Report No. 19037-VN Fueling Vietnam's Development- New Challenges for the Energy Sector (In Two Volumes) Volume l: Main Report December, 1998 Energy & Mining Development Sector Unit Vietnam Country Department East Asia and Pacific Document of the World Bank Currency Equivalents Currency Unit = Dong (D) US$1.00 = D12,990 (July 98) Fiscal Year January I - December 31 Date of last Sector Report June 18, 1993 Weights and Measures bbl - barrel bm3 - billion cubic meter bcf - billion cubic feet bcm - billion cubic meter bpd - barrel per day dwt - deadweight ton GWh - GigaWatt - hour (I million kilowatt - hours) ha - Hectare kcal - kilocalorie (3.97 British thermal units) km - kilometer (0.62 miles) kV - kilovolt (1,000 volts) kW - kilowatt kWh - kilowatt - hour m - meter m3 - cubic meter mm - millimeter mmb - million barrels mmcf - million cubic feet mt - million tons MW - mega watt ppm - parts per million t - ton tcf - trillion cubic feet toe - tons of oil equivalent Conversion Factors I million tons of oil equivalent is = 1.5 million tons of coal = 3 million tons of lignite = 1I .111 bcm of natural gas = 39.2 bcf of natural gas = 107 bcf per day of gas = 12,000 GWh of electricity Vice President Jean-Michel Severino Director Andrew Steer Sector Manager Yoshihiko Sumi Task Manager Anil Malhotra Abbreviations and Acronyms ADB - Asian Development Bank AFTA - ASEAN Free Trade Area ASEAN - Association of South East Asia Nations BOT - Build - Operate - Transfer BP - British Petroleum BTP - Bulk Transfer Price CC - Combined Cycle CIEM - The Central Institute of Economic Management COALIMEX - Coal Import-Export and Material Supply Corporation Doi Moi - Vietnam's economic renewal program launched in 1986 EDI - Economic Development Institute EHV - Extra High Voltage Transmission Line El - Energy Institute of Vietnam EIA - Environmental Impact Assessment ENPEP - Energy and Power Evaluation Program ESAF - Enhanced Structural Adjustment Facility ESMAP - Energy Sector Management Assistance Program EVN - Electricity of Vietnam FDI - Foreign Direct Investment GDP - Gross Domestic Product GEF - Global Environment Facility GSA - Gas Supply Agreement GT - Gas Turbine HCMC - Ho Chi Minh City EHVAC - High Voltage Alternative Current HVDC - High Voltage Direct Current IDF - Institutional Development Fund IMF - International Monetary Fund IUCN - International Union for the Conservation of Nature LPG - Liquified Petroleum Gas LRMC - Long Run marginal Cost MIS - Management Information System MOI - Ministry of Industry MPI - Ministry of Planning and Investment NEAP - National Environment Action Plan NGO - Non-Governmental Organization NPESD - National Plan for Environment and Sustainable Development ODA - Official Development Assistance OECD - Organization for Economic Cooperation and Development OECF - Overseas Economic Cooperation Fund PC I - Power Company I PC2 - Power Company 2 PC3 - Power Company 3 PCI - Pulverized Coal Injection PETECHIM - Petroleum Equipment Import Corporation PETROLIMEX - Importer and Exporter of Petroleum Products PVN - PetroVietnam PHRD - Population Human Resource Development PIDCI - Power Investigation and Design Company I PIDC2 - Power Investigation and Design Company 2 PSC - Production Sharing Contracts RAP - Resettlement Action Plan RoW - Right of Way SAC - Structural Adjustment Credit SCP - State Committee on Pricing SIDA - Swedish International Development Agency SOE - State Owned Enterprises SUC - Standard Unit Costs T&D - Transmission & Distribution TA - Technical Assistance TR - Transferable Rubles UNDP - United Nations Development Program UJNEP - United Nations Environment Program VITTEP - Vietnam Institute of Tropical Technology and Environmental protection VOC - Volatile Organic Compounds WASP - Wein Automatic System Planning Package WB - World Bank FUELING VIETNAM'S DEVELOPMENT NEW CHALLENGES FOR THE ENERGY SECTOR Volume I MAIN REPORT Acknowledgements ................................................................................................................ Executive Summary ..............i 1. Forecasting Economic Growth and Energy Demand. Impressive economic progress - and future prospects .3 Developments in the demand for energy .10 Controlling demand and increasing efficiency .19 2. Developing Energy Resources .23 Power .23 Responding to expanding generation needs .26 Addressing other power issues .31 A strategy for the power sector .40 Upstream oil and gas .42 Updating pricing and fiscal systems .42 Gauging hydrocarbon reserves .43 Assessing hydrocarbon production .46 Planning investment through 2002 .49 A strategy for the upstream oil and gas sector .50 Downstream oil and gas .51 Developing the gas market .5 1 Exploring options for the petroleum market .60 A strategy for the downstream oil and gas sector .64 Coal .65 Reserves are extensive .65 Demand will increase steadily .66 A strategy for the coal sector .72 3. Making Environmentally Responsive Energy Investments .75 Responding to environmental concers .75 Pricing the environmental impacts of energy projects .82 A strategy for environment-friendly energy .88 4. Financing Energy Development .91 Estimating investment requirements .91 Energy finance offers challenges .92 ... And choices ....... 94 Using guarantees to secure funds ................................................... 101 A strategy for energy financing ................................................... 102 5. Reforming Energy Institutions ................................................... 109 Improving corporate governance ................................................... 109 Developing market structure ................................................... 115 Strengthening regulation ....................................................118 Formulating policies and strategies ...................................................1 20 6. An Agenda for Action ............... 123 Maps 29557,29558 and 29559 Tables 1.1 Alternative growth scenarios, 1999-2001 ....................................................6 1.2 Exports and imports, 1997 ....................................................6 1.3 Balance of payments, 1990-96 ....................................................7 1.4 Modern energy consumption, 1985-95 ................................................... 10 1.5 GDP growth under the low-growth, base case, and high-growth scenarios ............1 1 1.6 Economic growth rates in the Republic of Korea, Malaysia, the Philippines, and Thailand, 1965-91 ........................................... 12 1.7 Electricity consumption, 1985-95 ........................................... 13 1.8 Coal consumption and exports, 1985-95 ........................................... 15 1.9 Petroleum product consumption, 1985-95 ........................................... 17 1.10 Current and projected demand for modern energy, 1995-2010 .............................. 19 2.1 Electricity generation by region, 1996 ........................................... 24 2.2 Vietnam's power system, 1998 ........................................... 25 2.3 Electricity generation demand forecasts ........................................... 26 2.4 Comparative cost assumptions ........................................... 28 2.5 Comparative cost estimates ........................................... 28 2.6 Base case investment scenario, 1997-2010 ........................................... 30 2.7 Demand for gas and coal under the base case scenario with two types of gas contracts, 1998-2010 .............................................. 33 2.8 Long-run marginal costs of electricity under the base case scenario ...................... 34 2.9 Cumulative net present value of the Son La plant under two scenarios, 2010-20 ........................................... 35 2.10 Electrification by region, 1996 ........................................... 36 2.11 Potential hydrocarbon reserves ........................................... 45 2.12 Upstream oil and gas investments, 1998-2002 ........................................... 50 2.13 Downstream gas investment requirements ........................................... 53 2.14 Estimated costs of gas delivered from the Nam Con Son basis .............................. 57 2.15 Maximum value of natural gas in various uses ........................................... 59 2.16 Projected investment in downstream petroleum ........................................... 62 2.17 Petroleum product prices, early 1997 ........................................... 63 2.18 Coal reserves in fields under exploitation ........................................... 66 2.19 Quality of exported coal ........................................... 68 2.20 Mine-head production costs, 1995 ................................................. 70 3.1 Disturbed area and production of coal mines ................................................. 84 3.2 Incremental investments in hydroelectric plants required to meet environmental standards .86 3.3 Incremental investments in thermal plants required to meet environmental standards ................................................. 87 3.4 Environmental costs under the base case scenario ................................................. 88 4.1 Energy financing requirements, 1998-2002 ................................................. 92 4.2 Assessment of financing sources ................................................. 97 5.1 Expected benefits and actual results of corporate governance reforms ................ 112 6.1 Recommendations for energy prices ................................................. 124 Figures 1.1 Major economic indicators have been strong in recent years ...................................4 1.2 Demand for electricity will grow fastest in the residential sector ........................... 14 1.3 Coal production for exports and electricity generation should increase considerably ...................................... 16 1.4 Demand for offshore natural gas will rise considerably ...................................... 17 1.5 Among petroleum products, demand will be greatest for diesel and gasoline ................................................ 18 1.6 Higher prices would lower the demand for electricity ............................................ 21 2.1 Vietnam's power system has a strongly regional character .................................... 24 2.2 Breakeven fuel prices depend o n the direction of electricity exports .................... 29 2.3 There is a close link between discovered reserves and exploration drilling .44 2.4 Oil production from the Cuu Long basin should peak early in the next century .47 2.5 Nam Con Son and Cuu Long show great potential for gas production .48 2.6 Gas netback values are especially high when gas substitutes for diesel ........................................... 58 5.1 The current gas industry is a mix of public and private actors .............................. 116 5.2 Electricity of Vietnam oversees generation, transmission, and distribution ........................................ 117 Boxes 2.1 The high cost of delaying the gas pipeline ........................................ 32 2.2 How can access to electricity be expanded in rural areas? .................................... 38 2.3 The Petroleum Law ........................................ 43 2.4 Stages of gas market development ........................................ 52 2.5 State management of petroleum operations ........................................ 54 2.6 Principles of gas price indexing .................................................... 59 3.1 Disappearing forests - and the role of fuelwood gathering .................... ............... 76 3.2 Phasing out lead: Success stories in Malaysia and the Philippines ....................... 81 4.1 Partial Risk Guarantees for IDA only countries ................................................... 106 Volume II - ANNEXES Annex 1. Economic Growth and Energy Demand .....................................................1 Annex 2.1. The Power Sector .................................................... 46 Annex 2.2. Upstream Oil and Gas .................................................... 72 Annex 2.3. Downstream Oil and Gas .................................................... 85 Annex 2.4. The Coal Sector .................................................... 109 Annex 3. Energy and Environment .................................................... 116 Annex 4. Investment Priorities and Financing Strategies ................................................. 121 Annex 5. Institutional Development and Regulation .................................................... 128 Annex 6. An Agenda for Action .................................................... 141 Acknowledgments This report was written by a team led by Anil K. Malhotra and comprising Ranjit Lamech, Bent Svensson, Hung Van Tien, and consultants Peter Eglington, Moiffak Hassan, Ray Tomkins, Sadhan Chattopadhya, P.T Venugopal, and Jack Ruitenbeek. The peer reviewers were Hossein Razavi, Peter Cordukes, and Mohammad Farhandi. Other World Bank staff to whom the team is grateful for contributions and comments are Darayes Mehta, Kyle Peters, Rebecca Sekse, Suman Babbar, Kazi Matin, and Shane Rosenthal. The task assistant was Nguyen Thuy Anh. The team benefited from fruitful discussions with many Vietnamese academics and government officials who were generous with their time and knowledge. We would like to thank Ministry of Planning and Investment which, with the key energy agencies and Ministry of Industry, organized a workshop in October 1997 to provide guidance and support to the team in preparing this report. Substantive discussions were also held with senior energy officials, including Tran Xuan Gia, minister of planning and investment; Thai Phung Ne, vice minister of industry; Nguyen Cong Su, vice minister in the Office of Government; Hoang Trung Hai, director general of Electricity of Vietnam; Nguyen Hiep, vice president of Petrovietnam; Doan Van Kien, president of Vinacoal; Phung Nhu Thach, director of Coalimex; Tran Van Duc, deputy director general of Petrolimex; Tran Ngoc Trang, Office of Government; Tran Quoc Cuong, director of the Energy Institute; and Nguyen Viet Hung, director of the Ministry of Planning and Investment. In addition, the team had extensive discussions with a number of officials from the Ministry of Planning and Investment, Ministry of Industry, Ministry of Finance, CIEM, Electricity of Vietnam, Petrovietnam, Petrolimex, Vinacoal, and the Office of Government whose contributions are gratefully acknowledged. The team also met with various international companies working in Vietnam, and their insights and experiences were invaluable in completing this report. The contributions of the Energy Institute in providing data and running simulations using assumptions provided by the Bank team are gratefully acknowledged. The report was edited by Paul Holtz of Communications Development Incorporated. Vice President: Jean-Michel Severino Country Director: Andrew D. Steer Sector Manager: Yoshihiko Sumi Task Team Leader: Anil K Malhotra FUELING VIETNAM'S DEVELOPMENT NEW CHALLENGES FOR THE ENERGY SECTOR EXECUTIVE SUMMARY During 1992-97 Vietnam's unprecedented economic growth-averaging 8.2 percent a year-and remarkably stable macroeconomic balance led many to conclude that it was a nascent East Asian tiger. But Vietnam's growth is now slowing because of the financial crisis in East Asia and because of its own inertia in implementing structural and policy reforms. These forces have reduced foreign direct investment, as some investors have less to invest and others are discouraged by Vietnam's policies. Vietnam cannot afford this slowdown. It remains one of the world's poorest countries- GNP per capita is less than $300, and more than half the population is classified as poor. Income disparities are growing between rural and urban areas and within rural areas. At 144 kilograms of oil equivalent per capita, modem energy consumption is one-seventh the level of neighboring Thailand and among the lowest in the developing world. More than half the population has no access to electricity, and Vietnam consumes less electricity in a year than industrial countries consume in a week. The energy sector can, however, provide a foundation for future economic growth (box 1). Oil and coal exports account for more than a quarter of foreign exchange earings, contributing $200 million in the first four months of 1998. ~During1993-97 domestic consumption of modemn V energy grew 30 percent faster than GDP, and ctn R l dcontinued expansion in energy supply and ru delivery is required to support growth in industry and exports. Developing energy infrastructure can alleviate poverty by providing the poor with access to moder energy, and it can mitigate environmental degradation by encouraging a shift from traditional to commercial energy and by increasing supply of cleaner fuels. Vietnam has yet to use its extensive primary energy resources for the benefit of all its citizens. Recently discovered nonassociated gas reserves are conservatively valued at about a quarter of 1997 GDP--or $7-8 billion-and only a quarter of the country's hydropower resources have been developed. Developing these resources for domestic supply and as exportable commodities will require mobilizing domestic and foreign capital on a scale that matches desired growth rates. Vietnam's rich natural and human resources are an excellent economic foundation on which to build. But the same external pressures and internal inertia that are clouding growth prospects undermnine the energy sector. New challenges in the energy sector require difficult structural and institutional reforms. - 11 - To address these challenges and achieve the country's goals, this report develops a framework for an aggressive second wave of energy reforms. This framework will facilitate the energy policy dialogue between the World Bank, the international community, and government policymakers, line ministries, and state-owned energy enterprises. The economic, resource, and institutional factors influencing the energy sector guided the development of the report's comprehensive reform strategy. While this strategy takes a long-term view, many responses are required in the short term. The Energy Sector Faces Four Main Challenges Vietnam's energy sector faces four main challenges in making the transition to a modern, industrialized society. First, to meet economic growth targets, energy supplies will need to grow about 30 percent (and electricity, 70 percent) faster than GDP. To achieve that growth, the energy supply will have to be efficient-by 2010 cumulative savings of 2,788 megawatts, or half the current installed capacity, are possible through loss reduction and demand management programs. Energy will also have to be more equitably distributed-today the 80 percent of the population that is rural consumes just 14 percent of electricity supplies. Second, though Vietnam is rich in natural resources, its limited financial resources demand careful planning in the energy sector. Recent discoveries of offshore natural gas provide an opportunity to make economically and environmentally beneficial energy choices. This opportunity should not be ignored. Third, Vietnam will have to invest 5.3-5.5 percent of GDP-twice the level of its Southeast Asian neighbors-in essential energy infrastructure. Moreover, the level and structure of energy tariffs should be changed to ease short-term financing constraints and ensure long-term efficiency in investment and resource use decisions. Two-thirds of the required investmnent will have to be financed with official development assistance, export credits, and foreign direct investment. The rest will come from internally generated funds, public resources, and government guarantees for private investment. Energy investments must be chosen carefully because their scale will stretch Vietnam's external debt capacity. Fourth, attracting foreign investment will require creating an enabling business environment, including a supportive legal framework. The government must restructure and rationalize state energy enterprises, develop a regulatory system, and coordinate energy policies and investments. As things stand, communications between line ministries and enterprises are neither smooth nor timely, leading to expensive delays and potentially perverse economic outcomes. Responding to Growing Demand for Energy Between now and 2010 Vietnam's energy supplies will need to increase 30 percent (and electricity, 70 percent) faster than GDP. Energy needs will be driven by economic growth, industrialization, urbanization, and globalization of trade. These changes require better infrastructure for power, roads, and telecommunications. In addition, international competitiveness calls for higher-quality energy and better services. - iii - Though there have been major changes in recent years, Vietnam continues to have one of the lowest levels of energy use in Asia (table 1). In 1996 per capita modem energy consumption was 144 kilograms of oil equivalent and electricity consumption was about 161 kilowatt- hourslevels that, although extremely low, are consistent with the country's income level. Table 1. Per capita modern energy and electricity consumption in Asia and the United States, 1996 Modern energy (kilograms of oil Countby equivalent) Electricity (kilowatt-hours) Bangladesh 64 85 China 664 780 India 248 420 Indonesia 366 315 Korea, Rep. of 2,982 4,174 Malaysia 1,699 2,032 Nepal 28 44 Pakistan 254 418 Philippines 316 399 Sri Lanka 97 242 Thailand 769 1,294 Vietnam 144 161 United States 7,819 12,711 Source: UNDP, Human Development Report 1997; World Bank staff estimates. If annual GDP growth averages 6 percent through 2001 and 7.5 percent thereafter, consumption of modem energy should grow by an average of 9 percent a year. By 2010 total modem energy demand will be three times the level in 1997 (table 2). Electricity demand will more than quadruple. Demand for petroleum products will be two and half times higher. Demand for natural gas will be nearly 10 times higher. And domestic coal demand will nearly double. Table 2. Demand for modern energy in Vietnam, 1995-2010 Fuel 1995 2000 2005 2010 Electricity (gigawatt-hours) 14,636 25,706 44,491 77,406 Petroleum products (thousands of barrels) 38,144 53,994 79,431 117,841 Natural gas (billions of cubic meters) 0.199 2.111 4.663 7.717 Coal (thousands of tons) 5,069 7,166 9,142 11,115 Total (thousands of tons of oil equivalent) 10,663 16,975 24,267 36,973 Source: World Bank staff estimates. Developing the energy sector will both support and stimulate economic growth-because energy exports are a significant component of total exports and because the provision of energy is vital for the development of industry and commerce. In 1995 crude oil production and exports were valued at more than $1 billion. Coal exports have increased significantly and now provide about $100 million in annual revenues. Domestically, the provision of electricity is crucial to powering high economic growth, alleviating poverty (especially in periurban and rural areas), and easing environmental problems from overcutting of fuelwood. - iv - Increasing efficiency in fuelproduction and consumption Given limited financial resources, Vietnam's energy strategy must be guided by efficient energy production, supply, and use. Electricity efficiency has two components: supply-side efficiency and demand-side (or end-user) efficiency. Supply-side efficiency is especially important. Electricity consumption in Vietnam almost tripled over the past 10 years, but system losses now average 20 percent. This implies that one-fifth of the electricity produced is being wasted or at least is not being paid for. By 2010 about 16,400 gigawatt-hours--more than the total production of the power sector in 1995-will be squandered if loss rates do not change. Inefficiencies in distribution include low system power factors, transformer inefficiencies, and poor-quality cables, particularly in rural areas. The government has developed a plan to cut these losses-targets for 2010 assume losses of 12 percent-but achieving this goal will require adequate investment in transmission and distribution systems, where most losses occur. There is also potential for encouraging more efficient consumption of electricity through demand-side management. A wide-ranging demand management program could reduce demand by about 700 megawatts and save $420 million in investment by 2010. The biggest contributors to end-use inefficiencies are domestically manufactured electric motors and irrigation and drainage pumps. An effective demand management program would improve load management for large energy users, introduce equipment and building standards, undertake industrial audits to improve lighting and motors, and design more efficient public lighting. These measures would cost about $80 million, but they would be ineffective in the absence of appropriate pricing policies. For both supply and demand, prices will have the greatest impact on the efficiency of electricity use (figure 1). Figure 1 Electricity Demand, MW, Case B and Variations 16,000 1997 to 2010 14,000 - X 12,000 10,000 S,000 6,000 4,000______________________________________ ---00 §_ + Case B, prices remain at present levels -_n-- Case B, prices phased up to LRMC 2,000 | Case B, no Loss Reduction * - Case B with non-price DSM Case B with LRMC prices and DSM O 1997 199S 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Years v - Extending access to the poor In expanding energy supplies, it also needs to be noted that in 1997 about 30 million Vietnamese had no access to electricity. Rural consumers use one-fifth as much electricity as urban consumers and pay almost twice as much per unit. In 1996 Electricity of Vietnam had total sales of 13,152 billion kilowatt-hours, but only 14 percent went to rural areas. Thus 20 percent of the country's population consumed 86 percent of its electricity. Without an aggressive expansion in rural electrification, these rural - urban disparities are likely to increase social tensions and drag down economic growth. An ambitious rural electrification program has been drawn up that envisages providing electricity to 80 percent of communes by 2000 and connecting all communes in the plains and reaching 60 percent of rural households by 2010. But such investments will cost about $3 billion. And several issues must be resolved before this program can be successfully implemented. Here other countries offer valuable lessons. An effective implementing agency is essential. Tariffs should recover costs. Areas should be chosen using open and objective criteria, with a focus on high-impact areas. Low barriers to obtaining service boost demand. And community involvement can foster grid expansion. Exploiting Extensive Energy Resources Energy supplies can be expanded in an economic manner because, relative to many developing countries, Vietnam is rich in primary energy resources: o Natural gas. Vietnam has potential nonassociated gas reserves of more than 360 billion cubic meters. Proven associated gas reserves are on the order of 57 billion cubic meters. Though undeveloped, this resource has the potential to be the main fuel for Vietnam's power sector- avoiding excessive reliance on more polluting fossil fuels. * Coal. Vietnam's primary coal resource, anthracite, is concentrated in Quang Ninh Province, which has potential recoverable reserves of 7-8 billion tons-of which 600 million tons are shallow (within a depth of 100 meters). Anthracite coal is in demand by the metallurgical industry, and exports have reached 3.6 million tons a year, from 0.6 million tons in 1990. Vietnam now accounts for 40 percent of global exports of anthracite coal. * Petroleum. Potential crude oil reserves in the southern offshore area stand at about 270 million tons and are likely to increase substantially with continued exploration. Production is about 9 million tons. * Hydropower. Vietnam's hydropower potential is estimated at 10,000 megawatts, with 7,000 megawatts in the north. With adequate environmental and social safeguards, hydropower will provide a valuable long-term renewable energy resource. - vi - With these options, Vietnam can both meet domestic demand and generate an exportable surplus. These resources should be harnessed with environmental sensitivity (box 2). Transforming traditionalfuel use Vietnam remains an essentially rural society. Though the share of traditional energy- mostly wood and other biomass fuels-in total energy consumption dropped to 66 percent in 1996, it continued to be more than three times modem energy consumption. While this report does not examine the traditional energy sector in detail, two points deserve mention. First, attention must be paid to expanding multipurpose tree plantations in the low-lying areas near heavy population concentrations in the North Midlands, Red River Delta, and Hoa Binh Province. These plantations can prevent woodfuel shortages, degradation of highland areas, and shortened life of the Hoa Binh hydropower plant. Properly managed, woodfuel production and distribution can be profitable and environrentally sustainable. Second, the government must continue to encourage households to switch to affordable, higher-grade fuel substitutes, including kerosene, liquefied petroleum gas, and coal briquettes. To alleviate the adverse environmental effects of coal use, the coal briquette industry should be modernized and made more efficient. 4eP Eo T E | E n ., E ; _, ,ts.p,om e 06n '~~~~~~~~~~~~~~o .nersy s_X~ vas~~in tbr, ,~~~~4 -:' 'v' ' ' ' - '' ""'''m""'' '~ ' aI'a -df.ctS riisX|+ X Ze ;eW ff C'nUs - vii - Planning the power system Power system planning is strongly influenced by Vietnam's long, narrow shape, the distribution of resources, and the concentration of population centers in the north and south. Hydropower resources are distributed all over the country but are especially prominent in the north. The north also has significant reserves of coal, the country's second most important power generation resource. Natural gas generation is expected to play a dominant role in the south. A high-voltage transmission line from north to south has a peak capacity of about 550 megawatts- about 15 percent of peak demand. Two tradeoffs should guide plans to expand power. First is the tradeoff between expanding natural gas or coal for power generation. Gas-based expansion would require a sizable upfront investment in production and transportation infrastructure-investment that can only be financed if a minimum throughput of gas is contracted. Expanding gas-based generation to meet these throughput requirements would require delaying investments in coal. But this delay would have only a short-term impact on the coal industry, while postponing gas investments would not only undermine the development of gas infrastructure (box 3), it would also slow hydrocarbon exploration efforts by international oil companies. Moreover, gas-fired combined cycle gas turbine plants are the least-cost investment (assuming take-or-pay contracts are used), though some coal plants will still be needed in the north. Once built, however, coal plants have lower operating costs. A second tradeoff involves striking a supply and demand balance between the north and south, or relying on the north-south transmission line to transfer bulk power. Large amounts of power could be transferred from the south to the north if the gas-based power supply exceeds demand, and from the north to the south if coal-based development takes off. But though the transmission line provides system stability, its capacity is small relative to the futurze of the system. Moreover, it is unlikely to be economic to substantially increase the connector's capacity solely to transport bulk power. Thus generation capacity in both the north and the south should be developed to balance expected demand. The north-south transmission line could serve as a backup for both systems, but in the short and medium term system expansion should be based on - viii - natural gas-an inexpensive fuel that is also environmentally beneficial. In addition, Vietnam should consider increasing its energy trade with its neighbors in the greater Mekong subregion. 35 -4- Hydm Generation Shares, Base Case 30 a Oild 25 -.^ Coal o 20 10 -x 515 10 5. 1999 1099 1997 1090& 1009 2000 2001 2002 2003 2004 2000 2006 2007 2009 2009 2010 Source: Mission estimates Expanding oil and gas supplies Recently discovered nonassociated gas reserves are conservatively valued at about a quarter of 1997 GDP, or six to eight times annual disbursements of official development assistance. Oil and gas production shows rich potential. Nine onshore and offshore basins have been identified, and significant oil and gas discoveries have been made in five. Recent gas discoveries have revived the interest of international oil companies, but the pace of exploration has dropped sharply in the absence of an adequate fiscal and regulatory framework. Vietnam urgently needs to boost hydrocarbon resource development, for two reasons. First, oil exports earn significant foreign exchange. Second, gas will be an environmentally and economically important source of energy. To ensure continued and balanced development of the hydrocarbon sector, the government should quicken the pace of exploration and develop pipelines, platforms, and other infrastructure. Exploration drilling has been limited, and most discoveries have not been fully appraised. Given the well-documented relationship between the number of exploration wells drilled and the accretion of hydrocarbon reserves, the government should promote exploration drilling and develop a strategy to appraise finds. Over the next six or seven years 80-100 wildcat wells should be drilled; this would cost about $950 million. An additional $7,850 million would be needed to develop fields and infrastructure. Top priority should be given to developing the Lan Tay and Lan Do fields-both of which are in the Nam Con Son basin-because these supplies are needed to meet the demand for gas in the power sector. - ix- To fulfill the promise of its oil and gas resources, Vietram must provide the right framework for private sector development. Fiscal incentives-such as acceptable fiscal terns in production shanng contracts-are needed to encourage international investment in exploration and production. An efficient, transparent system is needed to oversee contracts and award acreage for exploration. And gas pricing policy must be made clear and consistent, and include special provision for marginal fields. Financing Energy Investments Financing the production and distribution infrastructure needed to meet the growth in energy demand will be difficult but not impossible. Because the sector remains relatively backward, Vietnam will have to invest 5.3-5.5 percent of GDP in energy infrastructure-more than twice what its East Asian neighbors spend. Investment in power infrastructure alone will account for 4.9- 5.0 percent of GDP. These needs will place pressure on other capital expenditures. Thus financing strategies will have to mobilize a range of domestic and external resources. Getting prices right Energy pricing will be key to mobilizing domestic finances and ensuring the sustainable development of the sector. Getting electricity prices right is especially urgent given the financing required to expand the system. Retail tariffs should be raised to the estimated long-run marginal cost of supply-that is, from 4.5 cents per kilowatt-hour to about 8.0 cents-and provide at least 30 percent equity funding for future investments (table 3). Industrial tariffs should include capacity and time-of-day charges. Residential tariff steps should be changed, shrinking the lower steps and raising tariffs in the upper steps. And tariffs for bulk electricity should be rationalized, to encourage efficiency within distribution companies. Phasing these changes over four years would lower demand by 1,750 megawatts and reduce power investment requirements by some $1.8 billion by 2010. Prices for natural gas should be negotiated but tied to the price of fuel oil, possibly with an indexed ceiling and floor. These prices should strike a balance between supply costs and market value, between benefits to the private sector and government, and between the interests of upstream and downstream government agencies. Although using gas to produce fertilizer is considered a less than optimal use, if the government wants to cross-subsidize fertilizer production it should set the price of gas at least as high as the estimated social supply cost (that is, supply costs without taxes and royalties). x - Table 3. Recommendations for energy prices Sector Recommendation Retail electricity Average retail tariffs should be raised to the estimated long-run marginal cost of 8.0 cents per kilowatt-hour, and to a level that provides for at least 30 percent equity funding of needed investments. To achieve these levels, the govemment should consider changing residential tariff steps and increasing tariffs in the upper steps. The industry tariff should be revised to include capacity charges. Bulk electricity Bulk tariffs should be rationalized, to encourage efficiency in distribution companies. Natural gas Natural gas prices should be based on a negotiated initial price and indexed to the price of fuel oil, possibly with an indexed ceiling and floor. The price level must balance supply costs and market value, benefits to private and public market participants, interests of upstream and downstream govemment agencies, and short-term and long-term interests of Vietnam and the private sector. Using gas to produce fertilizer is considered a less than optimal use of gas, but if the government wants to cross-subsidize fertilizer production the gas price should be set at least as high as the estimated social supply cost of gas (that is, supply costs without taxes and royalties). Gas transmission A two-part tariff should be negotiated that reflects fixed and variable costs (capacity and commodity charges) and provides for a reasonable return on pipeline investment. The tariff should include incentives for increasing throughput volumes, with benefits being shared between shippers and pipeline owners. New shippers should be given fair access to the pipeline. Petroleum products Taxes on diesel and kerosene should be raised to levels closer to taxes on gasoline. Prices should be freed and competition should be opened, subject to a survey of existing and potential competition, and when retail prices are raised to levels similar to those in neighboring countries. Coal Export netback values should be used to determine coal prices for Electricity of Vietnam. Tariffs for gas transmission should also be negotiated, and should reflect both fixed and variable costs and provide for a reasonable rate of return on pipeline investment. Incentives should be provided to increase throughput, with the benefits from increased volume shared by shippers and the pipeline. New shippers should be given fair access to the pipeline. For petroleum products, taxes on diesel and kerosene should be raised to levels similar to those on gasoline. Once retail prices have been raised to levels comparable to those in neighboring countries, all prices should be freed and competition opened, subject to a survey of existing and potential competition in markets. For coal, export netback values should be used to determine prices to Electricity of Vietnam. - xi - Identifying financing needs About $6.9 billion is required for crucial infrastructure-crucial because of the extremely high economic cost of forgoing these investments. Essential investments include $3.8 billion for power generation, $2.0 billion for the transmission network, and $0.9 billion for the gas sector. An indicative financing scenario, based on investment needs, potential sources of capital, and committed funding, is shown in table 4. With limited domestic resources, Vietnam has no choice but to incur external liabilities to meet most of these financing requirements. Such borrowing must be prudent. Vietnam has a sizable external debt burden, and careful debt management is essential to macroeconomic stability. The government will incur direct and contingent obligations even when private debt and equity finance is obtained. This is because the government will need to guarantee the credit risk of state energy corporations for export credits and commercial bank loans, as well as the performance risk and credit risk of Electricity of Vietnam as power purchaser, Petrovietnam as fuel supplier, and PVGC as fuel purchaser when foreign-financed projects are undertaken on a project finance basis. In addition, the government will have to ensure that foreign exchange is available to convert revenues denominated in domestic currency. - xii - Table 4. Energy financing requirements, 1998-2002 (millions of U.S. dollars) Financing sources Cash disbursements Finance Financing required Public Export credits Private Sector/project Size period through 2002 sector and ODA investment 1998 1999 2000 2001 2002 Gas Nam Con Son field development 3 BCM/yr. 1998-2002 375 375 25 180 140 30 Offshore gas pipeline 400 km 1998-2000 490 490 270 150 70 Subtotal gas 865 0 0 865 Power Yaly hydropower 720 MW 1994-2000 220 220 120 80 20 Ham Thuan Da Mi 472MW 1996-2002 332 82 250 90 108 84 50 Song Hinh 70 MW 1995-2000 84 84 50 26 8 Dai Ninh 1997-2003 416 200 216 7 19 40 200 150 Sezan, Plei Krong, Dong Nai, Son La Misc. 2000-Ox 678 378 300 200 200 278 Hydro plants 1,730 964 766 0 BaRiaCCGT 156Mw 100 100 27 21 52 Phu-My 1-1 CCGT 213 MW 1998-99 140 40 100 40 90 10 Ba Ria Diesel 120 MW 1999-2000 70 70 70 Phu-My 2-2 Gas Turbine 288 MW 1999-2000 120 120 40 80 Phu-My 1-2,1-3 CCGT 426 MW 1999-2001 280 S0 200 100 140 40 PhaLai2Thermal(2x300) 600MW 1999-2001 600 600 70 150 210 170 Phu-My2-1 ConverttoCC 144MW 2000-01 94 94 10 40 44 Phu-My 2-2 Convert to CC 144 MW 2000-01 94 94 10 40 44 Phu-My 3 New 600 MW 2000-02 400 400 50 200 150 Quang Ninh Thermal 300 MW 2000-03 200 200 50 150 Thermal plants 2,098 214 1,100 684 Transmission and distribution, north 1998-2002 450 225 225 90 90 90 90 90 Transmission and distribution, south 1998-2002 500 250 250 100 100 100 100 100 Transmission and distribution, central 1998-2002 350 175 175 70 70 70 70 70 Rural electrification 1998-2002 700 350 350 140 140 140 140 140 Transmission and distribution 2,000 1,000 1,000 0 Subtotalpower 5,828 2,178 2,866 684 804 1,124 1,374 1,398 1,128 Coal Upgrading coal transport facilities 1999-2001 70 35 35 20 30 20 Investing in open pit mines 1999-2002 140 70 70 30 50 30 30 Subtotal coal 210 105 105 50 80 50 30 Total energy investments 6,903 2,283 2,971 1,549 829 1,624 1,744 1,548 1,158 Source: Mission Estimates Developing a financing strategy A hospitable business environment is essential for continued investor interest in the energy sector-and, more important, for lowering the costs and perceived risks of investing in Vietnam. Projects should be competitively bid, and investors should be treated fairly and transparently. Attractive bids have already been received for the Phu My 2.2 power project, and a number of international oil companies are interested or engaged in exploring and producing oil and gas. - xlii - Long-term energy financing requires creditworthy corporations. State-owned corporations should adopt internationally accepted accounting standards so that lenders and investors can assess risks. Financial restructuring may be required for some corporate entities. In addition, these entities need to provide adequate equity financing of future investrnents in order to secure large amounts of reasonably priced debt. Equity self-financing should be at least 30 percent, although higher levels would reduce the credit risk for investors and lenders and so lower financing costs. Energy corporations require wider access to equity sources, however, and should consider both domestic and foreign portfolio investment. Pilot equitization or privatization of urban distribution franchises, gas trading entities, and other suitable ventures should be considered. The energy sector provides a useful base for developing domestic capital markets. State energy corporations could start to issue domestic bonds, which may initially have short maturities. This move would establish domestic borrowing benchmarks and develop instruments to attract domestic savings. Finally, the government can access nonconcessional official development assistance for energy projects, to supplement the limited amounts of concessional assistance (such as IDA credits). Multilateral guarantees and direct loans can be used once Vietnam graduates to IBRD borrowing status. Reforming Institutions and Corporate Governance The main state-owned energy enterprises-Electricity of Vietnam, Petrovietnam, Vinacoal, and Petrolimex-employ more than 200,000 people and have a combined annual turnover of more than $2.5 billion. This major resource must be managed effectively. These corporations have been slow to adjust to an increasingly market-oriented environment. Reforms have given them a more commercial focus, but old-style controls remain in place. Four main areas require institutional reform (box 4). Strengthening corporate governance In 1995 state energy entities were made into state corporations, bringing them under the purview of the State Enterprise Law. This move was expected to facilitate the separation of ownership and management by assigning ownership responsibilities to a management board that resembles an independent board of directors. - xiv - But this corporate govemance structure has failed to minimize interference from supervising ministries. Government policy oversight has not been separated from commercial management because there is no clear definition of state management functions, no unambiguous assignment of functions, and no clarity on procedures. Clear operating relationships have not developed because ownership and other functions are diffused among government agencies and ministries. The new State Asset Management Department is just beginning its task, and its criteria for assessing state operations remain overly focused on physical growth targets. Effective corporate governance of state energy enterprises requires the government to distinguish and separate its roles as owner, operator, and economic regulator. Responsibilities and associated administrative procedures should be carefully defined and assigned to specific agencies. In addition, energy enterprises should be subjected to explicit financial and performance obligations. Improving market structure State energy enterprises are structured as large, integrated monopolies. Economies of scale and scope emerge from this organization, but so do inefficiencies. Integrated organizations lack competitive pressures from new entrants and entail large administrative structures. More competitive market structures are needed. In the gas sector, the gas trading company (PVGC) within Petrovietnam should stop being the sole gas trader and take on more of a market-making role. While markets are being created, PVGC could retain exclusive rights to purchase and sell gas to all consumers. As markets develop, it should retain only an option for sales to 70 percent of large consumers, giving other suppliers direct access to at least 30 percent of the market. This move would encourage continued investment in exploration and promote upstream and downstream development. With growth and maturity, the transition to a more competitive gas market would be easy and logical. In the power sector, Electricity of Vietnam should create independent distribution companies and initiate bulk power sales on a transparent, full-cost basis. This transition should be completed by the end of 2000 to facilitate the equitization of profitable distribution franchises. Given the increased entry of independent power producers in the generation of thermal and possibly hydropower, these changes would make distribution more efficient and help secure private capital, freeing public resources for rural electrification investments. Developing effective regulation Functionally and institutionally separate economic regulation is required to make an orderly transition to a market-oriented energy sector. Efficient economic regulation gives enterprise managers sufficient autonomy to run financially viable enterprises while protecting the interests of consumers. A number of energy regulations require revision. - xv - A new electricity law and supporting regulations are being developed. It is hoped that this law will create a separate regulatory body to regulate bulk and retail power tariffs based on market principles, and ensure that performance standards are achieved. The law should also allow the licensing of separate generation, transmission, bulk supply, and distribution functions to facilitate transparent cost separation and entry of new participants, particularly in generation and distribution. Finally, the law should provide an economic basis for expanding the power grid to rural areas and delineate the responsibilities of agencies involved in rural electrification. Although legislation and regulations have been drafted for upstream hydrocarbon activities, and some implementing decrees issued, many institutional mechanisms have yet to be created. Policy matters, rights management, and technical regulation should be separate from commercial petroleum operations. An upstream agency for rights management and technical regulation should be created to interact with international oil companies, particularly during contract bidding and negotiations. This agency should be a separate legal entity, independent of Petrovietnam, and should report directly to the Ministry of Planning and Investment or the Office of Government. There is no legal basis for regulation of downstream hydrocarbon activities. Thus one should be established that is compatible with the regulation proposed for the electricity sector. Downstream regulatory tasks include approving tariffs for pipeline use, preventing anticompetitive behavior, implementing technical standards for pipelines, and other tasks that are different from upstream regulation. Regulation of transmission pipelines and gas processing and distribution operations should be carried out by agency separate from the upstream regulatory agency. Combining regulation of downstream hydrocarbon and electricity activities has benefits and drawbacks. On balance, however, there appear to be advantages for Vietnam in combining regulation of these activities in one body, since they have more in common than upstream and downstream hydrocarbon regulation. Integration is also advisable because large volumes of gas are expected to be purchased for power generation. Streamlining policymaking and policy coordination Under current policies state companies develop five-year plans that are incorporated in the five-year plan produced by the Ministry of Planning and Investment, which is then subject to Office of Government approval. Thus the government is guiding development through project approvals and project funding. As the market economy develops, emphasis will need to shift from direct government control toward indirect, policy-based control. Energy policy for the medium and long term should go beyond specific projects, setting policy directions for each part of the energy sector. The govenmment should create a permanent energy policy committee, chaired by the prime minister and supported by an energy policy office. The committee should include the ministers of planning and investment, industry, finance, and trade, the heads of Petrovietnam, Electricity of Vietnam, and Vinacoal, and commissioners from the State Pricing Committee. Once they are established, regulatory authorities should also be represented at committee meetings. The committee would oversee efforts to build institutional capacity for the energy - xvi - sector, developing laws and regulations, crafting export and import strategies, and advising on energy pricing. The energy policy office would consolidate activities now spread over a number of agencies, providing the committee with the analysis required for policymaking. An Agenda for Action The costs of inaction on energy are simply too high. Thus a wide range of reforms are needed if Vietnam is to increase energy supplies to meet growth targets, develop energy resources along an environmentally sustainable and socially equitable path, ease financial constraints in the sector, and promote sustainability and efficiency. The agenda for action in the short and medium term should include several essential steps. Creating an economic and efficient modern energy delivery system to meet growing demand by: * Increasing the efficiency of energy use and controlling electricity growth through demand- side management. * Removing transmission and distribution bottlenecks as new generation capacity-both public and private-is added and system losses are reduced. * Completing competitively bid projects like Phu My 2.2 to provide a framework for other energy infrastructure projects in power, coal, and gas. * Developing-on time-gas supply infrastructure from the Nam Con Son basin. Delays could cause $140-200 million a year in direct financial costs and much larger economic losses. * Promoting exploration in Vietnam's hydrocarbon basins through appropriate fiscal incentives and systems. * Opening up the distribution of downstream petroleum products in markets that are large and diverse enough to support several competitive suppliers. * Making the coal industry more efficient to meet expected domestic demand and maintain exports. * Extending modem energy use in rural areas by implementing a financially and institutionally sustainable program for rural electrification and developing a program to provide electricity in remote areas. Ensuring that energy expansion is environmentally sustainable by: * Emphasizing the development of gas and hydro for power generation, to contain air pollution. * Strengthening pollution monitoring systems. * Increasing environmental awareness. * Revising inappropriate environmental standards. * Phasing out lead in gasoline. Developing a financing strategy for energy that includes: Mobilizing domestic financial resources through early action on tariffs for electricity, coal and petroleum prices. - xvii - * Raising electricity tariffs closer to their long-run marginal cost in the shortest possible period so that power companies can meet financial performance benchmarks. . Coordinating an external borrowing strategy for energy and prudently incurring external contingent liabilities for private investment. * Deferring direct public investment or government support for private investment in economically marginal projects-such as fertilizer production and petroleum refining. Improving corporate governance and creating creditworthy institutions by: * Redefining the government's role as owner. If state energy corporations are to become commercially viable operations, the government will have to use financial performance benchmarks in place of administrative project approvals, public budgets, and directed credit. * Implementing arm's-length regulation to facilitate fair and transparent oversight of energy investmnent and pricing, insulating energy corporations from arbitrary government demands, and attracting private investment on reasonable terms. Achieving these goals will require promulgating an electricity law and regulations and gas regulations, and bolstering the State Petroleum Management Authority. . Embarking on pilot equitization programs, perhaps starting with high-density urban electricity distribution franchises. This effort could then expand to private equity involvement in gas distribution. Rationalizing sector governance by: * Enunciating government intentions through specific energy policies. The government has already issued a policy paper for the power sector that includes a detailed reform action plan. A natural gas policy statement identifying the intended market structure would provide a framework for increased gas exploration and development. * Forming a national energy policy committee-supported by a national energy policy office- to coordinate activities in oil, gas, coal, and power. * Carefully defining the govermnent's continuing-and crucial-role in the energy sector. I I 1. FORECASTING ECONOMIC GROWTH AND ENERGY DEMAND 1.1 Vietnam has made remarkable economic progress in recent years. Macroeconomic and structural reforms introduced in the late 1980s stabilized the economy and yielded unprecedented income growth and poverty reduction. During 1992-97 annual GDP growth averaged 8.2 percent and the real exchange rate devaluation was less than 15 percent. This impressive performance led many observers to believe that Vietnam was a nascent East Asian tiger. But Vietnam's growth is now slowing because of the financial crisis in East Asia and because of its own inertia in implementing structural and policy reforms. Together these forces have reduced foreign direct investment, as some investors have less to invest and others are discouraged by Vietnam's policies. 1.2 Vietnam cannot afford this slowdown. It remains one of the world's poorest countries-GNP per capita is about $300. The economy is largely agricultural, with about four- fifths of the country's 76 million people living in rural areas and two-thirds dependent on agriculture. Income disparities are growing between rural and urban areas and within rural areas because the benefits of growth have been unevenly shared. At 144 kilograms of oil equivalent per capita, modem energy consumption is one-seventh the level of neighboring Thailand and among the lowest in the developing world. More than 65 percent of energy comes from traditional sources such as wood, charcoal, and straw. More than half the population has no access to electricity, and Vietnam consumes less electricity in a year than industrial countries consume in a week. 1.3 Modem energy can, however, provide a foundation for future economic growth. Oil and coal exports account for more than a quarter of foreign exchange earnings, contributing $200 rmillion in the first four months of 1998. During 1993-98 energy demand grew 30 percent faster than GDP, and continued expansion of energy supply and delivery will enable rapid growth in agriculture and industry. Developing energy infrastructure can alleviate poverty by providing access to the poor, and it can mitigate environmental degradation by encouraging a shift from traditional to commercial energy sources and by increasing the supply of cleaner fuels. 1.4 Vietnam has yet to use its extensive primary energy resources for the benefit of all its citizens. Recently discovered nonassociated natural gas reserves are conservatively valued at about a quarter of 1997 GDP-or $7-8 billion-and only a quarter of the country's hydropower resources have been developed. Developing these resources for domestic energy supply and as exportable commodities will require mobilizing domestic and foreign capital on a scale that matches desired growth rates. Vietnam's rich natural and human resources are an excellent economic foundation on which to build. But the same external pressures and internal inertia that are clouding growth prospects undermine the energy sector. New challenges in the energy sector require difficult structural and institutional reforms. 1.5 Recent years have seen several developments that will have a major impact on the future of the energy sector-and, consequently, on the future of the economy: - 2 - * The demand for electricity has been growing much faster than previously forecast-by 15-20 percent a year since 1994. By 2010 electricity demand will likely reach 77,400 gigawatt- hours, about five times the level in 1995. Growing demand for electricity, particularly in Hanoi and Ho Chi Minh City, will place severe pressure on technical and managerial systems. And if demand is not met, it could jeopardize industrial growth. * Although the first major offshore gas discovery was made in 1994, a number of issues in the production sharing contract must be resolved before the gas can be delivered to onshore power and fertilizer plants. How these issues are resolved will likely set the stage for future gas discoveries and the development of the gas industry. * More than 32 production sharing contracts have been signed for oil and gas exploration, and in recent years the private sector has been invited to invest in gas pipelines. Moreover, downstream terminal and gas processing projects and build-operate-transfer (BOT) power projects are being discussed. Yet not a single contract has been finalized or financed. The emerging mix of public and private operators and owners is creating new issues that must be resolved to sustain and enhance private participation in the energy sector. - Major policy changes have been instituted, including the passage of a new petroleum law and a BOT law and work on drafting a new electricity law. Entirely new institutions have been created in electricity (Electricity of Vietnam) and coal (Vinacoal), and the role of Petrovietnam in the oil sector has been greatly enhanced with the discovery of gas. But the transition to a market-oriented operating culture is proving difficult, requiring a major effort in organizational design and training. In addition, the absence of coordinating mechanisms between subsectors is creating implementation problems because investments are large and lumpy. * Preliminary estimates indicate that required investments in energy infrastructure will total $6.9 billion during 1998-2002, with about $1.5 billion coming from private sources. Financing of essential infrastructure will be a major challenge for both the energy sector and the entire economy. 1.6 To address these challenges and achieve the country's goals, this report develops a framework for an aggressive second wave of energy reforms. This framework will facilitate the energy policy dialogue between the World Bank, the international community, and government policymakers, line ministries, and state-owned energy enterprises. The economic, resource, and institutional factors influencing the energy sector guided the development of the report's comprehensive reform strategy. 1.7 The report covers a number of major energy challenges: establishing a sustainable industry structure, identifying options for state enterprises under the new structure, assessing the different-and often conflicting-roles of state energy companies, adapting the legal and regulatory framework, analyzing financing options for needed investments (including a proposed financing strategy), and reviewing policies to achieve short- and medium-term government objectives. While this strategy takes a long-term view, many responses are required in the short term. - 3 - Impressive economic progress-and future prospects 1.8 Vietnam's GDP is small by international standards-about $24 billion in 1996. In 1995 agriculture, including fisheries and forestry, accounted for 31 percent of the economy. Industry, including construction, accounted for 34 percent. The remainder, including trade and services, made up 35 percent. 1.9 Economic growth has been high in recent years, averaging 9.2 percent a year during 1995-97 (figure 1.1). Inflation has been low, averaging 8.7 percent over the same period. Investment averaged an impressive 28 percent of GDP, and savings was 18 percent. The resulting current account deficit, while large, was financed primarily by foreign direct investrnent, which averaged 10 percent of GDP during 1995-97. And the fiscal deficit remained low, averaging less than 0.5 percent of GDP, with revenues and expenditures averaging about 24 percent of GDP. - 4 - Figure 1.1 Major economic indicators have been strong in recent years GDP Growth Rate and Inflation Current Account Deficit and FDI Flows (Annual Average, %/6) (US$ bil.) I16.0% 3 14.0% 4.0% iE . 205 20.0% 4.0% 0 1994 1995 1996 1997 1998 Est. 1994 1995 1996 1997 Pre]. 1998 Est. GDP Growth Rate (%/) +. Inflation (annual avg) (%) FDI fowAs (US$ Billion) F l -- Current account deficit (US Bil) 3 Investment and Savings (% of GDP) Fiscal Deficit (% of GDP) 30.0% 25.0% 20. O/q% 15.0/01 0.6% 5.0% 0.2% 00/ 0, ov 1994 1995 1996 1997 Pre1. 1998 Est. 1994 1995 1996 1997 Pre]. 1998 Est. l Investent/GDP a Savings/GDP l a Fiscal deficit (inc. grantsyGDP (%/6) l~ l | Fiscal deficit (inc. grantsyGDP (%/.) 1.10 These achievements were the payoffs to major reforms launched in the 1980s. These reforms promoted market principles while maintaining a central role for state enterprises. Stabilization efforts stressed fiscal and monetary controls, tax and spending reforms, and interest rate liberalization. But in recent years the benefits of the first phase of reforms have waned, and the second phase has yet to be pursued. In addition, Vietnam has been hurt by the East Asian crisis. The slowdown in reforms and the regional crisis have given rise to four troubling signs: * Macroeconomic stability is less secure. The pace of growth is slowing. The quality of growth may be deteriorating. The social and environmental sustainability of the growth path has been eroding. 1.11 The first half of 1998 was difficult. Export growth and foreign investment plummeted. The exchange rate became uncompetitive. Foreign exchange reserves reached precarious levels. Available investment resources, both public and private, dipped. And prolonged drought reduced agricultural growth. 1.12 The slowdown in export growth was due mainly to the collapse of regional markets, which absorb two-thirds of Vietnam's exports. In addition, large devaluations in Indonesia, the Republic of Korea, and Thailand made it difficult for Vietnam's price-sensitive nontraditional exports-garments, footwear, marine products-to compete in these and third-country markets. 1.13 Foreign investment in Vietnam dropped 40 percent in the first quarter of 1998, for several reasons. East Asian economies account for two-thirds of foreign direct investment, and their corporate sectors are strapped for cash. Nearly half of the undisbursed foreign investment is in tourism and real estate, both of which are experiencing a slowdown. And bold structural reforms in the crisis countries, when contrasted with the slower reforms in Vietnam, make Vietnam less attractive to foreign investors. 1.14 As a result GDP growth could fall sharply in 1998, to 4-5 percent. Macroeconomic stability is being threatened and inflationary pressures are building-in April 1998 annualized inflation was 6.7 percent, the highest in two years. An unwelcome development is the increased allocation of credit to state enterprises. In 1997 less than 40 percent of new credit went to state enterprises, but during the first quarter of 1998 this share increased to 60 percent. 1.15 The depth and duration of the East Asian crisis are difficult to predict. Still, the general view is that growth rates in the region's crisis countries will not recover to precrisis levels until at least 2001. Medium-term prospects for Vietnam are also highly uncertain, because its 'economy is closely linked with those of its neighbors. Hence the economic slowdown in the region will continue to undermine Vietnam's economic prospects by slowing export growth and lowering foreign investment. 1.16 Medium-term growth scenarios for Vietnam depend on the external environment and on government reforms (table 1.1). The base case scenario assumes that East Asia will continue to recover slowly over the next three years, that growth in Europe and the United States will remain robust, and that reforms in Vietnam will continue at the current pace. Under this scenario Vietnam's GDP will grow by 4-5 percent a year over the medium term. The high- growth scenario assumes that despite unfavorable external conditions, Vietnam's low level of economic development will enable it to achieve annual growth rates of 7-8 percent if the reform program is reinvigorated. Achieving high growth will require moving decisively and implementing reforms in areas such as the financial sector and state enterprises. 1.17 Over the longer term Vietnam has enormous potential, mainly because its per capita income is so far below those of its neighbors. Long-term economic growth of 7.5-8.0 percent should be achievable if reforms are continued and macroeconomic stability is maintained. Industry will remain the leading sector, with oil and gas and light manufacturing expected to shine. - 6 - Table 1.1 Alternative growth scenarios, 1999-2001 (annual average real GDP growth) External environment Current prospects Further deterioration Reform program Current pace kse ^ ' . nfi . Low growth 4-pe¢cen ~/-, ¢0-3 percent Accelerated pace High growth Moderate growth 7-8 percent 4-5 percent Sourse: Mission Estimates Tapping the potential of exports 1.18 Trade has been the engine of growth. Exports jumped from about just over $2 billion in 1991 to nearly $9 billion in 1997, led by significant increases in exports of crude oil, rice, and other agricultural products (table 1.2). Exports of textiles, garments, and footwear have also increased considerably, but their full potential has yet to be realized-and is required to sustain high export growth. Imports have grown even faster than exports, from just over $2 billion in 1991 to more than $10 billion in 1997. The discrepancy between export and import growth rates has created problems. Table 1.2 Exports and imports, 1997 Amount Amount (millions of Share (millions of US. Share Exports U.S. dollars) (percent) Imports dollars) (percent) Crude oil 1,419 15.8 Oil products 1,094 10.6 Coal 111 1.2 Fertilizer 425 4.1 Agricultural products 3,141 35.1 Capital goods 1,777 17.2 Marine products 781 8.7 Other (incl. consumer goods) 7,017 68.0 Textiles, garments, and footwear 2,314 25.8 Total 10,313 100.0 Other 1,190 13.3 Total 8,955 100.0 Source: Ministry of Trade and Customs; World Bank staff estimates. 1.19 The continued success of Vietnam's export-led growth strategy will depend on the economic efficiency of resources deployed to export activities. Based on experience elsewhere, private light manufacturing-in areas such as packaging agricultural products and manufacturing textiles, garments, and footwear-should lead the way. Controlling the trade deficit and increasing creditworthiness 1.20 The gap between export and import growth rates has widened the trade deficit (table 1.3). Such a deficit is to be expected given the high economic growth experienced in Vietnam, but the recent divergence in growth rates is unsustainable. In 1996 the current account deficit was more than 11 percent of GDP. Capital inflows of foreign direct investment-causing inflows of capital goods-have been both the main contributor to the trade deficit and the main means of financing it. Table 1.3 Balance of payments, 1990-96 (millions of U.S. dollars) Average annual growth, 1990-95 Indicator 1990 1995 1996 a (percent) Current account balance (excl. grants) -350 -2,020 -2,850 Exports 1,731 5,198 6,780 24.6 Imports 1,772 7,543 10,194 33.6 Trade balance -41 -2,346 -3,414 Other current account items -309 326 564 Capital account balance -142 -177 290 Short-term loans (net) 48 310 386 Foreign direct investment 120 1,781 2,300 Grants 88 150 144 Other (net, incl. official development assistance) -48 -398 310 Change in reserves, to balance Change in reserves -159 -449 -445 IMF (net) 92 175 Other (incl. Arrears and rescheduling) 301 534 -20 a. Estimated. The current account balance for 1996 is estimated at 11.9 percent of DGP. In 1996 gross foreign exchange reserves were equal to 2.3 months of imports. Source: Ministry of Trade and Customs; State Bank of Vietnam; World Bank and IMF staff estimates. 1.21 By mid-1996 most bilateral agreements for restructuring outstanding external debt (made under the aegis of the Paris Club) had been finalized. Agreements for $900 million in outstanding arrears (made under the London Club) were completed in 1998. Obligations to former Soviet countries, particularly Russia, are being negotiated. The resulting agreement with Russia, which deals with about 9.5 billion transferable rubles, will greatly improve Vietnam's creditworthiness. Bolstering savings and investment 1.22 The domestic savings rate, both government and private, has increased dramatically in recent years. By 1995 domestic savings had risen to about 17 percent of GDP (from 7 percent in 1992), and investment to about 27 percent (from 12 percent). Foreign savings filled the 10 percentage point gap. This rate of investment is comparable to those of East Asia's tigers before the crisis. - 8 - 1.23 While the improvement in domestic savings has been remarkable, a further increase will be required to sustain high growth. In 1995 government savings were about 5 percent of GDP and private savings were about 12 percent. Both rates could be increased, partly through actions in the energy sector. A reasonable target for domestic savings, consistent with stable but high economic growth, is 19 percent of GDP by 2000.1 Reaching this target will require a stable macroeconomy, positive real interest rates (from 5 to 15 percent a year, depending on terms and conditions), higher internal cash flows in state enterprises, and selected higher taxes. 1.24 It will also be necessary to boost investment. The government has aggressive investment plans, and a crucial challenge is identifying financing to implement these plans without destabilizing the economy. Vietnam's main foreign donors-including the World Bank, Asian Development Bank, and Japanese government-have provided official development assistance, but it does not begin to meet the country's requirements. Foreign direct investment has been the main source of foreign funds. But the lack of a developed civil law and fully operational legal and institutional arrangements inhibits equity investment by the private sector. This is particularly a problem where large-scale investments are required, as in the energy sector. External financing requirements will be about $4 billion a year through 2000, implying significant increases in net official development assistance and continued high foreign direct investment. Controlling inflation and maintaining a stable exchange rate 1.25 The government has done well in controlling inflation-in 1997 it stood at 3.2 percent. During 1995-98 the dong stayed in the range of 11,000-13,000 dong to the U.S. dollar. Major reforms have been introduced in domestic banks, though problems remain. The State Committee for Pricing, which in the past set all prices in the economy, now only sets the prices for electricity, petroleum products, coal sold to Electricity of Vietnam, internal air tariffs, and a few other commodities. All other prices are set by the market. 1.26 The daily floating exchange rate policy-which keeps the official exchange rate within a 10 percent band-has worked well. In early 1998 the exchange rate was about 13,000 dong to the dollar. The official foreign exchange market establishes the rate and helps allocate foreign exchange to enterprises that can buy it. The black market for foreign exchange is small. Making state enterprises more efficient 1.27 Efforts have been made to cut and eliminate subsidies to floundering public companies. Although about 5,000 state companies have been allowed to cease operations, the state still owns and controls all of the country's large corporations. The energy sector is controlled by four of the largest companies in Vietnam. Electricity of Vietnam dominates electricity, Petrovietnam dominates upstream oil and gas, Petrolimex dominates downstream oil I World Bank, 1997, "Vietnam: Deepening Reform for Growth," Report 1703 I-VN, Washington, D.C. - 9 - and gas, and Vinacoal dominates coal. By making effective investments, working with the private sector, and implementing better pricing and tax policies, these companies can significantly contribute to state revenues, and thus government savings. 1.28 Rapid economic growth and govemment efforts to rationalize the activities of state enterprises have not reduced the importance of these enterprises in the economy, however. Their share of production has increased, mainly as a result of joint ventures with foreign partners. The government's goal of creating a "socialist market economy" is being realized in the form of a mixed economy. 1.29 Some economists are concerned that this growth strategy will be inefficient and will underemphasize labor-intensive, export-oriented manufacturing-which elsewhere has been dominated by the private sector and has been the key to high growth. Labor-intensive light manufacturing can reduce unemployment and expand exports faster than other industrial sectors. Unemployment is a pressing concem because the labor force is growing rapidly and migration to urban centers has accelerated. In the energy sector this issue is most apparent in the coal- producing regions of northern Vietnam. Vinacoal is tending toward a regional conglomerate, promoting alternative light industry, to employ underemployed mine workers. Highlighting the role of energy resources in economic development 1.30 Unlike most developing countries, Vietnam is rich in primary energy resources. Coal deposits, mostly in the north, are of good (largely anthracite) quality, and production reached 9.3 million tons in 1996. Coal exports were 3.6 million tons that year. About 8.8 million tons of crude oil is produced each year, primarily from the Bach Ho field operated by Vietsovpetro. In 1994 a large nonassociated gas field was discovered at Lan Tay and Lan Do, with estimated reserves of nearly 70 billion cubic meters. Vietnam's hydropower potential is estimated at 10,000 megawatts-3,000 in the south and 7,000 in the north-and major new projects under consideration include Son La (2,400-3,600 megawatts) in the north and Dai Ninh (300 megawatts) in the south. In 1998 total installed power generating capacity was 4,890 megawatts (2,732 in the north, 1,873 in the south, and 285 in the center). Thermal stations remain an essential component of development plans because they are required to compensate for seasonal variations in hydropower output. 1.31 The energy sector can both support and stimulate economic growth-because energy exports are a significant component of total exports and because the provision of energy is vital for the development of industry and commerce. In 1995 crude oil production and exports were valued at more than $1 billion. Coal exports have increased significantly and now provide about $110 million in annual revenues. Domestically, the provision of electricity is crucial to powering high economic growth, alleviating poverty (especially in periurban and rural areas), and easing environmental problems from overcutting of fuelwood. 1.32 The most obvious way for the energy sector to stimulate the economy is through economically efficient development of oil fields and oil exports. The second way is by developing a natural gas industry, based first on the existing Nam Con Son discoveries. Finally, - 10- coal exports can make a sizable contribution. The economic importance of the energy sector is reflected in the size of the main companies within it: Petrovietnam, Electricity of Vietnam, Vinacoal, and Petrolimex are the four largest state companies. Thus sector reforms-in terms of institutional development, market structure and regulation, and policy implementation-can have benefits throughout the economy by way of demonstration and by increasing the operating efficiency of each energy company. For example, establishing these companies as internationally creditworthy corporations could help normalize Vietnam's credit status. Developments in the demand for energy 1.33 Vietnam has one of the lowest levels of modem energy consumption in the developing world: an estimated 144 kilograms of oil equivalent per capita in 1995. This level is consistent, however, with Vietnam's GDP per capita, estimated at $262 in 1995 (table 1.4). Table 1.4 Modern energy consumption, 1985-95 Indicator 1985 1990 1995 Petroleum products (thousands of barrels) 14,461 21,742 38,144 Natural gas (billions of cubic meters) 0 0.030 0.199 Coal (thousands of tons) 5,083 4,039 5,069 Electricity sales (gigawatt-hours) 3,860 6,185 11,198 Total primary energy (millions of tons of oil equivalent) 5.8 6.5 10.7 Population (millions) 59.9 66.6 73.9 Modem energy consumption per capita (kilograms of oil equivalent) 96 97 144 GDP per capita (1990 U.S. dollars) 182 200 262 Source: World Bank staff estimates. 1.34 Nearly 65 percent of final energy consumption consists of traditional energy, mostly in rural areas, mainly in the form of fuelwood. Wood and rice straw are used extensively for cooking. In the south charcoal is also used, and in the north coal briquettes are used (especially in the northeast in areas surrounding coal mines). Kerosene is used primarily for lighting in rural areas. Gasoline consumption is low but growing rapidly as more private motor vehicles are introduced. 1.35 Since 1980 there have been three phases in the development of Vietnam's energy sector. From 1980 to 1985 the economic system was centralized. Consumption of petroleum products was essentially constant and consumption of electricity grew by about 8 percent a year, although supplies of both were limited. From 1986 to 1990, after the start of economic reform, consumption of petroleum products and electricity began increasing. And from 1990 to 1995 all types of energy consumption increased rapidly. In recent years consumption of petroleum products and electricity has increased by about 13 percent a year, and domestic coal consumption has started to increase again after reaching a low in 1993. Offshore natural gas from the Bach Ho field was brought into production for power generation in 1994. Since 1990 modem energy consumption has grown by 9.3 percent a year. Although domestic energy consumption has - II - increased rapidly, Vietnam has become much more self-sufficient in terms of its energy supply- primarily because of the increased availability of crude oil and increased coal production. 1.36 Vietnam's energy needs are driven by projected economic growth rates, bottlenecks due to inadequate financing in the past, rapid urbanization (an additional 7-10 million people will live in cities by 2010), and globalization of trade (which requires adequate and efficient power, roads, and telecommunications infrastructure). In addition, there is demand for better-quality energy and service to increase international competitiveness. Three scenarios for economic and population growth 1.37 As noted, short-term economic growth (through 2000) will largely depend on Vietnam's response to the Asian financial crisis. In these difficult circumstances short-term growth of 6 percent a year is likely and is used in the base case forecast (table 1.5). But growth could be as low as 4 percent or as high as 7 percent, depending mainly on events outside Vietnam-notably the timing of recovery in Japan. Over the longer term, economic growth of 7.5 percent a year is considered probable and is used in the base case forecast. Long-term growth of less than 6 percent is unlikely, and growth could be as high as 9 percent-as in the past in the Republic of Korea-if all circumstances turn favorable. This range of forecasts facilitates the examination of different scenarios for energy demand, required investments, suitable policies, and needed reforms. Table 1.5 GDP growth under the low-growth, base case, and high-growth scenarios (percent) 1996-97 1998-2000 2001-10 Forecast average, Scenario and region (actual) (forecast) (forecast) 1998-2010 Low growth North 7.5 3.6 5.7 5.2 Center 6.3 3.9 5.7 5.3 South 10.9 4.3 6.2 5.7 Total 9.2 4.0 6.0 5.5 Base case North 7.5 5.4 7.2 6.7 Center 6.3 5.7 6.1 5.9 South 10.9 6.4 7.9 7.5 Total 9.2 6.0 7.5 7.1 High growth North 7.5 6.4 8.0 7.6 Center 6.3 6.2 7.4 7.0 South 10.9 7.5 9.8 9.1 Total 9.2 7.0 9.0 8.4 Source: World Bank staff estimates. - 12- 1.38 The economic growth forecast in the base case scenario, averaging 7.1 percent a year to 2010, is driven by high export growth (especially for crude oil) and high and sustained investment (financed from official sources and the private sector, with an even split between domestic and foreign sources). A critical constraint on growth is the availability of financial capital to support investment of 20-25 percent of GDP. As noted, the domestic savings rate will have to increase from 17 percent now to about 19 percent by 2000. In addition, agriculture must grow by 3.3 percent a year, though by 2010 it will account for just 17 percent of the economy (from 31 percent in 1995). Industry will increase to 44 percent (from 34 percent) and services to 39 percent (from 35 percent). 1.39 Population growth is forecast to decline from the current 2.03 percent a year to 1.80 percent by 2005, and 1.56 percent by 2010. As a result the total population is projected to be 97 million by 2010. Populations in Ho Chi Minh City and Hanoi will grow by 4.75-5.0 percent a year, and by 2010 the cities will contain 10 million and 5 million people. The total urban population will reach 34 million by 2010. Mainly because of emigration to urban centers, growth in the rural population is expected to slow, leveling off at about 63 million. Though the pattern of development is urban and industrial, it would be a mistake to understate the importance of rural and agricultural activities. Even by 2010, about two-thirds of Vietnam's people will reside in rural areas. 1.40 To assess economic growth rates, the base case forecast can be compared with growth rates for Korea, Malaysia, the Philippines, and Thailand for 1965-91 (table 1.6). Only Korea had a growth rate above 9 percent. In Thailand growth averaged between 7 and 8 percent a year. The long-term forecast for Vietnam, reflecting increasing industrialization and urbanization, is similar to that for many other developing countries and to Thailand's experience between 1965 and 1980. Table 1.6 Economic growth rates in the Republic of Korea, Malaysia, the Philippines, and Thailand, 1965-91 (percent per year) Country 1965-80 1970-80 1980-91 Korea, Rep. Of 9.9 9.6 9.6 Malaysia 7.4 7.9 5.7 Philippines 5.7 6.0 1.1 Thailand 7.3 7.1 7.9 Source: World Bank and Asian Development Bank data. 1.41 Forecasts of regional development reflect urbanization and industrialization patterns, leading to the more rapid development of southern Vietnam than other parts of the country. Together the rural south and Ho Chi Minh City will increase their share of the economy from 54 percent in 1995 to 58 percent by 2010. The share of GDP from the rural north and central region will fall. Hanoi's share of the economy will increase slightly, from 6 percent to about 7 percent. - 13 - Electricity consumption will continue to grow much faster than GDP 1.42 For purposes of forecasting, the energy sector is different in each of Vietnam's three main regions. In particular, the central region is less economically advanced than the north and south (though it is receiving special government attention for its development). In 1995, for example, electricity consumption in the center was 108 kilowatt-hours per capita. In the north it was 154 kilowatt-hours and in the south it was 188 kilowatt-hours. Power consumption in Hanoi and Ho Chi Minh City, at 550-600 kilowatt-hours per capita, is much higher than elsewhere. 1.43 During 1980-95 electricity sales increased much faster than real GDP. The relationship over the period shows an average elasticity of electricity sales to GDP of 1.7- meaning that electricity sales increased 70 percent faster than GDP. This relationship between electricity and GDP is typical among low-income Asian countries. During the 1980s only China and Myanmar had elasticities below 1.7. Thus, if Vietnam's economy continues to develop, it is far from a stage at which electricity demand will slow relative to GDP. 1.44 During 1990-95 electricity consumption grew by 12.6 percent a year (table 1.7). The highest growth rate was in agriculture (from a small base), at 21.1 percent a year. Growth in residential demand was second highest, at 14.7 percent a year. Industrial demand grew much slower until 1990 but has since picked up, to 10.2 percent a year. The share of residential sales in total sales has increased in recent years, and was 36 percent in 1995. Electricity consumption increased significantly in all five distribution areas: Hanoi, the rural north, the central region, Ho Chi Minh City, and the rural south. In absolute terms the greatest increase was in Ho Chi Minh City, where sales rose from 1,380 gigawatt-hours in 1990 to 2,815 gigawatt-hours in 1995. Table 1.7 Electricity consumption, 1985-95 (sales of gigawatt-hours) Average annual growth, Sector 1985 1990 1995 1990-95 (percent) Residential 985 2,035 4,046 14.7 Industry 2,108 2,845 4,619 10.2 Agriculture 303 587 1,522 21.1 Commercial 464 718 1,010 7.1 Total 3,860 6,185 11,198 12.6 Source: Institute of Energy. 1.45 Electricity demand was forecast for the industrial, residential, and other (services and agriculture) sectors for all five distribution areas. Where possible, the elasticities forecast for each sector and region were based on historical relationships to sector GDP. Under all three scenarios-low growth, base case, and high growth-electricity prices were assumed to remain constant in real terms at their early 1998 levels. The divergence in electricity demand among the scenarios results primarily from the different assumptions for GDP growth. Within the base case scenario, a number of variations were explored to quantify the significance of loss reduction, nonprice demand-side management, and conservation from higher electricity prices (see below). - 14- 1.46 Forecasts for the low-growth and base case scenarios use the same detailed elasticity inputs; the high-growth scenario has slightly lower elasticities for residential demand because it assumes faster commercial and industrial development. While the forecasts use the same detailed subsector elasticities, the resulting overall sales elasticities (relative to GDP) are 1.74 for the low-growth scenario, 1.68 for the base case scenario, and 1.64 for the high-growth scenario. (As noted, the historical sales elasticity is 1.7.) 1.47 The forecast demand for electricity generation in 2000 ranges from 23.1 terawatt- hours in the low-growth scenario to 27.1 terawatt-hours in the high-growth scenario. By 2010 the demand forecast under the high-growth scenario is about 12 percent higher than under the base case developed by the Institute of Energy for Electricity of Vietnam in mid-1997 and slightly lower than the institute's high case. Thus our three forecasts bracket the institute's base case but are lower than its high case. 1.48 Demand is expected to grow slightly faster in the residential sector than in the other two sectors, an outcome consistent with but less pronounced than historical patterns (figure 1.2). This trend reflects increasing provision of electricity to periurban and rural areas (for example, the central region and the suburbs of Hanoi) and ongoing urbanization. Figure 1.2 Demand for electricity will grow fastest in the residential sector (gigawatt-hours) 30,000 25,000 Residential 20,000 - .__ Industry 15,000 _ - Other 10,000 5,000 , o '- Ns X~) t2or to 0 - a) o0 - N t tO (0 a)- co a0 0 0 0) 0) 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0) 0) 0) X) 0) 0) 0) 0) 0) 0) 0 0 0 0 0 0 0 0 0o 0 0 - - - , - - t- N N N N N1 N N N N N N Years Source: World Bank staff estimates. - 15- Coal use should continue to rise steadily 1.49 Domestic coal consumption was about the same in 1995 as in 1985 (table 1.8). In 1993, however, coal production for export sales began increasing significantly, and by 1996 had reached 3.6 million tons (figure 1.3). Coal use for electricity generation fell to a low of 0.5 million tons in 1993 but has also since been rising, reaching 1.5 million tons in 1996. Coal use in transportation (mainly railways) has fallen, but other large industrial users have shown consistent increases. During 1990-95 overall coal consumption increased 4.6 percent a year. Table 1.8 Coal consumption and exports, 1985-95 (thousands of metric tons) Sector 1985 1990 1995 Electricity 1,960 1,560 1,009 Cement 364 521 629 Chemicals and fertilizer 182 217 425 Other industry 377 308 497 Transportation 44 34 8 Local and residential 2,156 1,400 2,500 Total 5,083 4,039 5,069 Exports 604 677 2,735 Source: Institute of Energy. 1.50 Industrial coal use has increased consistently but slowly in the past and is expected to continue growing at about the same rate as in 1990-95-about 5.6 percent a year over the long term (coal demand elasticity of 0.5 to industrial GDP). Coal use for electricity generation was forecast through detailed modeling using the Wien Automatic System Planning (WASP) model, and residential consumption was forecast on the basis of rural population growth (demand elasticity of 1.0 to rural population growth). By 2000 industry will use 2.1 million tons of coal, electricity generation will use 2.3 million tons, and residential use will be 2.7 million tons. The use of coal for electricity generation increases markedly until 2004, then stays in the range of 4-5 million tons until 2010. Beyond 2010, the power sector's need for coal could be as high as 21 million tons a year-depending on whether coal or not-yet-discovered gas makes up for the shortfall in thermal generation. - 16- Figure 1.3 Coal production for exports and electricity generation should increase considerably (thousands of tons) Power 6,000 + Industry 5,000 _ Residential ___ 7(ExportXX t> IDawa) o o o o o o o oo 0) C) ) C) 0 C) C C) Col 0 4 0 2 0 oll0 0a 0 a 0 0, C C) C) C) ) C) C) ) C) C) ) 0 0 0 0M 0l C0 0 04 0l .~~~~~~~( N (N (IN N (N N (N (N (N (N Years Source: World Bank staff estimates. 1.51 Coal exports are projected to increase 3 percent a year until 2004, then stabilize at 4.5 million tons a year. Total coal production, for domestic and export use, will reach 15.6 million tons a year by 2010. Domestic coal requirements of 11.1 million tons should easily be met by Vietnam's coal industry (see chapter 2). It is not clear, however, whether the coal industry can increase efficiency enough to also supply 4.5 million tons of exports after 2005. Natural gas discoveries will be used primarily to generate electricity 1.52 Offshore natural gas from the Bach Ho field was brought to shore in 1994 to power the electricity plant at Ba Ria. Use of this gas rose from 0.19 billion cubic meters in 1995 to more than 1.0 billion cubic meters in 1998. Gas from the Nam Con Son basin is expected to start being used in 2000, when 2.1 billion cubic meters of offshore gas is forecast to be used by the power sector (figure 1.4). The demand for gas by the power sector is estimated from detailed power expansion plan simulations, as described in chapter 2. Industry and fertilizer plant use of Nam Con Son gas is expected to begin in 2002. The use of gas by industry is expected to grow quickly-by about 15 percent a year. By 2010 gas use is forecast at 7.7 billion cubic meters a year. - 17- Figure 1.4 Demand for offshore natural gas will rise considerably (billions of cubic meters) 7.0 5.0 . 5.0 - -Power Sector 4.0 3 A Fertilizer 2 Industry 2.0 __r 1.0 / X X ,( iS. ,,, - iv- - e'. 0.0 O - N ') '* U} WC ll O~ 0 N Cn t m~ tO 1 .. X al 0 Vn Nl N ° ° N N N N N ° Year Source: World Bank staff estimates. Demandfor petroleum products will increase with motor vehicle use 1.53 In 1995 total consumption of petroleum products was 38.1 million barrels (table 1.9). The main fuels were diesel (42 percent), gasoline (28 percent), fuel oil (15 percent), and kerosene (8 percent). Table 1.9 Petroleum product consumption, 1985-95 (thousands of barrels) Fuel type 1985 1990 1995 Diesel 6,281 8,627 16,184 Gasoline 2,938 5,800 10,693 Fuel oil 3,319 4,344 5,559 Kerosene 1,203 1,681 3,026 Liquefied petroleum gas 5 23 350 Aviation fuel 615 802 1,527 Other 100 465 805 Total 14,461 21,742 38,144 Source: Petrolimex and Institute of Energy. 1.54 The number of motor vehicles in Vietnam has been growing very quickly. Consumption of gasoline has been growing by more than 13 percent a year, and consumption of all petroleum products has increased by nearly 12 percent a year. With the current economic - 18 - slowdown and the introduction of natural gas into the power sector, however, forecast growth in demand for petroleum products is 7.3 percent a year, with gasoline growing at 9.2 percent a year and diesel growing at 7.6 percent a year (figure 1.5). The highest growth is expected for liquefied petroleum gas, from 0.35 million barrels in 1995 to 2.37 million barrels in 2010. Figure 1.5 Among petroleum products, demand will be greatest for diesel and gasoline (thousands of barrels) 45,000 Diesel 40,000 |-+ Petrol . .. . Other ,30 ,0 00 ....... ...... ........... ............ .......................... ..................-.--.--.. X25,000 . . i Fuel Oil.. I 20,000 . .. .............. . ........ . 10,000 . .................. . . . . ... 0 0o -h:: N ') L U C - -aDC 0 - - ) CD _ CD a 0 o N N N N N N4 N° N °N N Year Source: World Bank staff estimates. 1.55 The forecast growth rates for petroleum products are individually linked to the forecast growth rates for GDP. Gasoline and kerosene are linked to total GDP. Diesel, aviation fuel, fuel oil, liquefied petroleum gas, and other products are linked to industrial GDP. In each case the elasticities were assigned partly according to Vietnam's experience since 1990 and partly according to the experience of other developing countries. The resulting average elasticity of demand for petroleum products, except in the power sector, is 1.2, which is in the range experienced by other developing Asian countries. Diesel and fuel oil used to generate electricity were estimated using the WASP model, and are forecast to fall from recent levels. - 19- Summary of demandforecasts 1.56 Under the base case scenario the share of petroleum products in overall demand for modem energy declines-especially between 1995 and 2000-as natural gas is brought into the market (table 1.10). Natural gas increases its share from 1.8 percent in 1995 to 19.1 percent in 2010. The share of hydropower decreases slightly. Although coal use is forecast to increase to 11.1 million tons a year, its share also declines as the mix of primary energy becomes more diversified. In the past coal dominated the energy mix; in the future its share will be the lowest in primary energy. Table 1.10 Current and projected demand for modern energy, 1995-2010 Fuel 1995 2000 2005 2010 Petroleum products (thousands of barrels) 38,144 53,994 79,431 117,841 (47.7) (42.4) (43.7) (42.5) Natural gas (billions of cubic meters) 0.199 2.111 4.663 7.717 (1.8) (12.3) (16.6) (19.1) Coal (thousands of tons) 5,069 7,166 9,142 11,115 (25.6) (22.8) (20.3) (16.2) Electricity generation (gigawatt-hours)a 14,636 25,706 44,491 77,406 (24.8) (22.5) (19.5) (22.2) Total primary energy (thousands of tons of oil 10,663 16,975 24,267 36,973 equivalent) Memorandum item Modem energy demand per $1,000 of 1996 GDP (kilograms of oil equivalent) 483 541 544 578 Note: Numbers in parentheses are each fuel's share in total demand. a. Numbers in parentheses refer only to hydropower. Source: World Bank staff estimates. 1.57 Growth in the demand for modem energy is forecast to average 8.0 percent a year, somewhat higher than forecast GDP growth of 7.1 percent a year. Modem energy intensity per $1,000 of GDP will drift upward, from an estimated 541 kilograms of oil equivalent in 2000 to 578 kilograms of oil equivalent in 2010 (see table 1.10). Controlling demand and increasing efficiency 1.58 Given limited financial resources, Vietnam's energy strategy must be guided by efficient use in all areas, from exploration of resources to delivery to consumers. The power sector, for example, could save 10,000 gigawatt-hours if greater supply-side efficiency were introduced and losses were cut to 12 percent. 1.59 Electricity efficiency has two elements: supply-side efficiency and demand-side (or end-user) efficiency. Supply-side efficiency is especially important. Although electricity consumption in Vietnam nearly tripled over the past 10 years, technical and nontechnical energy - 20 - losses averaged about 20 percent-implying that one-fifth of the electricity produced is being wasted or at least is not being paid for. If loss rates stay at current levels, by 2010 about 16,400 gigawatt-hours-more than the total production of the power sector in 1995-will be lost. Inefficiencies in distribution include low system power factors, transformer inefficiencies, and poor-quality cables (particularly in rural areas). 1.60 The government has developed a plan to reduce these losses to 12 percent by 2010, but achieving this goal will require adequate investment in transmission and distribution systems, where most losses occur. The savings from a continuing loss reduction program would be about 850 megawatts by 2010 (figure 1.6). Transmission and distribution losses will need to be cut from 15.4 percent in 1998 to 10.9 percent in 2010, and nontechnical losses from 4.4 percent to 4.0 percent. The targets for 2010 are comparable to levels in Thailand's power system, which has total losses just below 14 percent. 1.61 There is also potential for encouraging greater efficiency in the use of electricity through demand-side management. A wide-ranging demand management program could reduce demand by about 700 megawatts and save $420 million in investment by 2010. The biggest contributors to end-use inefficiencies are locally manufactured electric motors (which have low power factors) and electric irrigation and drainage pumps (which represent almost half the load in rural areas). An effective demand management program would improve load management for large energy users through time-of-use tariffs and other programs, introduce equipment and building standards, undertake industrial audits to improve lighting and motors, and design more efficient public lighting. These measures would cost about $80 million to introduce, but they would be ineffective in the absence of appropriate pricing policies. 1.62 Efficient electricity pricing will have the greatest impact on the efficiency of electricity use, on both the supply and demand sides. If current average power tariffs, equivalent to 5.1 cents per kilowatt-hour, were increased to 8.0 cents per kilowatt-hour by 2002, the demand for generation capacity in 2010 would be 12 percent lower (1,720 megawatts) than under the base case scenario. Thus a pricing policy that gradually raises prices near the estimated long-run marginal cost is by far the most effective demand management tool. Moreover, higher prices would lower power investment requirements by $1.8 billion by 2010 and would help make Electricity of Vietnam creditworthy. Higher prices combined with a demand management program would reduce demand by an estimated 1,940 megawatts. - 21 - Figure 1.6 Higher prices would lower the demand for electricity (megawatts) 16,000 14,000 - - - -- - ----- --- ------- ----------- -------------- - -- 1 2 ,0 0 0 - -~ - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - 12, 0 00 - --------------------- ------ ---- --- ------ 10,000 - . _ _-Case B, no Loss Reduction 4,000 ------------- +Case B, prices remain at present levels 2,000 - . -- - - - - -.- - - - - -.- - - --- --X- -Case B with non-price DSM -UCase B, prices phased up to LRMC O 1 | l l l*Case B with LRMC prices and DSM 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Years 1.63 Similar conservation policies need to be followed in the coal and petroleum sectors. Taxes on petroleum products currently provide the government with about $500 million a year in revenues. Raising the tax on diesel from 25 percent to 45 percent would reduce consumption by about 24 million barrels and provide $3.4 billion in additional revenue during 1998-2010. Given its enormous projected needs-and the equally pressing need for efficient production and consumption-how should Vietnam develop its energy resources? The proposed investment strategy is the subject of chapter 2. - 23 - 2. DEVELOPING ENERGY RESOURCES 2.1 Vietnam remains an essentially rural society. In 1996 traditional energy-mostly wood and other biomass fuels such as charcoal and straw-accounted for 66 percent of energy consumption. Thus energy policies must recognize that ignoring traditional energy can have serious implications for environmental sustainability and social welfare. Although this report's focus is on modern energy, two key messages emerge for traditional energy. 2.2 First, attention must be paid to establishing and expanding multipurpose tree plantations in the low-lying areas near heavy population concentrations in the North Midlands, Red River Delta, and Hoa Binh province. These plantations can prevent shortages of woodfuel, degradation of highland areas, and shortened life of the Hoa Binh hydropower plant. Properly managed, woodfuel production and distribution can be a profitable and environmentally sustainable industry. Second, the government must continue to encourage households to shift to affordable, higher-grade fuel substitutes, including kerosene, liquefied petroleum gas, and coal briquettes. To alleviate adverse environmental impacts from wider coal use, the coal briquette industry should be modernized and made more efficient. 2.3 Over the next few years, however, the demand for modern energy is expected to increase much faster than the demand for traditional energy: 8.0 percent a year (under the base case scenario) compared with 1.3 percent a year. As economies develop, they shift toward modern energy-by 2010 traditional energy is expected to account for just 45 percent of Vietnam's energy. To ensure continued economic growth, Vietnam must make sound investments in its modern energy resources. Efforts should focus on power, upstream oil and gas, downstream oil and gas, and coal. Power 2.4 Vietnam's power sector has a regional character due to the geographic distribution of resources and the country's long, narrow shape (figure 2.1). In the north the system is dominated by hydropower, but there are also significant reserves of coal, the country's second most important fuel for power generation (table 2.1). The fast-growing south has hydro capacity as well but also has had to rely on diesel-fired generation. However, the offshore gas fields of Bach Ho and Nam Con Son provide the south with a growing share of natural gas for power generation. The central region has the smallest population and limited installed capacity in hydro and diesel-fired generation; in the medium term it will increase its hydro generation and export much of it to the south. 2.5 In 1998 total installed capacity was 4,890 megawatts, of which 59 percent was hydro plants, 17 percent was coal fired, 16 percent was gas, and 8 percent was diesel (table 2.2). A 500 kilovolt transmission line that runs from north to south has a peak capacity of about 550 megawatts and maximum annual load of around 4 terawatt-hours. In 1996 total generation was 16.9 terawatt-hours and technical and nontechnical losses were about 22 percent, so electricity sales were about 13.3 terawatt-hours. -24- Figure 2.1 Vietnam's power system has a strongly regional character North Table 2.1 Electricity generation by region, 1996 (terawatt-hours) Type North Center South Total Hydro 7.7 0.3 3.8 11.8 T'hermnal 2.4 0.2 2.5 5.1 Net regional imports -2.9 0.9 1.9 0 Total 7.2 1.4 8.2 16.9 Source: World Bank staff estimates. -25 - Table 2.2 Vietnam's power system, 1998 (megawatts) Region andplant type Plant name Installed Available North 2,732 2,653 Hydro Thac Ba 108 108 Hoa Binh 1,920 1,920 Small Hydro 17 17 Thennal Ninh Binh 100 100 UongBi 105 100 Pha Lai 440 400 Gas turbine Thai Binh 34 0 Diesel 8 8 Center 285 276 Hydro Vinh Son 66 66 Small Hydro 29 20 Diesel 190 190 South 1,873 1,658 Hydro DaNhim 160 160 Tri An 400 400 Thac Mo 150 150 Small Hydro 4 4 Thermal Thu Duc 165 156 Can Tho 33 32 Gas turbine Thu Duc 128 101 Old Baria 46 68 New Baria 225 30 Can Tho 75 204 Phu My 2.1 288 288 Diesel 199 65 Total 4,890 4,586 Source: World Bank staff estimates. 2.6 Between now and 2005 the generation and capacity mix will change significantly because each region is likely to invest in capacity for a different fuel: coal (and hydro) in the north, gas in the south, and hydro in the center. Because hydro plants are of limited use during the dry season-when their average monthly load factor drops to 30-40 percent-for several months of the year gas and other thermal plants run at maximum available generation. Until 2000 small amounts of electricity demand (1-3 percent of total demand) may not be served despite the fact that the plant reserve margin will likely be 14-30 percent during this period. Thus considerable investment in new capacity is required. In 1996 peak demand was about 3,160 megawatts; this is expected to grow by about 700 megawatts a year until 2005, and by more than 1,000 megawatts a year thereafter (table 2.3). -26 - Table 2.3 Electricity generation demand forecasts Year Low-growth scenario Base case scenario High-growth scenario Institute of Energy base case scenario Demand Peak Demand Peak Demand Peak Demand Peak (terrawatt demand (terrawatt- demand (terrawatt demand (terrawatt demand -hours) (megawatts) hours) (megawatts) -hours) (megawatts) -hours) (megawatts) 1996 16.9 3,161 16.9 3,161 16.9 3,161 17.0 - 2000 23.1 4,298 25.7 4,779 27.1 5,039 30.1 - 2005 36.7 6,739 44.5 8,195 50.9 9,326 53.6 - 2010 58.7 10,650 77.4 14,123 96.4 17,389 87.8 - Annual growth Annual growth Annual growth Annual growth Electricity GDP Electricity GDP Electricity GDP Electricity GDP 1998- 6.5 4.0 10.3 6.0 12.3 10.0 15.4 9.5 2000 2001- 9.9 6.0 11.8 7.5 13.7 9.5 11.3 9.0 10 Source: World Bank staff estimates; Institute of Energy. Responding to expanding generation needs 2.7 During 1981-93 electricity generation increased 9.2 percent a year and consumption increased 8.9 percent a year. (The difference between the two is due to increasing losses.) During 1994-96 growth in generation accelerated to 15-20 percent a year, leading to expectations of high future growth rates. With the East Asian crisis, however, growth fell to 13 percent in 1997. 2.8 Since 1994 the Vietnam Institute of Energy's generation forecasts have been revised sharply upward. Forecasts for 2000, for example, changed from 20-27 terawatt-hours in early 1994 to 30-33 terawatt-hours in 1995, then settled at 27-33 terawatt-hours (see table 2.3). The institute's current base case predicts growth of around 15.4 percent a year for the next four years, but the slowdown in 1997 and the economic uncertainty affecting the region suggest that these forecasts need to be lowered. Generation in 2000 will likely be no more than 27 terawatt- hours. - 27 - 2.9 The most recent official view of power investment requirements is contained in the 1995 Master Plan Study on Electric Power Development in Vietnam (Fourth Stage), but the situation has changed in a number of ways since then. Electricity of Vietnam, together with the Institute of Energy, keep plans for investment in generating capacity under continuous review because the medium-term demand outlook is uncertain, the availability of resources-especially new gas supplies-changes quickly, and plans and proposals for independent power producers are subject to considerable uncertainty in timing. Complicating matters, seasonal fluctuations in hydro availability have a major influence on capacity requirements, necessitating enormous reserve capacity. In 1996, for example, the reserve margin was 32 percent, and while the average demand load factor was 62 percent, the average plant load factor was 46 percent. Regional supply and demand should guide investment 2.10 The Wien Automatic System Planning (WASP) III model was used to examine least-cost expansion plans for a number of demand and fuel price scenarios. Because WASP can only treat the country as a single system, a separate spreadsheet model was used to allocate investment between the north and south. The main investment options are hydro plants in the north, center, and south, coal plants in the north, and gas plants in the south. Though other options exist, in the short and medium term parallel investment in coal in the north and gas in the south will likely proceed to balance the system. The model assumes a cost of unserved energy of $0.5 per kilowatt-hour. This cost-an important factor in determining the level of investment and reserve margin-is conservative but appropriate for Vietnam given its low per capita income. 2.11 The model rests on several comparative cost assumptions (table 2.4) and estimates (table 2.5). A few points are worth noting. Gas-fired combined cycle gas turbine plants are potentially the least-cost investment for new plants operating at base load, because a long-term take-or-pay gas contract effectively lowers the marginal cost of gas to zero. But if gas plants bear the average unit cost of gas (about $2.1 per million British thermal units), then coal generation is cheaper. And once built, the cheapest plants to dispatch are those with the lowest variable cost (fuel cost plus variable operating cost)-which are coal-fired steam turbine plants in the north, followed by coal-fired steam turbine plants in the north transmitting electricity to the south. Thus it will be cheaper to build coal-fired plants to meet demand once gas plants have been dispatched to the limit of the contracted gas supply. Still, coal plants in the north generating power for the center and south can only be dispatched up to the (limited) capacity of the north-south transmission line. -28- Table 2.4 Comparative cost assumptions Plant type Capital cost Efficiency Fuel cost Lifetime Variable operations Fixed operations and (dollars per (percent) (dollars)a (years) and maintenance maintenance cost kilowatt- cost (cents per (dollars per kilowatt- hour) kilowatt-hour) hour per month) Gas-fired combined cycle gas 500 48 2.10 25 0.40 0.30 turbine per million Btus Coal-fired steam turbine in 900 38 27.4 per 30 0.40 0.72 the north ton Coal-fired steam turbine in 900 34 27.4 per 30 0.60 0.72 the north transmitting ton electricity to the south Coal-fired steam turbine in 900 38 41.4 per 30 0.40 0.72 the south using coal from the ton north Coal-fired steam turbine in 900 38 47.8 per 30 0.40 0.72 the south using imported coal ton Fuel oil-fired steam turbine 450 31 23.9 per 20 0.28 0.51 barrel Diesel-fired gas turbine 350 34 32.2 per 20 0.83 0.20 barrel a. Assumptions are for 2000 and are based on projected opportunity value prices. Include delivery to the power station in each region. The forecast price for crude oil in 2000 is $21 a barrel free on board. Using current prices, oil product generation options would be the lowest cost-for example, fuel from the fuel oil-fired plant would cost 3.7 cents a kilowatt-hours, and the generation cost would be 5.03 cents a kilowatt-hour. Source: Institute of Energy using WASP input data. Table 2.5 Comparative cost estimates (cents per kilowatt-hour) Plant type Capital Fuel cost Variable operations Fixed operations Total Total cost cost and maintenance and maintenance operational cost cost cost Gas-fired combined 0.97 1.49 0.40 0.06 1.95 2.92 cycle gas turbine Coal-fired steam turbine 1.68 1.13 0.40 0.15 1.68 3.36 in the north Coal-fired steam turbine 1.68 1.25 0.60 0.15 2.00 3.68 in the north transmitting electricity to the south Coal-fired steam turbine 1.68 1.70 0.40 0.15 2.26 3.93 in the south using coal from the north Coal-fired steam turbine 1.68 1.80 0.40 0.15 2.35 4.03 in the south using imported coal Fuel oil-fired steam 0.93 4.33 0.28 0.11 4.72 5.64 turbine Diesel-fired gas turbine 0.72 5.59 0.83 0.04 6.46 7.18 Note: Assumes a 65 percent load factor and 10 percent discount rate. Source: World Bank staff estimates. - 29 - 2.12 The cost impact of the substitution between coal-fired plants in the north and gas- fired plants in the south is sensitive to the relative prices of coal and gas. The breakeven prices of these fuels for electricity generated by combined cycle gas turbine in the south (gas) and steam turbine in the north (coal) depends on the direction of electricity exports (figure 2.2). Here the cost of operating the north-south transmission line and the associated losses are allocated to the exporting region. Figure 2.2 Breakeven fuel prices depend on the direction of electricity exports Exports from north to south No net exports ;^ _Exports from south to north t V j i D00 00 X;E d .................................. X0r fi~~~~~~~~~~~~~~~~~~~~~~~~~~.. ... .. ... .. N4ote Asue__5prcn_odfcoradI_ecntdson ae . .: V g:tti.50 00 Note: Assumes a 65 percent load factor and 10 percent discount rate. Source: World Bank staff estimates. The base case investment scenario takes a realistic view 2.13 The three demand scenarios for electricity (low growth, base case, and high growth) from chapter 1 were combined with four supply scenarios that set upper or lower limits on various fuel and plant options (the effect of take-or-pay contracts on the gas supply, the capital costs of new combined cycle gas turbine plants, and the earliest availability of the Dai Ninh hydro plant). Thus 12 main options were examined. Table 2.6 shows the base case investment scenario, which assumes a minimum take-or-pay contract for gas supply and anticipates that new gas plants will run for at least 5,000 hours a year (with a 56 percent load factor). - 30 - Table 2.6 Base case investment scenario, 1997-2010 South North Year Project Total new capacity Project Total new capacity (megawatts) (megawatts) 1997 Phu My 2.1 (gas turbine) 144 Phu My 2.1 (gas turbine) 288 1999 Ba Ria new (combined cycle) 344 Phu My 1. I (gas turbine) 557 Phu My 2.1 (gas turbine) 845 Yaly I (hydro) 1,025 2000 Ba Ria new (combined cycle) 1,081 Phu My 1.2 (gas turbine) 1,507 Song Hinh (hydro) 1,577 Yaly 2, 3,4 (hydro) 2,117 2001 Phu My 2.1 (conversion to 2,261 Phai Lai 2.1 (coal) 300 combined cycle) Phu My 2.1 (conversion to 3,405 Phai Lai 2.2 (coal) 600 combined cycle) Phu My new (combined cycle) 2,705 Ham Thuan (hydro) 3,005 Da Mi (hydro) 3,177 2002 Phu My new (combined cycle) 3,477 2003 Phu My new (combined cycle) 3,777 Quang Ninh I (coal) 900 Quang Ninh 2 (coal) 1,200 2004 Dai Ninh (hydro) 4,077 Quang Ninh 3 (coal) 1,500 2005 Phu My new (combined cycle) 4,977 Sesan 3 (hydro) 5,197 2006 Phu My new (combined cycle) 5,497 Quang Ninh 4 (coal) 1,800 Dai Thi (hydro) 5,747 Thuong Kon Tum (hydro) 6,007 2007 Phu My new (combined cycle) 6,907 Buon Kuop (hydro) 6,992 Plei Krong (hydro) 7,112 2008 Ban Mai (hydro) 7,462 Quang Ninh 5 (coal) 2,100 Phu My new (combined cycle) 7,762 Son La 1, 2 (hydro) 2,700 Dong Nai 8 (hydro) 7,902 2009 A Vuong (hydro) 8,047 Son La 3, 4 (hydro) 3,300 Phu My new (combined cycle) 8,647 An Khe (hydro) 8,763 2010 Phu My new (combined cycle) 9,363 Son La 5, 6 (hydro) 3,900 New coal 9,863 New coal 10,363 Source: WASP analysis. - 31 - 2.14 This report has not made an independent assessment of required investments in transmission and distribution. Electricity of Vietnam has not updated its estimates since 1995, when it projected that cumulative required investment in transmission and distribution would be $2.3 billion during 1997-2010. More recent estimates from the Hagler Bailly tariff study place transmission and distribution investment at $3.8 billion during 1997-2005, and the Japanese International Cooperation Agency study estimates $8.7 billion during 1997-2010. None of these sources provides alternate investment plans because investment is transmission and distribution is lumpy and is not sensitive to slight changes in demand. Addressing other power issues 2.15 The power sector expansion scenarios raises several issues about the development of Vietnam's resources, including the uncertainty of demand forecasts and the cost of delays, the tradeoff between gas and coal, the level and structure of electricity tariffs, the development of the Son La hydro plant, rural electrification plans, and long-term developments. Demand is uncertain-as is the cost of delays 2.16 The least-cost expansion planning analysis has been carried out as if the various scenarios are known outcomes, but in fact there is considerable uncertainty about future developments-and uncertainty often raises costs. Here the two main risks are that demand forecasts will prove too high, leading to excess investment, and that delays in investment (in the offshore gas pipeline or new power stations) will lead to higher generation costs as more costly fuels are consumed. 2.17 As noted in chapter 1, future demand is uncertain because Vietnam has experienced exceptionally rapid growth in electricity demand over the past four years, creating expectations of continuing high growth. Thus, for example, in 1997 the low-demand forecast for 2000 was the same as the high-demand forecast in 1994. 2.18 If power sector planning is guided by the base case scenario but demand turns out to be lower (as in the low-growth scenario), the additional cost that could have been avoided is substantial. By 2010 the overinvestment could reach more than $2 billion, and the costs per unit of electricity generated could be more than 20 percent higher than is necessary. Vietnam's increasing exposure to market forces and international economic events will likely continue to create uncertainty in future demand. Thus it will be important to keep forecasts under review and adopt flexible plans that minimize the costly errors of forecasting. 2.19 Similarly, delaying the construction of the offshore pipeline and of stage 2 of the Pha Lai coal-fired plant could have sizable costs (box 2.1). Thus it will also be important to improve decisionmaking procedures to ensure that commercially attractive investments are carried out in a timely fashion. Improving the effectiveness of investment should be one of the main goals of sector reform. -32 - .t . . _ The tradeoff between gas and coal will depend on gas contracts 2.20 As noted, there is a tradeoff between the demand for gas and coal in power generation: any decision to expand one of these fuels will have major impacts on the other (though in the short term the substitutability of these fuels is limited by the capacity of the north- south transmission line). Gas-based expansion would require a sizable upfront investment in production and transportation infrastructure-investment that can only be financed if a minimum throughput of gas is contracted. Expanding gas-based generation to meet these throughput requirements would require delaying investments in coal. But this delay would have only a short- term impact on the coal industry, while postponing gas investments would not only undermine the development of gas infrastructure, it would also slow hydrocarbon exploration efforts by international oil companies. 2.21 Projected demand for gas (associated and nonassociated) is much higher under scenarios involving take-or-pay contracts because the variable costs of gas-fired generation are higher than the variable costs of coal-fired generation; the contracts would lower gas costs and so increase demand (table 2.7).1 Under the high-growth scenario with a take-or-pay contract, the demand for gas reaches 3 billion cubic meters by 2002, whereas under the low-growth scenario this level is not reached until 2006. Under the base case this level is reached by 2004. Demand under all three scenarios then grows to reach the maximum assumed to be available-7-8 billion cubic meters. 2.22 Without take-or-pay contracts the demand for gas would stagnate at 3-5 billion cubic meters. This contrast shows the importance of such contracts in guaranteeing the volumes that may be needed to encourage investment. Operating costs are higher with take-or-pay contracts, however-about 2 percent of total generating costs. l Today there is a seasonal swing in the demand for gas caused by the seasonality in hydro generation. Because hydro is expected to play a smaller role in future power generation-dropping from nearly 75 percent to 50 percent of total supply-this swing is expected to become more stable. - 33 - 2.23 Without take-or-pay contracts for gas the demand for coal could rise to 6-8 million tons by 2008 (see table 2.7). With take-or-pay contracts the demand for coal would likely stagnate around 4 million tons until 2011 (at which point current gas resources will have reached maximum exploitation and the Son La hydro plant will have been developed). 2.24 Under least-cost dispatching the north-south transmission line would be used to export coal-generated electricity from the north to the south (when plant capacities permit). This pattern of electricity exports would be similar to that in 1996-though not in 1997, when water shortages in the north led to the export of power from the south-and would require an expansion in transmission line capacity around 2006-08. Table 2.7 Demand for gas and coal under the base case scenario with two types of gas contracts, 1998-2010 With take-or-pay contracts Without take-or-pay gas contracts Year Gas (billions of Domestic coal Imported coal Gas (billions of Domestic coal Imported coal cubic meters) (millions of tons) (millions of tons) cubic meters) (millions of tons) (millions of tons) 1998 1.0 2.5 1.0 2.5 1999 1.8 2.4 1.8 2.4 2000 2.1 2.3 2.1 2.3 2001 1.7 2.5 1.5 2.9 2002 2.3 2.8 2.1 3.2 2003 2.6 3.6 2.1 4.7 2004 2.8 4.6 2.2 5.8 2005 3.9 3.8 3.0 5.8 2006 4.4 4.3 3.2 6.7 2007 5.6 3.9 4.2 6.8 2008 5.9 4.1 4.2 7.6 2009 6.5 4.0 4.7 7.7 2010 6.8 3.7 1.5 4.3 7.7 2.5 2011 7.2 3.4 2.9 4.1 7.4 5.1 2012 7.6 3.9 4.4 4.2 7.4 7.5 2013 8.2 5.1 6.1 4.6 7.5 10.4 2014 8.2 5.7 9.9 3.7 7.5 16.4 2015 8.3 6.4 15.1 3.2 7.5 23.3 Source: World Bank staff estimates. Electricity tariffs should cover long-run marginal costs 2.25 Electricity tariffs in Vietnam average 4.8 cents a kilowatt-hour. These tariffs are based on the costs of production and distribution submitted by power companies to the State Committee on Pricing. But these tariffs underestimate real costs because fixed assets tend to be undervalued and depreciation rates are too low to reflect amortization rates that would allow for the repayment of investments and the cost of capital. - 34 - 2.26 Tariffs should cover financing requirements as well as the marginal cost of supply, which is usually taken to be the long-run marginal cost. Thus tariffs should gradually be raised to the economic level indicated by analysis of the long-run marginal cost, including generation, transmission, and distribution-about 8 cents a kilowatt-hour (table 2.8; see also chapter 1). Reasonable price increases will also help control demand. Without increases, demand could rise faster, increasing the financing required for new capacity and reducing the incentive to use electricity efficiently. Table 2.8 Long-run marginal costs of electricity under the base case scenario (cents per kilowatt hour) Generation only Generation plus transmission and distribution Type of gas contract 1999-2010 1999-2015 1999-2010 1999-2015 Minimum take-or-pay contract Low 4.16 3.55 7.91 7.30 High 4.28 3.67 8.03 7.42 No take-or-pay contract Low 4.07 3.43 7.82 7.18 High 4.15 3.60 7.90 7.35 Take-or-pay contract and higher-cost combined cycle gas turbine Low 4.22 3.57 7.97 7.32 High 4.32 3.69 8.07 7.44 Average 4.21 3.59 7.96 7.34 Average transmission and distribution cost 3.75 3.75 Source: World Bank staff estimates. 2.27 There is also a need to improve the tariff structure. The May 1997 tariff increase led to some improvements-for example, increasing the difference between peak and off-peak rates-but a number of distortions remain: * There is no formal bulk supply tariff, and the bulk sales price to distribution companies appears to be far below an economic level. * Some retail tariffs appear to be too high (for example, for commercial and low-voltage rural customers) while others are much too low (for urban residents). * Although the official retail tariff is uniform, the unofficial tariff includes large variations, especially urban and rural customers. * Coverage by the lifeline rate is probably too large, providing a significant subsidy to better- off (and larger) small customers. 2.28 These problems can be addressed by revising the tariff structure to better reflect the long-run marginal costs of generation, transmission, and distribution at various voltages, and by shrinking coverage by the lifeline rate. A bulk supply tariff needs to be introduced with separate demand and energy charges. These issues were addressed in the Hagler-Bailly tariff study, and serious consideration should be given to implementing that study's proposals as soon as possible. - 35 - The Son La hydro plant appears promising 2.29 The Son La plant is the largest hydro project under consideration. Two schemes are being considered: a large Son La (with a capacity of 3,600 megawatts) and a small Son La (2,400 megawatts). The schemes would cost about $3.0 billion and $2.3 billion; the additional capacity of the large scheme has a much lower incremental capital cost than that of the small scheme. The scale of the investment and the broader social and environmental impacts will inevitably create uncertainty about when and whether the project will be undertaken, but current plans assume is that it will be implemented between 2007 and 2012. 2.30 A key benefit of the large scheme relative to the small scheme is its additional storage capacity-8 terawatt-hours compared with 2 terawatt-hours-which gives it greater control over seasonal water flows and increases energy production from the downstream Hoa Binh plant. The Son La plant will also control power, control floods, and regulate water for irrigation. 2.31 The low-growth, base case, and high-growth scenarios assume that the Son La hydro plant will be built at a large scale-that is, 600 megawatts will be added each year starting in 2007 and finishing in 2012. The economic benefit of the Son La project was projected by running sensitivity cases for the base case and low-growth scenarios (table 2.9).2 Table 2.9 Cumulative net present value of the Son La plant under two scenarios, 2010-20 (millions of U.S. dollars) Year Base case Low growth 2010 - 41 - 128 2015 261 161 2017 333 303 2020 463 Source: World Bank staff estimates. 2.32 At the 10 percent discount rate used in the WASP analysis, the Son La project is economically justified, with a net present value of $300 million five years after completion (in 2017). The result is similar for the low-growth and base case scenarios and, though it was not 2 The simulations assumed that each Son La turbine adds an equal amount of generation to the project. The small Son La scheme was not analyzed because the large scheme was found to be economic and so is expected to have higher economic returns. Thus it was felt that nothing would be learned by including both schemes in the investmnent options. - 36 - analyzed, the return would be similar under the high-growth scenario. (The return is based on the cost of avoided generation by other plants, so the effect would be similar for any level of demand above the base case.) Assuming that the Son La plant continued to displace thermal plants, after 30 years its net present value would be about $800 million. The plant's (roughly calculated) internal rate of return is more than 20 percent. 2.33 Thus the economic analysis of the Son La plant indicates that the feasibility of the project should continue to be investigated, including deeper analysis of its financial, social, and environmental implications. Rural electrification remains a challenge 2.34 In 1996, 426 of Vietnam's 470 districts were electrified, as were 5,698 of 9,022 communes (villages). Yet as many as 5.9 million households-or 30 million people, mostly in rural areas-had no access to electricity (table 2.10). Rural consumers use one-fifth as much electricity as urban consumers but pay more than twice as much per unit, partly because of poor- quality rural power networks. In 1995 Electricity of Vietnam sold 13,152 billion kilowatt-hours, but only 14 percent went to rural areas. Thus 20 percent of the country's population consumed 86 percent of its electricity. Table 2.10 Electrification by region, 1996 Share electrif ed Region Total households Electrified households (percent) North 6,143,293 4,156,559 68 Center 1,671,818 539,694 32 South 3,996,341 1,317,070 33 Total 11,881,452 6,031,323 51 Source: Ministry of Planning and Investment rural electrification master plan, 1997. 2.35 The government recognizes the electricity needs of rural areas and has developed an ambitious rural electrification program that envisages providing electricity to 80 percent of communes by 2000 (from 63 percent today) and connecting all communes in the plains and 60 percent of rural households by 2010. The program will require about $3 billion in investment. Under the program rural consumption would increase to 8,400 gigawatt-hours by 2010, but the share of rural areas in total consumption would drop to about 13 percent from 14 percent today. Without an aggressive expansion in rural electrification, these disparities are likely to increase social tensions and drag down economic growth. 2.36 Even with an aggressive program to extend the rural grid, many households in Vietnam's 2,800 remote or mountainous communes will not be connected by 2010. There is, however, considerable potential for using renewable energy sources to supply electricity to these - 37 - households. Micro and small hydropower could generate 1.5-2.0 gigawatt-hours. The potential for solar energy is also large, particularly in the south. In addition, Vietnam has long coastal areas where the wind speed is high enough to generate power. The organizational mechanisms for implementing and operating renewable energy sources will need to be carefully formulated. 2.37 A number of other issues will need to be resolved before the rural electrification program can be successfully implemented: * Planning access. The grid expansion program must be carefully designed, with clearly defined criteria for connection. * Demand forecasts and consumption levels. Average per capita electricity consumption in rural areas was less than 30 kilowatt-hours a year in 1995 and is expected to grow over the next 10 years. The financial and economic viability of the rural electrification program will require determining a realistic growth rate for this demand. * Financing. The costs for extending power grids to rural areas are shared by the government and consumers. The cost of connecting the center of a commune to the national grid is borne by power companies or the central government. The cost of connecting consumer group points to the commune center is borne by local governments or consumers. And the cost of connecting households to consumer group points is borne by consumers. As the system expands, appropriate technologies should be chosen to lower connection costs and subsequent operation and upgrade costs. In addition, it remains to be determined how the ambitious expansion plans will be financed without unduly burdening power utilities. o Pricing A sustainable rural electrification program will require tariffs that cover the cost of construction, operation, and maintenance and provide for economic expansion. * Organization. The current organizational structure for rural electrification is complex and overlapping. Power companies control the grid up to the substations in provinces, districts, and communes. Most power grids in communes are managed by commune people committees, though some are managed by power companies or through competitively bid contracts. And in the south some distribution companies have been created for district, commune, and village electricity supplies. Each of these management structures has benefits and drawbacks that should be carefully evaluated before an organizational form is adopted for the entire country. Other countries-Bangladesh and Thailand among them-offer valuable lessons on how to provide electricity to people in rural areas. Vietnam should incorporate these lessons in its rural energy programs. - 38 - Box 2.2 How can access to electricity be expanded in rural areas? Experience worldwide provides several guidelines on rural electricity expansion efforLs. * An effective implementing agency, with considerable autonomy and good leadership. is essential. A variety of approaches have been successful: a separate rural electrification authority (Bangladesh), rural electricity cooperatives (Costa Rica). a department of the national utilit', with a separate agency for program implementation (Thailand), and a regionai office of the utility (Ireland). * Planning and decisionmaking for rural electrification should be open and objective, with clearly defined criteria for selecting priority areas. Thailand used objective criteria to select villages and a contribution program that allowed villages to" jump the queue" if they helped defray costs for connection to the grid. * Tariffs should be set at realistic levels and, at a minimum, should recover costs: cost recover) is the most important factor determining the effectiveness of rural electrification programs. Most programs have provided subsidies-capital subsidies for construction costs (Ireland), lower- price bulk rate electricity for rural electrification (Thailand). grants for initial development (Costa Rica)-but these should be designed so that they do not undermine the financial viabilitv of the power company. Sonie countries have adopted a uniform pricing policy that included a cross-subsidy from urban to rural consumers and from large to small customers. * Lowerinlg costs-for example, through standardization and local manufacturing (Thailand) or sintgle-phase distribution (Costa Rica)--;,allows faster system expansion. * Lowering entry barriers-say, by spreading costs for initial connection charges over a numher of years (Bolivia), spreading the cost of line extension to the entire communit' (Costa Rica). or providing credit for connection fees and wiring costs (Thailand)-lowers costs per customer and builds demand. Load promotion activities could focus on using electricity to increase revenues (in industry and agriculture), promoting efficient use, and increasing the number of connections (for example, by offering incentives for conversion from diesel to electric motors). * Services should be extended to high-impact areas first-thiat is, regions with active economies. high population densities, complementary rural infrastructure, and other developilient programs-to increase the impact of rural electrification. * To ensure accountability, an effective and independent regulatorv agency should oversee tariff setting and financial and managerial performance in the electricity sector. * Community involvement-through, for example, consumer meetings ( Bangladesh), community contributions in cash or kind (Thailand). or parishes as a liaison ( lreland)-can assist grid expansion programs. - 39 - Several long-term issues require attention 2.38 Investment options after 2010. The investment plans simulated under WASP are realistic until 2010 (and in some cases beyond then, as for the Son La plant). Beyond that point there is considerable uncertainty, and domestic resources may become scarcer. There will be limited opportunities for further hydro development, and gas and coal resources may be approaching their maximum utilization rate. 2.39 Though more significant gas reserves may still be proven, the most likely development is increasing reliance on coal through the development of the massive Red River reserves. There will need to be corresponding infrastructure investments (rail or barge) to transport the coal to demand centers in the south, as this approach is likely to be more economic than generating bulk power in the north and transmitting it to the south. 2.40 Regional trade in electricity. Full-scale regional trade in electricity offers potentially enormous economic and environmental benefits for countries in the Greater Mekong subregion (Cambodia, China, Lao PDR, Myanmar, Thailand, and Vietnam). A regional electricity market would enhance economic cooperation and provide more equitable access to cheaper energy, cutting generation costs by $9.7-13.7 billion during 2000-20. Regional trade in electricity could also reduce emissions of greenhouse gases and other pollutants-benefits worth an estimated $400 million a year by 2020. The main barrier to power trade is coordinating countries' myriad institutional, policy, technical, commercial, and financial arrangements. The World Bank is supporting the development of a power trade strategy for the Greater Mekong region, focusing on the need to build consensus among countries. 2.41 Lao PDR, for example, has the technical potential to export significant quantities of electricity to Vietnam. Vietnam has shown some interest in this possibility but has not examined it in detail. The central region, however, will run into a serious power deficit in about 2010, so further thought should be given to importing electricity from Lao PDR. This option would need to be compared with the alternatives: transmitting energy from the north or south, or constructing coal-fired power stations in the center. Choosing the right import point could reduce the need to reinforce Vietnam's transmission system. An initial simulation indicated that imports from Lao PDR would substitute for imported coal or coal from the north transported to the south, and could lower overall costs. 2.42 Increasing the capacity of the north-south transmission line. All the demand scenarios are feasible within the capacity limits of the 500 kilovolt north-south transmission line until about 2010. The full capacity of the transmission line will probably be used seasonally and at peak periods, but overall capacity will be sufficient to handle the bulk electricity transfers forecast under normal operation. After 2010, and if the Son La plant is built by 2012, there will be excess capacity in the north for about five years. There will also be a rapidly growing deficit in the central region. Although it is costly to build new transmission capacity, the capacity of the transmission line will be small relative to future systems in the north and south, which will each be approaching 10,000 megawatts soon after 2010. - 40 - 2.43 Can an increase in the capacity of the transmission line be justified simply to transmit bulk power from one region to another? Doubling the line's capacity would cost about $500 million. Operated at full load in one direction throughout the year, this additional capacity could carry a maximum 4,000 gigawatt-hours a year. The cost of transmission, including losses, would therefore be about 1.7 cents per kilowatt-hour. This is far higher than the cost savings that could be achieved by substituting combined cycle gas turbine generation in the south for coal steam turbine generation in the north, or vice versa. Thus it is unlikely that construction of the line can be justified solely on the grounds of bulk regional electricity exports. 2.44 Investment in additional line capacity, however, needs to take account of all possible benefits-including increasing the reliability of the system. The lowest-cost way of achieving system reliability targets may require reinforcing some or all of the long-distance transmission system. To examine this issue properly, reliability studies need to be carried out using a model capable of simultaneously optimizing the investment and operation of the regional power systems and the transmission system, to compare options for ensuring reliability and to examine whether the additional capacity is economically justified. A strategy for the power sector 2.45 Vietnam is fortunate to have significant resources of three major fuels for power generation: hydro, gas, and coal. The modeling and analysis of alternative scenarios have shown that balanced regional development of power generation resources and capacity is the best approach. Coal resources should be developed in the north and gas resources in the south, and hydropower should be exploited in all three regions. While hydropower has boosted capacity in recent years, its share of generation will fall from nearly 75 percent today to around 50 percent over the next five years as additional investments are made in gas and coal. 2.46 The 500 kilovolt transmission line provides system stability and shifts electricity between the north and south at peak times, but its capacity is small relative to the future size of the system. Increasing the line's capacity is unlikely to be economic solely as a means of transporting bulk power because the transmission cost of that power would be excessive. Thus generation capacity in the north and south should be planned to roughly balance the expected demand after hydro has met its share. The seasonal variation in hydropower availability, combined with almost flat annual demand, requires high capacity reserves. 2.47 Gas-fired combined cycle gas turbine plants are the least-cost investment, but some coal plants are needed in the north. Once constructed, the coal plants will likely have lower operating costs than the combined cycle plants and, on least-cost grounds, should be dispatched up to the limit of the transmission line's capacity unless the gas supply is fully contracted.3 3 If the gas supply is on a take-or-pay contract, marginal gas consumption is effectively at zero cost and gas plants would then be dispatched ahead of coal plants. - 41 - 2.48 The demand for gas-fired generation will grow steadily, by about 0.3 billion cubic meters a year. Load factors on new gas plants will be quite low at times, partly because of seasonal variations in demand and partly because of the lumpiness of investment and the drop in load factor that occurs whenever a new plant is built. To keep load factors high enough to justify the investment, investment should stay in step with the growth in demand and not aim for too high a share of gas in the overall mix. Still, combined cycle gas turbine plants are the least-cost choice. Adding a 150 megawatt steam turbine unit to convert a gas turbine to a combined cycle gas turbine saves about $35 million. Thus, over the medium term, most gas turbine plants should be converted to combined cycle mode. 2.49 At current and expected prices of gas and coal in Vietnam, combined cycle gas turbine plants in the south should be preferred over coal-based plants in the north. The costs of generation by gas- and coal-fired plants are fairly similar, however, and if the price of gas rises substantially it will be necessary to reappraise the least-cost mix of plants (although increasing coal's role would require investing in infrastructure to deliver coal to power stations in the south). Gas from the new pipeline will be needed for power generation soon after 2000. If there is a delay in commissioning the pipeline, some coal investments will need to be moved forward (although doing so would put a considerable load on the north-south transmission line). The alternative is diesel-fired generation, which is very costly-a one-year delay in the pipeline could incur $70-140 million in additional generation costs if diesel is consumed instead of gas or coal. Thus it is of crucial importance to avoid further delays. Transmission and distribution bottlenecks require a special focus as generation capacity is expanded in both the public and private sectors. 2.50 Despite having been raised a few times in recent years, tariffs remain below economic levels. There are several reasons Vietnam should both raise tariffs and restructure them in line with marginal costs. Economic tariffs set relative to the long-run marginal cost (and taking into account social and financial objectives) send the right signals to consumers and help ensure that resources are used efficiently. Average electricity prices need to be raised by about 30 percent to reach economic levels, which are estimated to be about 8 cents per kilowatt-hour. At this level the demand for electricity could be up to 1,720 megawatts lower, easing investment requirements (see chapter 1). Higher tariffs will also help Electricity of Vietnam reach financial targets, including an acceptable level of self-financing. Finally, a number of distortions in retail prices paid by different consumers, and between retail and bulk electricity prices, need to be addressed. 2.51 As noted, the Son La plant is the largest hydro plant option. Thus any decision on the plant should await a detailed study of its environmental and social implications as well an evaluation of alternative options for power supplies. Since the earliest commissioning date (based on electricity demand projections) is 2007, a decision needs to be made only by 2000. Longer-term expansion options will depend on domestic oil, gas, and coal discoveries and the possibility of imports from Lao PDR. 2.52 Estimated investment under the preferred scenario is substantial. Between now and 2005 about $3.8 billion will be required for generation and $4.0 billion for transmission and distribution. Achieving these targets will require an appropriate financing strategy (see chapter - 42 - 4). In the short and medium term, developing the power sector will require ensuring the availability of adequate fuel supplies and financial resources as well as making the institutional changes needed for expansion. Vietnam has extensive natural resources, but it needs a well- designed strategy for exploring and developing them. Upstream oil and gas 2.53 Vietnam's continental shelf remains largely unexplored relative to those of its neighbors, including China, Indonesia, Malaysia, and Thailand. Petrovietnam has made intense efforts to attract international oil companies to explore the country's sedimentary basins, and recent discoveries of commercial quantities of oil and gas have revived interest in exploration. Vietnam's oil and gas resources can help attract foreign investment and meet future energy demand. Crude oil exports are already the country's largest foreign exchange earner, and natural gas reserves provide an environmentally clean way to meet domestic energy needs and could lead to exports. 2.54 To fulfill the promise of its oil and gas resources, however, Vietnam must provide the right framework for private sector development (box 2.3). Fiscal incentives-such as acceptable fiscal terms in production sharing contracts-are needed to encourage hydrocarbon exploration and production. An efficient, transparent system is needed to oversee contracts and award acreage for exploration. And gas pricing policy must be made clear and consistent, and include special provision for marginal fields. Updating pricing and fiscal systems 2.55 The perceived potential of different oil and gas basins helps determine appropriate terms for exploration contracts. When considering investment in Vietnam, international oil companies compare it with opportunities elsewhere. In the case of gas they compare it with investments in other Southeast Asian countries. At this stage Vietnam cannot compete directly with its neighbors, which have much larger gas reserves. Still, it needs to develop competitive policies and fiscal terms to make itself attractive relative to countries with similar investment opportunities. To that end, in November 1998 the government improved fiscal incentives- including tax breaks-to encourage foreign investments in exploration in high-cost and technologically difficult areas. - 43 - d~~~~ ~ 2.56 Most production sharing agreements in Vietnam were formnulated with a view to oil exploration, and in most cases they do not cover natural gas production. Gas clauses are negotiated every time a new field goes onstream. The long-term development of the gas industry will be slowed if lengthy negotiations are needed every time a new field goes onstream, and investors will demand higher returns because of the uncertainty. 2.57 The government could allow producers and buyers to negotiate gas prices under a generic fiscal regime-based on a sliding scale formula, providing for a reasonable government take, and sharing risks-under a wide range of price scenarios. Subsequent gas fields could then be based on this formula. This strategy has been used successfully in Colombia, Thailand, and many other countries. Whatever the fiscal arrangements, the treatment of costs should be clarified for income tax purposes. Gauging hydrocarbon reserves 2.58 Vietnam has nine onshore and offshore basins. Significant discoveries of oil and gas have been made in five: Cuu Long, Nam Con Son, Malay-Thu Chu, Song Hong, and Hanoi Trough. The size and nature of the hydrocarbon discoveries suggest that the Cuu Long, Nam Con Son, and Malay- Thu Chu basins contain most of Vietnam's hydrocarbon potential. Still, the remaining basins may also hold commercial quantities of hydrocarbons; exploration has been too limited to gauge their potential. Since the early 1970s the accretion of hydrocarbon reserves has been directly proportional to the number of exploration wells drilled (figure 2.3). For each exploration well drilled, an average of 27 rnillion barrels of oil equivalent has been discovered. This trend is expected to continue over the next few years given low exploration coverage and the opening of new blocks in deepwater areas. -44- Figure 2.3 There is a close link between discovered reserves and exploration drilling 3500 30002- 2500 o 2000t 2 1500 1000 500- I 0 II 0 20 40 60 80 100 120 140 Exploration wells Discovered potential has not been fully appraised 2.59 All the discoveries in the Cuu Long basin have been oil, while those in the Nam Con Son and Malay-Thu Chu basins have been mostly gas (some of it containing high levels of liquids) and oil. In terms of barrels of oil equivalent, discovered reserves of oil exceed those of gas, so it would be incorrect to classify Vietnam as a gas province. Most of the discoveries are single-well accumulations or are not fully appraised. Thus there is considerable uncertainty in the resource estimates communicated by well operators-particularly for discoveries considered marginal at the current state of market and infrastructure availability. 2.60 The discovered fields in the Cuu Long and Nam Con Son basins potentially contain 2,000 million barrels of oil and 230 billion cubic meters of gas, of which about 60 billion cubic meters is associated gas from the Cuu Long basin (table 2.11 shows the remaining reserves).4 These figures are likely to change because some of the main oil and gas discoveries are still at an early stage of appraisal. Proven oil reserves are about half of their potential, and proven gas reserves are about one-third. The Bach Ho, Dai Hung, and Rang Dong fields account for most of the proven oil reserves, and Lan Tay, Lan Do, and Bach Ho (associated gas) contain most of the proven gas reserves. 4 According to Petrovietnam, aggregate reserves in July 1997 (with 90 percent probability) were 630 million cubic meters of oil, 130 billion cubic meters of associated gas, 910 billion cubic meters of nonassociated gas, and 150 million cubic meters of condensates. Petrovietnam did not, however, provide Bank staff with the data required to verify this information. - 45 - Table 2.11 Potential hydrocarbon reserves Liquids Gas (millions of barrels) (billions of cubic meters) Basin Oil Condensate Associated Nonassociated Nam Con Son 150 205 4 158 Cuu Long 1,300 40 Malay 70 13 Song Hong 200 a Other 2 Total 1,520 205 57 360 Note: Remaining discovered potential reserves as of December 31, 1997. a. This gas has a high carbon dioxide content (more than 75 percent). Source: World Bank staff estimates and Petrovietnam. Undiscovered potential merits exploration 2.61 Accurate assessment of Vietnam's undiscovered hydrocarbon potential is not possible because exploration has been limited in all the basins. Most blocks in the Song Hong basin and Red River delta, for example, are considered frontier acreage. Nonetheless, preliminary analysis of the hydrocarbon potential of the Nam Con Son and Song Hong basins was made based on the country's geology and exploration history, and on the size and nature of discoveries made to date. The analysis indicates that future oil and gas discoveries in the Nam Con Son and Song Hong basins will most likely have a reserve potential of some 520 million barrels of oil and 355 billion cubic meters of gas, in addition to the already discovered reserves. Gas from the Song Hong basin will likely contain a high percentage of carbon dioxide, requiring much higher development costs. 2.62 Between 80 and 100 wildcat wells will be needed to discover the speculative potential. Recent operations in the two basins suggest that such an exploration program would cost about $950 million. These wells could be drilled over the next seven years if the pace of development during 1990-96 were continued. An additional $7,850 million would be needed to cover the development of fields and infrastructure. (The underlying assumptions, distribution and size of expected discoveries, and capital layout for exploration and development of the undiscovered potential are described in volume 2 of this report.) 2.63 While nonassociated gas reserves of at least 50 billion cubic meters have been proven in the Nam Con Son basin, total potential resources remain uncertain. Only one-third of an estimated 1,300 billion cubic meters of gas resources have been discovered, and most of these are still unproven. Converting potential gas resources to proven reserves that can be exploited economically requires a major exploration and appraisal program-a program supported by government policy. - 46 - 2.64 What is needed to enhance discoveries? Internationally acceptable fiscal terms in production sharing contracts. An efficient, transparent system for award and operation of contracts. A well-planned promotion campaign. Exploration of 20 new wells a year. A policy directive requiring installation of a gas transport system to markets and open access to producers. And a clear, consistent gas pricing policy. Assessing hydrocarbon production 2.65 Most hydrocarbon production in Vietnam comes from the Bach Ho field, which is operated by Vietsovpetro. Other sources of oil production are the Dai Hung (operated by BHP Petroleum), Rang Dong, and Ruby fields and a small structure in the Malay-Thu Chu basin. Bach Ho provides most current production 2.66 Bach Ho is offshore in the Cuu Long basin, about 120 kilometers southeast of Vung Tau. It is the largest hydrocarbon accumulation discovered so far, with potential oil reserves of more than 900 million barrels. The field was brought onstream in 1986 and has produced 355 million barrels of oil and 8.7 billion cubic meters of raw gas. Daily production from the field is 160,000 barrels of oil and 3.8 million cubic meters of associated gas. 2.67 Part of the gas from the field is used to generate power in Ba Ria and Phu My through a 16-inch pipeline operated by Petrovietnam. The rest of the gas from the field is being flared. A central compressor platform was completed in 1998, extending the transmission capacity of the pipeline to aboutl.5 billion cubic meters a year. Oil and gas production from Bach Ho is expected to be maintained until 2001 but will then decline to half the current level by 2004-05 and to one-quarter by 2008-09. Potentialproduction is uncertain but promising 2.68 Future oil and gas production from discovered fields is estimated based on the reserves data and development schedules provided by various operators and Petrovietnam. Thus projections carry significant uncertainty because a number of fields are still at an early stage of appraisal. Preliminary analysis indicates, however, that oil production from the Cuu Long basin will peak at 125 million barrels a year in 2001-02 as Rang Dong, Ruby, and other fields go onstream (figure 2.4). Production from these fields is expected to be relatively stable until 2005 and decline thereafter, to 43 million barrels in 2010. - 47 - Figure 2.4 Oil production from the Cuu Long basin should peak early in the next century (millions of barrels) 140.0 120.0 100.0 -... 60.0 - 40,0- 20.0 0.0 N cr o o oo - cl o. o, o 0 o 0 0 - o o O\ O~ 0 0 0 CD0 0 CD0 - - e-S c q C4 lN B Bach Ho a R Dong El Ruby jI Others* Source: Mission Estimates 2.69 Most associated gas production will come from the Cuu Long basin as well (figure 2.5). Annual production will increase from about 1.4 billion cubic meters in 1998 to more than 3.0 billion cubic meters in 2001-02. After that associated gas production from the Cuu Long basin will fall to about 1.0 billion cubic meters by 2010. Projected associated gas production is estimated potential; delivering these resources will require significant additional investment in offshore structures, compression, and pipelines. 2.70 The production potential of nonassociated gas from fields in the Nam Con Son basin was estimated for structures in blocks 5.2 and 6.1, essentially from discoveries made on British Petroleum, Oil and Natural Gas Corporation of India, and Statoil acreage (Lan Tay, Lan Do, Hai Thach). Assuming a normal rhythm of depletion, production of nonassociated gas from these blocks could reach 4.5 billion cubic meters a year for about 15 years (see figure 2.5; see also volume 2). Actual production will depend on the demand. Potential production from all discovered fields, such as Rong Doi and Moc Tinh in the same basin and from the Malay-Thu Chu basin, is much higher. - 48 - Figure 2.5 Nam Con Son and Cuu Long show great potential for gas production (billions of cubic meters) 8 7 r lok.1 _ M4 6 O thber 5 5aang Dong ill 3 2 0 Note: Blocks 5.2 and 6.1 are in the Nam Con Son basin; the remaining fields are in the Cuu Long basin. 2.71 Gas production potential from future discoveries is obviously speculative. It will depend on how the domestic demand for gas develops, which will determnine the pace of exploration, and on how soon future discoveries are developed and brought onstream. Preliminary estimates of production potential from future gas discoveries in the Nam Con Son and Song Hong basins are provided in volume 2. Priority should be given to developing gas resources 2.72 The proven and probable associated and nonassociated gas reserves from the Nam Con Son and Cuu Long basins are estimated at 140-170 billion cubic meters and, if fully developed, would have production capacity of 7-8 billion cubic meters a year. Such capacity would be sufficient to meet the projected demand in the south for at least the next 1 0 years (see figure 1.4) while appraisal of other discovered but unproven reserves and exploration for new resources continue. Development of gas from the two basins must be integrated and balanced to ensure that the required gas is delivered and to avoid excessive flaring of associated gas. Although the projected production of associated gas is significant, it does not provide sufficient guarantee of long-term regular supplies. This is because associated gas production is tied to oil production, and part of the gas will likely need to be reinjected to enhance the recovery of oil. 49 - 2.73 A balance between supply and demand has been worked out based on the most likely projection of gas demand and assuming that the deliverability of associated gas from the Cuu Long basin is not constrained by infrastructure availability. Two scenarios are considered: * Associated gas potential from Bach Ho, Rang Dong, Ruby, and other (smaller) discovered fields is fully developed. This scenario assumes that 80 percent of the raw gas produced from the larger fields (Bach Ho and Rang Dong) and 60 percent of the gas from the smaller fields would be available as sales gas. (Some gas is lost to shrinkage, internal consumption, and flaring.) The resulting balance indicates that the supply of gas from the discovered reserves in the Nam Con Son basin would be needed from 2002 to meet the projected demand. * Associated gas is available only from Bach Ho. Associated gas from the other structures would either be required for reservoir purposes or may be uneconomical to develop. Under this scenario the additional supply of nonassociated gas from the Nam Con Son basin would be needed as early as 1999 to meet the projected demand. 2.74 Top priority should be given to developing nonassociated gas from Lan Tay and Lan Do-which account for most of the proven reserves in the Nam Con Son basin-as more gas supply is needed to meet demand. Both structures offer readily deliverable reserves and low field development costs. Production potential for Lan Tay and Lan Do is estimated at 2.6 billion cubic meters a year for 15 years. Developing these structures would lay the foundation for exploiting other gas resources in the basin. Comparable production potential is expected from unproven discovered reserves in nearby structures, now under appraisal. 2.75 Recent discoveries in the Malay-Thu Chu basin have raised optimism about future gas production in this basin. There have been no commercial discoveries in the Song Hong basin, however, and future gas production there will depend on the pace of exploration activities. This, in turn, will be determined largely by international perceptions of deeper horizons and market opportunities for gas. The slow pace of exploration and limited interest of international oil companies suggest that gas supply from the Song Hong basin is unlikely in the coming decade. Planning investment through 2002 2.76 Developing associated gas reserves from the Cuu Long basin will cost $500 million (including facilities for liquefied petroleum gas but excluding exploration costs; see volume 2).5 It is assumed that associated gas from the various fields will be combined at an optimal location, where it would be processed and compressed to pipeline specifications. Development cost estimates for associated gas take into consideration the construction of a second pipeline from the aggregation point to shore in Ba Ria, but not the already constructed pipeline from the White Tiger field to Ba Ria. 5 The investment costs in this section were estimated in October 1997. Lower oil prices in 1998 reduced investment activity in the sector, significantly lowering investment costs. Costs will continue to fluctuate, reinforcing the need for Petrovietnam and the government to keep the fiscal terms for exploration and development activities under constant review. - 50- 2.77 Developing nonassociated gas from block 6.1 (Lan Tay and Lan Do) of the Nam Con Son basin will cost $865 million (including construction of a 380 kilometer pipeline but excluding exploration costs; see volume 2). Developing block 5.2 (Hai Thach) would cost $715 million (including a 40 kilometer pipeline but excluding exploration costs). 2.78 Over the next 10 years about 90 exploration wells will be needed to discover the speculative potential. Recent operations in the two basins suggest that such an exploration program would cost more than $950 million. The wells could be drilled over the next seven years if the pace of development of 1990-96 were continued. An additional $7,800 million would be required to cover the development of fields and infrastructure (table 2.12). Table 2.12 Upstream oil and gas investments, 1998-2002 (millions of U.S. dollars) Investment Cost Developing known discoveries of nonassociated gas 865 Developing known discoveries of associated gas 500 Exploring speculative resources (drilling and seismic) 950 Developing new discoveries 7,800 Total 10,115 Note: It is considered crucial to develop known discoveries of nonassociated gas. Cost estimates are as of October 1997. Source: World Bank staff estimates. A strategy for the upstream oil and gas sector 2.79 Despite discoveries of large oil reserves in the Cuu Long basin, Vietnam is known primarily for its gas resources. Apart from Bach Ho, most oil finds have been small or medium- size, and data on discoveries are insufficient-particularly in frontier areas. The challenge over the next 10 years will be to provide sufficient incentives and policy measures to induce international investment in exploration and development of oil and gas resources. 2.80 Several steps should be taken to increase international investment in exploration. Exploration should be continuously promoted; doing so will require giving foreign companies easy access to data and streamlining and clarifying procedures for contract evaluation and award. The government could create an independent body to manage data and promote exploration. A promotion campaign could, for example, offer exploration acreage to operating companies, with the areas offered a combination of low- and high-risk exploration. Fiscal terms should be reviewed periodically to keep investment in exploration and development in Vietnam competitive with other countries. 2.81 By 2001-02 associated gas production could reach 3 billion cubic meters a year. Making this gas deliverable, however, will require significant additional investment in offshore - 51 - structures, compression, and pipelines. Moreover, the projected production is unlikely to provide sufficient guarantee of long-tern regular supplies. 2.82 Similarly, marginal oil field development will require constructing pipeline and platform infrastructure with adequate capacity for future expansion. Early or floating production systems may generate early cash flows for parties to production sharing contracts, but the government needs to ensure that associated gas is not flared for lack of advance planning. 2.83 Because it will take about 24 months to bring the first Nam Con Son gas onstrearn, an agreement to develop nonassociated gas from Lan Tay and Lan Do should be considered an urgent priority, as these supplies are needed to meet demand for gas in the power sector. Simultaneous development of gas reserves from Cuu Long could take place but would not provide sufficient guarantee of long-term supply. Downstream oil and gas 2.84 The significant nonassociated gas discoveries in the Nam Con Son basin give the government an opportunity to develop a new industry based on gas. Associated gas in the Cuu Long basin (from the Bach Ho field) is produced by Vietsovpetro. Petrovietnam receives the gas offshore at no cost and transports it onshore through its pipeline, and the gas is consumed in the Ba Ria and Phu My 2.1 power plants. Nonassociated gas production in the Nam Con Son basin is planned by the private sector (Oil and Natural Gas Corporation of India, British Petroleum, Statoil). A consortium of producers and Petrovietnam plan to transport the gas through a pipeline and process it at an onshore delivery point. Petrovietnam is planning a gas distribution center to receive and distribute the gas at the Phu My power plant and a pipeline to extend gas distribution to Ho Chi Minh City. 2.85 To initiate and develop the gas market, the government appointed Petrovietnam as an exclusive gas trader in August 1996. But sustainable development of the country's gas resources will require an appropriate gas policy and industry structure. This section outlines an approach to developing the gas industry that could attract financing, increase efficiency, provide reasonable quality and prices for consumers, and reduce policy and market risk for private investors. Developing the gas market 2.86 Over the short and medium term the power sector will be the main market for gas in Vietnam. Associated gas from Bach Ho is consumed in the Ba Ria and Phu My 2.1 power plants, and most nonassociated gas from block 6.1 will be used for power generation as well, in the Phu My 1, 2, and 3 power plants. Subsequent phases of gas market development will also focus on demand from the power sector, as described in the first section of this chapter. 2.87 In addition to the planned uses for gas in electricity generation-including in existing power plants, replacing fuel oil with a potential 0.5 billion cubic meters a year-there is a market for gas in industry. Plans for fertilizer and methanol production, among other industrial - 52- uses, have surfaced. Such industries could consume an additional 1.5-2.0 billion cubic meters of gas each year. Moreover, there is potential demand in industries located near the planned extension of the gas transmission and distribution system beyond Phu My and toward Ho Chi Minh City. This demand, now being analyzed by Petrovietnam's gas company, is estimated at 0.7 billion cubic meters. Thus there is considerable potential for gas market growth. The move to market can be gradual 2.88 It is possible to create a gas market structure that permits an early start to the first gas project and gradually moves to a competitive market system (box 2.4). The gas trader (Petrovietnam) can retain exclusive rights to buy and sell gas to all consumers during the market creation stage, and exercise an option to serve 70 percent of large consumers during the market development stage. To give production sharing contractors adequate incentives to continue exploration and investments (both upstream and downstream), they should have direct market access for at least 30 percent of their discoveries and production. The government would retain the option of changing arrangements during the mature market stage based on the experience in the first two stages of gas market development. ft.. ; ;AecIw-d re .<ted*-tEa inito deeiduotats in the No 9~rwett r&d teri~tart . .... ... . "btAbu i itts oesbyI99Oie lie N&~~ (0koflg ins ~ir:f rdc-n i~~~~~~~~~~~~~~hd~adTi Ah Dan Tien, Tha Mo m the I ~ ~~ S%2re~~~~~fJotaIl,3 3.6 Though Vietnam is implementing environmental management programs, it will be some time before effective regulations and monitoring are in place. Through 2002 efforts will likely focus on building institutional capacity and on implementing or correcting regulations on pollution and environmental management. During 2003-07 these regulations should start being enforced in high-priority areas. 3.7 In the modem energy sector, implementation efforts will focus on supply-side management of readily identifiable and easily contained environmental imnpacts. Examples include watershed management (because it affects hydroelectric planning) and particulate emissions from thermal plants. Surface disruption by coal mines is also a high priority, but it will be addressed more slowly. Site-specific water pollution from energy investmnents and air pollution from sulfur, nitrogen oxide, and volatile organic compound emissions appear to be a lower priority, yet they are expected to be addressed by 2002 because they can be bandied using straightforward control technologies. Widely dispersed water pollution (such as from coal transport, oil tanker traffic, or oil spills) is a lower priority and will be difficult to address. - 77 - 3.8 In the traditional energy sector, the main concern is that fuelwood accounts for an estimated 85 percent of residential energy consumption. Implementation efforts have focused on promoting a sustainable supply of fuelwood and on substituting away from it. Mixed progress is being made on both fronts. Implementation of sustainable use programs has been hampered by inadequate assessment of priorities and institutional weaknesses in project delivery. Other efforts have focused on demand-side management: sales of fuel-efficient stoves are on the rise in Hanoi. And while there have been no explicit studies, increased electrification throughout the country is likely having an effect on traditional energy use. The cumulative effect of all these programs is best illustrated by the general decline in traditional energy use per capita. Between 1990 and 1995, when the population grew by almost 12 percent, the gross output of fuelwood dropped 7 percent. Most of this decline occurred in the south, where substitutes have been more readily available. Continued expansion of modem energy supplies, coupled with attention to demand management programs, will allow such trends to continue. Environmental responsibilities are widely dispersed 3.9 Two ministries are responsible for environmental management: the Ministry of Sciences, Technology, and Environment and the Ministry of Planning and Investment. Within the Ministry of Sciences, Technology, and Environment the National Environmental Agency takes the lead on environmental management and implementation issues. In the Ministry of Planning and Investment the Department of Sciences, Technology, and Environment oversees environmental issues within national development plans and budgeting exercises. Provincial offices of the department are responsible for planning. 3.10 Only in Ho Chi Minh City and Quang Ngai province have responsibilities for environmental management been given to local environmental committees. Line ministries (Agriculture, Fisheries, Industry) and government corporations are responsible for implementing the parts of the environment law that affect their sector. Few big state-run corporations have environmental management divisions or sections; most have fewer than three people working on environmental and safety issues. 3.11 In addition, a number of agencies have been established with specific environmental mandates. Most involve research and development and a monitoring network. The network, established in 1995, has several regional and thematic stations. It is intended to monitor changes in environmental quality, provide annual environmental data for the government and for national environmental management, and foster participation in regional and global environmental monitoring systems. 3.12 Energy sector links. The Ministry of Industry has not issued any laws, regulations, or standards related to environmental protection in the energy sector. All companies and units of the ministry follow the Law on Environmental Protection and the standards issued by the Ministry of Sciences, Technology, and Environment. There is no unit within the Ministry of Industry responsible for coordinating environmental management of the energy sector. - 78- 3.13 The Center of Chemical Safety and Environment (in Hanoi) and the Center of Industrial Environment (in Hanoi) share oversight duties for all industrial activities, including energy. Both agencies were established recently, however, and lack staff and equipment. Within Petrovietnam, the Center for Safety and Environment (in Ho Chi Minh City) addresses environmental matters; it is better equipped with field survey equipment and laboratory facilities. All these agencies are research and development institutions, however, and are not directly responsible for environmental management. Environmental planning capacity also exists within the Institute of Energy (in Hanoi), which regularly applies its own and external environmental expertise in feasibility and planning studies. 3.14 Recommendations. The organizational infrastructure for environmental management in Vietnam is typical of a transitional structure. Such a structure arises when environmental management tasks are being introduced in a country, and when such tasks initially are situated within existing institutional structures. While such structures can persist indefinitely, there are potential areas for improvement and reform: * Granting greater autonomy to the National Environmental Agency. The National Environmental Agency does not have the power to fulfill its mandate of implementing all environmental laws. Because it is only a subunit of a ministry, it has limited enforcement capabilities, budgetary resources, and jurisdiction over other ministries and state organizations. One way to increase autonomy would be to establish the agency as a general department belonging directly to the government, or as a separate ministry. Discussions on this topic are under way. * Strengthening provincial departments of sciences, technology, and environment. Except in Ho Chi Minh City and Hanoi, provincial departments of sciences, technology, and environment have just three to six employees working on environmental management. Most are young university graduates with degrees in science or engineering; few have long-term training or experience in environmental science and technology. Moreover, laboratory equipment and data handling facilities are limited, as are funds for routine inspection and monitoring. Thus these units are incapable of fulfilling their environmental management functions. * Strengthening environmental units in state corporations. Capacity in the environmental units of state corporations is weak. These units would benefit from strengthening similar to that given to provincial departments of sciences, technology, and environment. * Rationalizing institutional responsibilities. Overlaps and gaps persist among environmental agencies, leading to unclear jurisdictions. The National Environmental Agency is responsible for monitoring air, water, and soil quality. But the General Department of Meteohydrology is also responsible for monitoring air and water, the Ministry of Agriculture and Rural Development has a mandate to manage water and soil resources, and the Ministry of Health has a mandate in sanitary and environmental health. This overlap makes management systems inefficient-monitoring the environmental impacts of a single hydropower plant, for - 79 - example, requires several agencies. Many cross-sectoral issues can be addressed by using compensation payment systems and creating strong district-level planning institutions. This appears to be the intent of most policies, but establishing such institutions takes, at best, 10 to 15 years. * Increasing reliance on spatial planning. Most institutions are structured by sector. This setup creates problems for environmental management because there is little opportunity for planning in areas of multiple interest-particularly for coastal areas, watersheds, and airsheds. Establishing authorities that are responsible along "spatial" lines would lead to more rational implementation of pollution standards and control measures. Laws and regulations for energy are somewhat inconsistent 3.15 Environmental impact assessments. Environmental impact assessments began in 1984. By 1997 nearly 42,000 environmental audits had been prepared, of which 3,400 were formal environmental impact assessments. Environmental impact assessments of energy projects have generally followed Vietnamese regulations or those of donors such as the World Bank or Asian Development Bank. Assessments of offshore oil exploration projects have been implemented by foreign companies in cooperation with Petrovietnam. 3.16 Environmental impact assessments of thermal power plant projects were recently completed at Pha Lai, Phu My, and Quang Ninh. An assessment of the Omon thermal power plant is under way and is expected to be completed by 1998. And preliminary assessments have been completed for the main hydropower schemes in the near-term development plan (Song Hinh, Yaly, Ham Thuan, Da Mi), as well as for some that are not scheduled to come on line until after 2003. A preliminary assessment of the largest energy project in Vietnam-the Son La project-has been completed but will require more complete survey work as the project design proceeds. 3.17 Liquid and solid wastes. No specific standards for liquid and solid wastes are applied to energy projects, but all projects must comply with general standards for industrial projects. Industrial standards, similar to those in other countries in the region, have been established for a wide range of wastes. One exception is that, for water-borne effluents, the Ministry of Sciences, Technology, and Environment drafted specific standards for thermal plants in 1996. These standards are consistent with international best practice in thermal power plant design. No enforcement mechanisms are in place for the standards, however. 3.18 Oil spills. Legislation on oil spills classifies them as "accidents or mishaps" rather than as a regular or preventable source of pollutants. This categorization places oil spills on par with natural mishaps (such as storms, floods, or earthquakes) and a small number of other calamities (such as nuclear reactor leaks). As a result policies do not pay much attention to prevention, and the effort that are made focus on emergency response. To date, no substantial punitive or compensatory fines have been levied for any of the oil spill damage along Vietnam's coasts. - 80 - 3.19 Air quality. Air quality is regulated using ambient air quality standards and mobile source standards. Emission standards for stationary sources distinguish between the age of the source and the plant location. Mobile source emissions are unregulated, though the Law on Environmental Protection provides mechanisms for such regulation. 3.20 Ambient air standards cover sulfur oxide, particulates, nitrogen oxide, lead, carbon monoxide, and ozone. These standards are comparable to those in many industrial countries. Given the potential costs and benefits of achieving these standards, there is some question about whether they will be enforceable. 3.21 The regulations for stationary source emissions that are of greatest interest to the energy sector include those for sulfur oxide, nitrogen oxide, particulates, and carbon monoxide. In principle these standards apply to all stationary sources, but they are targeted at power generation. Sulfur oxide standards are comparable to those in industrial countries, but they are not sensitive to project size or fuel type, and the legislation provides no exceptions to these standards. Similarly, particulate standards in most industrial countries are site specific and sensitive to the type of project being operated; this philosophy is not reflected in Vietnam's standards. Moreover, particulate standards are somewhat more lenient than those elsewhere in the region. Vietnam's standards for nitrogen oxide are notable because they are considerably more lenient than those in other jurisdictions-despite the fact that, for new plants, these emissions are the least costly to control. 3.22 Motorcycles, three-wheel vehicles, buses, and trucks are the main motor vehicles in Vietnam. Many are old, of Eastern European design, and not well maintained. As noted, mobile emissions are not regulated. Thus there may be substantial increases in emissions as Vietnam develops and shifts to greater automobile use. Lead is the greatest concern. Lead content in gasoline is unregulated, and Vietnam has the most lenient ambient air quality standards for lead in the region. Yet the health effects of lead emissions have been well documented in other countries, and they appear to be relatively high in Vietnam. Monitoring of particulates (of which lead is an element) indicates that permissible limits were exceeded in 9 of 27 monitoring stations in Ho Chi Minh City in 1994. In Hanoi carbon monoxide and nitrogen oxide levels were about twice the permissible levels in heavy traffic areas, and particulate levels were 5 to 60 times permissible levels. 3.23 The health effects of this pollution are poorly documented and not well understood in Vietnam. Work conducted in 1991 by the Ministry of Public Health showed, however, that respiratory infections were a major problem: in three provinces more than one in four patients were being treated for respiratory diseases. Addressing mobile source pollutants effectively will require a long-term, multitiered approach that pays heed to the age of vehicles, the expense of fuel switching, and the need to build awareness among the public and policymakers. Vietnam lags behind other countries in the region in this area. Malaysia and the Philippines, for example, have introduced lead phaseout programs-with impressive results (box 3.2). - 81 - 3.24 Prices and taxes. Pricing structures in the energy sector are expected to undergo substantial reform with continuedt liberalization. Such reforms will likely have two main environmental ramifications. First, deregulating product prices and increasing power tariff-, to the long-run marginal cost-as advocated elsewhere in this report --will likelv lead to miore efficient energy, with less waste and fewer emissions. 3.25 Second, deregulating gasoline and diesel prices may create a distortion. Increases in diesel taxes will remove the efficiencv distortions that now exist with g,asoline. But this move may increase lead emissions (from gasohni-e) relative to sulfuir emissions (from diesel). This will likely have a moderately negative effect, because lead imipacts are cumuilative and more likely to be chronic, while sulfur impacts are more likely to be acute. The limited monitoring that has been done of these pollutants at street level in Hlo Chi Minh City, however, shows that both are a problem. In an; case, the hugle inicreases in denanid expected for both products will likelv overshadow any relative price effects. Thus the best long-term strategy would be for the government to change fuel specifications for these products. - 82 - Pricing the environmental impacts of energy projects 3.26 The environmental and economic implications of the various regulations are complex, and many of their indirect effects are difficult to predict. In general, however, environmental management will have one of the following effects on individual project economics: * The project is stopped or redesigned because of its environmental impacts. * The project incurs nondiscretionary costs to prevent environmental impacts. * The project incurs nondiscretionary costs to offset the economic losses associated with its environmental impacts. . The project incurs discretionary investment costs to ensure that it is not threatened by environmental degradation. * The project implements environmental controls that provide a direct financial return by increasing energy efficiency or improving operations. 3.27 Most economic implications will fall into one of the last four categories. Experience with environmental impact assessments suggests that there are adequate opportunities for project proponents to design-or redesign-projects to meet standards. 3.28 Two models were developed to demonstrate the incremental costs of environmental controls: a baseline plan reflecting best operating practice, encompassing environmental investments that would normally be built into project design; and an "environmental alternative" plan with incremental costs to meet higher standards. The environmental alternative plan includes measures to control pollution and to protect the environmental integrity of hydroelectric watersheds. 3.29 The baseline plan is largely reflected in the WASP models described in chapters 1 and 2. Both the base case and high-growth scenarios include best available technology for treating water, removing particulates, and reducing nitrogen oxide emissions. The WASP models assume that no specific controls will be put in place for sulfur emissions. Because this will probably cause sulfur emissions to exceed current guidelines, a sensitivity case was developed for the baseline plan to demonstrate the additional control costs of meeting this strict standard. Natural gas offers environmental benefits 3.30 Extensive use of natural gas in energy development offers several environmental benefits. Gas has fewer environmental externalities during production, transportation, and consumption than fossil fuels, especially coal and oil products. Particulate emissions are lower, which is of local concern, as are carbon emissions, which affect the global climate. And recovering natural gas that would otherwise be flared or vented during petroleum production reduces greenhouse gas emissions. Thus natural gas poses no incremental environmental costs. - 83 - Oil spills should be better contained 3.31 The main environmental costs associated with oil exploration, development, and production are those associated with oil spills. Vietnam recently reorganized the institutions responsible for responding to oil spills, but oil spill contingency planning remains a low priority. Why? Most of the marine pollution from oil exploration and development comes from organic wastes, not oil spills. All the oil traces that have been analyzed on Vietnam's beaches are caused by leaks from tankers that are not carrying Vietnamese crude. And modest (but inadequate) investments in oil spill containment equipment have been made. 3.32 Yet oil spill containment efforts require considerable upgrading. Facilities are understaffed and containment equipment is not readily available. No detailed costs have been estimated for implementing a full oil spill contingency plan, or for funding preventive measures. Surveys elsewhere in the region suggest that such costs are about 5 percent of investment costs for offshore exploration, development, and production, and can approach 10 percent if such activities occur near environmentally sensitive areas such as coral reefs or mangroves. Under the environmental alternative plan such costs would be incurred by operating companies. Protection efforts willfocus on new mines 3.33 The issues associated with coal supply primarily involve rehabilitation costs for existing mines and rehabilitation and reclamation costs for new mines. Environmental policy is expected to focus on reclamation standards; current and pending regulations do not effectively address water-borne pollution. 3.34 Open-pit mines in the north have caused extensive coal dust pollution and surface disruption- largely because environmental management has been neglected. Mines are not backfilled, topsoil is not reserved, and no attempts are made to replant or reclaim the disturbed areas. Some 2,016 hectares of land has been disturbed by mining operations, and indiscriminate piling has resulted in the accumulation of more than 100 million cubic meters of overburden. Simply backfilling this overburden would cost nearly $200 million. 3.35 Given that topsoil has not been reserved, it is uncertain whether reclamation and revegetation to an economically productive soil class is technically feasible. Even if it were, reclamation costs would exceed $100,000 per hectare. Such an investment would not be financially warranted given that productive land in these areas provides a maximum net return of $1,000 a hectare each year. In short, although past development may have caused substantial enviromnental devastation, replacing all of the removed overburden should not be considered unless a highly productive land use can be identified. 3.36 The situation for developing new mines or extending existing mines is different. With proper mine planning, topsoil can be reserved, overburden can be disposed in previously mined areas, and reclamation programs can be established. Regulations requiring such practices are included in the 1996 Mineral Law and in the environmental impact assessment procedures set by the Ministry of Science, Technology, and Environment. Under the environmental alternative - 84 - plan the incremental costs of this type of mine management are modest. A full cycle in such a mine plan will include the following incremental costs: reserving topsoil at the beginning of mine life ($5,000 a hectare), paying compensation for lost output during mine life ($1,000 a hectare a year), replacing topsoil at the end of mine life ($5,000 a hectare), and revegetating at the end of mine life ($500 a hectare). For new mines the incremental supply costs are estimated at $0.74 per ton of clean coal. 3.37 For existing mines on which only compensation needs to be paid-including the Nui Hong, Khanh Hoa, and Na Duong mines-the supply cost is about $0.50 per ton of clean coal. Selected mine characteristics are summarized in table 3.1, which shows the extent of disturbed area. Although total mine-mouth capacity is uncertain, for estimating purposes it has been assumed that production from open-cast mines will approach 10 million tons a year. Thus incremental costs under the environmental alternative plan would be about $7 million a year. Table 3.1 Disturbed area and production of coal mines Disturbed area Annualproduction Averageproduction Mine (hectares) (thousands of tons) (tons per hectare peryear) Cao Son a 405 715 1.77 Coc6 a 305 1,511 4.95 Deo Nai a 335 500 1.49 Hatu a 615 924 1.50 Hon Gai - 116 Khanh Hoa 61 85 1.39 Na Duong 115 125 1.09 Nong Son a 25 25 1.00 Nui Beo a 105 175 1.67 Nui Hong 50 110 2.20 Total 2,016 4,286 2.13 a. Existing mine on which it is not necessary to pay compensation. Source: Mission estimates Hydro projects require careful planning 3.38 Hydroelectric projects are expected to be an important component of Vietnam's generation capacity. The proposed Son La project, 200 kilometers upstream of Hoa Binh, would provide an additional 3,600 megawatts of capacity on this river system. In addition, the proposed Yaly project in the central region would provide 720 megawatts of capacity at a strategically important location. Both projects offer environmental benefits-and impose costs. Preliminary environmental impact assessments have been conducted that allow the incremental costs for these projects to be estimated, but there has been no comprehensive study of their benefits. 3.39 The potential downstream benefits from hydroelectric facilities are evident from the sporadically collected data that are available. All such dams increase downstream water flows in the dry season and decrease them in the wet season. At Hoa Binh, for example, flooding prior to dam completion typically destroyed 800 hectares a year of rice, maize, and other short-term crops. Erosion from the flooding caused permanent losses of up to 50 hectares of crop land a year, and more than 3,000 households were temporarily displaced during the flooding season. - 85 - Similar benefits from reduced crop, land, and infrastructure losses were evident after the completion of the Tri An dam in south Vietnam, as were notable improvements in drinking water quality. 3.40 Resettlement is the main environmental cost associated with hydroelectric projects. Past resettlement programs were not always well implemented, and current resettlement programs do not have enough money to provide needed land and infrastructure-forcing displaced families to use slash and bum methods in forest areas. Typical budget allocations are $500 per family, but the amount required for proper resettlement and stabilization is on the order of $1000 per person. Resettlement funding will be important for major projects such as Yaly (affecting 4,400 people), Dong Nai 8 (10,000 people), and Son La (112,000 people). 3.41 The second environmental cost relates not so much to the environmental impacts of hydroelectric projects but to the effects upstream environmental degradation has on the projects' long-term integrity. Specifically, sedimentation will be a growing problem if vegetative cover in upstream watersheds is not maintained. Detailed sedimentation studies of most proposed hydroelectric projects have commenced, and catchment basin management is an active area of study and programming. 3.42 Environmental costs for all the near-term (within five years) projects and some larger long-term projects are provided in table 3.2. These estimates are based on characteristics of the areas to be flooded and catchment basin areas, and on the population residing in the flooded areas. Under the baseline plan meeting anticipated regulatory requirements would require more than $86 million in capital outlays for resettlement and more than $40 million a year in compensation payments. 3.43 The environmental alternative plan, which provides for watershed protection and management, would require at least $750 million in capital outlays and more than $72 million a year for compensation and watershed management. These costs exclude watershed protection costs in China on the River Da watershed (to protect, in particular, the Hoa Binh and Son La projects); those costs are estimated to be an additional $350 million in capital outlays and $30 million a year in management costs. - 86 - Table 3.2 Incremental investments in hydroelectric plants required to meet environmental standards (millions of U.S. dollars) Baseline Environmental alternative Capacity Resettlement Compensation Investment Recurrent Plant (megawatts) (per year) (per year) Short-term projects (through 2002) Song Hinh 70 0.50 2.75 15.00 1.00 Yaly I and2 720 3.00 5.00 120.00 10.00 Ham Thuan 236 0.00 2.50 20.00 1.75 Da Mi 236 0.00 0.25 20.00 1.75 Total 3.50 10.50 175.00 24.50 Long-term projects (2003-1 0) Dai Ninh 300 - - - - Sesan 3 and 4 586 - - Dai Thi 250 - - - - Buon Kuop 85 - - - - Thuong Kon Tum 260 - - - Plei Krong 120 - - - Ban Mai 350 - - - A Vuong 145 - - - An Khe 350 - - - - Dong Nai 8, 3/4 340 8.00 0.40 125.00 13.00 Son La 3,600 75.00 30.00 450.00 35.00 a Total >83.00 >30.40 >575.00 >48.00 a - No estimate is available because the environmental impact assessment is incomplete or has not commenced. a. Excludes China. Costs in China are estimated to be an additional $350 million in investment and $30 million a year in recurrent expenditures. Thermal plants need better emission controls 3.44 The main environmental issues associated with thermal electricity generation are water treatment and particulate, nitrogen oxide, and sulfur emissions. The top priority for the Vietnamese is to limit particulate emissions from coal-fired facilities. There has been no systematic collection of emission data, and there are no monitoring facilities to measure emission levels or ambient concentrations. Sporadically collected data, however, give an idea of some of the more serious environmental problems. 3.45 Nitrogen oxide and sulfur emissions are not considered a problem. Low-sulfur fuels are used in most thermal applications, and sources of nitrogen oxide have been too few or too scattered to contribute to ground-level ozone. But this pattern will likely change in urban areas and heavily industrial areas. And even plants using low-sulfur fuels will likely exceed current emission standards without further controls. Thus some of the plans discussed here show the costs of meeting these stricter standards. - 87 - 3.46 Potential environmental investments include technology for treating water and reducing particulate, nitrogen oxide, and sulfur emissions. Planning assumptions are plant and site specific. All new coal-fired plants will require water treatment and particulate controls, and larger facilities should reduce nitrogen oxide emissions. Investment under the baseline plan would be $216 million under the base case scenario and $480 million under the high-growth scenario (table 3.3; see also chapters 1 and 2). The environmental alternative plan would cost $333 million under the base case scenario and $740 million under the high-growth scenario. Table 3.3 Incremental investments in thermal plants required to meet environmental standards (millions of U.S. dollars) Capacity Baseline Environmental Environmental Plant (megawatts) plan alternative plan alternative + plan PhaLai 2.1/2 600 72 111 201 Quang Ninh 1-4 1,200 144 222 402 New coal plants 2,200 264 407 737 Totals Base case scenario 1,800 216 333 603 High-growth scenario 4,000 480 740 1,340 Note: The baseline plan covers minimum investments, including particulate control and water treatment or recycling. The environmental alternative plan includes particulate control, water treatment or recycling, and nitrogen oxide controls. The environmental alternative + plan includes particulate control, water treatment or recycling, nitrogen oxide controls, and sulfur emission controls. Incremental control costs are estimated to be $120 per kilowatt for particulate and water controls, $65 per kilowatt for nitrogen oxide controls, and $150 per kilowatt for sulfur controls. Under the base case scenario Pha Lai 2.1/2 is commissioned in 2000-01 and Quang Ninh 1-4 is commissioned in 2000-06. The high-growth scenario is the same but also includes new coal plants-including PC2. P. Thiet and three other units-by 2010. 3.47 Controlling sulfur emissions would cost an additional $270 million under the base case scenario and $600 million under the high-growth scenario-or more than $2,000 per ton of sulfur abated. Although no specific studies have been conducted for Vietnam, studies elsewhere in the region (for example, in the Philippines) show that benefits are typically $200-$500 per ton of sulfur abated. Thus in Vietnam the benefits of abatement will rarely warrant the application of strict sulfur standards. Environmental protection is affordable 3.48 The cost estimates for the environmental alternative plan illustrate the direct costs of implementing environmental controls after the power system has been optimized. This approach reflects planning arrangements in Vietnam, where efficient delivery of power is a top development priority. Within the power sector, for example, this approach has incremental costs (above the baseline scenario) of $780 million in investments and $32 million a year in recurrent costs (table 3.4). With project scheduling, this is less than $1 billion in present value terms. To put this in perspective, the net present value of the system plan to 2010 exceeds $60 billion. Thus environmental costs, even under the environmental alternative scenario, are less than 2 percent of total investments. - 88 - Table 3.4 Environmental costs under the base case scenario(millions of U.S. dollars) Sector Baseline plan Environmental alternative plan Natural gas 0 0 Petroleum 0 5-10% of supply costs Coal 0 7 a year Hydroelectricity 86, 750 + 40 a year + 72 a year Thermal electricity 216 333 Total 302, 1,083 + 40 a year + 79 a year Source: Mission estimates 3.49 A different approach can be taken to estimating environmental costs, however. One can assume that the system plan must be constrained to meet a given environmental target, and that this constraint can only be realized by substituting fuel choices and scheduling power plants designed for such fuels. For example, substituting hydroelectric projects for coal projects would reduce sulfur emissions. 3.50 The Vietnam Institute of Energy undertook such an analysis. It found that sulfur emissions could be cut by 15 percent at a present value incremental cost of $217 million, nitrogen oxide emissions could be cut by 10 percent at a present value incremental cost of $205 million, and greenhouse gas emissions could be cut by 4 percent at a present value incremental cost of $1,006 million. The costs of reducing sulfur and nitrogen oxide emissions are higher than would be required for simple technological interventions at thermal plants themselves. Thus it is not considered cost-effective to adjust the system plan to meet emission targets. A strategy for environment-friendly energy 3.51 The government of Vietnam is committed to minimizing adverse environmental impacts from energy development and consumption. Air pollution, for example, will be contained largely by using gas and hydro to generate power; the costs of these changes were taken into account in the power system planning described earlier. But fully realizing the government's environmental commitment will be difficult. Monitoring data are lacking. Environmental awareness is limited. Environmental standards are inappropriate. Institutional capacity is weak. And meeting ambitious environmental targets will be costly. 3.52 Although Vietnam revised its pollution standards and regulations in 1995, those for the energy sector are often inappropriate. Lead in gasoline remains unregulated, and Vietnam has the most lenient ambient air quality standards for lead in the region. Moreover, there are no plans to phase out lead-despite the fact that about one-third of monitored locations exceed permissible levels. - 89- 3.53 By contrast, some pollutants are too strictly regulated. For new power plants, Vietnam has some of the strictest sulfur oxide standards in the region. Analysis and experience suggest that the economic and environmental benefits of such strict standards fall far short of the costs and that, in any event, the standards are seldom enforceable. In Vietnam the incremental financing required to meet sulfur oxide standards over the next 10 years is $270 million under the base case scenario and up to $600 million under the high-growth scenario; most of this would be in the north. 3.54 To address such distortions, Vietnam's emission standards must be comprehensively reviewed and rationalized. Such a review might be undertaken with a view to designing a lead phaseout program for gasoline, realigning emission standards to reflect the costs and benefits of meeting those standards, and introducing procedures that are more sensitive to conditions in local airsheds. A first step to realigning emission standards would be to implement the draft guidelines for thermal power plants issued in 1996; these provide a modest improvement over current guidelines, which treat all industrial operations in the same way. Still, the draft guidelines do not respond well to specific location characteristics, and a more comprehensive approach to airshed management is needed. Airshed management procedures could follow those developed in recent World Bank guidelines, or they could follow procedures being piloted by other countries in the region (such as the Philippines). In either event, substantial institutional strengthening would be required. 3.55 Institutional fragility is apparent in the treatment of land use and water quality. Although functional responsibilities for oil spill contingency planning were restructured in late 1997, there is no capacity to deal effectively with oil spills. Similarly, there is considerable capacity to undertake environmental impact assessments of hydroelectric projects, but recommended mitigation measures are often not implemented. 3.56 These institutional weaknesses, along with financing requirements, may constrain energy development. Preliminary environmental impact assessments for the large Son La scheme (see chapter 2), for example, indicate that at least $100 million will be needed to meet minimal mitigation standards, and as much as $500 million will be needed to stabilize the entire watershed. To ensure that environmental targets do not hinder the development of crucial economic infrastructure, significant institutional strengthening efforts will be required over the next five years. Capacity for monitoring should increase, as should capacity for intersectoral and interagency cooperation and coordination. In addition, efforts should be made to deliver information that increases environmental awareness. Vietnam will need money-public and private-to achieve its energy and environmental goals. To that end, chapter 4 proposes a financing strategy. - 91 - 4. FINANCING ENERGY DEVELOPMENT 4.1 Vietnam needs a systematic framework to evaluate the scale, constraints, and options for financing its energy infrastructure-including environmental costs. This chapter discusses the scale of needed investments, the characteristics of energy finance, and the constraints and sources of energy finance. The suggested strategy provides a framework to guide policy and structural reforms, as well as specific modes of raising capital in the medium term. Estimating investment requirements 4.2 Between 1998 and 2002 Vietnam needs to invest 5.3-5.5 percent of GDP a year in energy infrastructure. Unless sufficient production, distribution, and supply infrastructure is in place, the energy demand resulting from historically high and expected GDP growth rates will not be met. Energy financing needs are driven by the demand projections described in chapters 1 and 2. By assessing existing constraints and available supply options and by using reasonable assumptions on how the sector will evolve, a baseline energy investment estimate has been defined (table 4.1). Given the limited supply options, investments in power generation and gas delivery can be made with some certainty. 4.3 During 1998-2002 about $6.9 billion will be needed for essential gas, power, and coal infrastructure-that is, investments for which there are no alternatives and that are too costly to forgo. An additional $3 billion will be needed for upstream oil exploration and field development and for petroleum product distribution. Investments in petroleum are not as crucial, but it is important to create an environment in which oil companies can continue exploration. Possible investments in an oil refinery and fertilizer complex are estimated at $1.2 billion but should be deferred given the crisis in East Asia and constrained finances in Vietnam. 4.4 Crucial investments include $0.9 billion for the gas sector, $3.8 billion for power generation, and $2.0 billion to expand the transmission network (see table 4.1). Although changes in demand would change the timing of specific investments, they would not significantly alter how these investments need to be financed or the reforms required to meet the financing challenge. In evaluating the scale of investments, two points stand out: * Demand for electricity will drive medium-term investment in energy infrastructure. Through 2010 the implied income elasticity of growth in electricity demand is 1.1-1.4, which is well within what has been experienced in other parts of Asia. From this perspective, the demand for energy is well in line with income growth. * The required share of energy investment in GDP is higher in Vietnam than elsewhere in East Asia. Investment in power infrastructure will account for 4-5 percent of GDP (of total investment of 5- 6 percent of GDP); the projected average for the region ranges between 2.2 and 3.1 percent of GDP. Although low-income countries tend to have a higher share than wealthier countries, financing Vietnam's energy infrastructure may place pressure on other capital expenditures. - 92 - Table 4.1 Energy financing requirements, 1998-2002 (millions of U.S. dollars) Financing sources Cash disbursements Finance Financing required Public Export credits Private Sector/project Size period through 2002 sector and ODA investment 1998 1999 2000 2001 2002 Gas Nam Con Son field development 3 BCMlyr. 1998-2002 375 375 25 180 140 30 Offshore gas pipeline 400 km 1998-2000 490 490 270 150 70 Subtotal gas 865 0 0 865 Power Yaly hydropower 720 MW 1994-2000 220 220 120 80 20 Ham Thuan Da Mi 472 MW 1996-2002 332 82 250 90 108 84 50 Song Hing 70 MW 1995-2000 84 84 50 26 8 DaiNinh 1997-2003 416 200 216 7 19 40 200 150 Sezan, Plei Krong, Dong Nai, Son La Misc. 2000-Ox 678 378 300 200 200 278 Hydro plants 1,730 964 766 0 BaRiaCCGT 156Mw 100 100 27 21 52 Phu-My l-1 CCGT 213 MW 1998-99 140 40 100 40 90 10 Ba Ria Diesel 120 MW 1999-2000 70 70 70 Phu-My 2-2 Gas Turbine 288 MW 1999-2000 120 120 40 80 Phu-My 1-2,1-3 CCGT 426 MW 1999-2001 280 80 200 100 140 40 Pha Lai 2 Thermal (2x300) 600 MW 1999-2001 600 600 70 150 210 170 Phu-My2-1 ConverttoCC 144MW 2000-01 94 94 10 40 44 Phu-My 2-2 Convert to CC 144 MW 2000-01 94 94 10 40 44 Phu-My 3 New 600 MW 2000-02 400 400 50 200 150 Quang Ninh Thermal 300 MW 2000-03 200 200 50 150 7hermal plants 2,098 214 1,100 684 Transmission and distribution, north 1998-2002 450 225 225 90 90 90 90 90 Transmission and distribution, south 1998-2002 500 250 250 100 100 100 100 100 Transmission and distribution, central 1998-2002 350 175 175 70 70 70 70 70 Rural electrification 1998-2002 700 350 350 140 140 140 140 140 Transmission and distribution 2,000 1,000 1,000 0 Subtotalpower 5,828 2,178 2,866 684 804 1,124 1,374 1,398 1,128 Coal Upgrading coal transport facilities 1999-2001 70 35 35 20 30 20 Investing in open cast mines 1999-2002 140 70 70 30 50 30 30 Subtotal coal 210 105 105 50 80 50 30 Total energy investments 6,903 2,283 2,971 1,549 829 1,624 1,744 1,548 1,158 Source: World Bank staff estimates. Energy finance offers challenges... 4.5 Energy infrastructure finance has a lot in common with general infrastructure finance; it is distinguished primarily by the nature of energy assets and the vertical links in power - 93 - and gas markets. Four distinguishing characteristics constrain financing flexibility but provide unique financing opportunities: the mismatch between assets and liabilities, exposure to exchange rate risks, vertical links in markets, and the potential for foreign direct investment. Assets and liabilities are mismatched 4.6 Energy infrastructure is a long-term capital asset. Most energy assets-power plants, dams, production platforms, oil and gas wells, transmission towers, distribution transformers-have economic lives of more than 20 years. From a balance sheet perspective, the asset usually lasts longer than the liability incurred to finance it. 4.7 This asset-liability mismatch can lead to liquidity problems if the debt liabilities secured do not have sufficiently long maturities to maintain positive cash flows. But having attractive long-term investments offers the ability to create long-term investment instruments, such as bonds and other commercial paper, for institutional investors that need long-term assets. Exchange rate exposure creates risk 4.8 Except for exported crude oil, gas, or petroleum products, all energy revenues are in domestic currency. Borrowing foreign currency exposes the borrower to exchange rate risks, which can affect sectoral finances and macroeconomic stability. East Asia's financial crisis was partly a consequence of large foreign currency borrowings by nonexporting sectors, including energy. Such exchange risks should be insured or hedged to minimize the cost of financing. 4.9 The simplest financial hedge is to ensure that end-user prices are linked to foreign exchange fluctuations. But this approach may not always be possible or desirable. Thus alternative exchange rate hedges (or backstops) are usually needed for long-term foreign currency borrowings: exchange rate swaps, government guarantees of foreign exchange availability and convertibility, automatic tariff adjustments, or some combination. The need for hedges, of course, increases in line with reliance on external financing. Energy markets are vertically linked 4.10 Energy markets exhibit a higher degree of vertical market interdependence than comparable economic activities because of the nontradable nature of the markets and the long lives and specificity of assets. These vertical links usually extend through the entire energy chain. For example, gas producers normally seek some long-term understanding (or link) with gas consumers in order to justify the required investments. Power producers, in turn, seek long-term offtake agreements with power purchasers to secure investment capital and hedge purchase commitments. 4.11 These vertical links usually take the form of long-term financial and physical contracts between suppliers and intermediate or final consumers, and are often central to making energy infrastructure investments "bankable." Eliminating market-making intermediaries in the energy chain-such as gas marketing companies or bulk power purchasers-can reduce the - 94 - performance risk associated with these intermediaries, but it does not eliminate market risk altogether. As a result some type of contract is generally used to transfer the link down the chain. Foreign direct investment can be considerable 4.12 Foreign direct investment in Vietnam is expected to be significant, rising from 65 percent of extemal finance in 1996 to 70 percent in 2000. Foreign direct equity investment in Asia's energy sector has had two features. First, investors often seek a contractual guarantee to provide a floor on equity risk. Most long-term contracts in the energy sector include a minimum equity return for satisfactory performance. Thus this is not pure risk capital. Second, investors tend to balance the use of foreign direct investment with larger amounts of debt than in other industrial sectors. For example, most build-operate-transfer (BOT) projects have no more than 30 percent of the total initial investment financed by foreign direct investment. The remainder is financed by external or domestic borrowing. ...And choices 4.13 The financing required for energy infrastructure can be raised both domestically and externally. The government will have to provide $2,283 million from its own fiscal sources and from surpluses retained by relevant state-owned enterprises (see table 4.1). Preliminary commitments by multilateral and bilateral donors indicate that official development assistance will contribute $2,971 million. Private sources will need to provide $1,549 million for gas development and thernal power projects that are considered suitable for private financing. Hydropower projects were not considered in the baseline case because there is very little experience with private investment in greenfield hydro projects in developing countries-owing to uncertain revenue streams and the multipurpose nature of many hydro facilities. 4.14 In countries with creditworthy energy corporations and strong domestic capital markets, internal sources can contribute significantly to infrastructure financing. There are typically four sources of domestic capital for energy infrastructure: * Reinvested cash flows from enterprise operations. Reinvested cash flows represent the post-tax surpluses generated by state energy enterprises. Today reinvested cash flows provide very little financing. But Vinacoal estimates that it could provide half of its future investment requirements if domestic coal prices were equal to export netback values, and Petrovietnam (through its holdings in Vietsovpetro) could cover a sizable portion of its investment needs. Self-financing in the power sector is less than 25 percent. Other East Asian countries that have experienced rapid economic growth typically have self-financing ratios above 40 percent. * Debt from domestic banks. Vietnam's banks are being reformed and have not completely emerged from liquidity crises and asset restructuring. As a result there is little or no access to long-term savings, and these institutions have no capacity to provide debt in the long maturities required for energy investments. - 95 - * Domestic capital markets. Capital markets in Vietnam are underdeveloped and play a minor role in the economy. * Direct government finance. Over the medium term, capital spending from government fiscal resources-including official development assistance-will total 6-7 percent of GDP. Nearly 41 percent of these resources would have to be channeled to crucial investments in energy infrastructure. 4.15 Sources of external finance for infrastructure include concessional official development assistance (both multilateral and bilateral), nonconcessional official development assistance (including export credits), external commercial debt, foreign bond finance, and equity (through portfolio or foreign direct investment). Before external nonconcessional sources are tapped, however, two points need to be considered. First, Vietnam is dealing with external debt management issues that require prudent oversight of all external debt-creating flows. Second, Vietnam's perceived risk, external debt, and uncreditworthy energy enterprises do not allow financing without government guarantees. 4.16 It is easy to prescribe general strategies for mobilizing financial resources. Describing the details is much more difficult. Table 4.2 uses four factors to evaluate the limits, merits, and drawbacks of the four potential financing sources described above: their availability, their effect on the government budget, their potential for creating debt flows, and their potential for creating public liabilities. Is financing available? 4.17 It is essential to distinguish between financing sources that will actually be available in the short and medium term and those that are merely of academic interest. As capital markets develop, more options and more sophisticated means of raising finance will develop. Over the next few years, however, projections must be realistic. Does it affect the government budget? 4.18 Many forms of domestic financing affect-directly or indirectly-the government budget. For example, the government could direct state-owned lenders to provide credit to state energy enterprises. Even if this preferred credit were not provided at terms below official market- clearing levels, it could result in the government indirectly underwriting the loans. Calculating the precise effect on the government budget may not be possible, but this effect should be considered. The prospective medium-term burden on the government budget is already large; minimizing additional negative effects is crucial. 4.19 During 1998-2002 fiscal revenues are expected to contribute 6-7 percent of GDP for capital spending. Official development assistance should provide an additional 3-4 percent of GDP. Assuming that about $1.5 billion can be secured from the private sector over the next five years, around 40 percent of fiscal resources and official development assistance earmarked for - 96 - capital spending would be needed for essential energy infrastructure. These volumes are large, and may prove unsustainable. The implications of infrastructure spending crowding out social spending are beyond the scope of this report, however. Does it create external debt? 4.20 Given Vietnam's sizable external debt, it is important to examine whether the energy financing strategy will contribute to the stock of external debt.' International Monetary Fund-World Bank debt tables define a debt-creatingflow as one that has an original or extended maturity of more than one year, is owed to nonresidents, and is repayable in foreign currency. This includes private nonguaranteed external debt that is not guaranteed for repayment by a public entity. 4.21 The IMF has conditionally limited the quantity and tenor of external debt that Vietnam can incur. These limits cover loans contracted or guaranteed by the nonfinancial public sector as well as private nonguaranteed external debt that is an external obligation of a private debtor. Private sector borrowing is usually not covered by IMF program limits, but it has been included for Vietnam so that external debt and foreign exchange demands can be prudently managed. 4.22 The debt limit is $2 billion a year in new, nonconcessional external borrowing contracted or guaranteed by the public sector. External debt is considered nonconcessional when less than 35 percent of its present value is in the form of grants; thus this limit would cover nearly every form of export credit financing and all commercial borrowing. Within this limit, external commercial borrowing is restricted to about $500 million a year. This limit covers all debt with a maturity of less than 12 years incurred on commercial terms, including new debt incurred by the government or State Bank, debt contracted by state commercial banks, and debt contracted by state enterprises with or without a government guarantee and in joint ventures with a government guarantee. These limits are indicative-meaning they will be reviewed and revised to reflect macroeconomic performance. Does it create a public liability? 4.23 The government's role in facilitating access to domestic and external capital determines whether a public liability is created. A public liability is created when the state owns the enterprise incurring the direct liability or when the state has to provide (explicit or implicit) guarantees or backstops for external liabilities incurred by energy entities. Private ownership does not ensure that a project is free of public liabilities-as evidenced in nearly all Asian countries, regardless of whether they have investment grade sovereign credit ratings. ' Vietnam is considered a severely indebted low-income country. This classification is based on two ratios: the present value of total debt to GNP and the present value of total debt service to exports. In 1996 these ratios were 96 percent and 300 percent, respectively. - 97 - Table 4. 2 Assessment of financing sources Type offinancing Is this financing available? Does it affect the government Dosit create external debt? Does it create a public budget? liability? Reinvested cash flows Yes, but it is limited and Yes, in a positive way No No represent the post-tax inadequate surpluses generated by state Reduces reliance on However, the fnancing gap energy enterprises In the power sector the self- budgetary contributions. from inadequate enterprise fnancing ratio is less than Increasing the amount of reinvestment will require 25%. Reinvested cash flows reinvested cash flows would increased domestic or foreign could contribute significantly require raising government- borrowing. Increased foreign to self-financing in the oil controlled tariffs. Since the borrowing will create an and gas sector, but reinvested cash flows are a external debt-creating flow. Petrovietnam returns all post- post-tax surplus, the tax operating surpluses to the contribution of these state and then receives capital enterprises would also allocations for new increase. investnents. Generally sourced from state- Yes, but it is limitedfrom both Yes, in a negative way No Probably owned commercial banks. public andprivate commercial banks The government directs credit Because the govermment is to the energy sector, often at directing credit to state The savings rate has concessional terms. This energy enterprises, it is increased, but investment necessitates concessional implicitly accepting the credit needs have increased faster. budget refinancing for state risk of those enterprises. Because most deposits are commercial banks. short term, limited funds are available for long-term investment. - 98 - Table 4.2 Assessment of financing sources (continued) Type offinancing Is thisfinancing available? Does it affect the government Does it create external debt? Does it create a public budget? liability? Multilateral debt (from IDA) Yes Yes, in a positive way Yes Yes IDA's contribution to Multilateral debt provides The government explicitly Vietnam is limited to $500- substantial resources that are guarantees all multilateral 600 million a year. Energy cheaper than alternative borrowing. infrastructure can account for sovereign commercial about 20% of the total (about borrowing. $100 million a year). Bilateral debt Yes Yes, in a positive way Yes Yes The OECF contributes about The government explicitly $300 million a year. Other guarantees all bilateral donors do not make large borrowing. capital contributions to the energy sector. :3~~~~~~~~~~~~~~~~~~~~~~~~~~~~ 4 IBRD and Asian Only ADB lending is Yes, in a positive way Yes res Development Bank loans available The World Bank classifies Vietnam as an IDA-only country. IBRD resources should be available in three to five years, providing a significant resource that can be used to leverage additional commercial resources. Export credits Yes Yes, in a positive way Yes Yes Export credits have been The underlying guarantee obtained in all energy provided by an export credit subsectors, and their use will agency usually lowers the likely increase. average cost of financing. - 99 - Table 4.2 Assessment of financing sources (continued) Type offinancing Is thisfinancing available? Does it affect the government Does it create external debt? Does it create a public budget? liability? To sovereign government or Yes, but the amounts are Maybe Yes Yes subsovereign energy entities uncertain Depends on Vietnam's ability Sovereign and subsovereign to service debt. Total debt borrowing (by energy entities should not exceed prudent such as Vinacoal) have been limits. limited. There are few benchmarks for commercial borrowing By privately owned project Yes, but no deals have been Yes, in a positive way Yes Yes finance entities completed Private borrowing does not Revenue and currency When the project fmance A number of transactions are affect the government convertibility guarantees to entity depends on payment being discussed or negotiated. budget-except when it the project company create a from a subsovereign energy substitutes for fiscal sources. predictable annual enterprise, an explicit or requirement for foreign implicit public liability is xchange_ incurred Sovereign bonds Yes Maybe Yes Yes Depends on external debt Depends on Vietnam's ability rescheduling and agreements to service debt. Sovereign with the IMF and World bond financing provides the Bank. closest benchmark of the marginal opportunity cost of public funds. ___ _ Corporate bonds No Yes, in a positive way Yes Yes The lack of financiat At least until majority transparency in energy ownership is transferred to enterprises and large extemnal the private sector. debt make corporate bond financing more difficult that direct commercial debt. -100- Table 4.2 Assessment of financing sources (continued) Type offinancing Is thisfinancing available? Does it affect the government Does it create external debt? Does it create a public budget? liability? Portfolio (public) equity No Yes, in a positive way No No Medium-term potential is good, but is currently constrained by a lack of formal stock markets. Institutional equity No Yes, in a positive way No No Medium-term potential is good, but is currently constrained by institutional weaknesses. In addition, there are no rules allowing government pension funds to invest in euis Portfolio investment No Yes, in a positive way No Yes Medium-term potential is strong, but there is no stock market and no policy to facilitate privatization of energy entities. Foreign direct investment Yes Yes, in a positive way Possibly Possibly Investments are available for If the government is expected joint venture and wholly to backstop capacity foreign-owned projects payments that cover a minimum equity return - 101 - 4.24 Selecting the optimal mix of financing requires comparing the present value of liabilities incurred under different financing scenarios. The prevailing practice of creating vertical links in energy production and delivery through physical and financial contracts often creates indirect and contingent liabilities that are not directly apparent in traditional accounting methods. This liability analysis is important for two reasons. First, long-term off-balance sheet liabilities have financial consequences that should not be ignored in the commercial transition being undertaken in state energy enterprises. Second, the government's exposure to contingent liabilities arising from guarantees requires careful monitoring, particularly in light of the financial crisis in East Asia. Using guarantees to secure funds 4.25 All external debt, whether incurred publicly or privately, creates an external debt obligation. The main question is not so much whether the government should provide guarantees, but whether the required financing can be attracted on reasonable terms with limited macroeconomic impact For two reasons, explicit government guarantees will play an important role in obtaining external finance at reasonable terms over the next few years: * Because Vietnam does not have a credit rating even as a sovereign borrower, debt incurred by private entities who depend on repayment revenue from state entities will require some government support or guarantee. In other countries these forms of support are typically required during the early stages of development, when experience with country and sector risks is limited. The demand for explicit government support also stems from any outstanding external debt issues. Guarantees will be needed to ensure the availability of foreign exchange to convert revenues received in domestic currency in the case of project finance. * The state entities responsible for power and gas offtake from private projects have no independent credit standing. Electricity of Vietnam, Petrovietnam, and Vinacoal are potentially profitable and creditworthy entities, but they do not have credibly audited financial statements and projections to allow foreign investors and lenders to reach this conclusion. This situation is exacerbated by the lack of financial autonomy for state energy enterprises. Thus the government would be expected to underwrite the credit obligations of these enterprises when export credits and commercial bank loans are sourced on a corporate finance basis (that is, when the enterprises borrow funds directly on their balance sheets) and when foreign-financed projects are undertaken on a project finance basis (as in the case of BOT schemes). 4.26 Macroeconomic reforms have improved the business environment in many International Development Association (IDA) countries. Private investors have shown a growing interest in these countries-especially in sectors undergoing reform. To ease the transition in reforming countries, IDA recently decided to offer partial risk guarantees (on a pilot basis) to private lenders against country risks that are beyond the control of investors and where official agencies and private actors offer insufficient insurance coverage. - 102- A strategy for energy financing 4.27 Unless the government starts making credible structural and policy changes, the risk perceptions that help detennine the cost and availability of finance will not improve. Strategies to secure the required financing will need to balance four considerations: minimizing the cost of financing, minimizing the direct public financial liability for investments, minimizing the external debt incurred, and diversifying sources of financing to reduce the risk of default. 4.28 Capital would best be raised by adopting reforms and developing strategies aimed at both raising capital in the short term and providing access to wider sources in the medium to long term. Efforts should be made to increase internal financing in energy companies, develop creditworthy energy corporations, develop domestic bond financing for infrastructure, access foreign and domestic equity markets, diversify forms of public ownership, access nonconcessional official development assistance, minimize government guarantees, and coordinate external borrowing. Increasing internalfinancing in energy companies 4.29 Despite the growing popularity of external commercial borrowing, project- financed independent power producers, and the like, in most countries the main source of finance for energy infrastructure is still internally generated cash. For example, investor-owned utilities ir. the United States fund more than 70 percent of new investments from retained earnings-and often much more. In Vietnam less than 25 percent of energy investment is financed from internally generated cash. Achieving higher rates of internal self-financing will require improving the net cash flow of energy enterprises. 4.30 Average electricity tariffs need to be raised to the long-run marginal cost of development and to provide self-financing of at least 30-40 percent. Where coal prices are prescribed they should be based on export netback values. Price caps on petroleum products should be lifted so that Petrolimex and other state enterprises can generate internal cash flows of 35-40 percent. Similarly, if Petrovietnam were able to retain its internal cash flows (mainly from oil exports), it would be able to cover investments over at least the next few years, giving it good prospects for creditworthiness. Thus Petrovietnam should be allowed to keep, say, 40 percent of estimated future investment requirements. The rest will be financed by debt. Developing creditworthy energy corporations 4.31 All efforts to secure sustainable financing rest on creditworthy corporations. Yet neither the Vietnamese government nor the country's main energy companies are creditworthy. The government is in the process of resolving its external indebtedness: an agreement has been reached with the London Club of commercial creditors, and negotiations are under way on obligations to the Russian Federation. - 103 - 4.32 State energy companies lack international creditworthiness partly because the government has imposed on them noncommercial obligations that conflict with commercial criteria. The government has also retained control over companies' reinvestment of internal cash flows. As a result energy companies do not have arm's-length commercial financial statements. Moreover, the government does not fully account for the fiscal and budgetary costs of its direct and indirect support to the sector. 4.33 Without creditworthy corporations, the cost of financing energy projects will remain extremely high and government support will always be needed. To make state energy companies creditworthy, the government must remove inconsistencies in policy and instill transparency in budget allocations and state enterprise transactions. Real progress can only be made if the government and the energy companies clarify their financial dealings and work to achieve international creditworthiness. 4.34 Several steps should be taken. Comprehensive, arm's-length, independent accounting audits should be completed for the three state energy corporations. Certified financial statements-with complete disclosure- should be prepared. And balance-sheet debt and equity should be restructured to ensure that future cash flows support the development of financially acceptable credit. Developing domestic bondfinancingfor infrastructure 4.35 Increased reliance on domestic capital markets is essential for the energy sector, where most revenues are in local currency. Bond financing offers a potentially attractive means to channel domestic savings into infrastructure finance. Bonds could be issued by subsovereign energy enterprises with explicit government guarantees, at least initially. 4.36 Among the first steps in developing a domestic bond market is identifying potential issuers. Given Vietnam's small private sector, the government should focus on bond issues by state energy companies. These companies have an assured long-term market and future growth potential, and so are ideal choices for starting an infrastructure bond market. Given the absence of pricing benchmarks for longer-term issues, early bonds would probably have short maturities (three to five years). With macroeconomic improvements, the market will become increasingly willing to purchase bonds with longer maturities. 4.37 Bonds for energy infrastructure will not provide large amounts of capital in the medium term. Given market conditions and the savings profile of investors, issues will most likely range from $20 million to $50 million. Though bonds may initially raise limited capital, developing a bond market will provide several benefits. It will establish benchmarks that enable more accurate pricing of future bond issues. It will deepen the primary and secondary market in nongovernment securities. It will facilitate more commercially oriented treasury operations by energy companies. And it will provide institutional and individual savers with a broader range of investment options. - 104- 4.38 Because short bond maturities will create an asset-liability mismatch, the government may need to create a facility to roll over the bonds when they come due. With improving government finances and a stable macroeconomic environrment, the bond rollovers will be easily accomplished. Accessingforeign and domestic equity markets 4.39 The state owns all the equity in energy enterprises, but the government has limited resources to increase their equity capitalization. Attracting foreign and domestic investors to buy equity in energy enterprises-through gradual divestiture-would provide access to long-term capital. With complementary refonns in tariffs, the energy enterprises would offer fairly stable long-term returns to domestic equity investors. Foreign equity investors may seek strategic investments in areas such as generation, distribution, and gas pipelines, which are easier to form as independent operations. 4.40 Since Vietnam has no secondary equity markets, the government may need to package the companies' equity so that it is attractive to investors. If the government commits to divestiture and provides a stable regulatory framework, the following equity-raising options are possible: * Convertible debenture issues with guaranteed returns for three years or so, with conversion to a full equity instrument at the end of the period. The equity option allows investors to decide whether buying equity in the enterprise would be worthwhile, and the initial three-year period gives the enterprise and government time to implement reforms. * An initial equity offering with a limited repurchase guarantee from the government. Making this guarantee conditional on meeting policy and regulatory targets would insure investors against arbitrary policies that reduce the long-term value of the investment, and would strengthen government commitment to change. * Private offering of equity to a foreign strategic investor using Bolivia's successful "capitalization" approach. Here the strategic investor would be required to make an upfront contribution to the equity capital of the enterprise and a commitment to invest a certain amount over a specified period. The government would be responsible for maintaining a favorable regulatory environment. 4.41 Divestiture and public or private equity offerings are best undertaken after the first phase of sector and corporate restructuring reforms-specifically, after accounting entities have been separated from large sectoral holding companies and incorporated as smaller entities. This move would allow meaningful portions of equity in these companies to be divested, making it much more attractive. Even if the state continues to hold a majority stake in the medium term, market attractiveness would increase if 30-40 percent of equity were offered to nonstate investors. - 105 - 4.42 Distribution companies and generation assets are the best candidates for equity sales. Distribution companies are attractive to both domestic and foreign investors, and can easily be divided into smaller but viable entities (such as city distribution networks or district franchises). Allowing equity investment in distribution would minimize the public portion of network investments. These savings could then be directed to other needs, such as rural electrification. 4.43 Many generation assets-including pipelines and thermal and hydropower plants-are entirely owned by the government. Selling a sizable share of equity in these assets is immediately viable. This approach was used, for example, to sell shares in Pakistan's Kot Addu power plant. Transferring ownership of an operating asset eliminates construction risk, allowing a higher sale value to be realized and raising significant capital for new investments. Diversifyingforms ofpublic ownership 4.44 Increasing the number of debt and equity stakeholders is central to expanding the flow of capital to the energy sector. Divestiture strategies and fresh equity offers increase stakeholder representation and facilitate the shift to commercial operations. Another way to increase the number of stakeholders is to transfer some of the state's equity in energy corporations to state commercial banks and government pension funds. 4.45 Doing so would serve two purposes. First, other state-owned stakeholders would be able to exercise control over these corporations. Adding new stakeholders could help create a more commercial external environment without undermining state ownership. Second, having more stakeholders would help in the restructuring of state financial institutions. Future financial flows from energy corporations can be stable and predictable, and would be useful in developing a portfolio of income-producing assets on the balance sheets of Vietnam's financial institutions. This strategy would not raise additional capital, but it would increase the commercial prospects of these enterprises. Accessing nonconcessional official development assistance 4.46 Gaining access to alternative forms of nonconcessional official development assistance marks an important transition in multilateral financing. "Graduating" from IDA to IBRD borrowing status depends, of course, on factors external to the energy sector. But with continued macroeconomic stabilization, Vietnam could achieve IBRD borrowing status within two to three years. 4.47 An IBRD-IDA blend program offers new options for energy financing. Standard IBRD loans could be extended to subsovereign energy entities, and in some cases could be used as equity contributions in joint ventures with private entities. In addition, IBRD partial credit guarantees can be used to extend maturities of commercial finance-enabling additional debt to be leveraged at acceptable terms. IBRD partial risk guarantees would also be available. - 106- Box 4 Partial Risk Guarantees for IDA only countries Country EhigWlityt IDA only Countries - those countries that are eligible for concessionaf lending from IDA, excluding countries that also receive loans from rIBID. Project Eligibility The guarantee would be available where an IBRD Enclave guarntee is not available. It is expected that such guarantees would be provided primarily in Infratructure - power water, transport, & telecommunications - projec. The project must also comply with all applicable Bank requirements including those relating to the environment, social soundness, and resettlement. 7:vpe ofGuarantee Partial Risk Guarntee Guarantee Amount The Guarantee could cover up to 100% of the principal and interest of a private debt tranche. The amouit of private debt guaranteed by the Bank should be minimum required to complete the financing package. Risk Coverage Risk Coverage would be limited to specific sovereign risks such as: (a) the risk of the government not %lfillig its contractual paymnent obligations, including payment obligatiorts of state- owned entities; and (b) traditional countr risks such as foreign currency convertibility, war and civil disturbance, and -.exprpriaion. Thescope of risk coverage under the guarantee would be minimum required to mobilize financing for the project. Counter Guarantee from the IDA will obtain a counter-guarantee from the host Government. Government Guarantee Fee IDA would charge the projec cotmpany a minimum Guarantee Fee of 75 basis points, (bp) per annum. Gut of the Guarantee Fee, IDA would retain 75 basis points, which is the same as the service charge on IDA credits. Any fee in excess of 75 bp per annum would accrue to te govermnent provided that there have not been any calls on the guarantee*. During periods when the guarantee is not callble, a Comrmitment Fee-of 25 bp per annum will be Charged. This would normally apply only to the committed but undisbursed amount of the guaranteed debt. IDA's commitment charge is curently set at zero; therefore the proceeds would be passed on to the government after the guarantee expires without being dalled. Processing Costs For all guarantees to private sector borrowers, the sponsors or project company would be required to pay a one-time Initiation Fee of I 5 basis points and in addition reimburse the Bank costs incurred by the Bank in the course of drafting and negotiation of the guarantee agreements, and review of project documentation. The level of reimbursement shall be determined by the Bank on a case-by-case basis. in line with commercial practice, and shall be due upon notification by the Bank before guarantee effectiveness. ProjzetStructure Requirements Financial arrangements such as a special escrow account for debt service may be required to help provide a cushion against the possibility of a guarantee being called. - 107 - Minimizing government guarantees 4.48 The demand for government credit and performance guarantees will partly depend on the market structure in the energy sector. Giving private entities direct access to end consumers passes on some of the risks that would otherwise be borne by state enterprises. Two strategies would help reduce guarantee requirements. 4.49 First, allowing direct contracts between producers and consumers would minimize the need for government guarantees of state enterprise performance. Similarly, providing producers and owners of the gas pipeline with preferential future access rights would give them some upside potential for their investment and so minimize revenue guarantees. This move would have to be balanced with considerations of access by third parties and of the effect on long-term natural gas development. 4.50 Second, if the government guaranteed the capacity charge for independent power producer projects, bearing the fuel cost and fuel risk, it could minimize the revenue guarantees required by private independent power producers. This strategy may be particularly useful given that the industry structure has a single gas trader. Coordinating external borrowing 4.51 The government knows that it needs to access external capital for energy investments. But it lacks an effective coordination process to assess overall financing needs, decide which investments will be financed externally or privately, streamline approval for transactions that incur external financing liabilities, and provide guarantees to optimize financing terms. Given the scarcity of official development assistance and soft loans from multilateral finance institutions, it is essential to conduct a critical review of how such funds will be used when foreign direct investment is unavailable (such as for large, multipurpose hydro projects). The mix of official development assistance and guarantees should aim to maximize their leverage in mobilizing additional private resources. All these concerns underscore the need to immediately implement an effective coordination mechanism for external borrowing. Continuing reforms 4.52 The government of Vietnam must recognize that financing energy needs over the next 10 years will require innovative solutions and fundamental reforms. The economic cost of not meeting prospective energy demand is far greater than the marginal cost of private financing. 4.53 State energy enterprises must disclose their accounts so that their balance sheets can be restructured for commercial financing. Raising electricity tariffs would enable power utilities to expand using their own resources. By the same token, increasing public subsidies to energy companies would only prolong the needed transition from an unsustainable to a viable financing strategy. - 108 - 4.54 External borrowing limits are intended to limit risks of inflation, fiscal deficits, and unsustainable debt. But these limits also limit flexibility in energy financing. A transparent approach to external borrowing-endorsed by the IMF-is required to ensure that growth is not choked by the same leash that limits macroeconomic imprudence. 4.55 Unless the next phase of structural reforms is adopted soon, rapid growth cannot be taken for granted. Important reforms for energy infrastructure finance include equitizing assets to bring in risk capital and recapitalizing banks with long-term energy infrastructure assets. Major institutional changes will also be essential to mobilize foreign direct investment and make existing investments more efficient. Securing money is one thing. Spending it wisely is quite another. To do both, Vietnam needs to strengthen its energy institutions, giving them more of a market footing-the subject of chapter 5. - 109 - 5. REFORMING ENERGY INSTITUTIONS 5.1 Vietnam began reforming the institutions that own, manage, regulate, and supervise the energy sector more than four years ago. Yet institutional tinkering is still under way. The government knows that effective institutions are essential to an efficient, financeable, consumer-focused energy sector. The pace at which such institutions are developed will define the pace at which Vietnam can increase access to modem energy. Thus rapid institutional reform in the energy sector will be central to achieving economic objectives. 5.2 Four areas of reform are crucial: improving corporate governance, developing market structure, and strengthening regulatory oversight and sector governance, with a focus on formulating and coordinating policies. To achieve those goals, a commercial environment must be established for energy corporations, allowing competition where it can improve performance and increasing the number of players in the market. Nonpoliticized entities should regulate the energy sector, particularly in planning investment, approving tariffs, and improving service. Laws should be changed to facilitate institutional change, giving stability to new institutional processes and mechanisms-and providing judicial credibility to ensure that laws are obeyed. And government energy policy should set clear objectives and expectations, streamline approval processes, and define a sector strategy built on broad consensus. 5.3 Institutional reform has few short-term economic costs-mostly, it requires entrenched bureaucracies to give up controls and become more accountable. But reform has immense immediate and long-term benefits. A transparent institutional framework makes it easier to address social concerns, such as maintaining acceptable prices for vulnerable consumers and expanding energy access. Institutional reform also allows hidden economic costs to be recognized and efficient long-term decisions to be made. The resulting improvements in energy infrastructure stimulate industrial and agricultural growth, and increase resources for rural electrification. 5.4 Institutional reform requires properly sequenced progress on all fronts, from corporate governance to legal, regulatory, and policy issues. The prevailing political economy in Vietnam suggests that institutional reform should focus on corporate governance of state energy enterprises. Improving corporate governance 5.5 The term corporate governance is commonly used to denote the relationship between the owners and the managers of an enterprise. More specifically, it concerns how owners who are not directly in touch with their business ensure that the appointed managers maximize the value and use of the assets entrusted to them. In Vietnam corporate governance refers to how the government manages state-owned energy enterprises. Effective enterprise governance is often a reliable benchmark of whether institutional arrangements are adequate. -110- 5.6 Corporate governance consolidates all aspects of the internal and external incentives that are central to institutional change. Corporate governance is influenced by or an outcome of government financial policy toward enterprises, the market structure of the industry, the relevant legislation and sector regulation, the sophistication of the financial sector, and explicit or implicit government policy. 5.7 In Vietnam there are three main reasons to reform corporate governance. First, energy operations are almost entirely state-owned, so traditional modes of corporate control are the main source of institutional deficiency. Despite the new State Enterprise Law and other corporate reforms, government ministries have not markedly changed their behavior toward state enterprises. 5.8 Second, the legacy of central planning has left the economy with multiple market constraints that make immediate and large-scale ownership change difficult. These constraints include limited or absent capital markets, limited labor mobility because housing and other benefits are linked to employment, and a rudimentary legislative framework for a market economy. Immediate changes in corporate governance are essential to increase efficiency under majority government ownership, while reforms to remedy the market constraints should proceed in parallel. 5.9 Third, arm's-length economic regulation-an essential institutional component of a commercially focused energy sector-is indistinguishable from the government's role as owner. Corporate governance reforms clarify regulatory roles and responsibilities for the government. Recent efforts are a start 5.10 Vietnam took the first step toward corporate governance reform in early 1995, when it established state energy enterprises as state corporations. 'This transformation was part of broader reforms to consolidate economic activities and businesses under a single state management unit. The intent was to obtain economies of scale and scope in production, distribution, finance, and administrative and human resources. Eighteen state corporations were formed during this phase of enterprise reform; the three energy corporations are among the largest: Vietnam Oil and Gas Corporation, or Petrovietnam; Electricity of Vietnam; and Vietnam National Coal Corporation, or Vinacoal. 5.11 The transformation to state corporations established three key elements of corporate governance: Energy corporations were brought under the legal purview of the Law on State Enterprise and the Law on Government Organization. This allowed corporatization within a state-owned system by creating separate legal entities, independent from line ministries and distinct from In Vietnamese legal statutes a state corporation comprises multiple state enterprises or member units. In effect, a state corporation is a state holding company. - I11 - government agencies. Although the earlier corporate forms for energy enterprises resembled independent legal entities, they were actually government agencies engaged in revenue- producing activities. The decrees that established the energy corporations provide guidance on how the State Enterprise Law is to be interpreted for each entity. * Government policy explicitly separated state management functions from the corporations and their management. These functions were assigned to higher-level ministries and government agencies. (Although there is no clear definition of state management, it refers to supervision and authority over state enterprises by line ministries, government agencies, and commissions.) . The boards of management of these corporations were given the right-and the responsibility-to perform ownership functions on behalf of the state. The state allocated property and funds to the boards to conduct the activities assigned to them. 5.12 Corporate governance was expected to provide several institutional and financial benefits (table 5.1). Separating state management functions from business management functions would make enterprises less subject to the direct control of line ministries. Consolidating related activities under a single entity would achieve economies of scale and scope-particularly in the use of (scarce) experienced managers. And creating large, creditworthy entities would lower the cost of capital and reduce reliance on the state budget. 5.13 To date, however, these benefits have not been realized (see table 5.1). Because "state management" is poorly defined, functions have not been unambiguously assigned and procedures have not been clarified. The Ministry of Finance's recently created State Asset Management Department is just beginning its task, and it appears that criteria for assessing state operations remain simply and overly focused on physical growth targets. Boards of management have been established, but their accountability to the owner (that is, the state) has not been clearly enunciated. - 112- Table 5.1 Expected benefits and actual results of corporate governance reforms ! xpectWd bne^ Actulre&l -T..; ,, . '.. ....... ................ .. ........................................................... ...................................I............................................ ................. ..... .... . .t^ .. Eliminate direct line ministry control of energy (+-) Although energy operations have been established as operations corporations, line ministries continue to play a key role in investment, staffing, and operating decisions Create a single point of contact for government (+) Boards of management have provided a single point of interaction with management contact for all supervising ministries Clearly separate state management functions from (-) State management functions are not clearly defined or business management functions assigned, and procedures are unclear Achieve economies of scale and scope by consolidating related activities in a sector to: * Lower operating costs and improve (-) There is no evidence that costs have fallen or performance performance has improved because of structural consolidation Leverage skills of (scarce) experienced (±) The skills of a small number of experienced managers managers and experts have been leveraged to the benefit of the energy sector-but this move has reduced the autonomy of middle management Limit uneconomic behavior of enterprise (+) Uneconomic behavior by separate units is largely under managers control Achieve greater financial leverage to: .................................................I................................................................ ........ ...............................................................................I............................. ............................................................ L Lower the direct costs of financing (that is, the (-) Financing costs have not fallen cost of capital) ...................................................................................I.............................. . ......................................................................................... .......................................................................... Reduce reliance on the state budget (-) Budgetary and sovereign support are still necessary Pool risks, and so lower financial risks and (+I-) Financial risks may be lower, but they have not hence financing costs produce any financing advantages What more needs to be done? 5.14 The most pressing corporate governance problem lies in the charters of state energy corporations. Because the charters do not clearly define the ownership function, boards of management cannot act as value-maximizing owners. Thus there is a need to designate a single institution to act as a value-maximizing owner. Similarly, there is a need for a mechanism that limits the authority of supervising ministries, the prime minister, and other government agencies over the designated owner. Consensus on the institutional approach should be reached at the level of the National Assembly, accompanied by a legal statute to ensure stability-for example, a decree defining financial benchmarks and obligations of enterprises. 5.15 Designate the owner. The State Asset Management Department appears to be the lead agency responsible for asset ownership within state enterprises. This role needs to be made official and reasonably autonomous so that the department can objectively fulfill its responsibilities. A decree from the prime minister or a similar statute would limit any ambiguity in the department's role. 5.16 Make financial obligations explicit. To maximize asset value and ensure that economic decisions are made, state enterprises should be subjected to explicit, legally defined - 113- financial obligations. Separate obligations could be considered for energy enterprises within the context of overall economic regulation (see the section on regulation, below). The imperative here is to institute or mimic a commercial owner-manager relationship. 5.17 Instilling such discipline is perhaps the most difficult aspect of institutional reform in the energy sector. It requires the state, acting as owner, to acknowledge the social opportunity cost of the funds used by energy corporations. Doing so is essential for two reasons. First, it provides an objective basis for signifying the social cost of using government funds in any investment activity, whether infrastructure or social. Second, because the state underwrites all financial claims against state corporations, it must ensure that resources are well utilized and adequate returns are being generated. If not, the government's financial vulnerability will increase. 5.18 Corporations often lack incentives to reduce costs by rationalizing operations and making cost-effective purchases and sales. Management boards of energy corporations, for example, are allowed to spend predefined amounts for various items. Allowable costs are based on historic costs. Because the board cannot retain any savings if actual costs are below the allowable amounts, they have no reason to seek out savings. 5.19 Making corporations responsible for explicitly defined financial obligations would require: X Defining financial standards-based on commercial principles-for the management of state assets in the energy corporations, and for their monitoring by the Ministry of Finance. The Ministry of Finance monitors the profitability and finances of state energy corporations, but its standards are below reasonable commercial benchmarks, and the standards tend to be overridden by other financing and pricing factors. * Establishing accounting systems and internal corporate transfer prices the provide incentives to cut costs. One way to strengthen incentives would be for the government to encourage the buildup of cash for corporate expansion and investment. For example, the government should return a portion of Petrovietnam's oil and gas profits for investments and employee benefits. . Reassessing energy prices and tariffs, specifically with regard to subsidies. Energy corporations have become conduits for subsidies targeted to specific enterprises and consumer groups. The government should not stop using state corporations to deliver targeted subsidies-because the corporations are often efficient delivery mechanisms-but its approach should be part of the overall policy for energy prices and tariffs. Four considerations make this move crucial. Without a clear accounting framework to determine the cost of these subsidies, policymakers do not know their economic costs. Targeted subsidies intended as short-term support often become entrenched. Cross-subsidies undermine commercial discipline and cost-reducing behavior. And subsidies distort prices and lead to a suboptimal allocation of resources. - 114- Ensuring the production and availability of independently audited financial statements for all the energy corporations, including Electricity of Vietnam, Vinacoal, and Petrovietnam.2 Balance sheets should show realistic values for assets and profitability because they will be used by outsiders to measure performance and judge creditworthiness. 5.20 Streamline approval of planning and investment. The current planning process requires energy corporations and their supervisory line ministries to develop five-year plans. These plans are incorporated into the five-year indicative plan produced by the Ministry of Planning and Investment. This plan is then subject to the approval of the Office of Government and Office of the Prime Minister. 5.21 Within the framework of the five-year plans, one-year plans are submitted first to the respective ministry.3 The ministries then submit the plans to the Ministry of Finance and Ministry of Planning and Investment. The one-year plans are used to budget state funds to state enterprises, for their major investments, and to monitor and control foreign exchange. The Ministry of Finance focuses on companies' debt and their investment requirements. The main criterion for approval is whether a company is meeting its target growth rate. Finally, the one- year plans are authorized by the National Assembly through the Office of the Prime Minister. 5.22 In effect, the government directs the sector and implements policy by controlling each state corporation's investment budget. Thus the government guides energy sector development through project approvals and project funding. In addition to undermining the accountability of management decisions, this process creates a one-dimensional, hierarchical structure of responsibilities based on investment size. ' Bureaucratic authority is based solely on the size of the investment, and does not offer clear articulation of economic, financial, and performance criteria to benchmark investments. Adequate government oversight of investment planning and approval is essential. But it is equally essential to foster systemwide incentives by streamlining the process. 5.23 Investment planning should be based strictly on a financial and economic appraisal that recognizes the economic opportunity cost of funds. This analysis could incorporate social benefits and costs and assess distributive impacts. An objective decisionmaking framework would lead to economically and socially rational decisions. An investment appraisal handbook should be prepared to guide project evaluation at all levels in all sectors. This 2 The Ministry of Finance has promulgated accounting standards, formats, and business accounting policies; these were to have been fully implemented by January 1996. 3 Electricity of Vietnam and Vinacoal submit their plans to the Ministry of Industry, Petrolimex to the Ministry of Trade, and Petrovietnam to the Office of the Prime Minister. 4 Investment projects are classified into group A, group B, and group C projects. Group A projects costing more than 400 billion dong (about $1.5 million) require approval by the prime minister, based on reviews by the Ministry of Planning and Investment and the recommendation of the line ministry. Group B projects have costs between 30 and 400 billion dong and can be approved by the line ministry, with consent from the Ministry of Planning and Investment. Group C projects cost less than 30 billion dong and can be approved by the management board of the state corporation. - 115- handbook would specify the analytic methodology, financial and economic discount rates, inflation indexes, exchange rates, shadow prices for inputs and outputs, relevant social factors, and so on. 5.24 If this framework is implemented well, the investment approval process could eliminate hierarchical responsibilities based on investment size. Supervision would be based on whether a project met the objective criteria established by the state. Decisionmaking would likely become quicker and more efficient. As noted, the economic cost of subsidies and distortionary effects of cross-subsidies should be presented to policymakers to guide decisionmaking. Developing market structure 5.25 Market structure refers to how competitive (or potentially competitive) a sector is and to the organization of the entities operating within it (for example, whether they are vertically or horizontally integrated). There are four key objectives in examining market structure: 3 Determining how, where, and when the private sector can participate and under what terms and conditions. - Determining how state companies can divest some of their operations or restructure to attract financing. 3 Ensuring the creation of effective competition. 3 Determining the need for economic or technical regulation to curb any monopoly problems or other technical problems (such as for safety and environmental protection). Petrovietnam requires restructuring 5.26 Upstream petroleum activities are competitive, with many contenders for petroleum rights and exploration and development of oil and gas (figure 5.1). Economic regulation is effected through the issue of petroleum rights. Technical regulation is also required, for safety and environmental protection. - 116- Figure 5.1 The current gas industry is a mix of public and private actors Industry Structure: Gas Offshore Production: Private Sector and PVN-JV Pipeline P Pipeline Cons rtium PVN 38% Processing: PVN/privateJV Consumption: Power (EVN/IPP) Fertilizer (private) Gas Distribution Center: PVGC Consumption Power Industries 5.27 The state has designated Petrovietnam as its sole agent to conduct petroleum operations and enter into contracts with international oil and gas companies. Departments of Petrovietnam have also been designated to act as regulators (see chapter 2). As the hydrocarbon sector grows, it will be essential to separate nonoperational functions from Petrovietnam and more clearly delineate the company's role. A level playing field is essential for sustained exploration and development by international oil companies in Vietnamese territory. 5.28 Petrovietnam has also been made the monopoly gas trader. While this is an important function during the market creation phase of the gas industry, it must be seen as part of a transition to a mature market stage, which would include upstream and downstream competition. 5.29 The decree forming Petrovietnam envisages it as a fully operational holding company. Yet its internal cash flows are passed to government, and it operates on budgets reassigned from the state. Petrovietnam's corporate shell is a good first step, but there is a long way to go before the company becomes creditworthy and commercially oriented. It is essential that Petrovietnam publish its balance sheet (independently audited in accordance with international accounting principles) and financial projections in the medium term, and that a management audit and reorganization study be carried out as operations expand. 5.30 Petrovietnam has a number of independent accounting units that should be developed as stand-alone enterprises. Once the Nam Con Son gas project is under way, for example, PVGC should be restructured into an independent commercial company focused on its core business. The role of PVGC management would shift from operations to corporate strategy - 117- and finance, devolving the latter roles from Petrovietnam. Any links to Petrovietnam would primarily be for guidance on strategy, long-term planning. and annual targets. PVGC would then position itself to raise foreign financing-based on its balance sheet-for major investments. In due course it could operate mainly through joint ventures, to attract both financing and technical know-how. Electricity of Vietnam should eventually be subject to competition 5.31 Electricity of Vietnam was established as a state corporation in January 1995, consolidating all power entities engaged in generation, transmission, distribution, and associated services. The corporation is similar to a state holding company, with member entities grouped under two accounting systems: independent accounting units and dependent accounting units. From a market structure perspective, the core functions of generation and transmission are integrated and under direct management of Electricity of Vietnam headquarters (figure 5.2). This core unit sells electricity in bulk to five independent distribution companies. Figure 5.2 Electricity of Vietnam oversees generation, transmission, and distribution Generation Business Unit (12 Power Plants) Transmission Business Unit (NLDC & 4 Transmission Cos) iBTPI BTP2 BTP3 BTP4 BTP5 Hanoi Power HCM City Power Power Distribution Company Distribution Company Company Company No. 1 Company No. 2 No. 3 Consumers BTP : Bulk Transfer Price 5.32 The reform plan envisages Electricity of Vietnam as the sole or key buyer of power generation over the short and medium term. Competition will be encouraged in upstream generation, with a 20 percent target for private generation over the medium term. Transmission - 118- will remain the responsibility of Electricity of Vietnam but will be regulated by an independent agency. Electricity of Vietnam's distribution functions will gradually be equitized through diversified ownership of assets. Transmission and distribution should be separated as profit centers, balance sheets should be independently audited, and an electricity law should be passed creating a level playing field for public and private participation. Vinacoal 's operations should be rationalized 5.33 All facets of the coal industry were consolidated in one organization when Vinacoal was formed in late 1994. The company is authorized to make investments, enter into joint ventures, and use and control land and other resources provided by the state for coal mining. Vinacoal has developed several companies and activities totally unelated to its core business. These could be made into autonomous enterprises, and through equitization they could eventually be privatized by sale to domestic or foreign investors. Doing so would raise funds for Vinacoal investments and would place the companies in a competitive environment where they can focus on their core business. Strengthening regulation 5.34 Government regulation of the energy sector has three main aims: e Ensuring that consumers receive reliable energy supply and service at a reasonable price. - Supporting long-term investment in energy assets by ensuring a reasonable return on invested capital, and protecting investors and firms from arbitrary government action. * Promoting allocative and productive efficiency in the energy sector, both in the long-term use of natural resources and in the short-term use of physical assets. 5.35 Regulatory oversight facilitates economic decisionmaking by energy enterprises and consumers. For this reason, regulators need to be insulated from short-term, noneconomic objectives that influence other government entities. This task-creating a regulatory agency that can operate credibly with a degree of independence-is one of the key challenges of institutional reform. Regulatory reforms should be coordinated with corporate governance reforms to ensure that there is no overlap between the ownership function and the regulatory function. 5.36 Today the energy sector is overregulated, with pervasive government controls in all areas of enterprise operations. This problem has been recognized, however, and legislation is being drafted and implemented to define the regulatory function and allow for the formation and operation of regulatory bodies. Still, none of the new legislation is functional. - 119- Upstream oil and gas regulation has made little progress 5.37 The Petroleum Law, which covers the upstream oil and gas industry, was passed in 1993. It was followed by an implementation decree in December 1996. Yet none of the institutions called for in the law has been established except Petrovietnam and the Office of Government. Legislation and regulations for midstream (main transmission pipelines) and downstream oil and gas activities have not been drafted. 5.38 The most pressing need is to separate oil and gas rights management and technical regulation from commercial petroleum operations. Petrovietnam is currently responsible for all these functions. The Petroleum Law provides for the formation of an agency-the State Petroleum Management Authority-to handle rights management. Separating this function from Petrovietnarn is essential to minimize conflicts of interest, particularly if Petrovietnam starts to compete with international oil companies in exploration activities (see chapter 2). The government should organize an upstream agency to manage rights and implement technical regulation-as envisaged in the Petroleum Law-and to interact with international oil companies, especially during contract bidding and negotiations. This agency should be established as a separate legal entity, independent of Petrovietnam, and should report directly to the Ministry of Planning and Investment or the Office of Government. Downstream oil and gas lacks a legal basis for regulation 5.39 There is no legal basis for regulation of gas pipelines or gas processing and distribution. Given the rapid development of the gas industry, such a legal basis should be put in place and be made compatible with what is put in place for regulation of electricity. Downstream regulatory tasks include approving tariffs for pipeline use, preventing anticompetitive behavior, implementing technical standards for pipelines, and other tasks that are very different from upstream regulation. Thus downstream regulation should be carried out by an agency separate from the upstream regulatory agency. Incentives are neededfor foreign investment in coal 5.40 Despite government efforts, foreign investors have shown little interest in the mineral sector. Enabling legislation began with the 1987 Foreign Investment Law and the 1989 Ordinance on Mineral Resources. Both tried to open the sector, but impediments to foreign acquisition of land and land tenure remained. The 1993 Land Law tried to remove the remaining impediments, but it too fell short. 5.41 Several issues need to be addressed. Foreign investors should be given full rights to land tenure so that land can be used as collateral for investment loans. Points need to be clarified on issues ranging from exploration investment to exploitation rights. Limits should be lifted on operating control by the investor, including the obligation to enter into a joint venture with government agencies or private parties. Taxes should be adjusted on profits, royalties, retained earnings, and withholdings. And the restriction on repatriation of earnings should be removed. -120- Electricity regulation has made progress 5.42 In mid-1996 the government began drafting an Electricity Law and supporting regulations. The draft law defines regulatory functions, functions of other government agencies, principles to guide the formation of a regulatory agency, procedures and requirements for licensing sector operations by function (generation, transmission, bulk supply, distribution, retail supply), rights and obligations of licensed operators, and principles for setting and approving tariffs. Detailed implementing regulations are being drafted in parallel. 5.43 The law is expected to be passed in 2000. To supplement the law, secondary legislation will need to be drafted covering the scope and structure of the regulatory agency, procedures for setting and regulating tariffs, and administrative regulations and standards. This body of legislation would then provide a consistent legal basis for sector regulation. The regulatory body for electricity and gas should be combined 5.44 Combining downstream gas and electricity regulation has benefits and drawbacks. On balance, however, there appear to be advantages for Vietnam in combining these tasks in one regulatory body. Doing so would exploit economies of scale and scope in terms of leveraging staff skills. It would also facilitate economic regulation-including administering tariff adjustments, overseeing monopolies in gas and power transmission, and approving investments in gas and power distribution. Having one regulator for both industries would reduce the risk of the regulator developing a close relationship with one industry, and would minimize the risk of economic distortions by maximizing the regulator's understanding of the economic links between the two industries. Finally, combining these regulatory functions would minimize the formation of new government agencies. 5.45 Establishing regulatory institutions that operate with reasonable independence will be a significant institutional challenge in Vietnam. As a general rule, regulatory agencies should not be involved in formulating energy policy. Rather, they should limit their responsibility to regulatory policies, principles, and procedures. This leads to the one of the absolute imperatives for institutional reform-effective energy policy and strategy formulation. Formulating policies and strategies 5.46 As noted, state companies develop their own five-year policy plans; these are incorporated into the five-year indicative plan produced by the Ministry of Planning and Investment, which is subject to approval by the Office of Government and Office of the Prime Minister. State companies also produce one-year plans that the Ministry of Finance and Ministry of Planning and Investment use to budget investment funds, and to monitor and control foreign exchange. Thus the government is directly guiding the development process through project approvals and project funding. 5.47 As the market economy evolves and private sector participation increases, the emphasis should shift from direct government control to indirect control, through policy - 121 - instruments. That is, energy policy for the medium and long term should go beyond specific projects, focusing on published "policy directions" for each part of the energy sector. 5.48 The government should create a permanent energy policy comrnittee-the National Energy Policy Committee-chaired by the prime minister and supported by an energy policy office. The committee should include the ministers of planning and investment, industry, finance, and trade, the managing directors of Petrovietnam, Electricity of Vietnam, and Vinacoal, and commissioners from the State Pricing Committee. Once they are established, regulatory authorities should also be represented at committee meetings. The committee would oversee efforts to build institutional capacity for the energy sector, developing laws and regulations, crafting export and import strategies, and advising on energy pricing. The energy policy office would consolidate activities now spread over a number of agencies, providing the committee with the analysis required for policymaking. The committee's first task would be to articulate a comprehensive energy policy-one that is consistent across all the energy subsectors. Chapters 1-5 have set ambitious-but achievable-targets for Vietnam's energy sector. What should the government do to achieve the goals for energy and its links to the economy, the environment, financing, and institutions? An agenda for action is the subject of chapter 6. - 123 - 6. AN AGENDA FOR ACTION 6.1 As noted, in recent years Vietnam has achieved unprecedented economic growth while maintaining a remarkably stable macroeconomic balance. But growth is now slbwing because of the financial crisis in East Asia and the slow pace of structural and policy reforms. 6.2 The energy sector can provide a foundation for future growth, but Vietnam faces four major challenges in making the transition to a modem, industrialized society. Energy supplies will need to grow about 30 percent faster than GDP to meet economic growth targets. Ample energy resources will need to be developed along an environmentally sustainable and socially equitable path. Energy tariffs and resource mobilization-both public and private-will need to increase to ease financial constraints in the sector. And sector and corporate governance will need to change to promote sustainability and efficiency. 6.3 As the preceding chapters have outlined, the costs of inaction on energy are simply too high. Thus the Vietnamese government needs to implement a wide range of energy reforms. The agenda for action in the short and medium term should include several essential steps. Creating an economic and efficient modern energy delivery system to meet growing demand by: * Increasing the efficiency of energy use and controlling electricity growth through demand- side management. * Removing transmission and distribution bottlenecks as new generation capacity-both public and private-is added and system losses are reduced. * Completing competitively bid projects like Phu My 2.2 to provide a framework for other energy infrastructure projects in power, coal, and gas. * Concluding contract negotiations and developing by 2002 gas supply infrastructure from the Nam Con Son basin. Delays could cause $140-200 million a year in direct financial costs and much larger economic losses. * Promoting exploration in Vietnam's hydrocarbon basins through appropriate fiscal incentives and systems. * Opening up the distribution of downstream petroleum products in markets that are large and diverse enough to support several competitive suppliers. * Making the coal industry more efficient to meet expected domestic demand and maintain exports. . Extending modem energy use in rural areas by implementing a financially sustainable program for rural electrification-with effective institutional capacity for delivering services and operating and maintaining systems-and developing a program to provide electricity in remote areas, to complement grid extension work. Ensuring that energy expansion is environmentally sustainable by: * Emphasizing the developing of gas and hydro for power generation, to contain air pollution. * Strengthening pollution monitoring systems. * Increasing environmental awareness. * Revising inappropriate environmental standards. * Phasing out lead in gasoline. - 124 - Developing afinancing strategy for energy that includes: * Mobilizing domestic financial resources through early action on tariffs for electricity, coal and petroleum prices. Pricing recommendations are summarized in table 6. 1. * Raising electricity tariffs closer to their long-run marginal cost in the shortest possible period so that power companies can meet financial performance benchmarks. * Coordinating an external borrowing strategy for energy and prudently incurring external contingent liabilities for private investment. * Deferring direct public investment or government support for private investment in economically marginal projects (such as fertilizer production and petroleum refining). Table 6.1 Recommendations for energy prices Sector Recommendation Retail electricity Average retail tariffs should be raised to the estimated long-run marginal cost of 8.0 cents per kilowatt-hour, and to a level that provides for at least 30 percent equity funding of needed investments. To achieve these levels, the government should consider changing the size of residential tariff steps and increasing tariffs in the upper steps. The industry tariff should be revised to include capacity charges. Bulk electricity Bulk tariffs should be rationalized, to encourage efficiency in distribution companies. Natural gas Natural gas prices should be based on a negotiated initial price and indexed to the price of fuel oil, possibly with an indexed ceiling and floor. The price level must balance supply costs and market value, benefits to private and public market participants, interests of upstream and downstream government agencies, and short-term and long-term interests of Vietnam and the private sector. Using gas to produce fertilizer is considered a less than optimal use of gas, but if the government wants to cross-subsidize fertilizer production the gas price should be set at least as high as the estimated social supply cost of gas (that is, supply costs without taxes and royalties). Gas transmission A two-part tariff should be negotiated that reflects fixed and variable costs (capacity and commodity charges) and provides for a reasonable return on pipeline investment. The tariff should include incentives for increasing throughput volumes, with benefits being shared between shippers and pipeline owners. New shippers should be given fair access to the pipeline. Petroleum products Taxes on diesel and kerosene should be raised to levels closer to taxes on gasoline. Prices should be freed and competition should be opened, subject to a survey of existing and potential competition, and when retail prices are raised to levels similar to those in neighboring countries. Coal Export netback values should be used to determine coal prices for Electricity of Vietnam. - 125 - Improving corporate governance and creating creditworthy institutions by: . Redefining the government's role as owner. If state energy corporations are to become commercially viable operations, the government will have to use financial performance benchmarks in place of administrative project approvals, public budgets, and directed credit. * Implementing arm's-length regulation to facilitate fair and transparent oversight of energy investment and pricing, insulating energy corporations from arbitrary government demands, and attracting private investment on reasonable terms. Achieving these goals will require promulgating an electricity law and regulations and gas regulations, and bolstering the State Petroleum Management Authority. * Embarking on pilot equitization programs, perhaps starting with high-density urban electricity distribution franchises. This effort could then expand to private equity involvement in gas distribution. Rationalizing sector governance by: * Enunciating government intentions through specific energy policies. The government has already issued a policy paper for the power sector that includes a detailed reform action plan. A natural gas policy statement identifying the intended market structure would provide a framework for increased gas exploration and development. - Forming a national energy policy committee-supported by a national energy policy office- to coordinate activities in oil, gas, coal, and power. Carefully defining the government's continuing-and crucial-role in the energy sector. VIETNAM FUELING VIETNAM'S DEVELOPMENT- -S zNEW CHALLENGES FOR 2I Hn 1i~ 51\ Tia,G,', ____________ 23 TMiB,nh 53 B__ FU~~ELING VIETNAM'S DEVELOPMENT- \ / a /g<3 t;> >9 '_ ~~~~~3NEW CHALLENGES FOR X r-'2' ) JXtt <, ~~~~THE ENERGY SECTOR -220 kv POWR LINES \ di < ~ 14POWER. 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