52659 NOVEMBER 2009 ABOUT THE AUTHOR ARIANA PROGRI is an investment officer with dsas Keys to Power up Five a Private-Sector Participation Transaction: IFC Infrastructure Advisory in Europe and Central Asia. She the Albanian Experience joined IFC in May 2007 and has been involved with IFC Infrastructure advisory Privatizing electricity utilities while policy and regulatory reforms projects in Albania and Kosovo. are still ongoing may not always be advisable. However, IFC's experience with privatization of electricity distribution in Albania APPROVING MANAGER Georgi Petrov, regional shows that when there is strong political will and commitment, business line leader, Infrastructure Advisory, when the process of privatization is well integrated with other Europe and Central Asia. reform initiatives, and when a fair public-private balance is maintained, it is possible to successfully introduce private-sector participation. Albania was a net power exporter at the establishing new market operators. beginning of the economic transition in the Privatization also called for a number of early 1990s, but growing demand turned policy and regulatory reforms to allow for a the country into a net importer by 1998. competitive electricity market, consistent with European Union (EU) requirements, Heavy reliance on hydroelectric production, and for a sound regulatory regime with the government's inability to mobilize proper energy pricing and tariff policies. adequate investments, mismanagement of Such reforms were far from being complete the state-owned electricity utility, KESH,1 when the privatization process started. and inadequate tariff levels made it However, this offered an opportunity to impossible for the sector to keep up with the introduce the right public-private balance in demand. Large-scale expensive imports the newly drafted regulatory framework. further constrained the sector's financial The coordination among ongoing electricity stability. As a result, the country suffered reform initiatives and the integration of from major electricity supply shortages privatization with regulatory and legislative associated with extensive and regular load review helped structure the electricity sheds of 400 to 900 gigawatt hours per market and the transaction in such a way as year. to increase potential investors' interest. To address the electricity sector's The strong political commitment and the shortcomings, the government of Albania partnership that IFC built with the decided to undertake a series of initiatives government helped bring all stakeholders that aimed to improve constraints in on board and accelerate the reform generation and interconnection, reduce implementation process, without which the dependence on hydroelectric production, transaction would have never closed and liberalize the electricity market. The successfully. government also decided to unbundle and privatize the electricity distribution sector The excellent cooperation between IFC and and in January 2007 retained IFC as its lead the World Bank also proved critical in advisor in the process. achieving donor community consensus on major regulatory issues and in structuring an Privatization of the electricity distribution attractive transaction. The partial risk sector in Albania required restructuring the guarantee, a World Bank financial state-owned electricity utility and instrument designed to help governments 1 Korporata Energjitike Shqiptare mitigate political and regulatory risks, IFC SMARTLESSONS -- NOVEMBER 2009 1 helped to increase and maintain investors' interest in the Under such circumstance, the second-best option was to di- process of privatization. Also of paramount importance to vide the supply function into wholesale and retail. The risk the success of the transaction were coordinating efforts by of securing electricity supplies to satisfy customers' de- the U.S. Agency for International Development (USAID), mands was allocated to the wholesale public supplier, which was heavily involved with electricity regulatory which remained under government ownership. The retail reform and market liberalization. public supplier, responsible for purchasing electricity from the wholesale public supplier at a regulated price and sell- The transaction was completed successfully in May 2009 ing it to end consumers, was privatized, together with the when the CEZ Group paid 102 million for the purchase of distribution system operator. This model was applauded by 76 percent of the Albanian electricity distribution company, all power companies that met with the minister of econo- OSSH.2 CEZ is an electricity utility based in the Czech my and the IFC team in April 2009. Republic. In the past decade CEZ has become a leader in the electricity market in Central Europe and one of the most 2) To ensure economic, social, and political sustainability profitable power companies in Europe, with a proven track of the transaction, a fair balance must be established record of turning around distressed power utilities. between the public and private share of interest and risk. Lessons Learned When structuring a private-sector participation (PSP) 1) When the optimum privatization structure is not transaction, allocation of risk among parties must be done feasible, it may be advisable to settle for second-best in such a way as to ensure an increase in efficiency at the options. lowest possible cost. The process is not quite straightforward, as it is often difficult to determine which party can cover Privatization of electricity distribution utilities in developing certain risks at the lowest costs; and occasionally portions of and transition economies is often intended to improve the same risk must be allocated to different parties. To supply of electricity and service quality, reduce losses, and achieve the desired increase in efficiency, the performance expand the distribution network by securing adequate of the private operator is generally benchmarked against investment that the public sector has failed to provide. performance standards or indicators. In addition, a fair However, some of the objectives of privatization may not return on investment is essential in order to secure the be achieved in full when they are perceived by the private private sector's interest in the transaction. sector as unaffordable and unacceptable. In such cases, instead of striving to achieve the optimum results and risk In the electricity distribution business, the private operator transaction failure, second-best options should be adopted is typically expected to improve efficiencies by reducing to secure a long-term partnership with a strategic investor distribution losses, expanding distribution networks, and and address all other privatization objectives. increasing cash collections. To ensure the private sector's commitment and reduce the risk of renegotiations, The privatization package in Albania included the electricity reasonable performance standards must be specified in the public supply function, together with the distribution regulatory and/or transaction documentation. Such network, while the responsibility of securing an electricity standards must be clearly defined and easy to monitor by supply to satisfy tariff customers' demands was allocated to the regulator or contracting authority. To allow for a fair the private sector. However, discussions with power return on investment and provide further incentives to the companies that had recently privatized distribution utilities private operator to reduce distribution losses and increase in the region made it clear that, under the current situation, collections, the performance standards must be measured the private sector would not be prepared to take on the risk against elements of the distribution and retail tariff of securing electricity supplies to satisfy customers' calculation formula. demands. All potential investors who attended privatization events in Tirana invariably confirmed that such a risk was In Albania, the new tariff methodologies, drafted under unaffordable and unacceptable to the private sector. The Distribution losses before and after privatization uncertainties were many: volatile h y d r o l o g y , fluctuating energy market prices, and doubts about the government's ability to complete the ongoing initiatives and undertake new ones to increase generation and interconnection capacities. 2 Operatori i Sistemit te Shperndarjes 2 IFC SMARTLESSONS -- NOVEMBER 2009 the privatization framework, allow the distribution operator agreement. The process of structuring the PRG and to make sufficient revenue to cover operating costs and finalizing the necessary contractual agreements among the investments, including the cost of energy purchased to parties involved - the World Bank, the government, the cover technical and nontechnical distribution losses. The investor and the commercial bank issuing the letter of private operator was asked to commit to a loss reduction credit - may add to the time and costs of the transaction. schedule as part of the privatization offer (see chart This is why, if a PRG is needed to support the privatization below). of a distribution utility, it would be best if the World Bank is involved as early as possible in the process. While allowing a fair return on investment is important to attracting the private sector, the deal may prove to be both politically and economically unsustainable if tariffs are set at unaffordable levels. The adverse effect of unaffordable tariffs would also increase private-sector costs. Therefore, designing and implementing a satisfactory mechanism to protect vulnerable consumers is beneficial to all. In Albania, a deferred revenue compensation mechanism was introduced to prevent tariffs from reaching unaffordable levels. 3) Restore investors' confidence by effectively mitigating the regulatory risk. In recent years, private investors have shown reduced interest in the distribution utilities of developing countries. The number of bidders and, consequently, the degree of competition in similar transactions in the sector have been limited. The reasons for this include a weak institutional and administrative framework in the electricity sector, 4) Involve the private sector early in the process of policy incomplete regulatory regimes and tariff policies, and the and regulatory reform. poor performance record of regulatory institutions. Involving the private sector in the process of electricity To add to this, privatization of the electricity distribution policy and regulatory reform may help increase the chances company in Albania was initiated soon after privatization of drafting an impartial regulation and structuring a PSP of the electricity distribution company in neighboring transaction that is attractive to private investors. Potential Macedonia. Continuous disputes over regulatory and investors' feedback may be as constructive as that of any contractual issues between the government of Macedonia other stakeholders, and will especially help with assessing and the Austrian electricity company EVN, which had how much risk the private sector is prepared to take. recently purchased the majority of the Macedonian electricity distribution utility, increased investors' sensitivity To achieve this, traditional activities used for the recruitment to regulatory and political risks in the region. of potential investors, such as market sounding or pre-bid conferences, are also used to discuss and get investors' To restore investors' confidence, privatization efforts in feedback on major transaction and regulatory issues. As an Albania focused on establishing a sound regulatory example, an Investors' Roundtable, sponsored by USAID framework, with proper energy pricing and tariff policies, and organized by IFC in April 2008, not only informed and effectively mitigating the regulatory risk. The latter potential investors about the transaction and the process, was achieved by introducing contractual political but also presented them with the new regulatory commitment and proper dispute resolution mechanisms. To framework and asked for their feedback on key issues and this extent, the Regulatory Statement, a document that risks. specifies tariff calculation formulas and key performance indicators, was attached to the share purchase agreement All of the comments and recommendations received during (SPA) that was signed by the Albanian government and the this process highlighted some of the major issues that the winning bidder and then ratified by the Albanian government and the regulator needed to address in order Parliament. To further help mitigate the regulatory risk and to improve the regulatory framework and enhance backstop the government's commitment to the pre-agreed attractiveness of the transaction. The interesting fact was regulatory framework, the World Bank offered a partial that comments were provided not only from the companies risk guarantee (PRG). that later participated in the tender process, but also from those who didn't. They gave disinterested, free-of-charge The PRG is a financial instrument that the World Bank has advice and shared their knowledge, views, and concerns on designed a few years ago to help countries mitigate political the electricity market model and distribution tariff and regulatory risk in order to enhance investor interest methodologies. Making potential investors part of the and reinforce confidence in newly established regulatory regulation review helped strengthen their confidence in a frameworks and institutions. It must be noted that the PRG transparent and professionally run process. can only be put in place after the signing of the privatization IFC SMARTLESSONS -- NOVEMBER 2009 3 5) Resist government pressure to achieve responsibility to complete, within the first year rapid closure, and focus instead on the of operation, one study on the level of losses need to address all major issues. and one study on the age of the receivables. The two studies will be audited by independent Governments in developing countries are auditors selected by both CEZ Group and the often in a hurry to privatize and offload regulator. loss-making, debt-ridden electricity utilities. In addition, political pressure from upcoming Conclusion elections usually adds to the governments' desire to close transactions rapidly. For this IFC's experience in Albania shows that reason, it is important to constantly assess integration of the privatization process with and, where possible, resist government reform implementation initiatives is of pressure to achieve rapid closure by making paramount importance in the effectiveness of it aware of the high risks associated with transaction advisory work. From the beginning offering a transaction that may not be ready of an advisory mandate, it is important to for the market or rushing investors to submit obtain donor support as well as the their proposals before they have had an commitment of the highest political levels in opportunity to properly assess all of the the country. This commitment and support issues and risks. must be maintained throughout the project to ensure successful implementation of the To comply with clients' request for rapid transaction and a long-term partnership with closure and still address all major issues, it is a strategic investor. often necessary to implement in parallel as many processes as possible and also to use However, the long-term success of the synergies with other ongoing initiatives. privatization is still to be tested. It will take a However, the closer you get to election day, few years before we know whether CEZ will the more difficult it becomes to find the be able to turn OSSH around. A major concern right balance between government pressure remains the regulator's ability to monitor to speed up the process and the need to OSSH performance effectively with regard to address outstanding issues. reduction of losses, increase of collections, and adequacy of the investment to upgrade the As an example, despite everybody's efforts distribution network and improve quality of during the privatization process in Albania, service. It is imperative that donors such as there were still outstanding issues that could USAID and the World Bank remain involved-- not be resolved by the bid submission the former with providing assistance to the deadline at the end of September 2008. The regulator in implementing the new regulatory government was not prepared to move the framework, and the latter with making sure deadline because of the general elections that all parties follow the terms agreed to in scheduled in June 2009. To overcome this the regulatory framework and privatization obstacle, the IFC team identified the five agreement as defined in the partial risk most critical issues and convinced the guarantee documentation. government that potential bidders be allowed to make comments on them. Introducing changes in the process and allowing for conditional bids at that stage DISCLAIMER was quite risky, but it was the only way to IFC SmartLessons is an awards maintain bidders' interest in the process and program to share lessons learned in development-oriented advisory satisfy the government's request to close the services and investment bidding process by the preferred date. operations. The findings, interpretations, and conclusions Those five issues, which included the level of expressed in this paper are those return on equity, the initial level of of the author(s) and do not necessarily reflect the views of IFC distribution losses, the purchase price or its partner organizations, the adjustment mechanism, the property title, Executive Directors of The World and long-term debt, were negotiated with Bank or the governments they the winning bidder and included in the SPA represent. IFC does not assume any responsibility for the and the regulatory statement. Some items, completeness or accuracy of the such as the initial level of losses and the information contained in this current level of bad debt, both of which document. Please see the terms needed extensive work and study, could not and conditions at www.ifc.org/ be defined during the negotiations. As a smartlessons or contact the program at smartlessons@ifc.org. solution, the private operator was given the IFC SMARTLESSONS -- NOVEMBER 2009 4