Documentof The World Bank ReportNo: 25999 FOROFFICIALUSEONLY PROJECTAPPRAISALDOCUMENT ON A PROPOSEDLOAN INTHEAMOUNT OFUS$12.120MILLION TO THE FEDERATIVEREPUBLICOF BRAZIL FORAN ENERGYSECTORTECHNICALASSISTANCEPROJECT May 29,2003 Finance,PrivateSector and InfrastructureDepartment BrazilCountryManagementUnit LatinAmerica and CaribbeanRegion This documenthas a restricteddistributionandmay be usedby recipientsonly inthe performanceof their official duties. Its contents may not otherwisebe disclosed without World Bankauthorization. CURRENCY EQUIVALENTS (Exchange RateEffectiveMay 15,2003) CurrencyUnit = BrazilianReal R$l = US$0.33 US$l = R$3.00 FISCAL YEAR July 1 -- June 30 ABBREVIATIONS AND ACRONYMS AGU - Advocacia Geral da UniBo (Federal Govemment GeneralAtttomey 's Office) ANA - Agencia Nacional de Agua (Federal Water Regulatory Agency) ANATEL - Agsncia Nacionalde Telecomunicaqdes(Federal TelecommunicationsAgency) ANEEL - AgEnciaNacionalde Energia ElCtrica(Federal Electricity RegulatoryAgency) ANP - Agencia Nacional do Petr6leo(Federal HydrocarbonsRegulatory Agency) BNDES - BancoNacional de DesenvolvimentoEcondmico e Social (National Economic and Social Development Bank) CADE - ConselhoAdministrativo de DefesaEcondmica (Anti-Trust Agency) CAS - Country AssistanceStrategy CCPE - Comite Coordenadordo Planejamentoda Expando do SistemaElCtrico (Power SystemExpansionCoordinating Committee) CDE CEPEL -- Contade DesenvolvimentoEnergCtico(Fundfor Energy Development) Centro de Pequisas de Energia ElCtrica(Electricity Research Center) CGE - Ciimarade Gestgoda Crise de EnergiaElCtrica (Electricity Crisis ManagementChamber) CGSE - Ciimarade Gestgo do Setor ElCtrico (Electric Sector ManagementChamber) CHESF - CompanhiaHidro ElCtricado SBo Francisco (Hydroelectric Company of SBo Francisco) CNPE CNRH -- ConselhoNacional de Politica EnergCtica(National Energy Policy Council) ConselhoNacional de RecursosHidricos (National Water ResourcesCouncil) COEX/MAE - Comite Executivo do MAE(MAEExecutive Committee) COFIEX - ComissBode FinanaciamentoExtemo (External Financing Committee) COMAE - Conselhodo Mercado Atacadistade EnergiaElCtrica (Wholesale Electricity Market Council) CONAMA - ConselhoNacional de Meio Ambiente (National Environmental Council) COPPE - Programa de P6s-GraduaqBo de Engenharia da Universidade Federal do Rio de Janeiro (Graduate Engineering Programof the FederalUniversity of Rio de Janeiro) CPAR - Country ProcurementAssessment Review DSB DSM ------ Demand-sideBidding Demand-sideManagement EIA Environmental Impact Assessment ESFU Energy Sector Reform Loan ESTAL Energy Sector Reform Technical AssistanceLoan (this project) FERC FederalEnergy Regulatory Commission (U.S.) FMR - Financial ManagementReports FTR GOB -- Financial TransmissionRights Govemment of Brazil IBAMA - InstitutoBrasileiro do Meio Ambiente (Brazilian Environmental Institute) FOROFFICIAL USEONLY ICB International Competative Bidding IDB Inter-American Development Bank LOA Letter of Appointment L M P Locational Marginal Pricing MAE Mercado Atacadista de Energia (Wholesale Electricity Market) MAG MinistCrio de Agricultura (Ministry of Agriculture) MMA MinistCrio do Meio Ambiente e dos Recursos Renovaveis (Ministry of the Environment and Renewable Resources) MME MinistCrio de Minas e Energia (Ministry of Mines and Energy) MPO MinistCrio do Planejamento e Orqamento (Ministry of Planning and Budget) ONS Operador Nacional do Sistema (National System Operator) PPA Power Purchase Agreement PPIAF Private-Public Infrastructure Advisory Facility PROCEL Programa de Conservaqiio de Eletricidade (Energy ConservationProgram) PRODEEM Programa de Desenvolvimento EnergCtico de Estados e Municipios (State and MunicipalEnergy Development Program) PROWFA Programa de Incentivo 6s Fontes Alternativas de Energia (Incentive Program to Alternative Sources of Energy) PSR Project Supervision Report QCBS Quality and Cost-Based Selection Method RE-SEB Projeto de Reforma do Setor ElCtrico Brasileiro (Brazilian Electric Sector Reform Project) SEA Strategic Environmental Assessment SOE Statement of Expenses SPOA Sub-secretaria de Planejamento, Orqamento e Administrasiio (Sub-secretariat of Planning, Budget and Administration) STN Secretaria do Tesouro Nacional (National Treasury Secretariat) TCU Tribunal de Contas da Uni2o (Federal Court of Accounts) TOR Terms of Reference VN Valor Normativo (Normative Value) WEM Wholesale ElectricityMarket YPFB Yacimientos Petroliferos Fiscales Bolivianos (Bolivian Government-owned PetroleumCompany) Vice President: David de Ferranti Country Director: Vinod Thomas Sector Managermirector: Susan GoldmarkDanny Leipziger Task Manager: Nelson de Franco This document hasa restricteddistributionandmay be used by recipients only in the performance of their official duties. I t s contents may not be otherwise disclosed without World Bank authorization. BRAZIL ENERGY SECTOR TECHNICAL ASSISTANCEPROJECT CONTENTS A. Project Development Objective Page 1. Project development objective 2 2. Key performance indicators 4 B. Strategic Context 1. Sector-related Country Assistance Strategy (CAS) goal supported by the project 4 2. Main sector issues and Government strategy 6 3. Sector issues to be addressedby the project and strategic choices 21 C. Project Description Summary 1. Project components 22 2. Key policy and institutional reforms supported by the project 24 3. Benefits and target population 25 4. Institutional and implementationarrangements 26 D.ProjectRationale 1. Project alternatives considered and reasons for rejection 29 2. Major relatedprojects financed by the Bank andor other development agencies 30 3. Lessons learned and reflected in the project design 31 4. Indications of borrower commitment and ownership 32 5. Value added of Bank support in this project 32 E. Summary Project Analysis 1. Economic 33 2. Financial 33 3. Technical 34 4. Institutional 34 5. Environmental 35 6. Social 35 7. Safeguard Policies 35 F.Sustainabilityand Risks 1. Sustainability 36 2. Critical risks 36 3. Possible controversial aspects 38 G. Main LoanConditions 1. Effectiveness Condition 38 2. Other 38 H. Readinessfor Implementation 39 I.CompliancewithBankPolicies 39 39 Annexes Annex 1: Project Design Summary 40 Annex 2: Detailed Project Description 52 Annex 3: Estimated Project Costs 72 Annex 4: Cost Benefit Analysis Summary 74 Annex 5: Financial Summary 75 Annex 6: (A) Procurement Arrangements 76 (B)Financial Management and Disbursement Arrangements 82 Annex 7: Project Processing Schedule 86 Annex 8: Documents in the Project File 87 Annex 9: Statement of Loans and Credits 88 Annex 10: Country at a Glance 92 Annex 11:Energy Sector ReformLoan (ESRL) Summary 94 Annex 12: Improvementof Electricity Regulation and Market and System Operation Project 97 Annex 13: Brazilian Government Measures to Revitalize the Electric Sector 103 Annex 14: Environmental and Social Issues in the Power Sector: Context and Proposed Program 108 to Address Issues MAP(S) NIA BRAZIL Energy Sector Technical Assistance Project Project Appraisal Document Latin America and CaribbeanRegion PA9SS Date: May 29,2003 Team Leader: Nelson De Franc0 Sector Manager: Susan G. Goldmark Sector@): Generalenergy sector (100%) Country Director: Vinod Thomas Theme(s): Regulation and competition policy (P), Other Project ID: PO76977 Public sector governance (s) environmentand natural resources management (S), Other Lending Instrument: Technical Assistance Loan (TAL) ProjectFinancingData [XI Loan [ ] Credit [ ]Grant [ ] Guarantee [ 3 Other: For Loans/Credits/Others: Loan Currency: United States Dollar Amount (US$m): 12.12 Borrower Rationalefor Choiceof LoanTerms Availableon File: Yes ProposedTerms (IBRD): Variable-Spread Loan (VSL) Grace period(years): 5 Years to maturity: 15 Commitment fee: .75% Front end fee (FEF) on Bank loan: 1.00% Pavmentfor FEF: CaDitalizefrom LoanProceeds FinancingPlan(US$m): Source Local Foreign Total BORROWER I 8.00 I 0.00 I 8.00 BRD 5.01 I 7.11 12.12 rotal: 13.01 I 7.11 II 20.12 Borrower: FEDERATIVEREPUBLICOF BRAZIL Responsibleagency: MINISTRY OF MINESAND ENERGY Address: Esplanada dos MinistCrios Bloco U 70065-900 Brasflia, DF Brazil Contact Person: Carlos Augusto Hoffmann, Chief of Staff for the Executive Secretariat Tel: 55-61-319 52 11 Fax: 55-61-225 8767 Email: carloshoffmann@mme.gov.br EstimatedDisbursements( Bank FY/US$m): Projectimplementationperiod: 48 months Expectedeffectivenessdate: 10/01/2003 Expectedclosing date: 12/31/2007 A. Project Development Objective 1. Project development objective: (see Annex 1) The objective of this four-year Energy Sector Technical Assistance Loan (ESTAL) is to help ensure sustainable implementation of the Government's ongoing energy sector reform program, through technical assistance in specific areas, and by providing a mechanism for continuing dialogue with policy-makers about longer-term sector reform. This operation focuses on the power and gas sector, where there are more urgent reform needs. The hydrocarbons sector is also covered through some special issues on gas and to a more limitedway on oil, although the scope of institutional strengthening embodies all areas under the purview of the energy sector authority. The ESTAL would consist of five components, aimed at furthering reforms in five main priority areas identifiedby the Government: 0 Market development and regulation correcting problems with the regulatory system and with the wholesale and retail markets, with a view to providing the correct incentives for contracting and expansion inthe sector; 0 Benefits to the poor - increasingaccess to and affordability of electricity, natural gas and LPG, includingthrough tariff reformwith targeted, smart subsidies focusedon those who need most; 0 Environmental management - enhancing the sector's environmental framework, management capabilities, and licensing procedures; 0 Expansion planning - developing a strategy and methodologies for meeting future demand, integrating multiple sources of energy, as well as demandand supply sidepossibilities; 0 Institutional strengthening - enhancing the Government's capacity for policy-making, and its ability to implement reformmeasures, coordinate multiple initiatives, and monitor their progress. The ESTALelaboratedhere is part of an ongoing medium-term program of the Bank to Brazil's energy sector, in keeping with the Government's long standing vision of an efficient sector characterizedby a conducive environment for private sector investment and operations, as well as public oversight through policymaking and independent regulation. This program initiated in response to the previous federal administration's request for assistance following the 2001 drought-induced supply crisis in the power sector, which depends primarily on hydropower. In 2002, the Bank completed the US$454.55 million Energy Sector Reform Loan (ESRL). Still in 2002, the Bank started the preparation of this ESTAL, discussingpriority areas and agreeing on the scope of the assistance loan. As the attempt to include the Project in the 2002 national budget -- in time for effective use of its proceeds during the end of the administration term - did not materialize, continuation of the Project processing was left to the next administration, with its inclusion in the 2003 national budget. As it was felt at the beginning at 2002 that a gap would necessarily exist between addressing urgent needs and the effective start of the ESTAL implementation, the Bank obtained a grant from the Private-Public Infrastructure Advisory Facility (PPIAF) to bridge such gap. These PPIAF funds were used to provide short-term support in specific issues key to the revitalization of the reform such as tariff setting/assetvaluation, assessment of ANEEL roles and relationship with sector players, auction of the energy (old energy) under the Initial Contracts (vestedcontracts set at the beginning of the reformprocess), and pass-throughof energy costs. As the current federal administration and the Bank resumed processing of the ESTAL, it offered an opportunity to fine-tune the scope of work based on revised priorities in the energy area now being established. ESTAL should serve as a vehicle to continue the dialogue between the MME and the Bank, as well as to support the Government in the implementation of second-level energy sector reforms. Outcomes from ESTAL funded activities will likely be available in early 2004 and will continue until end 2007 (see Chart 1 below). ESTAL could lead to additional Bank assistance. To bridge the gap and - 2 - provide funds betweennow and the beginning of 2004, the Bank is now trying to obtain additional funds from PPIAF, which will helpthe Governmentaddress some immediate issues such as the alternative pool arrangements ,alternative uses for natural gas, organization of the planning function and follow up on recommendationsrelated to the ANEEL's institutional assessment mentioned above. The exact scope of this second PPIAF grant is currently being discussed with the Government and with PPIAF administration. ,..~I..___....I" - I. . . Chart . . . 1.Energy.I__._._...I____- ReformOperations,2001 2007 Sector - I! I! ... 2001 II 2002 2004 2005 2o06 2007 I ! reforms in: ESRL June 2001 -December 2002 .Market developmentand ........... regulation 1 (Approved 06/02) -Access of the poor [I.= First Results .Environmental management -Long-term planning Studies for second-level forms j i ~ PPIAF I Proiect - Januarv 2002 - March 2003 , -Market development and reaulation (Approved04/02) A=06/02 ' miccess of the poor 1 Workshops wfth stakeholders to. iI -Discuss results of studies ] 1ir. A=04/02 !1; experienceconsensus -Draw lessons from international ESTAL - Januarv 2002 - December 07 -.Building JI/V .... .. ..-i (Approved 06/03 First Results 01/04) iil lmplementabonof second-level reforms /n -Market development and regulation -Access of the Poor i -Environmental management A=06/03 - - .Long-term planning mlnstitutionalstrengthening FR=OI/O# _ _ I . I II I_ Studies for Second- 1 levelreforms =Poolarrangements PPIAF Proiect II- April 2003 - December 03 -Regulation -Natural Gas Market -----.-p A=06/03 -Energy planning - 3 - 2. Key performance indicators: (see Annex 1) Indicators of the project's achievementswould be closely linked to its overall progress in meeting Brazil's goals for the electric sector reform adjustments. The ultimate indicator for the success of the program is an adequate and sustainable energy supply without rationing. The indicators for eachoutcome would be as follows: A competitivepower market that includes opportunitiesfor a level-playing field private sector participation has been developed Increasedprivate sector investments andreducedmarket concentration. Modern energy sources are available hnd aflordable to poor Higher percentage of poor have access to, and can afford, modern energy services, including electricity, natural gas and LPG. Environmental sustainability of power sector is ensured Environmental concerns are estimated at project concept stage, licenses are granted in a timely manner, and incentives are inplace to internalize environmental responsibility. Long -term expansionplanning is an establishedprocess Long-term expansion plans, cyclically updated, are available and guide private sector investment decisions. EfSectivepolicy making and implementation capacity exists Energy and related environmental policies, regulations and procedures are designed and implemented through joint coordination by Government ministries, agencies and regulators, and are effective to foster competition, sustainability and increased private participation. 6. Strategic Context 1.Sector-related Country Assistance Strategy (CAS) goal supported by the project: (see Annex 1) Document number: CASDocument: 22116-BR,dated03/06/00; ProgressRepork22116-BR,dated 05/01/01 Dateof latest CAS discussion:05/01/01 The 2000 Brazil CAS and the 2001 progress report emphasize support for continuing structural reforms to address the key objectives of fiscal stability and renewed growth, while helping to meet Brazil's external financing requirements. The recent energy crisis, which reduced GDP growth by an estimated one percentage point in 2001, clearly illustrates the adverse macroeconomic impact that can result from failure to implement energy sector reforms adequately. Brazil will remain vulnerable to similar drought-induced crises, unless the underlying institutional and regulatory issues are addressed so as to enable a more responsive market and advance more efficient investment indiversified capacity additions. - 4 - Consistent with the CAS, the Bank has been responding to the energy crisis by designing a package of assistance which includes the ESRL (already disbursed), and the first PPIAF funded program. Both, which took place in 2002, helped Brazil implementkey immediate changes inthe regulatory framework necessary to attract further private investment. The proposed ESTAL focuses on longer term support to the agencies responsible for implementing these changes, and has been designed to complement the ESRL and its major objectives. A similar approach has been successfully adoptedin the financial sector, where an adjustment operation (Loan 7053-BR) was accompanied by a technical assistance project designed to support the implementation of the reforms in the context of a medium term program of Bank assistance. The ESRLcontributed to related sector and macroeconomic objectives and helped Brazil to meet its US$ 50 billion external financing requirements (some US$ 4 billion of this total were met from public sector sources including multilateral disbursements). At the sector level, the fulfillment of the conditions set forth by ESRL demonstrated GOB commitment to the reforms. In the longer term, the sector and macroeconomic objectives of the ESRLwill converge, as the power sector reforms are intended to promote economic growth, thereby easing external financing requirements. On the basis of the importance of the energy sector for growth, poverty reduction and environmental protection, and given the reform progress achieved by the Government of Brazil in 2001 and 2002, the Bank has confirmed that the sector is a priority area for longer-term assistance, including possible further programmatic lending, subject to the continuation of a quality sector dialogue and achievement of the reform goals supported by the ESRLand ESTAL , Links to Poverty Reduction By helping create the conditions to remove the power generation bottleneck, the ESTAL would contribute to renewal of broad-basedeconomic growth - the prerequisite to poverty reduction, as articulated in the CAS. Assured power supply i s especially crucial for poor northeastern Brazil, which was also the region most affected by the power crisis, given its over-dependence on a single hydro resource. The nine northeastern states are home to almost two thirds of Brazil's poor, and have an average poverty rate of 48%, more than twice the national average. From 1998 till 2001, the region suffered its worst drought in 70 years, with rainfall levels in 2001 less than 20% of the long-term averages (compared with 30-60% in the Southeast). While the 2001 drought was exceptionally severe, droughts are a recurring phenomenon, especially in the Northeast. In addition, by addressing the deficiencies in the current regulatory framework for low-income urban tariffs and expanding rural electrification, the operation would promote access by both urban and rural poor to affordable electricity services. Links to Environmental Protection The CAS points out that environmental management needs to become an integral part of Brazil's - 5 - overall development strategy, focusing on environmental policies that help reduce poverty and are compatible with economic growth. It notes approvingly that GOB'S environmental strategy emphasizes (a) using more economic instruments instead of command and control, (b) decentralizing environmental management, with accountability, both to lower levels of government and to sector agencies, (c) greater participation of the private sector and (d) mainstreaming of environmental concerns. The ESTAL environmental emphasis is consistent with this. Its objectives include building up environmental expertise in sector agencies, getting private firms to internalize environmental considerations, and mainstreaming environmental impacts in expansion planning. 2. Mainsector issues and Government strategy: Brazil is at a crossroads in its energy policy. The incomplete reform in key areas of the energy sector (market development, regulation, environment, planning, institutional strengthening) set the stage for the 2001 power crisis, in which institutions were unable to respond to unforeseen shortages. That crisis, in turn, created the political will to address system failures. During the crisis and its aftermath, the former administration has remained committed to its vision of a competitive power sector, characterized by private sector operating and investment decisions, and public oversight through policymaking and regulation. The current administration also believes that the reform process i s not complete, and that some of its key aspects need to be revised, particularly on how to promote the correct signals and incentives for contracting and expansion. There i s also a general belief that the Government has to play a stronger role in planning, coordination and, if necessary, being the provider of last resort, given the public service nature of electricity services. The current administration would like to revisit some of those aspects through the technical assistancefacilitated by the proposed Project. Despite the incomplete reform in the energy sector, Brazil also made considerable progress on the environmental and social aspects of the sector. Regarding the environment, the basic framework i s sound, although the licensing process and planning methodologies need to be adjusted to the new sector structure, and to requirements for integrated water resources management established by the 1997 National Water Resources Policy Law. In addition, institutional mandates need to be clarified, especially with regard to environment aspects of longer-term expansion planning. Capabilities also need to be better aligned with responsibilities; and emerging issues (global warming, environmental services, corporate responsibility, etc.) need to be addressed. Inthe social sphere, Brazil has donereasonably well inexpanding access to power, but needs to develop more consistent policies toward achieving universal service, especially with regard to definition and eligibility of lifeline tariffs or subsidized prices for electricity, natural gas and LPG. Those should be pursued in an integrated fashion, to avoid perverse incentives for inter-fuel competition. Until 1995, Brazil hadacentralized, predominantly public sector power system, with most generation and transmission owned by the Government through its holding company, ELETROBRAS (and its four regional subsidiaries: ELETRONORTE in the north, CHESF in the northeast, FURNAS in the southeast, and ELETROSUL inthe south); and by about half a dozen - 6 - state companies. ITAIPU,ajoint Brazilian-Paraguayan hydro undertaking, supplied about one fourth of the southeasthouth demand through FURNAS and ELETROSUL. Almost all of the distribution companies were owned by the individual states. In 1995, to establish a modem, competitive, more efficient private sector-operatedsystem, the Government initiated a major power sector reform, with support from Loan 3376-BR for design and implementation. The major achievements of that effort, oftentimes referred as RE-SEBProject, included: (a) a well-crafted blueprint for the reform, encompassinginstitutional, regulatory, and commercial aspects; (b) privatization of 23 percent of generation assets and 64 percent of distribution assets; (c) creation of a National SystemOperator (ONS), which assumedresponsibility for central cost-baseddispatch for the interconnected system; (d) creation of a Wholesale Electricity Market (MAE); and (e) creation of a new federal electricity regulatory agency (ANEEL).But after these initial successes, the reform lost momentum, for two main reasons. First, there was a lack of commitment and coordination on the partof the Government. And second, there was strong resistance to the reform by: (a) major regional utilities, which did not want to lose control of such economically and socially significant operations; and (b) political leaders inthe areas where the utilities were located, who did not want to lose the political influence on many fronts of the utilities' business. Furthermore, there was little sense of crisis, despite warnings that the lack of investment, non-completion of market reforms, and progressive depletion of hydro reservoirs were puttingthe power sector operations at risk. As a follow-up to the assistance provided at the inception of the reform, the Bank planned with the MME to provide a US$300 million loan to enhance the transmission system in some critical areas, and to strengthen the Ministry and the new electricity sector institutions. However, the proposed loan, as well as an associated loan from the Inter-American Development Bank (IDB), never came to fruition. This was due inpart to the financial market crisis of 1999, which caused the Government to shift its priorities. Also, the Government believed that the electricity sector reform was on track. As a consequence, continued Bank support to the power sector, as well as support from IDB, was not deemed critical, and the dialogue between the Government and both donors lost intensity. Furthermore, the politically charged issue of privatization of federally owned generation assets was an obstacle to a serious breakthrough in resuming the reform dialogue. Duringthis time, the Bank and IDB focused their attention on the hydrocarbons sector, by financing the implementation of the Bolivia-Brazil gas pipeline and supporting other measures to spur fuel liberalization. Imported natural gas from Bolivia indirectly helped the electricity sector by providing a clean, abundant, and relatively cheap fuel to support a thermal plant expansionprogram. Despite these achievements, the power sector remained, for a few years, in the dangerous position of no longer being centrally planned, while lacking the complete framework for a competitive market to fully substitute for the prior system. Among other problems, adequate incentives had never been established for expansion of thermal generating capacity, to provide insurance against the risk of water shortages in the predominantly hydroelectric generation system. By mid-1999, when a crisis seemed imminent, Brazil's attempt to promote the priority construction of thermal power plants had little concrete results. Private companies were reluctant to invest and unable to raise the necessary funding, while distribution companies were afraid to conclude long-term purchasepower agreements (PPA), given the regulatory uncertainties relating - 7 - to contract indexation clauses, foreign exchange risk, pass-through issues such as the generation price cap (known as Valor Nomzativo-VN),transmission cost volatility, and the non-functioning of the wholesale market. This lack of such insurance became very costly when Brazil was hit in 2001 by a severe drought, which sharply limited its ability to generate power. Once the dimensions of the problem became clear, the Government acted rapidly and effectively to minimize the damage through a well designed rationing program, and to prepare measuresboth to reduce the risk of future shortages and to complete the reforms aimed at improving efficiency and expanding coverage. The Government declared a crisis in May 2001, and introduced rationing of electricity to 80 percent of the previous year's May-July consumption levels from June 2001 untilMarch 2002. Most of the specific issues discussed below can be linked to the non-completion of the reform process and the resulting energy crisis. These issues were discussed in the context of a diagnostic of the crisis in July 2001, by a high-level committee of experts commissioned by the Electricity Crisis Management Chamber (CGE); and of a February 2002 CGE White Paper proposing 33 reform measures addressing the sector institutional, market, regulatory, environmental, and social weaknesses. The electricity crisis has thus provided the momentum for a second, more complete round of reform adjustments. The Bank was asked by the Government to assist in this endeavor, as indicated in A.1, Project Development Objectives. Several of the issues discussed below can be understood better by looking at the previous, presentand proposed long-term structure of the sector, as shown inthe following chart: - 8 - The evolving si icture of the Brazilia energy sector Pre 1995 Current Situation Long Term Vision Gas supply Publicly owned vertically Legally open access to Petrobrhsfaces effective integrated monopoly, exploration, transportation competition inexploration, Petrobrhs, responsiblefor and bulk supply activities, transportation and bulk exploration, transportation but in practicePetrobrhs supply, with open access to and bulk supply. continuesto occupy a existing pipelines and dominant position. rights of way. Publicly owned state Some state distribution All state distribution companiesresponsiblefor companieshave been companies have been distribution. privatized. privatized and the supply infrastructure expanded Generation Publicly owned, vertically 23% of generation Public and private integratedfederal capacity inprivate hands, companies operating on a companies, for generation but marketcontinues to be level playing field. and transmission. dominatedby vertically integrated Competitive markets, with ELETROBRAS effective control on subsidiariesand Petrobrhs generators' market power joint ventures. Transmission All publicly owned, Publicly owned, Multiplecompanies vertically integrated vertically integrated-three competing for new federaland state federal and three major transmission concessions. companies, for generation state- companies for andtransmission. generationand Independentnon- transmission, operating discriminatory operation of underan independent the power system. systemoperator. Distribution Publicly owned, mainly 64% of the market is in Privately operated. state companies, with private hands, but vertical Separationbetween some vertical integration, integration persists. distribution and including generation, commercialization transmissionand activities. 3istribution. Expand electrification to achieve universal access. 2.1 Institutionalframework for policy and crisis management The crisis revealed major flaws in the institutions responsible for overseeing the implementation of the new sector model - the inter-ministerial National Energy Policy Council (CNPE), the Ministry of Mines and Energy (MME),the electricity regulatory agency (ANEEL), the National System Operator (ONS) and the Wholesale Electricity Market (MAE). As the energy supply situation worsened gradually from 1998/99, making the crisis foreseeable, none of these institutions had the full information, capacity, incentives or clear legal mandate to address the situation. Until the reforms, most planning and, de facto, even policy-making was undertaken under the initiative of ELETROBdS. However, following the progressive reduction in the mandate of - 9 - ELETROBRAS in 1998 and 1999, this body of expertise was largely dispersed, without a corresponding increase in the capacity of the Secretariat of Energy within MME. Due to the recognition that policy formulation should involve key central ministries in addition to the sector one, CNPE was established by law in 1997 as an inter-ministerial body, to advise the President on matters relating to energy policy; however, it only became operational after th ecountry was hit by the rationingcrisis. The crisis revealed major flaws in the institutions responsible for overseeing the implementation of the new sector model - the inter-ministerial National Energy Policy Council (CNPE), the Ministry of Mines and Energy (MME), the electricity regulatory agency (ANEEL), the National System Operator (ONS) and the Wholesale Electricity Market (MAE). As the energy supply situation worsened gradually from 1998/99, making the crisis foreseeable, none of these institutions had the full information, capacity, incentives or clear legal mandate to address the situation. Until the reforms, most planning and, de facto, even policy-making was undertaken under the initiative of ELETROBRAS. However, following the progressive reduction in the mandate of ELETROBRAS in 1998 and 1999, this body of expertise was largely dispersed, without a corresponding increase in the capacity of the Secretariat of Energy within MME. Due to the recognition that policy formulation should involve key central ministries in addition to the sector one, CNPE was established by law in 1997 as an inter-ministerial body, to advise the President on matters relating to energy policy; however, it only became operational after th ecountry was hit by the rationingcrisis. Given the urgency to implement a rationing plan, GOB created a temporary high level commission, the CGE, headed by the President's Chief of Staff and made-up of senior representatives of the Ministries of Mines and Energy, Finance, Planning, and Environment, the National Economic and Social Development Bank (BNDES), the Federal Attorney General (AGU), ANEEL, and ELETROBRh. The CGE was charged with overseeing the immediate response to the crisis, diagnosing its underlying causes, and identifying the reforms necessary to prevent a repetition of the problem; it has proved to be both efficient and effective in discharging these functions. In mid 2002, CGE was replaced by the Electric Sector Management Chamber (CGSE), coordinated by the MME, which has been operational ever since. The CGE moved swiftly to introduce an incentive driven, market-based rationing program, thereby avoiding the need for much more damaging rolling blackouts. As insurance against further rationing in the 2002 dry season, the CGE also organized the contracting of a combined 2 GW of thermal plants for periods of two to three years. Finally the CGE put together a US$ 4.6 billion compensation package to resolve pending contractual and financial disputes raised by generatorsand distributors as a result of the rationing. The CGE also established a high level revitalization committee for the electric sector, in charge of identifying deficiencies in the regulatory and institutional system and proposing corrective measured.The CGE set itself an ambitious target of addressing 33 reform measuresby the end of 2002. Some of them required changes the legal framework. PPIAF supported the government in - 10- some of the critical tasks. Not all measures were addressed, but some important ones were implemented, with tangible results, such as: e Regularization of some contractual disputes which were plaguing the proper operation of the MAE, such as Annex V of the Initial Contracts and Itaipuexcess energy; e Establishment of an auction mechanism for the re-contracting of the first tranche of energy to be made available inJanuary 2003, due to the first decline of the Initial Contracts; e Enforcement of new regulations governing the purchase of power by distribution companies via competitive biddingand ensuing pass-through criteria; e Identificationof regulatory gaps inthe previous, "swiss-cheese" like regulatory framework, proposing concreteactions (Laws, and other infra-legal regulations) to bridge those gaps; e Creation of programs to foster the development of non-conventional sources of energy (PROINFA and CDE), to provide incentives to the universalization of the electricity service, and criteria to establish life-line rates. Enactment of specific legislation to foster energy conservation and efficient use of electricity; e Operationalization of the Electricity Wholesale Market, which startedfunctioning in early 2003, after a delay of several years, and has beenoperating smoothly ever since, under current administration. To implement several of these actions, 4 major Laws, several Decrees and a series of supporting regulations were enactedin2002. These are summarized inAnnex 13. Despite its undesirable consequences, the rationing served as a sort of wake-up call to the Brazilian Authorities, serving to underscore the importance of the electric sector as a key factor for growth and sustainable development. Current administration i s perfectly cognizant on the importance of this sector and i s fully engagedinputtingthe sector back on its feet. The new administration faces important challenges: Despite the benefits brought up by the rationing, in terms of energy efficiency rationalization and demand side actions, there has been a spillover effect on the profitability of sector, particularly indistribution. Current consumption levels are now at par with levels observed in 1998-1999, on a volumetric basis. Internal cash generation for the distribution business has fallen, as well as its ability to serve an increasing US$ denominated debt. To aggravate matters, ANEEL has started a process to review tariff levels for most utilities, which will likely imply transferring productivity gains achieved in the last few years back to the customers. While the process is legitimate, and has been carried out professionally, it further strains the financial condition of the distribution utilities; Second, generation companies are also facing a particularly difficult moment. Those plants -11 - with long positions in the market (either becauseof the decline of Initial Contracts or because of their merchant nature by default) are selling their excess energy at a low spot prices, therefore also experiencing a reduction in their revenues. Due the modest level of retail competition in the sector, there i s not an automatic mechanism whereby the industrial sector can benefit from this cheap energy, by increasing its production and consumption levels. It will be a real challenge for the new administration to manage this temporary financial crisis. There is a key trade-off to be made between keeping the lights on and at the same time not diverting socially necessary government funds to provide a generalized bail-out to the industry; 0 Third, there are still many regulatory and institutional aspects which remain open, despite the effort made post-rationing crisis, and despite the laudable efforts of the current administration inthinkingthrough those issuesingreat detail, as part of President's Lulapolitical campaign. The new administration agrees that some aspects of the reform were never completed such as the development of planning and coordination capabilities, particularly those affecting the Ministry of Mines and Energy. The new administration also believes that some of the basic pillars of the reform deserve to be revisited, the most important of which being: (i) organization of the bulk generation market, with the consideration of possible new pool arrangements, (ii)the treatment of generation as a public service, (iii)prioritization of expansion of the power sector based on hydro plants, (iv) a cost-effective solution to the volumes of gas already committed and to the use of the infrastructure already in place. There are some ideas, still at blueprint stage, which need to be detailed and worked out. ESTAL should help the Government analyze those concepts in more depth, by bringing valuable international experience, and by discussing how they have to be adjusted to provide the corrective incentives for contracting and expansion of the power sector, on a sustainablebasis. 2.2 Frameworkfor expansionplanning Prior to the reform, Brazil had a well-developed, centralized system for expansion planning, led by ELETROBaS. The reform reduced the public sector's responsibility and capacity for generation expansion; however, due to various impediments to private sector investment in generation, it was never really replaced by a market-based system. Given this new environment, GOB set up the Power System Expansion Coordinating Committee (CCPE) in 1999, under the Secretary of Energy within MME, representing all the major stakeholders. It is responsible for producing 10-year expansion plans for generation and transmission. However, unlike ELETROBRAS, the MMEdid not have (and still does not have) the necessary cadre of high quality permanent staff to exercise leadership in the CCPE. The MMEhas sought to offset this shortcoming by borrowing staff from the ELETROBaS group and other utilities, but the CCPE has yet to become fully operational. There are several issues regarding the preparation of river basin inventories, feasibility studies, and basic projects, which need to be addressed as part of ESTAL. Currently, ANEEL i s responsible for preparing the inventories and feasibility studies, which are legally mandatory requirements for the granting of hydro concessions. ANEEL has been hiring special consulting - 12- firms to develop those studies; those firms are paid for the services provided when the concession i s granted, and the winning bidder reimburses the consulting firms for those studies. This mechanism has worked satisfactorily so far, but allegedly it biases the inventory studies towards the most attractive basins and projects - the ones which will certainly be put out for bid and consultants will be reimbursed. Current administration believes that it would make more sense to internalize many of the study costs within the government, to have a broader and more accuratepicture of the hydro resourcesavailable for development. Another issue raised by current administration i s to have the environmental license granted before the hydro concessioni s put for bid (please refer to section 2.12). A recent resolution from CNPE has established that this procedure should be effective in 2004. There are several issues to be discussed and agreed before its implementation. The first i s what i s the level of detail of the quasi-basic project that will meet environmental authority requirements to license the project. The second i s that government does not want to limit, by any means, the developer's creativity to make improvements in the project down the road, to make it more attractive and to minimize the environment impact. However, the current level of detail contained in the feasibility studies does not allow IBAMA to issue the environmental license. There i s a clear trade-off to be made and more government resources will be necessary to carry out more detailed studies. Current administration understandsthat there are benefits interms on "internalizing" those costs, interms of reducing uncertainties and expediting the construction process. ESTAL should support the government to address those challenges. There i s also ambiguity of jurisdiction and inadequate coordination in policy-making and regulation between the power sector and the water sector with regard to hydroelectric plants, including environmental & social dimensions. The National Water Resources Council (CNRH) and the Federal Water Regulatory Agency (ANA), in line with the 1997 National Water Resources Policy, have overall joint responsibility for planning and licensing multiple uses of water that affect more than one state, but their roles overlap those of CCPE and ANEEL with respect to water use inthe power sector. These institutional issues have hindered the expansion of hydroelectric capacity. The available pipelineof projects will need to be revisited soon, because: i)ad-hoc granting of individual hydro projects without a thorough study of the complete basin or even of the cascade may not optimize generating capacity; ii)there i s a need to have a significant number of hydro sites ready to be auctioned to support demand expansion; and iii)multiple use of water resources, and environmental and social impacts have gained importance. It i s urgent that responsibility for river basin inventory work be clearly assigned, funds provided on a sustainable basis, methodologies updated to fully incorporate environmental, social and multiple use costs and benefits, and mechanismsfor institutional cooperationput inplace. 2.3 Technical capacity across sector agencies The reform of the power sector shifted responsibilities, but did not automatically move the personnel with experience in carrying out those responsibilities. This is particularly true with respect to roles shifted from ELETROBRAS to MME. For example, the Environment Coordination Unit of MME's Energy Secretariat currently has only two high-level staff. The -13- technical capability in environmental and social issues developed by the sector over the past two decades represents a tremendous investment in human capital. It i s still largely available, and could be realigned under the new model. ELETROBRAS and BNDES, on the other hand, have considerable environmental expertise. As potential investors and financing agents of power system expansion, they could have a prominent role in assessing environmental and social risks and mitigation in projects and programs in which they are likely to be involved. The situation i s similar with respect to expansion planning, where ELETROBdS, its subsidiaries (CHESF, FURNAS, ELETRONORTE) and a few state companies still have most of the expertise, even though the responsibility now lies with CCPE within MME. 2.4. Role of ANEEL Established in 1997, ANEEL rapidly became a key player in the energy sector, but has been affected by a number of institutional designproblems. First, due to the weaknesses of MMEand CNPE, ANEEL i s over-burdened with functions that could be exercised elsewhere, such as drafting new regulations or enforcing them country-wide, or that are inappropriate to a regulatory agency, such as preparing tenders for and awarding concessions, and carrying out hydroelectric inventories. Besides, due to the fact that CNPE has not become operational, ANEEL has preempted some of its policy-making roles, thereby blurring the boundaries between policy-making, planning and regulation. Second, there i s no effective appeal system (other than the slow and cumbersome ordinary judicial process) that allows operators to challenge ANEEL's decisions. Third, the relative jurisdictions of ANEEL and the competition agency (CADE) for dealing with anti-trust issues in the power sector are still unclear. Fourth, although ANEEL's operations are supposed to be governed by a performance contract with GOB, which sets out, inter alia, performance standards, this has never been used as an instrument for assessing and improving ANEEL's performance. As an outcome of the PPIAF Project, it was recommended that a more efficient vehicle for monitoring ANEEL (and other agencies) could be an in-depth assessment of the institutional responsibilities, carried out on a regular basis, such as every 2-3 years, and by an independent party. And fifth, unlike the telecom regulator ANATEL, which has regional branches, ANEEL is centralized in Brasilia. This makes it extremely difficult for it to deal with the large volume of consumer enquiries and complaints. One of the most serious immediate issues is that there i s no mechanism for ensuring consistency between decisions taken by ANEEL and the Federal Hydrocarbons Regulatory Agency (ANP). This is a significant problem, because the rigidity of gas supply contracts, together with the absence of a secondary gas market, has seriously jeopardized a seamlessintegration between hydro and thermal resources,therefore hindering the development of new thermal power generation. ANP was createdin 1997 as the regulatory institution for the hydrocarbons sector (after considerable debate about whether ANP and ANEEL should be a single agency). A seamless treatment of the interfaces between the gas and electricity markets i s still important to be achieved, in order to reach the desired natural gas-electricity convergence. 2.5 Competition in generation A central objective of the reform was to introduce competition in generation; however this goal - 14- has proved elusive. Most seriously, the reform failed to resolve the structural problems of the generation sector. Although the new legal framework mandated vertical unbundling of electric utilities, and encouraged subsequent privatization, progress has been limited. Vertically integrated ELETROBRAS subsidiaries continue to control about 60% of generation capacity nationwide, and as much as 90% in the North and Northeast sub-markets. This situation is likely to remain, given current administration's stated objectives of not carrying out the privatization program any further. Current administration i s also considering the implementation of a different pool arrangement, including a single buyer pool, which, depending on its final configuration, may be the single or major owner of all the energy produced by federally owned plants, therefore aggravating concerns on market concentration. Great care has to be taken to guarantee that the single buyer (or whatever format i s agreed) does not jeopardize the proper functioning of the market. A further structural problem impeding competition is the cross-ownership among both private and public generators and distributors, leading to a significant amount of self-dealing in long-term power purchase agreements (PPAs). It i s also possible to handle self-dealing issues by obliging distribution companies to procure a significant part of their energy needs via competitive procurement mechanisms (auction being one of them). As recommended by the PPIAF Project, the price deriving from those bids should also be used as a basis for pass-through purposes, gradually substitutingthe artificially set Normative Value (VN). 2.6 Revisingincentivesfor thermal generation Brazil's geography makes hydroelectricity generally a cheap option for power generation, if financed at reasonablylow costs of capital. Thermal generation, which has lower unit investment costs but much higher operating costs, has traditionally been used only in isolated systems, to provide a little extra capacity to protect against water shortages, and in a limited way through specialized units for peak demand. The former government tried to pushingBrazil to increase its thermal capacity, but results were short of initially stated goals. Reasons for encouraging the development of natural gas were multiple. First, natural gas produced domestically or piped from Bolivia could provide a clean and, for most locations, cheaper fuel than coal. Second, the private sector generally considers it easier to develop thermal rather than hydro power, because the latter requires lumpier investments and may have serious geological and resettlement complications that thermal plants to a large extent can avoid. And third, the recent crisis and the resulting greater appreciation of the risk of further droughts increased the desire to have the insurance of extra thermal generation capacity. However, the level and structure of the current pricing system made it unattractive to finance new thermal plants. Natural gas could only be obtained through quite restrictive `dollarized' take-or-pay contracts offered by Gaspetro (Petrobris' subsidiary), which i s still the sole significant importer of natural gas and which continues to dominate the upstream market for gas supply. In addition, due to the low opportunity cost of water for most of the operation of hydroelectric plants, thermoelectric plants are expected to be only occasionally dispatched, and the resulting income stream were inplace. But distribution companies were reluctant to sign new PPAs, due both to the uncertainties of the existing pass-through mechanism, and to their lack of - 15- familiarity with the new market environment, under which they were fully accountable for the energy to be supplied to their customers, and should purchase any shortfalls in the wholesale market. Additionally, and contrary to many other countries, Brazil had no explicit payment for capacity, which often serves as an extra incentive for developers to install new thermal plants to provide reserves (or an insurance) to the system. This subject i s still being discussed, as part of the overall wholesale market rules. The new administration wants to take a fresh look at those issues. It has clearly stated that hydro development should be the priority for expansion. However, it i s also cognizant that there is an entire pipeline infrastructure and significant volumes of contracted gas which will remain idle if the thermal program is abandonedcompletely, unless news uses for the natural gas can be found in the short term. ESTAL should help the Government deal with those aspects and expand the power system at minimum cost, taking into account long term priorities and the reality of the existing infrastructure. 2.7 Functioning of the wholesalemarket MAE failed to reach financial closure on a single transaction since its inception in September 2000 until January 2003. Failure was due to a series of financial and contractual disputes, mostly between generators and distributors (such as the delay in commissioning of the Angra I1nuclear power plant, imports from Argentina, a capacity contract between Furnas and CuiabB I,the buy-back energy during the rationing period, and lastly, the entitlement to the energy generated by Itaiputhat exceeds the nominal supply contract values). Those disputes were largely due to the lack of sector expertise in preparing and enforcing power contracts, which are meant to be a vehicle to assign and price risks among parties. Those disputes impacted market operations as a whole. Resolving those disputes was beyond the scope of MAE, an organization mainly intended to measure energy amounts and settle contract differences according to an agreed set of rules. In many instances, those disputes involved several government agencies and there was not a good level of coordination among those to clearly specify the property rights and energy entitlements embedded ineach contract. MAE also had governance problems, which have prevented it from finalizing the market rules and implementing the necessary accounting and settlement systems in time to support trade. In particular, MAE had a large, unwieldy stakeholder board (COEX), which had difficulties in reaching consensus, as well as a tendency to intervene in the day-to-day operation of the market. MAEalso sufferedfrom the absence of an adequatemechanism for resolvingdisputes among its members regarding the interpretation of market rules and procedures, and thus has failed to be self-regulating as was originally conceived. ANEEL intervened in MAE, reducing the size and changing the composition of its board to five independent members. Criteria for selection o f the future MAE board members on the basis of professional qualifications and neutrality need to be formalized. 2.8 Transmissionand distributionpricing There have been problems with the regulatory framework for controlling prices in the - 16- non-competitive transmission and distribution segments of the market. Distributors have complained that they were not being allowed to pass through changes in uncontrollable costs which include taxes, levies and special charges, and currency devaluation for the power from Itaipu, as well as regulatory lags for the cost of energy purchased under Initial Contracts. For their part, generators have complained that the regulatory price cap for the pass-through of energy purchased under new long term contracts (VN) was significantly below the true long run marginal cost of buildingnew thermal plant, and that the methodology used to change the levels of the price caps was non-transparent, which diminished their interest in signingnew PPAs. The distribution concessions call for tariffs to be reviewed every three to five years, depending on the contract. The first such review, of ESCELSA (the distribution utility for the state of Espirito Santo, which was the first distributor privatized, in 1995), and the debate over the ongoing tariff revision process, have shown that the existing legal framework provides ANEEL with very little guidance for setting distribution tariffs. There were major methodological gaps, including lack of procedures for determining the value of the capital base, the weighted average cost of capital, and the productivity factor (factor X), as well as no regulatory accounting guidelines to provide a sound information basis for the revision. Those problems started to be fixed in late 2002, in preparation for a two year review process, where tariffs will be reset for the great majority o f distribution companies in the country. In addition, current distribution tariff structures incorporate cross-subsidies from domestic to industrial customers. This undermines the incentive for the latter both to conserve electricity and to take advantage of their right to engage in direct purchase of power from generators. It i s therefore essential to consolidate a cost-reflective, transparent, consistent and defensible methodology in advance of the tariff reviews due during2003-04. The transmission pricing system does not provide adequateeconomic signals to generators about the cost implications of choosing different geographic locations on the transmission network, due to its strong fixed price component (independent of distance). Furthermore, transmission congestion costs have been "socialized" within each sub-market, via a System Service Fee charged to all load. This mechanism distorts plant locationdecisions as they ignore transmission constraints within the sub-market.As part of the Revitalization Committee effort, studies were carried out in 2002 to evaluate the optimal number of sub-markets to minimize perverse locational incentives. Studies have reduced the number of sub-marketseven further, even though the "physical" constraints still remain, therefore aggravating the congestion problem. This issue merits attention from the current administration. 2.9 Rural electrification strategy Although Brazil's overall electrification rate i s reasonably high for a developing country (around 90%), some 2.5 million rural households (10-12 million people) lack access to electricity; about three quarters of those live in extreme poverty. At present, neither public nor private distributors, in general, have explicit connection targets to meet (although some have in their concession contracts, and there i s a general but difficult to enforce obligation to meet requests for service within 6 months). There are some special GOB programs such as Luz no Campo, aimed at rural electrification and working basically with grid extension, and PRODEEMaimed at - 17- social development of states and municipalities through energy provision, and working basically with off-grid supply in rural areas. However, both programs have encountered problems of financial sustainability. Moreover, the lack of a comprehensive, coherent rural electrification policy has likely fostered conflicting practices and perspectives regarding institutional responsibility, financing mechanisms, and technological solutions. For example, according to Law 9,427 of 1996, concessionaires are entirely responsible for the investment costs of service expansion within their territory, and no connection charge should be required from the customer. However, this law was never enforced, and current schemes generally maintain the principle that customers should cover 90% of connection costs. Furthermore, in areas where rural cooperatives have traditionally been active, it has been unclear whether they or the host concessionaires are responsible for providing service in their overlapping territories. ANEEL has been trying to fix this problem by redefining areas of responsibility, granting permissions or authorizations, and setting ratesand subsidies between the cooperatives andthe incumbent utility. There are no financial incentives for concessionaires neither to invest aggressively in rural electrification, nor to maintain and operate rural investments financed by other players. Furthemore there are no adequate mechanisms to ensure efficient technology choices between grid-based and off-grid solutions, including adequate differentiation among quality of service options. Finally, there is a lack of clarity regardingthe potential role to be played by agents other than the distribution concessionairesin expanding coverage. GOB has been attempting to strengthen the service obligations of distribution concessionaires. Law 10,438, enacted in 2002, specifies on its Article 14 that the incumbent concessionaire should expand service in its territory and assume the ensuing connection and reinforcement costs within a reasonable timeframe. Some of those connection costs, currently borne in a large proportion by new customers, should gradually be tapered off. ANEEL has been in charge of customizing a universal access plan for each concessionaire, taking into account existing coverage, nature of markedserved, possibilities to use cross-subsidies within the concessionarea, and other sources of funding. As part of the Public Hearing process, ANEEL publishedin April 2003 targets for universal access goals for each concessionaire, in terms o f percentage of market served and dates for achieving these targets. Still along the lines of universalization, this Law also specifies, on its Article 15, the possibility of GOB granting sub-concessions via a bidding mechanism, to have other players serving particular areas where the incumbent is not able or willing to do so, and the existing concession contract does not grant exclusive rights. The objective of this Law regarding universal access i s laudable. Its success hinges upon a carefully designed plan with a sound trade off between expanding the service and maintaining the economic andfinancial equilibrium of each concessionaire. 2.10 Lifeline tariffs for thepoor Prior to the sector reform, all residential customers received discounts on their electricity bills. These becameprogressively smaller for higher consumption blocks, tapering away to zero above 200 kWh/month. In 1995, three changes were introduced. First, the magnitude of the discounts - 18- was reduced, to a maximum of 45%, so that those consuming below the subsistencethreshold faced tariff increasesof 25-30%. Second, those consuming above the subsistencethreshold no longer received any discount on their initial blocks of consumption. They consequently experienced much larger tariff increases,of some 75%-100% overall. And third, eligibility for tariff discounts was confined to those meeting low-income eligibility criteria. However, each distribution concessionaire was given the liberty to determine its own subsistence threshold (they currently range from 140 to 220 kWh per month) and its own eligibility criteria for these discounts. This provided perverse incentives to the concessionaires. A wide range of different criteria were usedincluding the technological characteristics of the connection, the installed load, the type of dwelling, and the geographic location. Moreover, ANEEL reported that the proportion of customers eligible for low-income tariffs in any particular state presented little correlation with the known levels of poverty in different states. Some concessionaires even claimed arbitrarily that none of their customers were eligible to receive low-income tariffs, which is implausible given that 23% of the population lives in poverty. Law 10,438 also dealt with this matter. It determined that all customers whose consumption was below 80 kWh per month should 1 be treated as low income and therefore be eligible to tariff discounts which might be as high as 65% for the first block of consumption of 30 kWh per month. For consumption levels between 80 and 220 kWh per month, the Law determined that ANEEL should regulate the eligibility for low income tariff discounts within one year, basedon consumption and other factors to be determined and agreed with each concessionaire. Along the same lines of establishing life-line rates for the poor, this Law exempted some categories of customers from paying the additional fixed and variable costs of the emergency thermal plants. This Law also exempted residential andrural customers whose consumption was below a certain threshold level from paying the additional costs of generation faced by incumbent utilities during the rationing period in 2001. In sum, there were several clauses in this Law dealing with issues related with the tariff for the poor, either providing outright discounts on rates or exempting some classes of customers from paying some costs that the electric sector has incurred or will incur to increase system reliability and to avoid future blackouts. However, a lot still has to be done interms of regulating the terms and conditions of universalization. Concession areas are very diverse, in terms of percentage of market served and particularly, the ability to provide cross-subsidies for the expansion of coverage. Sources of funds for the different paces of universal access still have to be discussed and agreed. There are policy and regulatory decisions which still need to be made. ESTALcould help GOB inaddressingthose issues. 2.11 Strategic approach to environmental issues in the sector Since the mid-eighties, GOB has been paying serious attention to the environmental and social aspects of the power sector. It has introduced reasonable legislation and regulations, and dealt with case-specific issues as they arose. What has been more difficult to achieve is a strategic approach that integrates environmental concerns into overall sector development in the longer - 19- term. The reform of the sector, with an increased emphasis on private-sector participation and a reconfiguration of mandates across sectoral agents, introduced new challenges and the need to redefine roles and responsibilities, methodologies, staffing needs, and coordination mechanisms. Annex 14 provides a detailed description of the environmental and social issues in the power sector, its context and the proposedprogram to addressthese issues. To achieve these strategic objectives, in March 2002, the Ministry of Mines and Energy (MME) and the Ministry of Environment and Natural Resources (MMA) signed an "Environmental Agenda", setting forth nine broad areas of collaboration for the coming years. In line with the Agenda, the Government proposes to implement a "Program to Strengthen Planning and Management of Environmental and Social Issues in the Power Sector" (see Annex 14, Attachment 1 for Terms of Reference). The program would be implemented in successive stages, the first of which would be within a four-year timeframe, with support from the ESTAL. Important approachesbeing considered are: strategic assessment of mediuidlong-term expansion paths; environmental and social impacts of thermal power plants seen on a regional rather than site-specific basis; and assessment of issues and opportunities for the power sector's participation in carbon emission reduction markets, as well as in markets for other environmental services (such as the protection of river basin headwaters). Given the increasing participation of the private sector, it will also be more and more important for the electric sector to promote voluntary compliance and the adoption of environmentally and socially responsible behaviors on the part of power producers, as a complement to the compliance and enforcement of regulations that are the responsibility of environmental agencies. And to better implement its environmental policies, GOB seeks to realign staffing expertise with institutional responsibilities. 2.12 Frameworkfor environmental licensing of power projects While there has been a reasonably solid framework in place since 1986 for handling environmental and social issues in the power sector, licensing of power sector projects is guided by norms that were adopted before the reform of the power sector and the establishment of the National Water Policy. They thus need to be selectively revised to fit the current context. The uncertainties and transaction costs associated with environmental licensing are perceived by many to be a serious limitation to timely expansion of the system in a private sector-basedmodel. During the recent supply crisis, changes were suggested ranging from centralization of the licensing system at the federal level, to special task forces to support state agencies in critical cases. But such "quick fixes" runthe risk of throwing away considerable advancesmade over the past twenty years and of introducing ad-hoc measures onto a basically consistent framework. Ultimately, potential environmental/social impacts of power sector projects need to be identified and addressed in a manner that avoids unnecessary damage and that mitigates and compensates for impacts when they occur. The environmental/social assessment and licensing processes are essentialinstrumentstowards this end. There is, however, room for making the licensing system more effective and responsive to the dynamics of the private sector, for instance by institutionalizing the use of strategic - 20 - environmental impact assessment (EIA), as in the oil and gas sector in the State of Rio de Janeiro. One of the potential areas for improvement beingconsidered by current administration has to do with the granting of environmental license prior to the competitive bidding process for hydro concessions (large plants). There are currently about 8,000 MW of hydro concessions already granted without corresponding environmental licenses. In a few alleged cases, the prospects of obtaining environmental licenses are unlikely. According to the existing concession agreement, the risk of not obtaining proper and timely licenses resides with the developer. However, as the perception of risk increases, fewer investors will be interested in participating in future ventures. There i s a sense that by having the environmental license granted prior to the concession, the investors' confidence could be restored, and chances of undesirable delays in the expansion plan could be minimized. This subject should be studied in great detail. Another promising development was the creation of the Environment Committee in CNPE and the Energy Committee in CONAMA to facilitate coordination across sectors. These coordination mechanisms need to be consolidated to help ensure that environmental & social issues are duly addressedin a timely manner inthe planning and licensing processes. MMA has recently assessedthe regulatory framework for the power sector. This, combined with the findings of the Special Commission for Analysis of the Hydro-Thermal Power System, the work of the CGE, and of other agencies, should form the basis for an in-depth evaluation (to be supported by this operation) of the adequacy and possible improvements in the current environmental licensing system for power sector projects. Strengthening of the institutional framework for environmental licensing and enforcement is beingsupported at the federal level by IDB's National Environment Project, and at the state level by the Banks National Environmental Project (NEP) II, as further discussedinAnnex 14. 3. Sector issuesto be addressed by the project and strategic choices: The proposed ESTAL encompasses a broad-based agenda of knowledge generation and sharing, consensus building, support for policy formulation, and institutional strengthening, to address many of the issues discussed above. It is linked to the set of 33 measures proposed by the CGE in 2002, as well as to the new priority areas set by the current administration. However, support would be focusedon a subset of these areas, for two reasons: 0 A number of the measureshave already beenimplemented or are to be implemented in a very short timeframe, and the analytic work on them i s scheduled to be completed before the ESTAL would become effective. In some of these cases, the Bank is making arrangements to provide a second grant to be provided by the Public-Private InfrastructureAdvisory Facility-PPIAF (see Annex 12); 0 The proposed operation has a strategic focus on the sector needs and on the basis of discussions with the Government, it prioritizesthe areas for support. -21- Accordingly, the five areas chosen are all ones of high priority in which there i s need for a substantial, medium-term program. Improving the regulatory system, the tariff structure and the functioning of the electricity marketis a challenging area, and Brazil can now improve its design based on its own recent experiences as well as the lessons from other countries. Expanding service in rural areas and making tariffs more affordable for the poor are important parts of Brazil's anti-poverty program. Improved environmental management i s important both for ensuring minimization of environmental and social impacts and for ensuring that critical network expansion i s undertaken in a timely manner with due consideration of environmental/social costs and benefits. It is also important in emerging markets for energy-related global externalities, such as climate change. The recent energy crisis has shown that strategic planning and coordination at the sector level remains essential even in the reformed system. The strengthening of MMEand CNPE are central to the success of the reform effort. In order to maintain focus and proceed rapidly, the ESTAL will not cover a number of other important areas. First, although a full reform of the hydrocarbons sector would also be important, this sector has not been in crisis, and there i s therefore less sense of urgency about this sector in Brazil, as well as less consensus on how to proceed. Therefore, that segment of the energy sector will be covered by the project only with respect to a few more pressingissues, like the supply of natural gas for power generation and low-income population's access to LPG and natural gas. Second, ESTAL will not be involved in the privatization of the ELETROBRAS' subsidiaries, beyond the study on concentration of ownership in generation, since the current administration has clearly stated that privatization of state-owned assets i s not a priority any longer, and that both private and public capitals should participate in the expansion of the power system. Third, although the environmental agencies have important roles to play in the ESTAL, strengthening of those agencies per se will not be tackled here - largely because the Bank and the IDB are addressingthis through projects more focused on that sector. C. Project DescriptionSummary 1. Projectcomponents(see Annex 2for adetaileddescriptionandAnnex 3 for adetailedcost breakdown): The project components, and their cost and financing, are summarized inthe table below. Detailed cost estimates are shown inAnnex 3. The five specific project components are mutually supportive. Component 1, on the development of the electricity market and regulation, would cover technical and coordination issues important for the efficiency of the energy market and improvement of the regulatory operations. The subcomponent on market development would include electricity-gas linkages, ownership of generation issues, wholesale market rules, retail level competition, wholesale-retail links, and barriers and opportunities for international energy integration. The subcomponent on regulation would cover inparticular collaboration among federal regulatory agencies and a study on options for appeals mechanisms, support to selected state public service commissions through ANEEL, performance contracts between Government (MME) and ANEEL and ANP, and the tariff review process, includingregulatory accounting. - 22 - Component 2, on energy access and affordability for the poor, would center on development of comprehensive and consistent strategies for rural electrification (including policy and coordination, funding mechanisms, baseline data collection, monitoring, and development and sustainability), lifeline power tariff criteria, and mechanismsfor facilitating the use of natural gas and LPGby low-income population. 3.Environmental Management 4.Long-termExpansionPlanning 5.InstitutionalStrengthening and Coordination 3.05 25.2 0.00 1.20 9.9 12.00 99.0 12.12 100.0 ~ Component 3, for environmental management, would support the mainstreaming of environmental concems under component 4 and would complement institutional strengthening efforts under component 5. Inparticular, it would cover environmental licensing, methodological improvements (for various stages of the planning cycle and for hydro and thermal plants and transmission lines), strategic environmental/social assessment of alternative expansion paths, assessment of issues and options in the area of climate change and other environmental services, monitoring and ex-post evaluation, incentives for enhanced corporate responsibility, and institutional realignment and strengthening of professional cadres. Component 4, for long-term expansion planning, would reinvigorate an essential activity that was one the main casualties of the first round of reforms. It would ultimately aim at developing a Govemment strategy. Inparticular, this component would cover an updating of system expansion methodologies, including integration of environmental and social concems. In a hydro dominated system, especially where much of the power comes from a few rivers, and where there are competing uses for water, as well as environmental and resettlement issues, river basin inventories need to be comprehensive and kept up to date. Additionally, a thermal plant macro location study as well as a plant catalogue for hydro sites would provide key inputs for system expansion. Component 5, for institutional strengthening and coordination, focus on MME and CNPE, and is central to building the capacity for implementing the other components. In particular, the strengthening of MME units would cover the areas of integrated planning, international energy integration, universal access to energy, energy efficiency, alternative technologies, oil and natural gas, and mines and metallurgy. This latter area i s included to ensure that the MMEstructure has all secretariesin good functional standing. -23- Ten percent of the Bank financing would be held in reserve, to be allocated either to the existing categories or to new activities that might be identified later. Experience with technical assistance projects has shown the importance of retaining such flexibility. The project support would be in three forms: e Consultant assistanceto carry out agreed studies and help GOB personnel structure the implementation plan, review organizational strategies and capabilities, build consensusaround proposedreforms, and design TORSfor both personneland for studies that will be neededto carry out the implementation plan, including support for selecting qualified candidates to directly staff the programmatic and policy areas; 0 Direct support by individual or small teams of consultants duringa transition period for a narrow range of tasks (e.g. complementary studies that are neededto clarify or evaluate certain issues before proceeding with implementation) until GOB has staffed its institutions appropriately for carrying out its own program; e Training for MME personnel, through, inter alia, regular courses and seminars offered in Brazil, visits to other regulatory and government institutions abroad, and the temporary hiringof recognized international experts to provide formal trainingor share specific knowledge with the Brazilianworking teams. 2. Key policy and institutional reforms supported by the project: The proposed ESTAL i s very closely aligned to the reforms required in order to bolster efficiency of the energy sector. The GOB is committed to addressing the key detected inadequacies in the implementation of the reform, mostly in the power sector, while preserving its underpinning principles. Some of the main principles of the reform and a Government vision as how to achieve the sought efficiency inthe energy sector are summarized in the table below. The main institutional areas included in the ESTAL would be: a) across-the-board strengthening of MME,as well as assistance targeted more specifically to its long-term expansion planningunit (CCPE), and programmatic units for international cooperation, universal access, energy efficiency, alternative technologies, and natural gas and oil; b) makingCNPE operational, so that it can take charge of policy formulation and advice to the President; c) strengthening cooperation and coordination processes between ANEEL, ANP and ANA; d) building up ANEEL's state-level counterparts; e) makingANEEL's performance contract more useful and assessingthe development of one for ANP; and f) clarifying responsibilities, and matching capacity for mainstreaming of environmental and social concerns in power sector planning and ensuring timely licensing of projects. - 24 - Efficiency of the Energy Sector Principles How to Achieve It 0 Increasecompetition 0 Inthe Power Sector - For the market, to createcontestability - At retaillevel, if cost-effective Inthe Hydrocarbons Sector - Across the entire supply chain - Monitor role of dominant players 0 Reduce poverty 0 Universal access to energy services 0 Smart subsidies, in electricity, gas, LPG 0 Safety net andlong-term sustainability 0 Attract private capital to support 0 Create a non-discriminatory environment expansion - Independentsystemoperation - Third party access, with correct tariffs - Strongregulatoryagencies 0 Revisit trading arrangements,to promote contracting and proper risk allocation 0 Plan least cost expansion, with 0 Strengthen planningand coordination roles concerns for the environment and social 0 Methodologies andportfolio of projects issues Optimize use of existing gas infrastructure 0 Better knowledge of hydro potential 0 Streamline environmental licensing process The policy reforms to be supported would include (a) establishing, for the first time, a comprehensive approach to rural electrification, (b) setting consistent criteria for overall power distribution tariff structure and for lifeline tariffs, as well as for pricing natural gas and LPG for low-income population, (c) harmonizing the policies for thermal generation and natural gas, (d) establishing correct regulations and monitor industry players' behavior, so as to minimize the risk of abuse of market power, (e) broadening retail power consumers' ability to purchaseon the free market, and (f) ensuring that environmental and social aspects are taken fully into account in investment planning. 3. Benefitsand target population: The project would have the following beneficiaries: 0 the Brazilianpopulation as a whole would benefit from havingmore reliable power, at eventually lower prices (because of the various efficiency gains expected) and from improved environmental conditions (less air pollution, cleaner water, healthy ecosystems) - 25 - resultingfrom more concertedattention to this indesigning systemexpansion; e the approximately 2.5 million, predominantly poor, rural households would get electrified sooner; e other poor families would havetheir tariffs reduced because of the introduction of consistent eligibility criteria for lifeline tariffs. 4. Institutionalandimplementationarrangements: The ESTAL would be implemented under full responsibility of the MME. The MME would create a Project Implementation Unit (PIU) under the MME Executive Secretary to coordinate all technical and administrative aspects of project implementation. The placement of the PIU under the MME Executive Secretary is because the ESTAL covers work of interest to more than one of the envisaged Secretariats under the new MME structure, and also because it provides a conveniently close link with the Minister. The PIU would be headed by an experienced, full-time Project Manager, who would provide general oversight and inter-agency coordination. The PIU would have a small technical and administrative group responsible for preparing TORS, processing contracts, managing accounts, adjusting or developing control systems as needed, preparing reports and providing general logistic support. The funds to staff the PIU are already assigned by the MPO under an arrangement with the UNDP, which would assist in procuring the requiredstaff and equipment. The establishment of the PIU i s a condition of loan effectiveness. The PIUwill be responsible to define the overall guidelines of the project program and the action plan, and will approve, evaluate, monitor and control all phases of Project implementation. A full-time team will be in place and also dedicated consultants will be hired, as required. In this context, the functions of the PIU would be to: e Act as the executive secretariat of the Project, e Identify the technical studies required and prepare the relevant TOR and Project's Operational Manual, according to MMEguidelines, e Perform the financial managementof the Project, e Assist in procuring and contracting the required consultants, technicians and services, in liaison with the MMEBiddingCommission, e Provide adequate facilities to the implementation team, consultants and technicians, e Evaluate consultants and technicians performance, e Review all documents andreports produced, e Follow up on the physical implementation and Project deadlines, e Adjust the Project operational plan, as required, e Provide support to external independent auditors. The PIU structure has already been designed. It will be headedby a Project Manager with overall responsibility for Project implementation, with a basic staff of 9 (nine) people including a Quality Controller, a Legal Advisor, a FinanciaUAdministrative Manager, a Procurement Specialist, 4 (four) Technical/Operational Managers, and a Secretary. The Project Manager will report directly to the Executive Secretary of the MME. The Quality Controller will have the - 26 - responsibility to assure that all Project actions adhere to the proposed principles and objectives, and that state of the art methods are selected and implemented to support the modernization, strengtheningand sustainability of all actions, both during and after the Project execution period. The Legal Advisor will review and approve all contracts and agreements, and also interface with MMELegal Department. The selection of individual consultants will be done by the PIU, in accordance with the Bank guidelines. The PIU would preparethe contractsfor signature of the assignedMMEauthority. In the case of hiring consultant firms, MME current structure i s adequate to process the bidding requirements, if the PIU supports the MME Bidding Commission (ComissZo de Licitagljes), including preparation of the packages and the technical reports that will enable the Commmission to eventually award the contracts. Many of the Project activities to be carried out by the MMEwould benefit from the participation of entities that play an important role in each specific activity. MME will seek the participation of these entities and will make arrangementsfor their participation in key aspects of the activity, as for instance, preparation of TORS for developing the activity and hiring consultants, and design of training programs. This process i s most advanced for the environmental component, where general TORSfor developing the component activities have already beenjointly prepared by MME and MMA. The details of the arrangements for the participation of entities in the Project would be spelled out inthe Operational Manual. Inorder to structure the organization of the work under the Project, it is envisagedthe creation of 8 task forces, to deal with the key technical aspects of project implementation, covering the following topical clusters: 1-Market Development; 2- Regulation; 3-Tariffs; 4-Rural Electrification; 5-Environment and Social; 6-Expansion Planning; 7-River Basin Inventories; and 8-Institutional Strengthening. These arrangements would ensure that sector entities as well as environmental, water and regulatory agencieshave a say in the components of relevance to them. - 27 - Arrangementsof Componentsby Cluster 1 transportationand storage ELETROBRAS,ANEEL, Petrobras, MAE, ANEEL, control systems 3 1.8.4 Regulatoryaccounting Accounting and Regulations MME, ANEEL 1.8.5. Tariff review Economicand regulatory MME, MF, CNPE, ANEEL 11.8. Life-linetariff criteria Internationalbest Dracticeson Dricina MME.. MF.. CNPE. ANEEL. land inter-fuelcompetition * - ~ANP 1II.C. LPGand naturalgas ]Market penetration studies IMME, MF, CNPE, ANP, ~ANEEL 4 III.A.1 to 5 Ruralelectrification [Economicand technical aspects, and IMME. CNPE. ANEEL. internationalbest practices ELETROBRAS, 5 1II.A. Environmentallicensing Process reengineering MME, MMA, ANA, ANEEL 111.8. Assessmentof Enaineerina/environmentaland social MMA lenvironmental/socialimpacts of lsciences - IMME. I /systemexpansion III1.C. Climate change & IWeather science; environmental IMME, MMA lenvironmentalservices Ieconomics III1.D. Monitoringand ex-post ]Environmental,social and computer IMME, MMA /evaluation lsciences 1III.E. Coroorateenvironmental/ IOraanization. incentivesand II I /socialresponsibility (governance;environmental economics IMME III1.F. Institutionalrealignment & lorganization design - - IMME, MMA /capacitybuilding 6 1IV.A. System expansion IElectric system planning, supply & IMME, CNPE methodology demand side economics 1V.C. Thermal plant macro-location Expansionplanning and operations MME research 7 1V.B. River-basininventories Engineering/environmentaland social MME, ELETROBRAS, sciences ANEEL, ANA 8 V.A. MME restructuring Organizationdesign, process MME reengineeringand management control systems V.B.l to 7 MME units strengthening Organizationdesign, process MME units reengineeringand management control systems V.C. CNPE operationalizing Organizationdesign, process MME, CNPE reengineeringand management control systems V.D. CDE operationalizing Organizationdesign, process MME, CNPE, re-engineering,cost-benefit analysis, ELETROBRAS,ANEEL control svstems - 28 - These task forces would combine representativesfrom the Government, academia and the private sector, in order to get different perspectives and foster cross-fertilization. Most of the members would be seconded from their organizations. The task force leaders would coordinate closely with the Project Manager. The task manager will ensure that early in project start-up there will be a Bank sponsoredproject launch, which will involve Bank specialists in procurement, financial management, and legal issues. In particular, the first two areas require special attention, because the corresponding assessments of the MME characterized the project as high-risk. This was due to the fact that MMEhad no experience as an implementing agency of a Bank-financed project. Additionally, it i s not expected that the PIU will be fully operational by loan signing. Supervision missions will be undertaken twice a year, although it i s likely that additional field supervision activities will be carried out given the task team leader's frequent missions to Brazil to work on other projects. The supervision missions will periodically include a financial management specialist and a procurement specialist. PSRs will be updated after each mission. When appropriate, these reports will include coverage of all issues related to financial control and audit issues, and the monitoring of the procurement plan. The major responsibility for procurement and financial management supervision and client assistance in these areas will be provided through the C M U Brasilia-based Implementation Team that is fully staffed to carry out these functions. Project supervision would be front-loaded and focus initially on ensuring that the PKJi s able to carry out its responsibilities, and on defining the terms of reference for key studies and consultants, and ensuring selection of qualified personnel. Thereafter, supervision would focus on indicators related to oversight of effective inter-agency coordination, market performance signals, and private sector confidence levels. While a supervision frequency of two field missions a year is planned, it i s likely that during the first year there may be an additional full supervision mission or short missions focusing on specific areas, to respond to needs detected by the task manager. The several measures described in this and preceding paragraph, including the establishment of a well-staffed PIU, seek as part of the project design to mitigate the inherent high-risk in project implementation due to the lack of previous experience of the MME as an implementing agency. In addition to regular supervision, and distinct from the assessment of the project implementation progress, the Bank would periodically review with the Government the progress on the reform of the sector. These reviews would be scheduled every 9 months, the first one takingplace not later than two months after the date of Loaneffectiveness. D. Project Rationale 1. Project alternatives considered and reasonsfor rejection: The main alternative considered was to make this a multi-sector TAL,, with a heavy emphasis on the regulatory system. The logic was that many of the issues affecting electricity regulation apply to other sectors as well, so it would be more efficient to address the various sectors together. This is particularly true, for example, in terms of the methodology for tariff - 29 - revisions. This would also have provided an opportunity to address comprehensively the question of regulatory agencies at the state level. This alternative was rejected for several reasons. First, based upon discussions with GOB, the balance of the content of the TAL for the energy sector (basically power) shifted away from regulation and more towards policy making, planning, environment and universal access. This reflected the recognition that electricity regulation, while still having some problem areas, was one of the best organized parts of the sector. Once the project was focused more on these other aspects of the power sector, there was less synergy with other sectors. Second, having a TAL that concentrated more on the power sector dovetailed better with the ESIU-Energy Sector Reform Loan. Third, the Bank i s addressing regulatory issues inthe water and transport sector in other operations limited to those sectors. Telecom i s the remaining important infrastructure sector, and while it faces some regulatory issues similar to those in electricity, the Bank has not been working closely with Telecom in Brazil, so there would have been a longer learning period on both sides before the project could be designed, thus critically delaying the essentialassistance to the energy sector. Further the Bank i s considering an adjustment operation geared towards enhancementof competitiveness in Brazil that would include Telecom regulation. 2. Major relatedprojectsfinanced by the Bank andlor other developmentagencies (completed, ongoingand planned). Implementation Development Bank-financed Progress(IP) Objective(DO) Improvinginstitutional framework, Energy Sector ReformLoan - increasing competition in generation, adjustment operation fully fixing the wholesale market, removing disbursed in June 2002 tariff distortions, developing a rural electrification strategy, makinglifeline tariffs more consistent, strengthening the environmental strategy and environmental licensing Clarifying ANEEL's responsibilities, Public Private Infrastructure improving the wholesale market, Advisory Facility (PPIAF- establishing a tariff review A020402-L-ETY -W-BR) methodology, and setting lifeline tariff grant: Improvement o f rates Electricity Regulation and Market and System Operations - completed in March 2003 Supportingenergy sector reform HydrocarbonTransport and S S including establishing ANEEL and Processing Project (Loan ANP, setting upthe wholesale market, 3376-BR) closed and promoting competition in generation (RE-SEB) - 30 - Availability andpricing of gas for Gas SectorDevelopment HS HS development of thermalgeneration Project (P006549) Promotingrural electrification Northeast RuralPoverty S S Alleviation ProgramProject (PO51701) Developingthe energy efficiency Energy Efficiency Project U S component of an environmental (Loan4514-BR) strategy for the power sector Improvingenvironmentallicensing SecondNational HS S EnvironmentalProject (PO35741) Dther development agencies RuralElectrification with Renewable Japanese SpecialFundandthe Energy, with emphasison social Inter-AmericanDevelopment aspects. Bank-Support to PRODEEM- under execution. Strengtheningof environmental IDB- NationalEnvironment licensing,enforcement and Program- under execution. post-licensemonitoringcapabilitiesat the federal level (IBAMA). P/DO Ratings: HS (HighlySatisfactory), S (satisfactory), U (Unsatisfactory),HI Highly Unsatisfactory) 3. Lessonslearnedand reflectedinthe project design: A number of lessons have beenlearned from the above-mentioned projects, in particular from the implementation of the TA component added to the Hydrocarbons Transport and ProcessingProject, as well as from other TA operations: (a) The new sector model should be seen as complementary to the expansion of the sector. Probably the biggest mistake made in design of the thermal plant packagewas to assumethat the private sector would invest without a sound regulatory and commercial framework inplace. When the private sector investment in generation did not materialize, due to some flaws indesign and delays in implementation of the reform program, there was no readily available fallback position; (b) Implementation of complex reform requires a strong, high-level orchestration between MMEandthe Ministriesof PlanningandFinance, as well as betweenANEELandANP onthe regulatory side, inter alia. Only when GOB, at the highest executive level and across a broad spectrum of core stakeholder institutions, got involved via the CGE in 2002 was there rapid and effective progressin resolving the power crisis; (c) Major power sector reform programs take years to be implemented, and "early-wins" should not lead to overconfidence andreduced top-level attention. Unanticipatedproblems may often arise due to the complexity and dynamics of the sector, and there needsto be a basic and consistent core of expertise available for analyzing them, and an effective mechanism for resolving them; (d) TA projects that only provide temporary consultants and do not ensurelonger term - 31 - institutional strengthening and policy reform, tend not to have sustainable benefits. Conversely, T A projects are more successfulifthey are implemented in tandem with adjustment operations, andifthey emphasize building up institutional capacity. (e) InTA projects, it is important to haveflexibility inthe allocation of funds, as by defining the project components broadly and having a significant reserve (unallocated) category; (f) The PIU should have both technical and administrative managementfunctions under a single umbrella. A strong PIUfrom early on, including a seasonedProject Manager, i s particularly important inprojects where the capacity for support from elsewhere inthe government i s likely to be limited. Its task forces should also be established very early, by identifying and motivating the best professionals. 4. Indicationsof borrowercommitment andownership: GOB'S commitment to resolution of the problems of the power sector has been reinstated unequivocal terms by the current administration. The power crisis entailed concomitant realization that the economy can suffer badly from a mishandled electricity sector. CGE, the former rationing chamber, has been reorganized and replaced by CGSE, still a multi-ministerial organization structure in charge of coordinating and monitoring the implementation of electric sector reform. CGSE i s chaired by the Ministry of Mines and Energy and provides suitable cross-coordination and a liaison point between CNPE and the several Ministries whose decisions affect the electric sector. On this basis, the GOB has also restored the central role in the sector of MMEandit hasdesignatedthat Ministry as the coordinating agencyfor the ESTAL. The ESTAL has been designed with the close cooperation of the Ministry of Planning; ANEEL, MMA, ANA andELETROBRAShave also beeninvolved, in accordancewith their mandates,in discussions of the regulatory, environmental and long-term expansion planningcomponents. The necessity of a multi-year TA project was initially counter-posed by the hope that all of the key issues could be promptly resolved in the aftermath of the power crisis. However, the more the project preparation team looked at the scope and magnitude of the tasks ahead, the more it realized the complexity of this undertaking and the need for high-quality, objective, well-equipped implementation teams. The MME conclusion was that the ESTAL should help design specific measures and implementation plans and even, in many cases, complementary studies before proceeding to take decisions, as well as for the careful design and time-consuming institutional capacity-building. 5. Value addedof Banksupport in this project: As in similarreformefforts in other countries, Bank support is helpful inensuring that the best worldwide expertise is made available to Brazil. This i s particularly relevant because of the size and complexity of the energy sector in Brazil. The Bank has been involved in similar reform efforts in many other countries, including neighbors such as Argentina, Bolivia and Peru, and can help inform the Brazilians of both the successes and failures (in specific elements) of those cases. The special value of Bank support in this case i s also to provide continuity during the transition between administrations, thus maintaining some of the institutional memory, as well as maintaining a steadfast vision of reform targets in the transformation of the sector in the - 32 - post-power crisis era. Also by doing the ESTAL intandem with the ESRL, the Bank can help in taking a comprehensive look at both the policy and institutional requirements of the sector, and can assist in consensus buildingaround proposedreforms. E. Summary Project Analysis (Detailedassessmentsare inthe projectfile, see Annex 8) 0Costbenefit 1. Economic(see Annex4): NPV=US$million; ERR = % (see Annex 4) 0Costeffectiveness Other (specify) Not applicable Note: Quantitative economic and financial analyses are not applicable for TA operations such as this. However, if carried out successfully, the project will improve the efficiency of the power sector and reduce the risk of future shortages, both of which would have major economic benefits. The current crisis is estimated to have reducedGDP growth by 1%. 2. Financial (see Annex 4 and Annex 5): NPV=US$ million; FRR= 5% (see Annex 4) The proposed loan will be for US$ 12 million (plus front-end fees), to be disbursed over aperiod of 4 years. The counterpart funding from the Government will be U$ 8 million. The required allocation for calendar year 2003 i s in the national budget approved by Congress. In its continuing macroeconomic dialogue with the Government, especially this year, the Brazil Country Management Unit should ascertain that the project i s assigned the required allocation and priority in the formulation of the Government budget proposal to the Congress for calendar year 2004. FiscalImpact: The project would have negligible direct fiscal impact. 3. Technical: The project involves addressing complex issues in terms of electricity market development and regulation, that are essential for sustainability of the reform, especially the envisaged private sector participating in generation expansion and alternative pool arrangements. These technical issues are planned to be tackled initially with the assistance of international and local experts under the new PPIAF-funded project, whose recommendations will be taken up by the ESTALto settle the issues in close dialogue with the relevant sector players. 4. Institutional: 4.1 Executingagencies: The executing agencyis the MME.Itwill work closely with entities which arerelevant to each specific activity, however the ultimate responsibility for the project execution rests with the - 33 - MME.Relevant entities mayinclude ANEEL, ANP, ANA, MMA,IBAMA,ELETROBdS, and selectedstate public utility commissions. ANEEL will be requestedto participate in many of the key activities of the project related to regulation. Likewise, MMA, and as necessary assisted by IBAMA, will be requestedto support MME in the detailed preparation andexecution of the Environmental Management component. The CNPE will be representedby the MME, which will liaise with other CNPE memberson important issues affecting the functioning and mandateof the CNPE. Becausethe executing agencyhad no experiencein implementing a Bank-financed project and the PIU was not inplace when the procurement and financial management assessments were carried out, these assessmentsratedthe project as high-risk.Inorder to mitigate this risk, special care should be taken by the Bankin assuringthat launching of the project is supported by a special workshop, that the PIUi s properly staffed and trained inBank procurement and financial managementrequirements, and that a concentratedsupervision effort is loaded up-front. 4.2 Project management: Project will be managedby aProject Implementation Unit (PIU), under the Executive Secretaryof the Minister of Mines and Energy. Eight task forces will deal with key technical aspectsfor topical clusters. 4.3 Procurement issues: The PIU will be responsiblefor overall procurement processing, and eachparticipating agency for the technical specifications and the consultancy terms of reference. Procurement plan to be updated every 6 months. Bank pre-approval will berequired for individual contracts exceeding $30,000 and contracts with firms exceeding $50,000. These amounts may be increased by the Bank duringproject implementation, ifthe Bank i s satisfied with the performance of the PIU. Given the needfor jumpstartingthis project with hiringof (mainly) individual consultants, retroactive financing up to 10%of the loan amount will be available for payments made within twelve months prior to the date of loan signing. 4.4 Financial management issues: Financial management will be under direct responsibility of the Financial Manager and team inPIU. The project preparation Team inMME will study and propose a financial system to use, before effectiveness. National Treasury Secretariat (STN) will advance funds to the project out of the national budget and special account for the project. 5. Environmental: Environmental Category: C (Not Required) 5.1 Summarize the steps undertaken for environmental assessment and EMPpreparation (including consultation and disclosure) and the significant issues and their treatment emerging from this analysis. As this project is aTechnical Assistance, it does not finance investments and therefore does not entail direct environmental or social impacts. The TA program includes three components that are of relevance to the strengthening of environmental and social planningand management inthe energy sector: i)institutional strengthening and coordination. ii) environmental management; and iii)long-term planning. The first includes the clarification of institutional mandates, capacity building and inter-agency coordination. The last two comprise a series of studies including strategic assessments of alternative expansion paths, river basin inventories and macro-location studies for thermal development, all of which will include - 34 - environmental and social dimensions 5.2 What are the main features of the EMPand are they adequate? NIA 5.3 For Category A and B projects, timeline and status of EA: Date of receipt of final draft: NIA 5.4 How have stakeholders been consulted at the stage of (a) environmental screening and (b) draft EA report on the environmental impacts and proposed environment managementplan? Describe mechanisms of consultationthat were used and which groups were consulted'? TORs for the Environmental Management component (presented inAnnex 14) were prepared by the Ministry of Mines and Energy working in close coordination with the Ministryof the Environment. Final TORs will be discussed with a broader set of stakeholders (other power sector agencies, academics and representatives o f environmental regulatory agencies) at the start o f project implementation. The TORs call for consultations at critical stages in the development of specific studies. The scope o f such consultation will be determined on a case by case basis, depending on the nature of the study. 5.5 What mechanisms have been established to monitor and evaluate the impact of the project on the environment? Do the indicators reflect the objectives and results of the EMP? NIA 6. Social: 6.1 Summarize key social issues relevant to the project objectives, and specify the project's social development outcomes. N/A (See 5.1 above). 6.2 Participatory Approach: How are key stakeholders participating in the project? See 5.4 above. 6.3 How does the project involve consultations or collaboration with NGOs or other civil society organizations? See 5.4 above. 6.4 What institutional arrangements have been provided to ensure the project achieves its social development outcomes? NIA 6.5 How will the project monitor performance in terms of social development outcomes? NIA 7. SafeguardPolicies: I CulturalProperty (OPN 11.03) - 35 - I I IndigenousPeoples(OD4.20) 0 0Yes NO InvoluntaryResettlement(OP/BP 4.12) 0 0Yes NO Safety of Dams(OP4.37, BP4.37) 0 0Yes NO ProjectsinInternationalWaters (OP7.50, BP7.50, GP7.50) 0 0Yes NO ProjectsinDisputedAreas (OP7.60, BP7.60, GP7.60)" 0 0NO Yes 7.2 Describeprovisions made by the project to ensure compliance with applicable safeguard policies. NIA F. Sustainabilityand Risks 1. Sustainability: A fundamental objective of the ESTAL is to make the power sector reforms more sustainable. The experience in Latin America and elsewhere has been that while it is very difficult to completely reverse a power sector reform program, lack o f commitment and coordination from Government authorities may jeopardize continued implementation. It i s necessary to have mechanisms in place to assure that decisions are made based on sound analysis and ina timely way. The ESTAL should help Government achieve this goal. The main question regarding the sustainability of the results of the project per se relates to the strengthening of MME and operationalizing of CNPE. GOB did not give highpriority to this before, but this stance has changed since the crisis. CGSE, a multi-ministerial organization structure which replaced CGE, is still in charge of coordinating the implementation of electric sector reform and building awareness about some of its challenges. CGSE is chaired by the MME and provides suitable cross-coordination and a liaison point between CNPE and the several Ministries whose decisions affect the electric sector. The decision to make MME the coordinating agency for the ESTAL is an indication of the commitment to strengthen that ministry. But this will have to be backed up by the allocation of budget and personnel; the Bank will focus on this during implementation. 2. CriticalRisks (reflecting the failure of critical assumptionsfound in the fourth column of Annex 1): From Outputs to Objective Market Developmentand Regulation: (1) Political support to: a) setting H Bank involvement, transparentregulationsand new rules to favor competition and tariff review process, competitive prices, and economic pricing, b) regulators' training of key stakeholders, contribute to administrative and operational autonomy provide sustainability to the regulatory effort. and independenttariff reviews. Review inpoliticalpriorities possibly leadingto delays inthe reform process and some contractualdisputes. (2) Interests of ANEEL, ANP, ANA, M Operational CNPE will provide a forum for IBAMA,and state regulatorsare not policy coordination and consensus building. reconciledand they are unwillingto work Bank plays catalytic role in harmonizationof - 36 - in a coordinatedmanner. conflicting views. Energy Access and Affordability for the Poor: (1) Distributors dispute its legal basis S Transparent regulations and sustainable and regulatory arrangements, or allege funding mechanisms, including allocation of lack of financial and economic federal funds, special development credits, and equilibrium,due to obligations to serve cross subsidies to partially cover costs, ruralpopulations; lack of utility minimize opposition to rural electrification engagement in the effort to implement programs and targeted life-line tariffs. more equitable lifeline rates for the poor. (2) GOB and the private sector do not S Careful design of delivery mechanisms, give priority or are unwilling to make dissemination of best practices, establishment investments in rural electrification. of realistic goals for each concession area, synergy with poverty alleviation programs help materialize investments in ruralareas. Environmental Management: As environmental groups and power S A consultative process ledby MMEand MMA sector disagree on approach to involving a broad set of stakeholders, environmental licensing and location supported by the Bank, buildsconsensus on a constraints, burdensome environmental balanced approach and leads to adjustment and licensing process causes delays and expediting of the current licensing process. increases opposition to environmental protection. LongTerm ExpansionPlanning: GOB i s unable or unwilling to devote M The recent energy crisis has succeeded to sufficient budget resourcesto this effort. demonstrate the need to have the Government planning in advance and providing close coordination, with the adequate information and policies to reduce social and economic costs of rationing. hstitutional Strengthening and Coordination: GOB does not give energy sector high S Society awareness raised by the energy crisis priority and does not provide MMEwith of the need to appropriately fund the MME :he necessarybudget. CNPE and CDE and ensure coordination with other not operational, MMEi s unable to stakeholders, in order to support long term 3ttract and retain sufficient high-caliber planning, policy development, and risk ?ersonnel,and PIU is discontinued. management. Focus of project in these areas helps to maintain GOB support and obtain participation of high-level specialists to ensure continuity and effectiveness of PIU 3om Componentsto Outputs iliscontinuity of power sector reform, H Bank involvement, bringinginternational iarticularly due to a fundamental review experience and best practices, and providing if energy policy, which will take time to support to a sustainable regulatory effort. ,e articulated, agreedupon and Project design aims to address fundamental mplemented, increasing perception of needs and has built-in flexibility to - 37 - riskamongprivate investors. accommodatechanges inpriorities. Loss of momentumanddecreased CGSEcoordinates the implementationof perception of importanceof energy issues electric sector reform, buildsawarenessabout amongtop government officials. some of its challenges, and provides suitable cross-coordinationandaliaisonpoint between CNPE andthe severalMinistries whose 'decisionsaffect the electric sector. hadequate counterpart funding. Societyconsensusthat avoidingrepetitionof the energy crisiscalls for ensuringappropriate funding of the key activitiesearmarkedby the project in the years to come. 3verall Risk Rating S It should be noted that the risks discussed above derive from conditions external to the project. Riskswhich result from choices or factors internal to the project are inherently mitigated by project design. An example is the highrisk inproject implementation due to lack of previous experience of the MME as a Bank-financed project implementing agency. The mitigation measuresare part of the project design (see C.4 and E.4.1 for discussion of these issues). 3. Possible Controversial Aspects: No controversial aspects, inaddition to those indicated above, are foreseen. G. Main Loan Conditions 1. Effectiveness Condition 1.1 Establishment of the PIU, headedby a qualified Project Manager and including procurement, financial management, environmental as well as energy expertise. 1.2 Establishment of a financial management system in accordancewith the requrements laid out in Annex 6 B 1.3 Furnishingof TOR for the Project external auditor. 1.4 Fumishingof aplan for the selection of consultants under the Project. 2. Other [classify accordingto covenant types usedin the Legal Agreements.] 2.1 Monitoring, review, andreporting: i)standard Bank covenants; ii)the Borrower will provide the Bank no later than 6 months after the end of each year procurement records audited by independentauditors, acceptable to the Bank. 2.2 Project Execution: 2.2.1 Mid-Term Review 2.2.2 The Bank and the Government will review progress of the sector reform every 9 months, the first review taking place not later than two months after the date of loan effectiveness. 2.3 Standardretroactive financing. - 38 - H. Readiness for Implementation 2 1. a) The engineering design documents for the first year's activities are complete and ready for the start of project implementation. 1. b) Not applicable. E2.The procurement documents for the first year's activities are complete and ready for the start of 2 project implementation. 3. The Project Implementation Plan has been appraised and found to be realistic and of satisfactory E4. quality. The following items are lacking and are discussed under loan conditions (Section G): 4.1 The PIU needs to be established. 4.2 A financial management system needs to be put in place. 1.Compliancewith Bank Policies 8 Thisproject 1. complies with all applicable Bank policies. 2. The following exceptions to Bank policies are recommended for approval. The project complies with all other applicable Bank policies. 4-v " NelsonDe Franco Susan . G ldmark d.Gbldmark I , VinodThomas Team Leader Sector M'9ager Country Director - 39 - Annex 1: Project Design Summary BRAZIL: Energy Sector Technical Assistance Project KeyIndicators Performance DataCollectionStrategy Sector Indicators: Sector/ countryreports: from Goal to Bank Mission) Energy: ndependent evaluations. dacroeconomic stability. Further develop a competitive Energy i s available with PEA reports. Zontinued political and social and sustainable energy market reduced environmental effects 3ank country and sector upport to power sector by improving its regulatory and is more affordable for the 'eports eform. framework and enhancing poor. competition, increase Effectivecompetitive structure commercial investments for is operational with increased system expansion, increase private sector participation. coverage of ruralenergy Good practice models are services, specially services to developed, disseminatedand the poor, and improve energy replicated. efficiency. Environmental protection and management: Modernize environmental Methodologies and procedures instruments and institutions, to estimate and address integrate environmental :nvironmentaVsocial impacts, concerns within sectors, license and monitor projects, increase private sector role, are revised and widely used, prioritize environmental Facilitating the achievement pollution problems, comply ifnationalobjectives and with international agreements :ompliance with intemational and develop and implement igreements. action plans - 40 - Data CollectionStrategy I Hierarchyof Objectives I Critical Assumptions project Development Outcome/ Impact 'roject reports: (from Objectiveto Goal) Ibjective: Indicators: Ielp ensure the sustainable Adequate and sustainable ndependent evaluations Society supportsregulatory mplementationof the GOB'S znergy supply (no more PEA reports environment that favors ,ontimingenergy sector rationing). 'ublic consultation records. competition, economic eform program through dAE, ONS, ANEEL, ANA, pricing, and environmental tudies andcapacity building WP, and IBAMA reports. and social responsibility. ctivities aimed to: 3ank country and sector eports. develop energy marketto [ncreasedprivate sector Governmentcreates a climate expandprivate sector investments and participants. conducive to new private participation and investments. competition, Contracts are honoredand 0 make modem energy Higherpercentageof poor private and public investors sources available and lave access and can afford are treatedon a affordable to poor, nodem energy services. non-discriminatory basis. 0 ensure longterm EnvironmentaVsocialimpacts environmental 3re assessedand appropriate sustainability of power 3ctionplansto avoid, mitigate sector development, ircompensatefor impactsare leveloped at project concept stage; licensesare grantedina imely and transparentmanner. 2nd incentives are ineffect to Jromoteimplementation of mvironmentallsocial action Jlans by power sector utilities. 0 improve long-term Zyclically updated, longterm expansionplanning, and :xpansion plans, incorporating mvironmentaVsocia1concems. ire available and guide private iector investment decisions. 0 strengthenpolicy making 2nergy and and implementation mvironment-related policies, capacity. .egulations,and procedures ire revisedl designedand mplementedin a coordinated 'ashion by Government ninistries, agencies and ,egulators,and are effective to oster competition, iustainability and increased rivate participation. -41 - Key Performance Data CollectionStrategy Hierarchy of Objectives Indicators Critical Assumptions htput from each Output Indicators: 'roject reports: from Outputs to Objective) :omponent: .Market Development and tegulation i.MarketDevelopment {lectricity-natural gas linkage Revisedregulations,covering 'ameas above plus Bank 'olitical and social support to tudy. the gas-electricity supply 'SRs and PIUreports. iew model to increase chain, that facilitate efficient fficiency and competition in use of natural gas for power he power sector. generation, andmeet gas and electric sectorefficiency and investmentrequirements. Study on ownership Revisedpolicy on actualor 'olitical and social support to concentrationin virtual split of generationto ncreasecompetition in generation, and potential foster competition. :eneration. for abuse. Rules on self-dealing, cross-ownership, marketshare limits, which identify, monitor and mitigate generationmarkel power. Wholesaleelectricity Wholesale electricity market Stakeholders' interests are marketrules revision, functioning effectively, with uffciently reconciled and building upon and transparentpricing, timely nake them willing to continue implementing financial settlements, and new iarticipatinginthe WEM. recommendationsof the rules that increasedemand Zontractualdisputesinvolving PPIAF study. responseand mitigate risks to mergy entitlements are power projects. iandled outside of WEM and Evaluation of the pros and -esolvedsatisfactorily cons of introducing new powei pool and trading arrangements, with implementation plansdetailed Zonsumers are increasingly Study on retail Evaluation of benefits and interested in participating competition. costs of retail competition. jirectly in power market and Definition of new thresholds insigning cortract (PPAs) and pre-requisitesfor free with IPPs. customersfrom 2004 onwards Perceptionof risks decreases, Regulatory treatment of andcontract sanctity is strandedcosts, if any. preserved Interactionbetween Harmonization of wholesale Powerpool arrangements wholesale and retail and retail competition to fostei conducive to more affordable markets. demandresponse and energy and reliable electricity cost, efficiency reducing the risk of energy an( capacityrationing. Studies of barriers and Conciliation of basic market Interest of Brazil's neighbors opportunities for structure and regulations inenergyintegration. international energy amongneighboring countries Willingness from all parties to - 42 - integration are carried to foster economic energy achieve some degree of out. trade. standardizationinterms of A catalogue of potential energy dispatch, trading private investmentslinking arrangements, and market Brazil's energy grid with rules. neighboringcountries. I.Regulation e Study on how to achieve a New proceduresto improve Interests of ANEEL, ANP, collaborative process coordination amongenergy, ANA andIBAMAare among regulatory environmentaland water reconciled. (electricity, hydrocarbons regulatory agencies. and water) and environmental agencies, for issuesof mutual interest, building upon PPIAF-funded project. e Establishing / State utility commissions Collaborative attitude among strengtheningstate utility reachlevel that enables federal and state regulators. commissions to cooperate ANEEL to delegateto them with ANEEL. responsibilities for handling matterssuch as service oversight and consumer complaints e Review of ANEEL Revision of ANEEL Political support to regulators' performancecontract and performancecontract and administrative and operational consideration of possible signing of similar ones for autonomy. management contract for ANP and ANA, if warranted. ANP. e Study on regulatory Establishmentof regulatory Political supportto accounting and efficiency accountingsystem and independenttariff reviews by benchmarks. efficiency benchmarksto be ANEEL, basedon transparent usedby ANEEL in tariff rules and conveying efficient revisions. signals to final customers. Actual application of the agreed tariff methodologies, minimizing political interference, and generalized subsidies. e Study of distribution tariff ANEEL has consistentand Tariff systemshould convey review methodology, xonomically justifiable correct price signals and building upon the :riteria and proceduresfor its provide safety net for the poor. PPIAF-funded project's regularrevisions of results. jistribution tariffs. [.EnergyAccessand ,ffordability for the Poor ,.RuralElectrification e Elaboration of aRural 3ovemment ability to define Distributors do not dispute ElectrificationPolicy and .argetsfor universal service, legal basis and regulatory - 43 - coordinatiodintegration key milestones and arrangements for imposing o f ongoing initiatives for cost-effective implementation obligations to serve rural achieving universal plans. populations. access, that incorporate development and sustainability issues. 0 Baseline data on rural First set of estimates that have electrification. a sound empirical basis and are generally accepted to support planning and decision making purposes. 0 Evaluationo f alternative Identification of sustainable GOB gives this area high funding mechanisms for sources of funds to support priority to devote increased un-servedrural rural electrification. budget resources. populations. Private sector is willing to invest inrural electrification e Study on development Design of tariffs that could be and sustainability issues. affordable, foster economic growth, and transmit correct economic signals to rural customers I 0 Monitoringand oversight. Designof objective criteria, methodologies and procedures to monitor implementation of new programs. i.LifelineTariffCriteria 0 Revisedtariff policies for More equitable and Distributors participate inthe the poor economically efficient criteria effort to implement more to define thresholds for equitable life-line rates. life-line rates on a regional basis, as well as a methodology to establish those rates, which involves the identification of funds and cross-subsidies. :.LPG and Natural Gas 0 Revised pricing policies Criteria to define life-line for the poor and for prices for both LPG and market penetration of natural gas potentialusers, natural gas taking into account inter-fuel substitution aspects Identification of natural gas market penetration opportunities. 11. Environmental danagement 0 Revisionof Sound and timely licensing environmental licensing process, revised and inplace, requirements, procedures - 44 - reflecting the recent reforms in tpproach to environmental and mandates. the power and water sectors, icensing, which is approved and allowing for proper )y CONAMA, if needed. coordination with relevant agencies. Improvedtreatment of Znvironmental agencies and e Strategic assessment of environmental/social impacts Jower sector agree on environmentallsocial in medium-long term ipproach to environmental impacts associated with expansion plans, river basin Issessment. alternative medium-long inventories, thermal power term expansion paths, development plans, and examining past site-specific projects, helping 3nvironmental and systems experiences, to extract GOB better balance expansion :xpansion groups within MME lessons learned and best and environmental goals. mdCNPEcoordinate practices Methodologies and manuals :ffectively . for assessmento f environmental and social impacts of system expansion. Power sector is better World makes progress on e Study onbamers and prepared to incorporate Kyoto Protocol. opportunities for the climate change into sector power sector's expansion, to participate in participation in carbon carbon-trading markets and to emissions reductions and explore markets for other other markets for environmental services. environmental services. Redesignedsystems to 4NEELissues Monitoringand e Updating of systemsfor monitor/evaluate impacts. Evaluation (M&E) guidelines. monitoring and ex-post Improved knowledge o f the evaluation o f impacts of power sector environmentallsocial projects. impacts. Better feedback available for the design and implementation of alternative mitigation strategies. Approaches other than Corporations convinced of e Assessmentof incentive "command-and-control" benefits to them. systemsfor corporate assessedand promotedto help environmentallsocial induce responsible corporate responsibility. behavior with respect to environmental and social issues. Institutionalcapacity for Power sector e Assessmentof environment management agenciedleadership reach institutional realignment strengthened, coordination agreement on institutional and capacity building for improved, and staff model management of imbalances resolved. environmentallsocial impacts in power sector operations. 45 - V. Long-TermExpansion 'lanning Revised systemexpansior Soundenergy expansionplans Interests of power, water and methodologies. ieingdeveloped, both for ,environmentalagencies :lectricity and hydrocarbons, reconciled. ncorporatingenvironmental ind socialcriteria, taking into iccount inter-fuel competition ind both supply and demand ,idealternatives. River basininventories 'ortfolio ("catalogue") of `GOB willing to devote carried out or updated. )ewer projectsdeveloped at a sufficient budget resourcesto ninimum levelof this effort. )re-feasibility, including lnalysisof environmental and ocial impacts. Thermal plant macro Iefinitionof areas in which locationstudies carried hermalplants should be built, I out. akinginto account economic nd environmentalaspects l. Institutional `trengtheningand :oordination 1. MMERestructuring 0 Strengthened WEreorganization Continuity of PIU. policy-making capacity :ompletedand effective. GOB provides MMEwith the for the Ministry of Mines nstitutional roles and necessary budget and enables Energy (MME) iroceduresfor medium-long MMEto attract and retain Organization structure erm planning within sector 1sufficient high-caliber and key processesrevised indin coordination with water personnel. to support energy, mining esources and environmental GOB continues to give energy and metallurgy policy igencies clarified. sector high priority, so other goals. 'rocesses inplace to detect ministries participate in CNPE inddeal with future `athigh level. mergenciesin timely fashion. GOB andMMEclosely ~ monitor and coordinate the implementation of the power and hydrocarbons sector reforms. GOB and MMEgive priority to support Mines and Metallurgy efforts in strengtheningits organization and key processes. B.MMESpecific Units !elevant MMEunits are Resourcesare made available 0 MMEcapabilities dequately staffed, and have and internal capability is enhanced in a few critical nd follow strategic plans. developed properly. areas, such as energy pecial, ad hoc studiesare evelopedto supportMMEin - 46 - planning, intemational cooperation, rural addressingkey issues in those electrification, areas. environmental management, energy efficiency, altemative technologies, as well as ir mining concession granting processes 0 DevelopMME Availability of a capabilities do execute comprehensiveenergy plan, Integrated Planning. updatedperiodically, and taking into account all source: of energy as well as possibilities bothon the supply and demandsides. MMEorganization Identificationof integration structureable to identify opportunities on a regional and evaluate intemational basis, and recommended integration opportunities, commercial arrangements. and sign initial MOUs. MMEparticipating Detailed plan for actively to define policy universalization available, aspects and funding for with identificationof sources universalization of energy of funds and regulatory access, discussingand arrangements to support it. coordinating macro-economicaspects with other relevant Ministries. 9MMEactively defining Found, sustainableenergy and integrating energy :fficiency program in place, efficiency programs. ncluding new technologies, lemandresponse to price ignals, and necessarytariff .ndregulatory arrangements. 1MMEknowledgeable 'rogram for the utilization of about new technologies ltemative technologies,on a for the energy sector. iilot or commercial basis, Ikinginto account regional iversities and covering both he electric and the ydrocarbons sectors. 1Mines and Metallurgy Strengtheningof DNPMand Secretariatable to carry CPRM agencies, with better out its duties efficiently. definition of policies, knowIedge of mineral resourcesand an streamlined and expedited concession -47- granting process. 0 Development of an oil Strategic plans developed, and gas organization in particularly addressing the MME, able to refining capacity issues, evaluateindustry issues market power of Petrobrhs, and make soundpolicy attraction of private capital, recommendations. and permanentmonitoring of market performancefor the hydrocarbonsindustry. :. CNPEOperationalizing CNPE meets regularly and 3NPE takes a leading role in 0 Study on how to make the makes decisionsand lefining energy policy matters, National Energy Policy recommendations, providing vhich will serveas a basisfor Council (CNPE) policy guidelines to the energy ,egulationsand to guide effective. sector. cgulatory agencies. 0 1.CDEOperationalizing A balancedallocation of funds ZNPE participates actively 0 Study to evaluatemost among universalization and tnd makesallocation of CDE efficient allocation from alternative sources of energy, unds according to stated CDE resources, taking reflecting energy policy :nergy policy and long terms into accountenergy policy aspects as definedby CNPE. :oak aspects. - 48 - Key Performance Hierarchy of Objectives Indicators Project Components I nputs: (budget for each 'roject reports: (from Components to Sub-components: :omponent) Outputs) In US$ million I. Developmentand Market 3.6 1 'IUquarterlyreports, MMEestablisheseffective Regulation. nid-termreview report, and PrUto coordinate project. inal report on investmentsand ierformanceof project omponents 11.Energy Access and I.43 Continuity of power sector Affordability for the Poor. reform, building upon accomplishmentsachieved thus far and addressingkey remaining problems. 111.Environmental 2.34 Management Adequate counterpart funding. IV.Long-term Expansion 6.48 Planning V. InstitutionalStrengthening and Coordination 2.80 VI. Project Management 1.13 VII. Reserve 1.20 VIII. Front-endfee 0.12 Total FinancingRequired 20.12 - 49 - Key PerformanceIndicators Annex l a - - Objective Output Indicators Year Year2 1 Year3 A. Market 1. Electricity-gas Completed Development linkages - implemented Study 1- Study 2 - 2Q I 2 OwnerShiDof COmDleted Study F 2 1 QCBS Aug-04 generation - - 4Q Implemented Study 3 - 3Q 2Q - Study - - 4Q Study - Studv 1- Study 2-3Q F 2 I QCBS Aug-04 - Rules- 1C Study - 3Q F 2 1 QCBS Sep-04 Study 3 - 3 0 Study - 3 1 2 1 CQ Nov-03 0 7 - 2 12 F 1 I QCBS Jul-04 - 1 1 1 CQ Feb-04 Contract - Study F I 1 QCBS Jul-04 - - 4Q Implemented 5. Tariff review process Implemented ~ II.EnergyAccessand Affordability for the Poor A. Ruralelectrification 1 1. Policyand QCBS Sep-04 coordination ICompleted - Implemented Study 1- Study 2 - I II I I - 1Q 2. Baselinedata Set 1 Set 2 - 30 F 2 1 QCBS Apr-04 collection IICompleted - 3 0 3. Fundingmechanisms Completed Study - - 4Q Study 2 - I 2 1 CQ Feb-04 4. Developmentand Completed Desigi I 1 1 CQ Dec-03 I sustainability -- 3 0 5, Monitoringand Completed Desigi I oversight - 3Q ~ E. LifelineTariff Revisedelectricity tariff Completed Desigi Criteria policiesfor the poor -- 3Q No. of 5 participating distributors - C. LPG& Natural Revised LPG and natural Completed Desigi Gas gas pricingpoliciesfor - 3Q the poor,and market studies - - 50 - Objective Output Indicators Year 1 Year 2 Year 3 Year 4 Typeof Numberof Numberof Intended immenceme Contract contracts contracts Selection1of Services (I-Idiwdu (Four (Year One) Method all Years) F-Fm) 111. Environmental Nov-041 Oct-04 Jan-04 1 Oct-03 Mar-04 D. CDE Completed support- General I 2 1 CQ Mar-04 Operationalizing 3Q 1 -51 - Annex 2: DetailedProject Description BRAZIL: EnergySector TechnicalAssistance Project By Component: Project Component1 US$3.61 million - I ElectricityMarketDevelopmentandRegulation - A. Market Development 1. Electricity-gas linkages. The introduction of thermal generation has beenhampered by the lack of competition in the natural gas industry. The only significant gas supplieri s still PetrobrAs, which relies on additional domestic gas production and on imports from YPFB in Bolivia through the Bolivia-Brazil gas pipeline to supply gas-fired thermal plants. The contracts between YPFB and Petrobras are based on high load factor, and firm contractual conditions for ship-or-pay and take-or-pay. This risk taken by Petrobrhs i s transferred to the local gas distribution in the gas supply contracts and by those to IPPs by mimicking the same load factor conditions. This results in unsuitable gas supply contracts for power generation, given the specific economic mode of thermal plant operation in the Brazilianpredominantly hydro system, with multi-year regulation reservoirs. The thermal plants may not be required to operate at high capacity factors during long periods of time, if the combination of storage in the reservoirs and expected stream-flows implies that the operation of thermal plant would cause spillage. An additional complicating factor is the lack of a reasonably sized secondarymarketfor gas and the transportation of the gas. In order to seek a long term solution for this problem, it would be important to look for alternative uses for gas and carry out studies for insertion of distributed generation in the country. The existing gas contracts do not provide correct incentives for the establishment of secondary markets by the local distribution companies. As the distributed generation i s stimulated and facilitated, consumers have an opportunity to have their own generation and independent producers can commercialize their generation. Additionally it dramatically reduces transmission and distribution costs. As a form of distributed generation, co-generation should also be stimulated, as from an energy standpoint it i s very attractive due to its high thermal conversion efficiency. To better understand the market dynamics, the entire energy supply chain for natural gas would be analyzed. Particular emphasis would be placed on identifying those key regulatory and commercial policies that create barriers and opportunities for enhancing competition, and creating gas supply conditions that can support the construction and operation of thermal plants and alternative uses for the available gas. Incentives and barriers, inclusive those of locational nature, should be evaluated. The study should identify market imperfections, either structural or induced, and proposemitigating actions. 2. Ownership of generation. The competitive model designed for the power sector in 1997 assumed that the power utilities would be unbundled, that is, its generation, transmission and - 52 - distribution activities would be separated, and further that generation would be privatized in pieces. This action would contribute to reduce potential horizontal and vertical market power from federally owned state companies. The premise assumed in the model design has not been realized. Vertically integrated ELETR0BR.h' subsidiaries continue to control about 60% of generation capacity nationwide, and as much as 90% in the North and Northeast sub-markets. This situation i s likely to remainin the foreseeable future, given current GOB'S stated objectives of not carrying out the privatization program any further. Currently, GOB is also considering the design and implementation of different pool arrangements that could assure the investments required for system expansion, while preserving the comparative advantages of hydroelectricity, and at the same time maintaining reasonable tariff levels. It is engagedinseekinga sector structure that could ensure continued investment, to avoid a repetition of the 2001 rationing crisis. Different solutions for pool arrangements, including single and multiple buyers, are currently under consideration. ESTAL would help GOB to evaluate pros and cons of different pools arrangements, including aspects related to potential exercise of market power. ESTAL would help GOB to deal with market concentration issues, by examining two important issues: (i)first i s to evaluate the incentives in place to make sure that some degree of contestability is built into the generation market. The idea of competition for the market, upon the granting process of hydro concessions, and other possible forms of competition should be analyzed. (ii)second i s to help create a level playing field to attract private capital - this involves, inter alia, a discussion on non-discriminatory treatment for private plants, dispatch decisions, and criteria for reinforcements of the power grid. ESTAL would also help review current structures and governance mechanisms for both ONS and MAE, in order to assure that independenceand perception thereof is achieved. Some other altematives may also be considered to mitigate market power of the federally owned generation, or of a major buyer acting on its behalf. One possibility, used in other countries, is to virtually slice generation capacity, by sharingthe title of the energy and ensuingrights among a larger number of players. Blocks of energy may be auctioned by generators (or by the single buyer) among multiplebuyers, who will then become the virtual owners of this capacity. Models like this, with different variations, have been tested successfully worldwide, in places such as France, and in a few states in the US, like Maine and New Jersey. An approach similar to New Jersey is currently being proposed for Italy in 2005. ESTAL would help GOB to identify potential market power and propose mitigation actions, basedon international experience. Cross-ownership or affiliation between generators, transmission companies, and distributors (which is not allowed in some Brazilian neighboring countries, like Bolivia or Peru) may create both the incentive and ability for favored PPA deals among affiliates, as well as discriminatory access to bottleneck facilities (e.g., transmission lines). This leads to a discussion whether stricter cross ownership requirements need to be strengthened, which, in tum, require an assessment of whether regulations that attempt to police discriminatory behavior are effective. Self-dealing could possibly be handled by obliging distribution companies to acquire a significant part of their energy needs via competitive procurement mechanisms (auction being one of them). Mandated - 53 - competitive procurement would also help to resolve a very controversial issue inBrazil related to the pass-through of energy costs (VN). Prices deriving from those bids should also be used as a basis for pass-through purposes, gradually substituting the artificially set VN, as recommended in one of the tasks carried out under the PPIAF Project in 2002 and taken into account in Decree 4,562 of 2002. All those aspects, as well as their detailed implementation, would be revisited as part of the scope of the ESTAL. The feasibility of creating an independent market surveillance entity to propose changes in market rules and to monitor for the exercise of vertical and horizontal market power should also be analyzed. Such entities have beenestablished or proposed in the US, Europe and Panama. All studies mentioned above will be coordinated by the MMEand will have the participation of relevant sector institutions. 3. Wholesale Market Rules. The competitive model partially implemented in the Brazilian power sector was based on competition in the market (contracts and spot) as well as on competition for the market (granting of concessions). The GOB analysis maintains that short time prices were taken as a reference for investment decisions, which would be inconsistent with the predominantly hydroelectric nature of the Brazilian power generation market. Under its review of the sector structure, the GOB i s assessing the possibility of limiting the concept of competitionfor the market only. The ESTALwill assist the GOB to identify the advantages and disadvantages of the new principle, as well the difficulties for its introduction. Additionally, the Project could assist in the transition towards the new competition principle, if such decision is taken. As the GOB considers that the bulk of the generation expansion should be hydroelectric, it would seek create more robust guarantee mechanisms for the investors in order to minimize risks for such projects with long implementation and capital recovery, thus providing sustainability to the sector's institutional arrangement. The Project would assist the GOB to analyze altemative mechanisms for financing the expansion and minimizing investor risks, while ensuring reasonabletariff levels for the final consumer. The establishment of a wholesale market is a continuous process. GOB recognized this fact when the Market Agreement was signed in 1998and the MAE rules were approved in September 2000. When ANEEL endorsed the MAE rules, the several phases of this process were spelled out in Resolution 290/2000. There would have been an initial phase, starting September 2000, with monthly spot prices and other simplifications necessary to kick-off the wholesale market. There would also have been a few additional phases in the future, such as an evaluation of the pros and cons of establishing a capacity payment. ANEEL also established that the MAEboard should be responsible for further refining the meteringsystems (in conjunction with ONS) and MAErules, over a three-phase, two-year time horizon. Many tasks which were planned at the outset have never been carried out, and those would have to be revisited. Despite some progress, only recently MAE became operational and current rules are basically those approved by ANEEL about three years ago. There were many problems that impeded the - 54 - functioning of MAE, including disputes on contracts whose property rights were poorly defined, the accounting of bi-lateral contracts and settlement of their differences, arrears and regulatory impasses. There i s a need to refine those rules, addressing issues such as Demand Side Bidding(DSB) and capacity payments, as well as revisiting existing rules governing bidding, pricing (NEWAVE model), the energy relocation mechanism (MRE) and many others. Recent proposals such as moving from cost basedbiddingto price based biddingfor hydro plants will need to be carefully evaluated to avoid possible exerciseof market power by large generators. Revisiting MAE and ONS governance mechanisms may also be necessary. In the first two years of operation, MAE has shifted from a stakeholder to a semi-independent board governance mechanism, which has given MAE more agility and independence for decision making . The stakeholder process, perhaps necessary to get buy in, proved to be very cumbersome, susceptible to deadlocks and controversyl. In 2001, 5 independent board members were appointed. Changes in governance are deemed to have achieved desirable results. After a few years of operation, it will be necessary to evaluate MAE and ONS performance, particularly in terms of stakeholder inputs and independence from the stakeholders. It may also be desirable to create a permanent and independent Market Surveillance entity (See Section B above.) A critical analysis of the existing concept of a congestion management system, based on zonal pricing (and with costs socialized via a levy chargedto customers), should be developed, drawing upon successful world experience with Locational Marginal Pricing (LMP) (such as the PJM pool in the US). Correct locational pricing should be one, among many other correct incentives, to promote distributedgeneration and give other large generators incentives for correct location, which take into account all transmission constraints within the sub-markets. As an interim measure, there i s the possibility of creating a larger number of sub-markets (a simplified and limited form of LMP), thus alleviating some of the existing perverse incentives for plant location which currently exist. The adoption of LMP (or even a larger number o f sub-markets or clusters of similar prices) may require market hedgingmechanisms such as financial transmission rights (FTRs) to reduce spot price volatility and bring more certainty to new generation investments. In the existing package of MAE rules there are no specific provisions to mitigate the spot price risk exposure of one stakeholder trading across sub-market boundaries. Such mechanisms would not only reduce risk for new projects, but also make the energy market more contestable. The benefits of FTRs, as well as their implicit cost of complexity should be carefully evaluated. In the second semester of 2002, the PPIAF Project assisted the CGSE in the general review of some of these issues associated with the MAE. The GOB considers MAE an important element in the sector's institutional arrangement that it intends to review. Two conclusions of that work have broad implications: "(...) it is required to consider the importance of a regulatory framework that lets the investors to bringnew financial resourcesto promote the expansion of the power system." "(...) themes as contract volume profiling, locational losses, energy reallocation mechanisms, - 55 - financial guarantees, and penalties, among others, are considered critical elements for the good functioning of the institutional arrangement." Taking from this body of work, the ESTAL would assist the GOB to analyze the historical evolution of the sector model and assess proposals for its adjustment, including prospective studies to inform the choice of the commercial model most suited to the characteristics of the national power system. This assessment of alternative sector structures and institutional arrangements should shed some light on the mode of participation of the several private and public agents capable of investing in the different segments of the power system. 4. Retail-level Competition. Legislation in Brazil supports the concept of retail competition, whereby an eligible customer (referred as free) has the option to choose an alternative energy supplier. The intent i s to create a contestable market in both generation and retail activities. As per Law 9,074/95, customers defined as "free" are currently the ones whose demand exceeds 3 MW and are servedat voltages equal or higher than 69 kV.Tariffs for the use of the transmission and distribution system, allowing "third party access" were also established in 1998, as per Law 9,648. More recently, Law 10,604/02 and Decree4,562/02 determined that all eligible customers who remain with the incumbent concessionaire, should substitute existing supply arrangements by unbundled contracts, whereby the wire and the commodity components are contracted separately. The separationof those two components hasjust been reiterated by a Decree issuedin 2003. The objective has always beento give more transparencyto those cost categories. According to the Law 9,074, the threshold limit which defines eligibility should be revised in 2003. There is a proposal being discussed to extend freedom of choice for some Group A customers (above 1MW) as of July 01,2004, and to all Group A customers as of July 2005. Despite the existence of the legal and regulatory apparatus described above, retail competition in Brazil has been very modest. The main reason is that the "commodity" component embedded in the supply arrangementsi s significantly under-priced currently - it is below the longrunmarginal cost of energy (LRMC) by some US$ lO/MWh or even more. Therefore, there are no economic incentives for customers to switch to alternative suppliers. No other supplier, pricing at LRMC, could beat the currently subsidized component of energy, except under very special conditions. The use of a single annual tariff percentage increase applied across the board over all customer categories in the last few years has aggravated the cross-subsidies between small and large customers, further reducing incentives for the latter to shift suppliers. This i s a situation very unique to Brazil. In most of the other countries where retail competition has been introduced, large customers were cross-subsidizing small ones, and retail competition, strongly advocatedby large users, came to the detriment of the smaller customers. Current and previous Federal administrations have been cognizant about this historic problem in the tariff structure and have implemented several gradual solutions to provide a more efficient and fair tariff system, without causing a major tariff shock to industrial customers. The decline of the Initial Contracts, as well as the more recent unbundlingof the supply contracts were the first measures, whose results were expected to take place over a long period of time. Currently the - 56 - GOB i s also considering differentiated tariff increases, as opposed to one single annual tariff increase across the board. All those actions should contribute to eliminate existing cross-subsidies and possibly create more "appetite" for customers to look for alternative suppliers. International experience has shown that the introduction of retail competition is not an easy task and should be managed very carefully. Many countries have spent millions of US$ in changing processes and systems to extend retail competition to the mass market, with questionable benefits. California has backed off, after the well known energy crisis in 2001. Other states in the US havepostponedthe implementation of retail competition. However, there seems to be a growing consensus that some form of retail competition i s beneficial to the electric system. On one hand, more buyers represent more opportunities to contract and expand the system, as opposed to having distribution companies as the single, de facto buyers in the market. Second, retail competition may facilitate the introduction of some demand elasticity in the market, with significant benefits to all customers in terms of energy reliability and affordability. Lack of demand elasticity, oftentimes referred as a plane flying without one wing, is deemed as a major cause for some of the recent failures inpower pools. ESTAL would help the GOB to examine in more detail a series of important issues, such as: 0 Evaluate how to reconcile retail competition with the overarching concept of energy as a public service, an issueof major concern to the GOB; 0 Analyze how to provide an orderly migration of free customers, with a correct tariff structure (including the wire and commodity components thereof); 0 Analyze how to achieve an orderly unbundlingof the existing supply arrangements, for customers who prefer to stay with the incumbent utility; 0 Determine the requisites for a customer to shift suppliers, without creating perverse incentives and distortions in the new institutional arrangements to be designed- for example, how to deal with the role of the incumbent as the provider of last resort, recovery of stranded costs (ifany); 0 Assess expected costs and benefits of retail competition for several threshold levels - this analysis has to weigh the costs associated with the design and implementation of new, oftentimes complex processes, such as metering, billing, sector levies and others. Intemational experience has shown that costs tend to grow exponentially with the number of eligible customers and that a successful implementation of retail competition depends, inter alia, on a detailed planning and re-engineering of severalfunctions such as metering, billing, and collection, as well as the introduction of new functions such as registration of new sellers, "shopping credits" and clearance mechanismscustomer protection, and many others; 0 Clarify interfaces with other agents, such as independent power producers, marketers, distribution companies, wholesale market (or single buyer, if implemented), etc.; 0 Develop cost-benefit analysis to evaluate the introduction of real-time metering for large customers who decided to shift suppliers. This action can contribute to introduce demand elasticity, improving affordability and reliability for all customers. Most power pools in the world are working hard to explore those possibilities, inmost cases overlooked so far; - 5 7 - 0 Identify international experiences in the utilities as providers of last resort services, and how to guarantee that they minimize the costs of procurement for their energy customers. Recent experiences in New Jersey and Maine should be discussed. Also, a revised version of the single buyer model beingproposed for Italy in 2005 should be examined; 0 Examine unbundling requirements and codes of conduct among affiliates. 5. Interaction between wholesale and retail markets. The ESTAL would examine the necessary inputs for a harmonious, seamless market, involving the supply market, independent producers, and the non-regulated (free) consumers. This would be undertaken paying due attention to the GOB'S intent to review the whole sector structure. A scenario where free consumers buy from independent producers or a pool of public service generators would be examined with a special focus on potential conflicts that could arise from this negotiation. International experience has demonstrated the benefits of joint design and implementation of sector restructuring initiatives (retail and wholesale). For example, an active, competitive retail market, with hourly metering for free $e., non-captive) customers, introduces a demand response which may reduce spot prices and the need for expensive reserves, and makes it harder for entities with market power to exercise that power. Large customers should have the ability to express their `willingness to pay', or demand elasticity, as part of the design of the organized day-ahead and possibly spot market.. An active demand response could, for example, be a pre-requisite to allow hydro generators to freely bid prices into the pool. Conversely, a market design where wholesale and retail are treated separately i s a recipe for disaster. For example, in California, retail customersnever saw the highprices in the wholesale market, while distribution companies were required to purchase all of their energy needs paying the spot price and with very limited ability to pass on these high prices in their retail tariffs. This not only prevented an efficient demand response, but also forced one of the largest distribution utilities to seek bankruptcy protection. 6. Barriers and opportunities for international energy integration. In the last decade there has been a strong increase in energy trading between Brazil and its South-American neighbors. Argentina and Bolivia supply Brazil with natural gas, Venezuela and Argentina deliver electricity. Similar trade among Brazil, Uruguay and Peru is likely in the future. On the other hand, Brazilian companies have shown interest in having a proactive role in such trade. On another related dimension, the Kyoto Protocol opens a great opportunity for Brazil becoming a strong market for renewable and clean energy, which i s a major driver for Clean Development Mechanism - CDM trading. The development of this international market will not only strengthen the South-American economies, but can also promote the use of renewable energy, which will contribute to reducing the use of fossil fuels and consequently on reducing the greenhouse gas emission and other pollutants. All these features are recent and bring in themselves a large amount of uncertainty which createsbarriers to the development of this market. In order to promote this market, the barriers must be understood and actions should be recommended.The ESTALwill help to coordinate international studies pursuingthe above target -58- and to suggest actions to the Ministry of Mines and Energy toward the promotion of Brazil in the international energy market. B: Regulation 1. Collaboration among Federal Regulatory Agencies. The collaboration among regulatory agencies becomes very important as GOB pursues an harmonization of energy policies. In this sense, it is very opportune that studies are conducted, considering as inputs policies and guidelines established by MME and aiming at developing proposals for cooperation among the agencies that would facilitate an ordering andintegration of their actions. Common themes that involve the agencies and possibly other sector agents should bear a common understanding to expedite the process of regulation and oversight and minimize controversies. While ANEEL and ANP are both definitively established intheir areas, gas supply for thermal power plants i s one of those common themes that require coordination. Environmental and multiple water use issues affecting hydro and thermal power projects also imply the need for collaboration between ANEEL, ANA and IBAMA. A general theme of common interest to agencies and private operators i s the creation of an effective appeal mechanism against regulatory decisions, following a study of institutional options. At present, disputes between private operators and a regulatory agency must be heard in regular judicial courts. It i s has been argued that this i s not an efficient system for resolving such disputes because the courts lack the technical expertise, usually decide the dispute on whether the regulator followed the correct administrative or legal process, and often take too long in rendering a decision. An alternate approach that has been' adopted or proposed in several other countries (Australia, New Zealand, England, Bolivia, India, Uganda and Chile) is to create a special appellate tribunal comprised of technical, economic and legal experts to deal with such disputes on a fast track basis for one or more infrastructure sectors and then limit further appeals to narrow legal grounds. While some preliminary work has been done under the PPIAF grant, it requires follow up actions. The ESTAL would assist the GOB to steer this collaborative process of understanding and integration among agencies, as well as bringing other relevant players into the process. 2. State Public Service Commissions. An assessmentof the institutional role of the regulatory agencies i s opportune. The PPIAF grant produced such an assessment for the Brazilian power sector. Regulation of the power sector is an exclusive responsibility of ANEEL in the whole Brazilian territory. However, the law that created ANEEL gives it the authority to delegate some of its functions to state public service commissions dealing with local energy matters. Only after these commissions have been developed through the states' own initiatives, can ANEEL propose such delegation of responsibilities to a degree compatible with their level of development, and transfer resources accordingly. ANEEL has entered into agreements with seventeen such state commissions. In general, these agreements provide for the state commission to monitor service quality and respond to customers' complaints or requests. The effectiveness of this system of limited delegated responsibility depends critically on ANEEL's ability to provide the state commissions with technical, training and institutional support. The ESTAL would help ANEEL - 59 - to provide such support to the establishedcommissions and to assist any interested states among the remaining 10 states in establishing their own commissions. It could also explore the desirability of delegating tariff setting authority to the state commissions (as is done, for example, in Argentina, the US, Canada and India). It i s envisaged that the acceleration of the studies and actions for delegation of services to the state commissions will strengthen ANEEL's role. 3. Performance Contracts. The law that created ANEEL calls for a performance contract between the agency and the Government, to enable the definition, monitoring and evaluation of the agency's goals, programs and performance indicators. Such a contract was signed in late 1998, but in practice the mechanism lacked in effectiveness and usefulness.The ESTAL would assist in reviewing this contract and identifying ways to improve this mechanism. While not exactly for regulators, international experiences of successful performance contracts between state-owned entities and their governments may provide valuable insights. The whole issue of whether there should exist such a contract deserves to be explored. If this were the case, they should be implemented as instruments for assessment of the performance of the agencies, and establishment of applicable governmental guidelines and policies. Whether Legislative or Executive branches of Government should be charged with this assessment, as well as its periodicity, also deserves analysis. Recent studies developed under the PPIAF Project suggested an alternative approach to the traditional Performance Contracts, whereby agencies would be subject to a periodic, institutional performance assessment. This exercise, recently developed for ANEEL in particular, seemed to be very promising as a process to be pursuedfurther and with other agencies as well - perhaps including also MAE and ONS. Finally, the convenience of having a performance contract for ANP (despite not being legally mandatory) or the alternative performance assessment should also be examined. 4. Regulatory Accounting. Any rational and sustainable tariff setting system for the sector's monopoly functions (e.g. high voltage transmission, low voltage distribution and system operation) must be built on a foundation of a clear and consistent regulatory accounting system. This has beenthe experience inother countries such as the United States where FERC (ANEEL's counterpart) established a uniform Chart of Accounts in the 1930s, which is now the standard accounting system for bothFERC and the 50 state commissions. ANEEL needsto develop a similar accounting systemfor Brazil andESTAL could helpANEEL to do it. This new accounting system must satisfy certain conditions: a) it must apply to all entities that engage in transmission, distribution and system operation; b) it must accommodate separatereporting for the distribution (Le., wires) and commercialization functions of distribution utilities, as well as differentiate between energy transactions to serve captive and free markets; c) it must promote uniform accounting determinations on particular components of overall cost that can support future efforts to "benchmark" the operational and cost performance of the separate public and privately owned distribution companies; and d) it mustbe flexible enough to accommodate future changes in the structure of the sector. 5. Tariff Review Process. In the period which followed issuance of Law 8,631/93, which sets the ground for sector reform, and upon the ensuing privatizations and concession renewals, -60- specific tariff rules were created.The new concessioncontracts contained, in addition to rules for tariff adjustment, definitions about periodic or extraordinary tariff revisions, as well an "X" factor aiming at capturing productivity gains. The first concession contracts had tariff revision periods from 4 to 8 years with an "X" factor equal to zero. The first tariff revisions are taking place in 2003, under ANEEL's responsibility. Unlike most other Latin American countries, Brazil does not have the benefit of detailed tariff setting guidelines in an overall electricity law or inthe concessioncontracts.For accomplishing these revisions, it has been necessaryto establish methodologies for the determination of the asset base for remuneration purposes, capital structure, the specific rate of remuneration of such capital, and an adequate structure for operation and maintenanceexpenses. For the first item, ANEEL presented a methodology, object of Public Hearing 005/2002, which was validated by Resolution 493/02. For the other items, ANEEL has been validating the methodology through Technical Notes of the revisions done or under way, a process which always includes Public Hearings. The first tariff revisions have shown the complexity, breadth and scope of regulatory, accounting and methodological issues involved. Ongoing revisions carried out this year have reiterated this complexity and called the attention for the needof a comprehensiveregulatory framework for tariff setting. The ESTAL would assist ANEEL in addressingsome of the key issues, by bringing international benchmarks and the most recent and accepted tariff-setting methodologies on the subject to current Brazilian reality and to the specifics of the concession contracts. Particular attention should be given to the asset valuation, rate of return (or WACC), and treatment of new investments for tariff making purposes, on an ongoing basis. The development and refinement of Brazilian benchmarks for efficiency would also contribute to this task. The work to be developed under the ESTAL would build on the preliminary findings and recommendations from activities supported by the PPIAF Project, as well as the ongoing experience being developed by ANEEL and MMEon the tariff review processfor several important distribution utilities. - 61 - Project Component 2 US$l.43 million - I1-EnergvAccessand Affordabilitv for the Poor A. Rural Electrification (includingsomeperi-urban areas and small towns) 1. Policy and Coordination. The most prominent rural electrification programs are under the MME (PRODEEM) and Eletrobrgs (Luz no Campo), but there are other federal, state-level (notably in Minas Gerais, Bahia, Cearfi and SFio Paulo), private sector and international initiatives. The ESTAL would collaborate with the GOB in the elaboration of an encompassing electrification policy, including evaluating and proposing integration or coordination of the multiple existing programs, and propose a structure that allows information to be centrally organized and disseminated. At the federal level, the ESTAL would primarily focus on the federal government's two major programs, Luz no Campo (which i s primarily for grid extensions) and PRODEEM (which focuses mostly on off-grid renewable energy options for remote communities). It would also explore other existing proposals and approaches, as well as ELETRONORTE andCHESFefforts, which include both grid and off-grid categories. 2. Baseline Data Collection. While rural electrification rates are uncertain, particularly in the North, it is estimated that the national rural electric service coverage i s of the order of 73%. The population without electricity i s some 2.5 million households (or 10 to 12 million people), mainly in rural areas. There are huge geographic disparities, with rural electrification rates as high as 94% in the southern state of Santa Catarina and as low as 27% in the northern state of Amazonas. The vast majority of householdswithout electricity are living inpoverty. The ESTAL would support data collection in order to more accurately determine the coverage gap and concomitant resource needs. These will then translate into targets for each concessionaire, to achieve universal access. The above efforts will include urban and pen-urban needs of smaller cities inthe interior as well. 3. FundingMechanisms. The ESTAL would evaluate several fundingalternatives. The options include: a) at the federal level, an alternative or enhancement to the Global Fundfor Reversion of Power Sector Asset Ownership (RGR), the Account for Energy Development (CDE) and dividends paid by ELETROBRAS to National Treasury; b) makingdistributors fully accountable for universal service within their concession area, with the additional costs cross-subsidized by their existing clients through general tariff increases; c) modifications in the revenue formula to provide specific incentives for rural electrification; and d) other mechanisms such as special sector funding or regional lines of development credit. 4. Development and Sustainability. The ESTAL would also assess and attempt to optimize the development impacts and sustainability of the various electrification alternatives. As most unservedpopulations are not able to pay the full recurrent cost o f the energy, much less cover the - 62 - investments, some sort of subsidy is necessary. The goal is that electrification be accompanied by other initiativesto accelerate sustainablelocal economic growth. 5. Monitoring and Oversight. The ESTAL would assist in designing objective criteria, methodologies, procedures and a financing scheme to monitor implementation of the new programs. The results should both enable these initiatives to be improved and provide informationto other countries, programs and institutions. B. Lifeline Tariff Criteria Until recently, it was up to each distributor to set the subsistence consumption level and eligibility criteria for the poor. Law 10,438/02 has provided more objective definitions, but several limits should still be differentiated on a regional basis. The ESTAL would provide a rigorous and consistent set of principles and eligibility rules, to ensure that tariff discounts are more effectively targeted towards the poor, and established on a sounder economic footing. The principles would include: 0 ensuringthat low-income tariff discounts are financed in such a way that they do not undermine incentives for private operators to servepoor households, as tends to happen with traditional cross-subsidies. 0 harmonizing the social tariff policy for urban and ruralareas. 0 establishing eligibility criteria for tariff discounts that have a proven link with the poverty status of households, basedon an empirical analysis of the correlation between electricity consumption, poverty, and other observablehousehold characteristics that might potentially serve as screening mechanisms. C. LPGand NaturalGas The use of natural gas by low-income population can only be effected with the adoption of subsidy programs, as for instance the ones adopted for LPG, and initially addressed to the cities of Rio de Janeiro and S5o Paulo, where the existing natural gas distribution networks had been used for decades for nafta gas distribution. There, the compulsory substitution of the LPG for natural gas resulted in higher price per kJ for the residential consumer. The case i s more complicated if the gas distributors have to invest in residential network expansion. They claim that such investment in most cases i s not economically or financially viable. An exception may be new, big residential developments, if the implementation of the distribution network i s considered in the planning phase and some subsidy i s offered to the consumers in order to have both affordable tariff and full remuneration of the service. The ESTAL would assist the GOB to develop a thorough diagnosis of the problems concerning natural gas utilization, and identification of measures that could be implemented for increasing access to gas andinparticular by low income populations through affordable tariffs. With respect to LPG, the GOB implemented a program for subsidizing cooking gas for low - 63 - income families ("Programa Auxilio-Gis"). This program i s partof apackage of social initiatives directed to the poorest segments of the Brazilian society. wider social .The model for evaluation of results and impacts of this specific program should consider the other social programs in their entirety, and define the format of managerial and monitoring reports. In that sense, the ESTAL would assist the GOB in the development and implementation of the evaluation methodologies. Project Component 3 US$2.34 million - 111. EnvironmentalManagement Expansion of power systems increasingly must balance sustainable use of natural resources, social equity in dealing with impacts, transparency in decision making, and responsivenessto the dynamics of the private sector (e.g., clear and simple rules of the game, low and/or predictable transaction costs). To achieve these objectives, the Government proposes to implement the Program to Strengthen Planning and Management of Environmental and Social Issues in the Power Sector. Draft Terms of Reference for the Program were prepared by a working group of senior power sector professionals, in close coordination with the MMA's Secretariat for Environmental Quality and the Bank (see Annex 14, Attachment 1). Detailed TORs will be prepared and discussed with a broader set of stakeholders (including environmentalists, the private sector and academia) before the start of project implementation. The Program will be undertaken in successive stages, with consultations carried out at each major stage (e.g., diagnostic, definition of priorities, formulation of a multi-year strategy, formulation of the first phase action plan).. An advisory board, technical groups and a consultation strategy have been outlined on a preliminary basis, and will be detailed and agreed in the final TORs of the Program during project implementation. This medium-term program might be further supported by the Bank through subsequent operations. The first phase, to be supported by the ESTAL, would focus on the following areas: A. Environmental licensing The project would finance the revision and adjustment, as needed, of the licensing process, to be carried out jointly by MME and MMA. The team would: i)evaluate the adequacy of the current licensing system as it applies to power sector projects; ii)revise and propose the updating, as necessary, Resolution 06/87 from CONAMA; and iii)revise other requirements, procedures and mandates, as needed. Special attention should be given to the implementation of a recent CNPE Resolution, establishing that as early as in 2004, new hydro concessions can only be granted if there is a corresponding environmental license. This will require a review in the licensing process, as agreements with environmental authorities on the minimum specifications to be contained in a pre-basic project, in such a way that the environmental license may be given without a detailed, full-fledged basic project inplace. - 64 - B. Environmentul/social impacts of system expansion The existing methodologies and manuals for river basin inventories, thermal plant location, and for design of hydro and thermal plants and transmission networks would be revised and updated to reflect recent changes in power and water sector policies, as well as emerging concepts and approaches to environmentalhocial impact assessment (EM). In the case of the assessment of alternative expansion paths, the strategic EL4 methodology proposed by the MMA in general terms i s beingadaptedto the power sector by CEPEL. The project will further support this effort by financing international experts and promoting workshops with multiple stakeholders to review and consolidate results. Ideally, the revised methodology should be applied and tested as an integral part of a real expansion plan for the sector. The results would serve as a basis for later methodological refinement. In the case of thermal plants, MME proposes to carry out a study that would first look at past experiences in terms of design, environmental licensing and operation of thermal plants inBrazil, to extract lessons learned and best practices. Based on this, guidelines for locating green-field thermal plants would be proposed, with environmental/social impacts examined on a regional, rather than site-specific basis, taking into consideration zoning recommendations, regional constraints, and criteria for project and technology selection. C. Climate change and environmentalservices The ESTAL would finance an assessment of issues and options for: i)incorporating climate change concerns and objectives into sector expansion; and ii)sector participation in international carbon emissions reductions markets. The potential for incorporating into power sector projects the payment for environmental services, such as protection of river basin headwaters and of riverine vegetation as a means to reduce siltation and minimize reservoir capacity reduction, would also be explored. D.Monitoring and ex-post evaluation The ESTAL would review the current status of systems for monitoring and ex-post evaluation of environmental and social impacts in the power sector, and propose, as needed, changeshpdates in: i)monitoring and evaluation system design; ii)data management and access protocols; and iii)resourceneeds.Specifically, theinterfacewithprivatepowerproducersshouldbeexamined. E. Corporate environmental/social responsibility Given the trend towards increased private sector participation in the sector expansion, it will be increasingly important for the power sector to promote voluntary compliance and the adoption of environmentally and socially responsible behavior on the part of power producers, as a complement to the compliance and enforcement of regulations that are the responsibility of environmental agencies. The project would assess issues and options to foster corporate responsibility as a means of improving power sector performance, comprising: (i) a survey of the - 65 - priority of environmental/social issues for power sector managers, in a sample of utility companies; and (ii)a review of emerging instruments and processes to promote environmental/social accountability among corporate entities, and their relevance to Brazil. F. Institutional realignment and capacity building The ESTAL would assess the mandates and capabilities of agencies in the power sector (MME, ANEEL, CCPE, ELETROBRAS) or involved in environmental management of power sector projects (MMA, ANA, CONAMA, CNRH), to: i)identify any bottlenecks, inconsistencies and overlaps, and recommend how to overcome them; ii)determine whether the allocation of environmental expertise and budgets in power sector agencies i s appropriate; and iii)recommend ways to reconcile dysfunctional arrangements, improve clarity of mandates and coordination across agencies, and adjust sector staffing profile and budget allocations to the new sector context. The project would also provide training for staff in the power and environmental sectors and strategic strengthening of environmental licensing agencies in regionsktates where expansion of the sector might be concentratedover the coming years. ProjectComponent 4 US$6.48million - IV. Long-termExpansion Planning The GOB acknowledges the need to build up both its capacity and methodology for long-term expansion planning, and its inventory of potential investments in the expansion of supply and energy infrastructure. These should cover all aspects - technical, economic, environmental and social. The GOB also has the vision that the expansion of supply in the energy sector should be borne by joint participation of the public and private sectors, sharing risks and benefits. It maintains that a strategic dimension of determinative nature should be added to the purely indicative dimension, as currently prevails in the expansion planning of power generation, in order to ensure the full satisfaction of the demand and avoid repetition of crises as the one occurred in 2001/2002. In the case of transmission, the planning is determinative and the private sector has responded satisfactorily by bidding for the specific facilities tendered and contributing to expand transmission capacity. The development of planning capacity in MME i s dealt with under item V.B.1 below. The component described here deals with the other two aspects - improvingthe system expansion methodology, and expanding the inventory of projects. A. System expansion methodologies The ESTAL would support preparation and/or updating of methodologies and technical manuals for: i)medium and long term energy system expansion, which would in turn support the elaboration of plans for ensuring balance between supply and demand; ii)location of thermal plants, taking into account fuel supply, water resources, environmental pollution, and location of demand centers; and iii)feasibility analysis of large power plants and bulk infrastructure systems. These methodologies would incorporate environmental and social criteria, and both supply and demand side alternatives. They would also clarify institutional roles and procedures for medium-long term planning within the sector and in coordination with water resources and environmental agencies. The elaboration of these methodologies and technical manuals for the - 66 - expansion of the power systemis key to achieve the desirable supply-demand balance. B. River basin inventories The inventory and feasibility studies of the hydroelectric potential should be intensified as there are still some 150,000 MW to study properly. Current federal administration believes that several of costs incurred in the studies on inventory, pre-feasibility, environmental feasibility, and possibly basic design should be funded by the government, at least until the projects are developed. Two important reasonsbeing mentioned include: (i)a recent resolution from CNPE, requiring that the hydro concession granting process be preceded by an environmental license - this action will require more effort from the government in terms of preparing basic design for many projects and getting the environmental licenses in place; and (ii) the need to expand geographical coverage for inventory and feasibility studies in new, unexplored areas. Current administration also believes that the current cost recovery mechanism for inventory and feasibility studies (paid by wining bidder upon granting of the concession), limits the interest of the private sector in exploring the more attractive, better known rivers and sites. The ESTAL could partially finance preparatiodupdate of inventories, with possibly detailed feasibility studies for a few, selected sites. Those studies should take into account provisions of the new National Water Policy regarding multipleuses as well as environmental and social impact concerns. These are fundamental elements for the medium and long term expansion planning studies as well as for keeping the stock of offers for the concessionauctions conducted by ANEEL. Because of the magnitude of this work, the ESTAL would be able to finance only part of the most urgent of these studies. C. Thermalplant macro-location A macro-location study of thermal plants would define in general terms the areas inwhich those plants should be built, taking into account location of demand, fuel supply, land availability and pollution issues. Incorporating the guidelines developed in Component ID, MME with support of the ESTAL would carry out an assessment of the most promisingpotential sites of thermal power plants, eliminating those where impacts might be unacceptable or mitigationkompensation programs excessively costly, with a view to facilitating the preparation of feasibility studies and the licensing of thermal power projects. Project Component 5 US$3.81 million - V InstitutionalStrengtheningand Coordination - A. MME Restructuringand Organization MMEmustplay the roleof formulator of power sectorpolicies. A recent organizational study by MME consultants concluded that the current organization must be strengthened to enable the MMEto carry out such Government responsibility, with the adequatepersonnel in terms of size and expertise. The TCU and the Senate, through its report about the recent electric crisis, made similarrecommendations.A new structure is being implemented. The ESTAL would help MME to critically evaluate the structure, to propose and supplement training plans review internal processes, communication flows and other key features necessary - 67 - to MME in its policy formulation as well as sector planning execution -- whether through the structure of CCPE or, as established by CNPE resolution 16/2002, by implementation of an organ directly linked to the MME, as a service provider for planning support, and detached from any interest in the competitive market.. In light of the need for greater incorporation of energy issues in broader GOB planning, the ESTAL will also support establishing the working plan, mechanisms and systematic channels by which MME will interface with the sector agents and specifically at executive and working group levels with MMA, MPO, MF, ANEEL, ANP, ANA, CNPE, etc. The ESTAL would also help MME to perform an overall needs assessment, to identify the further resourcesand capacity-building efforts required, once the overall strategy and objectives of the new organization are consolidated. The ESTAL would then help in preparing a plan and the necessaryTerms of Referencefor obtaining the additional services. B. MME Units Strengthening Under the current MME organization, all coordinating units, which are responsible for Planning, Energy Development, Electric Energy, Oil & Gas, and Mines & Metallurgy, would receive support from ESTAL in elaborating and monitoring their strategic operational plans, structuring the units and their procedures, identifying resource requirements and how to best obtain them, developing specific studies, and responding to new obligations and challenges. Each programmatic area would be first examined to ascertain that MMErequires the unit, to minimize overlapping of functions, to seek ways to capture synergies, and to communicate effectively with other MMEand non-MME units.Environmental Management i s being covered under component III.BelowisasuggestedmenuofactivitiesforsomeoftheareasbelongingtoeachoftheMME coordinating units. 1. Integrated Planning. Many of the sector planning responsibilities formerly undertaken by GCPS under coordination of ELETROBaS are now assigned to CCPE, under coordination from the MMEExecutive Secretary. CCPE has been making an attempt to improve the planning process, by gradually integrating the fuel strategies and sector expansion alternatives, prioritizing investment areas, and bringing into the picture energy efficiency and conservation options, and the utilization of emerging and non-conventional technologies, such as photovoltaic, wind, micro/small hydro and biomass energy and clean combustion techniques. Such new approach should entail the development of alternative scenarios, incorporate pricing and demand response, andinternalize environmental/social concerns. A monitoring system should also be developed. The studies that will underpinthis new energy planningwould be developed under a new concept of internal organizational structure, and would require the reinforcement of the MMEcadre with skilled specialists or through the planning support organ mentioned in A above. In either case, extensive trainingshould be considered given the complexity of this subject. 2. International Energy Integration. The ESTAL will provide short-term assistance to help organize this fledgling area with a work plan. Among the capabilities this area i s seeking are: a) better understanding and use of international cooperative agreements; b) approaches for - 68 - information exchanges with foreign public and private institutions; c) implications of bidding documents and contract terms and standards for foreign investors, and how to deal with these (public business relations); d) increase Brazil-Bolivia and Brazil-Argentina partnerships due to the joint energy commissions recently created; and e) coordination of international aspects dispersed in various MME departments. There are some ongoing bilateral cooperation efforts between Brazil and Ukraine to exchange technological expertise ingas turbines. This area should also be responsible for fostering the operational coordination of the power systems, to trade energy in the most economic and effective way. This may require, inter alia, the establishment of uniform market rules and grid procedures, as well as a strong interaction protocol between each country power operator. 3. Universal Access to Energy. This program has suffered from institutional and political weaknesses since its inception in 1995, which are well documented and were addressed by previous TA activities supported by various donors. As proposed in its business plan, structural changes would finally enable it to perform its tasks in a more sustainable and autonomous manner. The ESTAL would provide support to: a) resolve PRODEEM's structural and operational problems; b) establish the funding mechanisms for the productive market projects it i s launching; and c) clarify its relationship with the Luz no Campo Program. Indirect assistance to PRODEEM i s also included under the ESTAL component IIfor Energy Access and Affordability for the Poor. 4. Energy Efficiency. Although the Bank has a separate Energy Efficiency project in Brazil, this component would help a relatively new MME area to establish the capacity to formulate coherent, market-promoting policy initiatives. ESTAL would also support MME in the implementation of Law 10,295/2001, by establishing specific regulations to 20 critical pieces of equipment which represent a significant potential for energy conservation. Targets for maximum standards for consumption or minimum level of energy efficiency should be established, taking into account international benchmarksand manufacturing capabilities in Brazil and abroad. 5. Alternative TechnologiesAJtilization. The ESTAL would evaluate the objectives of these two areas, seek opportunities for synergies with the Universal Access Program, and develop a plan to acquire organizational, technical, training and other resources required to explore further supply alternatives such as wind, solar, biomass, urban waste, and clean combustion for domestic coal. ESTAL would also support the economic and environmental analysis of domestic coal, both for current and non-conventional combustion techniques. Additionally it may support MME ongoing efforts by developing complementary studies as required. Given the availability of extensive agricultural land, the development of fuels from renewable sources i s another theme of high interest for the GOB for which ESTAL could provide support to the MME. The production of bio-diesel i s not commercially feasible on the basis of current economic and financial parameters .However the share of the diesel in the energy matrix and its weight in defining the petroleum imports, as well as the likely global demand increase for more ecologically friendly fuels, point to the importance of revisiting the parameters that play in the economic feasibility of bio-diesel development. O f interest i s also the analysis of policies that call for a greater participation of renewable fuels in the demand, given that its environmental benefits are not always captured by market prices. - 69 - 6. Mines and Metallurgy. The management of the activities of geology and mining at the national level i s a specific competence of the MME, which assigns to the Secretariat of Mines and Metallurgy-SMM the formulation and implementation of the policy for the mineral sector. The current diagnosis of the mineral sector points to the progressive reduction of the participation of public federal agents as effective elements for the elaboration and execution of actions aimed at the development of the mineral production. The SMM directives for resuming the development of the Brazilian mineral sector are based on the consolidation of the organs directly under its responsibility - DNPM, the National Mineral Production Department and CPRM, the Mineral Resources Research Company -as effective agents for the integration of the geology and mining areas, under a more ample vision of management of water and mineral resources, land use, environment, and territory occupation. In terms of macro-functions, the DNPM is in charge o f concession grant, oversight and control of mineral resources of the country, while the CPRM executes the basic geological and hydrogeological surveys. The absence of public policies that entails actions for execution by these organs, has been key for the institutional vacuum during the last years. Furthermore both organs had their financial resources subjected to national budget cuts, what compounded the chronic insufficiencies for discharge of their constitutional mandates. Currently, there is a back log of some 150,000 applications for authorization of mineral activities by DNPM, which can be attributed to its organizational, personnel and financial deficiencies. The latter in turn impedes proper oversight of mining activities all over the country. The drastic reduction of CPRM financial resources has impeded the enhancement of geological knowledge of the Brazilian territory and the ensuing investment in research and exploration of new mines. Brazil i s among the large mineral producers in the world the one that least knows its subsoil. Finally, there i s a lack of training and capacity building for both organs, a problem compounded by the urgent need to replenish their professional cadres. MME's strategy to revert the unfavorable reality of investment decreasein mineral researchand miningconcentrates in the institutional strengthening of its two organs and seeks to increase the information about the country's mineral potential, thus reducing the gap ingeological knowledge and expertise and the underutilization of the mineral resources. The ESTAL would assist the MME in formulating this strategy in depth and establishing the policies that would permit its fulfillment. Additionally the ESTAL would assist the MME in launching the review of the mineral code, procedures and legislation with an aim to remove any obstacles to private investment. 7. Oil andNaturalGas 7.1 Oil. The GOB is concernedwith the lack of investments for expanding the refiningcapacity installed in the country. While Brazil i s on the verge of becoming a net exporter of petroleum, it i s progressively increasing its import o f derivatives, whose aggregated value i s larger. Differently from the oil, there i s low availability of derivatives in the world, and therefore apossible pressure for price increase. From a point of view of public policy, the GOB maintains that a new refinery with no or minority participation of PetrobrAs would foster the competitive process for internal supply of derivatives and possibly lead to a review o f the role of the distribution companies in the - 70 - Brazilian market. This would also contribute to reduce the dominant position of Petrobris in the refiningmarket, which has causedsome discomfort to potential investors. It is of ultimate importance for the GOB to equip itself with agile mechanisms for follow up of the petroleum and derivatives market, thus facilitating the identification of abusive practices of market power, and the defense of consumers . The ESTAL would assist the MME in carrying out studies for the implementation of a national information network on supply and demand of petroleum and derivatives, and the principles for its availability to the public. 7.2 Natural Gas. The MMEreckons the needto dispose of a robust databasefor enabling it to establish policies related to the natural gas industry, which will require coordination of actions, promotion of sustainable development and monitoring. A proposed national department for natural gas would be the vehicle for performing this role, for which it must build a structure that would perform data collection, storage and updating, and have capacity for analysis of the market and industry structure, including forecast and guidance for the industry development. This requires an agile mechanism, underpinned by modern information technology, for supporting its active relationship with other planning areas within MMEand in other sectors of the Government, as well as with A" and market agents - gas producers, transporters, shippers, distributors, and consumers, and their associations. The proposed department, as the envisaged manager of a database for the natural gas industry and key player in the envisaged integrated energy planning, should have personnel with hands-on experience of the industry in the field and knowledge of economics, business practices, equipment and operation of each segment of the sector - from the production well to the final consumption of the natural gas. The ESTAL would assist the MME in the structuring of its gas area. C. CNPE Operationalizing CNPE, a top-level inter-ministerial council responsible for energy policy-making and monitoring of sector coordination and policy implementation, was established in 1998 but only (incipiently) operative since 2000. It has an Executive Secretary and ad-hoc commissions, without own staff. Its entire support i s provided by MME.The ESTALwould evaluate this arrangement and identify options to improve the institutional structures that support CNPE, looking at the necessary interfaces and key processes between CNPE and MME, as well as among other agencies participating in CNPE. D. CDE Operationalizing Law 10,438/2002 created the CDE, a fund for energy development, and revoked energy subsidies. CDE's income accrues from fines charged by ANEEL, from levies charged for the use of public goods (hydro plants) and from special fees to be charged to all marketers selling to final consumers.This fundmust be usednot only to cover the gap between the economic and the competitive value for biomass, small hydropower plants and wind power plants, but also to support the Universal Access Program. The EST& would support studies, workshops, and simulations inorder to suggest ways to operate the CDE and how to allocate its funds in the most cost-effective way. -71 - Annex 3: EstimatedProject Costs BRAZIL: Energy Sector Technical Assistance Project Project Cost By Component I. DevelopmentandRegulation Market 1.60 2.01 3.61 II.ElectricityAccess&AffordabilityforthePoor 0.86 0.57 1.43 III. EnvironmentalManagement 1.28 1.06 2.34 IV.Long-TermExpansionPlanning 5.64 0.84 6.48 V. Institutional StrengtheningandCoordination 2.11 1.70 3.81 VI. ProjectManagement 1.13 0.00 1.13 VII. Reserve 0.30 0.90 1.20 NOTE: All costs above includephysicalandprice 0.00 0.00 0.00 contingencies Total Baseline Cost 12.92 7.08 20.00 PhysicalContingencies 0.00 0.00 0.00 PriceContingencies 0.00 0.00 0.00 12.92 7.08 20.00 0.12 0.12 12.92 7.20 20.12 IIdentifiable taxes and duties are 0 (US$m)and the total project cost. net of taxes, is 20.12 (US$". Therefore, the project cost sharing ratio is 60.24% of total project cost net of taxes. - 72 - Component - 7 3 - Annex 4: Cost Benefit Analysis Summary BRAZIL: Energy Sector Technical Assistance Project Note: Quantitative economic and financial analyses are not applicable for TA operations such as this. However, if carried out successfully, the project will improve the efficiency of the power sector and reduce the risk of future shortages, both of which would have major economic benefits. The current crisis is estimatedto have reducedGDP growth by 1%. - 74 - Annex 5: Financial Summary BRAZIL: Energy Sector Technical Assistance Project Years Ending June 30 IMPLEMENTATIONPERIOR 1 I Year1 I Year2 I Year3 1 Year4 I Year5 1 Year6 I Year 7 Total Financing Required Project Costs InvestmentCosts 3.7 5.7 5.7 3.8 0.0 0.0 0.0 Recurrent Costs 0.3 0.3 0.3 0.2 0.0 0.0 0.0 Total Project Costs 4.0 6.0 6.0 4.0 0.0 0.0 0.0 Front-endfee 0.1 0.0 0.0 0.0 0.0 0.0 0.0 Total Financing 4.1 6.0 6.0 4.0 0.0 0.0 0.0 Financing IBRD/IDA 2.5 3.6 3.6 2.4 0.0 0.0 0.0 Government 1.6 2.4 2.4 1.6 0.0 0.0 0.0 Central 1.6 2.4 2.4 1.6 0.0 0.0 0.0 Provincial 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Co-financiers 0.0 0.0 0.0 0.0 0.0 0.0 0.0 User FeeslBeneficiaries 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Other 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Total Project Financing 4.1 6.0 6.0 4.0 0.0 0.0 0.0 Mainassumptions: 1. All figures in US$ million equivalent 2. Recurrent costs borne by the Central Government correspond to Project management (Project Component 6, see Table under Cl) - 75 - Annex 6(A): Procurement Arrangements BRAZIL: EnergySector Technical Assistance Project Procurement I. ProcurementResponsibility. Theprojectimplementationwillrequireprocurementof about $12.0 million of technical assistanceservices for studies, other consultant assignments and training. A centralized Project Implementation Unit (PIU), headed by an experienced full-time project manager, will report to the Executive Secretary of the MME. The PIU will process the selection and hiring of individual consultants, including preparation of contracts for signature of the assigned MME authority. In the case of hiring consultant firms, MME current structure is adequate to process the bidding requirements, if the PIU supports the MME Bidding Commission (Comissgo de Licitqijes), including preparation of the packages and the technical reports that will enable the Commmission to eventually award the contracts. The PIU will coordinate as needed with each of the participating agencies in carrying out procurement activities and will assist them in monitoring and reviewing the consultants' work. The details of these arrangements would be spelled out in the Operational Manual. Inorder to enable the PIUto perform such procurement duties, it will include at least one high level procurement specialist with qualifications satisfactory to the Bank. The specialist will be provided with clear working instructions closely reflecting the Bank's procedures and outlining all procedural aspects of consultancy recruitment under the project. The working instructions, to be spelled out in the Operational Manual, should be integral part of a "black book" containing standard requests for proposals, forms of contract, model letters, timetables, model TOR and any other information related to procurement. 2. Procurement Plan. A procurement plan covering the first year of operation has been submitted by the MME. An extended plan covering the whole duration of the project, and including contract packaging, applicable procedures, and short lists selection criteria, will be a condition of effectiveness. The plan will be updated every 6 months and include: i)the list of contracts completed, under execution, under procurement, to be procured in the upcoming calendar semester and, tentatively in the subsequent semester; ii)costs of completed and under execution contracts, estimated costs for upcoming contracts; iii)schedule of bidding; and iv) particular methodsof selection of consultants. 3. Methodsfor the Bank FinancedProcurement. The Bank financed procurement will be carried out in accordance with the provisions stipulated in the Loan Agreement and the Guidelinesfor Selection and Employment of Consultants (published in January 1997, revised in September 1997 and January 1999).The Banks Standard Request for Proposals will be used for the Bank-financed consultant services. The arrangementsare summarized inTable A. 4. The Bank-Financed Consultant Services and Associated Procedures. The proposed project will finance consultant services and training for an estimated total cost of about US$12 million and consisting of (i) technical studies; ii)institutional strengthening, coordination and monitoring; and (iii)specific project related training (which includes study tours and workshops). - 76 - 5. The project's selection and employment of consultants will be carried out under arrangementsacceptableto the Bank(Table AI), using the Bank's StandardForms and Contracts. The Project's studies will be executed by consultant firms and procured following the Quality and Cost-Based Selection (QCBS) method. Individual consultants, included those for Training, will be selected on the basis of their qualifications for the assignment as per section V of the Consultants Guidelines. During project preparation, the MME Legal Department issued clarification that consultants selected by the PIU and hiredby the MME in accordance with the Bank's Guidelines are not entitled to acquire public employee status. 6. Procurement Review. The Bank's review of selection of consultants will be in accordance with Appendix 1 of the Guidelinesfor Selection and Employment of Consultants and the provisions stipulated in the Loan Agreement. Consultant firm contracts estimated to cost the equivalent of US$50,000 or more per contract will be subject to the Bank's prior review whereas consultant firm contracts estimated to cost less than the equivalent of US$50,000 per contract will be subject to post review. For employment of individual consultants estimated to cost the equivalent of US$30,000 or more, the qualifications, experience, terms of reference and terms of employment of the consultants will be provided for prior review and the contracts will be awarded only after the Bank's concurrence. Contracts for individual consultants estimated to cost less than the equivalent of US$30,000 will be subject to post review. The Bank will post review at least one in five contracts. Consultant contract documents to be reviewed will include TORS, short lists and evaluation reports, and contract forms. Table A 1 summarizes the methods used for hiring consultants under the Project. The aggregate amount for hiring individual consultants is limitedto US$2,000,000. 7. Advertising. A General Procurement Notice for procurement of consultant services will be published in the United Nations Development Business paper, no later than August 2003, assuming that the loan would be approved by end of June 2003. The Notice will be updated annually for outstanding consultant services. In addition, detailed consultant services and assignments will be advertised, as they become available, in at least one national newspaper of large circulation. Furthermore, the PIU may also advertise some of the project's studies in an international newspaper or a technical magazine. It may also seek "expressions of interest" by contacting embassies, professional organizations, or firms that it knows or that are registered in DACON (paragraph 1.15 of the Guidelinesfor Selection and Employment of Consultants). Inthis case, the information required would be minimum, limited to make a judgment on the firm's suitability. Sufficient time (not less than 30 days) will be provided for responses, before preparingthe short lists. 8. Procurement Records. Detailed procurement records, reflecting the project's supply of consultant services, including records of time taken to complete key steps in the process and procurement activities related to supervision, review and audits, will be maintained by the PIU. These records will include public notices for expression o f interest, request for proposals and addenda, technical and financial reports, formal appeals by consultants and outcomes, signed contracts, addenda and amendments, records on claims and dispute resolution and any other useful information. - 77 - 9. Procurement Risk Assessment. There has been no Country Procurement Assessment Review (CPAR) for Brazil. A Capacity Assessment of the MME was carried out before appraisal. It has been approved by the RPA's office on June 6, 2002 and will be in the project files. The CMUImplementation Team at B r a s h was retained to assist on this. 10. ProcurementAudits. The PIU will provide the Bank, no later than six months after the end o f each year, procurement records audited by independent procurement auditors, acceptable to the Bank. The records will be in accordance with internationally accepted standards. 11. Action Plan This action plan has been agreed with MME during negotiations to comply with all procurement requisites. Action Due Date 1) Submit a ProcurementPlanto the Bank. It was submittedby appraisalfor the first year of implementation; by effectivenesscovering the full period of implementation; to be updated every 6 months. 2) Set up the ProcurementTeam of the PIU (including at least By effectiveness one full-time professional experiencedinBank procurement) and arrange for its training in a seminar organizedtaking into account Bank requirements for procurement. 3) Submit to the Bank the TOR for the first two assignments Notional:30 and 90 days after with individual consultants, and TOR and RFP for the first effectivenessfor firms and individual two assignments with firms. consultants,respectively. 4) MME Legal Department to issue clarification on the It was submittedby appraisal. possibility of the PIU selecting and employing individual consultants in accordance with the Bank's uidelines without running the risk of possible claims by such consultants to acquire public employee status employee status. 5) Set up a procurement monitoring and information system, By effectiveness. as part of a Financial ManagementSystem. 6) Submit independentprocurementreviews to the Bank once June 30 each year starting in 2003. a year, producedby procurementauditors hiredin accordance with TOR acceDtableto the Bank. Note 1: Action 3 is not deemedto be a loan covenant; it is recommendedto be a benchmark for supervision. Note 2: For its best functioning, the ProcurementTeam would include: a) a full time procurementspecialist with experience in hiring consultant firms and individualsunder the Guidelines; b) a part time high level consultant of Bank-procurementto assist not less than 90 hours, per year, inthe procurement planningandproject implementation; c) an engineer, with experience in contracting administration; and d) ad hoc specialists to help review terms of reference, evaluate CVs and qualification criterion, prepare evaluation reports and assist in contract negotiations.The TOR and profileof the individualswill be reviewedby the Bank. - 78 - Procurement methods (Table A) Table A: ProjectCosts by Procurement Arrangements (US$million equivalent) (0.00) (0.00) (0.00) (0.00) (0.00) 2. Goods 0.00 0.00 0.00 0.00 0.00 (0.00) (0.00) (0.00) (0.00) (0.00) 3. Services 0.00 0.00 18.37 1.13 19.50 (0.00) (0.00) (11.50) (0.00) (11.50) 4. Training 0.00 0.00 0.50 0.00 0.50 (0.00) (0.00) (0.50) (0.00) (0.50) 5. Front-endfee 0.00 0.00 0.12 0.00 0.12 (0.00) (0.00) (0.12) (0.00) (0.12) Total 0.00 0.00 18.99 1.13 20.12 (0.00) (0.00) (12.12) (0.00) (12.12) Figuresin parentheses are the amounts to be financed by the Bank Loan. All costs includecontingencies. Includes consultingservices renderedby firms and individuals,the latterincluding consultantsfor Training; and expenditures relatedto Training, like travel, course fees, etc. Captions:ICB: InternationalCompetitiveBidding; NCB: National CompetitiveBidding; Other: includes Selection of Consultants; NBF: Not Bank-financed - 79 - Table A1: Consultant Selection Arrangements(optional) (US$millionequivalent) Selection Method Consultant Services ExpenditureCategory QCBS QBS SF6 LCS CQ Other N.B.F. Tota\cos( A. Firms 15.50 0.00 0.00 0.00 0.00 0.00 0.00 15.50 (9.50) (0.00) (0.00) (0.00) (0.00) (0.00) (0.00) (9.50) B. Individuals 0.00 0.00 0.00 0.00 0.00 2.87 1.13 4.00 (0.00) (0.00) (0.00) (0.00) (0.00) (2.00) (0.00) (2.00) Total I 15.50 0.00 0.00 0.00 0.00 2.87 1.13 19.50 (9.50) 1 (0.00) I (0.00) I(0.00) I (0.00) I (2.00) 1(0.00) 1 (11.50) I " Includingcontingencies Note:QCBS = Quality- and Cost-BasedSelection QBS = Quality-basedSelection SFB = Selection under a FixedBudget LCS = Least-CostSelection CQ = SelectionBasedon Consultants'Qualifications Other = Qualifications of individualconsultants (per Section V of ConsultantsGuidelines) N.B.F. = Not Bank-financed Figures in parenthesesare the amountsto be financed by the Bank Loan. - 80 - Prior reviewthresholds (TableB) Table B: Thresholdsfor ProcurementMethodsand Prior Review' ContractValue Contracts Subjectto Threshold Procurement Prior Review (US$thousands) Method (US$thousands) .Works !.Goods I.Services(Consu1tant >/=50 QCBS Firsttwo contractsinthe jet-vices) (firms) First year and all contracts >/=$50 equivalent Aggregate amount for contracts under prior review threshold: $1,000 >/=30 2ualifications of individual Firsttwo contracts inthe (individual consultants) consultants first year and all contracts (Section V of Guidelines) >/=$30 equivalent Aggregate amount for contracts under prior review threshold: $500 Post review, random sample, on all contracts below threshold. 15. Miscellaneous 6. Miscellaneous Total value of contracts subject to prior review: US$17.8 million Overall ProcurementRisk Assessment: High Frequency of procurement supervision missions proposed: One every 6 months (includes special procurementsupervision for post-reviewlaudits) While the post-review/auditswill coincide with a supervisionmission, they will take place once a year 'Thresholds ! generallydiffer by countryand project. Consult "Assessment of Agency's Capacityto Implement Procurement" and contact the RegionalProcurementAdviser for guidance. - 81 - Annex 6(B): FinancialManagementand DisbursementArrangements BRAZIL: Energy Sector Technical Assistance Project FinancialManagement 1. Summaryof the FinancialManagementAssessment Country Issues. According to conclusions of the Brazil's Country Financial Annual Assessment currently under finalization: "Brazil has a well developed and centralized system of public financial management. Overall it is able to reliably track budget expenditures. However the institutional arrangements and processes are complex. While good results are achieved in terms of aggregate fiscal control, the Government is less successful in achieving good expenditure prioritization and operational efficiency". The Brazilian system of public financial management yields reliable information and adequate management and tracking of the receipt and use of funds at national level, and is able to support Bank's lending programs. The country issues that could affect the project's financial management system and/or the fiduciary responsibilities of the implementing Agency are therefore manageable. Strengths and Weaknesses. The MMEhas never been a central implementinglexecuting Agency for Bank-financed projects. At the time the Financial Management Assessment visits were undertaken, there was no Financial Management capacity in place to implement this Project. An action plan is included below, to provide the PIU with capability to implement and manage the Project. Flow of Funds. As per procedures currently being used by the Brazilian Federal Government, the National Treasury Secretariat (STN) will advance funds to the Project for subsequent reimbursement by the Bank of eligible expenses. The first Bank disbursement out of the Loan Account will be the Special Account (SA) allocation, with an initial deposit of in the STN account of Banco do Brasil, New York. The maximum amount of the SA will be US$l.O million (equivalent to 4 months of average projected disbursement). STN cash advances to the Project, including counterpart funding, will be deposited in an operational account in R$ managed by and under the responsibility of the PIU. The PIU will request the funds in R$ to STN on basis of the Implementation and Procurement Plans. Subsequently the PIU will prepare SOEs to be forwarded to STN to draw from the Special Account and subsequent replenishment from the Bank's Loan account. Staffing - FinanciaYAdministrative Team. The Financial/Administrative team will consist of a Financial Manager plus three Administrative Assistants, including an IT specialist and an accountant. They will be responsible for the accounting, financial planning, reporting through Financial Management Reports-FMR, preparation of payment requests (Notas de empenho), preparation o f SOEs, and operation of the Financial Management/Monitoring system. The Sub-secretariat of Planning, Budgeting and Administration (SPOA) of the MME will provide support to the PIU in payments processing, accounting, office administration and information technology, and will also enter the annual Project budget into the Federal AccountingA3udgeting System - SIAFI. The Financial/Administrative team to be put in place, together with the support of SPOA, will be adequate for the financial management of the Project. Information and FinanciaYAccounting Systems. The MME will assign a group to study and propose the Financial Management/Monitoring system to be used. The system must be fully integrated with the FMR management system for monitoring and controlling project execution and financial management, including accounting, reporting, special account control, disbursements, and SOE preparation. It must be able to record budgets, estimates and objectives as per Government's Annual Operation Plan (POA) and/or implementing plans and compare these with actual figures and performance. The system must be able to produce the agreed formats of the Financial Monitoring Reports: Sources & Uses of Funds, Physical Progress Report and Procurement Report. Adequate internal controls must be implemented, including a financial administration chapter which will be part of the - 82 - Operational Manual. As part of the GOB financial/accounting and administration system, all project transactions will also be recorded in the Federal Integrated Financial Administration System (SIAFI). The SIAFI i s centralized in Brasilia and is interconnected with GOB agencies nationwide and abroad. It was implemented in 1987 and is the largest and most global instrument of public financial management in the country. It makes it possible for Brazilians to follow up and control the Government's financial activities on line and in real time. By means o f a data extraction software, it will be possible to prepare specific reports from data in the SIAFI and to compare these with other reports issued directly from the Project's financial system as deemed necessary by the MME.The Project's system will be fed with the SIAFI data in order to prepare the FMRs. 2. Audit Arrangements External Audit. Audits will be carried out yearly by the Federal Control Secretariat (SFC), in compliance with a protocol of understanding signed between the Bank and the Government in 1998. Terms of Reference (TOR) for project specific audits will be agreed between the Bank and Project management, who in turn will instruct SFC to carry out the audit accordingly. The TOR will include specific instructions to the auditors to audit the amounts applied in the Project and to certify the eligibility of the expenditures financed by the Bank. The SFC audit will encompass all of the financial transactions under all Project components. TOR will be issued on basis of the "Guidelines and Terms of Reference for auditing of Projects financed by World Bank in Latin America and Caribbean Countries". MMEreceivedacopy of this manual from the Bank. The objective of the SFC audit is to judge the accuracy of the financial statements prepared by the PIU for the year-end in the FMR format. The auditors will then express opinions on these yearly FMRs. The auditor's report should also include an opinion on the eligibility of the Project's expenditures and the adequacy of the internal controls. Any weaknesses should be reported in the auditors' management letter, together with the recommendations for improvement. The PIU and the overall Project are also subject to audit by the Federal Court of Accounts-TCU (Tribunal de Contas da Uniiio). The following audit reports will be required, all within six months after the end of the fiscal year: 0 Project accounts (FMRs) 0 SOE 0 Special account 0 Compliance with legal covenants 0 Management letter Reporting and Monitoring. The MMEwill report in the format of FMR Financial Statements, on a quarterly basis as per models agreed with the Bank during negotiatons. The reports will be generated directly from the Financial Management System. Additional reports will be issued for physical progress and Procurement. The year-end FMRs will be considered as the annual Financial Statements of the Project to be certified by the Auditors. 3. DisbursementArrangements Following recently revised procedures for external financing in Brazil, STN will pre-finance by advancing funds to the project. Disbursements will be made according to the Disbursement Letter - 83 - instructions released by LOA after compliance of all effectiveness conditions and completion of the action plan. Disbursements will be transactions and not report based, and will follow standard Bank procedures. All pertinent documentation will be filed at the PIU for inspection by the Auditors and Bank's supervision missions. Withdrawal applications for the eligible expenditures will be supported by SOEs/Summary Sheets as appropriate. In view of the "High" risk of this project regarding procurement matters, SOEs would be prepared and submitted for individual consultants for amounts less than the equivalent of US$ 30,000, and for consultant firms for amounts less than the equivalent of US$ 50,000. Above these limits, reimbursement requests shall be submitted via SS (Summary Sheets), with full documentation attached. The Minister of Mines and Energy will designate the personnel authorized to sign the applications and send in due course the relevant signature specimens to the Loan Department. Given the need for jumpstarting the project with hiring of (mainly) individual consultants, retroactive financing of up to 10% of the loan amount will be available for payments within twelve months prior to loan signing. 4. Action Plan. This action plan has been agreed with MMEto comply with all FMrequisites. Action Due Date 1. Set up the FinanciaVAdministrative team (including at least one professional By effectiveness accountant as a financial manager) of the PIU and arrange for its training in a Seminar organized taking into account Bank requirements for financial management. I 2. Set up support systems and control processes, including: b y effectiveness (iv) agreed funds flow mechanism with STN 3. On Auditing submit to the Bank: (i)TOR for External Auditing of the (i)byeffectiveness; project; (ii)management letter prepared by auditors commenting upon the (ii)monthsafter 6 PIU's internal controls adequacy; and (iii)audited yearly Financial Statements effectiveness; and (iii)June30eachvear - 84 - Allocation of loan proceeds (Table C) Table C: Allocation of Loan Proceeds ExpenditureCategory Amount in US$million Financing Percentage Consultant Services 11S O Upto 84% per contract* Training" * 0.50 100 Total ProjectCosts with Bank Financing 12.00 Front-endfee 0.12 100 *** There I 12.12 I will be contracts where the ultimate financing percentage will be lower than 84%. Refers to training logistics: travel, per-diem, course fees, etc. but not consultantsengagedin training Use of statementsof expenditures(SOEs): SOE-baseddisbursementwill be used. Specialaccount: The special account will have aceiling of US$l.O million. - 85 - Annex 7: Project ProcessingSchedule BRAZIL: EnergySector Technical Assistance Project ProjectSchedule Planned Actual Time taken to preparethe project (months) 3 5 First Bank mission (identification) 01/03/2002 01/23/2002 Appraisal missiondeparture 03/22/2002 0611712002 INegotiations 04/30/2002 05/23/2003 IPlanned Date of Effectiveness II 09/30/2002 II II Preparedby: Nelson de Franco Preparationassistance: Steve Ettinger (Cons.) Luis Vaca-Soto (Cons.) Deborah Davis (Cons.) SuzanneMaia (Cons.) Andre Ramalho (Cons.) Bankstaff who worked onthe projectincluded: Bernard Tenenbaum Regulatory Specialist Vivien Foster Economist Jayme Port0 Carreiro Energy Specialist Tulio Correa Financial Management Specialist Claudio Mittelstaedt Financial Management Specialist Regis Cunningham Financial Management Specialist George Bouza ACS Fernanda Pacheco ACS Peer Reviewers: Mark Segal Economist Jonathan Halpern Economist - 86 - Annex 8: Documentsin the Project File* BRAZIL: EnergySector Technical Assistance Project A. ProjectImplementationPlan Preparedby MME,May 8,2002 B. Bank Staff Assessments Financial Assessment and related working papers ProcurementAssessment and relatedworking papers C. Other Procurement Plan, preparedby MME,May 8,2002 andrevisedMay 1,2003 Minutesof IdentificationMission Minutes of Video Conferencewith MME Minutes of PCN Review meeting Minutes of PCD Review Meeting Detailed Project Cost Table Agreement betweenMMA and MMEfor the implementation of acommon Environmental and Power Sector Agenda, March7,2002 MMEResolution277, March 13,2002, creatingWorking Groupto prepareESTAL Letter from MMEto MPO ,April 17,2002, with request to COFEX ("Carta-Consulta") for approval of proposedborrowing from the Bank for ESTAL Bank's letter to MPOISEAINdated July 25,2002 with summary of appraisaland open invitation to negotiate MPO/SEAW's letter to Bank dated May 22,2003 confirmingnegotiations Minutes of negotiationsdated May 26,2003 Papers relatedto the Project *Includingelectronic files - 87 - Annex 9: Statement of Loansand Credits BRAZIL: Energy Sector TechnicalAssistance Project 16-Apr-2003 Differencebetweenexpected and actual 0.00 0.00 5.00 0.54 0.00 PO43869 2002 BR SANTA CATARINA NATURALRESOURCa P 62.80 0.00 0.00 0.00 61.56 4.34 0.00 PO57665 2002 BR-FAMILYHEALTHEXTENSIONPROJECT 68.00 0.00 0.00 0.00 67.32 24.82 0.00 PO57653 2002 BR- FUNDESCOLAIllA 160.00 0.00 0.00 0.00 179.56 -11.63 0.00 PO55954 2002GOlAS STATE HIGHWAYMANAGEMENT 65.00 0.00 0.00 0.00 55.40 21.10 0.00 PO51696 2002 SA0 PAULOMETROLINE4 PROJECT 209.00 0.00 0.00 0.00 206.91 60.91 0 00 PO74085 2002 SergipeRural PovertyReduction 20.80 0.00 0.00 0.00 18.19 3.89 0.00 PO73192 2002BR TA FinancialSector 14.50 0.00 0.00 0.00 11.70 -2.01 0.00 PO70552 2002GEF BR PARANABIODIVERSITYPROJECT 0.00 0.00 8.00 0.00 8.04 0.75 0.00 PO66170 2002 BR-RGN2ND RuralPoverty Reduction 22.50 0.00 0.00 0.00 22.03 2.53 0.00 PO60221 2002 FORTALUA METROPOLITANTRANSPORT PRO 85.00 0.00 0.00 0.00 95.70 21.02 0.00 PO50875 2001 Ceara RuralPovertyReductionProject 37.50 0.00 0.00 0.00 27.33 6.98 0.00 PO50772 2001 LAND-BASEDPOVERTYALLEVIATIONI (SIM 202.10 0.00 0.00 0.00 215.15 152.40 0.00 PO50880 2001 PemambucoRural PovertyReduction 30.10 0.00 0.00 0.00 26.16 8.99 0.00 PO50881 2001 PlAUl RURAL POVERlY REDUCTIONPROJEC 22.50 0.00 0 00 0.00 17.54 6.54 0.00 PO57649 2001 BahiaRural PovertyReductionProject 54.35 0.00 0 00 0.00 38.62 8.47 0.00 PO59565 2001 BR- EA BASIC EDUPROJECT(PHASEI) 69.60 0.00 0.00 0.00 15.08 4.18 0.00 PO59566 2001 BR- CEARA BASICEDUCATION 90.00 0.00 0.00 0.00 83.95 -6.05 0.00 PO73294 2001 BR Fiscal8 Fin. Mgmt.TAL 8.88 0.00 0.00 0.00 7.23 4.27 0.00 PO35741 2000 NATL ENV 2 15.00 0.00 0.00 0.00 10.70 9.20 7.47 PO50776 2000 NE MicrofinanceDevelopment 50.00 0.00 0.00 0.00 33.11 -16.89 0.00 PO62619 2000 INSSREFLIL 5.05 0.00 0.00 0.00 0.36 -0.14 0.36 PO39200 2000 ENERGYEFFICIENCY(ELETROBRAS) 43.40 0.00 0.00 0.00 42.97 33.57 0.00 PO39199 2000 BR PROSANEAR2 30.30 0.00 0.00 0.00 29.39 -0.91 0.00 PO06449 2000 BR CEARAWTR MGT PROGERIRHSIM 136.00 0.00 0.00 0.00 101.09 48.17 0.00 PO47309 2000 BR ENERGY EFFICIENCY(GEF) 0.00 0.00 15.00 0.00 14.30 10.57 0.00 PO54120 1999 BR- AIDS & STD Control II 165.00 0.00 0.00 3.50 7.46 10.96 0.00 PO58129 1999 BR EMER. FIREPREVENTION(ERL) 15.00 0.00 0.00 0.00 7.22 7.22 0.56 PO48869 1999 SALVADORURBANTRANS 150.00 0.00 0.00 0.00 100.71 90.71 0.00 PO50763 1999 BR- Fundescola2 202.00 0.00 0.00 0.00 22.87 0.37 0.00 PO43874 1999 BR- DISEASESURVEILLANCE VlGlSUS - 100.00 0.00 0.00 25.00 34.89 59.89 0.00 PO06559 1998 (BF-R)SP.TSP 45.00 0.00 0.00 0.00 4.70 4.70 0.00 PO43421 1998 RJ M.TRANSITPRJ. 186.00 0.00 0.00 17.17 128.95 146.12 0.00 PO51701 1998 MARANHAORPOVERTY 80.00 0.00 0.00 0.00 2.77 2.77 0.00 PO38895 1998 FED.WTR MGT 198.00 0.00 0.00 0.00 108.25 106.14 93.25 PO38947 1998 BR- SC. 8 TECH 3 155.00 0.00 0.00 0.00 106.76 106.76 0.00 PO43420 1998 BR WATER S.MOD.2 150.00 0.00 0.00 125.00 96.30 146.27 138.69 PO06474 1998 BR LANDMGT3 (SA0 PAULO) 55.00 0.00 0.00 0.00 50.19 41.19 28.69 PO48357 1998 BRAZILCENBANK TAL 20.00 0.00 0.00 0.00 0.02 0.02 -7.30 PO42565 1998 PARAIBAR.POVERTY 60.00 0.00 0.00 0.00 21.44 21.44 0.00 PO57910 1998 BR PENSIONREFORMLIL 5.00 0.00 0.00 0.00 3.06 3.06 2.25 PO35728 1998 BAHIAWTR RESOURCES 51.00 0.00 0.00 0.00 22.41 22.41 22.41 PO43868 1997 RGSLANDMGT/POVERTY 100.00 0.00 0.00 0.00 45.41 41.96 36.66 PO06532 1997 FEDHWY DECENTR 300.00 0.00 0.00 0.00 143.09 143.09 33.41 PO34578 1997 RGS HWYMGT 70.00 0.00 0.00 0.00 49.34 49.34 47.34 PO43873 1997 AG TECH DEV. 60.00 0.00 0.00 0.00 28.89 28.89 28.89 PO06562 1997 BAHIAMUN.DV 100.00 0.00 0.00 0.00 37.25 37.25 26.45 PO06554 1996 BR- HEALTHSECTOR REFORM REFORSUS - 300.00 0.00 0.00 10.00 68.76 78.76 0.00 PO37828 1996 BR (PR)R.POVERTY 175.00 0.00 0.00 0.00 64.25 64.25 64.25 PO06210 1996 GEFBR-NAT'L BIODIVERSITY 0.00 0.00 10.00 0.00 2.42 3.42 4.04 PO06436 1995 Ceara UrbanDevelopment& Water Resource 140.00 0.00 0.00 3.00 I 4 97 17.97 17.97 PO06564 1995 BEL0 H M.TSP 99.00 0.00 0.00 0.00 12.70 12.70 0.00 PO38882 1995 RECIFEM.TSP 102.00 0.00 0.00 0.00 9.23 9.23 0.00 - 88 Differencebetween expected and actual Original Amount in US$ Millions disbursements' ProjectlD FY Purpose IBRD IDA GEF Cancel. Undisb. Orig Frm Rev'd PO06522 1994 BR ESP.SANT0WATER 154.00 0.00 0.00 41.50 6.35 47.85 -6.15 Total: 4744.38 0.00 33.00 225.17 2595.05 1700.33 539.24 - 89 - BRAZIL STATEMENT OFIFC's Held andDisbursedPortfolio Jun 30 - 2002 InMillions US Dollars Committed Disbursed IFC IFC FY Approval Company Loan Equity Quasi Partic Loan Equity Quasi Partic 1998 Fosfertil 20.00 0.00 0.00 33.75 20.00 0.00 0.00 33.75 1998 Fras-le 9.33 0.00 10.00 0.00 9.33 0.00 6.70 0.00 1994 GAVEA 5.63 0.00 5.50 0.00 5.63 0.00 5.50 0.00 0 GP Cptl Rstrctd 0.00 9.67 0.00 0.00 0.00 9.35 0.00 0.00 2001 GPC 9.00 0.00 0.00 0.00 9.00 0.00 0.00 0.00 1997 Guilman-Amorim 25.78 0.00 0.00 57.41 25.78 0.00 0.00 57.47 1998 Icatu Equity 0.00 20.00 0.00 0.00 0.00 12.44 0.00 0.00 1999 InnovaSA 18.75 5.00 0.00 55.00 18.75 5.00 0.00 55.00 1980187197 Ipiranga 29.33 0.00 0.00 57.27 29.33 0.00 0.00 57.27 1999 Itaberaba 0.00 5.34 0.00 0.00 0.00 5.34 0.00 0.00 1999 JOSAPAR 8.00 0.00 7.00 0.00 3.00 0.00 7.00 0.00 1995 LATASA - Brazil 0.00 0.00 5.00 0.00 0.00 0.00 5.00 0.00 1995 LojasAmericana 12.00 0.00 5.00 0.00 12.00 0.00 5.00 0.00 1987192196199 MBR 20.00 0.00 0.00 0.00 20.00 0.00 0.00 0.00 0 MacedoNordeste 4.75 0.00 5.00 0.00 4.75 0.00 5.00 0.00 1996 Mallory 4.36 0.00 0.00 0.00 4.36 0.00 0.00 0.00 1975196 OxitenoNE 7.50 5.00 0.00 0.00 7.50 0.00 0.00 0.00 1994 Para Pigmentos 19.35 0.00 9.00 8.21 19.35 0.00 9.00 8.21 1987196 Perdigao 15.31 0.00 0.00 2.00 15.31 0.00 0.00 2.00 1989195 Politenofnd. 4.38 0.00 0.00 0.00 4.38 0.00 0.00 0.00 1994100102 Portobello 0.00 1.15 0.00 0.00 0.00 1.15 0.00 0.00 2000 Puras 4.33 0.00 0.00 0.00 4.33 0.00 0.00 0.00 1998 Randon 6.07 0.00 3.00 0.00 6.07 0.00 3.00 0.00 1991 Rhodia-Ster 0.00 5.95 0.00 0.00 0.00 5.95 0.00 0.00 1995 RhodiacoPTA 5.00 0.00 0.00 0.00 5.00 0.00 0.00 0.00 1990 Ripasa 0.00 5.00 0.00 0.00 0.00 5.00 0.00 0.00 1997 Rodovia 25.28 0.00 0.00 39.75 25.28 0.00 S.A.I.C.C. 0.00 39.75 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 1994196 SP Alpargatas 15.00 0.00 5.00 0.00 15.00 0.00 5.00 0.00 1987197 Sadia 19.50 0.00 6.50 104.00 19.50 0.00 6.50 104.00 1994195197 Samarco 10.80 0.00 0.00 5.33 10.80 0.00 0.00 5.33 1997 Samaritan0 20.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 2000 Saraiva 9.23 3.00 0.00 0.00 9.23 3.00 0.00 0.00 1998 SearaAlimentos 0.00 3.88 0.00 0.00 0.00 3.88 0.00 0.00 0 Sepetiba 27.00 0.00 5.00 8.00 12.00 0.00 5.00 8.00 2001 sucorrico 6.00 0.00 0.00 0.00 6.00 0.00 0.00 0.00 1997 Sudamerica 0.00 15.00 0.00 0.00 0.00 15.00 0.00 0.00 1999 Synteko 18.00 0.00 0.00 0.00 18.00 0.00 0.00 0.00 2001 TIGRE 11.54 0.00 5.00 4.27 11.54 0.00 5.OO 4.27 1996 TRIKEM 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 1992193 Tecon Rio Grande 6.38 0.00 5.50 13.60 6.38 0.00 5.50 13.60 1998 Tecon Salvador 3.50 1.oo 0.00 5.00 3.50 0.77 0.00 5.00 2001 Unibanco 150.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 1988194102 Vulcabras 15.01 0.00 0.00 0.00 15.01 0.00 0.00 0.00 1999 Total Portfolio: 1009.81 169.26 133.50 761.94 618.53 145.41 115.20 591.57 - 90 - Approvals PendingCommitment FY Approval Company Loan Equity Quasi Partic 0 Net 0.00 0.00 19.96 0.00 2002 Suape ICT 6.00 0.00 0.00 0.00 2002 Microinvest 0.00 0.00 1.25 0.00 2002 Net Servicos 50.00 0.00 5.00 0.00 2002 Macae 65.00 10.00 0.00 275.00 2002 Amaggi 30.00 0.00 0.00 0.00 2002 UP Offshore 16.80 0.00 10.00 25.20 2002 Andrade 30.00 10.00 0.00 120.00 1999 Cibrasec 0.00 0.00 7.50 0.00 2000 BBA 10.00 0.00 0.00 50.00 2001 Satipel 15.00 15.00 0.00 0.00 2001 Unisul 15.00 0.00 0.00 0.00 2001 BradTempleton 0.00 0.00 20.00 0.00 2001 Cataguazes 45.00 0.00 0.00 40.00 2002 Univali 10.00 0.00 0.00 0.00 2002 Unibanco-CL 0.00 0.00 0.00 150.00 2002 BancoItau 0.00 0.00 0.00 100.00 Total PendingCommitment: 292.80 35.00 63.71 760.20 - 91 - Annex 10: Country at a Glance BRAZIL: EnergySector Technical Assistance Project Latin Upper- POVERTY and SOCIAL America middle- Brazil &Carib. income 1 Development diamond' 2001 Population, midyear (millions) 1726 524 504 Lifeexpectancy GNI percapita (Atlas method, US$) 3,060 3,560 4,460 GNI (Atlasmethod, US5b/llions) 528.7 1,862 2,248 - Average annual growth, 199501 Populationph) 13 1.5 1.3 Labor force (y 1.8 2.2 1.8 GNi Gross per primary Most recentestimate (latest year available, 199501) capita nroliment Poveriyph ofpopulationbelownationalpovertyline) 22 Urban population (%of totalpopulabon) 82 76 77 Lifeexpectancyat birth (years) 68 70 71 Infantmortality (per 1,000livebirths) 30 29 24 Childmalnutrition (% of childrenunder5) 6 9 9 Access to improvedwater source Access to an improvedwater source (% ofpopulat/on) 87 85 87 Illiteracyph ofpopulation aqe 15+) 14 11 10 Grossprcmavenrollment (% of school-aqepopulation) 154 130 127 -Brazil Male 156 131 128 Upper-middle-incomegroup Female 152 128 126 KEY ECONOMIC RATIOSand LONG-TERM TRENDS 1981 1991 2000 2001 Economic ratios' GDP (US5b/llions) 263 6 407.7 593.8 502.0 Grossdomesac tnvestmenUGDP 23 1 19.8 21.7 21.o Exportsof qoods and servicesiGDP 94 8.7 10.8 13.4 Trade GrossdomeshcsavinqsiGDP 22 7 20.5 20.1 19.9 GrossnationalsavingsiGDP T 186 18.6 17.2 16.4 CurrentaccountbalanceiGDP -4.5 -0 3 -4.1 -4.6 Interestpayments/(; DP 3.1 0.5 2.2 2.1 Total debtIGDP 30.9 29 7 39.8 45 0 Total debtserviceiexports 66.4 23 3 92.0 60.5 Presentvalueof debUGDP 37.7 Presentvalueof debtfexports 327.4 Indebtedness 1981-91 199141 2000 2001 2001-05 (average annualgrowth) GDP 2.9 2.9 4.4 1.5 2.8 -Brazil GDP percapita 0.9 1.5 3.1 0.2 1.6 Uooer-middle-incomeO~OUD ~ Exportsof goods and services 68 64 114 12 1 3 7 STRUCTUREof the ECONOMY 1981 1991 2000 2001 Growth of investmentand GDP( O h ) (% of GDP) 1 % - Agriculture 10.7 7.8 7.4 9.3 Industry 43.7 36.2 28.3 21.o 33.9 10 Manufacturing 32.9 25.3 17.4 Services 45.5 56.1 64.3 56.8 0 Privateconsumption 68.0 61.6 60.6 60.1 Generalgovernmentconsumption 9.3 17.9 19.3 19.9 importsof goods and services 9.8 7.9 12.4 14.4 1981-91 1991-01 2000 2001 1 (average annualgrowth) Growth of exportsand imports(%) i Agriculture 2.5 3.4 3.0 5.1 Industry 2.2 2.5 4.9 -0.6 Manufacturing 1.4 1.9 6.1 0.6 Services 3.5 2.9 3.7 1.5 Privateconsumption 1.2 2.6 -1.o 5.0 3.7 Generalgovernmentconsumption 7.5 0.0 4.8 Gross domestic investment 3.9 3.5 11.2 -2.0 Importsof goods and services 2.9 10.0 12.4 0.7 ~ Note: 2001 data are preltminaiyestimates. *Thediamonds show four keyindicatorsinthe country(in bold) comparedwith its income-groupaverage. If data are missing,the diamondwill be incomplete, - 92 - Brad PRICESand GOVERNMENTFINANCE 1981 1991 2000 2001 Domesticprices ph change) Consumer prices 101.7 432.8 6.0 7.7 ImplicitGDP deflator 107.2 415.3 8.0 7.4 Governmentfinance/a ph of GDP,includescurrentgrants) Current revenue 21.9 23.0 96 97 98 99 00 01 Currentbudgetbalance 1.8 1.8 Overallsurplusldeficit 3.2 3.8 -GDP deflator +CPi TRADE 1981 1991 2000 2001 (US$mi//ions) 1 Exportand lmpon levels(US$ mill.) Totalexports (fob) 31,620 55,086 58,223 Ipl.ow T Coffee 2,870 3,048 2,932 Someans ...... 2,031 2,188 2,726 Manufactures ._ 20,483 41,027 41,144 Total imports (cif) .. 21,041 55,783 55,581 Food ...... 1,275 1,507 1,169 Fuelandenerw 3,371 6,362 6,276 Capitalgoods 5,966 13,591 14,803 w Exportprice index (1995=100) 81 81 97 94 95 96 97 98 99 01 Importpriceindex (1995=100) 70 68 118 114 Expotts Imports Terms of trade (1995=100) 116 120 82 a2 BALANCEof PAYMENTS 1981 1991 2000 2001 1 Currentaccountbalanceto (US$millions) GDP(X) Exportsof goods and services 25,522 34,333 64,584 67,545 Importsof goodsand services 27,200 26,142 72,443 72,652 Resourcebalance -1,678 8,191 -7,859 -5,107 Net income -10,272 -11,154 -17,886 -19,743 Netcurrent transfers 10 1,556 1,521 1,638 Currentaccountbalance -11,940 -1,407 -24,224 -23,212 Financingitems (net) 12,286 -3,272 31,904 19,468 Changesin net reserves -346 4,679 -7,680 3,744 Memo: Reserves includinggold (US$millions) 6,693 8,763 33,011 35,866 Conversionrate (DEC, local/US$) 3.38E-11 1.48E-4 1.8 2.4 EXTERNALDEBTand RESOURCEFLOWS 1981 1991 2000 2001 (US$ millions) :omposition of 2001 debt (US$ mill.) Total debt outstandingand disbursed 81,454 121,020 236,157 226,067 IBRD 2,286 8,165 7,377 7,963 A: 7 963 IDA 0 0 0 0 Total debt service 17,674 8,340 62,891 42,977 IBRD 317 1,917 1,351 1,362 IDA 0 0 0 0 Compositionof netresourceflows Official grants 8 50 54 Official creditors 1,230 -1,062 -1,780 786 Privatecreditors 7,512 1,701 7,936 3,615 Foreigndirect investment 2,520 1,103 32,779 22,457 Portfolioequity 0 803 3,076 2,481 F 152,416 World Bank program Commitments 1.039 1,348 1,290 1,609 \- IBRD E Bilateral Disbursements 387 840 1,692 1,639 I IDA - D -Other muitiiateral F Private -- Principalrepayments 136 1,248 887 828 :-IMF G -Short-term Netflows 251 -408 805 810 Interestpayments 181 669 464 533 Nettransfers 70 -1,077 341 277 ueveiopment tcoromtcs 911 mz a. Datarefer to centralgovernment. - 93 - Additional Annex 11 Energy Sector Reform Loan (ESRL) Summary Brazil: Energy Sector Technical AssistanceProject 1. The ESRL will support the Brazilian Government with a US$454.55 million loan to initiate a medium- term program of Bank assistance to the power sector. The program is designed to support the completion of reforms started in 1995 and subsequently stalled due to political tensions and an energy supply crisis. The Government remains committed to achieving the model envisioned in 1995; that is, a power sector characterized by competition,private sector operations and investment decisions, effective and independent regulation, and universal coverage. 2. During 2001 Brazil experienced one of the worst droughts on record which affected vast areas of the country. Because the production system is predominantly hydroelectric, power supplies were disrupted causing serious economic and social hardship, particularly in the poorest, northeast region. In 2002 precipitation returned to normal and the reservoirs are recuperating. The crisis brought to light serious limitations inthe organization of the power system as a whole. 3. The measures proposed in the ESRL reflect the Government's progress in addressing the underlying causes of the hydroelectric crisis. While the recent drought has undoubtedly played an important role in provokingthe crisis situation, the fundamental causes of the problemlie elsewhere. The crisis can ultimately be traced to a series of regulatory deficiencies and pricing distortions created during the early phase of the transition to the new power sector model (1995-2000). The Government managed the crisis successfully insofar as preventing major rolling blackouts, addressedthe need to implement the complete package of sector reforms as originally conceived, and established the foundational measures for achieving them. 4. The proposed operation will contribute to achieving the new sector model by pursuing interlocking sectoral and macroeconomic objectives. The financing provided by the ESRL is not earmarked to the power sector, but will go directly to the Ministry of Finance in the form of general budgetary support. Hence, at the macroeconomic level, the operation will contribute to financing Brazil's nominal public sector deficit and its US$50 billion external financing requirements. Some US$4 billion of this total is expected to be met from public sector sources, including multilateral disbursements such as the proposed ESRL. In the longer term, the sectoral and macroeconomic objectives of the proposed operation will interlock, since the policy reforms to be undertaken in the energy sector will help to promote economic growth, and thereby easethe external financing requirement. 5. Brazil embarked upon a major power sector reform process in 1995. The Brazilian power sector i s globally unique in that hydroelectric power represents 90 percent of its generation portfolio. Generation and transmission activities in Brazil were historically the responsibility of the Federal company Eletrobras, while distribution was largely undertaken by State utilities. In 1995, a sector reform process initiated the vertical unbundling and privatization o f the sector. Due to political resistance, the unbundling process was never completed, so that 58 percent of national generating capacity remains in the hands of vertically integrated Eletrobras subsidiaries. However, 23 percent of generation assets and 64 percent of distribution were successfully privatized. As part of the reform process, the Government introduced an independent system operator (ONS) to be responsible for central cost-based dispatch, and a new regulatory agency (ANEEL) to supervise the sector. Parallel reforms in the upstream gas market - 94 - ended the legal monopoly of Petrobras,but inthe absence of any structural reforms, competition has been very slow to develop. 6. Against this background, the Government has requested World Bank support for a long- term power sector program, with the ultimate objective of realizing the Government's original vision for the sector. The Government's long-term objective i s to create a power sector that provides universal access to reliable, sustainable and efficient electricity service. The Government believes that the only realistic way to achieve this objective i s by opening up the energy sector (including power generation and upstream gas supply) to effective competition, and promoting private sector participation in the operation of the existing infrastructure and the development of new capacity. To function effectively, such a sector needs to be supported by effective Government institutions. In particular, it requires a well-resourced and expert body to provide strategic policy guidance; an autonomous regulatory agency that makes transparent, consistent, and defensible decisions, and can be held accountable for them; and an impartial system operator to ensure the efficient utilizationof generating capacity. 7. The first step toward realizing this long-term vision has been to restore the normal functioning of the power sector. Now that the sector is back to normal, the next step will be to optimize the new power sector model by correcting remaining structural problems. Resolving the pricing and incentive problems in the sector i s a fundamental prerequisite for restoring its normal functioning and advancing toward the long-term vision. However, the full potential of power sector reform will not be realized unless the original package of institutional and structural reforms is completed. 8. The World Bank proposes to support the Government's efforts to achieve its long-term vision with a series of operations and a variety of instruments. Given that the original sector reforms were supported by a World Bank operation (Loan 3376-BR), continued Bank involvement in following through the reform process is particularly important. The new interventions will take the form of a program, to begin with the proposed ESRL. This operation is designed primarily to support the Government in its effective implementation of solutions to the energy crisis and its underlying causes, which involved reactivating the wholesale electricity market, raising tariffs toward a cost-recovery level, strengthening incentives for distributors to provide reliable energy supply, and undertaking the necessary groundwork for the next set of structural reforms. These structural measures would be implemented through one or more additional operations, thereby enabling the full realization of the original power sector reforms. Despite envisaging succeeding operations, the ESRL was not structured as a programmatic loan because of the imminence of the Presidential elections, scheduled to take place in October 2002; it would be inappropriate for the current administration to make commitments on behalf of the future Government. The underlying continuity for the program will be provided by the proposed Energy Sector Technical Assistance Loan (ESTAL). Whereas the adjustment operations will take the form of general budget support, the technical assistance operation will channel resources directly to those policymaking and regulatory institutions responsible for implementing the policy reforms. The proposed ESRL has also benefited from support by the PPIAF (Private-Public Infrastructure Advisory Facility) which has focused on studies and workshops sustaining the Government's achievements. 9. The proposed ESRL would be disbursed upon loan effectiveness to reflect the Government's effective management of the crisis together with the groundwork which established the foundation for achieving power sector reform. This can be seen in a number of areas, including the successful implementation of a socially and economically sensitive rationing program, the timely resolution of the compensation dispute between generators and distributors, actions taken to resolve the problem of cost-reflective pricing, progress towards normalization of the wholesale market, the removal - 95 - of tariff distortions, and the strengthening of incentives for distributors to provide reliable energy supplies. 10. The proposed operation is an important part of Brazil's poverty reduction strategy, as supported by the CAS. The strategy considers the broad renewal of growth, based on macroeconomic stability and fiscal adjustment, to be essential for large and sustainable poverty reduction." The proposed operation will contribute to poverty reduction through two independent channels: 0 By restoring the energy sector to a sound footing, the operation will remove one of the key domestic constraints to economic growth in Brazil. It i s estimated that the energy crisis reduced GDP growth in 2001 by about one percent, and continued rationing and uncertainty could further hurt macroeconomic performance next year. Recent estimates suggest that in Brazil, each percentage point of economic growth lifts 300,000 people out of poverty. 0 By addressing the deficiencies in the current regulatory framework for low-income urban tariffs and rural electrification, the operation will ensure that both urban and rural poor have access to affordable electricity service. 11. The operation has no negative environmental or social impacts, and supports the preparation of a strategic program to strengthen planning and management of environmental and social issues in the power sector. Although Brazil has a sound framework for environmental regulation, a number of shortcomings in the institutional framework often prevent its timely and consistent application, creating a potential impediment to private investment in the sector. The ESRL program and the parallel Energy Sector TAL will support a series of interventions designed to address these and other concerns related to the mainstreaming of environmental and social issues in the early stages of the expansion planning cycle. Finally, the operation will also support a range of policy measures designed to save at least 1 percent of electricity demand each year, thereby postponing US$300 million of investments in generation capacity each year. The program comprises the following key elements. (a) a review of environmental licensing requirements, procedures, and mandates for power sector projects; (b) a clarification of institutional roles and procedures for medium-long term planning and improved coordination with water resources management and environmental agencies; and (c) an assessment of environmental and social issues associated with alternative medium to long-term system expansion paths. 12. The adjustment program focuses on revisiting and updating as needed the overall framework of environmental regulation and management, as the basis to ensure effective environmental procedures in managing specific power projects and the sustainability of future sector expansion. The two operations (ESRL and ESTAL) complement each other in supporting preparation of a program comprising the following key elements: (i)a review of environmental licensing requirements, procedures, and mandates for power sector projects; (ii) a clarificationof institutional roles and procedures for medium-long term planning and improved coordination with water resources management and environmental agencies; (iii) carrying out a set of studies on priority topics including: project preparation methodologies; strategic assessment of longer-term system expansion paths; river basin inventories; strategic assessment of the thermal power program; issues and options relating to climate change; promotion of corporate responsibility; and (iv) support for the institutional realignment and strengthening of professional cadres within the power and environment sectors. While the first two activities are of relevance in the very short term, the last set of activities addresses issues related to the future of the sector. - 96 - Additional Annex 12: Improvement of Electricity Regulation and Market and System Operation Project (Supported by a Public-PrivateInfrastructureAdvisory Facility-PPIAFGrant) BRAZIL: EnergySector Technical Assistance Project A) Main Fatures basedon the Initial Proposal (as of March2002) The World Bank implemented the project Improvement of Electricity Regulation and Market and System Operation, supported by a recently awarded PPIAF grant, which provided short-term advisory work in the power sector for the Brazilian Government's Chamber of Electric Energy Crisis Management (CGE, or Ciimara da GestLio da Crise de Energia Elktrica ), established in May 2001 to deal with the energy crisis at hand. The project's principal objective was to assist the CGE in addressing urgent post-crisis market and regulatory framework issues that should be resolved to restore the health and dynamism of the power sector. It supported several key time-sensitive and critical revitalization measures formally identified by the GOB, which included some proposed mid-course corrections of the power sector reform program launched in 1995 with Bank support. The need for mid-course corrections was recognized in the 33 revitalization recommendations publicly releasedby the CGEon February 01,2002, accompanied by a 100-pageWhite Paper (see Annex 13). In particular, the project focused on the roles and institutional responsibilities of key sector entities and second generation market and system operation implementation problems that might have been contributing factors to the recent Brazilian power crisis. This PPIAF-supported project complemented two other proposed energy sector World Bank operations launched in Brazil in 2002: an Energy Sector ReformLoan (ESRL-a sector adjustment operation fully disbursed in June 2002) and this proposed Energy Sector Technical Assistance Loan (ESTAL). The ESRL did not provide any financial resources to energy sector institutions, but gave direct budgetary support for Brazil's balance of payments in returnfor implementation of the most critical policy reforms in the power sector. The PPIAF project helped ensure that these policy reforms were well designedand analyzed. The initial scope of work undertaken through the PPIAF project was designed to result in workable solutions that GOB and other sector entities would implement on a priority basis. International experience was captured and presentedto Brazil decision-makers by pairing leading international experts with local specialists, relevant to the PPIAF project's specific areas of focus, as follows: Task I: Reform of Electricitv Wholesale Market ( M A E ) The wholesale electricity market (MAE) was instituted in September 2000, but until the PPIAF was prepared, it had been only notional trades, with no settlement of accounts, as well as a total loss of confidence in its functions. Because of the failure of MAE to go operational, the PPIAF had the objective of assisting the GOB inredesigning some critical functions of the MAE. -97- Task2: Principles of Distribution Tariff Review Methodologv This activity was included in the Project help identify the key gaps in the current regulatory framework and to develop appropriate regulatory methodologies that could provide the basis for the 60 or so distribution tariff reviews scheduled for the 2003-2004period. The overall goal was to develop a defensible, predictable and transparent methodology for revisingtariffs in the future. Possible issues to be addressedincluded: (i) Procedures for valuing and rolling forward the value of the regulatory capital base; calculating the weighted average cost of capital; and using tracking and adjustment mechanisms for some cost components; (ii) Tariffbasketstopermitreadjustmentsintariffstructures; (iii)Regulatoryaccountingguidelinestosupporttariff-settingprocedures; (iv) Information requirements for establishing cross-company and time series benchmarking procedures to set efficiency targets in future tariff periods usingeither engineering estimatesor statistical and linear programming techniques; (v) A methodology to set distribution tariffs by type of customer, in particular industrial versus residential categories. Task 3: Reform of Power Purchase Pass-Through Arrangements This activity considered how best to improve the current system of regulatory price caps for power purchase pass-through, to more closely reflect the long run marginal costs of generation, with transparent adjustment mechanisms to reflect changes in underlying costs; as well as a separate task to examine possible alternatives to base the NormativeValue mechanism on market benchmarks that would be more appropriate as the wholesale power market evolves. Within the scope of this task were: evaluations to see if changes were needed to improve the operation of the VN system in force; whether there are better regulatory alternatives to the current VN mechanism that make better use of market information, as opposed to the current method of administratively-set price caps, such as caps tied to actual or estimated spot market prices with or without premiums for hedging; caps tied to the actual purchase power costs for a comparable group of distribution utilities; prior review of proposed power purchases; post-facto reviews of specific power purchases; and requirements for open, competitive procurement for establishedamounts of power purchaserequirements. Task 4: Independent Assessment of ANEEL's Key Regulatory Roles and Responsibilities This task was conceived as an independent assessment of the effectiveness of the new Brazilian electricity regulatory system with particular emphasis on ANEEL's roles and responsibilities within it, including those vis-&vis other government entities (executive, legislative andjudicial both at the federal and state levels) and different stakeholders in the sector (generators, market and system operators, distributors and customers). Recommendations would be produced in three areas: ambiguities that need to be clarified, functions that needed to be transferred to or away from ANEEL, and processes and interactions that needed to be improved. Particular attention were to be paid to how such changes would impact CGE's recommendations for responsibilities to be assumed by the Ministry of Mines and Energy (MME). PPIAF would also - 98 - help to determine the need for any modifications of existing laws that would be required to implement the recommendations. Task 5: Regulation of TariffDiscounts for Low-Zncome Customers Using an ongoing study by ANEEL on the current practice for low-income tariff discounts in each distribution concession, this task aimed at assisting in developing suitable regulatory guidelines to harmonize national policy on eligibility criteria and their application for low-income tariff discounts. It would also establish principles to govern social tariffs in Brazil, drawing upon the experience of other countries in the region that have used risingblock tariffs, geographic subsidies, or targeted subsidies to make services more affordable for the poor. Moreover, recommendations on low-income tariff discount policies derived from this activity would: i)incorporate financial mechanisms that would not undermine incentives for private operators to serve poor households; ii)harmonize social tariff policies for urban and rural areas; iii)ensurethateligibilitycriteriafortariffdiscountswerebasedonpublicpolicyratherthanon operator discretion. Such recommendations would also be relatively simple to administer and, based on an empirical analysis of the correlation between electricity consumption, poverty, and other observable household characteristics that could serve as screeningmechanisms, they would demonstrate a clear link with the poverty status of households; and finally, establish tariff levels that would be affordable for low-income households, including connection charges, with fully transparent, carefully targetedsubsidy mechanisms that have fully developed phase-out plans. Dissemination of Work Products Given that the ultimate success of the PPIAF project would depend on both the quality and credibility of the work produced by the consulting team, it was critical to enhance its transparency by publicizing that the advisory work is being undertaken, making its reports and assessments publicly available as soon as possible, publishing World Bank Viewpoints that disseminated the concepts generated by this project, and promoting specific workshops relevant to particular sub-tasks of the PPIAFProject. Indicators Some (longer-term) indicators expected to be applied in measuring the success of the PPIAF project in Brazil included the extent to which the recommendations of the project are adopted by the Government in sector rules, procedures or regulations; as well as Brazil's success in increasing new private investment in thermal and hydro (or alternative energy) generation and private ownership of distribution concessions currently under government ownership. Recommendations were produced in three areas: ambiguities that needed to be clarified, functions that needto be transferred to or away from ANEEL, and processes and interactions that need to be improved. Particular attention was paid to how such changes would impact CGE's recommendations for responsibilities to be assumed by the Ministry of Mines and Energy (MME). The PPIAF Project would also help determine the need for any modifications of existing laws that would be required to implement the recommendations. - 99 - B) ResultsAchieved The project achieved its objectives by supporting in critical areas the GOB to put the electric sector back on its feet. The key five task-forces were carried out, but resources were re-deployed among them during the project, in response to the revised priorities set forth by the Government. More resources where channeled to the area of tariff review process, and less resources were made available to the determination of life-line rates, since this was an effort being carried out by the GOB with its own resources. To ensure quick turnaround, the project intentionally avoided the commissioning of big reports (with the exception of Task 4). Instead, the strategy was to hire international consultants who could be brought to Brazil for short visits to work with our Brazilian government counterparts (Committee for the Revitalization of the Electricity Sector Model) and their consultants. A second element of the strategy was to pair the international consultants with a local Brazilian consultant to ensure that the analysis and recommendations would be relevant to Brazil. To ensure timeliness, the TORS were structured so that the two consultants would produce short reports and presentationsor provide side-by-side implementation assistance to key Brazilian government officials. Interms of accomplishments andresults achieved: o Helped to implement the first "virtual privatization" of publicly owned generation capacity in a developing country. This resulted in the sale of purchaseor marketingrights for about 1320 of "firm" MW of state-owned generation. A competitive auction mechanism was selected for the sale, o with 2635 tranches traded at an average price of R$ 5O/MWh (USD $15 to 16/MWh). This mechanism may set the basis for future competitive power purchasesin Brazil. o Helped the Brazilian government and electricity regulator to reconsider a proposed distribution asset valuation approach that would have been overly complicated and, if implemented, might have been perceived as a breach in the Concession Contracts agreement. The Project consultants suggested an alternative asset valuation technique used elsewhere in Latin America. Once the Brazilian counterparts expressed interest in this alternative approach, the Project financed sample calculations for three Brazilian distribution companies that were scheduled for tariff reviews in 2003. ANEEL adopted the alternative asset valuation approach in two technical notes publicly issued on February 17, 2003. It is expected that this new approach will serve as the regulatory model for tariff setting for all 60 Brazilian distribution companies. o Conducted an in depth "second generation" institutional and legal assessment of the Brazilian electricity regulatory system, according to the original plan described above under A, Task 4. The final report and its 29 recommendations seemed to be well received at a December 2002 workshop in Brasilia attendedby about 40 government and industry officials. - 100- o Proposed to the government andto the regulator alternative ways to treat the pass-through of energy costs, and how to gradually replace the current system of administratively determined caps on the prices of power purchases (VN) with caps that are market determined. There was general recognition that the existing system of administratively determined price caps was having a negative impact on private investment in new generation plants. Therefore, the task focused on providing information on market based alternatives that have been used in other countries. These market based alternatives included, among others, mandatory competitive biddingfor power purchasesby regulateddistribution companies. Dissemination of Work Products Much of the output was confidential because it was advisory work for the government. In most instances, the analysis and results were conveyed to government and sector officials in small briefings and in discussions triggered by working side by side on particular tasks (e.g., the auction of old energy from government owned hydro plants). The dissemination strategy was based on the conclusion that the analysis and techniques developed in this project would be of widespread interest to government and power sector officials in many other countries. Therefore, the following dissemination plan was proposed: 1. December 2002 workshop inBrasiliato discuss the specific recommendations of the Task 4 report on "Strengthening of the Institutional and Regulatory Structure of the Brazilian Power Sector." Attended by cross section of about 40 people from the power sector and government. 2. Presentation of the Task 4 recommendations to the top officials of the MMEand ANEEL on February 18 and 19,2003. 3. Presentation to the Brazilian Chamber of Electric Sector, chaired by the Minister of Mines and Energy, about the benefits of improving current energy cost pass-through regulations, and moving towards a more market basedcriterion. October, 2002. 4. Presentationat the World Bank's 2003 Energy Forum by the authors of the Task 4 report. February 24,2003 5. A Bank Viewpoint publication describing lessons to be learned from Brazil's experience with the auctions of marketing and purchase rights from state-owned generators (Le., the "virtual privatization"). Late spring2003. asset valuation techniques for setting tariffs for electricity distribution companies . Late 6. A Bank Viewpoint describing lessons to be learned from the controversy over different spring 2003. 7. A Bank's Energy and Mining Sector Board discussion paper that describes the Brazilian regulatory approach to setting ceiling prices for the pass through of power purchases by -101 - distribution entities andpossible alternative approaches). Early summer 2003. C) NextSteps 0 Pursuethe dissemination plan described above. e Continue discussions with MME about a possible application to PPIAF for a follow-up grant that reflects the government's policy agenda. In principle, a preliminary scope has been agreed, which would include the following topics: Task 1- International Assessment of the Single Buyer Model and Other Pool Arrangements- Best PracticesApplicable to the Brazilian Case. Task 2- Optimization of the Natural Gas Infrastructure - Expanding Possibilities in the Electricity Natural Gas Convergenceand inFindingAlternative Uses for the Gas. Task 3- Enhancing the Energy Planning Function - Organization Structure, Processes, and Resources. Task 4- Energy Policy, and Energy Regulations - Implementing Recommendations of PPIAF ITask 4. - 102- Additional Annex 13: Government Measuresto Revitalizethe Electric Sector in Brazil BRAZIL: EnergySector Technical Assistance Project Background Immediately after the design and implementation of rationing program, the Electricity Crisis Management Chamber (GCE) prepared a detailed diagnostic study to identify the major underlying reasons for the electric sector crisis in Brazil. It became clear that the crisis, while precipitated by the serious drought, was due to a combination of interrelated policy, regulatory and commercial factors, which needto be tackled. To address those factors and to propose corrective actions, the GCE established, on June 26, 2001, a high level task force, called the Revitalization Committee, coordinated by BNDES and with representatives from MME, MF, MPO, ANEEL, ANA, AGU. The Committee agreed to preservethe basic pillars on which the new model had been built in 1998. Those basic principles included competition in the generation and commercialization ends of the industry, expansion based on private capital, quality of service, and regulation of the "natural monopolies" of transmission and distribution. The Committee grouped and tackled the issues in four major areas: (i) Regulatory; (ii)Market; (iii)Contract and (iv) Planning, coordinated by BNDES, MF, AGUBNDES and MME respectively. During five months of intense work, several representatives from the public and private sector, industry associations and consulting companies were able to participate and express their views and concerns in plenary meetings and focused discussions. The World Bank had five meetings with the Revitalization Committee, to better understand the issues and help preparethe ESRL, ESTALand PPIAFProjects. As aresult of this effort, the Committee came up with a list of 18 priority measures, which were subsequently expanded to 33 measures. The list involved some design and implementation actions, and encompassed energy policy, regulatory, market and contract themes. It also addressedissues such as lifeline rates for the poor and universal service. The Committee realized that many of those measures were intertwined and that coherence needs to be sought across the multiple efforts. To facilitate this coherence, the Committee created umbrella themes or clusters, under which the proposed actions are grouped. A complete list of the 33 measures, grouped by major themes i s as follows: - 103- I lREVlTALlZATIONPROCESSMEASURESARRANGED BY CLUSTER OF COMMONTHEMES IMeasureNo. ICLUSTER I ----.-. . IENABLETHE ENERGYMARKETTO FUNCTIONPROPERLY General Agreement for the sector (December 2001) 1 Enhancements in the dispatchand price making rules 6 Continuationof MAE restructuring STRENGTHENTHE MARKET 2 Implementationof price biddingmechanismfor hydro plants 3 Regulationof commercializationof public service energy 16 Free and captive customers ASSURE SUPPLY EXPANSION 11 Revision of Assured Energy 12 Requirementsfor BilateralContracting 13 Reserve energy contracting 23 Incentivesto foster installationif peaking units 25 Incentivesfor conservationand efficient use of energy 31 Cooperation betweenMMEand MMA inthe environmentallicensing MONITOR SYSTEM RELIABlLlNAND ABILITYTO DELIVER FUTURENEEDS 21 Safeguard proceduresto alert potentialsupply shortages 22 MME processesand proceduresto monitor supply conditions IMPROVE INTERFACESBETWEENTHE REGULATEDAND UNREGULATEDSEGMENTS 14 Changes inthe VN methodology 9 Revisionof TransmissionTariffs I 24 - - I ' lmorovement on transmissionexDansion Dlanninamethodoloaies !FOSTER INDUSTRYCOMPETITION 7 De-verticalization 18 Limits of self-dealing 29 Unbundlingof D and C componentsin the customer tariffs 30 Improvementsin the tariff revisionprocessfor D/C concessionaires 33 Regularizationof the concessioncontracts ACHIEVE PRICWARIFF REALITYAND DEFENDCUSTOMER INTERESTS 5 Electricservice universalization 32 Low income tariffs (lifeline rates) 4 Non conventional sources of energy 15 Subsidies to natural gas transportation 17 Eliminationof electric tariff cross-subsidies ENHANCEINSTITUTIONS 8 Institutionalreorganizationof MME 10 ONS Governance 19 Improvementsin the ONS Grid Procedures 20 Improvementsand fiinalizationof the ONS dispatcNpricing models 26 Improvementin the MAE rules 27 Improvementsinthe processto define submarkets and congestion management 28 Improvementsin the MRE - energyallocationrules It should be noted that a general agreement on rationing compensation was achieved between the GOB and the utilities on December 2001, prior to the issuance of the complete list of measures by the Revitalization Committee, as indicated above. This agreement was deemed essential by the GOB to implement the first cluster of themes (Enable the Energy Market to Function Properly). - 104- Proposed Measures, PPIAFand ESTAL Both the PPIAF and ESTAL projects considered the Revitalization list of measures in their design- PPIAF more on short term support on some of the more pressing issues, while the ESTAL 1 focusing on the medium and long term implementation efforts. A list of the 33 measures and how they dovetailed with the PPIAFandESTALproject design i s as follows: I I COMPARISON OF ELECTRIC SECTOR REVITALIZATION PROGRAM, PPIAF AND ESTAL REVITALIZATION PROGRAM I PPIAF 1 ESTAL 32 Low income tariffs (lifeline rates) P P 33 Regulatization of the concession contracts P = Primary focus, to be fully addressed S = Secondary focus, to be partially addressed -105- RevitalizationEffort -Major Results Due to their wide scope and complexity, not all the issues raised by the Revitalization Committee were taken care in fiscal year 2002. Some of them were initially addressedbut further regulatory details need to be agreed upon. However, significant progress has been achieved, in terms of putting the electric sector back on its feet. The most important areas and achieved results are summarized as follows: a) Wholesale Electricity Market (MAE) - MAE was strengthened, its Board redesigned, professional members appointed, and a new company was created to assume former responsibilities of ASMAE. The governance system, including bylaws, was revisited and streamlined. Some long-standing taxation issues have also been addressedbefore Tax authorities. Market rules and procedures were clarified. Most of the contract disputes have been agreed and settled upon. Several of the actions required legal changes, which were carried out. After months of delays in contract settlement, MAEwas able to resume operations in early January, 2003, right after the new Federal administration took over. MAE has been operating smoothly ever since. Issues such as spot price determination, capacity payments, demand side bidding, bidding for hydro plants, number of sub-markets, and others are still pending and need to be revisited by the current Federal administration; b) Conservation efforts - the rationing program itself was a "learning" experience in terms of rational use of electricity, for all customer groups. Law 10,295, enacted in early 2002, specified an energy policy for conservation. Government planned to provide assistance to medium and small companies to foster conservation actions. Special performance indicators were established; c) Alternative sources of energy - a special Program, called PROINFA was established, to provide incentives and foster the development of alternative sources of energy, such as biomass, solar, wind and others. Special regulations and sources of funds are currently being discussed. The current supply excess has reduced the sense of urgency in havingthis extra capacity inplace; d) Universal access - attention was given to increase access of electricity to all customers. Universal access targets, pace of implementation, and sources of funds are currently being discussed. CDE, a special fund created in 2002, should provide resources to partly support universal access. Overall target is to have all country electrified by 2016. Target dates will vary by concession area, depending on the existing level of coverage and on the incremental cost to serve. Competing uses of funds between alternative sources of energy and universal access need to be reviewed by current administration. Ditto for reallocation of RGR resources, which have beenextended for 10years; e) Lifeline rates - reform has paid attention to the need to regulate the issue of lifeline rates, and how those should be implemented and funded. Some differentiated tariff increases were given to poor customers in 2002, aligned with the macro objective of making electricity more affordable for the poor. Much more is still needed in terms of defining detailed regulations governing the definition of beneficiary groups and the design of smart subsidies for those who really need it most; f) Auction of bulk energy - the need of energy auctions was set forth, both on the sellers and buyers' sides. On the sellers' side, transparent auctions were organized to allow federally owned generators to re-contract the first tranche of energy under Initial Contracts (25% of the assured energy), expired in January 01, 2003. Due to the current supply excess , not all energy was - 106- re-contracted and currently generators are selling the surpluson a spot basis. Legislation was also put in place to mandate distribution companies acquire their energy needs via a competitive process. Competitive procurement was waived for energy acquired by distribution companies from their affiliates and for energy sold by generators to their former large industrial clients. Issuesof self-dealing and details on the procurement processby distribution companiesremain to be resolved. Also, given the still limited extent of retail competition, some short term solutions need to be found to make current cheap energy accessible to large users, at affordable prices duringthis period of supply excess; g) Unbundling- contracts with large customers have beenunbundled, separatingthe commodity from the wire components of costs, and pricing them separately. This is the first step to give transparency to the real costs to serve, paving the road for gradual elimination of cross-subsidies between large (industrial) and smaller customers (residential and commercial); h) Elimination of cross-subsidies - the unbundling of commodity and wire tariffs (see g above), the decline of Initial Contracts, and differentiated tariff increases for large and small customers have been important steps to gradually eliminate the existing cross subsidies between those customer categories. More effort i s needed in this area, as the subsidies can not be eliminated overnight and constant pressure i s expected from some customers to get special relief on tariff increases; i)RegulatoryLagonParceZaA-theeconomicandfinancialeffectscausedbythedelaybetween distribution company's incurring and recovering "non-controllable" costs was mitigated by the establishment of a regulatory account. This mechanism was a satisfactory solution to a long-standing dispute between distribution companies and ANEEL, regarding the interpretation of pass-through of non-controllable costs in the concession contracts, and it was essential in a period of increasing costs of Itaipuenergy (due to exchange rate devaluation) and fuel covered by CCC account (due to more thermal generation); j) Pass-throughof energy costs - the mechanism of VN was revisited. Differentiationof VN by technology has been eliminated. Policy decisions should be governed by special allocation of funds via PROINFA or CDE, not by ANEEL's regulatory decisions. The administratively set, controversial VN will gradually be replaced by a market benchmark based on the price levels achieved at the energy auctions; k) Reorganization of CGE - the energy rationing chamber was replaced by CGSE, a multi-ministerial organization structure in charge of coordinating and monitoring the implementation of electric sector reform. CGSE i s chaired by the Ministry of Mines and Energy and provides suitable cross-coordination and a liaison point between CNPE and the several Ministries involved in the reform of the electric sector. In 2002, four Laws and about half a dozen important energy related Decrees were issued to consubstantiat the reform and the actions described in the last paragraphs. Despite the significant effort, a lot i s yet to be done in terms of detailing the necessary regulations. Some of the new energy policies of the new administration may also entail some further changes in the existing legal and regulatory framework. ESTAL should help GOB identify those needs and detail those regulations in a harmonic and cohesive fashion. - 107 - Additional Annex 14: Environmentaland Social Issues in the Power Sector: Context and Proposed Programto Address Issues BRAZIL: EnergySector Technical Assistance Project The Energy Sector Technical Assistance Project (ESTAL) and the Energy Sector Reform Loan (ESRL) The ESTAL i s a four-year operation that will help ensure sustainable implementation of the Government of Brazil's ongoing energy sector reform program, through technical assistance in specific areas and by providing a mechanism for continuing dialogue with policymakers about longer-term reform of the sector. The operation focuses on the power sector, where there are more urgent reform needs and greater consensus around the reform agenda. The ESTAL was designed to in parallel with and with the objective of complementing the ESRL, an adjustment operation which focuses on the legal, regulatory and institutional reforms that are underway in Brazil. The project has no direct or indirect adverse environmental or social impacts, since it focuses entirely on providing technical assistance to support the ongoing reforms. It i s accordingly rated as C for environmental/social safeguards purposes. Nonetheless, the Bank and the Government propose to take a proactive approach and have designed a strengthening program in line with the ongoing sectoral reforms. Environmental and social planning tools and institutional responsibilities will be revisited and updated as needed to fit the new, largely private sector-basedmodel which has been adopted by the Government of Brazil, with the objectives of (i)ensuringappropriate mainstreaming of environmental and social concerns in expansion planning and operation of power sector projects, and (ii) facilitating the timely licensing of future investment projects. This Annex summarizes the findings of an environmental issues paper, interviews and discussions conducted during preparation of the and the ESTAL with representatives of the power and environment sectors in Brazil. (A full version of the issues paper i s available in Portuguese in project files.) The annex also describes the program that has been designed to strengthen the mainstreaming of environmental and social issues in the power sector and to improve the licensing process. Regulatory Framework Power sector projects (i.e., generation plants, transmission and distribution systems), depending on their nature, scale and location, can potentially occasion involuntary population displacement, loss of livelihoods, impacts on indigenous peoples, destruction of natural habitats, displacement of regional infrastructure (such as roads and bridges), and impacts on health, among others. Generation also contributes to climate change, positively or negatively, depending on the source of primary energy being used. In accordancewith Brazilian legislation, all power plants with capacity above 10MW, whatever - 108- the source of primary energy used, and transmission lines above 230 kV must be licensed by environmental authorities. The licensing process (its scope, timing and procedures) i s regulated by resolutions issued by the National Environment Council (CONAMA). Of special relevance are Resolutions 001/86 (general licensing framework), 006/87 (licensing of power sector projects), 009/87 (public hearings), and 237/97 (licensing of infrastructure projects). This regulatory framework is complemented by extensive legislation pertaining to water, fisheries, forests, wildlife protection, gaseous emissions, and water discharges, among others. Table A.14.1 inthis Annex provides a brief summary of the key pieces. Three environmental licenses (Preliminary, Installation and Operation) are required at successive stages of the project cycle (respectively, before the conclusion of feasibility studies, before construction begins, and before filling of the reservoir, in the case of hydropower plants, or commercial operation, in the case of thermal plants). A detailed and comprehensive environmental impact assessment (EIA) should be presented to environmental authorities approximately six months before conclusion of the feasibility study. An environmental impact statement (RIMA), summarizing project objectives, impacts, and mitigation/compensation plans presented in the EIA, i s also prepared and forms the basis for discussions with government agenciesand the general public. Review of power sector projects by environmental authorities and discussion with potentially affected people may take place as early as the inventory stage, Le., before feasibility studies are undertaken. The legislation stresses the importance of public participation and recommends that the dialogue with stakeholders begin with a formal request for the Preliminary License, early in the feasibility stage. It also requires public disclosure of all EIAs. Public hearings, although not mandatory, have frequently been called for at the end of the feasibility stage to address public concerns and other issues before the Preliminary License is issued. They may be called for either by the licensing agency, an NGO, the Public Attorney Office (Ministe'rio Pu'blico) or by a group of at least 50 people. Specific technical guidelines for managing environmental and social impacts in power sector projects have been developed, over the years, to instruct project preparation, licensing, implementation and operation, notably: Environmental Impact Studies Manual (1986), policy guidelines (for resettlement, indigenous peoples, flora and fauna, coal-fired thermal plants, among others) featured in the Power Sector Environmental Master Plan (1990), methodological guidelines for river basin inventory studies (1984; 1997 update), public consultation and negotiation (1993), and environmentalhocial cost accounting (1995). Such guidelines, largely developed by ELETROBaS working in close collaboration with regional and state utilities and the power sector's researchcenter (CEPEL), continue to be used as technical references, although not mandatory for plants being designed since the transition to the new sectoral model. Institutional Framework Licensing and enforcement by the environment sector. Primary responsibility for environmental licensing and enforcement lies with the states. The Ministry of Environment, through the Brazilian Environment Institute (IBAMA), has responsibility for licensing binational projects, projects on national rivers or developed in two or more states, and projects which - 109 - impact national protected areas. State agencies are in charge in all other cases. Box 1 describes the basic components of Brazil's National Environment System. An assessment of the effectiveness of the licensing system in Brazil was recently conducted by UNDPand MMA. Overall, the results are positive, although there is considerable variation in the capacity of agencies across states. Strengthening their capacity i s a long-term proposition. To this end, a number of initiatives are currently underway, including the National Environmental I1 Project - NEP II(Loan 45240-BR), financed by the Bank. One of NEP ITScomponents i s dedicated to institutional strengthening of state agencies and includes a sub-component focusing specifically on environmental licensing, enforcement and post-license monitoring capabilities. Activities financed under this sub-component include: (i)assessment of the current status and future needs of state licensing systems; (ii) priority setting; (iii) development of streamlined procedures; (iv) production of technical manuals; (v) staff training; and (vi) the development of improvedpost-license monitoringand enforcement techniques, among others. It i s also foreseen that this sub-component could provide support for the development of innovative instruments such as compliance agreements, self regulation, voluntary compliance and tradable permits. At the federal level, the strengthening of environmental licensing and enforcement capabilities are supported by the IDB's National Environment Project, US$ 7 million of which focus on restructuring of IBAMA and its regional offices, and on the design of tools and manuals. The Federal Government has recently authorized the contracting of 2,300 professionals through competitive recruitment over three years. Within a first batch of 610 professionals, 50 staff will be added to the Brasilia office and 20 to the Rio de Janeiro regional office. Subsequent batches will reinforce teams in up to 10 regional offices. Priority i s being given to those offices serving states where infrastructure investment plans are foreseen, mostly inenergy and transport. - 110- Environmental management in the power sector. The institutional framework described above for the environment sector i s supplemented by planning functions carried out within the power sector itself. In the configuration that was in place prior to the reform of the power sector, state-owned and operated utilities with extensive generation programs (roughly eight of the nearly thirty companies that were inplace through 1995) had developed, over the years, in-house capacity to design, implement and operate environmental and social programs to address minimization, mitigation, and/or compensation of the impacts of power projects. Functions carried out by utilities with regard to specific projects and expansion of their power systems were complemented by others carried out by the Ministry of Mines and Energy (definition of sectoral policy), ELETROBRAS (coordination of power sector expansion planning and operation; generation of technical and methodological specifications for project design and operation), and CEPEL (researchand modeling). Under the new model of the Brazilian power sector, projects are concessioned to operators (public or private), whose responsibility it becomes to design the project and carry out the necessary impact assessments, develop mitigationkompensation plans, secure the appropriate licenses from the environmental authorities, and implement the approved action plans. Annex 3 presents a summary of the power sector's institutional framework. Box 2 highlights the responsibilities on the part of the relevant entities in charge or policy making, regulatory and -111 - planning functions as regards environmental and social issuesinthe sector today. The current pipeline of power sector projects was largely developed before the reform process began. The licensing process i s being carried out much as before privatization, following established procedures. However, ELETROBRAS no longer carries out technical reviews of projects before submission to the sector regulatory agency (formerly DNAEE, now ANEEL) and to environmental licensing agencies at each pertinent stage of the project cycle. Its former role entailed prior screening, quality assurance, and clearance of compliance with licensing requirements, especially at the feasibility stage. Thus, under the current model, demands on the technical expertise of environmental licensing agencies have increased significantly, in a context inwhich the quality of EIAsare still sub-optimal. -112- The Power Sector in Transition: Issuesfor the Short and Medium-term Since the beginning of the privatization process in 1995, the power sector has undergone extensive revision of its regulatory and institutional frameworks. This process i s still ongoing and, as part of the transition, some revision of regulations and significant realignment of institutional responsibilities with regard to the managementof environmental and social issues in the power sector will be needed. Because, as indicated above, a substantial pipeline of projects in advanced stage of design was already available when the transition began, the need for such changes in the regulatory and institutional frameworks did not immediately present itself. However it has surfaced in the context of the current crisis and will be a potential bottleneck to future systemexpansion if not addressedsoon. The sequence of adjustment operations of the and the ESTAL are meant to support the completion of power sector reform as regards, among other areas, the managementof environmental and social issues. Key issues faced by the power sector can be grouped under four areas (which are also discussed inthe main text): (a) During the current energy crisis, the licensingframework has come underfrequent attack as being untimely and unpredictable. While there is a reasonably solid framework in place for handling environmental and social issues in the power sector, licensing of power sector projects i s guided by norms that were adopted before the reform of the power sector and the establishment of the National Water Policy. They thus need to be revisited and selectively revised to fit the current context. In addition, some technical inconsistencies in the legislation also predate these changes and should be addressed (e.g., with respect to the minimum area required for the protection of reservoirs or for transmission line rights-of-way). O f special relevance i s the fact that the uncertainties and transaction costs associated with environmental licensing are perceived by many to be a serious limitation to timely expansion of the system in a private sector-based model. Suggestions for changes have emerged, ranging from a possible centralization at the federal level of the licensing system, to the institution of special task forces to support state agencies in addressing critical cases. "Quick fixes" run the risk of throwing away considerable advances made over the past twenty years and of introducing ad-hoc measures into a basically consistent framework. There is however room for improvement, making the licensing system more effective and responsive to the dynamics of the private sector, for instance by institutionalizing the use of strategic EIAs, as has occurred inthe case of the oil and gas sector in the State of E o de Janeiro. Another promising development was the creation in September 2000 of the Environment Committee in CNPE and in June 2001 of the Energy Committee in CONAMA to facilitate coordination across sectors. In March 2002, the Ministers of Environment and of Mines and Energy signed a Memorandum of Understanding establishing the scope and terms of a technical cooperation program covering nine broad areas relating to the mainstreaming of environmental and social concerns inenergy sector activities, and placing special emphasis on the strengthening of environmental licensing agencies, as well as on improved monitoring and ex-post evaluation of the impacts of energy sector activities on the part of the energy sector. These coordination - 113- mechanisms and agreements need to be fleshed out and consolidated to support effective and timely planningand licensing of power sector projects. A preliminary assessment of the current regulatory framework that applies to environmental licensing was conducted recently by MMA, which, joined with the findings of the Special Commission for Analysis of the Hydro-Thermal Power System, the work of the GCE, and other agencies, should form the basis for an in-depth evaluation of the adequacy and possible improvements in the current environmental licensing system as regards power sector projects. This evaluation, the revision of Resolution 006/97 and other specific recommendations resulting from the evaluation will be supportedthrough the proposed ESTAL. (b) There is considerable lack of clarity with respect to institutional responsibilities and imbalance in the availability of technical capacity across agencies in the sector. This is especially the case with respect to activities pertaining to the early stages of the project cycle, e.g., river basin inventories, studies of alternative locations of thermal plants, and sectoral expansion plans and strategies, for longer-term horizons. However it also applies to subsequent stages, in which activities which were formerly the responsibility of utilities and ELETROBRh have been transferred to operators, ANEEL and the MME.While this shift was meant to sort out roles and avoid conflicts of interest within institutions, the new agents do not necessarily have the technical capacity to respond to their mandates. For instance, the Environment Coordination Unit of MME's Energy Secretariatcurrently counts only two high-level staff. Inthis regard, it is important to note that the technical capacity in environmental and social issues developed by the sector in the past two decades or more represents a tremendous investment in human capital. It i s still largely available since the system i s in transition and could be realigned under the new model so as to minimize the uncertainties and delays currently associated to the licensing process. It would also be expected that ELETROBRAS and the National Social and Economic Development Bank (BNDES), as potential investors and financing agents of power system expansion, would have a prominent role in assessing environmental and social risks and mitigation projects and programs in which they are likely to be involved. As part of the ESTALassistanceto the Government in assessingthe collaboration among federal regulatory agencies (see Annex 2, Component I.B.l), it would be appropriate to include the clarification of the institutional role of MME, CCPE, ANEEL, ANA, and other government entities, with respectto the handling of environmental/social issues. (c) I n the longer term, dealing with the environmental and social externalities generated by power sector projects, requires coordination on thepart of energy, water resource management and environmental agencies. The available pipeline of projects will need to be revisitedsoon for a number of reasons, notably: (i)theBraziliansystemisstronglyhydro-basedandad-hocconcessioningofindividualprojects in disregard of a comprehensive study of the complete cascade has drawbacks in terms of optimizing generating capacity; and (ii)optimal multiple use of water resources has gained importance since the approval of the National Water Resources Policy in 1997 and the creation of the CNRH and ANA; inventories of river basins will need to be systematically updated to - 114- incorporate these as well as generally heightenedconcerns on the part of local communities and Brazilian society with respect to environmental and social impacts. Several agencies (ANEEL, ANA, MME and ELETROBRh) are currently advancing methodological and other studies to respond to what they perceive as their mandate. It is quite urgent that responsibility for extensive river basin inventory work be clearly assigned, that methodologies be updated so as to fully incorporate environmental, social and multiple costs and benefits, and that a mechanism for institutional cooperation be put in place. Updating the inventories for the country's major river basins would significantly minimize risks associated to power sector development. Given the potential relevance of thermal plants in future expansion of the generation system, strategic macro-siting (regional) studies are also apriority as an instrument to assess options and risks. The Memorandum of Understanding between MMA and MME, referred to previously, also places special emphasis on better mainstreaming environmental and social concerns during the early stages of the planning process, and on better integration of multiple objectives in resource development. Furthermore, a model of the longer-term planningresponsibilities within the sector has been proposed by MME. Broad-based discussion and agreement amongst the key institutional stakeholders is needed but i s likely to extend beyond the timeframe of the current operation. Thus, this process, as well as specific recommendations to strengthen planning functions, would be supported in the proposed ESTAL. The ESTAL would also support an updatehevision of river basin inventories, including the environmental/social impacts of alternative cascade arrangements, as well as strategic EIA for the sitingof thermal power plants. (d) A vision of the environmental and social implications of longer-term expansion of the power sector needs to be developed to reduce uncertainties and make best use of resources and opportunities. The power sector i s currently operating in a crisis mode, prioritizing immediate avoidance of a major collapse in the supply of electricity. Beyond this phase however, both private sector participation and consideration of the public interest in a capital intensive, long lead time sector such as power require some strategic planning. A clear identification of the likely expansion paths (e.g., fuel uses, comparative advantages across regions), key issues and implications of alternative paths (e.g., likely impacts, opportunities to participate in emerging markets for carbon emission reductions), and options for addressing them (e.g., mitigation strategies, synergies with other initiatives, institutional, regulatory and methodological requirements, financial implications, funding opportunities), is needed. The ESTAL will support formulation of a methodology to conduct strategic EIA in the power sector, based on a methodological proposal commissioned by MMA for strategic EIA generally and on international best practice. It will also support the carrying out of a pilot exercise to assess impacts and opportunities associated to alternative longer-term expansion paths for the power sector. The ProposedProgram Within the new sectoral framework, managementof environmental and social issues will needto reconcile public (i.e., societal) and sectoral interests (as previously was the case), but also private - 115 - interests.This entails balancing four objectives -- sustainable use of natural resources, social equity in dealing with impacts, transparencyin the decision makingprocesses, and responsivenessto the dynamics of the private sector (e.g., clear and simple "rules of the game," low andor predictable transaction costs). Inline with the natureof the proposedoperation, which focuses on legal, regulatory and institutional reforms inthe power sector, the issues identifiedinthe previous section will be dealt with in the ESTALthrough a strategic, sectoralapproach, covering: review and adjustment, as needed, of environmental requirements, procedures and mandates for licensing of power sector projects; assessment of the performance of power sector regulatory agencies to clarify their institutional roles and coordination requirements vis-&vis other government entities, such as the MMA, the National Water Agency, and the MME; revision and realignment of key institutions with regard to mandates and procedures for mainstreaming of environmental and social issues in longer-term expansion planning, including coordination with water resourcesmanagement andenvironmental agencies; carrying out a set of studies on priority topics including: project preparation methodologies; strategic assessment of longer-term system expansion paths; river basin inventories; strategic assessment of the thermal power program; issues and options relatingto potential participation of the sector in markets for carbon emissions reductions and other environmental services; and promotionof corporate responsibility; strengthening (number and qualification) of professional cadres within the power and environment sectors, with special emphasis on the environmental licensing capacity in regionshtates where expansion of the sector i s likely to be concentrated over the coming years; and strengthening of monitoring and ex-post evaluation of environmental and social issues in the power sector. While the first three activities are of relevance in the very short-term, the last two activities address issues related to expansion of the sector in the longer term. Overall, these activities will comprise a `Program to Strengthen Planning and Management of Environmental and Social Issues in the Power Sector', to be implemented in successive stages, over the medium-term. For the first four-year period, the program will be supported by the ESTAL. Terms of Reference of the Program have been agreed between the MME, the MMA and the Bank. (see Attachment 1) These terms of reference were prepared in coordination with a working group of senior power sector professionals. Detailed TORs will be prepared and discussed with a broader set of key institutional stakeholders (including representatives of the environmental "sector", the private sector, and academia) before the start of project implementation of the ESTAL. As currently envisaged in the TORs, development of the Program itself will be undertaken in stages, with consultations/validation carried out at each major stage (e.g., diagnostic, preliminary design and overview of program priorities, formulation of a multi-year strategy, formulation of the first phase action plan) and, as needed, in each one of the sub-projects. An advisory board, technical groups and a consultation strategy have been outlined on a preliminary basis and will be detailed and agreed in the final TORs of the Program during - 116- project implementation.This multi-year programwould extend over the medium-term,possibly supported by the Bankthrough subsequent operations. Table 1: Summary of Key Legal Framework with respect to Environmentaland Social Issuesinthe BrazilianPower Sector Legislation Brief Summary of Contents Constitution 1I Enacted in 1988, it deals with the environment, inseveral o f its provisions, covering about 20 different articles, one o f which, no. 225, deals exclusively with this subject. For this reason, it has been called by some jurists the "Green Constitution." It defines the environment, biodiversity and ecological systems and services as public goods, assigning their guardianship to public authorities inthe country's different political and administrative units, to the Public Attorney Office (Ministhio Pu'blico), to communities and citizens. It prescribes instruments and means to this end: environmental impact assessments (EIAs) which will be publicized; concurrent federal, state and municipal legislation; and public participationinprocessesrelating to creation o f environmental regulations, inthe formulation and implementation of environmental policies and in actions camed out through the Judiciary. Law 6938/8 1 .nstitutes the National EnvironmentalPolicy (PNMA), creates the National EnvironmentalSystem (SISNAMA), establishes as key instruments of the PNMA environmental impact assessments (EIAs) and the licensing o f projects and activities that are likely to have environmental impacts, and requires public disclosure at different stages o f the project cycle. SISNAMA i s comprised of: a Government Council (not created); the National Environment Council (CONAMA), a consultative and deliberative body, responsible for establishing national environmental guidelines and regulations; MMA, as central agency; IBAMA, as executing agency; state environmental agencies and entities; and municipal agencies or entities. This law was regulated by Decree 99.274/90, which confirmed the practices recommended by CONAMA with regard to environmental licensingthroughout the 1980s, as well as the diverse, collegiate composition o f CONAMA. Law 7347/85 Regulates citizens' suits regarding responsibility for environmental damages and provides other measures. It emphasizes injunctions under the initiative o f the Public Attorney Office(A4iniste`rio Pu'blico), the federal government, states and municipalitiesand environmental associations. It calls for the Public Attorney Office be a law enforcement agent with respect to the environment. Law 7990/89 Institutes financial compensations for states and municipalities for the development of water resources for purpose: o f power generation within their territories, as well as for mining. Law 9433/97 Institutes the National Water Policy (PNRH), the National Water Resources Council (CNRH) and the National System o f Water Resources Management. It creates Water Resources Plans for watersheds (PRHB), inobservance of criteria for multiple use of water resources and priorities established through shared decision-making processes, highlightingRiverBasinCommittees comprised o f representativesof the country's various political and administrative units involved inthe basin under analysis, o f water users and other stakeholders. It creates various instruments for the PNRH, in addition to PRHBs, highlightingthe granting o f and charges for the use of water and compensation to municipalities. Law 9605/98 Establishes, among other things, penalties for citizens, companies and their responsible agents who cause damage to the environment, as well as for public employees who commit crimes against environmental administration. Law Establishes the National System o f Protected Areas (SNUC), considering various categories o f sustainable 9985/00 management and integrated protection of natural resources. It provides the government with instruments for the effective implementation of the System, calls for the involvement o f populations residing within and outside the protected areas (conservation units), and establishes fines and penalties on offenders. It recognizes officially established private reserves, and institutes incentives for collaboration of the private sector with country's biodiversity conservation goals. CONAMA 1 CONAMA establishedrelevant environmental concepts, practices and requirements, through numerous resolutions Resolutions issuedsince 1986. Those having major sectoral repercussions (and their relevance to the power sector) are as follows: OOU86, requiring EIAs for power plants larger than 10Mw;006/87, establishing guidelines for environmental licensing o f power sector projects; 009/87, regulatingpublic hearings; 005/89, establishing the National Air Pollution Control Program; 003/90, defining air quality standards; 008/90, definingemissions standards for various gases inpower plants larger than 70 MW; 002/96, requiring ecological compensatiordmitigation,in the amount of at least 0.5% of the plant's total investments; 237/97, updating001/86 and 006/87 and seeking to define jurisdictions under the scope o f licensing agencies. - 117- Attachment 1 Programto Strengthen Planningand Managementof Environmentaland SocialIssues inthe Power Sector Terms of Reference A. Context Within the new sectoral framework, managementof environmental and social issues will needto reconcile not only public (Le., societal) and sectoral interests (as previously was the case), but also private interests. This entails balancing four key objectives -- sustainable use of natural resources, social equity in dealing with impacts, transparency in the decision-making process, and responsiveness to the dynamics of the private sector (e.g., clear and simple "rules of the game," low andor predictable transaction costs). To achieve these objectives, the MME and the MMA recently signed an "Environmental Agenda," setting forth nine broad areas of collaboration for the coming years. In line with the Agenda, the Government proposes to implement a "Program to Strengthen Planning and Management of Environmental and Social Issues in the Power Sector." The program would be implemented in successive stages, the first of which would be within a four-year timeframe, with support from the ESTAL from the World Bank. B. Objectives To promote adequate planning and operation of the Brazilian power system with regard to environmental and social issues, under a managementmodel in which participation of the private sector i s expectedto increaseover the coming years. Thus, more specifically: 1) To identify the main short-, medium- and long-term bottlenecks for the proper functioning of the sector and alternatives for resolving them. 2) To propose a medium-term strengthening program, to be carried out in stages, identifying priority actions of a legal, regulatory, institutional, methodological and analytical (studies and research) nature, with the respective responsibilities, timetables and budgets. 3) To design and carry out a select number of priority studies. 4) To promote consensus among the principal institutional stakeholders in the power, environmental and other sectors, taking into account national, regional, local, public and private interests. C. Activities and Methodology The process of preparing the medium-term Program and its first stage, the Priority Action Plan (PAP) would unfold in the following manner: - 118- 1) Identificationor establishmentof coordination andconsultation mechanisms, including: (a) an Executive Committee, coordinated by the Secretariat of Energy and comprised of representatives o f institutions with relevant participation in the planning and management of environmental and social issues in the power sector; the Committee would be responsible for (i) supervising the preparation of the Program, (ii)seeking its approval by relevant authorities, (iii) seeking the allocation of resources needed to implement the Program, and (iv) monitoring its implementation; (b) Technical Working Groups (for example, those of the CCPE), set up as needed by the Executive Committee; the groups would conduct the identification and discussion of priority problems, guide the work of consultants in preparing reports, recommendations and terms of reference for subsequent works, and follow up on execution as needed; and (c) Mechanism(s) for public consultation with collegiate bodies (for example, CONAMA, CNRH, CNPE and other permanent or ad hoc forums), associations of representatives of different sectoral agents (for example, ABRAGE, ABRATE, ABCE and others) and environmental entities (for example, MMA, IBAMA, OEMAs, ABEMA and others); such mechanism(s) would allow discussion of priority issues andproposals to solve them, as well as to build consensus around proposed courses of action. 2) Execution of a rapid diagnostic of the sector's main problems with regard to planning and management of environmental and social issues: Priority will be given to issues that correct distortions already identified before the start-up of sector reform, as well as to new challenges arising from the process of transition from a predominantly state-managedmodel to a model based on private participation, among others: a) defining the mandates of management agencies (within and outside the power sector) and seeking operational reconciliation among such mandates; b) balancing resourcesamong managementagencies; c) promoting institutional consolidation; and d) systemizing sectoral planning, with special emphasis on the strategic assessment of alternative expansion paths and on promotingan integrated view of the use of water resources. These issues transcend the scope of environmental and social concerns, implying that this rapid sectoral diagnostic should be closely coordinated with other initiatives taking place in the power sector that are also focused on or can contribute to addressingthe above four points. 3) Discussion and validation of the rapid diagnostic: The following, at least, should be included in the consultationhalidationprocess: (a) entities responsible for proper use of natural resources and for the fair treatment of those potentially affected by power sector projects or decisions; (b) entities responsible for decision-making and for allocating the (technical and financial) resources needed to resolve problems relative to environmental and social issues in the power - 119 - sector; and (c) entities with knowledge and informationthat are relevant to suchproblem-solving, 4) Workshop on strategicenvironmental assessment methodolorzies: Inorder to promote accessto international "best practice" andprovideexpert input to subsequent activities, a workshop will be held with the participation of sectoral and environmental entities and international specialists, focusing on strategic environmental assessment (SEA). Besides reviewing the current thinking on approaches to SEA and relevant case studies illustrative of such approaches, the workshop will discuss: (a) the sectoral diagnostic; (b) apreliminary view of issues that could bepotentially addressedinthe medium-term Program; and (c) study topics that, given their importance and relative urgency in the current context of the sector, would configure a Priority Action Plan (PAP) to be carried out over 2-3 years. 5) The topics that, in principle, are proposed as part of the PAP would be the following: (a) revision and adjustment, as needed, of the legal, regulatory and institutional frameworks; (b) formulation and/or revision of power system expansion planning methodologies, river basin inventories, and macro-location of thermal power plants; (c) strategic environmental assessment of sectoral expansion alternatives; (d) river basin inventory studies; (e) strategic assessment of the thermal power program; (f) potential participation of the sector in markets for carbon emissions reductions and other environmental services; (g) training of human resources in the power and environmental sectors and strategic strengthening of the environmental licensing capacity in regionshtates where expansion of the sector i s likely to be concentratedover the coming years; (h) strengthening of capacity for monitoring and ex-post evaluation of environmental and social issuesin the power sector; and (i)promotion of corporate accountability. 6) Preparation of a medium-term Strengtheninp Propram and of the Priority Action Plan (PAP) (preliminary versions): Based on the diagnostic and recommendations stemming from the consultation process and the workshop, this activity would specify medium- and long-term objectives and goals, as well as instruments to promote the strengthening of planning and management of environmental and social issues in the power sector, identifying: (a) priority actions of a legal, regulatory, institutional, methodological and analytical nature (studies andresearch), as needed; (b) implementation strategy for the Program, whose execution is planned in stages, over the - 120- medium-term , with a tentative definition of respective institutional responsibilities, timetables, budgets and monitoring arrangements; and (c) terms of reference, methodology and indicators of expected results for the projects/activities that would comprise the Priority Action Plan (PAP) to be implemented inthe first 2-3 years. 7) Discussion and validation of conclusions and recommendations: An approach similar to that in item 3 (Discussion and validation of diagnostic) should be used. Results achieved up to this stage (with emphasis on conclusions and recommendations) should also be presentedto relevant ministerial authorities (within MME,MMA, Planning andFinance). 8) Detailed formulation of the Strengthening Program and Priority Action Plan: The preliminary versions of the Program and the PAP should be adjusted to recommendations stemming from their discussion, and final versions of the following documents should be prepared: (a) Medium-term Strengthening Program, including objectives, premises and general implementation strategy (inaccordancewith item 5.b above); and (b) Priority Action Plan for the first 2-3 years, with detailed terms of reference for all the proposed projects and activities which are part of it, including institutional arrangements, coordination mechanisms, budgets, sources of financing, timetables, results indicators, and monitoring and evaluation mechanismsneededfor proper execution of projects and activities. 9) Approval of Medium-Term strengthening Program and Priority Action Plan by relevant ministerial authorities (within-MME and MMA). 10) Execution of Proaam and of Action Plan: The Program will be implemented in stages, by means of Action Plans agreed for each, according to the general process defined above. Monitoring and evaluation of the implementation process and of the results of one stage should provide informationfor the preparation of the next stage. D.Timetable The preparation of the Program and the Action Plan i s expected to take 6-8 months, and the priority studies which are part of the latter are expected to take 24-36 months, depending on the scope of some items (for instance, river basin inventories). E.Modality ofExecution Activities would be carried out with the assistance of consultants, under the guidance of the Executive Committee and with the support of the Technical Working Groups mentioned in item C.1.a and b of these terms of reference. Contracting of services would follow World Bank procurement guidelines and the implementation arrangementsagrred for the ESTAL. - 121-