Document of

The World Bank

FOR OFFICIAL USE ONLY

Report No. 56689-TO

INTERNATIONAL DEVELOPMENT ASSOCIATION

PROGRAM DOCUMENT

FOR A PROPOSED GRANT

IN THE AMOUNT OF SDR 3.4 MILLION

(US$5 MILLION EQUIVALENT)

TO THE

KINGDOM OF TONGA

FOR AN

ENERGY SECTOR DEVELOPMENT POLICY OPERATION

September 15, 2010

Timor-Leste, Papua New Guinea and the Pacific Island

Sustainable Development Department

East Asia and Pacific Region

This document has a restricted distribution and may be used by recipients only in the performance of their

official duties. Its contents may not otherwise be disclosed without World Bank authorization.

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TONGA - GOVERNMENT FISCAL YEAR

July, 1 – June, 30

CURRENCY EQUIVALENTS

(Exchange Rate Effective as of March 2010)

Currency Unit TOP

US$1.00 1.93

Weights and Measures

Metric System

ABBREVIATION AND ACRONYMS

AC alternating current

ADB Asian Development Bank

ADO Automotive diesel oil

ASTAE Asia Alternative Energy Program (Trust Fund managed by WB)

AusAID Australian Agency for International Development

BAU Business as Usual

BOO Build Own Operate

BOT Build-Operate-Transfer

CA Concession Agreement

CDM Clean Development Mechanism

CFL Compact Fluorescent Light

CNO Coconut Oil

CPI Consumer Price Index

CSCRE Cabinet Sub-committee on Renewable Energy

DC direct current

DSA Debt Sustainability Assessment

DSM demand-side management

EC European Commission

EC Tonga Electricity Commission

EIA Environmental Impact Assessment

EIB European Investment Bank

EPU Energy Planning Unit, Ministry of Lands, Survey and Natural Resources

ERC Expenditure Review Committee

EU European Union

FOB Freight On Board

GDP Gross Domestic Product

GEC Global Economic Crisis

IC Internal Combustion (engine)

IRENA International Renewable Energy Agency

IPCC Intergovernmental Panel on Climate Change

IPP Independent Power Producer

IUCN International Union for Conservation of Nature

GHG Green House Gas

GIS Geographical Information Systems

GoT Government of the Kingdom of Tonga

kV Kilo Volts (thousands of volts)

kW Kilowatt

kW-h Kilowatt Hour

kWp Kilowatt Hour peak for PV panels under standard conditions

LCT local coastal tankers

LED Light emitting diode (energy efficient light)

LPG liquid petroleum gas

MoF Ministry of Finance

MLA Multilateral Lending Agency

MR medium range (tanker)

MWh Megawatt hour (1000 kW-h)

MAFFF Ministry of Agriculture and Food, Forests and Fisheries

Nm3 Normal Cubic metre

NRBT National Reserve Bank of Tonga

NZAID New Zealand Agency for International Development

OI Outer Islands in Tonga

O&M Operation and maintenance

OPR Operational Procurement Review

PEFA Public Expenditure and Financial Accountability Assessment

PEMM Pacific Energy Ministers Meeting

PER Public Expenditure Review

PFM Public Financial Management

PEFM Public Expenditure and Financial Management

PIC Pacific Island Country

PoC Proof of Concept

PPA Power Purchase Agreement

PRIF Pacific Region Infrastructure Facility

PV Photovoltaic‘s

RAV Regulated Asset Value

RE renewable energy

REEEP Renewable Energy and Energy Efficiency Partnership

REF Regional Engagement Framework

RPM Road Map Project Manager

SCADA System Control and Data Acquisition

SME Small and Medium Scale Enterprise

TERM Tonga Energy Road Map (or ―the Road Map‖)

TEPB Tonga Electric Power Board

TGIF Tonga Green Incentive Fund

TPL Tonga Power Limited

TOP Tonga Pa‘anga

ToR Terms of Reference

TOISEP Tonga Outer Islands Solar Electrification Program

UNDP United Nations Development Program

US$ United States Dollar

VCNO Virgin Coconut Oil

WB World Bank

Vice President:

Country Director:

Sector Director:

Task Team Leader:

James W. Adams

Ferid Belhaj

John Roome

Wendy Hughes

TONGA

TN- ENERGY SECTOR DEVELOPMENT POLICY OPERATION

TABLE OF CONTENTS

Page

GRANT AND PROGRAM SUMMARY…………………..……………...……………………….…….............i

I. INTRODUCTION……………………………………………………………………….…………........4

II. COUNTRY CONTEXT…………………………………………………………………..……………..7

III. THE TONGA ENERGY ROAD MAP…………………………………….……….………………...21

IV. BANK SUPPORT TO THE GOVERNMENT’S PROGRAM……………………..……….………40

V. THE PROPOSED PROGRAM…………………………………………………………..……….......48

VI. PROGRAM IMPLEMENTATION……………………………………………………………..........55

ANNEXES

Annex 1. Operation Policy Matrix……………………………………………………………………………….65

Annex 2. Letter of Development Policy…………………………………………………………………….…...68

Annex 3. IMF Assessment Letter……...…………………………………………………..………………….....72

Annex 4. Country at a Glance…………………………………………………………………………………...75

Annex 5. Timetable Of Key Processing Steps…………………………………………………………………..77

Annex 6. Structure of Tonga Energy Road Map Implementation Unit…………………………………............78

Annex 7. Map of Tonga…………………………………………………………………………………………79

TABLES IN TEXT

Table 1: Selected Economic Indicators, 2005/06–2010/11………………………………………………………10

Table 2: Trends in Key Sources of Tax Revenue FY2005/06 – FY2009/10……………………………………..11

Table 3: Tonga Financing Gap FY2010/11………………………………………………………………………14

Table 4: Medium Term Macroeconomic Outlook FY2009/10 – FY2013/14……………………………………15

Table 5: Tonga External Debt Indicators………………………………………………………………………...16

Table 6: Characteristics of the Four Island Electricity Grids, 2009………………………………………………25

Table 7: Recent Fuel Use and Cost for Electricity Generation…………………………………………………...27

Table 8: Medium Term Demand Forecast on Tongatapu………………………………………………………..29

Table 9: Indicative Costs, Sources of Funding, Key Indicators…………………………………………………..38

Table 10: Summary of Prior Actions and Status.....................................................................................................50

FIGURES IN TEXT

Figure 1: A Sample Load Shape on Tongatapu…………………………………………………………………..27

Figure 2: Electricity Rates History in Tonga…………………………………………………………………….28

Figure 3: Energy Forecast, Sum of All Grids……………………………………………………………………29

The Tonga Energy Sector Development Policy Operation was prepared by an IDA team consisting of:

Core: Wendy Hughes, Senior Energy Specialist, EASNS; Vivek Suri, Lead Economist, EASPR; Virginia

Horscroft, Economist, EASPR; Lucy Pan, ET Consultant, EASPR; ‗Ana Tu‘ionuku, ET Consultant, EASNS;

Kylie Coulson, Senior Financial Management Specialist, EAPFM;

Contributors: Robert Jauncey, Senior Country Officer, EACNF; Tendai Gregan, Energy Specialist, EASNS;

Cristiano Nunes, Procurement Specialist, EAPPR; Saia Faletau, ET Consultant.

Peer Reviewers: Fanny Missfeldt-Ringius, Senior Energy Economist, AFTEG ; Franz Gerner, Senior Energy

Economist, ECSS2 ; Douglas Addison, Senior Economist, EASPR.

Task Assistants: Nicole Forrester, Team Assistant, EACNF.

i

GRANT AND PROGRAM SUMMARY

TONGA

TN- ENERGY SECTOR DEVELOPMENT POLICY OPERATION

Recipient The Kingdom of TONGA

Implementing Agency Ministry for Finance and Planning

Financing Data

IDA Grant

Terms:

Amount: SDR 3.4 million (US$5 million equivalent)

Operation Type The proposed operation is a Development Policy Grant, which consists

of a single tranche SDR 3.4 million (US$5 million equivalent) to be

disbursed upon effectiveness date.

Main Policy Areas

Policy areas the proposed operation will support include: (i) Energy

Sector reform to reduce Tonga‘s vulnerability to oil price rise and

shocks; and (ii) Public financial management reform.

Key Outcome Indicators The key outcome indicators over the medium term (5 years) to which the

proposed operation will contribute are; (i) Petroleum imports for

electricity generation relative to a "business as usual" scenario are

reduced by 15% in a cost-effective manner; (ii) Diversification of

sources of electricity generation to improve energy security and reduce

impact of oil price on the price of electricity supply; (iii) Petroleum

price risk management in place; (iv) Fiscal consolidation achieved

including reduction in risk of debt distress.

Program Development

Objectives and

Contribution to CPS

Tonga faces a fiscal deficit resulting in large part from the knock-on

effects of the global economic slow-down. The development objectives

of the proposed operation are to contribute to reducing Tonga‘s fiscal

deficit and to support the Government‘s efforts in implementing reforms

in the energy sector which will contribute to achieving steady and stable

growth in the medium term.

The proposed operation directly supports two of the three themes of the

Tonga Country Assistance Strategy which will be presented to the Board

with this operation: (i) Supporting policy reform to strengthen growth

prospects and improve service delivery, and (ii) Building resilience

against shocks.

Implementation of the energy sector reforms set out in the Tonga Energy

Road Map will reduce Tonga‘s vulnerability to oil price shocks and

achieve an increase in quality access to modern energy services – both

necessary conditions to strengthen prospects for equitable growth and

improve service delivery. By highlighting the Tonga Energy Road Map,

this operation reinforces the importance of addressing energy sector

ii

weaknesses as a necessary condition for economic growth and stability.

The proposed operation would provide fast-disbursing budget support

aimed at shorter-term economic recovery. The operation is an integral

part of the Bank‘s overall engagement in the energy sector. Following

the year-long dialog in preparing the TERM, this proposed operation

reinforces the importance of adhering to the objectives, principles and

strategy set out in the TERM. Progress on TERM implementation will

be further supported by the ―Tonga Energy Road Map Project‖ currently

under preparation, an investment project which will strengthen the focus

and provide support to achieve the medium term energy sector

outcomes.

Any subsequent budget support operations would include a focus on

continued implementation of the energy sector reforms discussed in this

Program Document. The operation has also served as a vehicle to

strengthen the Bank‘s dialog with the GoT in areas of public expenditure

and financial management. This DPO sets the stage for a more robust

engagement in PEFM going forward, particularly in the area of joint

public expenditure analysis which will be especially important as the

new Government works to rationalize expenditures while maintaining

and improving core service delivery functions in the medium term.

Risks and Risk

Mitigation

The main risks and their associated risk mitigations measures are the

following:

The need to address immediate budget shortfalls could distract the new administration from focusing on the implementation of critical

energy sector reforms, as per the TERM, needed to support medium

term economic stability and growth. Budget pressures could also

result in insufficient resources being available for the GoT‘s role in

implementation of the TERM. The mitigation measure is to

contribute, along with other development partners, to reducing the

budget gap through this proposed budget support operation.

A new, possibly inexperienced administration may take some time to appreciate the importance of focusing on energy sector reforms.

This could result in a loss of momentum, or actions at odds with the

TERM, which could undermine the progress and credibility to date.

The risk will be mitigated to some extent by clear signaling, in this

document and as part of the preparation of the energy sector SIL

which will be appraised after the new administration takes office,

that progress on energy sector reform will be an important

component of the overall country dialog going forward, as well as a

pre-requisite for further support in the energy sector. A further

mitigation measure is the strong development partner coordination

around the development of the TERM and the commitment provide

support in line with implementation of the TERM. The benefits and

importance of maintain the focus on energy sector reforms and on

adhering to the principles set out in the TERM will be emphasized

not only by the Bank, but by a wide range of other development

partners.

iii

Natural Disasters and Climate Change negatively impact the expected benefits associated with implementation of the planned

energy sector reforms. Two approaches to mitigating this risk are

built into the TERM. First, design of new investments will routinely

take into account Tonga‘s vulnerability to natural disasters and

specify equipment and designs accordingly. Second, one of the

Phase 0 activities of the TERM is ―Analysis of environmental

change impact on Tonga to identify any risks to long term safety and

security of energy infrastructure‖. The findings and

recommendations of this study will inform subsequent

implementation of the TERM.

Progress on Public Financial Management reforms could stall if the new administration focuses on other priorities. The primary

mitigation measure is the planned joint development partner efforts

to support the GoT in implementing improvements in the areas of

public expenditure and financial management. The Bank intends to

work closely with other development partners to provide the support

and emphasis necessary to maintain the GOT‘s focus and capacity to

take action on PEFM reforms.

Operation ID P121877

4

I. INTRODUCTION

1. The proposed Tonga Energy Development Policy Program will provide budget support to

reduce the near-term fiscal deficit. It will also reinforce the importance of implementation of

energy sector reforms necessary to reduce Tonga‘s vulnerability to oil price rise and shocks,

which otherwise would pose a significant risk to achieving stable growth in the medium term.

2. Like other Pacific Island nations, Tonga is highly vulnerable to natural disasters and to

external economic shocks because of its small size combined with a large distance from the

nearest large market. The knock-on effects of the global economic crisis, in particular in

remittances and tourism revenues, contributed to GDP contractions of 0.4 percent in FY2008/09

and an estimated 0.5 percent in FY2009/10. As the government recognized the extent to which

its tax revenues had been affected by the global economic crisis last year, it took emergency

measures to limit recurrent expenditures including imposing lower ceilings on the expenditures

in most ministries toward the end of FY2009/2010. It also sought budget support in the form of

grants from donors. While the outlook is for growth to recover in FY2010/2011 to around 1.5 to

2 percent, downside risks remain. Containing expenditure to the level set in the budget will be

challenging, even with greater attention to expenditure prioritization, given the emergency-nature

of the budget cuts already instituted in FY2009/10.

3. The budget support proposed under this operation would play an important role, in

conjunction with support from other donors, in reducing the projected financing gap in

FY2010/2011 from 7.8 percent of GDP to 3.2 percent of GDP. The proposed budget support

will allow the government the fiscal space to continue implementing key energy sector reforms

which are fundamental to securing medium-term economic growth and stability.

WHY THE ENERGY SECTOR IS IMPORTANT

4. Energy is a fundamental building block for Tonga in its social and economic development

and in enhancing the livelihoods of all Tongans. It affects all businesses and every household.

Accessible, affordable and sustainable electricity that is environmentally responsible and

commercially viable is a high priority. Tonga is highly dependent on imported fuels to meet its

overall energy requirements. In 2000 when the last energy balance for Tonga was compiled,

imported petroleum products accounted for about 75% of Tonga's total energy needs. Currently,

all grid-supplied electricity, which accounts for over 98% of electricity used in Tonga, is

generated using imported diesel fuel. Over 95% of Tongans are connected to grid-based supply

of electricity.

5. Tonga's total fuel imports account for about 25% of all imports and about 10% of GDP.

Hence changes in the price and amount of petroleum imports have a significant impact on

Tonga‘s balance of payments situation and inflation. In particular, sudden price shocks can be

difficult to absorb. Automotive Diesel Oil, ADO (i.e. ―diesel‖) accounts for about two thirds of

petroleum imports; the rest is petrol and aviation fuel, with minimal LPG. About one third of

total petroleum imported is used for electricity generation.

5

6. Oil prices over the last ten years illustrate the volatility to which the Tongan economy and

electricity consumers are exposed. Between 2001 and 2004, the average price of crude oil

increased from around US$25 per barrel to around US$40 per barrel - a 60% increase. This was

followed by a dramatic and continuous rise in crude oil prices between 2004 and 2008, where the

average annual price of crude rose from US$40 per barrel to a peak of around US$140 per barrel.

In late 2008 through 2009 crude oil prices fell to 2006 levels, with the average price in 2009

being around US$62 per barrel. Diesel prices tracked the price of crude oil.

7. The oil price spike of 2008 led to the highest electricity tariffs Tonga has ever seen, with

electricity prices peaking at over TOP1.00 per kWh (approximately 50USc/kWh). This had a

significant negative impact on economic activity and on the quality of life for all Tongans. The

experience highlighted the risk to Tongan electricity consumers and the economy as a whole of

the combination of 100% dependency on imported petroleum for grid-based electricity

generation together with essentially spot market pricing of all imported petroleum.

8. Scenarios for future petroleum price trends indicate that on average, the price is expected to

increase as the global financial situation normalizes. The history of international oil prices

demonstrates the high price volatility that characterizes this commodity. Acknowledging the

prospect of increasing and volatile petroleum prices, the Government recognized that the energy

sector as currently structured and operated represents a major risk to the economy overall, and to

the standard of living of individual Tongans. The Government determined that it must, as a

matter of priority, take measures to mitigate these risks. Without implementing reforms in the

energy sector, the economy will remain highly vulnerable to oil price rise and shocks. Reducing

this vulnerability is an important factor in securing stable economic growth in the medium term.

ACHIEVEMENT IN THE ENERGY SECTOR AND THE WAY FORWARD

9. In 2008, GOT initiated electricity sector reform by creating an electricity sector regulator and

putting in place a Concession Agreement between the newly-created, state-owned Tonga Power

Limited (TPL) and the regulator designed to keep the sector financially viable. These initial

steps set the stage for a second round of reform needed to address the risk of Tonga‘s high

dependence on imported petroleum combined with an absence of petroleum price risk

management.

10. In April 2009, the Government and Development Partners with the coordination of the

World Bank, embarked on a process to undertake a sector-wide review and develop an approach

to improving the performance of the energy sector and to mitigating the risks. The resulting

document entitled the ―Tonga Energy Road Map 2010-2020: Ten Year Road Map to Reduce

Tonga’s Vulnerability to Oil Price shocks and Achieve an Increase in Quality Access to Modern

Energy Services in an Environmentally Sustainable Manner‖, or ―Tonga Energy Road Map

(TERM)‖ addresses improvements in petroleum supply chain and consideration of price hedging

instruments, increased efficiency both in electricity supply and use, development of grid-

connected domestic renewable energy resources, improved access to quality electricity services

in remote areas, reduced environmental impacts both locally and globally, enhanced energy

security, and overall sector financial viability. The scope includes policy, legal, regulatory and

institutional aspects of the sector as well as investment. It covers a ten year time period. As

6

technologies, costs, demand for electricity and sources of financing change over time, it is

envisioned that the TERM will be periodically updated to take these factors into account.

11. The TERM focuses on reducing cost and volatility in the price of petroleum imports and on

de-linking electricity production from petroleum to the extent feasible. A further set of actions

could focus around use of petroleum for transport applications. This was beyond the scope of

the TERM exercise, but work is already underway in this area and would complement the

TERM.

12. Development of the TERM involved unprecedented information-sharing by Government

Ministries and Tonga Power Limited (TPL), and set a new standard in the Pacific for

Government leadership and coordinated development partner support. The process has benefited

from the active participation of more than fifteen development partners, including multi- and bi-

lateral agencies and regional organizations responsible for energy in the Pacific, over the course

of one year. The TERM is important not only for the expected impact on the energy sector in

Tonga. It is already being cited as an example in other PIC energy sector discussions and is

expected to serve as a model for Government leadership and development partner coordination

of sector-wide planning applicable to infrastructure more broadly.

13. The TERM sets out priority actions in the areas of policy, legal, regulatory and institutional

arrangements, and sets out an investment program based on a least cost approach for reducing

reliance on diesel for power generation, with explicit consideration given to managing risk

through development of a portfolio of options to meet the demand for electricity. The TERM

also recommends a detailed program of actions with indicative funding sources and costs for

each element. The TERM will serve as the guiding document for Government and TPL actions

and development partner support.

14. GoT formally adopted the TERM in August 2010 and by doing so, committed to key

principles for the energy sector and an indicative implementation plan. The Bank plans to

provide on-going support to the GOT in implementation of the TERM in the form of the ―Tonga

Energy Road Map Project‖, an investment project currently under preparation which will

reinforce the focus on, and provide support to achieve the medium term energy sector outcomes

highlighted for this proposed operation. Other development partners are also working with GOT

preparing support for specific aspects of TERM implementation.

BUDGET SUPPORT IS NEEDED TO MEET FINANCING NEEDS AND MAINTAIN MOMENTUM IN

ENERGY SECTOR REFORM

15. Absent budget support from donors, Tonga is facing a fiscal deficit of around 7.8% of GDP

in FY2010/11, following an estimated 3.9% deficit in the previous year. A fiscal deficit situation

is expected to continue for the next two to three years. Further borrowing is constrained due to

debt sustainability concerns. Medium term measures include implementation of plans to

improve Public Expenditure and Financial Management and improve revenue forecasting.

Government of Tonga has sought support from the Bank and other development partners for

assistance to close the fiscal gap.

7

16. At the same time, Tonga is preparing for a major political and constitutional transition from

a near-absolute monarchy under which the King appoints the Prime Minister and Cabinet, to a

constitutional monarchy where power is exercised by an elected Government. Elections for the

new government will take place in November 2010. As would be the case in any country

undertaking a significant political change, together with the expected benefits of the change there

is also a significant level of political uncertainty associated with the election process itself and

the performance of a new, possibly inexperienced administration.

17. The convergence of the fiscal deficit and the up-coming political transition poses a risk to

implementation of the reforms envisaged in the energy sector. If the fiscal gap is not addressed,

the budget pressures may lead to insufficient resources being available to support

implementation of the Energy Sector reforms. The need to address immediate budget shortfalls

could also distract the new administration from focusing on the implementation of critical

reforms needed to support medium term economic stability and growth, of which the energy

sector reform will be a key component.

18. The proposed program is designed to support the Government in implementation of energy

sector reform as per the TERM by (i) underscoring the importance of implementation of energy

sector reform; (ii) providing assistance in closing the near-term budget gap so that adequate

funds will be available to move forward with implementation of the TERM and the new

government is not unduly preoccupied in addressing a large financing gap; (iii) encouraging key

steps in PFM reform so that the resources provided under this program are used as effectively as

possible, and the momentum of wider public expenditure and financial management reforms is

maintained in the medium term.

II. COUNTRY CONTEXT

RECENT ECONOMIC DEVELOPMENTS

19. Tonga is a small and remote island economy, consisting of 176 islands with a total area of

748 km2, an Exclusive Economic Zone (EEZ) of about 700,000 km

2 and a total population of

102,000 spread across 36 inhabited islands. There are four groups of islands (Tongatapu,

Ha‘apai, Vava‘u and Niuas). The capital, Nuku‘alofa, is located on the largest island, Tongatapu.

Seventy-one percent of the population lives on Tongatapu.

20. In 2009, per capita income in Tonga was approximately USD 3,250. Over the past 15 years,

per capita income has grown modestly, with average real annual growth of around 1.9 percent

exceeding population growth of about 0.5 percent. Economic activity has exhibited significant

fluctuations as underlying structural constraints, political disturbances, and global economic

developments have adversely affected growth. Following the civil service strike in 2005 and civil

disturbances at the end of 2006, the economy recovered strongly in FY2007/08. But growth has

subsequently slowed sharply, initially due in large part to the food and fuel price shocks and

more recently as a result of the global slowdown, which, as discussed further below, has hurt

remittance flows, tourism arrivals and exports.

8

21. While external factors have resulted in economic contractions in Tonga over the past two

years, the country remains one the best performers among World Bank members in the Pacific in

terms of making progress toward the MDGs. Extreme poverty is almost non-existent, and Tonga

is on track to meet goals to significantly reduce maternal and child mortality, and achieve

universal primary education with no disparities between boys and girls. Only on broader

measures of empowering women is Tonga not largely on track to meet MDG goals.

22. The Tongan Government has also undertaken significant reforms over the past few years.

Most notable has been the constitutional reform that will see substantial power transferred from

the King to Parliament. Although constitutional reform has to some extent dominated the agenda

and the government‘s recent priorities, on the economic front Tonga did undertake extensive

structural reform as part of its successful bid to join the WTO in 2007. While a significant

outstanding structural reform agenda remains, Tonga is the highest ranked Pacific island member

country in terms of Doing Business (with a ranking of 52, Tonga is in the top third of all

countries). Similarly, an Australian-led Public Expenditure and Financial Accountability

Assessment (PEFA) completed in early 2010 found real improvements in overall public financial

management systems since the 2007 PEFA, although a significant reform agenda remains. This

is discussed further in paragraphs 44 - 49. Reflecting reforms, the World Bank‘s CPIA rating for

Tonga has been increased from 3.0 to 3.5 over the past 3 years; with Tonga‘s policy performance

now above average.

23. Tonga is highly vulnerable to external economic shocks and natural disasters. Small size

combined with a large distance from the nearest large market means that the country is unable to

exploit economies of scale in production. A narrow resource base and a small market result in a

production structure that is highly undiversified. Remittances account for a large share of the

GDP. Size and remoteness also have an impact on the cost of key imports such as petroleum,

exacerbating the risk to the economy from external shocks. All these vulnerabilities have come

into play in the last two years, taking a heavy toll on Tonga‘s economy. Table 1 highlights recent

trends in key economic indicators.

24. The knock-on effects of the global economic crisis resulted in GDP contractions of 0.4

percent in FY2008/09 and an estimated 0.5 percent in FY2009/10 (IMF estimate). GDP growth

in Tonga has not exceeded 2 percent in any of the last five years. Domestic political disturbances

in 2006 caused widespread damage in the capital, and GDP contracted by 1.2 percent in

FY2006/07. The economy rebounded to grow by 2 percent the following year, leading up to the

coronation of the new King in August 2008. However, Tonga was unable to build on this

upswing as it was adversely impacted by the global economic crisis. In addition, the country was

buffeted by two natural disasters, a tsunami on September 29, 2009 causing loss of life and

significant material damage, and then a cyclone in February 2010.

25. The main impact of the GEC was on remittances which, on average, are the equivalent of 67

percent of imports and 30 percent of GDP. As a result of the economic slowdown in the key

remittance-sending countries of the US, NZ and Australia, remittances are projected to fall by 18

percent in FY2009/10 compared with the previous year. This substantial decline comes on top of

a 12.5 percent fall in remittances in FY2008/09. Tourist receipts are projected to fall by 15

percent in FY2009/10 compared with the previous year, following a decline of 5.6 percent in

9

FY2008/09. The latest data indicate a 13 percent fall in the value of exports year on year, to

February 2010.

26. As a consequence the current account deficit is projected to widen to 17.4 percent of GDP in

FY2009/10 compared with 14.3 percent in the previous year. However the trade deficit is

projected to narrow to a 37¼ percent of GDP due to a projected decline in imports of 11 percent.

The increase in the current account deficit is thus a result of the sharp decline in remittances.

International reserves are estimated to have risen from USD 68 million in FY2008/09 to USD 71

million (5.3 months of imports) in FY2009/10 largely as a result of one-off factors, including the

recent allocation of SDRs by the IMF and the disbursement of donor grants.

27. Inflation, following the trend of international oil and food prices, reached 12 percent in mid-

2008 but fell to 1.2 percent by end 2009. Inflation is however expected to pick up to around 4

percent in 2010 with the strengthening of commodity prices and a pick-up in domestic demand.

Food accounts for 44 percent of the consumer price index (two-thirds of it imported), transport

accounts for 14 percent and domestic fuel and power for 12 percent. The food price shock of

2007-08 is estimated to have hurt most severely the urban poor, who have little land and must

pay cash for food. Rural populations and those on the outer islands relying more on subsistence

farming, are more likely to have been able to switch towards traditional root crops for their staple

diet.

10

Table 1: Selected Economic Indicators, 2005/06-2010/11 1/ Nominal GDP (2008/09): US$ 328.4 million GDP per capita (2008/09): US$ 3,220 2005/06 2006/07 2007/08 2008/09 2009/10 2010/11

Output and prices (Annual percent change) Real GDP 2/ 0.5 -1.2 2.0 -0.4 -0.5 1.7 Consumer prices (period average) 7.0 5.1 9.8 5.0 2.2 4.2 Consumer prices (end of period) 6.4 5.6 12.2 1.2 4.3 4.1 Central government finance (In percent of GDP) Total revenue and grants 26.6 28.3 26.3 24.0 25.3 29.2

Total revenue 24.9 24.6 24.9 17.4 18.7 18.8 Grants 1.7 3.7 1.3 6.6 6.6 10.4

Total expenditure and net lending 29.4 27.3 24.7 27.3 29.2 34.3 Of which: Current expenditure 28.8 26.2 24.3 24.1 23.9 22.8 Capital expenditure 0.8 0.9 0.4 2.3 2.7 8.6

Overall balance -2.8 1.1 1.5 -3.3 -3.9 -5.1 Overall balance 9excl. China’s EXIM bank loans) ... ... ... -3.3 -2.4 -2.5 External financing (net) 0.4 0.1 0.2 -0.7 3.6 5.4 Domestic financing (net) 2.4 -1.2 -1.7 8.6 0.5 -0.3 Privatization receipts 0.0 0.0 0.0 -4.6 -0.2 0.0 Money and credit (Annual percent change) Total liquidity 3/ 13.3 13.3 6.7 -1.1 4.3 1.4 Domestic credit 25.8 11.6 11.6 -4.2 -11.2 1.3

Of which: Private sector credit 22.6 9.5 18.0 -2.9 -11.0 2.0 Interest rates (end of period)

Average deposit rate 5.2 5.6 5.7 5.3 ... ... Base lending rate 9.0 9.4 10.0 10.0 ... ...

Balance of payments (In millions of U.S. dollars) Exports, f.o.b. 15.4 13.3 12.4 5.5 5.2 6.3 Imports, f.o.b. -122.2 -108.6 -138.1 -130.1 -115.7 -131.5 Services (net) -7.8 -17.9 -3.3 -2.6 -3.3 -5.0 Investment income (net) 2.8 3.5 3.4 4.6 3.2 3.1 Current transfers (net) 88.9 84.2 94.7 75.8 59.1 66.7

Of which: Private transfer receipts 102.0 93.3 106.7 84.0 63.0 70.7 Current account balance -22.8 -25.5 -30.9 -46.9 -51.5 -60.5

(In percent of GDP) -7.9 -8.4 -9.0 -14.3 -17.4 -19.9 Overall balance 0.6 4.2 -1.4 22.6 2.9 1.3 Gross official foreign reserves In millions of U.S. dollars 40.4 47.1 48.2 67.7 70.6 72.0 In months of goods and services imports 3.1 3.9 3.2 4.7 5.3 4.8 External Debt (in percent of GDP) External debt 29.0 27.1 25.3 31.5 44.2 50.7 Debt service ratio 1.1 1.1 1.4 1.2 1.1 1.5 Exchange rates Pa’anga per U.S. dollar (period average) 2.0 2.0 1.9 2.1 ... ... Pa’anga per U.S. dollar (end of period) 2.1 1.9 1.8 2.0 ... ... Real effective exchange rate (1990=100) 103.6 103.5 105.9 111.7 ... ... Nominal GDP (millions of T$) 580.1 604.1 652.2 685.0 704.9 747.1

1/ Fiscal year beginning July. 2/ Including preliminary data. 3/ From the Banking Survey, which includes the Tonga Development Bank.

11

28. In the year to April 2010, credit growth was –14.6 percent, due largely to highly risk-averse

behavior by the two major commercial banks. Reflecting in part the impact of slowing growth

and remittances and also inadequate risk management in the banks during a lending surge in

2008, bad debts began to build from mid-2008. The non-performing loan ratio stood at 20

percent in mid 2009 compared with 5 percent at end 2007. The ratio of non-performing loans has

now begun to fall, and is currently below 18 percent.

29. During FY2009/10 the National Reserve Bank of Tonga (NRBT) eased its monetary policy

stance. It lowered reserve requirements (from 10 percent to 5 percent), reduced the interest rate

on its repo facility (from 10 percent to 4½ percent), and stopped issuing central bank bills.

However the impact of this monetary easing on the real economy was more than offset by the

unwillingness of commercial banks to lend. Nevertheless, provisioning against bad loans has

risen ahead of write offs and profitability is expected to resume next year.

REVENUE AND EXPENDITURE TRENDS

30. In the last two years, the global downturn has pushed government finances into deficit. The

deficit was 3.3 percent of GDP in FY2008/09, and is expected to increase to 3.9 percent of GDP

in FY2009/10. In both years, tax revenues were significantly lower than they were previously, as

is evident from comparisons with the three-year averages for FY2005/06–FY2007/08 (see Table

2). As the government has recognized the extent to which its tax revenues have been affected by

the global economic crisis, it has taken steps to limit recurrent expenditures. It has also sought

budget support in the form of grants from donors.

Table 2: Tonga: Trends in Key Sources of Tax Revenue, FY2005/06-FY2009/10

FY2005/06 FY2006/07 FY2007/08 FY2008/09 FY2009/10 (In millions of pa’anga)

Tax Revenue 122.2 126.2 138.0 94.3 102.5 Change of FY2005/06-FY2007/08 -26.8% -20.4%

- Income and Profits taxes 26.9 26.4 26.8 40.3 24.5

Change on FY2005/06-FY2007/08 50.9% -8.2% - Consumption Tax 52.7 51.6 59.7 33.2 43.0

Change on FY2005/06-FY2007/08 -39.3% -21.3%

- Import Tariffs & Excise Taxes 41.9 47.6 51.4 19.3 34.9 Change on FY2005/06 –FY2007/08 58.9% -25.7%

Source: IMF

31. The fall-off in tax revenues experienced in FY2008/09 and FY2009/10 was led by

consumption, import tariffs and excise taxes. These key sources of tax revenue all depend

primarily on the value of imports – not only tariffs but also excises fall exclusively on imported

products, and approximately three-quarters of consumption tax receipts come from imported

products. The sharp decline in remittances and the contraction of the economy occurring in

FY2008/09 and FY2009/10 translated directly into a decline in the value of imports in USD

terms. Simultaneously, new tariff and excise regimes were implemented just prior to FY2008/09,

completing tax reforms begun in FY2004/05 in anticipation of Tonga‘s accession to the WTO

and involving significant tariff liberalization. Overall, the tax reform package was designed to be

revenue neutral, as reliance on border taxation was reduced in favor of general consumption

12

taxation, but within that calculation of revenue neutrality was an expectation that lower tax rates

under the reformed regime would yield increases in transaction volumes, which did not

materialize in the context of the global downturn.1

32. It is difficult to distinguish the contribution of changes in the value of imports and changes

in the import tax regime to the lower revenues Tonga experienced in FY2008/09 and FY2009/10.

Income and profits taxes, which lag economic activity, declined sharply in FY2009/10, after their

peak in FY2008/09. Leading this fall was the decline in profitability – or, in the case of the major

commercial banks, the losses – of a handful of large enterprises that normally provide around

half of income and profits tax revenue.

33. During FY2009/10, the government recognized that tax revenues were coming through

significantly below budget forecasts, and took steps to reduce spending and address the financing

gap. This delayed recognition of the impact of the GEC on tax revenues was due to several

factors. First, while the government expected the GEC to impact fiscal revenues, it found it

difficult to forecast its intensity and depth. Secondly, while current tax revenues were

significantly affected in FY2008/09, the government received a substantial payment of arrears,

which provided a degree of comfort. (Including arrears, the government actually experienced

higher revenues in FY2008/09 than in FY2009/10.) Thirdly, the task of recognizing the impact of

the GEC on tax revenues as it rapidly unfolded was made more complicated by lags in the

availability of data in real time. In addition to taking steps to reduce expenditure in FY2009/10

(see Box 1),2 the government sought budget support in the form of grants from donors, in

response to which the ADB provided some 9.7 million pa‘anga – reducing the deficit from 5.3 to

3.9 percent of GDP.

34. On the expenditure side, Tonga is still tackling the implications for the civil service wage

bill of the prolonged strike in late 2005. The strike resulted in a settlement whereby civil service

wages increased 60-70 percent over FY2005/06 and FY2006/07. In response, the government

introduced a large voluntary redundancy program which was taken up by some 800–1,000 civil

servants (about a quarter of the total), and sought to find other economies in overtime,

maintenance, subsidies and capital expenditures. These measures mitigated some of the impact

of the wage settlement (by FY2007/08, both the wage bill and total expenditure were around 40

percent higher than before the wage settlement), but at the cost of losing key skilled and

experienced staff. In FY2009/10, civil servants received a further 10 percent wage increase – the

first since the earlier settlement. This increase is viewed as an integral part of the ongoing reform

of the public sector that aims to contain the wage bill through reducing the size of the public

service, while improving performance through recognizing merit and flattening the grade

1 The introduction of the consumption tax and other tax reforms in April 2005 resulted in an increase in tax revenue

of some 35 million pa‘anga or 6 percent of GDP in FY2005/06. The decreases in tariffs and increases in excises that

were to accompany these changes were expected to be phased in during FY2005/06 and FY2006/07, but this did not

in fact occur until late in FY2007/08 (making FY2008/09 the first full year under the fully reformed tax regime).

2 The figures for total expenditure and net lending in the government‘s budget papers differ from those produced by

the IMF for FY2009/10, because the government‘s figures exclude capital expenditures proceeding from China‘s

Exim Bank loans but which are not disbursed through the government budget, as well as the on-lending of funds

from the first Exim Bank loan to the private sector. Taking account of these amounts, the IMF projects total

expenditure and net lending in FY2009/10 to be some 10 percent higher than the previous year. (Note that

government‘s budget papers do include donor expenditures that are disbursed through the government budget.)

13

structure. The current package, which is supported by the workforce, includes linking annual

salary increments to merit (not seniority), reducing leave entitlements and abolishing vacancies.

35. In the FY2010/11 budget, the government has adopted realistic revenue forecasts and has

extended its recent efforts to rationalize expenditure. On the revenue side, tax receipts are

projected to remain relatively flat, in line with the economic conditions likely to prevail in Tonga

in the coming year. Revenue forecasting has been assisted by recent reforms to revenue and

customs software, which have enabled finance officials to access much more timely data when

formulating the budget. These reforms mean that finance officials are also able to assess actual

revenue flows against forecasts in a timely manner, throughout the year. On the expenditure side,

the government has sought to adopt a more considered approach to expenditure rationalization

than was possible when making emergency budget cuts in the latter part of the previous fiscal

year (see Box 1). Notably, wage and salary expenditure is set to remain constant, in real terms.

However, once off-budget capital expenditure and lending activities relating to China‘s Exim

Bank loans are included, total expenditure and net lending is projected to rise by nearly 25

percent in FY2010/11 on the previous year (see the discussion below about debt sustainability).

Box 1: Expenditure Rationalization in Tonga

The government‘s expenditure rationalization is designed around the ‗government-funded

budget‘, a data format that differs from that used by the IMF. The ‗government-funded budget‘

includes all current and capital expenditure that is funded by government revenue and budget

support grants. (The ‗government-funded budget‘ does not include donor-funded or China‘s

EXIM loans-funded project expenditures).

In FY2009/10, when the government recognized that tax revenues were coming through

significantly below budget forecasts, it imposed new, lower ceilings on the expenditures of most

ministries. It is estimated that an overall expenditure cut of some 11½ percent was achieved as a

result (measured against the expenditure that was forecast to occur if spending patterns in the first

half of FY2009/10 were repeated in the second half of FY2009/10). The health and education

budgets were protected from the sharp cuts imposed on all other areas, with their respective

ministries asked to reduce their expenditure by about 2½ percent each. The preliminary outturn

shows that health expenditures were reduced by around 2½ percent –without cutting programs –

through efficiency improvements achieved in the course of ongoing reform initiatives, while

education expenditures were maintained at least at the level of the original budget allocation.

In advance of the FY2010/11 budget, Tonga‘s Expenditure Review Committee (ERC) consulted

with individual ministries to delineate essential and non-essential activities, and to prioritize the

former in their programs and budgets for FY2010/11. The objective was to adopt a more

considered approach to expenditure rationalization than was possible when making emergency

budget cuts in the latter part of the previous fiscal year. Overall, the FY2010/11 government

budget limits expenditure to a level 2.7 percent above the previous year in nominal terms – which

represents a decline of 1.5 percent in real terms. As in FY2009/10, the health and education

budgets are to be protected from the more stringent rationalization measures imposed on other

areas.

36. Containing expenditure to the level set in the budget will be challenging, even with greater

attention to expenditure prioritization under the leadership of the ERC, given the emergency-

14

nature of the budget cuts already instituted in FY2009/10. As the government seeks to continue

to contain its expenditure, measures to improve the quality of expenditure and of the resultant

service provision will be essential. The level of expenditure set in the budget considerably

exceeds government revenue and identified grants, making further financing necessary. It will be

important for this financing to be available on grant or highly concessional terms, given Tonga‘s

already high debt burden, discussed further below. The budget support proposed under this

operation would play an important role, in conjunction with other donors, in reducing the

projected financing gap from 7.8 percent of GDP to 3.2 percent of GDP (see Table 3).3

Table 3: Tonga: Financing Gap, FY2010/11

USD millions

Total revenue & grants (excluding budget support) 99.6

Current revenue 70.3 Capital revenue 0.0 Project-specific grants 29.3

Total expenditure and net lending 128.6

Total expenditure 117.4 Current expenditure 85.2 Capital expenditure 32.2 - of which, China’s EXIM Bank loans 13.6 Net lending 10.6 Exchange rate adjustment4 0.6

Balance (excluding budget support) -29.1 as a percentage of GDP -7.8%

Total financing (including budget support) 29.1

External financing (excluding budget support) 20.4 Budget support 17.1 - of which World Bank 5.0 ADB 5.0 EC 7.1 Domestic financing -8.4

Memorandum items:

Balance (including budget support) 12.0 as a percentage of GDP -3.2%5

Balance (excluding budget support and all grants) -58.4

as a percentage of GDP -15.6%

1/ Accounts for the exchange rate used by government for Bank and ADB budget support, which differs from that used in this document 2/ The FY2010/11 projected deficit figure of 5.1 percent of GDP in Table 1 does not account for the budget support expected from the EC Source: IMF

MACROECONOMIC OUTLOOK AND DEBT SUSTAINABILITY

37. The outlook is for growth to recover in FY2010/11 to around 1.5 to 2 percent but downside

risks remain. The projected recovery assumes that the construction of public infrastructure

3 Note that the FY2010/11 projected deficit figure of 5.1 percent of GDP in Table 1 does not account for the budget

support that the government expects to receive from the EC.

15

projects proceeds as planned, with the government being able to ensure an adequate contribution

from domestically available inputs, mainly labor. The recovery also crucially depends on a pick-

up in remittances and tourism revenues. In addition, it assumes a resumption of commercial bank

lending. However, global recovery is not assured and weak economic performance in key partner

countries would preclude the needed reversal in remittance and tourism receipts. In addition,

risks could arise from delayed fiscal consolidation, especially if the provision of donor grants

falls short. Key indicators of the medium-term macroeconomic outlook are presented in Table 4.

Table 4: Tonga: Medium Term Macroeconomic Outlook, FY2009/10 FY2013/14 2009/10 2010/11 2011/12 2012/13 2013/14

Proj.

Output and prices (annual percent change) Real GDP -0.5 1.7 1.7 1.8 1.8 Consumer prices (period average) 2.2 4.2 4.1 5.1 6.0 Central government finance (percent of GDP) Total revenue and grants 25.3 29.2 27.2 26.2 25.7 Of which Total Revenue 18.7 18.8 19.7 20.1 20.3 Total expenditure and net lending 29.2 34.3 32.0 31.4 28.6 Of which Current expenditure 23.9 22.8 22.3 21.2 21.1 Overall balance -3.9 -5.1 -4.7 -5.2 -2.8 Balance of payments (percent of GDP) Current account balance -17.4 -19.9 -20.2 -18.1 -16.2 Gross international reserves (end of period) In months of imports (goods and services) 5.3 4.8 4.5 4.2 3.8 External debt (percent of GDP) Public sector external debt 44.2 50.7 52.7 51.1 48.5 Source: World Bank/IMF

38. Reconstruction loans have caused a sharp increase in debt levels and Tonga is judged to be

at a high risk of debt distress on the basis of a joint IMF-Bank DSA. Tonga‘s total public sector

debt stock (including publicly guaranteed debt) is high and rose substantially in FY2008/09 and

FY2009/10, reaching over 50 percent of GDP. This increase reflects the contracting of two loans

from China‘s Exim Bank for reconstruction—together with face values totaling over 30 percent

of GDP—as well as the impact of the weaker external environment on both GDP and the fiscal

balance. The loan commitments were signed in November 2007 (for reconstruction of the central

business district) and February 2009 (for roads), and bear a 2 percent interest rate, a 5-year grace

period, and a 20-year maturity. Work under the first reconstruction loan was initially postponed,

as the government sought to ensure it was used productively and negotiated for a greater use of

local inputs. The first drawdown was made in April 2009, with over half the amount projected to

be disbursed by end-June 2010. Currently, it is believed only 30 percent of the funds from this

loan will be used to finance direct government capital spending, with the remaining 70 percent of

funds expected to be on-lent to the private sector for office, residential, and retail construction.

The second loan agreement was signed in February 2010, and the first disbursement (30 percent)

occurred shortly after the signing.

39. Despite the rise in overall debt, the government has continued to reduce its domestic debt

level. Domestic debt has fallen from around 20 percent of GDP at the beginning of the decade to

around a projected 7¼ percent of GDP by June 2010. Outstanding bank loans were repaid in

2007/08. This fiscal year, the government issued bonds amounting to a net issuance of 8 million

pa‘anga to partly cover the deficit, leaving outstanding bonds at an expected 4¼ percent of GDP

16

by end-June. The remaining domestic debt reflects mainly government guarantees and

obligations to the Retirement Fund Board.

40. The DSA assumes that near-term GDP growth will recover to rates close to its historical

average. Although the current reconstruction will likely lift growth in the short-term, the DSA

conservatively assumes little increase in long-term growth despite the current large infrastructure

investment. The reconstruction and road infrastructure projects are assumed to take place over

the period until FY2014/15, although they will be drawn down over the period through

FY2012/13. Excluding reconstruction and road spending, public spending will be set to grow

more slowly than projected revenues and grants over the medium term, limiting the longer-term

need for additional external borrowing. Remittances are assumed in the medium- and longer-

term to remain an important external cushion.

41. Under the baseline scenario of the DSA, the external debt trajectory breaches several policy

dependent thresholds in FY2009/10 before receding to safer levels. Public and publicly

guaranteed (PPG) external debt is currently over 30 percent of GDP, the indicative threshold

level (Table 5). Given the drawdown of the Exim Bank loans the present value (PV) of PPG

external debt is projected to increase to about 42 percent of GDP by FY2011/12, before falling

below the threshold in FY2017/18, and declining further to around 8 percent of GDP by 2030.

Table 5:

42. External debt remains well above the PV of debt-to-export distress threshold, but

remittances provide a cushion. Reflecting Tonga‘s low exports, the PV of PPG external debt-to-

exports ratio is well over two times the indicative threshold of 100 percent, and is projected to

remain above the threshold well past 2020. However, Tonga‘s large remittances would help to

reduce liquidity risks. Remittances have averaged more than twice export receipts over the past

decade, and have provided a considerably more stable source of foreign exchange inflows. When

the PV of PPG debt is considered relative to the sum of remittances and exports it remains above

the threshold only until FY2013/14, i.e., the threshold is breached for a shorter period. The PV of

debt is expected to decline below the revenue threshold by 2014. Debt and debt service are also

Indicative 2008/09 2009/10

Thresholds 1/

NPV of external debt

In percent of GDP 30 24 34

In percent of exports 100 171 220

In percent of remittances and exports 90 60 93

In percent of revenue 200 136 183

Debt service

In percent of exports 15 9 9

In percent of remittances and exports 14 3 4

In percent of revenue 25 7 7

1/ Represents Low Income Country DSA indicative thresholds for Tonga thiat is classified

as a poor performer under the World Bank's Country Policy Institutional Assessment.

The threshold for the ratios in percent of remittance and exports are modified by a

10 percent rule-of-thumb.

Tonga: External Debt Indicators

17

expected to stay above the exports threshold for most of the projection period, though not when

remittances are accounted for.

43. The macroeconomic policy framework discussed and agreed to with the government at the

time the DSA was conducted, is adequate for the purposes of this operation, but subject to

uncertainty. This judgment is subject to two important assumptions. First, it requires the

government to make a modest adjustment to current expenditure and an improvement in revenue

effort in the near term. Secondly, given the high risk of debt distress, the adequacy of the

macroeconomic policy framework depends on the continued availability of grants to finance

fiscal deficits in the near term. This medium-term macroeconomic framework also underlies the

DSA, which projects a return to primary surpluses of just under 1 percent of GDP from

FY2015/16. The uncertainty associated with Tonga‘s macroeconomic framework is due to the

difficulty in predicting the timing of Tonga‘s recovery from the impact of the global recession,

which in turn stems from uncertainty over the speed and strength of the global recovery.

REFORMS IN PUBLIC EXPENDITURE AND FINANCIAL MANAGEMENT

Financial Management

44. A Public Expenditure and Financial Accountability (PEFA) assessment was first undertaken

in Tonga in 2007 and a follow-up PEFA assessment was completed in May 2010. The PEFA

framework is a commonly used diagnostic tool to develop a benchmark of the quality of public

financial management (PFM) systems and processes in a country, and use that baseline data to

monitor progress over time. This most recent assessment was undertaken as a joint exercise by

the Government of Tonga and development partners including two experts engaged by AusAID

and the ADB/World Bank Focal Point in Tonga.

45. The report from the March 2010 PEFA provides an overview of the current performance as

well as an indication of areas of strength and weakness. The Public Financial Management legal

and regulatory framework in Tonga provides a solid basis for budgeting, spending and

accountability. The overall impression of the assessment team is that ―there are clear rules and

procedures in place and these tend to be followed.‖ Based on the ratings for the standard PEFA

performance indicators, about two-thirds of Tonga‘s PFM system is performing at or above

average levels compared to international best practice, and measured against six core PFM

indicators6, most parts of the system work reasonably well.

46. The PEFA assessment consists of 31 indicators, of which three relate to donor practices.

Tonga‘s 2010 performance in the five main groups of the 28 country-related PEFA indicators is

described below:

6 The six core indicators are (i) credibility of budget, (ii) comprehensiveness and transparency, (iii) policy-based

budgeting, (iv) predictability and control in budget execution, (v) external scrutiny and audit, (vi) donor practices.=

18

Credibility of the budget: Although aggregate revenue and expenditure outturns have broadly matched budget plans over the three years FY2006/07–FY2008/09,

7 there is

significant variation in the composition of the expenditure outturn at the agency level.

This transfer of resources between agencies within the year is not achieved through a

formal supplementary budget process, but instead through use of the Contingency Fund,

and this is a weakness of the system.

Comprehensiveness and transparency: The comprehensiveness of budget documents for government agencies has improved, but further improvements, such as the inclusion of

balance sheets and an assessment of financial risks, should be made for public

enterprises. The failure to make individual audits of government agencies publicly

available negatively impacts transparency.

Policy based budgeting: A significant PFM improvement since the 2007 PEFA is the introduction of a limited form of multi-year budgeting. The positive impact of this reform

will be strengthened if the government builds capacity within line agencies to accurately

cost their sector strategies and corporate plans on a multi-year basis. If these costs are

captured in the forward estimates, the credibility of the multi-year budget will be

improved. Additionally, the publication of forward estimates will enhance transparency

and accountability.

Predictability and control in budget execution: Significant improvements in revenue administration have occurred since the 2007 PEFA assessment, including more publicly

available information on taxation policy and rulings, the introduction of a tax appeals

mechanism, and improved management of arrears. Internal audit has improved, but the

lack of focus on systemic issues, and of publication of audit results, are two areas that

require attention.

External scrutiny and audit: The Audit Office has acted as both the internal and external auditor for government agencies, and there are significant delays in tabling and approving

audit reports by the Legislative Assembly. The Legislative Assembly receives a summary

of audit activities, instead of being able to scrutinize the actual audit reports, limiting

their oversight function.

47. Two areas for further reform are highlighted in the PEFA: (i) accountability and

transparency relating to both internal and external audit and (ii) formal adoption and

implementation of the Treasury Instructions.

48. Audit: One aspect of PFM that drew significant attention from the 2010 PEFA assessment

team was the lack of accountability and transparency relating to both internal and external audit.

The government has already taken steps to improve this key area of PFM, with introduction of

7 With respect to the aggregate revenue outturn, the PEFA team‘s assessment did not encompass FY2009/10, for

which the outturn was not available (the IMF estimate is for actual recurrent revenue to be 77 percent of forecast

recurrent revenue). For FY2008/09, the PEFA team appears to have used government revenue figures and thereby

the classification of funds made by government; using IMF figures and classifications, actual recurrent revenue was

only 66 percent of forecast revenue, as opposed to the 88 percent calculated by the PEFA team.

19

the Public Audit Act 2007 (effective February 2008), which provides greater independence of the

Audit Office, and by establishing an internal audit unit within the Ministry of Finance and

National Planning. It is expected that the internal audit unit will be able to focus attention on the

consideration of systemic issues undermining the quality of the PFM system, and that the Audit

Office will become Tonga‘s Supreme Audit Institution. In addition to the responsibility for the

audit of all ministries and government agencies, the Auditor General is now also mandated to

undertake an audit program to review and approve the audited financial statements of all public

enterprises audited by private audit firms. The AG is also mandated to conduct performance

audit i.e. to review whether the resources are employed and managed with economy, efficiency

and effectiveness, and there has been no waste or extravagance. Before this Act came into being

there was no mandate for performance audit.

49. In addition to these legislative and institutional arrangements to support the audit function, it

is crucial that the outcomes of the audits, and the responses by management to any issues raised,

are made publicly available. Currently, agencies receive an internal audit report and management

letter, but do not make these documents, or any management response, publicly available. The

Audit Office‘s Annual Report contains only a short (approximately half page) summary of key

audit findings for each agency, and does not contain useful details or the management response.

Without publication of the audit reports or management responses, it is not possible to accurately

determine what action, if any, is being taken to address audit recommendations. Increased

information availability is an important step to increase the value of the audit function.

50. Treasury Instructions: The 2010 PEFA report noted a number of areas of PFM that were

expected to be improved with the formal adoption of the draft Treasury Instructions. These

instructions codify the administrative rules that have been developed by the MoF for

implementing the Public Finance Management Act 2002, and their formal adoption will make

them legally binding. The Treasury Instructions will formalize the required procedures for a

number of key PFM processes, establishing, among other things:

The requirement that the corporate plans and annual management plans of government authorities be submitted as part of the preparation process for the budget each year,

together with the required content of all corporate plans (including the roles and

responsibilities of the authority, how these contribute to government policy objectives as

laid out in the NSPF, and the targets and measurement indicators for their outputs);

A set of procurement instructions aligned with the draft Public Procurement Regulations;

Rules governing changes to the personnel database and payroll;

Controls and processes in respect of expenditure commitments, including the recording and reporting of payment arrears;

Controls and processes in respect of receivables, including the requirement that all non-tax revenue be banked within 24 hours of receipt;

Processes for handling virements; and

20

Rules governing the use of the Contingency Fund.

Public Sector Procurement

51. An Operational Procurement Review (OPR) was carried out for Tonga in May-June 2003

and the OPR was issued by the Bank on June 30, 2003. The OPR identified that Tonga lacked a

legal framework governing public procurement, and noted the absence of any formal

procurement policies and guidelines. The Government of Tonga showed keen interest to pursue

reforms related to public procurement. As a follow up, the Bank provided an IDF grant to

support the implementation of public procurement reforms and capacity building. The technical

assistance supported preparation of a legal framework for public procurement; draft regulations

and procurement manual, along with standard procurement documents; and development of the

capacity of Government officials in managing public procurement. It was envisaged that with

these actions there would be significant efficiency gains in processing public procurement, and

more transparency in the award of contracts.

52. Under the leadership of the Ministry of Finance, the preparation of the legal and regulatory

framework, procurement manuals and standard procurement documents involved the active

participation of line agencies and consultation with development partners. Following ―in

principle‖ approval by Cabinet8, the draft Public Procurement Regulations were submitted to the

Law Committee in July 2010, together with the comments provided by the Bank and ADB. The

primary function of the Law Committee is to assess whether the proposed regulations are

consistent with the existing legal and regulatory framework and standards, before the final

regulations are submitted to Cabinet for approval and thereafter to Privy Council. As such,

submission to the Law Committee is a clear indication that the Government intends to pursue the

substance of the regulations. Approval of the regulations for public procurement by Privy

Council is a prior action for the second tranche of the ADB Economic Support Program.

53. The Bank has reviewed and provided comments on the draft Public Procurement

Regulations. It does not appear that there is any appreciable distance between ADB and the

Bank on the draft regulations. Overall the Bank comments were relatively minor, with only one

point of significant interest: for purposes of legal certainty, the Bank suggests a clarification on

Article 29, which seems ambiguous on the grounds for exclusion of foreign bidders. The

recommendation is that the grounds for excluding foreign bidders, if any, should be specified in

the law. Once cleared by the Law Committee, these will be submitted to Cabinet. A

procurement manual is in draft but requires modification to simplify the procedures.

8 As per normal procedure, the draft regulations were reviewed by Cabinet to determine whether the substance of the

draft regulations reflects the approach the GoT intends to pursue. Cabinet then issued a decision to submit the draft

regulations to the Law Committee. By issuing this decision, Cabinet is effectively endorsing the substance of the

draft regulations. The primary function of the Law Committee is to assess whether the proposed regulations are

consistent with the existing legal and regulatory framework and standards, before the regulations are submitted to

Cabinet for final approval. As such, submission to the Law Committee is a clear indication that the Government

intends to pursue the substance of the regulations.

21

54. At a donor meeting in April 2010, the government saw merit in conducting a Public

Expenditure Review (PER) jointly with the donors in order to increase the efficiency with which

public resources are deployed. The Bank has offered to join this effort, and will discuss with

government and development partners on its potential contribution to the PER process. The Bank

stands ready to strengthen the dialog with the incoming administration on PEFM more generally

and anticipates building the engagement in these areas, should there be interest from the new

government in further assistance. It is anticipated that the increased engagement would form the

basis for a component of any subsequent DPO.

III. THE TONGA ENERGY ROAD MAP

55. Tonga‘s development strategy aims to improve the living standards and quality of life of all

Tongans. The current articulation of Tonga‘s development strategy is the National Strategic

Planning Framework (NSPF), whose vision statement, objectives and enabling themes were

approved by Cabinet in February 2009. Relative to Tonga‘s previous development strategies, the

NSPF takes a longer-term view of national development, framed in a 5-10 year time horizon. It

emphasizes the need to build a foundation for sustainable and lasting economic growth. To this

end, the NSPF takes a more strategic approach, focusing on the key determinants of economic

and social development in Tonga.

56. Maintaining and developing infrastructure to improve the everyday lives of the people of

Tonga is among the primary outcome objectives of the NSPF. The NSPF explicitly recognizes

that high-quality infrastructure underpins the competitiveness of enterprises and is a pre-requisite

for a thriving and successful economy. Under this objective, the government is committed to

strengthening and modernizing Tonga‘s infrastructure in order to reduce business costs and

facilitate access to markets.

OVERVIEW OF THE ENERGY SECTOR

Petroleum

57. Petroleum Supply. Petroleum is supplied to Tonga by two international oil companies, BP

and TOTAL, and a locally owned company, Uata Shipping, which supplies the Ha‘apai group of

islands. Both BP and TOTAL have onshore storage and distribution facilities on Tongatapu,

while BP also owns the storage facilities on Vava'u. TOTAL bought Shell‘s assets in 2006 when

Shell decided to exit the storage and distribution of fuel in Tonga and other South Pacific

countries.

58. The bulk storage and distribution facilities on Ha‘apai are owned by a local Tongan

businessman. The Government of Tonga‘s own fuel storage facilities on Vava‘u, which were

leased to Shell, fell into disrepair and are now closed. BP and TOTAL are active in the

Tongatapu ground product market (ADO, kerosene and gasoline), and BP is the sole supplier of

aviation fuels across Tonga. LPG is bulk supplied by Tonga Gas, (a subsidiary of Fiji Gas, 51%

owned by Origin Energy, Australia), and marketed and distributed onshore by the GOT‘s

Homegas Company.

22

59. Like other small Pacific Island countries, Tonga faces a long supply chain from the refinery

source. Products are shipped from refineries in Singapore (or sometimes Australia) to bulk

storage in Fiji via medium range (MR) tankers, based on TOTAL and BP's regional supply

schedules, and then trans-shipped to Tongatapu and Vava'u in local coastal tankers (LCT). Thus,

landed costs of product in Tonga have a relatively high freight component.

60. The outer islands are supplied with products trans-shipped through Nuku‘alofa. The Niua's

and 'Eua islands are normally the only areas for which main products (gasoline, ADO, and

kerosene) are supplied by drum. Drum distribution is more expensive than bulk distribution and

costs are compounded by the fuel losses through evaporation, leakage and drum decanting which

contribute up to 15% of total drum content.

61. Price regulation. The Competent Authority is empowered to regulate petroleum prices

under Section 5 of the Price and Wage Control Act 1988. The Tonga Competent Authority

regulates the retail price of petroleum products, using a pricing template originally developed by

the Pacific Islands Forum Secretariat. The pricing template builds up the retail prices by taking

the Singapore price for fuel, then adding on shipping and storage fees and wholesale and retail

markups. In effect, the average price for the next month is determined by fuel prices, shipping

rates and margins two months prior.

62. The pricing philosophy seeks to build petroleum prices for Tonga that reflect the actual costs

of buying fuels on the international market and the various costs of delivering that fuel to Tonga

and then distributing it across the country. This petroleum pricing approach is exactly the same

as the ‗import parity pricing‘, which is used in Australia and New Zealand, and is common

across the petroleum industry.

63. The pricing methodology is subject to annual, triennial and ad-hoc reviews. Every year the

pricing template is supposed to be reviewed, using a consultation process with the oil companies

and other interested parties. However, there was no annual review in 2008. The 2009 annual

review, completed in June 2009, was the first since May 2007.9 The 2009 review resulted in

number of significant adjustments to some of the parameters used to build up fuel prices.

Triennial reviews assess regional freight rate differentials, and the overall incentives for

continued investment in petroleum supply, storage and distribution. Ad-hoc reviews of the

pricing templates may be required to deal with issues such as changes in Duties, Taxes, or

Wharfage costs.

64. Wholesale and retail fuel prices across Tonga vary, reflecting the higher transport costs to

provinces distant from the main island, Tongatapu. However, in each province, a single price is

set regardless of supplier. Retailers have a 7% mark-up on the wholesale price. The wholesale

price incorporates a 15% return on investment for the oil companies. Retailers have expressed

concern to the Competent Authority about the adequacy of the 7% retail margin.

65. Safety regulation. Both BP and TOTAL state that they operate under international standards

9 Hale & Twoomey 2009, Tonga Petroleum Pricing Annual Review, prepared for the Tongan Competent Authority

(TCA) & Pacific Islands Forum Secretariat, TCA, Nuku‘alofa, June 2009.

23

for petroleum handling and storage and that their insurance companies require annual

independent safety audits of their facilities and safety processes. Both companies claim that

international standards are more stringent and specific than the very general safety requirements

set out in Tonga‘s Petroleum Act. The model for ensuring compliance with safety standards

appears to be one of self-enforcement by the oil companies, under the oversight of

internationally accredited and independent auditors.

Electricity

Grid-connected Electricity

66. The Electricity Act 2007 provides the governance framework for the grid-connected

electricity sector in Tonga. In accordance with the Act, the Electricity Commission was

established in 2008 as the regulatory agency for grid-based electricity supply. The Act defines

the role of the Electricity Commission in regulating the generation and selling of electricity, and

establishes the role of a concessionaire in producing and delivering electricity. The Act provides

the Ministry of Finance (MOF) authority to be a party in the Concession Agreement (CA)

between the Commission and the Concessionaire and to establish regulations to ensure effective

management of the electricity utility. The CA formed under the Act states the utility‘s operations

in comprehensive detail, including very specific details as to how the tariffs are calculated.

67. The ownership of electricity assets has changed twice in recent years, firstly in 1998 when

the national utility was bought by Shoreline Power10

and more recently in mid-2008 when GoT

bought the assets from Shoreline to create Tonga Power Limited (TPL) as a state enterprise

wholly owned by GoT. This latest ownership change was already being planned in 200611

before rioting in Nuku‘alofa resulted in considerable damage to buildings in the downtown area.

The riots damaged international confidence in investment in Tonga and GoT chose not to

proceed with its preferred option to sell the assets to private interests. Given the intention of the

Crown Prince to assume a constitutional monarchy soon after his coronation and withdraw from

commercial activities within Tonga, the Government concluded the agreement with the Shoreline

Group to purchase the utility in 2008.

68. There remains a strong interest to bring the private sector into the electricity generation and

supply business as evidenced by regulatory policy and the subsequent CA intended to ensure that

TPL remains financially viable and therefore potentially interesting to private investors.

69. The CA distinguishes fuel and non-fuel components of the tariff. Although the CA allows

TPL to treat the four island grids individually, in May 2009 TPL chose to standardize tariffs

across all grids and consumer classes. Tariffs are allowed to be adjusted every three months, the

latest being a 2.5% increase effective June 1, 2010. The non-fuel tariff component follows the

CPI, while the fuel tariff component is adjusted so that the Concessionaire recovers the permitted

10

The Crown Prince of Tonga held a major share in Shoreline Power.

11 A Conditional Agreement existed in 2006 to sell the assets and business to Northpower Limited of New Zealand

but the Conditions Precedent of the Sale and Purchase Agreement could not be met due to the destruction of the

Shoreline Corporate Office including all its records.

24

fuel costs12

. The CA requires that TPL earn a rate of return (currently set at 12.9 %) of its

Regulated Asset Value (RAV). TPL is required to submit capital expenditure plans to the

Commission for approval and the Commission can deny approval of a capital expenditure that is

not in line with a least-cost supply strategy. The overall tariff structure is designed to ensure that

the TPL operates using full commercial standards.

70. The value of TPL assets when the company was established in mid-2008 was approximately

TOP48.5 million (US$24.25 million). TPL has since revalued its assets downwards based on

depreciated replacement costs for network assets and on depreciated historic costs for other

assets. TPL currently has a US$6 million loan from a commercial bank for operating capital

scheduled to be fully paid by the end of 2013, coinciding with the first year when TPL is

expected to start paying dividends. In addition, TPL is paying off the balance of a loan from

Caterpillar Financial Services Corporation for the purchase of the MaK diesel-generator. The

audited financial statements for 2008/09 have been submitted to the Auditor General. Based on

information provided by TPL, in 2009 TPL made an after-tax profit, with a current ratio of 1.3

and return on equity of 12.9%.

71. TPL has the concession and operates four grids in Tonga: the largest on Tongatapu, and

three smaller grids on the main islands of the Vava‘u and Ha‘apai island groups, and on the

island of Eua. Table 6 shows the characteristics of the grid.

12

To calculate the permitted fuel cost in a given month, the demand for electricity is estimated. Target system losses

are then used to calculate the amount of generation that should be required at the supply efficiency target. From this

level of generation and permitted fuel conversion efficiency the liters of fuel that should be required under those

target conditions is calculated. Liters of fuel, multiplied by the fuel price, gives the permitted fuel costs. This

adjustment mechanism is designed to provide an incentive for the Concessionaire to work to meet the CA mandated

targets of fuel and system efficiency.

25

Table 6: Characteristics of the Four Island Electricity Grids, 2009.

Grid Installed

Capacity and

Peak demand

(MW)

Characteristics Customers

(end-2009)

% total demand

(2009)

Tongatapu Inst. cap: 12.680

Peak: 8.142

Eight diesel

generating units

at Popua Station;

transmission at

11kV.

14,650

86%

Vava�