ASIAN DEVELOPMENT BANK RRP: IND 29473

Transcription

1 ASIAN DEVELOPMENT BANK RRP: IND REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE BOARD OF DIRECTORS ON PROPOSED LOANS TO INDIA FOR THE MADHYA PRADESH POWER SECTOR DEVELOPMENT PROGRAM November 2001

2 CURRENCY EQUIVALENTS (as of 1 November 2001) Currency Unit Indian Rupee (Re/Rs) Re1.00 = $ $1.00 = Rs47.98 In this report, an exchange rate of $1.00 = Rs0.47 was used for calculation purposes. This was the prevailing rate during appraisal. ABBREVIATIONS ADB Asian Development Bank BMU benefit monitoring unit CSEB Chhattisgarh State Electricity Board CIDA Canadian International Development Agency DFID Department for International Development EISP Energy Infrastructure Services Project ERC Electricity Regulatory Commission HP horsepower HT high tension IEE initial environmental examination LIBOR London interbank offered rate LT low tension MOU memorandum of understanding MP Madhya Pradesh MPEB Madhya Pradesh Electricity Board MPG Madhya Pradesh government MPPGCL Madhya Pradesh Power Generation Company Limited MPPTCL Madhya Pradesh Power Transmission Company Limited MPSEB Madhya Pradesh State Electricity Board MPSERC Madhya Pradesh State Electricity Regulatory Commission NHPC National Hydroelectric Power Corporation NTPC National Thermal Power Corporation PFC Power Finance Corporation PMU project management unit PRA participatory rapid appraisal SC/ST scheduled caste/scheduled tribe SEB State Electricity Board SPU strategic policy unit TA technical assistance T&D transmission and distribution NOTES (i) (ii) The fiscal year (FY) of the Government ends on 31 March. FY before a calendar year denotes the year in which the FY ends. Thus, FY2003 will start on 1 April 2002 and end on 31 March In this report, $ refers to US dollars.

3 WEIGHTS AND MEASURES GWh gigawatt-hour (1,000 megawatt-hours) kv kilovolt (1,000 watts) kwh kilowatt-hour (1,000 watt-hours) MW megawatt (1,000 kilowatts) W watt (unit of active power)

4 CONTENTS Page LOAN AND PROGRAM SUMMARY ii MAP viii I. THE PROPOSAL 1 II. INTRODUCTION 1 III. THE SECTOR 2 A. Macroeconomic Context 2 B. Sector Description and Recent Performance 4 C. Constraints and Issues 7 D. State Government Objectives and Strategy 9 E. External Assistance to the Sector 10 F. ADB s Operations and Strategy in the Sector 11 IV. THE SECTOR DEVELOPMENT PROGRAM 12 A. Rationale 12 B. Objectives and Scope 13 C. Policy Framework and Actions 14 D. The Investment Project 18 E. Social and Environmental Measures 20 V. THE LOANS 22 A. The Policy Loan 22 B. The Investment Loan 25 VI. BENEFITS AND RISKS 32 A. Expected Impacts 32 B. Risks and Safeguards 35 VII. ASSURANCES 36 A. Specific Assurances 36 B. Conditions for Loan Effectiveness 38 VIII. RECOMMENDATION 39 APPENDIXES 40

5 ii LOAN AND PROGRAM SUMMARY Borrower The Proposal Rationale India A sector development program (SDP) comprising a policy loan of $150 million and an investment loan of $200 million, for a total of $350 million from ordinary capital resources of the Asian Development Bank (ADB) to support restructuring of the Madhya Pradesh Power Sector. The SDP is designed to support the creation of an efficient, selfsustaining, and competitive power sector to provide sufficient quantity and quality of power to support the economic and social development of Madhya Pradesh (MP). Given the complexity of sector reforms, implementation will follow a phased approach over a period of time. The SDP supports the first stage of reforms that lay the foundation for change and create an enabling environment for future private sector involvement through independent sector regulation; institutional and organizational actions for improved sector governance; establishment and gradual operationalization of new sector companies; decisions about reconfigurating the distribution segment, and managerial, financial, and operational efficiency improvements in ongoing operations. These policy initiatives will be supported by targeted physical investments to reduce system losses, improve operational and financial performance, and increase the delivery capacity of the power sector to reap the benefits offered by sector restructuring. The SDP seeks to assist in improving public and private resource allocation in MP by increasing the operational efficiencies and delivery capacity, and progressively reducing the demands on the state budget for the power sector that have resulted in suboptimal allocation of public funds at the expense of other state responsibilities like education and health. This requires simultaneous intervention at the policy level to provide the necessary legal and institutional framework, and at the project level to support critical investment components to ensure the success of the reforms. Therefore, a mixed-modality SDP seeking to establish appropriate policies as well as supporting project investments is considered the best instrument for supporting power sector restructuring initiatives. Classification Thematic: Economic Growth Good Governance

6 iii The Sector Development Program Objectives and Scope Policy Framework and Actions The immediate objectives of the policy component (the Program) of the SDP are to (i) improve the policy environment and governance of the sector; (ii) initiate the establishment of a commercial and competitive business environment to promote efficiency gains and loss reduction; (iii) improve the financial viability of the Madhya Pradesh State Electricity Board (MPSEB) through financial restructuring; and (iv) introduce a computerized information and revenue management system. The policy framework includes support for several actions. The MP Vidyut Sudhar Adhiniyam, 2000 (the Reform Act), brought into force on 3 July 2001, is the most progressive in India to date and includes provision for (i) restructuring MPSEB, (ii) mandatory metering of all consumers; (iii) rationalizing tariffs so that all classes of consumers will pay at least 75 percent of cost of supply (progressively phased over 5 years); (iv) allocating subsidies from the MP government (MPG) budget before subsidizing any category of consumers; (v) creating the MP State Electricity Regulatory Commission (MPSERC); and (vi) referring dispute resolution between MPG and the MPSERC to the Central Electricity Regulatory Commission rather than to the courts. The existing MP Electricity Regulatory Commission was converted into the first MPSERC following the coming into force of the Reform Act. The generation, transmission, and distribution functions of MPSEB will be corporatized and commercialized. The MPSEB tariff structure will be rationalized and free power supply in the state will be restricted. The sector will undergo financial restructuring. The Investment Project The investment component (the Project) of the SDP comprises six components: A: 33 kilovolt (kv) and 11kV system improvements in Bhopal, Gwalior, Indore, Jabalpur, Khargone, Mandsaur, and Ujjain areas; B: Conversion of selected low-voltage feeders supplying agricultural pumps in selected divisions in Mandsaur and Ujjain districts to 11kV operation;

7 iv Cost Estimates C: Reinforcement and augmentation of the transmission system facilities in selected priority areas of MP; D: Setting up of a computerized information and revenue management system; E: Provision of three-phase meters; and F: Consulting services for the initial phase of project implementation. The Project is estimated to cost $318.9 million equivalent, comprising $200.0 million in foreign exchange and $118.9 million equivalent in local currency costs. ($ million) Financing Plan Source Foreign Exchange Local Currency Total Cost Percent ADB MPSEB/ MPG Total ADB = Asian Development Bank; MPG = Madhya Pradesh government, MPSEB = Madhya Pradesh State Electricity Board. Environmental and Social Measures The Project is classified as Category B. An initial environmental examination was undertaken and the summary is attached as a core appendix. The poverty impact assessment for the SDP indicates that the mandatory metering under the Reform Act is more beneficial for low-income and poor households than the flat rate currently charged, since the per-unit charge is higher on a flat rate basis. Under the SDP, access to power connections by consumers living below the poverty line will be facilitated through a scheme of amortizing the upfront connection charges and associated fees over 12 months. Improved technical and nontechnical efficiency will benefit all categories of consumers by improving supply quality.

8 v The Policy Loan Loan Amount and Terms Program Period and Tranching A loan of $150 million from ADB s ordinary capital resources will be provided under ADB s LIBOR-based lending facility. The loan will have a 15-year term, including a grace period of 3 years, an interest rate to be determined in accordance with ADB s LIBORbased lending facility, including commitment charges and frontend fee. The Government will bear the foreign exchange risk on the loan in accordance with its policy. The period of the policy loan is December 2001 to June The loan will be released in three tranches: Tranche 1 of $65 million when (i) the Reform Act is in force; (ii) MPSERC awards the first tariff order; (iii) MP Power Generation Company Ltd. (MPPGCL), MP Power Transmission Company Ltd. (MPPTCL), and MP Power Distribution Company Ltd. (MPPDCL) are incorporated and registered under the Indian Companies Act, 1956; (iv) MPG and MPSEB agree on all the arrangements, with all outstanding dues paid, in accordance with the memorandum of understanding; and (v) MPG issues an order allowing MPSEB to disconnect all defaulting municipalities. Tranche 2 of $40 million when (i) not less than 7,500 energy audit meters are installed and operationalized; (ii) boards of directors for the MPPGCL and MPPTCL are established with the majority of members recruited in an open and transparent basis from outside government services; (iii) distribution reconfiguration is decided by MPG; (iv) MPG pays Rs2,000 million of total outstanding dues as of 31 March 2001 owed by municipalities to MPSEB; (v) a satisfactory debt restructuring plan of MPSEB is submitted; and (vi) second tariff filing is done by MPSEB before MPSERC. Tranche 3 of $45 million when (i) all new distribution companies are incorporated and registered under the Indian Companies Act; (ii) transfer scheme(s) are finalized; (iii) MPSEB assets are transferred to MPPGCL, MPPTCL, and at least one of the newly incorporated distribution companies, in accordance with the transfer scheme(s); (iv) MPG pays Rs2,423 million of total outstanding dues as of 31 March 2001 owed by municipalities to MPSEB; and (v) third tariff filing is done by MPSEB before MPSERC. Executing Agencies The Executing Agencies will be the Finance Department and the Energy Department of MPG.

9 vi Procurement Counterpart Funds The proceeds of the policy loan will finance the foreign exchange costs (excluding local taxes and duties) of eligible items produced in and procured from ADB s member countries. Counterpart funds to be generated by the policy loan will be transferred from the Government to MPG under the normal arrangements for the transfer of external assistance and will be treated as an additionality to the Government s transfers allocated annually to MPG. Counterpart funds will be used by MPG, in accordance with arrangements satisfactory to ADB, to support the financial restructuring of MPSEB and adjustment costs associated with the SDP, including (i) payment of outstanding municipalities and other local bodies dues, (ii) rationalization of electricity duty, (iii) set-off on dues of market borrowing of MPSEB to MPG, (iv) set-off of cross-liabilities between MPG and MPSEB, and (v) payment of debt obligations of MPSEB. The Investment Loan Loan Amount and Terms Implementation Arrangements and Executing Agency Procurement and Consulting Services A loan of $200 million from ADB s ordinary capital resources will be provided under ADB s LIBOR-based lending facility. The investment loan will have a 20-year term, including a grace period of 5 years, an interest rate determined in accordance with ADB s LIBOR-based lending facility, a commitment charge of 0.75 percent per annum, and a front-end fee of 1.0 percent. The loan proceeds will be transferred by the Government to MPG under its normal transfer arrangements. MPG will relend the loan proceeds to MPSEB at an interest rate of 12 percent with a term of 20 years, including a grace period of 5 years. The Government will bear the foreign exchange risk on the loan in accordance with its policy. The Project will be executed by MPSEB (or its successor entities with the prior approval of ADB). MPSEB, a statutory organization created under the Government s Electricity (Supply) Act 1948, is managed by a board appointed by MPG. Its successor entities will be companies registered under the Companies Act, 1956 of the Borrower. Procurement of goods and services will be carried out in accordance with ADB s Guidelines for Procurement. International consultants will provide support for Project implementation and be recruited in accordance with ADB s Guidelines on the Use of Consultants. For implementation of component D, as also for

10 vii benefit monitoring of the SDP, MPSEB will engage consultants using its own funds and procedures. Time Frame Risks and Safeguards Project implementation will commence in January 2002 and be completed in December Disbursement under the project loan will continue until June The major risks of the SDP are (i) regulatory risk, (ii) financial situation of MPSEB, (iii) lack of adequate technical assistance support for outstanding analytical work, and (iv) operational ineffectiveness. These will be mitigated by (i) providing comprehensive institutional strengthening and training for MPSERC, (ii) initiating comprehensive financial restructuring of MPSEB with support from all stakeholders, (iii) soliciting cofinancing from bilateral assistance agencies and ADB providing additional technical assistance funds, and (iv) changing and strengthening organizational and management structures and practices and effective follow-up mechanisms.

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12 I. THE PROPOSAL 1. I submit for your approval the following Report and Recommendation on proposed assistance to India for the Madhya Pradesh Power Sector Development Program, that includes (i) a policy loan, and (ii) an investment loan. II. INTRODUCTION 2. India s economy has been growing by about 6 percent annually over the last six years. 1 The country s economic performance, however, does not necessarily imply that the economy is fully utilizing its growth potential. The slowing of economic reforms since the mid-1990s highlighted the major problems affecting the economy including severe infrastructure bottlenecks, widening fiscal deficits, poverty, and illiteracy. In particular, the deteriorating fiscal health of the central and state governments is significantly undermining the long-term growth potential of the economy. Insufficient investments in physical infrastructure, both public and private, prevent the economy from reaping the benefits that are offered by market reforms and liberalization. This is particularly worrisome as empirical evidence on India strongly suggests that economic growth is the most effective path to sustained poverty reduction. 3. Under the Indian federal structure the states are responsible for a large number of vital activities, including infrastructure facilities, education, health, and law enforcement. Consequently, the fiscal health of the states is crucial for delivering these public services. While a large part of the states fiscal deficit is due to financial mismanagement and the priority servicing of political interests, the inability of the states to recover the costs of their services is a further reason for their poor fiscal health. For example, in the power sector, the inadequate average tariff base necessitates high budgetary subsidies to power utilities. As one result of the fiscal crunch, the electricity generation expansion target set for the Eighth Five-Year Plan (1992/97) fell short by 50 percent due primarily to inadequate investment at the state level. If not remedied, the unavailability of sufficient power will be the single most important constraint to economic development in the coming years and will thwart efforts to attract domestic and foreign investment. 4. Recognizing the importance of improving policymaking at the state level to enhance structural reforms in India, in 1996 the Asian Development Bank (ADB) adopted a new strategy for its operations in India directly targeting a portion of its assistance to selected states that have demonstrated the political will to (i) undertake structural reforms in their macrofinances; (ii) improve their public resources management, (iii) restructure public sector enterprises; and (iv) undertake sectoral reforms. Gujarat was the first state chosen for this type of holistic support. ADB approved the first loan in December Based on the willingness and commitment of the Madhya Pradesh government (MPG) to reforms, the state of Madhya Pradesh (MP) was included as the second focal state. Kerala was included as the third focal state and policy dialogue has been initiated. The MPG and ADB agreed on a program to enhance resource allocation to social sectors, improve fiscal capabilities, reform the public enterprise sector, and promote an enabling environment for private sector participation in supporting infrastructure. The reform program was supported by the approval of the MP Public Resource Management Program loan, 3 which initiated power sector reform with ADB agreeing, in principal, to provide 1 CER: IND : Country Economic Review, India, December Loan 1506-IND: Gujarat Public Sector Resource Management Program, for $250 million, approved on 18 December Loan 1717-IND: Madhya Pradesh Public Resource Management Program, for $250 million, approved on 14 December 1999.

13 2 targeted assistance for power sector development. The Power Sector Development Program (SDP) is included in the 2001 country program for India. The Fact-Finding Mission and Appraisal Mission were fielded during March-April 2001 and August-September This report is based on the agreements reached during the missions. III. THE SECTOR A. Macroeconomic Context 1. Recent Macroeconomic Performance 5. In terms of area, MP was the largest state in India and fourth in population until it was bifurcated into two states, MP and Chhattisgarh, on 1 November 2000, on the basis of the MP Reorganization Act, Its rich deposits of coal, iron ore, limestone, and forest resources were the prime sources of industrial growth in the prebifurcated state. The major resource-tied industries were steel, cement, and newsprint. During the 1980 s, the state had three primary attractions for many industrial units not based on local resources, such as chemical, electrical appliances, yarns, and garments: abundant land, no labor problems, and uninterrupted power supply. Thus the state economy has shown robust growth averaging 4.4 percent since 1980/81, accelerating to 5 percent during 1990/96. The contribution of the primary sector in state domestic product declined gradually over time and the contribution of services and industry rose consistently. For example, the share of the primary sector declined from 43.4 percent in 1993/94 to 39.6 percent in 1998/99. Similarly, the share of manufacturing and construction rose from 21.4 percent to 23.0 percent during the same period. 6. However, the industrial growth situation has changed noticeably since 1995/96. Countrywide industrial recession and acute power shortages (almost 14 percent of the peak demand in 1995/96) led to a sharp decline in industrial growth in MP. 5 The growth rate of real net state domestic product of registered manufacturing declined sharply from 7.1 percent in 1994/95 to 4.4 percent in 1995/96, and 1.1 percent in 1996/97. Many industrial units were forced to shutdown leading to large-scale unemployment. For example, the ferro alloys industry made its debut in the state in The number of units rose to 22 by Power shortages coupled with steep hikes in the power tariff after 1995 and strong market pressure due to the new open import policy led to the closure of almost all of the 22 units as of 1999; 6 and their power consumption reduced from 424 million units in 1995/96 to in 1999/2000. Total investment in these plants was about Rs2 billion and 20,000 workers were involved directly or indirectly. Similarly many designated economic growth centers in MP failed to promote industrialization due to the lack of proper infrastructure, such as roads, water, and street lights etc. A recent small survey of constraints faced by small-and medium-sized enterprises in MP 7 identifies lack of infrastructure, in particular shortage of electricity and its quality, followed by the poor state of the roads. 4 The project team consisted of D. Graczyk, Senior Energy Sector Specialist and Mission Leader; IWEN; B. M. Karunaratne, Senior Project Engineer, IWEN; P. Ghosh, Senior Environment Specialist, ENVD; K. Gerhaeusser Senior Programs Officer, PW2; S. Chander, Senior Project Engineer, IWEN; Y. L. Feng, Senior Environment Specialist, ENVD; M. Mitra, Senior Social Specialist, SOCD; T. Kimura, Energy Sector Specialist, IWEN; C. Litwin, Poverty Reduction Specialist, IWEN; V. S. Rekha, Counsel, OGC; and H. Mukhopadhyay, Macroeconomist, INRM. 5 The reasons for postreform industrial recession in India are still being debated. However, high lending rates, credit squeeze, and political uncertainties are some of the important factors. 6 National Institute of Public Finance and Policy Fiscal Industrial Incentives of the Government of Madhya Pradesh: Costs and Benefits. New Delhi. 7 TA 3338-IND: Capacity Building for Public Enterprises Reform and Social Safety Net in Madhya Pradesh, for $750,000, approved on 14 December 1999.

14 3 7. MP is one of the poorest states in India. In 1998/99, the per capita annual income was Rs7,350 (in constant prices) as compared with Rs9,739 at the all-india level. The percentage of the population living below the poverty line was 37.4 in 1999/2000, much higher than the all- India figure of 26.1 percent. 8. The new MP comprises roughly two thirds of the state before bifurcation, in terms of land area and population, is industrially more diversified with a higher proportion of light and manufacturing industries, and will have a higher per-capita income than the undivided state. However, the new MP has lost most of its natural and mineral resources to Chhattisgarh, and will need to adopt a new strategy for stimulating industrial growth. Therefore, future plans for industrialization in the new MP should primarily focus on promoting industries that are not resource-tied. States in India are competing to attract these industries. As decided by the council of state finance ministers, all fiscal incentives for industrialization were ended by April Thus, future industrialization will critically depend on adequate infrastructure facilities including power and good roads, as well as adequate education and health facilities to attract growth industries and their employees. 2. Macroeconomic Linkages of Power Sector Reform 9. Delays in reforms and the MPG policy of free power supply to a large proportion of its agricultural and domestic consumers (para. 62) has brought the MP Electricity Board (MPEB) (para. 20) into a severe financial crisis. As a result, MPEB is unable to provide adequate power, which is the most important ingredient of growth in the state. Also, the state exchequer is losing potential revenues that could have been mobilized from a financially strong electricity board. For example, in fiscal year (FY) 2001 MPEB s dues from interest on MPG loans (Rs3.33 billion) and for electricity duty (Rs3.31 billion), which MPEB collects on behalf of MPG, is estimated to be equivalent to almost 8 percent of the state s own revenue (both tax and nontax), and 0.8 percent of the net state domestic product. However, as a result of misdirected power policies and a noncommercial tariff structure, MPG provides annual budgetary support for MPEB such as the rural electrification subsidy, subsidy for free power supply, and fresh loans. And although MPEB s dues are adjusted entirely against budgetary support, MPG s unpaid subsidy to MPEB amounted to Rs23.3 billion as of March In 1996, MPG adjusted Rs7.9 billion by writing off its loans to MPEB, and in FY 1998 converted another Rs7 billion of its loans to equity to clear the backlog of subsidy payment from the state budget to MPEB. 10. Although funds are not fully fungible, fiscal imbalances, budgetary allocations, and the financial deterioration of MPSEB are clearly linked, as state budget support to the power sector crowds out public expenditure and investments in alternative sectors more productive for poverty reduction. The cash shortfall of MPSEB under a no-reform scenario is estimated at Rs16.7 billion for FY2002. In terms of evaluating the opportunity cost of MPSEB s cash requirements, the cash shortfall translates into 32 percent of total social sector spending, including capital investments. In view of the state fiscal imbalances, the Government has been compelled to finance budgetary support for the power sector through the banking sector. The cash requirement of MPSEB would amount to 43 percent of the gross fiscal deficit. Further deterioration of MPSEB would increase resource requirements from the banking sector and affect the ability of the sector to lend for private sector investments, which are more productive for economic growth. The macroeconomic linkages of the power sector reform are summarized in Figure MPG support for the power sector is targeted primarily at operational subsidies instead of supporting investments in system expansion to improve quantity, quality, and reliability of

15 4 supply or at least for adequate maintenance of existing assets. The electrification ratio for households in MP is about 42 percent, with less than 29 percent electrified in rural areas. Efforts by the state to increase private sector investment in power generation were undermined by the MPEB s low credit rating. Recognizing its inability to fund the additional investments required in the power sector, MPG has decided to reorganize the power sector to increase the selffinancing capability with the objective of increasing the ability to allocate budget resources to social sectors. Figure 1: Macroeconomic Linkages of Power Sector Reform Power Sector Reform Fiscal relief to the state government Higher revenue growth Benefits to the real sector Increased credit available for private sector Higher expenditure on social sectors Higher capital expenditure Higher employment Stable demand for massconsumption items Reduction in Poverty B. Sector Description and Recent Performance 1. Organization 12. India consists of 28 states 8 and 7 union territories with a total population of over 1 billion. The organization of the power sector is determined by the country s federal structure. All major issues affecting the power sector require concurrent action by the central and state governments. 13. The central Government s Ministry of Power provides overall guidance to the sector through the Central Electricity Authority (CEA). The Government owns central power utilities such as the National Thermal Power Corporation (NTPC), National Hydroelectric Power 8 Three new states, Chhattisgarh, Jharkhand, and Uttaranchal, were created in November 2000 through the bifurcation of Madhya Pradesh, Bihar, and Uttar Pradesh states, respectively.

16 5 Corporation (NHPC), Nuclear Power Corporation and the Powergrid Corporation of India (Powergrid), which are engaged in generation and interstate power transmission. The Rural Electrification Corporation and the Power Finance Corporation (PFC) are Government-owned and dedicated to financing power sector activities. The Power Trading Corporation was recently established to be responsible for power trading for large independent power producers targeted to multistate purchases. 14. State governments control the rest of the sector through 17 state electricity boards (SEBs) and 12 electricity departments, which provide distribution facilities and set retail tariffs within a state, and share responsibility with the central power sector agencies for power generation and transmission. The central agencies own and operate 32 percent of the country s total generation, while the SEBs and electricity departments have 64 percent of the total. In addition, five private utilities in urban agglomerations have a 4 percent share in power generation. 15. In 1998, the Electricity Regulatory Commission (ERC) Act was passed by the Indian Parliament and in the same year the Central Electricity Regulatory Commission (CERC) was established. The ERC Act gives CERC full autonomy to regulate central power utilities and to set bulk tariffs. The ERC Act also encourages the states to establish state electricity regulatory commissions with full authority for state-level power utilities. 2. State Electricity Boards 16. The Indian Electricity Act of 1910 and the Electricity (Supply) Act of 1948 provide the legal basis for the establishment and operation of SEBs. SEBs are typically vertically integrated entities owned by their respective state governments. While they are nominally independent from the state governments, their commercial and financial operations are subject to substantial intervention by these governments, in particular for tariff setting, metering policies, and electrification targets. Most SEBs are ordered to provide free or highly subsidized power to the agriculture sector and to a substantial portion of domestic consumers. Continuous politicization of the sector combined with a lack of commercial culture and accountability have resulted in negative internal cash generation by SEBs, impeded expansion of the power system, and restrained adequate maintenance and rehabilitation of existing assets. As a result, the demandsupply gap has widened, and the quality of power supply has deteriorated in almost all parts of the country. 17. Recognizing the need to separate social obligations from commercial imperatives, some states initiated power sector reforms in the mid-1990s and passed their own power sector reform bills to provide a legal basis for SEB reorganization. The states that have reorganized, or are in the process of reorganizing, their power sectors are Orissa (1996), Haryana (1998), Andhra Pradesh (1999), Karnataka (1999), MP (2000), Rajasthan (2000), Uttar Pradesh (2000), Delhi (2001), and Gujarat (2001). The major objective of the state power sector reform is to increase the sector s self-generation of funds and to reduce its reliance on budget transfers from the state s budget. Although each state has adopted a unique model of power reform, all models reflect in one way or the other the desire to distance the government from power sector operations. 3. Central Power Utilities 18. Until 1972, the SEBs were almost solely responsible for developing power generation and transmission within their states, but were unable to meet the rapidly increasing demand for electricity. To improve the efficiency of generation, three central sector agencies NTPC,

17 6 NHPC, and Nuclear Power Corporation were established in 1975 to generate bulk power for sale to SEBs. In 1989, Powergrid was established as a transmission and dispatch company by amalgamating the transmission and dispatch assets of all central power sector agencies. In addition to these wholly owned companies, the Government also has shares in special-purpose generating companies. 19. The central agencies, including NTPC, NHPC, and Powergrid, are seriously affected by the poor financial health of most SEBs, as was evidenced several times in the past when excessive accounts receivable from SEBs seriously impaired the central agencies financial liquidity. To resolve this problem, NTPC has, in addition to restricting supply and obtaining Government appropriation to settle SEB debts, even resorted to taking over the SEB generation facilities in settlement of accounts receivable. 9 ADB s two loans to Powergrid, 10 restrict investments to SEBs that have a satisfactory payment record with Powergrid and make provisions for Powergrid to suspend power supply to delinquent SEBs. 4. Madhya Pradesh Power Sector 20. The MP power sector was operated by a vertically integrated monopoly, MPEB. Following the bifurcation of the state into MP and Chhattisgarh, in pursuance of subsection (4) of section 58 of the MP Reorganization Act, 2000, MPEB was succeeded by the MP State Electricity Board (MPSEB) and the Chhattisgarh State Electricity Board (CSEB), both vertically integrated monopolies. As of 1 November 2000, the total installed capacity in the undivided state of MP was 4,261 megawatt (MW). The division of generating capacity following the bifurcation is given in Table 1. Table 1: Generation Plant Details ( ) State Type Total A. Madhya Pradesh (new) Thermal Hydro B. Chhattisgarh Thermal Hydro C. Total (Old MP) Thermal Hydro Total (A) Total (B) (megawatts) 2, ,901 1, ,360 3, ,261 Total (C) Central Allocation 1,521 Source: MPSEB. 21. Based on a provisional Government order, generation capacity was allocated between the two states on the basis of asset location. Similarly, transmission assets, distribution regions, and project/asset-specific liabilities, including employees, would be split along geographic state borders. However, non-project/asset-specific liabilities (including employees) would be apportioned on the basis of population leaving MPSEB to assume approximately 79 percent of total long-term debt of MPEB. Both states have requested the Government to reconsider its 9 As part of the agreement to change the executing agency for Loan 907-IND: Unchahar Thermal Power Project, for $160.0 million approved on 29 September 1988 to NTPC, ADB, the Government, the Uttar Pradesh government, and NTPC agreed to transfer title to the 420-MW Stage-I to NTPC. NTPC has since taken over the Talcher Thermal Power Station from Orissa SEB, and the Tanda Thermal Power Station from Uttar Pradesh SEB in lieu of dues owned by these states. 10 Loan 1405-IND: Power Transmission (Sector) Project, for $275 million, approved on 16 November 1995 and Loan 1764-IND: Power Transmission Improvement (Sector) Project, for $250 million, approved on 6 October 2000.

18 7 order. Nonetheless, MPSEB was already granted the right of first refusal for purchasing surplus power from CSEB s own production. The key indicators for the new MP s power sector are given in Supplementary Appendix A. 22. From 1993 to 2000, power demand grew by a compounded 7.3 percent annually. However, annual growth rates fluctuated strongly due to the severe power shortages experienced from 1996 to Growth was also uneven between the different customer categories over the same period with high tension (HT) industrial consumers showing zero growth compared with a compounded 16 percent growth rate for agricultural consumers. 23. The size of load served, as well as the load mix, in the two new states differs significantly from that of the undivided MP state (Table 2). As a result, the new MPSEB is expected to be in a financially weaker position than erstwhile MPEB because (i) many highprofile industrial consumers reside in Chhattisgarh, (ii) 94 percent of agricultural consumers remain in the new MP, and (iii) allocation of 32 percent of generation capacity to Chhattisgarh will leave the new MP with a more serious power shortage. Table 2: Load Mix for MPSEB and MPEB in State Unit Domestic LT Agriculture HT Industry All Other Total Madhya Pradesh MU 2, , , , ,322.6 (MPSEB) 14% 49% 16% 21% 100% Chhattisgarh MU , ,413.2 % 17% 12% 54% 17% 100% Total (MPEB) MU 3, , , , ,735.8 % 15% 41% 25% 19% 100% HT = high tension, LT = low tension, MPEB = Madhya Pradesh Electricity Board, MU = million units. Source: MPSEB. C. Constraints and Issues 24. Load Restrictions. Power demand grew by 6.4 percent in 1999/2000 and the peak demand-supply gap in the same year is estimated at about 1,500 MW. This unserved, or suppressed demand, results from planned (load relief) and unplanned (load shedding) cuts. In response to the shortage, MPEB resorted to load restrictions for HT, low tension (LT), and rural consumers. Energy shortfall reached 1,060 gigawatt-hours in 1998/99 and is estimated to have increased to 1,552 gigawatt-hours for the year 1999/2000. Quality of supply has also suffered as a result of overloaded transmission and distribution facilities; the system has been operating at lower than normal frequency and voltage approximately 55 percent of the time. Transmission, distribution, and generation limitations are thus preventing the system from meeting demand. 25. Independent Power Producer Policy. In response to the growing supply gap, MPG initiated a policy to invite private power producers and entered into power purchase agreements with a total of 17 sponsors. However, none of the independent power producers has achieved financial closure yet due to MPEB s insufficient escrow capacity 11. In December 1999, the escrow capacity was reviewed and revised to 900 MW, which is only 35 percent of the capacity estimated 18 months earlier, pointing to the sector s severe financial problems. 11 The term escrow used here refers to the deposition of the revenue stream from a specific revenue collection center, e.g., a distribution unit, into a separate account in an identified bank, an escrow agent. In the power sector this mechanism is mostly used to guarantee payment of an independent power producer, to whom the primary claim on a revenue stream from a distribution zone is transferred or escrowed.

19 8 26. Tariff Structure and Subsidies. The financial problems of MPEB and its successor MPSEB are in large part due to an MPG policy (para. 62) to provide free power to single-point connections 12 in urban and rural areas and for agricultural pump connections up to 5 horsepower. Moreover, MPG instructed MPEB to supply almost free electricity to rural electricity cooperative committees (Rs0.07 per kwh) and to pursue a vigorous rural electrification program. This resulted in lopsided growth rates in the domestic and primarily the agriculture sectors at the expense of the industrial and commercial consumer categories. Industrial consumption was 82.7 percent of total energy consumption in 1970/71, but dropped to only 20 percent of consumption in 1999/2000. During the same period, the percentage of agricultural consumption went up from 3.4 percent to 41 percent. 27. With its high energy consumption, the agriculture sector contributed barely 6 percent of total MPEB revenue in 1999/2000, while the industry sector s contribution was 43 percent compared with 20 percent of consumption. In terms of average realization per kilowatt-hour (kwh), the agriculture sector accounted for Rs0.27 and the domestic sector for Rs0.93 as compared with an average cost of supply of Rs3.03 per kwh (Table 3). Table 3: Average Realization from Energy Sold FY1996 FY2000 Item %Total Consumption Average Tariff Rs/kWh %Total Revenue %Total Consumption Average Tariff Rs/kWh %Total Revenue Domestic a Irrigation/ Agriculture HT Industries b Ave.Overall Supply Cost HT= high tension, kwh= kilowatt-hour, Rs= Indian Rupee. a Includes single point consumers. b Includes steel plants. Source: MPSEB. 28. This situation has resulted in (i) MPSEB not having resources to finance its system expansion to meet unserved demand; (ii) industrial consumers paying high tariffs that impair their competitiveness and consequently establishing their own generation facilities, eroding MPSEB s consumer mix; and (iii) MPSEB being unable, without subsidies from the state government, to earn a return on its investments as prescribed by law. 29. Captive Power. In direct response to the deficient quantity and quality of power supply coupled with high tariffs, major industrial consumers have set up their own captive power generation plants. From 1995/96 to 1999/2000, growth of captive generation averaged 8.7 percent per year, with the last two years being above 9.3 percent for a total of 1,390 MW of installed captive capacity for MPEB. Of this, 671 MW or 48 percent is located in the territory supplied by the new MPSEB. This represents considerable loss of revenues for MPSEB. 30. System Losses. From 1994/95 to 1998/99, transmission and distribution (T&D) losses have varied within a range of 19.6 percent to 20.9 percent. Precise loss estimation is hampered by the fact that currently only about 38 percent of energy input into the distribution system is measured due to the policy of free supply for designated agricultural and domestic consumers, 12 These are unmetered connections intended for operation of a single power outlet point only.

20 9 and the charging of a flat rate for several other consumer groups. In addition, a significant number of meters are defective and consumption of those customers also needs to be estimated. 31. Losses consist of two major types: technical and commercial. Estimation of technical losses can be made rather precisely through load-flow analysis. Commercial losses are generally a function of the operation of the system; and can include theft, metering problems, and billing and collection inefficiencies. Given the current absence of energy audit and full enduser metering of agricultural customers, reestimation of consumption by MPSEB consultants based on connected load, supply restrictions, etc., provides strong evidence that agricultural consumption is gravely overstated and that losses are understated. This revised estimate shows losses of around 47 percent, of which 22 percent are considered technical and 25 percent commercial. Reduction in technical losses generally requires significant investment; because of the financial constraint of MPSEB, the improvement in technical losses is expected to be slow. On the other hand, major improvement in nontechnical losses can be quickly achieved with concerted management effort at much lower levels of investment. D. State Government Objectives and Strategy 1. The Policy Framework 32. As a result of efforts made by the National Development Council 13 the high-level Committee on Power was constituted in June In its report submitted in October 1994, the committee recommended (i) organizational reforms at the state level, consisting of commercialization and vertical and horizontal unbundling; (ii) large-scale involvement of the private sector in generation and distribution; (iii) depoliticizing electricity-tariff setting by creating national and regional tariff boards; and (iv) progressive phasing out of subsidies to agricultural consumers. These recommendations were renewed in the council meeting with Power ministers in October and December 1996, and are outlined in the Common Minimum National Action Plan for Power. 33. In response to the National Development Council s recommendation, MPG appointed a high-level committee in 1996 to review the existing power sector situation and to suggest measures for its restructuring in the context of economic liberalization and introduction of private capital into the sector. Named after its chairman, the Tata Rao Committee issued Guidelines on Restructuring and Privatization of Power Sector and Power Tariff in January The major recommendations of the report were to (i) divide MPEB along functional lines, (ii) maintain MPEB as a holding company, (iii) establish a regulatory authority, (iv) allow private sector investment in all functional areas, and (v) improve the financial and operational efficiency of the distribution segment before inviting private sector investment. The report recommended fundamental changes in the free supply of power to certain consumer segments, and that any subsidies must be transparent and reimbursed to the utility on a timely basis. The Tata Rao Committee advised against separating and privatizing urban area distribution from semiurban and rural distribution, as this would leave the remaining public sector distribution segment highly nonviable. It also recommended maintaining uniform tariffs for each category of consumers, as long as the areas continue to be MPEB subsidiaries. 13 India's highest political body, the council is chaired by the Prime Minister and comprises the chief ministers of all the states in India.

21 10 E. External Assistance to the Sector 34. The power sector has received a major portion of India's external assistance. Of ADB s total Government-guaranteed lending to India amounting to $9.898 billion as of 31 October 2001, 9 loans for $1.865 billion (18.8 percent) were approved for the power sector. The first four projects were for power generation; three were sector loans to support improvements in SEB efficiency and development of the national transmission grid; and the two most recent were for sector development to support the restructuring of a state s power sector. In addition, under its private sector operations, ADB has approved three loans and investments totaling $79.8 million for one captive transmission and two generation projects. 14 Power subprojects have also been considered for financing under ADB's private sector infrastructure facility 15 and the Infrastructure Development Finance Company. 16 ADB also has approved $12.9 million for 21 technical assistance (TA), mainly advisory, at both the national and state levels. The TAs have focused on environmental and pollution control issues related to power generation, bulk transmission tariffs, improved least-cost system planning, tariff studies at the retail level, improved technical and commercial operations, power sector restructuring, and establishment of an independent regulatory authority. Previous ADB assistance to India s power sector is listed in Supplementary Appendix B. 35. The major funding source to the sector is the World Bank Group. The World Bank has supported power generation, transmission, and distribution projects, including assistance directed to SEBs. The World Bank is supporting power sector reforms in the states of Andhra Pradesh, Haryana, Orissa, Rajasthan, and Uttar Pradesh. In Andhra Pradesh and Uttar Pradesh, power sector reform is viewed as part of overall reform of the state finances. ADB coordinates with the World Bank on the geographical demarcation of state-level operations, as well as to ensure overall complementarity of actions at both the central and state levels. ADB and the World Bank have concurrent ongoing operations for different projects with three organizations: PFC, Powergrid, and NTPC. Other major agencies funding the sector are the Japan Bank for International Cooperation, Kreditanstalt für Wiederaufbau for the Government of Germany, Department for International Development of the United Kingdom (DFID), Canadian International Development Agency (CIDA), and United States Agency for International Development. Although the combined assistance of all aid agencies constitutes only about 8-10 percent of the total investments in the sector, several key policy initiatives have been catalyzed as a result. Major external assistance provided to the power sector by other aid agencies is also listed in Supplementary Appendix B. 36. The Japan Bank for International Cooperation is supporting the expansion of public sector generation, transmission, and distribution including rural electrification. It has no geographic preferences. 37. DFID s exclusive objective in providing assistance is poverty reduction. It is financing studies for power sector restructuring in Andhra Pradesh, Haryana, and Orissa; and has no plans to participate in the financing of hardware other than in renewable energy systems. It is 14 Loan 7058/1036-IND: CESC Limited, for $17.8 million, approved on 4 October 1990; Loan 7082/1142-IND: CESC Limited II, for $32.0 million, approved on 13 December 1991; and Loan 7130/1499-IND: Balagarh Power Company Limited, for $15 million in equity and a loan for $25 million, approved on 5 December Loans 1480/1481/1482-IND: Private Sector Infrastructure Facility, for a total of $300 million, approved on 7 November Investment 7138-IND: Infrastructure Development Finance Company, for $30 million equity investment, approved on 14 October The loan amount was subsequently reduced to $ million due to greater than expected subscription from the investors.

22 11 considering (i) cooperating with ADB to fund studies on power sector restructuring in MP and West Bengal states; and (ii) assisting these states in other areas also, preferably in the "soft" sectors, like health and education. 38. The United States Agency for International Development has extensively supported and continues to support policy aspects of private sector participation. It has supported studies for state sector reforms through PFC, and by providing grant assistance for energy management, conservation, and training. 39. CIDA assisted Kerala in conducting extensive studies for restructuring its power sector. ADB is following up on CIDA s work through policy dialogue and preparation for a possible loan intervention. Together with the World Bank, CIDA is providing similar TA for power sector reforms in Andhra Pradesh. In Madhya Pradesh, CIDA and ADB are cooperating and coordinating closely in providing assistance to MPSEB and MPG for power sector reform. CIDA provides the most bilateral assistance and is providing an umbrella TA to MPSEB through the Energy Infrastructure Services Project (EISP). The EISP s components include (i) rationalizing the tariff structure; (ii) developing a power system master plan; (iii) supporting distribution reconfiguration and preparation of a grid code; (iv) restructuring MPSEB debt and preparing opening balance sheets for the new sector entities; (v) supporting capacity building for crosscutting themes in environment, gender equality, socioeconomic analysis, and governance; and (vi) developing a poverty reduction strategy as it relates to energy availability for the poor (para. 50). F. ADB s Operations and Strategy in the Sector 1. Lessons Learned 40. ADB operations in India s power sector have generally been successful from a project point of view, i.e., the projects concerned have achieved their physical objectives. However, except for the ongoing loans to Powergrid and Gujarat (footnote 10), 17 these projects were not designed to change the business environment, and sector performance continues to deteriorate. This was primarily on account of (i) political interference in tariff setting; (ii) rapid growth of the demand for electricity, making conventional investment strategies unworkable; (iii) government rules and regulations and control of the SEBs that inhibited speedy decision making; and (iv) the noncommercial setup of the sector, which did not generate the market for alternative players to step in to bridge the gap between supply and demand. 41. Although the past strategy enabled ADB to support many projects, it spread ADB's resources too thinly, with the result that it could not achieve its desired goal of policy reforms with its power sector borrowers. In most states, the power sector has been the largest recipient of state resources, in terms of subsidies as well as in terms of capital investments. Thus, macro management of the state's finances needs to be improved if the power sector is to be successfully turned around. Therefore, ADB is now assisting selected states with power sector reforms, only in the context of a holistic change in their macroeconomic management. 2. Operational Strategy 42. ADB s current operational strategy in India is to support efforts to achieve higher sustainable economic growth to promote employment and reduce poverty. Its contribution to 17 Loans 1803/1804-IND: Gujarat Power Sector Development Program, for $350 million, approved on 13 December 2000.

23 12 higher growth focuses on improving the supply-side efficiency of the economy, especially by reducing bottlenecks in key infrastructure sectors. Emphasis is on improving the policy, institutional, and regulatory framework to enhance the efficiency of public sector operations and to encourage private investment. Improving resource mobilization to finance the necessary investments is a key component of ADB s assistance, and includes support for the development of financial and capital markets, as well as for improving internal resource mobilization in the sector agencies and enhancing their creditworthiness. High priority is also given to assisting projects that contribute to environmental improvement. 43. ADB's strategy for India was revised in 1996 to accommodate an urgent need for a portion of its assistance to be provided in a systematic and comprehensive way at the subnational or state level. This need reflects the facts that (i) a geographic focus, together with the ongoing selective sector focus, enables ADB to maximize its developmental impact both in the states concerned and, through the demonstrational impact of its operations on other states as well; (ii) state-level economic reforms, which have been lagging behind initiatives taken by the Government, need support and incentives; and (iii) the states have considerable autonomy and have major legislative, administrative, and fiscal responsibilities in many economic and social sectors. Key elements of the subnational assistance include (i) improving the states' public resources management, (ii) reforming and restructuring public sector enterprises to improve operating efficiencies, and (iii) supporting reforms in key infrastructure sectors with a view to increasing private investment (para. 4). 44. Reflecting ADB s overall country strategy for India and in recognition of the dualistic structure of India's power sector, ADB's strategy for the power sector, which has been pursued in coordination with the World Bank, intends to operate at two levels. At the central level, assistance is provided to central power sector companies such as Powergrid (para. 18, footnote 10) and PFC 18 with a view to supporting their commercialization and using them as agents to leverage reform in their client SEBs. Through its support to PFC, ADB seeks to promote power sector reforms in states that would currently not qualify for direct lending operations. At the state level, by considering assistance only for states that demonstrate the political will to substantially restructure and commercialize their power sectors, and by assisting them to actualize the reforms, ADB is building up the reform process from the grassroots. Improvements in the power sector will increase the fiscal space of the state governments and increase their ability to allocate more resources for poverty reduction and socioeconomic development. IV. THE SECTOR DEVELOPMENT PROGRAM A. Rationale 45. The power sector has become one of the major budget items for MPG due to politicized sector management. Despite receiving high annual subsidies, the sector has not been in a position to meet the growing demand for power, and quality and reliability of power supply have deteriorated. Political interference in tariff setting and sector operations had adverse impacts on the operational and financial performance of the MPSEB, which finds itself in a severe financial crisis. The lack of sufficient and reliable power is eroding MP s competitiveness, and prevents it from attracting the same level of industrial investments as some of its neighboring states. At the same time, the demands on the state budget for the power sector have resulted in suboptimal allocation of public funds at the expense of other state responsibilities like education and health, 18 Loan 1161-IND: Power Efficiency (Sector) Project, for $250 million, approved on 26 March The loan account was closed on 18 December 1998.

24 13 further undermining the state s attractiveness as a location for new industrial developments, especially information technology and biotechnology, which are India s future growth sectors. Restoring the sector s financial viability and sustainability is a declared objective of MPG and the SDP provides the basis for MPG to reform and restructure the power sector. 46. MPG adopted the recommendations of the Tata Rao Report as the base model for sector reform, namely, (i) functional unbundling of MPSEB, (ii) retention of MPSEB as a holding company, (iii) establishment of a regulatory authority, and (iv) improvement of operational and financial efficiency of the distribution segment before inviting private sector investment. However, MPG found that given the complexity of the sector reforms to be undertaken, implementation should be phased. Stage I of the reforms will lay the foundation for change and create the conducive environment for future private sector involvement in the power sector 19 (Appendix 1 provides a vision for the long-term sector model). In close dialogue with ADB, MPG developed a detailed plan for stage I of the reform process that aims at creating an enabling environment and independent sector regulation; establishing new sector companies and their gradual operationalization; deciding on reconfiguring the distribution segment; and improving managerial, financial, and operational efficiency of its ongoing operations. Those policy initiatives would be supported by targeted physical investments to reduce system losses and increase the delivery capacity of the power sector to reap the benefits offered by sector restructuring. On the basis of the policy dialogue associated with the SDP, MPG submitted its development policy letter (Appendix 2), which includes a policy matrix and memorandum of understanding (MOU) between MPB and MPSEB. A detailed plan for stage I of the reform process is provided in Appendix The SDP is designed to support MPG s long-term goal to ensure an efficient, selfsustaining, and competitive power sector to provide sufficient quantity and quality of power to support the state s economic and social development. The SDP provides incentives for institutional and organizational actions for improved sector governance and the functional unbundling of MPSEB, and in parallel supports physical investments to strengthen the capacity of the power system and to reduce technical and nontechnical losses to improve operational and financial sector performance. The SDP seeks to improve public and private resource allocation in MP by increasing MPSEB s operational efficiencies and delivery capacity, and progressively reducing the need for transfers from the state government budget. This requires simultaneous intervention at the policy level to provide the necessary legal and institutional framework, and at the project level, to support critical investment components to ensure success of the reform. Therefore, a mixed-modality sector development program is considered the best instrument for supporting an initiative to restructure the power sector. The SDP constitutes the first stage of the reform process, and will be followed by a second loan intervention upon successful implementation of the first stage of reforms. B. Objectives and Scope 48. The immediate objectives of the SDP are to assist MPG and MPSEB to (i) improve the policy environment and governance of the sector; (ii) initiate the establishment of a commercial and competitive business environment to promote efficiency gains and loss reduction; (iii) improve the financial viability of the MPSEB through financial restructuring; (iv) improve the quality and quantity of supply by reinforcing, modernizing, and rehabilitating the T&D systems to 19 The India Country Strategy Program for 2003 includes TA for Increasing Private Sector Participation in Electricity Distribution.

25 14 promote economic growth; (v) introduce a computerized information and revenue management system; and (vi) pursue installation of meters. 49. Given the lack of creditworthiness of MPSEB to attract private capital and the parallel need to meet the growing demand for energy, the sector reform and restructuring strategy must focus on enhancing the cash flow at the distribution end. In addition to rationalizing the tariff structure, the SDP will (i) reduce T&D losses, (ii) pursue 100 percent metering, (iii) improve billing and collection efficiency, and (iv) install efficient operational management of power sector companies. To achieve these changes, autonomous functioning of the power sector along commercial lines, especially of the distribution functions, and independent sector regulation and corporatization of the generation, transmission, and distribution functions of MPSEB, are required. The SDP is designed to assist MPG and MPSEB in achieving these objectives. The SDP frameworks are provided in Appendix 4. C. Policy Framework and Actions 50. During its deliberation of the Tata Rao Report, MPG recognized that irrespective of the choice of the long-term sector model, a set of preparatory studies would be needed to optimize sector expansion, ensure its commercial viability, attract and optimize private capital investment, and establish benchmark performance for introducing competition. Consequently, MPG requested ADB assistance for preparing and financing the MP Power Sector Development Project. 20 The TA was designed as a cluster TA to include six studies, two financed by ADB and four by CIDA. 21 In addition, CIDA recently expanded the EISP scope to include funding of activities related to implementing stage I and preparing stage II of the power sector reforms (para. 39). ADB will coordinate the overall MP power sector reform program and CIDA is working closely with ADB to implement the studies. The first TA subproject to be implemented reviewed electricity legislation and regulation, and included drafting of the MP Power Sector Reform Bill and support for the selection of a base model for the restructured power sector. 51. In May 2000, an MOU was signed between the Union Ministry of Power and MPG. In the MOU both parties affirm their joint commitment to the reform of the power sector, and set out time-bound reform measures to be implemented by MP and the implementation support to be provided by the Government. The MOU outlines the objectives of the reform program: to promote the development of an efficient, commercially viable and competitive power supply industry, which will provide reliable and quality power at competitive prices to all consumers in the state and which will support the industrial development in the State. The Government commits to support the reforms by allocating additional power from central power stations; and providing financial support for investment projects through Powergrid and PFC, and technical consulting assistance. 1. Governance 52. ADB had extensive policy dialogue with MPG and MPEB about the legislative framework and the need to constitute the regulatory authority under a separate state power sector bill and 20 TA 2980-IND: Technical Assistance to India for the Madhya Pradesh Power Sector Development Project, for $1,000,000, approved on 7 January The six studies include (i) preparation of a power system master plan (CIDA); (ii) preparation of a framework for rationalization of tariffs (CIDA); (iii) review of electricity legislation and regulation (ADB); (iv) solicitation for private sector implementation of a generation project (ADB); (v) technical and managerial upgrading of distribution profit centers (CIDA); and (vi) demandside management (CIDA). 21 Implementation of CIDA s TA components was delayed due to then prevailing external environment. CIDA is currently implementing TA components (i) and (ii).

26 15 not under the ERC Act to ensure independence of the regulator. As a result of the policy dialogue, the MP Vidyut Sudhar Adhiniyam, 2000 (the Reform Act) was brought into force on 3 July The Reform Act is the most progressive in India to date and includes provision for (i) restructuring MPSEB, (ii) mandatory metering of all consumers, (iii) tariff rationalization so that all classes of consumers will pay at least 75 percent of the cost of supply (progressively phased over 5 years), (iv) allocation of MPG budget subsidies before subsidizing any category of consumers, (v) creation of the MP State Electricity Regulatory Commission (MPSERC), and (vi) dispute resolution between MPG and MPSERC by reference to the CERC as against reference to the courts. The Reform Act is primarily an enabling provision for reform and leaves sufficient flexibility for the power sector structure to evolve with future policy decisions and operational requirements. Its prescriptive elements, like mandatory metering and minimum tariff levels, are aimed at reducing political interference and ensuring the commercial management of power sector operations. 53. The MP Electricity Regulatory Commission was established in June 1999 under the ERC Act and was recognized as the first MPSERC upon bringing the Reform Act into force. MPSERC is gradually increasing its role as a proactive sector stakeholder. It formed an advisory committee consisting of representatives of different consumer groups, labor unions, nongovernment organizations, academic and research bodies, and various government departments, and issued a tariff philosophy paper for discussion. Its first tariff award was made after holding extensive public hearings throughout MP involving questions and answer sessions with MPSEB officials. Also, in response to MPG s recent proposals for a state-wide, loadshedding schedule, MPSERC held several public consultations before issuing an order. 54. In relation to the selection of a model for the postreform power sector, two large stakeholder meetings were organized during Representatives from unions, the MP Federation of Industries, academia, MPG officials, Madhya Pradesh Electricity Regulatory Commission, and MPEB staff attended the meetings. The workshops contributed significantly to an understanding of the objectives, strategies, challenges, and benefits of power sector restructuring, and increased the transparency of the reform process. 55. Both the MOU and the Reform Act define MPG s long-term vision for the sector and set the legal framework for restructuring. However, in the short-term, visible improvements in the power sector can only be achieved by combining internal efficiency enhancements of the utility and MPG actions to boost MPSEB s financial viability. 56. To depoliticize sector management, open and transparent recruitment processes must be used to fill boards of directors and senior management positions of the new sector companies. MPG has agreed to recruit experts from outside government services for functional areas including finance, commercial, corporate planning, and information technology. In recognition of the importance of installing and maintaining commercial discipline in the sector, MPG has taken the leadership role and issued an order to appropriate at source outstanding dues of municipalities and other government bodies. MPG also committed to make future subsidy payments to MPSEB in cash on a monthly basis. 2. Reform Model and Institutional Arrangements 57. Details of the power sector model for stage I of reforms were decided upon by MPG through continuous policy dialogue with ADB. As recommended by the Tata Rao Report, MPG decided to functionally segregate MPSEB into separate generation, transmission, and distribution companies incorporated under the Indian Companies Act, 1956, to conduct business on a commercial basis. MPSEB will remain as the holding company of the newly incorporated

27 16 companies, and will also act as the single buyer and system operator during the first stage of power sector reform. All generation assets of MPSEB will be transferred to the newly incorporated generating company, and each of the plants will be operated as an independent profit center. All transmission assets will be transferred to the newly established transmission company and it will act as the wheeling agent for intrastate transmission activities. 58. Stage I of the reforms also has to contend with the continuous uncertainty over apportionment of liabilities and employees between the two states as a result of bifurcation. The final apportionment will impact on MPG s decision on transfer schemes (proposed to be prepared under ADB TA) that are a prerequisite for full operationalization of the new sector companies. Further, MPG recognizes the importance of identifying and assessing any costs resulting from the transfer schemes early to be able to mitigate their impacts. 59. Detailed analytical work needs to be carried out before the final number of distribution companies can be decided upon. Moreover, the final decision on the number of distribution companies includes an element of political decision making about the extent of supportable cross-subsidization within and between the new distribution entities and the treatment of predominantly rural distribution areas. Therefore, MPG decided to retain the existing distribution regions under MPSEB as the holding company until a final decision has been reached on distribution reconfiguration. ADB also initiated policy dialogue with MPG and MPSEB that some of the existing distribution circles should already start operating as independent profit centers to provide practical experience and best practices before operationalization of the new distribution companies becomes effective. The most suitable candidates for the profit center approach are those distribution circles whose facilities are proposed for upgrading and strengthening. MPSEB should give priority to installing of meters for energy audit and for end-consumers in these circles; and fully delegate managerial powers to those circles as part of the overall internal efficiency enhancement measures currently being implemented. 60. While principally open to divestment and private sector involvement in all three functional areas, MPG wishes to make its decision based on full and detailed information about the current operational and financial situation and the business prospects of the power sector in the medium term. Learning from experiences made elsewhere, MPG will first establish the legal and regulatory framework and an enabling business environment to create certainty for investors before soliciting private sector investments. 61. MPG recognizes the benefits of creating a formal coordination mechanism for the reform process since effective reform management will require that a strategic and program overview be maintained at the highest level throughout the reform process to ensure effective use of resources and to establish priorities. MPG has set up an institutional framework for managing power sector reform under the apex of the Steering Committee for Power Sector Reform chaired by the chief secretary. The members of the committee include the principal secretaries for power, finance, law, and planning; secretary, finance; and chairman, MPSEB. In addition, the joint secretary reforms, Union Ministry of Power, and director, ADB, Department of Economic Affairs, have been included to ensure close coordination on power sector reforms. Reporting to the committee is the Strategic Policy Unit (SPU) headed by the principal secretary, power. The SPU is responsible for defining the critical path for reform and for preparing a time-bound implementation plan and review mechanisms, keeping in mind the institutional, financial, and regulatory imperatives. The SPU includes representatives from MPSEB and the Power and Finance ministries of MPG, and coordinates with ADB and other assistance agencies in the sector. Power sector experts from outside the state and representatives of consumer groups are invited to provide feedback and input to the SPU on an intermittent basis. The SPU should ideally be supported by a professional implementation task force to analyze best practices and

28 17 present alternative scenarios considering local conditions. With the assistance of ADB, MPG is currently identifying external funding for the implementation task force and the SPU. DFID has expressed general interest in supporting both. 3. Restriction of Free Power Supply 62. With effect from 1 January 2001, a new MPG policy became effective reducing free supply of power to agriculture consumers and single-point consumers. Under the new policy only scheduled castes and scheduled tribes (SC/ST) consumers who are living below the poverty line and with a monthly consumption of not more than 20 kwh will receive free power supply under the single-point scheme. SC/ST agricultural consumers are now only eligible for free electricity supply for pumps up to 5 horsepower if they have less than 1 hectare of irrigated land. As a consequence of this policy, about 95 percent of agriculture consumers and 75 percent of single-point consumers are now required to pay their electricity bills fully. MPSEB expects annual revenues from the agriculture sector to increase by Rs1,610 million, and from single-point connections up to Rs1,440 million once the new policy is fully implemented. The projected increase is equivalent to 19 percent of total revenues from LT consumers in FY Energy Audit and Metering 63. The MP Urja Vidheyak, 2001, or the MP Energy Act for the prohibition of unauthorized use of electricity; and the assessment, compounding, and recovery of arrears and dues to reduce losses caused by illegal abstraction, use, consumption, and pilferage of electricity was enacted on 17 April A comprehensive energy audit comprising the installation of 7,500 meters is being implemented on all feeders up to the 11 kilovolt (kv) level; electronic meters will be provided to all HT consumers. This will allow MPSEB to record and compare the energy input into a specific distribution feeder with the realized revenues coming from the same feeder. Grouping and accounting of consumers according to distribution feeder will be implemented as part of the energy audit. In addition to allowing specific targeting of high loss zones for efficiency improvements, the energy audit is a fundamental ingredient for distribution reconfiguration and corporatization/divestment to be carried out as part of sector reform. 64. While preparing for supplying and installing meters to all endusers, MPSEB has launched a campaign to regularize unmetered connections using self-assessment of electricity consumption. Under the scheme, administrative requirements for official connections are relaxed, and consumers are encouraged to self-assess their monthly electricity consumption and make payments based on this assessment. Once meters have been installed the connections will be billed based on the meter reading. The self-assessment campaign fulfills three objectives: (i) immediately increase MPSEB s revenues, (ii) lower resistance to meter installation, and (iii) assist in detecting tampering of meters if metered consumption is substantially lower than that self-assessed. It also benefits poorer consumers who until now could not obtain legal connections due to lack of titles to their land/housing. Under the new policy, proof of property titles is no longer a requirement for obtaining a connection from MPSEB. After an interim period, all nonregistered connections will be levied with heavy fines and ultimately disconnected. 5. Internal Reforms 65. The self-assessment scheme is part of the comprehensive measures implemented by MPSEB to increase the internal operational efficiencies. Simplifying procedural hurdles to obtain official connections will reduce nonmonetary access barriers to the network, while simultaneously reducing illegal connections and thus system losses.

29 Introduction of grievance procedures to better respond to customer needs and to increase public participation is another step toward a commercial and competitive power sector. MPSEB has formed grievance redress committees at district and subdivision levels headed by representatives of MPSEB and the local community. In anticipation of the new business environment, MPSEB has implemented measures to decentralize powers and to increase MPSEB officers responsibility for incidents of theft in their jurisdiction. As part of the internal restructuring, MPSEB banned all new recruitment and revised the retirement age from 60 to 58 years starting in January 2001, which immediately reduced the number of employees by about 1,200 (of a total of 67,000). 67. MPSEB recently delegated more operational responsibilities. Administrative, commercial, and financial responsibilities created on a graduated scale by MPSEB were delegated to individual generating plants and distribution circles. For example, in an effort to increase the number of high-profile customers, line extensions for HT consumers can now be approved by superintending engineers, and for industrial consumers up to 5 MW by regional chief engineers instead of requiring approval of MPSEB board members. 68. In response to the changes resulting from the sector reforms, MPSEB is adjusting its organizational set-up. MPSEB s reform coordination structure mirrors MPG s, in the sense that MPSEB s High-Level Reform Coordination Committee is supported by a coordination committee, which in turn collaborates closely with the Corporate Planning Group, (the counterparts for CIDA s EISP), which acts as MPSEB s resource center for coordination with the reform process and is equivalent to MPG s implementation task force. 69. A tariff and regulatory affairs cell is being created by MPSEB to concentrate and cultivate specialist expertise for the annual tariff filings and to act as the focal point for any data request by MPSERC. The expertise of senior officers assigned to the social and environmental management cell was obtained during their work with the Corporate Planning Group on power system planning, and financial and socioeconomic analysis. Officers assigned to the project management unit (PMU) were involved in preparing project reports for submission to ADB under the project loan and have been associated with reform-related activities carried out by corporate planning group. All new organizational units are staffed with officers representing generation, transmission, and distribution functions with a view to the unbundling of MPSEB, and the expertise and functional requirements of the new companies. 70. The successful implementation of the reform initiatives requires a combination of financial support for reform adjustment costs and system improvements, and technical advice on properly integrating the reforms into operational procedures and their implementation in dayto-day management of MPSEB. D. The Investment Project 1. Project Description 71. An outline description of the investment components (the Project) is given in Supplementary Appendix C. The components include the following: A B 33kV and 11kV system improvements in Bhopal, Gwalior, Indore, Jabalpur, Khargone, Mandsaur, and Ujjain areas; Conversion of selected low-voltage feeders supplying agricultural pumps

30 19 in selected divisions in Mandsaur and Ujjain districts to 11kV operation. C D E F Reinforcement and augmentation of the transmission system facilities in selected priority areas. Setting up of a computerized information and revenue management system. Provision of three-phase meters. Consulting services for the initial phase of Project implementation. 2. Cost Estimates 72. The summary cost estimates of the Project are in Table 4 (details are in Appendix 5). Table 4: Cost Estimates ($ million) Item Foreign Exchange Local Currency Total Cost I. Project Components A. 33kV and 11kV System Improvements B. 11kV Conversion C. Transmission System Reinforcements D. Computerized Information and Revenue Management System E. Metering F. Consulting Services Subtotal (I) II. Contingencies Physical Price Subtotal (II) Front-End Fee Taxes and Duties Interest /Commitment Charges during Construction Total KV = kilovolt. Source: MPSEB, Staff Estimates. 3. Financing Plan 73. The proposed financing plan for the Project is summarized in Table 5. Table 5: Financing Plan for the Project ($ million) Source Foreign Exchange Local Currency Total Cost Percent ADB MPSEB and MPG TOTAL ADB = Asian Development Bank, MPSEB = Madhya Pradesh State Electricity Board, MPG = Government of Madhya Pradesh. Source: MPSEB, Staff estimates.

31 20 E. Social and Environmental Measures 1. Social Dimensions 74. Participatory rapid appraisal (PRA) and extensive public consultations were undertaken throughout MP during appraisal of the SDP (Supplementary Appendix D). The PRA objective was to investigate the impacts of the reform process on consumers, especially the poor. The PRA also examined barriers for the poor to access electricity connections. In addition, consultations were held with three MPSEB labor unions and associations representing different classes of employees to discuss the concerns of the employees with regard to the current status of MPSEB and the reform process. The unions expressed concern in three major areas: (i) political interference in MPSEB operations, including tariff setting; noting that field staff were often put in a situation of implementing policies with little support for enforcement; (ii) MPSEB s financial status and allocation of resources for maintenance; and (iii) lack of generation capacity. Ultimately, the current situation in the areas where the unions expressed concern affects the morale, dedication, and incentives to enforce policies. 75. MP has a high percentage of scheduled tribes and scheduled castes (SC/ST). They are overrepresented among households living below the poverty line. The tribal population constitutes approximately 23.3 percent of the total population, is mainly rural, and is characterized by small and marginal landholdings; forest-based occupations; and limited access to water resources, and infrastructure and agricultural technology including electrical irrigation pumps. Under the new MPSEB policy on free power supply, SC/ST consumers living below the poverty line are eligible for the single-point scheme; the connection charge is amortized over four monthly installments. This policy does not apply to other consumers living below the poverty line. 76. The new mandatory metering policy of MPSEB was found to be more beneficial for lowincome and poor households as opposed to the flat rate tariff currently charged; the per-unit charge is higher on a flat rate basis. The current schedule of load shedding combined with billing on a flat rate basis is regressive in the sense that consumers experiencing more load shedding will be paying a higher unit rate than consumers experiencing less. 77. The PRA findings indicate a consistent demand and willingness to pay for improved supply of power services, even in remote areas, for irrigation and domestic use. This finding is also confirmed by the poverty impact assessment (Appendix 6). However, the seasonality of agriculture results in a mismatch of rural farm incomes and MPSEB billing practices. Furthermore, small and marginal SC/ST farmers who have been exempted from power charges and who now have to pay unless they are classified as living below the poverty line are finding it difficult to pay as their access to water resources and alternative income sources have declined. The PRA found that while MPSEB informally implements installment-based payments of bills, such installments need to be systematized and poverty-related policies and guidelines for the power sector more effectively communicated to MPSEB field staff. 78. The PRA found a substantial number of illegal connections among low-income households, which MPSEB finds difficult to legalize. These connections are partially a result of the recent policy changes requiring certificates to prove below-poverty status, which can be difficult to obtain for poorer households. While MPSEB and MPG are attempting to mitigate this problem by authorizing village heads to issue the certificates, not all village heads have yet been made aware of this new scheme. However, the PRA found that the major reason for illegal connections appears to be the inability of poorer consumers to pay up-front connection charges and associated fees in one payment, and found that 12 monthly installments would facilitate the

32 21 ability of these consumers to afford the initial charges. The findings where discussed with MPSEB, which agreed to introduce a 12 month installment facility applicable to all consumers living below the poverty line. A detailed analysis of the barriers for poor households to access electricity is also provided in Appendix Environment 79. The potential environmental impacts of the policy and institutional changes under the SDP as per the Reform Act were evaluated (Appendix 7). Most potential impacts are considered beneficial from an environmental point of view. Policy dialogue is ongoing with MPSERC to enhance benefits by institutionalizing environmental management in sector regulation and to also increase public participation during conceptualization of new investment projects. On the operational side, MPSEB has agreed to establish a fully functional social and environmental management cell; selection of officers is ongoing. The new cell will include an environmental management and monitoring section to ensure that the Project is undertaken, and all project facilities operated and maintained in compliance with all applicable laws, rules, and regulations, including ADB s Environmental Assessment Requirements. A proposed organizational setup for the cell is in Supplementary Appendix E. 80. The Project is classified as Environment Category B as it will have limited environmental impacts during construction and operational stages. Based on the environmental assessments and surveys conducted for components A and C, the associated potential adverse environmental impacts can be mitigated to an acceptable level by adequate implementation of the measures outlined in the initial environmental examination (IEE); a summary is given in Appendix 7. Although 1.4 kilometers of the alignment of the transmission lines is forested, it is either degraded Grade IV forest or no tree is standing on the affected area. No endangered, rare, or threatened species of flora or fauna have been reported in the project sites. Nevertheless, compensatory forestry will be strictly implemented in coordination with the State Forest Department. Adequate provisions have been made in the Project to cover the environmental mitigation and monitoring requirements, and their associated costs. 81. MPSEB s current technical specification for transformer oil and practices of reclamation of used transformer oil shows its capability of handling process-generated wastes to minimize adverse environmental effects of the components. MPSEB will comply with India s Environmental Protection Act and other applicable regulations for the handling of used transformer oil. All new transformer and capacitors purchased under the project loan by MPSEB must be polychlorinated biphenyl (PCB)-free and specifications in the bidding documents will be made accordingly. 82. No significant rehabilitation, land acquisition, or compensation is required for the Project. For the Jabalpur, Khargone, and Mandsaur areas under component A, site selection for substations and routing of transmission lines has been completed, and a land acquisition and compensation plan (Supplementary Appendix F) prepared in line with ADB s policy on involuntary resettlement. 22 The social assessment shows that 49 of the 62 proposed sites for substations are government owned, and will be transferred to MPSEB for nominal payments. These sites are free of encroachments. The remaining 13 sites are privately owned and are mostly agricultural lands belonging to small-and medium-sized landholders. Field visits revealed that the owners of these sites were willing to donate their land to MPSEB with the expectation that their power supply will improve. However, MPSEB decided to compensate the owners in 22 ADB The Bank s Policy on Involuntary Resettlement. Handbook on Resettlement. Manila.

33 22 accordance with market rates for comparable land. Crop compensation as per market rates and production levels will be paid for any crop losses that might occur during construction. Rs40 million is included is included in the project cost for these purposes. 83. For the remaining components, pending final site selection for construction of substations and routing of transmission lines, land acquisition and resettlement frameworks were prepared in keeping with ADB s policy on involuntary resettlement. The resettlement framework for the Project is based on the principles that involuntary resettlement will be avoided or minimized where possible by exploring other alternative project designs, and where land acquisition is unavoidable, people losing assets, livelihoods, or other resources will be assisted in restoring or preferably improving their former standard of living. All those affected are entitled to be compensated for their lost assets, incomes, and businesses at replacement cost, and provided with rehabilitation measures in keeping with the ADB policy. Lack of legal rights will not be a bar to rehabilitation assistance for people affected by the Project. Compensation for ethnic minorities, households headed by women, and families with disabled and other vulnerable families will be carried out with respect for their particular cultural and specific needs. The final land acquisition and resettlement plan will be prepared in keeping with ADB policy, and be reviewed and approved by ADB prior to construction activities. Implementation of the plans will be monitored by the PMU, which will submit regular reports to ADB. A. The Policy Loan V. THE LOANS 1. Amount of Loan, Terms, and Sources of Funds 84. The Government of India has requested a policy loan of $150 million from ADB s ordinary capital resources to help finance the policy component of the SDP. The loan will have a 15-year term, including a grace period of 3 years; an interest rate determined in accordance with ADB s LIBOR-based lending facility; a commitment charge of 0.75 percent per annum; a front-end fee of 1.0 percent, (the fee will be capitalized in the loan), conversion options that may be exercised in accordance with terms of the draft Loan Agreement, the Loan Regulations, and ADB s Conversion Guidelines; and other terms and conditions set forth in the draft Loan Agreement. The Government has provided ADB with (i) the reasons for its decision to borrow under ADB s LIBOR-based lending facility on the basis of these terms and conditions, and (ii) an undertaking that these choices were the Government s own independent decision and not made in reliance on any communication or advice from ADB. The counterpart funds to be generated from the loan proceeds will be transferred from the Government to MPG under normal arrangements for the transfer of external assistance. The funds transferred to MPG will be treated as additional to the Government s transfers allocated annually to MPG. The Government will bear the foreign exchange risk in accordance with its policy. 85. MPG is expected to incur the following costs of adjustments over the reform period: (i) (ii) Payments of outstanding dues of municipalities and other local and state bodies outstanding as of 31 March 2001 will cost approximately Rs7,423 million ($164 million) after deducting 26 percent on account of bifurcation. Rationalization of electricity duty is expected to cause a revenue loss of about Rs350 million ($7.5 million) each year in the next five years for a total of $37 million.

34 23 (iii) (iv) (v) Set-off of dues of market borrowing of MPSEB to MPG will result in costs of Rs6,750 million ($144 million) over a five years period. Set-off of cross-liabilities 23 between MPG and MPSEB will result in a one-time payment of Rs620 million ($13.2 million). Reduction of debt obligations of MPSEB. 2. Executing Agencies 86. The Executing Agencies will be the Finance Department and the Energy Department of MPG. 3. Procurement and Disbursement 87. The proceeds of the policy loan will be utilized to finance the full foreign exchange costs (excluding the local duties and taxes) of imports produced in and procured from ADB s member countries, other than those specified in the list of ineligible items (Supplementary Appendix G) and imports financed by other bilateral and multilateral sources. All procurement will be through normal commercial practices in case of procurement by the private sector, or prescribed procedures acceptable to ADB in the case of procurement by the public sector, having due regard for the principles of economy and efficiency. The Government will certify that (i) if the proceeds of the loan will finance imports already made, the value of eligible imports in the period concerned exceeds the amount of the requested withdrawal, or (ii) if the loan proceeds are to finance goods to be imported, the value of eligible imports in the immediately preceding 12 months period is equal to or greater than the amount of the requested disbursement plus all other amounts expected to be withdrawn from the loan during the succeeding one year. 4. Counterpart Funds 88. Counterpart funds generated by the policy loan will be transferred by the Government to MPG and be used by MPG under arrangements satisfactory to ADB, to support the financial restructuring of MPSEB and adjustment costs associated with the SDP, including (i) payment of outstanding municipalities and other local and state bodies dues owed to MPSEB, (ii) rationalization of electricity duty, (iii) set-off of dues of market borrowings of MPSEB to MPG, (iv) set-off of cross liabilities between MPG and MPSEB, and (v) reduction of debt obligations of MPSEB. 5. Monitoring and Tranching a. Tranche Release of the first tranche of $65 million (anticipated in December 2001) is dependent on fulfillment of the following actions: (i) (ii) The Reform Act is brought in force. MPSERC has announced the first tariff award. 23 MPG s subsidy-related liabilities owed to MPSEB (approximately Rs18.5 billion as of 31 March 2001) were adjusted against MPSEB s loans owed to MPG (approximately Rs17.9 billion as of 31 March 2001) and net amount of Rs620 million was in cash from MPG to MPSEB.

35 24 (iii) (iv) (v) MP Power Generation Company Limited (MPPGCL), MP Power Transmission Company Limited (MPPTCL), and MP Power Distribution Company Limited (MPPDCL) are incorporated and registered under the Indian Companies Act, MPG and MPSEB agree on all the arrangements, with all outstanding dues paid, in accordance with the MOU 24 between MPG and MPSEB. MPG issues orders allowing MPSEB to disconnect with immediate effect, all defaulting municipalities and other MPG bodies exceeding payables for more than the immediately preceding one month equivalent of sales. 25 b. Tranche Release of the second tranche of $40 million (anticipated in September 2002) is dependent on fulfillment of the following actions: (i) (ii) (iii) (iv) (v) (vi) MPSEB has installed and operationalized not less than 7,500 meters as required for the energy audit. Establishment of boards of directors of MPPGCL and MPPTCL that shall include majority of experts recruited in an open and transparent basis from outside government services, represented by the disciplines of finance, commerce, human resources, corporate planning, and information technology expertise. MPG has taken a decision on distribution reconfiguration based on, inter alia, the EISP study findings, as mutually agreed between ADB and MPG. MPG has paid MPSEB in cash Rs2,000 million out of total outstanding dues as of 31 March 2001 (approximately Rs7,423 million after deducting percent on account of bifurcation) owed by municipalities and other local and MPG bodies to MPSEB. MPG has submitted an approved debt restructuring plan for MPSEB to ADB, based on, inter alia, the EISP study, as mutually agreed between ADB and MPG, (the plan will also include a proposal of MPSEB through MPG to the Government on settlement of dues owed by it to central sector undertakings). MPSEB has made its second tariff filing before MPSERC. c. Tranche Release of the third tranche of $45 million (anticipated in June 2003) is dependent on fulfillment of the following actions: (i) New distribution companies are incorporated and registered under the Indian Companies Act, 1956 as per decision on distribution reconfiguration. 24 The MOU is attached to the Development Policy Letter. 25 The date of billing by MPSEB will be taken as the basis to calculate outstanding dues.

36 25 (ii) The transfer scheme(s) 26 are finalized as mutually agreed between ADB and MPG. (iii) (iv) (v) MPSEB assets are transferred to MPPGCL, MPPTCL, and at least one of the newly incorporated distribution companies, in accordance with the transfer scheme(s). MPSEB has made a third tariff filing before MPSERC. MPG has paid MPSEB in cash Rs2,423 million out of total outstanding dues as of 31 March 2001 (approximately Rs7,423 million after deducting percent on account of bifurcation) owed by municipalities and other local and MPG bodies. B. The Investment Loan 1. Amount of Loan, Terms, and Sources of Funds 92. The Government of India has requested an investment loan of $200 million from ADB s ordinary capital resources to help finance the investment component of the SDP. The loan will have a 20-year term, including a grace period of 5 years; an interest rate determined in accordance with ADB s LIBOR-based lending facility; a commitment charge of 0.75 percent per annum; a front-end fee of 1.0 percent, (the fee will be capitalized in the loan), conversion options that may be exercised in accordance with the terms of the draft Loan Agreement, the Loan Regulations, and ADB s Conversion Guidelines; and other terms and conditions set forth in the draft Loan Agreement. The Government has provided ADB with (i) the reasons for its decision to borrow under ADB s LIBOR-based lending facility on the basis of these terms and conditions, and (ii) an undertaking that these choices were the Government s own independent decision and not made in reliance on any communication or advice from ADB. The loan proceeds will be transferred by the Government to MPG under its normal arrangements of transfers to MPG. MPG will relend the loan proceeds to MPSEB, at an interest rate of 12 percent with a term of 20 years, including a grace period of 5 years. The Government will bear the foreign exchange risk in accordance with its policy. 2. The Executing Agency 93. The Executing Agency for the Project will be MPSEB (or its successor entities to be established as a result of the reform program, with prior ADB agreement). 94. MPSEB is a statutory body created under the Indian Electricity (Supply) Act of Its objectives are to generate, transmit, and distribute electricity in the state of Madhya Pradesh. 95. MPSEB is governed by a board appointed by MPG comprising a full-time chair and four full-time members for financial, generation, transmission, and distribution functions. See Supplementary Appendix H for the organization chart for MPSEB. 26 Scheme(s) concerning transfer of properties, rights, liabilities, and employees from MPSEB to its successor entities under the Reform Act.

37 a. Financial Performance 26 i. Financial Performance of MPEB 96. Income statements, balance sheets, and cash flow statements, both historical and projected are given in Supplementary Appendix I. Financial performance for FY1998 FY2001 is summarized in Table 6 and cost of supply and tariffs are shown in Table 7. Table 6: Summary of Historical Financial Performance of MPEB and MPSEB (Rs Million) MPEB MPSEB Items FY1998 FY1999 FY2000 FY2000 FY2001 Actual Actual Actual Pro Forma Provisional Power Generation & Purchase (GWh) 30,486 33, ,754 26,662 T&D Losses (%) Power Sales (GWh) 24,652 26,659 23,547 18,323 13,598 Sales Revenue (excl. subsidies and subventions) EBITDA (excl. subsidies and subventions) Net Income before Subsidies and Subventions Net Income after Subsidies and Subventions 47,333 48,217 54,507 36,373 34,508 3,426 (1,432) 388 (10,465) (14,070) (7,530) (16,067) (16,844) (23,504) (27,302) 1,225 1,169 (13,713) (21,206) (25,362) Net Fixed Assets 40,835 38,978 39,488 32,097 42,237 Long-Term Debts 43,585 52,466 61,147 48,289 48,926 Loans and Equity from the State 23,251 25,434 21,621 15,865 15,865 Government Return on Net Fixed Assets 3.0% 3.0% -34.7% -66.1% -60.9% EBITDA = earnings before interest, taxes, depreciation, and amortization, GWh = gigawatt-hour, MPEB = Madhya Pradesh Electricity Board, T&D = Transmission and Distribution, MPSEB = Madhya Pradesh State Electricity Board. Note: T&D Losses and Power Sales for FY2001 reflect reassessment of agricultural consumption. Source: MPSEB. Table 7: Average Cost of Power and Tariff (Rs/kWh) by Category and Consumption Share (%) MPEB MPSEB FY 2000 FY2001 Oct 2001 Consumer Category Share Avg. Tariff Share Avg. Tariff New tariff % increase Low Tension Consumers Domestic 12.4% % % Single Point 2.7% % % Commercial 3.3% % % Water Works 0.8% % % Industrial 3.5% % % Agricultural 41.0% % % Public Lighting 0.6% % % Total LT 64.4% % % High Tension Consumers Railway 6.2% % % Coal Mines 3.9% % % Steel Plants 0.8% % %

38 27 Water Works 1.3% % % Irrigation 0.1% % % Licensee 4.0% % % Border Village 0.1% % % Industry 19.2% % % Total HT 35.6% % % Average Tariff 100.0% % % Average Cost of Supply MPEB = Madhya Pradesh Electricity Board, MPSEB = Madhya Pradesh State Electricity Board. a. Tariff is exclusive of electricity duties and cess. b. Average cost of supply = (fuel cost + power purchase cost + administration cost + depreciation + financial charges) / sales volume. c. Share and average tariff of agricultural consumers for MPSEB reflect reassessment of consumption volume d. New tariff for single-point consumers reflects the recent change of policy described in para 62. Source: MPSEB. 97. While sales revenue of MPEB has consistently increased from Rs47.3 billion in FY1998 to Rs54.5 billion in FY2000, cash flow position has deteriorated as shown in earnings before interest, taxes, depreciation, and amortization, and in FY2000 revenue narrowly covered operating cost, leaving no cash available for debt service. One of the major reasons for this was the high cost structure due to the high level of T&D losses, estimated at 31.6 percent in FY2000 as compared with an estimated 19.3 percent in FY1999. This sharp increase resulted from reassessment of consumption of agricultural consumers. As most of agricultural consumers are not metered, their consumption tended to be overestimated and they are overbilled; this contributes to an underestimation of losses. A recent study by MPSEB in collaboration with EISP on actual consumption by unmetered consumers has revealed that the actual system losses for MPSEB could be as high as 47.1 percent in FY Another reason for the cash flow problems is low cost recovery as shown in Table 7. In FY2000, the tariff covered only 60 percent of cost of supply due to the highly subsidized tariff for LT consumers, particularly agricultural and domestic consumers. In addition, fuel and power purchase cost continually increased well above revenue increases. The lack of an automatic fuel or power purchase cost adjustment mechanism, which passes cost fluctuations on to consumers, has also contributed to squeezing profit margins of MPEB. MPEB started to have a serious cash flow problem in FY1999. In response to this, tariffs were raised in March However, the increase was only sufficient to cover increasing operating costs, and MPEB continued to post substantial net losses. 99. Until FY1999, MPEB continued to achieve 3 percent statutory rate of return on net fixed assets after subsidy and subvention from MPG. However, MPG was unable to budget for the required subsidy and subvention amounts, and was not even able to pay budgeted amounts in cash. Adjusting subsidy and subvention payments at the end of each fiscal year against MPEB s payments of liabilities to MPG has been common practice. In FY2000, MPEB stopped recognizing unbudgeted subsidies in its accounts and was thus not able to achieve a 3 percent rate of return. Even after this change of accounting policy, subsidy and subvention receivable of MPEB stood at Rs23.3 billion as of 31 March ii. Financial Position of MPSEB 100. In April 2001 the Government issued a provisional order whereby assets and projectrelated liabilities of MPEB would be apportioned on a geographical location basis between MPSEB and CSEB while non project-related liabilities would be apportioned based on a

39 28 population basis (MP: Chhattisgarh = 73.38:26.62). The pro forma financial figures in Table 6 were prepared as per this order. Accordingly, MPSEB would assume approximately 79 percent of the total long-term debt of MPEB. On the other hand, MPSEB would retain only approximately 67 percent of the total revenue base of MPEB, losing a substantial proportion of the high-profile industrial customers while keeping 94 percent of MPEB s agricultural consumers. Therefore, the Government s order further undermines MPSEB s capacity to service its debt obligations. Both MPSEB and CSEB have requested the Government to reconsider the order Independent from the final apportionment of assets and liabilities, the new MPSEB faces more serious financial problem than its predecessor. In addition to the shift in its customer base, T&D losses are estimated at about 49 percent in FY2001; this coupled with accumulating energy dues from public sector consumers (Rs8.75 billion as of 31 March 2001), continues to squeeze MPSEB s cash flow. MPG had no fiscal space to provide sufficient budgetary support in cash and has accumulated unpaid subsidy of Rs18.5 billion as of March 2001 (estimate after deducting percent on account of bifurcation). Consequently, with the current tariff level, MPSEB has been unable to fully pay its dues to power and fuel suppliers, and defaulted on its payment obligations to creditors To break the vicious spiral of this circular debt, MPG agreed under the SDP to offset its subsidy-related and other liabilities owed to MPSEB (Rs18.5 billion) against its loans owed to MPG (Rs17.9 billion). The net balance of Rs0.6 billion was paid in cash by MPG to MPSEB. Furthermore, MPG agreed to pay all outstanding energy dues of municipalities and other MPG bodies and to ensure that they will remain current with their bills. MPG will use the entire policy loan under the SDP to settle, in cash, municipality and other MPG arrears outstanding as of 31 March 2001 (Rs7.4 billion). As regards dues after March 2001, MPG has committed that if municipalities and state government bodies do not make full payments of their energy dues, appropriations at source will be made by MPG so that the balance of receivables do not exceed one-month equivalent of sales. These measures will help MPSEB overcome its immediate liquidity problem, clean up its balance sheet, repay some of its creditors, and improve its borrowing capacity for future investments As of 31 March 2001, MPSEB owed approximately Rs16 billion to central power sector undertakings, mainly NTPC, Nuclear Power Corporation, and Coal India. Since accumulated liabilities to central power sector undertaking is a common problem of SEBs throughout India, a committee was set up by the Government to look into strategies for a one-time settlement of debts. The committee proposed that the state governments take over the SEBs liabilities and issue a 15-year tax-free bond to the central power sector creditors bearing 8.5 percent interest per annum with a 5-year grace period for repayment. In this securitization scheme, payment of current dues by SEBs would need to be guaranteed by the state governments. To become effective, the scheme requires consent from a majority of state governments. However, some uncertainty exists as to whether the scheme would be workable given substantial liabilities to be assumed by state governments, many of which have little fiscal space. NTPC, one of the biggest nonfinancial creditors to MPSEB, has indicated that regardless of this one-time settlement issue it would continue to supply power unless MPSEB defaults on current dues. b. Projected Financial Performance 104. MPSEB s projected financial performance is summarized in Table 8 and the major assumptions used in the financial evaluation of the Project and detailed calculation are provided in Appendix 8. The opening balance sheet of MPSEB is based on the Government s order of April 2001 regarding apportionment of assets and liabilities of MPEB.

40 29 Table 8: Summary of MPSEB s Projected Financial Performance (Rs Million) Item FY2001 FY2002 FY2003 FY2004 FY2005 FY2006 FY2007 FY2008 FY2009 FY2010 Power Generation 26,662 25,944 24,545 24,378 25,554 25,673 25,904 26,592 27,707 28,887 & Purchase (GWh) T&D Losses 49.0% 43.2% 38.0% 35.0% 32.0% 29.0% 26.0% 24.0% 23.0% 22.0% Power Sales (GWh) 13,598 14,297 14,808 15,451 17,377 18,228 19,169 20,210 21,335 22,532 Sales Revenue a 34,508 36,218 42,908 47,411 55,642 61,964 68,507 75,410 83,853 93,765 EBITDA a (14,070) (11,453) (3,186) (283) 3,299 7,058 10,623 13,071 15,517 18,613 Net Income before Subsidy and Subvention (27,302) (20,720) (12,681) (11,777) (14,195) (12,337) (10,680) (9,191) (9,160) (6,263) Net Income after Subsidy and Subvention (25,362) (14,892) (5,580) (4,324) (6,049) (3,724) (1,572) 433 1,064 4,656 Net Fixed Assets 42,237 43,180 49,890 51,467 52,377 50,875 49,651 48,405 46,663 44,424 Long-Term Debt 48,926 63,162 82,800 89,062 97, , , , ,383 95,148 Loans and Equity from 15,865 17,627 1,696 1,696 1,696 1,696 1,696 1,696 1,696 1,696 State Government Return on Net Fixed 60.9% 38.0% 14.0% 9.4% 12.8% 7.8% 3.4% 1.0% 2.5% 11.8% Assets Debt Service Coverage Ratio (0.91) (1.78) (1.75) (1.94) (6.72) Gwh = gigawatt-hour, T&D = transmission and distribution. a Excluding subsidies and subventions Source: Staff Estimate MPSERC issued a tariff award in September As shown in Table 7, average tariffs for LT and HT consumers were raised by 16 percent and 13 percent respectively, resulting in an overall tariff increase of 11 percent due to expected change in the consumer mix from FY2001 to FY2002. Although the new agricultural tariff is still far below the cost of supply, new tariffs are expected to boost FY2002 revenue by 17 percent 27 on an annual basis. Further tariff increases are projected to enable MPSEB to achieve at least 75 percent cost recovery by FY2007 as required by the Reform Act except for agricultural consumers and a minor bulk purchaser. The projected average retail tariff per kwh for each consumer category is provided in Appendix 8, Table A8.2. The projection envisages that (i) a modest tariff increase will continue to be given to the consumer categories being already charged higher-than-cost tariff, and (ii) tariff increase above inflation rate for consumers paying tariff below cost of service until achieving 100 percent cost of recovery. For commercial and industrial consumers in HT and LT categories, no further tariff increase is assumed once the tariffs reach the breakeven point of cost of captive power (approximately Rs5.00/kwh). Also in September 2001, the MPG raised cess on electricity from Rs0.01 to Rs0.10 per unit. This is expected to generate additional tax revenue of Rs1.5 billion to Rs1.6 billion per year. c. Impact of the SDP on MPSEB s Financial Projections 106. The projected financial results also depend on substantial reduction of losses, particularly nontechnical losses. In the projection, the current T&D losses are assumed to be 49.0 percent in FY2001 based on the recent MPSEB estimate. The losses are projected to be reduced by 5 percent in FY2002, 3 percent annually up to FY 2007, and diminishing margins thereafter. The projected reduction of T&D losses is in line with MPSEB s comprehensive loss 27 Since new tariffs became effective on 26 September 2001, net increase of revenue in FY 2002 will be about 6.6 percent.

41 30 reduction plan partly financed under the Project. The projection also envisages improvement of collection efficiency due to computerization of the revenue management system financed under the Project and the MPG s assurance under the SDP of full recovery of dues from municipalities and other state government bodies Based on the MOU between MPG and MPSEB (agreed upon under the SDP), the projection envisages (i) any future subsidy and subvention to be paid in cash, (ii) free power supply bills to be fully reimbursed monthly, (iii) cash grant equal to electricity duties and cess to be provided monthly, and (iv) additional cash injection in the form of subvention and/or capital grant to be provided to the extent necessary for MPSEB to remain solvent. As MPSEB has defaulted on all creditors and cannot afford to fully service its debt obligations for the next few years, it needs to agree with lenders and bondholders on debt restructuring as soon as possible. Under EISP, CIDA is financing TA to prepare a debt restructuring plan for MPSEB. Initiation of negotiations with creditors based on the plan is a second tranche release condition under the Program. In the projection, debt service obligations, which have become due and unpaid, as well as ones that will become due over the next three years, are assumed to be rescheduled in a manner reasonably acceptable to creditors The financial projections in Table 8 and in Appendix 8 present a base case scenario during SDP implementation. The projection indicates that MPSEB would be able to overcome immediate liquidity shortage through additional cash in-flow from tariff increase, partial recovery of arrears from municipalities and state government bodies, and cash injection from MPG in the form of subsidies and subventions. In the medium to long term, efficiency improvement, particularly T&D loss reduction, will be a key driver for recovery of financial soundness. Reduction of losses by 3 5 percent annually, together with an average annual tariff increase of about 6 percent 28 and continued government support, is expected to bring MPSEB back to a break-even position in FY2008 and 3 percent rate of return in FY2010 on an after-subsidy and subvention basis. This means that from FY2010 onward, MPG would start to phase out the annual subsidies and subventions. An upside scenario would be feasible if MPSERC increases the agricultural tariff to achieve 75 percent cost recovery by FY2007 and MPSEB accelerates its loss reduction program to achieve target 22 percent by FY2007. In this scenario, MPSEB would achieve positive net income without subsidies and subventions by FY Implementation Arrangements a. Management 109. The MPSEB Chairman will be in overall charge of the Project. Day-to-day project implementation will be undertaken and supervised by the PMU, which was established in May 2001 specifically for the Project, headed by a senior MPSEB officer. The PMU will be assisted by a team of consultants to refine project details, procurement activities, and project management in general. MPSEB is in the process of expanding the staff strength of the PMU to correspond with the increased workload. Except for exceptional organizational requirements, the staff assigned to the PMU will be retained for the entire duration of project implementation in the PMU and any vacancy in the PMU will be filled before such vacancy is made effective. The PMU will be delegated decision-making powers. 28 Annual tariff increase is projected at 10 percent for LT consumers and 4 percent for HT consumers until FY2007.

42 31 b. Implementation Schedule and Performance Review 110. Project implementation will commence in January 2002 and be completed in December 2005 (Supplementary Appendix J). Direct supervision of implementation and monitoring the operational performance of the components will be the responsibility of MPSEB. The PMU will prepare progress reports for the respective project components and submit them to MPG and ADB on a quarterly basis within 20 days of the end of each quarter. The reports will contain a narrative description of progress made during the period. ADB will monitor the overall financial and technical performance of the state s power sector, and the MPG s fiscal position. MPSEB will set up a benefit monitoring unit (BMU) within and reporting to the PMU, to monitor and evaluate the scope, implementation arrangements, and progress of SDP achievement. The quarterly reporting will include socioeconomic and poverty indicators reflecting the impacts of the policy and the project components on end-consumers, particularly those living below the poverty line. Using consulting services, the BMU will undertake an in-depth qualitative and quantitative assessment of the impacts of the reform on end-consumers. Outline terms of reference for the consulting services are in Supplementary Appendix K. c. Disbursement Procedures 111. Since the disbursements under the Project will be mainly for supply of goods, ADB's commitment and direct payment procedures will be used for disbursement purposes. d. Reports, Accounts, and Audits 112. MPSEB and the PMU will prepare separate progress reports for their respective components and submit them to ADB on a quarterly basis within 20 days from the end of each quarter. The reports will include narrative descriptions of progress made during the period; changes to the implementation schedule, if any; problems or difficulties encountered and the remedial actions taken; the performance of the project implementation consultants where applicable; and the work to be carried out in the upcoming period. The reports will also include summary financial accounts for the Project consisting of project expenditures during the period, year to date, and total expenditure to date. ADB will review the implementation and operation of the Project based on these reports and meet with MPSEB and the MPG officials at least semiannually to discuss project progress. Completion reports will be submitted to ADB within three months from completion of each of the components. A project completion report will be submitted to ADB within three months of physical completion of the Project MPSEB will have its annual financial statements, including the income statement, balance sheet, and sources and applications of funds statements, audited by a professional auditing firm acceptable to ADB. Unaudited statements will be submitted to ADB within six months and audited statements within nine months from the close of the financial year. MPSEB will also submit to ADB audited project accounts and the auditors observations with respect to compliance with the loan covenants. 4. Procurement and Consulting Services 114. ADB-financed goods and services will be procured in accordance with ADB's Guidelines for Procurement. For such procurement, bidding documents will be prepared in a manner to ensure maximum competition under international competitive bidding. Each supply contract, estimated to cost the equivalent of $500,000 or more, will be awarded on the basis of international competitive bidding. Each contract estimated to cost less than the equivalent of $500,000 will be awarded on the basis of international shopping. For transmission lines and grid substations in

43 32 general, separate contracts will be let on the basis of supply of materials. The contract for erection of transmission lines will, however, include supply of tower steel. For facilities at 33kV and below, materials and equipment will be procured under supply only contracts. Erection will be done either by MPSEB s own staff or under separate erection contracts to be let on the basis of local competitive bidding. A list of the major contract packages under the Project with their estimated costs is attached in Appendix 9. To expedite the procurement process, advance procurement action was approved and MPSEB has been advised that approval of such advance procurement action by ADB does not commit ADB to finance any ensuing Project. The Project does not include retroactive financing To assist with timely project implementation, an international consulting firm with expertise in transmission line and substation construction, and project management will be engaged, following ADB s Guidelines on the Use of Consultants. About 72 person-months of consulting services are expected to be required for this purpose during the first two years of project implementation. A broad outline of the terms of reference for consulting services is given in Supplementary Appendix L For implementation of component D: Computerization of Information and Revenue Management System, as also to carry out benefit monitoring of the SDP, MPSEB will engage external consultants, using its own funds and procedures. If however, ADB financing is required for consulting services, then ADB s Guidelines on the Use of Consultants will be followed. VI. BENEFITS AND RISKS A. Expected Impacts 1. Financial Analysis 117. Financial evaluation was undertaken for components A, B, and C. The financial rate of return of each component is satisfactory compared with MPSEB s weighted average real cost of capital of 7.81 percent. The financial internal rate of return for each component and its sensitivity analysis are summarized in Table 9. The sensitivity analysis for components A, B, and C confirmed that they would be expected to produce reasonable financial returns under various downside scenarios. The major assumptions used in the financial evaluation of the Project and detailed calculations are in Appendix 10. Table 9: Sensitivity Analysis of the Financial Internal Rate of Return Scenario A B C Base Case 9.8% 10.0% 16.3% a. 10% Increase in Capital Cost 8.5% 8.9% 14.7% b. One Year Delay 8.7% 9.0% 14.1% c. 10% Decrease in Tariffs 8.4% 8.7% 14.5% d. a+b 7.7% 8.0% 12.8% 2. Economic Analysis 118. The SDP has as one of its immediate objectives establishing a commercial and competitive business environment in the power sector to promote efficiency gains and loss reductions. With overall T&D losses estimated at 47 percent, comprehensive reduction of losses is one of MPSEB s priorities. MPSEB s loss reduction strategy targets three levels: (i) energy audit and end-user metering, (ii) internal efficiency improvement through computerized billing and revenue system, and (iii) physical investments directly targeting loss reduction.

44 Benefits from loss reduction are threefold. First, they will generate additional revenue for MPSEB. Second, commercial loss reduction in particular will reduce power demand for different customer categories, and will thus indirectly contribute to reduced power shortages. Third, technical loss reduction in particular will result in economic resource cost savings as less units need to be generated, transmitted, and distributed to supply the same amount of energy to endconsumers Project components A and B are for investment in the five distribution regions of MP with the highest losses, namely, Bhopal, Gwalior, Indore, Jabalpur, and Ujjain. Component C is directed at transmission system improvements throughout MP to reduce technical losses. The methodology applied for the three components is similar The economic analysis was carried out at border price level using FY2001 prices. To convert financial cost into economic cost, taxes and duties were deducted. No price contingencies are included in the base capital cost, but the economic capital costs include 10 percent physical contingencies. The costs were separated into foreign exchange, indirect foreign exchange, and local currency costs. Local costs were further separated and specific conversion factors used for unskilled labor. The remaining local costs were converted to border prices by applying a standard conversion factor. Annual operation and maintenance cost were also calculated in economic prices The economic benefits of loss reduction were calculated separately for technical and commercial loss reduction. Technical loss reduction under component A was valued at the average cost of supply at LT level for FY2002, and for component C at the average cost of supply at extra high tension level for FY2000, the latest year for which the breakdown is available. Commercial loss reduction was valued at the increasing tariff levels up to FY2010, reflecting the changing relationship between average cost of supply and average tariff, which results in reduction of economic subsidies over the lifetime of the Project. Benefits are expected to build up gradually over three years The base case economic internal rates of return are estimated at 17.1 percent for component A, 16.8 percent for component B, and at 16.4 percent for Project component C. They were calculated for 25 years, including the construction period. No residual values were considered. Comprehensive sensitivity analysis, including calculation of switching values, indicated that the economic internal rate of return values for all components are above the 12 percent threshold for all adverse circumstances tested. Details of the economic analysis and the sensitivity analysis are in Appendix Poverty and Environmental Dimensions 124. The current state of electricity supply and operations has serious adverse impacts on income earning activities for the poor. They are affected both indirectly, through reduced wage employment opportunities, 29 and directly, through reduced farm profitability and household welfare. The restructuring process provides an opportunity for MPSEB to review its operations and the impacts on consumers. For MPG, it provides an opportunity to review the impacts of the tariff and subsidy policy and other interventions in the power sector. An in-depth poverty assessment was carried out to assess the impacts of the reforms and of the investment component on the poor under the SDP (Appendix 6). 29 This is particularly affecting the landless and the poorest of the poor.

45 The poverty assessment revealed that the poor face significant barriers to access electricity. The new policy of MPSEB includes applying connection charges retroactively. The poverty assessment revealed that the introduction of connection charges constituted a barrier for the poor to access electricity. Under the current policy SC/ST consumers below the poverty line are eligible for a single-point scheme for which the connection charge is amortized in four monthly installments. However, a majority of the poor do not fall into the SC/ST category and are as such not eligible for the scheme. On the basis of an affordability assessment and in consultations with the poor MPSEB will introduce an interest-free 12 month installment facility for all consumers below the poverty line The current tariff and subsidy structure has hampered economic growth through its burden on the fiscal budget, crowding out alternative public investments, and through its burden on the banking sector, with consequent credit squeeze for private investments. Most of the poor do not have electricity connections and as such they are not beneficiaries of subsidized electricity tariffs. However, they are indirectly paying in terms of forgone investments and are directly affected by the lack of ability of MPSEB to provide good quality of services and to expand the network into poorer areas. Thus, the current subsidy and tariff structure cannot be defended on the basis of providing cheap services to the poor. Although the agricultural tariffs subsidize input costs for the agricultural sector, this has severely hampered the ability of MPSEB to provide good quality of services. Tariffs set below the cost of supply, without adequate compensation from MPG, has made load shedding financially beneficial for MPSEB whereas it has adverse impacts on consumers and economic growth Most of the poor are not connected, and those who are, experience poor quality of services. Farm profitability has been especially affected by voltage fluctuations since in addition to reducing farm output, it has led to increased costs. The findings show that the impact of voltage fluctuations has been especially costly for the poor. Load-shedding has led to reduced farm output and forced consumers to diversify their energy sources, with consequent reduction in benefits of electricity use. The prevalence of unscheduled load-shedding, which represents about 62 percent of the total number of power cuts, has especially been devastating by increasing uncertainty in production and consumption activities The new mandatory metering policy was found to be beneficial for poor consumers and will act to reduce the impacts of tariff increases. Metered consumers pay a lower per unit tariff than unmetered consumers. In addition, it benefits consumers who consume more electricity. Since the majority of the poor are unmetered and consume small amounts the effect is regressive. These regressive effects of the tariff structure are further reinforced by the occurrence of load shedding. Consumers experiencing less load shedding are paying a lower per unit charge. Metering will reduce the impacts of tariff increases on the poor. Operational efficiency gains from the SPD will further reduce the need for and the impact of tariff increases The SDP is designed to improve the policy and institutional environment of the sector as outlined in the Reform Act with the long-term aim of improving the quality and quantity of the power supply. The Reform Act has positive impacts from an environmental point of view as it offers the opportunity to institutionalize environmental management in sector regulation beyond the existing all-india statutory environmental requirements. Also, the decentralization of powers for metering, revenue realization, disconnection, prosecution for theft, meter tampering, and diversion of electricity to new power sector companies will facilitate adoption of measures to prevent energy wastage. This will contribute positively to more economic use of resources that will enhance environmental conservation.

46 35 B. Risks and Safeguards 130. The SDP has several perceived risks: 131. Regulatory Risk. A central aspect of power sector reform is the establishment of an independent regulatory authority to ensure the commercial operation of the sector, including a rationalization for the tariff structure. A comprehensive program for institutional strengthening of MPSERC, in particular for tariff setting principles and other financial aspects is required. In the past, ADB supported participation of the three commissioners at an external training course and is currently preparing assistance to MPSERC for the drafting of rules, regulations, and licenses. DFID has prepared terms of reference for long-term consulting support for MPSERC and has already given approval in principal; the final decision by DFID is expected before the end of Financial Situation of MPSEB. To bring the sector to a sound commercial footing and to promote private investment, MPSEB will have to overcome the short-term liquidity crisis and improve its financial viability in the long run. Given uncertainty of future tariff increase and operational efficiency improvements, MPSEB will need to substantially reduce its financial burden through comprehensive financial restructuring with support from its stakeholders including creditors, MPG, and the Government. Mitigation measures include the following: (i) (ii) (iii) Settlement of unpaid revenue subsidy by MPG through a set-off against outstanding state government loans to MPSEB is a first tranche release condition. This will leave MPSEB less leveraged and will facilitate raising new funds in the market at lower cost. CIDA included analysis of debt and liabilities and preparation of an outline financial restructuring plan under their EISP assistance to MPSEB. MPG and MPSEB to agree on a future payment modality for subsidies and subventions over the reform period Support for Outstanding Analytical Work. The model for the postreform sector has been agreed upon in principle. However, in addition to the financial and accounting work required for the functional segregation and the distribution reconfiguration (provided by CIDA under the EISP), substantial work is needed to develop schemes to transfer assets, liabilities, and personnel to the new power sector companies and to introduce the computerized information and revenue management system. The India country strategy program for 2001 includes three small-scale TAs 30 and the 2002 program includes a TA for MP Power Sector Reform. The proposed scope of this TA is expected to focus on developing transfer schemes concerning MPSEB, under the Reform Act. If cofinancing for the outstanding work cannot be mobilized, ADB will make further TA funds available to support the reform activities Operational Effectiveness. The operational effectiveness of MPSEB and other power sector entities that will be created during the reform period will be critical in determining success or failure. To improve effectiveness, processes are being built into the system to strengthen the entities capacity to deliver over time. These include the following: 30 The TAs are for (i) corporate restructuring of MPSEB, (ii) business plan development, and (iii) capacity building for improved customer responsiveness.

47 36 (i) (ii) The composition of board of directors and senior management of new sector companies will be changed to include professional expertise from outside government services. The operational performance is expected to improve as a result of these measures. Delegation of authorities to management of distribution circles benefiting from ADB assistance is being promoted. This will increase the accountability and prepare employees and customers for the creation of new distribution companies with a more efficient and responsive management style Bifurcation of the Undivided State of Madhya Pradesh. Following the bifurcation of the undivided state of MP, the Government issued a provisional order on the bifurcation of the assets and liabilities (including employees) of MPEB between MPSEB and CSEB. MPG and the Chhattisgarh government are requesting reconsideration of the order. Further, MPSEB has pending litigation with the CSEB on the revenues collected and retained by the latter between 1 December 2000 and 15 April Since these two issues could impact on the agreement on the transfer scheme(s), it has been made a third tranche condition and an assurance has been included in the loan documentation that the Government will take timely steps to resolve these issues (para. 149). VII. ASSURANCES A. Specific Assurances 136. In addition to the standard assurances, the Government, MPG and MPSEB, have given the following assurances, which have been incorporated in the legal documents. 1. General 137. The policies adopted and actions taken prior to the loan, as described in the development policy letter and policy matrix, will continue to be in effect for at least the duration of the SDP The Government will transfer the counterpart funds generated under the policy loan, and the loan proceeds under the investment loan, under normal arrangements for transfer of external assistance to MPG and shall treat such counterpart funds as an additionality to transfers allocated annually to MPG The Government will cause MPG to ensure that sufficient budgetary allocations are made to MPSEB in a timely manner for efficient and timely implementation of the Project and the SDP. 2. Administrative 140. MPG will, at all times, continue to emphasize, respect, and support the autonomy of MPSEB with respect to commercial, administrative, and operational activities The Government and MPG will assist in expediting, issue of due permits and licenses for the effective functioning of MPSEB s successor entities as may be required by law.

48 MPG and MPSEB will review with ADB the recommendations of the EISP study and other technical assistance, towards the restructuring of the power sector for its long-term administrative, financial, and economic viability, for implementation thereof in a manner satisfactory to ADB Within 15 months from the loan effectiveness, MPG will ensure that the majority of the officers in the senior management of MPPGCL, MPPTCL, and one of the established distribution companies, are recruited through open and competitive selection process by the board of directors of the respective companies. 3. Financial 144. MPG will make timely and adequate budgetary appropriations to meet its subsidy and subvention payments to ensure that all dues are paid in cash to MPSEB (or its successor entities) within no more than six months of the raising of the claim by MPSEB or such entities MPG will make timely and adequate budgetary appropriations to meet its rural electrification subsidy/subvention payments based on the MOU between MPG and MPSEB; and will continue to make timely and appropriate budgetary appropriations to meet MPSEB s balance of receivables (excluding past dues until 31 August 2001) from municipalities and other local and state bodies so as not to exceed the immediately preceding one month s equivalent of sales at any time with effect from 1 January Sector Reforms 146. MPG will ensure that MPSEB or its successor entities carry out proper metering of all end consumers in MP, in a phased manner for completion within four years from the date of loan effectiveness of the SDP MPG will ensure that the power sector reforms under the SDP and the preparation of the transfer scheme(s) are undertaken with full information and participation of all stakeholders including, but not limited to, consumers, utilities, employees, and unions of MPSEB, and nongovernment organizations. In doing so, MPG will also ensure that such participation includes information to the stakeholders, procuring feedback on the same Recommendations of any employee transfer under the transfer scheme(s) will be in full participation and consultation of all affected, in accordance with the applicable laws and regulations of the Government and MPG The Government will take timely steps in resolution of issues relating to (i) the final allocation of assets and liabilities of MPSEB and the CSEB, (ii) the revenue collected by the CSEB from 1 December 2000 to 15 April 2001, and (iii) allocation of surplus power from CSEB and central sector utilities to MPSEB. 5. SDP Implementation and Benefit Monitoring 150. The MPG and MPSEB will undertake together with ADB, periodic reviews during SDP implementation, to evaluate the scope, implementation arrangements, progress, and achievement of the SDP objectives in accordance with ADB s Project Performance Management System guidelines. For this purpose, MPSEB will set up the BMU within three months of loan effectiveness.

49 38 6. Social Issues 151. MPG and MPSEB will allow all consumers living below the poverty line to make their payment for electricity connection charges, including all up-front charges associated with electricity connections, in 12 monthly installments. 7. Successor Entities 152. Owing to the functional segregation of MPSEB under the SDP, if at any time in the interest of proper implementation of the Project, ADB, MPG, and MPSEB find it necessary, MPSEB will transfer its rights and obligations under the related loan documents to its successor entity(ies) as required, with prior approval of and on such terms, conditions, and arrangements as acceptable to ADB, wherefore such successor entity(ies) as the case may be, will be deemed to be substituted for MPSEB. 8. Consulting Services 153. Within four months of the loan effectiveness and under its own financing, MPSEB will engage the domestic consultant required to implement component D of the Project. 9. Environmental Compliance and Resettlement Issues 154. MPSEB will establish a fully functional social and environmental management cell within four months of loan effectiveness to the satisfaction of ADB MPG and MPSEB will ensure that the Project is undertaken and all project facilities operated and maintained in compliance with all applicable laws, rules, and regulations of the Government and MPG, the initial environmental examinations, and ADB s environmental guidelines and the Environmental Assessment Requirements MPSEB will provide ADB with annual reports on the monitoring results, permits, licenses, and clearances obtained for the Project. In case of any violation of laws and standards cited, the report will include certification from the relevant authority that such violation has been rectified or an acceptable plan for correction approved MPG and MPSEB will ensure that in case of any specific land acquisition and resettlement under the Project, the Land Acquisition and Compensation Plan (where there is no resettlement) and the Land Acquisition and Resettlement Framework (where there is resettlement) for the various subprojects as agreed upon with ADB are implemented and due compensation is paid to those affected in accordance with ADB s involuntary resettlement policy and ADB s Handbook on Resettlement (1998) as amended from time to time. B. Conditions for Loan Effectiveness 158. In addition to the conditions set forth in the ADB s ordinary operations loan regulations, following are conditions for effectiveness for the SDP loans: (i) Legal opinions satisfactory to ADB will have been provided for the Loan and Program Agreements for the policy loan; and the Loan and Project Agreements for the investment loan.

50 39 (ii) The MP state legislature will have passed supplementary budget and MPG will have paid MPSEB not less than (a) Rs3,000 million out of total outstanding dues as of 31 March 2001 (approximately Rs7,423 million after deducting percent on account of bifurcation) and (b) total dues between 1 April to 31 August 2001, owed by municipalities and other local and MPG bodies to MPSEB. VIII. RECOMMENDATION 159. I am satisfied that the proposed loans would comply with the Articles of Agreement of ADB and recommend that the Board approve: (i) (ii) the loan of $150,000,000 to India for the Madhya Pradesh Power Sector Development Program from ADB s ordinary capital resources, with interest to be determined in accordance with ADB s LIBOR-based loan facility; an amortization period of 15 years, including a grace period of 3 years, and such other terms and conditions as are substantially in accordance with those set forth in the draft Loan and Program Agreements presented to the Board; and the loan of $200,000,000 to India for the Madhya Pradesh Power Sector Development Project from ADB s ordinary capital resources, with interest to be determined in accordance with ADB s LIBOR-based loan facility; an amortization period of 20 years, including a grace period of 5 years, and such other terms and conditions as are substantially in accordance with those set forth in the draft Loan and Project Agreements presented to the Board. TADAO CHINO President 14 November 2001

51 40 APPENDIXES CORE Number Title Page Cited On (page, para.) 1 Long-Term Sector Model 41 13, 46 2 Development Policy Letter 42 13, 46 3 Implementation Plan for Stage I 53 13, 46 4 Sector Development Program Frameworks 56 14, 49 5 Project Cost Estimates 60 19, 72 6 Poverty Impact Assessment 61 20, 77 7 Summary Initial Environmental Examination 70 21, 79 8 Financial Performance and Projections for MPSEB 77 30, Contract Packages and Cost Estimates 81 31, Financial Evaluation of the Project 83 32, Economic Evaluation 87 33, 123 SUPPLEMENTARY APPENDIXES (Available on request) A. Key Sector Indicators B. External Assistance to the Power Sector in India C. Project Description D. Participatory Rapid Appraisal and Social Dimensions E. Proposed Organization of Environmental Management Cell of Madhya Pradesh State Electricity Board F. Summary Land Acquisition and Compensation Plan G. List of Ineligible Items H. Organizational Chart of the MPSEB I. Financial Statements of MPSEB J. Project Implementation Schedule K. Terms of Reference for Benefit Monitoring and Impact Assessment L. Terms of Reference for Project Implementation Consultants

52 41 Appendix 1 LONG-TERM SECTOR MODEL for MADHYA PRADESH POWER SECTOR Component Status Quo Stage I Stage II Gov. Role Owner Owner Part owner Private Investors None, IPPs permitted None, IPPs permitted Private shares, partial divestment Independent Regulator Established under Central Act Established under State Act Fully operational control Generation Companies Multiple GenCos Transmission Companies Single TransCo Distribution Companies Energy Brokers / MPSEB Parastatal, vertically integrated utility, possible IPP generation Corporatized generation, transmission and distribution functions, IPP generation with MPG guarantee Multiple DistCos Single buyer or multiple buyer System Manager By TransCo Financial Performance Weak, not meeting current operating costs Strengthened, meeting operational costs Stable, raises commercial capital, meets commercial performance covenants Subsidies Subsidies from state budget and heavy cross-subsidies Cross-subsidies reduced in accordance with Reform Act and direct poverty reduction subsidies from MPG budget Direct poverty reduction subsidies from MPG budget Tariff Design Nonoptimal Tariff structure rationalized Wires rates for TransCo and DistCos Development Bank Role Important funding source, high involvement Limited new investment, work with MPG and Regulator Selective investment, noneconomic funding (e.g., rural electrification) DistCo = distribution company, GenCo = generation company, IPP = Independent Power Producer, MPG = Madhya Pradesh Government, MPSEB = Madhya Pradesh State Electricity Board, TransCo = transmission company.

53 42 A,ppendix 2, page 1 Tel Oft: ; Res : 'tit. $. ~ 1:1 &:r ~ Chief Secretary "tt~ ~ -q"ffi't ~. ~ Government of Madhya Pradesh Vaflabh Bhavan, Bhopal D.o. N~. 5:!. 3 /C.S./2001 Bhopal, Dated 9 November, 2()O ) Subject: Madhya Pradesh Power Sector Development Programme -ADB Assistance. The Government of Madhya Pradeh has developed a Power Sector Development Policy Frame Work in conectioll \\it 11 the above ADB loan. am enclosing a copy of the same along \vith thc associatcd Policy Matrix for your kind infonnation. EncI.:as above p ~ l- } U\i --c:. ;.--C:-.Vc..-...~ ~\ I Yours sincerely, I!\ v.'"'~,i ---2:" l1\ "'- (P.K. Mehrotra) Shri C.M. Vasudeva, Secretary. Govt. of India, Deptt. Of Economics Affairs, New Delhi.

54 43 Appendix 2, page 2 Dr. Adarsh Kishore Additional Secretary (FB, ADB & EF) Tel. No ~ ~ Ministry of Finance ~ -cr;m ~ Department (Jf Economic Affairs ~ ~/NewDelhi. New Delhi, the ~ November, 2001 Dear Mr. Chino, This is regarding the Madhya Pradesh Power Sector Development Programme Loan. I enclose a copy of the letter dated 1 st November 2001 of the Government of Madhya Pradesh to this Department, expressing the unequivocal commitment of the State to implement the Madhya Pradesh Power Sector Development Program, for which negotiations for a total loan of US$ 350 million are scheduled to take place from 71h November, 2001 in Manila. A Policy Matrix outlining the proposed actions by the Government of Madhya Pradesh and a copy of draft MoU is also enclosed. I am pleased to convey the full support of the Government of India to the Government of Madhya Pradesh in implementing the Programme, and request AD8 to lend US $ 350 million from its ordinary capital resources so as to enable the Government of India to re-iend these funds to the Government of Madhya Pradesh. I take this opportunity to convey my good wishes to you. With warm regards, Yours sincerely, ~~ EncJ: As above (Dt. Adarsh Kishore) Mr. Tadao Chino President Asian Development Bank Manila, Philippines.

55 44 Appendix 2, page 3 K. Shankar-Narayanan.I.A.S Principal Secretary Energy ~ Off. : (0755) , Fax :(0755) Resi. : (0755) kshankarnarayanan@hotmail.com GOVT. OF MADHYA PRADESH MANTRALAYA VALLABHBHAWAN BHOPAL Dear Shri k-~~ / D.~. Letter No.7"4~;1:;:;J~(! \- Dat~ I.I-~ l 1. The Government of India, at the request of the Government of ilj1adhya Pradesh. has aoprcached the Asian Deveiopment Bank (ADS) for financiaj assistance of $350 miilion to support implementaticn of the Madhya Pradesh Power Sector Development Program {MPPSDP) by the State of Madhya Pradesh, The Government of \~adhya Praqesh, togetrer..vith ACB. has carried out a rcvjevv of the power sector and have finalized the str~tegjes for the short,and medium term for restructuring of the sector based on (!) the state's High L~ve! Committee Report on PoY'/er SE-ctor Reforms (th8 Tc.ta Rao Com~ittee Report) off 1997; anj (ii) the preparatory studies conducted under technical asslstance projects funded by:aob and the Canaaian internationai Development Agency (CIOA); and (iii) the Nleli1oranc;um of Under?tanding dated May 2COO signed betvveen the Government of India 3nd tht Government c'f ~laphya Pradesh, The power sector has deteriorated in the past several years to su,::;h an e;<tent that its critical physical and financial situaticn is becoming a severe constraint to economic gruv\/t1 and has affected the \Melfare of the people in general, With thi$ backgroljn(j the Government of Madhya Pr3desh has resci'jed to urdertake pcwar sector,ef:)rms and make adequar? an(j erilcier:t pol;ver avaiiacie to aii secto(s of tne econorr;y and SCCiely', A. Objectives of Power S~ctor Reforms 2 'he objectives of tr1e ;.;c\;.l/er sector reforms are' (a) To achieve ccmmerciat =fficienc:1 and financia! viabilit-/ so that the sector jces not absorb "'1adhya Pradesh's financial resources that are needed for socioeconomic development; (b) To improve delivery of services and acr.ieve cost effecti'.jeness throl,lgh t=chn:cal, managerial and administrative restructuring of the utilities. (c\, j To increa~e the operating efficiency of all power sector utilities thtough greater competition, managerial autonomy ar.d higher accountability. (d) To create an environment which will attract private capita!, both domestic and foreign to supplement public sector investment; B. P.,pproach to the Reforms 3. The legislative basis for restructuring and regulating the State's power sector is tne ~l1adhya Pradesh Vidyllt Sudhar Adhin!yam 2000 (No.4 of 2001) (the Reform Act)

56 45 Appendix 2, page 4 4. The key provisions of the Act are (i) Independent tariff setting and regulation. through the establishment of the Madhya Pradesh Electricity Regulatory Commission; (ii) Compulsory metering of all consumers; (iii) Recovery of at least 75 percent of the cost to serve each consumer category, through the tariffs of that consumer category. progressively over a period of 5 years; (iv) Functional segregation of the sector into generation, distribution; transmission and (v) Reorganization of the Madhya Pradesh State Electricity Board into several successor companies, to enable competition; and (vi) Commercialization of all activities in the sector, including promotion of prnate sector participation wherever feasible and desirable. 5. Under the Act referred in paragraph 3, the Madhya Pradesh Electricity Regulatory Commission (MPERC) a ne',v statutory, independent regulatory authority has been established which is responsible for: (a) (b) setting electricity tariffs and determining the corresponding performance norms; collecting, verifying and disseminating sector statistics; (0) coordinating long term PQlNer planning; (d) creating and maintaining a non-discriminatory and commercial business environment in this sector; (e) (f) adjudicating disputes betvveen sector entities; and licensing. 6. In the power generation segment of the sector, it is expectea that in the long-term, there would be several generating companies, both public and private. The latter could be of various types including: (a) independent power producers; (b) (c) (d) cooperative generators; captive generating units selling their surplus energy to the grid; and private generating and distribution companies. 7. At present Madhya Pradesh's poller grid is being maintained by the MPSEB. After restructuring, in order to facilitate povjer pooling and wheeling between suppliers and consumers, the State's power grid will be maintained by the transmission subsidiary of MPSEB,

57 46 Appendix 2, page 5 which will re responsible for operation, system expansion and maintenance of proper parameters in the grid under the supervision of the regulator. This entity will ajso be responsible for the interconnections with other power systems of the country. 8. To have a sustainable power sector development and to provide quality power on demand to all consumers, GOMP would undertake segregation of the generation, transmission and distribution functions and will corporatize the utilities. GOMP will review the working of the reorganized utilities/companies and will take measures to restructure them to achieve commercial viability and reduction and elimination of power theft within a spe~ified time frame. If the achievement of those objectives required sufficient disinvestments for professionalising management and fully distancing it from Government, the same woujd be undertaken. c. Private Sector Participation 9. The Government of Madhya Pradesh reaffirms its commitmen~ to encourc.ge invoivement of private sector participation in generation and distribution in a i phased manner through a transparent and competitive bidding process. In support of this, the State's approech will be to foster a business environment, which will provide a level playing fieid both for the private and public sectors and also by separating sector regulation from operations. It is recognized, however, that to provide incentives for better technical performancl:1, there has to be competition and an appropriate enabling commercial business environmetnt. As already mentioned earlier, Madhya Pradesh has established the Madhya Pradesh jstate Electriclty Regulatory Commission to make tariff setting and regulation, transparent and apolitical, arid has made metering compulsorf. Further, in order to create an enabling environment' GOMP has also enacted a lay, prohibiting unauthorized use of electrical energy and to brihg into effect a transparent, effective and speedy mechanism for assessment and compounding of cases of illegal abstraction, use. consumption and pilferage of energy, and recovery of electricity charges in a manner \Nhich series public interest and ensures fair play and justice. D. Tariffs 10. The Government of Madhya Pradesh recognizes the fact that there has to be a tariff rationalization if private and foreign investments are to be forthcoming in the power sector. Utilities should operate on commercial principles and earn adequate rates of return on capital investments. On the other hand, grant of unrestrained freedom to fix the tariff ~y power utilities...vill lead to consumer interest being adversely affected. Looking to this Madhya Pradesh has set up an independent regulatory commission. While the Government of Madhya Pradesh recognizes, on the one hand, the need for the continuance of subsidized tariff for agricultural and socially obligatory activities like drinking water and street lighting and lighting for urban and rural poor, on the other hand, it also recognizes that these subsidies will have to be explicit, quantified, reasonable and targeted and that, while cross-subsidization cannot be fully eliminated, it has to be kept within reasonable limits. Thus, the Reform Act provides a minimum recovery of 75 percent of the cost to sene a category of consumers has been mandated. As a measure to demonstrate its will to rationalize electricity tariffs and reverse the trand of increasing cross-subsidization of agriculture consumers, rv1 PERC has raised the effective tariff for electricity, supply to the agriculture sector from Rs 1.00 per kwh to Rs ~er kvvh with effect from 5'h Oct This trend is expected to continue in the years ahead. In addition, the Government of f'v1adhya Pradesh has restricted the provision of free power supply to single-jight point urban and rural consumers and to agricultural consumers 'Nith purr,ps up to 5 HP effective January 2001.

58 47 Appendix 21 page 6 E. Public Consultations 11. The Government believes that po'ner sector reform requires concerted interventions at different levels of the sector to make the reforms a success. A phased approach taking into account the ground realities and the available financial and managerial resources of the Government and the sector has been drafted. The Government of Madhya Pradesh held public consultations about domestic and international experiences 't.jith power sector reform and the merits of different sector structures before it commenced the preparation of the Madhya Pradesh Reform Act. The Reform Act was brought into force on 3 July 2001 and is the most progressive in India todate. Similarly, many of reports generated by the ADS and CIDA-funded studies were prepared after consultations vvith various stakeholders and their views incorporated. This makes the Madhya Pradesh reform program one of the most transparent in India. F. Conclusion 12. Only a reliable and efficient electricity infrastructure will pave the V Jay for the contir,ued expansion of the state's economy and the welfare of its people. The Government of Madhya Pradesh once again reaffirms its commitment to restructure the pq\ner isector along commercial lines. Given its vast experience in the reform process in the po'\.'ier sectors of its developing member countries. ADS can playa major role in assisting Madhya Pradesh in restructuring the sector. On behalf of the Government of Madhya Pradesh, I wish to convey our unequivocal commitment to the ~J1ac!hy.a Pradesh Power Sector Development Prc~ram and request you to kindly for.;vard this letter to the President of ADB for the purpose of seel{ing ADS's assistance for its implementation. 13. A Policy Matrix outlining the proposed actions by the G0'11'ernr11ent of 1'v1adhya Pradesh and a copy of draft M au is enclosed. V'/ith regards, \( ~urs sincerely, (K. ShaRkat: d~~~}!'161==.~/q~~1)~ Shri Ashok Lavasa, Joint Secretary, Government of India, Ministry of Finance, Department of Economic Affairs, i'4ew DELHI.

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62 51 Appendix 2, page 10 Memorandum of Understandinq (MOU) between the Government of.madhva Pr:adesh and Madhva Pradesh State Electricitv Board 1. The aide-memoire of the ADB fact-finding mission visiting MP in March/April, 2001 included a covenant for GoMP and MPSEB to agree on a memorandum of understanding to settle the outstanding RE-subvention as of 31 st March 2001, acceptable to ADB (see page 12,para 40,point j of the said aide-memoire). The Status as of 14th April 2001 is as under: Pavables bv MPSEB (Rs.in Crore) Particulars MPEB 'MPSEB!% Share : : I 73.38% I ! 73.38% as on I i I 73.38% , i 73.38% 2. The above net amount of payable by the GoMP to MPSEB of Rs Crore has been paid in cash. ~v 3. GoMP has paid in cash to MPSEB energy bills for free supply of power from 2001 to August, Thereafter, GoMP will continue to pay in cash to MPSEB energy bills in full for free supply of power and also supply of power on account of subsidized tariff as directed by the GoMP on a monthly b~.sis. 4. GoMP will release grant to MPSEB every month, for an amount equal to the monthly energy duty and cess received from MPSEB. 5. GoMP has budgeted for the FY , an amount of Rs. 325 Crore for subsidies/subventions due to MPSEB, including for those mentioned under paras. 3 and 4 above. However, a re-assessment of the sufficiency of such budgeted amount will be undertaken promptly by GOMP, after announcement of tariff award by MPSERC for FY , and its impact on the financial position of MPSEB. Such re-assessment will ~ also take into account impact of such budgetary subsidies/subventions on the targets...:.-' - ~..

63 52 Appendix 2, page 11 agreed under the ADB-financed Madhya Pradesh Public Resource Management Program Loan, approved by ADB as on 14 December If such re-assessment indicates additional budgeting, GOMP will include such requirements under the immediately subsequent supplementary budget. ~ ON BEHALF OF ENERGY DEPARTMENT GOVT. OF M.P. ONZ- FINANCE DEPARTMENT GOVT. OF M.P. ON BEHALF OF MADHYA PRADBSH STATE ELECTRICITY' BOARD 9 November 2001