FOR OFFICIAL USE ONLY INTERNATIONAL DEVELOPMENT ASSOCIATION PROGRAM DOCUMENT FOR A PROPOSED CREDIT

Transcription

1 Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Document of The World Bank FOR OFFICIAL USE ONLY INTERNATIONAL DEVELOPMENT ASSOCIATION PROGRAM DOCUMENT FOR A PROPOSED CREDIT IN THE AMOUNT OF SDR MILLION (US$600 MILLION EQUIVALENT) TO ISLAMIC REPUBLIC OF PAKISTAN FOR A Report No PK FIRST POWER SECTOR REFORM DEVELOPMENT POLICY CREDIT Sustainable Development Department South Asia Region April 3, 2014 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.

2 PAKISTAN - GOVERNMENT FISCAL YEAR July 1 June 30 CURRENCY EQUIVALENTS (Exchange Rate Effective as of February 28, 2014) Currency Unit = Pakistan Rupee (PKR) US$1.00 = PKR SDR 1.00 = US $ ABBREVIATIONS AND ACRONYMS ADB BISP CPPA CPS DPC Disco ECC EFF FBR FDI FGD Genco GHG GTAP-E GWh HESCO HFO Hydel IDA IFC IPP JICA KESC kwh MEPCO MOF MPNR MW MWP MTB MYT NDT NEPRA NPL Asian Development Bank Benazir Income Support Fund Central Power Purchasing Agency Country Partnership Strategy Development Policy Credit Distribution Company, (WAPDA successor company) Economic Coordination Committee (of the Pakistan Cabinet) Extended Fund Facility (of IMF) Federal Board of Revenue Foreign Direct Investment Flue Gas Desulfurization Generation Company (WAPDA successor company) Greenhouse Gas Global Trade Analysis Project Computable General Equilibrium Energy Substitution Model Gigawatt Hour Hyderabad Electric Supply Company Heavy Fuel Oil Hydroelectric International Development Association International Finance Corporation Independent Power Producer Japan International Cooperation Agency Karachi Electric Supply Company Limited (now K-Electric) Kilowatt Hour MultanElectric Power Company Ministry of Finance Ministry of Petroleum and Natural Resources Megawatt Ministry of Water and Power Market Treasury Bill Multiyear tariff NEPRA-determined Tariff National Electric Power Regulatory Authority Non Performing Loan ii

3 NTDC OGRA PEFA PESCO PFM PMT PSIA SBP SDR SEPCO SOE USAID WAPDA National Transmission and Despatch Company Oil and Gas Regulatory Authority Public Expenditure and Financial Accountability Peshawar Electric Supply Company Public Financial Management Proxy Means Test Poverty and Social Impact Assessment State Bank of Pakistan Special Drawing Rights Sukkur Electric Power Company State owned Enterprise United States Agency for International Development Water and Power Development Authority iii

4 Vice President : Philippe Le Houerou Country Director : Rachid Benmessaoud Sector Director : John Henry Stein Sector Manager : Julia Bucknall Task Team Leader : Richard Spencer iv

5 ISLAMIC REPUBLIC OF PAKISTAN FIRST POWER SECTOR REFORM DEVELOPMENT POLICY CREDIT TABLE OF CONTENTS 1. INTRODUCTION AND COUNTRY CONTEXT MACROECONOMIC POLICY FRAMEWORK Recent economic developments Macroeconomic outlook Relations with the IMF THE GOVERNMENT S PROGRAM Key Issues In The Power Sector The Government s Policy and Program For The Electric Power Sector THE PROPOSED OPERATION Link To Government Program and Operation Description Prior Actions, Results and Analytical Underpinnings Policy Area A: Reducing subsidies and improving tariff policy Policy Area B: Improving Sector Performance & Opening the Market to Private Participation Policy Area C: Ensuring Accountability and Transparency Analytical Underpinning Link to CPS and Other Bank Operations Consultations and Collaboration With Development Partners OTHER DESIGN AND APPRAISAL ISSUES Poverty and Social Impact Environmental Aspects PFM Disbursement and Auditing Aspects Public financial management Disbursement and auditing Monitoring and Evaluation SUMMARY OF RISKS AND MITIGATION ANNEXES ANNEX 1: Policy and Results Matrix For the Pakistan Power Sector Reform DPC ANNEX 2: Letter of Development Policy ANNEX 3: Fund Relations ANNEX 4: Debt Sustainability Analysis ANNEX 5: PSIA Methodology ANNEX 6: Public Financial Management ANNEX 7: Country at a Glance ANNEX 8: Map of Pakistan v

6 TABLES Table 1: Key Macroeconomic indicators Pakistan FY09/10 to FY17/ Table 2: Key Fiscal Indicators Pakistan FY10/11 to FY17/ Table 3: Total Expenditure Functional Classification... 8 Table 4: Pakistan BOP Financing Requirements and Sources FY11/12 to FY15/ Table 5: External Debt Composition, FY12/ Table 6: The Five Main Targets of the National Power Policy (July 2013) Table 7: Prior Actions and Analytical Underpinnings Table 8: Technical Assistance To Support Program Table 9: Projected Increase in Cost of Living under Various Scenarios (Average by Income Quintile; FY15/16) FIGURES Figure 1: Pakistan Public Debt Sustainability FY08/09 to FY17/ Figure 2: Pakistan External Debt Sustainability FY08/09 to FY17/ Figure 3: Share of Electricity Subsidies Received by Income Quintile (FY16) vi

7 This Credit was prepared by an IDA team consisting of Beatriz Arizu de Jablonski, Mehwish Ashraf, Rashid Aziz, Abid Hussain Chaudhry, Rob Lesnick, Jose Lopez-Calix, Kristy Mayer, Ameet Morjaria, Kazim Saeed, Mohammad Saqib, Martin Serrano, Richard Spencer, Saraswathi Sundaram, Tjaarda Storm van Leeuwen, Thomas Walker and Paul Welton. Thanks are due to Satu Kahkonen and Zeljo Bogetic for their review and input. vii

8 Borrower Implementation Agency Financing Data Operation Type Pillars of the Operation And Program Development Objective(s) Result Indicators Overall risk rating Operation ID SUMMARY OF PROPOSED PROGRAM AND CREDIT ISLAMIC REPUBLIC OF PAKISTAN FIRST POWER SECTOR REFORM DEVELOPMENT POLICY CREDIT Islamic Republic of Pakistan Ministry of Finance Amount: SDR million (US$600 million equivalent). Terms: IDA Credit of 25 years maturity including five years grace period, with an interest rate of 1.25 percent, a service charge of 0.75 percent and a commitment fee of not more than 0.5 percent. Single-tranche, the first in a proposed programmatic series of two. This is the first in a proposed series of two development policy credits (DPCs) supporting Pakistan s goal of developing an efficient and consumer oriented electric power system that meets the needs of its people and economy sustainably and affordably. The DPC focuses particularly on policy and institutional actions that will improve financial viability and thus reduce the burden of public financing for the sector. The DPC is structured around three objectives: (A) Reducing subsidies and improving tariff policy; (B) Improving sector performance and opening the market to private participation; (C) Ensuring accountability and transparency. The following results indicators are selected for the project: (i) Reduced subsidies allocated in the federal budget from a baseline of 1.8 percent of GDP in FY12/13 to 0.4 percent by the end of FY15/16; (ii) Increased bill collection in Discos from a baseline of 86 percent of bills collected in FY12/13 to 94 percent of bills collected in FY15/16; (iii) Increased domestic gas supply from 3.8 billion standard cubic feet per day in FY12/13 to 5 billion standard cubic feet per day in FY 15/16; (iv) Separation of market operation and transmission system operation, with contracted power generated by IPPs, Gencos and WAPDA hydel traded through an independent Central Power Purchasing Agency by the end of FY 15/16; (v) Household consumer awareness of the extent to which the government subsidizes electricity increased from zero in FY12/13 to 25 percent in FY 15/16. High P viii

9 IDA PROGRAM DOCUMENT FOR A PROPOSED FIRST POWER SECTOR REFORM DEVELOPMENT POLICY CREDIT TO THE ISLAMIC REPUBLIC OF PAKISTAN 1. INTRODUCTION AND COUNTRY CONTEXT 1. This proposed first credit in a programmatic series of two single tranche operations supports Pakistan s goal of developing an efficient and consumer oriented electric power system that meets the needs of its people and economy sustainably and affordably. The proposed operation is aimed at improving financial viability and thus reducing the burden of public financing to support operations and investment in the sector. IDA financing would provide SDR million (US$600 million equivalent). The proposed operation is part of a wide program of reforms aimed at lifting Pakistan s growth potential. It is at the core of the Country Partnership Strategy (CPS) for and of the proposed CPS for and supports the World Bank s twin goals of poverty reduction and shared prosperity. 2. Pakistan s economic performance in the past several years has been weak. Over the last four years, GDP growth has averaged only 3.6 percent, barely adequate to support the growing population. Low growth is in part the result of recurrent natural disasters, including severe floods in 2010 and 2011, and the country has also been beset with a difficult security situation. Economic management has been poor and the government has not undertaken muchneeded structural reforms with sufficient vigor. In consequence, productivity growth has slowed, private investment has fallen, the external position has weakened and central bank reserves have declined to critical levels. The fiscal deficit for fiscal year 2012/2013 (FY12/13) was 7.6 percent of GDP and is projected to be 5.8 percent of GDP in the current year. 3. Poverty is declining. Despite falling and increasingly volatile per capita growth, poverty has declined over the last decade, and Pakistan s poverty rate broadly followed the per capita growth trend. The share of the population below the national poverty line fell from 34.7 percent in FY01/02 to an estimated 13.6 percent in FY10/11. Real per capita consumption growth of the bottom 40 percent of the population a measure of shared prosperity also exceeded that of the top 60 percent in the same period. Growth has been broadly inclusive, with the national Gini coefficient falling from 0.34 to 0.29 between FY98/99 and FY10/11. Social safety nets such as the Benazir Income Support Program (BISP) have redistributed wealth to the poor and vulnerable and have become especially important as growth has become more volatile. BISP has achieved high efficiency, with 73.5 percent of the program budget reaching the poor. 4. Pakistan s energy sector is facing a serious crisis, especially in electricity. Based on preliminary estimates, the poorly performing electricity sector is thought to have reduced GDP growth by two percent a year for the past several years. The sector relies heavily on government support, through direct subsidies amounting to about 1.75 percent of GDP in FY12/13. Costs that cannot be recovered from consumers or the government accumulate on the books of the public electricity distribution companies (Discos). The Discos in turn fail to pay fully for goods and services they receive, especially electricity, thus spreading the shortfall throughout the supply chain. Commonly called the circular debt, these accumulated arrears amounted to about four percent of GDP in FY12/13. Actions are required to address two main distortions: the longstanding gap between the cost of service and revenues gained either from tariffs or subsides; and the unusually high cost of providing that service. At the same time, there is a need to 1

10 address the inequities caused by poorly targeted subsidies and ensure that the sector develops in a socially and environmentally sustainable way. 5. The recent elections have given impetus for structural reform. The problems and potential solutions to the recovery of the Pakistan energy sector are well understood but until recently the political will to undertake deep structural reforms has been wanting. The general election of April 2013 delivered the new Federal government an absolute majority, and presaged the first democratic-to-democratic government handover. The convincing win provides a strong mandate to put in place a bold agenda for reform aimed at stimulating growth. The government agreed a three-year Extended Fund Facility (EFF) with the IMF early in its term, a major feature of which is structural reform of the energy sector. Early actions by the government have included settling the circular debt in June 2013, adopting a National Power Policy in July 2013, and increasing tariffs substantially in August and October The coincidence of a new and empowered government, a solid IMF program and broad consensus among business, households and donors on the need for deep reform offers the best opportunity in twenty years to have a lasting impact on the power sector. 6. The proposed operations are centered around three areas: (A) Reducing subsidies and improving tariff policy. (B) Improving sector performance and opening the market to private participation. (C) Ensuring accountability and transparency. 7. The proposed operations will support the key challenge of restoring financial viability to the electric power sector and thus reduce the burden on public sector finances. In addition the operations are expected to support faster economic growth, improve the business environment and attract greater private investment, focus government subsidies on the poor and help set the sector onto a more environmentally sustainable path. 8. The operations face high risks. Past efforts at reform of the power sector have stalled in the face of vested interests within the sector and government interference. Slowing down or reversal of subsidy reform resulting from political or popular opposition remains a risk. Resistance to change within the sector, especially if it increases individual accountability in companies and among consumers who benefit from the current weak governance present a major risk to achieving the operations objectives. 2. MACROECONOMIC POLICY FRAMEWORK 2.1 Recent economic developments 9. Pakistan s economy is at a turning point. Pakistan had not fully recovered from the slowdown in economic growth since the global and twin balance-of-payments crises of when the country was hit by a mix of large fiscal deficits, accommodative monetary policy and financial outflows; thus leaving it with few buffers to absorb shocks and little fiscal space to foster investment. As a result, real economic growth has averaged 3 percent over the last five years, which is about half the rate of the 1960s. Bank estimates also point to increased GDP volatility in past years, accompanied by slowing gains in poverty reduction, job creation and social indicators. Emerging growth constraints are shortage of electricity supply, falling 2

11 productivity growth, poor business climate, a difficult security situation and poor macroeconomic management. Business climate rankings have also worsened. Out of 189 countries, Pakistan s Doing Business indicators with the lowest scores are: getting electricity (171), paying taxes (162), enforcing contracts (155), registering property (135), issuing construction permits (109) and starting a business (98). Pakistan's ratings on the WEF Global Competitiveness Index are also poor. To change the growth trajectory, the new authorities adopted an ambitious growth enhancing package, supported by the EFF and the two proposed DPC series. The authorities approved a substantial increase and protection of the amount of targeted transfers to the poorest with aims to compensate for the effects of fiscal consolidation and rationalize social spending. The DPC described here addresses the electric power sector, and the Fiscally Sustainable and Inclusive Growth DPC series is aimed at reforms to state owned enterprises, (SOEs), trade policy, business climate and financial inclusion. 10. Economic activity is gradually improving. Preliminary data for FY13/14 show growth picking up mainly driven by services and manufacturing. They grew 5.7 and 5.2 percent respectively in the first quarter of FY13/14, supported by some decline in electricity shortages and unscheduled load-shedding. Over the past year, the growth in services has remained stable due to the offset of the slowdown in telecoms and transport with an improved performance by wholesale and retail trade, and by finance and insurance. There has been strong large-scale manufacturing performance, including of agro-based industries, enhanced capacity in iron and steel, some improvement in construction, and better external demand for cotton yarn and fabrics. Agriculture grew at a modest 2.5 percent in the first quarter of this year and continues to show significant variation in its contribution to growth owing to changing weather conditions, little use of new technologies, and few seed varieties. On the demand side, growth continues to be driven by private consumption, strongly supported by workers remittances. Private investment is low and declining: its share of GDP dropped to 10.3 percent in FY12/13 from 14.5 percent in FY06/07. Much of this stems from a shortage of private sector bank credit, whose growth was nil in FY12/13 owing to depressed demand, large excess capacity in manufacturing linked to persistent energy shortages, and to scarce supply due to massive placement of government paper with commercial banks. In FY13/14, credit to the private sector has started to rebound and posted year on year nominal growth of 5.6 percent. Public investment, constrained by lack of fiscal space, was also low at 3 percent of GDP in FY12/13 and remains contained this year due to fiscal constraints. 11. A significant correction of a loose fiscal stance is taking place to ensure sustainability. Pakistan is on track to meet a fiscal deficit target of 5.8 percent of GDP in FY13/14. This is remarkable as the country has had large fiscal deficits exceeding the budget target over the last six years, with a widening gap stemming from recurrent revenue shortfalls, and expenditure overruns mainly due to unbudgeted power subsidies. These problems stood out sharply in FY12/13: Federal Board of Revenue (FBR) revenue was about 1.9 percent of GDP below target due to low collection of the general sales tax (GST) and direct income taxes. Energy-related subsidies reached 1.75 percent of GDP in FY12/13, and circular debt continued to accumulate due to below cost recovery tariff rates, and delays in tariff determination and fuel cost adjustments. The government cleared 1.5 percent of GDP of this circular debt in June 2013 and an additional 0.6 percent of GDP in July Public debt remains high as large fiscal deficits have been financed mainly through domestic borrowing, crowding out private sector credit. As external financing available to 3

12 the government has become scarce, the government has had to borrow increasing amounts from the banking system to finance the budget. This has left very little commercial bank credit available for private investment, directly hurting recovery prospects. In addition, because Treasury Bills are the preferred instrument, there are high rollover/refinancing risks and high interest payments for the government equivalent to 4.3 percent of GDP. Since FY11/12, public debt has been above the 60 percent limit mandated by the Fiscal Responsibility and Debt Limitation Act of The external position is extremely fragile. The current account deficit was small at around one percent of GDP by end-fy12/13 and remains so. In contrast, net official foreign exchange reserves declined to the equivalent of 1.5 months of imports at the end of June 2013 (and to 0.8 month of imports by the end of December 2013). The overall balance of payments is under severe stress due to weak financial inflows coupled with high debt repayments, especially to the IMF. Net foreign direct investment (FDI) was a modest 0.5 percent of GDP in FY12/13 and is muted in the present fiscal year. In response, monetary and exchange rate policies have moved from an accommodative towards a tightening stance on monetary policy as needed to assure reserve accumulation and price stability. Last year, strong intervention by the State Bank of Pakistan (SBP) kept the Pakistan Rupee to U.S. Dollar exchange rate stable. As a result, the rupee suffered only a mild depreciation of 4.5 percent in FY12/13 and of 6 percent against the dollar since end-june. Since the second quarter of this year SBP has started to purchase dollars on the spot market, turning decisively toward rebuilding the external position. The relative stability of the rupee in nominal terms left the real effective exchange rate roughly unchanged during the past year. On a longer view, and following the steep correction the real effective exchange rate had in the aftermath of the crisis, the rupee remains overvalued by some 3-6 percent. 14. Inflation has been in double digits over the last four years, but more recently returned to single digits. The average headline rate declined to 7.4 percent in FY12/13, down from 17.0 percent in FY08/09. In FY13/14, headline inflation has been in single digits supported by the fall in food prices and core inflation. Some favorable supply and demand factors explain its recent decline: good weather has helped improve food supply; and nonfood and non-energy core inflation, a proxy measure of underlying inflationary expectations, declined from 11.5 percent in June of FY11/12 to 7.8 percent in June of FY12/13. Consistent with the recent tightening of monetary policy to address balance of payment concerns and support the deflationary move, SBP increased the policy rate by 50 basis points in September and again in November The financial sector appears reasonably provisioned, but vulnerable to further slowdown in the economy and overexposed to government securities. Banking profitability has been broadly positive over the last few years but slipped in an environment of monetary policy easing last year. The past year s decline in interest rates reduced returns of banks placements in government securities and, coupled with lower loan volumes, curtailed banks profitability, which was further dampened by higher provisioning charges in January to June In broad terms, the sector s liquidity and solvency positions remain strong, backed by sluggish growth in advances and a sizable concentration of the asset portfolio in government securities which carry low risk weightings. As banks risk appetite remains cautious for private sector credit amid weak but stabilizing credit quality, nonperforming loans (NPLs) slightly declined to around 15 percent of the overall loan portfolio in June 2013 and to 14.3 percent in 4

13 December NPLs in small and medium enterprises (SMEs) are still high at 36.9 percent of total loans, followed by those in agriculture (18.5 percent) and the consumer sector (15.6 percent). The largest share of credit to the private sector is the corporate sector (64.6 percent) where NPLs are 15.8 percent, mainly concentrated in textile firms. 16. Pakistan s Emerging Markets Bonds Index Plus (EMBI+) risk spread has declined significantly since the arrival of the new administration. The spread had been affected by continuous political instability, security concerns, and the lackluster performance of the fiscal and external sectors over the past two years. Market confidence in the Government s program is bearing fruit as the EMBI spread has almost halved from 1,011 basis points in March 2013 to around 560 basis points in February At a rating of Caa1 (Moody s) Pakistan's foreign- and local-currency bonds are high risk. The Government intends to return to the international markets with the placement of a US$500 million Eurobond in April Macroeconomic outlook 17. The economic cornerstone is the bold economic program of measures anchored in Pakistan s EFF and the proposed DPCs. The medium term macroeconomic framework FY13/14-FY17/18 projects gradual growth recovery-cum-low inflation, supported by fiscal consolidation and rebuilding of the external position. The program tackles the key identified growth constraints: power load-shedding, cumbersome business environment, low access to finance and macro risks embedded in past stagflations. Under a baseline scenario, higher growth rates are expected to be reached gradually and inflation is expected to remain low and declining. 18. On the supply side, growth will be driven by the service and large manufacturing sectors, which have benefitted from decreased power load-shedding and improved business climate. On the demand side growth drivers will be a mix of consumption recovery partly supported by remittances with strengthened private investment and renewed export dynamism and, to a lesser extent, increases in public investment. Fiscal consolidation is expected to reduce borrowing needs and create some fiscal space for public investment while reducing public debt. Scheduled banks liquidity is in turn expected to increase, helped by reduced crowding out, falling NPLs and increased provisioning, which is now above 70 percent. Relatively stable or declining international commodity prices, are also expected to help reduce inflationary pressures. 19. Ongoing recalibration of policy toward monetary tightening, but in a context of falling inflation rates, should help rebuild reserves. Aided by a gradually improving security situation, structural reforms are expected to spearhead productivity growth, lower country risk, attract foreign and domestic investment linked to the sale or restructuring of state-owned enterprises and foster competition in the banking, telecom and commercial service sectors. Strong remittances and recovery of private sector credit are also projected to support consumption. In sum, successful fiscal consolidation and gradual rebuilding of the external position, supported by satisfactory implementation of the EFF, are expected to ensure complementary donor external financing and enable the business environment to stimulate financial inflows. The baseline macro projections are shown in Table 1. 5

14 Table 1: Key Macroeconomic indicators Pakistan FY09/10 to FY17/18 FY09 /10 FY10 /11 FY11 /12 FY12 /13 FY13 /14 FY14 /15 FY15 /16 FY16 /17 FY17 /18 Actual Projections Real economy (Percentage change; unless otherwise indicated) Nominal GDP at market prices (in bn. of rupees) 14,867 18,285 20,091 22,909 26,139 29,485 33,171 37,217 41,795 Real GDP growth (at factor cost) Contributions: Agriculture Industry Services Per Capita GDP (current US$) 6/ 1,025 1,214 1,257.. Unemployment rate 1/ Consumer prices (period average) Consumer prices (eop) Fiscal sector (In percent of GDP; unless otherwise indicated) Expenditures Revenue Overall balance (excl. grants) Total public debt Foreign currency public debt 2/ Domestic currency public debt Monetary Sector (Percentage change; unless otherwise indicated) Broad Money Credit to non-government Interest (key policy interest rate) Balance of payments (In percent of GDP; unless otherwise indicated) Current account balance (incl. transfers) Exports of goods & services Imports of goods & services Capital and financial account Foreign direct investment, net Gross official reserves (in US$ million, eop) 3/ 13,112 15,662 10,852 6,047 8,427 13,142 16,641 17,562 17,419 Gross official reserves (in months of next year s imports of G&S) Total external debt 4/ Rupees per U.S. dollar (period average) Memo: Nominal GDP at market prices (in US$ billion) GDP, PPP (current international $) 5/ / National estimates. Estimated for FY12/13 as published in the Economic Survey of Pakistan 2012/13. Staff assumptions for projection years. 2/ Includes medium and long term PPG debt as well as short-term external debt and IMF debt (budget and balance of payments support). 3/ SBP Gross Reserves exclude Cash Reserve Requirement, gold and foreign currency deposits of commercial banks held with SBP. 4/ Total external debt is inclusive of medium and long term PPG debt as well as short-term external debt, IMF and private debt. 5/ Source: WDI. Growth and inflation. GDP growth is expected to be 3.6 to 4 percent in the current fiscal year and it should pick up from 4 to 5 percent from FY14/15 onwards. Inflation is expected to decline as a result of stabilization. This will result from the Government tackling its key growth constraints addressed by the reform agenda supported by both World Bank DPCs and tackles macroeconomic instability, mainly addressed by the EFF. At the sector level, the economic expansion will be supported by services and recovery of the large manufacturing sectors, fostered by less load-shedding, and better private sector credit conditions ensuing from fiscal consolidation and hence lower borrowing requirements. On the demand side, consumption will be supported by resilient remittances that are expected to show positive, albeit declining growth rates. Manufacturing exports of goods and services are expected to grow at their past decade average of 6 to 7 percent. Better external demand growth is expected due to GSP plus enhanced trade preferences for 75 new major export products entering in the European market, U.S. recovery and opening of new markets in South and 6

15 East Asia and trade normalization with India. Services are projected to expand with telecom, fostered by new 3G/4G services, power and transport services. Official figures place inflation in single digits by end-fiscal 2014, despite some pressures related to hikes in administered prices such as oil, electricity and gas that might bring about a 10 percent endyear rate. As fiscal consolidation and monetary tightening proceed, average inflation is expected to approach its medium-term target of 7 percent. Fiscal accounts. The fiscal deficit excluding grants is projected to decline from 5.8 percent of GDP in FY13/14 to about 4.4 percent of GDP by FY17/18. Provinces are expected to generate small fiscal surpluses. About half of the fiscal consolidation effort is expected to come from revenue increases and the other half from reducing untargeted power subsidies and recurrent spending. Recurrent expenditure cuts and gradual reduction of power subsidies would lead current expenditures to decline from 16.0 percent of GDP in FY12/13 to 14.2 percent in FY17/18. The tax strategy should support an increase of at least three percentage points of GDP in tax revenue over this period, from 9.6 to 12.6 percent of GDP. About two thirds of such effort are expected to come from the federal level and one-third from provinces. Part of such fiscal space generated would allow development spending and protected social safety net BISP outlays to increase slightly to around 5.6 percent of GDP by FY17/18, significantly higher than the 3.7 percent average during the last three years. Public debt to GDP ratios are expected to increase to 64.2 percent of GDP in FY13/14, but to decrease to below 60 percent of GDP by FY16/17, as projected fiscal consolidation will require smaller amounts of financing. Key fiscal indicators are shown in Tables 2 and 3. Table 2: Key Fiscal Indicators Pakistan FY10/11 to FY17/18 FY10 /11 FY11 /12 FY12 /13 FY13 /14 FY14 /15 FY15 /16 FY16 /17 FY17 /18 Percent of GDP Actual Projections Revenue and grants Total Revenue Tax revenue Taxes on goods and services Direct Taxes Taxes on international trade Other taxes Nontax revenue Grants Expenditure Current expenditure Interest payments Superannuation allowances & pension Transfers (other than provinces) Others Provincial Development expenditure & net lending Statistical discrepancy Overall balance (excluding grants\ Overall balance (including grants) Financing External Of which : privatization receipts Domestic Memo: Primary balance (excluding grants) Primary balance (including grants) Source: World Bank Staff estimates 7

16 Table 3: Total Expenditure Functional Classification FY11/12* Actual In percent of GDP Federal Punjab Sindh KP Balochistan General services Defense Public order and safety Economic affairs Health Education Community services Social protection Others 1/ Source: World Bank Staff calculation and estimates *Does not include net lending 1/ This category pertains to other social services in case of provincial governments. For federal government, this category is a balancing entry to reach the Ministry of Finance (MOF) published aggregate number on development expenditure using the Accountant General Pakistan Revenues disaggregated data (on account of data discrepancy) Revenue mobilization. The baseline assumes a marked improvement in FBR performance, allowing tax revenues to rise from 9.6 percent of GDP in FY12/13 to 12.6 percent by FY15/16, and consolidated total revenue and grants from 13.3 percent of GDP in FY12/13 to 15.7 percent of GDP by FY15/16. Increased revenue mobilization will be aided by tax buoyancy resulting from a revival of economic growth, a pickup in imports as well as the authorities own efforts to revamp and reform tax policy and tax administration. Government has a menu of tax policy priorities aimed to broaden the tax net and reduce the tax gap by strengthened compliance focused on five areas: (i) minimization of tax expenditure (including those which are SRO-related); (ii) upward revision of sales and general excise tax rates; (iii) upward revision of capital gains tax on securities and immovable property; (iv) revision of threshold taxes for sales tax registration; and (v) identification of new sectors for expanding the net of domestic taxes. The impact for FY13/14 is projected to be positive at about 0.7 to 0.8 percent of GDP, and next year estimated fiscal impact is expected to be again at least 0.7 percent of GDP. Of this, removal of SRO supported tax exemptions estimated at 0.35 to 0.4 percent of GDP have already been identified. This also assumes a mild decrease of nontax revenues, which over the forecast period are projected to fall from 3.8 percent of GDP in FY13/14 to 2.8 percent of GDP, mainly because of reduced US Coalition Support Funds offset by small increases on SOE profits resulting from their expected reform and privatization. External accounts. The current account deficit is projected to average a modest 1.2 percent of GDP between FY13/14 and FY17-18, with a positive trend in tandem with expected gradual growth recovery that will require additional imports (including oil). Export recovery, strong dynamism of remittances, despite some negative spillovers expected from expatriate workers returning from Gulf Cooperation Council countries and imports initially favored by low international oil prices, will support the current account balance. Higher financial inflows attracted by lower country risk, privatizations, new cooperation and trade relations with neighbors and the opening of special economic zones, especially attractive to China and Japanese investors, and multilateral flows, will support the financial account. Official foreign exchange reserves are expected to build from US$6.0 billion by the end of FY12/13 to about US$16.6 billion by the end of FY15/16, equivalent to 3 months of imports. This will be the outcome of a significant effort to close the financing gap in the initial years. Balance of payments (BOP) financing requirements are shown in Table 4. 8

17 Table 4: Pakistan BOP Financing Requirements and Sources FY11/12 to FY15/16 Actual Projections In million US Dollars FY11/12 FY12/13 FY13/14 FY14/15 FY15/16 Financing requirements 8,028 7,983 8,350 5,809 5,021 Current account deficit 4,658 2,530 2,311 1,988 2,717 Maturing short-term debt Amortization of medium- and long-term debt 3,270 5,062 5,892 3,721 2,203 To IMF 1,155 2,540 3,089 1, To other official creditors 1,477 1,881 2,203 1,849 1,941 To private creditors Financing sources 8,031 7,983 8,350 5,809 5,021 FDI and portfolio investments (net) 600 1,273 2,250 3,724 2,690 Capital grants Other net capital and financial inflows Short term debt disbursements Long term debt disbursements 3,191 2,454 8,230 5,936 5,444 From IMF 0 0 2,207 2,207 2,207 From other official creditors 2,633 2,089 5,336 2,912 2,756 From domestic private creditors Change in reserves (decrease = +) 4,430 4,556-2,433-4,715-3,399 Source: World Bank Staff calculations and estimates Financing gap. Gross financing requirements from the balance of payments are expected to decrease significantly once the bulge of the IMF amortization in FY13/14 and, to a lesser extent FY14/15, passes. They are projected to decrease from US$7,983 million in FY13/14 to US$5,021 by FY15/16. In closing the financing gap, the role played by front-loaded multilateral financing during the early stages of the EFF program is expected to decline, partly offset by a back-loaded increase in FDI attracted by privatization and private sector participation. In the critical initial year of FY13/14, the main projected sources of official financing are: Saudi Arabia (US$1.5 billion), the Coalition Support Fund (US$1 billion), Bahrain (US$0.5 billion); IMF (US$2.2 billion), World Bank (US$1 billion), Asian Development Bank (ADB) and Japan International Cooperation Agency (JICA) with US$500 million each and DFID (US$100 million). Pakistan Telecommunication Company Ltd. Privatization (US$800 million), and sales of third-generation telecoms licenses (US$1 billion) and placement of Eurobonds (US$0.5-1 billion) are also expected to contribute to the early rebuilding of the foreign reserves position. Given the difficult security conditions only slow increases in FDI flows are projected from 0.5 percent of GDP in FY12/13 until they reach the average level of percent of GDP of the period. This projection accounts for a privatization program that, despite some early successes, may face some implementation delays and a gradual return of investors appetite for investing in Pakistan only when key structural reforms build sustained momentum. Public Debt. Pakistan s public debt to GDP ratios are projected to peak in FY13/14 and then decline. Fiscal consolidation coupled with enhanced debt management and revenue from privatization proceeds will help reduce public debt levels. Public debt is projected to fall from 64.2 percent of GDP in FY13/14 to around 58 percent by FY17/18. Stress tests of a debt sustainability analysis show that the debt path is highly sensitive to exchange rate depreciation shocks and, to a lesser extent, the materialization of a contingent liability from power circular debt or SOE losses which might put the level of public debt above threshold of 60 percent of GDP. The debt sustainability analysis is shown in Figures 1 and 2 and Table 5 and discussed further in Annex 4. 9

18 Figure 1: Pakistan Public Debt Sustainability FY08/09 to FY17/18 Source: World Bank staff estimates Notes: 1/ One time 10 percent of GDP increase in other debt creating flows in 2014/15; 2/ Combination of three shocks: i. Real GDP growth is at baseline minus one-quarter standard deviation, ii. Primary balance is at baseline minus one-quarter standard deviation, iii. Real interest rate is at baseline plus one-quarter standard deviation; 3/ One time 30 percent real depreciation in 2014/15; 4/ Country team projections Figure 2: Pakistan External Debt Sustainability FY08/09 to FY17/18 Source: World Bank staff estimates Notes: 1/ Non-interest current account is at baseline minus one-half 10-year historical standard deviations; 2/ Combination of three shocks: i. Non-interest current account is at baseline minus one-quarter standard deviation, ii. Real GDP growth is at baseline minus one-quarter standard deviation, iii. Nominal interest rate is at baseline plus one-quarter standard deviation; 3/ One time 30 percent real depreciation in 2014/15; 4/ Country team projections Table 5: External Debt Composition, FY12/13 Million US Dollars Share of total debt % of GDP Monetary authoriities 4,981 8% 2.1% General Government 45,194 76% 19.1% Banks 1,554 3% 0.7% Other sectors 8,050 13% 3.4% Of which intercompany lending 2,829 5% 1.2% Total External debt 59, % 25.3% Long term 56,256 94% 23.8% Short term 3,523 6% 1.5% Source: Pakistan Authorities 10

19 20. The macroeconomic framework is appropriate for the proposed DPC operation. Economic activity is showing clear signs of pick-up, inflation is declining, and fiscal imbalances are narrowing. Moreover, on the external front, imbalances are at a point of inflexion, the current account remains modest and foreign exchange reserves have started to rebuild. 21. Downside risks to the macroeconomic outlook are high. Pakistan remains vulnerable to internal and external shocks that could derail the entire program. First, the country is exposed to natural disasters that might require significant fiscal resources. Second, the economy is vulnerable to terms-of-trade shocks, especially for oil. A US$10 increase per barrel in oil price raises the import bill by about US$600 million. Third, remittances growth might fall faster if tougher migration policies in labor-recipient countries such as Saudi Arabia, the United Arab Emirates, and other Gulf Cooperation Council countries stop or reduce migration. Fourth, the consolidation of the global economic recovery could take longer than projected, due to the impact of US Federal Reserve tapering or new unfavorable events in European or major emerging economies. Fifth, FDI might not materialize as expected, especially if the domestic or regional conflict in neighboring countries continues or even gets worse. Last, the IMF program might run off-track because, for example, lower revenues are collected at the federal or provincial levels or both; or power subsidies are reduced more slowly than projected due to political opposition; or no or slow progress on SOE privatization. If any of this happens, the mitigation response would depend on the nature of the shock, once it materializes. The summary results of a worst case scenario are included in Annex 4 and, compared with the baseline, they can be summarized as: lower growth, return to double digit inflation, larger fiscal deficits, and higher external current account deficits. While the reserve position would show initial improvements, these would reverse in later years. In a similar vein, public debt ratios would barely show marginal decreases Relations with the IMF 22. The IMF has agreed a 36 month EFF in the amount of US$6.68 billion. The Fund supported program aims to reduce the risk of a crisis in the short term and to address Pakistan s medium term problems to sustain higher and more inclusive growth. It focuses on reducing the government budget deficit to sustainable levels, reducing the crowding out of private investment, and recalibration of monetary policy to build reserves and reduce inflation. On the structural side, it supports reforms in tax administration, SOEs and the power sector. The program was approved in August 2013, with $540 million made available at that time and the remainder evenly phased over the life of the program, subject to quarterly reviews. The second review was satisfactorily concluded on March 24, 2014 and a disbursement of $555.6 million approved. The Bank has worked with IMF for the past two years in its discussions with government on power sector finances, and has developed a combined approach to structural reform for the sector. The proposed power sector operation reinforces the IMF reforms particularly relating to subsidy and tariff reform, further development of the market and improving transparency and accountability. 3. THE GOVERNMENT S PROGRAM 3.1. Key Issues In The Power Sector 23. Pakistan s power sector is in crisis in energy as well as financial terms. Despite significant efforts, the sector s performance is far from satisfactory and several problems remain 11

20 unresolved. In FY12/13, shortages averaged 4,000-5,000 MW, meaning that about one quarter of demand was not met. At the same time, up to 5,000 MW of capacity was lying idle because an acute liquidity crisis prevented sufficient fuel from being purchased. Yet in the same year, the government provided subsidies to the sector that amounted to four times federal expenditure on the health and education sectors. Both personal and economic life in Pakistan have been deeply affected by routine load shedding of 6-8 hours daily, and sometimes even more. 24. Power sector reform has solid foundations. In the early 1990s Pakistan was one of the first countries to initiate a comprehensive program of energy sector reform. The vision was to unbundle the Power Wing of the Water and Power Development Authority (WAPDA) into commercially oriented and efficiently managed and operated companies. The aim was to create an attractive environment for private sector investment and to introduce competition that would bring cost reductions. Separate corporate entities were created from WAPDA with responsibilities for: thermal generation through four Gencos and hydropower through WAPDA Hydel; transmission through the National Transmission and Despatch Company (NTDC), which is a natural monopoly; and distribution through nine Discos (now ten) and the now-private Karachi Electricity Supply Company (KESC, now K-Electric). Privately-financed generation by independent power producers (IPPs) was introduced in parallel, with some success; about one quarter of all electricity generated today is from IPPs. An independent economic regulator, the National Electric Power Regulatory Authority (NEPRA), was established by law. 25. The sector is unable to recover its costs from the current combination of tariffs and subsidies. Past governments have been reluctant to stand behind pricing that ensures full cost recovery, while managers of the Discos have been unable or unwilling to curb electricity theft and ensure full collection of electricity bills. Costs that cannot be recovered from consumers or the government accumulate on the books of the Discos, which in turn fail to pay fully for goods and services received, especially electricity, giving rise to the circular debt. As owner of the Discos, the government is liable for these debts, which it sporadically pays, thus providing a further capital subsidy to the sector. 26. The cost of electricity generation is unnecessarily high. Poor planning and implementation of power sector development strategies and failure to address adequately the concerns of stakeholders have stalled much hydropower development, the lowest cost source of generation in the country. Incentives for exploration and production of domestic gas have been weak. Capture in the gas market has resulted in administrative allocation of gas to economically inefficient segments including fertilizer production and compressed natural gas for transport purposes, with the result that there is insufficient gas even to meet the needs of the existing generation fleet. Tensions with neighboring countries have prevented the development of international electricity trade. The result is an avoidable reliance on expensive imported heavy fuel oil. 27. The institutional landscape remains weak. The new sector structure introduced the Single Buyer model, under which all electricity generated is intended to be purchased by a single entity, the Central Power Purchasing Agency (CPPA, currently a unit of NTDC), on behalf of the Discos. Contractual relationships have been established between IPPs and CPPA, acting on behalf of the Discos. Neither Gencos nor WAPDA Hydel has functioning or relevant contracts with CPPA. CPPA does not have agreements with any of the Discos to buy electricity on their behalf. The integration of CPPA into NTDC renders separate accounting and settlement of 12

21 liabilities opaque and individual companies accountabilities to consumers, the regulator or their owners are not recognized or enforced. Vested interests within the former WAPDA companies combined with unwillingness of government to cede its role in discretionary management create a considerable obstacle to further reform. The new government, and Ministry of Water and Power (MWP) in particular, recognizes the poor sector performance and the weak institutional setting are both a drain on its limited resources and a drag on the economy The Government s Policy and Program For The Electric Power Sector 28. Pakistan s goal is to develop an efficient and consumer oriented electric power system that meets the needs of its people and economy sustainably and affordably. The three guiding principles of the 2013 National Power Policy are efficiency, competition and sustainability, and it focuses on five main targets set out in Table 6. Table 6: The Five Main Targets of the National Power Policy (July 2013) Target Current Situation Goal and date Decrease gap between supply and demand Improve affordability by decreasing cost of generation 4,500 5,000 MW shortfall Reduce to zero by 2017 Average generation cost 12 US /kwh Reduce average generation cost to 10 US /kwh by 2017 Decrease aggregate technical and commercial transmission and distribution (T&D) losses T&D losses currently about percent Reduce T&D losses to about 16 percent by 2017 Improve collection of billed electricity Collections are currently about 85 percent of billing Increase collections to 95 percent of billing Improve governance by decreasing decision making times at Ministries, related departments and regulators Slow decision making Shorter processing times (goal yet to be established) 29. The government has developed an Action Plan to implement the National Power Policy over the next 3 to 5 years. The action plan ties together the policies and actions required to implement the specific strategies of the 2013 National Power Policy. The strategies are closely interlinked. Achieving financial sustainability requires improving cash flows through tariffs reflective of efficient costs, promoting efficiency and performance of the companies through commercialization, and reducing losses, in particular theft. Reductions in the cost of generation will come from increasing hydropower and gas in the generation mix and better efficiency, promoted through least cost planning. Subsidies must increasingly be targeted only to low-income households. Creating awareness and consensus for the policy implementation requires increasing transparency through greater access to information, strengthening the capacity of NEPRA and improving its accountability. 4. THE PROPOSED OPERATION 4.1 Link To Government Program and Operation Description 30. The proposed DPC series is aimed at supporting the government s Action Plan to implement the 2013 National Power Policy. The proposed first operation reflects prior actions taken by the the government to support the most pressing needs set out in the broader National Power Policy. The indicative triggers for the second operation in the series, expected to be 13

22 prepared within 12 months, have a bias towards longer term structural reform. Combined, the series have the particular aim of restoring the sector s financial viability and thus reducing the burden of public financing for it. It is centered around three policy aims: (A) (B) Reducing subsidies and improving tariff policy. Reducing, making more transparent and better targeting subsidies is essential if the sector is to become financially viable and the government s fiscal position is to improve. Measures in this area will limit subsidies, move tariffs to levels consistent with recovery of reasonable costs incurred through efficient operations, and strengthen the role of the sector s economic regulator, NEPRA. Improving sector performance and opening the market to private participation. Actions to be supported will reduce electricity theft and increase bill collection by the Discos, increase the supply of gas and move the electricity sector towards market oriented operation. (C) Ensuring accountability and transparency. Better monitoring, governance, transparency and rigor in reporting of results in the energy sector is important for implementation of reform and to ensure government and broader stakeholder support. Actions include monitoring and self-reporting mechanisms for sector entities, and oversight by independent experts. 31. There are synergies between the three pillars. Addressing subsidies and ensuring that the costs of providing an efficient service are reflected in tariffs will provide strong signals to Discos and their owner, the government, that they must address theft and uncollected bills because they will not be able to recover them from consumers. Increasing the supply of gas and taking forward commercially oriented sector unbundling will help bring down costs, thus reducing the subsidy burden further while supporting economic growth through increasing electricity supply. Improving transparency and accountability promotes demand for an efficient and well run sector and helps to create public ownership of the reforms. 32. The operation draws on previous experience in energy policy lending in Pakistan and elsewhere. Three lessons are particularly relevant: In Pakistan, complex or politically difficult sector reforms are best supported through dedicated sector operations. A multi-sector operation can play only a secondary or facilitating role when dealing with deep-rooted reluctance to reform as prevails in the power sector. Energy sector reform programs require sustained intervention over the long term but must be designed flexibly to allow assessment of progress and adaptation as the reform evolves, including leaving open the option to change indicative triggers or bring other instruments into play. Precise definitions of actions and when they are considered complete are needed to avoid delays or failures to achieve objectives, and these cannot always be described in the policy matrix alone. 14

23 4.2. Prior Actions, Results and Analytical Underpinnings Policy Area A: Reducing subsidies and improving tariff policy DPC1 Prior Action 1: Ministry of Water and Power notifies the revised tariffs determined by NEPRA resulting in an average 44% tariff increase for industrial commercial and bulk consumers and an average 32% increase for households using more than 200kWh/month, agriculture and other consumers compared with tariffs effective June DPC2 Indicative Trigger 1: Following the mechanism in 2014 Tariff and Subsidy Policy Guidelines, MWP informs NEPRA of the FY14/15 budgeted subsidy to incorporate in the tariff determination of each Disco, to apply in FY14/15 expected to result in electricity subsidies to be reduced to 0.7% of GDP. 33. Immediate and longer term steps are needed to curb subsidy payments to the power sector. Consistent with its plans for fiscal consolidation agreed with IMF, the government has reduced subsidies to the power sector from an expected 1.8 percent of GDP to 1.1 percent in FY13/14. The government has given subsidies to bring down the consumer tariffs and to allow for a uniform tariff to be applied despite varying costs of supply that have been paid to Discos to compensate them for revenue forgone. For industrial, commercial and bulk consumers the increases were applied from August 2013 and were on average 44 percent higher compared with June 2013 and for households using more than 200kWh per month, agriculture and other consumers were applied from October 2013 and were on average 32 percent higher compared with June The government has agreed with IMF to reduce subsidies further, to 0.7 percent, in FY14/15 and the indicative trigger will ensure that the subsidy amount is taken into account by the regulator in its determination of consumer tariffs at the start of the fiscal year. This will ensure that tariffs are adjusted promptly to the budgeted amount, in line with the government s wider targets of reducing the fiscal deficit. DPC1 Prior Action 2: MoF settles power sector circular debt in the amount of PKR 480 billion. DPC1 Prior Action 3: Economic Coordination Committee (ECC) approves the Tariff and Subsidy Policy Guidelines covering: (i) subsidy policy for low-income residential customers; (ii) multi-year tariffs; (iii) equalization mechanism and guidance for tariff setting as envisaged in the NEPRA Act, including forward looking fuel price adjustments; and (iv) guidance for circular debt management related to overdue payables to generators by CPPA. DPC2 Indicative Trigger 2: Further to Prior Action 3 of DPC 1: (i) NEPRA issues guidelines for Disco tariff determination covering principles, methodologies, timetable, formula and procedures for both annual and multi-year tariff (MYT); and (ii) MWP publishes in its website a cap for total overdue payables to power generators not to exceed [PKR 220 billion] 1 ; and (iii) overdue payables to power generators are below the cap for at least [3] months. 35. The chronic liquidity crisis in the sector has serious fiscal and sectoral impacts. Electricity distribution companies suffer liquidity shortages for three broad reasons. First, distribution companies are not able to recover the full costs they incur from electricity 1 Figures in brackets are indicative and to be agreed between the Government and the Bank during preparation of the second operation 15

24 consumers, because the tariff determined by the regulator disallows some costs, including excessive losses. Second, they do not yet recover all that they bill. Third, there are delays in determining tariffs and the government is slow to pay the subsidies and sometimes does not pay the full amount claimed. The cash shortfall builds up on the books of the distribution companies, with the result that they cannot pay their bills for electricity supplied to them. In turn, the public generators are unable to pay their fuel bills and IPPs curtail their supply. The consequent shortages of fuel and curtailed supply from IPPs lead to load shedding, with significant economic impact. The circular debt also adds to the contingent liability of the government as the owner of the Discos. 36. The government is taking steps to manage the circular debt. On taking office, the government settled the stock of circular debt that had built up, allowing purchases of increased amounts of fuel and payments to IPPs and increased generation. Until in the longer run costs and tariffs are matched and the Discos are operating efficiently, the circular debt must be managed as it will otherwise start to affect generationa again. The government plans to put in place a cap and reduction mechanism that will make more transparent the level of the circular debt, reduce the contingent liability on the government and enable continued generation. The mechanism is expected to be in place and to start operating by October Establishing policy guidance is crucial to rationalizing tariff setting and targeting subsidies. Approval of the Tariff and Subsidy Policy Guidelines supports the government s aim for a sustainable power sector and will improve transparency and predictability of tariff setting. The guidelines address several areas that hitherto have been subject to ad hoc decision making and have created budget uncertainty. Subsidy will be focused on the lower consumers, initially those using 200kWh per month or less, and will include a lifeline tariff for those using less than 50kWh/month. The guidelines introduce multi-year tariff (MYT) setting, to reduce the bunching and consequent delay of all tariff determinations so that new tariffs come into effect earlier in each fiscal year. The introduction of an equalization mechanism allows the government to maintain its policy of having uniform consumer tariffs across the whole country without having to meet the costs from its own budget. Automatic and forward-looking fuel price adjustments will ensure more timely price signals to consumers, allowing them to adjust consumption in response. 38. NEPRA has prepared complementary guidelines. NEPRA has prepared the Determination of Consumer-end Tariff (Methodology & Process) Guidelines 2014 which establish, among others, the timeline, revised determination procedures, mechanisms and methodologies. The NEPRA Guidelines ensure that future determinations meet the requirements set out in the Tariff and Subsidy Policy Guidelines. They are now being consulted with stakeholders and are expected to be introduced in time to govern the next round of tariff setting, for FY15/16, due to start in about March Results. Expected results from this policy area will be: a reduction of the subsidies allocated in the Federal budget from 1.8 percent in FY13/14 to 0.4 percent in FY15/16. Intermediate outcomes include reduced time taken for tariff determination and notification; and tariffs that reflect the costs of efficient operations. The expected outcome will be better management of the tariff and subsidy by reducing discretionary policy decisions and the lag in tariff approval and implementation. 16

25 Policy Area B: Improving Sector Performance & Opening the Market to Private Participation DPC1 Prior Action 4: (i) MWP instructs PESCO, HESCO, SEPCO, and MEPCO to outsource to the private sector collection of their respective feeders with losses of 50% or above; (ii) MWP instructs all Discos to implement a revenue protection program that ensures correct billing, reduces losses, in particular theft, and improves collections; (iii) Council of Common Interests initiates discussion on a mechanism to automatically withhold a proportion of the electricity arrears of provincial government entities; and (iv) Federal Government establishes mechanism to withhold budget transfers to federal agencies or entities which have arrears of payment for electricity that exceed 90 days of billing by Discos. DPC2 Indicative Trigger 3: Each Disco identifies and assesses existing consumer receivables and their respective recoverability to reflect, in accordance with the Companies Ordinance and the General Accounting Practices, re-classification and provisioning of the qualified receivables in its audited financial statements for fiscal year ended 30 June The government intends to improve performance of sector entities. Performance of sector entities can be improved in the short term in a number of ways that will support the government s broad aims of reducing the gap between supply and demand, reducing losses and improving collections, and making electricity more affordable. 41. All Discos perform below efficiency parameters allowed by the regulator. NEPRA permits certain levels of Disco technical and non-technical losses to be recovered from tariffs, and requires 100 percent collection of billings. All Discos fail on one or both of these dimensions, and government is making efforts to improve its companies performance. Peshawar and Hyderabad Electric Supply Companies (PESCO and HESCO respectively) and Sukkur and Multan Electric Power Companies (SEPCO and MEPCO respectively) account for a little over 40 percent of consumption and have particularly high losses. Parts of their franchise areas supplied by medium voltage lines ( feeders ) have losses of over 50 percent; several of these are in remote or insecure areas. Outsourcing is expected to allow local private entities that are known in the area to undertake bill collection under concessions that include incentives linked to reducing losses and increasing the amounts collected. They will focus especially on private consumers which are responsible for the largest proportion of overdue payments. It is expected to bring short term gains as well as some experience of private sector participation. Revenue protection programs are based on automatic remote reading (smart metering) and data management with monitoring and metering software to identify unusual demand behavior that can correspond to theft. Such programs do much to remove human involvement in the meterreading, bill-preparation and collection cycle. 42. Managing receivables will have higher priority. The government has taken action to withhold budget from federal agencies if they do not pay their bills within 90 days, and has put in place a mechanism to monitor outstanding payments through the Discos which have strong incentives to report slow payment. By doing this, the government is signaling its commitment to pay its bills. Managing provincial receivables, which amounted to nearly PKR 82 billion at the end of December 2013, is more sensitive. Government has raised the issue at the Council of Common Interests which is the Federation-level decision-making body, and is seeking consensus. Reassessment of Disco receivables is also required, as many are more than three years overdue and are of doubtful value. In addition to releasing cash into the system, these measures will ensure that Discos accounts better reflect the state of their businesses, giving private investors more confidence in the financial position of the sector. 17

26 DPC1 Prior Action 5: (i) MPNR 2 discloses the 2013 Model Petroleum Concession Agreement on its website; (ii) MPNR announces the award of petroleum exploration blocks for the 2013 bidding round; and (iii) OGRA 3 issues at least 3 pricing notifications to enable producers to start developing new and incremental gas production with increased prices allowed under the 2012 Petroleum Policy. DPC2 Indicative Trigger 4: MPNR notifies rules for enhancing gas production from producing, dormant or under-producing concessions. 43. Measures will increase the amount of gas available with the aim of increasing generation and reducing costs in the short term. Gas is a low cost and indigenous resource but has lost share in generation in recent years because of poor incentives to explore and produce it, and because administrative allocation of gas to other sectors has constrained its availability for power generation. In consequence generation costs are high and volatile and rely on expensive imported fuel. The 2012 Petroleum Policy is well regarded by the gas exploration and production industry in Pakistan. The proposed first set of measures will assure producers of a pricing regime that will allow them to develop gas supply from new and existing fields. This will act as a catalyst to increase power production from existing gas-fired plant which are not able to obtain sufficient fuel to run at full capacity. The second set of measures is expected to result in further gas development in later years. DPC1 Prior Action 6: CPPA s Memorandum and Articles of Association amended to establish CPPA as an agent to purchase electricity on behalf of distribution companies (including Discos); and CPPA and Genco Holding Company endorse Heads of Agreement reflecting key principles for Power Purchase Agreements (PPAs) for existing thermal plants, with energy price based on heat rate testing. DPC2 Indicative Trigger 5: (i) NTDC files request and NEPRA amends NTDC license to remove CPPA functions and NTDC s authority to purchase or sell electricity; and (ii) CPPA signs an energy supply agreement with each Disco to procure power on its behalf. DPC2 Indicative Trigger 6: (i) CPPA signs on behalf of Discos PPA with WAPDA Hydel for existing plant and PPAs with all Gencos, one PPA for each existing operational thermal plant of Gencos; and (ii) WAPDA enters into agreement with CPPA for administration of current PPAs of IPPs under 1994 policy. 44. The government intends to revitalize sector restructuring. The original design for the introduction of competition remains sound but has been undermined by the poor performance of recent years and has left the restructuring stuck in its initial phase. The immediate need is to separate market operation the sale by generators and purchase by distribution companies of electricity on long term contracts with associated billing and settlement from the system operation which covers the management of physical flows of electricity from generators over the transmission system, and thus to Discos bulk supply points. Currently, a transitional market operation function is managed by NTDC, which operates a cash flow and payment system that does not distinguish between market and systems operations. At present, Discos pay NTDC all revenues except for the regulated margin they receive for providing distribution services. NTDC then decides payment priorities to generators and other suppliers on behalf of the Discos. In practice this has not allowed proper accounting for sales and purchases of electricity between 2 Ministry of Petroleum and Natural Resources. 3 Oil and Gas Regulatory Authority 18

27 generators and the Discos nor permitted transparent pricing and contractual arrangements. The reforms will introduce competition between generators to supply distribution companies and in the longer term will pave the way for a competitive market for bulk supplies to third parties. 45. Separating power market operations is the key first step. The separation of the CPPA from the system operations of NTDC will enable contractual relations to be established at arms length from NTDC. This has to take place in multiple steps, starting with the establishment of CPPA as an agency so that it can buy electricity from generators on behalf of the Discos, and manage the settlement and billing on those purchases. It ends with the amendment of NTDC s license so that it becomes exclusively a provider of transmission and system operations services and is no longer permitted to buy and sell power. This sets the conditions for the development of a competitive market for generation, leading to a volatile market. 46. Results. The expected results from this Policy Area are threefold. First the rate at which amounts billed is collected is expected to improve from 86 percent now to 94 percent at the end of FY 15/16. Second, the amount of gas supplied from domestic resources is expected to increase from 3.8 billion standard cubic feet per day to five billion standard cubic feet per day by the end of the program. Last, market and systems operations will be separate, providing greater comfort to generators that they will receive contractually-obligated payments on time. The outcome expected is that more electricity will become available for consumption. Policy Area C: Ensuring Accountability and Transparency DPC1 Prior Action 7: NTDC implements web-based open access to operational information, including merit order, and daily payment instruction to generators. DPC2 Indicative Trigger 7: CPPA implements web-based access to monthly amount due and payment by each Disco including arrears, to CPPA and by CPPA to generators. 47. Measures to improve operational information for generators will improve accountability of NTDC and CPPA. IPPs in particular are uncertain whether generation plant is being dispatched according to the merit order which favors those plants with the lowest short run marginal cost. Publication will demonstrate that generators are not subject to discrimination and, at the margin, help bring down generation costs if they detect such discrimination. In addition, where there are concerns about liquidity in the sector it is also important for generators to know whether and when they will be paid, so that they can plan their own cash flows accordingly. Publication of the information initially by NTDC in the first instance and later by CPPA is linked to DPC 1 Prior Action 3 and DPC 2 Indicative Trigger 2. Greater accountability will improve the investment climate for generation if sponsors are confident about the predictability of the operational environment. DPC1 Prior Action 8: Each Disco (i) includes subsidy amount in customer s bills; and (ii) publishes on its website monthly billing and collection data aggregated by consumer category. DPC2 Indicative Trigger 8: MWP implements public web-based access to monthly results of performance contracts signed with Discos, NTDC and Gencos. 48. Improving accountability of sector participants also entails informing a wider group of stakeholders. International experience suggests that reporting to the wider public promotes greater accuracy and by focusing on facts leads to more informed discussion. As an initial step, informing consumers of the subsidies they receive and the billing and collection data will aid 19

28 understanding of the burden the electricity sector presents. It should make the declining subsidy amounts and greater targeting of small consumers easier for the government to explain and to obtain buy-in from the public. Making results of performance contracts of the publicly-owned companies will improve accountability of the boards and management of the companies, as well as providing stronger incentives for government to monitor the contracts. DPC1 Prior Action 9: ECC approves establishment of monitoring units within both MWP and MPNR with responsibilities for monitoring the energy sector, reporting on a quarterly basis; and MWP and MPNR formulate the scope of work for advisors who will review the quarterly monitoring reports and make those reviews public. DPC2 Indicative Trigger 9: NEPRA publishes at least monthly on its website, information provided by all licensees on selected performance standards results and indicators. 49. The government intends to monitor reforms and highlight constraints that need to be addressed. Monitoring of reforms through dedicated units and independent experts will ensure progress and highlight constraints that need to be addressed. Independent review and recommendations based on relevant international experience and the particulars of Pakistan s power sector will assist with benchmarking it against others. It will help inform investors and consumers about expected new developments and improvements and thus improve the efficiency of new investments. The report of advisors will also be made public, thus guaranteeing independent monitoring and disclosure of any constraint that negatively affects or stalls reform. As NEPRA s determination burden reduces, it will be able to turn its attention to performance of the licensees and link that performance to customer service. 50. Results. Greater accountability and transparency is expected to improve the quality of the structural reforms by ensuring better understanding among stakeholders, and thus help sustainability. It will also help manage the risk of reversal. Household awareness of the level to which the government subsidizes electricity will also be improved. Analytical Underpinning 51. The Bank and other partners have undertaken extensive analytical work that supports the prior actions for the proposed operation. Table 7 contains a detailed account of analytical work undertaken between 2010 and 2013 and their linkages to the prior actions supported by this operation. Prior Actions Table 7: Prior Actions and Analytical Underpinnings Analytical Underpinnings Policy Area A: Reducing Subsidies and Improving Tariff Policy Prior Action 1: Ministry of Water and Power notifies the revised tariffs determined by NEPRA resulting in an average 44% tariff increase for industrial commercial and bulk consumers and an average 32% increase for households using more than 200kWh/month, agriculture and other consumers compared with tariffs effective June Poverty Sector Impact Assessment, World Bank, Building an Efficient Energy Sector, Pakistan Policy Note 1, World Bank, Pakistan s Power Sector: A Joint ADB-WB Review, November Prior Action 2: MoF settles power sector circular debt in the amount of PKR 480 billion. USAID The Causes and Impact of Power Sector Circular Debt in Pakistan Prior Action 3: Economic Coordination Committee (ECC) approves the Tariff and Subsidy Policy Guidelines covering (i) subsidy policy for low-income Integrated Energy Sector Recovery Report and Plan, Friends of Democratic Pakistan, Energy 20

29 Prior Actions residential customers; (ii) multi-year tariffs; (iii) equalization mechanism and guidance for tariff setting as envisaged in the NEPRA Act, including forward looking fuel price adjustments; and (iv) guidance for circular debt management related to overdue payables to generators by CPPA. Analytical Underpinnings Sector Task Force, Manila Asian Development Bank, Rethinking Electricity Tariffs and Subsidies in Pakistan, World Bank Policy Note, July Policy Area B: Improving Sector Performance & Opening the Market to Private Participation Prior Action 4: (i) MWP instructs PESCO, HESCO, SEPCO, and MEPCO to outsource to the private sector collection of their respective feeders with losses of 50% or above; (ii) MWP instructs all Discos to implement a revenue protection program that ensures correct billing, reduces losses, in particular theft, and improves collections; (iii) Council of Common Interests initiates discussion on a mechanism to automatically withhold a proportion of the electricity arrears of provincial government entities; and (iv) Federal Government establishes mechanism to withhold budget transfers to federal agencies or entities which have arrears of payment for electricity that exceed 90 days of billing by Discos. Prior action 5: (i) MPNR discloses the 2013 Model Petroleum Concession Agreement on its website; (ii) MPNR announces the award of petroleum exploration blocks for the 2013 bidding round; and (iii) OGRA issues at least 3 pricing notifications to enable producers to start developing new and incremental gas production with increased prices allowed under the 2012 Petroleum Policy. Prior action 6: CPPA s Memorandum and Articles of Association amended to establish CPPA as an agent to purchase electricity on behalf of distribution companies (including Discos); and CPPA and Genco Holding Company endorse Heads of Agreement reflecting key principles for Power Purchase Agreements (PPAs) for existing thermal plants, with energy price based on heat rate testing. Policy Area C: Ensuring Accountability and Transparency Prior action 7: NTDC implements web-based open access to operational information, including merit order, and daily payment instruction to generators. Prior action 8: Each Disco (i) includes subsidy amount in customer s bills; and (ii) publishes on its website monthly billing and collection data aggregated by consumer category. Prior action 9: ECC approves establishment of monitoring units within both MWP and MPNR with responsibilities for monitoring the energy sector, reporting on a quarterly basis; and MWP and MPNR formulate the scope of work for advisors who will review the quarterly monitoring reports and make those reviews public. 4.3 Link to CPS and Other Bank Operations Building an Efficient Energy Sector, Pakistan Policy Note 1, World Bank, Integrated Energy Sector Recovery Report and Plan, Friends of Democratic Pakistan, Energy Sector Task Force, Manila Asian Development Bank, USAID Power Distribution Improvement Program, Action Plan Reports of each DISCO, Natural Gas Roundtable, World Bank Islamabad, December Building an Efficient Energy Sector, World Bank, ADB Technical Assistance: Establishment and Commencement of the CPPA, Gaining Traction: The importance of transparency in accelerating the reform of fossilfuel subsidies, International Institute for Sustainable Development, UNEP and Global Subsidies Initiative April Communication and Governance a Topic Guide: World Bank August The CPS for FY noted specifically the intention to support the adoption of policies to bring about financial sustainability, least cost expansion of generation, and improvement in the efficiency of transmission. It noted the emphasis the private sector placed on power shortages as a major obstacle to doing business and stated the intention to support the expansion of power provision, and thus to contribute to economic growth. The effort is continued in the CPS proposed for FY15-19, which seeks a structural and a cost transformation in the energy sector and includes reductions in load shedding, subsidies, and costs as its outcomes. The proposed DPC series is a cornerstone of the new CPS, and complements the proposed Fiscally Sustainable and Inclusive Growth DPC Series which addresses key structural efforts over the medium term, introducing new measures in tax administration, trade competitiveness, the business climate, and access to finance. 4 Report PK discussed on July 8,

30 53. The Bank Group has embarked upon a Transformational Power Initiative, to support significant new investments and reforms in the power sector. The initiative aims to mobilize over $10 billion over the next five years, to support new generation in a mix of public and private projects that address current supply gaps and future needs. The Bank supports sector reform and public investment, including the Tarbela hydropower fourth extension and the proposed Dasu hydropower project. International Finance Corporation (IFC) is considering equity investment with a private sector energy renewable group to develop around 3,000 MW over the next five years, including mid to large hydropower and wind. IFC will also be mobilizing capital from international equity investors and lenders to support a large pipeline of projects in hydropower and LNG import. It will also support private projects to import gas and increase domestic production. The Bank and IFC are working together on the Central Asia- South Asia Regional Electricity Transmission and Trade Project (CASA-1000) to bring Central Asian power to Pakistan. MIGA is seeking opportunities to support increased participation of international investors and lenders in Pakistan's power sector. The two elements of the Bank Group program are mutually reinforcing. Improvements in the business climate brought about by reforms are showing results in increased investment; the government recognizes this to be a product of structural reform and is thus encouraged to continue with its reforms. 4.4 Consultations and Collaboration With Development Partners 54. Government has made efforts to consult for the proposed operation. Historically the government does not have a good track record of consulting with stakeholders but during preparation of the proposed operation it has reached out to a number of groups. It has held roundtables for both the power and gas sectors which drew in industry and relevant agencies in an open forum to discuss challenges and formulate possible solutions. In the regulatory sphere, both NEPRA and OGRA have strong consultation protocols. 55. The proposed DPC series is planned to be co-financed with other development partners. Energy sector policy dialogue and support to the IMF over recent years has been carried out jointly with Asian Development Bank (ADB). The proposed series is a natural continuation of that joint venture with ADB which is contemplating parallel financing against substantially the same set of policy actions for the power sector as in the proposed operation. It is planned that the operations series will be monitored in cooperation with ADB. JICA has also confirmed its participation in the proposed operation. There have been frequent consultations with other donors throughout preparation of the proposed operation. 56. Technical assistance. A substantial program of technical assistance has been prepared with cofinanciers, and is outlined in Table 8. Table 8: Technical Assistance / Support Policy Area A: Reducing Subsidies and Improving Tariff Policy TA on social protection scheme to protect poor from impact of tariffs Technical Assistance To Support Program Policy Area B: Improving Sector Performance & Opening the Market to Private Participation Donor WB Support operationalization of CPPA and market rules Support for preparation of energy conservation measures; TA for preparation of least cost expansion plan TA for MPNR on policies and measures to enhance gas production. TA to improve performance of Discos through revenue protection program ADB JICA WB 22

31 Policy Area C: Ensuring Accountability and Transparency Support to MPNR and MWP monitoring unit Support to MPNR advisors Support for development of a communications program ADB WB 5. OTHER DESIGN AND APPRAISAL ISSUES 5.1 Poverty and Social Impact 57. The reduction of electricity subsidies will impact the poor. The IMF program requires Pakistan to reduce its electricity subsidies from 1.5 percent of GDP in FY12/13 to 0.4 percent of GDP in FY15/16. In October 2013 household tariffs were raised for all consumers of electricity above 200kWh/month, reflecting the reduction in subsidies. There were no increases for those on the lifeline tariff or for those consuming less than 200kWh/month, shielding the lowest electricity consumers, though not necessarily the poor, from the direct impacts of the initial round of increases. 58. The poor will be affected in three ways. The poverty and social impact analysis (PSIA) carried out in support of the proposed operation models the subsidy reduction as an increase in the final electricity prices paid by consumers. Annex 4 describes the methodology in detail. The first way in which the poor are affected is through tariff increases will mean poor households will pay more for electricity. Second, the price of other consumption goods that have some component of electricity in their cost will increase. Third, the broader reform process will improve reliability of electricity supply and reduce load shedding, and with it will come better employment prospects as the economy picks up. Moreover quality of life for the connected poor will improve as load shedding tends to affect the poor disproportionately. Those not yet connected, who are overwhelmingly poor, will have improved prospects of connection to the grid. 59. An across the board tariff increase will be progressive, but have a significant effect on the poor. If government extends its plans to reduce subsidies by increasing the final electricity price paid by all consumers by the same percentage and with no regard for the poor, the poorest two income quintiles would experience about a 2.5 percent increase in their cost of living by FY16. For the poor, about half of this increase is the direct impact from increasing electricity payments and the other half is due to increases in the prices of other goods. The latter impact occurs because aggregate prices are predicted to be about 2.5 percent higher by 2016 as a result of increased energy costs. 60. Dealing with the direct impacts requires further action by government. Although the first round of increases has not affected the consumers of smaller amounts of power, some poor people will have been affected because there is only a weak correlation between poverty and electricity consumption. The government has stated its intention to target electricity subsidies to the poorest 20 percent of the population. 61. Indirect impacts will be addressed through the BISP. The Fiscally Sustainable and Inclusive Growth DPC supports reforms to the BISP. A prior action includes increasing the basic payment and improved budget management. An indicative trigger for the second operation 23

32 would link BISP payments to inflation, thus addressing the indirect impacts of the tariff increases. 62. The PSIA examined a number of options for better targeting of the subsidies. These included changing the lifeline tariff cut-off to cover more poor people, reducing the lifeline tariff, and modifying the lifeline by concentrating all of the equalization surcharges and tariff increases on the upper consumption brackets. 5 This would mitigate the direct impacts of subsidy reduction for the poor already on the lifeline tariff and the full impact for those newly on the lifeline. The poor who do not qualify for the lifeline would be worse off. Table 9 shows the increase in the cost of living for the average poor household in FY15/16 under the uniform price increases and the various modifications to the lifeline scenario. Figure 2 shows the share of the total subsidy payments each income quintile would receive under each scenario. Table 9: Projected Increase in Cost of Living under Various Scenarios (Average by Income Quintile; FY15/16) Uniform Price Increase Modified Lifeline Mod. Life. + Comp. to Bottom 40% Rs/Month % Chg Rs/Month % Chg Rs/Month % Chg Poorest 20% % % % 2nd Quintile % % % 3rd Quintile % % % 4th Quintile % % % Richest 20% % % % Figure 3: 30% Share of Electricity Subsidies Received by Income Quintile (FY16) 25% 20% 15% 16% 14% 19% 19% 22% 22% 25% 24% 20% 19% 10% 5% 0% Poorest 20% 2nd quintile 3rd quintile 4th quintile Richest 20% Uniform Price Increase Modified Lifeline 63. Other options perform significantly better in protecting the poor and targeting subsidies. One option is to replace tariff-based subsidies with a direct subsidy, for example with cash subsidies or vouchers explicitly linked to electricity consumption. Another is to maintain 5 Though price increases to the non-poor would be commensurately greater and may not gain widespread support. 24

33 the current subsidized structure for smaller consumers, but restrict access to these tariffs based on poverty criteria, and charge all other households cost-recovery tariffs plus relevant surcharges even for low levels of consumption. The Bank is providing technical assistance to the government in analysis of the options with a view to introducing changes before the next round of tariff increases. 64. The indirect impacts can be covered by other mechanisms. Many households are not connected to the grid and so cannot receive tariff subsidies, and some poor households consume above the lifeline cutoff. To protect fully all of the poor from the indirect reform impacts, the government is also planning to provide income support to households in the bottom 20 percent of the population by poverty score. Broadening the coverage of the BISP and increasing the benefit in line with inflation is an indicative trigger for the second operation in the proposed Fiscally Sustainable and Inclusive Growth DPC. 5.2 Environmental Aspects 65. The reform program is a significant step to setting the power sector on a more environmentally sustainable path. The analysis is based on an energy balance model that permits the calculation of economic and environmental impacts on a consistent basis. It investigates the three policy actions which have quantifiable environment impacts: reducing subsidies and improving their targeting to the poor; improving sector performance by loss reduction and improving Disco collection rates; and increasing gas supply to generation. In addition, it takes into account two other objectives of the government: introduction of least-cost generation planning; and improving demand side efficiency. By 2020, these policy actions are expected to displace 11,906 GWh/year of oil fired generation and supply an additional 17,817 GWh/year of energy to the grid, representing an increase of 11.7 percent compared with no actions. An additional 15,026 GWh of energy will be supplied to end users, a 12.4 percent increase compared with no actions. 66. Greenhouse gas intensity will nearly halve. In 2008, the power sector emitted 27 percent of the total of Pakistan s 167 million tons of greenhouse gases (GHG). The energy balance model calculates 2014 emissions from the power sector at 43 million tons, increasing in the base case without reforms to 50 million tons/year by The corresponding emissions per capita increase from 0.23 tons/year to 0.24 tons/year. The program is forecast to bring about a net decrease of emissions from the power sector in absolute terms from 50 to 46 million tons. Emissions per unit of electricity produced are estimated to reduce from 0.49 kg/kwh to 0.27 kg/kwh, the result of a combination of substitution effects. New hydro and increased gas generation from existing plant are expected to substitute for generation using heavy fuel oil (HFO) and diesel. One coal plant, at Jamshoro, is expected to enter service. It will be financed by ADB and meet best international standards, including using supercritical technology. Offsetting this lower carbon intensity is the increased aggregate generation possible as a result of new capacity and additional fuel availability. These benefits are, however, at risk if hydropower projects are delayed, or if less than the targeted one billion cubic feet per day of additional gas is available. 67. Local environmental damage will be lessened significantly. Reducing commercial losses and subsidies will both increase the effective price of grid connected electricity. Consumers with low willingness to pay for electricity, whether they are pilferers or the poor, will 25

34 consume less. In Pakistan, where supply is constrained, the consumption forgone by these groups will be taken up by consumers with a higher willingness to pay, most likely those using a standby generator, the costs of which may be 25 /kwh or more. The analysis finds that the reforms are likely to result in a reduction in self-generation of about 11.7 Terawatt hours (TWh) per year. In Pakistan it is estimated that self-generation results in the emission of about 19.5 g/kwh of oxides of nitrogen (NOx) and 1.37 g/kwh of particulates with an effective diameter of 10 microns or less (PM10), thus the net reductions in these local pollutants as a result of reduced self-generation will be about 228,000 tons of NOx per year and about 16,000 tons of PM10. Health damage costs are estimated to be $14,171/ton NOx and $805/ton of particulates, thus there is an additional economic benefit of over $3 billion resulting from people enjoying better health as a result of lower pollution levels. 68. The implementation of the least cost investment plan will shift the generation mix towards hydropower and gas. Plants now being commissioned, under construction and with financing in place will continue to enter service as scheduled. From about 2019 onwards, there will be a shift towards hydropower and natural gas in the generation mix, offsetting incremental capacity additions of about 600MW of imported and domestic coal-fired plants by 2020, adding to the existing fleet of around 100MW today. 6 It will also include small hydropower, solar and wind generation. There will be less oil and diesel-fueled thermal plant. Energy efficiency will be an important part of the policy and will reduce demand for new plant in the future. 69. Impacts on natural resources are expected to be limited and manageable. New hydropower reservoirs have the potential to affect forests and consumptive water use (GHG emissions from Pakistan s hydro reservoirs are low) as well as displace people. Pakistan s hydropower resource, however, is largely based in the north west of the country, and many of the candidate projects are run of river and thus have relatively small reservoirs. They tend to be in areas where population density is low. Thermal generation will affect water abstraction primarily for cooling water make-up; coal projects will result in increased mining with attendant solid and liquid waste disposal requirements and other potential environmental impacts. Water requirements for modern, state-of-the-art thermal plant are lower than the existing HFO plant they will replace and can therefore expect to have a neutral or slightly beneficial effect on water consumption. 5.3 PFM Disbursement and Auditing Aspects Public financial management 70. Pakistan has a fairly well-developed infrastructure for public financial management (PFM). According to the Pakistan Federal Government Public Expenditure and Financial Accountability (PEFA) Update (2012), the trajectory of change is positive with PEFA scores comparing favorably with other countries in the South Asia region. The overall fiduciary risk associated with the proposed operation is rated as Substantial (see Annex 6). This assessment is made with due regard to the government s commitment to overall PFM reform exemplified by actions already taken at the federal and provincial levels, as well as the weaknesses in the PFM cycle identified in PEFA and other analytical reports. 6 The World Bank does not anticipate financing any coal-fired generation. In line with the 2013 Energy Directions Paper, the World Bank Group will finance coal-fired generation only in rare circumstances, but supports a long term approach to sector-wide planning to help secure adequate, reliable and sustainable energy supply. 26

35 Disbursement and auditing 71. Borrower and Credit agreement. The proposed Credit would be made to the Islamic Republic of Pakistan, represented by the Economic Affairs Division of MoF. The Credit proceeds would be transferred to the government in accordance with the terms of the Financing Agreement. 72. Funds flow arrangement. The government will identify a foreign exchange account with SBP forming part of the country s official foreign exchange reserves, into which the proceeds of the Credit will be disbursed. The proceeds will be released in one tranche following approval and notification by IDA of Credit effectiveness. The completion of the prior actions and the maintenance of a satisfactory macroeconomic framework are sufficient to release the funds. The Pakistan Rupee equivalent of the funds in the account will, within two working days, be transferred into the Consolidated Fund of the government Account No. 1 Non-Food, held with SBP, which is used to finance budgetary expenditures. 73. Disbursements. Disbursements from the Consolidated Fund for activities to be financed under the program by the government will not be linked to any specific purchases, and no special procurement requirements are needed. The proceeds of the credit shall, however, not be applied to finance expenditures in the excluded expenditures as defined in the Appendix of the Financing Agreement. If any portion of the credit is used to finance ineligible expenditures as defined in the Financing Agreement, IDA will require the government promptly, upon notice from IDA, to refund the amount equal to the amount of the said payment to the IDA. Amounts refunded to IDA upon such request will be canceled from the credit. 74. Accounting and assurance requirements for the credit. SBP, on behalf of the government, will continue to maintain an appropriate accounting system in accordance with generally accepted accounting principles. For this credit, because no special fiduciary arrangements are required, no additional assurance requirements in the form of a formal audit will apply. However, within 45 days of disbursement of the credit by IDA, the Finance Secretary, MoF, will provide a written confirmation to IDA certifying the receipt of the Pakistan rupee equivalent of the credit into the Consolidated Fund Account of the government, the date of receipt, and the exchange rate applied to translate the credit currency into Pakistan rupees. 5.4 Monitoring and Evaluation 75. Program monitoring is an integral part of the operation. A lesson learned from past energy policy lending is that solid monitoring and evaluation must be integrated into the policy dialogue. For this reason, Prior Action 9 requires the establishment of Delivery Units in MWP and MPNR with terms of reference to include monitoring of the energy sector, quarterly reporting and public disclosure. Further, independent advisors will be set up to oversee the work of the delivery units. They will be independent from the Ministries and will have the capacity to evaluate and advise on issues arising in the sector and bring relevant international experience. The Bank will support the establishment of the monitoring units and advisors with technical assistance. 76. Monitoring will be conducted jointly with government and cofinanciers. Ministry of Finance, cofinanciers including ADB and JICA, and the Bank will jointly monitor implementation. Formal review meetings will take place quarterly during the program s 27

36 lifetime, and will be aimed to coincide with the IMF s quarterly reviews. Reviews will be based on the monitoring reports of the Delivery Units, but will also involve other agents, including NEPRA; the Economic Affairs Department of the government has indicated its intention to participate. Progress towards achieving the indicative triggers for the proposed second DPC will be monitored, and adjustments made as required. 6. SUMMARY OF RISKS AND MITIGATION 77. The overall risk of the proposed operation is high. 78. There is a high risk of political, social and industrial opposition to increases in the retail electricity tariff and its impact on inflation undermining the government s willingness to implement the tariff and subsidy program and to tackle the circular debt. Although the new government has demonstrated its commitment to reduce the subsidy burden through transitioning to cost reflective tariffs, the recent tariff adjustments represented a percent increase for some domestic and agriculture consumers. This risk will be mitigated through maintaining the subsidized tariff for low income consumers; by institutions providing access to information on their websites; by working closely with government to enhance communication campaigns explaining the reform measures and the expected benefits to the public and industries of improvement; in improved quality of supply; through public consultation by NEPRA on its practices and procedures; and because future tariff increases for households will be less as the subsidized component for non-low income consumers is eliminated. 79. The risk of judicial intervention delaying implementation of tariff adjustments and other reform measures is moderate. Historically, consumer litigation and Supreme Court intervention have been based on different interpretations of the NEPRA Act or Tariff Rules. This risk will be mitigated by the proposed policy actions introducing greater clarity and enabling policies and rules to cover gaps and details that eliminate misinterpretation, and NEPRA adopting specific methodologies with forward looking benchmark based formulae. 80. Pakistan s vulnerability to external and internal shocks causing macroeconomic fluctuations could derail macroeconomic stability. Delays or ineffective implementation of policy measures would result in government not being able to maintain subsidy support to the power sector. This risk is mitigated by a new and empowered government and its strategic action plan under the National Power Policy 2013; and the leverage brought by combined IMF and coordinated donor support programs. In particular the Bank and IMF can work in tandem to ensure the program is not derailed. If between the DPC operations actions are required, IMF could review them in its quarterly cycle and insert them as structural benchmarks if needed. 81. Weak management at the Discos and Gencos as well as the government not reducing its direct control in the operation of those companies could fail to achieve much needed efficiency and creditworthiness improvements. This risk is mitigated through the indicators and strategic business plan in the performance contracts signed by Discos and Gencos; NEPRA s new Monitoring Unit carries out arms-length monitoring of licensees conditions and performance indicators; a law that is being adopted to criminalize the theft of electricity and performance contracts; and the power purchase and fuel purchase agreements are being concluded as part of the government s commercialization program. 28

37 82. The risk of opposition by vested interests within and outside the sector to commercialize, increase accountability and access to information is considered high. This risk will be mitigated through close dialogue and support to NEPRA in implementing reform measures; and ADB support (technical and TA) for the operationalization of CPPA as an independent company and adaptation of market rules. 83. The first DPC operation front loads politically challenging reforms and provides the seed for future reform in the power sector. While any reform package of such scale carries with it risk of derailment as well as the challenge of permanently changing the sector, the first operation is sufficiently potent to be seen as a no regrets intervention. The actions are politically challenging and will set the path for further reforms but if they stall the actions are self-contained to make substantial changes to the future trajectory of the sector. 84. Fiduciary risks are substantial, despite good progress in most phases of budget operations. This assessment is made with due regard to the government s commitment to overall PFM reform exemplified by actions already taken at the federal and provincial levels, as well as weaknesses in the PFM cycle identified in the PEFA and other analytical reports. According to the 2012 PEFA the trajectory of PFM change is broadly positive and PEFA scores for Pakistan compare favorably with other countries in the South Asia region, especially on budget classification, transparency, and accountability in rendering financial statements. Furthermore Government of Pakistan is in the process of developing a PFM reform strategy at federal level which should go some way to mitigating risks set out in the 2012 PEFA report. 29

38 ANNEX 1: Policy and Results Matrix For the Pakistan Power Sector Reform DPC Prior Actions DPC 1 Indicative triggers DPC 2 Results Policy Area A: Reducing Subsidies and Improving Tariff Policy 1. Ministry of Water and Power notifies the revised tariffs determined by NEPRA resulting in an average 44% tariff increase for industrial commercial and bulk consumers and an average 32% increase for households using more than 200kWh/month, agriculture and other consumers compared with tariffs effective June MoF settles power sector circular debt in the amount of PKR 480 billion. 3. Economic Coordination Committee (ECC) approves the Tariff and Subsidy Policy Guidelines covering: (i) subsidy policy for lowincome residential customers; (ii) multi-year tariffs; (iii) equalization mechanism and guidance for tariff setting as envisaged in the NEPRA Act, including forward looking fuel price adjustments; and (iv) guidance for circular debt management related to overdue payables to generators by CPPA. 1. Following the mechanism in 2014 Tariff and Subsidy Policy Guidelines, MWP informs NEPRA of the FY14/15 budgeted subsidy to incorporate in the tariff determination of each Disco, to apply in FY14/15 expected to result in electricity subsidies to be reduced to 0.7% of GDP. 2. Further to Prior Action 3 of DPC 1: (i) NEPRA issues guidelines for Disco tariff determination covering principles, methodologies, timetable, formula and procedures for both annual and multi-year tariff (MYT); and (ii) MWP publishes in its website a cap for total overdue payables to power generators not to exceed [PKR 220 billion] 7 ; and (iii) overdue payables to power generators are below the cap for at least [3] months. Result Indicator A1: Reduced subsidies allocated in Federal budget. Baseline (FY12/13): 1.8% of GDP. Target (end FY15/16): 0.4% of GDP. Policy Area B: Improving Sector Performance and Opening the Market to Private Participation 4. (i) MWP instructs PESCO, HESCO, SEPCO, and MEPCO to outsource to the private sector collection of their respective feeders with losses of 50% or above; (ii) MWP instructs all Discos to implement a revenue protection program that ensures correct billing, reduces losses, in particular theft, and improves collections; (iii) Council of Common Interests initiates discussion on a mechanism to automatically withhold a proportion of the electricity arrears of provincial government entities; and (iv) Federal Government establishes mechanism to withhold budget transfers to federal agencies or entities which have arrears of payment for electricity that exceed 90 days of billing by Discos. 5. (i) MPNR discloses the 2013 Model Petroleum Concession Agreement on its website; (ii) MPNR announces the award of petroleum exploration blocks for the 2013 bidding round; and (iii) OGRA issues at least 3 pricing notifications to enable producers to start developing new and incremental gas production with increased prices allowed under the 2012 Petroleum Policy. 3. Each Disco identifies and assesses existing consumer receivables and their respective recoverability to reflect, in accordance with the Companies Ordinance and the General Accounting Practices, re-classification and provisioning of the qualified receivables in its audited financial statements for fiscal year ended 30 June MPNR notifies rules for enhancing gas production from producing, dormant or under-producing concessions. Result Indicator B1: Increased bill collection in DISCOs. Baseline (FY12/13): 86% of bills collected by DISCOs. Target (end FY15/16): 94% of bills collected by DISCOs. Result Indicator B2: Increased gas supply. Baseline : (FY12/ 13) 3.8 billion SCFD. Target: (end FY15/16) 5 billion SCFD. 7 Figures in brackets are indicative and to be agreed between the Government and the Bank during preparation of the second operation 30

39 Prior Actions DPC 1 Indicative triggers DPC 2 Results 6. CPPA s Memorandum and Articles of Association amended to establish CPPA as an agent to purchase electricity on behalf of distribution companies (including Discos); and CPPA and Genco Holding Company endorse Heads of Agreement reflecting key principles for Power Purchase Agreements (PPAs) for existing thermal plants, with energy price based on heat rate testing. 5. (i) NTDC files request and NEPRA amends NTDC license to remove CPPA functions and NTDC s authority to purchase or sell electricity; and (ii) CPPA signs an energy supply agreement with each Disco to procure power on its behalf. 6. (i) CPPA signs on behalf of Discos PPA with WAPDA Hydel for existing plant and PPAs with all Gencos, one PPA for each existing operational thermal plant of Gencos; and (ii) WAPDA enters into agreement with CPPA for administration of current PPAs of IPPs under 1994 policy. Policy Area C: Ensuring Accountability and Transparency Result Indicator B3: Separation of market operations and transmission system operations. Baseline : (FY12/ 13) Market and system operations in single entity (NTDC/CPPA). Target: (end FY15/16) All contracted power generated by IPPs, GENCOs and WAPDA Hydel traded through an independent CPPA. 7. NTDC implements web-based open access to operational information, including merit order, and daily payment instruction to generators. 8. Each Disco (i) includes subsidy amount in customer s bills; and (ii) publishes on its website monthly billing and collection data aggregated by consumer category. 9. ECC approves establishment of monitoring units within both MWP and MPNR with responsibilities for monitoring the energy sector, reporting on a quarterly basis; and MWP and MPNR formulate the scope of work for advisors who will review the quarterly monitoring reports and make those reviews public. 7. CPPA implements web-based access to monthly amount due and payment by each Disco including arrears, to CPPA and by CPPA to generators. 8. MWP implements public web-based access to monthly results of performance contracts signed with Discos, NTDC and Gencos. 9. NEPRA publishes at least monthly on its website, information provided by all licensees on selected performance standards results and indicators. Result Indicator C1: Household consumer awareness of the extent to which the government subsidizes electricity. Baseline (FY12/13) zero. Target (end FY15/16) 25 percent of all household consumers. 31

40 ANNEX 2: Letter of Development Policy I 4)UC/2014 Suator Mobammad lsbaq Dar \1m Stcr for Fu~nc:e, R~-enuc. Eclonom~c: Affatn.. Slausuc:s and Pri\'11JJ;tlion 'IABAD \illrdl I.f Dear i>rsidcnis Kim, Nakao. and Tanal.t. inc:c our elections tn Ma)' our p cmmenr has adopud a!c.; la'lll -.:J 10 ~ ~ic: subllil) and ellhloce ccooomic: P'0"111. ia furthenac:e of tlicll ~ a-c llb:a vious initialh~ "'th respect 10. hsc:al consolidation and stllbi Iii); Rebuildinc forcijn nctuanee reso:t\cs. and Slruclural reforms. The: cncrty sec10r Is cmlrll 10 Ibis prop-am. and lhcreforc ow cftofu IOIO'&Id:5 its rtfona directly imp ~ lhe o c:rall ccooomic: C'O"~ of Pal.&SUn. ~ cbil lcuer "C '"* 10 ~ you about the: ~licnt fe:uurn of the Go\'CflliOall ofj>al.jswi' cnerr:> KCtOr refor8 prop.a. Our fo.."'is h&s bmllhe de "Ciopmcnl of a cn:dible and~~ "'hicll c. k ~ oow lhe medium term b) the A~ De\c:lopmcnl Bank (A08). the Worid BaM ('"8)..t ~ Oo emmcnt of J~p;on I!Cl na throu 11 the,..,.,. lntc:matiolal Coopmtion ~ (ltca). I. R CEI\T IU: VJH,OPMPN'!TS In June Pal.iSWI eehie-'cd lis f~ dtmoc:tulc ~ of po"'g' W. declld JO 'tl'lllnmt. The c:oncurrmtlmooch t.rai\sitlom Ill!be IIi~ IC\cls oflhe m1liur) ~ jdcilr) l'fo' Ide fi.wiber C\ idc:nce that!be clcmocrslic ptoccss Ills caked bold TillS of itjri(.:i Z0 a "a)' in support of the impkmenwion of cftc:c:thc: ~ 10 ~ ~ s c:ta:lc:l;j:;: economic sitwition characscril,c:d b) a low grew. tb rw:e. ininawc:tlft bcabech CaDir; in ~nt. gllj)s in fiscal rc:quirc:mmr. and \\C:ak ~io: frame,oorf,., 1llt p.oblie ~ GOP ralio ":u 62.?% in FY2013. mainly o--1na to ac:t.w deficit beir~j hjpcf cl.l ~ 'lh e'\p('c'ithat lhe ratio \\ill be 61.4~ for FY 2014 and'"" lake mc:aslfts to ma--11 ~ - frorn FY20 IS onwardi.. Il ls forecast thalccooomic JI'O"'Ih I lil.el) 10scale up ill theewrm~ h1al Yf* ~ ij e'q)c'ded to remain in single d pt for lhe rema.ndet of l!lc: )f* dllc: 10 smooth sappl) ol ~ items and beutr prior mcnitorio1 b)' the ptmmcnl Pllkblan'' energy ~or.,.hid! u a ph'oial contributor to the 0\"Cnlll-oe ~ ij eaa.c a K\'CI"C cri$is. especially,.jth ~ 10 elec1tlcity. Despite a 160 pactnt l3ritf idcrelk ill nominal terms stnec: I"C\cnues art )till f&lliftg sllon of and the eo-~~ to subsjdme clec~~iell) to at.mc: of up to about 2.75 ~of GOP ill FYil<l). 1llt ~ il C)'Ciica~ and ha> resulted 111 c:lvor!ic elc:c1ricoty ~~ ~ 81 0\U 7,00C\1V t 1\'C..-ging between ),OOQ.4.000~1W Weak JO 'tnwicc. poor ~..t a lllcl of ac:c:ounlabilit) 111 all IC\els - onl) contn'buled 10 1M shonagc:s bul rnulkd i.1 ~ - pa)ment of boll\. furthcr ~.Wt:nc the c:risis. lhe,_ ~iblc man'lnatioe of tid ij die cuculw debt v.hich rtac:hed PKR SOJ billion In mld

41 1 he major contributors of this sill.llllon include; l nsuff~<:ienl sllpply of fuel brouaj!t about by.cut.e l~uldil) ~ Reliance on expe~~sil,e ampotlld hea''y fud oil and diestl for scoentioa: Poor equipment maintenance: Poor cfficiau::y of usc by consumers: Poor pri<:ing; and Wi6esprc:od thcfl II. OVR POLicy RESPONSE has bcc:n "«IJJtg clasd) o * Slu To adclre.s$ till$ situ3tlon. the Go\etnmclll of Palistat~. ll:ank of Pali~tan and the ontetnaoonal communll} to ~riop and lmplams a -..pdleash--t poiky I'C$po!ISC:, 111med at :odo.e- ina 1113Cn>eeonomoc >Ub.lil:aoon "hilt aho ~ fundamenull fi~l. monct.ary, finm::~l ~ i~c$ and SCNCtwal impcd,_.. b ~ Pwstan's growth prospects in the medrwn tmn. The ck~ails 8I'C concaincd id che ~ parag,apfl$. A. ~I ICJ'OfCO DOm lc tabiur:atjo. To immed&ately il\iec:t Nbllil) in the counll)'s maerotcciciofnoc ftamt\o'(d. the Go-~ as a priority II'CI, immediately appo''cd fuaol consohd llion rneasun:s, such as ~ die moncuory policy to lqln rcbuildinj f~ JO ~dlanje n::lier'""" laund>tnj a ""' m ~ pr~ and O(hcr mcasui'\:s to ro6ik:e co-cmmcm budcet dcfoc:ils to ~lc levcb. In September 2013, on ~UWO II ofthe<le measutc$, the Go-o"C:mmentofPa1o$UJI a.'1d lbc lllkl..._, Moncmry Fund (IMF) entered into a }6 month E.~cndcd Fund FKilll)- (EFF) b ca-- o( about USS6.68 billion. The: IMF. af\cr beil'tl Sllli,rled.,.ith the pc:rfilnnance oldie Goo~ during the first rc iew of the EFF in No unbcr apprg\'cd lbc d~ ol US.S.SSJ million, Follo"ing the scc:ond mieio. IMF bu disbursed US SSS6 millioo in M.~. b ~be notod that the IMF's EFF is p311 of a "idtf proyam.ioi.i.i:ns a mutimum of USS12 ~ Dtedod to $uppor1 l'ajti$uj1 o -er the medium term. Immediately upon taking offioc. "" took ~cps co sc:ulc the IIO"''cr scccor circular dck. ~ b) J.l) hod reduced it by PKR -110 billion. thusllddingancscim~~tcd 1.700MWof~lllll r.d bccll I) ing idle for SC\Ctal months. We also increased cariffs for bull.. indtmrial * c rc:ill consumers by an average of 44 paqcnt in Augusc and for bouslcldd * ~ constjmers b) an :m~rase of32 percent in Occobtt The Go'-cmmenc bu also approached international I*1IICfS. ineludint the AD8. JJCA _, 6t World Bank. for budget.ary suppon to co-finanoe the.,.icier reform progam. 1lle- (or pole) refotms under discussions include ftc\\ measures in ID adatinisaltioft. u.dc ca.petilnu~css. 6t business clim&tc and access to fiiwicc as well as the ~ scccor 8. Tilt Co,tr mtot's VlsloD ud Obj~th n ror tlit i!mfoo' S«cor 0ein8 00$11.atlt Of the 50!\tfe consequences of the cnetgy SCCIOI 011 lbc Cl."llfttOJJie CC*ilioa oi6t people of Pakaswo, ~nd in fut1her.lnoe of iu. cornmitmena 10 0\ercoming tlw:sr dw""""' 6t Government announced.,tiofui l'o\\er Policy ia July 2013.,.,itltin dlroe.-mol~ offoc:c. 2 33

42 Ooel~ I To cnhlnce pmdion Cllplcil) 1n a slllllllimbk -..- Pto.-c ond.,..., a cul""" of.,.,..,...,._ and ~1bilicy Ensurt a!i'otdlblc dcwkll)', bl6od ("tlcte pos iblc) on i~ flds Mirumlze loue5 (ICC:hniul, fmoncial) and indticicac) Conuol pilfcnse ond IlleR..n.1. AI"" lbe ~or llllllblncs pro I8Cialllld fedc:nllllllhontics, ~ ed im~t1ltltlti, IOcoonflltlkac:ti\IIJa.and ~ CO - Tlf'&CU Dec:r<u<.thmirwe lllc dtmand s..ppl) ~-from Mt. pc.t - to be lima: a~rm~tly.io un> acllle\'01 Ot!cwtie "d~ttd a ~~-- rn. 8boal u 1 2.\.'ltll~, 10 b)' 2017 below 10 USe ~kw~ Reduoeltlnsmuslon anddislribwkln louel from ll-ls' aodoy ao-..16' lncmue oolloaion ni<s from aso.o (syi.- ide) 10 abo\oe 9S'.,IDd. R..WC. deei~ion b""" fot lilt Oo ~ rtlll.ed ~ ~ ctt. -- In Scpccmbcr the Go emmcnt ~a detailed plan armed Ill lumina djo l>*;.,.., actionable prouam. ubscqucntl). the propam was d~ "lth Slal.dloldlcn, iki!adiaa dlr prh11te sector. aeadcmia and ei il soc:i~. donor ~ the utilit) prc7'iders. a billkral io\"'t:mlntnb. and their ~"'li\c role in suppon of the prov&m -as idc:ntificc!.. i..e. a) Supporting the implcmenution of the Go =en( s policlc$; b) Public S«tOf COlllllctpaiU and utilities CIISUI"inllhll the) IIICCI thc1r obipcioas for 'llrious projccu and progams; and c) e.n.blinathe G<Mm~ 10 monitor the progcss in acbie\ing lk ~-cs _, laficls ~ ~ ouc in the Go 'emment's policies. and tal..c comcthe actic. tlae rcqaim1 The proposo:d policy IIICtlons. and fat \\flich we seck SupfiM from \\'B. JlCA. _, ADB..-e dis~:u.sscd in~ deta1l bckm. C. tractural Reform of tbc Euf'CY S«tor The rcfonn prop-am is aimed 111 impro.ma the fmancial iib1lll} of the poot.~-_, ilnohcs a three pronged strategy, i.e To better man!j8c wilts and subsidies: lmpro ing sector perfonnaoc:e and apcning the nwlelto prh"wk ~ IDd lmpro ing the tmlsjwmc) and IQCOUnQbihl) of <ltcior tmlliuijons. Ma.aa;Jar; Tariffs and Subsidies The Go 'tmmtnt recognizes thlli a significiiit dccruic il in 'esiments aod pc:nissc:al flillrc 10 increase electnc:tl)' prices tw c:n:aled a bad.log in terms of <losl I'CQO\"a)' 1lic:ll bu DOl been c l imin;~ted dt~pite the160 percent energy price inacasc bc:tti"ccii FY03'09 mf oaoticf o this end, "e h3 c 3g.teed on a phased program ofadj11stment.s,.1th the IMf a-.:1 ~ 111riffs to full oost reco ery. "flile lllc Go cmmcm,.ill pr"o'idc: onl) t.lrjeicd ~ 10 doe housdlolcls!mt fall "ithin the IO\\eg 20 percent in terms of pet cap1ts..-.. It,. ~ that these meas~s "'II rc:duoc the le\'ci of PQ\\'Cr sec10r dcf.c:it from ~ 10.,-._ 0...,_ ofgi>pbyfy Thcsesa ings,.illhelpinrccluc:illa the O>crallbud~ dtgal *also l 42 " 34

43 tnablt the Oo~crnmtnt to finance lnvcs.n~\s in low C05I ceocr-ion. rchllbi~ o( c:xisu:ia public sector generation plants, and implerncnli"j lou ~ pocnrns fie ~ oompsnics (DISCOs). Compn:hcnsi'e l4riff and subsidy policy guidelines for the e~if) - ll.a'-e abo bcc:d issued. These are simed at reducing the di51cmion v.1lidl is allo\\'011 under!lie c:xistilt& prooc:s.s for wio' dctcrmlnslion i.e. by 11\0\<'ing 10 a formula based and mv.lti-)-en Clrifr rep-. ililc anjlo"'erina ltle stionsl Elccllic Po-..cr Rcgulll«) Autboril) (1\"EPRA) 10 dclcnaido: o -.11 as not f> taziff). Pro' is.on lw ablo beta made for decmc:d DOCifiCII.ioft of lmift if 80l1101iticd by the Oovemmmt "ithin the lime >tipulated by NEPRA. It,.ill also~..:1 ~ the p!o()cs5 for the svbmiqion and dcttrm1nstion ofwiff peliijogs.. The polic:) auideli~ slso.-:jude a.rrangcments for tariff equalization ~ 10..,. the elimination of the Tariff DiO'ermtial ubsidy and a llaiisitioo 10 malli-)~ ariffs ijr DISCOs and 1<4rachi Elcctric:ity ~ Compo.n) (XESC).Based onlhb polic}. ~"EJ'RA ill be able to dc:,elop ~:~riff"'~ and reau!ation~ consis:tnt v.itll the polic). 8) FY17. all DISCOs will be on a muhi )'Cal wiff with -ic. fora'vd l~ fwd.4 mech311ism. Last. tlvougtl the policy guidelines.. we ha " put in place a ~i~ 10 lll:llpr'o""c lbe msnasnncnt of wio' subsidies and the cirtular dcbl. Tariff IUbsidies are alrcad) t.lptcd. and from FY 14/1 S "e "ill inuoduee a mechanism 10 mslr that subsidies do DCC c:xa:cd lhc bud~ allocation. We al5i0 illlroduoe in the comiltg fiscal )'CII, bcaa ~ 10 cmurc tbat the SOIJI'CC$ and account3bclity for the cin:ubr debt are ekatt)- idcmi6cd.. ~ " will institule a lne(:h:mi<m 10 cap and reduce ltle cua.llr debt. We,.;u ~die c:irca. debt by rcjl()h inl pro,;ne,al duet, r«o emjl prn2te rteei\abks and b) ll>:lobe;; rq;!lllt set1lemcnt if requ rcd. ~cral of the requu.,.,ttnl.' Introduced In 1M polic) SJ>idelincs ha t CXIftSCCIIICDCC ijr ariff 5Ctli11i- EPRA ~ 1n1rod~ eompltmenlat)' g~udclincs and is undctut.ill: CQIS1IItarioes We cxpeet the 'EPRA guideline$ to be in piau in time for Lhe FY 14 IS tw~ff ~ ro-1. expected 10 start tn abo,. Apnl2014. lmpro>in.g Sector Pcrlonnnr~ nd 0!H"'iDJ: t b~ Markd to Priut~ Pa rtidpau.. Six brosd!wj~s of acdon ha -e been idcntif~ed "ith rcspcc110 refonding and illlpro\ - perfonnance and faciliwe pri\'ate p31ticipation. I. Reduction or line km6 and i pro>t t toll«tlo s l.a dktrit.~ -,_.an (01 COs). As a tli'sl step. we plan 10 outsourcc billinc and oolloc:tioa fer fccdm ilc:k A~h! Technical and Commtreial {ATC) losses cxoe'od ~ 10 die ~ $dtcmes. We s~ al!.o requiring sll DISCOs to de\ clop and implement m~ ~ ~s. We h3~e fl.ltlhtr initiated actions to 8d'just recch-.bles oa'od b) po>wa.l JO>~mmenu and agencies. and fedctal agtneics or entities.. Proposals 10 ~ illcn:aloe the pnvate sector', role including managcmena conuacu. OUISOIItcilt:g tlddcal ~ open~tiorql function-, :and oullight pri.atl.tlllon- being coru.idcred b) dlt Go\u-. The Oo ernmtnt is also tndca,oring to cteate an Cll\iroomcnt "lid~ ~ die rrw.imum utilization of ni:sting wcu.. while di~ and ~..._ llld incflleinlcy. In th ~ effotts are bel,g ra.adc to imprc:m supply side cfficico:) llld strenatltmmi tner'&> conscn'ltion. 2. En«WY tff~eic-cy: Undct tbe IMf progam. we arc commiucd 10 ~ lbe Eller):) EnM:inley and Conscr ation Bill before Pwli3mcol..,.11ich Promotes intcm~~tional pcrf«m~~ncc sundatds a. Lhe ~ ijr all equipmctlt and appliances 10 be produced and ~ in Pal.iStan; 4 35

44 I'.>Ubli!lhc> ~ '"'~ le pllnl author it) 10 preper and im~ a "'*'Pcbc:aii>'C cncrj)' enic: ency and oon~nation ~rwn. AddrcsstS jwisdictio111l issues: Empower~ provinc~ to monit«the productioo and ~ o( Clqlli;laeal lbll oomplies "ith apprci\ed standards In.,.,alk:l "cal~ plan 10 issvc enabli11j rc:culations on mjnimum ClXIJ) pc>mwjc standatds. mcrgy labelling ~irc:menis and energy efficiency 5UIDCWds au or wt:idl will be not if oed in acconbnc:e " ith the law. 3. LA:ast Cos t Pl.. oln': The lack of focus on sclccbclft of the k:a5l COSl pnjjccts lloos abo conttibu!cd toward the high oost of gmcntioo. Ac:oorlfillJiy, the Go>~ is - inii'oducing the requirement f«least~ planaiqg in the :-:ationaj T,_issioa.S 0csl)3tch Comp3ll) {NTDC). 10 a~s"ure thai only lhosc projects - OCIISidcrcd b implemcnllllion "hich fat ~illed c:rittria. ~ in oaasidc:nlicm of loc:aiaa. fuel cboitc. and c:conomk COSt of J)OY>fl" to be produced o'-er the lifcti!k of tilt J:WOjcc1 as "'CIIAS nukina e'qllicit :~oeial. en' ironm<!nllll and Olhtt assoelat.ed saf~ cam. 4. Re-ia, igonotin~; Oomnti<' C~ Prod nioa: The 2012 Pcttoltum ~ -s Production Policy. "hid! sitnifiqntl) enh-=oed the price of ps follaoo~ -a.j disco\'ci)'. has been stro!w)' wckxjmed b) the andu$11)'. The Co,- ~ t:fforu 10 ptomo(c this polic) to in\est«s in 2012 also evoled fa,'cnble rcspon:!1c$. f'olbo.. tilt oonclusion of the tirsa biciding round in ~larcll 2013.,.'C 1'10" ba''c su'-iu a:nqe ill about ~ t\piotalton blocl...s ""kh arc: ready fot Pwd to the respcam: bidden. V.'e oomplcted the awatd of these blocks 111 JanUSI)' Oil ud Gas Rq;Diuor) Allllloril) (OGRA) has amounoed the apphcabihty of the 2012 Policy price and IX~ price tor tile rc:specti\'c concessioos for fh'c I'IC\\ b~ b) en6-j3liiyi) 20..._ ll il announoe the pricing for the rc:majninc blocks.. ithm lhl$ )'ear. l o c:j$r djit ~bert"" oo dela)s in the award of these blocks. Model c.onc:css- Acrc:emmt las been f~ b)' the Directonlle Gmcnl Petrola~m Conocs.sions and -.:d oa tbc \loaisuy o( ~eum and rqtural Rc-.rces "'Cb:!lk. In the oominc )'Car we,.,q m-!i.e siiuciurc: of the mid a.nd do-.nstrca.m ps - Ht.h a,...,_. 10 it$ ~ ia FYIS/16. IIcea We "ill ensure ~plilulcc "'th performance plll'1ll'nt1m of oompa.'\ies IMI lila'~ a"'arded concessioos fore'\ploralion as "ell as "'ecut- of Gas T~ ~ "ith the utilities. for" illi"' bu)~ and sellers. 5 Perfonnn" l)rhm MnaJ!el'lleat b) Publk Sector PO\Oer Lilltift: n.t DISCOsbeinc in~tructed to implement the requtrtments of the Companies' Ord..-x 19$4. Je dus rrgard, three DISCOs ha'-e alrc:acty ianed performance c:ontrxu "llh the Go>~.d a mcdlanism to monitor the utilities' perl'onnance undfl" t.'a~ Conl.raC:b IS be-a fg81i.zcd. B)' fy I S/16. all DISCOs. Gcnc:nltion Companies (Gt.-.:00\) and NTOC "ill be.-.ored througll such contracts. The Contracts,.;u iocha6e pc'o'"isions for lkllllrd:j of o..-s and managcmmis to be I'C:"wded "ben qrccd performance ~ arc donal «C\CCiedted 3lld pcmiized "hen they arc no1. 6. Oc-elopla& a Wholtsalt Po"tr ll1u krt: 0..-er lbe pas' (C'Y )'I:II'S, the <io>'cf1mciiii and the uulities have "or~ed "'th ADB to C5Ublish a "holcsalc mari.ct for poooer To ald. we intend to nuke the Cmual ~er PurdlaslnJ AUiboril) (CI'PA) iudc;., o( al other powe r ~ entities. \\ e "ill inuoduce IMII<c:c!'Illes 10 aijo,. clnc1 _.,. bd"een produc:cts and large consumers of clcctnc:iiy 111 ~ pnc:e iac:b5lrg / 36

45 pto\iding ttansparrnt pricing for "11cc:blll elcdnc:il) 0\a the public IIC'taort. la lllc tina phase, the power pwchssc and S3lc fwictions \\ill be dc:voh'tld from l\ioc 10 CPPA..t r!'t)c' licctuii.l will be modified SO thst it CUI 110 ~ p;rdlasc or sdj dcaric:il) ln.stitutionaliaotion of CPPA Is a priot action UftCb lilt l\ 1F progam. -.! c Ia\~ abo oomplctcd the ~ red fonnalitots tncluding amc:adment to and r-tjnrjre ol lllc Memorandum and Al1ic:les of A-sociation, appotnbll;& 1 CblcfEuc:uti c and od1cf U) suit Going fon.:\td. the proc.css will further C\oi\.'C in thr>c plwcs: a) Initial functioning of CPPA as agen1 of DISCOs, for the pore:'-': ol flo"''" &c. public and prhate scaot power produocn. All<XIrdii1JI>..., ill _..,... DISCOs each sig~~ ~cy agm:mrnts "'ith CPPA. CPPA "'ill abo sip poo>u purthd<e apmcnis (PPM) \\oth publi.: SCftC'1Illoo rocnpanics. -.! QS.c - administration of the t~dt,t ~cr producm' CCidD"actS fn. :.TDC: b) Provision of dircc:t sales ~cen ~ lind laree cu~10mtrs ~ a ~ Bu)-cr Plus (SBM+) model; and c) Tnlnsition 10 a \\ilolcsalc muilet. here 11rJC t;(jilsiimcn Qll t.y di:cdj) fi'oi:t gtnt~tors. with 1\"TOC and DISCOs pcrfonninj only tnnsmi~ -.1 ~ functions. l mpro i n; Acrount biut)' u d Tran,ptorucy 1he swu. of actions under the Po"-cr PolK)' and follow up actions under tbc ~ E~plonuion and Production Policy is beinc monilorcd rcsularl> b) tbc r-~ Coon:hMtlon Committee (ECC) of the Fedct.l CAbinet. ~ at tb: bic:tacs& '"-d dtmon~ttat e~ the importance "hich the Go'~ anxhes 10 am~ tbc ~ sector reform pl ~~n Mec:h3ni""" are also being set up for periodic: monilori11j of the po-tt..t ~ pohcic:,, We 113\ \1 esublishcd monitoring units in M\\-'P and \1f""R dllrjaj ilb monitonng of the progress of the reforms. rcportinc 10 the E.oono;wT!.,; Cooodiwliw Committee on a qulll1trl) basis. and disseminating cnc:rgy 5CCW infontlllioa 10 tk polbk. We 'VIII aoo hort adhiior$ 10 mie\\ the reports and 10 pi'o'ide COll\IDCUII),.d- lll make public their revi«:\\'s. We \\ ill ensure repcwting of the rcsulu ~ ~ forums " hich llow sll stalteholdtrs Concluding c:itiziciis) 10m~ progc:ss-.! ~ their i«:\\'s. The proposed culture of mcnitorifta and ~ ill also rcqllft enhanced ~Tg~~llltory all*it)', for \\hlch, bila!a'al'muhibtcral ~ is also bcq soughl We "ill abo cmbl!lfla cc»enuntnt Y>idc commu:ucalioas ~.J id sock assistance from our partnm 10 help '" its ~llsbmmt. Furtha mcesui'c$ 10 promo1e trsn"jl'wnc).orne of,.bic:b ha\c aii'cad) bcic8 iuilrcd, oriji increase acc~s to infonrn~toon in the Mcrg) seccoc-~ implcmcrttinj.. ~ ~ 10 operational informaloon on clecuicil) ~mtratlon. including 1be merit order~ llld payments made to cencn on. bill ina and collection de.. In the longer term, "' "ill omplcrntnt public "eb-basc:d informllion ~ llile ~ of 01 COs. GEl\COs and m>c apnst the bencbrnarl.s sec in their OCJIJirKtl. '"EPRA and OGRA will also be obliied to poblts!i tnformasion II'IOCIIbl) on tile~ of Uernsecs. This " ill be O''Cf$CUI b) the two m~ IWls aa!'o1wp and \ IP""R. 6 / 37

46 ID. GO\'fjRNMRffT C0;\1:\Iffi\lt:NT We lake lhls oppolllll'lity to reitcntc our commitment to reforms lll'ld ~ idl die polie) iss~~ We ha\'c already taltn somt daffocult dtelsions including subsunt.ial llriffilll:rc&ks..s tk settltment to lht pollotr StCtOr clrcubr debt ~~otlich are alre.d) )icldlng posith~ resus. Tilt lc\'d ofeleclrleity ~~tner.ttlon on a en~~t dunng Jut~e Jao!W)' 2014 has bcc:c 6.4 pcrcca ~ lhllll lht CMtSpondong period in the pre"ious )cal. We an: ccxnmiued 10 CClllliallae 10 malz k nect$$3t)' dteisionsto impro e the power sector's fananeial iabilit). You "ill appreciate that the metsui'c$ described abo ~ 10 reform the Cllel'llY--.iDa k Slrof1ie$1 eff<>fu yet underu~tn for mllll)' )eats. «"~ ~~oe I'CCOplitt.._ ~ tk Cnet&Y ~tor bock on lnltk requires e~nucd effo.u. The to-trnmtnl"s plio 10 dell idl k WIICtU!'II impediments 10 the pcrformanee of!he entfl) icclor s matdled by oar--b impro, ing the quantity and quality of ph)wl in\"c$1menl an the seetor,..._..-«pos;slwt IIIII private sector in cwnent pe.nieipation. In closing. "'C " 'OUJd like to express our <:ont«wed ~ of ADB,.llC\..S k V.Ortcl &nk for wotking "ith the JIO"cmmcnt in the dcvc:lopmcm of a si11j1e procrm~ b lbe aja'l) sedof tlw is closely integrated,.;lh tlllll of the 1\iF We look.or.."lrd 10 ClOCJiiDiaaiac 10 "'011 elosel) " 'th )'OUr institutions in our common~ ofimp'o"io& Paki$1an's CCOIIOGlia: pro5pcccs. Kind regards. Mr. Jim Y0111 Kim. President. The World Bank Mr. Ta.kdliko N.'slulo, President, Asi1111 IX\.elopment l~l Mr. Akihiko TanakA, President. Japan lntcmatiollll Coopmalion AJmcy (JICA) 7 38

47 ANNEX 3: Fund Relations Press Release No. 14/123 FOR IMMEDIATE RELEASE March 24, 2014 International Monetary Fund Washington, D.C USA IMF Executive Board Completes Second Review Under the Extended Arrangement for Pakistan and Approves US$555.6 Million Disbursement The Executive Board of the International Monetary Fund (IMF) today completed the second review of Pakistan s economic performance under a three-year program supported by an arrangement under the Extended Fund Facility (EFF). The completion of the review enables an immediate disbursement of an amount equivalent to SDR 360 million (about US$555.6 million). The 36-month extended arrangement under the EFF in the amount of SDR billion (about US$6.78 billion, or 425 percent of Pakistan s quota at the IMF) was approved by the Executive Board on September 4, 2013 (See Press Release No. 13/322). In completing the second review, the Executive Board also approved the authorities request for waivers of non-observance of the end-december 2013 performance criteria on net swap/forward position and government borrowing from the State Bank of Pakistan (SBP) based on corrective actions taken by the authorities. Following the Executive Board s discussion on Pakistan, Mr. David Lipton, First Deputy Managing Director and Acting Chair, said: The Pakistani authorities have made commendable progress in stabilizing the economy and launching important structural reforms. However, economic conditions remain challenging, and more needs to be done to reduce vulnerabilities. Fiscal consolidation is on track, but additional efforts to broaden the revenue base and improve tax administration are needed to sustain the adjustment. Recent steps to increase the equity and transparency in taxation are in the right direction. However, the December 2013 investment incentive package runs against these steps. Slippages on targeted cash transfers should be avoided to protect the most vulnerable segments of the population. It will also be important to strengthen public debt management. Monetary policy should increasingly focus on containing inflationary pressures and every effort should be made to reduce the stock of government borrowing from the State Bank of Pakistan in line with program targets. Efforts to build up foreign reserves should continue, including through greater exchange rate flexibility and a higher policy through greater exchange rate flexibility and a higher policy rate. 39

48 Agreed legislation to enhance central bank independence should be presented for parliamentary approval without undue delay. Tackling financial sector risks is an important policy priority. In particular, capital shortfalls at some banks and high nonperforming loans need to be addressed promptly. Additional steps to deepen the government debt market would also strengthen financial stability. Progress on structural reforms is welcome but more remains to be done. The rationalization of gas prices should move beyond the gas levy; regulation of the energy sector needs to be strengthened; privatization of public sector enterprises should move forward; and bolder actions are needed to improve trade policies and the business climate. 40

49 ANNEX 4: Debt Sustainability Analysis 4.1. The downward trend of the public debt-to-gdp ratio reverted in the last two years. Public debt-to-gdp ratio breached the bar of 60 percent limit specified by the Fiscal Responsibility and Debt Limitation Act 2005 in the last two Fiscal Years (Figure 4.1). Figure 4.1: Pakistan Evolution of Public Debt Rs trillion % 80% 75% 70% 65% 60% 55% 50% 45% 40% FY01 FY03 FY05 FY07 FY09 FY11 FY13 Domestic External Percentage of GDP 4.2. The main reason is the doubling of the amount of domestic debt issued. Domestic debt increased from Rs. 4.7 trillion at end-june 2010 to Rs. 9.5 trillion by end-june Increasing reliance on domestic financing and declining financing from external sources is explained by the large fiscal deficits and their monetary financing Domestic debt creation has become increasingly skewed towards short-term instruments. Domestic debt consists of Market Treasury Bills (MTBs), borrowing from the SBP through Market Related Treasury Bills and retail debt market instruments such as National Saving Schemes. At end-june 2013, almost 60 percent of domestic debt was issued in shortterm instruments, namely, 3-, 6-, and 12- months MTBs (see Figure 4.2); followed by Pakistan Investment Bonds (22.8 percent) and retail debt instruments (22.4 percent). Figure 4.2: Structure of Domestic Debt 1999/ /13 100% 80% 60% 40% 20% 0% FY00 FY02 FY04 FY06 FY08 FY10 FY12 Treasury Bills National Saving Schemes Bonds Source: State Bank of Pakistan 41

50 4.4. Borrowing from the SBP through Market Related Treasury Bills has also substantially increased. The SBP Amendment Act 2012 (Section 9c) stipulates that net borrowing from the SBP has to be brought to nil on a quarterly basis. However, this limit has been repeatedly breached in the past. Borrowing from the central bank at end-june 2013 stood at Rs. 2.3 trillion compared to Rs. 1.3 trillion at end-june Scheduled Banks remain the prime lenders to the government. The banking sector, despite their asset-liability mismatch balance sheet structures, dominated the government securities market (see Figure 4.3) while the participation of non-banks is still abysmally low. Growing budgetary needs led banks prefer such option. As a result, credit to the private sector was crowded out: its amount became almost negligible. Given recently accelerated placement of MTBs, refinancing risk has increased. The redemption profile on domestic debt has become highly frontloaded. By end-june 2013, its average time to maturity was 1.8 years which is high. This risk is further compounded by the put option embedded National Saving Schemes instruments which give investors the right of early redemption. Figure 4.3: Share of MTBs Holdings by Investor 100% Scheduled Banks Non-Banks/Corporates 80% 60% 40% 20% 0% Q1-FY11 Q2-FY11 Q3-FY11 Q4-FY11 Q1-FY12 Q2-FY12 Q3-FY12 Q4-FY12 Q1-FY13 Q2-FY13 Q3-FY13 Q4-FY13 Source: State Bank of Pakistan 4.6. As a result, external debt has become about one fifth of total public debt. Multilateral institutions accounted for nearly half of the external public and publicly guaranteed debt with the main two creditors being the Asian Development Bank and the World Bank (capturing 21 percent and 18 percent of total external debt). Bilateral held almost one third of total external debt. Within bilateral creditors, Paris Club countries accounted for almost 23 percent of total external debt. Currency composition of public and publicly guaranteed external debt is diversified. The main exposure of exchange risk to foreign currencies comes from USD denominated loans (see Figure 4.4). External debt US dollars-denominated represents 44 percent of total external debt. This is followed by Japanese Yen (26 percent) and euros (23 percent). Exposure to exchange rate risk is high but declining. The amount of foreign loans maturing in FY13/14 (including repayments to IMF) is equal to almost 68.5 percent of foreign exchange reserves. Hence, a depreciation of the Rupee would affect both the stock of the government debt as well as the debt servicing flows. 42

51 Figure 4.4: Currency Composition of PPG External Debt (including IMF) at End June 2013 USD EUR JPY Other 7% 26% 44% 23% Source: Economic Affairs Division, Government of Pakistan 4.7. Debt Sustainability Analysis. Under our baseline scenario, Pakistan s public debt-to- GDP ratios are projected to decline over the medium term. With a targeted consolidated fiscal deficit (excluding grants) of 4.4 percent of GDP by 2017/18, public debt is projected to fall from 64.2 percent of GDP in FY13/14 to 58 percent by 2017/18 (see Table 4.1). However, even though gross financing needs are also expected to decline from 33 percent of GDP in 2013/14 to 28 percent in FY17/18, these remain high, thus posing significant refinancing (or rollover) risk. These should be monitored, especially with regards to maturing short term domestic debt. Early fiscal consolidation reflecting adjustment measures deemed politically feasible including subsidy reduction a nd tax policy and administration actions and strong economic growth are expected to support the decline in public debt ratios. In percent of GDP unless otherwise indicated Table 4. 1: Base Case Debt Projections Actual FY10/ 11 FY11/ 12 FY12/ 13 Projections FY13/ FY14/ FY15/ 16 FY16/ 17 Public sector debt 1/ o/w foreign-currency denominated 2/ Macroeconomic and Fiscal Assumptions Real GDP growth (in percent) Inflation rate (in percent, period average) Primary deficit / Source: World Bank staff estimates 1/ General government gross debt 2/ This includes medium and long term PPG debt as well as short-term external debt. This also includes IMF debt (both budget support and balance of payments support), Foreign currency bonds as well as Central bank deposits. 3/ Excluding grants Stress tests show that public debt is particularly sensitive to an exchange rate depreciation shock. Stress tests show that the most important deterioration of public debt levels vis-à-vis the base case scenario would take place in a scenario of a one-time 30 percent depreciation shock, followed by a contingent liabilities shock, and a combined shock (see Figure 4.5). In the case of the most extreme shock, a 30 percent one-time depreciation, the public debt ratio would increase to 68.6 percent of GDP by end-2018; 11 percentage points of GDP above FY17/ 18 43

52 the baseline. Another scenario with significantly worse outcomes than the baseline is a one-time contingent liabilities shock, equivalent to 10 percent of GDP, which would lead to an increase in the debt stock to 67.1 percent by end-2018, 9 percentage points of GDP above the baseline Public debt dynamics will remain a source of fiscal vulnerability. Despite the gradual decline in public debt ratios, total interest payments will continue to absorb a large share of fiscal revenues (including grants), averaging close to 30 percent of total revenues. The public debt-torevenue ratio during the projection period is projected to average around 409 percent, well above other countries in the region. Figure 4.5: Public Debt Sustainability Analysis In percent of GDP / / / / / / / / / /18 Contingent liabilities 1/ Combined 2/ ER depreciation 3/ Actual Projections Source: World Bank staff estimates 1/ One time 10 percent of GDP increase in other debt creating flows in 2014/15 2/ Combination of three shocks: i. Real GDP growth is at baseline minus one-quarter standard deviation, ii. Primary balance is at baseline minus one-quarter standard deviation, iii. Real interest rate is at baseline plus one-quarter standard deviation 3/ One time 30 percent real depreciation in 2014/15 4/ Country team projections However, external debt sustainability risk is projected to remain low under the baseline scenario. External debt-to-gdp is projected to decline gradually over the medium term to 22 percent of GDP under the baseline scenario, owing to persistent inflationary pressures in the short term, sustained economic growth, and large IMF repurchases due in the medium term. External debt is robust to most shocks and is expected to follow a declining path under most standardized-shock scenarios (see Figure 4. 6). Most extreme shock appear to be sharp exchange rate depreciation which increases the external debt to GDP ratio to 32 percent of GDP by end-june 2018, which is 11 percent of GDP higher than the base case. Non-interest current account shock raises the external debt by 5 percent of GDP relative to the baseline. Shocks to the economic growth rate, the external interest rate, and the combined shock, make only small differences with respect to the baseline scenario. 44

53 Figure 4.6: External Debt Sustainability Analysis In percent of GDP / / / / / / / / / /18 Current account 1/ Combined 2/ ER depreciation 3/ Baseline 4/ Actual Projections Source: World Bank staff estimates 1/ Non-interest current account is at baseline minus one-half 10-year historical standard deviations 2/ Combination of three shocks: i. Non-interest current account is at baseline minus one-quarter standard deviation, ii. Real GDP growth is at baseline minus one-quarter standard deviation, iii. Nominal interest rate is at baseline plus one-quarter standard deviation 3/ One time 30 percent real depreciation in 2014 The Effects of a Worst Case Scenario An alternate scenario would assume slowdown in reforms efforts especially after 2015/16 due to political economy challenges mostly followed by an early start of the political cycle previous to the election process. Under this scenario, the IMF program would derail, reforms would slowdown, fiscal consolidation would lose steam, investors confidence would falter, and all this would result in lower GDP growth and higher inflation Inflation after falling till 2015/16 will return to double digit in 2017/18. Given the assumption that Pakistan will enter an election cycle in 2016/17 means that political considerations would kick in higher public sector expenditures due to higher subsidies, fuel consumption and thus inflation 2015/16 onwards. In addition, relatively weak external position would also exert inflationary pressures through exchange rate depreciation pass through in prices of imported goods and services Fiscal consolidation would stop. With lower revenues and higher expenditure, Government would struggle to bring this deficit below 5 percent in medium term The external current account would register relatively larger deficit post 2014/15. Higher exchange rate volatility emanating from relatively weaker macroeconomic position and the slowdown in reforms, post 2014/15, would dampen export dynamism. Fuelled consumption would support higher imports and a higher current account deficit. Resulting import coverage (months of reserves sufficient to cover next year s imports of goods and services) would decrease from 2.4 in 2015/16 to 1.1 months in 2017/18 mostly due to the financing of higher CAD. Key economic indicators in the worst case are shown in Table

54 Table 4. 2: Key Economic Indicators In Worst Case Scenario FY09/ 10 FY10/ 11 Actual FY11/ 12 FY12/ 13 FY13/ 14 FY14/ 15 Projections FY15/ FY16/ FY17/ 18 In percent otherwise indicated Output and Prices Real GDP at factor cost Consumer prices (period average) Balance of Payments Current account balance (% of GDP) (2.2) 0.1 (2.1) (1.0) (1.0) (1.1) (1.5) (2.2) (2.5) Exports of goods and services Imports of goods and services Remittances Gross official reserves (months of imports) 1/ Public Finance Revenues and grants Expenditures of which Current Overall fiscal balance 2/ (6.2) (6.5) (8.8) (8.0) (5.8) (5.5) (5.5) (5.7) (5.6) Total public debt (inc. obligation to IMF) Memorandum: GDP at market prices (PKR billion) 14,876 18,825 20,091 22,909 26,139 29,485 33,154 37,880 43,641 Source: IMF and World Bank staff estimates 1/ Excluding gold and foreign currency deposits of commercial banks held with SBPP 2/ Excluding grants 46

55 ANNEX 5: PSIA Methodology 5.1. This annex describes the methodology and assumptions underlying the poverty and social impact analysis presented in the main text of this PD. In addition to the analysis presented in the PD, the PSIA team is producing a just-in-time policy note for peer review and circulation to the Government and other stakeholders. The assumptions for that note are still being finalized based on updated inputs from the Government on their plans The PSIA models the changes in electricity prices that likely will be required to meet the 0.4 percent of GDP subsidy target by 2016, agreed upon by the Government of Pakistan and the IMF in development of the IMF s Extended Fund Facility for Pakistan. It examines the impact of these changes on household welfare and on the benefits incidence of electricity subsidies over the reform horizon of fiscal-year 2013/14 (FY2013/14) through FY2015/ The analytical framework developed for this analysis has three parts. First, it determines the expected increase in the cost of electricity supply and GDP for the three forecast years to FY2016, and calculate the increases in electricity prices that would be required to gradually lower electricity subsidies from 1.5 percent of GDP in FY2013 to 0.4 percent of GDP in FY2016. Second, these electricity price increases and the subsidy reduction path are used to develop reform scenario forecasts for growth, income and prices with a computable general equilibrium (CGE) model for Pakistan. Third, these forecasts are used to model the household-level welfare impacts and subsidy benefits incidence (share of total subsidies received by each income quintile) of different electricity pricing scenarios with the latest national household survey data In this PSIA, we analyze the impact of two mechanisms for protecting the poor from the negative impacts of subsidy reform. First, we examine modifications to the lifeline tariff; that is examined under the framework explained below for forming price increase assumptions and projecting their impact. Second, we examine the provision of cash transfers to poor households; the final section on cash compensation describes how we analyze the design and impact of these. Electricity Cost and Price Assumptions 5.5. The weighted average NEPRA-determined tariff (NDT; NEPRA s calculation of the tariffs that would recover each utility s allowed costs) across all utilities in Pakistan is taken as the cost of electricity. FY2014/15, provisional NDTs, suggest the average cost will be PKR per kwh. Any changes in the NDTs will be driven by a combination of oil prices (60 percent weight) and overall inflation in Pakistan (40 percent weight). Oil prices are taken from staff estimates, and are forecast to decline gradually to USD per barrel in FY2015. Inflation is taken from the IMF World Economic Outlook (October, 2013), augmented by the estimated marginal effect of electricity price changes taken from the CGE model. Overall inflation for the baseline is expected to pick up to 8.9 percent in FY2014/15, before dropping to 6.9 percent in FY2015/16. Inflation forecasts under the reform scenario are each about half a percentage point higher. These give a projected average cost under the baseline of Rs per kwh in FY2014/15 and 47

56 14.97 per kwh in FY2015/16, while the reform scenario costs are Rs per kwh in FY2015 and Rs per kwh in FY2015/ Total electricity subsidies as a percent of GDP each year, are calculated from the per-unit difference between the projected NDT for each consumer class and the electricity price charged to each consumer class multiplying that difference by the amount of electricity consumed by each consumer class. The sum of those amounts across consumer classes yields the total electricity subsidy needed, and division of that figure by GDP gives electricity subsidies as a fraction of GDP. This calculation implicitly assumes that electricity subsidies are defined as the payments the government needs to make to all of the utilities to compensate them for the difference between their allowed costs and their revenue from tariffs (this is the definition of the Tariff Differential Subsidy, or TDS). 8 To project consumption by consumer class, electricity consumption by each consumer class is assumed to increase at the same pace as GDP (and thus do not need a specific GDP assumption for this calculation) For electricity prices, the government already notified new tariffs in October 2013; the analysis assumes those will stay in place through FY2013/14. Under the previous calculation framework, these suggest electricity subsidies will be 0.6 percent of GDP in FY2013/14. Given that the electricity cost is likely to increase significantly in FY2014/15, the analysis assumes government will maintain electricity subsidies at 0.6 percent of GDP in FY2014/15, then it will increase electricity prices sufficiently to reduce subsidies to 0.4 percent of GDP in FY2015/ The analysis develops two scenarios of electricity prices the government might set to achieve these FY2014/15 and FY2015/16 levels; the government has not yet developed a plan for subsidy reduction, but it provided input to the PSIA team on what is broadly likely. Both scenarios assume an equalization surcharge (or other similar mechanism to maintain uniform national tariffs without a subsidy) is applied to charge consumers prices above the minimum NDT and shift revenue from lower-cost utilities to higher-cost utilities. 9 The first scenario is a basic reform scenario that models the impact if the price increases were applied with no measures to mitigate the welfare impacts. It assumes the government keeps the structure of tariffs unchanged from FY2014 and assumes greater price increases will be applied to higher residential consumption brackets and to non-residential consumption and lower but still significant price increases to agriculture and lower residential consumption brackets. Table 4.1 details the average increases 8 If the IMF expanded its definition of subsidies to also include, for example, equity the Government of Pakistan gives to the power sector to clear debt it accrues for mismatches between payments made and revenue received, then a larger electricity price increase than projected here would be required to bring total electricity subsidies down to 0.4 percent of GDP. That would magnify the impacts on the poor presented here and require larger mitigation measures to protect the poor. 9 This assumption does not change how to calculate the prices charged to each consumer class. Without the assumption of this or another revenue-transfer mechanism, even if consumer prices were set equal to the weighted average NDT, the government would still have to pay a subsidy to compensate higher-cost utilities for charging consumer prices below their cost-recovery tariffs. Assuming an equalization surcharge or other revenue-transfer mechanism means the government can essentially transfer revenue from lower-cost utilities, for whom the uniform national tariffs applied are above their cost-recovery tariffs, to higher-cost utilities. 48

57 assumed for the largest consumer groups, and Table 4.2 details the specific prices (tariffs plus any equalization surcharges) assumed for residential consumption brackets. Table 5. 1: Electricity Price Increases under Basic Reform Scenario (Annual nominal increase) 2013/ / /16 Residential 16% 14% 16% Commercial 31% 11% 5% Industrial 56% 12% 7% Agriculture Tubewells 22% 6% 5% Table 5. 2: Residential Electricity Tariffs under Basic Reform Scenario (PKR/kWh) / / /16 Lifeline: Up to 50 kwh/month kwh kwh kwh kwh kwh The second scenario developed proposes restructuring the residential lifeline tariff to protect the poor from electricity prices, to the extent possible using tariff-based subsidies. Specifically, it proposes increasing eligibility for the lifeline tariff (a special low tariff charged only to households with monthly consumption below a pre-specified ceiling) from 50 kwh to 100 kwh, eliminating the Rs 75/month minimum charge, and keeping the lifeline tariff at the current Rs 2 per kwh through FY2016. To offset the increased subsidy this would require tariffs on the highest consumption brackets and more so on non-residential consumption to increase slightly more. Table 4.3 details the average increases assumed for the largest consumer groups in this scenario, and Table 4.4 details the specific tariffs assumed for each residential consumption bracket. 10 From October 2013, residential tariffs (aside from the lifeline tariff) follow a previous-block structure, where households are charged two rates for their consumption: one rate for the final bracket they fall in for all consumption in that bracket, and the rate from the lower bracket for all consumption below the cut-off for the final bracket. For example, a household consuming 750 kwh in one month in FY2015 would pay Rs 18 for its th kwh and Rs 16 for its 1 st to 700 th kwh. 49

58 Table 5. 3: Electricity Price Increases under Modified Lifeline Scenario (Annual nominal increase) 2013/ / /16 Residential 16% 17% 11% Commercial 31% 14% 12% Industrial 56% 19% 9% Agriculture Tubewells 22% 6% 5% Table 5. 4: Residential Electricity Tariffs under Modified Lifeline Scenario (Rs per kwh) / / /16 Lifeline: Up to 100 kwh/month kwh kwh kwh kwh kwh Macroeconomic Modeling and Assumptions The Global Trade Analysis Project Computable General Equilibrium Energy Substitution (GTAP-E) model is used to simulate the whole-economy impacts of the subsidy reduction path and price increases detailed above. 12,13,14 The outputs of the CGE model provide parameter settings for a partial-equilibrium model of household demand (described in the next section), which yields estimates of the welfare effects of the reforms and potential compensatory measures In the macroeconomic modeling stage, GTAP-E model simulations yield for FY2013/14, FY2014/15 and FY2015/16 the household consumption, income growth and average price changes under the baseline and reform scenarios. The modeling exercise comprises two parts. 15 First, a baseline using the built-in dataset for Pakistan in the GTAP-E model (version 8) was developed. Economic growth rates and other parameters for the baseline are taken from the IMF World Economic Outlook (WEO) database and other official forecasts. Second, a set of scenarios were developed based on the projected 11 From October 2013, residential tariffs (aside from the lifeline tariff) follow a previous-block structure, where households are charged two rates for their consumption: one rate for the final bracket they fall in for all consumption in that bracket, and the rate from the lower bracket for all consumption below the cut-off for the final bracket. For example, a household consuming 750 kwh in one month in FY2015 would pay Rs 18 for its th kwh and Rs 16 for its 1 st to 700 th kwh. 12 For this exercise, only the price increases in Table 1 were simulated. 13 Hertel, T. W. (1997), Global Trade Analysis, Modeling and Applications, Cambridge, Cambridge University Press, 14 Further details on the CGE model and assumptions used are provided in the Appendix. 15 See Annex for more details on the partial-equilibrium model, data and baseline development. 50

59 increases in consumer electricity prices and decreases in government subsidy expenditures described previously The model distinguishes electricity as a separate consumption item in the household budget. On the supply side, electricity is produced using three different types of energy (hydropower, natural gas and oil) that are either domestically produced or imported. The baseline is developed on the hypothesis that world oil prices (the main input used in electricity production in Pakistan) will decrease over the next three years. 16 The removal of subsidies is treated as an exogenous shock on producer and consumer prices. Each production sector and household is hit differently as a result of the removal of electricity subsidies (as described in Table 4.1). On the production side, the CGE model describes the pass-through effect of subsidy removal in terms of possible increases of producer prices, which is likely to result in an increase in the average price level. Simultaneously, favorable trends in the world oil market predicted for FY14 and FY15 will help to attenuate the inflationary impact of subsidy removal. Energy intensive sectors are predicted to be the most affected by rising electricity prices. On the consumer side, two effects are predicted. The Pakistan economy will perform better under the IMF program; faster growth would result in increased income levels (both for skilled and unskilled labor) in the medium term. Household-level Modeling and Assumptions The outputs from the macroeconomic modeling in a partial-equilibrium model are based on the FY2010/11 Pakistan Social and Living Standards Measurement Survey (PSLM) data. The model takes FY2010/11 actual electricity consumption and projects it forward to FY2013 based on consumption growth, inflation and changes in electricity tariffs. No demographic or technological changes are assumed over that time and that total household consumption grows uniformly at the rate predicted by the CGE model. There is allowance for each household s electricity demand to evolve over time based on income and price growth rates and associated demand elasticities. From FY2013/14 to FY2015/16 electricity consumption and total household consumption is forecast under the baseline and reform scenarios. A cost of living index is calculated for each household based on the cost of food, non-food and electricity expenditures and their respective shares of total consumption. The welfare impact of the reforms is found by comparing real consumption under the baseline and reform scenarios (valued at purchasing power under the reform scenario) In this model, the reforms have three channels of impact on households: (i) a growth effect, captured by the CGE model; (ii) a direct effect on electricity prices and demand, captured by the price of electricity in the cost of living index and the elasticity of demand for electricity; and (iii) an indirect effect on other prices, estimated through the CGE model and applied to real consumption through the cost of living index. A range of different scenarios is then simulated using assumptions about cash transfers that the government might provide to compensate for the negative impact of the reforms 16 y.pdf 51

60 (described in the next section), and estimate how these affect the overall welfare calculus for each consumption quintile Specific calculations that are done using the household survey data from the PSLM are described in the following. For household i, the implied quantity of electricity consumed by each household each month,, is recovered from the observed monthly electricity expenditure, (net of taxes and charges), by inverting the all-slab benefit pricing formula which was in effect during the survey period and applying the prevailing tariff, tax and fee rates in 2010/11 (see Table 4.1):, 75,,,,,,,,,, 3,, Where is the tariff per kwh in bracket j, is the upper bound for bracket j, and n is the total number of brackets. Note that there is a minimum charge of Rs 75 per household per month, and that the lifeline tariff rate, p 1, applies only to consumers below b 1 (currently 50 kwh per month). Otherwise, all households benefited from the tariff in each bracket The household s total expenditure is assumed to grow each year at the same rate as nominal household consumption (obtained from the CGE model). We do not update the household weights for population growth, so that the distribution of household sizes remains static. The quantity of electricity consumed is updated each year based on the change in the marginal price of electricity for each household, dp i,t, and real household consumption growth, g t, according to the following formula: 17,, 1,, Where = is the price elasticity and = 0.8 the income elasticity of demand for electricity (as assumed in the CGE model). The change in the marginal price of electricity is just the change in the tariff for the block in which the consumer was located in the previous year Using the formula above for,, the household s electricity expenditure in each subsequent year is updated based on projected consumption. Under the previous-slab benefit formula, the calculation becomes: 17 This formula can easily be obtained by applying the Envelope Theorem to the first-order conditions of a standard, two-good consumer maximization problem. 52

61 75,,,,,,,,,,, 3,, As discussed in the text, for the time being there is a twist in the calculation above for consumers in the fourth bracket ( kwh), who pay the second bracket (1-100 kwh) tariff for their first 200 kwh. This is also accounted for in the calculations Defining as the unit cost for electricity at time t, the subsidy to the consumer can be calculated as follows:,,, The total cost of electricity, including taxes and fees, is denoted by,. Taxes and fees are separate in the calculation of the subsidy bill, since these revenues do not accrue to the ministry responsible for subsidies. The welfare effect of the reforms in each year is defined as the amount of compensation, in current rupees that each household would need to receive in order to enjoy the same real consumption under the scenario as they would have under the baseline.18 Let, be the cost of living index for consumer i in period t under the baseline assumptions, and, be the counterfactual cost of living for the same consumer under the reform scenario. Then define, can be defined as follows: Rearranging for,, gives:,,,,,,,,,, The welfare effect is represented as -,, namely the extent to which an uncompensated household is worse off as a result of the reform The cost of living indices, and, are defined following a chained Laspeyres price index formula, with three goods: food, non-food items, and electricity. 19 The expenditure shares of food ( ) and non-food ( ) items were estimated from the 2010 observed data, with each household allocated the mean food and non-food shares of their 18 In demand theory this is referred to as the compensating variation. The calculations here assume a money-metric utility function for simplicity, although the same results hold as long as we ignore the effects of relative price changes on baseline spending patterns. 19 Electricity is technically included in the non-food price index, but we adjust the non-food weight down to account explicitly for electricity. 53

62 per capita expenditure quintile. The electricity expenditure share ( ) is calculated from electricity and total expenditure in the base year, 2012/13. The cost of living index is then defined individually for each household as follows:,,,, Where F t and N t are the food-price and non-food price indexes (obtained from the CGE model) and, is a household-specific index of the average cost of electricity including taxes and fees (relative to the base year 0):,, /,., /, It is important to note that the cost of living index is defined relative to the base year in every case, so that the welfare comparison between baseline and counterfactual in each year measures the cumulative impact of all reforms up to that point. Cash Transfer Modeling and Assumptions Two cash transfer programs are simulated: giving a cash transfer to (a) the poorest 20 and (b) the poorest 40 percent of households based on Pakistan s poverty scorecard database. Pakistan has a national database of proxy means test (PMT) scores for each household; a PMT score is an index based on assets and other household characteristics that is designed to be highly correlated with household per capita consumption (and therefore with poverty). It is assumed that Pakistan would use this database to identify households to receive cash transfer The PSLM does not have household s PMT scores, so a PMT score for each household cannot be constructed using equivalent component data from the PSLM. For the first simulation, the cutoff is set at the 20 th percentile (equivalent to a PMT score of 17.42) and for the second at the 40 th percentile (equivalent to a PMT score of 26.25). 20 It is assumed that households receive a cash transfer only if their PMT score is below this cutoff. Each eligible household receives an equal share of the compensation budget An iterative program solves for the compensation budget that exactly compensates the bottom income quintile (or, for the second simulation, bottom two income quintiles), on average, for the impacts from the subsidy reform. The total budget, T t, which fully compensates these eligible households (on average) for the welfare effect of the reforms in year t is defined as follows: Solving for the values of that achieve full compensation on average: 20 In practice, the actual cutoff would need to be determined based on poverty scorecard database. 54

63 ,,,, 0 Where w i is the frequency weight of household i, and n is the number of eligible sample households. 55

64 ANNEX 6: Public Financial Management 6.1. Pakistan has a fairly well-developed infrastructure for public financial management (PFM). At the policy level, Parliament has a key role in authorizing revenues, expenditures, and debts. The Ministry of Finance (MoF) plays a pivotal role in budget preparation and expenditure control. Line ministries, departments, and agencies have well-defined roles in implementing budgets and rendering accounts. The Controller General of Accounts, with an extensive network of offices, makes payments, maintains accounts, and prepares annual financial statements. The World Bank funded Project for Improving Financial Reporting and Auditing has helped improve PFM, including via a world-class financial information system, which is now the core fiscal and financial management system of government. The government has established a sound legal framework for coordinating fiscal and debt management policies and for improving fiscal transparency through the Fiscal Responsibility and Debt Limitation Act of According to the Pakistan Federal Government Public Expenditure and Financial Accountability (PEFA) Update (2012), the trajectory of change is positive. PEFA scores compare favorably with other countries in the South Asia region (Figure 6.1). Average PEFA converted score 5 4 Figure 6.1. PEFA Assessment Scores for South Asia 3 Figure 1: Comparison of PEFA assessment ratings Federal government 2012 with average PI 1 PI 2 PI 3 PI 4 PI 5 PI 6 PI 7 PI 8 PI 9 PI 10 PI 11 PI 12 PI 13 PI 14 PI 15 PI 16 PI 17 PI 18 PI 19 PI 20 PI 21 PI 22 PI 23 PI 24 PI 25 PI 26 PI 27 PI 28 Federal South Asia Note: South Asia countries include Afghanistan (2008), Bangladesh (2006), Nepal (2008), Bhutan and India (2010), and Maldives (2009) Information in budget documents is comprehensive and budget documents are available to the general public. The improvement in the Open Budget Survey score for 2012 from 38 to 58 reflects this. Implementation of the Integrated Financial Management Information System is based on the Government Finance Statistics-compliant chart of accounts at all levels of government. This has facilitated budget tracking down to the third tier and preparation of timely reliable financial reports. It facilitates submission of annual financial statements for audit within two months of the close of the financial year and monthly financial reports are finalized days after the close of the month. Audit reports are presented to the legislature within eight months of the close of the financial year Despite progress in many areas of PFM, the latest federal and subnational PEFA reports show some areas of concern. The internal control system is largely based on rules and regulations issued by MoF, which are quite elaborate. Instances of 56

65 noncompliance have been reported by the Auditor General of Pakistan. It is therefore of particular concern that no progress has been made on internal audit in recent years. The internal audit function is assigned as a responsibility of chief finance and accounting officers, but has not yet been developed as an administrative operating function. Progress in legislative oversight has also been mixed across federal and provincial governments, largely due to the absence of functioning public accounts committees in some provinces. The scrutiny of audit reports by the most recent federal committee, however, was extensive and succeeded in addressing a large backlog of audit reports to be reviewed Improving PFM capacity at provincial and lower tiers has emerged as a key challenge. The capacity to plan, manage, implement, and account for results of policies and programs is critical for achieving development objectives. The majority of service delivery related functions have devolved to the provinces and the government realizes the need to strengthen its PFM systems by addressing the capacity of provincial institutions, processes, and individuals to use resources well. This is supported by findings of recent subnational PEFA assessments that have highlighted the scope for improving capacity to manage provincial finances. Weaknesses are somewhat mitigated by the consolidation of current PFM reforms which include nationwide automation of budgeting, accounting, and financial reporting; modernization of auditing practices; and adoption of medium-term budgetary frameworks SBP is now producing financial statements consistent with international accounting standards and formats. The financial statements of SBP for the financial year ended 30 June 2012 were independently audited. The auditors gave an unqualified opinion on the statements concluding that the statements gave a true and fair view of the financial position, financial performance, and cash flows. An IMF Safeguards Assessment of the SBP was issued on March and an update report was also produced on March 3, Both these reports have also been reviewed by the World Bank The overall fiduciary risk associated with the proposed operation is substantial. This assessment is made with due regard to the government s commitment to overall PFM reform exemplified by actions already taken at the federal and provincial levels, as well as the weaknesses in the PFM cycle identified in PEFA and other analytical reports. Disbursement and auditing 6.8. Borrower and Credit agreement. The proposed Credit would be made to the Islamic Republic of Pakistan, represented by the Economic Affairs Division of MoF. The Credit proceeds would be transferred to the government in accordance with the terms of the Financing Agreement Funds flow arrangement. The government will identify a foreign exchange account with SBP, which forms part of the country s official foreign exchange reserves, into which the proceeds of the Credit will be disbursed. The proceeds will be released in one tranche following approval and notification by IDA of Credit effectiveness. The completion of the prior actions and the maintenance of a satisfactory macroeconomic framework are sufficient to release the funds. The Pakistan Rupee equivalent of the 57

66 funds in the account will, within two working days, be transferred into the Consolidated Fund of the government Account No. 1 Non-Food, held with SBP, which is used to finance budgetary expenditures Disbursements. Disbursements from the Consolidated Fund for activities to be financed under the program by the government will not be linked to any specific purchases, and no special procurement requirement shall be needed. The proceeds of the credit shall, however, not be applied to finance expenditures in the excluded expenditures as defined in the Appendix of the Financing Agreement. If any portion of the credit is used to finance ineligible expenditures as defined in the Financing Agreement, IDA will require the government promptly, upon notice from IDA, to refund the amount equal to the amount of the said payment to the IDA. Amounts refunded to IDA upon such request will be canceled from the credit Accounting and assurance requirements for the credit. SBP, on behalf of the government, will continue to maintain an appropriate accounting system in accordance with generally accepted accounting principles. For this credit, because no special fiduciary arrangements are required, no additional assurance requirements in the form of a formal audit will apply. However, within 45 days of disbursement of the credit by IDA, the finance secretary, MOF, will provide a written confirmation to IDA certifying the receipt of the Pakistan rupee equivalent of the credit into the Consolidated Fund Account of the government, the date of receipt, and the exchange rate applied to translate the credit currency into Pakistan Rupees. 58

67 ANNEX 7:.. Pakistan at a g lance Country at a Glance Lower Key Development l ncncato" SO \All mwje "'po 12J P aii: 6Bn A~ nco me.llge <15trl0uton, 2012 lad«() F<I"'\R W P opu ta:b n. m D')'e.a r (m IliOn&) S".Jr'aceare ouuno~ tm) Poputa:b n qt~wl (~) U'IB'I oop,sbn (%o:totillpopublb n) G' (At~mt:"OOO.l.S$ OIDOI'I$) G' percapd (AIUrnei~O.l.S$ ) G per c:apta (PPP h!e:tnar~ionai S ) G:lP qti'm I'I(~"} G:lP petcapu gt)wli'in (mo~r Acenre~omue ) 1792 \~l D l2 t7 \3 t$ l.9 2,3!$ H10 \.260 V22 \ A t O 36 t O $ ~-: -...,..,...,...., ~ e e oet= «lei.oj~ POVel:Jile.aOcxnn: a:jo ats\2sao J{l"PP '0) PovecynoOOOU'll a:jo ats2doacny (PPP ~ lft I!J;)tcla~J all!i 11 (}tar5) n:1n1 morbitj {per 1000 Dlt lm'i6) CNkl man:.otrn~ n (%o ' en tote:'llnl er $) , l1 l6 31 J2 2t '"" A<lll ceracy. mal! ('Oo' a~ \Sa no oicier) A<lll llerac:y. ~ma r..o a~ \SanooiCiet) Gil u pl!ltnil'j enrolln n.male ~o age:qoup) G11upanaryenroonec 'e'llale ~o agegoup) ACCPSSIO an mpiivtowalet foouce (".O ' popuatlon) ACCt$610 tnproveo&~'iutb n~~ (%o:po pjbl10 n} ao to ~ 'IJ l H 39 t 1 : < n o~,...., o~~.,"'- llet Aiel FIOW6 ISSO oso {USSr:lllJOMi) 'I.e': O:JA ~0 o :!lcbl a}() t\31 TOp3tSono~ ~' 2D1J). t.ni i!osqii?& u t.nl eo Kt192om " -~pan 112 AICI(%0' G.'1) t6 Alelpettapl3 (...SS) \5 Long-Term Economic T rernu COn&U'IIe t prloe5 ~m I.W ~cnange) G:lP tnpiict Ot:li'IO r ~\Ill % Cll 9f) 91 ecl".ange ate (~tuilaveoge.joca lperuss ) 9.9 Tetm50' ~e hllex{ ) P opub!b m tl')'e.ar{m lllon&) aoo G:lP (USS mtjon5) Ag:lerJlure 295 'n<ll.:r, 2t9 t! anu!aaumg 1;.9 S4!1V1Ce5 l$6 -,GUU!IOIO ajcon&u'iip:jon t.jllenel.l:'.le 831 Gfo'ltralgov t ::rutcol'$u'iip:jon tjp~ I:J e 1J O Gllucaplal:b rna :Jon 8.5 fjp0/'$0 goooo and UIVICU 1:!.5 'mpon.o gooor. "10 u:vle:e& 2tl Gll665~9' \ 1! ;7 sa \197 $t 2t aD 20<1 2.1 to \ v \ H ~ m nn ll loolo t880 {"Of GOP) ll , Vt 1 7 l88 ~7 536 "' S f; t ll.9 1).5 13 t t2.3 23t ll t2.8 Gro w In o r GOP anci GOP per capita {%+ ]!~ --o-. C:l~ ~ o:: -- c:p o. ~.t~t oao-so oso-2ooo ji \~Qe -~n:ja/qfov.c/1,.., til l O '' 3..t " '' t3 l.9 l5 1J t \Ole.~ n U5C&ae orytar50tl'letflani~u5ptcl:ieo ~ AIICial:aae or 20'13 ::le'leiopmerc: l:co!lomic$ :::levtlop'llt'<'ll ;)aq GIIUO (OEo:>G} t' 3taiKOllla ife nouvaiji)l' 59

68 Pakistan Balanct or Paymtnh an<l Trade (USS t:'lllloiis) Total merwrki!oe expor.s od) TO!almerwJ'XIloe InDO It& (~ ~ uaoe ngooor.~ r.erv10tr as1 2l696 9E02 l 0l61 -U Qule'1aOCO(J"llDa Bnoe a;a%o G::>;> wo n:m ~em ur.ceuno co ~!':'IY: ton o: enployeu feee\016) ts tl Ctntntl Govtrnment Ft na net Co.rTt/s ~~e r ~-.: ( 010)) <t;..,.v _.. ~,~.,.~ jsoigdp) OJnen: rev!':'lue (neljclng~ts) Ta x ~ev~ue Qui! Ill flljlt"!!tjii! "'lgll!6lma~gnal:ax eee ('.") "XM:!UJI COrpol3le Exttmat OeDt 11\<1 RUO utc t F low I (USS t:'iijjoiis) TOlal ~~ 0 Jl:r.tancll"9 a"1d 0 I!.1)J IS eo Total ~t r.e u lee :>e!ll~ert ;>C. II:} 1;] tl2 61 ua S -sa TtChBOIOII'JIRO lnl ntiijuctutt Paveo roaa.s (%oaotal) 91ceo ea'lomobllepmne r.1116crbe:r.(per tlopeople) -;~gaec>no D g,o elljloc6 ~o man:tactjii!oexport5) Env ironm ent Agxu tur.tj tnl (~.o b'lllarn ) Fol!r.ta~ea('.o a'lllat~ea) Te RitlUJ pll eeaeo aren ( oo b:io am) Ot 3: $ ta 3l 2 1 1J.1 Total ~t r,.o: G::>;>) Total OPllt r.efl lee (0..0 expo U ) U fresi!waeerre-..o tkoer. percill)l a (c.~. me(e:r.) "mi!waeena~~:nnl nojllcm~m) 312 Forelglorecuves~m!':'l l (~ h:ow5) Port'ollO eqjiy (nel 1110W1>) compo~ltlon ortollltxttm al debt em&r.ion6peicapa (mt) G::>P per~n11o rltj:jf U:Se (2005PPP s pertgo o t ec.nrale,..) 07! $0 IM)JICI Gro up port!oi O (USS n Jl'OilS) :S'O T ODIC!$ O~Qa'li3tlg a'lo 015l1Urr.e0 ~.nemnr. P~alrfl)aym~r. r:cemtpa)mtl'lli 31) la2 \ Private sector oevetopmtnt :>A TOCilll1eot Ol.(6la'larlgil'lll<llitur.e0 Olsii.Jir.e'11e"C5 Toataeot r.ervlee n sao Tt!le I! QJIIeO to &~an a lhjr.l'le-oi (csa Ji) C06:~r.tuaiXJUleir.('Oo G.' oercapb) Tl'ne ecweo 10 ~er propecy (Cia :I') Rankeoaumc)orcon.:anuo 0Jr.l"eo6 roo mi:l ager& &:.I!VfjleO W'10 ageeo) na na Slocl: m acetcl!)la!iz3iichi ~O G::>P ) aa., t caplalto a;r.e~l3ll0 ~ s 4! St 00!'C~ J~ T OliiiO 61U'r.e0 a'lo OIA6lan<D'lg port'o lb Ol'l'rll:ll "COW1aOOOU"I ~..wr.emn& or "Cownaoco(J"lt Po C%1 10 'ale$.. PfePa'flle 1'16 ana _,,,m~r. or "Cownaccoun: IAGA Gror.r. r.cpor.t.re '-twguaal'llee C!>S 6H 2 tu 52 2$ 111 9$ 0 9$ Mte ~gjw. l'iu.'i:r. are ~o ryearr. otp>enrw. C'lor.e r.pecneo. l'lellcater. csata a" notavabble - h21:iller.o!j6ellilllln & not ap:~~able.. 60

69 Mi II ennium Development Goal s Pakistan 'A'th seleded tsrgetsto schieve bet.\ een 1990 end 2015,s:r.~a:e GJose-s11o <!a:estrj 'Ill. ~- 2 years) Pill, tan Goa I t: ~ rve IM rain for extreme povt rty a no malnutrllto n PovertJ neaooo ~ tta:io at$ usao;rj ppp ~o pop-jbtion) PovertJ nuooo~t r3:10 at nationalpovect e (%of po p.~aton) Shn! olnoomeo rconf>jmp~ion 10 tnepoore61 qj 1e (!o) Prevaence o lmahj:rco n ("'.o: cttllore'l ~oers ) ess r J.O 8:1 3( tD :t2l OG 309 Goll2: en5urt t~ t cn1oren are 1011 to complete pnmary 'cnooung Pl't'narJ ~?IOO i e'lciimen t (net %) PrlmarJ oompletlonr3:e ('!Oo" rew~ugegoup) seco"<<ar1 ~1'10olene~ l'lltnt(9'066 '!0) Yot.Cil l!l at"j rue ('Oo"peopleagef> ~2t) 11 $8 55 n 67 3S 11 Goat3: eliminate geootr Ol$parltJ In eoucatlon aooempower women '\a to o ~ 10 bo)$&1 plt'nar'f a no 6tool10arJ ectjcato n r. women e-np10yeo n t'le non~r.:utt.snj&eciorr-os nonagic:jtjrate:'llpioymelll} Pro ponl0no 6eatr.nell! oywomen1'1 natonatparla'llent N t S 23 GoaH: reouce un<ltr S mortality OJ two-tnlr05 L<1Cier~ monally me (per tooo) at'll monallf rale(pertoooille bllt'\6) t n66 tnm~uaon 'roportlono onf-'tearo 116 tnmunizeo ) 118 tl6 50 1! t7 59 as 71 ao Goats: reauce mate mal morta l ly Dr t nree-rourtn. Matematmona J aao (mooei!!oer.:tna:e perloo OOOilleOIIIl6) Stnll& ateenoeo tij Q IJeO neatl'l 613": r,.o total) ConlrEeptllepevatence (!.o"womenage ~'9) u o 380 $ l3 27 Goa": ~It and Dig In to rev ern trw' prno or H IV/A ID'S a 11<1 otner ma jor Cll$ euu Psn n i'iceo -.w (!.orpopubel:ln ~ f.- 9) o 1 heldenceo t\jlercutor.r. (perloo ooopeopte) 231 TJOercuiOu. ca6t0f'!tctl0n rate ('0 a1:orm6) Goat7: ~IV tne proportion o r paoplt w ttno ut 'U5 tatnadit a cceu to Dutc nttci' Accef>610 a1 m oroveo w ater6ou ~:e r..o: po p.~ra:to n) 85 Accef>6 10 tnproveo.an:a~:ton a ec~e6 r,.o popuato n) 27 "omtaea (~o 13"10aea) 3.3 Terer.:rulproteaeo areu (%ol tanoaea) til C02 etn15s DI'If> fll E'IOC percapla) o 6 G:>P per I'll o: en~rg> ur.t!(ooi'iiitarc 2005PPP S pertgolol eq"jiialerl} t ti l ti l t.2 t l l1 00 $..0 Goa t 8: Olvtlop a glodal partntrutp ror oevetopment T~1'10ne mal'lt'le6 C'et loopeople) f~o bitt pnone&~.e~roero (p er tio people) une: ur.m(pet tiopeople) "''use: old&wlllacomp;~!er ("') Eoucdon lnelcator5 1%1 '""' Mtult5 lmmunltdon (%ort1ear OICI').... :.:: tj ICT ln01ciid16(ptr 100 people),. ce :c :.: e 3.2 6U. 90 llo ~ ~.-;) a11 fc I I'ta t lldi-qtl l" CJ' f""\'e '"l ~ M CDt'C e "f o.c.,d"t O:) C ft'c'- ~bctfr;et'l o... w n -.~o:~~ 61