency incentives because standard costs, not actual costs, are used for tariff setting. 21. Taxation on electricity consumption has been simplified through incorporating selective consumption taxes into the rate base, increasing the general consumption tax on electricity to 18% (i.e., its economy-wide rate) and extending its coverage, and removing discretionary surcharges that distort price signals. A municipal surcharge, which had been collected by the electric utilities on behalf of the municipalities, was incorporated into the low-voltage tariff in early 1994, thus terminating the practice of collecting municipal revenues through electricity bills. All electricity companies have been made subject to corporate income tax at the standard rate, irrespective of their ownership. The Govermnent also plans to revoke the enterprises' exemption from specific fuel taxes. 22. Further Reforms to be Supported by the Loan. Electricity tariffs that cover economic costs are a prerequisite for economic efficiency and for a:-racting private investors to the sector. While non-residential tariffs and residential tariffs for consumption above 150 Kwh/month are at their economic cost, residential tariffs for consumption of less than 150 Kwh/month are still below it. As a condition of second tranche release, all tariffs are to be set at 100% of economic cost. Maintenance of non-residentil and residential tariffs at 100% of economic cost is a condition of third tranche release. 2. Economic costs in the Peruvian tariff system are defined as short-run marginal costs averaged over the following 48 months.  7 (d) Privation of Mectridty Holdig 23. Following its nationalization in the early 1970s, the electricity sector became the largest segment of the state-owned sector in the economy, with assets estimated at roughly US $3 billion, consisting of Electroperu (US$2.1 billion), Electrolima (US$0.7 billion) and the nine regional utilities (US$0.2 billion). This represents roughly 40% of assets of state-owned enterprises, which total US$7.5 billion. 24. Goverment Action. In preparation for privaizing its electricity holdings, the Govermnent has reorganized the sector. Ietroperu, Electrolima, and the larger regional utilities have been segmented into independent companies for generation, transmission, and distribution, in order to make their corporate structure consistent with the new reguatory principles. 25. The privatization of the electricity holdings is being carried out within the context of the Gc;.ernment's broad privatization program. The legal/instituional framework for privatization was laid out in the 1991 Decree Law 674, which established an inter-ministerial commission (COPRI) to oversee the program. The technical preparatory work, at the enterprise level, is the responsibility of Special Privatization Committees (CEPRIs) which are designated by COPRI to prepare and implement privatizions for either one or a group of state-owned entprises. CEPRIs have been formed for both Electroperu and Electrolima, and are in the process of being brimed for the major regional utilities. 26. The Government has decided to privatize Electrolima and Electropern in segments, consistent with its objective to promote competition in the sector. Technical consultaL analyzed the structural options for segmenting and privatizing the e ps. Following the consultants' recommendation, Electrolima's metropolitan distribution network has been separated into two roughly equivalent companies (Edelnor for Lima North; Edelsur for Lima South). This allows the regulator to measure comparative performance through bencbmark competition, notwithstanding that distribution remains a natural monopoly. Subsequent to the preparation of the sales memorandum and bidding documents including pre-qualification criteria for privatization of the two distribution companies by financial advisors, majority interests in Edelnor and Edelsur amounting to 60 percent in each company were sold in July 1994 to consortia of Peruvian and international investors (for US$176 million and US$212 million, respectively, considerably exceeding the base price that had beeu set by the Government at about US$130 milion). Electrolima also has minor distribution operations in two areas outside Lima, which will be transferred to existng regional utilities and privatized together with those enterprises. In addition to distnbution, Electrolima has seven generation plants (six hydro and one thermal), which account for 689 MW of insalled capacity (635 MW of effective capacity, representing one-third of the total effective capacity of Electrolima and Electroperu combined). T;- e will be sold as one unit. 27. Electroperu manages 1,864 MW of installed capacity (including a new 200 MW gas turbine plant at Ventanilla) and an effective capacity of 1,428 MW. Its system consists of 10 generation plants (7 hydro and 3 thermal). It is dominated by the Mantaro-Restituci6n hydro complex, which accounts for 1,014 MWIV of installed capacity (40 percent of total generation capacity) and 779 MW of effective capacity (38 percent). Consultants evaluated Electropeu's generation plants and analyzed the segmentation options for privatization. It is expected that Electroperu will be segmented into six units for privatization purposes, including the Mantaro-Restituci6n scheme which is planned to be  8 privatized last. Electroperu's financial advisors submitted their report in Septemnber 1994. Electroperu's units are expected to be privatized in late 1994/early 1995. 28. The transmission assets/operations of Electroperu and Electrolima have been transferred to two newly formed transmission companies (for the interconnected central-northern and southern systems), which will operate separately and provide regulated open access. The transmission companies probably will be the last components of the sector to be privatized, for both economic/ finaial and physical security reasons. 29. The privatization of the regional utilities is expected to get underway in 1995, starting with those in regions where support for privatization is strong. 30. Further Refonns to be Supported by the Loan. This operation will support the privatization of Electrolima and Electroperu, which account for over 90 percent of sector assets (as defined in Arnex 6). The proposed tranche conditions have been structured to reflect the degree of importance of the different assets of the electricity sector, as well as the expected segmentation, timing, and sequencing of the privatizations. During negotiations, a strategy for the privatization of Electrolima and Electroperu was agreed upon (Annex 4). The major elements of this strategy have been incorporated into the Govenment's Policy Letter for this operation. The proposed conditions provide flexibility, while ensuring sustained momentum of the privatization process. The conditions &ae: by second trandie relea: offer for sale of a majority interest In (a) each of the Etectrolhma distribution utilities for metropoltan Uima, and (b) Electlas and Electroperu's generating utilities whose combined assets represent not les than 12 percent of total assets to be privatized in the sector; and by third tranche: offer for sale of a majority interest in the generating utilities whose assets represent at least 52 percent of totd privatization assets to be prvatized in the sector; and actual sale of a majority interest in the utffies whose combined assets represent at least 25 percent of total assets to be privatimed in the sector. 31. Achievement of the tranche condition "offer for sale' requires the completion of technical studies, issuance of bidding documents, and public bidding for sale of the assets or shares. While the third ache also requires the actual sale of a portion of total assets, it does not require the sale of any specifc unit or company, and therefore will not influence the bidding process nor compel the Govermment to accept unatractive offers. This approach recognizes, however, that if few of the initial offers for sale were successful, it might not be worthwhile to contimue with additional offers for sale and third tranche release. This is consistent with the approach foIlowed under the preceding Privatzaton Adjustme Loan. 32. Since both Electrolima and Electroperu will be sold in segments, it is necessary to establish "reference values" for each segment for purposes of setting the privatization targets and measurng progress against these targets. In this manner, units can be credited against the tranche release targets as they are offered for sale and sold. As the sales prices of the generating units are currenty unavailable, a method has been developed to measure ex-ante the "value" of each generation unit to be privatized based on its contribution to production, including its effective capacity, firm energy and secondary energy (Annex 6). This method is preferable to using the book values of the units, which in many cases are inflated as a result of excessive construction costs. On that basis, the Mantaro-  9 Restituci6n bydroelectric complex represents 48.7 percent of total Electrolima/Electroperu generation. It has been estimated that metropolitan Lima distribution accounts for 20 percent of Electroperu/Elestrolima assets. Neither the regional utilities nor the transmission assets of Electroperu and Electrolima have been included in the privatization targets, as these units are expected to be privatized in a second round. 33. To ensure cosistency and transparency in the process, all privatizations in the electricity sector follow COPRI's operational guidelines to the special privatization committees. These guidelines have been agreed with the Bank earlier under the Privatizon Adjustment Loan and address such inplementation issues as: public announcements of companies or assets to be privatzedd issuance of preliminary and final biddiDg documents; communication with interested bidders; valuation and pricing (including the process for setting and antiouncing the base ptice); public bidding; employee participation; and use of consultants. The Bank will monitor compliance with these guidelines. Any privatization not following these guidelines will not be counted toward the tranche release tart ets. 34. It is Government policy to leave all major investments to the new owners of privatized firms. In the electricity sector, public investments will be limited to the expenditures needed for maintaining the current system in an operative state. Since the transmission system is expected to be the last to be privatized, some investments such as load dispatch facilities needed for operating the decentized system and interconnectng the two southern systems may be justified prior to privatization. 35. Environmental Aspects. Measures are necessary to remove or reduce adverse en ir impacts from electricity operations, notwithstanding that these impacts are comparatively limited (except for installing new hydro generating plants and operatng thermal plants if their emissions are inadequaly controlled). General enviromnental legislation is adequate and is complemented by detailed sector regulations, norms, and standards for the electricity sector acceptable to the Bank, over and above the stipulations in the 1992 Electricity Law. Environmeal regulations including specfic norms and standards acceptable to the Bank for the electricity sector have been issued. These are to ensure that electricity operations adequately take into account, and internalize, envirnmtal costs, and that cost-effective measures are taken to remove or reduce any adverse impacts. Potential investors thus will know which specific envirmental requiments exist in the sector before they commit themselves to major expenditures. The Bank through EMTAL has financed assistance for preparing environmental regulations and norms for the electicity sector. 36. The Government will ensure that environmental audits are carried out on all thermal power plants and other facilities, as appropriate, subject to privatization under this Loan, as required under the enviomental regulations for electricity-related activities. The Government will coordinate with the Bank on the TORs of such audits. These audits will determine (i) liabilities associated with past and current operating practices and with design features of the relevant facilities, and (ii) mitigatory measures, along with their capital and current costs, so that operations will comply with current standards. The environmental laws and regulations in Peru, the Bank's Eniwonmel Guidelines and Occupational Health and Safety Guidelines, and other international guidelines as appropriate will form the basis for conducting these audits. The audits will serve to clarify environental risks and liabilities for potental investors, and to identify the mitigatory measures to be undertaken by the new owners within a specified schedule. Privatized firms will be subject to the same environmental laws and standards as other companies. The Bank will monitor the adherence to these policies and procedures, as part of its review of the satisfactory progress of the privadzadon process, including for  10 the preparation of the bidding documents for individual privatizations, prior to counting the latter toward the tranche release targets. 37. Sodal Impact. The Goverunent has reduced excess employment in the sector by about 5,300 (42%) since August 1990. These layoffs have occurred mainly through voluntary acceptance of severance packages, and have been financed by the enterprises themselves. Severance payments to employees made redundant are the legal obligation of the enterprises, and the Govermment has ensured that these payments are made. The Government has also started retraining programs to facilitate the reintegration into the labor force of those employees displaced through the restructuring of enterprises slated for privatization. H. THE PROPOSED LOAN 38. Description. The US$150 million loan would be disbursed in three tranches of US $50 million each. The first tranche would become available on effectiveness and the second and third tranches on meeting specific conditions for tranche release. The Policy Matrix (Annex 3) summazs the reform program to be supported by the Loan and the proposed tranche release conditions. A oicy Leettr (Annex 4), which was finalized during negotiations, has been signed jointly by the Minister of Economy and Finance and the Minister of Energy and Mines. 39. Proposed Loan Conditions. The proposed loan conditions are sunmmaized below: Conditions of Loan Effectiveness: (i) Maintenance of a macroeconomic policy framework and financing plan consistent with the objectives of the overall structural reform program supported by the Bank (para. 8); (ii) Satisfactory progress in implementing the electricity sector reform program set out in the Policy Letter (para 8); Conditions of Second Tranche Release: (i) Maintenance of a macroeconomic policy framework and financing plan consistent with the objectives of the overall structural reform program supported by the Bank (para. 8); (ii) Satisfactory progress in implementing the electricity sector reform program set out in the Policy Letter (para. 8); (iii) Maintenance of full autonomy of the Electricity Tariff Commission (para. 16); (iv) All electricity tariffs to be set at 100 percent of economic cost (para. 22); (v) Official publication of antitrust rules for electricity sector enterprises, and provision to the Bank of final model concession conas for electricity transmission and  11 distribution, assuring third-party access and use, respectively, of the transmission and distribution systems (para. 17); (vi) Offer for sale of a majority interest in: (a) each of the Electrolima distribution utilities for metropolitan Lima, and (b) Electrolima's and Electroperu's generating utilities whose combined assets represent at least 12 percent of total assets to be privatized in the sector (para. 30); Conditions of Third Tranche Release: (i) Maintenance of a macroeconomc policy framework and financing plan consistent with the objectives of the overall structural reform program supported by the Bank (para. 8); (ii) Maintenance of full autonomy of the Electricity Tariff Commission (para. 16); (iii) Maintenance of all tariffs at 100 percent of economic cost (para. 22); (iv) Offer for sale of a majority interest in the generating utilities whose assets represent at least 52 percent of total assets to be privatized in the sector (para. 30); (v) Actual sale of a majority interest in the utilites whose combined assets represent at least 25 percent of total assets to be privatized in the sector (para. 30). 40. Technical Assitanc. Substantial technical assistance has been provided for preparing and implementing electricity privadzation and regulatory reform, through: (a) a Japanese grant for the energy sector (US$750,000 equivalent), which has financed consultants to develop the new legal/ regulatory regimes for electricity and hydrocarbons; (b) the US$30 million Privatization T.A. Loan (Loan No. 3540-PE; approved by the Board on December 10, 1992) for financing consulting services to assist with privadzation in all sectors, including electricity; (c) a Japanese grant for electricity privaizadon (US$855,000 equivalent) to assist the Government in preparing the program to be supported by this operation; and (d) the EMTAL, which is financing institutional development at MEM and related entities and the preparation of firther regulatory reforms, including for environmtl regulation and norms, in the electricity, hydrocarbons, and mining sectors. 41. Monitoring and Reporting. Prior to second and third tranche release, the Government will submit to the Bank a report on the overall progress in implementing the reform program set out in the Policy Letter. 42. Procurement, Disburement, Audit, and Ad tron. The proposed loan would finance 100 percent of the c.i.f. costs of general imports not contained in a negative list. Ineligible imports include: goods financed by other Bank loans or loans from official multi- or bilateral sources; alcohol, tobacco, luxury and environentally hazardous goods; and goods for military use. Retroactive financing in the amount of US$30 million (20 percent of the loan amount) would be available to finance eligible expenditures incurred less than four months prior to the date of expected loan signing. It is expected that the Borrower will have met all loan conditions by June 30, 1996, and will have acmulated sufficient documentation for full disbursement. The closing date for the loan would be December 31, 1996.  12 43. A Country Procurement Assessment Report prepared by the Bank in 1991 noted that the laws and decrees governing the procurement procedures followed by both public and private sector importers were in broad conformity with Bank Procurement Guidelines. The findings of this Report continue to be valid. In addition, the annual budget law provides that goods and works financed by international financial institutions will be procured in accordance with the requirements of these institutions. 44. Trade policy reform since August 1990 - consisting of large-scale reduction of tariff and non- tariff barriers, elimination of fiscal preferences, removal of controls on foreign-exchange transactions, and customs reforms - has strengthened the competitive environment in which private purchasing decisions are made. 45. In view of these reforms, procurement procedures under this Loan will be consistent with Bank guidelines, as follows: (a) Contracts for the procurement of imports made by public and private importers valued at or exceeding US$5.0 million would be procured under simplified ICB procedures in accordance with Bank Procurement Guidelines. Petroleum products and agricultural commodities would be imported under ICB procedures acceptable to the Bank. In addition, direct contracting would be acceptable if it is in accordance with the provisions of para. 3.5 of the Procurement Guidelines. Contracts below US$5,000 would not be eligible for Bank financing. The Bank's Standard Bidding Documents will be used for ICB procurement of goods. (b) Public sector imports valued at below US$5.0 million and above US$5,0OYv would be procured in accordance with public procurement procedures which have been assessed as acceptable to the Bank in the 1991 Country Procurement Assessment Report. The findings of this report continue to be valid. (c) Import conras by private importers below US$5.0 million and above US$5,000 would be awarded in accordance with established commercial practices, which are acceptable to the Bank. These practices generally consist of vitming more than one quotation, except for importers of small amounts of consumer goods, who generally buy from traditional sources using direct negotiation. 46. Disbursements for contracts under US $5.0 million would be made against Statements of Expenditure, for which the customs certificate documentation would be kept locally for supervision by Bank staff in the field and for auditors whose terms of reference for auditing would be acceptable to the Bank. 47. The Mnistry of Economy and Finance will administer the loan and will be responsible for submitting the relevant documentation for disbursement. A Coordination Unit has been established within the Ministry for administering prior adjustment loans, to ensure compliance with loan conditions, prepare disbursement requests, and meet reporting requirements to the Bank. This Unit will have similar responsibilities for this operation.  13 48. The Ministry of Economy and Finance and the Central Bank, in conjunction with the Customs Administration, has created a Special Procurement Unit responsible for the collection of relevant procuremen documentation, ensuring that only eligible and correctly procured imports are included in withdrawal applications. This unit has carried out these functions for prior adjustment loans and witl carry out the same tasks for this operation. Documentation would be retained for review by the Bank and the project auditors, as required. Audits will be prepared not later than six months after each tranche disbursement and year-end, whichever comes first. 49. Benefit. Regulatory reform and privatization in the electricity sector are expected to resut in a strengthening of the sector's position and thus, in major economic benefits. These include: (a) improved service reliability and responsiveness to demand through policy and legal/regulatory reforms; (b) increasd efficiency through pricing reform, improved management of the utilities, and introduction of competition; (c) new private investment, as a result of an improved incentive frmework; and (d) strengthened fiscal position through the elimination of subsidies and increased tax revenue from more profitable sector companies. 50. Risks. The macroeconomic situation is stitl fragile. Because of the lack of solid socio- economic underpigs, especially the prevailing divisions within Peruvian society, there is a risk that the adjustment will be weakened and that the reform process in its current form is not sustainable. Domestic pressures might bring about some backsliding in the Government's program, thereby underming economic recovery. There are already some indications of a slowdown in the overali reform process as new elections draw near. Institutional weaknesses, especially the lack of an effective civil service, compound these uncertaintes and could delay the adjustment process once the structural reforms are enacted. Thus, other scenarios are possible where the economy moves into a path of high inflation and low growth. Nevertheless, the Government is expected to achieve its program targets, given its adherence to sound macroeconomic policies since mid-1990 under difficult circumstances and its commitment to sustining the stabilization and structural reform program, as evidenced by its agreement with the Bank and IMF on a macroeconomic program and financing plan for the 1993-95 period. To address the risk of adjustment slowdown or reversal, maintenae of a satisfactory macroeconomic policy framework, financing plan, and structural reform program is a condition for aU tranche releases of the proposed Loan. 51. With respect to the privatization of the icity sector, there are two main risks: (a) that the Government will face difficulties in attracing - ate investors and operators for the sector; and (b) that there will be renewed government intervention in the tariff-setting process. To address the first risk, the new legal/regulatory regime and tariff system are designed to enbance the incentive framework, increase competition, and ensure economic and financial viability for the sector. This should stimulate private investment. Overall, the favorable record of the privatization program to date and promotional campaigns to attract foreign investment are expected to generate sustained investor interest in Peru's electricity sector. There has thus far been strong investor interest in ongoing privatizations in the electricity sector. To address the risk of possible political intervention in tariff setting, the 1992 Electricity Law establishes the authority of CTE and the automaticity of tariff adjustments. CTE's efective autonomy in tariff setting has been reestablished, and maininig this autonomy is a condition of second and third tranche release.  14 III. RECOMMNDATION 52. I am satisfied that the Loan would comply with the Articles of Agreement, and recommend that the Executive Directors approve it. Lewis T. Preston President Attachments Washington, D.C. October 27, 1994  15 Annex I PERU ELECTRICIY PRIVATIZATION ADJUSTMENT LOAN Relationshii Amoni Bank Adjustment Oneios Bank Privaization and Regulatory Operation Reform Obiectives Conditions Fulfillment of Conditions (i) Establish general policy, Fully disbursed. legal, and institutional framework for privatization Overall The Overall privatization: lTe and private sector Government will establish the Government has set up development. institutional framework for the inter-ministerial privatzation, set out in privatization commission Privatization Law 674. (COPRI) and appointed special privatization committees for each sector/major company. (ii) Establish sectoral Electricity Sector: The Electricity Sector: The privaization strategies for Government will develop a Government in June 1992 banking, fisheries, mining, policy frmnework, including an submitted a detailed hydrocarbons, electricity, implementation schedule for strategy/implementation telecommunications, private sector participation In timetable for electricity transport, water, and power generation, transmission, privatization and industry. and distribution by June 30, regulatory reform. 1992. P rivadzation Implenumentv pzation lTanche conditions linked to Second tanche disbursed. A4buIment strategies and regulatory progress in i Final tranche pending. Low (PAL reform in minig, privatization and regulatory Substantial progress telecommunications, reform in mining, telecom, towards 2nd trche hydrocaons, water, and hydrocabons, water and conditions re: further fisheries. fisheries. privatzation and new laws/regulations for hydrocarbons, telecom, water and fisheries. EBlectricitv Implemenlt privaization Tranche conditions linked to strategy and new legal/ progress in im nIH AdMM=nt reguatory fIrmework and privaization and legall tariff regime for electricity regulatory (including tariff (UPAL) sector. reforms in electricity sector (see Policy Matix - Annex Im).  16 kA;DIFX 2 Page 1 of 4 Peru* Key Econom hdicators Acat Estiae Projected lIdiator 1989 1990 1991 .992 1993 1994 1995 1996 Natlonal accounts (% of GDP at current prices) Gross domestic product Agriculture 13.3 12.7 12.6 12.2 12.1 12.2 12.4 12.4 Industry at 34.3 34.4 34.2 33.2 34.1 3S.1 35.4 35.6 Serv -s b/ 52.3 52.9 53.2 54.6 53.7 52.7 52.2 52.0 Total Consumption 77.8 83.9 85.3 87.1 84.7 82.9 83.2 83.4 Gross domestic fixed investment 19.1 16.8 16.8 16.3 18.6 19.9 20.0 20.0 Government investment 3.6 2.7 4.7 4.2 3.8 4.3 4.0 4.0 Private investmt 15.5 14.1 12.0 12.1 14.8 15.6 16.0 16.0 Exports GNFS 18.4 13.2 9.8 10.4 10.4 9.7 9.9 10.4 !mports GNFS 15.3 13.9 11.8 13.7 13.6 12.5 13.1 13.8 Gross domesfic savings 22.2 16.1 14.7 12.9 15.3 17.1 16.8 16.6 Gross national savings Cl 16.4 12.0 11.8 10.2 12.7 14.2 14.0 14.0 Memondum items Gross domestic product (US $ m) d/ 24249 32080 42672 41918 41232 46854 48370 49043 GNP per capita (Atal US) 1660 1006 1466 1708 1898 1955 1941 1961 Real annal growth rates (%, calculated from 1989 prices) e/ Gross domestic product at market prces -11.8 -4.4 2.7 -2.8 6.5 10.0 6.0 6.0 ross domesc income -13.6 -9.1 0.8 -5.3 6.0 4.4 4.7 5.6 Real annual per capita growth rates (%, calculed from 1989 prices) el Gross domestic product at madet prices -13.5 -6.2 0.6 -4.7 4.4 7.8 3.9 3.9 Total consumpdon -13.5 1.1 2.4 -2.7 2.0 0.8 3.2 4.2 Privat consmption -13.3 2.7 2.8 -3.1 2.2 1.0 3.4 4.4 (CUinged)  A'JNEX 2 17 Page 2 of 4 Peru - Ky Economic E nsator (Continued) Actual Esimee Projected Indicator 1989 1990r 1991 1992 1993 J994 1995 1996 lnce of paymens (s$ Exponts (ONFS) 4470 4248 4165 4345 4273 4529 4801 5089 Merchandie f.o.b. 3488 3231 3329 3484 3433 3585 3853 4174 IMPOts (ONFS) 3721 4467 5054 5762 5623 5861 6334 6755 Merchandise f.o.b. 2291 2885 3494 4051 3995 4133 4510 4906 Resource balince 749 -219 -889 -1417 -1350 -1332 -1533 -1666 Net currnt tranudrs -1207 -1288 -1310 -1072 -1265 -1267 -994 -1053 Curent account balance -458 -1507 -2199 -2489 -2615 -2599 -2527 -2719 Net foreig privaft direct invesmant 59 34 -7 127 537 3050 f 650 750 Long term loans (net) 635 416 712 485 500 172 -703 23 Offcil 247 88 356 6 567 337 211 -130 Privae 388 328 356 479 -67 -165 -914 g 153 OGtercapial (net, including erors and onissions) 627 1193 2745 2369 2078 1334 1466 2157 Coange in esrves b -863 -136 -1251 -492 -500 -1957 1114 -211 Memrandm items Resource balne (% of GDP) 3.1 -0.7 -2.1 -3.4 -3.3 -2.8 -3.2 -3.4 Read annu powt rates Merchandise expors (lo.b) 22.8 -12.1 1.1 3.7 -4.3 1.4 4.3 5.2 primary 22.3 -12.9 1.3 2.9 -9.4 -1.3 3.0 4.3 Manmnes 24.1 -5.6 -4.2 5.5 9.0 6.8 6.8 6.8 Merchandise imos (c.i.f.) -22.2 19.5 18.8 14.9 -4.3 0.4 5.9 5.6 (Q sr..ed)  ANNEX 2 18 Paee 3 of 4 Perau- Key Ronmic hitaors (Cond) Actua Emate Projected Indicator 1989 1990 1991 1992 1993 1994 1995 1996 Public fi (% of GDP at curen prices) V Curent revenues 7.1 9.5 9.5 10.6 10.5 12.5 14.2 14.8 Current expenditures 10.5 11.8 9.0 9.7 9.5 11.0 13.4 g 12.5 Current account surplus/deficit -3.4 -2.3 0.5 0.9 1.0 1.5 0.8 2.3 Privatization proceeds 0.0 0.0 0.0 0.5 0.7 5.1 f 2.1 0.6 Capital expendite 2.3 1.4 1.4 2.1 2.0 3.2 3.4 3.8 Foreign financtog 1.7 1.9 1.9 0.8 1.1 1.2 1.2 0.9 Montay ndiatos M2/GDP (at current market prices) 21.5 17.7 12.8 14.6 15.7 Growth of M2 (%) 2116.9 4924.8 269.1 81.4 68.5 Private setorcreditgrowth/totalct Aitgrwth(%) 74.5 79.4 :68.2 133.6 132.7 price Idces (198- 100) Merchandise export price index 100.0 104.4 94.8 96.6 89.5 92.2 95.6 100.9 Merchandise iport price indx 100.0 106.4 108.5 111.5 112.1 115.9 119.3 122.8 Merchandise terms of trade index 100.0 98.3 87.4 86.6 79.9 79.6 80.3 82.2 Real exchange rate jl 100.0 103.9 128.4 137.4 127.2 Real interest rates (%) kl -18.6 -40.4 15.5 40.1 34.2 Consumer price index (e.o.p. X growth rate) 2775.0 7649.6 139.2 56.7 39.5 20.0 12.0 10.0 GDP deflator (% growthiate) 2670.3 6142.3 421.1 72.4 47.9 20.4 12.2 10.0 Notes: a/ Includes fishing, mmiing. and manufactuing. b/ Inludes constucdon, government, commerce, and other. c/ Includes net unrequited transfrs excuding offcidal capital grams. d/ Calculated using average nomial exchange ates. e/ Calculated from GDP in domestic currency. f Includes US$ 2.4 billion of privatization proceeds. g/ Includes projected use of US$ I billion to pay for unfunded liabiltes. h/ Includes use of IMF resources. A negative change ndicates an increase In reserves. i/ Central gove t j/ An increase in the index denotes appreciation. k/ Real interest rate in domestic currency. Credit in domestic currency represented 22 percent of total credit in December of 1993.  19 ANMEY 2 Page 4 of 4 Peru - Ke Exposur Indicators AcMWl Estinate Projected Indicator 1989 1990 1991 1992 1993 1994 1995 1996 Total debt outstanding and disbursed (MDO) (US$m) a/ 18583 20068 20720 20297 21170 21742 21867 24047 Net disbursements (US$m) a/ .28 128 208 336 185 1171 774 785 Total debt service (TDS) (US$m) 407 476 1153 1033 5492 b 2764 3080 c 2060 Debt and debt service indicators (%) TDO/XGS d/ 415.7 472.4 497.5 467.1 495.4 480.1 455.5 472.5 TDO/GDP e/ 76.6 62.6 48.6 48.4 51.3 46.4 45.2 -.0 TDStXGS d/ 9.1 11.2 27.7 23.8 128.5 61.0 64.2 40.5 Concessional/TDO 1.2 1.1 1.1 1.1 1.0 1.0 1.0 0.9 IBRD exposure indicators (%) IBRD DS/public DS 0.0 0.0 16.7 20.2 58.2 25.3 31.1 12.0 Preferred creditor DS/public DS 17.4 12.8 62.4 42.1 64.4 56.9 67.7 27.7 IBRD DS/XGS d/ 0.0 0.0 4.2 4.5 21.9 4.0 4.2 4.2 IBRD portfolio share 1.4 1.3 1.2 0.9 1.4 1.4 1.4 1.4 IFC (US$m) Loans NA NA 0.0 87.0 76.0 89.0 NA NA Equity and quasieqiity f/ NA NA 0.0 13.0 24.0 11.0 NA NA MIGA MIGA guarantees (US$m) NA NA 0.0 0.0 0.0 38.0 NA NA Notes: a/ Includes public and pubLiy guranteed debt, private n ated. use of IMF credits, and net short term capital. b/Inc ldes bridge loans to pay arrears to TERD and IMP. It also nitludes arrears paid to IBRD and IMP. c/ Includes US$ I bilion to pay for unfunded liabilities. d/ XGS denotes exports of goods and sewrvices, including workers' renittance el GDP in US$ calculated using average nominal exchange rates. / Includes equit and quas-equity pes of both loan and equity insms.  PERU ELECTRICITY PRIVATIZATION ADJUSTMENT LOAN Policy Matrix BY SECOND BY THR REFORMS ACTIONS TO DATE BY EFFECTIVENESS TRANCHE TRANCHE A. Macroeonomc Since August 1990, the Govermnent has been Maintnance of a Maintenance of a Maitenance of Polcies and iplementing stabilization and struchta reform macroeconomic policy macroeconomic policy a macro- Performance programs. During a debt workout period, these fiamework and financing framework and economic policy programs were supported by the Bank (SAL, TPRL, plan, consistent with the finan^ing plan, framework and FSAL), IMP (Rights Acumulation Program), and objectives of the overal consistent with the fmancing plan, ]DB. Peru cleared its arrears with the Bank and structural reform objectives of the consistnt widh IME in March 1993. Agreement was reached on a program supported by the overall structural the objectives macroeconomic program and financing plan for Bank. reform program of overall 1993-95, to be suppo.ted by an BeM Extended Fund supported by the Bank. structural Facilty and further Bank adjustment loans (i.e., the reform program Privatization Adjustment Loan approved in April supported by 1993, and this Loan). A draft letter of intent has the Bank. been signed with the IMD for 1994. B. Policy Letter The Policy Letter sets out the electicity sector Satisfactory progess in Satisfactory progress in Satisfactory reform program being implemented under the implementing the implementing the progress in proposed Loan, including the program objectives and electricity sector reform elecricity sector implementing rationale. The draft Letter has been discussed with program set out in the reform program set out the electricity the Government and has been fialzed during Policy Letter. in the Policy Letter. sector reform negodatons. program set out in the Policy Letter. m 4 -h U"f  PERU ELECTRICITY PRIVATIZATION ADJUSTMENT LOAN Policy Matrix REFORMS ACTIONS TO DATE BY ECTIVENESS BY SECOND BY THIRD TRANCHE RACHE C. Electricity Tariffs The Governmeat has intodud a new tariff system - All tariffs to be set at Main nance of for regulated cutomers comprising: (a) tarMs at the 100% of their tariffs at 100% generation plus high voltage transmission level, economic costs. of their based on short-tem marginal costs (averaging over econmic costs. 48 months); (b) transmission charges; and (c) tariffs at the distribution level. In paralel, the Govenmment has inreased tariffs for all non-residenkial consumption and for resdti cnmptio above 150 Kwh/month to 100% of economic costs and those for residential consumption below 150 Kwh/month to an average of 94% of their economic costs. The Government plns that a tariffs will cover economic costs by end-November 1994. o n b1 4-  PERU ELECTRICITY PRIVATIZATION ADJUSTMENT LOAN Policy Matrix BY SECOND BY THMRD REPORMS ACTIONS TO DATE BY EFFECTIVEN TRANCHE TRANCHE D. Legal/Regulp.ory The Government enacted a new Electricity Law in - Maintenance of full Maintenance of Framework November 1992, issued corresponding regulations in autonomy of CTE. full autonomy Februaty 1993, and appointed a new Directorate to of CTE. the Electricity Tariff Commission. The new legislation establishes the principles of: (a) separation Offrcial publication of of generadon, tranission, and distribution, to be andirust rules for carried out by independent companies, with no electricity sector shareholdings by generaton and distribution enterprises. Submission companies in tranmission permitted and cross- to the Bank of fnal shareholdings between generation and distribution model concession companies restricted; (b) free contracting between contracts for electricity generation companies and large-volume consumers: transmission and and (c) tariff regulation through the autonomous distribution, assuring Eklctrity Tariff Commission (CTE) and technkal third-party access and regulation through the General Electricity Directorate use of, respectively, of the Ministry of Energy and Mines. the transmission and distribution system. 0 o% I tn  PERU ELECTRICITY PRIVATI7ATION ADJUSTMENT LOAN Policv Matrix BY SECOND BY THIRD REFORMS ACTIONS TODATE BY EFFECTIB NS TRANCHE E. Privtiaton The Government has launched a program to privatize - Offer for sale of a Offer for sale its holdings in the electricity sector. The majority interest in: (a) of a majority Government has (a) separated generation, each of the two interest in the transmission, and distribution into independent units; distnbution utilities for generating and (b) appointed special committees to metropolitan Lima; and utilities whose prepare/implement the privatization of Electrolima (b) the generating combined assets and Eectropern. Consultants have assessed the utilities whose represent at structural and fnacal options for privatizmg combined assets least 52 percent Electrolima and Electopern. Electrolima's two represent not less than of total assets to distribution unis have been privatized in July 1994. 12 percent of total be privatized in Electrolima's generaion unit and Electroperu's assets to be privatized the ekctricity generation units are to be privatized by end-1994. in the electric sector sector. Acual sale of a majority interest in the utilities whose combined assets represent at east 25 perceat of total assets to be privatized in I the electricity 0 sector. o >e in W  PERU ELECTRICITY PRIVATIZATION ADJUSTMENT LOAN Policy Matrix BY SECOND BY THIRD REFORMS ACTONS TODATE BYEPFECIIVESS TRANCHE TRANCB P. Environment The Government has (a) established a General - Enviromnental Directorate within the Ministry of Energy and Mines to foanldate environmental policies for the electricity, hydrocarbons, and mining sectors; and (b) issued Envirounental Regultions for electricity-relted activities. The General N Ekctricity Directoate will be responsible for monitoring and enforcing electricity-related envionmnt policies. The Policy Letter for this Loan includes commitments that: (a) environmental audits will be undertaken, in accordance with the Environmental Regulations for electricty-related activiies. for all thermal plants (and other istallations, as appropriate) subject to privatization under this loan, to idendty environmental problems and costs of clamwprovement. 00 0 eqA 'nw  25 ANNEX 4 Page 1 of 3 UINZSTERIO 0E LNEMxIA Y MI OFFICIAL NO-TE N 599--24EM-SG uLma. II 9 LAJ. 1994 Mr. Lewis T. Preston President The World Bank Washington, DC U.S.A Dear Mr. Preston, This Policy Letter sets out the Govemments program of legal/regulatoiy and Institutional reforms and prvatzation in the eleoicity sector. This program, to be implemented under the EJectricity Privatizaton Adjustment Loan. Is an Integral part of the Govemmenra oveall development strategy, which is aimed at llberalizing the economy and enhancing responsiveness to market forces. A. Macroeconomic Stabilzation Policies and Structural Reforms Upon taking office In August 1090, the Government launched a major reform program to correct fundamental problems In the economy. Key elements of the Initial package involved trade, price and exchanae rate liberalization, together with fiscal and monetary measures to reduce the fIscai deficit and inflation. The initial measures were reinforced from 1991 onward by economy-wide and sector-specific structural reforms aimed at furer strengthening public finances, promoting competitiveness, and deregulating economic activity to promote private sector Investment Agreement was reached In 1993 with the multilateral agencies and the Support Group on a medium-term macroenomic program and financing plan. The Government is committed to continuing its macroeconomic policies and to mnaintning and deepening the reform program. s. Ehectridty Sector Over the pest two years the Governent has Implemented major reforms In the electity sector. These reforms, and the agenda of fUrther measures to be Implemented under the Electdty Prvatizadon Adjustment Loan, are outined below. LegalJRegulatory and Institutional Reform. Our objectves for the electricity sector are to secure adequate and environmentally sustainable supplies. irnprove efficiency, and eliminate the burden of the sector on fiscal rsources. This is to be achieved through deregulation of activies where competition Is feasible, combined with arms-length regulation of natural nmonpolis and enhanced partcipation by private investors. to allow market forces to exert thek aoceative functon. The new legal framework - the Law on Eectricity Concessions enacted in 1992 and corresponding regulatons covering the public electricity system Issued In early 1993 - redefines the role of public situtions In policy making: sector ontry and exdt; pricing; investments; and quality of servIe. The now Law and regulations establish hat (a) generation will be decentralized, deregulated, and made subject to competifion; (b) the transnission network wIll provide third-party sccess to al suppliers and purchasers with an adequately regulated toll scheme: and (c) distribuion as natural monopoly wM be regulated, fuly establishing the nghts and duties of supptiems and customers and regulating prices based on marginal costs. Integrated entepnises have been separated into Independent companies at the generation,  26 AMNEX 4 Page 2 of 3 INISTi D MOA " ti transmission. and distribution stages. Cross-shareholdings wiJI be strictly lmited so as to establish clear accountability and prevent the emergence of market doml:.ation. WhUle protecting saler-volume consumers through reguladon, the new system leaves to market forces the purchases by lavrevolume consumers (mor than 1 MW. represntng 4060% of tol ales) whose negodating capacity Is deemed suffiint Finally. in areas f t counby currendy wihout electriit d t Govenment wii encouage now distribution firms and wil promte economically viable nral elecifiation schemes. In additon to the new reguletoy fSwTwBOrk for *ebc, new projecXt in the sector will to subjet to economy-wide regulai such as tho for compeiton, taxation. environmental protction, health and occupadonal safety, and urban pluuang. The Elcrcity Law and spedlcf regulati Irnorporate antit safeguards and principle; for environmental prtecton. In order to reinfrs conmption, we wHi introduce specifie antitrust measures for th loctricty r. The Govemment will also give high prIrity to the effectv operation of the Commitltes for Economic Opetion d the Intercnected Systms (COES) In the interconnected grids, in view of their importance for latco load dispatch in a decentralized and increasingly privatized system In order to carry out the envisaed reforms, the Govemment has taken steps to strngthen the Minist of Energy and Mines and othr relevnt public enties In their polky and regulatory functons, assisted through the Wold BanWs Enew and Mining Technical Assisance Loan (SMTAL). The Elecricity Tar Commission (CTE) wil continue to be in charge of sconoml/fnancl regulation especially related to tarift, and its auorty In rgard to tariff mtts Is fulL We are commited to preserving fth Commision's autonomy, ensuring Its Independent nding. prvat sector partipatio In Is Board. and adequate tenure of its Board mrnebers as specied In the 1092 Law of Electricity Concessions. At the Ministry of Energy and Mines, the Gen"ral Directorate of Electricity (DGE) will be responsible for technical regulaton, whereas the Technical Unit on Energy (OTERG) wil maintain an indicaive plan for generation and transmission expansion, and will advise on energy sectr strtgies and polices. Informaton on this Indicative plan and on electri utility operations will be available at OTERG and OGE, as information is a key element for market eMcency. Electeiity Priing. In the past tar Inadequacies both In terms of ls and structure have been a primary cause for ft weakness of the electricity sector. As a key component of deecricity sector reform, tariff have been increase sInc August 1990 toward theireconomic cost Country-wide uniform tariff and the associated system of rgionai cross-subsidizaton have been abolafhed. A fr-reaching reform of the tariff system was completed In 1993. Tarifs for consrumtion exceeding 150 kVVhlnonth have sarady reachd their economic cost Further Increases In real terms for smaller-valume residental consumpton have been scheduled, so that all tarffs will cover thir corsponding economic cost by November 1994. Tarff wil be maintained theafter at feir econamic levels. Taxation of electricity consumption has been consolidatd by eliminatn surcharges hat distot price signals, and applying the general sales tax (VAT) to all levels of elecity consumption at Its economy-wide rate. PrlvatzUaon of ElectrIlty Holdings. Since natlonsUzation of the eecticity sector In the early 1970s, over-centralzaton and heavy state intevention have been largely responsible for the sectors low efficiency. Our first prlority is the prhatizatfon of Electrolimr and Elctroparu, which account for about 90% of the sectors assets (by book value). Electomlmns ditrbution system for metropolitan Uma has been segmented Into two comparies. These have been prnvated In July 1994, to be followed by Eletollma's and Electroperu's generation units In late 1914/eary 1995. We plan to segment North- Central Interconnected System's geneation assets Into at least four companies, in order to ensure competiton In generation. The prfWatizaton of the regional uWit_es end of the transvission companies is planned to get underway In 1005. We expect to aain fult privtization of th above-mentioned companies  ANNEX 4 27 Page 3 of 3 MIIASWUO DE INUOIAU Y MINAS by end-1995. Future expansion oa the electricity secto wll be undertan mainly by the private sector, vwth the State playing only a subsidlay role. The privatization of the elecicity setcw will bs undertken within the context . Ihe polcies. eglislon, and procedures govening the cvraml prvazaon prgmm. as stablshed thmugh the 1091 Legislave Decre #674, and the operatonal guldelines lued by COPRI to the PrvatizaSon Commdttees (CEPRis). Each company willinnialy be offeed far sale through public bidding. Since our objecive Is to atowth now private operats to adjust t hecilies and operations in accordance with their business strategies. the Govemment does not innd to undertke any nvestments in the companies prior to priatation, wffh the posible excepton of minimal essntia expenditus. SocWal bIpac As part of their efdicy pxrovment program the eicity enterprises have educed tr staff by 42% snc August 1990. Sevnce payrmnts to emp oyees made redundant are the legal obliggaon of the nterp . The Govenment has ensured that thes payments have been made. The Govement wi also strt retbaining porams, as needed, to cilibte the reintgration into the labor foe of those employees displaced through th rstucwing of entepdses slated for privatization. EnvIronmental Impact Vhilo electricity opeations cause comparatively few environmental problems. the Govenment wil ensure that the necessay measures atrekn to reduce any negative Impact of existng ad iturm Instlatons. Envirnmnt regulatons for the elecrity sector issued in June 1994, which estabish the relevant nomrs n procedurs, vAi nsure that elctcity operatons adequately take Into accounk and intenize, envnmenbl co" and that cost-effeve measures are taken to remve or reduce any advere Irpacts. The Goverhment wi ensure that the sector enterpises will comply with their obigation to cay outi environmental sudits (PAMA). as indicated in the above-mentioned Regulation, on all thermal plants (and other failtes as appropria) subject to privaiaton under this Loan. As specified In the envkonmental Regulation for the lectricity sector, fte environmental laws and rgulatons of Peu. The Wtrld Ban*s Environmental Guidelines and Occupational Health and Safaty Guiderines, and other intemnetonal guidellnes as appropiate wvAi form the basis for conducting these audits. In all cases, privatized fims wiN be subject to the same environmental obigations as other companies. Jorge Camet Dickmann Daniel Hokama To Minister of Economy and Finance Minister of Energy and Mines  28 ANNEX 5 Page 1 of 9 PERU ELECTRICITY PRIVATIZATION ADJUSTMENT LOAN New LeWal/Regulatorv Framework for the Electrcity Sector Introduction and SuMMar, 1. As agreed under the SAL, the Government of Peru enacted a new Law of Electricity Concessions (November 1992), corresponding regulations (February 1993), and a reformed electricity tariff system (April-November 1993). This famework for managing the sector is based on the principles of decentralization, competition, deregulation where competion is feasible, and market- based, arms-length regulation of natural monopolies in transmission and distribution. It incorporates advanced practices successfully applied in Argentina and Chile. The Law detmines the institutional set-up and the rights and obligations of electicity suppliers and users, whereas the regulations define n greater detail the procedures for applying the Law. The tariff system specifies tariff structures and levels resulting from studies conducted in compliance with the Law ad reguations. 2. The new legal/regulatory framework, which covers public and private service, deals with the following issues: (a) Sector institutions: The Ministry of Energy and Mines (MEM) is the principal government authority responsible for enforcing compliance with electricity legislation. The public Electricity Tariff Commission (CTE) is responsible for economic/financial regulation. The sector's Committees for Economic System Operation (COES) are to ensure least-cost load dispatch and to calculate short-run marginal costs, as the basis for tariff setting; (b) Public electricity system: Distribution concessionaires are obliged to provide supphies of adequate quantity and quality. They must conclude contracts ensuring supplies fcr at least two years. The transmission system has to provide open access to all generating and distribution companies, which, in turn, must not carry out any activities related to primary transmission. The owners of primary transmission systems must not trade in electitcity on their own account; (c) Electricity pricing: Tariff regulation is applied for (a) node prices (comprising generation and primary and secondary transmission) for transactions between genemrating and distribution enterprises in respect to regulated end-users, based on the average of short-run marginal costs over the following 48 months, due to be revised every six months for generation and every 12 months for transmission, respectively; (b) prices to (regulated) end-users, to be revised every four years, but adjusted on indexes set forth in the Law and regulations; and (c) transactions between generating and transmission enterprises, whose charges are set yearly by CMh and which incorporate a variable (tariff revenue) and fixed (connection charge) element. Transactions between generating enterprises are self-regulated by the COES, which set  29 ANNEX 5 Page 2 of 9 payments among the enterprises based on instantaneous marginal cost. Electricity pricing is based on cost-of-service regulation. However, it contains elemen of incentive regulation as well as standard costs of - efficiendy operated - model enterprises and not actually incurred costs are recognized for transmission and distrbution, as a means to restrict market power emanating from natural monopoly conditioJns. Regulated prices are not to diverge by more than 10% from freely negotiated prices. qhe latter apply to sales to non-regulated customers and to transactions of capacity and energy oetween generating companies.) 3. The Law and regulations cover regulated and non-regulated electricity service, with emphasis on regulating those operations involving monopoly power. They define the obligations of the concessionaires for public service, the pricing system for regulated segments of the electricity sector, and the supervision of sector operations by regulatory agencies. Non-regulated consumers are those exceeding 1,000 kW contracted capacity, or 20% of maxim demand in systems whose max demand is less than 5,000 kW. Regulated (public-service) consumers receive regular supplies for collective use, normally from distribution companies operating under conditions of natural monopoly. Their maximum demand is less than that established for non-regulated customers. Concessions are required for hydro and geothermal generation above 10 MW installed capacity; transmission; and public service distribution for demand above 500 kW. Authorizations are required for all other operations, i.e. thermal generation exceeding 500 kW and hydro and geothermal generation between 500 kW and 10 MW. Concession holders of transmission and distrbution system are obliged to provide open access to third parties, which is essential for attending non-regulated clients. Electricity Sector Institutions 4. The Mnistry of En and Mes (MEM) exerts the authority to ensure compliance with the Law and to issue concessions. 5. The Electricity Tarff Commisson (Comisi6n de Tarifas El6ctricas; CTE) is a decentralized public entity with economic, technical, and adn ve autonomy in setting electricity tariffs, in accordance with the criteria established in the Law. CTE consists of a Bo_rd composed of five Commissioners - including one each representing the generating and distribufting companies - approved by MEM and confirmed by the Council of Ministers, for tariff decisions and resolving tariff-related disputes, and a Technical Secriat to carry out technical analysis through tariff studies and prepare proposals for tariff setting. The Commissioners are nominated for five years, and this period can be extended. The Law contains provisions to ensure that the Commissioners are nominated in accordance with strictly technical criteria and that they cannot be arbitrarily removed from office. 6. Committa for Economic System OperaioDn (Comit6s de Operaci6n Econ6mica del Sistena; COES) are formed by the generation and transmission enterprises within the interconected systems, with the objective to coordinate operations at least cost, ensure supplies, and improve the utilization of energy resources. Their principal functions are to (a) determine and monitor least-cost generation and transmission operations in the int systems, (b) calculate short-run marginal costs and firm capacity and energy in these systems, and (c) guarantee purchases and sales of contracted capacity and energy between generating enterprises, up to the limit of firm energy and capacity, at prices set by the COES and based on intantnes short-mn marginal cost.  30 ANNEX s Page 3 of 9 Electricty Pricing Principles 7. Operations in the public service system are subject to price regulation based on short-run marginal costs for generation and average costs for transmission and distribution. These operations comprise (a) transfer of capacity and energy - as determined by COES - among generating enterprises, (b) transformation and transmission, (c) energy sales by generating enterprises to public service distribution enterprises, and (d) sales to final electricity users in the public service. While price regulation is based on cost of service, it contains elements of incentive regulation since standard costs, not actually incurred costs, are used as yardstick for tariff setting. CTE determines the node prices (tarifas de barra) for transactions between generating and distribution enterprises every six months in regard to generation and every twelve months in regard to transmission, and costs of distribution every four years. In the interim, both prices can be adjusted monthly for inflation and currency devaluation, according to indexes reflecting changes in the most important cost components. The reformed tariff structures reflect fairly closely the resource costs of supplying electricity to the various end-user groups. 8. Electricity to non-regulated consumers is supplied under conditions of competition, subject to negotiations between buyers and sellers. Therefore, the prices of these transactions are not controlled.' Maximum Prices of Sales by GeneraIng to Distribution rises 9. Sales by generating to distnbution enterprises for serving regulated customers are undertaken at node prices at the primary transmission level. These prices are based (i) for energy, on the weighted average of short-run marginal costs for an optimized (i.e., least-cost) system projected over the following four yearsY to even out fluctuations that may result from seasonal consumption pattern, changes in hydrology, or commissioning of new eeratig plants;t and (ii) for capacity, the ammualized cost of an economically optimal peaking unit (e.g., gas turbine). 10. COES is responsible for calculating node prices and definig their underlying assumptions, for subsequent analysis and approval by CTE. The calculations comprise: (a) demand projecdons over the following 48 months, as basis of an expansion program for that period (including projects identified by the indicative expansion plan prepared by MEMl); 1/ As of March 1994, there have been about 230 non-regultd electicy consumer accounting for 34% of oal consumption, mainly under one-year tm conacts. As non-plated consm curenly pay reltively higher prces for electriciy, they tend to shift ward ceaper off-pea supplies. 2/ These costs can be related to hourly supply blocks. 3/ The use of average SRMC over the following four years (which intoduces dens of LRMC) intead of _smnunww SRMC (as basis for freely negotated prices) was also chosn bause he Peruvian electrcy system is not yet optimined mndtus, resul from applyiog bs _ SRMC would not be representate. Nevertheess, this approacb, which tak es em plans over the next four years ino account (so th geneatng entrpris would cover costs of expansion), ought to provide fairly accurate signals to inveso.  31 ANNEX 5 Page 4 of 9 (b) a least-cost program of operations, including the economic cost of expected outages for the period under consideration; (c) short-nm marginal costs of energy for hourly supply blocks established by CTE; (d) base price of energy for hourly blocks (as product of the weighted average of marginal cost and projected demand, both duly discounted); (e) annualzed capital cost of the least-cost peaking unit; (t) base price of capacity, based on (e) and augmented by a factor reflecting the theoretical unavailability of the system; (g) transmission losses of capacity and energy; and (h) node prices of capacity and of energy, respectively, at each node of the system.4 11. Tariffs set by CrE must not diverge by more than 10% from the weighted average of freely negotiated prices among generating enterprises (or in the absence of these prices, the average of prices that would prevail in an optimized system as determined by CME). CTE also sets tariffs for isolated systems, based on the same criteria as established for interconnected networks. Should energy rationing become necessary because of generation shortfalls, the generating enterprises have to compensae the regulated electricity users for such deficits. Maximum Prices for Transmission 12. Within the primary and secondary tranission systems as defined by MEM, the generating enterprises can trade capacity and energy at any node. Primary transmission comprises that part of the system where it is difficult to identify the exact extent of the system's use by specific generating or distrbuting companies. Seondary systems are those required by specific generatng enterprises to deliver energy to the primary system and/or to extract energy from that system for delivery to their customers. The Electricity Law prohibits ownership of primary transmission systems by generating and/or distnbuting companies, so as to rule out monopolistic abuses. 13. Primarv Transmission Systems. The costs of trsmission are composed of annuaized invs_tent cost plus the s d cost of operaons and (including marginal transmission lasses of an economically optimized system, so as to account for the effect of voltage and distance on transmission costs). The total cost of transmission is paid monthly through two charges, i.e., (a) tariff revenue (ingreso tarifario), a variable element, based on the actual use of the system (i.e., the difference in volume of capacity and energy delivered and withdrawn at various 4/ The node price of sait is calculaed by multiplying the base price of capacW by the factor of capacity losses, adding to it the connecdon charge for the tansmision system. The node price of is obained by muiplying the base prce of energy for each corspondg block by the respectve factor of enerW losses. The loss factors for capachy and energy are caulaed based on maginal tansmission losses of peaking capacity and energy in an y optimized system.  32 ANNEX S Page 5 of 9 nodes and valued at prices correponding to these nodes), which is to cover the marginal transmission cost;Y' and (b) connection charge (peaje de conexi6n), a fixed element which is to cover the cost of investment of the transformaion and transmission capacity on the system and ensure grid viability, and which is prorated according to the generatig enterprises' firm capacity. This charge corresponds to the difference between the annualized investm and operating cost of the transmission system and the tariff revenue based on marginal transmission cost. (It is to cover the difference between average and marginal transmission cost in those cases where the transmission tariff is based on the former). CTE revises annually the tariff revenue and connection charge and the adjustment formulae for both. 14. Secondary Transmission Systems. Payments for the use of secondary transmission (and distribution) systems to wheel electricity are to be negotiated between owners and users of those systems, based on costs of systems operated at average efficiency. They are paid by the generatng enterprises that use these systems to transmit energy to their customers as required under supply contracts, and are integrated into the respective node price. Connection charges are calcuated the same way as for primary transmission (i.e., as the difference between the anmualized cost of investment plus operating and maintenance costs and the tariff revemne). No payments are due for energy transmission moving opposite to the prevailing direction of electricity flows. Maximm Prices of Distribution 15. Prices to final users are the sum of node prices as defined above and aate distribution values. The latter represent the cost within the distribution system of making capacity and energy available to clients. They are based on operations of an efficient model enterprise within an optimized distribution system. They include: (a) standard costs of investment, maintenance, and operations in distribution, per unit of capacity distributed; (b) standard distribution losses for capacity and energy (expressed as a percentage of node prices for energy and capacity at medium voltage level); and (c) overheads caused by final users irrespctive of their actual demand for capacity and energy. 16. To define an efficient model enterprise, two factors are to be taken into account, i.e., (i) adaptation to an efficient system (e.g., not recognizing over-investment; application of appropriate technology), and (ii) replacement values for installations and equipment ensurng service of the same quality, at prevailing technology and cost. Aggregate distribution values are calculated for each concessionaire and approved by CTE, for a period of four years. For their calcuation, three model distribution sectors (i.e., high-, medium-, low-density sectors) have been established by MEM on I/ Dhe marginal transmission cost is equivalent to the cost of marginal losses of energy and capacity on the truansmsion system.  33 ANNEX 5 Page 6 of 9 CTE's recommendation Appropriate weights of the respective parameters are applied to each distribution concessiin. In contrast with generation costs, aggregate distribution values are based on average costs because in distribution, the capital and labor components are relatively rigid (there are relatively few economies of scale in expanding distribution systems), which would render short-mn marginal costs volatile and difficult to determine. 17. CTE calculates the internal rate of return for all distribution concessionaires, applying a period of analysis of 25 years, thereby taking into consideration (a) revenues that would have been received if all supplies would have been valued at base prices in the immediately preceding period; (b) costs of operations (including sta&xdard losses') and maintenance for the distribution system in question in the immediately preceding period; and (c) the replacement value of each enterprise's installations, assuming a residual value of zero. 18. The resulting rate must not differ by more than four percentage points from the discountr (set at 12% in real terms). 19. CTE sets distribution tariffs and automatic adjustment formulae for a period of four years. These can be recalculated only during this period if intermitt adjustments result in an increase of the initial tariff level by at least 100%. Distribution tariffs are diffentated according to technical/economic criteria of enduse (e.g., voltage levels) irrespective of the economic and social category of the end-users. A significant nmiber of tariff options has been offered to electricity conumers aording to consumption pattern (peak; off-peak) and masurmen (one or two eneWy and capacity measurements, respectively), in order to provide tarff stability and stngthe resistnce against pressures for subsidies. OthMr 20. The annualized investment cost is based on the va lue (valor nuevo de reemplazo) for installations as set and anmnally adjusted by CTE. The replacement value represens the cost of renewing installations that provide identical service for required demand, to be met with curent technology and at prevailing prices. These costs include (a) financial charges during the constuction period, at a rate of interest not exceeding the discount rate; (b) expenditu and compensions for establishing right-of-ways; and (c) expendius on project studies and supeision. The replacement value is calculated based on the illations' useful economic life (30 years) and a of 12% in real terms to determine the capital recovery factor. CTE up-dates every four years the replacement values for transmission and distnbution installations, baaed on information provided by the enterprises. Standard costs of investment are calculated based on annalzed replacement values for an economically optimized system. The discount rate can be modified only by MEM, based on a A/ Pamets for defing te sectors are as follows: i) aveage per-client consumption of ener; (li) ined subsion capacit per medium-volage distrbuti n (VAIm); and (ffl) exmnsin of low-vollage dhbn system per client (metesclient). 21 Transtori, 1his includes 50 peren of whe excess of acual over standard loses, to be grdually reduced to zero over ree four-year periods.  34 ANNEX 5 Page 7 of 9 study commissioned by CTE which needs to demonstrate that (i) underlying economic parameters have significantly changed, and (ii) the discount rate differs significantly from the prevailing financial rate plus risk premium. The new discount rate must not deviate from the existing one by more than two percentage points. Adjusment dx incorporate changes in the exchange rate, import duties, wholesale prices, the international copper price, and wage costs (the latter two parameters in respect to distribution tariffs only). 21. CTE is obliged to maintain and make available all information related to tariff setting, especially in regard to node prices, aggregate distribution values, and freely negotiated prices. Follow-Up 22. Subsequent to the setting of preliminary tariffs in May 1993, CME completed the reform of the electricity tariff system in November 1993 when node prices were revised and aggregate distribution values were finalized. This included the following refinements: (a) Setting new node prices, based on refined parameters in regard to optimized generation and transmission;W (b) Finalizing the formulae for distribution tariffs for the following four years, including the weights to be used for intermittent adjustments. 23. These measures were based on studies comprising: (i) for generation, revision of optimizaion models, updating of operating costs and costs of rationing, and revision of models of isolated systems; (ii) for transmission, establishing replacement values for installations; and (iii) for distribution, refining the criteria for the three typical system modules especialy aggregate distribution values for rural systems, and their weights in individual systems. Distribution-related studies included determining replacement values, determining energy and capacity balances for the individual distribution systems, and updatng the coincidence factors of capacities demanded for the different categories of users, to finalize the basis for setting tariffs to final users. 24. gmaWg Tasks. CTE will complete studies in 1994 required to refine the parameters related to price setting for generation and transmission. These include: (i) for generation, cost of rationing, overall system reserve margin, sf"'ndard mal plants' outage rates and efficiencies, and evaluation of freely negotiated prices; and Xt for transmission, operating and maintenance costs and investments for optimized systems. In addition, model concession contracts for supplying distribution concessionaires as well as non-regulated end-users and for generation and transmission need to be prepared by MEM. For distribution, the next revision of tariff regulation is due by October 1997. Public Electricity System 25. Distribution concessionaires are obliged to provide electricity supplies of adequate quantity and quality, in exchange for an exclusive franchise in a specified service area. But they are entitled to contributions from final users for financing the extension of existng systems. These contibutions are repayable to the users by means of shares, bonds, and other fi- 2cial insuments, at the users' discretion. Distribution companies must conclude contacts with generating companies ensuring supplies for at least two years, so as to meet their service requiements vis-a-vis end-users. In the I/ Freely negotiate prices for customers above 500 kW are expecled to be applied from mid-1994 onwards.  ANNEX 5 35 Page 8 of 9 case of interruptions in supplies of energy exceeding four hours, and in the case of scheduled outages due to shortage of energy at the generation level, the concessionaire must compensate the users for the cost of capacity and energy not supplied. 26. The owners of primary transmission systems are barred from trading in electricity on their own account. 27. Electricity users are not allowed to exceed the contracted demand, lest they will be liable to supply disconnection and payment of fines. Service will be immediately disconnected in cases of (a) non-payment for electricity service for more than two months, (b) unauthorized consumption, or consumption violating the conditions of the supply contract, and (c) deficient installations posing a safety hazard. 28. The distribution concessionaire is responsible to provide public lighting. The municipalities are resnonsible for paying the electricity consumed, as well as for any cest of instlltions exceeding standards set in the concession contract. Basic costs of developing and maintning public lighting systems are incorporated into the aggregate distribution values for low voltage, thus allowing the distribution companies to cover these costs through revenues from all customers. Control of Operations 29. MEM is responsible for ensuring compliance with electricity legislation/regulations, in particular the compliance by concessionaires with their obligations. The municipalities inform MEM about any infractions or other service inadequacies in their concession areas. 30. A fee is payable to the State for the use of hydro and geothermal resources for electricity generation. This fee is not to exceed one percent of the average price of energy at the generation level. Investment Guarantees 31. Concession contracts, once recorded in the Public Register, have the force of Law between the contracting parties. Cancellation of a concession, for reasons other than specified in this Law, gives rise to the right of indemnities. Concessionaires and other enterprises conducting electricity generation, transmission, and distribution are entitled to the same legal, fiscal, and foreign exchange guarantees listed in Legislative Decrees Nos. 662, 668, and 757, as any other national and foreign investors. Rights-of-Way 32. MEM through administrative resolution establishes rights-of-way to the use of public and private property required for electricity operations, against v-yment of a fee by the concessionaire to the owner(s) of said property. Rights-of-way expire when tue holder does not carry out the required works within the agreed period, fails to use the rights-of way for twelve consecutive months, or is using them for different purposes than those stated in the contract, or the purpose for which they were originally granted ceases to exist. 33. To the extent necessary, arrangements will be made to allow the multi-purpose use of hydrological resources.  3 sANNEX5 Page 9 of 9 Other Conditions 34. Electricity generation, primary transmission, and distribution cannot be carried out by the same enterprise, except in cases specifically permitted under this Law. Antitrust reguladons and other measures butressing competition in the electricity sector are being prepared by MEM and INDECOPI. 35. Non-regulated supply contracts, as well as purchase and sale of energy between generation and distribution enterprises, have to be adapted to meet the m ents established in this Law, within 120 days of its enactment. (Model concession contracts for generation, transmission, and distribution of electricity are being prepared by MEM's General Electricity Directorate.) Likewise, distribution enterprises providing public service need to renew and finalize their concessions within 360 days of enactment of the Eaw. The integrated enterprises providing public service for electricity distribution in the in onncted central-northern, south-western, and south-eastern systems have separated their generation, transmission, and distnbution activities into independent enterprises, based on conditions established by MEM.  PEW ELECTRICITY PRIVATIZATION ADJUSTYENT LOAU ISICATOUS TO MEAStME PROWESS IN THE PRIVATIZATION P10CESSe Effective Fim Secondary Production Age of Age Corrected Participation Capacity Ener Enry Factor Installation Correction Prodiction in Sector (1W) (QWh) (61h) (USS M/Y) (Yeers) Factor Factor Assets (Percent) A. - ELECTRUINA Al.- UENRATION Hulnco 240 743 214 63.3 28 0.78 49.6 5.2 Matucans 115 632 57 4.0 22 0.86 39.3 4.1 Callehumca 61 428 59 30.5 35 0.70 21.4 2.2 IbYOpaq26 60 446 49 31.3 42 0.62 19.3 2.0 tbMpnl 19 138 15 9.7 33 0.72 7.0 0.7 Santa Rose 140 245 23.1 10 1.00 23.1 2.4 A2.- OISTRIBUTItO Lime Nrth 10.0 Lima South 10.0 8.- ELECTROPEIN (1) I1.- CENTRAL-NCTNERN SYSTEM Nantro-testituclan 7T9 6,178 269 422.8 20 0.9 372.1 39.1 cruqso 75 1.402 102 30.7 5 1.0 30.7 3.2 Canon del Pato 101 936 75 63.7 18 0.9 57.6 6.1 w CdAhu 34 276 22 19.0 20 0.9 16.8 1.8 Ventanitll 200 350 33.0 1 1.0 33.0 3.5 TruiJilo 24 42 4.0 Is 0.9 3.7 0.4 Chidiote 45 79 7.4 15 0.9 7.0 0.7 12.- SCUTI SYSTEM ArScote 33 66 5.7 15 0.9 5.6 0.6 TOTAL BOTM UTILITIES 790.5 686.1 92.1 C. - OT SYSTENS Charcani V S8 369 206 29.7 10 1.0 29.7 3.1 NItc-Piechu 79 712 4 48.4 15 0.9 45.5 4.8 TOTAL SECTOR 868.6 761.3 100.0 AssumptiSos Each vtit's participation in the sector assets depends on Its firm cepncity and ffr ard secondry energy prodhictfon. These parmaters have been valued as follows: Ci) firm energy: 60 US410/; (if) Secondary Energy: 20 USS&/Wh; (iii) capacity cost: 6US$/U-year; (iv) age correction factor: (1-0.012*AGE) for any ACE in excess of ten years. * Transmission facilities are not included Sour: Electrothm; Electroperu; mission estimates.  ANNEX 7 39 Page 1 of 15 PERU ELECTRICITY PRIVATIZATION ADJUSTMENT LOAN ENERGY SECTOR STRATEGIES AND POLICIES Energy Sector Structure 1. Ener= Resources. Pera's energy resources are considerable, but mostly distant frm the coastal consumption centers and cosdy to develop. The kx4rpwe potential estimated at 74,000 MW- compared to an installed capacity of less than 2,900 MW- is largely located east of the Andes, while sites west of the Andes are susceptible to droughts. Proven reserves of hvdrocarbons are estimated at 400mn b of crude oil (8.8 years of 1993 output), concentrated in the Amazon and Talara basins, and 6.5tr cf of natural gas, without fully including the Camisea gas reserves. With 18 potendally hydrocarbon-bearing basins covering about 84,000 sq.km, less than 20% of the country has been explored to-ate. Proven reserves of minmal coal are relatively minor and dispersed. They are estmated at 56mn mt, mainly anthracite, not all of which are economically minable. Biornmass resrces are abundant. Forests cover about 60% of the national territory, but more than 95% are located in the thindy populated Selva region, and their exploitation needs to be restricted to conserve resources. Agricultural residues are widely used for meeting rural energy requiments. Geo and solar resources in the Sierra region and -vnd resources along the southern coast are potentially significant for localized water pumping and small-scale electricity generation. Their use would depend among others on a more adequate assessment of their potential. 2. EnerM in the Economy. Comnercial energy supplies composed of hydrcarbons, electricity, and coal accounted in the late 1980s/early 1990s for nearly 7% of GDP. Energy consumption has been a significant source of fiscal revenue: it generated nearly 25% of cetral government tax receipts in 1992, with taxes on energy production from Petroperu accounting for another 3-5%. While there were significan' petroleum exports during 1978-87 (peaking in 1982 at US$685mn, or 17% of foreign exchange earnings), Peru subsequetly shifted to net petroleum imports, which in 1993 absorbed US$135mn (equivalent to 4.5% of foreign exchange earnings) after US$188mn in 1992. Investment in the energy sector, estimated at US$250mn equivalent in 1992, accounts for about 4% of gross fixed investment. In contrast, direct employment probably is not much morethan 1% of the total labor force. 3. Ener_y SuJWly - Demand Balance. Gross energy supply/demand in 1992 totalled 11.5mn toe (654 toe per US$1mn of GDP) and final energy consumption, lOmn toe, which is only slightly above that in 1985. Petroleum products and natural gas combined met 49% of 1992 final energy consumptin (natural gas consumption is confined to field operations and some use as refinery fuel), biomass including charoal, 39%, and electricity, 9%, with coal and coke accounting for the remainder. The residential and commercial sectors absorb the largest portion of final energy consumption (45% combined), followed by transport (24%), and industry and mining (21% combined). Close to two-thirds of commercl energy is consumed in the Lima region. The ural  ANNEX 7 3