Future Strategy & Policy Issues

REPUBLIC OF INDONESIA MINISTRY OF MINES AND ENERGY

POWER SECTOR RESTRUCTURING POLICY, JAKARTA, AUGUST 1998

PART ONE:

OVERVIEW OF THE RESTRUCTURING POLICY

1: INTRODUCTION

1. Electricity is a vital ingredient for both economic and social development. An adequate, competitively priced and reliable supply of electricity is an essential input for the production of most goods and services. Making electricity available to households at affordable prices can transform the lives of the people and improve the prospects of the nation's children.

2. Accordingly, the Government has always given the power sector the highest priority in its development plans. However, although the power sector has made great strides over the last thirty years, today it is in a state of crisis. Not only is the sector badly affected by the economic crisis assailing Indonesia, but also a number of sectoral weaknesses have emerged over the last few years.

3. To respond effectively to the current crisis and to maximize the longer-term development potential of the power sector, the Government has decided to launch a new power sector restructuring program. Around the world, technological advances coupled with the experience of successful power sector restructuring have opened up new opportunities for more efficient-sectoral development. The Government has been pursuing electricity sector restructuring since 1993. With the advent of the current crisis, it is necessary to both deepen and accelerate this restructuring.

4. The purpose of this Policy Paper is to explain the Government's new policy program for the power sector: the set of measures which will not only restore financial viability to the sector but also restructure it to put it on a new and sounder footing. Section 2 provides background in terms of both Indonesia's achievements in the power sector, and the current crisis and its causes. Section 3 summarizes the Government's restructuring objectives. Section 4 provides an overview of the restructuring program itself. Part Two of the Paper then details the restructuring program. Six sections, Sections 5-10, detail the six key areas of restructuring the Government will be active in. The final section, Section 11, outlines implementation responsibilities.

2: BACKGROUND

Indonesia's Achievements in the Power Sector

5. The Government has consistently viewed expanding access to an affordable and reliable electricity supply as a central element in its strategy for rapid economic growth and equitable social development. The Government established PLN in 1950 as the national electricity utility. Now operating under the framework of Law 15 of 1985, PLN has overall responsibility for electricity supply throughout the national territory. PLN's activities are complemented by activities of other private enterprises and cooperatives who have obtained appropriate license approval. Private parties are also able to install their own captive power generation, again subject to certain limitation.

6. PLN has established a strong reputation for technical and professional excellence. It has succeeded in increasing installed generating capacity from 800 MW in 1973/ 74 at the end of Pelita I to 18,800 MW in 1997/98 at the end of Pelita VI. Over the same period, sales of electricity have increased from 2,200 GWh to 64,200 GWh, representing annual average sales growth of about 15 % per year. From a point at which only the major urban centers enjoyed electricity supply, some 54 % of village are now electrified -- 80% of villages on Java and 20 % on the other islands of Indonesia. In 1997 alone, PLN connected 2 million new costumes to give a total customer base of over 22 million.

7. PLN's technical performance has also improved significantly over time. Its losses have fallen from 19% ten years ago to 12% today. Its production costs have also fallen in real terms: PLN went from being a loss-maker through to the late eighties to being moderately profitable company in the nineties despite tariff increases well below the rate of inflation.

8. These achievements notwithstanding, massive challenges lie ahead. Electricity consumption is still low in Indonesia. Many areas face shortages. Many households who could afford electricity do not have access. And PLN's performance requires further improvement. Most importantly of all, Indonesia's monetary crisis has introduced significant new difficulties for the power sector.

Current Conditions

9. The current time marks a critical -- indeed pivotal -- stage in the development of Indonesia's electric power sector. After three decades of sustained and rapid growth, the sector today confronts an unprecedented set of problems. These are perhaps most visible in the dramatically changed financial circumstances of PLN. From being a profitable company in 1996, PLN is now experiencing deep financial difficulties.

10. As a result of several factors the financial condition of PLN could worsen over the coming two to three years. Electricity sales are already declining as a result of the sharp economic slowdown, while the needed tariff increases will cause further reductions. Several large private power generation plants are already under construction and scheduled to come on stream shortly.

11. While the monetary crisis is responsible for the severity of PLN's immediate cash flow problems, a range of problems internal to the sector were already impeding its efficient operation and development well before the onset of the crisis.

* PLN has becomes a large power utility by any measure, including asset value, sales volume, workforce size, customer base, geographic coverage, and annual investment needs. Its continued growth and monolithic structure -- which served it well in earlier times -- have in recent years begun to hinder its ability to respond to evolving customer demands, and to implement needed efficiency improvements in the diverse regions that it serves.

* PLN's freedom to respond to evolving needs and circumstances has also been circumscribed by constraints imposed on it by the Government. The company's commercial and social roles have placed PLN under pressure both to improve profitability and to expand loss-making sales in rural areas.

* The "Independent Power Producer (IPP) model" was very successful in attracting private sector investment, but resulted in an access of capacity, as a consequence of unsolicited offers at relatively high prices, giving the private sector high returns, but leaving public sector with high risks. Even before the growth slowdown, PLN faced the prospect of massive excess capacity over the coming years.

Identification of Solutions

12. This Paper sets out the solutions which the Government will pursue to build on the strengths and overcome the weaknesses in the preceding paragraphs. To summarize, the Government will first of all restore financial viability to the power sector, thus ending the current financial crisis. Second, the Government will make the sector more efficient and more responsive to customer needs by increasing the number of companies in the sector, and by introducing competition and strengthening regulation. Third, to improve efficiency and to provide new financing sources for the sector, the Government will increase the role of the power- sector, but -- unlike with the IPPs -- under conditions of full transparency and competition. Forth and finally, the Government will also improve transparency and efficiency by streamlining its own role in the sector and by separating out the sector's social mission from its commercial basis. The Government has based its restructuring program on extensive study of international experience and of domestic conditions, and is confident that the measures outlined in the Paper will address the problems identified above, and transform the power sector into an engine of economic growth and social development for the Republic of Indonesia.

3: THE GOVERNMENT'S VISION AND RESTRUCTURING OBJECTIVES

Government's Vision

13. The Government's long-term vision for the power sector has three central elements.

* The Government seeks a power sector which is growing rapidly and so able to provide universal coverage for Indonesian households and to support industrial and commercial growth across the country.

* The Government desires a world-class power sector able to provide high-quality, reliable service with increasing levels of efficiency, thereby benefiting consumers and promoting the global competitiveness of the Indonesian economy.

* The Government expects the power sector to becomes financially independent and self-reliant.

The restructuring program outlined in this Paper is initiated to move the power sector significantly closer to realization of this vision over the next five years.

Restructuring Objectives

14. Given PLN's serious financial difficulties, restoration of the power sector's financial viability must of necessity be the Government's first priority. However, this is not the Government's only objective. Rather, the Government believes that the time has come for a fundamental restructuring so that the power sector is able to overcome its difficulties, free of the weakness which have become apparent over the last few years, and able to provide better service to customers and to sustain resumed economic growth in Indonesia.

15. Indeed, the Government has long been conscious of the need for changes in the power sector. Starting with Private Paiton One, and accelerated by the issuance of Presidential Decree 37 of 1992, the use of private sector financing through IPPs has become an integral part of meeting the sector's financing requirements. In late 1993, the Ministrer of Mines and Energy issued a broad policy framework ("Goal and Policy for the Development of the Electric Power Sub-Sector") to guide the longer-term restructuring of the sector. As the first step of its implementation, PLN was converted in 1994 from public utility (Perum) to public company (Persero) status. This was followed in 1995 by the unbundling of PLN's Java-Bali generation assets into two new portfolio generation companies, PJB1 and PJB2, which were being prepared for partial privatization. In 1997, a Directorate of Electricity Business Supervision was established within DGEED as the first step towards creating a truly independent regulatory agency.

16. The Government has learnt from its experience with these various initiatives. The Government has adopted, in addition to the goal of restoring financial viability, three restructuring objectives: competition; transparency; and more efficient private sector participation. It should be noted that these are the very objectives that the Government is adopting economy-wide to respond to the crisis and pave the way for future growth.

Financial Viability

17. The Government is facing too many demands on its own tax revenue to be able to subsidize PLN. But PLN's lack of cash is already resulting in the deterioration of the existing system due to an inability to finance and spare parts, not to mention a complete inability to finance and spare parts, not mention a complete inability to finance any required expansions. Even with the current reduction in demand, there are power shortages in 8 of the 12 regions which PLN serves outside of Java. On Java, waiting lists are starting to mount as PLN is unable to finance new connections for the hundreds of thousands of households who have requested them.

18. At an exchange rate of 10,000 Rupiah per US dollar, PLN's average revenue is about 2 US cents per kilowatt-hour, compared to 7 cents or more as a typical commercially required level. Lifting tariffs to this level of full cost-recovery will take years rather than months. The Government will strive to completely remove general electricity subsidies by the year 2000, leaving only targeted subsidies for less developed regions, for rural areas and for poor residential consumers. In the interim period, the Government will provide PLN with the financial support required for it to function.

19. To restore the financial viability of PLN, not only must tariffs be increased, but PLN's production cost reduced. Investment have already been reduced, and a cost-reduction program is underway within PLN. In addition, every measure will be taken to improve PLN efficiency, including through the program of restructuring announced herein.

Competition

20. Experience around the world, in both developed and developing countries, shows that the introduction of competition into the power sector is not only feasible but desirable. Competitions drives down costs, allows sharing of efficiency gains between producers and consumers, promotes risk-sharing, and reduces the burdens on governments to plan and regulate. Competition in some parts of the power sector is not a viable proposition. The transmission and distribution of electricity are natural monopolies requiring government regulation, but the generation of electricity and its sale are competitive provided an appropriate industry structure is in place. Dividing the electricity sector into its different components is the first step in introducing competition into the power sector. A level playing-field for all players (e.g., PLN, captive power, IPPs, cooperatives) also has to be created to provide the basis for fair competition. The cross-subsidies which have traditionally burdened commercial costumers and reduced PLN competitiveness vis-a-vis captive will be removed, and rules of competition carefully put in place.

Transparency

21. The power sector as presently constituted suffers from a lack of transparency. This leads to uncertainty and often contradictory signals, excessive bureaucracy, justifiable suspicion from the public, and, ultimately, inefficiency. This lack of transparency has various sources. One is the lack of competition, already dealt with above. Another is the various roles the Government plays in the power sector. And the Government owns PLN, and provides much of its financing through loans from international agencies. The Government also sets policies for the power sector. And the Government regulates the sector through implementation of these policies. Recently, the Government has started to seperate the ownership's role from the policy and regulatory roles to place the sector on a sounder footing. In addition, the regulatory role will be separated and strengthened to ensure fair and impartial treatment of all sectoral players, to promote competition and eliminate anti-competitive practices and to protect the rights of consumers.

22. Another sources of confusion in the power sector is the mixture of commercial and social objectives which PLN is expected to meet. On the one hand, as a Persero, PLN is expected to maximize its profits. On the other, PLN is still burden with very important social missions, including not only rural electrification but also electrification in both urban and rural areas outside of Java, nearly all of which has been unprofitable to the company, on account of the greater costs involved in supplying electricity to the less-developed systems found outside of Java. This mix makes it very difficult for the Government to measure PLN's performance, and makes it next to impossible for PLN to give either objective the attention each deserves. To promote transparency, the Government intends to restructure the sector so that electricity providers operate along purely commercial lines. Social objectives -- as well as strategic ones, such as the promotion of indigenous resources -- will be promoted by the Government via the provision of subsidies and other incentives.

Private sector Participation

23. The lesson which the Government has drawn from its experiences with the IPP model is not that introducing private power participation is harmful to the sector, but that it must be carried out as part of a deeper restructuring process. In particular, private participation must not be allowed to harm financial viability and must be accompanied by increased competition and transparency. This is crucial if the goal of not only more, but also more efficient, private sector participation is to be realized.

24. Indeed, increasing the participation of the private sector including cooperatives in the power sector is now more important than ever. Government funds are currently severity constrained, and lending from international agencies is increasingly focused on balance-of-payments support, the financial sector, and the social sectors, leaving little money for the power sector. The Government intends to rely increasingly on private sources to meet the investment requirements of the power sector, and, in so doing, to go well beyond reliance on the traditional IPP model. The Government will actively pursue the privatization of PLN, and private sector participation in transmission and distribution as well as generation. The Government will also promote domestic private participation to avoid undue reliance on foreign funding sources in the future.

4: THE GOVERNMENT'S RESTRUCTURING PROGRAM

25. The monetary crisis has dictated the end of "business as usual" in the power sector. Achieving the Government' objectives of financial viability and competition, transparency and private sector participation will require far-reaching changes. Some have already been initiated, but the pace of change will be accelerated, and the scope of change broadened.

26. The Government has identified six key areas of activity where work will be required to achieve its restructuring objectives. These related to: industry structure and the unbundling of the electricity supply industry; the development of commercial relations and the introduction of competition; new method of tariff setting and management of subsidies; the rationalization and expansion of private sector participation; the clarification of government roles and strengthening of the regulatory framework. Each of these areas is summarized below and then dealt with separately in more detail in Part Two of this Paper in consecutive sections (5-10).

Industry Structure

27. PLN has been at the cornerstone of sector success. However, its monolithic structure has outlived its usefulness, and has become a barrier to improving efficiency. Moreover, the Government's restructuring objectives of developing competition and transparency require the unbundling of PLN so as to enable multiple players to operate within the sector, each with clearly-specified objectives.

28. The electricity system on Java is well-developed and can be run along commercial lines. Operations outside Java are much less developed, require stronger governmental support, and more akin to the provision of a social service than the undertaking of a commercial activity. In recognition of this difference, PLN's "Outside Java" assets will be placed in a separate company, under direct government ownerships. Within Java, PLN's operations are big enough to be divided into several separate companies for generation, transmission and distribution/ retailing.

Introduction of Competition

29. The Government has decided to make greater use of market mechanisms in the power sector. The Government's ultimate goal is the establishment of a fully-competitive power market. However, due to a number of system and institutional constraints, a gradual transition will be required. On Java, which constitutes 80 % of the Indonesian electricity market, the initial arrangement will involve generators competing against each other to deal to the new transmission company. This company will have the responsibility to purchase electricity from all generators connected to the grid on behalf of the distribution and retailing electricity companies. Over time, the Government will move to establish a fully-competitive power market and will lift all restrictions on direct contracting between retailers and generator.

30. The transmission company on Java will be responsible for generation and transmission expansion until the establishment of the fully competitive market, envisaged for 2003. Until that time, all additional generation requirements will be met by a process of competitive bidding. Outsourcing through competitive bidding will also be encouraged for transmission expansion.

31. Outside of Java, system conditions dictate a more gradual move to competition. The Government's main objective in this regard will be to maximize the contracting out of new opportunities for generation, transmission and distribution, and to ensure that all such private sector participation is secured on the basis of fully competitive and transparent bidding procedures. There will be no further scope for unsolicited proposals in any part of the electricity sector, or in any region of Indonesia.

Tariff Setting, Cost-recovery and Subsidies

32. The Government will significantly change the way in which it sets tariffs and handles subsidies. To promote national cohesion and unity and to protect to the poor, the Government will continue with its policy of providing regional subsidies and special rates to the poor, but will make these subsidies explicit and transparent. Average tariff will be increased over time to allow for full cost-recovery, particularly on Java. During the transitional period the Government will also provide financial support to PLN. New automatic tariff adjustment mechanisms will be put in place to provide incentives for greater efficiency, to prevent future build-up of subsidies, and to support the new industry structure.

Rationalization and Expansion of Private Sector Participation

33. The Government intends to rationalize the existing IPP program and to expand opportunity for private sector participation. The current opportunities in generation will be extended to transmission on both Java and other islands of Indonesia where appropriate projects exist. Opportunity will be sought to involve the private sector in distribution network development projects outside of Java to accelerate the pace of electrification. As mentioned, all private-sector participation will be strictly on the basis of competitive bidding.

34. Project based participation will be complemented by sale of shares in the companies on Java-Bali formed to take responsibility for generation, transmission and distribution. The Government recognizes that the success of these sales will be closely attuned to the financial viability of PLN, and that sales under current conditions would generate little revenue. The Government will, therefore, take a phased approach to the privatization of PLN.

Role of Government

35. The Government plans to take a number of measures to meet its objectives of clarifying its different roles of owner, policy-maker and regulator. The Government's ownerships role is now with the State Ministry for the Empowerment of State-Owned Enterprises. Development of policy will be the responsibility of the Directorate General for Electricity and Energy Development (DGEED) within the Ministry of Mines and Energy (MME). Initially, DGEED will also be responsible for regulation. The first move to separate the policy and regulatory roles has already been made by the establishment within DGEED of a Directorate for Electricity Business Supervision. However, the Government wishes to strengthen the regulatory function. It therefore proposes to establish an autonomous Badan (Agency) reporting to the Minister of Mines and Energy but outside of DGEED with regulatory responsibilities for the entire energy sector (electricity, gas and oil). The new regulatory agency will supervise all electricity companies -- state-owned and private -- through the issuance of licenses and supervision of compliance with the licenses.

Legal Framework

36. In parallel with these institutional measures, the legal framework within which the power sector operates also requires strengthening. The Government intends to seek passage of a new Electricity Law to replace Law 15 of 1985. This will permit the creation of a competitive power market, authorize the establishment of an energy regulator, and its issuance of multiple licenses for the separate activities of generation, transmission, distribution and retailing, and establish the basic principles for tariff setting and provision of subsidies. The Government will also establish new implementing regulations, such as a new Government Regulation to replace No. 10 of 1998, and a number of important industry codes such as those for tariff setting and subsidy management, expansion via competitive bidding, and system operation.

Implementation

37. Given the complexity of the restructuring proposed, the Government intends to carefully sequence the required restructuring. A realistic timetable for implementation will be established and adhered to rigorously. Lessons from other countries engaged in sector restructuring will be closely sought after and the Government will consult closely with all interested parties. In particular, the Government will ensure that the interests of consumers and of PLN's employees are safeguarded.

38. The Government will establish a high-level Steering Committee to oversee the restructuring process. This Committee will have a fully-staffed and senior Secretariat, located within the Directorate General for Electricity and Energy Development, and will hire consultants as required to assist with implementation.

Impact on Consumers

39. The Government expects consumers to derive substantial benefits from the restructuring program, including greater efficiency and wider access to electricity. There will be no interruptions to electricity supply, or other adverse effects, as result of the restructuring. To the contrary, the restructuring is expected to result in fewer outages and better customer service. Consumer protection will be greatly strengthened as a result of the rights of consumers. The impact of the restructuring on consumers will be closely monitored, and the Government will consult with consumer group and encourage their input into electricity sector restructuring. The Government will undertake consumer education activities to ensure that customers are well-informed of the restructuring and are in a position to benefit to the maximum extent possible from the changes.

PART TWO:

DETAILS OF THE RESTRUCTURING PROGRAM

5: INDUSTRY STRUCTURE: THE UNBUNDLING OF THE ELECTRICITY SUPPLY INDUSTRY

40. The Government is very proud of the achievement of PLN, its largest state-owned enterprise. The very success of PLN in growing the electricity sector now allows the Government to move on to a new phase of sectoral development in which PLN will be "unbundled" so as to enable multiple players to operate within the sector, each with clearly specified objectives.

41. Unbundling can be of two types: geographical and functional. Geographical unbundling is recommended because of the size and diversity of the Indonesian archipelago. Functional unbundling is based on recognition that the electricity business in fact comprises a number of sub-businesses. More precisely, the electricity business can conceptually be divided into the four main sub-businesses of generation, transmission, distribution and retailing. Unbundling these activities clarifies responsibilities, increases accountability and, for some activities, provides the basis for competition. The Government plans to embark on both types of unbundling and to divide PLN along both geographical and functional lines.

42. The electricity sector on the island of Java is now relatively mature, with an integrated transmission system, modern, large generating plants and a high level of electrification. Outside Java, the electricity sector consists of a large number of smaller systems and isolated single-plant sub-systems. Costs are higher, and electrification rate are lower. Whereas the Java system can now be run along commercial lines with little need for direct government involvement, the sector outside of Java will require direct government intervention for many years to come. Unbundling PLN geographically will allow for much better focus on these two different operating environments, and the very different issues which they raise. It will allow for different speeds of restructuring -- faster on Java, slower off it -- and it will allow the Government to target its financial support to where it is most needed, outside of Java.

Outside Java Operations

43. In response to this geographical diversity, PLN's "outside-Java" assets, personnel and contracts will be transferred into a separate company, "REC" (the Regional Electricity Company) directly owned by the Government.

44. The Government may at a future time break REC into separate subsidiaries for the different regions it will service. However, the Government plans first to learn the lessons from unbundling on Java before proceeding with this task on Indonesia's other islands.

Unbundling within Java-Bali

45. The Java-Bali system is sufficiently developed for the Government to apply its goal of functional unbundling. PLN assets, contracts and personnel will be divided into separate generation, transmission and distribution/ retailing companies.

46. During the restructuring program, PLN's Java-Bali generation and distribution operations will be unbundled into several independent companies. These will initially be placed under a holding company, "JBEC" (the Java-Bali Electricity Company). JBEC will act only as a holding company, and will have no role in operations, planning or construction. JBEC will be created as a transitional vehicle not a permanent fixture: its task will be to supervise the conversion of its subsidiaries into independent companies operating without a Holding. The Government will review different options for accelerating this process.

47. Java-Bali transmission and dispatch functions will be transferred to the Java-Bali Transmission Company (JBTC). The core business of JBTC will be that currently carried out by PLN's transmission and dispatch unit, P3B. The Government's decision to separate JBTC from PLN is based on international experience which shows the importance of separating system operation from generation and distribution for enabling effective competition. The Government therefore considers preferable that there be no direct affiliation between JBTC and the JBEC generation and distribution companies. Having them in separate companies will allow JBTC to treat all generators, public and private, on the same footing.

48. After the establishment of three new companies -- the Regional Electricity Company, REC, the Java-Bali Electricity Company, JBEC, and the Java-Bali Transmission Company, JBTC -- PLN will retain the company's Power Purchase Agreements and other inherited contracts. Its job will be to transfer contracts which can be moved to the successor companies, and to manage those contracts which it retains in the best interests of the Government. PLN's specialized units, such as testing and research, training center, management development center, and engineering services, could also remain with PLN to be transferred or divested as soon as practicable.

Generation on Java-Bali

49. One of the main lessons to emerge recently from the international experience with power sector restructuring is the need to create multiple players in the generation business so as to enable competition to work. To meet the objectives both of facilitating competition and of nurturing strategic generating companies, the Government proposes to divide the two currently-existing Java generating subsidiaries, PJB1 and PJB2, into around five. This number, combined with the competition provided by independent producers and potentially by captive power, should be sufficient to establish competition in generation. A study will be undertaken to determine the exact number of generating companies, as well as optimal mix and location of plant.

Distribution and Retail on Java-Bali

50. The Government proposes to convert the four Distribution Units (Distribusi) within PLN -- for Greater Jakarta (DKI), West Java, and East Java -- to four distribution and retail subsidiaries (Discos). In addition, the Government will create a separate Bali distribution/ retail subsidiary from existing Wilayah XI. The Government will reserve the right to split the Discos into smaller companies at a later stage through their licensing conditions.

51. To pave the way for the development of retail competition the five Discos will need to manage their network and retail activities as distinct business and to provide a breakdown of the financial results for each businesses in their accounts. When competition in the retailing of electricity to larger consumers is permitted, entry by independent retail companies will be allowed, indeed encouraged. To accommodate the entry of independent retailers, the network activities of distribution companies will be compensated separately from retailing activities and a Distribution Code will be developed.

52. The Disco will be directly responsible for completing the task of electrification on Java-Bali within their respective license areas. They will be given strong incentives to accomplish this task as quickly as is reasonably possible.

Transmission and Dispatch on Java-Bali

53. PLN has recently conducted a review of the asset boundary between distribution and transmission and has now established the boundary at the incoming side of the 20 kV busbar. This leaves all 150 kV and 70 kV assets with transmission, and 20 kV and below with distribution companies. In the interests of a smooth transition, the Government accepts this boundary on an interim basis, but will review it once the first stage of unbundling is complete with a view to passing the "sub-transmission" function to the distribution companies.

54. Once JBTC is well established, the Government may consider separation of the transmission and dispatch functions, and the possibility of this at a future time will be written into the license of the new company. However, this is not considered a high priority in the early stages of restructuring. The Government views it as important at this stage to have a single organization responsible for dispatch, transmission planning, construction and operations. Division of these between different organizational units within PLN is, at the current time, a major source of inefficiency.

Implication for PLN Employees

55. The Government recognizes that the changes in this Paper, but especially in this section, will have a major impact on PLN's 50,000 staff. The Government assures PLN employees that they will be kept fully informed of the plans as they are developed and their views will be taken into account, and their rights protected in the process of restructuring and privatization. The Government's proposals will provide wider career prospects and new opportunities for training and skills development. Employees will have rights to acquire shares in business being privatized on attractive terms. There will be no change in the benefits payable under pension schemes and the new successor companies will continue to have an obligation to meet pension liabilities.

Transitional Arrangements for Industry Structure

56. Considering the complexity of the proposed unbundling, and the need to properly sequence legal, regulatory and structural change, the Government plans to take a phased and reasonably-paced approach to the unbundling of PLN.

57. The Government's industry restructuring program will have two phases. In the first phase, implemented during 1999, JBEC will be separated from PLN, and PLN will itself be restructured along functional lines. Two new Directorates will be created: (i) for Java-Bali Transmission (which will have the dispatch and Single Buyer Functions) and (ii) for Regional Operations (covering areas outside Java). These two Directorates will be set up in such away that they will be ready to be established as independent companies as soon as the law is changed. Therefore, they will have full responsibility for planning, construction and operations for their respective regions within agreed budgets. Accounts of the two new directorates will be separately maintained and audited. In the second phase implemented during 2000, the Government will separate REC and JBTC from PLN. In the remainder of this paper, it is assumed that both JBTC and REC are in existence. For the transitional period in which they are not, any reference to either company should be replaced by reference to the appropriate Directorate within PLN.

6:COMERCIAL RELATIONS AND THE INTRODUCTION OF MARKE MECHANISMS

58. The Government believes that competition is the best means to secure efficiency and the lowest possible cost for electricity. Consistent with its general goal of deregulation, the Government plans to progressively increase the degree of competition to which the electricity sector is subject. Progress will faster on Java where the system is larger and more mature. Outside of Java, most transactions will remain within the corporate structure of the new Regional Electricity Company. Accordingly, most of this section deals with arrangement for Java. However, as outlined at the end of this section, the Government believes that there are even now certain opportunities for competition outside of Java, and that more will become available as lessons are learnt from restructuring on Java.

A Fully Competitive Market for Java-Bali: Objective and Constraints

59. The Government's ultimate restructuring objective for the Java-Bali system is the development of a fully-competitive market. Sometimes revere to as the "Multiple Buyer/ Multiple Seller" system, this market would be fully competitive for both generation and retailing, the two segments of the electricity industry which have the potential to be competitive. The power market would be revolving around a "power purchase pool" into which generators would bid and from which retailers and large end-users could purchase. Generation planning would become indicative only; generation and retailing charges would be progressively unregulated; and there would be free entry into both generation and retailing segments. Only transmission and distribution, as natural monopolies, would continue to be regulated.

60. An increasing number of power systems around the world are now run along these lines. The model has shown itself to be not only workable but efficiency-enhancing in both developed and developing countries. At the same time, the Indonesian Government recognizes that there are various constraints which would make the immediate adoption of a competitive market model into the Java-Bali system impractical and risky, and which would limit its likely benefits.

61. On the generation side, fuel markets have not yet been liberalized. There are contractual limits on dispatch flexibility from take-or-pay gas contracts and geothermal contracts, and there are an increasing number of IPPs whose contracts do not fit easily into a competitive market. It must also be recognized that the Java-Bali market is relatively small, with one plant, Suralaya, able to meet over one-third of maximum system demand.

62. East-West transfer of power is constraints in Java, and will continue to be constrained until the completion of the 500kV Southern Loop in around 2003. There are also many local constraints. The presence of these multiple transmission constraints reduces the potential for competition by limiting flexibility in dispatch and thereby increasing market power.

63. On the distribution side, PLN's distribution units have no experience in acting as separate companies, let alone in purchasing power from a pool. They have no track-record and their creditworthiness will be weak.

64. Finally, on the legal and regulatory side, management of the power sector through a fully competitive market is inconsistent with Law 15 of 1985. More importantly, Indonesia's regulatory capability is still developing. Designing, implementing and regulating the arrangement for bidding, dispatch and settlement under a fully competitive power pool, relating not only to energy, but to capacity and ancillary services, is a complex task which may be more successfully accomplished through an evolutionary and learning process.

65. None of these constraints is insurmountable, and each will be addressed over time. Transmission constraints are being addressed by new investment. The distribution companies will gain experience once established. And, as this Paper sets out, the Government intends to strengthen the regulatory function, to privatize PLN's successor companies, and to embark on a process of legal restructuring for the sector. However, all of this will take time.

66. A gradual transition to full competition is therefore required. The Government's intention therefore is to introduce the fully-competitive market in about five years' time. This is a realistic time-frame fully consistent with the approaches taken in many other countries.

Transitional Commercial Arrangements for Java-Bali: the Single Buyer Market

67. To pave the way to full competition, the Government plans to establish in 1999 a "Single Buyer" market. The new grid company, JBTC, will purchase power and sell it to the distributors and other large buyers directly connected to the transmission network at high voltage.

68. The five distribution/ retail companies on Java-Bali as well as all industrial consumers connected at high voltages would purchase energy from JBTC under a Bulk Generation Tariff which will allow JBTC to recover the cost of its generation purchases. Separate charges will be made to recover JBTC's transmission and operation costs.

69. On the generation side of the market, the Government proposes to establish a simplified power pool. Plants will bid in a variable charge, with price caps established by the regulator on a plant-specific basis. JBTC will dispatch on the basis of their bid-in variable charge, subject to system constraints. The arrangements for the price caps and for payments will be reflected in plant-specific Power Purchase Agreements (PPAs).

70. The contracts developed between JBTC and PLN plants will provide flexibility, incentives and risk-sharing wherever possible. They will be designed to facilitate the transition to the fully-competitive market: for example, contract duration will be strictly restricted. Subject to contractual obligations, IPPs will be required to compete against PLN plants.

71. A Grid Code will be required to govern the manner in which the system is operated with rules for dispatch, metering and connections among others. A Code for Java-Bali is already under preparation and will be finalized shortly and then authorized by the Minister of Mines and Energy.

72. JBTC will also have responsibility for planning and conducting tenders for new generation and transmission assets. Whichever market system is adopted it will take some time before developers are willing to construct new plant without a long-term contract. The Government will encourage moves toward the "merchant power plant" model especially once the fully-competitive market has been established. However, in the interim what is important is that excessive contracting be avoided, and that the prices of new plant be driven down by competitive bidding.

73. To avoid excessive contracting, a rigorous planning procedure will be adhered to. JBTC will be required to develop annually rolling 5-year plans, based on loss of load probability, reserve margin, and load forecast targets agreed to with the regulator, justified in writing, and open to the public.

74. To drive down prices, competitive tendering will apply to all major new generation projects. The bidding process will be public and a two-stage bidding process will be used so that the final stage will be solely on the basisof price. Tendering for small-scale generators will be done under the PSKSK regulations. This competitive tendering also will be applied for new transmission and distribution network project. Appropriate projects, chosen for their size, their physical and electrical characteristics and potential for clear demarcation of responsibilities, will be identified by the Single Buyer.

75. The above procedures for planning and tendering will embodied in a Planning and Competitive Tendering Code which will: govern the provision of data from all licensees for planning purposes; set out the procedures for preparation, approval and publication of a least cost development plan for the generation and transmission systems using agreed security criteria; and lay down procedures for issue of Request for Proposals from short-listed bidders and for the evaluation and award of contracts.

76. Given the current excess capacity in generation, the Government does not intend to develop new generation. Therefore, new generation tendering will not be needed for the time being.

Managing the Transition to Full Competition

77. The Government's target for the introduction of the multiple-buyer multiple-seller system is 2003. The Government will review whether to introduce the fully-competitive market in one move, or to move to that system gradually by, for example, the introduction of a competitive market parallel to the Single Buyer market. JBTC will understand at the outset that its role as the Single Buyer is only a transitional one, and will therefore be required to work towards the introduction of the fully-competitive market. Upon establishment of the competitive market, JBTC will continue to provide transmission services and system operation, but will cease buying and selling power. All PTJB customers will have a choice of suppliers: individual generators, or the pool, or any one of the distribution/ retail companies.

78. The transitional stage will be carefully designed to facilitate the move towards the fully-competitive market. The PPAs signed with PLN's generators would be of strictly limited duration, and could also allow for termination and reassignment by the regulator upon establishment of the fully-competitive market to the distribution/ retail companies.

Introducing Competition outside Java

79. Competition outside of Java will come mainly through the use of competitive bidding for new investments. The new company for outside Java, the Regional Electricity Company, will be required to contract out a substantial portion of new generation capacity requirements based on competitive tendering, and will be encouraged to bid out appropriate transmission projects to the private sector. REC will also be encouraged to define new distribution projects on the Outer Islands suitable for private sector participation. The projects will involve major extensions to existing networks and will offer the opportunity to accelerate the rural electrification program. The networks will be financed, built, owned and operated by the private sector. REC will then purchase rights to use the assets under a long term contract and have direct responsibility for retailing for consumers. (Such an approach will not be pursued on Java where electrification is at a more advanced stage and can more readily be achieved through investment by the four distribution companies.) All bidding will be on a competitive basis, and governed by the procedures of the Planning and Competitive Tendering Code.

80. The further development of competition outside of Java will deepen on unbundling of REC. While this would be premature at this stage, the Government does not intend to apply the Java-Bali model to the rest of Indonesia once it proves itself and the other systems are large enough for it. The first candidate for functional unbundling outside of Java-Bali would be Sumatra.

7: TARIFF SETTING, COST-RECOVERY AND SUBSIDIES

Tariff Objectives and Restructuring

81. Tariff setting is a very important and sensitive part of sectoral policy. The Government has a number of objectives with regards to its tariff policies:

* cost-recovery

* transparent subsidies where cost-recovery is not possible

* regional subsidies to promote national unity and development outside of Java

* protection for the poor

* consistency of tariff structure with the new competitive sector structure

* provision of incentives for ongoing efficiency improvements

82. To achieve these objectives, the Government will adopt a comprehensive program of tariff restructuring. Tariffs will be gradually increased over time to enable full cost-recovery, except in the case of targeted subsidies. To implement the Government's policy of providing regional subsidies, and to protect the poor, a new fund will be established to make the required subsidies explicit, namely the Social Electricity Development Fund. On Java-Bali, the tariff will be "unbundled" to provide separate charges for generation, transmission, distribution and retailing, and designed with incentives for efficiency. The details of this tariff restructuring program are described in the sub-sections below. A new Presidential-level Tariff Code will be developed to implement the above restructuring programs.

Cost-recovery

83. An on-going imperative for the power sector is the need to regain cost recovery. For most of the nineties, PLN was in a reasonably healthy financial position, but, with the shock of the economic crisis, it is now unable to meet its operating expenses. The Government has already taken important steps in this direction by increasing tariffs by 20% effective May 1998. PLN has slashed its investment program and acted to control its operating expenses. However, even with these measures, PLN is still defaulting on its debt-service to the Government, and the Government is now providing very large subsidies to PLN.

84. The Government's short-term objective is to allow PLN to meet all its outstanding obligations, Which requires a debt-service coverage of one. Beyond this, however, tariffs will need to be further increased over time to re-establish PLN's profits at commercial levels and to bring tariffs close to long-run marginal cost. Tariff increases, though necessary, will have to be phased over several years. In the interim period, the Government will continue to support PLN financially.

85. The Government recognizes that the power sector's shortage of cash must be taken into account when designing its restructuring. To prevent this from delaying or even derailing the restructuring program, there may be a temporary need for centralized cash-flow control mechanisms as the sector is being unbundled.

Regional Subsidies and Subsidies for the Poor

86. To date, identical consumers in different parts of Indonesia have paid the same charge for electricity. This policy is being reviewed in order to determined its affordability given the current circumstances and may not be and obligation in the future. The Government will ensure that regional subsidies are in place to assist less developed and rural regions and to help maintain national unity. The Government also intends to continue to subsidize poor consumers of electricity. However, these subsidies will be made explicit and transparent.

87. To finance the subsidies, the Government will create a "Social Electricity Development Fund". This fund will compensate the five Distribution/ Retail companies for Java-Bali, and REC for outside Java for the difference between their allowable costs and their revenue receipts. The establishment of the Fund and collections associated with it will be undertaken in accordance with existing law.

88. The government wishes to reiterate that allowed cost calculations -- on the basis of which tariffs and subsidies will be set -- will be made not on the basis of actual cost, but on the basis of allowed costs, which assume efficient operations. The Government will ensure a reduction in allowed costs over time to promote efficiency in the sector.

89. To minimize the tax impact of the proposed unbundling, payments to and from the Social Electricity Development Fund will be made on a pre-tax basis.

Unbundling the Tariff

90. Unbundling the sector also requires unbundling the electricity tariff. The Government will no longer set final retail tariffs on Java-Bali, except for particular subsidized customer classes, but rather the rules by which final tariffs are to be calculated. These rules will be given in the new Tariff Code which will authorize and define separate generation, transmission, distribution and retailing tariffs or charges on Java-Bali.

91. The generation charges will be embedded in plant-specific PPAs (as described in Section 6) up to the introduction of full competition. The transmission charges will be enable JBTC to recover its transmission costs by imposing charges for the use of transmission network and for customer connection. Since these charges cannot be imposed on IPPs, they will not be imposed on PLN's generators either, but rather will be paid solely by the distribution/ retail companies and by high voltage customers connected directly to the transmission network. This decision will be reviewed during the transition to the fully-competitive market as locational charges will need to be in place once free entry into generation is allowed. The distribution charges will likewise enable the distribution companies to recover network costs from their users -- final customers and, eventually, independent retailers. Finally, there will be separate retailing charges to cover the costs of marketing, billing and revenue collection. Price cap regulation, with strong incentives for efficiency, will be used for the transmission, distribution and retailing charges, though retailing charges will be progressively deregulated once full competition is introduced.

92. Given the current economic crisis, it will not initially be possible to allow full-cost recovery for all four segments of generation, transmission, distribution and retailing. Since no new expansion is required in generation, generation charges will initially be set low, for example only to cover variable costs and debt-service. In addition to having automatic pass-through mechanism for such factors as inflation and exchange rate fluctuations, the unbundled charges will also have a special "cost-recovery" adjustment mechanism, through which the Government will increase them over time to approach full cost-recovery.

8: PRIVATE PARTICIPATION

93. Increased private participation will be sought both for new investments on a project basis and through sale of shares in the companies created through the restructuring.

Project-based Investments

94. As described earlier, the Planning and Competitive Tendering Code will open up new opportunities for private sector participation in the industry but on a strictly competitive basis. On Java-Bali, all new thermal generation requirements will be contracted out through competitive tendering. Hydro is more complex and will be handled on a case-by-case basis,but, if contracted out, will be done so competitively. JBTC will also be encouraged to bid out transmission through competitive tendering. REC will be required to contract out a substantial portion of new generation capacity requirements, on a competitive and transparent basis, and will be encouraged to bid out appropriate transmission and distribution projects to the private sector.

95. The Government wishes to encourage greater domestic private sector participation in power projects, especially in their financing. This will reduce the exposure of the sector to exchange rate fluctuations, which is currently one of the sector's biggest weaknesses. To this end, the Government will explore establishment of a domestic infrastructure fund to encourage the flow of Indonesia's abundant domestic savings into power and other infrastructural sectors.

96. Before the Government is able to expand its private power program, and to ensure a successful restructuring it will be necessary to rationalize the existing IPP program and integrate it into the new structure. The Government is currently formulating a strategy for this.

Privatization

97. The sale of shares in the successor companies to PLN is a crucial element of the restructuring program. Sales of shares will raise money and bring new management expertise to the industry. In addition, divestiture will reduce the degree of vertical integration due to common (government) ownership of the different companies and thus increase the potential for competition. Privatization of the industry will be done on a gradual basis. The new company to be responsible for outside-Java operations, the Regional Electricity Company, will remain completely in government hands for the time being. Focus for privatization will therefore be on Java-Bali.

98. Various methods and mechanisms for privatization will be considered such as Direct Placements and Initial Public Offerings (IPþs). The choices will be influenced by the condition of the economy, the condition of domestic capital markets and the condition of the companies being privatized. The privatization program will be in accordance with a blueprint for the privatization of state-owned enterprises, currently under development by the State Ministry for the Empowerment of State-Owned Enterprises, and implemented consistently with this Policy.

9: REDEFINITION OF GOVERNMENT ROLES AND STRENGTHENING OF THE REGULATORY FUNCTION

The Government's Ownership Role

99. Until recently, the Ministry of Mines and Energy has combined the Government roles of owner, policy-maker and regulator. There is now a need to separate out these roles to promote clarity and transparency. Progress has already been made in this regard with the recent transfer of supervision of PLN from MME to the State Ministry for Empowerment of State-Owned Enterprises. This change allows MME to focus on its responsibilities for policy development and regulation of the power sector. The State Ministry for the Empowerment of State-Owned Enterprises, as the owner of PLN, will have responsibility for the corporate restructuring and privatization of PLN in accordance with this policy.

100. The Government will also continue to have a role in the financing of the electricity sector. To date, official financing has been the most important source of external funds to the sector. On-lending arrangements will be amended to reflect the unbundling of PLN, and loans will be made to PLN's successor companies in respect of existing and new loans.

Separating and Strengthening the Regulatory Function

101. There is also a need to separate out policy and regulatory roles of Government. As policy-maker, the Government develops sectoral policy through laws and regulations; as regulator, the Government applies those laws and regulations faithfully, consistently and impartially, and resolves any disputes which arise in relation to them. Again progress has already been made in this direction with the creation in 1977 within MME's Directorate General of Electricity and Energy Development (DGEED) of a Directorate of Electricity Business Supervision (DEBS) which will carry out regulatory function.

102. This is an important first step, but the Government intends to go considerably further. A major lesson from international restructuring experience concerns the need to establish a high-level, autonomous and well-staffed regulatory agency, not only to regulate and supervise but also to advise on the restructuring process. The Government therefore proposes to establish at the earliest possible stage an autonomous Badan (Agency) reporting to the Minister of Mines and Energy but outside of DGEED with regulatory responsibilities for the entire energy sector (electricity, gas and oil). The new regulatory agency will supervise all electricity companies -- state-owned and private -- through the issuance of licenses and supervision of compliance with the licenses. In relation to the issuance of licenses, the Badan will charge licenses fees. The use of these fees will in accordance with the legal framework for non-tax revenue.

103. As detailed in the next section, the independent regulatory Badan will be establish through the envisaged new Electricity Law.

10: LEGAL CHANGES

104. The changes described in this Paper amount to nothing less than a complete overhaul of Indonesia's power sector. It is not surprising therefore that the basic laws and regulations governing the sector will also require major change.

New Law

105. The legal framework for the industry at present is defined principally by Law 15/ 85 and Government Regulation 10/ 89. Law 15/85 is recent, forward-looking and flexible. It is able to accommodate many of the changes being proposed in this Paper, but is not consistent with the move to the fully competitive market because this would inconsistent with the requirement of central planning for electricity set out in the Law.

106. Given the importance of legal reform to the restructuring program, the Government proposes, as a matter of high priority, to seek passage of a new basic law for the sector. A draft new law is currently under review. Following the widest possible consultation, the Government will launch the necessary legislative processes with the intention of having the new law in place as soon as possible and no later than the end of 1999.

107. The New Law will, among other things:

* provide for the establishment of the position of Energy Regulator asdistinct from the Minister for Mines and Energy;

* remove the requirement of mandatory central planning for all regionsof Indonesia, thus enabling the establishment of a fully-competitivepool for Java-Bali, while leaving the timing for its establishment atthe discreation of the Minister after consultation with theRegulator;

* establish licenses as the key instruments of regulation: differentversions of these will govern the activities of all electricitycompanies;

* establish the basic principles for tariff setting and provision ofsubsidies.

New Government Regulation and Industry Codes

108. The new law will be flexible enough to accommodate both the partially-competitive transitional market and the fully-competitive market which is the Government's ultimate goal. There will also be a need for more detailed, subordinate regulation. This will be embodied through a new Government Regulation, and through a number of Industry Codes. The Government Regulation will be promulgated after passage of the new Electricity Law, for which it will provide implementing guidelines, such as setting out in more detail the role and functioning of the regulator and the licensing regime. The Industry Codes have already been discussed at various points in this Paper. To summarize, the ones required to launch the transitional Single Buyer market are:

* Tariff Code to establish tariff levels, tariff structures and themechanism needed to allow subsidies to continue on a transparentbasis;

* Planning and Competitive Tendering Code to define arrangements forprovision and use of planning data, publication of the least costdevelopment plan and the procedures for competitive tendering forgeneration and transmission Projects;

* Grid Code to govern the operation of the interconnected transmissiongrid on Java-Bali and scheduling and dispatch of generation.

The Tariff Code will have the status of a Presidential Decree, while the two other codes will be Ministerial Decrees. To meet the goal of establishing the Single Buyer market by mid-1999, these decrees will need to be introduced by this time as well. Drafts of these decrees have already been prepared, and are currently under review.

11: IMPLEMENTATION

109. The restructuring program outlined in this Paper is multi-dimensional and contains many inter-related steps. The Government's restructuring objectives cannot be fully achieved in a very short period for a variety of legal, institutional and technical reasons. Therefore, the Paper has also presented a transitional strategy up to the introduction of a fully-competitive power market in 2003.

110. The first key step in this strategy is targeted for around in the middle of 1999 with the creation of Java-Bali generation and distribution subsidiaries, and reorganization of PLN with new Java-Bali Transmission and Outside-Java Directorates. At the same time, the Government will launch the Single Buyer market on Java-Bali via promulgation of the required industry codes -- the Tariff Code, Planning and Competitive Tendering Code, and Grid Code -- and establishment of the simplified competitive power pool.

111. The Government will propose to Parliament a new electricity law with the aim of changing the law during the year 1999. The Government will, in early 2000, separate REC and JBTC from PLN, and also establish the envisaged regulatory Badan.

112. The Government will work towards the privatization of the new Java-Bali electricity entities with the privatization program extending over several years.

113. The various transitional measures proposed, covering the diverse areas of industry structure, commercial relations and private sector participation, are mutually reinforcing and combine to deliver the Government's goal of a sector consisting of many, independent and largely private companies operating under competitive conditions wherever possible.

114. Upon adoption of this policy, a realistic timetable for implementation, covering all intermediate steps, will be established. Lessons from other countries engaged in sector restructuring will be sought after and the Government will consult closely with all interested parties. In particular, the Government will ensure that the interests of consumers and of PLN's employees are safeguarded.

115. The Government will establish a high-level Steering Committee to oversee the restructuring process. This Committee will have a fully-staffed and senior Secretariat, located within the Directorate General for Electricity and Energy Development and will hire consultants as required to assist with implementation.

[Retyped by CHP Cooperative]