Document of The World Bank FOR OFFICIAL USE ONLY Report No. 100960-YF INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT DOCUMENT FOR A PROPOSED DEVELOPMENT POLICY LOAN IN THE AMOUNT OF EUR 182.6 MILLION (US$200 MILLION EQUIVALENT) TO THE REPUBLIC OF SERBIA FOR THE FIRST PUBLIC EXPENDITURE AND PUBLIC UTILITIES DEVELOPMENT POLICY LOAN December 14, 2016 Macroeconomics and Fiscal Management and Energy and Extractives Global Practices Europe and Central Asia Region 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. REPUBLIC OF SERBIA - GOVERNMENT FISCAL YEAR January 1 – December 31 CURRENCY EQUIVALENTS (Exchange Rate Effective as of November 18, 2016) Currency Unit Serbian Dinar US$1.00 116.2 EUR 1.00 123.2 ABBREVIATIONS AND ACRONYMS CPF Country Partnership Framework DPL Development Policy Loan EC European Commission EPS Serbia’s national electric power utility (Elektroprivreda Srbije) EU European Union FDI Foreign Direct Investment FCP Financial Consolidation Plan GDP Gross Domestic Product IFI International Financial Institution IFRS International Financial Reporting Standards IMF International Monetary Fund LEP Law on Environmental Protection MoF Ministry of Finance NBS National Bank of Serbia NES National Employment Service NPL Nonperforming loan PA Privatization Agency PDO Program Development Objective PEFA Public Expenditure and Financial Accountability PERS Public Enterprise Roads of Serbia (Putevi Srbije) PFM Public Financial Management PIFC Public Internal Financial Control PSIA Poverty and Social Impact Assessment SAI State Audit Institution SOE State-Owned Enterprise TA Technical Assistance Vice President: Cyril E. Muller Country Director: Ellen A. Goldstein Senior Practice Directors: Felipe Jaramillo/Riccardo Puliti Practice Managers: Gallina A. Vincelette/Ranjit Lamech Task Team Leaders: Ashley Taylor/Claudia Vasquez THE REPUBLIC OF SERBIA FIRST PUBLIC EXPENDITURE AND PUBLIC UTILITIES DEVELOPMENT POLICY LOAN TABLE OF CONTENTS SUMMARY OF PROPOSED LOAN AND PROGRAM ................................................................ 1 I. INTRODUCTION AND COUNTRY CONTEXT (INCLUDING POVERTY DEVELOPMENTS) ...... 2 II. MACROECONOMIC POLICY FRAMEWORK ................................................................... 3 2.1 RECENT ECONOMIC DEVELOPMENTS ...................................................................... 3 2.2 MACROECONOMIC OUTLOOK, DEBT SUSTAINABILITY ............................................ 7 2.3 IMF RELATIONS ...................................................................................................... 11 III. THE GOVERNMENT’S PROGRAM ............................................................................ 12 IV. THE PROPOSED OPERATION ................................................................................... 13 4.1 LINK TO GOVERNMENT PROGRAM AND OPERATION DESCRIPTION..................... 13 4.2 PRIOR ACTIONS, RESULTS, AND ANALYTICAL UNDERPINNINGS ............................ 14 4.3 LINK TO CPF, OTHER BANK OPERATIONS, AND THE WORLD BANK GROUP STRATEGY 28 4.4 CONSULTATIONS AND COLLABORATION WITH DEVELOPMENT PARTNERS ....... 28 V. OTHER DESIGN AND APPRAISAL ISSUES..................................................................... 29 5.1 POVERTY AND SOCIAL IMPACT .............................................................................. 29 5.2 ENVIRONMENTAL ASPECTS.................................................................................... 33 5.3 PFM, DISBURSEMENT, AND AUDITING ASPECTS ................................................... 33 5.4 MONITORING, EVALUATION, AND ACCOUNTABILITY............................................ 35 VI. SUMMARY OF RISKS AND MITIGATION................................................................... 36 ANNEX 1: POLICY AND RESULTS MATRIX .......................................................................... 38 ANNEX 2: LETTER OF DEVELOPMENT POLICY..................................................................... 41 ANNEX 3: FUND RELATIONS ANNEX.................................................................................. 51 ANNEX 4: ENVIRONMENT AND POVERTY/SOCIAL ANALYSIS TABLE.................................... 53 ANNEX 5: ADDITIONAL ANALYSIS OF POVERTY AND SOCIAL IMPACT ................................. 54 The First Public Expenditure and Public Utilities Development Policy Loan was prepared by a World Bank team led by Ashley Taylor (co-TTL) and Claudia Vasquez (co-TTL) and comprising Gianfranco Bertozzi, Cesar Cancho, Ruxandra Costache, Aleksandar Crnomarković, Baher El-Hifnawi, Katharina Gassner, Jonas Fallov, Zahid Hasnain, Nikola Ille, Lisa Lui, Jelena Lukic, Raymond Muhula, Dejan Ostojić, Daniel Owen, Monica Robayo, Lazar Å estović, Desanka Stanić, Srdjan SvirÄ?ev, Trang Van Nguyen, Ekaterina Vostroknutova, Svetlana Vukanović and Hermina Vuković. The team benefited from guidance and support from Ellen A. Goldstein (Country Director), Tony Verheijen (Country Manager), Ivailo Izvorski (Practice Manager), Gallina Andronova Vincelette (Practice Manager), and Ranjit Lamech (Practice Manager). The team gratefully acknowledges the excellent collaboration of the Government of Serbia and the guidance of the peer reviewers: Theo Thomas (GMFDR) and Vivien Foster (GEEDR). SUMMARY OF PROPOSED LOAN AND PROGRAM THE REPUBLIC OF SERBIA FIRST PUBLIC EXPENDITURE AND PUBLIC UTILITIES DEVELOPMENT POLICY LOAN Borrower The Republic of Serbia Implementation Agency Ministry of Finance Financing Data Amount: EUR 182.6 million (US$200 million equivalent). Terms: IBRD Variable Spread Loan; 20 years total repayment term, including 19.5 years of grace; bullet repayment of principal. Operation Type Programmatic (1st of 2), single-tranche Pillars of the Operation And This is the first in a proposed series of two development policy loans to support the Government of Program Development Serbia’s multi-year fiscal consolidation agenda and transformation of energy and transport sector Objective(s) public enterprises and state-owned companies. The programmatic DPL series supports critical policy and institutional reforms within three pillars with the following development objectives: (A) Improve public expenditure management through strengthened public financial management and public administration reform; (B) Improve the financial sustainability and efficiency of energy sector public enterprises; and (C) Improve the financial sustainability and efficiency of transport sector public enterprises and state-owned companies. Result Indicators A1 - Increased percentage of invoices for public to public commercial transactions recorded in the central register: Baseline (end-2015): 0 percent; Target (end-2018): 100 percent A2 - The number of employees in the public sector, as determined by the Law on the Ceiling on Public Sector Employees, does not exceed the total of institutional-level limits set under the Law and its decisions: Baseline (end-2015): no; Target (end-2018): yes A3 - Increased share of employees within the education, health and social protection sectors paid on the basis of their new grades set out in the Public Sector Job Catalogue: Baseline (end-2015): zero; Target (end-2018): 60 percent B1 -Increased convergence of the guaranteed electricity supply tariff to reach market parity levels: Baseline (end-2014): 64 percent; Target (end-2018): 80 percent B2 - Increased number of total beneficiaries of the Energy Vulnerable Program: Baseline (2014 annual): 60,600 households; of which 27 percent female headed households; Target (2018 annual): 100,000 households; of which 30 percent female headed households B3 - Reduction in EPS annual wage bill relative to 2015: Baseline (2015): 0; Target (2018): 10 percent B4 - Increase in Srbijagas’ collection rate of current receivables: Baseline (2015): 80 percent; Target (average 2016-2018): 87 percent B5 - The approved Srbijagas 10-year development plan for the Gas Transport System Operator and 5- year development plan for the Distribution System Operator are in accordance with the adopted economic and financial appraisal methodology: Baseline (2016): No; Target (2018): Yes C1 - Level of annual direct budget operational support to the Railways Companies: Baseline (2015): RSD 13.5 billion; Target (2018): RSD 11 billion C2 - Improvements in labor productivity (measured by train kilometers per employee) and in asset utilization (measured by passengers per kilometer of track and ton per kilometer of track) relative to 2015: Baseline (2015): zero; Target (2018): 15 percent (for both indicators) C3 - Reduction in annual wage bill of railways companies relative to 2015: Baseline (2015): zero; Target (2018): 25 percent C4 - The government agrees with Roads of Serbia on maintenance levels for the different road classes with associated guaranteed funding levels committed: Baseline (for 2016 budget): no; Target (for 2019 budget): yes Overall risk rating Substantial Operation ID P155694 1 IBRD PROGRAM DOCUMENT FOR A PROPOSED FIRST PUBLIC EXPENDITURE AND PUBLIC UTILITIES DEVELOPMENT POLICY LOAN TO THE REPUBLIC OF SERBIA I. INTRODUCTION AND COUNTRY CONTEXT (INCLUDING POVERTY DEVELOPMENTS) 1. This program document presents a proposed Public Expenditure and Public Utilities Development Policy Loan (DPL) – the first in a programmatic series of two operations – to support the Government of Serbia's multi-year fiscal consolidation agenda and transformation of energy and transport sector public enterprises and state-owned companies. The measures supported under the proposed series are an integral part of the Government of Serbia’s ambitious program of critical policy and institutional reforms and support the implementation of strategic sector objectives in the context of Serbia’s European Union (EU) accession process. The DPL series has three key development objectives: (A) Improve public expenditure management through strengthened public financial management and public administration reform; (B) Improve the financial sustainability and efficiency of energy sector public enterprises; and (C) Improve the financial sustainability and efficiency of transport sector public enterprises and state-owned companies. The DPL series is central to the World Bank Group Country Partnership Framework (CPF) FY16–20 Focus Area 1: Economic governance and the role of the state, and complementary to related operations and technical assistance (TA). 2. The global financial crisis resulted in a deterioration of living conditions in Serbia, although poverty has since slowly receded. As a result of the global financial crisis, poverty peaked at 15.1 percent in 2010 using the US$5/day poverty line (2005 PPP) and then declined to 14.5 percent in 2013, the latest year for which comparable data is available. Relative poverty, or the fraction of population living below 60 percent of the median income, was estimated at 25.4 percent in 2015 and inequality at 28.2 Gini points.1 Since the crisis, average consumption among the bottom 40 percent of the income distribution declined more than for the population average, due to more severe losses in employment and labor income experienced by the poor. Labor market outcomes have improved slightly in recent years, though unemployment remains high at 15.2 percent in the second quarter of 2016, and the employment rate is low at 45.9 percent of the population above 15 years of age. 3. Structural and fiscal reforms are helping Serbia’s growth to recover after the 2008 global crisis exposed structural weaknesses in the economy. The 2008 crisis and the subsequent economic downturn in Serbia highlighted the need for fiscal consolidation and acceleration of the unfinished transition to a market economy.2 Serbia’s rapid growth during 2001–08, driven by domestic demand and fueled by capital inflows, led to significant, and unsustainable, internal and external imbalances. As a result, in 2008, government spending was almost 45 percent of gross domestic product (GDP) with a sizeable state-owned and public enterprise presence adding to the state’s economic footprint. Between 2009 and 2015, public debt doubled to 76 percent of GDP. At the same time, the stock of public guarantees, mainly to SOEs and public enterprises, rose from below 3 percent of GDP in 2008 to 7.2 percent at end-2015. However, in stepping up structural and fiscal reforms, the government’s actions, complemented by improved external conditions, have supported a recovery, with growth of 2.7 percent projected for 2016. 1 In 2012, Serbia adopted the EU relative poverty measure —the fraction of the population living below 60 percent of the median income—as its official poverty rate. This indicator is based on the 2015 EU-SILC survey for Serbia. 2 For further analysis see World Bank (2015), Serbia Systematic Country Diagnostic. 2 4. The government’s economic program, as set out in its Fiscal Strategy for 2016-18, focuses on fiscal consolidation to ensure macroeconomic stability, improving financial sector stability and resilience, boosting competitiveness, and ensuring sustainable growth. Notwithstanding stronger- than-expected fiscal performance in 2015 and in 2016-to-date, the public financial management (PFM) and public administration reforms need to continue to ensure fiscal sustainability. Improving the financial sustainability and efficiency of energy and transport public enterprises and state-owned companies is also critical to reduce direct and indirect government support to these sectors, which weighs heavily on the budget. Successful implementation of reforms in public administration, energy, and transport sectors will improve public service delivery and economic efficiency and create foundations for faster medium-term growth and private-sector led job creation. 5. The combination of economic pressures, an improvement in relations with Serbia’s neighbors and domestic reform momentum, have provided an important opportunity to accelerate reforms. Following elections in March 2014, a government with a strong majority was formed, giving Serbia a new opportunity to overcome past fragmentation and build momentum for reform. The coalition of the Prime Minister subsequently won early Parliamentary elections held in April 2016, with a new government formed in August 2016. The government is committed to focus on transforming the state administration, public finances, and the economy, along with pursuing the EU accession process. 6. The proposed DPL will support implementation of challenging reforms that are critical to the government’s fiscal consolidation and structural reform agenda . The operation has a substantial risk, but could bring high reward. Risks to the operation include political, social and stakeholder risks related to sensitive measures such as labor rightsizing in public administration, electricity and rail companies, and electricity tariff increases for residential consumers. Substantial progress has been achieved in the implementation of key reforms to date, for example, in relation to fiscal consolidation and restructuring of electricity and rail companies, confirming their high priority for the government, with the recovery in growth showing to the public the potential pay-offs to reform progress. Other mitigating factors are the high-level and implementation support to these reforms from the three- year precautionary International Monetary Fund (IMF) Stand-By-Arrangement (SBA) as well as related World Bank activities. These include TA in energy and transport as well as reforms supported by the state-owned enterprise (SOE) Reform DPL series, which focuses on commercial SOEs as well as the governance framework for SOEs and measures to limit the social impact of SOE reform, and operations in support of public administration reform, and job creation and employment support (see Section 4.3). The ongoing EU accession process is also a fundamental anchor for the Government’s reforms. II. MACROECONOMIC POLICY FRAMEWORK 2.1 RECENT ECONOMIC DEVELOPMENTS 7. Serbia’s recent economic performance has been positive, as growth recovers from the three recessions experienced over 2009 to 2014. After average annual growth of 5.9 percent during the decade before the 2008 global financial crisis, the economy contracted by 3.1 percent in 2009. After a timid recovery in 2010 and 2011, it fell back into recession in 2012 and 2014 (primarily due to a drought and severe floods respectively). In response to the slowdown and a sharp rise in public debt, government reforms have focused on fiscal consolidation and structural measures to restore a sustainable growth path and address external and fiscal imbalances. Supported by the recovery of 3 industrial production following the 2014 floods, positive growth returned in 2015 (at 0.8 percent). Industry was the primary driver, with real value added up 4.3 percent y/y in 2015 while agriculture value added fell 7.7 percent, hit by a summer drought. The recovery continued in 2016, with strong y/y growth of 3.5 percent in Q1, 2.0 percent in Q2 and 2.5 percent in Q3, according to flash estimates. 8. Investment and exports have supported the recovery in growth. Unlike in 2014, when all components of GDP had a negative contribution to growth, investment and exports increased significantly in 2015 (up 7.7 and 10.2 percent in real terms y/y, respectively), aided by the recovery from the floods and improved external demand. However, consumption has been under pressure from cuts in public sector wages and pensions and increased by a mere 0.1 percent y/y in 2015. In early 2016, a pick-up in growth was seen, reaching 3.8 percent y/y in Q1. Net exports contributed 2.5 percentage points to this growth but in Q2 posted a negative contribution due to a strong growth of imports, in part because export-oriented business still have a high import component. This offset a significant positive contribution of consumption and investment (1.8 and 2.7 percentage points, respectively) resulting in a moderation in overall growth in Q2 to 2 percent y/y. Within investment, increased public investment offset some slowing in private investment growth, as foreign direct investment (FDI) declined, and the growth of capital goods imports and loans to enterprises slowed, perhaps reflecting uncertainty around the election. 9. Improved export performance has supported Serbia’s external adjustment follow ing the crisis, with the current account deficit falling from 11.5 percent of GDP in 2012 to 4.7 percent in 2015. Since 2010, and in particular in 2013 when the carmaker FIAT started production in Serbia, exports have been a significant driver of growth and narrowing of the trade deficit. Following the 2014 floods, export values (in euro) recovered to grow by 7.8 percent in 2015, and were up 10.1 percent y/y in the first nine months of 2016. The fall in the merchandise trade deficit supported a narrowing of the current account deficit, particularly in 2013, although an improved service balance and net transfers were the main drivers of the narrowing in 2015. The current account deficit continued to decline in 2016, mainly again due to a lower trade deficit. In the financial account, FDI has been on a positive trend until 2016, moving from 2.1 percent of GDP in 2012 to 5.5 percent in 2015, more than covering the current account. 10. The recent recovery in economic activity has been reflected in improved labor market outcomes. High unemployment is a longstanding issue in Serbia. The unemployment rate reached a peak of 24 percent in 2012 but has declined since. Results from 2015 were particularly encouraging, with the annual unemployment rate falling to 17.7 percent, and then to 15.2 percent in Q2 2016, as growth recovered. Overall real wages fell again in 2015, down 2 percent y/y, following declines of 1.5 and 0.8 percent over 2013 and 2014 respectively. The wage cut and freeze in the public sector, as discussed below, was a key driver of these trends. Overall wages increased in the first half of 2016 by 4.2 percent y/y in nominal or 3.2 percent in real terms. Over the same period, public sector wages increased by 1.8 percent y/y as limits on wages adjustment were partially lifted, while private wages rose by 5.7 percent. 11. Despite monetary policy easing, inflation continues to undershoot the inflation target band of the National Bank of Serbia (NBS). Low energy and food prices, and still relatively weak domestic demand, contributed to average consumer price inflation of 1.9 percent in 2015, below the current NBS target band of 4±1.5 percent. Over the first nine months of 2016, inflation averaged 1 percent y/y. Faced with low inflation, NBS has lowered its key policy rate since May 2013, and announced a lowering of the inflation target (as discussed below). The latest rate cut was in July 2016 (to 4 4 percent). The NBS’s inflation targeting framework and commitment to maintain a flexible exchange rate appear appropriate, although high levels of euroization limit the monetary transmission mechanism. 12. While falling against a strengthening US dollar, the Serbian dinar has been relatively stable against the Euro. The current account improvement in 2015 supported the exchange rate against the Euro. But – in line with other emerging economy currencies – the dinar depreciated significantly against the US$ in 2015 (with the annual average exchange rate down 11.8 percent y/y), particularly earlier in the year. In early 2016 the dinar depreciated slightly against the euro, but it has remained stable since. NBS continues to intervene regularly to prevent more significant fluctuations in the exchange rate against the euro. The average real effective exchange rate depreciated by 5 percent in 2015 relative to 2014 and as of September 2016 was down a further 1.5 percent on its 2015 average level. Table 1. Key Macroeconomic Indicators and Projections 2012 2013 2014 2015e 2016p 2017p 2018p 2019p Real Economy Annual percentage change, unless otherwise indicated GDP (nominal, RSD) 5.2 8.2 0.8 3.5 4.0 4.6 6.4 6.6 Real GDP -1.0 2.6 -1.8 0.8 2.7 3.0 3.5 3.5 Contributions: Consumption -1.2 -0.6 -1.1 0.1 1.2 1.3 2.0 2.5 Investment 0.6 -1.5 -0.1 1.5 0.8 1.2 1.2 1.0 Net Exports -0.4 4.8 -0.6 -0.8 0.6 0.5 0.3 0.0 Exports 0.3 7.4 2.3 4.5 4.5 4.0 4.1 4.2 Imports 0.7 2.6 3.0 5.4 3.8 3.4 3.9 4.32 Unemployment rate (average, ILO definition) 24.0 22.1 19.2 17.7 17.7 16.9 16.0 15.5 GDP deflator 6.3 5.4 2.7 2.7 1.3 1.6 2.8 3.0 CPI (eop) 12.2 2.2 1.7 2.1 1.5 2.8 3.0 3.0 Fiscal Accounts Percent of GDP Expenditures 46.6 43.5 46.3 44.0 43.9 42.6 42.0 41.4 Revenues 39.4 37.9 39.7 40.4 41.7 40.9 40.7 40.4 General Government Balance -7.2 -5.6 -6.6 -3.7 -2.1 -1.7 -1.3 -1.0 Public and Publicly Guaranteed a Debt (eop) 57.4 60.9 71.8 75.9 73.7 72.4 70.4 67.4 Selected Monetary Accounts Annual percentage change, unless otherwise indicated Base Money 5.2 25.9 10.9 17.1 .. .. .. .. Credit to non-government 9.8 -4.5 6.1 2.0 .. .. .. .. Interest (key policy interest rate) 11.3 9.5 8.0 4.5 .. .. .. .. Balance of Payments Percent of GDP, unless otherwise indicated Current Account Balance -11.5 -6.1 -6.0 -4.7 -4.2 -3.9 -3.9 -3.9 Exports 26.5 30.8 31.9 33.9 35.9 37.9 39.1 40.1 Imports 44.2 42.9 44.3 45.8 46.5 48.5 49.4 50.1 FDI 2.1 3.6 3.7 5.4 5.2 4.8 4.3 4.2 Gross Reserves (in EUR bill, eop) 10.9 11.2 9.9 10.4 .. .. .. .. In months of next year’s imports 7.4 7.4 6.3 6.4 .. .. .. .. In percent of short-term external .. .. .. .. 209 279 292 281 debt Terms of Trade -0.9 1.0 0.8 1.5 .. .. .. .. Exchange Rate (EUR, average) 113 113 117 121 .. .. .. .. 5 2012 2013 2014 2015e 2016p 2017p 2018p 2019p Other memo items GDP nominal in EUR billion 31.6 34.3 33.3 33.5 34.2 35.2 37.4 39.3 a Notes: World Bank projections. Includes non-guaranteed debt of local governments. Source: Ministry of Finance (MoF); World Bank estimates IMF; NBS. 13. The financial system is broadly stable, although weaknesses remain in some state-owned banks. The Serbian financial system weathered the global financial crisis and successive recessions relatively well, but a weak domestic economy resulted in a substantial increase in nonperforming loans (NPLs) and reduction in profitability. NPLs stood at 19.6 percent as of August 2016. While banks remains well-capitalized and liquid, additional challenges emerged related to the situation in Greece, since four Greek banks are operating in Serbia (accounting for about 11 percent of total assets in Q2 2016). The NBS has undertaken steps to prevent any shocks in these, and other commercial banks, through intensified oversight. In addition, the NBS is actively working on the resolution of the longstanding problem of non-performing loans under the new Action Plan for NPLs resolution (approved in August 2015). NPLs declined by 2 percentage points over the first eight months of 2016. 14. The recovery in credit growth has continued in 2016. Total loans were up 12.7 percent in September 2016 (y/y) mainly because of a significant increase of banks’ lending to the government sector. Household loans were up 10.4 percent while those to enterprises (both private and public) were 2.9 percent higher y/y, in line with the recovery in investment, as well as lower interest rates. This includes a return to positive growth for loans to private enterprises (up 7 percent y/y in September). 15. The government’s consolidation program, put in place in 2014, has contributed to a significant improvement in fiscal performance. The general government deficit in 2015 was 3.7 percent of GDP, down from 6.6 percent in 2014, primarily as a result of increased revenues (up 4.6 percent y/y in nominal terms). However, this was mainly supported by a major increase in non-tax revenues reflecting one-off measures (for example, payment of net income from SOEs and the sale of 4G licenses). Nominal government expenditures declined by 1.9 percent as a result of major savings on wages and pension (down by 8.4 and 3.5 percent, respectively). Solid budget performance has continued in 2016. Revenues were up 9.3 percent y/y though September 2016, although in this case the main driver was better collection of excises and value-added tax. Expenditures rose by 5.3 percent, driven by purchases of goods and services and capital expenditures (up 10 and 35 percent, respectively). The general government deficit in through September 2016 was just one tenth of its value in the same period of 2015 and is projected to be 2.1 percent of GDP for 2016 as a whole (down from a previously-projected 4 percent). 16. As a result, general government debt (including guarantees) has started to fall in 2016, after having reached 75.9 percent of GDP at end-2015. Although the deficit narrowed, government debt as a share of GDP increased in 2015 by almost 4 percentage points, partially due to the strengthening US dollar (with 33 percent of debt dollar-denominated). With repayments exceeding new borrowing, government debt decreased by €663 million over the first nine months of 2016 to reach 73.5 percent of GDP. Given the marked rise in the stock of debt, much of which was acquired at a time of relatively high interest rates, interest payments are a growing fiscal burden (7.5 percent of projected 2016 spending or 3.3 percent of GDP). Current financing conditions for Serbia are though favorable due to strong global demand for emerging market debt and the country’s own stronger macro-fiscal fundamentals. As a result, Serbian government global bonds trade at spreads that were until recently 6 more associated with investment grade credit (Serbia is current rated 3 to 4 notches below investment grade). 17. Reinforcing the importance of reforms supported by this operation, public guarantees take up a large part of debt (8.7 percent of total debt at end-September 2016), with 85 percent of the guarantees for public enterprises (particularly Srbijagas) and SOEs . A relatively large share of this high cost state guaranteed debt was contracted over the past few years when market conditions were more expensive. The amortization and interest payments on activated guarantees is projected at just under 2 percent of total government spending in 2016, or around 5 percent of total debt service costs. 2.2 MACROECONOMIC OUTLOOK, DEBT SUSTAINABILITY 18. Growth is projected to rise from 0.7 percent in 2015 to 3.5 percent by 2019, underpinned by more supportive external demand, improved investment, and a gradual recovery of consumption. Fiscal consolidation measures will limit the contribution of domestic demand to growth through 2017 but structural reform progress should support investment and employment. After contracting in 2013 and 2014, private investment has been supporting recent growth, reflecting improvements in the investment climate (including, for example, reforms to construction permits) and is projected to contribute around 1 percentage points to growth over the medium term. As activity and employment picks up, consumption is expected to be again the main driver of growth after 2017. 19. Thanks in part to the momentum of domestic reforms, the gradual narrowing of the current account deficit is set to continue, declining to 3.9 percent of GDP by 2019. Improvements in the goods trade deficit will continue, in part due to external developments (low energy prices and recovery in the EU) and as a result of recent foreign investments, while the services surplus will also rise gradually. FDI inflows, supported by reform progress, are projected to be 4 to 5 percent of GDP and to provide the bulk of the net financing of the current account deficit. Nevertheless, gross external financing requirements remain sizeable at around 16 percent of GDP over the projection period (Table 2), with debt disbursements accounting for approximately three-quarters of overall external financing sources, highlighting potential vulnerability to shifts in international financial conditions. Table 2. Balance of payments financing requirements and sources (In percent of GDP) 2015 2016 2017 2018 2019 Gross external financing requirements 13.1 10.8 15.1 16.6 16.5 Current account deficit 4.7 4.2 3.9 3.8 4.0 Debt amortization 7.0 9.7 11.2 12.5 11.7 Change in gross reserves (increase=+) 1.4 -3.1 0.0 0.3 0.8 Gross external financing sources 13.1 10.8 15.1 16.6 16.5 FDI and portfolio investments (net) 4.5 5.3 4.8 4.8 5.9 Official capital grants 0.0 0.0 0.0 0.0 Debt disbursements 8.1 8.2 11.2 10.7 9.7 Other net capital inflows 0.4 -2.6 -0.8 1.1 0.8 Source: IMF; NBS. 20. Inflation is set to remain subdued in 2016 and then pick up gradually as domestic demand recovers. As domestic demand picks up, inflation is projected to rise, returning to the NBS target band in 2017. Monetary policy will continue to be implemented through an inflation targeting framework combined with a flexible exchange rate (with any intervention focusing on managing excess currency 7 volatility). In November 2016, NBS announced that the inflation target for 2017 through end-2018 would be 3±1.5 percent, a lowering of the target mid-point by one percentage points due to improved macro fundamentals and reduced macro imbalances, as well as softer inflation expectations of the corporate and financial sectors. 21. Implementation of the Government’ s ambitious fiscal consolidation and structural reforms program will support a continuation of the downward trajectory of the public debt ratio. As mentioned, the fiscal consolidation program, supported by the IMF SBA, focuses on reducing public sector wage bills and pension costs, along with a reduction in fiscal support to public enterprises, in conjunction with broad-ranging structural reforms. In 2016, further fiscal adjustment is targeted beyond the already significant achievement in 2015. The approved 2016 budget aimed to keep the general government deficit at a similar level to 2015 (around 4 percent of GDP), but results from the year-to-date suggest that annual deficit will be most likely be just above 2.1 percent of GDP. The draft Budget for 2017 is based on a conservative projection of revenues (to drop by 0.8 percentage points of GDP compared to 2016) but, based on a fall in expenditures, the deficit is expected to narrow further to 1.7 percent of GDP. Budgetary savings are expected to come primarily from lower subsidies in 2017, as there will be a partial increase in public sector wages and pensions. Over the medium term, the deficit is projected to fall to around 1-1.5 percent of GDP with spending declining from 43.9 percent in 2016 to 41.4 percent of GDP by 2010, mostly through cutting recurrent spending (wages and pensions) and amortization costs on activated guarantees. The revenue-to-GDP ratio is set to decline gradually (from 41.7 percent of GDP in 2016 to 40.4 percent in 2019), with exports and investments, the main drivers of growth, not seen as helping revenues (for example, value-added tax) significantly. 22. Under the baseline scenario, public debt-to-GDP is projected to fall from a peak of 75.9 percent at end-2015 to under 68 percent by 2019. Assuming the fiscal consolidation strategy is implemented as planned through completion of the IMF program in 2018, the primary balance is projected to improve from a deficit of 3.7 percent of GDP in 2014 to a 2 percent surplus in 2019. However, given the high initial level of debt, even with this fiscal consolidation, public debt-to-GDP will remain high over the projection period, declining below 70 percent only by 2019. The government’s gross fiscal financing needs also remain significant at 16 percent of GDP in 2017. From 2016 and 2017, external debt amortizations are projected to rise from 2 percent to 5 percent of GDP, with the maturing in 2017 of a 5-year US$750 million dollar-denominated Eurobond and a EUR 293 million commercial loan. 23. The projected public debt path is highly sensitive to any slippages in the fiscal consolidation plan, weaker-than-expected growth or to a negative real exchange rate shock . In terms of the debt profile, only around 21 percent of central government debt is variable interest rate, with 79 percent fixed. Most public debt is external direct debt (43.6 percent of GDP) while domestic public debt accounts for 29.1 percent of GDP as of end-September 2016. Foreign-currency debt is high, with 41 percent in euro and 33 percent in US dollars versus 21 percent denominated in local currency. As a result, a sharp real depreciation would move the debt ratio up markedly. Both slippages in fiscal consolidation progress and lower-than-anticipated growth could also lead to the debt ratio rising again. 24. The MoF is taking steps to reduce financing costs and the fiscal risks associated with the size and structure of its debt. Taking advantage of current market conditions, it aims to reduce its financing costs through restructuring or refinancing of existing high-cost liabilities, to rebalance the 8 currency composition to lower currency risks, and to smooth the future amortization profile, thereby lowering refinancing risks. 25. The macroeconomic policy framework is considered adequate for the proposed operation. The authorities are committed to adjust fiscal policy as needed to maintain debt sustainability over the medium term while supporting growth through structural reform progress. The macro-fiscal framework is supported by the precautionary IMF program. There are though substantial downside risks to the macroeconomic framework, both external and internal. External risks relate to a lower- than-expected EU recovery would impact Serbia through exports, remittances and capital flows. Higher volatility in international financial markets could also pose risks to the outlook through financial channels given Serbia’s refinancing needs and foreign currency debt burden, and also via real channels through their potential spill over to external demand. A deterioration of the financial situation of foreign parent banks could similarly jeopardize credit recovery and undermine growth. Key domestic risks arise from the implementation of the fiscal reform program. If some of these risks, were to materialize the government would need to undertake even greater fiscal consolidation efforts to ensure that public debt remains sustainable. To mitigate these risks, the government is working, including with EU and international financial institution (IFI) partners, to ensure that key reforms (for example, on public administration, SOEs and public enterprises) remain on track. Table 3. Consolidated General Government Fiscal Operations (In percent of GDP) 2012 2013 2014 2015e 2016p 2017p 2018p 2019p Revenue 39.4 37.9 39.7 40.4 41.7 40.9 40.7 40.4 Taxes 34.2 33.4 35.0 34.6 35.9 35.8 35.8 35.7 Personal income tax 4.6 4.0 3.7 3.6 3.7 3.7 3.7 3.7 Social security 10.6 10.8 11.3 11.0 11.0 11.1 11.2 11.3 contributions Corporate income tax 1.5 1.6 1.9 1.6 1.9 1.8 1.8 1.8 Value-added taxes 10.3 9.8 10.5 10.3 10.6 10.6 10.6 10.6 Excises 5.1 5.3 5.4 5.8 6.3 6.2 6.1 6.0 Taxes on international 1.0 0.8 0.8 0.8 0.9 0.9 0.9 0.9 trade Other taxes 1.2 1.1 1.5 1.6 1.6 1.5 1.5 1.4 Non-tax revenue 5.0 4.2 4.4 5.5 5.4 4.8 4.7 4.5 Capital revenue 0.0 0.1 0.1 0.1 0.1 0.0 0.0 0.0 Grants 0.1 0.1 0.2 0.2 0.3 0.3 0.2 0.2 Expenditure 46.6 43.5 46.3 44.0 43.9 42.6 42.0 41.4 Current expenditure 42.5 40.8 42.7 40.4 39.8 38.5 38.0 37.5 Wages and salaries 10.5 10.1 9.9 8.8 8.5 8.4 8.3 8.1 Goods and services 8.0 7.2 7.9 7.5 8.0 7.8 7.9 7.8 Interest 1.9 2.4 2.9 3.2 3.3 3.2 3.1 3.0 Subsidies 4.1 3.3 4.0 3.3 2.9 2.5 2.5 2.5 Transfers 18.1 17.7 17.8 17.6 17.0 16.5 16.3 16.1 Pensions 13.2 12.8 13.0 12.1 12.0 11.6 11.4 11.2 Other transfers 4.8 4.9 4.8 5.4 5.0 4.9 4.9 4.8 Capital expenditure 3.3 2.1 2.5 2.9 3.1 3.2 3.4 3.4 Net lending 0.5 0.3 0.4 0.1 0.1 0.1 0.1 0.1 Amortization of activated 0.3 0.2 0.8 0.7 0.9 0.8 0.4 0.4 guarantees Fiscal balance (incl. -7.2 -5.6 -6.6 -3.7 -2.1 -1.7 -1.3 -1.0 9 (In percent of GDP) 2012 2013 2014 2015e 2016p 2017p 2018p 2019p amortization of called guarantees) Primary fiscal balance -5.3 -3.2 -3.7 -0.5 1.2 1.4 1.8 2.0 Source: IMF; MoF, World Bank staff estimates. 10 1,2 Figure 1. Serbia: Public Debt Sustainability Public debt-to-GDP, percent Debt under baseline, no reforms and growth shock Real depreciation and contingent liabilities shocks 120 120 30 % 100 depreciati 100.7 100 No reforms 100 on 94 Growth 85 contingent 80 shock 80 liabilities 79 shock Baseline 64 Baseline 60 64 60 40 40 20 20 2010 2012 2014 2016 2018 2020 2010 2012 2014 2016 2018 2020 1 Note: Shaded areas represent actual data. Individual shocks (growth, primary balance) are permanent ½ standard 2 deviation shocks from historical 10-year averages from 2015. One-time real depreciation of 30 percent and 10 percent of GDP shock to contingent liabilities occur in 2015, with real depreciation defined as nominal depreciation against US dollar minus domestic inflation (based on GDP deflator). Source: Serbia MoF, IMF, World Bank staff projections. 2.3 IMF RELATIONS 26. The Executive Board of the IMF approved a three-year, SDR 935.4 million (about €1.2 billion, 200 percent of quota) Stand-By Arrangement for Serbia on February 23, 2015, and on December 16, 2016 approved the sixth program review. The program is based on three pillars: restoring health of public finances; increasing the stability and resilience of the financial sector; and implementing comprehensive structural reforms, to form a solid foundation for job creation and return to sustained high growth. The World Bank, IMF and government have worked in close cooperation, for example, with the World Bank working collaboratively in providing upstream inputs on public administration reform and public enterprise restructuring and helping the government develop a clear, time-bound restructuring plan for public enterprises and to complete functional reviews of certain line ministries. The recent Fund 6th review mission (October-November 2016) highlighted the need to end the fiscal burden of large utility companies and other SOEs, in particular the discontinuation of the financing of weak public entities and companies through arrears to Srbijagas and Serbia’s national electric power utility (Elektroprivreda Srbije EPS).3 3 http://www.imf.org/en/News/Articles/2016/11/01/pr16476-IMF-Staff-Completes-Review-Mission-to-Serbia. 11 III. THE GOVERNMENT’S PROGRAM 27. The government’s overall program is strategically oriented toward accelerating the EU integration process, maintaining macroeconomic stability, creating jobs, and boosting competitiveness.4 EU accession falls within the first of the ten priorities of the new government’s program and, to accelerate this process, the government is committed to speed up the implementation of economic reforms. The government’s priorities for fiscal consolidation and structural reforms are embodied in its Fiscal Strategy and its Economic Reform Program (ERP), presented to Parliament and to the European Commission (EC), respectively.5 28. To achieve these objectives, an ambitious economic program is set forth that includes continued fiscal consolidation to ensure macroeconomic stability; putting debt on a downward trajectory; improving financial sector stability and resilience; and structural reforms to boost competitiveness and ensure sustainable growth. Structural reforms are organized in two broad sets. The first set focuses on reforming the real sector and includes critical steps to strengthen the business environment by ensuring greater policy and institutional predictability, better coordination of different agencies, and more efficient incentive policies; reforming the labor market to make it more flexible; reforming and streamlining of the system for issuing construction permits; and upgrading of critical transport infrastructure. The second set focuses on structural reforms of the public sector that aim to make it more efficient, reduce the footprint of the state, and lower fiscal risks. 29. Achieving a more effective use of public resources by improving delivery systems and strengthening PFM is the focus of the first area of public sector reforms.6 Important milestones in public administration reform have been achieved including a hiring freeze, enactment of legislation establishing the registry of public employees and the ceiling on their number, to support monitoring and control of staffing, and freezing of wage indexation. These reforms have already contributed to the reduction in the level of spending on public sector wages relative to GDP. As discussed below, the new, systemic, Law on the Salary System of Public Sector Employees was also adopted just before the spring 2016 elections. 30. Returning SOEs and public enterprises to financial sustainability, and reducing fiscal risks related to contingent liabilities, is the second area of public sector structural reforms. These pivotal reforms are taking Serbia further on the transition to a well-functioning market economy and helping fulfil commitments toward EU accession. A government priority is the finalization of commercial SOE privatization, as supported by the SOE Reform DPLs, and the corporatization of large energy utilities and transport companies so that they are run on a commercial and financially sustainable basis, as supported by this operation. Since the 1990s, the transition to commercially-oriented utilities in Serbia’s energy and transport sectors has lagged considerably oth er countries in the region due to 4 Serbia obtained the candidate status for membership in the EU on March 1, 2012 and in June 2013 the European Council endorsed the Commission’s recommendation to open accession negotiations. The formal start of Serbia’s accession negotiations was in January 2014 and the first chapters were opened in December 2015. 5 The Fiscal Strategy serves as an overview of ongoing and planned structural reforms and as a tool for budget planning. The ERP’s main purpose is to identify reforms for advancing the EU accession process. Both documents are updated annually. For the 2016–2018 ERP and Fiscal Strategy documents see http://www.mfin.gov.rs/UserFiles/File/dokumenti/2016/ERP-2016_en.pdf and http://www.mfin.gov.rs/UserFiles/File/dokumenti/2016/FS%20za%202016%20EN.pdf respectively. 6 Reform of public finances is one of the five main objectives in the broader Public Administration Reform Strategy, and the focus of the PFM Reform Program which was adopted in late 2015. 12 systemic institutional weakness and strong vested interests. Energy and transport reforms aim to improve the efficiency of these public services and reform them in line with commitments toward the EU. 31. Going forward, the challenge will be the implementation of these ambitious reform programs. While there has been strong political support in recent years to tackle these issues, such as advancing SOE and public enterprise reform and fiscal consolidation, the challenge going forward will be the implementation of these measures defined in the government’s reform programs. The proposed operation aims at supporting the government in this endeavor to realize the benefits of increased economic efficiency and job creation in the medium term. IV. THE PROPOSED OPERATION 4.1 LINK TO GOVERNMENT PROGRAM AND OPERATION DESCRIPTION 32. The proposed DPL series supports the Government of Serbia's multi-year fiscal consolidation agenda and transformation of energy and transport sector public enterprises and state-owned companies. In particular, the proposed DPL series supports three key areas of reform: ï‚· Pillar A: Improve public expenditure management through strengthened public financial management and public administration reform. ï‚· Pillar B: Improve the financial sustainability and efficiency of energy sector public enterprises. ï‚· Pillar C: Improve the financial sustainability and efficiency of transport sector public enterprises and state-owned companies. 33. The design of the operation reflects the lessons learned from previous DPL operations in Serbia and energy and transport sector reform programs .7 The programmatic series consists of two DPLs including reform measures supported by the highest levels of government, with prior actions and triggers sequenced to achieve the targeted results. A key lesson for the DPL is that it should be complemented with other World Bank instruments. Ongoing implementation support in the DPL reform areas is provided through TA with the DPL series complementing the SOE Reform DPLs focusing on commercial SOEs and the Program-for-Results (PforR) operation on Modernization and Optimization of Public Administration.8 Finally, the need to address policies or programs aimed at mitigating the adverse social impacts potentially caused by the transition is another important lesson of earlier SOE restructuring efforts in Serbia and elsewhere (see Poverty and Social Impact Assessment [PSIA] discussion below). 7 See, for example, the 2011 Second Programmatic Public Expenditure DPL on lessons learned from DPL lending in Serbia since 2000 and the overarching lessons learned from the FY12 –FY15 Serbia CPS Completion and Learning Report. 8 See, World Bank. 2016. Serbia - Program on modernization and optimization of public administration: program for results – environmental and social systems assessment. Washington, D.C.: World Bank Group. The PforR operation was signed on April 20, 2016, and as of November 1, 2016, was awaiting Parliamentary ratification before being declared effective. 13 34. The design of the operation involves complementary and prioritized reforms. For example, cross-cutting measures in Pillar A on payment discipline support the objectives of the energy and transport pillars. The design of the DPL was informed by a prioritization of reforms based on their (a) impact on fiscal consolidation,9 (b) the level of government support and feasibility within the envisaged time frame, (c) the scope to leverage the DPL series to support sustained implementation progress, and (d) the strength of the supporting evidence base and ongoing engagement and dialogue. 35. Policy actions in public administration, energy, and transport also support the implementation of strategic sect or objectives in the context of Serbia’s EU accession process. Public Energy and transport reforms are important vehicles to accelerate EU integration. The new Energy Law (2014) aligns the legislative framework with the EU’s third energy package and paves the way for the integration with the EU internal energy market. 10 In transport, the 2008–2015 transport strategy for railway, road, inland waterway, air and intermodal transport, the 2011 Road on Public Roads, the 2013 Railway Law, and the Railway safety interoperability Law set targets in line with the EU legal and regulatory frameworks. In 2016, Serbia opened negotiations with the EC on chapters 14 and 21 on transport policy and Trans-European networks, respectively. Policy actions supported under the DPL tackle areas such as electricity pricing reform and railways financing policy which are critical to advance the implementation of the EU framework for the creation of competitive railway and electricity markets. Similarly, measures relating to PFM and public administration also support the high priority objective of the government of aligning the public administration with the principles of the European Administrative Space. 4.2 PRIOR ACTIONS, RESULTS, AND ANALYTICAL UNDERPINNINGS PILLAR A: PUBLIC EXPENDITURE MANAGEMENT Strengthened PFM 36. PFM reform is one of the government’s key priorities, with a comprehensive PFM Reform Program for 2016–2020 adopted in late 2015 .11 This program was informed by the 2015 Public Expenditure and Financial Accountability (PEFA) assessment, as well as an Organization for Economic Cooperation and Development/Sigma assessment, and supported by the EU, World Bank, and several bilateral donors, GIZ and the Swiss Agency for Development and Cooperation, in particular. Weaknesses in ex-ante commitment control, particularly relating to multi-annual contracts, monitoring of fiscal risks associated with arrears and state and public enterprises, and budget preparation have impacted aggregate fiscal discipline and the quality of resource allocation and service delivery. Weaknesses in the planning, implementation and monitoring of public investment projects have also played a role prompting reform actions. 12 These challenges affect not only the 9 Based, for example, on analysis in World Bank (2015), Serbia Public Finance Review. 10 Specifically, it introduces full unbundling of the electricity and gas transport and distribution sectors, fully opens the market for competition, advances deregulation of energy prices, and enhances the independence of the national regulatory authority. 11 See www.mfin.gov.rs/UserFiles/File/dokumenti/2016/Public%20Financial%20Management%20Reform%20Program%2 02016-2010%20EN.PDF . 12 The legislative and regulatory frameworks for public investment management (PIM) are envisaged to be strengthened by the end of 2016 through adopting a by-law intended to regulate PIM, as well as a set of guidelines 14 aggregate fiscal performance but the efficiency and financial sustainability of large public enterprises and SOEs, including those in energy and transport sectors which are the focus of Pillars B and C of the DPL series. 37. The PFM-related actions under the DPL series aim to support improvements in recording and control of commitments and arrears . Measures have been taken to better manage arrears but the level of information and its quality remain a challenge. 13 The Law on Deadlines for Payments in Commercial Transactions adopted in 2013 set a maximum period for settlement of payment by a public sector entity to a private sector creditor, before interest could be charged. Complementing this measure, revisions to the Budget System Law from 2013 targeted improvements in commitment control and prevention of the creation and accumulation of expenditure arrears. 14 Nevertheless, although the MoF’s Macro-Fiscal Analysis Department and the Treasury collect data on arrears from most public entities, the data is not comprehensive, and concerns remain about its reliability as no mechanism of systematic monitoring or control framework exists.15 Despite a reported decrease in arrears in the past two years, certain sectors continue to struggle with significant arrears, and some, such as health, have actually registered an additional increase over the same period. 38. In an important development, amendments to the Law on Deadlines for Payments in Commercial Transactions (“RINO Lawâ€?) were passed in July 2015 to capture transactions between public entities. As discussed, public-public arrears are a sizeable impediment to the financial sustainability of certain public enterprises, such as Srbijagas. Supervision authority over implementation of the law was also changed to the Budget Inspection unit within the MoF for transactions between public entities and public to private entities, while the Tax Administration is assigned supervision over transactions between private entities. Prior Action #1 supports implementation of the amended Law through the adoption of the monitoring framework.16 This defines more closely the supervision arrangements and the communication of information between the Treasury, which collects information on payments, and entities in charge of supervision. The full positive impact of the RINO Law and accompanying by-laws is though subject to further constraints, such as unconfirmed accuracy and completeness of reported data by public sector entities. This issue is expected to be partly addressed by improved reporting discipline as the implementation period is longer and as the sanctions and on-site visits of the Budget Inspection —which are currently limited— are applied to a larger number of entities.17 39. Further measures are needed to improve the recording and transparency of the level of arrears and the data and control over commitments. Indicative Trigger #1 for the second DPL, for more efficient and effective management of public investment going forward. In addition, the Ministry of Finance is planning to implement a PIM Information System to support the various phases of PIM and improve the overview of the project portfolio. 13 See, MoF, PFM Reform Program 2016–2020, November 2015. 14 This primarily relates to the introduction of the software for commitments control (RINO, standing for “Registry of Settlement of Pecuniary Commitmentsâ€?) which is linked to payments software and which aims to improve the availability of information about assumed commitments, meeting of statutory deadlines for payment and to prevent accumulation of potential arrears. 15 For example, in terms of comprehensiveness, indirect budget users do not provide information on their arrears. 16 The “Rulebookâ€? for the method and procedure for monitoring the implementation of the revised Law was published in the Official Gazette, October 23, 2015. 17 Other supplemental steps to address these issues could include additional secondary legislation ensuring the accuracy and timeliness of reporting on outstanding commitments and arrears by users of public funds. 15 therefore, builds on the prior action through putting in place a central register of invoices for transactions that would allow for more efficient monitoring of commitments and arrears as recommended by the recent Functional Review of the MoF, and in line with the PFM Reform Program. The central register is intended to capture all invoices issued for commercial transactions, and, thus, ensure reliable and accurate data on incurred commitments and the level of arrears, supporting efforts to enforce the payment deadlines set out in the Law, as also supported under the Trigger. DPL1 Prior Action #1. The Borrower, through its Ministry of Finance, adopted the framework for monitoring the implementation of the Law on Deadlines for Payments in Commercial Transactions, which has been revised to extend its coverage to include public-public transactions, including those of state-owned enterprises. DPL2 (Indicative) Trigger #1. The Borrower, through its Ministry of Finance, (a) puts in place a central register of invoices for public-public transactions and (b) enforces payment deadlines for said transactions. 40. Expected results: The above actions are expected to support improved transparency and data on incurred commitments and the level of arrears. In particular, the percentage of invoice for public to public transactions recorded in the central register is expected to rise from zero at end-2015 to 100 percent at end-2018. Public Administration (PA) Reform 41. A key challenge facing the Serbian public sector is improving the management of public employment and the wage bill so as to support fiscal consolidation and enhance public sector performance. The general government wage bill grew significantly in the 2000s, rising from 8 to 10.7 percent of GDP from 2001 to 2008. Measures introduced by the Government to contain the wage bill have helped to reduce it from 9.9 percent of GDP in 2014 to a projected 8.5 percent in 2016. 42. The Government initially relied largely on across-the-board wage reductions and hiring freezes introduced in 2014 to restrain the wage bill, but this does not address more fundamental problems in human resource management . Some sections of public employment have more employees than are required and vice-versa, undermining the efficiency of human resource management, and public sector management more generally. For example, evidence of overstaffing is found in the health, judiciary, and police and to some extent, education sectors. Because a hiring freeze is not targeted, it does not focus on these positions. A wage freeze, similarly, fails to deal with underlying problems in the structure of compensation such as complex systems of pay and grading with compensation rates above market levels in low skilled positions and below market levels for high level positions (IPSOS, 2015). As a result, equal work is not equally rewarded. Also, the complex and arbitrary nature of the compensation system undermines staff morale and renders the system vulnerable to ad hoc pressure from public sector unions. 43. To address these problems, the government is focusing on three key activities – (a) revising the legislative and policy framework for public sector employment; (b) reforming the pay and grading system; and (c) rationalizing staffing levels in a structured manner. These reforms are central to the PA Reform Strategy Objectives of improving organizational and functional sub-systems 16 of the PA and introduction of a harmonized public service system relying on merits and improved HR management. 18 44. In July 2015, the government adopted the Law on the Ceiling on Public Sector Employees (Prior Action #2) setting the criteria of determining the maximum number of employees from 2015 to 2018, as well as the scope and limits for reducing their number to achieve the ceiling determined by this law.19 To strengthen its system for controlling staffing numbers, the government has established a registry of public employees and enacted legislation to make it effective. Under the new Law, 2016 ceilings for individual institutions were set in a government decision in December 2015 implying a reduction of 14,500 permanent employees in total relative to the end-2014 baseline.20 By end-September 2016, the net reduction was almost 22,000 relative to the end-2014 baseline (or approximately 4.4 percent), including cuts to due rationalization, retirement and other reasons. The government is focusing on rationalizing staffing levels in a structured manner. Subsequent annual decisions under the Law on the Ceiling on Public Sector Employees will set the staffing limits for future years (Trigger #2). These limits will be informed by functional reviews of staffing needs, both horizontal and for key sectors, such as health and education, which the government is undertaking supported by the World Bank. This is part of the “right -sizing and optimizationâ€? program intended to improve the organization of the public sector, the assignment of competences among tiers of government, and the organization of work processes within various institutions. Ministries are expected to simplify administrative procedures, eliminate redundant tasks, and eliminate or restructure departments with duplicate functions. Following consultations with stakeholders, a strategic staffing adjustment plan will be prepared and submitted to the cabinet. This will then be implemented, through a combination of attrition, reassignments, and dismissals. In parallel, the Government is strengthening its system of establishment control to improve payroll management. DPL1 Prior Action #2. The Borrower: (a) adopted the Law on the Ceiling on Public Sector Employees setting the criteria of determining the maximum number of employees in the public sector, from 2015 to 2018, as well as the scope and limits for reducing their number in order to achieve the established said maximum; and (b) established, as required by said law, the first institution-level limits on the number of employees in the public sector. DPL2 (Indicative) Trigger #2. Based on the Law on the Ceiling on Public Sector Employees, the Borrower has in 2017 set out updated institution-level limits on employees in the public sector, as determined by the Law. 45. The government is also taking important steps to reform the pay and grading system. The Law on the Salary System of Public Sector Employees which came into force on 9 March 201621 rationalizes the public pay structure helping to contain and control wage costs (Prior Action #3). 22 This involves moving down from 71 different elements of remuneration, 16 different base salaries, 900 18 The work on the PA Reform strategy was supported in close cooperation by the World Bank, the EU, and several bilateral donors (Germany, UK, and Switzerland). 19 Official Gazette of the Republic of Serbiaâ€? No. 68/2015 and 81/2016-CC. 20 The Law was enacted and published in Official Gazette, dated 4 August 2015. The decision was published in the Official Gazette dated 8 December 2015. 21 Official Gazette of the Republic of Serbia No. 18/2016. 22 The Law will take effect as from 1 January 2017, or 1 January 2018 for police officers and members of the Serbian Armed Forces, with secondary legislation required to set out the detailed regulations. 17 different job coefficients, and more than 2,200 job titles to a manageable level.23 The Law will also regulate and streamline the public sector pay and employment legislation that currently comprises of 19 laws and a plethora of by-laws that regulate salary levels. The Government is undertaking a comprehensive job evaluation and pay grading exercise, within current fiscal constraints, with the Law setting out the principle of the grading system and the timetable for implementation of the reform. The new structure will cover all public service employees including those in education, health, social protection, culture, and sport. A Catalogue of Jobs in the Public Sector, which will be adopted according to the Law on Salary System of Public Sector Employees, will catalogue and describe all jobs in the public sector.24 Under the proposal, all positions will be re-graded according to common criteria. Pay scales will be established for each grade, reflecting current market conditions and fiscal constraints. It is expected that a variety of pay scales and implementation strategies (for example, the extent of grandfathering) will be analyzed. Once this process is completed, new regulations governing the new pay and grading will be issued and the new pay system will be implemented. Indicative Trigger #3 supports the implementation of this process in sectors with large number of employees. DPL1 Prior Action #3. The Borrower adopted the Law on the Salary System of Public Sector Employees to rationalize the public sector pay structure. DPL2 (Indicative) Trigger #3. The Borrower, through its government, maps all employees within the education, health and social protection sectors to the new grades set out in the Public Sector Job Catalogue. 46. Expected results: The reforms are expected to contribute to implementation of improved control of staffing and the implementation of a new wage system in the public sector. It is expected that as of end-2018 the number of employees in the public sector, as determined by the Law on the Ceiling on Public Sector Employees, does not exceed the total of institutional-level limits set under the Law and its decisions (versus not at end-2015). In addition, the share of employees within the education, health and social protection sectors paid on the basis of their new grades set out in the Public Sector Job Catalogue is expected to increase to 60 percent by end-2018 versus a baseline of zero at end-2015. PILLAR B: ENERGY PUBLIC ENTERPRISES 47. Electricity and gas public enterprises are among the largest enterprises in the country and a priority for the fiscal reform agenda . Commercialization of electricity and gas public enterprises has lagged behind despite progress in the putting in place the legislative framework for the implementation of competitive energy markets.25 Because of their fiscal burden through government payment of debt service obligations guaranteed by the state and the fiscal risks they pose due to 23 See World Bank. 2016. Serbia - Program on modernization and optimization of public administration: program for results – environmental and social systems assessment. Washington, D.C.: World Bank Group. 24 The seven finalized sub-catalogues include 1. General government (including local self-government and provincial government), 2. Education sector, 3. Health sector, 4. Culture, 5. Sport, 6. Social Protection, and 7. Generic positions in the public sector. Before the catalogue is formally adopted by the government respective ministries should approve them. The police and defense sector will not be included in this catalogue and will prepare separate documents. 25 The 2014 Energy Law and the adopted secondary legislation ensure a compliant legal framework for the implementation of the EU’s Third Energy Package. 18 potential future need of government support, actions to improve the financial viability of these entities is critical to the government’s fiscal consolidation efforts. 48. Electricity: Elektroprivreda Srbije (EPS). Although not requiring direct transfers from the budget, EPS relies on government support through guaranteed loans (amounting to 0.9 percent of GDP, at end 2015) to finance its investment program and more recently, operating expenditures. The financial analysis carried out by the World Bank, carried out in 2015, projected that absent measures to improve operational efficiency and financial engineering, EPS will face liquidity issues by 2017. Key challenges include: (a) below-cost tariffs for regulated consumers; (b) lack of payment discipline particularly from public sector entities (collection rate of about 50 percent in 2014); (c) inadequate governance, which translated, among others, in overemployment; and (d) obsolete infrastructure and relatively low operational performance. 49. Over the past two years, the Government has taken bold steps to put the electricity sector on a financially sustainable footing. Corporate restructuring and financial consolidation plans (FCPs) for EPS were adopted in November 2014 26 and June 2015,27 respectively. The former plan led to streamlined organizational structure and management. 28 The FCP (2015–2019) includes time-bound measures aimed at transforming the company into a commercially and financially viable utility. Specific actions target: (a) increased revenues through the establishment of a tariff adjustment path aiming to reach market parity levels by 2019; (b) decreased operational expenditures, including time- bound targets for labor rightsizing, improved collections, and reduced distribution losses; and (c) changes in legal status from a Public Enterprise into a Joint Stock Company so as to improve corporate governance. 50. The DPL series will support measures deemed critical to the achievement of targets set out in the EP FCP. Specifically, measures on tariff adjustment and related protection of vulnerable households, and labor rightsizing. EBRD is supporting complementary policy actions set out in the FCP under its restructuring loan. Electricity Tariff Adjustments 51. This DPL supports the implementation of the second electricity tariff adjustment set out in the FCP, as a critical measure to improve the financial viability of EPS. The first guaranteed supply electricity tariff increase in the adjustment path was a 4.5 percent rise which took place in August 2015 which, together with the creation of a 7.5 percent excise tax, results in a 12 percent rise in household prices. This DPL supports the second tariff adjustment in 2016 of 3.8 percent (Prior Action #4). The Indicative Trigger #4 for the second DPL supports a further increase in 2017, informed by additional analysis based on the progress in the implementation of other measures in the FCP as well as in view of regional electricity prices. While relatively modest, such increases would also allow EPS to cover about 95 percent of its operational costs by mid-2018. These adjustments would allow 26 Program for Reorganization of EPS. Government Conclusion 05 No. 023-15149/2014. 27 Plan for Financial Consolidation of Public Enterprise EPS. Strictly Confidential Government Conclusion 05 No. 00- 169/2015. 28 The new structure became effective on July 1, 2015 and all 7 subsidiaries for electricity generation were merged into EPS and 4 subsidiaries operating the distribution network were merged into one company: EPS Distribution. In 2016, EPS supply was merged with EPS. As a result, there are now only two companies: EPS covering the activities of mining and power generation, supply, and retail activities and EPS Distribution for the operation of the distribution system. 19 convergence from 64 percent of regional wholesale parity levels in mid-2015 to approximately 80 percent by mid-2018.29 Regional wholesale prices are a relevant benchmark in the case of Serbia because: (a) prices for consumers in the free market (mostly industry) are aligned with regional wholesale market prices (adjusted for import costs) and (b) convergence to regional market prices will support the phasing out of price regulation four households, in line with country’s commitments toward the EU. Transmission and distribution fees are determined by the regulator according to a cost-based methodology. 52. To accompany tariff adjustments, the government put in place a targeted assistance program to protect vulnerable households . Electricity accounts for the largest share (72 percent) of household’s energy expenditures, especially for the poorest. It is estimated that 36 percent of households in the lowest quintile spend more than 10 percent of their budget on electricity. To address affordability concerns, the government put in place an ‘Energy Vulnerable Customer Program’ which provides a partial discount of electricity and gas bills depending on the number of household members. While designed with relatively good targeting, the current Energy Subsidy Program for energy vulnerable households is fairly limited in terms of its coverage and has low take up (see Annex 5). Table 4. Expected Impact of the Amendments of the Energy Vulnerable Customer Program Description/Year 2015 2016 simulations* Total budget allocated (million RSD) 900 1,785 Number of households covered 60,500 80,600 Coverage of electricity vulnerable and poor (% of households)** 5 9 Note: *Simulations based on the 2015 Households Survey and provisions of the new Decree for the Energy Vulnerable Customer Program and program allocation in the 2016 Budget. ** Electricity vulnerable are defined as those households spending more than 10 percent of their budget on electricity and poor are defined as households in the bottom quintile (B20) of the income distribution. 53. The proposed DPL also supports the strengthening of the Energy Vulnerable Customer Program and an increase in its budget allocation for 2016 (Prior Action #4). The new Decree on Energy Vulnerable Customers was approved in December 2015, entering into force in January 2016. The decree aimed to increase program coverage and strengthen protection of vulnerable populations in the face of rising electricity tariffs. It significantly increased the electricity consumption thresholds, allowing energy vulnerable households who have higher consumption (for example, due to electric heating) to still qualify for the protection scheme. In addition, under the 2016 Budget Law, the budget allocation was increased from RSD 900 million in 2015 to RSD 1,650 million in 2016. Table 4 presents the expected increase in coverage of the program in 2016 resulting from the budget increase and amendments to the program. There have been some concerns of low take-up, possibly due to the changes in the program’s implementation mechanisms, although it has improved recently. The government is monitoring program implementation to make necessary changes which would be supported under Trigger #4. Prior Action #4. The Borrower: (a) through its Council of the Energy Agency, approved a 3.8 percent increase of the electricity tariff for guaranteed supply; (b) amended the Energy Vulnerable Customers 29 In line with the tariff methodology for the public supplier, the convergence will be measured by the difference between the wholesale price charged by EPS and the prevailing regional wholesale price set on the basis of neighboring power exchanges (Hungarian exchange HUPX). 20 Program to increase coverage of targeted beneficiaries; and, (c) increased the budget for said program. DPL2 (Indicative) Trigger #4. The Borrower: (a) through the Council of the Energy Agency, approves an additional increase of the electricity tariff for guaranteed supply in 2017; and (b) takes measures, if necessary, to protect vulnerable households. EPS Rightsizing 54. Rightsizing of EPS’s labor force is an important measure to reduce cost s, thereby improving the financial position and efficiency of EPS . The total headcount of full-time employees was 32,140 by end-2014 and salary costs have been increasing. 30 Based on a benchmarking analysis with companies operating in Western and South-eastern Europe, as well as with internal best performing units in EPS, the potential for wage bill reduction was estimated to be about 15 percent. This cost reduction target translates in the FCP into a net reduction of employees of 5,000 between 2016 and 2019. The rightsizing not only focuses on costs but also on improving the adequacy of the workforce (for example, age and level of education) and operational efficiency. Also, rightsizing is meant to be implemented in parallel with technological improvements in EPS’s operations to bring them closer in line with commercial practices. 55. The proposed DPL supports the implementation of the 2016–2019 EPS labor optimization plan. The plan was drafted in line with international good practice and national legislation and regulations. It sets out the overall rightsizing targets for the medium term, processes, and timeline for their implementation. Labor reduction will be achieved through a combination of natural attrition, voluntary separation, and involuntary separation. The implementation focus of the plan is on the first year, during which a labor reduction of between 1,500 to 2,000 employees through attrition and voluntary separation is foreseen. For workers opting for voluntary separation, financial incentives, well above those specified in the legislation for State Owned Enterprises, will be provided according to eligibility criteria based on the worker’s age and years of service. The plan was adopted by the EPS Supervisory Board on August, 5, 2016 (Prior Action #6). Implementation is ongoing, with the first call for workers interested in voluntary separation launched on September 1, 2016 (with the deadline extended to October 15, 2016, to enable more interested employees to apply). As of October 15, 2016 about 1,800 EPS employees had voluntarily applied to leave the company. DPL1 Prior Action #5. The Borrower, through the Supervisory Board of Elektroprivreda Srbije (EPS): (a) adopted a labor optimization plan for 2016-2019 setting out the medium-term targets, process, compensation packages, selection criteria, grievance mechanisms and timeline for reductions in staffing; and (b) issued the first call for voluntary separations to implement the 2016 target for net staff reduction. DPL2 (Indicative) Trigger #5. The Borrower, through the Supervisory Board of EPS, implements the labor rightsizing in 2016 and 2017 in accordance with the EPS Labor Optimization Plan. 56. Natural Gas: Srbijagas. JP Srbijagas generates significant losses each year which reached €392 million (1.2 percent of GDP) in 2014. Past losses have accumulated to such an extent that by end-2015 30 EPS has in recent years added 4,400 more employees through mergers of subsidiary to parent company MB Kolubara and overtaking of employees from unprofitable and previously spun-off companies. These mergers increased staff costs from RSD 53.8 billion in 2013 to RSD 56.7 billion in 2014. 21 negative equity (net asset value) of €563 million was recorded in JP Srbijagas stand -alone financial statements. Given negative operating results, the company has covered expenses, including its substantial investment program, by assuming new government-guaranteed debt. Outstanding long- term loans to commercial banks amounted to €657 million in December 2015. To honor debt service obligations, the government has been making transfers to the company for it to be able to settle interest payments and due debt installments. This has in parallel led to an accumulation of short-term liabilities toward the government amounting to €476 million (RSD 57.9 billion) at year -end 2015. Total liabilities of Srbijagas amounted to €1.62 billion (RSD 197 billion) in December 2015, close to 5 percent of GDP. 57. Key challenges in the gas sector include (a) lack of payment discipline and low collection of due receivables; (b) high levels of debt as described above; (c) unsustainable investment program with most CAPEX targeted at distribution expansion which failed to generate positive incremental revenues; (d) acquisition on non-core business assets through debt to equity swaps with insolvent gas consumers (mostly state-owned); and (e) inadequate internal controls. In relation to the first challenge, tolerance of non-payment has been used as a means to support the operation of commercial SOEs and district heating companies. As of December 2015, more than 68 pe rcent (€ 486 million) of gross and 74 percent (€127 million) of net trade receivables related to state -controlled entities. Recent evidence of further sizeable arrears due to Srbijagas from Azotara and MSK ( €80 million in total as of October 2016) highlight the need to address both the stock of arrears and prevent their future accumulation. 58. The government approved a corporate restructuring plan for JP Srbijagas in December 2014. This is to transpose unbundling provisions in line with the requirements of the Second EU Energy Package. Two subsidiaries for transmission and distribution were registered in August 2015. While this is a positive step, substantial efforts are still needed to implement the unbundling as noted by the Energy Community.31 In an effort to refocus Srbijagas’ business, the government has initiated the divestment of part of Srbijagas non-core assets in 2015, including Agroziv (a poultry farm). To improve liquidity, in February 2015, an extraordinary transport fee was introduced to allow Srbijagas cover part of its debt repayment obligations; providing an estimated €15-17 million in additional revenues per year. Together with an improvement in collection of past receivables between 2014 and 2015, Srbijagas’ financial statement improved in 201 5. But even so, the company was unable to report positive cash flow in 2015, and a medium term FCP is necessary. 59. To sustain improvements in the financial position of Srbijagas, the DPL series supports the implementation of reforms laid out in the company’s FCP . Based on the findings of substantial analytical work carried out with the World Bank, the government prepared and adopted a FCP for Srbijagas in March 2016 (Prior Action #6). Measures outlined in the plan target market and development strategy for the sector, increased revenues by improving the bill collection rate and reduced costs, such as addressing the unsustainable debt burden, unprofitable investment plan and imperfect corporate governance framework of the company. The government is moving forward in the implementation of the plan, specifically by reducing the large outstanding stock of debt through early repayment and renegotiations of high-cost debt. 31 On October 12, 2016, the Government of Serbia in consultation with the Energy Community, adopted a conclusion setting out a time bound action plan for the effective implementation of the Srbijagas unbundling. Unbundling of the company is also one of the benchmarks for the opening of Chapter 15 – Energy in the context of Serbia’s EU accession process. 22 60. The proposed triggers in the second DPL would support implementation of key measures laid out in the FCP. These include enforcing payment discipline by setting out mechanisms for discontinuing gas supplies in case of non-payment, improved economic and financial assessment 32 of the company’s investment program so as to reduce potential inefficient spending (and build -up of related debt as mentioned above). In addition, the program would support the appointment of an audit committee to increase the quality of internal controls, internal and external audits, and the issuance of a report of the said committee on its activities (Trigger #6). DPL1 Prior Action #6. The Borrower adopted a financial consolidation plan for Srbijagas that defines measures to increase revenues and reduce costs. DPL2 (Indicative) Trigger #6. The Borrower improves Srbijagas financial management through: (a) implementation of the policy for gas supply interruption based on the government adoption of a conclusion defining the mechanisms to discontinue gas supplies to commercial consumers in arrears; (b) the Ministry of Mining and Energy issues an opinion on an investment appraisal methodology as adopted by the management of Srbijagas; and, (c) the Srbijagas audit committee documents its activities as the body in charge of the oversight of the system of internal controls, internal audit, and external audit. 61. Expected results. The expected results of EPS-related policy actions under the DPL series include: (a) increased convergence of the guaranteed supply electricity tariff to reach market parity levels, if this tariff remains in effect until 2017:33 Baseline (end-2014): 64 percent; Target (end-2018): 80 percent; (b) Increased number of annual beneficiaries of the Energy Benefit Program from 60,600 households in 2014, of which 27 percent are female-headed households,34 in 2014, to 100,000 households in 2018, of which 30 percent female headed; (c) A reduction in EPS’s annual wage bill by 10 percent or more in 2018 relative to 2015, resulting from the implementation of the labor optimization plan. For Srbijagas, expected results include an increase in the company’s collection rate of current receivables due to 87 percent (averaged over 2016-2018) from the baseline of 80 percent in 2015 and having in 2018 approved a 10-year development plan for the gas Transport System Operator and 5-year development plan for the Distribution System Operator in accordance with the economic and financial appraisal methodology adopted under Trigger #6. PILLAR C: TRANSPORT PUBLIC ENTERPRISES AND STATE-OWNED COMPANIES 62. Serbia’s transport sector public enterprises and state -owned companies have in recent years received significant direct budget support, and the fiscal cost of payments for activated government guarantees has been sizeable. Furthermore, improving the quality of infrastructure and service delivery in a fiscally conscious way is critical for fiscal consolidation as well as for facilitating economic growth and regional integration. According to the 2015–2016 Global Competitiveness Report, Serbia ranked 114th out of 144 countries on the quality of roads and 90 th out of 104 countries on the quality of its rail infrastructure, a decline from its 83 rd position in the previous year. Limitations in financial resources alone cannot account for the inadequate performance and unsatisfactory outcomes in the 32 Such an economic and financial assessment refers to the definition of a systematic process for examining alternative uses of resources, focusing on assessment of needs, objectives, options, costs, benefits, risks, funding, affordability and other factors relevant to Srbijagas’ investments decisions. 33 In accordance with the 2014 Energy Law, the Energy Agency will publish by May 2017 a report on the need to continue the regulation of the guaranteed supply tariffs. 34 The share of female shared households is not currently monitored. Estimates are the World Bank’s based on the 2013 Households Budget Survey data. 23 sector. Railways of Serbia has been characterized by low labor productivity,35 overstaffing, low railway traffic intensity and a lack of investment in priority network upgrading based on economic efficiency criteria. Absent reform, railway operations, with the current size of the network, labor force and assets could not be sustained without significantly more government financial support. In the road sector, inefficient asset management practices, where maintenance contracts are not procured on a competitive basis, the lack of clarity on year to year budgetary allocations for the national road network and a large backlog in rehabilitation needs estimated at about US$1 billion are the main reasons for the unsatisfactory condition of the road network. Across both sectors enhanced efficiency and quality of service delivery require improvements in sector-level policy and governance, as well as in the corporate governance and operational management of the public transport companies. 36 63. The government started the reform process in the railway sector several years ago in large part to control the large subsidies in the sector. Before its reorganization into 4 companies, Zeleznice Srbije (Serbian Railways) had been the largest recipient of direct budget subsidies (0.3 percent of GDP in 2015) and debt service for activated guarantees (0.13 percent of GDP in 2014) are were among the largest to SOEs. These direct budget subsidies do not take into account subsidies/non-payments for electricity purchases or operating losses. When included, budget support averaged 0.9 percent of GDP over 2008 to 2013. Railway reforms started with the adoption of modern legislation and the establishment of the railway regulatory body in line with the EU acquis. 64. As a first step, in early 2015, the Railway Reform Steering Committee was established, and the company was unbundled into three operating companies (passenger, freight, and infrastructure) and a transitional company. The unbundling became effective August 10, 2015. The primary role of the transitional (fourth) company is to address the resolution of surplus property that is not state property, and to wind itself down, with a life determined by the time for this process. The Steering Committee adopted a Railway Reform Plan (2016-2020) in October 2015, informed by a 2014 World Bank Railway Policy Note and an EU-funded consultancy report. This plan covers the financial and corporate reform of railway companies and centers on asset disposal, network optimization, and staff rationalization. Underlying the reform plan’s actions is the need to change the business culture in the sector to enable and empower the new railway companies, once established, to operate commercially. 65. The proposed actions supported under the DPL are key to implementation of the railways sectoral reform agenda. Positive progress has been made flowing from the adoption of the reform plans for the railway companies. This includes putting in place and operating under the new contractual framework for the sector and for the newly created railway operating companies, for example, through track access charges and public service obligation (PSO) for the infrastructure and passenger railway companies respectively (Prior Action #8). The PSO enables the government to define the extent and type of passenger railway services which the public sector supports, better targeting direct budget support. Clear performance criteria can help improve service delivery, 35 Labor productivity was estimated at about 30 percent of the EU-27 average (comparison is with EU-27 instead of EU- 28 because the data is from 2012 before Croatia became the 28th member of the EU). The sum of passenger- km and ton-km divided by total route km was about 30 percent of the EU-27 average – 11 percent for passenger and 54 percent for freight traffic. These figures are not expected to be have changed much since the analysis of the 2012/2013 figures. 36 See, for example, the 2011 Reform Action Plan for Roads of Serbia prepared under the World Bank supported Corridor X Highway Project and World Bank (2014), Republic of Serbia: Accelerating Railway Reforms in Serbia: A Roadmap. 24 management accountability for performance, and inform decisions on future network configuration and services. The October 2015 rail reform plan included Key Performance Indicators for the period 2015–2020 for each of the operating and infrastructure companies, with performance criteria included in the respective 2016 business plans of the new railways companies (Prior Action #7). 66. The indicative trigger in the second operation focuses on implementation of additional measures to put the new rail companies on a sound financial footing and improve their efficiency . Debt was allocated to the three new operating companies at their unbundling. Any government guarantees of debt continue to hold and are expected to be assumed by the government. While this is expected to help improve the financial standing of the new operating companies, there is a need to initiate the implementation of a plan to address their historic commercial debt so as to ensure that they are not burdened with previous debt which they cannot pay and which would otherwise impede their financial viability. Improving financial transparency standards will also be important for obtaining clear information on the performance of the new companies, to guide decisions by management and to guide the allocation of public sector support. A first step, as required by legislation, is preparing annual financial statements for the new rail companies under International Financial Reporting Standards (IFRS), as required for all Serbian companies under the Law on Accounting, and making them public on the internet, per the Public Enterprise Law. Modernization of financial and accounting systems of the railway companies will also be needed to allow effective implementation of IFRS. DPL1 Prior Action #7. The Borrower: (a) implemented a new framework for railways financing through conclusion of the track access contracts between the state-owned infrastructure rail company and the state-owned freight and passenger rail companies and approving a public service obligation agreement; and (b) adopted new performance criteria for the state-owned infrastructure, freight and passenger rail companies. DPL2 (Indicative) Trigger #7. The Borrower: (a) through the respective railways operating companies, approves and initiates the implementation of a plan to restructure their commercial debt in a manner that places the companies in a position to be financially viable; and (b) through the management of the respective railway companies, makes publicly available the annual financial statements of the new railways companies prepared under International Financial Reporting Standards, as required under the Law on Accounting, and modernizes their financial and accounting systems to allow effective implementation of IFRS. 67. Labor rightsizing is an important factor in delivering improved efficiency for the railways companies. For the restructuring process to deliver its objectives of improving the efficiency of the sector, it will be important to move forward in a fair and consistent way, with firm targets for labor rightsizing and adequate plans for the process and support to affected workers. In an important step forward in this process the four railway companies adopted “Labor Optimizationâ€? Plans in early September 2016 and October 2016, which were amended slightly in November 2016 to reflect updated agreements with the trade unions on the level of severance payments and modifications to the selection criteria (Prior Action #8) setting out the medium-term targets, process, compensation packages, selection criteria, grievance mechanisms and timeline for reductions in staffing. Unions were consulted on the packages. With funding for the severance packages also in place the process can now move forward, targeting a reduction of at least 2,700 in 2016 and a total reduction of at least 25 5,500 employees through 2020 or 30 percent of the end-2014 workforce.37 Subsequent to the adoption of these plans the railways companies have moved forward with implementation, for example, presenting for approval to the National Employment Service (NES) retrenchment programs in line with legal requirements and taking steps to identify employees for the implementation of the 2016 targets through issuance of a query to employees. As of October 24, 2016, employees expressing interest in taking a severance package had reached around 65 percent of the 2016 targeted numbers for staff reduction. Implementation of rightsizing in subsequent years is an indicative trigger for DPL2. DPL1 Prior Action #8. The Borrower: (a) through the Decisions of the General Assemblies of the respective railway companies, adopted labor optimization plans for 2016-2020 setting out the medium-term targets, process, compensation packages, selection criteria, grievance mechanisms and timeline for reductions in staffing; and (b) through the management of the respective railways companies, initiated the 2016 target for staff reduction by communicating to the companies’ respective employees the option for their participation. DPL2 (Indicative) Trigger #8. The Borrower, through the General Assemblies of the respective railways companies, implements labor rightsizing in 2016 and in 2017 in accordance with their respective Labor Optimization Plans. 68. On roads, the focus is on improving the sector’s efficiency through an improved policy framework. Public enterprise Roads of Serbia (Putevi Srbije, PERS) maintains and rehabilitates the National Road network (about 17,000 km) and Motorways (600 km). Because only the motorways are tolled, Roads of Serbia received substantial direct budget support, for the remaining maintenance work, equal to, 0.2 percent of GDP in 2015. 38 Reforms needed to improve sector efficiency include the introduction of monitorable service-level agreements between the transport line ministry and Roads of Serbia and introduction of competitive tendering for road maintenance works. The adoption of a medium-term service-level agreement with clear goals and performance targets linked to secure financing is proposed as a trigger and would support improved long-term planning, and lead to a better quality of investment and asset preservation, and improved accountability by Roads of Serbia. The ongoing World Bank-supported Road Rehabilitation and Safety Project is providing support to introduce efficiency in the tendering of maintenance contracts. DPL2 (Indicative) Trigger #9. The Borrower, through its government, prepares a framework service- level agreement with PERS defining standards for different road classes, committing to provide the agreed financing for roads and holding PERS accountable for service delivery. 69. Expected results: Prior Action #7 on railways financing policy and business performance criteria, along with the trigger on commercial debt restructuring and the establishment of financial transparency standards and modernized financial accounting systems are expected to contribute to improved efficiency and financial performance resulting in a reduced level of annual direct budget operational support to the railways companies (down from RSD 13.5 billion in 2015 to RSD 11 billion 37 The railways companies are in the process of carrying out a survey of potentially interested employees in voluntary separation and have prepared the draft retrenchment programs required by the Labor Law in cases of “technological surplusâ€? labor with a view to adopting them and starting implementation of such separation in late October 2016. 38 Starting from 2012, the financing model for the roads changed with some revenues from tolls and excises redirected from the company to that of the government budget. The budgetary transfers have been lower than what Roads of Serbia used to receive through the excise tax on fuel. 26 or below in 2018, which would be just for infrastructure and passenger companies) and improved labor productivity and asset utilization, up by 15 percent in 2018 relative to 2015 for both indicators.39 Prior Action #8 and Trigger #8 on labor rightsizing in the railways companies targets a reduction in their combined wage bill of 25 percent by 2018 relative to the 2015 baseline. The qualitative result indicator associated with Trigger #9 is that by the 2019 budget maintenance levels for the different road classes are agreed between the government and Roads of Serbia and associated funding levels committed. ANALYTICAL UNDERPINNINGS 70. The design of the proposed DPL series and the proposed prior actions are informed by substantial recent and ongoing TA and analytical work, undertake with strong collaboration with other development partners . Table 5 indicates specific sectoral work which complements the overarching analysis in the recent Serbia Public Finance Review and SCD reports. Table 5. DPL Prior Actions and Analytical Underpinnings Prior actions Analytical Underpinnings PA#1 on monitoring framework for 2015 PEFA report and World Bank Input to the Government’s PFM Reform implementation of revised Law on Program highlighted need to improve arrears monitoring, payment Deadlines for Payments in discipline and ex ante commitment controls. Commercial Transactions PA#2 on the Law on Ceiling on World Bank wage system TA and TA for preparation of the Modernization Public Sector Employees and and Optimization of Public Administration PforR highlighted fragmentation institution-level limits on of wage system and need for staffing limits and controls. Serbia Rightsizing employees and Restructuring Project, funded by the EU Commission, supports PA#3 on the Law on the Salary preparation of series of functional reviews aimed to identify options for System of Public Sector Employees optimization and rightsizing in the public sector. PA#4 on guaranteed supply tariff World Bank TA to EPS to support the preparation of the FCP (finalized) and increase and increased funding to updated in 2016 outlined measures to support financial sustainability of program to protect vulnerable company, including tariff rises and reductions in labor costs through consumers rightsizing process. TA: Energy Affordability, Tariff Increase, and Protection PA#5 on EPS labor optimization of Vulnerable Populations in Serbia carried out quantitative analysis to plan assess the implementation of the ongoing Energy Vulnerable Customer program and highlighted the need for additional funding, implementation challenges and provided policy recommendations to address these. PA#6 on financial consolidation Extensive TA to Srbijagas provided analysis to inform measures set out in plan (FCP) for Srbijagas the FCP. Specific issues analyzed included: (a) financial due diligence, (b) corporate governance, (c) market analysis, (d) options for debt restructuring, and (e) analysis of the distribution sector. PA#7 on railway companies World Bank Accelerating Railway Reform in Serbia 2014 set out an action financing policy and business plan for sector and corporate governance reforms to improve sector performance criteria efficiency; EU-funded consultancy in 2015 developed detailed PA#8 on railway companies labor recommendations for improvements in institutional and corporate optimization plans performance of the rail sector. These were preceded by several TAs financed by the EU and the EBRD that provided a sound analytical framework to guide preparation of Public Service Obligation contracts for passenger transport, Multi-Annual Infrastructure Contracts, Track Access Charge regime and asset management plans. 39 Labor productivity as measured by train kilometers per employee and asset utilization as measured by passengers per kilometer of track and ton per kilometer of track. 27 4.3 LINK TO CPF, OTHER BANK OPERATIONS, AND THE WORLD BANK GROUP STRATEGY 71. The proposed DPL series will contribute to the World Bank CPF FY16-20 Focus Area 1: Economic Governance and the Role of the State and its related objectives . The CPF was approved in June 2015 with the goal to support Serbia in creating a competitive and inclusive economy and, through this, to achieve integration into the EU. More specifically the CPF sets two focus areas for support: 1. Economic Governance and the Role of the State; and 2. Private Sector Growth and Economic Inclusion. This DPL series will contribute to the first CPF focus area, cutting across four of the five objectives of the focus area, namely (i) supporting sustainable public expenditure management, (ii) assist in creating a more effective public administration and improving service delivery, (iii) more efficient and sustainable power utilities, and (iv) more efficient public transport companies. 72. The design of the DPL builds on, and is coordinated with, several other World Bank ongoing or activities under preparation. The DPL series is firmly anchored in recent World Bank analytical work and TA, including those listed above and the recently completed Systemic Country Diagnostic and Public Finance Review. In addition, it builds on knowledge and expertise from recent projects, including the Floods Emergency Recovery Loan, and is closely coordinated with, and complements, other operations including the Corridor X Highway Project and the Road Rehabilitation and Safety Project which are supporting road sector reforms. 73. Three operations in particularly are closely linked to the DPL series. The first is the SOE Reform DPL series (first operation approved by the Board in March 2015, the second in October 2016) which supported reforms: to accelerate the restructuring and divestiture program for the PA portfolio and selected SOEs operating in the commercial sector; to strengthen the governance, regulatory and institutional framework, and monitoring and transparency arrangements for SOEs; and to mitigate the social and labor market impact of the SOE reform program. The latter two pillars link closely to the reforms in the energy and transport pillars under this DPL series. The second related operation is the PforR on Modernization and Optimization of Public Administration. This aims to support implementation of the Government’s Action Plan for Implementation o f Public Administration Strategy with results areas aiming to improve human resources management, financial management and procurement management. The PEPU DPL is coordinated with the PforR, supporting key legislative and policy reforms related to PforR results areas. The third related operation is the Competitiveness and Jobs project (Board approval in September 2015) which aims to facilitate job creation and to strengthen the capacity of the NES; to improve the effectiveness of active labor market programs; and facilitate the transition of social assistance beneficiaries into formal jobs. 4.4 CONSULTATIONS AND COLLABORATION WITH DEVELOPMENT PARTNERS 74. The government has designed their reform agenda through a consultative process. Most of the reforms supported by this operation have been developed including consultations organized by the government, for example on the broad ERP and the PFM Reform Program. For the public administration rightsizing, steps are being taken to improve the consultation process, which is part of the Action Plan in the World Bank-supported PforR program. Electricity price increases followed consultation and public awareness process established by the regulator. 75. On the labor rightsizing measures, the government has made efforts to involve respective unions in the reform process. The public sector rightsizing covers a broad range of sectors and type of 28 workers (for example, workers with the status of civil servants in the ministries, and workers to which labor law and various collective agreements apply in health, education, public services). Unions were involved in consultation around the adoption of the Law on the Ceiling on Public Sector Employees in 2015. In the case of rightsizing at EPS, unions participated in various stages of the process including negotiating voluntary compensation packages, involvement in the Call for voluntary applications and as members of the Employees support teams. The entire rightsizing process in EPS in 2016 is based on the voluntary separation of workers, who will retire upon termination of employment with EPS. In the case of the railways companies, unions participated in the negotiations around severance packages and the selection criteria for the retrenchment. The Labor Optimization plan contains a stipulation that the application of involuntary separations will be carried out in collaboration with the unions. 76. This operation is prepared in close coordination and cooperation with relevant stakeholders, including development partners . The World Bank team has collaborated and consulted closely with other development partners, including the EU, EBRD, and IMF, with regular exchange of information and participation in joint meetings with technical counterparts, contributing to the design of the program. World Bank support to PFM and public administration reforms is closely coordinated with the IMF and the EU.40 Electricity sector reforms in particular are coordinated with the IMF and with EBRD. Specifically, EBRD has recently extended a €200 million restructuring line to help EPS to restructure its balance sheet and support the implementation of policy actions, complementary to those supported under the DPL, aimed at improving the commercialization of the company, raising standards of corporate governance and improving energy efficiency. Policy actions and World Bank analysis in the energy and transport sectors have also helped inform the dialogue under the IMF program on issues such as company rightsizing, financing policy, debt restructuring, and electricity price increases, among others. In railways, in addition to the World Bank, a number of IFIs, including the IMF, are supporting the sector’s reform and restructuring, with the EU financing supporting TA. IFIs, including also EIB and EBRD, are invited to meetings of the High Level railway reform steering committee. V. OTHER DESIGN AND APPRAISAL ISSUES 5.1 POVERTY AND SOCIAL IMPACT 77. Some of the DPL prior actions will have adverse distributional and social impacts in the short run, though mitigating measures are in place and the overall poverty impact is expected to be limited. Reforms supported by the DPL which will have negative distributional and social impacts are: (a) workforce rightsizing in the public administration, EPS, public railways companies and the public administration (Prior Actions #2, 5, 8), and (b) higher electricity costs (Prior Action #4), including for poor and vulnerable consumers. The overall poverty impact is expected to be limited given that (a) mitigating measures are in place, including compensation packages for laid off workers, existing programs of employment support and labor regulations, (b) the affected workers tend to be in the middle and upper quintiles of the income distribution, and (c) the government increased the 2016 budget to expand the targeted Energy Vulnerable Customers Program and the 2016 electricity price increase is relatively low. The new Law on the Public Sector Wage System (Prior Action #3) is not expected to have significant adverse distributional impacts to the extent that the implementation of 40 For example, the PfoR program supports the same government program (though different aspects of it) as the EU’s Sector Budget Support instrument and the EU Commission also provides funding for the functional reviews to identify options for optimization and rightsizing in the public sector. 29 the Law includes only the re-categorization of public workers into harmonized categories, but no adverse salary adjustments. Poverty and Social Impacts of Prior Actions Relating to Labor Rightsizing 78. The labor rightsizing in the public administration, EPS and Railways Companies can adversely impact affected workers. As mentioned above, Prior Action #2 entailed the reduction in public administration workers by 14,500, mainly in the Health, Education and Interior sectors and local public enterprises. Prior Actions #5 and #8 target staff reductions in EPS (5,000 workers over 2015 to 2019) and Railways Companies (5,500 over 2016 to 2020). The rightsizing in these three sectors (public administration, railways and EPS) will be carried out as three distinct processes with separate consultations with unions (discussed above in section 4.4). Quantitative analysis to inform the PSIA based on company records and household surveys, shows that potentially affected workers tend to be located in the middle and top quantiles of the income distribution and that they are not amongst the most vulnerable41 (See Annex 5 for more details). However, workers and their families will be affected. While educated, workers in rail and EPS tend to be older and in the same position for a long time. They may not have the right skills set to be competitive in today’s labor market, which is already stagnant with high unemployment. Some workers, particularly from railways companies, are located in small towns or in regions (for example, in Southern and Eastern Serbia) where the prospects of finding new employment can be weak. Previous qualitative research of workers retrenched from PA companies suggests that their best chances of reemployment would be in informal casual jobs.42 79. Serbia has in place a relatively well developed policy and legal framework on labor relations and retrenchment along with an institutional system which is generally adequate, although some gaps exist. Serbia’s legal framework is generally in line with international standards. Existing labor legislation provides adequate protection of workers in instances when due to technological, economic or organizational changes a particular job becomes redundant or volume of work would be reduced. In such cases the Labor Law requires that the employer prepare a retrenchment plan, which must be consulted upon with Unions, with Laws and collective agreements provide provisions for redundancy (severance) payments and formulas for its calculation. However, recent environmental and social systems assessments carried out for the purpose of the World Bank supported Modernization and Optimization of PforR, indicate that there is a reason for caution. The assessment identified gaps related to the consistent implementation of consultation with workers in the context of the public administration entities, and to monitoring and evaluation of the retrenchment process, more specifically the status of the affected employees after they receive severance payments. 80. To address the above gaps in the public sector rightsizing program, a series of measures will be implemented in the context of the above mentioned PforR. The Program includes an action plan with specific measures to address the identified shortcomings, such as improve consultation with worker and unions, identification of staff at the Ministry of Public Administration and Local Self Government to coordinate, monitor and report on the rightsizing process and its effects, prepare selection criteria for selection of employees who will be made redundant, and establishment of 41 Cancho, Cesar and Trang Van Nguyen (2016) Poverty and Social Impact Analysis of Workforce Rightsizing in the Public Sector in Serbia: Discussion Draft. Unpublished mimeo. 42 Ruggeri, Caterina (2014) Addressing the Poverty, Gender and Social Impacts of Privatizations in Serbia: Discussion Draft. Unpublished mimeo. 30 monitoring of severance payment disbursement and status of retrenched workers. The implementation of the action plan will be monitored during the implementation of the PforR. 81. To minimize adverse effects on affected workforce, the design of the Labor Optimization plans for EPS and the railway companies in Prior Actions #5 and #9 was informed by the domestic policy and legal framework and international good practice. The EPS and railways’ labor optimization plans rely as much as possible on natural attrition and voluntary applications for separation. Workers who opt for early retirement will also receive stimulative packages. In the case of involuntary separation, or workers who are declared redundant due to business reasons, workers will receive compensation packages above the minimum required by the Labor Law and will have the right to receive unemployment benefits from the NES, health insurance and pension benefits for the period while they are registered with NES. Also, the retrenchment plans set out grievance mechanisms and clarify timelines and responsibilities for the processes (with EPS having established a separate grievance unit within the legal department, for example). 82. The NES has already in place specific measures to support retrenched workers and its capacity and effectiveness is being strengthened . This category of unemployed persons is considered one of the priority groups for the NES. Measures of support include job search counseling; trainings for prequalification, psychosocial support and opportunities to participate in public works. The SOE Reform DPL series and the World Bank’s Competitiveness and Jobs project, as well as other partners, also support NES. For example, the third pillar in the SOE Reform DPL series supports the government’s adjustments in the design of its public works program so that it can better serve as an additional safety net for vulnerable groups, including redundant workers, and an assessment of how low-paying work can become more viable in the formal sector in Serbia, addressing an important barrier for re-employment of redundant workers. The Competitiveness and Jobs project aims to facilitate job creation and to strengthen the capacity of the NES by enhancing the effectiveness of the NES labor intermediation services for employers and the unemployed; improving the effectiveness of active labor market programs; and facilitating the transition of social assistance beneficiaries into formal jobs.43 Poverty and Social Impacts of Higher Electricity Costs 83. The 2016 increase in household (guaranteed supply) electricity tariffs by 3.8 percent is expected to have a limited adverse impact on poverty and energy affordability in the short run . In 2013, more than 3 in 5 households in the bottom income quintile in Serbia already report that they cannot keep their home adequately warm.44 The poorest quintile and single elderly households, spent more of total expenditures on electricity than the average, 8.9 and 14.9 percent respectively. The effect of the electricity tariff increase of 3.8 percent in 2016 is simulated to have marginally increased the burden of electricity spending in total household budget: by 0.17 percentage points for the bottom quintile and by 0.13 percentage points for the average. The higher tariff is also estimated to have a limited impact on the overall poverty rate (0.2 percentage points) when measuring poverty using an anchored relative poverty line (60 percent of the median household consumption). 45 The 43 World Bank. 2015. Serbia - Competitiveness and Jobs Project. Washington, D.C.: World Bank Group. 44 World Bank (2016) How Vulnerable are Serbian Households to High Energy Expenditures? Energy Affordability, Tariff Increase, and Protection of Vulnerable Populations in Serbia. Unpublished mimeo. 45 Relative poverty rate is estimated at 15 percent, using the 2013 Household Budget Survey. For more details on the simulation see Nguyen, Trang Van and Monica Robayo-Abril (2016) Energy Affordability and Impacts of Tariff Reform on Household Welfare in Serbia. Unpublished mimeo. 31 share of electricity poor households, that is, those with electricity accounting for more than 10 percent of spending, is expected to increase the most for the poorest quintile and elderly living alone (both by 1.5 percentage point). Although the 2016 tariff rise impacts are limited, the poor and vulnerable may still find it difficult to cope after already facing a 12 percent price rise in 2015. Using the cumulative electricity price increase of 16 percent (initial 12 percent in August 2015 plus the prior action 3.8 percent increase in 2016) poverty (using an anchored relative poverty line of 60 percent of median household income) is projected to increase from 15.0 percent to 16.0 percent.46 84. Recognizing the need to protect vulnerable households against high energy expenditures, the government has increased the budget allocation for the existing energy bill discount program (supported under the DPL as part of Prior Action 4). Following an initial tariff increase in August 2015, an inter-ministerial working group was established to develop a new Decree on Energy Vulnerable Customers. By the end of 2015, the government provided additional budget allocation for the program and approved the new decree to enhance coverage and take-up (easing some of the eligibility criteria such as the energy consumption thresholds, the asset test, bill arrears). However, changes in implementation arrangements introduced at the same time (shifting all application processes to local government units) may have led to relatively low numbers of beneficiaries in early 2016, though these have been increasing to date. The DPL series, through Trigger #5, aims to support the government to strengthen further the protection of vulnerable households against rising electricity tariffs. As a lesson learned from the previous decree (2014 –2015), the new decree included the second instance body for complaints and redress (Ministry of Mining and Energy) to the beneficiary complaints mechanism. Gender Dimensions 85. Some of the impacts discussed are expected to vary by gender. With respect to rightsizing measures, in EPS and railways companies roughly 80 percent of the labor force are men. In contrast, workers tend to be mostly female in public administration, especially in health (75 percent) and education (71 percent) sectors where the expected staff reductions are among the largest. The National Action Plan for Employment for 2017 will include women over the age of 45 as a priority group for NES activities. Female-headed households (close to a third of households in Serbia), including elderly women living alone, are more vulnerable to the energy price increases. The incidence of electricity poverty in this group is higher than among male-headed households (21.1 percent vs. 16 percent). Strengthening the energy bill discount program as supported by the DPL is important to cushion the impacts, including for female-headed households. The World Bank intends to explore with the Borrower actions which could address the identified gender gaps related to energy price increases. These activities could include better monitoring of the uptake and beneficiary profile (for example, female headed households, elderly women living alone) of the energy bill discount program. In addition, the World Bank intends to engage with the Borrower to analyze, and potentially propose actions, targeting increasing gender balance at EPS. 46 As detailed in Annex 5, the cumulative electricity tariff increase is simulated to increase the electricity budget share by 0.68 percentage points for the bottom quintile and by 0.52 percentage points for the average due to the combined tariff rise and to increase the share of electricity poor households among the poorest quintile and elderly living alone by 6.3 and 7.0 percentage points, respectively. 32 5.2 ENVIRONMENTAL ASPECTS 86. Overall the reform policies supported by the DPL series are not likely to have significant effects on the environment, forests and natural resources . By supporting the electricity tariff rises, which help correct distorted price signals, the operation is likely to have some environmental benefits through improved energy efficiency. Energy and carbon intensity in Serbia are high compared to the other South East Europe countries, given the large share of fossil fuel (particularly lignite) in their mix. Gradually adjusting the electricity prices for households and Small and medium enterprises will create incentives to move toward the more efficient use of electricity, including discouraging use of electricity for heating purposes, and hence provide potential climate change mitigation co-benefits. Likewise, improvements in operational efficiency in railways and quality of roads are likely to result in fuel savings, thus contributing to improved environmental sustainability. 87. The overall legal and regulatory framework for addressing the environmental damage and liabilities is deemed adequate, although implementation is frequently hampered by broader institutional and financial capacity constraints. Serbia has made progress toward alignment of its policies with the EU environmental acquis, and further efforts are needed to strengthen the administrative capacity and implementation framework for management of environmental risks. 47 The Law on Environmental Protection (LEP) establishes the legal framework for environmental protection, and includes provisions for environmental impact assessment, integrated pollution prevention and control (IPPC), nature protection, air, water, soil protection, and waste management which are regulated by separate laws and by-laws.48 The authorities are preparing a new Law on Environmental Liabilities (LEL), which will transpose the EU Directive 2004/35/EC of 21 April 2004 and is expected to refine and clarify the institutional mechanisms to prioritize and address environmental liabilities. Practices in Serbia vary and are not always consistent with regulatory provisions for environmental protection. The potential indirect impact of rightsizing measures may be through implementation and financial capacity constraints, for example if labor rightsizing impacts government or companies’ implementation capacity (Prior Actions 2, 5, 8) or if the new financing framework on rail companies’ (Prior Action 7) impacts their financial capacity to address historical and ongoing stock of environmental liabilities. These risks are mitigated by the legal and regulatory framework and by labor rightsizing that prioritizes efficiency improvements and is not across-the-board. 5.3 PFM, DISBURSEMENT, AND AUDITING ASPECTS 88. The assessment of the country’s PFM system in relation to designing disbursement and auditing arrangements for the loan is based on the available diagnostic work in this area in Serbia. It primarily builds on the 2015 PEFA assessment as well the functional review of the MoF conducted in 2016, relevant chapters of EU Progress Reports, annual SIGMA assessments of public expenditure management and public internal financial control (PIFC), and in-country reports, such as those by the Fiscal Council. Disbursement and auditing arrangements have been determined based on the prevailing fiduciary environment, standard procedures for DPL disbursements and previous experience with similar operations in Serbia. 47 For further analysis see World Bank (2015). Serbia - First Programmatic State Owned Enterprises Reform Development Policy Loan Program Project. 48 The LEP has a number of provisions concerning environmental liabilities, notably based on the principle of polluters' and legal successors' liability, which stipulate that any legal or natural entity that is involved in activities negatively affecting that is, damaging the natural environment is liable and that the polluter or its legal successor is responsible for eliminating the cause of pollution and related direct or indirect consequences. 33 89. As discussed above, a number of reforms have been undertaken aiming to make PFM more efficient, but further improvements are needed. The Government has undertaken a number of PFM reforms, making efforts to strengthen treasury operations and financial controls, legislative and institutional framework, budget classification and coverage, internal and external audit. These reforms are encouraging, strengthening the transparency, accountability and control framework. However, sizeable challenges remain, as highlighted in the 2015 PEFA Report, and PIFC (including internal audit and financial management and control) still has a long path to cross to respond to EU requirements in the accession process. Nevertheless, the existing inherited system of internal controls is not so weak to represent a major risk for the operation. 90. Execution of the budget is operated by the Treasury and established processes, controls and procedures provide sufficient assurance about budget execution system . The Budget is executed for payments through the Consolidated Treasury Account (CTA) operated by the Treasury. Functioning of the CTA is assessed to be reliable with adequate controls instituted, and statements and reconciliations produced on daily basis. Foreign currency funds have not yet been integrated within the CTA, so foreign currency transactions are consolidated in Treasury reports only in certain intervals. Integration of these funds within the CTA is one of the next reform steps and is expected to be implemented by 2016. Payments are done within budget appropriations (defined by either the original or supplementary budget), and hard system controls prevent payments from exceeding annual budget appropriations by a given budget beneficiary. The annual budget is published and available on the internet.49 In terms of cash and liquidity management, each budget beneficiary is assigned with a payments quota for the coming quarter which is revised every month, and similarly payments exceeding such quotas do not get processed. The Public Procurement Law of 2013 and its amendment in 2015 significantly strengthened the legal framework for public procurement in Serbia, although capacity constraints have undermined implementation.50 91. Financial controls have been gradually strengthened in recent years. While the PIFC framework has been established by provisions of the Budget System Law, functions of internal audit and financial management and control in practice still require significant development. Internal audit has been established in a majority of public sector entities but further efforts to increase its effectiveness are needed. A financial management and control (FMC) function is yet to be established in a large number of entities and written procedures either do not exist or are not applied in practice. The State Audit Institution (SAI) has come a long way in terms of staffing and coverage of audited public expenditures but further challenges remain in expanding the number of audited entities and responding to broad scope of audits mandated by legislation. The SAI completed the audit of 2014 annual financial statements of the Government (audit of 2015 is ongoing), and issues identified in previous years persist, for example, lack of appropriate systems of internal controls, deficient information on non-financial assets and compliance with the Public Procurement Law. 92. The control environment and procedures applied in the NBS and the Treasury are considered adequate. As per the World Bank’s assessment of NBS and the Treasury system, the institutional and operational arrangements had been deemed reliable. Based on the assessment, since 2012 designated accounts for all World Bank’s loans are opened in the NBS. Annual independent financial audits of the NBS do not identify any significant issues either. The auditors (Deloitte) issued a 49 See for example, the 2016 Budget Law at http://mfin.gov.rs/pages/article.php?id=11799. 50 To address these problems, the Government’s Procurement Reform Strategy of 2013 identifies priority reforms in three areas: capacity building; process improvements; and performance measurement. 34 clean (unmodified) opinion on the NBS financial statements for 2014. Audits conducted by the SAI, as well as diagnostic assessments, likewise show that Treasury operating is one of the strengths of the country’s PFM system. 93. This operation is a single-tranche loan to the Republic of Serbia. The loan proceeds will be made available to the Borrower upon the effectiveness of the Loan Agreement between the World Bank and the Republic of Serbia and compliance with the withdrawal tranche release condition. The loan is included in the Law on Budget for 2016. The proposed loan will follow the World Bank’s disbursement procedures for DPLs. Upon approval of the loan and notification by the World Bank of the effectiveness of the Loan Agreement between the World Bank and Republic of Serbia, the Borrower will submit a withdrawal application to the IBRD. The IBRD will deposit the proceeds of the loan into a foreign currency deposit account that forms part of the country’s official foreign exc hange reserves, designated by the Borrower, to be held at the NBS. This account will be managed by and subject to control of the MoF. The Borrower shall ensure that upon the deposit of the Loan into said account, that it is available to finance budgeted expenditures and the management of public debt, and is accounted for in the budget execution system. 94. No audit of the deposit account will be required, but rather a confirmation letter to be provided. The MoF will provide IBRD with written confirmation that the loan proceeds were received in an account of the government that forms part of the country’s official foreign exchange reserves, and an equivalent amount has been accounted for in the country’s budget management system. This confirmation letter should be delivered within 30 days of the receipt of loan proceeds. No additional arrangements to mitigate fiduciary risks, such as audit, are required as the disbursement arrangements are confined to the NBS and CTA. 95. In summary, overall fiduciary risk is moderate. The country’s PFM system represents moderate risk to the use of the DPL funds with due economy, effectiveness, efficiency and value for money and fiduciary risk is moderate in relation to the potential impact of fiduciary arrangements negatively impacting the program development objectives (PDOs), which relate to the improved of public expenditures management, but also to improved financial viability and efficiency of transport and energy utilities. The above-mentioned arrangements, provide sufficient safeguard and transparency on the received inflows. On the use of funds, budget execution processes are assessed to be reliable with Financial Management and Control being implemented across the budget beneficiaries as a part of broader PIFC framework. 5.4 MONITORING, EVALUATION, AND ACCOUNTABILITY 96. The Ministry of Finance will be responsible for overall monitoring and assessment of the implementation of the proposed reform agenda and for coordinating actions with other concerned ministries and agencies. In addition to the Ministry of Finance, Ministry of Energy and Mining and the Ministry of Construction, Transport and Infrastructure, key entities directly responsible for implementing the supported program include EPS, Srbijagas, Railways, and Roads of Serbia. The Ministry of Energy is leading an inter-ministerial working group to monitor the implementation of EPS FCP with a Railway Reform Steering Committee also guiding and monitoring related reforms. The reforms under the DPL are key elements in a range of strategies and action plans with their own results framework and monitoring mechanisms, for example, the broad Economic Reform Program and the Public Administration and PFM Reform Action. Progress on the rightsizing measures is 35 particularly closely monitored by the government and respective entities, especially in the context of the IMF program discussions, as well as the related PforR operation. 97. The World Bank will monitor the status of the project implementation through supervision missions and tracking results indicators . The World Bank will track the results indicators provided in the policy and results matrix (Annex I) based on the economic and legislative data provided by the various government agencies and committees and disclosed in official sources. The PforR operation also has a detailed monitoring framework - and disbursement linked indicators – concerning public administration reform measures. This information will be supplemented by regular dialogue and supervision missions through the DPL series. If necessary, results indicators can be revisited during the preparation of the second DPL based on reform progress and additional information available to evaluate the results. 98. Grievance Redress. Communities and individuals who believe that they are adversely affected by specific country policies supported as prior actions or tranche release conditions under a World Bank Development Policy Operation may submit complaints to the responsible country authorities, appropriate local/national grievance redress mechanisms, or the WB’s Grievance Redress Service (GRS). The GRS ensures that complaints received are promptly reviewed in order to address pertinent concerns. Affected communities and individuals may submit their complaint to the WB’s independent Inspection Panel which determines whether harm occurred, or could occur, as a result of WB non- compliance with its policies and procedures. Complaints may be submitted at any time after concerns have been brought directly to the World Bank's attention, and Bank Management has been given an opportunity to respond. For information on how to submit complaints to the World Bank’s corporate Grievance Redress Service (GRS), please visit http://www.worldbank.org/GRS. For information on how to submit complaints to the World Bank Inspection Panel, please visit www.inspectionpanel.org. VI. SUMMARY OF RISKS AND MITIGATION 99. The overall risk rating of this operation is substantial, as are political and governance risks. The reforms supported by the DPL series, particularly on rightsizing and financial consolidation in energy and rail, will require strong political will to implement. The 2016 elections returned a coalition government to power which is committed to tackling reforms in the areas of focus of the DPL, as demonstrated by the implementation of key measures in these sectors already. Political and governance risks are also mitigated by the government’s overarching strategic objective of Serbia furthering economic integration with the EU which calls for an acceleration of the structural reforms, as well as Serbia’s ongoing IMF Standby Arrangement and the program of reforms support by the World Bank. This includes the SOE Reform DPL series which aims to strengthen the governance and institutional framework for public enterprises. Nevertheless, the residual risk is substantial. 100. Substantial macroeconomic risks remain. Although recent economic and fiscal performance has been positive, substantial macro-fiscal risks to the PDOs remain. External macro risks relate to Europe’s overall economic recovery or adverse shifts in global financial market sentiment while internal risks arise primarily from the high level of public debt, notwithstanding the reduced fiscal deficits, and the rate of progress on crucial but politically difficult reforms, such as public employment rightsizing. A weaker economic environment, particularly if linked to reduced labor market opportunities and income growth, could undermine key reforms, such as on labor rightsizing, and the achievement of the PDOs. However, such reforms are directly supported by IFI programs, including 36 the IMF program, this DPL series and related World Bank operations, as well as by the EU-monitored national economic reform program, mitigating the risks. 101. Implementation risks are also substantial. Implementation of the proposed reforms under the DPL will strain the institutional capacity of respective ministries and public utilities, which are also moving forward on a broader set of reforms. To mitigate these risks, the government has mobilized extensive TA and support from the World Bank, the EU, and other development partners, for example, through this DPL series and the World Bank operations discussed above. This is in addition to support from other partners in these areas, particularly the EU. 102. Stakeholder risks are rated as substantial. Tariff reform and reform in energy and transport companies faced strong resistance in the past due to strong power groups (for example, unions) and a lack of confidence that the increased revenues (through higher tariffs) and cost reduction (including labor rightsizing) would benefit the broader population. To mitigate these risks, the operation supports measures aimed at improving transparency and accountability mechanisms. In addition to a strengthened program to protect vulnerable population supported under the DPL series, the Government is also committed to implement communication measures to better inform the broader population on the need for electricity tariff adjustments. There is a high risk that affected employees and more broadly unions in energy and transport companies oppose the rightsizing program. Unions are powerful groups which could pose strong opposition, and eventually, reverse reform. To mitigate this risk, the rightsizing programs in rail and EPS have been discussed with the respective unions, with further consultation through implementation needed. 103. Social and environmental risks are also substantial: Notwithstanding the fact that significant adverse environmental impacts are not expected, social and environmental risks are rated as substantial for the above reasons. As highlighted in Section 4.1, the rightsizing and electricity tariff reforms are expected to have potential adverse distributional and social impacts in the short run. While mitigating measures are in place, as detailed in Section 4.1, and the overall poverty impact is expected to be limited, the residual social risk is substantial. Table 6. Systematic Operations Risk Rating (SORT) Category Risk Rating (H, S, M or L) 1 Political and governance S 2 Macroeconomic S 3 Sector strategies and policies M 4 Technical design of project or program L 5 Institutional capacity for implementation and sustainability S 6 Fiduciary M 7 Environment and social S 8 Stakeholders S 9 Other n/a Overall S Source: World Bank staff. 37 ANNEX 1: POLICY AND RESULTS MATRIX Prior actions and Triggers Results* Prior Actions under DPO 1 Triggers for DPO 2 (End of the calendar year unless otherwise specified) PILLAR A: PUBLIC EXPENDITURE MANAGEMENT Program Development Objective A: Improve public expenditure management through strengthened PFM and public administration reform Prior Action #1. The Borrower, through its Ministry of (Indicative) Trigger #1. The Borrower, through its Results Indicator A1 – Increased percentage of Finance, adopted the framework for monitoring the Ministry of Finance (a) puts in place a central register invoices for public to public commercial implementation of the Law on Deadlines for Payments of invoices for public-public transaction and (b) transactions recorded in the central register: in Commercial Transactions, which has been revised to enforces payment deadlines for said transactions. ï‚· Baseline (end-2015): 0 percent extend its coverage to include public-public ï‚· Target (end-2018): 100 percent transactions, including those of state-owned enterprises. Prior Action #2. The Borrower: (a) adopted the Law on (Indicative) Trigger #2. Based on the Law on the Ceiling Results Indicator A2 - The number of employees in the Ceiling on Public Sector Employees setting the on Public Sector Employees, the Borrower has in 2017 the public sector, as determined by the Law on the criteria of determining the maximum number of set out updated institution-level limits on employees in Ceiling on Public Sector Employees, does not employees in the public sector, from 2015 to 2018, as the public sector, as determined by the Law. exceed the total of institutional-level limits set well as the scope and limits for reducing their number under the Law and its decisions: in order to achieve the established said maximum; and ï‚· Baseline (end-2015): no (b) established, as required by said law, the first ï‚· Target (end-2018): yes institution-level limits on the number of employees in the public sector. Prior Action #3. The Borrower adopted the Law on the (Indicative) Trigger #3. The Borrower, through its Results Indicator A3 - Increased share of employees Salary System of Public Sector Employees to rationalize government, maps all employees within the education, within the education, health and social protection the public sector pay structure. health and social protection sectors to the new grades sectors paid on the basis of their new grades set out set out in the Public Sector Job Catalogue. in the Public Sector Job Catalogue: ï‚· Baseline (end-2015): zero ï‚· Target (end-2018): 60 percent 38 Prior actions and Triggers Results* Prior Actions under DPO 1 Triggers for DPO 2 (End of the calendar year unless otherwise specified) PILLAR B: ENERGY PUBLIC ENTERPRISES Program Development Objective B: Improve the financial sustainability and efficiency of energy sector public enterprises Prior Action #4. The Borrower: (a) through its Council (Indicative) Trigger #4. The Borrower: (a) through the Results Indicator B1 - Increased convergence of the of the Energy Agency, approved a 3.8 percent increase Council of the Energy Agency, approves an additional guaranteed electricity supply tariff to reach market of the electricity tariff for guaranteed supply; (b) increase of the electricity tariff for guaranteed supply parity levels: amended the Energy Vulnerable Customers Program to in 2017; and (b) takes measures, if necessary, to ï‚· Baseline (end-2014): 64 percent increase coverage of targeted beneficiaries; and, (c) protect vulnerable households. ï‚· Target (end-2018): 80 percent increased the budget for said program. Results Indicator B2 - Increased number of total beneficiaries of the Energy Vulnerable Program: ï‚· Baseline (2014 annual): 60,600 households; of which 27 percent female headed households ï‚· Target (2018 annual): 90,000 households; of which 30 percent female headed households Prior Action #5. The Borrower, through the Supervisory (Indicative) Trigger #5. The Borrower, through the Results Indicator B3 - Reduction in annual EPS wage Board of Elektroprivreda Srbije (EPS): (a) adopted a Supervisory Board of EPS, implements the labor bill relative to 2014: labor optimization plan for 2016-2019 setting out the rightsizing in 2016 and 2017 in accordance with the EPS ï‚· Baseline (2015): zero medium-term targets, process, compensation Labor Optimization Plan. ï‚· Target (2018): 10 percent packages, selection criteria, grievance mechanisms and timeline for reductions in staffing; and (b) issued the first call for voluntary separations to implement the 2016 target for net staff reduction. Prior Action #6. The Borrower adopted a financial (Indicative) Trigger #6. The Borrower improves Results Indicator B4 - Increase in Srbijagas’ consolidation plan for Srbijagas that defines measures Srbijagas financial management through: (a) collection rate of current receivables: to increase revenues and reduce costs. implementation of the policy for gas supply ï‚· Baseline (2015): 80 percent interruption based on the government adoption of a ï‚· Target (average 2016-2018): 87 percent conclusion defining the mechanisms to discontinue gas Results Indicator B5 - The approved Srbijagas 10- supplies to commercial consumers in arrears; (b) the year development plan for the Gas Transport Ministry of Energy and Mining issues an opinion on an System Operator and 5-year development plan for investment appraisal methodology as adopted by the the Distribution System Operator are in accordance management of Srbijagas; and, (c) the Srbijagas audit with the adopted economic and financial appraisal committee documents its activities as the body in methodology: charge of the oversight of the system of internal ï‚· Baseline (2016): No controls, internal audit, and external audit. ï‚· Target (2018): Yes 39 Prior actions and Triggers Results* Prior Actions under DPO 1 Triggers for DPO 2 (End of the calendar year unless otherwise specified) PILLAR C: TRANSPORT PUBLIC ENTERPRISES AND STATE-OWNED COMPANIES Program Development Objective C: Improve the financial sustainability and efficiency of transport sector public enterprises and state-owned companies Prior Action #7. The Borrower: (a) implemented a new (Indicative) Trigger #7. The Borrower: (a) through the Results Indicator C1 - Level of annual direct budget framework for railways financing through conclusion of respective railways operating companies, approves and operational support to the Railways Companies: the track access contracts between the state-owned initiates the implementation of a plan to restructure ï‚· Baseline (2015): RSD 13.5 billion infrastructure rail company and the state-owned their commercial debt in a manner that places the ï‚· Target (2018): RSD 11 billion freight and passenger rail companies and approving a companies in a position to be financially viable; and (b) Indicator C2 - Improvements in labor productivity public service obligation agreement; and (b) adopted through the management of the respective railway (measured by train kilometers per employee) and in new performance criteria for the state-owned companies, makes publicly available the annual asset utilization (measured by passengers per infrastructure, freight and passenger rail companies. financial statements of the new railways companies kilometer of track and ton per kilometer of track) prepared under IFRS, as required under the Law on relative to 2014: Accounting, and modernizes their financial and ï‚· Baseline (2015): zero accounting systems to allow effective implementation ï‚· Target (2018): 15 percent (for both of IFRS. indicators) Prior Action #8. The Borrower: (a) through the (Indicative) Trigger #8. The Borrower, through the Results Indicator C3 - Reduction in annual wage bill Decisions of the General Assemblies of the respective General Assemblies of the respective railways of railways companies relative to 2015: railway companies, adopted labor optimization plans companies, implements labor rightsizing in 2016 and in ï‚· Baseline (2015): zero for 2016-2020 setting out the medium-term targets, 2017 in accordance with their respective Labor ï‚· Target (2018): 25 percent process, compensation packages, selection criteria, Optimization Plans. grievance mechanisms and timeline for reductions in staffing; and (b) through the management of the respective railways companies, initiated the 2016 target for staff reduction by communicating to the companies’ respective employees the option for their participation. (Indicative) Trigger #9. The Borrower, through its Results Indicator C4 - The government agrees with government, prepares a framework service-level Roads of Serbia on maintenance levels for the agreement with PERS defining standards for different different road classes with associated guaranteed road classes, committing to provide the agreed funding levels committed: financing for roads and holding PERS accountable for ï‚· Baseline (for 2016 budget): no service delivery. ï‚· Target (for 2019 budget): yes Note: * Additional information on the results indicators is provided in the respective discussions in Section 4.2. 40 ANNEX 2: LETTER OF DEVELOPMENT POLICY 41 42 43 44 45 46 47 48 49 50 ANNEX 3: FUND RELATIONS ANNEX IMF Executive Board Completes the Sixth Review of Serbia’s Stand-By Arrangement Press Release No. 16/563, December 16, 2016 ï‚· The economy continues to strengthen, supported by the authorities’ efforts ï‚· Significant progress has been made on fiscal consolidation in 2016 ï‚· Serbia achieved notable improvement in business environment, but more needs to be done The Executive Board of the International Monetary Fund (IMF) on December 16, 2016 completed the sixth review of Serbia’s economic performance under the Stand-By Arrangement (SBA). The completion of the review will make available the cumulative amount of SDR 662.575 million (about €850.8 million). The Serbian authorities have indicated their intention to continue treating the arrangement as precautionary. The Executive Board approved the 36-month, SDR 935.4 million (about €1.2 billion at the time of approval) SBA for Serbia on February 23, 2015 (see Press Release No. 15/67). Following the Executive Board’s decision, Mr. Tao Zhang, Deputy Managing Director and Acting Chair, issued the following statement: “The Fund-supported program is delivering positive results, underpinning macroeconomic management and structural reforms in Serbia. The economy continues to strengthen, supported by the authorities’ efforts to improve public finances, address structural weaknesses, and strengthen the financial sector. Employment is rising, inflation remains firmly under control, and public debt has started to decline. Full implementation and strong ownership of the reform agenda are critical to consolidate hard-won gains, improve the business climate, and support Serbia’s medium-term growth. “Significant progress has been made on fiscal consolidation in 2016, on account of strong revenue and ongoing expenditure control. Institutional reforms aim to secure fiscal sustainability and improve public services. Priorities include eliminating domestic arrears, reforming the public administration and wage system, and strengthening public investment management. Further efforts are also needed to minimize fiscal risks through a restructuring of unviable state-owned enterprises, especially in the mining, energy, and transportation sectors, while enhancing social safety nets. The authorities are taking steps to strengthen public project appraisal and implementation, and modernize the educational system. “The reduction in the inflation target reflects improved macroeconomic fundamentals and market confidence. The lower target should support the dinarization strategy and help reduce long-term interest rates. The current cautiously accommodative monetary policy stance remains consistent with the new target. “Financial sector reforms have strengthened the resilience of the sector. The strategy for resolving nonperforming loans has helped reduce the overall bad loan ratio, and the authorities remain committed to its full implementation, especially with respect to state-owned banks. 51 “Serbia has achieved notable improvement in the business environment, but more needs to be done to boost investor confidence and medium-term potential growth. Particular efforts should be made to improve the court system, strengthen the quality of the judiciary process, and facilitate the use of effective out-of-court arbitration.â€? http://www.imf.org/en/News/Articles/2016/12/16/PR16563-Serbia-IMF-Executive-Board-Completes- the-Sixth-Review-of-Stand-By-Arrangement 52 ANNEX 4: ENVIRONMENT AND POVERTY/SOCIAL ANALYSIS TABLE Prior actions Significant Significant positive or poverty, social negative or distributional environment effects positive effects or negative (yes/no/to be (yes/no/to be determined) determined) PILLAR A: PUBLIC EXPENDITURE MANAGEMENT Program Development Objective A: Improve public expenditure management through strengthened PFM and public administration reform Prior Action #1: The Borrower, through its Ministry of Finance, adopted the framework No No for monitoring the implementation of the Law on Deadlines for Payments in Commercial Transactions, which has been revised to extend its coverage to include public-public transactions, including those of state-owned enterprises. Prior action #2: The Borrower: (a) adopted the Law on the Ceiling on Public Sector No Yes, negative Employees setting the criteria of determining the maximum number of employees in the public sector, from 2015 to 2018, as well as the scope and limits for reducing their number in order to achieve the established said maximum; and (b) established, as required by said law, the first institution-level limits on the number of employees in the public sector. Prior action #3: The Borrower adopted the Law on the Salary System of Public Sector No No Employees to rationalize the public sector pay structure. PILLAR B: ENERGY PUBLIC ENTERPRISES Program Development Objective B: Improve the financial sustainability and efficiency of energy sector public enterprises Prior action #4: The Borrower: (a) through its Council of the Energy Agency, approved a Yes, positive Yes, negative 3.8 percent increase of the electricity tariff for guaranteed supply; (b) amended the Energy Vulnerable Customers Program to increase coverage of targeted beneficiaries; and, (c) increased the budget for said program. Prior action #5: The Borrower, through the Supervisory Board of Elektroprivreda Srbije No Yes, negative (EPS): (a) adopted a labor optimization plan for 2016-2019 setting out the medium-term targets, process, compensation packages, selection criteria, grievance mechanisms and timeline for reductions in staffing; and (b) issued the first call for voluntary separations to implement the 2016 target for net staff reduction. Prior action #6: The Borrower adopted a financial consolidation plan for Srbijagas that No No defines measures to increase revenues and reduce costs. PILLAR C: PUBLIC TRANSPORT COMPANIES Program Development Objective C: Improve the financial sustainability and efficiency of transport sector public enterprises and state-owned companies Prior action #7: The Borrower: (a) implemented a new framework for railways financing No No through conclusion of the track access contracts between the state-owned infrastructure rail company and the state-owned freight and passenger rail companies and approving a public service obligation agreement; and (b) adopted new performance criteria for the state-owned infrastructure, freight and passenger rail companies. Prior action #8: The Borrower: (a) through the Decisions of the General Assemblies of the No Yes, negative respective railway companies, adopted labor optimization plans for 2016-2020 setting out the medium-term targets, process, compensation packages, selection criteria, grievance mechanisms and timeline for reductions in staffing; and (b) through the management of the respective railways companies, initiated the 2016 target for staff reduction by communicating to the companies’ respective employees the option for their participation. 53 ANNEX 5: ADDITIONAL ANALYSIS OF POVERTY AND SOCIAL IMPACT 1. This annex provides additional information on the potential poverty and social impact of the DPL prior actions. It focuses on quantitative analysis of the prior actions relating to labor rightsizing in EPS, the railways companies and public administration and the electricity tariffs adjustments. Discussion of mitigating measures and the overall PSIA is provided in Section 5.1. Poverty and Social Impacts of Labor Rightsizing in EPS, Railways Companies and Public Administration 2. Public workers potentially affected by the labor rightsizing in the public administration, EPS and railways companies are not the most vulnerable groups in Serbia’s population. An analysis based on the companies administrative records and household surveys show that overall poverty impacts would be limited, especially in the short run, since the potentially affected public workers are not the most vulnerable population.51 Workers in public administration, EPS and public railway companies, as a whole, are older and more educated than in the formal and informal private sector. Salaries are higher than in similar positions in the private sector, especially in EPS. They are in a better position than former SOE workers from the PA companies, which were rationalized in their vast majority a few years ago. However, although rightsizing in the public sector has received considerable public awareness in recent years, preparation of workers in advance for the possibility of losing their employment may be lower, on account of the stability of employment enjoyed until very recently (in contrast, most PA companies liquidated a few years ago were carrying arrears in their salaries and many companies were de-facto liquidated before formally laying off workers).52 In terms of welfare, workers from the three affected groups are not poor nor in a particular vulnerable position, though workers in transport are slightly less well-positioned. In general, the workers tend to be located in the mid to top quintiles of the distribution, and other vulnerability indicators (for example, single earners, household composition, health status) seem to be consistent with what is observed among formal private sector workers and better than the informal sector (Table 5.1). 3. Nonetheless, it is still important to acknowledge that workforce rationalization will have an important social cost on wellbeing of the retrenched workers and their families, and previous experiences indicate that it is very difficult for them to find new permanent positions. The immediate loss of a significant income source from public wages, unless compensated with a fair severance package, would imply a negative shock to household income in those families. More than a third of public workers report to be the only employed person in the household, and particularly for transport workers, a significantly higher share relies on public wage as the only source of income. The profile of these workers suggest that while educated, they tend to be older workers in the same position in the public sector for a long time, and may not have the right skills set to be competitive in a labor market already stagnant with high unemployment. Some workers, particularly from railways companies are located in small towns or in regions of the country (for example, Southern and Eastern Serbia) where the prospects of finding new employment can be weak. Previous qualitative research of 51 Cancho, Cesar and Trang Van Nguyen (2016) Poverty and Social Impact Analysis of Workforce Rightsizing in the Public Sector in Serbia: Discussion Draft. Unpublished mimeo. 52 Ruggeri, Caterina (2014) Addressing the Poverty, Gender and Social Impacts of Privatizations in Serbia: Discussion Draft. Unpublished mimeo. 54 workers laid off from PA companies suggests that their best chances of reemployment would be in informal casual jobs.53 4. The rightsizing impacts are expected to have gender dimensions. Workers are mostly female in Public Administration, especially in health (75 percent) and education (71 percent) where expected staff reductions are larger. In EPS and Railways, roughly 80 percent of the labor force are men. Table 5.1 Welfare Characteristics Across Groups of Workers Total Private Private Electricity /1 Transport /2 non-SOE Public Formal Informal Welfare characteristics Relative Poverty (<60% median income) Non-poor 98.9 89.5 96.7 88.3 52.7 Poor 1.1 10.5 3.3 11.7 47.4 Income Quintiles Lowest 1.1 4.6 1.9 8.6 39.1 2 5.8 17.2 8.6 16.1 26.8 3 10.1 25.3 14.6 22.3 17.6 4 24.6 22.4 26.4 26.1 10.6 Richest 58.4 30.5 48.5 26.8 5.9 Vulnerability Indicators Only adult employed in household 33.3 40.2 34.8 34.3 30.8 Only source of income 8.5 22.3 13.2 11.4 8.6 Bad health 5.4 7.7 4.9 3.8 13.3 Chronic illness 15.1 18.3 14.8 11.2 21.3 No one to talk problems 4.9 4.3 3.1 2.9 3.2 No friends or relatives to help 16.3 12.9 9.3 9.9 11.8 Pays rent 13.2 10.8 14.8 12.4 3.1 Source: World Bank staff elaboration based on 2013 Survey on Income and Living Conditions. Note: 1/ Electricity refers to public workers in the electricity, gas, steam and air-conditioning supply industry. 2/ Transport refers to public workers in the railways, road and pipeline transportation industry. Analyses available in Cancho and Nguyen (2016) show that Electricity and Transport categories capture to a large extent the characteristics of EPS and Railways Companies workers and hence can act as proxies for workers from those companies for the analysis. Non-SOE Public sector workers include public workers on the Public Administration, Health, Education, and Other Services (for example, financial, professional). Private formal and informal refers to registered and unregistered companies, as defined in the SILC. Poverty and Social Impacts of Higher Electricity Costs 5. An increase in household (guaranteed supply) electricity tariffs by 3.8 percent is expected to have a small adverse impact on energy affordability in the short run, particularly among the poor and single elderly. Based on the EU Survey on Income and Living Conditions (SILC), almost one in five households in Serbia report that they cannot keep their home adequately warm; a share higher than 53 Ruggeri, Caterina (2014) Addressing the Poverty, Gender and Social Impacts of Privatizations in Serbia: Discussion Draft. Unpublished mimeo. 55 in most of the new EU member countries.54 The rate is particularly high, 65.6 percent, among households in the bottom income quintile. Arrears and late payments of bills are common: 45.8 percent of lowest income households in Serbia have incurred at least one late payment in utility services, compared to only 14.7 percent in the top quintile. 6. The poor and the elderly living alone spend more of their budget on electricity than other household categories, making them more vulnerable to increases in electricity tariffs. The poorest quintile spends 8.9 percent of their total expenditures on electricity while the top quintile spends less than 5 percent. The elderly living alone, while often not among the poorest, tend to pay large heating and lighting expenses for their apartments out of their pension income. Single elderly households spend 14.9 percent of expenditure on energy and 8.6 percent on electricity, significantly higher than the average. Similarly, households with minimum pensions and recipients of financial social aid (FSA) have relatively high budget shares of electricity expenditures, at 7.6 percent and 6.7 percent respectively. 7. The 2016 tariff increase is expected to increase electricity poverty but would have a very limited impact on poverty. The effect of the electricity tariff increase of 3.8 percent in 2016 is simulated to have marginally increased the burden of electricity spending in total household budget: by 0.17 percentage points for the bottom quintile and by 0.13 percentage points for the average. The higher tariff is estimated to have a negligible impact on the overall poverty rate (0.2 percentage point increase) when measuring poverty using an anchored relative poverty line (60 percent of the median per adult equivalent household consumption).55 The share of electricity poor households, that is, those with electricity accounting for more than 10 percent of spending, is expected to increase the most for the poorest quintile and elderly living alone (both by 1.5 percentage points). The cumulative electricity tariff increase of 16.256 percent (initial 12 percent in August 2015 plus the prior action 3.8 percent increase in 2016) is simulated to have a larger effect, increasing the electricity budget share by 0.68 percentage points for the bottom quintile and by 0.52 percentage points for the average due to the combined tariff rise. The share of electricity poor households among the poorest quintile and elderly living alone is calculated to have increased by 6.3 and 7.0 percentage points, respectively, and poverty to increase from 15.0 percent to 16.0 percent. 8. As part of Prior Action 4, the DPL also supports additional funding of the existing energy bill discount program to protect vulnerable households against high energy expenditures. Following the implementation of the first tariff increase in August 2015, an inter-ministerial working group was established to develop a new Decree on Energy Vulnerable Customers. The working group, chaired by the Ministry of Mining and Energy, drafted the amended decree with the objective of expanding coverage of vulnerable households. The amended decree was approved on December 31, 2015 and additional budget allocation was provided. The decree eased some of eligibility criteria (for example, asset test under the local government window) with the most notable design change the setting of the energy consumption thresholds for 2016 at a significantly higher level. Another obstacle to take up was also removed - the existence of energy bill arrears will no longer affect the eligibility for the current bill. However, as an unintended consequence of the amended decree, the procedure for obtaining the status of vulnerable customer has become more complicated for the FSA and child 54 World Bank (2016) How Vulnerable are Serbian Households to High Energy Expenditures? Energy Affordability, Tariff Increase, and Protection of Vulnerable Populations in Serbia. Unpublished mimeo. 55 Relative poverty rate is estimated at 15 percent, using the 2013 Household Budget Survey. For more details on the simulation see Nguyen, Trang Van and Monica Robayo-Abril (2016) Energy Affordability and Impacts of Tariff Reform on Household Welfare in Serbia. Unpublished mimeo. 56 allowance (CA) beneficiaries in 2016. As a consequence of a legal challenge to the earlier Decree, the amended decree turned local self-governments into the only implementing agency for the benefit. This has led to a duplication of the verification process for FSA and CA recipients, representing a new and significant administrative hurdle that has led to relatively low numbers of beneficiaries in early 2016, though these have been increasing to date. The second DPL aims to support the government in further strengthening the protection of vulnerable households against rising electricity tariffs. 9. Electricity prices increases will have gender dimensions. 31.9 percent of households are headed by a female. In addition, female-headed households spent a much larger share of expenditure on energy (13.2 percent) than male-headed households (11.3 percent). The share of electricity is also higher among female-headed HH (7.2 percent vs. 6.6 percent). Finally, the incidence of electricity poverty in this group is higher than among male-headed households (21.1 percent vs. 16 percent), making them more vulnerable to electricity price increases. Strengthening the energy bill discount program is important to cushion the impacts, including for female-headed households. 57