37538 noTE no. 2 ­ APRIL 2006GRIDLINES Sharing knowledge, experiences, and innovations in public-private partnerships in infrastructure Armenia travels the bumpy road to all-day electricity supply How perseverance pays off in power sector reform Gevorg Sargsyan, Ani Balabanyan, and Denzel Hankinson A rmenia's power sector has suffered many setbacks: in the late 1980s Table 1 nuclearan earthquake that took its major Installed capacity of armenia's power plants, 1992­2004 plant off-line, and in the early 1990s the collapse of the Soviet Union, economic Capacity Generation plant (megawatts) blockade, and repeated sabotage of a new gas pipeline--all of which severely disrupted Thermal 1,746 fuel supply. Technical and commercial prob- Hrazdan 1,100 lems further crippled operations. Armenians Yerevan 550 endured hard winters with barely two hours Vanadzor 96 of electricity a day. The government set out to Hydropower 1,032 reform and privatize the sector, persevering Sevan-Hrazdan 556 through setbacks and learning from initial Vorotan 400 failure. Its persistence paid off: today the Small plants 76 system runs efficiently and delivers power Nuclear 408 24 hours a day. Medzamor Unit 2 408 The Soviet Union's collapse left Armenia with Total 3,196 a fragment of a power system, never meant to Source: Armenia, Ministry of Energy. function as a stand-alone grid. Plants were built to run on fuel imported from thousands of miles away, from neighbors that, without the Soviet neighboring Georgia, was regularly interrupted Union, could not offer certainty of supply or by acts of sabotage. terms that Armenia could afford. Armenia was left to rely almost entirely on its In 1992, at the beginning of the war over hydropower resources, at great expense to Lake the ethnic Armenian­dominated region of Sevan, one of the world's largest high-altitude Nagorno-Karabakh, neighbors Azerbaijan and lakes and a source of pride to Armenians. A source Turkey imposed an economic blockade, cutting for irrigation and drinking water as well as power off Armenia's only source of gas and oil for its thermal plants (see table 1 for details on Arme- generation, the lake was soon severely depleted. In nian power plants). Four years earlier a massive 1992­96 Armenians suffered brutal winters with earthquake had shut down the Medzamor nuclear little more than two hours of electricity a day. PUBLIC-PRIVATE INFRASTRUCTURE ADVISORY FACILITY power plant, source of roughly a third of Arme- Gevorg Sargsyan is a senior infrastructure specialist, and Ani nia's electricity generation at that time. Supply Balabanyan an operations analyst, at the World Bank. Denzel from a new gas pipeline, built in 1993 through Hankinson is manager of Castalia Strategic Advisors. Helping to eliminate poverty and achieve sustainable development through public-private partnerships in infrastructure PUBLIC-PRIVATE INFRASTRUCTURE ADVISORY FACILITY electricity reform is launched government. Moreover, the tender documents were By late 1996, 24-hour electricity supply was flawed, and the legal and regulatory framework restored. The Medzamor nuclear power plant incomplete. Still, the tender took place, and inter- was restarted, the gas pipeline sabotage abated, national operators expressed interest. Motivated the small hydropower plants pitched in their to try again, the government hired new transaction share. With donor assistance, the government advisers, overhauled the tender documents, and began a campaign to link service quality to refined its legal and regulatory framework. payment of bills. Tariffs were set at equal levels for all customers, spurring tariff rebalancing to In autumn 2001 the government launched its remove the cross-subsidies that were a legacy of second tender for the distribution system. But then the Soviet-era energy system. Large industrial the terrorists attacked the World Trade Center, and commercial customers had subsidized resi- Enron collapsed, and the California electricity crisis dential customers, with the result that tariffs in spawned litigation and investigations. International 1992­93 averaged roughly a tenth of the level operators had little appetite for new purchases in needed to cover costs. emerging markets and in a sector with regulated returns in an untested regulatory framework. Still, significant problems remained. In 1995 explicit and implicit subsidies to the power In 2002 the government went to plan B: a sector reached roughly 11 percent of GDP. Bill- management contractor rather than an owner. ing collections barely surpassed 50 percent, and A little-known company registered in Guernsey, nearly 25 percent of power produced disappeared Midland Resources Holding (MRH), expressed through commercial losses or electricity theft interest. Primarily a trading company, MRH (representing electricity injected into the trans- had no experience in electricity operations. mission system but not metered or billed, net of Though skeptical, the government proceeded electricity lost for technical reasons). (cautiously), accommodating this atypical "stra- tegic investor." The first, In 1995 the government unbundled the state utility Armenergo into separate companies for MRH assumed control of Armenia's distribution failed generation, transmission, and distribution. It system in autumn 2002, leading the way to priva- attempt at installed an independent regulator, the Arme- tization in generation. Several Russian companies privatization nian Energy Regulatory Commission (AERC), swapped financial control of Medzamor and owner- offered with a reform-minded team at the helm. It sold ship of the Hrazdan thermal power plant and several small hydropower generation plants in Sevan-Hrazdan hydropower cascade against US$96 lessons-- 1997. And in 1998 the government began efforts million in state debt forgiveness in 2002­03. and the to privatize the distribution company. a big turnaround government Reformers also tackled commercial losses and Armenia has maintained 24-hour electricity took note nonpayment (or undercollection), the power service since 1996. Collections are at nearly 100 sector's two biggest problems. Some 12,000 new, percent of sales. Commercial losses register at tamper-proof meters were installed and existing only 4 percent. Tariffs, set by a regulator with meters relocated to common areas of apartment eight years of experience, are nearly high enough blocks to discourage tampering and aid accurate to recover medium-term costs. The reforms have reading. An automated metering and data acqui- saved the government roughly US$386 million sition system and a customer information system in explicit and implicit subsidies since 1994. were adopted to identify the source and extent of the system's problems. The higher electricity prices brought gains in efficiency by prompting users to invest in more Privatization through trial and error energy-efficient technologies. Armenia's water The first attempt to privatize the distribution utilities, for example, upgraded inefficient electrical system, in 2001, met with little support within the pumping systems or switched to gravity-fed systems Armenia travels the bumpy road to all-day electricity supply that use no electricity. The higher prices also led to included indemnity against contingent liabili- the expansion of the gas network, and some users ties, registration of the assets of the electricity have switched to gas for heating and cooking. distribution company (now called Electricity Networks of Armenia, or ENA) with the govern- The higher prices must have been difficult for ment to prevent asset stripping, and 110-kilovolt the poorest Armenians to pay. But the govern- substations, a source of big commercial losses ment deemed that they would not have been beyond the distribution company's control. better off without the reform. Moreover, Arme- nia's poor customers generally had a good The government also rectified weaknesses in the record of paying utility bills. It was industrial legal and regulatory framework. It authorized customers and government institutions receiv- ENA to disconnect customers failing to pay. It ing free power (sometimes with authorization, Initiating guaranteed that the Central Bank would pay sometimes without) that accounted for most of the bills of defaulting "VIP customers"--mostly reform before the fiscal deficit. Social transfers may not yet be government agencies and state-owned enter- privatization enough to offset the effect of the price increases prises. And it no longer required that the new can signal on the poor. But with the power sector's higher owners commit to a fixed level of investment, earnings, the government can now fund those intent to instead outlining service quality standards for transfers. Indeed, social spending rose as a share judging their performance. private of both fiscal spending and GDP between 2001 investors and 2004. The privatization effort gained even more momen- tum when the justice ministry took over from the How did armenia do it? energy ministry, to address concerns about conflicts Armenia's strategy of relocating meters from of interest, political infighting, and obstruction. apartments to common areas, rather than replacing them all, proved to be cost-effective While donors and transaction advisers viewed in addressing the high commercial losses and MRH with skepticism, the government proceeded low collections at the heart of the power sector's with its own due diligence and imposed addi- problems. And the donor-supported information tional safeguards: systems helped the government pinpoint the problems. · To ensure that MRH had the necessary tech- nical capacity, the government required that These technical improvements, and the politically it hire a management contractor with power contentious tariff rebalancing, were completed sector experience. before privatization, spearheaded by the new · MRH would deposit all customer receipts in regulator. Faced with influential opponents in the an account agreed to with the power gener- early stages of reform, AERC effectively defended ators, to ensure that they would be paid before its role and mission. Its independence came other creditors. thanks to its early leadership. The first commis- sioners were reformers from outside the Ministry · To guard against misuse of cash flows and of Energy, respected by both the government and prevent the stripping of assets, no more than international donors. 25 percent of ENA's shares could be sold with- out prior approval by the regulator. Learning from the first failed tender for the distribution system, the government, the regula- The partnership appears to work. Commit- tor, advisers, and donors adopted critical changes ments to disconnect nonpaying customers have in the second try. The tender package now been honored, including when it came to such reflected the concerns of potential buyers. The prominent nonpayers as the Ministry of Internal two distribution companies were consolidated Affairs, a Russian military base, city govern- into a single asset. Cross-ownership of distribu- ment offices in Yerevan, and even the Ministry tion and generation was allowed. And the tender of Energy. And the government has stayed the course despite changes in leadership and a · A comprehensive, cross-sectoral approach difficult market. to reform is beneficial. The results of reform in the power sector can be enhanced by reform ENA is now a profitable and well-run enterprise.1 Suppliers and employees are paid in full and on in the water sector and other industries. When time. To control nontechnical losses, MRH raised these big consumers of electricity improve the the salaries of directors, engineers, and inspectors efficiency of their energy use, their financial by five- to tenfold and includes in employees' performance improves and they are better able (now far higher) salaries a variable component to pay their bills on time--and all this boosts based in part on improvements in losses and the performance of the power sector. To address collections. equity concerns, social protection mechanisms should be implemented in parallel. Sustained partnerships with donors allowed the government to proceed gradually and even · Reform should start before privatization. through trial and error. Donor representatives To attract serious bidders, a solid legal and regu- and government counterparts developed mutual latory framework must be in place well before respect and resolved issues through extensive privatization. consultation. · Donors should provide the right mix of support. The donor-funded effort to relocate What lessons for others? meters proved to be cheaper than and just as Armenia's experience offers lessons that may be effective as installing new meters. Much prog- helpful to other countries pursuing similar reforms: ress can be made by tackling the easiest and · Political will is paramount. The best efforts most cheaply solved problems early. of donors will ultimately prove ineffective if · Service quality matters most. In contracting a country's government and people do not with a private operator, governments should support the reform. focus less on investment and more on service · Champions matter. Government officials quality or other outputs in obtaining commit- who enjoy broad respect and influence and are ments from the operator. The government not perceived as having a vested interest drive need worry about inputs only if it is certain successful reform. Donors and governments what outputs it wants to achieve. can help enable these champions through early, Notes substantive consultations. The study on which this note is based, and the production of an accompanying video, were supported by a PPIAF grant of · Initial failure may be better than not trying US$60,300. at all. The bidding documents and legal and 1 In November 2004 MRH began discussions with a subsidiary of Russia's RAO UES (Interenergo BV) to sell 100 percent of regulatory framework in Armenia benefited its ownership in ENA. The Armenian cabinet approved the substantially from the lessons of the first, failed transaction in principle in September 2005. Final approval is subject to negotiations and the drafting of a contract between the government and the new owners. In early 2006 negotiations were GRIDLINES tender. still under way. · Frequent, substantive communica- Gridlines share emerging knowledge tions with bidders helps. Extensive on PPP and give an overview of a wide selection of projects from various regions of interaction between the govern- the world. Past notes can be found at www. ment and bidders established ppiaf.org/gridlines. Gridlines are a publication credibility between the parties of PPIAF (Public-Private Infrastructure Advisory Facility), a multidonor technical assistance and helped institutionalize a PUBLIC-PRIVATE INFRASTRUCTURE ADVISORY FACILITY facility. Through technical assistance and two-stage bidding process for knowledge dissemination PPIAF supports the efforts of policymakers, nongovernmental organizations, tendering other contracts. research institutions, and others in designing and implementing strategies to tap the full potential of private involvement in infrastructure. The views are those of the authors and do not necessarily reflect c/o The World Bank, 1818 H St., N.W., Washington, DC 20433, USA the views or the policy of PPIAF,the World Bank, the World Bank, Phone (+1) 202 458 5588 FAX(+1) 202 522 7466 or any other affiliated organization. PUBLIC-PRIVATE INFRASTRUCTURE ADVISORY FACILITY generAl eMAIl ppiaf@ppiaf.org web www.ppiaf.org