Document of

The World Bank

Report No. 15580-BR

STAFF APPRAISAL REPORT

BRAZIL

FEDERAL RAILWAYS RESTRUCTURING AND PRIVATIZATION PROJECT

May 29, 1996

Infrastructure and Urban Development DivisionCountry Department ILatin America and the Caribbean Regional Office

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CURRENCY EQUIVALENTS

Currency Unit = Real (R$)US$1 = R$0.995 (May 14, 1996)

This exchange rate has been used throughout the report unless otherwise indicated

WEIGHTS AND MEASURES

Metric System

FISCAL YEAR

January I - December 31

ABBREVIATIONS AN]) ACRONYMS

ABF - Associacao Brasileira de FerroviasBrazilian Association of Railways (proposed)

BNDES - Banco Nacional de Desenvolvimento Econ6mico e SocialNational Economic and Social Development Bank

CBTU - Companhia Brasileira de Trens UrbanosBrazilian Urban Train Company

COFER - Comissao Federal dos Transportes FerroviariosFederal Rail Transport Commission

CPMS - Computerized Project Management SystemCVRD - Companhia Vale do Rio Doce

Vale do Rio Doce CompanyDTF - Departamento dos Transportes Ferroviarios

Rail Transport Department of the Ministry of TransportEMC - Environmental Management ComponentERP - Emergency Rehabilitation ProgramFEPASA - Ferrovia Paulista S.A.

Sao Paulo State RailwayFRS - Financial Restructuring and Settlement ComponentIERR - Internal Economic Rate of ReturnGEIPOT - Empresa Brasileira de Planejamento dos Transportes

National Transport Planning AgencyGOB - Government of BrazilINSS - Instituto Nacional de Seguridade Social

National Social Security InstituteLA - Loan AgreementMT - Ministerio dos Transportes

Ministry of TransportNPV - Net Present ValueORC - Operations Restructuring and Concessioning ComponentPA - Project AgreementPIP - Project Implementation PlanPM - Project ManagerPMU - Project Management UnitREM - Real Estate ManagerRFFSA - Rede Ferroviaria Federal S.A.

Federal RailwaysREFER - Railway Staff Pension FundRRC - Regulatory Reform ComponentSR - Superintendencia Regional

RFFSA Regional SuperintendencySRP - Staff Retrenchment Program

BRAZIL

FEDERAL RAILWAYS RESTRUCTURING AND PRIVATIZATION PROJECT

STAFF APPRAISAL REPORT

Table of Contents

Page NoLoan and Project Summary ............................................. (i)

I. TRANSPORT SECTOR OVERVIEW.. IA. The Transport Sector in the Economy .1B. The Macroeconomic Policy Framework .1C. The Transport System. 2D. Sector Policy and Institutional Reform. 3E. The Railway Industry: Economic Role and Performance. 4F. Railway Regulation. 5G. Bank Sector Experience and Strategy. 6

II. THE FEDERAL RAILWAYS (RFFSA) ...................... 7A. Historical Summary . ............................................ 7B. Operations and Marketing .......................................... 8C. Operations Restructuring and Concessioning Plan .......................... 9D. Staff Productivity and Redundancy ................................... 10E. Investment and Maintenance . ....................................... 11F. Finances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

III. THE PROJECT ................................................ 13A. Project Origin, Objectives and Rationale ................................ 13B. Project Description .............................................. 14C. Project Cost and Financing . ....................................... 18D. Financial Analysis .............................................. 19E. Environmental and Economic Assessments .............................. 20F. Project Risks ................................................ 22

IV. PROJECT IMPLEMENTATION ............... .. ..................... 23A. Institutional Responsibilities ....................................... 23B. Organizational Arrangements . ..................................... 23C. Project Implementation Plan . ....................................... 24D. Procurement Arrangements . ....................................... 26E. Disbursement, Accounting and Audit Arrangements ......................... 27F. Monitoring and Supervision Plan .......... .......................... 28

V. AGREEMENTS REACHED AND RECOMMENDATION ...................... 29

This report is based on the findings of an appraisal mission which visited Brazil during February 1996. The mission comprisedMessrs. Jacques Cellier (Task Manager, LAIIU), Louis Thompson (Railway Adviser, TWUTD), Antonio Estache (SeniorEconomist, LAIIU), Newton de Castro (Consultant Economist), and Vitor Bellia (Environment Consultant). Messrs. IoannisKessides (PSD) and Roberto Mosse (OPR) were Peer Reviewers. Ms. Joy Obialor provided administrative support. Messrs. AsifFaiz, Orville Grimes, and Gobind T. Nankani are respectively the managing Division Chief, Projects Adviser, and DepartmentDirector for the operation.

VI. ANNEXES

1. Macroeconomic and Structural Reform Background ....................... 312. Bank Experience with Railway Projects in Brazil and Argentina. .... ....... ... 353. Operations Restructuring and Concessioning Component ................... 404. Staff Retrenchment Program, Retraining and Outplacement Assistance ....... ... 455. Emergency Rehabilitation Program ................................. 566. Environmental Management Component .............................. 617. Regulatory Reform Component ................................... 668. Financial Restructuring and Settlement Component ....................... 759. Financial Analysis ........................................... 78

10. Project Economic Analysis ...................................... 8611. Project Implementation Plan, Indicators and Targets ...................... 96

Table 1. Project Cost and Financing ................................ 962. Monitoring Indicators and Targets ............................ 973. Procurement Schedule for Major Contracts ...................... 984. Allocation of Loan Proceeds ............................... 995. Disbursement Schedule ................................... 99

Chart 1. Project Implementation Time Schedule ........................ 1002. RFFSA Reorganization .................................. 103

12. Project Monitoring and Supervision Plan ............................ 10413. Supporting Tables:

Table 1. Brazil's Transportation Expenditures by Mode ................... 1062. Brazil's National and Transportation Aggregates .................. 1073. Freight Railway Productivity Ratios .......................... 1084. RFFSA Traffic, Productivity and Financial Ratios, 1958-1995 ... ...... 1095. RFFSA Investments, 1987-1994 ............................ 1106. RFFSA Statements of Income .............................. 110

14. Selected Documents and Data Available in the Project File ................. 111

Map: IBRD No. 27392: Brazil - Railway Network, RFFSA Regions and Proposed Concessions

BRAZIL

FEDERAL RAILWAYS RESTRUCTURING AND PRIVATIZATION PROJECT

Loan and Project Summary

Borrower: Federative Republic of Brazil

Implementing Agency: Rede Ferroviaria Federal S.A. (RFFSA)

Beneficiary: Rede Ferroviaria Federal S.A. (RFFSA)

Poverty: Not applicable

Amount: US$350 million equivalent

Terms: Repayment in 15 years, including five years of grace, at theBank's standard variable interest rate for currency pool loans

Commitment Fee: 0.75% on undisbursed loan balances, beginning 60 days aftersigning, less any waiver

Onlending Terms: Not applicable

Financing Plan: See para. 3.17 and Table 1, Annex 11

Net Present Value: R$2.6 billion

Map: IBRD No. 27392: Brazil - Railways, RFFSA Regions andPlanned Concessions

Project Identification Number: BR-PA-40028

BRAZIL

FEDERAL RAILWAYS RESTRUCTURING AND PRIVATIZATION PROJECT

I. TRANSPORT SECTOR OVERVIEW

A. The Transport Sector in the Economy

1.01 The transport sector accounts for a rather low R$13 billion or 4.3 percent of Brazil's GNP. Roadtransport alone accounts for about 3.2 percent. But these figures exclude the very important segmentsof own-account transport, services by truck owner-operators, and private automobile use, which are notaccounted for in GNP calculations. Total transportation expenditures amount to about US$90 billionequivalent; road transport accounts for 85 percent, and rail transport for only about two percent of thattotal (Table 1, Annex 13). The transport industry has grown at rates which systematically exceeded thoseof GNP and other industries. In the 1970s, when GDP increased at an average 8.5 percent per year, thetransport industry grew at over 11 percent per year; in the 1980s and early 1990s, when GDP grew atan average two percent per year, the transport industry grew at three percent per year on average(Table 2, Annex 13).

1.02 Public investments in transport, which used to account for about 40 percent of total public capitalformation in the 1960s and the early 1970s and reached 3.3 percent of GNP in 1975, have drasticallydecreased to below one percent of GNP since 1981. Road expenditures in particular had to be curtailedseverely, which resulted in the deterioration of large portions of the networks built in the 1950s and1960s. The unsatisfactory operational and financial performance of the railways also led tounderinvestment, insufficient maintenance, and to the deterioration of railway tracks, motive power androlling stock. Because of the size of the transport industry, its direct impact upon the productive sectors,the extensive involvement of the government and the fiscal implications, the performance of the transportsector is critical to the success of the Government's economic stabilization and growth efforts.

B. The Macroeconomic Policy Framework

1.03 The macroeconomic policy framework in Brazil remains within the parameters outlined in theBase Case of the Country Assistance Strategy, which was discussed by the Board of Executive Directorson June 29, 1995. Core inflation remains below its targeted level with a rate of under one percent permonth, and actual inflation for 1995, at 15 percent, was the lowest in decades. The balance of paymentsalso remained strong, and gross international reserves have continued to accumulate, reaching $52 billionby December 1995, or 11 months of imports of goods and nonfactor services. This has occurred despitea weakening of the current account deficit to 2.6 percent of GDP, higher than anticipated as a result ofmore rapid growth in 1995 and an appreciation of the real exchange rate. These positive outcomes forinflation and the balance of payments appear set to continue in the medium term (Annex 1).

1.04 Fiscal policy, however, weakened in 1995, with the operational balance of the public sectordeclining from a surplus of 0.5 percent of GDP in 1994 to a deficit of 5 percent in 1995. The primarybalance remained in surplus in 1995 (0.4 percent of GDP), but was significantly lower than in 1994 (4.3percent of GDP). The most important factors behind this deterioration were an increase in wages anda much higher domestic interest bill resulting from tight monetary policy and an accumulation of internaldebt by Federal and State governments. While the Government is committed to reducing fiscal deficits

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over the medium term, it has been hampered by structural rigidities in public sector accounts (revenueearmarking, payroll and pension rigidities and interest consume almost all the budget). The structuralreforms required to improve the situation (privatization, pension, administrative and tax reforms) havebeen progressing slowly through the political system, but should provide the basis for fiscal improvementson both operational and primary balances in 1997 and 1998 (Annex 1). The sectoral adjustmentsupported by the project would contribute positively to this medium-term fiscal improvement.

C. The Transport System

1.05 Institutions. Through a Constitutional mandate, the Federal Government is required to operateinterstate and international rail, water, air and passenger road transport, including port and airportservices, either directly or through concessions or other forms of authorization. The state expanded itsdirect control over the sector in the 1950s-1970s. It took control of the many privately-owned railroads,merging them into the federal railways (RFFSA) and the Sao Paulo state railway (FEPASA), and it hasretained majority shareholder control, through Companhia Vale do Rio Doce (CVRD), of the two other,primarily ore-carrier railways. The port facilities and operations, with some exceptions, have beenincorporated into the former Portobras system. The state, through the Portobras system, Petrobras foroil-specialized operations and CVRD for minerals, and through concessions to private companies, hasbeen controlling the country's entire port system. In addition, the state owns and operates a substantialportion of the merchant fleet (through Lloydbras, Petrobras and Docenave) and is present in inlandshipping. The Federation also received a mandate to regulate road freight transport through a law passedin 1984, but this industry has never been regulated in practice and has generally remained efficient. Bycontrast, the State's direct control over the railroads has led to their poor operational and financialperformance (section E) and to inadequate railway regulations (section F).

1.06 Networks. The South and Southeast regions of Brazil have a dense system of highways andrailways. Substantial portions of the highway networks have deteriorated as a result of very heavy trafficand inadequate maintenance. Many highways require rehabilitation or strengthening, and some also needto be widened. There is scope, however, for the railways to increase their participation in the transportalong the main north-south and export corridors, which could help postpone some highway capacityinvestments. The Center-West frontier region, in which an unprecedented expansion of agriculture hasbeen taking place, has as yet very sparse highway and feeder road networks. The bulk of the region'sexports is transported by truck at a very high cost. Efficient inter-modal services based on the railwayswhich connect the southeastern part of the region to Sao Paulo-Santos and to Belo Horizonte-Vitoria andthe northern part of the region to Sao Luis, as well as on some of the rivers which flow from the region'speriphery, could reduce these costs. The Northeast region has a well developed highway network, withsubstantially lower traffic levels, and an extensive railway system, mostly uneconomic, except for theCarajas corridor. Coastal shipping has some importance in both intra- and inter-regional trades. TheNorth, with its sparse population and economic activity, has traditionally relied upon river transport forboth passenger and cargo movements in the Amazon basin. Air transport has an increasing role inmoving passengers and high-value goods over the long distances involved.

1.07 Operations. The unstable macroeconomic environment and the efforts made to control inflationthrough reducing public expenditures and containing the rates of the public companies has led to thepostponement of needed maintenance activities and capacity investments; to the rapid deterioration ofimportant portions of the transport system, including trunk highways, railway tracks, motive power androlling stock, and port facilities; and to traffic congestion in important corridors. The cost of roadtransport on deteriorated and/or congested highways increased despite technological advances in the truckand bus manufacturing industries. In addition, Government regulation or direct intervention in the

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management of public enterprises, through imposing uniform tariff policies and public service obligations,has reduced their ability to adapt to market and technological changes, and led to the inefficientoperations, to poor service quality and to the chronic financial losses that characterize public companies.This situation, together with the unattractive compensation packages offered in the public service, has ledto the present state of institutional degradation of the sector's public entities.

1.08 Investments. Public investments in the transport sector, through the 1970s, went towardsexpanding the transport system into the interior of the country to permit settlement and support neweconomic activities, and towards increasing transport capacity on the eastern seaboard. The largest sharewent to the construction of the primary highway network. After the first oil shock, federal priorities wentto the railway and port infrastructure of the main corridors, in support of the development of the steelindustry and of mineral and grain exports. In the early 1980s, public investments in the sector werescaled down drastically; and priorities gradually shifted from new construction to maintenance andrehabilitation. However, the Government's austerity program and the containment of the tariffs of thepublic entities led to the postponement of needed maintenance and rehabilitation works and to thedeterioration of large portions of essential transport infrastructure sector-wide. Investments in transportshould therefore, in the short term, be focused on the rehabilitation and maintenance of the facilities andon selected improvements and capacity increases to the existing systems, which are essential to therecovery of economic growth. They should primarily support the country's agricultural and industrialgrowth, and export objectives, and contribute to improving the efficiency and performance of transportoperators.

D. Sector Policy and Institutional Reform

1.09 The management of the transport sector is undergoing significant changes. A number of reforms,which aim at reducing government expenditures in the sector, at deregulating and privatizing transportservices so as to allow market forces to be the primary determinant of the services provided, and atdecentralizing expenditure and financing responsibilities to lower levels of government, have beenrecently undertaken or are about to be implemented. The Concession Law, enacted in February 1995,establishes the legal framework for private concessions of public services. A proposal for a newTransport Law, which would redefine the entire transport system under federal jurisdiction, is currentlybeing considered by the Congress. The following paragraphs summarize the status of these reforms inhighways, railways, ports and multimodal transport.

1.10 Highways. The Constitutional reform of 1988 decentralized fiscal revenues, transferring roaduser taxes to States and Municipalities, but kept unchanged the distribution of responsibilities among thethree administrative levels. The reform has affected the ability of the Federation to rehabilitate andmaintain an extensive federal highway network, and to finance needed capacity investments. TheGovernment has decided to reduce the size of the road network under federal jurisdiction to the interstatehighways and international connections, to transfer the operation and maintenance of high-traffic highwaysas well as capacity investments to private concessionaires where feasible, and to transfer other highwaysto state jurisdictions. A highway concession program has been developed and is being implemented, withfive concessions already awarded. Agreements have been reached with the state governments on thehighways to be transferred from federal to state jurisdictions and on the main conditions of the transfers.

1.11 Railways. The Government has decided to restructure the federal railways (RFFSA) and toconcession their operations. BNDES proposed and the Government approved a privatization model whichconsists of restructuring RFFSA into six regional systems and concessioning the operation andmaintenance of the systems. Concessionaires would lease fixed assets from RFFSA, and would have the

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option of buying or leasing motive power and rolling stock. The Government's restructuring andprivatization plan for RFFSA is presented in Chapter II. The proposed project would assist theGovernment in implementing the plan (Chapter III). Similarly, the Government of the State of Sao Paulodecided to restructure and to privatize FEPASA, following a similar model. The federal and the stategovernments are presently discussing FEPASA's transfer to federal jurisdiction. Finally, the FederalGovernment decided to privatize CVRD, including the EFVM and EFC railways. The proposed projectwould help implement the necessary measures to ensure adequate integration of the rail operations andpermit efficient inter-railroad and intermodal services (para 3.05).

1.12 Ports. The Government closed the National Port Holding Company "Portobras" in 1990 and theCongress approved a law for a broad deregulation of the port system in February 1993. The Port Lawliberalizes port activities, enabling private terminals to operate for public use. It also decentralizesnormative and tariff setting responsibilities to newly-created local Port Authority Councils, and authorizesprivate port operators to compete with the port administrations. The Government has recently developedpolicies and guidelines to assist with the full implementation of the reform, including the privatizationof the ports and terminals, and a new organizational scheme for the labor force; and some ports,including Santos, have made progress in implementing the reform.

1.13 Multimnodal Transport. The rapid evolution and expansion of intra- and inter-regional trade,fostered by regional trade bloc initiatives and by agricultural expansion and industrial development in theinterior of Brazil, will require important changes in the national and international transport systems.Freight carriers will be required to provide efficient and comprehensive logistic services to agricultural,industrial and commercial shippers, and for this purpose they will have to seek innovative multimodaltransport solutions which maximize productivity and quality of service. This in turn will require a muchbetter integration of the transport systems, particularly railroads and ports, which represent the majorbottlenecks in the present transport system. The restructuring and privatization of railroads and portterminals, if adequately carried out, is expected to resolve the bulk of the intra- and intermodalbottlenecks. Progress has already been made since 1991 in removing entry restrictions in the ocean andcoastal shipping and multimodal transport industries, as well as in removing restrictions on inlandcirculation of containers. New legislation currently before the Congress would establish flexibleregulation for multimodal transport, and remove restrictions on the inland use of international containers,and therefore would, if approved, further facilitate multimodal transport.

E. The Railway Industry: Economic Role and Perfonnance

1.14 Brazil's railway industry consists of four principal carriers: Rede Ferroviaria Federal S.A.(RFFSA), which is owned by the Federal Government; Ferrovia Paulista S.A. (FEPASA), which isowned by the State of Sao Paulo; Estrada de Ferro Vitoria a Minas (EFVM) and Estrada de Ferro Carajas(EFC), which are primarily ore-carrier railways owned by CVRD. With 30,000 km of track, and afreight traffic of approximately 120 billion ton-kilometers, Brazil's railway industry is the largest in LatinAmerica and can be compared to those in Mexico and Canada (Table 3, Annex 13). RFFSA is the mainoperating entity, accounting for about two-thirds of total track length, rolling stock and employees.RFFSA's traffic is reasonably well diversified, its iron ore traffic accounting for only 40%, while EFVMand EFC are highly specialized ore carriers. For this reason, RFFSA carries only about one third of totalrailway traffic measured in ton-kilometers (Table 3, Annex 13).

1.15 The role of the railway industry has declined with the development of the highway networks andthe trucking and bus industries over the past three decades. In particular, inter-city passenger serviceshave been almost entirely closed. The railway industry, however, continues to have an important role

in the transport of freight, since it accounts for about 25 % of total freight movements measured in ton-kilometers. The railways have an advantage in handling long-haul bulk commodities such as mineralores. They also have an advantage over trucking on long-haul flows of petroleum products, but they arelosing some traffic to newly-built pipelines. They have been competing with some success in handlinglarge volumes of grains and grain products to consumption, processing or export centers on the easternseaboard; with improved performance, they could substantially increase their share of such traffic. Theylost most of the general cargo traffic to trucking in the past, but efficient railways and intermodal carrierscould re-capture a significant share of this important and potentially profitable traffic, as appears to behappening in Argentina.

1.16 Both RFFSA and FEPASA have relatively low average traffic densities (1.8 and 1.5 million nettons per year, respectively), which vary widely across the systems. For example, RFFSA's trafficdensity ranges from over 11 million net-tons on its Southeastern lines which carry iron ore, to about200,000 net-tons per year on the Northeast network, and seven out of the current twelve operatingregions have traffic densities below I million net-tons per year (Table 3, Annex 13). Thus a substantialportion of the network is well below the level of minimum efficient density, and fails to earn revenuesin excess of variable costs. Because of Government intervention in response to local interests, therailways have been unable to abandon low-density branch lines, which, together with the lack of agressivemarketing on the part of the public railways, explain such low track productivity. Labor productivity hassubstantially increased with the important reductions of staff, although it still remains far belowcomparable railways in Northern America (less than I million net ton-km per employee in RFFSA andabout half a million in FEPASA, as compared to over 5 million net ton-km per employee in Canada andthe US (Table 3, Annex 13). Motive power and wagon productivities are also low by internationalstandards, thereby adversely affecting the railways financial performance. RFFSA, except for 1992,consistently incurred substantial operating losses ranging from US$390 million equivalent in 1988 toUS$159 million equivalent in 1994 (Table 6, Annex 13). These losses have contributed to the insufficientinvestments, inadequate maintenance and to the deteriorating service which characterize the two generalcarrier railways. A detailed analysis of Brazil's railway subsector is presented in Bank report No. 11752-BR entitled "The Brazilian Railroad Industry: Options for Organizational Restructuring", and datedFebruary 15, 1994.

F. Railway Regulation

1.17 Although intermodal competition has been a factor in the decline of Brazil's railways, manyperformance problems seem to have their origin, like in many other countries, in excessive governmentregulatory control and intervention in the railways' operations, investments and finances. Until 1989,the Government strictly controlled the level and structure of railway tariffs, and even after tariffs werefreed from the Government's direct control, railway tariff increases, as other prices, remainedsubordinated to macroeconomic considerations through various stabilization plans, including the currentPlano Real. In addition to the impact on average tariff levels, regulatory controls also caused significantdistortions. In particular, the value of service rate structure encouraged high-value cargoes to shift totrucks. Besides price controls, the Government has also imposed public service obligations to therailways, such as the operation of non-remunerative inter-city passenger and commuter services, and theoperation of uneconomic branch lines. Government justification for such intervention has generally beensocial and regional development objectives, but short term political benefits have also been a factor.Efforts made by the railways to obtain Government compensation for such public service obligationsgenerally were not successful. Inter-city passenger services were gradually closed, and commuter trainoperations were separated from the freight railways and are now being transferred to state and localgovernments. But there is still a need to rationalize the networks through abandonment of uneconomic

branch lines, in particular in the Northeast. Government interference in the railways' investments,imposing programs or projects which do not reflect the railways' true development priorities or theirfinancial capacities, has further affected the railways' operational and financial performance.

1.18 In order to reduce such intervention in railways' operations and investments, and to improve theirperformance, the Government recently redesigned the railway regulatory framework. The new regulationwould in particular: (a) permit operators to freely set their prices for services which face effectivecompetition; (b) permit operators to set prices that are responsive to differences in demands and inmarginal costs, and to enter into voluntary contracts with shippers that have individualized terms andconditions; and (c) constrain the prices which a railway sets for captive shippers over whom the railwayhas monopoly power, by the stand-alone costs of the shipper's services (Annex 7). The Governmentwould strengthen MT's Department of Rail Transport (DTF) to implement the new regulation, and wouldestablish a Rail Transport Commission for dispute resolution. The proposed project would assist theGovernment in implementing the regulatory reform (paras. 3.12 and 3.13).

G. Bank Sector Experience and Strategy

1.19 The Bank has made 30 loans in the transport sector since the early 1960s: 15 for highways andfeeder roads, five for railways, two for ports, and eight for urban transportation, in addition to financingrural roads under a number of agriculture projects and the construction of the Carajas railway under theCarajas Iron Ore project (Loan No. 2196-BR). Until the mid 1970s, the projects concentrated on theexpansion of the trunk highway network and on the improvement of the railway and mass transit systems.The first port project, completed in 1981, helped finance the construction of a container terminal inSantos. In subsequent years, emphasis gradually shifted to the maintenance and rehabilitation of theinterstate and trunk highway network, to the planning and implementation on a decentralized basis offeeder roads programs, to the rehabilitation of important railway corridors, and to the improvement ofpublic bus transport and traffic management in the major cities. More recently, the Bank has beensupporting the rehabilitation and decentralization of CBTU's urban train systems with four loans, andhighway rehabilitation, maintenance and decentralization with one loan to the Federation and five loansto states.

1.20 The Bank's involvement in the transport sector has been successful. The projects' physicalobjectives have generally been met although the more recent difficult economic conditions and relatedfunding problems have sometimes caused delays. Progress has been made on policy reforms andinstitutional strengthening (section D) though it has taken more time than expected, due to the size andcomplexity of the sector, the large number of government agencies and public enterprises involved, andthe difficulty of reaching the needed consensus for policy reforms. Under the two recently completedrailway projects, progress was made towards the commercially oriented operation of both RFFSA andFEPASA, in particular with the separation of commuter train operations, the closure of uneconomic inter-city passenger services, the railways' freedom to set rates, and with staff reductions. However, theGovernment's direct and indirect intervention in the management of the public railways has continued toadversely affect their operational efficiency and financial performance (Annex 2).

1.21 The assistance of the Bank to the transport sector of Brazil will remain oriented by broadercountry objectives, particularly: (a) the stabilization process, and the consequent need to contain publicexpenditures, increase revenue mobilization and improve resource utilization in the sector; (b) theresumption of economic growth, ensuring efficient and reliable infrastructure services to targeted growthsectors of the economy; (c) the redefinition of the role of the state, strengthening its regulatory functions,

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withdrawing from operational roles and promoting private sector operations and investment ininfrastructure; (d) the administrative decentralization; and (e) the environmental management dimension.

1.22 Emphasis will be upon the formulation and effective implementation of appropriate transportpolicies including: (a) pricing policies, through continued liberalization of price controls, restoration ofadequate pricing policies and mechanisms in the public sector, and efficient user taxation; (b) re-designof sector regulations, establishment of appropriate regulatory agencies, and effective implementation ofregulatory reform, which, together with efficient pricing mechanisms and privatization measures, aim atrestoring the role of market forces in the sector; (c) institutional reform, including effectivedecentralization of government responsibilities, seeking an appropriate balance between fiscal revenuesand responsibilities, strengthening the normative and monitoring functions as well as technological andhuman resource development at the center, and the planning, management and environmental controlcapabilities of the decentralized entities; (d) privatization of operation and maintenance services throughconcessions and management contracts; and (e) public investment programming and private sectorinvestment promotion based on appropriate economic, environmental and project finance analyses, aimingin particular at facilitating intra- and inter-regional trade flows.

II. THE FEDERAL RAILWAYS (RFFSA)

A. Historical Summary

2.01 RFFSA was created in 1957 under the jurisdiction of the Ministry of Transport (MT) by merging18 independent railways built mostly by British and French concessionaires beginning in the 19th century.The reason for unification and nationalization was to promote efficiency. In fact, Latin Americancountries experienced a wave of nationalizations during the post World War II period, of which therailways were a notable example. RFFSA had its origins in this movement.

2.02 Since nationalization, RFFSA's traffic has experienced relatively steady growth in line with therest of the Brazilian economy (Table 4, Annex 13). Unfortunately, the steady growth of traffic was notaccompanied by financial health or stable operations. Instead, a lack of business orientation at RFFSAcombined with constant Government intervention in RFFSA decision-making and politically imposedredundant labor led to years of insufficient earnings. Government did not adequately compensate for thelack of earnings, and RFFSA had to live through years of inadequate capital investment.

2.03 Government attempts at railway reform, which were supported by Bank lending, included laborreduction programs, reductions in intercity passenger services and, perhaps most important, transfer ofsuburban passenger operations and deficits into a separate organization (CBTU). There has been agradual shrinkage of the railway labor force and, with growing traffic, a consequent improvement in laborproductivity (Table 4, Annex 13). In spite of these reforms and improvements, however, RFFSA hasconsistently been in deficit, especially if full costs are taken into account (Table 4, Annex 13).

2.04 The Government, realizing that attempts to reform RFFSA under the public umbrella have failed,and after analyzing the experience of other Latin American countries, such as Argentina, Bolivia, Chile,Guatemala, and now Mexico, has decided to restructure and to concession the operation and maintenanceof its railways to the private sector, and to redesign railway regulation in order to permit effectivecompetition with the trucking industry. It will be the first large-scale privatization of public infrastructureservices in Brazil. However, the Government has already successfully privatized important customers

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of the railways, such as the steel industry, and is preparing to concession other transport services suchas ports and highways, as well as other sectors such as water and power. It is anticipated that mostshippers as well as transport operators will be privately organized, much less regulated, and much morecompetitive; hence the prospects are good for a significant improvement of the performance of thetransport industry as a whole.

B. Operations and Marketing

2.05 RFFSA is organized into 12 essentially non-competing geographic "Regional Superintendencies(SRs)" (IBRD Map No. 27392). RFFSA actually owns two rail networks, one meter gauge and the other"broad gauge" (1.60 meter). The map also displays the other railways in Brazil, of which the mostimportant are FEPASA in Sao Paulo State, which has both meter and broad gauge trackage, and the twoCVRD railways, of which the Carajas railway in the Northeast is standard gauge and the EFVM railwayfrom Belo Horizonte to Vitoria is meter gauge. The combination of historical fragmentation amongrailways and RFFSA's regions, gauge differences and Brazilian geography has effectively negated thepossibility of integrating Brazil's railways into one "system". Very little traffic is actually interchangedamong RFFSA's Regions and in the six proposed concessions, only two (Centro-Leste and Nordeste) arephysically contiguous and have the same gauge. RFFSA currently has relatively small interchange trafficwith FEPASA and EFVM railways, but the potential to increase such traffic is substantial. RFFSA hasalready established trackage rights with the other railways, and will establish further trackage rights asappropriate between the proposed concessions and the other railways (para. 3.05).

2.06 Substantial cross-regional differences in RFFSA's revenues and volumes of traffic exist whichhave profound implications for the feasibility of the various options to geographically restructure thesystem. The Southeast area, encompassing the economic triangle of Belo Horizonte, Rio de Janeiro andSao Paulo, generates almost three-quarters of the railway's tonnage. RFFSA's operation in the Southeastis also its most productive, accounting for only 31 % of its trackage and 49% of its staff but generating66% of its revenue. Three Superintendencies (SR3, SR2, and SR5) account for 80% of RFFSA's freighttonnage and over 75% of its revenue. The next three most important regions (SR6, SR10, and SR7)generate 14% of the railroad's traffic and 14% of its revenue. Finally, the remaining sixSuperintendencies (SR4, SR8, SR9, SR1, SR11, and SR12) account for less than 6% of the company'sfreight tonnage and 11 % of its revenue.

2.07 RFFSA's activities are organized along four business lines, each consisting of industry-relatedcommodities: iron ore and steel, fuels, agriculture products, and construction materials. RFFSA'sbusiness is distributed among these groups as follows: (a) iron ore and steel products, about 57% offreight tonnage and 48% of revenues; (b) fuels, including petroleum products and alcohol, about 16%of tonnage and 30% of revenues; (c) agriculture, including grain and grain products, about 18% oftonnage and 14% of revenues; and (d) construction materials, about 9% of tonnage and 8% of revenues.It is important to note that the average length of haul, approximately 450 km, is very short by NorthAmerican standards, confirming that the railway is very vulnerable to truck competition except for themajor movements of bulk commodities which are characterized by significant economies of scale.

2.08 RFFSA is burdened by excess capacity and uneconomic lines, in particular in the Northeastregion. It has a relatively low average traffic density (1.7 million net-tons per year) despite the fact thatit carries heavy freight traffic. This compares with over five million net-tons in the United States andin Canada (Table 3, Annex 13). But freight traffic density varies dramatically across the RegionalSuperintendencies, from 11 and 5 million net-tons in SR3 and SR4, to about 200,000 net-tons per yearin SRI and SR12. The system-wide average traffic density statistics, therefore, mask the severity of

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RFFSA's track productivity problem. Indeed, seven out of the 12 regions have traffic densities wellbelow 1 million net-tons, indicating that economies of scale of track are not being realized. Thus, asubstantial portion of RFFSA's trackage is well below the level of minimum efficient density and failsto earn revenues in excess of variable cost, at current rail rates. However, because of Governmentregulation and intervention, RFFSA has made only a modest progress in rationalizing its operations.Between 1975 and 1995, its trackage was reduced by only 10% indicating only little abandonment of low-density branchlines. In order to enable the concessionaires to effectively rationalize the networks, theGovernment has: (a) presented to the Congress a proposal for a new Transport Law (Sistema Nacionalde Viacao, SNV), which, inter-alia, substantially reduces the railway network of national interest underfederal jurisdiction; and (b) re-designed the railway regulation to enable operators to abandon branch lineswhich are not part of the new SNV, and to close operations on those branch lines under the SNV whichare shown to be uneconomic (Annex 7). The project would help to effectively implement the redesignedregulation (paras. 3.12 and 3.13).

C. Operations Restructuring and Concessioning Plan

2.09 The Government, through BNDES, studied a number of alternatives to the current structure ofRFFSA, which would introduce incentives for the rail sector to minimize production costs and provideprofitable services, including: (a) vertical separation, with governmental ownership of way and structureand privately organized and operated transportation services; (b) allowing private entrepreneurs to providetheir own services over the rail network, perhaps in competition with some of the services provided bythe integrated railroad itself; and (c) the lease or sale of the integrated railroad under a competitivebidding process. Each of the above options has its own advantages and drawbacks. In view of thegeographic characteristics of Brazil and the size of the federal railways, as well as of the significant cross-regional differences in RFFSA's traffic, the Government decided that RFFSA would be horizontallyrestructured into a number of vertically integrated regional systems, and that concessions for the operationand maintenance of these systems for 30 years would be auctioned to private operators, who would leasethe railway's assets. A minimum price is set for each concession. The price at which each concessionis bought is to be paid in part as a downpayment, shortly after the auction, and in part as a series ofquarterly lease payments to RFFSA. The proceeds from each downpayment would be divided, inproportions to be determined in each concession, between the National Treasury and RFFSA. TheGovernment would, in each case, specify the application of RFFSA's revenues to reduce its debts.

2.10 The restructuring plan, which was prepared by BNDES and approved by the Government, is todivide the RFFSA system into six regional concessions (IBRD Map No. 27392). The proposedconcessions are currently independent systems serving different markets, with no or limited inter-connections and interchange traffic. Two of the proposed concessions are dominated by a limited numberof commodities: Sudeste (former SR3 and SR4) is a broad gauge iron ore and steel product carrier whichcarries 52 percent of RFFSA's total ton-km on eight percent of its track; Tubarao (former SR9) is a smallcarrier of coal from mine to power plant. Traffic for these two carriers has been and will be highlydependent on a limited number of customers and markets. One potential concession, Nordeste (formerSRI, SRI 1 and SR12), is a light density "branch line" mixed commodity carrier operating in the poorestNortheast region of Brazil. At least in the near future, Nordeste's traffic potential will be limited andhighly competitive with other modes. Nordeste is not, and probably cannot in the short term befinancially self-sustaining. The other three potential concessions have separate outlooks: Sul (former SR5and SR6) carries a broad mix of commodities, all of which are either truck or pipeline competitive. Sulis located in the most rapidly growing region of Brazil and is well-positioned to take advantage of anytraffic growth resulting from regional integration. Oeste (former SR10) connects the agricultural regionof Southern Brazil and Bolivia to the Atlantic ports via FEPASA. Oeste will prosper if Brazilian soya

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exports continue to grow and so long as pipeline competition is limited. Centro-Leste (forner SR2, SR7and SR8) has a broad traffic mix based on its linkages between Rio, Sao Paulo and the Center-Westregion of Brazil, including Brasilia, and a good potential in the transport of grain and grain products fromthe Center-West to the consumption and export centers on the eastern seaboard. Centro-Leste, however,is vulnerable both to truck competition and to a petroleum pipeline already under construction.

2.11 The market and financial analyses of each of the proposed concessions carried out by RFFSA andBNDES suggest that all concessions could be profitable, with the possible exception of the Nordeste,which needs further studies (Annexes 3 and 9). The basic indicators and current productivity ratios forthe proposed concessions are compared with those of other railways in Table 3, Annex 13. TheArgentine and Chilean concessions, which are already in operation, with appropriate caution because ofinsufficient operating history, appear to be operating reasonably well. They provide benchmarks againstwhich to compare Brazil's concession prospects. Judging by traffic density (ton-km/km of line), all ofthe proposed concessions (except Nordeste) are significantly better than any of the Argentine or Chileanconcessions. This is an important measure because low traffic density suggests that the underlying trafficpotential is questionable or that the size of the network is too large. With the proposed staff retrenchmentand emergency rehabilitation and maintenance programs, the performance of the proposed concessionscan be brought into line with or better than that of Chile and Argentina concessions (Annex 9). Thereis every reason to believe that the proposed concessions can be solid financial propositions.

2.12 The implementation plan and timetable for the proposed operations restructuring andconcessioning plan is presented in Annex 11. The restructuring of the Oeste system has been completedand the concession was successfully auctioned on March 5, 1996 to a consortium of investors and banksfrom the United States. The restructuring and concessioning of the other systems is scheduled over 1996and 1997 (Annex 11, Chart 1).

D. Staff Productivity and Redundancy

2.13 Although RFFSA has already made significant progress in dealing with the labor redundancy, itslabor productivity continues to be low. RFFSA reduced its total staff from about 110,000 in 1975 toabout 42,000 in May 1995. This reduction led to a substantial increase in labor productivity from250,000 to almost 1 million net ton-km per employee. Still, RFFSA's labor productivity remains lownot only by North American standards (above 5 million ton-km per employee) but also when comparedto the recently restructured and concessioned railways in Argentina and Chile, which already haveproductivity ratios above 1.5 million net ton-km per employee (Table 3, Annex 13). The laborproductivity ratios in the various regional systems show the seriousness of the labor redundancy problemeven better. The proposed Sudeste concession, with essentially iron ore and other large bulk shipmenttraffic, has a productivity ratio of about 2 million net ton-km per employee, while the EFVM and EFCrailways respectively achieve 10 and 20 million ton-km per employee. The Sul, Centro-Leste, and Oestesystems, which have ratios ranging from 700 to 800,000 net ton-km per employee, would need to reducetheir staff by almost half in order to reach productivity levels which are comparable to the Argentina andChile concessions. The Nordeste and Tubarao systems have productivity ratios between 200 and 300,000net ton-km per employee.

2.14 In order to enable the implementation of the proposed concessionning plan, the Government hasdecided to reduce RFFSA staff as necessary to turn the proposed concessions viable. RFFSAmanagement has developed staffing plans for the six concessions, based on re-defined operationalprocedures and consolidated responsibilities, and identified the number of redundant staff by jobcategories. The total number of redundant staff was estimated at about 18,000 on the basis of RFFSA's

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May 1995 staff of 41,991, excluding 4,000 staff that retired with early retirement benefits in early 1995.The number of redundant staff by regional system is shown in Table 2, Annex 4. RFFSA designed andprepared a staff retrenchment program on the basis of an analysis of redundant staff profiles against labormarket characteristics in the various regions, and optimized the various parameters through an econonicanalysis (Annex 4). The program, in addition to legally-required severance payments, which, as anaverage, correspond to 10 months of salary, would include incentives for early retirement and voluntaryseparation, involuntary separation grants for remaining redundant staff, re-training programs based onregional employment opportunities, and job searching and outplacement assistance.

2.15 The program would be implemented in two phases at headquarters and in each region. In the firstphase, prior to concessioning, RFFSA would first implement the incentive schemes for early retirementand voluntary separation, which would be offered only to certain categories of redundant staff and withinpre-determined limits. Depending on the results of the voluntary schemes, RFFSA would then lay offredundant staff selectively, taking into account employee performance, and pay an involuntary separationgrant equivalent to 80% of the incentive. In the second phase, after concessioning, RFFSA would payan involuntary separation grant of the same amount as in the first phase to remaining redundant staff whowould not be hired by the concessionaire, up to a maximum number of staff specified in the concessionbidding documents. Compensation packages for additional layoffs beyond the specified number wouldbe the concessionaire's responsibility.

2.16 RFFSA has already reduced its staff by over 4,000 during 1995, mainly through early retirementincentives, at a total cost of about US$40 million. RFFSA also completed the first phase of theretrenchment program at headquarters (January 1996) and in the Oeste system (February 1996), reducingstaff by about 500 and 400 respectively. However, neither RFFSA nor the Government have theresources necessary to fully implement the program. Further implementation of the program depends onthe availability of appropriate financing. The project would support the full implementation of theprogram by providing financing for severance pay, re-training and outplacement assistance (paras. 3.07to 3.09, and Annex 4).

E. Investment and Maintenance

2.17 RFFSA's total investment in the railway system declined every year since 1988, from US$267million equivalent in 1988 to US$57 million in 1994, as a result of the railway's deteriorating financialsituation (Table 5, Annex 13). Until the late 1980s, the railway invested in the broad gauge system,completing the Steel Railway, improving the Center line, and in rehabilitating locomotives, mostly withfinancing from the shippers. From 1990, the only significant investments made by RFFSA were the trackrehabilitation and systems improvements in the Parana and Goias-Minas Gerais corridors, which werefinanced by the Bank under the Federal Railway - Export Corridor Project (Loan No. 2563-BR).Maintenance expenditures have also been drastically curtailed (Table 5, Annex 13).

2.18 As a result of insufficient investment and maintenance, locomotive availability, which is thecritical determinant of production capability, fell below 60 percent for the first time in 1994. RFFSA'slocomotive availability has continued to fall since 1994 and is now about 50 percent. This is comparableto the situation in Argentina just before concessioning and is at the level of some of the worst of therailways in the world. RFFSA is now actually refusing traffic, especially on the SR3 and SR4 systems,due to insufficient available locomotives. The situation is especially critical on the Sudeste concessionwhere the output of the iron mines depends on RFFSA for shipment to port terminals or to steel mills.

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2.19 Another consequence of RFFSA's lack of capital is the bad condition of the track. While it issomewhat harder to measure track and fixed facility degradation than locomotives, available informationshow that about one-third of RFFSA's network is in substandard condition owing to deferred trackmaintenance. RFFSA suffered over 200 accidents in the first eight months of 1995, which wereattributable to bad track condition. The deterioration of the roadbed has led to reduced speeds, anincreased number of accidents, and a deterioration of service, which leads to diversion of traffic tocompeting transport modes, causing a reduction in rail revenues, and further deferred maintenance andconcomitant deterioration in service. Also, because of shortage of capital, RFFSA was unable to makeinvestments which would have had very high rates of return. The most critical of these track problemswill need to be resolved before a concessionaire would be willing to take over operations on the lines.

2.20 Since neither RFFSA nor the Government have the resources to fund the necessary locomotiveand track repair and deferred maintenance programs which are necessary to allow for continued and safeoperation during the restructuring and concessioning process, and to enable the new concessionaires toassume the systems in operating conditions, the project would include an emergency rehabilitationprogram, and financing would be provided under the proposed loan for this purpose (para. 3.10). Theemergency rehabilitation program and its justification are presented in Annex 5.

F. Finances

2.21 During most of its history, RFFSA has generated losses on its operations. These persistentoperating losses reflect the pervasive organizational inefficiencies and low productivity, lack ofconimercial freedom, lack of market-oriented management structures, failure to significantly rationalizeoperations by exiting from uneconomic low-density lines and shedding excess labor, and continuinggovernment-imposed obligations that rendered the railroad uncompetitive in the face of the growingsophistication of road transport. Between 1988 and 1991, RFFSA incurred an average yearly operatingloss of US$378 million, after having received governmental contributions amounting to US$328 millionduring the same period (Table 6, Annex 13). RFFSA has only rarely covered its operating costs fromrevenues, even if "normalization" payments (i.e. Government payments to cover losses on public serviceobligations) are included in total revenues. Over the last seven years, only in 1992 did RFFSA's grossrevenues cover its operating costs. In 1994, one of the best years in RFFSA's traffic history, transportrevenues barely covered labor and fuel costs.

2.22 RFFSA's financial performance shows substantial cross-regional variation, which can be largelyexplained by the regional differences in the volume of traffic and track productivity. By most estimates,SR3 is the system's only profitable region. In SR2 and SR5, the railroad is breaking approximately even,while in the remaining regions it experiences operating deficits. SRI has the largest shortfall betweenoperating revenues and expenditures, followed by SR7 and SR8. The proposed operational restructuring,staff retrenchment, and emergency rehabilitation programs have been designed to make the proposedconcessions financially viable (Annex 9).

2.23 Since RFFSA has not generated sufficient revenues to meet its payment obligations, RFFSA hasbeen accumulating payment arrears which have been growing rapidly. RFFSA's debt, which amountedto almost US$3.0 billion by the end of December 1995, consists essentially of rapidly increasing shortterm liabilities to Government entities such as the social security administration (US$1.9 billion includinginterest and monetary correction), financial institutions (US$400 million), contractors (US$200 million),and to the staff pension fund (US$300 million). Long-term debts are only about US$200 million. Anumber of legal actions by creditors or labor are still pending, which could result in further liabilities.RFFSA's assets total about US$16 billion equivalent in accounting terms. RFFSA's non-operational

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assets are estimated at about US$1.0 billion in market value, but most cannot be sold in the short termdue to past judicial decisions on legal actions by creditors.

2.24 RFFSA's revenues from the leasing of operational assets and from any sale or lease of non-railassets are expected to be used to repay as much as possible RFFSA's debts, and as a guarantee againstpossible new labor and environmental liabilities. However, no decision has yet been made by theGovernment regarding the treatment of RFFSA's debts, or the financing of the residual public serviceobligations in the Northeast, which could be funded either from RFFSA's revenues, by the NationalTreasury (against revenues from the sale of the railway concessions), and/or by state and localgovernments. The Government is preparing to develop a plan, based on the results of the first auctions,for the settlement of RFFSA's debts and labor and environmental liabilities, and for financing residualpublic service obligations in the Northeast (para. 3.14).

111. TIHE PROJECT

A. Project Origin, Objectives and Rationale

3.01 Project Origin. The Government decided in 1992 to restructure and privatize RFFSA'soperations in order to stop the deteriorating trend in RFFSA's performance and to improve the efficiencyof rail transport. BNDES prepared and the National Destatization Council (CND) recently approved therestructuring and privatization plan. The plan basically consists of restructuring RFFSA's operations intosix regional systems and of transferring operation and maintenance responsibilities to privateconcessionaires who would lease the necessary assets from RFFSA. The Bank has assisted through policydialogue and the preparation of a comprehensive analysis of Brazil's railway industry and of alternativepublic policy options (Report No. 1752-BR, The Brazilian Railroad Industry: Options for OrganizationalRestructuring. February 15, 1994). The proposed proiect was designed to assist the Government andRFFSA in effectively implementing the plan.

3.02 Project Objectives. The project aims to reduce the cost of freight transport in Brazil's maincorridors by restructuring and privatizing the federal railways. Specific objectives would be to:

(a) improve performance by restructuring and concessioning RFFSA's operations to privateoperators, and by restructuring its finances to settle debts and labor liabilities;

(b) increase productivity through staff retrenchment and emergency rehabilitation of critical assetsin order to make the proposed concessions viable, while minimizing the social cost of staffretrenchment;

(c) enhance competition through regulatory reform, with a view to increase the railways' marketshare and reduce freight transport rates.

Achievement of these objectives would be measured and monitored during implementation through a setof key indicators (para. 4.12 and Annex 11, Table 2).

3.03 Rationale for Bank Involvement. The Bank's country assistance strategy for Brazil, discussedby the Board of Executive Directors on June 29, 1995, identifies human capital formation andinfrastructure development as the principal bottlenecks to Brazil's social and economic development. The

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emphasis is on structural reforms aimed at stabilization and resumption of broad-based growth, includingthe deregulation and privatization of infrastructure services, and on rebuilding and expanding adeteriorated and insufficient infrastructure in partnership with the private sector. The proposed projectis fully supportive of this assistance strategy. By helping to deregulate and privatize the federal railwayoperations, the project, in addition to reducing the financial burden on public sector finances, wouldsubstantially increase the efficiency of rail and intermodal transport in the country's important corridors,and thereby contribute to economic stabilization, resumption of growth in agriculture and industry, andincreased export competitiveness.

B. Project Description

3.04 The project, a specific investment operation, would consist of the following six components:

(a) Operations Restructuring and Concessioning Component (ORC) (1 % of total project cost),including the division of the railway into six regional operations, establishment of interchangetraffic arrangements and trackage rights, preparation of bidding documents, negotiation ofconcession and lease contracts, transfer of rail assets to concessionaires, closure of RFFSA'soperational divisions, and the organization and strengthening of RFFSA's technical supervisionunits;

(b) Staff Retrenchment Program (SRP) (56% of total project cost), including appropriate incentiveschemes for early retirement, voluntary separation, severance payment schemes for remainingredundant staff, retraining programs and outplacement assistance, aiming to reduce RFFSA staffby about 18,000, in addition to 4,000 staff that already retired, in order to increase staffproductivity while minimizing the social costs of staff retrenchment;

(c) Emergency Rehabilitation Program (ERP) (41 % of total project cost), consisting of theemergency rehabilitation, repairs and maintenance of locomotives, wagons and critical sectionsof track which are necessary to avoid further deterioration and traffic losses during therestructuring and concessioning process;

(d) Environmental Management Component (EMC) (less than 1 % of total project cost), includingenvironmental audits of railway facilities and strengthening of RFFSA's environmentalmanagement and safety unit;

(e) Regulatory Reform Component (RRC) (less than 1 % of total project cost), including thedevelopment, monitoring and evaluation of railway regulations, strengthening of the railwayregulatory and supervisory agency (MT/DTF), and establishment of a dispute settlementcommission (COFER); and

(f) Financial Restructuring and Settlement Component (FRS) (1.5% of total project cost),including establishment of a Settlement Division (SD) within RFFSA and contracting of a RealEstate Manager (REM) to manage and sell non-rail assets in order to settle debts and laborliabilities.

3.05 Operations Restructuring and Concessioning (ORC). The proposed six regional concessionswould result from a consolidation of RFFSA's 12 existing Regional Superintendencies. The Sudeste,which carries over 50% of RFFSA's traffic on only 8% of its track length, essentially iron ore and steelproducts, has consistently been profitable. The Centro-Leste and the Sul have a well diversified traffic

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base, in particular petroleum, agricultural and steel products, and construction materials, and RFFSA'sanalyses show strong profitable markets for both concessions. The Oeste also has a strong growthpotential with agricultural products and fuels. The Tubarao is a single customer (Eletrosul) coal carrierrailway. The Nordeste has by far the lowest traffic density and productivity; although it might bepossible to operate it profitably in the long term, in the short term the Government (and possibly stateand local governments) is likely to have to pay subsidies to ensure adequate services at affordable prices.In this case, appropriate mechanisms would be established to specify the concessionaire's public serviceobligations and to ensure reliable funding. Traffic between these regional systems is currentlyinsignificant. However, appropriate operating arrangements would be established to facilitate existingand potential traffic between the Sul and Oeste systems and FEPASA, and between Centro-Leste andCVRD's Vitoria - Minas railway. An Association of Brazilian Railways would be established to promotethe operational integration of the systems (Annex 3).

3.06 RFFSA's operational and operational support divisions would be closed when operation andmaintenance responsibilities and rail assets are transferred to the concessionaires. The remaining part ofRFFSA would be reorganized to effectively carry out its future and transitory responsibilities. A newTechnical Division (TD), with regional units for the four main concessions (Centro-leste, Sul, Sudeste,Nordeste) would be established to supervise rail asset leases, operational safety and, by delegation fromMT/DTF, the technical and the environmental aspects of the concession contracts. The TD would alsobe responsible to supervise any residual public service obligations in the Northeast region (Annex 3).Agreement was reached with RFFSA and/or the Government during loan negotiations on: (a) RFFSA torestructure its operations, separate rail and non-rail assets, lease its rail assets to eventual concessionaires,close its operational divisions and organize its technical supervision divisions; (b) the Government topresent a plan for the concessioning of the Nordeste operation to the Bank for comments by June 30,1997; (c) the Government, through CND and BNDES, to prepare and publish concession biddingdocuments, pre-qualify bidders, and to auction concessions; and (d) the Government, through MT, tocontract concessions to successful bidders, if any, and to transfer operation and maintenanceresponsibilities to concessionaires, all in accordance with the terms, timetable, indicators and targets ofthe Project Implementation Plan (PIP) (para. 4.05 (a) and Annex 11).

3.07 Staff Retrenchment Program (SRP). The objectives of the SRP are to reduce RFFSA staff byabout 18,000 over three years, in addition to the 4,000 employees who retired in 1995, to increase staffproductivity through retraining and outplacement assistance, and to minimize the social cost of adjustmentthrough appropriate severance payments. RFFSA has developed staffing plans for the six regionalsystems, based on redefined operational procedures and consolidated responsibilities, identified thenumber of redundant staff by job categories, and analyzed redundant staff profiles against labor marketcharacteristics in the various regions. The SRP was developed on the basis of these analyses, and thevarious parameters have been tested and optimized through an economic analysis (Annexes 4 and 10).In addition to legally-required severance payments which, as an average, correspond to 10 months ofsalary, the SRP would include incentives for early retirement and voluntary separation, involuntaryseparation grants for remaining redundant staff, re-training programs based on regional employmentopportunities, and job searching and outplacement assistance.

3.08 The SRP would be implemented in two phases in each region: (a) in the first phase, prior toconcessioning, RFFSA would first implement the incentive schemes for early retirement and voluntaryseparation, which would be offered only to certain categories of redundant staff and within pre-determinedlimits. Depending on the results of the voluntary schemes, RFFSA would then lay off redundant staffselectively, taking into account employee performance, and pay an involuntary separation grant; (b) inthe second phase, after the auction, RFFSA would pay an involuntary separation grant of the sameamount as in the first phase to remaining redundant staff who would not be hired by the concessionaire,

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up to a maximum number of staff specified in the concession bidding documents. Compensation packagesfor additional layoffs beyond the specified number would be the concessionaire's responsibility.

3.09 The voluntary separation incentive would be based on the time of employment as per Table 5,Annex 4. It would range from 4 to 12 months of salary. The involuntary separation grant would beequivalent to 80% of the incentive. The proposed severance payments reflect the importance of theGovernment's social concerns. The packages would also include targeted re-training, which would becontracted out to specialized training institutions such as SENAC, SENAI and SEBRAE, and re-employment assistance which would be contracted out to a specialized outplacement firm. Beneficiarieswho would not participate in the training programs would have their separation grants reduced by onemonth of salary. On the basis of the preliminary results of the incentive schemes, it is estimated thatabout 10,000 staff would apply for the incentives, and that the remaining 8,000 redundant staff wouldreceive involuntary separation grants. RFFSA's average monthly gross salary being about US$890equivalent, the total cost of the severance payments is estimated at US$380 million equivalent. The costof the re-training and outplacement assistance is estimated at about US$15 million equivalent. Duringloan negotiations, agreement was reached with RFFSA and the Government on: (a) the terms andconditions of the voluntary and involuntary separation packages, and the terms of reference of the trainingand outplacement assistance (Annex 4); (b) RFFSA not to re-employ program beneficiaries; and (c)RFFSA to implement the SRP in accordance with the agreed terms and conditions of the SRP, and withthe timetable, indicators and targets of the PIP (para. 4.05 (b) and Annex 11).

3.10 Emergency Rehabilitation Program (ERP). The objectives of the ERP are to carry outemergency repairs and maintenance of locomotives, wagons, tracks and other facilities which arenecessary to allow for continued and safe operations during the restructuring and concessioning process.The proposed investments would avoid further traffic and revenue losses by RFFSA and, subsequently,by the concessionaires, until the latter can carry out the necessary rehabilitation programs. The ERPwould include the following components: (a) emergency repairs and/or rehabilitation of about 240locomotives to reduce failures (US$110 million equivalent); (b) replacement of locomotive and wagonwheels to reduce derailments and wagon conversions (US$16.5 million); (c) emergency repairs of criticalsections of tracks to maintain safe operations and reduce derailments (US$23.0 million); and (d) smallinvestments in signaling and telecommunication systems and workshops to permit the planned reductionsof manpower (about US$18.5 million equivalent). The design and specifications of the proposedinvestments, and their justification, which shows high financial and economic returns, are presented inAnnex 5. The investments would be implemented through turnkey-type contracts with private specializedfirms. The procurement plan and the bidding documents have been completed by RFFSA, and werereviewed by the appraisal mission and found satisfactory. During loan negotiations, agreement wasreached with RFFSA and the Government on: (a) the description and scope of the ERP; and (b) the ERPimplementation timetable, indicators and targets included in the PIP (para. 4.05 (c) and Annex 11).

3.11 Enviromnental Management Component (EMC). The objectives of the EMC are to identifyand specify responsibilities for the environmental liabilities associated with rail assets to be transferredto concessionaires, and to strengthen RFFSA's capabilities to supervise the environmental surveys as wellas the environmental and safety conditions of the concession contracts. RFFSA would be responsible forexisting environmental liabilities at the time of concessioning, and for those which cannot be attributedto the concessionaires. The EMC would include: (a) environmental surveys and audits of facilities atpotential pollution sites, including workshops, fueling stations and sleeper treatment plants, to review theadequacy of facilities and equipment, identify possible diesel, oil or polychlorinated biphenyl (PCB) spills,define corrective measures and estimate associated costs; and (b) technical assistance and training of staffto strengthen RFFSA's environmental management and safety unit (Annex 6). Agreement was reachedwith RFFSA and the Government during loan negotiations on: (a) the strengthening of the environmental

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management and safety unit through technical assistance and training of staff responsible for thesupervision of the surveys and, through delegation from DTF, of the environmental and safety conditionsof the concession contracts; and (b) the description and scope of the EMC, including the carrying out ofenvironmental surveys prior to signing the respective concession contracts, in accordance with theimplementation timetable, indicators and targets included in the PIP (para. 4.05 (d) and Annex 1 1).

3.12 Regulatory Reform Component (RRC). Railway economic regulations are being developed to:(i) allow the concessionaires maximum freedom to set tariffs on services which face competition,including differentiating them to account for individual shippers' needs, and entering into confidentialcontracts with shippers; (ii) limit the role of the Government to regulate the tariffs for captive shippers,over whom the concessionaire has monopoly power, by the stand-alone costs of the shipper's service;(iii) authorize abandonment of lines or services which are shown to be financially not viable; and(iv) facilitate inter-concession traffic (Annex 7). The concession contracts would reflect the specificregulatory requirements of each concession and their different market and service characteristics.Presidential Decree No. 1832, enacted on March 4, 1996, revised the 1985 rail transport regulation.Because the Concession Law requires setting up maximum tariffs for concessions awarded on the basisof the highest bid price, concession contracts would include such maximum tariff tables, which wouldbe updated for inflation in accordance with the Government's price controls imposed through the PlanoReal law, and which, in practice, would not constrain the concessionaires' freedom. Agreement wasreached during loan negotiations that the Government, through MT, will: (a) by December 31, 1996,present to the Bank for comments a preliminary report on the results of a joint review, with other relevantMinistries, of the above-mentioned legislation, taking into account the experience with the existingrailway concessions; (b) after taking into account the comments of the Bank, submit a final report to therelevant authorities; and (c) develop appropriate mechanisms, criteria and guidelines to implement thecaptive shipper rate and the line abandonment regulations prior to concessioning the Sudeste and theNordeste systems respectively. The project would include technical assistance and training of MT staffto help develop, implement, and monitor the regulations.

3.13 The Transport Ministry's Department of Rail Transport (DTF) would be strengthened toeffectively implement the revised regulation and to supervise the concession contracts, with the exceptionof the technical, environmental and safety-related aspects of such supervision, which would be delegatedto RFFSA. An independent Rail Transport Commission (COFER), including representatives from theconcessionaires, the shippers, and from the Government, would be established to resolve disputes betweenthe concessionaires, the shippers, and/or the Government. The establishment of COFER was approvedby the President through a temporary executive measure (Medida Provisoria No. 1342) dated March 12,1996. Agreement was reached during loan negotiations that the Government will strengthen DTF andestablish COFER by December 31, 1996 (para 4.05 (e)).

3.14 Financial Restructuring and Settlement (FRS). RFFSA's revenues from the lease ofoperational assets and from the sale or lease of non-rail assets would be used to repay part of RFFSA'sdebts, and as a guarantee against possible new labor and environmental liabilities. The financing of theresidual public service obligations in the Northeast would be funded from RFFSA's revenues, by theNational Treasury from the revenues from the sale of the railway concessions, and/or by state and localgovernments. Some debts, including the debt to the National Social Security Institute (INSS), which ledto the judicial decisions which hamper RFFSA to sell most of its non-rail assets, would have to berescheduled. The Government is developing a plan to restructure and to settle RFFSA's debts. The plan,however, cannot be finalized until the first auctions are completed and until the plan for non-rail assetsis finalized (para. 3.19). In the short term, RFFSA would establish a Settlement Division (SD), withappropriate terms of reference, which will be responsible for managing debts and labor liabilities, andfor managing and selling the non-rail assets, under contract with a specialized Real Estate Management

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firm (REM). RFFSA's reorganization plan is shown in Chart 2, Annex 11. The Head of the SD wouldbe accountable to meet the agreed asset sale and debt reduction targets, and a portion of the REM'sremuneration would be subject to meeting such targets. The project would include funds for the REMcontract and for the purchase of computer hardware and software. Agreement was reached with RFFSAand the Government during loan negotiations on: (a) RFFSA to establish a Settlement Division (SD) andto contract a Real Estate Manager (REM), both with terms of reference satisfactory to the Bank; (b) theGovernment to take a decision by December 31, 1996, to settle RFFSA's debt with the INSS so as toenable RFFSA to sell its non-rail assets; (c) the Government to present a plan for RFFSA's financialrestructuring and debt settlement, including a revised financial projection incorporating payments of therescheduled debts and projected revenues from concessions and asset sales, by June 30, 1997, andthereafter implement it, taking into account the comments of the Bank (Annex 8); (d) outline terms ofreference for the REM contract (Annex 8); and (e) the FRS implementation timetable, indicators andtargets, including asset sale and debt reduction targets, included in the PIP (para. 4.05 (f) and Annex 11).It would be a condition of loan effectiveness that RFFSA has established the Settlement Division withterms of reference satisfactory to the Bank.

3.15 Project Management. In order to effectively coordinate the implementation of the project,RFFSA would restructure and strengthen its Project Management Unit (PMU), which has effectivelycoordinated project preparation, contract a project management consultant, and finalize its ComputerizedProject Management System (CPMS) (para. 4.04).

C. Project Cost and Financing

3.16 The total cost of the project is estimated atUS$700 million equivalent, including US$380 Table 3.1: Estinated Project Costs and Financingmillion for severance payments, US$15 million for (US$ million equivalent)

re-training and outplacenient assistance, US$230 Component Costs Local Foreign Total

mnillion for supply and installation of goods,US$65 million for civil works, and about US$10 SeverancePayments 380 - 380million for studies, technical assistance, and Retraining & Outplact. 10 5 15

training of railway staff. The foreign exchange Goods & Installation 50 155 205

cost component is estimated at about US$200 Civil Works 38 17 55

million, or 29%, and the tax component at aboutUS$105 million, or 15%. The total project cost Surveys& Studies 3 1 4

includes physical contingencies for US$26 million Tech.Assist.& Training 4 2 6

or about 10% of base cost of physical investments, Total Base Cost 485 180 665

and price contingencies for US$9 million (or about4% of base cost of physical investments plus Physical Conting. 10 16 26

physical contingencies), estimated on the basis of Price Conting. 5 4 9

the disbursement schedule and of a 2.4% average Total Cost 500 200 700

annual price increase for both local and foreignexpenditures expressed in US dollars. Cost Financinp Plan Gov/RF Bank Total

estimates for severance pay are based on Total Financing 350 350 700retrenchment program conditions and averagesalaries by staff categories. Cost estimates for supply and installation of goods are based on unit pricesof recent comparable contracts, and those for civil works are based on average per-kilometer costssupported by engineering estimates and recent contract prices. Cost estimates for consultant services arebased on prevailing local and foreign man-month rates, and those for training are based on unit prices

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of contracts which have already been awarded. Project cost estimates are detailed in Table 1, Annex 11,and are summarized in Table 3.1 herewith.

3.17 The project would be financed from the proposed Bank loan of US$350 million (50% of projectcost) and from RFFSA and Federal Government counterpart funds (US$350 million or 50%). Theproject financing plan is shown in Table 1, Annex 11, and is summarized in Table 3.1 above. The Bankloan would be disbursed against: (a) severance payments at the rate of 50% of total payments (US$170million); (b) supply and installation of goods at the rate of 80% of total expenditures (US$106 million);(c) supply of goods at the rate of 100% of foreign or local (ex-factory cost) expenditures and 85% ofother local expenditures (US$20 million); (d) civil works at the rate of 80% of total expenditures(US$34 million); and (e) training, outplacement, and technical assistance contracts at the rate of 100%of total expenditures (US$20 million). RFFSA would fund 100% specific locomotive and track repairand maintenance subprojects from advance payments from shippers (about US$80 million equivalent),and contribute to counterpart funding for project components partly financed by the Bank. Agreementwas reached during loan negotiations on: (a) Borrower guarantee of counterpart funds; and (b) in orderto enable the Government and RFFSA to keep project implementation on the schedule agreed at appraisalin spite of the delays in loan negotiations, retroactive financing, in an amount not exceeding US$70million equivalent (20 % of the loan amount), for severance payments, goods and services, and consultantand training expenditures incurred not earlier than twelve months before the date of the loan agreement.

D. Financial Analysis

3.18 In order to determine a minimum price for each concession, BNDES has been preparing detailedfinancial forecasts, which will be incorporated into the concessions' bidding documents. In the meantime,RFFSA has prepared traffic and financial forecasts and a preliminary assessment of the financial viabilityof each concession. RFFSA's forecasts, which are presented in Annex 9, show that, under conservativeestimates of traffic and revenues, all concessions except the Nordeste would be financially viable. TheOeste concession, which has a strong growth potential with grain exports and petroleum products, andwith its connection with the recently concessionned Oriental railway in Bolivia, could rapidly becomeincreasingly profitable. The Centro-Leste concession, which has a well diversified but relatively shorthaul traffic, would become gradually profitable after the planned staff reductions and locomotive repairs,despite losses of petroleum traffic to a new pipeline. The Sudeste concession, which carries over 50%of RFFSA's traffic, including the bulk of iron ore, will continue to be highly profitable. The Sulconcession, which has a substantial agricultural export traffic and a strong growth potential with theincreasing trade between Brazil and Argentina, would also rapidly become profitable. The Tubaraoconcession, a short haul, coal carrier railway serving a power plant, will depend on the position of thesingle shipper. The Nordeste concession, which by far has the lowest traffic density, will not likelybecome profitable in the short term, although a private operator might be able to turn it marginallyprofitable with stringent cost controls and imaginative marketing. The Government might therefore haveto pay subsidies to ensure adequate service levels and quality at affordable prices and therefore select theconcessionaire on the basis of the lowest subsidy required.

3.19 RFFSA management has prepared tentative financial projections for the residual RFFSA. TheOperations Division (OD), which would be phased out over 1996-97, is expected to break even in 1997,after the substantial staff reductions planned for 1996. The Technical Division (TD) would generate anet income from the leasing of the rail assets to concessionaires after deduction of its expenses forsupervising rail assets and the concessionaires' operations. The Settlement Division (SD) would generatea net income from the sale of non-rail assets after deduction of real estate management and transactionexpenses. The net income from the TD and the SD would be used to service and to settle part of

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RFFSA's debts, and as a guarantee against possible future liabilities. The tentative projection shows thatRFFSA could service its restructured debt and repay up to US$700 million equivalent of principal duringthe period 1996-2000 (Annex 9, Table 7). The projection, however, is based on a number ofassumptions, in particular regarding the concession lease prices which will be obtained at the auctions,the revenues from the sale of non-rail assets, and the new terms of the debts to be rescheduled. It willtherefore have to be revised to take into account the results of the first auctions and the actual terms ofthe rescheduled debts. The Government's plan for RFFSA's financial restructuring and debt settlement,which would be sent to the Bank for comments, would include a revised financial projection(para. 4.05 (f)).

E. Environmental and Economic Assessments

3.20 Environmental Analysis. Brazil has adequate environmental legislation and regulations, and MThas adopted specific Environmental Guidelines for the transport sector, including railways, which werereviewed and found satisfactory by the Bank. Railway operators will be required, under concessioncontracts, to comply with the environmental regulations for all their operations and investments. MT'sRail Transport Department (DTF) would delegate to RFFSA responsibility for ensuring operators'compliance with the regulations. Regarding possible environmental liabilities, the project would includeenvironmental surveys of the potential pollution sites, and the concession contracts would specify therespective responsibilities of RFFSA and the concessionaires, including RFFSA's responsibilities for anyexisting environmental liabilities at the time of concessioning, or which cannot be attributed to theconcessionaires. The project is classified in the environmental category B, since the possible adverseenvironmental effects of locomotive, wagon and track repairs can be prevented or mitigated throughappropriate measures. In particular, all contractors will be obligated, through appropriate clausesincorporated in contracts, to comply with the environmental regulations, and payments to contractors willbe subject to their full compliance with such clauses. RFFSA would carry out appropriate supervisionof the contracts, including environmental-related clauses. RFFSA would strengthen its environmentalmanagement and safety unit and the project would include training of RFFSA staff for this purpose.

3.21 Project Benefits. The project, by enabling more efficient, privately operated railway andintermodal transport services, would result in an increase of the railways' traffic from about 35 billionton-km in 1996 to about 53 billion ton-km in 2000, and in a 20 percent reduction in freight transportcosts in Brazil's main corridors. It would thereby contribute to economic growth in agriculture, industryand exports. It would also indirectly help relieve congestion on important highways. The direct benefitsof the staff retrenchment program (SRP) would be the net increases in the marginal productivity ofredundant staff who are redeployed from RFFSA to another productive activity, and the marginal gainfrom the avoided labor related costs. The direct benefits of the emergency rehabilitation program (ERP)would be the avoided costs of locomotive failures and train derailments, and the avoided incremental costsof transport of freight which would otherwise, without the ERP, be using trucks. The quantifiableeconomic benefits of the overall project would be thie transport cost savings on existing rail traffic andon traffic which would otherwise, without the project, be using trucks. The fiscal implications of theproject are also expected to be very positive. RFFSA's operational deficit, about US$250 millionequivalent as an average over the past seven years, is expected to be gradually reduced and eliminatedafter the staff retrenchment program and the concessioning process are completed. RFFSA's expectedrevenues from rail asset leases and from non-rail asset sales could be sufficient to service and to repaya portion of its restructured debt over the project's implementation period. The details of the economicanalyses of the SRP, the ERP, and of the overall project are presented in Annex 10.

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3.22 Economiic Analysis of the Staff Retrenchment Program. The economic costs of the SRP,essentially severance pay and training and outplacement costs, were compared with the economic benefitsestimated as the marginal productivity of redundant staff re-employed in another activity. A detailedanalysis of the labor markets in the various regions was carried out to assess re-employment opportunitiesand probabilities and to design the re-training and outplacement programs (Annex 4, section B). Labormarket data show that the average duration of unemployment is about seven months in most regions,except in the Northeast where it is about 14 months. A conservative estimate of the probability for anaverage worker of finding a job within one year is about 80 percent in all regions, except in the Northeastwhere it is about 64 percent. However, those workers who cannot find a job at their previous wage arelikely to accept a wage cut rather than stay unemployed. Therefore, the probability that all redundantstaff will be re-employed within one year is actually close to 100 percent in all regions; some redundantstaff would have to accept average pay cuts of less than 10 percent in most regions, except in theNortheast where they would have to accept pay cuts of up to 30 percent. On the basis of the mostconservative assumptions, the Internal Economic Rate of Return (IERR) of the SRP is estimated at 40percent overall, the IERRs for the various concessions ranging from 19 percent for the Nordeste to over50 percent for the Sudeste and at RFFSA's headquarters. If workers had to accept a further 10 percentwage cut beyond the conservative base case estimates, the IERR of the SRP would still be 36 percent.If, on the other hand, it is assumed that, with the proposed re-training and outplacement assistance, allredundant staff would be re-employed within one year, the IERR of the SRP would reach 50 percent.Therefore, the SRP as designed has a very satisfactory economic justification. The methodology and theresults of the economic evaluation of the SRP are presented in Annex 10, Section B.

3.23 Economic Analysis of the Emergency Rehabilitation Program. The economic benefits oflocomotive rehabilitation were estimated as the avoided costs of locomotive failures and the avoidedincremental costs of transport of freight which would otherwise, without the program, be diverted totrucks. The IERR of the locomotive rehabilitation component is estimated at 43 percent in the base case;the estimated IERR would be reduced to 40 percent if benefits were 20 percent lower than expected, andto 27 percent if rehabilitation costs were 20 percent higher than expected. The economic benefits oflocomotive and wagon wheel replacements were estimated as the avoided costs of train derailments. TheIERR of the wheel replacement component is estimated at 19 percent in the base case; it would bereduced to 13 percent if benefits were 20 percent lower than expected and to 14 percent if costs were 20percent higher than expected. The economic benefits of the wagon conversion component, which wouldenable RFFSA to capture a highly profitable traffic of manufactured products generated between Braziland Argentina, were estimated as the transport costs savings of shifting from truck to rail transport. TheIERR of the wagon conversion component is estimated at 60 percent in the base case, at 48 percent ifbenefits were 20 percent lower than expected and at 50 percent if conversion costs were 20 percent higherthan expected. The economic benefits of track repairs were estimated as the avoided incremental costsof train operation due to slow orders and the avoided costs of derailments. The IERR of the track repaircomponent is estimated at 19 percent in the base case; at 13 percent if benefits were 20 percent lowerthan expected, and at 14 percent if costs were 20 percent higher than expected. No rates of return werecalculated for the systems and workshop consolidation components, which are relatively small investmentsnecessary to allow for the planned reductions of staff and sales of real estate. Combining the aboveanalyses, which include 87 percent of the total ERP investments, excluding deferred maintenance fundedby RFFSA, the estimated IERR for the ERP overall is 36 percent in the base case. The estimated IERRwould fall to 31 percent if benefits were 20 percent lower than expected, and to 22 percent if investmentcosts were 20 percent higher than expected, which is still very satisfactory. The methodology and theresults of the economic evaluation of the ERP are presented in Annex 10, Section C.

3.24 Economic Analysis of the Project. The economic benefits of the overall project, including therestructuring and concessioning of RFFSA operations and the regulatory reform, in addition to the SRP

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and the ERP, were estimated as: (a) the transport cost savings on existing rail traffic to result from theimproved performance of privately-operated railways; and (b) the transport cost savings on the freighttraffic which, without the project, would be using trucks, calculated as the difference between the longrun marginal costs of railways and trucks. Project economic costs and benefits were calculated for theentire project as well as for each concession separately. The methodology and the results of the economicanalyses of the overall project are presented in Annex 10, Section D. The IERR for the project overallis estimated at 68 percent in the base case, and its net present value (NPV) ranges between US$1.9 billionand US$2.7 billion equivalent for discount rates ranging from 15 percent to 10 percent. The IERRs forthe concessions range from 20 percent for the Nordeste to over 100 percent for the Sudeste and Oesteconcessions. The IERR for the project overall would be reduced to 45 percent if the demand fortransport and/or the benefits were 20 percent lower than expected, and to 50 percent if costs were 20percent higher than expected, which is still very satisfactory.

F. Project Risks

3.25 The project would be subject to four types of risks. First, Brazil's first large-scale privatizationof a public service could bring a number of unexpected implementation problems, including legalchallenges, which could derail the proposed sequential concessioning process. Vested interests mayattempt to stop, delay or re-direct the process, and Government bureaucracy may not cooperate fully.A future Government could even revoke the proposed railway concessions, rehire retrenched railwaystaff, and/or oppose the sale of non-rail assets. The commitment of the Government, the assignment ofconcessioning responsibilities to the National Destatization Council and to BNDES, the proposed laborseparation incentive schemes, and the project implementation, monitoring and supervision plans mitigatesuch risks, which are taken into account in the conservative implementation timetable. The successfulauction of the Oeste concession provides additional assurances that the process is now firmly established.Second, some concessions which will be brought to auction might not find a buyer. Private investorshave shown a strong interest in, and are preparing to bid for the the Centro-Leste, Sudeste and Sulconcessions. The sole customer of the Tubarao line might have to take an interest in the concession andeither operate it directly or under contract. Although the Government would be committed to present aplan for the Nordeste concession to the Bank for comments, there is a real risk that this concession wouldnot find a buyer. In this event, the railway might have to be operated under a management contract,which would nevertheless represent an improvement over the current public operation.

3.26 Third, the emergency rehabilitation program could suffer from implementation delays, and/or theconcessioning process could be accelerated, and some rehabilitation and maintenance works might notbe needed or could be implemented by the concessionaires. The scope of the emergency rehabilitationprogram might therefore need adjustment during project implementation. Fourth, Brazil's institutionsand private companies are not familiar with the proposed form of economic regulation and unexpectedproblems could lead to some form of restrictive regulations in such areas as pricing, competitive accessor line abandonment. Enacting the new regulation for railways prior to concessioning, strengthening DTFand establishing the COFER, including the proposed training programs for MT/DTF and RFFSA staffand COFER members, are expected to help preserve competition and protect consumers' rights. Overall,the project carries real risks, but it also provides an exceptional opportunity to effectively reform Brazil'sfederal railways.

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IV. PROJECT IMPLEMENTATION

A. Institutional Responsibilities

4.01 The Government of Brazil (GOB), the Borrower, would transfer the proceeds of the loan to theFederal Railways (RFFSA) on a non-reimbursable basis. GOB under the Loan Agreement (LA) andRFFSA under the Project Agreement (PA) would be committed to implement the above projectcomponents in accordance with institutional responsibilities (section A), organizational arrangements(section B), the project implementation plan (section C), procurement arrangements (section D), anddisbursement, accounting and auditing arrangements (section E) included in the Project ImplementationPlan (PIP). The Bank would monitor and supervise project implementation in accordance with the projectmonitoring and supervision plan (section F).

4.02 GOB would be responsible for implementing: (a) the concessioning component through theNational Destatization Council (CND) and the National Bank for Social and Economic Development(BNDES); and (b) the regulatory reform component through the Ministry of Transport. RFFSA wouldbe responsible for implementing (c) the operations restructuring, (d) the staff retrenchment, (e) theemergency rehabilitation, (f) the environmental management, and (g) the financial restructuring andsettlement components. In particular, GOB, through CND and BNDES, would finalize and issueconcession bid documents, pre-qualify bidders, and auction concessions in accordance with the timetableincluded in the Project Implementation Plan (PIP). GOB, through MT, would enter into contracts withthe concessionaires who would assume the railways' operations, implement the revised railway regulationsand, for this purpose, strengthen MT's Department of Rail Transport (DTF) and establish the RailTransport Commission (COFER). RFFSA would in particular: (a) under the operations restructuringprogram, restructure operations. separate operational and non-operational assets, lease rail assets. closeits operational divisions, and establish technical supervision units; (b) under the staff retrenchmentprogram, retrench, indemnify, retrain, and assist redundant staff in finding new employment; (c) uinderthe emergency rehabilitation program, rehabilitate, repair and/or maintain locomotive, rolling stock andcritical sections of tracks; (d) under the environmental management component, survey ground pollutionat workshop and fueling sites, and strengthen its environmental management and safety unit; (e) underthefinancial restructuring and settlement component, establish a settlement division to sell non-rail assetsand to service and settle its debts.

B. Organizational Arrangements

4.03 BNDES, which is responsible for implementing the Federal Government's privatization programunder the direction of the CND. and has already effectively privatized large steel mills, petrochemicaland other parastatals, has adequate capability within its Privatization Department to auction the railwayconcessions. MT would strengthen its Department of Rail Transport to effectively implement its newregulatory and concession supervision functions, and would establish the Rail Transport Commission(COFER) to resolve disputes which may arise between shippers, concessionaires and/or the Government,in accordance with an agreed plan and timetable (Annex 7). Agreement was reached with GOB duringloan negotiations on strengthening DTF and establishing COFER by December 31, 1996.

4.04 RFFSA would restructure its Project Management Unit (PMU), which coordinated projectpreparation, to effectively coordinate project implementation. The Project Coordinator would reportdirectly to the President of RFFSA (Chart 2, Annex 11). The PMU would be reorganized into threeunits, responsible for coordinating the staff retrenchment, the emergency rehabilitation, and the

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institutional components, respectively, and staffed with a least ten qualified professionals. In addition,RFFSA's management plans to contract a Project Management consultant (PM) to assist the PMU andother divisions in managing the implementation of the project. Also, the PMU would complete theinstallation of a Computerized Project Management System (CPMS), which was started during projectpreparation. RFFSA's Operations Division (DIPRO), which will be gradually phased out, is adequatelystaffed to complete the operations restructuring component. The Development and Marketing Division(DICOD), which would become the Technical Division and implement the emergency rehabilitationprogram (ERP), has established and would maintain specific task forces to implement the respectivecomponents of the ERP. The environmental management and safety unit would be strengthened witheight qualified professionals and moved to the Technical Division. The Administration and FinanceDivision (DIAFI), which would implement the staff retrenchment program, has set up and would maintainadequate central and regional task forces until the program is completed. The proposed SettlementDivision (SD) would be responsible for implementing the asset sale and the debt settlement plans.Agreement was reached with RFFSA during loan negotiations on the above organizational arrangementsfor project implementation including: (a) the contracting of the Project Management consultant and thecompletion of the installation of the CPMS not later than 90 days after the date of the project agreement;(b) the terms of reference for the Project Management consultant; and, as conditions of loan effectiveness:(c) the restructuring of the PMU with staff, responsibilities and functions satisfactory to the Bank; and(d) the establishment of the Settlement Division with terms of reference satisfactory to the Bank.

C. Project Implementation Plan

4.05 The Governmnent of Brazil and RFFSA would be committed, under the Loan and ProjectAgreements, to carrying out the project in accordance with the Project Implementation Plan (PIP), whichis presented in Annex 11. The main conditions of the PIP, which are summarized below, were confirmedduring loan negotiations.

(a) Operations Restructuring and Concessioning Component (ORC)

(i) RFFSA will restructure its operations, separate rail and non rail assets, lease its rail assets toconcessionaires, close its operational divisions, and establish its technical supervision units inaccordance with the time schedule and with the monitoring indicators and targets set forth in thePIP (Annex 1 1, Chart 1, Table 2);

(ii) GOB, through CND and BNDES, will prepare and publish concession bidding documents, pre-qualify bidders, and auction and award concessions in accordance with the time schedule and withthe monitoring indicators and targets included in the PIP (Annex 11), and, by June 30, 1997,present a plan for the concessioning of the Nordeste operation to the Bank for comments, andthereafter implement it, taking into account the comments of the Bank; and

(iii) if auctions are successfully completed, GOB, through MT, will contract concessions with winningbidders and transfer operation and maintenance responsibilities to concessionaires in accordancewith the time schedule, monitoring indicators and targets set forth ii the PIP (Annex 11).

(b) Staff Retrenchment Program (SRP)

(i) RFFSA will implement the SRP in accordance with the agreed terms and conditions, includingnot re-employing program beneficiaries (Annex 4), and with the time schedule included in thePIP (Annex I 1, Chart 1);

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(ii) RFFSA will reduce its staff, retrain its redundant staff and provide outplacement assistance soas to meet the targets set forth in the PIP (Annex 11, Table 2); and

(iii) RFFSA will maintain an updated database on the employment status of SRP beneficiaries, andreport on employment status by staff categories under the quarterly reports to the Bank(item g (ii) hereinafter).

(c) Emergency Rehabilitation Program (ERP)

(i) RFFSA will procure goods and services and execute services for the ERP in accordance with theERP procurement and execution time schedule included in the PIP (Annex I1, Chart 1 andTable 3);

(ii) RFFSA will rehabilitate locomotives, replace locomotive and wagon wheels, replace locomotivebatteries, convert wagons, rehabilitate tracks, improve telecommunication and signaling systems,and consolidate workshops in accordance with the ERP monitoring indicators and targets set forthin the PIP (Annex 11, Table 2).

(d) Enviromnental Management Component (EMC)

(i) RFFSA will carry out environmental audits of workshops, fueling stations and sleeper treatmentplants, in accordance with the timetable and targets set forth in the PIP (Annex 11);

(ii) GOB, through CND, BNDES and MT, will specify the concessionaires' and RFFSA'sresponsibilities for the environmental liabilities within the concession contracts; and

(iii) RFFSA, in order to strengthen its environmental management and safety unit, will contracttechnical assistance and train its environmental staff in accordance with terms of referencesatisfactory to the Bank (Annex 6).

(e) Regulatory Reform Component (RRC)

(i) by December 31, 1996, GOB, through MT, will present to the Bank for comments a preliminaryreport on a review of the Concession Law and the Plano Real Law with respect to rail transporttariffs, and, after taking into account the Bank's comments, submit a final report to the relevantauthorities;

(ii) GOB, through MT, will develop appropriate mechanisms, criteria and guidelines to implementthe captive shipper rate and line abandonment regulations prior to concessioning the Sudeste andthe Nordeste systems respectively, present them to the Bank for comments, and thereafterimplement them, taking into account the comments of the Bank; and

(iii) GOB will, by December 31, 1996, strengthen DTF through training of its staff to effectivelyimplement the revised rail transport regulations, and establish an independent Rail TransportCommission (COFER) to resolve disputes between concessionaires, shippers and the Government.

(f) Financial Restructuring and Settlement Component (FRS)

(i) RFFSA will establish a Settlement Division, with terms of reference satisfacotry to the Bank, asa condition of loan effectiveness, and will contract a Real Estate Management (REM) firm on the

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basis of terms of reference satisfactory to the Bank to assist with managing and selling non-railassets (Annex 8);

(ii) GOB will: (a) by December 31, 1996, take a decision to settle RFFSA's debt with the INSS soas to enable RFFSA to sell its non-rail assets; and (b) by June 30, 1997, present to the Bank forcomments a plan for RFFSA's financial restructuring and debt settlement (Annex 8);

(iii) RFFSA will maintain its staff within the targets set forth in the PIP (Annex 11, Table 2); and

(iv) RFFSA will generate revenues from rail and non-rail assets and reduce its debts in accordancewith the targets set forth in the PIP (Annex 11, Table 2);

(g) Project Management

(i) RFFSA will: (a) as a condition of loan effectiveness, have restructured its Project ManagementUnit (PMU) with staff, responsibilities and functions satisfactory to the Bank; (b) not later than90 days after the date of the project agreement, contract with the Project Manager consultant andcomplete the installation of its Computerized Project Management System (CPMS); and(c) forward quarterly progress reports to the Bank; and

(ii) GOB and RFFSA will carry out the project in accordance with the PIP (Annex 11), including themonitoring indicators and targets (Annex 11, Table 2).

D. Procurement Arrangements

4.06 Procurementarrangements are Table 4.1: Procurement Method

presented in Table 3, (US$ million)

Annex 11 and are ------- Procurement Method-------------

summarized in Table 4. 1hemmarewiz in Table 4.1 Project Element ICB NCB Other n.b.f 1/ Total

herewith. Separation Grants 340 40 380

4.07 All goods and (170) (170)

services (supply and Goods & Services 100 35 70 205installation), and civilworks contracts (80) (26) (106)

estimated to cost US$5.0 Goods 20 20

million or more would (20) (20)

be procured throughI n t e r n a t i o n a Civil Works - 45 30 75

Competitive Bidding (34) (34)

(ICB) procedures, in Consultants & Training - 20 - 20

accordance with BankGuidelines and using (20) ___(20)

relevant standard bidding Total 120 80 360 140 700

documents issued by the (Bank financed) (100) (60) (190) - (350)

Bank. Any modifica-tions to such documents 1/ not Bank-financed severance pay, locomotive and track repairs and maintenance

which may be necessary expenditures

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would have to be agreed with the Bank. Goods and services, and civil works contracts below US$5.0million, up to an aggregate amount of US$80 million, would be procured through National CompetitiveBidding (NCB) procedures, based on standard bidding documents which were reviewed by the appraisalmission and found satisfactory. The value of individual civil works and goods and services contracts isexpected to vary between US$1.0 and US$20.0 million (total cost about US$180 million). Goods,including locomotive and wagon wheels and locomotive batteries would be purchased through ICBprocedures, in accordance with Bank Guidelines and using relevant standard bidding documents issuedby the Bank. NCB procedures would be used for contracts for goods below US$350,000 and aboveUS$100,000, and shopping procedures would be used for contracts below US$100,000, in the event thatsuch contracts are required. Consultants for detailed engineering, construction supervision, technicalassistance and training programs would be selected and engaged following Bank Guidelines for the Useof Consultants (August 1981) and the standard contract issued by the Bank would be used for complex,time-based assignments. The cost of these services is expected to aggregate to US$20 million equivalent.

4.08 RFFSA is the principal implementing agency, responsible for carrying out all procurement.RFFSA's organization for and experience with procurement were reviewed during appraisal and foundsatisfactory. The Borrower's procurement law (Law no. 8666 of June 21, 1993) specifically authorizesexecuting agencies to procure goods and services financed by multilateral institutions in accordance withthe norms and procedures of the financial institutions. All ICB contracts, the first two NCB contractsfor civil works and for the supply and installation of goods, all contracts with consulting firms estimatedat US$100,000 equivalent or more, and all contracts with individual consultants estimated at US$50,000or more would be subject to the Bank's prior review of bidding documents. These prior-reviewarrangements would cover contracts totaling about 65 % of the total cost of Bank-financed works, goodsand services. The balance of contracts would be subject to selective ex-post review by the Bank aftercontract award. Agreement was reached with RFFSA during loan negotiations on the above procurementarrangements.

E. Disbursements, Accounting and Audit Arrangements

4.09 The Bank would disburse for: (a) severance payments at the rate of 50%; goods and services(supply and installation contracts) and civil works at the rate of 80% of total expenditures; (c) goods atthe rates of 100% of foreign expenditures and 100% of local expenditures (ex-factory cost, excludingtaxes), and 85% of other local expenditures; and (d) consultant services and staff training at the rates of100% of expenditures. The allocation of the proceeds of the loan is shown in Table 4, Annex 11. Basedupon experience with similar projects and the relevant standard disbursement profile for enterpriserestructuring projects, the implementation period for the project is estimated at four years. The projectcompletion date would therefore be June 30, 2000, and the Closing Date would be December 31, 2000.The estimated loan disbursement schedule is shown in Table 5, Annex 1 1.

4.10 Disbursements for severance payments would be made against withdrawal applications whichwould provide all the necessary information on beneficiaries. including employee identification and staffnumber, dates of employment and of separation, latest salary and amount of separation grant paid. Theseapplications would contain a certification by an independent auditor satisfactory to the Bank that suchpayments were made in accordance with the agreed provisions of the Staff retrenchment Program. Asample of these applications would be reviewed by the Bank prior to disbursement. RFFSA wouldmaintain an SRP file with all the related documentation, including the employment contract terminationdocument which provides all the necessary information for the computation of the severancecompensation, and records the employee agreement. The documentation in the files would be periodicallyaudited by the independent auditor, and would be made available to Bank supervision missions.

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4.11 In order to reduce the interval during which the Borrower would finance the Bank's share ofproject cost with their own resources, the Borrower would establish a Special Account (SA) in US dollarsin a commercial bank to cover local and foreign currency expenditures of the project. The Bank woulddeposit up to US$40.0 million in the SA. The Bank would replenish the Special Account for the amountof withdrawals on account of eligible expenditures at the request of the Borrower. RFFSA has adequateaccounting control to enable disbursement to be made on the basis of Statements of Expenditures.Supporting documentation with respect to expenditures against contracts valued at up to US$5.0 millionequivalent for supply and installation of goods and civil works, US$350,000 equivalent for goods,US$100,000 equivalent for consulting firm services, and US$50,000 for individual consultants, wouldbe retained by RFFSA, be available for inspection by Bank supervision missions, and be subject toauditing by the independent auditor. Expenditures for contracts above these limits would be documented.During loan negotiations, agreement was reached with RFFSA and the Government on: (a) the abovedisbursement arrangements; and (b) RFFSA to retain an independent auditor, acceptable to the Bank, toaudit their accounts, including the project accounts, financial statements, severance payments, SpecialAccount and Statements of Expenditures, and to furnish the auditor's reports to the Bank not later thansix months after the end of each fiscal year.

F. Monitoring and Supervision Plan

4.12 The Bank would monitor and supervise the implementation of the project in accordance with theMonitoring and Supervision Plan presented in Annex 12. The Bank would monitor the implementationof the project against the times chedule and the monitoring indicators and targets, which are set forth inthe PIP (Chart 1, Table 2, Annex 11). The estimates of Bank monitoring and supervision inputs into keyactivities are shown in the Table 1, Annex 12.

4.13 RFFSA is developing and would establish an appropriate Computerized Project ManagementSystem (CPMS) to manage the implementation of the project. The system is designed to produceadequate information to report to RFFSA management and to the Bank to permit effective monitoring ofproject implementation against the agreed monitoring indicators and targets. During negotiations,agreement was reached with RFFSA on: (a) the CPMS to be fully installed not later than 90 days afterthe date of the project agreement; and (b) quarterly progress reports satisfactory to the Bank, to be sentnot later than one month after the end of each quarter.

4.14 In supervising the implementation of the project, the Bank would in particular review thefollowing documents: (a) withdrawal applications for severance payments and related documentation, ona sample basis; (b) procurement documentation for contracts under the ERP and EMC programs, ex-antefor all ICB-procured and the first two NCB-procured contracts, and ex-post, on a sample basis, for otherNCB-procured contracts; (c) terms of reference, invitation letters, short-lists and draft contracts forconsultant and staff training services, in accordance with the prior-review thresholds set forth inpara 4.08.

4.15 Comprehensive reviews of the implementation of the project would be carried out in the monthof June each year during project implementation, and when 50% of the loan amount allocated toseverance payments has been disbursed. The review would cover all the agreed actions, target dates, andimplementation indicators included in the PIP and the status of compliance with all covenants of the Loanand Project Agreements. Particular importance would be given to: (a) progress in the restructuring andconcessioning process; (b) staff reductions, re-training and outplacement assistance; (c) progress underthe emergency rehabilitation program and the environmental management component; and (d) progressunder the financial restructuring and settlement program, including achievement of targets for sale of non-

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rail assets and reduction of debt. The Government and RFFSA would be committed to implement all theproposed measures as necessary to ensure the efficient completion of the project and the attainment ofits objectives. The Bank would have the right to exercise appropriate remedies if performance is notsatisfactory.

VI. AGREEMENTS REACHED AND RECOMMENDATION

5.01 During negotiations, agreement was reached with the Government of Brazil (GOB) and RFFSAon the following:

(a) RFFSA to restructure its operations and GOB to auction concessions in accordance withtimetable and targets (paras. 3.06, 4.05 (a));

(b) RFFSA to implement the SRP in accordance with the agreed terms and conditions,indicators and targets (paras. 3.09, 4.05 (b));

(c) RFFSA to implement the ERP in accordance with time schedule and targets(paras. 3.10, 4.05 (c));

(d) RFFSA to strengthen its environmental management unit and to implement the EMC inaccordance with time schedule and targets (paras. 3.11, 4.05 (d));

(e) GOB to develop regulatory mechanisms and guidelines, present draft report on reviewof relevant legislation to the Bank, strengthen DTF and to establish COFER inaccordance with timetable (paras. 3.12, 3.13 and 4.05 (e));

(f) GOB to present plan for RFFSA's financial restruturing and debt settlement, RFFSA toestablish Settlement Division, contract Real Estate Manager, sell non-rail assets and tosettle debts in accordance with time schedule and targets (para. 3.14 and 4.05 (f));

(g) RFFSA to restructure the PMU, contract Project Manager consultant, and to completethe installation of the CPMS (paras. 3.15, 4.05 (g));

(h) Borrower guarantee for counterpart funds, and retroactive financing arrangements(para. 3.17);

(i) organizational and management arrangements for project implementation (paras. 4.03 and4.04);

(j) project implementation plan (para. 4.05 and Annex 1 1);

(k) procurement arrangements (paras. 4.06 to 4.08);

(1) disbursement, accounting and audit arrangements (paras. 4.09 and 4.11); and

(m) monitoring and reporting arrangements, including implementation targets and mid-termreview of project implementation (paras. 4.12 to 4.15).

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5.02 The following would be Conditions of Loan Effectiveness:

(a) RFFSA to establish a Settlement Division with terms of reference satisfactory to the Bank(para. 4.05 (f));

(b) RFFSA to restructure its Project Management Unit with staff, responsibilities andfunctions satisfactory to the Bank (para. 4.05 (g)).

5.03 Recommendation. Subject to the above, the project provides a suitable basis for a Bank loanof US$350 million equivalent to the Federative Republic of Brazil. The terms would be 15 years,including five years of grace, at the Bank's standard variable interest rate for currency pool loans.

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BRAZIL

FEDERAL RAILWAYS RESTRUCTURING AND PRIVATIZATION PROJECT

Macroeconomic and Structural Reform Background

A. Macroeconomic Framework

1. Since the beginning of 1994, the authorities have been implementing a stabilizationplan that has been carefully sequenced. The first phase involved a significant tightening offiscal policy to obtain a balance in the operational account of the consolidated public sector.The second phase marked the introduction of a new system of indexation of a co-temporaneousnature, intended to eliminate inertial components to inflation. The final phase, introduced inJuly 1994, saw the introduction of a new currency, the real, linked to the U.S. dollar and theelimination of indexation. Stabilization policies have been based on a nominal exchange rateanchor and tight monetary policies. External payments were normalized with a debt and debtservice reduction agreement with commercial banks and with arrangements under the ParisClub as a part of the stabilization plan.

2. Inflation has been reduced sharply under the plan from monthly rates of around 40 percent in mid-1994 to below 1 per cent currently. The economy has grown at annual rates ofover 4 per cent in the post-stabilization period; initially, the major contribution to growtharose from a sharp rise in domestic demand associated with a reduced erosion of real incomesfrom inflation, rises in real wages and consumer credit expansion, but after bouts of monetarypolicy tightening since early 1995, domestic demand has moderated and the externalcontribution turned positive.

3. The fiscal adjustment seen in 1994 was sharply reversed in 1995, when an operationalsurplus equivalent to 0.5 per cent of GDP was transformed into a deficit of 5 per cent of GDP.The underlying deterioration in the fiscal balance is even greater taking account of the strongcyclical upturn in 1995. The principal causes of the fiscal loosening lie in a steep rise in thepublic sector wage bill, as minimum wages and public sector pay were increased markedly inlate 1994 and early 1995, higher social security expenditures (in part related to the rise inminimum wage), increases in outlays for interest payments on public debt, and strong increasesin expenditures at states and municipalities.

4. The burden of adjustment has fallen on monetary policies. The authorities have takenperiodic measures to vary reserve requirements, impose tax and other restrictions on creditoperations and capital inflows, and have maintained interest rates at very high rates in realterms. Real interest rates in monthly terms have ranged at 2 to 3 per cent. The Central Bankhas engaged in sterilization operations on a massive scale in response to capital inflows -- adevelopment, which together with the need to fund the fiscal deficit, had led to a sharp rise inpublic debt to the equivalent of nearly one-third of GDP. A further cause of the rise in thepublic debt lies in Central Bank liquidity support given to several public and one private bankin distress. After an initial period of strong re-monetization of the economy in response to thefall in inflation, the broad money to GDP ratio has been stable in recent quarters.

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5. Upon its introduction, the real was allowed to float and traded at around 0.82 to theU.S. dollar, with an official floor of parity to the dollar. From March 1995, the authoritiesadopted an adjustable exchange rate band system to limit the appreciation in real terms andsafeguard the external accounts. The band has since then been depreciated on severaloccasions and currently stands at 0.97 to 1.06 to the dollar. Since its introduction, the real isestimated to have appreciated by over 25 per cent in real terms, but from an initial position ofa strongly competitive economy. The external current account registered a deficit of US$17.7billion (2.5 per cent of GDP) in 1995, but with strong capital inflows, gross internationalreserves rose by US$12 billion in the course of the year to stand at US$52 billion by year-end.

6. The success with the stabilization plan to date has been encouraging: inflation has beensharply reduced, whilst growth has been maintained. Furthermore, the reduction in inflationhas contributed greatly to a rise in real incomes of the poor. It will also lead to an upturn insavings in the economy that is necessary if growth is to be sustained. At the same time,reliance on external savings to finance growth has been limited and current account deficitshave been easily financed. The strengthening of confidence in Brazil has led to large capitalinflows and to reserve gains.

7. Consolidating stabilization in 1996 will require changes in the policy mix in 1996. Inparticular, it will be vital to tighten fiscal policy and to limit the growth in public debt. Ifthese can be achieved, the burden on monetary policy will diminish and real interest ratescould be safely reduced. A stronger fiscal position will, thus, also contribute to some realdepreciation of the currency and to a better balance between the external current and capitalaccounts.

8. Policy adaptations of this type will require strengthening the budget currently beforeCongress and also the passage of several key constitutional amendments that will removeconstraints to more efficient management of the public sector. These are discussed below.

B. Structural Reforms

9. The Cardoso Government has reinitiated the privatization program, slowed andtemporarily halted by the predecessor Franco Government. A law was passed in February1995, permitting private concessions for electric power distribution and transport of naturalgas. Several Brazilian state governments have launched programs covering the sale of stateequity in electricity distribution, telecommunications and the banking sector. Two large state-owned banks may have majority equity in private hands by the end of 1996.

10. The major reforms to come are follow-ups to the ending of state monopolies intelecommunications, petroleum, the gas sector and coastal shipping which also happened in1995. In the area of telecommunications, peripheral and value added services are being openedto competition. The privatization of the network may be delayed awaiting regulatory reformand the complexity of breaking up the existing structure. There are no plans to privatizePetrobras but it may collaborate with foreign companies in exploration.

11. In electric energy, the Government is seeking partners to finish incomplete existingplants. In electricity distribution minority shares are being sold with the publicly owned

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development bank, BNDES, forming a fund where shares may be deposited by stategovernments against future sale.

12. The Cardoso Government has reform plans in three other areas; social security, fiscalreform and administrative reform. The social security system is a defined benefit regime,largely funded by employer and general taxes. It is also biased towards early retirement bycertain categories of workers. This has resulted in a growing mismatch between payments andbenefits. Efforts at comprehensive reform, including a move towards a largely capitalizedsystem are unlikely to succeed politically at present and the administration's current reformgoal is a more modest one of correcting the bias towards early retirement and removing someof the legislation from constitutional to infra-constitutional status to be dealt with later.

13. Administrative reforms would involve allowing layoffs from the civil service andsetting limits to salaries plus benefits as well as retirement benefits. Currently no confirmedcivil servant can be removed from service and enjoying multiple pensions with no overall limiton the amount is widespread.

C. State Finance Reform

14. The decline of inflation and the insolvency of several major state-owned banks in 1995removed important explicit and implicit sources of financing from the Brazilian states. Theirdeficits rose to 2.5 percent of GDP or about 70 percent of the total national deficit in 1995.They also ran up large floating debts to contractors and private banks.

15. In order to adjust to the new economic environment the states are considering reformplans involving downsizing and rationalizing their workforce, debt workouts and privatizationsand concessions. Federal programs have been tailored providing incentives in these directions.The extent of the program and the degree of commitment to reform varies across states. Thedegree of success will depend not only on their own efforts but also on certain nationalparameters such as the degree of flexibility that emerges from the civil service reform and theterms of the debt workout of the state debt which will have to be largely refinanced by theFederal Government.

16. Finally, fiscal reform is intended to integrate the federal and state tax systems, removethe power of granting fiscal incentives from the states and remove the bias against exports andcapital goods investments present in the current value added tax system.

17. At present the social security bill is ready for presentation to the plenary of theCongress. The timing and content of the Administrative Reform bill and the fiscal bill areuncertain since there is likely to be significant opposition in Congress. The state governors arein favor of administrative reform as it will help them financially but are wary of fiscal reformwhich would diminish their power of independent action.

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D. Medium-Term Outlook

18. The projected GDP growth rates in 1996 and 1997 are 3 percent and 4.5 percentrespectively. While Brazil has achieved much higher rates of growth in the past, the need tokeep aggregate demand under control in order to prevent a resurgence of inflation suggests thatgrowth will be in this range or even slightly lower in 1996. Gross domestic fixed investmentis expected to rise steadily, financed largely by growing domestic savings.

19. Current account deficits will be contained to below 2.5 percent of GDP. Trends incapital flows suggest that deficits of this magnitude can be financed relatively easily.According to the Government, the consolidated fiscal account (operational basis) will show adeficit of about 2-2.5 percent of GDP or even slightly higher in 1996 but swing into balancebeyond that. The rate of inflation should gradually decline but will still be in the double digitrange through 1997. This scenario is posited on the Government making the necessary effortto sustain the Real Plan.

20. The Government's aim is to reach single digit inflation by 1998, the last year ofPresident Cardoso's mandate. So far, the record of economic management has been good.The rate of inflation continues to be low and an overheating of the economy was containedsuccessfully in 1995. The current account deficit is less than 3 percent of GDP and reservelevels are high. The economy is less indexed than in the past and inflationary expectations for1996 are favorable. However, there are risks to the program if the reform agenda in the caseof state reforms and structural changes discussed above are delayed or left incomplete. Theserisks are elaborated below.

E. Risks

21. The biggest risk to the Real Plan comes from the inability of the government so far todeal on a permanent and satisfactory basis with the causes of fiscal imbalance that have beenfundamental in fueling inflation in the past. In spite of substantial increases in revenue post-stabilization, the fiscal deficit worsened significantly in 1995. Major changes in federal-statefiscal relations, earmarking rules for budgetary receipts, the social security system and civilservice rules are needed to give federal and state governments the flexibility to balance theirbudgets. Many of these changes require Constitutional Amendments and furthercomplementary legislation. Their passage through Congress has been delayed and resisted byinterest groups. The outcome is uncertain since the Congress is split into a large number ofparties with frequent shifts of alliances on specific issues.

22. In the absence of a fiscal adjustment the government has relied on an interim policymix which has resulted in high domestic interest rates, growing internal debt and substantialshort term capital inflows. This can only be sustained if fiscal fundamentals improve. Therisks of the program, therefor, hinge around the rapidity with which a fiscal adjustment can beeffected. The financial sector, which has had to adjust rapidly to a decline in inflationary gainsand tight credit policies also needs to be monitored closely.

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BRAZIL

FEDERAL RAILWAYS RESTRUCTURING AND PRIVATIZATION PROJECT

Bank Experience with Railway Projects in Brazil and Argentina

A. Brazil Railway Projects

I The Bank approved five loans for railways in Brazil between 1971 and 1987, in addition tofinancing the Carajas railway under the Carajas Iron Ore Project (Loan No. 2196-BR, 1982, US$304.5million).

2. The First Railway Project (Loan 786-BR, US$6.0 million, 1971) was to finance the railwayportion of the Mineracoes Brasileiras Reunidas (MBR) iron ore project (partly financed by Loan 787-BR)to carry 10-12 million tons of iron ore annually from the Aguas Claras mine to the Sepetiba ocean portterminal. Although traffic started as planned in July 1973, it was hindered by operational problems, suchas derailments on the Central Line, whose rehabilitation (financed by RFFSA) took longer than expected.Also, delays were encountered in the bridge strengthening program and in completing new workshops.The traffic situation improved in 1974, reaching the forecast level by the end of the year. The project didnot address the institutional issues of RFFSA, and, in the end, the Bank's dialogue with the Governmenton this subject had to take place largely outside the loan's context. The project was completed inDecember 1977, about three years behind schedule (PPAR No. 4258 dated December 30, 1982).

3. The Second Railway Project (Loan 1074-BR, US$175.0 million, January 1975) financed thefirst two years of RFFSA's 1975-1979 investment plan and, in addition, included a program of technicalassistance. The main objectives were to enable RFFSA to meet future demands, particularly intransporting iron ore and steel products in the Central, and agricultural products in the Southern, regions.Assistance was also provided for the rehabilitation and modernization of the suburban passenger servicesin Rio de Janeiro and Sao Paulo. In addition to track rehabilitation, the project included purchase ofsignaling and telecommunications equipment and rolling stock for the suburban services in Rio and SaoPaulo, as well as workshop equipment. The project was completed in December 1981, about two-and-a-half years behind schedule. In retrospect, it appears that the project, which included a large number ofindividual projects for a total estimated cost of about US$3.2 billion, was too large for the railway toimplement, and the time schedule was clearly too optimistic. Many components had to be reformulatedand/or postponed. For institutional development, the measures and actions which were essentially internalto RFFSA were successful. Regarding broader questions of policies and relationships with the FederalGovernment, the difficulties involved were underestimated, and the appraisal objectives were mostly notachieved (PCR issued on June 22, 1983, PPAR No. 6295 dated June 20, 1986).

4. The Third Railway Project (Loan 1171-BR, US$75.0 million, October 1975) financed the firsttwo years of the 1975-1979 investment plan of the Sao Paulo State Railway (FEPASA). The objectives ofthe loan were to: (a) rehabilitate and, as necessary, expand the system; (b) improve the operational andfinancial performance of FEPASA; (c) improve suburban passenger services in the Sao Paulo area; and (d)strengthen urban transport coordination in the Sao Paulo area. During implementation, it soon becameevident that the program was too large for FEPASA, which, in any case, lacked the necessary funds. Inmid-1977, the Bank and FEPASA agreed to redefine the project. However, the redefinition was

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complicated by the fact that the loan funds were thinly spread over a large number of items for which thebidding process was already advanced; redefinition was completed only in early 1980. Theimplementation of the redefined project progressed satisfactorily until its completion in October 1983(PCR issued on June 29, 1984, PPAR No. 6295 dated June 20, 1986).

5. The Federal Railway-Export Corridor-Project (Loan 2563-BR, US$200.0 million, signed July1985), includes a policy and institutional development (action plan) component for the rationalization ofnon-commercial railway operations and network and normalization payments by the Government forpublic service obligations, tariff restructuring and better cost-accounting, and more effective operationsand maintenance management; and an investment component for the rehabilitation and improvement ofrailway and intermodal facilities in the Goias-Minas Gerais and the Parana export corridors. Theinvestment component was completed in early 1995, i.e. about three years behind the appraisal schedule.The delays have been due to a combination of macro-economic factors (the unstable macro-economicenvironment and the various stabilization programs have affected the implementation of the contracts andRFFSA's financial capacity to fund the project) and management weaknesses, especially in procurementand contract management. The track rehabilitation and improvement works and the signaling andtelecommunication investments, however, have substantially increased the railway's capacity andoperational performance in the two corridors, and contributed to the railway's increased modal share inthe transport of grains and derivatives in particular. Progress under the policy and institutionalcomponent was mixed. RFFSA discontinued almost all its inter-city passenger services. The urban trainsystems were transferred to a separate company, CBTU. The railways' freedom to set their rates, whichhad been approved as a condition for the project, became effective in 1990. But the Government did notallow RFFSA to close uneconomic branch lines, and did not make the corresponding normalizationpayments. RFFSA's profitable businesses continued to subsidize unremunerative services, especially inthe Northeast. RFFSA's operational deficits led to the postponment of the maintenance of locomotivesand tracks and of essential investments, and to the present situation which is characterized by lowproductivity and insufficient service quality (Loan closed on Dec. 31 1994, ICR issued on March 1,1996).

6. The FEPASA Railway Rehabilitation Project (Loan 2857-BR, US$100 million, July 27, 1987)was designed to assist in the financial rehabilitation and improved commercial performance of the SaoPaulo State Railway (FEPASA) and in increasing transport efficiency in FEPASA's main corridorsleading to Sao Paulo and to the port of Santos. The project, which was similar to the RFFSA project (seepara.5), also suffered from the same implementation problems: substantial delays in the rehabilitation andimprovement of track due both to the macro-economic environment and to project managementweaknesses; continued operation of unremunerative services, including, in this case, substantial inter-citypassenger services, and lack of normalization payments for public service obligations; overstaffing andinadequate staff compensation leading to low morale and motivation, and to low productivity and servicequality. (Loan closed on Dec. 31 1995, ICR under preparation).

7. Lessons Learned. The projects have generally achieved their physical objectives, despitesubstantial delays due to a combination of unstable macro-economic environment and railwaymanagement weaknesses. The track rehabilitation and capacity investments under the recent projects havesubstantially increased the railway's operational efficiency and modal shares in the main corridors. Thepolicy and institutional components, however, have often fallen short of their objectives. Although someprogress was made under the two recent projects towards a commercially-oriented operation of bothRFFSA and FEPASA. in particular with the separation of the conmmuter trains, the closure of uneconomicinter-city passenger services, the railways' freedom to set their rates, and recent staff reductions,

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Government direct and indirect intervention in the management of the public railways continues toadversely affect their operational efficiency and their financial performance.

B. Argentina Railway Projects

8. The Bank has made two loans for railways in Argentina, and has supported the recent reform ofArgentina Railways through a Public Enterprise Reform Adjustment Project (Loan No. 3291-AR, US$300million, 1991).

9. The First Railway Project (Loan 733-AR, US$6.5 million after cancellation, April 1971) wascompleted in July 1980 and was based on the Investment Plan of Argentine Railways (FA) for the five-year period 1971-1975. The project comprised the first two years (1971-1972) of the Investment Plan,together with a plan of action to improve the operations and financial position of FA. Investments of theequivalent of US$368 million were proposed during the project period 1971-1972, of which the foreignexchange component was estimated at US$172 million equivalent. The Bank loan of US$84 million wasto finance 23% of the project or 49% of the foreign exchange requirements. The implementation of theproject ran into trouble almost from the start. The action taken in implementation of the agreed programwas grossly inadequate, so the Bank decided to stop disbursements in July 1972. After an agreed projectamendment, project implementation resumed. By February 1974 it was apparent that no progress wasachieved, and US$27.5 million was canceled. Main features of the project implementation were: (a) theproject was completed in 1980 instead of 1972; (b) lack of adequate Government funds; (c) a cost-overrunof 11%; (d) only 31 % of the 1971-1975 investment prograrn expected to be made by 1975 was actuallymade; and (e) hardly any action was taken by FA to implement the plan of action agreed with the Bank atnegotiations.

10. The Second Railway Project (Loan 1677-AR, US$66.4 million after cancellation, March 1979)was completed in December 1984. The project was intended to strengthen FA through the redimensioningof its system; the rehabilitation of its track and equipment; and the improvement of its management andservices. Also, through technical assistance and studies, the project aimed to review various aspects ofFA and to develop its planning and project evaluation capabilities. The objectives were only partiallyachieved, despite a two-year extension of the loan. Frequent changes in top management (five presidentsbetween 1979 and 1985), uncertain political conditions, a deteriorating economic situation, andaccelerated monetary depreciation were significant negative factors. Positive accomplishments includedreasonable progress on main line rehabilitation and improvement, freight car turnaround time, and boxcarmodification. The overall IERR was less than expected at appraisal (18% versus 22%), mainly due to theresulting below-expectation traffic growth. However, only 4 projects (representing about 20% of the totaleconomic cost) had marginal IERRs of about 10%. In none of the project years did FA meet appraisalfinancial targets. The PCR concluded that the project had only limited success and the problems in FAwere serious enough to require urgent attention by the Government. A deep FA reform program,supported by the Bank, is now underway.

11. The Recent Reform. Ferrocarriles Argentinos (FA) has been divided into three separatebusinesses--freight, intercity passenger, and commuter rail--which were privatized or transferred to theprovinces in that order. The viable freight network was divided into six separate concessions. The first20-year concession was offered in early 1990, and by October 1993 five of the six were in privateoperation. All intercity passenger services were offered to the provinces, but most were ultimatelyabandoned (as mentioned earlier). FA's urban commuter rail services, centered around Buenos Aires,were divided into seven separate lines and offered as concessions to the private sector. The municipally-

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owned subway system was also placed in a concession jointly with one of the seven commuter lines.Private operations began on the first concession on January 1, 1994, and by June 1995 all but two of thecommuter lines had been transferred to the concession winners.

12. Reform Outcomes. The outcomes in terms of cost and traffic level and reliability have so farbeen very positive. First, the sector cost much less to the national government since the reforms and theneed for government subsidy has been cut significantly. Throughout the 1980s, FA required an averagesubsidy of about 0.6% of GDP per year, while the Buenos Aires subway lost approximately $1.5 billionper year in the years immediately preceding concessioning. The intercity freight concessionaires nowreceive no subsidy from the national government, while the urban commuter railroads and the subwayconcessionaires are expected to receive a subsidy averaging less than $100 million per year over the life oftheir 12-year concessions, most of which is for capital improvements. These changes have had a directimpact on the province, since several provinces provide modest subsidies for intercity passenger services.Moreover, while the national government continues to subsidize the only "unsold" intercity freight line(Belgrano), one of the options to reduce the burden of this subsidy is to devolve the line to the provincesand let them decide if they want to continue operations.

13. Second, except for intercity passengers, rail usage is stable or increasing. This suggests that railusers as a whole are no worse off or are better off under privatization. In many cases, service qualityquickly improved. By 1994, in the case of freight, the concessionaires were carrying about the sametonnage as in the late 1980s. In 1994, the first year in which some urban rail services were operated byconcessionaires, reported ridership increased 45 percent on urban conmmuter rail services and 18 percenton the subway compared to 1993. Half or more of the reported increase on the commuter railroads isthought to be due simply to dramatic reductions in the theft of fare receipts by train staff; the remainderand most of the reported gain on the subway is thought to be genuine. The increases in freight traffic aredue both to increased service reliability and to tariff reductions, while urban passenger growth is largelyattributed to additional trains, cleanliness, and security.

14. Lessons Learned. Three main lessons can be drawn from Argentina's experience in railwayreform thus far:

* Focus on a single bidding criterion. One lesson is the need to be very careful with the choice ofbidding criteria to award the concession contracts. The Argentinean authorities learned from thefreight concession experience and substantially simplified the method of bid selection applied to themetropolitan commuter railways. Trying to select the winning bid through numerous cumbersomecriteria with discretional weights is more likely to reduce the efficiency of the bidding process than toimprove it. Instead, the terms of the concession should be made clear and known to all potentialbidders, and bidding should take place on the basis of a single parameter, which encompasses theeconomic assumptions made by the bidders in relation to the terms of the concession. In the case ofthe metropolitan railways concession, for instance, each concessionaire calculated the expected valueof revenue from operations, compared them to the capital investment programs and then estimated thesubsidy to be requested from the Government. This subsidy estimate thus reflects the bidder's ownbest estimate of the expected return on the operation. The objective is to make the bidding process andthe final selection as transparent as possible and not to induce exaggerated or misleading assumptions.

* Make flexible contracts. A second lesson is the need to devise contracts which are inherentlyflexible enough to incorporate unforeseen circumstances. Many freight concessionaires are reportedlynot meeting the investment promises they made in their bids and are essentially disinvesting in the

- 39 - Annex 2

network they were provided by not maintaining their lightly used lines. Although there is somequestion whether the bids were honest from the start, there are logical reasons why these investmentsmay not now be needed. In the first place, the truckers responded to improved rail service byreducing their rates more sharply than expected, thereby reducing both rail traffic and railprofitability. In any event, strictly enforcing some of these contracts is not necessarily in the public'sinterest. In the case of rail, wasteful, unneeded investments would be made or the concessionaireforced into bankruptcy, disrupting service until a replacement could be found.

* Transfer the assets quickly. The third lesson is related to the process of privatization rather than tothe regulatory instrument or contract design. It suggests the need to shorten to a minimum the timebetween pre-awarding the concession and the start of operations. The poor state of the assets,including track, rolling stock, locomotives, and spare parts, when they are transferred to theconcessionaire from the public railway is a common complaint among concessionaires. There appearsto be a gap between what is recorded in the books and in the concession agreements in terms ofquantity and quality of assets before takeover and what is transferred afterwards to the privateoperator. Given the lack of incentives to carry out and maintain proper inventory purchases on thepart of the public company, the longer it takes for the transfer to take place, the poorer the state ofthese assets, and the more difficult it is for the private operator to start operations adequately.

- 40 - Annex 3

BRAZIL

FEDERAL RAILWAYS RESTRUCTURING AND PRIVATIZATION PROJECT

Operations Restructuring and Concessioning Component

A. Restructuring Plan

1. The proposed Table 1 - RFFSA 1993 Interchange Traffic: Regions and Other Raiways (000 tons)RFFSA concessionsare largely based onhistory. They simply Nordeste Centro-Leste Sudeste Sul Oeste Tubarao FEPASA CVRD Total

represent Nordeste 1,862 68 1,930

agglomerations of the Centro-Leste 14 11,558 2,573 794 2,589 17,528

old Regions, and no Sudeste 77 43,850 2,928 399 47,254

Regional boundaries Sul 14,460 791 15,251

are being changed. Oeste 1,736 727 2,463

They are also partly Tubarao 1,336 1,336based on the way FEPASA 914 3,869 1,587 928 11,814 19,112

bae onVteUwa 2,281 600 84.913 87,794ltraffic actually flows CVRD

today. Almost 80 percent of RFFSA's current traffic would be internal to the new concessions; i.e., itwould not cross the proposed concession boundaries. If flows to and from CVRD and FEPASA areexcluded, fully 96 percent of the current internal RFFSA traffic would remain within the proposedconcession boundaries (Table 1). The tendency for traffic to remain within concession boundaries ispartly due to gauge standards. While Sudeste is broad gauge, all other RFFSA lines are meter gauge(IBRD Map No. 27392). The impact of the difference in gauge can be seen in Table 1, which showsthat the broad gauge Sudeste tends to interchange much more traffic with the broad gauge lines ofFEPASA than do Centro-Leste, Sul and Oeste, whereas the meter gauge Centro-Leste interchangesmore traffic with the meter gauge CVRD. Another factor is geography, both because the distancebetween Northeast Brazil and the rest of the country is great, and because FEPASA divides the RFFSAsystem and tends to hinder interchange of traffic among those parts of RFFSA which have to crossFEPASA. In fact, there is no traffic interchanged among Sul and Oeste on the one side of FEPASAand any part of RFFSA on the North and East sides of FEPASA.

2. In order to facilitate the integration of the future concessions and to foster inter-regional railtransport, the project would promote the constitution of an Association of Brazilian Railways (ABF),following the model of the Association of American Railroads. The main objectives of the ABFwould be to: (a) promote the development of an integrated railway system, capable of offeringseamless services to shippers across concessions, through effective information systems integratingrailway operators, shippers and suppliers; and (b) increase railway productivity through technologicalresearch and development. The Association would be open to all Brazilian railway operators, shippersand suppliers. A draft constitution agreement and statutes have been prepared. The project wouldinclude funds to help finance the necessary studies to initiate the Association's program of activities.

3. The proposed concessions are varied in size and traffic. The main traffic, revenue,employment, rolling stock and line data for each RFFSA region and for the proposed concessions areshown in Table 2.

- 41 - Annex 3

Table 2 - RFFSA Regions and Proposed Concessions, 1994 Traffic, Rolling Stock and TracksLocomotives Waaons

Tons T-Km Revenue Employee Total Avail Dead RFFSA Out of Total Km of(mid95 R$) (mid95) (mid95) (mid95) (mid95) Owned Priv Serv Avail Line

(000) (00.000) (000)

SR I 911 319 13,304 2,361 42 27 12 978 108 469 617 2,388SR 11 461 516 12,972 1,300 32 22 9 703 152 262 593 1,365SR 12 512 91 2,341 741 14 9 2 223 0 35 188 507

NORDESTE 1,884 926 28,617 4,402 88 58 23 1,904 260 766 1,398 4,260

SR 2 16,044 5,815 197,474 7,307 248 139 37 6,453 381 1,049 5,785 3,810SR7 1,117 662 24,247 2,571 84 28 50 1,170 239 219 1,190 1,906

SR8 1,257 389 16,591 1,922 63 21 29 1,610 1 450 1,161 1,376CENTRO- 18,418 6,866 238,312 11,800 395 188 116 9,233 621 1,718 8,136 7,092LESTE

SR 3 40,834 19,886 342,821 7,699 288 193 58 7,061 1,590 1,115 7,536 1,642SR 4 5,515 484 25,580 2,283 91 33 52 4,345 303 1,384 3,264 128

SUDESTE 46,349 20,370 368,401 9,982 379 226 110 11,406 1,893 2,499 10,800 1,770

SR 5 11,402 5,851 159,369 5,649 219 149 40 6,125 0 453 5,672 3,631

SR6 4,629 3,168 79,868 4,559 149 71 29 4,411 2 583 3,830 3,183SUL 16,031 9,019 239,237 10,208 368 220 69 10,536 2 1,036 9,502 6,814

Tubarao 1,336 96 6,706 351 6 5 0 563 0 0 563 168

Oeste 2,590 1,916 40,495 2,655 88 51 10 2,777 1,259 845 3,191 1,611

Central Admin. 1,183RFFSA Total 86,608 39,193 921,768 40,581 1,324 748 328 36,419 4,035 6,864 33,590 21,715

4. The current productivity of RFFSA'S various regions, and their aggregate productivity for theproposed concessions, is shown in Table 3.

Table 3 - RFFSA Regions and Proposed Concessions Productivity Ratios (1994)

T-Km/ T-Klm/

Loco Wagon T-Km/ T-Kmi/ Avail Avail T-Km/ Rev/

Avail Avail Km Tonne Loco Wagon Employee T-Km

(%) (000) (000,000) (000) (000) (000)

Recife 64 57 134 350 11,815 517 135 0.042

Fortaleza 69 69 378 1,119 23,455 870 397 0.025

Sao Luis 64 84 179 178 10,111 484 123 0.026

Nordeste 66 65 217 492 15,966 662 210 0.031

Belo Horizonte 56 85 1,526 362 41,835 1,005 796 0.034

Salvador 33 84 347 593 23,643 556 257 0.037

Campos 33 72 283 309 18,524 335 202 0.043

Centro-Lesle 48 83 968 373 36,521 844 582 0.035JuizdeFora 67 87 12.111 487 103,036 2,639 2,583 0.017

Sao Paulo 36 70 3,781 88 14,667 148 212 0.053

Sudeste 60 81 11,508 439 90,133 1,886 2,041 0.018

Curitiba 68 93 1,611 513 39,268 1,032 1,036 0.027Porto Alegre 48 87 995 684 44,620 827 695 0.025

Sul 60 90 1,324 563 40,995 949 884 0.027

Tubarao 83 100 571 72 19,200 171 274 0.070Oeste 58 79 1,189 740 37,569 600 722 0.021

RFFSA Total 56 83 1,805 453 52,397 1,167 966 0.024

- 42 - Annex 3

B. Traffic Potential

5. Oeste. The Oeste concession, which consists of the Bauru-Corumba line (SR1O), seemspromising. Because of the need for fuel in the hinterlands, and the rapid growth of Brazil'sagricultural production for export, there is a strong growth potential for Oeste's traffic. The tariffs onthis type of traffic, particularly fuels, are relatively profitable, and the levels of traffic do not yetjustify a dedicated pipeline. Also, Oeste is the most likely link with the "Oriental" concession inBolivia, a linkage which might generate significant traffic when the Bolivian railway concession is infull private operation. An important factor in this concession will be the way in which the connectingFEPASA concessions are defined and marketed because all external Oeste traffic must connect witheither FEPASA or Bolivia. There are indications that FEPASA may permit the winning Oesteconcessionaire to have trackage rights from Bauru to the Port of Santos. This will need to be clearlydefined as soon as possible. Even as traffic flows today, Oeste has an average length of haul of about740 km, which is the longest of any of the proposed Latin American railway concession. Ifconnections can be made with the linked FEPASA concession, Oeste could be in an advantageousposition vis a vis trucking competition. Partly because of its long length of haul and locomotiveproductivity (see Table 3 for comparative data), Oeste should be among the more stable concessions asBrazil's transport market evolves. Supporting this prognosis, the Oeste concession was successfullysold to a US investor consortium in March 1996, for a price that was about R$3 million above theminimum price of R$62 million. In addition, the Bolivian Oriental concession is now startingoperations under the new concessionaire (Cruz Blanca -- the owner of the Chilean rail freightconcession), so there is a reasonable likelihood that the Oeste traffic patterns will develop rapidly.Certainly the ease of marketing the concession lends confidence to the process as planned.

6. Centro-Leste. The Centro-Leste concession, which incorporates the SR2, SR7 and SR8systems, occupies a central position in Brazil's heartland. As a result, it has perhaps the best potentialfor sharing in Brazil's industrial growth which will not be based on a single commodity, as with someof the other concessions. Unfortunately it will lose petroleum traffic to a pipeline in the near future,which will reduce its near-term growth and profits. Nevertheless, it appears that, even after the loss ofpetroleum traffic, Centro-Leste will enjoy a well-diversified and relatively stable traffic mix. Centro-Leste is also unfortunate in having a relatively short (373 krm) length of haul, a level which willencourage truck competition. In addition, Centro-Leste currently has RFFSA's lowest ratio oflocomotive availability which has clearly constrained output. Overall, while the traffic forecast hassome limitations, the opportunity for improvements in productivity under private operations should addto Centro-Leste's potential interest to bidders, though poor performance will be a problem in the shortrun.7. Sudeste. The proposed Sudeste concession, which incorporates the SR3 and SR4 regions,carries over 52 percent of RFFSA's traffic on only 8 percent of RFFSA's total track km. Further,over 80 percent of Sudeste's ton-km is driven by iron ore and steel supplies and products produced bya single iron ore company (MBR, 61 percent) and two steel companies (21 percent). Thus, at least theNorth-South route of Sudeste is actually an integral part of the production process for these companies,and is not a general carrier like most of the other concessions: it is unlikely that there will be anyeffective competition for Sudeste's traffic from trucks. RFFSA reports have consistently shownSudeste to be profitable on a full cost basis even under RFFSA operation, and the future looks evenmore positive under more efficient management. The key issue with Sudeste will be how to control thepotential market power of the concessionaire in the event that the iron and steel companies do not electto acquire the concession for their own account and thus become "captive shippers". Alternatively, if agroup of producers including MBR and the two steel companies forms a consortium and controls the

- 43 - Annex 3

monopsonist shipper/owners. These regulatory issues are discussed in Annex 7. Sudeste'sproductivity levels are the highest in RFFSA, and approach the levels found in North America. Thiskind of specialized, high volume, medium distance (439 kin), efficient carrier is well positioned tokeep its traffic base, and should grow at the same rate as the existing iron and steel business.

8. Sul. The Sul concession, which incorporates SR5 and SR6, already has a broad mix of trafficstrongly rooted in the agricultural sector, primarily in soybean exports. Sul will also be the outlet tothe sea for the new private railway now being constructed (Ferroeste) which is primarily based onsoybean export traffic. Sul, also, would be one of the most imrnediate beneficiaries of the growth ofrail traffic which has started to develop after the Mercosul trade agreement. Initial indications are thatthe Mesopotamico concession in Argentina and the Sul concession are already developing internationaltraffic from Argentina to Brazil, mostly in containers. RFFSA forecasts for Sul and Centro-Lestesuggest that there should be a strong market for them.

9. Tubarao. The Tubarao concession, which is the old SR9, is a single purpose carrier (coal)serving one customer (Electrosul) over a very short distance (72 km). It is not clear why Tubarao wasever included within the national railway network, but its future is wholly bound up with the needs ofone customer. In this case, the sole customer may need to take an active position in the railway byowning the concession and either operating it directly or contracting for its operation. Even thoughTubarao has a relatively short length of haul its average tariff per ton-km (for coal) is about two tothree times that of the rest of RFFSA, so there is probably considerable room for a newowner/operator to effect economies of operation and save money for Electrosul. At the same time,Tubarao's productivity levels are quite low, reflecting its limited market and the fact that traffic hasshrunk considerably in the last few years.

10. Nordeste. The Nordeste concession, by contrast, is to be a "social railway." It has by far thelowest traffic density and employee productivity of all of the RFFSA concessions and even therelatively optimistic financial forecasts for other concessions do not seriously suggest that Nordeste canbe profitable. While there may indeed be a possibility that Nordeste could be marginally profitable ifoperated with imaginative marketing and stringent cost controls as in Argentina or Chile, or as withUS shortline railways, it seems more likely that the kind of high tariffs needed to be profitable in theprivate sector could be unacceptable in the poorestregion of the country. Nordeste is thus a potential Table4- RFFSATraMcProjecdons

candidate for being a "negative" concession; that is, 1996 1997 1998 1999 2000

how much would the Government (or Governrments Oeste 2,041 2,415 2,788 3,081 3,374

at several levels) have to pay to ensure adequate Centro-Leste 7,060 7,771 8,482 8,876 9,269

service levels and quality at an affordable price.This is the approach which has been adopted with Tubarao 106 108 111 115 118

considerable success in the Buenos Aires suburban Sul 8,660 9,819 10,979 11,396 11,812

passenger concessions. Because of the politicalpower of the Northeast constituencies in the Brazilian Sudeste 22,253 24,208 26,162 28,281 30,400

Congress, it may not be easy to find a balance NOreste 886 971 1,055 1,098 1,141

between the cost of subsidies to the Northeast and theneed for efficiency and low cost to the national budget. This problem is likely to cause Nordeste to bethe most difficult concession to complete.

11. RFFSA prepared traffic projections for the six proposed concessions on the basis of theavailable market information and assuming effective private operations and marketing; the projections

- 44 - Annex 3

are summarized in Table 4. They were used as the basis for developing tentative financial forecasts foreach concession (Annex 9).

C. Concessioning Plan

12. Each concession is planned to be offered at auction to pre-qualified bidders for a period of 30years. BNDES, with technical assistance, is finalizing the preparation of bidding documents and thevaluation of each concession in order to determine the minimum prices for the auctions. Pre-qualifiedbidders would be allowed to bid at or above the established minimum price, which accounts for boththe right to operate the concession and the lease of RFFSA's rail assets. Payment is to be made overtime. First, a down payment equal to a percentage of the total price to be determined in each case(10% in the case of the Oeste concession) is to be made shortly after completion of the auction. Thebalance is to be paid through quarterly lease payments to RFFSA over the period of the concession,after a grace period of two years. After the auction is successfully completed and the concession isawarded to the highest bidder, the Government, through the Ministry of Transport, would enter intothe concession contract with the concessionaire, and transfer operations and maintenanceresponsibilities from RFFSA to the concessionaire, over a two-month transition period during whichthe activities of both RFFSA and the concessionaire are regulated through a transition contract. At thesame time, RFFSA would enter into a lease contract with the concessionaire, which would specify theterms and conditions of the lease. A tentative timetable for the various concessions has been definedconservatively, in order to account for the various project risks. Under the proposed timetable, the sixconcessions would be offered at auction over the 21-month period from March 1996 to December1997. The auction for the Oeste concession was successfully completed on March 5, 1996.

D. Reorganization of RFFSA's Rail Activities

13. RFFSA is separating its rail assets, which will be leased to the concessionaires, from its non-rail assets, which would be offered for sale to settle its debts. RFFSA's operational and operationalsupport divisions would be closed when rail assets are transferred to concessionaires, together withoperation and maintenance responsibilities. The residual activities of RFFSA will be organized intotwo divisions. A Settlement Division will be established to sell non-rail assets and to manage and settleRFFSA's debts (Annex 8). A new Technical Division, with regional units for the four mainconcessions (Centro-Leste, Sudeste, Sul and Nordeste), would be established to supervise rail assetleases. The Technical Division would also supervise the technical, environmental and safety aspects ofthe concession contracts, which would be delegated by MT/DTF to RFFSA under a delegationagreement. The Technical Division would also supervise any residual public service obligations of theNordeste concessionaire. RFFSA's reorganization chart is presented in Annex 11. The reorganizationwould be implemented in accordance with the implementation timeschedule (Annex 11) and with themonitoring indicators and targets set forth in Annex 11, Table 2).

-45 - Annex 4

BRAZIL

FEDERAL RAILWAYS RESTRUCTURING AND PRIVATIZATION PROJECT

Staff Retrenchment Program, Retraining and Outplacement Assistance

A. Introduction

1. International experience, including Argentina's recent example for the region, showsthat productivity gains are one of the most predictable outcomes of railways privatization.Productivity gains typically require significant cuts in employment. RFFSA's managers havebeen aware of it for some time. The last formal massive recruitment effort dates from 1985.The last time it transformed temporary staff into permanent staff was in 1988, when 2,000employees had their status changed to permanent employees. Recruitment has since beenfrozen. However, Brazil needs cheaper freight services and its labor force needs to move toactivities where it can be more productive. This means employment in this sector has to bereduced significantly.

2. When the private concessionaires take over Brazil's freight railways, only 57 percentof RFFSA's employees will still have a job. Over 20,000 people will have retired or left thecompany, and the concessionaires may still consider that more staff reductions are needed oncethey assess their needs, including changes in skill mix, consistent with an aggressivecommercial orientation.

3. The Brazilian authorities and RFFSA's managers are concerned with the future of theredundant employees. Their reform agenda includes the design of packages to minimizeadjustment costs to laid-off workers. This annex explains: (a) why it is in Brazil's interest toreduce RFFSA's employment; and (b) how the adjustment cost to laid-off workers can beminimized.

B. Rationale for Staff Reductions

4. The wage bill currently accountsfor4 70to 75e pagerce ofl c nthe rai ts' Table I - Comparison of Labor Productivity Indicators (1994)for 70 to 75 percent of the railways' 'osn e o-i

Thousand net ton-kmexpenditures. It illustrates the Countrv or Concession Employment rer employee

importance of employment policies forthe efficiency of freight railways in Argentina 5,151 1,259

Chile 800 1,389Brazil. If employment levels are too Conrail (U. S.) 24,728 5,200high or quality too low, the services are Canadian National 27,979 5,700

likely to be overpriced. This stimulates Brazil 40,581 966

road transport which, according to recent Nordeste 4,402 210

estimates, represents an additional cost to Centro-leste 8,608 800

Brazil's economy of about $1 billion/year Suldeste 9,2908 2,884

due to increased maintenance Oeste 2,655 722

requirements, pollution, road congestion Tubarao 351 274

and accidents. High labor costs due to overstaffing or poor skill mix are subsidized through

- 46 - Annex 4

reductions in maintenance and investments, which affects the overall performance of thesector.' Average indicators of labor productivity in Brazil's railways are much lower than insimilarly large countries such as the United States or Canada. It is also lower than inArgentina after the railways' privatization, and even lower than in Chile before privatization.The resolution of RFFSA's labor problem is therefore critical to the success of the reform.

5. There are significant differences in labor productivity across RFFSA's regions(Table 1). A detailed analysis was conducted with the regional managers to assess staffingneeds for each function performed, and the number of redundant staff. The number ofredundant staff was determined for each concession and by employment category on this basis.There is also a need to adjust the skill mix by type of employment category, but much of thisadjustment should be made by the new operators. By the end of this consultation process,RFFSA management had reasonable estimates of the staff reduction needs in each concession

2area.

6. Employmentlevels required to Table 2 - Minimum staff reduction requiirements and their productivity impact

operate and maintain Number of Number of Staff Resulting

the service given the employees as employees to reduction labor productivity

current state of rails Concession of May 1995 be laid-off % (OOOTkm/emploYee)Nordeste 4,546 1,909 41.9 331

and trains and in view Centro-leste 12,039 5,575 46.7 872

of expected increases in Sudeste 10,385 4,624 45.0 3,110

demand are much lower Sul 10.616 4,547 43.4 1,307Oeste 2,792 772 28.2 1,064

than current levels, Tubarao 367 30 8.3 320

even in the South-East, Central Admin. 1,209 590 48.8the most productive Total 41,991 18,047 43.0 1,415

region. Minimum staff reduction requirements for each concession are shown in Table 2.This process led in May 1995 to a target for staff reduction of 20,000 employees. BetweenMay 1, 1995 and September 1995, employment was reduced by 1,953 mostly through earlyretirement and staff turnover. By the time the first concession was announced in September1995, the new target was 18,047. Table 2 shows the distribution of the target acrossconcession areas.

7. One of the purposes of this analysis is to ensure that, with expected traffic levels, therailways could remain fully operational until the private operator takes over, and not behindered by massive voluntary reductions in job categories where reductions were notwarranted. These staff reductions are a major step in the right direction, but additionalreductions may be needed.

8. The new employment targets do not imply minimum levels. Once every concessionairehas taken over operations, the organization of each system will change and is likely to lead tomore reduction in staff, some additional changes in skill mixes, and improved productivity.But, additional changes in employment are likely to be marginal. For the Oeste concession,

1 de Castro, N. (1995), "Intermodalidade, Intramodalidade e o Transporte de Longa Distancia no Brasil",IPEA, Texto para discussao No. 367, Fevereiro.2 RFFSA (1995),"Proposta de readequacao dos procedimentos de operacao e manutencao visando aodimensinonamento do quadro de pessoal da area de producao", October, Rio de Janeiro (available inproject files).

-47 - Annex 4

for instance, it is estimated that in the short run 1,800 employees are needed to operate thesubsystem, in contrast to the 2,736 current employees. It is likely that the private operatorwould be able to operate within a year or two with about 1,400 people or fewer if productivitygains observed in Argentina are achieved in Brazil.

9. The optimal strategy might have been to leave all decisions to the privateconcessionaires. But this would not be consistent with the political reality of the country andsector. About 80 percent of its workers are represented by one of 7 unions in the sector.These seven unions deal only with railway workers, and 54 percent of unionized workers areaffiliated with them. All the unions are essentially opposed to privatization and reluctant toparticipate in the reform process, although they actively participate in briefing meetings for allemployees. Leaving it to the private sector to negotiate with the unions undoubtedly wouldhave affected the fiscal return of the privatization, and in some cases may have limited theinterest of the private operator. The advantage of the proposed strategy is that the bulk of theadjustment is made before privatization in order to minimize the risk of later conflicts. It alsohas the advantage of ensuring that the social concerns are addressed properly.

10. From a macroeconomic perspective, the potential spillovers of these productivity gainson Brazil's railways could be quite important. Transport services represent about 4 percent ofGDP, and railway transport about 16.5 percent of the value-added. Freight transport is anexpanding sector, increasing at an average of 4.1 percent per annum during the eighties, whenGDP grew at only 1.5 percent. The restructuring of the sector should lead to an even fasterexpansion based on a larger market share of interregional trade, as it becomes morecompetitive. The internal rates of the return to a more efficient railway are estimated at about68 percent for the economy as a whole (Annex 10, section D). This reflects the impacts ofincreased efficiency on all other sectors of the economy, lower prices for all users, and animproved distribution of freight traffic between trucks and railways consistent with a better useof resources .

C. Characteristics of RFFSA's Employees

11. To minimize the social cost of layoffs, the characteristics of the employees, includingage, experience, and education level were taken into account, compared to similarcharacteristics in the regional labor market where they will have to compete for a new job. Adetailed analysis of the characteristics of each regional labor market, and of the reemploymentopportunities for each retrenched worker, was conducted in preparation for the design of theredundancy packages.'

12 Brazil's regional labor market. The two main characteristics of Brazil's labor marketare: (a) the modest qualifications of its labor force; and (b) its capacity to generate jobs ofpoor quality.

13. The modest qualifications of its labor force reflects the low levels of formal schoolingand the low quality of basic education. Professional training is not entirely effective even forthe most educated worker s. Moreover, training on the job is often not sufficient because of the

3 Urani, A. and M.G. Carvalho (1995). "Minimizacao dos custos sociais da privatizacao: uma propostapara a RFFSA" (project files).

-48 - Annex 4

high turnover in the labor market. There are frequent short spells of unemployment. In manycases, these spells result into lower wages when workers return to the labor force.Increasingly also, there is a trend toward switching from the status of employee to independentcontractor. The main characteristics of the required labor market are summarized in Table 3herewith.

14. In spite of Table 3 - Regional Labor Market Characteristics (1990)

some similarities, Characterist,c/Re2ion Sudeste Sul Nordeste Centro-leste

such as the low level share of Brazil's employment (%) 45 17 27 7

of education, the share of urban population (%) 86 68 60 75of RFSSA proportion of illiterate in labor force (%) 9 8.5 34 14.2profile of RFSSA proportion with university degree(%) 24 20 13 20

employees differs proportion of legal workers (%) 48 38 20 32from the rest of the monthly wages & benefits (R$) 1.597 1,107 863 1,107

duration of unemployment (days) 229 190 396 202labor market duration of employment (days) 1095 912 1126 912

(Table 4). The age of average worker (years) 35 35 34 33unemployment rate (1995, in %) 5.4 4.6 7.7 4.9

average rail worker ISabout 41 years old, with about 18 years of service in the same company, without mucheducation and little or excessively specialized skills. The average worker in the general labormarket is at least six years younger. RFSSA's workers are paid between 10 percent and30 percent more than the average worker in the respective labor market.

Table 4 - Profile of RFFSA's Labor Force.(November 1995)

Average AverageAverage time of Primary Secondary Tertiary monthly

age service education education education wage(Years) (Years) ()%) (%) (reais)

Central Administration 41 18 16 32 53 2,412

Nordeste 45 18 67 25 7 1,215

Centro-leste 40 17 38 54 8 1,186

Sudeste 41 18 38 52 9 1,656

Sul 40 18 66 26 8 1,310

Tubarao 40 16 33 47 20 1,232

Oeste 41 17 9 88 3 1,302

15. Without assistance, many of the redundant rail workers are likely to find it difficult tobe competitive in the labor market, and if they find a job, they are likely to be paid less. Whatis needed is enough training to reduce the cost imposed by specialized job experience and thelack of formal education. A team composed of advisors from various training institutions wasconvened by RFFSA to prepare a menu of separation options for redundant staff to choosefrom, and to design training packages that best meet the employees' needs.

D. Staff Retrenchment Program

16. The staff retrenchment program has five components:

(a) incentives for early retirement;

(b) incentives for voluntary separation;

- 49 - Annex 4

(c) training;

(d) assistance in job search and outplacement; and

(e) compensation for involuntary separation.

(a) Incentives for Early Retirement

17. In January 1995, RFFSA started its efforts to reduce staff with the introduction of aprogram of incentives for early retirement. The main eligibility requirements were that theemployee had to be at least 50 years old and legally eligible to retire as of December 31, 1998,the date when all subsystems would be transferred to private concessionaires.

18. The proposed benefits under this program are:

(a) payments to the retiree of his/her net salary for a period of six months whilepaperwork is being processed by INSS (the National Social Security Institute);this means that for six months the employee receives a salary from RFFSA andwill eventually be paid his/her pension retroactively for the same period;

(b) if the paperwork is not completed within six months, RFFSA will continuepayments but in the form of an interest-free loan, since the employee will haveto reimburse all payments made six months after the date of retirement;

(c) payment of both the employer's and the employee's shares of the monthlycomplement to social security contribution specific to railways workers for amaximum of 5 years until the early retiree reaches the age of 55, which is theminimum age to be eligible for payments from this complementary fund(REFER). This reduces the incentive for people between 50 and 55 to stay onthe job to benefit from this additional payment when they reach the age of 55.Payments would be made at the time of retirement.

In 1995, 5,154 employees volunteered to retire under this plan. Eligible employeeswill be able to participate in this plan until the concessionaire assumes operations. Theconcessionaires would thereafter determine the pension plan which would be offered to theiremployees, and RFFSA would have no more pension obligations.

(b) Incentives for Voluntary Separation

19. The package for voluntary separation is meant to ensure that the employee whowillingly leaves the company is ready to start his/her own business or is competitive in thelabor market, and does not have to consider a job that would lead to a significant reduction inhis/her salary. The main purpose of the incentive package is to comply with a Federalguideline requiring that public enterprise retrenchment does not lead to increases in

4 INSS pays a pension calculated on the basis of the average salary for the last 3 years of work with10 years minimum; REFER does not allow retirement at age 50 like INSS, but requires the worker toremain until age 55; RFFSA will pay up to five years of both the employee's and the employer's shares ofthe fund so that the employee is allowed to receive a complementary pension when he/she reaches the ageof 55.

- 50 - Annex 4

unemployment that could threaten the social stability of the country. Eligibility for thepackages will be on a first-come-first-served basis, within specified limits by job category.

20. The key to achieving this goal is training of redundant staff. For workers interested instarting their own business, the program will provide the necessary tools to comply with thelegal and administrative requirements of self-employment. The redundant employees must alsoselect a specific professional training. For those not interested in starting a business, thedesign of the training programs is targeted to ensure that, after their training, the workers areequipped with the tools in demand in their respective regional markets. They also will beassisted in their search for employment.

21. The terms of eligibility are as follows. All employees are eligible on a first-come-first-served basis except for the following:

(a) employees who decided not to be associated with the employee savingsorganization FGTS (which is optional);5

(b) employees who are eligible for normal retirement;

(c) employees entitled to their job because of their status or responsibilities (unionleaders, representatives of employees in internal commissions to preventaccidents (CIPAS); these employees can resign from their responsibilities andthus become eligible for the package;

(d) pregnant employees;

(e) employees on administrative leave; and

(f) temporary employees.

22. The separation takes effect within 30 days of the decision to accept the application ofthe employee separating voluntarily. During that period, the decisions on the specific benefitsunder the program have to be taken and processed. They include calculation of the financialbenefits, standard legal entitlements, and incentives, and the preparation of the training whichis to be taken within 6 months of approval of the separation.

23. Financial Incentives. The financial incentives depend on the number of years ofservice of the employee. To assist the employees in their decision, every office of RFFSA hasbeen equipped with software that informs anyone interested of his or her options and computesthe benefits to be expected. The software calculates the benefits on the basis of the staff IDnumber. The incentive varies from 4 to 12 months of salary, depending on the number ofyears of service. To be eligible for this incentive, a worker should have at least 6 years ofservice. The financial incentives are shown in Table 5 herewith. They are structured asfollows:

(a) for staff with 6 to 25 years of service, the incentive is calculated as anincreasing geometric progression from 4 to 12 months of salary with19 increments of 1.0595 for each year of service;

5 FGTS: Since 1967, labor laws require that all mixed (or private) companies deposit 8 percent of thesalary to an employee account, which is a forced savings the employee can only withdraw at retirement orinvoluntary lermination of employment.

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(b) for staff with 25 to 30 years of service, the incentive is calculated as adecreasing geometric progression from 12 to 6 months of salary, with5 increments of 0.8705 for each year of service between these two points.

24. Employees who Table 5 - Financial Incentivesaccept the package would alsobenefit from the authorization No. of Years Total No. of Years Total

to continue living in with RFFSA Monthly Wages with RFFSA Monthly Wagesbuildings owned by RFFSA 6 4.00 19 8,48

for up to 12 months (if they 7 4,24 20 8,99do live in such buildings), and 8 476 21 190,5029

from social security payments 10 5,04 23 10.69

(REFER) by RFFSA for 12 11 5,34 24 11,33months, unless the employee 12 5,66 25 12.00

decides to withdraw the 13 6.00 26 10,45savings accumulated in that 15 6,73 28 7,92

plan. On average the value of 16 7,13 29 6,89the financial incentives is 17 7,56 30 6,00

$8,000 per worker, which i 18 8,01

adds up to about $18,000 including the legal entitlements calculated on the basis of the numberof years of service, age, and contribution to various forced savings accounts. The incentivepackage would be the equivalent of a fund from which the employee can draw whileunemployed, hence avoiding the kind of traumatic family situation that has been observed inmany labor redundancy programs. The average duration of unemployment varies from six tonine months for most regions. The incentive package would pay a full salary to workersduring much of their job search period. In addition the package would include training to helpreduce the job search period, thereby further reducing the probability of social problems.

(c) Training Program

25. To provide an additional incentive to workers to attend training sessions, theemployees who will not take the training option will receive one less monthly salary than thosewho will take it. But to ensure that the training is in the best interest of the employees, thetraining program was designed as follows:

(a) the regional labor markets in each subsystem was analyzed in detail by a labormarket specialist of the policy research institute IPEA to identify the nature andcomposition of jobs, relative to supply and demand. This information has beenused to select the types of training and target the efforts to maximize thechances of a match between the skills provided and those needed;

(b) each employee who requests training will have his/her training needs assessedbased on his/her profile assessment (e.g., education, experience, and interest).This has already been satisfactorily completed for the workers of the CentralAdministration and of the Oeste concession, who have separated voluntarily;and

- 52 - Annex 4

(c) every employee will be able to benefit from two types of training, which couldrequire about six months of their time. During that period RFFSA willcontinue to pay his or her health plan and supplementary pension fund. Thegovernment will continue paying the unemployment insurance for threemonths.

26. Although there is no center specialized in retraining of unemployed workers, Brazil hasthree major training centers which can provide this service: SEBRAE, SENAI and SENAC.All three are specialized in retooling employed workers and all have training centersthroughout Brazil.

(a) SEBRAE is an institution specialized in training for starting small and mediumsize businesses. It provides extensive consulting services on business,accounting, financial or legal aspects of small and medium businesses. Theirmain requirement is that participants have a high school or university degree.Training is targeted to employees interested in becoming independentbusinessmen;

(b) SENAI specializes in technical training for employees interested in retoolingtheir skills for the industrial sector. Most clients have a secondary degree; and

(c) SENAC specializes in technical training for employees interested in areas ofgeneral and commercial services. Their typical clients have a high schooldiploma.

27. SENAIand SENAC are i Table 7 - Estimated Demand for Training by Training Institution

and SENAC are ~~~~~~~~~~~~~~~~~~Total Costtypically SEBRAE SENAI SENAC Total (in R$000)

financed Nordeste 143 143 668 954 844

through Centro-leste 418 418 1952 2788 2,467

contributions Sudeste 347 347 1618 2312 2,047

levied on the Sul 341 341 1592 2274 2,012total wage bill Tubarao 2 2 11 15 12

in the sectors in Oeste 58 58 270 386 342Central Administration 142 106 92 169 760

which they are Total 1451 1415 6203 9069 8,486

specialized .SEBRAE is financed by a fee levied on all sectors. They are typically contracted bycompanies trying to retool their employees; however, individuals also can sign up for specificclasses, as long as they are willing to pay for them. For this program, the three institutionswould create new training programs or adapt their programs to the needs of RFFSA's workers.Their average fees per person are as follows: SEBRAE, R$2,000; SENAI, R$2,408; andSENAC, R$320. The training offered by SEBRAE and SENAI imply an average duration of150 hours. SENAC's training is only 40 hours because the implied degree of specialization islower (e.g., hotel services, driver). SENAI also includes a kit to assist trainees to open theirown business. The largest demand is likely to be for SENAC's program, since the type oftraining offered is well in line with current demand in the labor market, where the fastestgrowing needs are in the services sector. The total cost of the training program is estimated at

6 The retrenchment program at the Central Administration (AG) where excess employment was estimatedat 590, was completed in January 1996. The early retirement program absorbed 254 people, 315separated voluntarily, and only 21 were involuntarily terminated.

- 53 - Annex 4

about $10.5 million. An additional $2 million would be needed to train the staff of theresidual RFFSA.

28. A problem with the current institutional arrangement is that the differentiation of thetraining institutes' products (service vs. industry vs. independent business) is imposed by law,even if in practice there is not much difference in the content of much of the training theyprovide. This means that there is little room to expose these institutions to a real market testthat could result in a stronger incentive to ensure that trainees get at a job at least as satisfyingas they had before.

29. A noteworthy aspect of the reform package is that RFFSA will organize a literacyprogram for all staff whether redundant or not. RFFSA is entitled to this training but hasnever applied for it. Since the training is provided by SENAI and is financed out of regularcontributions to fund SENAI, there is no additional cost involved. It will be part of theexpected training of the company's staff.

(d) Assistance for Reemployment

30. The reform program also includes assisting redundant workers in their job search,including preparing resumes and providing information about employment opportunities.Redundant employees will also be assisted in addressing problems encountered in negotiatingnew employment contracts. A similar type of assistance will be offered to those trying to starttheir own business or to create cooperatives. Training is not a condition to be eligible for thisservice.

31. RFFSA is creating a data bank of redundant workers and firms potentially interested inthe skills of these workers. The service will be available for up to eight months after anemployee has concluded his or her training. In view of RFFSA's modest experience in thisarea, specialized firms will be hired to provide this service. Regional representation will be arequirement for these firms. Moreover, financial assistance to workers in isolated areas maybe needed to help them reach interview sites.

32. An issue some may be concerned with is that the training may only pay lip service tothe need of the workers. One solution would be to link the payment for training to the successof the employee in his or her choice in the job market. But this cannot be implemented in thisproject. Since RFFSA had already negotiated a fee with each of the training units before theBank's involvement, there is no room to built in better incentives in these fees. The alternativeis to add on a success fee of 10 to 20 percent for every worker that gets an equivalent or betterjob and keeps it for at least a year to the firm that is responsible to assist the workers infinding a new job. Criteria to measure success of the training program will have to be devised,however, achieving the market average based on worker qualification and experience would bea reasonable approach. It is likely that unions would favor maintaining the current salary orobtaining a better one.

33. To ensure that the training follows its proper course, the firm responsible for thereemployment program would also be requested to supervise its implementation. To the extentthat the success fee is sufficient, it will provide an additional incentive to this firm to perform

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in this monitoring role. The "reform team" in RFFSA will supervise the overall process andensure coordination.

(e) Compensation for Involuntary Separation

34. If enough workers have not left voluntarily with incentives or through earlyretirement, involuntary separation will occur. This will not necessarily be fully implementedby the time the concessionaire takes over. However, even after concessioning, RFFSA willmonitor the staff reductions until the targets are achieved. The workers dismissed under thisthird phase will receive only 80 percent of the value of the financial package offered toworkers separating voluntarily; however, they will enjoy all other benefits provided to workersseparating voluntarily, including assistance in job search and training. There is an incentivefor them to obtain training since their financial package is subject to the same penalty, i.e., onemonth's salary, if they decide not to take any training.

35. There is concern with the need to avoid firing people who are good performers and toavoid creating difficult personal situations by firing people who have significant socialresponsibilities. Information available in the personnel files is being used in the selection ofstaff to be declared involuntarily redundant. Selection of candidates would be based on thefollowing criteria:

(a) record of attendance level;

(b) frequency of penalties or suspensions;

(c) overall performance evaluation by the immediate supervisor; and

(d) family situation (e.g., marital status, number of children).

36. These workers will still get on average $17,751 in legal entitlements. However, theywill receive only $8,000 on average in incentives, 20 percent less than the workers whovolunteered. Including the value of training, this is still about $10,000 more than the legalrequirement, and represents 6 to 8 times the average monthly wage in most regional labormarkets.

E. Sequencing, Timing and Implementation

37. While it is obviously very difficult to predict the exact distribution of workers acrossincentive packages, RFFSA tried to do so based on small surveys in consultation with regionalmanagers. It is expected that the incentive packages are attractive enough to minimize the needto have to rely on involuntary separation. With the exception of Tubarao, where 53 percent ofworkers (30 staff) will lose their job involuntarily, on average only a small proportion of theworkers is expected to be in that situation. On the basis of experience with the CentralAdministration and Oeste concession, the package seems attractive enough, and well designed.

38. The staff reductions will be achieved in three stages and each will imply a verydifferent time-table, tenure and responsibility. The first is the reduction of staff through earlyretirement. This new plan began in January 1995 and will continue until December 1998,when all subsystems should have been transferred to private concessionaires. The second stageis voluntary separation, with a timetable for each subsystem beginning with the Centraladministration. Workers have 15 days to decide after the announcement of the availability of

-55 - Annex 4

the package. RFFSA is responsible for carrying out this second phase. The final stage isinvoluntary separation. The process ends when the targeted reduction is achieved. Therefore,part of the program will be implemented after the concessionaire has assumed operations. It isestimated that about 4,400 employees would be retrenched after the respective concessions

have been awarded.

39. If an employee retires, the value of the package is not affected by the timing of the

decision as long as it takes placebefore the concessionaire takes Table 8 - Tunetable for the hnplementation or Separation and Training

over. A worker separatin ~~~~~~~Total Staffover. A worker separating Time Table Reduction Retirement Separation Trained

voluntarily receives a package 30/06/96 7,000 5.000 2,000 1,000

equivalent to an average of 31/12/96 12.000 6,500 5,500 2,75030/06/97 17,000 7,100 9,900 4,950

US$8,000 in incentives as well as 30/06/98 19,000 7.700 11,300 5,650

about $10,000 in entitlements from 31/12/98 21,000 8,300 12,700 6,350

normal labor law (this is what any 30/06/99 22,000 8.900 13,100 6,550

private company would have to pay). In addition, workers will get on average the equivalentof $2,000 worth of training; it will take up to six months to complete but could be shorter if ajob is found. If the worker becomes redundant involuntarily, 80 percent of the incentivepackage and training and outplacement assistance are provided. The worker also gets extendedprotection in comparison to what would be given in a private company. Indeed, if the privateconcessionaire decides that the targeted reduction is not enough, it can cut staff further.However, during the first 12 months of his/her contract, the concessionaire will have to paythe same benefit that RFFSA paid to the workers declared redundant involuntarily. After 12months, however, any worker fired would receive an entitlement from normal labor law (about$10,000 for the average employee of RFFSA). The timetable for each option is given inTable 8).

40. A problem with this sequencing is that RFFSA has no leverage over how theconcessionaire will decide to staff its company. It is conceivable that a concessionaire wouldbe able to recruit someone who left and receives an incentive package. If this happens withinthe first 12 months of operation on the concession, the private operator must reimburse RFFSAfor the cost of the incentive package and the training. While this was not stipulated in thebidding documents for Bauru, it should be included in the next subsequent documents.

41. After the first year of operation, anyone can be rehired. The labor law impedes anyrestriction to recruitment, including people who received a package. The only restriction isthat any worker accepting a package will never again be able to work for RFFSA.

42. Finally, these options are being discussed in great detail with all workers. With onlyhis or her ID number in hand, any worker can find out how much cash he or she would receivewhen leaving. Every local office has access to a computer that can provide that information,and the system appears to be used effectively. Every worker also receives information on eachoption and expresses preferences. Since there is a literacy problem, RFFSA is also providingspecial assistance in explaining the options. In Bauru, for example. oral presentations havebeen attended by more than a third of the workforce. Union representatives also attendedofficially and while expressing concern with the loss of positions, recognized that the effortmade to minimize the social cost of redundancy was unusual.

- 56 - Annex 5

BRAZIL

FEDERAL RAILWAYS RESTRUCTURING AND PRIVATIZATION PROJECT

Emergency Rehabilitation Program

1. The capital investment component of the loan is divided into six components: (a) a locomotiverehabilitation ($106 million) to increase fleet availability thus increasing traffic carried and decreasingthe costs of locomotive failure; (b) a wheel replacement on both locomotives and wagons ($9.4million) to reduce derailments; (c) a conversion of freight wagons to container flat-wagons to capturetraffic now growing as a result of Mercosul development ($3 million); (d) a minimum track repairprogram ($23.3 million) to maintain safe operation and reduce derailments; (e) limited systemsinvestments primarily in signaling and remote switch control ($6.5 million) needed to permit plannedmanpower reductions to proceed; and (f) a program to close down and consolidate rolling stock repairshops ($11.2 million) to meet manpower reduction and asset sale targets. This investment program isneeded to ensure that RFFSA will not substantially decrease its performance during the transitionperiod to the concessions. Experience in Argentina and elsewhere has shown that during the transitionperiod to concessions, locomotives and rolling stock rapidly deteriorate, which substantially decreasesthe performance of the railway to levels well below those indicated in the bidding documents.Therefore, concessionaires would have to carry out a substantial amount of emergency repairs,affecting demand which then switches to other modes and takes a long time to recapture. The proposedrehabilitation program is the result of lessons learned in other systems, particularly in Argentina. Itwill prevent further deterioration of equipment and essential infrastructure. The concessionaireswould still have to invest their own funds to make the concessions a profitable operation.

A. Locomotive Rehabilitation

2. At present, as a result of deferred maintenance, only about 52 percent of RFFSA's locomotivefleet is operative, and those in operation are highly prone to failure en route. This imposes two costson the system: traffic is refused because there are not enough locomotives available to haul the trafficon offer, and operating costs are much higher than necessary because on-line failures are more costlythan preventive maintenance. The situation has become so difficult that there will be little tractivepower left to hand over the concessionaires, and the concession value will suffer accordingly, if somerepairs are not effected in the very near term. RFFSA plans to take 240 of their current fleet of 901locomotives, of which only 420 are in operation currently, and contract out the necessaryrehabilitation, which will yield much higher reliability and availability for an estimated eight-yearperiod. The program would help ensure an effective transition from RFFSA's to the concessionaire'soperation. Table 1 hereafter shows the characteristics and condition of the locomotives to berehabilitated.

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Table 1 - Locomotive Repair Program

Regions/Sub Annual kin Fleet in Failures/ Output Number of Locos in Reduction in

divisions Fleet Type Loco Operation 1000km 000,000 Tkm Failures Program Failures

1 42 ALCO RSD8 69.9 21.7 0.5 23.4 63.2 21 735

11 2 GE U8B 131.7 1.7 1.1 1.7 21.0 2 290

11 24 GE UIOB 131.8 14.2 0.4 32.4 62.4 14 737

12 4 GE U8B 60.0 1.0 1.0 1.4 4.9 4 238

12 10 GE U5B 65.8 5.5 0.6 4.4 18.1 3 119

Nordeste 82 44.12 63.3 169.6 44 2119

3 43 GM SD38 4.3 21.0 1.1 65.5 100.3 2 115

3 128 GE U23C 7.1 76.4 0.5 608.1 269.9 40 1695

4 15 GE U20C 4.5 7.0 0.9 7.0 28.2 8 386

4 13 HIT ELE 4.6 5.9 0.5 3.2 13.5 6 165

4 16 ENG ELEC 7.1 4.0 0.6 5.2 17.1 2 101

Sudeste 58 2,462

5 128 GM G22 UB/U 6.8 79.8 0.6 157.1 326.3 23 1128

5 30 GM GT22 CUMI 9.1 21.4 0.5 166.4 97.5 5 273

5 10 GM GT22 CUM2 8.6 7.7 0.6 65.1 39.6 8 497

5 22 GM G22 CU 7.3 12.1 1.0 42.4 88.2 4 349

6 26 GM G12 CAN 8.2 14.2 0.7 43.7 81.6 4 275

6 20GMGT22CUM 9.7 8.9 0.9 51.3 77.7 15 1572

6 30 GM G26CU 10.1 9.1 1.0 6.1 91.7 12 1457

Sul 71 5,551

Oeste 53 GE U20C 8.2 33.2 1.2 135.5 325.4 10 1176

2 88 GE U20C 8.3 47.6 1.0 157.0 394.4 23 2287

2 72 ALCO MX260 7.6 36.8 1.0 97.4 280.6 10 915

7 13 GM G12 CAN 8.9 5.6 0.6 11.2 30.0 5 323

7 17 GM G12 USA 8.5 6.8 0.6 13.8 34.7 5 306

7 35 GE UIOB 8.5 8.3 0.6 12.1 42.1 4 243

8 35 GE U13B 4.3 16.6 1.6 11.4 114.0 8 660

8 13 GE U20C 6.8 5.7 1.2 19.2 46.2 2 196

Centro-leste 57 4,930

Total 889 472 240 16238

3. The financial evaluation of Table 2 - Locomotive Rehabilitation Program (Financial Evaluation)

this locomotive rehabilitationconsiders two primary benefits: (a) Repair Revenue Rehab. Financial

Locos Failures Costs Losses Cost NPVthe incremental income that can be Concessions Rehab. Reduced US$I (US$) (US$ m.) (US$ m.)

generated from an added locomotive Nordeste 44 2,119 1,546 2,928 21.7 4.9

hour available; and, (b) the costs that Sudeste 58 2,462 1,653 3,233 31.8 2.4. , ~~~ ~~Sul 71 5,551 1,546 3,596 38.2 47.6

can be avoided if the locomotive SW1 ,5 154 359382 76canlurs be avoided in te loducomotive Bauru 10 1,176 1,546 3,311 5.5 11.2falures en route can be reduced and CCentro-Leste 57 4,930 1,546 2,686 30.2 26.7

replaced by preventive maintenance. Total 240 16,238 1,572 3,157 127.5 92.9

RFFSA records indicate that eachlocomotive failure costs in the range of $3,000 of net revenue because of loss of output capability.The average repair cost to recover from a failure is around $1,500, yielding a benefit per failureavoided of around $4,500, ranging for particular locomotive types in individual regions from $2,000 to$5,000. The average cost per locomotive for the rehabilitation program is $440,000, ranging from$350,000 to $500,000, which compares with a new locomotive price of about $2,000,000. The

- 58- Annex 5

locomotive rehabilitation program shows a substantial positive Net Present Value (financial) in allregions at a 12 percent discount rate (Table 2).

4. The results are also quite robust with respect to the base Table 3 - Locomotive Program:

parameters. The base case financial rate of return for the entire Sensitivity Analysis

component is 50 percent. A 20 percent reduction in the calculated cost Rate of Retum (%)

per failure would reduce the rate of return to 39 percent. A 20 percent Beneats-20% 39increase in the rehabilitation cost per locomotive would reduce the rate Costs+20% 41

of return to about 41 percent. Under both assumptions together, the Both 31

rate of return would still be a very satisfactory 31 percent.

B. Wagon Repair

5. The wagon repairprogram con s wgof thepr Table 4 - Wagon Repair Programprogram consists of the Number of Estimated Cost Number of Estimated Cost

replacement of worn wheels Concessions Wagon Wheels (million US$) Loco Wheels (million US$)

which are causing excessive Centro-leste 2.803 1.655 854 0.802

derailments. In total, about Sudeste 4.630 3.199 702 0.696

11,190 wagon wheels would Sul 3,330 1.966 647 0.647be relace. In dditon a Nordeste 427 252 195 0.180

be replaced. In addition, a Total 11,190 7.072 2.398 2.327

limited number of locomotivewheels (about 2,400) are also to be replaced. Due to limited historical data, RFFSA cannot distinguishbetween the consequences of locomotive derailments and wagon derailments. All investments havebeen analyzed as if they were wagon derailment costs. This is conservative as a locomotive derailmentis much more costly to repair than a wagon derailment. RFFSA records indicate that derailments dueto bad wheels cost around $2.7 million per year in lost revenues and added labor costs. Assumingthat these costs can be reduced by about 80 percent through the replacement of bad wheels, the wheelreplacement program would have an estimated rate of return of 19% (Table 5).

6. The base case financial rate of return of 19 percent is also arelatively robust result: a change in the derailment reduction by 20 Sensitivity Analysis

percent would reduce the rate of return to 13 percent. An increase in Rate of Return (%)

the replacement cost of 20 percent would reduce the rate of return to Base Case 19

14 percent. Given the conservative nature of the original calculation, Benefits -20% 13

(i.e., there is no allowance for the higher cost of locomotive wheel Costs +20% 14

faults, no allowance for the non-operating costs of derailments such as Both 8

human injury or environmental clean-up, and no allowance for lost cargo value), there is good reasonto conclude that the wheel replacement program will have an acceptable return for RFFSA and theconcessionaires.

C. Wagon Conversion

7. As a result of the Mercosul Trade Agreement, trade between Brazil and Argentina is increasingrapidly, especially in higher-valued manufactured products. Transport alternatives for this trade aretruck or rail. Rail movements necessitate a change of gauge at the Brazil/Argentina border since theArgentine Mesopotamico Railway is standard gauge, and Sul is meter gauge. These two factors --higher-value products needing better service and the change of gauge at the border -- combine to

-59 - Annex 5

encourage growth in rail-hauled containers if rail is to be competitive. In 1995, for example, RFFSA'scontainer traffic grew at about 20 percent per year.

8. In the long run, as traffic increases, the Sul concessionaire is likely to invest in specializedequipment. RFFSA currently has available 300 flat wagons that can be converted rapidly at a cost ofabout $10,000 per wagon. These wagons will be suitable in the short run, and will have a ten-yearlife. Discussions with a potential concessionaire confirm that the equipment would be consistent withcurrent plans and would be used as planned. On this basis, the value of the conversion program willbe reflected in the bids received.

9. On the basis of a relatively conservative wagon Table 7 - Wagon Conversion Program:

productivity of 540,000 ton-km per wagon annually and of a net Sensitivity Analysis

incremental financial revenue of about .005 Reals per ton-km (as Rate of Return (%)

compared to the total revenue of .024 Reals/ton-km for Base Case 23

container traffic) the financial rate of return was estimated at Costs +20% 18

23%. Both 12

10. The rate of return for the conversion program is robust. A reduction of 20% in the netbenefits still yield a rate of return of 17 percent. A 20 percent increase in the conversion cost wouldstill yield 18 percent rate of return. Under both assumptions together, the rate of return would still bea satisfactory 12 percent (Table 7).

D. Track Repairs

11. Shortage of capital has caused undermaintenance of track and infrastructure which has led toincreased derailments and safety risks, especially in areas where RFFSA carries hazardous cargoes.Since RFFSA's traffic mix in many regions is weighted toward petroleum products, there are manypoints at which a safety risk exists. An immediate program of rehabilitation is needed on the parts ofthe network which carry higher density traffic and are thus exposed to higher risks of derailment.Because it is basic work aimed at the higher priority parts of the network, the maintenance work willbe needed whoever is operating the tracks. Further, as the Government remains the owner of thetrack and structures, the value of the work accrues to the Government both in asset ownership and inthe value of the bids received for the concession.

12. The program would cost in total about $23.3 Table 8 - Track Repair Program

million, and will include the replacement of sleepers, Sleepers Rail Ballast

rails and ballasts (Table 8 herewith). For perspective, (units) (tons) (cubic meters)

there are about 1,800 sleepers, 100 tons of rail, and Nordeste 50,046 -- 16,800

1,000 cubic meters of ballast per km of line, and Centro-Leste 42,285 3,000 15,504

RFFSA currently has 22,000 km of line. In addition, Sudeste 77,589 270 2,900

the program includes minor works on otherinfrastructure facilities.

13. The benefits to be derived from the track repair component Table 9-Track Repair Program:

are the reduced derailments of trains. RFFSA statistics show that 48 Sensitivity Analysis

percent of the derailments are attributed to tracks. It was assumed Rates of Return Financial

conservatively that the proposed track repairs would reduce the costs Base 19

of such derailments by 15%. On this basis, the rate of return was Costs +20% 14

estimated at 19%. If benefits were 20% lower than expected, the Both 9

rate of return would be about 13 %. If costs were 20% higher than

- 60 - Annex 5

expected, the rate of return would be 14% (Table 9). There are other important benefits, such asimproved human safety and reduced environmental risks, but they are not easily quantifiable. There isno question that the investment is needed if the lines are to continue in service, whoever operates them,and the value will accrue to the Government.

E. System Investments

14. System investments comprise primarily telecommunication and signaling systems (autornationof control of remote switches) which today require independent staffing (Table 10). This program,which is estimated to cost about US$6.5 million equivalent, will reduce operating costs and increasethe ability to operate the railway safely and reliably. The investment is necessary to support thealready committed manpower reduction program. It will be needed by concessionaires. No rate ofreturn for the component has been calculated because the annual operating savings in manpower aloneare in excess of US$9 million. Costs will be recovered by RFFSA before concessioning in mostcases, and will accrue to the Government in the value of the bids received.

Table 10 - Systems Investment ProgramMixed

Telecom Preset RouteSystems System Total

Region /Subdivision (US$ m.) (US$ ni.) (US$ m.) Observations

SRI-Recife 0.063 0.516 0.579 Mixed System being implemented

SR3- J. de Fora 0 0.150 0.150 Preset Route System to beimplemented w/o Full train detectionSystem

SR5-Curitiba 0 0.928 0.928

SR6-Porto Alegre 0.300 0.300

SR7-Salvador 0.500 0.308 0.808

SR8-Campos 0.200 0.172 0.372

SR1 -Fortaleza 0.429 0.429 Mixed System already implemented

SR5-Sao Luis 0.200 0.234 0.434

Subtotal 1.263 2.737 4.000

Signaling of interfaces 2,500 Information of control of remoteFerrovia do Ago, Saudade- Barbara switches

F. Relocation of Maintenance Facility

15. RFFSA has too many maintenance shops scattered over the system. The concessioningprogram will require shop consolidation both in order to reduce costs and in order to free surplusproperty for subsequent development. Also, in many cases RFFSA shops are in urban areas whereclosing the shop will trigger an immediate need to make the shop area available for other uses. Theprogram ($ 6.5 million) consists of closing and relocating equipment from about 42 facilities rangingfrom small, general purpose facilities to larger rolling stock shops, including 15 in Nordeste, 14 inCentro-Leste, 5 in Sudeste, and 8 in Sul.

16. Because of the diverse nature of the activities involved, no rate of return was calculated for thispart of the program. Shop relocation is an important part of RFFSA's consolidation in support ofconcessioning, and labor savings alone are expected to repay the investment in the first year afterrelocation. In addition, the revenues of such subsequent sale of real estate should largely exceed thecost of relocation and consolidation.

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BRAZIL

FEDERAL RAILWAYS RESTRUCTURING AND PRIVATIZATION PROJECT

Environmental Management Component

A. RFFSA's Environmental Management and Safety Unit

1. RFFSA has created an Environmental Management and Safety (EMSU) unit, with thefollowing functions: plan, study, supervise, coordinate, and monitor activities related to environmentalprotection, threats to human life, damage control, human health, fauna, flora and natural resources, soas to prevent damage, enhance the value of the railroad, and promote safety, confidence, and betterquality of life. EMSU is in particular responsible for the preparation of environmental protectionstandards and procedures, traffic safety rules, work safety measures, and risk assessment.

2. With the proposed restructuring and concessioning of RFFSA's operations, and the proposeddelegation by MT/DTF of the environmental and safety supervision of the concessions, the EMSU willhave the following responsibilities:

(a) prepare, supervise and monitor the environmental and safety standards for theinstallations, equipment, and activities of RFFSA and the concessionaires, on the basis ofexisting laws and regulations, ensuring their compliance in order to avoid accidents, fires,spills, ruptures, pollution, and other environmental damage;

(b) monitor the condition of installations, equipment, and activities of RFFSA and theconcessionaires to ensure compliance with regulations and laws required for environmentalprotection;

(c) establish procedures and help develop and execute emergency plans in case of fire, spills,ruptures, and other potential catastrophes with the possibility of damage to soil, air, water,vegetation, animal and human life, a well as company assets and assets of others;

(d) establish procedures to coordinate and monitor the inspection of RFFSA's and theconcessionaires' activities, suggesting preventive or corrective measures as necessary toensure environmental risk prevention and control;

(e) prepare and monitor compliance with regulations and procedures for collection anddestination of industrial and sanitary wastes and effluents so as to ensure appropriateenvironmental protection;

(f) prepare regulations, directives, and methodologies for specific training aboutenvironmental risk prevention and control, and improve the ability to execute tasks and/orresponding to emergencies that occur from the transport of environmentally hazardousproducts;

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(g) help reduce railway accidents involving RFFSA, and monitor concessionaires' accidentswith the objective of reaching internationally comparable standards;

(h) research, supervise, coordinate, and manage activities concerning railway accidents,collecting and maintaining relevant statistical data;

(i) establish and enforce compliance with rules and guidelines concerning inspection ofequipment and installations, in order to reduce railway accidents or other potential risks thatcould be detected through preventive inspections;

(j) manage, record, and disseminate the management information necessary to interacteffectively with others units; and

(k) oversee the reduction of environmental liabilities caused by RFFSA in the past.

B. Environmental Management Work Program

3. The Environmental Management Program was set up in the context of RFFSA'sEnvironmental Policy mandate, applying modern risk management techniques as the basic strategy ofthe EMSU. Many of the following activities will be executed simultaneously with RFFSA's otheractivities including for the concessionaires. The program has four basic activities: (i) riskidentification; (ii) risk prevention and control; (iii) damage control; and (iv) analysis and feedback.

(a) Risk Identiflcation

4. This activity consists of the diagnosis of potential safety problems or hazardous situationsbefore the environmental risks occur. It includes detection of risks, analysis, evaluation, andestablishment of control procedures. Specifically, risks would be identified through inspections as wellas through the definition of environmental risks originating from sources not directly related to railwayoperations that affect the internal and external environment, employees, and assets, including:

- radioactive sources;- Ascarel depots (Normative Instruction SEMA/STC/CRS/N° 001/83, Instruction 019/81 MI,

MIC, MME);- Ascarel in use;- effluents contaminated by petroleum derivatives (Resolution 02/85 CNP);- petroleum derivative spills;- spills and ruptures of inflammable deposits;- stored agrotoxics (Instruction 157/82 Ml - stored wood preservatives);- pentachloro-diphenyl (PCD) deposits;- effluents from wood-treatment factories;- pollutant products used in work, deposits, and workshops;- scrap containing pollutant metals such as mercury (Hg) and others;- emanation of pollutants and unhealthy gases (Instruction 3214/78 MTb, Instruction 231/76

MI - Air Quality Standards);- ambient dust;- excessive noise sources (Instruction 092/80 MI - Noise Emissions, Resolution 001/90 -

CONAMA, Instruction 3214/78 MTh - Heat Sources - Instruction 3214/78MTb);

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- deficient illumination;- insufficient ventilation;- solid residues (Instruction 053/79 MI, Resolution CONAMA no 006/88);- quality of liquid effluents in rivers (Resolution CONAMA n° 20/86);- others to be detected.

(b) Risk Prevention and Control

5. This activity consists of eliminating risks whenever possible, implementing measures to avoidadditional risks, and operationalizing the Dangerous Products Informatics System. Environmentalaudits are intended to guarantee and sustain preventive procedures and risk control, ensuring that suchrisks minimize damage due to control failures.

(c) Damage Control

6. This activity includes attempts to control or minimize damage when risk controls fail. Itincludes emergency plans, liaison contingency plans, equipment, simulated accident exercises, specifictrainings, and projects to repair damage.

(d) Analysis and Feedback

7. This activity includes recording of past occurrences and periodic reporting. Data areanalyzed, failures reported, occurrences related to specific legislation, and recommendations andprograms of actions formulated, ensuring appropriate feedback to the program. It would include:

(a) collection and records of data on accidents involving environmental damage that happenedin the past 5 years, and establishment of data base;

(b) preparation and dissemination of monthly activity reports;

(c) analysis of data and reports providing recommendations and information of interest tomanagement;

(d) development and dissemination of details of accidents involving environmental damage orpotential damage, analyzing failures that occurred on transport systems, including riskprevention and control;

(e) maintenance of an updated data base, and dissemination of information on federal, state,and municipal environmental legislation, continuously verifying compliance with thelegislation through environmental audits;

(f) on the basis of an analysis of failures, development and promotion, with external entities,of better procedures, techniques, equipment, training, etc., to enhance technical developmentand operational and environmental safety;

(g) preparation of technical procedures, specifications, and standards; and

(h) through statistics, analysis of failures and legislation, and technical improvement,revision of the program, correction of distortions, and recommendations for remedial actions.

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This program is consistent with Directive No. 23 of the Transport Sector Priority EnvironmentalDirectives promulgated by GEIPOT.

C. Reorganization and Strengthening of RFFSA's Environmental Unit

(a) Reorganization

8. The reorganization of the EMSU is necessary since rail operations will be carried out by thefuture concessionaires, and the Transport Ministry plans to delegate its environmental and safetysupervision responsibilities to RFFSA. RFFSA will therefore be responsible for environmentalmonitoring and control of all activities related to operations and investments, including reduction ofenvironmental liabilities. For this purpose, the unit will be reorganized as shown in the organizationchart below, and staffed with at least eight technicians who are academically qualified.

ENVIRONMENTAL PROTECTION ANDSAFETY MANAGEMENT UNIT

ACCIDENT RISK INSPECTION and CONTROL ENVIRONMENTAL LIABILITYSUB- UNIT SUB- UNIT SUB-UNIT

The environmental liability sub-unit will perform a transitional function; it will be closed when pastenvironmental damage is significantly reduced.

(b) Strengthening

9. A training program was developed to strengthen the EMSU in the short and medium term.The project would include funding for:

(a) the participation of at least two academically-qualified professionals (Masters/PhDcourses) in environmental planning at a Brazilian university;

(b) the participation of at least two professionals in technical courses or training programsabroad, with emphasis on safety;

(c) the implementation of specialized courses and seminars with the assistance of specializedfirms and/or international organizations, for RFFSA staff.

The total cost of the training program is estimated at about US$250,000.

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D. Environmental Liability Settlement

10. Since railway operations will be transferred from RFFSA to private concessionaires, it willbe necessary to identify existing environmental liabilities, and to specify the respective responsibilitiesof RFFSA and the concessionaires for the existing and possible future liabilities under the concessioncontracts. In principle, RFFSA would be responsible for the existing liabilities prior to theconcession, and the concessionaires would be responsible for all future damages.

11. To this effect, the project would include a component for the identification and diagnosis ofenvironmental liabilities in the proposed six concessions. These environmental audits will cover thefollowing installations and operations: (i) 64 supply depots; (ii) 95 workshops; (iii) 10 wood-sleeperstreatment factories; (iv) depots and storage facilities; and (v) free plantations. The cost of theenvironmental audits is estimated at US$700,000. The reduction of environmental liabilities, throughthe recovery of destroyed areas/protection works, would be done by the concessionaires or RFFSA,depending on the results of the negotiations of the concession contract.

E. Environmental and Operational Safety

12. Environmental and operational safety mainly deals with: (a) handling dangerous products; (b)urban rail crossings; and (c) level crossings. The conditions under which dangerous goods aretransported will be analyzed on each route, considering the danger of the cargo. Operationalinstructions will be established in each case, in order to comply with regulations. All the crossingswill be analyzed, and recommendations will be formulated to reduce the risks of accidents. TheEMSU will prepare safety regulations and instructions, and will supervise their implementation by theconcessionaires.

13. In order to incorporate international know-how in this area, RFFSA will exchangeprofessionals with railway operators or supervisory agencies such as the Federal RailroadAdministration in the USA, which investigates railway operators when accidents occur. The cost ofthis component is estimated at US$ 200,000 equivalent.

14. In order to fulfill the role of regulating and monitoring the environmental and safety aspectsof the concessionaires' operations, the EMSU will develop and establish a data base which willprovide information about traffic accidents (verification, statistics, cause analysis, possible solutions).The project will include the purchase of hardware and software for this purpose, at an estimated cost ofUS$50,000 equivalent.

F. Summary of Cost Estimates

15. The estimated cost of the environmental managementcomponent is summarized in the table herewith. Comnonent us$

Training 250,000

Environmental Surveys 700,000

Safety 200,000

Data base 50,000

TOTAL 1,200,000

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BRAZIL

FEDERAL RAILWAYS RESTRUCTURING AND PRIVATIZATION PROJECT

Regulatory Reform Component

A. Regulatory Policy

1. In recognition of the critical importance of efficient transportation for national economicgrowth and prosperity, the Government of Brazil is undertaking substantive steps to restructure itsrailroad industry and to reform its public policy towards the sector. The government's basic premiseis that decentralized market-oriented decision-making that is freed from excessive regulatory controland that is energized by commercial incentives is the surest means of finding and implementingefficient and innovative solutions to problems posed by the country's transportation needs.

2. One key element of the government's restructuring program is to move most rail activitiesfrom governmental to private control in order to improve the incentives for internal efficiency, marketresponsiveness and fiscal responsibility. Another key element of restructuring is to unleash marketforces of competition to the fullest extent that is consistent with economic efficiency and the publicinterest. In this context, the government is undertaking significant regulatory reform initiatives and isadopting a pro-competitive regulatory system which will permit firms to set independent prices atlevels that are based on demand conditions and that cover the firms' total costs when they operateefficiently. Thus, to a much greater extent than in the past, market forces will shape the prices andlogistics of railroad services.

3. Regulatory Commitment. A necessary condition for effective restructuring and sustainedlarge-scale private investment in railroads is the country's institutional capacity to restrain arbitraryadministrative action and credibly commit to a stable regulatory regime. Indeed, one of the mostimportant lessons that has emerged from the experience of other countries is the need to establish awell-defined regulatory regime as early as possible in the privatization process and to adhere to atransparent and predictable process. This will reduce the risk premium demanded by investors andenhance the government's ability to capture the benefits of privatization.

4. The provision of many innovative and market-responsive rail services in Brazil will requirespecific investment in infrastructure, such as upgrading of way and structure facilities, construction ofloading and transhipment facilities and building spurs of track to reach shippers' locations. Theseinfrastructure costs are largely sunk because the assets are of minimal value for other purposes.Private railroads that are vulnerable to arbitrary administrative intervention can be expected to investless than the optimal amount. The government has a tight timetable in which to implement therestructuring and privatization of RFFSA. Still, it is very important to make the effort and commit theresources early on to establish a credible regulatory regime that contains substantive and proceduralconstraints on arbitrary administrative action.

5. Guiding Principles for Regulatory Reform. Two basic principles would guide the reform ofrailroad regulation. The first is that the competitive market should serve as the model for regulation.Regulatory restraints are to be imposed or continued only where market forces are insufficient toenforce competitive behavior. In such cases, regulation should be used as a substitute for the forces of

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the market--to induce suppliers to behave as if competition had guided their actions. The secondguiding principle is that regulatory impediments to adequate revenues should be eliminated. This doesnot mean that profitability will or should be guaranteed, only that carriers should be offered theopportunity to obtain competitive earnings. Indeed, in a regime of deregulation without generalsubsidies, one of the key elements in protecting the public interest is the avoidance of any residualregulation which effectively prevents the achievement of financial viability by the rail network.Regulatory reform should, therefore, provide railroads with substantial flexibility in the areas ofpricing and industry structure.

6. Revenue Adequacy and the Need for Demand-Differentiated Pricing. Regulation shouldnot impede railroads from achieving revenue adequacy. Revenues are defined to be adequate whenthey are sufficient to enable the firm to attract the capital needed for maintenance, replacement,modernization and whatever expansion demand conditions justify; that is, they are sufficient to coverthe replacement cost of the services demanded by shippers. If revenues of unsubsidized railroads arelower than this, the deterioration and eventual disappearance of the services in question are inevitable.

7. For prices to make sense economically they must never be incompatible with revenueadequacy--indeed this should be embedded as a statutory requirement within the regulatory framework.Where the costs of the enterprise are characterized by substantial fixed and common components, as is

the case in railroading, the need to earn adequate revenues generally requires rates to differsignificantly and systematically from the marginal costs of the corresponding services. Thus, itbecomes impractical, indeed unfeasible, to require rate setting to follow the maxim that each service ofthe supplying firm should be priced at a level so as to equal its marginal cost, the cost caused bysupplying an additional unit of that service.

8. If prices, then, cannot be made to equal marginal costs, the issue that faces the regulator iswhat principles should be followed to determine the deviations between prices and marginal costs thatare required for the solvency of the supplying firms. Here the goal of economic efficiency shouldserve as the primary guide. It implies that prices should, optimally, deviate from the correspondingmarginal costs in proportion to the "value of the service" in question -- that is, in inverse proportion tothe elasticity of demand for that service.

9. The reason is that consumers whose demands are relatively inelastic are those who mosteffectively resist the purchase disincentive provided by a rise in price relative to marginal cost, andwho will, consequently, behave in a manner that approximates most closely the way they would if ratesetting were to follow the unattainable ideal of marginal cost pricing. In other words, the efficientpricing solution to the requirement of revenue adequacy apportions the burden of covering fixed andcommon costs on the basis of demand, assigning prices in the way that minimizes the pricedisincentives to optimal behavior by suppliers and purchasers.

10. This Ramsey (demand-differentiated) solution to the optimal pricing problem has the advantageof both common sense and rigorous economic analysis. It is the only rational solution to the revenueadequacy problem and it is the principle that should be embedded in the Brazilian regulatory system.Given the natural incentives for railroads to charge Ramsey prices, there is an assurance that theseoptimal pricing principles will be applied in practice if the railroads are permitted to set their prices inaccordance with the market.

11. The Proper Role For Regulatory Intervention. Regulation has two fundamental issues todeal with if the public interest is to be protected. First, regulation should constrain the potential

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capacity of any carrier to preclude or impede any competition which satisfies the criterion ofefficiency. Second, even if all removable barriers to efficient competition have been eliminated,regulation should prevent the exercise of any power on the part of the carrier derived from the naturalmonopoly attributes of its activities, to extract excessive profits from shippers via prices which deviatefrom efficient levels--power which cannot be eliminated by rules against anticompetitive behaviorbecause the carrier's ability to act this way is attributable to its natural monopoly characteristics.

12. Maximum Rate Reasonableness Standards--Constrained Market Pricing. Towards thoseelements of railroad activities in which competitive pressures are judged to be inadequate (that is, inareas in which a railroad possesses market dominance or its shippers are captive) it is recommendedthat a policy of "Constrained Market Pricing" (CMP) is adopted--i.e., the railroads should be permittedto engage in Ramsey Pricing to achieve revenue sufficiency, and these Ramsey prices should beconstrained only by the overall revenue adequacy or the Stand Alone Cost (SAC) test, whichever is thelower.

13. Therefore, under the proposed CMP system: (a) ceilings on rates where there is marketdominance are established based on the SAC criterion--a shipper has a legitimate complaint of beingovercharged for services if and only if he can find a group of shippers of any products carried by therailroad such that the amount they pay, plus the amount he pays, exceeds what they would have to payto an efficient entrant specializing in providing those services with no barriers to entry; alternatively, asubset of prices charged by a railroad violates the SAC ceiling if any group of shippers who pay thoseprices could be served at lower cost by a hypothetical entrant specializing in providing the servicespurchased by the group; and (b) rate floors are designed to prevent cross-subsidies by reflecting thesame economic incremental costs that would set the floors on competitive rates. In between thesefloors and ceilings, railroads should be free to select their own rates based on their assessment ofmarket demand.

14. Under this regulatory system, rail carriers' rates for the transportation of market dominanttraffic would be subject to three separate constraining factors. First, a shipper could not be chargedmore than the stand-alone cost of providing service to it. Second, a captive shipper would not berequired to bear the cost of demonstrated management inefficiencies in the carriers' operations andpricing structure. Third, rate increases would generally only be permitted to the extent needed for thecarrier to reach and maintain revenue adequacy. CMP will, therefore, provide the necessary protectionfor captive shippers, while providing railroads the opportunity to earn adequate revenues.

15. Constrained Market Pricing is a practical and economically sound method of applyingcompetitive pricing principles to a regulatory framework. The objectives of CMP can be simplystated. A captive shipper should not be required to pay more than is necessary for the carrier(s)involved to earn adequate revenues. Nor should it pay more than is necessary for efficient service. Acaptive shipper should not bear the costs of any facilities or services from which it derives no benefit.Responsibility for payment for facilities or services which are shared (to its benefit) by other shippersshould be apportioned according to the demand elasticities of the various shippers. Thus railroadswould be given incentives to ensure that competitive traffic contributes as much as possible towardthese costs. Finally, changes in the rate structure should not be so precipitous as to cause severeeconomic dislocations.

16. Taken together, these constraints should ensure that a carrier does not use its marketdominance to charge its captive shippers more than they should have to pay for efficient rail service.A shipper will not be asked to subsidize long-term excess capacity, fund revenue shortfalls which could

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be eliminated by pricing non-captive traffic at the full level demand would support, or bear the costsassociated with avoidable operating inefficiencies. Carriers will be effectively limited in the rates theycan charge on captive traffic and will have the necessary incentive to maximize the net revenuecontribution from competitive traffic. Cross-subsidization from other shippers is effectively precluded.Therefore, the rate structure resulting from the interaction of market forces and the above constraintsis likely to produce rates that are economically efficient and fair to all shippers.

17. The guidelines offer the flexibility to approach the rate analysis from various perspectives: (1)the appropriate level and minimum cost of efficient service to the captive shipper (in the stand-alonecost analysis); (2) the appropriate level of carrier revenue needs (in the revenue adequacyexamination); (3) the other available means of meeting (or eliminating) those revenue needs (throughthe scrutiny of the carrier's efficiency); and (4) the public interest in minimizing economicdisruptions.

18. Competitive Access. "Competitive access", including the regulatory prescription of rate andservice terms for joint-line rail movements, becomes an issue only when a market dominant carriercontrolling a "bottleneck" segment attempts to engage in a predatory price squeeze or refusal to dealwith a more efficient connecting carrier for the purpose of preventing the connecting carrier fromparticipating in the movement. Only in that circumstance would there ever be any justification forregulatory intervention to require the bottleneck carrier to take steps that maintain or increase thetraffic handled by the connecting carrier. Such an intervention is never justified, however, to preservea market position that would otherwise be lost by a connecting carrier because joint-line service is lessefficient.

19. The primary challenge for public policy is to set a level and structure of access prices whichpromote dynamic efficiency through efficient entry and investment decisions while enabling the ownerof the network to remain financially solvent. The terms of access should not distort the process bywhich prices are adapted to consumer preferences and demands for services. Prices should besufficiently high to be compensatory (at least cover the long-run incremental cost of the use of thenetwork by the entrant), yet not so high as to preclude efficient operations by the entrant. Regulationshould, therefore, ensure that there is sufficient pressure on the owner of the infrastructure to operatein an efficient manner, but that no unnecessary duplication of network construction takes place. At thesame time, the opportunities for competition to work effectively would be enhanced by the availabilityon an unbundled and non-discriminatory basis of any basic network element, or any collection offunctions, that were needed by the entrant.

20. Reciprocal switching agreements should be encouraged when they are practical and in thepublic interest, or are necessary to provide competitive rail service--reciprocal switching could provideshippers with an avenue of relief for inadequate railroad service. However, railroads should bepermitted to cancel joint rates and abrogate interswitching agreements when they can demonstrate thatsuch reciprocal arrangements are detrimental to their financial performance.

21. Contract Rates. Carriers should be permitted to negotiate shipper contracts with confidentialterms and conditions--railways and shippers should be permitted to enter into contracts which wouldkeep confidential the rates to be charged, the conditions relating to the traffic to be moved, and themanner in which service obligations are to be fulfilled. The benefits of confidential contracts accrue toboth shippers and carriers. Shippers may negotiate for lower rates and for guarantee of a specifiedlevel of service. Carriers may be able to improve the efficiency of their service since the contract

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should assure a predictable flow of traffic, and further foreclose of competition for its term. Theimproved efficiency of resource utilization should also be beneficial to the economy at large.

22. Structural Flexibility--Line Abandonments. Public policy should recognize the need of theBrazilian rail carriers to streamline their systems and, therefore, should facilitate the abandonment ofuneconomic lines. It is highly desirable that strict time limits are imposed on the line abandonmentprocess.

B. Implementation

23. In practice, regulation of the railway concessions has three main aspects: (a) economicregulation including tariffs, division of tariffs, and service or track abandonment; (b) safetyregulation; and (c) monitoring and supervision of track condition.

(a) Economic Regulation

24. Given Brazilian conditions in the transport sector, competition will be the best regulator and,where adequate competition exists, regulation is generally not needed. In addition, since thecompetitors of railways are private and essentially unregulated, private operation and the lightestpossible regulation must be the basic model for railway concessions as well. Second, each concessionhas unique market and service characteristics, which will determine terms and conditions under whichregulation should be formulated and administered. Specifically, subject to broad controls over anti-monopolistic behavior, each concession will have different and appropriate terms governing regulationsover tariffs. Third, in general, the Government intends to restrict its role to the minimum actionsneeded to protect the public interest and leave the concessionaires to operate as much like normalbusinesses as is possible so that they can compete successfully with private trucking, pipeline andwater transport.

25. In general, railway enterprises shall be free to set their prices and services (quality andquantity) in such a way as to meet shipper needs and maximize the railway's total earnings. While thisapproach (Ramsay Pricing) is known to produce a wide spread of relationships between prices andcosts of service, it also minimizes the total cost of transportation to the country. Tables or charts of"Reference" or maximum rates shall generally be considered to establish those levels below whichtariffs are by definition reasonable and not subject to protest. DTF shall have the burden of adjustingthe reference tariffs to take into account changes in costs or other circumstances so that there willalways be a public indication of the target levels shown in the reference tariffs.

26. The guiding principles will be subject to several exceptions:

(a) prices below long-run variable costs (long-run variable costs are the costswhich change with respect to the traffic being priced) are predatory and are prohibited.If challenged, the concessionaire will have the burden of showing that the proposed

tariffs are not below their variable costs.

(b) contract tariffs (voluntary agreements between railway and shipper whichinclude volume guarantees, quality guarantees, or other services beyond normalcommon carrier obligations for a single wagon load of freight) may be confidential andare not subject to regulation except that they must be filed with DTF and are available

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to DTF only for confidential use in case of shipper allegations of discriminatorypricing. Contract tariffs may contain provisions for adjusting prices in accord withconditions defined in the tariff. Contract tariffs are not governed by the referencetariffs because they reflect special conditions not represented in the standard conditionsassumed in the reference tariffs.

(c) arbitrary discrimination. Price discrimination based on railway whim orshipper identity and no other factors is prohibited.

(d) protecting the "captive shipper". Under certain circumstances, such as lackof adequate commodity source or transport competition as a result of location orcommodity characteristics, the shipper can be said to be "captive" to the railway.Under these circumstances, and in the absence of a voluntary contract, and if thereference tariff is inappropriately high because of the volume of traffic being offeredby the shipper, DTF may be asked to consider whether a railway tariff should beprescribed. In general, when setting a maximum tariff for a captive shipper, DTFshould be guided by the principle of "stand-alone" costs; that is, what would it cost toprovide the services if the shipper (or shipper group) in question stood alone and didnot benefit from the economies and contributions of other shippers. In practice, stand-alone cost can often be approximated by permitting a shipper (or shipper groups) tooperate their own trains and pay a trackage use fee to the concessionaire which coversthe long-run variable cost of their use of track and track capacity.

(e) protecting the "captive railway". Where a single shipper, or consortium ofshippers, controls the railway, different possible abuses exist: (i) the tariffs forshippers outside the consortium might be forced up in order to reduce tariffs forconsortium members; (ii) a dominant member of the consortium might attempt to forceits tariffs down at the expense of other members of the consortium, or; (iii)consortium members may focus on their traffic and ignore opportunities for new oroutside business. If the railway is dominated by a shipper/owner, DTF may ask: 1)whether the railway's tariffs are generally high enough to permit adequate coverage ofoperating, maintenance and capital expansion costs; if not, members of the consortiumshould be required to pay higher tariffs; 2) whether the non-members of theconsortium are being charged tariffs which reflect arbitrary discrimination; if yes, thentheir tariffs may be lowered to reasonable levels; 3) whether the tariff decisions of theconsortium are adequately insulated from the interests of a single investor; if not, DTFmay require that the consortium institute an agreement to ensure non-discriminatorypricing among consortium members); or, 4) whether the consortium has organized therailway in a way that will promote attention to non-consortium business possibilities.The impact of many of these potential issues can be alleviated by a requirement thatshipper-owned consortia (if any) must insulate the business decisions of the railwayfrom the individual interests of the shippers; but this provision is difficult to enforce.

The following paragraphs provide an assessment of each of the proposed concessions with regard toregulatory requirements.

27. Centro-Leste, Sul, and Oeste. Potential concessionaires will be given tables of maximum"reference" rates, based on wagonload traffic moving various distances, and generally related to tariffsin force today. These tables will be different for each concession and for each of the major

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commodities. So long as a proposed tariff is below the appropriate level in the reference table, it willnot generally be subject to further review.

28. Nordeste. Bidding will commence subject to a table of reference rates. If, however, thisconcession turns out to be a "negative concession" (i.e., the Government must pay to provide for itsoperation), then the Government will reserve the right to intervene directly in tariffs in return forappropriate modification in the fee to operate.

29. Tubarao is a single shipper, single commodity carrier. Either Eletrosul should be theconcessionaire, or it may want to assist in formation of a concessionaire, which would carry coal undercontract to Eletrosul: in this case no further tariff regulation would be needed. If Eletrosul does notcontrol the concessionaire, then a maximum tariff which permits the concessionaire to earn areasonable rate of return under efficient operation should be prescribed in advance before theconcession is put on offer. After this point, very little regulation appears necessary.

30. Sudeste poses a unique challenge since such a large part of its traffic and revenues (over 80percent of Ton-Km and 70 percent of its revenue) comes from a very limited number of iron ore, steeland cement producers and shippers. Among these companies, about 75 percent of the traffic and 60percent of the revenue come from a single iron ore producer (MBR). This poses several issues: 1)would an MBR competitor be permitted to bid for and acquire a significant ownership position in thisconcession, which could create the potential for competitive abuse in the shipment of iron ore fromMinas Gerais to the Atlantic ports? 2) will MBR and the other iron ore/steel companies be permitted toform a consortium and bid for the concession as a group? If so, could the share of ownership of anysingle owner be restricted? and 3) how could the tariffs for these "captive shippers" or their "captiverailway" be regulated?

31. In many countries, including the US, railways are not permitted to haul their own commoditiesin order to avoid the potential abuses discussed above. Using this approach, no shipper, includingCVRD and MBR, would be allowed to have a significant ownership share in the Sudeste concession.If the concession owner is not a shipper consortium, then, along with a reference table of rates (ofwhich the iron and steel commodities will obviously be crucial and will justify great care inpreparation), the concessionaire could be required to permit any of the iron/steel shippers (or groupsthereof) to run their own private trains in return for a specified fee (per train-km, gross ton-km, orother) defined at the outset of the concessioning process. This would cap the exercise of market powerand would constitute an approach to stand alone costing.

32. If shipper groups are permitted to bid, then it appears desirable that no one shipper, (neitherCVRD nor MBR) have a controlling ownership share in the consortium, but either could well be aminority member of the Sudeste concessionaire group. In this light, one acceptable outcome would befor all of the iron/steel shippers (plus any others who are interested) to form a consortium to be one ofthe bidding groups, with the group structured so that no shipper has a controlling position in theconcession. If the shipper consortium wins the concession, the issue of regulation would be relativelysimple: all iron and steel transport charges for each shipper should be made available to DTF (but not,necessarily, to the public) and all differences in charges to each shipper should be readily justifiable toDTF in terms of the volumes, costs and quality of services provided. In addition, it is possible that acement, steel and iron ore-dominated Sudeste consortium might be indifferent to developingmerchandise traffic along the Rio/Sepetiba/Sao Paulo line; in this case, one could consider breakingSudeste into two concessions, one specialized in iron ore and steel, and another focusing onmerchandise traffic to/from Santos/Sao Paulo. Alternatively, in cooperation with the FEPASA

- 73 - Annex 7

concessioning, trackage rights could be given to the FEPASA broad gauge concessionaire to operate onthe line from Sao Paulo to Sepetiba and Rio.

33. Two critical issues remain for resolution. First, under the current Real Plan, rail tariffs areexternally controlled by agencies not involved in railway concessioning: the new concessionaires willhave to be exempted from these price controls. Second, the reference tariffs must not be interpreted asfixed numbers independent of changes in other values in the economy. Instead, the reference tariffsshould be understood as being stated in Reals as of the date of the signing of the concession. Proposednew public tariffs would then be considered to be under the reference level if they are lower than thereference levels when adjusted to the values pertaining as of the date of the concession contract.

34. Divisions of Tariffs Among Concessionaires. There is very little traffic moving among orbetween the proposed concessions -- in particular, Tubarao is physically isolated, and Nordeste iseffectively isolated by the distance. There may be significant potential for growth in traffic among thenew concessions and with FEPASA, CVRD, FERRONORTE AND FERROESTE. Thus, somemechanism for setting tariffs for inter-concession traffic is needed in the case where the individualconcessionaires cannot agree on a joint tariff or the division between or among them. Severalapproaches are available: the best approach is that joint tariffs be a matter of negotiation among theconcessionaires involved and either FEPASA or CVRD. Concessionaires could be required by DTF toestablish joint tariffs at a level equal to or less than the sum of their individual concessions' referencetariffs for the distance and commodity group involved. It is not clear whether there is, or needs to be,a mechanism for imposing tariffs and divisions of tariffs on traffic interchanged with FEPASA orCVRD.

35. Trackage rights. The Government may also want to retain the right to prescribe trackagerights, and charges therefor, for concessionaires to operate over the tracks of others in the event thatthe growth of rail traffic is being impeded by the inability of concessionaires to establish joint rates anddeliver high quality coordinated services. This right might also be extended to existing, or even new,concessionaires who wish to engage in long haul intermodal services. In any event, though, thetrackage rights should be restricted to point-to-point services involving major markets, and should notnecessarily be extended to cover all points along a rail line.

36. Abandonment of Service or Trackage. In principle, the Government intends to require thatconcessionaires provide a minimum level (or levels) of service over the network to be concessioned.This minimum might be one train per day, or one train per week, or service on demand by a shipper,or whatever else is appropriate to the Government's objectives. Action by a concessionaire which hasthe effect of falling below the specified levels of service will require DTF permission, which will notnormally be granted unless the lines in question can be shown to be uneconomic and unless allalternatives to service (tariff increases, contract operation by others, etc.) can be shown to beunfeasible, and unless the losses on the line constitute an undue financial burden on the concessionaire.In some cases such as a few lines on the Nordeste concession, the Govermnent may either transfer

certain uneconomic lines to local governments in advance of the concessioning, or may offerconcessionaires a choice at the outset as to whether or not certain lines will be operated by theconcessionaire.

(b) Safety Regulation

37. The public welfare will require that the concessionaires operate safely. MT/DTF will delegatethe supervisors of safety regulations to RFFSA, which will inspect the operations of the

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concessionaires to ensure that track and equipment are maintained adequately, and that safe operatingpractices are followed. The project would include technical assistance and training of RFFSA staff forthis purpose (Annex 6).

(c) Supervision of Track Conditions

38. The terms of the concessions will require that tracks be maintained to specified quality levelsthroughout the life of the concession in order to ensure that, if the concession is not renewed, theGovernment will receive a railway that is in adequate condition for a new concessionaire to operate.This will require that RFFSA inspect the track at appropriate intervals to verify that the track is beingmaintained in the conditions specified in the concession contracts.

C. The Regulatory Reform Component

39. The Regulatory Reform Component of the proposed project comprises the development,monitoring and evaluation of the Brazilian railway regulation, reorganization of the railway regulatoryand supervisory agency (MT/DTF), and the establishment of a dispute settlement commission(COFER). Considerable attention was dedicated to learn the lessons from the U.S.A. experience(Staggers Act) and the Canadian experience (Freedom To Move) and to illustrate to the Braziliandecision-makers the impact of well designed regulatory policies.

40. The railway economic regulation is being redesigned to: (i) allow the concessionairesmaximum freedom to set tariffs on services which face competition, including differentiating them toaccount for individual shippers' needs, and entering into confidential contracts with shippers; (ii) limitthe role of the Government to constrain the tariffs which a concessionaire sets to captive shippers, overwhom the concessionaire has monopoly power, by the stand-alone costs of the shipper's service; (iii)authorize abandonment of lines or services which are proved to be financially not viable; and (iv)facilitate inter-concession traffic . The concession contracts would reflect the specific regulatoryrequirements of each concession and their different market and service characteristics. PresidentialDecree No. 1852, issued on March 4, 1996, revised the 1985 rail transport regulation. The projectwould include technical assistance and training of MT staff to help develop, implement, and monitorthe regulation. Because the Concession Law requires setting up maximum tariffs, concession contractswould include such maximum tariff tables which, in practice, would not constrain the concessionaires'freedom. However, agreement would be sought during loan negotiations that the Government will, bya date to be determined, review the relevant legislation and regulations regarding rail transport tariffs,and inform the Bank of the decision and implementation of any executed modifications; and developappropriate mechanisms, criteria, and guidelines to implement the captive shipper rate and the lineabandonment regulations prior to concessioning the Sudeste and Nordeste systems respectively

41. The Transport Ministry's Department of Rail Transport (DTF) would be strengthened toeffectively implement the revised regulation and to supervise the concession contracts, with theexception of the technical, environmental and safety-related aspects of such supervision, which wouldbe delegated to RFFSA. An independent Rail Transport Commission (COFER), includingrepresentatives from the concessionaires, shippers and from the Government, would be established toresolve disputes between the concessionaires and the Government, and between shippers and theconcessionaires. The establishment of COFER was approved by the President through a temporaryexecutive measure (Medida Provisoria).

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BRAZIL

FEDERAL RAILWAYS RESTRUCTURING AND PRIVATIZATION PROJECT

Financial Restructuring and Settlement Component

A. RFFSA's Debts

1. During most of its history, RFFSA has generated negative returns on its operations. Thesepersistent operating losses reflect the pervasive organizational inefficiencies and low productivity, lackof commercial freedom, lack of market-oriented management structures, failure to significantly rationalizeoperations by exiting from uneconomic low-density lines and shedding excess labor, and continuinggovernment-imposed obligations that rendered the railroad uncompetitive in the face of the growingsophistication of road transport. Since RFFSA did not generate sufficient revenues to meet its paymentobligations, RFFSA has been accumulating payment arrears which have been growing rapidly. RFFSA'sdebt amounted to almost US$3.0 billion by the end of December 1995. The long term financial debtsare relatively small. The debt consists mainly of rapidly increasing short term liabilities to Governrmententities and to the staff pension fund.

2. Financial Debts. The long term debt was about US$360 million equivalent at the end of 1995,including accumulated unpaid interest of about US$60 million equivalent. It consists mainly of theoutstanding balance of Bank loan No. 2563-BR, which helped finance the Federal Railway - ExportCorridor - Project, and of some outstanding debts with BNDES and foreign banks.

3. Debts with the Staff Pension Fund. Almost all RFFSA employees, as well as many employeesof other railways, participate in the Railway Pension Fund (REFER). RFFSA has accumulated largearrears with the Pension Fund, which totaled over US$360 million equivalent at the end of 1995. Sinceit is an important objective of the proposed project to reduce the staff of RFFSA, in particular throughearly retirement, the outstanding debts with REFER need to be urgently settled so that the fund can honorthe acquired pension rights of RFFSA employees.

4. Debts with Government Entities. The debts with Government entities consist of accumulatedpayment arrears, including interest on such arrears. These debts totaled about US$2.0 billion equivalentat the end of 1995, and are increasing rapidly. The accumulated debt with the National Social SecurityInstitute (INSS) represents almost half of the total, with about US$950 million at the end of 1995. Thebalance of the debt to Government entities represents unpaid taxes such as social contributions, includingthe "Finsocial", FGTS, and PASEP social funds (about US$700 million equivalent), the ICMS tax (aboutUS$270 million), and the income tax (about US$110 million).

5. Pending Actions. A number of legal actions by creditors or labor are still pending, which couldresult into further liabilities.

B. RFFSA's Assets

6. RFFSA's assets total about US$16 billion equivalent in accounting terms. The rail assets, which,on the basis of a preliminary identification, are estimated at about US$12 billion equivalent, would beleased to the concessionaires. The non-rail assets, which consists essentially of land and buildings which

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are not used for operational purposes any longer, are estimated at about US$4 billion in accounting terms.RFFSA management, however, estimates the market value of the non-rail assets at only about US$1.0billion.

7. Most of the non-rail assets, however, cannot be sold in the short term due to lack of regularizedownership documents and as a result of past judicial decisions on legal actions by creditors, mainly theINSS. The project will include funds to contract a Real Estate Management (REM) firm, which, inter-alia, will make a detailed assessment of the market value of the stock of non-rail assets, and will identifythe requirements to regularize the documentation.

C. Financial Restructuring and Settlement

8. RFFSA will continue to own its rail assets, which will be leased to the concessionaires. RFFSA'srevenues from the leasing of rail assets and from any sale or lease of non-rail assets are to be used torepay as much as possible of RFFSA's debts, and to guarantee against possible future labor andenvironmental liabilities. However, no decision has yet been made by the Government regarding thetreatment of RFFSA's debts, nor regarding the financing of the residual public service obligations in theNortheast, which could be funded either from RFFSA's revenues, by the National Treasury (againstrevenues from the sale of the railway concessions), and/or by state and local governments. Some debtsto the Government could be settled by accounting means, since the Government has not generally madethe normalization payments to RFFSA for public service obligations. But other debts to Governmententities, including the debt to the National Social Security Institute (INSS), would have to be rescheduled.

9. The Government undertook to develop a plan to restructure and to settle RFFSA's debts. Theplan, however, cannot be finalized until the first auctions are completed and until the assessment of andthe plan for the management and sale of non-rail assets are prepared (para 11). RFFSA has prepared atentative debt restructuring plan in order to develop a tentative financial forecast for the residual company(Annex 9). The Government would be comrnmitted to complete the plan, including the terms andconditions of the rescheduled debts and a revised financial forecast for the residual RFFSA, and toforward it to the Bank for comments by a date to be determined, consistently with the timetables forconcessioning and for the market valuation of RFFSA's non-rail assets. However, the Government wouldhave to make an earlier decision regarding the rescheduling of RFFSA's debt with the INSS, in order toenable RFFSA to initiate the sale of non-rail assets as soon as possible.

10. In order to effectively manage and settle its debts within the plan to be determined by theGovernment, RFFSA will establish a Settlement Division (SD) with appropriate terms of reference(regimento interno), and transfer to this new division all responsibilities to manage and settle thecompany's debts and labor liabilities, and to manage and sell its non-rail assets (Annex 11). The Headof the SD would be accountable to meet the agreed asset sale and debt reduction targets (Table 2,Annex 11). RFFSA will also enter into a contract with a specialized Real Estate Management firm(REM) to help develop and implement a plan to manage and sell its non-rail assets. A portion of theREM's remuneration would be subject to meeting the asset sale targets. The project would include fundsfor the REM contract and for the purchase of the necessary computer hardware and software.

11. The terms of reference for the REM contract would include the following main tasks:(a) classification of non-rail assets by type; (b) assessment of market value of the stock, on the basis ofsample assessments; (c) analysis of documentation and identification of requirements for regularization;(d) definition of plan of action, including timetable and targets, in order to maximize revenues from thesale of RFFSA's non-rail assets; (e) identification of assets which could be brought to sale rapidly, and

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preparation for sale; (f) assistance to SD in the selection, contracting and supervision of real estate agentsto market the assets for sale; and (g) management and monitoring of the asset sale program. Theremuneration of the REM would be partly based on sales. The fixed part of the remuneration istentatively estimated at US$2.4 million equivalent.

12. The present targets for sales of non-rail assets have been based on RFFSA management's presentestimates of their market value (Table 2, Annex 11). They would be revised as necessary on the basisof the results of the REM's assessment and plan of action.

- 78 - Annex 9

BRAZIL

FEDERAL RAILWAYS RESTRUCTURING AND PRIVATIZATION PROJECT

Financial Analysis

A - Proposed Concessions

(a) Introduction

1. RFFSA has prepared financial forecasts for each of the proposed concession in order to assessthe financial viability of these concessions. BNDES is also preparing financial forecasts in order todetermine the minimum price for each concession. BNDES' forecasts, however, will remainconfidential until the publication of the concession bidding documents.

2. RFFSA's forecasts, which are presented in the following paragraphs, are based on RFFSA'sestimates of the potential demand for rail transport which are sumnmarized in Annex 3, and on thecorresponding traffic projections which are presented in Table I hereafter. They are slightly differentfrom, and generally marginally higher than, BNDES' traffic forecasts. The difference, however,would not affect the main conclusions of the analyses. RFFSA's forecasts also take into account theimpacts of the proposed staff retrenchment and emergency rehabilitation programs on the futureconcessions' operational expenses and productivity. As it can be seen in the following sections, theOeste, Centro-Leste and Sul concessions could rapidly become profitable, as soon as 1997 or 1998.The Sudeste concession will become increasingly profitable, while the Tubarao concession couldcontinue to be profitable. The forecast for the Nordeste concession shows that, in the short term, theGovernment is likely to have to pay subsidies to the concessionaire in order to offer adequate railwayservices and affordable prices.

Table 1 - RFFSA Traffic Projections(millions of ton-Km)

1996 1997 1998 1999 2000Oeste 2,041 2,415 2,788 3,081 3,374

Centro-Leste 7,060 7,771 8,482 8,876 9,269

Tubarao 106 108 111 115 118

Sul 8,660 9,819 10,979 11,396 11,812

Sudeste 22,253 24,208 26,162 28,281 30,400

Nordeste 886 971 1,055 1,098 1,141

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(b) Oeste Concession

3. Because of the need for fuels in the hinterlands, and the rapid growth of Brazil's agriculturaland mineral production for export, there is a strong growth potential for Oeste's traffic. The tariffs onthis type of traffic, particularly fuels, are relatively profitable. Also, Oeste is the most likely link withthe "Oriental" concession in Bolivia, a linkage which might generate significant traffic when theBolivian railway concession is in private operation. The traffic is expected to increase from about 2.0billion ton-km in the recent years (1992-1995), to about 3.3 billion ton-km in year 2000. Assumingthat average revenue can be maintained at about R$25 per thousand ton-kin, the concession net resultsshould change from recent annual deficits of about R$20 million under RFFSA operation, tosubstantial net income from 1998 onwards (Table 2).

Table 2 - Financial Forecast of Oeste Concession

Year 1994 1995 1996 1997 1998 1999 2000Expenses 66,511 52,961 48,644 44,341 46,152 47,639 49,915

Labor, inc1 benefits 45,868 38,158 32,774 27,390 28,485 29,265 30,810Fuels 8,949 7,009 7,254 7,508 7,771 8,043 8,324"Tiquete" 4,298 4,039 3,469 2,899 3,015 3,136 3,261Diarias 1,719 837 854 871 888 906 924ICMS 462 344 435 531 632 699 765Other Materials 2,009 930 1,465 2,000 2,100 2,205 2,315Other Services 1.441 630 1,365 2,100 2,205 2,315 2,431Utilities and Services 967 652 659 665 672 678 685Other Current Expenses 798 362 369 377 384 392 400

Revenues 43,047 40,496 50,781 61,994 75,235 83,141 91,048Transport Revenues 40,273 38,994 49,302 60,188 71,652 79,182 86,712Other revenues 1,916 570 1,479 1,806 3,583 3,959 4,336Normalization 858 932 0 0 0 0 0

Operating Results -23,464 -12,465 2,137 17,653 29,083 35,502 41,133

Maintenance of Rolling 0 6,022 7,226 8,430 9,634 10,839 12,043Stock

Economic Result -23.464 -18,487 -5,089 9,223 19,449 24,663 29,090

Cost of "Canon" 0 0 1,000 1,000 1,000 4,326 6,463

Net Result -23,464 -18,487 -6,089 8,223 18,449 20,337 22,627

Ton-Km (000,000) 1,945 1,668 2,041 2,415 2,788 3,081 3,374Average revenue 20.7 23.4 24.2 24.9 25.7 25.7 25.6(R$/000 T-Km)

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(c) Centro-Leste Concession

4. The Centro-Leste concession has perhaps the best potential for sharing in Brazil's industrialgrowth, but it will lose petroleum traffic to a pipeline in the near future, which puts a cap on its nearterm growth and profits. Nevertheless, it appears that, even after the loss of petroleum traffic isassimilated, Centro-Leste will enjoy a well-diversified and relatively stable traffic mix. Total traffic isexpected to increase from 7 billion ton-km in recent years to about 9 billion ton-km by year 2000.Assuming an average revenue of about R$32 per thousand ton-km (down from R$38 in 1994), theconcession could still generate a substantial net income as early as 1997-98.

Table 3 - Financial Forecast of Centro-Leste Concession

Year 1994 1995 1996 1997 1998 1999 2000Expenses 277,928 237,153 209,670 182,199 189,782 197,448 205,425

Labor, incl benefits 182,717 158,062 121,186 84,310 87,683 91,190 94,838Fuels 36,874 28,003 28,978 29,998 31,064 32,178 33,345"Tiquete" 17,141 17,473 13,397 9,320 9,693 10,081 10,484Diarias 4,122 2,742 2,797 2,853 2,910 2,968 3,027ICMS 13,681 11,235 12,315 13,359 14,367 15,178 16,001Other Materials 6,208 5,977 11,739 17,500 18,315 19,172 20,075Other Services 7,062 5,870 11,335 16,800 17,554 18,345 19,176Utilities and Services 3,525 2,319 2,342 2,366 2,389 2,413 2,437Other Current Expenses 6,598 5,472 5,581 5,693 5,807 5,923 6,042

Revenues 282,799 231,563 234,394 254,265 278,761 294,489 310,465Transport Revenues 258,724 207,612 227,567 246,859 265,487 280,466 295,681Other Revenues 11,388 12,722 6,827 7,406 13,274 14,023 14,784Normalization 12,687 11,229 0 0 0 0 0

Operating Results 4,871 -5,590 24,724 72,066 88,979 97,041 105,040

Maintenance of Rolling 0 16,729 20,074 23,420 26,766 30,111 33,457Stock

Economic Result 4,871 -22,319 4,650 48,646 62,213 66,930 71,583

Cost of "Canon" 0 0 5,300 12,928 17,844 22,969 27,033

Net Result 4,871 -22,319 -650 35,718 44,369 43,961 44,550

Ton-Km (000,000) 6,809 6,349 7,060 7,771 8,482 8,876 9,269Average revenue 38.0 32.7 32.2 31.8 31.3 31.6 31.9(R$/000 T-Km)

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(d) Sudeste Concession

5. The proposed Sudeste concession carries over 52 percent of RFFSA's traffic on only 8 percentof RFFSA's total track length. Further, over 80 percent of Sudeste's traffic (in ton-km) is driven byiron ore and other steel industry inputs and products produced by a single iron ore company (MBR, 61percent) and two steel companies (21 percent). Thus, at least the North-South route of Sudeste isactually an integral part of the production process for these companies and is not actually a generalcarrier like most of the other concessions. RFFSA reports have consistently shown Sudeste to beprofitable on a full cost basis. The future looks even more positive. According to RFFSA'sprojections, which take into account the most recent development plans of the industry, total trafficshould increase from about 20 billion ton-km in 1995 to about 30 billion ton-km by year 2000. Withthe proposed staff reductions and rehabilitation of locomotives, the concession's profits should rapidlyincrease as shown in Table 4 herewith.

Table 4 - Financial Forecast of Sudeste Concession

Year 1994 1995 1996 1997 1998 1999 2000Expenses 420,662 343,141 316,755 290,584 304,256 318,267 332,885

Labor, incl benefits 209,988 182,516 141,423 100,329 104,342 108,516 112,857Fuels 57,378 47,279 49,321 51,454 53,680 56,003 58,429"Tiquete" 14,398 15,246 11,813 8,381 8,716 9,065 9,427Diarias 4,757 2,583 2,635 2,687 2,741 2,796 2,852ICMS 16,656 15,855 18,007 20,269 22,641 24,840 27,094Other Materials 37,295 21,968 29,984 38,000 40,240 42,613 45,126Other Services 36,492 18,730 23,865 29,000 30,660 32,416 34,275Utilities and Services 4,905 3,666 3,703 3,740 3,777 3,815 3,853Other Current Expenses 38,793 35,298 36,004 36,724 37,459 38,203 38,972

Revenues 411,646 385,421 430,777 484,890 552,149 605,779 660,744Transport Revenues 400,278 368,245 418,230 470,767 525,856 576,932 629,280Other revenues 11,368 17,176 12,547 14,123 26,293 28,847 31,464Normalization

Operating Results -9,016 42,280 114,022 194,306 247,893 287,512 327,859

Maintenance of Rolling Stock 0 25,223 30,267 35,312 40,356 45,401 50,445

Economic Result -9,016 17,057 83,755 158,994 207,537 242,111 277,414

Cost of "Canon" 0 0 73,808 85,140 107,758 126,309 153,826

Net Result -9,016 17,057 9,947 73,854 99,779 115,802 123,588

Ton-Km (000,000) 20,237 20,299 22,253 24,208 26,162 28,281 30,400Average revenue 19.8 18.1 18.8 19.4 20.1 20.1 20.7(R$/000 T-Km)

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(e) Sul Concession

6. The Sul concession already has a broad mix of traffic, which is strongly rooted in theagricultural sector, primarily in soybean exports, and in petroleum products. Sal, also, would be oneof the inimediate beneficiaries of the rail traffic which is developing as a result of the Mercosul tradeagreement. The Mesopotamico concession in Argentina and RFFSA's Sul system are alreadydeveloping international traffic from Argentina to Brazil, mostly on containers. RFFSA's forecastssuggest a strong market for them. Overall, traffic is expected to increase from about 9 billion ton-kmin 1994-1995 to almost 12 billion by year 2000. The system, which has had substantial deficits underRFFSA operation, should become profitable as early as 1997-98, after the completion of the staffretrenchment and emergency rehabilitation programs (Table 5).

Table 5- Financial Forecast of Sul Concession

Year 1994 1995 1996 1997 1998 1999 2000Expenses 301,732 241,358 212,378 183,160 190,024 196,811 203,824

Labor, inci benefits 173,686 151,900 118,945 85,991 89,430 93,007 96,728Fuels 40,562 30,307 31,065 31,841 32,637 33,453 34,290"Tiquete" 14,444 15,466 12,111 8,755 9,106 9,470 9,849Diarias 4,011 2,074 2,115 2,158 2,201 2,245 2,290ICMS 18,078 15,653 17,113 18,315 19,260 19,904 20,543Other Materials 18,962 9,165 11,733 14,300 14,872 15,467 16,086Other Services 20,812 10,687 13,094 15,500 16,120 16,765 17,435Utilities and Services 4,166 2,623 2,649 2,676 2,702 2,730 2,757Other Current Expenses 7,011 3,483 3,553 3,624 3.696 3,770 3,846

Revenues 276,866 219,308 233,103 249,481 267,449 276,398 285,260Transport Revenues 260,164 207,011 226,314 242,215 254,713 263,236 271,676Other Revenues 15,071 11,181 6,789 7,266 12,736 13,162 13,584Normalization 1,631 1,116 0 0 0 0 0

Operating Results -24,866 -22,050 20,725 66,321 77,425 79,587 81,436

Maintenance of Rolling Stock 0 19,201 23,041 26,881 30,721 34,561 38,401

Economic Result -24,866 -41,251 -2,316 39,440 46,704 45,026 43,035

Cost of "Canon" 0 0 6.900 15,632 20,272 24,866 29,721

Net Result -24,866 -41,251 -9,216 23,808 26,432 20,160 13,314

Ton-Km (000,000) 9,000 7,500 8,660 9,819 10,979 11,396 11,812Average revenue 28.9 27.6 26.1 24.7 23.2 23.1 23.0(R$/000 T-Km)

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(f) Tubarao Concession

7. The Tubarao concession is a single purpose (coal) carrier serving one customer (Eletrosul)over a very short distance. It is not clear why Tubarao was ever included within the national railwaynetwork, but its future is solely bound to the needs of one customer. In this case, the sole customermay need to take an active position in the railway by owning the concession and either operating itdirectly or contracting for its operation. Even though Tubarao has a relatively short length of haul, itsaverage tariff per ton-km is about two to three times that of the rest of RFFSA, so there is probablyconsiderable room for a new owner/operator to effect economies of operation and save money forEletrosul. The revenues and the profitability of the concession will obviously depend on the positionof Eletrosul.

Table 6 - Financial Forecast of Tubarao Concession

Year 1994 1995 1996 1997 1998 1999 2000Expenses 8,662 7,873 7,680 7,485 7,776 8,050 8,334

Labor, inci benefits 5,838 4,957 4,751 4,544 4,726 4,915 5,111Fuels 401 314 319 323 328 333 338"Tiquete" 719 546 523 501 521 541 563Diarias 51 33 34 34 35 36 36ICMS 948 1,050 1,108 1,168 1,230 1,268 1,307Other Materials 283 285 243 200 206 212 219Other Services 246 95 98 100 103 106 109Utilities and Services 100 72 73 73 74 75 76

Other Current Expenses 76 521 531 542 553 564 575

Revenues 9,370 9,144 9,677 10,199 10,944 11,290 11,634Transport Revenues 6,625 8,901 9,395 9,902 10,423 10,752 11,080Other Revenues 2,745 243 282 297 521 538 554Normalization 0

Operating Results 708 1,271 1,997 2,714 3,168 3,240 3,300

Maintenance of Rolling Stock 0 531 637 743 850 956 1,062

Economic Result 708 740 1,360 1,971 2,318 2,284 2,238

Cost of "Canon" 0 0 300 300 519 526 533

Net Result 708 740 1,060 1,671 1,799 1,758 1,705

Ton-Km (000,000) 95 103 106 108 111 115 118Average revenue 69.7 86.4 88.9 91.4 93.9 93.9 93.9(R$/000 T-Km)

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(g) Nordeste Concession

8. The Nordeste concession has by far the lowest traffic density and employee productivity of allof the RFFSA concessions, and even RFFSA's financial forecasts do not suggest that Nordeste can beprofitable. While there may indeed be a possibility that Nordeste could be profitable if operated withimaginative marketing and stringent cost controls as in Argentina or U.S. shortline railway, it seemsmore likely that the high tariffs needed to be profitable in the private sector would be unacceptable inthe poorest region of the country. Therefore the Government (and/or state governments) may have topay a subsidy to ensure adequate service levels and quality at an affordable price. According toRFFSA's projections, traffic would increase from a low 800 million ton-km to about 1. 1 billion ton-kmin year 2000 under private operation. With the staff retrenchment and emergency rehabilitationprograms completed, the operational deficit could be reduced from about R$50 million in 1994-95 toless than R$20 million by year 2000 (Table 7). The Government would have to define an appropriatemodel for the Nordeste concession, including the public service obligations which would be requiredfrom the concessionaire and the mechanisms to ensure their appropriate funding.

Table 7 - Financial Forecast of Nordeste Concession

Year 1994 1995 1996 1997 1998 1999 2000Expenses 96,288 83,370 69,381 55,606 57,693 59,754 61,882

Labor, inci benefits 69,925 63,776 50,185 36,595 38,058 39,581 41,164Fuels 6,464 4,756 4,827 4,900 4,973 5,048 5,124"Tiquete" 6,801 6,621 5,210 3,799 3,951 4,109 4,274Diarias 1,228 913 931 950 969 988 1,008ICMS 1,369 1,191 1,351 1,519 1,692 1,761 1,830Other Materials 4,371 2,598 2,699 3,000 3,090 3,186 3,278Other Services 2,800 1,726 2,363 3,000 3,090 3,183 3,278Utilities and Services 1,409 926 935 945 954 964 973Other Current Expenses 1,921 863 880 898 916 934 953

Revenues 43,676 41,172 34,709 39,001 44,310 46,116 47,922Transport Revenues 31,057 29,697 33,698 37,865 42,200 43,920 45,640Other Revenues 1,044 1,181 1,011 1,136 2,110 2,196 2,282Normalization 11,575 10,294 0 0 0 0 0

Operating Results -52,612 -42,198 -34.672 -16,605 -13,383 -13,638 -13,960

Maintenance of Rolling Stock 0 1,924 2,309 2,694 3,078 3,463 3,840

Economic Result -52,612 44,122 -36,981 -19,299 -16,461 -17,101 -17,800

"Receipts of Administration" 0 0 42,290 25,147 23,109 24,015 24,996

Net Result -52,612 -44,122 5,309 5,848 6,648 6,914 7,196

Ton-Km (000,000) 922 802 886 971 1,055 1,098 1,141Average revenue 33.7 37.0 38.0 39.0 40.0 40.0 40.0(R$/000 T-Km)

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B. Residual RFFSA

9. RFFSA has also prepared a financial forecast for the residual RFFSA company, afteroperations have been transferred to the concessionaires. The forecast, however, is very tentative since:(a) future revenues from the leases of rail assets will be determined at the auctions; (b) the estimatedfuture revenues from the sale of non-rail assets are based on very preliminary estimates of the assetvalues; and (c) no decision has yet been made regarding the treatment of RFFSA's debts. After theauctions for the main concessions have been completed, and the plan for the sale of non-rail assets hasbeen completed, the Government would make a decision regarding the treatment of RFFSA's debts,and would present to the Bank a RFFSA financial restructuring and settlement plan including a revisedfinancial forecast.

10. The main assumptions used by RFFSA for the preparation of the tentative forecast are asfollows. Revenues from rail asset leases are based on BNDES' current minimum price estimates.Revenues from the sale of non-rail assets are based on a tentative target of R$1.0 billion over 1996-2000. The debts with the Government, essentially income tax and social contribution, would be dealtthrough settlement of accounts, including RFFSA's credit on account of normalization payments forGovernment-imposed public service obligations. The debts with Government entities such as INSS andsocial funds and the ICMS tax arrears would be rescheduled over 20 years at 10% interest. The debtwith the Pension Fund (REFER) would be rescheduled over 10 years at the same 10% rate. Noprovisions were made, however, for any possible future liabilities. Under these assumptions, andwith a R$150 million bridge loan in 1998, RFFSA could service its debts over 1996-2000 withouttransfers from the National Treasury, and reduce its stock of debts from about R$3.0 billion at the endof 1995 to about R$2.4 billion by year 2000 (Table 8).

Table 8 - RFFSA's Tentative Financial Forecast (R$ million)

1996 1997 1998 1999 2000A. RAIL DIVISIONOperational Revenues 82.3Lease Revenues 95.9 360.5 100.5 137,2 137,2-Downpayments 95.9 268.2-Quarterly payments - 92.3 100.5 137,2 137,2

Operational Expenses 26.4 29.6 34.8 34,8 34,8NE Subsidy 37.0 25.1 23.1 24,0 24,9Net Operational Income

B. SETTLEMENT DIVISIONReal Estate Revenues 10.0 100.0 200.0 300,0 400,0Real Estate Expenses 0.5 4.5 10.0 15,0 20,0Net Real Estate Revenues 9.5 95.5 190.0 285,0 380,0Debt Service (Overdue) 89.5 369.5 351.0 305,5 291,6

-Principal 89.5 169.5 169.5 139,5 139,5-Interest (10% a.a.) 199.9 181.5 166,0 152,1

Debt Service (Princ. + Interest) 32.2 29.1 26.2 23,8 10,4-BIRD 26.4 24.7 23.1 21,6 10,1-BNDES 5.8 4.4 3.1 2,2 0,3

Bridge Loan 150.0Dcbt Service 18,0 148,0Net Settlement income (112.2) (3031) (37.2) (62,3) (70,0)

RFFSA NET INCOME 2.6 2.7 5.4 16,1 7,5

Source: RFFSA

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BRAZIL

FEDERAL RAILWAYS RESTRUCTURING AND PRIVATIZATION PROJECT

Project Economic Analysis

A. Introduction

1. The project's main objective is to increase the performance and efficiency of the federalrailways through: (a) restructuring and concessioning its operations; (b) re-training and re-deploying itsredundant staff to more productive activities; (c) emergency repairs of locomotives, wagons and tracksto enable continued and safe operations during the restructuring and concessioning process; (d) re-designing railway regulation; and (e) restructuring RFFSA's functions and finances to effectivelymanage rail and non-rail assets and to settle debts and labor liabilities. The staff retrenchment and theemergency repair and maintenance programs, which are the main components of the project, will havea direct impact on reducing the railway's costs. A separate economic analysis was carried out for eachof these two programs (sections B and C). The overall reform project, however, including the otherprograms of relatively minor costs, is expected to substantially increase the railways' competitivenessvis-a-vis other modes of transport, particularly trucking, and the railways' share of transport, therebyreducing the long run marginal cost of freight transport in Brazil's main corridors. The economicanalysis of the project overall is presented in section D.

B. Economic Analysis of Staff Retrenchment Program

(a) Methodology

2. The economic (rather than financial) costs and benefits of the redundancy program are comparedas follows. The costs cover mainly the amount of the severance payment (early retirements and financialincentives) and the training cost. There is no loss of service value to RFFSA since, by definition, theworkers declared redundant have zero marginal productivity. The benefits include the additionalcontribution to the economy that the workers will be able to deliver by working where is there is a demandfor their services.

3. The costs. The costs of the retrenchment program in each concession are given by the sum ofthe net present value of:

(i) the marginal productivity value of RFFSA's retrenched employees, differentiated by year(i), employee (j), and concession area (k) (R Rk )

(ii) the severance payments (si );

(iii) the early retirement payments (P )

(iv) the training costs (Tijk ) .

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4. Item (1) represents the value of the services not rendered by RFFSA because of the laborreduction. Since the remaining personnel is sufficient to carry out current production levels of RFFSA,the value of the marginal productivity of retrenched workers is assumed to be zero.

5. Items (2) and (3) would not be labeled economic costs, in an environment without budgetconstraints or price distortions. Assuming no subsidy and no government budget constraint, theseoutlays would be considered income-efficient transfers to the redundant employees and would then notbe included as a cost in the analysis. But Brazil does have a budget constraint and a highly distortedtax system which results in many price distortions. These two terns were therefore included torecognize the importance of the costs of public funds. The underlying assumption is that the shadowprice of public funds is 100% and that each dollar of public resources used to finance severancepayments or early retirement packages has an equivalent economic cost which needs to be taken intoaccount. This also contributes to the conservative estimates of the rate of return as the cost estimatesare an upper bound of the costs rather than a lower bound. These payments are differentiated by year(i) and employee (j).

6. Item (4), training costs, have an economic component attached as long as the training agency(or firm) has an alternative use for its resources. In this case, the training will be provided by para-statal agencies that are fully subsidized by the government. These agencies appear to operate far belowtheir service capacity limits. Nevertheless, the full cost of the training program was included. Trainingcosts were estimated at R$ 200 to 250 per employee for 40 days, and all redundant workers have beenincluded. Training is differentiated by year (i), employee (j), and subsystem (k).

7. The pensions paid to normally retired employees are not included, since these costs would beincurred anyway. Earlier payments of regular pension have not been included since they are small andheir impact on the internal rate of return of the project would not be significant.

8. The Benefits. The benefits of redundancy reduction in each year are given by:

(i) the marginal productivity value of each laid-off employee elsewhere in the economy

(Rijrmp );

(ii) the marginal productivity value of the foregone labor cost of RFFSA (LCk ).

9. The marginal productivity value of the laid-off employee is the product of: (i) the probabilityof the employee's engagement in another productive activity, which depends on the effectiveness of thetraining which the employee receives, by (ii) the net income produced by such activity. RE isinfluenced by attributes such as age, education, etc., of each employee (j), and the location (m) he islikely to find an occupation (p). Region (m) may or may not be the same as where he previouslyworked and occupation (p) is related to the employee's attributes and the training which he receives.In some cases, the laid-off employee may get a job at the expense of someone else's job, and his netincome contribution may be zero. But since these cases are normally rare, their impact on the finalresults would not be significant. Provision was made for these assumptions in the sensitivity analyses.

10. The marginal productivity value of the foregone labor cost of RFFSA represents theopportunity cost of the outlays that will be saved by the program. These savings in labor costs can beused in investments in railways needed to provide additional service capacity, as well as further

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improvements in the existing system. In the economic analysis of this specific program they areestimated as equivalent to the foregone labor cost. In the economic analysis of the overall project, insection D, the savings in labor costs are translated in terms of a reduction in the long-run marginal costof rail transport. That cost reduction is the main reason for the increased rail competitiveness which inturn explains the improvement of the rail market share over trucking.

(b) Quantitative Assumptions

11. The quantitative assumptions made in estimating the return to staff reductions are conservative;in particular, it is assumed that not everyone will find a job. The probability of being re-employedwas computed on the basis of the time spent on the job and the average length of unemployment. Basedon the information available about the employment situation in the largest metropolitan areas, theprobability of finding a new job ranges from 0.64 in the Northeast and 0.81 in the Center to 0.83 in allother concession areas. These are strong assumptions since the probability of finding a job within ayear is in fact essentially 100% in all regions except for the North-East where on average it takes 14months to find a job. The main reason why unemployment duration is rather short is that prices adjustto clear the labor market. This implies that unemployment goes down as prices go down. Those whodo not find a job at their previous wage have to accept a wage cut consistent with the averageprobability of being employed. The reduction in wage depends on the region; wage is reduced to theaverage salary in the region where a worker is declared redundant. This implies wage losses varyingfrom 10% in the South and Southeast to 30% in the North East and Tubarao regions (Table 1,hereafter).

(c) Results

12. The net present value (NPV) of the staff retrenchment program is estimated at US$606 millionfor a 12% discount rate, and its internal economic rate of return (IERR) is estimated at 40%, under themost realistic and conservative assumptions (Table 1, hereafter). In financial terms, the payback periodis estimated to be a highly significant 1.6 years. There are wide differences across regions. Excludingthe Central Administration, the region with the highest return is the South East (the NPV is estimatedat US$223 million and the IERR is estimated at 51%). This is the region where labor productivity isthe highest, and also where the opportunity cost of not using the labor force effectively is the highest.The lowest rate of return (19%) is found in the North-East. In all other regions, these conservativeestimates suggest rates of return to the economy over 37%. Table 1 also shows the results of thesensitivity tests made: (a) if salaries are assumed to be 10% less than expected, the estimated rate ofreturn would be reduced to 36%. On the other hand, (b) if the probability of finding a new job is100%, the estimated rate of return of the program would be as much as 50%, and the minimum rate inthe North East would increase from 19% to 34%.

13. In summary, the redundancy program has a clear social value, under the most pessimisticassumptions. This social value does not stem from the fact that RFFSA's workers are laid-off, butrather because the redundant workers can be better used in other sectors where the demand has beenidentified, and from the specific efforts made to ensure that the quality of this labor force will beenhanced in the process through training. It also releases scarce public resources for better targetedand more effective uses including education, which is best completed earlier rather than through middlelife literacy programs.

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Table I - Analysis of Staff Retrenchment Program

CentralConcessions Nordeste Centro-leste Sudeste Sul Oeste Tubarao Admin TotalNo of Employees 4,479 11,948 10,268 10,480 2,736 360 1,209 41,480

No of Layoffs 1,909 5,575 4,624 4,547 772 30 590 18,047

Average Wage & Benefits 1,215 1,186 1,656 1,310 1,302 1,232 2,412 -

Average Age 45 40 41 40 41 40 41

Probability of Finding Job 0.64 0.81 0.83 0.83 0.83 0.83 0.83

Wage Reduction Coefficient 0.7 0.9 0.9 0.8 0.85 0.7 0.9

Marginal Productivity (US$) 591 741 1,035 728 769 599 1,508

Severance Payment (US$)

- Fixed 11,745 11,349 12,024 11,478 11,542 12,313 17,658

- Variable 7.048 6,811 7,215 6,887 6,925 7,387 10,000

Training cost/Employee (US$) 950 950 950 950 950 950 1,031

Training Percentage 70 70 70 70 70 70 50 -

Severance Payments (US$000) 35,875 101,239 88,961 83,505 14,256 591 16,318 340,748

Training Costs (US$000) 1,269 3,707 3,074 3,023 513 19 304 11,913

Outplacement Costs (US$000) 264 772 640 629 106 4 81 2,500

Program Cost (US$000) 37,409 105,719 92,676 87,159 14,876 615 16,704 355,161

Annual Wage Savings (US$000) 8,659 40,167 47,666 32,959 5,909 178 8,858 144,400

Average Remaining Years 10 15 14 15 14 15 14 13.86

Present Value of Savings (US$ m) 49 273 316 224 39 1 59 962

Net Present Value (US$m.) 12 168 223 137 24 1 42 607

Estimated IERR, Base Case 19 37 51 37 39 28 52 40

- Wages Reduced 10% 16 33 46 33 35 25 47 36

- 100% Probability of Job Within 34 46 61 45 47 34 63 50I Ye: r

C. Economic Analysis of Emergency Rehabilitation Program

14. The Emergency Rehabilitation Program (ERP) is divided into six components: (a) locomotiverehabilitation aimed at increasing the availability of locomotives, thus increasing traffic and avoidingthe costs of locomotive failure; (b) wheel replacement on both locomotives and wagons to reducederailments; (c) conversion of freight wagons to container flat-wagons to capture traffic now growingas a result of Mercosul development; (d) minimum repairs of trackage to maintain safe operation andreduce derailments; (e) limited system investment primarily in signaling and remote switch controlneeded to pennit planned manpower reductions to proceed; and, (f) investments needed to close andconsolidate rolling stock repair shops in order to meet manpower reduction targets and facilitate theoperations of the new concessionaires.

(a) Locomotive Rehabilitation

15. As a result of shortage of capital and consequent neglected maintenance, only about 52 percentof RFFSA's locomotive fleet is operative, and the locomotives in operation are highly prone to failureen route. This imposes two costs on the system: traffic is refused because there are not enoughlocomotives available to haul the traffic on offer, and operating costs are high because on-line failuresare far more expensive than preventive maintenance. The situation has become so difficult that therewould be little tractive power left to hand over to concessionaires, and the concession value will besubstantially reduced, if emergency repairs are not made. RFFSA identified 240 of their current fleet

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of 901 locomotives for emergency repair and rehabilitation, which would result in higher reliabilityand availability for an estimated eight year period.

16. The locomotive rehabilitation component has two main benefits: (i) the avoided economiccosts of the locomotive failures; and (ii) the avoided increases of long-run marginal economic transportcosts for traffic which would shift from rail to trucks if the program was not implemented. Theaverage added cost to recover from a failure is about $1,500. This is a conservative figure and itincludes only labor costs necessary for the typical repairs. Long run marginal costs for rail transportwere extracted from RFFSA's most recent cost study and differentiated by region according to theaverage length of the haul (see section D). Therefore these rail costs overestimate future rail costs thatwill be incurred under private operation and underestimate the returns of this program, because of theproductivity improvements expected from the project. Trucking costs for truck load shipments wereestimated from a representative sample of firms operating in the truck-load segment. The trucking costfunction adopted is sensitive to both economies of density and the average length of the haul. The unitcosts calculations for each subsystem were made in the region of the cost function where the economiesof density are exhausted for the average length of the haul observed at each subsystem.

17. The economic Table 2 - Locomotive Rehabilitation Analysis

analysis of the locomotive Locos Failures Repair Loss Per Rehabilitation Economic

rehabilitation component Concession Rehab Reduced Costs Failure Costs NPV

shows a positive net present (nb.) (nb.) (US$) (US$) (US$m) (US$m)

value of about US$73.6million at a 12% discount Nordeste 44 2,119 1,546 1,698 21.7 -8.3

rate (Table 2). The Sudeste 58 2,462 t,653 3,094 31.8variations by region are Sul 71 5,551 1,546 2,967 38.2 35.9

explained by the differences Bauru 10 1,176 1,546 2,858 5.5 10.0

in RFFSA's regional costs, Centro-leste 57 4,930 1,546 2,962 30.2 36.2mainly due to the variations .Total 240 16,238 1,572 2.811 127.5 73.6

in traffic densities. The expected reductions in the railways' operating costs, which are expected fromthe project, would further improve these results, and turn positive the NPV for the Nordesteconcession (see section D).

18. The above results are quite robust with respect to variations in the key assumptions. The basecase estimated economic rate of return for the entire program is 43 %. A 20 percent reduction in theestimated cost per locomotive failure reduces the rate of return to 40 percent. A 20 percent increase inthe rehabilitation cost per locomotive reduces the rate of return to about 27 percent. Under bothassumptions together, the rate of return would still be a satisfactory 25 percent.

(b) Wagon Repairs

19. The wagon repair component consists of the replacement of 11,200 worn wagon wheels whichare causing excessive derailments, and about 2,400 locomotive wheels. Due to limited historical data,RFFSA cannot distinguish between the consequences of locomotive derailments and wagonderailments. It was assumed that they are all wagon derailment. This is a conservative assumptionsince locomotive derailment is much more costly to repair than a wagon derailment. RFFSA recordsindicate that derailments due to bad wheels cost around $2.7 million per year in lost operations andadded labor costs (taxes are negligible in this case). Assuming that these can be reduced by about 80percent through replacing bad wheels, the wheel replacement program would have an economic rate ofreturn of 19 percent. Assuming that the derailment reduction would be 20 percent less than expectedwould reduce the rate of return to 13 percent. An increase in the replacement cost of 20 percent wouldreduce the rate of return to 14 percent. Since the assumptions made are conservative, and inparticular, no allowances have been made for the higher cost of locomotive wheel faults, for the non-

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operating costs of derailments such as human injury, environmental clean-up, or for lost cargo value,there is good reason to conclude that the wheel replacement program would have an acceptable intemaleconomic rate of return.

(c) Wagon Conversion

20. As a result of the Mercosul Trade Agreement, trade between Brazil and Argentina is increasingrapidly, especially in higher-value manufactured products. Transport alternatives for this trade aretruck or rail. Rail movement necessitates a change of gauge at the Brazil/Argentina border, since theArgentine Mesopotamica Railway is standard gauge, and the Brazilian Sul system is meter gauge.These two factors -- higher-value products needing better service and the change of gauge at the border-- combine to encourage growth in rail-hauled containers if rail is to be competitive. In 1995, forexample, RFFSA's container traffic was growing at about 20 percent per year.

21. In the long run, as traffic increases, the Sul concessionaire is likely to invest in specializedequipment. RFFSA currently has available 300 flat wagons that can be converted rapidly for about$10,000 per wagon. These wagons will be suitable in the short run, and will have a ten year life.Discussions with one of the potential concessionaires for Sul confirm that the equipment would beconsistent with current plans and would be used as planned: on this basis, the value of the conversionprogram would be reflected in the bids received.

22. Assuming a relatively conservative wagon productivity of 540,000 ton-km per wagon annuallyand a net economic benefit of R$0. 11 per ton-km, which was derived from the difference between railand trucking long run marginal cost , the wagon conversion component would yield a 60 percent rateof return. The economic rate of return for the conversion program is robust. Assuming the netbenefits would be 20% less than expected, the component would still yield a rate of return of 48percent. A 20 percent increase in the conversion cost would reduce the rate of return to 50 percent.Under both assumptions together, the component would still yield a high rate of return of 39 percent.

(d) Track Repairs

23. Shortage of capital has deferred the maintenance of track and infrastructure, resulting intoincreased derailments and safety risks, especially in areas where RFFSA carries hazardous cargoes.Since RFFSA's traffic mix in many of the regions is weighted toward petroleum products, there aremany points at which a safety risk exists. An immediate program of rehabilitation is needed on theparts of the network which carry higher density traffic and are thus exposed to higher risks ofderailment. Because it is basic work aimed at the higher priority parts of the network, the maintenancework will be needed no matter who is operating the tracks. Further, as the Government remains theowner of the track and structures, the value of the work accrues to the Government both in assetownership and in the value of the bids received for the concession.

24. The estimates of quantities of sleepers, rail and Table 3-Track Repair Quantities

ballast to be substituted, based on completed engineering (in thousand units)

designs, are shown in Table 3 herewith. In addition, the Sleepers Rail Ballastiunits) (tons Wm)

program includes minor works on other infrastructure Nordeste 50 1 7

facilities. The estimated cost of the track component is Centro-Leste 42 3.0 15

about $23.3 million. Sudeste 77 .3 3

Sul 26 3.2 20

25. The benefits to be derived from the track repair Total 195 6.5 55

component are the reduced derailments of trains.

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RFFSA statistics show that 48 percent of the derailments are attributed to tracks. It was assumedconservatively that the proposed track repairs would reduce the costs of such derailments by 15%. Onthis basis, the IERR was estimated at 19%. If benefits were 20% lower than expected, the IERRwould be about 13%. If costs were 20% higher than expected, the IERR would be 14%. There areother important benefits such as improved human safety and reduced environmental risks, but they arenot easily quantifiable. There is no question that the investment is needed if the lines are to continuein service, whoever operates them, and the value will accrue to the Government.

(e) Signaling and Telecommunications Systems

26. Signaling and telecommunications investments comprise primarily automation of control ofremote switches which now requires independent staff. This component, estimated at about US$6.5million, would reduce operating costs and increase the railways safety and reliability. The investmentis necessary to support the already committed manpower reduction program, and will be needed by theconcessionaires. No rate of return for the component has been calculated because it is considered anecessary investment under the Staff Retrenchment Program. The operating cost savings in manpoweralone, which would be made possible by the proposed signaling investments, are in excess of US$9million annually. These costs will be recovered by RFFSA before concessioning in most cases andwill accrue to the Government as owner and in the value of the bids received.

(f) Maintenance Facility Relocation

27. RFFSA has far too many maintenance shops scattered over the system. The concessioningprogram will require to consolidate some facilities in order to free unnecessary property for sale. Inmany cases, since RFFSA shops are in urban areas, the closing of the shops will make the landavailable for other uses. The component consists of relocating equipment from and close about 42facilities which range from small, general purpose facilities to larger rolling stock shops, including:15 in Nordeste; 14 in Centro-Leste; 5 in Sudeste ; 8 in Sul/Tubarao. Its cost is estimated at aboutUS$6.5 million.

28. Because this component is also considered a necessary investment under the Staff RetrenchmentProgram, no specific rate of return is calculated in this section. Shop relocation is an important part ofRFFSA consolidation in support of concessioning, and labor savings alone would repay the investmentin the first year. In addition, the value added through subsequent real estate development would easilyexceed the cost of relocation and consolidation.

D. Economic Analysis of Overall Project

(a) Methodology

29. The main benefit of the overall project would be the reduction in the total transport costs whichcan be achieved through the expansion of rail services. This expansion is likely to come not only fromthe natural growth of today's traditional rail markets, but also from the increased rail market share ininter-regional trade flows. Interstate commerce is estimated at about 200 million tons at an averagedistance of over 1,100 kilometers. Inter-regional flows along rail trunk lines exceed 77 million tons

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with an average haul of 1,500 kilometers.' The railways' market shares in these flows are currentlynegligible, trucking being the dominant mode. However, the comparative advantage of rail technologyover trucking is quite sensitive to the length of the haul. At distances above 500 kilometers, rail costand service advantages in freight transportation are far superior to trucking.

30. The macroeconomic benefits of the proposed project were estimated on the basis of theprojected rail traffic of the six regional systems, as estimated by BNDES in order to establishminimum bidding prices for the concessions. The benefits of the proposed project would be derivedfrom: (a) the reduction in rail costs resulting from the expected improvements in rail productivity; and(b) the difference in the long run marginal costs of the railway and trucks for the traffic which isexpected to be diverted from trucks to the railways. The improvements in rail productivity willenhance rail competitiveness with respect to trucking, allowing it to attract more shipments. But theseimprovements will also reduce the costs of hauling the existing traffic, making an additionalcontribution to the overall benefits of the project.

(b) Traffic Projections

31. The projections of rail traffic flows by region, show that the total production of the six RFFSAsystems would amount to 64 billion net ton-km by 2003 (i.e., the sixth year of operation afterconcessioning), representing a 25 billion ton-km increase from the current production of approximately39 billion net ton-km. This growth would represent about 13% of the projected inter-regional trade,which is estimated at 152 billion net ton-km, assuming a 4% growth of both the economy and ofRFFSA's traditional markets. Traffic projections for the six subsystems are presented in Table 4hereafter.

Table 4 - Projected Rail Traffic (million net ton-kn)Year Nordeste Centro-leste Sudeste Sul Oeste Tubarao Total

1996 926 7000 20000 9000 2000 96 39022

1997 1079 7857 21429 9857 2286 99 42607

1998 1233 8714 22857 10714 2571 102 46192

1999 1386 9571 24286 11571 2857 105 49777

2000 1540 10429 25714 12429 3134 109 53363

2001 1693 11286 27143 13286 3429 112 56948

2002 1847 12143 28571 14143 3714 115 60533

2003 2000 13000 30000 15000 4000 118 64118

2004 2153 13857 31429 15857 4286 121 67703

2005 2307 14714 32857 16714 4571 124 71288

2006 2460 15571 34286 17571 3857 127 74873

2007 2614 16429 35714 18429 5143 131 78459

(c) Transport Costs and Benefits

32. In 1994, RFFSA developed a detailed assessment of its operational cost management system,and of the cost structures of its competing modes. The study, financed under the institutionalcomponent of Loan No. 2563-BR, was aimed at enhancing RFFSA's strategic marketing planning.2

1. These estimates are based on the results of a multiregional input-output model developed for Brazil (Castro, N."Intramodalidade, intermodalidade e o transporte de longa distancia no Brasil", IPEA, Texto para Discussao 357.1994)

2 "Desenvolvimento do Plano de Acao de Custos" -RFFSA, 1994, Relatorio Final.

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The rail and truck cost estimates which were derived and are shown in the final report of the studywere used as a basis for this analysis.

33. Rail marginal costs were estimated on the basis of RFFSA's operational cost figures for theperiod 1991-93. These costs include all operational outlays, maintenance of rolling stock, equipmentand infrastructure, and depreciation of rolling stock and equipment. The labor component of rail long-run marginal costs (LRMC rail) was adjusted assuming that the private concessionaire would operatewith the labor force as determined by RFFSA for the Staff Retrenchment Program. Thus, the averageproductivity gains permitted by the program are incorporated in the projected rail cost estimates. Onthe other hand, it is also assumed that the railways' real average wages for the remaining employeeswould increase by 30% after privatization. These assumptions combined result in a 20% averagedecrease in the long-run marginal costs of rail transport. As the original data was available for each ofRFFSA's 12 production departments, the estimates for each concession were obtained as net ton-kmweighted average of the respective departments. RFFSA's average productivity of that recent periodwas conservatively projected for the lifetime of the program. Table 5 hereafter shows both present andprojected rail long-run marginal costs.

34. Trucking Table 5 - Long-Run Marginal Costs for Rail and Truck Transport

costs were also (in US$/ton-lkm)

taken from the same Nordeste Centro-leste Sudeste Sul Oeste Tubarao

study, and were Present rail LRMC 0.0292 0.0150 0.0090 0.0180 0.0170 0.0280

based on operating Projected rail LRMC 0.0232 0.0119 0.0072 0.0143 0.0135 0.0223

costs for truck-load Truck LRMC 0.0367 0.0400 0.0355 0.0294 0.0288 0.1360

freight. Thesecosts do not include road wear and environmental impact costs. The trucking cost function adopted issensitive to both economies of density and the average length of haul. The unit costs calculations foreach subsystem were made at the productive level of the cost function where the economies of densitywere exhausted for the average length of the haul observed at each subsystem. The resulting costs fortrucking (LRMC truck) are shown in Table 3 for the six regional systems. Marginal costs of truckingare differentiated by region according to the average length of haul.

(d) Investment Costs

35. The project economic cost, including all components but excluding taxes and contingencies, isestimated at about US$570 million (Table 6 hereafter). None of the additional benefits identified inthe economic analysis of the project components were considered. All payments made under the StaffRetrenchment Program were included in the totalization of the program's cost. The distribution of thecosts by region and component is presented in Table 6 hereafter.

Table 6 - Project Economic Costs by Component (US$ million)Project

Component Nordeste Centro-leste Sudeste Sul Oeste Tubarao TotalLocomotives 18.1 25.2 26.5 31.8 4.6 0.0 106.3

Wheels 0.3 2.1 3.9 3.0 0.0 0.0 9.4

Wagons 0.0 0.0 0.0 3.0 0.0 0.0 3.0

Tracks 2.5 8.6 6.5 5.6 0.0 0.0 23.9

Systems 3.2 1.0 0.4 1.7 0.0 0.0 6.5

Shops 3.9 3.7 1.3 2.1 0.0 0.0 11.1

Staff Retrenchment 37.0 110.0 105.0 95.0 15.0 0.6 362.6

Central Administration and other expenses 48.0

Total 65.2 150.7 143.7 142.4 19.6 0.6 570.2

- 95 - Annex 10

(e) Results of Base Case Analysis

36. The net present value of the project is estimated at about US$2.4 Table 7-Base Case Results

billion for a 12% discount rate, and its internal economic rate of return IRR NPV

(IERR) is estimated at a high 68% under the base case (rail costs Nordeste (2) (US2 in)

incorporating productivity gains and demands as shown in Table 4). The Centro-leste 68 652

net present value varies from about US$2.7 to US$1.9 billion for discount Sudeste 107 1198

rates ranging from 10% to 15%, respectively. The IERRs for the Sul 55 404

concessions are all above 20%, the lowest rate being found in the Ocste 101 141

Nordeste. In the important concessions of Centro-leste, Sudeste, Sul and Total 68 2435Oeste, rates of return are above 50%. (Table 7).

(f) Risk Analysis

37. The project would be subject to three major types of risks, as described in the first part of thisreport (stemming from institutional, implementation and regulatory problems). All three types of riskswould materialize mainly into delays in both the privatization process and in reaching the projectedlevels of rail production. The impacts of such circumstances have been examined in the sensitivityanalysis above. The results show that even in the most extreme and very unlikely case of completestagnation of rail traffic, the internal economic rate of return is an acceptable 13%. This result isobtained, including all the costs of the Emergency Rehabilitation Program, and none of its benefits.All the disbursements of the Staff Retrenchment Program were also considered in these calculationsand none of the benefits identified in section B. In financial terms, this latter program guarantees anexceptional return for the project in any case.

38. A first sensitivity test on the results above assumed that rail costs will not be reduced by theproject. Using the conservative rail cost estimates shown in Table 3, the project's internal rate ofreturn falls to 49%. Only in the North-East region does the return fall below 10%. A second test wasperformed assuming that demand levels would be 20% below the projected figures in the base case for2003. The overall rate of return, in this case, falls to 45%, but the results by region are all above14%. The reduction in demand penalizes less the benefits attributed to the North East concession,because the demand growth projected for that region are relatively more modest. A sensitivity analysismade on both trucking costs (-20%) and investment costs (+20%) showed that the economic results ofthe project are quite robust with an overall internal rate of return of 50%. An extreme case for theevolution of the demand for rail services assumed zero growth for the entire planning horizon. Theonly benefits in this case would be the reduction in rail costs permitted by the Staff RetrenchmentProgram only on the existing traffic (but including the costs of all other programs). The overallproject internal rate of return in this case would still be a satisfactory 13%. The switching value forthe traffic growth assumption, which would zero the NPV, is therefore a slightly negative growth.

Table 8 - Sensitivity AnalysisRail Cost Assumption base case +20% base case base case

Demand Assumption as projected as projected -20% zero growth

Trucking Costs as estimated as estimated as estimated -20%

Investment Costs as estimated as estimated as estimated as estimated

IRR NPV IRR NPV IRR NPV IRR NPV(%) (US$ m.) (%) (USS m.) (%) (US$ m.) (%) (US$ m.)

Nordeste 20 28 2 -26 14 6 -3 -30

Centro-leste 68 652 52 469 48 358 7 -26

Sudeste 107 1198 83 938 64 513 22 57

Sul 55 404 29 148 40 222 19 40Oeste 101 141 60 77 78 91 33 17

Tubarao 373 12 150 9 77 2 91 2

Total 68 2435 49 1615 45 1192 13 60

- 96 - Annex 11

BRAZIL

FEDERAL RAILWAY RESTRUCTURING AND PRIVATIZATION PROJECT

Table 1 - Project Cost and Financing

----------------------- Quantities --------- Base Cost---------------- Financing--Project Component Unit Price Total 1996 1997 1998 1999 2000 1996 1997 1998 1999 2000 Total GOB Bank

Operations Restructuring & Concessloning (ORC) 8.1 3.1 1.6 0.1 0.1 13.1. studies B.0 3.0 1.5 12.5 100%technical assistance hm 12.0 48 6 12 12 12 6 0.1 01 0.1 0.1 0.1 0.6 100%

Staff Retrenchment Program (SRP) 196.2 156.1 42.7 0.0 0.0 396.0early retirement u 10.0 4000 4000 40.0 0 0 0.0 0.0 0.0 40.0separation grants u 189 18000 8000 8000 2000 151.2 151.2 37.8 0.0 00 340.1 50% 50%retraining packages u 1.3 9500 3500 3000 3000 4.6 3.9 3.9 0.0 0.0 12.4 100%outplacement assistance u 0 5 5000 1000 2000 2000 0.5 1.0 1.0 0.0 0.0 2.5 100%

Emergency Rehabilitation Program (ERP) 107.6 128.1 12.6 0.0 0.0 248.3locomotive rehabilitation u 442.5 240 120 120 53.1 53.1 0.0 0.0 0.0 106.2 20% 80%locomotive & wagon wheel sub u 1.0 13500 7000 6500 7.0 6.5 0.0 0.0 0.0 13.5 100%locomotrve battery substitution u 20.0 200 100 100 2.0 2.0 0.0 0.0 0.0 4.0 100%wagon conversion u 10.0 300 100 200 10 2.0 0.0 0.0 0.0 3.0 20% 80%emergency track repair & stabil km 10.0 2300 500 1000 800 5.0 100 8.0 00 0.0 230 20% 80%telecom & signalling systems Is 10.0 650 150 350 150 1.5 3.5 1.5 0.0 00 6.5 20% 80%workshop consolidation Is 10.0 1210 300 600 310 30 6.0 3.1 0.0 0.0 12.1 10% 80%locomotive repair& maintenanc u 400.0 150 50 100 200 400 00 0.0 0.0 60.0trackmaintenance Is 10000 20 15 5 150 5.0 0.0 0.0 00 20.0

Environmental Management Component (EMC) 04 0.5 0.1 0.1 0.1 1.2site surveys Is 1 0 700 300 400 0,3 0.4 0.0 0.0 0.0 0.7 100%technical assistance and trainin Is 1.0 500 100 100 100 100 100 0.1 0.1 0.1 01 0.1 0.5 100%

Regulatory Reform Component (RRCJ 0.1 0.1 0.0 0.0 0.0 0.3technical assistance hm 15.0 12 6 6 01 01 0.0 0 0 0.0 0.2 100%training tr.week 1 0 100 20 40 40 0.0 0.0 0.0 0.0 0.0 0.1 100%

Financial Restructuring and SeKtlement (FRS) 1.2 2.6 2.1 1.1 04 7.5project management assistanc hm 12.0 108 18 36 36 18 0.2 0.4 0.4 0.2 0.0 1.3 100%real estate management assist hm 12.0 200 25 50 50 50 25 0.3 06 06 0.6 0.3 24 100%engineering&workssupervisio hm 80 320 70 150 100 06 12 0.8 00 00 26 100%equipment&software Is 1.0 800 100 300 200 200 0.1 0.3 02 02 00 0.8 100%training tr week 1.D 450 50 100 100 100 100 0.1 01 0.1 0.1 0.1 0.5 100%

Total Capital (base) Cost 313.6 290.6 59.2 IA 0.6 665.3

physical contingencies 10.0% 10.9 13.1 1.5 0.1 0.1 25.7 50% 50%price contingencies 0.6% 2.4% 2.4% 2.4% 2.4% 1.0 5.3 2.5 0.1 0.1 9.0 50% 50%

Total Project Cost 326.5 309.0 63.2 1.6 0.7 700.0 50%

Bank Financing: 148.3 161.3 38.3 1.5 0.6 350.0 50%category 1 (separation grants) 75.6 75.6 18.9 00 0.0 170.1category 2 (goods & services) 44 5 46.9 1 2 0.0 0.0 92.6category 3 (goods) 91 8.8 02 0.2 00 18.3category 4 (civil works) 64 128 89 00 0.0 28.1category 5 (consultants and training) 6.8 8 0 7 1 1.2 0.6 23.6category 6 (unallocated) 60 9.2 2.0 01 01 17.4

Government of Brazil 1020 102.1 246 0.1 01 2289 33%

RFFSA 75 3 45.6 0 3 0.0 0.0 121.2 17%

Sources: RFFSA and Mission EstimatesMay 1996

- 97 - Annex 11

BRAZIL

FEDERAL RAILWAY RESTRUCTURING AND PRIVATIZATION PROJECT

Table 2 - Monitoring Indicators and Targets

Proeram/Obietives Indicator 12/31196 6/30/97 12/31/97 6/30/98 12/31/98 12/31/99 12131/00I. IMPLEMENTATION PROGRESS'A. Operations Restructuring & Concessioning

concession bidding & contracting no. of bidding doc. published 2 4 6no. of auctions completed 2 4 5 6no. of concessions contracted 1 2 4 5 6

organization of RFFSA superv. function no. of regional units operational 1 2 4staffing of RFFSA2 no. of staff 755 400 450 500 500 500 500

B. Staff Retrenchment. reduction of staff3 no. of contracts terminated 8000 13000 16000 17000 18000. ofwhich retirement no. ofemployees retired 3000 3500 4000 4500 5000

re-training of redundant staff no. of staffre-trained 3000 5000 6000 8500 9000. re-employment assistance no. of staffre-employed 1900 5800 9400 11700 12500 12900 13000

C. Emergency Rehabilitationrehabilitation of locomotives no. of loco rehabilitated 80 160 240replacement of loco & wagon wheels no. ofwheels replaced 5000 10000 13500rehabilitation oftracks expenditures (US$ m) 5 10 15 23deferred maintenance of locomotives expenditures (US$ m) 50 150maintenance of tracks expenditures (US$ m) 1 5 20

D. Environmental Management. environmental surveys no. ofsites surveyed 100 150

E. Regulatory Reform.strengthening of regulatory function no. oftrainee-weeks 25 50 75 100

F. Financial Restructuring & Settlementrail asset management rail revenues (US$ m) 95 160 230 300 370 500 650real estate sales sale revenues (US$ m) 10 50 100 200 300 600 1000debt reduction payments of principal. (US$ m) 10 50 100 200 300 500 700

II. DEVELOPMENT OBJECTIVES' 1995 1996* 1997* 1997** 1998* 1998** 1999 2000

reduced transport costs average cost (US cent/ton-km) 2.5 2.5 2.4 2.4 2.3 2.2 2.1 2.0increased market share traffic (billion ton-km/year) 35 35 37 39 41 43 48 53staffproductivitv million ton-km per employee 1.0 1.1 1.3 1.5 1.7 1.9 2.1 2.3locomotive productivity loco availability (% offleet) 50 52 58 65 70 75 78 80

locoproductivity(millionton- 52 52 53 54 55 56 58 60km/yr)

I/All implementation progress targets are cumulative2/ Excluding staffin not-yet concessioned operations3/ Based on the 41,991 staffas of May 954/ All development objective targets are totals or averages during the period* first semester** second semester

Sources: RFFSA and Mission EstimatesMay 1996

- 98 - Annex 11

BRAZIL

FEDERAL RAILWAY RESTRUCTURING AND PRIVATIZATION PROJECT

Table 3 - Procurement Schedule for Major Contracts

Type of NO of Type of Documents Bids Prop. Contract Delivery InitiationComponent Contract Contracts Bidding Ready Invited Signature of Goods b/ of Works

LOCOMOTIVESBid 1-Lot 1 Supp/works 1 ICB Mar-96 Apr-96 Aug-96 Aug-96-Lot 2 Supp/works 1 ICB Mar-96 Apr-96 Aug-96 Aug-96-Lot 3 Supp/works 1 ICB Mar-96 Apr-96 Aug-96 Aug-96

Bid 2-Lot 1 Supplworks 1 ICB Mar-96 Apr-96 Aug-96 Aug-96-Lot 2 Supplworks 1 ICB Mar-96 Apr-96 Aug-96 Aug-96

Bid 3 Supplworks 1 ICB Mar-96 Apr-96 Aug-96 Aug-96

WHEELSBid 4-Lot 1 (Locos) Supply 1 ICB Apr-96 May-96 Aug-96 Sep-96 Oct-96- Lot 2 (Vag6es) Supply 1 ICB Apr-96 May-96 Aug-96 Sep-96 Oct-96

BATTERIESBid 5 Supp/works 1 ICB Apr-96 May-96 Aug-96 Sep-96 Oct-96

Bid 6 Supp/works 1 NCB Apr-96 May-96 Aug-96 Aug-96Bid 7 Supp/works 1 NCB Apr-96 May-96 Aug-96 Aug-96Bid 8 Supp/works 1 NCB Apr-96 May-96 Aug-96 Aug-96Bid 9 Supp/works 1 NCB Apr-96 May-96 Aug-96 Aug-96

TRACKSBid 10 Works 1 NCB May-96 Jun-96 Sep-96 Sep-96Bid 11 Works 1 NCB May-96 Jun-96 Sep-96 Sep-96Bid 12 Works 1 NCB May-96 Jun-96 Sep-96 Sep-96Bid 13 Works 1 NCB May-96 Jun-96 Sep-96 Sep-96Bid 14 Works 1 NCB May-96 Jun-96 Sep-96 Sep-96Bid 15 Works 1 NCB May-96 Jun-96 Sep-96 Sep-96Bid 16 Works 1 NCB May-96 Jun-96 Sep-96 Sep-96Bid 17 Works 1 NCB May-96 Jun-96 Sep-96 Sep-96

SYSTEMSBid 18(SMT) Supp/works 1 NCB May-96 Jun-96 Sep-96 Sep-96Bid 19(SRP) Supp/works 1 NCB May-96 Jun-96 Sep-96 Sep-96Bid 20(SINAL) Supp/works 1 NCB May-96 Jun-96 Sep-96 Sep-96

WORKSHOPSBid 21 Works 1 NCB Jun-96 Jul-96 Oct-96 Oct-96Bid 22 Works 1 NCB Jun-96 Jul-96 Oct-96 Oct-96Bid 23 Works 1 NCB Jun-96 Jul-96 Oct-96 Oct-96Bid 24 Works 1 NCB Jun-96 Jul-96 Oct-96 Oct-96

WAGON CONVERSIONBid 25-Lot 1 Supp/works 1 NCB Jun-96 Jul-96 Oct-96 Oct-96-Lot 2 Supp/works 1 NCB Jun-96 Jul-96 Oct-96 Oct-96

TECHNICAL ASSISTANCE Services Several NCB Jun-96 Jul-96 Sep-96 Sep-96

RETRAINING PACKAGES Services Several NCB May-96 Jul-96 Aug-96 Sep-96

Sources: RFFSA and Mission EstimatesMay 1996

- 99 - Annex 11

FEDERAL RAILWAYS RESTRUCTURING AND PRIVATIZATION PROJECT

Table 4 - Allocation of Loan Proceeds

AmountLoan Category ($ million) Disbursement Rates

1. Separation Grants 170.0 50% of total expenditures2. Goods and Services 95.0 80% of total expenditures3. Goods 20.0 100% of foreign expenditures

100% of local ex-factory cost4. Civil Works 25.0 80% of total expenditures5. Consultants & Training 100% of total expenditures

(a) retraining and outplacement 15.0(b) technical assistance and training 5.0

6. Unallocated 20.0Total 350.0

Table 5 - Estimated Schedule of Disbursements

Bank Fiscal Year Disbursement Cumulative DisbursementsQuarter ending in Quarter (US$m.) (US$m.) % of totalFY 1997September 30, 1996 1/ 80.0 80.0 23December 31, 1996 20.0 100.0 29March 31, 1997 25.0 125.0 36June 30, 1997 25.0 150.0 43FY 1998September 30, 1997 25.0 175.0 50December 31, 1997 25.0 200.0 57March 31, 1998 25.0 225.0 64June 30, 1998 25.0 250.0 71FY 1999September 30, 1998 20.0 270.0 77December 31, 1998 20.0 290.0 83March 31, 1999 10.0 300.0 86June 30, 1999 10.0 310.0 89FY 2000September 30, 1999 10.0 320.0 91December 31, 1999 10.0 330.0 94March 31, 2000 5.0 335.0 96June 30, 2000 5.0 340.0 97FY 2001September 30, 2000 5.0 345.0 99December 31, 2000 2/ 5.0 350.0 100

Sources: RFFSA and Bank Mission

1/ includes initial deposits less than US$40 million into Special Account

2/ loan Closing Date

May 1996

- 100-

BRAZIL Annex 11I ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~Chart I

FEDERAL RAILWAYS RESTRUCTURING AND PRIVATIZATION PROJECT

1996 1 1997ID Task Name Durat Start Finish Qtr 4 Qtr 1 Qtr 2 Otr 3 Qtr 4 | Qtr 1 Qtr 2 |Qtr 3 | Qtr 41 LOAN PROCESSING 80d 5113196 8130196

2 Loan Negobations lw 5/13/98 5/17/96

3 Board Review & Approval 14d 6/3/19 6&20/96 I-s4 Loan Signing Od 6121/96 6/28/96

5 Loan Effectiveness 46d 6/28196 /130/96

6 OPERATIONS RESTRUCTURING & 523d 1/1196 12131197

7 Oeste 95d 111196 5110196 _ _

8 separation of assets ld 1/1/96 1/1/96

9 pre-qualification 27d 1/29196 3/5/96

10 auction Od 315/96 3/5/96

11 contract negotiations & 45d 3/11/96 5/10/96

12 Cento-Leste 165d 111196 8111796 .

13 separation of assets 55d 1/1/96 3/15/96

14 pre-qualification 34d 4/30/96 6/14/96

15 auction Od 6/14/96 6/14/96

16 contract negotiations & 45d 6/17/96 8/17/96

17 Suldeste 232d 51/96 3/20/.97 .

18 separation of assets 65d 5/1/96 7/30/96

19 pre-qualification 67d 8/15t96 11115/96

20 auction Od 11 16/96 11/18/96

21 contract negotiations & B9d 11/16/96 3/20/97

22 Sul 188d 81/96 4/21/97 _

23 separation of assets 66d 811/96 10/31/96

24 pre-qualification 60d 11/25/96 2/14/97

25 auction Od 2114/97 2114/97

26 contract negotiations & 42d 2/21/97 4/21/97

27 Tubarao 155d 213/97 9/S997 l. ;__

28 separation of assets 20d 213/97 2Q26/97

29 pre-qualification 66d 3/14/97 6/13/97

30 auction Od 6/13/97 6/11397

31 contract negobations & 60d 6/16/97 9/5/97

32 Nordeste 2184d 313/97 12/31/97

33 separation of assets 66c 3/3/97 6/2197

Page 1

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- 102 -

BRAZIL Annex 11Chart 1

FEDERAL RAILWAYS RESTRUCTURING AND PRIVATIZATION PROJECT

1996 1997ID Task Name Durat Start Finish Qtr 4 Otr I Otr 2 Qtr 3 Qtr 4 Qtr 1 Qtr 2 Otr 3 Qtr 467 site sureys 316d 3/15/96 5130/97

68 training of environmental staff 370d 8/1/9 12/31t97 -69 Regulatory Reform (RRC) 449d 4115196 12131197

70 technical assistance 132d 4/15/96 10/15196

71 ftaining of regulatory staff 370d 8/1/98 12/31197

72 establishment of COFER Od 12/31t97 12t3t/97

73 Financial Restructuring & Settleme 327d 101196 12/31/97

74 real estate management conur 327d 10/1/9 12131197

75 Project Management 523d 11iiSs 12/31197

76 project management contract 327d 10/11t9 12/31/97

77 computerized project manage 196d 1/1/96 9/30/96

Page 3

- 103 - Annex 11

BRAZIL

FEDERAL RAILWAYS RESTRUCTURING AND PRIVATIZATION PROJECT

Chart 2 - RFFSA Reorganization Chart

AD ENISITRATNEI

COUN)5CIL

SETTLEMENT CAAAI PAON

DVSMSON DM90 mSGA

-4~4

ESITATE ANDI EI-SAEETY L TEC" C ---T----- -

I I - -- I~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~-- ---

._ ____,_____. _ ...... ... _ j .. _~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~T........ .. ...

* I r ~~ASMINSTRATIDN _ CONTROL -&NARIWBT I 8I __

UNIT5 ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~~~EET - OIT

CENTRO LEST E5TTI~~~~~~~~~~~~~ DEE_

LEGEND

UNITS TO BE CLOSED

TRANSITORY UTNTS

PERMANENT UNITS

- 104 - Annex 12

BRAZIL

FEDERAL RAILWAYS RESTRUCTURING AND PRIVATIZATION PROJECT

Project Monitoring and Supervision Plan

1. In order to effectively manage the implementation of the project, RFFSA has established a ProjectManagement Unit (PMU) and will contract project management assistance from a specialized ProjectManagement firm (PM). RFFSA, during project preparation, has started to develop and establish anappropriate computerized project management system (CPMS) to monitor the implementation of theproject, including producing adequate information to report to RFFSA management, the Government, andto the Bank. RFFSA will finalize the system and, on the basis of the CPMS, prepare and forwardquarterly progress reports to the Bank, not later than one month after the end of each quarter.

2. The Bank will supervise and monitor the implementation of the project in accordance with thePlan presented on the next page. In the course of project implementation, the Bank will in particularreview and approve: (a) disbursement applications for severance payments, on a sample basis; (b) allprocurement documentation for contracts for goods, services and civil works at or above the prior reviewthresholds; (c) the terms of reference, invitation letters, short-lists and draft contract for consultantservices; and (d) the quarterly progress reports. In addition, substantial Bank input will be needed duringthe first two years of the project in order to: (e) closely supervise and monitor the implementation of thestaff retrenchment program, in order to derive lessons for future reform operations; and (f) provideguidance on the development, monitoring and evaluation of the regulatory aspects of the concessions, inparticular for the Sudeste and the Nordeste concessions. The estimates of Bank supervision inputs intokey activities, which are shown in the table of this annex, take into consideration the expected supportneeded by RFFSA and the Government to effectively implement the project.

3. The Bank will monitor the implementation and the impacts of the project against the agreedproject implementation plan (PIP), including the implementation timeschedule, the procurement timetableand the set of implementation and development objective indicators which are set forth in the PIP(Annex 11). Detailed reviews of the implementation of the project would be carried out in June each yearduring project implementation and when 50% of the loan amount allocated to separation grants has beendisbursed. The reviews would cover all the agreed actions, target dates, and implementation indicatorsincluded in the PIP and the status of compliance with all covenants of the Loan and Project Agreements.Particular importance would be given to: (a) progress in the restructuring and concessioning process;(b) staff reductions, re-training and outplacement assistance; (c) progress under the emergencyrehabilitation program and the environmental management component; and (d) progress under thefinancial restructuring and settlement program, including achievement of targets for sale of non-rail assetsand reduction of debt. The Bank would have the right to exercise appropriate remedies if performanceis not satisfactory.

-105 - Annex 12

BRAZIL

FEDERAL RAILWAYS RESTRUCTURING AND PRIVATIZATION PROJECT

Bank Supervision Input into Key Activities

Approx. Key Activities Expected SkillDates Requirements

09196 Project Launch Workshop and supervision, Task Managerincl. conditions of effectiveness and Regulation Specialistorganizational arrangements, and Personnel Management Specialistregulatory arrangements for Sudeste. Procurement Specialist

1 2/96 Supervision Mission: review progress on Task Managerstaff retrenchment, contracting and Environment Specialistexecution of rehabilitation and TA, Financial Specialistregulation, Nordeste model, and financial Railway Engineerrestructuring.

06/97 Detailed Review: review progress under all Task Managercomponents and impacts against indicators Personnel Management Specialistand targets, compliance with covenants, Environment Specialistidentify deviations and agree on corrective Railway Engineeractions, benchmarks and remedies.

1 2/97 Supervision Mission: review progress under Task Managerall components, including actions and Railway Engineerbenchmarks agreed at detailed review. Organization Specialist

06/98 Detailed Review: review progress under all Task Managercomponents and impacts against indicators Personnel Management Specialistand targets, loan covenants, identify Railway Engineerdeviations and agree on corrective actions, Environment Specialistbenchmarks and remedies.

1 2/98 Supervision Mission: review completion Task Managerand post-evaluation of staff retrenchment Railway Engineerand emergency rehabilitation programs, Financial Specialistand progress on technical assistance andtraining.

1 999 Two Supervision Missions Task ManagerRailway Engineer

2000 Two Supervision Missions Task ManagerRailway Engineer

2001 Loan Closing Task Manager(Implementation Completion Report) Railway Engineer

Total Staff Input: 120 staff-weeks

-106 - Annex 13

BRAZIL

FEDERAL RAILWAYS RESTRUCTURING AND PRIVATIZATION PROJECT

Table 1 - Transportation Expenditures by Mode1'

PASSENGER US$m. CARGO US$m.

AIR 3360 AIR 998

- Domestic 1231 - Domestic 301

regular 1160 regular 267

regional 71 regional 14

- International 2129 - Intemational 696

AIRPORTS 182 RAIL 1659

- RFFSA 999

RAIL 605 - FEPASA 374

- Interurban 3 - EFVM 286

- Suburban 350

- Metro 252 ROAD 35245

- Truck 35245

ROAD 43267 urban 13917

- Bus 6177 intermunicipal 11120

urban 3257 interstate+intl 10208

intermunicipal 2115

interstate + intl 804 PORTS (Portobras) 590

- Auto 37090

WATER 5479

- inland 141

- coastal 533

- international 1905

TOTAL 47414 TOTAL 43970

Sources: Anuario Estatistico dos Transportes - GEIPOT - 1992/93Perfil das Empresas Estatais - SEST/SEPLAN 1985Empresas de Transporte Rodoviario - FIBGE 1990/92Estudo sobre o Transporte Rodoviario de Cargo - GEIPOT 1995

1994 Estimates of public and private service expendituresGDP in 1994 reached US$ 430 billion, in US$ of June 1994

May 1996

- 107 Annex 13

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FEDERAL RAILWAYS RESTRUCTURING AND PRIVATIZATION PROJECT

Table 2 - Evolution of National and Transportation Aggregates

GROSS PRODUCT

GDP DiESEL TKM PASS.KMIYEAR INDEX AGRICULTURE INDUSTRY SERVICES TRANSPOiR CONSUiMPTION (GEIPOT) (GEEPOI)

1970 100 100 100 100 100 100 100 100

1971 111 110 112 III 115 110 109 113

1972 125 115 128 125 124 128 115 129

1973 142 115 149 145 148 149 133 147

1974 164 116 162 160 170 165 159 167

1975 162 124 170 168 187 184 174 190

1976 178 127 190 187 211 212 189 217

1977 187 142 185 197 224 227 208 253

1978 196 138 209 209 243 248 225 289

1979 210 145 223 225 287 270 247 328

1980 229 159 243 245 297 290 208 374

1981 219 171 222 240 282 281 209 389

1982 220 170 222 245 287 287 287 405

1983 212 189 209 243 281 283 268 421

1984 224 175 223 253 293 292 296 438

1985 241 193 241 269 312 304 327 456

1986 260 177 270 291 347 342 355 476

1987 269 204 272 301 353 382 379 493

1988 268 205 265 308 379 375 403 510

1989 278 211 273 320 393 385 411 533

1990 287 203 201 317 376 378 423 552

1991 289 209 245 323 388 395 448 573

1992 267 220 237 323 397 405 427 589

1993 278 218 253 334 413 n.a. n.a. n.a.

1994 294 235 270 348 430 n.a. n.a. n.a.

GROWTH RATE:

70-80 8.63 4.73 9.30 9.39 11.11 11.29 10.40 14.0980-90 1.54 2.52 0.29 2.81 2.80 2.68 4.53 3.9690-94 2.45 3.75 1.92 2.29 3.28 3.58 0.55 3.33

ABSOLUTEVALUE ' 519910 68334 178241 273813 20548 26410 566078 684089(1990 US$ million) (1000 M3) (10E9 TKM) (IOE9 PASS. KM)

Sources: Anuario Estatistico dos Transportes - GEIPOTAnuario Estatistico do CNDAnuario Estatistico do Brasil - IBGE

I/ year of latest available data2/ Latest available data

May 1996

- 108 - Annex 13

BRAZIL

FEDERAL RAILWAYS RESTRUCTURING AND PRIVATIZATION PROJECT

Table 3 - Freight Railway Productivity Ratios (1994 or Latest Available Year)

Traffic Traffic Units FRT Rev/Ton-km Passenger-Km No. of Units/km per Employee T-km(million) (million) Line Km Employees (000) (000) (94 US cents)

ARGENTINA 1. 6,485 29,118 5,151 223 1,259 4.6NCA 1,189 4,520 865 263 1,375 4 9FEPSA 982 5,163 575 190 1,708 4 3FerrosurRoca 854 4,791 808 178 1,057 5.0Bs. As al Pacifico 2,029 5,493 1,079 369 1,880 3.8Mesopotamico 620 2,751 524 225 1.183Belgrano 811 6,400 1,300 127 624 5.2

CHILE FREIGHT (FEPASA) 2. 1,111 2,200 800 505 1,389 6.3

BRAZIL (RFFSA) 39,193 21,715 40,581 1,805 966 4.7Nordeste 926 4,260 4,402 217 210 6.5Centro-Leste 6,886 7,092 8,608 971 800 6.2Sudeste 20,370 1,770 9,982 11,508 2,041 3.9Sul 9,019 6,814 10,208 1.324 884 5.3Tubarao 96 168 351 571 274 3.8Bauru 1,916 1,611 2,655 1 189 722 4.8

BRAZIL (FEPASA)- 1994 6,520 1,100 4,929 15,319 1,546 497 6.7

BRAZIL (EFVM) - 1994 50,137 898 4.991 55,832 10,045 na

BRAZIL (Carajas) - 1994 37,500 1,175 1,814 31,915 20.673 na

BOLIVIA (1993) 697 3,698 5,255 188 133 8.9Andina 322 114 2,082 2,443 209 203Oriental 370 1,383 1,431 268 380

MEXICO (FNM) 37,200 20,445 48.000 1,820 775 6.2Northwest (est) 17,200 6,200 21,300 2,774 808Northeast (est) 14,000 3,960 9.830 3,535 1,424Southeast (est) 3,200 2,200 9,043 1,455 354Short Lines 2,900 8,000 7,827 363 371

PERU (1994) 484 241 1,609 3 337 450 217 1.8Southeastern 5 83 185 474Central 209 49 509 507Southern 269 110 915 414

GUATEMALA (94 est) 28 240 640 430 420 624 na

SUB-SAHARAN AFRICAN RAILWAYSCote d'lvoire/Burkina Faso 371 125 651 1,887 762 263 7.0Cameroun 592 450 1,006 3,853 1,036 270 1.6Malawi 52 65 789 3 658 148 32 3.4Gabon 295 98 683 1,893 575 208 5.0Congo 339 421 510 4,989 1,490 152 7.1Senegal/Mali (intl only) 752 346 1,548 4,935 709 222 0.3Zambia 1,025 241 1,273 8,544 995 148 2.0Togo (mgt contract) 19 9 532 800 53 35 na

MOROCCO 4.877 2,233 1,907 14,085 3,728 505 59

NEW ZEALAND 2,455 525 4,000 4,500 745 662 0.3

US RAILWAYSConrail 3. 128,627 19,082 24,728 6,741 5,202 2.7DSRGW 25,596 3,515 2,274 7,282 11,256 1.4

CANADIAN NATIONAL 159,540 29.700 27,979 5,372 5,702 3.8

Sources' RFFSA and Mission Estmates

1. Concessioned between 1993 and 1995. Suburban passenger concessions not shown.2. Concessioned in June. 19953. Privatzed in 1987

May 1996

- 109 - Annex 13

BRAZIL

FEDERAL RAILWAYS RESTRUCTURING AND PRIVATIZATION PROJECT

Table 4 - RFFSA Traffic, Productivity and Financial Ratios, 1958-1995

Working Operating

Traffic" Locomotive PRODUCTI\ATY AND EFFICIENCY MEASURES Ratio % Ratio (%)

Tonnes Ton-Km Pass. P-Km Units Track Employees Nb. avail. Wagons Avg Haul TUIKm TUJEmp TUILOC TU/Wag (Rev-Norm)/ (Rev-Norm)/

Year (000) (miilion) [million) (miilion) imiiliont KM _- I) Nb. (Ki) (0001 (000) (0001 (000) OPS EXP Est total cost

58 27,496 6,928 340 12,000 18.928 28,776 157,311 na. n a n a 252 658 120 na n a 47 36

59 29,509 7,635 359 12,000 19.635 28,728 154,266 n a n a n a 259 683 127 n a n a 43 33

60 29,769 7,791 371 12,914 20.705 28,809 153,539 n a n a n a 262 719 135 n a n.a 41 31

61 29,224 7,828 400 13,830 21.658 28,679 153,007 n a n a n a 268 755 142 n a n a 35 27

62 28,997 8,089 14,675 22.764 27,927 153,153 n a n a n a 279 815 149 n a n a 30 23

63 27,674 8,071 14,082 22.153 27.260 154,001 n a n a n a 292 813 144 n a n a 27 21

64 28.826 8,554 13,529 22,083 26,519 153,434 n a n a n a 297 633 144 n a n a 28 21

65 29,596 9,201 353 13,093 22,294 26,114 145,821 na na na 311 654 153 na n.a 40 30

66 29,413 9,631 302 10,532 20,163 25,093 137,712 na na na 327 604 146 n a na 43 33

67 28,564 9,462 293 9,680 19,162 25,116 132.533 n a n a n a 332 763 145 n a n a 42 32

68 30,495 10,464 313 9,993 20,457 24,864 127,427 n a n a n a 343 823 161 n a n a 53 41

69 32,141 10,570 303 9,497 20,067 25,313 125,230 n a n a n a 329 793 160 n.a n a 54 41

70 33,075 12,232 283 8,704 20,936 25,101 124,833 n a n a n a 370 834 168 n a na 58 45

71 30,589 11,580 261 7,764 19,344 24,772 121,492 na na na 379 781 159 na na 54 42

72 30,995 11,859 265 7,988 19,847 24,546 116,337 na na na 383 809 171 na na 60 46

73 35,492 14,150 259 7,802 21,952 24,064 113,851 n a n a n a 399 912 193 n.a n a 63 48

74 43,292 18,249 7,813 26.062 24,119 111,846 na na na 422 1,081 233 na na 67 51

75 46,446 19,851 243 7,628 27.479 24,491 110,279 na na na 427 1,122 249 n a na 44 34

76 51,090 23,447 8,686 32,133 24,163 110,279 n a n a n a 459 1,330 291 n.a n a 38 29

77 53,519 25,251 8,858 34.109 23,649 95,160 n a n a n a 472 1,442 356 n a n a 52 40

78 54,219 25,202 9,191 34.393 23,809 94,931 n a n a n a 465 1,445 362 n a n a 51 39

79 60,921 27,689 336 8,746 36,435 23,897 94,959 n a n a n a 455 1,525 384 n.a n a 55 42

80 70,760 33,260 370 9,460 42,720 23.951 89,420 2,090 88 9 47,570 470 1,784 478 20,440 699 99 76

81 67,856 31,087 384 10,018 41,105 23,171 88,325 2,146 87 7 47,897 458 1,774 465 19,154 649 96 74

82 69,828 31,687 396 10,386 42,073 23,087 84.632 2,221 87 1 47,411 454 1,822 497 18.943 668 87 67

83 69,774 29,633 429 11,033 40666 23,083 82,982 2,261 899 47,341 425 1,762 490 17,986 626 101 78

84 76,938 33,526 507 1,860 35386 22,837 85,736 2,328 924 47,175 436 1,550 413 15,200 711 101 78

85 82.622 37,176 50 1,688 38,864 22,184 67,522 1,669 886 46,533 450 1,752 576 23,286 799 101 77

86 85,661 38,768 46 1,742 40,510 22,057 63,878 1,590 87 7 46,397 453 1,837 634 25,478 836 116 89

87 82 259 37,264 41 1,469 38,733 22,067 62.829 1,590 81 9 45,120 453 1,755 616 24,360 826 103 79

88 81,476 37,399 7 700 38.099 21,865 58,683 1,561 83 0 43,867 459 1 742 649 24,407 853 87 67

89 81.149 37,609 6 427 36,036 22,137 58,449 1,545 823 42984 463 1,718 651 24,619 875 88 68

90 75,210 34,553 6 453 35,006 22,029 52,976 1,545 79 1 41 930 459 1,589 661 22,658 824 54 4291 80,579 36,402 5 401 36 803 22,029 49,341 1,516 77 5 41 837 452 1,671 746 24,276 870 65 50

92 80,689 37,057 37,057 22.011 47,759 1,431 759 41,492 459 1,684 776 25,896 893 91 70

93 85.618 39,803 39,803 22,069 46,063 1,403 732 41,025 465 1,804 864 28,370 970 113 86

94 86,608 39,193 39 193 22,069 44,646 1,396 69 5 40,544 453 1,776 878 28,075 967 86 66

95 83,012 36,388 36,389 21,833 37,469 1,390 530 36342 438 1,663 971 26,178 1,001 64 43

Sources

1 Brazil The Brazilian Railroad industry Options for Organizational Restructuring, World Bank Report No 11752 BR, February 15, 1994

2 RFFSA, "Tabela de Origem e Destino - 1993

3 World Bank Railway Database

4 RFFSA, "Evolucao da Disponibilidade - locomotive availabilty for various Regions

5 RFFSA, "Receita de Transpone Faturada", "Producao em Miihoes de TKU', "Producao em Milhares de TU', all for 1990 - 1995(est)

6 RFFSA, "Plano Para o Banco Mundial, Versao IIE Agosto de 1995 Has maps and certain operational data

7 RFFSA, "Modelo Financeiro" Has financial projections for concessions for 1995-2000

8 RFFSA, "Programa Comercial" Has traffic data by product for 1992-1994 and projections for 1995, 1998 and 2000 for each concession

9 RFFSA, "Projeto de Reestructuracao e Desestatizacao da RFFSA" Agosto 199510 RFFSA, "RFFSA- Documento de Trabalho - Prelimmnar'

1 1 Svejnar and Terrell "Labor redundancy in theTransport Sector The Case of Brazili, World Bank Research project no 675-21

Note 1/ Traffic Units are the sum of ton-km and passenger-km

May 1996

- 110 - Annex 13

BRAZIL

FEDERAL RAILWAYS RESTRUCTURING AND PRIVATIZATION PROJECT

Table 5 - RFFSA's Investments(1987- 1994)

1987 1988 1989 1990 1991 1992 1993 1994

Broad Gauge Network: 68.7 126.6 48.2 18.4 11.4 1.9 2.0 0.8Ferrovia do Aco (SR3) 17.2 86.2 31.6 6.0 2.0 1.2 0.2 0.1Central Line 15.9 18.5 5.0 1.1 0.5 0.2 1.7 0.6Other 35.6 21.9 11.6 11.3 8.9 0.5 0.2 0.1

Meter Gauge Network 88.0 109.1 79.5 35.7 35.2 62.1 58.1 37.1Parana Corridor 29.9 40.3 28.6 7.5 12.3 30.3 20.6 19.0Goias Minas Corridor 28.9 42.9 37.1 11.5 6.9 22.3 35.0 16.9Other 29.2 25.9 13.8 16.7 16.0 9.5 2.5 1.2

Motive Power/Rolling Stock 42.5 17.4 11.2 9.8 4.0 2.0 2.4 9.7

Miscellaneous 12.0 14.1 15.1 5.7 11.8 1.0 1.1 10.0

TOTAL RFFSA 211.2 267.2 154.0 69.6 62.4 67.0 63.7 57.5

Sources: RFFSA and Mission Estimates

Table 6 - RFFSA -- Statements of Income(US$ millions)

1988 1989 1990 1991 1992 1993 1994

Gross Operating Revenues 753.0 706.0 668.0 752.0 851.1 757.8 799.4Other Income 37.0 24.0 45.0 43.0 26.5 28.1 35.8

Gross Revenues 790.0 730.0 713.0 795.0 877.6 785.9 835.2

Less Taxes 0.0 38.0 42.0 59.0 39.0 34.5 40.9Net Operating Revenues 790.0 692.0 671.0 736.0 838.6 751.4 794.3

"Normalization Payments" ' 96.0 81.0 38.0 113.0 10.6 14.5 21.3TOTAL Net REVENUES 886.0 773.0 709.0 849.0 849.2 765.9 815.6

Operating Expenses-- Regional 868.0 914.0 809.0 948.0 791.5 816.2 935.3Operating Expenses-- Headquarters 408.0 193.0 381.0 203.0 38.3 34.2 39.4

Total Operating Expenses 1276.0 1107.0 1190.0 1151.0 829.8 850.4 974.7

NET OPERATING INCOME -390.0 -334.0 -481.0 -302.0 19.4 -84.5 -159.1

Sources: RFFSA and Mission Estimates' Normalization payments are payments made by the Government to RFFSA to compensate for public service oblligations.May 1996

- 111 - Annex 14

BRAZIL

FEDERAL RAILWAYS RESTRUCTURING AND PRIVATIZATION PROJECT

Selected Documents and Data Available in the Project File

Bank Documents

1. Initial Project Information Document, June 30, 19952. Preparation Mission Aide-Memoire. September 19953. Preparation Mission Aide-Memoire, October 19954. Pre-appraisal Mission Aide-Memoire, February 19965. Final Executive Project Summary, April 5, 19966. Staff Retrenchment Program, Retraining and Outplacement Assistance7. Procurement Schedule for Major Contracts

Borrower and/or RFFSA Documents

8. Anuario Estatistico das Ferrovias do Brasil, MT/DTF, 19959. Regulamnento dos Transportes Ferroviarios, Decreto No. 1832 de 4 de Mar,o de 199610. Medida Provisoria No. 1342 de 12 de Marco de 1996 (Creation of COFER)11. Avaliacao Econ6mica-Financeira. Malha Oeste, Rel. Conclusivo. BNDES/Ernst & Young12. Avaliac,o Econ6mica-Financeira, Malha Oeste, Rel. Conclusivo, BNDES/ENEFER13. Edital No. PND/A-05/95/RFFSA, Concessao Malha Oeste, BNDES/RFFSA14. Prospectus Notice No. PND/A-05/95/RFFSA, Concession of Western Network, BNDES/RFFSA15. Relatorio Anual, RFFSA, 199416. Projeto de Reestrutura,co e Desestatiza,ao da Rede Ferroviaria Federal SA, Out. 9517. Proposta de Readequa,co dos Procedimentos de Opera,co e Manutenpio, RFFSA, Out. 9518. Proposta de Readequac,o dos Procedimentos de Opera,co e Manutencao, RFFSA, Dez. 9519. Projeto de Treinamento e Reemprego de Pessoal, RFFSA, Out. 9520. Minirniza,co dos Custos Sociais da Privatiza,co. RFFSA. A. Urani, IPEA, Dez. 9521. Draft Technical Assistance Contract between RFFSA and Funda,ao Getulio Vargas, Nov. 9522. Contract No. 032/95 between RFFSA and Funda,co Getulio Vargas, Dec. 4, 9523. Situa,co da Frota de Locomotivas, RFFSA, Sept. 9524. Programa de Racionaliza,co de Oficinas, RFFSA, Dez. 9525. Seguran,a Industrial e Meio Ambienite, Diretrizes Ambientais Para a RFFSA, A,ces26. Seguranca Industrial e Meio Ambiente, Legisla,ao e Regulamenta,co27. Programa de ManutenSao de Locomotivas, RFFSA (2 volumes)28. Programa de Recuperacao de Vagoes, RFFSA (2 volumes)29. Programa de Seguranca de Via e Anexos, RFFSA (5 volumes)30. Programa de Seguranra de Via, Sistemas, RFFSA31. Programa de Racionaliza,co de Oficinas, RFFSA32. Rela,co dos principais Imoveis da RFFSA corn Potencial para Explora,co, RFFSA33. Reestrutura,co e Organiza,co da RFFSA, Proposta, RFFSA, Abril 199634. Plano de Acao para Alienac,o dos Ativos Nao Operacionais, RFFSA. Abril 199635. Real Estate Management, Draft Terms of Reference, RFFSA, Abril 199636. Outplacement and Monitorinig of Training, Draft Terms of Reference, RFFSA, Abril 199637. Prestac,o de Servi,os de Auditoria Independenite, Termos de Referencia, Abril 1996

-112- Annex 14

38. Draft Cooperation Agreement between MT/DTF and RFFSA for supervision of concessioncontracts

39. Draft Terms of Reference for Environmental Assessment and Liability Reduction Plan40. Draft Terms of Reference for Non-Rail Asset Sale Program41. Draft Terms of Reference for Outplacement and Monitoring of Training Program42. Draft Terms of Reference for project Management Consultant43. Draft Standard Bidding Documents for Track Repair Works44. Draft Standard Bidding Documents for Signaling System Investments45. Draft Standard Bidding Documents for Telecommunication System Investments46. Letter dated May 24, 1996 from the President of RFFSA and attached Terms and Conditions of

the Staff Retrenchment Program

iBRD 27397

5 VENEZUELA G) F R. B R A Z I L

\ -< (SuRINAME¶~GUIANA 0 250 500 750 1000 KILDMESRS RA ILVWAY SCOLOMBIA J 0-. 250 4o5 7 50WLE5 RFFSA REGIONS AND

>~~~ PLANNED CONCESSIONS- .Nfl. 'Q, D .. d

NORTHEAST

- _ U rP t o S do .o,o - SR I RECIFE (METER GAUGE)

- -- - ~~~~~~~~~----SR (I P ORTALEZA (METER)

-~~~~~~~~~~~ Pork ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~Sanlan ....... SR 1 2 SAG LUIS (METER)

By, / It o do Norte X OMongubo kEt;l

CENTRAL EAST

B.o do Non. B.I.nn ~~~~~~~~~~~~~~~~~~~~~~~~SR 2 BELO HORIZONTE (mETER)

-' / ') ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~SR 7 SALVADOR (METER)

!SoOnko'*in ) ~ o05 L-. SR 8 CAMPOS (METER)

Pornoiba ~~~~~~~~~~SOUTHEAST.' ,,! /: amba F co SR 3 JUIZ DE FORA (BROAD GAUGEI

.X'~~~~~~' I k 5 ct' . S ~~~~~~~~~~~~~~~~~ Mooor.p. ~~~~~~~~~~SR 4 SAO PAULO (BROAD)

! I.~.'v" X <e;einc; Mossoro Macau SOUTH

I S.,ra do Coro,os0

P,quet Corn.,, ~~~~~~~~~~~~~~SR 5 CURT(BA (METER)

p / S/ro de Co uic1° ) Plque Corn,r V ;) ------ SR 6 PORTO ALEGRE (METER)

.4 I / Croro 0020 ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~TUBARAO. o L3/ -S>MISEO Veii;° Jo c SR 9 TUBARAO (METER)

¾ Porno Veiho 0/ Sa(~~~~~~~~~~~~~~~~~~~~~~~~~~~u.oR R.o,6 RAURU~~~~~~~~~~~~S.9-BAR

¾ SNrto -elho

\ e°vskl/ Solgul d o R clh. SR 10 BAURU (METER)

4. .-~~~~~~~~~~~ Rornosro. *-. ~~~~~~~~~~~~~~~~~~~~~~~~PLANNED SECTIONS

"'N " 0Pr ? .noF'lroLno S Mosia - BROAD GAUGE (FEPASA)

Pnopr,a .~.Cff26i.METER GAUGE (PEPASA)/ t \ ) / An nonio Cionooloes0

ProlIO. _-El" -METER GAUGE (EFVM)

P E R U£M e5eL\ / TT0su r y STANDARD GAUGE (EBF CARAJAS)

P E R U ~ ~~~~~'N/RIVERS'So(oodon 0 SELECTED CITIES AND TOWNS

"5 ' /

@ NAT(ON AL CAPITAL

"$0 p I ~~~~~~~~~~~~~~~~~~~~~~~~~STATE BOUNDARIES

. \ Clombo 0

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(~ B O L I V I A \" . -sunlt.ze ro°o- PANAMA \ VENEZUELA 0'GUYANA

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Baud. ~~~~~~d.5k CHI

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O C E A N i J j doVmn°aMow° 0SdoFnoncaoodoSuC

OCEAN I. '-....'..aa'.'Mano.I,flO Roonos / ~~~~~~~~~~~~~~~~~~~~L..ARGENTINA / ?-

J COB Rosa 0 Lag.. Lnnbmkba ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~URUGUAY

7 U~~~~RLussng 0 )'i

, A R G E N T I N A 'C..g R.. d. onoAEj

j Uruquolonogt ~~~ ~~ ~~~~- . CosomaidaSul)

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MARCH 1906

IMAG ING

Report No: 15580 BRType: SAR