Action 1.2 Strengthen the legal framework and enforcement to protect property rights

23. 
    Sign into law and implement the Financial Rehabilitation and Insolvency (FRI) bill that was passed by both the Senate and the House in February 2010. A sound and stable investment climate depends on more than the ease of business entry and streamlined licensing. Most small businesses fail within three years and their owners need to start over again. Insolvency allows for businesses to end smoothly, allowing an efficient reallocation of capital and for entrepreneurs to start over again. A good insolvency law helps to resolve the competing claims on a business in a predictable, efficient and transparent manner. If lenders have the assurance that the country has a functioning insolvency system, they will be able to estimate more accurately the risk of a loan and charge a lower interest rate. It makes it easier for buinesses to obtain bank financing at more favorable rates.
    

24. 
    Once the FRI law is signed, it is necessary to approve implementing regulations. In developing these regulations, it would be desirable to give particular emphasis on the law’s application to SMEs and take into account international best practices as articulated, for example, in the World Bank Principles for Effective Insolvency and Creditor Rights Systems. Looking forward, there is a need to enhance the development and delivery of particular components of the revised insolvency system, e.g., developing informal workout systems (out-of-court insolvency procedures) to ease the burden on formal insolvency systems.
    

25. 
    Strengthen the Philippine collateral system. The cadastral titling of all lands in the country needs to be completed and a central registry for land titles established. A modern registration system for secured transactions needs to be established, with unified and searchable registries for all collateral. Moreover, the collateral value of agrarian reform land needs to be restored to increase farmer-beneficiaries’ access to credit from formal financial markets.
    

26. 
    To improve non-performing loan recovery and asset restructuring, as well as reduce the cost of doing business for foreign investors seeking to enter the Philippine market, review the Foreign Investment Negative List and consider relaxing foreign ownership restrictions on land and other assets in the Philippines.
    

27. 
    The recently approved FRI bill provides a new basis and opportunity for strengthening the legal framework for resolving non-performing loans (NPL). At the same time, the independence and capacity of the financial sector regulators – Securities and Exchange Commission, Bangko Sentral ng Pilipinas, Insurance Commission – need to be strengthened to bring the Philippine markets more in line with international standards. In this context, particular emphasis should be placed on the monitoring of related-party lending, risk-based capital adequacy, and corporate governance.
    

28. 
    The Philippines already passed the Credit Information System Act, but the credit bureau called for under the Act has not yet been established. By collecting, distributing and sharing credit information on borrowers, credit registries help lenders assess risk and allocate credit more efficiently. They also free entrepreneurs from having to rely on personal connections or savings. The prospective credit bureau should be encouraged to expand the range of information available by including history from other sources and distributing positive/negative information.
    

29. 
    Introduce a system of credit guarantees for SMEs to replace the existing system of mandated lending. Mandatory allocations for SME lending initially may have played a role in encouraging growth in the volume of SME lending, but they no longer suffice to meet the financing needs of Philippine SMEs and have proven to be counter-productive. A system of guarantees that seeks to encourage financial institutions to lend to SMEs stands a better chance of succeeding than the current system that seeks to coerce the banking system into making loans that are perceived as unprofitable or overly risky.
    

30. 
    An explicit competition framework is needed to help combat ongoing and potential anti-competitive practices that are not sanctioned under the existing legal framework. Once it is in place, a competition (or anti-monopoly) authority needs to be created to enforce this framework.
    

31. 
    To improve the quality of regulatory governance and improve the efficiency of regulations, there is a need to establish a vetting mechanism – typically called Regulatory Impact Assessment - which (a) ensures that new regulations meet regulatory quality criteria, and (b) impedes creeping re-regulation, thereby ensuring the sustainability of reform. A regulatory review unit should be established to vet new licenses/regulations and assess their impact on business activity while establishing a regulatory registry will provide positive legal security for businesses, i.e., only those regulations captured in the registry can be legally enforced.
    

32. 
    To make network service industries and the sectors competitive, these markets should be governed by independent regulators with full operational separation and impartiality. To be effective, the regulators must be subject to transparent public procedures (e.g., in procurement) and equipped with adequate expertise and resources to execute their mandates.
    

33. 
    Without an institutional structure in place to implement and coordinate the reform process effectively, there is the danger that the reform momentum will dissipate fairly quickly. There is a need for public education not only to generate ‘buy-in’ and create a constituency for reform but also a deeper appreciation of the importance of competition and the economic gains from contestable markets. It is important to have a structured dialogue with the private sector and other stakeholder groups on a multi-faceted action agenda on market competitiveness and contestability. An independent advisory body with an economy-wide view would ensure that full economic gains from competition would be realized. This body should have statutory independence, be adequately funded, and staffed with senior executives appointed for fixed terms.
    

1. 
   The Philippines Today: Progress and Challenges
   

1. 
   The restructuring and liberalization of the market, sparked by passage of the Electric Power Industry Restructuring Act 2001 (EPIRA), has progressed well, but remains incomplete in several critical areas – and, critically, is not widely seen as having delivered sufficient benefits. Since the passage of EPIRA, the country has built up a new regulatory authority, implemented a competitive wholesale electricity market, and embarked on an impressive and mostly successful privatization effort. The Electricity Regulatory Commission (ERC) has developed in a promising manner, and its continued development as an independent and credible regulator should be continued. Private sector distribution companies and generation facilities are already operating with high efficiency. But private ownership and/or administration of the remaining state-owned power plants need to be further advanced; transmission investment could be usefully accelerated; reform is urgently needed in the electric cooperative sector; and overall operating costs and customer tariffs remain high. Meanwhile, legacy and transition liabilities have grown significantly and have translated into significant financing challenges for the sector and the Government. (See Annex for additional background information on the power sector.)
   

2. 
   Much has been achieved to date, but there is a full agenda going forward. These include: managing the privatization of the remaining generation assets; creating conditions for effective competition; developing renewable energy; developing the natural gas market; restructuring debt held by government agencies; addressing the issue of non-bankable electric cooperatives; attracting timely generation investments; and efficient planning and execution of transmission expansion. And given the likely pace of demand growth, the Philippines could soon face supply shortages in all the major regions. The foundation is in place; action is now essential.
   

3. 
   Three critical issues loom large as the new government takes office. First, huge new investments must be attracted to build new power generation capacity and expand the transmission and distribution network. Second, millions of households remain to be electrified, and there are major questions about how this can be done in a financially sustainable manner. Third, there are significant parts of the power sector reform agenda still under implementation, and some of those could have important financial implications for the sector.
   

4. 
   The Philippines faces some unique power sector challenges. The country’s many inhabited, often mountainous, islands mean that connection and operational costs in some areas will be quite high. It is rapidly urbanizing and there are big gaps in relative wealth among regions, especially between the metro Manila area (accounting for almost half of the country’s GDP) and the rural areas (some of which are quite isolated). In addition to urban-rural disparities, there are regional issues, with Luzon relatively prosperous and Visayas, Palawan, and Mindanao among the poorer regions. These differences are mirrored in the electricity sector – Luzon and Manila in particular are relatively well-served, access is high, and a sophisticated power market is operational. In the other regions, by contrast, networks are less developed and less integrated, power supply is less abundant and reliable, and access rates are lower. The reliable capacity available to meet demand in Visayas and Mindanao is much lower than the nameplate installed capacity, and there is barely enough reliable generation capacity to meet peak demand. It is likely that both areas will suffer from increased power shortages until new capacity comes on line. In Luzon there is surplus of capacity for now, but shortages are looming.
   

5. 
   There is no single national grid, as Mindanao is not connected to the Luzon/Visayas network. Significant transmission constraints exist, exacerbated by the backlog in transmission investments that built up during the course of the Transco concessioning process. Luzon’s wholesale spot market cannot be extended soon to Visayas or Mindanao, and meeting the growing demand in Visayas will be difficult without well planned generation and transmission investments. The lack of adequate transmission capacity creates barriers to development of new power plants (including new renewable generation capacity and medium-sized geothermal within Visayas). The lack of integration among the three grids means that the Visayas and Mindanao generation markets will be overseen by administrative regulation rather than driven by competition.
   

6. 
   Tariffs in the Philippines are stubbornly high for several reasons. First, the archipelagic nature of the country makes services very costly in some areas (especially when generation has to be fueled by oil). Second, while the natural resource endowment is in some ways favorable, the development of geothermal, natural gas, and hydro resources has been expensive. Third, sector investments have been low and often not efficiently planned or implemented. Fourth, the response to the crisis was to contract a huge amount of new capacity with some procurement resulting in expensive projects.
   

7. 
   Electric Cooperatives (ECs) are generally inefficient. Generation costs account for only 43.8 percent of power tariffs charged by the ECs reflecting the high costs of transmission and distribution in a mountainous island chain. Among the private distribution companies, which serve mainly an urban customer base, generation costs make-up a somewhat more typical 57-59 percent of total recoverable costs. Tariffs recover costs only up to the allowed regulated cap on losses. Actual distribution losses, particularly among the ECs, are sometimes higher than the regulated cap, but overall, losses have come down over the last 15 years. Transmission costs as a percentage of overall tariffs are also high by international standards.
   

8. 
   The relatively high cost components at all levels of the system result in high prices. However, the Philippines is implementing a regulatory framework to collect legitimate costs from customers. The Government, for example, does not have to pay directly for operating deficits, though it is exposed to liabilities stemming from the Power Sector Asset and Liability Management (PSALM) finances. Cross subsidies have been eliminated. Many customers have become adept at managing their demand to take advantage of changes in electricity prices over the course of the day. On the supply side, the majority of distribution entities in the country, especially in the coop sector, have dramatically lowered their losses. Collectively these are important achievements which have proved sustainable and can be built upon.
   

*Luzon, Visayas and Mindanao average (June 2008); MERALCO (December 2007), CAPELCO (December 2007)

9. 
   The Government has amassed sizeable liabilities, which projected forward will run into numerous billions of dollars over the decade or so. PSALM has been able to re-finance its debt, in part by availing itself only through sovereign guarantees, but as the country approaches its foreign borrowing limit, this cannot continue indefinitely as it is likely to affect the Government’s overall credit rating. Even without considering borrowing limits, financing outcomes have not been efficient, and financing costs have been rising. The challenge for the Government will be to maintain the amount of debt at a level consistent with the projected revenue available for debt service. EPIRA limits the direct assumption of past power sector debt by the Government, so other approaches may need to be considered.
   

2. 
   Where the Philippines Could Be: Policy Options
   

10. 
    In this challenging context, the incoming Government needs to target policies that will help the power sector to expand access, meet demand, and operate efficiently. The following policy areas should be prioritized.
    

11. 
    The priority is to develop a series of options for managing PSALM’s debt overhang. The key is not necessarily to reduce these liabilities to zero in one fell swoop; but to put in place a long-term management solution that removes uncertainty from the market and is consistent with fiscal and debt management constraints of the treasury. In addition, there is a need to accelerate the privatization of remaining PSALM assets, so that the agency’s financial situation does not continue to impair the energy sector performance. Removing uncertainty should help in mobilizing investment by making borrowing requirements and tariff levels easier to project.
    

12. 
    There are serious financial problems at the operational levels of the National Power Company (NPC) and among the ECs. NPC is the generation supplier of last resort in 67 areas not connected to the transmission grid, and this activity is a serious source of losses for NPC (the operating unit is referred to as NPC-SPUG, or Small Power Utilities Group), because of the far flung nature of the operations, the dependence on expensive oil-fired generation, and the financial weakness of the ECs and their customers. At the coop level, meanwhile, the main historic financing agency, NEA (the National Electrification Administration) can only meet 13 percent of the estimated PHP 30-billion investment requirements. Currently, there are 119 ECs responsible for distributing electricity to 80 percent of the barangays in the Philippines. Based on NEA data in 2007, the financial and operational positions of the ECs vary widely. About 63 ECs had insufficient revenues to cover their operating and debt service costs, while 32 ECs were unable to cover even their operating costs.
    

13. 
    The steps to strengthen sector finances will need to be complemented by policy actions to reform the EC sector and, critically, complete some of the EPIRA-initiated reforms. The Government needs to stress the importance for ERC and technical competence, procedural efficiency, and transparency. In parallel, policy actions are needed to advance the institutional development of ECs, NPC-SPUG, the transmission concessionaire, and the market operator.
    

14. 
    The competitive market in Luzon – the Wholesale Electricity Spot Market, or WESM – has evolved more slowly than expected in EPIRA due to delays in privatization and lack of credit worthy off-takers. There is one dominant player (MERALCO, the biggest utility in the Philippines and responsible for service in Manila). After two years of operation, only eight Distribution Utilities (DUs)/ECs registered as WESM participants as others could not provide the required credit cover or had not implemented the required communication systems to comply with requirements for market participation. This underscores the challenge of distribution-level reform in the Philippines. The vision under EPIRA is to expand competition to the retail level – meaning that businesses and eventually households could choose their supplier of generation – but transition to this full, “open access” regime has been delayed. The action for Government related to WESM is to realize the vision of EPIRA of an independent market operator. Options for achieving this need to be developed.