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1 Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Energy and Infrastructure Unit South Asia Region Document of The World Bank IMPLEMENTATION COMPLETION REPORT (SCL PPFB-P2291 PPFB-P2290) ON A LOAN IN THE AMOUNT OF US$150 MILLION TO THE GOVERNMENT OF INDIA FOR THE UTTAR PRADESH POWER SECTOR RESTRUCTURING PROJECT May 24, 2005 Report No: 32423

2 CURRENCY EQUIVALENTS (Exchange Rate Effective ) Currency Unit = Indian Rupee (Rs.) Rs. 100 = US$ 2.28 US$ 1.00 = Rs FISCAL YEAR April 1 March 31 AP AT&C CAS CIDA Discoms EBITDA EMP ERR ESMU FRP FRR FY GOI GoUP GWh IBRD ICR IPP kv kwh MU OPCS PAD QAG SP&P T&D UP UPERC UPPCL UPSEB VRS WTP ABBREVIATIONS AND ACRONYMS Andhra Pradesh Aggregate technical and commercial Country Assistance Strategy Canadian International Development Agency Distribution companies Earnings Before Interest, Taxes, Depreciation and Amortization Environmental Management Plan Economic Rate of Return Environmental and Social Management Unit Financial Restructuring Plan Financial Rate of Return Fiscal Year Government of India Government of Uttar Pradesh Gigawatt-hour International Bank for Reconstruction and Development Implementation Completion Report Independent power producers Kilovolt Kilowatt-hour Million unit (unit=1 kwh) Operations Policy and Country Services Project Appraisal Document Quality Assessment Group Social Policy and Procedures Transmission and distribution Uttar Pradesh Uttar Pradesh Electricity Regulatory Commission Uttar Pradesh Power Corporation, Ltd. Uttar Pradesh State Electricity Board Voluntary Retirement Scheme Willingness to Pay Vice President: Country Director Sector Manager Task Team Leader/Task Manager: Praful C. Patel Michael F. Carter Penelope Brook Pedro E. Sanchez

3 INDIA UTTAR PRADESH POWER SECTOR RESTRUCTURING PROJECT CONTENTS Page No. 1. Project Data 1 2. Principal Performance Ratings 4 3. Assessment of Development Objective and Design, and of Quality at Entry 4 4. Achievement of Objective and Outputs 8 5. Major Factors Affecting Implementation and Outcome Sustainability Bank and Borrower Performance Lessons Learned Partner Comments Additional Information 25 Annex 1. Key Performance Indicators/Log Frame Matrix 26 Annex 2. Project Costs and Financing 27 Annex 3. Economic Costs and Benefits 29 Annex 4. Bank Inputs 38 Annex 5. Ratings for Achievement of Objectives/Outputs of Components 40 Annex 6. Ratings of Bank and Borrower Performance 41 Annex 7. List of Supporting Documents 42 Annex 8. Financial Overview of the Power Sector 43

4 Project ID: P Team Leader: Pedro E. Sanchez Project Name: UTTAR PRADESH POWER SECTOR RESTRUCTURING PROJECT TL Unit: SASEI ICR Type: Core ICR Report Date: May 24, Project Data Name: UTTAR PRADESH POWER SECTOR RESTRUCTURING PROJECT L/C/TF Number: SCL-45450; PPFB-P2291; PPFB-P2290 Country/Department: INDIA Region: South Asia Regional Office Sector/subsector: Power (97%); Other social services (3%) Theme: State enterprise/bank restructuring and privatization (P); Regulation and competition policy (P); Infrastructure services for private sector development (P); Pollution management and environmental health (S); Participation and civic engagement (S) KEY DATES Original Revised/Actual PCD: 11/02/1999 Effective: 08/11/ /11/2000 Appraisal: 11/11/1999 MTR: 10/01/ /01/2002 Approval: 04/25/2000 Closing: 12/31/ /31/2004 Borrower/Implementing Agency: Other Partners: GOVERNMENT OF INDIA/UTTAR PRADESH POWER CORPORATION LTD. (UPPCL) STAFF Current At Appraisal Vice President: Praful C. Patel Mieko Nishimizu Country Director: Michael F. Carter Edwin R. Lim Sector Manager/Director: Penelope J. Brook Alastair J. McKechnie Team Leader at ICR: Pedro E. Sanchez Mohinder Gulati ICR Primary Author: Michael Haney 1.1 The State of Uttar Pradesh, with a population of 166 million, is India s largest state and one of its poorest. In terms of human development indicators, it ranks among the least developed states in the country. While only 20% of the rural population has access to electricity, agriculture accounts for some 42% of Gross State Domestic Product and 75% of employment in the state. These basic facts about Uttar Pradesh are important determinants of the dynamics of power sector reforms in the state. 1.2 The World Bank first provided support to the development of the power sector in Uttar Pradesh (UP) through the Uttar Pradesh Power Project, approved by the Bank's Board of Executive Directors in 1988 in the amount of US$350 million; most of this amount was eventually cancelled. In the decade that followed, various initiatives in support of power sector reform were started but no substantive progress was made due to the political instability arising from frequent changes of government and the lack of support for reform. In late 1997, a reformist government took office. Acknowledging the deep fiscal crisis and economic stagnation in which the state found itself, the new government invited the Bank to collaborate in the formulation and implementation of a broad-based program of economic reform.

5 1.3 These developments in UP coincided with the elaboration of the Bank s 1998 Country Assistance Strategy that identified support to reforming states as a central component of the Bank s assistance to India. Given Uttar Pradesh s size and disproportionately high level of poverty (it has been estimated that 8% of the world s poor live in UP, while the state s population is less than 3% of total world population), the prevailing view at the time was that the state government s renewed reform focus represented an opportunity for poverty reduction with global implications. The Bank responded to this opportunity with a multifaceted program of technical advice and financial support. 1.4 The power sector enjoyed a prominence in the overall policy dialogue between Uttar Pradesh and the Bank in view of its significant fiscal impact as well as important role in economic development. A Bank economic report, India-Uttar Pradesh: From Fiscal Crisis to Renewed Growth (November 1998), identified three factors as obstacles to growth and poverty reduction in Uttar Pradesh: (i) inadequate infrastructure in general, and in particular shortages and unreliability in power supply, with the attendant adverse effects on investment and growth in agriculture and industry; (ii) poor development of human resources, the result of years of inadequate and ineffective spending on education and health; and (iii) a decline in the quality of governance that raised transaction costs throughout the economy and negatively affected the perceptions of businesses and external donors of the desirability of investing in the future of Uttar Pradesh. It is of note that the power sector has linkages to all three of these factors that stifled economic growth and frustrated efforts at poverty reduction in UP. In the case of the first and third factors, the relationship is direct; in the case of the second factor, the relationship is indirect but indisputable, as the significant fiscal resources consumed by the power sector were obviously not available to finance expenditures on health and education. 1.5 The Uttar Pradesh Power Sector Restructuring Project was developed as an integral part of a larger package of Bank assistance to UP that included the Uttar Pradesh Fiscal Reform & Public Sector Restructuring Loan/Credit (Loan/Credit No. SCL-45460/IDA-33410), which was designed to address the fiscal impact of power sector reforms (among others) through support to a medium-term fiscal framework. The investment project (the subject of this ICR), which was presented to the Bank s Board of Executive Directors together with the adjustment operation, was designed to complement the broad fiscal reform efforts through specific investments in the context of a sector reform program (based in part on the experiences of other states that were reforming their power sectors with World Bank support, Orissa, Haryana and Andhra Pradesh). Both operations sought to support the transformation of the power sector from a significant burden on the state budget and a constraint to economic development to a net contributor to the state s budget and economy. 1.6 As detailed in the Project Appraisal Document (PAD), GoUP had demonstrated its willingness to take difficult decisions and implement power sector reform through a number of actions: (i) a regulatory commission was established in September 1998; (ii) in January 1999, GoUP issued a power sector policy statement; (iii) the UP Electricity Reform Bill was enacted by GoUP in July 1999; and (iv) in January 2000, the UP State Electricity Board (UPSEB) was functionally separated into three companies: a thermal generation company, a hydropower company, and a single company combining the transmission and distribution systems (UP Power Corporation Limited, or UPPCL). It was expected that UPPCL would soon be further unbundled into separate companies for transmission and distribution, and that some part (perhaps all) of the distribution system would imminently be offered for sale to the private sector. These were necessary, difficult first steps that called for the demonstration of steadfast political will. The mere declaration of GoUP s intention to reform UPSEB provoked a strike by power sector employees in 1999 and again in January 2000 that attracted sympathy demonstrations by power sector employees in many states across the country. With widespread public support for the proposed reforms and consensus across the political spectrum, the Government of India and GoUP were able to resolve these strikes and maintain - 2 -

6 the momentum of the reform program. 1.7 GoUP also prepared a provisional Financial Restructuring Plan (FRP) for the power sector in 1999 which sought to address the financial problems of the sector and restore its creditworthiness over several years through a number of mechanisms: (i) cleaning-up of the UPSEB balance sheet and preparation of the provisional opening balance sheets of the successor entities; (ii) budget and other forms of support in the transition period; and (iii) debt rescheduling and large-scale debt write-off. (See Annex 8 for details on the financial standing of the sector.) In March 2000 (i.e. before the presentation of the project to the Bank s Board of Executive Directors), in a letter to the Bank GoUP stated its intention to allocate almost Rs 25 billion to the power sector during that year, which was a controversial decision that, in the event, was not implemented. 1.8 Following project effectiveness in August 2000, the implementation of the reform program diverged from the agreed schedule almost immediately. In the first year of project implementation, the financing that GoUP provided to UPPCL was not in keeping with the commitments it had assumed and which were important in securing the Bank s support. Some of GoUP s actions during that period contradicted its stated goals for the reform of the power sector. For example, GoUP s decision to provide escrows on the revenues of the distribution system to the benefit of independent power producers (IPPs) who were expected to play an important role in the state s ambitious generation expansion plan (which in the event did not materialize), was inconsistent with its policy of attracting the private sector to the distribution business. 1.9 While the implementation of the physical investments financed under the loan proceeded in a generally satisfactory fashion, the implementation of the sector reform program suffered from numerous problems that worsened over time. In January 2003, the Bank suspended disbursements under the loan due to non-compliance by GoUP and UPPCL with numerous covenants under the Loan Agreement and the corresponding Project Agreements, including in particular those pertaining to: (i) payment of compensation to individuals affected by the project, and submission of audit reports; (ii) provision of adequate financial support by GoUP to the power sector; (iii) finalization of a satisfactory financial restructuring plan (which was necessary to provide clean balance sheets to the successor entities); and (iv) the establishment of distribution companies as entities separate from the transmission company. Suspension was lifted in August 2003, upon completion of actions that were deemed sufficient to remedy these deficiencies, including a revised FRP under which GoUP assumed additional liabilities from the power sector and creation of four distribution companies Shortly following the lifting of the suspension, a new state government came to office in September The new government (apart from announcing a new power policy calling for increased private participation in the sector) mandated an increase in the power supply to the rural areas from 8 to 14 hours a day, considering this increase essential to support irrigation as well as for general social purposes. In the absence of adequate compensation from the state budget, this decision by GoUP aggravated the utility's already precarious financial condition as power for rural consumers is sold at a tariff far below the actual cost of supply. Citing this reason as well as a deterioration in the project's key performance indicators and an increase in the number of unmet covenants, the Bank downgraded the project s development objective rating to Unsatisfactory and the loan closed with this rating in December The Implementation Progress rating was Satisfactory throughout project implementation. The effective period of project implementation that is, not counting the seven months during which disbursements were suspended was less than four years; despite this constraint, disbursements effected under the project represented 97% of the loan amount

7 2. Principal Performance Ratings (HS=Highly Satisfactory, S=Satisfactory, U=Unsatisfactory, HL=Highly Likely, L=Likely, UN=Unlikely, HUN=Highly Unlikely, HU=Highly Unsatisfactory, H=High, SU=Substantial, M=Modest, N=Negligible) Outcome: Sustainability: Institutional Development Impact: Bank Performance: Borrower Performance: U UN M S U QAG (if available) Quality at Entry: Project at Risk at Any Time: Yes ICR U 3. Assessment of Development Objective and Design, and of Quality at Entry 3.1 Original Objective: The development objectives of the project as defined in the PAD were: (i) to support the initiation of the power sector reform process through the establishment of the new legal, regulatory and institutional framework; the creation of new power corporations; and the launch of the preparatory work for the privatization of the distribution business; (ii) to reduce the most critical constraints in the power system to help improve the quality of supply and establish the benefits that could be expected from power sector reform; and (iii) to build and develop support among key stakeholders in the state for power sector reform. The key performance indicators associated with these development objectives were (in summary): existence of a fully functional regulator; incorporation of new distribution companies; comprehensive distribution privatization strategy approved by GoUP; Financial Restructuring Plan under satisfactory implementation, with adequate financing as required by GoUP; tariff adjustments as required for meeting the financial objectives permitted by the regulator and implemented; specified time-bound levels of improvement in bill collection from Government and non-government consumers; specified targets for increasing the number of consumers billed on basis of metered consumption in Lucknow and Ghaziabad; specified target for reduction in forced interruptions in the distribution system; specified time-bound targets for UPPCL s return on equity; and continued communications on reform program Assessment. An overview of the general economic, political and social context in which this project was developed is given in the Introduction. The centrality of power sector reform to economic development in India is universally accepted. In the case of Uttar Pradesh, the relevance of power sector restructuring was heightened by the sector s significant negative fiscal impact and by the degree to which the sector posed a real constraint to economic development (through frequent brown-outs and black-outs, voltage fluctuations that burn out motors, load-shedding, exceptionally high levels of technical and commercial losses that drained financing from the budget and from industrial consumers through cross-subsidization, etc.). Reform of the power sector was, and remains, a matter of the highest priority for Uttar Pradesh and, on the national level, for the Government of India

8 3.1.2 The project was consistent with the focus in the Bank s Country Assistance Strategy on reforming states, and with the sector-related goal of reducing infrastructure bottlenecks. In their broad formulations, the project development objectives were relevant and comprehensive, covering general sector reform as well as the physical investments designed to further the implementation of the sector reforms. One might question whether the third development objective (to build and develop support among key stakeholders in the state for power sector reform) is a development objective per se, or more appropriately seen as a good practice that is subordinate to the first development objective (to support the reform program). However, for purposes of the present assessment the distinction is ultimately immaterial, and the assumption is made that in presenting this issue as a separate development objective, the project team made a conscious decision to stress the importance of this activity. It may be observed that the key performance indicators reflected aspirations for far-reaching, overall improvements in the sector and in this sense extended the reform ambitions of the project beyond those embodied in the project development objectives, which is a design consideration that proved problematic at the stage of implementation (see discussion below of quality at entry). If the reform objectives were ambitious, this was at least in part a reflection of broad expectations about the potential for reform shared at the time by the Bank and the reforming states. 3.2 Revised Objective: Project objectives were not revised. 3.3 Original Components: Project Component 1: Transmission System Rehabilitation and Augmentation (US$83 million, or 38% of the project s $220 million base cost). This component was designed to reduce transmission system bottlenecks and the associated losses by adding strategically placed transmission lines and increasing the number and capacity of substations. Based on load flow studies carried out for the projected system conditions in , sub-components were identified that included 400kV, 220kV and 132kV transmission lines and substations, and capacitors Project Component 2: Sub-Transmission and Distribution System Strengthening (US$66 million, 30% of base cost). Distribution investments financed under the project focused on the improvement of 33kV lines and 33/11kV substations across the state and critically overloaded city distribution systems. The allocation for this project component was divided between a subcomponent for the improvement of the distribution system in the capital city of Lucknow and a subcomponent for improvement of the most overloaded parts of the distribution system (33kV and below) elsewhere in the state Project Component 3: Metering System Improvement (US$58 million, 26% of base cost). The metering improvement works financed under the Bank loan included (in the original plan) replacement of 15,000 trivector meters; 470,000 single phase meters for all the residential consumers of Lucknow and Ghaziabad; and 300,000 three-phase electronic meters for high-value industrial, commercial and residential consumers throughout the state. The component also provided for the procurement of boundary meters for measurement of energy exchange between the new companies Project Component 4: Technical assistance (US$8 million, 4% of base cost). Of the total amount allocated to this component, US$3 million was set off against a Project Preparation Facility already used by UP, leaving US$5 million to finance technical assistance in the areas of restructuring implementation; regulatory and legal framework; power purchase agreements; load forecast and investment planning; environmental and social policy; joint venture distribution companies; and communications Project Component 5: Voluntary Retirement Scheme (US$5 million, 2% of base cost). This component was designed to provide financing for severance payments to workers who elected not to - 5 -

9 continue their employment in UPSEB successor companies. The Voluntary Retirement Scheme (VRS) had not been developed at the time of project appraisal but the expectation was that a VRS acceptable to the concerned parties and consistent with Bank policy would be developed in the course of project implementation and that there would be a demand for these funds Assessment. The project components are consistent with the project development objectives, if somewhat obviously and understandably biased towards the physical investments representing the bulk of loan proceeds. The focus on transmission and distribution rehabilitation was appropriate given the high level of technical losses in transmission and distribution. The decision to build all new transmission lines with double circuit support to provide second circuit support in the future as and when needed was a foresightful and economical response to the acute problem of obtaining rights of way in this most densely populated state The metering component was a sound investment choice; metering is a fundamental part of any power system s commercial infrastructure. More emphasis could have been put on addressing the significant problem of rural metering (which would have provided an important link with the third development objective). At the same time, in view of the extremely low level of metering (it was estimated that about 55% of total consumption was un-metered before the project and a large portion of existing meters was defective), it is clear that improvement of the situation in the urban areas was also an urgent priority for UPPCL and a more pragmatic starting point The technical assistance component was designed to support the reform program in its many aspects and was the most appropriate vehicle for such in the context of an investment loan. It is another question, however, whether a reform program of the ambitious scope of the present case can be adequately supported by a technical assistance project component with a small allocation The inclusion of the Voluntary Retirement Scheme as a project component was a good choice to facilitate the use of Bank funds to finance severance (on occasion this has been a complicated matter in other projects) and also sent a positive signal to counterparts in UP about the importance of agreeing with the power sector work force acceptable terms for voluntary retirement. 3.4 Revised Components: There was no formal revision of the project components. 3.5 Quality at Entry: The project was not reviewed by QAG for quality at entry. There are numerous positive aspects of the project preparation process that merit mention here. The PAD presents a comprehensive overview of the UP power sector at the time of appraisal. The project team had a solid grasp of the issues confronting the power sector in general and UP in particular, the result of long experience in the country and sector. Adequate arrangements were made for project implementation by the time of appraisal, including the creation of a separate project management unit to manage the investments planned under the project. Procurement arrangements were handled well, which allowed the implementation of the physical investments to stay on track despite the otherwise problematic course of project implementation. Bank safeguard policies were also adequately addressed (see para ff) At the same time, the project design included flaws that dogged the project throughout its implementation and largely influenced the unsatisfactory progress towards the achievement of the project development objectives. The most fundamental observation in this regard is that the inclusion of a highly - 6 -

10 ambitious reform component in what was essentially a loan for physical investments (from the perspective of the allocation of funds) was a poor project design decision, as it introduced a tension into the project design that persisted throughout the course of project implementation. It is appropriate to evaluate this fundamental project design decision in the broader context within the Bank in which it was made. The inclusion of ambitious reform objectives in an investment loan was considered best practice in the period during which this project was developed; indeed, a power sector reform project proposed in this period most likely would not have received sectoral endorsement if it lacked a major reform component. From this perspective, this design flaw is more appropriately viewed as a Bank-wide failure in advocating a particular model of project rather than as a design shortcoming that is specific to this project However, the project design also included flaws that are specific to the project itself and that warrant a quality-at-entry rating of unsatisfactory. Primary among these is the incongruity of the project development objectives as formulated and the key performance indicators (KPIs) and the related covenants that were used to interpret or measure the progress towards achievement of the project development objectives. Second, the KPIs and related covenants imposed conditions that were not adequately supported on the level of the project components, leaving the borrower accountable for performance in these areas without providing the resources to improve performance With respect to the first of the identified project-specific design flaws, it may be noted that the first development objective, which calls for support to the initiation of the reform process with an emphasis on institutional reforms, does not call for the financial rehabilitation of the sector. But the corresponding KPIs and covenants give prominence to this subject and, indeed, the poor state of the sector s finances overshadowed the project s implementation and was the chief determinant of the DO rating of Unsatisfactory with which the project closed. Without the additional overlay of these conditions that are not embodied in the project development objectives, the likelihood of a DO rating of Satisfactory would have been greatly enhanced. The problem of correspondence also exists between the second DO (representing the overwhelming bulk of loan proceeds) and the KPIs, but is of a somewhat different nature. In this case the KPIs do not adequately allow for an unambiguous demonstration of the reduction of the most critical constraints in the power system that is called for under this DO. And there is no meaningful performance indicator that captures the third development objective (developing support for power sector reform among key stakeholders) The number (51) of the project s legal covenants was excessive and made for difficulties in monitoring and reporting in the course of project implementation. Recognizing that today s prevailing view in favor of streamlining of conditions was not the prevailing view at the time of project preparation, it still appears that more effort could have been made to limit the number of covenants to a more manageable number An important aspect of quality at entry is the assessment made at appraisal of the Borrower s "reform readiness" and commitment to see through controversial, socially sensitive reforms requiring a long period of implementation. While this assessment is necessarily speculative, as Bank staff are outside observers of political processes (which in any event are notoriously difficult to predict in India s vibrant democracy), a degree of robustness can be brought to the design process through a systematic evaluation of project risks and development of associated mitigation measures. In this case, the treatment of project risks and associated mitigation measures could have been stronger. The project was given an overall risk rating of "Substantial", while a rating of "High" would have been more appropriate given the nature of the challenge posed by power sector restructuring in UP. Some important specific risks were given somewhat facile treatment in the PAD, as reflected in the claim that "the reform process has become irreversible" in response to the risk that political commitment might erode. A more thoughtful, realistic assessment of the - 7 -

11 risks could have informed the process of project design and helped avoid some of the difficulties of implementation through presenting options other than the extreme case of suspension of disbursements (e.g. phasing of investment packages against benchmarks) as a "last resort" measure Of note in this regard is the assessment of GoUP s willingness and ability to provide a high level of subsidization to the utility, as stated in a letter to the Bank before the presentation of the project to the Bank s Board of Executive Directors. Consultations carried out in the course of the preparation of the ICR indicated that the Bank s country economists who prepared and managed the Uttar Pradesh Fiscal Reform & Public Sector Restructuring Loan/Credit were concerned that the original agreement on the high level of subsidies to finance the losses of the power sector was unrealistic, unaffordable and failed to provide an incentive for the utility to reduce losses. This raises the question of the consistency of the policy prescriptions of the respective Bank teams and at a minimum suggests that considerably more caution should have been used in assessing GoUP s ability to commit large-scale financing to the power sector. In the event, the actual level of subsidies provided to the utility was much lower than stated in the letter to the Bank. 4. Achievement of Objective and Outputs 4.1 Outcome/achievement of objective: Overall, unsatisfactory, due to inconsistent implementation of the power sector reform program across the range of key power sector entities and the continued use of the sector as a vehicle to achieve social and political ends without due consideration for the sector's viability. This has been a significant factor in prolonging the sector s suboptimal performance and compromises the sustainability of such restructuring of the sector as has taken place. While nominally some aspects of the development objectives were achieved, most of the project's key performance indicators have not been achieved (see Annex 1). The financial condition of the sector is persistently grave, and this condition of chronic crisis comes at a high opportunity cost to the impoverished state. At the same time, the difficulty of distilling a single outcome rating (moreover, on a scale limited to four points) from the complex, multifaceted experience of the implementation of this project must be noted. There is a divergence between the satisfactory outcome of the implementation of the physical investments and the outcomes of the reform program as supported by the loan. Also, the problem of the appropriate time period for the evaluation exists. It is generally possible to meaningfully evaluate physical investments shortly after they are rendered operational, particularly those that are upstream, such as transmission lines, are not sensitive to institutional arrangements and do not entail a customer interface. In contrast, complex reforms that entail fundamental institutional reform necessarily require a longer period for meaningful evaluation. For purposes of this assessment, the decision was made to assign a greater weight to the poor results to date achieved under the reform program in view of the hierarchy of the relationship between the policy environment and the sustainability of physical investments: the value of sound investments is clearly compromised by a suboptimal policy environment and the sector's chronic financial crisis Development Objective 1 (to support the initiation of the power sector reform process through the establishment of the new legal, regulatory and institutional framework; the creation of new power corporations; and the launch of the preparatory work for the privatization of the distribution business): Unsatisfactory. In broad strokes, the core problems of the power sector in UP remain today what they were at the time of project appraisal. In analyzing the poor performance of the UP power sector, the PAD noted that the root causes of these chronic problems are the pervasive interference by the Government in most decisions affecting UPSEB s operations and expansion, the lack of a commercial orientation, and the absence of adequate internal controls, accountability and modern utility management practices in UPSEB. While power sector reforms have yielded some achievements in specific areas, this analysis remains - 8 -

12 broadly applicable today The experience of the last several years has demonstrated the enormous difficulty of maintaining momentum with the reform program against the backdrop of a number of changes of government (including a period of central rule, when no representative government could be formed in the state). Perhaps even more harmful to the continuity of the implementation of the reform program has been the failure to bring in a new management team at functional levels to ensure the rapid re-orientation of the working culture in the power sector enterprises, although the hiring of some professional managers of high caliber must be acknowledged The institutional transformation of the sector is an unfinished work. A technically competent regulatory agency has been functioning for several years, but its ability to induce efficiency improvements in the sector through the tools at its disposal (tariff orders, directives, etc.) is neutralized by the politicization of the sector and the related issue of the utility s persistent operational deficiencies. And while the de jure unbundling of the vertical monopoly has led to the creation of separate corporate entities in generation, transmission and distribution, the de facto relations between the various successor entities, to the extent that they are observable, are in no material way different from those that prevailed in the vertically bundled utility. The transmission company retains the authority of the erstwhile UPSEB and directly controls the distribution companies. The two state generators provide power to the transmission company and, when necessary, serve as a financial buffer by allowing the accumulation of arrears for power delivered. This financial flexibility offered by (or extracted from) the state generators which is generally not the conduct of commercially oriented enterprises, and has impacted on the generators ability to operate and maintain plant in accordance with industry standards is particularly important to GoUP and UPPCL now that state utilities' debts to the central generating stations have entered the domain of the fiscal relations between the central and state governments This development objective calls for the launch of the "preparatory work for the privatization of the distribution business", and the relevant performance indicator is the approval of a comprehensive distribution privatization strategy including the optimum configuration of system. In 2003, GoUP issued a new Power Policy calling for private participation in the power sector under which the government initiated the process of inviting private participation in the generation and distribution segments of the sector. In November, 2004, GoUP solicited expressions of interest for the privatization of the distribution system without having developed a comprehensive distribution privatization strategy. Subsequently, there has been no progress in this matter (e.g. the request for proposals containing the proposed privatization transaction structure has not been issued as of May 2005) and there is lack of clarity on how and when the process will go forward Data on the aggregate revenues and expenditures of the distribution and transmission companies over the period illustrate the severity of the sector s financial condition. UPPCL Profit/Loss Statement, (Rs. billion) FY ending March (Prov.) (i) Total Revenue (ii) Total Cash Operating Expenditure (iii) Surplus (deficit) after cash operating expenditures (EBITDA) (i-ii) (iv) Profit (loss) after tax (v) Subsidies and grants (vi) Incentive from central power utilities n.a (Est.) - 9 -

13 4.1.7 The sector continues to report very large losses that are not adequately covered by the subsidies provided by the State. This bleak financial picture represents the failure of the efforts to bring performance indicators into line with the agreed targets (variations exist in the targets agreed between the Bank and GoUP and those agreed between the utility and the regulator, but the general experience is the same). In the context of the support provided by the Bank, a pivotal role in the restoration of financial health to the restructured sector and, more generally, in advancing the reform of the sector was assigned to successive Financial Restructuring Plans (FRP), satisfactory implementation of which was a key performance indicator (which was not achieved). The specific purpose of the FRP was to provide clean opening balance sheets to the entities that succeeded UPSEB and to put forward detailed operating and financial projections for the successor entities that would, in turn, determine GoUP s financing commitments to the sector through the period of restructuring. The estimates for the required financing commitments in the various versions of the FRP were driven by assumptions concerning such core operational issues as reductions in technical and commercial losses, tariff increases, demand growth projections, and so on. In actual experience, the assumptions made in the FRPs diverged significantly from the operating performance of the sector, actual tariff increases, and the level of subsidization provided by GoUP. These shortcomings manifested themselves in terms of chronic non-compliance with numerous legal covenants, in particular those pertaining to the sector s financial sustainability (levels of receivables, cost recovery and return on equity). The dramatic rise in the utility's debt as a percentage of its turnover underscores the unsustainable nature of this situation: from 45% in FY2001, this indicator rose to an estimated 70% in FY Data on technical and commercial losses (which taken together give aggregate technical and commercial (AT&C) losses) provide the operational complement to the financial data: FY02 FY03 FY04 Target Actual Target Actual Target Actual T&D Technical Losses Collection Efficiency (%) AT&C Losses (%) Source: UPERC, Petition No. 183 of 2004 (Final Tariff Order for FY05, November 10, 2004) The targets given in the above table are those stipulated by the regulator in the multiyear framework of loss reduction targets that was introduced in The data suggest a general trend towards improvement (the improvement in collections from government offices is of particular note, although ultimately a small factor in the determination of overall collection efficiency), but they also show loss levels that remain very high even in FY Concerning tariffs and tariff policy, a few observations are of note. While the Power Sector Policy Statement by GoUP that was included in the PAD stated that the regulator would set tariffs to allow cost recovery, progress towards this goal has been minimal, with the attendant consequences for the sector s financial performance. The initial FRP projected tariff revisions in the range of 10-12% annually, but the actual tariff adjustments have been much lower (3% in FY01, 1.7% in FY02, 3% in FY03, 1.7% in FY04 and 2.7% in FY05). The underlying reasons for this include delayed filings with UPERC as well as the low adjustments approved. The inadequate tariff revisions have resulted in a higher than projected cash gap, leading to problems in debt service and to payments to power and fuel suppliers. Also, high levels of cross-subsidization continue, although the regulator is attempting to gradually phase these out in keeping with the Electricity Act, 2003 (i.e. the driver in this process is national legislation, not state policy)

14 Looking forward, there may be a negative impact on sector s finances in the short to medium term as a result of the open access provision of the Electricity Act (2003), as it is likely that some industrial consumers will move away from the grid or from the state sector suppliers to obtain cheaper supplies. Also the recent massive program for rural electrification launched by GoI aimed at providing electricity to all un-electrified villages and households in the next five years will have significant financial consequences for the power utilities and the state given that at present only 20% of rural households in UP have access to electricity and the rural tariffs are well below cost-recovery levels Development Objective 2 (to reduce the most critical constraints in the power system to help improve the quality of supply and establish the benefits that could be expected from power sector reform): Satisfactory. A load flow study of the transmission network that was carried out in early 2005 estimated a reduction in transmission system losses resulting from the Bank-financed investments equivalent to about 46 MW, which corresponds to an ERR of 30% for the transmission component, which is a satisfactory result and consistent with the component estimate made at appraisal. (Reference: Evaluation of World Bank Funded Transmission Projects, prepared by the CIDA-financed Energy Infrastructure Services Project-II and UPPCL, March 2005.) The same study also examined the investment package for the capital Lucknow, and found a significant reduction in overloaded lines and transformers in the Lucknow area. It was also found that the voltage profile in the Lucknow area had improved considerably because of the additional substations and lines Development Objective 3 (to build and develop support among key stakeholders in the state for power sector reform): Unsatisfactory. The information that was available for this assessment reveals relatively little emphasis during project implementation on the need to develop support for reforms among key stakeholders aside from the occasional general reference to this subject. While the PAD describes already completed communication campaigns and the Government s intentions at the time to engage advisors specializing in social marketing, there does not appear to have been a systematic approach to consultations with key stakeholders that, if handled effectively, could have made a crucial difference in public perceptions of the power sector reform program and, in turn, in the Government s own perceptions of what was politically feasible. Given the political weight of rural Uttar Pradesh and the perception of its significance in determining the dynamics of power sector reform, any serious effort at building support for reforms would have to be based on agreeing (in the broad, not formal, sense of the word) with rural consumers of power a socially and politically acceptable quid pro quo, e.g. increased tariffs and commitment to pay bills according to a meter in return for increased reliability of power supply. Farmers should be interested in such an approach, as the real cost of power to them is far greater than the low tariffs they pay: motors burnt-out from voltage fluctuations and unpredictability of supply take a heavy toll on the farmer who relies on irrigation pumps. The actual experience of power sector reforms clearly indicates that the problem of agricultural power consumption has not been embraced as central to the reform of the power sector. Little has changed in this regard. 4.2 Outputs by components: The implementation of the first three project components (investments in transmission, distribution and metering) is considered Highly Satisfactory. Investments generally proceeded as planned and, as noted above, despite the 7-month period of suspension of disbursements, 97% of the loan amount was disbursed. A physical audit of the Bank-financed investments was carried out by ASCI Hyderabad and the general finding was that installation of the investments was satisfactory. (Reference: UPPCL: Independent Appraisal of Project Management and Reform Programme of UP Power Sector Restructuring Project, Final Report, ASCI Hyderabad, April 2005.) Savings under the project allowed for additional procurement of meters so that actual procurement of single-phase meters was 1,000,500 (versus 470,000 planned) and

15 the procurement with loan proceeds of three-phase meters was 435,000 (versus 300,000 planned). Moreover, in the last year UPPCL has launched a hand-held metering initiative, entailing out-sourcing of metering, billing and collection activities, to maximize the benefit from the increased level of metering. As of October 2004, the initiative was underway in five towns, contracts had been awarded for another nine towns, and tenders invited for seven more towns in UP The implementation of Project Component 4, Technical Assistance, is considered Unsatisfactory in view of the low impact of the technical assistance that was procured under the loan. Reflecting the delays in the implementation of the reform program, disbursements under this component were poor (54% of the total allocation). The outcome under Project Component 5, Voluntary Retirement Scheme, is also considered Unsatisfactory due to the failure to develop a scheme and to use financing that was available under this component to facilitate the rationalization of the work force through voluntary retirement. The problems of over-staffing and the poor skills mix of the existing workforce remain acute. 4.3 Net Present Value/Economic rate of return: This is the fourth Bank project in support of state-level power sector restructuring projects for which ICRs have been prepared (the others being Haryana, Andhra Pradesh (AP) and Orissa). In the AP ICR, the estimation of project benefits could be precise, because detailed benefit evaluation studies had been done at appraisal, as well as at the end of the project, for all three components of the project. In Orissa, no benefit studies were available, and therefore the ICR economic analysis relied on an estimate of returns based on an assessment of the incremental cost and benefits streams derived from the aggregate financial statements (for the consolidated distribution and transmission businesses created in the unbundling). In UP, the only component for which a specific benefit estimate was available is transmission. Therefore for this component alone benefits were estimated using the standard approach, while for the investment program as a whole, the incremental approach was required At appraisal, the overall economic rate of return for the investments to be financed by the project was estimated at 29%, with estimates for the individual project components as detailed in the table below. Based on the best available information and an assessment of the incremental cost and benefit streams of the consolidated transmission and distribution businesses of UPPCL, the ICR estimates the baseline ERR of the overall investment program at 18%. Including a very conservative estimate of the economic benefits of pilferage (and/or defective meters) increases the ERR to 25%. Based on the load flow study of the transmission network that was carried out in early 2005, the ERR for the transmission component has been estimated at 30%, which is a satisfactory result and consistent with the component estimate made at appraisal. Economic rate of return Appraisal ICR Transmission 25% 30% Distribution 26% Metering 36% Total 29% 18-25% The difference in the overall ERR estimated at appraisal and the analogous estimate for the ICR is accounted for primarily by a lower assumed willingness-to-pay in the analysis carried out for the ICR. Details on the economic analysis carried out for the ICR are given in Annex

16 4.4 Financial rate of return: As shown in the table below, the overall financial return estimated at appraisal was 33%. The high financial returns projected for the metering component is consistent with the results of a detailed survey conducted for the Andhra Pradesh ICR (which estimated financial returns on the metering component at over 100%, reflecting significant increases in billing and collections within 6 months of the installation of new meters), while the modest financial returns anticipated for distribution and transmission is a consequence of the assumption that incremental energy would be sold at the average tariff (which includes a substantial portion of power sold at far below cost to agriculture). In the case of UP, the financial rate of return of the completed project has been estimated at 20%, which is significantly below the appraisal estimate of 33%. This result is highly sensitive to collection efficiency; a small improvement in the collection efficiency would result in a significant improvement in the FIRR. Financial rate of return Appraisal ICR Transmission 10% Distribution 9% Metering 86% Total 33% 20% Details on the financial analysis carried out for the ICR are given in Annex Institutional development impact: Support to the process of institutional reform was central to the project and included in the first development objective. While some formal (de jure) attributes of institutional change were effected earlier on in the process most obviously, the unbundling of UPSEB into separate generating companies and a company combining transmission and distribution the de facto reality is that the power system as a whole still functions broadly along the lines of UPSEB and remains vulnerable to political interference in its operations. In their present constellation, the power sector entities in UP are legally separate but not yet acting entirely as commercially-oriented enterprises In the years following its creation in 1998, UPERC has established itself as a competent regulatory agency that has embraced its mandate to safeguard the public interest while encouraging the utility to undertake efficiency improvements. UPERC plays an important role in carrying out the responsibilities conferred upon it by such recent national legislation as the Electricity Act, 2003 (which calls for the introduction of an open access regime and elimination of cross-subsidies, among other reforms). At the same time, the limitations on UPERC s ability to influence the utility s operations are clear; each UPERC tariff order devotes a chapter to the various entities compliance with its directives, and the degree of non-compliance is often significant While the institutional development impact of the support offered under the loan is limited from today s perspective, it is important to keep in mind that even narrowly de jure institutional reforms such as the creation of legally separate distribution companies (one of the positive results that emerged from the temporary suspension of disbursements under the loan) may, under future conditions, prove to be the all-important first steps towards establishing a truly commercially-oriented sector. These are long-term, difficult processes that cannot be fully instituted over a project implementation period of less than four years