Document of

The World Bank

Report No: 21892-1bR

PROJECT APPRAISAL DOCUMENT

ON A

PROPOSED CREDIT

IN THE AMOUNT OF SDR 22.2 MILLION(US$28.60 MILLION EQUIVALENT)

TO THE

KINGDOM OF LESOTHO

FOR A

UTILITIES SECTOR REFORM PROJECT

March 9, 2001

Private Sector GroupAfrica Region

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CURRENCY EQUIVALENTS

(Exchange Rate Effective March 5, 2001)

Currency Unit = Lesotho LotiLesotho Loti = US$0.12955

US$1 = 7.7 Maloti

FISCAL YEARJuly 1 June 30

ABBREVIATIONS AND ACRONYMS

AfDB African Development Bank LTC Lesotho Telecommunications CorporationCAS Country Assistance Strategy MOC Ministry of CommunicationsCPAR Countiy Procurement Assessment Report (CPAR) NCB National Competitive BiddingCTB Central Tender Board OMR Output Monitoring ReportEIB European Investment Bank PASPU Project Accounts Section of the Privatization

UnitEMP Environmental Mitigation Plan PFS Project Financial StatementEOI Expressions of Interest PEP Project Implementation PlanESKOM Electricity Services Company of South Africa PMR Project Management ReportFARAH Financial Accounting Reporting and Auditing lHandbook PPF Project Preparation FacilityFMC Financial Management Committee PPSD Privatization and Private Sector DevelopmentFMI Financial Management Initiative PSD Private Sector DevelopmentFMS Financial Management System PU Privatization UnitGoL Govermnent of Lesotho QCBS Quality and Cost Based SelectionGPN General Procurement Notice SADC South African Development CommitteeICB International Competitive Bidding SAPP Southem Africa Power PoolIDA International Development Association SDR Special Drawing RightsIMTF Interim Management Task Force SOE Statement of ExpensesLACI Loan Administration Change Initiative SPN Special Procurement NoticeLEC Lesotho Electricity Corporation UNDB United Nations Development BusinessLHDA Lesotho Highlands Development Authority USAID United States Agency for International

DevelopmentLHWP Lesotho Highlands Water Project VCL Voda Com LesothoLTA Lesotho Telecommunication Authority WTO World Trade Organization

Vice President: Callisto E. MadavoActing Country Manager/Director: Fayez S. Omar

Sector Manager/Director: Demba BaTask Team Leader/Task Manager: Mohua Mukherjee

LESOTHOUTILITIES SECTOR REFORM PROJECT

CONTENTS

A. Project Development Objective Page

1. Project development objective 22. Key performance indicators 2

B. Strategic Context

1. Sector-related Country Assistance Strategy (CAS) goal supported by the project 32. Main sector issues and Government strategy 33. Sector issues to be addressed by the project and strategic choices 10

C. Project Description Summary

1. Project components 122. Key policy and institutional reforms supported by the project 173. Benefits and target population 174. Institutional and implementation arrangements 18

D. Project Rationale

1. Project alternatives considered and reasons for rejection 192. Major related projects financed by the Bank and other development agencies 213. Lessons leamed and reflected in proposed project design 224. Indications of borrower commitment and ownership 235. Value added of Bank support in this project 23

E. Summary Project Analysis

1. Economic 242. Financial 253. Technical 254. Institutional 265. Environmental 276. Social 297. Safeguard Policies 30

F. Sustainability and Risks

1. Sustainability 312. Critical risks 323. Possible controversial aspects 33

G. Main Credit Conditions

1. Effectiveness Condition 332. Other 33

H. Readiness for Implementation 35

I. Compliance with Bank Policies 36

Annexes

Annex 1: Project Design Summary 37Annex 2: Detailed Project Description 45Annex 3: Estimated Project Costs 55Annex 4: Cost Benefit Analysis Summary, or Cost-Effectiveness Analysis Summary 56Annex 5: Financial Summary for Revenue-Earning Project Entities, or Financial Summary 67Annex 6: Procurement and Disbursement Arrangements 77Annex 7: Project Processing Schedule 92Annex 8: Documents in the Project File 93Annex 9: Statement of Loans and Credits 94Annex 10: Country at a Glance 95Annex 11: Letter of Sector Policy: Policy Statement on the Restructuring of the Power Sector 96

MAP(S)

LESOTHO

Utilities Sector Reform Project

Project Appraisal Document

Africa Regional OfficeAFTPS

Date: March 9, 2001 Team Leader: Mohua MukherjeeCountry Manager/Director: Fayez S. Omar Sector Manager/Director: Demba BaProject ID: P070673 Sector(s): BP - PrivatizationLending Instrument: Specific Investmnent Loan (SIL) Theme(s):

Poverty Targeted Intervention: N

Project Financing Data[ ] Loan [Xl Credit [ I Grant [ ] Guarantee [ Other:

For Loans/Credits/Others:Amount (US$m): $28.60 million

Proposed Terms: Standard CreditGrace period (years): 10 Years to maturity: 40Commitment fee: 0.5% Service charge: 0.75%Financing Plan: Source Local - Foreign otaBORROWER 0.00 0.00 0.00IDA 1.00 27.60 28.60AFRICAN DEVELOPMENT BANK 0.00 8.70 8.70EUROPEAN COMMISSION (UNIDENTIFIED) 0.00 0.20 0.20LOCAL GOVTS. (PROV., DISTRICT, CITY) OF BORROWING 2.00 0.00 2.00COUNTRY

Total: 3.00 36.50 39.50Borrower: GOVERNMENT OF LESOTHOResponsible agency: PRIVATIZATION UNIT, MINISTRY OF FINANCE

Address: The Director, Privatization Unit, Private Bag A249, Maseru 100, LesothoContact Person: Mr. M. T. Mashologu, DirectorTel: 266 317902 Fax: Email: dirpp@adelfang.co.za

Estimated disbursements ( Bank FYIUS$M):FY 2002 2003 2004 2005

Annual 3.00 9.00 14.60 2.00 _ _Cumulative 3.00 12.00 26.60 28.60

Project implementation period: Four YearsExpected effectiveness date: 06/15/2001 Expected closing date: 12/15/2005

OCS PAD F %o. Rev M, 2DOO

A. Project Development Objective

1. Project development objective: (see Annex 1)

The project will address a key constraint in the implementation of Govemment of Lesotho's (GoL's)ongoing private sector-led development strategy. Specifically, it will seek to improve businessinfrastructure such as electricity and telecommunications services, including provisions for intemetconnectivity in the future. The present low levels of service coverage have proved to be a major bottleneckto attracting private investment. A comerstone of GoL's overall economic growth and employmentgeneration strategy is to attract private foreign and domestic capital and expertise, given limited publicresource availability relative to the investment requirements. Improved business infrastructure will permitLesotho to take advantage of the contiguous large regional market that has opened up with the changes inSouth Africa. Increased private sector participation in the provision of goods and services will lead togreater integration and the improved use of resources.

The project supports the govermment's objective of giving priority to divestiture from the utilities sectors.This is proposed to be done through the privatization of Lesotho Electricity Corporation (LEC) andconsolidation of the Lesotho Telecommunications Corporation (LTC) privatization, together with theintroduction of a stable, transparent and modem utilities regulatory framework for both sectors. Thesereforms will pave the way for private sector investment capital and management to help to improve thecoverage, efficiency, affordability and reliability of electricity and telecommunications services, thusreleasing scarce GoL resources to be redirected to priority activities such as social service delivery.

2. Key performance indicators: (see Annex 1)

The following key perfornance indicators and project outputs will be monitored through projectimplementation to assess success in achieving the project's development objectives:

a. The majority of LEC capital stock is held by a private sector investor by not later thanDecember 31, 2002;

b. Decreasing fiscal transfers from Government to LEC to cover its loss-making operations--byDecember 31, 2002, no further subsidies are made by GoL with a view to sustaining LEC currentoperations;

c. Completion of studies on telecommunications regulation by December 2001 and regulationsupdated by no later than June 2002

d. Establishment of a suitably staffed and equipped telecommunications regulator by December2001.

e. Establishment of a suitably staffed electricity regulator by June 2003.f. Establishment of the Unit Trust and the privatization trust fund (warehouse) by March 2002;

minimum of 200 local investors shall have invested in the Unit Trust by June 2003.g. Implementation of LEC staff streamlining plan prior to divestiture.h. Completion of the Muela Options study according to timetable agreed in the PIP.i. Increased coverage of services in the telecommunication and electricity sectors by the end of the

project, relative to baseline in Year 2000.j. Improvement in operating efficiency indicators (i.e., staff per 1000 connections) for privatized

LTC and LEC by the end of the project, relative to the baseline in Year 2000.

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B. Strategic Context1. Sector-related Country Assistance Strategy (CAS) goal supported by the project: (see Annex 1)Document number: Document number: IDA/R98-56 Date of latest CAS discussion: 06/04/98

A major goal of the Bank's country assistance strategy is to help GoL improve competitiveness andachieve integration into the regional and global economy. The World Bank has been supporting thepnvatization and private sector development process in Lesotho for the past five years. Low coverage andhigh cost of infrastructure services (electricity and telecommunications services are accessible to less than5 percent of the population) have been reported as the most significant constraints to private sectorgrowth, development and competitiveness. Given the large investment requirements to expand the utilities'networks, GoL has concluded that it must attract private capital and private management. In the future,the private sector development (PSD) strategy will aim to attract private sector capital for manufacturingand service activities that will bring increased employment opportunities. The Bank is expected to providefollow-up support to GoL through a PSD project focused on regional integration opportunities, thedevelopment of sustainable micro-finance mechanisms, and entrepreneurship development, as pait of theCAS.

Another important CAS goal is the maintenance of fiscal restraint and improved macroeconomicperformance. Privatization of utilities will support this objective by reducing fiscal transfers. In 1997financial deterioration at LEC was the result of a collapse in the billing system that resulted in thenon-collection of revenues for almost 18 months. The fiscal transfers to LEC to cover losses resultingfrom its inefficient operations (in 1999 LEC's net deficit was M4.5 million) had become untenable byend-1999. As part of a Fund-monitored program, GoL has agreed to the transfer of management controlof LEC to the private sector, and to privatize the company through the sale of a majority of LEC shares toa strategic investor at the earliest opportunity.

The project will have some limited poverty reduction elements. Poor households are expected to receivebetter quality public services (health, education), and access to utilities may provide them withopportunities to engage in infonnal economic activities. Increased access to electricity is also expected toreduce the consumption of firewood in rural areas, and this will bring an accompanying reduction in therate of environmental degradation.

2. Main sector issues and Government strategy:

Private Sector Development Strategy of GoL:

The key objectives of GoL's private sector development strategy in the short term are to: (i) reduce thefiscal burden resulting from inefficient public enterprises, in particular the utilities; (ii) privatize theelectricity and telecommunications utilities, and implement a modem legal and regulatory framework tolay the foundation for open, market-driven development; and (iii) to ensure that the benefits ofprivatization are shared by the local population, including some local shareholding in privatizedenterprises. GoL's role in the utilities sectors will shift to policy-making rather than owning the assets andproviding the service. GoL will be supported under the proposed credit with implementing theliberalization of both sectors. Once service coverage and efficiency of electricity and telecommunicationsare imnproved on a financially sustainable basis, GoL will be in a better position to pursue its PrivateSector Development strategy of entrepreneurship development and the creation of an investor-friendlyenvironment in the Southern Africa Development Community (SADC) community.

Following the adoption of the Privatization Act of 1995, GoL embarked on a disinvestment program

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focused on the food, airlines, construction, tourism and phannaceutical industries. The program wassupported by the World Bank's Privatization and Private Sector Development (PPSD) project (Credit No.26120-LS). The program started slowly, but gained momentum and twenty-four transactions werecompleted. The PPSD project was designed to support privatization and did not provide for anyregulatory reform. The program's focus was affected by a rapid deterioration (1997/1998) in the banking,electricity, water and telecommunications sectors. The resulting crisis and the increase in fiscal burdenprompted GoL to give priority to the major utilities and banks, which became the central focus of theprogram, as stated in GoL's March 23, 1998 letter outlining its future policy for the privatizationprogram. The PPSD project was restructured to provide support to: stabilize the bankirng sector and averta banking crisis; promote the creation of a vehicle that would allow some local participation in the shareownership of divested GoL assets (Investment Fund); introduce a financial specialist team at LTC, whichmade significant progress with the collection of debts and downsizing the corporation; and begin work onthe establishment of a regulatory framework for the telecommunications, electricity and water sectors, toencourage private investment.

Telecommunications Sector:

In February 1999, the Ministry of Communications (MOC) published "The Lesotho TelecommunicationsPolicy". The policy paid particular attention to the potential contribution of the telecommunications sectorto the overall perfonnance and competitiveness of the economy, as well as broader social issues. The Policyprovided for:

* A clear division of roles between the various players in the sector (Ministry, Regulator, Operators)* The establishment of an independent regulatory authority, the Lesotho Telecommunications Authority

(LTA)* The introduction of competition and private investment in the sector* The possibility of a limited period of exclusive rights for basic services for LTC* The expansion of the availability of services via a Universal Service/Access policy* The expansion of the range of services available

The policy provided the basis for the corporatization and partial privatization of LesothoTelecommunications Corporation (LTC). Postal and telecommunications services had been split in 1997.The policy is silent on the matter of the Intemet, otherwise it falls within the scope of best intemationalpractice for such statements.

In June 2000 a new telecommunications Act, the Lesotho Telecommunications Authority Act was passedby Parliament. This Act implemented the key elements of the Telecommunications Policy. The Act interalia:

Established the LTA as an independent body:

* Broadly defined the functions, duties, powers and overall procedures of the LTA* Established the financial basis of the LTA* Broadly defined the licensing regime* Established the LTA as the body responsible for radio frequency management* Made provision for supporting Rules and Regulations to be issued either by the Minister or the LTA* Broadly defined the duties and obligations of service providers (including interconnection)* Facilitated the privatization of LTC

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The first stage of the privatization of LTC (sale of shares to strategic investor) is now complete, and theconsolidation process is underway, particularly in terms of strengthening the regulatory and policy capacityin the sector as it adjusts to the new ownership structure. One of the major objectives of theTelecommunications Policy was the reform of the sector in order to promote economic growth and privateinvestment. In this context the overall regulatory and legal environment is of vital concern to investors. Alegal and regulatory framework that enhances the security of investments, in the context of liberalization,will generate new products, services, exports and employment. The Regulatory Reference Paper of theWorld Trade Organization (WTO) provides a benchmark against which it is possible to assess theadequacy of a regulatory regime in this regard.

The essential minimum principles of the WTO regulatory ftamework are described in Table 1.

Table 1 Benchmark key elements of regulatory regime and adequacy of regulatory regime in Lesotho

Key elements Adequacy of regime in Lesotho

an independent regulatory authority adequate

transparency in general partial

competitive safeguards of the type that inadequatewould flow from competition law

Objective, non-discriminatory and partialtransparent allocation of scarce resources(e.g. frequencies, numbers, rights of way)

public availability of licensing criteria partial

equitable interconnection regime adequate

The regime in Lesotho is adequate with respect to the key matters of an independent regulatory authorityand an equitable interconnection regime, the framework for which is provided for in the Act. However, theregime is inadequate in certain key aspects, but these deficiencies can be easily rectified when drafting thelicense of LTC and the Rules and Regulations of LTA. The three matters that need to be addressed are:

* There is no competition law in Lesotho and while the Act makes reference to non-discriminatorybehaviour it does not provide for the powers of investigation and enforcement normally associated witha competition law. Until such time as such a law is in operation in Lesotho it is advisable to guardagainst abusive and/or anti-competitive behaviour by dominant operators through other instruments. Itis quite common for these safeguards to be included in licenses and such provisions should be providedfor in the license of LTC (the current draft appears to be adequate in this regard).

* Though the intention of the Act appears to provide for 'transparency in general' there is no explicitstatement in the Act that the criteria for licensing will be available to the public. Schedule I of the Act,'Business of the Authority' makes reference to public access to information which may be interpretedas meaning public availability of the criteria for licensing and frequency allocation.

* The Act does not explicitly state that the allocation of scarce resources (in particular frequencies) will

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be performed in an objective manner.

When these issues, competitive safeguards, transparency and objective allocation criteria, are resolved, theregulatory regime for telecommunications in Lesotho will be WTO compliant in terms of the necessarylegal instruments. The regime will be fully compliant when these instruments are implemented in aneffective manner by the major regulatory and policy parties - the LTA and the Ministry. This raises theissue of capacity building, which is discussed in the "Sector Issues" section below.

Key Sector IssuesThe key sector issues are summarized below:

Low level of telecommunications and Internet service: The overall level of telephone density in Lesothois very low at approximately 1.0 lines per hundred population compared to world average of 10.5. Further,there is a substantial gap between the level of service provision in urban areas compared to rural areas.Equally, mobile penetration is low. There is significant unmet demand as measured by the waiting list.Recognition of this state of affairs was a major driver of the Telecommunications Policy and the reformsundertaken. The challenge now is to implement these reforms in such a way that its objectives are achieved.

Internet: The most striking feature of the sector in Lesotho is the very low level of Intemet penetration byregional standards. The highest estimate for Internet subscribers in Lesotho is less than 500. In SouthAfrica there are over 650,000 subscribers or over 15,000 per million. The performance of Lesothorepresents a very serious "Digital Divide". Organisations like the UN, the G8 Summit and The World Bankrecognize the Intemet as a powerful instrument of development. Without easy access to information,farmers cannot know what price is fair for their goods, traders have no altemative to buying imports fromlocal sources, doctors rely on ancient technology, voters can make no informed choices. Faxing a 40-pagedocument from Madagascar to Cote d'Ivoire costs about $45, sending it by courier $75 and e-mailing itcosts 20 cents. More and more African newspapers now post online editions, and use foreign news foundon the Internet. Africa Online, based in Nairobi, works in eight countries. One of its aims is to provideInternet connections for people without their own telephones or computers. Using e-touch technology (asimple way to operate e-mail), it wants to put terminals in post offices throughout the East African region.Last month the company announced a deal with a bank to open a string of Internet centres. The currentstatus of the Internet in Lesotho means that the country is denied the opportunities mentioned above.

Separation of policy, regulatory and service provision functions: Separation of these roles has beensubstantially achieved and will be completed following the finalization of the transaction to privatize LTC.The achievement of the goals of the policy will then rest on the capacity of each party to fulfil its role andinteract in a positive manner with other actors.

Privatization: The transfer of LTC from the public sector to the private sector and the issue of a secondmobile license raises a set of issues never previously addressed in Lesotho, particularly in the context of thecommercial provision of services in a multi-operator environment. These issues include:

* Ensuring compliance with the roll out and other conditions of LTC's license* Providing safeguards against anti-competitive behaviour* Ensuring an equitable interconnection regime* Promoting competition and licensing new service providers* Regulating the tariffs of the dominant operator* Promoting greater access to services

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* Effective management, monitoring and charging for radio spectrum

It is universally recognized that a private monopoly, if not subject to appropriate and effective regulation,may act in its own narrow self-interest. The need for appropriate and effective regulation flows directlyfrom the policy adopted and the legislation enacted, initiatives which were supported by The World Bank.

Capacity of MOC to carry out its policy function: MOC has demonstrated its capacity to fonnulate andimplement policy and to facilitate the liberalization of the sector. In the past the MOC depended on LTCfor a large variety of inputs but circumstances have now changed. Universal Service and/or Access,Universal Service Fund, the Intemet/Web Economy, e-commerce, e-govenmuent and competition policy andpractices in a multi-operator environment are now on the policy agenda of the MOC. At the same time, theMinistry is not fully familiar with the regulatory practices and concepts that will be used by the LTA. TheMOC has recognized the need for strengthening its policy making capacity in order for it to fulfil its policymaking role, which will be implemented by the LTA. It also recognizes its need for a better understandingof regulatory practices.

Limited regulatory capacity of LTA: The LTA was established very recently and its personnel, who aremostly drawn from the Ministry of Communications, have some prior experience in the sector. However,this experience is largely limited to the parastatal monopoly environment. The LTA recognizes that it lacksthe full set of skill and capabilities required to discharge its duties under the Act. Box 1 below illustratesthe required set of capabilities.

BOX 1

* a modem licensing procedure and the means of revoking or modify'ing licenses* procedures to monitor and enforce timely compliance with legislative and license provisions* a detailed, timely, effective and practical means to resolve network interconnection issues, including

technical, capacity, compatibility, routing, price, billing, and other related matters* a capability and methodology to assess the costs of the provision of telecommunications services

provided to the public and to other operators for tariff approval purposes* a radio spectrum (frequency) monitoring and management capability, allocation plan, radio

authorisation policy for public and private networks, and a radio authorisation process* a telephone numbering plan and procedures for the allocation of blocks of numbers* a capability to specify standards for different classes of telecommunications equipment and for testing

compliance with these standards* appropriately defined Universal Service Obligations and costing of such obligations* procedures to monitor service quality and resolve disputes related to quality between operators and

between operators and customers* criteria whereby the tariffs for particular services gain unregulated status

All of the above capabilities were required of the LTA either directly or indirectly by the Act andnecessitate appropriate capacity building. Some specific issues are elaborated below.

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Spectrum management capability: The spectrum management function has been transferred to LTA asprovided for in the Act. There will be increasing use of wireless technology by both existing operators andnew entrants. In order to ensure that the best use is made of the radio spectrum, robust and effectiveprocedures and practices must be in place supported by appropriate infrastructure and staffed. Currentlythe LTA possesses one fixed monitoring station, installed in 1993 and in good working order, located nearthe capital, and one piece of portable equipment. LTA has a very limited monitoring capability. LTA canmonitor frequencies between 2khz and 1,000 Mhz. Even within this range of frequencies the equipmentcannot monitor the usage by the Global Satelite Module (GSM) 900 Mhz operator(s). This limitedcapability will impinge upon the discharge of the statutory duties of LTA and will reduce its ability tocollect fees from frequency users. Further, the lack of an effective frequency management and monitoringcapability may prove to be an obstacle to the provision of services to customers.

Tariff policy: Tariffs structure and levels will be determined by a price cap regime fonning part of thelicense of LTC. However, LTA lacks the necessary costing methodology. The regime will be reviewed aftertwo years. By that time the LTA must have fully developed a tariff policy which will sustain investment,promote greater penetration, facilitate new services and allow for the full benefits of the Internet. Facedwith these complex demands the LTA requires specific and early capacity building.

Interconnection: The key to sector development and competition is interconnection. Interconnection iscurrently practiced for calls between LTC and Voda Com Lesotho (VCL). This will need to be refined inorder to sustain an environment of 2 mobile operators, resellers, and numerous service providers. LTA hasrecognized the need for specific capacity building in this key area.

Universal Service/Access and Rural Access

A key component of the privatization transaction is the roll out of an additional 50,000 new lines, but thisconsiderable expansion in service will not necessarily address the urban v rural divide. Consequently, inconjunction with the MOC, the LTA needs to consider options, develop a strategy and implement thestrategy to address this issue. Both the MOC and the LTA recognize the need for specific assistance in thisarea.

Electricity Sector:

The right and obligation to supply electricity in Lesotho has been vested within the Lesotho ElectricityCorporation (LEC), which was created in 1969 by the Electricity Act. Despite a number of amendments,this Act still provides the legal basis for LEC to generate, transmit, distribute and supply electricity in thecountry. Power generation and transmission/distribution are in practice carried out by separate entities,although all assets are owned by GoL. The Muela hydroelectric power plant supplies LEC with about 85percent of its power requirements. One of the important modifications to the original Act is the requirementthat the LEC should be financially self-sufficient and should be operated on a fully commercial basis.However, LEC has been making losses and has been unable to meet increasing demand for services. Theselosses have been mainly due to its inefficient operations which have required fiscal transfers and thereforeadversely affected the national budget. In 1999, LEC made significant losses, primarily due tonon-collection of reVenues, and GoL transfers to cover these losses represented an important percentage ofgovernment expenditures.

The government has decided to privatize LEC, through the sale of a majority of shares to a strategicinvestor, and the transfer of full management control to this investor. To accomplish the privatization, thegovernment intends to take three key actions. First, the government must put in place a credible regulatory

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framework for electricity; second, the power system control function must be separated from LEC andestablished as an independent entity to ensure that the purchasers of LEC do not have control over thecountry's future trading with the Southern Africa Power Pool (SAPP); and third, adequate arrangementsmust be made to reduce staffing at LEC in a way that essential skills are retained in the country. Draftlegislation for the regulatory framework has already been proposed, and a task force has been appointed tofinalize the Electricity Bill for cabinet approval. The separation of the system control function will beguided by advisors that the government proposes to hire under the project. It is estimated that about 40-50percent of LEC staff may face retrenchment (i.e., about 250 people), and will have to be provided withseverance packages and training, in view of the scarcity of alternative employment opportmities in thecountry. These arrangements will be communicated early to staff and customers of LEC through a strongcommunications program by the Interim Management Task Force (IMTF) temporarily appointed tomanage LEC.

Proposed Retrenchment Program: GoL has a retrenchment policy that will guide the (MTF), which isexpected to implement the program. In particular, the cash payout component of the severance packagewill have to be in line with the employment contract and the labor law, and will be supplemented byadditional training and counseling, given the visibility of the transaction and the need to attract support ofthe key stakeholders such as labor unions and retrenched workers. The training (either entrepreneurship, ornew job skills, as appropriate) and counseling will be provided to retrenched workers in order to enablethem to pursue other opportunities and to alleviate the social impact of the staff reductions. GoL'sproposed retrenchment program will cover the following costs: (i) severance payments for all employees;(ii) assistance including early and sustained communication to LEC workers by IMTF on the subject ofretrenchment and restructuring; and (iii) counseling and training. The severance payments will befinanced out of the revenues collected from LEC's ongoing operations. Other items such as training,counseling and communication will be supported under the proposed project.

GoL has indicated that it intends to end budgetary support for the operations of LEC. However, the Muelahydropower plant, from which LEC purchases most of its electricity, was financed largely on commercialterms. If the bulk electricity tariff charged to LEC by Muela were to be based on costs, it would have toexceed what is currently paid. Agreement has been reached in principle between GoL and the Bank that thetariff paid by LEC to Muela will be set equal to the cross-border price; this is expected to be implementedin the context of the reform program. The government understands that no private sector investor will beinterested in acquiring a majority stake in LEC unless there is assurance that power will be purchased (fortransmission and distribution by LEC) at the cross-border price. To date, following non-payment by LECof its obligations to Muela for the purchase of power, GoL has provided major budgetary transfers to coverthe debt service obligations of Muela to its commercial creditors, which is also fiscally unsustainable.

The European Investment Bank (EIB) is one of the major financiers of Muela and its consent will berequired for any changes to the power purchase agreement (e.g. regarding tariffs) that exists between LECand Muela. EIB is in discussions with GoL and International Development Association (IDA) on theproposed privatization of LEC, and has indicated that it is prepared to accept a comprehensiverestructuring of the electricity sector as the basis for giving its consent to changes in the LEC-Muelacontract. The proposed credit will finance a study of the options to commercialize Muela, and EIB hasbeen a major contributor to the terms of reference for the Muela Options Study.

The main electricity sector issues to be addressed are: (a) to bring LEC finances under control and directresources towards expanded coverage. Financial distress of LEC prevents the implementation of thecountry-wide energy master plan, resulting in very low coverage of the population (only 3-5 percent ofhouseholds); (b) inefficient service provision resulting in part from low employee productivity of 18

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connections per employee (regional averages between 60 and 160); and (c) the power purchase agreementmust be amended to reflect the cross-border price prior to divestiture, and assurances to this effect must bein place.

3. Sector issues to be addressed by the project and strategic choices:

The government program calls for the privatization of LTC and LEC through the sale of majority shares toa strategic investor. GoL would also encourage some degree of local participation in any shares ofprivatized utilities that will not be held by the strategic investors in telecommunications and electricity.This is intended to distribute some financial benefits of privatization to local investors, as well as tostrengthen the education and communications / outreach to the local customer base of the privatizedutilities.

Telecommunications. The proposed credit will support capacity building and the establishment of atelecommunications regulator. Potential private investors require this, and it is in GoL's interest to have awell functioning regulator to balance the interests of all parties. The aim of privatization is to allow greaterflexibility and efficiency in the management of the main operator and to thereby prepare the company toface competition from new entrants. Furthermore, it is expected that LTC will get access to much neededcapital to re-capitalize and embark on an investment program.

Electricity. The project addresses the main sector issues of controlling LEC finances and improvingcoverage. To address the financial issue, and regain financial control at LEC, GoL is in the process ofrecruiting (through international tender) an Interim Management Task Force (IMTF) to operate LEC for 18months under a perfornance contract, and prepare the company for divestiture. The IMTF will undertakeimmediate actions to re-establish the integrity of the customer data base and increase revenue collection torestore financial viability. The management team will be responsible for pursuing a financial tumaround,and in particular, achieving at least a break-even position for LEC in order to limit the requirement forfiscal transfers.

To address the problem of low coverage of electricity, the IMTF will identify the potentially commerciallyviable service territory which will be the responsibility of the strategic investor. Finally, the IMTF willrecommend model institutional arrangements to deliver electricity services to areas which are outside theservice territory and which would be commercially un-viable to be connected by the strategic investor.Low coverage is also to be addressed through the regulatory framework. A Legislative Task Team,consisting of representation from all stakeholders (chaired by Ministry of Natural Resources andcoordinated by the Privatization Unit) has been recently established (June 2000) to redraft and finalize theElectricity Bill. Furthermore, in order to ensure fair treatment of the regulated companies and to protectconsumers, agreement has been reached with the government that an independent electricity regulator willbe established. Future private sector capital to address issues of low coverage, is expected to be availableto the sector once a credible electricity regulator is in place.

Lack of skills is contributing to low productivity of some LEC staff. In addition, LEC is overstaffed. GoLhas a policy statement which covers the retrenchment program at LEC, and there are clear governmentpolicy guidelines related to retrenchment in the course of privatization. The proposed credit will supportLEC staff streamlining and training (although it will not finance the actual retrenchment payments), whichis expected to address the productivity issue. The IMTF will carry out a comprehensive skills audit, withtraining recommendations for employees who will be retained, and the design of a comprehensive severancepackage (counseling, cash payout and training) for those who will be let go.

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The high cost of electricity in Lesotho is related to the purchase of power by LEC from Muela, as the tariffcharged by Muela to LEC incorporates the high commercial debt service that has resulted from Muela'sfinancing structure. Consultants will be engaged to recommend options for the commercialization ofMuela, including a debt workout. Annex 5 contains a detailed account of the sources of LEC's high costoperations, and the extent of technical and non-techical losses. The consultants' recommendations areexpected to result in the development of a strategy to eliminate Muela's dependence on growing fiscaltransfers to meet its repayment obligations to commercial creditors, in the face of a tariff adjustment tocross-border prices. EIB, a major stakeholder in the financing of Muela, will be closely involved in thetenns of reference for this study.

The government recognizes that the strategic investor will not expand the network all over the country, asthe rate of return required by international private capital will make the service unaffordable to poor, ruralhouseholds. Also, there will not be sufficient private sector interest in purchasing a majority stake in LECif there is a requirement to service commercially unattractive areas. Therefore, the IMTF, during its 18month management tenure at LEC, will provide a definition of the "service ternitory" to be offered to thefuture strategic investor, i.e., the commercially viable customer base. GoL will be supported by the Creditto explore and test, based on international best practices, the types of institutional and financingmechanisms that can be mobilized in order to provide electricity to communities outside the serviceterritory. These modalities will be tested on a pilot basis. An approach to be considered is to have aone-time capital subsidy to provide access to generation and distribution assets. The proposed project willinclude financing of the technical assistance to implement changes in the distribution standards used forrural electrification, and the establishment of appropriate institutional arrangements.

The distribution standards will be changed to utilize a mixed system of single phase and three phasedistribution. They will use small transformers that can be easily upgraded as demand increases and incases where the demand is low will use cost-saving devices such as steel wire rather than standardconductor. The project will also include a pilot for the use of renewables to supply remote villages.

The institutional changes will be designed around a cooperative system in which overheads will be sharedamong several villages. The structure will be designed to promote ownership by the beneficiaries and willbe required to be self-supporting after the distribution system is built using the capital subsidy. Anadditional aspect of the electricity access pilots that may be tested, would be to complement them withincome-generating opportunities, including truining and entrepreneurship development where appropriate,in parallel to the customers' first-time access to electricity.

Telecommunications. The project will address the following sector and capacity building issues. (a)Spectrum management capability: the spectrum management function has been transferred to LTA asprovided for in the Telecommunications Act. There will be increasing use of wireless technology by bothexisting operators and new entrants. In order to ensure that the best use is made of the radio spectrum,robust and effective procedures and practices must be in place supported by appropriate infrastructure andskilled personnel. (b) Tariff policy: Tariff structure and levels will be determined by a price cap regimeforming part of the license of LTC. However, LTA lacks the necessary costing methodology. The regimewill be reviewed after two years. By that time the LTA must have fully developed a tariff policy which willsustain investment, promote greater penetration, facilitate new services and allow for the full benefits of theIntemet. Faced with these complex demands the LTA requires specific and early capacity building. (c)Interconnection. The key to sector development and competition is interconnection. Interconnection iscurrently practiced for calls between LTC and VCL. This will need to be refined in order to sustain anenvironment of two mobile operators, resellers, and numerous service providers. LTA has recognized theneed for specific capacity building in this key area. (d) Universal Service/Access and Rural Access. A key

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component of the privatization transaction is the roll out of an additional 50,000 new lines, but thisconsiderable expansion in service will not necessarily address the urban rural divide. Consequently, inconjunction with the MOC, the LTA needs to consider options, develop a strategy and implement thestrategy to address this issue. Both the MOC and the LTA recognize the need for specific assistance in thisarea.

Local Participation: An investment fund to offer local investors shares in the privatized utilities (as wellas other privatized companies) will operate within a well-specified regulatory framework. The managementcontract for the private fund manager has been financed under the PPSD project. However, the proposedcredit will continue support to the Investment Fund so that local participation in utilities' shares can alsotake place. In particular, the major area of support under the proposed credit will be for the fund managersto establish a warehousing facility for shares to be temporarily held until they qualify for placement in theinvestment fund. This will be a suitable method of reserving shares of the privatized utilities for localinvestors, who will constitute, in addition to GoL, the minority shareholders in LEC and LTC.

C. Project Description Summary

1. Project components (see Annex 2 for a detailed description and Annex 3 for a detailed costbreakdown):

A. LEC Divestiture and Electricity Expansion

This component will focus on upgrading the electricity sector through the inflow of private capital, newtechnology and management necessary to increase access and improve the affordability and reliability ofelectricity services provided in the country. It comprises three sub-components:

(i) Interim Management Task Force. Technical assistance will be provided for 18 months by aninterim management task force (IMTF) that will manage the day-to-day activities of LEC until a strategicinvestor is in place. The IMTF will be held accountable (under a performance contract with incentives) for(a) the financial tumaround of LEC, (b) partially addressing the backlog by installing up to 8,000 newelectricity connections, (c) changing over 8,000 existing credit meters to pre-payment meters in order toimprove LEC's revenue base and also to reduce the need for meter-readers, (d) defining the service territorydeemed to be commercially viable, which will be offered to the strategic investor for expansion of thenetwork under the existing tariff regime, (e) a skills audit to serve as the basis for streamlining the LEClabor force, (f) design and implementation of the human resources (HR) restructuring/downsizing program,including the communication program, developing retrenchment packages, counseling and training ofretrenched workers, and training of retained workers, (g) developing and implementing a communicationplan regarding the LEC restructuring process to intemal and extemal stakeholders, (h) carrying out theAccess to Electricity study, (i) clearing the backlog of unaudited accounts for the last five years, and (j)providing the necessary accounting, financial and technical information required by the sales advisors.Under the IMTF management, the project will seek to promote the transfer of existing non-core activities ofLEC to the (local) private sector. This will be done in conjunction with the LEC streamlining/downsizingprogram wherever possible, in order to offer employment opportunities to laid-off LEC staff throughsub-contracting.

(ii) Sales Advisory Group. A professional advisory team, with expertise in investment banking,intemational law and technical issues will be appointed to assist GoL with developing a divestiture strategyfor LEC and the identification of, and negotiation with, a suitable strategic investor to purchase themajority stake in LEC. The Sales Advisory Group will support GoL until the privatization transaction is

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complete. The Credit will finance a communications strategy on three fionts, addressing informationalneeds related to LEC privatization: intemal to LEC; from LEC to its customer base, explaining theprivatization strategy and building awareness with respect to expected benefits; and marketing LECinternationally through roadshows, etc, to inform potential strategic investors. This will require a publicrelations campaign to promote a public awareness program for both intemal LEC staff and its customers,and the implementation of a strong Communications Program to promote private sector options to localstakeholders and strategic foreign operators/investors.

(iii) LEC Streamlining. Retrenchment payments will not be made using resources from theproject. This component will include (a) training and counseling of the retrenched employees, and trainingof retained employees that may be necessary in addition to the tasks undertaken by IMTF in the context ofimplementing the restructuring/downsizing program; (b) comprehensive monitoring and evaluation of theLEC downsizing program; and (c) a Government communication program on the LEC restructuringprocess.

B. Regulatory Reform

The role of the regulators will be to enforce appropriate regulations in the utilities sectors, ensure fair andtransparent treatment of sectoral operators, and encourage new entrants (particularly in the area ofvalue-added services for telecommunications. and access to the Intemet), private investment and thetransfer of technologies. GoL will be assisted with evaluating the possibility of merging these regulatoryfimctions together under a future multi-sector regulatory agency. Furthermore, the proposed credit willprovide support, including the financing of technical advisory services, to the Ministries of Communication,Natural Resources and Finance to oversee the implementation of the privatization process. Policy-settingcapacity is perceived to be an important element for both the telecommunications and the electricity sectors,and expertise at the respective ministries must keep pace with the introduction of strengthened regulatorycapacity. Policy advisors to the respective ministries, as well as study tours for ministry staff to gainfamiliarity and experience with intemational best practices, will be supported under the project.

Telecommunications Regulator. The Lesotho Telecommunications Policy, which supports liberalization ofthe sector and privatization of LTC, was adopted by Cabinet in February 1999, and theTelecommunications Act was passed by Parliament in February 2000. To date, legal and regulatoryassistance was provided to GoL by United States Agency for International Development (USAID), for: (i)drafting the Telecommunications Bill which provides for an independent regulator for thetelecommunications sector; and (ii) defining the new regulatory functions. However, additional assistanceis required to develop and enforce the set of regulations which will allow the framework to be implemented;especially in technical areas such as competition policy, interconnection, tariffs and universal service. ThePPSD Project has financed a study on the "Finalization of the Telecommunications RegulatoryFramework". The study is near completion and is expected to give guidance on implementing theappropriate regulatory framework needed in a newly liberalized and privatized environment. The new legaland regulatory framework aims at putting all operators on an equal competitive footing with respect toregulatory provisions on tariffs, interconnection and universal access. Resources will be provided to buildcapacity in the independent regulatory agency for the telecommunications sector (including on importanttopics such as introduction of regulations encouraging investment and competition in Intemet-host servicesand e-commerce), and will be complemented by the availability of an in-house regulatory advisor(intemationally recruited) for the duration of the project. From a sector development standpoint, technicalassistance under the project will examine and formulate recommendations related to liberalization ofintemational traffic, fully liberalizing the provision of intemet service, and liberalizing tariffs. Lesotho issurrounded by Africa's only real internet player, South Africa. To allow Lesotho to leverage its proximity

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to this market would have a positive developmental impact. Regulatory capacity-building will extend to anassessment of the potential for e-govemance (i.e., doing on-line any Governmental function that is nowdone on paper - customs, taxes, licensing, corporate filings, etc.) and the benefits of transparency that growfrom it.

The project will finance the following: (a) some of the running costs of the LTA for two years (anyshortfall after license revenues are taken into account; the agency must be fully self-sustaining after nomore than two years, from license revenues); (b) long tern resident advisor for two years to assist LTA inits duties and ensure the transfer of skills; (c) short term consultants for two years for advice on specificissues and to transfer skills; (d) training over two years to build LTA capacity through in-house, external,overseas elements, workshops linked to studies; (e) appropriate study tours and/or staff exchanges; (f)studies on universal service/access; interconnection; promoting Internet; and tariff policy; and (g) anyadditional requirements of frequency management and monitoring equipment to enable LTA to discharge itsstatutory duties.

Electricity Regulator. Technical assistance under the proposed credit consists of (a) finalization of thedefinition of new regulatory functions; (b) financial support for the establishment of an independentregulatory agency, including initial support as required for two years to assist with operating costs that arenot covered by license and concession revenues (the regulatory agency will have to be fully self-sustainingafter two years); and (c) establishment of operational procedures for the agency. In particular, elements ofthe proposed assistance include: a) an in-house long term regulatory advisor (internationally recruited) toprovide technical assistance to the regulator; (b) finalization of key procedures for the regulator to awardlicenses and concessions to the private sector; (c) in-house training programs for the staff of the regulatoryagency and other key agencies in the sector; and (d) study tours to suitably identified countries havingalready liberalized their power sector.

C. Future of Energy Sector in Lesotho

This will involve two activities:

--A two-part study on the future options related to hydroelectric power in Lesotho. The first partof the study will specifically recommend options related to the commercialization of Muela, and the secondpart will consider the potential for the development of additional hydropower resources for export.

--Electricity Access Pilots. This component is intended to assess the viability and modalities ofproviding service to those areas that will not be commercially viable, and will remain un-served followingthe transfer of LEC ownership from GoL to a private investor. Once the IMTF identifies the serviceterritory, it will seek to identify a series of pilot areas outside the service territory in consultation with GoLand concemed stakeholders, in which to develop institutional mechanisms and management arrangementsthat will allow for sustainable electricity service delivery, with the capital investment initially supported byIDA financing. Community-based private sector institutional arrangements (e.g., through local concessions)will permit recovery of operating cost, maintenance and depreciation allowance. It is anticipated thatapproximately 3,000 new customers outside the service territory will be connected by low-cost technologiesused to extend the grid, and separately, a total of up to 1,000 new customers spread over five pilot isolatedcommunities will be connected using stand-alone generation facilities. Studies will first be financed tosupport the development of these arrangements. In particular, intensive surveys of proposed pilotcommunities will be undertaken. In addition, the project will seek to develop access to income generatingopportunities/private sector development in these pilot areas, in parallel with the access to electricity.There is an ongoing effort by the government to implement a rural telephone service program. This

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proposed project will support the introduction of rural telephone services in the same locations as theelectricity access pilots wherever feasible.

D. Private Sector Development

This will involve two activities:

--Establishment of the Investnent Fund/Unit Trust. Financing will be provided to continuesupporting on-going work to establish the Lesotho Unit Trust. With financing provided under theIDA-financed Privatization and Private Sector Development Project, the Privatization Unit is in the processof recruiting a management company that will establish and operate the Unit Trust. The chosenmanagement company is required to undertake a consultancy that will constitute the essential activitiesrequired to establish and start operating the Unit Trust. The main principles relating to the structure of theportfolio of the Unit Trust are based on: accessibility (by Basotho to their savings at all times);competitiveness (in terms of returns and risks compared with other investment opportunities in Lesotho andSouth Africa); and manageable risk (to avoid potential loss of confidence in capital market development inthe medium term). It is crucial that the Unit Trust's local equity portfolio consists only of shares with aproven track record; shares of companies with growth potential (including the shares of the privatizedutilities) will be put in a Privatization Trust Fund (a warehouse) until they become financially viable. Theproject will support capacity building of the Unit Trust regulatory authority at Central Bank of Lesotho.

--Private Sector Development Studies. Technical assistance will be financed to identify andsupport activities that will encourage regional integration efforts and identify Lesotho's areas ofcomparative advantage. Potential areas to be included for study include the removal of administrativebarriers to investments, intemet and e-commerce possibilities within the region, targeting of high valueadded goods that may be developed as non-traditional exports, and identification of actions to boost thecompetitiveness of local firms. Technical assistance will also be provided to identify and support incomegenerating activities that can be associated with first-time access to electricity and telephone services,particularly in the electricity access pilot areas.

E. Advisory Services and Capacity Building.

Resources for advisory services and training of staff at the Ministries of Natural Resources,Communications and Finance will be funded under this component. Advisory services include a TechnicalAdvisor to the Board of LEC, to assist with the supervision of IMTF; a Technical Advisor to the Ministryof Communications on Policy Issues for Telecommunications; and a Legal Advisor to the Minister ofFinance to assist with the formulation of a Competition Law and other institutional matters related toregional commerce. Capacity building includes training needs for the staff of the Ministries of

Communications, Natural Resources and Finance, respectively. The procurement for agreed activitiespertaining to these Ministries will be carried out by the respective Ministry, with all necessary coordinationand support provided by the Privatization Unit, which has familiarity with IDA procedures andrequirements.

F. Implementation.

This component is proposed to include contracts of key senior staff at the Privatization Unit; legal,financial, audit and other consultancies that will be required by PU from time to time; some publicawareness costs; and the operational costs of PU within an agreed ftamework. The African Development

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Bank will finance training costs, office equipment and vehicles; the advisor to the director; other officers,support personnel, and some public awareness costs.

A Project Preparation Facility (PPF) of US$1.5 million was made available by IDA to GoL in August1998, for a proposed supplemental project on privatization and regulatory reform. The appraisal of thatproposed project had to be canceled due to the outbreak of civil disturbances the following month.Resources of that PPF were used for the study on Regulatory Reform for Electricity and Water Sectors, thefinancial workout team and market analysis for LTC, and the divestiture of Lesotho Bank. It is proposedthat the PPF, together with an additional PPF of US$0.6 million extended for preparation of the UtilitiesSector Reform project, will be refinanced under this project.

1. LTC, LEC DIVESTITURE AND 0.0 0.0ELECTRICITY EXPANSIONA. Interim Management Task Force BP 14.33 36.4 7.50 26.2B. Sales Advisory Group BP 3.56 9.0 3.56 12.4C. LEC Staff Streamlining BP 2.46 6.3 0.31 1.1

2. REGULATORY REFORMA. Electricity Sector Institutional 1.32 3.4 0.81 2.8

DevelopmentB. Telecommunications Sector Institutional 4.30 10.9 4.00 14.0

Development3. FUTURE OF ENERGY SECTOR Institutional 5.01 12.7 5.01 17.5IN LESOTHO Development

4. PRIVATE SECTOR Institutional 2.04 5.2 2.04 7.1DEVELOPMENT Development

5. ADVISORY SERVICES AND BP 1.30 3.3 1.30 4.5CAPACITY BUILDINGASSISTANCE6. IMPLEMENTATION 2.93 7.4 2.00 7.07. PPF I BP 2.10 5.3 2.10 7.3

Total Project Costs 39.35 100.0 28.63 100.0

Total Financing Required 39.35 100.0 28.63 100.0

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2. Key policy and institutional reforms supported by the project:

GoL has made a policy commitment to transfer responsibility for provision of electricity andtelecommunications services to the private sector, while reserving strategic planning and policy functionsfor the State. The broad policy guidelines formulated in the Power Sector Policy Statement propose, inparticular, the removal of monopoly for transmission and distribution, and the restructuring of the tariffstructure to cover operating costs and recover costs associated with investments. The proposed credit willsupport the government with the establishment of credible regulatory authorities for bothtelecommunications and electricity, and will support an assessment of their possible future consolidationinto a multi-sectoral regulator. Specifically, the key reformns supported by the project are:

(i) Power Sector Policy Letter, which undertakes liberalization of the electricity sector;

(ii) Liberalization of the telecommunications sector;

(iii) Transfer of LEC management control to private sector IMTF in preparation for divestiture;

(iv) Transfer of majority ownership of LTC and LEC to private sector strategic investors;

(v) Drafting of Electricity Bill, submission to Parliament and passage of Electricity Act;

(vi) Establishment of Electricity Regulator;

(vii) Support to the establishment of Telecommunications Regulator;

(viii) Preparation of Strategy for Muela Commercialization, based on recommendations ofConsultants' Study to be supported under the project;

(ix) Implementation of Warehousing facility and the Investment Fund, to broaden localparticipation in share ownership of privatized enterprises

(x) Institutional arrangements to support rural electrification and telephony, possibly includingthe establishment of an agency, in keeping with international best practice, to channelcapital subsidies, to maintain safety standards and to give technical and financial advice torural communities operating their own distribution systems; and

(xi) Legal adjustments to permnit the establishment of rural distribution utilities and have themco-exist with the main utility; in particular, rural utilities must be allowed to chargedifferent tariffs depending on the source of generation and individual customer densitycharacteristics.

3. Benefits and target population:

The primary beneficiaries are the business sector and individual customers utilizing utility services.Sector reform and associated liberalization and privatization will provide strong incentives for improvingservice delivery in the utilities sectors, which is currently one of the major constraints to private sectordevelopment and economic growth through regional integration.

The indirect benefits will arise from the reduction of public investments in the utility sectors and increasedtax revenue from privatized entities. The resultant impact will be that the project will free up scarce

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public resources for investment in social programs and other priority activities which are likely to accrueto the poorer parts of the population who are larger beneficiaries of (or more dependent on), governmentsocial sector spending.

On a pilot scale, there will also be beneficiaries in rural and undeserved areas, since the project will belooking to develop institutional mechanisms to mobilize local capital and management to bring utilityservices to these segments of the population.

4. Institutional and implementation arrangements:

1. Implementation Period: Four Years; June 200 1-June 2005

Executing Agency: Privatization Unit

Project Coordination and Oversight: The Privatization Unit (PU), which is linked to the Ministry ofFinance but exists as an independent entity as called for by the 1995 Privatization Act, has a complementof professional staff who have acquired knowledge and experience in the utilities sectors privatization andPSD and implementation of Bank-financed projects.

Overall coordination and project implementation will be the responsibility of the PU. The PU will be incharge of: (a) coordinating all project activities; (b) planning the annual work programs, preparing annualbudgets; preparing project accounts; (c) carrying out all procurement and selection of consultants inaccordance with Bank guidelines; (d) preparing project reports and eventually disbursement reportsensuring the smooth flow of funds; (e) monitoring project implementation and evaluating its impact; and (f)coordinating the preparation and timely delivery of audits.

Financial Management Arrangements

The Project Accounts Section of the Privatization Unit (PASPU) will be responsible for ensuring thatfinancial management and reporting procedures will be acceptable to the government, the World Bank andother Cooperating Partners.

The principal objective of the PASPU's Fnancial Management System (FMS) will be to supportmanagement in their deployment of limited resources with the purpose of ensuring economy, efficiency andeffectiveness in the delivery of outputs required to achieve desired outcomes, that will serve the needs of thepeople of Lesotho. Specifically, the FMS must be capable of producing timely, understandable, relevantand reliable financial information that will enable management to plan, implement, monitor and appraisethe project's overall progress towards the achievement of its objectives.

For the PASPU to deliver on the aforementioned objectives, its financial management system will bedeveloped in accordance with the Financial Management Action Plan presented in Annex 6D. Salientfeatures of the Action Plan include: retention of a Financial Management Consultant to develop and installthe project's FMS and to prepare the project's Financial Procedures Manual; establishment of a FinancialManagement Committee; recruitment of a Chief Accountant and the availability of support staff; capacitybuilding; establishment of a Fixed Assets Register and a Contracts Register; monthly bank reconciliationand quarterly reporting of financial information; cash flow management including variance analysis; anannual external audit will be undertaken on terms of reference acceptable to the Bank.

By credit effectiveness, the PASPU will not yet have in place a FMS that can provide, with reasonable

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assurance, accurate and timely information as required by the Bank for PMR-based disbursements i.e. theProject Management Report (PMR). However, the appointment of the Chief Accountant and the successfulimplementation of the project's FMS and Financial Procedures Manual should facilitate the introduction ofPMR-based disbursements within 18 months of credit effectiveness. In that regard, a financialmanagement review of the project will be undertaken by a World Bank Financial Management Specialistwithin 12 months of credit effectiveness to assess progress. In the short-term, existing disbursementprocedures, as outlined in the Bank's Disbursement Handbook, will be followed, i.e., Direct Payment,Reimbursement and Special Commitments.

Procurement Arrangements: Institutional Arrangements

The Privatization Unit will be responsible for all procurement funded by the project. It will handle theprocurement requests of each implementing agency according to monthly procurement schedules submittedto it. It will have staff who are fully familiar with Bank procurement procedures as they would have hadprior experience under the Privatization and Private Sector Development Project. Annex 6 and the ProjectImplementation Plan (PIP) describe component-specific procurement procedures and the procurement anddisbursement arrangements.

D. Project Rationale

1. Project alternatives considered and reasons for rejection:

GoL initially requested IDA support for a full-fledged follow up Private Sector Development project. Thisrequest was subsequently modified in favor of a project focused on addressing constraints in the utilitiessectors, in response to feedback obtained from the private sector. GoL's private sector developmentstrategy is expected to meet with better success once the business infrastructure is in place. Also, the LTCand LEC privatizations are highly visible operations which will set the tone for future intemational privatesector interest in Lesotho. Support for regulatory bodies has been included since utility regulation is a newarea in Lesotho and requires some initial startup support.

Once the decision was made to focus on utilities, the project design at first included water as well aselectricity. However, given the complex issues related to the sources of supply for water in the lowlands,water issues were dropped from the project. Water sector issues and the possibility of private sectorinvolvement in urban water supply are the subject of a separate project under preparation.

Several privatization options for LEC were considered following a study tour to Cote d'Ivoire andworkshops on privatization, which were attended by the key players in the sector. Among others, amanagement contract for LEC was considered but it was felt that, since it would not result in privatecapital flows into the utility and it would not necessarily address the issue of operational efficiency, it wasnot the desired form of privatization for LEC. It was then concluded by GoL that a concession contractwas the best option of privatizing the corporation, because private capital investments and managerial andoperational efficiency were assured under this strategy. However, after further consultations, it wasdecided that the sustainability of a concession in the medium to long term was doubtful. The finalconclusion was therefore to privatize the corporation through the sale of majority shares to a strategicinvestor. However, it was realized that, prior to the outright sale of the corporation, it was necessary toimprove the corporation's operating efficiency and financial status to enhance its marketability to investors.Also, in particular, it was necessary to generate some current financial information since this was lacking.To effect this, it was further decided that interim management should be engaged for LEC on aperformance-based contract.

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As noted, since there is limited information available on LEC's potential to generate cash flows, andtherefore to assign a fair market value to the shares proposed for sale, it was also felt that the introductionof an Interm Management Task Force (IMTF) operating under performance targets, and with reportingobligations to the LEC Board, would be the right way to proceed. The IMTF would bring financial,technical, operational and managerial efficiency to LEC, and would also generate valuable information thatwould allow the sales advisory group to maximize the value of LEC (based on future cash flows, ratherthan the sale of LEC's meagre existing assets). The IMTF would, in addition, be responsible for carryingout the study to define the service territory.

The staff streamlining of LEC was also carefully considered. Given the low-key manner in which LTCstaff retrenchments had taken place, and the fact that they were financed internally as part of LTC'sfinancial workout, gave rise to a view in government that LEC redeployed staff should not be givenpreferential treatment. On the other hand, it was felt that the downsizing issue should be dealt with beforemarketing LEC to a potential strategic partner. Therefore, LEC staff retrenchment payments could not besourced from the sales proceeds. If the retrenchment exercise were not handled carefully, it could prove tobe an obstacle for the future of Lesotho's remaining privatization agenda. Finally it was decided that inkeeping with the Bank's safeguard policies, the retrenchment exercise would be handled in a comprehensivemanner, with severance payments (to be financed by GoL from LEC revenues) accompanied byBank-supported counseling and training for departing LEC staff. A proactive communications policywould also be used for internal communications, in order to limit the threat of potential sabotage bydisgruntled staff who could undermine the performance of the IMTF. Staff remaining at LEC during theIMTF management period will be encouraged to take advantage of training programs and improve theirexperience and efficiency so as to increase the probability of their being retained by the future strategicinvestor.

Finally, the Electricity Access Pilots component came about with the realization that it would be unrealisticto require the private sector strategic investor to expand the network sufficiently to provide electricityaccess to much of the country. Given the mountainous terrain and the sparsely populated settlements inrural areas, it would be financially unviable for a private investor to venture outside of a well-defined"service territory". Conversely, if the investor were required to use his private capital to provide electricityto all parts of the country, it would be an extremely high cost solution and possibly unaffordable for theconsumers in question. A pilot plan is under discussion, which is in line with international experience oncosts to connect 3,000 additional customers to grid extensions outside the service territory, and a furthertotal of 1,000 customers in five pilot villages based on off-grid arrangements. At the government's request,it was also agreed that the design and implementation of the Electricity Access Pilot scheme would beflexible enough to accommodate rural telephony investments wherever possible, in order to provide accessto adequate business infrastructure to allow for income generation in rural areas.

The project will therefore identify the five proposed pilot communities outside the service territory, once itis defined by IMTF, as well as the locations which lend themselves most efficiently to low-cost technologyextension of the grid, and cover approximately 3,000 additional connections. Clearly, the service territoryitself is considered commercially attractive and will be "reserved" for the private strategic investor to makeinvestments in the expansion of the network. In these pilot communities which would otherwise remainunserved, the project will support the development of alternative institutional arrangements to seek toattract private resources and local management. It is understood that concessional donor funding may beused to offset part of the development costs and the initial setup costs in such areas, with subsequenttransfer of responsibility to the local private sector. Appropriate institutional mechanisms will be explored

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in this context. The other item of emphasis with the Electricity Access Pilots is to ensure that the arrival ofelectricity to a previously unserved area is accompanied by the development of some income generatingopportunities. The project will explore possibilities of linking the two in the pilot areas. While electricityaccess will be the primary criterion for selecting pilot areas, they will be eligible for rural telephonyinvestments as well; this matter will be addressed during the consultancy and design phase of the pilots.

2. Major related projects financed by the Bank and/or other development agencies (completed,ongoing and planned).

The two most relevant related projects are the PPSD Project (closed in December 2000) and the completedIndustry and Agro-Industry Development Project. The objective of the PPSD Project was to launch andsupport GoL's privatization program, and strengthen private sector development aspects such asentrepreneurship training. The objective of the Industry and Agro-Industry Development Project was toencourage foreign private and indigenous investment in the industrial and agro-industries sector.

Latest SupeisionSector Issue . P~rojc (kpS) Ratingls

(at-finncd poeclsonily)Implementation Development

Bank-financed Progress (IP) Objective (DO)

Privatization of state-owned banks, Privatization and Private Sector S Sfood industiy, airline, construction, Development Projecttourism, pharmaceutical and vehiclerental companies

U UPrivate Sector Development, Industry and Agro-Industrymicrofinance, employment generation Development Project

Other development agencies

IP/DO Ratings: HS (Highly Satisfactory), S (Satisfactory), U (Unsatisfactory), HU (Highly Unsatisfactory)

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3. Lessons learned and reflected in the project design:

Intemational/regional experience on privatization and sector reform indicate the following best practicefeatures: First, government commitment to and leadership of the privatization and sector reform programsare essential to success; the project should be supporting implementation of reforms that have beendeveloped with broad stakeholder consultation and where the agreements are contained in sector policystatements and laws. In particular, previous experience in the early stage of the ongoing privatizationprogramn included very close monitoring by Cabinet of the day to day aspects of divestiture, even of smalland non-strategic companies. This was manifested by a need to obtain Cabinet approval at every step, andresulted in delays and loss of investor interest. This leads to the next conclusion. Second, leadership and astrong privatization agency, with skilled staff empowered with appropriate authority to carry out theprocess, is needed. Third, there is a need to ensure the availability of resources to address the social cost ofreform by securing adequate govemment funding of severance packages for employees made redundant asa result of privatization. Fourth, there is a need to ensure a consistent approach across sector reform andprivatization processes, and to streamline and simplify procedures for relatively small disinvestmenttransactions. Fifth, there is a need to increase local community awareness of and support for the programthrough an effective communication strategy before changes start taking place. This includescommunication of a clear vision for the privatization process so that the program's impact on resolvingeconomic growth constraints is understood and maximized. Sixth, efforts should be made to increase theconfidence of the investor community (both foreign and local) through the establishment of improved andmore transparent procedures, clearly delineating the roles of political and technical decision makers in theprivatization process. Seventh, GoL needs to minimize restrictions on investment qualifications in order tomaximize competition and if possible, encourage local participation in the program.

Implementation of the ongoing privatization project indicates that: (i) there is now local ownership of theprivatization process and that therefore the likelihood of sustainability is relatively high. With capacitybuilt in the Privatization Unit, GoL has some capacity required to initiate follow up on future work inprivatization; and (ii) timely availability of resources is critical. To ensure that resources are available tomeet the tight deadlines that GoL has now imposed for the process to fit its own timetable and also that ofthe Fund-monitored program, a Project Preparation Facility (PPF) has been requested by GoL. This willbe used to engage the IMTF, to launch a government communications program for LEC staff, to undertakekey study tours and to engage regulatory and other technical advisors to support relevant cabinet-leveldecisionmakers.

Rural Electrification: Grid-based rural electrification executed by state-owned power utilities, together witha uniform national tariff to cross-subsidize consumers, has been common in the Bank's client countries.This approach rarely delivers any significant development impact. The utility is often reluctant to connecta significant number of household customers because it would increase its administrative costs. One of thekey lessons is that it is best to encourage community participation and shift to commercially orientedschemes. The standards and technologies utilized for urban electrification are inappropriate for ruralconditions.

The Implementation Completion Report of the Industry and Agro-Industry Development Project (CreditNo. 21 95-LS) explicitly states, under Key Lessons Learned, that today, reform priorities to support thistype of project would focus on private participation in infrastructure, implementing the necessary reformsto address constraints in infrastructure (power, telecommunications, water, etc.), and building the capacityof firms. Performance-monitoring indicators were not included and the project did not establish anadequate counterpart for overall project coordination and supervision, all of which contributed to theproject's "unsatisfactory" rating.

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Lessons Reflected: The proposed operation will be the first one in Lesotho entirely dedicated to utilitiessector reform. Key lessons learned and reflected from similar Bank supported operations in other countriesinclude: (a) the need for full commitment to the process at the highest levels of government, and theappropriate delegation of authority to the implementing agency; (b) the introduction of policy andregulatory reforms to promote competition and protect consumer welfare prior to the privatizationtransaction; (c) the establishment of a coordination mechanism within government to ensure consistencyand coherence, particularly when dealing with potential foreign investors, and to carry out projectmonitoring and financial management; (d) an efficient government procurement mechanism to ensure thatthe work is done in a timely manner in compliance with IDA procedures. The long term success of thedivestiture program will depend greatly on the establishment of an appropriate regulatory framework in therespective sectors. Also, on rural electrification, lower-cost technical standards and operationalprocedures that have already been tested and found acceptable in other places, will be introduced. Thecombination of rural electrification and rural telephony in selected pilot sites is an innovation intended tosupport accompanying income generation activities and could, if designed with adequate stakeholderparticipation, set a new standard for best practice.

4. Indications of borrower commitment and ownership:

Significant actions have been taken to restructure both telecommunications and electricity. Theconsolidation of LTC privatization (majority shares were transferred in early 2001) is expected to becompleted by end-December 2001. A Telecommunications Regulatory Authority has been established; keystaff have already been identified.

On electricity, the process of tuming over LEC to private management has been launched. Theinternational selection of the IMTF is complete, and the team has been managing LEC since February2001. The tender process for selecting the Sales Advisory Group is underway, since the invitation toexpress interest has been issued and a short-list formed. The primary role of the Sales Advisory Group isto conclude the privatization transaction in its role as advisor to GoL.

GoL has indicated, in a Power Sector Policy Letter provided to the Bank, that it proposes to sell a majorityof LEC shares to a qualified strategic investor.

5. Value added of Bank support in this project:

The Bank is uniquely placed to assist the GoL in the provision of this support, given its: (a) internationalexperience in the process of regulatory reform in promoting private sector participation in thetelecommunications and electricity sectors, and in the setting up of the accompanying legal and institutioinalregulatory framework; (b) regional role, particularly through the Southern African DevelopmentCommunity (SADC) in working in concert with other donors to ensure that national reforms in theelectricity and telecoms sectors, are in harmony with broader regional objectives; and (c) international andon-going Lesotho specific privatization experience.

From the Borrower's point of view, the Bank performs a number of functions that other players cannotreplicate:

(a) The Bank's presence in the privatization transaction gives comfort to a broad range of privatepotential investors/utilities operators, who would otherwise not participate in the bidding process for GoLassets. By bringing our credibility to the process, we ensure that GoL benefits to the maximum extent byincreasing competition and the number of bids.

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(b) The Bank, based on its accumulated knowledge, is uniquely able to add the Electricity andTelephone Access Pilots dimension to the proposed privatization project, and can draw on internationalbest practices to discuss with GoL which innovative strategies may potentially succeed in bringingelectricity and telephone coverage to underserved areas. In addition, the Bank is able to incorporate apossible income generation dimension to this pilot project.

(c) The Bank is able to design and finance comprehensive retrenchment-support packages, i.e.,accompanying features of the govemment's cash payout (counseling, FHV/AIDS awareness programs,training and monitoring and evaluation of the retrenchment process) in the context of LEC downsizing.This is likely to make the streamlining process more smooth and pave the way for a successful outcome ofthe IMTF contract, as well as increasing confidence among workers in other soon-to-be privatizedcompanies.

(d) The Bank is able to design and implement a workable solution for Lesotho in order to ensure avehicle for local participation in the shareholding of privatized utility shares, in the form of a WarehousingFacility for the Investment Fund.

E. Summary Project Analysis (Detailed assessments are in the project file, see Annex 8)

1. Economic (see Annex 4):* Cost benefit NPV=US$39.8 million; ERR = 23.1 % (see Annex 4)O Cost effectivenessC Other (specify)

The economic benefits in the cost-benefit analysis were measured through: (a) benefits from newly createdemployment opportunities in the private sector. The GOL employs only 15.5 percent of formal sectoremployment while the Private Enterprise sector employs a mere 3.4 percent of the formal sectoremployment (1995). With privatization, the domestic private sector employment share is expected toincrease further from 29.6 percent of the formal sector to about 35 percent in 5 years as the publicenterprise sector shrinks by 32 percent. Moreover, with the newly created jobs which are expected toincrease at an average of 3.2 percent per annum; (b) benefits from productivity and output in privatizedenterprise as gains are expected from higher total factor productivity, resulting from expected changes inwork ethics, training, better management, better equipment and new technology, as well as job-loss savingsgenerated by PE restructuring. This has been measured through changes in cost of providing the servicesto each customer in telecommunication and electricity. The increases in number of lines from 15,000 to50,000 requires a high rate of backlog reduction, approximately, 20 - 30 percent per annum. The currentoperating efficiency rate is in LEC is low at 33 customers per employee, even with the retrenchment of 40percent of the labor force, the rate remains low at 34 customers per employee. With privatization, this ratiois expected to improve due to increases in coverage by 25 percent to 20,000 customers and the operatingefficiency ratio will improve to 50 customers per employee by year 2005 by additional job creation;reduction of factor costs by a percentage of increased performance; and (c) consumer surplus through gainsin price and tariff. The benefits to the consumer are expected in the form of adjusted price/tariffs andimproved service quality, increased access and wider coverage due to competition and private sectorinvolvement. It is estimated that by the end of project, there will be 1,250 public pay phones compared to125 that are currently available. With privatization the capacity and number of telephone main linesconnected have increased from its 1997 level of 15,000, to 28,000, in 1999, and estimated to 50,000 in2005.

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The economical costs included project loan, co-financing from ADB and government's contribution. Thecost benefit analysis showed that the project is economically feasible, as indicated by NPV of $39.8 millionequivalent (using 12 percent discount rate) and ERR of 23.1 percent. Sensitivity analysis revealed that theproject is robust even when key assumptions deteriorate, giving a low probability of the NPV beingnegative. Moreover, the project has a positive impact on government finances. This is in the form ofreduced subsidies to PE of $13.7 million and gains in corporate and other taxes of US $10.8 million over aperiod of 15 years.

2. Financial (see Annex 4 and Annex 5):NPV=US$ million; FRR = % (see Annex 4)

A detailed financial analysis of LEC, and the factors underlying Lesotho's high cost electricity service, isprovided in Annex 5. Financial analysis of LTC has been undertaken by consultants in 1998/1999financed by the PPSD project, and the conclusions of this analysis have been used to carry out theprivatization process which is expected to be completed by December 2001.

Fiscal Impact:

The reform program is expected to have significant positive impact on the fiscal resources of Lesotho.Fiscal transfers to LTC have already ceased, and it is expected that Government transfers to LEC will bephased out by Year 3 of the project, prior to divestiture. The budgetary transfers to Muela remain an issueand are expected to be addressed by implementing the recommendations of the consultant's study which willbe part of this project. The issue of transfers to Muela will have to be addressed prior to the preparation ofthe Information Memorandum by the Sales Advisory Group, so that private investors are informed aboutthe conditions under which LEC is being offered for sale.

3. Technical:The project is technically sound and has been designed taking best practices into account. Within the CASagenda of promoting broad-based private sector-led growth, the project would help increase the scope ofprivate sector activity through support of: (a) privatization in key economic sectors (electricity andtelecommunications); (b) liberalization of utilities sector to promote new services and reduce transactioncosts. Design of project components took into account lessons leamed from previous operations inLesotho, notably the ongoing PPSD project and the completed Industry and Agro-Industrial Developmentproject. Of particular note on experiences of the ongoing privatization program is the need: (a) to take acomprehensive sectoral approach in promoting increased PSP in basic infrastructure and avoid focusingactions on simply resolving problems at the enterprise/operations level; and (b) ensure local privateparticipation (through outsourcing of non-core activities, for example) and local ownership of the processthrough the viable instruments (i.e., investment funds) that allow for indigenous private sector developmentand participation in the privatization program.

LEC restructuring: Extensive technical support (e.g. recruitment of the IMTF, appointment of salesadvisory group), will be provided to confirm the feasibility and scope of the proposed private sectorparticipation (PSP) and divestiture arrangements. Project design was govemed by the need to tawget thebest mix of public/private support in the delivery of utilities, given the small size of the country/market andregional initiatives (based on previous country experience in Bolivia and Cote d'Ivoire).

Detailed cost analysis is required on the basis for capital-cost savings in the distribution grid systems. Achange in technical standards will permit the rate of investment to match the growth in demand.

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4. Institutional:The Government has appointed a Cabinet Subcommittee on Economic Reform, which is advised by aTechnical Committee on issues related to utility sector reforms. In the context of a Fund-monitoredprogram for the period January to September 2000, GoL has agreed to address the crisis in the electricitysector, and in particular to put in place measures that will reverse the fiscal burden resulting from subsidiesto cover losses made by LEC.

Steering Committee: The proposed project requires inputs from the Ministry of Natural Resources and theMinistry of Communications, as well as the Ministry of Finance which is concerned with the budgetaryimplications of sector reform. The Ministry of Natural Resources is the supervising ministry for LEC andelectricity issues, including Muela and the regulatory agency. The Ministry of Communications is theprimary interlocutor for the Telecommunications Regulatory Authority and intemet connectivity issues.The Ministry of Industry, Trade and Marketing is also an interested stakeholder, in terms of private sectorresponse and feedback on the shortfalls in business infrastructure to date. In particular, the Ministry ofTrade, Industry and Marketing has been instrumental in raising the Intemet Connectivity issue from thestart, pointing out that it is an essential element of business infrastructure. All four Ministries arerepresented on the Technical Committee. The Principal Secretary (PS) of Finance is the Chair of theTechnical Committee and the Minister of Finance chairs the Cabinet Subcommittee on Economic Reform.The Technical Committee is the advisory body which recommends the course of action to the CabinetSubcommittee. The Cabinet Subcommittee takes the sector policy decisions.

Regarding the electricity access pilots, the assessment will need to ensure that the legal framework allowsfor cost-based tariffs to fully cover operating, maintenance and subsequent expansion costs as well asdepreciation charges.

4.1 Executing agencies:

The components will be implemented by the PU which is linked to the Ministry of Finance, and willmanage all contracting under the project. PU will manage the privatization of both utilities, andestablishment of the Investment Fund, in coordination with ministries of Natural Resources,Communications and the Central Bank of Lesotho.

4.2 Project management:

The PU will be responsible for managing the program. The PU will also ensure financial consolidation andproject monitoring in addition to ensuring coherence with sector strategies. It will also be in charge ofharmonizing procedures: accounting, reporting systems.

4.3 Procurement issues:

The PU will be the coordinating and responsible agent for all procurement funded by the project. It willhandle the procurement requests of each implementing agency according to monthly procurement schedulessubmitted to it. It has staff who are fully familiar with Bank procurement procedures as they have hadprior experience under the Privatization and Private Sector Development Project. A Procurement ActionPlan will be developed by the PU and will be incorporated in the Project Implementation Plan.

This project has attracted the interest of other donors (African Development Bank, EU) supportingprivatization and private sector development initiatives in the country. It is expected that the donorsco-financing this project would agree on the common thresholds for procurement under the differentprocurement methods, the use of pre- and post-review, standard documents and procedures for advertising,evaluating and awarding the contracts, and reporting formats.

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4.4 Financial management issues:

A private accounting firn has been hired to design administrative and accounting procedures, produce theoperation manual and train the accounting staff at the PU. A detailed Draft Financial Management ActionPlan is Provided as Annex 6D.

A Financial Management Committee has been established and will be responsible for the overall policyguidance of the project's financial management. The project will be implemented by the PU and Ministry ofFinance (MoF), in collaboration with relevant line Ministries. Under the supervision of the Director, the(PASPU) would be responsible for ensuring that financial management, procurement and repoitingprocedures will be acceptable to the Government, IDA, and other participating donor agencies.

Monitoring reports that will be provided on a quarterly basis include: (a) financial statements documentingthe sources and uses of funds by loan category and by project activity, forecasting expenditure,disbursement amount and reconciliation of the special account, and summarizing credit withdrawals usingstatement of expenditures; (b) project progress reports providing infoimation on project implementationprogress in physical and financial terms and covering monitoring indicators including deviations from planand reasons thereof, and (c) procurement management reports indicating the status of procurement andcontract commitments and expenditure.

In compliance with the Development Credit Agreement, the government will submit audited financialstatements to IDA within about six months after the year end. In addition to the audit report, the auditorwill be required to prepare a separate Management Letter giving observations and comments, and providingrecommendations for improvements of accounting records, systems, controls and compliance with financialcovenants.

5. Environmental: Environmental Category: B (Partial Assessment)5.1 Summarize the steps undertaken for environmental assessment and EMP preparation (includingconsultation and disclosure) and the significant issues and their treatment emerging from this analysis.

In compliance with the government's Environmental Assessment (EA), an environmental analysis wasconducted to ensure that potential environmental and social impacts are addressed and mitigatedappropriately. The review team was comprised of LEC officials and consultants. The team noted that theonly aspect of the project that is of some environmental concem is the rural and urban hookups and relatedactivities. The assessment also covered central handling, storage and maintenance of materials andequipment required to carry out the hookups. Since specific individual properties to receive connectionshave not been identified, the review was treated generically and a focus given to the general and significantenvironmental problems faced by the country, i.e., pollution, soil erosion, and impact on vulnerable species.

The Environment Assessment report (EA) identified a number of potential biophysical impacts such soilerosion and loss of biodiversity, as well as several socio-economic impacts such as property damage,occupational hazards and injuries, and disturbance of agricultural land. At the same time, the EA reportidentifies direct impacts, cause and effect of impacts, level of significance, practical mitigation measures,and residual impacts. A list of good practices provides additional information on mitigative measures.

The EAR concludes that while potential impacts are few and for the most part not significant, repetition of

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seemingly insignificant impacts at numerous sites can lead to significant cumulative impacts if leftunattended. For example, a very small quantity of litter at one connection site (i.e., a small piece of surplusand non-useable wire) is of no consequence. However, when multiplied at 7,000 sites, this would result in amore significant litter impact over the area. Similarly, a small loss of lubricant at one site, multiplied overan area sharing a common groundwater supply, could result in a highly significant impact on thegroundwater source.

As regards residual impacts, these are considered to be minor if mitigation measures as outlined areeffective. Minor residual impacts will relate to aesthetics and health. Thus, pole placement and a landscapeof wires where none were before may be considered a lessening of aesthetics. As regards health, it isconsidered unlikely that children will ingest any of the creosote used to treat the poles; but if it happens,sickness could occur.

5.2 What are the main features of the EMP and are they adequate?

The main features of the EMP include (i) mitigative measures, institutional responsibilities, scheduling, andcosts for their implementation; (ii) appointment of an environmental officer who will be responsible formonitoring the EMP; and (iii) environmental training. Environmental training for the environmental officerwill include courses on environmental management, environmental assessment, and environmentalmonitoring. Such courses should be at the introductory level, given that anyone designated asenvironmental officer will probably be recruited from within the organization and will have little or nobackground in the social and biophysical sciences. It is furthermore recommended that the environmentaltraining component include an environmental awareness workshop for the environmental officer as well asa number of field staff who will be dealing with the environmental issues described in the EA report. Suchan awareness course should be extended to management staff as well.

5.3 For Category A and B projects, timeline and status of EA:Date of receipt of final draft: Received August 16, 2000

A report titled "Environmental Review of the Utilities Sector Reform Project" was commissioned in June2000. The report details the actions related to the EMP, in particular the scheduling of activities, theinstitutional and financial arrangements for the execution of the plan. The final report was submitted to theBank on August 16, 2000.

5.4 How have stakeholders been consulted at the stage of (a) environmental screening and (b) draft EAreport on the environmental impacts and proposed environment management plan? Describe mechanismsof consultation that were used and which groups were consulted?

Due to the generally benign environmental nature of the project, no stakeholders, with the exception of theplanning department of the LEC, have been involved in the undertaking of this environmental analysis.

5.5 What mechanisms have been established to monitor and evaluate the impact of the project on theenvironment? Do the indicators reflect the objectives and results of the EMP?

The project will be monitored on a regular basis to ensure that the environmentmanagement plan is implemented effectively. The environment officer will be trained andwill be responsible for systematically and regularly carrying out this function. A detailedmonitoring plan and procedure will be developed during the monitoring training course.An environmental management report will be provided to management on a semi-annualbasis.

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6. Social:6.1 Summarize key social issues relevant to the project objectives, and specify the project's socialdevelopment outcomes.

To alleviate the hardship associated with retrenchment programs, the social cost of the privatizationprocess will be addressed through the availability of resources under the proposed credit to fundcommunication programs and counseling for redundant employees, and to provide them with training foralternative opportunities. The project will finance (i) assistance including early and sustainedcommunication to LEC workers on the subject of retrenchment and restructuring, as well as (ii) counselingand retraining. All ernployees will be interviewed by a tearn of counselors and will prepare theirassessment of their own achievements and capabilities. The idea is to provide assistance to those who wantit either for training in developing their entrepreneurial skills or retraining those who are job seekers. Theprogram intends to finance, upon request by the retrenched, a scheme to assist entrepreneurs to developtheir projects. This would include (a) specific retraining at the beginning, including assistance for thepreparation of a business plan, and (b) monitoring during the first two years following implementation.There will also be a tracer study to assess the well-being of retrenched employees. All key stakeholders,including workers and labor unions, will be consulted on the design of the retrenchment program.Wherever possible, workers will be retrained to be able to participate as private contractors in anyactivities which will be outsourced by LEC.

Other social impacts: the project will increase access to electrical energy by a larger proportion of thepopulation - through private management of the existing distressed operator, and increased competition inthe sector - and will result in savings from the substitution of electricity in end-users, which typicallycurrently depend on kerosene, candles, and batteries, and will make possible increased economic activity.

The project has an explicit component to address the needs of consumers that are likely to remain unservedby the private sector. On a pilot basis, the project will explore, through consultative mechanisms, how bestto provide electricity and telephone access to such consumers on a sustainable basis, and furthermore, toconvert the arrival of electricity and telephone service into an income generating opportunity as well.However, some uncertainty remains about the willingness of communities to accept commercially-orientedrural electrification schemes. This is mainly because their tariffs would be expected to be higher thanLEC's average tariff, and also because of the heavy responsibility associated with the formation of acooperative distribution business. These issues would be addressed by discussing them with thecommunities identified for the electrification program. The criteria used to select the pilot communities willdepend on the findings of the Electricity Access Study. Once the pilot communities are identified, they willbe evaluated for telephone access as well, on a selective basis.

6.2 Participatory Approach: How are key stakeholders participating in the project?

The GoL counterpart team to draft the electricity legislation is a multi-ministry, cross-disciplinary teamreflecting the interests of key stakeholders: Finance, Natural Resources, PU and Attomey General's Office.Extensive consultation with a wider group of stakeholders has taken place in workshops organized by theintemational consultants who were engaged to prepare the first draft of the legislation. Inputs have beensystematically gathered, including from the Ministry of Local Govemment, and are now being incorporatedin the final Electricity Bill which will be submitted for Cabinet approval by October 2000. During projectimplementation, following the definition of the service territory to be controlled by the private investor,rural stakeholders will be extensively consulted with respect to the design of the electricity access pilotcomponents.

Labor unions and other associations representing the interests of retrenched LEC employees will be

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consulted with respect to the design of the retrenchment program. Key labor representatives will also beconsulted, to the extent possible, regarding the design of the internal communications program for LECstaff.

The Investmnent Fund is another mechanism by which key stakeholders, i.e., local private sector, includinglocal institutional investors, will be participating in GoL's privatization process. The Unit Trust has beendesigned as a mechanism to offer local investors the possibility of shareholding in privatized enterprises.

The credit will finance extensive communication programs from LEC to its customer base, to explain theprocess of privatization, the role of the strategic investor and the electricity access pilot program to lay outa vision of how coverage will be improved nationwide. At the same time, potential income generatingopportunities and other aspects of rural development that can be helped by improved utilities coverage willbe included in the communications campaign as part of GoL's private sector development effort. It isintended to have a participatory element to the communications and outreach efforts which will besupported under the project, in order to enable the participation of as many stakeholders as possible.

6.3 How does the project involve consultations or collaboration with NGOs or other civil societyorganizations?

NGOs will be actively involved in the design and implementation of the electricity access pilots and theaccompanying income generation activities that will be supported together with access to electricity.

6.4 What institutional arrangements have been provided to ensure the project achieves its socialdevelopment outcomes?

The IMTF will have a human resource manager and other support specialists in the area of human resourcerestructuring, who are expected to take a professional approach to designing and implementing the humanresource restructuring/retrenchment program.

Additional consultancy assistance will be available to GoL to design and implement the comprehensivemonitoring and evaluation of the downsizing program, in addition to carrying out the task of counseling andtraining both retrenched and retained employees.

6.5 How will the project monitor perfornance in terms of social development outcomes?

There will be a tracer study to assess the well-being of the retrenched employees.

7. Safeguard Policies:7.1 Do any of the following safeguard policies apply to the project?

Environmental Assessment (OP 4.01, BP 4.01, GP 4.01) 0 Yes 0 NoNatural habitats (OP 4.04, BP 4.04, GP 4.04) 0 Yes 0 NoForestry (OP 4.36, GP 4.36) O Yes * NoPest Management (OP 4.09) 0 Yes * NoCultural Property (OPN 11.03) O Yes * NoIndigenous Peoples (OD 4.20) 0 Yes 0 NoInvoluntary Resettlement (OD 4.30) 0 Yes 0 NoSafety of Dams (OP 4.37, BP 4.37) O Yes * NoProjects in International Waters (OP 7.50, BP 7.50, GP 7.50) 0 Yes 0 NoProjects in Disputed Areas (OP 7.60, BP 7.60, GP 7.60) 0 Yes 0 No

7.2 Describe provisions made by the project to ensure compliance with applicable safeguard policies.

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A report titled " Environmental Review of the Utilities Sector Reform Project " was commissioned andprepared (June 2000) which detailed the EMP and actions related to that plan. The plan clearly indicatesthe scheduling of activities, the institutional and financial arrangements for execution of the plan. Theproject will fund: (i) enviromnental training of LEC's Enviromnental Officer in environmental assessmentand management; (ii) organize an environmental awareness workshop with the objective of enhancing theawareness of field staff as well as the senior management of LEC. To ensure compliance with the Bank'ssafeguard policies and meet the Government of Lesotho's environmental requirements, the implementationof the Environmental Mitigation Plan will be closely monitored by LEC's Environmental Officer. TheMonitoring Plan will be prepared during the training course, and an environmental management report willbe provided to the government and the Bank on a semi-annual basis for their review and advice.

F. Sustainability and Risks

1. Sustainability:

It is expected that the utilities sector will be liberalized with several operators participating in differentsegments of the market. The reforms are not easily reversible.

The project will make an investment in the improved financial and operational performance of LEC andLTC. This project has the short term objectives of reversing the fiscal drain and attracting a private sector,strategic investor to LEC (LTC already has a strategic investor). Future issues, such as how to bestexpand the coverage of electricity services in urban and rural areas of the country by attracting privatecapital, will become clearer once the dialogue with potential strategic investors is underway. The "donothing" altemative, or a reversal of the reforms by GoL is not considered to be feasible at this stage, giventhe fiscal drain imposed on GoL, by remaining involved in these sectors.

The regulatory framework and the regulatory authority that will be put in place by the proposed project isalso a sustainable entity, and will be provided with the required training and capacity building inputs. Anintemationally recruited regulatory advisor will also be available to ensure that adequate capacity buildingand support are provided, as needed, to ensure sustainability following completion of the project. Finally,the project will finance the costs of running the regulatory agency for three years, or at least until there isassurance that operating costs can be met from license fees, etc.

An evaluation will be carried out before the end of the project, conceming the advisability of merging thevarious regulatory agencies into a single multi-sectoral regulator. Depending on the outcome of theevaluation, a Consolidating Act may be passed in future to unify the electricity and telecommunicationsregulators; it would also keep a provision to accommodate a future water sector regulator. If this is done, itwill further serve to make the reforms irreversible.

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2. Critical Risks (reflecting the failure of critical assumptions found in the fourth column of Annex 1):

From Outputs to Objective

Political situation may deteriorate MThere may be a change in government M Awareness meetings with new Cabinetthat may reduce commitment because of sub-Committee on Economic Reform; regularthe entry of new decision makers who involvement of Country Director,question the approach being followed here macroeconomist, project teamWeak private sector response to sector M Well-structured project design; well-designedliberalization; lack of foreign investor retrenchment program; effectiveinterest, in which case the sector cannot communications strategybe privatizedLack of capacity to deliver on regulatory M Support capacity building and institutionalframework development of all relevant agencies, e.g.

Ministry of Natural Resources, provide UtilityAdvisor to LEC Board, support multi-sectoralregulator with advisor for two years

Lack of domestic private sector interest, M Extensive consultation and the introduction ofparticularly in supporting the electricity guarantee mechanisms to reduce riskaccess pilotsForeign investors' perceptions about the M Provide access to information for all keyattractiveness of investing in LEC may be decisionmakers, and support thelinked to decentralization, SADC issues communications campaign of the utilitiesor restructuring of the South African privatization programpower sector

From Components to OutputsSpeed of execution of transactions could M Institutional Capacity Building for the Projectbe reduced by lack of capacity in Implementation Unit, the Ministry of NaturalImplementation Unit, or inefficient Resources, the Ministry of Communications,institutional framework leading to lack of and the Multi-Sector Regulator financed by thecoordination between LEC and IMTF Project. Recruitment of Technical Advisor to

LEC Board who will ensure coordinationbetween IMTF and LEC

Timely availability of counterpart funds M Counterpart contributions are mostly in-kind,and are already in place. Others involving cashoutlays have been budgeted for

Overall Risk Rating M

Risk Rating - H (High Risk), S (Substantial Risk), M (Modest Risk), N(Negligible or Low Risk)

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3. Possible Controversial Aspects:

The retrenchment program to be supported as part of LEC streamlining, but not to be financed by theBank, is possibly the most controversial aspect of this project. It is not a donor-financed component, but itis indeed a design component that will be financed by govemment resources as represented by LECrevenues. However, there are clear government policy guidelines in place, related to retrenchment in thecourse of privatization. These will be followed by the IMTF during implementation of the streanliningprogran. Furthermore, there is also a recognition that 95 percent of the population still needs to beconnected to electricity service, and that measures must be undertaken to keep any scarce skilled laborresources in the country, particularly with any kind of expertise in the electricity sector. To this end, acomprehensive dimension of counseling and training will be included as part of the retrenchment programand a monitoring and evaluation system will be set up to track the welfare of retrenched employees. Anintensive communications effort will be undertaken at the earliest opportunity to alleviate workers' anxietieswith respect to the retrenchment program, and all concemed stakeholders will be consulted to the extentpossible regarding the design of the retrenchment package.

Another possible controversial item is the issue of privatization itself. This risk is mitigated however, bythe fact that the government's program has been ongoing for the past five years, and that vehicles now existfor local participation in privatized companies' shareholding. There is less of a risk, therefore, thatprivatization is automatically interpreted as selling national assets to foreigners. Again, this risk will beaddressed by launching a strong communications campaign regarding LEC privatization to the public ingeneral that will be carried out by the Sales Advisory Group.

G. Main Credit Conditions

1. Effectiveness Condition

The following events are specified as conditions to the effectiveness of the Development Credit Agreementwithin the meaning of Section 12.01 (b) of the General Conditions:

(a) The African Development Bank Loan Agreement has been executed and delivered and allconditions precedent to its effectiveness or to the right of the Borrower to make withdrawals thereunder,except only the Development Credit Agreement, have been fulfilled; and

(b) the Borrower has adopted the PIP in form and substance satisfactory to the Association.

2. Other [classify according to covenant types used in the Legal Agreements.]

Agreed Covenants

(a) The Borrower shall, no later than June 30, 2003, establish and thereafter maintain LEC withfunctions and responsibilities acceptable to the Association and with staff in adequate numbers, whosequalifications and experience shall at all times be satisfactory to the Association;

(b) The Borrower shall enter into contractual arrangements acceptable to the Association, with atechnical operator whose qualifications and experience shall be satisfactory to the Association. The saidcontractual arrangements shall provide, inter alia, that full managerial autonomy for the conduct of LEC'sday to day operations shall be vested with qualified experts and staff working directly under theresponsibility and control of the technical operator;

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(c) The Borrower shall implement Part B, C, D and E of the project, as defined in the DevelopmentCredit Agreement, in accordance with the procedures, guidelines, timetables and criteria as set forth in thePIP and, except as the Association shall otherwise agree, the Borrower shall not amend or waive anyprovision of said PIP if, in the opinion of the Association, such amendment or waiver may materially andadversely affect the implementation of the project;

(d The Borrower shall maintain policies and procedures adequate to enable it to monitor and evaluateon an ongoing basis, in accordance with the performance indicators set forth in Schedule 6 of theDevelopment Credit Agreement and re-stated below, the carrying out of the project and to fulfill the annualreporting obligations to the Association;

(e) Not later than November 30, 2003, or such other date as the Borrower and the Association shallagree upon, the Borrower and LEC and the Association shall carry out a mid-term review;

(f) The Borrower shall carry out studies to expand the development of the Private Sector, and not laterthan

June 30, 2003, shall submit the results and recommendations of the said studies to the Associationfor its review

and comments;

(g) The Borrower shall establish the Unit Trust and the warehousing facility not later than March 31,2002,

and promptly thereafter shall take all measures required on its part to implement the said financialmechanisms.

(h) LEC shall implement Part A of the project, as defined in the Development Credit Agreement, inaccordance with the procedures, guidelines and timetables set forth in the PIP;

(i) LEC shall maintain policies and procedures adequate to enable it to monitor and evaluate, on anongoing basis, in accordance with the performance indicators set forth in Schedule 2 of the ProjectAgreement, the carrying out of the project and shall fumish annual reports to the Association;

(j) LEC shall (a) design the LEC reform program and the LEC staff redeployment plan referred tounder Part A of the project as defined in the Project Agreement, not later than May 31, 2001; and (b)promptly thereafter take all measures required on its part, to implement the said programs.

Agreed Performance Indicators

The Borrower shall, from time to time, review jointly with the Association and LEC, the progress achievedin the execution of the project inter alia through the following performance indicators:

1. The majority of LEC capital stock is held by a private sector investor by not later than December31, 2002;

2. By December 31, 2002, no further subsidies are made by the Borrower with a view to sustainingLEC current operations;

3. The Unit Trust and warehousing facility have been established and by June 30, 2003, at least 200

- 34 -

local investors have invested under the said mechanism;

4. By July 31, 2002, the LEC streamlining and downsizing program has been completed as defined inSchedule 6 of the Development Credit Agreement;

5. By December 31, 2004, the efficiency ratio in Tele-Communications Lesotho (TCL) stands at oneemployee per 100 telephonic lines;

6. By July 31, 2001, LEC shall have increased its rate of revenue collection to 85% of outstandingbills; and (b) by December 31, 2001, the said rate of revenue collection shall have been increased andthereafter maintained at 95% of outstanding bills;

7. By December 31, 2002, TCL shall have connected 25,000 users to the telephonic network; and (b)by December 31, 2004, 15,000 additional users shall have been connected to the said network;

8. By July 31, 2002, a total of 8,000 additional new users shall have been connected to the electricitygrid by LEC.

Remedies of the Association

Pursuant to Section 6.02 (1) of the General Conditions, the following additional events are specified:

(a) A situation has arisen which shall make it improbable that the Program, or a significant partthereof, will be carried out;

(b) LEC shall have failed to perform any of its obligations under the Project Agreement;

(c) As a result of events which have occurred after the date of the Development Credit Agreement, anextraordinary situation shall have arisen which shall make it inprobable that LEC will be able to performits obligations under the Project Agreement;

(d) The contractual arrangements referred to in Section 3.06 of the Development Credit Agreementshall have been amended, suspended, abrogated, repealed or waived without prior approval by theAssociation;

(e) The Electricity Act No. 7 of 1969 of the Borrower shall have been amended, suspended,abrogated, repealed or waived so as to affect materially and adversely the ability of LEC to perform any ofits obligations under the Project Agreement; and

(f) The right of the Borrower to withdraw the proceeds of the AfDB loan or the EU grant made to theBorrower for the financing of the project shall have been suspended, canceled or terminated in whole or inpart, pursuant to the terms of the AfDB Loan Agreement or the EU Grant Agreement, or the AfDB loanshall have become due and payable prior to the agreed maturity thereof.

H. Readiness for Implementation

0 1. a) The engineering design documents for the first year's activities are complete and ready for the startof project implementation.

Z 1. b) Not applicable.

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2. Tha p_ oa d uens fr the s yats t wae mpb r adyr he ut ofprojax inIzem,antleno.t, t

[ 3. T*PrOc IinPlmutsiPlm h lbenpuisdandod to be rea nd of sahictoyquay.

O 4., T Lowig insam a g gd mdiscsd uner lon Witlm (Section 0);

1. Compliance with Bank Policies

C 1. TIs pjct complies wilh aUi spoi= Bank poiio.0 2, Th &Uawi ng iceptoula to aLk p4licie a* ft==Miuded for &Wpmv.L .he prject complie With

al otihor applcble Bak polic,

-lohua Mnldmujac lB hye2 S. OmarTom Loar sctor Manager couttiy Manager

-360

Annex 1: Project Design SummaryLESOTHO: Utilities Sector Reform Project

Sector-related CAS Goal: Sector Indicators: Sectorl country reports: (from Goal to Bank Mission)To promote broad-based, Annual average GDP growth National Statistics Achievement of broad basedprivate sector-led growth of rate of 3.5 percent over the growth and poverty alleviationthe economy next five years as a result of existing

programs under the CAS

Project Development Outcome I Impact Project reports: (from Objective to Goal)Objective: Indicators:To improve the quality, 1. Complete the installation of Bank mnission reports No sector policy reversal;coverage and econouic 8,000 new connections by Sufficient foreign investorefficiency of utility services IMTF no later than July 31, interest to allow successfulunder competitive and 2002 divestitureregulated conditions Surveys of regulatory

2. Define service territory to agencies, and Annualbe connected by strategic Regulatory reportsinvestor according totimetable in the PIP

To improve financial and 3. Completion of LEC Annual Report ofoperational performance of privatization no later than Privatization Unit Regulatory agencies are notutilities sector (LTC, LEC) December 31, 2002, and co-opted by special interestscloser to international consolidation of LTCstandards, and to reduce and privatization by the same date;eliminate the need for and achievement of onebudgetary support to utilities employee per 100 connections

at LTC by December 31, 2004

4. Budgetary transfers to LECreduced to zero, no later thanDecember 31, 2002

5. Establishment of electricityregulators no later than June30, 2003

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6. Establish Unit Trust and Project Progress Reports Macroeconomic conditionsTo promote possibilities for warehousing facility by no will be conducive to privatelocal ownership in later than March 31, 2002; by sector entities implementingshareholding of privatized June 30, 2003 at least 200 investment / expansionutilities local investors shall have programs

invested under the saidmechanism

7. Completion of Muelacommercialization study inaccordance with timetables setforth in the PIP, andimplementation ofrecommendations also inaccordance with the PIP

8. Successful completion ofLEC streamlining program (asdefined in Schedule 6 of theDCA) by July 31, 2002

9. Additional 25,000 workingtelephone lines by December31, 2002, and a further 15,000new telephone lines byDecember 31, 2004.

10. Additional 8,000 newelectricity connections by July31, 2002.

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Output from each Output Indicators: Project reports: (from Outputs to ObjectJve)Component:A. LTC, LEC Divestiture Sale of controlling interest in 1. Sale Agreements for LTC Continued politicaland Electricity Expansion LEC to a strategic investor by and LEC commitment to privatization

no later than December 31, process2002; and consolidation of 2. Periodic reports from the

Increased telephone and LTC privatization by the same Privatization Unit No significant lag in privateelectricity coverage and date; sector response toimproved revenue position of privatization opportunitiesLEC Backlog of up to 8,000 new

electricity connections cleared Transactions are carried outand total electricity according to the PIPconnections increased at least Funding for retrenchmentby up to 20,000 by June 30, program made available2005; telephone connections

Training of remaining and increased up to 40,000 by Tracer study on progress ofredeployed workers provided, December 31, 2004 retrenched LEC employees toand severance packages be completed by the end of the GoL remains committed todelivered. Communication Number of staff trained under project implementing the regulatorycampaign conducted the project and number of framework in a manner to

redeployed workers trained promote competition andand received severance efficiencypackage by end of project,based on HR restructuringplan to be provided by IMTF.

B. Regulatory Reform Sector reforms implemented Sector refonn policies GoL maintains efficient entryand institutional capacity apprved by Cabinet and exit policies into utility

Establishment of Electricity strengthened to regulate services marketsand Telecommunications private participation in Publication in Official GazetteRegulators teleconnnunications and of new legislation Regulatory agencies are

electricity; adequately staffed and able toAnnual reports of regulatory work without interferenceagencies from vested interests

Project progress reportsRecommendations of Updated regulations Consultants' studiesRegulatory StudiesimplementedC. Future of Energy Sector Completion of Muela Consultants' Report1. Studies Commercialization Options2. Electricity and Telephone study according to agreedAccess Pilots (institutional timetable in the PIP, andmechanisms to deliver implementation ofelectricity and telephone recommendations also asservice to nral communities agreed in PIPthat will not be served by thestrategic investor)

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Implementation of Electricity Project Progress Reports Adequate consultativeand Telephone Access Pilots processes with key rualby June 2005 stakeholders can be

implemented, and that there issufficient demand from ruralpopulations to enable therecovery of operating costs

D. Private SectorDevelopment

1. Investment Fund Unit Trust and warehousing Privatization Unit reports There is sufficient domesticfacility to be established by investor interest and the UnitMarch 31, 2002 and at least Trust is marketed effectively200 local investors shall haveinvested in the Unit Trust byJune 30, 2003

2. Studies and pilots Reports outlining strategies to Consultants' Studies Economic prospects of SADCencourage regional region remain attractive, sointegration, targetting of high that GoL's regional integrationvalue-added goods that may be efforts pay off in terms ofdeveloped as non-traditional increased growth andexports, etc., to be completed employmentno later than June 2005

E. Advisory Services and Adoption of the regulations Consultants' studies and the GoL maintains itsCapacity Building recommended as outputs of engagement of various commitment to the

various studies advisors, provision of training privatization processto policymakers

F. Support to Project Delivery of financial Timely delivery of all key GoL maintains itshmplementation Unit and management procedures and reports commitment to therefinancing of PPF manuals, retention of key privatization process

experienced staff

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.9 .....Project Components I Inputs: (budget for each Project reports: (from Components toSub-components: component) Outputs)A. LTC, LEC Divestiture Quarterly Project Management Effective coordinationand Electricity Expansion Reports; between LEC and IMTF

Definition of Service regarding control, autonomy1. Recruitment of an Interim $14.3 million Territory; and accountability inManagement Task Force Electricity Access Study, management decision making1.1 Completion of the Financial Accounts to befinancial turnaround of LEC, given to LEC Board and Salesincluding change-over for Advisory Team8,000 credit meters topre-payment meters1.2 Installation of 8,000 newconnections1.3 Completion of two studies:Service Territory andElectricity Access Government maintains1.4 Skills audit of LEC labor comnmitmnent to Divestitureforce Process1.5 Design andimplementation of HRrestructuring/downsizingprogram at LEC, includingcommunication program,developing retrenchmentpackages, counseling andtraining of retrenchedworkers, and tmining ofretained workers1.6 Developing andimplementing acommunication plan tointernal and externalstakeholders1.7 Clearing the backlog ofun-audited accounts for thelast five years1.8 Pmviding the necessaryfinancial and technicalinformation required by theSales Advisors

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2. Recruitment of a Sales $3.6 million Ongoing dialogue regarding Severance Packages areAdvisory Group divestiture strategy designed well enough so thai2.1 Definition of Divestiture LEC layoffs do not become aStrategy, technical advice e.g. political issuehow to treat system controletc.2.2 Preparation of InformationMemorandum, and support toGoL until the privatizationtransaction for LEC iscomplete2.3 Communications strategy IMTF Progress Report on HRon three fronts, including issues; outputs of monitoringinfonnational needs internal and evaluation process of theto LEC, from LEC to its retrenchment programcustomer base, andinternationally through atleast two Roadshows tomarket LEC to potentialstrategic investors $2.5 million

3. LEC StreaniliningProgram

3.1 Counseling and Trainingfor retrenched workers, andany additional training ofretained employees that maybe necessary in addition towhat is undertaken by IM1F3.2 Comprehensivemonitoring and evaluation ofthe LEC downsizing program3.3 A governmentcommunication program onthe LEC restructuring process

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B. Regulatory Reform $5.6 million Timely availability ofcounterpart funds and

4.1 Part of the initial resources, e.g. identification ofestablishment cost for LEA premises, suitable candidatesand some of the running costs etc.of LTA and LEA for twoyears, to cover any initialshortfalls after licenserevenues are taken intoaccount.4.2 long term resident advisorfor two years, for LTA andLEA, to assist in duties andensure transfer of skills4.3 short term consultantsover two years for advice onspecific operational issues andto transfer skills4.4 training programs andstudy tours to build regulatorycapacity in the first two years;4.5 Any additionalrequirements of frequencymanagement and monitoringequipment to enable LTA todischarge its statutory duties4.6 for LEA, finalization ofnew regulatory functions andkey procedures for theregulator to award licencesand concessions to the privatesector.C. Future of Energy Sectorin Lesotho5.1 Muela Options Study $5.01 million Project Status Reports, All parties are agreeable to the5.2 Study on Future of delivery of studies consultants' recommendations

Hydroelectric Power and on the Muela debt workoutExport Possibilities5.3 Design andImplementation of Electricity(and telephone) Access Pilots

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D. Private Sector $2.04 million Project Progress Reports Adequate consultation will beDevelopment possible for the design of rural6.1 Warehousing pilots; no capture of theFacility/Investment Fund process by political interests6.2 Studies on specific privatesector development issues, Consultants' reports Interest shown by localpilot models for investors and mobilization ofentrepreneurship training, private resources to participatestudies to develop in the fundsector-specific regionalintegration strategies Regional business climate

remains attractiveE. Advisory Services and $1.32 million Delivery of consultants' Climate remains favorable forCapacity Building reports continued work of the7.1 Ministry of Finance: Privatization UnitAdvisor and Training7.2 MinistryofCommunication: Advisor andTraining7.3 LEC Board: Advisor and Study tour reportsTraining7.4 Capacity Buildingincludes training needs forselected senior staff atMinistries of Finance,Communication and NaturalResources.

F. Implementation Support $2.93 million Climate remains favorable forcontinued policy refonn

8.1 Contracts of key senior Delivery of consultants'staff at the PU; reports8.2 Legal, audit, financial and Establishment of Financialother consultancies that will Management Committeebe required from time to time; (FMC) and delivery of8.3 Some public awareness minutes of FMC's quarterlycosts; meetings8.4 Operational costs of PUwithin an agreed framework

8.5 PPF Refinancing $2. 1 milion

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Annex 2: Detailed Project DescriptionLESOTHO: Utilities Sector Reform Project

Introduction

TelecommunicationsSector Overview

Lesotho Telecommunications Sector OverviewExisting Institutional Framework (September 2000)

Category Description

Ministry Responsible for MOCPolicy

Regulatory and Licensing LTAAuthority

Legislation New Telecommunications Act No 5 2000to establish LTA and facilitaterestructuring of LTC.

Basic Services including LTCleased lines

National Long Distance LTC

Intemational Service LTC

Cellular Service VCL

Intemet Liberalized

Value Added Services LiberalizedResale & Paging

Radio Spectrum Authority LTA

As part of the privatisation transaction LTC will be granted a five year period of exclusivity for basicservice, the underlying infrastructure of these services and leased lines. While this is frequent practice insuch transactions it is also common to grant shorter (or even no) period of exclusivity. However, thetransaction may stimulate competition between the fixed and mobile sectors and within the mobile sector.VCL is ajoint venture, offering mobile services, between Vodacom of South Africa and the GOL, wherethe shareholding of the latter rests with LTC. Vodacom currently holds 88 percent of VCL's equity, that ofLTC having been diluted from 49 percent. One aspect of the transaction is the issuance of a second mobilelicense to the strategic investor in LTC and the withdrawal, and possible sale, of the 12 percent held byLTC in VCL.

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Competition is provided for under the Act in non-Basic Services, private services for own use and by themeans of Resale of basic services. As yet, competitive market entry is limited and while the LTA is chargedto promote competition this activity will require some strengthening.

International Comparisons

Table 3 locates the performance of the sector within the regional context. Here, both Botswana and moreparticularly South Africa stand out, and with the exception of these countries, the performance of Lesothois not particularly different from other countries. But this performance is poor, as noted by theTelecommunications Policy. The World average penetration rate is over 10 per 100 population but is lessthan 1 per 100 in Lesotho. Also of concern are the disparity between penetration rates in urban areascompared to the overall rate, indicating the low level of service in rural areas, and the very poorperformance for Intemet access. These factors indicate that Lesotho is the wrong side of the "DigitalDivide".

Table 3 Lesotho Telecommunications Performance in the Regional Perspective

Lesotho Malawi Moz Zambia Zimb Bots South Africa

$GDP per 547 242 86 463 712 3252 2979cap

Mainlines 20.1 37.4 75.4 77.7 212.0 85.6 5075K

Main lines 0.97 0.35 0.40 0.88 1.72 5.64 11.46per 100

Waiting 20.0 30.9 19.7 8.0 109.0 11.8 116.2list K

Public pay 0.15 0.51 0.28 0.55 2.50 1.94 153.48phones K

Largest 5.84 6.18 2.40 2.30 7.52 17.95 41.52Citytele-density

Mobile 0.48 0.10 0.04 0.06 0.43 1.46 5.64subs per100

Internet 50 50 194 200 909 500 15385Users permillionpop*

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$permain 684 877 847 1313 639 967 1177line Source

figuresfor1998except

WorldBank1999

The privatization of LTC is close to completion. A draft Sales Agreement has been signed with a privatestrategic investor, and is currently awaiting Cabinet approval. The proposed agreement contains roll-outtargets that must be met by the investors for connected lines, public pay phones, intemet accessinfrastructure and fixed line capacity for each of the first five-years. The following five year targets apply:connected lines: 50,000, and public pay phones: 1,250. A national target for all payphone providers,including LTC (target of 1,375 subject to market demand). Quality of service targets (seven separatetargets defined with percentage requirements in years 1, 2 & 3) requiring increased quality of service overthe first three years (followed by review).

Separately, the old govermment-owned LTC has held a 12 percent stake in VCL, the only cellular operatorcurrently offering service in Lesotho. This 12 percent stake is in the process of being sold to a group oflocal investors. The exclusivity period offered to VCL will end in June 2001. At that time the new,privatized LTC will be granted the second cellular license and will engage in competition with VCL.Regulatory capacity for the telecommunications regulator, particularly in the area of regulating cellularcompetition, is therefore an essential item of support required, and is expected to be provided under theproposed project.

The ongoing privatization project has supported the financial restructuring of LTC, and the followingpre-privatization actions: (a) improvements in customer service, billing procedures, collection on overdueaccounts, and credit management; (b) right sizing of the firm through outsourcing of non-core services; (c)reconciliation of billing data between LTC and many of its large clients (including the cellular service); (d)reconciliation, first, with the Lesotho Bank on international payments in favor of LTC; second, on debtrepayments including installation costs of a VSAT network linking bank branches; and, third, with theCommissioner of Income Tax on LTC's cumulative corporate tax liability; (e) presentation of evidence ofownership on land and buildings (including disputed sites involving the Post Office) and other clarificationsrequired for the preparation work of the 1997 through 1999 audit reports; (f) agreements on the proposedsale of LTC's shares in the cellular operator (12 percent of VCL) by public tender as approved by Cabinetand the Privatization Steering Advisory Committee; (g) clarification with the Lesotho HighlandsDevelopment Authority on LTC's ownership and/or tenancy rights in the East-West digital microwavesystem which forms a vital component in the national telecommunication network. The ongoing project hasalso supported the recruitment of the sales advisor for the privatization process, and the technicalconsultants to assist with drafting of the regulations.

Telecommunications Components

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Based on the discussions held and the forgoing analysis, the following elements of the Telecommunicationscomponent have been agreed.

Funding of LTA: For a period of two years the running, including staff, costs of the LTA to the extent thatthere is a shortfall of revenues from licenses awarded.

Funding of long term resident advisor: For a period of two years the full costs of a resident advisor to theLTA, recruited internationally, to assist LTA in its duties and ensure the transfer of skills.

Funding of short term resident advisor(s): For a period of two years, short term resident advisor(s) to theLTA for specific advice on specific issues and to transfer skills.

Funding of Training: For a period of two years, a training programme to build LTA capacity withrn-house, external, overseas elements, workshops linked to studies (see below), and appropriate study toursand/or staff exchanges.

Funding studies: For a period of two years, in order to assist LTA in its duties and to build capacity, fourstudies on the topics of Universal Service/Access; Interconnection; promoting Internet; and Tariff policy.

Funding of frequency Management and Monitoring: The direct capital costs of upgrading the existingcapability so that the NTA can discharge its statutory duties.

Electricity

The main actor in the power sector is the Lesotho Electricity Corporation (LEC), which is primarily atransmission and distribution company. Prior to 1998, LEC was purchasing all of its bulk electricity fromESKOM in South Africa. The electricity supplied by ESKOM is mostly generated in coal-fired powerplants, and is among the cheapest in the world. Lesotho, which is potentially rich in hydropower resources,has recently become an operating member of the Southem Africa Power Pool (SAPP), and now can buyand sell in the regional power market. Lesotho has an existing treaty obligation with South Africa underwhich Lesotho supplies water to its neighbor and receives royalties. The Lesotho Highlands Water Project(LHWP) is administered by both GoL and the Govenmment of South Africa, through the Lesotho HighlandsDevelopment Authority (LHDA). Prior to the political changes of 1994 in South Africa, GoL had beenconcemed about its total dependence on ESKOM for bulk electricity purchases, and had considered itstrategically important to develop a domestic power generation capacity. GoL chose to do so through thestrategic placement of hydro power turbines in the path of the water which was flowing to South Africaunder its treaty obligations. The Muela hydropower project was therefore commissioned seven years later,in 1998, and currently supplies about 85 percent of the bulk power purchased by LEC. The remaining 15percent of bulk power used in Lesotho is sourced from ESKOM. (Muela alone is unable to supply all ofLesotho's year-round power requirements because its power output depends on the volume of water that isbeing transferred by LHWP to South Africa. The water demanded by South Africa is less in winter, whenpower demand in Lesotho is highest. Since the water is used for agricultural purposes in Gautengprovince, the demand for water from the LHWP is highest in summer. Muela thus produces more powerthan LEC customers need in summer, and vice versa in winter).

At present the National Control Center (NCC) which monitors and controls the power flows from Muelaand South Africa to Lesotho is a part of LEC. The government needs to decide whether it wants toseparate the NCC prior to privatization or let a private operator control the national grid, especially in the

- 48 -

light of potential electricity trade through the Southem Africa Power Pool. The Sales Advisory Group willadvise GoL on this matter.

Low coverage levels and high-cost service delivery of electricity have been identified among the principalconstraints to private sector-led growth and regional integration. The government's prior strategy ofholding tariffs below cost has been retarding system development and has held back increased access toelectricity, since LEC has been unable to generate adequate funds for system maintenance and requiredinvestments. This problem was further exacerbated by LEC's poor operating and financial performance,which began when the billing system collapsed in late 1997 and very few revenues could be collected forthe next two years. The impact has been threefold. First, access to electricity is very low, with about18,000 households of the total 400,000 households in Lesotho having access to grid supplied electricity.Second, the lack of reliable power services and a limited distribution network are resulting in substantiallosses to the real sector (especially industry), which is further burdened by the need for self-generation ofelectricity at high cost. Third, there has been a significant impact on the government budget. Furthermore,in January 2000, GoL assumed about $7.5 million of the outstanding debt of LEC to LHDA for bulkelectricity purchase costs.

By Component:

Project Component I - US$20.40 millionLEC Divestiture and Electricity Expansion

This component will focus on upgrading the electricity sector through the inflow of private capital, newtechnology and management necessary to increase access and improve the affordability and reliability ofelectricity services provided in the country. It comprises three sub-components:

(i) Interim Management Task Force. Technical assistance will be provided for 18 months by anIMTF that will manage the day-to-day activities of LEC until a strategic investor is in place. The IMTFwill be held accountable (under a performance contract with incentives) for (a) the financial turnaround ofLEC, (b) parially addressing the backlog by installing up to 8,000 new electricity connections, (c)changing over 8,000 existing credit meters to pre-payment meters in order to improve LEC's revenue baseand also to reduce the need for meter-readers, (d) defining the service territory deemed to be commerciallyviable, which will be offered to the strategic investor for expansion of the network under the existing tariffregime, (e) a skills audit to serve as the basis for streamlining the LEC labour force, (f) design andimplementation of the human resources (HR) restructuring/downsizing program, including thecommunication program, developing retrenchment packages, counseling and training of retrenched workers,and training of retained workers, (g) developing and implementing a communication plan regarding theLEC restructuring process to internal and external stakeholders, (h) carrying out the Access to Electricitystudy, (i) clearing the backlog of unaudited accounts for the last five years, and (j) providing the necessaryaccounting, financial and technical information required by the sales advisors. Under the IMTFmanagement, the project will seek to promote the transfer of existing non-core activities of LEC to the(local) private sector. This will be done in conjunction with the LEC streamlining/downsizing programwherever possible, in order to offer employment opportunities to laid-off LEC staff throughsub-contracting.

(ii) Sales Advisory Group. A professional advisory team, with expertise in investment banking,international law and technical issues will be appointed to assist GoL with developing a divestiture strategyfor LEC and the identification of, and negotiation with, a suitable strategic investor to purchase the

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majority stake in LEC. The Sales Advisory Group will support GoL until the privatization transaction iscomplete. The Credit will finance a communications strategy on three fronts, addressing informationalneeds related to LEC privatization: internal to LEC; from LEC to its customer base, explaining theprivatization strategy and building awareness with respect to expected benefits; and marketing LECinternationally through roadshows, etc., to inform potential strategic investors. This will require a publicrelations campaign to promote a public awareness program for both internal LEC staff and its customers,and the implementation of a strong Communications Program to promote private sector options to localstakeholders and strategic foreign operators/investors.

(iii) LEC Streamlining. Retrenchment payments will not be made using resources from theproject. This component will include: (a) training and counselling of the retrenched employees, andtraining of retained employees that may be necessary in addition to the tasks undertaken by IMTF in thecontext of implementing the restructuring/downsizing program; (b) comprehensive monitoTing andevaluation of the LEC downsizing program; and (c) a govemment communication program on the LECrestructuring process.

Project Component 2 - US$5.60 millionRegulatory Reform

B. Regulatory Reform

The role of the regulators will be to enforce appropriate regulations in the utilities sectors, ensure fair andtransparent treatment of sectoral operators, and encourage new entrants (particularly in the area ofvalue-added services for telecommunications. and access to the Intemet), private investment and thetransfer of technologies. GoL will be assisted with evaluating the possibility of merging these regulatoryfunctions together under a future multi-sector regulatory agency. Futhermore, the proposed credit willprovide support, including the financing of technical advisory services, to the Ministries of Communication,Natural Resources and Finance to oversee the implementation of the privatization process. Policy-settingcapacity is perceived to be an important element for both the telecommunications and the electricity sectors,and expertise at the respective Ministries must keep pace with the introduction of strengthened regulatorycapacity. Policy advisors to the respective Ministries, as well as study tours for Ministry staff to gainfamiliarity and experience with intemational best practices, will be supported under the project.

Telecommunications Regulator. The Lesotho Telecommunications Policy, which supports liberalization ofthe sector and privatization of LTC, was adopted by Cabinet in February 1999, and theTelecommunications Act was passed by Parliament in June 2000. To date, legal and regulatory assistancewas provided to GoL by USAID, for: (i) drafting the Telecommunications Bill which provides for anindependent regulator for the telecommunications sector; and (ii) defining the new regulatory functions.However, additional assistance is required to develop and enforce the set of regulations which will allowthe framework to be implemented, especially in technical areas such as competition policy, interconnection,tariffs and universal service. The PPSD Project has financed a study on the "Finalization of theTelecommunications Regulatory Framework." The study is near completion and is expected to giveguidance on implementing the appropriate regulatory framework needed in a newly liberalized andprivatized environment. The new legal and regulatory franework aims at putting all operators on an equalcompetitive footing with respect to regulatory provisions on tariffs, interconnection and universal access.Resources will be provided to build capacity in the independent regulatory agency for thetelecommunications sector (including on important topics such as introduction of regulations encouraginginvestment and competition in Internet-host services and e-commerce), and will be complemented by theavailability of an in-house regulatory advisor (internationally recruited) for the duration of the project.

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From a sector development standpoint, technical assistance under the project will examine and formulaterecommendations related to liberalization of international traffic, fully liberalizing the provision of internetservice, and liberalizing tariffs. Lesotho is surrounded by Africa's only real internet player, South Africa.To allow Lesotho to leverage its proximity to this market would have a positive developmental impact.Regulatory capacity-building will extend to an assessment of the potential for e-govemance (i.e., doingon-line any governmental function that is now done on paper - customs, taxes, licensing, corporate filings,etc.) and the benefits of transparency that grow from it.

The project will finance the following: (a) some of the mnning costs of the LTA for two years (anyshortfall after license revenues are taken into account); (b) long term resident advisor for two years to assistLTA in its duties and ensure the transfer of skills, (c) short term consultants for two years for advice onspecific issues and to transfer skills; (d) training over two years to build LTA capacity through in-house,external, overseas elements, workshops linked to studies; (e) appropriate study tours and/or staffexchanges; (f) studies on universal service/access; interconnection; promoting Internet; and tariff policy;and (g) any additional requirements of frequency management and monitoring equipment to enable LTA todischarge its statutory duties.

Electricity Regulator. Technical assistance under the proposed credit consists of: (a) finalization of thedefinition of new regulatory functions; (b) financial support for the establishment of an independentregulatory agency (including initial staff salaries that will subsequently be fully covered by licenserevenues; and (c) establishment of operational procedures for the agency. In partieular, elements of theproposed assistance include: a) an in-house long term regulatory advisor (internationally recruited) toprovide technical assistance to the regulator; (i) finalization of key procedures for the regulator to awardlicences and concessions to the private sector; (ii) in-house training programns for the staff of the regulatoryagency and other key agencies in the sector; and (iii) study tours to countries having already liberalizedtheir power sector.

Resources will be provided to develop the regulatory framework and establish an independent regulator forthe power sector. The Electricity Bill is being drafted and reviewed, and is expected to be submitted forCabinet and subsequent Parliamentary approval by June 2001. Following passage by Parliament, theelectricity regulatory authority will be established, and staff will be trained, to implement the newelectricity legislation. The regulators will: enforce appropriate regulations in the utilities sectors, ensurefair and transparent treatment of sectoral operators, and encourage new entrants, private investment and thetransfer of technologies.

As noted above, assistance will also be provided to a regulatory agency for telecommunications, toimplement the Telecommunications Act which has been passed recently by Parliament. Thetelecommunications regulator will require additional assistance relative to the electricity regulator. This isdue to the fact that the telecommunications regulator will need to address issues of competition in thecellular network, and promote Internet connectivity and e-commerce, by gaining access to international bestpractice on how to encourage entry and competition in these areas. Specifically, issues that will beincluded in the regulatory support to telecommunications, are:

* basic competition regime, (prohibitions against abuse of dominance or significant marketpower) entering into anticompetitive contracts and arrangements (vertical and horizontal),anticompetitive cross subsidies and anticompetitive practices

* interconnection* tariff policy* infrastructure sharing

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* licensing* number portability* frequency management (possibly including equipment)* universal access policy & implementation* type approval* financial and accounting procedures* investigative procedures* complaint handling* dispute resolution

GoL will also be assisted with evaluating the possibility of merging these regulatory functions together withthose for the water sector under a future multi-sector regulatory agency.

Project Component 3 - USS 5.01 millionFuture of Energy Sector in Lesotho

The costs are allocated as follows: Muela Options Study (US$101,000); Future of Hydroelectric Power inLesotho and Export Possibilities through SAPP (US$509,000); Electricity Access Pilots (US$4.4 million)

This will involve two activities:

--A two-part study on the future options related to hydroelectric power in Lesotho. The first partof the study will specifically recommend options related to the commercialization of Muela, and the secondpart will consider the potential for the development of additional hydropower resources for export.

--Electricity Access Pilots. This component is intended to assess the viability and modalities ofproviding service to those areas that will not be commercially viable, and will remain un-served followingthe transfer of LEC ownership from GoL to a private investor. Once the IMTF identifies the serviceterritory, it will seek to identify a series of pilot areas outside the service territory in consultation with GoLand concerned stakeholders, in which to develop institutional mechanisms and management arrangementsthat will allow for sustainable electricity service delivery, with the capital investment initially supported byIDA financing. Community-based private sector institutional arrangements (e.g. through local concessions)will permit recovery of operating cost, maintenance and depreciation allowance. It is anticipated thatapproximately 3,000 new customers outside the service territory will be connected by low-cost technologiesused to extend the grid, and separately, a total of up to 1,000 new customers spread over five pilot isolatedcommunities will be connected using stand-alone generation facilities. Studies will first be financed tosupport the development of these arrangements. In particular, intensive surveys of proposed pilotcommunities will be undertaken. In addition, the project will seek to develop access to income generatingopportunities / private sector development in these pilot areas, in parallel with the access to electricity.There is an ongoing effort by the government to implement a rural telephone service program. Thisproposed project will support the introduction of rural telephone services in the same locations as theelectricity access pilots wherever feasible.

Project Component 4 - US$2.04 millionD. Private Sector Development

The costs are allocated as follows: Support to Investment Fund US$509,000, and PSD Studies plus otherPrivatization Activities US$1.53 million.

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This component will involve two activities:

--Establishment of the Investment Fund/Unit Trust. Financing will be provided to continuesupporting on-going work to establish the Lesotho Unit Trust. With financing provided under theIDA-financed Privatization and Private Sector Development Project, the Privatization Unit is in the processof recruiting a Management Company that will establish and operate the Unit Trust. The chosenManagement Company is required to undertake a consultancy that will constitute the essential activitiesrequired to establish and start operating the Unit Trust. The main principles relating to the structure of theportfolio of the Unit Trust are based on: accessibility (by Basotho to their savings at all times);competitiveness (in terms of returns and risks compared with other investment opportunities in Lesotho andSouth Africa); and manageable risk (to avoid potential loss of confidence in capital market development inthe medium term). It is crucial that the Unit Trust's local equity portfolio consists only of shares with aproven track record; shares of companies with growth potential (including the shares of the privatizedutilities) will be put in a Privatization Trust Fund (a warehouse) until they become financially viable. Theproject will also support capacity building of the Unit Trust regulatory authority at Central Bank ofLesotho.

--Private Sector Development Studies. Technical assistance will be financed to identify andsupport activities that will encourage regional integration efforts and identify Lesotho's areas ofcomparative advantage. Potential areas to be included for study include the removal of administrativebarriers to investments, internet and e-commerce possibilities within the region, targetting of high valueadded goods that may be developed as non-traditional exports, and identification of actions to boost thecompetitiveness of local firms. Technical assistance will also be provided to identify and support incomegenerating activities that can be associated with first-time access to electricity and telephone services,particularly in the electricity access pilot areas.

Project Component 5 - US$1.30 millionE. Advisory Services and Capacity Building Assistance

Resources for advisory services and training of staff at the Ministries of Natural Resources,Communications and Finance will be funded under this component. Advisory services include a TechnicalAdvisor to the Board of LEC, to assist with the supervision of IMTF; a Technical Advisor to the Ministryof Communications on Policy Issues for Telecommunications; and a Legal Advisor to the Minister ofFinance to assist with the formulation of a Competition Law and other institutional matters related toregional commerce. Capacity building includes training needs for the staff of the Ministries ofCommunications, Natural Resources and Finance, respectively. The procurement for agreed activitiespertaining to these Ministries will be carried out by the respective Ministry, with all necessary coordinationand support provided by the Privatization Unit, which has familiarity with IDA procedures andrequirements.

The Technical Advisor to the Board of LEC has been selected and negotiations are underway. Draft ternsof reference for the Advisor to the Ministry of Communication will be prepared by mid-April 2001.Recruitment is expected to be finalized by July 2001, with the consultancy to begin around September2001. The Ministry of Communications has informed IDA of its proposed training requirements to besupported under the project. These are being studied and will be considered for inclusion. Comments willbe provided to the Ministry of Communications by end-April 2001. Terms of reference for the LegalAdvisor to the Ministry of Finance will be finalized by May 2001 and the recruitment process will belaunched in June 2001. Training needs for the Ministries of Natural Resources, and Finance for the next

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two years are being identified and will be communicated to IDA by end-April 2001.

Project Component 6 - US$2.93 millionF. Implementation.

This component is proposed to include contracts of key senior staff at the Privatization Unit; legal,financial, audit and other consultancies that will be required by PU from time to time; some publicawareness costs; and the operational costs of PU within an agreed framework. The African DevelopmentBank will finance training costs, office equipment and vehicles; the advisor to the director; other officers,support personnel, and some public awareness costs.

Of the total, foreign costs are being financed as follows: IDA $2.0 million and AfDB $0.93 million.

Resources will be provided to support the operating budget of the Privatization Unit (salaries of key seniorstaff and any expansion of office equipment, as needed). In addition, external support will be provided tostrengthen financial management capacity at PU. This will include the short-term recruitment of aninternational accounting firm to develop systems and manuals for financial management and reporting, andthe long-term recruitment (18 months to two years) of a consultant to support PU in carrying out thereconimendations of the international accounting firm. Any consultancies that may be required by the PUin furthering the objectives of this project (legal, audit, financial) will also be supported.

Project Component 7 - US$2.10 millionPPF RefinancingA PPF of US$1.5 million was made available by IDA to GoL in August 1998, for a proposed supplementalproject on privatization and regulatory reform. The appraisal of that proposed project had to be cancelleddue to the outbreak of civil disturbances the following month. Resources of that PPF were used for thestudy on Regulatory Reform for Electricity and Water Sectors, the financial workout team and marketanalysis for LTC, and the divestiture of Lesotho Bank. It is proposed that the PPF will be refinanced underthis project. An additional PPF of US$0.6 million was provided to GoL in June 2000 for the initiation ofactivities under the Utilities Sector Reform Project.

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Annex 3: Estimated Project CostsLESOTHO: Utilities Sector Reform Project

;.. ....... .1404~~:4

1. Privatization of LEC 0.001.1 Interim Management Task Force 0.00 13.90 13.901.2 Sales Advisory Group 0.00 3.50 3.501.3 Retrenchment Program 1.80 0.40 2.20

2. Regulatory Framework 0.002.1 Electricity Sector 0.30 1.00 1.302.2 Telecommunications Sector 1.00 3.20 4.20

3. Future Electricity Options 0.00 5.20 5.204. Capacity Building Assistance 0.00 1.30 1.305. Private Sector Development 0.10 1.90 2.006. Implementation 2.40 0.40 2.807. PPF I 0.00 1.50 1.50Total Baseline Cost 5.60 32.30 37.90Physical Contingencies 0.00 0.30 0.30Price Contingencies 0.20 1.00 1.20

Total Project Costs 5.80 33.60 39.40Total Financing Required 5.80 33.60 39.40

_i ~~~~~~~~~~~ ~p.

Consultancy services 2.40 19.10 21.50Works 0.00 0.10 0.10Goods 0.10 13.90 14.00Retrenchment Program 1.90 0.00 1.90Operation/Maintenance 1.90 0.00 1.90

Total Project Costs 6.30 33.10 39.40Total Financing Required 6.30 33.10 39.40

Identifiable taxes and duties are 0 (US9n) and the total project cost, net oftaxes, is 39.5 (US9n). Therefore, the project cost sharing ratio is 72.41% oftotal project cost net oftaxes.

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Annex 4: Cost Benefit Analysis SummaryLESOTHO: Utilities Sector Reform Project

[For projects with benefits that are measured in monetary terms]

S~~~~~~ ' t,-YP,a '-a:>t!<MM, 00

cQ%~~~~~~~~~~~~~~~om~~~~~~~~~~~ ,~~~~~~~~~~~~ ~~~~~~~...........

Benefits:Base Year: 2000

Benefits (US $m) 69.7 10.8 13.7

Costs: 29.9

Net Benefits: 39.8(US$m)

iRR: 23.1%

lProbability that IRRis below 10% isneglible _________________

Notes (a) Using a discount rate of 12%;(b) Benefits are estimated using incremental taxes obtained from privatized enterprises and new businesses;(c) Savings derived from reduced direct subsidies to public enterprises.

if the difference between the present value of financial and economic flows is large and cannot be explained byta,xes and subsidies, a brief explanation of the difference is warranted, e.g. "The value of financial benefits is lessthan that of economic benefits because of controls on electricity tariffs."

Summary of Benefits and Costs:Base Case Results. The net present value of the project is estimated at about US$39.8 million for a 12percent discount rate, and its internal economic rate of return is estimated at 23.1 percent. The net presentvalue of the project varies from about US$53.3. million to US$16.4 million for discount rates of 10 percentand 17 percent, respectively.

Main Assumptions:1. Stable macroeconomics environment as projected in the CAS with real GDP growth averaging at 5percent.2. Additional capital investment will be available for rehabilitation of equipment, new technology, trainingof staff, which will boost capacity utilization rates and increase productivity.3. It has also been assumed that: (a) GOL is fully committed to Public Enterprise Reform; (b) the projectwould develop a market friendly and competitive environment through the establishment of an appropriateregulatory framework, which, in turn, would help attract foreign capital, technology, and managerialexpertise required to improve the efficiency of the sectors and their value added contributions to GDP.4. Detailed quantitative assumptions are described in Annex 4-1.

Sensitivity analysis / Switching values of critical items:

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Switching values of critical items: Two sensitivity tests were carried out: (a) the first test assumed thatgains in productivity and output were half of the case base; and (b) the second assumed that gains inproductivity and output were half of the case base, consumer gains in price/tariff are 25 percent of basecase and a zero growth in employment. They show an ERR at 15.9 percent and a NPV at US$10.8 million,an ERR at 12.6 percent and a NPV at US$1.8 million respectively. These tests demonstrates that thisproject produces solid results. The pay-back period is 8 years and the ERR is 12 percent when NPV iszero.

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Annex 4-1Lesotho Utilities Sector Reform Project

Economic Analysis of Overall Project

I. Recent Macro-Economic Developments

1. Despite the economic uncertainties and the rapid changes in the economic landscape, Lesotho'srecent economic performance has been quite mixed. It was impressive at an average annual real growth of4.2 percent in the 1980s. Between 1994-1998, the real GDP growth averaged 5.6 percent per year mainlydue to the Lesotho Highland Water Development Project (LHWDP). The Improved growth performancealso reflected the impact of the LHWP and the strong output growth in export-oriented manufactunngresulting from high foreign investment in the early 1990s. This trend was heavily affected by a sharpcontraction of the economy in 1998 following the political turmoil in that years (May-August 1998) with a8.6 percent real GDP growth, thus undermining the process. Inflation, which largely reflects pricedevelopments in South Africa, was at about 7.8 percent in 1997, increased to 9.1 percent in 1998 and fellslightly to 8.7 percent in 1999. This progress was achieved despite the constraints imposed by severedroughts, high unemployment of around 35-40 percent mainly due to the retrenchment of Basotho miners inSouth Africa and rapid growth of the labor force.

Private Sector Development

2. The private sector in Lesotho is small, estimated at 45 large firms in the formal private sector,mostly in Maseru. It is characterized by lack of entrepreneurial tradition. This picture is changing as theindustrial sector increasing its share of GDP; in 1995 it was 11 percent. Over a twenty year period, thesector has grown at an average of 18 percent a year. This growth was due to inflow of foreign investmentin the late 1970s and 1980s which was motivated by the trade-related reasons and Lesotho's comparativeadvantage with respect to labor costs. The global economic sanctions imposed against The Republic ofSouth Africa and the Multi-Fibre Agreement which had quotas on Asian producers who relocated theirfirms to Lesotho and Mauritius. About 50 percent of the largest enterprises are owned by predominantlyforeigners or are joint ventures with foreign partners. Firms owned by South Africans avoiding sanctionshave been important as they represent half the foreign firms in the sector. These firms have made industrialexports the most buoyant element of Lesotho's total exports. This development in textile and footwearindustries have been accompanied by a buoyant construction industry.

3. There are high levels of under- and unemployment and far too few employment opportunities, inboth Lesotho and South Africa. Underemployment is widespread in rural Lesotho and open unemploymentis growing in urban areas. The unemployment rate in 1993 -- counting both unemployment andunderemployment -- was estimated to be an alarming 35-40 percent. The little data on employment thatexists shows the labor force to be greatly under-used. Projections from the 1986 census showed that thelabor force was about 800,000. The potential labor force in 1993 (that is people 15 to 64) was slightly over1 million, out of a total population of about 1.9 million. The actual labor force is calculated assuminglabor force participation rates of about 85 percent for men and 75 percent for women. And populationgrowth rates were high (2.5 percent a year), so net annual increases to the potential labor force ranges from20,000 to 25,000 over while only 2,000 new jobs are created annually.

4. In 1993, opportunities for formal employment fell far short of demand. Altogether only 28 percent

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ofthe workforce, or an estimated 225,000 people held fonmal wage jobs, distributed roughly as follows(based on estimates from various sources):

Private sector* 115,000 Basotho worked in South African mine (51.1 percent).* 20,000 were employed in domestic manufacturing.* 18,000 worked in retail trade.* 15,000 worked in construction.* 13,000 did other work in South Africa -- for example, in agriculture, private industry, domestic

service, or a professional occupation.* 7,000 had jobs in hotels, restaurants, transportation, or financial services.* 2,000 worked in other services, nonprofit organizations, or private health care.

Public Sector* 21,000 were civil servants (including both salaried and waged workers).* 10,000 were employed as teachers.* 4,000 were employed in military or police security.

Public Enterprise Sectoro 7,700 employed in the public enterprises (3.4 percent).

Women make 60 percent of employees in the formal sector. This confirms that employment for women inthe formal sector is very high, and it is linked to textile industry.

5. That left roughly 72 percent of the labor force (about 575,000 workers) to work in agriculture andthe informal sector, sectors in which retums to labor are generally low. The informal sector has beenplaying a crucial role for the economically active labor force in commercial activities by producing goodsand services and other products. Therefore, employment in the informnal sector has increased significantlywith an estimated 660,000 employees of which only 12 percent are in the capital city, Maseru. Theremaining 79 percent of the small enterprises are found in the rural areas (this number includes microenterprises in Lesotho). Roughly 30 percent of all Basotho households engage in some form of informal orsmall-scale nonfarm business activity and for about half of those who do, the business is their main sourceof income. Nearly 103,000 small businesses (including microenterprises) were operating in Lesotho in1990, employing an estimated 161,000 people. Small businesses in Lesotho tend to be very small but thereare so many of them that they are an important source of employment, providing more work to the Basothothan either the South African mines or the domestic formal sector.

II. Cost-Benefit Analysis of the Overall Project

6. Methodology. Undertaking the project is a resource allocation decision which would not onlycreate economic benefits but also deprive other socially desirable programs of resources. It createsopportunity costs in terms of foregone social and economic services. The economic cost-benefit analysisapproach provides a rational framework for analyzing the potential net benefits. Altemative analytical toolssuch as Cost-Effectiveness analysis or Cost-Utility analysis have their limitations in elucidating the netsocio-economic benefits of a project of this nature. The cost-benefit analysis concentrates on identificationand measurement problems that are encountered in all project evaluations. Therefore, to address theidentification issue for the project costs and benefits, only direct and indirect incremental impacts on theGovenmment and society of Lesotho were considered. The welfare gains and losses were estimated by using

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net change in average economic output price. Where explicit prices were not available, and ornon-indicative of true socioeconomic cost and benefits, indicative proxies have been applied. Theevaluation was done in terms of economic cash flow analysis which was developed from the financial cashflow of the project. Recognition was given to the fact that not all economic costs and benefits aremeasurable in monetary terms.

7. Most of the expected benefits would occur in the medium term since the project is expected tofacilitate essentially institutional development through capacity building in both public and private sectors.The identified indirect benefits were quantified to obtain their monetary values because no direct costrecovery mechanisms have been built into the project. Monetary values inputted to the indirect benefitsrepresents measurable gains from additional income generated from newly created jobs, economicefficiency from reduction in factor costs and consumer surplus. Furthermore, expected non-monetizedbenefits from the project include improved management, changes in quality and quantity of services,conducive business environment, changes in poverty alleviation and social distress. Non cash flow financialvalues such as amortization charges, sunk costs for physical requirements, and the debt service obligationswere considered only in relation to fiscal impact of the project.

8. Cost-benefit analysis was done for the overall project, using a cost-benefit evaluation frameworkthat determined the economic rate of return and net present value. The distributional aspect of the benefitshave been analyzed by identification of the project beneficiaries. It has been difficult to deal with inter-firmlinkages and inter-industry dependencies within the PE sector. The utilities enterprises have accruedbenefits from monopoly charges to other PEs and indirectly provided short term financing in form of hugereceivable accounts (arrears). It would be difficult to include such costs in the economic analysis.

9. Assumptions: The assumptions made for the EA. are as follows:

3 that GOL is genuinely and continuously committed to PE sector reform. To prove this GOL inFebruary 1999, published " The Lesotho Telecommunications Policy" that paid attention to thepotential contributions of telecommunication sector to the overall economic performance.Furthermore, in February 2000 a new Telecommunication Act was passed by Parliament toimplement primarily the key elements of the Telecommunication Policy. To this end, the LTC -telecommunication company improved on its financial management in order to shape the companyprior to its privatization. To bring the financial discipline and management in LEC - electricitycompany, the GOL is in the process of recruiting an interim management task force for 18 monthsto prepare the company for privatization.

* that GOL will continue with its prudent macroeconomics policies to stabilize its economicenvironment and improvements in extemal competitiveness through concrete actions to deal withthe public utilities;

* that the private sector, both local and foreign investors, will respond positively to the reforms forthe benefits to materialize. GOL has institute an open and on-going dialogue with interested andaffected parties and the private sector to ensure that participation is maximized -- especially on theInvestment fund which is intended to promote local equity participation, in both, local and regionalenterprises;

* that the project would develop a market friendly and competitive environment because of the newregulatory framework which would help to attract foreign capital, technology, and managerialexpertise required to improve the efficiency of the sectors and their value added contributions to thecountry's GDP;

* that the existing prices in the economy are market determined.

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* that the GOL has made adequate arrangements to meet its obligations under the retrenchmentprogram in LEC.

10. Project Costs. Total project costs have been estimated at US$ 39.0 million. They includetransaction costs for financial restructuring and privatization of LEC, development and establishment ofindependent energy sector regulatory agency and strengthening of the telecommunication sector'sregulatory agency by providing funds to meet these costs and operating costs. The IDA will finance $ 25.9million representing 66 percent of the total project cost while the GOL's contribution is estimated at 5percent of total project costs. To accommodate unforeseen expenses and in-built flexibility in the use orallocation of funds, a 2.5 percent contingency fund has been included. However, 31 percent of the totalproject cost will be in the form of co-financing from the African Development Bank (ADB) to the project.In addition, 3.7 million has been earmarked to meet retrenchment costs paid to the laid-off staff includingre-absorption measures of the retrenchment workers. This has been taken into account in the economicanalysis of the program (See Section III below).

Table 1. Project Costs by Component (US $ million)

Project Component Total

1. Divestiture and Immediate Connections 20.4

2. Regulatory Reform 5.6

3. Private Sector Development Activities 2.0

4. Capacity Building assistance 1.3

5. Future Energy Sector Issues 5.2

6. Project Coordination 2.9

7. PPF 1.5

Total Project Cost 39.0

Note: These figures are not discounted and includes ADB cofinancing and GOL contributions. The discounted amount is $29.9 million.

11. Project Benefits. The economic effects of privatization are normally estimated using ex anteversion of partial equilibrium analysis developed by Jones, Tandon and Vogelsang which is emerging as theleading edge technology in the analysis of divestitures since 1 980s. The method involves developingprojections for the flows generated by a firm in the case of continued public ownership within public sectorwhich serves as a project altemative to the estimated flows from private operation following privatization.The present value of the difference between the two cases provides an estimate of the change in benefitsaccruing to the society as the result of privatization. This method is applicable only if the historical data onthe performance and other institutional changes of the firm are available.

12. In addition, the post privatization projections would also require some form of creativity inadaptations to simplify the evaluation. In this case, the economic analysis did not evaluate the increased

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value of the privatized enterprises to the Basotho society as a benefit. Instead, four other major economicbenefits were identified and quantified as follows:

a) Benefits from newly created employment opportunities in the private sector. The GOLemploys only 15.5 percent of formal sector employment while the PE sector employs a mere 3.4 percent ofthe formal sector employment (1995). With privatization, the domestic private sector employment share isexpected to increase further from 29.6 percent of the formal sector to about 35 percent in five years as thepublic enterprise sector shrinks by 32 percent. Moreover, with the newly created jobs which are expected toincrease at an average of 3.2 percent per annum; incremental income will be generated and has beenestimated on the basis of expected additional job creation due to new investment and increased demand forservices.

b) Benefits in Productivity and Output: Gains are expected from higher total factor productivity,resulting from expected changes in work ethics, training, better management, better equipment and newtechnology, as well as job-loss savings generated by PE restructuring. This has been measured throughchanges in cost of providing the services to each customer in telecommunication and electricity. Theincreases in number of lines from 15,000 to 50,000 requires a high rate of backlog reduction,approximately, 20 - 30 percent per annum. The current operating efficiency rate is in LEC is low at 33customers per employee, even with the retrenchment of 40 percent of the labor force, the rate remains lowat 34 customers per employee. With privatization, this ratio is expected to improve due to increases incoverage by 25 percent to 20,000 customers and the operating efficiency ratio will improve to 50 customersper employee by year 2005.

Table 2. Projected Economic Benefits 1998-2007 (US $ million)

Economic Benefits Total Overall Project Discounted Benefits.

A. Benefits from newly created Employment 1.0Opportunities

B. Benefits from Productivity & Output 58.0

C. Consumer Surplus (Gains in Price/Tariff) 10.7

TOTAL 69.7

c) Consumer Surplus (Gains in price and tariff): Benefits to the consumer are expected in the formof adjusted price/tariffs and improved service quality, increased access and wider coverage due tocompetition and private sector involvement. LEC effective tariff rates are heavily subsidized at the expenseof industrial and commercial customers. It is about US$ 0.05/kWh. Investment cost per telephone line arenot really higher than that of the region but could be reduced to meet international standards. Hence, it isestimated that by the end of project, there will be 1,250 public pay phones compared to 125 that arecurrently available. It has been assumed that the tariff structure will be reviewed to reflect the cost of newinvestment and competition. With privatization the capacity and number of telephone main lines connectedhave increased from its 1997 level of 15,000 to 28,000 in 1999 and estimated to 50,000 in 2005. Inaddition, the privatization of will bring welfare gains to all parties in the economy through increased

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efficiency particularly in system losses which are relatively high at 17 percent. Cameroon, Cote d'Ivoire,Botswana, Zambia and Zimbabwe recorded system losses of lower than 10 percent in 1992. LEC had12-13 percent system losses in 1995, but it deteriorated to 19 percent in 1999 due to the collapse of LEC'sbilling system. It is however expected that by the end of project - 2005, the system losses in LEC will bereduced to 8 percent. However, only benefits from estimated reduced prices have been quantified for theanalysis. It is estimated that even with a 10 percent percent reduction in system losses could result in 10percent to 15 percent reduction in tariffs under current consumption levels. Therefore, the project haspotential of creating cost savings on tariff.

13. Target groups. Key target groups have been identified and include:

a) Consumers would gain about US$10.7 million. The sources of benefits (consumer surplus)include expected adjustments in tariffs, expected increases in access to utilities services, expectedelimination of waste, expedited accounts receivable collection and productivity gains.

b) Retrenched employees who would benefit from project's arrangements with GOL to providerequired resources to finance services to reduce the social cost impact especially when the retrenchedemployees will be searching for income-generating activities that would provide a sustainable employmentfor the individuals who will opt for self-employment.

c) Employees remaining in the privatized enterprises and the restructured public enterprises wouldgain through increased welfare. This would be achieved either through employee share purchase plans andthrough new labor contracts, that normally takes place after privatization. There could also be someincreases in the average wage bill and welfare due to private enterprise productivity performance, trainingand additional employment opportunities.

d) The private sector, including local and foreign investors, small, medium and micro enterpriseswhose investment opportunities have been restrained due to unfavorable business environment resultingfrom public enterprise monopoly power would benefit from removal of entry barriers and reduction infactor costs of production specifically in telecommunications and energy. This is shown on the economicbenefit values on estimated increases in productivity and output. Growth in the private sector is expected togenerate employment opportunities to further alleviate the social costs of unemployment. These economicbenefits are reflected in the estimated benefits from increased employment, productivity and output.

e) The Government of Lesotho would benefit from the project through savings made throughelimination of direct subsidies and transfers to the PE sector of equivalent to US$13.7 million per annum.US$1.8 million is an estimate of subsidies from GOL to the 5 PEs in form of debt service, working capitaletc. (IDC Report 1995). Therefore, the present value of the savings in subsidies amounts to US$13.7million. At the end of the privatization program project, the extensive privatization program which includesmonopolistic markets such as electricity, water and telephone enterprises will result into a reduced size ofthe public enterprise sector by at least 43.8 percent. Total PEs in Lesotho were 57: (a) 20 companies andfinancial institutions; (b) Three of the PEs have total of 31 subsidiaries; (c) GOL have minority shares insix other companies. The privatization program will privatize 25 PE. Thus, reflecting a dramatic decline inthe role of the state.

14. Base Case Results. The net present value of the project is estimated at about US $39.8 million fora 12 percent discount rate, and its intemal economic rate of return is estimated at 23.1 percent. The netpresent value of the project varies from about US$53.3 million to US$16.4 million for discount rates of 10

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percent and 17 percent, respectively (see Table 3. below). The base case scenario has been relativelyconservatively estimated because other benefits have not been quantified in monetary terms to be includedin the analysis. These benefits includes: (a) the increased levels of foreign investmnent in the country, (b)occasional creation of jobs due to construction for expansion, (c) increases in trade volume - exports andimports, and (d) revenue to be received as net sales of the privatized enterprises.

Table 3. Base case Results

ERR (0/%) NPV ($m)Overall project at 12% 23.1 39.8Overall project at 10% 23.1 53.3Overall Project at 17% 23.1 16.4

15. Sensitivity Analysis. Three sensitivity tests were carried out: (a) the first assumed thatgains in productivity & output were half of the base case; and (b) the second assumed that gains inproductivity & output were half of the base case, consumer surplus 25 percent of the base case and zeroemployment growth. The results are shown in Table 4.

Table 4. Sensitivity Analysis

Benefits Base case Sensitivity Ana;ysis (a) Sensitivity Analysis (b)

Additional Income as estimated as estimated 0 growth

Gains in Productivity & as estimated -50% -50%Output

Consumer Surplus as estimated as estimated -25%

IRR(%/6) NPV($m) IRR(%) NPV($m) IRR(%) NPV($m)OverallProject 23.1 39.8 15.9 10.8 12.6 1.8

They show an ERR at 15.9 percent and a NPV at US$10.8 million, and an ERR at 12.6 percent and aNPV at US$1.8 million, respectively. This table demonstrates that this project produces robust results.The payback period is 8 years and the NPV is zero when the ERR is at 12 percent.

16. In addition, the project will generate over a US$24.5 million of savings in public finance in theform of resource allocation efficiency. These savings are expected to come from significant reduction indirect and indirect subsidies to public enterprises, reduction of transfer of productive capital resources intothe PE sector (US$13.7 million), and increase in corporate and other tax gains from privatized and newfirms (US$10.8 million). This would reduce government fiscal burden and free resources for newinvestment in the social sectors. Additional fiscal impact will be derived from the net sales of the privatizedenterprises.

17. Useful perfornance indicators that GoL could use to verify improvement in performance of

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privatized enterprises and realization of the expected benefits are: (a) private profitability, which measuresthe bottom line for private shareholders. This is influenced by prices as well as quantities, thus increases inoutput; (b) total factor productivity, which removes price effects to show what happens to productivity.This is derived by measuring the index of quantity of output to the index of the quantity of inputs, inparticular labor productivity; and (c) investment, which shows the dynamic effect of privatization over alonger period of time. This is measured by fixed capitalformation in the enterprises. It is therefore, crucialfor GoL to pay attention to what they are selling, to whom they are selling and how the sale is conductedespecially in the financing of the transaction. The Utilities Sector Reform Project will assist GoL to meetthese challenges.

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UTILITIES REFORM PROJECT

COST- BENEFITANALYSISBasecase Scenario(USS Thousands)

COSTS BENEFITS

AdditionalIncome Generated Gains in NET

Other project from Employment Productivity & Consumer Gains Cost or BenefitYear IDA Project Costs Cost I Opportunities Output in Price/Tariffs for the year

l (1 200 (4 300. 00' (7J400)2 (8I125 1 1160Q71 59 2,238 1.112 (5, 77)3 (7 1 75 (797.19 59 2.503 1.523 (3J 86)4 (5 125 60 2756 1 901 (408)5 152 5,340 2 331 7. 236 1 55 6,065 2-533 8, 527 158 6,724 1344 8 268 161 7.727 1,462 9,2509 265 13 084 1-590 14S4010 273 15 598 L no 17, f0211 2_ _ L * 81 18,617 1.883 20J8112 r T _ _362 22_245 2_048 242(5513 373 r 26605 2229 2920714 _____3841 31_851 2426 34 (6115 I T 396 38.164 2,640

(23,625) (6,258) 3,138 199,517 26,753 NPV A12% 38j282l __________________ l ____________ l ____________ l ________________________________________ IR R 23 C6%

1. Stable macroeconomics environment as projected in the CAS with real GDP growth averaging at 5.0%.2. Additional capital investments from the private sector will be available for rehabilitation of equipment, new technology, training

of staff that will boost capacitv utilization and increase Droductivitv.3. Reduction in electricity and teleconmmunication losses will increase consumption of current output by 10%

Thus causing savings through reduction in tariffs and factor costs

12/28/00 16:13

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Annex 5: Financial Summary

LESOTHO: Utilities Sector Reform Project

Years Ending

Financial Assessment of the Lesotho Electricity Corporation

I. Introduction

1. The Lesotho Electricity Corporation (LEC), established by the Government of the Kingdom ofLesotho in 1969, is responsible for power transmission and distribution in the country. The utility alsooperates four mini-hydro plants in remote areas of the country. Until August 1998 the only source ofelectricity supply to Lesotho was the power that LEC purchased from the ESKOM network in SouthAfrica through two intake points. After the Muela Hydropower Station was commissioned as a part of theLesotho Highlands Water project (LHDA), LEC started to buy the bulk of its power requirement ftom theLHDA. Recently the amount of electricity purchased from Muela accounted for about 85 percent of totalenergy demand. Maximum demand of the system is about 80 MW.

2. Both LEC's technical and financial performance have deteriorated in recent years. This Annexreviews the historical financial performance of LEC as well as the financial prospects of the utility underthe Interim Management Task Force.

II. Historical Financial Performance

3. LEC's present accounting system cannot provide reliable and timely financial information. Thelatest audited accounts have been produced for FY96 (LEC financial year ends on March 31). LEC'sbilling system failed in 1997 causing major inaccuracies in its customer database and tremendous delays inbilling. At present, the database is being gradually cleaned up and billing and collections are picking up.For 350 large customers (industrial and commercial), that generate approximately 50 percent of LEC'srevenue, recent billing has been done using Microsoft Access based template developed by the utility. Thebills for the rest of the customers are prepared manually. LEC have recently prepared draft accounts forFY97 which are yet to be audited.

4. No accounts have been prepared for FY98, FY99 and FY2000. The financial information(indicative only), for the purposes of this analysis, for these years was fumished by the LEC and is a resultof a joint effort that required going through original receipts and accounts that have been kept manually.

5. In addition to the problems with billing, the following major weaknesses of LEC's accountingpractices in the last three years should be highlighted:

* fixed assets register was not maintained;* aging schedules of accounts receivable were not prepared;* there is no procedure for bad debt write-off;* stores were not physically verified.

6. LEC's financial results in recent years are summarized in Tables 1 and 2 below:

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Table 1: Financial Performance of LEC (FY93-FY0O)(Maloti '000)

Profit and Loss Account | = -Fiscal year ending March 31(M aloti '000) _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

1993 1994 1995 1996 1997 1998 1999 2000Electricity purchases (GWh) 253 292 337 332 329 314 305 326Electricity sales (GWh) 223 257 293 303 300 256 246 272Energy losses (°/O) 12% 12% 13% 9% 9% 18% 19% 17%Average tariff (Maloti/kWh) 0.30 0.33 0.27 0.28 0.28 0.34 0.36 0.34Average purchase price 0.10 0.11 0.11 0.12 0.13 0.13 0.14 0.16(M/kWh) = =

Revenue (M '000) _

Electricity sales 67,230 83,582 79,323 85,401 84,889 86,586 88,318 93,550Other revenue 1,098 1,008 1,188 1,434 1,062 200 200 2,607

Total revenue 68,328 84,590 80,512 86,834 85,950 86,786 88,518 96,157

ExpensesElectricity purchased 25,802 31,743 35,647 39,701 41,868 41,672 42,278 53,739Fuel for generation 1,070 1,324 1,489 2,213 1,966 1,500 1,000 738O&M 5,579 5,764 7,306 8,840 9,698 8,758 9,196 6,870Admin& other 11,151 17,073 16,949 22,011 21,966 24,383 27,065 32,485Depreciation 6,032 6,588 7,360 8,694 9,114 9,384 10,020 10,262

Total expense 49,634 .62492 _ 6751 81_459 84_612 85_697 89559 104.093

Operating income 18,695 22,099 11,760 5,376 1,338 1,090 (1,041) (7,936)Interest received/(paid) (9,423) (8,179) 3,376 1,508 (781) (4,447) (3,111) (1,915)Provision for taxation 4,838 10,647 6,657 3,545 1,187 0 0 0

Net income 4,433 13,273 8,480 3,339 (630) (3,358) (4,152) (9 ,851)

Operating ratio (%) 73% 74% 85% 94% 98% 99% 101% 108%

Gross Operating Margin 0.48 0.46 0.56 0.59 0.63 0.60 0.59 0.66

Interest Coverage 7.35 11.75 28.24 17.64 2.32 1.63 2.60 0.20

Customer per employee 17 17 17 19 21 25 29 33

7. The above table calls for the following comments:

Purchase of energy

LEC's energy purchases in GWh in recent years decreased from 329 GWh in 1997 to 314 GWh in 1998and 305 GWh in 1999. This happened due to the political unrest in the country and scaling down of theoperations of LHDA contractors - LHDA construction works were one of major LEC's consumers. The

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demand started to pick up in 2000 and energy purchases increased to 326 GWh.

Electricity purchases accounted for about 55 percent of total operating expenses of LEC (excludingdepreciation) in FY98 and FY99. In 2000 they increased to 57 percent. The average purchase price of akWh of power was M 0.13 in 1998, M 0.14 in 1999 and M 0.16 in 2000. After the Muela plant (LHDA)was commissioned, LEC was obliged to buy whatever power was produced by Muela and cover the rest ofthe demand by importing electricity from ESKOM, South Africa. It had an impact on the average ESKOMrate: though the ESKOM energy rate was about M 0.065 per kWh, the effective unit price from ESKOM inFY99 /FY2000 was M 0.26 (about US 4 cents). In previous years it was M 0.14 per kWh. This was dueto the following factors:

* In 1999 LEC did not have cash to pay electricity bills to ESKOM of about M 8 million and theGovernment of Lesotho had to pay these bills in order for ESKOM to continue the supply of power.This bridge financing had to be repaid by LEC and calculations of the unit purchase price include theinterest on the above financing.

* The calculation of average unit cost of a kWh from EKCOM included, in addition to the energy chargeand monthly demand charge, a fixed charge of about M 1.7 million a year to repay the cost ofconstructing the transmission line that interconnects the South African and Basotho power systems.Due to the fact that recently only about 15 percent of the power was bought from ESKOM this chargewas spread over a small number of units, increasing unit cost. Purchases from ESKOM accounted for23 percent of cost of electricity purchased.

The effective price of electricity bought from LHDA (Muela) in the same period was about M 0.14 perkWh though the LHDA energy rate was M 0.082 - 26 percent higher than ESKOM's. The Power SalesAgreement with LHDA includes a fixed charge of about M 0.9 million per month which LEC paid for thefirst time in March 2000 after 18 months of non-payment. The average ESKOM rate has been paid byLEC for bulk power supply from LHDA since April 2000 but the utility has been billed with rates based onthe Power Sales Agreement. However, there is a firm government decision to change the LEC/LHDAsupply agreement to bring the energy rates in line with ESKOM price relieving the utility from paymentsfor some of the Muela capital costs, so that LHDA will apply ESKOM rates for its sales to LEC(retroactively) from February 1, 2000.

Losses

Unaccounted for electricity (technical losses as well as unbilled consumption on account of theft andinaccurate billing) was as the level of 12-13 percent from 1993 to 1995 and improved to 9 percent from1996 to 1997 - a more reasonable ratio for such a system. However, due to the collapse of the billingsystem and the general deterioration of the utility's operations in recent years, losses increased to a level of18 percent in 1998, 19 percent in 1999, and 17 percent in 2000. Had losses been sustained at about 10percent, over last three years LEC would have been able to bill an additional 75 GWh or receive M 26million in additional revenue.

Tariffs

Tariffs have remained unchanged since 1993. The average effective tariff in FY2000 was M 0.34 per kWhor about US$ 5.7 cents. Tariffs are heavily cross subsidized, largely at the expense of industrial andcommercial customers. LEC management has submitted a tariff increase proposal to the government butno tariff adjustments have been made.

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Billing and collections

The main reason for the disaster in the electricity billing, apart from the failure of the billing system in1997, was lack of systematically organized monthly reading of electricity meters or appropriate averagingbetween readings. The delays in issuing the bills were tremendous - customers were billed over six monthsafter the service provision. In FY2000 this situation began to improve and the delays in billing reduced toabout two months on average, while for industrial customers bills were usually current. The collections(including payments from customers for arrears) improved to about 89 percent of electricity billed. Atpresent, about 13 percent of electricity is sold through prepayment meters (cash sales) but there is a lack ofconsolidation of data about cash receipts from different vending points, which distorts the collectionspicture.

Operations and Maintenance Expenses

Due to financial constraints operation and maintenance expenditures in FY2000 have fallen by 25 percentcompared to FY99, causing a deterioration of the transmission and distribution system. LEC operates fourmini-hydro plants in rural areas: Tlokoeng, Mantsonyane, Semokong and Qucha's Neck, which arecomplemented by back-up diesel generators for the periods when there is not sufficient water. The averagefuel costs for the diesel stood at M 2 million. In recent years LEC did not have cash to buy enough dieselfor backing up the mini-hydros and the fuel costs in FY2000 went down by 63 percent as compared toFY97, and the power supplies to the above areas were heavily interrupted.

Labor costs

LEC is an extremely overstaffed utility. In FY95, servicing a total of 13,900 customers, it employed 805people so that the "customers per employee" ratio was only 17 people. In FY2000 LEC employed 639people, and the ratio improved to 33 customers per employee but it is still unacceptably low. In FY2000the annual labor cost (salaries and related expenses) was M 29 million. It represented 31 percent of totaloperating expenses excluding depreciation or 72 percent of operating expenses excluding depreciation andenergy purchases. Salaries to LEC staff are paid in arrears.

Debt service

A particular difficulty in preparation of LEC's estimated accounts for FY98, FY99 and FY2000 wastreatment LEC's foreign loans. The Govenrnent of Lesotho, to implement its plans to bring industrialdevelopment to the south of the country secured foreign financing for the Central and Southem Networkproject which included two extensions of the power distribution network (Maseru to Mafeteng - Phase Iand Mafeteng to Mohale's Hoek - Phase 2). The financiers were Nordbanken (Norway) andEksportfinance (Sweden).

The total amount of loans incurred to finance this project was M85 million. Phase 1 started in 1993 andwas completed in 1996 and Phase 2 started in 1997 and finished in May 2000. Both of these gridexpansions/reinforcements tumed out to be expensive as the demand in the connected areas is extremelylow and the assets do not generate enough revenue to service the debt. The Govermment of Lesotho hasbeen processing invoices from creditors through the Central Bank, issuing subsequent invoices to LEC forreimbursement of these payments. The lines constructed have not been transferred to LEC' fixed assetsregister and the loans are not on the utility's books. However, LEC was repaying these loans up to April1999.

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At present there is an amount of M13 .5 million for which the Government has claimed repayment fromLEC. These are technically not debts of LEC, since the assets are not owned by the utility. Theoutstanding debt service, which has been affected by devaluation, is going to be resolved by theGovernment of Lesotho before the privatization occurs. For the purposes of this analysis these two loansare not included in the FY99 and FY2000 estimated accounts and projected accounts for 2001 - 2004.

8. Due to the lack of proper management over the period of FY97-2000 LEC turned from a viableutility into a loss maker that does not have cash to pay for its power supplies and is in arrears on salaries toits employees. The net loss in FY99 was estimated at M 4.2 million and in FY2000 - M 9.9 million. If thepayments of interest and principal on loans that financed the Central and Southern Network project werereflected in LEC's accounts, the loss would be M 6.2 million and M 15.4 million respectively.

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Table 2: LEC's Summary Balance Sheets (FY93-FYOO)(Maloti '000)

SummaryBalance Sheet

Fiscal year ending Actual Actual Actual Actual Actual Estimate Estimate EstimateMarch 31 d d d

1993 1994 1995 1996 1997 1998 1999 2000

Fixed Assets

Net book value 116,320 118,918 120,039 120,436 123,869 127,485 142,000 146,840

Capital work in 3,996 5,347 12,995 32,047 41,638 39,649 44,000 48,465progress

120.316 124,266 133.034 152,483 165506 167.133 186000 195',305

Current Assets

Stock 2,615 3,337 3,247 6,791 8,618 4,264 4,199 3,257

Accounts 22,988 27,645 31,115 32,744 22,354 41,237 42,998 61,588receivable

Cash and cash 18,423 28,220 24,814 11,991 5,361 1,719 1,719 1,720equivalents

4426 5922 59,17 51526 36333 47220 48.916 66,564

CurrentLiabilities

Accounts payable 10,225 16,927 13,323 13,528 13,621 16,770 30,000 60,000

Other 15,867 20,097 19,611 22,580 14,250 16,522 18,423 19,282

26,092 37.024 32,934 36,108 27.871 33,292 48.423 79,282

Net Current 17,934 22,179 26,241 15,418 8,462 13,928 493 (12,718)Assets

Total Net Assets 138,250 146,444 159,275 167,901 173,968 181,061 186,493 182,587

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Long Term Debt 12,118 12,641 6,683 6,683 6,683 13,945 22,753 20,847

Equity 126,132 133,804 152,592 161,218 167,285 167,116 163,740 161,740

Total Debt and 138,250 146,444 159,275 167,901 173,968 181,061 186,493 182,587

EquityI I

Current ratio 1.7 1.6 1.8 1.4 1.3 1.4 1.0 0.8

Debt to Equity 0.23 0.27 0.21 0.21 0.17 0.22 0.30 0.38

Accounts receivable 123 119 141 138 95 173 177 234(days)

9. LEC's liquidity position is precarious as demonstrated in the balance sheets and calls for thefollowing comments:

* LEC's liquidity problem is due to weak collections. Accounts receivable of LEC increased from M 23million in FY93 to M 62 million in FY2000, equivalent to eight months of sales.

* In recent years accounts payable increased tremendously and tripled in FY2000 as compared to FY98.Due to severe cash constraints LEC was unable to pay its suppliers. In early 2000 the govemmentwaived M 50 million of LEC arrears to LHDA for the energy supply. This helped resulted in thesharp reduction of accounts payable during FY0 1.

10. In summary, LEC's financial performance has been unsatisfactory. The management wasdependent on government support to maintain the utilities operations. As a result it was not able to allocatesufficient resources to meet the system's operation and maintenance requirements and contribute towardsthe financing of an investment program commensurate with the requirements of the sector. On the otherhand, the govemment required LEC to engage into not economically viable investments, without providingsubsidies for such activities which had a detrimental impact on the utility's operations.

11. To improve LEC's operational and financial performance the government made a decision toprivatize LEC and to hire an outside management team to run the utility in the interim. The IMTF will bealso mandated prepare the accounts for FY98, FY99 and FY2000 and have them audited. Credit meterswill be replaced by prepayment meters to improve the situation with receivables. A new agreement withLHDA will allow to lower the cost of electricity purchases.

III. Financial Prospects

12. The financial prospects of LEC are summarized in Table 3 and Table 4 below. The followingassumptions have been made for the preparation of the financial projections of LEC performance duringthe project period:

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* The credit for the implementation of the project is assumed by the GoL without on-lending to LEC.

* The outstanding loans for the implementation of the Central and Southern Network project are assumedby the GoL.

* Annual demand growth is at a rate of 5 percent in fiscal 2001- fiscal 2004.

* Total losses are assumed at a level of 17 percent in fiscal 2001, 14 percent in fiscal 2002, 10 percent infiscal 2003 and 8 percent in fiscal 2004.

* Average tariff is M 0.34 per kWh; no tariff increase is assumed.

* Average energy purchase price is M 0.14 per kWh, irrespective of the source of supply (LHDA orESKOM).

* Operation and maintenance costs are 12 percent of electricity sales.

* Labor costs increase at a rate of 10 percent per annum. The retrenchment program under the InterimManagement Task Force starts in fiscal 2001: out of existing 631 employees 100 staff are retrenchedin fiscalOl and 160 in fiscal 2002, bringing the total number of employees to 471 from fiscal 2002onwards. The cost of retrenchment packages, M 3.12 million, is paid out of LEC's earnings, anaverage package amount is M 12,000.

* The new investment is limited to the program financed under the project.

Effective tax rate is 35 percent of net earnings.

The investment program financed by the project is implemented as follows: 1000 prepayment meters areinstalled in fiscal 2001 and the rest of the meters are installed in fiscal 2002; new connections areimplemented in fiscal 2002.

Existing assets are depreciated at the rate of 5 percent per annum - straight line depreciation over 20 years.New additions (meters and distribution lines) financed by the project are depreciated over 25 years (4percent per annum).

Accounts receivable in fiscal 2001 are reduced by the amount of M 50 million which the govemment paidfor the LEC's arrears to LHDA. Due to the change to prepayment system and improved collections,accounts receivable in fiscal 2002 decrease to 15 percent of sales and to 10 percent of sales from fiscal2003 onwards.

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13. Based on the assumptions listed above, LEC starts to make profit, M 1.5 million, in fiscal 2002.In fiscal 20 03 it makes a profit of M 2.5 million and in fiscal 2004 - M 2.7 million.

14. Sensitivity analysis has been done using several variables:

(a) losses are maintained at the current level of 17 percent throughout the project;(b) only 85 percent of the revenue is collected;(c) average purchase price of energy is M 0.16 per kWh.

This would have the following negative effects on LEC's profitability (M '000):

Table 3: LEC's Projected Summary Balance Sheets(Maloti '000)

(a)

2000 2001 2002 2003 2004

Net Income (9,851) (3,392) 690 460 (21)

(b)

2000 2001 2002 2003 2004 l

Net Income (9,851) (15,627) (6,842) (6,303) (6,519)

(c)

2000 2001 2002 2003 2004

Net Income (9,851) (10,075) (2,935) (2,037) (1,955)

15. A business-as-usual scenario for Basotho electricity sector is unacceptable. Currently the steps arebeing taken to improve the operational and financial performance of LEC, but they can be sustained only ifreform measures are implemented - introduction of a new management team and eventual private sectorownership and management of the utility. Private ownership will provide the right opportnity for instillingcommercial discipline in the sector and promote positive change.

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tYear 1 Year 2 Year 3 0Year 4 Year Year 6 .Year 7Total Finaning RequiredProject CostsInvestment Costs 62 14.2 15.2 1.4 0.0 0.0 0.0Recurrent Costs 0.8 0.8 0.8 0.6 0.0 0.0 0.0

Total Project Costs 7.0 15.0 16.0 2.0 0.0 0.0 0.0

Total Financing 7.0 15.0 16.0 2.0 0.0 0.0 0.0

FinancingIBRDaIDA 3.0 9.0 14.6 2.0 0.0 0.0 0.0Government 0.5 0.0 0.0 0.0 0.0 0.0

Central 0.2 2.5 0.5 0.0 °. °. ° °° Provincial 0.3 0.5 0.0 0.0 0.0 0 0 0 0

Co-financiers 0.0 0.0 0.0 0.0 0.0 0. O O User Fees/Beneficiaries 0.0 0.0 0.0 0.0 0.0 0.0Others 3.0 3.0 1.5 1.0 0.0 0.0 0.0

Total Project Financing 6.5 12.0 16.1 3.0 0.0 0.0 0.0Main assumptions:IDA is financing a total of US$28.6 million out of the overall project size of US$39.4 million. The bulk ofIDA's disbursements will occur in Years 2 and 3 of the Project. These are related to the payments under theTA contracts for IMTF and the Sales Advisors and the establishment and capacity building of the regulators.Year 4 disbursements (will) primarily reflect the implementation of the Electricity Access Pilots.

The African Development Bank is financing all of the 6,000 connections to be installed by the IMTF. Themajority of these are expected to occur in Year 2 of the project. The upfront disbursements are related to thecommunications program and the study tours etc. for the regulatory staff. Year 3 disbursements are primarilyconnected to implementation support to the PU.

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Annex 6: Procurement and Disbursement ArrangementsLESOTHO: Utilities Sector Reform Project

Procurement

Procurement Environment. A Country Procurement Assessment Report (CPAR) was prepared in 1997. Itconcluded that the existing procurement law and regulations are inadequate to provide the necessaryguidance for public procurement, which hampered project implementation and disbursement of funds. TheCentral Tender Board has centralized procurement decision making and low thresholds for prior review areoverburdening it with reviews while it is understaffed and ill-equipped to oversee public procurement. Theprocurement proficiency of staff involved in procurement is quite low. The recommendations included thepreparation of a new procurement law and in the short term use the most efficient procurement services(Ministry of Works) to implement procurement. In the longer term, procurement should be decentralizedaccompanied by a broad procurement training program. It is being considered that a public administrationreform project which is in preparation would include a procurement reform component.

Use of Bank Guidelines

The procurement of works and goods will be in accordance with the Bank's Guidelines under IBRD Loansand IDA Credits (January 1995, lastly revised in January 1999). The Bank's Standard Bidding Documentsand the Standard Evaluation Report will be used. For National Competitive Bidding (NCB), the Bank'sSBDs will be used suitably adapted. For NCB procedures, the government will give assurances duringnegotiations that: (a) bids will be advertised in national newspapers with wide circulation; (b) methodsused in the evaluation of bids and the award of contracts are made known to all bidders and not be appliedarbitrarily; (c) any bidder is given adequate response time (four weeks minimum) for the preparation andsubmission of bids; (d) bid evaluation and bidder qualifications are clearly specified in the biddingdocuments; (e) no preference margin is granted to domestic contractors, manufacturers or suppliers; (f)eligible firms, including foreign finns, are not precluded from participation; (g) award will be made to thelowest evaluated bidder in accordance with pre-determined and transparent methods.

Aggregate values for NCB for goods and works are limitative and should not be exceeded without priorIDA no-objection. The Privatization Unit, which will implement the procurement under the project, willmaintain a tracking record to monitor when aggregate values are being reached in order to advise IDAtimely when this occurs to establish the appropriate procurement method for subsequent procurement.

Consultants services will be contracted in accordance with the Bank's Guidelines for the Selection andEmployment of Consultants by World Bank Borrowers (January 1997, lastly revised in January 1999). TheBank's Standard Request for Proposals will be used as well as the Sample Form of Evaluation Report forthe Selection of Consultants by World Bank Borrowers. Standard forms of contract will be used fortime-based or lump-sum contracts, and simplified contracts may be used for short-term assignments notexceeding six months.

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Advertising

A General Procurement Notice (GPN) will be prepared and issued in the United Nations DevelopmentBusiness (UNDB), as well as in the local newspapers to advertise for any ICB for goods and for majorconsulting assignments to obtain expressions of interest. The GPN will also be issued in the national pressfor contracts to be let under NCB. The GPN will be updated annually for bids still to be launched. SpecificProcurement Notices (SPN) and Expressions of Interest (EOI) for large contracts for consultants services(above US$200,000) will also be advertised in Development Business and sufficient time will be allowedfor responses to such notices (minimum 30 days) before preparing the short list. Advertisements for EOIseven below these limits are generally beneficiary to the implementing agency to obtain the best possiblecandidates for the assignment.

Procurement Capacity.

A capacity assessment of the Privatization Unit (PU) was carried out as well as Lesotho ElectricityCompany (LEC). Although linked with the Ministry of Finance, the PU operates as an independent agencyand has several staff familiar with IDA financed procurement because of their prior experience under theIDA financed Privatization and Private Sector Development Project. Its procurement performance isreasonably satisfactory, but procurement in Lesotho still needs close supervision. Procurement expertise inLEC is substantially weaker and LEC will therefore not be associated with the procurement process. Sincethe AfDB uses Standard Bidding Documents similar to those of IDA, AfDB financed procurement shouldalso not encounter major problems in the PU. The CTB may be involved in an oversight function but sincestandard Bank documents and procedures will be used which are familiar to the CTB, no conflicts areexpected in the implementation. The action plan to strengthen the procurement function of PU includestraining and regular supervision of visiting Bank missions (once every four months is recommended duringthe first year, and semi-annually thereafter). The prior review thresholds have been set in accordance withthe capacity assessment and the overall procurement risk is rated "average". The Interim Management TaskForce, which has been recruited under the PPF, will provide additional procurement capacity under itsterns of reference.

Procurement Plan

A procurement plan is being prepared by GoL and will be incorporated into the Project ImplementationPlan (PIP) as a condition for project effectiveness. The plan, which will include the contributions of othercofinanciers, was discussed during negotiations.

Procurement Implementation Arrangements.

The Privatization Unit will be responsible for procurement funded by the Project. It will handle theprocurement requests of each implementing agency according to monthly procurement schedules submittedto it. In addition, the Interim Management Task Force (IMTF) will provide procurement services under itscontract. Where IMTF manages procurement, it will do so in accordance with the Bank's Guidelines forprocurement using the Bank's Standard Bidding Documents. The PU will maintain a suitable filing systemof procurement documentation for review by visiting procurement missions and technical audits.

Procurement Methods (Table A)

The procurement methods, expenditure category and costs are summarized in Table A below. Thresholds

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for procurement methods and prior review are summarized in Table B. Contracts for similar works andgoods, to the extent feasible, will be grouped into larger bid packages up to US$100,000, so that they canbe launched by NCB, or ICB should they exceed this amount, in order to obtain more favorable prices.

Works. Only small works (about US$ 100,000) are included in the project to improve the facilities of theTelecommunications Regulatory Authority and will be contracted by NCB. [In the event that smallcontractors will be used for works in remote areas, for contracts costing between US$20,000 - US$50,000,up to an aggregate value of $200,000, the Africa simplified procurement procedures will be followed byobtaining quotations from at least three qualified small contractors. Contracts may be procured underlump-sum, fixed price contracts awarded on the basis of written quotations to bid. The invitation willinclude a detailed description of the works, including basic specifications, the required completion date, abasic form of agreement acceptable to IDA, and relevant drawings where applicable. The awards will bemade to the contractors who offer the lowest price quotation for the required work, provided they have theexperience and resources to complete the contract successfully.]

Goods. Goods will include packages to install new electricity interconnections, the change over to prepaidmeters, the purchase of frequency monitoring equipment, and equipment and materials required for the pilotelectricity and telecommunications access program in rural areas. International competitive bidding (ICB)procedures will be used for procurement packages for goods estimated to cost US$100,000 or more.National competitive bidding (NCB) will be used for goods estimated to cost less than US$100,000equivalent per contract up to an aggregate value of $500,000, and works estimated to cost $50,000equivalent or more per contract. For goods purchased through ICB, the Borrower may grant a margin ofpreference of 15 percent to domestic manufacturers of goods in accordance with the Guidelines referred toabove. Intemational, or national shopping procedures, based on a comparison of written price quotationsobtained following written solicitations issued to at least three qualified suppliers, may be used for thepurchase of goods costing less than US$30,000 per contract up to an aggregate value of US$75,000. Thewritten solicitation will include specifications and request infomnation on delivery time should the goods notbe immediately available. In the event of Intemational Shopping, quotations will be solicited from at leastthree suppliers in two different countries. Quotations will be opened and evaluated at the same time, and anevaluation report will be prepared for review by procurement supervision missions and technical audits.

Consulting Services. The Quality and Cost Based Selection (QCBS) methodology was used to select thefirm that will manage the Unit Trust which holds shares of privatized companies for sale to Basothoinvestors, and the Interim Management Task Force. This method will also be used for the Sales AdvisoryGroup, the regulatory advisors, and other services estimated to cost US$100,000 or more per contract.The least cost selection method will be used for audit services estimated to cost US$100,000 or less.Individual consultants will be recruited following Section V of the Guidelines. Consulting services forspecific technical advice estimated to cost less than US$100,000 and for training services estimated to costmore than US$20,000 per training course will be selected using the Consultant's Qualification (CQ)method.

IDA's Prior Review

IDA's prior review will be required for all contracts for goods procured under ICB. In addition, the firsttwo NCB contracts for goods below the threshold of US$ 100,000, as well as each contract for worksestimated to cost the equivalent of $50,000 or more, will be subject to prior review. For consultancyservices, IDA's prior review will be required for: (i) all contracts based on the QCBS methodologyestimated to cost US$100,000 and above. This will include IDA review of the technical evaluation beforeopening of the financial proposals; and (ii) for individual consultant contracts amounting to $50,000 and

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above, and the first two contracts below this amount, which should include the qualifications, experience,terms of reference and terms of employment. In addition, all terms of reference irrespective of the contractvalue, and all single source contracts are subject to prior review. Annual training programs will bereviewed with IDA prior to initiation.

Procurement Supervision

In accordance with the procurement capacity assessment, procurement supervision missions will be carriedout quarterly during the first year and semi-annually thereafter. This will include post-review and audits.

Monitoring and Evaluation Arrangements: Monitoring and Evaluation will be guided by the projectdesign summary in Annex I and the Implementation Plan through: (a) quarterly progress reports, preparedby the Privatization Unit; and (b) Bank supervision missions, annual progress review and project mid-termreview. The government will transmit an Implementation Completion Report (ICR) fbr the project, withinsix months of credit closing, to IDA.

The PU will consolidate and analyze statistical, financial and physical data on the implementation of theproject. Quarterly progress reports will be prepared by the PU and submitted to the MOF and IDA. Themonitoring and outcome indicators provided in Annex 1 will provide the government, IDA and other donorswitli measures to determine progress and form the basis for joint supervision.

Formal supervision will take place twice a year to review implementation progress. The government, IDAand other donors will jointly prepare the terms of reference and will participate in the mission. A mid-termevaluation of the project will take place no later than 24 months after Credit effectiveness in accordancewith terms of reference agreed upon by the government, IDA and other donors. The PU will prepare amid-term report detailing implementation progress under all the project components and identifyingimplementation issues. This report will be sent to the govemment, IDA and other donors not later than twomonths prior to the mid-term review. During the mid-term review, in response to the implementation issuesidentified, solutions will be developed. If required, project redesign steps will be taken. The ICR will alsobe jointly prepared by the PU and IDA witiin six months after the closing date of the Credit.

Procurement methods (Table A)

Table A: Project Costs by Procurement Arrangements(US$ million equivalent)

W~

1. Works 0.00 0.10 0.00 2.00 2.10(0.00) (0. 10) (0.00) (0.00) (0. 10)

2. Goods 6.80 0.20 0.00 9.80 16.80(6.80) (0.20) (0.00) (0.00) (7.00)

3. Services 0.00 0.00 15.29 1.90 17.19

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Consultant (0.00) (0.00) (14.29) (0.00) (14.29)Services/Communication,Studies, Training4. Operating Cost 0.00 0.00 1.70 0.30 2.00

(0.00) (0.00) (1.60) (0.00) (1.60)5. Retrenchment Package 0.00 0.00 0.00 1.90 1.90

(0.00) (0.00) (0.00) (0.00) (0.00)6. PPF Refinance plus 0.00 0.00 0.00 0.00 0.00Unallocated expenditures (0.00) (0.00) (6.00) (0.00) (6.00)

Total 6.80 0.30 16.99 15.90 39.99(6.80) (0.30) (21.89) (0.00) (28.99)

' Figures in parenthesis are the amounts to be financed by the IDA Credit. All costs include contingencies

21 Includes civil works and goods to be procured through national shopping, consulting services, services ofcontracted staff of the project management office, training, technical assistance services, and incrementaloperating costs related to (i) managing the project, and (ii) re-lending project funds to local governmentunits.

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Table Al: Consultant Selection Arrangements (optional)(US$ million equivalent)

Exp~kur XV ToaICs

A. Firms 12.70 0.00 0.00 0.00 0.00 0.00 0.40 13.10

(11.70) (0.00) (0.00) (0.00) (0.00) (0.00) (0.00) (11.70)B. Individuals 0.00 0.00 0.00 0.00 2.90 4.20 1.40 8.50

(0.00) (0.00) (0.00) (0.00) (1.90) (1.20) (0.00) (3.10)Total 12.70 0.00 0.00 0.00 2.90 4.20 1.80 21,60

(11.70) (0.00) (0.00) (0.00) (1.90) (1.20) (0.00) (14.80)

1\ Including contingencies

Note: QCBS = Quality- and Cost-Based SelectionQBS = Quality-based SelectionSFB = Selection under a Fixed BudgetLCS = Least-Cost SelectionCQ = Selection Based on Consultants' QualificationsOther = Selection of individual consultants (per Section V of Consultants Guidelines),Commercial Practices, etc.

N.B.F. = Not Bank-financedFigures in parenthesis are the amounts to be financed by the Bank Credit.

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Prior review thresholds (Table B)

Table B: Thresholds for Procurement Methods and Prior Review'

1. Works <100 NCB 0.1

2. Goods >=l00 ICB 6.8>30<100 NCB firsttwo contracts

<30 Shopping ex-post3. ServicesFirms >=100 QCBS 11.5

(LCS for Auditor) 0.1CQ

<100 (technical advice/training

Individuals >50,000 IC >=$50,000<$50,000

first two contractsothers ex-post

Total value of contracts subject to prior review: US$19.0 million

Overall Procurement Risk Assessment

Average

Frequency of procurement supervision missions proposed: One every 4 months during the first year,semi-annually thereafter months (includes special procurement supervision for post-review/audits)

Ex-post reviews: I out of 6 contracts

Thresholds generally differ by country and project. Consult OD 11.04 "Review of ProcurementDocumentation" and contact the Regional Procurement Adviser for guidance.

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Disbursement

Allocation of credit proceeds (Table C)Disbursement Arran2ements

Disbursements and withdrawal procedures are detailed in the World Bank Disbursement Handbook (1992edition). All disbursements are subject to the conditions of the Development Credit Agreement and theprocedures defined in the Disbursement Letter. The proposed IDA credit of US$ 28.6 million would bedisbursed over four years with an expected Project Completion Date of June 30, 2005 and a Closing Dateof December 30, 2005. The proposed allocation of Credit Proceeds is shown in table C below.

Table C: Allocation of Credit Proceeds

g pndii,,e Cate:gory AmBB a .... OS$riilin : i#0ancin v -' jtag.

Works 0.10 100% of foreign and 95% of local costsGoods 7.10 100% of foreign and 95% of local costsConsultancy Services 14.80 100Operating Costs 1.60 90Refunding of Project Preparation 2.10 100%

AdvanceUnallocated 2.90 100% of foreign and 95% of local costs

Total Project Costs 28.60

Total 28.60

The Privatization Unit (PU) will be responsible for processing all disbursement requests while ensuring thatfinancial management and reporting procedures for the project meet GOL and the World Bank standards. AFinancial Management Action Plan has been developed to lay out an essential institutional set-up andintemal controls mechanisms as well as to set forth necessaiy actions for systems development for soundfinancial management, and incorporate them in the Financial Procedures Manual. As the PU is not yetready for Project Management Report (PMR)-based disbursements, existing disbursement procedures, asoutlined in the World Bank's Disbursement Handbook, will be followed. This means direct payment,reimbursement and special commitment. However, the development of the PU's financial managementsystem, in accordance with the Financial Management Action Plan, is expected to facilitate the introductionof PMR-based disbursements within about 18 months of credit effectiveness.

Use of Statements of Expenditure (SOEs):

All applications to withdraw proceeds from the Credit Account will be fully documented except forexpenditures against contracts (a) with an estimated value of US$100,000 or less for works, goods andconsulting firms; and (b) contracts with an estimated value of US$50,000 or less for individual consultants;(c) all operating costs which may be claimed on the basis of certified statements of expenditure (SOE).Documents supporting these expenditures would be retained by PU and other implementing agencies for

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their respective components, and will be available for review upon request by IDA supervision missionsand project auditors.

Special account:

To facilitate disbursements of eligible expenditures for works, goods and services, the government willopen a Special Account within a commercial bank maintained by the Central Bank in US Dollars to coveIpart of IDA's share of eligible expenditures to be managed and administered by the PU under terms andconditions satisfactory to IDA. The authorized allocation of US$ 1 million for the Special Account willcover an estimated four months of eligible expenditures financed by IDA. Initially, the authorizedallocation will be limited to an amount of US$0.5 million until the aggregate amount of withdrawals fromthe credit account plus the total amount of all outstanding special commitments entered shall be equal toSDR 3 million. Replenishment of funds from IDA will be made upon evidence of satisfactory utilization ofthe advance, reflected in the Statement of Expenditures (SOE) or on full documentation of payments abovethe SOE thresholds. Replenishment applications should be submitted montly, but not exceeding threemonth intervals. To the extent possible, all of IDA's share of expenditures should be paid through theSpecial Account. If ineligible expenditures are found to have been made from the Special Account, thegovernment will be obligated to refund the cost and submit evidence with the next request forreplenishment. In addition, if the Special Account remains inactive for more than six months, thegovernment may be requested to refund to IDA the amounts advanced in the Special Account.

Financial Management

PU has familiarity with IDA procedures. IDA staff conducted a financial management assessment andmade recommendations to strengthen PU's capacities. As part of this assessment, a Financial ManagementAction Plan has been prepared.

A Financial Management Committee is being established and will be responsible for the overall policyguidance of the project's financial management. The committee will include representatives of theMfinistries of Finance, Planning, the project Director, the project accountant and the procurement specialist.

A qualified Chief Accountant with proficiency in computer applications and good communication skills,has been recruited to direct the financial management operations of the Project. The Chief Accountant willbe assisted by a senior accountant and relevantly qualified and experienced procurement,administrative/support staff. As required, staff training will be provided in: financial management(including internal controls), information systems and computer applications, procedures relating to use offunds, e.g., IDA (Special Accounts, SOEs, Special Commitments, Procurement, LACI, etc.) andgovernment regulations, performance measurement; general professional skills (presentation, analytical,negotiating, counseling and writing).

The Financial Procedures Manual is being prepared and will document the internal control procedures to befollowed by the PU and computerized systems will be set up to enable the PU to maintain accountingrecords in accordance with international accounting standards and practices. The strengthened PU willprepare and distribute consolidated periodic reports (Progress Reports) reflecting: the status ofimplementation progress, problems encountered and corrective actions needed; and current costs of each

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project component together with estimated costs of completion.

Financial reports generated by the financial management system will be communicated to the FinancialManagement Committee on a quarterly basis and will include comparison of actual against budgetedamounts; monthly special account reconciliation with bank and loan statements and quarterly andsemi-annual eligible disbursement analysis with actual compared to budget; and bi-annual financial reportindicating variances between actual outputs and matched costs compared to forecasts and measured againstbudget.

Other monitoring reports that will be provided on a quarterly basis include: (a) financial statementsdocumenting the sources and uses of funds by loan category and by project activity, forecastingexpenditure, disbursement amount and reconciliation of the special account, and summarizing creditwithdrawals using statement of expenditures; (b) project progress reports providing information on projectimplementation progress in physical and financial terms and covering monitoring indicators includingdeviations from plan and reasons thereof; (c) procurement management reports indicating the status ofprocurement and contract commitments and expenditure.

The PU will enforce all internal control procedures according to the Financial Procedures Manual, willdocument all the accounting procedures and internal controls. Internal controls for the PU would comprisepolicies and procedures adopted by management to assist it in achieving its objectives of ensuring, as far aspossible, the orderly and efficient conduct of its operations, including: (a) adherence to managementpolicies, laws and regulations; (b) safeguarding of assets; prevention and detection of fraud and error; (c)promoting orderly, economic, efficient and effective operations consistent with the project objectives;accuracy and completeness of the accounting records; and (d) preparing on a timely basis all requiredfinancial information.

The PU will keep the finds from IDA and, in due course, each other donor, in separate accounts but willmove toward common procurement, financial management and auditing procedures acceptable to allpartners. Financial statements will show all expenditures and the source of funds. For IDA funds, the PUwill maintain accounting records including maloti, dollar and SDR movements in respect of the bankaccount and, in accordance with good accounting practice, accounting records will be reconciled monthlyby the PU with the bank statements for the account upon its receipt.

Project accounts will be audited annually according to international auditing standards by an independentauditor acceptable to IDA; Special accounts and all disbursements under Statement of Expenditures(SOEs) will be audited semi-annually. The annual audit report will be submitted to IDA within six monthsof the end of each fiscal year, and the semi-annual audit report within three months of each period. Theauditors will provide a management letter that recommends improvements to the accounting records,systems, controls and compliance with financial covenants. Two copies of the audit reports will beforwarded to the FMC and IDA by the PU six months after the end of the fiscal year. The project willfinance preparation of the audit reports except the final one which will be funded by the government. InLesotho, the Office of the Auditor General is responsible for the external auditing of all government funds.Besides expressing a primary opinion on the Annual Financial Statements in compliance with InternationalAuditing Standards (IFAC/INTOSAI pronouncements), the auditor will be required to include a separateparagraph commenting on the accuracy and propriety of expenditures withdrawn under SOE proceduresand the extent to which these can be relied upon as a basis for loan disbursements. The auditor will also beexpected to form an opinion as to the degree of compliance with World Bank procedures on the specialaccount and the balance at the year-end.

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By project effectiveness, the financial management arrangements are not expected to be ready forPMR-based disbursements, as discussed in the World Bank's Loan Administration Change InitiativeHandbook (LACI, September 1998). Thus, in the short-tenn, existing disbursement procedures, asoutlined in the World Bank's Disbursement Handbook, will be followed, i.e., direct payment,reimbursement, etc. Also, the timely appointment of the proposed Project Accountant, coupled with thedevelopment of the PASPU's financial management system, is expected to facilitate the introduction ofProject Management Report (PMR) based disbursements by end-2002.

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LESOTHO: UTILITIES SECTOR REFORM PROJECTAnnex 6D: Financial Management Action Plan

A. GENERAL

Under the supervision of the Project Director, the Project Accounts Section of the Privatization Unit(PASPU) will be responsible for ensuring that financial management and reporting procedures will beacceptable to the Government, the World Bank and other Cooperating Partners.

The principal objective of the PASPU's financial management system (FMS) will be to supportmanagement in their deployment of limited resources with the purpose of ensuring economy, efficiencyand effectiveness in the delivery of outputs required to achieve desired outcomes, that will serve theneeds of the people of Lesotho. Specifically, the FMS must be capable of producing timely,anderstandable, relevant and reliable financial information that will enable management to plan,implement, monitor and appraise the project's overall progress towards the achievement of itsobjectives.

For the PASPU to fully deliver on the aforementioned objectives, it's FMS will be developed inaccordance with the Financial Management Action Plan presented in Section B below.

B. FINANCIAL MANAGEMENT ACTION PLAN

Financial Management Committee fFMC)

A representative FMC will be appointed to review the ProjectManagement Report (PMR) everyquarter. The PMR will comprise:

Pinancial Statements, as discussed below. Members of the FMC will review and approve Quarterlyand Annual Financial Statements; they will also examine material variances between budget/actualfigures, seeking remedial action as appropriate within an agreed timeframe.

Proiect Progress, i.e. Ouiput Monitoring Report (OMR). The format and details of the OMR willneed to be developed. An important aspect of the OMR will be the accompanying narrativeinterpreting the Project's progress with agreed financial performance indicators and how costs to daterelate to those planned at appraisal, and the likely effect on the Project by completion.

Procurement Management Report (including Goods, Works and Services).

Staffing

A Chief Accountant will be appointed to direct and guide the financial operations. Relevantlyqualified/experienced support staff will be available. Varying levels of staff training will be requiredin financial, management and government accounting; information systems and computer applications;and procedures relating to the utilization of funds (e.g. Special Accounts, SOEs, SpecialCommitments, Procurement, etc.). On-the-job coaching will also be provided.

F`inancial Procedures ManuaUlAccounting System

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A Financial Management Consultant has been retained to develop and install the Project's FMS(manual and computerized) and to prepare the Project's Financial Procedures Manual.

Provision has been made in the Budget for hardware and software requirements.

Planning and Budgeting

Counterpart Funding will be approved in line with the Government's budgetary process. The ChiefAccountant, in consultation with the Project Director and the FMC, will be responsible for preparingthe Project's Quarterly/Annual Cash Flow Forecast in line with generally accepted accountingpractice.

Government Accounting-Cash Versus Accruals Bases

The PASPU will meet the Treasury's requirement for cash accounting. This requirement is notexpected to change in the short to medium term. Thus, for the foreseeable future, project funds will beaccounted for on a cash basis. In due course, for management reporting purposes, the FMC willdecide whether to convert to an accruals accounting basis.

Procurement of Goods, Works and Services

World Bank and Governmcnt procurement regulations will be observed. The Chief Accountant andsupport staff will be conversant with those procedures, as intemal control issues and the incurring ofliabilities on behalf of the project will be matters of concem to the financial management function.

Procurement procedures will be documented in the Financial Procedures Manual. A ProcurementManagement Report, showing procurement status and contract commitments, will be preparedquarterly for consideration by the FMC (see above).

BankingActivities-Flowv Of Funds

The PASPU will maintain 4 accounts as follows:

(a) Current Account in Maloti with Bank X (Part 1 Account) to which draw-downs from the SpecialAccount will be credited for project financing and administrative expenses.

(b) Current Project Account in Maloti with Bank X (Part 2 Account) to which Counterpart Fundingwill be deposited. Initially, a three months float will be provided and, thereafter, it will bereplenished monthly.

(c) Special Account with Bank X in US Dollars/Maloti, which will show:

I Dollar/Maloti cost of transfers to Part 1 Account with Bank X;

P Dollar/Maloti cost of direct payments to suppliers;

P Dollar advances (Maloti cquivalent cost) from the IDA Ledger Loan Account;

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P Opening and Closing Balances.

(d) IDA Ledger Loan Account (Washington) in US Dollars/Maloti/SDR, which will show:

P Cost of transfers to Bank X;

p Cost of direct paymen1ts to suppliers;

P Opening and Closing Balances.

Bank accounts will be reconciled monthly; identified differences will be expeditiously investigated.Control procedures will be documented in the Financial Procedures Manual.

Withdrawals/Disbursements

By effectiveness, the PASPU will not be ready for PMR-based disbursements (World Bank's LoanAdministration Change Initiative Handbook, LACI, September 1998). Thus, in the short term,existing disbursement procedures as outlined in the World Bank's Disbursement Handbook will befollowed, i.e. Direct Pav'nicit, Reimbursement and Special Commitment. However, the appointmentof the Chief Accountant, coupled with the development of the PASPU's financial managementsystems, should facilitate the introduction of PMR-based disbursements within 18 months of crediteffectiveness.

In due course, the adoption of PMR-based disbursements (which integrates project accounting,procurement, contract maniagement, disbursement and audit with physical progress through the ProjectManagement Report, as summarized above) should enable the PASPU to move away fromtime-consuming voucher-by -voucher disbursement methods to quarterly disbursements to the SpecialAccount based on the PMR.

FixedAssets/Consultantsl/Civil Works

Control procedures will be documented in the Financial Procedures Manual. A Fixed Assets Registerwill be prepared, regularly updated and checked. Regarding Construction/Capital Work in Progress,controls will be established to ensure that payments are made only for certified work (includingphysical verification). A Contracts Register will be maintained for all contracts with consultants. AProcurement Management Report, showing procurement status and contract commitments, will beprepared quarterly for consideration by the FMC.

Financial Reporting (Mont7hly and Quarterly/Annually)

Monthly Cash Reporting

In compliance with Govemment reporting requirements, the Chief Accountant will be responsible forpreparing a Monthly Return to the Treasury (MOF) for incorporation into the National Accounts.

Quarterly/Annuailly

The Financial Statements. following determination by the FMC, are likely to include:

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* A Consolidated Statement of Sources and Uses of Funds (IDA, Counterpart andDonor Funds);

* Project Balance Sheet as at the reporting date;

* Notes on significant accounting policies and accounting standards adopted bymanagement when preparing the accounts; and on any supplementary information orexplanations that may be deemed appropriate by management to enhance thepresentation of a "true and fair view";

* A Statement reconciling the balances on the various Bank Accounts (including the IDASpecial Account) to the bank balances on the Statement of Sources and Applications ofFunds;

* SOE Withdrawal Schedule, listing individual withdrawal applications relating todisbursements by the SOE Method, by reference number, date and amount;

* A Cash Forecast for the next two quarters.

Indicative formats for Financial Statements are outlined in a number of World Bank publications -Financial Accounting Rcporting and Auditing Handbook (FARAH, January 1995), The LoanAdministration Change Initiative Handbook (LACI, September 1998) and the Draft Project FinancialManagement Manual (February 1999). In due course, the formats adopted by the FMC will bedocumented in the Financial Procedures Manual.

External Audit

Audited financial statements will be submitted to the Bank within six months after the financialyear end. In Lesotho, as outlined in the Constitution of Lesotho 1993, the Office of the AuditorGeneral (AG) is responsiblc for the extemal auditing of all government Funds. Besides expressing aprimary opinion on the financial statements in compliance with Intemational Auditing Standards(IFAC/INTOSAI pronouncements), the AG will be required to include a separate paragraphcommenting on the accuracy and propriety of expenditures withdrawn under SOE procedures andthe extent to which these can be relied upon as a basis for loan disbursements. Regarding the SpecialAccount, the AG will also be expected to form an opinion as to the degree of compliance with WorldBank procedures and the balance at the year-end. Additionally, the AG will be required to prepare aseparate Management Letter giving observations and comments, and providing recommendationsfor improvements of accounting records, systems, controls and compliance with financial covenants.

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Annex 7: Project Processing Schedule

LESOTHO: Utilities Sector Reform Project

Time taken to prepare the project (months) 9 11First Bank mission (identification) 03/12/2000 03/12/2000Appraisal mission departure 09/01/2000 09/01/2000

Negotiations 10/15/2000 02/14/2001Planned Date of Effectiveness 06/15/2001

Prepared by:

Preparation assistance:

PPF Q238-0-LSO

Bank staff who worked on the project included:

Mohua Mukherjee Team LeaderGaiv Tata Subregional ManagerLudmilla Butenko Financial SpecialistAlfred Gulstone Power SpecialistGareth Locksley Telecommunication SpecialtySerigne Omar Fye Environmental SpecialistFrancesco Sarno Procurement SpecialistAnthony Martin Hegarty Financial Management AdvisorMarilyn Manalo Operations OfficerRichard Cambridge Overall Project Quality AdvisorT. Mpoy-Kamulayi LawyerIrene F. Chacon Program AssistantRona Cook Team Assistant

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Annex 8: Documents in the Project File*

LESOTHO: Utilities Sector Reform Project

A. Project Implementation Plan

First draft provided by Pnrvatization Unit in November 2000

B. Bank Staff Assessments

1. "Small-Scale Enterprises in Lcsotho: Summary of a Countrywide Survey," GEMINI (Growth and Equitythrough Microenterprise Investments and Institutions) Project, Technical Report No. 14.

2. 1993 Sechaba Household Survey for Lesotho.

3. Jones, Leroy, Pankaj Tandon and Ingo Vogelsang. 1990. Selling Public Enterprises: A Cost BenefitMethodology. Cambridge MA: MIT Press.

C. Other

*Including electronic files

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Annex 9: Statement of Loans and Credits

LESOTHO: Utilities Sector Reform Project

Difference between expecredand actual

Original Amount in USS Mllions disbursementsProject ID FY Purpose IBRD IDA SF GEF Cancel. Undisb. Orig Frm Rev'd

P001402 1998 AG POL & CAP BLDG 0.00 6.80 0.00 6.05 3.06 0.00

P058050 2000 Community Development Support Project 0.00 4.67 0.00 4.83 0.26 0.00

P001409 1998 HILAND WATER IB 45.00 0.00 0.00 38.02 11.02 000

P053200 2000 Health Sector Reform Project 0 00 6.50 0.00 6.54 0.00 0.00

P001401 1994 PRIVATISATIONIRESTRU 0.00 11.00 0.00 2.52 -1.25 0.00

P001403 1996 ROADREHAB.&MAINT 000 40.00 0.o0 28.79 25.82 21.49

P056416 1999 SECONDEDUSECDEVP 0.00 21.00 0.00 1892 2.89 0.00

Total: 45.00 89.97 0.00 105.67 41.80 21.49

LESOTHOSTATEMENT OF IFC's

Held and Disbursed Portfolio

In Millions US Dollars

Committed DisbursedIFC IFC

FY Approval Company Loan Equity Quasi Partic Loan Equity Quasi Plartic

Total Portfolio: 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00

Approvals Pending Commitment

FY Approval Company Loan Equity Quasi Partic

Total Pending Commitment: 0.00 0.00 0.00 0.00

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Annex 10: Country at a GlanceLESOTHO: Utilities Sector Reform Project

Sub-POVERTY and SOCIAL Saharan Low-

Lesotho Africa income Development diamond'1998Population, mid-year (millions) 2.1 628 3,515 Life expectancyGNP per capita (Atlas method, US$) 570 480 520GNP (Atlas method, USS billions) 1.2 304 1,844

Average annual growth, 1992-98

Population (%) 2 2 2.6 1.7Labor force (%) 26 26 1 9 GNP Gross

per primaryMost recent estimate (latest year available, 1992-98) capta enrollment

Poverty (% of population below national poverty line) 49Urban population (% of total population) 26 33 31Life expectancy at birth (years) 56 51 63Infant mortality (per 1,000 live births) 93 91 69Child malnutrition (% of children under 5) 16 . . Access to safe waterAccess to safe water (% of population) 62 47 74Illiteracy (% of population age 15+) 18 42 32Gross primary enrollment (% ofschool-age population) 108 77 108 Lesotho

Male 102 84 113 Low-income groupFemale 114 69 103

KEY ECONOMIC RATIOS and LONG-TERM TRENDS

1977 1987 1997 1998Economic ratlos

GDP (US$ billions) 0.19 0.37 1 02 087Gross domestic investment/GDP 25.0 45.4 85.5 48.6 TradeExports of goods and serviceslGDP 10.7 16.3 32.5 33.5Gross domestic savings/GDP -74 5 -70.0 -9 8 -42.7Gross national savings/GDP -58.0 -41 5 47 2 14.5

Current account balance/GDP -90.2 -89.0 -26 3 -27.2 DomesticInterest payments/GDP 0.1 1 5 1.8 2.4 Sains InvestmentTotal debt/GDP 12.7 69.9 64.5 600 SavigsXTotal debt service/exports 02 3.5 6.4 8.1Present value of debt/GDP . 46.4Present value of debt/exports . . 62.4

Indebtedness1977-87 1988-98 1997 1998 1999-03

(average annual growth)GOP 1 8 6.7 8.0 -3.6 5.8 LesofhoGNP per capita -0 2 1 3 2.1 -5.4 3.8 Low-income groupExports of goods and services 1 6 8.0 19.1 15.8 12.6

STRUCTURE of the ECONOMY1977 1987 1997 1998 Growth rates of output and investmentt%)

(% of GDP) 3Agriculture 34.3 20.1 11.5 11.5Industry 15.5 32.5 42.0 42.0

Manufacturing 5.0 149 17.2 .. o' , ,Services 50 2 47.5 46.5 46 5

Private consumption 157 2 147.2 82.0 120.9 .20General government consumption 17.4 22.8 27 8 21.7 GDI eGDP

Imports of goods and services 110.2 131.8 127.8 124.7

1977-87 1988-98 1997 1998 Growth rates of exports and lm ports (%)(average annual growth)Agriculture -5.6 2.3 07 4.6 40Industry 41 10 3 1.1 -12.3 30

Manufacturing 16 5 5.3 I . 20Services 43 6.0 6.6 4.8

Private consumption 1 4 -2.7 13.8 5.0 101X 9 g

General government consumption 8.0 4.4 17.0 0.9 _ s 96 OsGross domestic investment 2.0 13.3 35 -10.4 15Imports of goods and services 2.3 1 6 11.9 1.6 Exporils -*ImportsGross national product 2.4 36 4.5 -3 1

Note: 1998 data are preliminary estimates.

The diamonds show four key indicators in the country (in bold) compared with its income-group average. If data are missing, the diamond willbe incomplete.

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PRICES and GOVERNMENT FINANCE

ANNEX I I

MINISTRY OF FINANCE

LESOTHO

Office Of the MinisterP.O. Box 396

Maseru 100

CPO/C/4/014 27 October, 2000

Ms Mohua MukherjeeTeam LeaderAFTPSAfrica RegionThe World Bank1818 H Street N.W.Washington, D.C. 20433U.S.A.

Dear Ms Mukherjee,

LESOTHO: UTILITIES SECTOR REFORM PROJECT (USRP)A POLICY STATEMENT ON THE RESTRUCTURING

OF THE POWER SECTOR - OCTOBER 2000

Reference is made to the above project, particularly theGovernment of Lesotho's Policy Statement on the Restructuring of thePower Sector.

I have pleasure in submitting the said statement together withthe updated implementation schedule which is attached as an Annex.

Your attention is drawn first to the legal framework andestablishment of a Regulatory Authority for which a draft bill hasbeen submitted to Cabinet for approval, and second to theprivatization of the Lesotho Electricity Corporation for whichGovernment of Lesotho has decided to either sell or transfer themajority shares to the strategic investor.

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2

I hope this response will facilitate finalization of the AideMemoire and the signing thereof so"that the target dates forimplementation can be achieved.

Thank you for your usual co-operation.

Yours sincerely

'iOPMINISTER OF FINANCE AND OF

DEVELOPMENT PLANNING

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MINISTRY QF NATURAL RESOURCES

A POLICY STATEMENT ON THE RESTRUCTURING OF THE POWERSECTOR. OCTOBER 2000

INTRODUCTION

The Government of Lesotho (GOL) has decided to restructure its power sector witha view to introducing private sector participation (psp) into the Lesotho ElectricityCorporation (LEC) and commercializing the operations of 'Muela HydropowerPlant. This document thus presents basic information on GOL's policies for thesector.

In the early nineteen nineties, GOL embarked on a pnrvatization and private sectordevelopment and reforn programme incorporating the privatization, liquidationand restructuring of public enterprises over the five-year period 1995 to 2000.Amnong the main objectives of the GOL were the improvement of thecompetitiveness of its productive sectors and the broadening of local shareownership in tne enterprises.

Within the power sector in Lesotho, the two institutions that are particularlyaffected by the reforms are the Lesotho Electricity Corporation and the 'MuelaHydropowe- iPlant. Priority has been given to the privatization of LEC due to itscurrent problems, which include high financial losses, operating inefficiency, non-competitive tariffs and the inability to meet the demand for electricity connections.

REFORMS

To enable reforms to proceed efficiently in the power sector, GOL has made thepolicy decisions provided below. The schedule for implementation of the decisionsis provided in the Annex.

a) Revised Lcgal Framework and Establishment of Regulatory Authority

The provision of services in the power sector by private operators willrequire simple and transparent regulation that assures a favourableenvironment to attract private investors while also protecting consumers. Itis also necessary to establish an autonomous regulatory authority, which will

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be part of a multi-sectoral regulatory authority including thetelecommunications and water sectors.

To this end, a draft bill for the establishment of a regulatory authority is beingfinalized and should be submitted to Cabinet%r approval by the end of September2000. The Bill will then be tabled before Parliament by November 2000.

T1he Bill caters for the restructuring of the sector in the following ways:

a It allows for several generators to operate in the country;a It allows for several distributors to operate in the country;* It allows for several transmission/dispatch operators to do business in the

country. However, to ensure equal access to regional trading andcompetition amongst the several stakeholders no single operator will belicensed to operate the National Control Center (NCC). A mechanism willhave to be put in place which will ensure that all operators share theresponsibility for the NCC in an equitable manner; and

- It is the basis for establishing a regulatory authority. It is planned that theproposed Lesotho Electricity Authority to be established under the Bill willbe operational by March 2001.

b) Privatization of the Lesotho Electricity Corporation

GOL has decided that the LEC's privatization will entail either selling ortransferring the majority shares of the corporation to a strategic investor. Astrategic private sector investor is expected to have taken over the utility by April2002. The final decision on the type of private sectoral participation to be followedwill be made after receiving advice from a sales advisor to be employed by theGovernment by not later than December 2000.

With regard to the current mini-hydropower plants owned and operated by LEC,GOL expects the Sales Advisory Group's Proposals on the appropriate method onhow they should be treated.

Prior to the full privatization of LEC it is necessary to turn around the corporationand bring it to the level where it would be operating along sound businessprinciples. To achieve this, Government has decided to employ a team of expertsto take over the management of the corporation and remain in LEC for a period ofeighteen months.

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Key issues to be tackled by the new management, the Interim Management TaskForce (IMTF), are financial and operational efficiency of LEC, the connection of6000 additional consumers, the streamlining of the functions of the utility and therightsizing of LEC. The IMTF will also be required to undertake a study and makerecommendations for the optimal service territoiy for a privatized LEC as well asundertake a study on access to electricity to identify future potential customersthroughout the country. The IMTF is scheduled to commence its duties inNovember 2000.

c) 'Muela Hydropower and Future Hydropower Generation Issues

With regard to the 'Muela Hydropower Plant, GOL policies are aimed at ensuringthat it operates as a commercial business. The plant will be expected to sell powerat affordable prices and to contribute to the repayment of the debt accumulatedduring its construction.

The GOL will carry out a study on 'Muela, whose findings will assist theGovernment in deciding whether 'Mucla should be privatized or not. TheGovernment will approach the European Union (EU) for financing of the study.

The proposed diagnostic and options study for 'Muela will also consider the futurehydropower generation in consideration of electrification targets and possibilities ofregional power export.

d) Electricity Tariffs

The overall responsliblity of setting tariffs will lie with the Lesotho ElectricityAuthority once it becomes operational. However, since consumer tariffs have notbeen reviewed for over six years, the IMTF will be allowed to makc tariffproposals, which may become effective before the Authority is in its place.

Measures have been taken to bring 'Muela bulk tariffs in line with regional levels.Of particular consideration has been the tariffs of Eskom, the South African powerutility. Further measures will be taken to determine the bulk tariffs taking intoconsideration the Southern African Power Pool rules and guidelines. Once theElectricity Authority is in place, it will take over this responsibility for setting bulktariffs.

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Annex

POWER SECTOR REFORM IMPLIMENTATION SCHEDULE

Activities Targets Dates

a) Privatization of Lesotho Electricity Corporation

1. Recruitment of IMTF December 20002. Commencement of IMTF contract at LEC January 20013. Recruitment of Sales Advisors March 20014. Recruitnent of Advisor to LEC Board January 20015. Selection of Strategic Partner June 200 1-July 20026. Take over of LEC by partner August/September 2002

b) Establishment of Electricity Regulatory Authority

1. Submission of Electricity Bill to Cabinet September 20002. Enactment of Electricity Bill February 20013. Appointment of Regulatory Staff April 20014. Recruitnent of Electricity Regulatory Advisor February 20015. Preparation of Approval of Regulations June 20016. Training of Elec/Telecom Regulators April 2001 - Dec 2002

5

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The 1993 Power Sales Agreement (PSA) between the Lesotho HighlandsDevelopment Authority (LHDA) and LEC is presently under review. The PSA'stariffs are being reviewed as a result of GOL approving LHDA's proposal on therefinancing of 'Muela, but the review is subject to the European Investment Bank'sendorsement of proposed amendments.

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