Conference on Distribution Reforms
October 12-13, 2001, New Delhi

Address by Edwin R. Lim, Country Director, The World Bank

I would like to thank FICCI and the Ministry of Power for this opportunity to speak, and, indeed, for organizing this Forum. As well as the other conferences being organized by the Ministry of Power with the partnership of the French Government, this Forum is an important opportunity for all of us to learn from experiences in India and abroad. Both the organizers and the sponsors of these forums are congratulated for taking these initiatives.

It is opportune that we are focusing on distribution reforms today. Distribution is where money from the rest of the economy flows into the power sector. Unless these flows are increased, the power sector will never be sustainable.
My remarks are in four parts:

• the urgent need for reforms in the power sector;
  
• key elements of distribution reforms, drawing on lessons from experiences in India and abroad;
  
• the critical role of the Government of India; and
  
• possible support the World Bank Group can provide.
  

Need for Reforms

I am sure that everyone in this room is convinced of the need for reforms. Nevertheless, it is worth reminding ourselves of the magnitude of the problem India is facing in the power sector.

In 1992-93, the total financial losses of the power sector came to Rs.4,600 crore, itself a huge sum. In just three years, these losses doubled. Three years later, they'd doubled again. Today, combined state utility financial losses are estimated at Rs.26,000 crore, somewhat more than US$ 5 billion a year .' If current trends continue, in another three years, state utility financial losses will reach Rs.45,000 crore a year.

To put this magnitude of losses into perspective, Rs.26,000 crore is half of what all the states governments in India combined are spending on all levels of education every year. It is double what they are all spending on health, and three times what they are spending on water supply. If power sector financial losses were reduced by only one-third, the savings of this from a single year would be sufficient to fill every teacher vacancy in the country and provide every school with running water and toilet facilities.

This huge amount of direct and indirect government financial support to the power sector is often justified in the name of the poor: it is often said that power sector reforms will hurt the poor. But, as I will discuss later in greater detail, power sector subsidies mainly benefit the rich and India's poor would benefit far more if the Rs.26,000 consumed by the power sector was indeed spent on basic health or education.

This Rs.26,000 of losses is funded by various government agencies. State governments pay part of the bill through budgetary subsidies. Utilities borrow some of the rest, but also don't pay their bills. The latest estimate of state power utility arrears to central government power utilities and suppliers is Rs.42,000 crore. This large and growing volume of arrears is threatening to bankrupt central utilities and financial institutions, and is placing enormous fiscal stress on virtually all the state governments as well.

This huge amount of financial losses borne by every Indian every year would perhaps be more tolerable if it led to a high quality of power supply. On the contrary, deteriorating financial viability has led to inadequate investment and maintenance. As a result, India is among the worst in developing countries in reliability of power supply. This is a major constraint to development and growth in the country, not to mention a negative influence on the quality of life.

Industry suffers twice over from India's power sector policies. It receives low-quality power, but is forced to pay tariffs above cost to cross-subsidize residential and agricultural consumers. Industrial tariffs in India at Rs.4 to 5 per kWh or US 7-10 cents are among the highest in the world. Typical rates in Western Europe and US are in the range of 6-7 cents. Even among other developing countries, industrial tariffs are lower than that in India - in Argentina it is 8 cents, Bolivia 7 cents, Brazil and Thailand 6 cents, and China 3-4 cents.

What are the reasons for this unacceptable situation in the power sector - this combination of poor financial and technical performance? It is not as if India does not have the technical and management skills.

The first problem is inadequate tariffs for non-industrial consumers. In fact, the gap between tariffs and costs has been growing over the nineties. In many states tariffs are not even sufficient to cover operating costs. Both agricultural and residential customers are heavily subsidized. The average domestic customer pays less than 60% of the cost of supply, while the average farmer pays about 10% of the cost of supply.

The second problem is one of excessive losses. Losses cannot be measured accurately in India because so much consumption is un-metered. But T&D losses in Delhi are now reported to be over 50%, Orissa 45%, Haryana and UP around 40%, and Rajasthan 38%. Even these high figures may be under-estimates.

Technical or physical losses are likely to be up to 20% of power supplied, double the international best practice of about 10%, on account of under-investment in an under-funded system. Another 20-30% of supply is lost due to non-technical factors, or, more bluntly, theft and non-payment. For the country as a whole, about Rs.19,000 crores of electricity is stolen annually.

There are a myriad of ways through which theft and non-payments occur; At the lowest level of the bureaucratic chain, meter readers, linesmen and billing clerks do not read meters, bill or collect, many presumably benefiting from personal receipts and political protection. These officials have often been in their position for 15 to 20 years and therefore have long-established links with local vested interests. In some states, local mafia groups, with the protection and complicity of local leaders, reportedly provide illegal supply of electricity to urban slum dwellers. Non-payments also result from high-level collusion involving big industrialists. Utility managers are often helpless to prevent such theft, even if they want to; there is often rampant political interference in the operations of the state utilities, starting from the appointment of directors down to the transfer of field staff

Key Elements of Distribution Reforms

Governance reforms, to stem the theft and corruption that plague the power sector, and tariff reforms, to ensure that tariffs more closely reflect costs and are more predictable, are clearly critical parts of any attempt to reform the distribution system. I now consider each of these in turn.

Governance Reforms

Let us try to estimate the magnitude of the financial leakages from India's power sector. We already have an estimate of Rs. 19,000 crore for theft. In recent years, the value of unpaid bills has grown by about Rs.2,000 crore a year. In addition, part of what is accounted for as agricultural consumption, therefore enjoying the heavily subsidized tariffs, is actually domestic and industrial consumption. As a result, there must be some Rs.20,000 - 30,000 crore (US$ 4-6 billion) flowing every year into the pockets of individuals and institutions through theft, graft and corruption in the power distribution sector.

With such huge amounts of money involved, is it any surprise that the vested interests against reforms are so strong. And resistance at many levels so violent? The most important, and most challenging element, of power sector reforms is to combat this widespread theft, graft and corruption. This will require nothing less than a new governance system in the power sector.

Many of us believe that a necessary condition to achieve lasting and radical change in the power sector is to privatize distribution. The lesson from decades of experience in India and many other countries, developed and developing, is that if the public sector is trying to fulfill a commercial function, and is not filling that role effectively, then the most effective solution is to allow the private sector in. Private firms would have the financial discipline and incentives to cut losses and maximize efficiency.

But privatization by itself is not enough as we have seen in Orissa. For private distributors to operate properly, they must have the protection of the laws of the land, and cut off supply to non-paying customers, even if they are ministers or government agencies. Governments must be prepared to prosecute those suspected of power theft. Containing graft and corruption, maintaining law and order - these are all government responsibilities, not those of private firms. Without governments fulfilling these responsibilities, power reform will not succeed.

Beyond ensuring law and order, governments have a critical role to play in improving the enabling environment in the sector: ending political interference in the sector, nurturing commercial discipline, and so on.

Recent experience in this regard is encouraging. Andhra Pradesh, for example, has regularized 2 million domestic and 0.3 million agriculture consumers. Significant efforts have been made to improve billing, collect arrears and improve collections: collection efficiency since October last year has been over 100%. Andhra is also the first state to enact a law to control theft and pilferage of electricity; special courts and police stations have been created through out the state for dealing with theft cases. Compared to the annual average of about 500 theft cases per year, during last year 2,500 theft cases were registered per month.

Rajasthan has also initiated several measures to strengthen the commercial culture in the power sector. It has replaced about 2 lakh old meters with high accuracy electronic meters during a period of six months since March this year. This effort is planned to be scaled up to replace an additional 5.5. lakh meters in the next six months.

Maharashtra has launched a disconnection drive, and disconnected 1.4 million households in six months. The Maharashtra SEB also took the bold step of transferring a large number of officials who had been in the same zone for their entire career, thus hitting at the nexus between corrupt officials and power thieves.

Improving the performance of the utilities under public ownership, and placing these utilities under private ownership are complementary strategies. Indeed, improving performance, especially cash-flow, by means of enhanced governance in the distribution sector, should give comfort to potential investors and make the task of privatization much easier.

Looking forward, and considering the complexity of the power sector reform challenge, we suggest that much greater emphasis be put on the formulation of true privatization strategies, which are much broader than transaction plans. These strategies must deal explicitly with risk exposure during the transition period to the time that the financial and technical performance of v the privatized distribution businesses approach commercially viable standards and, in particular, their cash-flows become strongly positive. A detailed analysis of the risks and options for mitigating these are an essential step in this process.

Tariff Reforms

The above reform measures should be able to stem the financial hemorrhage in the power sector through so-called non-technical losses. But reforms of the tariff setting regime are also essential for the power sector to achieve financial sustainability.

Power tariffs in India are unfortunately embroiled in a complicated web of social economic and political issues. The first step in untangling this web is to de-politicize tariff setting through the establishment of regulatory commissions for retailing power. India has made considerable progress in this respect over the past few years: regulatory commissions are functioning at the center and in most of the states. However, the working of the regulatory commissions needs to be
improved.

Sometimes, state governments are tempted to interfere with the functioning of these commissions, for example, by delaying tariff filings, thus undermining the basic purpose for which these commissions were established. State governments have to learn to treat their regulatory commissions effectively as judicial bodies, and not subject them to government interference. This does not mean that government as a key stakeholder and a representative of the consumers cannot play a role in actual tariff setting. The government for instance is free under the Reform Acts to provide subsidies to bring down tariff levels below full cost. But this must be done in a transparent way, and through the regulatory process for setting tariffs.

Adjusting to the new world of regulatory commissions is a big challenge for both governments and their power utilities; much learning-by-doing is needed. It is important that regulators are allowed to establish themselves so that their independence, and the transparency of the system, grows rather than is diminished over time. At the same time, regulators need to recognize that they are part of a reform process, and need to be responsive to the policy goals of governments, and so supportive of fundamental changes such as privatization.

The predictability which regulators are meant to introduce into the sector would be greatly enhanced if India were to move in the direction of multi-year tariff setting. Multi-year tariff setting systems have been the norm in the more than 20 countries that have successfully privatized distribution systems in recent years. Indian regulators must clarify much better the basis on which utilities will be compensated, not just for the coming year, but for some 5-7 years into the future. Since the availability and reliability of information about costs is notoriously poor, regulators and utilities must devise mechanisms to deal with this uncertainty, and make adjustments to allowable costs when more accurate and reliable information becomes available.

As well as delivering greater predictability, the regulatory system also needs to ensure financial viability. Unless revenues cover costs at privatization or within two or three years, power sector reforms will not succeed, and privatization in particular will not work, as we have seen in Orissa. Poor service and high inefficiency cannot be used as an excuse not to raise tariffs. Rather, regulators must both provide higher tariffs and ensure better quality of service.

Finally, competitive pressures should be introduced into the bulk power markets through restructuring and regulating open access to these markets. It would enable trading across state boundaries and improve operational and financial discipline in the regional grids - in short, making power available to those who pay, and not to those who don't. Another closely related measure, proposed in the 2001 Electricity Bill, would be to allow a variety of power suppliers and large users of electricity to trade with each other directly. This would spur owners of existing power generating plants - not only the few existing IPPs, but also central stations and user-owned captive power units - to produce more power from their installed capacity. And the increased competition would put pressure on states to accelerate governance and retail tariff reforms.

No tariff issue causes greater consternation or controversy than agricultural power pricing. If power sector reforms are said to be anti-poor in general, they are indicted as being anti-farmer in particular. To respond to these concerns, two years ago the Bank launched a major empirical study on power supply to agriculture. We hired teams to go out and actually meter how much energy farmers are receiving, to survey which farmers receive electricity, and how much they earn, and to talk to farmers to get their views. The results were certainly revealing. First, they cast doubt on the extent to which current subsidies actually help poor farmers:

• Electric pump owners are not the poor farmers. In Haryana, one of the states covered, electric pump owners had net income one-third above the average for the state's farmers, and four times that of rainfed farmers.
  
• The fixed-rate, per horsepower method used to charge farmers is regressive. Small land-holders use less electricity, but pay the same amount as large land-holders, Tariff costs are 13% of gross incomes for marginal farmers who own pump-sets, but only 6% of incomes for pump-owning large landholders.
  

Second, and very importantly, the results suggested that power sector reforms would help, not hurt farmers. Farmers benefit from power being cheap, but they are hurt by power being unreliable and of low quality. In Haryana we found that it took 10 days on average to repair a transformer in rural areas, Losing 10 days of irrigation during the cropping season will lead to a much lower crop.

We simulated realistic policy reform packages which combined large tariff increases with substantial improvements in reliability, and reductions in days of supply lost due to transformer burn-outs as well as in frequency of motor burn outs. Depending on the extent of quality improvements brought about, gains in net farmer income range from 13 to 100%. Marginal and small farmers gain at least twice as much as medium and large farmers.

Though farmers do stand to gain rather than lose from power reforms, there is a problem of phasing: tariffs can be increased immediately, but improvements in supply will take some time. For this reason, it is simply not feasible to talk of raising farmers tariffs from the current level of about 10% of the cost of supply to the full cost of supply in the near future. Subsidies for farmers will have to remain in place. Mechanisms should be put in place to deliver these subsidies from the state budgets to power distributors on time and in full or, preferably, directly to the farmers.

Role of the Center

It is often said that, since the SEBs, or their restructured successors, belong to the state governments, the fate of power sector reforms lies in the hands of these state governments. Of course, power reforms can't succeed without the states, and my remarks so far have focused on what the state governments need to do. But in the power sector, as with so many of the challenges which India faces, solutions lie in co-operative action; state reforms will only succeed if the center plays a leadership role and creates a conductive environment for reform.

All areas of reforms, including the maintenance of law and order, and the combating of theft and corruption, require the strong political support of the center. The center also has a role to play in consensus building, which needs to extend beyond the Chief Ministers to cover all major political leaders in Delhi and in the states. In this regard, the active role of the Ministry of Power, the Minister, and the Primer Minister, over the last year augurs well for power sector reforms in India. I want to dwell here on what may be the most decisive step the central government can take to propel reform forward in the power sector: and that is to change the sector's financial equations.

The importance of the center in this regard derives from the Rs.42,000 crore which the state utilities have run up in arrears to central government utilities and suppliers. By not insisting on payments, by allowing these accumulation of arrears, these companies have accommodated .the state governments' mismanagement of the power sector, and in effect have provided a bail out to the states. Yes, it is true that in very extreme and rare cases, power supply to individual utilities is restricted on account of unpaid bills. But this is the exception rather than the rule. And obviously it is difficult to turn off the lights - to plunge families, farmers and businesses into darkness because of bills someone else didn't pay. It is also the case that the central government deducts from most states a small amount of the annual transfers due to them on account of overdue liabilities to the central utilities. But the amounts involved are very small, and there is no impact at the margin.

As a result, what we have in operation is a classic case of what economists call a soft budget constraint - under which governments and utilities, can give power away, not bother to challenge power theft - and get away with it. No wonder state governments are unwilling to raise tariffs or crack down on theft if they know there is always a soft option of not taking these difficult actions and coping by running up arrears with the central utilities, and not paying loans from the financial institutions.

The means to harden budget constraints in the power sector lie within the hands of the central government. A line needs to be drawn in time. Past arrears need to be written-off and restructured based on burden sharing among all stake holders, as they would be in any bankruptcy proceedings in a modern market economy. This formalization of the current informal burden sharing between state utilities and central suppliers and creditors will clean up the books of the state utilities, reduce their interest burden, and allow them to move forward. Indeed, having a financial "work-out" for the state utilities, recognizing the bankrupt state they are in, is essential prior to privatization, to ensure that the privatized utility is able to start with a clean slate and not burdened with the sins of the past.

This will solve the problem of past arrears, the "debt overhang" and the huge amounts of unfounded liabilities such as pensions of the SEBs. To prevent recurrence of such a problem in the future, a drastic measure has been recommended by the Report on the Expert Group on SEB Financial Restructuring. The Group has suggested that, after restructuring, any state's arrears to a central utility or creditor should become fully payable by the central government against the relevant state's revenue share. The Group itself recognizes this proposal to be "an extraordinary measure," but argues that, without it, and I quote again: "there would be little assurance that SEBs would reform their financial conduct and allow the power sector to develop in an orderly manner."

Support from the World Bank Group

I now turn to how the World Bank may support the reform efforts of many of the state governments, as well as the initiatives launched by the Ministry of Power.

The overriding objective of the World Bank Group in India is to promote poverty reduction. We see few areas which can have as major an impact on poverty reduction as reform of the power sector. As described earlier, power sector reforms could free up huge amounts of funds for the government to invest in health, education and other poverty reduction programs. They could help create a sustainable fiscal system, especially at the state level. They could offer poor farmers and urban dwellers reliable power supply which would greatly improve the quality of their lives. And they could help India to achieve the 8%+ economic growth that it is aiming at - and without such a rate of growth, poverty reduction in this country with the largest number of poor in the world will proceed at an unsatisfactorily slow pace.

Supporting the development of the power sector has always been part of the core business of the World Bank. In India, we have been lending to the power sector since 1950, and have made about 60 loans and credits for some US $ 10 billion. We have been involved in power sector reforms since our 1996 loan to Orissa. Since then we have made another 4 reform loans - to Haryana, AP, UP, and Rajasthan. While our support for the power sector has remained constant, our approach has certainly shifted over time - we have moved from funding generation to distribution, and from focusing on capacity expansion to restructuring. We certainly recognize that we have made a lot of mistakes in the past. But we have no fixed dogmas, and are determined to learn with our partners, here in this room, as we move forward together.

We seek to be a partner with India in promoting power sector reforms. The first challenge in this partnership is to learn from the ongoing reform experiences in India. Such as in Orissa, the pioneer in implementing power sector reforms. There are important lessons to be learned from the Orissa experience, both mistakes to be avoided as well as successes to be emulated. Several other states are at various stages of reforms and there are important lessons to be drawn from all these experiences.

In addition to the continuous learning about India, the World Bank will also continue to provide knowledge about international experience and examples of global best practice. This is an integral and increasingly central part of our work, which we pursue through a variety of means: through studies, by project preparation and supervision, by funding the services of advisers and consultants, and through catalyzing resources from other donors.

In addition to participating in the learning process, the World Bank Group is prepared to support power sector reforms in the following ways:

• Financing of key pre-privatization investments before privatization, such as for meters, capacitors, and other quick-yielding de-bottlenecking types of investments in distribution. One note of caution: while no-one can argue about the extent of under-investment in the power sector, pre-privatization investments should be selective and kept to a minimum. A public sector set-up that has mismanaged the power sector for so long cannot be expected to undertake efficient investments in the last years of its involvement.)
  
• Financing of investment of private distribution companies by IFC - the arm of the World Bank Group supporting the private sector, either through equity or loans. Commitment for such financing can be made in the course of the privatization process.
  Use of the Bank's guarantee instrument to lower the risk perception of investors and their financiers by guaranteeing debt taken out for post-privatization investments against deviations in the performance of new regulators from their approved procedures and the performance of governments in providing administrative and judicial support to the utilities in exercising their legal rights against theft of property. These guarantees would help the privatized power companies raise financing. They would also provide a long-term incentive for governments to stick to reforms at times of trouble - failure to perform, failure to implement committed reforms, would lead into the Bank guarantee being called. Another arm of the World Bank Group, the Multilateral Investment Guarantee Association (MIGA) would consider providing similar support directly to equity investors.
  
• Though Sector Adjustment Lending provision of program (cash) support, on the basis of policy milestones achieved, either to the concerned state governments (in the form of budgetary support) to fund subsidies or VRS, as transitional measures in the reform program, or as part of a financial workout. The latter would only be possible as part of burden sharing among stakeholders.
  
• Financing of technical assistance to support the reform programs in individual states. Many such programs already exist, hi the states in which it is active, the Bank has financed technical assistance in such areas as industry and market restructuring, developing a legal and regulatory framework, financial analysis, institutional development of both the regulatory commission and the utilities, T&D loss assessment, and, of course, distribution privatization. Other funding agencies, particularly DFID, have also been active financiers in these areas. We could consider funding state governments to hire long term resident advisers to help plan, oversee, and adapt the entire reform process.
  

Conclusion

I have said a lot in this speech about the complexity of reforms, and their multi-faceted nature. I would like to conclude by stressing the urgency of power sector reforms. As I began by saying, the magnitude of the financial crisis in the power sector is escalating rapidly. The longer power sector reform is delayed, the slower its pace, the deeper the pit from which to dig out the sector.

I wish the Forum every success, and I assure you of the World Bank's continued commitment to, and support for, your reform plans.